Proposed Recommendations Regarding Money Market Mutual Fund Reform, 69455-69483 [2012-28041]

Agencies

• Financial Stability Oversight Council

[Federal Register Volume 77, Number 223 (Monday, November 19, 2012)]
[Notices]
[Pages 69455-69483]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-28041]


=======================================================================
-----------------------------------------------------------------------

FINANCIAL STABILITY OVERSIGHT COUNCIL


Proposed Recommendations Regarding Money Market Mutual Fund 
Reform

AGENCY: Financial Stability Oversight Council.

ACTION: Proposed recommendation.

-----------------------------------------------------------------------

SUMMARY: Section 120 of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act authorizes the Financial Stability Oversight Council 
(Council) to issue recommendations to a primary financial regulatory 
agency to apply new or heightened standards and safeguards for a 
financial activity or practice conducted by bank holding companies or 
nonbank financial companies under the agency's jurisdiction. The 
Council is seeking public comment on proposed recommendations that the 
Council may make to the Securities and Exchange Commission to implement 
structural reforms for money market mutual funds (MMFs). Proposed 
Recommendations Regarding Money Market Mutual Fund Reform provides an 
overview of MMFs, an outline of the history of reform efforts and the 
role of the Council, the Council's proposed determination that MMFs' 
activities and practices create or increase certain risks, three 
proposed alternatives for reform, and an assessment of the impact of 
the Council's proposed recommendations on long-term economic growth. In 
addition, the Council is requesting public comment on alternative 
structural reforms for MMFs.

DATES: Comment due date: January 18, 2013.

ADDRESSES: Interested persons are invited to submit comments on all 
aspects of Proposed Recommendations Regarding Money Market Mutual Fund 
Reform according to the instructions below. All submissions must refer 
to docket number FSOC-2012-0003.
    Electronic Submission of Comments. Interested persons may submit 
comments electronically through the Federal eRulemaking Portal at 
https://www.regulations.gov. Electronic submission of comments allows 
the commenter maximum time to prepare and submit a comment, ensures 
timely receipt, and enables the Council to make them available to the 
public. Comments submitted electronically through https://www.regulations.gov can be viewed by other commenters and interested 
members of the public. Commenters should follow the instructions 
provided on that site to submit comments electronically.
    Mail: Comments may be mailed to Financial Stability Oversight 
Council, Attn: Amias Gerety, 1500 Pennsylvania Avenue NW., Washington, 
DC 20220.
    Public Inspection of Comments. Properly submitted comments will be 
available for inspection and downloading at https://www.regulations.gov.
    Additional Instructions. In general, comments received, including 
attachments and other supporting materials, are part of the public 
record and are immediately available to the public. Do not include any 
information in your comment or supporting materials that you consider 
confidential or inappropriate for public disclosure.

FOR FURTHER INFORMATION CONTACT: Amias Gerety, Deputy Assistant 
Secretary for the Financial Stability Oversight Council, Department of 
the Treasury, at (202) 622-8716; Sharon Haeger, Office of the General 
Counsel, Department of the Treasury, at (202) 622-4353; or Eric Froman, 
Office of the General Counsel, Department of the Treasury, at (202) 
622-1942.

SUPPLEMENTARY INFORMATION: 

Table of Contents

I. Executive Summary
II. Overview of Money Market Mutual Funds
III. History of Reform Efforts and Role of the Financial Stability 
Oversight Council
IV. Proposed Determination That MMFs Could Create or Increase the 
Risk of Significant Liquidity and Credit Problems Spreading Among 
Financial Companies and Markets
V. Proposed Recommendations
VI. Consideration of the Economic Impact of Proposed Reform 
Recommendations on Long-Term Economic Growth

I. Executive Summary

    Reforms to address the structural vulnerabilities of money market 
mutual funds (MMFs or funds) are essential to safeguard financial 
stability. MMFs are mutual funds that offer individuals, businesses, 
and governments a convenient and cost-effective means of pooled 
investing in money market instruments. MMFs are a significant source of 
short-term funding for businesses, financial institutions, and 
governments. However, the 2007-2008 financial crisis demonstrated that 
MMFs are susceptible to runs that can have destabilizing implications 
for financial markets and the economy. In the days after Lehman 
Brothers Holdings, Inc. failed and the Reserve Primary Fund, a $62 
billion prime MMF, ``broke the buck,'' investors redeemed more than 
$300 billion from prime MMFs and commercial paper markets shut down for 
even the highest-quality issuers. The Treasury Department's guarantee 
of more than $3 trillion of MMF shares and a series of liquidity 
programs introduced by the Federal Reserve were needed to help stop the 
run on MMFs during the financial crisis and ultimately helped MMFs to 
continue to function as intermediaries in the financial markets.
    The Securities and Exchange Commission (SEC) took important steps 
in 2010 by adopting regulations to improve the resiliency of MMFs (the 
``2010 reforms''). But the 2010 reforms did not address the structural 
vulnerabilities of MMFs that leave them susceptible to destabilizing 
runs. These vulnerabilities arise from MMFs' maintenance of a stable 
value per share and other factors as discussed below. MMFs' activities 
and practices give rise to a structural vulnerability to runs by

[[Page 69456]]

creating a ``first-mover advantage'' that provides an incentive for 
investors to redeem their shares at the first indication of any 
perceived threat to an MMF's value or liquidity. Because MMFs lack any 
explicit capacity to absorb losses in their portfolio holdings without 
depressing the market-based value of their shares, even a small threat 
to an MMF can start a run. In effect, first movers have a free option 
to put their investment back to the fund by redeeming shares at the 
customary stable share price of $1.00, rather than at a price that 
reflects the reduced market value of the securities held by the MMF.
    The broader financial regulatory community has focused substantial 
attention on MMFs and the risks they pose. Both the President's Working 
Group on Financial Markets (PWG) and the Financial Stability Oversight 
Council (Council) called for additional reforms to address the 
structural vulnerabilities in MMFs, through the PWG's 2010 report on 
Money Market Fund Reform Options and unanimous recommendations in the 
Council's 2011 and 2012 annual reports, respectively.
    In October 2010, the SEC issued a formal request for public comment 
on the reforms initially described in the PWG report, and in May 2011 
the SEC hosted a roundtable on MMFs and systemic risk in which several 
Council members and their representatives participated. However, in 
August 2012, SEC Chairman Schapiro announced that the SEC would not 
proceed with a vote to publish a notice of proposed rulemaking to 
solicit public comment on potential structural reforms of MMFs.
    Under Section 120 of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (the Dodd-Frank Act),\1\ if the Council determines that 
the conduct, scope, nature, size, scale, concentration, or 
interconnectedness of a financial activity or practice conducted by 
bank holding companies or nonbank financial companies could create or 
increase the risk of significant liquidity, credit, or other problems 
spreading among bank holding companies and nonbank financial companies, 
the financial markets of the United States, or low-income, minority, or 
under-served communities, the Council may provide for more stringent 
regulation of such financial activity or practice by issuing 
recommendations to a primary financial regulatory agency to apply new 
or heightened standards or safeguards. The recommended standards and 
safeguards are required by Section 120 to take costs to long-term 
economic growth into account, and may include prescribing the conduct 
of the activity or practice in specific ways, such as applying 
particular capital or risk-management requirements.
---------------------------------------------------------------------------

    \1\ Public Law 111-203, 124 Stat. 1376 (2010).
---------------------------------------------------------------------------

    The Council is proposing to use this authority to recommend that 
the SEC proceed with much-needed structural reforms of MMFs. There will 
be a 60-day public comment period on the proposed recommendations. The 
Council will then consider the comments and may issue a final 
recommendation to the SEC, which, pursuant to the Dodd-Frank Act, would 
be required to impose the recommended standards, or similar standards 
that the Council deems acceptable, or explain in writing to the Council 
within 90 days why it has determined not to follow the recommendation.
    Pursuant to Section 120, the Council proposes to determine that 
MMFs' activities and practices could create or increase the risk of 
significant liquidity, credit, and other problems spreading among bank 
holding companies, nonbank financial companies, and U.S. financial 
markets. This is due to the conduct and nature of the activities and 
practices of MMFs that leave them susceptible to destabilizing runs; 
the size, scale, and concentration of MMFs and the important role they 
play in the financial markets; and the interconnectedness between MMFs, 
the financial system and the broader economy that can act as a channel 
for the transmission of risk and contagion and curtail the availability 
of liquidity and short-term credit.
    Based on this proposed determination, the Council seeks comment on 
the proposed recommendations for structural reforms of MMFs that reduce 
the risk of runs and significant problems spreading through the 
financial system stemming from the practices and activities described 
above. The Council is proposing three alternatives for consideration:
     Alternative One: Floating Net Asset Value. Require MMFs to 
have a floating net asset value (NAV) per share by removing the special 
exemption that currently allows MMFs to utilize amortized cost 
accounting and/or penny rounding to maintain a stable NAV. The value of 
MMFs' shares would not be fixed at $1.00 and would reflect the actual 
market value of the underlying portfolio holdings, consistent with the 
requirements that apply to all other mutual funds.
     Alternative Two: Stable NAV with NAV Buffer and ``Minimum 
Balance at Risk.'' Require MMFs to have an NAV buffer with a tailored 
amount of assets of up to 1 percent to absorb day-to-day fluctuations 
in the value of the funds' portfolio securities and allow the funds to 
maintain a stable NAV. The NAV buffer would have an appropriate 
transition period and could be raised through various methods. The NAV 
buffer would be paired with a requirement that 3 percent of a 
shareholder's highest account value in excess of $100,000 during the 
previous 30 days--a minimum balance at risk (MBR)--be made available 
for redemption on a delayed basis. Most redemptions would be unaffected 
by this requirement, but redemptions of an investor's MBR itself would 
be delayed for 30 days. In the event that an MMF suffers losses that 
exceed its NAV buffer, the losses would be borne first by the MBRs of 
shareholders who have recently redeemed, creating a disincentive to 
redeem and providing protection for shareholders who remain in the 
fund. These requirements would not apply to Treasury MMFs, and the MBR 
requirement would not apply to investors with account balances below 
$100,000.
     Alternative Three: Stable NAV with NAV Buffer and Other 
Measures. Require MMFs to have a risk-based NAV buffer of 3 percent to 
provide explicit loss-absorption capacity that could be combined with 
other measures to enhance the effectiveness of the buffer and 
potentially increase the resiliency of MMFs. Other measures could 
include more stringent investment diversification requirements, 
increased minimum liquidity levels, and more robust disclosure 
requirements. The NAV buffer would have an appropriate transition 
period and could be raised through various methods. To the extent that 
it can be adequately demonstrated that more stringent investment 
diversification requirements, alone or in combination with other 
measures, complement the NAV buffer and further reduce the 
vulnerabilities of MMFs, the Council could include these measures in 
its final recommendation and would reduce the size of the NAV buffer 
required under this alternative accordingly.
    These proposed recommendations are not necessarily mutually 
exclusive but could be implemented in combination to address the 
structural vulnerabilities that result in MMFs' susceptibility to runs. 
For example, MMFs could be permitted to use floating NAVs or, if they 
preferred to maintain a stable value, to implement the measures 
contemplated in Alternatives Two or Three.

[[Page 69457]]

    Other reforms, not described above, may be able to achieve similar 
outcomes. Accordingly, the Council seeks public comment on the proposed 
recommendations and other potential reforms of MMFs. Comments on other 
reforms should consider the objectives of addressing the structural 
vulnerabilities inherent in MMFs and mitigating the risk of runs. For 
example, some stakeholders have suggested features that only would be 
implemented during times of market stress to reduce MMFs' vulnerability 
to runs, such as standby liquidity fees or gates. Commenters on such 
proposals should address concerns that such features might increase the 
potential for industry-wide runs in times of stress.
    The Council recognizes that regulated and unregulated or less-
regulated cash management products (such as unregistered private 
liquidity funds) other than MMFs may pose risks that are similar to 
those posed by MMFs, and that further MMF reforms could increase demand 
for non-MMF cash management products. The Council seeks comment on 
other possible reforms that would address risks that might arise from a 
migration to non-MMF cash management products. Further, the Council is 
not considering MMF reform in isolation. The Council and its members 
intend to use their authorities, where appropriate and within their 
jurisdictions, to address any risks to financial stability that may 
arise from various products within the cash management industry in a 
consistent manner. Such consistency would be designed to reduce or 
eliminate any regulatory gaps that could result in risks to financial 
stability if cash management products with similar risks are subject to 
dissimilar standards.
    In accordance with Section 120 of the Dodd-Frank Act, the Council 
has consulted with the SEC staff. In addition, the standards and 
safeguards proposed by the Council take costs to long-term economic 
growth into account.

II. Overview of Money Market Mutual Funds

A. Description of Money Market Mutual Funds

    MMFs are a type of mutual fund registered under the Investment 
Company Act of 1940 (the Investment Company Act).\2\ Investors in MMFs 
fall into two categories: (i) Individual, or ``retail'' investors; and 
(ii) institutional investors, such as corporations, bank trust 
departments, pension funds, securities lending operations, and state 
and local governments, that use MMFs for a variety of cash management 
and investment purposes.\3\ MMFs are widely used by both retail and 
institutional investors for cash management purposes, although the 
industry has become increasingly dominated by institutional investors. 
MMFs marketed primarily to institutional investors account for almost 
two-thirds of assets today compared to about one-third of industry 
assets in 1996.\4\
---------------------------------------------------------------------------

    \2\ 15 U.S.C. 80a-1--80a-64.
    \3\ At times, these two categories may overlap. For example, 
retail investors may invest in institutional MMF shares through 
employer-sponsored retirement plans, such as 401(k) plans and broker 
or bank sweep accounts. Investment Company Institute, ``Report of 
the Money Market Working Group'' (March 17, 2009), at 24-27, 
available at https://www.ici.org/pdf/ppr_09_mmwg.pdf.
    \4\ Investment Company Institute, ``2012 Investment Company Fact 
Book'' (``ICI Fact Book''), at Table 39; ``Weekly Money Market 
Mutual Fund Assets'' (Oct. 25, 2012), available at https://www.ici.org/research/stats/mmf.
---------------------------------------------------------------------------

    MMFs are a convenient and cost-effective way for investors to 
achieve a diversified investment in various money market instruments, 
such as commercial paper (CP), short-term state and local government 
debt, Treasury bills, and repurchase agreements (repos). This 
diversification, in combination with principal stability, liquidity, 
and short-term market yields, has made MMFs an attractive investment 
vehicle. MMFs provide an economically significant service by acting as 
intermediaries between investors who desire low-risk, liquid 
investments and borrowers that issue short-term funding instruments. 
MMFs serve an important role in the asset management industry through 
their investors' use of MMFs as a cash-like product in asset allocation 
and as a temporary investment when they choose to divest of riskier 
investments such as stock or long-term bond mutual funds.
    The MMF industry had approximately $2.9 trillion in assets under 
management (AUM) as of September 30, 2012, of which approximately $2.6 
trillion is in funds that are registered with the SEC for sale to the 
public. This represents a decline from $3.8 trillion at the end of 
2008.\5\ As of the end of 2011, there were 632 such funds, compared to 
783 at the end of 2008.\6\
---------------------------------------------------------------------------

    \5\ Based on data filed on SEC Form N-MFP as of September 30, 
2012; ``Weekly Money Market Mutual Fund Assets'' (Oct. 25, 2012), 
available at https://www.ici.org/research/stats/mmf; ICI Fact Book, 
at Table 39.
    \6\ See ICI Fact Book, at Table 5.
---------------------------------------------------------------------------

    MMFs are categorized into four main types based on their investment 
strategies. Treasury MMFs, with about $400 billion in AUM, invest 
primarily in U.S. Treasury obligations and repos collateralized with 
U.S. Treasury securities. Government MMFs, with about $490 billion in 
AUM, invest primarily in U.S. Treasury obligations and securities 
issued by entities such as the Federal Home Loan Mortgage Corporation 
(Freddie Mac), the Federal National Mortgage Association (Fannie Mae), 
and the Federal Home Loan Banks (FHLBs), as well as in repo 
collateralized by such securities. In contrast, prime MMFs, with about 
$1.7 trillion in AUM, invest more substantially in private debt 
instruments, such as CP and certificates of deposit (CDs). Commensurate 
with the greater risks in their portfolios, prime MMFs generally pay 
higher yields than Treasury or government MMFs. Finally, tax-exempt 
MMFs, with about $280 billion in AUM, invest in short-term municipal 
securities and pay interest that is generally exempt from state and 
federal income taxes, as appropriate.

B. Rule 2a-7 and the 2010 Reforms

    Like other mutual funds, MMFs must register under the Investment 
Company Act and are subject to its provisions. An MMF must comply with 
all of the same legal and regulatory requirements that apply to mutual 
funds generally, except that rule 2a-7 under the Investment Company Act 
\7\ allows MMFs to use special methods to value their portfolio 
securities and price their shares, subject to the conditions in the 
rule. These methods permit MMFs to maintain a stable NAV per share, 
typically $1.00. Pursuant to rule 2a-7, MMFs generally use the 
amortized cost method of valuation and the penny rounding method of 
pricing in order to effectively ``round'' their share prices. Under 
these methods, securities held by MMFs are valued at acquisition cost, 
with adjustments for amortization of premium or accretion of discount, 
instead of at fair market value, and the MMFs' price per share is 
rounded to the nearest penny. This permits an MMF to price its shares 
for purposes of sales and redemptions at $1.00 even though the fund's 
NAV based on the fair market value of its portfolio securities--rather 
than amortized cost--may vary by as much as 0.50 percent per share 
above or below $1.00. All other types of mutual funds, in contrast, 
must value their NAVs using the market value of the funds' portfolio 
securities and sell and redeem their shares based on that NAV without 
using penny rounding.
---------------------------------------------------------------------------

    \7\ 17 CFR 270.2a-7.
---------------------------------------------------------------------------

    In order to protect investors from being treated unfairly, an MMF 
may continue to use these valuation and

[[Page 69458]]

pricing methods only when the fund's stable $1.00 per share value 
fairly represents the fund's market-based share price. Rule 2a-7 
requires an MMF to periodically calculate its market-based NAV, or 
``shadow price,'' and compare this value to the fund's stable $1.00 
share price. If there is a difference of more than 0.50 percent (or 
$0.005 per share), the fund's board of directors must consider promptly 
what action, if any, should be taken, including whether the fund should 
discontinue the use of these methods and re-price the securities of the 
fund at a value other than $1.00 per share, an event known as 
``breaking the buck'' (i.e., the fund would fail to maintain a stable 
NAV of $1.00).
    In order to reduce the likelihood that an MMF would experience such 
a significant deviation, rule 2a-7 imposes upon MMFs certain ``risk-
limiting conditions'' relating to portfolio maturity, credit quality, 
liquidity, and diversification. These risk-limiting conditions limit 
the funds' exposures to certain risks, such as credit, currency, and 
interest rate risks.\8\
---------------------------------------------------------------------------

    \8\ SEC, Money Market Fund Reform, 75 FR 32688, 10060 (Mar. 4, 
2010).
---------------------------------------------------------------------------

    The risk-limiting conditions, in their current form, include 
numerous changes to rule 2a-7 that were adopted by the SEC in 2010 as 
an initial response to the financial crisis. These 2010 reforms 
strengthened maturity limitations, increased MMFs' diversification and 
liquidity requirements, imposed stress-test requirements, improved the 
credit-quality standards for MMF portfolio securities, increased 
reporting and disclosure requirements on portfolio holdings, and 
provided new redemption and liquidation procedures to minimize 
contagion from a fund breaking the buck, as described below. The 2010 
reforms were a necessary and important step in reducing MMF portfolio 
risk and increasing the resiliency of MMFs to redemptions.
    Quality of portfolio securities. MMFs may purchase a security only 
if the security, at the time of acquisition, has received a specified 
credit rating from a nationally recognized statistical rating 
organization (``NRSRO''), generally the highest short-term rating (or 
is an unrated security of comparable quality as determined by the board 
of directors), and the fund's board of directors determines that the 
security presents minimal credit risks based on factors pertaining to 
credit quality in addition to any credit rating assigned to the 
security by an NRSRO.\9\ The 2010 reforms sought to reduce MMFs' 
exposure to risks from lower-rated securities--so-called ``second-
tier'' securities--in several ways.\10\ First, the reforms reduced the 
limit on investments in these securities from 5 percent to 3 percent of 
the fund's total assets. Second, MMFs' allowable exposure to a single 
issuer of second-tier securities was reduced to 0.5 percent.\11\ Third, 
MMFs are only permitted to purchase second-tier securities with 
maturities of 45 days or less. The previous limit was 397 days. The 
reforms also tightened requirements relating to MMF holdings of repo 
that are collateralized with private debt instruments rather than cash 
equivalents or government securities.
---------------------------------------------------------------------------

    \9\ An MMF's board of directors may delegate to the fund's 
investment adviser or officers the responsibility to make this 
determination pursuant to written guidelines that the board 
establishes and oversees. In addition, Section 939A of the Dodd-
Frank Act requires the SEC (and other regulators) to review its 
regulations for any references to or requirements regarding credit 
ratings that require the use of an assessment of the 
creditworthiness of a security or money market instrument, remove 
these references or requirements, and substitute in those 
regulations other standards of creditworthiness in place of the 
credit ratings that the agency determines to be appropriate. The SEC 
has proposed to remove references to credit ratings from rule 2a-7. 
See SEC, References to Credit Ratings in Certain Investment Company 
Act Rules and Forms, Investment Company Act Release No. IC-28807, 76 
FR 12896 (Mar. 9, 2011). It is the Council's understanding that the 
SEC intends to act on removal of credit ratings from rule 2a-7 as 
required by the Dodd-Frank Act, and therefore the Council is not 
addressing this issue in these recommendations.
    \10\ Second-tier securities are defined in rule 2a-7 generally 
as securities that have received the second-highest short-term debt 
rating from an NRSRO or are of comparable quality.
    \11\ The previous limit was the greater of one percent or $1 
million.
---------------------------------------------------------------------------

    Maturity limitations. MMFs generally are prohibited from acquiring 
any security with a remaining maturity greater than 397 days (certain 
features, like an unconditional ``put,'' can shorten a security's 
maturity for this and certain other purposes under rule 2a-7), and are 
subject to a maximum allowable dollar-weighted average portfolio 
maturity (WAM) and weighted average life (WAL). The 2010 reforms 
strengthened the maturity limitations by reducing the maximum allowable 
WAM of an MMF's portfolio from 90 days to 60 days, which reduces an 
MMF's exposure to interest-rate risk. In addition, the 2010 reforms 
introduced a new 120-day WAL limit, which lowers MMFs' exposure to 
credit-spread risk from floating- or variable-rate portfolio holdings 
by taking into account the securities' ultimate maturity.\12\
---------------------------------------------------------------------------

    \12\ Widening credit spreads, reflecting additional yield 
demanded by investors over a comparable risk-free rate, can 
negatively affect the value of a fund's portfolio securities. The 
limit on an MMF's WAL is designed to protect the fund against spread 
risk because longer-term adjustable-rate securities are more 
sensitive to credit spreads than short-term securities with final 
maturities equal to the reset date of the longer-term security. 
Under rule 2a-7, therefore, MMFs are permitted to use interest-rate 
reset dates to shorten the maturity of an adjustable-rate security 
or a floating rate security in their WAM calculation, but not in 
their WAL calculation.
---------------------------------------------------------------------------

    Diversification requirement. Generally, MMFs must limit their 
investments in the securities of any one issuer (other than government 
securities) to no more than 5 percent of fund assets at the time of 
purchase. They must also generally limit their investments in 
securities subject to a demand feature or a guarantee from any 
particular provider to no more than 10 percent of fund assets.
    Liquidity requirements. The 2010 reforms added a requirement that 
each MMF maintain a minimum liquidity buffer. Each MMF must have at 
least 10 percent of its assets invested in ``daily liquid assets'' and 
at least 30 percent of its assets invested in ``weekly liquid assets.'' 
\13\ Daily liquid assets are cash, U.S. Treasury obligations, and 
securities that convert into cash (by maturing or through a put) within 
one business day. Weekly liquid assets are daily liquid assets, 
securities of an instrumentality of the U.S. Government that have a 
remaining maturity of 60 days or less, and securities that convert into 
cash within five business days. The amendments also reduced the amount 
of illiquid securities--those that cannot be disposed of within seven 
days without taking a discounted price--that an MMF can hold from 10 
percent to 5 percent. These liquidity requirements are designed to help 
MMFs meet shareholder redemptions without selling portfolio securities 
into potentially distressed markets at discounted prices.
---------------------------------------------------------------------------

    \13\ Tax-exempt MMFs are exempt from the requirement regarding 
daily liquid assets.
---------------------------------------------------------------------------

    Stress-testing requirement. The 2010 reforms introduced a stress-
testing requirement for MMFs, requiring that a fund's board of 
directors adopt procedures for periodic stress tests of the fund's 
ability to maintain a stable share price. The stress tests are based on 
certain hypothetical stress events and the results of these tests must 
be provided to the MMF's board.
    Disclosure and reporting. The 2010 reforms introduced enhanced 
reporting and disclosure obligations that require funds to post 
portfolio information on their Web sites within five business days 
after the end of each month. MMFs are also required to submit to the 
SEC each month more detailed portfolio holdings information, including 
the shadow price, which is made available

[[Page 69459]]

to the public 60 days after the end of the month to which the 
information pertains. These requirements allow the SEC, investors, and 
others to better monitor fund risk taking.
    Facilitation of orderly fund liquidation. The 2010 reforms 
introduced a new rule, rule 22e-3 under the Investment Company Act, 
that permits the board of directors of an MMF, upon notification to the 
SEC, to suspend redemptions and liquidate the fund if it has broken, or 
is in danger of breaking, the buck. The rule is designed to prevent 
shareholder harm from distressed sales of securities that can occur 
with rapid liquidations when a fund breaks the buck.
    While the enhancements introduced in the 2010 reforms increase 
resiliency and limit MMFs' exposure to certain risks, they do not 
address MMFs' structural vulnerabilities. These vulnerabilities and the 
resulting risks to financial stability are described in more detail in 
the following sections.

