
[Federal Register Volume 75, Number 215 (Monday, November 8, 2010)]
[Notices]
[Pages 68636-68654]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-28177]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. IC-29497; File No. 4-619]


President's Working Group Report on Money Market Fund Reform

AGENCY: Securities and Exchange Commission.

ACTION: Request for comment.

-----------------------------------------------------------------------

SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is seeking comment on the options discussed in the report 
presenting the results of the President's Working Group on Financial 
Markets' study of possible money market fund reforms. Public comments 
on the options discussed in this report will help inform consideration 
of reform proposals addressing money market funds' susceptibility to 
runs.

DATES: Comments should be received on or before January 10, 2011.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/other.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number 4-619 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number 4-619. This file number 
should

[[Page 68637]]

be included on the subject line if e-mail is used. To help us process 
and review your comments more efficiently, please use only one method. 
The Commission will post all comments on the Commission's Internet Web 
site (http://www.sec.gov/rules/other.shtml). Comments are also 
available for Web site viewing and printing in the Commission's Public 
Reference Room, 100 F Street, NE., Washington, DC 20549, on official 
business days between the hours of 10 am and 3 pm. All comments 
received will be posted without change; we do not edit personal 
identifying information from submissions. You should submit only 
information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Daniele Marchesani or Sarah ten 
Siethoff at (202) 551-6792, Division of Investment Management, 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549-8549.

SUPPLEMENTARY INFORMATION:

I. The President's Working Group Report

    Following the recommendation in the U.S. Department of the 
Treasury's 2009 paper on Financial Regulatory Reform: A New Foundation, 
the President's Working Group on Financial Markets (``PWG'') conducted 
a study of possible reforms that might mitigate money market funds' 
susceptibility to runs.\1\ The results of this study are included in 
the report issued on October 21, 2010 and attached to this release as 
an Appendix (the ``Report'').\2\
---------------------------------------------------------------------------

    \1\ The members of the PWG include the Secretary of the Treasury 
Department (as chairman of the PWG), the Chairman of the Board of 
Governors of the Federal Reserve System, the Chairman of the SEC, 
and the Chairman of the Commodity Futures Trading Commission.
    \2\ The Report is also available at http://treas.gov/press/releases/docs/10.21%20PWG%20Report%20Final.pdf.
---------------------------------------------------------------------------

    The Report expresses support for the new rules regulating money 
market funds that the Commission approved last February.\3\ These new 
rules seek to better protect money market fund investors in times of 
financial market turmoil and lessen the possibility that money market 
funds will not be able to withstand stresses similar to those 
experienced in 2007 and 2008.\4\ When we adopted these rules, we 
recognized that they were a first step to addressing regulatory 
concerns as the events of 2007 and 2008 raised the question of whether 
further, more fundamental changes to the regulatory structure governing 
money market funds may be warranted.\5\
---------------------------------------------------------------------------

    \3\ Money Market Fund Reform, Investment Company Act Release No. 
29132 (Feb. 23, 2010) [75 FR 10060 (Mar. 4, 2010)] (``SEC Adopting 
Release'').
    \4\ The new rules further limit the credit, liquidity, and 
interest rate risks money market funds may assume and require fund 
managers to stress test their portfolios against potential economic 
shocks. They also require money market funds to improve their 
disclosure to investors and the Commission and provide a means to 
wind down the operations of a fund that ``breaks the buck'' or 
suffers a run, in an orderly way that is fair to the fund's 
investors and reduces the risk of market losses that could spread to 
other funds. For a discussion of the market stresses experienced by 
money market funds in 2007 and 2008, see Money Market Fund Reform, 
Investment Company Act Release No. 28807 (June 30, 2009) [74 FR 
32688 (July 8, 2009)], at section II.D (``SEC Proposing Release'').
    \5\ See SEC Adopting Release, supra note 3, at section I. In 
proposing the new rules, we had requested comment on additional, 
more fundamental regulatory changes, including several of those 
discussed in the Report. See SEC Proposing Release, supra note 4, at 
section III. Following the adoption of the new rules, the Commission 
has continued to explore more significant changes in light of the 
comments received on that release and through our staff's work 
within the PWG.
---------------------------------------------------------------------------

    The Report identifies the features that make money market funds 
susceptible to runs as well as the systemic implications of the run on 
prime money market funds that occurred in September 2008. The Report 
states that the Commission's new rules alone could not be expected to 
prevent a run of the type experienced in September 2008. Accordingly, 
the Report outlines possible reforms that could supplement the new 
rules we adopted and, individually or in combination, further reduce 
money market funds' susceptibility to runs and the related systemic 
risk. Some of the measures discussed in the Report could be implemented 
by the Commission under our existing statutory authority; others would 
require new legislation, coordination by multiple government agencies, 
or the creation of new private entities.\6\
---------------------------------------------------------------------------

    \6\ In particular, the Report notes that reforms may be needed 
to avoid migration of institutional money market fund assets into 
unregulated or less regulated money market investment vehicles. 
Without new restrictions on such investment vehicles, money market 
reform may motivate some investors to shift assets into money market 
fund substitutes that may pose greater systemic risk than registered 
money market funds. See section 3.h of the Report.
---------------------------------------------------------------------------

II. Request for Comment

    The Commission requests comment on the Report. Comments received 
will better enable the Commission and the newly-established Financial 
Stability Oversight Council (which will be taking over the work of the 
PWG in this area) to consider the options discussed in this Report to 
identify those most likely to materially reduce money market funds' 
susceptibility to runs and to pursue their implementation. As the 
Report states, we anticipate that following the comment period a series 
of meetings will be held in Washington, DC with various stakeholders, 
interested persons, experts, and regulators to discuss the options in 
the Report.
    We request comments on the options described in the Report both 
individually and in combination. Commenters should address the 
effectiveness of the options in mitigating systemic risks associated 
with money market funds, as well as their potential impact on money 
market fund investors, fund managers, issuers of short-term debt and 
other stakeholders. We also are interested in comments on other issues 
commenters believe are relevant to further money market fund reform, 
including other approaches for lessening systemic risk not identified 
in the Report. We urge commenters to submit empirical data and other 
information in support of their comments.

     Dated: November 3, 2010.

    By the Commission.
Elizabeth M. Murphy,
Secretary.
BILLING CODE 8011-01-P

[[Page 68638]]

[GRAPHIC] [TIFF OMITTED] TN08NO10.038

BILLING CODE 8011-01-C

[[Page 68639]]

Table of Contents

Executive Summary

1. Introduction and Background
    a. Money Market Funds
    b. MMFs' Susceptibility to Runs
    c. MMFs in the Recent Financial Crisis
2. The SEC's Changes to the Regulation of MMFs
    a. SEC Regulatory Changes
    b. Need for Further Reform To Reduce Susceptibility to Runs
3. Policy Options for Further Reducing the Risks of Runs on MMFs
    a. Floating Net Asset Values
    b. Private Emergency Liquidity Facility for MMFs
    c. Mandatory Redemptions in Kind
    d. Insurance for MMFs
    e. A Two-Tier System of MMFs, With Enhanced Protections for 
Stable NAV MMFs
    f. A Two-Tier System of MMFs, With Stable NAV MMFs Reserved for 
Retail Investors
    g. Regulating Stable NAV MMFs as Special Purpose Banks
    h. Enhanced Constraints on Unregulated MMF Substitutes

Executive Summary

    Several key events during the financial crisis underscored the 
vulnerability of the financial system to systemic risk. One such event 
was the September 2008 run on money market funds (MMFs), which began 
after the failure of Lehman Brothers Holdings, Inc., caused significant 
capital losses at a large MMF. Amid broad concerns about the safety of 
MMFs and other financial institutions, investors rapidly redeemed MMF 
shares, and the cash needs of MMFs exacerbated strains in short-term 
funding markets. These strains, in turn, threatened the broader 
economy, as firms and institutions dependent upon those markets for 
short-term financing found credit increasingly difficult to obtain. 
Forceful government action was taken to stop the run, restore investor 
confidence, and prevent the development of an even more severe 
recession. Even so, short-term funding markets remained disrupted for 
some time.
    The Treasury Department proposed in its Financial Regulatory 
Reform: A New Foundation (2009), that the President's Working Group on 
Financial Markets (PWG) prepare a report on fundamental changes needed 
to address systemic risk and to reduce the susceptibility of MMFs to 
runs. Treasury stated that the Securities and Exchange Commission's 
(SEC) rule amendments to strengthen the regulation of MMFs--which were 
in development at the time and which subsequently have been adopted--
should enhance investor protection and mitigate the risk of runs. 
However, Treasury also noted that those rule changes could not, by 
themselves, be expected to prevent a run on MMFs of the scale 
experienced in September 2008. While suggesting a number of areas for 
review, Treasury added that the PWG should consider ways to mitigate 
possible adverse effects of further regulatory changes, such as the 
potential flight of assets from MMFs to less regulated or unregulated 
vehicles.
    This report by the PWG responds to Treasury's call.\7\ The PWG 
undertook a study of possible further reforms that, individually or in 
combination, might mitigate systemic risk by complementing the SEC's 
changes to MMF regulation. The PWG supports the SEC's recent actions 
and agrees with the SEC that more should be done to address MMFs' 
susceptibility to runs. This report details a number of options for 
further reform that the PWG requests be examined by the newly 
established Financial Stability Oversight Council (FSOC). These options 
range from measures that could be implemented by the SEC under current 
statutory authorities to broader changes that would require new 
legislation, coordination by multiple government agencies, and the 
creation of new private entities. For example, a new requirement that 
MMFs adopt floating net asset values (NAVs) or that large funds meet 
redemption requests in kind could be accomplished by SEC rule 
amendments. In contrast, the introduction of a private emergency 
liquidity facility, insurance for MMFs, conversion of MMFs to special 
purpose banks, or a two-tier system of MMFs that might combine some of 
the other measures likely would involve a coordinated effort by the 
SEC, bank regulators, and financial firms.
---------------------------------------------------------------------------

    \7\ The PWG (established by Executive Order 12631) is comprised 
of the Secretary of the Treasury (who serves as its Chairman), the 
Chairman of the Federal Reserve Board of Governors, the Chairman of 
the Securities and Exchange Commission, and the Chairman of the 
Commodity Futures Trading Commission.
---------------------------------------------------------------------------

    Importantly, this report also emphasizes that the efficacy of the 
options presented herein would be enhanced considerably by the 
imposition of new constraints on less regulated or unregulated MMF 
substitutes, such as offshore MMFs, enhanced cash funds, and other 
stable value vehicles. Without new restrictions on such investment 
vehicles, which would require legislation, new rules that further 
constrain MMFs may motivate some investors to shift assets into MMF 
substitutes that may pose greater systemic risk than MMFs.
    The PWG requests that the FSOC consider the options discussed in 
this report to identify those most likely to materially reduce MMFs' 
susceptibility to runs and to pursue their implementation. To assist 
the FSOC in any analysis, the SEC, as the regulator of MMFs, will 
solicit public comments, including the production of empirical data and 
other information in support of such comments. A notice and request for 
comment will be published in the near future. Following a comment 
period, a series of meetings will be held in Washington, DC with 
various stakeholders, interested persons, experts, and regulators.

MMFs Are Susceptible to Runs

    MMFs are mutual funds. They are investment vehicles that act as 
intermediaries between shareholders who desire liquid investments and 
borrowers who seek term funding. With nearly $3 trillion in assets 
under management, MMFs are important providers of credit to businesses, 
financial institutions, and governments. In addition, these funds are 
significant investors in some short-term funding markets.
    Like other mutual funds, MMFs are regulated under the Investment 
Company Act of 1940 (ICA). In addition to ICA requirements for all 
mutual funds, MMFs must comply with SEC rule 2a-7, which permits these 
funds to maintain a stable net asset value (NAV) per share, typically 
$1. However, if the mark-to-market per-share value of a fund's assets 
falls more than one-half of 1 percent (to below $0.995), the fund must 
reprice its shares, an event colloquially known as ``breaking the 
buck.''
    The events of September 2008 demonstrated that MMFs are susceptible 
to runs. In addition, those events proved that runs on MMFs not only 
harm fund shareholders, but may also cause severe dislocations in 
short-term funding markets that curtail short-term financing for 
companies and financial institutions and that ultimately result in a 
decline in economic activity. Thus, reducing the susceptibility of MMFs 
to runs and mitigating the effects of possible runs are important 
components of the overall policy goals of decreasing and containing 
systemic risks.
    MMFs are vulnerable to runs because shareholders have an incentive 
to redeem their shares before others do when there is a perception that 
the fund might suffer a loss. Several features of MMFs, their sponsors, 
and their investors contribute to this incentive. For example, although 
a stable, rounded $1 NAV fosters an expectation of safety, MMFs are 
subject to credit, interest-rate, and liquidity risks. Thus, when a 
fund

[[Page 68640]]

incurs even a small loss because of those risks, the stable, rounded 
NAV may subsidize shareholders who choose to redeem at the expense of 
the remaining shareholders. A larger loss that causes a fund's share 
price to drop below $1 per share (and thus break the buck) may prompt 
more substantial sudden, destabilizing redemptions. Moreover, although 
the expectations of safety fostered by the stable, rounded $1 NAV 
suggest parallels to an insured demand deposit account, MMFs have no 
formal capital buffers or insurance to prevent NAV declines; MMFs 
instead have relied historically on discretionary sponsor capital 
support to maintain stable NAVs. Accordingly, uncertainty about the 
availability of such support during crises may contribute to runs. 
Finally, because investors have come to view MMFs as extremely safe 
vehicles that meet all withdrawal requests on demand (and that are, in 
this sense, similar to banks), MMFs have attracted highly risk-averse 
investors who are particularly prone to flight when they perceive the 
possibility of a loss. These features likely mutually reinforce each 
other in times of crisis.

