[Federal Register Volume 75, Number 215 (Monday, November 8, 2010)]
[Notices]
[Pages 68636-68654]
[FR Doc No: 2010-28177]

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SECURITIES AND EXCHANGE COMMISSION

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

President's Working Group Report on Money Market Fund Reform

AGENCY: Securities and Exchange Commission.

ACTION: Request for comment.

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

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

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

Electronic Comments

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

Paper Comments

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

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

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

FOR FURTHER INFORMATION CONTACT: Daniele Marchesani or Sarah ten
Siethoff at<PHONE_NUMBER>, Division of Investment Management,
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549-8549.

SUPPLEMENTARY INFORMATION:

I. The President's Working Group Report

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

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

     Dated: November 3, 2010.

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

Executive Summary

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

Executive Summary

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

MMFs Are Susceptible to Runs

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

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

The SEC's New Rules

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

The Need for Further Measures

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

Policy Options

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

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

asset value (NAV) per share, typically $1, through the use of the
``amortized cost'' method of valuation. Under this method, securities
are valued at acquisition cost, with adjustments for amortization of
premium or accretion of discount, instead of at fair market value. To
prevent substantial deviations between the $1 share price and the mark-
to-market per-share value of the fund's assets (its ``shadow NAV''), a
MMF must periodically compare the two. If there is a difference of more
than one-half of 1 percent (or $0.005 per share), the fund must re-
price its shares, an event colloquially known as ``breaking the buck.''
    Historically, the stable NAV has played an important role in
distinguishing MMFs from other mutual funds and in facilitating the use
of MMFs as cash management vehicles. Rule 2a-7 also imposes credit-
quality, maturity, and diversification requirements on MMF portfolios
designed to ensure that the funds' investing remains consistent with
the objective of maintaining a stable NAV. A MMF's $1 share price is
not guaranteed through any form of deposit or other insurance, or
otherwise--indeed, MMF prospectuses must state that shares can lose
value. However, by permitting amortized cost valuation, rule 2a-7
affords MMFs price stability under normal market conditions.
    MMFs pursue a range of investment objectives, with corresponding
differences in portfolio composition. For example, tax-exempt MMFs
purchase short-term municipal securities and offer tax-exempt income to
fund shareholders, while Treasury-only MMFs hold only obligations of
the U.S. Treasury. In contrast, prime MMFs invest largely in private
debt instruments, such as commercial paper and certificates of deposit,
and, commensurate with the greater risks in prime MMF portfolios, they
generally pay higher yields than Treasury-only funds.
    MMFs are marketed both to retail investors (that is, individuals),
for whom MMFs are the only means of investing in many money market
instruments, and to institutions, which are often attracted by the
convenience and cost efficiency of MMFs, even though many institutional
investors have the ability to invest directly in the instruments held
by MMFs. Institutional MMFs, which currently account for about two-
thirds of the assets under management in MMFs, have grown much faster,
on net, in the past two decades than retail funds. The rapid growth of
institutional funds has important implications for the MMF industry,
because institutional funds tend to have more volatile flows and more
yield-sensitive shareholders than retail funds.
    MMFs compete with other stable-value, low-risk investments. Because
MMFs generally maintain stable NAVs, offer redemptions on demand, and
often provide services that compete with those offered to holders of
insured deposits (such as transactions services), many retail customers
likely consider MMF shares and bank deposits as near substitutes, even
if the two classes of products are fundamentally different (most
notably because MMF shares are not insured and because MMFs and banks
are subject to very different regulatory regimes). Some institutional
investors may also view bank deposits and MMFs as near substitutes,
although usual limitations on deposit insurance coverage and interest
payments on deposits likely reduce the attractiveness of bank deposits
for most such investors.\8\ Institutional investors also have access to
less-regulated MMF substitutes (for example, offshore MMFs, enhanced
cash funds, and other stable value vehicles) and may perceive them as
near substitutes for MMFs, even if those vehicles are not subject to
the protections afforded by rule 2a-7.
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    \8\ Under the Federal Deposit Insurance Corporation's (FDIC)
Temporary Liquidity Guarantee Program, coverage limits on
noninterest-bearing transaction deposits in FDIC-insured
institutions were temporarily lifted beginning in October 2008 and
coverage will extend through 2010. Effective December 31, 2010,
pursuant to the Dodd-Frank Wall Street Reform and Consumer
Protection Act, Public Law 111-203, (``Dodd-Frank Act''), all
noninterest-bearing transaction deposits will have unlimited
coverage until January 1, 2013. In addition, section 627 of the
Dodd-Frank Act repeals the prohibition on banks paying interest on
corporate demand deposit accounts effective July 21, 2011.
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b. MMFs' Susceptibility to Runs
    In the twenty-seven years since the adoption of rule 2a-7, only two
MMFs have broken the buck. In 1994, a small MMF suffered a capital loss
because of exposures to interest rate derivatives, but the event passed
without significant repercussions. In contrast, as further discussed
later, when the Reserve Primary Fund broke the buck in September 2008,
it helped ignite a massive run on prime MMFs that contributed to severe
dislocations in short-term credit markets and strains on the businesses
and institutions that obtain funding in those markets.\9\
---------------------------------------------------------------------------

    \9\ Section 1(c) contains more detail on the MMF industry's
experience during the recent financial crisis.
---------------------------------------------------------------------------

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

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

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

    (iv) Discretionary sponsor capital support. MMFs invest in assets
that may lose value, but the funds have no formal capital buffers or
insurance to maintain their $1 share prices in the event of a loss on a
portfolio asset.
    The MMF industry's record of maintaining a stable NAV reflects, in
part, substantial discretionary intervention by MMF sponsors (that is,
fund advisers, their affiliates, and their parent firms) to support
funds that otherwise might have broken the buck.\11\ Sponsors do not
commit to support an MMF in advance, because an explicit commitment may
require the sponsor to consolidate the fund on its balance sheet and--
if the sponsor is subject to regulatory capital requirements--hold
additional regulatory capital against the contingent exposure. Nor is
there any requirement that sponsors support ailing MMFs; such a mandate
would transform the nature of MMF shares by shifting risks from
investors to sponsors and probably would require government supervision
and monitoring of sponsors' resources and capital adequacy.\12\
Instead, sponsor capital support remains expressly voluntary, and not
all MMFs have a sponsor capable of fully supporting its MMFs.
Nonetheless, a long history of such support probably has contributed
substantially to the perceived safety of MMFs.
---------------------------------------------------------------------------

    \11\ For example, more than 100 MMFs received sponsor capital
support in 2007 and 2008 because of investments in securities that
lost value and because of the run on MMFs in September and October
2008. See Securities and Exchange Commission (2009) ``Money Market
Reform: Proposed Rule,'' pp. 13-14, 17, and notes 38 and 54.
    \12\ Even discretionary support for MMFs may lead to concerns
about the safety and soundness of MMF sponsors. Sponsors that foster
expectations of such support may be granting a form of implicit
recourse that is not reflected on sponsors' balance sheets or in
their regulatory capital ratios, and such implicit recourse may
contribute to broader systemic risk.
---------------------------------------------------------------------------

