The Federal Reserve Bank of New York published a "Staff Report" entitled, "Money Market Fund Vulnerabilities: A Global Perspective." Written by ESMA's Antoine Bouveret, the NY Fed's Antoine Martin and the Federal Reserve Board of Governor's Patrick McCabe, the Abstract explains, "Money market funds (MMFs) are popular around the world, with over $9 trillion in assets under management globally. From their origins in the 1970s, MMFs have operated in a niche between the capital markets and the banking system, as investment funds that offer private money-like assets with features similar to those of bank deposits. Hence, they are vulnerable to runs that arise from liquidity transformation and from sudden changes in investor perceptions of the funds' ability to serve as money-like assets. Since 2000, MMF runs have occurred in many countries and under many regulatory regimes. The global pattern of runs and crises shows that MMF vulnerabilities are not unique to a particular set of governing arrangements, and that mitigating these vulnerabilities requires fundamental reforms that either place MMFs more clearly within the investment-fund sector or establish protections for MMFs similar to those for deposits." (Note: There's just one week until our Bond Fund Symposium conference, which takes place March 28-29 in Newport Beach, Calif! We look forward to seeing some of you in LA next week!)
The paper tells us, "Money market funds (MMFs) are mutual funds – that is, open-end collective investment funds -- that invest primarily in short-term instruments and aim to maintain stable, or near-stable, share prices. MMFs were first created in the United States and then in France to offer investors money market rates of interest when bank deposit rates were constrained by regulatory caps. From their origins, MMFs operated in the niche between the capital markets and the banking system, as investment funds that offered private money-like assets with features similar to those of bank deposits. Even the earliest funds in the United States were designed to blend investment and deposit features, such as share prices rounded to $1.00 and check-writing privileges, and rounded share prices were adopted in some other countries. MMFs today are popular around the world, with over $9 trillion in assets under management (AUM) as of mid-2021, about 13 percent of global mutual fund assets."
It says, "However, MMFs are also vulnerable to disruptive waves of redemptions and runs. MMFs, like other investment funds, are not eligible for the protections provided to modern bank deposits, including public backstops such as deposit guarantee schemes and routine central bank liquidity support. Hence, the money-like features of MMFs have made them vulnerable -- just as bank deposits historically were -- to runs that arise from liquidity transformation and from sudden changes in investor perceptions of the funds' moneyness. Rapid growth of the MMF industry, increasing use of MMFs by institutional investors for cash management, larger footprints in the short-term funding markets that contribute to contagion risk, and cross-border investing have heightened vulnerabilities."
The report continues, "Since 2000, MMF runs and other crises have occurred in many countries and under many regulatory regimes, with early strains mostly due to poor management of credit or interest-rate risks but more recent runs arising from liquidity transformation. For the most part, the crises have occurred among MMFs that invest in private-debt instruments, such as U.S. prime funds that hold commercial paper and bank obligations. After these crises, authorities have often modified MMF rules to prevent recurrence of the problems just observed and with the intention of mitigating broader vulnerabilities. The severe repercussions of runs on MMFs during the global financial crisis and at the onset of the COVID-19 pandemic, and the need for central bank interventions, as well as taxpayer support in some instances, have led to calls for significant additional reforms to limit the risk MMFs pose to financial stability. The global pattern of runs and crises shows that MMF vulnerabilities are not unique to a particular set of governing arrangements, and that mitigating these vulnerabilities requires structural reforms that either place MMFs more clearly within the investment-fund sector or establish protections for MMFs similar to those for deposits."
It adds, "Although this paper focuses on MMFs, other nonbank financial institutions use liquidity transformation to offer money-like features to investors and hence may be vulnerable to runs. Examples include private liquidity funds and bank-sponsored short-term investment funds (STIFs) in the United States and the rapidly growing worldwide stablecoin sector."
Discussing "MMF vulnerabilities and their significance," the authors comment, "The vulnerabilities of MMFs have been extensively described and documented, both in academic research and in official publications. Academic research was largely silent on MMF risks until the Global Financial Crisis (McCabe, 2010), but the run on MMFs in 2008 prompted a wave of studies of factors that contributed to redemptions (see, for example, Baba, McCauley, and Ramaswamy, 2009; McCabe, 2010; Kacperczyk and Schnabl, 2013; Schmidt, Timmermann, and Wermers, 2016). Additional research has focused on the factors behind heavy redemptions from U.S. MMFs during the 2011 European debt crisis (Chernenko and Sunderam, 2014) and amidst the runs on MMFs at the outset of the COVID-19 pandemic (Li, Li, Macchiavelli, and Zhou, 2021; Cipriani and La Spada, 2020). Other papers focused more specifically on vulnerabilities and policy proposals to address them (for example, McCabe, Cipriani, Holscher, and Martin, 2013; Hanson, Scharfstein, and Sunderam, 2015)."
