While Final Money Market Fund Reform Rules were adopted last week, two SEC Commissioners, Michael Piwowar and Kara Stein, voted in opposition. Here are excerpts from their statements, explaining why they opposed the new rules. First, we look at Piwowar's remarks. "As to the first recommendation, while I support the adoption of all the amendments to the disclosure, reporting, and stress testing requirements, I am not able to support the adoption of the so-called combination approach which would require institutional prime and tax-exempt money market funds to price and transact at a floating net asset value (NAV) calculated to the fourth decimal place (nearest basis point) and also would require liquidity fees and discretionary redemption gates." (For more on the new Reforms, see the SEC's press release here, the SEC's "Speeches" page here, the archived Webcast here, and the full 869-page Final Rule here.)
Piwowar explained, "The combination impedes one of the Commission's stated goals of this reform effort -- "preserving, as much as possible, the benefits of money market funds." Other less onerous alternatives exist that would sufficiently achieve the Commission's goals of lessening money market funds' susceptibility to heavy redemptions, improving their ability to manage and mitigate potential contagion from high levels of redemptions, and increase the transparency of their risks. Most commenters opposed the combination of a floating NAV and liquidity fees and gates because it would not offer either stability of principal or liquidity. Therefore, the continued utility of institutional prime and tax-exempt money market funds as a cash management tool is highly questionable. All of the investors with whom I spoke opposed the combination approach for the same reason. The investors were divided between those that could invest in a fund with a floating NAV calculated to the third decimal place, subject to the tax and operational issues being solved, and those that could invest in a fund subject to a liquidity fee and gate. As a result, I suggested an "investor choice" approach as a possible alternative to consider. The investor choice alternative would allow investors to choose whether to invest in a fund that floats its NAV or one that can impose a liquidity fee and gate. The key feature of this approach is that investors, after receiving complete information as to the benefits and risks of each alternative, could choose which alternative best fits their own unique investment objectives, rather than the Commission choosing which to impose on all investors."
On fees and gates, he said, "After carefully reviewing the possible alternatives for addressing susceptibility to heavy redemptions, I believe that the fees and gates approach would be the most effective at stopping runs on money market funds and would best preserve their benefits. Only the imposition of a gate would stop redemptions, thus ending any run on a money market fund and obviating the need for any future taxpayer bailouts. In addition, the imposition of a liquidity fee increases the cost of redeeming shares, which may mitigate investors' incentives to redeem and would treat remaining investors more equitably by offsetting the costs of liquidity provided to redeeming shareholders. Moreover, the ability to impose fees and gates should not preclude investors from using prime money market funds as effective cash management tools because, in the absence of severe market stress, the day-to-day operations of the funds would not be affected and investors would still have the protection of their principal and the liquidity that they seek in order to cover their expenses as needed."
He added, "I would support giving money market fund boards even more discretion in imposing gates. It is possible that, due to specified triggers for when boards may impose fees and gates, investors may seek to redeem shares as the triggers are approached. Giving the board the power to impose a gate at any time when the board finds it is in the best interests of the fund would make it much more difficult for investors to anticipate exactly when a fund might be subject to a gate, thus mitigating the risk of anticipatory runs. However, even if a run were to commence, the imposition of a gate would stop it. Moreover, in an important change from the proposed reforms, the reforms we are adopting today give the board the power, once the trigger is reached, to impose a gate immediately, rather than wait until the next business day."
On floating NAV he commented, "While fees and gates would stop runs, requiring institutional prime and tax-exempt money market funds to float their NAV would not. The imposition of a floating NAV on these funds is intended to reduce the "first mover advantage" and the chance of unfair investor dilution. The first mover advantage, as described in the adopting release, is the incremental incentive to redeem from a money market fund with a market-based NAV (also known as the "shadow NAV") below $1.00 that is at risk of breaking the buck. Thus, the floating NAV is designed to combat the risks of heavy redemptions during times of stress. However, even putting aside that a floating NAV will not stop runs and will not deter redemptions that constitute rational risk management by shareholders or reflect an incentive to avoid loss, a floating NAV would not stop the first mover advantage during times of stress. During times of stress, when cash on hand is more likely to be insufficient to meet redemptions, a fund may be forced to sell portfolio securities into illiquid secondary markets at discounted prices, and the market-based NAV may not capture the likely increasing illiquidity of a fund's portfolio. Therefore, even if the NAV floats, sophisticated investors with significant money at stake that have a lower risk tolerance, the very investors at which the floating NAV is aimed, will still have incentive to redeem ahead of other investors."