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    Of the five features that make MMFs vulnerable to runs (see section
1(b)), the two most directly addressed in the new SEC rules are
liquidity risks associated with maturity transformation and MMF
portfolios' exposures to credit and interest-rate risks. The SEC's new
rules should substantially reduce these risks, but systemic risks
arising from the other features of MMFs and their investors--the
stable, rounded NAV, a system of discretionary sponsor support, and a
highly risk-averse investor base--still remain, as do many of the
amplifying interaction effects. Some mitigation of the destabilizing
effects that one or a few MMFs can impose on the rest of the industry
through contagion might be achievable through further modifications to
rule 2a-7 and other SEC rules. Importantly, however, other reforms that
could more substantially reduce the risk of contagion and that, as
such, merit further consideration, would require action beyond what the
SEC could achieve under its current authority.
    Mitigating the risk of runs before another liquidity crisis
materializes is especially important because the events of September
2008 may have induced expectations of government assistance at minimal
cost in case of severe financial strains. Market participants know, and
recent events have confirmed, that when runs on MMFs occur, the
government will face substantial pressure to intervene in some manner
to minimize the propagation of financial strains to short-term funding
markets and to the real economy. Importantly, such interventions would
be intended not only to reduce harm to MMF investors but also to
prevent disruptions of markets for commercial paper and other short-
term financing instruments, which are critical for the functioning of
the economy. Therefore, if further measures to insulate the industry
from systemic risk are not taken before the next liquidity crisis,
market participants will likely expect that the government would
provide emergency support at minimal cost for MMFs during the next
crisis. Such market expectations of (hypothetical) future non-priced or
subsidized government support would distort incentives for MMFs and
prices in short-term funding markets and would potentially increase the
systemic risk posed by MMFs. To forestall these perverse effects, it is
thus imperative that MMFs be required to internalize fully the costs of
liquidity or other risks associated with their operation.
    MMF regulatory reform in light of the run on MMFs in September and
October 2008. The run on MMFs in 2008 provides some important lessons
for evaluating potential reforms for mitigating systemic risk. For
example, the triggering events of the run and the magnitude of the
outflows that followed underscore the difficulty of designing reforms
that might prevent runs and the associated damage to the financial
system.
    Making each individual MMF robust enough to survive a crisis of the
size of that experienced in 2008 may not be an appropriate policy
objective because it would unduly limit risk taking. Indeed, although
the SEC's tightening of restrictions on the liquidity, interest-rate,
and credit risks borne by individual MMFs will be helpful in making
MMFs more resilient to future strains, there are practical limits to
the degree of systemic risk mitigation that can be achieved through
further restrictions of this type. For example, an objective of
preventing any MMF from breaking the buck probably would not be
feasible for funds that invest in private debt markets. Changes that
would prevent funds from breaking the buck due to a single Lehman
Brothers-like exposure would have to be severe: Only limiting funds'
exposures to each issuer to less than one-half of 1 percent of assets
would prevent a precipitous drop in the value of any single issuer's
debt from causing a MMF to break the buck.\20\ But even such a limit on
exposure to a single issuer would not address the risk that MMFs may
accumulate exposures to distinct but highly correlated issuers, and
that funds would remain vulnerable to events that cause the debt of
multiple issuers to lose value.
---------------------------------------------------------------------------

    \20\ At the time of its bankruptcy, Lehman Brothers' short-term
debt was still a first-tier security, so MMFs were able to hold up
to 5 percent of their assets in Lehman Brothers' debt. The SEC's new
rules do not affect this limit.
---------------------------------------------------------------------------

    Beyond diversification limits, new rules to protect MMFs from
material credit losses would be difficult to craft unless regulators
take the extreme step of eliminating funds' ability to hold any risky
assets. But that approach would be clearly undesirable, as it would
adversely affect many firms that obtain short-term financing through
commercial paper and similar instruments. In addition, such an extreme
approach would deny many retail investors any opportunity to obtain
exposure to private money market instruments and most likely would
motivate some institutional investors to shift assets from MMFs to less
regulated vehicles.
    Similarly, liquidity requirements sufficient to cover all
redemption scenarios for MMFs probably would be impractical and
inefficient. The SEC's new liquidity requirements help mitigate
liquidity risks borne by the funds, and if MMFs had held enough liquid
assets in September 2008 to meet the new liquidity requirements, each
MMF would have had adequate daily liquidity to meet redemption requests
on most individual days during the run. Even so, the cumulative effect
of severe outflows on consecutive days would have exceeded many funds'
liquidity buffers. Moreover, without external support in 2008--
specifically, the introduction of the Treasury's Temporary Guarantee
Program for Money Market Funds and the Federal Reserve's AMLF--outflows
likely would have continued and been much larger, and they would have
forced substantial sales of assets to meet redemptions. Such asset
sales would have contributed to severe strains in short-term markets,
depressed asset prices, caused capital losses for MMFs, and prompted
further shareholder flight. Hence, MMFs' experience during the run in
2008 indicates that the new SEC liquidity requirements make individual
MMFs more resilient to shocks but still leave them susceptible to runs
of substantial scale.
    Raising the liquidity requirements enough so that each MMF would
hold adequate daily liquidity to withstand a large-scale run would be a
severe constraint and would fail to take advantage of risk-pooling
opportunities that might be exploited by external sources of liquidity.
During the run in 2008, individual MMFs experienced large variations in
the timing and magnitude of their redemptions. Liquidity requirements
stringent enough to ensure that every individual MMF could have met
redemptions without selling assets would have left most of the industry
with far too much liquidity, even during the run, and would have
created additional liquidity risks for issuers of short-term
securities, since these issuers would have had to roll over paper more
frequently. Some of the approaches discussed in section 3 are aimed at
buttressing the SEC's new minimum liquidity requirements without simply
increasing their magnitude.
    Finally, the run on MMFs in 2008 demonstrated the systemic threat
that such runs may represent. Without additional reforms to more fully
mitigate the risk of a run spreading among MMFs, the actions to support
the MMF industry that the U.S. government took beginning in 2008 may
create an expectation for similar government support during future
financial crises, and the resulting moral hazard may make crises in the
MMF industry more

