Comments on the SEC’s proposed money market fund reforms were due April 11, so it is time to wrap up my series on the swing pricing proposal included in the reform package. In this final post, I want to consider some baffling references to “liquidity externalities that money market fund liquidity management practices may impose on market participants transacting in the same asset classes.” I cannot find an interpretation of these references that comport with my understanding of “externalities.”
What Are Externalities?
Thanks to Google, I found a wonderfully terse explanation of an “externality.”
Externality: Externalities arise whenever the actions of one economic agent directly affect another economic agent outside the market mechanism
Externality example: a steel plant that pollutes a river used for recreation
Not an externality example: a steel plant uses more electricity and bids up the price of electricity for other electricity customers
Externalities are one important case of market failure”
This comes from lecture slides prepared by Stéfanie Stantcheva, an economics professor at Harvard University.
What Externalities Are the SEC Talking About?
The proposing release uses “liquidity externalities” to refer to two situations. First:
redeeming investors impose negative liquidity externalities on investors remaining in the fund (“fund dilution”) ….”
My earlier posts have considered “fund dilution” at length. On the rare occasions that redemptions require a money market fund to sell portfolio holdings this results in a true externality, insofar as the remaining shareholders bear costs caused by redeeming shareholders.
Second, the proposing release refers to “liquidity externalities … impose[d] on market participants transacting in the same asset classes.” I cannot find a description of these externalities in the proposing release. The next reference to this type of externality states:
Moreover, as discussed above, liquidity management by money market funds imposes externalities on all participants investing in the same asset classes.”
But the only topic “discussed above” is fund dilution.
Subsequent references to externalities imposed on market participants (rather than remaining shareholders) occur in the discussion of “market impact factors.” For example, the explanation for why the SEC did not propose to leave the imposition of market impact factors to the discretion of the swing pricing administrator includes a concern that:
because money market funds may not internalize the externalities that their liquidity management practices may impose on investors in the same asset class, they may not be incentivized to use such discretion in a way that mitigates those externalities.”
Given the context, I can only conclude that the second “externality” is the market impact of a money market fund selling securities.
Market Impacts Are Not Externalities
The “market impact” would occur when a money market fund sells a security at a price below the current best bid at which other market participants have valued the security. Bidders do not offer to purchase unlimited quantities of a security. If the quantity being sold exceeds the capacity of the best bid, the fund must accept the next best bid(s) for the remaining amount.
But the reduction in price does not occur “outside the market mechanism,” which is critical to the definition of an externality. A fund’s demand for liquidity is analogous to a steel plant’s demand for electricity, which is not an externality. Price changes are a sign of a functioning market, not of a market failure.
I suspect that this is an inapt reference to the risk that a run on a fund may transform into a run on the market, with numerous market participants trying to sell before prices drops any lower and thereby force prices to continue dropping. This is a cause for concern, but it is not an externality. Panicked sellers are imposing a cost on themselves, so the cost is internalized. Indeed, I wonder if the tendency of some investors to take losses now to avoid greater losses in the future calls into question the efficacy of swing prices as a defense against runs.
I do not know how to prevent runs, but I am sure that the SEC’s swing pricing proposal is not the right approach. Imposing constant, arbitrary swing prices on institutional money funds may drive more investors out of the funds, so they will have less of a market impact. But killing the patient is not the same as curing the disease.