money market fund reform: an alternative to the sec’s proposal

Opening the Gate to Money Market Fund Reform

Hester PeirceSenior Research Fellow

Robert GreeneResearch Associate

This presentation is based on a forthcoming paper, which contains additional information and references.

Overview

• What is a money market fund (MMF)?

• How is a MMF regulated?

• What happened to MMFs during the financial crisis?

• How have MMF regulations changed since then?

• How should MMF regulations be changed?

Before We Discuss MMFs … What is a Mutual Fund?

• Mutual funds are a collectively owned pool of assets

• Registered with and regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940

• Organized as business trusts or corporations under state law, and investors in the fund are shareholders

How are Mutual Funds Structured?

• A separate company—a fund sponsor—sets up a mutual fund typically as part of a diverse, multi-fund complex

• Shareholders elect a board to oversee the fund’s relationships with the adviser and other outside entities that provide services to the fund

• Fund sponsor serves as the principal investment adviser to the fund, and may also provide “back-office” administrative functions

How is a Mutual Fund Structured?

Shareholders

Board of Directors

Mutual Fund 1

Investment Adviser

Principal Underwriter Administrator Transfer Agent

Custodian

Independent Public Accountant

Source: Investment Company Institute

Fund Sponsor

Sets up Mutual Fund 2

Mutual Fund 3

Mutual Fund FamilySets up

Oversees Oversees

What are Boards?

• Shareholders elect a board of directors to oversee the fund’s relationships with the adviser and other outside entities that provide services to the fund

• At least 40% of the board’s directors must not be “interested persons” (i.e., independent of the fund the fund’s adviser, underwriter, etc.)

• About 90% of fund complexes in 2011 had boards with 75% independent directors

Board Responsibilities

But what exactly do boards of directors do?


• Performance evaluation

• Approval of advisory/underwriter contracts

• Fee approval

• Pricing of fund shares

• Oversight of portfolio management and compliance issues


• Provide “management direction” to the fund

• Approve major transactions

• Monitor conflicts of interest

• “Duties of care and loyalty” (require that directors act with diligence and care to pursue fund’s best interests – directors may not put interests of another person or organization above those of the fund)

What are MMFs?

• MMF shares generally are bought and sold at a $1.00 per share (enabled by Rule 2a-7, which we will discuss in detail later)

• Typically invest in low-risk securities, such as high-grade commercial paper and government securities

What Makes MMFs Special—Stable NAV

• MMF sales don’t have same tax implications as sales of other MMFs

• MMFs are treated as cash equivalents for accounting purposes

• Retail investors have check-writing features and ATM access

Types of MMFs

• There are 3 basic types of MMFs• Prime - invest in money market instruments other than

simply Treasury and agency securities• Government – invest in Treasury and agency securities• Municipal (or tax-exempt) – invest in municipal debt

• There are 2 main investor types• Institutional – firms, pension plans, municipalities• Retail – mom, pop, you

• The concerns of the crisis largely surrounded institutional prime funds

Size of MMF Industry

$10.3 trillion

$2.7 trillion

Other Mutual Funds

Money Market Funds


MMFs are $2.7 trillion of the $13 trillion mutual fund industry

Why Do Investors Like MMFs?

• MMFs are an important cash management tool for corporate treasurers and a vital source of short-term funding for banks, municipalities, and corporations because of the stable NAV, low-risk, and high liquidity.

• Retail investors like MMFs too because they provide stability, but also can offer higher returns than bank accounts

History of MMFs

• MMFs arose as a response to investor frustration over Regulation Q, which imposed interest rate caps on bank savings accounts

• Throughout 1970s and 1980s, MMFs offered higher interest rates and the same ready liquidity and one dollar in/one dollar out feature as bank accounts

• MMFs went through a regulatory odyssey at the SEC that ultimately resulted in the promulgation of rule 2a-7 in 1983

Rule 2a-7

• Since 1983, rule 2a-7 has been amended multiple times, the most recent of which was in 2010

• May maintain a stable NAV as long as actual value of fund shares remains within a narrow band around one dollar and complies with rule’s parameters on:• Portfolio maturity• Quality• Liquidity• Diversity

MMFs During the Financial Crisis

• As discussed above, MMF shareholders like the $1.00 NAV

• The events of 2007 through 2009 cast money market funds in a new light; money market funds were not immune from problems


Mid-2007

• 25% of MMFs were invested in asset-backed commercial paper (ABCP)• Short-term, privately-issued debt backed by revenue-

generating assets like mortgages and credit card receivables

• Came under stress mid-July

• Outstanding ABCP grew to $1.16 billion by July

• Reserve Primary Fund begins purchasing ABCP and other commercial paper (this will matter later)

• In late July, 2 Bear Stearns hedge funds collapse

MMFs During the Financial CrisisSummer 2007

ABCP Interest Rates ABCP Outstanding

First 7 Months of 2007 August 2007

ABCP Yield Spread (Basis Points) Over Target Federal Funds Rate

2-6 47

3 BNP Paribas funds suspend redemptions

Widespread ABCP concern 25% of ABCP

programs experience

runs!

