CALLAN

INVESTMENTS
INSTITUTE

October 2014

Research

What do Money Market Reforms Mean for Investors?

A Roundtable Discussion with Callan Experts

Money market funds are an important source of liquidity and are critical to our financial markets. Following
the financial crisis of 2008, some money market funds broke the buck, with net asset values (NAVs) falling
below $1 per share. The chaotic scene that ensued surprised investors, and regulators have responded by
updating laws to prevent a repeat of that difficult time.
On July 23, 2014, the Securities and Exchange Commission adopted amendments to the rules that govern
money market mutual funds. The amendments address the risks of an investor run on money market funds,
while seeking to preserve the benefits of these funds. The new rulesthe second wave of reforms since
2008are effective October 14, 2014, but have a long compliance period (two years or more) to ease the
transition. New requirements include:
Institutional prime money market funds will have a floating NAV. Portfolios must value securities according to their current market value and redeem shares based on the floating NAV.
Non-government money market fund boards will now be able to impose liquidity fees and redemption
gates to address investor runs.
The 2014 changes further tighten disclosure requirements (e.g., the requirement to disclose a funds level
of daily and weekly liquid assets, net flows, and market-based NAV on a website) and define enhanced
diversification requirements and stress testing.1

The ruling impacts many institutional investors, including sponsors of defined benefit and defined contribution plans. We assembled a group of Callan experts to highlight key provisions and their potential impacts
on investors. Jim Callahan, CFA, manager of Callans Fund Sponsor Consulting group, sat down with his
colleagues to discuss the latest money market reforms. Roundtable participants included Bo Abesamis,
Steve Center, CFA, and Jimmy Veneruso, CFA, CAIA, from Callans Trust and Custody, Fund Sponsor, and
Defined Contribution groups. (Their full biographies can be found at the end of the paper.)

1 Details on the new rules can be found at: http://www.sec.gov/rules/final.shtml

Knowledge. Experience. Integrity.

Jim Callahan

What are the proposed money market reforms? How will they likely impact
institutional investors?

Bo Abesamis

Reforms to SEC Rule 2a-7, which governs money market funds, actually started back in January 2010,
when the SEC introduced sweeping changes impacting a funds investment policies and guidelines. At that
time, reforms were instituted around seven key areas: portfolio liquidity, portfolio maturity, eligible securities, periodic stress tests, portfolio disclosure, know your investor, and rating agencies. The more recent
rule, released July 23, 2014, incorporates the final changes to SEC Rule 2a-7, and tackles the more contentious issues of fluctuating NAV, stable value NAV, and redemption restrictions (or gating)/liquidity fees.
(The areas of focus for each year of reform are summarized in Exhibits 1 and 2.)

Exhibit 1
2010 Money Market
Fund Reform

Portfolio
Liquidity

Daily requirement: at least 10% of assets must be in cash or cash-like securities maturing in
one day
Weekly requirement: at least 30% of assets must be in cash, or cash-like securities that

Summary

convert to cash within one week

Illiquid securities: restricts portfolio to 5% (change from prior 10% restriction); redefines
illiquid as any security that cannot be sold within seven days at carrying value
Portfolio
Maturity

Restricts maximum weighted average life (WAL) portfolio maturity to 120 days; measured
without regard to interest rate adjustments
Restricts the maximum weighted average maturity (WAM) of the portfolio to 60 days

Eligible
Securities

Lowers portfolio holding percentage restriction of 3% on second tier securities2

Restricts investment to 0.5% of second tier assets issued by a single issuer
Restricts investment in second tier securities that mature in more than 45 days

Periodic
Stress Tests

Fund managers must test the funds ability to maintain a stable NAV per share in the event
of shocks such as interest rate changes, higher redemptions, and changes in portfolio
credit quality

Know Your
Investor

Funds must hold sufficiently liquid securities to meet foreseeable redemptions. Must identify
investors whose redemption requests may pose risk for funds, and forecast likelihood of
large redemptions
Fund complexes must have extensive know your customer (KYC) policies for all new
clients that are considered investors

Portfolio
Disclosure

Monthly fund website posting of portfolio holdings

Monthly SEC reporting of portfolio holdings as well as submit changes to the SEC in order to
create an interactive database

Rating
Agencies

Continued limitation on a funds investment in rated securities to investments in the top two
rating categories.
Funds must perform an independent credit analysis of every security purchased.

2 First tier and second tier securities: An eligible money market security must receive the top short-term rating from any two nationally
recognized statistical rating organizations (NRSROs). If only one NRSRO has rated the security, it must receive the highest shortterm rating from that NRSRO to be considered first tier. U.S. government securities are considered first tier. Eligible money market
securities that are not first tier, and receive one of the top two short-term ratings from any two NRSROs are second tier. If only one
NRSRO has rated the security, it must receive the second-highest short-term rating from that NRSRO to be considered second tier.
Source: iMoneyNet Money Fund Vision(98) and Goldman Sachs Asset Management.

