Breaching the Debt Limit: Operational Considerations (pdf)

Breaching the Debt Limit: Operational Considerations

DECEMBER 2017

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Breaching the Debt Limit: Operational Considerations

Contents

A Debt Ceiling Event . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Assessing the Potential Impact of a Government Default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Funds Are Well-Positioned to Withstand a Possible Event . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Debt Ceiling Event Assumptions and Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

3BREACHING THE DEBT LIMIT: OPERATIONAL CONSIDERATIONS

A Debt Ceiling EventPeriodically, Congress is called upon to consider raising the limit on the amount of debt the United States government can hold.1 Though Congress (under both Republican and Democratic administrations) has never failed to raise the debt limit when called upon to pass this administrative matter, more recent increases in the debt limit have occurred well after the limit is reached, and only when “extraordinary measures”2 are nearly exhausted. This has repeatedly been the pattern since 2011, where the debt limit crisis is only temporarily resolved, either through suspension of or increase to the debt limit.3

Because of this repetitive last-minute pattern to resolution of a debt limit event, it is important to understand the potential implications to the mutual fund industry if the debt limit is not increased in a timely, orderly fashion and extraordinary measures are no longer available. If this should occur, the US government would default on its obligations, including the payment of interest on debt securities it has issued. The “full faith and credit” of the US government could be called into question.

Assessing the Potential Impact of a Government DefaultWhat would be the impact of an unresolved debt limit event on the fund industry? It is possible—and likely—that a specific fund may experience no impact to ongoing operations, but the potential impact is unclear. A number of factors (both within and outside a specific fund’s control) could minimize or amplify the effects. Because it is a systemic event that affects the industry’s operating environment, even a small effect may be magnified.

Most logically, the potential impact would be greatest to the trading, clearance, settlement, valuation, and income payout (i.e., dividend) activities of fund portfolios with broad exposure to government debt. With investors (especially larger institutional investors) moving between portfolios, either through asset allocation rebalancing or regular buy/sell activities, a cash flow crisis caused by government default could create significant volatility in the market and a cascading impact to other funds. For this reason, it is prudent for all fund industry members to assess the potential impact from a government default.

1 According to the US Department of the Treasury, “the debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. The debt limit does not authorize new spending commitments. It simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past.” See “Debt Limit: Myth v. Fact,” US Department of the Treasury. Available at www.treasury.gov/initiatives/Documents/Debt%20Limit%20Myth%20v%20Fact%20FINAL.pdf.

2 “Extraordinary measures” are actions taken by Treasury to manage legal financial obligations of the US government once the debt limit has been reached and to avoid default on financial obligations. See “Description of Extraordinary Measures: March 16, 2017,” for a description of available extraordinary measures. Available at www.treasury.gov/initiatives/Documents/Debt%20Limit%20Myth%20v%20Fact%20FINAL.pdf.

3 “The Debt Limit Since 2011” by D. Andrew Austin, Congressional Research Service, August 9, 2017. Available at https://fas.org/sgp/crs/misc/R43389.pdf.

4 BREACHING THE DEBT LIMIT: OPERATIONAL CONSIDERATIONS

Funds Are Well-Positioned to Withstand a Possible EventFunds and investors are well-positioned to withstand a debt limit crisis because of resilient fund construction and limited investor exposure.

Fund Construction: Practices That Have Improved ResilienceSince the financial crisis of 2008, financial services in general—and the mutual fund industry in particular—has adopted and reinforced practices that improve resilience when facing uncertainty or that require additional cash availability.

» Creating a cash buffer. Both prudent management and regulatory reform have caused portfolios, in general, to increase their overall cash position. This creates a cash buffer to better absorb any disruptions that may occur. In addition, asset managers may have extensive lines of credit and strong partnerships with their banks to provide additional tools to manage cash flow and fulfill trading and settlement obligations.

» Increasing government money market fund cash holdings. Portfolios with larger exposure to government obligations may be more susceptible to the effects of a debt limit crisis. Some may be concerned by the increased investment in government money market funds by investors in response to the Securities and Exchange Commission’s 2014 money market fund reforms. However, requirements for government money market fund cash holdings correspondingly increased, mitigating the impact of default.4

» Limiting investment in government debt. Some fund portfolios are not (or are minimally) invested in government debt, limiting their direct exposure to any default.

Minimal Investor ImpactIndividual retail or institutional investor impact of government default would most likely be minimal. The impact depends on investment portfolio composition, as well as the investor’s transaction activity—the fund selected, whether a buy or sell transaction, and the relative size of the transaction in relation to the portfolio.

» Limited investor exposure. Retail or institutional investor portfolios may not hold funds with appreciable government debt. Others may hold funds with greater exposure to government debt; the investor impact is minimized, however, if the investor does not sell affected securities within the portfolio.

