This is the third in my series of posts analyzing the SEC’s recent proposal to require money market funds with floating share prices (“institutional money funds”) to implement “swing pricing” for pricing periods in which the fund has net redemptions. The first post generally explains the proposal. The second summarizes the swing pricing process and illustrates how it would apply to net redemptions below the market impact threshold. This post illustrates how the proposal would address net redemptions exceeding the market impact threshold.
Recap
The previous post assumed an institutional money fund with net assets of $100 million and a net asset value per share (“NAV”) of $1.0000. The fund prices its shares twice each business day, so it has two pricing periods. Under the proposal, the market impact threshold for each pricing period would be 2% of the fund’s net assets.
One of the fund’s holdings is a 2.125% Treasury Note maturing December 31, 2022, with a face amount of $5 million. The current bid price for this note is $101.184 and the asked price is $101.190. The fund uses the “mid” price ($101.187) to value the note.
During the first pricing period on Day One, the fund received orders with a net purchase amount of $1 million, which it priced at $1.0000 per share. During the second pricing period, the fund received orders with a net redemption amount of $1 million. This required the fund to apply a swing factor, but I explained why the swing factor was unlikely to change the fund’s share price. Thus, these orders were also priced at $1.0000. The fund ended Day One as it began, with $100 million in net assets and 100 million shares outstanding.
Day Two/First Pricing Period
If the orders during the first pricing period result in net redemptions of $4 million, the amount would exceed the market impact threshold of $2 million (2% of $100 million), so the fund must apply a swing factor using market impact factors. As explained in the previous post, the proposal would require the fund to base its swing factor on the estimated cost of selling $4 million of its securities on a pro rata basis. This represents 4.0% of its net assets, so the estimate would assume that the fund sells this percentage of each of its investments.
Four percent of the $5 million face amount of the Treasury Note would be $200,000. If the fund sold this face amount for the bid price of $101.184, it would receive $202,368. This is $6 less than the value of a $200,000 face amount of the note using the “mid” price of $101.187. ($200,000 x 101.187/100 = $202,374). This minuscule spread cost is still unlikely to lower the fund’s NAV.
As noted, the swing factor must also include market impact factors. The market impact factor must estimate the change in the price of an investment expected to result from the sale of that amount of the investment under current market conditions.
As noted in my first post, the proposing release states that
The Treasury Note would be a daily liquid asset (Rule 2a-7(a)(8)(ii)) even though it would not mature for a year. Would zero still be a reasonable market impact factor for this note? The release requests comments on this question.
Zero might be a reasonable market impact factor in any case, given that the fund would be selling $200,000 of the note into a market (for Treasury coupon notes with less than two years to maturity) with a monthly trading volume in excess of $50 billion.
Nevertheless, assume for purposes of illustration that the spread and transaction costs and market impact factors for the other investments result in a swing factor of $10,000, which reduces the value of the fund’s net assets to $99,990,000 and its NAV to $0.9999. This would increase the number of shares required to redeem $10,000 to 10,001, with a corresponding increase in the number of shares purchased with a $10,000 investment. Hence, the swing pricing would leave shareholders redeeming during this pricing period with fewer shares and those purchasing with more shares. The $4 million of net redemptions would reduce the net assets to $96 million and the outstanding shares by 4,000,400.04, leaving 95,999,599.96 shares outstanding.
Day Two/Second Pricing Period
If the orders during the second pricing period result in net purchases of $2 million, the fund will not apply a swing factor when calculating the NAV used to price these orders. Without a swing factor and assuming no change in the prices for its portfolio, the fund’s net assets will be $96 million. (The $2 million in subscriptions are what is being priced, so they are not yet included in the fund’s assets). When divided by 95,999,599.96 shares this results in an NAV slightly above $1.00 ($1.0000042), which would round to $1.0000. Note that a shareholder who bought shares in the first pricing period for $0.9999 could realize a gain by redeeming them in the second pricing period for $1.0000.
Having explained my understanding of how the swing pricing proposal would work, subsequent posts will discuss concerns I have with this proposal.