Strengthening Money Market Funds to Reduce Systemic Risk

Today [July 23, 2014], the Commission considers adopting long-considered reforms to the rules governing money market funds. I commend the hard work of the staff, particularly the Division of Investment Management and the Division of Economic and Risk Analysis (“DERA”), who worked tirelessly to present these thoughtful and deliberate amendments. It is well known that the journey to arrive at the amendments considered today was a difficult one, and I can confidently say that this has been, at times, perhaps one of the most flawed and controversial rulemaking processes the Commission has undertaken.

The amendments we consider today arose in response to the worst financial crisis this country has experienced since the Great Depression. Six years have passed since the failure of Lehman led to the Reserve Primary Fund “breaking the buck.” As we all know, Lehman’s failure, the failure of other well-known financial institutions, and the markets’ related concerns about the quality of other corporate paper, led to unprecedented redemptions from a number of other money market funds. This run of redemptions, in turn, led the short-term financing markets to freeze, and the U.S. Department of the Treasury had to step in to guarantee the investments that were in registered money market funds as of September 19, 2008.

Accordingly, it became extremely important that the SEC take deliberate action to strengthen the framework governing money market funds. To that end, I strongly supported the Commission’s January 2010 adoption of a number of amendments to the rules governing money market funds. In fact, I suggested we implement Form N-MPF to obtain more real-time disclosures of money market fund portfolio holdings because I remember too well the strain we felt not knowing which money markets funds had invested in particular securities. It is well recognized that the 2010 amendments made money market funds more resilient in a number of ways, including by limiting the types of investments money market funds can make and adopting more robust liquidity requirements.

In the 2010 adopting release, the Commission forecast that further reforms to money market funds were on the horizon. At the time, I stated that future proposals—like all of our proposals—should be based on a rigorous analysis of the possible consequences. In that vein, I highlighted the possibility that adoption of further amendments could cause a flight of significant dollars from regulated vehicles to unregulated vehicles. Because these vehicles lack the transparency and protections provided by registered money market funds, I deeply believed that the Commission had to address the danger of money migrating to these riskier vehicles.

In 2012, the SEC’s former leadership discussed with the Commissioners a possible set of additional structural reforms to money market funds. As a threshold matter in response, a majority of the Commission requested that the staff conduct a thorough and comprehensive study of the effects of the 2010 amendments before proceeding with additional and fundamental changes to money market funds.

To be clear, millions of investors—retail and institutional alike—rely upon and benefit from money market funds. Thus, it was particularly important that the Commission’s actions be firmly grounded upon reliable information and rigorous analysis, which included the causes of investor redemptions in 2008, the efficacy of our 2010 reforms, and the potential impacts of further reform.

At the time, the SEC staff stated that they possessed the in-house resources and data necessary to conduct and complete such a study in five weeks. However, for reasons that still remain unclear, the SEC’s former leadership declined to authorize the staff to undertake such a study, and instead pushed ahead with proposed amendments that failed to be informed by any analysis of the impact of the 2010 amendments or to appropriately consider the risks of funds migrating from the transparent money market funds market to opaque and less-regulated—or completely unregulated—vehicles. As has been well-documented in the press, that proposal was withdrawn in August 2012 before it was put to the Commission for a vote.

Fortunately, at the further insistence of a majority of the Commission who thought the matter too important to simply let drop, the staff completed and presented to the Commission a thoughtful, well-supported, and in-depth study of the causes of investor redemptions in 2008 and the efficacy of the Commission’s 2010 amendments. The staff’s November 2012 study concluded that the probability of a money market fund breaking the buck had indeed been substantially mitigated by the 2010 reforms, but that those reforms would have been unlikely to prevent a fund from breaking the buck when faced with a market turmoil like the one experienced in 2008. The study facilitated a productive and informed discussion between the Commissioners, and its findings and conclusions formed the basis for the proposed amendments that were unanimously approved in June 2013.

The quality of the June 2013 release resulted in the Commission receiving thoughtful input and a considerable amount of data and detailed analysis, which, in turn, has significantly improved today’s proposal. In total, the Commission received over 1,400 comment letters from a variety of commenters, including individuals, academics, investment companies, investment advisers, banks, operating companies, professional and trade associations, and government entities. The comment letters commented on all aspects of the June 2013 proposal from a variety of perspectives, including, expressing support, or opposition, to the floating NAV proposal, indicating varying degrees of support, or opposition, for liquidity fees and/or redemption gates (or the combination thereof), and mostly support of the enhanced disclosure requirements in the proposed reforms.

These comments make it clear that many will believe that today’s reforms may go too far; while conversely, others will believe that we have not gone far enough. Today’s rulemaking, however, is a result of extensive data and in-depth analysis, much of which is the product of work conducted in-house by staff economists in the Division of Economic and Risk Analysis (“DERA”). For example, just to name a few: (i) DERA analyzed the liquidity costs during market stress and non-market stress periods, and its study supports the appropriateness of the 1% default liquidity fee being adopted in today’s reforms; (ii) DERA analyzed government funds’ exposure to non-government securities, and the findings provides support for the significant reduction in the non-government securities basket in today’s reforms; (iii) DERA measured the extent to which municipal money market funds may be exposed to guarantees or demand features from a single guarantor, and its study supports the staff’s recommendation for reducing the 25% basket for guarantees and demand features from a single institution; and (iv) lastly, DERA analyzed the overall availability of domestic and global safe assets, and concluded that, given the size of the global market for safe assets, DERA does not anticipate that the proposed reforms will result in a large impact to the domestic and global markets for safe assets.

