In his latest "Money Market Monitor" report, Garret Sloan, money market strategist at Wells Fargo Securities, analyzes the latest plot twist in the ongoing money market reform saga, i.e., Fidelity's announcement that it will be converting some $130 billion in prime funds to government funds, including the $112 billion Fidelity Cash Reserves. He believes there are three major factors that led to Fidelity's shift from prime retail. Sloan writes, "Those of you that are familiar with the George R.R. Martin series of books made popular to non-geeks by the HBO series Game of Thrones know of the progressively dark twists and turns that the author forces his characters to endure as the plots progress. The money market fund universe seems to have undergone its own "Red Wedding" moment last July, but until recently it appeared that while the industry was begrudging the change, it was nevertheless taking it in stride. That view may have completely changed this month as the market is digesting the recent news from Fidelity Investments that it has chosen to convert its largest prime money market fund, Fidelity Cash Reserves, along with two other smaller funds, to the government retail category."
Explains Sloan, "The change was like a shot heard round the world for the money fund industry, not only because the size of the fund makes ignoring it impossible, but also because Cash Reserves is a retail fund that has never needed to directly address the risk of a floating NAV. The proposed change indicates that the industry is perhaps a bit more worried about flows and structural reforms than the initial period of calm has suggested. The questions we face now are what are the changes that the money fund industry is facing that may have precipitated such a preemptive shift in strategy, and does this switch represent a turn of the tide for the entire prime money market fund space? We would suggest that there are factors, other than the floating NAV, that Fidelity believes place sufficient pressure on prime funds that would warrant the change. These include: 1. A permanent structural reduction in short-term investments options. 2. The reality that redemption gates and liquidity fees may turn out to be a bigger regulatory hurdle. 3. The additional structural issues involved with sweep-related money market fund products."
Concerning the first factor, supply, he writes, "It is no secret that money funds are heavily exposed to the bank sector. Both domestic and foreign holdings in prime funds are dominated by bank-related exposure. Regulatory changes in the banking sector are expected to place direct pressure on the supply of short-term bank-related assets, and it is likely that these assets will continue to diminish as these changes permeate the global banking landscape."
Sloan noted three such pressures: 1. Liquidity Coverage Ratio, which requires banks to maintain at least one dollar in high quality liquid assets (HQLA) for every dollar in short-term financial-related deposits,; (2) Net Stable Funding Ratio, which requires banks to maintain certain stable types of funding for less liquid assets; and (3) Supplementary Leverage Ratio, which puts "somewhat of a cap on certain repo funding as the SLR does not allow for the offsetting of exposure under "open repo" transactions, or those that do not have an explicit maturity date."
Regarding the second factor, fees and gates, Sloan contends, "Shifting gears away from the supply situation, we return to the question of Fidelity Investments and its proposed decision to transition Fidelity Cash Reserves from a prime retail fund into a government retail fund. Why is this being proposed in a retail fund? Will other fund families follow suit? Is this a bellwether event that will force other funds to follow suit? The first question is why retail and why not institutional? This can only be answered by the fact that gates and fees do not mix well with the Fidelity Cash Reserves’ client base."
He asks, "So who are the Fidelity Cash Reserves’ clients? It is our understanding that the fund is, among other things, a large investment vehicle for ... "sweep" products, and in Fidelity's estimation "sweep" products and redemption gates/liquidity fees are incompatible. That view is not necessarily shared by all market participants, and because other views exist, the fact that Fidelity chose this path does not mean that other fund providers will immediately follow."
Sloan continues, "An issue with the sweep vehicle is that sweep redemptions are often done on a "next day" basis with the money market fund as one "batch" transaction, but the cash being available to individual clients the same day. This is equivalent to the sweep provider lending money to the depositor on an overnight basis until the "batch" transaction with the money market fund can be conducted the next day. This makes sweep vehicles in the new 2(a)7 world difficult for two reasons."
"First," he writes, "if a sweep provider (bank) redeems a sweep depositor at one price but liquidates the position the next day at another price, the bank provider could potentially suffer a loss on the position and not be able to recoup the cost. It is likely that the sweep provider could quickly debit the account of the investor for the difference, but the risk exists that the investor could redeem all bank and fund balances, leaving the bank exposed to the price volatility of the fund portfolio. Second, Gates and Fees could be equally as difficult. Clearly they are, given that Fidelity chose to convert its retail prime funds. The issue again seems to do with the extension of overnight credit. In the event that a sweep provider delivers cash to a depositor and the next day, a gate is introduced on the fund, the bank sweep provider would be left with credit and liquidity exposure to the money market fund for up to ten days. Bank sweep providers are unlikely to be willing to accept this risk."
On sweeps he continues, "Fees are an equally sticky problem, in that a bank sweep provider could be exposed to the risk of paying a fee on a sweep redemption it has already made. However, alternative solutions are being discussed by other money market fund complexes, and we anticipate that fund providers will work with their bank sweep partners to solve the issue.... One relevant question is whether the lowering of a redemption gate introduces incremental credit risk to the sweep provider? Or did the risk exist all along? In our opinion, the answer is no ... and yes. Since the client has already been paid, the sweep provider is exposed to the failure of the fund whether a gate is in place or not. However, the provider is exposed to greater liquidity risk, and under the bank regulatory framework discussed in previous sections, it may be costly to provide short-term liquidity to regulated funds."
Sloan concludes, "Whether we have effectively made the argument that the transition of Fidelity Cash Reserves and its smaller prime siblings to a government retail fund is not the next shoe to drop for prime funds is yours to decide. What we do know is that we fully expect other money market fund complexes to continue exploring other options. We suspect that time will be needed for investors to warm up to any of the options trickling into the market, and flows will move to the options most palatable to that client base."
He adds, "Conversely, while we wait for other fund complexes to address 2(a)7 regulatory issues in their own ways, we would suggest that if other money market funds follow Fidelity's lead, the pressure that banks may feel as a result of a reduced buyer base could cause the shape of the short-term bank funding curve to twist even more awkwardly, presenting even stronger relative value opportunities for short-term investors that can buy beyond the money markets."
Finally, Sloan comments, "For our part, we do not anticipate a stampede of funds following Fidelity's lead, even in the sweep product market. Nor do we believe that Fidelity's pivot suggests a shifting belief that 2(a)7 funds no longer have a strong value proposition. The landscape for money market funds is riddled with supply and demand challenges, but we believe more opportunities than risks exist for investors that can flexibly deploy cash."
