One of the most controversial, and in some cases misunderstood, components of the SEC money market reforms are the "liquidity fees and redemption gates" provisions. In a new white paper entitled, "Break Glass Only in Case of Emergency," BofA Global Capital Management's Jeffrey Coleman, Head of Fund Operations, and Nitin Mehra, Head of Strategy and Product, analyze this portion of the new rules and explain why "Liquidity fees and redemption gates are valuable shareholder protections that would be used only under dire circumstances." They write, "With its latest money market fund reforms, the Securities and Exchange Commission (SEC) seeks to mitigate the impact of runs on money market funds by giving fund boards the option to impose temporary liquidity fees and redemption restrictions or "gates" to protect shareholders should liquidity fall below certain thresholds." (Note: Crane Data also released the August issue of its new Bond Fund Intelligence publication yesterday. Watch for excerpts from our "profile" with Fidelity Conservative Income's Kim Miller later this month, or e-mail us to request the latest issue.)
BofA's piece explains, "To take effect in October 2016, the new rules are as follows: Fund boards will have discretion to either impose a temporary liquidity fee of up to 2% of the value of the redemption or to suspend redemptions temporarily should a money market fund's level of weekly liquid assets fall below 30% of its total assets and if the board determines that the fee or gate is in the best interests of the fund and its shareholders. Fund boards will be required to impose a liquidity fee of 1% of the value of the redemption if a money market fund's level of weekly liquid assets falls below 10% of its total assets if they determine that imposing a fee is in the best interests of the fund and its shareholders. If a board decides to impose a fee, it can choose to levy a fee that is higher or lower than 1%. Liquidity fees and redemption gates must be lifted as soon as weekly liquid assets meet the 30% minimum. A redemption gate may be imposed for no more than 10 business days in any 90-day period."
It tells us, "With the exception of the 1% liquidity fee that could be levied if weekly liquidity falls below 10% of a money market fund's total assets, none of the above rules would be triggered automatically (and as noted above, fund boards can opt not to levy that fee or adjust the amount of the fee). It is up to each fund board to determine the appropriate response to a liquidity crisis. Faced with similar liquidity pressures, one board might implement a 2% liquidity fee; another might impose a 0.5% fee; a third might levy no fee at all, choosing instead to implement a redemption gate until the fund met the SEC's minimum liquidity requirements; and a fourth might not impose a fee or a gate at all. Ultimately, the fund board has total discretion to apply a fee or gate based on the best interests of the fund and its shareholders, taking into account the particular facts and circumstances confronting the fund at the time."
Coleman and Mehra continue, "Investors likely are questioning whether the fees-and-gates provision will deprive them of one of the core benefits of money market funds -- ready access to their cash. When assessing the likelihood of a given fund imposing a liquidity fee or gating redemptions, investors should keep in mind that fund boards must exercise reasonable care before taking such actions. Put simply, a fund's board must ensure that the imposition of liquidity fees or the gating of redemptions is in the best interests of the fund and its shareholders before implementing either measure."
They state, "It may surprise liquidity investors that measures intended to raise the cost of redeeming shares -- or halt redemptions altogether -- could be in their best interests. However, these actions could prove beneficial by protecting investors from losses that stem from panic selling and contagion -- the spread of a run on one money market fund to others. By allowing funds to mitigate the impact on nonredeeming shareholders of significant redemption activity, whether due to a market crisis or a credit event affecting a particular fund, fees or gates potentially buy time for a portfolio manager to generate liquidity without having to sell securities at prices that could have a negative impact on the fund's NAV. Indeed, given the reputational damage that would result from the imposition of a fee or gate, these clearly are "break-glass-only-in-case-of-emergency" measures"."
