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Developments in Money Market Fund Reform

March 28, 2017

Dollar Bill

Institutional investors have traditionally utilized money market funds (MMFs) as a safe way to park cash for short-term purposes. Money market fund companies have historically set their net asset value (NAV) at $1, meaning that investors could buy shares for $1 and expect to get $1 back at any time. 

New rules which took effect in October 2016 have the potential to change the landscape of the money market fund industry. Among other changes, the rules affect the way NAVs are calculated for certain money market funds. 

2016 SEC Money Market Fund Reform Rules

In October 2016, the Securities and Exchange Commission (SEC) adopted amendments to rules governing money market funds. The amendments address risks of runs on money market funds, and intend to preserve existing benefits of these types of funds. The new rules expound upon the original reforms adopted by the SEC in 2010.  

The new rules are a regulatory reaction to the aftermath of the 2008 financial crisis, in which the Primary Reserve Fund’s NAV fell below $1. The rules are designed to prevent investors from making a run for the exits during times of panic, as was the case after Lehman’s bankruptcy.

The new rules create reforms in three main areas:

  • Floating NAV: Institutional prime and municipal funds must now compute NAVs according to market-based factors. This will allow the NAV of one share of prime money market to “float,” meaning it will move according to the value of holdings, effectively abandoning the fixed $1 NAV that had been a defining characteristic of the money market fund sector.
  • Gates and Fees on Redemptions: Under certain stress scenarios, prime and muni funds must impose liquidity fees and temporarily suspend withdrawals (known as “gates”). These provisions are intended to provide fund managers with new tools to directly address potential runs on a fund.
  • Portfolio Provisions: The rules also create enhanced requirements for portfolio diversification, disclosure, and stress testing. There are also updated reporting rules involved as well.

The new regulations apply to institutional prime funds, i.e., those that invest significantly in commercial paper, as well as municipal bonds. Government funds — those that invest mostly in government assets — as well as taxable retail funds can still use the fixed $1 NAV standard.

Initial Reactions to the October 2016 Amendments

Initially, the main concerns and reactions to the rules revolved mainly around the floating NAV provisions. Some expressed concern that MMF shares would “break the buck” — i.e., that a share would drop below $1. If this happened, institutional prime and muni funds might experience negative consequences, such as loss of shareholder confidence and material adverse effects on business operations.

Another concern for funds regarding the floating NAV provisions is the challenge involved in calculating and posting up-to-date NAVs for their funds. For instance, a situation could arise in which a redemption request is put in at 8 a.m., but not processed until the next day at noon, by which time the NAV may have changed. 

Regarding the gates and fees, many prime funds are taking steps to avoid triggering suspensions of redemption or liquidity fees. This is done largely in part by ensuring that the funds have sufficient liquidity. 

New Study Provides Data on Effects of the Money Market Fund Reforms

The Federal Reserve Bank of New York has conducted new research which studies the effect of the new amendments on the composition of the MMF industry and activity occurring in response to the new regulatory regime. In particular, the study outlines three main shifts:  

Shift From Prime and Muni MMFs to Government Funds
From January to November 2016, total net assets (TNA) in the prime and muni industry fell by more than half. In comparison, TNA for government money market funds increased by $1.032 trillion.  

On the other hand, there are indications that prime money market funds have been gaining favor again in recent months. 

Shifts Within Fund Families
While there have been large shifts from prime funds into government funds, it is interesting to note whether investors kept their assets in their original family of funds. While it might be difficult to track exactly how flows operate in the MMF sector, data indicates that investors remained within their original fund complex for the most part. This may suggest that the reforms do not actually have a significant impact on the overall assets of individual fund families. 

Shifts to Higher Yield Government Funds
Investors in prime and muni MMFs typically have a higher risk tolerance, but at the same time seek higher yields. Thus, it may be expected that those moving assets from these MMFs into government MMFs would seek funds which provide higher yields.

There are two types of government money market funds: agency funds and treasury funds. Historically, agency funds have delivered higher yields than treasury funds. Federal Reserve Bank research data indicates that from January to November 2016, the share of agency MMFs increased from 24.4% of the overall industry to 55.4%. 

Thus, investors who moved their assets from prime and muni funds to government funds have concentrated on the higher-yield agency funds. This may allow them to work with a fixed NAV, while at the same time maximizing yields and avoiding the potential for gates and fees.

Maintaining a stable and well-diversified portfolio is a challenge, especially amidst regulatory changes. Keeping pace with changes in policies and reforms is important for large investors, especially those involved in the money market fund sector. If you have any questions or concerns regarding portfolio management, and how different developments can affect your interests, contact us today at Kessler Topaz. Our team understands the various challenges involved in monitoring diverse institutional portfolios, and is committed to helping funds ensure their financial security.