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SEC Meets on Money Market Fund Reform

Securities and Exchange Commission (SEC)  

Open Meeting on Money Market Fund Reform

July 23, 2014 

Key Topics & Takeaways 

  • Fundamental Change: Chair White stated that the reforms “will fundamentally change the way that most money market funds operate” and will make the financial system more resilient by reducing the risk of runs and enhancing transparency.
  • Controversial Rulemaking: Commissioner Aguilar stated that called the process of MMF reforms “perhaps one of the most flawed and controversial rulemaking processes the Commission has undertaken.”
  • IRS Guidance: Commissioner Gallagher explained that the IRS’s tax guidance on the MMF reforms: 1) allows investors to calculate their taxable gain or loss on an aggregate basis at the end of the tax year, based on information already provided in their year-end statements; and 2) exempts taxpayers invested in funds subject to a floating NAV from the “wash sale” rules. 
  • Muni MMFs: SEC’s Bolter noted that municipal MMFs would not be exempted from the floating NAV because a large number of municipal MMF assets are held by individuals who would qualify for an exemption under the definition of a retail fund.

SEC Commissioners and Staff

Opening Remarks – Chair White

Chair Mary Jo White, in her opening remarks, stated that the reforms voted on at the meeting “will fundamentally change the way that most money market funds operate” and will make the financial system more resilient by reducing the risk of runs in money market funds (MMFs) and enhancing transparency. 

White noted that issuers and investors “rely daily” on MMFs and “the benefits of such funds are significant,” but said that their widespread use can create risks through investor runs on the funds and contagion that can result. She noted that while MMF reform was not directly mandated by the Dodd-Frank Act, it “stands squarely within the vision of that statute” which called on financial regulators to address systemic risks in the economy. 

The rule’s “combination approach” of imposing a floating net asset value (NAV) on institutional prime funds and discretionary liquidity fees and gates for non-government funds, White explained, seeks to address areas of risks identified in the years of debate on this topic: 1) the “first mover advantage” that incentivizes investors to be the first to redeem, addressed by the floating NAV; and 2) the risk of widespread runs and the potential for contagion when one fund experiences heavy redemptions, addressed by fees and gates. 

White admitted that the combination of these requirements “could diminish the attractiveness of institutional prime funds for some investors, and consequently reduce demand for some corporate issuances” but said the Commission “cannot shrink from requiring a needed change in the marketplace.” 

She explained that the Treasury Department and Internal Revenue Service (IRS) will be putting out “key tax guidance” which will “eliminate significant costs of the floating NAV reform” by: 1) allowing money market fund investors to use a simplified tax accounting method for determining gains and losses, thus eliminating the need to track individual purchase and sale transactions for tax reporting purposes; and 2) providing relief from the “wash sale” rules for any losses on shares of a floating NAV money market fund. 

White noted that the SEC has made significant modifications from the original proposal to mitigate “pre-emptive run risk” including: 1) increasing the thresholds for imposing a fee or gate to a higher level of remaining liquid assets; 2) making the imposition of a fee or gate more discretionary, rather than the result of strict triggers; and 3) lessening the liquidity impact for investors of a fee or gate by permitting only a short maximum gate time. 

Staff Presentation

Norm Champ, SEC Director of Investment Management, explained that the SEC had received over 1,400 comment letters on their original MMF reform proposal in 2013 and said that the staff recommendations are designed to address risk in a manner that targets the issues raised while still preserving the utility of the funds. 

Champ explained that the floating NAV will apply to prime institutional funds, but not retail or government funds, because these funds have “the most potential for credit impairment.” He then stated the fees and gates provision will lessen the impact of heavy redemptions and enable MMFS to rebuild liquidity during such an event. 

Champ noted the staff recommendation includes a two year transition period for MMFs to come into compliance with the rules. 

Jennifer Marietta-Westberg, Deputy Director and Deputy Chief Economist in the Division of Economic and Risk Analysis (DERA), stated that the reforms for MMFs put in place in 2010 were effective in reducing interest rate, credit, and liquidity risks, but that analysis has found that even with these changes, no fund would have been able to withstand the losses experienced by the Reserve Primary Fund during the crisis without “breaking the buck.” 

She stated that a floating NAV requirement would be applied to institutional prime funds, which are the most susceptible to heavy redemptions and that deviation between the NAV and the “shadow price” will be reduced by requiring the value of the fund to be calculated to the fourth decimal place. This floating NAV requirement, she continued, would address share dilution where a shareholder can redeem at a stable NAV that is higher than the value of the underlying fund holdings. 

Westberg said that liquidity fees should reduce a shareholder’s incentive to redeem their shares by requiring them to bear some of the liquidity costs, which would lessen the frequency and effects of redemptions and lower the risk of fire sale prices. She added that these fees may also help restore value of the fund. 

Redemption gates, she added, will provide a fund’s board with tools to stop heavy redemptions and that the delay would allow: 1) time for the board to assess the condition of the fund and determine strategy to meet redemptions; 2) liquidity buffers to grow as the fund’s holdings mature and produce cash; 3) investors to assess the value of their holdings; and 4) market panic to subside. 

