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.