Bond funds may get their cross-trades back

The Securities and Exchange Commission on Friday proposed amendments to the Investment Company Act's cross-trading rule that would restore the ability of registered funds to trade most fixed-income securities with their affiliates. The proposal "would restore the ability to cross trade most fixed-income securities and modernize the rule's conditions, including those related to pricing and oversight of cross trades," the Commission said in its announcement.

The rule permits securities transactions between a registered fund and its affiliates under certain conditions. "When executed appropriately, cross trades allow registered funds to avoid costs associated with open market trades and to then pass those savings on to investors," SEC Chairman Paul Atkins said. Rule 17a-7 was adopted in 1966, according to the proposing release, and Atkins said in a statement that its conditions have not been substantively updated since the 1980s.

The door closed in 2022. The rule requires a security to have readily available market quotations, and a 2020 valuation rule, Rule 2a-5, defines that narrowly as an unadjusted quoted price in an active market for identical investments. Most fixed-income securities trade infrequently, so they have generally been ineligible for cross trading since 8 September 2022, when that rule's compliance date arrived, the release says. The Commission acknowledged at the time that some securities might become ineligible, and said it had amendments to Rule 17a-7 on its agenda.

The proposal would limit eligibility to securities whose fair value measurement falls in level 1 or level 2 of the US accounting fair-value hierarchy, which covers most bonds. Securities valued with significant unobservable inputs, "level 3," would stay out. A cross trade would be priced by one of two methods: the value in the fund's next net asset value calculation on the day of the trade, or a current market price set by the adviser from one or more unaffiliated pricing sources. Non-firm indications of interest and accommodation quotes would not qualify, the release says.

Oversight would move. Today a fund's board must review cross trades at least quarterly. The proposal would instead have the fund's chief compliance officer review them quarterly and report to the board, and test the results at least annually for patterns suggesting disadvantage to the fund compared with its affiliates, the release says. The brokerage-commission ban would stay, with de minimis payments to unaffiliated parties for clearing, settlement, custody and similar services expressly allowed.

New data would come with it. Funds that cross trade would have to report aggregate information by asset class on Form N-PORT and Form N-MFP about the securities they traded in the preceding month and their cross-trading activity. The release says funds do not currently report cross trades in a structured way, and that the lack of transparency about cross-trade prices and volumes may harm price discovery and distort perceptions of liquidity.

The release also lists the abuses the rules guard against: "parking," where an adviser pre-arranges a cross trade intending to repurchase the securities at prices that disadvantage clients, "cherry-picking" and "dumping." It cites settled enforcement actions involving Morgan Stanley Investment Management and portfolio manager Sheila Huang in December 2015, Western Asset Management in January 2014, SeaCrest Wealth Management in December 2024 and Macquarie Investment Management Business Trust in September 2024.

The industry's own numbers show the scale of what was lost. Registered funds investing mainly in fixed income grew from about $1.5tn to about $7.9tn in assets over 20 years, the release says, citing the Investment Company Institute. An Institute survey submitted to the Commission in April 2021 found registered funds did more than $200bn of fixed-income cross trades in 2020, saving funds and shareholders an estimated $300m or more. The survey's authors put cross trades at about 3.7 per cent of the funds' total fixed-income trading, and 99.6 per cent of the fixed-income securities cross-traded were level 2, the release says.

Commissioner Mark Uyeda tied the change to stress. Fixed-income cross trades are used for liquidity management, index rebalancing, duration adjustments and meeting redemptions, he said, and in distress a cross trade can spare a fund from selling a thinly traded bond at a fire-sale price that then pulls down valuations at other funds. "Cross-trading can help interrupt this cycle and mitigate systemic risk concerns," he said in his statement. That matters in a market where Treasury yields have been moving sharply: the 30-year sold at 5.308% at an auction we reported last month.

The proposal will be published on SEC.gov and in the Federal Register, and the comment period will stay open for 60 days after Federal Register publication, the Commission said. Comments should refer to File No. S7-2026-36, according to the SEC's rule page. It follows the SEC's September proposal to rescind Rule 14a-8 on shareholder proposals.