Part 1 of 3
Money market funds are under the SEC microscope again with significant reforms being contemplated by the SEC. Based on how money market fund shareholders responded to the turbulent markets in March 2020, the SEC believes that it needs to reform the money market fund structure again to improve the liquidity and provide a more effective buffer against chaotic redemptions during disruptive markets.
In December 2021, the SEC proposed amendments to the SEC Rule 2a-7 which governs how money market funds are operated and structured. The proposed rule changes require that institutional prime and institutional tax-exempt money market funds adopt a new mechanism to handle redemptions to be more equitable to all investors. The SEC is considering a “swing pricing” approach so that investors that redeem their shares in the fund cover the costs of liquidating their investment.
The SEC’s rationale is that currently, when investors redeem their shares the transaction costs are borne by all of the investors, impacting the remaining investors the most. The use of “swing pricing” is intended to discourage rapid, large withdrawals which led to liquidity squeezes in March 2020.
In times of market stress there may be extreme levels of fund trading activity as money market fund managers trade to meet the cash requirements for redeeming investors. Increased trading may generate trading costs and other costs as the fund’s daily and weekly liquid assets are rapidly depleted. Under the current liquidity structure, the additional costs are carried by the investors that remain in the money fund.
The SEC in considering removing the current “gates and fees” limitations which have been very unpopular with investors and managers. The regulators believe that this mechanism has the potential to dilute the investments of the remaining investors. This in turn may trigger investors to accelerate large redemptions to avoid high costs, especially during volatile markets.
Now we will take a look at some of the proposed changes:
“Swing Pricing“
The SEC’s new answer to treat all investors equitably is “swing pricing” which is a mechanism or approach that adjusts the money market fund’s current net asset value (NAV) upon redemption. The redemption proceeds would be included or be reduced by the transaction costs generated by that specific redemption. Under this mechanism, the redemption costs are absorbed by those investors redeeming their shares in the fund. This is intended to insulate the remaining shareholders from bearing the transaction costs caused by the redemptions of other investors.
Liquidity Requirement Changes
The proposed rule would change the requirements on prime funds for daily and weekly assets. On prime funds, the liquidity requirements would be increased from 10% to 25% for daily and from 30% to 50% for weekly assets. This extra liquidity cushion may help the money market fund meet redemptions, but also forces money managers to compete for a higher volume of very short maturities which may result in lower yields.
Institutional Government Money Funds
The SEC proposal would require that constant net asset value (CNAV) funds, namely government funds, convert to floating net asset value (FNAV) funds should the fund’s yield become negative. Turbulent markets combined with conversion requirements may accelerate redemptions and lead to more chaotic investor behavior, which is not the SEC’s intention.
New Disclosure Requirements
The SEC would also require additional new detailed disclosures and reporting. Institutional prime and tax-exempt funds would be required to report on the types of investors, percentage of shareholder interest and concentration of large investors. The SEC would seek transparency as to large shareholder investors in the funds to assess their potential adverse impact on the money funds’ overall liquidity. The SEC assumes that large investors could represent liquidity risk to other shareholders if they make large redemptions over a short period.
Join us in part 2 of this 3-part blog where we discuss “swing-pricing” in greater detail including the mechanics, calculation, implementation and monitoring requirements.