New Money Market Fund Reform Seeks to Better Protect Investors

The Securities and Exchange Commission this week adopted new rules for money market funds aimed at further strengthening them against market-driven disruption. Public funds investors make significant use of MMFs as an investment vehicle, and many local government investment pools follow MMF rules, though they are not required to do so by Federal law. This note provides a summary of the implications The of the new rules for public funds investors. A new issue of our Spotlight next week will review how the rules may implicate LGIPs.

MMFs rank high when measured by public funds investors against their investment goals (safety, liquidity, yield). The challenge is that MMFs may not be able to achieve these goals during disruptive markets—just when they are most important. In fact, the market disruptions of 2008 and 2020 necessitated support from the Federal Reserve and Treasury to stabilize the industry. The 2008 disruption also led to two rounds of SEC reforms, in 2010 and 2014 and the 2020 events precipitated this round.

The MMF Promise. Investors in MMFs expect to deposit and withdraw funds at will. Fund managers seek to fulfill this promise, but they also take a few modest risks in order to produce income for the shareholders (and, of course, to pay the fund’s expenses). This results in modest mismatches between the maturity and liquidity of the short-term assets held by funds and the potential liquidity demands. All is well as long as shareholders don’t rush to redeem and as long as financial markets function normally.  But, as we learned in 2008, and again in 2020, when markets freeze some shareholder panic and MMFs have problems.

Besides presenting a challenge to investors, disruptions to the MMF industry can threaten financial stability. MMFs have about $6 trillion of assets and are a significant mechanism in providing short-term funding for the Treasury, Federal agencies, banks, and corporations.

The new rules. The SEC’s new rules (see a summary here)  address fund operations in four areas:

• Liquidity. To buttress the promise to redeem investor shares on demand the new rules require all MMFs to maintain at least 25% of their assets in daily liquid assets and 50% in weekly liquid assets. This is up from 10% and 30% in the current rules. This is a positive for investors, though it may come at the cost of a modest give-up in income.

• Redemptions. The new rules remove the ability of MMFs to impose temporary gates to suspend redemptions. This ability was implemented in prior reforms and tied to MMF liquidity, but it became clear during the 2020 market disruption that this actually was an incentive for some investors to rush to exit before fund redemptions might be suspended. The industry and regulators are nearly unanimous in supporting the elimination of these gates.

• Liquidity fees. The new rule requires institutional prime and institutional tax-exempt money market funds to impose mandatory fees on redeeming shareholders when a fund’s daily net redemptions exceed 5% of the fund’s assets. (Note that this only applies to prime and tax-exempt funds.) These funds already differ from government funds in that they do not offer to maintain a constant net asset value; their NAV floats. It is unlikely that public funds investors make significant use of prime funds, so liquidity fees should not be of major concern. That said, the liquidity fee requirement is new to the industry and the details about how it will be implemented are unknown. A number of MMF sponsors have warned that it will be burdensome and could lead to an end of prime institutional funds. These funds lost about $1.2 trillion in assets when the requirement to float their NAV was implemented in 2016, and at their current size ($660 billion) they represent about 11% of MMF assets.

• Provision for negative interest rates. The 2020 market events led the SEC and mutual fund companies to take seriously the possibility of negative short-term interest rates. The new rules provide that retail and government money market funds may handle the accounting for negative rates either by converting to a floating net asset value or by reducing the number of shares outstanding to maintain a stable net asset value.

• Reporting. The new rules require additional reporting to the SEC. This reporting will enhance transparency around fund investment strategies and holding.

The new rule is effective 60 days after publication in the Federal Register. MMFs will then have six months to transition to the new portfolio liquidity requirements and 12 months to comply with the mandatory liquidity fee provisions. Reporting requirements will be effective in June 2024.

The bottom line. What this means for public funds investors:

 Investors in government funds will benefit from the enhanced liquidity that these funds will be required to maintain. This may come at a cost since fund managers will have to maintain enhanced minimum liquidity, but since most assets normally held in government money market funds qualify as weekly liquid assets the cost is likely no more than one or two basis points.

Investors in institutional prime funds may have little reason to maintain these investments in the future. They will benefit from the required enhanced liquidity but the cost to the fund of maintaining enhanced minimum liquidity and fund manager positioning to minimize the liquidity fee, if it becomes necessary to impose one, is likely to reduce or eliminate the income advantage when compared with government money market funds. The average yield advantage of institutional prime MMFs since March 1, 2020, is only six basis points when compared with government MMFs (based on SEC data). The yield advantage vs. retail prime MMFs is greater—15 basis points--because it appears that MMF managers employed a more conservate strategy with regard to average maturity and portfolio sector allocation in funds designed for institutional investors.  The new rules will accentuate this difference and one would expect a further reduction in the yield difference between institutional government and prime portfolios. Given also that prime portfolios have a floating NAV, public funds investors would be well-served to avoid them.

Other important implications for public funds investors. The imposition of liquidity fees is likely to continue shrinking the size and importance of prime MMFs that began with the 2016 money market reforms requiring intuitional prime funds to float their NAVs. And the managers of these funds are likely to further limit purchases of commercial paper and other less liquid money market instruments. This could push yield spreads wider on these instruments, presenting an opportunity for public funds investors who employ them in separate portfolios and in LGIPs. But the shrinkage may also reduce market depth and liquidity so investment should be undertaken with additional caution, at least until market behavior is assessed.

Fitch Maintains Negative Rating Watch on the US Sovereign Debt.

Fitch Ratings issued an update this week to its rating outlook (U.S. Debt Limit Deal Leaves Key Fiscal Challenges Unaddressed) for US sovereign debt.  Fitch placed the rating on negative watch in May 2023 during the height of the debt ceiling brinkmanship. The update serves as a reminder that spending authority for the new Federal fiscal year beginning October 1 remains unresolved and could impact the timing and amount of Federal aid to state and local governments.

While the Federal debt limit was extended temporarily in May, the underlying agreement on spending levels for next year seems to have frayed. A default on debt has been avoided, but unless spending authorization is approved a shutdown of non-essential services could occur after September 30. This could affect the timely receipt of Federal aid to state and local governments and stress cash flow and investment balance forecasts.

We’ll (hopefully) know more in the next 30 days but something to keep an eye on.

Briefly noted:

Public officials are always keen on funding community/economic development and sometimes ask about investing operating/reserve funds to support these efforts. State and local laws and investment policies very much limit possibilities. Pension funds have broader investment authority. An opinion piece in Governing magazine this week by Girard Miller offers a plan for local public pension systems to fund economic development. It makes interesting reading.