The BofA paper continues, "Liquidity fees were approved by the SEC to offset the "first-mover" advantage that otherwise might be afforded to shareholders who exit early from a fund. Early redeemers might make remaining shareholders more vulnerable to losses if the portfolio manager needed to sell securities at inopportune times or at unfavorable prices to pay early redeemers. Liquidity fees are intended to deter shareholders from exiting money market funds en masse during crisis periods, ideally preventing the NAV deterioration that threatened some money market funds during the global financial crisis. It is imperative that investors see these potential liquidity fees for what they are -- payments that go directly to the fund (not the fund advisor). Liquidity fees serve first to deter investors from exiting the fund, while also helping to minimize the potential negative impact of redemptions on shareholders remaining in the fund."
On gates, it says, "The SEC's redemption gate provision gives a fund's board the option to suspend, on a temporary basis, redemptions if the board determines that doing so would be in the best interests of the fund and its shareholders. Essentially, gates serve as a braking mechanism that buys time for portfolio managers to conduct price discovery and formulate an orderly plan to raise liquidity and to try to avoid or minimize losses on the sale of securities -- losses that could pressure funds' NAVs. It is important to remember that money market funds typically do not liquidate securities before they mature at par.... The new liquidity gate measure merely gives fund boards the option to halt redemptions temporarily without requiring that a fund be liquidated."
They explain, "Some critics of the fees and gates measures have hypothesized that investors might exit a fund en masse should its liquidity even approach the 30% minimum on concerns that the imposition of fees and/or gates could be imminent. Because it is impossible to know exactly how investors would react should a money market fund's weekly liquidity approach the 30% minimum, fund managers likely would be even more diligent about meeting or, in most cases, exceeding the minimum liquidity requirements. The level of liquidity maintained by each fund will depend on the investment philosophy of the fund manager, its shareholders' liquidity requirements and redemption histories and, importantly, the type of fund. A municipal money market fund, for example, typically will maintain higher weekly liquidity than a prime money market fund due to the nature of the instruments in which it invests. Indeed, it's not at all uncommon for a municipal money market fund to maintain weekly liquidity of 70% to 80% of total assets. Exceeding the 30% weekly liquidity requirement by such a large margin would make the imposition of fees or gates very unlikely."
Further, BofA writes, "Money market fund managers generally can keep their liquidity levels stable by managing their portfolios' durations, tracking inflows and outflows over time; and by knowing their shareholders' liquidity requirements. One wild card that can disrupt funds' liquidity-management efforts, however, is a credit default, which can trigger liquidity crises by unleashing runs on money market funds as investors hope to redeem before the valuation impact of a defaulted security is reflected in a fund's NAV. Fortunately for investors, the money market fund industry is better positioned to withstand highly disruptive credit events like the collapse of Lehman Brothers in part because of the SEC's 2010 reforms and those to be implemented in 2016."
They add, "In addition to the new rules providing for liquidity fees and redemption gates, the SEC's 2016 Rule 2a-7 reforms introduced enhanced disclosure requirements mandating daily website reporting of daily and weekly liquid assets, net fund flows and market-based NAVs. These provisions are designed to give investors increased visibility into funds' liquidity positions well in advance of events that could trigger the implementation of fees and gates."
BofA comments, "For investors in prime and municipal money market funds, the fees-and-gates reforms raise an important question: "Can I get my money if I need it?" We believe that in a normal market environment, the answer to that question is "Yes." First and foremost, money market fund portfolio managers would make every effort to avoid imposing fees or gates because, absent an industry-wide crisis or credit event that causes panic selling, the reputational damage a fund sponsor would incur by implementing either measure could be irreparable."
Finally, they add, "As a practical matter, fund shareholders and the market would be unlikely to tolerate a redemption restriction absent an emergency. For this reason, fund boards would think very carefully about the ramifications of such an action, as they determine whether imposing fees or gates is in the best interests of the fund and its shareholders. Indeed, given the price funds would pay were they to impose fees and gates, the most important benefit presented by these emergency measures might be the incentives they create for funds to manage their portfolios such that fees and gates need never be employed."
