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News February 1, 2010 Issue

Money Market Fund Reforms Approved

And so it begins.

The SECís first major rule adoption of 2010 arrived last Wednesday, when the Commission approved new rules to strengthen the resiliency of money market funds.

We know youíre working on compliance with the new custody rule, but take a break with us for a minute and see whatís coming for money funds.

The stable $1 net asset value still reigns.

Floating rate money market funds in the general marketplace are still a possibility, but have been put off for now. They will be considered later with other potential reforms that were not included in this rulemaking.

Boards will have the power to suspend redemptions, and to require redemptions at prices other than $1.

Investment in tier two securities will be limited to no more than three percent of a money fundís assets, down from the current five percent. No investment in a single tier two issuer may exceed one half of one percent of the fundís assets, down from the one percent or $1 million current limit. Maturities for tier two securities will be reduced to 45 days, down from the current 397 days.

Weighted average maturities of a fund portfolio will drop from 90 days to 60 days. "Weighted average life" of the portfolio, a new measurement designed to limit spread risk, will be capped at 120 days.

Minimum liquidity requirements will be imposed on taxable money market funds. On a daily basis, at least ten percent of a fundís assets must be held in cash, U.S. Treasury securities, or securities that convert into cash within one day. On a weekly basis, at least thirty percent of fund assets must be held in cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less, or securities that convert into cash in one week.

Illiquid securities purchases will be restricted when such securities represent five percent or more of fund assets, reduced from the current ten percent limit. The money market fundís portfolio will be subject to regular stress testing, and the results must be reported to the board.

Shadow NAVs (the actual value of a share) and detailed portfolio information will be reported to the SEC on a monthly basis, and made available to the public on a 60-day delayed basis. Money market fund portfolio holdings will be posted on the fundís web site each month, also on a 60-day delayed basis.

Affiliates will be permitted to assist a fund in maintaining its stable $1 NAV by purchasing portfolio securities under certain circumstances without the need to obtain no-action relief from the staff.

"Know Your Investor" procedures will be adopted, to require funds to hold liquid securities to meet foreseeable redemption requirements. The procedures will also identify investors "whose redemption requests may pose risks for funds."

Credit ratings remain in the rule. Boards will approve up to four preferred NRSROs annually whose ratings are considered to be "reliable." Those rating organizations may then be looked to exclusively by a fund to provide ratings in satisfaction of Rule 2a-7ís minimum rating requirements for portfolio securities.

Repurchase agreement collateral will be tightened to cash and government securities only. Counterparties will be evaluated for creditworthiness.

In the open meeting on January 27, the atmosphere appeared to be cautiously confident. Chairman Mary Schapiro described the rules as containing significant revisions that will have substantial benefits for investors and that represent an important first step in the reform of money market funds. "While no set of rules could make money market funds impervious to risk of loss, money market fund investments will be safer as a result of todayís actions," she said. Division of Investment Management director Buddy Donohue said he was pleased to present the final rule proposal to the Commission, and praised the Commissionís strong action as an important step toward improving money market fundsí ability to withstand "the stresses they will inevitably experience."

Not everyone in the room however, was as enthusiastic.

Commissioner Kathleen Casey said that while money market fund reform "couldnít be a more important topic," the reforms in the rule proposal before the Commission "simply donít go far enough for me today." Money market funds have grown too large for Rule 2a-7, she said, and stable NAV funds will remain susceptible to runs. The path ahead, she challenged, must be more fundamentally rethought.

One of two logical paths lie ahead, said Casey. Money market funds should have recourse to dedicated liquidity facilities and be regulated as a bank, or they should move to a floating NAV. Floating NAV money market funds would be "unyoked" from each other and "allay fears that a decline in the value of one fund would lead to a run with the resultant choking of short-term credit markets and the tie-up of investor assets that we witnessed in 2008."

Casey had hoped the Commission would have taken a more significant step toward the floating NAV by providing closer-to-real-time shadow NAV disclosure. If the 60-day lag was instituted in part based on fears that greater transparency will encourage runs, she said, then once again she "must question the Rule 2a-7 regulatory model as it currently exists."

In addition to that broad concern, Casey specifically disagreed with the reformís result of further embedding NRSRO ratings in Rule 2a-7. This component goes in the wrong direction and is at odds with lessons from the current crisis, she said.

NRSRO ratings are a crutch, a substitute for due diligence, and they encourage gaming, said Casey, and they create a false sense of comfort and protection.

Casey had several questions for the staff.

Although the rule proposal considered a range of options for reducing a fundís weighted average maturity, what was the rationale for the move to 60 days, and what protections does the staff believe those extra days bring to the fund?

