Mutual Fund Industry Battles Back Against FSOC Reform Efforts

WASHINGTON — Firms managing some of the largest money market mutual funds in the U.S. are sending one clear message to the Financial Stability Oversight Council: Leave us alone.

In more than a hundred comment letters, industry representatives often "strongly" objected to all three of the council's proposals for reform, arguing they would significantly reduce the size of the industry and potentially create further systemic risk.

But some also went further, claiming the FSOC was acting inappropriately in pursuing reform in the first place, saying that was the sole jurisdiction of the Securities and Exchange Commission.

"The SEC is the only agency with the appropriate statutory authority to recommend additional MMF reforms," wrote William McNabb, chairman and chief executive for Vanguard, which invests roughly $200 billion on behalf of shareholders into money market funds. "FSOC should not make specific MMF reform recommendations to the SEC at this time, but should permit the agency, as the primary regulator of the capital markets and MMFs, to proceed with its statutory authority to consider reasonable reforms narrowly tailored to address FSOC's concerns, if they are supported by facts."

Fidelity Investments, the largest money market mutual fund provider in the U.S. that manages more than $430 billion in money fund assets, also questioned whether the FSOC had appropriately provided justification to use its Dodd-Frank authority to make recommendations to the SEC.

"Respectfully, Fidelity's message to the FSOC is simple: take no further action on MMFs at this time," Scott Goebel, senior vice president and deputy general counsel for Fidelity wrote in a Feb. 14 letter. "The SEC is the regulator with the authority and expertise to consider whether and how to adopt additional reforms on MMFs. Furthermore, the alternatives the FSOC has proposed are not workable, and the FSOC has failed to meet the procedural and substantive requirements as well as the policy justifications that are necessary to exercise its authority under Sec. 120 and make the proposed recommendations."

Regulators from across a range of different agencies, including the heads of all 12 Federal Reserve banks, have expressed concerns that money market mutual funds pose a systemic risk without significant structural reforms. Regulators worry that the funds are particularly susceptible to runs because investors are not necessarily aware of the market risks associated with them. They also argue that a stable net asset value creates a "first mover" advantage for early redeemers if there is a market crisis.

In November, the FSOC released three proposed recommendations to reform the industry. The move by the council — utilizing its authority under Dodd-Frank — was intended to break through a logjam at the SEC, where former Chairman Mary Schapiro had been unable to win board approval to move forward with the agency's own reform plan (Schapiro supported the FSOC's move).

In its proposal, the FSOC said funds could be required to float their net asset values; required to hold a capital buffer in order to absorb losses; or required to keep a buffer of 3% to absorb losses combined with other measures to bolster resiliency.

But in comment letters, stakeholders said all three recommendations have fatal flaws.

"Each of the three recommendations would significantly reduce the appeal of MMFs, which would curtail the size of the industry," said McNabb. "We believe regulators should give more consideration to reform options that could reasonably address their more pressing concerns while retaining the key features of MMFs, particularly for the retail investor."

Stakeholders also said there was no pressing need for reform because past efforts had already addressed the risks raised by regulators.

"Fidelity believes that the 2010 SEC reforms have made all types of MMFs more resilient, and that additional reform is not necessary," said Goebel. "There are vast differences in portfolio composition, liquidity, and risk profiles across the different types of MMFs. Inexplicably, the FSOC failed to consider these varying levels of risk within each category of MMFs and would apply their proposed recommendations to the entire MMF industry, with very limited exceptions. This is not a prudent and balanced approach to reform, and risks imposing excessive costs on the economy and investors."

Commenters specifically objected to the structural reforms proposed by the council, saying that additional reforms should be limited only to those funds that invest primarily in securities issued by banks, other financial institutions, or operating companies. Those funds, commonly known as "prime money market funds," are subject to the runs that regulators are concerned about.

They urged regulators to take a narrowly tailored approach, rather than provide additional regulation to a wider swath of funds that would include Treasury, government, tax-exempt, or retail prime MMFs.

"Only prime funds suffered runs on their assets and posed a systemic risk to the wider markets during the crisis," wrote Patricia Maleski, president of JPMorgan Mutual Funds, one of the world's largest MMF managers in the world overseeing $412 billion in fund assets, in a Jan. 14 letter. "Government and Treasury funds were a safe haven for investors leaving prime funds during the 2008 crisis, and government and Treasury debt enjoyed excellent liquidity across the spectrum."

While some stakeholders argued that regulators should differentiate between institutional and retail funds, JP Morgan's Maleski argued that there is "no difference in terms of exposure to credit risk between these classes of investors. Retail funds are not immune to a run on their assets, and so should be subject to the same regulatory protections."

Commenters also tackled other flaws they saw in the council's proposed recommendations.

For example, industry participants argued against using a floating NAV due to accounting, tax treatment, and operational considerations that would need to be taken into consideration.

"A requirement for MMFs to float NAVs would fundamentally reshape the product and its ability to deliver these core benefits to investors," said Maleski. "Floating the NAV has the benefits of providing transparency of market values to investors and reducing the possibilities for transaction activity that results in non-equitable treatment across all shareholders; however, it will likely give rise to a number of consequences for investors and market participants that should be examined rigorously and addressed in order to arrive at a constructive solution."

