UNDERSTANDING LIQUIDITY FEES AND REDEMPTION GATES

UNDERSTANDING LIQUIDITY FEES AND REDEMPTION GATES

Over a series of upcoming papers we aim to help money market fund investors understand and assess money market fund rules by exploring the impact of the Securities and Exchange Commission s ( SEC ) recent amendments for Rule 2a-7 under the Investment Company Act of 1940 ( the 1940 Act ) in detail. We will focus on topics such as the floating NAV ( FNAV ), the new definition of institutional and retail funds, rules for increased portfolio diversification, rules for enhanced transparency and new disclosures for private funds sharing characteristics similar to money market funds. Our first area of focus lands on liquidity fees and redemption gates for money market funds. In this paper we focus on the SEC s regulations for fees and gates. We aim to explore the impact of these new features including: } How the new rules build on changes introduced in 2010 around portfolio liquidity and powers introduced to suspend redemptions } How the SEC arrived at the fee levels and liquidity thresholds in the new amendments } Why fees and gates are far from unusual in the US and European mutual fund industry } How the role of fund boards and their discretionary power are critical to the new rules } Why the concept of best interests for a fund and its shareholders is important } Understanding how and why fees and gates may be applied [2] MONEY MARKET FUND REFORM

The Road To Fees and Gates Preservation of capital, daily liquidity, and competitive yields have long been defining characteristics of money market funds, making them a leading cash investment choice for institutional and retail investors. With the recent amendments to Rule 2a-7 announced on July 23, 2014, the SEC has steered the industry into a period of significant change. With a required implementation date of October 14, 2016 for structural changes, the SEC has given industry participants time to digest the new rules and operationally adapt to the new money market fund structures while also giving investors time to evaluate the range of products available to them. The road to this point has been long and complex, with many twists and turns, if not controversy. Since the financial crisis events of September 2008, the SEC s over-riding goals for money market fund reform have been: 1. Increasing transparency thereby mitigating runs on money market funds and the associated contagion that could arise to short-term credit markets and the economy; and WHAT IS A REDEMPTION GATE? A redemption gate is a temporary measure that may be implemented by a fund s board of directors that limits redemptions in a fund for a short period of time (up to 10 business days in a 90 day period). Its purpose is to prevent a run on a fund in times of market stress. 2. Preserving the benefits of money market funds for investors and the markets. SEC changes to Rule 2a-7 in 2010 introduced heightened controls for money market funds around credit risk, interest rate risk and liquidity, as well as increased levels of transparency and reporting. Additional changes were proposed in 2013, and the recent amendments became law in July 2014 following a 3-2 vote by the five commissioners. Building on the extensive research, analysis and debate over the last several years following the 2008-2009 credit crisis, the SEC s new amendments combine floating net asset value (FNAV) per share pricing for institutional prime and institutional municipal funds, and discretionary liquidity fees and redemption gates ( fees and gates ) for all non-government money market funds. In introducing these new regulations the SEC has sought to achieve its stated goals in money market reform. Many commentators have noted that the combination of FNAV and liquidity fees and redemption gates is the most onerous outcome for the industry and investors. While we recognize that change is difficult, we also believe that despite these changes, money market funds will continue to provide a useful solution for cash investors. WHAT IS A LIQUIDITY FEE? For investors who require access to their cash in times of stress, a fee may be levied in order to pay for that liquidity (i.e; investors might be required to pay a fee if they redeem shares during this time). This may be applied at the discretion of the board of directors in the best interest of shareholders of the fund. UNDERSTANDING LIQUIDITY FEES AND REDEMPTION GATES [3]

