What’s Behind the SEC’s Changes to Money Market Funds —and How Do They Affect Me?
- The Security and Exchange Commission (SEC) has adopted amendments to the rules that govern money market funds, but many of the key changes won’t take effect until the second half of 2016.
- Funds geared to institutional investors—typically banks, corporations or governments—will no longer have a stable $1-per-share price. Those geared to individual investors, however, will maintain their stable share price.
- Individual investors should benefit from new disclosure requirements that will provide more information about money market funds. These requirements should go into effect in early 2016.
It can be a little unnerving when securities regulators impart new rules or amend existing regulations. For a while the story is all over the financial news, but soon enough, it begins to fade. Attentive investors, however, want to know more: What was the issue being addressed? What’s behind the amendments? And most important: How do they affect me?
What’s the Issue?
In a nutshell, on July 23, 2014, the SEC approved a series of reforms to money market mutual funds with the goal of preventing a repeat of the 2008 financial crisis, when one fund’s net asset value (NAV) fell to below $1 per share—a hallowed benchmark that characterized all such funds. The amendments are intended to help protect individual investors from future runs (panicked withdrawals) on money funds. In our view, they represent a balanced compromise that brings to an end four years of SEC and securities-industry wrangling over how to strengthen this important and ubiquitous cash-management vehicle.
The sweeping amendments, most of which will go into effect in two years, require some money market funds for institutional investors to value their portfolio securities based on a floating NAV. Funds for individual retail investors, however, will be allowed to retain their stable, $1-per-share price. The amendments also require that additional disclosure be provided to investors that will include significantly more information relating to the strength and stability of the money market funds in which they invest.
Because of the broad popularity of these funds, we thought that many investors would be interested to know more about the regulatory reform and what led to it.
How Did We Get Here?
First, a bit of background: Most mutual funds calculate their share price on their actual NAV at the end of each trading day by dividing the total value of all underlying holdings by the number of fund shares outstanding. Because that value fluctuates due to changes in underlying share prices, most funds have what is known as a “floating NAV.”
Money market funds, on the other hand, have long maintained a stable NAV of $1, assuring investors safety and security on their investments. When interest rates allow, they also offer the additional benefit of yield. To many investors, money market funds are thought of just like cash—as safe as bank deposits. While not exactly true, their investments in short-term securities (less than one year) representing high-quality, liquid debt and monetary instruments have generally rendered them stable and safe. Until 2008, only one money market fund had “broken the buck”—fallen to an NAV of less than $1—and that was in the aftermath of the 1994 bankruptcy of Orange County, California.
In the fall of 2008, global financial services firm Lehman Brothers—then the fourth-largest investment bank in the country—filed for bankruptcy following drastic losses in its own portfolio, an exodus of most of its clients, and devaluation of its assets by credit-rating agencies. Money market funds that had invested in Lehman Brothers’ debt were suddenly faced with assets worth less than what was shown on their books. The NAV of one of them, after writing off its Lehman- issued debt, fell to 97 cents, triggering a run on that fund that spread to others. In the short term, the Treasury Department stepped in with a temporary guarantee program, halting the run and stabilizing the funds. In the longer term, the SEC pursued stronger government regulation. In 2010, they approved some reforms to increase the liquidity, transparency and resilience of the funds in volatile markets, but they felt there was more to be done to ensure that the situation didn’t occur again.
A Second Round of Reform
In 2012, the SEC proposed amendments requiring a floating NAV for all money market funds, alarming the securities industry that such a change would render the funds unattractive to individual investors seeking a safe haven for their cash. A public comment period drew more than a thousand responses, some of which led to changes to the proposal. Ultimately, the reforms were mostly directed toward funds that invest in short-term corporate debt and other securities (so-called “prime funds”), versus those that invest in Treasuries and government securities. The reforms also distinguished between individual and institutional investors.
- A floating NAV for institutional prime and municipal funds. The amendments create two classes of prime and municipal funds: “institutional” prime and municipal funds—used by large investors such as corporations, governments or banks—will be required to float their NAV; “retail” prime or municipal funds (those open only to “natural persons”—or actual human beings) would continue to retain their stable NAV. All types of Treasury and government money market funds, whether institutional or retail, would continue to maintain stable NAVs.
- Liquidity fees and redemption gates. The amendments provide discretion to the boards of all types of money market funds to impose liquidity fees of up to 2% on redemptions when liquidity levels fall below a specified target, as well as to temporarily suspend redemptions (gate) during times of extreme market stress, if it’s in the best interest of the fund.
- Enhanced transparency. To give investors more-robust information about a money market fund’s health and stability, the amendments require daily disclosure on money market fund websites of the following: the “shadow NAV”—the NAV per share most recently calculated using available market quotations (or an appropriate substitute that reflects current market conditions), extended to four decimal places; the levels of daily and weekly liquidity in the fund; net shareholder inflows and outflows; and information about whether any gates or fees are in place. On a monthly basis, money market funds will be required to report their portfolio holdings online vs. quarterly reporting today.
In addition, the amendments impose stronger diversification requirements for money market funds and enhanced stress testing.
Implications for Individual Investors
At Schwab, we believe that the amendments represent a balanced outcome and are good for both individuals and the market as a whole. By explicitly distinguishing between retail and institutional investors, the SEC is targeting the area of highest potential risk: the ability of large institutional investors to move quickly out of funds during a market crisis in a way that potentially leaves individual investors at risk of bearing the brunt of any resulting losses. The effect to retail investors, however, will likely be negligible. For them, the amendments ensure access to stable, $1-per-share money market funds for their cash management needs.
The new disclosure requirements should be visible to investors in early 2016. Because of the resulting operational complexity and recognition that it will take time for fund complexes to come into compliance, the SEC has allowed for an implementation period of two years, with the bulk of the amendments effective in the second half of 2016.
The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.