President's Working Group Report on Money Market Fund Reform, 68636-68654 [2010-28177]

Agencies

• SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 75, Number 215 (Monday, November 8, 2010)]
[Notices]
[Pages 68636-68654]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-28177]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. IC-29497; File No. 4-619]


President's Working Group Report on Money Market Fund Reform

AGENCY: Securities and Exchange Commission.

ACTION: Request for comment.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is seeking comment on the options discussed in the report 
presenting the results of the President's Working Group on Financial 
Markets' study of possible money market fund reforms. Public comments 
on the options discussed in this report will help inform consideration 
of reform proposals addressing money market funds' susceptibility to 
runs.

DATES: Comments should be received on or before January 10, 2011.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (https://www.sec.gov/rules/other.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number 4-619 on the subject line; or
     Use the Federal eRulemaking Portal (https://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number 4-619. This file number 
should

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be included on the subject line if e-mail is used. To help us process 
and review your comments more efficiently, please use only one method. 
The Commission will post all comments on the Commission's Internet Web 
site (https://www.sec.gov/rules/other.shtml). Comments are also 
available for Web site viewing and printing in the Commission's Public 
Reference Room, 100 F Street, NE., Washington, DC 20549, on official 
business days between the hours of 10 am and 3 pm. All comments 
received will be posted without change; we do not edit personal 
identifying information from submissions. You should submit only 
information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Daniele Marchesani or Sarah ten 
Siethoff at (202) 551-6792, Division of Investment Management, 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549-8549.

SUPPLEMENTARY INFORMATION:

I. The President's Working Group Report

    Following the recommendation in the U.S. Department of the 
Treasury's 2009 paper on Financial Regulatory Reform: A New Foundation, 
the President's Working Group on Financial Markets (``PWG'') conducted 
a study of possible reforms that might mitigate money market funds' 
susceptibility to runs.\1\ The results of this study are included in 
the report issued on October 21, 2010 and attached to this release as 
an Appendix (the ``Report'').\2\
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    \1\ The members of the PWG include the Secretary of the Treasury 
Department (as chairman of the PWG), the Chairman of the Board of 
Governors of the Federal Reserve System, the Chairman of the SEC, 
and the Chairman of the Commodity Futures Trading Commission.
    \2\ The Report is also available at https://treas.gov/press/releases/docs/10.21%20PWG%20Report%20Final.pdf.
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    The Report expresses support for the new rules regulating money 
market funds that the Commission approved last February.\3\ These new 
rules seek to better protect money market fund investors in times of 
financial market turmoil and lessen the possibility that money market 
funds will not be able to withstand stresses similar to those 
experienced in 2007 and 2008.\4\ When we adopted these rules, we 
recognized that they were a first step to addressing regulatory 
concerns as the events of 2007 and 2008 raised the question of whether 
further, more fundamental changes to the regulatory structure governing 
money market funds may be warranted.\5\
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    \3\ Money Market Fund Reform, Investment Company Act Release No. 
29132 (Feb. 23, 2010) [75 FR 10060 (Mar. 4, 2010)] (``SEC Adopting 
Release'').
    \4\ The new rules further limit the credit, liquidity, and 
interest rate risks money market funds may assume and require fund 
managers to stress test their portfolios against potential economic 
shocks. They also require money market funds to improve their 
disclosure to investors and the Commission and provide a means to 
wind down the operations of a fund that ``breaks the buck'' or 
suffers a run, in an orderly way that is fair to the fund's 
investors and reduces the risk of market losses that could spread to 
other funds. For a discussion of the market stresses experienced by 
money market funds in 2007 and 2008, see Money Market Fund Reform, 
Investment Company Act Release No. 28807 (June 30, 2009) [74 FR 
32688 (July 8, 2009)], at section II.D (``SEC Proposing Release'').
    \5\ See SEC Adopting Release, supra note 3, at section I. In 
proposing the new rules, we had requested comment on additional, 
more fundamental regulatory changes, including several of those 
discussed in the Report. See SEC Proposing Release, supra note 4, at 
section III. Following the adoption of the new rules, the Commission 
has continued to explore more significant changes in light of the 
comments received on that release and through our staff's work 
within the PWG.
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    The Report identifies the features that make money market funds 
susceptible to runs as well as the systemic implications of the run on 
prime money market funds that occurred in September 2008. The Report 
states that the Commission's new rules alone could not be expected to 
prevent a run of the type experienced in September 2008. Accordingly, 
the Report outlines possible reforms that could supplement the new 
rules we adopted and, individually or in combination, further reduce 
money market funds' susceptibility to runs and the related systemic 
risk. Some of the measures discussed in the Report could be implemented 
by the Commission under our existing statutory authority; others would 
require new legislation, coordination by multiple government agencies, 
or the creation of new private entities.\6\
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    \6\ In particular, the Report notes that reforms may be needed 
to avoid migration of institutional money market fund assets into 
unregulated or less regulated money market investment vehicles. 
Without new restrictions on such investment vehicles, money market 
reform may motivate some investors to shift assets into money market 
fund substitutes that may pose greater systemic risk than registered 
money market funds. See section 3.h of the Report.
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II. Request for Comment

    The Commission requests comment on the Report. Comments received 
will better enable the Commission and the newly-established Financial 
Stability Oversight Council (which will be taking over the work of the 
PWG in this area) to consider the options discussed in this Report to 
identify those most likely to materially reduce money market funds' 
susceptibility to runs and to pursue their implementation. As the 
Report states, we anticipate that following the comment period a series 
of meetings will be held in Washington, DC with various stakeholders, 
interested persons, experts, and regulators to discuss the options in 
the Report.
    We request comments on the options described in the Report both 
individually and in combination. Commenters should address the 
effectiveness of the options in mitigating systemic risks associated 
with money market funds, as well as their potential impact on money 
market fund investors, fund managers, issuers of short-term debt and 
other stakeholders. We also are interested in comments on other issues 
commenters believe are relevant to further money market fund reform, 
including other approaches for lessening systemic risk not identified 
in the Report. We urge commenters to submit empirical data and other 
information in support of their comments.

     Dated: November 3, 2010.

