Equal treatment under the regulation | SEC’s Plaze argues for money market reform

Are money market funds fundamentally unfair? Bob Plaze, Deputy Director of the Division of Investment Management of the SEC, argues that they are and that their special treatment “violates the principles of the Investment Company Act.” Plaze spoke yesterday morning at the Mutual Fund Directors Forum 2012 Policy Conference in Washington, DC, standing in for the soon-to-retire Eileen Rominger, Director of the Division.

Fielding questions from the Forum’s Executive Director Susan Wyderko on a number of topics, Plaze was most eloquent about the need for change in the regulation of money market funds. His argument was based not on concerns about systemic risk — but on a desire to provide equal investor protection.

A question of unfairness. . .

Plaze suggests that money market fund regulation, as structured today, favors sophisticated institutional investors who have the resources to track the holdings in their money market funds closely. They can use their superior understanding of the fund to shift losses to the other investors in the funds — the ones who aren’t paying as much attention.

Here’s how that could happen. Imagine a money market fund with two investors — Big Corporation and Mom and Pop. They each have $100,000 in the fund for a total of $200,000 in assets.

The money market fund invests in the commercial paper of a company that goes belly up. As a result, the fund takes a 25 basis point loss, so that the value of the fund’s assets falls to $199,500 $0.9975 per share.

Under current regulations, the fund still accepts investments and pays out redemptions at a price of $1 per share. Big Corporation — who has been keeping a close watch on the holding in question — decides to redeem. It withdraws $100,000, leaving $99,500 in the fund.

As a consequence of the redemption, Mom and Pop is left with shares worth only $0.9950 each. In other words, Mom and Pop ends up bearing Big Corporation’s losses, simply because they weren’t as fast to cash in their shares.

. . . Requiring regulatory change

Plaze called the current system a “prisoner’s dilemma” — where individuals have huge incentives to act in their own best interests even if by doing so they harm others, leading to a less than optimal result overall. He notes that fund managers have helped keep the system going — because of their willingness to bail out money market funds experiencing difficulties.

But Plaze questions whether fund managers can continue to provide such comprehensive financial support to their money funds. Assets in these funds have grown tremendously, and prices of their holdings are more likely to move together than in the past — suggesting that it’s more likely that losses will be beyond the ability of a fund manager to subsidize.

In his opinion, regulators need to create a fundamental change in the money fund dynamic so that investors no longer have an incentive to be the first to redeem. They could achieve this through a floating net asset value or by requiring that funds build a capital buffer (essentially requiring that asset value be slightly above $1 per share in ordinary times) while at the same time placing restrictions on redemptions.

Available alternatives

Regulatory change would cause disruption, Plaze acknowledges, but he believes that investors have alternatives. Smaller investors could simply return to bank deposits — and gain the security of Federal deposit insurance.

Plaze suggests that large investors would likely stay in money funds, even if the proposed changes were implemented. Moving money back to the banks isn’t an option for most larger investors, since they hold cash balances that exceed deposit insurance limits. It puts them at too much risk if the bank fails.

However, Plaze rejects the argument that large investors will move cash to accounts overseas. In his view, it doesn’t make sense for them to reject a floating net asset value or redemption restrictions as too risky — and then invest in completely unregulated vehicles.

Unanswered questions

But what about mid-sized investors? They have assets that exceed deposit insurance limits — and don’t want to become unsecured creditors of a bank that goes bust. At the same time, they don’t have the resources to cope with the complexities of the solutions being proposed — whether it’s the capital gains and losses generated by a floating net asset value or the liquidity issues posed by a redemption limit.

Money market funds have made cash management infinitely easier for many mid-sized investors — which include many small businesses — speaking as the manager of a small business myself.

And are banks clearly  a better alternative? And do money market funds provide important competition to banks? Plaze sidestepped these systemic risk questions.

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