Exhibit 2
2014 Money Market
Fund Reform

Fluctuating
NAV

Institutional prime and tax-exempt municipal money market funds must operate a fluctuating
NAV based on the current market value of securities held and priced at four decimal places.
Funds in this category cannot use the amortized cost method (or penny rounding) and can-

Summary

not maintain the $1.00 NAV classification.

Stable Value
NAV

Government and retail money market funds would be allowed to maintain a $1.00 NAV valuation and continue to use the amortized cost basis.
Retail money market funds must be limited to investors classified as natural persons in
order to operate as stable or constant $1.00 NAV money market funds.

Redemption
Restrictions
(or Gating)/
Liquidity Fees

All non-government money market funds are subject to redemption restrictions and
liquidity fees.
Money market fund boards are allowed to impose a liquidity fee of up to 2% of redemptions if the weekly liquid assets are less than 30% of total assets, and a fee of up to 1% of
redemptions if the weekly liquid assets are less than 10% of total assets.
Money market fund boards are permitted to impose redemption restrictions (or gating) and
suspend withdrawals if deemed in the best interest of the fund. Redemption restrictions
cannot extend beyond 10 days and cannot be imposed for more than 10 days over a
90-day period.
Government money market funds can (but not required) voluntarily adopt the above redemption restrictions and liquidity fees.

Enhanced
Disclosure
and Other
Requirements

The 2014 changes further tighten disclosure such as daily website posting of a funds liquidity levels, presence of gates and fees, daily NAV, portfolio holdings, and support structures.
Enhanced diversification and stress testing requirements were also defined.
The SEC noted that fluctuating NAV money market funds can be reported as cash equivalents. During times of liquidity and credit risks, investors will need to assess whether such
funds are still valid cash equivalents.
The Department of the Treasury and the Internal Revenue Service released tax guidance on
gains and losses emanating from fluctuating NAVs, including a simplified tax accounting for
gains and losses and relief from wash sale rules for losses.

Bo Abesamis (cont.)

The final rule regarding fluctuating NAV requires a fund to provide a more accurate picture of investment
risk. Money market funds are not risk-free. They are subject to three primary risks: liquidity, credit, and
interest rate risks. A stable $1.00-NAV construct mimics the proverbial money hidden under the mattress, wherein there is no risk of losing or gaining money. The redemption restrictions and liquidity fees
were designed to deter fund runs and take away the first-mover advantage. The first-mover advantage
refers to the initial group of shareholders to exit a fund, who generally recover their full investment by
harvesting the funds liquidity. Investors left behind shoulder the funds losses emanating from less liquid
and impaired securities. Liquidity fees have the effect of providing capital to a money market fund and
can be cost prohibitive to those seeking liquidity, and therefore remove the incentive to be the first one
to redeem.

Although I do not see a far-reaching impact to institutional investors, they should be aware of their liquidity profile. A fluctuating NAV can bring the extra anxiety of not having enough cash for benefit payments
or to fund other capital calls. Investors should maintain appropriate cash buffers (liquidity cushions) to

Knowledge. Experience. Integrity.

prevent being overdrawn. Institutional investors should also be aware of their securities lending cash collateral reinvestment guidelines in light of the money market fund reform. The cost of capital for long/short
strategies may also be impacted. Institutional money market funds or prime money market funds should
also be verified for the presence of so-called sticky money (cash reinvestments emanating from securities lending), which can create havoc on a funds liquidity profile. Remember, securities lending cash
collateral is often a large sum of money with a liability duration of one day, and can further exacerbate
liquidity needs of cash pools.

The intent of the money market fund reform is to bring order to the chaos that transpired in the financial
crisis of 2008. Money market funds are an important source of liquidity and are critical to our financial
markets. Short-term commercial paper, which is held predominantly by money market funds, actually
finances vehicles used by large corporations to fund their short-term cash needspayroll, inventory, etc.
The short-term markets are also heavily utilized in the areas of repo financing, credit facilities, securities
lending, securitization, inter-bank borrowing, and central bank monetary policies.

Jim Callahan

What actions should institutional investors take over the next two years as this
transition unfolds?

