This is the fifth in my series of posts analyzing the SEC’s recent proposal to require money market funds with floating share prices (“institutional money funds”) to implement “swing pricing” for pricing periods in which the fund has net redemptions. This post completes the illustration from my last two posts and examines the impact of swing pricing on the fund and its shareholders.
The illustration started with an institutional money fund with net assets of $600 million and 600 million shares outstanding. The fund prices its shares at nine, noon and three, so it has three pricing periods. The market impact threshold for each pricing period is 1 and ⅓% of the fund’s net assets.
The fund had net redemptions during both the nine and noon pricing periods, so it had to calculate a swing price. Net redemptions in the second pricing period exceeded the market impact threshold, so the swing price for that period included market impact factors. The estimated costs of net redemptions in the first pricing period were $301. Larger net redemptions and market impact factors increased the estimated costs to $675 in the second period. When rounded to the fourth digit, however, the swing price for both periods was $0.9999.
The fund processed $4 million of subscriptions at the swing price during the two periods, resulting in the issuance of 4,000,400.04 shares. The fund processed $19 million of redemption orders at the swing price during the periods, resulting in the redemption of 19,001,900.19 shares. Hence, the net redemptions during these periods reduced the fund’s net assets by $15 million to $585 million and reduced its outstanding shares by 15,001,500.15 to 584,998,499.85. This left the fund with a net asset value per share (“NAV”) slightly above $1 at the beginning of the final pricing period, which rounds down to $1.0000.
Closing Out the Day
To bring this illustration to a quick close, assume the fund has net subscriptions of $15 million during the three o’clock pricing period. The proposal does not require a swing price for pricing periods in which there are net subscriptions, so these orders will be processed at $1.0000. It should not matter what combination of subscriptions and redemption orders produced this result; what matters is that the net subscriptions return the fund to the same net assets with which it began the day. At a $1.000 NAV, the net subscriptions will also increase the fund’s outstanding shares by 15 million.
The following table shows the cumulative impact of trading during this day.
|Dollar Amount||Shares||Impact of Swing Pricing
|Start of Day||$600,000,000||600,000,000||—||$1.0000000|
|Redemptions @ Swing Price||($19,000,000)||(19,001,900.19)||$1,900.19|
|Subscriptions @ Swing Price||$4,000,000||4,000,400.04||($400.04)|
|Net Subscrip-tions @ NAV||$15,000,000||15,000,000.00||—|
|End of Day||$600,000,000||599,998,499.85||$1,500.15||$1.0000026|
Impact on the Fund
In this example, the swing pricing proposal accomplishes its purpose of withholding a sufficient amount from the redeeming shareholders to cover the estimated cost of the net redemptions. The fund could spend up to $1,500.15 before its net assets would equal its outstanding shares and thereby return its NAV to exactly $1.0000. This is more than enough to cover the $976 of estimated costs of selling vertical slices of the portfolio. The additional $524.15 is attributable to rounding the swing price down to $0.9999.
The fund should never incur these estimated costs, however. Rule 2a-7 requires the fund to maintain at least 10% of its net assets ($60 million) in daily liquid assets, so the fund will have more than enough cash to cover the $15 million of net redemptions in the first two periods. Net subscriptions in the final period will fully restore the outlay, so the fund will not need to sell anything to return to the same position as it began the day. In this circumstance, swing pricing would produce a $1,500 windfall for the fund’s remaining shareholders at the expense of shareholders redeeming in the first two pricing periods.
Impact on Subscribers
Subscribers during the swing pricing periods receive an additional windfall of 400.04 more shares than they would have received if they purchased at the NAV. This windfall also came at the expense of the shareholders redeeming at the swing price, which is why the swing price increased the number of shares redeemed by 1,900.19 but reduced the shares outstanding by only 1,500.15. In effect, the redeeming shareholders gave the subscribing shareholders 400.04 of their shares for free.
The SEC regards this windfall to subscribers as a feature, not a bug, of swing pricing:
under the proposed swing pricing approach redeemers compensate the fund for the dilution of redemptions as well as the dilution from subscriptions. Thus, redeemers would subsidize subscribers in the fund – an incentive effect that may be particularly important when liquidity is scarce and a fund is facing a wave of redemptions.”
The proposing release was published in the Federal Register on February 8, and comments are due on April 11. So, it’s time to begin an assessment of the merits of the swing pricing proposal.