Money Market Reform's High Stakes
People passing through Washington, D.C.'s Union Station can't help but notice the ad campaign urging the preservation of the regulatory status quo for money market funds. The placement (the SEC adjoins Union Station) and timing of the campaign reflect the expectation that the SEC is poised to take another step towards stricter regulation of money market funds. Along with the Congressional and industry letters that have been flowing into the SEC, this ad campaign is evidence of the high stakes in the debate over money markets, which hold more than $2.5 trillion. If we want to put solutions in place that will not themselves become the source of future crises, some important implications of past and future reforms need to be part of the discussion.
Money market funds, long viewed as boring, but essential cogs in the financial system, invest primarily in short-term, low-risk securities and seek to maintain a stable $1 per share price. If the value of the underlying assets falls too much, a money market fund "breaks the buck," and shares can no longer trade at $1. Companies, municipalities, and the U.S. government rely on money market funds to help finance their operations.
Money market funds' stable value and ready redeemability enable many retail investors and corporations to use them a lot like bank accounts. Unlike bank accounts, though, they are not usually backed by a government insurance scheme.
In the wake of the failure of Lehman Brothers in 2008, these funds popped up as yet another point of vulnerability in our already weakened financial system. The Reserve Primary Fund, which held a lot of Lehman securities, broke the buck. Investors rapidly ran from the Reserve Fund, as well as other money market funds. The government responded with, among other emergency measures, a hastily cobbled together temporary insurance program.
A more permanent response came in 2010, when the SEC tightened its money market fund rule. The changes sought to make money market funds more liquid, less risky, and easier to manage in the event of a run. The SEC warned that additional, deeper changes - capital requirements, a move away from the stable $1 net asset value, and new limits on redemption - could follow. Some prominent voices from the banking world would prefer the even more fundamental change of forcing money market funds to become FDIC-insured banks.
In assessing the first phase of reform and determining what the next phase should look like, some important principles should be kept in mind. First, we need to reject the assumption that once one product has a government guarantee, every product needs one. Slapping government insurance on one sector after another undermines the financial system's stability by replacing investors' natural inclinations to monitor the keepers of their money with clunky, inflexible regulatory oversight. Investors should have the option of keeping their money in uninsured money market funds, rather than insured bank accounts. This option, of course, comes with the chance of losing some or all of your investment.
A second principle is that the stable $1 share price is a regulatory fiction, so its proponents should bear the burden of justifying it. The run began when market realities cracked this regulatory fiction. Allowing the net asset value to float along with current market prices of the fund's holdings would remind investors that their money is not in a bank account. Fund managers could continue to strive to maintain a stable net asset value and could compete for investor funds based on their ability to do so. Opponents correctly argue that floating the net asset value would be an administrative, tax, and operational hassle, but it is worth exploring ways, short of maintaining the regulatory fiction, to address these issues.
Third, a poorly designed or inadequate capital buffer or insurance requirement for money market funds would be worse than doing nothing at all. It would create a false sense of security by luring people into believing that money market funds have been run-proofed. This fantasy would further decrease the monitoring of these funds and increase the likelihood of a problem going unnoticed until disaster is imminent.
Fourth, because money market funds are so large, constraints on their holdings affect the companies and governments that depend on them for funding. Shortening the permissible tenor of securities in fund portfolios increases reliance on very short term funding, which, as we saw in 2008, can be deadly in a time of crisis.
Finally, new constraints that homogenize money market portfolios could magnify a future crisis. The 2010 rule changes limited the types of securities money market funds can hold. If a security or class of securities that money market funds are allowed to hold suffers a shock, many funds may be forced to sell simultaneously, which will further depress prices.
The question of how to reform money market funds in a manner that will continue to serve investors and the broader economy is a difficult one. As the D.C. advertising campaign suggests, the sponsors and users of these funds have a lot riding on this decision. So do taxpayers, who will end up holding the bag if reforms are poorly designed.