Swing Pricing: A Tool in the Fight against Financial Fragility

By Itay Goldstein and Yao Zeng

Last year’s Nobel Prize in Economics went to Douglas Diamond and Philip Dybvig for their pioneering illustration of bank runs. In a nutshell, banks use investors’ liquid deposit money to invest in illiquid projects like factories and houses. If depositors expect other depositors to take their money out, they want to get out first or they might have nothing left due to the bank’s inability to quickly exit the illiquid waters. Everyone runs and the bank collapses.

Coincidentally, the U.S. Securities and Exchange Commission (SEC) is pushing for a new regulatory mandate at the same time. It’s not about banks. But it does have the potential to reshape an equally large and important financial industry. And it turns out to be quite close to Diamond and Dybvig’s search for a solution to runs. 

It is called swing pricing. And it is about fighting against financial fragility in open-end mutual funds, a century-old industry that is of first-order importance to households and corporations.

Understanding swing pricing requires first understanding to what extent mutual funds resemble a bank and why mutual funds may be vulnerable to runs. Traditionally, mutual funds largely invested in liquid stock markets. And the Investment Company Act of 1940 requires mutual funds to redeem shares in cash at the end-of-day net asset value (NAV). When investors redeem mutual fund shares, managers quickly sell stocks. As stock prices fall, NAV falls, making investors re-think if it’s wise to redeem in the first place. This doesn’t sound like a bank, and fund managers often follow this narrative to defend why mutual funds should be free of panic runs. 

Since the global financial crisis of 2008, however, mutual funds have increasingly stepped into illiquid waters: U.S. bond mutual funds saw their total assets increase from $1.3 trillion in 2008 to $5.6 trillion in 2020. Unlike stocks, the average corporate bond is traded less than once a month. Still, investors are entitled to redeem their shares at the end-of-day NAV every day. Redemptions are thus met at a higher NAV before the fund can sell the bonds and mark down the NAV which would only happen in days or weeks. This makes mutual fund shares deposit-like. As Goldstein, Jiang, and Ng point out, it creates a classic first-mover advantage among investors that is essentially the same as that underlying bank runs.

This mutual fund run story describes what happened to U.S. bond funds in March 2020, at the onset of the COVID-19 pandemic, as investors jointly pulled an unprecedented $240 billion. Falato, Goldstein, and Hortacsu examined the flow dynamics of bond mutual funds and found the first-mover advantage among investors to be a major driver. Corporate funding costs rose as a result, and the issuance of new bonds halted. The U.S. Federal Reserve took the extraordinary move to offer to buy corporate bonds for the first time in history, which has prevented a major financial crisis but also led to widespread moral hazard concerns.

Illiquid mutual funds hold many advantages of course. They allow investors to access otherwise hard-to-access markets, and this may well help corporations and the real economy. The critical issue is finding the right spot to balance the bright and dark sides of illiquid mutual funds. 

Swing pricing provides a powerful solution: as funds invest in illiquid assets, we can make their liabilities less deposit-like, and hence reduce fragility. With swing pricing, a fund manager adjusts the NAV down to account for the transaction costs that will be incurred in the future due to today’s redemptions. This makes mutual fund shares less deposit-like because their NAVs get closer to the true yet unrealized post-liquidation value.

Although the benefits of adopting swing pricing seem straightforward, there are also costs. One main pushback from fund managers is that swing pricing would hurt mutual funds’ core function of providing daily liquidity and make bond funds less appealing. This is understandable. After all, the entire point of swing pricing is to make bond funds less appealing to some redeeming investors! But we believe that there is more to think about; swing pricing may eventually benefit everyone despite its seeming unfriendliness to redeemers. Ma, Xiao, and Zeng propose a framework showing that swing pricing may allow illiquid funds to hold less cash as a buffer because of the reduced run risk. And less cash holding in the absence of runs benefits long-term investors because investors can better harvest the long-term asset returns. In the end, everyone ends up investing in a more appealing fund.

Another main pushback for swing pricing is from operational aspects. Swing pricing requires fund managers to know how many redemptions they will have to meet, and how much liquidation cost will occur as a result. This is not easy because liquidation costs can take days or even weeks to realize. Nevertheless, keep in mind that the United States is already behind its European peers in the use of swing pricing. Mutual funds in countries like the UK, France, Germany, Ireland, and Luxembourg have successfully adopted swing pricing. Particularly notable is the experience in Luxembourg, where most funds are global funds and are dealing with even more operational issues. In the UK context, Jin, Kacperczyk, Kahraman, and Suntheim find that mutual funds investing in illiquid assets not only exhibit higher resilience to outflows but indeed hold less cash buffer after the adoption of swing pricing.

The bottom line: We believe that it is both beneficial and necessary for mutual funds investing in illiquid assets such as corporate bonds and bank loans to adopt swing pricing. We recognize that a successful implementation of swing pricing would require not only a mandate from the SEC but also careful coordination with all market participants. It is not something we should expect to happen overnight like a run.  It is a change more constructive than disruptive.

Itay Goldstein is Joel S. Ehrenkranz Family Professor and a Professor of Finance at the Wharton School and co-director of the Wharton Initiative on Financial Policy and Regulation.

Yao Zeng is Assistant Professor of Finance at the Wharton School.