Liquidity risk in markets with trading frictions: What can swing pricing achieve?

A key role of …nancial intermediaries is to provide liquidity – essentially, on-demand access to cash –to their investors. Typically, …nancial intermediaries that provide liquidity also engage in maturity transformation. For example, banks issue long-term loans but grant their depositors the right to withdraw their funds on demand. Similarly, open-end mutual funds (“funds”) that invest in comparatively illiquidsecurities, such as corporate bonds, give their investors the option of redeeming their shares in cash every day. Daily redemptions allow fund investors to insure against their liquidity needs while participating in the higher return their fund earns on less liquid assets. At the same time, funds need to adequately insure the residual liquidity risk that they incur.1 Insu¢ ciently insured liquidity risk can trigger and amplify …nancial crises.

Focus
Can swing pricing, an innovative fund management tool, reduce the redemption risk for open-end mutual funds? How does it affect the liquidity risks of fund investors?
Contribution
Open-end mutual funds are exposed to liquidity risks: they allow investors to redeem their fund shares at short notice, but their own investments are in less liquid assets to earn a return. If investor redemptions are large, the fund needs to sell assets. This is costly and dilutes the value of the fund, hurting investors that stay the course. Funds need to ensure they have enough protection against liquidity risks because, otherwise, investor behaviour could trigger asset price declines and amplify financial crises. We assess the role of “swing pricing”, how the fund should best apply it, and whether this helps to insure against liquidity risks.
Findings
Within a theoretical model, we study how a fund should set the price for investors that want to redeem shares or subscribe to new shares, and how much cash the fund should hold. We find that the best results are achieved if the fund lowers the price when redemptions are large, charging to redeeming investors at least some of the trading costs that the fund incurs. The higher the fund’s trading costs, the lower the settlement price. Correspondingly, the fund raises the price if redemptions and trading costs are low or when it experiences inflows. That said, the difference between the optimal settlement price and the market price of the fund’s assets remains relatively small. This is to discourage costly arbitrage trades that aim to exploit a large difference between the two prices. The fund should also hold a large enough cash buffer to meet expected redemptions. We argue that swing pricing might help ease the risk of self-fulfilling runs on funds.
Abstract
In this paper, we assess the e¤ect of swing pricing –a tool for managing liquidity risk in funds, which several types of US funds will be able to use from November 2018 onwards. Swing pricing permits a fund to pay out less than net asset value (NAV) per share when net redemptions are large. It thereby alleviates a situation in which the fund, in the absence of swing pricing, would have to sell assets at a large discount to generate su¢ cient cash to pay out its redeeming shareholders. Symmetrically, swing pricing allows the fund to raise the price per share above the NAV per share when the fund experiences large net in‡ows. It can thus help to ensure that the costs associated with purchasing additional assets are borne by incoming investors. If investors anticipate that the fund will settle share transactions above the NAV when net demand for its shares is high, and below the NAV when net demand is negative, swing pricing can help reduce the volatility of ‡ows into and out of the fund.
Summary of the BIS Working Papers nr. 663.
Source: http://www.bis.org/