U.S. Money Market Reform: Not Our First Rodeo

February 14, 2021
Money market funds are an area under ongoing intense scrutiny ever since the 2008 global financial crisis. Delve into the SEC’s Ten Recommendations for U.S. Money Market Funds.

As we settle into 2021, global regulators continue to assess the fallout and ongoing effects of the pandemic-generated volatility that sprung up across the globe in 2020.

Even before the pandemic, regulators were already acutely attentive to systemic risk. That’s to say pockets of risk likely to trigger severe market instability or even specific or widespread economic collapse. One area that has been an area of ongoing intense scrutiny ever since the 2008 global financial crisis is money market funds. And once more, despite their seeming resilience in the face of severe spikes in volatility and redemption activity, money market funds are once back front and center to the systemic risk debate. As money market funds once more jump to the forefront of policymaker’s minds, experienced market professionals wonder how many times we must go through the same issues. For many, this latest review of money funds is not their first rodeo.

In Europe, there has been no widespread call for fundamental changes of the E.U. Money Market Fund Regulation. However, after a pandemic-influenced call from the European Systemic Risk Board, all E.U. Money Market Funds (EUMMF) are already currently finalizing their preparations for new stress-test guidelines, originally published on December 16th that come into effect later this month.

The new guidelines have resulted in all EUMMFs being required to recalibrate the data, parameters, and calculations for portfolio stress testing for inclusion in a revised schema for regulatory filing. A host of other regulatory bodies from around the globe have also chimed in on money market reform, but recently the U.S., by far the largest money market pool in the world, has moved to action.

In the United States, the call for revisions has been more forceful than elsewhere. The Securities and Exchange Commission in the United States has already moved to engage with industry to assess whether U.S. Money Market Funds (MMFs) really did weather the pandemic fueled storms of 2020. The SEC consultation leans heavily on findings of a December 2020 report issued by the President’s Working Group on Financial Markets, an influential group comprised of stakeholders from the U.S. Treasury, the Federal Reserve, the SEC, and the CFTC. The report found that, even though funds did not “break the bank”, the pandemic shone a light on certain structural vulnerabilities and product resilience in both prime and tax-exempt money market funds which added to undue levels of stress in short-term funding markets when COVID-19 first struck. The other factor is that U.S. Treasuries themselves are such a large component of the USMMF portfolios, the Treasury always has a special interest in their functioning. In a press release accompanying the consultation, the acting Chair of the SEC, Alison Herron Lee, underpinned the importance of MMFs in the U.S. markets:  “Money market funds play a significant role in our short-term funding markets, and they are utilized by both large institutions and individual retail investors.” There is some evidence from review of the March 2020 MMF data that the regulations may have encouraged investor redemption activity rather than constrained it as intended as the investor “dash for cash” escalated amid the March pandemic fueled volatility. A Financial Stability Board November report suggests that the MMF rules actually had adverse impacts on both the purchase and issuance of non-government short term commercial paper and certificate of deposits, so often a stable source of non-bank funding for corporates. These unintended consequences of investor behavior and counter-cyclical liquidity impacts now form central components of the SEC’s US MMF consultation. 

The focus on USMMFs is not surprising because of the significant levels of outflows experienced by the funds in March 2020.

During one two-week period in March 2020, investors redeemed more than $100 billion from institutional prime funds (about 30 percent of total AUM of such funds). The redemption levels triggered the Federal Reserve and the U.S. Treasury to establish support liquidity facilities in order to avoid amplification of systemic risks. On a relative basis, money fund outflows as a percentage of fund assets exceeded the outflows of the September 2008 financial crisis as investors looked to flee to cash from the most liquid component of their investment portfolios.  This led the Federal Reserve to buy more than $1.6 Trillion worth of U.S. Treasuries and other bonds as a market stabilization move.

Since then, the Fed has continued to buy more than $80 billion worth of bonds and all the while commentators wonder aloud what would happen market liquidity generally and money market funds specifically if the ongoing supports were to be withdrawn.

However, the SEC consultation asks whether the fact that such market shocks now almost build in such governmental supports as a de facto liquidity tool. Is this a “structural vulnerability” itself which needs to be addressed? Technically, USMMFs didn’t themselves request the governmental supports at the time.

Rather neatly, the December report and the SEC’s public consultation flag 10 possible policy moves, to be deployed in times of market stress. The SEC wants the industry to chime in on these 10 proposals, some of which were previously assessed and rejected before in either 2010 or 2014. The 2010 revisions primarily increased transparency and reduced investment risks and the 2014 changes broadly looked to manage issues around large redemption activity, so called “run on funds” through liquidity tools such as redemption gates and liquidity fees. The previous revisions also required all institutional prime and municipal money market funds to adopt a floating, rather than fixed NAV which inadvertently led to a massive flight of investments from prime money funds into government products. The SEC is casting its net far and wide by seeking broad commentary from respondents on all aspects of the December report, or any other suggestions on how to reform the U.S. MMF market.

Looking at the data, institutional prime money market funds came under the most stress in March, and these are likely to be the area of most significant focus.

This is not the first time industry has had to assess proposals. It is quite likely that on this occasion, industry participants will advocate for more stringent parameters on liquidity fees and gating provisions, rather than the more consequential increases to capital buffer requirements which would have both commercial and compliance consequences to impacted funds.

