How Money Market Funds Got Safer With Rule 2a-7

At their inception in the 1970s, money market funds were marketed as "safe" investments. Essentially, their pitch was this: "If your investments in the stock market are keeping you from sleeping at night, it's time to learn about the safer alternatives in money market funds."

The focus on safety and solid returns was justified, as money markets traditionally maintained a net asset value (NAV) of $1 per share and paid a higher rate of interest than checking accounts. The combination of a stable share price and a good interest rate made them good places to store cash. This positioning held true until September 2008 when the Reserve Fund broke the buck—a financial services industry phrase used to describe the scenario when a money market fund has its NAVs fall below $1 per share.

While the Reserve Fund's meltdown directly hurt a relatively small number of investors, it revealed that the safety investors had relied on for decades was an illusion. If the Reserve Fund, which had been developed by Bruce Bent (a man often referred to as the "father of the money-fund industry"), couldn't maintain its share price, investors began to wonder which money market fund was safe. (See also: Money Market Mayhem: The Reserve Fund Meltdown.)

The failure of the Reserve Fund called into question the definition of "safe" and the validity of marketing money market funds as "cash equivalent" investments. It also served as a stark reminder to investors about the importance of understanding their investments.

The Securities And Exchange Commission (SEC) recognized the threat to the financial system that would be caused by a systemic collapse of money market funds and responded with Rule 2a-7. This regulation requires money market funds to restrict their underlying holdings to investments that have more conservative maturities and credit ratings than those previously permitted to be held. From a maturity perspective, the average dollar-weighted portfolio maturity of investments held in a money market fund cannot exceed 60 days. From a credit rating perspective, no more than 3% of assets can be invested in securities that do not fall within the first or second-highest ranking tier.

Increased liquidity requirements are also part of the package. Taxable funds must hold at least 10% of their assets in investments that can be converted into cash within one day. At least 30% of assets must be in investments that can be converted into cash within five business days. No more than 5% of assets can be held in investments that take more than a week to convert into cash.

Funds must undergo stress tests to verify their ability to maintain a stable NAV under adverse conditions, and they are required to track and disclose the NAV based on the market value of underlying holdings and to release that information on a 60-day delay after the end of the reporting period.

The enactment of the legislation had no significant impact on investors. The NAV disclosure requirement has been a non-event, as investors must go find the historical information. Fund companies are not required to provide it proactively. Yields on money market funds may be lower than they would be if the funds could invest in more aggressive options, but the difference is only a few basis points. (See also:  Do Money Market Funds Pay?)

In 2016, reforms required money market funds to allow their NAV to "float" or fluctuate. That means money market funds may not have a stable NAV of $1 at any given time.

If a money market fund's NAV drops below the $1 share price, this can cause investors to lose money. Since the interest rate differential between a money market fund and checking or savings account is generally small, investors have to watch the NAV closely to make sure they are getting the full benefit of their interest rate. In other words, loss of NAV could eat up the gains from interest. (See also: Why Money Market Funds Break the Buck.)