frequent than the historical record would suggest. Accordingly, despite
the risk reduction that should be achieved by the initial set of new
SEC rules, policymakers should explore the advantages and disadvantages
of implementing further reforms before another crisis materializes.
3. Policy Options for Further Reducing the Risks of Runs on MMFs
    This section discusses a range of options for further mitigation of
the systemic risks posed by MMFs. The SEC requested comment on some of
these options, such as requiring that MMFs maintain a floating NAV or
requiring in kind redemptions in certain circumstances. In addition,
the SEC received comments proposing a two-tier system of MMFs in which
some funds maintain a stable NAV and others a floating NAV. Other
options discussed in this section go beyond what the SEC could
implement under existing authorities and would require legislation or
coordinated action by multiple government agencies and the MMF
industry. While the measures presented here, either individually or in
combination, would help diminish systemic risk, new restrictions
imposed solely on MMFs may reduce their appeal to some investors and
might cause some--primarily institutional--investors to move assets to
less regulated cash management substitutes. Many such funds, like MMFs,
seek to maintain a stable NAV and have other features that make them
vulnerable to runs, so such funds likely also would pose systemic
risks. Therefore, effective mitigation of MMFs' susceptibility to runs
may require policy reforms beyond those directed at registered MMFs to
address risks posed by funds that compete with MMFs. Such reforms,
which generally would require legislation, are discussed in section
3(h).
a. Floating Net Asset Values
    Historically, the $1 stable NAV that MMFs maintain under rule 2a-7
has been a key element of their appeal to a broad range of investors,
and the stable NAV has contributed to a dramatic expansion in MMFs'
assets over the past two decades. At the same time, as noted in section
1(b), the stable, rounded NAV is one of the features that heighten the
vulnerability of MMFs to runs. The significance of MMFs in financial
markets and the central role of the stable, rounded NAV in making MMFs
appealing to investors and, at the same time, vulnerable to runs, make
careful discussion of the potential benefits and risks of moving MMFs
away from a stable NAV essential to a discussion of MMF reform.
    The stable, rounded NAVs of MMFs contribute to their vulnerability
to runs for several reasons.
     First, the stable, rounded NAV, coupled with MMF sponsors'
longstanding practice of supporting the stable NAV when funds have
encountered difficulties, has fostered investors' expectations that MMF
shares are risk-free cash equivalents. When the Reserve Primary Fund
failed to maintain those expectations in September 2008, the sudden
loss of investor confidence helped precipitate a generalized run on
MMFs. By making gains and losses a regular occurrence, as they are in
other mutual funds, a floating NAV could alter investor expectations
and make clear that MMFs are not risk-free vehicles. Thus, investors
might become more accustomed to and tolerant of NAV fluctuations and
less prone to sudden, destabilizing reactions in the face of even
modest losses. However, the substantial changes in investor
expectations that could result from a floating NAV also might motivate
investors to shift assets away from MMFs to banks or to unregulated
cash-management vehicles, and the effects of potentially large
movements of assets on the financial system should be considered
carefully. These issues are discussed in more detail later.
     Second, a rounded NAV may accelerate runs by amplifying
investors' incentives to redeem shares quickly if a fund is at risk of
a capital loss. When a MMF experiences a loss of less than one-half of
1 percent and continues to redeem shares at a rounded NAV of $1, it
offers redeeming shareholders an arbitrage opportunity by paying more
for the shares than the shares are worth. Simultaneously, the fund
drives down the expected future value of the shares because redemptions
at $1 per share further erode the fund's market-based per-share value--
and increase the likelihood that the fund will break the buck--as
losses on portfolio assets are spread over a shrinking asset base.
These dynamics are inherently unstable. Thus, even an investor who
otherwise might not choose to redeem may do so in recognition of other
shareholders' incentives to redeem and the effects of such redemptions
on a fund's expected NAV. The growth of institutional investment in
MMFs has exacerbated this instability because institutional investors
are better positioned than retail investors to identify potential
problems in a MMF's portfolio and rapidly withdraw significant amounts
of assets from the fund.
    In contrast, a floating NAV eliminates some of the incentives to
redeem when a MMF has experienced a loss. Because MMFs must redeem
shares at NAVs set after redemption requests are received, losses
incurred by a fund with a floating NAV are borne on a pro rata basis by
all shareholders, whether they redeem or not. Redemptions from such a
fund do not concentrate already incurred losses over a smaller asset
base and do not create clear arbitrage opportunities for investors.
However, as discussed below, a floating NAV does not eliminate the
incentive to redeem shares from a distressed MMF.
     Third, the SEC rules that permit funds to maintain a
stable, rounded NAV also force an abrupt decrease in price once the
difference between a fund's market-based shadow NAV and its $1 stable
NAV exceeds one-half of 1 percent. So, although NAV fluctuations are
rare in MMFs, when prices do decline, the change appears as a sudden
drop. This discontinuity heightens investors' incentives to redeem
shares before a loss is incurred, produces dire headlines, and probably
raises the chance of a panic.
    These considerations suggest that moving to a floating NAV would
reduce the systemic risk posed by MMFs to some extent. Under a required
floating NAV, MMFs would have to value their portfolio assets just like
any other mutual fund. That is, MMFs would not be able to round their
NAVs to $1 or use the accounting methods (for example, amortized cost
for portfolio securities with a maturity of greater than 60 days)
currently allowed under rule 2a-7.
    To be sure, a floating NAV itself would not eliminate entirely
MMFs' susceptibility to runs. Rational investors still would have an
incentive to redeem as fast as possible the shares of any MMF that is
at risk of depleting its liquidity buffer before that buffer is
exhausted, because subsequent redemptions may force the fund to dispose
of less-liquid assets and incur losses. However, investors would have
less of an incentive to run from MMFs with floating NAVs than from
those with stable, rounded NAVs.
    Notwithstanding the advantages of a floating NAV, elimination of
the stable NAV for MMFs would be a dramatic change for a nearly $3
trillion asset-management sector that has been built around the stable
$1 share price. Indeed, a switch to floating NAVs for MMFs raises
several concerns.
     First, such a change might reduce investor demand for MMFs
and thus diminish their capacity to supply credit to businesses,
financial institutions, state and local governments, and other

borrowers who obtain financing in short-term debt markets. MMFs are the
dominant providers of some types of credit, such as commercial paper
and short-term municipal debt, so a significant contraction of MMFs
might cause particular difficulties for borrowers who rely on these
instruments for financing. If the contraction were abrupt, redemptions
might cause severe disruptions for MMFs, the markets for the
instruments the funds hold, and borrowers who tap those markets. While
there is no direct evidence on the likely effect of a floating NAV on
the demand for MMFs, the risk of a substantial shift of assets away
from MMFs and into other vehicles should be weighed carefully. Assets
under management in MMFs dwarf those of their nearest substitutes, such
as, for example, ultra-short bond funds, most likely because ultra-
short bond funds are not viewed as cash substitutes. To the extent that
demand for stable NAV funds is boosted by investors who hold MMFs
because they perceive them to be risk-free, a reduction in demand for
these funds might be desirable.\21\ However, some investors face
functional obstacles to placing certain assets in floating NAV funds.
For example, internal investment guidelines may prevent corporate cash
managers from investing in floating NAV funds, some state laws allow
municipalities to invest only in stable-value funds, and fiduciary
obligations may prevent institutional investors from investing client
money in floating NAV funds. In addition, some investors may not
tolerate the loss of accounting convenience and tax efficiencies that
would result from a shift to a floating NAV, although these problems
might be mitigated somewhat through regulatory or legislative
actions.\22\
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    \21\ Even a contraction in the credit extended by MMFs might be
an efficient outcome if such credit has been over-supplied because
markets have not priced liquidity and systemic risks appropriately.
    \22\ A stable NAV relieves shareholders of the administrative
task of tracking the timing and price of purchase and sale
transactions for tax and accounting purposes. For investors using
MMFs for cash management, floating NAV funds (under current rules)
would present more record-keeping requirements than stable NAV
funds, although certain tax changes beginning in 2011 will require
mutual funds, including MMFs, to report the tax basis (presumably
using an average basis method) to shareholders and thereby help
reduce any associated accounting burden from a floating NAV.
---------------------------------------------------------------------------