    By the Commission.
Elizabeth M. Murphy,
Secretary.
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Table of Contents

Executive Summary

1. Introduction and Background
    a. Money Market Funds
    b. MMFs' Susceptibility to Runs
    c. MMFs in the Recent Financial Crisis
2. The SEC's Changes to the Regulation of MMFs
    a. SEC Regulatory Changes
    b. Need for Further Reform To Reduce Susceptibility to Runs
3. Policy Options for Further Reducing the Risks of Runs on MMFs
    a. Floating Net Asset Values
    b. Private Emergency Liquidity Facility for MMFs
    c. Mandatory Redemptions in Kind
    d. Insurance for MMFs
    e. A Two-Tier System of MMFs, With Enhanced Protections for 
Stable NAV MMFs
    f. A Two-Tier System of MMFs, With Stable NAV MMFs Reserved for 
Retail Investors
    g. Regulating Stable NAV MMFs as Special Purpose Banks
    h. Enhanced Constraints on Unregulated MMF Substitutes

Executive Summary

    Several key events during the financial crisis underscored the 
vulnerability of the financial system to systemic risk. One such event 
was the September 2008 run on money market funds (MMFs), which began 
after the failure of Lehman Brothers Holdings, Inc., caused significant 
capital losses at a large MMF. Amid broad concerns about the safety of 
MMFs and other financial institutions, investors rapidly redeemed MMF 
shares, and the cash needs of MMFs exacerbated strains in short-term 
funding markets. These strains, in turn, threatened the broader 
economy, as firms and institutions dependent upon those markets for 
short-term financing found credit increasingly difficult to obtain. 
Forceful government action was taken to stop the run, restore investor 
confidence, and prevent the development of an even more severe 
recession. Even so, short-term funding markets remained disrupted for 
some time.
    The Treasury Department proposed in its Financial Regulatory 
Reform: A New Foundation (2009), that the President's Working Group on 
Financial Markets (PWG) prepare a report on fundamental changes needed 
to address systemic risk and to reduce the susceptibility of MMFs to 
runs. Treasury stated that the Securities and Exchange Commission's 
(SEC) rule amendments to strengthen the regulation of MMFs--which were 
in development at the time and which subsequently have been adopted--
should enhance investor protection and mitigate the risk of runs. 
However, Treasury also noted that those rule changes could not, by 
themselves, be expected to prevent a run on MMFs of the scale 
experienced in September 2008. While suggesting a number of areas for 
review, Treasury added that the PWG should consider ways to mitigate 
possible adverse effects of further regulatory changes, such as the 
potential flight of assets from MMFs to less regulated or unregulated 
vehicles.
    This report by the PWG responds to Treasury's call.\7\ The PWG 
undertook a study of possible further reforms that, individually or in 
combination, might mitigate systemic risk by complementing the SEC's 
changes to MMF regulation. The PWG supports the SEC's recent actions 
and agrees with the SEC that more should be done to address MMFs' 
susceptibility to runs. This report details a number of options for 
further reform that the PWG requests be examined by the newly 
established Financial Stability Oversight Council (FSOC). These options 
range from measures that could be implemented by the SEC under current 
statutory authorities to broader changes that would require new 
legislation, coordination by multiple government agencies, and the 
creation of new private entities. For example, a new requirement that 
MMFs adopt floating net asset values (NAVs) or that large funds meet 
redemption requests in kind could be accomplished by SEC rule 
amendments. In contrast, the introduction of a private emergency 
liquidity facility, insurance for MMFs, conversion of MMFs to special 
purpose banks, or a two-tier system of MMFs that might combine some of 
the other measures likely would involve a coordinated effort by the 
SEC, bank regulators, and financial firms.
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    \7\ The PWG (established by Executive Order 12631) is comprised 
of the Secretary of the Treasury (who serves as its Chairman), the 
Chairman of the Federal Reserve Board of Governors, the Chairman of 
the Securities and Exchange Commission, and the Chairman of the 
Commodity Futures Trading Commission.
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    Importantly, this report also emphasizes that the efficacy of the 
options presented herein would be enhanced considerably by the 
imposition of new constraints on less regulated or unregulated MMF 
substitutes, such as offshore MMFs, enhanced cash funds, and other 
stable value vehicles. Without new restrictions on such investment 
vehicles, which would require legislation, new rules that further 
constrain MMFs may motivate some investors to shift assets into MMF 
substitutes that may pose greater systemic risk than MMFs.
    The PWG requests that the FSOC consider the options discussed in 
this report to identify those most likely to materially reduce MMFs' 
susceptibility to runs and to pursue their implementation. To assist 
the FSOC in any analysis, the SEC, as the regulator of MMFs, will 
solicit public comments, including the production of empirical data and 
other information in support of such comments. A notice and request for 
comment will be published in the near future. Following a comment 
period, a series of meetings will be held in Washington, DC with 
various stakeholders, interested persons, experts, and regulators.

MMFs Are Susceptible to Runs

    MMFs are mutual funds. They are investment vehicles that act as 
intermediaries between shareholders who desire liquid investments and 
borrowers who seek term funding. With nearly $3 trillion in assets 
under management, MMFs are important providers of credit to businesses, 
financial institutions, and governments. In addition, these funds are 
significant investors in some short-term funding markets.
    Like other mutual funds, MMFs are regulated under the Investment 
Company Act of 1940 (ICA). In addition to ICA requirements for all 
mutual funds, MMFs must comply with SEC rule 2a-7, which permits these 
funds to maintain a stable net asset value (NAV) per share, typically 
$1. However, if the mark-to-market per-share value of a fund's assets 
falls more than one-half of 1 percent (to below $0.995), the fund must 
reprice its shares, an event colloquially known as ``breaking the 
buck.''
    The events of September 2008 demonstrated that MMFs are susceptible 
to runs. In addition, those events proved that runs on MMFs not only 
harm fund shareholders, but may also cause severe dislocations in 
short-term funding markets that curtail short-term financing for 
companies and financial institutions and that ultimately result in a 
decline in economic activity. Thus, reducing the susceptibility of MMFs 
to runs and mitigating the effects of possible runs are important 
components of the overall policy goals of decreasing and containing 
systemic risks.
    MMFs are vulnerable to runs because shareholders have an incentive 
to redeem their shares before others do when there is a perception that 
the fund might suffer a loss. Several features of MMFs, their sponsors, 
and their investors contribute to this incentive. For example, although 
a stable, rounded $1 NAV fosters an expectation of safety, MMFs are 
subject to credit, interest-rate, and liquidity risks. Thus, when a 
fund

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incurs even a small loss because of those risks, the stable, rounded 
NAV may subsidize shareholders who choose to redeem at the expense of 
the remaining shareholders. A larger loss that causes a fund's share 
price to drop below $1 per share (and thus break the buck) may prompt 
more substantial sudden, destabilizing redemptions. Moreover, although 
the expectations of safety fostered by the stable, rounded $1 NAV 
suggest parallels to an insured demand deposit account, MMFs have no 
formal capital buffers or insurance to prevent NAV declines; MMFs 
instead have relied historically on discretionary sponsor capital 
support to maintain stable NAVs. Accordingly, uncertainty about the 
availability of such support during crises may contribute to runs. 
Finally, because investors have come to view MMFs as extremely safe 
vehicles that meet all withdrawal requests on demand (and that are, in 
this sense, similar to banks), MMFs have attracted highly risk-averse 
investors who are particularly prone to flight when they perceive the 
possibility of a loss. These features likely mutually reinforce each 
other in times of crisis.

