Federal Reserve Vice Chair Janet Yellen spoke Friday on "Pursuing Financial Stability at the Federal Reserve." In her speech, she commented, "Less-discernible progress has been made to date, however, in addressing other key vulnerabilities that came to the fore during the financial crisis. Indeed, short-term funding markets remain an important source of structural risk. Despite some significant reforms that enhance liquidity and impose additional restrictions on portfolios, money market funds are still susceptible to liquidity constraints largely because of attributes like their rounded net asset value (NAV) feature and the low risk tolerance of their investors. Options for further reforms being considered by the Securities and Exchange Commission (SEC) include a mandatory floating NAV to mute the incentive for investors to be the first to redeem, capital buffers to allow funds to deal better with actual and potential losses while sustaining a stable NAV, and limits on redemptions both to provide more time for fund managers to address problems and to emphasize to investors that money market funds do not guarantee bank-like liquidity. The triparty repurchase agreement (repo) market also continues to exhibit important vulnerabilities. In particular, the settlement process for triparty repo trades continues to rely on massive amounts of intraday credit and, as a result, remains vulnerable to a decision by a clearing bank to withhold funding from a market participant in default or perceived as facing distress. The FSOC has recommended reforms to deal with these problems, and an industry task force has taken some key initial steps in that direction -- for example, by coordinating the implementation of a robust confirmation process for triparty trades. But more needs to be done. Indeed, given the centrality of this market to the financial system, taking further steps to reduce its vulnerabilities should be given a high priority. In addition to addressing the unfinished business from the financial crisis, financial stability authorities and market participants need to be alert to new structures and products, not just those that caused problems in the past. New financial products -- for example, exchange-traded funds and collateralized commercial paper -- may foster more efficient intermediation, but they may also raise systemic risk if they increase the complexity and interconnectedness of the financial system."