III. History of Reform Efforts and Role of the Financial Stability 
Oversight Council

A. Reform Efforts to Date

    Following the financial crisis, the Department of the Treasury 
(Treasury) released a roadmap for financial reform in June 2009 \14\ 
calling for: (i) The SEC to complete its near-term MMF reform efforts 
and (ii) the PWG to evaluate the need for structural reform of MMFs. 
The SEC addressed this first element when it adopted the 2010 reforms.
---------------------------------------------------------------------------

    \14\ Treasury, ``Financial Regulatory Reform: A New Foundation'' 
(2009), available at https://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf.
---------------------------------------------------------------------------

    At the time of the adoption of the 2010 reforms, the SEC noted that 
these reforms served as a ``first step'' in addressing MMF reform.\15\ 
In October 2010, the PWG released a report outlining a set of 
additional policy options intended to address the risks to financial 
stability posed by MMFs' susceptibility to runs.\16\ This report stated 
that the 2010 reforms ``alone could not be expected to prevent a run of 
the type experienced in September 2008.'' This report was released for 
public comment and generated a large number of thoughtful and detailed 
responses, including suggestions by both academics and industry 
participants that MMFs maintain a capital buffer or impose a liquidity 
fee to help absorb losses and mitigate liquidity pressures. To further 
engage the public on reform, the SEC hosted a roundtable to discuss 
potential reform options in May 2011 that included Council members and 
their representatives, other regulators, trade groups, issuers of 
securities in which MMFs invest, MMF sponsors, and MMF investors. 
Throughout this period, the SEC engaged with stakeholders and 
regulators in an intensive effort to consider and refine various 
potential reform options.
---------------------------------------------------------------------------

    \15\ SEC, Money Market Fund Reform, Investment Company Act 
Release No. IC-29132, 75 FR 10600, 10062 (Mar. 4, 2010) (``Our June 
2009 proposals were the product of [the SEC's and staff's review of 
MMFs] and were, we explained, a first step to addressing regulatory 
concerns we identified.'').
    \16\ President's Working Group on Financial Markets, ``Money 
Market Fund Reform Options'' (Oct. 2010), available at https://www.treasury.gov/press-center/press-releases/Documents/10.21%20PWG%20Report%20Final.pdf.
---------------------------------------------------------------------------

    Concurrently, the broader financial regulatory community in both 
the United States and abroad has made repeated calls for MMF reform. 
The Council, in both its 2011 and 2012 annual reports, highlighted the 
need for additional MMF reform to address structural vulnerabilities in 
the U.S. financial system. In 2012, the Council specifically 
recommended that the SEC publish structural reform proposals for public 
comment and ultimately adopt reforms that address MMFs' lack of loss-
absorption capacity and susceptibility to runs. The Office of Financial 
Research, in its 2012 annual report, identified the run risk for MMFs 
as one of the ``current threats to financial stability.''
    Internationally, on October 9, 2012, the International Organization 
of Securities Commissions (IOSCO) issued policy recommendations for 
reforming MMFs. The IOSCO recommendations demonstrate the efforts by 
the G-20 and the Financial Stability Board to fulfill the mandate of 
strengthening the oversight and regulation of the ``shadow banking 
system.'' \17\ There are also other international efforts, along with 
IOSCO's, to consider aspects of MMF regulation where greater 
harmonization between jurisdictions and regulatory improvements could 
occur in an effort to avoid jurisdictional arbitrage.\18\
---------------------------------------------------------------------------

    \17\ IOSCO, ``Policy Recommendations for Money Market Funds'' 
(Oct. 2012), available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD392.pdf. Substantially all of IOSCO's recommendations are 
included in the SEC's current regulation of MMFs or are addressed in 
these proposed recommendations. IOSCO noted in a media release 
issued on October 9, 2012, that although a majority of the SEC's 
commissioners did not support the publication of IOSCO's 
recommendations, there were no other objections, and IOSCO's board 
approved the report containing the recommendations during its 
meeting on October 3-4, 2012. In addition, in a statement issued on 
May 11, 2012, three of the SEC's commissioners stated that IOSCO's 
consultation report on MMFs, published on April 27, 2012, did not 
reflect the views and input of a majority of the SEC and, 
accordingly, cannot be considered to represent the views of the SEC.
    \18\ The European Commission is also considering the need for 
further reforms to their regulation of money market funds. See 
European Commission Green Paper on Shadow Banking (Mar. 19, 2012), 
available at https://ec.europa.eu/internal_market/bank/docs/shadow/green-paper_en.pdf; European Commission Consultation Document, 
Undertakings for Collective Investment in Transferable Securities 
(UCITS) Product Rules, Liquidity Management, Depositary, Money 
Market Funds, Long-term Investments (Jul. 26, 2012), available at 
https://ec.europa.eu/internal_market/consultations/docs/2012/ucits/ucits_consultation_en.pdf.
---------------------------------------------------------------------------

    On August 22, 2012, SEC Chairman Schapiro announced that the 
majority of the SEC's Commissioners would not support seeking public 
comment on the SEC's staff proposal to reform the structure of MMFs. As 
a result, on September 27, 2012, the Chairperson of the Council, 
Treasury Secretary Geithner, sent a letter to Council members urging 
the Council to take action in the absence of the SEC doing so.

B. Role of the Council and Dodd-Frank Act Section 120

    The Dodd-Frank Act established the Council ``(A) to identify risks 
to the financial stability of the United States that could arise from 
the material financial distress or failure, or ongoing activities, of 
large, interconnected bank holding companies or nonbank financial 
companies, or that could arise outside the financial services 
marketplace; (B) to promote market discipline, by eliminating 
expectations on the part of shareholders, creditors, and counterparties 
of such companies that the Government will shield them from losses in 
the event of failure; and (C) to respond to emerging threats to the 
stability of the United States financial system.'' \19\
---------------------------------------------------------------------------

    \19\ Dodd-Frank Act Section 112(a)(1).
---------------------------------------------------------------------------

    To carry out its financial stability mission, the Council has 
various authorities, including the authority under Section 120 of the 
Dodd-Frank Act to issue recommendations to primary financial regulatory 
agencies to apply ``new or heightened standards and safeguards'' for a 
financial activity or practice conducted by bank holding companies or 
nonbank financial companies under the regulatory agency's jurisdiction. 
Prior to issuing such a recommendation, the Council must determine that 
``the conduct, scope, nature, size, scale, concentration, or 
interconnectedness'' of the financial activity or practice ``could 
create or increase the risk of significant liquidity, credit, or other 
problems spreading among bank holding companies and nonbank financial 
companies, financial

[[Page 69460]]

markets of the United States, or low-income, minority or underserved 
communities.'' \20\ The Council believes that MMFs are ``predominantly 
engaged in financial activities'' \21\ as defined in section 4(k) of 
the Bank Holding Company Act of 1956 \22\ and thus are ``nonbank 
financial companies'' \23\ for purposes of Title I of the Dodd-Frank 
Act.
---------------------------------------------------------------------------

    \20\ Dodd-Frank Act Section 120(a).
    \21\ See 12 U.S.C. 5311(b).
    \22\ See sections 4(k)(1), 4(k)(4)(A), 4(k)(4)(D), and 
4(k)(4)(H) of the Bank Holding Company Act (12 U.S.C. 1843(k)(1), 
1843(k)(4)(A), 1843(k)(4)(D), 1843(k)(4)(H)).
    \23\ See 12 U.S.C. 5311(a)(4).
---------------------------------------------------------------------------

    Pursuant to Section 120 of the Dodd-Frank Act, the Council proposes 
to determine that the activities and practices of MMFs, for which the 
SEC is the primary financial regulatory agency, could create or 
increase the risk of significant liquidity, credit, or other problems 
spreading among bank holding companies, nonbank financial companies, 
and the financial markets of the United States. This proposed 
determination is set forth below in Section IV. The Council seeks 
public comment on this proposed determination.
    To address the concerns regarding MMFs, the Council also seeks 
public comment on the proposed recommendations described in Section V. 
Comments are due 60 days after publication in the Federal Register. The 
Council will then consider the comments and may issue a final 
recommendation to the SEC, which, pursuant to the Dodd-Frank Act, would 
be required to impose the recommended standards, or similar standards 
that the Council deems acceptable, or explain in writing to the 
Council, not later than 90 days after the date on which the Council 
issues the final recommendation, why the SEC has determined not to 
follow the Council's recommendation. If the SEC accepts the Council's 
recommendation, it is expected that the SEC would implement the 
recommendation through a rulemaking, subject to public comment, that 
would consider the economic consequences of the implementing rule as 
informed by the SEC staff's own economic study and analysis.
    The SEC, by virtue of its institutional expertise and statutory 
authority, is best positioned to implement reforms to address the risks 
that MMFs present to the economy. If the SEC moves forward with 
meaningful structural reforms of MMFs before the Council completes its 
Section 120 process, the Council expects that it would not issue a 
final Section 120 recommendation to the SEC.
    In addition to the proposed recommendations to the SEC under its 
Section 120 authority, the Council and some of its members are actively 
evaluating alternative authorities in the event the SEC determines not 
to impose the standards recommended by the Council in any final 
recommendation.
    For instance, under Title I of the Dodd-Frank Act, the Council has 
the authority and the duty to designate any nonbank financial company 
that could pose a threat to U.S. financial stability. Designated 
companies are subject to supervision by the Federal Reserve and 
enhanced prudential standards. Alternatively, the Council's authority 
to designate systemically important payment, clearing, or settlement 
activities under Title VIII of the Dodd-Frank Act could enable the 
application of heightened risk-management standards on an industry-wide 
basis. Additionally, other Council member agencies have the authority 
to take action to address certain of the risks posed by MMFs and 
similar cash-management products, as appropriate.

IV. Proposed Determination That MMFs Could Create or Increase the Risk 
of Significant Liquidity and Credit Problems Spreading Among Financial 
Companies and Markets

    In order to issue a recommendation under Section 120 of the Dodd-
Frank Act, the Council must determine that the conduct, scope, nature, 
size, scale, concentration, or interconnectedness of MMFs' activities 
or practices could create or increase the risk of significant 
liquidity, credit, or other problems spreading among bank holding 
companies and nonbank financial companies, or U.S. financial markets.
    As further discussed below, the conduct and nature of MMFs' 
activities and practices make MMFs vulnerable to destabilizing runs, 
which may spread quickly among funds, impairing liquidity broadly and 
curtailing the availability of short-term credit.\24\ Because of the 
size, scale, concentration, and interconnectedness of MMFs' activities, 
the liquidity pressures on the MMF industry resulting from a run can 
cause this stress to propagate rapidly throughout the financial system 
and to the broader economy.
---------------------------------------------------------------------------

    \24\ The inherent fragility and susceptibility of MMFs to 
destabilizing runs has been the subject of considerable academic 
research and commentary. See, e.g., Sean S. Collins and Phillip R. 
Mack, ``Avoiding Runs in Money Market Mutual Funds: Have Regulatory 
Reforms Reduced the Potential for a Crash,'' Working Paper 94-14, 
Federal Reserve Board Finance and Economics Discussion Series (June 
1994); Naohiko Baba, Robert N. McCauley, and Srichander Ramaswamy, 
``US dollar money market funds and non-US banks,'' BIS Quarterly 
Review (March 2009), at 65-81; Gary Gorton and Andrew Metrick, 
``Regulating the Shadow Banking System,'' Brookings Papers on 
Economic Activity (Fall 2010), at 261-297; Patrick E. McCabe, ``The 
Cross Section of Money Market Fund Risks and Financial Crises,'' 
Working Paper 2010-51, Federal Reserve Board Finance and Economics 
Discussion Series (September 2010); Squam Lake Group, ``Reforming 
Money Market Funds,'' Letter to the Securities and Exchange 
Commission re: File No. 4-619; Release No. IC-29497 President's 
Working Group Report on Money Market Fund Reform (Jan. 14, 2011), 
available at https://www.sec.gov/comments/4-619/4619-57.pdf; Eric S. 
Rosengren, ``Money Market Mutual Funds and Financial Stability: 
Remarks at the Federal Reserve Bank of Atlanta's 2012 Financial 
Markets Conference,'' (April 11, 2012), available at https://www.bos.frb.org/news/speeches/rosengren/2012/041112/041112.pdf; 
Marcin Kacperczyk and Philipp Schnabl, ``How Safe are Money Market 
Funds?'' (April 2012); Burcu Duygan-Bump, Patrick Parkinson, Eric 
Rosengren, Gustavo A. Suarez, and Paul Willen, ``How effective were 
the Federal Reserve emergency liquidity facilities? Evidence from 
the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity 
Facility,'' Journal of Finance, forthcoming; Patrick E. McCabe, 
Marco Cipriani, Michael Holscher, and Antoine Martin, ``The Minimum 
Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by 
Money Market Funds,'' Working Paper 2012-47, Federal Reserve Board 
Finance and Economics Discussion Series (July 2012); David S. 
Scharfstein, ``Perspectives on Money Market Mutual Fund Reforms,'' 
Testimony before U.S. Senate Committee on Banking, Housing, & Urban 
Affairs (June 21, 2012); Jeffrey N. Gordon and Christopher M. 
Gandia, ``Money Market Funds Run Risk: Will Floating Net Asset Value 
Fix the Problem?'' Columbia Law and Economics Working Paper No. 426 
(Sept. 23, 2012), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2134995.
---------------------------------------------------------------------------

    As was evidenced in the financial crisis, even small portfolio 
losses may cause a fund to break the buck. If investors perceive a risk 
of such an event, MMFs' lack of explicit loss-absorption capacity, the 
first-mover advantage enjoyed by redeeming investors, investor 
uncertainty regarding sponsor support, and the similarity of MMFs' 
portfolios can incite widespread runs on MMFs. Heavy redemptions may 
magnify losses for other funds and potentially cause them to break the 
buck and suspend redemptions under rule 22e-3, harming investors by 
impairing their liquidity. Further, due to the significant role MMFs 
play in the short-term credit markets, an industry-wide run on MMFs can 
reduce the availability of credit to borrowers. Ultimately, a run on 
MMFs can create or increase the risk of significant liquidity, credit, 
or other problems spreading among bank holding companies, nonbank 
financial companies, and U.S. financial markets.
     Conduct and nature of activities and practices: Several 
activities and practices of MMFs combine to create a vulnerability to 
runs, including: (i) Relying on the amortized cost method of

[[Page 69461]]

valuation and/or penny rounding to maintain a stable $1.00 per share 
price; (ii) offering shares that may be redeemed on demand despite 
MMFs' limited same-day liquidity; (iii) investing in assets that are 
subject to interest-rate and credit risk without having explicit loss-
absorption capacity; (iv) relying upon ad hoc discretionary support 
from sponsors, which has often shielded investors from losses and 
obscured portfolio risks; and (v) attracting a base of highly risk-
averse investors that are prone to withdraw assets when even small 
losses appear possible. Together, these activities and practices foster 
MMFs' structural vulnerability to runs by creating a first-mover 
advantage that provides an incentive for investors to redeem their 
shares at the first indication of any perceived threat to an MMF's 
value or liquidity. Because MMFs lack any explicit capacity to absorb 
losses in their portfolio holdings without depressing the market-based 
value of their shares, even a small threat to an MMF can start a run.
     Size, scale, and concentration of activities and 
practices: The MMF industry is large, with $2.9 trillion in assets, and 
provides a substantial portion of the short-term funding available to a 
range of borrowers in the capital markets. The industry is also highly 
concentrated, as the top 20 MMF sponsors operate funds with 90 percent 
of aggregate MMF assets under management.
     Interconnectedness of activities and practices: MMFs are 
highly interconnected with the rest of the financial system and can 
transmit stress throughout the system because of their role as 
intermediaries, as significant investors in the short-term funding 
markets, as potential recipients of economic support from the financial 
institutions that sponsor them, and as important providers of cash-
management services.

Below is a further discussion of MMFs' activities and practices and how 
they contribute to the funds' vulnerability to runs, how those runs may 
transmit stresses throughout the financial system, evidence from the 
run on MMFs during the financial crisis, and an explanation of why 
action is needed beyond the 2010 reforms. The Council solicits public 
comment on this proposed determination.
Conduct and Nature
    MMFs' vulnerability to runs results in part from the conduct and 
nature of the activities and practices of MMFs, their sponsors, and 
their investors.
    The stable, rounded NAV per share. Unlike other mutual funds, most 
MMFs rely on valuation and rounding methods to maintain a stable NAV 
per share, typically $1.00. Rounding obscures the daily movements in 
the value of an MMF's portfolio and fosters an expectation that MMF 
share prices will not fluctuate. Importantly, rounding also exacerbates 
investors' incentives to run when there is risk that prices will 
fluctuate. When an MMF that has experienced a small loss satisfies 
redemption requests at the rounded $1.00 share price, the fund 
effectively subsidizes these redemptions by concentrating the loss 
among the remaining shareholders. As a result, redemptions from such a 
fund can further depress its shadow NAV and increase the risk that the 
MMF will break the buck. This contributes to a first-mover advantage, 
in which those who redeem early are more likely to receive the full 
$1.00 per share than those who wait. Thus, first movers have a free 
option to put their investment back to the fund by redeeming shares at 
the customary stable NAV of $1.00 per share (rather than at a share 
price reflecting the market value of the underlying securities held by 
the MMF). In the absence of an explicit mechanism to take losses in the 
value of the securities held by an MMF without depressing the fund's 
shadow NAV, the ``first movers'' leave other fund investors sharing in 
such losses.
    Shares that can be redeemed on demand despite limited portfolio 
liquidity. MMFs perform maturity transformation by offering shares that 
investors may redeem on demand -- providing shareholders unlimited 
daily liquidity -- while also investing in relatively longer-term 
securities. MMFs invest not only in highly liquid instruments, such as 
securities that mature overnight and Treasury securities, but also in 
short-term instruments that are less liquid, including term CP and term 
repo. In the event of shareholder redemptions in excess of an MMF's 
available liquidity, a fund may be forced to sell less-liquid assets to 
meet redemptions. In times of stress, such sales may cause funds to 
suffer losses that must be absorbed by the fund's remaining investors, 
further reinforcing the first-mover advantage. Importantly, while the 
minimum liquidity requirements implemented in the SEC's 2010 reforms 
should make MMFs more resilient to market disruptions by increasing the 
funds' supply of liquid assets that can quickly be converted to cash, 
as noted below, these requirements are not designed to mitigate the 
first-mover advantage when a fund is at risk of suffering losses.
    Investments with interest-rate and credit risk without explicit 
loss-absorption capacity. MMFs invest in securities with credit and 
interest-rate risk to increase the yields they offer to investors, but 
the funds do so without any formal capacity to absorb losses.\25\ The 
short maturities of these securities and their high credit quality 
generally limit portfolio risks, but MMFs on occasion have been exposed 
to potentially significant losses. For example, 29 MMFs participating 
in the Treasury's Temporary Guarantee Program for Money Market Funds 
reported losses in September and October 2008 that, absent sponsor 
support, would have exceeded 0.50 percent of assets, and losses among 
those funds averaged 2.2 percent of assets.\26\ As discussed in more 
detail below, the Reserve Primary Fund's experience demonstrates that 
the loss in value of a single security in an MMF's portfolio can cause 
the fund to break the buck. As a result of investors' expectations of a 
stable $1.00 per share NAV, even a small capital loss at an MMF can 
give its investors a strong incentive to redeem their shares.
---------------------------------------------------------------------------

    \25\ See SEC, ``Unofficial Transcript: Roundtable on Money 
Market Funds and Systemic Risk'' (May 10, 2011), available at https://www.sec.gov/spotlight/mmf-risk/mmf-risk-transcript-051011.htm 
(quoting Seth P. Bernstein of J.P. Morgan Asset Management, ``We 
find ourselves uncomfortable about the informal arrangements that 
have existed in the industry for some time because we believe it's 
both an issue of credit risk embedded in the portfolios, as well as 
the liquidity issues that arise in a run'').
    \26\ These data exclude losses that were absorbed by some forms 
of sponsor support, such as direct cash infusions to a fund and 
outright purchases of securities from a fund at above-market prices, 
so the number of funds that would have broken the buck in the 
absence of all forms of support may have exceeded 29. See McCabe, 
Cipriani, Holscher, and Martin, 2012.
---------------------------------------------------------------------------

    Reliance on discretionary sponsor support. In the absence of 
capital, insurance, or any other formal mechanism to absorb losses when 
they do occur, MMFs historically have relied upon ad hoc discretionary 
support from their sponsors to maintain $1.00 per share prices.\27\ 
Unlike other types of

[[Page 69462]]

mutual funds, MMF sponsors have often supported their funds, with 
researchers documenting over 200 instances of such support since 
1989.\28\
---------------------------------------------------------------------------

    \27\ See SEC, ``Unofficial Transcript: Roundtable on Money 
Market Funds and Systemic Risk'' (May 10, 2011), available at https://www.sec.gov/spotlight/mmf-risk/mmf-risk-transcript-051011.htm. At 
the roundtable, Bill Stouten of Thrivent Financial stated, ``I think 
the primary factor that makes money funds vulnerable to runs is the 
marketing of the stable NAV. And I think the record of money market 
funds and maintaining the stable NAV has largely been the result of 
periodic voluntary sponsor support. I think sophisticated investors 
that understand this and doubt the willingness or ability of the 
sponsor to make that support know that they need to pull their money 
out before a declining asset is sold.''
    \28\ Moody's found 144 cases in which U.S. MMFs ``would have 
`broken the buck' but for the intervention of their fund sponsor/
investment management firm'' from 1989 to 2003. Moody's identified a 
total of 146 funds that would have lost value before 2007 in the 
absence of support, but one of these losses occurred before the 
adoption of rule 2a-7 and another loss was in a European fund. The 
Moody's report covers ``constant net asset value'' funds other than 
MMFs, but we understand that the remaining 144 funds in question 
were all registered U.S. MMFs. Moody's Investors Service, ``Sponsor 
Support Key to Money Market Funds'' (Aug. 8, 2010). Separately, 
other researchers documented 123 instances of support for 78 
different MMFs between 2007 and 2011. These totals include support 
in the form of cash contributions from sponsors and outright 
purchases of securities from MMFs at above-market prices. However, 
the totals cited here exclude some forms of sponsor intervention, 
including capital support agreements and letters of credit that were 
not drawn upon. See Steffanie A. Brady, Ken E. Anadu, and Nathaniel 
R. Cooper, ``The Stability of Prime Money Market Mutual Funds: 
Sponsor Support from 2007 to 2011,'' Federal Reserve Bank of Boston 
Risk and Policy Analysis Unit, Working Paper RPA 12-3 (Aug. 13, 
2012).
---------------------------------------------------------------------------