The SEC's New Rules

    In January 2010, the SEC adopted new rules for MMFs in order to 
make these funds more resilient and less likely to break the buck. The 
regulatory changes that mitigate systemic risks fall into three 
principal categories. First, the new rules enhance risk-limiting 
constraints on MMF portfolios by introducing new liquidity 
requirements, imposing additional credit-quality standards, and 
reducing the maximum allowable weighted average maturity of funds' 
portfolios. Funds also are required to stress test their ability to 
maintain a stable NAV. Second, the SEC's new rules permit a fund that 
is breaking the buck to suspend redemptions promptly and liquidate its 
portfolio in an orderly manner to limit contagion effects on other 
funds. Third, the new rules place more stringent constraints on 
repurchase agreements that are collateralized with private debt 
instruments rather than government securities.

The Need for Further Measures

    The SEC's new rules make MMFs more resilient and less risky and 
therefore reduce the likelihood of runs on MMFs, increase the size of 
runs that MMFs can withstand, and mitigate the systemic risks they 
pose. However, the SEC's new rules address only some of the features 
that make MMFs susceptible to runs, and more should be done to address 
systemic risk and the structural vulnerabilities of MMFs to runs. 
Indeed, the Chairman of the SEC characterized the new rules as ``a 
first step'' in strengthening MMFs, and Treasury's Financial Regulatory 
Reform: A New Foundation (2009) anticipated that measures taken by the 
SEC ``should not, by themselves, be expected to prevent a run on MMFs 
of the scale experienced in September 2008.''
    Mitigating the risk of runs on MMFs is especially important because 
the events of September 2008 may have created an expectation that, in a 
future crisis, the government may provide support for MMFs at minimal 
cost in order to minimize harm to MMF investors, short-term funding 
markets, and the economy. Persistent expectations of unpriced 
government support distort incentives in the MMF industry and pricing 
in short-term funding markets, as well as heighten the systemic risk 
posed by MMFs. It is thus essential that MMFs be required to 
internalize fully the costs of liquidity or other risks associated with 
their operation.
    In formulating reforms for MMFs, policymakers should aim primarily 
at mitigating systemic risk and containing the contagious effect that 
strains at individual MMFs can have on other MMFs and on the broad 
financial system. Importantly, preventing any individual MMF from ever 
breaking the buck is not a practical policy objective--though the new 
SEC rules for MMFs should help ensure that such events remain rare and 
thus constitute a limited means of containing systemic risk.

Policy Options

    The policy options discussed in this report may help further 
mitigate the susceptibility of MMFs to runs. Some of these options may 
be adopted by the SEC under its existing authorities. Others would 
require legislation and action by multiple government agencies and the 
MMF industry.
    (a) Floating net asset values. A stable NAV has been a key element 
of the appeal of MMFs to investors, but a stable, rounded NAV also 
heightens funds' vulnerability to runs. Moving to a floating NAV would 
help remove the perception that MMFs are risk-free and reduce 
investors' incentives to redeem shares from distressed funds. However, 
the elimination of the stable NAV for MMFs would be a dramatic change 
for a nearly $3 trillion asset-management sector that has been built 
around the stable share price. Such a change may have several 
unintended consequences, including: (i) Reductions in MMFs' capacity to 
provide short-term credit due to lower investor demand; (ii) a shift of 
assets to less regulated or unregulated MMF substitutes such as 
offshore MMFs, enhanced cash funds, and other stable value vehicles; 
and (iii) unpredictable investor responses as MMF NAVs begin to 
fluctuate more frequently.
    (b) Private emergency liquidity facilities for MMFs. The liquidity 
risk of MMFs contributes importantly to their vulnerability to runs, 
and an external liquidity backstop to augment the SEC's new liquidity 
requirements for MMFs would help mitigate this risk. Such a backstop 
could buttress MMFs' ability to withstand outflows, internalize much of 
the liquidity protection costs for the MMF industry, offer efficiency 
gains from risk pooling, and reduce contagion effects. A liquidity 
facility would preserve fund advisers' incentives for not taking 
excessive risks because it would not protect funds from capital losses. 
As such, a liquidity facility alone may not prevent broader runs on 
MMFs triggered by concerns about widespread credit losses. Importantly, 
significant capacity, structure, pricing, and operational hurdles would 
have to be overcome to ensure that such a facility would be effective 
during crises, that it would not unduly distort incentives, and that it 
would not favor certain types of MMF business models.
    (c) Mandatory redemptions in kind. When investors make large 
redemptions from MMFs, they may impose liquidity costs on other 
shareholders in the fund by forcing MMFs to sell assets in an untimely 
manner. A requirement that MMFs distribute large redemptions in kind, 
rather than in cash, would force these redeeming shareholders to bear 
their own liquidity costs and thus reduce the incentive to redeem. 
Depending on whether redeeming shareholders immediately sell the 
securities received, redemptions in kind may still generate market 
effects. Moreover, mandating redemptions in kind could present some 
operational and policy challenges. The SEC, for example, would have to 
make key judgments regarding when a fund must redeem in kind and how 
funds would fairly distribute portfolio securities.
    (d) Insurance for MMFs. Treasury's Temporary Guarantee Program for 
Money Market Funds helped slow the run on MMFs in September 2008, and 
some form of insurance for MMF shareholders might be helpful in 
mitigating the risk of runs in MMFs. Unlike a private liquidity 
facility, insurance would limit credit losses to shareholders, so 
appropriate risk-based pricing would be critical in preventing 
insurance from distorting incentives,