They state, "Government authorities and international organizations have also weighed in with a focus primarily on developing and analyzing proposals for reforms that might mitigate MMF vulnerabilities. These include official publications in the wake of the 2008 crisis (PWG, 2010; FSOC, 2012; SEC, 2013; EC, 2012; IOSCO, 2012) as well as after the March 2020 money market stress (PWG, 2020; ESMA, 2021, 2022; FSB, 2021; ESRB, 2021, 2022; SEC, 2021). For example, the FSB's 2021 report on 'Policy Proposals to Enhance Money Market Fund Resilience' lists two types of vulnerabilities for MMFs: They are susceptible to sudden and disruptive redemptions, and they can face challenges in selling assets to meet heavy redemptions. The report also notes that the susceptibility to redemptions arises because the funds perform liquidity transformation, they are used for cash management, and they are exposed to credit risk."
The paper summarizes, "Here, we argue that MMF vulnerabilities have two fundamental sources: They perform liquidity transformation, and they serve as private money-like assets that can -- like other such assets -- suddenly lose their 'moneyness.' Both can contribute to sudden redemptions, and together they make MMFs vulnerable to runs."
Finally, under "Policy implications and conclusions," the report explains, "Operating in the niche between banking and investment funds, MMFs appear to offer the best of both worlds, with money-like shares that pay market rates of interest. However, when crises have occurred, MMFs repeatedly have proven vulnerable and have failed to measure up to either the banking or the mutual fund models. Without the protections provided to bank deposits, the moneyness of MMFs is fragile. And, unlike the mutual fund model that disperses risks across a wide range of investors in proportion to their ownership of shares, MMF risks are disproportionately borne by non-redeeming shareholders, and -- in some jurisdictions -- by sponsors and taxpayers."
It says, "The hybrid bank-fund nature of MMFs suggests two approaches for addressing their vulnerabilities. One is the banking package: Insurance, access to lender-of-last resort liquidity, and supervision to mitigate moral hazard and protect taxpayers. A drawback of this approach is that the financial system already has banks. The mutual fund model, in which risks are borne by shareholders, offers a second approach (McCabe, 2015). Mitigating vulnerabilities within the mutual fund model would require more novel policies to address liquidity transformation and the fragility of moneyness."
The economists also write, "The fundamental challenge of liquidity transformation is how to allocate a scarce, underpriced resource -- liquidity in a MMF -- efficiently. Currently, liquidity is provided at no charge to the first investors to redeem. Three approaches might be possible to address this problem: Increase liquidity enough so that it isn't scarce, by requiring that MMFs hold only WLA or government securities; ration liquidity among investors by delaying redemptions or imposing partial gates (where investors can only redeem a fraction of their shares) to reduce the convertibility of shares to cash when liquidity is scarce; or price liquidity by introducing swing pricing or economically equivalent measures. Official publications by national and jurisdictional authorities and international bodies have assessed some of these options in detail (PWG, 2020; ESMA, 2021, 2022; FSB, 2021; SEC, 2021)."
They state, "Making moneyness less fragile within the context of the mutual fund model -- which is designed to impose risks transparently, rather than create information-insensitive, NQA assets -- is more challenging. One possible approach would be to outsource risks to third parties who are compensated accordingly. For example, investors outside the MMF could provide a capital buffer (Hanson, Scharfstein, and Sunderam, 2015)."
The conclusion summarizes, "While some of these reform options for MMFs have been discussed for a decade or more, adopting robust structural reforms for MMFs has proven difficult. For example, the SEC's 2014 reforms came only after the Commission had failed to act in 2012 and the Secretary of the Treasury initiated a Financial Stability Oversight Council proposed recommendation for further reforms (Geithner, 2012; FSOC, 2012). Moreover, reforms put in place in the prior decade in the United States and Europe proved insufficient to contain the runs in March 2020. The difficulty of implementing effective reforms reflects, at least in part, the benefits of MMFs as they are currently structured for broad constituencies of investors, issuers, and asset managers and the implicit subsidies they receive from central bank support when MMF runs occur. Indeed, recent comment letters from the MMF industry express near-universal opposition to all structural reform options, including swing pricing and capital buffers. So, meaningful mitigation of MMF vulnerabilities is likely to continue to be a challenge for policymakers."
It adds, "Finally, MMFs are not the only institutions with these vulnerabilities. Any vehicle that engages in liquidity transformation to provide money-like services presents similar challenges. In the United States, for example, private liquidity funds and bank-sponsored short-term investment funds (STIFs) have similar features. Worldwide, the explosive growth of stablecoins, which aim to offer not only stable value and liquidity but also access to the payments system, all backed by assets that are likely to become illiquid in crises, suggests that policymakers may have a new challenge on their hands."
