New Rule Likely to Reduce Mutual Fund Fixed Income Cross Trades

DEC 08, 2020 | PRACTUS LLP

New Rule Likely to Reduce Mutual Fund Fixed Income Cross Trades

Authored by Karen A. Aspinall

What Should You Be Doing Now With the Valuation Rule? 

On December 3, 2020, the SEC issued its final mutual fund valuation rule (the “ Valuation Rule”).1  The Valuation Rule has been on the SEC’s rulemaking agenda for some time and was anticipated to be released prior to year-end. 

What we didn’t expect are some of the collateral consequences of the Valuation Rule as adopted, and the related SEC guidance therein, that are likely to severely limit fixed income cross trades under Rule 17a-7 under the Investment Company Act of 1940, as amended (the “Cross Trade Rule”). 

What is the Relevant Background

For those who follow the SEC’s rulemaking agenda, you know that revisions to the Cross Trade Rule is listed as a current rulemaking priority and the SEC staff has been actively engaging with market participants on this topic.  Howeverwhile we have yet to see a proposal to amend the Cross Trade Rule, the Valuation Rule defines certain concepts that directly impact the application of the Cross Trade Rule.   

Let me explain.  At the heart of the Valuation Rule is the requirement that funds value their investments using the market value when market quotations are readily available.  If market value is not readily available, then the investment must be fair valued.  Under the Valuation Rule, the SEC adopted a new definition to determine when market quotations are readily available.”  

To be considered readily available, a market quotation would need to be a “quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable.”2  This definition tracks U.S. GAAP requirements for the classification of Level 1 securities.* 

The SEC goes on to say in the Release that a security will only be considered to have readily available market quotations if its value is determined solely by reference to Level 1 inputs (emphasis added).  Moreover, the SEC expressly states that security valuations that are based on Level 2 inputs are not consistent with the definition of readily available market quotations.3   

* Under financial reporting rules for mutual funds, there are three levels to the valuation hierarchy:  

□ Level 1: observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets  

□ Level 2: inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or indirectly 

□ Level 3: unobservable inputs (e.g., a reporting entity’s or other entity’s own data) 

 What Does this Have to Do with Cross Trades?

Under the Cross Trade Rule, the first requirement is that the “transaction is a purchase or sale, for no consideration other than cash payment against prompt delivery of a security for which market quotations are readily available” (emphasis added).4  The SEC specifically notes in the Release that the definition of readily available market quotations in the Valuation Rule applies in all contexts under the Investment Company Act, including the Cross Trade Rule.5 

If an asset that is valued using Level 1 inputs is the only type of asset that can meet the definition of one for which there is readily available market quotation, this will severely limit a fund’s ability to engage in cross trades of many fixed income instruments (and any other security that is not valued based on Level 1 inputs).  This is because most fixed income instruments are valued by pricing vendors using “evaluated prices.”  Evaluated prices are typically based on various inputs, such as TRACE and MSRB data, broker quotes, matrix pricing or other valuation models.  Under the GAAP hierarchy, evaluated prices generally fall under Level 2.  

In the new Valuation Rule, the SEC specifically rejected the notion that securities valued with Level 2 inputs could be consistent with the definition of securities for which there are “readily available market quotations and will require such assets to be fair valued under the Valuation Rule.6  

Therefore, any instruments (not just fixed income instruments) that are valued using any method other than Level 1 inputs will need to be re-evaluated for eligibility for cross trading under the Cross Trade Rule.  The Release also notes that the SEC staff is re-examining certain no-action letters that enable cross-trades in certain instruments for which Level 1 inputs are not available to determine whether those letters should be withdrawn in whole or in part.7   

What Should You DNow? 

The SEC acknowledges that the new definitions under the Valuation Rule will have an impact on current fund practices, stating that “to the extent that market participants are currently engaged in practices that are not consistent with [the readily available market quotations] definition, they will need to conform their practices, including those related to cross trades.8  Accordingly, if your firm actively engages in cross trades of assets that are priced based on Level 2 inputs, you should: 

  • Review your firm’s history of cross trades and the pricing sources that apply to those assets.  If any of the assets are priced based on any inputs other than a Level 1 pricing input, consider whether there are alternative pricing methods for the asset that would result in Level 1 categorization. 
  • If that is not possible, you should actively evaluate whether these instruments are appropriate for cross trades. 
  • You should also evaluate your policies and procedures and other aspects of your compliance program to determine whether any amendments are necessary, including amendments to your testing program. 
  • You should alert your investment personnel of this change in requirements.  Cross trades provide the opportunity to reduce client transaction costs, including bid-ask spreads.   Traders may want to re-evaluate their trading practices based on this guidance. 
  • You should review you cross trade training materials to determine if any updates are required.   
  • Finally, some firms may seek to adopt a bifurcated approach to cross trading by having one policy for their funds and another policy for clients who are not subject to the Cross Trade Rule (e.g., separate account clients).  Given the SEC’s views on pricing and concerns of subsidization when crossing assets with more subjective values, you should consider whether this practice would be appropriate in light of this guidance.   If you do proceed with such an approach, you will want to make sure that your disclosures are very clear on how you are applying your cross trade policies and any associated risks. 

Practus has a number of attorneys who are well versed and very experienced in cross trade issues.  We’d be happy to discuss this with you and assist in reviewing your practices and policies.  

About the Author

Karen A. Aspinall is a Financial Services Partner at Practus LLP.  She brings a wealth of experience and a solutions-oriented approach to our legal team as an authority on regulatory compliance matters involving SEC, DOL, NFA and CFTC matters.  Karen’s practical experience and pragmatic approach to problem solving are valuable for clients who are looking to navigate the complex and ever-changing regulatory landscape.

Article Footnotes

  1. Good Faith Determinations of Fair Value, Investment Company Act Rel. No. IC-34128, available at (the “Release”). 
  2. Rule 2a-5(c). 
  3. Release at 89.
  4. Rule 17a-7(a). 
  5. Release at 93. 
  6. The SEC states in the Release that “evaluated prices are not readily available market quotations as they are not based upon unadjusted quoted prices from active markets for identical investments.”  Release at 89. 
  7. See, e.g., United Municipal Bond Fund, SEC Staff No-Action Letter (Jan. 27, 1995) and Federated Municipal Funds, SEC Staff No-Action Letter (Nov. 20, 2006). 
  8. Release at 93-94.
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Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.

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