Bear Stearns shuts 2 hedge funds


Late 2007

The emergence of ABCP troubles causes a “repricing of the money markets” that enables MMFs to choose “whether to invest in assets with a substantial risk premium to safe government securities (Kacperczyk & Schnabl)

Many funds chose to move assets out of commercial paper … others did not ... high yields!!!


Reserve Primary Fund DID NOT

• First MMF

• Historically not a large commercial paper investor

• Began buying ABCP and other commercial paper in August 2007

• ABCP holdings rise from 1% to 60%


Reserve Primary Fund’s Competitive Gamble

• Yield rises 50 basis points

• Moves fund from bottom 20% to top 10% of institutional funds

• Between July 2007 and July 2008 its assets double largely because of institutional investors

• By August 2008 1.18 percent of its $62.5 billion under management is invested in Lehman Brothers commercial paper


Lehman Brothers files for Bankruptcy September 15th!

Reserve Primary Fund’s Lehman Paper is in trouble

Reserve Primary investors want to get out fast

Fund’s adviser worries that “the fund would be unable to sell holdings at par if forced to do so to meet redemption requests”


• Lehman’s woes cause Reserve Primary Fund’s NAV to fall to $0.97 – it “breaks the buck”

• This had only happened once before

• SEC retroactively approves Reserve Primary Fund’s request to suspend redemptions “until the markets are liquid to a degree that enables each Fund to liquidate portfolio securities without impairing the net asset value of each Fund … ”

• Eventually, investors are repaid $0.99 on the dollar


Reserve Primary Fund’s troubles lead to large-scale redemptions from MMFs…. but not ALL MMFs

Certain funds much more likely to be redeemed from

Institutional prime MMFs (30% redeemed during September 2008) vs. Prime retail MMFs (5% redeemed)

Government MMFs

experience inflows

Riskier funds (as measured by portfolio

yields & sponsor credit default spreads)

experience higher outflowsLess liquid portfolios experienced more run behavior


• Many sponsors step in to support their funds• Prevented more MMFs from “breaking the buck”• Estimates range from 28 (Kacperczyk &

Schnabl) to 300 (former SEC Chairman Mary Schapiro)

• Fund managers responded to large scale redemptions• Some had to sell assets to meet redemptions• Some liquidated and consolidated into other

funds

Government Response (Short-Term)

• MMFs protect their ability to repay shareholders by sharply reducing their commercial paper holdings

• Financial institutions, which are highly dependent on short-term funding provided by MMFs, begin to feel the impact

• The government intervened to make sure that big banks could keep funding themselves

Government Response (Short-Term)Treasury’s Temporary Guarantee Program (Sept. 19)

• Guaranteed the multi-trillion dollar MMFindustry with the $50 billion Exchange Stabilization Fund created by the GoldReserve Act of 1934

• The program lasted for 1 year & guaranteed $1 NAV for funds in MMFs as of Sept. 19 . MMFs paid to participate.

• At its peak, 93% of MMF assets participated

• Program generated $1.12 billion in premiums & didn’t make any payouts

• The real cost was moral hazard—after the 2008 intervention, MMFs are perceived as carrying a government guarantee

?

Government Response (Short-Term)Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (Sept. 19)

• Program under Section 13(3) of the Federal Reserve Act to prevent fire sales of ABCP

• Enabled banks and other financial institutions to borrow from Fed discount window to purchase ABCP from MMFs

• Program peaked on Oct. 1, 2008 at $152 billion

Government Response (Short-Term)

Commercial Paper Funding Facility (Oct. 7)

• Program under Section 13(3) of the Federal Reserve Act to prop up commercial paper markets

• The Federal Reserve Bank of New York established a special purpose vehicle to purchase three-month commercial paper directly from issuers

• CPFF was a major buyer in the commercial paper market and grew to hold over twenty percent of outstanding commercial paper in the US

Government Response (“Long-Term”)• Large-scale crisis in MMFs prompted calls for reform

• Treasury 2009 white paper encouraged SEC to “move forward with its plans to strengthen” the MMF regulatory framework

