US Money Market Fund Reform - The Potential Consequences of Change

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27 February 2012
Scott Sullivan
The SEC has already drastically reduced Money Market Fund risk with its changes to Rule 2a-7 in 2010. The changes dramatically increased the liquidity of funds and took away most of the risks that funds faced in 2008. However, the SEC could be going too far by considering a floating NAV. A floating NAV will negate the entire incentive that investors have to buy and sell these funds and ultimately eliminate the $2.7 trillion industry. Looking at the financial crises that have occurred since the 20th century began, a trend has emerged. Although each crisis has its own distinct attributes and causes, liquidity is a common theme. The ability to buy or sell financial assets quickly and in a manner that will not move prices dramatically is imperative for a stable system. For Money Market Funds that were required to hold a NAV of $1.00, regardless of conditions, the withdrawal demands by investors became too much of a strain. The funds needed to raise cash and the only way to do so was to sell assets into a market with few buyers. With rates at historic lows and most fees being waived by fund sponsors, the viability to operate under such a scheme is already challenging. The repercussions for the $2.7 trillion industry, which are unknown, are particularly worrisome at a time when both the domestic and world economies are at their most fragile state. The Money Market Fund industry has provided up to 36% of US short term business assets. The overwhelming majority of commentary submitted to the SEC has been opposed to the floating of a fund’s NAV or capital cushion requirements. Should investors choose to quickly remove a vast proportion of short term funding to US businesses, liquidity will be reduced significant in a very short period of time. As businesses search for alternative sources to fill the void left by the money market industry a downward liquidity spiral could begin. Although Bear Stearns and Lehman Brothers had issues outside of their commercial paper funding, it was ultimately the inability to roll over their short term debt, including commercial paper that made opening for business the following day impossible. Healthy and vibrant markets are largely driven by positive economic activity; however positive economic activity tends to occur only when there is certainty in economic commerce. The sheer number of proposed regulatory changes, combined with poorly defined time lines and the possibility of still more changes in the near future, could stifle economic progress and counteract earlier positive reforms. "The current financial crisis will undoubtedly spur further regulation. Successful regulation should be aimed not at preventing all failures, but rather at establishing a clear and credible process such that if a failure were to occur, it would take place in an orderly fashion and not cause industry-wide panic.” - James Bullard President and CEO Federal Reserve Bank of St. Louis, The Regional Economist - As In the Past, Reform Will Follow Crisis, July 2009 Video: Money Market Reform Overview - US Mutual Fund Reform Overview - Reuters TV

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