Since the U.S. Financial Stability Oversight Council (“FSOC”) issued proposed recommendations to the U.S. Securities and Exchange Commission (“SEC”) regarding additional reforms to money market fund (“money fund”) regulation on November 13, 2012 (“FSOC Recommendations”),1 there have been a number of important developments, including:
In December 2012, the SEC published for public comment a report prepared by the staff of the Division of Risk, Strategy, and Financial Innovation (“Staff Report”), which responded to questions that had been posed by Commissioners Aguilar, Paredes and Gallagher regarding the need for additional money fund reform;2
In January 2013, the Investment Company Institute (“ICI”) released a study entitled “Money Market Mutual Funds, Risk, and Financial Stability in the Wake of the 2010 Reforms” (“ICI Study”), in which the ICI concluded that money funds’ ability to manage both the Eurozone crisis and U.S. debt ceiling crisis in 2011 demonstrated the efficacy of the 2010 Amendments (as hereinafter defined);3
In January 2013, several large money fund complexes announced that they would be posting on their websites daily marked-to-market net asset values (“NAVs”), a move interpreted by some as an effort to dispel the need for further money fund reform; and
In February 2013, the comment period on the FSOC Recommendations ended and many commenters expressed their concerns regarding many aspects of the FSOC Recommendations, especially the FSOC’s proposal for requiring certain money funds to convert to a “floating NAV.”
These developments have added to the discussion in the ongoing debate over whether additional reforms of money fund regulations are necessary, but their effect on the SEC and the FSOC remains unclear. There are some indications that the SEC may take the lead to issue proposed reforms, based on public comments from SEC Commissioners who previously opposed additional money fund reform and have modified their positions.4 In addition, an SEC Commissioner recently expressed concerns over the FSOC’s structure and its involvement in the money fund reform process.5 The nomination and potential confirmation of Mary Jo White as the new SEC Chairman may also lead to action by the SEC on money fund reform. However, at present, Ms. White’s views on the advisability of further money fund reform or on particular reforms are unknown.
This DechertOnPoint provides an update regarding these developments.
In response to the financial crisis of 2008, the SEC adopted amendments to Rule 2a-7 under the Investment Company Act of 1940 (“1940 Act”) and other rules governing money funds in January 2010 (the “2010 Amendments”).6 These reforms included enhanced liquidity requirements and tighter maturity, diversity and credit quality standards for money funds’ investments. When the 2010 Amendments were adopted, the Chairman of the SEC at that time, Mary Schapiro, described them as “an important first step in our efforts to strengthen the money market regime.”
In 2012, the SEC staff prepared for the SEC a proposal that would have required money funds to either: (i) convert to a floating NAV; or (ii) maintain a stable NAV while maintaining a capital buffer and imposing certain restrictions on redemptions (the “Staff Proposals”). However, Chairman Schapiro was not able to reach a consensus with other SEC Commissioners on the Staff Proposals and announced in late August 2012 that the SEC would not be moving forward with the Staff Proposals.7 Democratic Commissioner Luis Aguilar and Republican Commissioners Daniel Gallagher and Troy Paredes subsequently issued statements detailing their reasons for not supporting the Staff Proposals.8 In their statements, Commissioners Aguilar, Gallagher and Paredes cited the lack of information on the impact of the 2010 Amendments and the economic costs and benefits of the Staff Proposals as two of the important factors in their opposition to the Staff Proposals. They then called on the SEC Staff to conduct a study to analyze these issues.
Prompted by the SEC’s failure to act on the Staff Proposals, on November 13, 2012, the FSOC exercised its authority under Section 120 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and issued the FSOC Recommendations, which included the following three alternatives: (i) a floating NAV (along with money funds pricing their shares at $100.00 as opposed to $1.00 per share); (ii) a stable NAV subject to a buffer of up to 1% of a money fund’s assets and the imposition of a holdback requirement, or minimum balance at risk, by certain redemptions for investors with account balances in excess of $100,000; and (iii) a stable NAV subject to a buffer of 3%, which amount possibly could be reduced if the money fund were to implement a combination of other measures. At the meeting at which the vote took place, several members of the FSOC stated their belief that the SEC should adopt its own set of reforms for money funds before the FSOC pursued further action.
DISCUSSION OF THE STAFF REPORT
On December 5, 2012, the SEC published for public comment the Staff Report. The Staff Report sought to respond to questions posed by Commissioners Aguilar, Paredes and Gallagher regarding the need for additional money fund reform, and, in particular, the following three categories of questions: (i) whether a money fund “breaking the buck” outside of a period of financial distress would cause a systemic risk to the financial system; (ii) whether the 2010 Amendments had been effective in addressing perceived issues involving liquidity, credit risk and interest rate risk of money funds; and (iii) how future reforms might affect the demand for investments in money fund substitutes and the implications for investors, financial institutions, corporate borrowers, municipalities and states that sell their debt to money funds.