• Treasury called on the President’s Working Group on Financial Markets (PWG) to prepare a report analyzing “more fundamental changes”, including floating the NAV or mandating access to private emergency liquidity facilities

• But SEC adopts reforms to Rule 2a-7 before the PWG report is released

SEC’s 2010 September MMF Reforms• Liquidity

• Cap on illiquid securities holdings dropped from 10% of total fund assets to 5%

• “Illiquid security” redefined to mean any security that cannot be sold “at approximately the value ascribed to it by the fund” holding it within 7 days

• 10% of holdings must be invested in “daily liquid assets; 5% in “weekly liquid assets”

• MMFs must “hold securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions.”

• Portfolio Quality• Cap on second tier securities from 5% to 3%• Amount a MMF can invest in second tier securities of a particular

issuer was reduced from 1% to 0.5%• Maximum allowed maturity for second-tier securities reduced from

397 days to 45 calendar days

SEC’s 2010 September MMF Reforms• Maturity Requirements

• Dollar-weighted average portfolio maturity for MMFs was reduced from 90 to 60 calendar days

• New dollar-weighted average life requirement (excludes specially-valued securities) was added that restricts WAL to no more than 120 days

• Disclosure Requirements• Funds must post detailed portfolio holdings within 5 business

days of each month’s end and leave it posted for at least 6 months

• MMFs must monthly electronically file with the SEC interactive data portfolio holdings on new Form N-MFP

• SEC publicly discloses the Form N-MFP information 60 days “after the end of the month to which the information pertains.”

SEC’s 2010 September MMF Reforms• Credit Ratings

• Added a requirement to rule 2a-7 that MMF boards annually designate and assess the reliability of at least four Nationally Recognized Statistical Rating Organizations (NRSROs)

• ratings of chosen NRSROs are used by the fund to determine whether a security meets the portfolio quality standards established by Rule 2a-7

• However, fund board may not exclusively rely on credit ratings in determining whether the fund should acquire a security

• Suspension of Redemptions• Required MMFs to develop the capability of redeeming

shares at a market-based NAV rather than a stable NAV• And…

SEC’s 2010 September MMF ReformsNew rule 22e-3

• 2010 amendments provide an exemption from Investment Company Act section 22(e), which prohibits mutual funds from suspending redemptions unless:• NYSE has closed or its trading is restricted• Emergency when it is not “reasonably practicable” to

dispose of or value portfolio securities• SEC creates an exemption

• Rule 22e-3 creates an exemption that allows MMFs to suspend redemptions if the Board:• Determines that a deviation exists between the market-

based NAV and a stable NAV• Irrevocably approves the fund’s liquidation

SEC’s 2010 September MMF Reforms

The rule “is intended to reduce the vulnerability of investors to the harmful effects of a run on the fund, and minimize the potential for disruption to the securities markets.” --SEC

Nevertheless, the requirement that the fund be in the process of liquidation is a significant limitation on the rule’s ability to protect MMF investors from runs.

2010 reforms were just the beginning …

The Continuing MMF Regulatory Odyssey

• PWG’s report (2010) looked at:• Floating the NAV• Setting up a private emergency liquidity facility• Requiring certain redemptions to be in-kind• Insuring MMFs• Imposing additional requirements on stable NAV

funds• Restricting stable NAV funds to retail investors• Regulating stable NAV funds like special purpose

banks• Increasing restrictions on MMF alternatives

• These and other reforms have been debated by regulators, industry, and academics


• In August 2012, SEC Chairman Schapiro pushed for one of or a combination of the following three reform options:• Floating the NAV• Capital Buffers• Minimum Balance-at-Risk (developed by

economists at Federal Reserve Bank of New York)

• Her colleagues rightfully expressed trepidation about proposing these options without adequately understanding their potential effects on MMFs, investors, and entities that rely on MMFs for funding


• Rather than brokering compromise, Chairman Schapiro invited the Financial Stability Oversight Council (FSOC) to act

• Dodd-Frank gives the FSOC, a multi-regulator systemic oversight body, authority to make recommendations to regulatory agencies

• Agency to which the recommendation is directed must—within ninety days—either to follow the recommendations or explain why it is not doing so


• FSOC Proposed Recommendations (2013):• Floating the NAV• Pairing a 1% capital buffer with a 3%

minimum balance at risk• Pairing a 3% capital buffer with stricter

diversification requirements


• New SEC Chairman White managed to step in front of FSOC with a compromise proposal:• Floating the NAV of prime institutional

