While we're just starting to read through the recently released 698-page "Money Market Fund Reform Proposal released by the SEC and posted yesterday (see the SEC's Proposed Regulations page here, we wanted to spend a little more time covering the Commissioner's opening statements before we dive into the gory details. In particular, we wanted to highlight Commissioner Troy Paredes "Statement at Open Meeting Regarding a Rule Proposal on Money Market Fund Reform," which contains a withering attack on the floating NAV option. He says, "The Commission, given its experience, expertise, and mission, is best positioned to shape the regulation of money market funds. The Commission has continued to consider additional money market fund reforms beyond those we adopted in 2010 before Dodd-Frank was even enacted. We have made good progress since last summer because of the hard work of the Commission staff, and I believe that the Commission would have moved forward with a rulemaking even without FSOC's intervention."
Paredes comments, "I join my colleagues in thanking the staff — most notably those from the Division of Investment Management and the Division of Risk, Strategy, and Financial Innovation ("RSFI") -- for your professionalism and dedication. I am especially pleased that the robust study that the economists in RSFI undertook to answer a series of questions that were posed has revealed new insights and allowed us to better root this rulemaking in economics and data. This economic study facilitates the kind of rigorous cost-benefit analysis that is needed to determine the regulatory approach that will most effectively lessen the susceptibility of money market funds to heavy redemptions during a period of market stress, halt a run if one starts, and preserve the benefits of money market funds."
He explains, "Two alternatives are at the core of the proposal before us. Either alternative could be adopted by itself, or a combination of the two could be adopted. The first alternative would require institutional prime money market funds to float their net asset value (their "NAV"). The second alternative would permit money market funds to continue transacting at a stable $1 share price, but would require a fund to impose a liquidity fee on redeeming investors if the fund's weekly liquid assets drop below 15% of its total assets, unless the fund's board determines that imposing the fee is not in the fund's best interest. Under the second alternative, a fund's board would also be permitted to suspend redemptions temporarily -- that is, to "gate" the fund -- if the 15% liquidity threshold is crossed."
Paredes tells us, "Each alternative calls for several significant disclosure enhancements, such as requiring a fund to disclose any sponsor support it receives, to disclose its liquidity in more detail, and to disclose additional information about its portfolio holdings. Other disclosures would explicitly warn that investors can lose money when investing in a money market fund. Under the fees and gates alternative, although a fund's NAV would not float, a fund would have to disclose its market-based "shadow" NAV on a daily basis, a practice that many funds have already begun."
He continues, "I support the staff's recommendation. That said, to be clear, at present, I remain unconvinced that floating the NAV is justified on a cost-benefit basis. But floating the NAV is just one of the proposed alternatives. It is particularly important to me that liquidity fees and gates are being proposed as a separate, standalone alternative so that, if appropriate, this alternative can be adopted by itself without requiring money market funds to float their NAVs. Indeed, Commissioner Gallagher and I have pressed for gates since last year, but it was not until this recommendation took shape that gates were included on a standalone basis in a proposal for the Commission to consider."
Paredes states, "Because the proposing release is so thorough, instead of engaging the proposal's many details, the balance of my remarks this morning will summarize my current take on the two proposed alternatives, realizing, of course, that the Commission will receive many thoughtful comments. In evaluating each alternative, I have tried to keep my eye on a simple question: "What are we solving for and does the alternative solve for it at an acceptable cost?" An alternative that does not sufficiently reduce the incentive to redeem at a time of stress, such as during the recent financial crisis, may not be worth pursuing, especially if the alternative could jeopardize the benefits that money market funds afford both investors and issuers."
He says, "This takes me to the first alternative, requiring institutional prime money market funds to float their NAV. The animating purpose behind floating the NAV is to address the incentive to redeem that the stable $1 share price can create. Simply put, an investor may be motivated to exit a fund if the investor can get out at $1 when the fund's shadow price is less than $1. If the NAV floats, then by definition there can be no deviation between a fund's NAV and its shadow price for an investor to take advantage of by selling ahead of others."
