Changes Pending for Money Market Funds
by David Rothon, Global Fixed Income Product Specialist, Northern Trust
The upheaval in the money market fund sector during the past 18 months has prompted a number of proposed regulatory changes in the United States, United Kingdom and Europe. Although designed to enhance the safety and transparency of these investments, the proposed changes are also likely to cause institutional investors to rethink their approach to investing in money market funds.
Investors have demanded a higher level of transparency to understand the underlying risks with a fund.
Money market funds have long been considered a bastion of safety, even during times of financial crisis. That changed last September, however, when the net asset value (NAV) of a US money market fund fell below US$1 per share and the fund couldn’t meet redemption requests.
The unprecedented events of last year serve as a reminder that money market funds do carry investment risk and that investors can lose money. “Investors have demanded a higher level of transparency to understand the underlying risks with a fund,” says David Rothon, global fixed income product specialist at Northern Trust, London.
Changes on the horizon
Money market funds represent a large and critical segment of the financial world. According to Crane Data, money market fund assets have grown to about US$3.6tr at the end of 2009 from about US$1.8tr at the beginning of this decade.
“The money market sector has proven to be important to a well-functioning financial system,” says Peter Yi, director of money markets at Northern Trust. “It’s the grease that allows the wheels of the financial system to turn. That’s why the credit freeze within this sector was one catalyst to a broader credit crunch,” he notes.
In the United States, Rule 2a-7 of the Investment Company Act of 1940 governs money market funds. The rule was amended in the 1990s and worked effectively for about a decade, but faltered under the recent market turmoil, says Bradford Adams, senior product manager, Northern Trust. In fact, the Reserve Primary Fund actually was operating within 2a-7 when it ran into trouble. “That highlighted the fact that 2a-7 was inadequate for the challenges money market funds faced,” Adams says.
To remedy this, the US Securities and Exchange Commission (SEC) is considering changes to the regulations, and has received proposals from several groups, including the Investment Company Institute (ICI). The main objective of any regulatory changes would be to manage systemic risk. Currently, about 40 million investors hold registered money market products. When significant redemptions occur, the liquidity in the system is unable to accommodate them, which means sales take place into a distressed market. The proposals are intended to mitigate that. “In general, we’re looking at the proposals with optimism,” Yi says. “They’re ultimately good for the industry and will strengthen it.”
A closer look at the proposals
Several of the proposed changes concern the maturities of the securities within money market funds. One of these changes would reduce the weighted average maturity (WAM) of a fund’s portfolio from 90 to 60 days. By convention, WAM measures maturity based on interest-rate reset. So a floating-rate note with an interest rate that changes each month is considered to have a WAM of one month, not the time to the final maturity, which could be as much as a year longer.
Another proposal would cap the weighted average final maturity (WAFM) of a portfolio at 120 days; no current regulation limits this. The WAFM measures the assets based on final maturity and this change would limit funds’ ability to invest in long-term floating-rate securities.
Several other proposals focus on liquidity. One requires institutional money market funds to maintain at least 10% of their holdings in securities that mature within one day and 30% in securities that mature within one week. The current version of Rule 2a-7 contains no liquidity requirements. Interestingly, the ICI is proposing a slightly different version of this change and suggests that funds keep 5% of their portfolio in securities that mature within one day and 20% in securities with maturities of up to a week.
In another proposed change, money market funds would be restricted to only A1/P1, or the highest quality, securities. This proposal has a good chance of moving forward, Adams says: “It’s important to note, however, that such a change wouldn’t have prevented the Reserve Primary Fund from breaking the buck. Lehman Brothers was an A-rated issuer until the day it filed for bankruptcy. Allowing funds to invest in A2/P2 securities enables them to diversify away from financial sector issuers, which account for more than half of A1/P1 securities. An argument can be made for continuing to allow A2/P2 securities in money market funds because it tends to help diversification more than it lowers credit quality.”