Regulating liquidity risk in mutual funds!

Globally greater than USD30 trillion in assets are locked in open-ended mutual funds that provide short-term redemptions while purchasing longer-dated and potentially illiquid assets for example corporate bonds. Following the Covid-19 pandemic put severe pressure around the industry, the Fed Board known as for structural reforms in line with the assessment that ”fixed-earnings mutual funds continue being susceptible to large, sudden redemptions, and sizable outflows can continue to result in a degeneration in market liquidity of underlying assets” (Fed Board 2020). This quote reflects a continuing arguements for and against academics and policy makers concerning the financial stability implications of illiquid mutual funds and also the results of regulatory interventions.

While there’s mounting empirical evidence showing that mutual funds holding illiquid assets can induce fragility in underlying asset markets (Jiang et al. 2020), inside a recent paper (Cucic 2020), I suggest a theoretical type of the bond between investor redemptions in mutual funds, fire sales, and asset market liquidity. The theoretical framework enables analyzing the equilibrium results of two regulatory reform proposals, namely liquidity needs for mutual funds and redemption gates. Particularly, I reveal that regulatory policies reducing the requirement for asset (fire) sales by mutual funds have unwanted effects on liquidity supply towards the underlying asset market. This adverse general equilibrium reaction to regulation might be sufficiently strong enough to create a loss of asset market liquidity as well as an elevated probability of fire sales.

Investor redemptions, fire sales, and market liquidity

To evaluate the hyperlinks between investor redemptions, asset (fire) sales by mutual funds, and market liquidity, I model mutual funds purchasing dangerous assets, for instance, a company bond portfolio, with respect to their investors. When investors get access to alternative investment possibilities, they decide to redeem a few of their mutual fund shares. Mutual funds accommodate redemptions by selling a few of their dangerous asset holdings to specialized liquidity providers for example hedge funds. I suppose that liquidity providers can finance their dangerous asset purchases just with liquid assets (“cash”) within their portfolio, that they determine in an earlier date. Liquidity providers’ ex-ante selection of the amount of money to carry is driven by their anticipation of utilizing it to buy undervalued assets from mutual funds in fire sales.

Within the competitive equilibrium, the dangerous asset may trade at fundamental prices or fire sales. Fire sales occur when liquidity providers don’t have the liquid funds to buy the dangerous asset at its fundamental value, resulting in a good outcomes of market liquidity and asset prices as with Allen and Gale (1994). Mutual funds’ share cost reflects the marketplace worth of their asset holdings, that’s, the funds mark their shares to promote. I reveal that market liquidity is inefficiently lower in the competitive equilibrium, which results in an elevated probability of fire sales.

The inefficient way to obtain liquidity is a result of a pecuniary externality that’s driven through the assumption of market incompleteness: since liquidity providers can finance dangerous asset purchases just with their funds holdings, mutual funds’ revenues from asset sales to pay for redeeming investors are restricted through the available market liquidity. Liquidity providers neglect to internalize the outcome of the cash holdings on asset prices and eventually around the payout to redeeming investors.

Controlling liquidity risk in mutual funds

I evaluate the potential for two popular policy proposals to mitigate liquidity risk in mutual funds: first, a liquidity requirement leading mutual funds to carry liquid assets within their portfolio, and 2nd, a redemption gate that restricts investor redemptions during occasions of market turmoil. For any given degree of asset market liquidity, the direct aftereffect of both policies would be to reduce the requirement for asset sales by mutual funds. This reduces the probability of fire sales, which lowers liquidity providers’ expected returns to holding cash ex-ante. The indirect aftereffect of both policies is thus home loan business liquidity supply towards the asset market.

The internet aftereffect of both policies is dependent upon the relative strength of the indirect and direct effects. Since redemption gates insulate mutual funds in the most unfortunate fire sales, when returns to liquidity providers’ cash holdings are greatest, they lead to an equilibrium with lower market liquidity along with a greater incidence of fireside sales. By comparison, liquidity needs assistance to avoid only small fire purchase periods, which leaves sufficient incentives for liquidity providers to carry cash. Consequently, market liquidity increases and the probability of fire sales declines.

The positive internet aftereffect of liquidity needs enhances the wonder if mutual funds would develop sufficient liquidity buffers absent a regulatory policy mandate. To deal with this, I study extra time from the model by which mutual funds invest their collected funds inside a portfolio from the dangerous asset and funds. Mutual funds’ cash holdings reduce the requirement for asset (fire) sales when confronted with redemptions but come at the expense of foregone returns from investing more within the dangerous asset. Interestingly, I reveal that in the existence of incomplete markets, mutual funds’ endogenous liquidity buffers are inefficiently small. This result further strengthens the situation for liquidity needs for mutual funds.

Conclusion

This paper plays a role in the continuing debate about structural reforms to deal with liquidity risk within the mutual fund industry. The theoretical framework it develops might help policy makers measure the impact of numerous regulatory reform proposals. The outcomes highlight that regulators must take into account the reforms’ effect on liquidity within the underlying asset markets. Failing to do this may lead to ill-designed policies that worsen the outcome of liquidity risk within the mutual fund industry.

References

Allen, Franklin, and Douglas Gale. 1994. “Limited Market Participation and Volatility of Asset Prices. American Economic Review 84 (4): 933-955.

Cucic, Dominic. 2021. “Controlling Liquidity Risk in Mutual Funds.” Danmarks Nationalbank Working Paper No 172.

Jiang, H., Li, Y., Sun, Z. and Wang, A., 2020. “Does Mutual Fund Illiquidity Introduce Fragility into Asset Prices? Evidence in the Corporate Bond Market.”

Fed Board. 2020. “Financial Stability Report.” November.

Leave a Reply

Your email address will not be published.