The Securities and Exchange Commission on July 12 adopted new rules to strengthen the resiliency of money market funds. The rules make significant changes to the way these funds operate. Local government investment pools are not subject to these rules, but their boards and sponsors should use this opportunity to review the principles behind the rules and consider how the funds they oversee address the issues that led to the SEC action.

In this issue of the Spotlight, we’ll review the reasons behind the SEC’s rules, what will change for money market funds, and whether these or similar changes might be appropriate for certain LGIPs.

Why LGIPs Should Respond to the SEC Money Fund Reform Rules

1. Many LGIPs are designed to offer benefits that parallel those of money funds, and they are subject to similar risks.  
   • These LGIPs offer a stable net asset value as do money market funds.
   •  They are subject to some of the same market and investor dynamics that have caused money fund problems twice in the past 15 or so years.
   •  Because LGIPs in total size are less than 20% of the size of MMF assets, LGIP problems are not likely to create large systemic risks, but they would most certainly impact investors in a troubled LGIIP and could lead regulators to seek to intervene in the industry.
2. The SEC’s rules address four key elements of fund resiliency that are also characteristic of   LGIPs.
   • Fund liquidity.  Funds that offer daily liquidity should be prepared to fund that liquidity even under stressed market circumstances.
   • Market risk.  Funds that invest in credit instruments or investments with maturities of more than one day are subject to market risk.  The risk can be amplified in volatile markets and could lead to “breaking the buck” if securities cannot be sold at close to their carrying value to meet redemption demands.
   • First mover advantage.  Investors who redeem shares early in an uncertain market may drain fund liquidity and/or be paid from the sale of higher-quality fund holdings, thus leaving remaining investors at a disadvantage.
   • Reporting and transparency. Investors may be disadvantaged when comparing LGIPs if they are not provided with timely information on portfolio characteristics and fund holdings.  While fund sponsors could perceive a disadvantage in publishing this information, LGIP boards should weigh their overall responsibility as fiduciaries and as representatives of the broader public funds investment community in setting policies around reporting and transparency.

While the particulars of the SECs rules may not be applicable to the circumstances of an individual LGIP, the principles that are addressed by the rules and lessons learned from recent investor and market behavior are strong reasons for fund boards and sponsors to evaluate the way they manage to the regulatory principles behind the SEC money fund reform.

Lessons Learned from Market Stresses

Important lessons can be learned from the financial market disruptions of 2008 and 2020 and reinforced by the bank crisis around the failure of Silicon Valley Bank. These are:

• Liquidity that might seem ample under normal business conditions can suddenly become insufficient.
• investor behavior in a world of online social media and instant market information may be less certain than in the past.
• Events beyond the control of a single fund, or even an entire industry, can be contagious and cause systemic problems. Loss of confidence can quickly create turmoil. (Think “I have no issues with my fund, but just to be sure, I’ll take my money out until things settle down.”)
• First movers can disrupt normal markets and activities even when they represent a small minority of an investment class.

The SEC’s money fund reform effort originated after industry problems in 2008 required Federal government support to avoid investor losses and minimize market disruption. The Commission adopted rules in 2010 and 2014 crafted around extensive research, comments and feedback from the money market fund industry, including the world’s largest money managers and academic and other market observers.  The new rules build on these efforts.

Many LGIPs have historically looked to the SEC rules for guidance. This is not to say LGIPs should automatically adopt them; rather it is to observe that to pass on the new rules without detailed consideration would be to turn away from widely vetted responses to the principles underlying the operation of stable value funds. Circumstances specific to the operation of an LGIP should inform a decision on whether and how to modify its operating rules.

The SEC’s money fund reform effort originated after industry problems in 2008 required Federal government support to avoid investor losses and minimize market disruption. The Commission adopted rules in 2010 and 2014 crafted around extensive research, comments and feedback from the money market fund industry, including the world’s largest money managers and academic and other market observers.  The new rules build on these efforts.