MMFs• Allowing MMFs to impose triggered

emergency liquidity fees and redemption suspensions

• A combination of the first two options

Discussion of Proposed Reforms

For the sake of brevity we will only discuss the SEC’s and FSOC’s proposed reforms…

• Minimum Balance at Risk

• Capital Buffer

• Floating NAV

• Triggered Liquidity Fees and Gating

And then explain our own proposal…. (it’s a surprise)

Minimum Balance at Risk

• Proposed by the FSOC, and developed by Patrick McCabe of the Federal Reserve Bank of New York

• Aims to dissuade MMF shareholders from redeeming in times of crisis by requiring that a portion of a large investor’s total investments in a fund be …

• Held back for a specified period during which hold-back amount would be available to absorb fund losses …

• Available to bear losses according to a subordination formula


Benefits

• Early redeemers would pay a price for the privilege of leaving early

• Would force large shareholders—the ones most prone to run—to think carefully about their redemption decisions and thus could avert MMF runs


Drawbacks

• Would be very difficult for MMFs to implement and would leave investors uncertain about how much they could withdraw and when

• The FSOC acknowledges, the “operational and technology costs . . . could be substantial”

• The FSOC’s own analysis shows that a buffer of at least 4 percent would be necessary to stop runs in times of severe crises – likely not feasible


Drawbacks

• Regulators would have to determine how long a one-size-fits-all holdback period should be• Too short—MMFs more vulnerable to runs• Too long –unduly inconvenient to MMF

investors

• Even during normal times, a minimum balance at risk will affect MMF shareholders adversely because it will interfere with normal redemption patterns

Capital Buffer

• A capital buffer is a separate pool of cash or cash-like assets to shore up MMFs’ stable NAV

• The FSOC proposed:• A 1% risk-tailored percent buffer + minimum

balance at risk• A risk-tailored 3% buffer + more stringent

diversification and liquidity standards• Risk-tailoring means that amount held would be less than

1% and 3% – the FSOC estimates the 3 percent buffer would actually be only 2.51 percent for prime MMFs

Capital Buffer

Benefits

• An appropriately-sized capital buffer could help curb runs by giving MMF shareholders confidence that there is no need to redeem early because there will be sufficient assets available through the capital buffer to repay them

Drawbacks• The FSOC’s proposed buffers would have been insufficient to stop

the Reserve Primary Fund from breaking the buck • The largest buffer’s size is only 2.51 percent, but

Reserve Primary Fund’s NAV declined 3 percent• According to SEC Commissioner Gallagher:

“A buffer too small “would have given investors – especially retail investors … – a false sense of security”

• An effective capital buffer would have to be quite large and consequently very difficult to build up• The FSOC’s proposed risk-based three percent

capital buffer would cost prime MMFs roughly $37.3 billion over six years – Inv. Co. Inst.

Capital Buffer

Capital Buffer

Biggest Drawback

“It became clear to me early on in this process that the only real purpose for the proposed buffer was to serve as the price of entry into an emergency lending facility that the Federal Reserve could construct during any future crisis – in short, the “buffer” would provide additional collateral to facilitate a Fed bailout for troubled MMFs”

– SEC Commissioner Gallagher

Floating NAV

• SEC proposed floating the NAV for prime MMFs

• FSOC proposed floating the NAV for all MMFs

• Would remove the stable NAV, a key feature of MMFs

Floating NAV

Benefits

• Stable NAV creates a first-mover advantage for investors that run during a financial crisis; floating NAV would diminish that advantage

• When a MMF’s market-based NAV falls below $1.00, investors have a significant incentive to redeem at the $1.00 stable NAV, a price that is higher than the value of the proportionate share of underlying assets

• Remaining investors are left with a less liquid and less valuable portfolio

• The floating NAV could lessen the number and magnitude of MMF runs

Floating NAV

Drawbacks

• The floating NAV does not address the core cause of runs• Evidence suggests that investors run from funds that

have taken on riskier assets or lack liquidity to meet redemptions.

• Investors would still have an incentive to run early from funds that they anticipated would later experience problems

• Would impair the day-to-day utility of MMFs for many investors by creating tax and accounting hurdles to rapid redemptions and repurchases.

