WASHINGTON - The SEC's move to finalize a controversial package of reforms overhauling money market funds hands providers a new set of compliance challenges that some in the sector warn will create a considerable operational burden and make the funds a less attractive investment vehicle.
When the rules take effect in two years, institutional prime money market funds, including institutional municipal money market funds, will have to allow their net asset value to float in measure with the value of the underlying portfolio, untethering the daily share price from the $1 benchmark.
Additionally, the boards of both institutional prime and retail funds will have the ability to levy fees on investors who sell off shares in times when the fund is under stress, and then to impose a "gate" that would temporarily cut off redemptions to avoid a run.
The SEC is limiting the floating NAV mandate to those funds serving institutional investors such as pension funds, corporations and foundations, and is exempting government funds and those that chiefly serve retail investors.
With the retail carve-out, many of the funds catering primarily to individual investors from the likes of Vanguard, Fidelity and Schwab will likely be exempt from the floating NAV requirement. But that's small solace for players in the institutional market.
Federated Investors, an outspoken critic of the SEC's reform effort, said in a statement that it is "disappointed" with the vote to approve the money market proposal, reiterating its view that there is no "evidence that instituting a floating NAV would do anything to eliminate runs" during a time of stress.
"In addition, a floating NAV imposes significant and costly daily operational burdens on money-market fund users, limiting the utility of such funds as a cash management tool, which runs counter to the SEC's other stated goal of preserving the benefits of money-market funds for investors and issuers," Federated said.
The SEC and other regulators acknowledged the tax-accounting burden that could arise from a floating NAV, when shares are bought and sold at variable prices. In response, the same day that the commission approved its rules, the Treasury Department and the IRS announced a proposal for a simplified accounting method that would allow for the reporting of gains and losses from floating NAV shares on an aggregate, annualized basis. Even with that tax relief, the SEC concedes that the new rules will create new operating expenses for funds. Norm Champ, director of the SEC's Division of Investment Management, says that the two-year implementation window the commission is offering for compliance with the rules aims "to provide both funds and investors appropriate time to fully adjust their systems, operations and investment practices." At the same time, he acknowledges that "today's reforms would come with costs, and we do not take those costs lightly."
Nevertheless, SEC Chairwoman Mary Jo White argues that the reforms are necessary to guard against runs and make pricing more transparent. White hailed approval of the floating NAV and fees and gates rules as a "strong reform package" that will stabilize a sector that was brought to its knees in the financial crisis of 2008. "Today's reforms will fundamentally change the way that most money market funds operate," White said at Wednesday's meeting, when the commission approved the new rules by a 3-2 vote. "They will reduce the risk of runs in money market funds, and provide important new tools that will help further protect investors and the financial system in a crisis."
TARGETING PRIME FUNDS
The floating NAV rule is designed as a safeguard against the so-called first mover advantage, the fear that savvy investors who spot signs of trouble could dump their shares while the fund's share price is still at $1, even as the value of the underlying portfolio slumps below that mark. When the Reserve Primary Fund broke the buck in September 2008, announcing that it would no longer redeem shares on the dollar-for-dollar basis, it triggered a sell-off that saw investors pull some $300 billion out of institutional prime funds, or about 14% of the total assets in that sector. Credit markets seized up, freezing access to short-term financing, and the Treasury Department ultimately intervened with a temporary guarantee program to restore confidence in prime funds.
Champ explains that the SEC singled out prime funds because they have shown "the greatest proclivity for heightened redemptions and have the most potential for credit impairment."
"The floating NAV would not apply to retail money market funds, in particular, because those funds have not experienced heightened redemptions, even in times of market stress," Champ says. "The floating NAV also would not apply to government money market funds, primarily because the nature of those funds' investments does not expose them to the level of credit risk seen in prime money market funds." Some advocates had been pressing for the commission to apply the floating NAV rule to all classes of money market funds. White says that the agency opted for a more limited approach in to achieve the goal of stabilizing the market without undermining an important vehicle for retail investors who "have come to rely on the liquidity and stability of money market funds."
"All money market funds are not alike," she says.
DISCLOSURES, FEES AND GATES
The SEC is also rolling out a new set of requirements for disclosures, diversification and stress testing. Under those rules, for instance, funds on a daily basis will have to post information on their websites about liquid asset levels, net inflows and outflows, and per-share market NAVs. The stress-testing provision will require funds to gauge their ability to maintain a 10% weekly asset liquidity rate, and to game out how they would mitigate principal volatility in a set of hypothetical scenarios. In addition to the floating NAV requirement, the SEC is authorizing the boards of institutional prime and retail funds to impose liquidity fees and redemption gates at times of stress to prevent runs and avoid the spillover that occurred in 2008. Under those provisions, if a fund's weekly liquid assets dipped below 30% of its total assets, the board would have the ability to impose a fee of up to 2% on all redemptions. Boards would be required to impose a liquidity fee of 1% in the event that weekly liquid assets fell below 10%.
DISSENT IN THE SEC
Two of the five commissioners voted against the money market fund rules. Democrat Kara Stein warned that the gates provision could backfire, and in times of stress compel certain investors to cash in their shares ahead of the gate dropping, leaving others with their assets frozen. Michael Piwowar, a Republican, took issue with the decision to pair the floating NAV with the fees and gates proposal. While he favors fees and gates, Piwowar warns that the floating NAV would fail to guard against a run and could actually prompt sophisticated investors to redeem shares early when they observe signs of declining liquidity in a fund, exactly the first mover advantage the rule seeks to prevent.