Jimmy Veneruso

The rules allow for a two-year implementation period, so institutional investors have time to weigh the actions of fund companies, custodians, and recordkeepers. Defined benefit plans, endowments, foundations,
operating funds, and similar pools should closely examine their liquidity needs and how the announced
reforms will impact their choice of liquidity vehicle. Defined contribution (DC) plan sponsors should consult
the investment advisor of the money market fund and/or the mutual fund complex offering the money market
fund to determine the nature of the fund they are offering in their DC plan. They should ask what stepsif
anywill be taken to update documentation (sales materials, prospectus, etc.) and procedures to comply
with the natural person stipulation. Once investors feel confident about the full implications of the new rules
and how their plan or fund will be affected, they have several courses of action. Options include:
1. Do nothing. Plan sponsors may decide they are comfortable with the changeswhatever they may
beimposed by the new regulations on their existing money market fund.
2. Switch to a government money market fund. This may avoid gating fees and the floating NAV
restrictions. The downside is that government funds may be expected to have even lower yields as
they move to comply with the 99.5% holding requirement.
3. Switch from an institutional to a retail money market fund (if possible). This will avoid the floating NAV but not the gating and redemption fee requirements.
4. Switch away from money market funds altogether. Plan sponsors may wish to explore the viability of moving to a short duration fixed income separate account, if asset levels are sufficient enough.
Eligible DC plans may also consider a stable value fund as their capital preservation vehicle.

Jim Callahan

What does the SEC mean when it classifies a money market fund as retail vs. institutional?

Steve Center

This is a tricky bit of semantics, as the terms retail and institutional are often used in the investment world
as a way to differentiate strategies based upon the minimum initial investment level: institutional funds carry
higher minimums, and usually lower fees, than retail funds. The SEC chose to use the same terms to classify
municipal and prime money market funds in two categories for regulatory purposes, but the differentiating
factor will be the ultimate beneficial owner of the fund, rather than the minimum initial investment level.

The new regulations define retail funds as those that limit their beneficial owners to natural persons.
A natural person would include shares held by personal trusts, brokerage accounts, IRAs, 457 plans,
401(k) plans, 529 plans, and other similar plans. Funds classified as retail, regardless of the underlying
securities they purchase, will not be subject to a floating NAV requirement and thus will continue to report
a stable NAV of $1.00 per share. These funds will, however, be required to impose liquidity fees and
redemption gates as needed, just like their institutional siblings. As the new regulations go into effect
over the next two years, we anticipate many of the money market fund families will create low-cost funds
for larger investors that clearly meet the SECs definition of retailperhaps by creating funds that are
limited for use only in 401(k), 457, and 529 plans.

Jim Callahan

How are DC plans likely to be impacted by these revisions?

Jimmy Veneruso

As a result of the new rules, government money market funds may feature even lower yields going forward. This decrease would be attributable to the new rules requiring government money market funds
to hold 99.5% of the underlying securities in government securities. Many currently hold around 80% in
government securities, so its conceivable that this increase in government holdings will result in even
lower yields.

DC plan sponsors should also be ready to work with their plans recordkeepers to communicate the
impact of any changes to their participants. These may include a floating NAV and the risk that funds may
impose liquidity gates and/or redemption fees. Additionally, plan sponsors may need to communicate the
enhanced disclosures that are included as part of the rule changes.

Jim Callahan

Will these rules impact custodial/cash sweep accounts, short-term investment fund (STIF)
vehicles, or other cash funds not directly governed by Rule 2a-7?

Bo Abesamis

Yes, the rules will likely have an indirect effect. These vehicles will probably be subject to closer scrutiny
and may end up adopting the same set of principles and procedures.

STIF vehicles are often used by institutional investors in custodial/cash sweep accounts; the trust/custodian banks that manage these have adopted most of the requirements of SEC Rule 2a-7. Effective
July 2013, bank-maintained STIFs for fiduciary accounts and those subject to OCC Reg 9 are required
to implement floating NAV unit pricing procedures in certain stress situations. The STIF Rule of 2013
requires STIFs to state that the primary fund objective is to operate with a stable NAV of $1.00 per participating interest as opposed to maintain a stable NAV. Although STIFs are able to use the amortized
cost basis and maintain the $1.00 NAV for purposes of admissions and withdrawals, STIFs are subject
to almost the same parameters promulgated by SEC Rule 2a-7 and the burden of monitoring the difference of cost and current market value is well defined.

Knowledge. Experience. Integrity.

Other cash funds or money-market-like vehicles

not directly governed by SEC Rule 2a-7 and OCC

Jim Callahan

Reg 9 would be subject to closer scrutiny and

The final rule adds safeguards designed to ad-

may end up adopting the same set of principles

dress the risk of loss to a STIFs principal, includ-

and procedures.

ing measures governing the nature of a STIFs

Will these new rules result in a mass migration from money market funds to stable
value funds within DC plans?

Steve Center

The Short-Term Investment Fund (STIF) Rule

investments, ongoing monitoring of its mark-tomarket value and forecasting of potential changes
in its mark-to-market value under adverse market
conditions, greater transparency and regulatory

While it is always difficult to predict the institu-

reporting about a STIFs holdings, and proce-

tional reaction to newly announced regulations,

dures to protect fiduciary accounts from undue

Callan doesnt believe the SECs actions will re-

dilution of their participating interests in the event

sult in an increase in asset transfers from money

that the STIF loses the ability to maintain a stable

market funds to stable value funds. When the

net asset value (NAV).

