Perhaps the most controversial aspect of the SEC's Money Market Reforms is the provision that requires prime institutional money market funds to maintain a floating net asset value for sales and redemptions based on the current market value of the securities in their portfolios rounded to the fourth decimal place (e.g., $1.0000). The requirement, which would also apply to institutional municipal money market funds, would result in the daily share prices of MMFs fluctuating along with changes in the market-based value of the funds' investments. The amendment would not have passed without an assurance from the IRS and the Department of Treasury for tax accounting relief. (SEC Commissioner Gallagher said that he would have joined Commissioners Kara Stein and Michael Piwowar in opposition to the reforms if the tax accounting issues weren't addressed.) We take a closer look at what the Floating NAV means for investors.
The SEC explains the reasoning behind the Floating NAV. "We considered the many reasons shareholders may engage in heavy redemptions from money market funds -- potentially resulting in the dilution of share value that the Investment Company Act's provisions are designed to avoid -- and have tailored today's final rules accordingly. In particular, while many investors may redeem because of concerns about liquidity, quality, or lack of transparency -- and our fees and gates, disclosure, and reporting reforms are primarily intended to address those incentives -- an incremental incentive to redeem is created by money market funds' current valuation and pricing methods. As discussed below, this incremental incentive to redeem exacerbates shareholder dilution in a stable NAV product because non-redeeming shareholders are forced to absorb losses equal to the difference between the market-based value of the fund's shares and the price at which redeeming shareholders transact."
They continue, "For the reasons discussed below, we believe that this incentive exists largely in prime money market funds because these funds exhibit higher credit risk that make declines in value more likely (compared to government money market funds). We further believe history shows that, to date, institutional investors have been significantly more likely than retail investors to act on this incentive. Thus, given the tradeoffs involved in requiring that any money market fund transact at a floating NAV, we are limiting this reform (and thus the repeal of the special exemptive relief allowing these funds to price other than as required under the Investment Company Act) to institutional prime funds.... One possible reason that institutional prime funds may be more susceptible to rapid heavy redemptions than retail funds is that their investors are often more sophisticated, have more significant money at stake, and may have a lower risk tolerance due to legal or other restrictions on their investment practices."
The objectives of the Floating NAV is: "(1) to reduce the first mover advantage inherent in a stable NAV fund due to rule 2a-7's current valuation and pricing methods by dis-incentivizing redemption activity that can result from investors attempting to exploit the possibility of redeeming shares at the stable share price even if the portfolio has suffered a loss; and (2) to reduce the chance of unfair investor dilution, which would be inconsistent with a core principle of the Investment Company Act. An additional motivation for this reform is that the floating NAV may make it more transparent to certain of the impacted investors that they, not the fund sponsors or the federal government, bear the risk of loss. Many commenters suggested that, among the reform alternatives proposed, the floating NAV reform is the most meaningful."
The SEC continues, "Under our reform, institutional prime money market funds will value their portfolio securities using market-based factors and will sell and redeem shares based on a floating NAV. Under the final rules, and as we proposed, institutional prime funds will round prices and transact in fund shares to four decimal places in the case of a fund with a $1.00 target share price (i.e., $1.0000) or an equivalent or more precise level of accuracy for money market funds with a different share price (e.g., a money market fund with a $10 target share price could price its shares at $10.000). Institutional prime money market funds will still be subject to the risk-limiting conditions of rule 2a-7. Accordingly, they will continue to be limited to investing in short-term, high-quality, dollar-denominated instruments, but will not be able to use the amortized cost or penny rounding methods to maintain a stable value.... Although some commenters, including some sponsors of money market funds, expressed general support for the floating NAV reform as it was proposed, the majority of commenters generally opposed requiring institutional prime money market funds to implement a floating NAV."
On fund pricing, the final rule says, "Having determined to adopt the floating NAV reform for institutional prime funds, there is a separate (albeit related) issue of how to price the shares for transactions. Today, for the reasons discussed previously in this section, we are amending rule 2a-7 to eliminate the exemption that currently permits institutional prime funds to maintain a stable NAV through amortized cost valuation and/or penny rounding pricing. We are also adopting, as proposed, an additional requirement that these money market funds value their portfolio assets and price fund shares by rounding the fund's current NAV to four decimal places in the case of a fund with a $1.0000 share price or an equivalent or more precise level of accuracy for money market funds with a different share price (e.g., a money market fund with a $10 target share price could price its shares at $10.000). Accordingly, the final amendments change the rounding convention for money market funds that are required to adopt a floating NAV -- from penny rounding (i.e., to the nearest one percent) to "basis point" rounding (i.e., to the nearest 1/100th of one percent), which is a more precise standard than other mutual funds use today."
It tells us, "In considering whether to require basis point rounding or, instead, to allow 10 basis point rounding, we have looked to the potential for price fluctuations under the two approaches. Based on our staff analysis of Form N-MFP data between November 2010 and November 2013, 53% of money market funds have fluctuated in price over a twelve-month period with a NAV priced using basis point rounding, compared with less than 5% of money market funds that would have fluctuated in price using 10 basis point rounding. We recognize that, either way, this limited fluctuation in prices is the result of the nature of money market fund portfolios, whose short duration and/or high quality generally results in fluctuations in value primarily when there is a credit deterioration or other significant market event."
On basis point rounding it explains, "After considering the results of the staff's analysis, we are persuaded to require basis point rounding. We believe that some of the institutional investors in these funds may not appreciate the risk associated with money market funds. As for this subset of institutional investors, we believe that the basis point rounding requirement may accentuate the visibility of the risks in money market funds by causing these shareholders to experience gains and losses when the funds' value fluctuates by 1 basis point or more. We further believe this may, in turn, have two potential effects that are consistent with our overall goal of addressing features in money market funds that can make them susceptible to heavy redemption. First, to the extent that some of these investors become more aware of the risks, they may develop an increased risk tolerance that could help make them less prone to run. Second, by helping make the risk more apparent through periodic price fluctuations, basis point rounding may help signal to those investors who cannot tolerate the risk associated with the fluctuating NAV that they should migrate to other investment options, such as government funds."
Regarding intraday liquidity and same day settlement, some commenters expressed concern that intraday liquidity and/or same-day settlement would not be available to investors in floating NAV money market funds. "We believe that floating NAV money market funds should be able to continue to provide shareholders with intraday liquidity and same-day settlement by pricing fund shares periodically during the day (e.g., at 11 a.m. and 4 p.m.).... We believe that many floating NAV money market funds will continue to be able to provide same-day settlement. Second, we note that under the revised retail money market fund definition adopted today, retail investors should have ample opportunity to invest in a fund that qualifies as a retail money market fund and thus is able to maintain a stable NAV. As a result, this should significantly alleviate concerns about the costs of altering these features and permit a number of funds to continue to provide these features as they do today. Nonetheless, we recognize that not all funds with these features may choose to qualify as retail money market funds, and therefore, some funds may need to make additional modifications to continue offering these features."
In conclusion, the new rules add, "We are providing a two-year compliance date (as proposed) for money market funds to implement the floating NAV reform. A long compliance period will give more time for funds to implement any needed changes to their investment policies and train staff, and also will provide more time for investors to analyze their cash management strategies."
