Since the SEC passed its Money Market Fund Reforms in July, the big question from investors shifted from "What will reforms look like?" to "How will reforms impact money funds?" While implementation is still over two years away, money managers are already planning their strategies for the new realities. The SEC certainly took this into account and offered some guidance in its new rules. We explore the potential implications a little further, excerpting from the section of the final rules titled, "Certain Macroeconomic Consequences of the New Amendments" (which starts on page 593).
On the potential for outflows, the SEC explains, "The Commission recognizes that imposing fees and gates on non-government money market funds and an additional floating NAV requirement on institutional prime funds will likely affect the willingness of investors to commit capital to certain money market funds. On the one hand, the fees and gates requirements will have little effect on funds and their investors except during times of fund distress. On the other hand, we recognize many current investors in non-government funds, especially institutions, may prefer products that offer guaranteed liquidity and a stable NAV rather than non-government funds that will be subject to fees and gates and a floating NAV requirement after the reforms.... Investors also may be prohibited by board-approved guidelines, internal policies, or other restrictions from investing in products that do not have a stable value per share. A floating NAV also could drive investors with a more limited loss tolerance away from money market funds."
Where might assets flow? "The Commission acknowledges, and many commenters concur, that, as a result of our reforms, some investors may reallocate assets to either government money market funds or other investment alternatives. We do not anticipate our reforms will have a substantial effect on the total amount of capital invested, although investors may reallocate assets among investment alternatives, potentially affecting issuers and the short-term financing markets. We anticipate few investors in retail funds will reallocate assets to other investment choices, given that retail funds will continue to offer price stability, yield, and liquidity in all but exceptional circumstances.... We expect, however, that at least some investors who are natural persons that currently are invested in non-government funds that are not designated retail may reallocate their assets to retail funds. We anticipate these investors will likely move to retail funds that have investment objectives that are similar to the objectives of their current funds."
Outflows will likely hit institutional prime funds. "Institutions invested approximately $1.27 trillion in non-government money market funds as of February 28, 2014. Of this $1.27 trillion, institutional prime funds, other than tax-exempt funds, managed approximately $1.19 trillion in assets and institutional tax-exempt funds managed $82 billion. Under the reforms, these funds will be subject not only to fees and gates, but also to an additional floating NAV requirement. As such, we believe as much as $1.269 trillion in assets could be at risk for being reallocated to government funds and other investment alternatives." However, the SEC continues, "neither the Commission nor most commenters believe that all institutional investors in non-government funds will reallocate their assets. Institutional prime funds typically offer higher yields than government funds, and certain investors receive tax advantages from investing in tax-exempt funds."
The Treasury/IRS tax accounting proposal will mitigate some of the outflows, they say. "Additionally, the Commission, which has authority to set accounting standards, has clarified that an investment in a floating NAV money market fund generally meets the definition of a "cash equivalent." And according to one commenter, more than half of survey respondents indicated the likelihood of using a floating NAV money market fund would increase if such a fund's shares are considered cash equivalents for accounting purposes. Thus, we believe these factors and actions taken by the Commission and other regulatory agencies should help preserve the attractiveness of institutional prime funds to investors, perhaps reducing the assets reallocated to alternatives."
How much will flow out? "It is difficult to estimate the amount of assets that institutional investors might reallocate from non-government funds to either government funds or other investment alternatives. One commenter estimated that 64% or $806 billion could shift from prime funds to government funds, whereas another commenter estimated that 25% of assets in its institutional prime funds would transfer permanently into government funds. A third commenter estimated a shift in assets of between $500 billion and $1 trillion." However, notes the SEC, these and other estimates were made before the tax accounting relief was approved. For these reasons the estimates "may overstate how investors are likely to actually behave under the final amendments that we are adopting today .... Commenters specifically noted that a combination of proposals would force most money market fund sponsors to exit the prime space, and would cause many investors to invest their cash assets in government money market funds, direct investments, bank deposits, or other investment alternatives."
Should flows increase to government funds, the SEC says, "To the extent that assets under management in government funds increase, we anticipate investors will have more government funds from which to choose than they do today. This expected increase in the number government funds could be because complexes that currently offer government funds will offer additional government funds or because other complexes will offer new government funds. In either case, competition among government funds should increase although the impact on competition likely should, at the margin, be larger if new complexes enter the government fund market. If an increase in demand for government funds, which must largely invest in eligible government securities, subsequently increases the demand for these securities, the rates on eligible government securities and hence yields on government funds might fall."
How might portfolio managers of institutional prime funds be impacted? "We anticipate that some institutional investors will continue to demand a combination of relative price stability, liquidity, and yields that are higher than the yields offered by government funds. Managers of floating NAV money market funds may respond to these investors in one of several ways. Some managers may respond by altering their portfolio management and preferentially investing portfolio holdings in shorter-maturity, lower-risk securities than they do today. They would do so to reduce NAV fluctuations and lessen the probability the fund's weekly liquid assets decline sufficiently for a fee or gate to be possible. These portfolio management changes may affect competition within the institutional prime money market fund industry (or broader money market fund industry) if these funds more favorably compete with other less conservatively managed funds. They also could affect capital formation to the extent they shift portfolio investment away from certain issuers or certain maturities or lessen the yields passed through to investors from their money market fund investments. In addition, an increase in these types of funds could encourage issuers to fund themselves with shorter term debt."
Here's more on portfolio management of institutional prime. "Some portfolio managers of institutional prime money market funds may seek to competitively distinguish their funds post-reform by altering their portfolio management and investing in relatively longer-term or riskier securities than they do today. These funds may seek to appeal to investors that, if investing in a floating NAV money market fund that could be subject to fees or gates, now may be willing to sacrifice liquidity in times of stress or some principal stability for greater yield. The emergence of these types of money market funds may enhance competition in the money market fund industry among different types of institutional prime money market funds along the risk-return spectrum. It also would affect changes in capital formation post-reform to the extent that it shifts investment to issuers of longer-term or riskier securities or increases yields paid to investors (or increases management fees paid to certain types of fund complexes). Thus, depending on the magnitude of the primary reforms' effect on the assets managed by different types of money market funds, the type and number of institutional prime funds may contract overall, potentially limiting investors' choices among them, or may expand, potentially enhancing investors' choices among them. Accordingly, competition among institutional prime funds may increase or decrease with an impact that will likely be stronger if the number of complexes offering institutional prime funds changes."
On the competitive landscape, the SEC says "fund complexes that primarily advise government money market funds may benefit competitively as these funds are generally not affected by our primary reforms and may experience inflows, which would raise these fund advisers' management fee income. Similarly, fund complexes that manage mostly retail money market funds may be competitively advantaged post-reform over those that primarily manage institutional prime funds. These latter funds will be subject to both our floating NAV and fees and gates reforms and thus may experience a greater decline in assets than retail money market funds as a result of our primary reforms. We thus anticipate our primary reforms may significantly alter the competitive makeup of the money market fund industry, producing related effects on efficiency and capital formation. We believe, however, that these changes are necessary to accomplish our policy goals."
Finally, they talk about the potential effects on CP. "Historically, money market funds have been a significant source of financing for issuers of commercial paper, especially financial commercial paper, and for issuers of short-term municipal debt.... Thus, we acknowledge that a shift by investors from non-government money market funds to other investment alternatives could cause a decline in demand for commercial paper and municipal debt, reducing these firms and municipalities' access to capital from money market funds and potentially creating a decline in short-term financing for them. If, however, money market fund investors shift capital to investment alternatives that demand the same assets as prime money market funds, the net effect on the short-term financing markets should be small."