SEC first began discussing regulatory reforms,

Source: Department of the Treasury, OCC 12 CFR Part 9

Final Rule Short-Term Investment Funds

there was a possibility that all money market

funds would have fluctuating NAVs. If that had

been the SECs ultimate decision, stable value funds may have indeed seen a spike in interest as plan
sponsors moved to replace money market funds with an option that had a stable NAV. However, the
ultimate regulation announcement allows for DC plans to offer retail money market fund options that
retain a stable NAV of $1.00.

What remains to be seen, however, is how the new diversification, stress testing, and disclosure requirements could impact the ability of money market funds to earn an attractive rate of return, particularly in the
current low-rate environment. If money market funds continue to offer very little yield, stable value could
garner additional consideration from plan sponsors.

Biographies
Virgilio Bo Abesamis III is an Executive Vice President and is the Manager of
Callans Trust, Custody, and Securities Lending Group. He joined Callan in 1987
and is a shareholder of the firm. He previously worked in the Capital Markets Research group on asset/liability modeling, manager structure, benchmark and database reviews, style analysis, and research. Bo earned an MBA with a double major
in Finance and International Business from the University of San Francisco and a
BS degree in Accounting and Finance from Ateneo de Manila, Philippines.

James A. Callahan, CFA, is an Executive Vice President and is the Manager of

Callans Fund Sponsor Consulting group. In this role, Jim oversees all of Callans
Fund Sponsor Consulting offices. His clients include public, corporate, and TaftHartley pension plans, foundations, and endowments. Jim works directly with his
clients in the development of strategic planning including asset allocation and
investment policy development, investment manager research and selection, and
performance evaluation. In addition to being a member of Callans Management
Committee, Jim serves on Callans Manager Search Committee, Client Policy Review Committee,
Alternatives Review Committee, Defined Contribution Committee, and is a shareholder of the firm.
Jim joined Callan in January 1993. He earned a BA in Economics from Boston College and earned
the right to use the Chartered Financial Analyst designation.
Steven Center, CFA, is a Vice President and consultant in Callans Fund Sponsor
Consulting group. He works with fund sponsor clients on investment manager reviews, performance evaluation, and other projects. Steve joined Callan in 2010. He
earned an MBA with Honors from the Michael G. Foster School of Business at the
University of Washington and a BA in Economics from the University of California,
Irvine. Steve has earned the right to use the Chartered Financial Analyst designation
and is a member of CFA Institute and the CFA Society of Seattle.
James Veneruso, CFA, CAIA, is a Vice President and defined contribution consultant
in Callans Fund Sponsor Consulting group. He provides analytical support to Callans
DC clients and consultants, including investment structure evaluations, fee analyses,
and target date fund research. Jimmy joined Callan in 2007 and is a shareholder of
the firm. He received his Masters in Economics from University of Illinois and graduated with departmental honors earning a BS in Computer Science and Economics at
Vanderbilt University. He has earned the right to use the Chartered Financial Analyst
designation and the CAIA designation. Jimmy is a member of the CFA Society of Chicago where he serves
on the Finance Advisory Committee.

Knowledge. Experience. Integrity.

If you have any questions or comments, please email institute@callan.com.

About Callan Associates
Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have
empowered institutional clients with creative, customized investment solutions that are uniquely backed
by proprietary research, exclusive data, ongoing education and decision support. Today, Callan advises
on more than $1.8 trillion in total assets, which makes us among the largest independently owned investment consulting firms in the U.S. We use a client-focused consulting model to serve public and private
pension plan sponsors, endowments, foundations, operating funds, smaller investment consulting firms,
investment managers, and financial intermediaries. For more information, please visit www.callan.com.
About the Callan Investments Institute
The Callan Investments Institute, established in 1980, is a source of continuing education for those in
the institutional investment community. The Institute conducts conferences and workshops and provides
published research, surveys, and newsletters. The Institute strives to present the most timely and relevant
research and education available so our clients and our associates stay abreast of important trends in the
investments industry.
2014 Callan Associates Inc.
Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be
reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this
report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular
situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or
endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist
of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Investments
Institute (the Institute) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No
party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web
sites any part of any material prepared or developed by the Institute, without the Institutes permission. Institute clients only have the
right to utilize such material internally in their business.

Corporate Headquarters

Regional Offices

Callan Associates
600 Montgomery Street
Suite 800
San Francisco, CA 94111
800.227.3288
415.974.5060

Atlanta
800.522.9782

Denver
855.864.3377

Chicago
800.999.3536

New Jersey
800.274.5878

www.callan.com