» Many factors must align for potential investor impact. The greatest potential impact to investors would occur in the highly unlikely event of the portfolio’s net redemption activity exceeding the fund’s cash availability (including lines of credit) and requiring the fund to delay settlement of some (typically larger) redemptions. Delayed settlement could create a cash availability issue for the redeeming investor. Further, any purchase settlement dependent upon any delayed redemption proceeds could be affected, thereby creating a limited “contagion” effect on a seemingly unrelated portfolio—even one that has minimal or no exposure to government debt.

4 Refer to the Federal Register from August 14, 2014, page 47791 for a definition and portfolio composition requirements of government money market funds.


Other Possible EffectsWhile uncommon, many mutual funds do reserve the right to settle transactions “in-kind,” by transferring portfolio securities to settle a redemption request.5 This option may be more likely when markets are more volatile, with large transactions, or when trade settlement through regular channels could be significantly delayed.

Debt Ceiling Event Assumptions and ConsiderationsIt is critical for mutual funds, investors, and intermediaries to assess the nature of their holdings, or those of their customers, and understand the potential impacts of a government default.

A task force of the Investment Company Institute’s Operations Department’s Broker/Dealer Advisory Committee, which is made up of intermediaries, mutual fund companies, and the Depository Trust and Clearance Corporation (DTCC), documented the following assumptions and considerations for the mutual fund industry in the areas of mutual fund valuation, trading, clearance, and settlement. Specific business scenarios may affect other areas, which underscores the importance of each industry participant to separately evaluate the potential impact of a government default on their operation.

Assumptions » The impact of reaching a debt limit tends to be fluid, as “extraordinary measures” can be taken by Treasury to temporarily delay the impact of a government default, even when the debt limit is reached. It is the expiration of “extraordinary measures,” without a corresponding debt limit increase or suspension, that precipitates the government default.

» In the event that a government default occurs, it is expected that maturities and/or coupon payments for Treasury-issued debt would likely need to be adjusted (worst case scenario could result in a downgrade to the US credit rating). During a default, Treasury will decide which obligations will be paid and in what time frame. Asset managers will need to monitor and respond to Treasury’s actions.

» A government default could affect mutual fund managers in varying ways, based on one or more of the following factors:

» portfolio composition, including cash availability and the amount and composition of government debt held;

» availability of lines of credit and other means to meet any cash availability concerns that may arise during a default; or

» the nature of portfolio and end-investor trading activity during a government default.

5 If applicable to a mutual fund, such disclosures are stated in fund documents, either the mutual fund’s prospectus or statement of additional information. Exchange-traded funds (ETFs), by design, make greater use of “in-kind” redemptions.


» If Congress fails to raise the debt ceiling, mutual fund industry managers should ask the following questions:

» How and when should we communicate—both internally and externally regarding perceived and/or actual impact—to ensure our counterparties are informed of our assessment and potential impact of the government default?

» What effect could there be to portfolio valuation, and subsequently, the pricing of mutual funds, including potential for delayed release of daily net asset values (NAVs) to the market?

» How might mutual fund trading and settlement be affected?

ConsiderationsAdvance preparation—internally and with key service providers (e.g., transfer agent, fund accounting agent, custody and/or cash management banks), as well as ongoing external and internal communication about real and potential effects—is critical to successfully navigate any effects with minimal disruption to shareholders and partners.

Communication and Planning6

» Use standard playbook and client communication scripts/templates (e.g., guide for an unexpected market close,7 initiation of an exchange “circuit breaker”).

Funds

» Early identification of and communication with key stakeholders (e.g., fund accounting, fund pricing, NAV distribution, legal, compliance, operational leadership, intermediaries) will be crucial in successfully managing the event.

» Identifying and communicating internally about portfolios that are more/less affected by the government default should focus the monitoring of larger investor trades for impact to the most at-risk portfolios.

» Early communication of expectations to intermediaries regarding the fund’s anticipated response to operational issues will be crucial to ensure that intermediaries are reasonably prepared to meet the fund’s expectations (e.g., continuing to accept trades for a future trade date, continuing to accept trades with the prior NAV, reject trades).

» Consider necessary updates to rules or configurations related to user interfaces and processing/recordkeeping platforms/connections (internal), website (external), and/or service provider–dependent services.

» Communication scripts for shareholder-facing associates could be warranted. For example, such scripts could answer questions on the impact of the government default on their fund investment, or actual impact to trade placement/settlement activities.

6 If the industry develops a real-time communication standard, such as through the DTCC, ICI recommends the adoption of the capability to communicate to partners during such an event. An example of this would include communicating alternative settlement arrangements (e.g., announcing delayed settlement), if applicable.

