Larry Locke Associate Dean at McLane College of Business at the University of Mary Hardin-Baylor, sent Crane Data a recent commentary entitled, "The Mysterious, and Critical, Future of Money Market Fund Regulation." He explains, "The compliance date for the new money market fund regulations is October 14, 2016, and the industry has been furiously preparing for the new regulatory regime. Most visibly, fund companies have been altering their product mix to include fewer institutional prime funds that will be required to trade at a floating Net Asset Value. Institutional funds are furiously converting from prime funds to government funds, which will be able to continue to sell shares at $1.00."
He continues, "Even more is happening behind the scenes. Retail funds are preparing their procedures, and their investors, for the possibility of liquidity fees and trading gates that might be imposed if a fund's weekly liquid assets falls below preset levels. Fund companies and their service providers are building the infrastructure to handle multiple strike prices per day, vastly increased disclosure requirements, and new diversification limits. Record keepers, selling brokers, plan sponsors, accountants, lawyers, and trustees are also preparing for the new world of money market funds. Most importantly, the industry is continuing to consolidate."
Locke states, "The fund provider universe is shrinking even as total assets remain more or less stable. After the selloff from 2008 to 2011, total money market funds assets have risen slightly every year from 2011 to 2015.... Starting in October, the business also will become exponentially more complex.... Marginal players are exiting rapidly."
He adds, "Those fund companies remaining in the money market business are making a major bet on an industry in transition. Whether the determination of the remaining firms will pay off is largely dependent on the future after October 14. If investor markets adapt to the new universe and remain invested in the funds, and regulatory authorities seem satisfied with the results, profits for fund companies may follow as interest rates increase and the new systems and administrative requirements create barriers that help protect the firms from new entrants."
Locke writes, "Whether the regulatory landscape remains stable after October 2016 depends on one thing -- systemic risk. The reforms promulgated in 2014 that are now about to take effect have nothing to do with failures of disclosure or investor satisfaction. They are driven by the desire to reduce the real or perceived systemic risk that money market funds throw off on the larger economy. [O]n that front the new regulations appear to have a mixed scorecard. The fundamental effectiveness of the new regulatory regime is unknowable, but the restructuring of the industry in anticipation of that regime has already had obvious effects on its overall risk profile."
The commentary says, "Whether the overarching stated purpose of reducing runs on money market funds will be promoted by having prime institutional funds trade at a variable NAV is unknowable. There are certainly experiences in equity and bond funds that might offer some insights but whether those same dynamics would hold true in a money fund context is anyone's guess. Whether liquidity fees and trading gates will create more stable fund markets is also unknowable. Certainly both mechanisms are very unpopular with investors and fund managers and boards will do their best to avoid invoking them. The fundamental behavioral question of whether an imminent possibility of a trading gate or liquidity fee would increase or decrease redemptions from that fund or from others is very much an open question."
It adds, "The migration from institutional prime to government funds, however, should produce a reduction in credit risk within those funds, contributing to an overall reduction in systemic risk. At the same time, increased competition within the government fund space may well lead to an increase in derivative investments designed to pass through tax and credit characteristics of the underlying government securities that will entail an increase in structural and counterparty risk. (It behooves us to recall that the last money market fund that broke the buck before 2008 was the Community Bankers' U.S. Government Money-Market Fund, a government fund that failed in 1994 after purchasing derivative structures its manager may not have fully understood.)"
Locke concludes, "The consolidation in the industry is pushing out marginal players and reducing the breadth of regulatory scope. This will make it easier for the SEC and other regulators to police the industry and reduce systemic risk. At the same time, consolidation of funds and stability of total assets has caused the average size of money market funds to increase. In 2015 the mean size of all money market funds was $5.7 billion, 17% larger than it was in 2008. This consolidation of fund assets in fewer funds also increases the risk that any fund failure will have systemic impact.... Clearly, the net systemic risk impact of the regulatory changes and the industry restructuring it is producing is an open issue."
In other news, StoneCastle and Fitch Ratings published the results of a "Money Fund Reform Survey." The release says, "According to the Fitch Ratings and StoneCastle Treasurer Money Fund Reform Survey, the majority of financial professionals have liquidity concerns related to money fund reform. The survey, completed by 76 corporate treasurers from a wide array of sectors and company sizes, indicates that only 7% of treasurers plan to stay in prime funds with many others searching for alternative vehicles."
StoneCastle explains, "A recent survey conducted ... throughout the end of July shows the potential for considerable additional flows of cash from prime funds. 71% of respondents used prime funds as part of their cash strategy, but 33% of these noted they will move entirely out of prime funds and 29% will move a percentage. Only 7% do not plan to make additional re-allocation. Of the respondents currently invested in prime funds, 19% expect to reallocate out of prime funds by the end of August, while a significant 52% plan to reallocate by the end of September. Underscoring the uncertainty that prime fund managers contend with, more than a quarter of survey respondents needed to determine their cash strategy post reform."
They explain, "So far government money funds have been the primary recipients of cash leaving prime money funds, and this trend is expecting to persist. Investors also indicated interest in other alternative products such as structured bank deposits and separately managed accounts. However, in an effort to attract prime fund flows, fund managers have also been launching ultra-short bond funds, and other cash alternatives like private and short maturity MMFs that investors are considering."
Finally, StoneCastle adds, "The yield spreads between the various liquidity products will be a key driver of asset flows. Recent declines in prime money fund yields due to the general shortening of these portfolios ahead of Oct 14 increases the likelihood of cash migrating out of prime funds to government funds and these other alternatives."
