Money Market Fund Reform in the United States

Money market fund reform continues to be an area of great importance to money market investors and the capital markets on both sides of the Atlantic Ocean. In the United States alone money market funds today hold approximately $2.9 trillion of assets [1] and they comprise over 25 percent of all U.S. mutual fund assets. [2] U.S. and European based money market funds play a critical role in the U.S. and the world economy, and although they may have taken somewhat different paths in their economic and regulatory development in Europe, there are more similarities than differences. In the United States, for instance, money market funds arose as a cash alternative to bank deposits principally for retail investors during the 1970s when interest rates were high but regulatory requirements capped interest rates banks could pay on deposits. [3] In this way, money market funds fulfilled a retail niche by providing a relatively high market-driven rate of return to investors with an expected high degree of safety. Since then the industry and its investor base have changed. Now, about two-thirds of money market fund assets are in institutional money market funds (or classes), and U.S. money market funds now provide institutional as well as retail investors with an important cash management tool. [4] Money market funds have grown from a convenience provided by fund managers who primarily offer equity and bond funds to becoming the primary engine for a substantial portion of the short-term credit in the U.S. economy. This includes over 40 percent of outstanding commercial paper and approximately 65 percent of short-term municipal debt. [5] Another significant development among U.S. money market funds is their concentrated nature: over 70 percent of all money market fund assets reside in the top ten money market fund complexes; for institutional money market funds, including tax-free funds, over 75 percent of assets are held in the top ten complexes. [6] I understand that in Europe, on the other hand, money market funds started primarily as institutional investments and have only recently moved into the retail space. [7]

Regardless of the different paths money market funds took in gaining their prominence, and the differing nature of the retail and institutional money market fund sectors in each of our markets, the increasing significance of the role these funds currently play in our economies and for investors is undeniable. Furthermore, regulatory issues surrounding money market funds have reached a critical point for each of us. As we — industry and regulators — seek to address some of the growing pains that accompanied money market funds development, it is important that we get it right, as the stakes are high in each of our markets.

Today, I would like to review with you some of the recent steps we have taken on the money market fund journey in the United States, particularly as these funds faced the unprecedented challenges presented to them in the last three years. I would then like to look at the challenges that remain and discuss some of the approaches we might consider to address them.

Before I do, however, I must note that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

Challenges Money Market Funds Faced Since Summer 2007

Money market funds in the U.S. began experiencing challenges in the fall of 2007 when difficulties in the residential home mortgage market first affected money market funds’ holdings of commercial paper issued by “structured investment vehicles,” or SIVs. While most SIVs had little exposure to sub-prime mortgages, investors began to avoid all asset-backed commercial paper. [8] This caused spreads to widen, the value of such paper to fall and consequently threatened to force some money market funds to “break the buck.” No money market funds “broke the buck” as a result of their exposure to SIV commercial paper, however, because either the SIV sponsors supported the troubled SIVs or money market fund sponsors provided financial support to the money market funds owning the troubled paper. While there is no legal obligation for fund sponsors to provide such support (and in fact regulatory relief is necessary in most cases for such support to be provided), many firms have voluntarily done so.

However, the pressure on money market funds reached its apex the week of September 15, 2008, when the bankruptcy of Lehman Brothers led to heavy redemptions from about a dozen money market funds holding Lehman debt. [9] While several money market funds had exposure to Lehman Brothers that their sponsors could manage, the bankruptcy of Lehman Brothers led to losses at The Reserve Primary Fund, a $60 billion money market fund, that its sponsor did not have sufficient resources to support. [10] As a result, The Primary Fund reduced its net asset value below $1.00 or “broke the buck” by re-pricing its shares to 97 cents (although investors were eventually paid 99 cents). [11] The Reserve Fund was the first widely held money market fund in the U.S. to “break the buck” and the first since a small institutional fund did so in 1994. As a side note, the Reserve Fund was also the first U.S. money market fund, having been formed in 1971. This particular fund having broken the buck, ironically demonstrated that money market funds had come full circle.

The combination of the uncertainty caused by the Lehman bankruptcy and the news of the Reserve Fund precipitated extremely high redemptions in many institutional money market funds, with investors withdrawing approximately $300 billion from prime money market funds, or 14 percent of the assets held in those funds, with most of these redemptions coming from institutional investors. [12] Furthermore, over 100 money market funds faced their own credit or liquidity challenges during this period. Notably, most retail money market funds experienced normal cash flows.

