When the net asset value of Reserve Primary Fund fell below $1.00/share in 2008 (“breaking the buck”) in the U.S., the consequent run on redemptions in money market funds triggered a domino effect on global short-term credit markets. Short-term financing markets froze, and access to credit was impaired. In response, the U.S. Department of Treasury implemented a guarantee program to support the shares of money market funds. The Federal Reserve System also granted extensions of credit allowing banks to finance purchases of commercial paper from money market funds to help slow redemptions in prime money market funds and provide money market funds with additional liquidity.
These extraordinary measures in the U.S., and the effect felt by the short-term credit markets around the world, ignited a debate on whether the current structure of money market funds poses systemic risk. Particularly focusing on the risks of funds that use a stable net asset value pricing mechanism, the funds’ vulnerabilities to “runs” on redemptions, and investors’ misperception that returns are guaranteed, regulators are considering a number of reforms aimed at mitigating systemic risk.
U.S. Proposes Reform Measures
First deemed systemically risky by the Financial Stability Oversight Council (FSOC) and now on the Securities and Exchange Commission’s reform agenda, the future of money market mutual funds in the U.S. remains uncertain. Whether funds should have to adopt a stable net asset value (NAV) pricing (or a combination of stable and floating valuation systems, based on the type of fund) remains at the heart of the issue.
In a recent comment letter to the SEC, CFA Institute recommends both a short- and long-term approach to reforming the industry to reduce the recognized systemic risks implications. Urging the money market industry to eventually move to adopt a floating net asset value valuation for all money market funds, the comment letter supports the SEC’s proposal to immediately adopt an approach that would (1) require institutional money market funds to use a floating NAV and (2) allow retail and government money market funds to continue using a stable NAV, with important qualifications.
Recognizing the challenges in reconciling the need for immediate reform without unduly restricting investor options, CFA Institute hopes that this measured approach will guarantee important safeguards while ultimately leading to a fair value accounting approach for these financial instruments. The industry awaits the SEC’s final say as to what approach it will adopt.
Money Market Fund Reform is Far from Just a U.S. Issue
While U.S. regulators have parried over territorial issues, European authorities have already issued a number of consultations addressing perceived systemic risk implications in money market funds.
Just last month, the European Commission proposed a draft regulation for money market funds that would establish “capital buffers” of 3% for stable NAV funds to support orderly redemptions in times of market stress. It also proposed rules for liquidity management and on exposure limits, including provisions that would require funds to maintain at least 10% of portfolio assets in instruments that mature within a day and 20% that mature within a week.
And this comes on the heels of a 2012 EC proposal seeking to address the risks involved in money market funds using a stable (or constant) net asset value (CNAV). In its response to that consultation, CFA Institute again noted strong support for mark-to-market valuation methodologies, while also recognizing the range of uses of money market funds and need for improved regulation for CNAV funds. In particular, the letter recommended that sponsors providing capital guarantees be required to maintain capital reserves and that funds adopt enhanced liquidity structures.
Enhanced Disclosures for Investors
While regulations proposed in Europe and in the United States may emphasize different aspects of reform, regulators in both regions note the confusion by some investors that investments in money market instruments may be “riskless.” To that end, CFA Institute comment letters filed with both regulators strongly urge better and more prominent disclosures in all relevant fund documents that clearly address, among other things, the misconception that returns are guaranteed and that sponsors are obligated to provide support to the funds in times of stress.
While regional regulators may emphasize different regulatory approaches to shoring up the money market industry, what remains clear is their agreement that money market funds, in their current form, continue to present systemic risks. And given the interconnectedness of our financial markets, no region can consider the potential risks to its market without also considering the risk implications for the global markets. We need not go back any farther than 2007 to be reminded of the precarious interdependency of market risks. Let’s hope the regulators in both regions get this one right.
For more on the investor perspective on this issue, review the CFA Institute Money Market Funds Survey Report providing views of both European and U.S. members.
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