Under rules recently finalized by the SEC
, all money market funds will be permitted, and under some circumstances required, to impose liquidity fees and gates against investor redemptions if the fund’s weekly liquid assets fall below specified thresholds. In their release, the SEC said the purpose of these new rules is to mitigate money market funds’ susceptibility to heavy redemptions and improve their ability to manage and thwart possible contagion from redemptions. An April 14, 2014 paper
published by the the staff of the New York Fed, however, finds that in some cases the imposition of redemption gates may actually increase, rather than decrease, the possibility of runs on a fund.
According to the paper's authors, three Fed economists, if a money fund investor suspect the possibility of a redemption gate, there is less of an incentive for the investor to wait through the period of uncertainty that make the gates necessary, and increases the incentive to preemptively redeem so that the investor will avoid potential losses when the redemption gates are lifted.
As we experienced in the financial crisis, premature redemptions force money funds to liquidate large volumes of securities to meet redemption needs. Consequently, it is generally accepted that it would be better for money market funds and the economy as a whole if investors wait out a period of uncertainty rather than redeeming preemptively at the first sign of trouble. According to the authors, however, the prospect of barriers to exit from a fund may encourage investors to get out quickly rather than play the long game and wait out the market stress. The Fed economists say this is true whether we are talking about redemption gates or liquidity fees: “[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.”
According to the paper's abstract, the authors found:
. . . that allowing the intermediary to impose redemption fees or gates in a crisis—a form of suspension of convertibility—can lead to preemptive runs. In our model, a fraction of investors (depositors) can become informed in advance about a shock to the return on the intermediary’s assets. Later, the informed investors learn the realization of the shock and choose their redemption behavior based on this information.
In testing their hypothesis, the authors built a model of a financial intermediary, in the tradition of Diamond and Dybvig (1983). Using this model, the Fed economists were able to prove two results:
First, there are situations in which informed investors would wait until the uncertainty is resolved before redeeming if redemption fees or gates cannot be imposed, but those same investors would redeem preemptively if fees or gates are possible.
Second, we show that for the intermediary, which maximizes the expected utility only of its own investors, imposing gates or fees can be ex post optimal.
Though the paper's analysis is built primarily upon a model of a financial intermediary, not necessarily the money market mutual funds addressed by the SEC's new rules, the results of the study are nonetheless important in understanding the behavior of investors during periods of financial stress.
These results have important policy implications for intermediaries that are vulnerable to runs, such as money market funds, because the preemptive runs that can be caused by the possibility of gates or fees may have damaging negative externalities.