United States: Time to Get Cross!

By: Thoreau A. Bartmann and Lance C. Dial

It’s been a rocky road for cross trading fixed-income securities by mutual funds.

Before 2020, when the Securities and Exchange Commission (SEC) adopted the valuation rule, the primary challenge was that Rule 17a-7’s pricing requirements were difficult to implement. Then the valuation rule made such trading far more difficult, effectively carving most fixed-income securities out of Rule 17a-7 altogether. At that point, funds missed the days when it was merely difficult to cross trade fixed-income securities!

Well, today the SEC proposed amendments to Rule 17a-7 that would not only fix the problem for fixed-income securities, but make cross trading easier in several other respects.

The Good News:

Fixed-income securities are back! The proposal would expand the securities eligible for cross trading to include securities valued using Level 2 inputs, which would cover most fixed-income securities.

Data Vendors are In! Solving the problem, funds can price cross trades using prices determined for NAV purposes or current market prices based on independent pricing sources, including pricing vendors.

De Minimis Transaction Fees! The proposal would permit certain de minimis fees paid to unaffiliated parties for clearing, settlement, custody, recording and reporting.

Modernized oversight! The proposal would shift quarterly compliance reviews from fund boards to fund CCOs, although it would also introduce new requirements, including pre-trade best-interest determinations and annual reviews.

The Other News:

But the proposal doesn’t deliver everything.

First, the proposal relies on GAAP concepts to determine which securities are eligible for cross trading. The challenge is that requiring traders to determine whether a security satisfies a GAAP-based standard at the time of a cross trade could introduce uncertainty and operational complexity into decisions that often need to be made in real time.

Second, the proposal expressly prohibits cross trading of securities with no observable pricing inputs. So these “Level 3” securities would remain excluded, even where appropriate safeguards could address the potential conflicts (though the SEC does ask questions about whether they should be included in the adoption….)

There are other considerations, including new reporting and compliance requirements. But overall, this is a welcome proposal that could meaningfully benefit mutual funds and their shareholders.