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News November 26, 2012 Issue

FSOC’s Plan for Money Market Fund Reform

It’s here. And – surprise, surprise – it looks a lot like the stalled SEC version.

Like it or not, via the SEC or the Financial Stability Oversight Council (FSOC), further money market fund (MMF) reforms are coming.

Lobbied against heavily by the Investment Company Institute (ICI), the U.S. Chamber of Commerce, and a big swath of corporate America, regulators responsible for the prevention of the next crisis aren’t buying it.

When SEC Chairman Mary Schapiro couldn’t carry the ball of further MMF reforms across the line earlier this year, she lateraled the issue to another teammate – the FSOC.

Treasury Secretary and FSOC Chairman Timothy Geithner also supported additional reforms. He shared Schapiro’s view that the risk of runs on MMFs in danger of breaking the buck must be addressed. In the FSOC’s annual report to Congress, Geithner testified that additional MMF reforms were among the top five items remaining on the FSOC’s "to do" list.

Back on August 22, Schapiro announced she did not have the votes to issue a fully formed rule proposal.

The Republican SEC Commissioners, Troy Paredes and Daniel Gallagher, did not favor imposing additional reforms. Commissioner Luis Aguilar wanted a thorough analysis of the effectiveness of the initial reforms. Only if that analysis indicated that further action was warranted was he willing to consider further reforms.

Schapiro urged the FSOC to take action and step into the breach a majority of SEC commissioners refused to fill. "Other policymakers now have clarity that the SEC will not act to issue a money market fund reform proposal and can take this into account in deciding what steps should be taken to address this issue," she said.

The FSOC wasted little time in answering her call.

In a meeting on November 13, the FSOC unanimously approved proposed recommendations for further money market fund (MMF) reforms.

Schapiro said during the meeting that she believed a floating NAV for MMFs was the purest and simplest option and was most consistent with the SEC’s historical approach to investment products. She recognized the value investors place on a stable NAV product though, and she said she was open to hearing from commenters about other options.

Federal Reserve Board Chairman Ben Bernanke reminded the group that in 2011, MMFs suffered a mini-run related to concerns about exposure to European banks. Over eight weeks institutional investors redeemed $180 billion. Acknowledging it was a smaller event, nonetheless it suggested that the basic run issue relating to MMFs had not been solved, he said.

CFTC Chairman Gary Gensler cautioned that balancing the risk of runs against significantly changing MMFs was the challenge for policy makers. He noted that changing MMFs could diminish their use, both as an investment product and a source of funding.

Gensler noted that the FSOC’s role was primarily advisory, and it was ultimately the SEC’s responsibility to implement MMF reform. He said he supported the FSOC’s proposal because it was important to obtain broad public input on how to balance the risk of runs against the effects alternatives might have on the utility of MMFs and on the economy.

The FSOC has ten voting members, the heads of the Treasury Department, Federal Reserve, Office of the Comptroller of the Currency, FDIC, SEC, CFTC, Consumer Financial Protection Board, Federal Housing Finance Agency, National Credit Union Administration, and a Senate-appointed independent member with insurance expertise. All were present and voted for issuing the proposal.

"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 associated with MMFs," said the release.

Geithner expressed his hope that the proposal would encourage public debate on concrete options for reform. He noted however, that if at any point the SEC had a majority to support a set of recommendations for MMF reform, the FSOC would suspend its work to allow the SEC process to play out.

Section 120 of the Dodd-Frank Act authorizes the FSOC to provide more stringent regulation of an activity or practice that it determines poses a significant risk to the nation’s financial system.

Specifically, the FSOC must determine that the "conduct, scope, nature, size, scale, concentration or interconnectedness" of MMF activities or practices could "create or increase the risk of significant liquidity, credit, or other problems" spreading among bank holding companies, nonbank financial institutions, U.S. financial markets, or low-income, minority, or underserved communities.

The risk of destabilizing runs in a concentrated and interconnected industry.

In making its determination, the FSOC said that MMFs present such significant risks to the financial system.

"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 curtain the availability of liquidity and short-term credit," said the release.

The liquidity pressures on the MMF industry resulting from a run can propagate rapidly throughout the financial system and to the broader economy, said the release. MMFs lack explicit loss-absorption capacity, are too similar, and have demonstrated a "first-mover" advantage for redeeming investors, all of which can incite widespread runs.