BACKGROUND The September 2008 financial crisis for money market funds and the short-term credit markets was largely driven by the Lehman Brothers bankruptcy and failure of The Reserve Primary Fund. These events ultimately translated into heavy redemptions from prime institutional money market funds and a short-term funding squeeze that had ripple effects into the wider economy. The SEC and other commentators have maintained that only government intervention in September 2008 allowed money market funds and the short-term markets to continue to operate. Moreover, the SEC believed that the crisis was not only a credit event, but was also caused by the inability of money market funds to raise sufficient liquidity to meet shareholder redemptions when needed. Against this backdrop, the SEC adopted reforms to Rule 2a-7 introducing new regulations for overnight and weekly liquidity whereby money market funds would need to maintain 10% of their portfolios in overnight securities and 30% of their portfolios in securities maturing within a week, or five business days. These changes were widely welcomed by industry participants and in their commentary accompanying the July 2014 amendments to Rule 2a-7, the SEC refers to the effectiveness of these new rules in helping money market funds navigate the European debt crisis in 2011 and the U.S. debt ceiling sagas of 2012-13. DECIPHERING THE NEW RULES The effectiveness of the 2010 reform s 30% weekly liquidity threshold in helping funds navigate periods of market stress is directly linked to the new requirements for fees and gates. 1 The new regulations can be summarized as follows: } Should a fund s weekly liquidity fall below 30%, its board has the discretion to introduce fees on redemptions of up to 2%, and/or gates for a maximum of 10 business days within a 90 day period, if it is in the funds best interests; } Should a fund s weekly liquidity fall below 10% a board is required to introduce a redemption fee of 1% unless the board, through a majority vote of its independent directors decides to introduce a fee that is higher (up to a maximum of 2%) or lower, or no fee at all, whichever is in the fund s shareholders best interests; } As soon as a fund s weekly liquidity exceeds 30% a board must cease to apply either a fee or gate, as applicable; } Gating is always entirely discretionary, and if a board thinks a gate is not in the best interests of a fund, it need not apply it; } Similarly, if a board believes only one of the tools (fees or gates) is necessary it has the discretion to use one and not the other; } Critically, the SEC emphasizes the principal of the fund s best interests whereby a fund s board has discretion whether or not to introduce fees and gates, depending on the circumstances and if the board believes it to be in the best interest of a fund and its shareholders. The concept of a fund s best interests is fundamental in understanding the SEC s recent changes. The SEC stresses that a board s full application of this concept is intended to provide it with the ability to execute the most appropriate solutions to help a fund navigate periods of stress. In its release, the SEC stresses the importance of the board as an independent body of directors making decisions in the best interests of the fund and its shareholders. The fund sponsor does not have a decision making role under the new fees and gates rules but will provide the board with appropriate information for effective execution of those decisions. In the SEC s 2013 Rule 2a-7 proposals, a weekly liquidity threshold of 15% was put forward as the recommended level combined with the ability to introduce gates for 30 days in a 90-day period and a required fee of 2% on all redemptions. In its recent release, the SEC takes great care to explain that the new rules are deliberately structured to provide more flexibility and effectiveness than the 2013 proposals. 1. Applies to all money market funds, except government funds. Application to government funds is optional, and in reality unlikely to be adopted by fund boards for these fund types [4] MONEY MARKET FUND REFORM

WEEKLY LIQUIDITY AND ITS IMPLICATIONS Under a new requirement for fund sponsors, the 30% weekly liquidity threshold is published daily and becomes an amber flashing light for investors. Should a fund s liquidity approach this level, investors will become alerted to the potential for liquidity stresses in the fund. Knowing that crossing the 30% threshold only triggers a board s ability to apply fees and gates, but not the requirement, investors should be diligent in monitoring the various reports and public disclosures made available by a fund s sponsor to help make an informed decision to redeem or remain in the fund. Even at the 10% threshold, investors should be alert to the fact that the tools available to the board provide considerable protection for their assets. Given its new early warning status and potential impact on shareholder s reaction as they seek to avoid gates and fees, the 30% weekly liquidity threshold is likely to have a tangible effect on the way fund sponsors manage portfolios as we expect managers to keep a watchful eye on the liquidity levels in their money market funds. The illustration below explores how the new fees and gates framework can be seen in the context of a large prime institutional money market fund s past weekly liquidity performance and fund sponsor s potential liquidity management objectives. WEEKLY LIQUIDITY ASSETS AS OF MONTH END 60% 50 40 Decrease due to heightened concerns regarding money market funds European bank exposure. Prime MMF weekly liquidity has rarely approached 30%. Averaged 37% over this time period. Liquidity (%) 30 20 10 At all times the board must act in the best interests of a fund and its shareholders. At the 30% threshold a board must meet and has the discretion (but is not required) to introduce either or both fees and gates. At the 10% threshold the fund s board is required to impose a 1% liquidity fee (or more up to 2%, or less, or none at all) unless the fund s board of directors, including a majority of the independent directors finds it is not in the best interest of the Fund. 0 12/10 4/11 7/11 10/11 1/12 4/12 7/12 10/12 1/13 4/13 7/13 10/13 1/14 4/14 7/14 10/14 1/15 4/15 7/15 9/15 For illustrative purposes only UNDERSTANDING LIQUIDITY FEES AND REDEMPTION GATES [5]

