U.S. Securities & Exchange Commission Division of Investment Management Director William Birdthistle gave a speech Tuesday entitled, "Remarks at PLI: Investment Management 2022," where money market funds and MMF reforms were a major topic of the talk. He comments, "The final topic I would like to touch on today is money market funds. These funds, together with a few others, have at times been called 'shadow banks.' Today, the more common, slightly less pejorative term is 'non-bank financial institution.' As a proud member of the SEC's Division of Investment Management, I tend to view the $128 trillion in regulatory assets under management subject to our oversight as a substantial universe in its own right, worthy of its own adjective. But I understand that things might seem otherwise to advocates for the non-fund community."

Birdthistle explains, "Money market funds enjoyed their rise to prominence, of course, largely following the adoption of Regulation Q. Regulation Q imposed ceilings on interest rates that could be paid on bank deposits, which proved to be a competitive liability during the period of high inflation in the late 1970s and early 1980s. Instruments such as money market funds that could offer market interest rates (which peaked above twelve percent in 1981) prospered at the expense of bank accounts capped at the Regulation Q ceiling (which remained below six percent at the time). That moment served as the spark of life for an instrument that has since grown to hold approximately $5 trillion in assets."

He tells us, "While many practitioners may be most familiar with the 2008 financial crisis, the breaking of the buck in the Reserve Primary Fund, and the role of the run on money market funds in the 2008 crisis, there is another notable incident in the life of money market funds. That event is March 2020. It is hard not to notice that this incident has garnered considerably less interest among legal academics than the 2008 financial crisis. March 2020 is known to most of us as the onset of COVID-19, but there is not as much attention focused on these events by practitioners of law and finance as one might expect."

Birdthistle continues, "Today, I would like to dedicate some time to discussing March 2020 and hopefully inspire further intellectual exploration of this event with a few observations and questions for your consideration. September 2008 started primarily as a credit event. In contrast, the market stress of March 2020 was more of a liquidity event. As investors -- particularly institutional investors – sought liquidity and safety, they reallocated their assets into cash and short-term government securities in a dramatic bouleversement of the money market fund ecosystem. Government money market funds enjoyed record flows of $838 billion in March 2020 and an additional $347 billion in April 2020. That spike of well over a trillion dollars came from a variety of places, but the most challenging sources were prime money market funds. During the fortnight of March 11 to 24, publicly offered institutional prime funds experienced a 30% redemption rate (representing about $100 billion), which included outflows of approximately 20% of assets during the week of March 20 alone. One fund experienced a weekly redemption rate of approximately 55%."

He asks, "So how does a fund adviser manage this level of redemptions in one week? Not comfortably. Stresses such as these can lead to circumstances in which areas of the market can freeze and cause rates to spike. That tends to be when central bankers start having to write checks -- and deploring the operations of shadow banks."

Birdthistle also queries, "But what of gates adopted in response to 2008, don't they stop the redemptions? As March 2020 has vividly illustrated, some investors may have feared that if they were not the first to exit their fund, there was a risk that they could be subject to gates or fees, and this anticipatory, risk mitigating perspective potentially further accelerated redemptions."

He responds, "So what is a better solution? To make all these instruments bank accounts? The market had that choice forty years ago and rejected it. When interest rates are high, any instrument with an artificial ceiling is going to suffer the maladies of price controls. When interest rates are low, bank accounts may struggle to generate returns for citizens charged with providing for their own retirement. In a land largely bereft of private-sector pensions, that reduction in choice would be a true impediment. With neither pensions nor higher yielding investment instruments, ordinary Americans would face greater economic challenges. To paraphrase an Irish playwright, to lose one source of financial security may be regarded as a misfortune, to lose both looks like carelessness."

Birdthistle explains, "But there is another story at work here, beyond retail investors, inasmuch as most reforms of money market funds focus upon institutional dollars. No matter how much academics, bankers, and some practicing lawyers might suggest otherwise, institutional money is unlikely to return to bank accounts and more likely to find its way to ultrashort bond funds. Funds now play a role in the markets that bank accounts would have a hard time replacing. Banks do not offer diversified exposure or a market rate in non-zero rate environments. Institutional deposits also impose significant costs to banks in our post-Dodd-Frank regime. In attempting to make banks safer, we have locked in a much larger role for the capital markets in our economy. Attempting to deconstruct that architecture could impose intolerable consequences upon the U.S. economy and financial system. Indeed, money market funds are now so ingrained in our system that the Federal Reserve uses them as a conduit through which to set floors for monetary policy."

He posits, "Perhaps there are other paths that would allow mutual funds to flourish, while still being able to operate in moments of great stress. The United States tends to pride itself, rightfully, on exporting financial innovation around the world. But on this topic, European funds have experience with a process that might be a creative solution to future liquidity crises here: swing pricing. Swing pricing allows investors in a fund to leave whenever they wish but, in moments of tight liquidity, the departing shareholders must bear the higher costs of their exit. Economists everywhere would, I suspect, celebrate a mechanism that essentially prices preferences. In that vein, we are certainly looking forward to reviewing comments on this aspect of the recent money market fund proposal -- which does indeed address swing pricing."

Birdthistle also tells us, "For both regulators and practicing lawyers, the money market story may hold a few lessons. First, regulation is a challenge and an iterative process. Rules can be written to address behavior and analyze the likely consequences, but behavior can still change in a variety of ways that may require additional modifications. As a personal fan of soccer, I have lived through many adjustments to the offsides rule. And of course my teams have suffered more than anybody else's, and the referees are all terrible, and so forth. Yet I'm still a fan, I'm still learning the nuances of that rule, and soccer is still the world's most popular sport. So even with the breaking of the buck in September 2008 and the liquidity crunch of March 2020, our capital markets are the envy of the world. Because our vigilance and oversight is indefatigable and we are always considering ways to make market instruments more resilient."

He continues, "Second, the challenges of a solution like swing pricing can at times be less conceptual and more practical. Do we have a financial plumbing system that will easily allow for this solution? Like many circumstances in which a late arrival enjoys leap-frogging technology, Europe has the benefit of comparatively younger financial infrastructure. Parts of our system hearken back to Buttonwood trees, vacuum tubes, and reel-to-reel computing. Swing pricing, broadly adopted, might require upgrades to parts of that network. But perhaps the world's largest, most globally critical financial system ought to be more modern and robust. Theories are vital, and lawyers are good at them. But learning the plumbing is an underappreciated talent. In our Division, some of the most essential members are those who best understand the pipes of America's financial system."

Finally, Birdthistle adds, "Third, let me be clear that we all need to pay close attention to when things break, regulators most of all. So although I do not think everything should be a bank, nor am I sanguine about problems with money market funds and other instruments vulnerable to liquidity mismatches. On the contrary, I share Chair Gensler's position that the Securities and Exchange Commission has a responsibility to protect for financial stability and to increase the resilience of our financial system. I have seen what happens when firms disregard regulation in an unchecked pursuit of 'innovation.' When some insist on moving fast and breaking things, sometimes that just leaves things broken."

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