Money market fund reform remains one of the most prominent unsettled issues in financial markets regulation after the 2008 crisis. The Securities and Exchange Commission’s most recent effort which aims at balancing reforms with a desire to preserve the major benefits of money market funds has not achieved that objective. The Mercatus Center at George Mason University invites you to join Hester Peirce and Robert Greene for a Regulation University program that examines the need for money market fund reform, identifies potential problems with the SEC’s proposal, and offers recommendations for meaningful reform. This program will highlight the key findings from Ms. Peirce and Mr. Greene’s recent public interest comment, Money Market Fund Reform; Amendments to Form PF, and provide specific suggestions for money market fund reform.

1. Opening the Gate to Money Market Fund
Reform
Hester Peirce
Senior Research Fellow
Robert Greene
Research Associate
This presentation is based on a forthcoming paper, which contains additional information and references.

2. Overview
•
What is a money market fund (MMF)?
•
How is a MMF regulated?
•
What happened to MMFs during the financial crisis?
•
How have MMF regulations changed since then?
•
How should MMF regulations be changed?

3. Before We Discuss MMFs … What is a Mutual
Fund?
•
Mutual funds are a collectively owned pool of assets
•
Registered with and regulated by the Securities and
Exchange Commission (SEC) under the Investment
Company Act of 1940
•
Organized as business trusts or corporations under
state law, and investors in the fund are shareholders

4. How are Mutual Funds Structured?
•
A separate company—a fund sponsor—sets up a
mutual fund typically as part of a diverse, multi-fund
complex
•
Shareholders elect a board to oversee the fund’s
relationships with the adviser and other outside
entities that provide services to the fund
•
Fund sponsor serves as the principal investment
adviser to the fund, and may also provide ―backoffice‖ administrative functions

5. How is a Mutual Fund Structured?
Mutual Fund Family
Fund Sponsor
Shareholders
Mutual Fund 3
Board of Directors
Mutual Fund 2
Oversees
Oversees
Mutual Fund 1
Investment
Adviser
Principal
Underwriter
Administrator
Source: Investment Company Institute
Custodian
Transfer Agent
Independent
Public Accountant

6. What are Boards?
•
Shareholders elect a board of directors to oversee
the fund’s relationships with the adviser and other
outside entities that provide services to the fund
•
At least 40% of the board’s directors must not be
“interested persons” (i.e., independent of the fund
the fund’s adviser, underwriter, etc.)
•
About 90% of fund complexes in 2011 had boards
with 75% independent directors

7. Board Responsibilities
But what exactly do boards of directors do?

8. Board Responsibilities
•
Performance evaluation
•
Approval of advisory/underwriter contracts
•
Fee approval
•
Pricing of fund shares
•
Oversight of portfolio management and compliance
issues

9. Board Responsibilities
•
Provide ―management direction‖ to the fund
•
Approve major transactions
•
Monitor conflicts of interest
•
―Duties of care and loyalty” (require that directors
act with diligence and care to pursue fund’s best
interests – directors may not put interests of
another person or organization above those of
the fund)

10. What are MMFs?
•
MMF shares generally are bought and sold at a
$1.00 per share (enabled by Rule 2a-7, which we will
discuss in detail later)
•
Typically invest in low-risk securities, such as highgrade commercial paper and government securities

11. What Makes MMFs Special—Stable NAV
•
MMF sales don’t have same tax
implications as sales of other MMFs
•
MMFs are treated as cash equivalents
for accounting purposes
•
Retail investors have check-writing
features and ATM access

12. Types of MMFs
•
There are 3 basic types of MMFs
•
•
•
•
There are 2 main investor types
•
•
•
Prime - invest in money market instruments other than
simply Treasury and agency securities
Government – invest in Treasury and agency securities
Municipal (or tax-exempt) – invest in municipal debt
Institutional – firms, pension plans, municipalities
Retail – mom, pop, you
The concerns of the crisis largely surrounded institutional
prime funds

13. Size of MMF Industry
MMFs are $2.7 trillion of the
$13 trillion mutual fund
industry
$2.7 trillion
Other Mutual Funds
Money Market Funds
$10.3 trillion
Source: Investment Company Institute