He added, "Today's recommendation requires institutional prime funds to transact at four decimal places (the nearest 1/100th of one penny) instead of rounding to the nearest penny when selling and redeeming shares. All other mutual funds are permitted to transact at three decimal places (the nearest 1/10th of one penny). The stated rationale for transacting at four decimal places is that, as intended by rule 2a-7's investment duration and quality limitations, the floating NAV rarely floats when calculated to the third decimal place and, therefore, some institutional investors may not appreciate the risk associated with money market funds. However, the reason for requiring institutional funds to float their NAVs at all is precisely because institutional investors are sophisticated and well aware of the actual market-based per share value."
Piwowar continued, "The Department of the Treasury is expected to propose today new regulations that would make a simplified aggregate method of accounting available to investors in floating NAV money market funds and would allow taxpayers to rely on the regulations for tax years ending on or after the date the proposed regulations are published in the Federal Register. Treasury believes that this would eliminate any requirement to track individually each share purchase and redemption, and the basis of each share redeemed. However, investors, funds, and outside tax experts have not yet had an opportunity to review and comment on whether this Treasury proposal will solve the tax issues. In fact, a bipartisan group of four members of the Senate Committee on Banking, Housing, and Urban Affairs have requested that the Commission refrain from adopting a floating NAV for any money market funds until the public has had an opportunity to review and comment on the proposed Treasury regulations. While their concerns should not dissuade us from moving forward with the rest of our reforms, I agree with this bipartisan group of Senators that we should wait to adopt the floating NAV until the public has had a chance to comment on Treasury's proposed tax fix."
The actions will lead to a shift in assets. "Due to fund and investor opposition to a floating NAV and the fact that we are also combining it with the fees and gates alternative for institutional prime funds, many institutional money market fund sponsors and many, if not most, institutional investors could decide to abandon prime money market funds. As of July 3, 2014, institutional prime money market funds, held more than $800 billion in assets, constituting about 33% of all money market fund assets. It is estimated that institutional investors hold an additional $76 billion in tax-exempt funds. Therefore, about $880 billion in assets will be subject to both the floating NAV and fees and gates requirements. Nobody knows how these assets will be allocated in the wake of today's reforms or the resulting impact. As of July 3, 2014, government money market funds held about $863 billion in assets (or about 35% of all money market fund assets). If one assumes that stability of principal and liquidity are the paramount concerns for institutional investors, most of these assets could be reinvested in government money market funds. This would result in government funds more than doubling in total assets, while at the same time under our reforms today government funds would be more restricted as to the securities they may invest in. To the extent that these institutional assets are invested in government funds or deposited in banks, they would no longer be available for the short-term funding of state and local governments or businesses."
Commissioner Stein also voted no, but for different reasons than Piwowar. She commented, "While the rules before us today are important, it is critical to remember why we are considering them. We are trying to strengthen a part of our markets that was at the heart of the last financial crisis. We know firsthand the significance of, and risks related to, the wholesale funding markets and money market funds in particular.... Today's rule focuses on money market funds. That focus is appropriate given the sizeable role that these funds play in the wholesale funding markets and the structural features that make them susceptible to runs. But the Commission simply cannot address all of the vulnerabilities in these vibrant and important markets through money market fund rules. It also must strengthen capital, leverage, liquidity, and margin rules for broker-dealers. And it must leverage market forces by empowering investors to better police issuers who may become over-reliant on short-term credit."
Stein added, "Making these markets more resilient to inevitable stresses requires regulators to work together. This means that we at the Commission need to step outside of our jurisdictional silo, and think broadly with our fellow regulators, both domestically and internationally. Collaboration has been promising in the reform of the tri-party repo market, where our staff has been working with staff at the Federal Reserve Bank of New York. This has resulted in the significant accomplishments of reducing intraday credit risk, and minimizing weaknesses in credit risk management. We need to build on these accomplishments to address remaining issues in the tri-party repo market, such as fire-sale risks."
