BlackRock just published an extensive and excellent overview of potential regulatory options entitled "Money Market Funds: Potential Capital Solutions." The paper, written by Barbara Novick, Rich Hoerner, and Simon Mendelson, says, "The money market fund industry has come under heightened scrutiny in the aftermath of the worst financial crisis in recent history. The events of 2008, including the historic 'breaking of the buck' by the Reserve Primary Fund in September of that year, exposed both idiosyncratic (fund-specific) and systemic (industry-wide) risks associated with money market mutual funds, and gave rise to several reform measures designed to mitigate such risks and enhance the overall value and viability of this important investment vehicle. The Securities and Exchange Commission (SEC) Money Market Reform rules, effective in May 2010, outlined more conservative investment parameters related to the credit quality, maturity and liquidity of money market fund portfolios, and prescribed enhanced guidelines around transparency to investors. Shortly after, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) imposed further safeguards that touch nearly every part of the financial industry."
They continue, "While these efforts have gone a long way toward strengthening the industry and enhancing investor protection, additional proposals related to money market funds (MMFs) remain highly topical today and were aired on May 10, 2011 at the "SEC Roundtable on Money Market Funds and Systemic Risk." In this ViewPoint, we review the objectives and constraints surrounding additional structural reform in the MMF industry and focus specifically on the capital solutions that remain topics of conversation today. Ultimately, we believe the goal of the investment community and policymakers is one and the same: to further reduce systemic risk without undermining money market mutual funds' important role as a source of value to investors and funding to the short-term capital markets."
BlackRock reviews the background of money funds, the 2008 crisis, and "The Regulatory Response," explaining, "Prior to the unprecedented credit crisis of 2008, MMFs successfully provided liquidity to the financial markets for nearly 40 years without requiring government intervention. During the height of the credit crisis and in its immediate aftermath, the concerted actions by policymakers were essential in restoring order and confidence to the markets in a time of great uncertainty. Following is a brief review of reforms that have been implemented and those proposals still under consideration."
They write, "In May 2011, the SEC assembled a panel to address "Money Market Funds and Systemic Risk." SEC Chairman Schapiro and Commissioners Casey, Walter, Aguilar and Paredes were in attendance, as were six representatives from the FSOC and a wide array of interested parties that included corporate Treasurers, institutional investors, academics, industry group representatives and regulators. During the roundtable, Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, along with other bank regulators, emphasized the floating NAV as a key means for limiting MMF-related systemic risk. Institutional investors and industry participants presented the opposing view."
The paper continues, "While floating the NAV was a central topic, other views were presented, including the idea of sponsor capital introduced by Seth Bernstein, Global Head of Fixed Income for JP Morgan Asset Management, and the concept of supplemental shareholder capital presented by Bob Brown, President of the Money Market Group for Fidelity Management & Research Company. In the President's Working Group Report, the ball was passed to the FSOC as the interagency group to take forward structural reforms to MMFs. The 2011 FSOC Annual Report published in July states, "To increase stability, market discipline, and investor confidence in the MMF market by improving the market's functioning and resilience, the Council should examine, and the SEC should continue to pursue, further reform alternatives to reduce MMFs' susceptibility to runs, with a particular emphasis on (1) a mandatory floating NAV, (2) capital buffers to absorb fund losses to sustain a stable NAV, and (3) deterrents to redemption, paired with capital buffers, to mitigate investor runs." Needless to say, regulators are focused on structural reforms for money market funds.
BlackRock says, "Issuers of commercial paper, fund managers and MMF investors have universally expressed concerns about the floating-NAV structure for a vehicle that for decades has been differentiated and prized for its stable-NAV feature. In response to the PWG report, and based on subsequent dialogue, a number of new ideas have been proposed. These include: an NAV buffer within each MMF portfolio, a trust structure or other special purpose entity (SPE) outside the individual MMF, a subordinated share class and/or the imposition of redemption fees. In this paper, we examine the pros and cons of each of these approaches."
Novick & Co. explain, "Before additional change can be made in the MMF industry, it is important that all interested parties agree on exactly what the problem is that requires solving and, to that end, which tools are available and which are off limits. Importantly, the solutions must work for all constituencies, including regulators, MMF sponsors, investors and commercial paper issuers.... We would identify two key and universally accepted objectives of structural change: (i) to maintain MMFs as a viable cash vehicle, and (ii) to strengthen Rule 2a-7 to enable MMFs to better withstand risks. We believe particular attention should be paid to fund-specific risks, including factors related to a fund's credit quality and liquidity, and its ability to withstand acute risks in the event of a systemic situation."
They say, "There are a number of meaningful obstacles to MMF reform that must be factored into the development of an acceptable solution. Among them: The status quo is not acceptable to regulators.... A floating NAV is not acceptable to investors, and the demise of MMFs as we now know them is likely to cause unintended consequences.... Access to the Federal Reserve discount window is not available.... Socialized or shared capital could result in idiosyncratic risk.... This effectively eliminates industry-wide insurance as well as government insurance as potential solutions. Segregating retail and institutional investors does not solve the MMF problem. Much like institutional investors, individual (or retail) investors also have been known to redeem MMF assets when trouble arises.... Importantly, it is also difficult to differentiate between institutional and retail investors."
The paper continues, "Capital solutions to the MMF debate can include multiple structures (or forms of capital) and multiple sources of capital.... Notably, the proposals outlined above need not constitute an allor-nothing proposition. A hybrid approach that uses some facet of the aforementioned models could be a desirable solution. Rather than being overly prescriptive, regulators could allow for some market innovation -- specifying the minimum amount of capital and timeframe for capital to be in place, and then allowing each plan sponsor to address the problem in a way that best meets its needs. However, the benefits of flexibility need to be weighed against the cost of complexity. Ultimately, a hybrid approach may introduce too much complexity."
In Conclusion, Novick, Hoerner and Mendelson comment, "When considering MMF reform, it is important to reflect on the role MMFs play in the overall short-term financing markets for corporations and municipalities and, by extension, the tremendous impact they have on the functioning of our economy. As additional structural change is considered, care must be taken to ensure that the reforms, both individually and collectively, achieve the objective of protecting MMFs and the shareholders who invest in them without inadvertently destabilizing financial markets. BlackRock has advocated "capital solutions" from the outset of the MMF reform discussions, and we are not surprised that many of these solutions remain under consideration today. We welcome the opportunity to continue to engage in finding the optimal solution that would both maintain MMFs as a viable cash vehicle and strengthen Rule 2a-7 to enable MMFs to better withstand risks."
Finally, they add, "Following are several important considerations: Amount of capital. The amount of capital required by MMFs to ensure a sufficient cushion is a critical discussion and one that is important regardless of the source of capital. We believe the amount of capital should reflect the level of risk in a given portfolio.... The SEC can further modify Rule 2a-7 to reduce liquidity risk even more through a requirement that MMFs limit concentration by not permitting any shareholder to purchase shares if, after such purchase, the shareholder would own more than 5% of the MMF's outstanding shares.... As discussed earlier, the inclusion of redemption fees in Rule 2a-7 could further protect a fund from a run and reduce the amount of capital required. Based on the capital guidelines that ultimately are established, some plan sponsors may decide that the amount is achievable, whereas others may choose to exit the MMF business.... MMF participants must focus on refining the remaining options. Setting out clear objectives and constraints will help all interested parties (investors, CP issuers, plan sponsors, regulators, trade associations) focus their efforts and energy on finding the best possible solution. Each of the remaining options has unresolved issues; however, an intense collaborative effort will be important in addressing these issues and strengthening and enhancing the MMF industry."
