Published: September 01, 2012
The MMF industry has overwhelmingly rejected regulatory reforms based on the premise that MMFs are shadow banks, or that would require CNAV funds to adopt a VNAV. Instead, the industry has endorsed regulatory reforms that focus on managing liquidity risk. What regulatory reforms are supported by the industry? What regulatory reforms remain contentious? And how is this debate likely to resolve itself?
There is broad support within the MMF industry for the following narrative about the events of 2008.
MMFs provide a simple but valuable intermediation service between lenders and borrowers in the short-term debt markets. They are used, in particular, by corporate treasurers whose cash assets are generally in excess of the amount guaranteed by deposit insurance schemes. To that extent, investors are exposed to credit risk when they make deposits, and manage that risk by diversifying deposits between creditworthy banks. But there are constraints on the level of diversification that investors can achieve on their own, in particular because they don’t have the expertise to assess creditworthiness across a large number of issuers. Therefore they use MMFs which – like other collective investment schemes – can provide higher levels of diversification than investors could achieve individually, and can employ specialist credit analysts through economies of scale.
Prime MMFs invest substantially all of their assets in high-quality, low duration fixed income instruments issued by banks, businesses and governments. In September 2008, a series of headline events undermined investor confidence in the solvency of the global banking system. That caused some US investors to switch their investment from prime MMFs to treasury and government MMFs (which invest in US Treasury Bills and other government agency securities): a classic ‘flight to quality’.
US MMF investors were not the only party to lose confidence in the global banking system: banks lost confidence in one another! Consequently, the interbank market and secondary market for money market instruments essentially closed, which made it increasingly difficult for MMFs to sell assets to raise cash to make redemption payments. The flight came to an end when the US Treasury Temporary Guarantee Programme effectively made prime MMFs ‘as good as’ treasury MMFs and made further switching unnecessary.
Non-US investors didn’t react so strongly, and therefore redemptions from non-US MMFs were less severe. Nevertheless, to generalise from the experience of US MFs in 2008: a loss of confidence in the banking system may cause some investors to ‘fly to quality’, including switching their investments from prime to treasury MMFs. The only credible way of stopping that flight to quality is to restore confidence in the banking system, and quickly. In the intervening period and in the absence of a functioning secondary market, the primary objective of MMF reform should be to ensure that funds have sufficient natural liquidity to meet redemption payments.
Therefore, there is broad support within the MMF industry – including IMMFA – for the following regulatory reforms:
Some regulators have taken the narrative further. They have observed that, insofar as a loss of confidence in the banking system may cause a switch from prime to treasury MMFs, then the funding provided by prime funds to the banking system would necessarily decrease; but in those circumstances, reduced funding would further undermine confidence in the banking system. Therefore, they recommend that MMF reform should not merely focus on ensuring that funds have sufficient liquidity to meet redemption payments, but also should actively disincentivise investors from redeeming.[[[PAGE]]]
The MMF industry has strong misgivings about this proposal. Investors are entitled to redeem from a MMF if they have legitimate concerns about the creditworthiness of one of its underlying issuers; and a MMF is similarly entitled to withdraw funding from an underlying issuer if that would otherwise frustrate its investment objective (‘security of capital and daily liquidity’). If MMFs are reformed in a manner that interferes with those entitlements, then investors are likely to seek an alternative wrapper.
Nevertheless, in the interest of engaging regulators, the industry has assessed the effectiveness of various reform proposals in disincentivising redemptions.
The proposal that has received the most discussion in recent months goes by the name of ‘hold back’. In summary, it is proposed that 95% of an investor’s redemption proceeds would be payable at T1 (in the normal way) but 5% would be held back by a MMF for 30 days until T30. At T30 the held-back amount would be paid to the investor unless, during the hold-back period, the fund had experienced a credit event. In that case the losses resulting from the credit event would be first attributed to the held-back amount before any excess would be attributed to remaining investors in the fund in the normal way.
In theory, this mechanism is intended to disincentivise investors from redeeming from a MMF by creating a complex dynamic between redeeming and remaining investors. (The dynamic is described in IMMFA’s response to a recent consultation on MMF reform by the International Organisation of Securities Commissions, IOSCO.) In practice, few industry practitioners believe the mechanism would actually disincentivise redemptions. What’s worse, many fear investors would not invest in MMFs that had such a feature; a recent survey of US corporate treasurers indicated 90% of investors would either decrease or discontinue their use of MMFs.
An alternative proposal goes by the name of a ‘liquidity fee’. In summary, during a financial crisis (i.e., subject to a predetermined trigger) MMFs would impose a fee on redemptions, equal to that amount required to ‘equalise’ remaining investors in the fund. The objective of the fee is to ensure that redeeming investors do not disadvantage remaining investors, i.e., to ensure fairness between investors, which is a fundamental principle of investment fund regulation. Indeed, many investment funds already have this feature, often described as a ‘dilution levy’. Coincidentally, anecdotal evidence suggests that when liquidity fees/dilution levies are imposed to ensure fairness between redeeming and remaining investors, they actually disincentivise redemptions from occurring in the first place.
Many industry practitioners have expressed reservations about liquidity fees, which they fear might discourage investors from using MMFs. However, it is generally recognised that liquidity fees are at least worthy of further investigation.
MMF reform is the subject of intense debate, globally.
In the US, the Securities and Exchange Commission (SEC) implemented significant reforms in 2010 (including by imposing minimum liquidity requirements and an obligation to ‘know your clients). But pressure is being put on the SEC to ‘do more’, including by the Federal Reserve and the US Treasury.
In the European Union, the European Commission has recently issued a Green Paper on shadow banking. The Green Paper implies (but does not make explicit) a preference for VNAV funds over CNAV funds.
In the international space, IOSCO has issued a comprehensive and sophisticated consultation on MMF reform, which deals with all of the proposals described in these articles, and more besides.
It is clear that regulators have an appetite to ‘do more’, but it is unclear at this point precisely what they will do, or whether the actions of US and European regulators will be consistent with one another.
For those reasons, it is urgent that investors should engage in this debate. IMMFA has therefore reached out to the Association of Corporate Treasurers (ACT) and the European Association of Corporate Treasurers (EACT) in an effort to encourage engagement.
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