The Future of MMFs: Preparing for the Second Wave of Regulation
Last month, the US Treasury released a document entitled Report of the President’s Working Group on Financial Markets: Money Market Fund Reform Options, which laid out “a number of options for reforms related to money market funds” intended to “address the vulnerabilities of money market funds that contributed to the financial crisis in 2008.” Though the report doesn’t strongly endorse any option and most of the more radical changes discussed remain long-shots, it is clear that further regulatory action is in store for US money market funds (MMFs), and probably for European and ‘offshore’ funds too.
As many of you know, earlier this year the US Securities & Exchange Commission (SEC) tightened the quality, maturity and diversity rules (Rule 2a-7) governing MMFs and added a new liquidity mandate (10% overnight; 30% weekly). Also early this year, the Committee of European Securities Regulators (CESR) proposed implementing a new two-tiered definition system for MMFs. But both regulators have also indicated that more changes are coming. (See Vince Tolve’s article for more details on the SEC’s recent 2a-7 changes.)
Of course, regulatory uncertainty isn’t the only issue MMFs are faced with. Ultra-low yields, fee waivers, consolidation, lack of supply and continued concerns over credits all have buffeted money funds and cash investors over the past year, and none of these appear to be going away any time soon. Nonetheless, MMFs in the US continue to hold US$2.8 trillion in assets, and worldwide money funds total almost US$4.9 trillion. While this is down over US$1 trillion over the past 22 months, it is still an astounding total given the near-zero yields.
These still-massive balances indicate that corporate and institutional investors continue to believe that ‘cash is king’ in the current economic environment. Note that US bank deposits now hold over US$5 trillion in additional ‘cash’, but that the rates they pay have been decreasing relative to money funds’. It’s clear that MMFs and money market deposit accounts remain the primary options for parking liquid investments. Though enhanced cash and separate accounts have garnered some interest, the vast majority of institutions remain convinced that ‘return of principal’ is still more important than ‘return on principal’ (apologies to Mark Twain).
The US Treasury’s 21 October press release on the President’s Working Group report says: “Following the crisis, the Treasury Department directed the PWG to develop this report to assess options for mitigating the systemic risk associated with money market funds and reducing their susceptibility to runs. The PWG agrees that, while a number of positive reforms have been implemented, more should be done to address this susceptibility. The PWG now requests that the Financial Stability Oversight Council (FSOC), established by the Dodd-Frank Wall Street Reform and Consumer Protection Act, consider the options discussed in this report and pursue appropriate next steps. To assist the FSOC in any analysis, the Securities and Exchange Commission, as the regulator of money market funds, will solicit public comments.”
The SEC indeed began soliciting comments on the PWG report and future regulatory changes to MMFs earlier this month. Given the overwhelming opposition to a floating rate regime the last time the SEC asked for comments, we don’t expect this time to be any different. Expect to see the more radical reform options – floating net asset value (NAV), bank regulation, and dual-regime – get thoroughly lambasted prior to the 11 January deadline. A series of meetings in Washington will follow the end of the comment period in early 2011, so stay tuned.
Note that the report, while suggesting a number of areas for review, emphasised that the PWG should consider ways to mitigate possible adverse effects of further regulatory changes, such as “the potential flight of assets from MMFs to less regulated or unregulated vehicles.” It adds, “Importantly, this report also emphasises that the efficacy of the options presented herein would be enhanced considerably by the imposition of new constraints on less regulated or unregulated MMF substitutes, such as offshore MMFs, enhanced cash funds, and other stable value vehicles. Without new restrictions on such investment vehicles, which would require legislation, new rules that further constrain MMFs may motivate some investors to shift assets into MMF substitutes that may pose greater systemic risk than MMFs.”
Of course, everything is still on the table. MMFs could be forced to move to a floating price, or NAV, or to move away from US$1.00 a share. The floating NAV is one of the seven options listed in the PWG report. The others include: private emergency liquidity facilities; mandatory redemptions in kind; insurance; a two-tier system with enhanced protection for stable NAV funds; a two-tier system with stable NAVs reserved for retail investors; and regulating MMFs as special purpose banks. The report also lists “enhanced constraints on unregulated MMF substitutes” as an option, though this is more like an additional task to investigate.
As we implied above, a floating NAV regime is unlikely. The move, which likely would entail a switch to a higher price, like US$10.00 a share, and the switch to mark-to-market pricing from the current amortised cost regime, is fraught with peril. The PWG says, “To be sure, a floating NAV itself would not eliminate entirely MMFs’ susceptibility to runs.” They add, “Notwithstanding the advantages of a floating NAV, elimination of the stable NAV for MMFs would be a dramatic change for a nearly US$3 trillion asset-management sector that has been built around the stable US$1 share price. Indeed, a switch to floating NAVs for MMFs raises several concerns.” These include: a reduction of credit supplied, a shift into unregulated entities, systematic risk from the switch itself, an increase in risk-taking and the realisation that the new floating NAV money funds may not float.
Almost all of the other options all also appear to have more drawbacks than benefits, according to the PWG report (and according to industry and investor feedback to date). MMF insurance, or a shift to a banking regulatory regime, involves massive change. A dual system of stable and floating MMFs also would likely invite confusion and the risk of cross-contamination. Thus, the idea of a “private liquidity facility” or “liquidity exchange bank” appears to have the highest odds of implementation, given its support by the mutual fund industry.
The PWG report explains, “The programs introduced at the height of the run on MMFs in September 2008 – Treasury’s Temporary Guarantee Program for Money Market Funds and the liquidity backstop provided by the AMLF – were effective in stopping the run on MMFs. More generally, policymakers have long recognised the utility of liquidity backstops for institutions engaged in maturity transformation: Banks, for example, have had access to the discount window since its inception, and backstop lending facilities also have been created more recently for other types of institutions. Thus, enhanced liquidity protection should be considered as part of any regulatory reform effort aimed at preventing runs on MMFs. At the same time, such enhanced liquidity protection does not have to be provided necessarily by the government: A private facility, adequately capitalised and financed by the MMF industry, could be set up to supply liquidity to funds that most need it at times of market stress.”
This option has issues too. But for now it’s clearly the most palatable to fund groups and it’s likely the least disruptive option to the broader economy. The trick will be getting the regulators to go along and working out the funding and participation. Note that the SEC also asked for feedback on additional options, so it’s possible another solution could emerge. But for now the betting is on a private liquidity backup facility being implemented to help prevent future runs on MMFs.