She said that boards will be given “significant discretion” in the application of fees and gates, which would address pre-emptive redemption problems because investors would not be able to anticipate their strategy or timing for using gates. She noted that the maximum gating period has been reduced from 30 calendar days to 10 business days in any 90 day period, which should lessen the incentive to redeem shares preemptively. She added that transparency reforms will allow investors to better assess the health of funds they hold. 

Adam Bolter, Senior Counsel in the SEC’s Division of Investment Management, stated that the floating NAV requirement would only apply to institutional prime funds because they have the greatest credit risk and exposure to redemptions. He noted that these funds would no longer be able to maintain a stable value through “amortized cost valuation or the penny rounding method of pricing” and that they will value their assets based on market factors. Bolter also noted that the funds would be valued to the fourth decimal place to regularly show gains or losses in its portfolio. 

Bolter noted that government and retail MMFs would be able to maintain a stable market share price, but that municipal MMFs would not be exempted from the floating NAV reform. He said that a large number of municipal MMF assets are held by individuals who would qualify for an exemption under the definition of a retail fund. 

He explained that a government MMF would be defined as one that invests at least 99.5 percent or more of its assets in cash, government securities, and government repos, noting these assets tend to increase in value in times of stress. He then said the “non-conforming basket” would be reduced from 20 percent to a 0.5 percent de minimis basket, due to concerns that having 20 percent of assets in riskier non-government securities may promote a “hybrid fund” not consistent with the goals of the reforms. 

Bolter then explained that a retail fund would be defined as one that has policies and procedures “reasonably designed to limit all beneficial owners of the fund to natural persons.” 

Next, Bolter noted that the staff recommend proposed exemptive relief under Rule 10b-10 “the so-called ‘confirmation rule'” be adopted to further reduce the costs of implementing the reforms. He said the proposed relief would “exempt, under certain conditions, broker-dealers from having to send immediate confirmations when affecting transactions in floating NAV MMFs.”

On fees and gates, Bolter noted that all MMFs would be able to impose a liquidity fee of up to two percent or “temporarily gate the fund if its weekly liquid assets fall below 30 percent of its total assets.” Non-government MMFs, he added, would be required to impose a default liquidity fee of one percent if the funds weekly liquid assets fall below 10 percent of its total assets, unless the fund’s board decides that not imposing the fee or setting a different level is in the fund’s best interest. Bolter noted that government MMFs would not be required to uses these fees and gates, but could employ them if they provide adequate notice to their shareholders. 

Bolter went on to recommend that the SEC adopt the following to better inform investors about the risks of MMFs: 1) amendments to Form NMFP, the monthly portfolio reporting form for MMFs, to make the information publically available upon filing; 2) amendments to Form PF, to require the same information from private funds that is currently received from MMFs; 3) a new Form NCR, where funds would make prompt disclosures of certain events, including imposition of fees and gates; 4) adopt various other disclosure documents; and 5) enhancements to MMF diversification requirements to reduce risk exposures. 

He then stated that the staff recommends re-proposing Rule 2a-7, dealing with references to credit rating agencies, and Form NMFP in light of the broader MMF reforms. He explained that the amendment would remove the credit ratings standards used to asses fund securities. 

Commissioner Remarks

Commissioner Aguilar

Commissioner Luis Aguilar, in his remarks, stated that the “journey to arrive at the amendments considered today was a difficult one,” and that at times it was “perhaps one of the most flawed and controversial rulemaking processes the Commission has undertaken.” 

He stressed that “millions of investors, retail and institutional alike, rely and benefit” from MMFs and their importance was illustrated in the number of comments received on the original proposal. 

Aguilar said that the current rulemaking is a result of “extensive data and in-depth analysis” conducted by the SEC’s DERA noting that this group’s research: 1) supports the appropriateness of the one percent default liquidity fee; 2) analyzed government funds’ exposure to non-government securities, and provides support for the significant reduction in the non-government securities basket; 3) measured the extent to which municipal MMFs may be exposed to guarantees or demand features from a single guarantor, and supports reducing the 25 percent basket for guarantees and demand features from a single institution; and 4) concluded that the reforms will not result in a large impact to the domestic and global markets for safe assets.

Aguilar said that he “struggled” with the fees and gates provision of the rule as it “is in direct conflict with the foundations of the Investment Company Act of 1940, which require that investors be able to redeem their money.” However he said that the combination of providing investors with full disclosure of the fees and gates along and the benefits to “investors and the country as a whole” justifies the Commission “taking these extraordinary steps.” 

On the recommendation to re-propose amendments on removal of credit ratings references, Aguilar, encouraged commenters to “express their views about the adequacy of external, objective factors in assessing the credit quality of portfolio securities, and whether a more prescriptive approach is needed.” 

