Rule 2a-7 [CapiPedia]

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======Rule 2a-7======
Rule 2a-7 is a crucial piece of regulation from the U.S. [[Securities and Exchange Commission]] (SEC) that governs [[money market funds]] (MMFs). Think of it as the strict rulebook that allows these funds to behave like high-yield savings accounts. Its primary purpose is to enable MMFs to maintain a stable [[net asset value]] (NAV) of $1.00 per share, making them appear as safe and simple as cash. To achieve this, the rule imposes tight restrictions on the investments a money market fund can hold, focusing on credit quality, diversification, and liquidity. It was established under the [[Investment Company Act of 1940]] to provide a framework for these cash-like investment vehicles, ensuring they remain low-risk havens for investors' short-term cash. However, as history has shown, this stability is a carefully constructed convention, not an ironclad guarantee.
===== What Rule 2a-7 Actually Does =====
At its heart, Rule 2a-7 is all about risk management. It provides a special exemption that allows money market funds to use amortized cost accounting. This method lets the fund value its securities at their purchase price plus any accrued interest, rather than their fluctuating market value. This is what makes the stable $1.00 share price possible. Without this rule, a money market fund's NAV would bounce around daily, just like any other [[mutual fund]].
In exchange for this privilege, the rule acts like a strict chaperone for fund managers, forcing them to operate within a very tight "safety box." The goal is to minimize the risk of the fund's NAV falling below $1.00—an event famously known as "breaking the buck."
==== Key Safeguards Under Rule 2a-7 ====
The rule sets forth several non-negotiable conditions to keep the funds on a short leash. The main pillars of this regulation include:
  * **High Credit Quality:** Funds can only invest in top-tier, short-term debt securities. These are typically from issuers with the highest credit ratings, such as U.S. government debt, high-grade [[commercial paper]] from corporations, and other low-risk debt instruments.
  * **Strict Maturity Limits:** The rule enforces a very short lifespan for the fund's holdings. It mandates a [[weighted average maturity]] (WAM) of 60 days or less. This means the average time it takes for all the securities in the portfolio to be repaid is extremely short, reducing sensitivity to interest rate changes.
  * **Portfolio Diversification:** To prevent the fate of the fund from being tied to a single company, Rule 2a-7 generally prohibits a fund from investing more than 5% of its assets in any one issuer.
  * **Liquidity Requirements:** The rule mandates that funds hold a minimum percentage of their assets in daily and weekly liquid assets. This ensures the fund has enough cash (or assets that can be converted to cash within a day or a week) to handle large-scale withdrawals from investors without having to sell less liquid assets at a loss.
===== Why Value Investors Should Care =====
For a value investor, cash is not just idle money; it's a strategic asset waiting to be deployed when opportunities arise. Understanding the safety of where you park that cash is paramount.
==== Stability and the Illusion of Safety ====
The ultimate test for Rule 2a-7 came during the 2008 financial crisis. The [[Reserve Primary Fund]], a large money market fund, held debt from the investment bank [[Lehman Brothers]]. When Lehman went bankrupt, the fund was forced to write off that debt, and its NAV fell to $0.97 per share. It "broke the buck."
This event shattered the illusion that money market funds were perfectly safe and triggered a panic. Investors rushed to pull over $300 billion from prime MMFs, forcing the U.S. Treasury to step in with a temporary guarantee to halt the run. For value investors, this was a stark lesson: //an investment that looks and feels like cash is not the same as cash in an [[FDIC]]-insured bank account//. Always understand the underlying assets.
==== The Floating NAV Reform ====
In response to the 2008 crisis, the SEC enacted significant reforms to Rule 2a-7. The most important change was the introduction of a [[floating NAV]] for certain types of MMFs.
  * **Institutional Prime and Municipal MMFs:** These funds, which are used primarily by large corporations and institutions, must now let their share price float based on the market value of their underlying assets. The stable $1.00 NAV is gone for them.
  * **Government and Retail MMFs:** Government MMFs (which invest almost exclusively in government debt) and retail MMFs (sold only to natural persons) are still permitted to maintain the stable $1.00 NAV.
This distinction is critical. If you are an individual investor, the retail money market fund in your brokerage account likely still operates under the old model, but the underlying risks, though small, remain.
===== Practical Takeaways for Investors =====
  - **Know What You Own:** Money market funds are not bank deposits. They are securities subject to investment risk, including the possible loss of principal.
  - **Safety Is Relative:** Government MMFs are generally considered the safest type due to the nature of their underlying assets (e.g., U.S. Treasury bills).
  - **Rules Mitigate, Not Eliminate, Risk:** Rule 2a-7 provides a robust framework for safety, but extreme market events can still test its limits.
  - **Cash Is King, So Protect the Kingdom:** For a value investor, the cash portion of a portfolio is dry powder. Keeping it in a vehicle you fully understand—and whose risks you accept—is a fundamental part of a sound investment strategy.