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From Securities Regulation Daily, June 5, 2013

SEC Proposes to Revamp Money Market Funds; The Long Road From 2010

By Mark S. Nelson, J.D.

The SEC today unanimously proposed a draft of new money market mutual fund (MMMF) rules aimed at taming run risks. The proposal comes just months after the Financial Stability Oversight Council (FSOC) pressured the SEC to act by issuing its own recommendations. Today’s proposal offers two alternatives: (1) float net asset values (NAVs) for institutional prime MMMFs, but exempt equivalent retail and government funds; and/or (2) permit MMMF boards to impose liquidity fees and temporary redemption gates.

The proposal specifically asks for public comment on whether the SEC should combine the two alternatives. According to the proposing release, a combined rule that requires floating NAVs for some MMMFs and allowing for fees and gates would give funds the largest possible emergency toolkit to minimize losses during crises and may best assure the equitable treatment of fund shareholders.

SEC open meeting. SEC Chairman Mary Jo White said in her opening remarks that the proposal seeks to reduce the likelihood of runs on MMMFs during times of economic stress. She noted that these funds hold $3 trillion in assets and that one MMMF failed despite extraordinary government assistance during the 2008 financial crisis.

Chairman White observed that the SEC has consistently viewed the 2010 reforms as a “first step” and that today’s proposal takes the next step in further reforming MMMFs. “These proposals are important in and of themselves and because they advance the public debate that will shape the final rules to address one of the most prominent events arising from the financial crisis,” said Ms. White.

Norm Champ, Director of the SEC’s Division of Investment Management, said the proposal addresses four key items: (1) redemptions; (2) contagion from redemptions; (3) enhanced transparency; and (4) ensuring that MMMFs retain key features. On this last item, Mr. Champ said that investors’ beloved MMMF features would be kept in place “to the greatest extent possible.”

A defining characteristic of today’s proposal is its cost-benefit analysis. The SEC’s Division of Risk, Strategy, and Financial Innovation (RSFI) has been deeply involved in crafting the data analysis that allowed the investment management division to bring today’s proposal to the Commission. Craig Lewis, RSFI’s Director, said today’s release integrates the staff’s economic analysis throughout the proposal, and there is no stand-alone cost-benefit section.

Commissioner Elisse B. Walter shepherded the proposal during her brief tenure as SEC chairman earlier this year. Ms. Walter said her “preliminary preference” is to adopt the combined alternatives, and she cautioned against assuming the Commission will decide between them.

Commissioner Luis A. Aguilar noted that the proposal addressed the topics of greatest concern to him: retail funds and economic analysis. With respect to economic analysis, he had been concerned about the potential that new reforms may cause MMMF holdings to migrate to risky, less-regulated funds. He also said the proposal addressed his concern that new reforms adequately distinguish between retail and institutional investors because retail investors did not flee MMMFs during the 2008 financial crisis.

According to Commissioner Troy A. Paredes, the floating NAV alternative is unlikely to be effective because the cost-benefit analysis does not support this option as a way to stop runs. He said that, while the data analysis is uncertain, the 2008 MMMF crisis likely resulted from a flight to safety that would have occurred even if there had been a floating NAV.

Mr. Paredes, however, said he could support letting MMMFs’ boards impose liquidity fees and redemption gates. He said today’s proposal was the first time that the gate/redemption alternative had been proposed as a possible stand-alone option. He also said that concerns about preemptive redemptions are “overstated,” although he shared Commissioner Aguilar’s concerns about the migration of investors to riskier funds.

Commissioner Daniel M. Gallagher said today’s MMMF proposal is “a very good one.” He noted that RSFI’s recent study had changed the MMMF reform process for the better. Mr. Gallagher also remarked how difficult it was for him to believe that the SEC had come so far since last year’s failed MMMF proposal.

Commissioner Gallagher expressed support for both options. He said that the floating NAV will reiterate that MMMFs do have risks and are not equivalent to bank deposits. He also said that redemption gates are the only way to stop a run. According to the commissioner, the proposal would expand Investment Company Act Rule 22e-3’s authority for liquidating MMMFs to suspend redemptions.

Mr. Gallagher said that he had changed his views on the floating NAV since 2012 because today’s proposal squarely addressed key issues glossed-over by the earlier proposal, including tax and accounting issues regarding cash equivalents. He also said that the 2012 proposal had been rushed forward without adequate input from other commissioners or the SEC staff.