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but such pricing might be difficult to achieve in practice. The 
appropriate scope of coverage also presents a challenge; unlimited 
coverage would likely cause large shifts of assets from the banking 
sector to MMFs, but limited insurance might do little to reduce 
institutional investors' incentives to run from distressed MMFs. The 
optimal form for insurance--whether it would be private, public, or a 
mix of the two--is also uncertain, particularly given the recent 
experience with private financial guarantees.
    (e) A two-tier system of MMFs with enhanced protection for stable 
NAV funds. Reforms aimed at reducing MMFs' susceptibility to runs may 
be particularly effective if they permit investors to select the types 
of MMFs that best balance their appetite for risk and their preference 
for yield. Policymakers could allow two types of MMFs: Stable NAV 
funds, which would be subject to enhanced protections such as, for 
example, required participation in a private liquidity facility or 
enhanced regulatory requirements; and floating NAV funds, which would 
have to comply with certain, but not all, rule 2a-7 restrictions (and 
which would presumably offer higher yields). Because this two-tier 
system would permit stable NAV funds to continue to be available, it 
would reduce the likelihood of a substantial decline in demand for MMFs 
and large-scale shifts of assets toward unregulated vehicles. At the 
same time, the forms of protection encompassed by such a system would 
mitigate the risks associated with stable NAV funds. It would also 
avoid problems that might be encountered in transitioning the entire 
MMF industry to a floating NAV. Moreover, during a crisis, a two-tier 
system might prevent large shifts of assets out of MMFs--and a 
reduction in credit supplied by the funds--if investors simply shift 
assets from riskier floating NAV funds toward safer (because of the 
enhanced protections) stable NAV funds. However, implementation of such 
a two-tier system would present the same challenges as the introduction 
of any individual enhanced protections (such as mandated access to a 
private emergency liquidity facility) that would be required for stable 
NAV funds, and the effectiveness of a two-tier system would depend on 
investors' understanding the risks associated with each type of fund.
    (f) A two-tier system of MMFs with stable NAV MMFs reserved for 
retail investors. Another approach to the two-tier system already 
described could distinguish funds by investor type: Stable NAV MMFs 
could be made available only to retail investors, who could choose 
between stable NAV and floating NAV funds, while institutional 
investors would be restricted to floating NAV funds. The run on MMFs in 
September 2008 was almost exclusively due to redemptions from prime 
MMFs by institutional investors. Such investors typically have 
generated greater cash-flow volatility for MMFs than retail investors 
and have been much quicker to redeem MMF shares from stable NAV funds 
opportunistically. Hence, this approach would mitigate risks associated 
with a stable NAV by addressing the investor base of stable NAV funds 
rather than by mandating other types of enhanced protections for those 
funds. Such a system also would protect the interests of retail 
investors by reducing the likelihood that a run might begin in 
institutional MMFs (as it did in September 2008) and spread to retail 
funds, while preserving the original purpose of MMFs, which was to 
provide retail investors with cost-effective, diversified investments 
in money market instruments. This approach would require the SEC to 
define who would qualify as retail and institutional investors, and 
distinguishing those categories will present challenges. In addition, a 
prohibition on sales of stable NAV MMFs shares to institutional 
investors may have several of the same unintended consequences as a 
requirement that all MMFs adopt floating NAVs (see option (a) in this 
section).
    (g) Regulating stable NAV MMFs as special purpose banks. Functional 
similarities between MMF shares and bank deposits, as well as the risk 
of runs on both, provide a rationale for requiring stable NAV MMFs to 
reorganize as special purpose banks (SPBs) subject to banking oversight 
and regulation. As banks, MMFs could have access to government 
insurance and lender-of-last-resort facilities. An advantage of such a 
reorganization could be that it uses a well-understood regulatory 
framework for the mitigation of systemic risk. But while the conceptual 
basis for this option is fairly straightforward, its implementation 
might take a broad range of forms and would probably require 
legislation together with interagency coordination. An important hurdle 
for successful conversion of MMFs to SPBs may be the very large amounts 
of equity necessary to capitalize the new banks. In addition, to the 
extent that deposits in the new SPBs would be insured, the potential 
government liabilities through deposit insurance would be increased 
substantially, and the development of an appropriate pricing scheme for 
such insurance would present some of the same challenges as the pricing 
of deposit insurance. More broadly, the possible interactions between 
the new SPBs and the existing banking system would have to be studied 
carefully by policymakers.
    (h) Enhanced constraints on unregulated MMF substitutes. New 
measures intended to mitigate MMF risks may also reduce the appeal of 
MMFs to many investors. While it is likely that some (particularly 
retail) investors may move their assets from MMFs to bank deposits if 
regulation of MMFs becomes too burdensome and meaningfully reduces MMF 
returns, others may be motivated to shift assets to unregulated funds 
with stable NAVs, such as offshore MMFs, enhanced cash funds, and other 
stable value vehicles. Such funds, which typically hold assets similar 
to those held by MMFs, are vulnerable to runs but are less transparent 
and less constrained than MMFs, so their growth would likely pose 
systemic risks. Hence, effective mitigation of this risk may require 
policy reforms targeting regulatory arbitrage. Reforms of this type 
generally would require legislation and action by the SEC and other 
agencies.
1. Introduction and Background
a. Money Market Funds
    MMFs are mutual funds that offer individuals, businesses, and 
governments a convenient and cost-effective means of pooled investing 
in money market instruments. MMFs provide an economically important 
service by acting as intermediaries between shareholders who desire 
liquid investments, often for cash management, and borrowers who seek 
term funding.
    With nearly $3 trillion in assets under management, MMFs are 
important providers of credit to businesses, financial institutions, 
and governments. Indeed, these funds play a dominant role in some 
short-term credit markets. For example, MMFs own almost 40 percent of 
outstanding commercial paper, roughly two-thirds of short-term state 
and local government debt, and significant portions of outstanding 
short-term Treasury and federal agency securities.
    Like other mutual funds, MMFs are regulated under the Investment 
Company Act of 1940 (ICA). In addition to the requirements applicable 
to other funds under the ICA, MMFs must comply with rule 2a-7, which 
permits these funds to maintain a ``stable'' net

