The President’s Working Group on Financial Markets (PWG)1 on December 22, 2020 released a report on potential reform options for money market funds (Report).2 The Report states that the significant outflows experienced by prime and tax-exempt money market funds (MMFs), as well as the stress experienced in the short-term funding markets beginning in March 2020, underscores the need for further improvements to the regulation of MMFs beyond the reforms enacted following the 2008 financial market crisis. The Report acknowledges that there have been several iterations of reforms since the 2008 crisis, designed to improve MMF resiliency to credit and liquidity stresses. However, the Report recommends that more should be done to address systemic risks and the structural vulnerabilities of MMFs to large-scale redemptions. To that end, the Report presents several possible reform options for prime and tax-exempt MMFs to facilitate discussion among regulators, including the Securities and Exchange Commission. Following the publication of the Report, the staff of the SEC's Division of Investment Management (Division) requested feedback on the Report's recommendations.3 While it is unclear whether the SEC and other regulators will adopt any of the Report’s recommendations in light of the change in Administrations, the Report may serve as a blueprint for those regulators in considering future MMF reforms. Below are the 10 MMF reforms proposed by the Report, each of which is discussed in more detail in this OnPoint.
- Removal of the tie between MMF liquidity and fee and gate thresholds;
- Reform of the conditions for imposing redemption gates;
- Imposition of a minimum balance-at-risk (MBR);4
- MMF liquidity management changes;
- Countercyclical weekly liquid asset requirements;
- Floating net asset value (NAV) requirements for all prime and tax-exempt MMFs;
- Swing pricing requirement;
- Capital buffer requirements;
- Requirement for liquidity exchange bank (LEB) membership; and
- New requirements governing sponsor support.
Although the Report discusses various reform measures, the PWG does not recommend any particular reform. Rather, the Report discusses potential benefits and drawbacks of each option, with the overarching goals that any future reforms should: (i) “effectively address the MMF structural vulnerabilities that contributed to stress in short-term funding markets”; (ii) “improve the resilience and functioning of short-term funding markets”; and (iii) “reduce the likelihood that official sector interventions and taxpayer support will be needed to halt future MMF runs or address stresses in short-term funding markets more generally.”
Removal of the Tie Between MMF Liquidity and Fee and Gate Thresholds
The Report notes that the original purpose of enabling MMFs to impose liquidity fees and/or redemption gates if weekly liquid assets (WLAs) drop below 30 percent of total assets was to reduce shareholders’ incentives to redeem shares.5 However, MMF shareholder behavior during the COVID-19 market crisis revealed that fees and gates in fact may have accelerated redemptions. Shareholders were aware that, pursuant to Rule 2a-7 under the Investment Company Act of 1940, if an MMF’s WLAs drop below 30 percent of the MMF’s total assets, the MMF’s Board may impose a fee of up to two percent and temporarily halt redemptions if the Board determines that the fee or suspension of redemptions is in the best interests of the MMF. As a result, during the COVID-19 market crisis, many shareholders chose to preemptively redeem their shares to avoid the potential of a fee or gate. The Report proposes to remove the “tie” between the 10 and 30 percent thresholds and fees or gates, so that Boards can impose fees or gates whenever they determine these to be in the best interest of the fund. The Report notes certain benefits and drawbacks, including:
- This option may reduce the incentive for preemptive redemptions by eliminating a specified trigger, and, consequently, an investor focal point for the imposition of fees or gates.
- This option may enable MMFs to sell their more liquid assets in periods of market stress without the risk of dropping below the 30 percent WLA threshold, and, subsequently prompting a preemptive “run” on the MMF.
- This option may cause MMFs to maintain lower WLAs, and, consequently, MMFs may not have enough liquidity to manage a high volume of redemptions in times of market stress.
- This option would not reduce other incentives for large-scale redemptions.
