Money funds and the problem with successful regulation

I am a firm supporter of regulation where it is successful.  But I’m also a firm believer in thinking hard about what it means for regulation to be successful.  Perhaps money market funds are an example of an investment product that was made dangerous by “successful” regulation.

Money market funds are built on a contradiction.  They are investment funds — and like any investment fund expose investors to losses; however, they are allowed to report and calculate their returns as if the Net Asset Value of one share in the fund is always equal to $1.  This subterfuge means that under normal circumstances a well managed money market fund will behave a lot like a bank savings account:  any money an investor puts in the account stays there until it is withdrawn and periodically the account accrues interest.

In the absence of regulation this subterfuge would be recognized for what it is — because there would always be a bunch of high-flying money funds malinvesting assets and going bust.  Every investor would know to take the warning about possible losses seriously and would spend time evaluating the quality of money market funds.

Over the past couple of decades, however, money market funds have been carefully regulated and in the 25 years preceding the Reserve Fund failure there was only one small money fund failure.  This successful regulation bred complacency amongst investors who began to to view money market funds as excellent substitutes for bank deposits.

In my view the fact that investment funds were treated as having NAVs of $1 was misleading in an environment where these bank-like investment funds almost never failed.  Investors were told that money funds (i) were investment accounts that could lose value and (ii)  would almost certainly preserve a NAV of $1 per share.  For obvious reasons both statements can not be true simultaneously.

Each shareholder in an investment fund has a right to his or her share of the underlying assets — neither more, nor less.  The use of a fixed NAV for money funds makes it appear that shareholders have a right to more than the simple fraction of assets that they own.

Despite the fact that money funds advertise a NAV of $1 per share, their only assets are the assets of the investment fund.  Thus, money funds have no way to support the NAV that they advertise. This is a problem.

In my view, any fund that seeks to maintain a fixed NAV per share must necessarily establish a reserve fund that will be used to support the fixed NAV in the event that value of the investment fund in fact falls.  Any fund that claims to maintain a fixed NAV without maintaining a reserve fund is guilty of false advertising.

In short, because money funds are inherently contradictory financial products, regulators made a mistake by permitting their development.  And compounded this mistake by regulating the product so strictly that failures were effectively eliminated.  The lesson I take from this:  Either regulators need to be very critical of financial innovation and repress products that are based on contradictory premises, or regulators need to remember that markets are often strengthened, not weakened by failures and allow unsafe versions of such products to be sold to investors.

The worst outcome for regulators is the current money market fund situation: the product is inherently contradictory, but it is so heavily regulated that the market’s faults have become the responsibility of regulators.  We must not forget that there are tensions between protecting investors from bad products, promoting efficient financial innovation and allowing failure to act as a market force that limits systemic risk.


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