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asset value (NAV) per share, typically $1, through the use of the 
``amortized cost'' method of valuation. Under this method, securities 
are valued at acquisition cost, with adjustments for amortization of 
premium or accretion of discount, instead of at fair market value. To 
prevent substantial deviations between the $1 share price and the mark-
to-market per-share value of the fund's assets (its ``shadow NAV''), a 
MMF must periodically compare the two. If there is a difference of more 
than one-half of 1 percent (or $0.005 per share), the fund must re-
price its shares, an event colloquially known as ``breaking the buck.''
    Historically, the stable NAV has played an important role in 
distinguishing MMFs from other mutual funds and in facilitating the use 
of MMFs as cash management vehicles. Rule 2a-7 also imposes credit-
quality, maturity, and diversification requirements on MMF portfolios 
designed to ensure that the funds' investing remains consistent with 
the objective of maintaining a stable NAV. A MMF's $1 share price is 
not guaranteed through any form of deposit or other insurance, or 
otherwise--indeed, MMF prospectuses must state that shares can lose 
value. However, by permitting amortized cost valuation, rule 2a-7 
affords MMFs price stability under normal market conditions.
    MMFs pursue a range of investment objectives, with corresponding 
differences in portfolio composition. For example, tax-exempt MMFs 
purchase short-term municipal securities and offer tax-exempt income to 
fund shareholders, while Treasury-only MMFs hold only obligations of 
the U.S. Treasury. In contrast, prime MMFs invest largely in private 
debt instruments, such as commercial paper and certificates of deposit, 
and, commensurate with the greater risks in prime MMF portfolios, they 
generally pay higher yields than Treasury-only funds.
    MMFs are marketed both to retail investors (that is, individuals), 
for whom MMFs are the only means of investing in many money market 
instruments, and to institutions, which are often attracted by the 
convenience and cost efficiency of MMFs, even though many institutional 
investors have the ability to invest directly in the instruments held 
by MMFs. Institutional MMFs, which currently account for about two-
thirds of the assets under management in MMFs, have grown much faster, 
on net, in the past two decades than retail funds. The rapid growth of 
institutional funds has important implications for the MMF industry, 
because institutional funds tend to have more volatile flows and more 
yield-sensitive shareholders than retail funds.
    MMFs compete with other stable-value, low-risk investments. Because 
MMFs generally maintain stable NAVs, offer redemptions on demand, and 
often provide services that compete with those offered to holders of 
insured deposits (such as transactions services), many retail customers 
likely consider MMF shares and bank deposits as near substitutes, even 
if the two classes of products are fundamentally different (most 
notably because MMF shares are not insured and because MMFs and banks 
are subject to very different regulatory regimes). Some institutional 
investors may also view bank deposits and MMFs as near substitutes, 
although usual limitations on deposit insurance coverage and interest 
payments on deposits likely reduce the attractiveness of bank deposits 
for most such investors.\8\ Institutional investors also have access to 
less-regulated MMF substitutes (for example, offshore MMFs, enhanced 
cash funds, and other stable value vehicles) and may perceive them as 
near substitutes for MMFs, even if those vehicles are not subject to 
the protections afforded by rule 2a-7.
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    \8\ Under the Federal Deposit Insurance Corporation's (FDIC) 
Temporary Liquidity Guarantee Program, coverage limits on 
noninterest-bearing transaction deposits in FDIC-insured 
institutions were temporarily lifted beginning in October 2008 and 
coverage will extend through 2010. Effective December 31, 2010, 
pursuant to the Dodd-Frank Wall Street Reform and Consumer 
Protection Act, Public Law 111-203, (``Dodd-Frank Act''), all 
noninterest-bearing transaction deposits will have unlimited 
coverage until January 1, 2013. In addition, section 627 of the 
Dodd-Frank Act repeals the prohibition on banks paying interest on 
corporate demand deposit accounts effective July 21, 2011.
---------------------------------------------------------------------------

b. MMFs' Susceptibility to Runs
    In the twenty-seven years since the adoption of rule 2a-7, only two 
MMFs have broken the buck. In 1994, a small MMF suffered a capital loss 
because of exposures to interest rate derivatives, but the event passed 
without significant repercussions. In contrast, as further discussed 
later, when the Reserve Primary Fund broke the buck in September 2008, 
it helped ignite a massive run on prime MMFs that contributed to severe 
dislocations in short-term credit markets and strains on the businesses 
and institutions that obtain funding in those markets.\9\
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    \9\ Section 1(c) contains more detail on the MMF industry's 
experience during the recent financial crisis.
---------------------------------------------------------------------------

    Although the run on MMFs in 2008 is itself unique in the history of 
the industry, the events of 2008 underscored the susceptibility of MMFs 
to runs. That susceptibility arises because, when shareholders perceive 
a risk that a fund will suffer losses, each shareholder has an 
incentive to redeem shares before other shareholders. Five features of 
MMFs, their sponsors, and their investors principally contribute to 
this incentive:
    (i) Maturity transformation with limited liquidity resources. One 
important economic function of MMFs is their role as intermediaries 
between shareholders who want liquid investments and borrowers who 
desire term funding. As such, MMFs offer shares that are payable on 
demand, but they invest both in cash-like instruments and in short-term 
securities that are less liquid, including, for example, term 
commercial paper. Redemptions in excess of MMFs' cash-like liquidity 
may force funds to sell less liquid assets. When money markets are 
strained, funds may not be able to obtain full value (that is, 
amortized cost) for such assets in secondary markets and may incur 
losses as a consequence. Investors thus have an incentive to redeem 
shares before a fund has depleted its cash-like instruments (which 
serve as its liquidity buffer).
    (ii) NAVs rounded to $1. Share prices of MMFs are rounded to the 
nearest cent, typically resulting in a $1 NAV per share. The rounding 
fosters an expectation that MMF share prices will not fluctuate, which 
exacerbates investors' incentive to run when there is risk that prices 
will fluctuate. When a MMF that has experienced a small (less than one-
half of 1 percent) capital loss redeems shares at the full $1 NAV, it 
concentrates the loss among the remaining shareholders. Thus, 
redemptions from such a fund further depress the market value of its 
assets per share outstanding (its shadow NAV), and redemptions of 
sufficient scale may cause the fund to break the buck. Early redeemers 
are therefore more likely to receive the usual $1 NAV than those who 
wait.
    (iii) Portfolios exposed to credit and interest rate risks. MMFs 
invest in securities with credit and interest-rate risks. Although 
these risks are generally small given the short maturity of the 
securities and the high degree of portfolio diversification, even a 
small capital loss, in combination with other features of MMFs, can 
trigger a significant volume of redemptions. The events of September 
2008--when losses on Lehman Brothers Holdings, Inc. (Lehman Brothers) 
debt instruments caused just one MMF to break the buck and triggered a 
broad run on MMFs--highlight the fact that credit losses at

[[Page 68643]]

even a single fund may have serious implications for the whole industry 
and consequently for the entire financial system.\10\
---------------------------------------------------------------------------

    \10\ Souring credits and rapid increases in interest rates have 
adversely affected MMFs on other occasions. For example, beginning 
in the summer of 2007, MMF exposures to structured investment 
vehicles and other asset-backed commercial paper caused capital 
losses at many MMFs, and many MMF sponsors voluntarily provided 
capital support that prevented some funds from breaking the buck.
---------------------------------------------------------------------------