Mr. Gallagher also said today’s proposal did not address the Commission’s need to remove references to credit ratings from MMMF rules. The proposing release, however, explicitly states that the SEC did not rescind its 2011 proposal to accomplish this task and that the SEC will act later. Today’s proposal is limited to reform of Investment Company Act Rule 2a-7.

Moreover, Mr. Gallagher noted that today’s proposal does not contain a capital buffer. Mr. Gallagher said the capital buffer considered in 2012 would have been either too small to be effective or too costly for funds. He said that the inclusion of a capital buffer in the defunct 2012 proposal was a key flaw.

Commissioners Walter, Aguilar, and Paredes each mentioned that the SEC is best suited to tackle new MMMF reforms. This was a clear reference to FSOC’s 2012 proposed recommendations. Mr. Paredes said that he believed the SEC would have proposed new MMMF reforms without “intervention” from FSOC.

With the exception of Chairman White, the SEC Commissioners who voted on today’s MMMF proposal are the same ones who, for many reasons, could not agree on a proposal last fall. It is likely that at least two of these Commissioners will not participate in a future vote on whether to adopt final MMMF reforms.

On May 23, 2013, President Obama nominated Michael Sean Piwowar and Kara Marlene Stein to replace SEC Commissioners Elisse B. Walter, whose term has expired, and Troy A. Paredes, whose term will soon expire. Commissioner Paredes has said that he will remain at the SEC until his replacement takes office. The Senate has received both nominations and has referred them to the Senate banking committee.

Floating prime NAV. The SEC’s proposal would require prime institutional MMMFs to use a floating NAV. The purpose is to reduce run risk and improve transparency. According to a fact sheet issued by the SEC, the rule would bar prime MMMFs from fixing portfolio security values based on amortized cost. Similarly, these funds would switch from penny rounding to basis point rounding, which the proposal said requires a greater degree of precision (1/100th of 1 percent or 4 decimals for some funds).

Although the proposal would rescind rules no longer applicable to prime institutional funds, the proposing release clarified that other risk-limiting conditions will still apply to MMMFs. The proposing release also noted that a floating NAV may not completely stop runs. For this reason, the proposal sought comment on numerous questions about the efficacy of a floating NAV.

Government and retail MMMFs, however, would be exempted from the floating NAV requirement. These funds would continue to use penny rounding to calculate stable NAVs. The exemption recognizes the differences between institutional and retail funds.

Under the exemption, “government money market fund” means a MMMF that has, at minimum, 80 percent as cash, government securities, or repurchase agreements that are collateralized by government securitiesLiquidity fees and gated redemptions. The SEC also proposed liquidity fees and redemption dates that may be adopted as stand-alone reforms or in combination with the floating NAV alternative. Unlike the floating NAV alternative, however, the proposing release said that the fee/gate alternative would allow MMMFs to have stable share prices. According to the proposing release, fees and gates should work in tandem in order to maximize their impact due to their varied trade-offs.. “Retail money market fund” means a MMMF that bars a shareholder from redeeming over $1 million per business day.

Liquidity fees and gated redemptions. The SEC also proposed liquidity fees and redemption dates that may be adopted as stand-alone reforms or in combination with the floating NAV alternative. Unlike the floating NAV alternative, however, the proposing release said that the fee/gate alternative would allow MMMFs to have stable share prices. According to the proposing release, fees and gates should work in tandem in order to maximize their impact due to their varied trade-offs.

A MMMF could require all redeeming shareholders to pay a 2-percent liquidity fee if the fund’s weekly liquid assets (WLA) fell below 15 percent. Even then, a fund’s board could decide that imposing a fee is against the fund’s best interests, although a fund’s board could decide that a lower fee is best for the fund.

Currently, Investment Company Act Rule 2a-7(c)(5)(iii) requires MMMFs to have WLA equal to 30 percent of total assets. Rule 2a-7(a)(32) defines “weekly liquid assets” to mean cash, direct U.S. government obligations, government obligations that have remaining maturities of 60 or fewer days, and securities that are payable within 5 business days. The proposal would allow liquidity fees if a fund’s required minimum WLA has been cut in half.

