The US Securities and Exchange Commission (SEC) recently proposed amendments (Amendments) to its rules governing money market funds. The Amendments are intended to incorporate lessons learned from the COVID-19-related market turbulence in March 2020.
The Amendments, proposed on December 15,[1] follow the SEC’s February 2021 request for comment on money market reform,[2] and were designed to improve the resilience of money market funds by, among other things:
While some of these proposals, such as the removal of liquidity fees and redemption gates may be easily implemented, money market fund sponsors may face significant challenges implementing the swing pricing provisions, and the increased daily and weekly minimum liquid asset requirements may require changes in how some money market funds are managed.
Money market funds have been a regulatory focal point since the 2008 financial crisis, during which one prominent money market fund “broke the buck,” and countless others received financial support from their advisers and/or obtained insurance against losses from the US Department of the Treasury. In 2010, the SEC amended Rule 2a-7 to, in part, require money market funds to maintain liquidity buffers (i.e., minimum levels of daily and weekly liquid assets), perform periodic stress testing, and tighten rule provisions on portfolio qualify and maturity intended to limit the market risk of a money market fund’s portfolio. In 2014, the SEC acted again with amendments that, among other things, provided boards of non-government money market funds[3] with the ability to impose redemption fees and/or gates under redemption pressures and required institutional prime and institutional tax-exempt money market funds to float their net asset values (NAVs) (i.e., not fix the NAVs at $1.00 per share).
The proposed Amendments seek to build on the experience from the market volatility in 2020, where economic concerns about the impact of the COVID-19 pandemic created stress on short-term funding markets generally and money market funds in particular.
Removal of Liquidity Fees and Redemption Gates
Currently, the board of a non-government money market fund is permitted to impose a liquidity fee of up to 2% or temporarily suspend redemptions for up to 10 business days in a 90-day period if the money market fund’s “weekly liquid assets”[4] fall below 30% of its total assets, and a non-government money market fund is required to impose a 1% liquidity fee on all redemptions if its weekly liquid assets fall below 10% of its total assets, unless its board determines that imposing such a fee would not be in the best interests of the fund. These fees and gates were designed to provide a “cooling off” period to calm short-term investor panic, preserve liquidity levels in times of market stress, and better allocate the costs of providing liquidity to redeeming shareholders.
During its review of market activity during and immediately following the period of market stress in March 2020, the SEC found that although no money market funds imposed liquidity fees or gates in March 2020, the possibility of their imposition appears to have exacerbated redemption pressure on money market funds during that period. Specifically, the SEC noted research papers that found increased redemption pressures on money market funds with weekly liquid assets closer to the 30% threshold that would have permitted the imposition of fees and/or gates. Based on this experience, the SEC conceded that the fees and gates did not have the intended effect and, accordingly, the Amendments would remove the liquidity fee and redemption gate provisions from Rule 2a-7.
Swing Pricing Requirement
In lieu of redemption fees and gates, the Amendments would require institutional prime and institutional tax-exempt money market funds to implement swing pricing for any periods of net redemptions. In accordance with this requirement, an institutional prime or institutional tax-exempt money market fund would be required to adjust its current NAV by a swing factor reflecting spread and transaction costs, and, if the fund has net redemptions exceeding a “market impact threshold,” market impact costs.[5] The adjusted NAV would reflect costs resulting from shareholder redemptions, and would, in the view of the SEC, ensure that these costs are fairly allocated to the redeeming shareholders.
A swing pricing administrator, designated by the money market fund’s board, would be responsible for administering the money market fund’s swing pricing policies and procedures and determining the swing factor. The swing pricing administrator would also determine whether the money market fund should adopt a “market impact threshold” lower than the default threshold (i.e., 4% of the fund’s net asset value divided by the number of pricing periods the fund has in a business day). In addition, the swing pricing administrator would be responsible for drafting an annual report that would include the following:
The SEC is not proposing to require retail or government money market funds to implement swing pricing. The SEC observed that retail funds have historically had smaller outflows than institutional funds and that retail investors appeared to be less focused on reported fund liquidity levels. Similarly, the SEC noted that government money market funds have seen inflows during periods of market instability. Further, swing pricing would represent a significant change for investors in retail money market funds and government money market funds, as it would effectively require these funds to operate with a floating NAV.
The SEC believes that this swing pricing approach would address some of the issues the SEC observed as problematic in the March 2020 market turmoil. Specifically, in the SEC’s view, the swing pricing provisions would mitigate the risk of institutional investors seeking first-mover advantage and discourage excessive redemptions, particularly in times of stress. It remains to be seen whether commenters will agree that the potential imposition of swing pricing—and the inherent uncertainties that it will create—will not provide a similar incentive for institutional investors to redeem their shares in times of stress.
The SEC acknowledged, however, that the swing pricing requirement would create significant new operational issues and costs for money market funds, including obtaining timely flow information to inform swing pricing decisions, determining whether the fund has net redemptions, and calculating and applying the swing factor to the NAV prior to processing shareholder transactions—potentially multiple times per day. To that end, the proposing release includes numerous requests for feedback on the swing pricing requirement and its operational challenges.
