Opinion

Felix Salmon

The SEC gets closer to regulating money-market funds

By Felix Salmon
February 7, 2012

Banks need to be regulated. Depositors can’t be expected to do due diligence on their financials, so you need deposit insurance. And in turn, the government — which provides the deposit insurance — needs to make sure that the banks have certain minimum levels of capital. Otherwise, the insurance fund will go bust in no time.

All of this is wholly uncontroversial — until you get to the subject of money-market funds. At heart, as they exist today, MMFs are banks. They borrow money which is repayable on demand, and they lend it out for fixed terms, taking a certain amount of credit risk while doing so. If their borrowers fail to repay the money, or if their depositors all demand their money back at once, then they’ll be left needing to be bailed out.

Paul Volcker, in September, gave a speech laying out the problem with MMFs very clearly:

Started decades ago essentially as regulatory arbitrage, money market funds today have trillions of dollars heavily invested in short-term commercial paper, bank deposits, and notably recently, European banks.

Free of capital constraints, official reserve requirements, and deposit insurance charges, these MMMFs are truly hidden in the shadows of banking markets. The result is to divert what amounts to demand deposits from the regulated banking system. While generally conservatively managed, the funds are demonstrably vulnerable in troubled times to disturbing runs, highlighted in the wake of the Lehman bankruptcy after one large fund had to suspend payments. The sudden impact on the availability of business credit in the midst of the broader financial crisis compelled the Treasury and Federal Reserve to provide hundreds of billions of dollars by resorting to highly unorthodox emergency funds to maintain the functioning of markets.

Recently, in an effort to maintain some earnings, many of those funds invested heavily in European banks. Now, without the backstop official liquidity, they are actively withdrawing those funds adding to the strains on European banking stability.

The time has clearly come to harness money market funds in a manner that recognizes both their structural importance in diverting funds from regulated banks and their destabilizing potential. If indeed they wish to continue to provide on so large a scale a service that mimics commercial bank demand deposits, then strong capital requirements, official insurance protection, and stronger official surveillance of investment practices is called for. Simpler and more appropriately, they should be treated as an ordinary mutual funds, with redemption value reflecting day by day market price fluctuations.

Wonderfully, it seems that the SEC has been listening. The WSJ article is a bit hard to follow, but the SEC seems to have a three-pronged approach to regulating these beasts.

Firstly, they’ll be forced to raise capital. Secondly, depositors won’t be able to withdraw all of their money at once, just 95% of it. The last 5%, they’ll have to wait 30 days. And thirdly, the net asset value should be allowed to float, rather than being fixed at $1.

What are the chances of all of this happening? Zero. Reading between the lines, it seems that the SEC is making a big ask, and will probably be willing to compromise: even Volcker painted reform as a choice between more capital and a floating NAV, rather than a both-and approach.

But just forcing MMFs to raise capital will be a huge and important step forwards. Not that it’s going to be easy:

J. Christopher Donahue, president and chief executive of Pittsburgh-based Federated Investors Inc., which manages $255.9 billion of money-fund assets, said he plans to sue the SEC if the new regulation interferes with his firm’s ability to do business.

“We’re going to do everything in our power to attack it,” Mr. Donahue said of the possible regulations.

This is kinda hilarious, given the official Federated argument against Volcker:

With 30 million investors and $2.6 trillion in assets, MMFs are hardly unseen, hidden or surreptitious. Not only are they subject to significant control, examination and oversight by the Securities and Exchange Commission, with detailed prospectus requirements for the issuance of their shares, demanding reporting requirements, regular surveillance, and substantial requirements as to liquidity, asset quality and maturities, but they must publicly and frequently disclose the contents of their portfolios, on their websites and in regulatory filings – down to the individual security level.

In other words, the reason that MMFs need no further regulation is that they’re already regulated by the SEC. On the other hand, if the SEC itself wants to step up its regulation of MMFs, then they’ll sue it.

The reality is that MMFs are a monster source of systemic risk in the US, and the SEC is absolutely right to want to get some kind of a grip on them. They need to make a choice: are they mutual funds, where investors risk taking losses? Or are they banks, which need to be regulated by the government? Up until now, they’ve managed to have their cake and eat it — but those times must come to an end. Here’s hoping Mary Schapiro sticks to her guns on this one, in the face of what is sure to be extremely stark opposition.