Paredes explains, "The floating NAV alternative is also designed to make the risk of money market funds more transparent. The proposing release explains, "Our floating NAV proposal is designed to increase the transparency of risks present in money market funds. By making gains and losses a more regular and observable occurrence in money market funds, a floating NAV could alter investor expectations by making clear that money market funds are not risk free and that the funds' share price will fluctuate based on the value of the funds' assets." The release continues, "Investors in money market funds with floating NAVs should become more accustomed to, and tolerant of, fluctuations in money market funds' NAV and thus may be less likely to redeem shares in times of stress.""
But he adds, "Even if floating the NAV would affect investors in these ways, would it be enough to solve for the kind of widespread redemptions that came about during the upheaval of the financial crisis? As the proposing release acknowledges, money market fund investors may redeem for many reasons that are unrelated to the stable NAV. These other incentives to redeem -- which persist even if a money market fund's NAV floats -- can result in flights to liquidity, transparency, and quality that manifest as heavy redemptions. Flights to liquidity, transparency, and quality stem from a common source: investors' need or desire to avoid losses. Because investors routinely use money market funds as cash management vehicles, a loss of any size may be intolerable. The bottom line under a floating NAV, then, is that when investors see signs of stress, they will have an incentive to redeem sooner rather than later before the NAV floats downward. At a time of stress, even investors that are accustomed to seeing a fund's NAV fluctuate may redeem if they expect the fund's price to fall."
Paredes tells the Open Meeting, "We do not know for sure why investors left money market funds during the financial crisis. The data we do have, however, is consistent with the view that investors predominantly left in search of safety and that investors would have done so even if NAVs floated. First, European floating value money market funds experienced significant redemptions during the financial crisis. Second, U.S. ultra-short bond funds also saw heavy redemptions. Third, even as institutional investors exited from prime money market funds in 2008, significant sums flowed into institutional government money market funds, further suggesting that investors were reallocating their investments to the highest quality assets they could find."
He says, "All of this is to say that the floating NAV alternative suffers from a fundamental limitation. Because money market fund investors will always prefer to exit at a higher price instead of a lower one, even if NAVs float, plenty of reasons will remain for investors to redeem, particularly during a period of financial turmoil when investors seek out quality and as much certainty as they can find. Moreover, if a run does start, a floating NAV is unable to stop it. If, in fact, floating the NAV does not stave off heavy redemptions, then one has to question whether abandoning the stable NAV is justified given the significant costs and burdens that investors and issuers would have to bear if a floating NAV undercuts the usefulness of money market funds as a cash management vehicle. In this case, what would the Commission have solved by floating the NAV?"
Paredes adds, "Let me now turn to make four observations about the fees and gates alternative, which I favor. First, regardless of the reasons investors might redeem, liquidity fees can discourage them from doing so. By requiring redeeming investors to pay for the liquidity they take, liquidity fees reduce the incentive to redeem, whether the incentive is created by the stable NAV or an overarching desire to avoid risk and any chance of loss. Investors may stay put when they have to internalize at least some of the fund's liquidity costs. If some investors nonetheless opt to exit, then the liquidity fees they pay can help shore up the fund's net asset value to the benefit of the remaining investors. The result, according to the proposing release, is that "[the] explicit pricing of liquidity costs in money market funds could offer significant benefits to such funds and the broader short-term financing market in times of potential stress by lessening both the frequency and effect of shareholder redemptions.""
Finally, he says, "As Commissioner Aguilar has emphasized many times, to the extent investors withdraw from money market funds because the funds become less useful, we have to concern ourselves with where the money will go. To my mind, it would be regrettable if we instituted costly regulatory changes only to find out that the changes do not reduce systemic risk. If that were the result, what would we have solved for? It would be even more regrettable if systemic risk actually increased. The sum effect of these observations leads me to think that the fees and gates alternative would more fully accomplish the goals of this rulemaking."