The SEC's New Rules

    In January 2010, the SEC adopted new rules for MMFs in order to 
make these funds more resilient and less likely to break the buck. The 
regulatory changes that mitigate systemic risks fall into three 
principal categories. First, the new rules enhance risk-limiting 
constraints on MMF portfolios by introducing new liquidity 
requirements, imposing additional credit-quality standards, and 
reducing the maximum allowable weighted average maturity of funds' 
portfolios. Funds also are required to stress test their ability to 
maintain a stable NAV. Second, the SEC's new rules permit a fund that 
is breaking the buck to suspend redemptions promptly and liquidate its 
portfolio in an orderly manner to limit contagion effects on other 
funds. Third, the new rules place more stringent constraints on 
repurchase agreements that are collateralized with private debt 
instruments rather than government securities.

The Need for Further Measures

    The SEC's new rules make MMFs more resilient and less risky and 
therefore reduce the likelihood of runs on MMFs, increase the size of 
runs that MMFs can withstand, and mitigate the systemic risks they 
pose. However, the SEC's new rules address only some of the features 
that make MMFs susceptible to runs, and more should be done to address 
systemic risk and the structural vulnerabilities of MMFs to runs. 
Indeed, the Chairman of the SEC characterized the new rules as ``a 
first step'' in strengthening MMFs, and Treasury's Financial Regulatory 
Reform: A New Foundation (2009) anticipated that measures taken by the 
SEC ``should not, by themselves, be expected to prevent a run on MMFs 
of the scale experienced in September 2008.''
    Mitigating the risk of runs on MMFs is especially important because 
the events of September 2008 may have created an expectation that, in a 
future crisis, the government may provide support for MMFs at minimal 
cost in order to minimize harm to MMF investors, short-term funding 
markets, and the economy. Persistent expectations of unpriced 
government support distort incentives in the MMF industry and pricing 
in short-term funding markets, as well as heighten the systemic risk 
posed by MMFs. It is thus essential that MMFs be required to 
internalize fully the costs of liquidity or other risks associated with 
their operation.
    In formulating reforms for MMFs, policymakers should aim primarily 
at mitigating systemic risk and containing the contagious effect that 
strains at individual MMFs can have on other MMFs and on the broad 
financial system. Importantly, preventing any individual MMF from ever 
breaking the buck is not a practical policy objective--though the new 
SEC rules for MMFs should help ensure that such events remain rare and 
thus constitute a limited means of containing systemic risk.

Policy Options

    The policy options discussed in this report may help further 
mitigate the susceptibility of MMFs to runs. Some of these options may 
be adopted by the SEC under its existing authorities. Others would 
require legislation and action by multiple government agencies and the 
MMF industry.
    (a) Floating net asset values. A stable NAV has been a key element 
of the appeal of MMFs to investors, but a stable, rounded NAV also 
heightens funds' vulnerability to runs. Moving to a floating NAV would 
help remove the perception that MMFs are risk-free and reduce 
investors' incentives to redeem shares from distressed funds. However, 
the elimination of the stable NAV for MMFs would be a dramatic change 
for a nearly $3 trillion asset-management sector that has been built 
around the stable share price. Such a change may have several 
unintended consequences, including: (i) Reductions in MMFs' capacity to 
provide short-term credit due to lower investor demand; (ii) a shift of 
assets to less regulated or unregulated MMF substitutes such as 
offshore MMFs, enhanced cash funds, and other stable value vehicles; 
and (iii) unpredictable investor responses as MMF NAVs begin to 
fluctuate more frequently.
    (b) Private emergency liquidity facilities for MMFs. The liquidity 
risk of MMFs contributes importantly to their vulnerability to runs, 
and an external liquidity backstop to augment the SEC's new liquidity 
requirements for MMFs would help mitigate this risk. Such a backstop 
could buttress MMFs' ability to withstand outflows, internalize much of 
the liquidity protection costs for the MMF industry, offer efficiency 
gains from risk pooling, and reduce contagion effects. A liquidity 
facility would preserve fund advisers' incentives for not taking 
excessive risks because it would not protect funds from capital losses. 
As such, a liquidity facility alone may not prevent broader runs on 
MMFs triggered by concerns about widespread credit losses. Importantly, 
significant capacity, structure, pricing, and operational hurdles would 
have to be overcome to ensure that such a facility would be effective 
during crises, that it would not unduly distort incentives, and that it 
would not favor certain types of MMF business models.
    (c) Mandatory redemptions in kind. When investors make large 
redemptions from MMFs, they may impose liquidity costs on other 
shareholders in the fund by forcing MMFs to sell assets in an untimely 
manner. A requirement that MMFs distribute large redemptions in kind, 
rather than in cash, would force these redeeming shareholders to bear 
their own liquidity costs and thus reduce the incentive to redeem. 
Depending on whether redeeming shareholders immediately sell the 
securities received, redemptions in kind may still generate market 
effects. Moreover, mandating redemptions in kind could present some 
operational and policy challenges. The SEC, for example, would have to 
make key judgments regarding when a fund must redeem in kind and how 
funds would fairly distribute portfolio securities.
    (d) Insurance for MMFs. Treasury's Temporary Guarantee Program for 
Money Market Funds helped slow the run on MMFs in September 2008, and 
some form of insurance for MMF shareholders might be helpful in 
mitigating the risk of runs in MMFs. Unlike a private liquidity 
facility, insurance would limit credit losses to shareholders, so 
appropriate risk-based pricing would be critical in preventing 
insurance from distorting incentives,

[[Page 68641]]

but such pricing might be difficult to achieve in practice. The 
appropriate scope of coverage also presents a challenge; unlimited 
coverage would likely cause large shifts of assets from the banking 
sector to MMFs, but limited insurance might do little to reduce 
institutional investors' incentives to run from distressed MMFs. The 
optimal form for insurance--whether it would be private, public, or a 
mix of the two--is also uncertain, particularly given the recent 
experience with private financial guarantees.
    (e) A two-tier system of MMFs with enhanced protection for stable 
NAV funds. Reforms aimed at reducing MMFs' susceptibility to runs may 
be particularly effective if they permit investors to select the types 
of MMFs that best balance their appetite for risk and their preference 
for yield. Policymakers could allow two types of MMFs: Stable NAV 
funds, which would be subject to enhanced protections such as, for 
example, required participation in a private liquidity facility or 
enhanced regulatory requirements; and floating NAV funds, which would 
have to comply with certain, but not all, rule 2a-7 restrictions (and 
which would presumably offer higher yields). Because this two-tier 
system would permit stable NAV funds to continue to be available, it 
would reduce the likelihood of a substantial decline in demand for MMFs 
and large-scale shifts of assets toward unregulated vehicles. At the 
same time, the forms of protection encompassed by such a system would 
mitigate the risks associated with stable NAV funds. It would also 
avoid problems that might be encountered in transitioning the entire 
MMF industry to a floating NAV. Moreover, during a crisis, a two-tier 
system might prevent large shifts of assets out of MMFs--and a 
reduction in credit supplied by the funds--if investors simply shift 
assets from riskier floating NAV funds toward safer (because of the 
enhanced protections) stable NAV funds. However, implementation of such 
a two-tier system would present the same challenges as the introduction 
of any individual enhanced protections (such as mandated access to a 
private emergency liquidity facility) that would be required for stable 
NAV funds, and the effectiveness of a two-tier system would depend on 
investors' understanding the risks associated with each type of fund.
    (f) A two-tier system of MMFs with stable NAV MMFs reserved for 
retail investors. Another approach to the two-tier system already 
described could distinguish funds by investor type: Stable NAV MMFs 
could be made available only to retail investors, who could choose 
between stable NAV and floating NAV funds, while institutional 
investors would be restricted to floating NAV funds. The run on MMFs in 
September 2008 was almost exclusively due to redemptions from prime 
MMFs by institutional investors. Such investors typically have 
generated greater cash-flow volatility for MMFs than retail investors 
and have been much quicker to redeem MMF shares from stable NAV funds 
opportunistically. Hence, this approach would mitigate risks associated 
with a stable NAV by addressing the investor base of stable NAV funds 
rather than by mandating other types of enhanced protections for those 
funds. Such a system also would protect the interests of retail 
investors by reducing the likelihood that a run might begin in 
institutional MMFs (as it did in September 2008) and spread to retail 
funds, while preserving the original purpose of MMFs, which was to 
provide retail investors with cost-effective, diversified investments 
in money market instruments. This approach would require the SEC to 
define who would qualify as retail and institutional investors, and 
distinguishing those categories will present challenges. In addition, a 
prohibition on sales of stable NAV MMFs shares to institutional 
investors may have several of the same unintended consequences as a 
requirement that all MMFs adopt floating NAVs (see option (a) in this 
section).
    (g) Regulating stable NAV MMFs as special purpose banks. Functional 
similarities between MMF shares and bank deposits, as well as the risk 
of runs on both, provide a rationale for requiring stable NAV MMFs to 
reorganize as special purpose banks (SPBs) subject to banking oversight 
and regulation. As banks, MMFs could have access to government 
insurance and lender-of-last-resort facilities. An advantage of such a 
reorganization could be that it uses a well-understood regulatory 
framework for the mitigation of systemic risk. But while the conceptual 
basis for this option is fairly straightforward, its implementation 
might take a broad range of forms and would probably require 
legislation together with interagency coordination. An important hurdle 
for successful conversion of MMFs to SPBs may be the very large amounts 
of equity necessary to capitalize the new banks. In addition, to the 
extent that deposits in the new SPBs would be insured, the potential 
government liabilities through deposit insurance would be increased 
substantially, and the development of an appropriate pricing scheme for 
such insurance would present some of the same challenges as the pricing 
of deposit insurance. More broadly, the possible interactions between 
the new SPBs and the existing banking system would have to be studied 
carefully by policymakers.
    (h) Enhanced constraints on unregulated MMF substitutes. New 
measures intended to mitigate MMF risks may also reduce the appeal of 
MMFs to many investors. While it is likely that some (particularly 
retail) investors may move their assets from MMFs to bank deposits if 
regulation of MMFs becomes too burdensome and meaningfully reduces MMF 
returns, others may be motivated to shift assets to unregulated funds 
with stable NAVs, such as offshore MMFs, enhanced cash funds, and other 
stable value vehicles. Such funds, which typically hold assets similar 
to those held by MMFs, are vulnerable to runs but are less transparent 
and less constrained than MMFs, so their growth would likely pose 
systemic risks. Hence, effective mitigation of this risk may require 
policy reforms targeting regulatory arbitrage. Reforms of this type 
generally would require legislation and action by the SEC and other 
agencies.
1. Introduction and Background
a. Money Market Funds
    MMFs are mutual funds that offer individuals, businesses, and 
governments a convenient and cost-effective means of pooled investing 
in money market instruments. MMFs provide an economically important 
service by acting as intermediaries between shareholders who desire 
liquid investments, often for cash management, and borrowers who seek 
term funding.
    With nearly $3 trillion in assets under management, MMFs are 
important providers of credit to businesses, financial institutions, 
and governments. Indeed, these funds play a dominant role in some 
short-term credit markets. For example, MMFs own almost 40 percent of 
outstanding commercial paper, roughly two-thirds of short-term state 
and local government debt, and significant portions of outstanding 
short-term Treasury and federal agency securities.
    Like other mutual funds, MMFs are regulated under the Investment 
Company Act of 1940 (ICA). In addition to the requirements applicable 
to other funds under the ICA, MMFs must comply with rule 2a-7, which 
permits these funds to maintain a ``stable'' net

[[Page 68642]]

asset value (NAV) per share, typically $1, through the use of the 
``amortized cost'' method of valuation. Under this method, securities 
are valued at acquisition cost, with adjustments for amortization of 
premium or accretion of discount, instead of at fair market value. To 
prevent substantial deviations between the $1 share price and the mark-
to-market per-share value of the fund's assets (its ``shadow NAV''), a 
MMF must periodically compare the two. If there is a difference of more 
than one-half of 1 percent (or $0.005 per share), the fund must re-
price its shares, an event colloquially known as ``breaking the buck.''
    Historically, the stable NAV has played an important role in 
distinguishing MMFs from other mutual funds and in facilitating the use 
of MMFs as cash management vehicles. Rule 2a-7 also imposes credit-
quality, maturity, and diversification requirements on MMF portfolios 
designed to ensure that the funds' investing remains consistent with 
the objective of maintaining a stable NAV. A MMF's $1 share price is 
not guaranteed through any form of deposit or other insurance, or 
otherwise--indeed, MMF prospectuses must state that shares can lose 
value. However, by permitting amortized cost valuation, rule 2a-7 
affords MMFs price stability under normal market conditions.
    MMFs pursue a range of investment objectives, with corresponding 
differences in portfolio composition. For example, tax-exempt MMFs 
purchase short-term municipal securities and offer tax-exempt income to 
fund shareholders, while Treasury-only MMFs hold only obligations of 
the U.S. Treasury. In contrast, prime MMFs invest largely in private 
debt instruments, such as commercial paper and certificates of deposit, 
and, commensurate with the greater risks in prime MMF portfolios, they 
generally pay higher yields than Treasury-only funds.
    MMFs are marketed both to retail investors (that is, individuals), 
for whom MMFs are the only means of investing in many money market 
instruments, and to institutions, which are often attracted by the 
convenience and cost efficiency of MMFs, even though many institutional 
investors have the ability to invest directly in the instruments held 
by MMFs. Institutional MMFs, which currently account for about two-
thirds of the assets under management in MMFs, have grown much faster, 
on net, in the past two decades than retail funds. The rapid growth of 
institutional funds has important implications for the MMF industry, 
because institutional funds tend to have more volatile flows and more 
yield-sensitive shareholders than retail funds.
    MMFs compete with other stable-value, low-risk investments. Because 
MMFs generally maintain stable NAVs, offer redemptions on demand, and 
often provide services that compete with those offered to holders of 
insured deposits (such as transactions services), many retail customers 
likely consider MMF shares and bank deposits as near substitutes, even 
if the two classes of products are fundamentally different (most 
notably because MMF shares are not insured and because MMFs and banks 
are subject to very different regulatory regimes). Some institutional 
investors may also view bank deposits and MMFs as near substitutes, 
although usual limitations on deposit insurance coverage and interest 
payments on deposits likely reduce the attractiveness of bank deposits 
for most such investors.\8\ Institutional investors also have access to 
less-regulated MMF substitutes (for example, offshore MMFs, enhanced 
cash funds, and other stable value vehicles) and may perceive them as 
near substitutes for MMFs, even if those vehicles are not subject to 
the protections afforded by rule 2a-7.
---------------------------------------------------------------------------