14. Why Do Investors Like MMFs?
•
MMFs are an important cash management tool for
corporate treasurers and a vital source of short-term
funding for banks, municipalities, and corporations
because of the stable NAV, low-risk, and high
liquidity.
•
Retail investors like MMFs too because they provide
stability, but also can offer higher returns than bank
accounts

15. History of MMFs
•
MMFs arose as a response to investor frustration
over Regulation Q, which imposed interest rate caps
on bank savings accounts
•
Throughout 1970s and 1980s, MMFs offered higher
interest rates and the same ready liquidity and one
dollar in/one dollar out feature as bank accounts
•
MMFs went through a regulatory odyssey at the
SEC that ultimately resulted in the promulgation of
rule 2a-7 in 1983

16. Rule 2a-7
•
Since 1983, rule 2a-7 has been amended multiple
times, the most recent of which was in 2010
•
May maintain a stable NAV as long as actual value
of fund shares remains within a narrow band around
one dollar and complies with rule’s parameters on:
•
•
•
•
Portfolio maturity
Quality
Liquidity
Diversity

17. MMFs During the Financial Crisis
•
As discussed above, MMF shareholders like the
$1.00 NAV
•
The events of 2007 through 2009 cast money
market funds in a new light; money market funds
were not immune from problems

18. MMFs During the Financial Crisis
Mid-2007
•
25% of MMFs were invested in asset-backed commercial paper
(ABCP)
•
•
Short-term, privately-issued debt backed by revenuegenerating assets like mortgages and credit card receivables
Came under stress mid-July
•
Outstanding ABCP grew to $1.16 billion by July
•
Reserve Primary Fund begins purchasing ABCP and other
commercial paper (this will matter later)
•
In late July, 2 Bear Stearns hedge funds collapse

19. MMFs During the Financial Crisis
Bear Stearns shuts 2 hedge funds
Summer 2007
3 BNP Paribas funds
suspend redemptions
Widespread ABCP concern
ABCP Interest Rates
ABCP Outstanding
ABCP Yield Spread (Basis Points) Over Target Federal Funds Rate
2-6
47
First 7 Months of 2007
August 2007

20. MMFs During the Financial Crisis
Late 2007
The emergence of ABCP troubles causes a ―repricing
of the money markets‖ that enables MMFs to choose
―whether to invest in assets with a substantial risk
premium to safe government securities (Kacperczyk &
Schnabl)
Many funds chose to move assets out of commercial
paper … others did not ... high yields!!!

21. MMFs During the Financial Crisis
Reserve Primary Fund DID NOT
•
First MMF
•
Historically not a large commercial paper investor
•
Began buying ABCP and other commercial paper in
August 2007
•
ABCP holdings rise from 1% to 60%

22. MMFs During the Financial Crisis
Reserve Primary Fund’s Competitive Gamble
•
Yield rises 50 basis points
•
Moves fund from bottom 20% to top 10% of institutional
funds
•
Between July 2007 and July 2008 its assets double largely
because of institutional investors
•
By August 2008 1.18 percent of its $62.5 billion under
management is invested in Lehman Brothers commercial
paper

23. MMFs During the Financial Crisis
Lehman Brothers files for
Bankruptcy September 15th!
Reserve Primary Fund’s Lehman
Paper is in trouble
Reserve Primary investors want to get out fast
Fund’s adviser worries that ―the fund would be unable to sell
holdings at par if forced to do so to meet redemption
requests‖

24. MMFs During the Financial Crisis
•
Lehman’s woes cause Reserve Primary Fund’s NAV to fall
to $0.97 – it ―breaks the buck‖
•
This had only happened once before
•
SEC retroactively approves Reserve Primary Fund’s
request to suspend redemptions ―until the markets are
liquid to a degree that enables each Fund to liquidate
portfolio securities without impairing the net asset value of
each Fund … ‖
•
Eventually, investors are repaid $0.99 on the dollar

25. MMFs During the Financial Crisis
Reserve Primary Fund’s troubles lead to large-scale redemptions
from MMFs…. but not ALL MMFs
Certain funds much more likely to be redeemed from

26. MMFs During the Financial Crisis
•
Many sponsors step in to support their funds
• Prevented more MMFs from “breaking the buck”
• Estimates range from 28 (Kacperczyk & Schnabl) to
300 (former SEC Chairman Mary Schapiro)
•
Fund managers responded to large scale
redemptions
• Some had to sell assets to meet redemptions
• Some liquidated and consolidated into other funds

