Two weeks ago, Crane Data hosted its Money Fund University "basic training" event, which reviews the history of money funds, interest rates, regulations (Rule 2a-7), ratings, rankings, money market instruments such as commercial paper, CDs and repo, and portfolio construction and credit analysis. (See our Jan. 26 News, "Money Fund University Highlights: J.P. Morgan's Teresa Ho Talks Supply.) Today, we quote from the session on the "Federal Reserve & Money Markets, which featured BofA Securities' Mark Cabana. Cabana gave an extensive overview of the Fed, but also addressed several hot topics, including the recently proposed money fund reforms. (Note: Crane Data Subscribers and MFU Attendees may access the Powerpoints and recordings via our "Money Fund University 2022 Download Center." Mark your calendars too for our next live event, Bond Fund Symposium, which is March 28-29 in Newport Beach, Calif.)
Cabana tells the virtual MFU, "Okay, one final topic for me and maybe the most important for this audience, money fund reform.... You can see a summary of what the SEC has proposed.... There are really two biggies, in our view.... Swing pricing, that's the single most important potential reform that the SEC is considering. And ... higher daily and weekly liquid asset requirements. Swing pricing will only be applied to prime institutional funds, but it is essentially we think of it as almost a redemption fee, especially if you are a large investor in a prime institutional fund."
He explains, "I believe the threshold is if you as an investor comprise 4% of the total prime institutional fund.... If you do that, and if you want to redeem all of that quickly, then you are subject to essentially seeing your withdrawal charge a liquidity fee or a downward NAV adjustment on the cash that you're trying to get back. In times of market stress, that liquidity fee for that downward NAV adjustment can be quite high. It's also very difficult for funds to estimate and implement. So again, to us, that's the real big element of these reforms."
Cabana continues, "If you are an investor in a money fund, you likely ... prize liquidity above anything. You just want to make sure that you can get your money back when you want it and hopefully get a little bit of a return. What you don't want to do is have an investment in the money fund and yield 25 basis points, maybe 125 basis points at the end of this year, but then be hit with a 5% redemption fee if you're trying to get your money back. That doesn't work."
He says, "If swing pricing is implemented as we expect, we think it is essentially going to kill the prime institutional business. And it may not even require prime institutional funds to tell their investors and have their investors withdraw funds. Look, it's very possible that institutional prime funds just close the funds because they know what's coming. They know how difficult it would be to apply these redemption fees and as the swing pricing adjustments, and we think that they're well aware of the impact that it would have on investors."
Cabana also tells us, "So swing pricing to us is the single most important reform here. And sadly, when we read the rule, our interpretation of the SEC rule is that the SEC knows that swing pricing could kill prime institutional funds. And the way they wrote the rule led us to believe that the SEC actually sees this risk as a feature of the rule, not a flaw. They're not crying a river about the potential end of the existence for prime institutional funds. Not at all. And again, that's just the reality of the regulatory environment. So, it would not surprise us to see a number of prime institutional funds announce fund closures once the SEC rules are final."
He states, "But the other big or secondary but still relevant reform is ... higher daily and weekly liquid asset requirements. So, increasing daily and weekly liquid asset requirements to 25% and 50%, respectively, from 10% and 30%, across funds. To us, this, especially if you're a prime fund, just further reduces the yield advantage that you're going to be able to offer to clients. If you're an investor, your money fund, you know, why are you going to invest in a prime fund? Especially a prime institutional fund if the yield enhancement is being deteriorated? So again, we just think that this is going to further reduce the attractiveness of money funds, especially in the prime side, and probably see more inflows into the government side."
Cabana also says, "We don't know how much of an impact this will have. We don't know what type of outflows we're going to see yet. But 2016 provides us with a little bit of a footprint, and you can see that again, it's a pretty substantial reduction in overall prime balances that we saw during the last money fund episode. We think we very well could be looking at something similar after this round of money fund reform. What that means for broader money markets is that CP, CDs, unsecured funding [rates are] going to increase because the industry is going to be losing a good source of unsecured funding demand."
He explains, "Again, exactly how much and what the spread widening is, is tough to know. We've estimated that it will be between three to seven basis points.... We arrive at that by looking at what happened last time, sort of sizing that to today's values in terms of the amount of CPs and CDs that current prime funds buy, and then run a range of scenarios of potential outflows to come up with that three to seven basis points. But it's going to be negative for at least funders at the front end of the curve. It's going to reduce a source of prime investment option or reduce the source of CP or CD issuer demand."
Cabana adds, "So again, stay tuned on that in terms of timing, as Pete alluded to. But the SEC came out with this rule in the middle of December. They said that the comment period would be 60 days after the proposed rule hits the Federal Register. The last time I checked to see if it was in the Federal Register last week, it was not there yet. So this 60-day period has not yet started, but we imagine that it will happen soon. Maybe it's happened since last I checked, and we imagine that comments will be back to the SEC by, you know, let's call it, the end of March April timeframe."
Finally, he comments, "The SEC will probably take three to six months to review those comments, and come back with final rules ... maybe by the end of Q3 or the end of the year. We're going to hear a final rule from the SEC on this. And again, our base case is that it's not going to be favorable. So, I'm sure this is very much top of mind to everybody who's participating in the Money Fund University today. And again, I just think that you've got to acknowledge that it's very likely that prime funds and especially prime institutional funds face a pretty meaningful upward challenge in the years ahead."