Many LGIPs have historically looked to the SEC rules for guidance. This is not to say LGIPs should automatically adopt them; rather it is to observe that to pass on the new rules without detailed consideration would be to turn away from widely vetted responses to the underlying principles related to the operation of stable value funds.

Circumstances specific to the operation of an LGIP should inform a decision on whether and how to modify its operating rules.

The Challenge of Offering a Stable Net Asset Value              

Many LGIPs offer stable net asset value funds, just as do money market funds. These funds are designed to:

•  Preserve principal;
• Offer daily liquidity; and
• Provide a yield that is competitive with that of bank deposits and other high quality money market instruments.

“Invest $1 million today, leave it in for as long as you’d like, then on a moment’s notice get some or all of it back immediately with no loss,” is what investors in these funds expect.

That would be straightforward if a money fund or an LGIP kept all its assets in investments that it could draw on or redeem on demand regardless of market events.

But that is not what money funds or LGIPs do.  They seek to earn a bit more income than that available in an immediately available investment by buying somewhat longer-maturity securities (30 to 60 days on average) and in securities that might involve a small amount of risk (short term corporate obligations). 

That is fine as long as shareholders do not suddenly seek to draw down their accounts. It’s also fine if shareholders suddenly want their money back and either (a) other investors add to their accounts to offset the redemptions, or (b) the fund’s manager is able to meet the redemption demand by selling investments for cash at a value that is about the same as their carrying value.

This promise to return one dollar to investors for each dollar invested relies in part on trust, faith and “business as usual.”

 Business as Usual can be Disrupted Suddenly by Seemingly Modest Financial Market Moves

 If investors as a group decide to redeem their accounts and market participants (brokers, dealers, and other money market funds) cease bidding on securities, the market freezes, the fund may not be able to honor redemption requests and panic may result.

This happened twice in the last 15 or so years, in 2008 and 2020, the first around the failure of Lehman Brothers and the second around the COVID-19 lockdowns. In both cases shareholders in prime money market funds—those that invest in commercial paper and other credit-based instruments—sought greater safety by redeeming shares.  Those first to act were institutional investors.  Institutional investors (including government entities) are generally more quickly aware of market dynamics, account sizes are larger than those of retail investors, and they have well-defined risk management objectives.  That is why they are more likely “first movers.”

The money markets, though quite sizeable, are also fragile.   Commercial paper and negotiable CDs  held by money funds,  LGIPs and individual investors total about $2 trillion.  In the normal course almost all of these are purchased at issuance and held to maturity. Brokers and dealers do not support robust secondary markets and are reluctant to buy these investments from sellers.  The result is that the market is quite thin and efforts to sell even small amounts from a  portfolio could fail because there will not be any bidders.

In 2020 it did not take a big move for these first movers to disrupt the market. A study by the staff of the SEC concluded that institutional prime fund investors drew down roughly $125 billion over three weeks in March 2020. That is about $40 billion a week.  The following graph puts the drawdown in the context of overall market size.

Redemptions of $125 billion represented about 30% of the assets of publicly offered institutional prime funds.  They totaled perhaps 5% of the overall outstanding amount of commercial paper and negotiable CDs.

For additional perspective, consider that prime money market funds held about $1.1 trillion in investments so in a typical day they would “roll over” (reinvest) an amount--$40-$50 billion—about equal to the weekly redemptions. When liquidity in these markets quickly dried up it was virtually impossible to liquidate holdings to meet redemptions or replenish liquidity buckets that were being drawn down.

The SEC’s Rules, Put in Place After 2008, Did Not Prevent the 2020 Problems

 In 2020 the SEC’s mandated minimum liquidity rules were in place and in fact fund managers had provisioned liquidity far in excess of the minimums.  When the COVID lockdowns began, weekly liquid assets for prime funds totaled 40% to 45% of assets—notably higher than the 30% minimum required by the SEC rules.   

As the following chart shows, fund managers quickly expanded their liquidity positions in February and March 2020 to provide an added liquidity buffer.

These actions and the improved liquidity ratios were disclosed daily for each money market fund on its website. But institutional investors rushed to the exit nevertheless, seemingly worried that fund redemptions in excess of liquid amounts could trigger the imposition of fees and gates or reduce the value of their shares.