THE RATIONALE BEHIND REDEMPTION GATES In providing context for the new gating powers, the SEC referenced a few key points: } Rule 2a-7 already provides boards the ability to suspend redemptions, albeit should this power be used, a fund would need to be liquidated, which will no longer be the case under the new fees and gates rules. } UCITS money market funds in the European Union today have the ability to apply redemption gates, but no runs have been ascribed to this. } Other types of U.S. registered FNAV mutual funds have the ability to suspend redemptions today, but no runs have been ascribed to this capability. The SEC explains that liquidity fees provide investors access to their liquidity, but at a cost. In applying fees during times of stress, a fund board would have the ability to pass the costs of liquidity on to those that use it, rather than allow those costs (in the form of diluted portfolio prices) to be borne by shareholders choosing to remain in a fund. As well as compensating funds for liquidity used by redeeming shareholders, liquidity fees also play the important role of reducing shareholders propensity to flight. That is, some investors may choose to remain in a fund and wait out a crisis rather than bear the costs of accessing liquidity in the form of liquidity fees. In the SEC s words: The amendments should allow funds to moderate redemption requests by allocating liquidity costs to those shareholders who impose such costs on funds through their redemptions and, in certain cases, stop heavy redemptions in times of market stress by providing fund boards with additional tools to manage heavy redemptions and improve risk transparency. 2 In the SEC s recent rule release, they state their belief that money market funds would have managed the impact of the 2008 financial crisis better had these tools been available to fund boards at the time. COMBINING FNAV WITH FEES AND GATES Since 1983, Rule 2a-7 money market funds have been permitted to price their portfolios using amortized cost and/ or penny rounding thereby maintaining a constant net asset value (CNAV) of $1.00 per share. This pricing convention has been a foundation of the money market fund industry, but also has been criticized by many as understating the risks inherent in large portfolios of money market instruments 2. The Federal Register / Vol. 79, No. 157 Thursday August 14, 2014, Rules / Regulations where securities may individually and collectively be experiencing mark to market pricing stresses at a given time, leading to a decrease in the overall portfolio s NAV that is obscured by the fund s ability to round to a CNAV share price using amortized cost and/or penny rounding. In requiring fees and gates for non-government funds and mandating institutional prime and institutional municipal funds to adopt a 4 decimal place share price where changes in the underlying mark to market prices will be more visible, the SEC has moved to a framework of greater transparency where investors are able to assess the risk and quality of their fund investment through multiple signals. The FNAV provides insight into portfolio credit quality and interest rate sensitivity, while the 30% weekly liquidity threshold provides a first level barometer for investors to assess the ability of a fund to provide liquidity. Finally, the 10% weekly liquidity level, a trigger required for board action provided it is in the best interests of the fund, allows investors further insight into a fund s stability. By combining FNAV pricing with fees and gates, the SEC has moved to a framework of greater risk awareness whereby investors are better able to assess the risk and quality of their fund investment through multiple signals. Some commentators view fees and gates as the new break the buck risk for the money market fund industry. This risk (of not maintaining a $1.00 per share NAV) has been viewed by industry participants as having irreparable reputational damage to fund sponsors franchises. With the move to FNAV for institutional funds, the reputational risk for a fund sponsor of breaking the buck may fade, only to be replaced by the implementation of fees and gates as an event from which a sponsor s reputation will not easily recover. The SEC acknowledges this risk but views the positive benefits of introducing tools that allow major outflows from a fund or funds to be managed with more flexibility and sensitivity to a specific situation as critical to mitigating the systemic risk associated with money market fund runs. In the SEC s opinion, fees and gates will provide for more orderly management, and ultimately liquidation of a fund if necessary, than the current framework provides. [6] MONEY MARKET FUND REFORM

Conclusion The requirement for institutional prime and municipal money market funds to float their NAV, in combination with the introduction of fees and gates, is designed to lessen the systemic risks associated with runs on money market funds. Through providing price transparency, the FNAV is intended to reduce the incentive for investors to redeem ahead of others, a practice which the SEC and other commentators see existing under the current constant NAV fund valuation and pricing methods. Fees and gates are intended to slow the incentive for investors to redeem quickly, either through creating the potential for a transfer of the costs of liquidity on to redeeming investors, or through closing a fund to redemptions. These changes potentially represent a major shift for the industry and investors. However, we believe that the usefulness of money market funds is likely to evolve and continue. The utility of these funds will be influenced by many factors including the availability of alternative products, the degree of technological and operational innovation by industry participants, and the practical tax and accounting changes which the IRS and Treasury departments have introduced to ensure FNAV money market funds continue to be viable as cash and cash equivalent investments. There will be costs and operational impact to industry participants as they ensure the logistical frameworks are in place to support the implementation of fees and gates. For fund sponsors, intense focus will be applied to ensuring that weekly liquidity is managed so that fees and gates are regarded by investors as what they are tools that protect shareholders assets in extraordinary conditions, but that they should be considered in the same way as the current rules that allow funds in exceptional circumstances to suspend redemption proceeds for up to 7 days. Fees and gates grant fund boards greater flexibility and control than exists today and enhances the tools that were already at their disposal. By emphasizing the concepts of best interests and discretion in decision-making, the SEC has arguably shifted great responsibility on to fund boards, but also placed control in the hands of a group of individuals best suited to understand the specifics of a fund or funds under their supervision. These measures set in motion by the SEC in the latest amendments are an extension of existing board capabilities and we believe will have a direct impact on fund sponsors and their management of money market funds, particularly their liquidity levels, further enhancing the resiliency of this important product. UNDERSTANDING LIQUIDITY FEES AND REDEMPTION GATES [7]

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