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SEC's money fund plan adds worst parts of banking

By Craig McGlashan
19 Aug 2014

The Securities and Exchange Commission has tried to cut the risk of runs in the money market fund industry by introducing liquidity fees and redemption gates. But as the Federal Reserve has just pointed out, by doing so it has done the opposite of what it intended, and made the funds more like banks.

You can see what the SEC was trying to achieve with its proposals for money market funds, announced last month. If a fund’s level of weekly liquid assets — such as cash and US Treasuries — falls below 30% of total assets, then managers will be able to charge investors for leaving funds or block them altogether.

The thinking is that such measures should stop a stampede for the exits which could lead to disaster. The size of such a disaster could be great — there was about $1.4tr in prime money market funds (vehicles that can invest in non-government paper) on August 13, according to figures from the Investment Company Institute, an industry association.

That’s a lot of potential paper that managers would have to liquidate in a fire sale.

But as a blog post on Monday by researchers and economists from the Fed and the University of Padua points out, the ability to impose gates and liquidity fees could actually encourage investors to pull out when otherwise they would not.

According to the researchers’ models, if expected returns from funds are volatile and some investors know that they are likely to be more volatile than others, they are less likely to liquidate their holdings if there is no risk of a gate or fee being imposed than if managers have such an option.

It isn't hard to see why.

The threat of a gate or fee being imposed will make investors more jumpy and more likely to leave at the first sign of trouble. It becomes a race to the bottom, where investors will want to leave before any other investors in the fund do. Money funds will be hit by redemptions ever earlier, so even the faintest whiff of volatility could lead to exits.

Such uncertainty is unlikely to make money fund managers’ jobs any easier, though that was never the SEC’s intention.

But it was the SEC’s intention to provide stability to the money fund industry and avoid a repeat of 2008, when the Reserve Primary Fund went bust in the wake of the Lehman Brothers bankruptcy and other funds needed to be shored up by their providers.

Specifically, the SEC was worried that investors treated money funds like banks. For that reason, they will also remove prime funds' right to have a stable asset price and will instead force them to float their share prices as their underlying holdings' prices fluctuate.

But by including liquidity fees and gates, the SEC has made money funds more susceptible to runs akin to those that have happened in banks for centuries. Unlike banks, however, money funds don't have the government backed deposit insurance to fall back on — meaning the SEC's move will make the US financial system less steady.

By Craig McGlashan
19 Aug 2014