Speech by SEC Commissioner:
Strengthening the Money Market Framework with Investors in Mind
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
June 24, 2009
Thank you Chairman Schapiro.
Money market funds were founded nearly 40 years ago. And, as is well known, one of the hallmarks of money market funds is their ability to maintain a stable net asset value — typically at a dollar per share.
In the time they have been around, money market funds have grown enormously — from $180 billion in 1983 (when Rule 2a-7 was first adopted), to $1.4 trillion at the end of 1998, to approximately $3.8 trillion at the end of 2008, just ten years later. The Release in front of us sets forth a number of informative statistics but a few that are of particular interest are the following: today, money market funds account for approximately 39% of all investment company assets; about 80% of all U.S. companies use money market funds in managing their cash balances; and about 20% of the cash balances of all U.S. households are held in money market funds. Clearly, money market funds have become part of the fabric by which families, and companies manage their financial affairs.
As we know, the Commission is responsible for regulating money market funds. Because of the importance of money market funds to so many investors and to other market participants, the Commission must keep a watchful eye on their operations. To that end, Rule 2a-7 was established in order to provide some limits on the risk that these funds may take. Accordingly, in order for a fund to hold itself out to the public as being a money market fund, the SEC requires that such a fund must meet the strong protections contained in Rule 2a-7. Among other things, Rule 2a-7 has "risk-limiting conditions" that protect investors and funds from excessive exposure to certain risks, such as credit, currency and interest rate risks.
Under Rule 2a-7, investors have found money market funds to be resilient over the years. Only a couple of money market funds have ever actually "broken the buck." Still, given the events of the last year and the continuing economic turmoil, it is only appropriate that the Commission revisit the safeguards embedded in Rule 2a-7. Accordingly, I am pleased that the staff's proposal would increase the resilience of money market funds to market disruptions. The changes proposed today should make it even less likely that a money market fund will fail to provide investors with the security they seek. Investors in money market funds expect the SEC to keep a watchful eye to protect their interests, and I'm pleased to support the staff's proposal.
I want investors to know that my support for this proposal comes after careful review. I've been a practitioner in the securities industry for over 30 years. Although a lot of my practice involved capital formation — such as representing public and private companies financing their businesses — I also have a deep understanding of investment management, and money market funds. I spent a substantial portion of my career in the investment management industry. In the 90's and the early part of this decade I served as General Counsel and Head of Compliance of a large global asset manager. During my private career, I organized and advised closed-end investment companies, mutual funds and money market funds.
Because of my experience with money market funds, I understand that Rule 2a-7 contains a highly technical set of conditions that a fund must comply with when it holds itself out as a money market fund. I have spent more time than I care to recount thinking through the language in 2a-7 and providing counsel on how to apply the rule under real operating conditions. I know well that this is a rule that has always been written and amended with investors and the general public in mind, and we must keep that as our touchstone.
Overview of the Proposal
Enhances the core protections of 2a-7
It is with investors in mind that I commend the staff for making recommendations to the Commission as to how to strengthen the regulation of money market funds and Rule 2a-7. The proposal offers sound amendments that go to the heart of how a money market fund is organized, operated, and liquidated. The proposal would amend Rule 2a-7 in order to strengthen portfolio quality, maturity, and liquidity requirements. The proposal also would require that critical information be reported regularly to the Commission and would set forth conditions pursuant to which funds could engage in an orderly liquidation procedures if needed.
In a proposal filled with constructive ideas and strengthening amendments, there is one particular proposal that stands apart. This release raises, yet again, the question of whether the Commission should remove the protections in Rule 2a-7 that relate to security ratings.
External and Internal Determinations are in Current 2a-7
Let me take a moment to summarize how the Rule works.
Rule 2a-7 currently requires a money market fund to hold only very high quality securities in its portfolio. The board of directors of the fund (which typically relies on the fund's adviser) is charged with determining that the portfolio investments present "minimal credit risk," based on factors pertaining to credit quality, in addition to any credit ratings on a security. In the real world, this means that money market portfolio securities must be, number 1, highly rated securities, and number 2, also pass the scrutiny of the board of directors (or of the delegated adviser). In short, the current rule contains both an external determination — which is the credit rating — and an internal determination — which is the board's independent evaluation.
