A recent study by University of Mary Hardin-Baylor Assistant Professor Larry Locke and published in The Clute Institute's "Journal Of Business & Economics Research" is entitled, "The SEC's Attempted Use Of Money Market Mutual Fund Shadow Prices To Control Risk Taking By Money Market Mutual Funds." The work's Abstract says, "One of the major advantages of money market mutual funds as a short term cash investment vehicle is that they are always purchased and sold for $1 per share. That constant $1 share price is maintained, despite the obvious fact that the funds' holdings are frequently changing value, through a permissive SEC regulation that entitles money funds to value their portfolio securities at amortized cost rather than market value. At the same time, funds have always monitored their true market value in what is referred to as the funds' "shadow price", disclosed on a semi-annual basis. Starting in December, 2010, the SEC ordered money funds to publish their shadow prices monthly in hopes that investors would take notice and provide market discipline to money funds that failed to keep the funds' market value sufficiently close to $1 per share. The expressed intention of the SEC was that investors would restrain money market fund managers from taking undue risks. This study analyzes whether the SEC's strategy is working. By assessing the relationship between money market funds' shadow prices and subsequent changes in net assets, the authors can look for evidence of whether the market is performing the function the SEC intends. The authors have examined monthly disclosures of shadow prices and asset changes for over 100 money market funds since the funds commenced reporting. Through a series of linear regression analyses, the authors have found no relevant correlation between money funds' shadow prices and investor activity."

The Abstract adds, "The ramifications of this lack of correlation are potentially significant, particularly now as financial regulators are concerned that money fund holdings of European banks might transmit the current credit deterioration in Greece to U.S. markets. The SEC and other financial regulators are counting on disclosure of shadow prices as a tool to avoid the kind of risk taking that ultimately contributed to the credit market freeze experienced in 2008. If that tool is, in fact, not working, the SEC may be obliged to attempt alternative strategies. The authors discuss the policy implications of their findings."

The full study says in its "History of Money Market Mutual Funds," "What made the product possible, however, was a permissive rule under the Investment Company Act of 1940, Rule 2a-7 (17 CFR S 270.2a–7, n.d.). Rule 2a-7 allowed money funds to price their shares consistently at $1 even though the true value of the shares fluctuated fractions of a cent up and down as the value of the funds' investment portfolios changed due to interest rate changes and credit events. Rule 2a-7, however, had an important limitation. It made the fixed $1 pricing only available to money market funds whose true share price (or shadow price) remained within 1/2 of one cent of $1 per share, or between $0.995 and $1.005. (Rule 2a-7(c)). Any deviation between the shadow price and $1 per share greater than 1/2 of one cent would require the Board of Trustees of the fund to take immediate corrective action, such as floating the fund’s share price, suspending redemptions or liquidating the fund. (Rule 2a-7(c)(8)(ii)(B))."

It explains, "The implications of the lack of correlation found between shadow price disclosures and investor activity are potentially significant from a regulatory policy point of view. Financial regulators have a philosophical preference for allowing markets to discipline financial institutions. Financial regulation in the U.S. relies heavily on market forces to reward firms that perform well and punish firms that do not. One of the major criticisms of the banking deposit insurance regime is that it creates a moral hazard by encouraging depositors to patronize the riskiest institutions (who tend to pay the highest rates) (McCoy, 2007). Because bank depositors enjoy the protection of federal deposit insurance, they need not fear losing their deposits and therefore fail to provide discipline to the banking industry. This study, however, indicates that money fund investors are not presently providing discipline to money fund advisors despite the absence of a government insurance program during the period of the study. It would instead provide evidence that investors have already succumbed to the moral hazard of believing that money market funds are not subject to risk of loss."

The paper continues, "It is possible that investors did not provide the hoped for discipline during the period of the study because it was not needed. The study captures only the first few months of the SEC's strategy being in operation and during that period there was not a Lehman Brothers-type failure to motivate investors to discipline their fund managers. Nonetheless, the time frame of the study was a period in which money market funds were often in the news. The financial media published a number of stories about the financial crisis in Greece and its possible negative effect on money market funds through major French banks that are both lenders to Greece and borrowers from money market funds. (Tudor, 2011), (Farrell, 2011), (Coy, 2011), (Crane & Holding 2011). If there were a period in which headline risk would cause an investor to investigate the safety of their money market funds, the period of the study should qualify."

It adds, "It also is possible that as a particular fund's shadow price fell closer to $0.995 (the point at which the fund would break the buck) the market would take notice and investors would begin to withdraw funds in substantial volumes. The lowest shadow price recorded in the data for the study was $0.9983. One could certainly imagine investors being more motivated to withdraw their money as a fund's shadow price reached $0.997 or $0.996. Even if a data point at that level had existed in the data analyzed by the study, the effect of investor activity in that one fund could have been severely muted by the size of the sample analyzed. The authors have presumed, however, that the SEC's goal is not to cause troubled funds to break the buck more quickly, but rather to provide a broad based market discipline favoring funds that tend to maintain higher shadow prices. It is that broad based discipline that the study indicates is currently absent."

Locke writes, "Without the assistance of the market to help discipline money market fund advisors, the SEC's obvious alternative might be to shoulder more of that burden through regulatory activity. Money market funds may need to be more frequently examined, more carefully monitored or more tightly constrained. The drawback of such an approach, of course, is that it sets the regulator and the industry in a state of perpetual conflict. The regulatory enterprise is also grossly understaffed and underfunded in terms of resources compared to the industry. In a speech given on January 27, 2010, Commissioner Aguilar made the point that the industry has grown from one fund in 1971 to over 750 funds and over $3 trillion in assets with very little growth over that same period in SEC staff responsible for regulating money market funds (Aguilar, 2010). The result can be one in which the SEC finds itself forever behind in a race to control the creativity of the industry seeking to take on a preferred level of risk without incurring the regulatory cost."

It says, "A possible alternative to applying more regulatory pressure might be to make a more clear call for investor discipline by making shadow prices more public, more quickly. Retail investors are unlikely to check the SEC's EDGAR database before purchasing a money market fund and even institutional investors might see this as an inefficient use of time and resources when the investment is likely to be very short term and the shadow price information available is already over 60 days out of date. If, instead, investors were able to access a fund's shadow price with less delay (perhaps 30 days or even in real time) and if funds were required to publish the shadow price on their own web sites within that time period, it might conceivably result in a greater correlation between shadow prices and investor activity."

Finally, it concludes, "This study is an example of how sometimes the absence of notable results is, itself, noteworthy. Notwithstanding the variety of regressions run by the authors, the results remain the same. The data provides no indication of a correlation between money fund shadow prices and changes in fund total assets. Interesting, because the entire reporting regime was instigated to create such a correlation. One could argue that the study is too longitudinally limited to detect the correlation but if that is true it cannot be helped. The study captured data for all months available. The study would have to be repeated at a future date to determine if more months of data would make a difference."

The study adds, "The results of the study are potentially troubling from a regulatory policy perspective. If indicative of the investing public's fundamental attitude regarding money market mutual funds, the results suggest that market discipline is unavailable as a risk control device. If the SEC maintains its policy goal of further limiting risk taking by money fund managers it will either have to provide greater incentives to investors to supply that discipline or it will have to resort to means other than market forces. Either approach is available to the SEC. What may not be available is to do nothing. The potential systemic risk to the economy from money market funds has become too large to ignore."

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