     Second, a related concern is that elimination of MMFs'
stable NAVs may cause investors to shift assets to stable NAV
substitutes that are vulnerable to runs but subject to less regulation
than MMFs. In particular, many institutional investors might move
assets to less regulated or unregulated cash management vehicles, such
as offshore MMFs, enhanced cash funds, and other stable value vehicles
that hold portfolios similar to those of MMFs but are not subject to
the ICA's restrictions on MMFs. These unregistered funds can take on
more risks than MMFs, but such risks are not necessarily transparent to
investors. Accordingly, unregistered funds may pose even greater
systemic risks than MMFs, particularly if new restrictions on MMFs
prompt substantial growth in unregistered funds. Thus, changes to MMF
rules might displace or even increase systemic risks, rather than
mitigate them, and make such risks more difficult to monitor and
control. Reforms designed to reduce risks in less regulated or
unregulated MMF substitutes are discussed in more detail in section
3(h).
    Elimination of MMFs' stable NAVs may also prompt some investors--
particularly retail investors--to shift assets from MMFs to banks. Such
asset shifts would have potential benefits and drawbacks, which are
discussed in some detail in section 3(g).
     Third, MMFs' transition from stable to floating NAVs might
itself be systemically risky. For example, if shareholders perceive a
risk that a fund that is maintaining a $1 NAV under current rules has a
market-based shadow NAV of less than $1, these investors may redeem
shares preemptively to avoid potential losses when MMFs switch to
floating NAVs. Shareholders who cannot tolerate floating NAVs probably
also would redeem in advance. If large enough, redemptions could force
some funds to sell assets and make concerns about losses self-
fulfilling. Hence, successful implementation of a switch to floating
NAVs would depend on careful design of the conversion process to guard
against destabilizing transition dynamics.
     Fourth, risk management practices in a floating NAV MMF
industry might deteriorate without the discipline required to maintain
a $1 share price. MMFs comply with rule 2a-7 because doing so gives
them the ability to use amortized-cost accounting to maintain a stable
NAV. Without this reward, the incentive to follow 2a-7 restrictions is
less clear. Moreover, the stable, rounded NAV creates a bright line for
fund advisers: Losses in excess of \1/2\ of 1 percent would be
catastrophic because they would cause a fund to break the buck. With a
floating NAV, funds would not have as clear a tipping point, so fund
advisers might face reduced incentives for prudent risk management.
     The fifth and final concern is that a floating NAV that
accomplishes its proponents' objectives of reducing systemic risks may
be difficult to implement. Under normal market conditions, even a
floating NAV would likely move very little because of the nature of MMF
assets. For example, although a requirement that MMFs move to a $10 NAV
and round to the nearest cent would force funds to reprice shares for
as little as a 5 basis point change in portfolio value, NAV
fluctuations might still remain relatively rare. Enhanced precision for
NAVs (for example, NAVs with five significant figures) could bring more
regular, incremental fluctuations, but precise pricing of many money
market securities is challenging given the absence of active secondary
markets. In addition, if fund sponsors decided to provide support to
offset any small deviations from the usual NAV, deviations from that
NAV might remain rare.
    Thus, a floating NAV may not substantially improve investors'
understanding of the riskiness of MMFs or reduce the stigma and
systemic risks associated with breaking the buck. Investors'
perceptions that MMFs are virtually riskless may change slowly and
unpredictably if NAV fluctuations remain small and rare. MMFs with
floating NAVs, at least temporarily, might even be more prone to runs
if investors who continue to see shares as essentially risk-free react
to small or temporary changes in the value of their shares.
    To summarize, requiring the entire MMF industry to move to a
floating NAV would have some potential benefits, but those benefits
would have to be weighed carefully against the risks that such a change
would entail.
b. Private Emergency Liquidity Facilities for MMFs
    As discussed in section 1(b), the liquidity risk of MMFs
contributes importantly to MMFs' vulnerability to runs. The programs
introduced at the height of the run on MMFs in September 2008--
Treasury's Temporary Guarantee Program for Money Market Funds and the
liquidity backstop provided by the AMLF--were effective in stopping the
run on MMFs.\23\ More generally, policymakers have long recognized the
utility of liquidity

backstops for institutions engaged in maturity transformation: Banks,
for example, have had access to the discount window since its
inception, and backstop lending facilities also have been created more
recently for other types of institutions. Thus, enhanced liquidity
protection should be considered as part of any regulatory reform effort
aimed at preventing runs on MMFs. At the same time, such enhanced
liquidity protection does not have to be provided necessarily by the
government: A private facility, adequately capitalized and financed by
the MMF industry, could be set up to supply liquidity to funds that
most need it at times of market stress. Depending on its structure,
such a private facility itself might have access to broader liquidity
backstops.
---------------------------------------------------------------------------

    \23\ Outflows from prime MMFs totaled about $200 billion in the
two days prior to the Treasury and Federal Reserve announcements on
Friday, September 19, 2008. However, in the two business days
following the announcements (Monday and Tuesday, September 22 and
23), outflows were just $22 billion.
---------------------------------------------------------------------------

    A private emergency liquidity facility could be beneficial on
several levels. First, a private liquidity facility, in combination
with the SEC's new liquidity requirements, might substantially buttress
MMFs' ability to withstand outflows without selling assets in
potentially illiquid markets.\24\ Second, a private emergency facility
might offer important efficiency gains from risk pooling. Even during
the systemic liquidity crisis in 2008, individual MMFs experienced
large variations in the timing and magnitude of redemptions. An
emergency facility could provide liquidity to the MMFs that need it; in
contrast, liquidity requirements for individual MMFs would likely leave
some funds with too much liquidity and others with too little. Third, a
private liquidity facility might provide funds with flexibility in
managing liquidity risks if, for example, regulators allowed MMFs some
relief in liquidity requirements in return for the funds' purchase of
greater access to the liquidity facility's capacity.
---------------------------------------------------------------------------

    \24\ For example, as noted in the text, even if MMFs in
September 2008 had held liquid assets in the proportions that the
SEC has recently mandated, the net redemptions experienced by the
funds following the Lehman Brothers bankruptcy would have forced
MMFs to sell considerable amounts of securities into illiquid
markets in the absence of the substantial government interventions.
But a liquidity facility with the capacity to provide an additional
10 percent overnight liquidity to each fund would double the
effective overnight liquid resources available to MMFs. If MMFs in
September 2008 had already been in compliance with the new liquidity
requirements, a facility with this capacity would have considerably
reduced funds' need to raise liquidity (for example, through asset
sales) during the run. In addition, the very existence of the
facility might have reduced redemption requests in the first place.
---------------------------------------------------------------------------

