On December 15, 2021, the Securities and Exchange Commission (SEC) voted (three-two) to propose amendments to rules regulating money market funds under the Investment Company Act of 1940, which are designed to increase the transparency and resiliency of money market funds. The SEC proposed to:
- Increase the minimum amount of daily liquid and weekly liquid assets required to be held by money market funds so that there is additional liquidity to meet redemptions.
- Remove the ability of money market funds to use liquidity fees and redemption gates.
- Require institutional prime and institutional tax-exempt money market funds to implement policies and procedures for swing pricing when there are net redemptions so redeeming shareholders will bear the liquidity costs of redeeming their shares.
- Address how money market funds with stable net values operate in a negative interest rate environment.
- Amend certain reporting requirements to improve information transparency and the SEC’s monitoring of money market funds.
Prime, municipal and government money market funds are differently regulated under the Investment Company Act. All money market funds regulated under Rule 2a-7 are managed to provide principal stability and allow access to liquidity by investing in high-quality, short term debt securities. Prime money market funds invest in taxable short-term obligations issued by corporations and banks, repurchase agreements and asset-backed commercial paper. Municipal (or tax-exempt) money market funds invest primarily in obligations of state and local governments; and government money market invest almost exclusively in government securities and repurchase agreements collateralized by government securities. Institutional prime and municipal money market funds transact at floating net asset values and government and retail money market funds transact at stable net asset values.
Beginning in March 2020, institutional prime and municipal money market funds experienced large outflows and government money market funds had record inflows due to investors reallocating their assets into cash or short-term government securities to preserve liquidity. In response to the stress put on money market funds to liquidate large positions to accommodate redemptions, the Federal Reserve in March 2020 established the Money Market Mutual Fund Liquidity Facility, which provided loans to financial institutions to support their purchases of securities being sold by money market funds to fund redemptions. In December 2020, the President’s Working Group on Financial Markets (PWG) issued a report on potential money market fund reforms after its review of the March 2020 events, and in April 2021, the SEC requested comment on the various reform options described in the PWG report. The comments received informed the SEC’s rulemaking and some of these options discussed in the PWG report are being currently proposed by the SEC.
Proposed Amendments to Money Market Fund Regulations
Increase Liquidity Requirements for Money Market Funds
The SEC has proposed to increase the daily and weekly liquidity requirements for money market funds to better enable money market funds to manage heavy redemptions like those experienced in March 2020. Currently, under Rule 2a-7, daily liquid assets and weekly liquid assets are cash or securities that can be readily converted to cash within one business day or five business days, respectively. Money market funds (other than municipal money market funds) must hold at least 10% of its total assets in daily liquid assets, and all money market funds must hold at least 30% of their total assets in weekly liquid assets. The proposed amendment would increase these daily and weekly requirements to 25% and 50%, respectfully. A fund would be required to notify its board of directors and the SEC if daily or weekly liquid assets fell below 50% of the proposed new minimums.
Remove the Use of Liquidity Fees and Redemption Gates
Also, the SEC proposed to remove the ability of money market funds to impose liquidity fees or institute a redemption gate. Currently, money market funds may choose to impose liquidity fees or redemption gates when a fund’s weekly liquid assets drops below 30% of its total assets if the board of directors of the fund believes it is the best of interests of the fund. Additionally, a non-governmental fund is required to impose a liquidity fee of 1% if its weekly liquid assets fall below 10% of its total assets unless the fund’s board of directors determines that it would not be in the best interest of the fund to impose such a fee. The SEC noted in the proposing release that it believes removing these provisions will disincentivize first movers from rushing to redeem shares when market conditions become disrupted, as with the March 2020 events. To date, no fund has implemented fees or gates. However, the SEC acknowledged in its proposing release that the possibility of fees and gates contributed to investors redeeming from money market funds and the funds maintaining higher levels of weekly liquid assets rather than using those assets to meet redemptions. The SEC noted that a money market fund’s board of directors had the option of implementing redemption fees (up to 2% of the value of shares redeemed) pursuant to Rule 22c-2 under the Investment Company Act even if the provisions under Rule 2a-7 were removed.