The effort by fund managers to add to liquidity by selling investments triggered a market freeze which affected all market participants, including institutional prime funds, LGIPs that invest in prime-type investments (commercial paper and bank instruments) and investors who held these securities in separately managed accounts.  For a period in late February/March the markets in which money market funds and LGIPs participate froze and it was virtually impossible to sell any investments.

Assets of institutional prime money market funds declined in the first weeks of the COVID-19 lockdowns—when the SEC’s fees and gates rules were in place and some have speculated that the 2020 rush was an effort to avoid the imposition of fees and gates. 

But as the accompanying chart illustrates, they showed a similar pattern of decline in the weeks around the Lehman bankruptcy in 2008 when there was no fees and gates rule.

The 2023 bank liquidity crisis led to a similar market freeze.

 The failure of Silicon Valley Bank in March of this year resulted from the sudden move to withdraw $42 billion in deposits.  This was equivalent to about 20% of the bank’s assets, a level that understandably created a problem at the bank.  But, as with the money fund asset flows in 2020  it represented a tiny fraction of the $17+ trillion of US bank assets.  As the following chart illustrates, even the follow-on effects that drew down total US bank deposits by $400 billion represented only about 2% of the national total.

Lessons learned:  

• Market disruptions which might be caused by a variety of (unknowable forces) lead to first movers acting and the first mover advantage can disadvantage remaining fun investors.

• It doesn’t take big moves to create waves in the financial markets and waves can sweep up innocent bystanders quickly. 
• Does the difference between LGIP and money fund investor behavior mean LGIPs need not be concerned about a “Run on the fund”?  We think not.

A Principles-Based Framework for Managing LGIP Liquidity and Market Risk

The SEC rules, although they do not apply to LGIPS, can be thought of as a kind of safe harbor or recommended way to minimize risk in a stable net asset value fund.  If so, LGIPs should start with the behind the SEC rules, consider the facts related to money market funds that led the SEC to its specific recommendations, and consider differences in the operations of a specific LGIP that would/could support addressing the principles differently. This effort should involve LGIP boards or contracting authorities (who have fiduciary responsibility for a fund) and managers (who have the expertise to recommend policies and responsibility to carry out board policies.)

 Here is a framework for such an evaluation:

LGIPs should review fund liquidity rules in light of recent events.

Fund liquidity is essential if an LGIP is to offer dollar in/dollar out.  There are basically two ways to manage liquidity: limit redemptions or limit the quality and maturity of portfolio holdings so that if investors suddenly demand all of their money from the fund the gap between maturities and demands is manageable.

Many stable value LGIPs adopted the SEC’s 10%/30% daily/weekly liquidity minimums to address this.   Some LGIPs have procedures (such as maximum account size, or requirements for notice and manager approval for large withdrawals) to permit the sponsor/manager to deal with unscheduled liquidity.

The SEC’s new rules seek to further limit the mismatch between the shareholder expectation that money be available immediately and the reality of fund maturities that may be as long as one year. They do this by requiring that 25% of the fund’s assets be in daily liquidity and 50% in weekly liquidity, up from 10% and 30% in the existing rule. (Note that the liquidity rules combine security maturity and security quality so that direct obligations of the US government are counted within the daily/weekly maturity buckets regardless of their actual maturities.)

