The "Gates" Are Closing: SEC Votes Through Money Market Reform

Tyler Durden's picture

It was nearly five years ago when Zero Hedge first wrote: "This Is The Government: Your Legal Right To Redeem Your Money Market Account Has Been Denied" in which we predicted as part of the ongoing herding of investors away from every other asset class and into stocks, regulation will be implemented to enforce that "money market fund managers will have the option to 'suspend redemptions to allow for the orderly liquidation of fund assets" or in other words implement redemption "gates." The logic: spook participants in the $2.6 trillion money market industry with the prospect of being gated (i.e., having no access to ones funds) and force them to reallocate funds elsewhere.

Moments ago the gates arrived, when following a close 3-2 vote (with republican commissioner Piwowar and democrat Stein dissenting), the SEC adopted new rules designed to curb the risk of investor runs on money market funds, capping the end of a years-long heated debate between regulators and the industry dating to the financial crisis according to Reuters.

Among the changes, funds will have to switch to a floating share price instead of the current $1/share (hence the term breaking the buck). But the key part: "The SEC's rule will require prime money market funds to move from a stable $1 per share net asset value, to a floating NAV. It also will let fund boards lower redemption "gates" and fees in times of market stress."

And therein lies the rub, because the very presence of the "gate" effect will be enough to send money market investors rushing out (as they are all sophisticated enough to know that this fake, rigged market is a house of cards just waiting to come down) and into other asset classes.

Of course, it is the desire of the SEC, the Fed and the US Treasury that the one asset class picked as an alternative to money markets is equities: considering that the entire rally since 2009 has been on the back of the Fed and the primary dealers, with virtually none retail participation, the SEC decided it was about time to herd the "retail investor" out of the ZIRP "danger" of money markets and into the "safety" of an all time higher stock market where even Janet Yellen admits there is at least a biotech and a social media stock bubble.

Below are some of the concerns voice by one of the objectors, Kara Stein, via Bloomberg which incidentally are all spot on:

Redemption gates are the “wrong tool to address risk,” said SEC Commissioner Kara Stein during open meeting.

Fear incentives will result in “greater chance of fire sales in times of stress and spread panic to other parts of the financial system while denying investors and issuers access to capital”

  • “Money market funds are only one part of wholesale funding markets that need to be strengthened”
  • In the event the gate imposed increases, investors have a “strong incentive to redeem ahead of others”
  • While a gate may be good for one fund, “it can be very damaging to the financial system as a whole”
  • When the gate for a fund is used, it doesn’t mean the “impact on wholesale funding markets will be prevented”

She is spot on. But forget about our opinion, or even that of the SEC, because while on the surface this now enacted proposal to establish withdrawal limits is spun as benign, it was the Fed itself who warned in April of 2014 that "the possibility of suspending convertibility, including the imposition of gates or fees for redemptions, can create runs that  would not otherwise occur... Rules that provide intermediaries, such as MMFs, the ability to restrict redemptions when liquidity falls short may threaten financial stability by setting up the possibility of preemptive runs."

Clearly, everyone understand that the only purpose behind implementing "gates" is to redirect the herd. And with some $2.6 trillion in assets, money markets can serve as a convenient source of "forced buying" now that QE is tapering if only for the time being. The only question is whether the herd will agree to this latest massive behavioral experiment by the Fed, and allocate their funds to a stock market which is now trading at a higher P/E multiple than during the last market peak.

And should this particular exercise in inflating stock bubbles fail, then gating bond funds, another "reform" which as we reported last month is in the works, should certainly force equities to unseen bubble proportions.

On the other hand, a blow off top in which the S&P rises by a few hundred points in weeks if not days may be just what this market needs for its final catharsis before everyone realizes just how insane centrally-planned things have gotten, and the long-delayed reset can finally take place.

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For those curious, here is the section in Kara Stein's objection remarks dealing with gating:

... while the rule contains improvements, I believe it has a significant shortcoming – redemption gates.  I agree with the staff that a floating net asset value, even when combined with these other improvements and the 2010 amendments, is not a panacea.  Money market funds remain vulnerable to runs because investors will still have an incentive to redeem in a crisis.

However, after careful study, I am concerned that gates are the wrong tool to address this risk.  As the chance that a gate will be imposed increases, investors will have a strong incentive to rush to redeem ahead of others to avoid the uncertainty of losing access to their capital.  More importantly, a run in one fund could incite a system-wide run because investors in other funds likely will fear that they also will impose gates.  I share the concerns of many commenters and economists that while a gate may be good for one fund because it stops a run in that fund, it could be very damaging to the financial system as a whole.

Even further, while a run by investors in one fund may be halted when the gate for that fund is used, that does not mean the impact on the wholesale funding markets will stop.  To the contrary, a fund that drops a gate likely would need to build liquidity to meet redemption requests when the gate is lifted.  This means the fund is likely to stop re-investing maturing securities during the gated period, or will invest primarily in government securities, thereby cutting off funding to issuers.  This effect could be amplified by investors, who likely will redeem assets from other funds if one fund imposes a gate.  And if investors are not able to redeem before the gate comes down, they will be harmed as they are deprived of access to their capital. Ultimately, this contagion could freeze the wholesale funding markets in much the same way as occurred during the recent financial crisis.

I appreciate that the rule seeks to mitigate some of these concerns by allowing the fund’s board to impose gates at a higher liquid assets threshold than was proposed, by shortening the length of the gate, and by requiring daily disclosure of a fund’s level of liquid assets.  However, I do not believe that these changes adequately address the risk of destabilizing pre-emptive runs for the following reasons.

First, adding discretion that makes it easier for a fund to impose a gate could actually increase an investor’s incentive to redeem because it makes the use of a gate more likely.  This could be especially problematic in a crisis, when an investor’s preference to avoid uncertainty could be magnified.  Second, shortening the gating period to ten business days may only marginally decrease the incentive to redeem since even a ten business day gate is significant, particularly for corporate treasurers or other investors seeking to make payroll or meet other daily demands.  Third, while disclosure could help, it also could have the opposite effect by highlighting that a fund could be at or approaching a threshold that would allow it to impose a gate.

I also am not sufficiently persuaded by the argument that many investors with a low tolerance for gates will seek alternative financial products that are better aligned with their risk-return preferences.  While this could happen, it seems just as likely that those same investors will continue to invest in money market funds because they believe they will be able to redeem before a gate is imposed, or that sponsor support will prevent the gate from ever being used.  While the rule requires disclosure of sponsor support, it unfortunately does little to address the moral hazard that is created by it.

In the end, these are difficult issues with uncertain answers.  Ultimately, despite the rule’s efforts to mitigate the risks posed by gates, I believe the incentives to avoid them will remain powerful.  I fear these incentives may result in a greater chance of fire sales during times of stress, and a spread of the panic to other parts of our financial system, while also denying both investors and issuers access to capital.  I am, therefore, in the unfortunate position of not being able to support the rule that the staff recommends adopting today, despite some of its well-considered and thoughtful components.

Whatever the result today, money market funds are only one part of the wholesale funding markets that needs to be strengthened.  We and our fellow regulators need to take additional steps to improve the transparency and resiliency of these markets.  I look forward to working with the staff, my fellow Commissioners, and my fellow regulators on this more comprehensive and necessary project as we move ahead.