4 Factors to Know About the Money Market Reform of 2016

The U.S. Securities and Exchange Commission’s (SEC’s) reforms for money market funds were implemented on Oct. 14, 2016. These reform rules drastically changed the way investors and the affected fund providers view money market funds as an alternative for short-term cash investing.

Many investors, especially institutions, faced increased risks or lower yields on their short-term money, while fund providers reconsidered the worth of their offerings.

With about $3 trillion invested in money market funds at the time, investors and providers alike had a lot at stake in the changes in how funds were managed. Although nominal for most individual or retail investors, institutional investors, and fund providers, the money market reform of 2016 required significant rethinking of the value of money market funds.

Key Takeaways

• In 2016, the Securities and Exchange Commission (SEC) implemented reforms to enhance the stability of money market funds and to reduce investor risks.
• As a means of preventing a run on a fund, the regulations require money market fund providers to institute liquidity fees and suspension gates.
• A key change was to require money market funds to move from a fixed $1 share price to a floating net asset value (NAV).
• The SEC decided to implement these changes after the 2008 financial crisis caused a large New York fund manager to reduce the NAV of its money market fund below $1, a move that caused panic selling among institutional investors.

The Reason Behind Money Market Fund Reform

At the peak of the 2008 financial crisis, the Reserve Primary Fund, a large New York-based fund manager, was forced to reduce the net asset value (NAV) of its money market fund below $1 due to massive losses generated by failed short-term loans issued by Lehman Brothers.

It was the first time a major money market fund had to break the $1 NAV, which caused a panic among institutional investors, who began mass redemptions. The fund lost two-thirds of its assets in 24 hours and eventually had to suspend operations and commence liquidation.

Six years later in 2014, the Securities and Exchange Commission (SEC) issued new rules for the management of money market funds to enhance the stability and resilience of all money market funds. Generally, the rules placed tighter restrictions on portfolio holdings while enhancing liquidity and quality requirements.

The most fundamental change was the requirement for money market funds to move from a fixed $1 share price to a floating NAV, which introduced the risk of principal where it had never existed.

In addition, the rules required fund providers to institute liquidity fees and suspension gates as a means of preventing a run on the fund. The requirements included asset-level triggers for imposing a liquidity fee of 1% or 2%.

If weekly liquid assets fell below 10% of total assets, it triggered a 1% fee. Below 30%, the fee increased to 2%. Funds also suspended redemptions for up to 10 business days in a 90-day period. While those are the fundamental rule changes, there are several factors investors need to know about the reform and how it might affect them.

Note

Money market fund returns are tied to short-term interest rates, which can result in low yields in a low interest rate environment.

Retail Investors Not Completely Affected

The most significant rule change, the floating NAV, did not affect investors investing in retail money market funds. These funds maintained the $1 NAV. However, they were still required to institute the redemption triggers for charging a liquidity fee or suspending redemptions.

Many of the larger fund groups took action to either limit the possibility of a redemption trigger or avoid it altogether by converting their funds into a government money market fund, which had no requirement.

The same cannot be said for people who invest in prime money market funds inside their 401(k) plans because these are typically institutional funds subject to all of the new rules. Plan sponsors had to change out their fund options, offering a government money market fund or some other alternative.

Institutional Investors Have a Dilemma

Because institutional investors are the target of the new rules, they were the most affected. For them, it came down to a choice of securing a higher yield or higher risk. They could invest in U.S. government money markets, which were not subject to the floating NAV or redemption triggers.

However, they had to accept a lower yield. Institutional investors seeking higher yields had to consider other options, such as bank certificates of deposit (CDs), alternative prime funds that invested primarily in very short maturity assets to limit interest rate and credit risk, or ultra-short duration funds that offered higher yields but also had more volatility.

Adapt or Exit

After the SEC announced its money market reforms, most of the major fund groups, such as Fidelity Investments, Federated Investors Inc., and Vanguard Group, said they planned to offer viable alternatives to their investors. Fidelity converted its largest prime fund into a U.S. government fund.

Federated took steps to shorten the maturities of its prime funds to make it easier to maintain a $1 NAV. Vanguard assured its investors that its prime funds had more than enough liquidity to avoid triggering a liquidity fee or redemption suspension.

However, many fund groups had to assess whether the cost of compliance with the new regulations was worth keeping their funds. In anticipation of the new rules, Bank of America sold its money market business to BlackRock in 2016.

What Is a Money Market Fund?

A money market fund is a type of mutual fund that invests in low-risk, high-quality, and short-term debt instruments, such as Treasuries, commercial papers, and certificates of deposit (CDs). The goal of these funds is to provide investors with returns that are slightly higher than regular savings accounts while maintaining low risk.

What Are the Drawbacks of Money Market Funds?

One of the main drawbacks of money market funds is their low returns. While the funds are low-risk and liquid, this is the reason they provide lower returns than other types of investment funds. Their returns may not outpace inflation, causing investors to lose purchasing power over time. Additionally, money market funds are not FDIC-insured like savings accounts. This makes the return difference between the two an important investment choice. The funds have fees that take away from investor profits, and some funds may require minimum account balances.

Do You Pay Taxes on Money Market Accounts?

Yes, you must pay taxes on the interest earned in money market accounts. All interest income earned needs to be reported to the Internal Revenue Service (IRS). Most institutions will send you Form 1099-INT noting the amount of interest you earned for the year.

The Bottom Line

In 2016, the SEC implemented reforms for money market funds with the goal of increasing stability and reducing risk after the 2008 financial crisis. These reforms, such as moving to a floating NAV and introducing liquidity fees, had a large impact on investors and fund managers.

Retail investors were not affected as much as institutional investors because the reforms were targeted at large-scale institutions that had a larger impact on the economy. Some fund managers adjusted their money market offerings to comply while others found it better business to exit the product altogether.