J.P. Morgan Securities' Alex Roever and Cie-Jai Brown comment this week in a weekly "Short-Term Fixed Income Research Note" on the SEC's recently published proposed amendments to Rule 2a-7 of the Investment Company Act. The pair say, "The proposed changes span a wide range of issues, which we will address in a series of reports." Their most recent report "`is the first in that series and addresses SEC proposals affecting money fund liquidity." Roever and Brown have not posted their comments publicly, but we've received their permission to reprint some of their piece below.
Roever and Brown write, "[T]he SEC is proposing a new three pronged framework for liquidity management that consists of 1) eliminating exposure to illiquid assets, 2) establishing periodic and general liquidity requirements, and 3) stress testing to identify further liquidity needs. The proposal is entirely within the construct of Rule 2a-7 and makes no presumption about the Federal Reserve, as lender of last resort, providing any form of liquidity support to funds like that provided via emergency programs like the AMLF or the MMIFF. In addition, even though the SEC is also proposing a rule that would make it easier for fund affiliates to buy distressed assets from funds, the availability of this kind of nonexplicit support appears to be excluded from this analysis."
They argue that the "SEC's proposed rules for liquidity management would not have been sufficient to address the redemption volume faced by the Reserve Primary Fund and that, "over 100 other stress[ed] funds managed to find external support that kept these funds from failing." They conclude, "We don't think in means the proposed rules are worthless. The presence of the rules should mitigate the risk of runs starting by giving comfort to shareholders that there are significant cash reserves in place to meet redemptions. Also, should a run start the presence of the new liquidity scheme wouldn't preclude the use of outside support, and the additional cash cushion could buy time for that support to be arranged."
"But the proposed rules are not ideal either. They probably won't prevent an extreme case like the Reserve. The new rules will be expensive to implement, and the costs will be born by fund sponsors, shareholders and borrowers that rely on the money markets for funding. Furthermore, while the future role of the Fed as a lender of last resort for MMMFs is uncertain, the value of a program like the AMLF as a source of liquidity should not be ignored. In doing so, the SEC is most likely setting its minimum liquidity thresholds higher than they need to be and thereby imposing greater costs than necessary on stakeholders," say the JPM Analysts.
Roever and Brown continue, "As it stands, the costs of implementing these proposed rules may lead some sponsors and shareholders to exit the money fund space. The loss of fund sponsors will lead to further concentration in an already very concentrated business, which means issuers of money market debt will have to rely on fewer lenders. History suggests investors that leave MMMFs in search of higher yields will migrate to less regulated alternatives that are not as well protected against credit and liquidity risks. Ultimately this may mean that tighter MMMF regulations don't eliminate systemic risk, but rather simply pushes it into another market."
"Finally, one area of potential concern for issuers of CP and other investments favored by prime funds is the impact the proposed rules may have on availability of funding. Clearly, rules that force a higher percentage of fund assets into shorter maturities necessarily mean there is less money available to fund longer term assets. But, also recall that the proposed rules state that no other investments can be made unless a fund is in compliance with the daily and weekly tests. This means events that lead to increased redemptions will potentially curb availability of longer-term funding at times when redemptions push liquid assets below threshold levels (e.g, tax days, quarter-ends, etc.) or during times of market stress. For issuers, the proposed rules likely mean both less credit availability in general and less credit availability when they most want it," they write.
