As we mentioned in our October Money Fund Intelligence and originally learned from Stadley Ronon Counsel Jamie Gershkow, the U.S. Securities and Exchange Commission's Division of Economic and Risk Analysis recently released a study entitled, "U.S. Credit Markets Interconnectedness and the Effects of the COVID-19 Economic Shock." It explains, "March 2020 also saw strains in the almost $1 trillion CP market, as investors stopped rolling (or reinvesting proceeds from maturing securities) to preserve cash. In the normal course, secondary trading volume in CP and CD markets is limited as most investors purchase and hold these short-dated instruments to maturity. However, in March 2020, as some market participants, including money market mutual funds (MMFs; 21% of the CP market) and others, may have sought secondary trading, they experienced a 'frozen market.' As a practical matter, both secondary trading and new issuances halted for a period. Dealers (including issuing dealers) faced one-sided trading flows and were experiencing their own liquidity pressures and intermediation limits, including those discussed above." (Note: The SEC will host a "Roundtable On Interconnectedness And Risk In U.S. Credit Markets" on Wednesday, October 14 from 1-5pm ET.)

The DERA study continues, "In another illustration of the interconnectedness among the capital markets and the banking system, issuers who found the CP/CD market frozen turned to other sources of borrowings to meet near-term needs and, perhaps more so, as a matter of shoring up their cash balances to mitigate risk. These other sources of credit included bank revolvers and corporate lines of credit. Borrowers drew down over $275 billion in revolvers in 2020Q1. We believe the Federal Reserve's prompt action in the CP market and establishment of USD swap lines with a number of central banks mitigated the potential adverse effects of these interconnections, including a more general draw on liquidity from banks, which in turn could put further pressure on intermediation and other banking system activities important to orderly market functioning."

On the role of "Money Market Mutual Funds," they write, "MMFs are key participants in the STFM (short-term funding markets). MMFs' assets under management (AUM) grew by $705 billion in March and by $462 billion in April to $5.2 trillion, or an increase of 29% from the end of February. Government funds benefited with net inflows of $1.2 trillion, and they ended April with $4 trillion in AUM. Assets in prime institutional and retail MMFs increased by $105 billion in April after declining by $125 billion in March to $1.1 trillion, roughly $20 billion below their February level. In March 2020, prime MMFs, especially those offered externally to institutional investors, experienced substantial outflows. Over the two-week period from March 11 to 24, net redemptions from publicly-offered prime institutional funds totaled 30 percent of the funds' assets (about $100 billion). These outflows likely contributed to stress in the CP/CD markets. These outflows caused weekly liquid assets (WLAs) in prime institutional MMFs to decline, and some funds' WLAs (which must be disclosed publicly each day) approached or fell below the 30 percent minimum threshold required by SEC rules. Staff outreach to market participants indicate that prime fund outflows accelerated as WLAs fell close to 30 percent. The Federal Reserve's announcements of liquidity facilities, including the Money Market Mutual Fund Liquidity Facility (MMLF), helped to restore market liquidity and improve market sentiment within days."

Regarding the Repo Market, the report tells us, "The approximately $4 trillion repo market provides secured, short-term, marked-to-market funding against various forms of securities collateral. The collateral from several short- and long-term funding markets and participants connects the repo market to the rest of the financial system. The repo market is a critical source of liquidity and, accordingly, essential to the ongoing operations of various market participants, including market makers in virtually all sectors of the capital markets. A repo contract in essence offers an interest-bearing cash loan against securities collateral, but the contract can also be structured to borrow securities.... [B]roker-dealers (many of the larger ones being bank affiliates), MMFs, hedge funds, mREITs, and the Federal Reserve are the primary participants in the repo market. The MMFs are the main investors of cash (i.e., the lenders) into the repo market. Recipients of repo financing (i.e., the borrowers) include hedge funds that pledge many different securities and mREITs that mainly pledge MBS securities in repo transactions. Broker-dealers intermediate virtually all repo transactions."

The SEC states, "The repo market provides a quintessential example of the myriad interconnections among banks, brokers, and other market participants and the functioning and performance of capital markets.... Dealers use the repo market to finance their Treasury auction purchases. U.S. Treasuries also provide an efficient means of supporting short-term borrowings. Treasuries serve as collateral in nearly half of all repo transactions, and agency MBS in approximately one third of such transactions. The remainder of the collateral in this market (approximately one-fifth) consists of equities, corporate bonds, and non-agency MBS. MMFs' portfolio holding disclosures are another valuable source of information about the composition of repo collateral. Historically, close to 70% of collateral accepted by MMFs consists of Treasury securities.... Dealers in their intermediation role participate on both sides of the market and account for approximately 40% of the borrowing and 33% of the lending. MMFs account for another 24% of investments (i.e., lending) in the repo market, followed by other smaller participants such as banks, government agencies, and hedge funds."

