On Wednesday July 23, 2014, the SEC plans to adopt a final rule implementing changes in the regulation of money market funds (“MMFs”). The SEC issued its proposed rule in June 2013, but it was grossly inadequate to address the systemic stability risks posed by MMFs. Better Markets will be watching closely to see if, in the final rule, the SEC has strengthened its weak proposal enough to provide meaningful reform in the regulation of MMFs. In short, the actual content of the final rule is critically important, and it will have a huge impact on the stability of our financial markets in times of stress.
Why it’s so important. The financial crisis of 2008 dramatically illustrated that MMFs are vulnerable to runs and pose significant systemic risks. In the most compelling example—although not the only one—the Reserve Primary Fund broke the buck on September 19, 2008 due to losses on debt instruments issued by Lehman Brothers Holdings, Inc. The ensuing run quickly spread throughout the prime MMF industry, causing immediate havoc in the short-term funding markets and triggering the beginning of a vicious cycle of asset fire sales, depressed prices, redemption requests, more asset fire sales, and rapidly evaporating liquidity. The run stopped only after the Treasury and the Federal Reserve established a variety of facilities to support the then-$3.7 trillion MMF market as well as the credit markets frozen by the MMF crisis.
The SEC’s earlier proposals have been inadequate, to the point of prompting action by the FSOC. The current regulatory framework applicable to MMFs is not adequate to address the types of known systemic risks presented by MMFs. In 2010, the SEC issued some modest rules to require greater portfolio diversity and stress testing of fund assets against potential threats, but the effort to adopt more comprehensive reforms in 2012 stalled because three SEC Commissioners could not agree on what to do. As a result, in November 2012, the FSOC took the unprecedented, but required step of issuing a proposed recommendation that the SEC adopt strong measures to reform the MMF industry in ways that would make their operations more transparent and much less prone to run risk.
The Pending SEC proposal is still inadequate. In June 2013, the SEC proposed another set of MMF reforms, supposedly aimed at fully and finally addressing the risks associated with MMFs. However, those proposals are still inadequate to ensure that MMFs do not spread massive instability throughout our financial system in times of market stress, as Better Markets detailed in its comment letter. Essentially, the SEC proposal would provide for:
- A floating the net asset value for each fund share—but not for retail or government MMFs, representing two-thirds of the MMF market.
- Liquidity fees and gates under certain circumstances—but only on a voluntary basis and not for government funds. The proposed rule would permit a fund to impose a 2% redemption fee when weekly liquid assets fell below 15% of total assets. However, a fund board could affirmatively vote not to impose a liquidity fee. And, the proposed rule would permit—but not require—a fund board to suspend redemptions for a period of up to 30 days when weekly liquid assets fell below 15% of total assets. Further, the SEC views these measures as alternatives to the floating NAV, although it recognizes that it might choose to impose both sets of reforms.
- Capital buffers—are not part of the SEC proposal.
- An assortment of diversification, disclosure, and stress testing measures—including stronger diversification requirements; disclosure of sponsor support; publication of an MMF’s daily and weekly liquid assets and market-based NAV on the MMF’s website; and enhanced stress testing requirements.
These measures are not only inadequate, but may well make things much worse by incentivizing institutional investors in MMFs to run faster and earlier to avoid the risk of fees and gates. This would not only be bad for the increased systemic instability it would create, but it would also greatly disadvantage retail investors who would be left in the funds subject to the fees and gates.
What the SEC’s final rule must include. Here’s a summary of what the SEC must actually require in its final rule to adequately prevent MMFs from again starting a run and destabilizing the entire financial system:
- A floating NAV for all MMFs, which will likely greatly reduce the risk of runs and which will be more accurate, more transparent, and more fair to all investors;
- A capital buffer that can absorb a significant level of fund losses, thus promoting stability, instilling investor confidence, and reducing the likelihood of damaging runs;
- A mechanism for requiring liquidity fees when a fund is sufficiently stressed that its buffer is exhausted, to discourage further redemptions and to more fairly allocate the costs and risks associated with a loss of fund liquidity;
- A system of required gates that can halt a vicious cycle of redemptions and asset fire sales when liquidity fees are inadequate; and
- The full array of diversification, disclosure, and stress testing measures contained in the initial proposal, to maximize transparency, stability, and investor confidence in MMFs.
What’s next. If the SEC fails to adopt these critical reforms, then the FSOC will have to step in again to ensure that the known run risk and systemic instability posed by MMFs are properly and fully addressed. Otherwise, investors, markets, taxpayers, the financial system and our entire economy will remain at needless risk from this single product.
Helpful Resources. Here are links to some of the key documents on this important issue.
