Real Clear Markets

Hits and Misses On Money Market Reforms

Many U.S. regulators view money market funds as a key source of systemic risk because of what happened to the Primary Reserve Fund during the 2008 financial crisis. When that Fund's holdings in the commercial paper of Lehman Brothers went south, the Fund "broke the buck"—leading other investors to redeem the shares of similar money market funds, even if they did not hold any Lehman paper.

Under current SEC rules, all money market funds are allowed to maintain a constant net asset value (NAV) of $1 per share unless they experience losses of more than one half of one penny per share. At that point, a money market fund's NAV would fall to 99 cents per share—thereby "breaking the buck."

Last month the SEC proposed new restrictions on money market funds, which sensibly distinguish among the various types of these funds. These funds can be divided into four categories, based on the kind of assets they hold and the kind of investors they serve.

Two categories of funds are institutional and retail "prime" funds; they invest in highly rated, short term commercial paper of financial institutions and large industrial companies. Institutional "prime" funds serve large institutional investors, which often own more than $10 million in fund shares. By contrast, the investors in retail "prime" funds are mainly individuals who own fund shares worth less than $1 million.

The other two categories of money market funds are institutional and retail government funds. These funds invest almost entirely in securities issued or guaranteed by the U.S. government, such as U.S. Treasuries or mortgage-backed securities guaranteed by the U.S. government.

The SEC proposed that institutional "prime" funds no longer be allowed to maintain a constant NAV of $1 per share, and instead move to a floating NAV. Under the proposed rules, such money market funds would be required every day to ascertain the actual value of their assets and use that NAV per share for purchases and redemptions of fund shares.

The SEC is correct in singling out institutional prime funds for the most significant reforms. The commercial paper held by these prime funds has from time to time experienced losses. More importantly, institutional shareholder of prime funds own large positions, carefully monitor fund holdings and redeem at the first whiff of problems. And once one institutional prime fund breaks the buck-as the Primary Reserve Fund did in 2008-large institutions tend to pull out of other institutional prime funds as well.

The SEC proposed that institutional and retail government funds be exempted from this new system of a fluctuating NAV. This exemption is deserved because U.S. government securities are not going to cause losses by defaulting. Although the current value of government securities does change from day to day based on changes in interest rates, the portfolio of money market funds must have an average maturity of 60 days or less. Thus, any temporary declines in the value of U.S. government securities will soon be recouped as they move close to their maturity date.

The SEC's second main proposal—known as "fees and gates"—is more troublesome. It would require certain money market funds to impose a 2% fee on all redemptions once a fund's liquid assets drop below 15% of its total assets. In addition, at that time, the fund may suspend all redemptions for a period of up to 30 days.

Although all government money market funds would again be exempted from this SEC proposal, it would apply to both institutional and retail "prime" funds. This proposal is intended to reduce "runs" on money market funds - by increasing the costs of redemption or preventing them entirely for up to 30 days.

However, will this "fees and gates" proposal have the intended effect? I doubt it. A 2% redemption fee on a money market fund is huge, especially in today's rate environment. The returns of most money funds are currently less than 0.5% per year. And the possibility of an outright suspension of fund redemptions would be downright terrifying to most investors. How would families make their mortgage payments or companies meet their payroll obligations?

As a practical matter, investors are likely to flee from any "prime" money market fund as soon as its liquid assets drop below 20% or even 25%. Most investors would not want to take the chance of being locked into a money market fund.

This practical result would be reinforced by other SEC proposals for faster and more precise disclosures by money market funds of their asset composition. The media will widely trumpet the news that the liquid assets of a money market fund just dropped below 20% or 25%.

In short, the SEC should promptly adopt its first proposal requiring a fluctuating NAV for all institutional "prime" funds. But it should examine whether its second proposal for fees and gates would be counterproductive—increasing the risk of runs on "prime" money market funds, rather than decreasing them.