The following is an edited version of a speech delivered by Securities and Exchange Commission Chairman Mary Schapiro at the annual meeting of the Securities Industry and Financial Markets Association on Nov. 7 in New York.
I wanted to take this opportunity to address an important policy issue that has not been fully resolved following the financial crisis of 2008. That policy issue relates to money market funds and the SEC's ongoing efforts, in close coordination with the Financial Stability Oversight Council, to pursue further structural reform of these vehicles. The purpose of this reform would be to improve market resiliency by reducing money market funds' susceptibility to runs and providing for a greater cushion in the case of a poor credit decision or decrease in short-term liquidity.
Our money market fund efforts complement the SEC's ongoing focus on market structure reform. As the capital markets regulator, we seek to foster markets that are orderly and efficient so investors are rewarded for finding the most effective ways to allocate capital.
The financial crisis revealed shortcomings in the functioning of the short-term-credit markets. And money market funds represented a weakness. Structural flaws were exposed. The crisis began with the failure of a large investment bank, followed by a run on a single money market fund that spread. Within days, the short-term-credit market was frozen.
Just as the SEC has taken substantial steps to address market structure inadequacies in the equity markets that were revealed on May 6 of last year, we have an obligation to evaluate and address weaknesses in the short-term-credit market, and the $2.6 trillion money market fund industry, in particular.
Money market funds are investment vehicles that are widely used by both retail and institutional investors for cash management needs. The delineating feature of money market funds is that they seek to maintain a stable $1 net asset value. SEC rules permit these funds to use amortized cost accounting in order to maintain that stable net asset value. As a result, investors can transact in the fund on an efficient basis and essentially use a money market fund as a liquid cash account.
These funds work very well almost all of the time, handling significant inflows and outflows on a daily basis. This general success long allowed money market funds to be regarded as a sleepy, low-risk part of the financial world, growing to nearly $4 trillion in assets at their height.
Money market funds catapulted into the public consciousness in September of 2008 in the midst of the financial crisis. It was then that the Reserve Primary Fund “broke the buck,” triggering a wide-scale run on institutional prime money market funds.
RETREAT AND REDEMPTION
The significant role of money market funds in the financial system became very clear, as sizable redemptions and uncertainty about counterparties led money market fund managers to retreat en masse from the commercial-paper market. Banks, corporations and others who relied on money market funds as a source of short-term financing were suddenly locked out of the market. To make matters worse, many money market funds were scrambling to liquidate assets in order to meet the redemption demands of nervous investors.
During the week of Sept. 15, 2008, investors withdrew approximately $310 billion from prime money market funds, with the heaviest redemptions coming from money market funds with large institutional investors. These redemptions represented 15% of those funds' assets, and on an individual basis, certain money market funds saw assets under management drop by more than one-third in less than a week.
The run was halted by the announcement of the Treasury Temporary Money Market Fund Guarantee Program, which temporarily guaranteed money market fund account balances as of Sept. 19. In addition, government facilities were put in place to provide liquidity to the commercial-paper market in which prime money market funds invest.
Following the crisis, the SEC enacted significant reforms to our money market fund regulations. Through this effort, we tightened credit quality standards, shortened weighted-average maturities and, for the first time, imposed a liquidity requirement on money market funds.
Those reforms, which we adopted in February 2010, have been in effect for over a year. And they have made a substantial difference, particularly in the liquidity profiles of money market funds. The reforms were “tested” this summer when money market funds remained resilient despite substantial redemptions and large changes in day-to-day flows.
As part of our reforms, the SEC also adopted new reporting requirements that provide public transparency so investors can see their money market funds' exposures. The reporting also enables the SEC and other regulators to better monitor trends in money market funds' holdings and risk profiles.
Complementing these developments, we have provided investors access to money market funds' mark-to-market valuations, known as the “shadow NAV.” This information is reported on a monthly basis, with a 60-day lag to the public. The public shadow NAV information is expected, in part, to help sensitize investors to the fact that money market fund shares actually are interests in pools of investments that fluctuate in value, although those fluctuations generally are very small and measured in decimal point increments.
While the SEC's new money market fund reforms were a critical first step, and many voices have said, “You've done enough,” I believe additional steps should be taken to address the structural features that make money market funds vulnerable to runs.
While I've listened to commenters who say we have done enough, I remember the destabilizing events that followed the breaking of the buck by the Reserve Primary Fund and the need for unprecedented government support. We all should be committed to preventing that from occurring again.NO COMMITMENT TO $1 NAV
A money market fund's $1 stable NAV is brittle. Money market funds have no committed source of stability to draw upon, except for the discretionary support of their sponsors. This support may be there or it may not. And there certainly is no current legal requirement that sponsor support or any other backup exist. In addition, investors, particularly institutional investors, often treat the $1 NAV as an all-or-nothing proposition and run at the first sign of trouble.
Notwithstanding their generally strong record, there is a lingering concern about how money market funds will stand up in a significant financial crisis or whether a particular money market fund holding unexpectedly could default, making matters worse. There still is concern that a money market fund portfolio manager simply could make a mistake.
Despite our first round of reforms, risks remain because even though every money market fund prospectus says the fund is not guaranteed and that investors may lose money, investors want, and have come to expect, their dollar, not something shy of that.
