BlackRock, the world's fourth largest manager of money market funds with over $145 billion, published a "ViewPoint" white paper last week entitled, "Money Market Funds: A Path Forward," which criticizes the money market fund reform options being discussed to date and which proposed a new "circuit breaker" or "standby liquidity fee" (SLF) as a possible compromise solution. BlackRock writes, "Policymakers globally continue to grapple with the regulation of Money Market Funds ("MMFs") in the wake of the 2007/2008 financial crisis. A seemingly simple product has challenged some of the best regulatory, industry and academic minds, and consensus on a proposal for additional MMF reforms still appears to be elusive. We at BlackRock have been deeply engaged in these discussions and – like others – have worked on numerous proposals for reform based on the lessons learned in 2008. In this ViewPoint, we propose a path forward that takes into account the various concerns and objections that have been raised in past discussions. We make three basic proposals that address the concerns of those who believe that MMFs are a systemic risk while preserving the benefits of the product for investors and the short-term funding markets. Importantly, these proposals can be applied to MMFs that are subject to regulation in various jurisdictions globally."
The paper, written by Barbara Novick, Rich Hoerner, and Simon Mendelson, explains, "We believe that any proposed further regulation of MMFs must pass two basic tests. First, it must preserve the core benefits of the product. The benefits to investors in MMFs are well known: diversification, ease of operation and accounting, and market competitive returns. But what is often overlooked are the benefits to borrowers in the capital markets (e.g., issuers of commercial paper, certificates of deposit and sovereign and supranational securities). Looking at MMFs solely as "shadow banks" misses this point; MMFs are better considered as a form of market finance."
It continues, "The second test for further regulation of MMFs is that it must address the issue of "runs". There is no question that in 2008 -- for the first time in history -- "Prime MMFs" (US MMFs that are not limited to holding only exposure to US Agencies/Treasuries) experienced unprecedented redemption demands, coupled with a complete failure of market liquidity as investors fled any exposure to banks and mortgage securities. The events of September 2008 created a significant contraction of credit and were part of the broader global financial crisis. As a result, any successful MMF reform must address this scenario – massive client redemptions."
BlackRock says, "Most ideas on the table today fail the two-part test.... The proposals recently considered by the SEC were to add continuous redemption holdbacks and capital requirements to MMFs. Under those proposals, redeemers from MMFs would leave behind a fixed percentage of their deposit, which would only be returned after a delay. This would be in force even during times of normal functioning in the markets. These ideas fail both parts of our test. First, the proposals would have destroyed the MMF industry. In our discussions with our US MMF clients, they uniformly told us that they would abandon the product if the SEC proposals were implemented. Many current managers of MMFs and their service providers would not have undertaken the expensive operational work required to deliver the product because it was unclear that an industry would exist afterward."
They add, "Second, it was not clear that the proposals would have reduced the risk of mass redemptions. Clients in our research told us that the punitive nature of the holdback would make them more likely to redeem, if they invested at all, and they would do so sooner in order to secure their investment before market stresses took hold. In short, the SEC proposals were fundamentally flawed and failed to win Commission and industry support. They would have caused a major contraction in short-term funding without solving the core issue of mass redemptions."
BlackRock's latest ViewPoint tells us, "Another idea often discussed is to do away with CNAV accounting for MMFs. Our research suggests that this would change but would not destroy the industry; indeed, both CNAV and VNAV products are offered and are successful in Europe. If CNAV funds were eliminated, we believe the industry would contract significantly but would survive in reduced form. However, this idea fails the second of our two tests – it will not solve the problem of mass redemptions. Both CNAV and VNAV funds experienced substantial redemptions during the 2007/2008 financial crisis. The safety of MMFs is driven fundamentally by three things: the quality of the assets in the funds, the duration of those assets and the amount of available liquidity held in the funds. CNAV versus VNAV merely relates to the accounting treatment of the calculation of the NAV of the fund. Economists speculate about the potential first mover advantage of CNAV versus VNAV, but in our experience, clients decide to leave the fund based on their assessment of the quality of assets, duration of assets and liquidity levels and whether those are deteriorating in an unusually dramatic way. The "run" on prime MMFs in 2008 did not represent fears of investors regarding the pricing structure of one type of MMF, but rather their concern regarding the creditworthiness (that is, solvency) of financial institutions in which the MMFs had invested. Even in a pure floating VNAV fund, clients will run for the exits if they believe that those NAVs will be substantially (and perhaps irreparably) worse in the future."