    \8\ Under the Federal Deposit Insurance Corporation's (FDIC) 
Temporary Liquidity Guarantee Program, coverage limits on 
noninterest-bearing transaction deposits in FDIC-insured 
institutions were temporarily lifted beginning in October 2008 and 
coverage will extend through 2010. Effective December 31, 2010, 
pursuant to the Dodd-Frank Wall Street Reform and Consumer 
Protection Act, Public Law 111-203, (``Dodd-Frank Act''), all 
noninterest-bearing transaction deposits will have unlimited 
coverage until January 1, 2013. In addition, section 627 of the 
Dodd-Frank Act repeals the prohibition on banks paying interest on 
corporate demand deposit accounts effective July 21, 2011.
---------------------------------------------------------------------------

b. MMFs' Susceptibility to Runs
    In the twenty-seven years since the adoption of rule 2a-7, only two 
MMFs have broken the buck. In 1994, a small MMF suffered a capital loss 
because of exposures to interest rate derivatives, but the event passed 
without significant repercussions. In contrast, as further discussed 
later, when the Reserve Primary Fund broke the buck in September 2008, 
it helped ignite a massive run on prime MMFs that contributed to severe 
dislocations in short-term credit markets and strains on the businesses 
and institutions that obtain funding in those markets.\9\
---------------------------------------------------------------------------

    \9\ Section 1(c) contains more detail on the MMF industry's 
experience during the recent financial crisis.
---------------------------------------------------------------------------

    Although the run on MMFs in 2008 is itself unique in the history of 
the industry, the events of 2008 underscored the susceptibility of MMFs 
to runs. That susceptibility arises because, when shareholders perceive 
a risk that a fund will suffer losses, each shareholder has an 
incentive to redeem shares before other shareholders. Five features of 
MMFs, their sponsors, and their investors principally contribute to 
this incentive:
    (i) Maturity transformation with limited liquidity resources. One 
important economic function of MMFs is their role as intermediaries 
between shareholders who want liquid investments and borrowers who 
desire term funding. As such, MMFs offer shares that are payable on 
demand, but they invest both in cash-like instruments and in short-term 
securities that are less liquid, including, for example, term 
commercial paper. Redemptions in excess of MMFs' cash-like liquidity 
may force funds to sell less liquid assets. When money markets are 
strained, funds may not be able to obtain full value (that is, 
amortized cost) for such assets in secondary markets and may incur 
losses as a consequence. Investors thus have an incentive to redeem 
shares before a fund has depleted its cash-like instruments (which 
serve as its liquidity buffer).
    (ii) NAVs rounded to $1. Share prices of MMFs are rounded to the 
nearest cent, typically resulting in a $1 NAV per share. The rounding 
fosters an expectation that MMF share prices will not fluctuate, which 
exacerbates investors' incentive to run when there is risk that prices 
will fluctuate. When a MMF that has experienced a small (less than one-
half of 1 percent) capital loss redeems shares at the full $1 NAV, it 
concentrates the loss among the remaining shareholders. Thus, 
redemptions from such a fund further depress the market value of its 
assets per share outstanding (its shadow NAV), and redemptions of 
sufficient scale may cause the fund to break the buck. Early redeemers 
are therefore more likely to receive the usual $1 NAV than those who 
wait.
    (iii) Portfolios exposed to credit and interest rate risks. MMFs 
invest in securities with credit and interest-rate risks. Although 
these risks are generally small given the short maturity of the 
securities and the high degree of portfolio diversification, even a 
small capital loss, in combination with other features of MMFs, can 
trigger a significant volume of redemptions. The events of September 
2008--when losses on Lehman Brothers Holdings, Inc. (Lehman Brothers) 
debt instruments caused just one MMF to break the buck and triggered a 
broad run on MMFs--highlight the fact that credit losses at

[[Page 68643]]

even a single fund may have serious implications for the whole industry 
and consequently for the entire financial system.\10\
---------------------------------------------------------------------------

    \10\ Souring credits and rapid increases in interest rates have 
adversely affected MMFs on other occasions. For example, beginning 
in the summer of 2007, MMF exposures to structured investment 
vehicles and other asset-backed commercial paper caused capital 
losses at many MMFs, and many MMF sponsors voluntarily provided 
capital support that prevented some funds from breaking the buck.
---------------------------------------------------------------------------

    (iv) Discretionary sponsor capital support. MMFs invest in assets 
that may lose value, but the funds have no formal capital buffers or 
insurance to maintain their $1 share prices in the event of a loss on a 
portfolio asset.
    The MMF industry's record of maintaining a stable NAV reflects, in 
part, substantial discretionary intervention by MMF sponsors (that is, 
fund advisers, their affiliates, and their parent firms) to support 
funds that otherwise might have broken the buck.\11\ Sponsors do not 
commit to support an MMF in advance, because an explicit commitment may 
require the sponsor to consolidate the fund on its balance sheet and--
if the sponsor is subject to regulatory capital requirements--hold 
additional regulatory capital against the contingent exposure. Nor is 
there any requirement that sponsors support ailing MMFs; such a mandate 
would transform the nature of MMF shares by shifting risks from 
investors to sponsors and probably would require government supervision 
and monitoring of sponsors' resources and capital adequacy.\12\ 
Instead, sponsor capital support remains expressly voluntary, and not 
all MMFs have a sponsor capable of fully supporting its MMFs. 
Nonetheless, a long history of such support probably has contributed 
substantially to the perceived safety of MMFs.
---------------------------------------------------------------------------

    \11\ For example, more than 100 MMFs received sponsor capital 
support in 2007 and 2008 because of investments in securities that 
lost value and because of the run on MMFs in September and October 
2008. See Securities and Exchange Commission (2009) ``Money Market 
Reform: Proposed Rule,'' pp. 13-14, 17, and notes 38 and 54.
    \12\ Even discretionary support for MMFs may lead to concerns 
about the safety and soundness of MMF sponsors. Sponsors that foster 
expectations of such support may be granting a form of implicit 
recourse that is not reflected on sponsors' balance sheets or in 
their regulatory capital ratios, and such implicit recourse may 
contribute to broader systemic risk.
---------------------------------------------------------------------------

    However, the possibility that sponsors may become unwilling or 
unable to provide expected support during a crisis is itself a source 
of systemic risk. Indeed, sponsor support is probably least reliable 
when systemic risks are most salient.\13\ Moreover, MMFs without deep-
pocketed sponsors remain vulnerable to runs that can affect the entire 
industry. The Reserve Primary Fund was not the only MMF that held 
Lehman Brothers debt at the time of the Lehman Brothers' bankruptcy in 
September 2008, but it broke the buck because the Reserve Primary Fund, 
unlike some of its competitors, had substantial holdings of Lehman 
Brothers debt and Reserve did not have the resources to support its 
fund. Investors also recognized the riskiness of sponsor support more 
broadly during the run on MMFs in 2008. For example, outflows from 
prime MMFs following the Lehman Brothers bankruptcy tended to be larger 
among MMFs with sponsors that were themselves under strain (as measured 
by credit default swap spreads for parent firms or affiliates), 
indicating that MMF investors quickly redeemed shares on concerns about 
sponsors' potential inabilities to bolster ailing funds.
---------------------------------------------------------------------------

    \13\ Other forms of discretionary financial support, such as 
that provided by dealers for auction rate securities, did not fare 
well during the financial crisis.
---------------------------------------------------------------------------

    (v) Investors' low risk tolerance and expectations. Investors have 
come to view MMF shares as extremely safe, in part because of the 
funds' stable NAVs and sponsors' record of supporting funds that might 
otherwise lose value. MMFs' history of maintaining stable value has 
attracted highly risk-averse investors who are prone to withdraw assets 
rapidly when losses appear possible.
    MMFs, like other mutual funds, commit to redeem shares based on the 
fund's NAV at the time of redemption. MMFs are under no legal or 
regulatory requirement to redeem shares at $1; rule 2a-7 only requires 
that MMFs be managed to maintain a stable NAV. Yet sponsor-supported 
stable, rounded NAVs and the typical $1 MMF share price foster 
investors' impressions that MMFs are extremely safe investments. 
Indeed, the growth of retail MMFs in recent decades may have reflected 
some substitution from insured deposits at commercial banks, thrifts, 
and credit unions, particularly as MMFs have offered transactions 
services and other bank-like functions. Although MMF shares, unlike 
bank deposits, are not government insured and are not backed by capital 
to absorb losses, this distinction may have become even less clear to 
retail investors following the unprecedented government support of MMFs 
in 2008 and 2009. Furthermore, that recent support may have left even 
sophisticated institutional investors with the mistaken impression that 
MMF safety is enhanced because the government stands ready to support 
the industry again with the same tools employed at the height of the 
financial crisis.
    The growth of institutional MMFs in recent years probably has 
heightened both the risk aversion of the typical MMF shareholder and 
the volatility of MMF cash flows. Many institutional investors cannot 
tolerate fluctuations in share prices for a variety of reasons. In 
addition, institutional investors are typically more sophisticated than 
retail investors in obtaining and analyzing information about MMF 
portfolios and risks, have larger amounts at stake, and hence are 
quicker to respond to events that may threaten the stable NAV. In fact, 
institutional MMFs have historically experienced much more volatile 
flows than retail funds. During the run on MMFs in September 2008, 
institutional funds accounted for more than 90 percent of the net 
redemptions from prime MMFs.
    The interaction of these five features is critical. Taken alone, 
each of the features just listed probably would only modestly increase 
the vulnerability of MMFs to runs, but, in combination, the features 
tend to amplify and reinforce one another. For example, equity mutual 
funds perform maturity transformation and take on capital risks, but 
even after large capital losses, outflows from equity funds tend to be 
small relative to assets, most likely because equity funds are not 
marketed for their ability to maintain stable NAVs, do not attract the 
risk-averse investor base that characterizes MMFs, and offer the 
opportunity for capital appreciation. If MMFs with rounded NAVs had 
lacked sponsor support over the past few decades, many might have 
broken the buck and diminished the expectation of a stable $1 share 
price. In that case, investors who nonetheless elected to hold shares 
in such funds might have become more tolerant of risk and less inclined 
to run. If MMFs had attracted primarily a retail investor base rather 
than an institutional base, investors might be slower to respond to 
strains on a MMF. And even a highly risk-averse investor base would not 
necessarily make MMFs susceptible to runs--and to contagion arising 
from runs on other MMFs--if funds had a credible means to guarantee 
their $1 NAVs. Thus, policy responses that diminish the reinforcing 
interactions among the features discussed herein hold promise for 
muting overall risks posed by MMFs.
c. MMFs in the Recent Financial Crisis
    The turmoil in financial markets in 2007 and 2008 caused severe 
strains both among MMFs and in the short-term debt markets in which 
MMFs invest. Beginning in mid-2007, dozens of funds faced losses from 
holdings of highly

