Swing pricing is widely used in Europe to regulate money market mutual funds. If instituted here in the U.S., funds would be required to adjust their share prices to reflect transactions costs. During periods of heavy withdrawals, that would also include the effect of selling assets that are less liquid.AFP recently caught up with Peter Crane, president of Crane Data, publisher of Money Fund Intelligence, to talk about how this would work in the U.S. under the SEC’s four proposals.
AFP: The SEC had proposed four basic proposals. The first one was an amendment for portfolio liquidity, daily to 25% and 50% to weekly. Was this impacting both government and prime?
Crane: On the surface, it looks like it covers all funds, but because treasuries are considered daily liquid assets and government agency discount notes are considered weekly liquid assets, most government funds are already 90% weekly liquid or 100%, so they would have no trouble hitting it just in the normal course of what they're doing.
Retail gets hit with this too. With most of the other regulations, it gets a pass. So yes, this is going to make them hold more government securities and have less yield. Certainly, this will have an impact, but it's an understood, manageable impact and the funds might be able to barbell, pick up more yield with a piece of their portfolio if they know they have these big liquidity cushions. And, in the near future, they won't get hurt because with rates going up, repo and overnight stuff is where you want to be. It adjusts faster, so holding these giant swaths of repo won't hurt, like it may in a falling rate environment.
AFP: If this applies to prime funds, that's really going to push those securities that are very short; there's going to be a higher demand and a premium for a lot of that, especially if issuing from the corporate space, that might be a cheaper source of liquidity for them potentially versus out further, correct?
Crane: Yes. There's not a whole lot of corporate supply in that short window space. It's short, but it's not daily and weekly. You're talking about treasuries, and normally it makes sense to hold. One year treasury qualifies as daily liquid assets, so you could buy a one-week treasury or a one-year treasury and pick and choose, depending on what the yield curve's doing. And that's the Fed RRP, the Fed repo program with that unlimited bucket in the short term. How long that'll be there, we don't know. We assume it'll be there for the foreseeable future. So the Treasury bills and Fed repo are going to be doing most of the heavy lifting in that short term, and then whatever maturities you have coming into that window would qualify as well. Supply's been a challenge in the money markets in general, but the Fed repo program has alleviated a lot of that.
AFP: Let's move to the proposal then, which is a big one: removing gates and fees. And again, does this apply to both government and prime?
Crane: The government funds could have opted into a gates and fee regime. None ever did. So in practicality, it doesn't apply to them. This would be prime institutional and it’s giving a little kiss to prime retail, because of their lack of outflows.
If indeed the gates and fees are removed in the final rule, you could see, depending on how the swing pricing (or whatever they choose to do) is implemented, retail money funds or retail prime funds come out ahead in this. But yeah, it's a shocker that they just totally dismantled the gates and fees regime.
The swing pricing proposal may have been more for show than actuality. They may have known it's going to get beaten back and changed, or at least it may get defanged a little bit. There are a lot of issues underneath there that need to be worked out.
AFP: Let's jump into swing pricing. How does this actually work? Does it move like a closed mutual fund where there's a premium and discount applied to the NAV? How does swing pricing work in a money market fund?
Crane: In effect, it's another form of a liquidity fee where the managers are going to have to price their securities during the day, which nobody has ever done. Mid-day, they're going to have to know, while they're seeing flows, whether they need to implement a penalty price. Where they're not at a dollar, they're taking a fraction of a haircut because they see that it may cost them money to sell a representative slice of their portfolio. So they're supposed to look at their portfolio, estimate if we had to liquidate say 2% of it right now, what would the cost of those transactions be? Would the bid price be under the market price?
And the problem is that money market securities don't trade during the day. Treasury bills trade, commercial paper and CDs, though the vast majority is held to majority. So that intra-maturity pricing is already a subjective exercise. And you're looking at a lot of the end-of-the-day shadow pricing, mark to market pricing on the four-digit NAV that prime institutional funds have. A lot of that's marked to model where they're taking various spots along the yield curve, they're saying, "Okay, the price probably would be here." So it's a subjective exercise in the first place, doing that inter-day and then adding on this fudge factor, this market impact on top. Certainly, the whole goal of it is you're really trying to penalize those investors that are leaving and not have them get a higher price than what is left in the portfolio.
