A staff report (the Report) released by the Federal Reserve Bank of New York (FRBNY) provides the first official written outline of two possible reform options for money market funds.1 The options would require money market funds to either:
- adopt a floating net asset value (NAV); or
- both: (a) maintain a capital buffer, and (b) impose on shareholders a minimum account balance that would be used to offset losses that arise and cause the fund to break the dollar.
The Report focuses on the benefits of the second aspect of the latter of these reform options: a requirement that each shareholder maintain a minimum account balance (a minimum balance at risk or MBR) between 2 percent and 5 percent of his/her account that would be retained in the fund if the shareholder sought to redeem more than 98 percent (or 95 percent) of his/her account. The MBR would be used to absorb losses that arise within a period of up to 30 days after the redemption and cause the fund to break the dollar. The report contemplates that the second aspect of this reform option would complement the MBR: a capital buffer in the money market fund in the suggested amount of 50 basis points of share value. As an alternative to that combination of reforms, the Report suggests that money market funds instead operate with a floating net asset value. The Report also suggests that money market funds that hold only Treasury securities might be exempt from both the MBR/capital buffer arrangement and from the requirement to float the NAV. The Report states that the alternatives offered by this “flexible reform package” would “minimize reductions in demand” for money market funds as a result of reform.
These outlines are consistent with press reports that began to surface in late January 2012 of proposals reportedly circulating within the SEC. It has been unclear whether the SEC has the votes necessary to issue a reform proposal for comment, and the Report does not dispel that uncertainty. At least three of the five commissioners must vote to issue a reform proposal for public comment. Press reports in late June stated that the commissioners were considering a draft proposal and might vote to issue the proposal for comment as soon as late July.
Until the release of the Report, the outline of reform options has been limited to broad generalizations by government officials and position papers and reports prepared by various nongovernmental industry participants, such as fund sponsors and the Investment Company Institute (ICI), who summarized what they knew of regulators’ thinking.
The Report and this summary focus largely on the MBR rather than on the capital buffer or floating NAV.
Larger Agenda
The Report states that it “presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments” and that the views in the Report “are those of the authors and are not necessarily reflective of views at the” FRBNY. While the Report does not have the formal authority of action by the Federal Reserve Board or of regulation issued by the SEC, the views of the FRBNY staff are likely to carry weight with the SEC and likely reflect conversations that have already occurred within the SEC.
To understand this dynamic, it is necessary to understand that the SEC’s money market reform mission is part of a larger regulatory agenda to stem systemic risk. The Dodd-Frank Act created the Financial Stability Oversight Council (FSOC), a council of regulators comprised of the chairs of the 10 major U.S. securities, banking and other financial regulators, including the chairman of the Federal Reserve.2 FSOC is charged with comprehensive monitoring to ensure the stability of the U.S. financial system by identifying threats to the financial stability of the U.S., promoting market discipline, and responding to emerging risks to the stability of the U.S. financial system. It was at FSOC’s direction that the SEC began collecting comments on the President’s Working Group on Financial Markets’ Report on Money Market Reform Options during 2010.
As part of FSOC’s risk oversight powers, it has specific authorities that could reach money market funds. Bloomberg has reported that if the SEC does not take action on reform of money market funds, FSOC may use its authority to act on its own. (April 12, 2012.) Specifically, FSOC may designate a financial institution for supervision by the Federal Reserve Board as a “systemically important financial institution (SIFI).” FSOC issued a rule on April 3, 2012 regarding the process for designating SIFIs, which appears to indicate that money market funds are not in the crosshairs for designation as a SIFI.3 But even if a financial institution is not designated as a SIFI, FSOC wields an additional power: the Dodd-Frank Act authorizes FSOC to recommend that an institution’s primary regulator (the SEC, in the case of money market funds) impose new or heightened regulation on financial activities or practices. If the primary regulator does not impose the regulation, the primary regulator must respond in writing to FSOC why it has decided not to impose the regulation. Consequently, it is possible that the SEC will accord weight to the views of members of FSOC (and staff of related entities such as the FRBNY) even apart from the weight normally accorded to views of fellow regulators.
Not Addressed
Importantly, the Report does not address one of the major objections that the industry has raised to holdback proposals: the difficulty and cost involved in applying a holdback to omnibus accounts. The MBR would need to be applied to the underlying shareholder who makes the decision to redeem his shares to achieve the policy goal of discouraging runs and also to avoid unfairly penalizing the wrong shareholders. If omnibus accounts are treated as a single account in an MBR arrangement, underlying shareholders could be treated inequitably. For example, consider an omnibus account that has 100 underlying shareholders, each holding 1 percent of a fund. No shareholder would be affected by the MBR until 97 shareholders had redeemed in full (assuming a 3 percent MBR). After those redemptions, remaining shareholders would be disproportionately burdened by the MBR. Attributing the holdback to each underlying shareholder could require costly new systems and information sharing among the fund, intermediaries and the underlying shareholders. The ICI has suggested that intermediaries may refrain from offering money market fund shares rather than undertaking costly systems adjustments.
