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Investment Company Act of 1940: Rule 2a-7
Rule 2a-7 of the Investment Company Act of 1940 is a crucial regulation governing money market funds (MMFs) in the United States. It aims to maintain the stability and liquidity of these funds, protecting investors from potential losses. MMFs are investment vehicles designed to provide investors with a safe and convenient way to earn short-term interest while maintaining a stable net asset value (NAV), typically $1 per share.
The rule establishes stringent requirements for the types of securities MMFs can invest in, their maturity profiles, and their credit quality. Its primary objectives are to minimize credit risk, interest rate risk, and liquidity risk. These risks can destabilize an MMF, potentially causing it to “break the buck,” meaning its NAV falls below $1 per share, triggering investor panic and widespread redemptions.
Key aspects of Rule 2a-7 include:
- Eligible Securities: MMFs are primarily restricted to investing in high-quality, short-term debt instruments. These generally include U.S. government securities, municipal securities, commercial paper, certificates of deposit, and repurchase agreements. The rule specifies minimum credit ratings required for eligible securities, typically the two highest short-term rating categories.
- Maturity Limitations: To limit interest rate risk, Rule 2a-7 imposes strict maturity limitations on portfolio holdings. The weighted average maturity (WAM) of the portfolio must not exceed 60 days, and the weighted average life (WAL) must not exceed 120 days. WAM measures the average time until maturity of the securities in the portfolio, while WAL considers the potential for securities to have their interest rates reset or re-priced.
- Credit Quality Standards: Rule 2a-7 mandates continuous monitoring of the credit quality of portfolio securities. If a security is downgraded below the required minimum rating, the fund must take prompt action, which may include selling the security.
- Liquidity Requirements: MMFs must maintain sufficient liquidity to meet investor redemption requests. The rule requires funds to hold a minimum percentage of their assets in readily available cash or securities that can be quickly converted to cash.
- Stress Testing: Funds are required to conduct regular stress tests to assess their resilience to various market conditions, such as interest rate shocks and credit downgrades. These tests help identify potential vulnerabilities and ensure the fund can maintain a stable NAV under adverse circumstances.
Following the 2008 financial crisis, the Securities and Exchange Commission (SEC) further amended Rule 2a-7 to enhance the resilience of MMFs. These amendments included the introduction of:
- Floating NAV for Institutional Prime Funds: This change required institutional prime MMFs (those primarily held by institutional investors) to adopt a floating NAV, meaning their share price would fluctuate based on market conditions, reflecting the actual value of the underlying securities.
- Liquidity Fees and Redemption Gates: These measures allowed fund boards to impose liquidity fees or temporarily suspend redemptions during periods of stress to protect remaining investors.
These reforms aimed to reduce the risk of “runs” on MMFs and make them more resilient to market volatility. While Rule 2a-7 cannot eliminate all risks associated with MMFs, it provides a comprehensive framework for managing those risks and protecting investors.
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