Require Institutional Prime and Institutional Tax-Exempt Money Market Funds to Implement Swing Pricing During Periods of Net Redemptions
The SEC’s proposed amendments require that institutional prime and institutional tax-exempt money market funds adopt policies and procedures to implement swing pricing during periods of net redemptions. The SEC believes that by implementing swing pricing under certain circumstances, money market funds will be able to protect remaining investors’ interests and remove the incentive to be a first mover. Currently, investors who remain in these funds bear the costs associated with the exiting investors’ redemptions, further incentivizing investors to exit the fund to avoid the value of their shares from being reduced.
During periods of net redemptions, an institutional prime or institutional tax exempt money market fund would be required to adjust its net asset value per share for redemptions by applying a swing factor that reflects the spread and transaction costs associated with the redemption (i.e., the costs of selling a pro rata amount or each security in the fund’s portfolio). Also, in cases when the net redemptions exceed 4% of a fund’s net assets, the fund would be required to include in the swing factor a good faith estimate of the market impact of selling a pro rata portion of the fund’s portfolio. A fund could estimate transaction costs and market impact for each type of security with the same or substantially similar characteristics, rather than determine separately for each security in its portfolio.
Under the SEC’s proposal, the money market fund’s board of directors would be required to approve the fund’s swing pricing policies and procedures and appoint a swing pricing administrator to administer the policies and procedures. The administrator could be the investment adviser or another provider, but administration personnel would be required to be reasonably segregated from portfolio management and not include any portfolio managers. In addition, the board of directors would be required to review at least annually a report on the effectiveness and adequacy of the swing pricing policies and procedures. Unlike certain provisions of Rule 2a-7, the board of directors would not be able to delegate their responsibilities for swing pricing.
In its proposing release, the SEC acknowledged that most commenters had previously opposed a swing pricing requirement. It recognized that funds and intermediaries would be required to create new systems and swing pricing introduced new operational complexities. Finally, it could impact financial reporting for funds and potentially increase the burden for investors if there were tax implications.
Stable NAV Money Market Funds in Negative Interest Rate Environment
Currently, under Rule 2a-7 government and retail money market funds that transact at a stable net asset value are required to be able to transact at a floating net asset value. The proposed amendment extends the requirement to intermediaries. The SEC’s proposal requires a government or retail money market fund to determine whether an intermediary purchasing its shares has the capacity to redeem and sell at a price other than a stable net asset value or if it cannot, the fund must prohibit the intermediary from purchasing the fund’s shares in nominee name.
Also, the SEC’s proposal would prohibit money market funds from operating a reverse distribution mechanism, routine stock split or other method that would periodically reduce the number of outstanding shares of a money market fund to maintain a stable net asset value. The SEC requested comment on other possible ways a government or retail fund could operate other than transacting at floating net value values if interest rates became negative.
Amend Certain Reporting Requirements to Improve Information Transparency
Lastly, the SEC proposed to require further disclosures on Form N-MFP and N-CR. Of note, a money market fund would be required to report a liquidity event on Form N-CR if its daily or weekly liquid assets (discussed above) fell below 50% of the required minimum. Also, among other things, shareholder concentration information (similar to the 5% shareholder information reported in the fund’s statement of additional information) would be required to be reported more frequently on Form N-MFP. The SEC believes that these amendments will improve the transparency and information for investors in money market funds, as well as assist the SEC staff in monitoring these funds.
Comment Period and Commissioner Comments
The SEC has requested comments on the rule amendments and the comment period will remain open for 60 days after publication in the Federal Register.
SEC commissioners voted three-to-two in favor of the proposed amendments at the open meeting with Commissioners Hester Peirce and Elad Roisman opposing. Commissioner Peirce raised concerns about the heightened regulatory restrictions reducing creativity in the managing of these funds. Commissioner Roisman also commented that the uniformity of these restrictions could constrain fund performance and rejected the “one size fits all” approach of the SEC.
Practice Points and Thoughts
The proposed amendments will have the most significant impact on the operations of institutional prime and tax-exempt money market funds, particularly if required to implement swing pricing. Although mutual funds, other than money market funds, currently may institute swing pricing, no funds have done so. We recommend money market funds and their advisers, as well as investors in money market funds, review the potential impact of the proposed amendments on their operations, such as with intermediary and sweep relationships, daily net value calculation and cut-off times, as well as cash portals, and consider whether to comment on the proposed rulemaking.