Since the Reserve Primary Fund ‘broke the buck‘ in September 2008, there have been concerns regarding the risks investors would face should there be another ˜run’ on money market assets. The first set of reforms came in March 2010, when the agency adopted reforms to reduce interest rate, credit, and liquidity risks in the funds. Not satisfied, regulators have been pushing for even stricter reform.
The new rules, adopted by the SEC on July 23, 2014 by a 3-2 vote, are divided into three primary areas of reform, which include fund: structure, fund diversification, and disclosures.
To assist in the implementation of the new rules, the SEC segmented money market funds by the type of investor, either institutional or retail. A retail fund is any fund beneficially owned by a natural person and an institutional fund is any fund not owned by an individual. The SEC expects a social security number to be used to confirm ownership by a natural person.
Additionally, the agency focused on three types of money market mutual funds: prime, municipal, and government. Prime funds generally invest in a variety of short-term obligations of corporations and banks, as well as repurchase agreements and asset-backed commercial paper. Municipal or tax-exempt funds primarily invest in short-term obligations of state or local governments and their instrumentalities. Government funds invest in Treasury and Agency securities. Under the new rules, a government fund will be required to invest at least 99.5% (the prior definition required 80%) of assets in cash, government securities and/or repurchase agreements collateralized solely by government securities or cash.
The two most significant changes that could affect a money market fund are a floating NAV in addition to liquidity fees and gates.
With a floating NAV, a fund’s daily pricing would fluctuate based on the changes in the market value of the underlying fund securities. This is a huge change from the never changing $1.00 NAV price. The SEC’s intent to impose a floating NAV is to dis-incentivize redemption activity to exploit the possibility of redeeming shares at a stable price even though the fund has incurred a loss due to underlying price declines. Ultimately, the SEC is attempting to address the lack of investor understanding and lack of transparency concerning the risks of money market funds.
According to estimates from SEC staff, almost 20% of money market funds received some support from sponsors in the form of purchased securities from the portfolio or capital support. The SEC wants investors to realize they bear the risk of loss due to price fluctuations, not the fund family or the Federal government.
Along with a floating NAV, a fund is required to price shares to more precise standard of four decimal places instead of the penny round or two decimal places currently used.
These new rules will impact retail and institutional investors differently. All retail investor money market funds will maintain a stable NAV.
The next major change is liquidity fees and gates. These controls will be tied to the level of weekly liquid assets in the fund. Weekly liquid assets are defined as cash, Treasury securities and certain other government securities with a remaining maturity of 60 days or less. Securities that can be converted into cash within one week also fall into this group of assets.
An amendment to a current rule will allow a money market fund to impose a 2% liquidity fee or suspend redemptions (i.e., gate) if the percentage of weekly liquid assets falls below 30% of the fund’s total assets. The amendment gives board of directors of a fund family discretion to impose liquidity fees and a gate if the measures would be in the best interest of the fund. A board could only suspend redemptions for a maximum of 10 days within a 90 day period.
Finally, if the level of weekly liquid assets falls below 10% of total assets, the amended rule requires a fund to impose a 1% liquidity fee unless the board determines the fee would not be in the best interest of the fund.
Government funds owned by either a retail or institutional investor will be exempt from liquidity fees and gates unless the board for the mutual fund voluntarily imposes a fee or gate. In order for the board to impose a liquidity measure, the liquidity fee or gate must be previously disclosed to investors. Prime and municipal money market funds, regardless of investor type, will be subject to the ˜optional’ liquidity fees and gates.
The SEC also adopted amendments to make money market funds more resilient through increased diversification requirements, enhanced stress testing, and improved disclosures to increase transparency to investors and regulators reporting. We will not go into the details of the changes, but we do want to outline a new disclosure aimed to retail investors. The following will be a required disclosure in any advertisement and the prospectus for funds that will maintain a stable NAV (i.e., retail investor):
“You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund may impose a fee upon the sale of your shares or may temporarily suspend your ability to sell shares if the Fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund’s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.”
The amendments become effective at the end of September 2014 (60 days from July 23rd). The SEC has established a 2-year transition period for compliance for the floating NAV amendments as well as the liquidity fees and gates amendments. That means retail investors in a prime or municipal money market fund will not have to worry about potential liquidity fees or gates until July 23, 2016.
As of the end of June, retail money market funds accounted for approximately 40% of the total money market fund assets according to Crane Data LLC.
For a PDF copy of this article, click here. Written by Robert W. Little, Jr., CFA, CPA, VP, Investment Strategy & Research