Money Market Reform June 2014

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1 Research Money Market Reform June 2014 payden.com LOS ANGELES BOSTON LONDON PARIS

2 Since the financial crisis, there has been greater scrutiny of money market funds (MMFs) and the systemic risk they pose if they break the buck and the net asset value (NAV) falls below $1. Because of the fixed redemption rate of $1 for investors in MMFs, significant downturns that cause the underlying assets of the money market funds to rapidly devalue will increase the risk of runs, as the fund can no longer meet the obligations of all of its investors. Thus, those who are able to get their money out of the fund first are able to get their $1 redemption value while Assets Under Management by Fund Type as of May 31st, 2014 (Billions of US Dollars) 1 Government/ Treasury- Retail $201 B Government/ Treasury- Institutional $712 B Tax-Exempt $258 B those who try to redeem later could be left with less than they had originally invested. The threat of runs spreading to all money market funds prompted the Fed to step in during the 2008 crisis and guarantee investments, which did successfully prevent a cascade of runs but ultimately left taxpayers liable for keeping these funds afloat. Table 1: Summary of SEC Reforms Prime-Institutional, $901 B Prime-Retail, $516 B The SEC first implemented reforms in January 2010, introducing daily and weekly liquidity requirements, higher credit quality limits, and shorter average maturity requirements, all intended to improve the ability of investors to access their money during crises. In addition, greater transparency and stress testing were instituted, increasing the focus on liquidity in money funds. Despite these changes, there remained a sense that the reforms did not go far enough. The SEC, led by then chairwoman Mary Shapiro, pursued further reforms but could not muster the votes to continue forward due to intense lobbying from industry. In November 2012, the Financial Stability Oversight Council (FSOC), still looking for further reform, submitted official recommendations to the SEC laying out specific measures for the SEC to consider applying to the money market fund industry. Proposed Reforms First announced in June 2013 during an SEC Open Meeting, reforms would be comprised of two alternate though not mutually exclusive options, both of which are briefly explained below in Table 1. Firstly, institutional prime money market funds would be required to sell and redeem shares based on marketbased values of the underlying securities rounded to the nearest 1/100 of a cent, floating the net asset value per share, rather than fixing the share value at $1. By floating funds NAVs, the SEC believes shareholders will have increased transparency of investment risk, discouraging redemption rushes. Government, municipal (tax-exempt), and retail prime MMFs, which historically have not faced runs, would be exempt from this rule. Secondly, the SEC is considering imposing a liquidity fee (around 2% on redemptions) and temporary Potential Reforms What it is Who it impacts Floating Net Asset Value Redemption Restrictions The redemption rate for a share of a money market fund will no longer be pegged at exactly $1, but would fluctuate with the changing values of the fund s underlying assets. When the liquidity of a fund falls below a certain benchmark (at least 15% of the fund can be withdrawn within one week), a 2% fee on redemptions or a suspension of further redemptions are triggered. Prime institutional funds only (approximately $900 B in assets) All prime funds (approximately $1.4 T in assets) How it impacts funds and investors Daily impact on pricing of assets, must report gains and losses for tax purposes Decreased liquidity in times of distress, lower overall return

