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Monthly Cash Review – USD May 2022 Update on US Money Market Reform

Portfolio Strategist

There were a total of 51 entries submitted during the SEC’s Rule 2a-7 comment period whose deadline was April 11th: 17 from asset managers, one from a law firm, four from political associations or politicians, 15 from retail investors or individuals and 14 from affiliated associations. Asset managers tended to write the most comprehensive letters with one manager taking the prize at three separate comment letters totaling 163 pages.

Without question, the opposition to swing pricing is practically unanimous. Operational experts tell us it does not work for the multiple pricing points of a T+0 institutional prime money market fund., After speaking with a number of operational and accounting experts, it’s clear to us that the opposition to swing pricing is not just directed towards money market funds, but for the broader mutual fund industry.

There are notable differences regarding how the market works in the US vs. Europe, where swing pricing is more common for mutual funds (not MMFs), specifically the notification period. the MMF industry maintains that because US registered mutual funds allow T+0 notification, swing pricing is not feasible. There is not enough time between when the fund closes to shareholder activity and the time it must release the NAV. In Europe, similar types of funds have a notification period of T-1, thus allowing for necessary processing time to calculate the swing and price the fund. It should be noted there are two types of swing pricing in Europe. The first is the actual calculated swing (“haircut”) of all securities in a fund where the fund manager would adjust each price on each security in a fund. The second type of swing is a default factor swing whereby a predetermined haircut is applied to a funds’ calculated NAV rather than the individual securities – a process that is much simpler to apply to the fund. In the case of a money market fund this could also be interpreted as a redemption fee. And that, it appears, is what the industry is prepared to support in order to satisfy the SEC’s desire to impose a “swing” price but one that is both practical to administer and where the infrastructure and processing already exists and is tested for MMFs.

Of the 17 comment letters written by fund managers, about half support a predetermined mechanism, or trigger, by which a fee would be applied to the fund’s NAV. In our response, SSGA supported a dual trigger (as is the structure in Europe)– a certain amount (percent of AUM) of shareholder redemptions and the breach of a certain level of weekly liquid assets (WLA). Should both situations occur, they would trigger the fee to be applied to the NAV. Others support this approach although definitions of “triggers” vary. It is important to note that there would be no subjectivity to this rule. Once the trigger(s) are hit, the fee is applied. To this point, the SEC is interested in eliminating any subjectivity to the decision, such as the fund’s Board having to make the decision in the best interest of the shareholders. Concerns arise when specific metrics, like WLA, become the shareholder’s focus in times of stress as has been the case with WLA since the ’16 reforms. If a fund’s WLA drops to a specific level and an investor is concerned, does that concern lead to a redemption, potentially exacerbating the run?

A case could be made that any commingled vehicle, no matter what the strategy or asset type, could experience a run. However, in the case of ‘cash’ vehicles those runs should not be caused by the rules put in place to protect shareholders. The money market fund shareholder’s reaction function since the Reserve Prime Fund broke the buck in 2008 has been to exit prime money market funds when there are significant liquidity strains in the money markets. Thus the SEC will have to spend considerable time debating how to best create rules that allow fund managers to use their liquidity in times of stress rather than being forced to sell assets to manage panic from shareholders. We believe that the SEC should consult with the shareholders of these funds to discern what they will be monitoring to gauge if a fund is stressed.

Another proposed rule garnering mixed opinions centers around an increase in the required liquidity levels in prime funds. The SEC has proposed increasing the required daily liquidity (DLA) from 10% to 25%, and the required weekly liquidity (WLA) from 30% to 50%. We believe the change in DLA is not a significant adjustment given that it is very difficult to structure the WLA in a fund to be above 40% and not have the DLA at or above 25%. As for the WLA, today prime funds typically run WLA above 40%. We learned, back in ’14 when the SEC announced the ’16 reforms, that shareholders expected prime funds to run some level of liquidity well above the required 30% (typically at least 10%) in order to be comfortable that they would not be exposed to the potential of a gate or fee. If the new rule is 50%, does that include the cushion, or will funds have to run 60%? A typical government fund currently runs at about 80% WLA, depending on market conditions. If a prime fund must run WLA at 60%, your fund may look more like a government fund than a prime fund, and offer a similar yield. Perhaps that is the ultimate intention of the SEC.

The expanded disclosure of fund metrics has created a paradox for fund managers. With the enhanced transparency and availability of information, they know many investors are monitoring and making real-time decisions based on this information. Therefore, fund managers must be extraordinarily cautious when managing the fund and the associated metrics. Is it possible that the SEC will switch the narrative from weekly liquid asset levels to shareholder redemption levels or both? While it is not typical for a money market fund to have a 5% redemption, it can happen. Often times these redemptions are known and planned for. But if shareholders are now watching this metric and are not aware that the redemption is known and planned for would they see it as warning and redeem? Complexity persists.

Lastly, regarding institutional prime funds, we look at the total assets levels in these vehicles. According to Crane Data there is a total of $635bln in SEC registered institutional prime money market funds as of May 26, 2022. Of that $635bln there are 24 funds with $164bln that are open to the public while the remaining 13 funds ($471bln) are utilized primarily as internal-only sweep vehicles. The internal sweep vehicle structure serves two benefits. First, it gives the portfolio manager more liquidity options when investing cash. Instead of being limited to government and treasury debt, managers can invest in securities such as time deposits, CDs and commercial paper, allowing for optimized risk and broader liquidity. Second, though the shareholder in these funds have T+0 liquidity, they cannot exit the fund without warning as well as an established process to convert to another sweep vehicle. This restriction allows the portfolio manager to prepare for a conversion with some advance warning. In a way, the segregation of investors in sweep vehicles has solved some of the SEC’s problem by reducing the number of clients that can create a run on a fund.

Reverse Distribution Mechanism

The banning of reverse distribution mechanism (RDM) during times of negative interest rates is a proposal that needs considerable study by the SEC and a final ruling should be delayed until that can be done. When the SEC announced the 2014 2a-7 reforms that took effect in 2016, the rule that initially received the most attention was a breach on Weekly Liquid Asset (WLA) levels that would trigger a redemption gates or a liquidity fee. This rule was initially thought of as a ‘nonstarter’ for most prime fund investors, with many threatening to exit their investments amid the potential for a redemption gate or a liquidity fee. As investors prepared for the rule to go into effect and further research was done, it turned out that many institutional prime fund shareholders’ accounting and cash management systems could only accept a steady $1.00 NAV rather than a variable NAV. If, during a time of negative interest rates (like the first half of ’21), money market fund yields were to turn negative, the industry could see redemptions out of government and treasury money market funds simply because MMF shareholder’s systems could not accommodate a variable NAV. Currently there is over $4 trillion in government and treasury MMFs. Let’s say, for arguments sake, 1/4 of this money is intolerant of a variable NAV, then $1 trillion would have to find a new home. It’s unclear who could accommodate this inflow. Given bank balance sheet constraints, and current capital and liquidity ratio requirements, would the banks want it? Not to mention the potential negative implications for liquidity in the T-Bill market. Further study is necessary by the SEC.

What do investors in money market funds need to do right now? In a word – nothing. The SEC will spend most of this year considering the comment letters and deliberating the modifications to the rule. At some point later this year or early in ’23 they will announce the modifications to the rule 2a-7. We would expect a lengthy implementation period during which investors will have ample time to determine what is the right choice for their liquidity needs.

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