SEC Passes Money Market Reform
The SEC, by a narrow vote of 3 to 2, passed new laws this week which would limit the ability of money market funds to claim a stable NAV of $1.00. Last year we blogged about the impending changes to this $3 trillion market, and the rules which have now been passed are not expected to take effect for several years. If the drawn-out process of SEC reform had not been prodded along by the Financial Stability Oversight Committee (FSOC), the proposals may have taken even longer to be adopted.
The new regulations are part of the Dodd-Frank reforms, implemented to avoid future situations where a money market fund "breaks the buck" and fails to be able to defend the $1.00 NAV quoted to investors. In 2008, as Lehman was going under, the Reserve Primary Fund was unable to meet investor redemptions, which rippled out into a general credit contraction across the entire short-term financing marketplace. Investors’ implicit belief that money market funds were like bank deposits (and perhaps even carried FDIC insurance) led the industry to be a target for reform in the aftermath of the crisis. Interestingly, the Reserve Primary Fund was primarily an institutional money market fund, meaning that retail investors were largely not impacted by the decline below a $1.00 NAV. In fact, the wave of withdrawals that hit the institutional group seems to have missed retail money market funds almost entirely (see Chart below, taken from the SEC). This pattern and similar behavior during the European debt crisis would have an impact on the proposed rule changes.
The new law will be an addition to rule 2a-7 under the Investment Company Act. Previously, money market funds had been allowed to report a stable share price of $1.00, subject to a number of conditions related to credit quality, maturity and diversification. In exchange for the privilege of reporting a stable NAV, funds had to maintain high credit standards, short maturities (weighted average maturity below 60 days), and invest no more than 5% in a single issue (or 10% in a single issuer). They were also required to keep capital on hand to meet redemptions, with 10% of their portfolio invested to meet daily liquidity and 30% to meet weekly liquidity needs.
The SEC's new rules make two major changes. First, floating NAVs will be introduced to the market. Prime institutional money market funds will now be required to sell and redeem shares on a floating NAV basis, rounded to four decimal places. Funds will still be required to adhere to the policies noted above which previously allowed them the stable fund exemption (credit quality, maturity, diversification, etc.). As we noted above, the proposed change (because of retail investor behavior in the last crises) will not apply to prime retail money market funds, nor will it apply to government (retail or institutional) funds which invest 99.5% of assets in cash, government securities, or repurchase agreements collateralized by cash/government securities. This is actually a change in the definition of government money market funds, which were previously evaluated based on the "names rule" and were allowed to invest 20% of assets in non-government/cash securities. So, while the new rules will not affect government funds from a floating NAV standpoint, there will still be a fundamental change introduced in what constitutes a government money market fund. Retail funds themselves will now be defined based on limiting investors to natural persons only, and verifying this via social security numbers. The SEC believes the burden on funds of producing social security numbers will be low, since this information is already being collected under "know your customer" and Anti-Money Laundering rules. In discussing the distinction between retail and institutional investor behavior, the SEC noted the following:
"One possible reason that institutional prime funds may be more susceptible to rapid heavy redemptions than retail funds is that their investors are often more sophisticated, have more significant money at stake, and may have a lower risk tolerance due to legal or other restrictions on their investment practices. Institutional investors may also have more resources to carefully monitor their investments in money market funds. Accordingly, when they become aware of potential problems with a fund, institutional investors may quickly redeem their shares ...even a few high-dollar redemptions by institutional investors (because of their greater capital at stake) may have a significant adverse effect on a fund as compared with retail investors whose investments are typically smaller..."
Money market funds will also be required to introduce fees and gates in order to control the flow of investor redemptions in volatile markets. These changes are designed to prevent funds from having to sell at fire sale prices in distressed markets in order to meet redemptions, and to allow for a cooling off period to prevent panic selling by investors. Funds may charge liquidity fees of up to 2%, and may "gate off" investors access to redemptions under the new rules. However, gates may be in place for no more than 10 business days in any 90 day period. If weekly liquid assets fall below 10% of total assets, funds will be required to impose a 1% liquidity fee, unless the Board determines that the fee is not in the best interest of the fund (it may also impose a lower fee or a higher fee up to the 2% cap). Boards will also have discretion to introduce gates or liquidity fees any time their weekly liquid assets falls below the 30% requirement. The presence of a mandatory fee is designed to prompt funds (and their Boards) to examine the liquidity issue once it hits a certain threshold. The discretionary use of gates, and fees, is designed to give them flexibility in managing their exposure to redemption requests. Retail and institutional funds will be subject to the fee and gate requirements, as will municipal money market funds. Government funds will remain exempt, though, with an option to adopt fee and gate practices at their discretion.
Dissenters to the proposed rules include SEC Commissioner Kara M. Stein (one of two "no" votes), who voiced concerns that the new liquidity fees and gates would create an incentive for institutional investors to withdraw funds when they sensed markets were turning, thus creating the run on the fund issues the regulation is designed to prevent.
The rule changes will have a big impact on BlackRock, Fidelity, Vanguard and Charles Schwab, among others, as those companies manage approximately one-third of all institutional money market funds. However, some analysts suggest that the retail focus of Schwab, Vanguard and Fidelity will largely protect them from the rule changes. Charles Schwab Investment Management CEO Marie Chandoha commented that "From our perspective, not everything in the rule is what we had hoped for, but at a very high level, it is also along the lines of what we are advocating for."
Prior to the announced rule changes, Barron's reported that the move could create an outflow of up to $500 billion from money market funds.
While the compliance dates to meet both of the new rule requirements are more than two years away, there will likely be some reshuffling ahead of that time, as investors move to position themselves prior to the regulations taking effect.