Citi's Kang on Prime Inst Problems
Citi's Research's Steve Kang writes about "Stress tests on banks and prime funds" in his latest "Short-End Notes." His piece contains, "Thoughts on Prime fund closures and a possible reform," and tells us, "2016 MMF reform seems to have failed COVID-19 stress test. Prime funds, in essence, are serving as foreign banks' bank for USDs. Foreign banks typically lack stable funding source vs domestics, which are funded with more stable FDIC-insured retail deposits, FHLB advances (backed by stable government MMFs) and closer access to the Fed. Foreign banks rely on less diversified sources including prime funds, which in turn are backed by less sticky cash investors. Prime funds have been prone to runs in times of stress and foreign bank's USD funding prices (USD L/OIS and FX basis) has been pro-cyclical as a result." Kang explains, "Since 2008 financial crisis, as with banks, MMFs have been a target of regulatory reforms to make it less susceptible to runs, with 2016 MMF reform being the most notable effort, where institutional prime funds were mandated to offer VNAV instead of CNAV and both retail and institutional prime funds were mandated to impose gates/fees in times of stress. The liquidity crisis brought by COVID-19 was the first real stress test to see how resilient MMFs have become after the reform. Sadly, the pace of Prime outflow, frozen CD/CP market in March and another intervention directed at MMFs imply that fundamental issue of prime fund runs were not adequately addressed. Moreover, arguably, complex and unclear mandate on gates/fees made the pro-cyclicality worse, as it created first-mover advantage incentive to cash-out prior to others to avoid a possible lockdown of cash -- which initiated a feedback loop of a cheaper paper and lower VNAV, which further reinforced the first-mover incentive to cash out at a higher pricing. We also saw preference of MMFs to use a sponsor support rather than gates/fees to avoid reputational risk. Hence, regulatory mandate on gates/fees were rendered as an inadequate tool at the best and a counter-productive tool at the worst." He adds, "Runnable Prime institutional cash is problematic not only to regulators but also to the fund sponsors via increased sponsor support and a potential for yet another regulation. The industry is already facing challenging prospects as ZLB forced funds to waive management fees to pass along positive yields to clients -- making funds without scale especially unattractive. Two weeks ago, Fidelity Investments, the largest manager of money market funds, decided to liquidate their two institutional prime funds they offered to investors on Aug 12, 2020, citing investor behavior. At first blush, this can seem idiosyncratic, as the two closing funds amount to only $14bn in total, less than 2% of their MMF assets." Finally, the Citi article says, "The larger impact may come on changes in regulation. Very simplistically, the composition of the government is likely to determine the direction of this, a divided government is likely to keep the status quo, whereas a democratic sweep may tilt towards more regulation for this space. As for the latter scenario, we may see re-consideration of proposals that were more fundamental in nature, than what was delivered for the 2016 reform. The previous administration's options included (1) privately-backed emergency lending facilities for MMFs (2) government-backed insurance for MMFs similar to Treasury's Temporary Guarantee program for Money Market Funds (3) regulating CNAVs as special purpose banks.... The fundamental approach seems to be falling into two buckets, with the first kind being a bail-in provisions via private backstops (sponsor or privately-backed lending facilities) and the second kind treating funds like a public utility (such as banks) hence granting an access to a public backstop at a cost with a heavier regulatory burden. It is also possible for regulators to find a solution for foreign banks rather than on prime funds to address the problem of pro-cyclicality.... With the LIBOR reform well-underway for end-2021 target, we think it is unlikely for the regulators to consider implementing anything sweeping before that date. If the reform for Prime funds comes after the LIBOR reform, we expect FX basis to capture the change and move wider instead."
