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Up Close: SEC’s Proposed Rule Changes to the Floating NAV

  • By Jeanine H. Arnett, Director, Government Relations & Policy, AFP
  • Published: 2013-06-27

First of a two-part examination of the SEC's proposed money-market fund rule changes.

On June 5, 2013, the Securities and Exchange Commission (SEC) released its long-awaited proposed rule changes for money-market funds (MMFs). In the 700+ pages, the SEC attempts to anticipate every conceivable question about how a change of this magnitude would impact MMFs.

The first proposal, most commonly referred to as floating the net asset value (NAV), would allow MMF shares to fluctuate on prime institutional funds. This would remove the special exemptions that allow MMFs to use amortized-cost accounting and rounding to maintain stable NAVs.

The proposed reforms are designed to:

  • Mitigate MMFs' susceptibility to heavy redemptions during times of stress
  • Improve MMFs' ability to manage and mitigate potential contagion from high levels of redemptions
  • Preserve as much as possible the benefits of MMFs for investors and the short-term financing markets
  • Increase the transparency of risk in MMFs.

In addition to an extensive economic study and analysis, the SEC proposed two major changes to the rules governing funds that would: 

  • Allow the value of MMF shares to fluctuate, and
  • Limit redemptions or charge fees for full redemptions of MMF holdings.

Floating NAV

The first proposed alternative would require that all institutional prime money market funds operate with a floating NAV. That is, they could no longer value their entire portfolio at amortized cost and they could not round their share prices to the nearest penny. The set dollar would be replaced by a share price that actually fluctuates, reflecting the changing values in these money market funds.

This floating NAV proposal specifically targets the funds where the problems during the financial crisis occurred: institutional, prime MMFs. Retail and government MMFs-which have not historically faced runs in even the worst of times-are exempt.

This approach preserves the stable value fund product for retail investors and it would allow municipal and corporate investors access to government money market funds-a stable value product-if necessary, although it would be a product that holds federal government securities as opposed to the higher-yielding investments of a prime fund.

  • The SEC is seeking comment regarding the proposed floating NAV and AFP urges members to file them here.
  • Read the proposals here.
  • You can read other public comments here.

Critics of MMF reform have pointed out that there were likely other incentives that may lead to heavy redemptions of floating NAV funds in times of stress. As such, the SEC would like to receive comments on the performance of other floating NAV investment products during the 2007-2008 financial crisis.

Among its proposals, the SEC wants prime MMFs to price their shares using a method that would require them to price and transact calculated to the fourth decimal place for shares with a target NAV of $1 (e.g., $1.0000). Funds with a current share price other than $1.00 would be required to price their shares at an equivalent level of precision (e.g., a fund with a $10 target share price would price its shares at $10.000).

The proposed change to MMF pricing under this proposal would change the rounding convention for money market funds-from penny rounding (i.e., to the nearest 1 percent) to "basis point" rounding (to the nearest 1/100th of one percent). "Basis point" rounding is a significantly more precise standard than the 1/10th of one percent currently required for most mutual funds.

The SEC believes that their proposal provides the level of precision necessary to convey the risks of MMFs to investors. According to the SEC, "basis point" rounding should help stabilize MMFs in times of market stress by deterring redemptions from investors that would otherwise seek to take advantage of less precise pricing.

Tax and accounting implications

The SEC believes that MMFs' ability to maintain a stable value per share simplifies tax compliance for shareholders. Currently, purchases and sales of MMF shares at a stable $1.00 share price generate no gains or losses, and MMF shareholders therefore generally need not track the timing and price of purchase and sale transactions for capital gains or losses.

The SEC states that by requiring some MMFs to use floating NAVs, taxable investors in those MMFs, like taxable investors in other types of mutual funds, would experience gains and losses. Therefore, shareholders in floating NAV MMFs could owe tax on any gains on sales, or could have tax benefits from any losses, and would have to determine those amounts.

If the SEC were to adopt the floating NAV proposal, some MMF shareholders question whether they would be able to treat their fund shares as "cash equivalents" on their balance sheets. The SEC in its proposal said it understands that classifying MMF investments as cash equivalents is important because, among other things, investors may have debt covenants that mandate certain levels of cash and cash equivalents.

Current U.S. GAAP defines cash equivalents as "short-term, highly liquid investments that are readily convertible to known amounts of cash and that are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates." In addition, U.S. GAAP includes an investment in a MMF as an example of a cash equivalent. Notwithstanding, some shareholders are concerned given this guidance came before MMFs using floating NAVs.

The SEC believes that the adoption of a floating NAV alone would not preclude shareholders from classifying their investments in MMFs as cash equivalents because fluctuations in the amount of cash received upon redemption would likely be insignificant and would be consistent with the concept of a 'known' amount of cash.

AFP Position

AFP has expressed concerns regarding proposals to eliminate the stable NAV in favor of a floating NAV in the past and we continue to have grave concerns. We believe it would greatly reduce investors' interest in utilizing MMFs as a cash management and investment tool, whether they be retail or institutional investors. For purchasers of MMFs, the return of principal is a much greater driver of the investment decision than return on principal. For a large number of institutional investors, the potential of principal loss would preclude floating NAV MMFs from being an internally-approved investment alternative.

AFP has submitted comment letters that account for all proposed reforms and we believe that that the rules enacted in 2010 were significant reforms that address liquidity concerns and systemic risks posed by MMFs. We continue to argue that the SEC should allow the rules to serve their intended purpose before instituting further proposals, such as floating the NAV, which compromises MMFs as a viable investment alternative for corporate investors.

The move to a floating NAV would also create significant disruptions in the corporate funding market. Many organizations issue commercial paper to meet their short-term financing needs, such as funding payroll, replenishing inventories, and financing expansion. Since the mid-1980s, MMFs have been major, reliable buyers of those securities and today purchase more than one-third of the commercial paper issued by American businesses. Commercial paper issuers are very concerned the changes as proposed would alter the investment structure of money-market funds so much that investors will reduce or even eliminate them from their investment portfolios, thereby wiping out the single largest investor base for commercial paper and its source as a liquidity vehicle and low-cost financing alternative. If commercial paper issuers must pursue other forms of debt financing, it is possible that smaller and lower-quality issuers may be crowded out of the debt markets entirely. Additionally, a reduction in MMF balances would also reduce the capital available to purchase commercial paper, making short-term financing for businesses less efficient and more costly.

AFP maintains that U.S. businesses make their investment decisions based on a variety of factors unique to their organizations. In many instances, MMFs are the investment option that most closely matches the risk/return profile companies seek to generate surplus operating cash, as specified by an organization's own written investment policy. Changing to a floating NAV would significantly change the risk/return profile of MMFs. Nearly two-thirds financial professionals indicate their organizations would be less willing to invest in MMFs and/or would reduce/eliminate their current holdings of MMFs in their short-term investment portfolio in response to a floating NAV. Large organizations, those that are publicly held and net investors would be more likely than other companies to make changes in their MMF investments in response to reform.

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All rights reserved.

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