A Critical Evaluation of the Money Market Fund Reforms
In 2008, the $60 billion Reserve Primary Fund, the oldest money market fund in the United States, broke the buck – net asset value (NAV) dropped below $1 per share. This drop in NAV was caused by the bankruptcy of Lehman Brothers, in which the Reserve Primary Fund had made significant investments. Lehman’s bankruptcy led to a “flight to quality” by risk-averse investors, which resulted in a bank run on money market funds by investors who feared that more funds would break the buck. Since then, the Securities and Exchange Commission (SEC) has implemented several regulatory reforms designed to enhance the stability of money market funds so as to prevent them from breaking the buck. In 2014, the SEC introduced money market fund reforms by amending the rules that govern money market funds under the Investment Company Act of 1940. In this article, I will analyse how the introduction of liquidity fees and redemption gates, enhancements to diversification requirements under Rule 2a-7 of the Investment Company Act of 1940 and stress testing prevent money market funds from breaking the buck.
The reforms introduced liquidity fees – a fee imposed on shareholders for redeeming their shares of the fund – and redemption gates – a temporary suspension of the right of shareholders to redeem their shares of the fund – for institutional and retail money market funds to address runs. The new rules state that if a fund’s weekly liquid assets fall below 10% of its total assets, the fund must impose a 1% liquidity fee, unless the board determines that imposing such a fee would not be in the fund’s best interest or that a higher (up to 2%) or lower fee is more appropriate. On the other hand, if a fund’s weekly liquid assets fall below 30% of its total assets, the fund’s board may impose a liquidity fee of up to 2% and/or suspend redemptions for up to 10 business days in any 90-day period. The imposition of liquidity fees or gates must be disclosed to the SEC.
The liquidity fees serve as a disincentive for shareholders to redeem their shares and the redemption gates impose a temporary suspension on share redemption by shareholders in times of distress. These measures in turn prevent runs that could cause money market funds to break the buck. When there is a run on money market funds, the most liquid assets will be sold off first to pay off the redeeming investors. No investor wants to be in a fund where there are illiquid assets, which will be sold at a discount because of the lack of ready buyers. Consequently, early redeemers get $1 per share whereas later redeemers may get less than $1 per share.
The latest reforms contain other significant changes such as enhancements to diversification requirements. Under Rule 2a-7 of the Investment Company Act of 1940, the general rule is that a money market fund must not have invested more than 5% of its total assets in securities of a single issuer. Under the new rules, money market funds are required to aggregate affiliates of issuers when calculating the 5% limit. Entities will be considered as “affiliates” if one is controlled by the other or both are under common control. Control means ownership of more than 50% of an entity’s voting stock. The diversification requirement reduces the risk that a single failed investment would cause the NAV to decrease and eventually break the buck.
The reforms also introduce stress testing. Money market funds will periodically be tested on its ability to maintain weekly liquid assets of at least 10% and minimize principal volatility. Ensuring that at least 10% of the assets of money market funds are in assets that could be converted into cash quickly provides some guarantee that money funds have enough liquid assets on hand to meet redemption demands and therefore do not have to sell illiquid assets at a discount which affects the NAV.
The new rules governing money market funds recognise the susceptibility of money market funds to heavy redemptions in times of stress and are designed to improve the ability of money market funds to deal with such redemptions so that they do not break the buck.
Zhaoguo Deng serves as the graduate editor of the NYU Journal of Law & Business. Zhaoguo is from Singapore and is an LLM student specializing in corporation law. Prior to enrolling at NYU, he completed his LLB at the University of Exeter, UK. His desire to deepen his understanding of the interconnections between law and business motivated him to pursue an LLM at NYU. Outside of the classroom, Zhaoguo enjoys running, travelling and exploring the quaint cafes in the Village.