[[Page 68644]]

rated asset-backed commercial paper (ABCP) issued by structured 
investment vehicles (SIVs), some of which had exposures to the subprime 
mortgage market. Fear of such losses at one MMF caused that fund to 
experience a substantial run in August 2007, which was brought under 
control when the fund's sponsor purchased more than $5 billion of 
illiquid securities from the fund. Indeed, financial support from MMF 
sponsors in recent years probably prevented a number of funds from 
breaking the buck because of losses on SIV paper.
    The crisis for MMFs worsened considerably in September 2008 with 
the bankruptcy of Lehman Brothers on September 15 and mounting concerns 
about other issuers of commercial paper, particularly financial firms. 
The Reserve Primary Fund, a $62 billion MMF, held $785 million in 
Lehman Brothers debt on the day of Lehman Brothers' bankruptcy and 
immediately began experiencing a run--shareholders requested 
redemptions of approximately $40 billion in just two days. In order to 
meet the redemptions, the Reserve Primary Fund depleted its cash 
reserves and began seeking to sell its portfolio securities, which 
further depressed their valuations. Unlike other MMFs that held 
distressed securities, the Reserve Primary Fund had no affiliate with 
sufficient resources to support its $1 NAV, and Reserve announced on 
September 16 that its Primary Fund would break the buck and re-price 
its shares at $0.97. On September 22, the SEC issued an order 
permitting the suspension of redemptions in certain Reserve MMFs to 
permit their orderly liquidation.
    The run quickly spread to other prime MMFs, which held sizable 
amounts of financial sector debt that investors feared might decline 
rapidly in value. During the week of September 15, 2008, investors 
withdrew approximately $310 billion (15 percent of assets) from prime 
MMFs, with the heaviest redemptions coming from institutional funds. To 
meet these redemption requests, MMFs depleted their cash positions and 
sought to sell portfolio securities into already illiquid markets. 
These efforts caused further declines in the prices of short-term 
instruments and put pressure on per-share values of fund portfolios, 
threatening MMFs' stable NAVs. Nonetheless, only one MMF--the Reserve 
Primary Fund--broke the buck, because many MMF sponsors provided 
substantial financial support to prevent capital losses in their funds.
    Fearing further redemptions, many MMF advisers limited new 
portfolio investments to cash, U.S. Treasury securities, and overnight 
instruments, and avoided term commercial paper, certificates of 
deposit, and other short-term credit instruments. During September 
2008, MMFs reduced their holdings of commercial paper by about $170 
billion (25 percent). As market participants hoarded cash and refused 
to lend to one another on more than an overnight basis, interest rates 
spiked and short-term credit markets froze. Commercial paper issuers 
were required to make significant draws on their backup lines of 
credit, placing additional pressure on the balance sheets of commercial 
banks.
    On September 19, 2008, Treasury and the Board of Governors of the 
Federal Reserve System (Federal Reserve) announced two unprecedented 
market interventions to stabilize MMFs and to provide liquidity to 
short-term funding markets. Treasury's Temporary Guarantee Program for 
Money Market Funds temporarily provided guarantees for shareholders in 
MMFs that elected to participate in the program.\14\ The Federal 
Reserve's Asset-Backed Commercial Paper Money Market Mutual Fund 
Liquidity Facility (AMLF) extended credit to U.S. banks and bank 
holding companies to finance their purchases of high-quality ABCP from 
MMFs.\15\
---------------------------------------------------------------------------

    \14\ MMFs that elected to participate in the program paid fees 
of 4 to 6 basis points at an annual rate for the guarantee. The 
Temporary Guarantee Program for Money Market Funds expired on 
September 18, 2009.
    \15\ The AMLF expired on February 1, 2010.
---------------------------------------------------------------------------

    The announcements of these government programs substantially slowed 
the run on prime MMFs. Outflows from prime MMFs diminished to about $65 
billion in the week after the announcements and, by mid-October, these 
MMFs began attracting net inflows. Moreover, in the weeks following the 
government interventions, markets for commercial paper and other short-
term debt instruments stabilized considerably.\16\
---------------------------------------------------------------------------

    \16\ Several other unprecedented government interventions that 
provided additional support for the MMF industry and for short-term 
funding markets were introduced after the run on MMFs had largely 
abated. For example, the Federal Reserve in October 2008 established 
the Commercial Paper Funding Facility (CPFF), which provided loans 
for purchases (through a special purpose vehicle) of term commercial 
paper from issuers. The CPFF, which expired on February 1, 2010, 
helped issuers repay investors--such as MMFs--who held maturing 
paper. Also in October 2008, the Federal Reserve announced the Money 
Market Investor Funding Facility (MMIFF), which was intended to 
bolster liquidity for MMFs by financing (through special purpose 
vehicles) purchases of securities from the funds. The MMIFF was 
never used and expired on October 30, 2009. In November 2008, 
Treasury agreed to become a buyer of last resort for certain 
securities held by the Reserve U.S. Government Fund (a MMF), in 
order to facilitate an orderly and timely liquidation of the fund. 
Under the agreement, Treasury would purchase certain securities 
issued by government sponsored enterprises at amortized cost (not 
mark to market), and $3.6 billion of such purchases were completed 
in January 2009.
---------------------------------------------------------------------------

2. The SEC's Changes to the Regulation of MMFs
    The effects of the financial turmoil in 2007 and 2008 on MMFs--and, 
in particular, the run on these funds in September 2008 and its 
consequences--have highlighted the need for reforms to mitigate the 
systemic risks posed by MMFs. Appropriate reforms include changes to 
MMF regulations as well as broader policy actions. This section first 
examines rule changes that have been adopted by the SEC to improve the 
safety and resilience of MMFs and then discusses some limitations in 
these measures' mitigation of systemic risk and the need for further 
reforms.
    Notwithstanding the need for reform, the significance of MMFs in 
the U.S. financial system suggests that changes must be considered 
carefully. Tighter restrictions on MMFs might, for example, lead to a 
reduction in the supply of short-term credit, a shift in assets to 
substitute investment vehicles that are subject to less regulation than 
MMFs, and significant impairment of an important cash-management tool 
for investors. Moreover, the economic importance of risk-taking by 
MMFs--as lenders in private debt markets and as investments that appeal 
to shareholders' preferences for risk and return--suggests that the 
appropriate objective for reform should not be to eliminate all risks 
posed by MMFs. Attempting to prevent any fund from ever breaking the 
buck would be an impractical goal that might lead, for example, to 
draconian and--from a broad economic perspective--counterproductive 
measures, such as outright prohibitions on purchases of private debt 
instruments and securities with maturities of more than one day. 
Instead, policymakers should balance the benefits of allowing 
individual MMFs to take some risks and facilitating private and public 
borrowers' access to term financing in money markets with the broader 
objective of mitigating systemic risks--in particular, the risk that 
one fund's problems may cause serious harm to other MMFs, their 
shareholders, short-term funding markets, the financial system, and the 
economy.
a. SEC Regulatory Changes
    In January 2010, the SEC adopted new rules regulating MMFs in order 
to make these funds more resilient to market

[[Page 68645]]

disruptions and thus less likely to break the buck. The new rules also 
might help reduce the likelihood of runs on MMFs by facilitating the 
orderly liquidation of funds that have broken the buck. The SEC 
designed the new rules primarily to meet its statutory obligations 
under the ICA to protect investors and promote capital formation. 
Nonetheless, the rules should mitigate (although not eliminate) 
systemic risks by reducing the susceptibility of MMFs to runs, both by 
lessening the likelihood that an individual fund will break the buck 
and by containing the damage should one break the buck. The rule 
changes fall into three principal categories.
    (i) Enhanced Risk-Limiting Constraints on Money Market Fund 
Portfolios. Each of the changes that follow further constrains risk-
taking by MMFs.
    Liquidity Risk. One of the most important SEC rule changes aimed at 
reducing systemic risk associated with MMFs is a requirement that each 
fund maintain a substantial liquidity cushion. Augmented liquidity 
should position MMFs to better withstand heavy redemptions without 
selling portfolio securities into potentially distressed markets at 
discounted prices. Forced ``fire sales'' to meet heavy redemptions may 
cause losses not only for the fund that must sell the securities, but 
also for other MMFs that hold the same or similar securities. Thus, a 
substantial liquidity cushion should help reduce the risk that strains 
on one MMF will be transmitted to other funds and to short-term credit 
markets.
    Specifically, the SEC's new rules require that MMFs maintain 
minimum daily and weekly liquidity positions. Daily liquidity, which 
must be at least 10 percent of a MMF's assets, includes cash, U.S. 
Treasury obligations, and securities (including repurchase agreements) 
that mature or for which the fund has a contractual right to obtain 
cash within a day. Weekly liquidity, which must be at least 30 percent 
of each MMF's assets, includes cash, securities that mature or can be 
converted to cash within a week, U.S. Treasury obligations, and 
securities issued by federal government agencies and government-
sponsored enterprises with remaining maturities of 60 days or less.\17\ 
Furthermore, the new rules require MMF advisers to maintain larger 
liquidity buffers as necessary to meet reasonably foreseeable 
redemptions.
---------------------------------------------------------------------------

    \17\ Tax-exempt money market funds are exempt from daily minimum 
liquidity requirements but not the weekly minimum liquidity 
requirements, because most tax-exempt fund portfolios consist of 
longer-term floating- and variable-rate securities with seven-day 
``put'' options that effectively give the funds weekly liquidity. 
Tax-exempt funds are unlikely to have investment alternatives that 
would permit them to meet a daily liquidity requirement.
---------------------------------------------------------------------------

    Credit Risk. The new rules reduce MMFs' maximum allowable holdings 
of ``second-tier'' securities, which carry more credit risk than first-
tier securities, to no more than 3 percent of each fund's assets.\18\ 
In addition, a MMF's exposure to a single second-tier issuer is now 
limited to one-half of 1 percent of the fund's assets, and funds can 
only purchase second-tier securities with maturities of 45 days or 
less. These new constraints reduce the likelihood that individual funds 
will be exposed to a credit event that could cause the funds to break 
the buck. Also, since second-tier securities often trade in thinner 
markets, these changes should improve the ability of individual MMFs to 
maintain a stable NAV during periods of market volatility.
---------------------------------------------------------------------------

    \18\ Under SEC rule 2a-7, for short-term debt securities to 
qualify as second-tier securities, they generally must have received 
the second highest short-term debt rating from the credit rating 
agencies or be of comparable quality. Section 939A of the Dodd-Frank 
Act requires that government agencies remove references to credit 
ratings in their rules and replace them with other credit standards 
that the agency determines appropriate. As a result, the SEC will be 
reconsidering this rule and its provisions relating to second-tier 
securities to comply with this statutory mandate.
---------------------------------------------------------------------------

    Interest Rate Risk. By reducing the maximum allowable weighted 
average maturity (WAM) of fund portfolios from 90 days to 60 days, the 
new rules are intended to diminish funds' exposure to interest rate 
risk and increase the liquidity of fund portfolios. The SEC also 
introduced a new weighted average life (WAL) measure for MMFs--and set 
a ceiling for WAL at 120 days--in order to lower funds' exposure to 
interest-rate, credit, and liquidity risks associated with the 
floating-rate obligations that MMFs commonly hold.\19\
---------------------------------------------------------------------------

    \19\ For purposes of computing WAM, a floating-rate security's 
``maturity'' can be its next interest-rate reset date. In computing 
WAL, the life of a security is determined solely by its final 
maturity date. Hence, WAL should be more useful than WAM in 
reflecting the risks of widening spreads on longer-term floating-
rate securities.
---------------------------------------------------------------------------

    Stress Testing. Finally, the SEC's new rules require fund advisers 
to periodically stress test their funds' ability to maintain a stable 
NAV per share based on certain hypothetical events, including a change 
in short-term interest rates, an increase in shareholder redemptions, a 
downgrade or default of a portfolio security, and a change in interest 
rate spreads. Regular and methodical monitoring of these risks and 
their potential effects should help funds weather stress without 
incident.
    (ii) Facilitating Orderly Fund Liquidations. The new SEC rules 
should reduce the systemic risk posed by MMFs by permitting a fund that 
is breaking the buck to promptly suspend redemptions and liquidate its 
portfolio in an orderly manner. This new rule should help prevent a 
capital loss at one fund from forcing a disorderly sale of portfolio 
securities that might disrupt short-term markets and diminish share 
values of other MMFs. Moreover, the ability of a fund to suspend 
redemptions should help prevent investors who redeem shares from 
benefiting at the expense of those who remain invested in a fund.
    (iii) Repurchase Agreements. The SEC's new rules place more 
stringent constraints on repurchase agreements that are collateralized 
with private debt instruments rather than cash equivalents or 
government securities. MMFs are among the largest purchasers of 
repurchase agreements, which they use to invest cash, typically on an 
overnight basis. Because the collateral usually consists of long-term 
debt securities, a MMF cannot hold the securities underlying this 
collateral without violating SEC rules that limit MMF holdings to 
short-term obligations. Accordingly, if a significant counterparty 
fails to repurchase securities as stipulated in a repurchase agreement, 
its MMF counterparties can be expected to direct custodians to sell the 
collateral immediately, and sales of private debt instruments could be 
sizable and disruptive to financial markets. To address this risk, the 
SEC's new rule places additional constraints on MMFs' exposure to 
counterparties through repurchase agreement transactions that are 
collateralized by securities other than cash equivalents or government 
securities.
b. Need for Further Reform To Reduce Susceptibility to Runs
    The new SEC rules make MMFs more resilient and less risky and 
therefore reduce the likelihood of runs on funds, increase the size of 
runs that they could withstand, and mitigate the systemic risks they 
pose. However, more can be done to address the structural 
vulnerabilities of MMFs to runs. Indeed, the Chairman of the SEC 
characterized its new rules as ``a first step'' in strengthening MMFs 
and noted that a number of additional possible reforms (many of which 
are presented in section 3 of this report) are under discussion. 
Likewise, Treasury's Financial Regulatory Reform: A New Foundation 
(2009) anticipated that measures taken by the SEC ``should not, by 
themselves, be expected to prevent a run on MMFs of the scale 
experienced in September 2008.''

