HSBC Global Asset Management published a paper entitled, "Liquidity Fees: A proposal to reform money market funds," which says, "This paper proposes the introduction of a liquidity fee on money market funds (MMFs); an initiative that could make MMFs more resilient under extreme market conditions and position them to withstand another deep and widespread loss of liquidity in the money markets." The Summary explains, "Since 2008, regulators and industry participants have been debating how to improve the robustness of money market funds (MMFs). In this paper we propose that MMFs could be made significantly more robust if they were empowered to impose a 'liquidity fee' on redeeming shareholders, during periods of market dislocation. Although the paper focuses on US-domiciled MMFs ('2a-7 funds'), our proposal is also relevant to non-US MMFs, such as those domiciled in the European Union."
HSBC continues, "2a-7 funds provide an important service to investors (including corporate treasurers, financial institutions, sovereign wealth funds and others who have large cash balances they wish to place). These investors often prefer to diversify their cash investments in order to manage credit risk. 2a-7 funds offer an attractive solution, providing diversification and a degree of term premium, both of which might be difficult for investors to achieve on a standalone basis. In most respects an investment in a 2a-7 fund is like that in any other investment fund; the monies invested are unambiguously at the investor's risk, and returns are equal to the return on the fund as a whole."
They tell us, "However, there are two subtle, but important differences between the operation of a 2a-7 fund and a typical investment fund. First, the pricing mechanism of a 2a-7 fund means that an investor who invests today and then experiences a sudden need for cash tomorrow can redeem with minimal risk of loss of principal, even if interest rates and/or credit spreads have risen in the intervening period. Second, and more generally, there is a de facto mutualisation or cross subsidisation of risk and return between the investors in a 2a-7 fund: in essence, term premium accrues to all regardless of holding period whilst at the same time all investors have immediate access to their cash."
Authors Jonathan Curry, Chris Cheetham, Travis Barker, and Christopher Martin write, "These two features work well and to the mutual benefit of all investors in almost all circumstances. However, in some circumstances they fail to appropriately price risk, and therefore can result in risk transference. Specifically, when markets are dislocated, costs that ought to be attributed to a redeeming shareholder are externalised on remaining shareholders and on the wider market. Our proposal for a liquidity fee is intended to internalise those costs, and ensure they are paid by the redeeming shareholder and not transferred elsewhere. Since this will result in more effective pricing of risk (in this case, liquidity risk) we believe it will act as a market-based mechanism for improving the robustness and fairness of 2a-7 funds."
They explain, "Like any other investment fund, the value of a share in 2a-7 fund is a function of the value of its portfolio. Since shares in 2a-7 funds are priced to two decimal places, they are sensitive to mark-to-market movements of 50bps (half of one percent) or more in the underlying portfolio. Because it is rare for the portfolio of a 2a-7 fund to move by as much as 50bps, its share price tends to remain constant, hence the description of the fund as tending to have a 'constant' NAV. In September 2008, funding pressure on the banking system meant that the market value of 2a-7 prime funds deteriorated -- but not by as much as 50bps. Therefore, investors were able to continue to redeem from the funds at a constant price, and switch their proceeds into 2a-7 treasury funds, or elsewhere. But in fact, investor redemptions exacerbated the funding pressure of the banking system, which caused a further deterioration in the market value of 2a-7 prime funds. In effect, investors had a free option to switch, by externalising the cost of their redemptions on remaining investors in the fund, and on the market as a whole."
HSBC adds, "The objective of a liquidity fee is to internalise those costs, i.e. to remove the free option and ensure that the costs associated with redemptions are borne by redeeming investors. This will have three important consequences: First, a liquidity fee makes redemptions less likely. Specifically, since redemptions will be properly priced, investors will consider their needs more carefully; unless they believe that certain cost of the liquidity fee is less than the potential cost of remaining in a fund, then they will be unlikely to redeem. Second, a liquidity fee eliminates the 'run dynamic'. Specifically, in the absence of a liquidity fee, there is a first mover advantage.... By requiring investors to pay the full cost of their redemption, the first mover advantage is eliminated, as is the run dynamic. Third, a liquidity fee enhances investor protection, because even if investors do decide to redeem, their decision will be valued in such a way as to equalise remaining investors in the MMF."
Finally, HSBC says, "To conclude, we recommend that 2a-7 funds should have language in their prospectus that requires the Board of Directors to decide whether to impose a liquidity fee if the mid-value per share falls below USD 0.9975. We believe this would have a number of advantages: A liquidity fee makes redemptions less likely. Specifically, since redemptions will be properly priced, investors will consider their needs more carefully; unless they believe that certain cost of the liquidity fee is less than the potential cost of remaining in a fund, then they will be unlikely to redeem. A liquidity fee re-mutualises taking risk between investors by removing the 'first mover' advantage and eliminating the run dynamic. A liquidity fee enhances investor protection, because even if investors do decide to redeem, their decision will be valued in such a way as to equalise remaining investors in the MMF. Finally, a liquidity fee unambiguously ensures that the risks of investment remain with investors, and are not transferred on to the market, tax payers or fund managers."
