After several months of minimal feedback, the SEC has posted a number of "Comments on Proposed Rule: Money Market Fund Reform; Amendments to Form PF" over the past month. A recent letter comes from David F. Freeman, Jr., Arnold & Porter LLP, on behalf of Federated Investors, Inc., which explains, "Enclosed for filing in the above-referenced comment docket is a copy of a comment letter that we submitted to the Financial Stability Board/IOSCO on their Consultation Report on "Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions (BIS Ref. 1/2014)." The enclosed letter to the Financial Stability Board, International Organization of Securities Commissions, c/o Secretariat of the Financial Stability Board Bank for International Settlements addresses "Proposed Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions (Ref no: 112014)."
The letter says, "We are writing on behalf of Federated Investors, Inc. and its subsidiaries ("Federated") to comment on the Consultative Document Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions (NBNI G-SIFis), published by the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO). The Consultative Document ("Consultation") poses a number of questions regarding the assessment methodologies that should be used to identify NBNI G-SIFis -- those institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity."
Freeman writes, "The Consultation requests comments on detailed NBNI financial sector-specific methodologies for finance companies, broker-dealers, and investment funds. The investment funds sector is designed to cover authorised/registered open-end schemes that redeem their units or shares (whether on a continuous or periodic basis), as well as closed-end ones. The Consultation states that, by way of example, the methodology applicable to investment funds "would therefore cover disparate fund categories, from common mutual funds (including subcategories thereof such as money market funds (MMFs) and exchange-traded funds (ETFs) to private funds (including hedge funds, private equity funds and venture capital).""
The letter explains, "Our comments will address the various questions posed, based on the application of the methodologies to investment funds and, in particular, money market mutual funds-particularly European "short-term" money market mutual funds that conform to CESR/ESMA guidelines, and U.S. money market mutual funds that meet the requirements of Securities and Exchange Commission ("SEC") Rule 2a-7 (MMFs). In brief: Federated agrees with the approach of the Consultation of developing specific, measurable, published criteria for use in designating NBNI G-SIFis; Federated agrees with the Consultation that, to the extent the proposed methodologies are applied to the investment fund sector, it is appropriate to focus on individual funds and not investment managers or fund families; Federated further agrees with the Consultation's analysis regarding certain key aspects of investment funds (and MMFs in particular) that weigh strongly against listing them as NBNI G-SIFis, including their lack of leverage and their substitutability, simplicity and transparency, as well as applicable legal requirements and practices designed to mitigate risk; and Using the methodologies presented in the Consultation, properly applied, we do not believe that any MMF should be listed as an NBNI G-SIFI."
Federated's comment continues, "In the context of mutual funds and other regulated investment companies, the absence of material amounts of leverage or derivatives, the detailed regulatory program applicable to regulated funds, the many competing funds and other institutional investors in the relevant markets, and the small percentage any one fund owns of the relevant portfolio asset market, in combination, suggest that a regulated investment company, even a large one, is unlikely to be systemically important. In the specific case of MMFs, an unlevered fund which invests only in short-term, highly liquid, high credit quality fixed income instruments, as part of a very large market for an investment category (the general U.S. money market is well over $12 trillion in assets) with many competing investors (not only other MMFs, but also other types of investment funds as well as banks, insurance companies, governments, corporate treasurers and pension plans all investing directly in money market instruments) is far less likely to be systemically important at $100 billion in net assets under management ("AUM") than is a more highly levered fund or other entity with $100 billion in net AUM that is investing in more idiosyncratic assets in less liquid, smaller, and less active markets. In other words, if $100 billion in net AUM is a threshold number for an investment fund generally, a much larger number would be appropriate for judging whether a MMF is an NBNI G-SIFI, due to the large size of the portfolio asset class in which MMFs invest, the low risk of that asset class, the absence of meaningful debt or other leverage, derivatives or counterparty exposures, and the well-developed regulatory framework that governs MMFs."
It tells us, "In addition, the indirect consequences of designating a firm as an NBNI G-SIFI must be considered in establishing the criteria as well as in determining whether to designate a particular firm as an NBNI G-SIFI. For example, if a consequence of such designation would be the imposition of bank-like capital or other regulatory requirements on a mutual fund such that the fund would no longer be attractive to investors or economic to operate, the consequence would be an exit of large funds from the markets. The assets would move somewhere else -- either to the balance sheets of already too-big-to-fail banks, or smaller funds, to less-regulated private funds, or to direct investment by individual corporate treasurers in money market or other safe assets -- but this change would not in any way reduce the risks inherent in the financial system. Instead, it potentially would increase them."
