The SEC's money market rules: Buridan's Ass redux
Thursday, July 24, 2014 at 11:56AM
The SEC finally passed it’s final regulations on money market “reform”. The short story is that institutional money market funds will now mark to market & trade at Net Asset Value, such as it can be priced from the market. Retail funds sold to individual investors will continue the mythology of trading at $1 per share. All money market funds will have the ability to temporarily block redemptions and impose a 2% redemption fee at their discretion.
Our conclusion: while the NAV mechanic presents an improvement on the margin, the basic problems remain the much same, unchanged from the days of crisis. The SEC’s proposals
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are in and of themselves ineffective in significantly reducing systemic risk or altering the mechanic of transmitting it. The interconnections of the participants are unchanged while the concentration of the markets are greater than they were in the days of crisis
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will not improve underlying credit quality or provide incentives to funds to improve risk management
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rely on the NAV mechanic for liquidity. This is untested in distressed markets. How this works when price discovery itself is opaque is open to question.
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require no directly paid in capital to support the risk implicit in all money market funds
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for retail investors promulgate no real change in fund liquidity or risk but rather provide a sanctioned regulatory framework in which the failure of liquidity could occur (akin to an injury time out in a soccer game)
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provide improvement in required pricing schemes (from amortized cost to penny rounding)
Money market funds of all variety are essentially large banks that make loans to sovereigns, financials & corporations. The new regulations now preclude funding of that risk by direct, segregated capital. Their indirect capital, in the form of limited, committed short term lines of credit, is sourced from the same institutions that they fund, leaving all vulnerable to systemic distress. Yes, you read that correctly. It remains entirely circular, which is how you manufacture systemic risk.
We also see an interesting phenomena that strikes us as, well, stupid. Consider the simple example of two money market funds, one institutional and one for retail. Let’s assume they are identical in holdings. The SEC creates now two schemes for pricing, disclosure and liquidity of identical product differentiated only by who is buying the product. The institutional investor trades product at NAV while the retail investor trades the identical product at a fixed $1, which may or may not reflect the NAV and most likely will not during a period of distress. The institutional investor has access to the disclosure of the components of the NAV calculation and the retail investor does not. The institutional investor has the option to sell at NAV (whatsoever it may be, accurate or not) and the retail investor does not.
So we have pricing asymmetry of pricing, information and liquidity per force of regulation and nothing but a cul de sac solution to liquidity risk for the retail investor. One wonders about equal protection under the law or plain old fashioned fairness? Implicit in the exemption from NAV for retail funds is moral hazard, a bail-out by the government. This we call regulatory capture: the best politicians & regulation that industry money can buy.
The 2% “liquidity fee” is a required penalty imposed ex post facto for a risk the investor assumed at inception. One might ask why an investor would buy a money market fund that has a mandated, implicit risk of a 2% loss? They may not. And who is to say that 2% is sufficient to cover the losses incurred during a period of chaotic pricing? Data suggests that may be insufficient.
“Gating” or suspension of redemptions is self evidently problematic, a non-solution. This creates a mechanic of regulatory sanctioned admission of failure of the money fund (which is OK, evidently) in lieu of a market driven failure (which is evidently not OK). So the SEC’s solution for investors in money market funds? “Come back in 30 days and we’ll see.”
Implications: we suspect institutions and retail investors will reduce but not eliminate allocations to money funds and seek to manage larger portions of their excess liquidity directly. That’s not necessarily a bad thing, but all investors will see costs go up and liquidity go down.
We also look for the capital markets to generate new products to accommodate the hole in the bucket: they will underwrite and syndicate insurance against any the 2% redemption fees. And, yes, these would be mostly the same institutions that are designated as Too Big To Fail.
We see challenges for fiduciaries who should think carefully before they sign off on redemption fees and suspensions of redemptions. 2% of even a small portion of a $1.1 trillion market is a non-trivial amount that will likely attract litigation.
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We recall the following conversation during the money market crisis:
“We regret to inform you that we have no bid for your paper today, nor do we have any further capacity to inventory your paper. We further advise that none of our investors have a bid for your paper and all have put you on a restricted list pending further notice. We have also heard, but have no direct knowledge, of your paper trading away at significant discounts in the secondary market. We will continue to monitor the situation and will keep you advised of any developments or new information...”
Head of Global Commercial Paper Origination of a major, global commercial paper dealer to the Deputy Finance Minister of an Asian sovereign issuer during the money market crisis
So how does a manager of a money market fund or the SEC price that puppy now, after that pleasant conversation? How do the SEC mechanics work know? The NAV at least provides some relief to institutional investors but the provisions for retail don’t work, and there is nothing inherent in the design of the proposed regulations prevent it.
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A better fix: the path not taken
We view the NAV solution as a marginal improvement over the current status, but only if it is applied to all investors. We see no reason to expose taxpayers to moral hazard for the convenience of many retail money market funds & a stable value $1. We have already seen how that system works.
Let’s define the problem by its components and work our way to a better solution.
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It is impossible to eliminate risk in money market funds. They warehouse credit, liquidity, interest rate, and operational risk
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There is no direct capital supporting any of those risks. There are limited amounts of contingent capital in the form of committed back-up lines of credit, but those lines are provided by banks which are themselves subject to the same disruption of liquidity and systemic risk that infect money market funds.
