In October of that year, new Securities and Exchange Commission rules took effect that were designed to bring more transparency into institutional prime funds by imposing a floating net asset value (NAV) instead of a $1 fixed price per share. The change was designed to enable investors to know at all times the exact value of their position.
In addition, to address the risk of runs on an institutional prime fund, the SEC allowed fund boards to impose a 2% redemption fee and temporarily halt redemption requests by imposing “gates” preventing assets from being withdrawn if the weekly liquid assets of the fund fall below 30% of its total assets. This change was aimed at ensuring funds keep enough of a liquidity buffer to counter sudden, large investor withdrawals.
It was the possibility of breaking that 30% threshold—and a fund board considering imposing a redemption fee or a gate if that were to happen—which prompted two fund sponsors to step in and buy assets from their prime fund affiliates that week.
No board of directors is known to have imposed either fees or redemption gates during the height of the March market dislocation, but many observers are strident in their opinion that the 2016 regulations only height ened investor outflows at the time, instead of alleviating them.
“The 30% weekly liquidity threshold for gates and fees was essentially pulled out of thin air by the regulators — there was no quantitative modeling conducted, which said that 30% is the optimal number,” says James Angel, associate professor in the McDonough School of Business at Georgetown University.
Another issue is that 10% of prime fund assets have to mature overnight to meet daily liquidity requirements, in addition to the 30% that has to meet weekly liquidity requirements. According to Professor Angel, if funds fear they will face more redemptions than their maturing paper will accommodate, they will sell their most liquid assets first, leaving the less desirable assets for the investors remaining in the fund.
“If six months from now the Fed and the SEC announce they are going to reexamine money market fund regulation, I would not be surprised,” says Jonathan Spirgel, global head of liquidity and segregation services at BNY Mellon Markets. “Although much of that renewed attention will likely be around redemption fees and gates, the transition from a fixed to a floating NAV appeared to work as intended in boosting confidence during the stress period.”
The flip side is that increased liquidity may come at the price of a reduced yield. Advocates have argued that the future of prime funds is assured by the crucial role they play in the CP market and the invaluable short-term liquidity they provide to corporate America.
Between the two of them, 2a-7 funds and separately managed accounts (prime funds fall into both categories) represent around 40% of buyers, making money funds by far the largest investor type and emphasizing the important role they play in funding.
Nevertheless, until recently prime funds were significantly larger buyers of CP. In 2015, the year before the U.S. money market regulations took effect, prime fund balances were as high as $872 billion, according to Crane Data. Balances dropped precipitously as the late 2016 deadline for the new reforms approached, bottoming out at just $125 billion on October 31 that year.
Although prime fund balances today are north of $620 billion, the historical data illustrate that the CP market has absorbed an almost nine-fold reduction in prime fund buying capacity, and corporate issuers were still able to secure short-term financing without much difficulty. This suggests that a dramatic reduction in the number of U.S. prime funds in the market may not be all that disruptive to issuers.
Other proposed structural changes to prime funds include the imposition of capital buffers provided by fund sponsors that would absorb redemptions and circumvent the issue of attempting to liquidate CP in a downturn.
Amid the uncertainty, one thing that seems likely is that once the current crisis is behind us, prime funds will again come under regulatory scrutiny. It remains to be seen whether any future changes would rescind fees and gates or impose maturity lim itations in their holdings.
“Money funds make almost no money; their margins are razor thin,” says Drew Winters, professor of finance in the Rawls School of Business at Texas Tech University. “If they want to fix this sector, they should start by rolling back the 2016 reforms.”
Peter Madigan is editor-at-large for BNY Mellon Markets.