On October 21, 2010, the President’s Working Group on Financial Markets1 (the “PWG”) released its long-awaited report on money market fund reform.2 The report was prepared in response to the Department of the Treasury’s June 2009 request that the PWG assess the additional reforms needed to further reduce the money market fund industry’s susceptibility to runs and risk to the U.S. financial system. The report states that, even though the SEC has already tightened money market fund regulation,3 further reform is needed. However, it does not endorse any particular approach to reform but rather provides a summary of reform options and the potential benefits and risks of each option.
The PWG has requested that the newly established Financial Stability Oversight Council (the “FSOC”) examine further the options detailed in the report. In support of this effort, the SEC will solicit public comments and empirical data on the reform proposals in the near future.
While the PWG’s report argues that further money market fund reforms are necessary, its inability, after more than a year of deliberation, to make a definitive recommendation highlights the fact that further reforms would not be without cost and risks. Among those risks is the possibility that the role of money market funds as a source of credit and liquidity for our financial system may be undermined. It remains to be seen whether the FSOC, the SEC and other policy makers will conclude that the benefits of any specific reform proposal outweigh the associated costs and risks.
The report discusses the following options for money market fund reform, which are described in greater detail below:
Floating NAVs. The report highlights how the historic $1 stable NAV of money market funds (sometimes maintained through the financial support of fund sponsors) has been a key element to their appeal to investors. However, the report also states that the $1 stable NAV has increased money market funds’ vulnerability to runs by fostering a perception that they are risk-free cash-equivalent vehicles. The report contends that moving to a floating NAV may help alter this perception and reduce investors’ incentives to redeem shares from distressed funds. The report also notes potential negative effects of a floating NAV, including decreased demand for money market funds and a corresponding reduction in their ability to provide short-term credit and liquidity crucial to the operation of the U.S. financial markets.
Private emergency liquidity facilities. The report argues that the liquidity risk inherent in money market funds contributes significantly to their susceptibility to runs. The report notes the success of the guarantee program and liquidity backstops provided by the Department of the Treasury and the Federal Reserve after the Reserve Primary Fund “broke the buck.” The report states that a private liquidity facility, with costs to be internalized by the industry rather than the government, could be a potentially important supplement to the SEC’s new liquidity requirements. However, the report acknowledges that a liquidity facility alone may not prevent runs on money market funds triggered by concerns of widespread credit losses. It also notes that significant capacity, structure, pricing and operational hurdles would have to be overcome to ensure that a facility would be effective during a crisis, that it would not unduly distort incentives for managers and that it would not favor certain types of money market fund business models over others.
Mandatory redemptions in kind. The report evaluates the possibility of requiring large redemptions to be made in kind so that redeeming shareholders would bear the costs of such redemptions. The report notes that this option would present numerous operational and policy challenges, including requiring the SEC to make key judgments on the circumstances under which a fund would be required to redeem in kind.
Money market fund insurance. The report states that, while insurance protection would limit the susceptibility of money market funds to runs, numerous issues would need to be resolved prior to implementation, including determining whether the insurance should be provided by the government or private sector, the appropriate level and costs of such insurance, and whether participation in an insurance program should be mandatory.
Two-tier money market fund system with enhanced protection for stable-value funds. Another reform option addressed by the report is the creation of two types of money market funds, one with a stable NAV and the other with a floating, or variable, NAV. Stable value funds with enhanced protections such as mandatory participation in a private liquidity facility and/or with enhanced regulatory requirements may appeal to more risk-averse investors. Floating value funds with less regulation and presumably higher yields may appeal to investors with greater risk tolerance. The PWG notes that such a two-tier system may prevent a flight to less-regulated or unregulated money market fund alternatives and would avoid the problems involved in transitioning the entire industry to a floating NAV. Nonetheless, the implementation of any reforms required for stable value funds under such a system (such as access to a private liquidity facility) would pose the same challenges as would be posed without the creation of a two-tier system.
Two-tier money market fund system with stable NAV funds reserved for retail investors. The report states that institutional investors have historically been quicker to redeem from money market funds and that such redemptions have contributed to the susceptibility of money market funds to runs. The report evaluates the possibility of allowing institutional investors to invest only in floating value funds in a two-tier system where retail investors would be still be allowed to participate in either stable or floating value money market funds. The report notes, however, that any outright ban on participation in stable value NAVs by institutional investors may result in unforeseen industry-wide effects including large capital outflows and related tightening of short-term credit availability and enhanced use of less regulated or unregulated money market fund alternatives.
Regulating stable-value money market funds as special-purpose banks. The report argues that the functional similarity of stable-value NAV money market fund shares to bank deposits and the susceptibility of money market funds to runs provides a rationale for regulating money market funds as special purpose banks. The report contends that an advantage of such an approach is that it would rely on the well-understood banking regulatory framework for mitigating systemic risk. The report notes that this approach would require adoption of new legislation, and interagency cooperation. This approach would also require that fund sponsors raise significant amounts of equity to capitalize the new special purpose banks. The report notes that this approach would present numerous other issues including the potential increase in government liabilities for deposit insurance, and issues as to how that insurance would be priced.
Enhanced constraints on money market fund alternatives. Finally, the report states that any reforms that reduce the appeal of money market funds will likely increase the demand for closely related alternative products including offshore funds and enhanced market cash funds. As part of the overall evaluation of further money market fund reform, the PWG urges that systemic risks posed by such alternative products be considered carefully and addressed in the overall reform strategy. The report notes that to mitigate the potential for regulatory arbitrage in favor of less regulated products, legislation and action by the SEC and other agencies would be required.
As noted above, the SEC will solicit public comments and empirical data on the reform proposals discussed in the report. Industry participants may be well-advised to take advantage of that opportunity to comment on the potential costs, benefits and risks of those proposals.
For assistance, please contact the following lawyers:
Lea Anne Copenhefer, Partner, Investment Management
leaanne.copenhefer@bingham.com, 617.951.8515
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615
This article was originally published by Bingham McCutchen LLP.