The March issue of Money Fund Intelligence, which went to subscribers on April 7, featured the article, "Plaze Says Doing Nothing Better Than SEC Proposals." We excerpt the first half of the piece below (and will excerpt the second half tomorrow).... This month MFI interviews Robert Plaze, a Partner at Stroock & Stroock & Lavan LLP, and the former Deputy Director of the Division of Investment Management at the U.S. Securities & Exchange Commission. Plaze, who left the SEC in early 2013, has been involved in regulatory issues involving money market mutual funds for three decades. He is partially responsible for writing much of the existing Rule 2a-7 regulations. Our Q&A follows.
MFI: How long have you been involved in money fund issues? Plaze: I first got involved in the late 1980's. I was there when the first bailout requests came in to the Division. I was in the room when more senior Division Staff were trying to figure out how to deal with them, and I saw the look of concern on everyone's faces. No one knew what might happen if a fund broke the buck, and no one wanted to find out. It was the closest thing I had ever seen at the time to a crisis, because everyone was extraordinarily worried about the prospect of a fund breaking the dollar. Shortly after, I became an Assistant Director in the Division and went on to draft the 1991, 1996, and the 2010 Amendments to 2(a)-7. During that period my staff and I handled all requests for no-action by fund sponsors to bailout their money market funds.
I did this for about 25 years, so it gave me quite a perspective on the development of the money market fund industry and how it dealt with periodic market stresses. On perhaps the most memorable day of my career, I took the call from the lawyer representing Reserve Primary Fund who told me that the Primary Fund would break the buck, and later that day had to try to explain to the chairman of the SEC what was about to happen. Stroock has been around for over 100 years, and has represented money market funds and their boards from the earliest days of money market funds. Today some of the better known fund groups with money market funds we work with include UBS, Bank of America, Dreyfus, and Goldman Sachs. In some cases we represent the board, in some cases we represent the funds, and in others we represent the fund adviser.
MFI: What are you working on now? Plaze: I periodically answer rule 2a-7 questions from clients, which I find quite enjoyable. The rule is a puzzle at times, but one I know. I've also spent a bit of time with fund managers and fund boards trying to help them understand the implications of the current SEC money market fund proposals, as well as what is happening at the Financial Stability Oversight Counsel (FSOC).
MFI: What do you think will happen? Plaze: Predictions are dangerous in this space, because I don't think anyone at the SEC yet knows what it's going to do. Right now, it appears that the SEC Staff is trying to develop some a consensus among the Commissioners without a lot of commitment to a particular approach. I think that's going to be a challenge. Everyone tends to think they're an expert on money market funds, but the real experts are deeply divided and understand the implications of getting it wrong. Regulation is like medicine where the rule is (or should be) "first do no harm." And the most powerful law governing money market funds is not the Investment Company Act, but the law of unintended consequences. So you come up with a solution that solves for one problem. But if it begets two or three other problems, the result might be worse than the problem you are trying to fix. So that's what makes the rulemaking such a challenge for the Commission. That they are trying to solve the problem in an extremely low interest rate environment exacerbates the difficulty.
The ultimate solution -- and there is not only one possible solution -- has to involve requiring money market funds to internalize the cost of risks that are currently borne by the markets. This means that money market funds' yield advantage over other short-term alternatives is going to shrink. If policy-makers want to make money market funds a riskless investment (which is how investors perceive them) then it's going to be difficult for funds to pay a yield that is much more than the risk-free yield. If policymakers conclude that an investment in money market funds should continue to bear risks, then the risks need to be explicitly allocated so that no one is surprised when losses are incurred and that the consequences are not destabilizing to the larger economy. Today, as a practical matter, advisers bear the risk of loss (because of the compelling business need to bail out the funds). But they are not required [to] have the resources sufficient to absorb losses -- hence the Reserve Primary Fund. A move to a floating NAV is essentially a move to push the risk to investors.
I'm always surprised when people assume that when at the SEC I always favored a floating NAV. But I think those who promote the floating NAV would really like to turn back time. If the SEC had never permitted money market funds to use a stable NAV, and there wasn't a 25 year history of bailouts, investors would never have become conditioned to treat money market funds cash. In a floating NAV world, early redeemers would no longer be able to capture the spread between the $1.00 share price and the shadow price. But a floating NAV would not eliminate an investor's interest in avoiding potentially larger losses in the future as the fund is forced to sell of increasingly less liquid investments to meet redemptions. Nor would it eliminate investor fear that it could lose liquidity. (Indeed, the second alternative would exacerbate that fear.) There would be a lot of costs involved in moving to a floating NAV. It strikes me that if it's not going to fix the problem, then those costs are not well spent.
MFI: Will they actually float? Plaze: Well, if you go back to 1970's when you had substantial interest rate fluctuations, you might have seen daily or weekly NAV changes. But not in today's interest rate environment. The SEC's answer is to require funds to price out to additional decimal places. But they seem to be using equity fund pricing as a model where actual prices for real transactions feed into the NAV. Market-based NAV is largely based on mark-to-model prices where fine pricing differences are largely a function of the model or inputs, not real prices. So it's not at all clear to me that a floating NAV would send the market-clearing signals that the SEC economists seem to think.
Moreover, the SEC proposal for a floating NAV gives fund managers an opportunity to manage the NAV if it strays from a narrow band. By permitting fund managers to continue to bail out their funds, the SEC proposal actually cuts against the success of the floating NAV. Investor's expectations are less likely to change if they continue to expect sponsors to step up. I think the SEC also undercuts its floating NAV proposal by proposing that institutional investors to continue to hold money market funds as cash on their balance sheets. So I don't believe moving to a floating NAV would solve the problem in 2014. It might have been a good idea in 1983.... But we are where we are, and you can't turn back time.
