Recent money market fund reforms giving funds the ability to impose redemption gates and liquidity fees may actually increase run risk, according to several economists from the Federal Reserve Bank of New York. According to the group, the possibility of a redemption gate reduces the incentive for the investor to wait through a period of uncertainty and increases the incentive to preemptively redeem so that the investor is not forced to share in any potential loss when the gate is lifted. The post notes that the fund and the economy as a whole would be better off were investors to wait through a period of uncertainty as opposed to preemptively redeeming and forcing the fund to prematurely liquidate investments. The same reasoning applies to liquidity fees as well: “[t]he possibility of a fee or any other measure that is costly enough to counter investors’ strong incentives to run amid a crisis will give investors a strong incentive to run preemptively to avoid such measures.”
Interestingly, the SEC discussed these arguments in its adopting release. While acknowledging that “fees and gates do not fully eliminate the incentive to redeem ahead of other investors in times of stress or fully present investors from redeeming shares,” the release explained that nonetheless, in the view of the agency, “fees and gates provide funds and their boards with additional tools to stem heavy redemptions and avoid the type of contagion that occurred during the financial crisis by allocating liquidity costs to those shareholders who impose such costs on funds and by stopping runs.” The SEC also noted that during the financial crisis, if liquidity fees had been imposed, some investors may potentially have “made the economic decision not to redeem because the liquidity fees imposed by the fund and incurred by an investor would have been certain, whereas potential future losses would have been uncertain.”
The post by the economists summarizes findings from a paper released in April entitled here, which more fully details the group’s findings and methodology. The SEC’s adopting release, discussing many of the concepts explored by the group, can be found here.