Reform of the Conditions for Imposing Redemption Gates
The Report suggests that the threat of redemption gates may increase the risk of preemptive redemption runs. It goes on to suggest various possible reforms regarding when gates may be imposed. These include: (i) requiring MMFs to notify, or obtain permission from, the SEC prior to imposing a redemption gate; (ii) requiring MMFs to first implement liquidity fees, prior to gates; (iii) reducing the WLA threshold for when gates could be imposed to 10 percent; and (iv) reforming the gating process to make gates “soft” or “partial” (for example, soft or partial gating could include gating with respect to a particular day’s assets so that each redemption request is reduced pro rata with remaining redemption amounts deferred to the next business day). The Report notes certain benefits and drawbacks, including:
- This option may make the 30 percent WLA threshold less of a focal point for investors and, consequently, less of a trigger for preemptive redemptions from MMFs.
- If a soft or partial gate is imposed, investors would be permitted to redeem a portion of their shares, simultaneously reducing the severity of the restriction on investors and enabling an MMF to reduce the rate of redemptions.
- If the WLA threshold for imposing a gate is reduced to 10 percent, the reduction in threshold may simply change the focal point for preemptive runs on MMFs rather than prevent such runs from occurring.
- Soft or partial gates may be complex to implement and, if such a gate is imposed, it may still incentivize preemptive investor redemptions from MMFs. Further, soft or partial gates may be less useful to MMFs in slowing such redemptions, as investors would continue to be able to redeem after the gate is in effect.
The Report suggests that an MBR mechanism could help to discourage investors from redeeming MMF shares during periods of stress. The MBR concept is not new and was a proposed recommendation of the Financial Stability Oversight Council (FSOC) in 2012.6 An MBR represents a portion of an MMF shareholder’s recent balance that is subject to a redemption delay. Should a shareholder wish to redeem, the MBR would remain invested in the MMF and, as a result, the shareholder would participate in any gains or losses the MMF experiences during that time. The Report suggests that a “strong form” MBR mechanism could require any redeeming shareholders’ MBR remaining in the MMF to be “first in line to absorb any losses, which creates a disincentive to redeem.” An alternate MBR mechanism would allocate losses to MBRs only in certain circumstances, such as when the MMF’s NAV experiences a large drop. The Report notes certain benefits and drawbacks, including:
- An MBR, and, in particular, a strong form MBR, may diminish a shareholder’s “first-mover advantage” because a shareholder’s MBR would be “first in line to absorb any losses” associated with significant redemptions from the MMF.
- In the case of a strong form MBR, the subordinated shares of redeeming shareholders would provide the MMF with an ability to cause the redeeming shareholders to absorb the losses to protect the investments of non-redeeming shareholders.
- The MBR is not a concept that is used in the mutual fund industry, and implementation of the MBR may be challenging for MMFs, intermediaries and MMF service providers, as they would need to make changes to their internal systems to facilitate the usability of the MBR mechanism.
- Determining the appropriate MBR may be challenging, because an MBR amount that is too small may not disincentivize redeeming shareholders, and an MBR amount that is too large may unnecessarily reduce the liquidity of the MMF’s shares.
MMF Liquidity Management Changes
The Report suggests making changes to the current daily liquid assets and WLA requirements, as well as associated disclosures on MMF websites. Potential changes include creating a new category of liquidity requirements for assets with slightly longer maturities, which the Report suggests could “strengthen [MMFs’] near-term portfolio liquidity when short-term funding markets become stressed.” The Report also suggests adding another WLA threshold (e.g., 40 percent), with penalties directed towards management and not shareholders (e.g., requiring the escrow of fund management fees) as a way to strengthen the current 10 and 30 percent WLA liquidity buffers. The Report notes certain benefits and drawbacks, including:
- Requiring MMFs to have an additional “tier” of liquidity may increase an MMF’s ability to withstand an influx of redemptions.