[[Page 68646]]

    Of the five features that make MMFs vulnerable to runs (see section 
1(b)), the two most directly addressed in the new SEC rules are 
liquidity risks associated with maturity transformation and MMF 
portfolios' exposures to credit and interest-rate risks. The SEC's new 
rules should substantially reduce these risks, but systemic risks 
arising from the other features of MMFs and their investors--the 
stable, rounded NAV, a system of discretionary sponsor support, and a 
highly risk-averse investor base--still remain, as do many of the 
amplifying interaction effects. Some mitigation of the destabilizing 
effects that one or a few MMFs can impose on the rest of the industry 
through contagion might be achievable through further modifications to 
rule 2a-7 and other SEC rules. Importantly, however, other reforms that 
could more substantially reduce the risk of contagion and that, as 
such, merit further consideration, would require action beyond what the 
SEC could achieve under its current authority.
    Mitigating the risk of runs before another liquidity crisis 
materializes is especially important because the events of September 
2008 may have induced expectations of government assistance at minimal 
cost in case of severe financial strains. Market participants know, and 
recent events have confirmed, that when runs on MMFs occur, the 
government will face substantial pressure to intervene in some manner 
to minimize the propagation of financial strains to short-term funding 
markets and to the real economy. Importantly, such interventions would 
be intended not only to reduce harm to MMF investors but also to 
prevent disruptions of markets for commercial paper and other short-
term financing instruments, which are critical for the functioning of 
the economy. Therefore, if further measures to insulate the industry 
from systemic risk are not taken before the next liquidity crisis, 
market participants will likely expect that the government would 
provide emergency support at minimal cost for MMFs during the next 
crisis. Such market expectations of (hypothetical) future non-priced or 
subsidized government support would distort incentives for MMFs and 
prices in short-term funding markets and would potentially increase the 
systemic risk posed by MMFs. To forestall these perverse effects, it is 
thus imperative that MMFs be required to internalize fully the costs of 
liquidity or other risks associated with their operation.
    MMF regulatory reform in light of the run on MMFs in September and 
October 2008. The run on MMFs in 2008 provides some important lessons 
for evaluating potential reforms for mitigating systemic risk. For 
example, the triggering events of the run and the magnitude of the 
outflows that followed underscore the difficulty of designing reforms 
that might prevent runs and the associated damage to the financial 
system.
    Making each individual MMF robust enough to survive a crisis of the 
size of that experienced in 2008 may not be an appropriate policy 
objective because it would unduly limit risk taking. Indeed, although 
the SEC's tightening of restrictions on the liquidity, interest-rate, 
and credit risks borne by individual MMFs will be helpful in making 
MMFs more resilient to future strains, there are practical limits to 
the degree of systemic risk mitigation that can be achieved through 
further restrictions of this type. For example, an objective of 
preventing any MMF from breaking the buck probably would not be 
feasible for funds that invest in private debt markets. Changes that 
would prevent funds from breaking the buck due to a single Lehman 
Brothers-like exposure would have to be severe: Only limiting funds' 
exposures to each issuer to less than one-half of 1 percent of assets 
would prevent a precipitous drop in the value of any single issuer's 
debt from causing a MMF to break the buck.\20\ But even such a limit on 
exposure to a single issuer would not address the risk that MMFs may 
accumulate exposures to distinct but highly correlated issuers, and 
that funds would remain vulnerable to events that cause the debt of 
multiple issuers to lose value.
---------------------------------------------------------------------------

    \20\ At the time of its bankruptcy, Lehman Brothers' short-term 
debt was still a first-tier security, so MMFs were able to hold up 
to 5 percent of their assets in Lehman Brothers' debt. The SEC's new 
rules do not affect this limit.
---------------------------------------------------------------------------

    Beyond diversification limits, new rules to protect MMFs from 
material credit losses would be difficult to craft unless regulators 
take the extreme step of eliminating funds' ability to hold any risky 
assets. But that approach would be clearly undesirable, as it would 
adversely affect many firms that obtain short-term financing through 
commercial paper and similar instruments. In addition, such an extreme 
approach would deny many retail investors any opportunity to obtain 
exposure to private money market instruments and most likely would 
motivate some institutional investors to shift assets from MMFs to less 
regulated vehicles.
    Similarly, liquidity requirements sufficient to cover all 
redemption scenarios for MMFs probably would be impractical and 
inefficient. The SEC's new liquidity requirements help mitigate 
liquidity risks borne by the funds, and if MMFs had held enough liquid 
assets in September 2008 to meet the new liquidity requirements, each 
MMF would have had adequate daily liquidity to meet redemption requests 
on most individual days during the run. Even so, the cumulative effect 
of severe outflows on consecutive days would have exceeded many funds' 
liquidity buffers. Moreover, without external support in 2008--
specifically, the introduction of the Treasury's Temporary Guarantee 
Program for Money Market Funds and the Federal Reserve's AMLF--outflows 
likely would have continued and been much larger, and they would have 
forced substantial sales of assets to meet redemptions. Such asset 
sales would have contributed to severe strains in short-term markets, 
depressed asset prices, caused capital losses for MMFs, and prompted 
further shareholder flight. Hence, MMFs' experience during the run in 
2008 indicates that the new SEC liquidity requirements make individual 
MMFs more resilient to shocks but still leave them susceptible to runs 
of substantial scale.
    Raising the liquidity requirements enough so that each MMF would 
hold adequate daily liquidity to withstand a large-scale run would be a 
severe constraint and would fail to take advantage of risk-pooling 
opportunities that might be exploited by external sources of liquidity. 
During the run in 2008, individual MMFs experienced large variations in 
the timing and magnitude of their redemptions. Liquidity requirements 
stringent enough to ensure that every individual MMF could have met 
redemptions without selling assets would have left most of the industry 
with far too much liquidity, even during the run, and would have 
created additional liquidity risks for issuers of short-term 
securities, since these issuers would have had to roll over paper more 
frequently. Some of the approaches discussed in section 3 are aimed at 
buttressing the SEC's new minimum liquidity requirements without simply 
increasing their magnitude.
    Finally, the run on MMFs in 2008 demonstrated the systemic threat 
that such runs may represent. Without additional reforms to more fully 
mitigate the risk of a run spreading among MMFs, the actions to support 
the MMF industry that the U.S. government took beginning in 2008 may 
create an expectation for similar government support during future 
financial crises, and the resulting moral hazard may make crises in the 
MMF industry more

[[Page 68647]]

frequent than the historical record would suggest. Accordingly, despite 
the risk reduction that should be achieved by the initial set of new 
SEC rules, policymakers should explore the advantages and disadvantages 
of implementing further reforms before another crisis materializes.
3. Policy Options for Further Reducing the Risks of Runs on MMFs
    This section discusses a range of options for further mitigation of 
the systemic risks posed by MMFs. The SEC requested comment on some of 
these options, such as requiring that MMFs maintain a floating NAV or 
requiring in kind redemptions in certain circumstances. In addition, 
the SEC received comments proposing a two-tier system of MMFs in which 
some funds maintain a stable NAV and others a floating NAV. Other 
options discussed in this section go beyond what the SEC could 
implement under existing authorities and would require legislation or 
coordinated action by multiple government agencies and the MMF 
industry. While the measures presented here, either individually or in 
combination, would help diminish systemic risk, new restrictions 
imposed solely on MMFs may reduce their appeal to some investors and 
might cause some--primarily institutional--investors to move assets to 
less regulated cash management substitutes. Many such funds, like MMFs, 
seek to maintain a stable NAV and have other features that make them 
vulnerable to runs, so such funds likely also would pose systemic 
risks. Therefore, effective mitigation of MMFs' susceptibility to runs 
may require policy reforms beyond those directed at registered MMFs to 
address risks posed by funds that compete with MMFs. Such reforms, 
which generally would require legislation, are discussed in section 
3(h).
a. Floating Net Asset Values
    Historically, the $1 stable NAV that MMFs maintain under rule 2a-7 
has been a key element of their appeal to a broad range of investors, 
and the stable NAV has contributed to a dramatic expansion in MMFs' 
assets over the past two decades. At the same time, as noted in section 
1(b), the stable, rounded NAV is one of the features that heighten the 
vulnerability of MMFs to runs. The significance of MMFs in financial 
markets and the central role of the stable, rounded NAV in making MMFs 
appealing to investors and, at the same time, vulnerable to runs, make 
careful discussion of the potential benefits and risks of moving MMFs 
away from a stable NAV essential to a discussion of MMF reform.
    The stable, rounded NAVs of MMFs contribute to their vulnerability 
to runs for several reasons.
     First, the stable, rounded NAV, coupled with MMF sponsors' 
longstanding practice of supporting the stable NAV when funds have 
encountered difficulties, has fostered investors' expectations that MMF 
shares are risk-free cash equivalents. When the Reserve Primary Fund 
failed to maintain those expectations in September 2008, the sudden 
loss of investor confidence helped precipitate a generalized run on 
MMFs. By making gains and losses a regular occurrence, as they are in 
other mutual funds, a floating NAV could alter investor expectations 
and make clear that MMFs are not risk-free vehicles. Thus, investors 
might become more accustomed to and tolerant of NAV fluctuations and 
less prone to sudden, destabilizing reactions in the face of even 
modest losses. However, the substantial changes in investor 
expectations that could result from a floating NAV also might motivate 
investors to shift assets away from MMFs to banks or to unregulated 
cash-management vehicles, and the effects of potentially large 
movements of assets on the financial system should be considered 
carefully. These issues are discussed in more detail later.
     Second, a rounded NAV may accelerate runs by amplifying 
investors' incentives to redeem shares quickly if a fund is at risk of 
a capital loss. When a MMF experiences a loss of less than one-half of 
1 percent and continues to redeem shares at a rounded NAV of $1, it 
offers redeeming shareholders an arbitrage opportunity by paying more 
for the shares than the shares are worth. Simultaneously, the fund 
drives down the expected future value of the shares because redemptions 
at $1 per share further erode the fund's market-based per-share value--
and increase the likelihood that the fund will break the buck--as 
losses on portfolio assets are spread over a shrinking asset base. 
These dynamics are inherently unstable. Thus, even an investor who 
otherwise might not choose to redeem may do so in recognition of other 
shareholders' incentives to redeem and the effects of such redemptions 
on a fund's expected NAV. The growth of institutional investment in 
MMFs has exacerbated this instability because institutional investors 
are better positioned than retail investors to identify potential 
problems in a MMF's portfolio and rapidly withdraw significant amounts 
of assets from the fund.
    In contrast, a floating NAV eliminates some of the incentives to 
redeem when a MMF has experienced a loss. Because MMFs must redeem 
shares at NAVs set after redemption requests are received, losses 
incurred by a fund with a floating NAV are borne on a pro rata basis by 
all shareholders, whether they redeem or not. Redemptions from such a 
fund do not concentrate already incurred losses over a smaller asset 
base and do not create clear arbitrage opportunities for investors. 
However, as discussed below, a floating NAV does not eliminate the 
incentive to redeem shares from a distressed MMF.
     Third, the SEC rules that permit funds to maintain a 
stable, rounded NAV also force an abrupt decrease in price once the 
difference between a fund's market-based shadow NAV and its $1 stable 
NAV exceeds one-half of 1 percent. So, although NAV fluctuations are 
rare in MMFs, when prices do decline, the change appears as a sudden 
drop. This discontinuity heightens investors' incentives to redeem 
shares before a loss is incurred, produces dire headlines, and probably 
raises the chance of a panic.
    These considerations suggest that moving to a floating NAV would 
reduce the systemic risk posed by MMFs to some extent. Under a required 
floating NAV, MMFs would have to value their portfolio assets just like 
any other mutual fund. That is, MMFs would not be able to round their 
NAVs to $1 or use the accounting methods (for example, amortized cost 
for portfolio securities with a maturity of greater than 60 days) 
currently allowed under rule 2a-7.
    To be sure, a floating NAV itself would not eliminate entirely 
MMFs' susceptibility to runs. Rational investors still would have an 
incentive to redeem as fast as possible the shares of any MMF that is 
at risk of depleting its liquidity buffer before that buffer is 
exhausted, because subsequent redemptions may force the fund to dispose 
of less-liquid assets and incur losses. However, investors would have 
less of an incentive to run from MMFs with floating NAVs than from 
those with stable, rounded NAVs.
    Notwithstanding the advantages of a floating NAV, elimination of 
the stable NAV for MMFs would be a dramatic change for a nearly $3 
trillion asset-management sector that has been built around the stable 
$1 share price. Indeed, a switch to floating NAVs for MMFs raises 
several concerns.
     First, such a change might reduce investor demand for MMFs 
and thus diminish their capacity to supply credit to businesses, 
financial institutions, state and local governments, and other

[[Page 68648]]

borrowers who obtain financing in short-term debt markets. MMFs are the 
dominant providers of some types of credit, such as commercial paper 
and short-term municipal debt, so a significant contraction of MMFs 
might cause particular difficulties for borrowers who rely on these 
instruments for financing. If the contraction were abrupt, redemptions 
might cause severe disruptions for MMFs, the markets for the 
instruments the funds hold, and borrowers who tap those markets. While 
there is no direct evidence on the likely effect of a floating NAV on 
the demand for MMFs, the risk of a substantial shift of assets away 
from MMFs and into other vehicles should be weighed carefully. Assets 
under management in MMFs dwarf those of their nearest substitutes, such 
as, for example, ultra-short bond funds, most likely because ultra-
short bond funds are not viewed as cash substitutes. To the extent that 
demand for stable NAV funds is boosted by investors who hold MMFs 
because they perceive them to be risk-free, a reduction in demand for 
these funds might be desirable.\21\ However, some investors face 
functional obstacles to placing certain assets in floating NAV funds. 
For example, internal investment guidelines may prevent corporate cash 
managers from investing in floating NAV funds, some state laws allow 
municipalities to invest only in stable-value funds, and fiduciary 
obligations may prevent institutional investors from investing client 
money in floating NAV funds. In addition, some investors may not 
tolerate the loss of accounting convenience and tax efficiencies that 
would result from a shift to a floating NAV, although these problems 
might be mitigated somewhat through regulatory or legislative 
actions.\22\
---------------------------------------------------------------------------

    \21\ Even a contraction in the credit extended by MMFs might be 
an efficient outcome if such credit has been over-supplied because 
markets have not priced liquidity and systemic risks appropriately.
    \22\ A stable NAV relieves shareholders of the administrative 
task of tracking the timing and price of purchase and sale 
transactions for tax and accounting purposes. For investors using 
MMFs for cash management, floating NAV funds (under current rules) 
would present more record-keeping requirements than stable NAV 
funds, although certain tax changes beginning in 2011 will require 
mutual funds, including MMFs, to report the tax basis (presumably 
using an average basis method) to shareholders and thereby help 
reduce any associated accounting burden from a floating NAV.
---------------------------------------------------------------------------

