Daily Rules, Proposed Rules, and Notices of the Federal Government
Reforms to address the structural vulnerabilities of money market mutual funds (MMFs or funds) are essential to safeguard financial stability. MMFs are mutual funds that offer individuals, businesses, and governments a convenient and cost-effective means of pooled investing in money market instruments. MMFs are a significant source of short-term funding for businesses, financial institutions, and governments. However, the 2007-2008 financial crisis demonstrated that MMFs are susceptible to runs that can have destabilizing implications for financial markets and the economy. In the days after Lehman Brothers Holdings, Inc. failed and the Reserve Primary Fund, a $62 billion prime MMF, “broke the buck,” investors redeemed more than $300 billion from prime MMFs and commercial paper markets shut down for even the highest-quality issuers. The Treasury Department's guarantee of more than $3 trillion of MMF shares and a series of liquidity programs introduced by the Federal Reserve were needed to help stop the run on MMFs during the financial crisis and ultimately helped MMFs to continue to function as intermediaries in the financial markets.
The Securities and Exchange Commission (SEC) took important steps in 2010 by adopting regulations to improve the resiliency of MMFs (the “2010 reforms”). But the 2010 reforms did not address the structural vulnerabilities of MMFs that leave them susceptible to destabilizing runs. These vulnerabilities arise from MMFs' maintenance of a stable value per share and other factors as discussed below. MMFs' activities and practices give rise to a structural vulnerability to runs by
The broader financial regulatory community has focused substantial attention on MMFs and the risks they pose. Both the President's Working Group on Financial Markets (PWG) and the Financial Stability Oversight Council (Council) called for additional reforms to address the structural vulnerabilities in MMFs, through the PWG's 2010 report on
In October 2010, the SEC issued a formal request for public comment on the reforms initially described in the PWG report, and in May 2011 the SEC hosted a roundtable on MMFs and systemic risk in which several Council members and their representatives participated. However, in August 2012, SEC Chairman Schapiro announced that the SEC would not proceed with a vote to publish a notice of proposed rulemaking to solicit public comment on potential structural reforms of MMFs.
Under Section 120 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act),
The Council is proposing to use this authority to recommend that the SEC proceed with much-needed structural reforms of MMFs. There will be a 60-day public comment period on the proposed recommendations. The Council will then consider the comments and may issue a final recommendation to the SEC, which, pursuant to the Dodd-Frank Act, would be required to impose the recommended standards, or similar standards that the Council deems acceptable, or explain in writing to the Council within 90 days why it has determined not to follow the recommendation.
Pursuant to Section 120, the Council proposes to determine that MMFs' activities and practices could create or increase the risk of significant liquidity, credit, and other problems spreading among bank holding companies, nonbank financial companies, and U.S. financial markets. This is due to the conduct and nature of the activities and practices of MMFs that leave them susceptible to destabilizing runs; the size, scale, and concentration of MMFs and the important role they play in the financial markets; and the interconnectedness between MMFs, the financial system and the broader economy that can act as a channel for the transmission of risk and contagion and curtail the availability of liquidity and short-term credit.
Based on this proposed determination, the Council seeks comment on the proposed recommendations for structural reforms of MMFs that reduce the risk of runs and significant problems spreading through the financial system stemming from the practices and activities described above. The Council is proposing three alternatives for consideration:
These proposed recommendations are not necessarily mutually exclusive but could be implemented in combination to address the structural vulnerabilities that result in MMFs' susceptibility to runs. For example, MMFs could be permitted to use floating NAVs or, if they preferred to maintain a stable value, to implement the measures contemplated in Alternatives Two or Three.
Other reforms, not described above, may be able to achieve similar outcomes. Accordingly, the Council seeks public comment on the proposed recommendations and other potential reforms of MMFs. Comments on other reforms should consider the objectives of addressing the structural vulnerabilities inherent in MMFs and mitigating the risk of runs. For example, some stakeholders have suggested features that only would be implemented during times of market stress to reduce MMFs' vulnerability to runs, such as standby liquidity fees or gates. Commenters on such proposals should address concerns that such features might increase the potential for industry-wide runs in times of stress.
The Council recognizes that regulated and unregulated or less-regulated cash management products (such as unregistered private liquidity funds) other than MMFs may pose risks that are similar to those posed by MMFs, and that further MMF reforms could increase demand for non-MMF cash management products. The Council seeks comment on other possible reforms that would address risks that might arise from a migration to non-MMF cash management products. Further, the Council is not considering MMF reform in isolation. The Council and its members intend to use their authorities, where appropriate and within their jurisdictions, to address any risks to financial stability that may arise from various products within the cash management industry in a consistent manner. Such consistency would be designed to reduce or eliminate any regulatory gaps that could result in risks to financial stability if cash management products with similar risks are subject to dissimilar standards.
