Below, we continue to excerpt from our recent "profile" article, "Plaze Says Doing Nothing Better Than SEC Proposals," which interviews Robert Plaze from Stroock & Stroock & Lavan. MFI: What about the alternative to require redemption fees and gates? Plaze: The liquidity fee fees and gates alternative is perhaps even more troublesome. There are two things investors in money market funds worry about -- one is losses of principal, and the other is loss of liquidity. In my view, the loss of liquidity is a more serious fear than loss of a small amount of value.
I suspect fund investors will treat imposition of a liquidity fee or a gate as if it were a "break the buck event." Here the proposed cure may be as bad as the disease. Investors will redeem in anticipation of the imposition of a fee or a gate. [I]f there was only one fund in the world and none of the investors understood that the manager could impose a fee or suspend redemptions, it all might work. But investors are smarter than that. After 2008, investors are acutely aware of the advantages of getting out of a fund before the door is shut.
It's also not clear to me that a fund that imposes a gate would ever re-open for business, because its investors will likely all submit redemption requests. The current SEC rules are predicated on the assumption that a fund suspending redemptions won't open again. By permitting suspension of redemption only when a fund is liquidating, they are designed to prevent a fund board from precipitously suspending redemptions with the potential consequence to other funds and short-term markets. While the SEC proposals theoretically allow a fund putting up a gate to bring it down, most industry participants I've spoken to don't believe that will ever really happen.
Believe it or not, I think that doing nothing would be better than adopting either of the two alternative proposals the SEC has offered up. In the short run, there is pressure on the SEC to do something and get it over with and to forestall separate action by FSOC. But everybody is supporting one of their preferred alternatives based upon how it will affect their current business model. No one is imagining how they might benefit from a new paradigm around which they could build a new business model. But the problem for the money market fund industry is the long-term consequences of the failure of the SEC to fix the problem, which could be devastating. There isn't going to be another government bailout under current laws. Even if there is, there will be no third bite at the apple: money market funds will be folded into the banking system, which will be a tragedy.
MFI: What about the FSOC? Plaze: I feel the frustration of everyone, although I sense a tendency on both the Office of Financial Research (OFR) and the asset management industry to exaggerate concerns. Some financial regulators are frustrated that they do not have direct authority to deal with some types of systemic risk, and that they must rely on the SEC to fix the problems.... The problem is if they don't exercise that jurisdiction or responsibility, at some point either the FSOC or the other financial regulators will need to step in to prevent another financial crisis. The asset management industry is frustrated because it feels that the other financial regulators don't understand their industry, and they're worried that they won't have the leverage with them to prevent change from happening. Will FSOC act if it collectively concludes what the SEC has done is inadequate, which is perhaps unlikely, or will it act later after there is another market event that demonstrates that what the SEC has done is inadequate?
MFI: What about other parts of the proposal? Plaze: One of the issues I believe industry participants are missing, and that is really important, is the daily disclosure of liquidity and portfolio information. I know some fund groups are already providing this disclosure voluntarily, but it worries me that it could accelerate a crisis. If a few large shareholders redeem one day for completely unconnected reasons, the following morning the fund will report a loss of liquidity.... How do investors respond? Will some institutional investors establish automatic redemption triggers? As a consequence of this part of the proposal, the impact of what might otherwise be a hiccup could be accelerated.
Another thing I worry about is that there is sort of an "arms race" going on. Funds are better invested, better positioned, more liquid, and better managed today than they were in 2008. But their institutional investors also learned something from 2008. They learned that the people in the Reserve Fund that got out in the morning were better off than the people who tried to get out in the afternoon.
MFI: Any thoughts on the future? Plaze: I think that the industry has to accept some significant changes in order to make money funds viable in the long run. As you know, working for Mary Schapiro at the SEC, we and some people working in the Fed and Treasury came up with some ideas that were rejected by the SEC Commissioners. Those ideas aren't the only possibilities, but whatever the Commission does it has to create a different set of incentives on both fund sponsors as well as investors.... I think the industry has to come to terms with long-run solution to change the destabilizing dynamics while still maintaining the best features of money market funds, which provide a significant source of competition for banks and an important source of short term capital for the markets. But we have got to figure out how to change the dynamics that can lead investors acting in their own rational interests do act in ways that damage the enterprise in the fund itself.