    Importantly, a properly designed and well-managed private liquidity
facility would internalize the cost of liquidity protection for the MMF
industry and provide appropriate incentives for MMFs and their
investors.\25\ Such a facility would not help funds that take on
excessive capital risks or face runs because of isolated credit losses
(a well-designed private liquidity facility would not have helped the
Reserve Primary Fund or its shareholders avoid losses in September 2008
due to holdings of Lehman Brothers debt). Moreover, a liquidity
facility alone may not prevent runs on MMFs triggered by concerns about
more widespread credit losses at MMFs. However, a liquidity facility
could substantially reduce the damage that a run on a single distressed
fund might cause to the rest of the industry.
---------------------------------------------------------------------------

    \25\ A private liquidity facility could also result in retail
fund investors bearing some of the costs of meeting the likely
higher liquidity needs of institutional funds. Consideration should
be given as to whether and how to prevent such an outcome.
---------------------------------------------------------------------------

    While a private emergency liquidity facility would be appealing in
several respects, setting up an effective facility would present a
number of challenges. The structure and operations of a private
liquidity facility would have to be considered carefully to ensure that
it would be effective during crises and that it would not unduly
distort incentives, while, at the same time, that it would be in
compliance with all applicable regulations and that it would not favor
certain market participants or business models. For example:
     On the one hand, if MMFs were required to participate in a
private facility, regulators would assume some responsibility for
ensuring that the facility was operated equitably and efficiently, that
it managed risks prudently, and that it was able to provide liquidity
effectively during a crisis. On the other hand, if participation were
voluntary, some MMFs would likely choose not to participate to avoid
sharing in the costs associated with the facility. Non-participating
MMFs might present greater risks than their competitors but would free-
ride on the stability the liquidity facility would provide. In a
voluntary participation framework, one means of balancing risks between
MMFs that do and do not participate in a liquidity facility would be to
require nonparticipants to adhere to more stringent risk-limiting
constraints or to require such funds to switch to a floating NAV. Such
an approach (in which some MMFs have stable NAVs and others floating
NAVs) is considered in section 3(e).
     Ensuring that the facility has adequate capacity to meet
MMFs' liquidity needs during a crisis would be critical to the
effectiveness of the facility in mitigating systemic risk. Inadequate
capacity might, for example, create an incentive for MMF advisers to
tap the facility before others do and thus make the facility itself
vulnerable to runs. News of a depleted liquidity facility might amplify
investor concerns and trigger or expand a run on MMFs. However, raising
enough capital to build adequate liquidity capacity without undue
leverage would be a challenge for the asset management industry.
Accordingly, meaningful mitigation of systemic risk may require that
the facility itself have access to alternative sources of liquidity.
     A private facility may face conflicts of interest during a
crisis when liquidity is in short supply. Responsibility to the
facility's shareholders would mandate prudence in providing liquidity
to MMFs. For example, facility managers would want to be selective in
providing liquidity against term commercial paper out of concern about
losses on such paper. However, excessive prudence would be at odds with
the facility serving as an effective liquidity backstop. In addition, a
private facility may face conflicts among different types of
shareholders and participants who may have different interests, and a
strong governance structure would be needed to address these conflicts
as well as prevent the domination of the facility by the advisers of
larger funds.
     Rules governing access to the facility would have to be
crafted carefully to minimize the moral hazard problems among fund
advisers, who could face diminished incentives to maintain liquidity in
their MMFs. However, excessive constraints on access would limit the
facility's effectiveness. An appropriate balancing of access rules
might be difficult to achieve.
    Notwithstanding these concerns, a private emergency liquidity
facility could play an important role in supplementing the SEC's new
liquidity requirements for MMFs. The potential advantages and
disadvantages of such a facility, as well as its optimal structure and
modes of operation, should be the subjects of further analysis and
discussion.
c. Mandatory Redemptions in Kind
    When investors make large redemptions from MMFs, they impose
liquidity costs on other shareholders in the fund. For example,
redemptions may force a fund to sell its most liquid assets to raise
cash. Remaining shareholders are left with claims on a less liquid
portfolio, so redemptions are particularly costly for other

shareholders during a crisis, when liquidity is most valued.\26\
---------------------------------------------------------------------------

    \26\ The problem is exacerbated by a rounded NAV, because a fund
that has already incurred a capital loss but that continues to
redeem each share at $1 also transfers capital losses from redeeming
shareholders to those who remain in the fund.
---------------------------------------------------------------------------

    A requirement that MMFs distribute large redemptions by
institutional investors in kind, rather than in cash, would force these
redeeming shareholders to bear their own liquidity costs and reduce
their incentive to redeem.\27\ If liquidity pressures are causing money
market instruments to trade at discounts, a MMF that distributes a
large redemption in cash may have to sell securities at a discount to
raise the cash. All shareholders in the fund would share in the loss on
a pro rata basis. However, if the fund distributes securities to the
investor in proportion to the claim on the fund represented by the
redeemed shares, the liquidity risk would be borne most directly by the
redeeming investor. If the fund elects to dispose of the securities in
a dislocated market and incurs a loss, other shareholders are not
directly affected.\28\
---------------------------------------------------------------------------

    \27\ Such a requirement also would force redeeming shareholders
to bear their share of any losses that a MMF has already incurred--
even if the fund maintains a stable, rounded NAV and has not yet
broken the buck--rather than concentrating those losses entirely in
the MMF and thus on remaining MMF shareholders.
    \28\ If the investor sells securities at a loss, however, and
the MMF also holds the same or similar securities, the fund may be
forced to re-price the securities and lower its mark-to-market,
shadow NAV. So, remaining investors in the fund may be affected
indirectly by the redeeming investor, even if that investor receives
redemptions in kind.
---------------------------------------------------------------------------

    Requiring large redemptions to be made in kind would reduce, but
not eliminate the systemic risk associated with large, widespread
redemptions. Shareholders with immediate liquidity needs who receive
securities from MMFs would have to sell those assets, and the
consequences for short-term markets of such sales would be similar to
the effects if the money market fund itself had sold the securities.
Smaller shareholders would still receive cash redemptions, and larger
investors might structure their MMF investments and redemptions to
remain under the in-kind threshold.
    An in-kind redemption requirement would present some operational
and policy challenges. Portfolio holdings of MMFs sometimes are not
freely transferable or are only transferable in large blocks of shares,
so delivery of an exact pro rata portion of each portfolio holding to a
redeeming shareholder may be impracticable. Thus, a fund may have to
deliver different securities to different investors but would need to
do so in an equitable manner. Funds should not, for example, be able to
distribute only their most liquid assets to redeeming shareholders,
since doing so would undermine the purpose of an in-kind redemptions
requirement. Thus, the SEC would have to make key judgments on the
circumstances under which a fund must redeem in kind, as well as the
criteria that funds would use for determining which portfolio
securities must be distributed and how they would be valued.
d. Insurance for MMFs
    As noted in section 1(b), the absence of formal capital buffers or
insurance for MMFs, as well as their historical reliance on
discretionary sponsor support in place of such mechanisms, further
contributes to their vulnerability to runs. Treasury's Temporary
Guarantee Program for Money Market Funds, announced on September 19,
2008, was a key component of the government intervention that slowed
the run on MMFs. The program provided guarantees for shares in MMFs as
of the announcement date. These guarantees were somewhat akin to
deposit insurance, which for many decades has played a central role in
mitigating the risk of runs on banks.\29\ Therefore, some form of
insurance for MMF shareholders might be helpful in mitigating systemic
risks posed by MMFs, although insurance also may create new risks by
distorting incentives of fund advisers and shareholders.
---------------------------------------------------------------------------

