Despite last year’s near-miss of a Money Market Fund catastrophe, the SEC’s current Money Market Reform proposal asks for only modest reforms that fail to address the key issues of this $3.8 trillion financial intermediary; indeed, that may well aggravate systemic risk.   First, the proposal does not appreciate that there are really two separate MMF types, retail MMFs and institutional MMFs, with different regulatory needs.  Retail MMF investors are looking for a bank account that combines safety with a higher rate of interest.  For them there is no substitute for fixed NAV, “safety and soundness” portfolio constraints and deposit insurance paid for with risk-adjusted premiums. Institutional MMFs, which now account for approximately 60% of MMF assets, function as low-cost providers of a corporate treasury function for large business entities.  This outsourcing saves these entities (corporations, life insurers, pension funds) the need to assemble individual portfolios of money market instruments the value of which would of course fluctuate.  Institutional MMFs thus should not carry a fixed NAV or the associated portfolio constraints.   Second, the SEC proposal fails to appreciate how MMF regulation creates systemic risk by artificially increasingly the supply of short term finance.  The consequence is to shift maturity transformation away from banks to short term credit markets, which, as last fall demonstrated, may seize-up in times of financial distress.  As suggested by the Group of 30’s report in February 2009, whether money market funds are a desirable innovation needs full scale examination.

These ideas are developed in a comment letter I submitted to the SEC on its Money Market Reform Proposal.   Here’s the text of the letter:

This letter is submitted by me personally in response to the SEC’s request for comments on its proposed Money  Market Reform Rule announced in Release No. IC-28807.   This letter proposes a different direction to reform, one that begins with the division between retail and institutional money market funds and that takes account of the different motives and needs of the investors in each.

“Reform” is of course timely in light of the fragility of Money Market Funds (“MMFs” ) revealed in the financial distress that followed the failure of Lehman Brothers.  As the Commission describes quite well in the Release, Lehman’s failure unexpectedly led to the “busting of the buck” by the Reserve Fund, which held a large amount of Lehman’s commercial paper in its portfolio.  The problems at the Reserve Fund in turn triggered a “run” especially by institutional investors on non-Treasury MMFs that was staunched only by an extraordinary MMF guarantee program provided by Treasury and by the creation of a special MMF liquidity facility by the Federal Reserve.  It is also widely believed that FDIC decisions in addressing bank failures – whether or not to protect bank creditors – were influenced by concerns about the solvency of MMFs that held bank paper.   Various MMFs undertook their own safeguards against the risk of runs, principally by selling off commercial paper (that is, making use of the Fed’s facility) and by shifting their portfolio composition towards Treasury instruments (Federal agency debt for the adventurous) and   by shortening maturities.  These measures had their own consequence, namely a sharp contraction in the demand for commercial paper and other short term credit instruments that industrial and financial firms had come to rely upon in their corporate finance plans.  The Federal Reserve responded with another special liquidity facility in which the Fed’s became a buyer of last resort of commercial paper.

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