The Birth of the Money Market Fund, 1971–1983

In August 1969, in a cramped office on the edge of the New York financial district, two men who advised pension funds for a living sat looking at a gap that was arithmetic rather than opinion. Treasury bills were paying above seven percent. The passbook savings account at the bank down the street was paying five. Nothing about credit risk explained the difference — a bank deposit was federally insured and a Treasury bill was a claim on the United States, and both were about as safe as money gets. What explained it was a rule written in 1933 and administered by the Federal Reserve Board, and the rule applied to the bank but not to the bill.

Bruce Bent and Henry B. R. Brown were the men, and the thought Bent had that afternoon was not complicated. A small saver with two thousand dollars could not buy a Treasury bill, which came in ten-thousand-dollar minimums, and could not buy commercial paper, which came in lots of a hundred thousand or more. But a mutual fund could. Pool the two-thousand-dollar accounts, buy the wholesale paper, pass the yield back, and the ceiling on deposit rates stops mattering to anyone who bothers to move.

What they built out of that observation took four years to attract any money at all, and then seeded an industry that grew from under two billion dollars to more than two hundred billion inside a decade. It drained the savings and loan industry, provoked the Federal Reserve into invoking an emergency credit statute, and forced Congress to dismantle the interest-rate regime that had governed American banking since the Depression. The instrument was a checking account that paid the money market rate. The fight was over who got to set the price of cash.

A Ceiling at 5.25 Percent

Regulation Q was the Federal Reserve's implementation of a statutory command, enacted in 1933, that banks stop competing for deposits on price. Congress believed rate wars had driven banks into reckless lending before 1929, and the remedy was to cap what a depositor could be paid. For decades the cap was irrelevant because market rates sat below it. That stopped being true in the second half of the 1960s.

By the early 1970s the ceiling on passbook savings stood at 5.25 percent, with thrift institutions permitted a quarter-point advantage over commercial banks to protect the mortgage lenders. When Treasury bills yielded four percent, no depositor cared. When they yielded eight, and later fifteen, the ceiling became a tax on anyone who did not know how to escape it. R. Alton Gilbert's assessment of what the regulation actually accomplished, written after its repeal, concluded that it had transferred income from small savers to borrowers and to bank shareholders without measurably improving bank safety (Gilbert, 1986).

Escaping the ceiling was easy for institutions and hard for households. A corporate treasurer bought commercial paper. A wealthy individual bought Treasury bills directly at auction. A schoolteacher with four thousand dollars had a passbook and no alternative, because every instrument paying the market rate had a minimum denomination that priced her out. The ceiling was not merely a cap on rates; it was a cap that bound only the people with the least money.

The Fund Nobody Wanted

Bent and Brown incorporated the Reserve Fund and filed with the Securities and Exchange Commission, and then discovered that a regulator confronted with a genuinely new kind of investment company moves slowly. Accounts of the launch differ in a way worth naming: the partners dated the fund's opening to 1971, while the Commission's clearance of its registration came in late 1972 after an extended review of whether an open-end fund could sensibly hold nothing but short-term debt and redeem shares on demand.

Either way, the money did not come. The fund's expenses ran ahead of its fee income, and the two founders accumulated roughly $250,000 of debt keeping it alive. A product whose entire appeal was a three-point yield advantage over a bank account turned out to be nearly impossible to explain to the people it was designed for, and impossible to sell through the brokers who sold everything else, because a fund yielding seven percent on a half-percent management fee cannot pay a salesman a commission.

What rescued it was journalism. In January 1973 The New York Times published a piece describing the fund, and by the end of that year the Reserve Fund held about $100 million. Joseph Nocera's account of how American households were pulled into securities markets treats this moment as the hinge — the point at which a retail investor learned that the yield on wholesale money was available to her, and that the bank had never mentioned it (Nocera, 1994).

Imitators arrived quickly, and one of them added the feature that mattered more than yield. In 1974 Fidelity launched Fidelity Daily Income Trust, the first money market fund to let shareholders write cheques against their balance. That single administrative decision changed the category from an investment into a substitute for a current account. A saver no longer had to choose between liquidity and return; she could have the money market rate on a balance she could spend.

The Drain

Growth from 1974 onward followed the spread between market rates and the Regulation Q ceiling with a tightness that left little room for argument about causation. Money market fund assets stood at roughly $1.7 billion at the end of 1974 and stayed in a band between three and four billion until late 1977, the years when short rates sagged and the yield advantage thinned. Then short rates climbed, and the funds went vertical.

Timothy Cook and Jeremy Duffield, writing from the Federal Reserve Bank of Richmond in 1979 while the growth was still accelerating, framed the question in their title: were money market funds "a reaction to government regulations or a lasting financial innovation?" Their answer was both, and the distinction mattered for policy, because a purely regulatory arbitrage would collapse the moment the regulation did (Cook and Duffield, 1979).

These figures come from compilations that do not all define the universe identically — some cover taxable funds only, others include tax-exempt and institutional vehicles — and the 1980 value in particular is a lower bound drawn from contemporary narrative accounts rather than a reconciled year-end series. Read the shape rather than the decimal places. By the end of 1982 money market funds held about 74 percent of all United States mutual fund assets, against roughly five percent in 1974. An entire industry had been reorganised around a cash product.

