Another Go at Money Fund Stability Rules

There are a lot of thankless jobs in society. Sanitation. Fruit picking. Dishwashing. Here is another: being the people at the SEC in charge of preventing runs on money market funds. In 2010, two years after the Reserve Primary Fund “broke the buck” in 2008, they tried stress tests and reducing the cap on low-quality securities in a fund. In 2014, they added redemption gates for institutional money market funds and allowed fund managers to impose liquidity fees when assets under management fell below a certain threshold. But these didn’t prevent a run on money market funds in 2020, forcing the Fed to step in. So now they are trying again, revoking some of the past measures and adding new ones. Time will tell whether this works, but the forthcoming rules are worth being aware of.

To many investors, money market funds are a handy cash management tool. They boast higher yields than bank deposits and seem equally liquid, in large part because they are the default holding for “cash” in many brokerage accounts. Yet when you dig into the details, you find they are managed funds that hold short-term debt (typically Treasury bills and/or commercial paper), which creates what the industry calls a liquidity mismatch. To users, the funds are cash-like and instantly available. But for the fund managers, meeting redemption requests can force security sales, which may not be easy when markets are rocky. A redemption rush could force the fund manager to take a haircut when selling, impacting the shareholders who stay. Forced selling also risks further pressuring asset prices, prompting more redemptions, forcing more selling, on and on in a vicious cycle. This is the conundrum regulators seek to fix.

The 2014 rules sought to do this by giving fund managers the ability to suspend redemptions in institutional funds during periods of market stress—known as “redemption gates”—and charge redeeming shareholders a fee to leave if the fund’s liquid assets fell below a given threshold. Basically, this meant fund managers could make it so that shareholders either couldn’t or wouldn’t want to leave during a severe bout of volatility. But it didn’t work in 2020. To regulators’ chagrin, fear of getting trapped behind redemption gates prompted furious selling, potentially creating worse flight than might have otherwise occurred when markets plunged during the initial COVID lockdowns. Everyone wanted to get out before the gates came down.

Admitting you were wrong is a rare virtue, so it is encouraging to see regulators acknowledge redemption gates didn’t work as intended. They are now getting the axe. It is also encouraging that they didn’t simply rush to a new solution. For instance, the initial rules released for public comment in 2021 included “swing pricing” for institutional money market funds, which would require fund managers to impose a haircut on redeeming shareholders. This is common in Europe, but fund managers argued it would raise costs and scare off investors, hollowing out the industry. So those, too, hit the scrap heap.

But we are skeptical the chosen solutions will have the desired effect. In place of redemption gates—and instead of swing pricing—the SEC will require most institutional money market funds to impose liquidity fees when daily redemptions exceed 5% of the fund’s net assets. This replaces the liquidity fee that kicked in when assets fell below a certain threshold, but it has the same effect: If enough fund investors flee, the next to depart will have to pay exit fees.

We can see a world where this limits panic selling by making redemptions more expensive. We can also see one where investors race to be the first out—to be part of that initial 5% that isn’t subject to exit fees—creating the same stampede redemption gates did. Accelerating panic selling is a risk. We are also sympathetic to those who argue this new system will add compliance costs and be difficult to administer, though given the rules won’t take effect until August 2024, we suspect the funds will figure it out—especially since there is already a framework for liquidity fees.

The other big change seems more helpful: Minimum liquidity requirements will increase. Funds will have to increase the percentage of holdings with same-day maturity from at least 10% to at least 25%. The minimum amount of holdings that will mature within one week will rise from 30% to 50%. Some in the industry argued these thresholds are excessive, and they could reduce the funds’ yields (all else equal, shorter maturities tend to be lower-yielding), but if they improve liquidity it could reduce the temptation to panic-sell. That is a positive, as is the long transition period funds will have to meet the new standards.

Now, most of our readers probably use retail, rather than institutional money market funds, so these new rules may not impact you directly. Our interest here is more from the overall market stability standpoint, as the Fed’s money market fund interventions in 2008 and 2020 added to the general, indiscriminate panic. We suspect the new rules won’t erase the potential for another run and another round of Fed intervention during a future crisis. Knowing this is a risk can help demystify it and reduce the temptation to succumb to panic.