Whether a Money Fund “Breaking the Buck” Outside of a Period of Financial Distress Would Cause a Systemic Problem
Before addressing whether a money fund breaking the buck outside a period of financial distress would cause a systemic problem, the Staff Report responded to several background questions from the Commissioners relating to the possible causes of redemptions in prime money funds during the 2008 financial crisis. The Staff Report briefly summarized the significant events of the financial crisis and then focused on the Reserve Primary Fund’s breaking the buck, noting that “several other money market funds would have broken the buck without sponsor support.” The Staff Report noted, however, that, as investors redeemed their shares of prime money funds, they generally began buying shares of government money funds, including Treasury money funds.
Recognizing the difficulty of indentifying a single explanation for this prime money fund redemption activity and movement to government money funds, the Staff Report explored five possible explanations: (i) flight to quality; (ii) flight to liquidity; (iii) flight to transparency; (iv) flight to performance; and (v) the structural design of money funds. The Staff Report did not identify any one explanation as definitive, but rather discussed issues related to the structural design of money funds and concluded that the design of money funds may have accelerated investor redemptions during the crisis, particularly by sophisticated institutional investors.
The Staff Report also addressed the following question: “If a money market fund were to break the buck outside a period of financial distress, would it cause a systemic problem, or only a problem limited to that particular fund?” The Staff Report documented 11 non-systemic events since 1989 that led to sponsors providing support to money funds or seeking no-action relief to provide such support. The Staff Report noted, however, that none of the events included a fund breaking the buck, and that there was no evidence that the funds that applied for such no-action relief necessarily would have broken the buck had their sponsors not provided support. Overall, the Staff Report concluded that each of these events affected multiple money funds and sponsors, but did not appear to cause systemic problems.
The Efficacy of the 2010 Amendments
Turning its attention to the Commissioners’ questions regarding the efficacy of the 2010 Amendments, the Staff Report first evaluated the effects of the 2010 Amendments on the liquidity, credit risk and interest rate risk of money funds. The Staff Report found that the highest weighted average maturities (“WAM”) and average WAM of money funds fell after the 2010 Amendments. The Staff Report also stated that money funds have more liquid portfolios than before the 2010 Amendments, with the typical prime money fund holding over one quarter of its portfolio in daily liquid assets and nearly one half of its portfolio in weekly liquid assets. Additionally, the Staff Report noted that some prime money funds have chosen to hold considerably more daily and weekly liquid assets than required. However, the Staff Report cautioned that liquidity is not necessarily a measure of portfolio risk.
The Staff Report then found that the probability of a money fund breaking the buck is significantly lower if the fund has a WAM of 60 days as required by the 2010 Amendments, as opposed to the previously required 90 days. In fact, the Staff Report concluded that the probability that a money fund with a WAM of 60 days would break the buck would be close to zero under various scenarios. The Staff Report stated that it was not possible to identify in isolation the independent effects of specific measures of the 2010 Amendments, such as greater transparency in portfolio holdings.
The Staff Report found that concerns over the 2011 Eurozone sovereign debt crisis and the U.S. debt ceiling debate led to significant redemptions of money funds during the summer of 2011, with some prime money funds experiencing redemptions of nearly 20 percent of their assets. The Staff Report noted that money funds with higher exposures to Eurozone banks suffered greater redemptions, but no money funds broke the buck during this period and money funds were able to reduce their exposure to Eurozone issuers without suffering significant capital losses. The Staff Report explained that money funds had sufficient liquidity to satisfy redemptions due to the enhanced liquidity requirements required as part of the 2010 Amendments. However, the Staff Report also concluded that the slower speed at which the 2011 Eurozone sovereign debt crisis and U.S. debt ceiling impasse developed likely allowed money funds to better manage anticipated redemptions. The Staff Report also observed that heavy redemptions in money funds reduced short-term funding liquidity in the U.S. commercial paper market.
The Staff Report then analyzed how money funds would have performed during the 2008 financial crisis if the 2010 Amendments had been in effect at that time. The analysis considered whether the weekly liquid assets requirements that were adopted as part of the 2010 Amendments would have helped prevent money funds from breaking the buck. The Staff Report found that the Reserve Primary Fund still would have broken the buck had the 2010 Amendments been in place.
