On June 5, 2013, the Securities and Exchange Commission ("Commission") unanimously voted to propose rules that would alter the way that money market funds operate. Shortly thereafter, the Commission released the proposed rule, titled "Money Market Fund Reform."
As described in the meeting and the accompanying press release, the proposal includes two principal alternative amendments to Rule 2a-7, which could be adopted alone or in combination. The proposal also includes additional amendments to Rule 2a-7 that would impose a stricter diversification regime, enhanced disclosure requirements, and best practices with respect to stress testing. These additional amendments would apply under either of the principal alternative amendments.
Industry participants may have been somewhat surprised by the direction taken by the Commission. Certain of the "reforms" that had previously been widely discussed were not included in the proposal, namely the minimum balance at risk and capital requirement options. We expect that the Federal Reserve Banks and FSOC will object to these omissions, and advocate more onerous changes.
However, during the meeting, the Commissioners delivered a uniform message that the Commission is the appropriate regulator to guide money market fund reform; and that the Commission would have pursued money market reform even absent the intervention of FSOC. The Commissioners uniformly praised the December 2012 study relating to money market funds that was produced by its Division of Risk, Strategy, and Financial Innovation, and suggested that such study had heavily influenced the proposal. Commissioner Gallagher, in particular, contrasted this process with last year’s money market fund proposal under Chairman Shapiro, which he indicated was drafted "without involvement of the Commissioners." Accordingly, we believe that the Federal Reserve Banks or FSOC cannot railroad the current Commissioners.
Common Elements of the Alternatives
Money market funds will no longer be permitted to use the amortized cost method to maintain a stable price: all stable value funds must become penny-rounding funds. All money market funds will be permitted to use amortized cost to the same extent as other mutual funds, i.e., for securities maturing in 60 days or less. This will have operational implications, as the stable value funds will need to strike a penny-rounded price before processing purchases and redemptions.
Apart from switching to penny rounding, government money market funds will be largely unaffected by the proposed alternatives. A government money market fund would be defined as any money market fund that holds at least 80% of its assets in cash, government securities, or repurchase agreements collateralized by government securities. Tax-exempt funds would be treated in the same manner as prime funds.
Alternative One: Floating NAV
Under the first alternative, non-government money market funds would have to either: (1) limit daily redemptions by any shareholder to not more than $1 million; or (2) calculate a floating net asset value (NAV) to the nearest basis point. Omnibus accounts would be permitted to exceed the $1 million limit if the intermediary implemented the limit on underlying accounts. The accuracy requirement for funds that do not impose the limit would be 10 times that required for other mutual funds.
Alternative Two: Liquidity Fees and Redemption Gates
Under the second alternative, all money market funds would continue to transact at a stable, penny-rounded price, but would be able to use liquidity fees and redemption gates in times of stress.
Specifically, if a money market fund’s level of "weekly liquid assets" were to fall below 15% of its total assets, the money market fund would be required to impose a 2% liquidity fee on all redemptions. However, the fund’s board of directors would have the latitude to eliminate or reduce such fee if it determined that (1) the fee is not in the best interest of the fund; or (2) a lesser liquidity fee is in the best interest of the fund.
To the extent that the 15% threshold were breached, the money market fund’s board of directors also would be able to impose a temporary suspension of redemptions (or "gate"). A money market fund that imposes a gate would be required to lift the gate within 30 days, although the board of directors could determine to lift the gate earlier. Money market funds would not be able to impose a gate for more than 30 days in any 90-day period.
Potential Combination of Alternatives One and Two
The Commission indicated that it would seek comment regarding whether to combine the floating NAV and the liquidity fees and gates proposals into a single reform package. Based on their comments at the meeting, Commissioners White, Gallagher and Walter appear to support such a combination, while Commissioners Aguilar and Paredes do not. Commissioners Walter and Paredes will be leaving the Commission, however, before any final rule will be voted upon.
Other Potential Amendments to Rule 2a-7
The Commission outlined the following other potential amendments to Rule 2a-7:
Stricter Diversification Regime
Aggregation of Affiliates – Money market funds would be required to aggregate parent companies and their majority-owned subsidiaries for purposes of determining whether they are in compliance with diversification limits.
Removal of the 25% Basket for Guarantees and Demand Features – All of a money market fund’s assets would be required to meet the concentration limits for guarantors and providers of demand features, thereby removing the 25% basket set forth in Rule 2a-7(c)(4)(iii)(A) that permitted a money market fund to have a 25% exposure to a single guarantor or demand feature provider.
Asset-Backed Securities – Sponsors of asset-backed securities would be deemed to have guaranteed the asset-backed securities, unless the money market fund’s board of directors determines the fund is not relying on the sponsor’s strength or structural enhancements of the asset-backed security in determining the quality or liquidity of the asset-backed security.
Website Disclosure – Money market funds would be required to disclose on their website, on a daily basis, their levels of daily and weekly liquid assets, flows, and market-based NAVs per share.
New Material Event Disclosure – Money market funds would be required to promptly disclose certain events on a new form (Form N-CR). Examples of such events include the imposition or lifting of fees or gates, portfolio security defaults, and sponsor support.
Disclosure of Sponsor Support – Money market funds would be required to disclose historic instances of sponsor support for money market funds (in addition to the current event disclosures required on Form N-CR).
N-MFP Amendments – Form N-MFP would be amended to require reporting of additional information relevant to assessing money market fund risk. In addition, the amendments would eliminate the current 60-day delay on public availability of the information filed on the form, and would make it public immediately upon filing.
Private Fund Reporting – In order to effectively monitor whether substantial assets migrate to liquidity funds in response to money market fund reforms, the proposal would amend Form PF, which private fund advisers use to report information about certain private funds they advise. The proposed changes would require a "large liquidity fund adviser" (a liquidity fund adviser managing at least $1 billion in combined money market fund and liquidity fund assets) to report substantially the same portfolio information on Form PF as registered money market funds would report on Form N-MFP.
Enhanced Stress Testing
Under the proposal, there would be enhancements to the stress testing requirements adopted by the Commission in 2010. In particular, a money market fund would be required to stress test against the fund’s level of weekly liquid assets falling below 15% of total assets.
The public comment period for the proposal will last for 90 days after its publication in the Federal Register. The proposed transition period would be two years if Alternative 1 is adopted, nine months if Alternative 2 is adopted, and nine months after adoption for the other proposed amendments to Rule 2a-7.