Liquidity in Money Market Funds

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Concept of liquidity

Money Market Funds

Liquidity in Money Market Funds

Sam Bourgi Nov 19, 2019



Funds that are highly liquid have a significant level of trading activity. That means there are plenty of buyers and sellers in the market. In this environment, converting holdings into cash is relatively easy. If there are only a few buyers and sellers, the market is said to have low liquidity. The process of buying and selling at stable prices becomes much more difficult.
 
The Reserve Primary Fund meltdown during the 2008 financial crisis offers a practical example of why liquidity matters. On September 16, 2018, the Reserve Primary Fund’s net asset value (NAV) fell below $1 – breaking the buck like only a few money market funds have done before. Fearing for the value of their holdings, investors quickly pulled their money out of the fund, leading to a substantial drop in assets over the next 24 hours. The Reserve Fund was unable to meet all redemption requests. It eventually suspended operations and liquidated.
 
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Liquid Assets


Learn about the advantages and risks of money market funds.
 
Rule 2a-7 requires that each money market fund be sufficiently liquid to meet future redemption requests. This includes minimum requirements for the amount of daily and weekly liquid assets that a fund must hold, as well as rules for restoring liquidity when the minimum levels are breached.
 
Under the rule, money market funds are prohibited from investing more than 5% of their total assets in illiquid assets (i.e., those that cannot be sold in seven calendar days at reasonable value).
 
If a fund’s weekly liquid assets fall below 30%, the SEC rule permits the board of directors of a prime fund or municipal fund to either charge a liquidity fee of up to 2% on shareholder redemptions or impose a redemption gate for up to 10 days. The fee is lifted once the weekly liquid assets return to 30% or when the fund’s board determines that a liquidity fee is no longer required.
 
The SEC imposes such fees to ensure that investors have access to liquidity, but at a cost. If the fund is under duress, the board has the ability to pass on the cost of liquidity to those that use it rather than to shareholders who remain part of the fund.
 
Liquidity fees have an additional benefit: they limit shareholders’ propensity to flight during volatile periods. If a crisis hits, shareholders have more incentive to remain in the fund rather than pull their money out and incur the liquidity fee.
 
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