“the essence of shadow banking is giving people a liquid claim on illiquid assets.”

Today’s terrifying thought – the Fed is worried enough about a big disruption in the bond market that they’re actually considering a bond fund exit fee, which, in theory, might help slow down a race for the door should rates rise too rapidly.

Yeah, okay.

It’s hard to believe that this kind of thing would have any chance in hell of becoming a reality. But a) you never know and b) it’s the mere fact that this is even being pondered that should cause us to pay attention.

The issue here is that the global bond market – which is now $100 trillion-strong – is largely held by mutual funds and, too a lesser extent, ETFs, which have instant liquidity as one of their primary selling points. But what if everyone wants their money out at once? One of the unintended consequences of Dodd-Frank is that Wall Street banks will be unable to take the buy side of a lot of those sell orders, now that they don’t make markets or trade prop to the same extent they once did.

But there’s no way an exit fee of any kind is going to do anything other than make a bad situation worse. The Fed prides itself as being an organization that learns from history – name one financial crisis that was aided by liquidity constraints. No? Didn’t think so.

I want you to head over and read the full story at the Financial Times today and understand this risk. We’ll probably be discussing this liquidity mismatch more in the future.

Fed looks at exit fees on bond funds (Financial Times)