    (iv) Discretionary sponsor capital support. MMFs invest in assets 
that may lose value, but the funds have no formal capital buffers or 
insurance to maintain their $1 share prices in the event of a loss on a 
portfolio asset.
    The MMF industry's record of maintaining a stable NAV reflects, in 
part, substantial discretionary intervention by MMF sponsors (that is, 
fund advisers, their affiliates, and their parent firms) to support 
funds that otherwise might have broken the buck.\11\ Sponsors do not 
commit to support an MMF in advance, because an explicit commitment may 
require the sponsor to consolidate the fund on its balance sheet and--
if the sponsor is subject to regulatory capital requirements--hold 
additional regulatory capital against the contingent exposure. Nor is 
there any requirement that sponsors support ailing MMFs; such a mandate 
would transform the nature of MMF shares by shifting risks from 
investors to sponsors and probably would require government supervision 
and monitoring of sponsors' resources and capital adequacy.\12\ 
Instead, sponsor capital support remains expressly voluntary, and not 
all MMFs have a sponsor capable of fully supporting its MMFs. 
Nonetheless, a long history of such support probably has contributed 
substantially to the perceived safety of MMFs.
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    \11\ For example, more than 100 MMFs received sponsor capital 
support in 2007 and 2008 because of investments in securities that 
lost value and because of the run on MMFs in September and October 
2008. See Securities and Exchange Commission (2009) ``Money Market 
Reform: Proposed Rule,'' pp. 13-14, 17, and notes 38 and 54.
    \12\ Even discretionary support for MMFs may lead to concerns 
about the safety and soundness of MMF sponsors. Sponsors that foster 
expectations of such support may be granting a form of implicit 
recourse that is not reflected on sponsors' balance sheets or in 
their regulatory capital ratios, and such implicit recourse may 
contribute to broader systemic risk.
---------------------------------------------------------------------------

    However, the possibility that sponsors may become unwilling or 
unable to provide expected support during a crisis is itself a source 
of systemic risk. Indeed, sponsor support is probably least reliable 
when systemic risks are most salient.\13\ Moreover, MMFs without deep-
pocketed sponsors remain vulnerable to runs that can affect the entire 
industry. The Reserve Primary Fund was not the only MMF that held 
Lehman Brothers debt at the time of the Lehman Brothers' bankruptcy in 
September 2008, but it broke the buck because the Reserve Primary Fund, 
unlike some of its competitors, had substantial holdings of Lehman 
Brothers debt and Reserve did not have the resources to support its 
fund. Investors also recognized the riskiness of sponsor support more 
broadly during the run on MMFs in 2008. For example, outflows from 
prime MMFs following the Lehman Brothers bankruptcy tended to be larger 
among MMFs with sponsors that were themselves under strain (as measured 
by credit default swap spreads for parent firms or affiliates), 
indicating that MMF investors quickly redeemed shares on concerns about 
sponsors' potential inabilities to bolster ailing funds.
---------------------------------------------------------------------------

    \13\ Other forms of discretionary financial support, such as 
that provided by dealers for auction rate securities, did not fare 
well during the financial crisis.
---------------------------------------------------------------------------

    (v) Investors' low risk tolerance and expectations. Investors have 
come to view MMF shares as extremely safe, in part because of the 
funds' stable NAVs and sponsors' record of supporting funds that might 
otherwise lose value. MMFs' history of maintaining stable value has 
attracted highly risk-averse investors who are prone to withdraw assets 
rapidly when losses appear possible.
    MMFs, like other mutual funds, commit to redeem shares based on the 
fund's NAV at the time of redemption. MMFs are under no legal or 
regulatory requirement to redeem shares at $1; rule 2a-7 only requires 
that MMFs be managed to maintain a stable NAV. Yet sponsor-supported 
stable, rounded NAVs and the typical $1 MMF share price foster 
investors' impressions that MMFs are extremely safe investments. 
Indeed, the growth of retail MMFs in recent decades may have reflected 
some substitution from insured deposits at commercial banks, thrifts, 
and credit unions, particularly as MMFs have offered transactions 
services and other bank-like functions. Although MMF shares, unlike 
bank deposits, are not government insured and are not backed by capital 
to absorb losses, this distinction may have become even less clear to 
retail investors following the unprecedented government support of MMFs 
in 2008 and 2009. Furthermore, that recent support may have left even 
sophisticated institutional investors with the mistaken impression that 
MMF safety is enhanced because the government stands ready to support 
the industry again with the same tools employed at the height of the 
financial crisis.
    The growth of institutional MMFs in recent years probably has 
heightened both the risk aversion of the typical MMF shareholder and 
the volatility of MMF cash flows. Many institutional investors cannot 
tolerate fluctuations in share prices for a variety of reasons. In 
addition, institutional investors are typically more sophisticated than 
retail investors in obtaining and analyzing information about MMF 
portfolios and risks, have larger amounts at stake, and hence are 
quicker to respond to events that may threaten the stable NAV. In fact, 
institutional MMFs have historically experienced much more volatile 
flows than retail funds. During the run on MMFs in September 2008, 
institutional funds accounted for more than 90 percent of the net 
redemptions from prime MMFs.
    The interaction of these five features is critical. Taken alone, 
each of the features just listed probably would only modestly increase 
the vulnerability of MMFs to runs, but, in combination, the features 
tend to amplify and reinforce one another. For example, equity mutual 
funds perform maturity transformation and take on capital risks, but 
even after large capital losses, outflows from equity funds tend to be 
small relative to assets, most likely because equity funds are not 
marketed for their ability to maintain stable NAVs, do not attract the 
risk-averse investor base that characterizes MMFs, and offer the 
opportunity for capital appreciation. If MMFs with rounded NAVs had 
lacked sponsor support over the past few decades, many might have 
broken the buck and diminished the expectation of a stable $1 share 
price. In that case, investors who nonetheless elected to hold shares 
in such funds might have become more tolerant of risk and less inclined 
to run. If MMFs had attracted primarily a retail investor base rather 
than an institutional base, investors might be slower to respond to 
strains on a MMF. And even a highly risk-averse investor base would not 
necessarily make MMFs susceptible to runs--and to contagion arising 
from runs on other MMFs--if funds had a credible means to guarantee 
their $1 NAVs. Thus, policy responses that diminish the reinforcing 
interactions among the features discussed herein hold promise for 
muting overall risks posed by MMFs.
c. MMFs in the Recent Financial Crisis
    The turmoil in financial markets in 2007 and 2008 caused severe 
strains both among MMFs and in the short-term debt markets in which 
MMFs invest. Beginning in mid-2007, dozens of funds faced losses from 
holdings of highly

