The Federal Reserve Bank of New York recently published a "Staff Report" entitled, "Investors' Appetite for Money-Like Assets: The Money Market Fund Industry after the 2014 Regulatory Reform." Written by Marco Cipriani, Gabriele La Spada, and Philip Mulder, the paper's Abstract says, "We document the reaction of money market fund (MMF) investors and portfolio managers to a new SEC regulation that came into effect in October 2016. This regulation forces all prime and municipal MMFs to adopt a system of redemption gates and fees and institutional prime and muni MMFs to also operate under a floating net asset value (NAV). First, we show that in anticipation of the new regulatory framework, investors flowed from prime and muni into government MMFs and especially toward the riskier type of government MMF, agency MMFs, consistent with their likely higher risk appetite profile. Second, the flows from prime and muni MMFs into government MMFs mostly occurred within fund families, supporting the hypothesis that the flows were due to the regulatory changes."
They explain, "This contrasts with past outflows from prime and muni MMFs into government MMFs, such as those seen during the 2008 crisis; in those cases, investors often left not only their prime and muni fund but also the fund family. We relate such differences in investors' behavior to their appetite for money-like assets, whose supply was impacted by the new regulation, as opposed to traditional flight-to-safety motives. Third, the outflow from prime and muni MMFs was stronger for institutional investors, consistent with the fact that these investors are more elastic to industry developments and have been subject to a stricter regulation than retail investors. Finally, as a result of the outflows from prime and muni funds, MMF credit to the private sector has been significantly reduced, whereas credit to government-sponsored enterprises (and in particular Federal Home Loan Banks) has increased substantially."
The report's "Introduction" tells us, "After the 2008 run on the money market fund (MMF) industry, academics and policy makers have spent much effort to try to understand the sources of fragility in the industry and make it more resilient. These efforts have led the SEC to approve a new regulation in July 2014, which came into effect in October 2016. U.S. money market funds are open-ended mutual funds that invest in money market instruments. MMFs are pivotal players in the financial markets: as of the end of 2014, they had roughly $3 trillion in assets under management and held approximately 35% of the global outstanding volume of commercial papers (see ICI, 2015)."
It continues, "In particular, they are a critical source of short-term financing for financial institutions: in May 2012, they provided roughly 35% of such funding, with 73% of prime MMF assets consisting of debt instruments issued by large global banks (see Hanson, Scharfstein, and Sunderam, 2015).... In contrast to other mutual funds, however, until the new SEC regulation came into effect in October 2016, all MMFs aimed to keep the NAV of their assets at $1 per share; they have done so by valuing assets at amortized cost and providing daily dividends as securities progress toward their maturity date."
The report claims, "Since their deposits are not insured by the government and are daily redeemable, this stable NAV feature makes MMFs susceptible to runs. If a fund "breaks the buck," i.e., its NAV drops below $1, investors will likely redeem their investment en masse (i.e., run on the fund) to preserve the value of their capital. This happened on September 16, 2008, when Reserve Primary Fund, the oldest MMF, broke the buck after writing off debt issued by Lehman Brothers."
The NY Fed paper states, "The interaction between risk-taking incentives and exposure to runs made MMFs a key ingredient of the recent financial crisis. Indeed, in September 2008, the run on Reserve Primary Fund quickly spread to other prime MMFs, triggering investors' redemptions of more than $300 billion within a few days after Lehman's default. This caused a severe shortage of short-term credit to the banking sector (see Kacperczyk and Schnabl, 2013). In the summer of 2011, a "slow-motion run" hit the prime MMF sector as fears about European sovereign debt problems mounted, causing redemptions of more than $170 billion in approximately two months and disrupting the ability of both European and non-European firms to raise financing in the money markets (see Chernenko and Sunderam, 2014)."
It explains, "MMFs are regulated under Rule 2a-7 of the Investment Company Act of 1940. This regulation restricts fund holdings to short-term, high-quality debt securities. For example, prime MMFs can only hold commercial papers that carry either the highest or second-highest rating from at least two of the nationally recognized credit rating agencies.... Also, the weighted average maturity of the portfolio was capped to 90 days. The MMF industry is divided in three main sectors based on funds' portfolio composition: 1) prime MMFs mainly invest in private unsecured and secured debt in addition to Treasuries and Agency debt; 2) muni MMFs mainly invest in municipal and local authorities debt; 3) government MMFs mainly invest in Treasuries and Agency debt and can only lend to the private sector through repurchase agreements (repos) collateralized by Treasuries or Agency debt. Government MMFs can be further divided in two subgroups: Treasury MMFs, which can only invest in Treasuries and repos collateralized by Treasuries; and Agency MMFs, which can also invest in Agency debt and repos collateralized by Agency debt. MMFs can also be divided into institutional and retail funds based on the profile of their investors."