Industry could probably live with some variant of tighter fund liquidity requirements and increased disclosure of when a sponsor will or will not intervene to support funds. There may even be consideration of swing pricing (not easy for U.S. funds by nature as we have previously flagged), so long as they can avoid the “nuclear option” of increased capital buffers or creation if syndicated banks which MMF sponsors must participate in.

With competition fierce and margins on MMFs wafer thin due to prevailing lower for longer interest rate environment, if the rules are too stringent you may see certain managers no longer offering these funds, thus reducing investor choice and conceivably increasing concentration risk.

Balancing competing goals will be important for policymakers – just as it has been for over a decade in reviewing this issue.

SEC’s Ten Recommendations for U.S. Money Market Funds

The pre-defined weekly liquid asset (WLA) limits often have the unintended consequence of triggering investors to redeem in advance of fee or gate being applied, the opposite of the desired outcome to stem redemptions in stressed scenarios.

March 2020 redemption data shows evidence that some investors preemptively redeem when hard limits which trigger gating come close, alternative methods of reducing their significance are requested.

The proposals would mean a small fraction of each fund investors share balance be ringfenced to absorb losses in the event of fund liquidation; these shares would be “held back” and redemptions delayed for 30 days thus creating some disincentive to redeem in stressed situation and in theory curbing “runs on funds”. All other shares outside the MBR would be freely redeemable. 

Proposals include the contemplation of a new liquidity category with longer maturities (e.g. biweekly liquid assets), increase to liquidity thresholds (e.g. a Weekly Liquid Asset threshold of 40 percent) and punitive measures such as the escrowing of fees until the level of WLA is restored so managers rather than investors bearing the burden of portfolio illiquidity first.

The minimum WLA, fee, and gating requirements should automatically decline when the fund is met with large net redemptions or when the SEC provides temporary relief. This would reduce redemption pressures created as a direct consequence of the current 30 percent WLA threshold. However reduced WLA in stressed markets might make funds less equipped to fund redemptions in such conditions and dynamic calibration and adjustments of thresholds increases complexity.

Imposing floating net asset value for all prime and municipal money funds, not just institutional ones is recommended. This would give better transparency to the true value of funds but also there is scant evidence that floating NAV reduces “runs on funds” and making these retail MMF funds less “cash-like” will likely reduce investor demand.

U.S. investors redeeming from money funds typically do not incur the costs associated with such redemption activity, the investors who remain do. Swing pricing allocates trading costs more equitably between existing and redeeming investors.  Swing pricing could eliminate the first-mover advantage for redeeming investors, however, as we have stated before a major drawback to adoption of swing pricing for all U.S. funds is it requires a substantial reconfiguration of existing fund distribution and order-processing practices, as well as the fact some U.S. MMFs strike their NAVs more than once per day and allow intraday purchases and redemptions. This is not the case for E.U. MMFs where the practice works successfully, for example.

The SEC will require funds to set aside capital to cover losses or fluctuations in net asset value (a "capital buffer"). Capital buffers commit dedicated financial resources within or attached to a fund to absorb losses and can act as shock absorbers to portfolio fluctuations. They protect both investors and taxpayers from required governmental supports. They are the least favored option of asset managers however due to the costs of maintenance in an already hyper-competitive and cost conscious MMF marketplace. MMF shares are not bank deposits but capital requirements make them appear eerily similar. While it might reduce the U.S. MMF industry’s reliance on discretionary sponsor or governmental support, it could reduce investor choice and concentrate MMF risks to a select few providers (most like bank sponsors), thus having the unintended consequence of increasing rather than decreasing systemic risk.

Proposals suggest that MMF sponsors would come together as a syndicate and capitalize the LEB through initial capital contributions and ongoing commitment fees.  In market stress, the LEB (rather than federal government) would purchase eligible assets from MMFs that need cash, thus internalizing the costs of liquidity protection for the MMF industry. The LEB would not be intended to provide credit support or to act as a “regular bank” but this could impact its ability to obtain a banking charter or access the Fed’s discount window. Also, non-bank asset management sponsors might not wish to bear the cost or burden of bank like regulation as a result of LEB participation. Again, the probability of reduced competition, and increased bank sponsor concentration is a likely outcome.

A recommendation for a proposal to issue new requirements for sponsors to clarify when they must provide financial support to their money funds. Currently, sponsors may provide support to MMFs under certain conditions including the public disclosure of any “financial support” to their funds. However, there is no uniformity of approach across all MMF sponsors so an enhanced regulatory framework is proposed to more explicitly clarify who bears MMF risks and instances where a sponsor would be required to provide support.

The balance between making the U.S. money market fund sector safer and more trustworthy, while keeping it competitive is going be a delicate needle for the SEC to thread.

Too much regulation will force some to leave and further concentrate such activity into the hands of bank affiliated sponsors - the exact opposite effect to what U.S. policymakers would wish for from systemic risk and investor choice perspectives.

From the industry’s perspective, there are parts of the 10 MMF proposals they could live with even if it would increase compliance burden. However, there are others, such as the capital provision related ones, which for some would be “deal breakers”.

For most stakeholders, this is not their first or even their second rodeo when it comes to grasping the MMF bull by the horns. However, depending on which way the final rules land, for some it could be their last.

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