In July 2023, the Securities and Exchange Commission (SEC) issued a new set of reforms for the US money market fund (MMF) industry. The reforms increase the amount of daily and weekly liquid assets a fund must hold, eliminate the link between weekly liquid assets (WLA) and the option to impose liquidity fees and redemption gates, and introduce a dynamic liquidity fee. This article describes some of the most important provisions of the reforms.
Mandatory “dynamic” liquidity fees
An important feature of the new reforms is the introduction of mandatory “dynamic” liquidity fees for institutional prime and tax-exempt MMFs (institutional funds are those held by institutional investors, such as corporate treasurers and insurance companies, rather than retail investors). The fees will be imposed if, on a given day, a fund experiences net redemptions in excess of 5 percent of its assets. The fees are dynamic, in that they are set based on current market conditions. Specifically, the fee will be based on the cost of liquidating a slice of a fund’s entire portfolio (not just the most liquid assets in the portfolio). The fee should incorporate all costs of redemptions (including transactions costs, bid-ask spread costs, costs of portfolio rebalancing to replenish liquidity, and market impact).
Since estimating liquidity costs can be difficult, a fund that cannot accurately quantify those costs also has the option to impose a default liquidity fee of 1 percent. Moreover, to prevent a fee being imposed when a fund experiences heavy redemptions but is not otherwise under stress, a fund will be allowed to waive fees that are less than 1/100 of a cent (1 basis point) per share.
Dynamic liquidity fees and swing pricing
The SEC’s dynamic liquidity fees are economically identical to partial swing pricing, where a fund reduces, or “swings” down, the price it pays redeeming investors on days when the costs of managing redemptions are high. Like swing pricing, dynamic liquidity fees impose liquidity costs on redeeming investors when same-day redemptions exceed a specified threshold. This reduces investors’ incentive to run when liquidity conditions in the markets deteriorate. Moreover, the fees protect remaining shareholders from dilution and allocate redemption costs more fairly across redeeming and non-redeeming investors.
As explained in an earlier post on Liberty Street Economics, since swing pricing is based on same-day net outflows, it is not a source of preemptive runs. The logic is straightforward: If investors seek to redeem preemptively, that day’s extra redemptions increase the odds of a downward swing in share prices, reducing the incentive to run. The same logic applies to the dynamic liquidity fees introduced by the SEC in the 2023 reforms, as these fees are also based on same-day net outflows. This contrasts with the existing system of WLA-linked fees, abolished by the new reforms. With those fees, investors can run preemptively as a fund’s liquidity starts to dwindle, since they know that no amount of same-day redemptions triggers a fee.