The increasingly ill-tempered battle of wills between the financial industry and its regulators erupted into a full-blown slanging match at the end of the summer when the SEC threw in the towel over further reform to the $2.5 trillion money market fund industry.
Money market funds have been at the centre of the financial crisis since its inception, thrust into the spotlight when the $62.5 billion Reserve Primary Fund broke the buck shortly after Lehman’s collapse in 2008. They have controversially been viewed as an integral part of the shadow banking sector that has so worried the regulators ever since.
But on August 22 SEC chairman Mary Schapiro announced that she was abandoning a two-and-a-half-year project to bring structural reform to these funds following the decision by three fellow commissioners (Luis Aguilar, Daniel Gallagher and Troy Paredes) to veto a proposal to do just that. Democrat Elise Walter supported the proposal. But Schapiro did not go down without a fight.
"I – together with many other regulators and commentators from both political parties and various political philosophies – consider the structural reform of money markets one of the pieces of unfinished business from the financial crisis," she said. "While as commissioners we each have our own views about the need to bolster money market funds, a proposal would have given the public the chance to weigh in with their views as well."
Gallagher and Parades expressed "dismay" at her remarks five days later, stating that "the current discourse about the Commission’s regulation of money market funds is rife with misunderstandings and misconceptions. The Chairman’s statement creates the misimpression that three Commissioners – a majority of the Commission – are not concerned with, or are somehow dismissive of, the goal of strengthening money market funds. This is wholly inaccurate."
Round one
This is a fight about whether money market fund reforms that the SEC introduced in 2010 are sufficient. The regulator introduced the first changes to rule 2a7 (which was published in 1983) in May 2010, tightening up the rules on credit quality, diversification, liquidity, maturity, portfolio stress testing and transparency. In her August 22 statement Schapiro emphasized: "The Commission made clear that the first round of reforms in 2010 were a first step and that additional structural reforms were expected to follow as a second step. In fact, I specifically said as much at the time."
But the money market industry has been emphatic in its dismissal of further regulation and insistence that the market is sufficiently regulated already.
Paul Schott Stevens, CEO of the Investment Company Institute, claims that the summer of 2011 (when there was an escalation of the eurozone crisis, the showdown over the US debt ceiling and the downgrade of US government long-term debt) put the existing reforms to the test. "From early June to early August 2011 investors withdrew 10% of their assets from prime money market funds – $172 billion in all," Stevens says. "During the debt ceiling crisis prime and government funds together saw an outflow of $114 billion in just four trading days. But this withdrawal had no discernible effects at all – either on the funds or the markets." He points out that between April and December the average mark-to-market price of the shares of prime money market funds with the greatest exposure to European financial institutions fell by nine-tenths of a basis point. "That’s nine one-thousandths of a penny," Stevens points out, helpfully. Schapiro has, however, testified to 300 examples of sponsors having to step in to stop money market funds breaking the buck.
Hold back
Schapiro’s proposals envisaged funds operating with either a floating NAV or a stable NAV with capital buffers and redemption limits. Redemption restriction would most likely have been implemented via a "holdback": investors would be required to hold a minimum account balance, which would be held back on full redemption for a waiting period and could even be subordinated to absorb losses ahead of other shareholders, acting as a contingent capital cushion.
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| SEC chairman Mary Schapiro |
This – not surprisingly – provoked outrage among fund managers. In March, BlackRock said that 43% of its clients dipped below the mooted minimum account balance at least once in 2011, and 10% did so more than five times in a year. "Many clients go below the minimum account balance because of the nature of their business, which calls for a ramp-up of assets and then a redemption to zero," the asset manager explained. "In addition, many clients operate under guidelines that prohibit them from using funds with redemption restrictions – sweep accounts and collateral accounts must have access to 100% of their funds."
BlackRock concluded that Schapiro’s redemption restriction proposals would actually increase the risk of clients running in a financial crisis. "Many of them told us that with a portion of their balance held back for 30 days and subordinated they would choose to redeem much sooner – at the first sign of nervousness."
