SEC’s Division of Investment Management Issues Recommendations for Funds and Fund Advisers in Light of Reduced Market-Making Capacity in Fixed Income Markets

by Dechert LLP

The Division of Investment Management (“Division”) of the U.S. Securities and Exchange Commission (“SEC”) recently published guidance (“Guidance”) addressing steps that funds and fund advisers should consider in light of changes in the markets for fixed income securities.The Guidance explains that recent fixed income market volatility and fund outflows – which the Guidance attributes to potential Federal Reserve Board policy changes and rising interest rates – are occurring in the context of a different environment as compared to previous periods of rising interest rates. Specifically, the Guidance observes that market-making capacity in the fixed income markets has declined as a result of reduced broker-dealer inventories relative to fund assets, reduced broker-dealer proprietary trading activity and increased regulatory capital requirements applicable to broker-dealer holding companies. As the Guidance explains, “[a] significant reduction in dealer market-making capacity has the potential to decrease liquidity and increase volatility in the fixed income markets.”

To manage these potential risks, the Division suggests that funds and fund advisers:

    • assess and stress test fund liquidity needs;

    • conduct additional stress testing and scenario analyses assessing factors beyond liquidity;

    • evaluate fund risk management strategies in response to changing fixed income market conditions;

    • consider what should be communicated to fund boards in light of changing fixed income market conditions; and

    • assess the adequacy of shareholder disclosures.

This DechertOnPoint summarizes and expands on the Guidance’s explanations for reduced market-making capacity in fixed income markets and the SEC Staff’s recommendations for funds and fund advisers.

Declining Market-Making Capacity in Fixed Income Markets

According to the Guidance, current primary dealer capacity (i.e., ability to intermediate or “make a market”) is roughly in line with the level of primary dealer capacity in 2001, while fixed income mutual fund and exchange-traded fund assets have quadrupled over the same time period. Moreover, relative to market size, primary dealer corporate bond inventories are at an all-time low.2 The Guidance notes that attendant reductions in market-making capacity “may be a persistent change,” as regulatory capital requirements increase at the holding company level and broker-dealer proprietary trading activity declines. Although the Division specifically noted increased bank capital requirements as a reason for this change, there is evidence that other regulatory developments, including the adoption of the Volcker Rule, also may impact market-making going forward.3

Regulatory Capital Requirements and Broker-Dealer Market-Making

The Guidance acknowledges that “increased regulatory capital requirements at the holding company level” may be contributing to reduced market-making capacity in the fixed income markets. To expand on the Guidance’s brief mention of regulatory capital requirements,4 we note that the vast majority of market making activity in the United States undertaken by broker-dealers owned by, or affiliated with, banking institutions.5 Moreover, these banks and bank holding companies are subject to certain risk-based capital requirements, and these capital requirements are expressed as ratios, with qualifying capital divided by weighted risk assets.

Capital Ratio


Qualifying Capital

Weighted Risk Assets

Capital requirements state that such ratios must be maintained at certain levels. Thus, increases in weighted risk assets result in greater requirements for qualifying capital. Two recent regulatory changes had just that effect. In August 2012, banking regulators adopted a final rule (“Market Risk Final Rule”) that, among other things, included regulations concerning a new incremental risk charge (“IRC”) and stressed value-at-risk (“Stressed VaR”) measure, each of which implicates the activities of bank holding companies’ affiliated broker-dealers.6

The IRC requirement involves an obligation placed on banking entities to calculate the so-called “incremental risk” associated with portfolios of debt positions.7 In general, the riskier a portfolio of debt positions, the larger the institution’s IRC. The IRC is a factor adding to a banking entity’s weighted risk assets – that is, with riskier debt positions, a banking entity’s IRC will be larger, and thus the amount of qualifying capital the banking entity must hold in order to satisfy its capital requirements will increase. As such, one effect of the IRC requirement is to discourage banking entities – and, thus, their affiliated broker-dealers – from holding debt positions that would increase the capital that the banking entity must hold.

