In a recent article, David M. Geffen and Joseph R. Fleming of Dechert LLP's Boston office, take an alternative look at the source of the systematic risk posed by money market funds. In their article, Geffen and Fleming propose that the systematic problems posed by money market funds are not necessarily a function of the structure or regulation of these funds, but a result of volatility created by institutional investors, and their effect on money market fund liquidity.
Rather than attributing the systemic risk engendered by money market funds susceptibility to runs to the structure of money market funds, the systemic risk could be deemed to arise from institutional shareholders, which can demand liquidity when money market instruments in which money market funds invest are experiencing a period of exceptional illiquidity.
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Ultimately, the structure of money market funds, by itself, is not the source of systemic risk associated with those funds. Equally important are institutional investors — the investors that redeemed $300 billion from non-U.S. Treasury money market funds in September 2008 — that are a source of the systemic risk associated with money market funds. Viewed in this light, institutional money market funds and their investors are a classic tragedy of the commons — a situation in which independent actors, each acting rationally to maximize its own interest, deplete a shared, finite resource (i.e., the limited liquidity available to their fund during a liquidity crisis), despite the fact that it is in each actor’s interest to avoid the destruction of the resource.
Geffen and Fleming propose that, given their theory, an appropriate response would be to impose, temporarily, a redemption fee in times of market stress where a money market fund may face a period of illiquidity.
The alternative suggested here is that, during a period of illiquidity, as declared by a money market fund’s board13 (or, alternatively, the SEC or another designated federal regulator), a money market fund may impose a redemption fee on a large share redemption approximately equal to the cost imposed by the redeeming shareholder and other redeeming shareholders on the money market fund’s remaining shareholders. For example, if redemptions in cash are expected to impact the market value of the fund’s remaining portfolio securities by an estimated dollar value or percentage, then the redeeming shareholders would be entitled to receive their principal value (i.e., the $1.00 NAV) minus the market impact that the redemptions have on the fund. Thus, during a period of declared illiquidity, a shareholder who insists upon making a large redemption of its shares would receive less than the full amount of its shares’ NAV. As soon as the declaration is withdrawn at the end of the period of illiquidity, money market funds would no longer be permitted to impose a redemption fee on redeeming shareholders and, once again, share transactions would occur at the $1.00 NAV.
Geffen and Fleming's provocative theory and proposed alternative to structural reform are interesting counterpoints to the findings of the President’s Working Group on Financial Markets report on money market funds. The full text of Geffen and Fleming's article is available here.
(Provided with permission from the authors)