By Ted Howard
SEC moves forward with floating NAV proposal, but also considers lock-ups.
The Securities and Exchange Commission voted on June 5 to proceed with new rules that would require prime money market fund managers to report marked-to-market daily net asset values. These variable NAV (or VNAV) funds would coexist with standard $1-per-share constant net asset value (CNAV) funds, although the CNAV reporting would only be permitted on US Treasury and government securities funds, not prime funds.
turf tensions
Spurred by the threat of the Financial Stability Oversight Counsel muscling into its regulatory turf, the SEC changed tack after rejecting a less detailed VNAV fund proposal last summer. The FSOC has argued that CNAV money funds could pose a systemic risk.
However, the SEC also voted to put a related proposal out for comment, one that would give some MMF managers the ability to charge redemption fees or implement outright lockups, called “redemption gates” when it appears that a run on a fund has begun.
While the VNAV proposal has some advantages for treasury, the redemption fees/gates are troubling. That’s because the VNAV’s attraction is its ability to signal problems with a fund early on, allowing its investors to head for the door. But a redemption fee or lockup will reduce the value of that transparency. If both the VNAV and the redemption proposals go through, investors may get a better view of their credit and market risks, but in some cases not be able to do anything about them.
Difficult Birth
Most money fund managers and many investors have opposed the idea of VNAV funds, arguing that they are operationally unwieldy and could be prone to runs.
The first major fund provider to back the idea was Deutsche Asset & Wealth Management, which proposed using market prices to set NAVs in an SEC comment letter in 2009, in the wake of the Reserve Fund problems. The VNAV idea went nowhere at the time, and in 2010, the SEC tightened up duration and credit quality requirements for money funds, causing an outcry among providers and compressing potential returns for investors.
Reeling from the changes to the assets they could buy, MMF managers were generally opposed to the different but equally radical changes that VNAVs would require. They involve a significant operational challenge: to offer the same liquidity features as CNAV funds, VNAV funds need to be priced and settled at T+0, as opposed to all other bond funds that settle funds at T+1.
Corporate Considerations
Corporate treasury cash managers have been wary of the VNAV proposal because they were not sure that the funds would qualify as “cash or cash equivalents” under GAAP accounting rules, and were concerned over increased accounting and tax complexity due to frequent tracking of realized gains or losses.
Most of the time, based on the definition of cash and cash equivalents, there is strong evidence to support the case that VNAV funds will meet the requirements, says Kevin Bannerton, head of liquidity for the Americas at Deutsche Asset & Wealth Management (DAWM) in New York. In fact, SEC Commissioner Gallagher addressed this point specifically in the SEC’s June 5 meeting.
However, in some cases, if there are related gains and losses, they may not qualify, Mr. Bannerton says. It is unclear whether there would be tax relief granted for de minimis realized gains or losses. In those cases, “Treasurers may want to segment their spending operational cash from their investments.”
If they perform as advertised, the VNAV MMFs will actually lower the risk corporates bear in their cash investment portfolios. That’s because the floating price reflects the value of the underlying assets, and is therefore a measure of their market and credit risks. With $1 per-share CNAV funds, investors may not find out about a deterioration in their money fund’s underlying portfolio until it is downgraded or it breaks the buck.
In both scenarios, treasury cash investment managers realize too late that they have been bearing risk without knowing it, and without being compensated for it. They also have to swap out of the deteriorating money fund, which may be difficult and costly, as investors in the Reserve Fund, which broke the buck in 2008, found to their dismay.
Test Case
It might take the money fund industry some time to gear up to offer VNAV prime funds. That’s because there are some logistical challenges to pricing and settling at T+0, which is necessary if the fund is to qualify as cash or equivalent. Most other short-term fixed income funds settle at T+1.
DAWM has managed a VNAV fund since 2011, when it solved the T+0 problem. While the fund is relatively small, it has performed well through the market crises of the past two years. A number of other asset managers, including Blackrock, have begun to express interest in launching VNAV funds, or have at least come around to the idea that they will become a necessary part of the investment landscape.
The VNAV and redemption fee/redemption gates proposals are now out for comment. The former could provide treasury with some welcome risk transparency, but the latter could threaten liquidity just when a company needs it most.
With the FSOC, the fund industry and corporate treasury all having a large stake in the outcome, the comment period promises to yield some interesting views.