3 redemption suspensions on all non-government MMFs. These gates would be triggered when a fund s liquidity (calculated from the percentage of funds able to be removed in a standard time frame, like one week) falls below a certain threshold. These measures would discourage or, in the case of redemption suspensions, completely prevent investors from removing their money from MMFs during market swings, limiting the cascading effect of a MMF failure. Both of these restrictions, though contributing to the stabilization of money market funds during and between crises, also will make such funds less attractive to investors, as they create additional liquidity constraints and costs. Industry Response to Reforms Since the announcement in June 2013, the money market industry has been defensive of further reforms, with many other financial institutions providing their opinions publicly, both directly to the SEC and in the media. Unsurprisingly, the response to the proposed regulation from large money market mangers has been primarily negative, with particular disagreement over the necessity and effectiveness of a floating NAV. They argue that the floating of the NAV will remove the convenience of money market funds (easy liquidity and tax reporting) while not gaining much transparency. Critics note that only two funds in the 40 year history of money market funds have actually broken the buck (this fact must be caveated by the fact that fund sponsors frequently step in and add their own capital during distressed times to prevent them from officially breaking the buck. 2 ) Other commentators note that the fluctuations in the NAV outside of a crisis are miniscule: in January 2013, only 16 out of 785 money market funds had NAVs less than $0.9999, far from the limit of $0.995 for breaking the buck 3. Only retail money market fund managers like Vanguard and Charles Schwab, who stand to benefit from their preferential status under the proposed regulation, have shown strong support for the float. Another concern is the differentiation between retail and institutional funds. The SEC seeks to base the distinction off of the size of daily redemptions, while the industry seeks to maintain its current criteria based on whether the funds are held by natural persons. It appears that the SEC is considering adopting the industry standard definition of retail in its recent deliberations. 4 These definitions are summarized in Table 2 below. SEC Studies on Impacts of Reform In March 2014, the SEC released several studies evaluating the potential effects of reform. Among them were analyses related to the cost of liquidity during crisis periods, the amount of non-government securities exposure in government MMFs and the supply of safe assets in the economy. These studies were open to commentary, with responses from MMFs and industry groups that generally disagreed with the findings and methodologies of the SEC. 5 The findings and responses are summarized in Table 3 on the next page. Countering market criticism has been the Financial Stability Oversight Council s staunch support of reform, particularly the first alternative of floating MMF NAVs. It has already wielded its clout by compelling the SEC to undertake a review of money market reform, and it could do it again by forcing the SEC to execute particular reforms via section 120 of the Dodd-Frank Reform Act should it find the SEC s decision unsatisfactory. However, commenters note that the SEC can avoid being controlled by the FSOC by simply explaining why the Commission decided to reject the FSOC s recommendations. Additionally, the SEC must also balance the interest of the investors, who could sue and impede the implementation of the new rules. 6 Table 2: Fund Designations Fund Designation Original SEC Definition Market Consensus Retail Funds that prohibit shareholder redemptions Owned by natural persons greater than $1 million per business day. Institutional Funds that allow shareholders to redeem more than $1 million per business day. Owned by some other corporate entity or group

4 Table 3: Study Summary Study Topic Study Purpose Main SEC Findings Industry Response Cost of Liquidity Determine if proposed liquidity fee is sufficient to discourage runs. Non-govt security exposure in govt MMFs Safe Assets in Economy Assess non-govt exposure in govt funds and whether govt MMFs should be regulated. Evaluate whether other cash management vehicles will be able to handle inflows from prime MMFs. Note: The SEC s total safe asset base includes those denominated in non-usd currencies. The estimated cost of obtaining liquidity during crisis is around 50 to 105 bp for Tier 1 and Tier 2 MMFs. Low non-govt exposure in govt MMFs. Govt funds can be exempt from reform. $74 Trillion of safe (investment grade govt and corporate debt, MBS, ABS, covered bonds, and gold) assets globally. Movement of money from prime to govt MMFs should be manageable. Cost is likely overstated due to difference between transactions studied and actual MMF transactions. 1% liquidity fee preferred to 2%. Agree on govt MMF exemption. Option for govt MMFs to invest up to 20% in non-govt securities should remain. SEC uses relatively loose definition for safe securities. More relevant pool is US safe assets, which is significantly smaller ($6.8 trillion in short term govt securities). Unclear if govt MMFs have capacity to absorb prime MMFs funds. Next Steps for Reform The FSOC s 2014 annual report notes that the Council doesn t expect to need to ask the SEC again for reforms, so it appears content with the SEC s direction. This could suggest a host of different outcomes, but many observers see it as the SEC s acquiescence to the FSOC s expectations (namely a combined restriction with both redemption limits for all prime funds and the floating of the NAVs of institutional prime MMFs). However, recent developments suggest significant disagreement among the SEC commissioners. 7 SEC commissioner Michael Piwowar has suggested that MMFs should have the choice of either floating their value or creating redemption restrictions during tumultuous periods rather than the burden of both. This compromise would still create substantial market reform without being as burdensome as other forms of regulation proposed by the SEC and commissions in other jurisdictions such as in the EU. 8 If given a choice, the vast majority of money market funds would adopt redemption gates as opposed to a floating NAV, which would lower profitability and would negatively impact investor perceptions of prime institutional funds. Additionally, newly added SEC commissioner Kara Stein has expressed concern about redemption limits. These concerns may have originated with a April 2014 Fed study that suggests that investors could engage in preemptive runs, pulling their money out of funds as they neared liquidity cut-offs that trigger the redemption gates. 9 Additional regulation will cause investors to hesitate about leaving all their operational money in money market funds if there is a risk of not being able to redeem all of it when they require it. Investors may pull at least some of their money from the affected money market funds and look toward other short term vehicles. No specific date has been announced for the release of the new regulation but speculation has targeted an announcement in summer At the May 22nd Investment Company Institute Conference, SEC Chairwoman Mary Jo White stated that new rules imposing safeguards on MMFs would be out in the very near term, bolstering speculation that the news could come in the next few months. However, reports emerged in mid-june that there remained significant disagreement amongst the SEC commissioners about the details of the reform. This continued debate could postpone the announcement of reforms later than previously anticipated, maybe into the fall. It is important to note that the announcement of reforms will occur well before any actual regulations are put into effect and become enforceable. The SEC has hinted at a long lead time for funds to adapt to the new regulations. While firms such as Fidelity have asked for a grace period of at least three years, the SEC has indicated that it is considering a two year transition, meaning no changes will take effect until 2016 at the earliest.