Increased Minimum Daily and Weekly Liquidity Requirements
Money market funds, other than tax-exempt money market funds, currently must hold at least 10% of their total assets in “daily liquid assets,”[6] and all money market funds must hold at least 30% of their total assets in weekly liquid assets. The Amendments would increase these minimum daily and weekly liquid asset requirements from 10% to 25% and from 30% to 50%, respectively. These increased minimums are intended to better equip money market funds to manage substantial and rapid investor redemptions, such as those experienced in March 2020. Tax-exempt money market funds would continue to be exempt from the daily liquid asset minimum requirement.
The Amendments would also impose a new board reporting requirement upon a “liquidity threshold event,” i.e., where a money market fund’s weekly liquid assets fall below 25% of its total assets, or its daily liquid assets fall below 12.5% of its total assets. Upon the occurrence of a liquidity threshold event, a money market fund must notify its board of directors. Within four business days, the money fund would be required to provide the board with a brief description of the facts and circumstances that led to the liquidity threshold event. In addition, money market funds that experience a liquidity threshold event would be required to make a notice filing with the SEC providing certain information within one business day, with up to four business days to amend the filing to include a description of the facts and circumstances leading to the event.
Interestingly, these board and SEC reporting requirements seem to apply to tax-exempt money market funds whose daily liquid assets fall below the 12.5% floor, even though such funds are exempt from the daily liquid assets requirement.
Amendments Related to Potential Negative Interest Rates
The SEC provided guidance in the proposing release related to the operation of government and retail money market funds that seek to maintain a stable NAV in negative interest rate environments. According to the proposing release, if negative interest rates turn a stable NAV money market fund’s gross yield negative and the fund’s board reasonably believes that the stable share price does not fairly reflect the fund’s market-based share price, the fund would be required to convert to a floating share price. The SEC further explained that although government and retail money market funds may, under Rule 2a-7, seek to maintain a stable share price by using amortized cost and/or penny-rounding accounting methods, such approach is only permitted if the fund’s board believes that the stable share price fairly reflects the fund’s market-based NAV.
The Amendments would require a government or retail money market fund to determine that its financial intermediaries are able to process transactions in the fund’s shares at prices that do not correspond to a stable price per share (in the event the fund converts to a floating NAV). If such determination cannot be made, the Amendments would require the money market fund to prohibit the relevant financial intermediary from purchasing the fund’s shares in nominee name. Thus, the requirement could potentially result in operational issues and additional costs for government and retail money market funds. Additionally, the Amendments would prohibit money market funds from operating a reverse distribution mechanism, routine reverse stock split, or other device that would periodically reduce the number of the fund’s outstanding shares to maintain a stable share price.
Other Amendments
In addition to the key Amendments outlined above, the other Amendments discussed in the proposing release would:
The SEC voted to propose the Amendments along party lines with a 3-2 vote, and because these Amendments represent significant changes, especially with respect to the imposition of swing pricing for institutional prime and tax-exempt funds, they may be meaningfully revised prior to their adoption. If the Amendments are ultimately adopted as proposed, money market funds, their sponsors, and their boards will be required to undertake the implementation of new policies and procedures as well as re-evaluate the way in which they operate their money market funds in order to come into compliance with the new regulatory regime.
Comments on the Amendments are due 60 days after the proposing release is published in the Federal Register.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Boston
Lea Anne Copenhefer
Barry N. Hurwitz
Roger P. Joseph
Jeremy B. Kantrowitz
Paul B. Raymond
Toby R. Serkin
Mari Wilson
New York
Elizabeth Belanger
Philadelphia
David W. Freese
Timothy W. Levin
John J. O’Brien
Sean Graber
Orange County
Laurie A. Dee
Jonathan J. Nowakowski
Washington, DC
Laura E. Flores
Thomas S. Harman
Christopher D. Menconi
W. John McGuire
Joseph (Beau) Yanoshik
Mana Behbin
Kathleen M. Macpeak
[1] See “Money Market Fund Reforms,” Rel. No. IC-34441 (Dec. 15, 2021).
[2] See “Request for Comment on Potential Money Market Reform Measures in President’s Working Group Report,” Rel. No. IC-34188 (Feb. 4, 2021).
[3] A “government money market fund” is defined in Rule 2a-7 as a fund that invests 99.5% or more of its total assets in cash, government securities, and/or repurchase agreements that are collateralized fully. A “retail” money market fund is defined in Rule 2a-7 as a money market fund that has adopted policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons.
[4] “Weekly liquid assets” include cash, US Treasury securities, certain other government securities with remaining maturities of 60 days or less and certain securities that convert to cash within five business days.
[5] The “pricing period” means the period of time in which an order to purchase or sell securities issued by the money market fund must be received to be priced at the next computed NAV.
[6] “Daily liquid assets” include cash, US Treasury securities, certain securities that convert to cash within one business day, or amounts unconditionally due within one business day from pending portfolio security sales.