The Financial Stability Oversight Council on Tuesday released Proposed Recommendations Regarding Money Market Mutual Fund Reform (Nov. 2012). The proposed recommendations were issued under Section 120 of the Dodd-Frank Act, which authorizes FSOC to determine that a financial activity or practice could create or increase the risk of significant liquidity, credit, or other problems and to issue recommendations for more stringent regulation to the primary financial regulatory agency; the primary regulatory agency in this case would be the Securities and Exchange Commission. FSOC proposes to determine that money market funds' activities and practices could create or increase these risks and to recommend three alternative reforms to money market funds. These reforms could be adopted in the alternative, in which case a money market fund could choose which reform applied to it. FSOC also requests comments on other possible reforms, including liquidity fees and gates.
FSOC is fairly candid in acknowledging the destructive impact these recommendations would have on the money market fund industry. It believes that the activities and practices of money market funds that have made them appealing to investors also contribute to their vulnerability to runs, and that reforms that would provide meaningful mitigation of the risks posed by money market funds would likely reduce their appeal to investors by altering one or more of their attractive features.
Floating Net Asset Value
This reform would require money market funds to value their portfolios as other mutual funds do, without using amortized cost or penny rounding. Each money market fund would re-price its shares to $100.00 per share, in order to be more sensitive to fluctuations in the fund's net asset value per share. In addition, this reform would involve the rescission of Rule 22e-3, which allows a money market fund to suspend redemptions and begin an orderly liquidation if the fund has broken or is about to break the buck, and Rule 17a-9, which allows affiliates of a money market fund to purchase portfolio securities from the fund in order to support the fund's stable price per share. The recommendations do not address whether the SEC would be able to issue no-action letters allowing sponsor support of money market funds, although FSOC seems to think that all forms of sponsor support would be unnecessary. Existing money market funds could be grandfathered and allowed to maintain a stable NAV for a phase-out period, potentially lasting five years.
The recommendations acknowledge that floating-NAV money market funds still would be vulnerable to runs, particularly if they continue to be used as a cash management product. They also acknowledge that moving to a floating NAV may cause the money market fund industry's assets under management to contract, which would diminish the funds' capacity to invest in the short-term securities of financial institutions, businesses, and governments, and that if the transition to the floating NAV prompted investors to redeem suddenly and substantially, the transition itself could create financial instability.
NAV Buffer and Minimum Balance at Risk
A second reform alternative would require that money market funds (other than Treasury funds, which would be exempt) (i) maintain an NAV buffer, which would be a tailored amount of assets in excess of those needed for a fund to maintain its $1.00 share price and which would absorb day-to-day fluctuations in the value of the fund's portfolio securities, and (ii) apply a minimum balance at risk requirement to shareholders. The NAV buffer would be calculated as follows: no buffer requirement for cash, Treasury securities, and Treasury repos; a 0.75% buffer requirement for other daily liquid assets (or for weekly liquid assets, in the case of tax-exempt funds); and a 1.00% buffer requirement for all other assets. To fund the buffer, a money market fund sponsor could contribute assets to an escrow account pledged to support the fund's NAV; a fund could issue a class of subordinated, nonredeemable equity securities that would absorb first losses in the fund's portfolio and that could be sold to third parties or purchased by a fund's sponsor or affiliates; or a fund could retain some earnings it otherwise would distribute to shareholders. FSOC notes that the second and third options would require the SEC to amend Rule 2a-7 to allow funds to maintain a $1.00 NAV even when the value of the fund's assets is above $1.00. Half the buffer would be required to be in place one year after the effective date of any rule, and the full required buffer in two years after the effective date.
