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Yet again, the Securities and Exchange Commission (SEC) is aiming to address one of the weakest links in the US financial system: money market mutual funds, the object of at least two reform efforts and two major federal rescues in as many decades.
This time around, regulators might actually be getting it right.
Money market funds emerged in the 1970s as a relatively unregulated alternative to banks, which at the time faced limits on the interest they could pay depositors. Such funds offered higher returns and an appealing pledge: They’d seek to maintain a value of exactly $1 per share. Given that they lacked deposit insurance, frequently invested in risky assets, and had no capital to absorb losses, this promise was always dubious. But it held up for long enough that investors came to believe it. By 2007, funds had attracted more than $2 trillion and had become a major source of short-term financing for everything from American corporations to European banks.
The 2008 financial crisis exposed the charade, when the Reserve Primary Fund — among the largest in the industry — “broke the buck,†dropping the dollar-a-share fiction amid losses on defaulted bonds. This triggered a broader exodus and demonstrated a key vulnerability of such funds: In times of trouble, investors had a huge incentive to get out first, before the buck was broken and before their selling exacerbated the losses. In three weeks, the assets of institutional prime funds declined by almost 30%, triggering a severe credit crunch that only a government
rescue could relieve.
This episode inspired two rounds of reforms. In 2010, the SEC increased the amount of easy-to-sell “liquid†assets that money market funds must keep on hand to satisfy redemptions. In 2016, it required institutional prime funds to value their shares in line with their underlying securities, rather than at $1. In case this didn’t eliminate the incentive to run, the SEC also allowed funds to charge penalties or even pause withdrawals if their liquid assets fell below a certain level.
In 2020, the Covid-19 pandemic put the new approach to the test, with disastrous results. As it turned out, floating share prices alone weren’t enough to prevent runs. Investors still had an incentive to get out while funds had liquid assets to sell, leaving others to suffer the losses that would come when they tried to unload more thinly traded securities such as commercial paper and corporate bonds. The threat of penalties and pauses exacerbated the problem: Investors pulled more money from funds that were closer to their minimum liquidity thresholds. As a result, prime funds lost some 30% of their assets in just two weeks, before the
government again stepped in.
Now, regulators have proposed yet another reform: swing pricing, a mechanism already used widely in Europe. Instead of allowing first movers to get out with little or no price impact, it would require funds to adjust their share prices to reflect transaction costs and — during periods of particularly heavy withdrawals — the effect of selling less-liquid assets.
If the prospect of getting back less than $1 per share causes some investors to switch to bank deposits, that’s merely the salutary effect of recognising true risks.
—Bloomberg