By David Larrabee, CFA
The $2.7 trillion U.S. money market fund industry, which greases the wheels of industry while offering institutional and individual investors a vehicle for cash management and savings, is being targeted for regulatory reforms designed to make it more transparent and less risky. But critics argue that adoption of the proposed changes may trigger unintended consequences with far-reaching effects. The new rules proposed by the Securities and Exchange Commission (SEC) have ignited a vigorous debate over the necessity and impact of tighter regulations. While the government sees the reforms as overdue and crucial to the stability of financial markets and the protection of investors, the fund industry is circling the wagons and crying foul.
Introduced in the early 1970s, money market funds are investment products that are not guaranteed, either by the fund sponsor or any government agency. Since 1983, they have been subject to the SEC’s Rule 2a-7 under the Investment Company Act of 1940, which restricts the quality, maturity, and diversity of investments held by money market funds. Money market funds seek a stable net asset value, or NAV, usually $1 in the U.S. Fund managers are allowed to assume the NAV is always $1, valuing assets at their amortized cost, so long as the “shadow NAV,” or NAV marked-to-market, doesn’t fall below $0.995. Falling below this threshold means the fund has “broken the buck.” But because of the short-term nature and high quality of the securities that money market funds typically hold, this has rarely been a problem. Only twice in their 40-year history have money market funds broken the buck.
In 1994, the Community Banker’s U.S. Government Money Market Fund, an institutional fund, reported an NAV below $1 as a result of a derivatives bet gone bad and ultimately returned $0.96 on the dollar to shareholders.
More recently, following the September 2008 collapse of Lehman Brothers, panic ensued and financial markets were largely frozen. The illiquidity caused many money funds to have difficulty selling assets to meet redemptions, which that week amounted to $310 billion, or about 15% of industry assets. The Reserve Fund, with $62 billion in assets (and 1.3% in Lehman paper) and ironically the first money market fund in the U.S., broke the buck, eventually returning $0.99 on the dollar to investors. Many other fund sponsors stepped in to provide capital support to their funds in order to maintain their $1 NAV. Additionally, the U.S. Treasury provided a backstop, guaranteeing industry funds until the crisis abated. Moody’s Investors Service estimated that 36 of the top 100 largest U.S. prime money market funds would have broken the buck without financial support.
In 2010, on the heels of the Lehman failure and the financial crisis, and in an attempt to prevent future “runs” and government bailouts, the SEC put in place tighter restrictions on money market funds, including liquidity requirements, shorter maturity limits, and enhanced transparency. These changes were accepted largely without a challenge from the fund industry, but given their earlier near-death experience, as a practical matter they had little choice.
The industry has since weathered a near-default and downgrade of U.S. government debt and ongoing weakness in Europe. Nevertheless, in her November 2011 speech to Securities Industry and Financial Markets Association (SIFMA), SEC Chairman Mary Schapiro called for additional structural reforms for money market funds, and the proposed changes under consideration have caused a minor uproar in the industry.
Proposed SEC Reforms
The proposed SEC reforms, made public in January 2012, but still subject to change, call for the following:
- Funds would be required to maintain a capital buffer of up to 1%, and additionally hold back between 3% and 5% of investor funds for 30 days following a redemption request.
- Funds would be required to “float” their NAV rather than maintain the stable $1 NAV.
The capital buffer and redemption restrictions would make the funds better able to withstand runs, lessening systemic risk, while the floating NAV would help to address perceptions of a guaranteed investment. These are the primary arguments put forth by proponents of additional reforms, including heavy hitters like former Federal Reserve chairman Paul Volcker and current Fed chairman Ben Bernanke.
Volcker is on record as saying:
We’ve got an [industry] here which is vulnerable to a crisis. We had a big crisis, it turned out to be terribly vulnerable. There was no backstop, no capital, no official assistance available.
And last month Bernanke told Congress:
Part of the reason that investors invest in money market funds mutual funds is that they think that they are 100% safe. And if that is not true, then we have to make sure that investors are aware and that we take whatever actions are necessary to protect their investments.
But sophisticated investors who rely on the money market industry for short-term financing may feel differently about rules that are likely to impact liquidity. Approximately one-third of the commercial paper market, which corporations use for short-term financing, and about two-thirds of the short-term municipal bonds issued are absorbed by money market funds.