[[Page 68644]]

rated asset-backed commercial paper (ABCP) issued by structured 
investment vehicles (SIVs), some of which had exposures to the subprime 
mortgage market. Fear of such losses at one MMF caused that fund to 
experience a substantial run in August 2007, which was brought under 
control when the fund's sponsor purchased more than $5 billion of 
illiquid securities from the fund. Indeed, financial support from MMF 
sponsors in recent years probably prevented a number of funds from 
breaking the buck because of losses on SIV paper.
    The crisis for MMFs worsened considerably in September 2008 with 
the bankruptcy of Lehman Brothers on September 15 and mounting concerns 
about other issuers of commercial paper, particularly financial firms. 
The Reserve Primary Fund, a $62 billion MMF, held $785 million in 
Lehman Brothers debt on the day of Lehman Brothers' bankruptcy and 
immediately began experiencing a run--shareholders requested 
redemptions of approximately $40 billion in just two days. In order to 
meet the redemptions, the Reserve Primary Fund depleted its cash 
reserves and began seeking to sell its portfolio securities, which 
further depressed their valuations. Unlike other MMFs that held 
distressed securities, the Reserve Primary Fund had no affiliate with 
sufficient resources to support its $1 NAV, and Reserve announced on 
September 16 that its Primary Fund would break the buck and re-price 
its shares at $0.97. On September 22, the SEC issued an order 
permitting the suspension of redemptions in certain Reserve MMFs to 
permit their orderly liquidation.
    The run quickly spread to other prime MMFs, which held sizable 
amounts of financial sector debt that investors feared might decline 
rapidly in value. During the week of September 15, 2008, investors 
withdrew approximately $310 billion (15 percent of assets) from prime 
MMFs, with the heaviest redemptions coming from institutional funds. To 
meet these redemption requests, MMFs depleted their cash positions and 
sought to sell portfolio securities into already illiquid markets. 
These efforts caused further declines in the prices of short-term 
instruments and put pressure on per-share values of fund portfolios, 
threatening MMFs' stable NAVs. Nonetheless, only one MMF--the Reserve 
Primary Fund--broke the buck, because many MMF sponsors provided 
substantial financial support to prevent capital losses in their funds.
    Fearing further redemptions, many MMF advisers limited new 
portfolio investments to cash, U.S. Treasury securities, and overnight 
instruments, and avoided term commercial paper, certificates of 
deposit, and other short-term credit instruments. During September 
2008, MMFs reduced their holdings of commercial paper by about $170 
billion (25 percent). As market participants hoarded cash and refused 
to lend to one another on more than an overnight basis, interest rates 
spiked and short-term credit markets froze. Commercial paper issuers 
were required to make significant draws on their backup lines of 
credit, placing additional pressure on the balance sheets of commercial 
banks.
    On September 19, 2008, Treasury and the Board of Governors of the 
Federal Reserve System (Federal Reserve) announced two unprecedented 
market interventions to stabilize MMFs and to provide liquidity to 
short-term funding markets. Treasury's Temporary Guarantee Program for 
Money Market Funds temporarily provided guarantees for shareholders in 
MMFs that elected to participate in the program.\14\ The Federal 
Reserve's Asset-Backed Commercial Paper Money Market Mutual Fund 
Liquidity Facility (AMLF) extended credit to U.S. banks and bank 
holding companies to finance their purchases of high-quality ABCP from 
MMFs.\15\
---------------------------------------------------------------------------

    \14\ MMFs that elected to participate in the program paid fees 
of 4 to 6 basis points at an annual rate for the guarantee. The 
Temporary Guarantee Program for Money Market Funds expired on 
September 18, 2009.
    \15\ The AMLF expired on February 1, 2010.
---------------------------------------------------------------------------

    The announcements of these government programs substantially slowed 
the run on prime MMFs. Outflows from prime MMFs diminished to about $65 
billion in the week after the announcements and, by mid-October, these 
MMFs began attracting net inflows. Moreover, in the weeks following the 
government interventions, markets for commercial paper and other short-
term debt instruments stabilized considerably.\16\
---------------------------------------------------------------------------

    \16\ Several other unprecedented government interventions that 
provided additional support for the MMF industry and for short-term 
funding markets were introduced after the run on MMFs had largely 
abated. For example, the Federal Reserve in October 2008 established 
the Commercial Paper Funding Facility (CPFF), which provided loans 
for purchases (through a special purpose vehicle) of term commercial 
paper from issuers. The CPFF, which expired on February 1, 2010, 
helped issuers repay investors--such as MMFs--who held maturing 
paper. Also in October 2008, the Federal Reserve announced the Money 
Market Investor Funding Facility (MMIFF), which was intended to 
bolster liquidity for MMFs by financing (through special purpose 
vehicles) purchases of securities from the funds. The MMIFF was 
never used and expired on October 30, 2009. In November 2008, 
Treasury agreed to become a buyer of last resort for certain 
securities held by the Reserve U.S. Government Fund (a MMF), in 
order to facilitate an orderly and timely liquidation of the fund. 
Under the agreement, Treasury would purchase certain securities 
issued by government sponsored enterprises at amortized cost (not 
mark to market), and $3.6 billion of such purchases were completed 
in January 2009.
---------------------------------------------------------------------------

2. The SEC's Changes to the Regulation of MMFs
    The effects of the financial turmoil in 2007 and 2008 on MMFs--and, 
in particular, the run on these funds in September 2008 and its 
consequences--have highlighted the need for reforms to mitigate the 
systemic risks posed by MMFs. Appropriate reforms include changes to 
MMF regulations as well as broader policy actions. This section first 
examines rule changes that have been adopted by the SEC to improve the 
safety and resilience of MMFs and then discusses some limitations in 
these measures' mitigation of systemic risk and the need for further 
reforms.
    Notwithstanding the need for reform, the significance of MMFs in 
the U.S. financial system suggests that changes must be considered 
carefully. Tighter restrictions on MMFs might, for example, lead to a 
reduction in the supply of short-term credit, a shift in assets to 
substitute investment vehicles that are subject to less regulation than 
MMFs, and significant impairment of an important cash-management tool 
for investors. Moreover, the economic importance of risk-taking by 
MMFs--as lenders in private debt markets and as investments that appeal 
to shareholders' preferences for risk and return--suggests that the 
appropriate objective for reform should not be to eliminate all risks 
posed by MMFs. Attempting to prevent any fund from ever breaking the 
buck would be an impractical goal that might lead, for example, to 
draconian and--from a broad economic perspective--counterproductive 
measures, such as outright prohibitions on purchases of private debt 
instruments and securities with maturities of more than one day. 
Instead, policymakers should balance the benefits of allowing 
individual MMFs to take some risks and facilitating private and public 
borrowers' access to term financing in money markets with the broader 
objective of mitigating systemic risks--in particular, the risk that 
one fund's problems may cause serious harm to other MMFs, their 
shareholders, short-term funding markets, the financial system, and the 
economy.
a. SEC Regulatory Changes
    In January 2010, the SEC adopted new rules regulating MMFs in order 
to make these funds more resilient to market

