Today, we again look at the SEC's Proposal on Money Market Fund Reform with a focus on the section on "Stress Testing (page 468). It says, "In 2010, we adopted amendments to rule 2a-7 that, for the first time, required the board of directors of each money market fund to adopt procedures providing for periodic stress testing of the money market fund's portfolio, which we refer to as the stress testing requirements. We adopted this requirement based on our belief that "stress testing procedures would provide money market fund boards a better understanding of the risks to which the fund is exposed and would give managers a tool to better manage those risks.""
The release explains, "Under these amendments, we required that the fund adopt procedures providing for periodic testing of the fund's ability to maintain a stable price per share based on (but not limited to) certain hypothetical events. These hypothetical events include a change in short-term interest rates, an increase in shareholder redemptions, a downgrade of or default on portfolio securities, and the widening or narrowing spreads between yields on an appropriate benchmark selected by the fund for overnight interest rates and commercial paper and other types of securities held by the fund. At the time, we declined to specify further tests that a money market fund should conduct to fully assess its ability to maintain a stable value, leaving it to the fund's board (and the fund manager) to establish additional scenarios or assumptions on which the tests should be based and to tailor the tests, as appropriate, for different market conditions and different money market funds."
The SEC writes, "Since 2010, we and our staff have continued to monitor the stress testing requirement and how different fund groups are approaching its implementation in the marketplace. Through our staff's examinations of money market fund stress testing procedures, we have observed disparities in the quality and comprehensiveness of stress tests, the types of hypothetical circumstances tested, and the effectiveness of materials produced by the fund's manager to explain the stress testing results to the board. For example, although some funds actively embrace the spirit of the requirement by testing a variety of additional hypothetical events and tailoring their stress testing to the particular market conditions and potential risks that they may face, other funds test only for the events specifically listed in the rule. Some funds test for combinations of events, as well as for correlations between events and between portfolio holdings, whereas others do not. We also have examined how funds share information about stress testing results with their boards."
They continue, "Since adopting the stress testing requirement in 2010, we have had several opportunities to assess its effectiveness during periods of market stress, including the 2011 Eurozone debt crisis and the 2011 U.S. debt ceiling impasse. Our staff observed, for example, that during the 2011 Eurozone debt crisis, funds that had strong stress testing procedures were able to use the results of those tests to better manage their portfolios and minimize the risks associated with the crisis. After considering this information and experience, we believe that certain enhancements to our stress testing requirements may be warranted. We also note that our floating NAV proposal and our liquidity fees and gates proposal may have different implications regarding the need for and nature of stress testing of a money market fund's portfolio. Accordingly, we are proposing a variety of amendments and enhancements to our stress testing requirements. The amendments and enhancements we are proposing to the stress testing requirements would largely be identical under either reform alternative we might adopt, except that for floating NAV money market funds we would remove the standard to test against preserving a stable share price if we were to adopt the floating NAV alternative, as further discussed below."
Under the "Floating NAV Alternative," the Proposal says, "As discussed above, we acknowledge that requiring that money market funds transact with a floating NAV mitigates but does not eliminate the possibility of heavy shareholder redemptions. We understand that in times of broad financial market stress, shareholders in floating NAV money market funds may still have an incentive to redeem shares because of funds' limited internal liquidity or because of overall flights to quality, liquidity, or transparency. Accordingly, stress testing the liquidity of floating NAV funds could enhance a fund board's understanding of risks and fund management of those risks."
It adds, "If we adopt the floating NAV alternative, we propose to amend the current stress testing requirement as it would apply to floating NAV money market funds to require that such funds test the impact of certain market conditions on fund liquidity, instead of requiring that they test the fund's ability to maintain a stable price per share. More specifically, we are proposing that each floating NAV money market fund stress test its ability to avoid having its weekly liquid assets fall below 15% of all fund assets. This requirement also would be in accord with the proposed requirement, discussed in the next section, that would require funds to stress test their ability to avoid crossing the same 15% weekly liquid asset threshold because it could trigger fees or gates. We selected this 15% weekly liquid asset test for similar reasons that we selected that threshold under our liquidity fees and gates alternative -- that a money market fund falling below this liquidity threshold can indicate stress on the fund. Funds that go below the 15% weekly liquid asset threshold may face significant adverse consequences, and thus fund boards and advisers should understand and be aware of what could cause a fund to cross such a threshold."
The Reform proposal also comments, "For a money market fund that would be exempt from the floating NAV requirement under our proposal (a government or retail money market fund), we propose requiring that it stress test for both its ability to avoid having its weekly liquid assets fall below 15% of its total assets and its ability to maintain a stable share price. This would augment the current testing that these funds conduct to test not just against stresses that could cause these funds to "break the buck" but also for liquidity stresses."
Under the "Liquidity Fees and Gates Alternative," the SEC comments, "If we adopt our liquidity fees and gates alternative proposal, we are proposing that money market funds stress test against the potential for a money market fund's level of weekly liquid assets to fall below 15% of its total assets, in addition to stress testing against the fund's ability to maintain a stable share price. If we adopt this alternative, we would also adopt the same enhancements and clarifications to the stress testing provisions of rule 2a-7 discussed above under our floating NAV proposal."
They add, "Money market funds currently must stress test their ability to maintain a stable NAV per share, because failing to maintain such stability may result in significant adverse consequences for its investors, as discussed above. Under our liquidity fees and gates alternative, if a fund's level of weekly liquid assets falls below 15%, we would require a fund to impose liquidity fees (unless the board determines otherwise) and a fund may impose a gate. Much like the inability to maintain a stable price, the triggering of such fees or gates may result in significant consequences for a fund and its shareholders. Accordingly, we are proposing an additional metric against which the fund would have to stress test: the fund's level of weekly liquidity assets falling below 15%. Requiring funds to stress test their ability to avoid crossing this threshold should help inform boards and fund managers of the circumstances that could cause a fund to trigger fees or gates and provide them a tool to help avoid doing so."
Finally, the SEC's proposal says, "Generally, we expect that a fund would use similar hypothetical circumstances when testing its ability to avoid triggering fees and gates that it uses when stress testing its ability to maintain a stable price. However, some funds may identify different circumstances that are more relevant to testing one standard than another, and thus may use different versions of the hypothetical scenarios, or weigh them differently for each. For example, certain events, such as significant shareholder redemptions in a short time period, may more strongly affect the ability of a fund to avoid crossing the 15% weekly liquid asset threshold than the ability to maintain a stable price. Other events, such as a credit default in a portfolio security, may more strongly affect the ability of a fund to maintain a stable price than avoid crossing the liquidity threshold. Stress tests should thus account for a variety of circumstances that affect the ability of a fund to meet each standard."
