If near-zero interest rates don’t do the job, proposed money market fund reforms will dramatically change the $2.6 trillion money market industry, driving assets away from money funds and into riskier bank accounts.

Better reforms can be found that won’t hurt the industry, which both institutional and retail investors now rely on. That’s the contention of some of the biggest money market players. They argue that the reforms, before the Securities and Exchange Commission and the Treasury Department’s Financial Stability Oversight Council (FSOC), should be carefully considered.

The FSOC has proposed a series of rule changes. The council said these are needed because previous money market reforms, passed by the SEC in 2010 after the market meltdown of 2008, left unaddressed “core characteristics that continue to contribute to [money market funds’] susceptibility to destabilizing runs.” (See sidebar, “FSOC, The Money Market Proposals.”)

Money market funds, the FSOC claimed in its annual report last year, “have no mechanism to absorb a sudden loss in the value of a portfolio security without threatening the stable $1.00 NAV.” A danger remains, the FSOC said, that investors will “redeem at the first indication of a perceived threat to value or liquidity of the MMF.”

FSOC, The Money Market Proposals
The financial stability oversight council (fsoc) was created in the wake of the 2008 crisis to ensure that interconnected financial institutions don’t create a systemic failure. It has three proposals pending that would change how money market funds operate.
1. The creation of a floating net asset value. This would, according to the FSOC, “Require MMFs to have a floating net asset value per share by removing the special exemption that currently allows MMFs to utilize amortized cost accounting and/or penny rounding to maintain a stable NAV. The value of MMFs’ shares would not be fixed at $1.00 and would reflect the actual market value of the underlying portfolio holdings, the same as all other funds.”
2. Requiring money market funds to create NAV buffers and have a minimum balance at risk. This would “require MMFs to have an NAV buffer with a tailored amount of assets of up to 1% to absorb day-to-day fluctuations in the value of the funds’ portfolio securities and allow the funds to maintain a stable NAV. The NAV would have an appropriate transition period and could be raised through various methods. The NAV buffer would be paired with a requirement that 3% of a shareholder’s highest account value in excess of $100,000 during the previous 30 days—a minimum balance at risk (MBR)—be made available on a delayed basis.”
3. Requiring a stable NAV with a NAV buffer and other measures. “Require MMFs to have a risk-based NAV buffer of 3% to provide explicit loss-absorption capacity that could be combined with other measures to enhance effectiveness of the buffer and potentially increase the resiliency of MMFs. Other measures could include more stringent diversification requirements, increased minimum requirement levels and more robust disclosure requirements.” Source: FSOC

So what should be done?
The FSOC proposals would call for a floating net asset value. That means discontinuing the steady $1 value per share, rendering money market funds a virtual clone of short-duration funds. The council also calls for the adoption of new capital requirements with certain other limitations. These would require balance-at-risk rules for the funds, possibly slowing down withdrawals in times of crisis such as the 2008 market meltdown.

Yet critics argue that the SEC money market changes of 2010 were tested during the market turmoil of the following year. That’s when problems were occurring in euro zone debt markets and in the U.S. there were questions about whether the government was about to default on its debt.

“Money market funds passed these tests,” declares a paper by the Investment Company Institute, the fund industry’s trade group.

“The data show that money market fund managers proved themselves careful stewards of their investors’ assets, adjusting their holdings in response to changing conditions and maintaining liquidity levels above those stipulated by 2010 requirements,” the ICI said in “Money Market Funds, Risk and Financial Stability in the Wake of the 2010 Reforms.”

FSOC critics also charge that, if the new FSOC rules were adopted, they would add new costs and make funds more difficult to operate (See “Academic Opposes New Money Market Fund Rules.”) They would “have the potential to eliminate an important source of capital for U.S. businesses, state and local governments,” says John Woerth, a spokesman for the Vanguard Group of Funds. Vanguard, which has some $200 billion in money market assets, says the FSOC proposals, if accepted, would further concentrate risk in the banks.

But others say these reforms are needed or money market investors might be burned in the next market meltdown. The industry already has flirted with problems, with sponsors having to step in and save shaky funds, according to former SEC Chairwoman Mary Schapiro. (See sidebar, “The Primary Reserve Fund Episode.”)

“Based on SEC staff review, sponsors have voluntarily provided support to money market funds on more than 300 occasions since they were first offered in the 1970s,” said Schapiro in testimony last year to Congress, in a discussion about the 2008 crisis. That year, money market fund investors cashed in $300 billion in just one week.

The most celebrated money market fund problem was what happened at the Primary Reserve Fund where some investors lost money. Schapiro warned that “the next run might be more difficult to stop.”