Notably, the proposing release cited behavioral economics in support of liquidity fees. Citing to work by Daniel K. Kahneman, the proposing release suggested that, because of investors’ dislike for certain losses, they may opt to stay in a troubled MMMF because the prospect of future losses is more palatable than the certainty of paying the liquidity fee if they redeem. The theory would hold even if the amount of the future losses could exceed that of the near-term fee.

The proposal also would require MMMFs to conduct stress tests on WLA amounts under the 15-percent threshold. The proposal contains more stress-test enhancements, including enhanced methods for reporting results to fund boards.

Gated redemption rules would give MMMF boards authority to temporarily suspend redemptions for up to 30 days. A gate would automatically lift once the fund had restored its WLA to the required 30-percent level. The proposing release said that many commenters on the SEC’s 2009 proposal had expressed interest in temporary redemption gates.

The proposing release said that the gate provision is broader than the authority under existing Investment Company Act Rule 22e-3 and that gates can function as “circuit breakers” that may give a fund “breathing room.” Brian Johnson of the SEC’s Investment Management staff told the Commission today that the purpose of the gate option is to help a troubled MMMF to regain its liquidity. The gate, said Mr. Johnson, “let[s] assets mature to give liquidity and limit panOther 2013 proposals. The SEC proposed a number of new disclosure requirements beyond the two alternative reform tracks. MMMFs would have to disclose material events on new Form N-CR. Material events include fund action regarding liquidity fees or gates, defaults by portfolio securities, failure to maintain a stable share price, and sponsor support.ic.”

Gates cannot be imposed for more than 30 days during a 90 day period. Government and retail MMMFs are exempt from the gate rules, but they can opt-in. The proposing release clarified that, unlike the floating NAV alternative, the fee/gate alternative does not exempt government and retail MMFs. MMMFs would be required to promptly disclose when their WLA falls below 15 percent of total assets and when gates are imposed or lifted.

Other 2013 proposals. The SEC proposed a number of new disclosure requirements beyond the two alternative reform tracks. MMMFs would have to disclose material events on new Form N-CR. Material events include fund action regarding liquidity fees or gates, defaults by portfolio securities, failure to maintain a stable share price, and sponsor support.

The SEC’s 2010 reforms imposed portfolio disclosure requirements to be made by MMMFs on Form N-MFP. These disclosures are now made public after a 60-day time lag. Today’s proposal would amend MMMFs’ reporting obligations on Form N-MFP and eliminate the 60-day lag.

Commissioners Aguilar and Gallagher have publicly expressed concern that new MMMF reforms could drive money from regulated funds to riskier, less-regulated private funds. According to the proposal, large liquidity fund advisers would have to make disclosures on Form PF akin to those made by MMMFs on Form N-MFP.

“Large liquidity fund adviser” means a liquidity fund adviser that has combined money market fund and liquidity fund assets under management of $1 billion or more. The SEC staff emphasized at today’s open meeting that the new Form PF disclosures would be “surgical” in their scope.

Other proposals would address MMMFs’ concentration limits. One proposal requires MMMFs to aggregate affiliates. Another proposal would remove the 25-percent basket regarding a single guarantor. Asset-backed securities would need to be aggregated for purposes of guarantor diversification.

The 2010 Reforms. The road to today’s MMMF reform proposal has been a long one. Chairman White likened the SEC’s path to a “journey.” On February 23, 2010, the SEC issued final rules aimed at curtailing MMMF risks. The immediate goal was to gird MMMFs against some of the risks exposed by the 2008 financial crisis. These reforms fell into three categories: portfolio risk; new disclosures; and redemptions and fund liquidation.

Rules aimed at portfolio risk reduced the amount of total assets that could be held in second tier securities from 5 to 3 percent, a level that would give funds an incentive to hold these securities. The rules changed the concentration limit for these assets from the greater of 1 percent or $1 million to one-half of one percent. Limited remaining maturities for second tier assets had to be 45 or fewer days.

Portfolio maturity requirements also limited weighted average portfolio maturity to no more than 60 days and limited weighted average life to maturity to no more than 120 days. Certain government securities maturity limits were eliminated because few funds relied on them.