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Regulators and industry have historically promulgated a false perception of risk in the money market product.
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Regulators are unable to timely, accurately & uniformly define the real risk embedded in money market funds and therefore unable to define adequate capital levels necessary to support that risk.
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The markets are hugely concentrated, and there is globally a near instantaneous cycle time for both credit decisions & liquidity requirements on both the buy and sell sides.
Require real, paid in capital to support the risk of money market funds. Risk requires capital in the money market funds to protect investors. To prevent transmission of market distress the capital must be segregated and vest in the money market fund. As to form, we prefer subordinated (or “equity”) tranches that provide more robust protection to senior holders from both credit and liquidity risks. A continuous market for the subordinated tranches would provide vital information and tactical flexibility in times of normalcy or stress. Flexibility in chaotic markets is key to effectively managing them. Not having to transact is one way to survive a liquidity crisis.
The ability to defer payment provides greater flexibility on whether to sell assets or to defer payment on the equity tranche... what to sell; when; and at what price. The pricing of equity tranches provide better continuous market information as to risk, and tactically the subordination provides a better shot at timely & complete payment to the senior holders in a stressed market. And that is the goal.
We propose a modest minimum level of capital be required with the expectation that the funds would compete for different risk/reward preferences of investors. We also have the expectation that some funds might suffer during periods of stress and others would not. This is precisely what retains the discipline of the process: “Sight of the gallows sharpens the mind.”
The variable NAV model will likely suffer in illiquid or volatile, hence informationally deprived markets. No bid is still no bid. But note that a bad bid impairs the entire value of the fund, not just the subordinated tranche. Retail investors will be informationally disadvantaged in the NAV model. If you are informationally disadvantaged in a stressed market ... well, it's not good.
The equity tranche model will bring informational parity to the assessment & pricing of the problematic event and market driven accountability. And no halting of redemptions and no path to the Fed window.
Kill the public perception that there is an implied support for any money market fund. New message: no risk free solution: caveat emptor.
Provide a limited safe harbor for retail investors. Provide or cause to be provided via banks or other distribution systems a US Treasury Money Market Fund, limited to $500,000 (or whatever) per US citizen available through banks and the Post Office to individuals. This would not be available to corporations, LLCs, partnerships, or other unincorporated business accounts. Businesses are on their own and accountable for their results.
Force funds to compete in risk, liquidity, and yield space and with different methodologies. Require full, public, and real time disclosure of all holdings; ratings, and capital levels of all money market funds. The current regulatory framework essentially eliminates incentive to improve analytics, process, product or policy. Eliminate the defective regulatory presumption that there is one ‘correct’ method of risk definition & management. There is simply no empirical data to support it and a bunch of train wrecks to evidence its failure.
We propose an anti-fragile, market driven portfolio of approaches that will let the markets sort out the best solutions to the main drivers in the money markets.
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“Give me my money. All of it. Now.”
hb
Thanks to LS for pointing out the typo, now correctly appearing as "Buridian". A few other nits also corrected after posting.
hb
The SEC's press release of July 23: SEC Adopts Money Market Fund Reform Rules
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All 869 pages of the SEC's complete final rules.
hb
The SEC's actions on money market reforms must be viewed in context with the Federal Reserve program called the Overnight Reverse Repurchase Facility, also referred to as ON RRP. they are two sides of the same systemic coin. RRP is a new large scale program and no doubt will cause disruption in the event of any market distress. We highly recommend Shelia Blair's analysis linked below.
The Federal Reserve's Risky Reverse Repurchase Scheme
We also note the prior malfunction of the repo market in spring of 2013 induced by the massive QE. You may read about it in our Commentary here:
THE FED, COLLATERAL AND REPO: MORE SYSTEMIC RISK?
hb
John Cochrane brings a different view in Blair and Reserves for All. It's hard to argue with him because he pretty much knows everything, and we don't presume he reads our Commentary, but we do recommend you read him. He is correct in respect of the layers of intermediaries between investors and the Fed in a flight to quality. Our concern, however, is different.
Downstream real capital directly to the vehicles, such as commercial paper, teach the animals that there is a cliff, and if they jump off it there is no fed to catch them. That's how you contain systemic risk. The carcasses at the bottom of the cliff make for good eating, which takes us to our next sentence.
As to Ms. Blair, to all who dismiss her concerns about systemic risk and flights to quallity to the lender of last resort we present this little gem from the dustbins of history: THE LEHMAN BROTHERS GUIDE TO EXOTIC CREDIT DERIVATIVES
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Headline from the Financial Times of today: US banks braced to lose $1tn in deposits
While the story is framed in the context of rising rates, the regulatory framework is directly involved. The competition for finding described by Ms. Blair starts small: money funds will use the RRP facility directly, and look for the cost of deposits to go up substantially. From the article: "estimates ... US banks have increased their deposits by 23% in the past four years, while their cost of deposit funding has dropped to a 10 year low."
These are big numbers. But look at the essense of what will transpire. This is the mechanic, although in currently benign form, of the liquidity squeeze that Ms. Blair highlights.
Look for a significant increase in cost of bank funding which may adversely impact bank earnings and a reduction over time in retail money market fund outstandings as investors allocate more liquidity to direct management.
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