SEC Reforms' Swing Pricing Proposal
As we reported last week, the SEC's Money Market Fund Reforms Proposal recommends higher liquidity levels, the removal of the emergency gates and fees and a new swing pricing mandate for Prime Inst MMFs. (See the Proposed Rules here, the press release here and the Fact Sheet here. Also, see our Dec. 16 News "SEC Proposes MMF Reforms: More Liquidity, No Gates/Fees, Swing Pricing.") We're still wading through the 325-page rule, but today we quote from the most controversial section of the proposal, "swing pricing." On page 44, the SEC writes about its "Proposed Swing Pricing Requirement," "We are proposing a swing pricing requirement specifically for institutional prime and institutional tax-exempt money market funds that would apply when the fund experiences net redemptions. This requirement is designed to ensure that the costs stemming from net redemptions are fairly allocated and do not give rise to a first-mover advantage or dilution under either normal or stressed market conditions. The swing pricing requirement would complement our proposal to require funds to hold additional liquidity by requiring redeeming investors to pay the cost of depleting a fund's liquidity. Requiring swing pricing also would address a fund's potential reluctance to impose a voluntary liquidity fee even when doing so might be beneficial to the fund. Swing pricing is a process of adjusting a fund's current NAV such that the transaction price effectively passes on costs stemming from shareholder transaction flows out of the fund to shareholders associated with that activity. Trading activity and other changes in portfolio holdings associated with meeting redemptions may impose costs, including trading costs and costs of depleting a fund's daily or weekly liquid assets. These costs, which currently are borne by the remaining investors in the fund, can dilute the interests of non-redeeming shareholders. This can create incentives for shareholders to redeem quickly to avoid losses, particularly in times of market stress. If shareholder redemptions are motivated by this first-mover advantage, they can lead to increasing outflows, and as the level of outflows from a fund increases, the incentive for remaining shareholders to redeem may also increase. Regardless of whether investor redemptions are motivated by a first-mover advantage or other factors, there can be significant, unfair adverse consequences to remaining investors in a fund in these circumstances, including material dilution of remaining investors' interests in the fund. Swing pricing can reduce the potential for dilution of investors who choose to remain in the fund." It explains, "The proposed swing pricing requirement is designed to address these concerns. Under the proposal, an institutional fund would be required to adjust its current NAV per share by a swing factor reflecting spread and transaction costs, as applicable, if the fund has net redemptions for the pricing period. If the institutional fund has net redemptions for a pricing period that exceed the 'market impact threshold,' which would be defined as 4% of the fund's net asset value divided by the number of pricing periods the fund has in a business day, or such smaller amount of net redemptions as the swing pricing administrator determines, the swing factor would also include market impacts, as described below. The 'pricing period' would be defined, in substance, to mean the period of time in which an order to purchase or sell securities issued by the fund must be received to be priced at the next computed NAV. This is designed to address money market funds that compute their NAVs multiple times per day. For example, if a fund computes a NAV as of 12:00 p.m. and 4:00 p.m., the fund would determine if it had net redemptions for each pricing period and, if so, apply swing pricing for the corresponding NAV calculation. Consistent with the approach taken by the Commission with respect to the swing pricing provision in rule 22c-1, an institutional fund with multiple share classes must determine whether it experienced net redemption activity across all share classes in the aggregate, rather than determining net redemption activity on a class by class basis. A mandatory swing pricing regime for net redemptions is intended to address funds' (or fund boards') likely reluctance to impose a voluntary swing pricing regime or voluntary liquidity fee. For example, while money market funds were permitted to impose liquidity fees on redeeming investors under rule 2a-7 if a fund had less than 30% of its assets invested in weekly liquid assets no money market fund imposed such fees during the March 2020 market turmoil. Moreover, even if all institutional money market funds recognized the benefits of charging redeeming investors for liquidity costs, we believe there is a collective action problem in which no fund would want to be the first to adopt such an approach. We believe past experience with the existing liquidity fee regime supports a mandatory approach to dilution mitigation for institutional funds." The section adds, "Our proposed money market fund swing pricing framework specifies how an institutional fund would determine its swing factor, which would differ based on the amount of net redemptions.... The swing factor would be determined by calculating identified types of costs the fund would incur, as applicable, by selling a pro rata amount of each security in its portfolio to satisfy the amount of net redemptions for the pricing period. The requirement that a money market fund calculate costs to sell a pro rata amount of each security in its portfolio -- a 'vertical slice' of the portfolio -- is designed to ensure that a fund's adjusted NAV incorporate the costs of selling its less liquid holdings, which may protect remaining shareholders from dilution and may discourage investors from redeeming quickly during periods of market stress to seek to avoid potential costs from a fund's future sale of less liquid securities. For example, when investors redeem, if those redemptions are met through daily or weekly liquid assets, the redemptions leave the fund with less liquidity. This increases the likelihood that further redemptions could require the fund to sell less liquid assets or incur costs in rebalancing the portfolio. Although further redemptions may be more likely to require the fund to sell less liquid assets in times of market stress when redemptions may be elevated, redeeming investors depleting a fund's daily and weekly liquid assets can impose liquidity costs on the remaining shareholders as well as the fund generally, even during non-stressed periods. This depletion of a money market fund’s liquidity can dilute the interests of remaining investors and also can create a first-mover advantage for investors who redeem in an attempt to avoid bearing the costs created by other investors' redemptions. The factors a fund must take into account when calculating the swing factor vary depending on the size of net redemptions for the pricing period.... If the fund has net redemptions that do not exceed the market impact threshold, the swing factor reflects the spread costs and other transaction costs (i.e., brokerage commissions, custody fees, and any other charges, fees, and taxes associated with portfolio security sales), as applicable, from selling a vertical slice of the portfolio to meet those net redemptions."