Aguilar, Gallagher and Paredes have been at pains to emphasize that they are not against further regulation per se, they just dispute whether Schapiro’s proposal is the right way to go.
In a response to Schapiro’s statement, Gallagher and Paredes announced that "the changes the chairman advocated were not supported by the requisite data and analysis, were unlikely to be effective in achieving their primary purpose and would impose significant costs on issuers and investors while potentially introducing new risks into the nation’s financial system".
Redemption gates
They claim that the best way forward is for fund boards to be empowered to impose gates on redemptions. At present they are allowed to do this only if the fund is put into liquidation. Not surprisingly, this approach finds far more favour among industry participants. BlackRock argues that stand-by redemption gates are the best way to stop a run on a money market fund, partly because this is the only proposal that would close off all redemptions in a crisis situation. They envisage stand-by redemption gates with an automatic trigger such as the fund’s liquidity dropping below a predetermined level or the marked-to-market NAV declining below a specified price.
Given the fact that the money market fund industry has poured millions into its lobbying effort against further regulation (together with the fact that Luis Aguilar worked at Invesco for 11 years), the abandonment of the vote is seen as a big win for the industry. Further regulation by the SEC is effectively dead in the water.
"The point of Schapiro’s statement was to indicate that it is over," a Washington insider tells Euromoney. "This has been a big distraction for her and she wanted to fish or cut bait. She wants to draw a line under this. It is not really her fight, it was foisted on her by the Financial Stability Oversight Council (FSOC)."
Schapiro’s capitulation from proposed reform is not without a sting in the tail. Twice during her August 22 statement she pointed out that the resolution of the issue at the SEC paves the way for other regulators to act – observations that have not gone down well with fellow commissioners. "We wish to stress that money market funds are squarely within the expertise and regulatory jurisdiction of the SEC," Gallagher and Paredes have squealed. "We do not intend to abdicate our responsibility to regulate money market funds, which would be unjustified and at the expense of our mission to oversee the securities markets."
But Schapiro’s veiled suggestion sparked a frenzy of speculation that the FSOC itself could designate all money market mutual funds as non-bank systemically important financial institutions (Sifis) and regulate them through the Federal Reserve itself.
However, some are sceptical as to the practicalities of such a plan. "Several meetings [we have had] with FSOC staff have indicated that they believe there are no good options for regulating MMFs outside of the SEC," notes David Barrosse, managing director at Capstone DC, a Washington DC-based financial advisory firm specializing in policy analysis and regulatory due-diligence services for institutional investors. "Our reading of the non-bank Sifi final rule suggests that it is not possible to designate an asset class as a Sifi and the Federal Reserve does not by itself have jurisdiction over investment managers. It is possible that large money market sponsors could be designated as non-bank Sifis. It is also possible that the Fed chooses to increase regulation of bank-sponsored money market funds. However, both of these measures have severe practical downsides. We do, however, recognize that regulators (especially the Fed) are extremely focused on the issue."
Indeed, Joseph Abate, money market strategist at Barclays in New York, reckons that the money fund industry should not breathe a sigh of relief too soon. He points out that the April FSOC ruling notes that the council "may develop additional guidance" regarding asset managers – although so far nothing has been released. "We think it is extremely unlikely that money market reform has ended with the SEC’s inability to get a vote," Abate warns.
It is difficult to overstate how important the outcome of this will be to the financial industry. When the Reserve Fund broke the buck in 2008, more than $300 billion was withdrawn from other prime money market funds within days.
The damage was only contained by the Treasury department’s unprecedented decision to step in and guarantee the sector – an option that is no longer available to it.
"We must be cognizant that the tools that were used to stop the run on money market funds in 2008 no longer exist," Schapiro warns. "There is no back-up plan in place if we experience another run on money market funds because money market funds effectively are operating without a net."
