Today, we excerpt from a supplement to an ICI conference panel in Palm Desert entitled, "Money Market Funds: The Regulatory Hot Potato." Panelist Stephen Keen of Reed Smith LLP included a 20-page summary of recent regulatory discussions, "Money Market Fund Reform from a Risk Management Perspective. His "Outline for 2013 Mutual Funds and Investment Management Conference" says, "Money market fund regulation is fundamentally an exercise in risk management. This may be due to the ease with which the objective of a money market fund -- provision of daily liquidity at a stable net asset value -- is translated into a simple risk: the possibility that the fund may fail to maintain a stable net asset value (known as "breaking a dollar"). Generally, two strategies may be employed to manage risk: first, to reduce the probability of a risk and, second, to limit the consequences of a risk. Another basic principle of risk management is that you cannot eliminate the intrinsic risks of an activity."
Keen writes, "When viewed from a risk management perspective, the history of money market fund regulation (from the original exemptive orders, to the adoption of Rule 2a-7 in 1983 and the subsequent amendments thereto) reflects a continual expansion and refinement of risk controls. Our firm takes this perspective when interpreting Rule 2a-7: consistently favoring the interpretation that reduces the probability or consequences of a fund breaking a dollar. We also believe that risk management provides a useful basis for evaluating proposed reforms to money market fund regulations. This approach promotes clarity by forcing identification of the risk(s) a reform is intended to manage, and whether the reform is intended to reduce the probability of the risk, reduce its potential consequences, or both."
He explains, "This outline systematically reviews the risk controls currently imposed by Rule 2a-7 and assesses whether proposed reforms might enhance these controls. Controls intended to limit the probability of risks are reviewed first, followed by a review of controls intended to limit the consequences of risks, both to a money market fund's shareholders and to other money market funds. Before reviewing possible enhancements, however, we begin by explaining why forcing funds to float their net asset values ("NAVs") should be a "non-starter" from a risk management perspective."
Keen continues, "From a risk management perspective, proposals to force money market funds to "float" their NAVs should not be regarded as "reforms." Floating the NAV would force money market funds to break a dollar, thus assuring the event regulations hitherto sought to prevent. This is particularly true of the first alternative proposed by FSOC, which would magnify trivial fluctuations in the portfolio's value to assure fluctuations in the fund's NAV. It was Orwellian for the former Chairman of the SEC to refer to this proposal to abandon the principle objective of 40 years of money market fund regulation as an effort to "shore-up" the funds. In reality, the floating NAV proposal would truncate the objective of a money market fund to the mere provision of daily liquidity."
He adds, "The Board of the International Organization of Securities Commissions' "Policy Recommendations for Money Market Funds" (FR07/12, Oct. 2012) illustrates the cognitive dissonance that results from treating a floating NAV as a "reform" proposal. Most of the substantive recommendations address standard risk controls already imposed by Rule 2a-7 on U.S. money market funds. E.g., Recommendation 2 ("Specific limitations should apply to the types of assets in which money market funds may invest and the risks they may take."); Recommendation 6 ("Money market funds should establish sound policies and procedures to know their investors."); Recommendation 7 ("Money market funds should hold a minimum amount of liquid assets to strengthen their ability to face redemptions and prevent fire sales."); Recommendation 8 ("Money market funds should periodically conduct appropriate stress testing."); and Recommendation 13 ("money market fund documentation should include a specific disclosure drawing investors' attention to the absence of a capital guarantee and the possibility of principal loss.")."
He continues, "Recommendation 10, in contrast, provides that: "Regulators should require, where workable, a conversion to floating/variable NAV." IOSCO believes that: "A conversion to floating NAV money market funds ... will allow fluctuations in share prices as it [sic] is the case for any other collective investment scheme, improving investors' understanding of the risks inherent to these funds and the difference with bank deposits, and will reduce the need and importance of sponsor support." IOSCO appears oblivious to the paradox that the more successful the implementation of the other Recommendations, the less fluctuation in share prices investors will experience upon implementation of Recommendation 10. To state it from the opposite perspective, if regulators convert money market funds to a floating NAV, regulators would no longer need to limit the volatility of their portfolios. If money market funds become like "any other collective investment scheme," they should no longer need greater risk controls than "any other collective investment scheme.""
Keen adds, "Any money market fund that complies with Rule 2a-7 seeks to maintain a stable NAV. Even if the fund does not use the amortized cost or penny rounding method, and calculates a $10 share price to the nearest penny, by complying with Rule 2a-7 the fund will necessarily tend to stabilize its NAV at $10. Proposing to force the NAVs of money market funds to fluctuate would thus subvert, rather than reform, Rule 2a-7."
He concludes, "Given the 30-year history of Rule 2a-7 and the extensive revisions to the rule during the intervening decades, we should not be surprised to find that many possible enhancements to the rule's risk controls have already been considered and rejected. Unless reformers are intent on subverting the essential nature of money market funds altogether, the avenues for further enhancements are limited. More significantly, the most promising enhancements relate primarily to controlling the consequences of breaking a dollar rather than to reducing the probability of breaking a dollar. This may explain why the industry continues to explore gating, redemption fees and similar reforms that would take effect only when a fund is already threatened with breaking a dollar."
Finally, Keen writes, "What should also be clear from this review is that the proposals under consideration by FSOC all lead to dead ends. Floating the NAV would be the antithesis of reform; capital is uneconomical; and a minimum balance requirement offers no advantages to having a fund break a dollar. FSOC's attempts to interfere in the SEC's deliberations have, since the end of 2011, impeded the SEC's progress on reform proposals that might benefit shareholders, other money market funds and the money market generally. Therefore, it would be best for FSOC and its members to turn their attention to more pressing matters, such as belated adoption of regulations required by the Dodd-Frank Act, and drop money market funds from their agenda."