In accordance with Section 120 of the Dodd-Frank Act, the Council has consulted with the SEC staff. In addition, the standards and safeguards proposed by the Council take costs to long-term economic growth into account.
MMFs are a type of mutual fund registered under the Investment Company Act of 1940 (the Investment Company Act).
MMFs are a convenient and cost-effective way for investors to achieve a diversified investment in various money market instruments, such as commercial paper (CP), short-term state and local government debt, Treasury bills, and repurchase agreements (repos). This diversification, in combination with principal stability, liquidity, and short-term market yields, has made MMFs an attractive investment vehicle. MMFs provide an economically significant service by acting as intermediaries between investors who desire low-risk, liquid investments and borrowers that issue short-term funding instruments. MMFs serve an important role in the asset management industry through their investors' use of MMFs as a cash-like product in asset allocation and as a temporary investment when they choose to divest of riskier investments such as stock or long-term bond mutual funds.
The MMF industry had approximately $2.9 trillion in assets under management (AUM) as of September 30, 2012, of which approximately $2.6 trillion is in funds that are registered with the SEC for sale to the public. This represents a decline from $3.8 trillion at the end of 2008.
MMFs are categorized into four main types based on their investment strategies. Treasury MMFs, with about $400 billion in AUM, invest primarily in U.S. Treasury obligations and repos collateralized with U.S. Treasury securities. Government MMFs, with about $490 billion in AUM, invest primarily in U.S. Treasury obligations and securities issued by entities such as the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Banks (FHLBs), as well as in repo collateralized by such securities. In contrast, prime MMFs, with about $1.7 trillion in AUM, invest more substantially in private debt instruments, such as CP and certificates of deposit (CDs). Commensurate with the greater risks in their portfolios, prime MMFs generally pay higher yields than Treasury or government MMFs. Finally, tax-exempt MMFs, with about $280 billion in AUM, invest in short-term municipal securities and pay interest that is generally exempt from state and federal income taxes, as appropriate.
Like other mutual funds, MMFs must register under the Investment Company Act and are subject to its provisions. An MMF must comply with all of the same legal and regulatory requirements that apply to mutual funds generally, except that rule 2a-7 under the Investment Company Act
In order to protect investors from being treated unfairly, an MMF may continue to use these valuation and
In order to reduce the likelihood that an MMF would experience such a significant deviation, rule 2a-7 imposes upon MMFs certain “risk-limiting conditions” relating to portfolio maturity, credit quality, liquidity, and diversification. These risk-limiting conditions limit the funds' exposures to certain risks, such as credit, currency, and interest rate risks.
The risk-limiting conditions, in their current form, include numerous changes to rule 2a-7 that were adopted by the SEC in 2010 as an initial response to the financial crisis. These 2010 reforms strengthened maturity limitations, increased MMFs' diversification and liquidity requirements, imposed stress-test requirements, improved the credit-quality standards for MMF portfolio securities, increased reporting and disclosure requirements on portfolio holdings, and provided new redemption and liquidation procedures to minimize contagion from a fund breaking the buck, as described below. The 2010 reforms were a necessary and important step in reducing MMF portfolio risk and increasing the resiliency of MMFs to redemptions.
While the enhancements introduced in the 2010 reforms increase resiliency and limit MMFs' exposure to certain risks, they do not address MMFs' structural vulnerabilities. These vulnerabilities and the resulting risks to financial stability are described in more detail in the following sections.
Following the financial crisis, the Department of the Treasury (Treasury) released a roadmap for financial reform in June 2009
At the time of the adoption of the 2010 reforms, the SEC noted that these reforms served as a “first step” in addressing MMF reform.
Concurrently, the broader financial regulatory community in both the United States and abroad has made repeated calls for MMF reform. The Council, in both its 2011 and 2012 annual reports, highlighted the need for additional MMF reform to address structural vulnerabilities in the U.S. financial system. In 2012, the Council specifically recommended that the SEC publish structural reform proposals for public comment and ultimately adopt reforms that address MMFs' lack of loss-absorption capacity and susceptibility to runs. The Office of Financial Research, in its 2012 annual report, identified the run risk for MMFs as one of the “current threats to financial stability.”
Internationally, on October 9, 2012, the International Organization of Securities Commissions (IOSCO) issued policy recommendations for reforming MMFs. The IOSCO recommendations demonstrate the efforts by the G-20 and the Financial Stability Board to fulfill the mandate of strengthening the oversight and regulation of the “shadow banking system.”
On August 22, 2012, SEC Chairman Schapiro announced that the majority of the SEC's Commissioners would not support seeking public comment on the SEC's staff proposal to reform the structure of MMFs. As a result, on September 27, 2012, the Chairperson of the Council, Treasury Secretary Geithner, sent a letter to Council members urging the Council to take action in the absence of the SEC doing so.
