One June 5, 2013, the SEC proposed amendments impacting money market funds and money market type funds. This is Part III of a Four-Part Blog on the 671-page proposal delineated in the following compliance areas: (ia) changes the net asset value per share (“NAV”) from fixed-rate to floating-rate for certain money market funds; (ib) authorizes money market funds to suspend redemptions or impose liquidity fees during heavy redemption periods. These proposed rule changes are “designed to address money market funds’ susceptibility to heavy redemptions, improve their ability to manage and mitigate potential contagion from such redemptions, and increase the transparency of their risks, while preserving, as much as possible, the benefits of money market funds.” Under this proposal, the SEC continued that they could adopt either alternative by itself or a combination of the two alternatives.;” (ii) additional disclosures, including new Form N-CR and Form N-MFP; (iii) portfolio diversification and stress testing of money market funds holdings; (iv) additional disclosure on Form PF of money market type funds held by private equity firms.
The current rule 2a-7 requires a money market fund’s portfolio to be diversified, both as to the issuers of the securities it acquires and providers of guarantees and demand features related to those securities. Money market funds must limit their investments in the securities of any one issuer of a first tier security (other than government securities) to no more than 5% of fund assets. They must also limit their investments in securities subject to a demand feature or a guarantee to no more than 10% of fund assets from any one provider, except that the rule provides a so-called “twenty-five percent basket,” under which as much as 25% of the value of securities held in a fund’s portfolio may be subject to guarantees or demand features from a single institution.
However, the SEC’s concern that the diversification requirements in rule 2a-7 today may not appropriately limit money market fund risk exposures has resulted in these proposed amendments to rule 2a-7.
Treatment of Certain Affiliates for Purposes of Rule 2a-7 Five Percent Issuer Diversification Requirement
The possibility for financial distress to transmit across affiliated entities was demonstrated during the 2007-2008 financial crisis when, American International Group Inc. came under financial stress, which affected a number of its affiliates. In some cases, AIG’s corporate group contagion required the sponsors of money market funds that owned AIG’s affiliates’ securities to seek no-action relief from the SEC in order for the sponsors to support their funds.
The SEC determined that although affiliates may be separate legal entities, their valuations and the creditworthiness of their securities may depend on the financial well-being of other firms in the group. And a firm may issue debt securities that would be considered to be in default if one of the firm’s affiliates is unable to meet its financial obligations.
Consequently, money market funds would aggregate their exposures to certain entities that are affiliated with each other when applying the 5% issuer diversification limit. Specific to this proposal, the definition of affiliated is if one controlled the other entity or was controlled by it or under common control with it, and control would be defined to mean ownership of more than 50% of an entity’s voting securities.
Asset Backed Securities
Also, rule 2a-7 would have diversification provisions to limit the amount of exposure money market funds can have to ABS sponsors that provide express or implicit support for their ABSs. Subject to an exception, money market funds investing in ABSs, including ABCP, who rely on the ABSs sponsors’ financial strength or their ability or willingness to provide liquidity, credit, or other support to the ABSs would treat the sponsor of an SPE issuing ABS as a guarantor of the ABS subject to the diversification limitations applicable to guarantors and demand feature providers. Therefore, a fund could not invest in an ABS if, immediately after the investment, it would have invested more than 10% of its total assets in securities issued by or subject to demand features or guarantees from the ABS sponsor.
Moreover, it was proposed that, subject to an exception, all ABS sponsors would be deemed to guarantee their ABSs, unless the money market fund’s board of directors (or its delegate) determines that the fund is not relying on the ABS sponsor’s financial strength or its ability or willingness to provide liquidity, credit, or other support to determine the ABS’s quality or liquidity.
The Twenty-Five Percent Basket
The SEC noted that in 2008, as much as 30% of the municipal securities held by tax-exempt money market funds were supported by bond insurance issued by “monoline insurance companies” (a monoline insurance company generally is an insurance company that only provides guarantees to issuers of securities.). This concentration led to considerable stress in the municipal markets when some of these bond insurers were downgraded during the financial crisis. For example, a lack of confidence in the bond insurers was a primary contributor to the market “freeze” that occurred in variable-rate demand notes in 2008 when money market funds and other investors reduced their purchases of these securities or sold them to the financial institutions that had provided demand features for the securities. The freeze in turn strained the providers of the demand feature and also increased the interest the issuers of the securities were required to pay.