27. Government Response (Short-Term)
•
MMFs protect their ability to repay shareholders by
sharply reducing their commercial paper holdings
•
Financial institutions, which are highly dependent on
short-term funding provided by MMFs, begin to feel
the impact
•
The government intervened to make sure that big
banks could keep funding themselves

28. Government Response (Short-Term)
Treasury’s Temporary Guarantee Program (Sept. 19)
?
•
Guaranteed the multi-trillion dollar MMF
industry with the $50 billion Exchange
Stabilization Fund created by the Gold
Reserve Act of 1934
•
The program lasted for 1 year & guaranteed $1 NAV for funds in MMFs
as of Sept. 19 . MMFs paid to participate.
•
At its peak, 93% of MMF assets participated
•
Program generated $1.12 billion in premiums & didn’t make any payouts
•
The real cost was moral hazard—after the 2008 intervention, MMFs are
perceived as carrying a government guarantee

29. Government Response (Short-Term)
Asset-Backed Commercial Paper Money Market
Mutual Fund Liquidity Facility (Sept. 19)
•
Program under Section 13(3) of the Federal Reserve
Act to prevent fire sales of ABCP
•
Enabled banks and other financial institutions to
borrow from Fed discount window to purchase ABCP
from MMFs
•
Program peaked on Oct. 1, 2008 at $152 billion

30. Government Response (Short-Term)
Commercial Paper Funding Facility (Oct. 7)
•
Program under Section 13(3) of the Federal Reserve
Act to prop up commercial paper markets
•
The Federal Reserve Bank of New York established a
special purpose vehicle to purchase three-month
commercial paper directly from issuers
•
CPFF was a major buyer in the commercial paper
market and grew to hold over twenty percent of
outstanding commercial paper in the US

31. Government Response (―Long-Term‖)
•
Large-scale crisis in MMFs prompted calls for reform
•
•
•
Treasury 2009 white paper encouraged SEC to “move
forward with its plans to strengthen” the MMF
regulatory framework
Treasury called on the President’s Working Group on
Financial Markets (PWG) to prepare a report analyzing
“more fundamental changes”, including floating the
NAV or mandating access to private emergency
liquidity facilities
But SEC adopts reforms to Rule 2a-7 before the PWG
report is released

32. SEC’s 2010 September MMF Reforms
•
Liquidity
•
•
•
•
•
Cap on illiquid securities holdings dropped from 10% of total fund
assets to 5%
“Illiquid security” redefined to mean any security that cannot be
sold “at approximately the value ascribed to it by the fund” holding
it within 7 days
10% of holdings must be invested in “daily liquid assets; 5% in
“weekly liquid assets”
MMFs must “hold securities that are sufficiently liquid to meet
reasonably foreseeable shareholder redemptions.”
Portfolio Quality
•
•
•
Cap on second tier securities from 5% to 3%
Amount a MMF can invest in second tier securities of a particular
issuer was reduced from 1% to 0.5%
Maximum allowed maturity for second-tier securities reduced from
397 days to 45 calendar days

33. SEC’s 2010 September MMF Reforms
•
Maturity Requirements
•
•
•
Dollar-weighted average portfolio maturity for MMFs was
reduced from 90 to 60 calendar days
New dollar-weighted average life requirement (excludes
specially-valued securities) was added that restricts WAL to
no more than 120 days
Disclosure Requirements
•
•
•
Funds must post detailed portfolio holdings within 5 business
days of each month’s end and leave it posted for at least 6
months
MMFs must monthly electronically file with the SEC
interactive data portfolio holdings on new Form N-MFP
SEC publicly discloses the Form N-MFP information 60 days
“after the end of the month to which the information
pertains.”

