After years of heated debate, the Securities and Exchange Commission, the US regulator, recently adopted stricter rules for US money market funds. The new rules are intended to limit the potential systemic risks of money market funds by reducing the likelihood of runs on these vehicles.

The rules will have the biggest impact on money market funds serving institutional investors, which will have to move from a constant to a floating net asset value. The rules will also put pressure on most institutional and retail money market funds to impose liquidity fees and suspend redemptions during financial crises. But neither set of rules will apply to money market funds holding 99.5 per cent or more of government securities.

Thus, the two critical questions are what constitutes a government security, and what differentiates an institutional from a retail money market fund?

The rules narrowly define governmental securities to include cash, US Treasuries and securities issued by US federal agencies. Notably, for this purpose, government securities do not include securities issued by state or city governments – the assets held by most tax-exempt money market funds.

All non-governmental money market funds must abide by the SEC’s new requirements for fees and gates. If such a fund’s weekly liquidity assets falls below 30 per cent of its total assets, its board would be authorised to impose a liquidity fee of up to 2 per cent on all redemptions. The board would have to determine that a liquidity fee would be in the best interests of the fund.

If the weekly liquidity assets dropped below 10 per cent of its total assets, the fund would be required to impose a liquidity fee of 1 per cent on all redemptions.

Similarly, if the weekly liquidity assets of a non-government money market fund dropped below 30 per cent of its total assets, its board could in its discretion suspend redemptions temporarily. To impose an exit gate (lasting no more than 10 business days), the board would have to find that such a gate is in the best interest of the fund.

In contrast to the rules on liquidity fees, if the weekly liquidity assets of a non-government money market fund dropped below 10 per cent of its total assets, there would be no requirement to impose a redemption gate. The decision on the gate would still be left to the discretion of the fund’s board.

This difference in regulatory treatment reflects the SEC’s concerns that mandatory redemption gates might encourage runs on money market funds. The SEC prefers liquidity fees because they provide investors with a choice: they can remain in the fund or leave by paying a modest exit fee.

The other significant distinction is between retail and institutional money market funds.

Retail non-government money market funds will continue to report a constant net asset value of $1. Under the final rule, a retail fund must be designed to provide reasonable assurances that it will attract only natural persons, as opposed to institutions such as corporations or pension funds.

However, institutional non-governmental money market funds will soon have a floating net asset value on a daily basis. This requirement is a sensible way to discourage institutional investors from redeeming fund shares at a constant $1 value, even if the fund is experiencing significant losses. During the 2008 crisis, many institutional investors made large redemptions from money market funds to get out before the funds could no longer maintain a constant $1 value.

One concern is that investors will realise a small gain or loss every time they redeem shares of a money market fund with a fluctuating net asset value.

In short, the new rules are likely to reduce the chances of runs on money market funds in times of financial crisis. But it remains to be seen whether these tougher requirements will diminish the appeal of the funds relative to bank deposits for short-term investors.