In July 2014, the U.S. Securities and Exchange Commission (SEC) issued new rules to enhance the stability and resilience of money market funds. These rules, which are to be implemented by October 2016, place tighter restrictions on portfolio holdings, enhance liquidity and credit quality requirements, and provide for greater transparency. Furthermore, the rules allow all money market funds, during times of extreme volatility, to temporarily prevent investors from making withdrawals or to impose fees for investors who redeem shares.
At the peak of the 2008 financial crisis, the Reserve Primary Fund, a large New York-based fund manager, was forced to reduce the net asset value (NAV) of its money market fund below $1 due to massive losses generated by failed short-term loans issued by Lehman Brothers. It was the first time a major money market fund had to “break the buck” (the $1 NAV), which caused a panic among institutional investors, who began mass redemptions. This behavior added stress to the markets, which the SEC determined to resolve with its new rules.
The most fundamental change is the requirement for money market funds to move from a fixed $1 share price to a floating NAV, which introduces the risk of principal where it had never existed. In addition, the rules require fund providers to institute liquidity fees and suspension gates as a means of preventing a run on the fund. The requirements include asset level triggers for imposing a liquidity fee of 1% or 2%. (If weekly liquid assets fall below 10% of total assets, it triggers a 1% fee. Below 30%, the fee is increased to 2%.) Funds may also suspend redemptions for up to 10 business days in a 90- day period.
The changes will be nominal for most individual or retail investors. The most significant rule change, the floating NAV, is not likely to affect investors who invest in retail money market funds. These funds may maintain the $1 NAV; however, they may still be required to institute the redemption triggers for charging a liquidity fee or suspending redemptions. Many of the larger fund groups are taking actions to either limit the possibility of a redemption trigger or avoid it altogether by converting their funds into a government money market fund, which has no requirement.
Changes will be more significant for community banks whose customers invest in prime money market funds inside their 401(k) plans because these are typically institutional funds subject to all of the new rules. Plan sponsors will have to change out their fund options, offering a government money market fund or some other alternative. Because institutional investors are the target of the new rules, they will be the most affected. For them, it will come down to a choice of securing a higher yield or lower risk. They can still invest in U.S. government money markets, which are not subject to the floating NAV or redemption triggers, but they will have to accept a lower yield. Institutional investors seeking higher yields may have to consider other options, such as bank certificates of deposit (CDs), alternative prime funds that invest primarily in very short maturity assets to limit interest rate and credit risk, or ultra-short duration funds that offer higher yields but also have more volatility.
In summary, the 2008 financial crisis left an indelible mark on financial regulatory reform. In regard to money market reform, institutional investors and fund providers will need to significantly rethink the value of money market funds.