     Second, a related concern is that elimination of MMFs' 
stable NAVs may cause investors to shift assets to stable NAV 
substitutes that are vulnerable to runs but subject to less regulation 
than MMFs. In particular, many institutional investors might move 
assets to less regulated or unregulated cash management vehicles, such 
as offshore MMFs, enhanced cash funds, and other stable value vehicles 
that hold portfolios similar to those of MMFs but are not subject to 
the ICA's restrictions on MMFs. These unregistered funds can take on 
more risks than MMFs, but such risks are not necessarily transparent to 
investors. Accordingly, unregistered funds may pose even greater 
systemic risks than MMFs, particularly if new restrictions on MMFs 
prompt substantial growth in unregistered funds. Thus, changes to MMF 
rules might displace or even increase systemic risks, rather than 
mitigate them, and make such risks more difficult to monitor and 
control. Reforms designed to reduce risks in less regulated or 
unregulated MMF substitutes are discussed in more detail in section 
3(h).
    Elimination of MMFs' stable NAVs may also prompt some investors--
particularly retail investors--to shift assets from MMFs to banks. Such 
asset shifts would have potential benefits and drawbacks, which are 
discussed in some detail in section 3(g).
     Third, MMFs' transition from stable to floating NAVs might 
itself be systemically risky. For example, if shareholders perceive a 
risk that a fund that is maintaining a $1 NAV under current rules has a 
market-based shadow NAV of less than $1, these investors may redeem 
shares preemptively to avoid potential losses when MMFs switch to 
floating NAVs. Shareholders who cannot tolerate floating NAVs probably 
also would redeem in advance. If large enough, redemptions could force 
some funds to sell assets and make concerns about losses self-
fulfilling. Hence, successful implementation of a switch to floating 
NAVs would depend on careful design of the conversion process to guard 
against destabilizing transition dynamics.
     Fourth, risk management practices in a floating NAV MMF 
industry might deteriorate without the discipline required to maintain 
a $1 share price. MMFs comply with rule 2a-7 because doing so gives 
them the ability to use amortized-cost accounting to maintain a stable 
NAV. Without this reward, the incentive to follow 2a-7 restrictions is 
less clear. Moreover, the stable, rounded NAV creates a bright line for 
fund advisers: Losses in excess of \1/2\ of 1 percent would be 
catastrophic because they would cause a fund to break the buck. With a 
floating NAV, funds would not have as clear a tipping point, so fund 
advisers might face reduced incentives for prudent risk management.
     The fifth and final concern is that a floating NAV that 
accomplishes its proponents' objectives of reducing systemic risks may 
be difficult to implement. Under normal market conditions, even a 
floating NAV would likely move very little because of the nature of MMF 
assets. For example, although a requirement that MMFs move to a $10 NAV 
and round to the nearest cent would force funds to reprice shares for 
as little as a 5 basis point change in portfolio value, NAV 
fluctuations might still remain relatively rare. Enhanced precision for 
NAVs (for example, NAVs with five significant figures) could bring more 
regular, incremental fluctuations, but precise pricing of many money 
market securities is challenging given the absence of active secondary 
markets. In addition, if fund sponsors decided to provide support to 
offset any small deviations from the usual NAV, deviations from that 
NAV might remain rare.
    Thus, a floating NAV may not substantially improve investors' 
understanding of the riskiness of MMFs or reduce the stigma and 
systemic risks associated with breaking the buck. Investors' 
perceptions that MMFs are virtually riskless may change slowly and 
unpredictably if NAV fluctuations remain small and rare. MMFs with 
floating NAVs, at least temporarily, might even be more prone to runs 
if investors who continue to see shares as essentially risk-free react 
to small or temporary changes in the value of their shares.
    To summarize, requiring the entire MMF industry to move to a 
floating NAV would have some potential benefits, but those benefits 
would have to be weighed carefully against the risks that such a change 
would entail.
b. Private Emergency Liquidity Facilities for MMFs
    As discussed in section 1(b), the liquidity risk of MMFs 
contributes importantly to MMFs' vulnerability to runs. The programs 
introduced at the height of the run on MMFs in September 2008--
Treasury's Temporary Guarantee Program for Money Market Funds and the 
liquidity backstop provided by the AMLF--were effective in stopping the 
run on MMFs.\23\ More generally, policymakers have long recognized the 
utility of liquidity

[[Page 68649]]

backstops for institutions engaged in maturity transformation: Banks, 
for example, have had access to the discount window since its 
inception, and backstop lending facilities also have been created more 
recently for other types of institutions. Thus, enhanced liquidity 
protection should be considered as part of any regulatory reform effort 
aimed at preventing runs on MMFs. At the same time, such enhanced 
liquidity protection does not have to be provided necessarily by the 
government: A private facility, adequately capitalized and financed by 
the MMF industry, could be set up to supply liquidity to funds that 
most need it at times of market stress. Depending on its structure, 
such a private facility itself might have access to broader liquidity 
backstops.
---------------------------------------------------------------------------

    \23\ Outflows from prime MMFs totaled about $200 billion in the 
two days prior to the Treasury and Federal Reserve announcements on 
Friday, September 19, 2008. However, in the two business days 
following the announcements (Monday and Tuesday, September 22 and 
23), outflows were just $22 billion.
---------------------------------------------------------------------------

    A private emergency liquidity facility could be beneficial on 
several levels. First, a private liquidity facility, in combination 
with the SEC's new liquidity requirements, might substantially buttress 
MMFs' ability to withstand outflows without selling assets in 
potentially illiquid markets.\24\ Second, a private emergency facility 
might offer important efficiency gains from risk pooling. Even during 
the systemic liquidity crisis in 2008, individual MMFs experienced 
large variations in the timing and magnitude of redemptions. An 
emergency facility could provide liquidity to the MMFs that need it; in 
contrast, liquidity requirements for individual MMFs would likely leave 
some funds with too much liquidity and others with too little. Third, a 
private liquidity facility might provide funds with flexibility in 
managing liquidity risks if, for example, regulators allowed MMFs some 
relief in liquidity requirements in return for the funds' purchase of 
greater access to the liquidity facility's capacity.
---------------------------------------------------------------------------

    \24\ For example, as noted in the text, even if MMFs in 
September 2008 had held liquid assets in the proportions that the 
SEC has recently mandated, the net redemptions experienced by the 
funds following the Lehman Brothers bankruptcy would have forced 
MMFs to sell considerable amounts of securities into illiquid 
markets in the absence of the substantial government interventions. 
But a liquidity facility with the capacity to provide an additional 
10 percent overnight liquidity to each fund would double the 
effective overnight liquid resources available to MMFs. If MMFs in 
September 2008 had already been in compliance with the new liquidity 
requirements, a facility with this capacity would have considerably 
reduced funds' need to raise liquidity (for example, through asset 
sales) during the run. In addition, the very existence of the 
facility might have reduced redemption requests in the first place.
---------------------------------------------------------------------------

    Importantly, a properly designed and well-managed private liquidity 
facility would internalize the cost of liquidity protection for the MMF 
industry and provide appropriate incentives for MMFs and their 
investors.\25\ Such a facility would not help funds that take on 
excessive capital risks or face runs because of isolated credit losses 
(a well-designed private liquidity facility would not have helped the 
Reserve Primary Fund or its shareholders avoid losses in September 2008 
due to holdings of Lehman Brothers debt). Moreover, a liquidity 
facility alone may not prevent runs on MMFs triggered by concerns about 
more widespread credit losses at MMFs. However, a liquidity facility 
could substantially reduce the damage that a run on a single distressed 
fund might cause to the rest of the industry.
---------------------------------------------------------------------------

    \25\ A private liquidity facility could also result in retail 
fund investors bearing some of the costs of meeting the likely 
higher liquidity needs of institutional funds. Consideration should 
be given as to whether and how to prevent such an outcome.
---------------------------------------------------------------------------

    While a private emergency liquidity facility would be appealing in 
several respects, setting up an effective facility would present a 
number of challenges. The structure and operations of a private 
liquidity facility would have to be considered carefully to ensure that 
it would be effective during crises and that it would not unduly 
distort incentives, while, at the same time, that it would be in 
compliance with all applicable regulations and that it would not favor 
certain market participants or business models. For example:
     On the one hand, if MMFs were required to participate in a 
private facility, regulators would assume some responsibility for 
ensuring that the facility was operated equitably and efficiently, that 
it managed risks prudently, and that it was able to provide liquidity 
effectively during a crisis. On the other hand, if participation were 
voluntary, some MMFs would likely choose not to participate to avoid 
sharing in the costs associated with the facility. Non-participating 
MMFs might present greater risks than their competitors but would free-
ride on the stability the liquidity facility would provide. In a 
voluntary participation framework, one means of balancing risks between 
MMFs that do and do not participate in a liquidity facility would be to 
require nonparticipants to adhere to more stringent risk-limiting 
constraints or to require such funds to switch to a floating NAV. Such 
an approach (in which some MMFs have stable NAVs and others floating 
NAVs) is considered in section 3(e).
     Ensuring that the facility has adequate capacity to meet 
MMFs' liquidity needs during a crisis would be critical to the 
effectiveness of the facility in mitigating systemic risk. Inadequate 
capacity might, for example, create an incentive for MMF advisers to 
tap the facility before others do and thus make the facility itself 
vulnerable to runs. News of a depleted liquidity facility might amplify 
investor concerns and trigger or expand a run on MMFs. However, raising 
enough capital to build adequate liquidity capacity without undue 
leverage would be a challenge for the asset management industry. 
Accordingly, meaningful mitigation of systemic risk may require that 
the facility itself have access to alternative sources of liquidity.
     A private facility may face conflicts of interest during a 
crisis when liquidity is in short supply. Responsibility to the 
facility's shareholders would mandate prudence in providing liquidity 
to MMFs. For example, facility managers would want to be selective in 
providing liquidity against term commercial paper out of concern about 
losses on such paper. However, excessive prudence would be at odds with 
the facility serving as an effective liquidity backstop. In addition, a 
private facility may face conflicts among different types of 
shareholders and participants who may have different interests, and a 
strong governance structure would be needed to address these conflicts 
as well as prevent the domination of the facility by the advisers of 
larger funds.
     Rules governing access to the facility would have to be 
crafted carefully to minimize the moral hazard problems among fund 
advisers, who could face diminished incentives to maintain liquidity in 
their MMFs. However, excessive constraints on access would limit the 
facility's effectiveness. An appropriate balancing of access rules 
might be difficult to achieve.
    Notwithstanding these concerns, a private emergency liquidity 
facility could play an important role in supplementing the SEC's new 
liquidity requirements for MMFs. The potential advantages and 
disadvantages of such a facility, as well as its optimal structure and 
modes of operation, should be the subjects of further analysis and 
discussion.
c. Mandatory Redemptions in Kind
    When investors make large redemptions from MMFs, they impose 
liquidity costs on other shareholders in the fund. For example, 
redemptions may force a fund to sell its most liquid assets to raise 
cash. Remaining shareholders are left with claims on a less liquid 
portfolio, so redemptions are particularly costly for other

[[Page 68650]]

shareholders during a crisis, when liquidity is most valued.\26\
---------------------------------------------------------------------------

    \26\ The problem is exacerbated by a rounded NAV, because a fund 
that has already incurred a capital loss but that continues to 
redeem each share at $1 also transfers capital losses from redeeming 
shareholders to those who remain in the fund.
---------------------------------------------------------------------------

    A requirement that MMFs distribute large redemptions by 
institutional investors in kind, rather than in cash, would force these 
redeeming shareholders to bear their own liquidity costs and reduce 
their incentive to redeem.\27\ If liquidity pressures are causing money 
market instruments to trade at discounts, a MMF that distributes a 
large redemption in cash may have to sell securities at a discount to 
raise the cash. All shareholders in the fund would share in the loss on 
a pro rata basis. However, if the fund distributes securities to the 
investor in proportion to the claim on the fund represented by the 
redeemed shares, the liquidity risk would be borne most directly by the 
redeeming investor. If the fund elects to dispose of the securities in 
a dislocated market and incurs a loss, other shareholders are not 
directly affected.\28\
---------------------------------------------------------------------------

    \27\ Such a requirement also would force redeeming shareholders 
to bear their share of any losses that a MMF has already incurred--
even if the fund maintains a stable, rounded NAV and has not yet 
broken the buck--rather than concentrating those losses entirely in 
the MMF and thus on remaining MMF shareholders.
    \28\ If the investor sells securities at a loss, however, and 
the MMF also holds the same or similar securities, the fund may be 
forced to re-price the securities and lower its mark-to-market, 
shadow NAV. So, remaining investors in the fund may be affected 
indirectly by the redeeming investor, even if that investor receives 
redemptions in kind.
---------------------------------------------------------------------------

