Finding Continued Systemic Risk after 2010 Reforms, IOSCO Proposes Further Reforms of Money Market Funds

As the SEC and the Financial Stability Oversight Council wrestle with the scope of money market fund reforms in the US, IOSCO has set forth recommendations for money market fund  reforms as the basis for common standards for the cross-border regulation and management of money market funds. The recommendations are articulated around key principles for valuation, risk management, use of ratings, and disclosure. A key recommendation is that money market funds that offer a stable NAV should be subject to measures designed to reduce the specific risks associated with their stable NAV feature and to internalize the costs arising from these risks. Regulators should require, where workable, a conversion to floating/ variable NAV.

IOSCO’s work on money market fund reform is an important part of the efforts by the G20 and Financial Stability Board to strengthen the oversight and regulation of the shadow banking system. It follows the endorsement by the G20 Leaders of the Board’s initial recommendations and work plan regarding shadow banking submitted at the November 2011 Cannes Summit. The Board asked IOSCO to undertake a review of potential regulatory reforms of money market funds following the September 2008 run on some money market funds that alerted regulators to the systemic relevance of these funds.

Compared to the earlier SEC 2010 reforms, which mainly focused on the asset side of funds, the present IOSCO recommendations address vulnerabilities arising from the liability side, as well as the crucial issue of valuation and the display of a constant net asset value. In particular, the  IOSCO recommendations seek to address the vulnerabilities around the risk of run and first mover advantage, which could have broader consequences for the financial system.

IOSCO pointed out that the size, features and systemic relevance of money market funds differ significantly from country to country. Thus, the implementation of the recommendations may vary from jurisdiction to jurisdiction, depending on local circumstances, as well as according to the specificities of the existing domestic legal and regulatory structure.

While recognizing that the 2010 reforms in the US were a very important step in reducing the risks of money market fund portfolios and in making them more resilient in the face of important redemption pressure, IOSCO said that they did not fully alter the systemic features of money market funds. In particular, investors still have the incentive to redeem quickly when they fear that the fund will record a loss, which can lead the fund to burn the rest of its liquidity through fire sales and can lead to contagion effects to other funds.

To support the call for additional reform, IOSCO pointed to the 2011 slow-motion  run on U.S. money market funds that surfaced because of concerns about their exposure to European sovereign debt through their lending to European banks. This episode indicated that post-crisis regulation did not fully mitigate the systemic risks money market funds represent for the broader economy and the possibility of runs.

Specifically, IOSCO called on regulators to closely monitor the development and use of other vehicles similar to money market funds, such as collective investment schemes or other types of securities. This is especially important to avoid confusion among investors as well as to limit the risk of regulatory arbitrage. Money market funds should also comply with the general principle of fair value when valuing the securities held in their portfolios. Amortized cost method should only be used in limited circumstances.

In addition, money market fund valuation practices should be reviewed by a third party as part of the periodic reviews of the funds accounts. Third parties should review the overall appropriateness of the procedures in place and notably the sourcing of prices for valuing assets and, if the amortized cost accounting is used, the conditions for its use and the processes for calculating shadow-NAV. Responsible entities should ensure that prompt remedial actions are taken when weaknesses in valuation practices are identified.

Money market funds should establish sound policies and procedures to know their investors. They should ensure that appropriate efforts are undertaken to identify patterns in investors’ cash needs, their sophistication, their risk aversion, as well as to assess the concentration of the investor base.

Money market funds should also hold a minimum amount of liquid assets to strengthen their ability to face redemptions and prevent fire sales. Disclosure to investors should include all necessary information regarding the funds’ practices in relation to valuation and the applicable procedures in times of stress.

As part of risk management, IOSCO recommended that money market funds should periodically conduct appropriate stress testing. As part of prudent liquidity risk management and in accordance with IOSCO’s proposed Principles for Liquidity, money market funds should periodically test their portfolios based upon certain hypothetical and/or historical events, such as a rise in short-term interest rate or an increase in shareholder redemptions. When stress tests reveal specific vulnerabilities, responsible entities should undertake actions to reinforce their risk management.