Securities & Exchange Commission Chair Gary Gensler spoke yesterday before the "2023 ICI Leadership Summit." "" His talk, entitled, "Bear in the Woods" tells us, "There is a saying when you're in the woods. 'You don't have to outrun the bear; you just have to outrun one of your fellow campers.' A bit gruesome, yet this helps explain why investors might try to cash out of investments before the proverbial bear -- of dilution and illiquidity -- catches them. It also helps explain why savers might try to cash out of deposits before that proverbial bear catches them at the bank. Bear this in mind, this is not a new feature of finance; it has been around for centuries. Runs, when otherwise uncorrelated actors suddenly become correlated, have brought down many a financial firm over time. Financial fires at banks and nonbanks alike have led policymakers to put in place laws to prevent such fires and associated runs, as well as to help fire departments contain fires."
He explains, "Registered investment funds have grown to more than $30 trillion, with more than 16,000 funds. More than half of American households and more than 120 million individual Americans own registered funds. When I started on Wall Street, it was less than 6 percent of households. There have been significant innovations over the decades. Money market funds came about in the early 1970s. Individual retirement accounts and 401(k)s began investing in mutual funds after the Revenue Act of 1978. Exchange-traded funds (ETFs) brought even lower costs to investors in the 1990s."
Gensler comments, "The 1940 Acts along with SEC rules to implement them addressed the failures of the Depression-era investment funds and have lowered the risk of financial fires spreading from funds. They've done so through fiduciary duty obligations, liquidity requirements, leverage limits, daily net-asset valuations, and pricing rules for sales and redemptions to help guard against dilution. To be sure, however, risk remains -- particularly in times of stress. Money market funds and open-end bond funds, by their design, have a potential liquidity mismatch -- between investors' ability to redeem daily on the one hand, and on the other, funds' securities holdings that may have lower liquidity."
He says, "Indeed, in 2008 and 2020, sparks emanated from registered funds, particularly money market and open-end bond funds, putting everyday Americans at risk. In 2008, after one money market fund 'broke the buck,' the government's fire departments stepped in with extraordinary actions. The Federal Reserve established liquidity facilities, and the Department of the Treasury temporarily guaranteed money market funds. In response, the SEC sought to address structural issues in these funds through a series of reforms adopted in 2010 and 2014."
Gensler continues, "At the onset of COVID-19, during the 'dash for cash,' again there were calls for fire department support both for money market and open-end bond funds -- in other words, Federal Reserve support. I'm not going to name any names, but you in the industry who called the SEC and other agencies know who you are. The government stepped in yet again to stabilize short-term funding markets, establishing the Money Market Mutual Fund Liquidity Facility and other programs. It also, for the first time, broadened that support to the corporate and municipal bond markets, including through the Secondary Market Corporate Credit Facility and the Municipal Liquidity Facility."
He states, "As these real-world events demonstrate, stress on these funds is not unsubstantiated hypothesis. President's Working Group and Financial Stability Oversight Council reports under several Treasury secretaries and presidents have written about them. The Financial Stability Board has written about them as well. Liquidity and dilution management has been a bedrock principle of open-end funds since the passing of the Investment Company Act. As Commissioner Healy said in the hearings leading to the Act: 'Due to the right of the stockholder to come in and demand a redemption, the [open-end fund] has to keep itself in a very liquid position. That is, it has to be able to turn its securities into money on very short notice.' Recent events are a reminder there is more work to be done. Thus, we've put out proposals intended to address the structural issues and enhance liquidity risk management for both money market and open-end funds."
On the SEC's Money Market Funds Proposals, he says, "Money market funds came about in the 1970s, offering a cash management tool to investors. This was a time when high inflation surpassed Federal Reserve regulations limiting what banks could pay on deposits. Money market funds gave shareholders market-based returns fully backed one to one in the markets. Money market funds and banks both are involved in the transformation of maturity and liquidity risk. Thus, policymakers over the years have put in place laws and rules to address such risks."
Gensler explains, "Based on the reforms of the 1940s and subsequent SEC rules, money market funds' assets are valued on a daily basis as well as priced for redeeming and purchasing shareholders. Money market funds are invested dollar for dollar in readily marketable securities -- in essence, a narrow bank concept. Further, money market funds are invested in instruments with short maturity duration. Subsequent to the SEC reforms adopted in 2014, nearly 80 percent of money market fund assets are in government funds. These funds primarily are invested in and funding the U.S. Treasury and Federal Reserve."
He comments to the ICI, "Such money market funds, though, are not without risk. Remember that bear rattling the campers -- there still is the risk of runs and resulting dilution. Money market funds also have no capital buffer. Money market funds now stand at $5.8 trillion. During the last year, when interest rates were rising, we saw an increase of $717 billion in these funds. Further, given the rise of the digital economy coupled with the higher-rate environment, we might see consequential changes to the deposit and banking landscape. Money market funds could potentially take a greater share."
Gensler also says, "This is all the more reason to update rules last addressed in 2014 to lower the chance the fire department, the Federal Reserve, has to be called in yet again. Given the experience of the last nine years, we proposed changing a rule from 2014 that could be procyclical in times of stress. The proposal would prevent money market funds from imposing limits on redemptions in times of stress, such as so-called 'gates.' We also proposed enhanced liquidity requirements. To better address pricing and reduce dilution in times of stress, we proposed so-called swing pricing as well as alternatives regarding liquidity fees. Such swing pricing or liquidity fees would apply only to institutional prime and tax-exempt money market funds, less than 20 percent of the field. These institutional funds invest in bank-issued commercial paper and certificates of deposit, which tend to be illiquid in stress times."
He adds, "Before I close, I want to touch upon two related forms of collective investment vehicles overseen by bank regulators, short-term investment funds and collective investment funds. Such funds managed by bank trust departments or for certain tax-qualified retirement funds are exempt from SEC oversight. Short-term investment funds, estimated to total more than $300 billion in assets, operate similarly to money market funds. Collective investment funds are estimated to be $7 trillion, $5 trillion at the federal level and $2 trillion at the state bank level. The Office of the Comptroller of the Currency last substantively revised rules for short-term investment funds in 2012."
Finally, he says, "Rules for these funds lack limits on illiquid investments and minimum levels of liquid assets. There is no limit on leverage, requirement for regular reporting on holdings to investors, or requirement for an independent board. We know from history that financial fires can spread from regulatory gaps as well as herding and network interconnectedness. Such gaps include when regulations don't treat like activities alike. Market participants may then seek to arbitrage such differences. We're in discussions with the bank regulators on these topics."
Gensler concludes, "I hope you can tell from my bear hug of collective investment vehicles that I believe they have really benefited investors. That doesn't mean, though, that we don't need to protect investors from the bear of dilution. To me, this is about getting back to what Roosevelt and Congress were trying to address in 1940 -- that funds are liquid to meet redemptions, and valuations appropriately reflect the prices of the underlying portfolio. We've benefitted from a great deal of feedback on the SEC's proposals. The goal, if adopted, is that the rules help keep investors from getting eaten by the bear and minimize calls for fire department support."
