A liquidity fee is a charge that a money market fund deducts from the proceeds paid to investors who redeem shares when the fund is under strain. The fee is kept by the fund, not by its manager, and is meant to make departing investors pay the trading costs their withdrawals create. In the United States the tool is governed by Rule 2a-7 under the Investment Company Act of 1940, administered by the Securities and Exchange Commission (SEC).
Liquidity fees were designed to reduce the first-mover advantage that can drive runs on funds. They are distinct from redemption gates, which suspend withdrawals altogether, and from swing pricing, which adjusts a fund's price rather than charging a separate fee.
Liquidity fee in plain terms
Picture a group sharing a holiday rental. If one person leaves early and asks for their share back in cash, the others may have to sell something quickly, at a poor price, to raise it. A fair arrangement is that the person leaving covers that loss, rather than leaving it with everyone who stayed.
A money market fund works the same way. Most days, investors come and go and the fund pays them from cash and very short-term holdings at almost no cost. On a bad day, when many leave at once, the fund may have to sell assets into a nervous market. A liquidity fee asks the leavers to cover that cost, which removes the reward for being first out of the door.
Why money market funds need it
Money market funds invest in short-term instruments such as Treasury bills, commercial paper and certificates of deposit, and many investors treat their shares like cash. That makes them vulnerable to runs, a weakness associated with shadow banking. In September 2008 the Reserve Primary Fund fell below a one-dollar net asset value (NAV), known as breaking the buck, after losses on Lehman Brothers debt, setting off heavy withdrawals from prime funds across the money markets.
The SEC responded in 2014 with rules that allowed non-government funds to impose fees of up to 2% and gates of up to 10 business days when weekly liquid assets fell below 30% of total assets. In March 2020, however, prime funds again suffered large outflows, and the Federal Reserve set up a temporary facility to support them. The SEC concluded that tying fees and gates to a visible liquidity threshold had encouraged investors to redeem before the threshold was reached.
The 2023 SEC reforms
On 12 July 2023 the SEC adopted amendments that changed the approach:
- Gates removed. Funds can no longer temporarily suspend redemptions under Rule 2a-7, and the link between weekly liquid assets and fees was cut.
- Mandatory fee. Institutional prime and institutional tax-exempt funds must charge a liquidity fee when daily net redemptions exceed 5% of net assets, unless the fund's liquidity costs are below one basis point; the compliance date was 2 October 2024.
- Discretionary fee. Any non-government fund's board may impose a fee of up to 2% if it decides this is in the fund's best interests.
- More liquidity. Minimum daily liquid assets rose from 10% to 25%, and weekly liquid assets from 30% to 50%.
Government money market funds, which hold mostly cash, Treasury securities and repos backed by them, are not required to apply either fee.
How the mandatory fee is set
The fee must reflect the fund's good-faith estimate of what it would cost to sell a pro rata slice of every holding to meet the day's net redemptions, including spreads and market impact. If the fund cannot make a supported estimate, it applies a default fee of 1%. In simplified form:
The rate is then applied to each redeeming investor's proceeds. For example, a 10 billion dollar institutional prime fund receives net redemptions of 800 million dollars in a day, which is 8% of net assets and above the 5% trigger. If selling a slice of the portfolio would cost an estimated 1.6 million dollars, the fee rate is . An investor redeeming 5 million dollars that day receives 4.99 million dollars, and the 10,000 dollar fee stays in the fund.
Other jurisdictions and criticism
In the European Union, the Money Market Funds Regulation of 2017 lets constant and low-volatility NAV funds use liquidity fees, gates or suspensions when weekly liquid assets fall below 30% and daily net redemptions exceed 10%; reform of those links has been debated since 2020.
Critics argue that a mandatory fee raises costs for institutional investors and may push assets towards government funds or bank deposits, reducing short-term funding for companies. Supporters reply that it puts the cost of liquidity on those who demand it and lowers the chance that a public rescue by a lender of last resort is needed again.