    While MMF prospectuses must warn investors that their shares may 
lose value,\29\ the extensive record of sponsor intervention and its 
critical role historically in maintaining MMF price stability may have 
obscured some investors' appreciation of MMF risks and caused some 
investors to assume that MMF sponsors will absorb any losses, even 
though sponsors are under no obligation to do so. As such, it is not 
the sponsor support itself, but rather its discretionary nature that 
contributes to uncertainty among market participants about who will 
bear losses when they do occur. This uncertainty likely makes MMFs even 
more vulnerable to runs during periods of financial instability, when 
broader financial risks are most salient and when concerns arise about 
the health of the sponsors and their wherewithal to provide support to 
affiliated MMFs.
---------------------------------------------------------------------------

    \29\ An MMF's prospectus must state, ``An investment in the Fund 
is not insured or guaranteed by the Federal Deposit Insurance 
Corporation or any other government agency. Although the Fund seeks 
to preserve the value of your investment at $1.00 per share, it is 
possible to lose money by investing in the Fund.'' SEC Form N-1A, 
Item 4(b)(1)(ii).
---------------------------------------------------------------------------

    Highly risk-averse investors. Although MMFs invest in assets that 
may lose value and the funds are under no legal or regulatory 
requirement to redeem shares at $1.00, the industry's record of 
maintaining stable and rounded $1.00 per share NAVs combined with the 
funds' low-risk investment strategies has attracted highly risk-averse 
investors that are prone to withdraw assets rapidly when losses appear 
possible.\30\ This has been exacerbated by the outsized growth of 
institutional MMFs in recent decades. MMFs marketed primarily to 
institutional investors made up only about one-third of industry assets 
in 1996 but account for almost two-thirds of assets today.\31\ 
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.
---------------------------------------------------------------------------

    \30\ See SEC, ``Unofficial Transcript: Roundtable on Money 
Market Funds and Systemic Risk'' (May 10, 2011), available at https://www.sec.gov/spotlight/mmf-risk/mmf-risk-transcript-051011.htm 
(quoting Lance Pan of Capital Advisors Group, ``[MMF investors] will 
take zero loss, and they're loss averse as opposed to risk averse. 
So to the extent that they own that risk, at a certain point they 
started to own that risk, then the run would start to develop. It's 
not that throughout the history of money market funds we did not 
have asset deterioration. We did. But I think over the last 30 or 40 
years, people have relied on the perception that even though there 
is risk in money market funds, that risk is owned somehow implicitly 
by the fund sponsors. So once they perceive that they are not able 
to get that additional assurance, I believe that was one probable 
cause of the run.''
    \31\ ICI Fact Book; Investment Company Institute, ``Weekly Money 
Market Mutual Fund Assets,'' available at https://www.ici.org/research/stats/mmf (Oct. 25, 2012).
---------------------------------------------------------------------------

    Interaction of these activities and practices. In combination, the 
activities and practices of MMFs described above tend to exacerbate 
each other's effects and increase MMFs' vulnerability to runs. For 
example, by relying on the amortized cost method of valuation and/or 
penny rounding to maintain a stable $1.00 per share NAV, offering 
shares that may be redeemed on demand despite limited same-day 
portfolio liquidity, and investing in assets with interest-rate and 
credit risk without explicit loss-absorption capacity, MMFs create a 
first-mover advantage for investors who redeem quickly during times of 
stress. If MMFs with rounded NAVs had lacked sponsor support over the 
past few decades, many might have broken the buck, causing investors to 
recalibrate their perception of MMF risks and resulting in a less risk-
averse investor base. Or if funds maintained credible loss-absorption 
capacity, even a risk-averse investor base might be less likely to run 
because the funds would be better equipped to maintain a stable $1.00 
per share NAV. As a result, policy responses that diminish these 
destabilizing interactions hold promise for mitigating the risks that 
MMFs pose--even if not all five of these activities and practices are 
fully addressed through reform.
Size, Scale, and Concentration
    MMFs' size, scale, and concentration increase both their 
vulnerability to runs and the damaging impact of runs on short-term 
credit markets, borrowers, and investors.
    As discussed in Section II, the MMF industry is large, with $2.9 
trillion in assets under management.\32\ MMFs are important providers 
of short-term funding to financial institutions, nonfinancial firms, 
and governments, and play a dominant role in some short-term funding 
markets. For example, as of September 30, 2012, MMFs owned 44 percent 
of U.S. dollar-denominated financial CP outstanding and about 30 
percent of all uninsured dollar-denominated time deposits, including 
nearly two-thirds of the CDs that are tradable in financial 
markets.\33\ These funds also provided approximately one-third of the 
lending in the tri-party repo market and held significant portions of 
the outstanding short-term securities issued by state and local 
governments, the Treasury, and Federal agencies.\34\ Given the dominant 
role of MMFs in short-term funding markets, runs on these funds can 
therefore have severe implications for the availability of credit and 
liquidity in those markets.
---------------------------------------------------------------------------

    \32\ Aggregate assets under management in all MMFs that are 
registered under the Investment Company Act of 1940 and report on 
Form N-MFP to the SEC totaled $2.9 trillion at September 30, 2012. 
However, shares for some of these MMFs are not registered for sale 
to the public under the Securities Act of 1933. The assets in funds 
that are sold to the public totaled $2.6 trillion at September 30, 
2012, according to data from the Investment Company Institute and 
iMoneyNet.
    \33\ Based on MMFs' filings of SEC Form N-MFP, CD data from the 
Depository Trust & Clearing Corporation (``DTCC''), large time 
deposits data from the Federal Reserve Board Flow of Funds Accounts, 
and CP data from DTCC and the Federal Reserve Board.
    \34\ For repo data, see Federal Reserve Bank of New York, https://www.newyorkfed.org/banking/tpr_infr_reform.html; for short-term 
municipal securities, see SIFMA, https://www.sifma.org/research/item.aspx?id=8589940509 and Flow of Funds Accounts of the United 
States.
---------------------------------------------------------------------------

    In addition, because of the concentration of the MMF industry, even 
heavy withdrawals from (or shifts in portfolio holdings of) MMFs 
offered by a handful of asset management firms may reverberate through 
financial markets. As of September 30, 2012, the top five MMF sponsors 
managed funds with $1.3 trillion in assets (46 percent of industry 
assets), and the top 20 sponsors managed $2.6 trillion (90 
percent).\35\
---------------------------------------------------------------------------

    \35\ Based on Form N-MFP filings with the SEC.
---------------------------------------------------------------------------

Interconnectedness
    MMFs' extensive interconnectedness with financial firms, the 
financial system, and the U.S. economy can

[[Page 69463]]

create a significant threat to broader financial stability because the 
shocks from a run on MMFs can rapidly propagate to other entities 
throughout the financial system.
    Most of the short-term financing that MMFs provide to non-
government entities is extended to financial firms. As of September 30, 
2012, 86 percent of the funding that MMFs extended to private entities 
was in the form of financial sector obligations, including CDs, 
financial CP, asset-backed commercial paper (ABCP), repo, other MMF 
shares, and insurance company funding agreements.\36\ Among the top 50 
private sector firms that received funding from prime MMFs in September 
2012, only four were nonfinancial firms.\37\ Moreover, because 13 of 
the top 15 private-sector firms receiving funding were domiciled 
outside the United States, MMFs can also represent a potential channel 
for rapid transmission of global stress to the U.S. financial markets.
---------------------------------------------------------------------------

    \36\ Based on Form N-MFP filings with the SEC.
    \37\ Based on Form N-MFP filings with the SEC; see Scharfstein, 
2012.
---------------------------------------------------------------------------

    MMFs are further interconnected with the U.S. financial system 
because bank and savings and loan holding companies sponsor MMFs. 
Sponsors face potential risks because, historically, sponsors have 
absorbed nearly all MMF losses that threatened the funds' $1.00 per 
share NAVs, and sponsors would likely face pressure from investors and 
other market participants to continue to do so in the future. As of 
September 30, 2012, MMFs that are sponsored by subsidiaries of bank 
holding companies accounted for 41 percent of industry assets, and MMFs 
sponsored by subsidiaries of thrift holding companies accounted for 
another 11 percent of the industry's assets.\38\
---------------------------------------------------------------------------

    \38\ Based on Form N-MFP and form ADV filings with the SEC, 
company Web sites, and staff analysis from Federal Reserve Bank of 
Boston.
---------------------------------------------------------------------------

    The interconnectedness of the financial system and MMFs is 
exacerbated by the role of banks in providing liquidity enhancements 
and guarantees for securities held by MMFs. As of September 30, 2012, 
for example, three large U.S. banks provided liquidity or credit 
support for approximately $100 billion in securities held by MMFs, and 
European financial institutions provided liquidity or credit support 
for more than $115 billion in such securities.\39\ Tax-exempt MMFs hold 
many of these securities, which are largely obligations of state and 
local governments and other tax-exempt issuers.\40\ Due to these 
interconnections with financial firms, stress at MMFs can spread 
rapidly into the banking system and then more broadly through the 
financial system.
---------------------------------------------------------------------------

    \39\ Based on Form N-MFP filings with the SEC.
    \40\ Based on Form N-MFP filings with the SEC.
---------------------------------------------------------------------------

    MMFs may also transmit risk to the broader economy through the 
payments system because MMFs are used as cash management vehicles by 
individual investors, businesses and other institutional investors, and 
governments. MMFs offer services such as check writing and other bank-
like functions, particularly for retail investors. In addition, MMF 
shares outstanding are sizable relative to money stock measures. As of 
September 30, 2012, assets in MMFs registered with the SEC for sale to 
the public were 25 percent of the size of the Federal Reserve's M2 
money stock measure, and prime fund assets alone were 14 percent of 
M2.\41\ Hence, a widespread run on MMFs could quickly pose liquidity 
problems for the millions of investors--households, businesses, and 
governments--that use MMFs for cash management, and such an event would 
resonate rapidly throughout the payments system.
---------------------------------------------------------------------------

    \41\ The M2 money-stock measure includes retail MMF assets 
(excluding IRA and Keogh balances at MMFs) but not institutional MMF 
assets. M2 totaled $10.1 trillion in September 2012.
---------------------------------------------------------------------------

    Finally, not only are MMFs interconnected with the financial sector 
and payments system, but the funds themselves are also highly 
interconnected due to their common exposures. The largest prime funds 
generally provide funding to a relatively small group of firms with 
high credit quality,\42\ consistent with the requirements of rule 2a-7, 
leading to the potential for highly correlated losses. As of September 
30, 2012, for example, financing for the top 50 firms accounted for 91 
percent of prime MMF investments in private entities,\43\ while 10 
firms accounted for 39 percent. In addition, 14 firms individually 
received funding from more than half of the 243 prime MMFs.\44\ The 
similarity of MMF portfolio holdings increases the contagion risk to 
the entire MMF industry and to the broader financial system in the 
event that one MMF encounters stress.
---------------------------------------------------------------------------

    \42\ This discussion focuses on prime MMFs, but holdings of 
other types of MMFs within the same category (such as different tax-
exempt MMFs that specialize in the same state) also tend to be 
similar.
    \43\ Based on Form N-MFP filings with the SEC; see Scharfstein, 
2012.
    \44\ Based on Form N-MFP filings with the SEC.
---------------------------------------------------------------------------

Evidence From the 2007-2008 Financial Crisis
    The financial crisis demonstrated how the conduct, nature, size, 
scale, concentration, and interconnectedness of MMFs' activities and 
practices described above can interact and amplify the transmission of 
risk of significant liquidity and credit problems in the financial 
system.
    Run on prime MMFs. MMFs came under intense stress after the Reserve 
Primary Fund announced on September 16, 2008, that it would break the 
buck due to losses on the Lehman Brothers Holdings, Inc. (Lehman) debt 
instruments that the fund owned. These holdings represented just 1.2 
percent of that fund's assets--well below the 5 percent limit 
applicable to such holdings--but, due to the lack of explicit loss-
absorption capacity, that exposure was large enough to cause the fund 
to break the buck.\45\
---------------------------------------------------------------------------

    \45\ The Reserve Primary Fund was only the second MMF to break 
the buck since rules for MMFs were first introduced in 1983. In 
1994, the Community Bankers U.S. Government Money Market Fund, a 
small government MMF, broke the buck because of exposures to 
interest rate derivatives. The event passed without significant 
repercussions, in part because the Community Bankers U.S. Government 
Money Market Fund was very small (less than $100 million in assets 
when it closed) and was sold to a narrow group of investors, 
``principally to small community banks seeking an alternative to 
lending money overnight on deposit at Federal Reserve banks at the 
Federal funds rate'' (see SEC, In the Matter of Craig S. Vanucci and 
Brian K. Andrew, Respondents: Order Instituting Public 
Administrative and Cease-and-Desist Proceedings (Jan. 11, 1998), 
Administrative Proceeding File No. 3-9804). In addition, the 
contagion risk stemming from this MMF's problem may have been 
limited by its idiosyncratic portfolio. According to the SEC cease 
and desist order, the fund had an ``unsuitable investment'' (27.5 
percent of its assets) in adjustable-rate derivative securities. See 
also Jeffrey N. Gordon and Christopher M. Gandia, ``Money Market 
Fund Run Risk: Will Floating Net Asset Value Fix the Problem?'' 
Columbia Law School (Sept. 4, 2012).
---------------------------------------------------------------------------

    The Reserve Primary Fund's loss immediately started a run on that 
fund, as investors sought to redeem approximately $40 billion from the 
fund in just two days.\46\ More importantly, the run quickly spread to 
other prime MMFs and illustrated several activities and practices that 
make MMFs vulnerable to runs as well as the contagion risk to the 
industry. The failure of Reserve Primary Fund's sponsor to deliver 
support for its fund may have heightened investors' uncertainty about 
the likelihood of discretionary sponsor support at other MMFs and, as a 
result, accelerated the run on the entire prime MMF industry.

[[Page 69464]]

At least a dozen MMFs held Lehman securities at the time of the Lehman 
bankruptcy, and the Reserve Primary Fund's Lehman holdings were below 
the average holdings among MMFs with exposure to Lehman.\47\ However, 
the most serious phase of the run on MMFs occurred not in the two 
business days immediately after the Lehman bankruptcy, but in the two 
days following the Reserve Primary Fund's announcement that it had 
broken the buck.\48\
---------------------------------------------------------------------------

    \46\ However, the Reserve Primary Fund evidently did not honor 
all of these redemptions, because it announced on October 30, 2008, 
that ``[t]he Fund's total assets have been approximately $51 billion 
since the close of business on September 15.'' The Reserve, 
``Reserve Primary Fund Makes Initial Distribution of $26 Billion to 
Primary Fund Shareholders'' (Oct. 30, 2008). See also McCabe, 2010, 
at A-1; SEC, Securities and Exchange Commission v. Reserve 
Management Company, Inc. et al. Civil Action No. 09-CV-4346 (May 5, 
2009).
    \47\ Moody's Investors Service, ``Lehman Support in Prime Money 
Market Funds,'' mimeo, April 30, 2012. The sponsors of the other 
MMFs with exposure to Lehman provided support to their funds, and as 
result did not break the buck as the Reserve Primary Fund did.
    \48\ According to data from iMoneyNet (with adjustments to 
correct misreported assets for the Reserve Primary Fund and for one 
closed MMF), prime MMF assets fell $81 billion in the two business 
days after the Lehman bankruptcy. In the two days following the 
Reserve Primary Fund's late-afternoon announcement on September 16 
that it had broken the buck, prime MMF assets dropped $194 billion. 
But see, e.g., Comment Letter of Treasury Strategies, Inc., SEC File 
No. 4-619 (Jun. 1, 2012) (stating that MMFs ``have been 
misidentified as a proximate contributor to the financial crisis'').
---------------------------------------------------------------------------

    In addition, outflows from institutional prime MMFs following the 
Lehman bankruptcy tended to be larger among MMFs with sponsors that 
were themselves under stress, indicating that MMF investors redeemed 
shares when concerned about sponsors' potential inabilities to bolster 
ailing funds.\49\ These run dynamics were primarily prevalent among the 
more sophisticated, risk-averse institutional investors, as 
institutional funds accounted for 95 percent of the net redemptions 
from prime funds.\50\
---------------------------------------------------------------------------

    \49\ As measured by credit default swap spreads for parent firms 
or affiliates. See McCabe, 2010.
    \50\ Based on data from iMoneyNet for the week following the 
Lehman bankruptcy.
---------------------------------------------------------------------------

    Aggregate daily outflows from other prime MMFs tripled the day 
after the Reserve Primary Fund announced its loss.\51\ During the week 
of September 15, 2008, investors withdrew approximately $310 billion 
(15 percent of assets) from prime MMFs. The run slowed only after 
Treasury established the Temporary Guarantee Program for Money Market 
Funds and the Board of Governors of the Federal Reserve System 
established facilities aimed at stabilizing markets linked to MMFs.
---------------------------------------------------------------------------

    \51\ Based on data from iMoneyNet.
---------------------------------------------------------------------------

    Despite government intervention, the run in September 2008 led to 
rapid disinvestment by MMFs of short-term instruments which severely 
exacerbated stress in already strained financial markets. For example, 
in the three weeks following the Lehman bankruptcy, prime MMFs reduced 
their holdings of CP by $202 billion (29 percent) and repo by $75 
billion (32 percent).\52\ The reduction in CP held by MMFs accounted 
for a substantial portion of the decline in outstanding CP during that 
period \53\ and contributed to a sharp rise in borrowing costs for CP 
issuers.\54\ MMFs managed by just a dozen firms accounted for almost 
three-quarters of the $202 billion decline in the industry's holdings 
of CP, and five MMF sponsors accounted for almost half of the 
decline.\55\
---------------------------------------------------------------------------

    \52\ Based on data from iMoneyNet on changes in prime MMFs' 
portfolio holdings from September 9 to September 30, 2008.
    \53\ Data from the Federal Reserve Board show that total CP 
outstanding declined $206 billion in that three-week period.
    \54\ See Federal Open Market Committee, ``Minutes of the Federal 
Open Market Committee, October 28-29, 2008,'' at 3, 5.
    \55\ Based on data from iMoneyNet.
---------------------------------------------------------------------------

    Impact on government MMFs. While the run in September 2008 centered 
on prime MMFs, government MMFs attracted inflows of $192 billion during 
the week following the Lehman bankruptcy.\56\ Some commenters have 
argued that these inflows provide evidence that MMFs are not 
structurally vulnerable to runs.\57\ However, the activities and 
practices discussed above do not lead investors to redeem their shares 
in all types of funds simultaneously, but rather they increase the 
possibility that losses at one or more MMFs may lead to widespread 
redemptions at other funds that share similar characteristics. Such 
contagion was evident among prime MMFs in 2008 due to, among other 
factors, the similarity of their portfolios. Government MMFs did not 
face similar run vulnerabilities at the time because they had 
significantly different portfolio holdings than the distressed prime 
funds and many government MMF investments were appreciating in value. 
Government MMFs nonetheless may pose the same structural risks, in that 
the funds' investors would have an incentive to redeem if they feared 
even small losses.
---------------------------------------------------------------------------

    \56\ Based on data from iMoneyNet.
    \57\ See, e.g., Comment Letter of the Investment Company 
Institute, SEC File No. 4-619 (Aug. 20, 2012) (stating, ``Investors 
pulled about $300 billion from prime money market funds, which held 
such securities. But those investors didn't run from money market 
funds. For every dollar that left prime funds, 61 cents went into 
Treasury and government and agency funds. It was a classic flight to 
quality--and money market funds were the vehicle of choice for 
fleeing investors.'').
---------------------------------------------------------------------------

    Importantly, the inflows to government funds in 2008 did not 
mitigate the damage caused by the run on prime MMFs. Government MMFs 
only purchase limited amounts of private debt securities and hence 
could not alleviate the reduction in the availability of credit for 
businesses and financial institutions that relied on MMFs for short-
term financing.\58\
---------------------------------------------------------------------------

    \58\ MMF shareholders moving their investments from prime MMFs 
to government MMFs in September 2008 may have reduced the effect of 
this episode on the availability of repo financing (since some 
government funds invest in repo), on the aggregate assets of MMFs, 
and on the fees earned by MMF advisers.
---------------------------------------------------------------------------

    Furthermore, government MMFs also can be vulnerable to runs. In 
November 2008, Treasury agreed to assist with the liquidation of the 
Reserve Fund's U.S. Government Fund by serving as ``a buyer of last 
resort'' for securities held by the fund, which suspended redemptions 
in September 2008.\59\ In addition, during the last three business days 
in July 2011, amid large net redemptions from institutional MMFs 
(discussed below), outflows from government MMFs totaled 7 percent of 
assets and exceeded (as a percentage of assets) outflows from prime 
funds.\60\
---------------------------------------------------------------------------

    \59\ See Treasury, ``Treasury Enters Into Agreement To Assist 
the Reserve Fund's US Government Money Market Fund'' (2008), 
available at https://www.treasury.gov/press-center/press-releases/Pages/hp1286.aspx.
    \60\ Based on daily data on MMF assets from iMoneyNet.
---------------------------------------------------------------------------

The 2010 Reforms Do Not Address These Structural Factors
    The SEC's 2010 reforms are important, but further reform is needed. 
The SEC's 2010 reforms helped to make MMFs more resilient to certain 
short-term market risks and more transparent. However, they did not 
address certain activities and practices of MMFs that continue to make 
the funds vulnerable to runs. Moreover, MMFs remain concentrated and 
highly interconnected with one another, the U.S. banking system, and 
the broader financial system.
    Of the activities and practices listed above that make MMFs 
susceptible to runs, the two most directly addressed in the SEC's 2010 
reforms are liquidity risks associated with maturity transformation and 
MMF portfolios' exposures to credit and interest-rate risks. While the 
reforms reduced these risks, many of the credit and liquidity risks at 
issue in 2008 persist today. Importantly, if the rules adopted in 2010 
had been in place in 2008, they would not have prevented the Reserve 
Primary Fund from breaking the buck due to its holdings of Lehman 
securities.
    Moreover, the redemptions from many MMFs during the run in 2008 
exceeded the liquidity buffers now mandated by the daily and weekly 
liquidity requirements that were adopted as part of the 2010 reforms. 
At

[[Page 69465]]

the height of the run in 2008, 40 institutional prime MMFs (excluding 
the Reserve Primary Fund) had one-day outflows in excess of the new 10 
percent daily liquidity requirement, and 13 of those funds' one-day 
outflows exceeded 20 percent of assets. In addition, 10 institutional 
prime funds had five-day outflows exceeding the new 30 percent weekly 
liquidity requirement, including eight funds with five-day outflows 
greater than 40 percent of assets.\61\ Notably, outflows in 2008 
probably would have been considerably larger in the absence of the 
unprecedented government interventions to support MMFs and short-term 
funding markets.
---------------------------------------------------------------------------

    \61\ Based on daily data on MMF assets from iMoneyNet.
---------------------------------------------------------------------------

    Evidence from 2011. Heavy outflows from institutional prime MMFs in 
the summer of 2011 further highlighted MMFs' continued vulnerability to 
runs, even after the 2010 reforms. In the eight weeks ending on August 
3, 2011, institutional prime funds experienced net outflows of $179 
billion (16 percent of assets).\62\ Because the pace of outflows in 
2011 was well below that experienced during the run in September 2008 
(total net redemptions from prime institutional funds in two days in 
2008 exceeded the eight-week outflow in 2011),\63\ MMFs were able to 
withstand redemption pressures without further repercussions.
---------------------------------------------------------------------------

    \62\ Based on weekly data on MMF assets from the Investment 
Company Institute.
    \63\ Based on daily data on MMF assets from iMoneyNet, prime MMF 
assets fell a total of $194 billion on September 17 and 18, 2008.
---------------------------------------------------------------------------

    The institutional investor redemptions were apparently in response 
to concerns about the funds' European holdings and the U.S. debt-
ceiling impasse.\64\ Importantly, these outflows occurred despite the 
fact that the MMFs suffered no material losses during this episode.\65\ 
This is in stark contrast to August 2007, when many MMFs held 
distressed ABCP that ultimately lost significant value, yet 
institutional investors generally did not respond by redeeming MMF 
shares, likely because investors expected sponsors to absorb the 
losses.\66\ Redemptions in the summer of 2011 may indicate that 
institutional investors have become more reactive and run-prone since 
2008, when the Reserve Primary Fund's sponsor was unable to provide 
support to prevent that fund from breaking the buck. Furthermore, the 
increase in certain MMFs' exposure to European securities in 2011 
appears to have been motivated by increased risk-taking in an attempt 
to boost investment yields and revenues.\67\ This motive was also 
reportedly a significant factor in the investment policies that 
ultimately led the Reserve Primary Fund to break the buck.\68\
---------------------------------------------------------------------------

    \64\ Outflows from institutional prime MMFs were highly 
correlated with the funds' European exposures, particularly in June 
2011. See Sergey Chernenko and Adi Sunderam, ``The Quiet Run of 
2011: Money Market Funds and the European Debt Crisis,'' (May 12, 
2012). During this eight-week period, retail prime MMFs had small 
net inflows.
    \65\ During this episode of heavy redemptions (from May to 
August 2011), the largest monthly decline in any prime MMF's 
reported shadow NAV was 12 basis points, and only five funds 
experienced shadow NAV declines of more than 4 basis points. Such 
small changes in shadow NAVs are not unusual: In the first seven 
months of 2012, three prime MMFs reported shadow NAV declines of 10 
basis points or more. Presumably, if MMFs had suffered material 
losses in the summer of 2011, redemptions would have been larger.
    \66\ See SEC, Money Market Fund Reform, Investment Company Act 
Release No. IC-28807, 74 FR 32688, 32691 (July 8, 2009); McCabe, 
2010; Brady, Anadu, and Cooper, 2012.
    \67\ See Chernenko and Sunderam, 2012 and Rosengren, 2012.
    \68\ See Investment Company Institute, ``Report of the Money 
Market Working Group'' (March 17, 2009); McCabe, 2010; Kacperczyk 
and Schnabl, 2012.
---------------------------------------------------------------------------

Council Proposed Determination Regarding MMFs
    As described above, the conduct and nature of MMFs' activities and 
practices make MMFs vulnerable to runs that can spread quickly across 
the industry. As evidenced in the financial crisis, runs on MMFs can 
result in significant liquidity, credit and other problems in the 
short-term credit markets, particularly given the size and scale of the 
MMF industry's participation in those markets; cause or exacerbate 
substantial stresses in the financial system; and threaten financial 
stability. The interconnections among MMFs and the concentration of the 
MMF industry increase the likelihood that stresses at one MMF will 
spread to other MMFs, and MMFs' interconnectedness with other financial 
firms means that stresses in MMFs can spread rapidly to the larger 
financial system, further limiting system-wide liquidity and credit. 
Therefore, the Council proposes to determine that the conduct, nature, 
size, scale, concentration, and interconnectedness of MMFs' activities 
and practices could create or increase the risk of significant 
liquidity and credit problems spreading among bank holding companies, 
nonbank financial companies, and the financial markets of the United 
States.

