Yesterday, we excerpted from BlackRock's latest "Viewpoint" entitled "Money Market Funds: Potential Capital Solutions," which discusses the pros and cons of various regulatory reform options. Today, we excerpt from the sections describing the "Wide Spectrum of Possible Capital Solutions." These include: "Status Quo: Rule 2a-7 enhancements are sufficient; Redemption Fees: Institute an economic incentive to discourage runs; NAV Buffer: Establish an NAV buffer (or cushion) within individual MMF portfolios; Subordinated Share Class: Create a new share class to co-exist with common shares; Trust/Special Purpose Entity: House a buffer outside the individual portfolio(s); Hybrid Approach: Employ some combination of the prior three options; and, Floating NAV: Eliminate stable NAV and find new market equilibrium." BlackRock says, "Assuming that both the first and final options in this continuum (maintaining the status quo and floating the NAV) are unacceptable -- for the reasons noted above -- the following discussion focuses on various forms of capital solutions as well as the possibilities around redemption fees."
Regarding the "NAV Buffer," BlackRock writes, "Under this scenario, a "buffer" would be established within each MMF by siphoning a small amount of income from the portfolio to be set aside as an NAV cushion. The assumption is that a uniform "fee" would be set by regulators (e.g., 4 basis points). The buffer capital is regarded as an asset of the portfolio and, as such, is calculated into the NAV and results in a higher NAV for the MMF. The siphon would be turned on and off depending on the size of the buffer relative to the pre-determined minimum capital requirement. In other words, the portfolio would stop retaining income when the target buffer is reached. Shareholders of the MMF would "own" the buffer. Although this option appears to be embraced by many industry participants, regulators have signaled that this may be insufficient based on the challenges outlined below."
Under, "Key Benefits," they explain, "The NAV buffer concept would be relatively simple to implement.... It affords no advantage or disadvantage for large or small fund families; however, it would create a barrier to entry for new fund sponsors, as existing funds would already have established a buffer.... For shareholders who are worried about the NAV breaking the buck, the buffer affords a higher NAV that removes part of their incentive to redeem. In the event of a run, assuming the fund's NAV is above $1 per share, the NAV accretes, providing further disincentive for shareholders to redeem and again putting a brake on the run."
BlackRock says of the "Subordinated Share Class," "Under this approach, each MMF would have two share classes: senior and subordinated. The senior class would act much like current MMF shares, with investment income and dividends based on the underlying portfolio less an amount allocated to the subordinated share class. The subordinated share class would have a variable payout based on a fee charged to the total portfolio and distributed to the subordinated shareholders.... Given the nature of this new security, we assume the market will demand a yield similar to a low investment grade or a strong high yield issue."
The paper adds, "Given that MMFs have large inflows and outflows, the fund sponsor would need to be able to issue additional subordinated shares and/or redeem subordinated shares to right-size the subordinated share class relative to the overall size of the fund.... This approach sets a market price for the level of risk involved. Assuming efficient markets, poor risk managers will be disciplined by the market in that higher returns will be demanded of them for their inherently higher level of risk. The subordinated security is a new type of security that is quite complex, entailing variable interest as well as extension features. Investor appetite for this security will depend on the ability to obtain a rating and on the development of a liquid secondary market."
BlackRock's "Potential Capital Solutions" continues, "An alternative approach is a trust or special purpose entity (SPE) structure that would house the money market mutual fund. In many ways, the trust structure is similar to the subordinated share class, however, there are several key differences. While BlackRock initially considered the idea of one SPE per fund sponsor and potentially multiple funds supported by a single SPE, we have concluded that it would be much simpler (and pose fewer conflicts) if each MMF portfolio had its own SPE."
It also discusses, "Redemption fees could be established to create economic disincentives to redeem. The redemption fee would need to be applied using a clear set of rules. These rules could include a provision for di minimis withdrawals, and could provide for a notice period after which the fee would not apply. Any fees collected from redemptions would be retained within the MMF for the benefit of remaining shareholders. This type of 'circuit breaker' would further protect a fund from excessive redemptions. While not eliminating the need for capital, the presence of redemption fee features should mitigate the amount of capital required. Some institutional investors may be resistant to products with redemption fees and the triggering mechanism will be important to their analysis."
Finally, BlackRock writes, "Notably, the proposals outlined above need not constitute an all-or-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."
