As the coronavirus pandemic rocked capital markets in March, US policymakers were confronted with a rapidly escalating crisis in a crucial part of the financial system: money market funds.
Huge investor outflows from prime money market funds — instruments that invest in corporate, agency and other short-term debt — left managers scrambling to sell assets, threatening a vital source of funding for businesses across America.
The Federal Reserve rushed to stem the bleeding, which sliced more than $100bn off the sector’s assets, by effectively backstopping the market. The Fed’s actions evoked memories of when it was forced to step in after the Reserve Primary fund “broke the buck” in 2008 and triggered a run on money market funds.
While the intervention helped to avert a fully fledged liquidity crunch this time around, the events raised difficult questions for policymakers, who had only recently introduced reforms designed to make the funds less vulnerable to destabilising runs.
Regulators in the US and Europe are now under pressure to review whether rules that they introduced in the aftermath of the 2008 crisis are fit for purpose.
“There’s no doubt that we need to re-examine the [money market fund] reforms of the last time,” said Jay Clayton, chair of the Securities and Exchange Commission, in September.
Steven Maijoor, his counterpart at the European Securities and Markets Authority, said this month that money market funds’ “inadequate” response to the March turmoil showed that further rule changes were needed.
A fresh regulatory overhaul could have major reverberations for the sector, coming at a time when it is already struggling to navigate ultra-low interest rates. However, the funds’ interconnections with the wider financial system means that policymakers have no choice, some analysts say.
“The unique niche money market funds inhabit, and the fact they were at the centre of the liquidity storm in March, mean they will be a high priority for regulators,” said Alastair Sewell, head of funds and asset manager ratings for Emea and Apac at rating agency Fitch.
A central question in this debate is whether a safety measure introduced as part of the prior reforms to protect investors has had the opposite effect. The rules require funds to hold a minimum level of assets that are liquid, meaning they can be easily sold. In the US, if a fund’s weekly liquid assets fall below 30 per cent of its portfolio, it can suspend redemptions, temporarily preventing investors from accessing their money.
Concerns are now mounting that this threshold may have pushed investors to redeem at a faster pace in March in order to avoid becoming trapped. Preliminary research published by Fed economists in July found that investor withdrawals accelerated as prime funds’ liquidity levels fell close to 30 per cent. This brought to mind the way investors collectively headed for the exit in 2008 when the net asset value of the Reserve Primary fund fell below $1.
“One might ask whether we have exchanged one psychological bright line for another,” deputy US treasury secretary Justin Muzinich said in a recent speech.
This pressure effectively prevented funds from dipping in to their liquidity reserves to meet redemptions in March, according to BlackRock vice-chairman and co-founder Barbara Novick. “What is the point of a 30 per cent buffer if you can’t actually use it?” Ms Novick said at an SEC roundtable this month.
In Europe, several funds that operate a stable NAV came close to no longer being able to guarantee their €1 per share price, a move that would have resulted in losses for investors and potentially triggered further outflows, according to Fitch’s Mr Sewell. Speaking anonymously, one senior European regulator said: “It could have been a negative market event and destabilised market confidence, with consequences for financial stability.”
BlackRock is among those calling for policymakers to review the current rule to ensure it does not lead to a ‘first mover’ bias. It recommends removing the link between the 30 per cent threshold and the imposition of redemption gates, and wants regulators to allow the ratio to be waived or modified at times of stress. The second idea has the backing of regulators including the French financial watchdog, whose chairman voiced support recently for alleviating liquidity requirements during a crisis.
However, the forthcoming regulatory reviews could also reopen a debate about whether prime money market funds should be forced to hold a greater proportion in cash or liquid assets that are easy to sell in volatile conditions. But the introduction of more onerous requirements could prove the final straw for some managers, analysts say. Wafer-thin interest rates has made it harder for prime money funds to generate enough yield to support their fees, encouraging managers including Vanguard, Fidelity and Northern Trust to close or convert their funds.
Analysts at JPMorgan warn that future reforms could push more asset managers out of the market if they make prime funds more costly to operate.
“[Greater liquidity ratios] could further limit funds’ investment options which makes it harder to run a money-market fund,” added Joseph Abate, a managing director at Barclays.
Industry bodies argue that policymakers’ focus should also be on fixing liquidity problems in the broader credit market, pointing to the fact banks and dealers were unwilling to buy securities from funds in March.
Neal Epstein, a senior analyst at Moody’s in New York, points out that it was the Fed’s intervention that ultimately prevented a liquidity crisis this year, suggesting that regulatory safeguards alone are not enough.
“It may make sense to institutionalise the role of the Fed as a lender of last resort,” he suggests. “I doubt that anyone could have provided sufficient liquidity [to funds] when investors wanted to get out of risk assets.”
Funds in Europe did not benefit directly from either central bank support or assistance from their banking parents. EU regulators have signalled that they intend to review this disparity with the US, where banks including Goldman Sachs and BNY Mellon stepped in to help their money market funds.
Regardless of the approach they take to reforming the rules, policymakers will have to be conscious of the fact that money market funds are likely to be at the centre of an investor ‘dash for cash’ once again.
“Everyone values liquidity in a period of uncertainty,” said BlackRock’s Ms Novick. “Any solution we think about has to take that as a given, because people will run again for cash if there is a period of uncertainty of this magnitude.”