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ICI’s Response to 2013 Proposed Regulations for Money Market Funds
Questions and Answers
ICI has filed a detailed comment letter on the 2013 proposal from the Securities and Exchange Commission (SEC) to amend the rules governing money market funds. This document provides background information on the response from ICI and the fund industry.
What has the SEC proposed?
What is ICI’s view of the floating NAVs alternative?
What is ICI’s view of the liquidity fees and gates alternative?
Why is combining the SEC’s proposed policy alternatives the wrong approach?
Why does ICI believe that tax-exempt funds should be excluded from any fundamental structural reform?
Why does ICI agree that U.S. government funds should be exempted from any floating NAV proposal?
What is ICI’s view of the proposed exemption for retail investors?
Why is it important to preserve amortized cost accounting for stable value funds?
What happens next in the regulatory process?
Following up on a set of comprehensive reforms for money market funds that it adopted in 2010, the SEC in June 2013 proposed two major policy alternatives for these funds. One option would impose a floating net asset value (NAV) on prime and tax-exempt funds held by institutional investors. The other proposal would impose liquidity fees and redemption limits, or “gates,” on all prime and tax-exempt funds, triggered when a fund’s liquidity has fallen below a set level. Some commissioners also have suggested combining both proposals.
In section IV of its comment letter, ICI discusses its view of the floating NAV policy alternative. Key points include the following:
- Floating NAVs could eliminate key benefits to investors. Forcing some money market funds to use floating NAVs as proposed would place significant tax, accounting, and operational burdens on shareholders, funds, and intermediaries.
- Floating NAVs are unlikely to significantly reduce redemption activity. Floating NAV funds are unlikely to alter investor behavior because the NAV will move little. From January 2011 to July 2012, 96 percent of prime money market funds recorded an average absolute monthly change in their mark-to-market value of 1/100th of a cent (1 basis point, or $0.0001) or less. Second, floating NAVs are unlikely alter the tendency of investors to shift toward the safest, most liquid market—usually the U.S. Treasury market—during periods of financial stress.
- Floating NAVs are unnecessary to improve transparency. Robust monthly disclosure of funds’ portfolio holdings and other characteristics, combined with the daily disclosure of funds’ mark-to-market share prices, would accomplish the same goal without eliminating the stable share price, which greatly benefits investors.
- Floating the NAV likely would reduce capital market funding to the private sector. Requiring prime institutional money market funds to float their NAVs risks precipitating an outflow of hundreds of billions of dollars from prime money market funds to other products. This could result in a major restructuring and reordering of intermediation in the short-term credit markets, a transition that is likely to be highly disruptive.
The SEC’s liquidity fee/temporary gate proposal has the support of a number of ICI members. In section III of its comment letter, ICI examines the advantages of this policy alternative, which include:
- Liquidity fees and temporary gates address SEC concerns. Liquidity fees and temporary gates promise to slow or stop significant fund outflows. Importantly, liquidity fees and temporary gates would be triggered only when a fund is facing unusual circumstances, such as a period of heavy redemptions associated with general stress in the financial markets at large, or an idiosyncratic credit issue. Gates would be a temporary expedient designed to allow a fund breathing room to determine whether and how it could address its portfolio liquidity issues (without having to rapidly sell assets) or to start an orderly liquidation process.
- Liquidity fees and temporary gates, as proposed, would enhance disclosure and transparency. The liquidity fee and temporary gate proposal would be coupled with measures to further enhance the transparency of money market fund portfolios. Such measures would benefit both investors and regulators.
However, ICI cautions that the proposal has potential drawbacks, including reduced liquidity for investors, tax implications, and operational complexities that would have to be addressed over a number of years.
In section V of its comment letter, ICI discusses the reasons why the SEC should refrain from adopting both major policy options.
- It would push investors away from money market funds. An investor simply would not purchase a fund that is saddled with the combination of a floating NAV, the prospect of having to pay a fee to redeem or of being prohibited from redeeming for some time, and the strict portfolio requirements imposed by Rule 2a-7. Investors have other, less onerous, options readily available.
- Cost and operational burdens would affect the viability of money market funds. Funds, transfer agents, intermediaries, institutional investors, and others would incur significant operational costs, including costs for establishing or modifying a wide range of systems and procedures, to process transactions at floating NAVs. They also would incur costs for necessary changes to accommodate increased recordkeeping, accounting, and tax-reporting burdens. Then, in addition, they would incur costs in establishing or modifying systems to administer a liquidity fee and temporary gate.
