“[B]ecause three Commissioners have now stated that they will not support the proposal and that it therefore cannot be published for public comment, there is no longer a need to formally call the matter to a vote at a public Commission meeting,” Schapiro said in a statement. She added that some Commissioners have instead suggested a concept release, which at this point does not advance the discussion. “The public needs concrete proposals to react to,” she stated.
Retirement plan industry groups also presented objections to the SEC’s proposal in a letter to Schapiro (see “Trade Groups Object to Money Market Fund Regulations”).
Schapiro said she and many other regulators and commentators from both political parties and various political philosophies consider the structural reform of money markets one of the pieces of unfinished business from the financial crisis. She called on other policymakers, who now have clarity that the SEC will not act to issue a money market fund reform proposal, to take this into account in deciding what steps should be taken to address this issue.“One of the most critical lessons from the financial crisis is that, when regulators identify a potential systemic risk—or an industry or institution that potentially could require a taxpayer bailout—we must speak up. It is our duty to foster a public debate and to pursue appropriate reforms. I believe that is why financial regulators, both past and present, both Democrats and Republicans, have spoken out in favor of structural reform of money market funds. I also believe that is why independent observers, such as academics and the financial press—from a variety of philosophical ideologies—have supported structural reform of money market funds, as well,” the statement said.
The Issues With Money Market Funds
While the 2008 financial crisis dramatically exposed the risks presented by money market funds, it also highlighted that the risks stem from flaws inherent in the structure of the funds, Schapiro said. In particular, most of the risks resulted from the valuation standards and stable net asset value (NAV) that are permitted to exist by SEC rule, without any capital or asset cushion to back them up.
Schapiro pointed out two structural issues with money market funds:
- Money market funds have no ability to absorb a loss above a certain size without breaking the buck. Schapiro said that this was seen firsthand with the Reserve Primary Fund, where just over 1% of that fund's assets were held in commercial paper of Lehman Brothers. When Lehman Brothers declared bankruptcy, its commercial paper became worthless, the fund broke the buck, investors began to flee the fund and other funds began to experience high rates of redemptions as a result.
- Investors of money market funds have every incentive to run at the first sign of a problem. Schapiro said this phenomenon played out in the week of September 15, 2008, when over $300 billion was withdrawn from prime money market funds. Under the “first-mover advantage,” those who redeem first get out with their full $1.00 invested, even if the fund's assets are worth slightly less. This leaves all the other investors holding the bag—usually the slower-moving retail investors who can lose both value and access to their money. They lose the value when the fund reaches a mark-to-market NAV of 99-and-a-half cents and breaks the buck. They also lose access, for an unknown period, because fund boards are now permitted to suspend redemptions and liquidate a fund if it breaks the buck.
“This inability to absorb a loss in value of a portfolio security and the incentive to run at the first sign of a problem are the two structural issues we were seeking to address with the proposals under consideration by the Commission,” Schapiro stated.
The Proposed Reforms
The SEC was considering alternative proposals that would address these two structural issues in different ways:
- First, money market funds float the NAV and use mark-to-market valuation like every other mutual fund. This would underscore for investors that money market funds are investment products and that any expectation of a guarantee is unwarranted. In such a scenario, investment losses in money market fund portfolios could be both absorbed and reflected in the price—as would gains, for that matter. Similarly, while the incentive to run may not be reduced entirely, the “cliff” effect of redeeming at $1 or getting stuck with a loss and no immediate access to one's assets would no longer exist.
- Second, and alternatively, is a tailored capital buffer of less than 1% of fund assets, adjusted to reflect the risk characteristics of the money market fund. This capital buffer would be used to absorb the day-to-day variations in the value of a money market fund's holdings. To supplement that capital buffer in times of stress, it would be combined with a minimum balance at risk requirement. That requirement would enable investors to redeem up to 97% of their assets in the normal course as they do today. However, it would require a 30-day holdback of the final 3% of a shareholder's investment in a money market fund. That holdback would take a so-called "first-loss" position and could be used to provide extra capital to a money market fund that suffered losses greater than its capital buffer during that 30-day period. The result is that remaining investors would be unharmed by a redeeming investor's full withdrawal and the incentive to redeem fully and quickly at the first sign of trouble would be diminished.
“I believe these proposals have merit, address the two structural issues identified and deserved to see the light of day so that we could receive public feedback,” Schapiro said.