On Thursday, February 4, 2021, the U. S. Securities and Exchange Commission (“SEC”) issued a Release (No. IC-34188) (the “Release”) entitled “Request for Comment on Potential Money Market Fund Reform Measures in President’s Working Group Report.” The President’s Working Group (“PWG”) had issued its “Report of the President’s Working Group on Financial Markets Overview of Recent Events and Potential Reform Options for Money Market Funds” (“PWG Report”) on December 22, 2020. The PWG is chaired by the Secretary of the Treasury and includes the Chair of the Board of Governors of the Federal Reserve System (“Fed”), the Chair of the SEC, and the Chair of the Commodity Futures Trading Commission.

SEC Requests Comments on MMF Reforms

The Release notes that the PWG Report is intended to provide insight into “… the effects of the growing economic concerns related to the COVID-19 pandemic in March 2020 on short-term funding markets and, in particular, on money market funds.” The PWG Report (in the words of the Release) “provides an overview of prior money market fund reforms in 2010 and 2014, as well as how different types of money market funds have evolved since the 2008 financial crisis.” The Release also notes that the PWG Report “…discusses events in certain short-term funding markets in March 2020,” and then “…discusses significant outflows from prime and tax-exempt money market funds,” and how that contributed to “…general stress in short-term funding markets.” This, the Release notes, “occurred despite prior efforts to make money market funds more resilient to credit and liquidity stresses,” concluding that the PWG Report shows that more work needs to be done to “reduce the risk that structural vulnerabilities “ in money market funds will cause exacerbated stresses in short-term funding markets. The SEC requests comments on the PWG Report (and the reform proposals it discusses) within 60 days of its publication in the Federal Register.

Money Market Funds

Money Market Funds date to 1971, when Bruce R. Bent and Henry B. R. Brown established the first money market fund (“MMF”), the Reserve Fund. MMF’s are a type of mutual fund registered under the Investment Company Act of 1940 (the ”Act”), and since 1983, regulated under SEC Rule 2a-7 of the Act. MMF’s were attractive as a vehicle for saving money, as until 1982 the Fed’s Regulation Q, which prohibited paying interest on demand deposit accounts and otherwise limited to 5.25 % the amount of interest banks and credit unions could pay on deposit other types of accounts. MMF’s seek to maintain a stable Net Asset Value (“NAV”) of $1.00. If a MMF’s NAV drops below $1.00, it is said that the MMF “broke the buck.” That would happen if the market value of the MMF’s holdings falls below the amortized cost of them, for instance when a bond or note held in the MMF is worth less than it cost (from an insolvency or because of a change in interest rates that makes the bond or note worth less than its purchase price, or both). MMF’s are allowed only a 50 basis point ($0.005) weekly variant from market value without being seen as “breaking the buck.”

From 1971 until 2008, only two MMF’s “broke the buck.” The first occurred in 1978, when First Multifund for Daily Investment (“FMDI”) had to liquidate when its NAV dropped to $0.94. Although FMDI had claimed that it invested “solely in Short-Term (30-90 days) MONEY MARKET obligations,” the average maturity of securities in its holdings exceeded two years. FMDI had purchased increasingly longer maturity securities seeking higher yield; rising interest rates caused the market value of those securities to decline. The Community Bankers U.S. Government Fund “broke the buck” in 1994 when the Fund had a large percentage of its holdings in adjustable rate securities. Again as interest rates increased these securities declined in market value. Then in 2008, on Monday, September 15, Lehman Brothers Holdings, Inc., filed for bankruptcy and the Great Recession began. On Tuesday, September 16, 2008, the venerable Reserve Primary Fund “broke the buck” and its NAV fell to $0.97 when it wrote off its holdings of Lehman Brothers short-term debt securities. On Friday, September 19, 2008, the U.S. Department of the Treasury announced that it would “insure the holdings of any publicly offered eligible money market mutual fund – both retail and institutional- that pays a fee to participate in the program.” This program, similar to FDIC insurance on bank accounts, stemmed the run on MMF’s.

