The U.S. Department of the Treasury has posted a "Note" entitled, "Five Questions on the FSOC's Proposed Recommendations for Money Market Mutual Fund Reform," which says, "Earlier this month, the Financial Stability Oversight Council (the Council) voted unanimously to advance proposed recommendations for money market mutual fund (MMF) reform for public comment. Here are five frequently asked questions about MMFs." We excerpt the Q&A below, and we also cite a recent paper, "Do Money Market Funds Require Further Reform?," that argues against further reform due to the lack of any incentive to run (or "first-mover advantage") and it argues for splitting retail and institutional share classes into separate funds.
The Treasury's "Five Questions" explains, "What are MMFs? MMFs are mutual funds that offer individuals, businesses, and governments a means of pooled investing in money market instruments. MMFs are a significant source of short-term funding for businesses, financial institutions, and governments, as MMFs had approximately $2.9 trillion in assets under management as of September 30, 2012. However, the 2007–2008 financial crisis demonstrated that MMFs are susceptible to runs that can have destabilizing implications for financial markets and the economy."
It continues, "Why do MMFs need to be reformed? In the days during September 2008, after Lehman Brothers Holdings, Inc. failed and an MMF "broke the buck," investors redeemed more than $300 billion from prime MMFs, and commercial paper markets shut down for even the highest-quality issuers. Government intervention was needed to help stop the run on MMFs during the financial crisis. While the Securities and Exchange Commission (SEC) took important steps in 2010 by adopting regulations to improve the resiliency of MMFs, these reforms did not address the structural vulnerabilities of MMFs that leave them susceptible to destabilizing runs."
Treasury writes, "This structural vulnerability to runs is driven by the "first-mover advantage," which provides an incentive for investors to redeem their shares at the first indication of any perceived threat by allowing investors who redeem first to do so at the customary share price of $1.00, even if the fund's assets are worth slightly less. Because MMFs lack any explicit capacity to absorb losses in their portfolio holdings without depressing the market-based value of their shares, even a small threat to an MMF can start a run."
They ask, "Why is the Financial Stability Oversight Council involved if they don't regulate MMFs? The broader financial regulatory community has focused substantial attention on MMFs and the risks they pose. The SEC, by virtue of its institutional expertise and statutory authority, is best positioned to implement reforms to address the risks that MMFs present to the economy and financial markets. However, as the SEC has not been able to move forward with MMF reform, Secretary Geithner urged the Council to take up these important reforms using the Council's authority under Section 120 of the Dodd-Frank Wall Street Reform and Consumer Protection Act."
Treasury's Amias Gerety tells us, "Section 120 of the Dodd-Frank Act is an authority given to the Council to help it carry out its financial stability mission. It enables the Council to issue recommendations to primary financial regulatory agencies to apply "new or heightened standards and safeguards" for a financial activity or practice conducted by bank holding companies or nonbank financial companies under the agency's jurisdiction."
The piece says, "What are the Financial Stability Oversight Council's proposed recommendations for MMF reform? The Council is proposing three alternatives, which are not mutually exclusive and could be implemented in combination: 1. Floating net asset value, which would remove a special exemption under SEC rules that allows MMFs to maintain a stable net asset value per share.... 2. Stable NAV with a NAV buffer and minimum balance at risk, which would require MMFs to build a buffer of up to 1 percent of assets to absorb day-to-day fluctuations in value. This would be paired with a "minimum balance at risk".... 3. Stable NAV with a NAV buffer and other measures, which would require MMFs to build a buffer of 3 percent of assets, and that could be combined with other measures to enhance the effectiveness of the buffer and potentially increase the resiliency of MMFs. To the extent that these other measures complement the NAV buffer and further reduce the vulnerabilities of MMFs, the size of the NAV buffer could be reduced. Additionally, the Council recognizes that there may be other reforms that could achieve similar outcomes, so the Council is seeking comment on other potential reforms of MMFs that meet the objectives of addressing the structural vulnerabilities inherent in MMFs and mitigating the risk of runs."
Finally, Treasury writes, "What happens now that these proposed recommendations have been released? A 60-day public comment period began November 19, 2012, when the proposed recommendations were published in the Federal Register. During the comment period, all stakeholders -- including institutional and individual investors, industry participants, municipalities, and other interested parties – are welcome to submit their comments. Once the public comment period closes on January 18, 2013, the Council will carefully consider the comments and plans to issue a final recommendation to the SEC. Under the Dodd-Frank Act, the SEC will be required to implement the recommended standards, or similar standards that the Council deems acceptable, or explain in writing within 90 days why it has determined not to follow the recommendation. However, if the SEC moves forward with meaningful structural reforms of MMFs before the Council completes its Section 120 process, it is expected that the Council would not issue a final recommendation to the SEC."
In other news, a recent paper, entitled, "Do Money Market Funds Require Further Reform?", written by Robert Comment, says, "The merit of further reform of money market funds by the SEC hinges on the extent to which runs on prime funds pose an investor-protection problem. Reformers assume that the many runs on prime funds in 2008 reflected rational inter-shareholder opportunism, but there is no evidence that retail investors need more protection from this. Notably, the non-redeeming shareholders of the Reserve Primary Fund were the only fund shareholders damaged in the runs on prime funds in 2008, and their avoidable loss amounted to just 1/3rd of one percent of their investment. Still, one-quarter of prime funds in 2008 had a mix of retail and (run-prone) institutional shareholders in the same fund. As the rest did not, this hypothetical hazard is unnecessary and the industry should act voluntarily to eliminate mixed-clientele prime funds."
Comment explains, "The case for more SEC regulation hinges substantially on whether the runs on prime funds in 2008 posed, and by projection future runs will pose, an investor-protection problem stemming from rational, incentive-driven opportunism.... The likelihood that the runs on prime funds in 2008 were irrational undermines the argument that runs on prime funds are incentivized by funds' stable-NAV policies, and this possibility undermines the remaining reform agenda."
He tells us, "The rationality of fund runs is questionable as theory for the same reason the prisoners' dilemma is broken when the prisoners all are represented by the same defense attorney. The proposition that fund shareholders can expect to benefit from gaming fund accounting rests on a presumed absence from the game of a player empowered to serve as agent for the non-redeeming shareholders.... Regarding empowerment, the boards of funds that use amortized-cost accounting are required, by SEC Rule 2a-7, to "promptly consider what action, if any, should be initiated by the board of directors" if the deviation between shadow, mark-to-market NAV and amortized-cost NAV should exceed 1/2 of 1 percent (or $0.005 per share). A board is required to take remedial action when such a deviation "may result in material dilution or other unfair results to investors or existing shareholders".... `Decisive board action to protect the interest of continuing shareholders is not what happened at the Reserve Primary Fund, but the Reserve example is not generalizable due to the outstanding ineptitude of this fund's board."
Comment concludes, "It would be a mistake for the SEC to adopt the contemplated further reform of money market funds. The SEC's regulatory thicket, nearly impenetrable already, ought not to be expanded to serve the aims of central bankers, as laudable as those aims may be. The further reform contemplated by the SEC is only tenuously related to investor protection but poses a tangible threat to a product attribute (stable NAV) that is prized by consumers."
