Three Ways Money Funds Could Protect the Buck
April 18, 2011
The Securities and Exchange Commission on May 10 plans to hold a roundtable discussion on how to guard against systemic risk involving money market funds, the investment industry's $2.8 trillion alternative to checking accounts.
The discussion comes less than three years after the failure of the nation's oldest money market fund, the Reserve Primary Fund, which suffered a run on its assets in September 2008 because those assets were concentrated in Lehman Brothers holdings. The fund's net assets "broke the buck," meaning their value fell to 97 cents a share, instead of $1, the bedrock promise of shares in these funds.
The roundtable will include participants from the Financial Stability Oversight Council, the body set up by the Dodd-Frank Wall Street Reform Act to mitigate "systemic" risk in the finances of the U.S. economy.
To prevent a recurrence of the Reserve collapse, where the U.S. government actually stepped in and provided reserve funds to Reserve shareholders, the Investment Company Institute in January proposed the creation of an industry-funded Liquidity Facility, for a future emergency.
But exchange-traded fund giant BlackRock and mutual fund paragon Fidelity Investments want funds to stand on their own. BlackRock wants "special purpose entities" created (and regulated) that can only operate money market mutual funds. And Fidelity recommends that every fund be required to retain a portion of its income to build a reserve against potential losses.
Here's how the three approaches stack up, in each case. The descriptions are in the organizations' own words, as submitted to the SEC in comment letters.
ICI: Private Emergency
A private emergency liquidity facility for prime money market funds has the most promise, with the least negative impact.
The proposed facility is an industry-sponsored solution intended to enhance liquidity for prime money market funds during times of unusual market stress. Our proposal contemplates that all prime money market funds would be required to participate.
The facility would be formed as a state-chartered bank or trust company, and would be capitalized through a combination of initial contributions from prime fund sponsors and ongoing commitment fees from member funds. Additional capacity would be gained from the issuance of time deposits to third parties.
Prime money market funds that did not participate would be required to switch to a floating net asset value or to a Treasury or government fund.
During times of unusual market stress, the facility would buy high-quality, short-term securities from prime money market funds at amortized cost. This function has two main benefits. First, the facility would enable participating funds to meet redemptions while maintaining a stable $1.00 NAV, by ensuring them a purchaser for high quality, short-term paper, essentially serving as a dedicated market maker when markets are frozen.
Second, in doing so, the facility would help protect the broader money market by allowing funds to avoid selling into a challenging market, mitigating a downward spiral in the market prices of money market instruments.
The facility would be a state-chartered bank or trust company, compliant with applicable banking laws. It would be a member of the Federal Reserve, eligible to access the discount window in the ordinary course, and would issue time deposits that are eligible for Federal Deposit Insurance Corporation insurance, although the facility would not seek to insure those deposits.
The facility would have two direct sources of capital. Initial capital would come from sponsors of prime money market funds, based on their assets under management, with an aggregated target initial equity of $350 million. The minimum contribution for the smallest funds or new market entrants would be $250,000 and the maximum contribution would be capped at 4.9% of the total initial equity.
The facility also would require ongoing commitment fees of its member funds, which would accrue for the benefit of current and future money market fund shareholders, not liquidity facility equity holders.
Special Purpose Entities
Our proposal would require the sponsor or investment manager, not the money market fund itself, to be regulated as a special purpose entity (SPE) and to hold capital.
We believe that this SPE structure, combined with access to liquidity through the Fed window, would address both idiosyncratic (i.e., limited to one or a few funds) and systemic risk while permitting the current Rule 2a-7 money market fund structure to continue with its advantages for investors and the financial markets.
Money market funds are currently pass-through vehicles in which interest earned, less fees and expenses, is passed through to investors. Under current rules, the manager of a fund cannot accrue a liability or record "capital/reserves" in retained earnings to cover future potential losses. Our proposal entails a new structural approach in which money market funds would be managed by a SPE with a charter limited to managing money market mutual funds.