On floating NAV she said, "As for today's main proposal, my primary consideration is whether the reforms will mitigate the risks -- to investors, businesses, municipalities, and our economy -- posed by our wholesale funding markets. When viewed through this lens, several parts of the rule are significant steps forward. For example, requiring institutional prime funds to have a floating net asset value directly addresses a structural feature of money market funds that makes them susceptible to redemption runs. It helps investors understand and experience that these funds are not risk free. And it nudges investors who are unable to tolerate any risk of loss towards other financial products better aligned with their risk-return preferences. I also am pleased that the rule has narrowed the definition of a government fund and tightened its diversification requirements."
On her opposition to gates, she explained, "But while the rule contains improvements, I believe it has a significant shortcoming -- redemption gates. I agree with the staff that a floating net asset value, even when combined with these other improvements and the 2010 amendments, is not a panacea. Money market funds remain vulnerable to runs because investors will still have an incentive to redeem in a crisis. However, after careful study, I am concerned that gates are the wrong tool to address this risk. As the chance that a gate will be imposed increases, investors will have a strong incentive to rush to redeem ahead of others to avoid the uncertainty of losing access to their capital. More importantly, a run in one fund could incite a system-wide run because investors in other funds likely will fear that they also will impose gates."
Stein said, "I share the concerns of many commenters and economists that while a gate may be good for one fund because it stops a run in that fund, it could be very damaging to the financial system as a whole. Even further, while a run by investors in one fund may be halted when the gate for that fund is used, that does not mean the impact on the wholesale funding markets will stop. To the contrary, a fund that drops a gate likely would need to build liquidity to meet redemption requests when the gate is lifted. This means the fund is likely to stop re-investing maturing securities during the gated period, or will invest primarily in government securities, thereby cutting off funding to issuers. This effect could be amplified by investors, who likely will redeem assets from other funds if one fund imposes a gate. And if investors are not able to redeem before the gate comes down, they will be harmed as they are deprived of access to their capital. Ultimately, this contagion could freeze the wholesale funding markets in much the same way as occurred during the recent financial crisis."
She added, "I appreciate that the rule seeks to mitigate some of these concerns by allowing the fund's board to impose gates at a higher liquid assets threshold than was proposed, by shortening the length of the gate, and by requiring daily disclosure of a fund's level of liquid assets. However, I do not believe that these changes adequately address the risk of destabilizing pre-emptive runs for the following reasons. First, adding discretion that makes it easier for a fund to impose a gate could actually increase an investor's incentive to redeem because it makes the use of a gate more likely. This could be especially problematic in a crisis, when an investor's preference to avoid uncertainty could be magnified."
Stein commented, "Second, shortening the gating period to ten business days may only marginally decrease the incentive to redeem since even a ten business day gate is significant, particularly for corporate treasurers or other investors seeking to make payroll or meet other daily demands. Third, while disclosure could help, it also could have the opposite effect by highlighting that a fund could be at or approaching a threshold that would allow it to impose a gate. I also am not sufficiently persuaded by the argument that many investors with a low tolerance for gates will seek alternative financial products that are better aligned with their risk-return preferences. While this could happen, it seems just as likely that those same investors will continue to invest in money market funds because they believe they will be able to redeem before a gate is imposed, or that sponsor support will prevent the gate from ever being used. While the rule requires disclosure of sponsor support, it unfortunately does little to address the moral hazard that is created by it."
In conclusion, she said, "In the end, these are difficult issues with uncertain answers. Ultimately, despite the rule's efforts to mitigate the risks posed by gates, I believe the incentives to avoid them will remain powerful. I fear these incentives may result in a greater chance of fire sales during times of stress, and a spread of the panic to other parts of our financial system, while also denying both investors and issuers access to capital. I am, therefore, in the unfortunate position of not being able to support the rule that the staff recommends adopting today, despite some of its well-considered and thoughtful components."