MMF Reforms

The Great Recession led to many changes in American capital markets, including MMF’s. It will be useful to look first at the different types of MMF’s. The PWG Report states that there are three types of MMF’s in terms of categories of investors:

1. Retail, limited to retail investors

2. Publicly-offered institutional MMF’s, held primarily by institutional investors

3. Non-publicly-offered institutional MMF’s, such as central funds used by asset managers as part of their investment administration

There are also three general types of MMF’s based on the types of securities they hold:

1. Prime MMF’s (the type of MMF most used by retail investors, although there are also prime institutional MMF’s)

2. Tax-exempt MMF’s whose holdings are limited to municipal securities

3. Government MMF’s, whose holdings are limited to U.S. Treasury and Agency securities

The PWG Report observes:

As investors commonly use MMF’s for principle preservation and as a dash management tool, many MMF investors may have a low tolerance for losses and liquidity limitations.

The MMF reforms implemented by the SEC in 2010, in response to the Great Recession and consistent with the 2010 enactment of the Dodd-Frank Act, focused on improving transparency, and as stated in the PWG Report, reducing credit, liquidity, and interest rate risks. The 2010 reforms introduced new liquidity requirements: at the time a MMF acquires an asset, it must hold at least 10% of the Fund’s total assets in daily liquid assets (“DLA”) and at least 30% of total assets in weekly liquid assets (“WLA”). These two requirements are intended to work in combination to ensure that a MMF has the capacity to raise enough cash to meet redemption requirements, especially when market conditions lead to heightened redemption requests. MMF’s must meet a 120-day limit on the weighted average life of portfolio holdings, as well as a reduction in the limit on the portfolio’s weighted average maturity from 90 to 60 days, to address both credit and interest rate risks. Moreover, MMF’s were required to disclose their holdings every month. The 2010 reforms also required stress testing and adoption of protocols that would facilitate orderly liquidation of a MMF if it “broke the buck.”

In 2012, the Financial Stability Oversight Council created by the Dodd-Frank Act recommended that the SEC adopt an additional series of MMF reforms, which included the following having MMF’s use a floating NAV; having a 3% buffer to provide loss absorption capacity; and having a minimum balance at risk to the MMF investor. In 2014, in response to these recommendations, the SEC required that institutional MMF’s use floating NAV, so that those MMF’s must sell and redeem their shares at the market value of the MMF’s underlying portfolios. In addition, all prime and tax-exempt MMF’s (including retail funds) were permitted to impose liquidity (redemption) fees of up to 2%, or even to suspend redemptions, if the fund’s WLA falls below the 30% minimum requirement imposed by the 2010 reforms. Further, if the WLA falls below 10% of total assets, the MMF must impose a 1% liquidity fee (unless the fund Board determines that the imposition of the fee is not in the best interest of the fund). These 2014 reforms also require prompt disclosure, including posting on the MMF website, of imposition or termination of liquidity fees, any suspension or reactivation of redemptions, any defaults in the securities it holds, any infusion of capital from the fund’s sponsor, and any fall in the market value of the holdings of a retail or government MMF below $0.9975 per MMF share. In addition, MMF’s are to disclose on their respective websites the following: its DLA, its WLA, its market-based NAV, and net flows into and out of the fund.