That's the whole quandary the SEC has, and money funds have had since their inception, is if somebody's selling and they're getting a dollar back, you don't want your portfolio to be less than a dollar, because if you got a little hole and people are selling, the hole grows.
The gates and fees concept was elegant. It was actually well designed, but in practice, investors just hated it, so it didn't work. The goal is, as you're selling, you want your NAV going up, not down. And there are issues with that too. It's like, well is that income? Is that a gain? And so like last time, they're going to have to get a series of tax act exemptions.
But it seems that they're looking at multiple strike prices and some institutional funds will strike three times a day. Some will strike at the end of the day. And what this may do is cause the ones that do multiple strikes to disappear, and you may get just one at end of the day. Because the SEC has this odd feature in there, if it's a 4% asset move, then you have to divide it by the number of strike prices. So if any of those windows is 1.5% percent down, then you'd have to calculate and take a lower price. Those transactions get spread out. It's not like you have a bunch in the morning, a bunch at noon and a bunch at the end of the day. You have a tiny fraction in the morning, a tiny fraction noon and at the end of the day is when you get most of your trades coming in and being done. So those intra-day issues are just mystifying and confusing. How the industry handles that is going to be, I don't want to say a nightmare, but it's not going to be fun when they look at that.
Thankfully the proposal states this is a 4% level. They looked at historical flows and that won't be triggered often, but certainly, you're going to have to be looking at things every day and saying, should you swing price? No. And then all of a sudden you get an outflow and PMs will have questions like, what if you have an outflow that you know is coming? That's what a lot of funds have, they have KYC mandates, and they know when some of these big, chunky moves are coming in. With the very big funds, of course, everything gets washed in, and even one customer can't really move the needle. But with smaller and intermediate-term funds, in which the prime funds are not the size of the government funds anymore, they're not that gigantic. A planned move may, all of a sudden, trigger a swing pricing question or look at whether you should be using that. So, yeah, it's ugly. I don't understand it, and I'm still reading.
Commissioner Peirce of the SEC said, "The proposed version of swing pricing — with its market impact factors — may differ from what commenters envisioned, but I remain unconvinced that the addition of complexity and subjectivity to swing pricing calculations will succeed in altering investor decision-making. Commenters also pointed to the real operational difficulties associated, which the release acknowledges."
There's this third-party pricing mandate too, where the portfolio managers aren't supposed to be doing the swing pricing. They've got to get a transfer agent or a custodian or an outside pricing service to do this for them. Even then, I can imagine them picking up the phone or WhatsApp or whatever they're doing now, and saying, "Can you get me the price?" And they'll give them the price. You need a real-time price while some of the stuff's going on, and it's just a real tough problem.
AFP: It could make prime money market funds more expensive to operate and therefore less profitable to have, I'm assuming.
Crane: Whatever they come up with, they're not going to remove the gates and fees and just leave you with nothing. You'll get a swing-pricing regime. It may be defanged and structured so it operates a little more like a liquidity fee or an emergency liquidity fee, or you may get a straight emergency liquidity fee, but either way, you're likely going to have a shrinkage decline in prime assets, whether it's by a little bit or a lot, we'll see. But the interesting thing is the whole prime segment is only 16.5% of the $5 trillion in money funds; a big chunk of those are these internal prime funds that the SEC acknowledged. They're not available to outside investors. The ones held by institutional investors are $200-300 billion max.
When the last amendments went into effect in 2016, a lot of firms started offering ultra-short bonds, separately managed accounts and other vehicles that have taken up some of the slack. The commercial paper market and institutional CD market have a diversified base. It's not going to be good for them, but where there's a yield, there's a way. And oddly enough, the Fed is talking about raising rates while we're talking about regulation, and almost the same timetable happened in 2014.
AFP: With swing pricing, it could also influence certain types of securities issued, right? Would they want to go to more floating rate securities or certain issuers?