V. Proposed Recommendations

    The Council seeks comment on proposed recommendations to the SEC to 
address the structural vulnerabilities of MMFs discussed in Section IV. 
In particular, the Council aims to address the activities and practices 
of MMFs that make them vulnerable to destabilizing runs: (i) The lack 
of explicit loss-absorption capacity in the event of a drop in the 
value of a security held by an MMF and (ii) the first-mover advantage 
that provides an incentive for investors to redeem their shares at the 
first indication of any perceived threat to an MMF's value or 
liquidity.
    In considering options for further reform, the Council notes three 
key features of MMFs that make them appealing to investors: The 
stability of principal associated with the funds' stable $1.00 per 
share NAV, liquidity through shares that can be redeemed on demand, and 
market-based yields that often exceed those of short-term Treasury 
securities and rates on FDIC-insured bank deposits.
    The activities and practices of MMFs that have made them appealing 
to investors also contribute to their vulnerability to runs. For 
example, both MMFs' reliance on rounding to maintain stable NAVs and 
the liquidity of MMF shares contribute to a first-mover advantage for 
redeeming investors. MMFs' practice of investing in short-term 
securities with interest-rate and credit risk to boost yields, without 
explicit loss-absorption capacity, makes them more vulnerable when 
losses do occur.
    Therefore, reforms that would provide meaningful mitigation of the 
risks posed by MMFs would likely reduce their appeal to investors by 
altering one or more of their attractive features. The first proposed 
alternative would require funds to have a floating NAV by removing the 
valuation and pricing provisions in rule 2a-7 that currently allow 
funds to maintain a stable, rounded $1.00 NAV. Alternatives Two and 
Three would preserve, and potentially bolster, the principal stability 
that investors currently enjoy by preserving the stable NAV, but would 
likely reduce the higher yields and/or the liquidity that MMFs offer to 
investors. These reform alternatives, therefore, present trade-offs 
between stability, yield, and liquidity.
    Different MMF investors may have different preferences. 
Accordingly, it may be optimal to offer both floating NAV funds and 
stable NAV funds with enhanced protections and to allow investors to 
determine which they prefer. The Council seeks comment on the merits of 
adopting such a flexible approach as well as the merits of recommending 
a single structural reform alternative.

[[Page 69466]]

A. Alternative One: Floating Net Asset Value

    Require MMFs to have a floating net asset value per share (NAV) by 
removing the special exemption that currently allows MMFs to utilize 
amortized cost accounting and/or penny rounding to maintain a stable 
NAV. The value of MMFs' shares would not be fixed at $1.00 and would 
reflect the actual market value of the underlying portfolio holdings, 
consistent with the requirements that apply to all other mutual funds.
(i) Description of the Alternative
    Overview. This reform alternative would require MMFs to have a 
floating NAV instead of a stable NAV. The price per share would 
fluctuate based on small changes in the value of the MMF's portfolio, 
rather than remaining at $1.00 absent a break the buck event. As such, 
the value of MMFs' shares would reflect the market value of the 
underlying portfolio holdings, consistent with the valuation 
requirements that apply to all other mutual funds under the Investment 
Company Act. As discussed in more detail below, a requirement that MMFs 
use floating NAVs could make investors less likely to redeem en masse 
when faced with the prospect of even modest losses by eliminating the 
``cliff effect'' associated with breaking the buck. Regular 
fluctuations in MMF NAVs likely would cause investors to become 
accustomed to, and more tolerant of, fluctuations in NAVs. A floating 
NAV would also reduce the first-mover advantage that exists in MMFs 
today because investors would no longer be able to redeem their shares 
for $1.00 when the shares' market-based value is less than $1.00. This 
alternative does not contemplate requiring funds to have an NAV buffer.
    Rule 2a-7 protections remain. Consistent with investors' 
expectations about the nature of their MMF investments, the risk 
limiting provisions of rule 2a-7 that govern the credit quality, 
maturity, liquidity, and diversification of MMFs' portfolios would 
continue to apply to any fund that called itself a ``money market 
fund'' or used a similar name.
    Portfolio valuation. This alternative would require removing the 
provisions of rule 2a-7 that allow MMFs to use the penny rounding 
method of pricing and the amortized cost method of valuation for their 
portfolios, except to the extent other mutual funds may do so. Rather, 
MMFs would value their portfolios like all other mutual funds, 
including using amortized cost valuation only under certain limited 
circumstances.\69\
---------------------------------------------------------------------------

    \69\ All mutual funds, when fair valuing a portfolio debt 
security, may value the security at its amortized cost only if the 
security has a remaining maturity of 60 days or less and the fund's 
board of directors determines, in good faith, that the security's 
fair value is its amortized cost value and the circumstances do not 
suggest otherwise (e.g., an impairment of the creditworthiness of an 
issuer). See SEC, Valuation of Debt Instruments by Money Market 
Funds and Certain Other Open-End Investment Companies, Investment 
Company Act Release No. 9786, 42 Fed. Reg. 28999 (June 7, 1977).
---------------------------------------------------------------------------

    Share pricing. Under this alternative, each floating-NAV MMF would 
re-price its shares to $100.00 per share (or initially sell them at 
that price) to be more sensitive to fluctuations in the value of the 
portfolio's underlying securities than under a $1.00 share price. For 
example, a 5 basis point loss would not move the share price of a 
floating-NAV MMF with a share price of $1.00.\70\ If the fund's shares 
were priced at $100.00, in contrast, the fund's share price would 
decrease by 5 cents to $99.95. Hence, a $100.00 share price is more 
likely than a $1.00 share price to result in regular fluctuations in 
NAVs and therefore changes in investor expectations and behavior. Just 
like in any other mutual fund, shareholders would be able to purchase 
and redeem fractional shares, and as a result the re-pricing would not 
impact shareholder purchases and redemptions. For example, a 
shareholder could still purchase or redeem $50 of MMF shares regardless 
of the fund's price per share.
---------------------------------------------------------------------------

    \70\ The fund would have a share price of $0.9995 after the loss 
which, even without penny rounding, would be rounded up to $1.00.
---------------------------------------------------------------------------

    Removing exemptions under the Investment Company Act. Because MMFs 
would no longer seek to maintain a stable NAV, the SEC also would need 
to rescind two rules under the Investment Company Act that provide 
exemptions to MMFs to prevent a fund from breaking the buck:
     Orderly Liquidation. Rule 22e-3 currently allows an MMF to 
suspend redemptions and begin an orderly liquidation if the fund has 
broken or is about to break the buck. With a floating NAV, the need for 
MMF sponsors or boards of directors to suspend redemptions or otherwise 
intervene upon share price declines should be significantly reduced 
except under the most extreme market circumstances.\71\
---------------------------------------------------------------------------

    \71\ Any mutual fund, including a floating-NAV MMF, may seek an 
order from the SEC permitting the fund to suspend redemptions and 
liquidate.
---------------------------------------------------------------------------

     Sponsor Support. Rule 17a-9 allows affiliates of an MMF to 
purchase portfolio securities from an MMF and typically is used to 
support an MMF's stable price per share. Because a floating-NAV MMF is 
designed to fluctuate in value, allowing the type of affiliate support 
currently permitted under rule 17a-9 would appear to be unnecessary. 
This type of affiliate support is not permitted for any other type of 
mutual fund.
    Transition. To reduce potential disruptions and facilitate the 
transition to a floating NAV for investors and issuers, existing MMFs 
could be grandfathered and allowed to maintain a stable NAV for a 
phase-out period, potentially lasting five years. Instead of requiring 
these grandfathered funds to transition to a floating NAV immediately, 
the SEC would prohibit any new share purchases in the grandfathered 
stable-NAV MMFs after a predetermined date, and any new investments 
would have to be made in floating-NAV MMFs. This would discourage 
significant and sudden investor redemptions that could occur out of 
fear that a fund would force existing shareholders to incur a loss 
immediately upon the fund's transition to a floating NAV.
(ii) Benefits and Considerations
    An SEC requirement that all MMFs operate with a floating NAV could 
reduce financial instability and the risk of runs among MMFs in several 
ways.
    Modified investor expectations. A floating NAV would make gains and 
losses on MMF investments a regular occurrence. It would accustom 
investors to changes in the value of their MMF shares and reduce the 
perception that shareholders do not bear any risk of loss when they 
invest in an MMF. Such beliefs can make MMFs prone to runs if 
shareholders suddenly become concerned that they may bear losses. 
Breaking the buck should no longer be a significant event because MMFs 
would simply fluctuate in value in the same manner as other mutual 
funds. Losses--which are inevitable in an investment product--would no 
longer be obscured by valuation and rounding conventions, but would be 
borne by shareholders and reflected in a fund's share price just like 
all other mutual funds.
    Similar to other mutual funds. A floating NAV would allow MMFs to 
operate with the same price transparency as all other mutual funds. 
Currently, shadow prices for stable NAV funds are disclosed on a 
monthly basis with a 60-day delay. Under a floating NAV model, 
shareholders would not be required to obtain and analyze an MMF's 
portfolio to surmise the fund's mark-to-market value. Rather, investors 
would see day-to-day fluctuations in value in different market 
conditions and interest-rate environments, just as they

[[Page 69467]]

do today with all other mutual funds. This information should help all 
types of investors in MMFs make investment decisions that better match 
their risk-return preferences.
    Investors bear risk. A floating NAV would remove uncertainty or 
confusion regarding who bears the risk of loss in an MMF. A floating 
NAV would reinforce the principle that investors, not fund sponsors or 
taxpayers, are expected to bear the pro rata risk of loss in MMFs, as 
they do with other investment vehicles.
    Reduced first-mover advantage. Such a change would reduce, though 
not eliminate, the first-mover advantage currently present in MMFs 
because all redemptions would be priced at a fund's per share mark-to-
market value. MMF shareholders would no longer have the opportunity to 
redeem shares at $1.00 when their market-based value falls below $1.00; 
so redemptions would no longer threaten to concentrate an MMF's loss 
over a shrinking shareholder base. In addition, even if some 
shareholders redeem due to a sudden change in perceived risk, a 
floating NAV results in a fairer allocation of losses among redeeming 
and remaining investors.
    Though this first-mover advantage would be reduced, the incentive 
to redeem before others may remain, in part, because each MMF has a 
limited supply of liquid assets with which to meet redemptions. 
Shareholders still may have an incentive to redeem quickly from an MMF, 
just as they do from any mutual fund that is at risk of depleting its 
most liquid assets, because subsequent redemptions may force the fund 
to dispose of less liquid assets and potentially incur losses. In 
addition, while a floating NAV would remove the ability of a 
shareholder to redeem shares at $1.00 when the market value is less 
than $1.00, it would not remove a shareholder's incentive to redeem 
whenever the shareholder believes that the NAV will decline 
significantly in the future, consistent with the incentive that exists 
today for other types of mutual funds.
    Evidence from other jurisdictions and U.S. ultra-short bond funds 
suggests that floating-NAV MMFs could experience redemption pressures 
under stressed market conditions.\72\ Such behavior could be more 
likely if a floating-NAV MMF continues to be used as a cash management 
product and investors do not fully adjust their expectations of the 
risks inherent in MMFs. This adjustment could fail to take place 
because, under normal market conditions, the value of a floating-NAV 
MMF, even re-priced to $100.00 per share, would likely not fluctuate to 
the same degree as other mutual funds because of the risk-limiting 
conditions applicable to MMFs.\73\ Investors may come to accept small, 
temporary variations in the value of their MMF shares, but still redeem 
at the prospect of larger declines.
---------------------------------------------------------------------------

    \72\ Floating NAV cash funds in other jurisdictions and U.S. 
ultra-short bond funds also suffered heavy redemptions during the 
financial crisis. See, e.g., Gordon and Gandia, 2012 and Comment 
Letter of the Investment Company Institute, SEC File No. 4-619 (Jan. 
10, 2011), at 33-34 (``ICI January PWG Letter'') (noting that ``by 
the end of 2008, assets of [ultra-short bond] funds were down more 
than 60 percent from their peak in mid-2007'' and ``French floating 
NAV dynamic money funds (or tr[eacute]sorerie dynamique funds), lost 
about 40 percent of their assets over a three-month time span from 
July 2007 to September 2007''); Comment Letter of the European Fund 
and Asset Management Association, SEC File No. 4-619 (Jan. 10, 2011) 
(``In a matter of weeks, EUR 70 billion were redeemed from these 
[enhanced money market] funds, predominantly by institutional 
investors; around 15-20 suspended redemptions for a short period, 
and 4 of them were definitely closed''). In each case, these funds 
were not subject to the same investment restrictions as U.S. MMFs 
and as a result the experience of these funds is not necessarily 
indicative of the way floating-NAV MMFs and their investors would 
respond under this alternative in times of stress. In addition, many 
European MMFs accumulate dividends, rather than distributing any net 
income the fund earns to shareholders. Accordingly, losses in these 
funds are generally reflected as a negative yield rather than a loss 
in the value of a share.
    \73\ See, e.g., Comment Letter of HSBC Global Asset Management 
on the European Commission's Green Paper on Shadow Banking (May 28, 
2012), available at https://ec.europa.eu/internal_market/consultations/2012/shadow/individual-others/hsbc_en.pdf.
---------------------------------------------------------------------------

    Tax considerations. A floating NAV for MMFs also would present 
certain federal income tax issues for MMFs and their investors. The 
stable NAV of MMF shares under present law results in simpler tax-
reporting rules for transactions in MMF shares than the rules for 
transactions in shares of all other types of mutual funds. Because all 
purchases and sales of MMF shares are at the same $1.00 price, these 
transactions generate no taxable gains or losses, obviating the need 
for shareholders to track the basis and holding period of particular 
shares. If the NAV of MMF shares were instead to fluctuate, there would 
be gains and losses to report. More specifically, because each 
redemption of MMF shares could produce a gain or loss for the 
shareholder, it would be necessary to determine for every redemption--
(i) which share was redeemed, (ii) the tax basis (generally, the 
acquisition cost) of that share, and (iii) whether the holding period 
of that share was long term or short term. In addition, if a 
shareholder purchases shares in an MMF within thirty days before or 
after a redemption, the Tax Code's ``wash sale'' rules would limit the 
extent to which the shareholder could deduct any loss realized on the 
redemption.\74\
---------------------------------------------------------------------------

    \74\ See 26 U.S.C. 1091.
---------------------------------------------------------------------------

    Because of the high volume of redemptions of shares of MMFs, 
however, and because of the minimal per share losses that may result 
from each redemption, the Council understands that the Treasury 
Department and the IRS will consider administrative relief for both 
shareholders and fund sponsors. Among the questions that the Council 
understands they plan to address are whether changes to tax rules and 
forms (including new assumptions and default methods) could simplify 
the measurement and reporting of gains and losses from floating-NAV 
MMFs. Today, the sponsors of non-MMF \75\ mutual funds must report the 
basis and holding period of redeemed shares both to the IRS and to 
redeeming shareholders (referred to as ``basis reporting''). The 
Treasury Department and the IRS have indicated to the Council that they 
will consider the extent to which expansion or modification of basis 
reporting could help shareholders deal with floating-NAV MMFs. Finally, 
they will evaluate the possibility of some administrative relief from 
the wash sale rules for de minimis losses on floating-NAV MMF shares.
---------------------------------------------------------------------------

    \75\ 26 CFR 1.6045-1(c)(3)(vi) exempts MMFs from this 
requirement.
---------------------------------------------------------------------------

    Accounting impacts. There also are accounting considerations 
relating to floating-NAV MMFs. U.S. generally accepted accounting 
principles (GAAP) currently include investments in MMFs as an example 
of a cash equivalent.\76\ Shareholders and their accountants would need 
to evaluate whether a floating-NAV MMF meets the characteristics of a 
cash equivalent under relevant accounting guidance.
---------------------------------------------------------------------------

    \76\ Financial Accounting Standards Board, Accounting Standards 
Codification paragraph 305-10-20.
---------------------------------------------------------------------------

    Operational costs. MMFs also would have to change their operations 
to accommodate a floating NAV. MMFs and their transfer agents are 
currently required to have the capacity to transact at the fund's 
floating NAV,\77\ but a permanent change to a floating NAV may require 
additional operational changes.\78\ These costs may be mitigated, 
however, because MMFs are required periodically to determine their 
market-based NAV and currently have systems in place to do so. In 
addition,

[[Page 69468]]

MMF sponsors may be able to adapt the systems used by their other 
mutual funds, which price at market value each day, to their floating-
NAV MMFs. For example, funds may need to modify policies and procedures 
in order to calculate a daily floating NAV per share and to communicate 
that value to their distribution partners and shareholders on an 
ongoing basis. Both fund complexes and other intermediaries in the 
distribution chain may need to reprogram systems to accommodate a 
permanent floating NAV.
---------------------------------------------------------------------------

    \77\ 17 CFR 270.2a-7(c)(13).
    \78\ For a discussion of potential operational costs, see e.g., 
Comment Letter of John D. Hawke, Jr. on behalf of Federated 
Investors, Inc., SEC File No. 4-619 (Dec. 15, 2011).
---------------------------------------------------------------------------

    MMFs' current ability to transact at a stable NAV also generates 
other operational efficiencies that may be lost with a floating NAV. 
Some of these conveniences have evolved due to expectations that MMF 
share prices would never fluctuate and are not consistent with the 
actual risks in MMF portfolios. For example, a stable NAV facilitates 
same-day settlement of purchase and redemption transactions. MMFs would 
need to modify systems to allow same-day settlement to continue with a 
floating-NAV MMF or shift to next day settlement.\79\
---------------------------------------------------------------------------

    \79\ To see one example of a floating-NAV MMF that conducts 
same-day settlement, see DWS Variable NAV Money Fund Prospectus 
(Dec. 1, 2011) (``If the fund receives a sell request prior to the 
4:00 p.m. Eastern time cut-off, the proceeds will normally be wired 
on the same day. However, the shares sold will not earn that day's 
dividend.'').
---------------------------------------------------------------------------

    Impact on industry size. Moving to a floating NAV may cause the MMF 
industry's AUM to contract. Some MMF investors may be unwilling or 
unable to conduct their cash management through an investment vehicle 
that does not offer a stable value.\80\ Some institutional investors 
may be prohibited by board-approved guidelines or firm policies from 
conducting cash management using MMFs that do not have a stable NAV and 
may be unwilling to change these policies. Other investors, such as 
some state and local governments, may be subject to statutory or 
regulatory requirements that permit them to invest certain assets only 
in funds that seek to maintain a stable net asset value.
---------------------------------------------------------------------------

    \80\ See generally ICI January PWG Letter; Comment Letter of the 
American Bankers Association, SEC File No. S7-11-09 (Sept. 8, 2009); 
Comment Letter of Fidelity Investments, SEC File No. 4-619 (Feb. 3, 
2012); Comment Letter of Treasury Strategies, Inc., SEC File No. S7-
11-09 (Sept. 8, 2009).
---------------------------------------------------------------------------

    These factors may reduce overall investor demand for MMFs, which 
would diminish the funds' capacity to invest in the short-term 
securities of financial institutions, businesses, and governments, 
possibly impacting their costs of funding.\81\ Elimination of the 
stable NAV would be a significant change for a multi-trillion dollar 
industry in which the stable $1.00 share price has been a core feature. 
It may take time for investors and short-term funding markets to adjust 
to such a change, and the ultimate long-term reaction to such a change 
is difficult to predict with any precision. In addition, if the 
transition to the new regulatory regime prompted investors to redeem 
suddenly and substantially, the transition itself could create 
financial instability. A longer transition period and the 
grandfathering of existing fund shareholdings are designed to lessen 
this risk.
---------------------------------------------------------------------------

    \81\ See, e.g., Comment Letter of the Investment Company 
Institute, SEC File No. 4-619 (Apr. 19, 2012) (enclosing survey data 
reflecting, among other things, that 79 percent of the 203 
respondents (corporate, government, and institutional investors) 
would decrease or stop using MMFs if the funds had floating NAVs); 
Comment Letter of Fidelity Investments, SEC File No. 4-619 (Feb. 3, 
2012) (enclosing survey data reflecting, among other things, that 57 
percent of surveyed institutional investors and 47 percent of 
surveyed retail investors would reduce or eliminate their 
investments in MMFs if the funds used floating NAVs). Some 
institutional investors could be required to seek changes to 
investment policies or statutory or regulatory restrictions that 
otherwise could preclude them from investing certain assets in funds 
with floating NAVs. See, e.g., Comment Letter of the American 
Bankers Association, SEC File No. S7-11-09 (Sept. 8, 2009).
---------------------------------------------------------------------------

(iii) Questions
    The Council requests comment on this alternative as well as on all 
aspects of the discussion presented above. The Council also requests 
any quantitative analysis or data from commenters relating to this 
alternative.
    Would requiring that all MMFs operate with a floating NAV make them 
less susceptible to runs? Would it reduce or increase the potential 
financial instability associated with MMFs? Would it enhance their 
resiliency?
    Would floating the NAV alter investor expectations and make them 
substantially more willing to bear losses from their MMF investments? 
Alternatively, would shareholders become accustomed only to relatively 
small fluctuations in value but redeem heavily in the face of more 
significant losses?
    Would some MMF sponsors support their MMFs despite the elimination 
of rule 17a-9 (for instance, by contributing capital) under this option 
and thereby prevent their share prices from deviating materially on a 
day-to-day basis? If so, would this mitigate the achievement of reform 
objectives? Should sponsor support of MMFs be prohibited? \82\
---------------------------------------------------------------------------

