The SEC Wants to Let Funds Trade Bonds Directly With Their Own Affiliates Again

The Securities and Exchange Commission proposed on October 9 to widen the set of securities a mutual fund may trade directly with an affiliate. The target is fixed income. Bonds have been largely shut out of these transactions since 2020, not by a deliberate restriction but as a side effect of a separate rule about how funds value their holdings.

What a cross trade is

Rule 17a-7 under the Investment Company Act of 1940 is an exemption. The Act's default position is that a registered fund may not trade with its own affiliates, because the adviser sits on both sides and can favour one account over another. Rule 17a-7, adopted in 1966, carves out an exception: a fund may buy from or sell to an affiliate if the transaction meets conditions designed to make the price independent of the adviser's discretion.

The appeal is cost. A fund that needs to sell a bond and an affiliated fund that wants to buy the same bond can transact with each other and avoid the dealer spread and market impact of two separate open-market trades. SEC Chairman Paul S. Atkins made that the stated rationale for the proposal.

When executed appropriately, cross trades allow registered funds to avoid costs associated with open market trades.

Why fixed income dropped out

Funds traded both equities and fixed income under Rule 17a-7 for decades. That changed with Rule 2a-5, the fund valuation rule adopted in 2020. Commissioner Mark T. Uyeda's statement accompanying the proposal notes that fixed-income securities previously cross traded under Rule 17a-7 have generally not been eligible since Rule 2a-5's compliance date.

The mechanism is the pricing condition. Rule 17a-7 required a price that could be independently verified in a way that most bonds, which do not trade continuously on an exchange, could no longer satisfy once Rule 2a-5 governed how funds determine fair value. The SEC's release says market developments since have made bond pricing more verifiable and transparent than it was.

What the proposal would require

Rather than restore the old conditions, the proposal rewrites them. Uyeda's statement sets out the main elements.

• Eligibility would extend to securities classified as level 2 under generally accepted accounting principles — those priced from observable inputs other than quoted prices in active markets.
• Updated pricing conditions and oversight requirements intended to guard against cherry-picking, in which an adviser allocates favourable prices to preferred accounts, and dumping, in which an unwanted holding is pushed onto another fund.
• A best-interest determination by the adviser, reviewed by the fund's chief compliance officer.
• Aggregate reporting on Form N-PORT or Form N-MFP of the value of investments bought and sold under the rule, broken down by asset class.

Uyeda's statement illustrates the pricing question with a hypothetical: a bond crossed at $98.0 where a prior level 2 valuation may have been $98.5. The half-point difference is the kind of gap the oversight conditions are meant to catch.

The argument about stressed markets

Uyeda sets out a second rationale beyond cost. Fixed-income cross trades are used for liquidity management, index rebalancing, duration adjustments and meeting redemptions. In a distressed market, he argues, the ability to cross a bond internally can let a fund avoid a fire sale — and because other funds mark similar holdings to models fed by observed transactions, one forced sale can transmit stress outward. He notes this matters most where redemption pressure is low, as with funds held largely through 401(k) plans.

What would be visible afterwards

The reporting the proposal contemplates is aggregate: how much a fund crossed, by asset class, not the price of any individual trade. Uyeda flags that limitation himself and asks whether transaction-level reporting to TRACE or the Municipal Securities Rulemaking Board's RTRS would improve price discovery and impose more pricing discipline. That is a question put to commenters, not a provision of the proposal.

This article explains a proposed rule and the mechanics it would change. It is not advice about any fund or security.