This summer the SEC finally issued its long-awaited new Money Market Fund (MMF) rules, with the hopes of avoiding a future run on money markets similar to what happened during the 2008 financial crisis when the Reserve Primary (money market) fund "broke the buck" due to its holdings in short-term Lehman bonds and the Treasury and Federal Reserve had to intervene in the MMF marketplace to stem the panic by providing a series of temporary guarantee programs to protect shareholders.
After applying some modest initial reforms in 2010, and considering a wide range of potentially more significant money market reforms going forward - from floating NAVs to allowing for redemption fees and gates during times of crisis - the SEC has ultimately adopted a combination approach. As Duane Thompson explains in this guest post, the new rules from the SEC will provide for floating NAVs for institutional money market funds, redemption fees (up to 2%!) and gates (limiting investor liquidations) for retail and institutional funds that can be imposed by fund boards during times of financial stress, and reduced limitations for money market funds that invest purely in government bond holdings (so-called "government money market funds") due to their reduced riskiness (though governmental MMF boards can still potentially apply redemption fees and gates if necessary). Fortunately, the new rules also require money market funds to hold greater liquidity buffers (reducing the risk of problems in the first place), and dramatically reduce the permitted use of derivatives in many types of MMFs.
Nonetheless, the end result of these reforms may potentially be a significant shift into government money market funds to avoid these potential limitations, and while consumers and institutions may ultimately still prefer what will likely be the slightly higher yields of non-government money market funds, the decision to use them - and face the floating NAVs, or redemption fees and gates that may apply - will have significant implications regarding money market fund due diligence obligations for advisors. In fact, greater money market fund reporting requirements may leave advisors with little excuse for not having done effective money market fund due diligence in the future!
SEC Adopts New Money Market Rules
The SEC on July 23, 2014, adopted new money market fund (MMF) rules designed to discourage runs like the Reserve Primary Fund’s well-known “breaking the buck” during the 2008 financial crisis. On September 17, 2008, the Reserve imposed a seven-day freeze on redemptions after its $785-million holdings in Lehman Brothers debt securities (1.2 percent of its assets) were valued at zero. According to a 2012 white paper by the Boston Federal Reserve, during the crisis another 20 MMFs could have broken the buck without sponsor support. News that the Reserve fund had dropped from a stable $1 share value to 97 cents panicked institutional investors, leading to massive outflows of $350 billion in one short week throughout the industry, or 14 percent of all MMF assets. The U.S. Treasury reacted within a few days of the news by guaranteeing MMF accounts and slowing the wave of redemptions.
Under the latest reform measures adopted by the SEC, which follow more modest changes in 2010, the Commission hopes that a combination of floating net asset values (NAVs) for institutional funds and fees and gates for retail funds, among other things, will discourage investors from repeating history in the next financial panic. Since institutional investors were responsible for 90 percent of the outflows in 2008, the SEC has imposed the least popular alternative for the fund industry—floating NAVs—on institutional funds. Both institutional and retail funds also will be subject to fees-and-gates requirements, and under the new rules that go into effect in July 2016, at their discretion MMF boards of directors may impose up to 2-percent redemption fees or temporarily halt investor redemptions.
Although the $3-trillion money market industry remains an important component of defined contribution plans and for cash-flow needs of retail investors today, financial advisors should consider undertaking due diligence in light of the significant restructuring of MMFs under the new rules. Due diligence activities may include reassessing clients’ appetite for risk in this asset class, reevaluating whether MMFs are suitable as designated investment alternatives in defined contribution plans, and revisiting their practical role as a cash-flow tool. While the risk of a panic leading to extensive redemptions is considered a low-probability event, recent research by the Federal Reserve and others has cast new light on the potential risks involving this unique asset class. This Legislative Intelligence Update highlights how MMFs will be structured under the new SEC rules in its response to systemic and credit event risk.
Money Market Fund (MMF) Restructuring
Institutional and retail MMFs are mutually defined by limiting investments in retail funds only to “natural persons,” or individuals. The new guidance generally defines retail funds as providing for policies and procedures “reasonably designed to limit all beneficial owners to natural persons.” According to the SEC, this means existing funds with separate share classes for institutional and retail investors will have to be reorganized. Retail fund investors probably will furnish Social Security numbers for verification, passport identification numbers, or comparable information from foreign investors.
Although municipal MMFs are not defined in the new rules, according to the SEC these funds must be classified as either institutional or retail funds for purposes of the new requirements, with the classification dependent on whether the municipal fund meets the definition of a retail fund. Because data suggests the majority of municipal funds hold retail assets, it is anticipated that most will end up as retail MMFs.
Finally, government MMFs will not be subject to either restriction, although government boards of directors can choose to impose fees and gates if they deem it necessary. The SEC believes such board actions will be rare. Under the new rules, the maximum holdings of riskier assets in government funds, such as derivatives, have been reduced significantly from 20 percent to no more than 0.05 percent because of the SEC’s concern with credit risk in the current “hybrid” model. Post-recession studies of the U.S. debt-ceiling impasse and Eurozone debt crisis confirmed a similar flight to quality in U.S. government securities, leading the SEC to essentially eliminate riskier holdings in government funds as well as the corresponding requirement for a floating NAV or fees-and-gates solution.
Floating Money Market NAVs
During the two-year restructuring period, the SEC believes the new floating NAV funds may be valued only once a day until continuous pricing systems can be implemented. This may result in institutional shares having earlier closing times for trading orders than the current 4 p.m. Eastern Time deadline, at least until continuous pricing is in place. Share valuations to the fourth decimal place must be reported for $1 shares, or beginning at 1.0000, three decimal points for $10 shares, and so forth. Valuations will be updated on fund websites for easy access by investors and financial advisors.