Federated adds, "Notably, the European Parliament's Committee on Economic and Monetary Affairs recently issued a report on systemic risk issues associated with various types of non-bank financial firms, including asset management firms. The Report called upon the European Commission to take into account whether the firms "trade on their own account and are subject to requirements regarding the segregation of the assets of their clients," noted that asset management firms' "client assets are segregated and held with custodians, and that therefore, the ability for these assets to be transferred to another asset manager is a substantial safeguard" and stated the committee's belief that "an effective securities law regime may mitigate many of the issues involved in the case of a large cross border asset manager." The European Parliament committee report further stated that "[t]he size and business model of the asset management sector does not typically present systemic risk."
The letter also says, "In the MMF subcategory of investment funds, the same investment manager may advise many different MMFs with different investment focuses. Regardless of what specific investments are in a particular MMF, each MMF portfolio stands alone. The liabilities (if any) and shareholder interests of one MMF do not have a claim on the portfolio assets of another MMF, even if they are invested in the same issuers. The portfolio of each MMF is diversified by issuer and maturity, resulting in limited exposure to any one issuer or group of issuers."
It states, "Because MMFs hold only very short-term money market instruments, the portfolio composition of every fund is continuously changing, with the great majority of the assets turning over every two or three months. MMFs managed by the same investment manager may invest in many of the same issuers, but at different times with different maturity dates, such that the performance and payment on the two investments will differ and will not necessarily bear the same risks or market values. MMF investment managers select portfolio investments for the funds through extensive and on-going credit review of issuers, which results in a list of permitted issuers and instruments, and the maximum portfolio investment in each fund. To this is applied a matrix of the maturity profile required to meet the liquidity and return objectives of the fund and other investment and diversification requirements. The portfolio manager and traders then select particular investments from the approved list that meet the requirements of the matrix as they become available, depending on price, market outlook on the issuers and instruments, and other considerations, seeking to pick the best of the available investments to optimize the MMFs performance within the criteria set forth in the matrix. For these reasons, Federated believes it would not be appropriate to aggregate MMFs in a fund family for purposes of applying the methodologies, to focus on asset managers on a standalone entity basis, or to focus on asset managers and their funds collectively."
They write, "Using leverage to enhance return generally is not an investment strategy for mutual funds; it is categorically not an investment strategy for MMFs. MMFs have no debt or leverage and are 100% equity. MMFs do not use or invest in derivatives to any material degree. Due to the absence of borrowed funds and derivatives, MMFs cannot transmit portfolio losses to lenders or derivatives counterparties, as they have none to speak of. These characteristics of MMFs are addressed in more detail in the discussion of the "Interconnectedness" indicator further below."
Arnold's Freeman continues, "In addition, investors in MMFs are equity investors who bear the risk of losses which, in view of the high credit quality and liquidity of MMF portfolios, generally would be very minimal. The potential loss to shareholders of a MMF are far too low to transmit systemic risk from the MMF to investors. For example, in the United States, only two MMFs have ever "broken the buck," or failed to maintain a constant net asset value ("CNAV") of $1 dollar per share, in the more than 40 years that MMFs have been in operation. In one case, investors received more than 96 cents back on the dollar, in the other, more than 99 cents on the dollar, and in each case at no cost to the government. In the second case -- the failure of the Reserve Primary Fund to maintain a CNAV of $1 per share during the height of the Financial Crisis in September 2008 -- more than 800 U.S. MMFs in operation at the time were able to maintain CNAV of $1 per share. In contrast, over this same period nearly 3,000 U.S. government-insured banks failed, causing losses of nearly $200 billion to the deposit insurance funds."
He adds, "The magnitude of shareholder losses on MMFs are simply too small as a percentage matter, and too infrequent, to be a means of transmission of systemic risk from MMFs to shareholders and beyond. MMF investors are able to absorb such small and infrequent losses; a MMF' s portfolio losses could not be transmitted to other financial institutions or pose a threat to financial stability."
Finally, the Federated letter comments, "The contention that a MMF may transmit risk to financial institutions and markets through the liquidation channel is based on the overreliance of some banks on short-term funding and the fact that MMFs (and all other non-sovereign lenders) may not renew maturing funding to troubled banks in a crisis, resulting in a liquidity issue at these banks. In some cases, the pressure not to roll over short-term investments is applied by regulators, as in the 2011 European debt crises, when U.S. regulators pressured U.S. MMFs not to renew funding to European banks. SIFI designation will not change this behavior by regulators or the underlying economic incentives involved. However, Basle III requirements (in the U.S., the proposed liquidity coverage ratio rule applicable to banks) will regulate this issue directly by regulating bank liquidity and reliance on short-term funding. If bank regulators implement those rules properly, MMFs cannot transmit liquidity risk to banks because banks will not be allowed to depend upon short-term funding. Regulating MMFs as a way to prevent banks' circumvention of the new bank liquidity rules is unnecessary."
