US Money Market Fund Regulation – More Work Needed!
Earlier this month the Securities and Exchange Commission (SEC) published a request for public comment on potential reform measures to improve the resilience of money market funds. The request follows the report of the President’s Working Group on Financial Markets issued in December 2020.
The report noted that certain short-term funding markets experienced stress in March 2020 amid economic concerns related to the onset of the COVID-19 pandemic.
The report also reviewed prior money market fund reforms, the evolution of different types of money market funds since the 2008 financial crisis, and events in certain short-term funding markets in March 2020.
“More work is needed to reduce the risk that structural vulnerabilities in prime and tax-exempt money market funds will lead to or exacerbate stresses in short-term funding markets.”
– Report of the President’s Working Group on Financial Markets
The report also discusses various potential reforms that policymakers could consider.
What are the potential reforms?
The potential policy measures for prime and tax-exempt MMFs explored in the report are:
Currently, MMF boards have discretion to impose fees or gates when weekly liquid assets (WLAs) fall below 30% of total assets and generally must impose a fee of 1% if WLAs fall below 10%. Although this rule is intended to stem heavy redemptions by imposing a fee to reduce shareholders incentives to redeem for a period of time, the report notes that it may accelerate redemptions as the threshold approaches – a dash for cash!
To address the dash for cash issue, a proposal has been put forward to remove the tie between the 30 percent and 10 percent WLA thresholds, and the imposition of fees and gates. Fund boards would instead be permitted to impose fees or gates when doing so is in the best interest of the fund, without reference to any specific level of liquidity.
Further potential reforms to address a dash for cash identified in the report include:
- Funds being required to obtain permission from the SEC or notify the SEC prior to imposing gates;
- Fund boards being required to consider liquidity fees before gates;
- Lowering the WLA threshold at which gates could be imposed to, for example, 10 percent.
- Create “soft” or “partial” gates – a fund could reduce each investor’s redemption pro rata
The report proposes the implementation of a “minimum balance at risk” (MBR) mechanism. An MBR is a portion of each shareholder’s balances in a MMF that would be available for redemption with a time delay. This ensures that redeeming investors still remain partially invested in the fund over a certain time period.
MMFs are currently subject to daily and weekly liquid asset requirements and must disclose the amount of daily and weekly liquid assets each day on the fund’s website. The report proposes introducing a new category of liquidity requirements. For example, an additional category for assets with slightly longer maturities (e.g., biweekly liquid assets).
Additionally, an additional WLA threshold has been proposed – a WLA threshold of 40 percent to augment current liquidity buffers. If a fund’s WLAs fell below this threshold, penalties such as requiring the escrow of fund management fees until the level of WLA is restored could be imposed on fund managers.
A countercyclical WLA requirement has been proposed. Under the proposal, minimum WLA requirements could automatically decline in certain circumstances, such as when net redemptions are large or when the SEC provides temporary relief from WLA requirements.
Retail prime MMFs and retail tax-exempt MMFs can currently use a rounded NAV and value portfolio assets at their amortized cost. This permits the funds to sell and redeem shares at a stable share price (e.g., $1.00) without regard to small variations in the value of the securities in their portfolios.
The report suggests that introducing a floating NAV requirement – this would ensure that MMFs instead sell and redeem their shares at a price that reflects the market value of a fund’s portfolio and any changes in that value.
Under current rules, MMF investors redeeming their shares in a prime or tax-exempt fund typically do not incur the costs associated with this redemption activity. Instead, these costs are largely borne by other investors in the fund – this contributes to a first-mover advantage for those who redeem quickly in a crisis.
The introduction of swing pricing would allow a fund to impose the costs stemming from redemptions directly on redeeming investors by adjusting the fund’s NAV downward when net redemptions exceed a threshold. This would help ensure that redeeming shareholders bear liquidity costs throughout market cycles.
Capital (or “NAV”) buffers, which could be structured in a variety of ways, can provide dedicated resources within or alongside a fund to absorb losses and can serve to absorb fluctuations in the value of a fund’s portfolio, reducing the cost to taxpayers in case of a run.
For a floating NAV fund, capital buffers could be reserved to absorb the fund’s losses only under certain rare circumstances, such as when it suffers a large drop in NAV or is closed.
The report proposes in order to provide a liquidity backstop during periods of market stress, prime and tax-exempt MMFs could be required to be members of a private liquidity exchange bank (LEB).
Under one LEB proposal, MMF members and their sponsors would capitalise the LEB through initial contributions and ongoing commitment fees.
The proposals suggest a new regulatory framework governing sponsor support. This new framework would clarify who bears MMF risks by establishing when a sponsor would be required to provide support.
The reform could also include changes to prevent the need for future SEC staff no-action letters relating to the interaction of rule 17a-9 and certain banking law provisions, which may provide more certainty with respect to sponsor support.
The broad consensus is that the US MMF reforms adopted by the SEC in 2010 and 2014 have not fully achieved their intended aims. The COVID-19 pandemic highlighted the deficiencies within the regulations with the prime and tax-exempt MMFs seeing significant outflows, and increasingly illiquid markets for the funds’ assets. Importantly, outflows did not subside, and short-term funding market conditions did not improve until the Federal Reserve established the Money Market Mutual Fund Liquidity Facility.
The SEC’s request for comment is an important step in the MMF reform process – comments must be submitted within 60 days of the request’s publication in the Federal Register. The comments received will assist the SEC and other relevant financial regulators in further analysis of potential reforms.
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