Ever since the oldest money market fund in the US “broke the buck” last September, it has been inevitable that regulators would look at ways to address the weaknesses of these crucial cogs in the global financial system.
So it is no surprise that reforms covering everything from liquidity to the credit quality and maturity of money market fund portfolios are under consideration.
Money market funds are hugely influential in the credit markets, and increasingly so as they have grown rapidly in recent years to hold about $4,000bn in assets.
The funds account for a quarter of the short-term money market – defined as instruments with a maturity of one year or less – and hold 40 per cent of all commercial paper. The latter gives them a crucial role in financing companies’ and state and local governments’ short-term debt needs.
They also account for more than 40 per cent of total mutual fund assets, making them a key business for big money managers such as Fidelity, JPMorgan, Vanguard, Federated, BlackRock and Legg Mason.
The funds have built their reputation on being one of the safest investments around. But that reputation was challenged in 2007 when weaknesses in money market funds became apparent, to the alarm of regulators, investors and industry members.
In September last year the Reserve Fund, the oldest money market fund in the US, “broke the buck”. This long-dreaded event caused huge dislocation in the credit markets as funds rushed to liquidate assets to meet hundreds of billions of dollars in redemptions. Funds “break the buck” when they return less than 100 cents in the dollar. The commercial paper market, which was already becoming illiquid, froze.
But by the time the Reserve hit trouble, there had been serious warning signs for months. By the end of 2007, seven fund companies had stepped in to bail out their money market funds, mostly because the funds had invested in structured investment vehicles, which had slumped in value. Prime funds – which invest in corporate paper – were all struggling with increasingly illiquid markets, making it difficult for them either to meet redemptions or to value their portfolios accurately.
So regulators and industry members have gone into a huddle to see what can be done to shore up the funds’ weaknesses while maintaining their crucial role in financial markets.
In January a team called the Group of 30, led by Paul Volcker, former chairman of the Federal Reserve, recommended that money market funds turn themselves into short-term bond funds or special-purpose bank accounts.
Racing to head off this plan, the main mutual fund trade group, the Investment Companies Institute, last month came up with its own plan to ensure the funds’ survival.
Mary Schapiro, chairman of the Securities and Exchange Commission, says the regulator will “act quickly this spring to strengthen the regulation of money market funds by considering ways to improve the credit quality, maturity and liquidity standards applicable to these funds”.
But the new regulations might go further than the ICI suggestions.
A key ICI recommendation is that money fund managers shorten the maturities in their portfolio, buying shorter-dated maturities to allow for greater liquidity. The law currently requires that the average holding be 90 days or less. That would be cut to 75 days.
The ICI wants the funds to have daily and weekly liquidity requirements, which would also result in shorter maturities. A fund would need to keep 5 per cent of its assets in cash or the equivalent on any given day, and a total of 20 per cent of the fund would need to be in securities that could be sold within seven days.
The ICI also recommends funds show their holdings each month rather than quarterly. That could mean that end-of-quarter dislocations, where the funds clean their investing slates to show only the safest investments, will henceforth occur monthly. It suggested the SEC might require average monthly holdings rather than spot holdings, which would end those “window dressing” dislocations altogether.
Finally, it would require the funds to raise the credit quality of their portfolios, which would result in fewer market buyers at the junk end of the credit spectrum. The funds at present can have up to 5 per cent of their assets in “tier-two” securities rated less than A1 by Standard & Poor’s. Under the ICI recommendations, no such securities would be allowed.
This and the liquidity requirements, if enacted, would mean the funds will almost certainly offer slightly lower yields to investors. With many of them struggling to offer any yield at all, as interest rates drop to near zero and long-dated Treasury yields have fallen, this could put the funds in a sticky situation.
However, it appears they have little choice, given that an industry-wide disaster has been narrowly averted. Indeed, it seems likely that reforms will go further than the ICI wants.
The Federal Reserve has extended until October the guarantee for money market fund assets. Presumably it expects some form of regulatory change to be in place by then.
In the meantime, some smaller players, such as Janus, have decided to get out of money market funds altogether, deciding the game is not worth the candle.
Those that remain no doubt hope they never see a repeat of the events of the past year.
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