Comments
10 comments so far | RSS Comments RSS

“At heart, as they exist today, MMFs are banks.”
Yes, and they operate without capital. Whether the SEC would be the right regulator is debatable. (Remember the SEC’s Consolidated Supervised Entities: Bear Stearns, Lehman et al….)

Posted by alea | Report as abusive
 

Allowing a floating NAV is a simple fix that resolves the problem. The fixed $1 redemption price is at the heart of why there was/can be a run on money market funds. Without that, a money market fund is just bond fund with short-term, highly-rated assets. Assets that are extremely different from the assets that a bank holds, by the way.

Let’s also provide some context for the crisis of the Reserve Primary Fund and its eventual outcome. Shareholders of that fund have received over 99% of their money – http://en.wikipedia.org/wiki/Reserve_Pri mary_Fund. Even at the height of the panicked flight from money market funds, the real concern wasn’t that the holdings of funds would take massive losses. It was that a small, sub-5% loss of principal for the fund would turn into a huge loss for the last holder out because of the fixed $1 redemption price for holders who redeemed earlier. Floating NAV solves that problem.

Posted by realist50 | Report as abusive
 

During the meltdown only one fund broke the buck — the riskiest, highest-yielding fund — and everyone got 99% recovery. Even if it were a good idea to add regulations to the entire industry as a result, surely the SEC can focus on other priorities (quite a few come to mind) until the ultra-low rate era is over. Moving to impose costs and decrease yields on a product that is paying 0.1% interest is probably a decision to put a lot of funds out of business.

Posted by RogerNegotiator | Report as abusive
 

Let’s face it, many of these funds exist solely to provide Financial Advisors with a way to avoid cashing in a client’s mutual fund and having the money lose his or her ‘control’; similarly for pension funds and insurance companies. If the client moves the money to his bank account, you can bet the bank will want to get their hands on the money, meaning no reinvestment opportunity for advisor, insurance company, or pension fund.

Sure, there are other purposes too, but as you say if they carry risk they really should be paying more interest to pay for it. Whenever I’ve compared them with ordinary cash accounts, the cash accounts usually have better interest rates, so I can’t see any great attraction in recommending them to my clients.

Of course, use of a floating NAV will pretty much kill the class as an ‘investment’ vehicle, while forcing capital holding will make them uneconomic. Perhaps it is about time they were sorted out?

Posted by FifthDecade | Report as abusive
 

The idea that Money Market funds grew out an arbitrage play is said so often that it’s just assumed to be true. I highly recommend reading Zoltan Pozsar’ IMF paper “Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System”. The paper looks at the rise of the “shadow Banking” system from a demand perspective. It is a good read and a gives some needed perspective to the debate on Money Market fund regulation.

Posted by BRJohansson | Report as abusive
 

Everyone got 99% recovery because the government served as a backstop. You can’t pretend like the market would have survived without an implicit government guarantee.

There has to be some kind of middle ground for the floating NAV idea. It would create an operational, accounting, and tax nightmare for many and may drive them out of the MMF market if all funds were just forced to float a NAV tomorrow. Something along the lines of striking a real NAV on a daily basis and keeping the per share value at $1 until your real NAV falls below a set threshold at which point you are forced to float, and perhaps exempting funds invested in say only U.S. government debt.

As to the 5% lockup, that’s crazy. Why would I continue to keep my $ there when I could put it in something that’s actually liquid?

Posted by clumsymohel | Report as abusive
 

This is going to kill the industry. The rules amount to closing the barn door after the horse has left the stable.

Posted by DougT | Report as abusive
 

No US regulator wants money market funds to exist in the size and scale that they do currently. Most money market funds are sponsored by the large commercial banks. These bank managed funds have already shrunk sharply because when the FDIC told banks to stop subsudizing them with management fee consessions the yields dropped all the way to zero and banks are still breaking even or losing money.

The problem is that the banks can’t handle the deposits. There is nothing to do with the money. 91 day t-bills also yield zero so if I take a billion dollars in at zero % lend it out to the goverment at 0% then I made no money and tied up 100 million worth of my capital cushion.

Posted by y2kurtus | Report as abusive
 

If Money Markets are banks and can’t survive being treated like banks, then get rid of them and go back to banks. No point in privatizing profits and socializing losses if these things blow up again.

Posted by Abe.Froman | Report as abusive
 

y2kurtus – and don’t forget that I also have to pay a fee to the FDIC for deposit insurance

Posted by realist50 | Report as abusive
 

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