he Securities and Exchange Commission on Wednesday voted unanimously to propose long-awaited reforms for money market funds (MMF). >
The first proposal would affect prime institutional money market funds, which are allowed to take on credit risk and account for about $826 billion in assets. They would be required to convert from a fixed, $1 par net asset value (NAV) to a floating net asset value (FNAV) share price.
Under the second proposal, MMFs may be required to impose liquidity fees and gates on redemptions during times of severe market stress. (Government MMFs, which invest primarily in government securities, would not be subject to these new regulations.)
The SEC is seeking public comment on whether one or both of these proposals should be adopted. In addition, the SEC outlined several other possible enhancements to MMFs, such as increased diversification and disclosure policies.
PIMCO views this vote as a pivot point for cash and liquidity management. Approximately 40 years ago, the emergence of regulated 2a-7 money market funds caused a shift in liquidity management; monies intended for short-term savings migrated away from traditional bank-managed accounts into MMFs, which offered a stable NAV and attractive yields.
Now, we expect a shift away from the 2a-7 dominated $1 par NAV regime. In our view, actively managed short-term fixed income strategies will become increasingly important for liquidity management.
Prime MMF investors will have time to prepare during the 90-day public comment period, which will be followed by a review period and then a final announcement and implementation. These changes won’t be finalized for several months – if not more – and could take years to be implemented.
Nevertheless, a potential change has just begun. We are not saying that the demise of prime 2a-7 funds is imminent or even likely. Rather, we are simply highlighting that other compelling complements for liquidity management are available for investors to consider in response to these regulatory changes.
Here are some key questions and answers:
Why are new regulatory proposals for 2a-7 funds under consideration?
In 2010, new rules were imposed on money market funds in response to the Reserve Primary Fund having broken the buck in 2008. However, many regulators felt that further reform was necessary to offset the risk that MMFs might still be susceptible to runs on assets, particularly prime institutional MMFs.
How might these changes impact MMF and cash management investors?
Returns in money market funds continue to remain close to 0%, net of fees, without much potential for an increase in the foreseeable future given the expected continuation of the Fed’s accommodative policies. Under the current fixed NAV regime, prime MMFs represent an asset with no volatility and almost no yield (three basis points on average).
Under the SEC’s first proposed rule, prime funds will face a structural shift to a floating NAV. Thus, the daily NAV of these funds will likely exhibit some volatility, yet we do not expect any substantial increase in yield in the near-to-medium term. In short, with the altered risk-reward tradeoff, investors will need to consider whether using prime MMFs for cash management will remain as attractive as before if the first proposal is adopted.
If the SEC’s second proposal is adopted, investors across both institutional and retail prime MMFs could potentially face fees and gates on their redemptions during times of severe market stress, or when a fund’s weekly liquid assets drop below 15% of its total assets. A retail fund would be defined as a fund that limits redemptions to $1 million per shareholder per day.
Although we recognize that the SEC intends these proposed reforms to reduce systemic risk and the risk of runs, we believe that investors need to consider other options for liquidity-oriented portfolios. In fact, while perhaps seemingly novel, many prime MMF alternatives – which seek capital preservation and liquidity while balancing risk and reward – have been used routinely and successfully by several money managers for decades.
What are alternative cash management options for MMF investors?
Investors in the $2.6 trillion MMF universe may face a critical decision in the coming months.
It will likely be most pressing for investors in prime institutional MMFs, which would be affected by both proposed rules. We see five main investment options for prime MMF investors should the SEC’s recommendations be adopted:
- Remain in existing 2a-7 prime MMFs, and tolerate any volatility associated with the FNAV structure.
- Shift to U.S. Treasury or other government-focused MMFs which remain fixed at $1 par NAV but typically offer lower yields than prime funds.
- Move funds to bank deposits (insured and uninsured account options).
- Self-invest in U.S. Treasury bills.
- Invest in short-term fixed income offerings focusing on capital preservation with, as we see it, more compelling risk and reward profiles than traditional money market funds.
Perhaps the most obvious choice, simply switching from prime funds to government-only MMFs, may not ultimately be the best solution. We estimate that investors could seek that switch with more than $500 billion in assets. However, the supply of AAA-rated investable assets for these funds to invest their proceeds is shrinking as the U.S. government deficit declines and other issuers opt for longer-term financing in the low interest rate environment. Demand, meanwhile, is rising, in part due to central clearing collateral requirements for derivatives. Both retail and institutional investors could be left out in the cold if the supply-demand dynamic leads sponsors of government-focused MMFs to spurn additional inflows due to more limited investment options.
Given the uncertain outcome of these proposals, most investors will likely wait and react once the SEC’s actions are fully implemented. However, we would urge all investors to recognize this possible change in traditional cash management vehicles and educate themselves on alternative liquidity-management options that offer return opportunities in excess of the near-zero returns that are available within this changing landscape.
Money market reform is upon us and the cash management landscape is changing. Soon we will see how MMF investors react to the next steps in the evolution of cash management.