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A New Chapter in the Money Market Saga

Rob Silverblatt

The Financial Stability Oversight Council has officially entered the money-market regulatory fray with a set of policy proposals aimed at convincing a reluctant Securities and Exchange Commission to act.

[Read: RIP Money Market Reform.]

The proposals mark the latest development in a saga that dates back to 2008, when the infamous Reserve Primary Fund "broke the buck," thereby sending panic waves throughout the multi-trillion-dollar money market industry. Though largely technical in nature, the proposals have significant implications for retail investors, who frequently rely on money market funds as a safe parking spot for their cash.

The FSOC's proposals also set the stage for fresh tension between a vocal group of regulators, who feel that despite limited reforms in 2010, money market funds are still vulnerable to havoc-wreaking asset runs, and the fund industry, which has devoted significant public-relations efforts to arguing that reform would harm investors by making money market funds less viable investments.

Already, the FSOC's action has prompted criticism from the fund industry, which feels "backed into a corner," according to Peter Crane, the president and chief executive of the money market tracking firm Crane Data. However, the proposals may provide enough cover for SEC Chairman Mary Schapiro, whose most recent attempt to push money market reform through the Commission failed by one vote, to get approval for a new set of regulations.

[Read: How Money Market Reform Would Affect Your Investments.]

Created by Dodd-Frank and comprised of 10 voting members and five non-voting members, the FSOC is vested with congressional authority to issue recommendations to regulators such as the SEC. On Tuesday, after encouragement from Treasury Secretary and FSOC Chairman Timothy Geithner, the Council exercised that authority by releasing a list of three proposals. The Council is seeking comment on them with an eye toward eventually presenting a recommendation to the SEC.

Two of the three proposals were previously considered by the SEC before being abruptly taken off the table in August after Schapiro indicated that she could not put together the three-commissioner majority needed to put them into effect. The first of these proposals is to require money market funds to "float" their net-asset values. Money market funds, though well-known in most households for their stable $1 per share prices, frequently have actual NAVs that drift by small fractions from the $1 targets. The floating NAV rule would force funds to publicize these fluctuations.

The second previously considered option is for funds to, instead of floating their NAVs, maintain 1 percent capital buffers and put limits on certain shareholders' ability to pull out more than 97 percent of their assets. The latter limitation, which would apply to individuals who have more than $100,000 invested in a fund, would require that funds establish a waiting period for the remaining 3 percent.

In addition to those two proposals, which were the subject of the aborted SEC action, the FSOC also suggested a third option, which would require funds to maintain 3 percent capital buffers in addition to "other measures." These other measures "could include more stringent investment diversification requirements, increased minimum liquidity levels, and more robust disclosure requirements," according to the FSOC. The FSOC indicated that if these additional measures can be shown to be effective, it might be willing to back away from the 3 percent number.

The FSOC, echoing arguments that Schapiro has been advancing, contends that money market funds are currently "susceptible to runs that can have destabilizing implications for financial markets and the economy." That's what happened in 2008, when exposure to Lehman Brothers investments caused the Reserve Primary Fund to "break the buck." When its NAV destabilized, investors rushed for the doors in a frenzy that had market-wide implications.

[Read more about the Reserve Primary Fund in The Decade's 10 Worst Fund Disasters.]

However, in light of the failed August effort, it remains to be seen whether the FSOC's recommendations will be enough to get reform through the SEC. Mike Krasner, the managing editor of the money market research firm iMoneyNet, labels the FSOC's proposals "a lot of reheated leftovers," based on their similarity to the failed SEC efforts. "I'm not sure that fund providers and fund investors have much appetite for what's on the menu at the moment," he said.

It is also unclear what form the FSOC's final recommendation, which will follow the public comment period, will take. The FSOC indicated, though, that it would be willing to combine aspects of the various proposals in order to find a happy medium.

In the event that the SEC turns down the FSOC's recommendation, that could lead to a turf war. The New York Times, in evaluating the possibilities, reports: "Only the [SEC] can enact regulations on money market funds. But if it fails to heed a council recommendation, the oversight group could designate individual funds or fund companies as 'systemically important,' making them subject to even tougher oversight by regulators." Krasner calls the "systemically important" designation the "nuclear option."

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