Securities industry attorney Bill Singer praised Schapiro for raising the issue of these funds failing. “Just because we survived the meltdown of 2008 doesn’t mean we’ll survive the next one,” says Singer, an industry gadfly. “Usually what we get from regulators is spin, but this time Mary Schapiro is right.”

Still, Schapiro’s proposals died at the SEC last year, with some fund industry officials questioning the research behind the 300 reports of fund problems. That’s because, some fund officials say, the rules would add new costs to funds, making them less competitive. And that, they add, would drive investors to banks, which are more likely to have problems and fail.

For example, Vanguard, in its comment letter criticizing the proposed changes, warned that “regulators must be mindful of the unintended consequences that draconian reform measures may have on the capital markets and investors.”

Still, some money market industry officials who have been among the critics of the reforms say they are ready to commit to some change. Many are ready to support a floating NAV, but on institutional, not retail, funds. And they are ready to back some form of liquidity fees that could be triggered in time of crisis. This, in theory, would slow down the rush to cash out all at once.

Structuring a proposed redemption gate, accompanied by a fee, said officials of an industry trade group, would be reasonable reform. “The gate,” SIFMA writes in a comment letter, “when triggered, would prohibit investors from redeeming and provide a period of time for a fund to restore its market-based NAV and liquidity.”

Academic Opposes Proposed New Money Market Rules
Jonathan macey, a professor of corporate law at yale law school, questions whether the FSOC proposals are needed and argues they will hurt both the funds and investors by raising costs.
A floating NAV, he writes, “would reduce investor demand for MMFs, because of operational, tax, accounting and legal impediments or because of convenience and efficiency considerations.”
In his paper, Money Market Funds: Vital Source of Systemic Stability, Macey warns that one of the key reforms, a minimum holdback period, will “deter” investors from using the funds. The reforms’ increased capital requirement costs, he adds, “will have to be borne by someone—and either will reduce investor demand or deter MMF sponsors.”
Macey contends that the FSOC would increase systemic risk and would “decrease
efficiency, dampen competition and hinder capital formation.”

And Charles Schwab Corp., one of the bigger money market players, says it is ready to accept a floating NAV on institutional money market funds, as numerous big players already have. “We believe this more frequent report can serve as indicator of the stability of our money market products for investors looking for real-time information,” says Marie Chandoha, president of Charles Schwab Investment Management. She adds that a floating NAV won’t change how Schwab manages its money market funds nor change its expectation that they will remain at a dollar a share.

Vanguard, in its comment letter, says the FSOC should butt out, arguing that the council is confusing retail and institutional, or prime, money market funds. (The FSOC, under pressure from the industry, had agreed at press time to extend the comment period on its plan to February 15.)

Vanguard said in its letter that the SEC is the agency that should properly be developing money market fund rules. Vanguard “does not believe that FSOC should make specific money market fund recommendations to the SEC. However, if FSOC does make recommendations to the SEC, the recommendations should apply only to prime money market funds.” 

The letter, signed by Vanguard chairman F. William McNabb, defends the $1 NAV. It also advocates a standby liquidity fee as a tool to slow down any possible crisis, but that it should only apply to prime money market funds, which serve institutional accounts.

“The key to preventing a run on prime MMFs from contributing to broader dislocations in the financial markets during a widespread crisis is to ensure that these funds have adequate liquidity, and have the ability to slow redemptions when a fund’s liquidity becomes scare,” writes McNabb. “We believe a standby liquidity fee (“SLF”) is an effective tool to accomplish both of these objectives.”

How would the SLF be applied?

Normally, it wouldn’t apply, McNabb says. However, if the fund’s liquidity level falls below a certain point, then redemptions would be suspended until the SLF could be imposed.

“We recommend a fee in the amount of 1%–3%,” McNabb writes. “We believe a fee in this amount will serve as an adequate deterrent to investors who may attempt to flee a fund out of fear, but would still allow those investors who have a need to access their cash the ability to redeem a portion of their holdings.”

The Primary Reserve Fund Episode
During the market meltdown of 2008, a large part of the $785 million primary Reserve Fund was in debt issued by Lehman Brothers. When Lehman, which had heavily invested in toxic mortgage-backed securities, went bankrupt, panic spread through the money market community.

Primary Reserve Fund officials valued the fund’s Lehman holdings at zero. Primary’s NAV dropped to 99 cents a share. Then massive liquidations forced the NAV down to 97 cents. Later the fund was liquidated under a process overseen by the SEC. Shareholders then received 99 cents a share. A few other money market funds also experienced problems, but the sponsors of those funds made shareholders whole.

Critics see this as an example of why basic changes, beyond the 2010 reforms, are needed in money market funds. Industry defenders say it was a unique situation and that, under hectic circumstances in which investments were wiped out in shares of Freddie Mac, relatively small amounts of MMF shares were lost.