On July 17, Craig M. Lewis, who has just ended his tenure as Chief Economist of the U.S. Securities and Exchange Commission (SEC) and moved back to his position as Madison S. Wigginton Chair of Management at Owen Graduate School of Management, Vanderbilt University, held a SAFE Policy Lecture on U.S. money market funds (MMF) and their regulatory reform. He was introduced by Professor Christian Schlag, Program Director of the SAFE research area “Financial Markets”.
Lewis started by reviewing the structure of MMF, a type of fund holding highly liquid, short-maturity assets that is quite popular in the U.S. MMF provide on-demand liquidity, just like a bank account; yield enhancement, because the securities they own pay a higher yield than a bank account would; and price stability, because they are legally allowed to mark their portfolios to book value, not market value, and thus maintain a constant share price of $1. In the US, money market funds are very popular both among individual retail investors, corporate treasuries (often for short-term cash management), and institutional investors.
The Lehman bankruptcy brought money market funds into the limelight
He noted that the money market fund industry came into the limelight after it exhibited run-like behavior in the US financial crisis, in 2007-08. One of the “prime” funds, that invest in short-term corporate debt, Primary Reserve, had invested heavily in Lehman Brothers commercial paper (CP). The bankruptcy of Lehman led the fund to “break the buck” – that is, its marked-to-market share price diverged from its book share price of $1 by more than 0.5%; in the wake of this, there was a huge withdrawal of funds from prime MMFs, most of which were reinvested into government security holding, risk-free MMFs. Of course, this might be a flight to quality, a flight to liquidity, or a flight to transparency. However, an additional incentive to run had to do with what Lewis calls the “built-in redemption put option” that the book value pricing of MMFs provides: if investors suspect the portfolio is worth less than the book value of $1 per share, they can still sell at $1 a share until the MMF assets run out.
In 2010, the SEC made two initial post-crisis regulatory changes to American money market funds: firstly, it restricted the portion of funds that could be invested in so-called Tier 2 (illiquid, risky) assets; and secondly, it limited the maximum maturity of securities MMFs can hold from 90 to 60 days. Lewis noted these two measures alone reduced the chance of “breaking the buck” 9-fold.
However, the SEC has concluded that those reforms were not sufficient, especially because of the fact that money market funds are still allowed to invest up to 5% of their funds in any one particular security. There has been some internal debate within the SEC on what additional alternatives, if any, should be taken. Bank regulators (e.g. the Fed) were worried because they saw money market funds as systemic; hitherto they have been crucial for many American banks’ short term funding models, loaning from MMF through issuing CP.
Obviously, one could theoretically use bank regulation directly to require American banks to restrict their reliance on commercial paper-based short-term funding; but this solution is not politically feasible in the U.S. Thus, American regulatory agencies are pursuing an indirect approach, by looking for ways to ensure that MMFs will always have funds available to continue buying bank CP.
Imposing a capital buffer, liquidity fees or a withdrawal gate?
Lewis pointed out that any MMF regulation would automatically affect one of the three merits he laid out earlier. To preserve yield enhancement, one could require MMFs to implement floating net asset value (NAV) share pricing – i.e. pricing at market value, not book value. However, this is not as easy as it sounds because there are no secondary markets for some of the securities in their portfolios (e.g. bank CP). Also, floating NAV would mean giving up a stable price. To preserve stability, on the other hand, one could introduce a capital buffer to absorb losses. However, the capital would have the entire extra yield, because it would also carry all the risk. A recent SEC proposal (ultimately rejected) and a European Securities and Markets Authority (ESMA) proposal in Europe (currently on hold) both proposed implementing a 3% capital buffer for MMFs – Lewis noted that this represents a figure that is larger than any single loss in the history of MMFs. The final alternative would be to require MMFs to impose liquidity fees (whereby in a run-like situation, they would be allowed to charge investors wanting to withdraw a 2% fee) or a withdrawal gate (i.e. temporarily suspend withdrawals). Imposing a floating NAV would essentially mean turning money market funds into mutual funds; whereas imposing a capital buffer would make them more bank-like.
Lewis told the audience that the SEC currently seems to be leaning toward combining a floating NAV requirement with liquidity fees and withdrawal gates as its final proposal for U.S. MMF regulation, which is set to be finalized in the summer/fall 2014.