Moreover, the 2010 reforms required funds generally to have enough liquidity to meet reasonably foreseeable redemptions under Investment Company Act Section 22(e) and any shareholder commitments. Illiquid securities could be no more than 5 percent of total assets. Taxable funds’ minimum daily liquidity had to be at least 10 percent of total assets (the provision did not apply to tax exempt funds). Funds had to maintain minimum weekly liquidity of 30 percent of total assets.

The 2010 reforms altered how MMMF boards must act. Boards had to designate one of at least 4 nationally recognized statistical rating organizations (NRSROs) whose ratings funds can rely on and determine (at least annually) that these NRSROs’ ratings are reliable. Funds also had to undergo stress testing at intervals set by their boards. The results of stress tests had to be reported to a fund’s board at the board’s next scheduled meeting or more frequently, if appropriate. The reforms, however, did not require MMMF boards to design stress tests.

MMMF disclosure obligations also changed. Each fund had to post a schedule of investments and other portfolio holdings data on the fund’s website. Funds also had to file reports with the SEC on Form N-MFP under Investment Company Act Rule 30b1-7. The SEC was to make these reports public on a delayed basis.

Lastly, the 2010 reforms altered transaction processing requirements and provided a key exemption for purposes of fund liquidation. A MMMF or its transfer agent had to be able to redeem or sell fund securities at a price based on NAV under Investment Company Act Rule 22c-1. Funds also had to be capable of redeeming or selling at a price that did not comport with a stable NAV or price per share. Prompt notice had to be given to the SEC of certain affiliate purchases that rely on Investment Company Act Rule 17a-9.

In the case of fund liquidation, Investment Company Act Rule 22e-3 created an exemption from Investment Company Act Section 22(e) to allow funds to suspend redemptions and postpone related payments to aid the fund’s orderly liquidation.

President’s Working Group. In October of 2010, the President’s Working Group on Financial Markets issued its report on MMMF reforms. The report discussed a variety of reform options, including floating NAVs, creation of an emergency MMMF facility, mandatory in-kind redemptions, insurance, a tiered system with more protections for stable NAV funds, an alternative tiered system that has stable NAV funds with protections just for retail investors, use of the special purpose bank form of organization, and placing limits on unregulated MMMF substitutes.

Reform efforts since the President’s Working Group issued its report have focused on floating NAVs and limits on redemptions. Despite criticism that the floating NAV option may especially impact retail investors, this option persists. The SEC’s 2010 adopting release noted that public comments on the SEC’s 2009 proposal indicated that commenters “strongly objected” to reforms that could alter the stable NAV feature of MMMFs.

Failed 2012 proposal. New MMMF reform ideas had been percolating at SEC ever since the Commission adopted the 2010 reforms. On August 22, 2012, however, then-SEC Chairman Mary L. Schapiro abruptly issued a public statement noting that these reforms were unlikely in the near term. The basis for her statement was that she had been informed that three Commissioners would not support a staff proposal for more MMMF reforms.

Said Chairman Schapiro, “I…consider the structural reform of money markets one of the pieces of unfinished business from the financial crisis.” The chairman also observed that the staff proposal would have provided the Commission an opportunity to receive public comments on these reforms.

Ms. Schapiro noted that some commissioners suggested an alternative approach might be to issue a concept release on new money fund reforms. However, Ms. Schapiro appeared to reject this approach by suggesting that public comment on a proposal would be more valuable. Said Ms. Schapiro: “[a] concept release at this point does not advance the discussion. The public needs concrete proposals to react to.”

She cited two reasons favoring new reforms: (1) MMMFs poorly absorb losses above a certain size; and (2) investors tend to withdraw funds quickly in a crisis resulting in run risk. The SEC had previously considered a floating NAV and mark-to-market valuation to remind investors that MMMF investments are not guaranteed. Alternatively, the SEC could require money funds to have a capital buffer and a minimum balance at risk requirement.

Former Chairman Schapiro also noted that no federal securities laws permit money market mutual funds. Rather, these funds exist due to Investment Company Act Rule 2a-7, which allows money funds to do business in exchange for limits on the types of investments these funds can make. She further observed that, while many sponsors supported their MMMFs during the 2008 financial crisis, there is no legal requirement to provide support, nor is there a guarantee that sponsors will be able to provided support when it is most needed. She noted that Commission staff had logged 300 instances of sponsor support to money funds from the 1980s to the present.