Commissioner Gallagher

Commissioner Daniel Gallagher, in his remarks, stated that he has consistently been a proponent of requiring MMFs to adopt “market-based pricing” or a floating NAV and stressed that MMFS are “not bank products.” He said the SEC’s adoption of Rule 2a-7 created the unintended consequence of market participants viewing the MMF industry as “providing the functional equivalent of insured bank products” and said the reforms “correct any misconceptions of federal backstops and bailouts for money funds.” 

Gallagher said that the “tailored floating NAV requirement” eliminates the first mover “put” advantage that favors sophisticated institutional investors over retail investors and clarifies the risk associated with investing in MMFs. 

He said the fees and gates approach gives fund boards “a mechanism to stem the tidal wave of redemptions” that can occur in a market crisis and said the gating component is “actually just a codification of the status quo with mandated disclosure,” so that investors understand the potential of a liquidity event. 

Gallagher said his support for the reforms was contingent on the IRS resolving tax issues that arise with the new NAV structure and assured that with the IRS’s release “the accounting issues have been completely addressed.” He noted that taxpayers may rely on the IRS’s guidance “beginning on the same date that today’s rule becomes effective” 

On the IRS’sguidance, Gallagher explained that it: 1) allow investors to calculate their taxable gain or loss on an aggregate basis at the end of the tax year, based on information already provided in their year-end statements; and 2) exempts taxpayers invested in funds subject to a floating NAV from the “wash sale” rules, which prohibit taxpayers from recognizing a loss on the sale of a security if the investor buys a substantially identical security within 30 days. 

He also highlighted that the SEC has created a new internal working group “dedicated to closely monitoring the application of the rule and responding to any issues that are identified or raised by registrants and taxpayers between now and the compliance date.” 

Commissioner Stein

Commissioner Kara Stein, in her remarks, stated that “while an over-reliance on short-term funding can accelerate credit supply and asset price increases in good times, it also can accelerate precipitous declines in asset prices and credit in bad times.” She added that the SEC cannot address all of the vulnerabilities of the wholesale funding markets through their MMFs reforms alone and said the SEC “also must strengthen capital, leverage, liquidity, and margin rules for broker-dealers.” She said the SEC should finalize rules proposed in 2010 to improve disclosures regarding issuers’ short-term borrowings and said “to be effective, these disclosures must shed light on balance sheet window dressing and provide insight into the tenor of a dealer’s collateral financing.”  

Stein stated that several parts of the MMF rules are “significant steps forward” citing that they “help investors understand and experience that these funds are not risk free” and that the reform “nudges investors who are unable to tolerate any risk of loss towards other financial products better aligned with their risk-return preferences.” She also appreciated that the rule “has narrowed the definition of a government fund and tightened its diversification requirements.” 

However, Stein expressed concern that the redemption gates approach is the “wrong tool” to address run risk because it creates “a strong incentive” to redeem ahead of other shareholders. A fund that “drops a gate” would need to build liquidity to meet redemption requests when it is lifted, she explained, and this could lead the fund to stop re-investing maturing securities during the gated period, or investing primarily in government securities, “thereby cutting off funding to issuers.” 

She also expressed concern that 1) adding discretion to impose a gate could increase an investor’s incentive to redeem because it makes the use of a gate more likely; 2) shortening the gating period to ten business days may only marginally decrease the incentive to redeem; and 3) disclosures have a negative effect by highlighting that a fund could be at or is approaching a threshold that would allow it to impose a gate.  

Commissioner Piwowar

Commissioner Michael Piwowar, in his remarks, stated that he believes the fees and gates approach “would be the most effective at stopping runs on money market funds and would best preserve their benefits.” He added that “only the imposition of a gate” would stop redemptions and prevent the need for a future taxpayer bailout. He added that a liquidity fee would “treat remaining investors more equitably by offsetting the costs of liquidity provided to redeeming shareholders.” 

Piwowar said that fees and gates “should not preclude investors from using prime money market funds as effective cash management tools” because under normal market conditions, the day-to-day operations of funds would not be affected. He then stated that he would support giving MMF boards even more discretion in imposing gates and said giving boards the power to impose a gate immediately once a trigger is reached, rather than having to wait until the next business day, is an important change from the original proposal.

Piwowar, however, did not support the floating NAV approach. He said it would not stop the “first mover advantage” in a time of stress because a market-based NAV may not capture the “likely increasing illiquidity of a fund’s portfolio” if it is forced to sell securities at discounted prices. He explained that a fund’s market-based NAV would have to be determined using “mark-to-model” or “matrix pricing” estimates which may be “no more accurate than the amortized cost method.” Piwowar added that market‑based pricing will limit same-day settlements and that it is likely “at least initially, that floating NAV money market funds will only be able to price once a day, thus limiting the funds’ use as an efficient cash management tool by Main Street businesses and state and local governments.” 

Piwowar concluded that the floating NAV “will impose costs on money market funds that will ultimately be borne by its shareholders in the form of higher fees and expenses, and lower returns” and noted that funds, intermediaries, and investors “will have to change their systems and operations in order to transact at four decimal places.”

For more information on this hearing and to view a webcast, please click here. 

Please see links below for the SEC’s releases and rule text on: