Not All Money Market Funds Are Equal

There is a sensible compromise to the debate over money market fund reform that regulators should seriously consider: requiring a fluctuating share price for some money market funds owned by institutional investors, but not for those owned by retail investors. Currently, all money market funds may use a fixed share price – known as the “net asset value”, or NAV – at one dollar per share, subject to strict conditions.

Regulators have argued that a fixed NAV creates systemic risk in the financial system and misleads investors into thinking their investment is guaranteed. They believe that money market funds should instead calculate their NAV daily based on the market value of their investments, as stock and bond mutual funds do – meaning that the NAV may fluctuate from day to day. However, the fund industry argues that a fluctuating NAV would drastically undermine the utility of money market funds. Most investors use money market funds as an alternative to bank deposits, so most investors require the convenience and liquidity of a fixed-dollar account. Additionally, the industry points out that only two money market funds – both institutional – have ever caused any investor losses by “breaking the buck”.

Walt Bettinger, president and CEO of investment services firm Charles Schwab, recently advocated a smart proposal that would treat different types of funds differently. The first category of funds would include retail money market funds and “nonprime” money market funds – which invest solely in debt issued or guaranteed by the US government. These funds could continue to use a fixed NAV.

By contrast, Mr Bettinger proposed that certain “riskier” money market funds should transition to a fluctuating NAV. This proposal would apply only to “prime” institutional money market funds – that is, those funds that are both owned by large institutions and that invest in securities other than US government debt. Of course, policymakers would have to decide what qualifies as an “institutional” fund. We would argue for a test based on a maximum account size, such as $1m or $2m, perhaps augmented by other tests of concentration in ownership.

There is a stronger case for reforming institutional money market funds because those funds are more vulnerable to runs, which can spread from one fund to another. In September 2008, the Reserve Primary Fund – a prime institutional fund – incurred losses on Lehman Brothers assets, forcing it to break the buck and pass losses onto investors. The resulting wave of redemptions shortly forced another investment manager to shut down one of its prime institutional money funds, even though that fund did not own any toxic Lehman assets.

While prime institutional funds were associated with much turmoil during the crisis, other types of money market funds remained much more stable. Prime retail money market funds saw redemptions of no more than $10bn on any day, compared to a peak of about $130bn per day for prime institutional funds.

Why have institutional money market funds been much more susceptible to runs? Most obviously, concentrated ownership means that a small number of large shareholders can put a money market fund at serious risk by redeeming their shares all at once.

Furthermore, institutional investors constantly monitor their investments for any changes in interest rates or credit risk – making them more likely to redeem their shares if the investments begin to look shaky. This tendency is exacerbated by a fixed NAV: if institutions believe that the assets owned by the fund have slightly decreased in value, they are incentivised to sell their shares quickly – before the fund comes close to breaking the buck.

Under a fluctuating NAV, investors would have less incentive to redeem right away, since any changes would be immediately reflected in the value of their shares. Additionally, a fluctuating NAV will remove the psychological trauma of breaking the buck as a discrete event. Small variations in the fund’s daily NAV would condition institutional shareholders of money market funds to take small losses in their stride.

In short, regulators can target most of the systemic risks created by money market funds by focusing on prime institutional funds. Requiring these funds to fluctuate their NAV would improve the stability of the financial system, without imposing substantial costs on retail investors in money market funds.