The Securities and Exchange Commission (SEC) recently adopted final rules on money market (2a-7) fund reforms. These reforms are designed to make money market funds more resilient and liquid, potentially making them safer and more attractive vehicles for mutual funds to use as collateral pools for their securities lending programs.
How do mutual funds use 2a-7 funds?
Regulated investment companies (i.e., mutual funds) use money market funds for a variety of purposes, including:
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To back their securities lending transactions. When an institutional investor loans securities to a borrower, the borrower must provide collateral. Money market funds are popular choices for cash collateral because they are relatively safe and liquid. The SEC requires that the assets used as collateral for securities loans by mutual finds must be highly liquid —typically, cash, government securities, or bank letters of credit. Loaned securities must be available for recall on short notice if the fund needs to sell the securities or cast proxy votes. Borrowers expect to redeem their collateral at the same time that they return the loaned securities. Therefore, 2a-7 money market funds are usually the best option due to their high level of safety and liquidity.
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To back their repurchase agreements. Money market funds are often used as collateral for repurchase agreements because they are liquid and offer a competitive yield.
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To invest their idle cash. Money market funds are a popular investment choice for idle cash because they are safe, liquid, and offer a competitive yield.
How will the money market reforms affect cash collateral pools?
The changes to the rules will likely positively affect institutional investors who invest their cash collateral in 2a-7 funds. Ultimately, the changes will make money market funds more attractive and efficient vehicles for institutional investors to use to manage their cash flow and risk.
Here are examples of the ways in which the money market reforms could benefit institutional investors:
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Increased liquidity requirements: The money market reforms will increase the minimum liquidity requirements for money market funds. This will make money market funds more likely to meet their redemption obligations, even in stressed market conditions. This benefits institutional investors who use money market funds to back their securities lending transactions and repurchase agreements.
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Elimination of swing pricing and redemption gates: The money market reforms will eliminate swing pricing and redemption gates for money market funds. Swing pricing is a mechanism that allows money market funds to adjust their net asset values (NAVs) to reflect the costs of buying and selling securities in volatile markets. Redemption gates are a mechanism that allows money market funds to suspend redemptions if they experience heavy outflows temporarily. The elimination of swing pricing and redemption gates will make it easier for institutional investors to access their collateral and manage their cash flow.
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Mandatory redemption fees: Swing pricing and redemption gates have been replaced by a new liquidity fee framework for institutional prime and institutional tax-exempt money market funds. The framework requires funds to impose mandatory liquidity fees when net redemptions exceed 5% of net assets, unless liquidity costs are de minimis. The Commission chose this approach instead of swing pricing because it is less confusing and more transparent to investors. The goal is to protect remaining shareholders from dilution and to more fairly allocate costs to redeeming shareholders. The mandatory liquidity fee is expected to reduce operational burdens associated with swing pricing, while still achieving many of the benefits sought by the SEC with swing pricing. Institutional investors should benefit from these fees focused on addressing the “first mover” problem in institutional prime and institutional tax-exempt money market funds.
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Increased transparency: The money market reforms will require money market funds to disclose more information about their portfolios. This will help institutional investors better understand the risks and rewards of using these funds for collateral.
In addition to the benefits mentioned above, these money market reforms are also expected to reduce the overall cost of using money market funds for collateral. This is because the reforms will make money market funds more attractive to investors, leading to increased competition among fund providers.
Conclusion
Overall, the money market reforms are a positive development for institutional investors like mutual funds who use money market funds for collateral. The reforms potentially will make money market funds more attractive and efficient vehicles for institutional investors to use to manage their cash flow and risk.