- Penalizing management, instead of shareholders, for breaches of an MMF’s WLA thresholds may reduce the importance of the 30 percent WLA threshold, because management would have the disincentive of allowing WLAs to fall below a higher WLA threshold.
- The penalties imposed under this option may further disincentivize an MMF from using its WLA buffer when the MMF is under stress.
- Based on historical outflows during times of market stress, an increase in WLA requirements may not provide MMFs sufficient time to combat a shareholder run.
Countercyclical WLA Requirements
Under a countercyclical WLA approach, the minimum WLA threshold would automatically decline in certain circumstances, including, for example, when there are large net redemptions or the SEC provides temporary relief from WLA requirements. The Report points out that current WLA requirements provide incentives for MMFs to avoid reaching the 30 percent WLA threshold, because MMFs want to avoid the shareholder scrutiny that accompanies public disclosure of low WLAs. The Report suggests, however, that a countercyclical WLA requirement could relieve some of these concerns. The Report notes certain benefits and drawbacks, including:
- Under this option, the 30 percent WLA threshold may have less impact on shareholder sentiment and redemption activity, because the minimum WLA requirement, as well as the trigger for fees or gates, could decrease automatically under certain circumstances (such as when an MMF’s net redemptions are significant).
- If an MMF’s minimum WLA requirement is reduced under this option, the MMF might not have sufficient liquidity to handle additional redemptions.
Floating NAVs for all Prime and Tax-Exempt MMFs
The Report suggests that a floating NAV requirement for retail prime and retail tax-exempt MMFs (which currently are permitted to operate with a stable $1.00 NAV per share using the amortized cost method of valuation) would allow shareholders to sell and redeem their MMF shares at prices more accurately reflecting the market value, to ensure that these MMFs sell and redeem their shares at prices that reflect the market value and variations in value. This pricing requirement is currently in place for institutional prime and institutional tax-exempt MMFs. The Report notes certain benefits and drawbacks, including:
- This option would make “breaking the buck” less of an investor focal point.
- If an MMF publishes the fluctuations in its NAV on an ongoing basis, shareholders will have more insight into the actual risks associated with investing in such MMF.
- Recent evidence of large-scale redemptions from institutional prime MMFs demonstrates that floating NAVs may be ineffective in reducing the likelihood of large-scale redemptions.
- A floating NAV requirement for retail prime and retail tax-exempt MMFs could result in a reduction in the size of those MMFs because of reduced investor demand for a floating NAV MMF.
Swing Pricing Requirement
The Report notes that redeeming MMF shareholders currently do not bear any of the MMF’s costs associated with their respective redemptions. Rather, remaining shareholders bear those costs, which provides redeeming shareholders with a first-mover advantage. Under current SEC rules, mutual funds (other than MMFs) can implement swing pricing, which allows a fund to adjust its NAV per share to effectively pass on the costs stemming from shareholder redemptions to those shareholders who redeem.7 The PWG report suggests that, by allowing MMFs to impose swing pricing, costs associated with redemptions would be shifted onto redeeming MMF shareholders, and an MMF would eliminate the costs ordinarily passed on to the remaining MMF investors. The Report notes certain benefits and drawbacks, including:
- This option may diminish a shareholder’s first-mover advantage by ensuring that redeeming shareholders bear a portion of the costs associated with such redemptions.
- The use of swing pricing under normal market conditions may desensitize shareholders to the use of swing pricing during periods of market stress.
- To date, mutual funds have not implemented this option because of the significant time and resources dedicated to the reengineering of a processes for distributing shares and receiving orders.
- Management of this option for MMFs that permit intraday purchases and redemptions may be difficult, particularly in times of market stress.
Capital Buffer Requirements
The Report suggests that capital or NAV buffers may be structured to assist MMFs with losses and fluctuations in portfolio value. Similar to the MBR concept, a capital buffer for MMFs is not new and was a proposed recommendation of FSOC in 2012.8 These buffers primarily would assist stable NAV MMFs, and would be necessary only to absorb losses for floating NAV MMFs in unusual circumstances. The Report notes certain benefits and drawbacks, including:
- This option lessens risk of loss to MMF shareholders by providing preemptive “loss-absorption capacity” to MMFs.