Because MMFs play a significant role in the short-term credit markets, an industry-wide run can also reduce the availability of credit to borrowers.

Provided the SEC remains unable or unwilling to act, once the public comment period concludes on January 18, the FSOC will consider those comments and can issue its final recommendation to the SEC.

The SEC must act on the recommendation, either "to impose the recommended standards, or similar standards that the [FSOC] deems acceptable, or explain in writing to the [FSOC] within 90 days why it has determined not to follow the recommendation."

The release noted that the FSOC will suspend the Section 120 process should the SEC move forward with its own "meaningful structural reforms" before final recommendations are issued.

Three alternatives.

The FSOC proposed three alternatives for structural MMF reforms for public comment.

Floating net asset value.

The FSOC’s first alternative would remove the exemption allowing MMFs to use amortized cost and penny rounding methods to maintain a stable $1.00 NAV.

The price per share would be increased to $100.00 to reflect more accurately the fluctuations in share value. Fractional share redemptions would be permitted.

Existing MMFs would be potentially grandfathered, or be permitted a phase-in period. The proposal asks for feedback on suitable time periods for either.

Stable NAV with NAV buffer and "minimum balance at risk."

The FSOC’s second alternative would require MMFs to maintain an NAV "buffer" using a tailored amount of fund assets of up to one percent.

The buffer would absorb day-to-day fluctuations in the value of portfolio securities and allow the fund to maintain its stable $1 NAV. A fund with a deficient buffer would be limited to investing only in cash, Treasury securities, and Treasury repos until the buffer is restored.

The buffer would be combined with a three percent delayed redemption feature for investors with MMF balances over $100,000. Such shareholders would be subject to delayed redemption of three percent of the highest account value in excess of $100,000 during the previous 30 days. This minimum balance at risk (MBR) could not be redeemed for 30 days.

Treasury MMFs would be excluded from these requirements, and shareholders with fund balances below $100,000 would not be affected.

The release noted that "in the event that an MMF suffers losses that exceed its NAV buffer, the losses would be borne first by the MBRs of shareholders who have recently redeemed, creating a disincentive to redeem and providing protection for shareholders who remain in the fund."

Stable NAV with NAV buffer and other measures.

The FSOC’s third alternative would require a risk-based NAV buffer of three percent to provide "explicit" loss-absorption capacity.

The buffer could be combined with other measures, such as heightened investment diversification, minimum liquidity, and disclosure requirements. The intended result would be to enhance the effectiveness of the buffer and potentially increase MMF resiliency.

The FSOC noted that to the extent other measures could be demonstrated to successfully enhance buffer effectiveness and further reduce MMF vulnerabilities, in its final recommendation the FSOC could reduce the size of the NAV buffer under this alternative.

While it all sounds so reasonable as the FSOC explains it, industry representatives have a different take.

Law firm Goodwin Procter observed that alternatives one and two are essentially the same as the SEC proposal for which Schapiro was unable to get majority approval.

ICI president Paul Schott Stevens in a same-day statement called the FSOC’s actions "regrettable," and "deeply flawed."

"While we appreciate and will respond to the FSOC’s invitation for other reform ideas, we are disappointed by the proposals featured in the FSOC’s release – forcing money market funds to ‘float’ their value, capital requirements, and daily redemption holdbacks. These concepts already have been the subject of extensive analysis and commentary. It appears that little of this analysis has even been considered by the FSOC," said Stevens.

Bingham partners Lea Anne Copenhefer and Roger Joseph and associate Caroline Cai observed in a client alert that perhaps it was the other way around.

"FSOC’s vote signals a growing impatience with the status quo and in effect rejects reform measures proposed by the money market fund industry such as implementing liquidity fees and/or temporary restrictions on redemptions during times of market stress," they said.

The fund industry doesn’t take rejection easily, however.

It has repeatedly taken rulemakings it believes to be onerous and unworkable to court – with a 100 percent success rate so far. Policy makers and regulators would do well to keep that in mind as they chart the way forward.

"The fund industry has engaged consistently on this issue for more than four years, offering ideas and detailed analysis.

It’s deeply disappointing that the Council has proceeded without giving due weight to the views of fund sponsors, investors, and the issuers who depend upon money market funds for vital financing," said Vanguard CEO William McNabb in a joint statement.

McNabb is also chairman of the ICI Money Market Working Group.