• Would require substantial operational and technology changes

Triggered Liquidity Fees and Gating• The SEC proposed to require MMFs to impose a

liquidity fee of up to 2% if weekly liquid assets fall below a liquidity threshold of 15%of total assets

• Under the SEC’s proposal, the Board may decide the size of the liquidity fee or not to impose a liquidity fee

• The Board may also decide to gate the fund (restrict redemptions) upon this 15% trigger being reached, but only for 30 days in any 90 day period

Triggered Liquidity Fees and GatingBenefits• Would preserve most of the core features of MMFs

• Would mitigate the risk of runs by addressing the core of their cause – high volumes of redemptions that deplete liquidity

• Liquidity fees would allow investors that wanted liquidity to pay for it by compensating remaining shareholders

• Gating portion of the proposal would afford MMF boards additional flexibility in responding to a crisis situation

Triggered Liquidity Fees and GatingDrawbacks

• The SEC’s proposal is trigger-based:• Academic research suggests there could

be redemptions in anticipation of triggers• Regulators are unlikely fit to adequately

determine appropriately sized fees and triggers

• Unnecessarily Limits board discretion

So, What to Do?

Our Proposal – Discretionary Gating• We propose to allow boards of directors to halt

redemptions at any time and for any length of time without any conditions other than an affirmative board vote that suspending redemptions is:• In the best interests of the fund• Necessary to protect the fund’s stable NAV• Necessary to ensure equitable treatment of

fund shareholders

• The vote must include the majority of the fund’s disinterested directors

Our Proposal – Discretionary Gating• A board’s gating decision would take effect at the

beginning of the next business day and would end as soon as the board determined that the conditions necessitating gating were no longer present.

• This Board responsibility could not be delegated

• MMFs would be required to disclose the existence of the board’s authority to impose gates and, if gates were imposed, to inform fund shareholders and the SEC promptly

Our Proposal – Discretionary Gating• In essence, we remove the liquidation requirement that

presently exists in rule 22e-3

• This condition unnecessarily dissuades boards from suspending redemptions

• Suspending redemptions would no longer be a fatal event for a MMF

Remember this?

Shareholders

Board of Directors

Mutual Fund 1

Investment Adviser

Principal Underwriter Administrator Transfer Agent

Custodian

Independent Public Accountant


Fund Sponsor

Sets up Mutual Fund 2

Mutual Fund 3

Mutual Fund FamilySets up

Oversees Oversees

BenefitsNatural Extension of Board Responsibilities

• A fund board already makes many key decisions for the fund• Performance evaluation• Contract approval• Fee approval• Pricing of Fund Shares• Oversight of Portfolio Management• Compliance Issues• Determining “what action, if any, should be initiated”

when a fund’s NAV deviates from $1.00

• Our proposal is a natural extension of these responsibilities

BenefitsHarnesses the powers of Boards, and their knowledge of the fund and its unique risks

• Boards in the midst of a crisis are better able to decide when gating is necessary than regulators who attempt to make that decision before a crisis occurs

• Boards will be able to decide, based on the volume of redemption requests and a close consideration of their portfolios’ liquidity, quality, and maturity, whether and for how long gating is necessary

• Boards of directors are, in the words of former SEC Chairman Arthur Levitt, “in an ideal position to monitor new developments and trouble-shoot problems as they arise”

BenefitsForces MMFs to compete on safety as well as on yield

• An analysis of hedge funds—which employ discretionary gating—reveals that more stringent restrictions on redemption requests are correlated with higher fund yields

• The prospect of gating will cause MMF investors to more closely scrutinize their investments and will incentivize diversification

BenefitsPrevents Runs and Facilitates Equitable Treatment of Shareholders• Funds would not need to resort to the sale of securities at

fire-sale prices or the disposal of liquid assets to meet redemption requests

• Gating would enable boards to prevent first movers from benefiting at the expense of a fund’s remaining shareholders

• To the extent one fund’s suspension of redemptions triggered redemptions at other MMFs, their boards could use their discretion to gate

BenefitsWould Not Affect the Day-to-Day Operations of MMFs• Costly and disruptive systems changes would be kept

to a minimum

• MMFs’ regular interactions with funds would remain largely unchanged

Possible Objections

• Microprudential focus, but …• The responsibility of MMF boards is to their funds,

not the larger economy• The larger economy could benefit from

regulations that facilitate effective private risk management

• Decreasing attractiveness of MMFs, but …• To the extent giving boards broad discretion to

gate makes MMFs less attractive to investors, it is a positive step toward helping them find appropriate investments

Possible Objections

• Inadequately responsive boards• Fund directors are accountable for their actions• Poorly behaving boards would be punished by the

market; assets would go to funds with boards willing to take action as needed

• Board members on multiple funds• The question of whether and when it is appropriate

to sit on multiple boards is a broader question• But board members have a fiduciary duty to each

fund on the board of which they serve and may not weigh external interests

Questions?

money market fund reform: an alternative to the sec’s proposal

Economy & Finance