Fund Industry Response
While the fund industry as a whole is lined up in firm opposition to the proposed changes, the SEC has managed to garner grudging acquiescence, if not a modicum of support, from some big fund industry players. Deutsche Bank AG’s DB Advisors has backed the idea of a floating NAV. And earlier this month, BlackRock published a report outlining some ways that regulators could make a floating NAV proposal more palatable to investment management firms and their clients. BlackRock’s Vice Chairman, Barbara Novick, told Bloomberg News that her firm is neither opposed nor in favor of a floating NAV, and said: “We’re pragmatists. The regulators are going down this path. Do you want to fight them or try to work for the best possible solution?”*
With profits at stake, it’s no surprise that the fund industry is fighting back. They argue that tighter regulations will have far-reaching effects on liquidity, savings, and industry profitability. Industry profits, already impaired by record-low interest rates, will likely be pinched further, threatening the viability of the smallest players. Already, the number of money market funds has dropped by 40% since 2008. An unintended consequence, fund firms argue, is that significant redemptions would put additional financial pressure on banks, which rely on money market funds for short-term funding. This, in turn, could have ripple effects on the broader economy.
The industry trade group Investment Company Institute has pointed to its 2011 paper titled “Pricing of U.S. Money Market Funds” in defense of the stability of money market fund pricing. ICI asserts that three-month Treasury bill rates would have to rise by 1% in a single day to reduce the portfolio value of the average money market fund by $0.0012. Such an extreme rate change has happened only once in the past 30 years — in 1982. Similarly, investor net redemptions must reach 80% of a fund’s assets to reduce the average fund’s per-share market value to $0.9950, absent any other changes in market conditions. ICI calls a floating NAV “an illusory benefit at best” and cites the accounting, transactional, and tax costs that would accompany such a change.
Fidelity Investments, the dominant player in money market funds, with more than $400 billion in assets, disputes the notion that retail investors are unaware that their principal is at risk, citing an internal survey that found that 81% of their investors understood that there were daily price fluctuations in the securities held by money market funds. Based on the same survey, Fidelity has told regulators that more than half of their retail clients would invest less or stop investing in money market funds altogether if there were floating NAVs or redemption restrictions.
Federated Investors (NYSE:FII), the third-largest industry player, has approximately three-quarters of its assets under management in money market funds and clearly a lot at stake in this debate. CEO Christopher Donahue has called the proposals “various forms of death and destruction” and has vowed to take legal action to block the contemplated changes.
Implications for Investors
What would the contemplated changes mean for investors? Greater transparency for one thing. A floating NAV would leave no doubt that money market funds are investment vehicles susceptible to loss of principal. A capital buffer and redemption restrictions would probably result in a lower return and possibly some investor angst if required to wait 30 days for a portion of their funds.
Institutional investors account for roughly 70% of money market fund assets, using them primarily as cash management vehicles. Carol DeNale, treasurer of CVS Caremark (NYSE:CVS), participated in a 2011 SEC roundtable discussion on money market funds and systemic risk, and seemed to speak for many of her industry peers when she said, “I am not running an investment house. I will not invest in a floating NAV product. We are not geared to mark to market on a daily basis.”
There are estimated to be 30 million individuals invested in money market funds. The relatively attractive yields historically offered by money market funds made them popular alternatives to traditional bank offerings. But as the Fidelity survey shows, many retail investors are likely to flee if the changes under consideration are implemented. Where will they go? Short-term bond funds and FDIC-insured products, including savings accounts and certificates of deposit, are likely to see inflows. And, ironically, unregulated and riskier offshore money market funds may benefit as well.
What to Watch For
While many expect the reforms to be formally proposed and put out for public comment by the end of March, they must first be approved by a majority of the five SEC commissioners, three of whom have expressed opposition to, or at least doubts about, the need for more regulation.
With the public still suffering from bailout fatigue, strengthening capital requirements to lessen the likelihood that taxpayers are asked to backstop troubled funds does hold a certain appeal. And while redemption restrictions may provide for a more orderly exit in times of extreme stress, they run counter to a primary selling point of money market funds — their liquidity.
The case for a floating NAV was perhaps best summarized by a recent Wall Street Journal editorial, which argued that transparency should not be sacrificed in the name of accounting convenience and financial innovation would ultimately fill any void created by such a change.
While it’s hard to argue against a call for more transparency, the potential dislocation caused by a floating NAV needs to be considered carefully. With only two failures in 40 years, the money market fund industry has proven itself to be more stable than most.
Despite its long-standing support of fair-value accounting, CFA Institute, in a 2011 comment letter written in response to the “Report of the President’s Working Group on Financial Markets,” stopped short of calling for a floating NAV, citing the potentially disruptive impact. Instead, CFA Institute called for improved disclosure and supported the idea of a voluntary, private insurance fund for the money market fund industry, as well as certain redemption restrictions.
* An earlier version of this blog post characterized BlackRock’s new position as “supportive” of a floating NAV. The firm disputed that assertion in a letter to the editor.