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

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.