In March 2020, in response to the general lockdown of the economy, capital market participants (in the words of the PWG Report) “sought to rapidly shift their holdings to cash and short-term government securities.” The result was substantial stress on short-term funding markets including prime and tax-exempt MMF’s, the repo (repurchase agreements) market, the commercial paper (“CP”) market, and the short-term municipal securities market. That stress on MMF’s led to an acceleration of redemptions, which in turn amplified the stresses on the short-term funding markets. An example of these stresses was the shift in CP as interest rates rapidly increased, so that by March 23, 2020, 90% of new CP had overnight maturities when typically CP is sold with 30- to 270-day maturities. MMF’s which rely on CP for much of their holdings (MMF’s held 19% of outstanding CP as of February 28, 2020), shed some $35 billion in March, accounting for 74% of the overall $48 billion decline in outstanding CP for the same period. In addition, the asset values of MMF’s were declining, risking the possibility of required liquidity fees or even suspension of redemption, lest the MMF’s “break the buck.” A similar sequence of cause and effect struck the short-term municipal debt market in the same time period. Tax-exempt MMF’s experienced what the PWG Report understatedly called “unusually large redemptions” beginning on March 12, 2020. These contributed to “worsening conditions in short-term municipal debt markets.” The 7-day municipal swap index maintained by the Securities Industry and Financial Markets Association (“SIFMA”), and used as a benchmark of weekly rates in the short-term municipal securities markets, “shot up 392 basis points on March 18, 2020, which in turn, caused a drop in the market-based NAV’s of tax-exempt MMF’s, one of which reported a market-based price below $ 0.9975, and hence, essentially “broke the buck.” WLA declined precipitously, in some cases below the 30% minimum threshold. For example, one institutional prime fund had assets worth $3.8 billion at the end of February, which were worth only $1.5 billion by the end of March.

On March 18, 2020, the Fed, with the concurrence of the Secretary of the Treasury, authorized the Money Market Mutual Fund Liquidity Facility (“MMMFLF”), which began operating on March 23. The MMMFLF provides non-recourse loans to U.S. depository institutions (banks) and to bank holding companies to finance their purchase of eligible assets from MMF’s. Simultaneously, the bank prudential regulators (the FDIC, the OCC, and the Fed) adopted regulatory positions to “neutralize” the effects that purchasing those assets had on the respective institutions’ risk-based and leveraged capital ratios and on liquidity coverage ratios. These steps were intended to, and did, stabilize the U.S. financial system by allowing MMF’s to raise cash to meet redemption requests and to increase liquidity in the markets for the types of assets typically held by MMF’s. The Department of the Treasury allocated $10 billion of credit protection to the Fed in connection with the MMMFLF from the Treasury’s Exchange Stabilization Fund. The MMMFLF provided just over $50 billion, peaking in early April 2020. The “run” on MMF’s abated rapidly once the MMMFLF was implemented, and with a return to more “normality” in the short-term funding market, with a sharp decline in the issuance of CP with overnight maturities. But the Spring 2020 experience strongly suggested that more MMF reforms are needed to increase the stability of MMF’s in the face of unexpected external events which precipitate a national and intense desire for cash or equivalents.

Bucking the Break

As a result of the PWG study that produced the PWG Report, ten possible revisions are laid out for consideration. The PWG states in the Report that they are “meant to facilitate discussion” and that “the PWG is not endorsing any given measure at this time.” This blog post summarizes those ten possibilities below. It should also be noted that the PWG did emphasize certain points about some of the ten as forcing MMF’s to internalize more of the responsibility for liquidity and, in any event, to make crystal clear that MMF investors, not U.S. taxpayers, should bear market risks. One possible innovation would involve the creation of a Liquidity Exchange Bank (“LEB”) as a kind of private-sector support facility to provide emergency capital to MMF’s in times of severe stress. The ten possible revisions are as follows:

1. Remove the link between MMF Liquidity Fees and “Gate” Thresholds – the concern is that MMF investors will accelerate redemptions as MMF asset value declines toward those preset thresholds; removal would leave the use of these devices to the discretion of the MMF board to act in the best interest of the fund

2. Reform of limitations on Redemption – MMF’s could be required to notify the SEC or even obtain SEC permission prior to imposing restrictions on redemption; if redemptions exceeded preset thresholds, the limitations would constrain any fund investor’s redemption request by a pro rata “haircut” while also providing partial liquidity for the investor

