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 surveyed how institutional money funds are supposed to determine swing prices under the proposal, I am turning to when swing pricing would be required. First, I want to consider a unique feature of institutional money funds, namely that many funds calculate a floating net asset value per share (“NAV”) more than once a day. The proposed amendments would define the time from the calculation of one NAV to the next as a “pricing period.” Pricing periods pose two conflicting problems for swing pricing.
First Problem: A Pricing Period Needs a Price
Institutional money funds have pricing periods so they can process orders several times a day. More particularly, they calculate a NAV early in the day so redeeming shareholders will receive their wire transfers from the fund early in the day. This allows redeeming shareholders to apply cash wired from the fund throughout the day.
Once a fund sends money to a redeeming shareholder, it cannot get it back. This means that a fund needs to know whether to use a swing price when it calculates its NAV at the end of each pricing period. This presumably is why the SEC proposes to require swing prices whenever there are net redemptions for any pricing period rather than for an entire day. This may also be why the market impact threshold is divided among the pricing periods. This approach would assure that, if cumulative net redemptions of multiple pricing periods eventually exceed 4%, market impact thresholds would have been applied to the swing price for each pricing period.
Second Problem: Pricing Periods Have Patterns
Recall that the objective of swing pricing is to—
The SEC’s proposed pricing period-by-pricing period approach presumes that net redemptions in an individual pricing period will result in costs that should be passed onto the redeeming shareholders via a swing price. My previous post explained why the structural liquidity of institutional money funds make this unlikely. Beyond this, net subscriptions may offset net redemptions, thus reducing or eliminating any drain on the fund’s liquidity.
My earlier example illustrated this when net subscriptions from the last pricing period exactly offset net redemptions from the first two periods. Many funds regularly experience this pattern of net redemptions in early pricing periods and net subscriptions in the final pricing period. As explained above, early pricing periods give shareholders access to money during the day, so shareholders who need cash often place their redemption orders early. But there is no rush to place a subscription; funds pay dividends to record shareholders at the end of each day, which allows an investor to wait until the last pricing period to determine what cash balances need to be invested.
Causing Dilution to Prevent Dilution
Here is the critical fact that will guide my posts going forward: A swing price that “passes on” estimated costs a fund never incurs will dilute shareholders redeeming at the swing price. This dilution will benefit (1) investors whose subscriptions are priced at the swing price and (2) the remaining shareholders. In this circumstance, the swing price will have the same effect as an NAV error.
If a fund has a common pattern of net redemptions in early pricing periods followed by net subscriptions in the final pricing period, the swing pricing proposal will consistently overcharge shareholders who redeem in the earlier pricing periods. This is because a fund would not sell holdings before the final pricing period when the fund could determine the cumulative impact of the day’s orders on its liquidity. Even if net subscriptions in the final pricing period do not offset net redemptions in the earlier periods, as in my example, they will reduce the liquidity the fund needs to replace, thereby reducing the costs of rebalancing the fund.
The problems of pricing periods create a dilemma: an institutional money fund cannot wait until the final pricing period to determine whether to impose a swing price for an earlier period, but the fund cannot tell until the final pricing period whether the swing price will create or prevent unfair dilution. Resolution of this dilemma requires (1) basing the swing price on realistic cost estimates and (2) using a swing price only when net redemptions reach a level at which the fund is likely to incur the estimated costs.