    \29\ All publicly offered stable NAV MMFs were eligible to
participate in the program. If a MMF elected to participate, the
program guaranteed that each shareholder in that MMF would receive
the stable share price (typically $1) for each share held in the
fund, up to the number of shares held as of the close of business on
September 19, 2008. In the event that a participating MMF broke the
buck, the fund was required to suspend redemptions and commence
liquidation, and the fund was eligible to collect payment from
Treasury to enable payment of the stable share price to each covered
investor. Treasury neither received any claims for payment nor
incurred any losses under the program.
---------------------------------------------------------------------------

    Like an external liquidity facility, insurance would reduce the
risk of runs on MMFs, but the consequences of insurance and a liquidity
facility would otherwise be different. A liquidity facility would do
little or nothing to help a fund that had already experienced a capital
loss, but such a facility might be very helpful in mitigating the
destabilizing effects that one fund's capital loss might impose on the
rest of the industry. Insurance, in contrast, would substantially
reduce or eliminate any losses borne by the shareholders of the MMF
that experienced the capital loss and damp their incentives to redeem
shares in that fund. Although either option might reduce the incentives
for asset managers and shareholders to minimize risks, a liquidity
facility without an insurance scheme would leave intact shareholders'
incentive to monitor funds for the credit and interest rate risks that
may trigger a run. However, in a crisis that triggers concerns about
widespread credit losses, liquidity protection without some form of
insurance may still leave MMFs vulnerable to runs.
    In addition to these general considerations, the design and
implementation of an insurance program for MMFs would require
resolution of a number of difficult issues. For example:
     Insurance could, in principle, be provided by the private
sector, the government, or a combination of the two, but all three
options have potential drawbacks. Private insurers have had
considerable difficulties in fairly pricing and successfully
guaranteeing rare but high-cost financial events, as demonstrated, for
example, by the recent difficulties experienced by financial
guarantors. That no private market for insurance has developed is some
evidence that such insurance for MMFs may be a challenging business
model, particularly if funds are not required to obtain insurance.\30\
Making insurance for MMFs mandatory could attract private insurance
providers, but the pricing and scope of coverage that these providers
could offer would need to be the subject of careful consideration. In
any case, insurers would need to maintain capital and carry reinsurance
as necessary to cover losses during extraordinary events. Public
insurance would necessitate new government oversight and administration
functions and, particularly in the absence of private insurance, would
require a mechanism

for setting appropriate risk-based premiums (either pre- or post-
event). A hybrid insurance scheme--for example, with MMFs or their
sponsors retaining the first level of losses up to a threshold, private
insurers or risk pools handling losses up to a certain higher
threshold, and a government insurance program serving as a backstop
(perhaps with post-event recoupment)--might offer some advantages, but
it would be subject to the risks of private insurance and the
challenges of public insurance.
---------------------------------------------------------------------------

    \30\ The degree of insurance coverage provided by Treasury's
Temporary Guarantee Program for Money Market Funds was
unprecedented. Private insurance with considerably narrower coverage
has been available to MMFs in the past: ICI Mutual Insurance
Company, an industry association captive insurer, offered very
limited insurance to MMFs from 1999 to 2003. This insurance covered
losses on MMF portfolio assets due to defaults and insolvencies but
not losses due to events such as a security downgrade or a rise in
interest rates. Coverage was limited to $50 million per fund, with a
deductible of the first 10 to 40 basis points of any loss. Premiums
ranged from 1 to 3 basis points. ICI Mutual reportedly discontinued
offering the insurance in 2003 because coverage restrictions and
other factors limited demand to the point that the insurance was not
providing enough risk pooling to remain viable. Of course, MMFs
continue to have access to other market-based mechanisms for
transferring risks, such as credit default swaps, although holdings
of such derivative securities by MMFs are tightly regulated by rule
2a-7.
---------------------------------------------------------------------------