    \82\ See, e.g., Comment Letter of HSBC Global Asset Management 
on the European Commission's Green Paper on Shadow Banking (May 28, 
2012), available at https://ec.europa.eu/internal_market/consultations/2012/shadow/individual-others/hsbc_en.pdf. ``We 
believe any ambiguity of risk ownership must be removed so risk is 
correctly priced. We therefore propose a prohibition on MMF sponsors 
providing support to their MMFs. This will make clear to all 
investors that they are buying an investment product and own the 
risks and rewards of that investment.''
---------------------------------------------------------------------------

    Would initially re-pricing MMF shares to $100.00 per share help 
sensitize investors to fluctuations in fund value and better change 
investor expectations? Should they be initially re-priced to a 
different value than $100.00 to best achieve this goal, for instance, 
$10.00?
    Should existing MMFs be grandfathered for a limited phase-in 
period, as discussed above, or should they be grandfathered 
indefinitely? What length of time should be the optimal phase-in 
period? What length of time would be appropriate after which the SEC 
would prohibit any new share purchases in stable-NAV MMFs, and any new 
investments would have to be made in floating-NAV MMFs?
    Should the current basis reporting rules applicable to other mutual 
funds be extended to MMFs in their present form, or can those rules be 
simplified in a manner that better reflects the comparatively larger 
volume of transactions in MMF shares and the greater likelihood that 
gains or losses arising from those transactions will be relatively 
small on a per-share basis? Are there changes to the basis-reporting 
rules, such as the use of rounding conventions, that would reduce 
compliance costs for MMFs while providing shareholders with the 
information they would need?
    Are there classes of MMF shareholders to which current law does not 
require basis reporting but which may be unable to obtain this 
information from an MMF fund in the absence of an explicit regulatory 
requirement?
    If the Treasury Department and the IRS were to provide 
administrative relief for de minimis losses on wash sales of shares in 
MMFs, what should be the terms of that relief?
    How significant are the accounting and operational considerations 
relating to floating-NAV MMFs? To lessen possible issues arising from 
these considerations, what recommendations would commenters have for 
possible changes to accounting treatment for floating-NAV MMFs? What 
amount of operational costs would fund groups incur to implement a 
floating NAV for MMFs? To what extent are funds and their 
intermediaries currently prepared to operate floating-NAV MMFs on an 
ongoing basis due to the current

[[Page 69469]]

requirement that MMFs be able to transact at a price other than the 
fund's stable price per share and as a result of the group's existing 
systems for their other mutual funds?
    Would investors and their accountants consider floating-NAV MMFs to 
be cash equivalents under relevant accounting guidance without 
clarification by accounting standard setters? If not, what are the 
implications for a shareholder that treats MMF shares as an investment 
for accounting purposes? If not, and if there were relief on the 
potential accounting considerations, would these funds be an attractive 
investment to investors?
    Should any types of MMFs be exempt from a requirement that they 
operate with a floating NAV, such as retail MMFs, Treasury MMFs, or 
government MMFs? If so, why? If there were an exemption for retail 
funds, how should the SEC define a retail MMF?
    Should MMFs be required to mark-to-market all assets in their 
portfolios under this option and be limited in using the amortized cost 
method of valuation to the same extent as other mutual funds? Why or 
why not? If the SEC required MMFs to use floating NAVs like other 
mutual funds, should it nonetheless continue to permit different 
valuation practices regarding portfolio securities for MMFs versus 
other mutual funds? How effective would this be during times of stress, 
when markets for such securities may be less liquid or transparent?
    Should a floating NAV requirement be combined with any other 
regulatory reform options, such as redemption restrictions, to further 
lessen funds' susceptibility to runs? If so, which restrictions and 
why?
    How would floating the NAV affect investor demand for MMFs? To what 
extent and why would investors discontinue investing in MMFs if they 
operated with a floating NAV? Where would investors shift their 
investments and how would this mitigate or increase risks to financial 
stability?

B. Alternative Two: NAV Buffer and Minimum Balance at Risk

    Require MMFs to have an NAV buffer with a tailored amount of assets 
of up to 1 percent to absorb day-to-day fluctuations in the value of 
the funds' portfolio securities and allow the funds to maintain a 
stable NAV. The NAV buffer would have an appropriate transition period 
and could be raised through various methods. The NAV buffer would be 
paired with a requirement that 3 percent of a shareholder's highest 
account value in excess of $100,000 during the previous 30 days--a 
minimum balance at risk (MBR)--be made available for redemption on a 
delayed basis. Most redemptions would be unaffected by this 
requirement, but redemptions of an investor's MBR itself would be 
delayed for 30 days. In the event that an MMF suffers losses that 
exceed its NAV buffer, the losses would be borne first by the MBRs of 
shareholders who have recently redeemed, creating a disincentive to 
redeem and providing protection for shareholders who remain in the 
fund. These requirements would not apply to Treasury MMFs, and the MBR 
requirement would not apply to investors with account balances below 
$100,000.
(i) Description of the Alternative
    A second regulatory reform alternative would mandate that most 
MMFs: (i) Maintain an NAV buffer, which would be a tailored amount of 
assets of up to 1 percent in excess of those needed for a fund to 
maintain its $1.00 share price and which would absorb day-to-day 
fluctuations in the value of the fund's portfolio securities; and (ii) 
require that 3 percent of any shareholder's highest account value in 
excess of $100,000 during the previous 30 days (the MBR) be available 
for redemption with a 30-day delay. The MBR requirement would have no 
effect on any redemptions that leave an investor's remaining balance at 
least as large as the MBR; only redemptions of the MBR itself would be 
delayed. In the event that an MMF suffers losses that exceed its NAV 
buffer, those losses would be borne first by the MBRs of shareholders 
who have recently redeemed. These requirements would not apply to 
Treasury MMFs, and investors with balances of less than $100,000 would 
not be subject to the MBR requirement.
    The NAV buffer and the MBR would be designed to reduce MMFs' 
susceptibility to runs by allowing a fund to absorb day-to-day 
fluctuations in the value of its portfolio securities, providing a 
disincentive for shareholders to redeem in times of stress, and 
allocating more fairly the costs to the fund that can result when 
shareholders do redeem. This alternative would be designed to address 
the structural vulnerabilities of MMFs while also allowing them to 
continue to maintain a stable NAV under most conditions.
NAV Buffer
    Overview. MMFs would be required to maintain an NAV buffer, which 
would provide a fund with additional assets that would be available to 
absorb daily fluctuations in the value of the fund's portfolio 
securities. The NAV buffer would allow funds generally to maintain a 
$1.00 stable value per share and replace the provisions of rule 2a-7 
that allow MMFs to use the penny-rounding method of pricing and the 
amortized cost method of valuation.
    Size of the NAV buffer. The required minimum size of a fund's NAV 
buffer would be tailored based on the riskiness of the fund's assets, 
using the following formula:
    (i) No buffer requirement for cash, Treasury securities, and 
Treasury repos (repos collateralized solely by cash and Treasury 
securities);
    (ii) A 0.75 percent buffer requirement for other daily liquid 
assets (or for weekly liquid assets, in the case of tax-exempt funds); 
\83\ and
---------------------------------------------------------------------------

    \83\ Daily and weekly liquid assets are defined in rule 2a-7, as 
described in Section II.
---------------------------------------------------------------------------

    (iii) A 1.00 percent buffer requirement for all other assets.\84\
---------------------------------------------------------------------------

    \84\ Based on data reported to the SEC on Form N-MFP as of 
September 30, 2012, the average NAV buffer would be approximately 
0.84 percent for prime funds; 0.80 percent for tax-exempt funds; and 
0.70 percent for government funds.

Treasury MMFs--MMFs that invest at least 80 percent of their assets in 
cash, Treasury securities, and Treasury repos--would not be required to 
maintain an NAV buffer.\85\ A fund whose NAV buffer fell below the 
required minimum amount would be required to limit its new investments 
to cash, Treasury securities, and Treasury repos until its NAV buffer 
was restored, using the methods discussed below. A fund that completely 
exhausted its NAV buffer would be required to suspend redemptions and 
liquidate under rule 22e-3, which the SEC would have to amend for this 
purpose, or could continue to operate as a floating-NAV MMF 
indefinitely or until it restored its NAV buffer.\86\
---------------------------------------------------------------------------

    \85\ Treasury MMFs, despite not having an NAV buffer, generally 
would be able to maintain a stable value because they would be 
permitted to continue to use penny rounding. Treasury MMFs also 
would not be required to have minimum balances at risk, as discussed 
below.
    \86\ In the event that a fund is converted to a floating-NAV 
MMF, any subordinated portion of investors' MBRs (as discussed 
below) would be depleted before repricing the shares.
---------------------------------------------------------------------------

    Funding the NAV buffer. An MMF would be permitted to use any 
funding method or combination of methods it found optimal to build the 
NAV buffer, and could vary these methods over time in response to 
market conditions and other considerations. An NAV buffer that may be 
raised from the capital markets, fund sponsors, and income from the 
fund itself would be designed to provide flexibility for funds to raise

[[Page 69470]]

the buffer at the lowest possible cost. We have identified three 
funding methods that would be possible with SEC relief from certain 
provisions of the Investment Company Act:
     Escrow account. An MMF's sponsor could establish and 
contribute assets to an escrow account pledged to support the fund's 
NAV. The escrow account would be limited to holding weekly liquid 
assets (i.e., cash, Treasury securities, certain short-term government 
securities, and securities payable within five business days). These 
accounts would be similar to the segregated accounts established by 
some MMF sponsors during the financial crisis to support their funds' 
stable values,\87\ and therefore are a tested and, for some, familiar 
method of funding.
---------------------------------------------------------------------------

    \87\ See, e.g., SEC Staff No-Action Letter to Legg Mason 
Partners Institutional Trust--Western Asset Institutional Money 
Market Fund (Oct. 22, 2008).
---------------------------------------------------------------------------

     Subordinated buffer shares. MMFs could issue a class of 
subordinated, non-redeemable equity securities (buffer shares) that 
would absorb first losses in the funds' portfolios and that could be 
sold to third parties or purchased by a fund's sponsor or affiliates. 
The buffer shares would be permitted to pay higher dividends than those 
paid to redeemable shares but would have a subordinated claim on the 
fund's assets. The fund's redeemable shares would offer a preferred 
claim on the fund's assets up to $1.00 per share (i.e., the buffer 
shares would absorb losses before they affect the redeemable 
shareholder's $1.00 share value).\88\
---------------------------------------------------------------------------

    \88\ To prevent overreaching on the part of a sponsor or 
affiliate, the MMF would not be permitted to pay buffer shares held 
by a sponsor or affiliate dividends at a higher rate than that paid 
to the redeemable shares unless at least 75 percent of the fund's 
buffer shares were owned by unaffiliated persons. This limitation 
would be designed to ensure that sponsors and other affiliates would 
receive dividends on their buffer shares at rates established in an 
arms'-length process.
---------------------------------------------------------------------------

     Retained earnings. An MMF could retain some earnings it 
otherwise would distribute to shareholders. The usefulness of this 
method of funding, however, would be greatly limited by the tax law 
requirements for maintaining the ability to avoid any fund-level tax. 
In addition to incurring tax on any amount retained, an MMF would be 
required to pay tax on the amounts that it does distribute if it fails 
to distribute substantially all of its earnings each year.

In order to permit an MMF to build its NAV buffer through the issuance 
of buffer shares or the retention of earnings, the SEC would need to 
amend rule 2a-7 to allow the fund to redeem and sell its redeemable 
shares for $1.00 per share, even when the value of the fund's assets, 
including the NAV buffer, is above $1.00.\89\ In addition, a fund could 
be permitted to reduce an NAV buffer that becomes too large relative to 
the size of the fund's portfolio. A fund's board of directors could 
allow the fund to repurchase buffer shares, and a sponsor could recover 
assets it had contributed to an escrow account, in both cases only if 
the fund would exceed the minimum required NAV buffer immediately 
thereafter.
---------------------------------------------------------------------------

    \89\ Today, in contrast, if a fund's market-based NAV exceeds 
$1.00 by more than 50 basis points, the fund would have to re-price 
its shares to $1.01 (or higher).
---------------------------------------------------------------------------

    Transition period. In order to allow sufficient time for funds to 
raise the NAV buffer, an MMF would be required to put in place a buffer 
equal to one-half of the buffer described above one year after the 
effective date of any rule. The full required buffer would have to be 
in place two years after the effective date.
Minimum Balance at Risk
    Overview. The NAV buffer would be coupled with a requirement that 3 
percent of any shareholder's highest account value in excess of 
$100,000 during the previous 30 days (the shareholder's MBR) be 
available for redemption only with a 30-day delay. The MBR requirement 
would have no effect on any redemptions that leave an investor's 
remaining balance at least as large as the MBR. Shares other than those 
in the investor's MBR would be redeemable on demand, just as MMF shares 
are today; only redemptions of the MBR itself would be delayed. The MBR 
requirement, like the NAV buffer, would not apply to Treasury MMFs. In 
addition, the MBR requirement would not apply to investors with account 
balances of less than $100,000.
    The MBR requirement would ensure that an investor who redeems from 
an MMF remains partially invested in the fund for 30 days and would 
share in any losses that the fund incurs during that time. This is 
designed to dampen investors' incentive to redeem quickly in a crisis, 
because they cannot entirely avoid imminent losses simply by redeeming. 
Furthermore, as discussed in more detail below, if the MMF suffers 
losses that exceed its NAV buffer, those losses would be borne first by 
the MBRs of shareholders who have recently redeemed. This allocation of 
losses would be designed to create a disincentive to redeem when an MMF 
is under stress and would provide some protection for shareholders who 
do not redeem.
    Size of the MBR. An investor's MBR would be equal to 3 percent of 
the investor's ``High Water Mark,'' which would be the amount, if any, 
by which the highest balance in that investor's account over the 
previous 30 days exceeded $100,000. At any point in time, an investor's 
account balance available for immediate redemptions would be equal to 
the account balance less the MBR (the investor's ``Available 
Balance'').\90\
---------------------------------------------------------------------------

    \90\ The MBR calculation would exclude any MBR shares that the 
shareholder has tendered for redemption but that have not yet been 
redeemed due to the required delay period.
---------------------------------------------------------------------------

    MBR delay period. If an investor chooses to redeem more than the 
Available Balance (e.g., all of the shares in the account), the fund 
would be required to delay redemption of the MBR for 30 days. The 
investor would receive the MBR redemption proceeds, priced at $1.00 per 
share, after the 30-day delay period, unless the MMF suffered a loss in 
excess of its NAV buffer during that period. The MBR requirement would 
have no effect on an investor's transactions in the fund as long as the 
remaining shares exceeded the MBR.
    Subordination of the MBR. For those investors subject to an MBR 
requirement, a portion of the investor's MBR could be subject to first 
loss (subordinated) if the investor had made net redemptions in excess 
of $100,000 during the prior 30 days, with the extent of subordination 
approximately proportionate to the shareholder's cumulative net 
redemptions during the prior 30 days.\91\ In the event that an MMF 
suffered losses in excess of its NAV buffer, and only in such an event, 
the subordinated portions of shareholders' MBRs would absorb losses 
before other shares do.\92\
---------------------------------------------------------------------------

    \91\ Specifically, the number of subordinated shares would be 
zero for an investor whose account value exceeds the High Water 
Mark, as would be the case for any investor with an account balance 
that has not recently (or ever) exceeded $100,000. Otherwise, the 
fund would determine the number of subordinated MBR shares as 
follows: MBR x ((High Water Mark-current balance) / (High Water 
Mark-MBR)).
    \92\ Losses that exceed the total of the fund's NAV buffer and 
the subordinated portions of shareholders' MBRs would be absorbed by 
the remaining portions of investors' MBRs. Any losses that exceed 
the total of the fund's NAV buffer and all of its shareholders' MBRs 
(subordinated and unsubordinated) would be allocated proportionally 
among the remaining shares in the fund. MMFs would be required to 
file as exhibits to their registration statements plans of 
liquidation providing for the liquidation of their assets in 
accordance with these priorities.
---------------------------------------------------------------------------

    Illustrative examples.\93\ The following examples illustrate how an 
MBR requirement would operate:
---------------------------------------------------------------------------

    \93\ For additional analysis on the operation of a minimum 
balance at risk requirement, see Patrick E. McCabe, Marco Cipriani, 
Michael Holscher, and Antoine Martin, The Minimum Balance at Risk: A 
Proposal To Mitigate the Systemic Risks Posed by Money Market Funds, 
Federal Reserve Bank of New York Staff Report No. 564 (July 2012).

---------------------------------------------------------------------------

[[Page 69471]]

    (a) An investor with a $200,000 MMF account and a $100,000 High 
Water Mark redeems $120,000. The transaction is unaffected by the MBR 
requirement because the remaining balance of $80,000 exceeds the MBR of 
$3,000 (equal to 3 percent of the High Water Mark). The transaction 
does, however, cause a portion of the investor's MBR to be placed in a 
subordinated, or first-loss, position. The portion of the MBR that 
would be subordinated is $619.\94\
---------------------------------------------------------------------------

    \94\ The subordinated portion of the MBR would be: MBR x ((High 
Water Mark-current balance) / (High Water Mark-MBR)). Here, this 
amount is $3,000 x (($100,000-$80,000) / ($100,000-$3,000)) = $619.
---------------------------------------------------------------------------

    (b) The investor closes the account the next day. The investor 
receives $77,000, all of the Available Balance, immediately. This 
represents the entire remaining account value of $80,000 less the 
$3,000 MBR. The MBR shares will be redeemed after a 30-day delay. By 
closing the account, the investor causes its entire MBR to be 
subordinated for that 30-day period.\95\ However, the investor will 
receive the full $3,000 after the 30-day delay, unless the fund suffers 
losses in excess of its NAV buffer.
---------------------------------------------------------------------------

    \95\ That is, the subordinated portion of the MBR would be: MBR 
x ((High Water Mark-current balance) / (High Water Mark-MBR)). Here, 
this amount is $3,000 x (($100,000-$3,000) / ($100,000-$3,000)) = 
$3,000.
---------------------------------------------------------------------------

    Design considerations. The 30-day delay period is designed to 
provide protection against preemptive runs while not unnecessarily 
inconveniencing redeeming shareholders or blunting the role of 
redemptions in imposing market discipline on MMFs. The delay should be 
sufficient to ensure that redeeming shareholders remain invested in the 
fund long enough to share in any losses due to stress on the fund at 
the time of redemption or liquidity costs that might be generated by 
their redemptions. On average, about half of MMF portfolio assets 
mature in 30 days or less,\96\ and a 30-day period likely would be long 
enough to prevent a shareholder from avoiding a specific anticipated 
loss by preemptively redeeming. As a result, the 30-day delay period 
would provide more protection against preemptive runs than might occur 
with shorter delay periods. The MBR may also enhance market discipline 
by causing MMF investors to monitor more carefully MMF operations and 
risk-taking and redeem shares from a poorly run MMF well in advance of 
any specific problems developing in the fund's portfolio because 
investors would be unable to redeem quickly during a crisis to avoid 
losses.
---------------------------------------------------------------------------

    \96\ Data reported to the SEC on Form N-MFP show that as of 
September 30, 2012, 52 percent of all MMF assets and 47 percent of 
prime MMF assets matured in 30 days or less.
---------------------------------------------------------------------------

    The size of the MBR (3 percent) is designed to be large enough to 
mitigate the risk of destabilizing runs while, at the same time, not so 
large as to unnecessarily inconvenience shareholders. In order to 
reduce the incentives for investors to redeem from an MMF under stress, 
the combined size of the MBR and the NAV buffer must be greater than 
the expected portfolio losses in such an MMF as well as the liquidity 
losses that investors may suffer as a consequence of the MMF's closure.
    The 3-percent MBR, combined with the NAV buffer, is designed to 
mitigate this risk in most potential loss scenarios. For example, 
although the record of MMF losses has been obscured by sponsor support 
actions, two MMFs have broken the buck since the adoption of rule 2a-7 
in 1983. The Community Bankers U.S. Government Money Market Fund lost 
3.9 percent of its value in 1994, and the Reserve Primary Fund 
announced a 3-percent loss on September 16, 2008. In addition, as 
previously discussed, data collected from MMFs participating in the 
Treasury's Temporary Guarantee Program for Money Market Funds show that 
losses among MMFs that would have broken the buck in the absence of 
sponsor support averaged 2.2 percent, including five funds that had 
losses exceeding 3 percent.\97\ A default of MMFs' largest single-name 
exposures could also produce similarly sized losses. As of September 
30, 2012, the average prime MMF had investments in approximately 20 
firms that each exceeded 1 percent of the fund's assets and had 
investments in securities issued by seven firms, predominately 
financial institutions, that each exceeded 3 percent of the fund's 
assets.\98\
---------------------------------------------------------------------------

    \97\ These data exclude losses that were absorbed by some forms 
of sponsor support, such as direct cash infusions to a fund and 
outright purchases of securities from a fund at above-market prices, 
so the number of funds that would have broken the buck in the 
absence of all forms of support may have exceeded 29. See McCabe, 
Cipriani, Holscher, and Martin, 2012.
    \98\ Based on data reported to the SEC on Form N-MFP as of 
September 30, 2012. Excludes exposures through repo backed by U.S. 
government securities and sponsored ABCP conduits. The definition of 
firm in this analysis differs from the definition of issuer in rule 
2a-7, as it combines all affiliates within a single consolidated 
group as one firm.
---------------------------------------------------------------------------

    Importantly, because the MBR creates a disincentive for large 
redemptions when a fund is under stress and expected losses are less 
than the size of the MBR, the MBR's size need not exceed every 
conceivable loss to be effective in preventing runs from spreading 
among funds. While the combination of the NAV buffer and the 3-percent 
MBR likely would not be sufficient to stop a run on an MMF if investors 
anticipate very large losses in that fund, such a combination may be 
large enough to stem runs on most other funds unless investors expect 
that very large losses would be incurred across MMFs.
    Application to recordholders. MMFs would be required to apply the 
MBR requirement to each of their recordholders. This would include 
recordholders that are financial intermediaries, such as banks or 
broker-dealers that hold shares on behalf of their customers, unless 
the intermediaries provide the MMF sufficient information to apply the 
MBR requirement to the intermediaries' individual customers directly. 
Absent such information, an MMF and its financial intermediary 
recordholders would allocate between themselves the responsibility (and 
associated costs) of applying the MBR requirement equitably.\99\
---------------------------------------------------------------------------

    \99\ Although financial intermediaries would not be required by 
rule 2a-7 to apply the minimum balance at risk to their customers, 
they may need to do so (or take other measures) to ensure their 
customers are treated fairly in times of stress (i.e., to ensure 
that delays in redemptions for various customers are managed 
equitably).
---------------------------------------------------------------------------

    Treasury MMFs and retail investors. Treasury MMFs would not be 
required to maintain NAV buffers, and their shareholders would not have 
MBRs. Treasury MMFs are unlikely to suffer credit events; tend to 
experience net inflows, rather than net redemptions, in times of 
stress; and may be more likely to maintain a stable value during times 
of market stress, when Treasury securities generally maintain their 
values. Treasury MMFs would continue to be able to use penny rounding 
to maintain a stable value.
    Because the MBR only applies to investors with account balances 
greater than $100,000, many retail investors would not be subject to 
the MBR requirement. The experience of MMFs during the financial crisis 
and the redemption pressures that some MMFs experienced in the summer 
of 2011 suggest that retail investors are far less likely to redeem in 
times of stress. In both episodes, institutional MMFs experienced 
substantially more redemptions than retail MMFs.\100\
---------------------------------------------------------------------------

    \100\ See Section IV.
---------------------------------------------------------------------------

(ii) Benefits and Considerations
    A requirement for most MMFs to maintain NAV buffers and MBRs could 
mitigate funds' susceptibility to runs

[[Page 69472]]

and reduce the likelihood of resulting financial instability in several 
ways.
    Reduced first-mover advantage. A buffer-supported NAV would reduce 
the first-mover advantage that exists under rule 2a-7's current 
rounding conventions.\101\ Specifically, by removing shareholders' 
ability to redeem at $1.00 per share when the fund's market-based NAV 
is below $1.00, the NAV buffer would be designed to prevent redeeming 
shareholders from extracting more than their pro rata share of fund 
assets.\102\
---------------------------------------------------------------------------

