Gary Gensler, who has been nominated to run the SEC, was asked several times at his recent confirmation hearing about the WallStreetBets/GameStop saga and whether he would require greater disclosure on climate change risks and corporate political contributions. None of that was surprising; nor were his answers.
What was surprising was that no senator asked about regulatory reform of money market funds. That should be at the top of Gensler’s to-do list because the federal government has had to rescue the industry twice in 12 years. Last March, when the pandemic caused market convulsions, the Fed quickly provided a liquidity backstop to prevent runs. That was a replay of what took place in September 2008, when the Treasury provided a sweeping guarantee of all money market funds after Lehman Brothers failed.
Following the global financial crisis, the SEC enacted reforms that were supposed to reduce the risk of investors rushing to pull assets for fear of losses. It required transparency and liquidity measures and permitted funds to impose fees and gates on redemptions that were intended to stop or slow a potential run.
Some might say it’s not surprising those measures weren't sufficient given the severity of the stress last March as shutdowns rippled across the economy. Nevertheless, there's been skepticism about the adequacy of the reforms since they were adopted. Now is the time to reexamine them.
This could be something that Democrats and Republicans might actually agree on, including the leadership of the Senate Banking Committee, which held the Gensler hearing. Its Democratic chairman, Sherrod Brown, has been a leading critic of government bailouts of Wall Street, and its Republican ranking member, Pat Toomey, insisted that the December COVID-19 relief measure contain restrictions on emergency lending by the Fed.
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To its credit, the Trump administration teed up the issue with a report of the President’s Working Group on Financial Markets in December, which said that “while many of the reforms implemented after the global financial crisis increased market stability, the events of March 2020 show that more work is needed” when it comes to money market funds.
Money market funds are one of the largest forms of short-term debt vulnerable to investor runs in our financial system. They offer individuals and corporations a cash-management tool with many advantages, including immediate liquidity and price stability in normal circumstances. But unlike bank deposits, they're not insured, which means investors may flee in times of stress. Rapid redemptions can cause stress in other short-term funding markets, particularly commercial paper. And if corporations cannot roll over commercial paper because funds aren’t buying, they may have to draw down bank credit lines, which would intensify the general stress on the system.
The President's Working Group report didn't recommend any particular reform, but several options are worth considering. One is to require a capital buffer, or a commitment by fund sponsors to provide additional support, to create a cushion that could absorb losses. While that would presumably hurt fund yields, it might be justified if it enabled funds to withstand stress. But would it truly cause investors to stay put? After all, it's typically safer to flee at the first signs of serious stress than to wait to find out whether a fund or institution will pull through.
Policymakers could also strengthen liquidity requirements. But even significant increases might only delay a run if the stress is severe. Similarly, proposals to enhance the fees and gates provisions on investor withdrawals would probably provide only modest improvement.
It may make more sense to explore reforms that require redeeming shareholders to bear the cost of their redemptions to eliminate or reduce the incentive to be the first to pull out. One way is to establish a certain amount that investors would have to keep in the fund, called “a minimum balance at risk,” which could be redeemed only after a prescribed delay. This would ensure that redeeming investors would still share in any losses incurred by the fund during a particular period.
Some have even suggested that the minimum balances absorb the first losses, but that might be too severe a penalty. Alternatively, swing pricing would allow a fund to adjust its net asset value downward when net redemptions exceed a threshold so that redeeming investors — not those who remain in the fund — assume the costs. These reforms are more complicated than requiring a certain level of capital or strengthening liquidity requirements, so a good education effort would be needed to make sure investors understand the risks.
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Because of the interconnections between money market funds and short-term debt markets, any reforms should be considered in a broader context, including proposals to address the plumbing of the Treasury and repo markets. The good news is the SEC has already invited comments on money market funds, so let’s hope Mr. Gensler keeps the issue high on his agenda.
As the President's Working Group noted in its December report, failing to take action could have “the consequence of solidifying the perception … that similar [government] support will be provided in future periods of stress.” Last March's Fed intervention may have already been an example of philosopher George Santayana’s famous observation that those who don’t understand history are doomed to repeat it. Let’s not wait for a third time.
