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January 31, 2022

Pricing Liquidity without Preemptive Runs

Prime money market funds (MMFs) are vulnerable to runs. This was dramatically illustrated in September 2008 and March 2020, when massive outflows from prime MMFs worsened stress in the short-term funding markets and eased only after taxpayer-supported interventions by the Treasury and the Federal Reserve. In this post, we describe how mechanisms like swing pricing that charge a price for liquidity can reduce the vulnerability of prime MMFs without triggering preemptive runs.

Prime MMF Fragility

One feature of prime MMFs that contributes to their run vulnerability is liquidity transformation. That is, prime MMF shares are more liquid than many of the assets they hold, and even in crises when market liquidity costs for those assets rise, investors who redeem quickly are able to obtain liquidity for free. The costs of their redemptions are instead borne by investors who don’t redeem so fast, so all investors have an incentive to redeem quickly—that is, to run. This first-mover advantage for redeeming investors is present even for funds with floating net asset values (NAVs), such as institutional prime funds, whose share prices fluctuate along with changes in the market-based value of the funds’ assets. Investors in these funds who redeem quickly in times of stress can avoid paying the liquidity costs arising from their redemptions because those costs typically are not immediately reflected in the fund’s NAV.

One way to mitigate run vulnerability is to put a price on liquidity during times of stress, so that redeeming investors pay the costs arising from their redemptions. However, doing so can cause additional problems: if investors are able to foresee when the cost of redeeming will rise, they can run preemptively, as they did in March 2020. Is it possible to price liquidity without causing preemptive runs?

Preemptive Runs

The vulnerability of prime MMFs to runs is well documented following major runs in September 2008 and March 2020. After the 2008 crisis, the Securities and Exchange Commission (SEC) implemented two sets of reforms, in 2010 and 2014. The latter allows prime MMFs to impose redemption fees or gates if their weekly liquid assets (WLA) fall below 30 percent of total assets. The redemption fees and gates were intended, in part, to impose a cost on redeeming investors and thereby to slow runs, but recent research by Li, Li, Macchiavelli, and Zhou (2021) and Cipriani and La Spada (2020) shows that the rule had the opposite effect. MMFs with WLAs close to the 30 percent threshold had larger outflows than MMFs with greater amounts of WLA, and the research links the increased outflows to the redemption fees and gates. In other words, prime fund investors ran preemptively before fees or gates could be used.

The occurrence of preemptive runs should not be surprising. For example, in a 2014 Staff Report and a Liberty Street Economics post, we explained how fees or gates contingent on depleted liquidity could lead to preemptive runs.

Swing Pricing and Equivalent Mechanisms

Recent reports on potential MMF reforms by the President’s Working Group (PWG) on Financial Markets and the Financial Stability Board suggest that “swing pricing”—or economically equivalent mechanisms—could be a safer way of pricing liquidity than the current system of fees and gates. In December 2021, the SEC proposed a swing pricing requirement for institutional prime funds. How would these measures work?

The idea behind swing pricing is to impose a cost for redemptions on the same day that the fund faces large outflows. On those days, the NAV of the fund “swings” down so that redeeming investors receive less for their shares than they otherwise would. The reduction in NAV should be calibrated to match the liquidity costs associated with redemptions. This is the approach proposed by the SEC, although other economically equivalent measures could also be effective. One alternative would be to charge a redemption fee on the same day that the fund has large outflows, rather than reducing the NAV. Whether the price of liquidity is imposed through a reduction in NAV or a fee, the key to avoiding preemptive runs is that the price depends on same-day redemptions.

Preemptive runs can occur when investors are able to anticipate a future increase in liquidity cost and avoid it by redeeming before it’s imposed. For example, under current rules, if a prime fund’s WLA has fallen to near 30 percent and looks likely to drop below that threshold soon, investors can redeem immediately to avoid a possible fee or gate.

By contrast, suppose that the fund charges a price for liquidity that increases with the size of the fund’s same-day net outflows. Investors who believe that a liquidity cost will be imposed tomorrow could choose to redeem today. However, since the liquidity price increases with today’s net outflows, by redeeming, those investors increase the expected liquidity charge that they pay today, so their redemptions are not preemptive. Moreover, since the liquidity price reflects the liquidity cost of redemptions, that cost is no longer borne by remaining investors, and the incentive to run preemptively is eliminated.

This argument is intuitive and is also backed by the academic literature that studies run behavior. This literature shows that when payouts for redeeming investors can be set based on the amount of requested redemptions and if payouts are reduced to offset liquidation costs, runs are eliminated.

Swing pricing has been used by mutual funds in Europe and studied in this paper. As we would expect, the European experience shows that swing pricing has not generated preemptive runs. Moreover, swing pricing eliminates the first-mover advantage arising from liquidity transformation and significantly reduces outflows during market stress.

To Sum Up

Putting a price on MMF liquidity could reduce the fragility of prime funds if that price can be charged without creating a risk of preemptive runs. Preemptive runs can be avoided by using swing pricing or similar tools that price liquidity based on same-day net outflows. These tools would be beneficial for many stakeholders in the short-term funding markets. For example, they would insulate MMF investors from the costs of others’ redemptions when liquidity costs rise. Liquidity pricing could also be useful for fund managers who currently lack tools to stop runs on their funds. Finally, liquidity pricing could benefit taxpayers by reducing the likelihood of future bailouts for MMFs.

Marco Cipriani is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Antoine Martin is a senior vice president in the Bank’s Research and Statistics Group.

Patrick McCabe is a deputy associate director in the Federal Reserve Board’s Division of Research and Statistics.

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