    \101\ Commenters have suggested that an NAV buffer could make 
MMFs less susceptible to runs. See, e.g., Comment Letter of Fidelity 
Investments, Charles Schwab, and Wells Fargo, SEC File No. 4-619 
(May 3, 2011). Some commenters, however, have argued for 
substantially larger buffers to accomplish this objective. See, 
e.g., Comment Letter of the Squam Lake Group, SEC File No. 4-619 
(Jan. 14, 2011).
    \102\ As one commenter explained, the NAV buffer, in contrast to 
the buffering effect of the rounded NAV, generally would increase in 
size as investors redeem, assuming there are no portfolio losses. 
See Comment Letter of Fidelity Investments, Charles Schwab, and 
Wells Fargo, SEC File No. 4-619 (May 3, 2011) (``[A] key feature of 
the NAV buffer is that a fund's market value per share would 
typically increase as shareholders redeem. This greatly reduces any 
incentive for shareholders to run on the fund.'')
---------------------------------------------------------------------------

    Explicit support. A fully funded NAV buffer would give the fund an 
explicit form of support that would be designed to enable the fund to 
absorb day-to-day fluctuations in the value of its portfolio, such as 
declines in the value of assets following increases in interest rates 
and minor credit losses. Unlike the discretionary sponsor support 
discussed in Section IV, the availability of the prefunded NAV buffer 
to support the fund during times of stress would not be in question.
    Additional discipline on fund managers. The NAV buffer could impose 
additional discipline on fund managers by ensuring that small losses, 
which today are not reflected in funds' share prices, force changes in 
portfolio management. If an MMF's NAV buffer fell below the required 
amount, until the buffer is repaired, the fund would be required to 
limit its new investments to cash, Treasury securities, and Treasury 
repos. Repairing the buffer could be costly, and foregoing potentially 
higher-yielding investments to repair the buffer could reduce the 
fund's yield and its appeal to investors. As such, the buffer 
requirement may diminish the attractiveness of risky portfolio 
strategies that might lead to losses that erode a fund's NAV buffer.
    Increased flexibility to sell securities. The NAV buffer also could 
increase the resilience of MMFs by providing them with additional 
flexibility to sell securities that have suffered small losses because 
such losses could be absorbed by the buffer. Today, in contrast, such 
losses may reduce the fund's market-based NAV below $1.00 per share and 
potentially heighten the risks of a run. Recognizing this, MMFs tend to 
avoid selling securities that have suffered small losses and instead 
dispose of securities that have not suffered losses first. Hence, the 
reluctance to sell securities that have suffered small losses can 
contribute to the first-mover advantage for redeeming investors.
    Redeeming shareholders share in losses caused by redemptions. The 
MBR requirement could make MMFs more resilient by diminishing or 
reversing the first-mover advantage for investors who might otherwise 
redeem MMF shares when their fund is under stress. Investors who make 
sufficiently large redemptions from an MMF subject to an MBR 
requirement would remain partially invested in the fund for 30 days and 
would share in any losses that the fund might experience during that 
time, including losses that may be caused directly or indirectly by 
their own redemptions.
    Disincentive for investors to redeem during times of stress. The 
MBR requirement would be designed to create a disincentive for 
redemptions from a fund that is at risk of suffering losses that an 
investor expects will be less than the NAV buffer plus the MBR. An 
investor with an account balance greater than $100,000 in such a fund 
could minimize or potentially avoid entirely any expected losses by not 
redeeming and not subordinating a portion of its MBR.
    Protection for shareholders who do not redeem. The MBR requirement 
would provide some protection for investors who do not redeem from an 
MMF under stress. Because redeeming investors would share in losses 
that immediately follow their redemptions, investors who have not 
redeemed would not be forced to bear all of the fund's losses in excess 
of its NAV buffer. In addition, the portions of redeeming investors' 
MBRs that are subordinated would, by absorbing first losses, provide 
additional protection for the shareholders who do not redeem from a 
fund that suffers losses that exceed its NAV buffer.
    Reduced investor yields. The NAV buffer likely would either 
directly or indirectly reduce the yield funds offer investors. For 
example, an NAV buffer funded through the issuance of buffer shares or 
a combination of the issuance of buffer shares and the retention of 
earnings would diminish the net yields paid to investors who hold the 
fund's redeemable shares. Although a sponsor-provided buffer would not 
directly reduce the fund's yield,\103\ sponsors likely would pass on to 
investors some or all of the costs of providing the buffer. In 
addition, this may raise fairness concerns if MMF investors receive 
reduced yields in order to build a buffer that benefits subsequent 
investors.
---------------------------------------------------------------------------

    \103\ The escrow account, although it would not itself directly 
decrease a fund's yield, also would not increase it, because any 
yield earned on the instruments held in the account would be for the 
benefit of the fund's sponsor as the owner of the account.
---------------------------------------------------------------------------

    Impact on sponsors. Sponsors that chose to provide NAV buffers for 
their MMFs also could be required to consolidate their MMFs on their 
balance sheets for accounting purposes. If the MMFs were consolidated 
on sponsor balance sheets or the sponsor provided explicit guarantees 
or liquidity facilities to their MMFs, this could have bank regulatory 
capital implications if the sponsor was affiliated with a bank or bank 
holding company.
    Operational and technology costs. All three of the methods for 
funding the NAV buffer that are discussed above likely would involve 
operational and technology costs. These include the costs of raising 
capital for MMFs that issue buffer shares and for sponsors that obtain 
funding for their funds' NAV buffers in the capital markets. Capital-
raising costs also would include legal, accounting, and issuance 
expenses (e.g., road show costs). Funds also could incur one-time costs 
in seeking any shareholder approvals that may be necessary, such as 
authorization to issue buffer shares. MMFs that enhance buffers by 
retaining earnings would face additional tax costs. It is important to 
note, however, that some of these costs associated with capital raising 
may be reallocations of existing costs that have been borne indirectly 
by fund sponsors that have provided, or were prepared to provide, 
discretionary support.
    Costs also would include one-time set-up costs (e.g., reprogramming 
systems to fair value certain portfolio securities, rather than valuing 
them at their amortized cost, and reprogramming compliance systems to 
track NAV buffer levels). There also may be ongoing operational costs 
associated with the requirement to fair value a larger number of the 
securities in funds' portfolios.
    The MBR also would involve operational and technology costs, which 
could be substantial, including to implement and maintain systems to 
track investors' High Water Marks, MBR shares that are subject to 
redemption

[[Page 69473]]

delays, and any subordinated MBR shares. Institutional shareholders 
also could incur one-time operational costs to reprogram their cash 
management systems to take account of the MBR requirement.
    Impact on derivatives clearing organizations and futures commission 
merchants. An MBR requirement could lead the Commodity Futures Trading 
Commission (CFTC) to reassess customer funds investment regulations as 
they pertain to MMFs other than Treasury MMFs. Investments in MMFs 
subject to an MBR would not satisfy the CFTC's requirements for 
investment of customer funds supporting futures and swaps positions. 
The CFTC's next-day redemption requirement provides that for such 
investments in MMFs, the MMF must be ``legally obligated to redeem an 
interest and to make payment in satisfaction thereof by the business 
day following a redemption request.'' \104\ The next-day redemption 
requirement is intended to ensure that an investment of customer funds 
is sufficiently liquid, thereby permitting the reliable and timely flow 
of daily customer variation margin payments.
---------------------------------------------------------------------------

    \104\ Investment of Customer Funds, 17 CFR 1.25(c)(5)(i) (2012). 
For such investments, the MMF may postpone the redemption only in 
certain enumerated, extraordinary circumstances such as the non-
routine closure of the Fedwire or the existence of an emergency 
situation (as determined under SEC rules).
---------------------------------------------------------------------------

    Impact on demand for MMFs. While this alternative likely would make 
MMFs more resilient, it also could make the funds less appealing in 
other respects by diminishing the net yields that the funds pay to 
investors and by placing constraints on the liquidity currently 
available to MMF shareholders. The MBR may be confusing to some 
investors, particularly initially, and may be unattractive to those who 
have come to expect full and immediate liquidity from their MMFs 
(potentially to the detriment of the investors who remain in the fund). 
Some investors may find the MBR inconvenient and may require 
significant operational changes. Institutional investors may not be 
willing to incur the operational costs necessary to accommodate an 
MBR.\105\ The application of the MBR could be particularly complex as 
applied to fund shares sold through series of intermediaries in the 
MMFs' distribution chains.\106\ Some investors therefore could reduce 
or eliminate their investments in MMFs subject to the NAV buffer and 
MBR requirements.\107\ Some MMF sponsors may be less willing to offer 
MMFs subject to the NAV buffer and MBR requirements because they expect 
that demand for such funds might be limited and because of additional 
costs required to operate them.\108\
---------------------------------------------------------------------------

    \105\ See, e.g., Comment Letter of the Investment Company 
Institute, SEC File No. 4-619 (June 20, 2012) (providing an analysis 
of operational impacts of proposed redemption restrictions); Comment 
Letter of Treasury Strategies, SEC File No. 4-619 (Apr. 27, 2012) 
(providing an analysis on holdback requirements); Comment Letter of 
DST Systems, Inc., SEC File No. 4-619 (Mar. 2, 2012) (describing 
``systems and operational impacts'' associated with a holdback 
requirement based on a stated percentage of an investor's average 
account balance over a 30-day period).
    \106\ See, e.g., Comment Letter of DST Systems, Inc., SEC File 
No. 4-619 (Mar. 2, 2012) (``The omnibus accounting layers that 
exists in the mutual fund shareholder recordkeeping environment 
would provide further complexity with a minimum balance 
requirement.'').
    \107\ See, e.g., Comment Letter of the Investment Company 
Institute, SEC File No. 4-619 (Apr. 19, 2012) (enclosing survey data 
reflecting that some investors would reduce their investments in 
MMFs, or stop using the funds, if MMFs had a holdback requirement); 
Comment Letter of Sungard Global Network, SEC File No. 4-619 (Mar. 
16, 2012) (stating that ``88 percent of corporate treasurers and 
cash managers surveyed in the 2011 SunGard investment study cited 
immediate access to cash as a major requirement of their cash 
investment policies'') (emphasis in original).
    \108\ Comment Letter of the Investment Company Institute, SEC 
File No. 4-619 (June 20, 2012) (``[The costs of these changes 
[operational changes required to implement an MBR] could be 
prohibitive and * * * the industry would be unlikely to undertake 
them, particularly if the SEC's changes result in shrinking the 
asset base of money market funds.'').
---------------------------------------------------------------------------

    All of these considerations could reduce the size and assets of the 
MMF industry as funds exit the market to avoid the NAV buffer and MBR 
requirements or as investors choose other investment vehicles. This 
could lead to an increase in demand for other investment vehicles not 
subject to these requirements.
(iii) Questions
    The Council requests comment on this alternative as well as on all 
aspects of the discussion presented above. The Council also requests 
any quantitative analysis or data from commenters relating to this 
alternative.
    Would requiring most MMFs to maintain NAV buffers and MBRs make the 
funds less susceptible to runs? Would this alternative reduce the 
potential financial instability associated with MMFs?
    Would this alternative make MMFs more resilient by replacing the 
rounding conventions currently provided by rule 2a-7 with a transparent 
and prefunded NAV buffer? Would the buffer requirement help foster 
discipline for fund managers? Would it reduce the uncertainty for 
investors caused by the current reliance on sponsor support to absorb 
minor losses in MMF portfolios? Would such uncertainty be maintained if 
sponsors, on a discretionary basis, provided financial support to 
prevent material decline of the required NAV buffer?
    Should MMFs be required to maintain an NAV buffer of a different 
size? When combined with an MBR requirement, should the NAV buffer be 
larger or smaller? Should the NAV buffer requirements applicable to 
various types of MMF portfolio assets be different? Should funds have 
the flexibility to raise the NAV buffer through a variety of funding 
methods? If not, which methods should funds be required to use and why? 
What governance, incentive, and other concerns are raised by each 
method of funding a buffer? Are there additional funding methods that 
would require relief from the SEC, or particular methods that the SEC 
should preclude? Could additional types of buffer shares, other than 
equity securities, be used to create an NAV buffer? Would some 
sponsors' cost advantage in providing their funds' NAV buffers give 
competitive advantages to their MMFs? If so, how would this affect the 
financial instability associated with MMFs? How could the SEC design an 
NAV buffer requirement to mitigate any such competitive advantages? 
Should the SEC, for example, mandate that the NAV buffer could be 
raised only through a combination of the issuance of buffer shares and 
a fund's retention of earnings, because these methods of funding 
potentially would be available to all MMFs? Is the contemplated NAV 
buffer phase-in appropriate? If not, should it be shorter or longer?
    Would the MBR requirement make MMFs more resilient by requiring 
some redeeming investors to remain partially invested in an MMF for 30 
days? Would a 3 percent MBR be sufficiently large to mitigate the risk 
of runs on MMFs? Should be it be larger or smaller? Should the length 
of the redemption delay be longer or shorter than 30 days? Does a 3 
percent MBR with a 30-day redemption delay appropriately balance the 
objectives of reducing the vulnerability of MMFs to runs without 
burdening unnecessarily the funds and their shareholders? Does it 
preserve the role of redemptions in providing market discipline for 
MMFs? Should each investor's MBR be a portion of its High Water Mark, a 
portion of the average of the investor's balance over the previous 30 
days or some other period, or some other measure? Would an alternative

[[Page 69474]]

approach toward subordination be more effective? \109\
---------------------------------------------------------------------------

    \109\ See McCabe, Cipriani, Holscher, and Martin, 2012 for a 
discussion of a number of alternative methods of allocating first 
losses.
---------------------------------------------------------------------------

    Are the exemptions from the NAV buffer and MBR requirements for 
Treasury MMFs appropriate? Should the SEC provide exemptions for other 
types of funds?
    Some retail investors--those with balances of less than $100,000--
would not be subject to the MBR requirement because retail investors 
may be less likely to participate in a run. Are retail investors less 
likely to participate in a run? Would MMFs consisting primarily of 
retail investors not subject to an MBR requirement be at increased 
risk? Is it appropriate to define a retail investor for this purpose by 
reference to the size of the investor's account? If so, should the 
threshold be $100,000, or should it be higher or lower, and why? If 
not, what other characteristics would be more appropriate? How would 
MMFs apply this exemption to omnibus accounts? Should MMFs be required 
to have transparency through these accounts to apply the exemption?
    Should the SEC provide an exemption from the MBR for redemptions 
made in accordance with a plan that a shareholder has provided to the 
fund in advance? If so, how far in advance should a shareholder be 
required to notify the MMF of the shareholder's redemptions plans in 
order to prevent the shareholder from using the exemption to avoid 
redemption delays when MMFs are under stress?
    Are there ways to reduce the operational and other costs associated 
with implementing the NAV buffer and the MBR? What is a realistic 
timeframe for implementation of these changes from an operational 
perspective? Who would bear these one-time and recurring costs? Would 
these costs end up being absorbed by fund sponsors, financial 
intermediaries, or investors in these funds? To what extent would these 
costs affect MMF sponsors' willingness to offer non-Treasury MMFs under 
this alternative? To what extent are the costs associated with the NAV 
buffer new costs, as opposed to costs that have been borne by some fund 
sponsors?
    How would the combined effects of any reduction in yield from the 
NAV buffer and inconvenience caused by restrictions on redemptions from 
the MBR affect investor demand for MMFs? To what extent and why would 
investors discontinue investing in MMFs subject to these requirements? 
If a reduction in demand is anticipated, to which other investment 
vehicles would investors most likely shift money? What would be the net 
effect on financial stability?

C. Alternative Three: NAV Buffer and Other Measures

    Require MMFs to have a risk-based NAV buffer of 3 percent to 
provide explicit loss-absorption capacity that could be combined with 
other measures to enhance the effectiveness of the buffer and 
potentially increase the resiliency of MMFs. Other measures could 
include more stringent investment diversification requirements, 
increased minimum liquidity levels, and more robust disclosure 
requirements. The NAV buffer would have an appropriate transition 
period and could be raised through various methods. To the extent that 
it can be adequately demonstrated that more stringent investment 
diversification requirements, alone or in combination with other 
measures, complement the NAV buffer and further reduce the 
vulnerabilities of MMFs, the Council could include these measures in 
its final recommendation and would reduce the size of the NAV buffer 
required under this alternative accordingly.
Description of the Alternative
    This alternative would incorporate a larger risk-based NAV buffer 
than Alternative Two, of 3 percent, that could be combined with other 
measures to enhance MMFs' loss-absorption capacity and mitigate the run 
vulnerabilities that would be addressed by the MBR in Alternative Two. 
To the extent that more stringent investment diversification 
requirements, alone or in combination with other measures, complement 
the NAV buffer and reduce MMFs' vulnerabilities, the Council could 
include them in its final recommendation. These measures could serve to 
reduce the size of the NAV buffer required under this alternative 
accordingly. The Council requests comment on how the other measures 
might be structured; how, if at all, they could complement the NAV 
buffer and reduce the vulnerabilities described in Section IV; and 
whether more stringent investment diversification requirements, alone 
or in combination with other measures, would increase MMFs' resiliency 
sufficiently to warrant a smaller NAV buffer requirement.
NAV Buffer
(i) Description
    The NAV buffer would function as outlined in Alternative Two in 
most respects, including the various funding methods for the NAV buffer 
(such as an escrow account, subordinated buffer shares, and retained 
earnings), the exclusion for Treasury MMFs from the requirement, and 
the implications of depleting the buffer. However, in contrast to 
Alternative Two, the NAV buffer of 3 percent would be designed to 
provide greater loss-absorption capacity.
    Buffer size. In Alternative Two, the NAV buffer is primarily 
designed to absorb day-to-day variations in the mark-to-market value of 
MMFs' portfolio holdings, and the MBR serves as the primary tool to 
reduce investors' incentive to redeem their shares when a fund 
encounters stress. In Alternative Three, the NAV buffer would serve as 
the primary tool to increase the resiliency of MMFs and reduce their 
vulnerability to runs. While the other measures described below would 
be designed to complement the NAV buffer, they would be unlikely to 
provide the same structural protections as the MBR described in 
Alternative Two. Given these considerations, the NAV buffer in this 
alternative must be significantly larger to provide greater capacity to 
absorb losses, lower the probability that a fund would fully deplete 
its buffer, and, accordingly, reduce the incentive of investors to run 
during times of stress.
    As in Alternative Two, the required minimum size of a fund's NAV 
buffer would be tailored based on the riskiness of the fund's assets, 
using the following formula:
    (i) No buffer requirement for cash, Treasury securities, and 
Treasury repos (i.e., repos collateralized solely by cash or Treasury 
securities);
    (ii) A 2.25 percent buffer requirement for other daily liquid 
assets (or for weekly liquid assets, in the case of tax-exempt funds); 
\110\ and
---------------------------------------------------------------------------

    \110\ The definitions of daily and weekly liquid assets are 
those provided by rule 2a-7. See Section II.
---------------------------------------------------------------------------

    (iii) A 3.00 percent buffer requirement for all other assets.\111\
---------------------------------------------------------------------------

    \111\ Based on data reported to the SEC on Form N-MFP as of 
September 30, 2012, the average NAV buffer would be approximately 
2.51 percent for prime funds; 2.39 percent for tax-exempt funds; and 
2.10 percent for government funds.
---------------------------------------------------------------------------

    If more stringent investment diversification requirements, possibly 
in combination with other measures outlined below, are determined to 
work in tandem with the NAV buffer and reduce MMFs' vulnerabilities, 
they could be included in this alternative in the Council's final 
recommendation and the level of this buffer requirement would be 
lowered accordingly. Similar to Alternative Two, Treasury MMFs would 
not be required to maintain an NAV buffer.

[[Page 69475]]

    Transition period. In order to allow sufficient time for funds to 
raise the larger NAV buffer, under this alternative a phase-in period 
would be provided for funds to reach the full buffer levels. An NAV 
buffer of one-sixth of the total amount would become effective after 
one year and an NAV buffer of one-third of the total amount would 
become effective after two years. A multi-year transition period would 
follow to allow the full implementation of the required NAV buffer 
levels contemplated in this alternative.
(ii) Benefits and Considerations
    The main benefits and considerations associated with the NAV buffer 
were discussed in Alternative Two. However, given the absence of an MBR 
in this alternative, a brief discussion of the calibration of the 
buffer amount and transition period is warranted.
    Additional loss-absorption capacity. A larger NAV buffer would 
provide funds with additional capacity to absorb fluctuations in the 
market value of portfolio securities and credit losses. While MMFs 
generally provide stable value and invest in lower-risk securities, 
experience has shown (as discussed in Section IV) that funds can 
experience losses exceeding the NAV buffer level of 1 percent 
contemplated in Alternative Two. In addition, based on the size of 
MMFs' largest single-name exposures (as discussed in Section V.B), the 
failure of any of these firms could result in losses potentially 
exceeding a buffer of such size. The additional loss-absorption 
capacity provided by the larger NAV buffer in this alternative could 
reduce the number of firms whose failure could fully deplete the fund's 
NAV buffer and decrease the likelihood that an MMF experiences losses 
that threaten the stable value per share. This may reduce the first-
mover advantage and decrease the motivation for investors to redeem 
during periods of stress as long as they expect any losses to be less 
than the size of the buffer (discussed further below).
    Reduced incentive for excessive risk-taking. Additionally, capital 
buffers can increase the cost of risk-taking ex ante, further reducing 
the probability of distress of an MMF or the MMF industry. For buffers 
raised through the sale of subordinated buffer shares, third parties 
purchasing shares may require higher dividends based on the perceived 
risks of the fund's portfolio securities, therefore limiting the yield 
benefit any increased risk-taking provides to the redeemable shares. 
For buffers provided by fund sponsors or retained earnings, the threat 
of losing this contributed capital may lead fund managers to 
internalize the cost of any increased risk-taking. This may reduce 
MMFs' incentive or ability to shift towards riskier assets in order to 
attract additional investments. The reduction in MMFs' incentive or 
ability to shift towards riskier assets could be more significant than 
under Alternative Two because of the increased size of the NAV buffer 
under this alternative.
    Additional costs to MMFs, sponsors, or borrowers. The increased 
size of the buffer would likely impose additional costs on MMFs or the 
sponsors who would need to raise the capital.\112\ Increasing the size 
of the NAV buffer may increase the costs of short-term funding, 
particularly for financial institutions, if MMFs demand higher yields. 
These costs could also be passed on to MMF investors, in whole or in 
part, in the form of reduced yield. They also could alter the financial 
returns for sponsors such that they contemplate exiting or reducing 
their MMF businesses.
---------------------------------------------------------------------------

    \112\ See, e.g., Comment Letter of the Investment Company 
Institute, SEC File No. 4-619 (May 16, 2012) (enclosing an analysis 
of certain implications of capital buffers for MMFs); Christopher 
Payne, Capital Buffer for Money Market Funds Not as Costly as 
Predicted, Bloomberg Government Study (Sept. 20, 2012).
---------------------------------------------------------------------------

    Depending on the funding method chosen (such as an escrow account, 
subordinated buffer shares, or retained earnings), building higher 
levels of capital in periods of low interest rates, as exist today, may 
prove difficult or costly. Although a transition period may reduce the 
costs of implementing the buffer, it will also result in MMFs having 
NAV buffers that are smaller than deemed adequate during the transition 
period.
    Reduced, but not eliminated, vulnerability to run. In addition, 
while the NAV buffer may reduce the probability that an MMF investor 
suffers losses, it is unlikely to be large enough to absorb all 
possible losses and may not be sufficient to prevent investors from 
redeeming when they expect possible losses in excess of the NAV buffer. 
For instance, the largest average exposure in prime MMFs to a single 
firm, when aggregating all affiliates and weighting by fund assets, was 
4.5 percent.\113\ Additionally, as noted in Section IV, prime MMF 
exposures may be heavily correlated. Therefore, if one firm were to 
fail, there is a higher probability that additional firms would also 
fail concurrently, potentially resulting in multiple MMF portfolio 
losses.
---------------------------------------------------------------------------