5 Timeline of Reform Sept Lehman collapse; Reserve Primary Fund breaks the buck Jan SEC reforms target MMF guidelines Nov FSOC asks SEC for more MMF reforms June 2013 SEC suggests NAV float and gates, open to Industry comment (Estimate) Summer 2014 SEC rule announcement (Estimate) Mid 2016 Rules fully implemented Conclusion The extension of regulation over prime money market funds could have a dramatic impact on their desirability. As suggested by the SEC s own research into the ability of government MMFs to handle the exodus of investors from prime MMFs, reform will cause a redistribution of how institutions will store their money in the short term. Options include money market funds exempt from regulation such as tax-exempt and government funds, bank deposits, separately managed accounts, and short duration bond funds. 65% of organizations would either eliminate or reduce their MMF allocations should a floating NAV structure be adopted. 10 A gated system may not lead to quite as dramatic a flight from MMFs, but the increased costs of maintaining additional capital and lower yields would disproportionately affect smaller funds who could not pass along these costs and thus close, leading to MMF consolidation and a shrinking asset base in the money market industry overall. While a portion of money held in prime funds will be transferred to government and tax-exempt funds, many investors seeking greater returns will continue to look beyond MMFs in favor of short duration bond funds or separately managed accounts such as those at Payden & Rygel. For alternative cash management vehicles, the primary impact of money market fund reform will be increased demand. Sources: 1 Investment Company Institute Money Market Funds Weekly Report, May 29th, Note that the distinction between retail and institutional funds follows industry standard and not the SEC s $1 million daily redemption limit. 8 Ackerman, Andrew. SEC s Piwowar: Give Investors Money-Fund Choices - MoneyBeat - WSJ. MoneyBeat. Wall Street Journal, 28 Feb Web. 27 May Brady, Steffanie, Ken Anadu, and Nathaniel Cooper. The Stability of Prime Money Market Mutual Funds: Sponsor Support from 2007 to Working paper no. RPA Federal Reserve Bank of Boston, 13 Aug Web. 18 June USA. Federal Reserve. Bank of New York. Gates, Fees, and Preemptive Runs. By Marco Cipriani, Antoine Martin, Patrick McCabe, and Bruno Parigi. Federal Reserve Bank of New York Staff Reports, Apr Web. 13 June Kephart, Jason. Three Money Fund Giants Embrace Daily NAV. InvestmentNews. N.p., 9 Jan Web. 05 June AFP Research AFP Liquidity Survey. Association for Financial Professionals, 19 June Web. 4 Ackerman, Andrew. SEC Set to Alter Stance on Money Funds. The Wall Street Journal. Dow Jones & Company, 25 Mar Web. 05 June Roever, Alex. JP Morgan U.S. Fixed Income Markets: Short Duration Strategy Weekly (9 May 2014). 6 Keen, Stephen. United States: Money Market Fund Reform: The Next Crossroads. Money Market Fund Reform: The Next Crossroads. N.p., 17 Oct Web. 02 June Ackerman, Andrew. SEC Divided on Money-Market Fund Rules. The Wall Street Journal. Dow Jones & Company, 12 June Web. 13 June 2014.

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