Money Market Fund Managers: SEC Ships New Operational Challenges

After years of uncertainty about how regulatory reform would play out, money market fund managers may be relieved to know finally how they will be regulated by new rules adopted by the US Securities and Exchange Commission.

But the news won’t be particularly comforting to the operations, compliance and technology staff of the funds, which represent a third of the mutual fund sector and are run by some of the largest investments firms like Charles Schwab, Fidelity, Vanguard, Pimco and Federated Investors. There will be lots of extra work to make necessary changes to middle and back-office operations. In fact the changes will be so fundamental and costly that, in a rare show of dissent, two of the five SEC commissioners voted against the new regulatory plan. The opposition did not reflect party lines: Kara Stein is a Democrat and Michael Piwowar a Republican.

The saving grace: the SEC gave a some money market funds — those investing in US government debt and most investing in tax-exempt municipal bonds along with those that solely serve retail investors — a pass on the new rules. Recognizing the potential hardship, the SEC even allowed so-called institutional prime money market funds two years to comply. “The timetable reflects the massive operational and technological adaptations to systems necessary to implement the new requirements,” acknowledges Stephen Cohen, an attorney with the law firm of Dechert in Washington DC.

NAVs Afloat

Among the panoply of changes the SEC wants in to see in the operation of money market fund, three will be particularly challenging to implement, agree legal and operations experts. The are the floating net asset value for money management funds that generally fall under the category of institutional prime funds, the additional disclosure on underlying assets on the fund’s website, and the new power given to a fund’s board of directors to impose liquidity fees and redemption gates to control potential runs of redemptions by investors trying to get their money out. That’s a big change from the historic practice of daily pricing at US$1 a share and allowing for daily redemptions.

The new rules build on preliminary reforms adopted by the SEC in March 2010. This was less than two years after the Reserve Primary Fund, a USS$60 billion prime money market fund “broke the buck” — aka could no longer honor its NAV of $1 a share — because it held bonds issued by Lehman Brothers. The investors ultimately ended up with 97 cents a share and ever since 2010, the SEC has tried to figure out a way to more clearly highlight the potential — albeit small — risk of money market funds and prevent a potential run to government funds as occurred after the collapse of Lehman.

Several more severe alternatives were floated — including an industry-backed liquidity facility and capital buffers — and the new rules represent a compromise in bifurcating money market funds into institutional and retail funds while carving out some exemptions. Still, in opposing their adoption, SEC Commissioner Stein suggested they could easily increase systemic risk. The reason: by preventing a run on one fund, the SEC would be encouraging runs on other funds by panic-stricken investors.

Since their inception, money market funds and the word safe have gone hand in hand. They were always priced at US$1 a share, regardless of whether or not the underlying market values of each of the fund’s net asset values generated that exact figure. The US$1 a share NAV reflects a perfectly legitimate accounting methodology, called amortized cost, which along with the penny rounding method allows fund managers to round out the net asset value of a money market fund to the nearest penny so that it will almost always come out to US$1 a share.

While it would logically seem that money market funds should easily accommodate a floating NAV, that’s not necessarily so. Their operating systems — as well as those of their administrators and accounting agents — are designed for a standard US$1 NAV. “Relying on a variable figure will require them to recode their accounting systems or ask their fund administrators or subaccounting agents to tweak theirs,” says Cohen. What’s more, even if they are lucky enough to have systems which calculate daily NAVs for typical mutual funds, those are based on rounding to the third decimal place.

Rounding Tighter

The US regulatory agency wants four decimal places instead. “The SEC is holding money market funds to an even higher rounding convention than other mutual funds,” says Cohen. The reason: such a level of precision may more effectively get the message across to investors about the potential for fluctuation of an NAV. However, when the SEC announced the rule changes, Commissioner Piwowar criticized the agency for requiring a “false level of precision” at the expense of investors, who will ultimately bear the cost of the additional expense needed to comply.

While fund managers and administrators will bear most of the burden of revamping their operational systems for a variable net asset value, custodians also will feel the heat. Those which act as subaccounting agents and strike daily NAVs for money market funds will also need to adapt their systems. Custodians, acting as lending agents or intermediaries for investment funds lending out securities, may also need to calculate a floating NAV for registered money market funds in which they invest cash collateral. Borrowers of securities — often broker-dealers — will typically post cash as collateral to back a US securities lending deal.

