Capital market regulations often have unintended consequences.
The Securities and Exchange Commission's recent rule regarding money market redemptions is no exception. The rule is intended to ensure orderly liquidations of money market funds during financial panics. However, the rule may reduce investment liquidity and flexibility during periods when these advantages are critical. A thoughtful evaluation of accounting controls over treasury functions is required to manage this risk.
Money market funds have long been considered highly liquid, stable instruments for securing reasonable short-term yields with flexibility for managing corporate cash. Companies often came to view these funds, albeit incorrectly, as a substitute for lower-yielding bank deposits or treasury paper.
During the financial vortex in the fall of 2008, the unthinkable occurred - two noted money market funds "broke the buck." In other words, their net asset value declined below a dollar per share. Many other money market funds faced issues during this period. In fact, major sponsors such as Morgan Stanley, Wachovia and Credit Suisse felt compelled to take a variety of steps to ensure that their funds didn't ultimately suffer the same fate.
In response to the 2008 events, the SEC adopted Rule 22e-3, effective May 5, 2010. The rule permits a fund to suspend redemptions and payments of redemption proceeds if:
The money market fund's board, including a majority of disinterested directors, determines that the deviation between the fund's amortized cost price per share and the market-based net asset value per share may result in material dilution or other unfair results to shareholders;
The board, including a majority of the disinterested directors, irrevocably has approved the liquidation of the fund; and,
The fund, prior to suspending redemptions, notifies the commission of its decision to liquidate and suspend redemptions.
This rule may also apply under certain conditions to conduit funds (i.e., funds that invest in other money market funds) and unit investment trusts - a structure that many insurance companies use.
In a 2009 release, the SEC stated that the rule is intended to reduce the vulnerability of investors to the harmful effects of a run on the fund, and minimize the potential for disruption to the securities markets.
The commission recognized that the rule may cause liquidity problems for investors, and specified that the rule may be applied only when the fund's board has irrevocably approved liquidation of the fund. In other words, the commission sought to prevent funds from suspending redemptions merely for the fund sponsor's convenience. The commission may rescind or modify a fund's application of the rule if a proper liquidation plan has not been devised.
GOOD INTENTIONS
Nominally, the commission's intent behind the new rule was properly motivated, but the best-laid plans often have unusual consequences.
Markets can turn very bad, very quickly. Many recent studies of market behavior confirm that the frequency of extreme stock price moves far exceeds the nearly 0 percent chance the lognormal distribution would predict. Some studies have indicated that a four-sigma move is as much as 20 times more likely than would be expected if prices were normally distributed. Many other financial assets also exhibit this.
Furthermore, abrupt price moves in many markets often induce a virulent contagion in other markets. Fixed-income securities are not immune to this behavior. If markets tank again, fixed-income securities and the packages in which many of them are marketed could experience substantial volatility once again.
In order to predict when this rule will be applied, we only need to know the underlying market behavior that would likely cause a fund to resort to its application. The answer is compelling and simple - panic.
After 40 years of experience with stable dollar-per-unit values, punctuated with the problems in 2008, no other market profile would make sense.
Why apply the rule if matters are not dire? Dire circumstances are the very times when companies require maximum liquidity. Unfortunately, this is also the time when fund managers are most likely to resort to this rule. If a financial panic has begun, and redemptions have been suspended, it is too late to get out intact. A company should not rely on SEC rules to protect them. History is littered with reliance on financial regulations that failed to protect.
Remember portfolio insurance in 1987? The ease and liquidity of shorting futures was supposed to protect mutual funds' investments in stocks. It worsened the speed of decline.
Remember circuit breakers? Stocks are supposed to pause, and investors refresh. Unfortunately, the stocks do, but the investors do not, and most trends resume after the circuit breakers are lifted.
Remember short-selling restrictions? With no one ready to buy in a panic as stocks fall, less buying activity is available to sustain stock prices. Prices tend to pause - and then plunge.
The commission's objective is to try to establish a level playing field for most investors, and ensure orderly markets. The objective of a corporate controller or treasurer is the stewardship of the company's assets - not everyone else's. An orderly liquidation is of scant solace as redemptions are locked and a fund's value continues to decline. You want your money now, before a panic worsens; they want a nice weighted average sharing of the pain. This is still capitalism (at least for a while). Let the bureaucrats fret over fairness.
If we could accurately forecast, this rule would not pose a problem, but as philosopher Yogi Berra observed, "Prediction is very hard, especially about the future." The best policy is to apply simple rules, and ensure that internal controls over investment placement and cash management are strong. For example, controllers and treasurers should:
Not count on this new rule to protect their asset value.
Examine their concentration of investments in money market funds relative to other assets. The funds may still be desirable, but other asset classes may provide similar liquidity (e.g., very short-term government paper) without the risk that a third party (such as the fund's board) may pre-emptively invoke this rule, and limit access to assets.
Examine their concentrations of investments in specific money market funds.
Examine to the extent possible the concentration and nature of assets in the funds.
Examine the performance and strength ratings of the funds, their history, and the financial stability of the sponsoring manager.
Finally, examine their cash requirements, assuming that access to a certain portion of assets may be temporarily restricted.
A few simple steps can ensure that this new attempt to make markets orderly does not disrupt their purpose of being in business - to have the resources available when they need them.
