In June 2012 I wrote two analysis pieces on IOSCO for the CLMR portal.  IOSCO Part I examined the history and governance structures of IOSCO to date.  IOSCO Part II considered some of the key agendas which might be the focus for IOSCO in 2012 and beyond.  The latter noted that: “..the harsh reality is that national economic self-interest exerted through domestic political pressure is more likely to hold sway over a domestic securities regulator than any IOSCO initiative promoting for example harmonisation or enforcement cooperation.  It is perhaps unwise to expect otherwise and it is through this realpolitik prism that one must evaluate IOSCO agendas for future activity.”  IOSCO Part III is prompted by the Technical Committee of the IOSCO’s report of 27 April 2012 Money Market Fund Systemic Risk Analysis and Reform Options (the IOSCO Report). In particular, the focus is on reaction to that report in the US, especially within the Securities Exchange Commission (SEC) at the levels of both Chair and Commissioner, and the US mutual fund industry.  It seems that this current debate in the US regarding possible increased supervisory requirements for Money Market Funds (MMFs) is indeed an example of rubber hitting the road, as the public interest priorities of a multi-lateral actor such as IOSCO meet the hard surface of economic self-interest, in this case the commercial interests of MMFs in the US.

First of all some brief background on what MMFs are, their scale and their systemic importance.  MMFs are investment funds that invest in high-quality low-duration fixed-income instruments such as US Treasuries.  They comprise a strategically important element of the financial sector.  For example, in the third quarter of 2011 the IOSCO Report notes that MMFs totalled US$4.7 trillion in funds under management.  That enormous figure constitutes approximately 20% of the assets of Collective Investment Schemes (CIS) globally and so it is clear that the sheer scale of this sector ensures that it is systemically important.  This issue of the MMFs as part of the broader cash management industry is important, especially regarding the decision (discussed in more detail below), by SEC Commissioner Luis Aguilar and his fellow Commissioners, Troy Paredes and Daniel Gallagher to oppose SEC Chairman Mary Schapiro’s efforts to persuade the SEC to raise the regulatory requirements for MMFs as suggested by IOSCO.  The strategic importance of MMFs was highlighted dramatically during the Global Financial Crisis (GFC) of 2008, when the collapse of Lehman Brothers was a trigger for a run on the oldest MMF in the US, the Reserve Primary Fund which owned $785 million in Lehman Brothers commercial paper.  The contagion spread to other MMFs and was the catalyst for the GFC to impact significantly on Main Street America not just Wall Street, because it meant that many US corporations were unable to issue new securities and so the US Treasury and Federal Reserve intervened to back the assets of the MMFs.  Their actions averted the collapse of the financial system but made US taxpayers potentially liable for more than US$3 trillion, the assets held by MMFs at that time.

This episode demonstrated clearly the global systemic risk posed by the cash management industry in general and MMFs in particular.  So as part of its broader mandate from the G20 Leaders to strengthen the oversight and regulation of the shadow banking system, the Financial Stability Board (FSB) asked IOSCO to undertake a review of potential regulatory reforms for MMFs that would mitigate the systemic risk that they posed.  In its October 2011 Report (the FSB Report), the FSB estimated the size of the global shadow banking industry to be US$60 trillion of which MMFs at US$4.7 trillion are clearly a significant segment. The IOSCO report was in response to this FSB mandate, but nevertheless it is important to remember that the Report, as acknowledged by the Technical Committee of IOSCO is for public consultation only and that IOSCO has no substantive enforcement processes, relying essentially on peer pressure and a consensual approach.  However, in this instance that limited and essentially voluntary character has still stirred up significant opposition and controversy.

That opposition has centred largely around two issues, both of which the FSB specifically mandated IOSCO to investigate.  The first surrounds the practice of Variable Net Asset Value (VNAV) which ordinarily in market practice means that the value of bonds held by funds fluctuates as funds comply with mark to markets valuations.  However, for more than thirty years MMFs in the US under the SEC exemption rule 2a-7 have not had to operate with a VNAV.  Instead they have maintained a steady $1 Stable Net Asset Value (SNAV) by utilising amortised cost accounting and penny rounding.  This SNAV approach worked steadily for many years but as the Reserve Primary Fund scenario described above showed, it may not always be an effective way to absorb loss in the value of a security held within a portfolio.  That seems to be the view of the IOSCO Report as it urged its member organisations to consider the option of moving to a VNAV approach.  The second major point of contention concerns liquidity management and the prospect that MMFs should be required to increase their capital buffers and hold back a small percentage of funds that had been deposited for a fixed period of time to help reverse the dynamics of any future run on funds.

It is evident that SEC Chairman Mary Schapiro thought that both of these options had merit.  In a November 2011 speech in New York to the Securities Industry and Financial Markets Association (SIFMA), Chairman Schapiro stated that: “..additional steps should be taken to address the structural features that make money market funds vulnerable to runs”; that “A money market fund’s stable NAV is brittle”; and that the current focus on VNAVs and a capital buffer option were “the result of a long and careful review conducted jointly with fellow financial regulators.” These two reform options were not then, and are still not now part of official SEC policy, but the prospect of either of these two reforms being mandated has brought howls of protest and furious lobbying efforts from the MMF industry in the US.  For example, in May 2012 the Investment Company Institute (ICI) described the IOSCO proposals as detrimental and severely flawed. In a recent interview, Mr John S. Woerth, a spokesman for the Vanguard, the largest mutual fund in the US, argued that the VNAV and capital buffer reform options: “..would end money market funds” because their profit margins were so low, (quoting a yield of just 0.4% for one of Vanguard’s major funds), and the proposals were simply too onerous.  However, in that same article published in September 2012 Chairman Schapiro argued that: “..if you’re opposed to government bailouts, you have to support these reforms.” So, as is discussed below Chairman Schapiro is not yet prepared to abandon permanently the merits of the proposed MMF reforms no matter what the official position of the SEC may be.

