Measuring money... faster, cheaper, cleaner

Federal Reserve Bank of Boston President & CEO Eric Rosengren submitted a Comment letter on the Financial Stability Oversight Council's Proposed Recommendations Regarding Money Market Mutual Fund Reform today, which, unsurprisingly, supported the FSOC's reform proposals. He says, "I am writing on behalf of the Presidents of the 12 Federal Reserve Banks, all of whom are signatories to this letter. We appreciate the opportunity to respond to the request for comment on the Proposed Recommendations Regarding Money Market Mutual Fund ("MMF") Reform (the "Proposal") issued by the Financial Stability Oversight Council (the "Council") on November 19, 2012. We agree with the Council's proposed determination that the conduct, nature, size, scale, concentration, and interconnectedness of MMFs' activities and practices could create or increase the risk of significant liquidity and credit problems spreading among bank holding companies, nonbank financial companies, and the financial markets of the United States. For this reason, we support the Council's efforts to address the structural vulnerabilities of MMFs by releasing the Proposal."

Rosengren writes, "Our comments in this letter will focus primarily on prime MMFs where the greatest credit risk can be taken and where financial stability risks consequently appear to be the greatest. Once reforms are instituted to address the structural vulnerabilities of prime MMFs, we would encourage consideration of what reforms, if any, are worth pursuing for other categories of MMFs."

He explains, "As support for the Council's proposed determination and to set the context for identifying the essential elements of reform, we briefly discuss some of the risks associated with MMFs' activities and practices in Section I. Section II focuses on issues that should be addressed as part of any prime MMF reform proposal -- most notably, suggestions for the enhancement of the accuracy of market-based net asset values ("NAVs" and each, a "NAV"), particularly in the context of Alternative 1, the Floating NAV. Section III then presents observations concerning each of the three reform alternatives included in the Proposal. Section IV briefly discusses standby liquidity fees and redemption gates and explains why these mechanisms, as proposed by some industry participants, do not meet reform requirements. Finally, we conclude by concurring with the Council's view that more than one MMF reform alternative could address the financial stability concerns posed by MMFs, in which case fund complexes could be permitted to choose from among multiple alternatives. For example, a complex could offer both a floating NAV fund and separately a stable NAV fund with a capital buffer (and possibly coupled with a Minimum Balance at Risk ("MBR")), from which investors could choose."

Rosengren tells us, "Under any reform alternative, it is critical that market-based NAVs, now known as the "shadow NAV", be computed accurately. By accurate, we mean that a market-based NAV needs to reflect the market value of all fund assets at the time fund shareholders transact, and not some other value such as amortized cost or a value that is not available in the market. This requirement is in effect today for MMFs in calculating their shadow NAV and should continue to be applied to the market-based NAV requirements under all the reform alternatives. Currently, an accurate shadow NAV provides investors with some protection from share value dilution, even though penny rounding reduces this protection."

He adds, "We support the Council's efforts to address the structural vulnerabilities of MMFs by releasing the Proposal. We agree with the Council's proposed determination that the structural vulnerabilities of MMFs could create or increase the risk of financial instability. As currently structured, MMFs provide a stable price at which an investor may purchase or sell an interest in the MMF, but MMFs have no explicit loss absorption capacity. By allowing redemptions at a constant share price rather than at a share price reflecting the current market value of the underlying portfolio assets, MMFs give investors a financial incentive to redeem before others during times of stress. As such, reforms are necessary to address fundamental instabilities in MMFs."

Rosengren continues, "As discussed above, we believe that reforms should initially focus on prime MMFs as this is where the greatest credit risk can be taken. We also believe that under any reform alternative it is critical that market-based NAVs accurately reflect the value of a fund's underlying portfolio and that disclosures of funds' asset composition be made daily or weekly. In addition, appropriately sizing any NAV buffer will be critical as investors may run if a fund's buffer becomes depleted."

He says, "We share the Council's concerns that standby liquidity fees and temporary redemption gates may increase the potential for industry-wide runs in times of stress, and therefore do not meet the Council's reform requirements. Once reforms are instituted to address the structural vulnerabilities of prime MMFs, we would encourage consideration of what reforms, if any, are worth pursuing for other categories of MMFs. In conjunction with prime MMF reform, we also urge the Council and relevant regulators to use their authorities, where appropriate and within their jurisdictions, to address any potential financial stability concerns associated with the broader cash management industry, where certain products have structural instabilities similar to those found in MMFs."

Finally, he adds, "We concur with the Council that more than one MMF reform alternative could address the financial stability concerns posed by MMFs, in which case fund sponsors may offer both a floating NAV fund and, separately, a stable NAV fund with a capital buffer (or a capital buffer coupled with a MBR). It is also worth noting that if initial reforms apply only to prime MMFs, investors will have the ability to continue investing in a traditional stable NAV fund by investing in a non-prime MMF."

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