The Dodd-Frank Act established the Council “(A) to identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace; (B) to promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the Government will shield them from losses in the event of failure; and (C) to respond to emerging threats to the stability of the United States financial system.”
To carry out its financial stability mission, the Council has various authorities, including the authority under Section 120 of the Dodd-Frank Act to issue recommendations to primary financial regulatory agencies to apply “new or heightened standards and safeguards” for a financial activity or practice conducted by bank holding companies or nonbank financial companies under the regulatory agency's jurisdiction. Prior to issuing such a recommendation, the Council must determine that “the conduct, scope, nature, size, scale, concentration, or interconnectedness” of the financial activity or practice “could create or increase the risk of significant liquidity, credit, or other problems spreading among bank holding companies and nonbank financial companies, financial
Pursuant to Section 120 of the Dodd-Frank Act, the Council proposes to determine that the activities and practices of MMFs, for which the SEC is the primary financial regulatory agency, could create or increase the risk of significant liquidity, credit, or other problems spreading among bank holding companies, nonbank financial companies, and the financial markets of the United States. This proposed determination is set forth below in Section IV. The Council seeks public comment on this proposed determination.
To address the concerns regarding MMFs, the Council also seeks public comment on the proposed recommendations described in Section V. Comments are due 60 days after publication in the
The SEC, by virtue of its institutional expertise and statutory authority, is best positioned to implement reforms to address the risks that MMFs present to the economy. If the SEC moves forward with meaningful structural reforms of MMFs before the Council completes its Section 120 process, the Council expects that it would not issue a final Section 120 recommendation to the SEC.
In addition to the proposed recommendations to the SEC under its Section 120 authority, the Council and some of its members are actively evaluating alternative authorities in the event the SEC determines not to impose the standards recommended by the Council in any final recommendation.
For instance, under Title I of the Dodd-Frank Act, the Council has the authority and the duty to designate any nonbank financial company that could pose a threat to U.S. financial stability. Designated companies are subject to supervision by the Federal Reserve and enhanced prudential standards. Alternatively, the Council's authority to designate systemically important payment, clearing, or settlement activities under Title VIII of the Dodd-Frank Act could enable the application of heightened risk-management standards on an industry-wide basis. Additionally, other Council member agencies have the authority to take action to address certain of the risks posed by MMFs and similar cash-management products, as appropriate.
In order to issue a recommendation under Section 120 of the Dodd-Frank Act, the Council must determine that the conduct, scope, nature, size, scale, concentration, or interconnectedness of MMFs' activities or practices could create or increase the risk of significant liquidity, credit, or other problems spreading among bank holding companies and nonbank financial companies, or U.S. financial markets.
As further discussed below, the conduct and nature of MMFs' activities and practices make MMFs vulnerable to destabilizing runs, which may spread quickly among funds, impairing liquidity broadly and curtailing the availability of short-term credit.
As was evidenced in the financial crisis, even small portfolio losses may cause a fund to break the buck. If investors perceive a risk of such an event, MMFs' lack of explicit loss-absorption capacity, the first-mover advantage enjoyed by redeeming investors, investor uncertainty regarding sponsor support, and the similarity of MMFs' portfolios can incite widespread runs on MMFs. Heavy redemptions may magnify losses for other funds and potentially cause them to break the buck and suspend redemptions under rule 22e-3, harming investors by impairing their liquidity. Further, due to the significant role MMFs play in the short-term credit markets, an industry-wide run on MMFs can reduce the availability of credit to borrowers. Ultimately, a run on MMFs can create or increase the risk of significant liquidity, credit, or other problems spreading among bank holding companies, nonbank financial companies, and U.S. financial markets.
• Conduct and nature of activities and practices: Several activities and practices of MMFs combine to create a vulnerability to runs, including: (i) Relying on the amortized cost method of
• Size, scale, and concentration of activities and practices: The MMF industry is large, with $2.9 trillion in assets, and provides a substantial portion of the short-term funding available to a range of borrowers in the capital markets. The industry is also highly concentrated, as the top 20 MMF sponsors operate funds with 90 percent of aggregate MMF assets under management.
• Interconnectedness of activities and practices: MMFs are highly interconnected with the rest of the financial system and can transmit stress throughout the system because of their role as intermediaries, as significant investors in the short-term funding markets, as potential recipients of economic support from the financial institutions that sponsor them, and as important providers of cash-management services.
MMFs' vulnerability to runs results in part from the conduct and nature of the activities and practices of MMFs, their sponsors, and their investors.
