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Fidelity and Schwab oddly take opposite sides on issue critical to money market funds as an SEC, alarmed by systemic risks, puts NAVs under spotlight

The Boston and Westlake, Tex., providers disagree about whether the once sacred $1 net asset value should now float accross prime money market funds -- and potentially municipal money market funds.

Monday, May 10, 2021 – 5:28 PM by Oisin Breen
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Cynthia Lo Bessette: Any reforms must preserve and protect the availability of money market funds.

Brooke's Note: The great thing about money market funds was you always got a much better return on your cash than bank accounts and with almost as much liquidity. The only downside was purely theoretical. Whereas bank accounts were FDIC insured, you were flying without a net holding cash in money market funds. But it never seemed to matter, and there seemed to be an implicit guarantee of safety in numbers alone. Occasionally, that implicit guarantee became explicit when the Treasury, in times of national financial crisis, backed the funds knowing that $5 trillion of ready cash could not be allowed to fail. But low, low rates and an SEC tired of having money markets have it both ways could be about to change the rules of the game. None of the ways forward look good, so maybe it should come as no surprise that Schwab and Fidelity disagree about which fork in the road makes sense on NAVs -- or whether to put a fork in the whole category.

Split where you might expect unity, Fidelity Investments and Charles Schwab Corp. are clashing on a matter that may determine whether prime and municipal money market funds will still exist.

At issue is whether to keep net asset values fixed at one dollar for certain types of retail money market funds and whether sub-categories contorted by unrelenting interest rate drops even warrant the name "money market fund."

Rick Wurster
Rick Wurster says prime funds with floating NAVs might need to drop the 'money market' tag.

The Boston and Westlake, Tex., brokerage giants are butting heads over the potential introduction of a floating net asset value (NAV) for all prime and municipal money market funds.

The split surfaced in letters submitted in April to the Securities and Exchange Commission (SEC), following a Feb. 4 request from the regulator for comment on money market reform.

The SEC issued its request for comment after the President's Working Group (PWG) on Financial Markets called for further money-market fund regulation in the wake of a run on redemptions in March 2020.

"Schwab believes the time has come to consider whether the stable one dollar per share price of prime and municipal money market funds is based on an accounting convention whose time has passed," writes Schwab executive vice president for asset management solutions Rick Wurster, in a letter to the SEC.

"The commission will also need to resolve whether floating NAV funds should continue to be permitted to call themselves '​money market funds,'" he adds.

Yet floating NAVs demonstrably don't prevent redemption runs, and by unpegging prime funds from the dollar, the SEC could kill the prime market, Fidelity chief legal officer, Cynthia Lo Bessette asserts in a response.

"The floating NAV did not prevent outflows in institutional prime funds in March 2020. The decline in institutional prime fund assets ... began in 2016 with the full implementation of the [institutional floating NAV] reforms adopted by the SEC in 2014," she explains, in her letter to the SEC.

The SEC declined a request for comment.

Taking sides

Fidelity's view matters on floating NAVs. It is top dog in the retail prime market with $91.9 billion under its management (AUM), followed closely by Schwab with $86.7 billion.

Ari Sonneberg
Ari Sonneberg: The real question is, how much of this is already a fait accompli.

The pair have a massive lead over all other vendors; Federated Hermes ($27.5 billion) and JPMorgan ($11.1 billion) are their closest competitors, according to Westborough, Mass., money-market fund tracker Crane Data.

Of 49 respondents to the SEC, just five companies or individuals and four trade groups joined Schwab in backing the introduction of floating NAVs, including PIMCO, Vanguard and Wharton professor of legal studies David Zaring.

Some 31 respondents rejected floating NAVs, including Fidelity, Federated Hermes, JP Morgan, BlackRock and BNY Mellon.

A spokeswoman for Federated Hermes says, via email that  floating NAVs would be an "ineffective and likely harmful solution to a non-existent problem."

The majority of respondents rejected NAV changes because they consider them unsuited for the SEC's and PWG's goal of reducing liquidity risk.

"Schwab decided to break ranks and say 'we've got to give a significant concession or else [regulators] will hit us with something harder' [and] the floating NAV on prime money funds might be enough," says Peter Crane, president of Crane Data.

"It's all about throwing the SEC a bone, and everyone wants to throw a bone that doesn't hurt their business," he adds.

Systemic risk

The bone throwers fear a rambunctious SEC might devour the whole money market business, should two of the strictest imperatives under consideration come to pass.

Walt Bettinger
Walt Bettinger previously lobbied in favor of floating NAVs for institutional prime funds.

Money markets -- post-2008-2009 -- are a giant systemic risk because the $4.9 trillion tranche of assets, en masse, is too big to fail. Hence, the Fed keeps stepping into guarantee the balances, which offer returns as if they have no guarantee.