7 An ICI-sponsored industry working group developed the Mutual Fund Operations Planning Guide for an Unexpected Market Close, available at www.ici.org/pdf/14_ops_manual_marketclose.pdf. Other materials available in response to market disruption, such as effects on pricing and valuation, can be found at www.ici.org/continuity.


Intermediaries

» Determine how varying fund family responses and expectations will be inventoried and communicated to the branch and/or individual advisers.

» Review fund expectations with service providers for appropriate system configurations, manual workarounds, or other dependencies.

» Consider necessary updates to rules or configurations related to user interfaces and processing/recordkeeping platforms/connections (internal), website (external), and/or service provider–dependent services.

Service providers

» Remind customers of pertinent capabilities to manage or modify valuation, trading, clearance, and settlement behaviors that could be helpful when responding to challenges related to the government default.

» Track and confirm temporary changes made by/for customers as needed so they may be returned to business-as-usual status following the event.

Pricing » Consider upstream/downstream effects to pricing vendors, NAV calculation/approval, or NAV release/delivery that may occur if valuation is somehow affected or delayed due to the government default.

» Communicate the status of portfolio or fund family delays to releasing NAVs as soon as practicable. Clear expectation-setting by the fund will help firms to prepare for any potential delays. (See “Communication and Planning” section.)

» Evaluate policies on release of NAVs, especially if the practice is to release all fund family NAVs simultaneously. If there is a delay in one NAV because of the government default, it could cause a delay in the release of all NAVs, which could cause significantly greater adverse impact to the industry than necessary. This is especially true if the affected portfolio is not widely distributed.

Dividends » Consider upstream/downstream effects to daily and/or periodic dividend calculation and timely delivery of rates/factors.

» Proactive communication of any changes to process or policy, especially at traditional end-of-period time frames (e.g., month- or quarter-end), is especially important for both internal and external constituencies.

» Review procedures and time lines for communicating delayed delivery of dividend rates/daily factors, both internally and with external partners.

» Delayed settlement of daily accrual fund transactions will most likely require attention:

» Intermediaries will need to manage the cascading effect that delayed settlement creates on dividend payment entitlements. Subaccounts will require adjusted allocation of earnings.

» Funds may also need to adjust reporting and accruals for internal purposes.

» Funds should be prepared to assist intermediaries through enhanced communication and support during this period.


TradingIt is unclear if the government default could affect the ability for a fund portfolio to buy and sell securities and whether that could have any related impact to investor trading of mutual fund shares. Changes to trading and settlement guidelines by the fund to delay settlement of individual investor trades, cash flow volatility affecting the ability to settle previously confirmed trades, or other unforeseen matters could create challenges for funds, intermediaries, and investors alike.

With most automated trading networks used for trading mutual fund shares, the trade clearance and settlement time line is almost always conveyed at the time of trade confirmation. Therefore, it is important for asset managers and intermediaries to understand the expectations and capabilities of all automated trading networks in which a fund may participate. Changes by funds to rules that govern trading and/or settlement of mutual fund shares will affect others and need to be accommodated, either manually or possibly with corresponding rules adjustment of the partners’ systems. Manual trading may provide additional flexibility regarding communication between counterparties, but also increases operational risks. Shareholder communication becomes all the more critical if changes in response to a government default are instituted. All of these factors must be considered when making decisions and while monitoring trading activities.

» National Securities Clearing Corporation (NSCC) activity via Fund/SERV®: Funds are encouraged to review the following questions to understand the capabilities available to them and possibly consult with service provider(s) to fully understand system functionality. Intermediaries should review these questions to understand the potential changes they may need to accommodate, and how that can be accomplished. Service providers should use the questions to prepare for inquiries they may receive and consider proactive communication of capabilities to their customer base:

» Would the fund consider altering settlement rules at the individual security (i.e., CUSIP) level with the DTCC? If so, how?8

» Would the fund consider disabling “auto-confirmation,” if currently used, at the CUSIP level? If yes, how does that alter operational procedures for timely review, monitoring, and approval/rejection of trades?

» Does the fund’s trade management technology permit intraday view or reporting of trades, for all trades or those at a predetermined dollar or share threshold, to evaluate the potential to delay settlement?

» Does the organization have the staffing to manage the volume that increased manual work may introduce, should that become necessary?

» What are the fund’s capabilities to update a trade value and confirm and settle an alternative value if the fund can only accept a portion of a trade request? How would an intermediary respond to receiving a trade confirmation such as this?

» Could the fund and its trading counterparty use “EX-Fund/SERV”9 settlement, leveraging DTCC trading while managing settlement outside of the DTCC?

