Money market funds are under regulatory attack. Their critics are calling for radical change in how these funds operate, proposing that money market funds either be prohibited from maintaining a constant $1 share price or required to maintain a substantial cushion against potential losses.
These proposals would threaten the viability of an investment vehicle that has been an attractive alternative to banks for individual savers, businesses, and local governments.
The critics contend they are correcting weaknesses in money market funds that were unmasked by the credit crisis.
In 2008, one US money market fund, the Reserve Primary Fund, “broke the buck”, meaning that it could no longer maintain a $1 share price because of losses on securities held within the fund. To ensure that the Reserve Fund’s problems did not spark a rush of fund redemptions throughout the industry, the US Treasury stepped in with a guarantee programme, which temporarily protected fund shares against loss.
In their rush to “fix” money market funds, however, critics are undervaluing the significant benefits the funds provide to investors and issuers.
For individual consumers, money market funds normally have higher yields than bank passbook savings accounts that provide the same ready access to funds. To obtain higher rates at the bank, investors must give up daily liquidity – by committing to a three-month investment in a certificate of deposit, for example – and maintain a larger minimum investment.
US money market funds also provide retail investors with an option that is not available at the bank: they can invest in a tax-exempt fund that buys short-term instruments issued by state and local governments. These securities are exempt from federal income taxes, a tax benefit that is passed on to shareholders.
On the negative side, money market fund investments are not covered by federal deposit insurance, which covers US bank deposits against loss up to $250,000 per account.
Businesses, however, often hold cash balances exceeding this insurance limit, so many invest part of their cash in money market funds to diversify their risk. In 2010, the average non-financial business in the US held 25 per cent of its cash in money market funds.
Money market funds benefit businesses in another way: they provide a significant source of funding. Today, money market funds buy one-third of all the commercial paper issued by US companies. They play a similar role for state and local governments, owning $330bn in municipal obligations.
For both businesses and governments, money market funds serve as an important alternative to banks. Competition between funds and banks drives down the interest rates they must pay on short-term borrowings. Their funding costs would surely rise if money market funds were no longer able to compete effectively.
Yet the latest set of reform proposals, if implemented, could well hobble money market funds, to the point where they are no longer an attractive option for investors or borrowers.
The proposals for a floating share price, in place of a stable $1 per share, would make money market funds less attractive to consumers. With a fluctuating share value, money market funds would be much less attractive to conservative investors who want to earn interest on short-term cash without incurring either capital gains or losses.
At the same time, requiring funds to hold some sort of a cushion against losses, in the form of a liquidity facility, earnings reserve or capital position, will increase the cost of managing money market funds. Higher costs ultimately translate into lower yields, making funds less appealing to all types of investors.
Money market fund yields are already under pressure, because of the tighter investment restrictions that the Securities and Exchange Commission imposed in 2010. The new rules lowered limits on average maturity, raised liquidity requirements and upped quality standards – thereby reducing portfolio risk. But these new rules will also lower the yields of money market funds, making them less competitive with banks.
The new SEC rules will substantially reduce the chance of any money market fund “breaking the buck”. To provide yet more protection, every fund should change the way it handles large redemptions by institutional investors – redemptions that played a major part in the only two instances when a fund broke the buck.
Money market funds usually sell securities in order to pay cash to the redeeming investor. We suggest funds make greater use of existing rules that allow them to meet redemptions “in kind” and give the investor a proportional share of all the securities held by the fund. This approach would reduce systemic risk without reducing the yields of money market funds.
Would the remaining risk to money market funds be worth the benefits to investors seeking the best yield for their cash and issuers looking for the lowest rate on their short-term borrowings? The answer seems clear.