To delete the external evaluation, that is, the credit rating, would remove the baseline protection provided by third-party credit ratings and would re-fashion 2a-7 to be solely dependent on the internal evaluation. I see no reason to sacrifice the important safeguard of the external determination.
Request for Comment on Removing References to Credit Ratings in 2a-7
Nonetheless, the Commission in this release is asking, yet again, for comment on removing the references to credit ratings from 2a-7. For many of you, it will feel like déjà vu as the Commission has on two occasions previously asked for comments on this idea, most recently in June 2008. Each time, the vast majority of comments we received strongly objected to deleting the references to credit ratings in Rule 2a-7 and the comments highlighted the serious harm that would flow from such an ill-advised action.
For example, we have on file 46 comment letters that specifically addressed the issue of removing credit rating references from 2a-7. Of the 46 letters, 41 advocated that the Commission retain the references in 2a-7 as a vital investor protection. It is notable that these letters came from a wide variety of commenters, from investor advocates, independent trustees and boards of directors, large investment advisers, large and small fund complexes, consultants, state government officials, ratings agencies and individual investors, among others. The fact that this coalition is so broad and diverse speaks volumes about the significant investor protection that the references to credit ratings provide in the context of Rule 2a-7.
I ask investors, fund managers, and others to share their expertise and comment yet again on the importance of credit ratings to ensuring that money markets hold high quality securities. In fact, it would be informative to hear the views as to whether the recent market turmoil lends support to the importance of credit ratings as an important additional safeguard.
Strengthening Quality of NRSRO ratings
As today's proposal makes clear, the use of credit ratings in Rule 2a-7 was designed to provide a clear reference point to regulators and to market participants, but it was not designed as a substitute for reasoned analysis and judgment by the fund's board or adviser (as the Board's delegate). Both ratings and judgment are required.
It is true that, relying on credit ratings and the conduct of credit ratings agencies have been widely criticized. But to apply that criticism here reflects a fundamental lack of appreciation for how money market fund regulation works. Reliance on credit ratings is often criticized because, the argument goes, fund managers do not use their own judgment in evaluating a security, they merely rely on a credit rating. That reasoning simply doesn't apply in the context of money market funds because the board has an express duty under the rule to independently evaluate the credit risk of portfolio securities. A high credit rating is just part of that evaluation, and removing the requirement to consider credit ratings removes an important additional safeguard.
Instead, the better way to resolve concerns about credit ratings, while also preserving the external evaluation part of Rule 2a-7's protections, is to improve the reliability of the ratings themselves.
There has been legitimate criticism of NRSRO credit ratings, including criticism as to the NRSROs' management of conflicts of interest, poor ratings quality — particularly in the structured finance area — and lack of transparency regarding the determination of ratings.
However, the Commission is in the midst of addressing those concerns. We have recently taken important steps toward toughening the standards applicable to credit rating agencies and to increase their accountability, transparency and competition. I've been supportive of those actions as being necessary for investor protection — and I will continue to insist on high standards from NRSROs.
But the determination to remove references to credit ratings in our rules has to be based on a sound understanding of the role that credit ratings play in the operation of the particular rule in question. The general criticisms about the use of credit ratings don't really apply in the case of 2a-7. Ratings are an important safeguard, but ratings do not, and cannot under the current rule, replace the judgment of the fund board and its responsibility to make an independent evaluation of credit quality. Requiring both provides strong investor protection.
Money market funds are a key part of our capital markets. And the Commission has overseen the development of money market funds from their inception. In fact, the Commission's money market staff — some of whom are at the table today — have been involved in overseeing or developing this industry since its inception. They have, once again, come up with sound proposals.
In closing, I support today's proposal, and I look forward to public comments.
I join the Chairman and fellow Commissioners in thanking the staff for their hard work and for their thoughtful recommendations.