This post begins a detailed consideration of the SEC’s proposal to require money market funds with floating net asset values (“institutional money funds”) to implement swing pricing during any pricing period in which the fund has net redemptions. I begin with the estimated costs that an institutional money fund “must include for each security in the fund’s portfolio” when determining any swing price, namely:
- spread costs,
- brokerage commissions,
- custody fees, and
- any other charges, fees, and taxes associated with portfolio security sales.
This post considers spread costs and brokerage commissions.
What Are Spread Costs?
We can use the Treasury Note from my previous examples to illustrate spread costs. The note, maturing 12/22/2022, had a coupon of 2.25%. At the time, the asking price for the note published in the Wall Street Journal was $101.074 and the bid price was $101.070, in each case per $100 face amount. So, if a fund purchased a note in the face amount of $100,000, it would pay $101,074, while the dealer that sold the note to the fund would have purchased it for $101,070. The “spread,” or $4 difference between the two amounts, is the dealer’s compensation for both the purchase and sale of the note.
Does the Buyer or Seller Pay the Spread Costs?
The answer is “Yes.” Because the dealer does not charge buyer or seller directly, we can answer this question in one of three ways:
- The note’s market value is $101,070, and the buyer paid the spread cost, for a total purchase price of $101,074;
- The note’s market value is $101,074 and the seller paid the spread cost, netting $101,070; or
- The note’s market value is between $101,070 and $101,074, and both parties paid part of the spread cost.
All three answers seem equally valid.
It Should Not Matter Who Paid
As explained in an earlier post, one aim of swing pricing is to make redeeming shareholders bear the costs, including spread costs, of selling portfolio securities to pay for their redemptions. As a fund must have bought a security before it can sell it, the fund must have been both a buyer and a seller. With respect to our $100,000 Treasury Note, this means the fund paid a total of $4 in spread costs either when it bought the note, sold the note, or (if buyer and seller are deemed to share the spread cost) both when it bought and sold the note.
It Should Not Matter How Securities Are Valued
Although a spread cost is a fixed amount, the swing pricing proposal would include different amounts depending on how the fund calculates its NAV. The swing price will reflect spread costs only if the fund uses “mid-prices” (the average of bid and asked prices, or $101.072 in our example) to determine its net assets rather than bid prices. Thus, mid-priced funds will recover half of their spread costs from redeeming shareholders while bid-priced funds will not recover any spread costs.
This treatment of spread costs focuses on the impact of the sale to the exclusion of the purchase. Valuing the note at its bid price results in a $4 reduction in the fund’s net assets at the time of purchase, since the spread cost, although paid as part of the purchase price, is not included in the carrying price. Selling the note “costs” the fund the value of this initial expenditure. The fund spent $4 to acquire the note and now has nothing to show for it apart from whatever interest may have accrued.
This is half true when the fund uses the mid-price. Valuing the note at its mid-price lowers the net assets by $2 when it is purchased for $101,074 but carried at $101,072, and another $2 when it is sold for $101,070. Again, the sale deprives the fund of the benefit of the initial $2 expenditure as well as incurring a $2 expenditure on the sale.
You will search in vain for references to brokerage commission in an institutional money fund’s financial reports. Money market instruments trade in dealer markets, and dealers charge spreads rather than commissions. So, commissions should rarely factor into a swing price.
No matter how its characterized, the consequences to the fund of selling the Treasury Note before maturity will be the same: the dealers will have $4 that used to be an asset of the fund. The effect of the swing pricing proposal would be that all the shareholders of a bid-priced fund would share the entire spread cost whereas the shareholders of a mid-priced fund would share only half of the spread cost, with the other half being passed through to shares redeemed at the swing price.