Analyzing the New Money Market Fund Rules

The Securities and Exchange Commission revised the rules for money market funds earlier in 2014, making the first substantive overhaul of the funds in decades. Investors need to understand the rules and consider if they want to make changes to where they cash is held after the rules are effective.

The first thing to know is the rules don’t take effect for two years. You and the money market funds have plenty of time to plan. The other thing to know is that not all money funds are affected.

The new rules divide money funds into six categories.

The first two categories are Treasury and Government money market funds. Treasury money funds hold only U.S. Treasury securities and repurchase agreements collateralized by them. Government money funds invest in those items plus U.S. agency securities and repurchase agreements collateralized by them. There are no changes in these two types of funds under the regs. They still are allowed to have a stable $1.00 per share value and full daily liquidity with no forced redemption fees.

The rest of the money fund universe first is divided into two categories. Tax Exempt/Municipal funds are one category. Not surprisingly, these own primarily securities issued by state and local governments and non-profit entities.

The other category is the Prime/General Purpose money funds. These funds are allowed to invest in any instrument that regulations allow money funds to own and include any funds that don’t fit into the other categories.

These last two categories of funds-Tax Exempt/Municipal and Prime/General Purpose-are divided again into two categories: Retail and Institutional. Retail money funds are funds with policies reasonably designed to limit all beneficial owners to natural persons, meaning individuals or human beings. An institutional money fund is one that doesn’t qualify as a retail fund. Its ownership can include pension plans, corporations, and small businesses as well as natural persons. Institutional funds usually have lower fees than retail funds, and many fund families allow individuals to invest in institutional class funds when the individuals have sufficient minimum balances. So your individual account might be in an institutional fund.

As we approach full implementation of the new rules, it’s likely that at least some fund sponsors will change the rules for their funds so that any non-natural persons are kicked out of what are now considered retail funds. Shareholders in institutional funds probably will be informed several times before the new regs take effect that they are in institutional funds subject to different rules than retail funds, giving individual shareholders an opportunity to change funds.

Retail money market funds will continue to be allowed to maintain a $1.00 stable net asset value. Institutional funds, however, will have to use a floating net asset value for shares and carry the value out to four decimal places. The IRS already issued regulations stating that investors in floating rate money funds will have to report capital gains and losses on transactions in shares, but they’ll be able to report one aggregate number for all the transactions engaged in a money market fund for the year instead of each individual transaction. Also, money funds with floating NAVs won’t be subject to the wash sale rules that defer losses when shares are purchased and sold within 30 days.

Both retail and institutional funds in these two categories-Tax Exempt/Municipal and General Purpose-will be subject to the liquidity fee and redemption gate rules.

To understand the liquidity fee and redemption gate, you first need to know a money fund has to classify its assets according to how quickly they can be converted to cash. At least 10% of a fund’s asset must be convertible into cash within one business day. At least 30% of assets must be convertible into cash within five days.

A fund’s board of directors may impose a liquidity fee of up to 2% of shareholder redemptions any time the five-day liquidity falls below 30% of fund assets. The board can impose a lower fee or no fee at all if it determines that is in the best interests of the fund. After the fee is imposed, it would be removed when the five-day liquidity returns to 30% or the board decides it no longer is in the best interests of the fund.

The board is required to impose a 1% liquidity fee when five-day liquidity falls below 10%, unless the board decides it is in the best interests of the fund not to. This fee also can be eliminated when the board decides it is in the best interests of the fund or the liquidity level is restored.

Whenever five-day liquid assets fall below 30% of total assets, a fund’s board may impose a temporary suspension of all redemptions, known as a gate. The gate may be in place for as long as 10 consecutive days or a total of 10 days over a 90-day period. The gate would be removed after five-day liquidity returns to at least 30% or the board determines it no longer is in the best interests of the fund.

When a fund’s five-day liquidity falls below 30% of assets, the fund may impose either the gate or a liquidity fee of up to 2%, not both.

Remember the liquidity fee and redemption gate apply to both retail and institutional funds in the Municipal/Tax Exempt and Prime/General Purpose money market fund categories. Those funds will have to begin disclosing net asset values as well as daily and weekly liquid asset percentages on their web sites as the implementation date for the new rules nears. So, you’ll be able to track them and perhaps exit a fund before either of these restrictions can be imposed.

The SEC is trying to protect shareholders who remain in a money market fund during bad times from the effects of those who panic and withdraw all or most of their money in times of economic stress, such as 2008. The SEC says that in the past institutional investors have been more likely to withdraw their money than individuals.

You don’t need to take any action now. The new rules aren’t effective until October 16, 2016. I expect money market funds will make some changes in their rules and operations in the next couple of years, making a more clear distinction than exists now between retail and institutional money funds. Brokers probably will do more to define the types of accounts in their “cash sweep” and similar programs and perhaps give investors more choices for investing their cash.

We’ll know your full options as we get closer to the implementation date. One thing that is clear is that you’ll be able to avoid floating net asset values, liquidity gates, and redemption fees by investing in U.S. Treasury or Government money market funds instead of the other types. But you’ll likely earn a lower yield than from the alternatives.

RW November 2014.