Our take: financial services regulatory update – February 5, 2021

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Change remains a constant in financial services regulation. Read "our take" on the latest developments and what they mean.

Current topics - February 5, 2021

SEC requests comment on potential money market fund reforms

Yesterday, the SEC released a request for comment on potential reform measures for money market funds (MMFs). The request stems from the stress experienced by short-term funding markets in March 2020 as a result of the pandemic-related economic crisis and follows a report on the impact to MMFs released by the President’s Working Group on Financial Markets in December 2020. Potential policy options described in the report and echoed in the SEC’s request include:

  • Removing the tie between MMF liquidity and thresholds for fees and gates. Currently, MMFs have discretion to impose fees and redemption gates when weekly liquid assets fall below 30%, and they are generally required to impose a fee of one percent when it falls below 10%. While these rules are intended to stem heavy redemptions in times of stress, the report notes that they have the unintended effect of causing a dash-for-cash as funds approach the thresholds. To address this problem, the report highlights the policy option of removing specific thresholds and instead allowing the funds themselves to impose fees and gates when it is in their best interest.
  • Reforming redemption gate rules. To avoid the dash-for-cash out of fear that MMFs will impose redemption gates, the report proposes various potential reforms including requiring that funds notify the SEC prior to imposing gates, requiring that they consider imposing fees before gates, adjusting the threshold at which they may impose gates and allowing for “partial” gates that allow limited redemptions per day.
  • Implementing a “minimum balance at risk” (MBR) mechanism. The report outlines the policy option of requiring that a portion of each shareholder’s balance to be only redeemable with a time delay and share in any losses within that period.
  • Liquidity management requirements. Potential policy reforms include imposing penalties on fund managers, such as requiring the escrow of fund management fees if WLA falls below a certain threshold until the level of liquidity is restored, to encourage firms to maintain higher levels of liquidity. Another potential reform would be to create an additional category for assets with slightly longer maturities (e.g., biweekly liquid assets) to strengthen funds’ near-term portfolio liquidity.
  • Countercyclical liquidity requirements. The report explains that requiring countercyclical WLA could reduce funds’ resistance to using liquid assets to meet redemptions in times of stress. Specifically, it suggests that minimum WLA requirements could automatically decline in certain circumstances such as when net redemptions are large.
  • Floating NAVs. The report explains that requiring retail prime and tax-exempt MMFs to use floating net asset value (NAV) for their portfolio assets would eliminate the incentive for investors in funds that use stable NAVs to redeem their shares for more than they are worth in times of stress.
  • Swing pricing. Currently, MMF investors do not incur the costs associated with their redemptions, creating a first-mover advantage in times of stress. The report highlights that this advantage could be eliminated by allowing funds to impose the costs stemming from redemptions directly on redeeming investors.
  • Additional policy options. Other areas discussed in the report include capital buffers, mandatory liquidity exchange bank membership, and rules around when fund sponsors would be required to provide support.

Our take

After the crisis-related stress experienced by MMFs in March of last year, the Financial Stability Board as well as industry members and other regulators from around the globe have recognized the need to address the moral hazard of funds failing to internalize their liquidity risk in anticipation of future central bank interventions in times of stress as has occurred during the last two crises. They have also agreed that reforms are needed to prevent future systemic shock. Nearly a year later, we are now beginning to see movement from the SEC on what these reforms might look like. Many of these ideas (e.g., MBR, floating NAVs extended to all MMFs such as prime and tax exempt funds, capital or NAV buffers, or liquidity exchange bank formation and membership) were raised at the time of the 2008 financial crisis but were ultimately not adopted. While we expect industry pushback as these ideas are raised again, the regulators may decide that some of these liquidity risk mitigation reforms are warranted considering it is the second time in just over a decade that the Fed has had to step in. We may see agreement on some of the other proposed reforms but many will be challenging to design in a way that mitigates unintended consequences. For example, the industry has advocated for more discretion in its use of fees and gates, but the SEC will likely be careful to ensure that this policy would not result in funds holding less liquid assets. In addition, as swing pricing comes under consideration, the SEC will face the challenge of balancing the benefits of reducing the first mover advantage with the drawbacks of the associated uncertainty and unequal investor treatment.

Going forward, we expect that there will be significant discussion, academic research, hearings, and an active SEC chair all involved as these potential reforms materialize into new requirements. While it remains to be seen whether the result will be minor adjustments (e.g., tweaking the thresholds for imposing gates) or more significant safeguards, it is clear that regulators are ready to take action to avoid allowing MMFs to take a “third strike” during the next period of stress.

FINRA releases examination priorities report

On Monday, the Financial Industry Regulatory Authority (FINRA) released its 2021 report on its risk monitoring and examination program, a new publication that replaces its annual examination findings report and priorities letter. The report explains that upcoming examinations will continue to focus on firms’ adherence to the SEC’s Regulation Best Interest, but it notes that this year examiners will look beyond the letter of the law to assess a “more comprehensive scope” of practices to prevent consumer harm. It also focuses on compliance with FINRA’s Communications with the Public Rule, particularly emphasizing communications regarding new products and the use of digital channels. For example, the report stresses that when developing interactive digital features to promote products, firms should keep in mind their obligations to accurately disclose material facts and risks as well as avoid making statements that can be misleading. Another area that the report emphasizes is anti-money laundering (AML), reminding firms of recent changes under the AML Act of 2020 and highlighting obligations to collect beneficial ownership information, ensure data quality and document investigations related to potentially suspicious activity. Other key priorities include Consolidated Audit Trail reporting, cybersecurity, and best execution obligations.

Our take

The themes of FINRA’s examination priorities look similar to last year’s on the surface, but the details of expectations in each area reveal new points of emphasis. As Regulation Best Interest went into effect last year, its inclusion in the 2020 priorities meant that firms had to demonstrate a good faith effort to comply with the requirements. In contrast, this year firms should be prepared for closer scrutiny into the adequacy of their disclosures and whether they are demonstrating reasonable care and diligence to make sure recommendations are in line with customers’ investment portfolios and risk appetites. In addition, firms should make sure that they have processes in place to carefully review and approve all forms of communication before they are sent out. In doing so, they should place emphasis on processes governing the current work environment where communications are increasingly taking place on social media, messaging apps and other digital channels.

On our radar

These notable developments hit our radar over the past week:

  • California consumer watchdog takes first enforcement action. On Wednesday, the recently-formed California Department of Financial Protection and Innovation issued an enforcement action against a student loan debt relief company, alleging that it fraudulently guaranteed that it would erase debt while charging “exorbitant fees.” It also announced that it is launching an investigation into other student loan debt relief companies.
  • BOE says to prepare negative rate solutions. Yesterday, the Bank of England’s (BOE) Prudential Regulatory Authority sent a letter to its regulated firms providing them with feedback on their readiness to implement negative interest rates and indicating that it expects firms to have tactical solutions to implement such rates in the next six months.
  • Europe adopts legislative solution for legacy LIBOR-based contracts. The European Council on Tuesday adopted proposed amendments to the EU Benchmarks Regulation (BMR) that would provide a solution for existing LIBOR-based contracts that feature no, or inadequate provisions to address a permanent cessation of LIBOR. The European Parliament had adopted the amendments earlier this month. Under the legislation, which is now expected to go into effect on February 13 of this year, the European Commission could designate a statutory replacement for LIBOR in such contracts upon its cessation.
    Similar legislation that would address LIBOR-based contracts written under New York State law had been introduced by Governor Cuomo to the state’s legislature earlier this month. 

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Julien Courbe

Financial Services Leader, PwC US

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