Money market funds investing exclusively in U.S. Government securities, particularly U.S. Treasuries, were flooded with new investments, creating additional challenges. [13] This “flight to quality”, as investors, principally institutions, moved into U.S. government money market funds, as well as a flight directly to Treasuries by other investors, prompted the lowest yields on U.S. Treasury securities that we had seen in 50 years. [14] As portfolio securities owned by funds matured and funds purchased new treasuries with new money, yields were diluted even further. In this environment, we saw at least three treasury money market funds close to new investors, [15] as well as funds waiving fees and expenses in order to avoid negative yields. [16] We understand that some sponsors even left the business entirely as they saw profits evaporate, although there were new entrants as well. [17]

Response to the Challenges by Money Market Fund Providers

The run on money market funds in the U.S. in the fall of 2008 prompted the need for emergency measures across the U.S. government to respond to the severe problems that had arisen. The responses from various federal government agencies attested to the importance of money market funds within the U.S. financial system, as well as the magnitude of the money market fund sector. In the week following the Reserve Fund’s breaking a buck, the heavy redemption activity in prime money market funds, and the flight to quality, the U.S. Treasury Department announced a Temporary Guarantee Program for Money Market Funds [18] to insure the value of certain investments by investors in money market funds. The Commission staff estimated that approximately 79 percent of money market funds participated in this program [19] and over $1.2 billion of premiums were paid by the funds. [20]

The U.S. Federal Reserve Board also established a number of liquidity facilities: First, it set up an Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility to finance banks’ purchases of certain types of asset-backed commercial paper from money market funds at the securities amortized cost value. [21] This program created substantial liquidity for money market funds in their less liquid holdings. Eleven banks and broker-dealers borrowed an average of $68 billion dollars from this facility to purchase asset-backed commercial paper from 105 prime money market funds (of these, 17 funds from six fund complexes accounted for 50 percent of the loans). [22] At its peak during this program, the Federal Reserve Board held as much as $152 billion of asset-backed commercial paper. [23]

Another facility established by the Federal Reserve Board, was the Commercial Paper Funding Facility, [24] which was used to finance the purchase of highly rated, three-month, unsecured and asset-backed commercial paper issued by high quality U.S. issuers. This facility purchased approximately $350 billion of commercial paper. [25]

The Federal Reserve also established another facility, the Money Market Investor Funding Facility, aimed at providing secondary market liquidity for money market funds’ bank-related securities holdings in order to ease pressure on money market funds meeting sudden redemption requests. [26]

The Commission and its staff also responded promptly to address the challenges facing money market funds. Under the law governing mutual funds in the United States, certain transactions among affiliates even if beneficial to the funds, are restricted. For this reason, the SEC staff provided relief from these restrictions for more than 100 funds in what we call a “no-action position,” in which the staff assures that it will not recommend enforcement action to the Commission so long as the fund and its affiliate act in accordance with conditions outlined in a staff issued letter. [27] As a result, fund sponsors were able to support money market funds with asset purchases or credit support arrangements. My Division at the Commission actively worked with the managers of money market funds to facilitate these no-action positions in an admirable example of cooperation among the SEC and the industry for the benefit of investors as funds coped with events during this period. Through no-action letters, the staff was also able to facilitate money market funds’ participation in the Treasury and the Federal Reserve liquidity facilities. [28] My staff also worked with the industry to address regulatory questions that may have arisen as firms considered their options for operating money market funds for an extended period in a low interest rate environment.

During this difficult and challenging period for money market funds in the United States, sponsors of money market funds expended billions in capital to support money market funds through the purchase of troubled assets, the purchase of certain illiquid assets and through credit support arrangements. This extraordinary assistance was provided to over 100 money market funds in 18 different complexes. [29]

Further Preventive Regulatory Action

In addition to U.S. government agencies taking action in response to the market turmoil, money market funds and their potential impact on the financial system also prompted the administration to look at how regulation may be used to prevent any future harm to investors and the markets in this area. Through a Money Market Working Group of the ICI, the industry also issued a report in March 2009 that included helpful regulatory recommendations regarding money market funds. [30]

In the White Paper by the U.S. Treasury Department, entitled Financial Regulatory Reform: A New Foundation, [31] issued in June of last year, the administration recommended that the SEC move forward with its plans to strengthen the regulatory framework around money market funds. It also suggested that the President’s Working Group on Financial Markets should prepare a report assessing whether more fundamental changes are necessary to further reduce the money market fund industry’s susceptibility to runs.