Just how will a fund manager know whether it must change from a stable $1 NAV to a variable NAV? The answer is pretty simple; it’s a matter of who their investors are. If the investors are all Mom and Pop individuals or “natural persons,” the fund will be classified as a retail money market fund and can retain its current practice of pricing at US$1 share.

But if a money market fund has just one institutional investor — any type of firm which is not a “natural person”– it will likely need to immediately and involuntarily redeem that investor to hold onto its retail status.  The SEC says that money market funds must have procedures “reasonably designed” to ensure that its beneficial owners are natural persons and if an institution just happens to sneak into the mix, the money market fund can temporarily hold onto its retail fund status. That is as long as it acts quickly to buy out the non-retail investor. Otherwise it risks falling under the category of institutional prime money fund and must play by the new rules.

Real People Only

How will a fund manager know just who its beneficial or end investors are? It won’t be able to depend solely on its own records. “The identify of such investors is often obscured behind layers of intermediaries,” says Roger Joseph, a partner in the law firm of Bingham McCutchen in Boston. “A money market fund manager might only have the names of financial intermediaries on its books, while those banks and broker dealers have the names of their customers on their books.”

The money market fund manager doesn’t need to know the identities of the ultimate investors, but does need its distributors to certify that all of the investors are natural persons. Fund managers may need to amend their agreements with distributors to provide this information, although most agreements may already be broad enough to cover this requirement. Distributors currently offer enough data to their fund manager clients to meet anti-money laundering rules and ensure that investors aren’t engaged in illegal market-timing strategies. Those distributors will also have to review their investor list on a regular basis — likely every quarter — to make certain that not even a single institutional name crops up.

With the SEC wanting investors better informed of the risks involved in money market funds, disclosure is always the holy grail for the regulator. Explaining the new pricing rules in offering documents is just the beginning. Next up, informing investors daily about the levels of liquid assets, net shareholder inflows or outflows, market-based NAVs and any redemption fees or restrictions. Collecting the information, verifying its accuracy and then winning a signoff from responsible corporate officers or the board will all become critical for fund managers. Count on operations, compliance and even marketing specialists to be involved in verifying and re-verifying the figures as well as the language used on fund managers’ websites. Money market funds do currently report detailed information about their portfolio holdings to the SEC monthly on Form N-MFP, but that is monthly and certainly not in daily changes.

Stalling Redemptions

Although variable NAV is the most obvious change affecting institutional investors in money market funds, the close second is the new power of a fund’s board to slow or stop redemptions temporarily if the fund’s level of weekly liquid assets falls below a certain threshold. To make redemptions less attractive to investors, the board has the option of imposing a liquidity fee of up to two percent of the value of the investor’s redemption proceeds, if the value of weekly liquid assets fall to less than 30 percent of total asset value. Should the liquid assets fall to less than 10 percent of total value, a one percent liquidity fee will automatically be imposed. That is unless the board of the money market fund deems it not in the best interest of the fund or its shareholders.

The new power to impose a redemption gate is a heavier blockade against a potential run on the fund. Fund boards can now limit the ability of shareholders to redeem their shares for up to 10 days over a ninety-day period if weekly liquid assets fall below 30 percent. Weekly liquid assets generally include cash, US Treasury securities, certain other government securities with maturities of up to 60 days and securities that convert into cash within a week.

With the board’s power to temporarily change redemption terms comes the responsibility for money market fund managers to more closely monitor their investments for breach of these liquidity thresholds. “Money market fund managers may decide to establish policies and procedures to notify board of directors when the fund may be potentially close to passing the thresholds,” says Cohen. Doing so, will ensure that a board has enough time to consider whether a liquidity fee or redemption gate would be in the best interst of the money market fund.

Living with this level of scrutiny, as well as the potential for fees and restrictions that may infuriate investors, could also prompt fund managers to rethink their investment strategies. “A fund manager may invest the fund’s portfolio more conservatively to ensure that the fund’s weekly liquid assets remain above the thresholds,” says Cohen.

Just as important as notifying board of directors will be communicating any redemption fees and restrictions to distributors who then have to inform the ultimate end investors, says Bingham. Fund managers will have to verify that distributors are enforcing the fees and restrictions and canceling them when the the liquidity thresholds are no longer in breach.

Bottom line: for the money market funds affected, there will be plenty of disruption to go around. Everyone from the board of directors to the operations, compliance and technology departments, service providers and intermediaries and down to the investors will be challenged by implementation and communication issues raised by the SEC’s new rules.