The European Securities and Markets Authority, which regulates European financial markets, published, "ESMA Report on Trends, Risks and Vulnerabilities," which features a section on "Vulnerabilities in money market funds." Author Antoine Bouveret writes, "The intense stress experienced by MMFs in March 2020 has shown that, despite regulatory reforms, MMFs remain subject to vulnerabilities. This article focuses on structural risks and vulnerabilities in the MMF industry." A "Market overview" explains, "The EU MMF industry is diverse across types and currencies. As of November 2020, the size of the EU MMF industry amounted to around EUR 1400 bn according to the ECB, spread across MMF types. LVNAVs and VNAVs each account for 47% and CNAVs for 6% of MMFs. Overall, slightly more than half of EU MMFs offer redeemability at par (CNAVs and LVNAVs). EUR MMFs account for 48% of MMFs, followed by USD (28%) and GBP (24%)."
It goes on, "The EU MMF industry is concentrated mainly in three Member States. Ireland accounts for around 37% of MMFs by size, followed by France (31%) and Luxembourg (30%), with other EU countries accounting for around 2%. By MMF types, there are large differences between countries: LVNAVs are almost all domiciled in Ireland (67%) and Luxembourg (31%), while VNAVs are mainly domiciled in France (59%) and in Luxembourg (26%). Those differences may partly reflect historical factors such as the prohibition of CNAV MMFs in France, accounting issues (VNAVs are presumed to be cash equivalent in France) or different demands from investors. MMFs' portfolio compositions reflect their regulatory type: CNAVs invest almost exclusively in public debt and repo, while LVNAVs and VNAVs are predominantly exposed to CP and CD markets."
In a section on "The role of credit ratings agencies," ESMA comments, "Using a sample of MMFs domiciled in Ireland and Luxembourg, covering around 60% of the EU universe, more than 99% of those MMFs have an MMF rating from at least one of the three CRAs, and more than 80% of MMFs are rated by at least two CRAs. However, in France, very few MMFs are rated, implying that at the EU level the share of rated MMFs is more likely to be around 60%. All rated MMFs have an AAAmmf rating. The use of MMF ratings is related to the predominance of institutional investors, whose investment policy usually restricts them to investing only in MMFs rated AAAmmf by at least two CRAs (IMMFA, 2014). According to the European Commission (2013), the use of MMF ratings was also related to the lack of clear rules around MMFs, except in France, leading investors to rely on external assessments provided by CRAs."
Discussing "Vulnerabilities in the MMF sector," ESMA explains, "In March 2020, some segments of the US and EU MMF industry experienced very high levels of stress. MMFs exposed to private markets (LVNAVs and VNAVs in the EU, prime MMFs in the US) recorded very high outflows, while facing challenges in disposing of their assets due to the lack of liquidity in CP and CD markets. Following actions by central banks to support money markets, redemptions slowed while liquidity improved in money markets. No EU or US MMFs had to implement fees or gates or suspend redemptions. However, this episode shows that MMFs remain subject to a range of vulnerabilities. Those vulnerabilities can be split across a few dimensions: (i) liquidity of underlying markets, (ii) regulatory requirements, (iii) role of CRAs and (iv) investor behaviour."
They tell us, "MMFs are exposed to three intertwined challenges regarding liquidity on their asset side: MMFs have a large market footprint in the asset classes they invest in; those markets are not very liquid even in normal times; and MMFs have a high degree of portfolio overlap. MMFs have a very large market footprint in private money markets. As of February 2020, US prime MMF and USD LVNAVs and VNAVs exposures amounted to around one third of the US CP market. More importantly, those MMFs held more than half of the CP issued by financial institutions, including 82% of all CP issued by foreign financial institutions. The footprint is lower in other currencies but still substantial: MMFs hold more than 50% of the EUR and GBP financial CP markets, although precise estimates are challenging because of limited transparency in some segments of the European CP market."
Bouveret states, "The limited absorption capacity of the CP market was tested in March, as MMFs sold instruments to meet investor redemptions. We estimate that USD MMFs (US prime and EU USD MMFs) sold more than USD 50bn of financial CP, more than five times average dealer inventories. Over the same period the yield on CP surged by almost 100 bps. Similar patterns were also observed in EUR CP markets, with MMFs selling around EUR 18bn of CP, while yields rose by 30 bps."
He explains, "The combination of those three characteristics (large market footprint, high degree of overlap and low liquidity in underlying markets) makes MMFs particularly vulnerable to symmetric shocks. If several MMFs face large redemptions at the same time, they are likely to try to sell the same type of assets simultaneously. Given the limited absorption capacity of the underlying asset market, such sales will be challenging to execute, thereby creating liquidity issues for MMFs."
Bouveret also tells us, "During periods of stress, LVNAVs are likely to face challenges to meet all those constraints at the same time. [A chart] shows three MMFs that faced very high outflows in March (more than 10% in 2 weeks).... To meet those redemptions, funds can sell their most liquid assets, but that will result in a decline in WLA ... and a risk of breaching the 30% requirement. Funds can also choose to dispose of less-liquid assets, but in that case the sales could result in mark-to-market losses. Such losses will lead to a deviation between the mark-to-market NAV and the constant NAV. Although no LVNAV breached the 20 bps collar in March, a few funds were close to the threshold, with one fund having an 18 bps deviation."
ESMA's "Conclusion" states, "MMFs are an integral part of the EU financial system, as they provide maturity and liquidity transformation. However, despite important regulatory reforms, the COVID-19 crisis has shown that vulnerabilities remain. The evidence related to these vulnerabilities presented in this article can serve as input to the currently ongoing discussions on MMF regulatory reforms."
It continues, "On the asset side, EU MMFs have a very large market footprint in short-term private markets with limited liquidity. MMFs tend to have similar exposures, implying that, in the event of a wave of redemptions, MMFs would struggle to dispose of their assets. On the liability side, investors consider MMFs cash-like instruments and expect daily liquidity with very limited risks. Such expectations might make MMFs vulnerable to runs."
Finally, ESMA writes, "In addition, some regulatory provisions regarding liquidity management tools (such as the use of fees and gates) might create incentives for investors to redeem ahead of others, for example to avoid being subject to fees and gates. Methodologies used by CRAs could also reduce managers' flexibility, especially during times of stress, as managers may want to limit the probability of an MMF rating downgrade."
