On Monday, we excerpted from a Federal Reserve Bank of New York report, "Money Market Fund Vulnerabilities: A Global Perspective." (See our March 21 News, "NY Fed Paper: Money Market Fund Vulnerabilities: A Global Perspective.") Today, we quote from the section involving "MMF origins," which includes an excellent history on money market funds globally. They tell us, "MMFs were first introduced in the United States and then in France to offer investors money market rates of interest when bank deposit rates were capped by regulation. As such, from their origins, MMFs straddled the functions of bank deposits and investment funds.... MMFs were invented in the United States and first approved by the U.S. Securities and Exchange Commission (SEC) in September 1972. The first MMFs were intended to give investors with modest wealth -- including small businesses -- access to money market yields, as bank interest rates were capped at the time by Federal Reserve Regulation Q, and Treasury bills (which were a popular means of earning market rates) were subject to $10,000 minimum investments. From the beginning, U.S. MMFs were designed to mimic deposit features, with many funds maintaining stable share prices (that is, net asset values per share, or NAVs) fixed at $1 or $100. By 1974, Fidelity was offering check writing privileges for its MMFs."
The paper explains, "By straddling the functions of bank deposits and investment funds, MMFs gained popularity but also stirred controversy. Assets in MMFs grew from $1.7 billion in 1974 to $220 billion in 1982 -- that is, from 5 percent to 74 percent of all U.S. mutual fund assets.... The banking industry saw MMFs, which were already 10 percent of the size of bank deposits by 1982, as an end-run around bank regulations and a competitive threat. Banks mounted campaigns at the federal and state levels to reign in MMFs and liberalize deposit-rate policy. Only the latter was successful: Bank deposit-rate ceilings were effectively eliminated in 1986. Thus, MMFs survived and had a key role in giving middle-class investors access to competitive short-term interest rates."
It continues, "Meanwhile, within three years of approving the first MMFs, the SEC was already expressing concerns about practices that foreshadowed the vulnerabilities of MMFs. The SEC in 1975 and 1977 noted 'deficiencies' in MMFs' use of amortized (historical) cost for valuing portfolio assets and stated that use of amortized cost -- which to this day helps MMFs in many countries maintain stable NAVs -- might advantage redeeming investors over others: 'The Commission is concerned that the use of the amortized cost method ... may result in overvaluation or undervaluation of the portfolios of [MMFs] ... [so that] investors purchasing or redeeming shares could pay or receive more or less than the actual value of their proportionate shares of the funds' current net assets. The effect of such sales or redemptions may therefore result in inappropriate dilution of the assets and returns of existing shareholders.'"
The Staff Report says, "Based on these considerations, the SEC in 1977 stated that amortized cost would be inappropriate 'under all but very limited circumstances'.... Nonetheless, after many MMFs sought to use amortized cost, the SEC changed direction. In 1983, it adopted Rule 2a-7, which allowed funds to use amortized cost and NAV rounding to maintain stable share prices if they adhered to certain restrictions, including holding only short-term assets that present 'minimal credit risks' and limiting portfolio average maturity to no more than 120 days (SEC, 1983). Over the next decade, the U.S. MMF industry tripled in size to more than $500 billion in assets under management. Today, the U.S. MMF sector is still the world's largest, with AUM of over $5 trillion."
Discussing "France," they write, "The first European MMFs were created in France for regulatory arbitrage purposes similar to those that spurred development of the U.S. industry. In 1981, a large share of French term deposits became subject to an interest rate cap, as the government sought to reduce bank funding costs. To avoid losing clientele, banks bypassed the rate caps by setting up MMFs through their asset management affiliates to offer money market yields to investors. Initially, MMFs invested mostly in short-term government debt, but deregulation in the mid-1980s and the opening of French capital markets allowed MMFs to invest more in private short-term debt instruments, such as commercial paper (CP) and certificates of deposit (CDs). Demand for MMFs expanded due to favorable changes to the tax code in 1989 ... and the introduction in the early 1990s of new types of 'dynamic' MMFs with higher credit risk and longer portfolio maturities. By 1993, total assets of French MMFs had reached almost €240 billion... and accounted for more than 60 percent of the French open-end investment (mutual) fund industry."