The former chairman issued her statement little more than one week after the Federal Reserve Bank of Boston staff published a report noting that many MMMFs would have broken the buck without support from their sponsors during the financial crisis. The report identified 21 prime money market mutual funds that would have broken the buck without a single instance of sponsor support. The report also found 31 prime money funds would have failed without repeated sponsor support.

One day later, Commissioner Aguilar replied to then-Chairman Schapiro by expressing his support for a concept release, but he raised questions about the potential impact a proposal focused on just one MMMF segment could have under the then-current economic conditions.

Said Commissioner Aguilar: “[t]he cash management industry is a large industry that includes many pooled vehicles exempted from registration and largely excluded from regulatory oversight. There are larger macro questions and concerns about the cash management industry as a whole that must be considered before a specific slice of that industry — money market funds — is fundamentally altered. To move forward without this foundation is to risk serious and damaging consequences in contravention of the Commission’s mission.”

Specifically, Commissioner Aguilar said that a concept release would allow for an opportunity to study the entirety of the cash management industry, as well as to study the effectiveness of the Commission’s 2010 money market reforms. He also noted that questions had arisen regarding the accuracy of the list of 300 MMMFs identified by Commission staff that may have received sponsor support during the last several decades. A concept release would provide an opportunity to conduct rigorous data analysis of money markets to inform a future reform proposal.

Commissioner Aguilar also expressed concern that the “mere publication” of a money fund reform proposal may cause investors to move large sums from regulated, more transparent money market funds to unregulated and less-transparent corners of the money markets. According to Commissioner Aguilar, “[s]uch transfers could cause significant damage to the country’s short-term capital markets.”

A joint statement issued by Commissioners Paredes and Gallagher nearly one week after Ms. Schapiro’s announcement said they were “dismayed” by her statement and viewed their reply “ one step in setting the record straight.” Both commissioners, however, praised Commissioner Aguilar’s earlier statement.

Commissioners Paredes and Gallagher said that, while they were not opposed to new MMMF reforms, they believed the Commission should evaluate alternatives to a floating NAV and capital buffers with holdback restrictions. Specifically, there was insufficient data to show how a floating NAV and capital buffer would perform during a financial crisis.

According to Commissioners Paredes and Gallagher, a “flight to quality” may “overwhelm” a capital buffer and thus negate the benefits of any holdback requirements. Similarly, the commissioners said that a floating NAV, which logically means a fund cannot break the buck, still may not stop investors from leaving money funds during a crisis because investors would have an incentive to leave early to get the highest valuation. As a result, the prospect of future government policy support for commercial paper markets during crises would remain.

Commissioners Paredes and Gallagher also noted the lack of data analysis suggesting that the 2010 money fund reforms were ineffective. The commissioners observed that MMMFs have since withstood some big economic events, including the European economic crisis and the 2011 U.S. debt ceiling crisis and credit rating downgrade. Said the commissioners, “[w]e agree with Commissioner Aguilar that even just proposing rule amendments that advance the Chairman’s alternatives at this time could have harmful consequences.”

Additional MMMF reforms, said Commissioners Paredes and Gallagher, must be founded on empirical analysis that shows the reforms would be effective without disrupting MMMFs and short-term credit markets. Specifically, the commissioners favored an approach that includes discretionary gates on redemptions, improved disclosure of money fund risks, and further study of key questions about money market funds.

Questions the commissioners asked SEC staff to review covered a range of topics, including: (1) the behavior of investors during the 2008 crisis regarding flows of monies from prime money market funds to Treasury money market funds; (2) the effectiveness of the 2010 reforms; (3) where sums now invested in MMMFs could migrate to if large numbers of investors left money market funds due to new reforms; and (4) the impact of outflows from money market funds on commercial paper and municipal debt markets.

Chairman White took the SEC helm on April 10, 2013, with MMMF reforms still looming. In her May 16, 2013, testimony to the House Financial Services Committee, she said “[a] rule proposal pertaining to money market mutual fund reform is well underway at the SEC and has been the product of a comprehensive and collaborative process.” The proposal, she said, would retain key features of MMMFs but would also seek to reduce run risk, limit contagion from redemptions, and improve MMMFs’ transparency.