To make money markets carry their own weight, the SEC has floated several possible reforms. Yet asset managers fear the regulator might insist on greater capital reserves, and the creation of a mutually owned liquidity bank.

Investors could also be hit with minimum balance requirements, making money markets more like CDs so investors can only cash out at certain set times, and not in full.

The irony is that regulators already have tools in their arsenal to stop runs, as they demonstrated in 2008 and in 2020, says Crane.

"Money funds didn't lock up the commercial paper market; the commercial paper market locked up and no one dares utter the obvious solution, which is to say what we just did worked like a charm, just do it again next time," he argues.

"[Let] the Fed come in and say its backing something. All it costs is words," he adds.

Curtains?

Wurster acknowledges that untethered NAVs could hurt the prime and municipal markets, and even hand banks a major boost if their introduction spooked investors.

"This change could have wider implications for the financial system, particularly the banking sector, which could see significant inflows from investors seeking a stable return and the guarantee against losses provided by federal deposit insurance," he writes.

Today, institutional and retail prime funds account for just 18% of the $4.9 trillion held in US money market funds.

Peter Crane
Peter Crane: It's all about throwing the SEC a bone ... [but] no one dares utter the obvious solution.

Yet if money market funds can't offer higher returns than typical bank accounts--and they add more risk--then it's curtains, says Gary Zimmerman, CEO of New York City RIA cash manager, MaxMyInterest, via email.

"Money Market Funds were an important innovation at a time when short-term securities paid out higher yields than banks ... [but] the trillions of dollars still held in [them] are much like the trillions of dollars still held in brick-and-mortar bank accounts; they are the result of inertia," he says, via email.

Out of the top 20 money market fund managers, 10 own banks, including Schwab. Of the nine institutional prime vendors with over $10 billion of AUM, three own a bank. Of the four retail prime vendors with over $10 billion of AUM, two own a bank.

Fighting the float

Standard money market funds have long aimed to maintain a one dollar NAV, ensuring investor payouts.

Bill Singer
Bill Singer: We brew a distillate by which the stronger get stronger and fewer in numbers.

Should a fund fall below this level, it 'breaks the buck.' The fund may also fail to recoup or exceed operating expenses or investment losses.

Floating NAVs, one of 10 possible reforms under consideration, eliminate this issue, but they can also eat up payouts.

The introduction of floating NAVs into the retail prime and municipal money market could also force comparatively small competitors out, according to Ari Sonneberg, partner and chief marketing officer at Wagner Law Group in Boston.

"It's no mere coincidence ... Goliath can afford to stay in the game and jump the compliance hurdles. David has neither the resources nor the wherewithal to do so," he says, via email.

Lesser evil

Schwab's break with the majority of money market fund vendors is based, in part, on a strategic bet that floating NAVs represent the least damaging of the 10 regulatory options on the SEC and PWG list, says Sonneberg.

Gary Zimmerman
Gary Zimmerman: The trillions of dollars still held in money market funds are ... the result of inertia.

"There is no doubt that Schwab and Vanguard expressed their support for floating NAVs for prime and municipal money market funds because they view some form of regulation as inevitable and that it's the lesser of all the perceived evils," he explains.

Vanguard could also benefit if investors pull out of prime funds, says Daniel Wiener, a long-time Vanguard observer, via email.

"[Without] a prime money fund any longer, does Vanguard see a floating price for competitors’ as a negative for them, and a positive for Vanguard?" asks the chairman of Newton, Mass.-based RIA Adviser Investments.

Schwab's Wurster claims floating NAVs as fairer, more transparent and likely to "diminish any belief that the one dollar constant net asset value is the equivalent of a guarantee of [an] investment."

Instead, in submissions to the SEC, many vendors supported the possibility of scaling back or removing pre-set "gate" thresholds that require the imposition of withdrawal fees or the barring of withdrawals.

Many also stated that such gates contribute to runs, rather than reduce them, as regulators intended, following their 2014 introduction.

Yet most money market fund companies doubt the SEC will opt to roll-back restrictions, according to Crane.

"The real question is, how much of this is already a fait accompli and how much real room there is, if any at all, for influence?" asks Sonneberg.

Indeed, in a recent release, the SEC asserts that "more work is needed to reduce the risk that structural vulnerabilities in prime and tax-exempt money market funds will lead to or exacerbate stresses in short-term funding markets."

Worst case scenario

The most unwanted of possible reforms -- and one the industry desperately wishes to stave off -- is the introduction of mandatory capital buffers and the creation of a central liquidity exchange bank, according to Crane.

Justin Muzinich
Justin Muzinich: Money markets experienced significant outflows [in March 2020], forcing Treasury and the Federal Reserve to step in.

"Those are radical concepts, which could destroy the government money funds sector as well," he says.

