During the 2012 Mutual Funds and Investment Management Conference Monday, SEC Commissioner Elisse Walter called for the money market fund industry to stop taking shots in the media about any proposed regulations governing money market funds and instead re-open a “constructive dialogue” with the commission.
But a panel session later in the day indicated that industry players and regulators were still in heated disagreement over the proposed rules. The agency is expected to officially propose regulation this spring.
“Let’s continue a process of ‘constructive engagement,’ instead of one of ‘unconstructive disengagement,’” Walter said during the conference, sponsored by the Investment Company Institute and Federal Bar Association. “I would certainly like that, and know I’m not alone in this way of thinking.”
The various proposals are aimed at preventing money market funds from breaking the buck in the future, as they did in late 2008. On Sept. 15 of that year, The Reserve Primary Fund, a $62 billion money market fund, broke the buck when its $785 million position in Lehman Brothers debt went to $0. From Sept. 10 to Oct. 1 of 2008, investors redeemed $396 billion from prime money market funds, according to the ICI.
Now, the SEC wants a major change to how money market funds operate. There are various options: The SEC is considering a floating net asset value for money market funds, similar to a mutual fund. This proposal has drawn a lot of criticism from the mutual fund industry.
The second option would put in place capital buffers, similar to banks, and redemption restrictions to avoid investor runs.
A less-discussed option, proposed by the ICI in January 2011, is the creation of a private bank to provide a liquidity backstop for money market funds in case of a future market crisis. This is the option the mutual fund industry supports the most. The SEC has said little about it.
A Magic Talisman?
Speakers at the conference seemed to take the greatest issue with how the SEC has gone about analyzing the options.
Paul Atkins, CEO of Patomak Global Partners, argued that 2008 was an anomalous event, one that should not be the basis for overhauling the money market fund industry.
“Just to wave 2008 as a magic talisman, to change all sorts of rules and with a lack of a cost-benefit analysis, I think is very dangerous,” he said. “For the chairman of the SEC, I think it borders on irresponsibility, quite frankly, for her to talk about systemic risk of this product, without having done that essential groundwork to begin with.”
Robert Plaze, deputy director of the SEC’s Division of Investment Management, agreed that the regulators can’t solve all the problems with money market funds that caused them to break the buck in 2008. “We can’t build a damn so high from 2008.” But the SEC continues to see risks in the fund industry, so they’ve made it a priority to address those risks and prevent another event from happening that would have contagious effects, he said.
There is a possibility that the SEC will reach out to investors to see what they think about a floating NAV product, but any regulation would likely increase the costs to investors. “I will stipulate that they would not like it,” Plaze said.
Simon Mendelson, global co-head of BlackRock’s cash and securities lending business, said his clients feel that a floating NAV option would be a lesser of two evils if it came down to it. But they’d be interested in certain modifications, such as tax relief and keeping government funds at a stable NAV.
The 2010 Amendments
In 2010, the SEC made several amendments to rule 2a-7 to make funds more resilient to short-term market risks and provide greater protections for money market fund investors, Walter said. The amendments included requiring the funds to maintain a portion of their portfolios in highly liquid investments, reducing their exposure to long-term debt, and limiting their investments to the highest quality securities. It also required monthly disclosures of holdings and allowed for the suspension of redemptions if a fund broke the buck.
During the panel session on Monday afternoon, speakers argued that those amendments worked, so there’s no need for further regulation.
Jane Heinrichs, senior associate counsel for ICI, said that the money market fund industry was greatly tested in the summer 2011, through the European debt crisis, the debt-ceiling impasse, the zero interest rate environment, and regulatory uncertainty. From June to November, prime money market funds lost 10 percent of their overall assets, yet they were still able to maintain their $1 NAV. These managers had adequate liquidity to meet redemption pressures, and also reduced their exposure to European banks, the ICI said.
BlackRock’s Mendelson said his firm was largely supportive of the 2010 changes, and that they basically just reconfirmed a lot of the practices they already had in place. “We always held excess liquidity; we always measured our liquidity amounts.”
But the SEC’s Plaze argued that the amendments still leave a lot of room for money market fund managers to take risks that could cause another 2008 event. He pulled up a slide showing several fund outliers that had higher than average yields. Average gross yield is a good measure of the risk a manager’s taking, he said.
“The ingenuity of the financial mind knows no bounds,” he said. “These outliers are a concern to us because if an event happens with respect to one of these funds, the transmission to the rest of the fund industry is a concern.”
What’s on the Table
Whether or not the 2010 changes did work as the fund industry argues, the SEC is still adamant there be a round two of reform. The floating NAV option would essentially treat money market funds as mutual funds and allow market pricing. Plaze argued that you don’t see the kind of investor runs that you saw in 2008 with equity or bond funds because they float.
But money market funds are not like mutual funds because they don’t really float, Heinrichs argued. She pointed to a slide showing that the average prime money market fund did not float from $1 throughout 2011. “That’s why that option might not be the optimal option,” Plaze responded.
Lloyd Wennlund, executive vice president and managing director at Northern Trust Global Investors, said that by treating a cash instrument like a mutual fund, it would have unintended consequences. In particular, investors would likely move up the risk spectrum to capture as much return as they can.
If you turn what’s seen as a cash instrument into a total return investment, it changes not only the nature of the investment but its perception among investors, he said.
The alternative, however, is to the treat money market system like a “shadow banking system,” Plaze said. This would allow them to maintain a stable NAV.
Atkins said he took exception to calling it the ‘shadow banking system,’ because the money market fund system is not operating in the shadows. “It’s operating out in the open. They’re not taking bank-type risks.”
But Plaze said a stable NAV is an attempt to compete with the banks for the same cash product. “The question is now, after 2008, is which direction does regulation go in? More towards a prudential bank regulated model or more towards capital markets?”