In a greatly anticipated rule release, the Securities and Exchange Commission (SEC) voted to adopt amendments to the rules that govern U.S. money market funds (USMMFs).1
The reform proposals were published in December 2021 after pandemic-related market stress triggered substantial redemptions from institutional prime money market funds. They also reflect the ongoing global assessment of funds as a possible source of systemic risk.
Let’s look at the final rules in detail.
Welcome Rule Revisions (and Omissions)
The good news is that the SEC appears to have taken on board several industry submission concerns and calibrated the rules accordingly. Topics they’ve considered include:
- Decoupling of weekly liquid assets threshold and liquidity fees. The original proposal may have made redemption runs worse as the known trigger limits came close to being breached since investors likely would proactively redeem before being hit with the fee. In its release, the SEC acknowledged that the proposed provisions might result in “unintended consequences”.
- No imposition of a mandatory swing pricing regime: Industry was uniformly opposed to the proposed swing pricing requirement2 due to operational concerns as well as a resolute belief that swing pricing in practice would not have the intended effect of preventing runs on money market funds.
- Even with mandatory swing pricing removed, the mandatory liquidity fee framework itself will impose several operational complexities for in-scope funds.
- Helpfully, these proposals have also removed the requirement for stable NAV MMFs to determine whether their distribution intermediaries can support a floating NAV.
- Removal of the allowance of temporary redemption gates from Rule 2a-7, which require an MMF must hold at least 10% of its total assets in daily liquid assets and at least 30% of its total assets in weekly liquid assets.
Plenty of Work Lies Ahead
While there are several positives coming from the final rules, there are plenty of changes which will require analysis and action.
Unquestionably, the new mandatory liquidity fee framework for institutional prime and tax-exempt MMFs will draw most attention and commentary. The dissenting commissioners believe fund boards and sponsors should retain ultimate discretion on how to manage redemptions and liquidity events – and opposed the mandatory component.
Mandatory Liquidity Fee Framework
Under the new rules, institutional prime and institutional tax-exempt money market funds must impose a liquidity fee when a fund encounters daily net redemptions above 5% of net assets based on subscription/redemption information available within a reasonable period after the computation of the fund’s NAV on the day.
Should the fund calculate that the trading costs of satisfying the large redemption activity is de minimis (less than 1 basis point), then it can choose not to apply the liquidity fee. The board of any fund is also given discretion to apply liquidity fees on a lower redemption threshold as they see fit. All liquidity fees must be calculated based on a good faith estimate, supported by empirical data, of the trading costs a fund would incur if it sold a pro rata amount of each portfolio holding to satisfy net redemptions. If the costs of selling a pro rata amount of each security in a fund’s portfolio cannot be estimated in good faith and supported by data, the fund must impose a default fee of 1%.
The 5% level in practice is a relatively high threshold and higher than the original SEC proposal. It also likely reduces the frequency of instances where the mandatory liquidity fee is imposed.
The computational work required to adhere to the mandatory liquidity fee considers many of the same factors on trading costs and dilution effects that they would in calculating a swing factor. However, from an operational perspective, a liquidity fee is a lot easier to implement than swing pricing since it’s a much simpler calculation. Transfer agents, brokers and fund administrators already have hard-wired fee calculation and dissemination systems set up. Swing pricing would have totally disrupted downstream stakeholders more materially than a fee imposition.
Discretionary Liquidity Fees
The new rules expressly grant discretion to the boards of non-government money market funds to impose a discretionary liquidity fee (not to exceed 2% of the value of the shares redeemed) if it determines that such a fee would be in the best interests of the fund.
Liquid Asset Thresholds
The proposal significantly increases the requirements for minimum levels of applicable daily and weekly liquid assets for all MMFs.
- The required minimum levels of daily liquid assets changes from 10% to 25%
- The required minimum levels of weekly liquid assets changes from 30% to 50%
One industry concern regarding the elevated liquidity thresholds is that the more conservative limits will further restrict portfolio construction in terms of taking on more risk and therefore potentially dampen expected yield expectations. The most liquid and safest securities usually come with lower return expectations.
Registered money market funds must file a report on Form N-CR if the percentage of its total assets in daily liquid assets or weekly liquid assets falls below 12.5% or 25%, respectively.
Reverse Distribution Mechanism (RDM)
Stable NAV MMFs are now authorized to implement a reverse distribution mechanism (RDM), also known as share destruction, or similar mechanisms during negative interest rate environments to maintain a stable $1.00 share price. While the existing ability to convert to a floating NAV is retained, this RDM is a far more commercially viable option should the need arise. Utilization of RDM is subject to certain board determinations and investor disclosures.
Revisions to Form PF
The revised rules enhance reporting requirements of registered money market funds as well as SEC-registered investment advisers to private liquidity funds on Form PF.
The SEC believes liquidity funds “follow similar investment strategies as money market funds” and therefore must now report additional information such as “asset turnover, liquidity management and secondary market activities, subscriptions and redemptions, and ownership type and concentration”.
Industry will need to comply with the mandatory liquidity fee requirements within 12 months of the rules being published in the Federal Register (60 days); they also need to comply with discretionary liquidity fee, increased minimum liquidity requirements, and other amendments six months after that date, and amendments relating to Form PF and other reporting on June 11, 2024.
The final rules are a mixed bag. They have widespread impacts across products and impact operations, portfolio composition, regulatory reporting, fund boards, and interactions with and disclosures to investors. They will add costs and will involve relatively tight compliance windows.