Cipriani, La Spada and Mulder write, "On July 23, 2014, the SEC approved a new set of rules for MMFs (SEC Release No. IC-31166) focusing on the prime & muni segment of the industry. The main pillar of these rules is that from October 2016, institutional prime & muni MMFs must sell and redeem shares based on the current market-based value of the securities in their underlying portfolios. That is, they have to move away from a stable NAV to a floating NAV. The purpose of this regulatory change is to eliminate (or at least mitigate)the risk of runs by making investments in MMFs less money-like(and more similar to investments in traditional mutual funds). In addition, all prime & muni MMFs will have discretion to impose "gates" on redemptions or charge redemption fees of up to 2% in times of stress."
They continue, "The new regulation came into effect in October 2016. In this paper, we study the evolution of the MMF industry ahead of the implementation of the new regulation. We do so by studying MMF portfolio data from MMF regulatory filings with the SEC (form N-MFP). We find that from November 2015 to October 2016, there have been large outflows from prime & muni MMFs to government MMFs. Moreover, the outflows from prime & muni into government MMFs have occurred mostly within fund families: investors have switched from one MMF type to the other but have kept their investment in the same fund complex; this supports the hypothesis that the observed outflows from prime & muni into government MMFs are due to the regulatory changes."
The paper also says, "We also document that investors in prime & muni MMFs have mainly flowed toward the riskier segment of the government MMF sector: agency MMFs. This is consistent with the likely higher risk-appetite profile of investors coming from the prime & muni segment of the industry. Finally, the observed outflows from prime & muni MMFs are stronger for institutional investors, consistent with the fact that they are more elastic with respect to developments in the industry and have also been subject to a stricter version of the regulation. Section 2 describes the N-MFP form. Section 3 describes investors' flows within the MMF industry. Section 4 describes the changes in MMF portfolios after the new regulation by looking at private versus public investment. Section 5 describes the changes in MMF portfolios after the new regulation in terms of asset class composition. Section 6 concludes."
It adds, "The Form N-MFP is a publicly available regulatory filing that every MMF is required to submit to the SEC each month. Each filing contains information on a fund's balance sheet, share classes, security-level portfolio holdings, performance, and investor flows. Funds reports all of this information as of the end of the month and submit their filings to the SEC within the first five business days of the next month. The SEC makes all N-MFP submissions publicly available. The form was created in May 2010 along with a set of MMF reforms adopted in the immediate aftermath of the financial crisis. The first N-MFP filings were submitted in December 2010 and have continued every month since. Funds occasionally submit their forms late or make small corrections by amending filings from previous months."
The piece discusses, "The Response of MMF Investors to the New Regulation." It tells us, "This section studies the response of MMF investors to the 2014 SEC regulation. [T]he total net assets (TNA) of the whole MMF industry remain roughly constant at around $3 trillion. Within the industry, however, the relative size of the MMF categories changes dramatically. The TNA of prime & muni funds decrease by $1,315 billion (i.e., by approximately 65%), while the TNA of government funds increase by $1,191 billion (i.e., by more than 115%). As a result, the share of government funds in the MMF industry goes from 33.3% in January 2015 to 75.4% in February 2017. The bulk of these flows (about 60%) occurs between June and October 2016, that is, before the SEC regulation comes into effect. Indeed, the first major flow from prime & muni into government funds directly attributed to the new SEC regulations occurred in December 2015, when Fidelity converted $130 billion of its prime MMFs into government MMFs. From November 2016 to February 2017, after the adoption of the new SEC regulation, there has been a very modest net flow back into prime & muni funds."
Finally, the paper talks about, "Past Episodes of Outflows from Prime & Muni MMFs," and comments, "It is instructive to compare portfolio flows after the SEC regulation came into effect in October 2016 with what happened during two past episodes of turmoil in the MMF industry: the period around September 2008 after the Primary Reserve Fund broke the buck (the so-called "2008 MMF Run"), and the second half of 2011 at the height of the European debt crisis (the so-called "Silent Run"). Whereas portfolio flows over the 2015-2016 were the results of new regulation, both the 2008 MMF Run and the Silent Run were driven by investors' concerns over the safety of prime & muni MMFs (after Lehman's bankruptcy and after the European debt crisis respectively)."
