Jill E. Fisch is the Perry Golkin Professor of Law and Co-Director of the Institute for Law and Economics at the University of Pennsylvania Law School.
By a split 3-2 vote, the U.S. Securities and Exchange Commission recently adopted a final rule designed to reduce the risk of a run on money market funds and to limit potential contagion if a run does occur. In the words of Commission Chair Mary Jo White, the new rule “will fundamentally change the way that most money market funds operate.”
Under pressure from the Department of Treasury and the Financial Stability Oversight Council, the Commission has been debating regulatory reform for money market funds (MMFs) since the Reserve Primary Fund broke the buck in 2008. The final rule adopts a compromise between two previously suggested reform alternatives: it implements fees and gates to allow non-governmental MMFs to stem redemptions during periods of reduced liquidity and requires a floating net asset value (NAV) for prime institutional funds (including municipal funds) – the funds deemed most vulnerable to “runs.” Although the compromise may have been politically feasible, it likely destroys a valuable financial product – prime MMFs – while potentially increasing the run risk for other MMFs.
Although the final rule is similar to earlier Commission proposals, there are important differences. First, the rule broadly exempts retail MMFs from the requirement of a floating NAV. This exemption dramatically reduced opposition to the reform by dividing the powerful mutual fund industry. The retail exemption is a major gain for the large mutual fund sponsors that serve primarily individual clients, such as Schwab, Vanguard and Fidelity. At the same time, sponsors of institutional MMFs such as Federated, the third largest MMF sponsor, are clear losers.
Second, the rule dictates limited circumstances in which funds can impose fees and gates and makes the imposition of those restrictions purely discretionary with the individual fund board. As critics widely observed in response to the Commission’s earlier proposal, fees and gates can exacerbate redemption pressure in a time of crisis by creating a high-powered incentive for investors to redeem preemptively before the fees and gates are triggered. The discretionary feature of the final rule creates uncertainty about the manner in which a particular fund board will exercise its discretion, a feature that the Commission touts as a benefit but which may instead increase run pressure. Nonetheless, so long as fees and gates are discretionary, it is questionable whether sponsors will ever use them. A large mutual fund sponsor would likely be irreparably damaged if it prevented investors from accessing their funds on even a temporary basis.
Third, the rule exempts government MMFs, defined under the new rule as funds that invest at least 95.5% of their assets in cash or U.S. government securities, from both the requirement of a floating NAV and the fees and gates provision. The advantage of this exemption is that it retains a viable option for institutional investors that invest in MMFs for cash management. Although the Commission announced the adoption of tax and accounting accommodations to simplify compliance and recordkeeping obligations for floating NAV funds, many if not most institutional investors will be unable to use a cash management tool that offers the regular potential for a negative return. The disadvantage is that the exemption retains government MMFs as a potential source of financial fragility. As the Commission notes in the adopting release, government MMFs experienced substantial outflows in connection with the 2013 debt ceiling impasse. With increased institutional money invested in government MMFs, future events that affect the yield or perceived quality of government securities would have greater effects.
A more detailed examination of the new reforms highlights fundamental misconceptions in the Commission’s understanding of the MMF industry. For example, the Commission attempted to finesse the debate over a floating NAV by mandating that all MMFs calculate and disclose a market-based NAV on a daily basis. For stable value MMFs, this is a requirement to calculate and disclose a shadow NAV. Importantly, the rule requires the calculation to be made to four decimal places or to the nearest ten thousandth of a cent. Faced with empirical data showing that the prices of MMFs have historically been highly stable, the required precision – a higher degree of precision than for any other type of mutual fund – is designed to create a type of synthetic volatility, suggesting to investors that MMFs are less stable than they really are.
The precision is also misleading. Calculating a market-based NAV is difficult for MMFs in that many of the assets that they hold are not actively traded and do not have readily-available market quotations. Indeed, both the stability of MMFs’ NAVs and the nature of the assets they hold were factors that led to the Commission’s original decision to authorize a stable $1 share price. The new rule explicitly requires MMFs, even those that are able to continue to use amortized cost valuation, to calculate and publish their assets’ fair value on a daily basis. These fair value determinations were accurately described by one commentator as “noisy guesstimates of true value.” They also pose a substantial compliance challenge for MMF directors who must oversee these determinations, particularly in light of the Commission’s enforcement action against the directors of the Morgan Keegan bond funds. The Commission’s response to the problem is to provide “expanded valuation guidance,” which includes extensive references to the use of third-party pricing services. The Commission’s willingness to authorize reliance on intermediaries is reminiscent of prior endorsements of the services of credit rating agencies and proxy advisors and, in light of the controversies over those intermediaries, surprising.
The Commission also takes a troubling approach to the subject of sponsor support. A key component of MMF stability has been the willingness of MMF sponsors, on a discretionary basis, to provide financial support for the $1 share price in times of financial turmoil. Although sponsor support is not a legal obligation, sponsors have an incentive to provide support because of the adverse consequences of breaking the buck on their reputations and businesses. Sponsor support can take a variety of forms, including injections of cash, purchasing distressed or illiquid assets, or waiving management fees. Despite extensive evidence of the importance of sponsor support, the Commission views it as a source of fragility and has implemented disclosure requirements designed to reduce investor reliance on sponsor support and sponsor willingness to provide such support.
What should the Commission have done? As I demonstrate in a current working paper, rather than discouraging sponsor support, the Commission should have embraced it and affirmatively required sponsors to commit in advance to supporting the $1 NAV as a condition of offering a stable value MMF. The unique structure of MMFs, in which the assets of the sponsor are legally separated from the assets of the fund, enables sponsor support to serve as a valuable resource for a distressed MMF. At the same time, mandated sponsor support would create appropriate incentives for MMF sponsors to internalize the costs of MMF fragility and to limit such fragility through their management decisions, such as by controlling fund size and portfolio risk. Importantly, mandated sponsor support, unlike the Commission’s reforms, reduces both the likelihood of a run and the potential contagion effect from such a run.
Two critical questions remain. First, how will market participants respond? As the Commission itself notes, it is not possible to predict the degree to which investors will move their funds out of MMFs; indeed, the new rule has a two-year implementation period designed to reduce the likelihood that its adoption alone will precipitate a run. Second, if challenged, will the rule withstand review by the D.C. Circuit Court of Appeals? At the end of the day, the additional costs imposed by the rule on investors, fund sponsors, and the short term credit markets can only be justified by showing that it reduces the risk of runs and increases MMF stability. It is unclear that the Commission can make that showing.