FSOC pressure. In September 2012, then-Treasury Secretary Timothy F. Geithner urged FSOC to spur SEC action on new MMMF reforms by invoking its power to make recommendations under Dodd-Frank Act Section 120. The Treasury Secretary (FSOC’s chairman) and the SEC chairman are 2 of 10 voting FSOC members. According to then-Secretary Geithner, FSOC was to be prepared to act if the SEC failed to swiftly move forward on new MMMF reforms.

Mr. Geithner noted that MMMF reforms are still needed to improve these funds’ financial stability, despite the SEC’s 2010 reforms in order to address lingering concerns over funds’ loss-absorption capabilities and lessening the redemption risks that arise from the first-mover advantage. Specifically, Mr. Geithner said FSOC should recommend three options for the SEC to pursue: (1) a floating NAV; (2) a capital buffer of less than 1 percent with a minimum balance at risk requirement (MBR); or (3) enhanced capital and liquidity standards that could be mated with liquidity fees or temporary redemption gates instead of a MBR.

In testimony before the Senate banking committee on May 21, 2013, current Treasury Secretary Jacob J. Lew testified on FSOC’s annual report to Congress. Mr. Lew made similar remarks to the House Financial Services Committee the following day. Senator Jack Reed (D-RI) noted that broker-dealers’ reliance on tri-party repos was problematic. Mr. Lew agreed that tri-party repos present a “serious systemic concern” regarding wholesale funding.

In both his testimony and prepared remarks, Mr. Lew noted that both MMMFs and the tri-party repo markets present similar run risks during economic crises. Mr. Lew said some progress has been made on tri-party repos, but that MMMF reforms still loomed. He noted that FSOC had issued proposed recommendations last fall.

On November 13, 2012, FSOC published its recommendations for MMMF reform. The first option was to remove current exemptions that allow for stable NAVs and instead let NAVs float. This option would allow a funds’ share price to track the market performance of its underlying portfolio. This option also would reduce the “cliff effect” and “first-mover advantage” that can result when a fund that maintains a stable $1 NAV breaks the buck.

FSOC’s second option would impose a NAV capital buffer and a MBR. A 1-percent NAV buffer would help to absorb daily changes in portfolio securities’ valuations while a 3-percent MBR for large accounts would help stanch redemptions. Investors could redeem MBR funds on a delayed basis, subject to a requirement that MBRs must be the first funds to take losses beyond a fund’s NAV buffer. Treasury MMMFs and accounts under $100,000 would not have to comply with the second option’s requirements.

Under FSOC’s third option, MMMFs would have a NAV buffer plus a range of additional limits. Here, FSOC said the NAV buffer must be raised to 3 percent to offset the absence of a MBR. Beyond the NAV buffer, FSOC recommended lowering the current non-single-state fund 5-percent limit on securities from one issuer and redefining “issuer” to embrace affiliates of a consolidated group.

The third option may also be teamed with higher minimum-liquidity requirements. This would entail raising the minimum daily required liquidity level from 10 to 20 percent of total assets; a similar amendment would raise the minimum weekly liquidity required from 30 to 40 percent.

Additional disclosures under the third option would enhance and/or increase the frequency of current MMMF website disclosures and required filings on Form N-MFP. The SEC could even accelerate or repeal current built-in delays prior to making these disclosures public. Still other possibilities include requiring disclosure of valuation methods, MMMFs’ boards’ considerations, and whether a fund has received sponsor support.

FSOC’s ability to exert pressure on financial regulators caught the attention of Commissioner Gallagher. Speaking at the PLI-sponsored The SEC Speaks in 2013 conference in Washington, D.C. in February of this year, Commissioner Gallagher noted that independent agency heads serving on FSOC do so ex-officio and that, while the SEC’s chairman may vote for FSOC action, he or she cannot commit the SEC to binding FSOC action.

According to Commissioner Gallagher, FSOC’s structure may reveal its vulnerability to political influence. This is especially true, said Commissioner Gallagher, regarding FSOC’s chairman, the Treasury Secretary, whom the president can remove from office. Commissioner Gallagher also noted that a SEC chairman’s loyalties may be tested by his or her dual SEC/FSOC roles. Commissioner Gallagher observed that FSOC has already issued recommendations on MMMF reforms, thus encroaching upon the SEC’s unique legal and financial expertise.

