Starting Oct. 14, 2016, institutional prime money market funds won’t be able to price themselves at a constant $1.00 a share.
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New SEC rules will require these giant funds to value shares based on actual market prices for underlying assets in their portfolios.
That means their per-share prices will fluctuate on a daily basis.
While that’s not exactly good news, it gets worse.
The rules allow funds to charge up to a 2% redemption fee when investors want out.
But the killer is, funds can put up “gates” that prevent investors from selling shares.
Besides problems investors will have with the new rules, unintended consequences affecting companies and municipalities that rely on selling their commercial paper and other short-term debt instruments to these big funds could end up killing the market.
Here’s what you need to know and what to do…
Why They’re Changing the Rules
Money market funds used to price their shares at a constant $1.00. It used to be “a dollar in and a dollar out.”
If the underlying assets in a money market fund rose above $1.00, funds could pay the excess out as a dividend. If the underlying value of assets fell such that the pro-rata per share price was below $1.00, funds could use amortizing accounting methods to still maintain the fund’s constant $1.00 a share price.
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In 2008, the oldest and largest money market fund in the United States, the Reserve Primary Fund, “broke the buck” and priced its shares at $0.97 when Lehman Brothers collapsed and the price of Lehman’s commercial paper the Reserve Fund held imploded.
The Reserve Fund breaking the buck panicked investors who immediately withdrew hundreds of billions of dollars from money market funds before they could lower their prices, too.
That run on money market funds brought the financial system to a standstill.
Instantly, there were no buyers for the billions of dollars of commercial paper and other short-term debt instruments corporations and municipalities sold to money market funds on a daily basis to fund their payrolls and other short-term cash needs.
In July 2014, the U.S. Securities and Exchange Commission handed down new rules to make some money market funds more transparent in terms of pricing their underlying assets and to temporarily steady funds during times of extraordinary financial stress.
Making institutional funds float their share price makes it more transparent to impacted investors so that they, and not the fund sponsors or the Federal government, bear the risk of loss.
By allowing these funds to charge up to a 2% redemption fee, under certain circumstances, the SEC hopes to slow redemptions when investors would normally head for the exits.
By allowing funds to put up “gates” to shut down redemptions altogether, the SEC expects to halt debilitating money market runs when the financial system can least afford them.
The Letter of the Law
Here’s how the SEC explains the new pricing requirements, the new redemption fees, or “liquidity fees,” and gates:
Showing Fluctuations in Price – Institutional prime money market funds would be required to price their shares using a more precise method so that investors are more likely to see fluctuations in value. Currently, money market funds “penny round” their share prices to the nearest one percent (to the nearest penny in the case of a fund with a $1.00 share price). Under the floating NAV amendments, institutional prime money market funds instead would be required to “basis point round” their share price
Liquidity Fees – Under the rules, if a money market fund’s level of “weekly liquid assets” falls below 30 percent of its total assets (the regulatory minimum), the money market fund’s board would be allowed to impose a liquidity fee of up to two percent on all redemptions. Such a fee could be imposed only if the money market fund’s board of directors determines that such a fee is in the best interests of the fund. If a money market fund’s level of weekly liquid assets falls below 10 percent, the money market fund would be required to impose a liquidity fee of one percent on all redemptions. However, such a fee would not be imposed if the fund’s board of directors determines that such a fee is not in the best interests of the fund or that a lower or higher (up to two percent) liquidity fee is in the best interests of the fund. Weekly liquid assets generally include cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less, and securities that convert into cash within one week.
Redemption Gates – Under the rules, if a money market fund’s level of weekly liquid assets falls below 30 percent, a money market fund’s board could in its discretion temporarily suspend redemptions (gate). To impose a gate, the board of directors would find that imposing a gate is in the money market fund’s best interests. A money market fund that imposes a gate would be required to lift that gate within 10 business days, although the board of directors could determine to lift the gate earlier. Money market funds would not be able to impose a gate for more than 10 business days in any 90-day period.
You can read the SEC’s full release here.
What the Unintended Consequences Mean for Your Money
Now, let me be clear: Not all money market funds are subject to the new rules.
Retail and government money market funds are exempt and can still price their shares at a constant $1.00 per share.
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Retail funds cater to natural persons, individual accounts (brokerage or mutual fund), retirement accounts, including workplace defined contribution plans, college savings plans, health savings plans, ordinary trusts, and accounts sold through intermediaries with the underlying beneficial ownership being a natural person.
Government money market funds only invest in government-issued debt instruments and are exempt.
But these rules could still have a big impact on your investments.
Besides affecting the industry already, where almost $500 billion has exited institutional prime funds this year, there are sure to be unintended consequences from the new rules.
Big institutional investors who invest in prime money market funds, a lot of them whose companies issue the commercial paper held by prime funds, aren’t going to take kindly to being subjected to redemption fees when they want their money out of funds as prices are falling.
And they for sure aren’t going to want to be in prime funds if they can’t get their money out at all, while prices are plummeting.
That means there will be hundreds of billions of dollars, possibly more than $1 trillion, not available to banks, corporations, and municipalities who borrow on an almost daily basis by selling their commercial paper and debt instruments to institutional prime money market investors.
Besides drastically choking short-term borrowers, who will have to find other ways to raise short-term funds, investors who would normally invest in money market funds are moving into government money market funds, who now have to find hundreds of billions of dollars of short-term Treasury bills to hold in their portfolios.
There’s already a shortage of T-Bills.
Between banks, hedge funds, and institutional investors hoarding T-Bills for liquidity purposes, there’s very little supply in the $1.7 trillion T-Bill market. The Treasury plans to add another $188 billion to the T-Bill supply in anticipation of the new money market rules and the move by big investors out of prime funds and into government funds.
That’s not nearly enough supply. Any rush into Treasuries, which are across the yield curve in short supply because the Fed‘s hoarding over $3 trillion of government notes and bonds, could result in severe liquidity problems if any kind of market sell-off triggers a further rush into safe governments and there aren’t enough of them.
The new rules will undoubtedly spawn unintended consequences that regulators and investors haven’t considered but are likely because of the massive disruption to corporate borrowers and big investors we’re about to witness.
Whenever the market encounters huge unknowns, there’s likely to be disruptions, dislocations, and possibly panic if something somewhere all of a sudden breaks or stops working.
You’ve been warned.
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