This week the US Securities and Exchange Commission (SEC) has added another set of proposals to its regulatory to do list, this time in the form of new reporting requirements for money market funds. The rules, should they be passed, would require these funds to regularly report their net asset value (NAV) to the regulator, a turnaround from the current situation where these funds are often treated in a similar manner to cash and carry a steady value of US$1 a share. The proposals are likely to prove unpopular with the market as a whole and would entail a data challenge in tracking pricing and valuations data on a monthly basis, as well as impose changes to the way ratings data is used and introduce new stress testing requirements.
First and foremost, the SEC rule would require money market funds to disclose any slight fluctuations around the NAV US$1 figure on a monthly basis with a 60 day gap. The aim of the regulation is to make investors aware of these changes in value, however small, and the regulator has also mooted the idea of scrapping the US$1 figure altogether in favour of a floating rate.
The proposals are a response to the financial crisis and the weaknesses revealed by the Reserve Primary Fund’s “breaking the buck” in September 2008, says the regulator. A money market fund “breaks the buck” when its NAV falls below US$1 per share, meaning investors in that fund will lose money. The SEC’s new rules are therefore intended to increase the resilience of money market funds to economic stresses and reduce the risks of runs on the funds by tightening the maturity and credit quality standards and imposing new liquidity requirements.
SEC chairman Mary Schapiro explains: “These rules will help reduce risks associated with money market funds, so that investor assets are better protected and money market funds can better withstand market crises. The rules also will create a substantial new disclosure regime so that everyone from investors to the SEC itself can better monitor a money market fund’s investments and risk characteristics.”
Funds would need to include in a monthly report to the regulator detailed portfolio schedules in a format that can be used to create an interactive database through which the SEC can “better oversee the activities of money market funds”. The information reported to the SEC would then be available to the public 60 days later. This information would include a money market fund’s “shadow” NAV, or the mark to market value of the fund’s net assets, rather than the stable US$1 NAV at which shareholder transactions occur. Currently, a money market fund’s “shadow” NAV is reported twice a year with a 60 day lag.
This obviously has implications for the funds’ storage and usage of this pricing and valuations data and would require a degree of investment in order to facilitate the production of these reports. Transparency will become an important factor for this data and funds will likely to be compelled to invest in new third party pricing data feeds to further justify any mark to market valuations used.
The new rules would also require money market funds to have a minimum percentage of their assets in highly liquid securities so that those assets can be readily converted to cash to pay redeeming shareholders. Where, currently, there are no minimum liquidity mandates. For all taxable money market funds, at least 10% of assets will need to be in cash, US Treasury securities, or securities that convert into cash within one day. For all money market funds, at least 30% of assets must be in cash, US Treasury securities, certain other government securities with remaining maturities of 60 days or less, or securities that convert into cash within one week, says the regulator.
Moreover, the rules would further restrict the ability of money market funds to purchase illiquid securities by redefining as “illiquid” any security that cannot be sold or disposed of within seven days at carrying value. If, after the purchase, more than 5% of the fund’s portfolio is in illiquid securities, rather than the current limit of 10%, then the use of these illiquid securities will be restricted.
The new proposals would also place new limits on a money market fund’s ability to acquire lower quality (or second tier) securities. They would do this by restricting a fund from investing more than 3% of its assets in these securities, rather than the current limit of 5%. The rules would also restrict a fund from investing more than half of 1% of its assets in second tier securities issued by any single issuer, rather than the current limit of the greater of 1% or US$1 million. Furthermore, these funds would be unable to buy second tier securities that mature in more than 45 days, rather than the current limit of 397 days.
The rules propose to shorten the average maturity limits for money market funds, which the regulator says will help to limit the exposure of funds to certain risks such as sudden interest rate movements. They would do this by restricting the maximum “weighted average life” maturity of a fund’s portfolio to 120 days. According to the SEC, the effect of the restriction is to limit the ability of the fund to invest in long term floating rate securities. The rules would also restrict the maximum weighted average maturity of a fund’s portfolio to 60 days, down from the current limit of 90 days.
New “know your investor” procedures would be introduced that would require funds to hold sufficiently liquid securities to meet foreseeable redemptions. Currently, there are no such requirements. In order to meet this new requirement, funds would need to develop procedures to identify investors whose redemption requests may pose risks for funds. As part of these procedures, funds would need to anticipate the likelihood of large redemptions. This is likely to entail a data challenge in itself, as funds attempt to track counterparty risk in a space with a lack of globally standardised entity data.
Of course, any regulation introduced this year cannot ignore the area of stress testing. To this end, the new rules would require fund managers to examine the fund’s ability to maintain a stable NAV per share in the event of shocks – such as interest rate changes, higher redemptions, and changes in credit quality of the portfolio. The risk data challenge involved in this process has been noted by Reference Data Review previously, when looking at liquidity risk testing in particular, and includes gathering together disparate risk data sets in a coherent manner in a siloed environment.
The proposals would also continue to limit a money market fund’s investment in rated securities to those securities rated in the top two rating categories (or unrated securities of comparable quality). At the same time, the new rules would also continue to require money market funds to perform an independent credit analysis of every security purchased. The SEC indicates that it views the credit rating as a screen on credit quality, but says it can never be the sole factor in determining whether a security is appropriate for a money market fund.
The new rules also aim to improve the way that funds evaluate securities ratings provided by ratings agencies by requiring funds to designate each year at least four agencies whose ratings the fund’s board considers to be reliable. This therefore would permit a fund to disregard ratings by ratings firms that it has not designated, for purposes of satisfying the minimum rating requirements, while promoting competition among these agencies, says the SEC. The rules would also eliminate the current requirement that funds invest only in those asset backed securities that have been rated by a ratings agency.
According to the SEC, mandatory compliance with some of these new rules will be phased in during the year and the final version of thee rules, including compliance dates, will be posted on the SEC website in the near future.