In addition, I think everyone agrees that our country should never again be in the position of having to choose between providing support to private-market participants, including money market funds, or risking a breakdown of the broader financial system.
We need to remember that the focus on additional structural reform is not an indictment of the benefits that money market funds provide to investors, or a critique of their managers. Instead, it is a recognition — informed by the events of 2008 — that money market funds, because of their size and their role in the short-term-credit markets, are significantly intertwined with the U.S. economy and the global marketplace.
As was stated in the FSOC annual report issued in July, the SEC — working with the FSOC — is evaluating options to address the structural vulnerabilities posed by money market funds. We are focused in particular on a capital buffer option to serve as a cushion for money market funds in times of emergency and floating NAVs, which would eliminate the expectation of stability that accompanies the $1 stable NAV. Both of these reform options would ensure that investors who use money market funds realize the costs that might be imposed during rare market events.
The current focus on these two reform options is the result of a long and careful review conducted jointly with fellow financial regulators. In October 2010, the President's Working Group on Financial Markets released a report on money market funds. That report discussed a series of possible reform options to address the systemic risks money market funds can pose. In November 2010, the SEC requested public comment on those reform options, in an effort to better understand their pros and cons.
The SEC also held a very informative public round table on money market funds and systemic risk in May of this year. Participants included FSOC members and their designates, foreign financial regulators, money market fund industry participants, academics and investors.
At the time the PWG report was published, there were numerous reform options on the table. And then additional ones were suggested by commenters along the way. At this point, however, floating NAVs and capital buffers, possibly combined with redemption restrictions, seem to be the options with the greatest viability.
Throughout the process of considering reform options, we have benefited greatly from meaningful comment, critical thinking and in-depth analysis from both regulators and public commenters. Reform will be the better for it.
Many have asserted that forcing money market funds to float their NAVs is draconian and would end money market funds as we know them. I agree that money market funds would change very dramatically as a result. They would no longer look like a specialized product. They would look like any other mutual fund, although with very short-term, high-quality portfolio holdings.
I also have sympathy for the fact that floating the NAV potentially would deprive investors' access to a stable net asset value product that has met many of their needs.
While floating NAVs would reinforce what money market funds are — an investment — and what they are not — a guaranteed product — this option poses challenges for policymakers, particularly in fostering an orderly transition from stable NAVs to floating NAVs.
Another option, a capital buffer for money market funds, also holds promise. And much of the energy of the SEC staff, working jointly with counterparts from other FSOC member agencies, is focused on developing a meaningful capital buffer reform proposal. In addition, a capital buffer potentially could be combined with redemption restrictions in order to address incentives to run that may not be curtailed by a capital buffer alone.CAPITAL AS A CUSHION
An express and transparent capital buffer would make explicit what for many, but not all, money market funds is implicit today: namely that there is a source of capital available to the fund in times of emergency. Today that source of capital comes from discretionary sponsor support. If a money market fund held a troubled security, for example, the fund's sponsor — or the sponsor's well-capitalized parent — might buy the security out of the fund's portfolio.
Clearly, such activity saved investors from losses and was in their interests. But it also had the perverse effect of lulling investors into the belief that losses were extremely remote, if not somehow impossible, due to sponsor support.
The problem, as illustrated in 2008, is that sponsor support has been provided at the discretion of the sponsor. There is no dedicated, transparent, and sizable source of capital on which money markets fund can draw in times of trouble.
A dedicated capital buffer, or similar structure, could provide that type of cushion. It could mitigate the incentive for investors to run since there would be dedicated resources to address any losses in the fund. A sudden market or interest rate fluctuation would not have the potential dramatic “break the buck” effect that it could have today. It also would reduce the potential moral hazard and uncertainty that revolve around a fund's possibly breaking the buck in the current environment.
In assessing potential capital buffer structures, we are examining the pros and cons of various sources of the capital. The capital in a money market fund could come from (1) the fund's sponsor, (2) the fund's shareholders or (3) the market through the issuance of debt or a subordinated equity class. In addition, we are closely examining the appropriate size of any capital buffer. A challenge is how to establish a capital buffer that offers meaningful protection against unexpected events, without overprotecting and unnecessarily interfering with the prudent and efficient portfolio management of the fund.
We also face the challenges of developing and implementing money market reforms in a low- or nearly no-interest-rate environment. Reform needs to be implementable now, yet be workable in all interest rate environments.
I look forward to making substantial progress on our money market fund reform initiative in the coming months so that we can issue a proposal in very short order. We cannot let this issue linger.
Once the SEC issues any reform proposal, a critical step will be hearing from interested parties through the public-comment process. We definitely value the input of market experts, market participants and the investors that we are sworn to protect. We want and need your input.
The issues we face are not easy. If they were, further structural money market reforms would be implemented by now. But just because something is a challenge, or is unpopular, does not mean that we should not do it.
As a financial regulator, I feel a responsibility to learn every lesson and take every step to address the shortcomings revealed in the last crisis, in part to avoid the next. Money market funds, while perhaps not the cause of the downward spiral of events, certainly exacerbated the financial breakdown. I believe that we at the SEC need to be leaders in continuing to pursue money market fund reform. And I look forward to sharing a reform proposal with you soon.