     On the one hand, mandatory participation in an insurance
system likely would be necessary to instill investor confidence in the
MMF industry, to ensure an adequate pooling of risk, to prevent riskier
funds from opting out yet free-riding on the stability afforded by
insured funds, and to create a sufficient premium base. On the other
hand, an insurance requirement would create new government
responsibilities, and the regulatory and economic implications of such
a requirement would have to be evaluated carefully.
     Insurance increases moral hazard and would shift
incentives for prudent risk management by MMFs from fund advisers, who
are better positioned to monitor risks, to public or private insurers.
In addition, insurance removes investors' incentives to monitor risk
management by fund advisers. Broadly speaking, insurance fundamentally
changes the nature of MMF shares, from pooled pass-through investments
in risky assets to insured products with relatively low yields and
limited or no risk.
     Appropriate pricing would be critical to the success of a
MMF insurance program, as pricing would affect the financial position
of the guarantor, the incentives of MMF advisers, and the relative
attractiveness of different types of MMFs and their competitors (for
example, bank deposits). Insurance pricing that is not responsive to
the riskiness of individual MMF portfolios, for example, would heighten
moral hazard problems that undermine incentives for prudent MMF risk
management. Underpriced insurance might cause disruptive outflows from
bank deposits to MMFs and would be a subsidy for sponsors of and
investors in MMFs. Still, insurance for MMFs might be easier to price
fairly than deposit insurance for banks, as MMF portfolios are highly
restricted, relatively homogeneous in comparison with bank portfolios,
transparent, and priced on a daily basis.
     Limits on insurance coverage (perhaps similar to those for
deposit insurance) would be needed to avoid giving MMFs an advantage
over banks and to preserve incentives for large investors to monitor
the risk management practices at MMFs. However, such limits would leave
most institutional investors' shares only marginally covered by
insurance and do little to reduce their incentive to run should MMF
risks become salient.
e. A Two-Tier System of MMFs, With Enhanced Protections for Stable NAV
MMFs
    Reforms intended to reduce the systemic risks posed by MMFs might
be particularly effective if they allow investors some flexibility in
choosing the MMFs that best match their risk-return preferences.
Policymakers might accommodate a range of preferences by allowing two
types of MMFs to be regulated under rule 2a-7:
    (i) Stable NAV MMFs. These funds would continue to maintain stable,
rounded NAVs, but they would be subject to enhanced protections, which
might include some combination of tighter regulation (such as higher
liquidity standards) and required access to an external liquidity
backstop. Other options to provide enhanced protection for stable NAV
funds might include mandatory distribution of large redemptions in kind
and insurance. (Policymakers may also consider limiting the risk
arising from investors in stable NAV funds by restricting sales of such
funds' shares to retail investors, as discussed in section 3(f).)
    (ii) Floating NAV funds. Although these MMFs would still have to
comply with many of the current restrictions of rule 2a-7, these
restrictions might be somewhat less stringent than those for stable NAV
funds. So, floating NAV funds could bear somewhat greater credit and
liquidity risks than stable NAV funds, might not be required to obtain
access to external sources of liquidity or insurance, and most likely
would pay higher yields than their stable NAV counterparts. Regulatory
relief--for example, allowing simplified tax treatment for small NAV
changes in funds that adhere to rule 2a-7--might help preserve the
attractiveness of such funds for many investors.
    A two-tier system could mitigate the systemic risks that arise from
a stable, rounded NAV, by requiring funds that maintain a stable NAV to
have additional protections that directly address some of the features
that contribute to their vulnerability to runs. At the same time, by
preserving stable NAV funds, such a system would mitigate the risks of
a wholesale shift to floating NAV funds. For example, a two-tier system
would diminish the likelihood of a large-scale exodus from the MMF
industry by investors who might find a floating NAV MMF unacceptable.
    Floating NAV MMFs would face a lower risk of runs for the reasons
outlined in section 3(a): Frequent changes in these funds' NAVs would
help align investor perceptions and actual fund risks, and investors
would have reduced incentives to redeem early in a crisis without a
rounded NAV. In addition, investor sorting might ameliorate the risk of
runs: Under such a two-tier system, investors who choose floating NAV
funds presumably would be less risk-averse and more tolerant of NAV
changes than the shareholders of stable NAV funds.
    During a crisis, investors would likely shift at least some assets
from riskier floating NAV MMFs to stable NAV MMFs, which would
presumably be safer because of their enhanced protections. Such flows
might be similar, in some respects, to the asset flows seen during the
September 2008 crisis from prime MMFs to government MMFs, but a shift
between tiers of prime funds could be less disruptive to short-term
funding markets and the aggregate supply of credit to private firms
than a flight from prime to government MMFs. Effective design of a two-
tier system would have to incorporate measures to ensure that large-
scale shifts of assets among MMFs in crises would not be
disruptive.\31\
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    \31\ If stable NAV MMFs carried mandatory insurance, some
limitations on insurance coverage (for example, stipulating that
individual shares in such funds could be insured only after a given
number of days) might reduce the magnitude of flows between
different types of MMFs and reduce implicit subsidies for investors
who purchase shares in stable NAV funds only during crises. However,
such rules might diminish the value of insurance in preventing runs.
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    For a two-tier system to be effective and materially mitigate the
risk of runs, investors would have to fully understand the difference
between the two types of funds and their associated risks. Investors
who do not make this distinction might flee indiscriminately from
floating NAV and stable NAV funds alike; in this case, a two-tier
system would not be effective in mitigating the risk of runs.
    The relative ease or difficulty of implementing a two-tier system
would depend on the nature of the stable NAV and floating NAV MMFs that
comprise it. For example, if the stable NAV funds simply were required
to satisfy more stringent SEC rules governing portfolio safety,
creation of a two-tier system would be fairly straightforward. A
requirement that stable NAV funds obtain access to an emergency
liquidity facility would likely make stable NAV

funds less prone to runs and would reduce the likelihood that investors
flee indiscriminately from both types of funds in the event of severe
market strains. However, this approach also would face the challenges
associated with the creation of an effective liquidity facility
(discussed in more detail in section 3(b)).
f. A Two-Tier System of MMFs, With Stable NAV MMFs Reserved for Retail
Investors
    Another approach to the two-tier system described in section 3(e)
could distinguish stable NAV and floating NAV funds by investor type.
Stable NAV MMFs could be made available only to retail investors, while
institutional investors would be restricted to floating NAV funds.
    This approach would bring enhanced protections to stable NAV MMFs
by mitigating the risk arising from the behavior of their investors,
because institutional investors have historically generated greater
risks of runs for MMFs than retail investors. As noted previously, the
run from MMFs in September 2008 was primarily a flight by institutional
investors. More than 90 percent of the net outflows from prime MMFs in
the week following the Lehman Brothers bankruptcy came from
institutional funds, and institutional investors withdrew substantial
sums from prime MMFs even before the Reserve Primary Fund broke the
buck.
    Moreover, evidence suggests that the additional risks posed by
institutional investors during the run on MMFs in September 2008 were
not unique to that episode. Relative to retail investors, institutional
investors have greater resources to monitor MMF portfolios and risks
and have larger amounts at stake, and are therefore quicker to redeem
shares on concerns about MMF risks. Institutional MMFs typically have
greater cash flow volatility than retail funds. Net flows to
institutional MMFs have also exhibited patterns indicating that
institutional investors regularly arbitrage small discrepancies between
MMFs' shadow NAVs and their $1 share prices.\32\ These observations
suggest that many institutional investors are aware of such
discrepancies--which are likely to widen during financial crises--and
are able to exploit them.
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    \32\ For example, after Federal Open Market Committee (FOMC)
actions that lower the FOMC's target for the federal funds rate, MMF
shadow NAVs rise and institutional MMFs often experience large net
inflows.
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    A two-tier system based on investor type would protect the
interests of retail investors by reducing the likelihood that a run
might begin in institutional MMFs (as it did in September 2008) and
spread to retail funds. Moreover, such a system would preserve the
original purpose of MMFs, which was to provide retail investors with
cost-effective access to diversified investments in money market
instruments. Retail investors have few alternative opportunities to
obtain such exposures. In contrast, institutional investors, which can
meet minimum investment thresholds for direct investments in money
market instruments, would be able to continue doing so.
    One advantage of this alternative is that it could be accomplished
by SEC rulemaking under existing authorities without establishing
additional market structures. A prohibition on institutional investors'
use of stable NAV MMFs would have some practical hurdles, however.
Successful enforcement of the rule would require the SEC to define who
would qualify as retail and institutional investors. In practice, such
distinctions may be difficult, although not impossible, to make. For
example, retail investors who own MMF shares because of their
participation in defined contribution plans (such as 401(k) plans) may
be invested in institutional MMFs through omnibus accounts that are
overseen by institutional investors (plan administrators). Simple rules
that might be used to identify institutional investors, such as
defining as institutional any investor whose account size exceeds a
certain threshold, would be imperfect and could motivate the use of
workarounds (such as brokered accounts) by institutional investors. The
SEC, as part of its rulemaking, would need to take steps to prevent
such workarounds.
    Because many institutional investors may be particularly unwilling
to switch to floating NAV MMFs, a prohibition on sales of stable NAV
MMFs shares to such investors may have many of the same unintended
consequences as a requirement that all MMFs adopt floating NAVs (see
section 3(a)). In particular, prohibiting institutional investors from
holding stable NAV funds might cause large shifts in assets to
unregulated MMF substitutes. This concern is of particular importance
given that institutional MMFs currently account for almost two-thirds
of the assets under management in MMFs.
    In addition, a two-tier system based on investor type would
preclude some of the advantages of allowing institutional investors to
choose between stable NAV MMFs and floating NAV MMFs (as the option
described in section 3(e) would permit). For example, under the two-
tier system described in section 3(e), investor sorting would provide
some protection for the floating NAV funds, because institutional
investors holding floating NAV MMFs likely would be less risk-averse
than those who held stable NAV funds. With institutional investors
prohibited from holding shares in stable NAV MMFs, such sorting among
these investors would not occur. During a crisis, under the system
described in section 3(e), institutional investors might be expected to
shift assets from floating NAV MMFs to stable NAV funds, but a ban on
institutional holdings of stable NAV MMF shares would prevent such
shifts.
g. Regulating Stable NAV MMFs as Special Purpose Banks
    Functional similarities between MMF shares and deposits, as well as
the risk of runs on both types of instruments, provide a rationale for
introducing bank-like regulation for MMFs. For example, mandating that
stable NAV MMFs be reorganized as SPBs might subject these MMFs to
banking oversight and regulation, including requirements for reserves
and capital buffers, and provide MMFs with access to a liquidity
backstop and insurance coverage within a regulatory framework
specifically designed for mitigation of systemic risk.\33\ If each MMF
were offered the option of implementing a floating NAV as an
alternative to reorganizing as a bank, the reorganization requirement
for stable NAV MMFs might be viewed as part of a two-tier system for
MMFs.\34\
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    \33\ Such an approach to MMF reform was advocated by the Group
of Thirty. See Group of Thirty, Financial Reform: A Framework for
Financial Stability, released on January 15, 2009.
    \34\ There may be a question as to whether floating NAV MMFs--if
such funds are offered--should or should not be required to
reorganize as SPBs. Other mutual funds with floating NAVs, such as
ultra-short bond funds, presumably would not be affected by a
mandate that MMFs reorganize as SPBs. The principal distinction
between other (non-MMF) mutual funds and floating NAV MMFs would be
that the latter are constrained by rule 2a-7 and thus have less
risky portfolios, so the advantages and disadvantages of mandating
these funds to reorganize as banks would have to be carefully
evaluated. However, policymakers could consider prohibiting floating
NAV MMFs from offering bank-like services that attract risk-averse
investors, such as the ability to provide transactions services.
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    Although the conceptual basis for converting stable NAV MMFs to
SPBs is seemingly straightforward, in practice this option spans a
broad range of possible implementations, most of which would require
legislative changes and complex interagency regulatory coordination.
The advantages and disadvantages of this reform option depend on how
exactly the conversion to SPBs would be implemented and