Therefore, they would amend rule 2a-7 to tighten the diversification requirements applicable to guarantors and providers of demand features. The amendments would eliminate the so-called “twenty-five percent basket,” under which as much as 25% of the value of securities held in a fund’s portfolio may be subject to guarantees or demand features from a single institution.
Stress Testing under the Floating NAV Alternative and Trigger Gates
If the floating NAV alternative is adopted, the SEC would amend the current stress testing requirement as it would apply to floating NAV money market funds to require that such funds test the impact of certain market conditions on fund liquidity, instead of requiring that they test the fund’s ability to maintain a stable price per share.
Currently stress testing required at such intervals as the board of directors determines appropriate and reasonable in light of current market conditions, of the money market fund’s ability to maintain a stable net asset value per share based upon specified hypothetical events that include, but are not limited to, a change in short-term interest rates, an increase in shareholder redemptions, a downgrade of or default on portfolio securities, and the widening or narrowing of spreads between yields on an appropriate benchmark the fund has selected for overnight interest rates and commercial paper and other types of securities held by the fund.
Now, each floating NAV money market fund would have to stress test its ability to avoid having its weekly liquid assets falls below 15% of all fund assets. In addition, they would stress test their ability to avoid crossing the same 15% weekly liquid asset threshold because it could trigger fees or gates.
Definitions of Daily Liquid Assets and Weekly Liquid Assets
Clarification of definitions amendments were proposed for certain characteristics of instruments that qualify as a “daily liquid asset” or “weekly liquid asset.”
First, money market funds cannot use the maturity-shortening provisions in current paragraph (d) of rule 2a-7 regarding interest rate readjustments when determining whether a security satisfies the maturity requirements of a daily liquid asset or weekly liquid asset, which include securities that will mature within one or five business days, respectively. The reason given was that using an interest rate readjustment to determine maturity as permitted under current paragraph (d) for these purposes would allow funds to include as daily or weekly liquid assets securities that the fund would not have a legal right to convert to cash in one or five business days. Therefore, this would not be consistent with the purposes of the minimum daily and weekly liquidity requirements, which are designed to increase a fund’s ability to pay redeeming shareholders in times of market stress when the fund cannot rely on the market or a dealer to provide immediate liquidity.
Second, agency discount notes with a remaining maturity of 60 days or less qualifies as a “weekly liquid asset” only if the note is issued without an obligation to pay additional interest on the principal amount. Therefore interest-bearing agency notes that are issued at a discount do not qualify.
Finally, the rule would include in the definitions of daily and weekly liquid assets amounts receivable that are due unconditionally within one or five business days, respectively, on pending sales of portfolio securities. These receivables, like certain other securities that qualify as daily or weekly liquid assets, provide liquidity for the fund because they give a fund the legal right to receive cash in one to five business days. It is expected that a fund (or its adviser) would include these receivables in daily and weekly liquid assets only if the fund (or its adviser) has no reason to believe that the buyer might not perform.
Definition of Demand Feature
It was proposed to amend the definition of demand feature in rule 2a-7 to mean a feature permitting the holder of a security to sell the security at an exercise price equal to the approximate amortized cost of the security plus accrued interest, if any, at the time of exercise, paid within 397 calendar days of exercise. This would eliminate the requirement that a demand feature be exercisable at any time on no more than 30 calendar days’ notice.
Short-Term Floating Rate Security and Second Tier Securities
Rule 2a-7(d)(4) would be amended to provide that, for purposes of determining WAL, a short-term floating rate security shall be deemed to have a maturity equal to the period remaining until the principal amount can be recovered through demand.
For second tier securities, it is currently required that money market fund shall not acquire a second tier security with a remaining maturity of greater than 45 calendar days. Immediately after the acquisition of any second tier security, a money market fund shall not have invested more than three percent of its total assets in second tier securities. However, to state more clearly the way in which this limitation operates, rule 2a-7 would state that the 45-day limit applicable to second tier securities must be determined without reference to the maturity-shortening provisions in rule 2a-7 for interest rate readjustments.