This continues my series of posts on 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. Having address the estimated costs that institutional money funds must always include in their swing price, this post considers the “market impact factor” to be included when net redemptions exceed the market impact threshold. I suspect the SEC underestimated the difficulty of estimating market impact factors.
How Should Funds Estimate a Market Impact Factor?
To review, a market impact factor
The proposing release acknowledges
To make the process more manageable:
the proposed rule would permit a fund to estimate costs and the market impact factor for each type of security with the same or substantially similar characteristics and apply those estimates to all securities of that type….”
The release does not explain how a swing pricing administrator should estimate these market impacts.
The Structural Liquidity of Money Funds
The proposing release does ask for comment on whether “institutional funds already estimate market impact factors, or perform similar analyses, to inform trading decisions?” Money funds may do this, but rarely and for a narrow subset of their portfolio. The reason lies in the inherent liquidity of a money fund portfolio.
Generally, any mutual fund has four potential sources of liquidity (short of recourse to lines of credit or overdrafts):
- Cash equivalents (e.g., overnight investments or daily demand features);
- Net subscriptions;
- Maturing investments; and
- Sales from their portfolios.
Rule 2a-7 requires money funds to maintain 10% of their net asset in daily liquid assets and 30% in weekly liquid assets, which is much higher than most other types of mutual funds. In practice the percentages are even higher.
According to analysis of Form N-MFP data from October 2016 to February 2020, the average amount of daily liquid assets and weekly liquid assets for prime money market funds was 31% and 49%, respectively.”
While the SEC concedes that institutional money funds use daily liquidity to fund redemptions without selling portfolio holdings, it asserts that swing pricing
This assumes that an institutional money fund must sell holdings (thereby incurring transaction costs) to rebalance its portfolio.
But this ignores the cash provided by maturing securities. As noted above, on average 18% of a prime fund’s portfolio will mature within seven-days, quickly restoring the fund’s daily liquidity without selling holdings. There will be another tranche of maturing securities behind these weekly liquid assets. One fund that provides a maturity distribution for its portfolio shows another 6.5% maturing between 8 and 30 days. Altogether, three-quarters of that fund’s portfolio were scheduled to mature in 30 days or less.
Given that institutional money funds historically maintain weighted average lives in the 50 day range, maturing investments provide a significant source of liquidity not available to other types of mutual funds. Funds use this cash to rebalance their portfolio without selling holdings.
No Trading, No Analysis
A fund that rarely trades has few occasions to “estimate market impact factors, or perform similar analyses, to inform trading decisions.” Unless the market impact threshold is set at a level when funds would really need to sell holdings, swing pricing administrators may lack the data needed to estimate market impact factors.
When an institutional money fund needs to sell holdings, it is most likely to sell Treasury securities and federal agency notes. These investments count as daily and weekly liquid assets (respectively) even if they do not mature in one or seven days. I have previously explained why the market impact of selling Treasury securities is likely to be zero. I cannot find trading data for agency securities, but the Federal Home Loan Banks have over $300 billion of discount notes outstanding, so I would not expect a sale of a few million dollars to have a market impact.
The short-term structure of an institutional money fund’s portfolio means that:
- The fund is more likely to raise liquidity from maturing investments than from portfolio sales; and
- When the fund needs to sell holdings, it is most likely to sell Treasury and federal agency securities, which sales are least likely to have a market impact.
One consequence of this structural liquidity is that a swing pricing administrator will find it challenging to estimate market impacts. A more important consequence is that it makes it unlikely that a fund will actually incur the estimated costs being passed onto redeeming shareholders by the swing price. I will discuss the significance of this in my next post.