New York Fed Offers Up Woeful Redemption Restriction Idea
July 23, 2012
The Federal Reserve Bank of New York in a recent staff report on money market funds puts forth a proposal for a “minimum balance at risk” (MBR) which according to the authors “would be a small fraction of each shareholder’s recent balances that would be set aside in the event they withdrew from the fund.” Redemptions of the MBR could be delayed for thirty days, in the event of ‘stress’ or if the MMF ‘breaks the buck’. The MBR is similar to the redemption restrictions or holdbacks that are among the draconian proposals for additional MMF regulation discussed by SEC, albeit refined a bit and with a catchy new name and acronym. Interestingly, there have numerous thoughtful and detailed comment letters filed with the SEC on the practical, technical and legal challenges associated with this approach which the authors of the report have apparently ignored.
Redemption restrictions of any kind will destroy the essence of money market funds and the reason millions of investors, businesses, state/local governments and non-profits rely on the funds. The MBR would go against one of the foundational principles of all mutual funds – that investors have the right to redeem their shares at any time.
Recent studies have demonstrated the critical importance of 100 percent liquidity for MMF users. A 2011 SunGard investment study found that 80 percent of corporate treasurers and cash managers surveyed said immediate access to their funds is a major requirement of their cash investment policy. Furthermore, a recent study from Treasury Strategies reported that 90 percent of institutional MMF users would decrease or stop using the funds if there was any form of holdback – and of those 55 percent would stop using MMFs entirely. In fact, the MBR or any redemption restriction would conflict with the investment policies of most government and institutional investors.
Redemption restrictions would discourage investors from using MMFs in sweep accounts, retirement plans, securities lending and other investment programs. An MBR or holdback would significantly impact many of the popular aspects of MMFs for individual investors such as check writing and debit card access.
While the New York Fed’s floating of the MBR leaves out many details that would still need to be worked out by regulators, any redemption restriction sought to be enacted by the SEC would wreak havoc on the MMF industry as there are no practical means of implementing it. As a general matter any holdback must involve: (1) setting aside a certain percentage of shares or proceeds from the redemption of shares for a period of time and (2) charging any losses incurred by the fund during the period against the shares or proceeds set aside. Fund organizational documents and share trading systems were not designed to do these things. Therefore, implementing redemption restrictions would entail completely rewriting every fund’s organization documents and getting shareholders to approve the changes, and reprogramming every trading system for fund shares. The transition costs would be staggering, as would the ongoing operational cost of tracking and restricting shares or proceeds. Many intermediaries would probably stop offering MMFs rather than bear these costs.
The MBR adds a new wrinkle to the redemption restriction concept but as the New York Fed points out in its paper they are unsure of what its impact will be and downplay the potential flight of investors out of MMFs. In reality, any holdback will send investors heading elsewhere to less appealing venues that would have severe consequences for investors as well as the economy in general. Likely destinations could be toward banks – which are already beset by numerous issues and would have difficulty absorbing the funds that could heighten systemic risk. At the end of the day this may be the real goal of the Fed and the regulators. To the Fed and the regulators it seems clear that investor choice and the free movement of capital should be subordinated to the desire to control outcomes which can be more readily accomplished by forcing investors back to banks. Another option would be less regulated or even off-shore cash pools or funds that are beyond the reach of the SEC and other regulators as well as lacking in the transparency, liquidity and credit quality requirements applied to MMFs.
In the end, however you dress it up and whatever you call it any redemption restriction put on MMFs and investors in the funds will strip them of the utility, simplicity and effectiveness that have made the funds so popular and such a keystone of the American economy for over 40 years.