Money market fund reform

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The low interest rate environment and pending reform has caused some investors to question the purpose of investing in money market funds…and rightly so. As such, we thought it would be valuable to address both issues on our blog and offer readers some perspective.

We use money market funds (MM funds) as a place to park cash, until we decide to invest it elsewhere. The advantages of the MM fund is that investors can gain incremental income in this zero rate environment with the ability to view this investment as the equivalent of same day cash. When the Fed does decide to raise rates, the differences will become clear, but at this point the liquidity is more important than the rate.

To put some context to this discussion on pending reform, I’d like to take a look back to September 2008, after the failure of Lehman Brothers, when the largest money fund in the nation “broke the buck” due to its holding of Lehman and some SIV’s (structured investment vehicles) associated with distressed mortgages. During the process, large institutional clients scrambled to get their cash out and caused a “run on the funds,” in this particular fund and other money funds with similar investment parameters. Banks directly involved in the crisis were unable and unwilling to provide liquidity to the funds that were seeing unprecedented outflows of assets.

In order to put some stability into the market, the SEC and other regulators had to essentially insure the assets and assure the public that their cash would be safe in these funds. At the same time, boards of these funds put “gates” up to stem the outflows of cash and limited the investor to how much they could take out during each quarter. These unprecedented actions ultimately succeeded in preserving the investors’ cash, but it highlighted some serious flaws in the system. This brings us to where we are today with Money Market Reforms.

After much back and forth between the policy makers and the fund managers, the SEC has decided to implement a series of reforms that go into effect in 2016. These reforms are largely directed on institutional clients that could front run the retail client and leave them holding the bag after the fog clears. By separating the institutional client from the retail client, the regulators believe they can protect the retail client from large losses. Although these regulations sound good on the surface, it still remains to be seen if they will be effective amid another crisis.

While there have been reforms to address the liquidity and prevent a run on the funds, the fundamental risks of investing in these funds have not changed. The retail funds will maintain the ability to mark these funds at a constant $1 net asset value (NAV) but, just like in 2008, there is a chance the assets in the fund can depreciate. They have never been risk-free and should not be viewed as such.

The new money fund regulations will not affect the $1 constant NAV of retail clients, but the underlying risks of investing in these funds, from a credit standpoint remain unchanged. If rates rise, the value of these funds, along with almost all other fixed income instrument will decrease, but the yields the client receives should increase in conjunction.

 

Nathan Boxx, Bradley Newman, Jason Seltzer

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