Richard Schwartz: Hello, I'm Richard Schwartz, head of research at Global Custodian. And I'm here with Krishna Shetty, executive director at S&P Global Market Intelligence. The subject for our discussion today is we want to unpick and unpack SEC Rule 2a-5.

Krishna, can you tell us in a nutshell, what is SEC Rule 2a-5 and when does it come into force? Why are we talking about it today?

Krishna Shetty: Absolutely, thank you for having me here, Richard. Currently, funds valuation practices, are guided by the Investment Company Act of 1940, which was last amended several decades ago. We've seen that the market has significantly evolved since then. To modernize these practices, the SEC adopted Rule 2a-5 in December 2020, which goes into implementation on 8 September 2022. What this new rule does is it provides a framework for fund valuation practices and establishes requirements for fair value determination in good faith. Now the Fund board is ultimately responsible for these fair value determinations. However, the rule will permit fund boards to designate certain parties known as valuation designees, which could be the investment advisor to the fund to perform some of these fair value determinations. The only caveat here is that the board has to have oversight over them.

The core requirements for the new rule include:

• assessing and managing evaluation risks;
• establishing and applying methodologies;
• testing methodologies;
• and, evaluating pricing services.

Richard Schwartz: From the point of view of the board and the people responsible, is it a big change from what existed before in terms of determination as presumably fair value and good faith was always needed?

Krishna Shetty: Yes, exactly. Fair value and good faith were always needed. However, with Rule 2a-5, the SEC is providing a framework as to what funds need to do. Some of the core requirements include assessing and managing valuation risks and what this means is that funds will have to further refine their processes and their valuation practices to comply with this rule. Now, in addition to that, they also have to establish and apply fair value methodologies, and this comes into play when a fund has additional asset classes or various different asset classes and sub-asset classes. So, for each one of these asset or sub-asset classes, they'll have to develop methodologies to correctly value these secured, testing the methodologies as well. To validate the pricing of these methodologies, funds may have to run some backtesting studies or run vendor to vendor comparisons and finally evaluating pricing services, which is a bucket that we fall under as a pricing service where the SEC has provided six factors that funds will need to take into consideration before choosing a pricing service.

Richard Schwartz: What challenges is this rule likely to bring in your view to the buy-side? Is it going to be easy to meet the requirements of the rule?

Krishna Shetty: As with every new regulation that comes into effect, I think the buy-side is still trying to figure out how to improve the evaluation process and what we have seen is that in most cases buy side firms already had valuation processes in place. However, they have to refine it to comply with the rule in two ways. For now, in most cases, the board will have to appoint an evaluation designee who can run the fair value processes for them and report it to them on a regular basis. Now, in addition to that, there are six factors that fund boards and the valuation designee will need to pay attention to when it comes to pricing services and what they choose. The pricing service and the valuation designee will be responsible for putting all the documentation together when it comes to pricing services and presenting it to the board, either on a monthly basis, quarterly basis, or yearly basis. In some instances, what we have also seen, and this is especially true for smaller funds, is that they may have traditionally had only a primary vendor. However, as part of this rule, they're looking at multi-sourcing, which means that they still have a primary vendor but in addition to that, they may have a secondary and tertiary vendor as well.

And finally, along with Rule 2a-5 rule, 31a-4 also goes into effect in September 2022. As part of this rule, valuation designees and the fund board are required to maintain appropriate documentation to support fair value determination. Now, specifically, when it comes to pricing services, the fund's board or valuation designee will have to take the following factors into consideration before deciding on a pricing service. The first one is qualification experience and history of the pricing service. The second point is evaluation methods, techniques and inputs that go into pricing certain securities, assets and sub asset types. The third one is the quality of the pricing information, and this especially matters to what time the price is determined prior to NAV calculation. The fourth point is the pricing service’s price challenge process, whether they have an established process for price challenges, how they deal with price challenges. The fifth one is the pricing service’s actual and potential conflicts of interest and what they're doing to determine how to mitigate these conflicts of interest. And finally, the testing procedures that are used by the pricing service to validate their pricing.

Richard Schwartz: In practical terms, what is S&P Global bringing to the table to help clients deal with the implementation?

Krishna Shetty: It's a good question, and since the rule was adopted in December 2020, we have looked extensively at the rule to see what client impact is going to be and how we can help our clients comply with Rule 2a-5, and it ultimately came down to two broad themes. One was coverage, whether we have coverage to support. Our clients across all asset classes and between our CDS pricing offering loans, securitized products, municipal securities, corporate and sovereign bonds, and derivatives. We identified that we could service our clients across the majority if not all asset classes that they're looking at. And secondly, it was the six pillars of the factors that the SEC recommends funds look at while choosing a pricing service and across all of these, what we identified was that we were already providing a lot of the information to our clients. But how do we make this easier for clients to access?

We've developed a self-service portal called the PVR Source, where clients can log in and they can pull down all the information that's required for them to comply with Rule 2a-5 such as methodology documents, back testing, information, requests for transparency documents, and any other additional services that they may require.

Richard Schwartz: Final question, given that it's fairly imminent, can clients start now to prepare? Is it the time to get ready?

Krishna Shetty: Yes, absolutely. What we have seen over the last several months slash year and a half we have been working very closely with several clients, so a lot of clients have actually already put their paperwork and their processes in place. Several clients have actually got board approval for these practices to be implemented in September of 2022. And if they haven't already got board approval, they will be getting approval in the next board meeting. So, when it comes to preparation for Rule 2a-5, we feel like a lot of clients are well on their way to getting ready for this rule to go into effect in September 2022.