"[Floating NAVs] might forestall broader regulatory scrutiny from not just the SEC, but the Financial Stability Oversight Council and international regulators ... it's a nice fat goat," he adds.

Fidelity's Lo Bessette shares Crane's concerns.

"A private liquidity exchange bank [would be] unnecessarily complex, economically unworkable … [and] could create moral hazard by forcing responsible funds to insure less responsible funds," she explains.

"Any reforms must preserve and protect the availability of money market funds ... [and] government funds, which now represent a significant majority of the industry, should be excluded entirely from further rounds of reform," she adds.

Yet even if regulators only move on floating NAVs, recent history suggests the respite would only be temporary, according to Sonneberg.

"It's possible that the SEC accepts the sacrificial lamb, but I don’t know that Schwab and Vanguard would have expressed their support for [floating NAVs] so quickly if they weren't concerned the SEC was not seriously considering going way further," he says.

Indeed, in a 2012 opinion piece published by the Wall Street Journal, Schwab CEO Walt Bettinger lobbied for the introduction of floating NAVs for institutional prime funds, describing it as "a compromise ... necessary for the good health of our industry and the economy."

Yet in the same article, Bettinger also argued for retail prime funds to stay fixed to one dollar in 2012. Wurster pushed the same position for government money market funds in his letter to the SEC.

Spate of closures

Both the municipal and prime money market fund industry have been hit hard in recent years, as low interest rates battered them on two fronts -- supply and return.

Mutual Fund Families
The largest mutual fund families in the US. Source: Crane Data.

The quantity of medium-term notes underpinning municipal markets, for instance, has suffered a squeeze.

Issuers are taking taking advantage of rock-bottom rates on ultra-short and long-term borrowing. As a result, Vanguard and BNY-owned Dreyfus, among others, opted to close a number of funds. See: Vanguard's shuttering of municipal money market funds sends clarion call to RIAs.

In August 2020, Fidelity also closed its two publicly offered institutional prime money market funds with $14 billion in cash assets. This past September Vanguard converted its $125 billion non-treasury prime money market fund into a government bond fund. See: Fidelity Investments intends to 'hard close' two institutional money market funds.

Additionally, the low-rate environment has prompted renewed interest in the ultra-short bond market among asset managers, again including Vanguard.

Daniel Wiener
Daniel Wiener: Does Vanguard see a floating price for competitors’ as a negative for them, and a positive for Vanguard?

"Fidelity and Vanguard are hedging their bets and bulking up their ultra short bond fund offerings," says Crane. See: A 'late' Vanguard Group joins crowd selling ultra-short bond ETF --managed by humans -- after money markets refuse to rebound.

"They can live with government money funds and ultra short bond funds," he adds.

Schwab is the municipal money market fund leader, with 2.5% marketshare in state money market funds, ahead of Vanguard (1.4%) and Fidelity (1.2%).

The brokerage controls 7.2% of the market for institutional municipal money market funds, ahead of Vanguard (3.5%); and 12.9% of the retail municipal money market fund market, where it trails TRowe Price (15.6%), according to Crane Data.

Yet Schwab is a bit player in institutional prime money market funds, which have had floating NAVs since October 2016, with $3 billion under its management. Fidelity is the third largest ($89.8 billion), behind American Funds ($119.9 billion) and Vanguard ($112.6 billion).

Accidental oligopoly

In a Dec. 2020 Fed release, Justin Muzinich, former deputy secretary of the US Treasury Dept. outlined the case for potential SEC and PWG backed reforms to the money market industry.

March 2020 outflows forced the Treasury and the Fed to "step in to prevent a destabilizing run," a "vulnerability" that could "threaten financial stability in the future," he said.

Yet reform could hasten the birth of an accidental money market fund oligopoly, says Crane.

"The ones that will make it through are the bigger and stronger ones, who should benefit from there being limited competition. So, you'll continue to see grinding, slow consolidation and product shifts and adaptation," he explains.

Fidelity is the largest money market fund vendor, with $897 billion of AUM, followed by BlackRock ($522 billion), and Vanguard ($494 billion). Schwab sits in eleventh place with $160 billion, according to Crane data.

Indeed, more regulation equals higher costs at a time when fee waivers and expenses are already forcing fund closures, so only the largest scale players will survive, Crane continues.

"Money funds now are charging [approximately] 10 basis points instead of 30. The big firm can live on 10 basis points forever," he says.

"The small firms, maybe not, but there aren't a whole lot of small firms left. A couple of the [SEC] comment letters have hinted that every time [the SEC does] this, it's forcing concentration," he concludes.

It's the sad irony of good intentions, adds Bill Singer, attorney and writer of the Broke and Broker blog, via email.

"There has always been an oligarchy on Wall Street, and when the likes of Bear Stearns or Lehman Brothers vanish, we brew a distillate by which the stronger get stronger and fewer in numbers so that their influence is even more concentrated and potent."


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