The study states, "Unlike their U.S. counterparts, French MMFs all had variable net asset values (VNAVs, or 'floating' NAVs), as so-called 'constant' NAVs (CNAVs) -- equivalent to the stable NAVs that prevailed in the United States -- were prohibited. French MMFs were permitted to use amortized cost to value assets with less than three months to maturity in part because of very limited secondary market activity for these assets and hence the lack of adequate market data to value them."
On "Luxembourg and Ireland," they summarize, "In addition to France, Ireland and Luxembourg have become major domiciles for European MMFs. MMFs have remained relatively small in most other European countries, where they are mainly targeted at retail investors. Luxembourg has long been a hub for European mutual funds, and MMFs first appeared there in the late 1980s. Early MMFs in Luxembourg were VNAV funds patterned on French MMFs but with tax advantages that allowed them to invest economically in a broader range of (non-French) assets. Tax advantages also encouraged investment by residents of other European countries, such as Germany and Spain.... In addition, Luxembourg developed a U.S. dollar (USD) MMF sector with CNAV funds mainly targeted at non-resident institutional investors, who were mostly outside of Europe."
The piece continues, "Ireland's first MMFs were a CNAV USD government fund and a USD prime fund opened in 1991 and 1993, respectively, by Federated, a U.S. asset management firm. Moreover, many of the Irish-domiciled management companies that offered additional Irish MMFs belonged to U.S. asset management groups. Like most other European mutual funds, Irish MMFs complied with European UCITS rules. At the same time, they largely adhered to U.S. MMF rules and guidelines from credit rating agencies (CRAs), as there was no European regulatory framework specifically for MMFs before 2018 and the funds were offered largely to non-resident institutional investors, who were familiar with U.S. rules and credit ratings. Hence, an AAA money market fund rating from a CRA was initially seen as a prerequisite for authorization of an Irish MMF. Up to this day, almost all Irish MMFs offer a stable NAV. Most MMFs in Ireland have been issued in foreign currencies (mainly USD and sterling), reflecting their foreign investor bases. Luxembourg MMFs are denominated in a mix of USD, euros, and sterling."
Then on "Japan," the report tells us, "Money management funds (JMMFs) were introduced in Japan in 1992 and marketed as a safe but higher-yielding alternative to bank deposits. JMMFs maintained stable Y10,000 NAVs, even though these funds had virtually no safeguards like those that limited risk in U.S. or European funds.... Within two years of their introduction, JMMFs had Y12 trillion in AUM and accounted for more than a quarter of the Japanese mutual fund sector, but, as discussed below, a run on these funds beginning in late 2001 nearly wiped them out. A second, safer type of money fund, the money reserve fund (MRF), which first became available in 1997, did have credit quality restrictions. MRFs were used in customer securities trading accounts at broker-dealers for settlement purposes and as a place to temporarily invest cash."
After mentioning "South Africa," the paper discusses "China," saying, "MMFs were first introduced in China in 2003. As was the case in the United States and France, MMF growth in China was driven, particularly after 2010, by below-market caps on bank deposit rates and an easing of portfolio restrictions for MMFs in 2011.... Growth in recent years has been propelled by linkages between MMFs and major e-commerce platforms, such as Alibaba, Baidu, and Tencent.... The Chinese MMF sector is now the second largest in the world, with $1.4 trillion in AUM as of mid-2021."
Finally, they add, "Chinese MMFs mostly maintain stable NAVs, with sponsor support expected when the MMF portfolio experiences small losses (IMF, 2017), and are held by a mix of retail and institutional investors. Unlike their counterparts in the United States and Europe, MMFs in China regularly employ leverage, largely by using repo financing."
