Last week, Federal Reserve Bank of New York Executive Vice President Simon Potter spoke on "Money Markets at a Crossroads: Policy Implementation at a Time of Structural Change," where he discussed the Fed's "new and innovative framework to control money market rates." Potter says, "Since late 2015, we have seen several significant developments in money markets that have tested this new framework. These include a profound reshaping of the money market fund industry as a result of new Securities and Exchange Commission (SEC) rules, significant shifts in cash management practices at the Treasury and large foreign reserve managers, and continued pressure on bank balance sheets due to the ongoing implementation of Basel III capital requirements. Also since that time, the Federal Open Market Committee (FOMC) has directed three 25 basis point increases in its target range for the federal funds rate."

He continues, "I will discuss these structural developments, and evaluate the continued efficacy of the Federal Reserve's policy implementation framework in light of their effects on money market competition and integration. I'll briefly review the means by which we implement policy, and the reasons why we do so differently now from before the financial crisis. I'll explain why changes in money market structure could conceivably impair the transmission of monetary policy. We will see that the impact of many of the recent structural developments were smoothed by the presence of the Federal Reserve's overnight reverse repurchase facility. Then, I will take you through some data about money market dispersion to see what effect these developments had in practice."

Potter says, "The takeaway from all this is clear: our framework remains highly effective, and has proved quite resilient, even to these significant shifts in market structure. It continues to provide the FOMC with excellent control over money market rates. Indeed, the effective federal funds rate remained within the FOMC's target range 100 percent of the time in 2016 and this has continued so far this year.... Changes in the federal funds rate continue to transmit in a predictable way to other money market rates, thereby affecting, as intended, the broad financial conditions upon which the price and quantity of private sector credit depend. However, recent evidence on dispersion in overnight and term rates suggests that we should continue to monitor the transmission of the FOMC's policy stance into money market rates carefully."

He explains, "Our current framework relies, instead, on providing the market with two overnight investment opportunities to help steer money market rates: interest on reserves (IOR) and the overnight reverse repurchase agreement (ON RRP) facility. By law, IOR is available only to depository institutions. Absent frictions, IOR should provide a floor on interest rates, since competition between banks that can acquire funds in the wholesale market at rates below IOR and earn the spread should bring these rates very close to that paid on reserves. In practice, a number of frictions have led money market rates to trade moderately below IOR. ON RRP, which is offered to a broad selection of counterparties that includes money market funds, is intended to intensify competition in money markets and enhance the transmission of IOR into other overnight money market rates. It also has proved useful as a shock absorber."

Potter also comments, "Some structural changes could reduce the ability of our operations to affect rates on other transactions within those same markets. For example, our ON RRP operations provide a floor on the repo rate offered by dealers to cash investors because of the competitive pressure the Fed's offer rate places on borrowers of funds in the repo market. If this competitive pressure were less effective, perhaps because of greater constraints on lenders' switching counterparties, changes in the ON RRP rate could become less effective in influencing repo market rates."

On "Recent Developments in Money Market Structure," he tells us, "Since 2015, my staff and I have focused on four changes in money market structure that some observers believed could have had an impact on the implementation or transmission of monetary policy. I'll discuss each of these in turn. To begin with, we are now firmly off the zero lower bound. After seven years at very low levels, the federal funds rate is now trading at 91 basis points. [T]he distribution of overnight federal funds activity is now quite distant from zero, in comparison to the period before liftoff. (Figure 3) shows a similar presentation for the triparty repo market, similarly revealing that traded rates are now consistently well above the zero bound and largely above or at the ON RRP offer rate."

Potter continues, "The second development, in October 2016, was the entry into force of new SEC rules for money market funds. These new rules require, among other things, a floating net asset value for institutional prime money market funds, provide for liquidity fees and redemption gates for prime funds, and establish more stringent rules for portfolio diversification and financial reporting for all money market funds. Many of these reforms are aimed at least in part at enhancing financial stability, and in particular at addressing the potential for runs on prime funds to intensify financial stress. They could also make prime funds, which can hold a broad spectrum of money market assets, less attractive to investors who desire an investment opportunity with a fixed net asset value or who are concerned about redemption fees or gates."

He states, "Our contacts in the money market fund industry could foresee, based on their own business plans and discussions with their clients, that these reforms would lead to a substantial shift in money market fund assets. Substantial amounts were expected to come out of prime funds and into government-only funds, which generally hold Treasury securities, repo against Treasury collateral, or similar ultra-low-risk assets. As a result, this reallocation was expected to bring about somewhat lower rates on Treasury bills and repo backed by Treasury collateral, and somewhat higher unsecured rates."

Potter informs us, "The size of the reallocation ended up being quite a bit larger than most had expected. [A]bout $1 trillion of assets had migrated from prime to government funds by late 2016. This resulted in a major reallocation of the investments held by the money market fund industry.... This reallocation had far-reaching effects on the structure of money markets, as described in a recent blog by some of my New York Fed colleagues. For example, banks that were relying on the funding by prime funds had to find other institutions that would be willing to lend to them. Government funds, which received large inflows, had to place the additional funds they had received, for example into Treasury or agency securities or into repo. Such a large change in funding flows could have created significant movements in money market interest rates."

He adds, "The good news is that the ON RRP facility served as a shock absorber for overnight rates. As shown in (Figure 6), money market funds, particularly government funds, increased their use of ON RRP during the transition. Because of the availability of ON RRP, government funds knew they would be able to temporarily place some of the new funding they received at the ON RRP facility while they were looking for new investment opportunities, and prime funds knew they would have access to a very secure and liquid overnight investment as they increased their liquidity to meet an uncertain level of redemptions. As a result of this elastic provision of a risk-free investment opportunity, overnight secured and unsecured rates were only modestly affected by these large flows, and overnight markets continued to move as intended following changes in the FOMC's target for the federal funds rate. That said, the runoff in prime fund assets did leave an imprint on term unsecured rates, although some of this has retraced recently as markets have adapted."

Finally, Potter comments, "To conclude: I continue to be greatly encouraged by the performance of our framework for policy implementation, which has provided the FOMC with excellent control over the federal funds rate and predictable pass-through of the monetary policy stance into broader money market conditions. Transaction-level dispersion measures demonstrate markets that are competitive, and suggest that the effects of policy tightening are realized as expected and intended. These markets, and our framework, have proved resilient to major shocks to the structure of money markets, including the reshaping of the money market fund industry."

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