The Commission also took strong action on January 27th of this year when it voted to adopt new rules governing money market funds. [32] The rules are aimed at improving the ability of money market funds to withstand the financial stresses that they will inevitably experience. In doing so, they address the regulatory challenge of striking the right balance between improving the safety of money market funds and preserving the ability of money market funds to generate yield for their investors. The rules require, among other things, that money market funds comply with new, more stringent credit quality and maturity standards [33] that make them less vulnerable to market risks; and that they meet new daily and weekly liquidity standards [34] so that they have a greater portion of their assets in liquid investments and will be in a better position to pay redeeming investors under any market conditions. Also under the new rules, money fund managers have to stress test their portfolios under different scenarios, such as a sudden increase in interest rates, redemption pressure, or the default of issuers of securities held by the fund. Furthermore, money funds must disclose portfolio information to the public each month on their web sites. This disclosure will equip investors with information they can use to better evaluate the risks of investing in particular funds. In addition, money funds must file more detailed portfolio reports each month with the Commission to enable it to better oversee the funds. The information, which includes the money market fund’s shadow NAV, [35] also will be available to the public on a 60-day delay and will help investors to see more detail about the risks that a fund may be taking with their money. In my view, the public availability of this information also may cause fund managers to think more carefully about the decisions they make about the fund’s investments. The Commission also provided money market fund directors with the ability to promptly close and orderly liquidate a money market fund facing the possibility of breaking the buck.

The Remaining Challenges and Possible Approaches

The new rules adopted by the SEC represented strong action to make money market funds a more transparent and safe investment. However, these were but a first step in a continuing effort to improve the regulation of money market funds in the U.S. SEC Chairman Schapiro has indicated that more is yet to come. At the Commission meeting adopting the new money market fund rules, she noted that the Commission’s work in this area “is not yet complete” and that “it will continue to pursue more fundamental changes to the structure of money market funds to further protect them from the risk of runs.” Accordingly, the SEC has announced a second phase of rulemaking, [36] which I expect will commence later this year.

Although now that credit markets are no longer frozen and a sense of normalcy has returned to the money markets, some might question why the Commission needs to consider taking any further steps in this area. The answer is fundamental. While the new rules effectively reduce the risk in money market funds and strengthen them, thus making it less likely that another fund will “break the buck” and protecting shareholders’ interests in the event that happens, the events of the fall of 2008 showed that money market funds are susceptible to runs, particularly by institutional investors. I believe the Commission needs to explore how to improve the regulatory framework under which money market funds operate and how it can be made to more effectively deal with that fundamental risk.

For obvious reasons, reducing the susceptibility of money market funds to runs has become an important policy objective not just at the SEC but among the other U.S. financial regulators as well. The events of the fall of 2008 precipitated the need for a massive intervention by governmental agencies with respect to money market funds. We need to avoid this in the future.

Despite the significant improvement the Commission has made to the regulation of money market funds, investors, particularly institutional investors, still have an incentive to flee a money market fund when there is an increase in short-term interest rates, a decline in the mark to market value of a money market fund’s holdings, concern with the credit quality of the money market funds holdings or concern that other investors may flee the fund. The financial crisis we just came through exposed certain systemic risks connected to money market funds and the susceptibility of money market funds to runs, especially in times of extreme market stress.