Broker-dealer and investment adviser firm Edward D. Jones & Co., which provides services to more than seven million clients, raised specific concerns that the reforms would have on individual investors who have long used money market funds as a key investment product.

"We believe any proposed reforms should seek to maintain money market mutual fund features that are critical to the needs of individual investors," wrote James Weddle, managing partner for Edward Jones, in a Feb. 15 letter. "Specifically, we are concerned that some aspects of the proposed recommendations, notably a floating NAV and delayed redemptions, would so fundamentally change the character and utility of money market mutual funds as to render them no longer attractive or useful to individual investors."

Using a floating net asset value, or NAV, would require individual investors and others to calculate taxable gains and losses on their money market funds that would be incurred because of market fluctuations on even minimal purchases or sales within the fund, Weddle said.

"Indeed, it would be incongruous for individual investors to have to consider the daily price fluctuations in their money market account prior to writing a check, making a purchase with their debit card or making a cash withdrawal at the ATM machine," said Weddle.

That concern was shared by others, including UBS Global Asset Management Inc., which argued that the council's proposal to require money market funds to float their NAVs would ultimately increase systemic risk.

A floating NAV would drive investors toward "higher yielding, short-term bond funds, which also have floating NAVs, increasing investors' interest rate and credit risk," wrote Robert Sabatino, managing director of the head of U.S. Taxable Money Markets for UBS.

Market participants also dislike the council's second option, calling for MMFs to hold capital. While they saw some benefits to this approach, which entails a first loss reserve that could be used in case of liquidation or day-to-day fluctuations in market-based values, they also saw several challenges. Those included the difficulty in raising capital in the current low-interest rate environment.

"Capital requirements can create barriers to entry," said Maleski. "Investors who delay their share purchases would receive all the benefits of the reserve but incur none of its costs. With regard to a dedicated amount of sponsor support, sponsors without access to capital would find it difficult to enter or remain in the market."

Buffers, others noted, would also inaccurately provide investors with a sense of security.

"Capital buffers are also likely to carry unintended consequences, as some funds may purchase riskier, higher-yielding securities to compensate for the reduction in yield," Vanguard's McNabb wrote. "As a result, capital buffers are likely to provide investors with a false sense of security."

"FSOC and SEC should not underestimate the unintended effects of a capital buffer. At the end of the day, capital buffers reduce total returns for investors in MMFs. A permanent, built-in reduction to returns may result in funds purchasing investments that are higher-yielding and more prone to default."

A third idea floated by the council was a minimum account balance at risk or other forms of holdbacks that could help to slow the rate of a run once it had been triggered. Such an approach, some in the industry argued, could introduce other complications, which would likely significantly reduce the demand of MMFs and potentially accelerate the risk of runs.

"Based on our own investor discussions, it is also likely that such a structure would encourage a heightened level of restlessness across the investor base and thereby enhance the likelihood of a run," said Maleski. "If a portion of investor balances were held back for 30 days and subordinated, investors will seek to anticipate the possibility of systemic risk causing them to suffer an economic loss in their holdback position and attempt to request their full balance well ahead of the anticipated market event, resulting in a serious of 'self-induced' runs triggered by market headlines or slight dips in market sentiment."

Stakeholders suggested an alternative that would impose liquidity-triggered redemption gates and fees on MMFs during times of market stress.

"If regulators' ultimate goal is to stop significant redemptions on the types of funds that they have identified as susceptible to runs (prime funds owned primarily by large, institutional investors), then regulators should consider redemption gates and/or fees, which are the only effective means to achieve that goal," Goebel wrote.

Under this approach, in the event a MMF's weekly liquidity level fell below a set threshold, the fund would institute a temporary restriction that would automatically suspend redemptions for a period of time for a fund to restore its health. If the fund's weekly liquidity level continued to fall, shareholders could have the option to redeem by paying a fixed redemption fee of 1%.

"After a MMF has been gated (temporarily closed) during a period of market stress, it would no longer be subject to immediate redemption pressure, unlike a fund that remains open," Goebel wrote. "Because the gated fund would not be forced to sell assets to meet redemptions, it would not be contributing to potential disruption of the short-term markets. Moreover, as the fund builds liquidity by allowing its holdings to mature, it would act as a market stabilizing force by reinvesting the proceeds of its maturities over a horizon consistent with its targeted re-opening date."

BlackRock, one of the leading asset management firms, overseeing roughly $3.7 trillion on behalf of institutional and individual clients globally, similarly proposed an alternative solution, which would include a stable net asset value fund with a standby liquidity fee that would preserve the benefits of money funds as a liquidity management tool for investors.

"We recommend that a fee of 1% be imposed on withdrawals occurring after the gate has been put in place," wrote Barbara Novick, vice chairman of BlackRock. "This rate has been chosen to create incentives for investors not to run. The SLF rate is likely to be in excess of the cost of selling securities to raise cash to meet redemptions, and the excess would remain in the fund and accrue to the benefit of the remaining shareholders."

Taking such an approach, Novick wrote, clients would be given a choice in a crisis and those that required liquidity to meet payments or those who wanted their cash could get it by paying a fee for that access.

"Those investors choosing to access their cash will pay a fee which is comparable to the situation they would face if they owned another instrument and decided they must sell into a distressed market situation," Novick wrote. "On the other hand, if a client can wait for their liquidity, they are not disadvantaged by remaining in the fund."