34. SEC’s 2010 September MMF Reforms
•
Credit Ratings
•
•
•
•
Added a requirement to rule 2a-7 that MMF boards annually
designate and assess the reliability of at least four Nationally
Recognized Statistical Rating Organizations (NRSROs)
ratings of chosen NRSROs are used by the fund to determine
whether a security meets the portfolio quality standards
established by Rule 2a-7
However, fund board may not exclusively rely on credit ratings
in determining whether the fund should acquire a security
Suspension of Redemptions
•
•
Required MMFs to develop the capability of redeeming
shares at a market-based NAV rather than a stable NAV
And…

35. SEC’s 2010 September MMF Reforms
New rule 22e-3
•
2010 amendments provide an exemption from Investment
Company Act section 22(e), which prohibits mutual funds from
suspending redemptions unless:
•
•
•
•
NYSE has closed or its trading is restricted
Emergency when it is not “reasonably practicable” to dispose
of or value portfolio securities
SEC creates an exemption
Rule 22e-3 creates an exemption that allows MMFs to suspend
redemptions if the Board:
•
•
Determines that a deviation exists between the market-based
NAV and a stable NAV
Irrevocably approves the fund’s liquidation

36. SEC’s 2010 September MMF Reforms
The rule ―is intended to reduce the vulnerability of
investors to the harmful effects of a run on the fund, and
minimize the potential for disruption to the securities
markets.‖ --SEC
Nevertheless, the requirement that the fund be in the
process of liquidation is a significant limitation on the rule’s
ability to protect MMF investors from runs.
2010 reforms were just the beginning …

37. The Continuing MMF Regulatory Odyssey
•
PWG’s report (2010) looked at:
•
•
•
•
•
•
•
•
•
Floating the NAV
Setting up a private emergency liquidity facility
Requiring certain redemptions to be in-kind
Insuring MMFs
Imposing additional requirements on stable NAV funds
Restricting stable NAV funds to retail investors
Regulating stable NAV funds like special purpose banks
Increasing restrictions on MMF alternatives
These and other reforms have been debated by
regulators, industry, and academics

38. The Continuing MMF Regulatory Odyssey
•
In August 2012, SEC Chairman Schapiro pushed for one of
or a combination of the following three reform options:
•
•
•
•
Floating the NAV
Capital Buffers
Minimum Balance-at-Risk (developed by economists at
Federal Reserve Bank of New York)
Her colleagues rightfully expressed trepidation about
proposing these options without adequately understanding
their potential effects on MMFs, investors, and entities that
rely on MMFs for funding

39. The Continuing MMF Regulatory Odyssey
•
Rather than brokering compromise, Chairman Schapiro
invited the Financial Stability Oversight Council (FSOC)
to act
•
Dodd-Frank gives the FSOC, a multi-regulator systemic
oversight body, authority to make recommendations to
regulatory agencies
•
Agency to which the recommendation is directed
must—within ninety days—either to follow the
recommendations or explain why it is not doing so

40. The Continuing MMF Regulatory Odyssey
•
FSOC Proposed Recommendations (2013):
• Floating the NAV
• Pairing a 1% capital buffer with a 3% minimum
balance at risk
• Pairing a 3% capital buffer with stricter diversification
requirements

41. The Continuing MMF Regulatory Odyssey
•
New SEC Chairman White managed to step in front of
FSOC with a compromise proposal:
• Floating the NAV of prime institutional MMFs
• Allowing MMFs to impose triggered emergency
liquidity fees and redemption suspensions
• A combination of the first two options

42. Discussion of Proposed Reforms
For the sake of brevity we will only discuss the SEC’s and
FSOC’s proposed reforms…
•
Minimum Balance at Risk
•
Capital Buffer
•
Floating NAV
•
Triggered Liquidity Fees and Gating
And then explain our own proposal…. (it’s a surprise)

43. Minimum Balance at Risk
•
Proposed by the FSOC, and developed by Patrick
McCabe of the Federal Reserve Bank of New York
•
Aims to dissuade MMF shareholders from redeeming in
times of crisis by requiring that a portion of a large
investor’s total investments in a fund be …
•
•
Held back for a specified period during which hold-back
amount would be available to absorb fund losses …
Available to bear losses according to a subordination
formula

44. Minimum Balance at Risk
Benefits
•
Early redeemers would pay a price for the privilege of
leaving early
•
Would force large shareholders—the ones most prone
to run—to think carefully about their redemption
decisions and thus could avert MMF runs

45. Minimum Balance at Risk
Drawbacks
•
Would be very difficult for MMFs to implement and would
leave investors uncertain about how much they could
withdraw and when
•
The FSOC acknowledges, the ―operational and technology
costs . . . could be substantial‖
•
The FSOC’s own analysis shows that a buffer of at least 4
percent would be necessary to stop runs in times of severe
crises – likely not feasible