It explains, "The CNAV/VNAV debate is further confused by the fact that the terms are used in an imprecise manner. We believe there are actually three types of funds [CNAV funds, floating NAV and "accumulating" funds].... While it is tempting to believe that a simple change in accounting treatment is all that is needed to provide run-protection for this industry, none of these types of funds is insulated from runs. Each type has its pros and cons but none passes the second of our two tests, the need to be more resilient to significant client redemptions. As discussed above, a major regulatory change focused on VNAV will be expensive, time consuming, and ultimately will not achieve the goal of reducing systemic risk."
BlackRock also critiques "capital requirements" then states, "Having now spent considerable time engaged in the debate on MMF regulatory reform, we have identified three regulatory steps that pass our two-part test of preserving the benefits of the product and answering the challenge of "runs". Upon reflection, we realize that the term "shadow banking" may have diverted attention from the real issues. It implied that MMFs are best understood as a kind of bank and therefore bank-like solutions should work. But when we focused on MMFs as a form of market finance, this led us to consider ideas that have helped to ensure the robustness and safety of markets: asset standards; disclosure; and circuit breakers."
They explain, "Based on this concept, we recommend the following steps be taken by global regulators with appropriate tailoring to local markets: 1. Consistent Standards for Asset Quality, Duration and Liquidity.... 2. Enhanced Disclosure.... 3. Circuit Breakers. Build in circuit breakers to all MMFs to limit runs in the time of a crisis. We believe these should take the form of stand-by liquidity fees (SLFs). We recommend these have the following features: a) Objective triggers. The SLFs would not be active during times of normal market functioning. They would be triggered when a fund has fallen to half the requirement for NAV rounding or to one quarter the required liquidity levels based on the standards set above. In the case of US Rule 2a-7 MMFs, this means that the SLFs would be triggered when the fund fell below a mark-to-market NAV of 99.75 or when its 1-week liquidity fell below 7.5%. b) The amount of the fee is a simple calculation. We recommend the amount of the fee charged when the SLFs are in force to be twice (2x) the difference between the mark-to-market NAV and $1. As an example, if the mark-to-market NAV fell to 99.70%, the fee would be 60 basis points (30 bps x 2). The rationale for this fee is to create a positive cycle as clients redeem in place of a negative cycle. As each client redeems and leaves behind twice the deficit, the NAV for the remaining shareholders is strengthened."
Finally, BlackRock writes, "Finding a solution to money market fund reform has been elusive. We continue to search for a workable solution that meets the needs of investors, issuers, policy makers, and MMF sponsors. The three steps outlined above would pass our two-part test for the regulation of MMFs. While many clients may initially object to the idea of SLFs, and the industry will initially contract (perhaps substantially at first), we believe clients will adjust. Those that simply cannot tolerate any form of liquidity limits will favor government MMFs. Others may choose to use government MMFs for some portion of their assets and Prime MMFs subject to liquidity fees for their longer term cash. The SLFs will also encourage fund managers to deal with potential problems sooner, to avoid tripping a SLF trigger. Borrowers from MMFs (e.g., issuers of commercial paper) will continue to use MMFs but will limit their reliance to ensure other sources of funding. The changes proposed in this paper will preserve the industry in providing its important function in the short-term capital markets. And, this approach will create an effective brake on a run by introducing a mechanism that requires runners to pay for the cost of their liquidity plus an increment to protect clients that do not redeem."