The NAV buffer would be coupled with a requirement that 3% of any shareholder's highest account value in excess of $100,000 during the previous 30 days (the shareholder's minimum balance at risk, or MBR) be available for redemption only with a 30-day delay. The MBR requirement would apply to each record holder, including financial intermediaries, unless the intermediaries provide the fund sufficient information to apply the requirement to the intermediaries' individual customers directly. If an investor with an MBR chose to redeem all (or nearly all) its shares, the fund would be required to delay redemption of the MBR for 30 days, during which time the MBR would be subordinated to other investors. In addition, a portion of an investor's MBR could be subordinated if the investor had made net redemptions in excess of $100,000 during the prior 30 days, with the extent of subordination approximately proportionate to the shareholder's cumulative net redemptions during the prior 30 days. In the event that a fund suffered losses in excess of its NAV buffer, losses would first be absorbed by the subordinated portions of shareholders' minimum balances at risk, then by the remaining portions of investors' minimum balances at risk, and only then allocated proportionally among the remaining shares in the fund. Money market funds would be required to file as exhibits to their registration statements plans of liquidation providing for the liquidation of their assets in accordance with these priorities.
The recommendations again acknowledge that this alternative would make money market funds less appealing to investors in a number of respects, and that these considerations could reduce the size and assets of the money market fund industry as funds exit the market to avoid the NAV buffer and MBR requirements or as investors choose other investment vehicles.
NAV Buffer and Other Measures
The third reform alternative would incorporate a larger NAV buffer requirement with several additional measures. There would be no buffer requirement for cash, Treasury securities, and Treasury repos; a 2.25% buffer requirement for other daily liquid assets (or for weekly liquid assets, in the case of tax-exempt funds); and a 3.00% buffer requirement for all other assets. Treasury funds again would be exempt from the requirement. The NAV buffer requirement would be phased in over a multi-year transition period, with one-sixth of the total amount effective after one year and one-third of the total amount effective after two years.
This alternative also contemplates several complementary additional measures. First, the existing diversification requirement, which requires that most money market funds limit their exposure to a single issuer to 5% of their assets, could be strengthened by reducing the 5% limitation by some unspecified amount and by extending the limit to cover an issuer's affiliates. Second, the minimum liquidity levels could be increased by raising the required level of daily liquidity from the current level of 10% to 20%, and the minimum weekly liquidity requirement from the current level of 30% to 40%. Tax-exempt funds would remain exempt from the daily liquidity requirement. Third, the level or frequency of required disclosures of portfolio holdings could be enhanced and the current delay before public disclosure could be reduced or eliminated.
The recommendations acknowledge that this reform option, and particularly the larger NAV buffer, would likely impose additional costs on money market funds or the sponsors who would need to raise the capital. However, this alternative apparently is seen as being less harmful to the money market fund industry than the other two reform alternatives, which have more emphatic discussion of the negative effects on the industry's assets under management.
Comments on the proposed recommendations will be due 60 days after publication in the Federal Register. FSOC will then consider the comments and may issue a final recommendation to the SEC. The SEC then is required by the Dodd-Frank Act to impose the recommended standards, or similar standards that FSOC deems acceptable, or explain in writing to FSOC within 90 days why it has determined not to follow the recommendation. If the SEC accepts the FSOC recommendation, FSOC expects that the SEC would implement the recommendation through a rulemaking, subject to public comment, that would consider the economic consequences of the implementing rule as informed by the SEC staff's own economic study and analysis.
Now, the striking thing about that process is its complete impossibility. It is beyond the bounds of plausibility that the SEC could conduct an economic study and analysis, write and issue a rulemaking proposal, receive and analyze public comments, and write and adopt final rules, all within 90 days. However, FSOC also states that if the SEC moves forward with meaningful structural reforms of money market funds before FSOC completes its Section 120 process, FSOC expects that it would not issue a final Section 120 recommendation to the SEC. Renewed attention by the SEC, apparently, is the option that FSOC considers most promising. It is possible that FSOC also hopes that the rather onerous nature of some of its reform options would make an SEC reform more appealing to the industry.
The FSOC press release, with a link to the proposed recommendations, is available at
For my post on Treasury Secretary Timothy Geithner's September letter preliminarily outlining the options now proposed by FSOC, see
John M. Baker <JMB@...
Stradley Ronon Stevens & Young, LLP http://www.stradley.com
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Washington, DC 20036
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