However, three is a majority for the five member SEC, so whatever the personal views of Chairman Schapiro on these two reform options may be, the political rubber really hit the ground with the SEC Statement of 11 May 2012 by Commissioners Aguilar, Paredes and Gallagher that: ‘..a majority of the Commission expressed its unequivocal view that the Commission’s representatives should oppose publication of the Consultation Report and that the Commission’s representatives should urge IOSCO to withdraw it for further consideration and revision.” The political heat on Chairman Schapiro was further evident from hostile questioning that she received from both Democrats and Republicans when she appeared before the US Senate Banking Committee in June 2012.  In that Hearing she told the Panel that IOSCO normally waits for the SEC’s full input and prematurely released the IOSCO Report in a timing mismatch, which was “a genuine screw-up.” Nevertheless, Chairman Schapiro has continued to champion the proposals.  In a statement on 22 August 2012, she confirmed that: “Three Commissioners, constituting a majority of the Commission, have informed me that they will not support a staff proposal to reform the structure of money market funds.”  She went on to add that she believed: “..these proposals have merit, address the two structural issues identified, and deserved to see the light of day so that we could receive public feedback.”

So, it would seem that this issue is not closed as far as Chairman Schapiro is concerned and even if she does not have the official backing of the SEC, she does have supporters both in the US and internationally.  On 25 August 2012, Masamichi Kono, Chairman of IOSCO issued his own statement taking “careful note” of Chairman Schapiro’s statement of 22 August 2012, adding that IOSCO would continue its work on MMFs and other areas of shadow banking “..on the basis of the mandate given to it by the G20 Heads of State and the FSB.” The IOSCO Board will consider these issues at its meeting in Madrid on 3-4 October 2012 and report to the G20 Finance Ministers Meeting in November 2012.  Regarding support within the US, Press reports in The Wall Street Journal and other media forums state that the proposed reforms have widespread public agency support, including within the Obama Administration, the US Treasury and the Federal Reserve.  Also, it remains a possibility that the Financial Stability Oversight Council (FSOC) which is chaired by US Treasury Secretary Timothy Geithner may yet play a role regarding these reform issues for MMFs. Under the Dodd Frank Wall Street Reform and Consumer Protection Act 2010 the FSOC has a statutory duty to facilitate regulatory coordination and can make recommendations to Congress to close what the FSOC sees as specific gaps in regulation, especially with regard to issues of systemic risk.  This may include removing authority on specific issues from a specific regulator and transferring that regulatory authority to the US Treasury or Federal Reserve.  It is conceivable that the FSOC may view the recent history of the proposed MMF reforms in this light despite the current majority position of the SEC.

So, given this perceived widespread support for the proposed reforms within the broader regulatory community why have Commissioners Aguilar, Paredes and Gallagher adopted the position that they have?  It is too simplistic and quite conceivably incorrect to see this as three Commissioners simply caving in to vested interests in the cash management industry as many commentators have argued.  Subsequent to the statement of 11 May 2012 Commissioner Aguilar has sought to provide substantiation for the current majority view of the SEC.  He is adamant that the cash management industry as a whole should be reviewed in the form of an SEC concept release before a specific segment such as MMFs is fundamentally altered, which is his view would be the effect of the reforms discussed above.  Such immediate alteration raises in his view the very real threat of substantial amounts of capital being withdrawn from the relatively transparent MMF sector to more opaque, less regulated areas of the shadow banking system. 

In Commissioner Aguilar’s view these potential harms are exacerbated in the current climate of volatility in capital markets and the fragile state of the economy.  Also, he argues strongly that neither the Commission, nor its staff, have undertaken a comprehensive study of the effects of the SEC’s 2010 Money Market Amendments.  For Commissioner Aguilar such a review should precede any further reform proposals for MMFs and/or the cash management industry in general. As part of its May 2010 Amendments (the SEC Amendments), the SEC increased the obligations of MMFs in a number of ways, these included: improving credit quality; mandating stress testing; raising the transparency of fund holdings; raising liquidity requirements; and reducing maturity periods. Commissioner Aguilar offers some substantive arguments here.  He is not completely dismissing VNAV or capital buffers as future policy options for MMFs, rather arguing for a policy position that is based on thorough review of the efficacy of the 2010 Amendments.  However, one might wonder why there has been no visible concerted push from he or his fellow Commissioners to review the 2010 Amendments until the momentum of the VNAV and/or capital buffers reform proposals had gathered speed. 

It will be interesting to follow what happens in both international and US domestic contexts, immediately, and in the longer term.  In the multi-lateral arena it seems unlikely that IOSCO, the FSB or the G20 itself will simply turn away from the issue of reform of shadow banking in general, or MMFs in particular.  Those same issues are also important in the US domestic financial regulatory environment, with the added intrigue of what active role the FSOC may or may not decide to play regarding the proposed reforms.  The only certainty would seem that these MMF reform issues will continue to produce tensions both nationally and internationally.  Also, it is interesting to ponder whether there may well be more alleged “screw-ups” involving how IOSCO reports on other international regulatory issues are coordinated and published in the future, as part of the contestation that almost inevitably accompanies the realpolitik that is the development of financial regulation in both public and private domains.