Tuesday, June 4, 2013

SEC to Vote on New Money Market Fund Rules

By Tim Dulaney, PhD and Tim Husson, PhD

Tomorrow, the Securities and Exchange Commission will vote on new rules pertaining to the $2.6 trillion money market fund (MMF) industry.  The SEC hopes that the new rules will safegaurd against future runs on MMFs, such as those that occurred during the financial crisis after the collapse of Lehman Brothers.  A "run on" MMFs occurs when many investors (or a few very large investors) attempt to redeem their shares in near unison, resulting in significant liquidations of MMF holdings.

A money market fund is an open-end mutual fund that is subject to the restrictions imposed by Rule 2a-7 of the Investment Company Act of 1940.  The holdings are generally restricted to "government securities, certificates of deposit, commercial paper of companies, or other highly liquid and low-risk securities." The holdings must be sufficiently diversified (less than 5% from a single issuer) and must have a weighted-average maturity of 60 days or less.  MMFs, which are often compared to bank accounts, tend to have relatively low yields but little risk of loss.

Currently, MMFs attempt to keep a stable net asset value (NAV) of one dollar.  When a MMF's investments are performing well, the fund will pay a higher dividend and have a higher yield.  If the portfolio experiences shortfalls, the fund sponsors will often eat the losses so that the fund will not lose face in the eyes of their investors.  If the NAV of a MMF does fall below $1, the fund has "broken the buck".  This has only occurred twice since Rule 2a-7 was introduced to the Investment Company Act of 1940, but an estimated 21 MMFs would have during the financial crisis without government assistance.

The SEC has been looking to reform the MMF industry to reduce structural instabilities and to reduce the need for government support.  According to Reuters, new rules to decrease the likelihood of runs could take the form of "capital buffers and redemption holdbacks, or alternatively, a switch from a stable $1 per share net asset value to a floating NAV" and are expected to target "prime funds used by institutional investors, who are considered most likely to incite runs on money funds."  The idea is that since institutional investors tend to have the largest holdings of MMFs, they are most likely to cause a run if they were to withdraw those assets all at once.

Which is precisely what happened in the financial crisis.  The Reserve Primary Fund was a MMF with over $64.8 billion in assets in 2008, but held $785 million in Lehman commercial paper.  When Lehman filed for bankrupcy, the fund valued these holdings at zero, and therefore the NAV of the fund was reduced from $1 to 97 cents--'breaking the buck' for only the second time in US history.  Investors tried desperately to redeem at $1, causing a run.

A November 2012 Treasury Department report (PDF) gives some hints as to what form these rules might take.  The most promising alternative seems to be the destabilization of MMF NAVs.  In the approach, investors would bear the risk of a decrease in NAVs, but there would be less sensitivity of so-called cliff effects: when the stable NAV becomes destabilized by a breaking of the buck.  This approach would lead to a change in the way MMFs value their holdings (becoming more consistent with other mutual funds) and potentially to changes in tax and accounting rules.  For more information concerning this alternative, see the Treasury's discussion of "Alternative One" in the report.

As Walt Bettinger of Schwab points out, the stable NAV of MMFs prevents investors from creating tax events when shares are sold.  If the NAV was no longer stable, retail investors buying shares for a price that does not correspond to their sale price would be exposed to capital gains taxes.  The MMF industry is concerned that the loss of this attractive feature will encourage investors to leave MMFs and park their cash in other securities.  Furthermore, there seems to be no straight-forward approach to implementing stable NAVs for retail investors while simultaneously allowing a floating NAV for institutional investors.

We'll have a post once the SEC has reached a consensus over the new MMF rules that will include commentary on their implications for retail investors.

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