Charles Schwab Corp., the 5th largest manager of money market funds with $154 billion, appears to have broken ranks with most other major money fund managers and endorsed a compromise involving a floating NAV for Prime Institutional money funds. In a Friday Wall Street Journal Opinion piece entitled, "Time for Compromise on Money-Market Reform," and subtitled, "Not all money-market funds are created equal. The riskier 'prime' ones should be subject to a variable net-asset value," President & CEO Walt Bettinger writes, "It is time to address the challenges that the country faces in a spirit of collaboration and compromise. As a firm serving the needs of millions of individual investors, Charles Schwab believes this includes compromise on money-market fund reform. A thoughtful and responsible compromise will help restore trust and confidence in our financial markets -- and set an example for other urgent changes that are needed in Washington, D.C."
Bettinger explains, "Money-market funds are a critically important tool for investors to manage their cash. Our firm has vigorously opposed "reform" proposals that would, in effect, put an end to them. Still, there are reasonable arguments in favor of change. After more than two years of debating the merits of various regulatory proposals, Charles Schwab believes that requiring certain money-market funds to have a variable net-asset value is the right thing to do to bring the debate to closure -- and to provide clarity for millions of investors who depend on these financial products."
He says, "A money-market fund faces two different kinds of risk. The first is "breaking the buck" -- when the net-asset value of its investments falls below $1. The second kind of risk is a run -- when investors race for the exit by redeeming their shares. Significantly, these two problems are characteristics of prime money-market funds and, more specifically, prime money markets in which institutions invest.
Bettinger continues, "As far as risk goes, not all money-market funds are alike. A prime money-market fund invests in short-term, fixed-income securities issued by entities other than U.S.-based governments, such as corporations, banks, foreign governments and the like. The problem here is fairly obvious: If a company gets into trouble, a money-market fund's assets can decline and the value of its holdings may no longer equal $1 per share. But nonprime money-market funds invest exclusively in securities issued by U.S.-based governments -- Treasury bills, U.S. government agency debt and sometimes debt issued by state governments. These entities present far less risk."
He tells the Journal, "Now consider the risk of a run. A run occurs when many investors all want out of a fund at the same time, right? Wrong. A run occurs when many investors who also represent a large percentage of the fund's total assets all want out of the fund at the same time. In the 2008 financial crisis, there was no evidence -- none -- that retail investors ran from their money-market funds. Institutional investors did run from their money-market funds -- thus adding to the financial crisis."
Bettinger adds, "Mary Schapiro, chairman of the Securities and Exchange Commission, explained the problem neatly a few months ago in testimony before Congress. "Early redeemers tend to be institutional investors with substantial amounts at stake who can commit resources to watch their investments carefully and who have access to technology to redeem quickly," she said. "This can provide an advantage over retail investors who are not able to monitor the fund's portfolio as closely. As a consequence, a run on a fund will result in a wealth transfer from retail investors (including small businesses) to institutional investors.""
He explains, "When you lay out these facts, the solutions are pretty simple. Most objective observers would say that money-market funds investing exclusively in U.S. Treasury instruments, U.S. government agency paper or debt issued by states have minimal credit risk. These "nonprime" money-market funds should continue to operate as they do now with careful oversight, transparency, regulation by the SEC and a stable $1 per share net-asset value. But prime money-market funds do have a degree of potential credit risk that could arise in extreme capital-market credit crises. And the reaction of institutional investors in these funds to this credit risk creates a potential for runs."
Bettinger writes, "Retail and institutional prime funds should be treated in ways that reflect their risk. Institutional prime money-market funds -- meaning any fund in which a shareholder owns more than a defined percentage of the fund -- should be subject to a variable net-asset value that would immediately reflect losses from credit events. The defined percentage should be determined after careful analysis. The fund's price should be reported at the end of the day, just like other kinds of mutual funds."
He adds, "But resolving the tax and accounting issues that arise upon switching to a variable net-asset value system is critical. In today's environment, operating at a static $1 net-asset value, investors can sell shares as often as they need from a money-market fund each day without creating taxable events. This simplicity is central to a money-market fund's usefulness. Variable net-asset valuation creates taxable events for every transaction, adding enormous complexity."
Finally, Bettinger writes, "Retail prime money-market funds, in which all shareholders have less than a determined percentage of shares, should be permitted to maintain their stable $1 per share price. But they should be subject to additional oversight, including enhanced transparency and disclosure standards. As a manager of both types of funds, Charles Schwab realizes this will considerably complicate the business model. But the company believes it is manageable -- and a compromise on the issue of variable net-asset value is necessary for the good health of our industry and the economy."