The effect of the recently-adopted Stressed VaR measure is similar. In addition to general VaR-based measures that banking entities are required to calculate (and which factor into a banking entity’s capital ratio denominator), banking entities are now required to calculate a Stressed VaR measure, which also factors into the capital ratio denominator. Under the Stressed VaR measure, a banking entity’s model must include historical data from a continuous 12-month period that reflects a period of significant financial stress to the banking entity’s portfolio.8 The impact of the Stressed VaR measure on a banking entity’s weighted risk assets is expected to be substantial; indeed, in adopting the Market Risk Final Rule, regulators noted that they “generally expect that a [banking entity’s] Stressed VaR-based measure will be substantially greater than its VaR-based measure."9

The Volcker Rule and Broker-Dealer Market-Making

Although the Guidance does not specifically identify it as an issue, the recent adoption of the Volcker Rule may contribute to declines in market-making activity going forward. The Volcker Rule regulations, proposed in November 2011 and adopted in December 2013, seek to limit bank and bank affiliate proprietary trading operations, among other things.10 The regulations incorporate exceptions for certain activities to which the trading restrictions do not apply, including market-making activities of banks’ affiliated broker-dealers.11

After the Volcker Rule regulations were proposed, market participants expressed concern that market makers would be forced to limit their market-making activities, and press accounts noted the apparent effects of the proposal on such activities.12 In adopting the Volcker Rule, regulators acknowledged that the additional costs associated with compliance with the market-making exception “may have an impact on banking entities’ willingness to engage in market making-related activities."13 Regulators also acknowledged the likelihood of associated liquidity reductions and “increased trading costs, higher costs of capital, and greater market volatility."14

Although they expressed hope that “over time, non-banking entities may provide much of the liquidity that is lost by restrictions on banking entities’ trading activities,” the regulators recognized that “a market-making operation requires certain infrastructure and capital, which will impact the ability of non-banking entities to enter the market-making business or to increase their presence. Therefore, should banking entities retreat from making markets, there could be a transition period with reduced liquidity . . . ."15 Thus, as the Guidance notes, regulatory changes reducing broker-dealer proprietary trading activity will continue to impact market-making capacity in fixed income markets.

Risk Management and Disclosure in Light of Fixed Income Market Conditions

The Guidance warns that reductions in market-making capacity in fixed income markets resulting from the regulatory changes discussed above may be a “persistent change” and that this “has the potential to decrease liquidity and increase volatility in the fixed income markets.” The Guidance suggests a number of steps that funds and fund advisers should consider in response to these circumstances:

    • Assess and Stress Test Fund Liquidity Needs. Section 22(e) of the 1940 Act requires funds to pay shareholders for securities tendered for redemption within seven days of tender. Consistent with this requirement, fund advisers generally assess a fund’s liquidity as well as the fund’s ability to meet potential redemption requests. The Guidance indicates that fund advisers may wish to conduct assessments and stress test fund liquidity during both normal and stressed environments, and such assessments and tests may include needs and sources of fund liquidity over various periods of time (e.g., 1 day, 5 days, 30 days or longer).
    • Conduct Additional Stress Tests and Scenario Analyses Assessing Factors Beyond Liquidity. The Guidance suggests that fund advisers may want to consider factors beyond liquidity, including, among others, interest rate hikes, widening spreads, price shocks to fixed income products, increased volatility and reduced liquidity.
    • Evaluate Fund Risk Management Strategies. The Guidance notes that fund advisers may want to evaluate risk management strategies based on changing fixed income market conditions and whether actions should be taken with respect to a fund’s portfolio composition, concentrations, diversification and liquidity.
    • Consider What Should Be Communicated to Fund Boards. The Guidance states that, in order to ensure that fund boards are fully informed, advisers may wish to consider what information should be provided in order to inform boards of fund risk exposures and liquidity positions, as well as regarding the fund’s ability to manage through changing interest rate conditions and increased fixed income market volatility. For example, fund advisers may wish to review fund policies and procedures, such as liquidity determination procedures, and provide a report to the board regarding whether any changes are necessary in light of the developments discussed in the Guidance.
    • Assess the Adequacy of Shareholder Disclosures. The Guidance suggests that funds should consider assessing shareholder disclosures to ensure that they encompass risks due to the potential impact of the Federal Reserve Board “tapering” its quantitative easing program as well as rising interest rates, including the potential for periods of volatility and increased redemptions. The Guidance states that, to the extent a fund determines that its risk disclosures are not sufficient, the fund should consider the appropriate manner of communicating risks to shareholders, such as through additional disclosures in the prospectus and/or shareholder reports.

