Blaming Open-End Funds Doesn’t Hold Water: Let’s All Get Serious About Improving the Treasury Markets

Earlier this week, US Treasury Undersecretary Nellie Liang gave remarks on improving the functioning of the Treasury market. We applaud Liang for taking on this topic. For several years, ICI has urged policymakers to examine structural fixes to improve liquidity in the Treasury and wholesale trading markets. And we hope Liang is successful in her efforts to get prudential regulators to revisit the supplementary leverage ratio (SLR).

In making her case, however, Liang unfortunately repeats some flawed narratives about regulated funds’ role in the Treasury market, undermining the strength of her points. Given that the topic of her speech is so critical to the health of our financial markets, we consider it vital to explain why these narratives are flawed.

First, Liang repeated a claim that funds have an incentive to buy Treasury futures rather than actual Treasuries in part because the interest expense of funding Treasury securities through repo is included in fund expense ratios, while the cost of a Treasury derivatives transaction is not. However, ICI noted in a recent Risk.net opinion piece—which was in response to Liang raising this assertion previously—that there is no evidence that funds use Treasury futures for this reason. Funds’ primary motivation for using Treasury futures is because they are valuable tools for the benefit of their shareholders. Fund managers are able to quickly and efficiently adjust duration and yield curve positioning and better manage credit risk and counterparty risk using Treasury futures. And because the futures market can be more liquid than the cash market, Treasury futures can help funds manage their overall liquidity profiles.

Furthermore, managers have a fiduciary duty to fund shareholders, including a duty of best execution. As we wrote in Risk.net, “if taking a long position in Treasury futures is better or more efficient for a fund and its shareholders than buying Treasury securities directly, or vice versa, that is what the fund’s manager will do.”

Second, Liang was incorrect to suggest that bond mutual funds had a disruptive effect on the Treasury market during the March 2020 crisis. Analysis of bond mutual funds’ role in the fixed income markets during the events of March 2020 shows that outflows from bond mutual funds were not a major contributor to stress in the Treasury and corporate bond markets. The Treasury market was dislocated days before bond funds began selling Treasury bonds in any appreciable magnitude. Further, bond mutual funds’ small share of Treasury trading volumes—peaking around 5%—illustrates that their net sales had only a minor impact on the Treasury market.

Third, Liang issues a call to address so-called liquidity mismatch for Treasuries in open-end funds and bemoans the lack of a swing pricing element in the SEC’s recently adopted rule—which, when proposed, contained swing pricing for mutual funds as a cornerstone. However, the way “liquidity mismatch” as defined in her remarks relies on “the longer time it takes to sell the underlying bonds…” That sounds like a problem for the overall market and all participants in the market. Swing pricing doesn’t solve this market problem—it only puts mutual fund investors at a distinct disadvantage to other investors.?

Finally, she suggests that one solution for the operational challenges to implementing swing pricing in the United States. is to “lengthen the period in which investors should be able to redeem shares, from daily to the number of days it would typically be expected to take to sell the underlying securities even in normal periods.” Such a suggestion would change a fundamental characteristic of mutual funds and negatively impact the over 120 million Americans who own mutual funds. That may sound good in theory, but it would be a failure in reality. ??

Instead, what would very likely help this market problem is Liang’s recommendation for prudential regulators to consider changes to the SLR. We think this is an area ripe for needed reforms and would recommend Treasuries and banks’ deposits at the Fed be excluded from the SLR calculation permanently and continuously, rather than temporarily (as they did during the COVID pandemic—an exclusion that proved tremendously successful). That approach would help dealers intermediate during stress periods and decrease market uncertainty as to whether SLR relief was on the horizon.

Other steps that should be taken include exempting directly held Treasuries from the SLR, facilitating all-to-all trading in the Treasury market, and the SEC making it easier for funds to?carry out “done away” trading.?

ICI will continue to base our conclusions on data and urge policymakers to avoid relying on unsupported assumptions. And what does the data tell us?

Open-end mutual funds have a long history of successfully managing liquidity, enabling them to meet shareholder redemptions in a timely manner while pursuing their investment objectives. Over the past 40 years, 99.94% of these funds have met redemptions, including every single fund during the 2020 “dash for cash.”

A good question for policymakers to answer: how many other areas of the financial system can show the same track record of resiliency over the past 40 years?