Crane: I'm not well versed in how the pricing operates currently, but there must be a premium for higher quality, bigger issuance and floating rate and something that does not have your principle. A longer maturity is going to move the principle a little bit. And as we saw in March 2020, you saw the longer-term CDs, the big bank CDs that are chunky, that's giving them the yield, but some funds were forced to sell those to provide liquidity. And that's what disturbed the SEC: funds weren't using their liquidity; they were selling their chunkiest pieces at the end because those were the pieces that were starting to move the NAV and were the hardest to value. So you're going to have not just those big liquidity buckets, but people being afraid of the pricing impact. One of my jokes is that amortized cost and mark to market are the same until something blows up and then they're both wrong. So you're going to spend all this time and effort, and the prices are going to be exactly the same. But then, how do you account for a scenario where all of a sudden world governments decide we're going to shut down the economy on Monday? The ludicrousness is that it's the government's fault that this all happened. Sure, they were trying to protect people, what they thought was the right thing to do, but they caused the problem by shutting down and by raising the question, “When are we going to get cash again?" Of course businesses and institutions are going to freak out and raise cash like there’s no tomorrow. You didn't tell them when they might get cash again, so they're going to scramble for as much cash as they can. AFP: From an investor perspective, the risk-return paradigm might push some investors out, especially on the institutional side, if there isn't a slight premium over government funds for prime funds. Because of the swing pricing, it's probably not going to be very appetizing for institutional investors. Have you heard that from anyone that you work with?
Crane: Yeah. That's nothing new. You look at institutional assets and 90% of them are government that the prime recovery has been grudging. You've even seen some declines in prime assets throughout the last couple of months when money funds got their end of the year bump. Government assets have been growing strongly, so prime has been drifting down a little bit. But the yield spreads are one basis point, two basis points, on a gross basis there you're looking at maybe eight basis-point spreads. And so, the providers actually have a little bit of an incentive because they don't have to wave as many fees. But from an end-user's perspective, there's no incentive. Historically, when yields are back toward normal, we had discussions of how many basis points it would take to make people like the emergency gates and fees. That level of certainly is higher than where it is right now. And so I yield, if and when it returns, may start rebuilding interest in that space. But yeah, the zero yields with regulatory overhang is a double whammy for prime.
AFP: Did the yield curve adjust when the Fed announced they'll probably do three rates increases next year? Did it move as a result?
Crane: Grosses on prime retail funds went up a basis point last month. You've seen a bottoming out; the low was four or five months ago, so you've seen this tiny recovery in yields. And you'll see that because even though they're looking out into next year, prime funds are mandated to hold 30% liquidity, but they typically hold 40% anyway; a lot hold 45%, 50%. So that 50% weekly liquid is not a big stretch. The daily liquid's going to have to make them hold a little more repo and Treasury, and that's a bigger hurdle to jump, but their other stuff is short too. Especially if they don't want their NAV moving, they're stuck in here. So it's going to take them getting closer to that March or June hike, or whenever it might be, to real start getting more yield coming in. And they'll inch up ahead of it, but not until the Fed moves. Money fund yields follow the Fed, so it takes the hike to move them more than a few basis points.
AFP: The last section in the proposal is called “other proposed amendments.” This one was interesting, where a stable NAV could be converted to a floating NAV fund if future market conditions result in negative fund yields. Has that ever happened, where there's been negative fund yields?
Crane: No, but the flip side of that coin, they proposed banning the reverse distribution mechanism, so you had several periods where money funds were staring it in the face, and they've been waiving fees — they're waiving two-thirds, three-quarters of the 30 basis points, 25 basis points in fees that they'd normally charge. They’re surviving on seven basis points — less for government funds, more for prime funds. But they never had to go negative. The option was shut the fund or pass through these costs, so funds decided, "We're just going to eat the cost or survive on these lower revenues." You need something to pass those costs along, and your two choices are you float the NAV and gradually erode down, you bend the buck or erode the buck going down, or you've got to sell shares with a mechanism.
That was this reverse distribution mechanism Europe used to have, and the U.S. was talking about having. And the SEC came out and said, "No, you won't be able to do that" in this proposal, which was odd. I don't know why. It seemed like a better choice than allowing the NAV to just float down.
