Now we know where the convoluted idea for a 30-day redemption "holdback" came from. A paper entitled, "The Minimum Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market Funds," coauthored by Fed economists Patrick McCabe, Marco Cipriani, Michael Holscher, and Antoine Martin, was just posted on the Federal Reserve Bank of New York's website. A statement published yesterday, entitled, "New York Fed Releases Staff Report on Money Market Fund Reform," says, "The Federal Reserve Bank of New York today released a staff report describing how a proposal for money market mutual fund (MMF) reform would make the financial system safer and more fair, reducing systemic risk and protecting small investors who do not redeem quickly from distressed funds."
The release explains, "The paper discusses a proposal to mitigate the vulnerability of MMFs to runs by introducing a "minimum balance at risk" (MBR) that that would provide a disincentive to withdraw funds from a troubled money fund. The MBR would be a small fraction of each shareholder's recent balances that would be set aside in the event that they withdrew from the fund. Most regular transactions in the fund would continue as before, but redemptions of the MBR would be delayed for thirty days. The delay would ensure that redeeming investors remain partially invested in the fund long enough to share in any imminent portfolio losses or costs arising from their redemptions."
The New York Fed's statement continues, "At present, investors in a troubled fund have a strong incentive to run because those that are first to the exit can get out with 100 cents on the dollar, leaving other investors in the same fund to bear any losses. The MBR proposal would substantially reduce the incentive to run and ensure more equitable distribution of any loss among investors in a fund. Under the proposal discussed in the paper, as long as an investor's balance exceeds the MBR, the rule would have no effect on transactions and no portion of any redemption would be delayed if the remaining shares exceed the minimum balance."
It adds, "Additionally, MBRs could strengthen market incentives for early market discipline for MMFs by clarifying that investors cannot quickly redeem all shares from a fund during a crisis. Investors would have strong incentives to identify potential problems well before any losses are realized. Furthermore, by discouraging investors from redeeming shares in a troubled MMF, the MBR would help the fund avoid the need for fire sales of assets to raise cash -- an effect that not only benefits the fund and its investors, but also reduces contagion risk throughout the system."
William Dudley, president of the New York Fed, comments, "Further reform of money funds is essential for our nation's financial stability. Proposals currently under consideration, that are consistent with the basic idea discussed in this staff report, would make the financial system much safer. I strongly endorse their adoption." The release adds, "Mr. Dudley noted that small investors could be exempted from the requirement to maintain a minimum balance as they were less prone to withdraw their money at the first sign of trouble."
The full paper says in its Abstract, "This paper introduces a proposal for money market fund (MMF) reform that could mitigate systemic risks arising from these funds by protecting shareholders, such as retail investors, who do not redeem quickly from distressed funds. Our proposal would require that a small fraction of each MMF investor's recent balances, called the "minimum balance at risk" (MBR), be demarcated to absorb losses if the fund is liquidated. Most regular transactions in the fund would be unaffected, but redemptions of the MBR would be delayed for thirty days. A key feature of the proposal is that large redemptions would subordinate a portion of an investor's MBR, creating a disincentive to redeem if the fund is likely to have losses. In normal times, when the risk of MMF losses is remote, subordination would have little effect on incentives. We use empirical evidence, including new data on MMF losses from the U.S. Treasury and the Securities and Exchange Commission, to calibrate an MBR rule that would reduce the vulnerability of MMFs to runs and protect investors who do not redeem quickly in crises."
The study's "Conclusion" states, "The MBR offers some important advantages over other proposals for reducing the vulnerability of MMFs to runs. Importantly, the MBR could allow MMFs to maintain features that are central to their attractiveness to investors, particularly their stable $1 NAVs, their market-based yields, and the immediate liquidity of the vast majorities of investors' balances. The MBR would not require raising the large sums that would be needed to create a meaningful capital buffer, so the MBR likely would be more feasible than a standalone capital option (although a capital buffer could complement an MBR rule well). Moreover, the MBR rule creates a deterrent to redeeming in times of stress that cannot be provided by a floating NAV or a capital buffer. And unlike some proposals for conditional restrictions or fees on redemptions, an MBR rule would not set up incentives for preemptive runs. Indeed, the MBR likely would improve market discipline for MMFs by strengthening investors' incentives to monitor and respond to MMF risks when they first arise, rather than waiting to redeem until serious problems are imminent."