On March 11, 2021, the staff of the SEC’s Division of Investment Management issued a statement addressing cross trading among affiliated registered funds and soliciting feedback in this area.  The staff issued the statement in response to public feedback on the SEC’s recent adoption of the “Valuation Rule,” which will create challenges to cross trading fixed income securities between funds and their affiliates, due to questions of whether these securities would continue to qualify as “having readily available market quotations.”

Under Rule 17a-7 under the Investment Company Act of 1940 (the “1940 Act”), securities transactions may be effected between a fund and certain affiliates (i.e., cross trades), subject to the conditions of the rule.  Among other conditions, Rule 17a-7 generally requires that cross trades: (a) involve a security for which market quotations are readily available; and (b) be effected at the independent current market price of the security.  In December 2020, the SEC adopted Rule 2a-5 under the 1940 Act (the “Valuation Rule”), which addresses valuation practices and the role of fund boards with respect to the fair value of the fund investments.  The Valuation Rule includes a definition of the term “readily available market quotations” that raises implications for fund cross-trading practices under Rule 17a-7, as the SEC has long stated that the phrase “for which market quotations are readily available” has the same meaning in the context of both Rule 17a-7 and the valuation provisions under the 1940 Act.

Notably, the definition of readily available market quotations is consistent with the standard for U.S. GAAP Level 1 valuations; however, most fixed income securities are valued using Level 2 inputs.  As a result, absent additional SEC or staff action, many fixed income securities will no longer qualify as having readily available market quotations under the definition of that term in the Valuation Rule and, therefore, will no longer qualify for the exemptive relief allowing cross trades under Rule 17a-7.

In adopting the Valuation Rule, the SEC noted that, whenever it defines a term, to the extent market participants currently engage in practices that are not consistent with that definition, they will need to conform their practices.  However, the SEC also noted that consideration of potential amendments to Rule 17a-7 is also on its rulemaking agenda.  Recognizing the potential magnitude of the effect of the Valuation Rule on fixed income cross trading, the staff issued the statement to seek feedback from market participants with respect to overall cross-trading practices, pricing and valuation of securities used in cross trades, controls governing cross trades, and market transparency.

Commissioner Elad Roisman issued his own statement in which he commended the staff for seeking comment in this manner.  Roisman has been outspoken about the importance of attention paid to, and matters affecting, the fixed income markets, including speeches at the 2020 and 2019 U.S. Treasury Market Conferences and addressing matters raised via FIMSAC (the SEC’s Fixed Income Market Structure Advisory Committee).

The staff’s efforts to address this issue are a welcome development, as (according to the statement) funds that invest primarily in fixed income instruments have expanded from around $800 billion in assets to over $4.5 trillion in the last two decades.  Although some progress has been made with respect to price discovery and electronic trading of fixed income securities, it is unlikely that sufficient progress would be made prior to the Valuation Rule’s September 8, 2022 compliance date to allow fixed income cross trading to continue as usual.  While there is no guarantee, the staff’s statement may serve as a prelude to staff- or Commission-level guidance or relief prior to the Valuation Rule’s compliance date.

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