Thankfully neither of those scenarios is a really big concern right now. Of course, you could get negative yields or the threat of negative yields again at some point in the future, so the SEC is doing a little housekeeping there. Then of course the other piece is the additional disclosures that are thrown in there, and I call that the Crane Data Christmas present list.
AFP: I would think you would like that, a little more transparency.
Crane: It's a pain in the behind, but with all that extra disclosure data, firms like ours are going to be digging through and trying to make it easier for people.
AFP: Government funds never went negative, especially in March, did they?
Crane: No. The treasuries have flashed negative, there have been periods where a few trades went negative, but they never went solidly negative.
We had some trades go negative, and what you saw back in 2009, 2012, and again in 2020 a little bit, when you had some of these negative flashes, you would have treasury funds restrict inflows too, because if securities traded negative, the institutional money would move into the funds. And the treasury funds held the older, higher yielding securities, so they would mini-arbitrage and do that. So when they saw that money coming in, they'd restrict it because they knew to reinvest it, they'd have to put it into negative stuff and drive stuff even lower. And once the Fed RRP program came in, it was in part to avoid that, to put in that five basis point floor. That really was the end of it, where if you could get five basis points from the Fed, nobody had to worry about getting negative on anything else.
AFP: Is it still five basis point for RRP?
AFP: And they were quiet about their plan regarding that program, weren't they?
Crane: Yes, but it's quietly a trillion and a half. It's quiet, but it's very big.
AFP: It's one of the levers.
Crane: Yeah. It saved a lot of strain, a lot of stress and there has been talk about getting rid of that or that being a crutch to the market. It's been seen as more good than bad, unlike a lot of the government support. It's crazy because any time they help someone, they figure, "Oh, we've got to stop that. It's no good. We don't want to help any big banks or anyone who's doing any good in the economy."
AFP: How many fund sponsors had to prop up their funds in March? Was it a lot of them?
Crane: You had to provide liquidity, and you could see these in the footnotes of the release if you read through, it's laden with footnotes. One of the SEC's concerns was that you didn't have anyone to implement a liquidity fear gates, and that's what it was designed to do. And then the fear was, if you did that, it would trigger even more concern. How they avoid that problem is the trick here. It's like if someone, all of a sudden, starts swing pricing and starts pricing with a penalty, I don't think that's going to be interpreted as thank goodness either.
AFP: That could really differentiate a lot of funds. I mean, there could be some wide pricing.
Crane: That's the interesting part: The SEC decided that the solution was to take that decision out of the funds’ hands, because the funds would be reluctant to give the medicine. They're trying to make it automatic, but how it's automatic across funds is unclear. And, with their series of questions, they're like, "Should different funds be able to do different things to solve this?" It's an ugly mess. If you include the European regulatory issues going on, you're going to see another big round here in the next 60 days.
It's not unprecedented for the SEC to come out, propose one thing and then change their mind and just throw something different in. The last round, you had them come in and propose something softer and then come in and hit with the gates and the fees. There's a lot of moving pieces. All the comment letters are going to hold sway, as will what European regulators are doing with their money funds. I think that's one of the reasons they came to swing pricing is because the Europeans like it. But it may be just to appease them to throw it out there and then to get more ammo to say, "Listen everybody hates this thing.”
AFP: There are three formats of money funds in Europe, right? There's the stable NAV, the CNAV, then the floating NAV, where is most of —
Crane: The LVNAV. That may get changed; it’s an odd hybrid of a CNAV and a VNAV. You're CNAV until you reach a certain level and then you go floating. So that LVNAV has worked well in the past, but that may be at risk where they say you've got to fully float. As we've seen in the U.S., the fully floating NAV is what people originally feared would be unpalatable to big investors, and it turned out they didn't mind the floating NAV — as long as it doesn’t go down.
But even in March 2020, some of the NAVs were down to 0.9991. And you'll still see negative returns on institutional money funds over some period. And people just don't seem to be averse to those or react because in the end, the floating down and floating up should even out unless you get a default, or something blows up. Those scenarios are mercifully few in money fund land; we haven't seen a default in a long, long time.