    \113\ Based on data reported to the SEC on Form N-MFP as of 
September 30, 2012 among 243 prime MMFs that filed form N-MFP with 
the SEC. Analysis excludes exposures through repo backed by U.S. 
government securities and sponsored ABCP conduits.
---------------------------------------------------------------------------

(iii) Questions for Comment
    The Council requests comment on this alternative as well as on all 
aspects of the discussion presented above. The Council also requests 
any quantitative analysis or data from commenters relating to this 
alternative.
    The Council seeks comment on the size of the NAV buffer. Should the 
NAV buffer be larger or smaller? Does a larger NAV buffer address the 
structural vulnerabilities described in Section IV? What type of 
analysis of MMF portfolio exposures should be undertaken when 
considering an appropriate size for the NAV buffer?
    How would this higher NAV buffer impact investors, short-term 
financing markets, and long-term economic growth? How would the NAV 
buffer requirement, and particular MMF's choices of buffer funding 
methods, affect MMFs' yields? To what extent would an NAV buffer funded 
solely through buffer shares and the retention of earnings affect a 
MMF's yield? Could it cause a prime MMF's yield to decrease below those 
offered by government or Treasury MMFs? In what circumstances could 
this occur and how likely is it to occur?
    The Council also requests comment on the design and duration of the 
transition period to implement the NAV buffer. How long should the 
transition period be? Should the transition period be based on economic 
or market conditions rather than a pre-determined phase-in deadline?
    How would the larger NAV buffer in Alternative Three, alone or 
combined with investment diversification requirements and other 
measures as discussed below, affect investor demand for MMFs? To what 
extent and why would investors discontinue investing in MMFs subject to 
these requirements? Where would investors shift their investments and 
how would this mitigate or increase risks to financial stability?
    When considering the larger NAV buffer in Alternative Three, what 
mix of other measures described below can most effectively complement 
the NAV buffer? To the extent that more stringent investment 
diversification requirements reduce MMFs' vulnerabilities, as discussed 
below, could such requirements be combined with a lower minimum NAV 
buffer and, if so, what would be the appropriate minimum? Could other 
measures be combined with more stringent investment diversification 
requirements to provide additional protections? Should the

[[Page 69476]]

Council consider additional risk-based tailoring of the NAV buffer, for 
instance, based on specific types of MMF assets? Should the required 
NAV buffer be larger for MMFs with more concentrated exposures, 
particularly those to financial institutions?
Other Measures
    Description. Alternative Three contemplates possible additional 
measures that may complement the NAV buffer in mitigating run 
vulnerabilities. These include more stringent investment 
diversification requirements, increased minimum liquidity levels, and 
more robust disclosure requirements. These measures individually would 
likely not significantly alter the activities and practices that make 
MMFs vulnerable to runs. To the extent that it can be adequately 
demonstrated that more stringent investment diversification 
requirements, alone or in combination with other measures, complement 
the NAV buffer and further reduce MMFs' risks and increase their 
resiliency, the Council's final recommendation could include these 
additional measures with the NAV buffer requirement, and the size of 
the NAV buffer would be reduced accordingly.
More Stringent Investment Diversification Requirements
(i) Description
    As noted above, prime MMFs generally have numerous large exposures 
to individual firms' securities. Rule 2a-7 currently provides that an 
MMF, other than a single-state fund, ``shall not have [immediately 
after the acquisition of any security] invested more than 5 percent of 
its Total Assets in securities issued by the issuer of the security.'' 
The Council requests comment on two proposed modifications to this 
provision: (i) Reducing the 5 percent limitation; and (ii) revising the 
definition of ``issuer'' in this context to include all affiliates of a 
consolidated group.
(ii) Benefits and Considerations
    More stringent investment diversification requirements, 
particularly when paired with a material NAV buffer, could allow MMFs 
to potentially weather the default of securities issued by large firms.
    Lower maximum loss from default of one firm. A lower limit on 
exposure to a single firm, when combined with an NAV buffer of 3 
percent, would reduce the likelihood that losses from the failure of a 
single firm would threaten a fund's stable NAV. Similar requirements 
are utilized in other contexts, including risk management for financial 
institutions and central clearing parties.
    Modifying the calculation to aggregate all related affiliates would 
align more closely the rule 2a-7 limits with traditional credit 
analysis concepts. For instance, it is highly likely that material 
distress at a financial holding company would occur at the same time 
that its bank or broker-dealer subsidiary was experiencing similar 
distress, and these interrelationships would have implications for the 
obligations of both entities.
    Reduced funding and less creditworthy investments. However, 
tightening the investment diversification requirements could materially 
reduce the amount of funding that MMFs can provide to larger issuers. 
It also could result in MMFs investing in less creditworthy issuers if 
MMFs are required to reduce their largest exposures and invest in other 
firms, or it could cause MMFs to withdraw funding from the financial 
system and instead invest in less-risky securities (such as Treasury 
securities) that are not subject to issuer diversification 
requirements.
(iii) Questions
    What impact would these changes have on large issuers and on the 
short-term funding markets? To the extent that MMF investments are 
constrained or reduced in response to these restrictions, in what types 
of securities would MMFs invest?
    At what level should the issuer diversification requirements be 
set? Does adopting a ``cover one'' methodology--whereby each MMF would 
have sufficient loss absorption capacity to mitigate the failure of its 
largest investment--provide adequate protection to MMFs? How should 
these standards be compared to those used in other regulatory contexts?
    Should these standards be applied differently to different types of 
funds (for instance, prime MMFs, government MMFs, and tax-exempt MMFs)? 
What changes, if any, should be made with respect to the 
diversification requirements for demand features and guarantees? Should 
diversification limits apply to credit enhancements other than 
guarantees and demand features?
    What changes should be made, if any, to the definition of 
``issuer'' in the context of issuer diversification requirements? Are 
there other changes to the issuer diversification calculations that 
would further strengthen these reforms? For example, should 
diversification requirements for asset-backed securities generally 
treat as the issuer of the securities the special purpose entity that 
issued them, the sponsor of the asset-backed securities, or the issuers 
of the securities underlying the asset-backed securities?
    Are there other credit exposure limits that should be tightened to 
reduce MMFs' risks? For example, should certain types of exposures, 
such as financial-sector exposures, be subject to limitations? If so, 
what should the limits be? How should such exposures be defined? Should 
limits on second-tier securities be tightened? If so, how? Should 
collateral requirements be more stringent? How should that be 
accomplished?
    Should diversification requirements for providers of demand 
features and guarantees be tightened? How and to what extent? How might 
more stringent diversification requirements for providers of demand 
features and guarantees affect securities markets (particularly markets 
for tax-exempt securities) in which demand features and guarantees are 
important? Should limitations on other credit or liquidity enhancements 
be tightened?
Increased Minimum Liquidity Levels
(i) Description
    As discussed in Section II, MMFs are required to maintain liquidity 
buffers in the form of minimum levels of daily and weekly liquid 
assets. These liquidity buffers could be increased, for instance, by 
raising the required level of daily liquidity from the current level of 
10 percent to 20 percent, and the minimum weekly liquidity requirement 
from the current level of 30 percent to 40 percent. While these 
liquidity requirements would be a significant increase over the current 
requirements, which were adopted in 2010, they are below the liquidity 
levels many funds have maintained since Form N-MFP reporting began in 
late 2010.
    As under existing rule 2a-7, if a fund falls below the minimum 
liquidity requirement, it would be prohibited from acquiring any 
securities other than daily liquid assets until it is in compliance 
with the requirement. Tax-exempt funds would remain exempt from the 
daily liquidity requirement.
    Investor transparency. Additional ``know-your-investor'' 
requirements could be implemented to provide MMFs with increased 
visibility into omnibus accounts to improve their ability to understand 
their shareholder base and to predict investors' redemption activity. 
Today, many MMF shares are held by financial intermediaries on behalf 
of their customers--the MMF's

[[Page 69477]]

beneficial owners--making it difficult for MMFs to obtain information 
about their beneficial owners and predict their redemption activity. 
Requiring MMFs to obtain more information about their beneficial owners 
could help MMFs better understand and predict those investors' 
behavior, and allow the funds to better manage their liquidity to meet 
anticipated redemption requests.
(ii) Benefits and Considerations
    Increased minimum liquidity levels may limit MMFs' investment risks 
and increase an MMF's ability to meet heightened redemption requests 
without selling portfolio securities.
    Improved ability to meet redemption requests. Increased minimum 
liquidity levels may improve a fund's ability to convert portfolio 
holdings into cash to pay redeeming shareholders. Absent a sufficient 
supply of liquid assets, heavy redemptions could force a fund to sell 
less-liquid assets at a discount or at fire-sale prices, not only 
imposing losses on the fund's remaining shareholders but also 
potentially causing losses for other funds that hold similar 
securities. Increased minimum liquidity levels may increase the 
effectiveness of the NAV buffer and reduce the likelihood that periods 
of stress force fire sales that deplete MMFs' buffers.
    Enhanced liquidity management. Know-your-investor requirements may 
improve the ability of MMFs to predict and manage investor liquidity 
needs. This could reduce the likelihood that unexpected redemptions 
would force MMFs to sell assets, which may cause losses, particularly 
during times of stress.
    Reduced investment risk. Shifting the composition of MMFs' 
investment portfolios may decrease the risk of losses. The shorter-
duration investments would reduce MMFs' exposure to interest rate risk 
and, to the extent these requirements cause MMFs to increase their 
investments in U.S. Treasury obligations, this may also reduce their 
overall credit risk.
    Decreased investor yields. If funds shift their investments into 
shorter-duration, lower-yielding assets, this may decrease the return 
they provide to investors. In addition, the current level and slope of 
the yield curve may have led funds to hold higher levels of short-
duration assets than they might otherwise. In future periods in which 
interest rates are higher and there is a greater interest-rate premium 
paid for longer-duration assets, funds may be less likely to maintain 
this level of daily and weekly liquid assets if increased liquidity 
requirements are not implemented.
    Reduced term funding. While the increased liquidity requirements 
may improve funds' ability to meet redemption requests, they may also 
reduce the supply of term funding in certain markets in which MMFs 
invest. Borrowers, particularly financial institutions, may need to 
shift to funding at shorter durations, making their exposure to short-
term markets more pronounced and potentially increasing the fragility 
of the financial system.
    Modified nature of MMFs. Enhanced liquidity requirements would 
reduce MMFs' ability to invest in longer-dated or higher-risk 
instruments, which would impact the ability of MMFs, particularly prime 
MMFs, to serve their traditional role as a financial intermediary and 
potentially change the nature of the product.
(iii) Questions
    Would enhanced liquidity requirements mitigate the impact of 
increased redemptions on a fund? Are the proposed minimum liquidity 
requirements sufficient for funds to meet redemption requests during 
times of stress? Would higher or lower requirements be more 
appropriate? Rather than increasing both the daily and weekly liquid 
asset requirements, are there greater benefits or costs associated with 
increasing one or the other? Should tax-exempt funds continue to be 
exempt from any daily liquidity requirement?
    What harmful impacts would higher liquidity requirements have? How 
might they impact the funding markets in which MMFs participate? Would 
these requirements result in the institutions that borrow from MMFs 
shifting to shorter-term borrowing, increasing the risk that they may 
be unable to refinance their outstanding debt when necessary? If so, 
how might this impact financial stability? How would this impact the 
ability of borrowers to address new liquidity and stable funding 
requirements contemplated in Basel III?
    The current definitions of MMFs' ``weekly'' and ``daily'' liquid 
assets used in the minimum liquidity requirements include all assets 
that can be converted into cash within pre-defined timeframes, 
including unsecured and secured exposures to financial institutions. An 
alternative would be to exclude all non-government securities (and repo 
backed by non-government securities) from these definitions. This would 
potentially reduce the risk of credit or liquidity strains in the 
securities counted towards these buffers. This may also alleviate the 
concern, discussed above of, of potential unintended consequences such 
as pushing financial institutions into shorter duration borrowing. 
Should such a change to the definitions of daily and weekly assets be 
made? If so, should this be in place of, or in addition to, higher 
minimum liquidity requirements?
    Should MMFs be required to gather more information about their 
beneficial owners? MMFs also could be required to perform certain risk 
management procedures and consider information about beneficial owners' 
historical redemption behavior when stress testing their funds. To what 
extent can MMFs currently increase investor transparency? If regulatory 
changes would be necessary to facilitate this level of transparency, 
how could this be done most effectively by the SEC under its current 
statutory authority?
    Should MMFs be prohibited from having too concentrated an investor 
base, or should additional limitations apply if a fund has a 
concentrated investor base? For example, should an MMF investor be 
limited to owning no more than a specified percentage of any particular 
MMF? What limit would be appropriate?
    How might higher minimum liquidity levels complement the NAV 
buffer? Would they reduce the risks present in MMFs' investment 
portfolios? Would they reduce the probability that an MMF investor 
would redeem its shares based upon concerns about the MMF's portfolio 
liquidity?
More Robust Disclosure Requirements
(i) Description
    An NAV buffer could also be accompanied by enhanced disclosure 
requirements that would increase investors' ability to monitor MMFs' 
investment risks. Rule 2a-7 requires MMFs to disclose information about 
their portfolio holdings each month on their Web sites within five 
business days. MMFs are also required to provide to the SEC monthly 
filings, on Form N-MFP, containing more detailed information regarding 
their portfolio holdings, including their mark-to-market NAV per share. 
This information is then publicly released 60 days after the end of the 
month for which the information was reported.
    The transparency of MMF portfolio holdings could be increased by 
enhancing the level or frequency of required disclosures. This could 
include more frequent (e.g., daily or weekly) public reporting of 
portfolio information such as daily and weekly liquidity levels and 
mark-to-market per share

[[Page 69478]]

valuations. These adjustments also could include reducing or 
eliminating the current delay before public disclosure. This could be 
supplemented with additional disclosure of MMFs' valuation 
methodologies and the factors that their boards of directors (or the 
boards' delegates) take into account, or the processes they follow, 
when assessing whether a portfolio security poses minimal credit risk. 
MMFs could also be required to disclose any instances of sponsor 
support, including purchases of distressed portfolio securities.
(ii) Benefits and Considerations
    More robust disclosure requirements may improve investors' ability 
to monitor the portfolio holdings and the risk of an MMF.
    Improved investor monitoring of MMFs' risks. More robust disclosure 
requirements would provide investors greater transparency into the 
risks of the investments held by the MMFs in which they invest and 
important indicators of its health, including the fund's liquidity and 
NAV buffer levels. This may allow investors, particularly in times of 
stress, to differentiate MMFs based on the quality and stability of 
their investments, potentially preventing uninformed, across-the-board 
runs. This also may impose additional investor discipline on MMFs and 
reduce their ability to take increased risks, potentially enhancing the 
effectiveness of the NAV buffer.
    Increased volatility of MMFs' flows. There is a risk that more 
frequent reporting of portfolio information may make investors quicker 
to redeem when these indicators show signs of deterioration. In 
addition, more frequent reporting of portfolio information such as 
daily mark-to-market per share values or liquidity levels could 
increase the volatility of MMFs' flows, even when the funds are not 
under stress, if investors are highly sensitive to changes in those 
levels. More frequent disclosure of portfolio holdings may also limit 
funds' ability to utilize differentiated investment strategies.
(iii) Questions
    Would more frequent reporting of the portfolio holdings, mark-to-
market NAVs, and liquidity levels help investors and others 
differentiate among MMFs? If so, what would be the appropriate 
frequency (e.g., daily or weekly)? How might investors respond to daily 
changes in an MMF's mark-to-market NAV or liquidity levels? Should MMFs 
be required to disclose the mark-to-market value of their investments? 
Would enhanced disclosure decrease or increase the probability of 
indiscriminate runs across MMFs? Would MMFs be adversely affected by 
the need to provide enhanced disclosure of their portfolio holdings? 
Would enhanced transparency have unintended consequences?
    Should MMFs be required to notify their investors and the public 
each time they receive support from their sponsors? This would include, 
for example, purchases of distressed securities under rule 17a-9 under 
the Investment Company Act, if that rule is not rescinded in connection 
with any structural reforms. What other kinds of support warrant 
disclosure? Would this kind of disclosure help investors and others 
better understand and appreciate the risks in particular MMFs? How 
should this disclosure be made (e.g., on an MMF's Web site or in its 
prospectus)? Should MMFs be required to disclose their performance 
absent sponsor support? Where SEC relief is required for sponsor 
support, should the SEC no longer entertain requests for the relief? 
Should the SEC otherwise prohibit sponsor support?
    Should MMFs be required to provide increased disclosure on their 
valuation methodologies? Should MMFs be required to provide greater 
information about the factors that their boards of directors (or the 
boards' delegates) take into account, or the processes they follow, 
when assessing whether a security poses minimal credit risk? How might 
more robust disclosure requirements complement the NAV buffer? Would 
they reduce the risks present in MMFs' investment portfolios or improve 
investors' ability to differentiate between funds?

D. Request for Comment on Other Reforms

    The policy alternatives discussed in the proposed recommendations 
described above aim to address the structural vulnerabilities inherent 
in MMFs and reduce their susceptibility to runs. The alternatives are 
not mutually exclusive but could potentially be implemented in 
combination. For example, sponsors could manage funds that have 
floating NAVs as well as stable NAV funds with the appropriate enhanced 
structural protections.
    The Council recognizes that there may be other reforms it could 
consider that are not mentioned above that may mitigate risks to 
financial stability by providing a substantial reduction in the 
susceptibility of MMFs to runs. Accordingly, in addition to the request 
for feedback on the proposed recommendations above, the Council also 
solicits comment on other possible reforms of MMFs that the Council 
should consider for its final recommendation.
    Analysis of other reforms. Any comments submitted under this 
section should discuss how such reforms would address the structural 
vulnerabilities inherent in MMFs and mitigate the risk of runs and the 
threat they pose to financial stability. The comments also should 
address the potential impacts to the MMF industry, shareholders, and 
long-run economic growth.
    Liquidity fees and/or gates. For example, some market participants 
and other stakeholders have suggested alternative features that only 
would be implemented during times of market stress to reduce MMFs' 
vulnerability to runs. Specifically:
    (i) Standby liquidity fees that, when triggered, may directly 
charge shareholders who redeem their shares to compensate MMFs and the 
remaining MMF investors for the potential cost of withdrawing this 
liquidity from the fund; or
    (ii) Temporary restrictions on redemptions, or ``gates'' that, when 
triggered, would prohibit investors from redeeming and provide a period 
of time for a fund to restore its health.

The Council welcomes views on such features and how they, alone or in 
combination with other reforms, could provide a substantial reduction 
in the susceptibility of MMFs to runs. These proposals may provide some 
benefits by limiting investors' ability or motive to redeem during 
periods of stress and by potentially helping to restore a fund's NAV or 
NAV buffer. Some of these benefits may include fairer treatment of 
redeeming and non-redeeming investors, giving investors unfettered 
access to liquidity except during times of stress, and imposing 
additional discipline on fund managers, who would be motivated to 
manage their funds to avoid triggering a fee or a gate.
    However, members of the Council are concerned that standby 
liquidity fees and temporary gates may not adequately address--and in 
fact may further increase--the potential for industry-wide runs in 
times of stress. Standby liquidity fees and temporary gates may 
increase the risk of preemptive runs by investors who would be 
motivated to redeem before a fee or gate is triggered. Such fees or 
gates may also increase contagion risk, because the triggering of fees 
or gates in one MMF could encourage shareholder redemptions in other 
MMFs. Additionally, these proposals in isolation do not provide 
explicit loss-absorption capacity and may not significantly alter the 
activities

[[Page 69479]]

and practices of MMFs discussed in Section IV.
    Description of fees or gates. Standby liquidity fees or gates could 
provide targeted redemption restrictions that would only be implemented 
once a pre-determined threshold, intended to indicate stress in the 
fund, has been breached. While a variety of features have been 
proposed, the below discussion outlines several possible design 
considerations.
    Trigger. Standby liquidity fees or gates could be imposed 
automatically based on specific measures indicating stress on an MMF's 
condition, such as a decline in the fund's NAV or in the fund's 
holdings of daily or weekly liquid assets below a certain level. For 
example, some have suggested imposing fees or gates if an MMF's shadow 
NAV fell below $0.9975 per share or if its level of weekly liquid 
assets fell below 7.5 percent.\114\ Alternatively, the trigger could be 
at the discretion of an MMFs' board.
---------------------------------------------------------------------------

    \114\ See Blackrock Viewpoint, ``Money Market Funds: A Path 
Forward'' (2012) (recommending this trigger for the automatic 
imposition of a liquidity fee as opposed to a temporary gate), 
available at https://www2.blackrock.com/global/home/PublicPolicy/ViewPoints/index.htm; Comment Letter of HSBC Global Asset Management 
on the European Commission's Green Paper on Shadow Banking (May 28, 
2012), available at https://ec.europa.eu/internal_market/consultations/2012/shadow/individual-others/hsbc_en.pdf.
---------------------------------------------------------------------------

    Duration. The fee or gate could apply to any redemption until the 
health of the MMF has improved and the trigger measure, such as the 
fund's NAV or liquid assets, returns to levels required under rule 2a-
7. The length of the temporary fee or gate could be limited to a 
prescribed period, such as 30 days, after which the MMF would allow 
redemptions or liquidate.
    Fee level. The level of a fee could be based on the level of stress 
in the fund. As the level of the stress grows, so would the size of the 
fee. For example, the fee size could be based on the size of the 
decline in the fund's NAV or its liquid assets. Alternatively, the fee 
could be structured as a fixed percentage of the amount sought to be 
redeemed. In either case, the fee would be intended to shift the cost 
of liquidity to redeeming shareholders and help relieve potential 
strains on the fund.\115\
---------------------------------------------------------------------------

    \115\ For MMF shares held through omnibus accounts, the 
financial intermediary would need to ensure that any standby 
liquidity fees apply to the ultimate beneficial owners to prevent 
unfair results, just as they must do today when other types of 
mutual funds impose redemption fees.
---------------------------------------------------------------------------

    Gate operation. While rule 22e-3 allows a fund's board to suspend 
redemptions if the fund has broken the buck or is in danger of breaking 
the buck, the board must first irrevocably approve the liquidation of 
the fund and notify the SEC of its decision to liquidate and suspend 
redemptions. The gates discussed here, in contrast, would be temporary 
and could provide the MMF a short period of time to increase its 
liquidity levels to meet redemption requests and could allow the fund 
to remain in operation after the gates are lifted.
    Sequencing. If paired together, standby liquidity fees and 
temporary gates could be structured such that the fees are triggered 
before or after gates. If standby liquidity fees are triggered first, 
this may reduce the likelihood that gates are needed. If standby 
liquidity fees are imposed after gates are triggered, this may allow 
funds to permit redemptions if they determine that the liquidity fee 
would reduce the risk these redemptions pose to the fund.
    Enhanced Transparency. MMFs could be required to disclose 
information on their financial condition more frequently so investors 
could monitor if an MMF was approaching its triggers.
    Questions on liquidity fees and gates. Would investors' concerns 
about the potential triggering of a standby liquidity fee or gate 
increase the likelihood of preemptive runs? Would one fund imposing 
fees or gates lead to runs at other funds? Would a fee, as some have 
suggested, serve as a sufficient deterrent to investor redemptions such 
that MMFs' liquidity buffers would prove able to absorb shareholder 
redemptions in times of stress?
    Should the trigger be based on a fund's NAV, levels of daily and 
weekly liquid assets, or both? At what levels and why? Are there other 
triggers that would be more effective?
    What would be the appropriate size of a standby liquidity fee? 
Should the fee's size be based on the magnitude of losses or liquidity 
costs, or should it be a fixed percentage of the investor's redemption? 
How would they affect the composition of funds' portfolios and funds' 
risk-taking? Would a flat fee based on the size of the investor's 
redemptions fairly allocate liquidity costs?
    Should standby liquidity fees or gates be applied automatically 
based on pre-determined thresholds or instead at the discretion of the 
fund's board of directors (or its independent directors)? Would a 
fund's board fail to impose a fee or gate even when it would benefit 
the fund and its shareholders? How could such discretion be structured 
to make it more likely that it would be imposed when appropriate?
    Would a gate be more effective combined with a liquidity fee? If 
so, how should the combination be structured? For example, should a 
fund impose a liquidity fee first, allowing investors to continue to 
redeem, but impose a gate if the fund is unable to sufficiently recover 
and reaches a higher level of stress? How would investors view gates?
    Should there be exemptions to a fee or a gate based on the type of 
fund or investor? For example, should retail accounts or funds be 
exempt? If so, should such an exemption be based on account size? How 
could such exemptions work with omnibus accounts? Should there be 
exemptions for very small withdrawals? If so, what size? Should there 
be exemptions for Treasury or government MMFs?
    The Council also requests comment on how a standby liquidity fee or 
gate would alter investors' view of MMFs.\116\ How might it impact the 
size of the MMF industry? How would the impact be different if the fee 
were mandatory or discretionary?
---------------------------------------------------------------------------

    \116\ On the one hand, see Comment Letter of Fidelity 
Investments, SEC File No. 4-619 (Feb. 3, 2012) (stating that in a 
survey of their retail money market fund customers 43 percent stated 
that they would stop using a money market fund with a 1 percent non-
refundable redemption fee charged if the fund's NAV per share fell 
below $0.9975 and 27 percent would decrease their use of such a 
fund). But see Comment Letter of BlackRock on the IOSCO Consultation 
Report on Money Market Fund Systemic Risk Analysis and Reform 
Options (May 28, 2012) (``based on our client discussions, standby 
liquidity fees are less likely to cause clients to abandon the 
product in large numbers.'').
---------------------------------------------------------------------------

VI. Consideration of the Economic Impact of Proposed Reform 
Recommendations on Long-Term Economic Growth

    Under Section 120 of the Dodd-Frank Act, the Council is required to 
``take costs to long-term economic growth into account'' when 
recommending new or heightened standards and safeguards for a financial 
activity. If the SEC accepts the Council's recommendation, it is 
expected that the SEC would implement the recommendation through a 
rulemaking, subject to public comment, that would consider the economic 
consequences of the implementing rule as informed by the SEC staff's 
own economic study and analysis.\117\
---------------------------------------------------------------------------

    \117\ The Regulatory Flexibility Act (RFA) (5 U.S.C. 601-612) 
provides that whenever an agency is required by 5 U.S.C. 553, or any 
other law, to publish general notice of proposed rulemaking for any 
proposed rule, the agency must either provide an initial regulatory 
flexibility analysis or certify that the proposed rule will not have 
a significant economic impact on a substantial number of small 
entities. Because these proposed recommendations are not a ``rule'' 
for purposes of the RFA, neither an initial regulatory flexibility 
analysis nor certification by the Council is required. However, in 
any case, these proposed recommendations would not have a 
significant economic impact on a substantial number of small 
entities because the proposed recommendations would directly impact 
only the SEC, and any rulemakings by the SEC imposing the 
recommended standards would be expected to apply only to MMFs, of 
which few, if any, are believed to be small entities.