The stable, rounded NAV per share. Unlike other mutual funds, most MMFs rely on valuation and rounding methods to maintain a stable NAV per share, typically $1.00. Rounding obscures the daily movements in the value of an MMF's portfolio and fosters an expectation that MMF share prices will not fluctuate. Importantly, rounding also exacerbates investors' incentives to run when there is risk that prices will fluctuate. When an MMF that has experienced a small loss satisfies redemption requests at the rounded $1.00 share price, the fund effectively subsidizes these redemptions by concentrating the loss among the remaining shareholders. As a result, redemptions from such a fund can further depress its shadow NAV and increase the risk that the MMF will break the buck. This contributes to a first-mover advantage, in which those who redeem early are more likely to receive the full $1.00 per share than those who wait. Thus, first movers have a free option to put their investment back to the fund by redeeming shares at the customary stable NAV of $1.00 per share (rather than at a share price reflecting the market value of the underlying securities held by the MMF). In the absence of an explicit mechanism to take losses in the value of the securities held by an MMF without depressing the fund's shadow NAV, the “first movers” leave other fund investors sharing in such losses.
Shares that can be redeemed on demand despite limited portfolio liquidity. MMFs perform maturity transformation by offering shares that investors may redeem on demand — providing shareholders unlimited daily liquidity — while also investing in relatively longer-term securities. MMFs invest not only in highly liquid instruments, such as securities that mature overnight and Treasury securities, but also in short-term instruments that are less liquid, including term CP and term repo. In the event of shareholder redemptions in excess of an MMF's available liquidity, a fund may be forced to sell less-liquid assets to meet redemptions. In times of stress, such sales may cause funds to suffer losses that must be absorbed by the fund's remaining investors, further reinforcing the first-mover advantage. Importantly, while the minimum liquidity requirements implemented in the SEC's 2010 reforms should make MMFs more resilient to market disruptions by increasing the funds' supply of liquid assets that can quickly be converted to cash, as noted below, these requirements are not designed to mitigate the first-mover advantage when a fund is at risk of suffering losses.
Investments with interest-rate and credit risk without explicit loss-absorption capacity. MMFs invest in securities with credit and interest-rate risk to increase the yields they offer to investors, but the funds do so without any formal capacity to absorb losses.
Reliance on discretionary sponsor support. In the absence of capital, insurance, or any other formal mechanism to absorb losses when they do occur, MMFs historically have relied upon
While MMF prospectuses must warn investors that their shares may lose value,
Highly risk-averse investors. Although MMFs invest in assets that may lose value and the funds are under no legal or regulatory requirement to redeem shares at $1.00, the industry's record of maintaining stable and rounded $1.00 per share NAVs combined with the funds' low-risk investment strategies has attracted highly risk-averse investors that are prone to withdraw assets rapidly when losses appear possible.
Interaction of these activities and practices. In combination, the activities and practices of MMFs described above tend to exacerbate each other's effects and increase MMFs' vulnerability to runs. For example, by relying on the amortized cost method of valuation and/or penny rounding to maintain a stable $1.00 per share NAV, offering shares that may be redeemed on demand despite limited same-day portfolio liquidity, and investing in assets with interest-rate and credit risk without explicit loss-absorption capacity, MMFs create a first-mover advantage for investors who redeem quickly during times of stress. If MMFs with rounded NAVs had lacked sponsor support over the past few decades, many might have broken the buck, causing investors to recalibrate their perception of MMF risks and resulting in a less risk-averse investor base. Or if funds maintained credible loss-absorption capacity, even a risk-averse investor base might be less likely to run because the funds would be better equipped to maintain a stable $1.00 per share NAV. As a result, policy responses that diminish these destabilizing interactions hold promise for mitigating the risks that MMFs pose—even if not all five of these activities and practices are fully addressed through reform.
MMFs' size, scale, and concentration increase both their vulnerability to runs and the damaging impact of runs on short-term credit markets, borrowers, and investors.
As discussed in Section II, the MMF industry is large, with $2.9 trillion in assets under management.
In addition, because of the concentration of the MMF industry, even heavy withdrawals from (or shifts in portfolio holdings of) MMFs offered by a handful of asset management firms may reverberate through financial markets. As of September 30, 2012, the top five MMF sponsors managed funds with $1.3 trillion in assets (46 percent of industry assets), and the top 20 sponsors managed $2.6 trillion (90 percent).
MMFs' extensive interconnectedness with financial firms, the financial system, and the U.S. economy can
Most of the short-term financing that MMFs provide to non-government entities is extended to financial firms. As of September 30, 2012, 86 percent of the funding that MMFs extended to private entities was in the form of financial sector obligations, including CDs, financial CP, asset-backed commercial paper (ABCP), repo, other MMF shares, and insurance company funding agreements.
MMFs are further interconnected with the U.S. financial system because bank and savings and loan holding companies sponsor MMFs. Sponsors face potential risks because, historically, sponsors have absorbed nearly all MMF losses that threatened the funds' $1.00 per share NAVs, and sponsors woul