IM associate director Bob Plaze said that in any kind of debt fund, one of the factors affecting share price stability is the weighted average maturity (WAM) of the portfolio. It relates to a fundís exposure to interest rate risk, which will affect longer-term securities more than shorter-term securities, and in the money market fund context it also refers to the fundís liquidity. A fund with shorter-term securities has more of its portfolio coming due every week that can be used to satisfy redemptions in the event there are significant redemptions.

A fund with a 90-day WAM can withstand a 200 basis point increase in interest rates, he said. A fund with a 60-day WAM can withstand a 300 basis point change. A swing in interest rates of those magnitudes has not been seen since the 1970s, said Plaze, but he noted that multiple smaller shocks could reach the same result.

For example, a 100 basis point change in interest rates, coupled with a change in spread duration of 75 basis points and shareholder redemptions of 15 percent would result in pressure on a stable $1 NAV. Plaze said the staff considered these and a number of other data points in determining the appropriate WAM. At the end of the day, said Plaze, the shorter WAM was more resilient and better reflected actual industry practice. He pointed out that developing money market fund standards in Europe employ the 60-day limit. In large part, the move to 60-day WAM has most to do with outliers, he noted. "There is not a magic line one can draw, where on one side of the line itís too risky and on the other side of the line it is not risky enough," said Plaze, "it is a continuum, and thatís how we came to the 60-day threshold."

Could you also talk a little bit about the liquidity requirements, and the differences between retail and institutional funds?

"September 8th is a Petri dish in which you can measure what can go wrong in the resilience of money market funds, because so much went wrong during that period," said Plaze. Institutional funds saw large outflows, as much as 90 percent of their assets. Retail funds, however, experienced around ten percent in outflows, and some retail money market funds had net sales during that period.

The reform proposal discussed differentiated liquidity standards to reflect what was seen in 2008, said Plaze. The proposal included thirty percent weekly liquidity and ten percent daily liquidity standards for institutional funds, and fifteen percent weekly and five percent daily liquidity standards for retail funds.

As a result, the staff received numerous comments, many saying it would be impossible to differentiate liquidity standards. A significant number of money market funds offer both retail and institutional classes, or are structured as master-feeder funds with both retail and institutional feeder funds. Compliance with differentiation requirements would require fund reorganizations, which commenters would be loathe to undertake. Plaze also noted the potential problem of institutional assets migrating into retail funds with lower liquidity requirements. Based on those comments and the staffís lack of confidence that the industry could successfully differentiate fund liquidities, the final rule amendments impose one standard for all funds. As a result, said Plaze, "we probably will have higher liquidity for some funds and insufficient liquidity for others." He said that these reforms include an indication that the staff is willing to revisit varying liquidity standards in the next round of money market fund reforms if the industry can present a workable means of differentiating funds.

What about the objective of shadow pricing disclosures? Would something less than a 60-day lag work? And how does that data inform, if at all, considerations of moving to a floating rate NAV for money market funds?

Donohue responded that money market funds are now the exception in the regulatory regime with respect to transparency. Securities are shown at amortized cost, he said, and that doesnít help inform investors of the fundís true value. Thereís informational asymmetry in the money markets, where institutional investors can price and value a portfolio of money market securities on their own and infer what the fundís NAV would be. Retail investors, without institutional sophistication, donít have that ability.

The primary objective of money market funds is to maintain a stable $1 NAV, said Donohue. If no information is provided to investors regarding how well a fund manager is doing in managing toward that goal, all the investors see is $1. Moving disclosure from a bi-annual basis to a monthly basis, even while retaining the 60-day information lag, will permit investors and others to gauge over time how well the manager is doing in achieving that goal.

"One would hope that information would have a couple of effects," said Donohue. First, the information would better enable investors to determine which funds are taking less risks and are more likely to achieve the stable $1 goal. Second, over time, the information would acclimate investors to the reality of variations in money market portfolio values. "You buy at $1 and you should receive $1," he said, "but portfolios do vary and thereís nothing wrong with variance if the portfolio is managed properly." Shadow NAV information lets investors know the true story of whatís happening with their portfolio.

Commissioner Elisse Walter supported the reforms, but had a few questions of her own for the staff.

If you could put your finger on the one development with money market funds that has created the greatest risk for investors in the markets, what would it be?

"I think it would be the sheer growth of money market funds," said Plaze, "in particular the institutional money market funds." The growth has been so large that the ability of the dealer markets to absorb the liquidity needs of money market funds Ė as everyone saw on September 8 Ė was tapped out. Also, money market funds have gotten better and more transparent over time, he said. Some fund shareholders looking at money market funds can understand that thereís a problem and make an exit, and do so before other shareholders. We saw that happen also, and that some money market funds did not have the ability to meet those liquidity needs. "We address, not all the problems in this rulemaking," said Plaze, "thereís going to be a number of tweaks, but we address really the significant ones."

