Comment Letter Q&A

A Private Emergency Liquidity Facility for Prime Money Market Funds

ICI’s January 10, 2011 comment letter to the Securities and Exchange Commission states that a private emergency liquidity facility has the most promise to further strengthen and provide a liquidity backstop for prime money market funds in times of severe market stress. This page covers highlights from the comment letter on the proposed liquidity facility’s design, operation, and how it would address challenges identified by the President’s Working Group on Financial Markets (PWG) Report on  Money Market Fund Reform Options.

Why would money market funds need an additional liquidity backstop in times of market stress?

During the financial crisis of 2008, money market funds experienced heavy redemption pressure, even when their portfolios were full of high-quality assets. The need to sell these instruments into a stressed market to meet redemptions created challenges for funds and downward pressure on the prices of the assets.

Policymakers have already made great strides toward the goal of making money market funds more resilient under extreme market conditions. A private emergency liquidity facility for prime money market funds (LF) would bolster money market funds even further.

What is the private emergency liquidity facility for prime money market funds?

The proposed LF is an industry-sponsored solution intended to enhance liquidity for prime money market funds during times of unusual market stress. The LF would be structured as a state-chartered bank or trust company, capitalized through a combination of initial contributions from prime money market fund sponsors and ongoing commitment fees from member funds. The LF would grow additional capacity from the issuance of time deposits to third parties. All prime money market funds—those that invest in high-quality, short-term money market instruments, including commercial paper—would be required to join the LF.

The LF would be a member of the Federal Reserve, subject to regulation by state banking authorities and the Fed, and eligible to access the Fed’s discount window under the same terms as other banks.

What would the LF do?

When markets are operating normally, the LF would invest the proceeds of its sponsor capital, commitment fees and the time deposits issued to third parties in a portfolio of short duration Treasury and agency securities.

During times of unusual market stress, the LF would be available to purchase high-quality, short-term assets including commercial paper, asset-backed commercial paper, bank notes and banker’s acceptances from member funds at amortized cost, subject to risk-limiting policies and conditions. We anticipate that the LF would hold these securities to maturity, at which point it would reinvest the proceeds in Treasury securities after the market stress subsides.

How would the LF help investors in the money market?

During times of unusual market stress, the LF would enable funds to meet redemptions while maintaining a stable $1.00 net asset value (NAV) by purchasing securities at amortized cost – the cost at which the securities are held on the fund’s books.

In doing so, the LF would also provide important systemic protection for the broader money market by allowing funds to avoid selling securities into a challenging market, mitigating a downward spiral in the market prices of money market instruments.

When does the LF provide a liquidity backstop for a fund?

The LF is designed to provide a liquidity backstop for a fund only after the fund has used a substantial portion of its required  liquidity buffer. Rule 2a-7 of the Investment Company Act requires each prime fund to maintain a buffer of 10 percent of assets under management in cash, treasuries, or securities than can convert to cash within a day, and 30 percent in cash, treasuries, certain other government securities, or securities that can convert to cash within seven days. For the prime money market fund industry as a whole, these positions amount presently to approximately $160 billion in daily liquidity and $485 billion in weekly liquidity, based on ICI data for prime money market fund assets of $1.65 trillion as of August 31, 2010.

Who would pay for the LF?

Initial capital would come from sponsors of prime money market funds, based on the assets under management of those funds, with an aggregated target initial equity of $350 million.

The LF also would require ongoing commitment fees from its member funds, which would accrue for the benefit of current and future money market fund shareholders.

At the end of its third year, the LF would begin to issue to third parties time deposits paying a rate approximately equal to the 3-month bank CD rate.

Does ICI’s proposal for the LF address concerns raised by the President’s Working Group Report?

The PWG Report thoughtfully notes several concerns that could arise in the structure and operation of a liquidity facility, including ensuring the facility has adequate capacity; avoiding “free riding” and moral hazard; and reducing the potential for conflicts of interest when market liquidity is in short supply. The ICI proposal addresses each of these concerns.

How well capitalized would the LF be?

The LF would seek to achieve and maintain a target leverage ratio (total capital to assets) of 5 percent, making it “well capitalized” under the Basel I and II standards.

The ability to borrow from the Fed’s discount window during times of market stress, together with the LF’s direct sources of capital, will provide the LF with an estimated capacity of approximately $7 billion at its start, $12.3 billion at the end of the first year, $30 billion at the end of five years, and $50 to 55 billion at the end of 10 years. (We anticipate that the facility would continue to increase capacity after year 10; we modeled to year 10 for illustrative purposes.)

How would the LF deal with the challenge of “free riding?”

The PWG Report recognizes the challenge of permitting voluntary participation in a liquidity facility, which would allow non-participating funds to “free ride” on the market stability the facility provides.

One means of mandating participation would be to require participation in the LF as a condition for prime funds that wish to continue using amortized cost pricing to offer a stable $1.00 net asset value (NAV). Under this option, funds that opt out of the LF could either switch to a floating NAV or convert to a Treasury or government fund.

How would the LF manage conflicts of interest when liquidity is in short supply?

One potential conflict is the tension between avoiding losses on commercial paper while still purchasing such paper to function as a useful liquidity backstop. The LF’s independent credit analysis function, and ability to select which assets it will accept, should enable it to effectively minimize losses while providing liquidity.

Another possible conflict may arise from competing interests among the members of the LF. The proposed LF governance structure, which includes a board comprised of representatives from a range of fund sizes as well as independent directors, is intended to guide the LF to pursue the best interests of the entire prime money market fund industry.

How would the LF prevent “moral hazard?”

The PWG report notes that a liquidity facility could create moral hazard by giving money market funds incentives to maintain less liquidity within their funds. The liquidity buffer required by Rule 2a-7 substantially addresses this moral hazard concern. In addition, under ICI’s model, the LF would have limitations on access designed to encourage funds to maintain adequate liquidity. A fund would typically be limited to its proportionate share of the LF’s available liquidity, based on its assets under management. The LF would also charge an access fee for using the facility. The fee is designed to prevent funds from attempting to sell low-yield securities to the LF in a rising interest rate environment, but would still be less costly than accessing liquidity through the markets in times of stress.

How widespread is support for ICI’s LF proposal within the fund industry?

Although ICI has worked hard to build a consensus on this issue in the fund industry, given the complexities of the issue and the variety of fund business models, industry support is not unanimous.

For more information on regulatory developments on the reform of money market funds, please visit ICI's Money Market Funds Resource Center.