Why a Valuation Rule Restricted Bond Trading
Rule 17a-7 provides an exemption from restrictions on transactions between registered funds and certain affiliates, provided specified conditions are met. Such transactions can allow one fund to sell a security directly to another fund managed within the same organization, avoiding the need for both to trade separately through the market.
Historically, the exemption supported transactions involving equities and fixed-income instruments. The 2020 valuation framework complicated its application to bonds because the cross-trading rule relied on market quotations that were not readily available for many fixed-income securities under the newer valuation standards.
This created a difference between the ability to value a bond for portfolio accounting purposes and the ability to establish a qualifying price for an affiliated cross trade. A security might have a defensible fair value without satisfying the specific conditions required for an exempt internal transaction.
The proposed amendments would recognize developments in fixed-income pricing and allow a wider range of securities to qualify, subject to safeguards. For asset managers overseeing multiple portfolios, this could restore a method of transferring investment exposures without generating two separate external trades.
Where the Trading Cost Savings Come From
Consider an asset manager whose investment-grade bond fund needs to reduce exposure to a corporate issuer while another fund within the group wants to increase its position. Without a permissible cross trade, the selling fund may need to execute with a dealer and the buying fund may separately purchase the same security.
Both transactions can incur bid-ask spread costs, market impact and execution expenses. A properly priced cross trade can potentially reduce those costs by matching the opposing investment interests internally.
The economics are especially relevant to fixed income because many corporate and structured bonds trade less frequently than major listed equities. Transaction costs may depend on dealer inventory, trade size, liquidity conditions and the availability of competing quotes.
However, eliminating an external dealer does not automatically establish that the transaction benefits both funds. A price advantageous to the selling fund may be unfavorable to the buyer, and vice versa. Internal trading therefore replaces part of the external execution process with a greater responsibility for independent pricing controls.
Pricing Is the Main Investor-Protection Challenge
The SEC’s history of cross-trading enforcement illustrates the danger. In an earlier case covered by FinanceFeeds, Macquarie agreed to pay $79.8 million after the regulator found valuation misconduct involving mortgage-backed securities and cross trades that favored certain advisory accounts over retail mutual funds.
The SEC found that valuations derived from institutional-sized transactions had been applied to smaller, less liquid positions. Those valuations did not necessarily represent executable prices for the securities being transferred.
That case illustrates why a pricing service alone cannot eliminate conflicts of interest. A quoted or modeled price may be independently produced without accurately reflecting the liquidity, size or characteristics of the actual transaction.
Under an expanded exemption, asset managers would need to demonstrate that pricing methodologies are appropriate for the securities involved and that neither participating fund is disadvantaged. The SEC’s proposed modernization of oversight conditions is therefore as important as the expansion of eligible instruments.
New Reporting Could Reveal How Widely Cross Trading Is Used
The SEC also proposes aggregated reporting of trading activity and cross trades by registered funds engaging in the practice. That information could provide regulators and investors with a clearer picture of how extensively managers use affiliated transactions.
Reporting may also help identify unusual patterns, such as funds repeatedly transferring difficult-to-sell assets within the same management complex or conducting a disproportionate share of transactions internally.
For fund boards and compliance teams, the challenge will be balancing transaction-cost savings against the resources required for pricing verification, recordkeeping, surveillance and conflict management.
Institutional trading desks may also need to update workflows to document why a particular cross trade was appropriate, how the execution price was determined and whether the transaction satisfied the applicable exemption.
What Changes for Fund Investors?
The proposed amendments could benefit shareholders through lower trading costs, particularly in bond strategies with substantial portfolio turnover. The scale of any savings would depend on how frequently funds have offsetting trading interests and how much they currently pay to execute those transactions externally.
The proposal does not eliminate fiduciary obligations or authorize managers to transfer securities between affiliated portfolios at arbitrary prices. Nor does it require funds to conduct cross trades when external execution offers better terms.
Investors should distinguish the potential reduction in transaction costs from improvements in investment performance. Lower execution expenses can help returns at the margin, but do not change the credit quality, interest-rate exposure or investment risks of the underlying securities.
The SEC will accept public comments for 60 days following publication in the Federal Register. Until amendments are adopted and become effective, the existing regulatory framework continues to govern eligible cross trades.