State Street Global Advisors' latest "Monthly Cash Review - August 2023 (USD)" discusses, "Money Market Fund Reform 2023." Author Will Goldthwait writes, "The Securities Exchange Commission (SEC) recently proposed some changes to Rule 2a-7, the standard that governs money market mutual funds (MMFs). We consider some of the challenges of the new rule and what it could mean for the industry, fund providers and investors. (Note: We hope to see some of you next week at our European Money Fund Symposium, which will take place Sept. 25-26, 2023 in Edinburgh. The agenda features sessions on U.S. and European MMFs regulations. For those attending, safe travels and see you in Scotland!)
Giving us "A Brief History," he states, "Moving cash back and forth between banks and non-bank entities, such as investment managers and brokerages, had become cumbersome, and sparked the invention of money market mutual funds in 1971. These new funds used amortized cost accounting, allowing them to report a steady USD 1.00 as net asset value (NAV), and, in theory, resembled a bank deposit. There were challenges in the early days, similar to what the cryptocurrency space is experiencing today."
Goldthwait continues, "It took the SEC more than a decade to create Rule 2a-7, in 1983, which would specifically govern MMFs, making them separate and distinct from other (stock and bond) mutual funds. The rule was revised in the early 1990s and again after the Global Financial Crisis (GFC), in 2010 and 2014, to create a more robust, commingled vehicle. The 2014 rule change that took effect in 2016 spurred the most significant shift in MMF strategies and led to over USD 1 trillion in assets moving from prime funds to government funds."
He says, "But some of the 2014 rule changes created unintended consequences, such as the first-mover advantage, thus necessitating further changes to the rule in 2023. The 2023 rule changes continue to focus on investor behavior during market disruptions and how to protect shareholders. For instance, the SEC made several observations regarding the COVID-19-induced investor panic in March 2020. One of them was that institutional investors fled a week before retail investors."
SSGA's piece then states, "During the first two weeks of market turmoil (11–24 March), publicly offered institutional prime funds experienced a 30% redemption rate (about USD 100 billion). Some institutional prime MMFs experienced redemptions greater than 50% of their AuM. Alternatively, privately offered institutional prime funds had redemptions of just ~6% of their assets. Retail prime funds lost approximately 11% of their assets (about USD 48 billion), while tax-exempt funds, mostly retail, lost 8% (about USD 12 billion). The SEC's current reform is mainly aimed at rebalancing risks and eliminating the first-mover advantage for institutional prime funds."
It tells us, "The SEC has increased the liquidity requirements of prime funds. Reminder: Liquidity is considered ready cash or securities that can be easily converted to ready cash, like US Treasury securities. The daily (1-business-day) liquidity requirement will increase to 25% of AuM, when previously it was 10%. The weekly (5-business-day) liquidity requirement will increase to 50% of AuM, when previously it was 30%. This increase could be worth 1–3 bp of yield depending on the interest rate environment. Most funds have already been running their liquidity levels at or close to these new requirements; therefore, this rule change is not a game-changer."
Goldthwait then comments, "The SEC had proposed a swing price mechanism. This mechanism is common in Europe and in other non-SEC-regulated comingled vehicles in the US. The regulator had proposed that if a fund loses 4% of its AuM, the fund would have to calculate a swing price. This means the fund would calculate the cost of selling a pro rata amount of each security in the portfolio and apply that cost to the NAV. Most, if not all, fund managers said this would not work. Simply, there was not enough time between the fund closing and determining the amount of the redemptions, and then implementing a swing price. The SEC listened, modified, and adopted a different rule. The new rule will require a fund that loses 5% or more of its AuM to apply a determined fee to the NAV for those who are redeeming. The amount of the fee will be calculated using a good faith estimate on market liquidity and the cost of liquidating those bonds in the portfolio."
He writes, "The SEC has made it clear that there is no discretion in applying the fee. The fee will be determined anytime there are redemptions of 5% or more of AuM and it will be applied at the start of the redemptions, not at the end. The current rule would allow the fee to be applied after the fund had seen redemptions, essentially after everyone had 'run.' If the impact to the NAV from the estimated cost of the redemption is less than 1 bp of the fund's NAV, no fee needs to be applied. The impact will be considered de-minimis. The SEC believes this to be the result the majority of the time."
SSGA continues, "In the event that the estimated cost of liquidity is larger than 1 bp, the size of the fee would be determined by making a good faith estimate of the liquidity costs the fund would incur if it were to sell a pro rata share of each position in the fund. This gets complicated. If the fund cannot estimate the cost of liquidity, the fee would default to 1.0%. Recall 'breaking the buck' is a 0.5% move in NAV. There is no limit on the size of the fee a fund can apply. The previous rule (2014) limited the fee to 2%. The SEC has removed this limit."
They add, "The board is responsible for administrating the fee, but it can delegate that authority to the fund's investment advisor. We suspect all boards would delegate. The current rule does not allow the board to delegate. Thus the current rule creates a delay in applying a fee. The new rule will trigger the fee; no decision making is necessary by the board or anyone else. The cost of a vertical slice is intended to compensate the remaining shareholders for staying in the fund, and not penalize them for staying in the fund as the current rule allows. The SEC is trying very hard to remove the first-mover advantage."
Finally, state, "A good faith estimate can be difficult because not all securities price easily. Because of this, the SEC has provided guidance for estimating the price of a security. First, grouping securities in certain categories by region, sector, issuance size, credit worthiness, distribution (widely held), etc. Second, daily and weekly liquidity should incur zero cost. Third, a grid could be used to apply different market conditions to the vertical slice: credit stress, liquidity stress, and interest rate stress. This grid would need to be updated from time to time. Importantly, the fee is only applied to redemptions. Thus, intermediaries that net their flows will need to update their reporting. There will be two prices -- one for subscribing and one for redeeming in case a fee is applied."