Where the money came from was no mystery to the institutions losing it. Savings and loans funded thirty-year mortgages with passbook deposits they were forbidden to reprice, and when depositors left for a fund paying eleven percent, the thrifts could not follow without breaking the law. Disintermediation was the polite word. The consequences ran directly into the savings and loan crisis that destroyed a thousand institutions between 1980 and 1995, and they were sharpened by the Volcker Fed's decision to break inflation by letting short rates go wherever they had to go. A ceiling of 5.25 percent is survivable when bills yield six. At sixteen it is a demolition order.

The Credit Control Act

On 14 March 1980, with President Carter's approval, the Federal Reserve Board did something that had no precedent in the regulation of investment companies: it imposed a special deposit requirement on money market mutual funds. Funds were required to place fifteen percent of any increase in their total assets after that date with the Federal Reserve, earning no interest.

The authority came from the Credit Control Act of 1969, which empowered the Board to "regulate and control any or all extensions of credit" whenever the President found it necessary to control inflation. Stacey Schreft's reconstruction of the 1980 programme documents how little the Board understood about what it was doing to credit aggregates, and how fast the effects exceeded what anyone at the Board had forecast (Schreft, 1990). Some funds closed to new investors. Others opened parallel vehicles that had no assets on 14 March and therefore no base against which growth could be measured. The requirement was lifted on 28 July 1980, four and a half months after it began.

Seventeen days after imposing it, the same administration signed the legislation that made it pointless. The Depository Institutions Deregulation and Monetary Control Act, enacted on 31 March 1980, established a committee to phase out Regulation Q ceilings over six years. Congress had looked at the arbitrage and decided to close it from the other side — not by taxing the funds, but by letting the banks compete.

One Dollar a Share

A money market fund's usefulness rests on a convention that is, examined closely, a small accounting fiction. The fund holds debt whose market value fluctuates, yet it reports a share price of exactly $1.00 and pays the fluctuation out as income. Two techniques make this work: amortised cost, under which a security is carried at purchase price adjusted toward par, and penny rounding, under which a share value that has not fallen more than half a cent below a dollar is reported as a dollar.

Neither technique was obviously legal under the Investment Company Act of 1940, which required portfolio securities to be valued at market. Funds applied for exemptive orders; the Commission held hearings from November 1978 through March 1979; the applicants offered settlements accepting conditions on maturity and credit quality, and relief began to issue in 1979. In 1982 the Commission proposed a general rule, and on 11 July 1983 it adopted Rule 2a-7 — a text of just over 1,800 words that has governed the largest cash pool in the world ever since.

The fiction held for a long time. It failed for the first time in 1994, when the Community Bankers U.S. Government Money Market Fund — an institutional fund of roughly $80 million holding some $35 million of structured notes issued by federal agencies — lost about four percent of its value as rates rose, and could not restore the dollar. That episode belongs to the bond market rout that seven Federal Reserve rate increases produced in 1994. It failed far more consequentially in September 2008, when the Reserve Primary Fund — run by the firm Bruce Bent had founded — held $785 million of Lehman Brothers commercial paper on the morning Lehman filed for bankruptcy after the Federal Reserve declined to rescue a 158-year-old firm, and broke the buck two days later. Bruce Bent lived to watch the firm he had founded demonstrate his product's central weakness.

December 1982

Congress finished the job with the Garn–St Germain Depository Institutions Act, signed on 14 December 1982, which authorised banks and thrifts to offer money market deposit accounts: no interest ceiling, federal insurance, up to six transfers a month. For the first time since 1933, a bank could match a money market fund's yield and add a government guarantee on top.

The response was immediate and one-directional. Speaking on 12 May 1983, SEC Chairman John Shad reported that the new bank money market and Super NOW accounts "grew from scratch to over $370 billion" in five months while money market funds fell $54 billion, or 24 percent, to $168 billion. Cook and Duffield's question had been answered in the least ambiguous way available: remove the regulation, and a large share of the money goes home.

A large share, not all of it. Funds stabilised near $170 billion and then resumed growing, because the product had acquired uses that had nothing to do with Regulation Q — corporate treasury management, brokerage sweep balances, a place for institutions to hold cash in size without concentrating credit risk on one bank. Regulation Q's remaining ceilings expired on 31 March 1986, leaving only the prohibition on paying interest on demand deposits. The funds kept growing anyway, past a trillion dollars in the 1990s and past six trillion in the 2020s.

What the Ceiling Taught

Bent and Brown's insight was not about interest rates. It was that a price control creates a business for whoever can legally stand outside it, and that the minimum denomination of a Treasury bill was the only thing keeping ordinary savers inside. Remove the denomination barrier with a pooling vehicle, and the control has no subjects left except the people who have not heard the news.

The same logic reappears in nearly every regulated market where the regulated and unregulated sectors offer the same economic service. Both Bent's fund and John Bogle's First Index Investment Trust of 1976 were bets that retail investors would eventually notice an arithmetic fact that the existing industry had no incentive to point out. Both waited years for anyone to notice. Both ended up reshaping the institutions that had ignored them.

Henry Brown died in 2008, weeks before the fund bearing his firm's name broke the dollar it had been built to defend. The convention he and Bent invented — a share worth exactly one dollar, redeemable today, paying whatever the money market paid yesterday — is still the plumbing under several trillion dollars of American corporate cash, and it is still, in the last analysis, a rounding rule.