Late last week, the European Central Bank (ECB) published a paper entitled, "Mind the liquidity gap: a discussion of money market fund reform proposals." They write, "This article assesses proposed reforms to the Money Market Funds (MMF) Regulation to enhance the resilience of the sector. Specifically, the article provides a rationale for requiring private debt MMFs to hold higher levels of liquid assets, of which a part should be public debt, and considers the design and calibration of such a requirement. The article also proposes that the impediments to the use of liquidity buffers should be removed and authorities should have a role in releasing these buffers. Finally, while the removal of a stable net asset value (NAV) for low-volatility MMFs would reduce cliff effects, we argue that this might not be necessary if liquidity requirements for these private debt MMFs are sufficiently strengthened."

The Introduction tells us, "MMFs fulfil a dual economic function, namely liquidity management for investors and the provision of short-term funding for financial institutions, non-financial corporations and governments. MMFs perform a central function for the financial system by bringing together the demand for and supply of short-term funding. By investing in a portfolio of short-term debt and offering daily liquidity, MMFs enable investors to store liquidity and manage their cash needs, while at the same time they contribute to the short-term financing of banks and other companies in the wider economy."

It continues, "This dual economic function can make private debt MMFs vulnerable under stressed market conditions, and the associated systemic risk was highlighted during the coronavirus (COVID 19) market turmoil in March 2020. Following the onset of the COVID 19 crisis in Europe in early 2020, non-public debt MMFs experienced significant outflows resulting from liquidity pressures, flight-to-safety considerations, and various other factors.... These MMFs came under stress and had to reduce their holdings of private debt assets, compromising their ability to simultaneously provide cash management services to investors and short-term funding to banks and non-financial corporations (NFCs). These risks were examined and documented by the Financial Stability Board (FSB) in its recommendations on MMFs and were discussed in the Eurosystem's response to the European Securities and Markets Authority (ESMA) consultation on the regulatory framework for MMFs in the EU."

The ECB piece summarizes, "This article assesses possible MMF reform proposals to enhance the resilience of MMFs by targeting liquidity mismatch and makes the case for a mandatory public debt quota alongside other measures. The article highlights the need for private debt MMFs to strengthen their liquidity position, including through the introduction of a public debt buffer. The article also discusses the role authorities should play in the use of liquidity management tools and the release of liquidity buffers. Finally, the article considers whether the stable NAV for low-volatility net asset value (LVNAV) funds needs to be removed."

Discussing "liquidity requirements," they comment, "Higher and more usable liquidity buffers, including a component of public debt holdings, would be particularly effective in reducing risks associated with liquidity mismatch in private debt MMFs. To preserve the cash management function of MMFs, it is important that MMFs can deal with large and unexpected outflows under stress. Ensuring that liquidity buffers are usable in a crisis is helpful in this respect. At the same time, given the low market liquidity of most private debt assets and the relatively long lead time of weekly maturing assets, it is important to diversify liquidity sources alongside removing impediments to the use of liquidity buffers. Requiring MMFs to hold public debt is thus highly complementary to existing liquidity requirements, given that public debt typically has high market liquidity even if it is not about to mature."

The paper states, "A mandatory public debt holding would help to diversify liquidity sources beyond the concept of weekly maturing assets. A minimum share of public debt as part of the broader liquidity buffer would help to ensure that MMFs have a broader range of liquidity sources at their disposal to meet elevated redemption requests. Given that public debt markets are substantially more liquid and deeper than CP and CD markets, funds would be able to sell public debt more easily and with a lower price impact in almost all circumstances, including during periods of stress. This means that, depending on the type of shock and market conditions, fund managers would be able to draw on a broader range of assets to meet redemption requests, rather than relying on proceeds from maturing assets or selling other private debt assets. The weighted average maturities of funds would not be altered, as the current requirements would be maintained."

It also says, "The calibration of a public debt requirement needs to consider possible costs and constraints, while aiming to strengthen the resilience of MMFs. The calibration of a minimum public debt quota should be high enough to increase MMFs' overall liquidity buffers, but not so high that it would have an excessive footprint in underlying public debt markets or unduly reduce MMF returns. It is also important that such a quota is mandatory, since MMFs' (voluntarily held) public debt holdings currently tend to fluctuate over time, as seen after the March 2020 market turmoil when fund managers in private debt MMFs first increased their public debt holdings and then reduced them again. A mandatory quota would help ensure that private debt funds have sufficient shock-absorbing capacity to meet large and unexpected outflows under a range of different stresses, thereby significantly enhancing MMF resilience."

The ECB speculates, "The emergence of a new stress channel between MMFs and sovereigns is also unlikely for several reasons. First, there is no bail-out expectation for MMFs and therefore no market perception of contingent liabilities for sovereigns. Second, there is evidence that MMFs currently hold diversified sovereign debt portfolios focused on the most liquid issuers, limiting their exposure to stress in any one country. Finally, the MMF footprint in short-term public debt markets would only increase by a small amount and remain relatively contained. Given the high liquidity of public debt in most circumstances, there should, therefore, not typically be a significant price impact when MMFs dispose of assets in an episode of stress."

The article then addresses, "Considerations on removing stable NAVs for LVNAV funds," explaining, "Removing the stable value for LVNAV funds may complement reforms to improve funds' liquidity risk profiles. The March 2020 market turmoil highlighted particular vulnerabilities in LVNAV funds, as these funds faced elevated outflows and investors became concerned about a breach of the collar around the stable value. The removal of the stable value from LVNAV funds would have the benefit of fully eliminating unintended cliff effects related to possible transformations from LVNAV to VNAV funds in periods of stress. Furthermore, a variable share price would also reflect the underlying asset value more accurately, reducing first-mover advantages associated with a decline in asset values. However, imposing a variable NAV does not address vulnerabilities associated with liquidity mismatches in private debt MMFs more generally. The removal of the stable NAV of LVNAV funds may thus not be necessary, provided there is a substantial improvement in the liquidity risk profile of these funds."

It adds, "Any removal of the stable NAV of LVNAV MMFs should be part of a comprehensive package aimed at reducing liquidity risks in private debt MMFs more broadly. MMF holdings of private sector debt proved particularly vulnerable during the period of market turmoil. This posed a risk to both variable and stable NAV MMFs. Therefore, while removing the stable value pricing for LVNAV funds may reduce some risk, this measure in isolation would not be a substitute for tackling liquidity risks via enhanced liquidity requirements and greater usability of buffers."

Finally, the ECB concludes, "MMF vulnerabilities should be targeted through higher levels of liquid asset holdings, including a mandatory public debt requirement, and improved usability of liquidity buffers. This article has advocated the introduction of both a mandatory public debt requirement and increased WLA requirements to enhance the shock-absorbing capacity of MMFs. In addition, the article also suggests that liquidity buffers must be made more usable and that authorities should have a role in directing their use. But the deployment of liquidity management tools should remain the responsibility of fund managers in managing their liquidity position. This package of measures should substantially enhance the resilience of the MMF sector to future shocks and thereby reduce systemic risk. The upcoming review of the MMF Regulation by the Commission will present an opportunity to implement such proposals to the benefit of both the sector and financial stability."

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