3. Subject some percentage of each MMF shareholder’s holding to a time delay in redemption, which could be withheld until the redemption is financially supportable and, until then, serve as a capital buffer for the fund

4. Change liquidity requirements- A new longer-term (such as bi-weekly) liquidity assessment in addition to the DLA and WLA could be required; a new WLA threshold could be added (say 40%), which if crossed would require the escrow of management fees

5. Revise WLA requirements so that the 30% threshold could be automatically reduced in the face of high net redemptions or when the SEC authorizes relief, so that WLA would have a countercyclical component

6. Change the NAV measurement for ALL MMF’s, including retail prime and tax-exempt, so that all MMF’s sell and redeem shares at prices that reflect the market value of the funds’ portfolios, which would end the risk of “breaking the buck”

7. Allow MMF’s to collect the costs of redemption transactions from redeeming MMF investors. This so-called Swing Pricing would ensure that redeeming shareholders bear liquidity costs as opposed to those costs being borne by other investors in the fund

8. Impose new capital buffer requirements- such requirements would mean that the MMF had a “reserve” to provide additional liquidity for redemptions in the face of a run; buffers could be moneys set aside at the time of share purchase

9. Create and require membership in a LEB- the LEB would be chartered as a bank; each MMF would be required to make an initial contribution and annual fees; during periods of market stress the LEB could purchase eligible MMF assets to provide MMF’s with additional cash to fund redemptions; the LEB would not be a commercial bank, but would be subject to supervision and regulation by one of the prudential regulators

10. Impose sponsor support requirements on MMF’s to replace the current environment where fund sponsor support in times of stress is purely voluntary; this would end the uncertainty of whether a particular fund sponsor will provide cash infusions to stabilize the fund. If the SEC does move forward on this, the Fed would have to create an exemption from the strictures on banks providing capital support to MMF’s with which the banks are affiliated (under section 23A of the Federal Reserve Act), otherwise, bank fund sponsors would be unable to comply with the SEC requirement

In the Release, the SEC requests that commenters discuss BOTH the effectiveness of the 2010 and 2014 MMF reforms AND the projected effectiveness of implementing any one or more of the ten possible revisions, whether as additions to OR as replacements of any of the 2010 and 2014 reforms. In all cases, commenters are asked to focus on:

1. Addressing MMF structural vulnerabilities

2. Improving MMF resilience and the functioning of short-term funding markets

3. Reducing or eliminating the need for government funding intervention

As documented in the PWG Report of September 30, 2020, MMF’s total net assets were $4.9 TRILLION. Many if not most MMF investors do NOT think of MMF’s as an investment vehicle, but rather as a bank account alternative that has a higher yield. Since the passage of the 1933 Banking Act and the creation of Federal Deposit Insurance bank accounts (subject to caps that have grown over time) have been seen as “risk-free,” as the Federal Treasury guaranteed that depositors would not incur losses (up to the relevant cap), even if the bank failed. Unfortunately, the identification in the popular mind of MMF’s as equivalent to bank accounts has probably lulled MMF investors into a false sense of security. Unexpected but material market developments can (and have) produced runs on MMF’s, with cascading consequences for U.S. capital markets (especially short-term funding markets). And we know from our experiences since 2008 that when short-term funding seizes up, the potential for a total economic collapse is near. Hence, further MMF reform is necessary to impede the risk that MMF’s will “break the buck.”

In the wisdom of the Gospel according to St. Matthew (World English version) 7: 24-27:

Everyone therefore who hears these words of mine, and does them, I will liken him to a wise man , who built his house on a rock. The rain came down, the floods came, and the winds blew, and beat on that house; and it didn’t fall, for it was founded on the rock. Everyone who hears these words of mine, and doesn’t do them will be like a foolish man, who built his house on the sand. The rain came down, the floods came, and the winds blew, and beat on that house; and it fell-and great was its fall.

MMF reforms are needed to provide a better “rainy day fund,” so that they do not fall and “break the buck.”