• Important Considerations:
  • What is the investor concentration in the fund?  Concentration does not seem to have been a factor in the runs on institutional prime funds. But LGIPs  where one or a small number of investors control 10% or more of shares may have different (heightened) first mover-related liquidity risks.  (But note that where a sponsor such as a state or county has a major share of the LGIP concentration may actually act as a buffer.)
  • What is the historic redemption experience of the LGIP in adverse markets? What could cause a sudden acceleration of redemptions beyond historic experience?  If that were to occur, what would the fund/fund manager/sponsor do?
  • At what point would shareholder redemptions require selling less liquid securities (i.e., non-government securities) to meet liquidity demands?  An LGIP that holds only government obligations would have a much different liquidity (and market risk) profile than one which holds a majority of investments in commercial paper or other corporate obligations.
  • Is there a single party sponsor, such as a state, with assets invested in the fund that could provide a base of stable assets?   This would buffer the effect of redemption demands by other investors.   If so, is there an understanding, whether formal or informal, around this base of support?
  • What is the historic response of the LGIP’s investors to market stresses? Are they highly loyal or not? (But note that depositors in Silicon Valley Bank were all very loyal until suddenly they were not.) What types of events could cause them to suddenly redeem funds?   
  • If the LGIP’s liquidity buckets include marketable securities (such as Treasury bills) with maturities beyond the liquidity bucket threshold, how certain is it that there will be a market for the securities under stressed market conditions?
  • Does the LGIP have access to alternate sources of liquidity such as a credit line from the sponsor/manager or a third party?  If so, this could justify a lower direct liquidity minimum for the fund.

LGIPs should review market risk-limiting rules with particular attention to how the portfolio would perform in a stressed market if faced with large redemptions.

The events of 2020 demonstrated how fund liquidity and market risk are related. In particular, the promise to offer immediate, unlimited liquidity could require the sale of securities prior to maturity.  If the fund’s liquidity is drawn down to pay for redemptions, the shareholders who remain after redemptions will own shares in a less liquid fund, so they are less well-protected.

 In a normal market the fund’s manager may try to restore the fund’s liquidity and portfolio allocations by selling some securities and putting the proceeds into cash.   If the market freezes, then the redemption promise may be met only at an unexpected cost to the fund.  In all events unless redemptions are paid by liquidating a proportionate amount of each security holding (a “portfolio slice”), the liquidity of the portfolio (e.g., liquid investments as a percentage of overall portfolio value) would likely be lowered and the market risk increased by the redemption.

To limit market risk the SEC’s rules have limited the maturity of investments to 397 days and require that the board (or its designee) determine that the security presents minimal credit risk. The rules also have two limits on maturity:  a WAM of no more than 60 days and WAL of 120 days. The rules also require diversification of fund investments.  The rules also prohibit institutional prime funds (but not funds whose investments are limited to government securities) from offering a stable net asset value.  Requiring a floating NAV for these funds was thought to better-reflect the potential volatility of markets and behavior of institutional investors. 

Institutional prime funds typically have modestly higher market risk than government funds or retail prime funds. Managers of these funds thus are likely to maintain shorter WAMs and liquidity in excess of the SEC’s minimums.

A study by the staff of the SEC (see below graph) concluded that when the SEC reforms were implemented in 2016  to establish liquidity buckets and require institutional prime funds to float their share prices, managers of these funds increased holdings of securities that have lower market risk and greater liquidity.

In particular government securities increased from about 10% of holdings (in 2016) to 45% in February 2021, the end date of the study. 

The shift to liquid securities has persisted. As of June 2023, money fund reports filed with the SEC showed 48% of assets of prime money market funds were invested in government obligations.

LGIPs should consider how to manage the first mover advantage problem.

The SEC found that when an institutional prime fund experiences significant liquidity demands remaining shareholders could be left at a disadvantage because they would bear the cost of liquidity. The SEC attempted to deal with this in the prior rules by imposing a default fee when current weekly assets declined below 10%.  In the COVID-19 crisis this appears to have encouraged the investor rush to redeem as a fund’s weekly liquidity declined.  

 The new rules eliminate the link between liquidity and redemption fees and gates. Rather than a fee tied to the fund’s liquidity, the new rules require a fee on any day when net redemptions exceed 5% of assets.   It sems like a blunt approach that says:

“If too many of you head for the exit at once there could be a cost on remaining shareholders.  It’s too complex to identify exactly when redemptions create stress so on any day when 5% or more of shares are redeemed we’re going to charge everybody to pass through the door.”

The Fund’s advisor will be required to calculate the fee as if the redemptions were paid by selling a pro rata share of every security in the portfolio (a portfolio slice).  This approach eliminates any first mover advantage, but it may or may not prove to slow redemptions in a stressed environment. Time will tell.

