Wednesday, June 18, 2014

Exit fees on bonds funds? So much for liquidity

The FT reported that the Fed is considering exits fees on bonds funds to avert a run on the funds. The Fed is considering corporate bonds funds a part of the "shadow banking" system since they compete in the loan market. In this case, those bond funds have the same liquidity risk as a bank that could have a run when depositors ask for their money and the bank is holding illiquid assets. The Fed stated that a fund run is more likely because banks and Wall Street dealers do not have the same commitment to market-making given the added regulations on these institutions. In a crisis, there is less liquidity available when funds have to sell bonds to raise cash for investor redemptions.

So let's make sure we get this straight. The Fed regulated bank dealers out of committing capital to market-making which makes the trading of bonds more risky Given this risk, you now have to charge investors a fee to get out of investments when the market turns against them. You tax liquidity so it is harder for investors to pull their money out of unsafe investments. Ok, this makes a lot of sense. Why stop with an exit fee? Why not just give the Fed the authority to declare a fund holiday and stop people from getting their money? See what that will do to the markets.

There will be liquidity events when there will be more sellers and buyers which will result in price declines, but is it the place of government to now impose an exit fee on when investors want their money? Would it be imposed all of the time or just some of the time? 

The law of unintended consequences will be imposed. Would investors avoid corporate bond funds because of this rule? Is it possible the cost of capital for firms trying to raise debt financing will increase when bond fund investors will be required to pay a fee to get their money back?

The intention of this proposal may be good, but the result of imposing the fee could be worse.

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