The Securities and Exchange Commission on May 10 plans to hold a roundtable discussion on how to guard against systemic risk involving money market funds, the investment industry's $2.8 trillion alternative to checking accounts.
The discussion comes less than three years after the failure of the nation's oldest money market fund, the Reserve Primary Fund, which suffered a run on its assets in September 2008 because those assets were concentrated in Lehman Brothers holdings. The fund's net assets "broke the buck," meaning their value fell to 97 cents a share, instead of $1, the bedrock promise of shares in these funds.
The roundtable will include participants from the Financial Stability Oversight Council, the body set up by the Dodd-Frank Wall Street Reform Act to mitigate "systemic" risk in the finances of the U.S. economy.
To prevent a recurrence of the Reserve collapse, where the U.S. government actually stepped in and provided reserve funds to Reserve shareholders, the Investment Company Institute in January proposed the creation of an industry-funded Liquidity Facility, for a future emergency.
But exchange-traded fund giant BlackRock and mutual fund paragon Fidelity Investments want funds to stand on their own. BlackRock wants "special purpose entities" created (and regulated) that can only operate money market mutual funds. And Fidelity recommends that every fund be required to retain a portion of its income to build a reserve against potential losses.
Here's how the three approaches stack up, in each case. The descriptions are in the organizations' own words, as submitted to the SEC in comment letters.
ICI: Private Emergency
A private emergency liquidity facility for prime money market funds has the most promise, with the least negative impact.
The proposed facility is an industry-sponsored solution intended to enhance liquidity for prime money market funds during times of unusual market stress. Our proposal contemplates that all prime money market funds would be required to participate.
The facility would be formed as a state-chartered bank or trust company, and would be capitalized through a combination of initial contributions from prime fund sponsors and ongoing commitment fees from member funds. Additional capacity would be gained from the issuance of time deposits to third parties.
Prime money market funds that did not participate would be required to switch to a floating net asset value or to a Treasury or government fund.
During times of unusual market stress, the facility would buy high-quality, short-term securities from prime money market funds at amortized cost. This function has two main benefits. First, the facility would enable participating funds to meet redemptions while maintaining a stable $1.00 NAV, by ensuring them a purchaser for high quality, short-term paper, essentially serving as a dedicated market maker when markets are frozen.
Second, in doing so, the facility would help protect the broader money market by allowing funds to avoid selling into a challenging market, mitigating a downward spiral in the market prices of money market instruments.
The facility would be a state-chartered bank or trust company, compliant with applicable banking laws. It would be a member of the Federal Reserve, eligible to access the discount window in the ordinary course, and would issue time deposits that are eligible for Federal Deposit Insurance Corporation insurance, although the facility would not seek to insure those deposits.
The facility would have two direct sources of capital. Initial capital would come from sponsors of prime money market funds, based on their assets under management, with an aggregated target initial equity of $350 million. The minimum contribution for the smallest funds or new market entrants would be $250,000 and the maximum contribution would be capped at 4.9% of the total initial equity.
The facility also would require ongoing commitment fees of its member funds, which would accrue for the benefit of current and future money market fund shareholders, not liquidity facility equity holders.
Special Purpose Entities
Our proposal would require the sponsor or investment manager, not the money market fund itself, to be regulated as a special purpose entity (SPE) and to hold capital.
We believe that this SPE structure, combined with access to liquidity through the Fed window, would address both idiosyncratic (i.e., limited to one or a few funds) and systemic risk while permitting the current Rule 2a-7 money market fund structure to continue with its advantages for investors and the financial markets.
Money market funds are currently pass-through vehicles in which interest earned, less fees and expenses, is passed through to investors. Under current rules, the manager of a fund cannot accrue a liability or record "capital/reserves" in retained earnings to cover future potential losses. Our proposal entails a new structural approach in which money market funds would be managed by a SPE with a charter limited to managing money market mutual funds.
This SPE would be a regulated subsidiary of the investment manager. This entity would be required to have capital, the level of which would be determined based on the total assets under management and the composition of those assets.
This entity would have access to the Federal Reserve discount window as a source of emergency liquidity. In order to make this solution workable for the Federal Reserve, guidelines could determine a minimum size of such an SPE and permit consortia of SPEs to attain this minimum size. The funds' existing structures as well as their existing share-class structures would be unchanged.
Under this structure, firms will have a strong incentive to manage their funds prudently as they will have direct financial "skin in the game" in addition to the substantial reputational risk that they already bear.
The risk of systemic failure would be addressed by providing access to the discount window. In return for this access, in addition to regulation under the Investment Advisers Act of 1940 and the Investment Company Act of 1940 to which managers of MMFs already are subject, the special purpose entity would be subject to regulatory oversight by the Federal Reserve Board and might be assessed an annual fee from the FRB.
In the event of market deterioration or a credit event, the SPE would have capital to support the share value of the funds managed by the SPE.
The rules establishing this structure would need to be structured in such a way to ensure that the funds sponsored by the SPE would not be consolidated on the books of the asset manager.
The required capital should be significantly lower than that required for a commercial bank, to reflect the special nature of these entities and the specific funds being offered. Unlike a traditional bank, money market funds are limited to very high quality, very short maturity securities or other instruments pursuant to SEC Rule 2a-7. There would be no large maturity mis-match between "deposits and lending," nor would the credit exposure be comparable to a traditional bank.
This reserve would be funded by a holdback of a portion of a fund's income. The holdback would be disclosed in the money market fund's prospectus, as either a shareholder "charge" or "fee.'' Each fund's reserve would be used to protect shareholders of the fund in the event of an unrealized or realized loss in that fund.
This idea addresses all five features of money market funds that the President's Working Group report argues create an "incentive to redeem shares before other shareholders."
First, it addresses the feature of "maturity transformation with limited liquidity resources" because a fund would have a reserve to absorb losses if a fund had to sell assets in the secondary market at a loss.
Thus, the "incentive to redeem shares before a fund has depleted its cash-like instruments" would be substantially mitigated [emphasis in original].
Second, the focus on the $1.00 stable NAV would be less of a concern for shareholders because money market fund market value NAVs would be above $1.00 on a regular basis. Accordingly, there would be no incentive to redeem early out of fear of not receiving $1.00 in return.
Third, the loss reserve would help ensure that funds are able to handle credit and interest rate risks that may result in unrealized losses.
Fourth, we recommend that the required loss reserve be mandatory, regulated and transparent. Moreover it would be subject to board oversight.
Finally, this idea would fit well with money market fund investors' low risk tolerance and expectations.
Investors would understand the cost of the stable net asset value in the form of a slightly lower net yield. Funds would be safer because shareholders would pay to protect a fund against losses.