In the Commission release proposing the most recent money market fund reforms, [37] the Commission asked more fundamental questions about money market funds and their ability to maintain a stable net asset value of one dollar per share. For instance, in its release, the Commission raised the issues of requiring redemption in-kind for certain large redemptions and considered floating the NAV of money market funds. Others within the government and elsewhere have also raised proposals regarding money market fund reform. A report issued on January 15, 2009, the Group of 30, led by Paul Volcker, recommended that money market funds with stable net asset values should be required to reorganize as special purpose banks; and that the remaining money market funds should not be permitted to use amortized cost pricing, with the implication that they carry a fluctuating NAV rather than a stable $1.00 value. [38] The June 2009 White Paper issued by the Treasury Department also raised this issue in regard to systemic risk issues, suggesting that consideration be given to requiring money market funds to move to a fluctuating NAV or to imposing some other liquidity protection for fund shareholders. [39] The White Paper tasked a group of high level government officials, including the SEC’s Chairman Schapiro, as part of the President’s Working Group on Financial Markets, as it is called, with examining alternatives to addressing systemic risk in money market funds and issuing a report on the subject. The report is expected to discuss advantages and disadvantages of different policy options. We can look forward to a robust public discussion following its release.

There also have been certain ideas floated about a private liquidity bank funded by the industry that would provide an additional source of liquidity that money market funds could tap after exhausting their own internal liquidity. [40] This facility would operate to augment the significant liquidity required by the recent rule changes which require money market funds to meet the new rule’s daily and weekly liquidity requirements. With some $2.9 trillion of money market fund assets, these requirements mandate that the money market fund industry have $290 billion in daily liquidity and $870 billion in weekly liquidity to meet the rule’s liquidity standards. While this liquidity bank might better enable money markets to deal with runs, it may not reduce the incentives for such runs. It also does not address the credit risk assumed by funds, nor prevent funds from breaking the buck.

Conclusion

In my view, none of us can afford to ignore the lessons of the past few years. In the U.S., investors in money market funds were quite fortunate that advisers to the funds responded to the credit and liquidity challenges faced by the funds by bailing out a large number of funds and their shareholders. Investors were also the beneficiaries of the significant intervention by the government in providing credit protection through the Treasury Temporary Money Market Fund Guarantee Program and liquidity through the facilities set up by the Federal Reserve Board. In the U.S., I want to stress that we all need to work cooperatively — the government, the industry and investors — to help ensure that money market funds stand on their own, that investors in money market funds understand and embrace the risks and returns associated with the funds and their investments and that money market funds are not dependent on the support of their advisers or the government. I am hopeful that the industry in the U.S. will work with the Commission in addressing these remaining issues as they did with the first installment of money market fund reform.

I am also hopeful that as we continue to address the issues that arise with respect to money market funds in each of our markets, that we keep an open dialogue as to how to best protect investors in these products of ever-increasing importance on a global level. As we continue looking at systemic risks associated with money market funds, the global aspect of our markets is of course something we cannot ignore. For this reason, I am grateful to have the opportunity to speak with you today about our experience in the U.S. and to learn from you about your experiences as well. The lessons we can learn from each other are invaluable, particularly during these very challenging and interesting times.

