The U.S. Treasury's Office of Financial Research published its "OFR 2021 Annual Report to Congress" Wednesday, which analyzes threats to the financial stability of the U.S. and contains several sections relating to money market funds. Under "Assessing Risks Inside the Markets," the OFR writes, "With respect to the financial markets themselves, vulnerabilities pose potential liquidity risks. While liquidity risks were contained this year at the printing of this report, the OFR continues to study the uncertainty surrounding the impact of future investor runs in short-term funding markets. Sudden pressure on money market funds and other alternative cash vehicles to raise large amounts of cash strained liquidity in these markets in 2020 and prompted intervention by the Federal Reserve. As regulators explore reform options, there is a continuing need to monitor the interconnectedness of these markets and their participants."

They tell us, "To increase the transparency of financial data, the OFR in 2021 updated its U.S. Money Market Fund (MMF) Monitor to show both the principal amount of repurchase agreement (repo) transactions and the collateral pledged against these loans. The Short-term Funding Monitor was also upgraded to shed more light on the repo markets and to include a new collateral product that the Fixed Income Clearing Corporation (FICC) rolled out in September."

The OFR comments on "Stable Coins," "It bears emphasizing that run-like events could occur even for stablecoins fully backed by assets. A stablecoin that is 100% backed by short-term, liquid assets denominated in U.S. dollars is similar to a money market mutual fund in that it aims to meet the liquidity needs of holders while maintaining a value at or very close to par. In September 2008, and again in March 2020, some money market mutual funds experienced runs by their investors that ended only after the U.S. Treasury and the Federal Reserve intervened. Under the right set of conditions, stablecoins could face similar runs."

They explain, "This comparison also highlights that the precise assets held by a stablecoin arrangement may prove important in determining its ability to weather financial stress. There were no runs on government money market mutual funds, which hold only obligations of the U.S. government and government-sponsored enterprises, in either 2008 or 2020. However, runs did occur on prime funds even though these funds only hold short-term obligations of highly rated corporations. A lack of transparency about the assets backing existing stablecoin arrangements is worrisome in this regard. In February 2021, Tether reached an agreement with the New York State Attorney General's office that included a fine of $18.5 million to settle charges that it made false statements about the assets backing its coins."

"What are the risks if things go wrong?" OFR's report comments, "The modern financial market has become far more complex. The flow of monies from borrowers to lenders occurs through a variety of financial instruments that span the various timeframes and risk tolerances. These instruments range from loans, stocks, and bonds to commercial paper and money market fund shares, providing capital to businesses to expand operations and to consumers to purchase homes, goods, and services. In the modern U.S. financial system, banks are not the sole intermediaries. Increasingly, the financial system is reliant on nonbank financial institutions to transfer money through financial markets. This is known as 'market-based finance.'"

It states, "The repo market has become an increasingly critical link among financial intermediaries and provides an important example of market-based finance.... In the repo market, financial institutions lend or borrow cash using securities as collateral. Funds invested with money market funds or other asset managers are transferred to cash borrowers such as hedge funds and foreign banks through intermediaries. The cash borrowers then use these funds to purchase securities issued by the Treasury, U.S. government agencies, or corporations. The daily volume of transactions in the repo market exceed $2 trillion. Data from OFR's cleared repo collection shows that most of these transactions occur within a tight window between 7:30 and 8:30 a.m. Eastern time."

OFR continues, "When the repo market is working well, large amounts of cash flow quickly and safely among varying types of institutions, meeting the needs of borrowers and lenders. However, since market-based finance directs cash through multiple layers of intermediation, through asset managers to dealers and large banks and finally to hedge funds and other cash borrowers, there are several ways the system can break down."

On page 60, the report says, "Market turmoil in March 2020 once again highlighted vulnerabilities with open-ended funds, in particular, prime money market funds. During this time, investors withdrew substantial amounts from these funds as they redeemed their shares for cash. Subsequent flows back into prime money market funds, combined with renewed risk-taking and the continued mismatch in liquidity of shares relative to the underlying assets, potentially increase risks to financial stability."

It continues, "Through August 2021, excluding reorganized and liquidated funds, assets in prime money market funds were up 3.2% since March 2020. At the same time, the share of commercial paper and deposits included in underlying assets are near pre-pandemic levels, while the share of U.S. Treasury debt and certain government securities are at or near pre-pandemic levels."

OFR writes, "Investors use money market funds as a cash-management tool because they promise safety and liquidity, regardless of the value and liquidity of the underlying assets. An imbalance between the value and liquidity of a fund and its underlying assets can create a first-mover advantage for investors and precipitate a run. Runs, in turn, can depress asset prices. Stresses on money market funds and the broader money markets in March 2020 led to increased redemptions and, in turn, stressed the short-term funding markets. Over a two-week period from March 11 to March 24, net redemptions at publicly offered prime institutional money market funds amounted to roughly $100 billion, or 30% of assets."

They add, "Flows out of retail prime money market funds and tax-exempt funds were lower than outflows from institutional prime funds. Similar to actions taken during the 2008 financial crisis, the Federal Reserve stepped in to support money markets through its Money Market Mutual Fund Liquidity Facility, slowing redemptions and easing stress in the funding markets. Fund sponsors also provided support."

The Annual Report explains, "Money market funds are a key provider of short-term funding.... They held over $4.9 trillion in assets at the end of September 2021. The U.S. government and the Federal Home Loan Banks (FHLBs) are the largest recipients of funding from government and Treasury funds. Banks, particularly foreign-owned banks, are the largest recipients of funding from prime money market funds. The sudden investor withdrawals from prime funds in March 2020 reduced the availability of short-term funding for foreign banks, prompting the Federal Reserve to ease pressure through a central bank swap credit facility."

It also says, "The SEC's 2010 and 2014 regulatory reforms boosted the liquidity of MMFs, but they did not completely eliminate the risk of investor runs. The reforms also tightened the quality of assets held by money market funds, allowed for gates and fees on redemptions in certain circumstances, and required prime institutional funds to float their net asset values. Despite these reforms, prime institutional money market funds had outflows of 30% in aggregate during March 2020. It is possible these funds would have experienced further stress without government support."

The OFR adds, "The SEC is currently evaluating several reform options identified by the President's Working Group on Financial Markets to make money market funds more resilient under stress. They include changes to the fund structure that reduce losses for remaining investors, new liquidity risk tools that deter runs, and a new regulatory framework governing sponsor support. A combination of the proposals may mitigate the knock-on effects of risks posed by money market funds but is unlikely to eliminate liquidity risk in the underlying short-term wholesale funding markets for a couple of reasons."

Finally, they write, "One reason is that other investment funds also experienced heavy outflows contributing to the stress in the funding markets in March 2020. These included dollar-denominated off shore prime funds, some private liquidity funds, and ultra-short corporate bond mutual funds. These funds serve a similar purpose as money market funds but are subject to varying degrees of regulatory oversight and portfolio transparency. Arguably, investors in these products have the same incentive to run when markets are under severe stress. SEC Form PF data have also showed a dash for cash in private liquidity funds, with aggregate commercial paper and deposit holdings declining 34% and 23%, respectively.... Last year's financial stress precipitated widespread runs in similar cash management products with floating net asset values (NAVs), such as dollar-denominated offshore prime funds, local government investment pools, and ultra-short corporate bond mutual funds." (The OFR report also lists the PWG Proposals for MMF Reform.)

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