{
  "title": "How Illiquid Open-End Funds Can Amplify Shocks and Destabilize Asset Prices",
  "publication": "IMF Blog, October 4, 2022",
  "sourceUrl": "https://www.imf.org/en/blogs/articles/2022/10/04/how-illiquid-open-end-funds-can-amplify-shocks-and-destabilize-asset-prices",
  "canonical": "https://www.imf.org/en/blogs/articles/2022/10/04/how-illiquid-open-end-funds-can-amplify-shocks-and-destabilize-asset-prices",
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  "summary": "Mutual funds holding hard-to-sell assets but offering daily redemptions can spark volatility and magnify the impact of shocks, especially in periods of market stress",
  "sections": [
    {
      "heading": "Role and scope of open-end investment funds",
      "content": "- Open-end investment funds allow investors to buy or sell their shares daily and have grown to \"$41 trillion in assets globally this year.\"\n- These funds represent \"about one-fifth of the nonbank financial sector’s holdings.\"\n- Funds may hold liquid assets (stocks, government bonds) or less-frequently-traded securities (corporate bonds); those with less-liquid holdings face a liquidity mismatch because \"it may take fund managers several days to sell assets to meet these redemptions.\""
    },
    {
      "heading": "Mechanism of amplification and investor incentives",
      "content": "- Daily redemptions priced at end-of-day can fail to reflect full trading costs when assets are hard to sell, shifting costs to remaining investors and creating \"an incentive for redeeming shares before others do.\"\n- This incentive can trigger run-like outflows; forced rapid asset sales by funds can \"further depress valuations\" and \"amplify the impact of the initial shock,\" potentially undermining financial stability."
    },
    {
      "heading": "Empirical observations and stress scenarios",
      "content": "- During the start of the pandemic, open-end funds experienced outflows \"of about 5 percent of their total net asset value,\" exceeding global financial crisis redemptions a decade and a half earlier.\n- Assets such as corporate bonds held by illiquid funds \"fell more sharply in value than those held by liquid funds.\"\n- Analysis shows returns of assets held by relatively illiquid funds are generally more volatile than comparable holdings in less-exposed funds—\"especially in periods of market stress.\"\n- Scenario example: \"if liquidity dries up the way it did in March 2020, the volatility of bonds held by these funds could increase by 20 percent.\"\n- Cross-border considerations: \"A decline in the liquidity of funds domiciled in advanced economies can have significant cross-border spillover effects and increase the return volatility of emerging market corporate bonds.\"\n- Current context (October 2022): rising interest rates and high economic uncertainty have led to increased outflows from open-end bond funds and raise the risk that a \"sudden, adverse shock like a disorderly tightening of financial conditions could trigger further outflows and amplify stress in asset markets.\""
    },
    {
      "heading": "Policy tools and calibration challenges",
      "content": "- Passing transaction costs to redeeming investors can reduce asset volatility induced by open-end funds.\n  - Swing pricing: \"allows funds to adjust their end-of-day price downward when facing outflows,\" reducing first-mover redemption incentives and easing outflow pressures and forced asset sales.\n  - Antidilution levies: \"pass on transaction costs to redeeming investors by charging a fee.\"\n- Calibration issues:\n  - \"The adjustments that funds can make to the end-of-day prices—known as swing factors—are often capped at insufficient levels, especially in times of market stress.\"\n  - For very illiquid assets (e.g., real estate) calibrating swing-pricing or similar tools \"may be difficult even in normal times.\"\n  - Operational or jurisdictional constraints may prevent implementation of swing pricing."