In a segment on "Money Market Mutual Funds," they comment, "With about $5 trillion of assets as of June, 2020, MMFs are an important participant within the STFM. Companies invest their excess cash in MMFs, financial institutions manage their liquidity demands such as margin call and redemptions through MMFs and many households invest their savings in MMFs. MMFs can be identified as government MMFs (approximately $3.8 trillion in net assets as of June 2020), prime MMFs (approximately $1.2 trillion), and tax-exempt MMFs (approximately $137 billion).... Prime MMFs that cater to natural persons are known as prime retail MMFs and had around $455 billion in net assets in June 2020, while prime MMFs offered to other investors, known as prime institutional MMFs, had $707 billion. Furthermore, some prime institutional money market funds are not offered publicly. Typically, these funds disclose in their filings and public communications that their shares are not intended to be offered to the public. Prime institutional money market funds not providing such disclosures are considered to be offered to the public. Through their participation in the STFM, MMFs serve an important financial and economic function for both retail and institutional investors and for the capital markets. For example, MMFs invest about $250 billion in CP, $950 billion in repos, and $540 billion in short-term securities issued by Federal Home Loan Banks (FHLB). About 21% of outstanding CP is purchased by MMFs."

On "March 2020 Events and Stress in Prime MMFs," the SEC writes, "Amid escalating concerns about the impact of the COVID-19 economic shock and increased demand for liquidity, prime and tax-exempt MMFs experienced heavy redemptions beginning in the second week of March 2020. The scale of the outflows was the most substantial among prime institutional MMFs that are publicly offered. Over the two-week period from March 11 to 24, net redemptions from publicly-offered prime institutional funds totaled 30 percent (about $100 billion) of the funds' assets. The outflows from prime institutional MMFs that are not publicly offered were much smaller, around $17 billion or 6 percent of assets. These non-public prime funds had smaller outflows than their public counterparts, likely because the former do not have the same vulnerabilities as funds that are offered publicly to unaffiliated institutional investors. For prime retail MMFs, outflows as a share of assets in March 2020 totaled $33 billion, or 7 percent of assets."

They continue, "Government MMFs had record inflows of $838 billion in March and an additional $347 billion in April. The assets in government MMFs grew to about $4 trillion by the end of April 2020 compared to about $3 trillion at the end of 2019.... As prime MMFs experienced heavy redemptions, their weekly liquid assets (WLAs) dropped notably, and some funds' WLAs (which must be disclosed publicly each day) approached or fell below the 30 percent minimum threshold required by SEC rules. When a fund's WLA falls below 30 percent, it can impose fees or gates on redemptions. Market participants reported concerns that imposition of a fee or a gate by one fund could spark widespread redemptions from others. Preliminary research indicates that prime fund outflows accelerated as WLAs fell close to 30 percent."

The study explains, "Staff understand that at least four factors contributed to rapid outflows from the prime MMFs in March 2020. First, the sudden economic shutdown due to COVID-19 reduced revenues for most industrial and service organizations of all sizes. In response, many firms might have sought to bolster their liquidity position by withdrawing from the prime MMFs. Second, increased economic uncertainty and greater market volatility in March 2020 lowered asset valuations. This may have adversely affected the marked-to-market valuation of swap and other derivative positions of certain investors who had cash in MMFs that they needed to withdraw and post as additional collateral positions. Third, in an environment of great uncertainty, many investors might have converted their assets sensitive to liquidity and credit risk into safer, more highly rated government debt, including government MMFs. Finally, some investors may have feared that if they were not the first to exit their fund, then in the event the fund breached the 30% WLA limit, there was a risk that they could be subject to restrictions on withdrawals known as 'gates.' This anticipatory, risk-mitigating perspective potentially further accelerated redemptions."

It continues, "Conditions in short-term funding markets deteriorated rapidly in the second week of March. Spreads for money market instruments widened sharply, and new issuance of CP and CDs declined markedly and shifted to short tenors. Spreads to OIS for AA-rated nonfinancial CP reached new historical highs, while spreads for AA-rated financial CP and A2/P2-rated nonfinancial CP widened to the highest levels seen since the 2008 GFC. Stress among prime MMFs likely contributed to these problems, as funds reduced their holdings of CP and CDs. In addition, MMFs with WLAs close to 30 percent were likely reluctant to purchase assets with maturities of more than 7 days that would not qualify as WLA."

The report adds, "Outflows from MMFs abated fairly quickly after the Federal Reserve's announcement of the MMLF on March 18 and market conditions began to improve after the launch of the MMLF. The share of CP issuance with overnight maturity began falling on March 24, and spreads to OIS for most types of term CP began falling a few days later. The March 2020 stress in the prime MMFs brought the economics of prime MMFs into question because investors expect immediate liquidity, which is more difficult to deliver in periods of heightened uncertainty that often increase the demand for simultaneous redemptions. This dynamic -- which was present under different circumstances in the GFC of 2008 -- might have contributed to certain managers' recent decisions to close some of their prime institutional MMFs."

The SEC concludes, "In summary, the events related to the COVID-19 economic shock led to a decline in business activity worldwide and spurred the demand for cash and safe assets. This affected MMFs as investors drew on their cash balances to address their emerging funding needs and as they moved their other investments into the safe, liquid government MMFs. The effects included a significant net inflow into government MMFs and meaningful outflows from prime MMFs, which abated when the Federal Reserve established liquidity facilities for the assets in which MMFs invest." (See also, Cadwaladar's "SEC Reports on U.S. Credit Market Performance in Light of COVID-19 Pandemic".)

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