Prime cash market funds (MMFs) are susceptible to runs. This was dramatically illustrated in September 2008 and March 2020, when large outflows from prime MMFs worsened stress within the short-term funding markets and eased solely after taxpayer-supported interventions by the Treasury and the Federal Reserve. On this submit, we describe how mechanisms like swing pricing that cost a worth for liquidity can scale back the vulnerability of prime MMFs with out triggering preemptive runs.
Prime MMF Fragility
One function of prime MMFs that contributes to their run vulnerability is liquidity transformation. That’s, prime MMF shares are extra liquid than most of the property they maintain, and even in crises when market liquidity prices for these property rise, buyers who redeem shortly are capable of get hold of liquidity at no cost. The prices of their redemptions are as a substitute borne by buyers who don’t redeem so quick, so all buyers have an incentive to redeem shortly—that’s, to run. This primary-mover benefit for redeeming buyers is current even for funds with floating internet asset values (NAVs), equivalent to institutional prime funds, whose share costs fluctuate together with adjustments within the market-based worth of the funds’ property. Buyers in these funds who redeem shortly in instances of stress can keep away from paying the liquidity prices arising from their redemptions as a result of these prices sometimes aren’t instantly mirrored within the fund’s NAV.
One solution to mitigate run vulnerability is to place a worth on liquidity throughout instances of stress, in order that redeeming buyers pay the prices arising from their redemptions. Nevertheless, doing so could cause further issues: if buyers are capable of foresee when the price of redeeming will rise, they’ll run preemptively, as they did in March 2020. Is it potential to cost liquidity with out inflicting preemptive runs?
Preemptive Runs
The vulnerability of prime MMFs to runs is nicely documented following main runs in September 2008 and March 2020. After the 2008 disaster, the Securities and Change Fee (SEC) applied two units of reforms, in 2010 and 2014. The latter permits prime MMFs to impose redemption charges or gates if their weekly liquid property (WLA) fall under 30 p.c of complete property. The redemption charges and gates had been supposed, partially, to impose a price on redeeming buyers and thereby to gradual runs, however latest analysis by Li, Li, Macchiavelli, and Zhou (2021) and Cipriani and La Spada (2020) reveals that the rule had the other impact. MMFs with WLAs near the 30 p.c threshold had bigger outflows than MMFs with larger quantities of WLA, and the analysis hyperlinks the elevated outflows to the redemption charges and gates. In different phrases, prime fund buyers ran preemptively earlier than charges or gates might be used.
The incidence of preemptive runs shouldn’t be shocking. For instance, in a 2014 Workers Report and a Liberty Avenue Economics submit, we defined how charges or gates contingent on depleted liquidity might result in preemptive runs.
Swing Pricing and Equal Mechanisms
Current reviews on potential MMF reforms by the President’s Working Group (PWG) on Monetary Markets and the Monetary Stability Board counsel that “swing pricing”—or economically equal mechanisms—might be a safer approach of pricing liquidity than the present system of charges and gates. In December 2021, the SEC proposed a swing pricing requirement for institutional prime funds. How would these measures work?
The concept behind swing pricing is to impose a price for redemptions on the identical day that the fund faces giant outflows. On these days, the NAV of the fund “swings” down in order that redeeming buyers obtain much less for his or her shares than they in any other case would. The discount in NAV ought to be calibrated to match the liquidity prices related to redemptions. That is the strategy proposed by the SEC, though different economically equal measures is also efficient. One various can be to cost a redemption payment on the identical day that the fund has giant outflows, slightly than lowering the NAV. Whether or not the value of liquidity is imposed by a discount in NAV or a payment, the important thing to avoiding preemptive runs is that the value is determined by same-day redemptions.
Preemptive runs can happen when buyers are capable of anticipate a future enhance in liquidity value and keep away from it by redeeming earlier than it’s imposed. For instance, beneath present guidelines, if a primary fund’s WLA has fallen to close 30 p.c and appears prone to drop under that threshold quickly, buyers can redeem instantly to keep away from a potential payment or gate.
In contrast, suppose that the fund expenses a worth for liquidity that will increase with the dimensions of the fund’s same-day internet outflows. Buyers who imagine {that a} liquidity value can be imposed tomorrow might select to redeem right this moment. Nevertheless, for the reason that liquidity worth will increase with right this moment’s internet outflows, by redeeming, these buyers enhance the anticipated liquidity cost that they pay right this moment, so their redemptions aren’t preemptive. Furthermore, for the reason that liquidity worth displays the liquidity value of redemptions, that value is not borne by remaining buyers, and the motivation to run preemptively is eradicated.
This argument is intuitive and can be backed by the tutorial literature that research run conduct. This literature reveals that when payouts for redeeming buyers will be set primarily based on the quantity of requested redemptions and if payouts are diminished to offset liquidation prices, runs are eradicated.
Swing pricing has been utilized by mutual funds in Europe and studied on this paper. As we might count on, the European expertise reveals that swing pricing has not generated preemptive runs. Furthermore, swing pricing eliminates the first-mover benefit arising from liquidity transformation and considerably reduces outflows throughout market stress.
To Sum Up
Placing a worth on MMF liquidity might scale back the fragility of prime funds if that worth will be charged with out making a threat of preemptive runs. Preemptive runs will be averted by utilizing swing pricing or related instruments that worth liquidity primarily based on same-day internet outflows. These instruments can be useful for a lot of stakeholders within the short-term funding markets. For instance, they might insulate MMF buyers from the prices of others’ redemptions when liquidity prices rise. Liquidity pricing is also helpful for fund managers who at present lack instruments to cease runs on their funds. Lastly, liquidity pricing may gain advantage taxpayers by lowering the chance of future bailouts for MMFs.
Marco Cipriani is an assistant vp within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.
Antoine Martin is a senior vp within the Financial institution’s Analysis and Statistics Group.
Patrick McCabe is a deputy affiliate director within the Federal Reserve Board’s Division of Analysis and Statistics.
