This article originally ran on November 18, 2014.
By Byron Bowman
In August, the financial press covered the Securities and Exchange Commission’s (SEC’s) amendment of Investment Company Act Rule 2a-7, otherwise known as the “Money Market Fund Rule” (or, as I’ll refer to it, the Rule). The changes the SEC made came after five years of controversy, but were probably as clear as mud to the public.
I’ve been asked to explain the changes to the Rule and to comment on its effect on you and your customers.1
The first part is hard, but the second part is easy — it’s unlikely that you or your customers will actually experience anything more than negligible change under the Rule.
As you probably know, money market funds (MMFs) are mutual funds that invest in high-quality, short-maturity securities. Because of the Rule’s limitations on their portfolio holdings, MMFs have been permitted to maintain their price-per-share at $1, inspiring the slogan, “a dollar in, a dollar out.” Since MMFs were first established in the late 1970s, there had never been a failure of a money market fund to meet this standard — until the financial crisis of 2008-2009.
The overnight demise of Lehman Brothers forced one major fund — the Reserve Fund — to “break a buck” when it was forced to devalue its Lehman holdings. This failure resulted in a run on many MMFs, particularly those that invested in commercial paper. In turn, this threatened the liquidity of the commercial paper market — the source of liquidity for many major industrial corporations. Only when the federal government stepped in and offered a guarantee of liquidity in the commercial paper market did the “run” on MMFs end. Interestingly, no MMF was ever forced to rely on this guarantee, and no other MMF “broke a buck.”
In the past five years, the SEC and the fund industry have debated what changes, if any, were necessary in order to prevent a recurrence of this situation. In August, the SEC finally adopted amendments to the Rule intended to accomplish this goal. To do this, the SEC divided MMFs into four categories:
- retail MMFs, which are open only to investment by natural persons (individuals);
- institutional MMFs, which are open to investment by anyone;
- government MMFs, which invest only in government securities; and
- non-government MMFs, which invest in commercial paper, municipal securities, or other non-government securities.
The SEC then imposed certain requirements on certain of these categories of MMFs:
- All retail MMFs and government institutional MMFs may continue to value their shares at $1 per share.
- Non-government institutional MMFs must allow their shares to “float,” that is, they must be valued at the market every day, just like other mutual funds.
- All non-government MMFs (both retail and institutional) must institute either liquidity fees or “gates” to discourage redemptions in the event of a liquidity crisis (a shortage of cash in their portfolio).
- Government MMFs (both retail and institution) may institute either liquidity fees or “gates,” but they aren’t required.
Liquidity Fees: Any MMFs may institute a liquidity fee of up to 2% on each redemption if cash and cash equivalents fall below 30% of total assets. Non-government MMFs (both retail and institutional) must institute a liquidity fee of 1% on redemptions if cash and cash equivalents fall below 10% of total assets.
Gates: As an alternative to liquidity fees, any MMF may temporarily suspend redemptions for up to 10 business days in a 90-day period if cash and cash equivalents fall below 30% of total assets. (But non-government MMFs will still be required to charge a 1% liquidity fee if cash and cash equivalents fall below 10% of total assets.)
What, you are probably wondering, will this mean to me and my clients? The answer is: Probably nothing.
First of all, almost all of the MMFs in which your clients invest will become Retail MMFs, so they won’t be affected by the “floating NAV.” (A lot of MMFs may split into retail and institutional “Fundlets.”)
Second, MMF portfolio managers will make every effort to avoid the 30% and 10% liquidity barriers. Although some government MMFs may choose not to adopt liquidity fees or gates, I anticipate that most retail government MMFs will implement these safeguards.
Third, these limitations may cause MMF rates to decline, due to the liquidity barriers. It’s unlikely that this will affect rates in good times, but if market rates rise rapidly or another credit crisis occurs, portfolio managers will be forced to shorten the maturity of their portfolios, resulting in lower rates of return.
Finally, most MMF managers already manage their portfolios within strict guidelines, so it’s unlikely that these new guidelines will have any material effect on the way they manage. Remember, only one out of thousands of MMFs “broke a buck” in the worst credit crisis of our lifetimes — a substantially better record than the banks.
All in all, MMFs remain a safe and secure investment for your clients’ cash and a useful tool for managing their accounts.
Byron F. Bowman is general counsel, PlanMember Financial Corporation.
1 Given that the release adopting the amendment to the Rule ran more than 800 pages in 12-point type (or 250 pages in itty-bitty Federal Register type), this will be like condensing "The Bourne Supremacy" to: “POW!”