46. Minimum Balance at Risk
Drawbacks
•
Regulators would have to determine how long a one-sizefits-all holdback period should be
•
•
•
Too short—MMFs more vulnerable to runs
Too long –unduly inconvenient to MMF investors
Even during normal times, a minimum balance at risk
will affect MMF shareholders adversely because it will
interfere with normal redemption patterns

47. Capital Buffer
•
A capital buffer is a separate pool of cash or cash-like
assets to shore up MMFs’ stable NAV
•
The FSOC proposed:
•
•
•
A 1% risk-tailored percent buffer + minimum balance at
risk
A risk-tailored 3% buffer + more stringent diversification
and liquidity standards
Risk-tailoring means that amount held would be less than
1% and 3% – the FSOC estimates the 3 percent buffer
would actually be only 2.51 percent for prime MMFs

48. Capital Buffer
Benefits
•
An appropriately-sized capital buffer could help curb
runs by giving MMF shareholders confidence that there
is no need to redeem early because there will be
sufficient assets available through the capital buffer to
repay them

49. Capital Buffer
Drawbacks
•
The FSOC’s proposed buffers would have been insufficient
to stop the Reserve Primary Fund from breaking the buck
•
•
•
The largest buffer’s size is only 2.51 percent, but Reserve
Primary Fund’s NAV declined 3 percent
According to SEC Commissioner Gallagher:
“A buffer too small “would have given investors –
especially retail investors … – a false sense of security”
An effective capital buffer would have to be quite large and
consequently very difficult to build up
•
The FSOC’s proposed risk-based three percent capital
buffer would cost prime MMFs roughly $37.3 billion over
six years – Inv. Co. Inst.

50. Capital Buffer
Biggest Drawback
―It became clear to me early on in this process that the only
real purpose for the proposed buffer was to serve as the
price of entry into an emergency lending facility that the
Federal Reserve could construct during any future crisis – in
short, the “buffer” would provide additional collateral to
facilitate a Fed bailout for troubled MMFs‖
– SEC Commissioner Gallagher

51. Floating NAV
•
SEC proposed floating the NAV for
prime MMFs
•
FSOC proposed floating the NAV for
all MMFs
•
Would remove the stable NAV, a key
feature of MMFs

52. Floating NAV
Benefits
•
Stable NAV creates a first-mover advantage for investors that run
during a financial crisis; floating NAV would diminish that
advantage
•
When a MMF’s market-based NAV falls below $1.00, investors
have a significant incentive to redeem at the $1.00 stable NAV, a
price that is higher than the value of the proportionate share of
underlying assets
•
Remaining investors are left with a less liquid and less valuable
portfolio
•
The floating NAV could lessen the number and magnitude of
MMF runs

53. Floating NAV
Drawbacks
•
The floating NAV does not address the core cause of runs
•
•
Evidence suggests that investors run from funds that have
taken on riskier assets or lack liquidity to meet redemptions.
Investors would still have an incentive to run early from funds
that they anticipated would later experience problems
•
Would impair the day-to-day utility of MMFs for many investors by
creating tax and accounting hurdles to rapid redemptions and
repurchases.
•
Would require substantial operational and technology changes

54. Triggered Liquidity Fees and Gating
•
The SEC proposed to require MMFs to impose a
liquidity fee of up to 2% if weekly liquid assets fall
below a liquidity threshold of 15%of total assets
•
Under the SEC’s proposal, the Board may decide the
size of the liquidity fee or not to impose a liquidity fee
•
The Board may also decide to gate the fund (restrict
redemptions) upon this 15% trigger being reached, but
only for 30 days in any 90 day period

55. Triggered Liquidity Fees and Gating
Benefits
• Would preserve most of the core features of MMFs
•
Would mitigate the risk of runs by addressing the core of
their cause – high volumes of redemptions that deplete
liquidity
•
Liquidity fees would allow investors that wanted liquidity to
pay for it by compensating remaining shareholders
•
Gating portion of the proposal would afford MMF boards
additional flexibility in responding to a crisis situation

