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. In this post, I consider the effects of swinging a price too frequently.
The Cost of Swing Pricing
My last post observed that: “A swing price that ‘passes on’ estimated costs a fund never incurs will dilute shareholders redeeming at the swing price.” This dilution will enrich investors who subscribe at the swing price and the remaining shareholders at the redeeming shareholders’ expense. This would be a “cost” swing pricing imposes on redeeming shareholders.
On the other hand, if the fund eventually incurs costs attributable to the redemptions, then a swing price that passes on these costs would reduce dilution of the remaining shareholders. This is the benefit swing pricing seeks to achieve.
Two factors would increase the benefits and reduce the costs of the swing pricing proposal:
- basing the swing price on realistic cost estimates, and
- using a swing price only when the fund is likely to incur the estimated costs.
I hope my earlier posts have established that the “selling a vertical slice” approach to estimating costs would not result in realistic estimates and would systematically overcharge redeeming shareholders. In this post, I hope to establish that the proposal would require swing pricing when there is no reasonable prospect of the fund incurring any costs.
Ordinary Net Redemptions
The proposed amendments would require a fund to calculate a swing price whenever there are net redemptions in a pricing period. The SEC concedes that
Although the SEC posits that funds will need to sell assets to rebalance their portfolios, I have explained how funds use structural liquidity and net subscriptions to rebalance without such sales. I have been working with money market funds for over 30 years and, besides the exercise of demand features at no cost to a fund, have not seen a fund sell assets in response to ordinary net redemptions during a day, still less during a pricing period.
The Market Impact Threshold Is too Low
Swing pricing would be unwarranted even if it was only required when a fund reach the proposed market impact threshold of 4%. The SEC based the market impact threshold on “an analysis of daily flows reported in CraneData on 1,228 days between December 2016 and October 2021.” The SEC chose a 4% threshold so that
In other words, the SEC chose the threshold so every day some institutional money fund would have to apply market impact factors, not because of any relationship between the threshold and the market impact of net redemptions.
Peter Crane was kind enough to share this data set with me, and my (admittedly inexpert) Excel analysis showed at least one institutional money fund with net redemptions exceeding the threshold on 86% of the days in the period. I also analyzed the six-months flow data available at year end on several fund websites.
- Chart 1 shows flows for an institutional municipal money fund, which had net redemptions exceeding 4% on over 30% of the days during the period. Net redemptions exceeded 10% on six days during the period. As nearly 90% of the fund’s portfolio had demand features, the fund had ample capacity to rebalance its portfolio at no cost to the remaining shareholders.
- Chart 2 shows flows for a large institutional prime money fund with a pattern of receiving large inflows on the first day of each week followed by a large outflow on the next day. This pattern produced net redemptions exceeding 4% on 18% of the days during the period. The fund’s daily liquid assets remained over 40% on each of these days and increased to well over 50% over the course of the period.
The SEC’s swing pricing proposal bears no relationship to the frequency with which institutional money funds incur costs due to net redemptions or to the costs incurred. Thus, the SEC cannot have a reasonable expectation that the proposal will “effectively pas[s] on costs stemming from shareholder transaction flows out of the fund to shareholders associated with that activity.” Instead of protecting shareholders from dilution, the proposal would provide windfalls to some shareholders by arbitrarily diluting redeeming shareholders.