The Report also says little about the costs of updating transfer agency systems, which would apply to all transactions (whether or not through an omnibus account). The Report simply points out that transfer agents or fund distributors would need to develop systems to implement the MBR. The ICI has issued an extensive report on the negative operational impacts of restrictions on redemption.4
The Report does not address the comments of some that statutory or fiduciary law requirements would preclude certain institutions from investing in funds that do not return 100 percent of principal upon redemption and might be an impediment to a fund’s ability to implement a holdback.
Portions of the analysis in the Report described below depend on assumptions regarding investor behavior, which cannot be known in advance with certainty.
The Issue
The Report states that money market funds are vulnerable to runs, and because money market funds are an important source of short-term funding, this vulnerability poses systemic risk to the U.S. financial system. The Report states that the “potentially dire” consequences of a run were evidenced during the liquidity crisis of 2008, when outflows from money market funds were “a key factor in freezing of short-term funding markets and a broader curtailment of credit supply.” Some in the industry have taken issue with this analysis, which views money market funds as a cause of the financial crisis, and rather see money market funds as a victim of widespread financial dislocation. (See, for example, comment letters by Melanie L. Fein on the President’s Working Group on Financial Markets’ Report on Money Market Reform Options posted on the SEC’s website on June 28, June 26, May 11, April 18 and March 30, 2012.)
The Report states that money market funds’ vulnerability to runs stems, in large part, from their stable $1.00 share value. Money market funds value their shares by using the amortized cost method to value their assets and rounding to the nearest penny on a $1.00 share. Under the amortized cost method, assets are valued based on acquisition cost, with no adjustment for factors that might be expected to affect share value, such as changes in creditworthiness of the issuer, changes in prevailing interest rates and reductions in liquidity in the market for the asset. The money market fund must calculate periodically the “shadow price” or market value per share. If shares have a market value of less than $0.995, the shares will no longer be valued based on amortized cost value but will “break the dollar” and be valued based on market values.
Critics of amortized cost valuation assert that the amortized cost value hides the true share value. Under this view, savvy shareholders (generally institutional investors, the Report states) have an opportunity to redeem shares for $1.00 when the shares are worth slightly less than $1.00, further diluting remaining shares. Accordingly, early redeemers have an advantage if shares are headed toward breaking the dollar. Proponents of the floating NAV argue that it will reduce the tendency of money market funds to experience large redemptions during periods of financial distress.5
The FRBNY staff believes that the MBR could mitigate systemic risks of money market funds by protecting shareholders, such as retail investors, who do not redeem quickly from distressed money market funds. The MBR limits the ability of redeeming investors to benefit by imposing risks, costs and losses on nonredeeming shareholders and instead ensures that risks, costs and losses are spread among redeeming shareholders.
Click here for further detail on the MBR, a summary of new ideas that appear in the Report and the Report’s response to arguments against holdback arrangements.
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The Report is unlikely to be the last word on money market fund reform. We look forward to keeping you informed as the landscape evolves.
1 “The Minimum Balance at Risk: A Proposal to Mitigate Systemic Risks Posed by Money Market Funds,” posted on the New York Federal Reserve Bank website on July 19, 2012. The report is authored by FRBNY personnel Patrick E. McCabe, Marco Cipriani, Michael Holscher and Antoine Martin.
2 There are 10 voting members of the FSOC: the secretary of the U.S. Treasury Department (who serves as chair of FSOC), chair of the Federal Reserve Board of Governors, Comptroller of the Currency, director of the Bureau of Consumer Financial Protection, chair of the SEC, chair of the FDIC, chair of the Commodity Futures Trading Commission, director of the Federal Housing Finance Agency, chair of the National Credit Union Administration Board and a presidential appointee.
3 Threshold criteria for designation as a SIFI include such factors as a threshold of at least $3.5 billion in derivatives liabilities; service as a reference entity for at least $30 billion in credit default swaps; threshold of at least $20 billion of outstanding debt; threshold leverage ratio of assets to total equity of at least 15 to 1; and threshold ratio of debt maturing in less than 12 months to assets of at least 10 percent. See FSOC’s Notice of Proposed Rulemaking dated Oct. 11, 2011.
4 “Operational Impacts of Proposed Redemption Restrictions on Money Market Funds,” report filed by the ICI with the SEC on June 20, 2012.
5 The Report notes two additional negative consequences of rapid redemptions. First, money market funds meet redemptions by disposing of their highly liquid assets rather than selling a cross section of holdings, which typically may include less liquid assets. Accordingly, nonredeeming shareholders are left with a claim on a less liquid portfolio. Second, redemptions that force one money market fund to sell less liquid assets at a loss may exert downward pressure on asset prices, placing other money market funds at risk of loss and prompting shareholders in those other funds to redeem shares pre-emptively.
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