The SEC also believes that due to operational costs in modifying sweep platforms, sweep accounts using institutional MMFs likely will migrate to government funds which, as noted earlier, are not subject to floating NAVs or the complications involving fees-and-gates restrictions.
The potential problem associated with tracking capital gains and losses in a floating NAV fund, as well as coping with wash-sale rules in an environment where the price may fluctuate constantly has been eliminated. According to a Treasury release, institutional funds will be able to summarize gains and losses on an annual basis via shareholder account statements.
The SEC acknowledges that, during a panic, a floating NAV cannot stop redemptions. “However,” the adopting release notes somewhat optimistically, “the floating NAV reform reduces the benefit from redeeming ahead of others to at most one-half of a hundredth of a cent per share—100 times less than it is currently.”
New Money Market Redemption Fees and Gates On Liquidation
As a second tool available to fund boards during times of market stress, institutional and retail funds will be subject to fees and/or gates on redemptions. Relying on the 30-percent weekly liquidity requirements imposed on funds in 2010, fund boards of directors will closely monitor the weekly and also daily holding restrictions in determining whether to take action. For example, if a fund’s weekly liquidity level falls below the 30-percent liquidity level, a fund’s board can impose up to a 2-percent liquidity fee on redemptions, or halt shareholder redemptions for up to 10 business days in any 90-day period. If the daily liquidity level falls below 10 percent, a default 1-percent redemption fee will be triggered automatically unless the fund board determines it should take some other action (including not imposing any fees). Additionally, if the fund’s daily liquidity level falls below 10 percent, a fund board may permanently suspend redemptions and liquidate the fund, returning the balance to shareholders.
Under the 2010 reform rules, MMFs are required to hold two levels of liquid assets: one level of liquidity to meet shareholder redemptions during any five-business-day period, called 30-percent weekly liquidity holdings; and a second level of liquidity to meet redemption requirements during a single day. At the weekly liquidity level, 30 percent of all assets must be in cash and short-term securities such as Treasuries or other government securities with maturities of 60 days or less that can be converted to cash within a week. The 10-percent daily liquidity holdings require sufficient reserves that can convert into cash (i.e., mature) within one day. Municipal funds will continue to be exempt from the daily liquidity requirements, because they were under the 2010 amendments, and government funds in practical terms always should have sufficient liquidity to meet redemptions, given the new holdings requirement.
Anticipating the new controls on institutional and retail funds will discourage runs, the new rules require fees and gates to be automatically lifted once a fund’s weekly liquidity rises above 30 percent. It is important to keep in mind that an MMF board always has the option to do nothing, although if it does not take action when the 10-percent daily liquidity level is breached, the default 1-percent fee is triggered. The SEC modified the original proposal to allow greater board discretion in imposing restrictions because of concerns that investors would “game the system” by closely monitoring liquidity levels and time their redemptions before funds reach mandatory fees-and-gates thresholds. The SEC believes that permitting broad discretion on the timing of those restrictions (including doing nothing) will alleviate speculative market-timing by shareholders.
In summary, the determination to either impose or lift gates or fees is the responsibility of the fund board, which must act in the best interest of the fund in making that decision. Fund boards have those options available once the weekly liquidity levels drop below the 30-percent threshold. A 1-percent redemption fee is imposed automatically when the daily liquidity level of institutional and retail MMFs drop below 10 percent and the fund board takes no action.
Other Issues With New SEC MMF Rules
Financial advisors need to be aware of the potential impact of the new rules on various clients, ranging from 401(k) plans and individual retirement accounts (IRAs) to required minimum distributions (RMDs). For example, in discussions between the SEC and Department of Labor (DOL) staff regarding a general fiduciary duty to prudently manage the anticipated liquidity needs of qualified plans, DOL staff responded that the potential for redemption restrictions is just one of many factors that Employee Retirement Income Security Act of 1974 (ERISA) fiduciaries would need to consider. Future guidance may be provided by the DOL, although it appears that liquidity concerns may prompt pension advisors to replace institutional funds with government MMFs, which have no fee-and-gate restrictions.
In addition, SEC staff considered the impact of temporary gates on RMDs and the ability to process payments from a plan or an IRA on a timely basis. However, the adopting release indicated that in practical terms, most account holders or their beneficiaries likely would have other investment options available for withdrawal purposes. As a last resort, an individual unable to make a withdrawal could request a waiver from potential excise taxes from the IRS.
With regard to private trusts and charitable foundations, investment managers should keep in mind that the state laws governing the management of trusts generally list specific suitability factors that must be considered in portfolio construction. These include reviewing the tax consequences of certain investments, which likely would include consideration of a MMF’s ability to make timely disbursements.
Monitoring MMF Holdings, Available Actions By Fund Boards
Finally, as part of an investment fiduciary’s ongoing monitoring responsibilities, managers will have additional disclosure information available to assess the suitability of specific MMF holdings. Disclosure of holdings, for example, will be stepped up from monthly, as required in 2010, to a daily basis under the new rules. Share values will be posted daily on the funds’ websites, including the 30-percent required liquidity holdings.
In addition, once the new rules go into effect, funds will be required to disclose in the prospectus or statement of information a 10-year look-back period on various types of information, beginning after the effective date in July 2016. This information must include any use of gates, fees, or sponsorship support to maintain stable share values, as well as when daily liquid assets dropped below 10 percent.
These additional disclosures should be helpful for advisors in addressing their fiduciary responsibilities in selecting and monitoring MMF investment options.