Despite FSOC’s potential to challenge SEC independence, Commissioner Gallagher noted that recent data published by the SEC’s RSFI Division offered a basis for the SEC to move ahead with another round of MMMF reforms.

Former SEC Chairman Schapiro, however, in a story reported by Reuters yesterday, noted that FSOC’s 2012 recommendations may be partly responsible for the SEC’s latest MMMF proposal. Ms. Schapiro also said that a SEC rule proposal will often fade into obscurity if the chairman lacks the votes to move it forward.

Data on 2010 Reforms. The SEC eventually found a way to propose new MMMF reforms based on data analysis by RSFI that had been requested by Commissioners Aguilar, Paredes, and Gallagher. These commissioners made their request in their joint and separate replies to former Chairman Schapiro’s statement announcing the failure of the 2012 proposal and in a memorandum to Ms. Schapiro and RSFI Director Lewis.

RSFI’s study focused on three issues: (1) why did prime MMMF investors moved their funds to treasury MMMFs during the 2008 financial crisis; (2) whether the 2010 reforms have been effective; and (3) what would have occurred in 2008 if the 2010 reforms had been in effect.

With respect to prime MMMFs, RSFI found that investors likely fled to Treasury MMMFs due to a “flight” to quality, liquidity, transparency, and performance. Investors perceived that Treasury MMMFs were safer and that these funds’ underlying portfolio assets were more liquid than prime funds’ assets. Investors also moved to Treasury funds because of the “first-mover advantage” in order to redeem shares at $1 before prime funds could no longer maintain a stable $1 NAV.

Kathleen Weiss Hanley, Deputy Director and Deputy Chief Economist, speaking on a panel at this year’s The SEC Speaks event in February, noted RSFI’s role in reviewing new data on MMMFs and the 2008 financial crisis. Ms. Hanley confirmed that there was no “dominant explanation” for the flight from prime to Treasury MMMFs, but the shift could be partially explained by quality, transparency, performance, and the substitution effect (but no perfect substitutes exist).

RSFI next found that the 2010 reforms generally have been effective, although many questions remain because of the mixed results of the studies RSFI reviewed. Overall, the highest WAMs at funds dropped, but other funds’ WAMs changed little. Prime funds now tend to have daily liquid assets of 25 percent and weekly liquid assets (WLAs) of 50 percent. MMMFs also have reduced commercial paper holdings, but these results are “confounding” because MMMFs may have previously emphasized short-term Treasury holdings because of the Fed’s operation twist policy.

There also was no clear link between the 2010 reforms and lowered yield volatility. Similarly, RSFI found it difficult to study post-2010 redemptions because no MMMF liquidated during the study period.

MMMFs generally performed well after the 2010 reforms became effective despite two key economic events during the summer of 2011. First, the European sovereign debt crisis led to redemptions in prime MMMFs that had unsecured loan exposures to European banks. The U.S. debt ceiling/rating downgrade crisis led to redemptions at government MMMFs.

The study, however, noted some important differences between 2008 and 2011. The 2010 reforms mandated greater liquidity at MMMFs, and no funds broke-the-buck. The pace of events was much slower in 2011 than in 2008. Lastly, although MMMF investors were unscathed, redemptions due to 2011’s events disrupted commercial paper markets by increasing the scarcity of short-term funding liquidity.

According to Ms. Hanley’s remarks at The SEC Speaks, the 2010 money market mutual fund reforms had lessened overall risk that funds would break the buck. A simulation of 2008 conditions under the 2010 reforms showed that the reforms would have mitigated, but not prevented, funds from breaking the buck. She further noted that the decades-long tension between MMMFs and bank deposits is ongoing and the role these funds play in short-term financing markets is a critical consideration for additional MMMF reforms.

Specifically, RSFI’s study found that The Reserve Primary Fund still would have failed. The Lehman Brothers commercial paper that upended this fund would have had a tier 1 rating that met concentration limits. Although higher WLAs have made funds more resilient, some MMMFs still would have been impacted by 2008’s events.

Disclosures on Form N-MFP required by the 2010 reforms also are no panacea because the delayed release of this form’s data may undermine investors’ ability to make timely decisions. RSFI noted that delayed transparency still might spur MMMF managers to question fund holdings whose ratings and risk are poorly matched.

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