How Future Reforms Might Affect the Demand for Investments in Money Fund Substitutes and the Implications for Investors, Financial Institutions, Corporate Borrowers, Municipalities and States that Sell their Debt to Money Fund
The Staff Report discussed money fund alternatives and considered how money fund shareholders might invest if they determined that money funds were no longer a viable investment. The Staff Report analyzed the following alternatives, among others: (i) bank deposits; (ii) offshore money funds (European money funds); (iii) enhanced cash funds (private funds); (iv) short-term investment funds (“STIFs”); (v) local government investment pools; (vi) short-duration exchange-traded funds; and (vii) direct investment in instruments typically held by money funds. The Staff Report found that each of these alternatives provides certain advantages and disadvantages when compared to money funds and none would represent a perfect substitute. Overall, the Staff Report determined that, due to varying trade-offs, the extent to which investors would choose a particular alternative would be based on individual preferences. The Staff Report noted that many unregistered alternatives, such as offshore money funds and STIFs, impose restrictions on their investors, as well as the possible imposition of gates and suspension of redemptions. The Staff Report also found that a shift from money funds to bank deposits would increase reliance on deposit insurance and increase the size of the banking sector. However, the Staff Report did not explore the systemic risks that may be associated with those consequences.
Effect of Decreased Demand for Money Funds on Commercial and Municipal Debt Issuers
The Staff Report concluded by analyzing the impact on issuers of commercial and municipal debt if substantial assets were to flow out of prime money funds and into alternatives. The Staff Report found that the effects from such movement of assets would likely be the most significant for commercial paper issuers, particularly financial company issuers. However, the Staff Report stated that the impact of the decreased demand of money funds would likely be diminished by increased demand from money fund alternatives.
With respect to municipal issuers, the Staff Report noted that such issuers have been able to increase their aggregate borrowings since the 2008 financial crisis in spite of reduced holdings of municipal securities by money funds. Thus, the Staff Report concluded, municipal issuers would not be significantly adversely affected by further money fund reforms.
In January 2013, the ICI issued the ICI Study, which supports the view that the 2010 Amendments have been effective in addressing many of the issues that occurred in 2008. The ICI Study noted, in particular, the success of the shortened liquidity requirements, greater transparency, orderly liquidation and other features of the 2010 Amendments during two recent financial challenges – the possible U.S. debt ceiling debate during the summer of 2011 and the issues relating to the Eurozone sovereign debt crisis. The ICI Study examined how money fund managers prepared for a potential U.S. government default, by shortening the average maturity of money funds invested in government securities in order to meet anticipated higher investor redemptions if the government defaulted. The ICI Study reported that prime money funds that invested in Eurozone banks responded to the Eurozone crisis of 2011 by reducing their holdings of those banks from 30% of their total assets in May 2011 to 14% in November 2011. The ICI Study concluded that the credit risk of prime money funds in 2011 remained minimal, even though the events of the Eurozone crisis led to small increases in credit risk.9 The ICI Study then examined the impact of portfolio holdings by money funds on the financial system. This analysis challenged the notion that money funds pose a systemic risk to the overall U.S. financial system, which is an argument that has been made by those advocating fundamental changes to money funds and their regulation.
Daily Posting of Marked-to-Market NAVs
Also in January, several major money fund complexes independently announced plans to post daily the marked-to-market NAVs of money funds they manage, thereby increasing the transparency of those funds to investors.10 One press release announcing the decision stated that “[g]iven that much of the discussion about systemic risk has centered on the commercial paper fund market in the US, we have decided as a first step to disclose those funds’ market value NAVs.”11
Comments on the FSOC Recommendations
Many large money fund complexes submitted comment letters expressing their concerns regarding the FSOC Recommendations.12 Most of the commenters focused on the proposal to require the conversion to a floating NAV. Some commenters also expressed the view that the SEC, rather than the FSOC, would be the proper regulator to consider money fund reform. Many commenters supported the imposition of liquidity fees upon redeeming shareholders during times of market turmoil. Other commenters proposed the imposition of redemption gates as an alternative to a floating NAV and the other proposals in the FSOC Recommendations. In addition, many commenters suggested additional changes to Rule 2a-7 to further tighten up the risk-limiting requirements of that rule.
Although the Staff Report did not provide definitive responses to the Commissioners’ questions or analyze the potential impact of proposed reforms recommended in the Staff Proposals or by the FSOC, the Staff Report may assuage some concerns expressed by those Commissioners who had opposed the Staff Proposals in August. In fact, statements from Commissioners Aguilar and Gallagher indicate that their previous positions regarding additional reforms may be changing.13
Commissioner Gallagher also recently stated that a proposal on money funds could be coming in the next few months.14 If this is the case, the SEC may consider additional reforms before the FSOC offers final recommendations that the SEC would be required to consider under Section 120 of Dodd-Frank. In a recent speech, Commissioner Gallagher also expressed concerns regarding the FSOC’s involvement in money fund reform, noting the active role taken by the SEC in examining the need for further money fund reforms and questioning the FSOC’s continued involvement in the process.15 The nomination and potential confirmation of Mary Jo White as the new SEC Chairman may also spur further action by the SEC on money fund reform, although Ms. White’s views on the advisability of further money fund reform or on particular reforms are, at present, unknown.16
If the events described above are any indication, we can expect that the debate over the future of money fund regulation will continue to be both lively and contentious going forward.