8 There are options available to both funds and firms to potentially override standard settlement dates on specific orders, or alter rules that would change the default settlement cycle. See www.dtcc.com/wealth-management-services/mutual-fund-services/fund-serv for details and contact DTCC Client Support or Relationship Management to learn more about these capabilities.

9 The trade benefits from automated processing through Fund/SERV, but settlement occurs manually, outside (“EX”) Fund/SERV. For example, this could be beneficial if payment of settlement proceeds will be delayed or involve “in-kind” settlement.


» Would the fund ever consider shutting off a fund from being traded via NSCC? What would be the impact to “in-flight” trades? Are there contractual obligations with intermediaries that would preclude this option? What would be the short- and long-term impact to intermediaries of pursuing this option?

» Are existing exception processing policies and procedures sufficient to accommodate any increase in trades that miss Fund/SERV cutoffs for same-day consideration? Examples include leveraging the standard “as of” trade process or expanded price protection considerations to manage or remediate.

» Other trading channels and platforms: Similar questions may pertain to these options as with NSCC Fund/SERV. Users of these solutions should review the capabilities that exist to assist with trade management and consider how those could be beneficial.

» Monitoring of “preliminary” processing (e.g., trades received in the morning for which settlement is expected later in the day, or next-day) to forecast cash impact to the portfolio; respond accordingly.

» Review prearranged client events (e.g., asset allocation rebalancing), large transactions, and the cash flow impact of any corporate actions.

» Review corrective trade, “as-of,” and price protection policies and procedures to ensure they can adequately address anticipated scenarios that may be encountered.

» Evaluate current reconciliation and oversight policies, procedures, and reporting for completeness to manage anticipated scenarios that may be encountered.

» Consider potential impact and options for response if intermediaries are unable to fully comply with the fund’s instructions.

» Establish or update existing management checkpoints and resources to assist with monitoring for any increased risks related to a government default. This may include reporting that captures both the volume and magnitude of trading activities, reports on available staffing levels to assist with manual activities (if warranted), and the capabilities of technology to address any issues encountered.

SettlementThe orderly functioning of capital markets is predicated upon, among other things, timely settlement of trade orders. As stated in the “Trading” section, the time line for trade settlement is typically set during trade confirmation. Any divergence from this expectation, either through delayed settlement by either party, or settlement “in-kind” that was not anticipated and accommodated for at time of trade confirmation, can create significant disruption.10

It is perhaps even more important for activity processed through the NSCC and net settled through the DTCC to be settled in a timely way.11 Any settlement delay could create a cash shortfall for a DTCC member that would need to be covered by other means. Individual NSCC members should not expect the DTCC to assume the risk to daily settlement by requesting removal of a trade or trades from the daily net settlement process. As previously stated, NSCC members are encouraged to review their potential operating cash needs with their banking relationships, including the consideration of lines of credit or other resources as backstops to meeting settlement obligations.

10 Delayed settlement of one trade can have a cascading impact on other portfolios. For example, it is not uncommon that proceeds from a redemption trade are intended to settle a purchase trade in a different portfolio. A delayed settlement of the redemption trade would require use of alternative funding sources (e.g., line of credit) to avoid a negative impact to settlement of the purchase transaction.

11 Based on the settlement date assigned during trade confirmation, an NSCC member’s mutual fund activity is netted and settled in one aggregate credit or debit transfer between the DTCC and the member’s settling bank. Refer to the Fund/SERV page at www.dtcc.com for details on mutual fund net settlement.

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» What are the alternatives available to mitigate the impact of delayed settlement or a failure to settle any particular transaction, either through the NSCC or other means?

» What is the impact to various cash-related operational processes and procedures?

» Money movement between fund custody and operating bank accounts

» Monitoring and managing federal funds wire activity between counterparties

» How could reporting between various systems (e.g., order management, recordkeeping, portfolio accounting, cash management) be affected by settlement delays or a failure to settle any particular transaction? What additional reporting may be beneficial in that environment?

» How does a fund’s large trade monitoring relate to settlement management or decisions? What changes to large trade monitoring and/or notification procedures, if any, may be warranted for portfolios that may be more susceptible to the effects of a government default?

» What may be the additional effects to fund and intermediary business operations if “in-kind” settlement is used?

ConclusionThe recent congressional approach to addressing the debt limit to avoid a US government default on its financial obligations suggests it is prudent to be prepared in case the “what-if ” scenario becomes a reality. The mutual fund industry, like the entire financial services industry, has proven it is capable of responding in highly adverse and uncertain operating environments. In addition, funds are well-positioned to withstand any possible event. Through prudent management, thoughtful preparation, and extensive communication with counterparties and shareholders, the industry can be best prepared to manage any disruption that may emerge from a government default.