Considerations related to first movers in LGIPs:

• Any LGIP that has a concentrated investor base is more likely to be harmed by first movers.  What constitutes a concentrated investor base?  The rules do not provide guidance though they do require enhanced reporting to the SEC on any holders of 5% or more of the shares of as fund. One might use this 5% level as one indication of concentration; there could be other concentration elements including the cumulative holdings of a small number of shareholders (cumulative holdings of top 10 shareholders, for example).

• The first mover advantage is likely to be more consequential in a fund with lower liquidity minimums and higher concentrations of less liquid investments (primarily corporate obligations).  

• Some LGIPs have formal limits on redemptions such as requiring the approval of the sponsor/manager for redemptions in excess of a pre-determined schedule.  This can reduce the effect of first movers.

LGIPs should consider whether their reporting and disclosure provides adequate information for investors and potential investors.

 Reporting to shareholders, potential shareholders, and the public by LGIPs varies greatly.  A few LGIPs conform completely or largely to the SEC’s requirements for money funds but most LGIPs report less information, and with less frequency/currency, than the SEC requires of money funds.

There are two perspectives on the rationale for reporting/transparency.  The SEC believes that transparency through robust reporting reduces systemic risk by informing investors directly about their investments and acts as a governor on fund portfolio management. (“If you don’t like what you see, don’t invest.”) A counter view is that portfolio details are competitive information or that publicizing holdings might precipitate  investor withdrawals if they became concerned about a specific holding or fund’s liquidity. 

The money fund reforms expanded somewhat the SEC’s required public reporting which had required a wide range of fund information on a near-current basis.  The below chart summarizes the reporting framework required for money funds.

As fiduciaries, LGIP boards should consider the level of disclosure that is appropriate to protect investors.  There is likely no one-size-fits-all approach, and without a single national standard or mandate there are considerations about competitive standing, but  it is likely that investors, if polled, would opt for robust disclosure of where/how their funds are  being invested.  Public disclosure in and of itself could act as a regulator of fund management activities that are risky, and disclosures would also provide LGIP boards with information that could help them evaluate the relative effectiveness of their programs by providing benchmark information on other LGIPs.

LGIPs should consider how they would deal with negative interest rates.

An amendment to the money fund rules adopted by the SEC as part of the reforms provides guidance on how funds may deal with negative interest rates. This may seem untimely, with short-term interest rates at the highest they have been in 22 years, but market volatility in the past two decades and two periods of short-term interest rates barely above zero suggest contingency planning is appropriate.  

Accommodating negative interest rates requires agreement on how to account for the fact that a dollar invested today could earn less than zero, resulting in a loss of value between the time of deposit and time of redemption.  It also requires that the fund’s manager have systems in place to account for and keep track of the result.  

The new rules permit retail and government funds to convert to a floating net asset value or account for negative income by reducing the number of shares in an investor’s account in order to maintain a stable NAV. 

Considerations: 

• State laws or investment policies may limit the options for some/all LGIP investors, for example by prohibiting investment in securities that have zero or negative interest accruals, but if short term interest rates were to become negative in a short period a fund could face a crisis with little time to respond. 

• As a matter of prudence boards should ascertain whether sponsor/manager accounting and transfer agency systems are fully capable of handling negative rates.

A note on sources:

1. Unless otherwise noted statistics on money fund assets are as reported by the SEC https://www.sec.gov/files/mmf-statistics-2023-05.pdf and Cranedata https://cranedata.com/ for May and June 2023
2. The SEC money fund rules adopted in July 2023 are here.
3. The SEC staff published a study in 2021 of the behavior of money funds at the onset of COVID-19 here.
4. The SEC staff published a study of Prime Money Fund Asset Composition and Asset Sales in June, 2022 here.
5. The Federal Reserve published a study in 2022 of the prime money market fund investor base during the COVID-19 lockdown here.
6. Investment Company Institute Report of the COVID-19 Market Impact Working Group  2020 here.
7. Fitch Ratings Local Government Investment Pools:1Q23  here.