[[Page 68645]]

disruptions and thus less likely to break the buck. The new rules also 
might help reduce the likelihood of runs on MMFs by facilitating the 
orderly liquidation of funds that have broken the buck. The SEC 
designed the new rules primarily to meet its statutory obligations 
under the ICA to protect investors and promote capital formation. 
Nonetheless, the rules should mitigate (although not eliminate) 
systemic risks by reducing the susceptibility of MMFs to runs, both by 
lessening the likelihood that an individual fund will break the buck 
and by containing the damage should one break the buck. The rule 
changes fall into three principal categories.
    (i) Enhanced Risk-Limiting Constraints on Money Market Fund 
Portfolios. Each of the changes that follow further constrains risk-
taking by MMFs.
    Liquidity Risk. One of the most important SEC rule changes aimed at 
reducing systemic risk associated with MMFs is a requirement that each 
fund maintain a substantial liquidity cushion. Augmented liquidity 
should position MMFs to better withstand heavy redemptions without 
selling portfolio securities into potentially distressed markets at 
discounted prices. Forced ``fire sales'' to meet heavy redemptions may 
cause losses not only for the fund that must sell the securities, but 
also for other MMFs that hold the same or similar securities. Thus, a 
substantial liquidity cushion should help reduce the risk that strains 
on one MMF will be transmitted to other funds and to short-term credit 
markets.
    Specifically, the SEC's new rules require that MMFs maintain 
minimum daily and weekly liquidity positions. Daily liquidity, which 
must be at least 10 percent of a MMF's assets, includes cash, U.S. 
Treasury obligations, and securities (including repurchase agreements) 
that mature or for which the fund has a contractual right to obtain 
cash within a day. Weekly liquidity, which must be at least 30 percent 
of each MMF's assets, includes cash, securities that mature or can be 
converted to cash within a week, U.S. Treasury obligations, and 
securities issued by federal government agencies and government-
sponsored enterprises with remaining maturities of 60 days or less.\17\ 
Furthermore, the new rules require MMF advisers to maintain larger 
liquidity buffers as necessary to meet reasonably foreseeable 
redemptions.
---------------------------------------------------------------------------

    \17\ Tax-exempt money market funds are exempt from daily minimum 
liquidity requirements but not the weekly minimum liquidity 
requirements, because most tax-exempt fund portfolios consist of 
longer-term floating- and variable-rate securities with seven-day 
``put'' options that effectively give the funds weekly liquidity. 
Tax-exempt funds are unlikely to have investment alternatives that 
would permit them to meet a daily liquidity requirement.
---------------------------------------------------------------------------

    Credit Risk. The new rules reduce MMFs' maximum allowable holdings 
of ``second-tier'' securities, which carry more credit risk than first-
tier securities, to no more than 3 percent of each fund's assets.\18\ 
In addition, a MMF's exposure to a single second-tier issuer is now 
limited to one-half of 1 percent of the fund's assets, and funds can 
only purchase second-tier securities with maturities of 45 days or 
less. These new constraints reduce the likelihood that individual funds 
will be exposed to a credit event that could cause the funds to break 
the buck. Also, since second-tier securities often trade in thinner 
markets, these changes should improve the ability of individual MMFs to 
maintain a stable NAV during periods of market volatility.
---------------------------------------------------------------------------

    \18\ Under SEC rule 2a-7, for short-term debt securities to 
qualify as second-tier securities, they generally must have received 
the second highest short-term debt rating from the credit rating 
agencies or be of comparable quality. Section 939A of the Dodd-Frank 
Act requires that government agencies remove references to credit 
ratings in their rules and replace them with other credit standards 
that the agency determines appropriate. As a result, the SEC will be 
reconsidering this rule and its provisions relating to second-tier 
securities to comply with this statutory mandate.
---------------------------------------------------------------------------

    Interest Rate Risk. By reducing the maximum allowable weighted 
average maturity (WAM) of fund portfolios from 90 days to 60 days, the 
new rules are intended to diminish funds' exposure to interest rate 
risk and increase the liquidity of fund portfolios. The SEC also 
introduced a new weighted average life (WAL) measure for MMFs--and set 
a ceiling for WAL at 120 days--in order to lower funds' exposure to 
interest-rate, credit, and liquidity risks associated with the 
floating-rate obligations that MMFs commonly hold.\19\
---------------------------------------------------------------------------

    \19\ For purposes of computing WAM, a floating-rate security's 
``maturity'' can be its next interest-rate reset date. In computing 
WAL, the life of a security is determined solely by its final 
maturity date. Hence, WAL should be more useful than WAM in 
reflecting the risks of widening spreads on longer-term floating-
rate securities.
---------------------------------------------------------------------------

    Stress Testing. Finally, the SEC's new rules require fund advisers 
to periodically stress test their funds' ability to maintain a stable 
NAV per share based on certain hypothetical events, including a change 
in short-term interest rates, an increase in shareholder redemptions, a 
downgrade or default of a portfolio security, and a change in interest 
rate spreads. Regular and methodical monitoring of these risks and 
their potential effects should help funds weather stress without 
incident.
    (ii) Facilitating Orderly Fund Liquidations. The new SEC rules 
should reduce the systemic risk posed by MMFs by permitting a fund that 
is breaking the buck to promptly suspend redemptions and liquidate its 
portfolio in an orderly manner. This new rule should help prevent a 
capital loss at one fund from forcing a disorderly sale of portfolio 
securities that might disrupt short-term markets and diminish share 
values of other MMFs. Moreover, the ability of a fund to suspend 
redemptions should help prevent investors who redeem shares from 
benefiting at the expense of those who remain invested in a fund.
    (iii) Repurchase Agreements. The SEC's new rules place more 
stringent constraints on repurchase agreements that are collateralized 
with private debt instruments rather than cash equivalents or 
government securities. MMFs are among the largest purchasers of 
repurchase agreements, which they use to invest cash, typically on an 
overnight basis. Because the collateral usually consists of long-term 
debt securities, a MMF cannot hold the securities underlying this 
collateral without violating SEC rules that limit MMF holdings to 
short-term obligations. Accordingly, if a significant counterparty 
fails to repurchase securities as stipulated in a repurchase agreement, 
its MMF counterparties can be expected to direct custodians to sell the 
collateral immediately, and sales of private debt instruments could be 
sizable and disruptive to financial markets. To address this risk, the 
SEC's new rule places additional constraints on MMFs' exposure to 
counterparties through repurchase agreement transactions that are 
collateralized by securities other than cash equivalents or government 
securities.
b. Need for Further Reform To Reduce Susceptibility to Runs
    The new SEC rules make MMFs more resilient and less risky and 
therefore reduce the likelihood of runs on funds, increase the size of 
runs that they could withstand, and mitigate the systemic risks they 
pose. However, more can be done to address the structural 
vulnerabilities of MMFs to runs. Indeed, the Chairman of the SEC 
characterized its new rules as ``a first step'' in strengthening MMFs 
and noted that a number of additional possible reforms (many of which 
are presented in section 3 of this report) are under discussion. 
Likewise, Treasury's Financial Regulatory Reform: A New Foundation 
(2009) anticipated that measures taken by the SEC ``should not, by 
themselves, be expected to prevent a run on MMFs of the scale 
experienced in September 2008.''

[[Page 68646]]

    Of the five features that make MMFs vulnerab