how the new banks would be structured. A thorough discussion of the
full range of possibilities--including their feasibility, probable
effect on the MMF industry, broader implications for the banking
system, and likely efficacy in mitigating systemic risk--would be quite
complex and is beyond the scope of this report.
    As an example of the issues that this option involves, one possible
approach to its implementation would be to preserve stable NAV MMFs as
standalone entities but to treat their shares as deposits for the
purposes of banking law. These shares, unlike other deposits, might be
claims specifically (and only) on MMF assets, which could continue to
be subject to strict risk-limiting regulations such as those provided
by rule 2a-7 or similar rules. The introduction of such hybrid
investment vehicles would preserve investors' opportunity to benefit
from mutualized investments in private money market instruments, but,
being a novel combination of features of banks and mutual funds, such
vehicles would also present complex regulatory and operational
challenges. In contrast, other approaches to converting MMFs to SPBs,
such as absorbing or transforming stable NAV MMFs into financial
institutions that offer traditional deposits, might be simpler to
accomplish in practice, but nonetheless subject to different sets of
challenges. In particular, if the deposits offered by the new SPBs were
only of the types currently offered by other banks, investors--and
particularly retail investors, who have few alternative opportunities
to obtain diversified exposures to money market instruments--would lose
access to important investment options.\35\ In addition, to the extent
that banks have different preferences for portfolio assets than MMFs, a
simple transformation of MMFs into depository institutions might lead
to a decline in the availability of short-term financing for firms and
state and local governments that currently rely on money markets to
satisfy their funding needs. Considerable further study would thus be
needed in pursuing this option.
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    \35\ In contrast, institutional investors could continue to
obtain such exposures either by investing directly in money market
instruments or by holding shares in offshore MMFs, enhanced cash
funds, and other stable value vehicles. Hence, absorption of MMFs by
banks might have the unintended effect of reducing investment
opportunities for retail investors, who generally did not
participate in the run on MMFs in 2008, while leaving money market
investment options for institutional investors largely intact.
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    Leaving aside the details of how exactly this option could be
implemented, in general terms, a principal advantage of reorganizing
MMFs as SPBs is that such a change would provide MMFs with a broad
regulatory framework similar to existing regulatory systems that are
designed for mitigation of systemic risk. Investments in MMFs and
insured deposits--which already serve some similar functions,
particularly for retail investors--could be regulated similarly. MMFs
and their investors might benefit from access to government insurance
and emergency liquidity facilities at a price similar to that currently
paid by depository institutions. Importantly, such access would not
require any extraordinary government actions (such as the establishment
in September 2008 of Treasury's Temporary Guarantee Program for Money
Market Funds or the creation of the Federal Reserve's AMLF); instead,
the terms of such access would be codified and well-understood in
advance.
    Moreover, by providing explicit capital buffers, access to a
liquidity backstop, and deposit insurance, a conversion of stable NAV
MMFs to SPBs might substantially reduce the uncertainties and systemic
risks associated with MMF sponsors' current practice of discretionary
capital support. Clear rules for how the buffers, backstop, and
insurance would be used would improve the transparency of the
allocation of risks among market participants.
    However, the capital needed to reorganize MMFs as SPBs may be a
significant hurdle to successful implementation of this option. Access
to the Federal Reserve discount window and deposit insurance coverage
most likely would require that the new SPBs hold reservable deposits
and meet specific capitalization standards.\36\ Given the scale of
assets under management in the MMF industry, MMF sponsors (or banks)
that wish to keep funds operating would have to raise substantial
equity--probably at least tens of billions of dollars--to meet
regulatory capital requirements.\37\ Raising such sums would be a
considerable challenge. The asset management business typically is not
capital intensive, so many asset managers--and several of the largest
sponsors of MMFs--are lightly capitalized and probably could not
provide such amounts of capital. If asset managers or other firms were
unwilling or unable to raise the capital needed to operate the new
SPBs, a sharp reduction in assets in stable NAV MMFs might diminish
their capacity to supply short-term credit, curtail the availability of
an attractive investment option (particularly for retail investors),
and motivate institutional investors to shift assets to unregulated
vehicles.
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    \36\ Currently, MMFs are essentially 100 percent capital--their
liabilities are the equity shares held by investors--so the meaning
of ``capital requirements'' for such funds is not clear. However, if
MMFs were reorganized as SPBs, their capital structure would become
more complex. MMF shares would likely be converted to deposit
liabilities, and MMFs would have to hold additional capital (equity)
buffers to absorb first losses. Capital requirements would regulate
the size of such buffers.
    \37\ The magnitude of the capital required might be reduced if