Nearly ten years after SEC Rule 22c-2 went into effect, the SEC is still focused on frequent trading that negatively impacts long-term investors. While the mutual fund environment has changed significantly, and both asset management firms and distributors have worked together to comply with this regulation, I believe the intent of 22c-2 – to increase intermediary transparency and reduce the effects of market timing on long-term investors – remains as relevant as ever.
Background on SEC Rule 22c-2
With the goal of reducing the dilutive effects of short-term trading and market timing activities on long-term investors, SEC Rule 22c-2 requires:
- Fund boards impose redemption fees of up to 2%, or determine one is not necessary
- Redemption fees must be paid to the fund itself
- Funds have written agreements with its financial intermediaries that require the provision of shareholder-level transaction details
22c-2 Trade Monitoring from 2007-2010
Rule 22c-2 was passed in the wake of market timing events that led many asset managers to be conservative with their trade monitoring activities, setting relatively low dollar thresholds for review and closely monitoring all their major distributors. During the first three years of the rule, this conservative approach produced a significant number of potential violations that had no material impact on mutual funds.
As funds started realizing resources were being used to investigate potential violations with no demonstrable reduction in risk, we began seeing dollar thresholds raised and a focus shift to high-risk distributors. High-risk distributors are generally firms which focus more on moving trades, rather than coding their trading system to conform to each fund’s prospectus rule. In contrast, low-risk distributors typically code their systems to align with the fund prospectus, and actively monitor frequent trading.
In the early years of 22c-2, on the intermediary side, much of the data required for trade monitoring came from the NSCC or the intermediary in a standard data request format (SDR). Specific to 22c-2 data needs, these records contained only 150 bytes of basic trade data, and were restricted in their use. This basic trade data was strictly used for monitoring frequent trading.
Trade Monitoring Today
One of the effects of 22c-2 has been the reduction in the number of funds that impose redemption fees, down to 10% of eligible funds. Hedge funds, once a favored vehicle for short-term trading, have given way to ETFs, which are not covered by Rule 22c-2.
Nevertheless, trade monitoring is still a requirement of the SEC, and asset managers who eliminated redemption fees took a good look at their 22c-2 monitoring process to insure that an effective means of deterring frequent trading was in place.
There have also been changes in the data we receive from intermediaries. We now receive approximately 70% of our data in daily sales activity (DSA) files, which offer 1,632 bytes of underlying shareholder data, and are not restricted in their use, provided the asset manager and distributor have an agreement that the data can be used by the asset manager’s service providers. In 2007, Boston Financial monitored frequent trading for 19 full service clients. Today, Boston Financial services 40 clients; analyzing over 74 million subaccount transactions, and investigating more than 67 thousand potential trading violations on an annual basis.
Trade Monitoring in the Next Ten Years
Is 22c-2 trade monitoring still relevant? Absolutely. And, given the SEC’s continued goal of achieving trade transparency, there is potential for 22c-2 monitoring to expand in scope. For example:
- Distribution-in-guise guidance, released by the SEC in January 2016, offered fund boards detailed indicators of potential violations of the 12b-1 rules, which prohibit the use of fund resources to pay for distribution services outside of the 12b-1 parameters. Asset managers and their service providers can help fund boards use the information contained in the DSA and monthly position files provided by distributors who hold subaccounting records to validate subaccount service fees and rights of accumulation.
- As part of proposed liquidity risk management reforms for both mutual funds and ETFs, the SEC has rekindled the idea of using “swing pricing” during periods of market volatility to deter excessive trading by passing on the costs stemming from spikes in purchase or redemption activity to the shareholders associated with that activity. This initiative reaffirms the SEC’s focus on excessive trading.
As part of its mandatory review of 22c-2, the SEC invites comments from the public on whether the rules should be continued without change, or should be amended or rescinded to minimize any significant economic impact of the rules upon a substantial number of such small entities. This comment period will close Thursday, October 20, 2016. I look forward to reading the text of the full review, and learning how it might be adapted to meet the changing demands of the regulatory environment.