Last week, we covered the "Report of the President's Working Group on Financial Markets" and new "Overview of Recent Events and Potential Reform Options for Money Market Funds." (See our Dec. 24 News, "PWG Paper Discusses Potential Reform Options for Money Market Funds.") Today, we highlight more, in particular the discussion of potential money market reform options. The PWG writes, "An assessment of the effectiveness of reform options in achieving these goals should take into account: (a) how each option would address MMF structural vulnerabilities and contribute to the overarching goals; (b) the effect of each option on short-term funding markets and the MMF sector more broadly, including through its effects on the resilience, functioning, and stability of short-term funding markets, as well as whether the reform option would trigger the growth of existing investment strategies and products, or the development of new strategies and products, that could either exacerbate or mitigate market vulnerabilities; and (c) potential drawbacks, limitations, or challenges specific to each reform option. The reform options considered in this report seek to achieve the goals in different ways. For example, some are intended to address the liquidity-related stresses that were evident in March 2020, while others also touch on potential credit-related concerns. This menu of options reflects the possibility that future financial stress events may affect the liquidity of short-term investments, their credit quality, or both."
A section entitled, "How the reform options would seek to achieve the goals," tells us they would, "Internalize liquidity costs of investors' redemptions, particularly in stress periods. Some options would impose a cost on redeeming investors that rises as liquidity stress increases to reflect the costs of redemptions for the fund. These options, particularly swing pricing and the MBR [minimum balance at risk], could reduce or eliminate first-mover advantages for redeeming investors and protect investors who do not redeem."
They may also, "Decouple regulatory thresholds from consequences such as gates, fees, or a sudden drop in NAV. Some options, such as those that revise fee and gate thresholds or introduce the floating NAV for retail prime and tax-exempt MMFs, could eliminate or diminish the importance of thresholds (such as 30 percent WLA or an NAV of $0.995) that may spur investor redemptions. By diminishing the importance of thresholds, these options could also give MMFs greater flexibility, for example, to tap their own liquid assets to meet redemptions."
Reforms might, "Improve MMFs' ability to use available liquidity in times of stress. In March 2020, some prime and tax-exempt MMFs may have avoided using their liquid assets to meet redemptions. Options such as countercyclical WLA requirements or revisions to fee and gate thresholds could make MMFs more comfortable in deploying their liquid assets in times of stress." They could also "Commit private resources ex ante to enable MMFs to withstand liquidity stress or a credit crisis. When prime and tax-exempt MMFs have encountered serious strains, official sector interventions have followed quickly. Options such as capital buffers, explicit sponsor support, and the LEB could provide committed private resources to supply liquidity or absorb losses and thus reduce the likelihood that official sector support would be needed to calm markets."
Other options include to: "Further improve liquidity and portfolio risk management. Changes to liquidity management requirements could include raising required liquid-asset buffers. Other options could motivate more conservative risk management by explicitly making fund sponsors or others responsible for absorbing any heightened liquidity needs or losses in their MMFs." Or to: "Clarify that MMF investors, rather than taxpayers, bear market risks. Government support has repeatedly provided emergency liquidity to prime and tax-exempt funds and also has obscured the risks of liquidity and credit shocks for MMFs. Some options, such as the floating NAV for retail prime and tax-exempt MMFs, swing pricing, and the MBR could make risks to investors more apparent."
Discussing the "Effects on the short-term funding markets," the report comments, "The reform options are intended to reduce the structural vulnerabilities of MMFs, which could make them a more stable source of short-term funding for financial institutions, businesses, and state and local governments. This would improve the stability and resilience of short-term funding markets."
It continues, "At the same time, some of the reform options would likely diminish the size of prime and tax-exempt MMFs, which would also affect the functioning of short-term funding markets. A shrinkage of MMFs could reduce the supply of short-term funding for financial institutions, businesses, and state and local governments. Making prime and tax-exempt MMFs less desirable as cash-management vehicles also could cause investors to move to less regulated and less transparent mutualized cash-management vehicles that are also susceptible to runs that cause stress in short-term funding markets."
The PWG explains, "A reduction in the size of prime and tax-exempt MMFs may not necessarily be inappropriate if, for example, the growth of these funds has reflected in part the effects of implicit taxpayer subsidies and other externalities (that is, broader economic costs of runs that are not borne by investors or the funds). In addition, if these MMFs remain run prone, a reduction in the size of the industry could mitigate the effects of future runs from these funds on short-term funding markets."
It tells us, "The aftermath of the 2014 MMF reforms provides a precedent for the consequences of a substantial reduction in the size of prime and tax-exempt funds, although a future experience could differ. In the year before the October 2016 implementation deadline for those reforms, aggregate prime MMF assets shrank by $1.2 trillion (69%) and tax-exempt MMF assets declined about $120 billion (47%). Nonetheless, to the extent that spreads for instruments held by these MMFs were affected, they generally widened only temporarily, and investor migration to other mutualized cash-management vehicles was largely limited to shifts to government MMFs. (Over the next three years, prime MMFs regained about half of the 2015-2016 decline.)"
The report emphasizes, "These considerations are important, because some of the reform options could reduce the size of the prime and tax-exempt fund sectors by: Reducing attractiveness of prime and tax-exempt MMFs for investors. The costs associated with some options, such as capital buffers and LEB membership, may reduce the funds' yields. The MBR would limit the liquidity of their shares in some circumstances. The floating NAV requirement and swing pricing would make NAVs more volatile and MMF shares less cash-like. And investors may view some policies, such as swing pricing and the MBR, as unfamiliar, restrictive, and complicated."
It also discusses, "Increasing costs associated with MMF sponsorship. Some options, such as the introduction of capital buffers, required LEB membership, and explicit sponsor support, could raise operating costs for sponsors. Other options, such as swing pricing and MBR, may also have sizable implementation costs. Increased costs and operational complexity could lead to increased concentration and a reduction in the overall size of the MMF industry."
Finally, the report adds that, "Evaluation of the reform options also should take into account potential drawbacks, limitations, and challenges of each option, such as implementation challenges or limits on an option's ability to achieve the desired goals. The report discusses these considerations for each option below." (For more coverage, see the FT's "Money market funds need reform to prevent runs, US regulators say" and Cadwalader's "President's Working Group Reviews COVID-19 Impact on Money Market Funds.")