Why does ICI believe that tax-exempt funds should be excluded from any fundamental structural reform?
In section II of its comment letter, ICI argues that there is no basis for fundamental structural reform—either floating NAV or fees and gates—for funds that invest primarily in tax-exempt municipal securities. The reasons include the following:
- Tax-exempt money market fund investors do not redeem heavily during market events. During the crisis month of September 2008, for example, tax-exempt money market funds saw outflows of $38 billion, compared with $360 billion flowing out of prime institutional money market funds.
- Tax-exempt funds are highly liquid. As of June 2013, tax-exempt funds had weekly liquidity amounting to 79 percent of their total assets— far in excess of the 30 percent of total assets required under SEC Rule 2a-7. This level of liquidity provides a high degree of protection against shareholder outflows. For example, in the unlikely event that tax-exempt money market funds faced wide-scale redemptions, they could accommodate $203 billion in outflows within one week.
- Tax-exempt money market funds play a critical role in providing affordable short-term funding for state and local entities across the United States. Tax-exempt money market funds are the largest investors in short-term municipal debt, holding $252.7 billion as of June 30, 2013. This was almost two-thirds of state and local short-term debt (64 percent as of June 2013). Requiring tax-exempt money market funds to restructure themselves to accommodate a floating NAV could be highly disruptive to their investors and the short-term tax-exempt debt markets.
- The proposed retail exception to the floating NAV requirement does not solve the serious problems that floating NAVs will cause for tax-exempt money market funds. If the SEC intended that these funds would qualify for the retail exception, it failed to take into account the costs and disruption to shareholders and intermediaries that would be involved with splitting existing funds and maintaining two separate “retail” and “institutional” funds.
The reasoning for this position is also covered in section II of the comment letter.
- Government money market funds have significantly different portfolios from other money market funds. Although all money market funds are required to hold securities with minimal credit risk, credit losses would occur in government securities only if the U.S. government failed to repay its maturing debt in full or allowed a federal agency to default on its outstanding short-term debt.
- During periods of financial stress, government money market funds typically experience inflows, rather than outflows. As the SEC itself acknowledges, assets of these funds also tend to increase, rather than decline, during times of stress.
ICI examines the proposed exemption for retail investors in section IV of its comment letter. As proposed by the SEC, a retail fund would be defined as a money market fund that does not permit any shareholder of record to redeem more than $1 million per business day.
- Maintaining the availability of prime stable NAV money market funds for retail investors is important. These funds provide diversification and a market-based rate of return that is not otherwise available through a bank deposit account.
- The SEC’s proposal to define retail funds through a redemption limit would be less investor-friendly and onerous operationally. The SEC’s proposal would negatively affect investors by restricting their daily liquidity in money market fund investments. Moreover, many shareholders hold money market fund shares through intermediaries (e.g., broker-dealers or retirement plans) that provide recordkeeping and other services to their clients, and that transact money market fund shares on their behalf. Thus, intermediaries would be responsible for enforcing a fund’s retail exemption with respect to their customers’ money market fund shares.
- Use of Social Security numbers (SSNs) provides a better method of defining retail investors. The SSN is well establish as an identifier issued to a natural person who qualifies under the Social Security Administration requirements. Thus, an SSN can clearly distinguish individual or retail investors from institutions, which are typically corporations or other entities. In addition, intermediaries already use an SSN as a core component of their customer-account opening and compliance processes.
Today, virtually all money market funds maintain a stable value through both the amortized cost method of valuation and penny-rounding pricing. Under both the floating NAV and the liquidity fee/temporary gate proposals, stable NAV money market funds would no longer be permitted to use the amortized cost method of valuation (other than for securities with remaining maturities of 60 days or less), but could continue to use the penny-rounding method of pricing.
As detailed in section VI of the comment letter, ICI is strongly opposed to this aspect of the proposal. The ability to use amortized cost to provide a stable NAV for money market funds facilitates the current process for same-day settlement—a feature that is vitally important to many investors.
The SEC will consider the comments it received by the September 17, 2013, deadline. Based on the timelines of past rulemakings, it is likely that a new rule on money market funds will be issued in mid- to late 2014.