ICI economists Sean Collins and Chris Plantier issued a rebuttal to NY Federal Reserve economists -- (see our August 19 "Link of the Day", "NY Fed Blog on Gates, Fees, and Runs") – in which they argue that the SEC's adoption of gates and fees on MMFs could increase run risk. In their August 20 column, "Preemptive Runs and Money Market Gates and Fees: Theory Meets Practice," Collins and Plantier disagree. They write, "A recent post on the blog of the Federal Reserve Bank of New York discusses the possibility that new rules by the Securities and Exchange Commission allowing money market funds to temporarily impose fees or gates during times of market instability could increase the risk of preemptive runs on such funds during times of stress, rather than helping to limit destabilizing withdrawals, as the SEC intended. Although the Fed's blog post provides an interesting theoretical insight, the discussion brings to mind the quote by Yogi Berra that "In theory, there is no difference between theory and practice. But in practice, there is." In "Gates, Fees, and Preemptive Runs," the authors -- Fed economists Marco Cipriani, Antoine Martin, Patrick McCabe, and Bruno Parigi -- note that the academic literature on banks has traditionally seen "suspension of convertibility" (preventing the exchange of deposits at par for cash) as a means of preventing damaging bank runs. For example, by requiring a bank that cannot meet all depositors' withdrawals to temporarily close its doors, regulators might prevent further and potentially destabilizing withdrawals."
Collins and Plantier continue, "The authors then compare this to the new SEC rule, which -- among other things -- allows a money market fund to impose a liquidity fee of up to 2 percent and to "gate" (temporarily suspend) redemptions for up to 10 business days during a 90-day period if the fund's weekly liquid assets fall below 30 percent <b:>`_ of its total assets, and if the fund's board of directors determines that imposing a fee and/or gate is in the fund's best interests <b:>`_. In addition, a money market fund will be required to impose a liquidity fee of 1 percent on all redemptions if its weekly liquid assets fall below 10 percent of its total assets, unless the fund's board determines that this would not be in the best interests of the fund. Cipriani et al. suggest that this could in theory lead to "preemptive runs" on money market funds because "investors who face potential restrictions on their future access to cash may run when they anticipate such restrictions may be imposed."
Specifically, quoting the NY Fed piece, it says, "A bank, MMF, or other FI with the option to suspend convertibility may become more fragile and vulnerable to runs. In other words, we show that instead of offering a solution, policies relying on gates and fees can be part of the problem.... Giving an FI [financial intermediary] the option to impose gates or fees may be destabilizing because the option itself can trigger damaging runs that otherwise would not have occurred. This result is likely to hold for a variety of adjustments to the assumptions in our model, because the intuition is stark: The possibility of a fee or any other measure that is costly enough to counter investors' strong incentives to run amid a crisis will give investors a strong incentive to run preemptively to avoid such measures. Even though our model does not address how runs on FIs can create large negative externalities for the financial system and the real economy, one important policy implication is clear: Giving FIs, such as MMFs, the option to restrict redemptions when liquidity falls short may threaten financial stability by setting up the possibility of preemptive runs."
To which the ICI economists reply, "Theory and practice differ, however. In practice, fees and gates are just one aspect of the nuanced package of money market fund reforms that the SEC adopted in July 2014 after long study. Most notably, the reforms require institutional money market funds -- the kinds of funds that were most at risk of redemptions during September 2008 -- to move away from a fixed $1.00 net asset value (NAV) and adopt a floating NAV. All 12 Federal Reserve Bank presidents -- including William Dudley, the president of the Federal Reserve Bank of New York -- are on the record stating that money market funds are susceptible to runs because they seek to maintain fixed NAVs. If correct, the SEC's new rule addresses this issue by requiring institutional money market funds to float their NAVs. Thus, by the Fed's logic, it is unlikely that a money market fund with a floating NAV would need to adopt fees and/or gates. Alternatively, putting this in the language of the Fed's blog post, requiring a money market fund to float its NAV means that a fund has already permanently suspended "convertibility at par" -- rendering "suspension of convertibility" through a fee or gate redundant."
Collins and Plantier add, "In addition, as the SEC pointed out in its rule proposal, gates and fees have in practice "been used successfully in the past by certain non–money market fund cash management pools to stem redemptions during times of stress." Some hedge funds and European-domiciled mutual funds operating under the Undertakings for Collective Investment in Transferable Securities (UCITS) directives have provisions allowing them to impose gates. These provisions, which are disclosed to investors, have not caused runs. Moreover, since February 2010 -- when the SEC adopted its first postcrisis reform of money market funds -- these funds have had the ability (again, disclosed to investors) to halt shareholder redemptions, albeit with the restriction that a money market fund would then liquidate (i.e., go out of business). This provision has not fostered "preemptive runs" on money market funds."
They conclude, "And, in a final way that practice would differ from theory, money market funds would almost certainly take strong measures to avoid ever having to impose fees or a redemption gate. Investors value money market funds as a cash management tool, and fund managers would work very hard -- just as they have always done -- to avoid reducing that value."
Here's what the SEC said about the ramifications in its final Money Fund Reform rules. "We acknowledge the possibility that, in market stress scenarios, shareholders might pre-emptively redeem shares if they fear the imminent imposition of fees or gates (either because of the fund's situation or because other money market funds have imposed redemption restrictions). A number of commenters suggested investors would do so. Some commenters also suggested that sophisticated investors in particular might be able to predict that fees and gates may be imposed and may redeem shares before this occurs. While we recognize that there is risk of pre-emptive redemptions, the benefits of having effective tools in place to address runs and contagion risk leads us to adopt the proposed fees and gates reforms, with some modifications. We believe several of the changes we are making in our final reforms will mitigate this risk and dampen the effects on other money market funds and the broader markets if pre-emptive redemptions do occur."
The final rules state, "As discussed below, the shorter maximum time period for the imposition of gates and the smaller size of the default liquidity fee that we are adopting in these final amendments, as compared to what we proposed, are expected to lessen further the risk of pre-emptive runs. We understand that the potential for a longer gate or higher liquidity fee before a restriction is in place may increase the incentive for investors to redeem at the first sign of any potential stress at a fund or in the markets. We believe that by limiting the maximum time period that gates may be imposed to 10 business days in any 90-day period (down from the proposed 30 days), investor concerns regarding an extended loss of access to cash from their investment should be mitigated. Indeed, some money market funds today retain the right to delay payment on redemption requests for up to seven days, as all registered investment companies are permitted to do under the Investment Company Act, and we are not aware that this possibility has led to any pre-emptive runs historically."
It adds, "In addition, we note that under section 22(e), the Commission also has the authority to, by order, suspend the right of redemption or allow the postponement of payment of redemption requests for more than seven days. The Commission used this authority, for example, with respect to the Reserve Primary Fund. To our knowledge, this authority also has not historically led to pre-emptive redemptions. We believe that the gating allowed by today's amendments extends and formalizes this existing gating framework, clarifying for investors when a money market fund potentially may use a gate as a tool to manage heavy redemptions and thus prevents any investor confusion on when gating may apply."