The Guidance provides a timely discussion of fixed income market conditions and a starting point for the actions that fund advisers and funds should consider as a result. Fund advisers and funds should assess the impact of Federal Reserve Board policy changes, the Volcker Rule and potentially rising interest rates in the context of reduced liquidity and the increased volatility resulting from diminished broker-dealer market-making capacity. Fund advisers and funds should also consider the steps noted in the Guidance as well as other actions that may be appropriate or useful in addressing the risks and challenges of today’s fixed income markets.


1.) IM Guidance Update: Risk Management in Changing Fixed Income Market Conditions (January 2014), available here (PDF). In 2013, the Division began posting IM Guidance Updates, which summarize the SEC Staff’s views regarding various requirements of the Investment Company Act of 1940 (“1940 Act”). These Guidance Updates are not subject to Commission approval and do not have the force of a rule or regulation.

2.) The Guidance notes that dealer inventory size serves as a proxy for market-making capacity. See Guidance at 3 and n.4.

3.) The Guidance also notes that fewer proprietary trading desks at broker-dealers may contribute to a reduction in market-making capacity. See Guidance at 4.

4.) For the Guidance’s discussion of bank and bank holding company regulatory capital requirements, see Guidance at 4 and n.9.

5.) Oliver Wyman, The Volcker Rule Restrictions on Proprietary Trading: Implications for Market Liquidity, Feb. 2012 (“Wyman Study”) at 10 and n.11 (“The dominant market makers in the [U.S.] corporate bond market are owned by or affiliated with banks: with the conversion of Goldman Sachs and Morgan Stanley to Bank Holding Companies in 2008, 17 of the 21 [U.S.] primary government securities dealers are now owned by or affiliated with banks. . . .  While these dealers have no formal role in the [U.S.] corporate debt market, in practice these 21 dealers (given their scale and creditworthiness) are the primary ‘market making’ counterparties for all [U.S.] debt markets.”).

6.) Risk-Based Capital Guidelines: Market Risk, 77 Fed. Reg. 53,060 (Aug. 30, 2012). Both the IRC provisions and the Stressed VaR measure concern the “covered positions” of a banking entity, which are related to trading activities including: underwriting or dealing in securities; trading in foreign exchange rate, commodity, equity, and credit derivative contracts; and trading in other financial instruments and assets for resale.

7.) Under the Market Risk Final Rule, a banking entity’s incremental risk model must account for default risk and credit migration risk. Id. at 53,088. A number of additional factors, such as the risk attributable to holding less liquid fixed income positions, also impact the IRC. See id. at 53,088-89, 53,105-106.

8.) Id. at 53,072.

9.) Id.

10.) See Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 76 Fed. Reg. 68,846 (Nov. 7, 2011); Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Covered Funds, 77 Fed. Reg. 8,332 (Feb. 14, 2012) (setting forth the Commodity Futures Trading Commission’s (“CFTC”) proposal for the common Volcker Rule rulemaking); Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5,536 (Jan. 31, 2014) (“Volcker Rule Adopting Release”); see also Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5,808 (Jan. 31, 2014) (setting forth the CFTC’s companion release to the Volcker Rule Adopting Release).

11.) See Volcker Rule Adopting Release. For purposes of the Volcker Rule, “proprietary trading” means “engaging as principal for the trading account of [a] banking entity in any purchase or sale of one or more financial instruments.” Id. at 5,545-46. The Volcker Rule Adopting Release specifically notes that “trading account” includes dealer trading accounts. Id. at 5,548.  Moreover, “[t]he dominant market makers in the [U.S.] corporate bond market are owned by or affiliated with banks . . . . As such, they are subject to [the] Volcker Rule restrictions on proprietary trading.” Wyman Study at 10.

12.) See, e.g., Wyman Study; Ben Eisen, Volcker Rule May Be Exacerbating Bond Selloff, MarketWatch (June 24, 2013), available here.

13.) Volcker Rule Adopting Release at 5,584.

14.) Id.

15.) Id. Indeed, the Volcker Rule Adopting Release noted that “the investment that banking entities have made in infrastructure for trading and compliance would take smaller or new firms years and billions of dollars to replicate.” Id. at 5,580 (citing the Wyman Study).


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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