Liquidity risk in markets with trading frictions: What can swing pricing achieve?
BIS Working Papers No 663
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?
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.
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.
Open-end mutual funds expose themselves to liquidity risk by granting their investors the right to daily redemptions at the fund's net asset value. We assess how swing pricing can dampen such risks by allowing the fund to settle investor orders at a price below the fund's net asset value. This reduces investors' incentive to redeem shares and mitigates the risk of large destabilising outflows.Optimal swing pricing balances this risk with the benefit of providing liquidity to cash-constrained investors. We derive bounds, depending on trading costs and the share of liquidity-constrained investors, within which a fund chooses to swing the settlement price. We also show how the optimal settlement price responds to unanticipated shocks. Finally, we discuss whether swing pricing can help mitigate the risk of self-fulfilling runs on funds.
JEL classification: G01, G23, G28, C72
Keywords: Financial stability, mutual funds, regulation, liquidity insurance, trading frictions