The immediate liquidity crisis passed. But breaking the buck is kind of like forgetting your anniversary: If it happens once, you’ll hear about it for years.
Regulators – still smarting from a run on the Reserve Primary Fund in September of 2009 that caused its NAV to decline to “break the buck,” falling to 97 cents rather than the stable dollar normally expected of money market funds – are looking at some reforms that could transform how we think of these staple investments.
Reformers Call for a Floating NAV
So some observers have been calling for reforms: Specifically, removing the expectation that money market funds maintain a share price of $1 per share. Instead, money market NAVs should be “floating,” say reformers, led by the former SEC chairperson Mary Shapiro.
Such a measure would simply shed daylight on something that is already a reality – money market portfolios do sometimes deviate from the $1 per share benchmark. It’s just that in all but two instances, the differences have been small enough to paper over so far. The money market industry, in essence, proceeds with a wink and a nod. The market simply pretends they are stable.
Shapiro also proposed requiring money market funds to maintain a reserve of 1 percent of assets against the possibility of breaking the buck, as well as impose early redemption penalties of 1 to 3 percent on money market investors who pull balances out within 30 days of investing in the fund. Whoever panic sells in a declining market would give up that percentage of their balance to protect shareholders remaining in the fund. Ultimately, the SEC proposal, as it stands now, would give investors a choice between a stable value fund with these restrictions and reserve requirements, or one with a floating net asset value.
Both adopting a floating NAV – just like any other mutual fund – and imposing liquidity restrictions strike at the heart of what a money market is and its function in the market. Without a fixed NAV and high liquidity, they become just another mutual fund.
The Politics of Money Market Reform
Major money market managers have vigorously opposed the reform. Fidelity Investments, the single largest money market manager in the country, wrote a letter to the SEC stating that the possible reform could destroy the money market fund as we know it. And since money market funds are among the principal means by which large corporations and municipalities finance their payrolls, the wholesale abandonment of the concept could cause incalculable disruption to the economy.
Schwab President and CEO Walt Bettinger, has come out against the floating NAV. Not all money market funds are created equal, argues Bettinger in a recent op-ed in the Wall Street Journal Requiring all money market funds to adopt a floating NAV would ignore an important distinction:
Most objective observers would say that money-market funds investing exclusively in U.S. Treasury instruments, U.S. government agency paper or debt issued by states have minimal credit risk. These “nonprime” money-market funds should continue to operate as they do now with careful oversight, transparency, regulation by the SEC and a stable $1 per share net-asset value.
But prime money-market funds do have a degree of potential credit risk that could arise in extreme capital-market credit crises. And the reaction of institutional investors in these funds to this credit risk creates a potential for runs.
Additionally, both Shapiro and Bettinger recognize that mixing individual shareholders and institutional shareholders in the same fund causes a problem: Institutions hold much, much larger accounts, they keep much closer watch on their investments, and they sell faster – driving down NAVs and potentially leaving individual investors high and dry before they can react to protect themselves.
On the other hand, if the stable $1 NAV is a fiction, it is a noble one – it acts to keep the peace in the markets while allowing quite a bit to get done. Says Federated Investors chairman and CEO J. Christopher Donohue in a recent op-ed at Forbes:
The ability to transact at the $1 NAV provides a real benefit to corporations, government entities and other money fund users by allowing them to use automated cash management processes, facilitating same day transaction processing, shortening settlement cycles, and reducing float balances and counterparty risk. These are measurable benefits that translate directly into lower costs of capital and higher returns on assets.
BlackRock went so far as to survey their own client base, however, and found that a large segment of their own money market depositors were sour on the capital restrictions. 43 percent of them, for example, had zeroed out their money market balances in the past 12 months, and many of them do so regularly in the course of their business. A redemption fund or restricted withdrawal regimen would cause them to avoid that money market in the future. These schemes, in which a percentage of the balance is held back for 30 days or so, and used as a reserve to protect other shareholders subjects these regular users to an unacceptable risk of loss.
Interestingly, BlackRock’s investors told them, overwhelmingly, that a redemption or restricted capital arrangement would make them more likely to bolt from the fund, not less, in the event of a market crisis.
A Floating NAV Would Make Money Markets More Like the Rest
In truth, the $1 NAV is a vital differentiator for the money market industry – and it is a particularly important one for individual investors. Institutions have the wherewithal to accept a floating NAV and manage and balance risk exposures accordingly. Individual investors, on the other hand, rely on the $1 per share convention as an important shorthand for what these funds do: Provide a steady, safe return with a very minimal risk of loss.
If NAVs float, then money markets will become virtually indistinguishable from any other short-term bond mutual fund – and loads of retail investors will not have the sophistication or financial education to grasp the difference.
Furthermore, some investors are operating under strict investment guidelines that prohibit them from exposing the money market portion of their portfolios to loss. A floating NAV would cause them to violate their charters. So-called “sweep” accounts and accounts used as collateral also typically need to have access to 100 percent of the balance. Another BlackRock policy paper, adopted by the Investment Company Institute, details the impact.
Options for Investors
As a result, the retail investor will have a harder time identifying havens for safe money. They would have to turn to banks to fill the same role – a role for which they are ill-suited. After all, the traditional banking model is to borrow short from CD holders to lend long on mortgages. It’s a liquidity crunch waiting to happen. There would eventually be less transparency, and more money market balances would be subject to the credit risk of a single bank, rather than to the risk of a diversified portfolio of short-term, highly liquid investments.
The intent of Shapiro’s reform effort is laudable – but adopting a floating NAV and imposing liquidity barriers to money market funds risks throwing the baby out with the bathwater.