56. Triggered Liquidity Fees and Gating
Drawbacks
•
The SEC’s proposal is trigger-based:
• Academic research suggests there could be
redemptions in anticipation of triggers
• Regulators are unlikely fit to adequately determine
appropriately sized fees and triggers
•
Unnecessarily Limits board discretion

57. So, What to Do?

58. Our Proposal – Discretionary Gating
•
We propose to allow boards of directors to halt
redemptions at any time and for any length of time
without any conditions other than an affirmative board
vote that suspending redemptions is:
• In the best interests of the fund
• Necessary to protect the fund’s stable NAV
• Necessary to ensure equitable treatment of fund
shareholders
•
The vote must include the majority of the fund’s
disinterested directors

59. Our Proposal – Discretionary Gating
•
A board’s gating decision would take effect at the
beginning of the next business day and would end as
soon as the board determined that the conditions
necessitating gating were no longer present.
•
This Board responsibility could not be delegated
•
MMFs would be required to disclose the existence of
the board’s authority to impose gates and, if gates were
imposed, to inform fund shareholders and the SEC
promptly

60. Our Proposal – Discretionary Gating
•
In essence, we remove the liquidation requirement that
presently exists in rule 22e-3
•
This condition unnecessarily dissuades boards from
suspending redemptions
•
Suspending redemptions would no longer be a fatal
event for a MMF

61. Remember this?
Mutual Fund Family
Fund Sponsor
Shareholders
Mutual Fund 3
Board of Directors
Mutual Fund 2
Oversees
Oversees
Mutual Fund 1
Investment
Adviser
Principal
Underwriter
Administrator
Source: Investment Company Institute
Custodian
Transfer Agent
Independent
Public Accountant

62. Benefits
Natural Extension of Board Responsibilities
•
A fund board already makes many key decisions for the fund
•
•
•
•
•
•
•
•
Performance evaluation
Contract approval
Fee approval
Pricing of Fund Shares
Oversight of Portfolio Management
Compliance Issues
Determining “what action, if any, should be initiated” when a
fund’s NAV deviates from $1.00
Our proposal is a natural extension of these responsibilities

63. Benefits
Harnesses the powers of Boards, and their knowledge of
the fund and its unique risks
•
Boards in the midst of a crisis are better able to decide
when gating is necessary than regulators who attempt to
make that decision before a crisis occurs
•
Boards will be able to decide, based on the volume of
redemption requests and a close consideration of their
portfolios’ liquidity, quality, and maturity, whether and for
how long gating is necessary
•
Boards of directors are, in the words of former SEC
Chairman Arthur Levitt, ―in an ideal position to monitor new
developments and trouble-shoot problems as they arise‖

64. Benefits
Forces MMFs to compete on safety as well as on yield
•
An analysis of hedge funds—which employ
discretionary gating—reveals that more stringent
restrictions on redemption requests are correlated with
higher fund yields
•
The prospect of gating will cause MMF investors to
more closely scrutinize their investments and will
incentivize diversification

65. Benefits
Prevents Runs and Facilitates Equitable Treatment of
Shareholders
• Funds would not need to resort to the sale of securities
at fire-sale prices or the disposal of liquid assets to
meet redemption requests
•
Gating would enable boards to prevent first movers
from benefiting at the expense of a fund’s remaining
shareholders
•
To the extent one fund’s suspension of redemptions
triggered redemptions at other MMFs, their boards
could use their discretion to gate

66. Benefits
Would Not Affect the Day-to-Day Operations of MMFs
• Costly and disruptive systems changes would be kept
to a minimum
•
MMFs’ regular interactions with funds would remain
largely unchanged

67. Possible Objections
•
•
Microprudential focus, but …
• The responsibility of MMF boards is to their
funds, not the larger economy
• The larger economy could benefit from regulations
that facilitate effective private risk management
Decreasing attractiveness of MMFs, but …
• To the extent giving boards broad discretion to gate
makes MMFs less attractive to investors, it is a
positive step toward helping them find appropriate
investments

68. Possible Objections
•
Inadequately responsive boards
•
•
•
Fund directors are accountable for their actions
Poorly behaving boards would be punished by the
market; assets would go to funds with boards willing to
take action as needed
Board members on multiple funds
•
•
The question of whether and when it is appropriate to sit
on multiple boards is a broader question
But board members have a fiduciary duty to each fund
on the board of which they serve and may not weigh
external interests

69. Questions?