When the Securities and Exchange Commission finalized its new Money Market Fund rules last month, it explained that fund managers have the option to impose liquidity fees and temporary gates when liquidity fell below a certain point to halt redemptions and prevent the ‘first-mover advantage’ from driving a run on the fund. But Federal Reserve Bank of New York researchers Marco Cipriani, Antoine Martin and Patrick McCabe along with University of Padua economics professor Bruno Parigi argue that this simply increases stability by forcing informed investors to make a decision earlier than they would under the old rules.
Gates increase uncertainty for informed investors, say Fed researchers
The basic argument in Gates, fees and preemptive runs is that as uncertainty in a money market fund’s (or other financial intermediary’s) investments increase, some well-informed investors will become aware of the increased risk before it becomes obvious to everyone else.
Without gates, informed investors will know to keep a close eye on money market funds between points 1 and 3 on the graph above, because at some point they may need to move in quickly to rescue their investments. But when fund managers have the option of imposing gates this consideration shifts, now investors will need to withdraw their money sometime between points 1 and 2 with the additional uncertainty that they don’t know when or if point 2 will come. This raises the possibility of preemptive runs on money market funds caused not by a financial crisis but by the possibility of a financial crisis being anticipated by too many informed investors.
While this might seem obvious, the researchers also prove that there are situations where imposing gates is the optimal strategy for financial intermediaries. Even if they assure investors that they have no intention of halting redemptions, without a way for investors to enforce those assurances a preemptive run is still possible.
Money market reforms – Fed researchers suggest that one preemptive run could trigger others
The paper, which addresses the SEC money market reforms by name, doesn’t try to estimate the impact that preemptive runs would have on the rest of the economy, but it does suggest that a contagion of preemptive runs is possible.
“One notable concern, given the similarity of MMF portfolios, is that a preemptive run on one fund might cause investors in other funds to reassess whether risks in their funds are indeed vanishingly small,” they write.
In other words, if a group of informed investors start a preemptive run at one fund you can count on the rest of the market to notice (those who pay careful attention and those who don’t), and a rash of preemptive runs could result.