Endnotes

[1] As of May 12, 2010, the Investment Company Institute. See http://www.ici.org/research/stats/mmf.
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[2] As of March 31, 2010 total net assets of U.S. mutual funds were $11.2 trillion. See, the Investment Company Institute Trends in Mutual Fund Investing (Mar. 2010) at http://www.ici.org/research/stats/trends.
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[3] Report of the Money Market Working Group at 21, available at http://www.ici.org/pdf/ppr_09_mmwg.pdf.
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[4] See note 1 above.
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[5] See SEC Proposing Release at notes 14, 16.
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[6] This is based on analysis of data from the iMoneyNet Money Fund Analysis Database.
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[7] See Christine Senior, Money market funds look for steady footing in Europe, FT Mandate (July 2006), available at http://www.ftmandate.com/news/fullstory.php/aid/1166/Money_market_funds_look_for_steady_footing_in_Europe_.html (“[M]oney market funds first arrived in Europe in the mid-1990s when Europe-based U.S. multi-nationals introduced them as a means to manage their own cash, a practice which then spread further afield.”).
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[8] See Money Market Fund Reform, Investment Company Act Release No. 28807 (June 30, 2009) [74 FR 32688 (July 8, 2009)] (“SEC Proposing Release”) at text accompanying note 38.
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[9] SEC Proposing Release, at paragraph following note 43.
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[10] Id. See also http://www.nytimes.com/2009/11/26/business/26fund.html?_r=1. The Reserve Primary Fund, a $62 billion money market fund, owned $785 million principal amount of Lehman Brothers. To date, investors in The Reserve Primary Fund have received at least $0.99 per share.
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[11] SEC Proposing Release, at text accompanying note 44.
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[12] Id. at text accompanying note 47.
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[13] See Hannah Glover, Fidelity Acts to Slow Money Fund Flows, Ignites (Dec. 31, 2008).
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[14] See Rising U.S. bond yields may spark Credit Crisis II, Reuters (June 1, 2009), available at http://uk.reuters.com/article/idUKLNE55001H20090601?sp=true
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[15] See Fidelity Acts to Slow Money Fund Flows, supra note 13.
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[16] Id.
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[17] See Beagan Wilcox Volz, Money Fund Rules Mean Lower Yields, Consolidation, Ignites (Feb. 1, 2010).
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[18] Press Release, U.S. Department of the Treasury, Treasury Announces Guaranty Program for Money Market Funds (Sept. 19, 2008), available at http://www.treas.gov/press/releases/hp1147.htm.
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[19] Disclosure of Certain Money Market Fund Portfolio Holdings, Investment Company Act Release No. 28903 (Sept. 18, 2009) at note 3.
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[20] See Press Release, U.S. Department of the Treasury, Treasury Announces Expiration of Guarantee Program for Money Market Funds (Sept 18, 2009), available at http://www.treas.gov/press/releases/tg293.htm.
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[21] See Federal Reserve Board, Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (“AMLF”), available at http://www.federalreserve.gov/monetarypolicy/abcpmmmf.htm; Federal Reserve Discount Window, AMLF Frequently Asked Questions, available at http://www.frbdiscountwindow.org/mmmf.cfm?hdrID=14#f14.
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[22] See Burcu Duygan-Bump et al., How Effective Were the Federal Reserve Emergency Liquidity Facilities? Evidence from the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, Federal Reserve Bank of Boston, available at http://www.bos.frb.org/bankinfo/qau/wp/2010/qau1003.pdf
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[23] See Reuters, AFX Asia, FACTBOX-Four Emergency Fed Lifelines Expire (Feb 1, 2010).
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[24] See Federal Reserve Bank of New York, Commercial Paper Funding Facility: Program Terms and Conditions, available at http://www.newyorkfed.org/markets/CPFF_Terms_Conditions.html.
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[25] See Tobias Adrian et al., The Federal Reserve’s Commercial Paper Funding Facility, Federal Reserve Bank of New York, available at http://www.newyorkfed.org/research/staff_reports/sr423.pdf.
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[26] See Press Release, Federal Reserve Board, available at http://www.federalreserve.gov/newsevents/press/monetary/20081021a.htm.
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[27] See SEC, No Action Letters Regarding Affiliated Transactions Involving Money Market Funds, available at http://www.sec.gov/divisions/investment/im-noaction.shtml#affiliatedtrans_mm
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[28] See, e.g., Letter to J.P. Morgan Securities Inc. (Oct 22, 2008), available at http://www.sec.gov/divisions/investment/noaction/2008/jpmsi102208.pdf.
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[29] See proposing Release at notes 38 and 54. No-Action letters are available at http://www.sec.gov/divisions/investment/im-noaction.shtml#money.
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[30] Investment Company Institute, Report of the Money Market Working Group (Mar. 17, 2009), http://www.ici.org/pdf/ppr_09_mmwg.pdf.
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[31] See http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.
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[32] See Money Market Fund Reform, Investment Company Act Release No. 29132 (Feb. 23, 2010) [75 FR 10060 (Mar. 4, 2010)] (“SEC Adopting Release”).
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[33] Second tier securities limited to no more than three percent and WAM limited to maximum of 60 days and WAL limited to maximum of 120 days.
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[34] Minimum of ten percent daily and 30 percent weekly
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[35] See SEC Adopting Release at section E.
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[36] Id. at text following note 27.
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[37] See, Money Market Reform, Release No. IC-28807, June 30, 2009 (Proposing Release).
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[38] See Financial Reform: A Framework for Financial Stability, at http://www.group30.org/pubs/recommendations.pdf
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[39] See Financial Regulatory Reform: A New Foundation supra note 31, at 38.
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[40] See Fidelity, Vanguard Said to Plan Emergency Bank for Money Market, Bloomberg (September 19, 2009) at http://www.bloomberg.com/apps/news?pid=20601087&sid=a8wiCA9.CbZ0
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