- MMFs would be equipped to absorb losses in advance of periods of stress, thereby reducing MMFs’ dependence on discretionary support that is currently provided to them after the fact.
- Time and resources would need to be spent in determining a capital buffer size that would neither be too costly to the MMF nor leave the MMF subject to the risk of large-scale redemptions.
- Requiring a capital buffer could result in certain asset managers discontinuing their MMF offerings.
Requirement for Liquidity Exchange Bank Membership
The Report suggests that requiring MMFs to be members of a chartered private liquidity exchange bank (LEB) could provide MMFs with liquidity in times of market stress. An LEB for MMFs, which was an idea initially floated following the 2008 crisis but viewed as impracticable at that time, would be able to purchase eligible assets of an MMF under stress up to a certain amount, although it would not provide credit support. The Report also references certain arrangements where MMF members provide initial capital contributions to the LEB and ongoing commitment fees to ensure its stability. The Report notes certain benefits and drawbacks, including:
- This option would create a “liquidity backstop,” thereby reducing an MMF shareholder’s incentive to redeem preemptively.
- MMFs would receive liquidity from an LEB, which could diminish the impact to the market created by investor expectations of support from entities such as the Federal Reserve.
- It is not clear whether an LEB, which would not provide traditional banking services, would be able to obtain a banking charter.
- Even if an LEB were to be granted a banking charter, the LEB might not be able to obtain sufficient funding from the Federal Reserve’s “discount window” in order to provide adequate liquidity to MMFs under stress, if the amount of funding needed by the MMFs exceeds what is available through the discount window.
New Requirements Governing Sponsor Support
The Report suggests that another option is to clarify the extent of support and risk of loss a sponsor of an MMF would be required to bear. Although the Report acknowledges the temporary relief provided by the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency and the temporary no-action relief provided by the SEC in March 2020 allowing an affiliate to purchase certain securities from an MMF, the Report suggested that the “discretionary nature of sponsor support contributes to uncertainty.” The Report notes certain benefits and drawbacks, including:
- This option would make clear to investors that sponsors would commit resources under certain circumstances, potentially alleviating investor risk of loss and reducing the impetus for investors to redeem in times of market stress.
- Requiring sponsor support may incentivize the sponsor of an MMF to focus on reducing MMF risks.
- This option may create concentration in MMFs sponsored by advisers that are affiliated with banks.
- As a result of requiring sponsors to provide resources under certain circumstances, investors may be subject to higher fees on their investments, which could reduce demand for prime and tax-exempt MMFs.
Certain of the reforms proposed in the Report (e.g., imposing an MBR, requiring all prime and tax-exempt MMFs to use a floating NAV per share, imposing a capital buffer, mandating LEB membership) were considered by certain regulators following the 2008 financial crisis, and ultimately were not included in the reforms adopted by the SEC in 2010 and 2014. Among the new reforms proposed by the Report (and one that certain industry participants have supported) is the decoupling of the 30 percent WLA minimum threshold from the imposition of fees or gates. The PWG Report: echoes, in part, many of the ongoing discussions among market participants and regulators; provides additional considerations for the policy debate that is ongoing in the wake of the COVID-19 market crisis; and lends significant weight to the push for further reform. On December 23, 2020, Division Director Blass requested industry feedback backed by data, where possible, regarding the perceived effectiveness of the proposals in the Report to assist the Division in making recommendations to the SEC. Despite the Division's request for feedback on the Report, it is uncertain whether the SEC and other industry leaders will embrace some or all of the Report’s specific recommendations. It also is unclear whether any new politically appointed members of the PWG from the Biden Administration will take up the cause of pushing these reforms or prioritize other matters.