Since the financial crisis, I have had several occasions, on behalf of corporate treasurers in the U.S., to convey to legislators and regulators the practical effects of their well-intended remedies. In markets as complex and interrelated as we have now in the global financial system, a change at one end often produces an unintended consequence several steps down the chain. For example, non-financial end-users of derivatives hedging risks in their businesses, were about to be required by U.S. banking regulators’ initial interpretation of provisions in the Dodd-Frank Act to post cash margin against real-time mark-to-market valuations of their derivative positions. While this may be appropriate for financial market-makers trading open derivatives positions, we argued it would be an undue burden on corporate end-users to divert cash from operating their businesses into this regulatory set-aside. After all, end-users’ derivative positionsare matched exactly against their underlying business exposures. Requiring cash margining would be a direct subtraction from funds the businesses would otherwise have to invest in more inventory to supporthigher sales, research and development for new products, and ultimately to grow and sustain more jobs. We also made the argument that corporate treasury systems would have to replicate to a large degree those that bank counterparties operate as trading, valuation, and settlement systems. This would require a significant investment in systems development and compliance training on the part of end-users’ treasury departments. In January 2015, a bi-partisan majority in the U.S. Congress made clear their intention that end-users be exempted from this well-intentioned diversion of funds through passage of one of only a very few amendments to the Dodd-Frank Act.
“The cumulative effect of the regulatory changes on MMMFs (money market mutual funds) has caused US$1 trillion to leave prime funds”
A significant area of concern during the financial crisis in 2008 was in money market mutual funds (“MMMFs”). This has been a market of more than US$2.5 trillion not only selling short-term investments to handletreasurers’ temporary excess cash, but on the other side, buying the commercial paper (“CP”) corporate treasurers issue to finance the day-to-day funding needs of their companies. However, in September 2008 the Primary Fund of the Reserve Fund group of mutual funds “broke the buck” when it reported a net asset value per share that rounded to less than a dollar. In the period since the financial crisis, regulators have sought new rules for MMMFs to strengthen the market during times of financial stress. MMMFs had always operated with fixed net asset values (“NAV”) with a price per share greater than US$0.995 and less than US$1.005, so that the NAV rounded to the nearest cent was one dollar per share. The first round of rule changes in the U.S. went into effect in 2010, with more significant changes effective on October 14, 2016 by the United States Securities and Exchange Commission. These latest changes impose liquidity fees and redemption gates that would be imposed during periods of market stress. A requirement for a prime fund’s NAV to float and be reported to the nearest hundredth of a cent significantly complicates investments in prime funds for corporate treasurers. The floating NAV requirement does not apply to MMMFs investing in government securities such as those with the full faith and credit of the U.S. government.
The practical implications of this new rule are daunting for corporate treasurers and their CIO counterparts. Corporate treasury and financial reporting systems up until now have treated fixed NAV MMMFs as cash equivalents. Now MMMF shares in non-government funds will have a floating NAV per share that must be tracked essentially in real time. For U.S. federal and state income tax purposes, a floating NAV requires treasurers to keep track of gains and losses when they inevitably buy MMMF shares at one price and sell them at another in the routine redemption of their investment. Since treasury systems must compete with other departments for internal IT resources, the question of what alternatives are available must be answered. Corporate treasurers can abandon the prime MMMF market and instead invest in government MMMFs that can retain the dollar per share fixed NAV. However, prime funds are important to treasurers not only as a flexible alternative for investments of temporary excess cash balances, but also as providers of short-term funding by buying corporate CP notes. As the graph below shows, in the year running up to the October 14, 2016 implementation of the new regulations, fund purchases of corporate CP declined significantly.
Source: Fitch Ratings and Crane Data
Concerns about investors fleeing prime MMMFs have proven true, with their assets declining by over US$1 trillion to US$376 billion since the rule became final (see chart below).
Source: Federal Reserve, iMoneyNet, Fitch Ratings
The cure proved worse than the disease for many fund managers as they closed almost 200 institutional prime funds (see chart below).
The cumulative effect of the regulatory changes on MMMFs has caused US$1 trillion to leave prime funds with much of that moving to government funds unaffected by all the same rules. Corporate treasury investors in these funds were unable to justify or implement quickly enough changes to their treasury and financial reporting systems required by the new rules. Regulators did not expect this as corporate treasurers were hit by their latest law of unintended consequences.