    Requiring large redemptions to be made in kind would reduce, but 
not eliminate the systemic risk associated with large, widespread 
redemptions. Shareholders with immediate liquidity needs who receive 
securities from MMFs would have to sell those assets, and the 
consequences for short-term markets of such sales would be similar to 
the effects if the money market fund itself had sold the securities. 
Smaller shareholders would still receive cash redemptions, and larger 
investors might structure their MMF investments and redemptions to 
remain under the in-kind threshold.
    An in-kind redemption requirement would present some operational 
and policy challenges. Portfolio holdings of MMFs sometimes are not 
freely transferable or are only transferable in large blocks of shares, 
so delivery of an exact pro rata portion of each portfolio holding to a 
redeeming shareholder may be impracticable. Thus, a fund may have to 
deliver different securities to different investors but would need to 
do so in an equitable manner. Funds should not, for example, be able to 
distribute only their most liquid assets to redeeming shareholders, 
since doing so would undermine the purpose of an in-kind redemptions 
requirement. Thus, the SEC would have to make key judgments on the 
circumstances under which a fund must redeem in kind, as well as the 
criteria that funds would use for determining which portfolio 
securities must be distributed and how they would be valued.
d. Insurance for MMFs
    As noted in section 1(b), the absence of formal capital buffers or 
insurance for MMFs, as well as their historical reliance on 
discretionary sponsor support in place of such mechanisms, further 
contributes to their vulnerability to runs. Treasury's Temporary 
Guarantee Program for Money Market Funds, announced on September 19, 
2008, was a key component of the government intervention that slowed 
the run on MMFs. The program provided guarantees for shares in MMFs as 
of the announcement date. These guarantees were somewhat akin to 
deposit insurance, which for many decades has played a central role in 
mitigating the risk of runs on banks.\29\ Therefore, some form of 
insurance for MMF shareholders might be helpful in mitigating systemic 
risks posed by MMFs, although insurance also may create new risks by 
distorting incentives of fund advisers and shareholders.
---------------------------------------------------------------------------

    \29\ All publicly offered stable NAV MMFs were eligible to 
participate in the program. If a MMF elected to participate, the 
program guaranteed that each shareholder in that MMF would receive 
the stable share price (typically $1) for each share held in the 
fund, up to the number of shares held as of the close of business on 
September 19, 2008. In the event that a participating MMF broke the 
buck, the fund was required to suspend redemptions and commence 
liquidation, and the fund was eligible to collect payment from 
Treasury to enable payment of the stable share price to each covered 
investor. Treasury neither received any claims for payment nor 
incurred any losses under the program.
---------------------------------------------------------------------------

    Like an external liquidity facility, insurance would reduce the 
risk of runs on MMFs, but the consequences of insurance and a liquidity 
facility would otherwise be different. A liquidity facility would do 
little or nothing to help a fund that had already experienced a capital 
loss, but such a facility might be very helpful in mitigating the 
destabilizing effects that one fund's capital loss might impose on the 
rest of the industry. Insurance, in contrast, would substantially 
reduce or eliminate any losses borne by the shareholders of the MMF 
that experienced the capital loss and damp their incentives to redeem 
shares in that fund. Although either option might reduce the incentives 
for asset managers and shareholders to minimize risks, a liquidity 
facility without an insurance scheme would leave intact shareholders' 
incentive to monitor funds for the credit and interest rate risks that 
may trigger a run. However, in a crisis that triggers concerns about 
widespread credit losses, liquidity protection without some form of 
insurance may still leave MMFs vulnerable to runs.
    In addition to these general considerations, the design and 
implementation of an insurance program for MMFs would require 
resolution of a number of difficult issues. For example:
     Insurance could, in principle, be provided by the private 
sector, the government, or a combination of the two, but all three 
options have potential drawbacks. Private insurers have had 
considerable difficulties in fairly pricing and successfully 
guaranteeing rare but high-cost financial events, as demonstrated, for 
example, by the recent difficulties experienced by financial 
guarantors. That no private market for insurance has developed is some 
evidence that such insurance for MMFs may be a challenging business 
model, particularly if funds are not required to obtain insurance.\30\ 
Making insurance for MMFs mandatory could attract private insurance 
providers, but the pricing and scope of coverage that these providers 
could offer would need to be the subject of careful consideration. In 
any case, insurers would need to maintain capital and carry reinsurance 
as necessary to cover losses during extraordinary events. Public 
insurance would necessitate new government oversight and administration 
functions and, particularly in the absence of private insurance, would 
require a mechanism

[[Page 68651]]

for setting appropriate risk-based premiums (either pre- or post-
event). A hybrid insurance scheme--for example, with MMFs or their 
sponsors retaining the first level of losses up to a threshold, private 
insurers or risk pools handling losses up to a certain higher 
threshold, and a government insurance program serving as a backstop 
(perhaps with post-event recoupment)--might offer some advantages, but 
it would be subject to the risks of private insurance and the 
challenges of public insurance.
---------------------------------------------------------------------------

    \30\ The degree of insurance coverage provided by Treasury's 
Temporary Guarantee Program for Money Market Funds was 
unprecedented. Private insurance with considerably narrower coverage 
has been available to MMFs in the past: ICI Mutual Insurance 
Company, an industry association captive insurer, offered very 
limited insurance to MMFs from 1999 to 2003. This insurance covered 
losses on MMF portfolio assets due to defaults and insolvencies but 
not losses due to events such as a security downgrade or a rise in 
interest rates. Coverage was limited to $50 million per fund, with a 
deductible of the first 10 to 40 basis points of any loss. Premiums 
ranged from 1 to 3 basis points. ICI Mutual reportedly discontinued 
offering the insurance in 2003 because coverage restrictions and 
other factors limited demand to the point that the insurance was not 
providing enough risk pooling to remain viable. Of course, MMFs 
continue to have access to other market-based mechanisms for 
transferring risks, such as credit default swaps, although holdings 
of such derivative securities by MMFs are tightly regulated by rule 
2a-7.
---------------------------------------------------------------------------

     On the one hand, mandatory participation in an insurance 
system likely would be necessary to instill investor confidence in the 
MMF industry, to ensure an adequate pooling of risk, to prevent riskier 
funds from opting out yet free-riding on the stability afforded by 
insured funds, and to create a sufficient premium base. On the other 
hand, an insurance requirement would create new government 
responsibilities, and the regulatory and economic implications of such 
a requirement would have to be evaluated carefully.
     Insurance increases moral hazard and would shift 
incentives for prudent risk management by MMFs from fund advisers, who 
are better positioned to monitor risks, to public or private insurers. 
In addition, insurance removes investors' incentives to monitor risk 
management by fund advisers. Broadly speaking, insurance fundamentally 
changes the nature of MMF shares, from pooled pass-through investments 
in risky assets to insured products with relatively low yields and 
limited or no risk.
     Appropriate pricing would be critical to the success of a 
MMF insurance program, as pricing would affect the financial position 
of the guarantor, the incentives of MMF advisers, and the relative 
attractiveness of different types of MMFs and their competitors (for 
example, bank deposits). Insurance pricing that is not responsive to 
the riskiness of individual MMF portfolios, for example, would heighten 
moral hazard problems that undermine incentives for prudent MMF risk 
management. Underpriced insurance might cause disruptive outflows from 
bank deposits to MMFs and would be a subsidy for sponsors of and 
investors in MMFs. Still, insurance for MMFs might be easier to price 
fairly than deposit insurance for banks, as MMF portfolios are highly 
restricted, relatively homogeneous in comparison with bank portfolios, 
transparent, and priced on a daily basis.
     Limits on insurance coverage (perhaps similar to those for 
deposit insurance) would be needed to avoid giving MMFs an advantage 
over banks and to preserve incentives for large investors to monitor 
the risk management practices at MMFs. However, such limits would leave 
most institutional investors' shares only marginally covered by 
insurance and do little to reduce their incentive to run should MMF 
risks become salient.
e. A Two-Tier System of MMFs, With Enhanced Protections for Stable NAV 
MMFs
    Reforms intended to reduce the systemic risks posed by MMFs might 
be particularly effective if they allow investors some flexibility in 
choosing the MMFs that best match their risk-return preferences. 
Policymakers might accommodate a range of preferences by allowing two 
types of MMFs to be regulated under rule 2a-7:
    (i) Stable NAV MMFs. These funds would continue to maintain stable, 
rounded NAVs, but they would be subject to enhanced protections, which 
might include some combination of tighter regulation (such as higher 
liquidity standards) and required access to an external liquidity 
backstop. Other options to provide enhanced protection for stable NAV 
funds might include mandatory distribution of large redemptions in kind 
and insurance. (Policymakers may also consider limiting the risk 
arising from investors in stable NAV funds by restricting sales of such 
funds' shares to retail investors, as discussed in section 3(f).)
    (ii) Floating NAV funds. Although these MMFs would still have to 
comply with many of the current restrictions of rule 2a-7, these 
restrictions might be somewhat less stringent than those for stable NAV 
funds. So, floating NAV funds could bear somewhat greater credit and 
liquidity risks than stable NAV funds, might not be required to obtain 
access to external sources of liquidity or insurance, and most likely 
would pay higher yields than their stable NAV counterparts. Regulatory 
relief--for example, allowing simplified tax treatment for small NAV 
changes in funds that adhere to rule 2a-7--might help preserve the 
attractiveness of such funds for many investors.
    A two-tier system could mitigate the systemic risks that arise from 
a stable, rounded NAV, by requiring funds that maintain a stable NAV to 
have additional protections that directly address some of the features 
that contribute to their vulnerability to runs. At the same time, by 
preserving stable NAV funds, such a system would mitigate the risks of 
a wholesale shift to floating NAV funds. For example, a two-tier system 
would diminish the likelihood of a large-scale exodus from the MMF 
industry by investors who might find a floating NAV MMF unacceptable.
    Floating NAV MMFs would face a lower risk of runs for the reasons 
outlined in section 3(a): Frequent changes in these funds' NAVs would 
help align investor perceptions and actual fund risks, and investors 
would have reduced incentives to redeem early in a crisis without a 
rounded NAV. In addition, investor sorting might ameliorate the risk of 
runs: Under such a two-tier system, investors who choose floating NAV 
funds presumably would be less risk-averse and more tolerant of NAV 
changes than the shareholders of stable NAV funds.
    During a crisis, investors would likely shift at least some assets 
from riskier floating NAV MMFs to stable NAV MMFs, which would 
presumably be safer because of their enhanced protections. Such flows 
might be similar, in some respects, to the asset flows seen during the 
September 2008 crisis from prime MMFs to government MMFs, but a shift 
between tiers of prime funds could be less disruptive to short-term 
funding markets and the aggregate supply of credit to private firms 
than a flight from prime to government MMFs. Effective design of a two-
tier system would have to incorporate measures to ensure that large-
scale shifts of assets among MMFs in crises would not be 
disruptive.\31\
---------------------------------------------------------------------------

    \31\ If stable NAV MMFs carried mandatory insurance, some 
limitations on insurance coverage (for example, stipulating that 
individual shares in such funds could be insured only after a given 
number of days) might reduce the magnitude of flows between 
different types of MMFs and reduce implicit subsidies for investors 
who purchase shares in stable NAV funds only during crises. However, 
such rules might diminish the value of insurance in preventing runs.
---------------------------------------------------------------------------

    For a two-tier system to be effective and materially mitigate the 
risk of runs, investors would have to fully understand the difference 
between the two types of funds and their associated risks. Investors 
who do not make this distinction might flee indiscriminately from 
floating NAV and stable NAV funds alike; in this case, a two-tier 
system would not be effective in mitigating the risk of runs.
    The relative ease or difficulty of implementing a two-tier system 
would depend on the nature of the stable NAV and floating NAV MMFs that 
comprise it. For example, if the stable NAV funds simply were required 
to satisfy more stringent SEC rules governing portfolio safety, 
creation of a two-tier system would be fairly straightforward. A 
requirement that stable NAV funds obtain access to an emergency 
liquidity facility would likely make stable NAV

[[Page 68652]]

funds less prone to runs and would reduce the likelihood that investors 
flee indiscriminately from both types of funds in the event of severe 
market strains. However, this approach also would face the challenges 
associated with the creation of an effective liquidity facility 
(discussed in more detail in section 3(b)).
f. A Two-Tier System of MMFs, With Stable NAV MMFs Reserved for Retail 
Investors
    Another approach to the two-tier system described in section 3(e) 
could distinguish stable NAV and floating NAV funds by investor type. 
Stable NAV MMFs could be made available only to retail investors, while 
institutional investors would be restricted to floating NAV funds.
    This approach would bring enhanced protections to stable NAV MMFs 
by mitigating the risk arising from the behavior of their investors, 
because institutional investors have historically generated greater 
risks of runs for MMFs than retail investors. As noted previously, the 
run from MMFs in September 2008 was primarily a flight by institutional 
investors. More than 90 percent of the net outflows from prime MMFs in 
the week following the Lehman Brothers bankruptcy came from 
institutional funds, and institutional investors withdrew substantial 
sums from prime MMFs even before the Reserve Primary Fund broke the 
buck.
    Moreover, evidence suggests that the additional risks posed by 
institutional investors during the run on MMFs in September 2008 were 
not unique to that episode. Relative to retail investors, institutional 
investors have greater resources to monitor MMF portfolios and risks 
and have larger amounts at stake, and are therefore quicker to redeem 
shares on concerns about MMF risks. Institutional MMFs typically have 
greater cash flow volatility than retail funds. Net flows to 
institutional MMFs have also exhibited patterns indicating that 
institutional investors regularly arbitrage small discrepancies between 
MMFs' shadow NAVs and their $1 share prices.\32\ These observations 
suggest that many institutional investors are aware of such 
discrepancies--which are likely to widen during financial crises--and 
are able to exploit them.
---------------------------------------------------------------------------

    \32\ For example, after Federal Open Market Committee (FOMC) 
actions that lower the FOMC's target for the federal funds rate, MMF 
shadow NAVs rise and institutional MMFs often experience large net 
inflows.
---------------------------------------------------------------------------

