On October 7, 2012, the International Organization of Securities Commissions (IOSCO) issued policy recommendations requested by the Financial Stability Board (FSB) as part of the FSB’s plans to strengthen the oversight and regulation of the shadow banking system (see below), endorsed by the G20 Leaders in 2011. These recommendations supplement the existing frameworks where IOSCO considers there is still room for further reforms and improvements.
The FSB’s mandate indicated that a key issue to be considered was the Constant Net Asset Value feature of some money market funds. In developing its policy recommendations, IOSCO considered this crucial question but also other aspects of MMF regulation where greater harmonization between jurisdictions and improvements to existing regulations were seen necessary. They stated that compared to the reforms introduced in 2010 which mainly focused on the asset side of funds, the present recommendations also address vulnerabilities arising from the liability side, as well as the crucial issue of valuation and the display of a constant NAV.
The report cited that the 2011 “slow-motion” or “quiet” run on U.S. MMFs that surfaced because of concerns about their exposure to European sovereign debt through their lending to European banks, illustrates the high and increasing responsiveness of money market funds’ investors to potential risks and the overall systemic importance of the sector. ICI data show that assets managed by prime money market funds reached $1.66 trillion on June 1, 2011 and declined by over $170 billion (10%) to $1.49 trillion on August 31, 2011. This episode tends to indicate that post-crisis regulation did not fully mitigate the systemic risks MMFs represent for the broader economy and the possibility of runs. In its 2011 annual report, the U.S. Financial Stability Oversight Council described MMFs as an important conduit through which “amplification of a [European sovereign debt] shock” could happen. Indeed, when concerns started to soar on European sovereign debt, the massive redemptions from money market funds harmed the functioning of money markets for other firms. It also led to significant pressures for European banks.
The IOSCO issued 15 Recommendations which received several comments from the ICI, mutual fund companies and interest groups. Most of their Recommendations are similar to SEC Rule 2a-7. Recommendation #1 adopts money market funds to the Collective Investment Scheme (CIS) international regulations. Recommendation #4 does not allow mark-to-market as the predominant pricing method for MMFs. Recommendation #10 adopts the floating NAV for MMFs, if workable.
Recommendation 1: Money market funds should be explicitly defined in CIS regulation.
Recommendation 2: Specific limitations should apply to the types of assets in which MMFs may invest and the risks they may take.
Recommendation 3: Regulators should closely monitor the development and use of other vehicles similar to money market funds (collective investment schemes or other types of securities).
Recommendation 4: Money market funds should comply with the general principle of fair value when valuing the securities held in their portfolios. Amortized cost method should only be used in limited circumstances.
Recommendation 5: MMF valuation practices should be reviewed by a third party as part of their periodic reviews of the funds accounts.
Recommendation 6: Money market funds should establish sound policies and procedures to know their investors.
Recommendation 7: Money market funds should hold a minimum amount of liquid assets to strengthen their ability to face redemptions and prevent fire sales.
Recommendation 8: Money market funds should periodically conduct appropriate stress testing.
Recommendation 9: Money market funds should have tools in place to deal with exceptional market conditions and substantial redemptions pressures.
Recommendation 10: MMFs that offer a stable NAV should be subject to measures designed to reduce the specific risks associated with their stable NAV feature and to internalize the costs arising from these risks. Regulators should require, where workable, a conversion to floating/ variable NAV. Alternatively, safeguards should be introduced to reinforce stable NAV MMFs’ resilience and ability to face significant redemptions.
Recommendation 11: MMF regulation should strengthen the obligations of the responsible entities regarding internal credit risk assessment practices and avoid any mechanistic reliance on external ratings.
Recommendation 12: Credit rating agencies supervisors should seek to ensure credit rating agencies make more explicit their current rating methodologies for money market funds.
Recommendation 13: MMF documentation should include a specific disclosure drawing investors’ attention to the absence of a capital guarantee and the possibility of principal loss.
Recommendation 14: MMFs’ disclosure to investors should include all necessary information regarding the funds’ practices in relation to valuation and the applicable procedures in times of stress.
Recommendation 15: When necessary, regulators should develop guidelines strengthening the framework applicable to the use of repos by money market funds, taking into account the outcome of current work on repo markets.
In October 2011, the FSB issued a report that defined shadow banking as “the system of credit intermediation that involves entities and activities outside the regular banking system.” They recommended focusing on entities and activities implying maturity/liquidity transformation, imperfect credit risk transfer and/or leverage. This report set the basis for the creation of five workstreams in charge of assessing the need for further regulatory action, the second of which deals with the regulatory reform of MMFs. Money market funds are investment products subject to securities markets regulation. They are considered part of the Shadow Banking System on the basis that they perform maturity and liquidity transformation and are important sources of short-term funding, particularly for banks. In contrast with bank deposits, MMFs do not have access to official support and backstop facilities, and, whereas they have little ability to absorb losses, they also do not have explicit support from sponsor companies.