A new paper, "Regulatory constraints for money market funds: The impossible trinity?," written by Michel Baes, Antoine Bouveret and Eric Schaanning, looks at European LVNA money funds and potential regulatory changes. Its Abstract says, "Despite substantial regulatory reforms, MMFs exposed to private assets experienced severe stress in March 2020. In the EU, Low Volatility Net Asset Value (LVNAVs) MMFs faced acute challenges to meet regulatory requirements while facing high redemptions. Such funds have to maintain their mark-to-market net asset value within 20 basis points of a constant net asset value, and their weekly liquidity asset above the 30% requirement. We provide a stylized model to show that under certain conditions related to outflows and market liquidity of their assets, LVNAVs may face difficulties in fulfilling both regulatory constraints at the same time. We calibrate the model to EU data to assess possible reforms to MMFs. Increasing the NAV deviation and improving the market liquidity of the assets MMFs invest in would substantially improve the resilience of MMFs. Introducing countercyclical liquidity buffers would also enhance their resilience especially in times of stress, and the effect is larger than increasing liquidity requirements."
The Introduction tells us, "In March 2020, at the onset of the COVID-19 crisis, Money Market Funds (MMFs) experienced massive redemptions from investors. In the European Union and in the US, MMFs investing in private short-term assets saw outflows up to 20% of their net asset value in less than two weeks (FSB (2021b)). Levels of redemptions were higher than those observed during the Global Financial Crisis of 2007-2008 (Investment Company Institute (2020)). Faced with large outflows, MMFs had to dispose of assets to raise cash to meet redemptions. However, private money markets froze in March, forcing some MMFs to use their liquidity buffers to raise cash, and in a few cases US MMFs sponsors chose to step in to support their MMFs. To safeguard financial stability, the Federal Reserve and the European Central Bank decided to intervene to support money markets and MMFs. Despite far-reaching regulatory reforms of the MMF sector on both sides of the Atlantic, it is the second time in less than 15 years that MMFs experience acute stress requiring external intervention."
It explains, "In this paper, we look at MMFs' vulnerabilities related to the interplay between regulatory constraints and asset liquidity. When faced with redemptions, MMFs have to dispose of assets while maintaining liquidity buffers above regulatory requirements. We show that for MMFs offering constant net asset value, such as Low Volatility Net Asset Value (LVNAVs) in the EU, limited asset liquidity can make MMFs unable to maintain simultaneously (i) liquidity buffers above regulatory requirements and (ii) the deviation between the mark-to-market net asset value within the required range."
The European authors comment, "We derive the optimal liquidation strategy for MMFs in a stylized model and show how the maximum levels of redemptions relate to asset liquidity and regulatory constraints. Given asset liquidity levels and regulatory constraints related to liquidity requirements and NAV deviations, managers optimize their sales of assets to be maximize the amount of redemptions requests they could meet. Using portfolio data on European LVNAV MMFs, we estimate the maximum amount of redemptions such MMFs could meet without breaching regulatory requirements and find those levels to range between 40% and 65%."
They continue, "Overall, our results shed light on vulnerabilities related to the interaction between asset liquidity and regulatory requirements and provide pointers for MMF reform. MMF resilience can be significantly increased by removing stable NAV and improving asset liquidity. The introduction of countercyclical liquidity buffers (where regulatory WLA would be lowered to allow MMFs to dispose of their most liquid assets in times of stress) would also increase MMF resilience, and the effect is larger than increasing liquidity requirements at all times. This paper also provides some insights about how macroprudential stress tests could be used to identify coordination failures related to the simultaneous sales of similar assets with limited liquidity."
The piece adds, "This paper complements recent work on MMFs vulnerabilities, which have tended to focus on the role of investors and the link between run risk and liquidity requirements. Li et al. (2021) show that US prime MMFs more likely to use fees and gates (due to lower liquid assets) experienced higher outflows than MMFs with high liquidity buffers. Using data on US and European MMFs, Cipriani, Marco and La Spada, Gabriele (2020) show that runs were more severe for MMFs offered to institutional investors and at risk of imposing fees or gates due to the breach of regulatory requirements. Avalos and Xia (2021) find that MMFs serving large institutional investors had large outflows irrespective of their liquidity levels, while the liquidity of the funds was more relevant for small institutional investors."
It explains, "The remainder of the paper is as follows: Section 1 describes the institutional back ground for European MMFs; Section 2 discusses MMF vulnerabilities in the context of the COVID-19 crisis; Section 3 outlines a stylized model; Section 4 applies the model to data on European MMFs; Section 5 discusses coordination failures and Section 6 concludes."
On "Potential reforms of MMFs," the paper says, "Following the events of March 2020, there has been a range of proposals to reform MMFs. In the US, the President Working Group released a report in December 2020 outlining possible reforms (President Working Group (2020)). In the EU, ESMA published a Consultation Report in March 2021 with the objective to review the stress experienced by MMFs during the March 2020 crisis as well ass proposing potential reforms (ESMA (2021)). At the international level, the Financial Stability Board is also expected to publish soon a Consultation Report with proposals to improve the resilience of MMFs (FSB (2021a))."
It tells us, "In that context, the model can be used to assess potential regulatory reforms to MMFs and see which type of reforms could have the larger impact in enhancing the resilience of MMFs. In particular, the model can be used to assess reforms targeted at the asset side of MMFs. In this section, we perform comparative statics of different reform options in order to evaluate their impact on the resilience of MMFs. To this end, we use the analytical formulas developed in the preceding sections numerical methods for a representative."
Finally, Baes, Bouveret and Schaanning conclude, "We have shown how the use of amortised cost and liquidity requirements can create challenges for MMFs exposed to instruments with limited liquidity. In particular, in times of stress, MMFs face difficulties in selling assets to meet redemptions while complying with regulatory requirements. Using data on EU LVNAV MMFs, we use our model to assess the impact of policy reform on the resilience of MMFs. Overall, we find that changing required liquidity requirements has limited effects on the resilience of funds. In contrast, increasing the NAV deviation and at the limit removing the use of amortised cost have a large effect on the maximum amount of redemptions a fund can meet. Relatedly, introducing countercyclical liquidity buffers can foster resilience by providing additional flexibility to MMFs in times of stress. Finally, improving the liquidity of underlying markets has also a significant impact on the resilience of MMFs. The framework outlined in this paper can be used by Authorities when considering reforms to MMFs."