---------------------------------------------------------------------------

[[Page 69480]]

    The financial crisis demonstrated that MMFs' activities and 
practices make them susceptible to runs that can have destabilizing 
implications for financial markets and the broader economy. If 
investors perceive a risk of even small losses, MMFs' lack of explicit 
loss-absorption capacity, the first-mover advantage enjoyed by 
redeeming investors, investor uncertainty regarding sponsor support, 
and the similarity of MMFs' portfolios can incite widespread runs on 
MMFs. Due to the significant role MMFs play in the short-term credit 
markets, an industry-wide run on MMFs can reduce the availability of 
credit to borrowers. During the financial crisis, despite government 
intervention, the run on the MMF industry led to rapid disinvestment by 
MMFs of short-term instruments which severely exacerbated stress in 
already strained financial markets.
    The Council expects that the proposed recommendations would 
significantly reduce the risk of runs on MMFs and, accordingly, lower 
the risk of a significant long-term cost to economic growth.\118\ 
Specifically, the proposed recommendations could bolster the resilience 
and stability of MMFs during periods of financial stress, and reduce 
the severity of financial crises. Given the large adverse effects of 
financial crises on real GDP, such reductions imply important expected 
benefits. At the same time, the proposed recommendations described in 
Section V could lead to an increase in the cost of lending that MMFs 
provide, which could reduce economic growth in normal periods.\119\ 
However, even assumptions that would tend to overstate these potential 
costs suggest a very small increase in the weighted-average cost of 
credit for U.S. businesses, households, and state and local 
governments, with commensurately small potential costs to long-term 
economic growth.
---------------------------------------------------------------------------

    \118\ In the consideration herein, long-term economic growth 
refers to the average rate of change of overall economic activity, 
as measured by the rate of change in real GDP (that is, GDP measured 
in constant dollars) over an extended period. Specifically, we 
consider expected costs and benefits over a horizon sufficient to 
include a transition period and the potential costs and benefits 
with respect to long-term capital formation and a diminished 
probability and severity of future financial crises. As such, these 
costs and benefits are likely to accrue over a period of a decade or 
substantially longer. The potential benefits of the proposed 
recommendations, in terms of long-term economic growth, arise from 
the higher level of economic activity expected to prevail from a 
reduction in the likelihood or severity of a financial crisis and 
the consequent adverse effects on investment and overall spending; 
similarly, the potential costs in terms of long-term economic growth 
stem from the reduced level of spending that may accompany higher 
costs of financing investment and other outlays. Such positive or 
negative effects on the level of real GDP would raise or lower the 
growth rate of economic activity in future years relative to the 
levels expected to prevail absent adoption of the recommendations.
    \119\ Policymakers with responsibility for mitigating systemic 
risks may face an economic tradeoff between accepting higher costs 
in normal times in order to significantly reduce the costs of 
financial crises. Systemic risks are an externality that individual 
firms would not, on their own, seek to mitigate efficiently, because 
they would bear the full costs of doing so while the benefits would 
accrue to the broader financial system and the economy.
---------------------------------------------------------------------------

    The Council's consideration of the cost to long-term economic 
growth is based on the potential effects of the proposed 
recommendations on the rates at which MMFs would lend to borrowers and 
the consequent effects of such higher borrowing costs on investment and 
other spending by U.S. businesses, households, and governments. The 
consideration assesses the cost of financing an NAV buffer for MMFs and 
how this could increase the lending rates of MMFs. For example, 
Alternatives Two and Three contemplate MMFs raising NAV buffers that 
would replace some short-term claims with longer-term, subordinated 
claims to absorb fluctuations in the value of the fund's assets. The 
longer-term, subordinated claims may raise costs because providers of 
the NAV buffer will require a higher return for their greater term, 
credit, and liquidity risk. This assumes a required return for NAV 
buffers based on historical experience in the United States for claims 
subject to similar risks and duration. This assumed return is used to 
estimate an implied increase in the rates at which MMF would lend if 
they were to raise an NAV buffer. Although the NAV buffer would 
diminish the risks associated with MMF shares it is assumed that the 
required returns on those claims (net yields paid to shareholders) 
would not decline.
    In addition, for the purposes of this consideration, the Council 
has assumed that borrowers will not shift borrowing away from MMFs and 
as a result will be forced to fully absorb this higher cost. If 
substitution toward other sources of credit were considered, the 
estimated cost to economic growth likely would be smaller. In 
particular, if MMFs are not able to pass through their higher costs, 
and instead were forced to absorb some of the costs in the form of 
reduced profits for sponsors or lower yields for MMF shareholders, the 
costs to economic growth through the borrowing-cost channel would be 
lower. There may be economic impacts associated with lower profits for 
MMF sponsors if they are unable to pass through initial transition 
costs or higher operating costs, but the impact of such costs on long-
term economic growth are likely to be less direct and smaller than the 
costs that affect borrowing rates.
    There are substantial uncertainties around estimates of both the 
benefits and the costs to long-term economic growth. Moreover, both the 
benefits and costs to economic growth would vary for the different 
alternatives set forth in section V.
    Estimated costs to long-term economic growth. The cost of a 3 
percent NAV buffer in Alternative Three is the component of the 
proposed recommendations that may have the most direct and largest 
effect on lending costs. The cost of financing a 3 percent NAV buffer 
would depend on providers' required return for absorbing first losses 
from any fluctuations in the value of MMF portfolios, particularly the 
declines in value that might result from credit losses. To put this 
required return in context, a range of riskier investment returns are 
considered. The yield on a ten-year BBB-rated corporate bond has 
averaged 6.5 percent since 1997, while prime MMF gross yields have 
averaged 3.2 percent over the same period, indicating an estimate of a 
spread for longer-term claims of 3.3 percentage points over the past 15 
years. Another estimate of the additional required return is based on 
the long-run required return to equity, which is estimated to be about 
9.0 percent since 1997, suggesting a spread to prime MMF gross yields 
of 5.8 percentage points. These calculations suggest reasonable 
assumptions for the additional required return can range from 3.3 
percentage points to 5.8 percentage points. Hence, the remainder of 
this discussion of lending costs assumes a 5 percentage point 
additional required return.
    Under the assumption that MMFs would fully pass on this additional 
cost to borrowers, the rate at which MMFs would lend would increase by 
0.05 percentage points for each percentage point of short-term claims 
replaced by subordinated, longer-term claims. To the extent that higher 
costs result in lower net yields for MMF shareholders, and as a result 
are not passed on fully to borrowers, the estimated impact on costs to 
long-term economic growth through borrowing costs would be smaller.
    This increased lending rate would impact economic growth through 
its effect on the weighted-average borrowing costs of U.S. businesses,

[[Page 69481]]

households, and state and local governments that obtain financing, 
directly or indirectly, from MMFs. However, while MMFs provide such 
financing through a variety of channels and play a significant role in 
a number of credit markets (as discussed in Section IV), the total 
credit that they supply is relatively small compared to aggregate 
nonfederal, nonfinancial debt outstanding.
    As of June 30, 2012, the financing provided by MMFs included their 
holdings of $35 billion in domestic nonfinancial unsecured CP and $341 
billion in municipal securities. MMFs also held $117 billion in ABCP, 
which is often backed by loans to businesses and households (for 
example, credit card and other receivables),\120\ and $60 billion in 
other notes and instruments issued by U.S. firms. In addition, MMFs 
purchase the debt of financial institutions and government agencies 
that themselves provide credit to businesses, households, and state and 
local governments, including $56 billion in securities issued by U.S. 
financial institutions, $396 billion of securities issued by U.S. 
government agencies and government-sponsored enterprises (``GSEs''), 
and $323 billion in repo backed by such securities. MMFs also held $71 
billion in repo backed by securities other than U.S. government 
securities, which may include nonfinancial business debt and asset-
backed securities.\121\
---------------------------------------------------------------------------

    \120\ Based on data reported to the SEC on Form N-MFP. This 
total includes all ABCP held by MMFs, not just paper issued by ABCP 
programs with U.S. sponsors, since foreign-sponsored ABCP conduits 
purchase the obligations of U.S. businesses and households.
    \121\ This total includes all such repo held by MMFs, not just 
repo conducted with U.S. counterparties, since repo with foreign 
counterparties may be used to finance the obligations of U.S. 
businesses and households.
---------------------------------------------------------------------------

    Under the assumption that MMF financing for financial institutions, 
government agencies, and GSEs is ultimately used to provide credit to 
businesses, households, and state and local governments, this data 
suggests that MMFs provided direct and indirect credit of as much as 
$1,400 billion to businesses, households, and state and local 
governments. While significant, this amount represented only 5 percent 
of the total debt outstanding of U.S. businesses, households, and state 
and local governments, which was $27,874 billion as of June 30, 
2012.\122\
---------------------------------------------------------------------------

    \122\ Based on the Flow of Funds Accounts of the United States. 
A similar analysis focusing only on business debt indicates that 
financing provided by MMFs represented less than 3 percent of all 
nonfinancial business debt at the end of June 2012. Indeed, 
relatively few firms rely heavily on short-term financing through 
the types of instruments held by MMFs. See Paolo Colla, Filippo 
Ippolito, and Kai Li, ``Debt specialization,'' Working Paper, 
University of British Columbia (2011) (showing that, among a sample 
of roughly 3,000 publicly traded firms, 0.1 percent of firms 
obtained more than 90 percent of their total debt financing from CP, 
but 26 percent of firms obtained more than 90 percent of their debt 
financing from senior bonds and notes).
---------------------------------------------------------------------------

    Based on this share of total debt outstanding and the estimated 
0.05 percentage point increase in MMF lending rates per percentage 
point of capital, this implies that the weighted-average cost of credit 
for businesses, households, and state and local governments would 
increase 0.0075 percentage points if the required NAV buffer were 3 
percent.\123\ As already noted, this estimate assumes that the costs of 
the buffer are passed on entirely to businesses, households, and state 
and local governments that ultimately obtain credit directly or 
indirectly from MMFs, rather than absorbed by MMF shareholders, asset 
management firms, or other financial intermediaries. This assumption 
leads to a larger estimated increase in borrowing costs for the 
nonfinancial sector than would occur if MMF shareholders or others 
absorbed some of the cost. The estimate also assumes that other 
providers of short-term funding do not increase their lending rates.
---------------------------------------------------------------------------

    \123\ This figure reflects the assumption that MMF lending rates 
would increase 0.15 percentage points in total and the fact that MMF 
lending could represent as much as 5 percent of overall borrowing 
for these entities.
---------------------------------------------------------------------------

    The small estimated increment to borrowing costs implies that the 
potential costs to long-term economic growth also would be small. An 
illustration of the magnitude of such effects can be derived using 
recent analyses that model the effects of higher interest spreads on 
economic activity. For example, the Macroeconomic Assessment Group 
(established by the Financial Stability Board and the Basel Committee 
on Banking Supervision) examined the impact of higher borrowing costs 
on aggregate output. Based on that group's standard approach, an 
increase in borrowing spreads of 15 basis points was associated with 
median expected reductions in GDP for 32 quarters ahead (the longest 
horizon considered in the report) of 0.10 percent.\124\ Importantly, 
these estimates incorporated reduced loan volumes as well as higher 
lending spreads. Scaling these estimates, the 0.0075 percentage point 
increment in borrowing costs for U.S. businesses, households, and state 
and local governments translates into an 0.005 percent reduction in 
output 32 quarters after the capital requirement is imposed. In terms 
of per-year economic growth, this level effect is very small.
---------------------------------------------------------------------------

    \124\ There is considerable uncertainty around these estimates. 
Nonetheless, the overall effects remain modest across the range of 
assumptions considered in this study. For a discussion of this 
range, see Macroeconomic Assessment Group, ``Interim Report: 
Assessing the macroeconomic impact of the transition to stronger 
capital and liquidity requirements,'' Bank for International 
Settlements (Aug. 2010), at 18.
---------------------------------------------------------------------------

    Estimated benefits for long-term economic growth. As noted in 
Section IV, several activities and practices of MMFs combine to make 
them vulnerable to runs. Because of MMFs' lack of loss-absorption 
capacity, the first-mover advantage enjoyed by redeeming investors, and 
investor uncertainty regarding sponsor support, a run on a single MMF 
can spread quickly to other funds, as MMF investors seek to minimize 
losses in funds with potentially correlated portfolio holdings. Due to 
the fact that MMFs are large and highly interconnected with the rest of 
the financial system and can act as a channel for transmission of risks 
and contagion, a run on MMFs can create or increase the risk of 
significant liquidity, credit, or other problems spreading among bank 
holding companies, nonbank financial companies, and U.S. financial 
markets.
    By reducing the likelihood of runs on MMFs, the proposed 
recommendations would be expected to diminish the severity of financial 
crises. The Council acknowledges the inherent difficulty in assigning a 
probability to runs on MMFs and how such runs could contribute to a 
financial crisis. Nonetheless, the very high degree of 
interconnectedness of MMFs and other parts of the financial system 
indicates that runs on MMFs and subsequent disruptions to financing are 
likely to occur at the same time when other parts of the financial 
system also are under stress, so runs on MMFs would be expected to 
increase the severity of a crisis. Indeed, the run in September 2008 
exacerbated already severe strains in financial markets and contributed 
to a broader curtailment in the availability of credit. In addition, as 
described in section IV, some evidence suggests that institutional 
investors have become more attuned to MMF risks in the aftermath of the 
financial crisis, which may make them more prone to runs.
    Reducing the likelihood of financial crises or the damage that they 
cause would have large salutary effects on long-term economic growth. A 
recent review of multiple studies documents extensive evidence that 
financial crises have large adverse effects on economic activity over 
an extended period. Estimated costs of financial crises ranged from 
about 20 percent to more

[[Page 69482]]

than 150 percent of real GDP, depending on whether the effects of the 
crisis are transitory or permanent, with a central tendency of about 60 
percent of real GDP.\125\ Given these large costs, reforms that even 
modestly reduce the probability or severity of a financial crisis would 
have considerable benefits in terms of greater expected economic 
activity and, therefore, higher expected economic growth.
---------------------------------------------------------------------------

    \125\ See Basel Committee on Banking Supervision, ``An 
assessment of the long-term economic impact of stronger capital and 
liquidity requirements,'' Bank for International Settlements (Aug. 
2010), at 12-13.
---------------------------------------------------------------------------

    Effects of other alternatives. This consideration of the impact on 
long-term economic growth of the proposed recommendations in Section V 
focuses on the significant NAV buffer in Alternative Three because, 
among the different alternatives set forth in section V, that component 
would have the most direct potential effect on borrowing costs. 
Alternative Two would require a smaller NAV buffer than Alternative 
Three, so the direct effect on MMF lending rates under Alternative Two 
would be smaller. However, the 3 percent MBR in Alternative Two would 
reduce the liquidity of investments in MMFs for large investors. While 
the effects of such a reduction in investors' liquidity on borrowing 
costs are less clear, they are not likely to exceed those associated 
with financing a larger NAV buffer.\126\ Because the Council views both 
Alternatives Two and Three as means of reducing the structural 
vulnerabilities of MMFs, Alternative Two's smaller NAV buffer and 3 
percent MBR could be expected to have similar benefits for long-term 
economic growth as Alternative Three.
---------------------------------------------------------------------------

    \126\ In the extreme, each investor subject to an MBR that 
desired to maintain full liquidity might maintain an extra balance 
of approximately 3 percent to main that liquidity, so MMF 
shareholders themselves effectively would provide a buffer equal to 
the size of the MBR.
---------------------------------------------------------------------------

    Alternative One, which would mandate that MMFs adopt a floating 
NAV, would not require that MMFs have an NAV buffer or other 
protections that would be required of MMFs under Alternatives Two or 
Three. When evaluated using the methodology described above, 
Alternative One likely would have a smaller direct impact on borrowing 
costs and hence smaller costs to long-term economic growth than the 
other alternatives. However, the adoption of Alternative One in 
isolation, and hence a requirement that all MMFs adopt a floating NAV, 
could prompt shifts by MMF shareholders away from MMFs to alternative 
cash-management or investment products that maintain stable NAVs. Such 
a shift could reduce the expected benefits if the alternative products 
were vulnerable to runs.
    The scope of the reform package that is adopted will affect 
investors' demand for MMFs and the costs to long-term economic growth. 
A package of reforms that allows asset managers to offer different 
types of MMFs would allow investors to choose the MMF that best suits 
their preferences. For example, if the range of options includes both 
floating NAV and stable NAV funds (with additional protection provided 
by an NAV buffer, an MBR, or a portfolio that is limited to Treasury 
securities or Treasury repo), investors who are willing to sacrifice 
some principal stability might choose the floating NAV funds, those 
willing to sacrifice some yield might choose a Treasury-only MMF or a 
fund with a significant NAV buffer, and those willing to sacrifice some 
liquidity might prefer a fund with an MBR.\127\ Hence, a broad range of 
options could reduce the likely impact of the recommended reforms on 
demand for all MMFs while preserving the net benefits to long-term 
economic growth that would result from the reduced vulnerability of 
MMFs to destabilizing runs.
---------------------------------------------------------------------------

    \127\ Such investor sorting may indeed be beneficial, since the 
most risk-averse, run-prone investors would likely invest in 
Treasury funds or MMFs with substantial NAV buffers or other 
protections.
---------------------------------------------------------------------------

    Uncertainty regarding estimates of costs and benefits for long-term 
economic growth. There are substantial uncertainties around the 
estimates of costs to long-term economic growth. Several assumptions 
noted above, including a full pass-through of higher costs to 
borrowers, attempt to produce a conservative estimate of the costs to 
long-term economic growth. To the extent that borrowers substitute away 
from the short-term financing provided by MMFs, for example, and sell 
short-term instruments directly to investors or to other types of cash-
management vehicles, costs to long-term economic growth could be 
smaller. As noted above, however, such substitution would reduce 
expected benefits for long-term economic growth if investors move money 
to products that are vulnerable to runs.
    Of course, some factors could lead to larger estimated costs to 
economic growth. For example, the estimated effects on the weighted-
average cost of credit could be larger if short-term funding markets 
were to become less liquid, raising the costs of short-term funding 
provided by other lenders. But the overall effect of a broader increase 
in short-term rates on the weighted-average cost of capital would still 
be minimal, given the small share of business, household, and state and 
local government debt that is short-term. For example, commercial paper 
outstanding accounted for just 1.1 percent of domestic nonfinancial 
business debt on June 30, 2012.\128\ There could be costs that are 
associated with lower profits or shrinkage for MMF sponsors if they are 
not able to fully pass on higher costs or are capital constrained and 
cannot quickly and economically build an NAV buffer. However, lower 
profits and transition costs associated with building the buffer are 
not likely to have a significant direct effect on long-term economic 
growth. In addition, the estimates from the macroeconomic studies cited 
above suggest some uncertainty about the drag on economic activity from 
higher borrowing costs.
---------------------------------------------------------------------------

    \128\ Based on the Flow of Funds Accounts of the United States.
---------------------------------------------------------------------------

    Expected benefits could be diminished if investors switched to 
alternative cash-management vehicles because MMFs become less 
attractive. If those cash-management vehicles are themselves vulnerable 
to runs and are also interconnected with other parts of the financial 
system, the benefits to long-term economic growth that result from 
mitigating the probability and severity of financial crises could be 
reduced. Nonetheless, the expected reductions in the probability or 
severity of crises associated with MMF reform would imply a sizable net 
benefit in terms of higher expected economic growth, given the very 
large costs of financial crises on economic output. Moreover, the 
Council and its members intend to use their authorities, where 
appropriate and within their jurisdictions, to reduce or eliminate 
regulatory gaps to address any risks to financial stability that may 
arise from dissimilar standards for other cash-management products with 
risks similar to MMFs.

Questions

    How can the assumptions used to estimate costs to long-term 
economic growth be further refined?
    For each of the alternative reform proposals, what do you estimate 
would be the effect on the total AUM in MMFs? For each of your 
estimates, what are your underlying assumptions? Given these estimates, 
what would be the effect on long-term economic growth of such change in 
the total AUM of MMFs?
    Which features, if any, of the alternatives would potentially make 
MMFs less attractive to investors? If MMFs became less attractive to 
potential shareholders, where would

[[Page 69483]]

they invest their funds? Would institutional customers or retail 
investors be more likely to withdraw funds? What alternative cash-
management vehicles would investors likely move to? Would this affect 
the expected benefits of MMF reform? What impact would this have upon 
the credit markets in which MMFs invest? How should the role of other 
financial intermediaries be considered? What risks could that pose for 
financial stability?
    If MMFs became less attractive to potential borrowers, how might 
they change their financing methods? Would this affect the expected 
costs or benefits of MMF reform for long-term economic growth?
    Would yields on redeemable MMF shares decline, in light of 
reductions in risk? Would there be additional costs to long-term 
economic growth from reduced yields to MMF shareholders? If yes, what 
would they be?
    Would a reduction in profits for MMFs sponsors absorb some of the 
increase in costs? How would their reduced profits affect long-term 
economic growth?
    Are there factors other than borrowing costs, reduced yields to 
shareholders, and reduced profits for MMF sponsors that may be expected 
to impact long-term economic growth?
    Would higher short-term borrowing rates from MMFs affect other 
short-term borrowing rates? Are BBB corporate rates and the equity risk 
premium appropriate proxies for the returns likely to be demanded by 
providers of the NAV buffer? How should reductions in the structural 
vulnerability of MMFs impact the potential probability of a financial 
crisis? The severity of such a crisis? What additional benefits to 
long-term economic growth might result from reductions in the 
structural vulnerability of MMFs?

    Dated: November 13, 2012.
Rebecca H. Ewing,
Executive Secretary, Department of the Treasury.
[FR Doc. 2012-28041 Filed 11-16-12; 8:45 am]
BILLING CODE P