Could you put your finger on the top two or three recommended changes in terms of those most likely to have an impact?

The leading recommended changes all address systemic risk issues, said Plaze. Even though the SEC is not a systemic risk regulator, there are three issues in particular in this area that the reforms address. First, he said, is the liquidity requirement. Funds must be able to meet the redemption demands of shareholders. Thatís the essence, said Plaze, of the 30 percent requirement.

Second, the reforms impose a limitation on repurchase agreements. This is an area of systemic risk the SEC is working on with a number of other financial regulators, Plaze noted, in an effort led by the NY Federal Reserve Bank.

Money market funds, unlike other market participants, canít accept repo collateral when the collateral is in longer-term securities, said Plaze. And if repo counterparties fail, as happened with Lehman Brothers and Bear Stearns, money market funds must direct the custodian to sell the securities. If all the money market funds are selling the collateral at the same time, he observed, it has a devastating effect on the market for that collateral. As a result, the staff determined that limiting repo participation was prudent, so money market funds will neither contribute to the problem nor be affected by the problem, said Plaze.

Third, the reforms provide a money market fund with the ability to shut down in an orderly way. Giving the board authority to suspend redemptions and to redeem fund shares at prices other than $1 provides that mechanism. Part of what we saw, said Plaze, was the catastrophic situation of the Reserve Fund, which was forced essentially by a devastating amount of redemptions to put its portfolio on the market, depressing the prices for all fund shares. The virus that began with the Reserve Fund metastasized very quickly to the other money market funds and out into the market itself. Funds had to come in to the SEC and seek an order to suspend redemptions, and of course, by that time, the run had begun. The response in such a situation under the reforms, is to get the board of directors to shut down the fund quickly and proceed to orderly liquidate.

Chairman Schapiro rounded out the panelís inquiries with several questions that appeared to address certain concerns raised earlier in the meeting.

She shared the concerns of other commissioners about continued reliance on credit ratings, she said.

Wonít managers be unable to use ratings as a shortcut because they are still required to conduct an independent analysis of every security purchased for the fund? How does the staff ensure the required independent analysis takes place?

The 1991 amendments to rule 2a-7 that we are essentially building on today, said Plaze, require money managers to keep rating files and our examiners to look at those files to ensure the analysis is conducted independently. OCIE did a sweep of those files to confirm independent analysis in 2008 and reported back to the Division of Investment Management that in large part, funds were doing the analysis. Funds were not Ďbatting a thousandí with the special investment vehicles, as history would show it, Plaze observed. But they were conducting independent creditworthiness analyses as required by the rule.

Schapiroís final question highlighted the new procedures aimed at reducing redemption sensitivities of funds.

"Whatís the importance of the know your investor procedures, and how are they going to interact with the minimum liquidity requirements? Whatís our expectation about what funds will do?"

Rule 2a-7 itself, even under the amendments, doesnít require fund managers to specifically know their investors, said Plaze. It does include liquidity requirements, however, for the funds to have a reasonable belief that the fund is sufficiently liquid to meet the reasonably expected redemption requests of their investors. That means you have to have a reasonable belief for what your investor redemption demands are likely to be, said Plaze, which in turn says youíve got to understand your investors.

For instance, if youíre an institutional investor, in certain circumstances you may need more than the 30 percent minimum required weekly and ten percent daily liquidity. Similarly, if you have omnibus accounts, in which thereís a blind, you may have to look through that blind or draw conclusions based upon historical patterns of redemption that you get through that omnibus account. "That will impose what Iíd say is a good practice, a better practice, and would impose it across the board," he said.

Donohue echoed the thought. "In our experience it is a best practice used by money managers Ė particularly in the institutional space Ė of knowing and being able to anticipate redemption activity and purchase activity on behalf of the investor," he said. The new liquidity requirements make it quite clear to others that may not have been as aware of this practice that the SEC has an expectation that funds will work to anticipate redemption demands.

While the Commission approved the package of reforms, the commissioners agreed more work is needed and pledged to continue the work begun by this rule adoption. "We will continue to pursue more fundamental changes to the structure of money market funds to further protect them from the risk of runs," said Schapiro.

Among the possible reforms for future consideration:

  • floating NAV (of particular interest to the staff, Schapiro noted);
  • mandatory in-kind redemptions for large, institutional-sized redemptions;
  • real-time disclosure of shadow NAVs;
  • private liquidity facilities to backstop money market funds in times of stress;
  • a possible "two-tiered" system of money market funds, with both stable and floating NAVs; and
  • other options being discussed with the Presidentís Working Group.