    A two-tier system based on investor type would protect the 
interests of retail investors by reducing the likelihood that a run 
might begin in institutional MMFs (as it did in September 2008) and 
spread to retail funds. Moreover, such a system would preserve the 
original purpose of MMFs, which was to provide retail investors with 
cost-effective access to diversified investments in money market 
instruments. Retail investors have few alternative opportunities to 
obtain such exposures. In contrast, institutional investors, which can 
meet minimum investment thresholds for direct investments in money 
market instruments, would be able to continue doing so.
    One advantage of this alternative is that it could be accomplished 
by SEC rulemaking under existing authorities without establishing 
additional market structures. A prohibition on institutional investors' 
use of stable NAV MMFs would have some practical hurdles, however. 
Successful enforcement of the rule would require the SEC to define who 
would qualify as retail and institutional investors. In practice, such 
distinctions may be difficult, although not impossible, to make. For 
example, retail investors who own MMF shares because of their 
participation in defined contribution plans (such as 401(k) plans) may 
be invested in institutional MMFs through omnibus accounts that are 
overseen by institutional investors (plan administrators). Simple rules 
that might be used to identify institutional investors, such as 
defining as institutional any investor whose account size exceeds a 
certain threshold, would be imperfect and could motivate the use of 
workarounds (such as brokered accounts) by institutional investors. The 
SEC, as part of its rulemaking, would need to take steps to prevent 
such workarounds.
    Because many institutional investors may be particularly unwilling 
to switch to floating NAV MMFs, a prohibition on sales of stable NAV 
MMFs shares to such investors may have many of the same unintended 
consequences as a requirement that all MMFs adopt floating NAVs (see 
section 3(a)). In particular, prohibiting institutional investors from 
holding stable NAV funds might cause large shifts in assets to 
unregulated MMF substitutes. This concern is of particular importance 
given that institutional MMFs currently account for almost two-thirds 
of the assets under management in MMFs.
    In addition, a two-tier system based on investor type would 
preclude some of the advantages of allowing institutional investors to 
choose between stable NAV MMFs and floating NAV MMFs (as the option 
described in section 3(e) would permit). For example, under the two-
tier system described in section 3(e), investor sorting would provide 
some protection for the floating NAV funds, because institutional 
investors holding floating NAV MMFs likely would be less risk-averse 
than those who held stable NAV funds. With institutional investors 
prohibited from holding shares in stable NAV MMFs, such sorting among 
these investors would not occur. During a crisis, under the system 
described in section 3(e), institutional investors might be expected to 
shift assets from floating NAV MMFs to stable NAV funds, but a ban on 
institutional holdings of stable NAV MMF shares would prevent such 
shifts.
g. Regulating Stable NAV MMFs as Special Purpose Banks
    Functional similarities between MMF shares and deposits, as well as 
the risk of runs on both types of instruments, provide a rationale for 
introducing bank-like regulation for MMFs. For example, mandating that 
stable NAV MMFs be reorganized as SPBs might subject these MMFs to 
banking oversight and regulation, including requirements for reserves 
and capital buffers, and provide MMFs with access to a liquidity 
backstop and insurance coverage within a regulatory framework 
specifically designed for mitigation of systemic risk.\33\ If each MMF 
were offered the option of implementing a floating NAV as an 
alternative to reorganizing as a bank, the reorganization requirement 
for stable NAV MMFs might be viewed as part of a two-tier system for 
MMFs.\34\
---------------------------------------------------------------------------

    \33\ Such an approach to MMF reform was advocated by the Group 
of Thirty. See Group of Thirty, Financial Reform: A Framework for 
Financial Stability, released on January 15, 2009.
    \34\ There may be a question as to whether floating NAV MMFs--if 
such funds are offered--should or should not be required to 
reorganize as SPBs. Other mutual funds with floating NAVs, such as 
ultra-short bond funds, presumably would not be affected by a 
mandate that MMFs reorganize as SPBs. The principal distinction 
between other (non-MMF) mutual funds and floating NAV MMFs would be 
that the latter are constrained by rule 2a-7 and thus have less 
risky portfolios, so the advantages and disadvantages of mandating 
these funds to reorganize as banks would have to be carefully 
evaluated. However, policymakers could consider prohibiting floating 
NAV MMFs from offering bank-like services that attract risk-averse 
investors, such as the ability to provide transactions services.
---------------------------------------------------------------------------

    Although the conceptual basis for converting stable NAV MMFs to 
SPBs is seemingly straightforward, in practice this option spans a 
broad range of possible implementations, most of which would require 
legislative changes and complex interagency regulatory coordination. 
The advantages and disadvantages of this reform option depend on how 
exactly the conversion to SPBs would be implemented and

[[Page 68653]]

how the new banks would be structured. A thorough discussion of the 
full range of possibilities--including their feasibility, probable 
effect on the MMF industry, broader implications for the banking 
system, and likely efficacy in mitigating systemic risk--would be quite 
complex and is beyond the scope of this report.
    As an example of the issues that this option involves, one possible 
approach to its implementation would be to preserve stable NAV MMFs as 
standalone entities but to treat their shares as deposits for the 
purposes of banking law. These shares, unlike other deposits, might be 
claims specifically (and only) on MMF assets, which could continue to 
be subject to strict risk-limiting regulations such as those provided 
by rule 2a-7 or similar rules. The introduction of such hybrid 
investment vehicles would preserve investors' opportunity to benefit 
from mutualized investments in private money market instruments, but, 
being a novel combination of features of banks and mutual funds, such 
vehicles would also present complex regulatory and operational 
challenges. In contrast, other approaches to converting MMFs to SPBs, 
such as absorbing or transforming stable NAV MMFs into financial 
institutions that offer traditional deposits, might be simpler to 
accomplish in practice, but nonetheless subject to different sets of 
challenges. In particular, if the deposits offered by the new SPBs were 
only of the types currently offered by other banks, investors--and 
particularly retail investors, who have few alternative opportunities 
to obtain diversified exposures to money market instruments--would lose 
access to important investment options.\35\ In addition, to the extent 
that banks have different preferences for portfolio assets than MMFs, a 
simple transformation of MMFs into depository institutions might lead 
to a decline in the availability of short-term financing for firms and 
state and local governments that currently rely on money markets to 
satisfy their funding needs. Considerable further study would thus be 
needed in pursuing this option.
---------------------------------------------------------------------------

    \35\ In contrast, institutional investors could continue to 
obtain such exposures either by investing directly in money market 
instruments or by holding shares in offshore MMFs, enhanced cash 
funds, and other stable value vehicles. Hence, absorption of MMFs by 
banks might have the unintended effect of reducing investment 
opportunities for retail investors, who generally did not 
participate in the run on MMFs in 2008, while leaving money market 
investment options for institutional investors largely intact.
---------------------------------------------------------------------------

    Leaving aside the details of how exactly this option could be 
implemented, in general terms, a principal advantage of reorganizing 
MMFs as SPBs is that such a change would provide MMFs with a broad 
regulatory framework similar to existing regulatory systems that are 
designed for mitigation of systemic risk. Investments in MMFs and 
insured deposits--which already serve some similar functions, 
particularly for retail investors--could be regulated similarly. MMFs 
and their investors might benefit from access to government insurance 
and emergency liquidity facilities at a price similar to that currently 
paid by depository institutions. Importantly, such access would not 
require any extraordinary government actions (such as the establishment 
in September 2008 of Treasury's Temporary Guarantee Program for Money 
Market Funds or the creation of the Federal Reserve's AMLF); instead, 
the terms of such access would be codified and well-understood in 
advance.
    Moreover, by providing explicit capital buffers, access to a 
liquidity backstop, and deposit insurance, a conversion of stable NAV 
MMFs to SPBs might substantially reduce the uncertainties and systemic 
risks associated with MMF sponsors' current practice of discretionary 
capital support. Clear rules for how the buffers, backstop, and 
insurance would be used would improve the transparency of the 
allocation of risks among market participants.
    However, the capital needed to reorganize MMFs as SPBs may be a 
significant hurdle to successful implementation of this option. Access 
to the Federal Reserve discount window and deposit insurance coverage 
most likely would require that the new SPBs hold reservable deposits 
and meet specific capitalization standards.\36\ Given the scale of 
assets under management in the MMF industry, MMF sponsors (or banks) 
that wish to keep funds operating would have to raise substantial 
equity--probably at least tens of billions of dollars--to meet 
regulatory capital requirements.\37\ Raising such sums would be a 
considerable challenge. The asset management business typically is not 
capital intensive, so many asset managers--and several of the largest 
sponsors of MMFs--are lightly capitalized and probably could not 
provide such amounts of capital. If asset managers or other firms were 
unwilling or unable to raise the capital needed to operate the new 
SPBs, a sharp reduction in assets in stable NAV MMFs might diminish 
their capacity to supply short-term credit, curtail the availability of 
an attractive investment option (particularly for retail investors), 
and motivate institutional investors to shift assets to unregulated 
vehicles.
---------------------------------------------------------------------------

    \36\ Currently, MMFs are essentially 100 percent capital--their 
liabilities are the equity shares held by investors--so the meaning 
of ``capital requirements'' for such funds is not clear. However, if 
MMFs were reorganized as SPBs, their capital structure would become 
more complex. MMF shares would likely be converted to deposit 
liabilities, and MMFs would have to hold additional capital (equity) 
buffers to absorb first losses. Capital requirements would regulate 
the size of such buffers.
    \37\ The magnitude of the capital required might be reduced if 
floating NAV MMFs were not required to reorganize as SPBs and if a 
substantial number of funds elected to float their NAVs rather than 
reorganize as banks. In addition, the capital required might be 
reduced somewhat if regulators determined that the nature of the 
assets held by MMFs justifies capital requirements that are lower 
than those imposed on commercial banks and thrifts.
---------------------------------------------------------------------------

    An additional hurdle to converting MMFs to SPBs would be the 
substantial increase in explicit government guarantees that would 
result from the creation of new insured deposits. The potential 
liability to the government probably would far exceed any premiums that 
could be collected for some time.
    Uncertainties about the reaction of institutional investors to MMFs 
reorganized as SPBs raise some important concerns about whether such 
reorganizations would provide a substantial degree of systemic-risk 
mitigation. Coverage limits on deposit insurance would leave many large 
investors unprotected in case of a significant capital loss. Thus, even 
with the protections afforded to banks, MMFs would still be vulnerable 
to runs by institutional investors, unless much higher deposit 
insurance limits were allowed for the newly created SPBs. Moreover, 
even in the absence of runs, institutional MMFs often experience 
volatile cash flows, and the potential effects of large and high-
frequency flows into and out of the banking system (if MMFs become 
SPBs) would need to be analyzed carefully.
    The reaction of institutional investors to the altered set of 
investment opportunities may also have unintended consequences. For 
example, SPBs that pay positive net yields to investors (depositors) 
would be very attractive for institutional investors who currently 
cannot receive interest on traditional bank deposits.\38\ Thus, on the 
one hand, the new SPBs might prompt shifts of assets by institutional 
investors from the traditional banking system. On the other hand, a 
substantial mandatory capital

[[Page 68654]]

buffer for MMFs would reduce their net yields and possibly motivate 
institutional investors to move assets from MMFs to unregulated 
alternatives (particularly if regulatory reform does not include new 
constraints on such vehicles). The effect of these competing incentives 
on institutional investors' cash management practices is uncertain, but 
it is at least plausible that a reorganization of MMFs as SPBs may lead 
to a net shift of assets to unregulated investment vehicles.
---------------------------------------------------------------------------

    \38\ Section 627 of the Dodd-Frank Act repeals the prohibition 
on banks paying interest on corporate demand deposit accounts 
effective July 21, 2011.
---------------------------------------------------------------------------

h. Enhanced Constraints on Unregulated MMF Substitutes
    New rules intended to reduce the susceptibility of MMFs to runs 
generally also will reduce the appeal of the funds to many investors. 
For example, several of the reforms recently adopted by the SEC 
probably will reduce the net yields that the funds pay to shareholders, 
and a switch to floating NAVs would eliminate a feature that some MMF 
shareholders see as essential.
    Reforms that reduce the appeal of MMFs may motivate some 
institutional investors to move assets to alternative cash management 
vehicles with stable NAVs, such as offshore MMFs, enhanced cash funds, 
and other stable value vehicles. These vehicles typically invest in the 
same types of short-term instruments that MMFs hold and share many of 
the features that make MMFs vulnerable to runs, so growth of 
unregulated MMF substitutes would likely increase systemic risks. 
However, such funds need not comply with rule 2a-7 or other ICA 
protections and in general are subject to little or no regulatory 
oversight. In addition, the risks posed by MMF substitutes are 
difficult to monitor, since they provide far less market transparency 
than MMFs.
    Thus, effective mitigation of systemic risks may require policy 
reforms targeted outside the MMF industry to address risks posed by 
funds that compete with MMFs and to combat regulatory arbitrage that 
might offset intended reductions in MMF risks. Such reforms most likely 
would require legislation and action by the SEC and other agencies. For 
example, consideration should be given to prohibiting unregistered 
investment vehicles from maintaining stable NAVs, perhaps by amending 
sections 3(c)(1) and 3(c)(7) of the ICA to specify that exemptions from 
the requirement to register as an investment company do not apply to 
funds that seek a stable NAV. Banking and state insurance regulators 
might consider additional restrictions to mitigate systemic risk for 
bank common and collective funds and other investment pools that seek a 
stable NAV but that are exempt from registration under sections 3(c)(3) 
and 3(c)(11) of the ICA.

[FR Doc. 2010-28177 Filed 11-5-10; 8:45 am]
BILLING CODE 8011-01-P


