The SEC Gets Money-Fund Reform Half Right

The Securities and Exchange Commission recently proposed two new rules to help prevent sudden redemptions of money-market shares by investors from wreaking havoc on the financial system. The first proposal, requiring a "floating NAV" (net asset value), deserves support because it is limited to the most risky type of money-market funds: those held mainly by fast-moving institutions and invested largely in prime commercial paper.

By contrast, the second proposal would apply to both institutional and retail money-market funds that invest mainly in commercial paper (so-called prime funds). Such funds would generally be required to impose "fees" and "gates" to slow down redemptions once a fund's liquid assets drop below 15% of total assets. This proposal could be counterproductive. To avoid these barriers to redemptions, investors would likely flee en masse as soon as their fund approached the 15% trigger.

Under current rules, money-market funds maintain a constant NAV of $1 per share unless its fair market value drops below 99.5 cents per share. During the financial crisis in 2008, the Reserve Primary Fund—an institutional prime fund—"broke the buck" when its position in the commercial paper of Lehman Brothers went sour. Then some investors, especially large institutions, rushed to redeem shares in other prime money-market funds, leading to distressed sales of commercial paper.

In response, the first SEC proposal would force institutional prime funds to move from a constant NAV of $1 per share to a fluctuating NAV—reflecting the actual market value of its assets every day. Since the fund's NAV per share would gradually reflect any deterioration in the market value of its assets, there would be no dramatic and sudden event of "breaking the buck." Without such an event, institutional investors would be less inclined to flee from a money-market fund to avoid a sharp drop in its NAV from $1 to 99 cents per share.

Sensibly, the SEC's first proposal would not apply to money-market funds holding mainly U.S. government-guaranteed securities. Such securities are effectively immune from default and unlikely to cause a permanent decline in a fund's value. The funds that have broken the buck in the past have invested primarily in commercial paper issued by large corporations. Nor would this proposal apply to retail funds. The money-market fund holdings of any individual retail investor are relatively small and these investors have historically been much slower to redeem than large institutions. Institutional investors follow closely their holdings of money-market funds and make large redemptions as soon as they sniff the possibility of a serious problem.

Unfortunately, the second SEC proposal would apply to prime money-market funds owned mainly by retail investors (although it would not apply to money-market funds that invest primarily in U.S. government-guaranteed securities.) The proposal would generally require funds to impose a 2% charge on all shareholder redemptions once a fund's liquid assets dropped below 15% of total assets. This 2% redemption fee is huge for retail investors in money-market funds, whose total annual returns are often less than 2%.

The second proposal also allows a retail money-market fund to suspend all shareholder redemptions for a period of up to 30 days. The threat of being locked into a money-market fund would terrify most retail investors.

While retail investors have been relatively slow to move in the past, the new rules will require prompt disclosure of the liquidity level of a money-market fund. When a fund's liquid assets dip below 20%, this will be widely noted by the financial press, so retail investors would be put on notice of impending barriers to redemptions.

In response, some retail investors might shift their savings from money-market funds to bank deposits. Such a sharp rise in deposits would be challenging for many banks that are already struggling to meet higher capital standards. More fundamentally, short-term borrowers would receive much less financing from money-market funds.

Other retail investors might keep their savings in a money-market fund, but redeem as soon as it reported liquid assets below 20%. At that point, the risk of redemption fees and suspension would be uncomfortably high, so retail investors would rush to redeem—causing the very "run" that the SEC is trying to prevent.

In short, the SEC should adopt its first proposal to require a floating NAV for institutional prime money-market funds. The agency should rethink its second proposal because it could inadvertently increase—not decrease—redemption waves from retail money-market funds in times of financial stress.