    },
    {
      "heading": "Policy recommendations and supervisory actions",
      "content": "- Policymakers should provide guidance on how to calibrate swing pricing and monitor implementation to ensure effectiveness.\n- Consider alternative measures for very illiquid funds or where swing pricing is not operationally feasible, such as \"limiting the frequency of investor redemptions.\"\n- Increase supervisory monitoring of liquidity management practices and require additional disclosures by open-end funds to better assess vulnerabilities.\n- Encourage market structure reforms to boost liquidity, including:\n  - More trading through central clearinghouses.\n  - Making bond trades more transparent.\n- These actions aim to \"reduce risks from liquidity mismatches in open-end funds and make markets more robust in times of stress.\"\n\nThis blog is based on Chapter 3 of the October 2022 Global Financial Stability Report, “Asset Price Fragility in Times of Stress: The Role of Open-End Investment Funds.”\n\n---\n\n\n References\n\n- Global Financial Stability Report\n- speech\n\nSource: https://www.imf.org/en/blogs/articles/2022/10/04/how-illiquid-open-end-funds-can-amplify-shocks-and-destabilize-asset-prices"
    }
  ],
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    "[Markdown version](/en/blogs/articles/2022/10/04/how-illiquid-open-end-funds-can-amplify-shocks-and-destabilize-asset-prices/index.md)",
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    "Authors: Fabio Natalucci, Mahvash S Qureshi, Felix Suntheim",
    "Published: October 4, 2022",
    "Open-end investment funds allow investors to buy or sell their shares daily and have grown to \"$41 trillion in assets globally this year.\"",
    "These funds represent \"about one-fifth of the nonbank financial sector’s holdings.\"",
    "Funds may hold liquid assets (stocks, government bonds) or less-frequently-traded securities (corporate bonds); those with less-liquid holdings face a liquidity mismatch because \"it may take fund managers several days to sell assets to meet these redemptions.\"",
    "Daily redemptions priced at end-of-day can fail to reflect full trading costs when assets are hard to sell, shifting costs to remaining investors and creating \"an incentive for redeeming shares before others do.\"",
    "This incentive can trigger run-like outflows; forced rapid asset sales by funds can \"further depress valuations\" and \"amplify the impact of the initial shock,\" potentially undermining financial stability.",
    "During the start of the pandemic, open-end funds experienced outflows \"of about 5 percent of their total net asset value,\" exceeding global financial crisis redemptions a decade and a half earlier.",
    "Assets such as corporate bonds held by illiquid funds \"fell more sharply in value than those held by liquid funds.\"",
    "Analysis shows returns of assets held by relatively illiquid funds are generally more volatile than comparable holdings in less-exposed funds—\"especially in periods of market stress.\"",
    "Scenario example: \"if liquidity dries up the way it did in March 2020, the volatility of bonds held by these funds could increase by 20 percent.\"",
    "Cross-border considerations: \"A decline in the liquidity of funds domiciled in advanced economies can have significant cross-border spillover effects and increase the return volatility of emerging market corporate bonds.\"",
    "Current context (October 2022): rising interest rates and high economic uncertainty have led to increased outflows from open-end bond funds and raise the risk that a \"sudden, adverse shock like a disorderly tightening of financial conditions could trigger further outflows and amplify stress in asset markets.\"",
    "Passing transaction costs to redeeming investors can reduce asset volatility induced by open-end funds.",
    "Calibration issues:",
    "Policymakers should provide guidance on how to calibrate swing pricing and monitor implementation to ensure effectiveness.",
    "Consider alternative measures for very illiquid funds or where swing pricing is not operationally feasible, such as \"limiting the frequency of investor redemptions.\"",
    "Increase supervisory monitoring of liquidity management practices and require additional disclosures by open-end funds to better assess vulnerabilities.",
    "Encourage market structure reforms to boost liquidity, including:",
    "These actions aim to \"reduce risks from liquidity mismatches in open-end funds and make markets more robust in times of stress.\"",
    "[Global Financial Stability Report](https://imf.org/en/Publications/GFSR/Issues/2022/10/11/global-financial-stability-report-october-2022)",
    "[speech](https://www.imf.org/en/News/Articles/2021/09/17/sp081721-financial-stability-priority-boosting-the-resilience-of-investment-funds)"
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