Accordingly, the amendments being considered for adoption today reflect an enormous amount of analysis and study and are designed to address money market funds that may be susceptible to heavy redemptions in times of market stress and to help reduce the contagion effects stemming from such redemptions. They are also designed to increase transparency and investor awareness of the risks of investing in money market funds.

There are several aspects of today’s amendments that warrant special mention. First, today the Commission adopts a floating NAV for those money market funds that have tended to exhibit greater volatility. As the release states, for such funds, it is expected that the floating NAV will reduce the chance of unfair investor dilution by weakening the incentive for certain investors to take a “first mover advantage” by redeeming in times of market stress or when there is a price discrepancy between the market-based NAV and the stable share price. Additionally, it will make it even more transparent that money market fund investors bear the risk of loss on their investment, as is always the case.

Nevertheless, many have expressed concerns about requiring money market funds to have a floating NAV. In particular, concerns have been raised as to accounting and federal income tax considerations that would make such funds virtually unworkable. However, as today’s release discusses, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) will announce today proposed regulations and a revenue procedure to address these issues. As a result, it is expected that money market funds, even with a floating NAV, will continue to be viable and efficient products. In that regard, I would like to thank the respective staff at the Treasury and the IRS for helping to address the difficult issues raised by the implementation of today’s floating NAV amendments.

However, as is noted in the Commission’s release, the floating NAV requirement will not by itself stop runs on money market funds in times of market stress. For that reason, the Commission is also authorizing the use of “fees and gates,” as a necessary aid in the reduction of the systemic risks that today’s reforms are designed to address.

Some observers, including staff at the Federal Reserve Bank of New York, have suggested the possibility that fees and gates may themselves cause pre-emptive runs, by encouraging investors to redeem their shares before fees and gates are imposed. However, as discussed at length in today’s release, the Federal Reserve staff’s conclusion that fees and gates may cause pre-emptive runs is based on a model whose assumptions and features are different than the reforms we are adopting today. Accordingly, as noted in the release, the Federal Reserve paper’s findings regarding the risks of pre-emptive redemptions are not likely to apply.

In addition, there are several aspects of today’s amendments that are designed to mitigate the risk of pre-emptive runs as the result of “fees and gates,” and to reduce the effects of such runs should they occur. These include a maximum time period for the imposition of gates that is shorter than what was proposed and a significantly smaller default liquidity fee than initially proposed. As noted in the release, these changes from the proposal are expected to lessen further the risk of pre-emptive runs.

The use of fees and gates, like other provisions recommended today, has required particularly close and thoughtful deliberation. I struggled with a change that allows fund boards to temporarily prevent investors from redeeming their own cash, even when it is limited to a severe market stress scenario. This amendment is in direct conflict with the foundations of the Investment Company Act of 1940, which require that investors be able to redeem their money. It seems equally concerning to me to support the imposition of a fee on redeeming investors in a time of such high market volatility and investor stress, even when the fee provides additional liquidity to other non-redeeming investors in the same fund. Investors may be required to pay fees when they are least able to do so. I ultimately conclude, however, that the combination of providing investors with full disclosure concerning the possibility that gates and fees will be imposed in certain limited circumstances, and the benefits to investors and the country as a whole of reducing systemic risk and lessening the risk of a future economic collapse, justifies the Commission taking these extraordinary steps.

Today’s amendments also address, in part, the possible migration of assets from registered money market funds to private investment funds. In particular, the amendments to Form PF will require large liquidity fund advisers to provide the SEC, on a monthly basis, with basically the same information in respect to their funds’ portfolio holdings as is provided by registered money market funds. While Form PF does not cover all unregulated funds or vehicles, the additional information will provide important information and transparency to the Commission. I expect the Commission staff to closely monitor these developments and to recommend to the Commission and, if necessary, to Congress, any possible amendments or legislative reforms needed to address the operations of these dark, less regulated markets.

More generally, while I support the adoption of today’s amendments, I expect the staff to monitor the impact and effects of these amendments and to provide regular and frequent reports to the Commission.

Re-Proposing Amendments to Remove References to Credit Ratings from Rule 2a-7

Today, I will also vote to approve the re-proposal of amendments that would remove references to credit ratings from Rule 2a-7, as mandated by the Dodd-Frank Act. Under this re-proposal, a money market fund would be limited to investing only in securities that the fund’s board of directors determines to have “minimal credit risk,” a determination that includes a finding that a security’s issuer has an “exceptionally strong capacity to meet its short-term obligations.”

These re-proposed amendments would replace the current requirement that an assessment of credit quality be based on both an objective standard (i.e., credit ratings) and a subjective standard (i.e., a fund’s board of directors’ independent credit evaluation), with an entirely subjective evaluation of credit quality by the fund’s board. As I said when these amendments were first proposed back in March 2011, removing the objective baseline of credit rating references from Rule 2a-7 could encourage funds to invest in riskier portfolio securities and may therefore increase, rather than decrease, risks to investors.

There are aspects of today’s re-proposal that seek to address these concerns, which were echoed by several commenters. Most notably, the re-proposal provides guidance on specific objective factors that should be considered by funds’ boards in assessing credit quality, such as issuers’ financial condition and liquidity. Importantly, however, consideration of such objective factors is not required under today’s re-proposal. I therefore strongly encourage commenters to express their views about the adequacy of external, objective factors in assessing the credit quality of portfolio securities, and whether a more prescriptive approach is needed.

Notice of Proposed Exemptive Order from the Confirmation Requirements of Rule 10b-10

Finally, the Commission is also providing notice of a proposed exemptive relief that would grant an exemption from the confirmation requirements of Exchange Act Rule 10b-10 for money market funds, including those with a floating NAV, provided certain conditions are met. I will vote to approve the issuance of this notice.