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From Securities Regulation Daily, September 12, 2013

Federal Reserve Bank presidents support SEC proposal of floating NAV and enhanced disclosure for money market funds

By Jim Hamilton, J.D., LL.M.

In a letter to the SEC, the presidents of the 12 Federal Reserve Banks expressed their support for a floating NAV for money market funds as the best avenue for reform of this vital sector. The central bankers urged the SEC to pursue this option and consider ways in which the benefits of a floating NAV could be enhanced, such as continuing to monitor funds’ procedures for determining that amortized cost accurately reflects fair value and eliminating the retail exemption. More broadly, the Fed senior officials accept the principle that the disruptions in the ability of money market funds to function as credit intermediaries can have a significant negative impact on the broader financial system and that, despite the SEC’s meaningful 2010 amendments, such funds remain a significant risk to financial stability. Thus, they urged the SEC to proceed with these additional reforms.

In its proposed release on money market reform, the SEC is considering two alternatives that could be adopted alone or in combination. In one scenario, prime institutional money market funds would be required to transact at a floating NAV, while Government and retail money market funds would be allowed to continue using stable NAV. In the other, non-government money market funds would be permitted to use liquidity fees and redemption gates to reduce run risks in times of stress.

The Federal Reserve Bank presidents do not believe that the liquidity fees and temporary redemption gates alternative would constitute meaningful reform since this alternative bears many similarities to the status quo. In their view, investors would still have an incentive to be the first to redeem, and the price of those early redemptions, before the trigger is breached, may still be inaccurate and unfair to remaining shareholders if such redemptions occur under a fixed NAV regime.

Liquidity fees and temporary redemption gates notwithstanding, however, the Fed officials recognize the importance of maintaining a fund board’s ability to suspend redemptions in order to liquidate a fund as specified in the 2010 amendments to SEC Rule 2a-7.

Floating NAV. If properly implemented, noted the officials, a floating NAV requirement could recalibrate investors’ perceptions of the risks inherent in a fund by making gains and losses a more regularly observable occurrence. Further, the floating NAV alternative reduces investors’ incentives to redeem by tempering the “cliff effect” associated with a fund “breaking the buck.” The first mover advantage is reduced, they explained, because redemptions would be processed at a NAV reflective of the market-based value of the fund’s underlying securities.

The SEC proposes to exempt prime retail money market funds, defined as those with a daily shareholder redemption limit of $1 million or less, from the floating NAV requirement. But the central bankers asked the Commission to make all prime money market funds, including those characterized as retail, subject to the floating NAV requirement. They posited that a structural incentive would remain for investors in retail money market funds that are exempt from the floating NAV requirement to be the first to redeem during times of stress.

While acknowledging that retail investors did not en masse act on this incentive during the crisis, the central bankers cautioned that it cannot be assumed that investor behavior in the future will be the same as in the past. They are also concerned that the $1 million redemption threshold may not fully exclude institutional investors from retail funds, as services might emerge to spread large cash balances across numerous money market funds eligible for the retail exemption. In that event, the entry of institutional investors into retail funds would likely increase the run risk to which the retail investors are exposed.

Liquidity fees and redemption gates. Under this alternative, non-government money market funds would be permitted to transact at a stable share price under normal market conditions, but would be required to impose a stand-by liquidity fee of no more than 2 percent on all redemptions if a fund’s weekly liquid assets were to fall below 15 percent of total assets, unless a majority of the fund’s independent directors determined that such action was not in the best interest of the fund. In addition, the directors may opt to “gate” the fund upon breaching the weekly liquid assets threshold, if they determine that such action is in the best interest of the fund.

The letter to the SEC flatly states that stand-by liquidity fees and temporary redemption gates do not meaningfully address the risks to financial stability posed by money market funds. This option does not eliminate run risk, as investors could have an incentive to redeem before their fund breaches the weekly liquid assets threshold. Because investors are unable to predict how other investors would react once a fund’s weekly liquid assets level begins to deteriorate, noted the central bankers, their safest option may be to run in advance of the fund breaching the trigger. Further, because of the relative homogeneity in many money market fund holdings, the imposition of a liquidity fee or redemption gate on one fund may incite runs on other funds which are not subject to such measures.

Enhanced disclosure. The central bankers strongly support the enhanced disclosure requirements contained in the SEC proposal, under which money market funds would be required to disclose current and historical instances of sponsor financial support; daily liquid assets and weekly liquid asset levels; current NAV rounded to the fourth decimal place; and daily net flows. The SEC also proposes to require money market funds to promptly file (within one business day) a new Form N-CR when certain significant events occur, such as a portfolio security default or insolvency, and weekly liquid asset levels falling below 15 percent under the liquidity fees and redemption gates alternative.

The senior officials also urged the SEC to implement additional steps to enhance disclosure, such as requiring weekly or even daily disclosures of portfolio holdings. During times of stress, uncertainty regarding portfolio composition could cause money market fund investors to redeem if they believe the fund could be exposed to distressed assets. More frequent disclosure alleviates this uncertainty.

The Fed officials also suggested that the SEC consider requiring money market funds to publicly disclose their ten largest investors on a weekly or monthly basis. But they hastened to add that the identity of individual shareholders need not be disclosed, just the size of their investment in the fund. Under current requirements, all mutual funds disclose shareholders that own 5 percent or more of the outstanding shares of a class of funds.

This information is reported annually in mutual funds’ Statement of Additional Information (SAI) with a significant lag. In the Fed presidents’ view, enhanced disclosure would allow investors to better assess the shareholder concentration risk in the fund. A fund with a small number of large investors is more likely to experience large redemptions, they reasoned, and is thus more exposed to liquidity risk compared to a less concentrated fund.

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