A Safer Money Market With Rule 2a-7

By Lisa Smith AAA

Since their inception in the 1970s, money markets had been marketed as "safe" investments. This positioning is highlighted in the introductory text to The Money Market tutorial, which states, "If your investments in the stock market are keeping you from sleeping at night, it's time to learn about the safer alternatives in the money market."

The focus on safety and solid returns was justified, as money market funds traditionally maintained a net asset value (NAV) of $1 per share and paid a higher rate of interest than checking accounts. The combination of a stable share price and a good interest rate made them stable places to store cash. This positioning held true until the Reserve Fund broke the buck - a financial services industry phrase used to describe the scenario when a money market fund has its NAVs fall below $1 per share.

While the Reserve Fund's meltdown directly hurt a relatively small number of investors, it revealed that the safety investors had relied on for decades was an illusion. If the Reserve Fund, which had been developed by Bruce Bent (a man often referred to as the "father of the money-fund industry"), couldn't maintain its share price, investors began to wonder which money market fund was safe. (To learn more about the Reserve Fund fiasco, read Money Market Mayhem: The Reserve Fund Meltdown.)

The failure of the Reserve Fund called into question the definition of "safe" and the validity of marketing money market funds as "cash equivalent" investments. It also served as a stark reminder to investors about the importance of understanding their investments.

Rule 2a-7
The Securities And Exchange Commission (SEC) recognized the threat to the financial system that would be caused by a systemic collapse of money market funds and responded with Rule 2a-7. This regulation requires money market funds to restrict their underlying holdings to investments that have more conservative maturities and credit ratings than those previously permitted to be held. From a maturity perspective, the average dollar-weighted portfolio maturity of investments held in a money market fund cannot exceed 60 days. From a credit rating perspective, no more than 3% of assets can be invested in securities that do not fall within the first or second-highest ranking tier.

Increased liquidity requirements are also part of the package. Taxable funds must hold at least 10% of their assets in investments that can be converted into cash within one day. At least 30% of assets must be in investments that can be converted into cash within five business days. No more than 5% of assets can be held in investments that take more than a week to convert into cash.

Funds must undergo stress tests to verify their ability to maintain a stable NAV under adverse conditions, and they are required to track and disclose the NAV based on the market value of underlying holdings and to release that information on a 60-day delay after the end of the reporting period.

Impact to Industry and Investors
The enactment of the legislation had no significant impact on investors. The NAV disclosure requirement has been a non event, as investors must go find the historical information. Fund companies are not required to provide it proactively. Yields on money market funds may be lower than they would be if the funds could invest in more aggressive options, but the difference is only a few basis points. (Learn more in Do Money Market Funds Pay?)

Next Phase
Looking ahead, issues around the NAV and the NAV disclosure requirement are the most troublesome prospects for money market providers and for investors. The SEC is interested is seeing real-time disclosure of NAVs in money market funds and the creation of a privately funded liquidity facility that would provide support to failing funds.

Real-time disclosure would be the next step along the path toward the SEC's goal of instituting a floating NAV for money market funds. Should a floating NAV be enacted, the value of holdings in a money market fund would rise and fall on a daily basis like the holdings in other mutual funds.

The Bottom Line
A floating NAV would likely have a severe dampening affect on the money market fund business. Money market funds appeal to investors because they pay higher rates of interest than checking or savings accounts, and they maintain steady NAV of $1 per share. If the NAV floats, it can drop below the $1 share price, causing investors to lose money. Since the interest rate differential between a money market fund and checking or savings account is generally small, investors would have little incentive to invest in money market funds. (For related information, take a look at Why Money Market Funds Break The Buck.)

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