Earlier this month, researchers at the European Central Bank (ECB) published a working paper entitled, "Is the EU Money Market Fund Regulation Fit for Purpose? Lessons from the COVID-19 Turmoil." The Abstract tells us, "The market turmoil in March 2020 highlighted key vulnerabilities in the EU money market fund (MMF) sector. This paper assesses the effectiveness of the EU's regulatory framework from a financial stability perspective, based on a panel analysis of EU MMFs at a daily frequency. First, we find that investment in private debt assets exposes MMFs to liquidity risk. Second, we find that low volatility net asset value (LVNAV) funds, which invest in non-public debt assets while offering a stable NAV, face higher redemptions than other fund types. The risk of breaching the regulatory NAV limit may have incentivised outflows among some LVNAV investors in March 2020. Third, MMFs with lower levels of liquidity buffers use their buffers less than other funds, suggesting low levels of buffer usability in stress periods. Our findings suggest fragility in the EU MMF sector and call for a strengthened regulatory framework of private debt MMFs."
It explains, "Following the global financial crisis, EU legislators have introduced new rules on money market funds (MMFs), in particular through the adoption of the EU MMF Regulation in 2017. The COVID-19 market turmoil in March 2020 tested the resilience of the MMF sector as private debt MMFs faced large investor outflows. We focus on the events in March 2020 to assess the effectiveness of the EU MMF Regulation from a financial stability perspective…. Our paper contributes to the literature on run risks in MMFs and how regulation can impact incentives among MMF investors and managers. We assess key aspects of the EU MMF Regulation, with a particular focus on low-volatility net asset value (LVNAV) funds and weekly liquidity requirements. By investigating the behaviour of investors and fund managers during the COVID-19 market turmoil in March 2020, we provide new evidence for fragility in the EU MMF sector and call for a strengthened regulatory framework, in particular for private debt MMFs."
The authors write, "Our results identify three key vulnerabilities in the EU MMF sector. First, investment in private debt assets exposes MMFs to liquidity risk. We find that investors in MMFs investing in less liquid assets redeem more strongly than other investors during crisis periods. Second, LVNAV funds are particularly vulnerable to liquidity shocks as they invest in non-public debt assets while offering a stable NAV. The prospect of breaching the regulatory NAV limit may have incentivised outflows among some LVNAV investors during the March 2020 turmoil. Third, although some LVNAV funds experienced large outflows, fund managers did not draw down on their weekly liquid assets to the same extent, suggesting low levels of buffer usability. According to the MMF Regulation (MMFR), falling below liquidity requirements can lead LVNAV and CNAV MMFs to consider ap- plying extraordinary liquidity measures, which may encourage investors to redeem early. We find that investors redeem more strongly from MMFs with lower liquidity buffers than from funds with larger buffers. At the same time, we find that funds with lower levels of weekly liquidity buffers use their buffers less than funds with higher buffers, suggesting a preference for those funds to sell other (often less liquid) assets, possibly to avoid getting too close or falling below the regulatory threshold."
The "Introduction" says, "MMFs play a critical role in the financial system. They provide short-term funding to issuers, in particular banks, and are used as cash management vehicles by investors. MMF shares display cash-like properties since they are redeemable on demand and are typically perceived as providing low-risk and stable investments. Similarly, MMFs are commonly expected to raise liquidity by allowing assets to mature, rather than selling them in secondary markets. However, even though MMFs are generally perceived as safe and liquid investments, they are subject to credit and liquidity risks, in particular when investing in less frequently traded instruments such as commercial paper and certificates of deposit issued by the private sector (Financial Stability Board (2020), Bouveret and Danieli (2021))."
It continues, "The 2008 global financial crisis highlighted several key vulnerabilities through which MMFs can amplify risks in the financial system (International Organization of Securities Commissions (2012)). A prominent example is the Reserve Primary Fund in the US. When the Reserve Primary Fund’s share price fell below its constant share price (’broke the buck’), other prime funds also suffered severe outflows and falling returns (McCabe (2010)). Since then, legislators in Europe and the US have adopted new rules to make the sector more resilient. In 2017, the EU adopted the MMF Regulation, which among other rules (i) requires constant NAV (CNAV) funds to invest in public debt; (ii) introduces an additional fund type (LVNAV) that aims to offer a stable NAV while investing in a broader range of instruments; and (iii) introduces daily and weekly liquidity requirements with a view to strengthen MMFs’ ability to meet redemptions and mitigate procyclical asset sales."
The ECB staffers comment, "Despite the experience of the 2008 global financial crisis and the new regulatory framework, the COVID-19 turmoil has been challenging for MMFs’ liquidity management. Following the onset of the crisis in early 2020, private debt MMFs (meaning variable NAV (VNAV) and LVNAV funds) experienced significant outflows, while public debt CNAV funds saw net inflows.... At the same time, the liquidity of money market instruments on the asset side of many MMFs deteriorated. This was particularly the case for VNAV and LVNAV funds, which invest largely in commercial paper and certificates of deposit…. While the level of stress stabilised following central bank interventions, this episode highlighted important vulnerabilities in the sector. At the same time, it raised questions about the EU MMF Regulation’s effectiveness to ensure that private debt MMFs are capable of meeting large and unexpected outflows without spillovers to the MMF sector and the broader financial system. This paper assesses the effectiveness of the EU MMF Regulation in safeguarding financial stability, with a particular focus on the developments during the COVID-19 turmoil."
They tell us, "We run multivariate panel regressions to study several hypotheses about the behaviour of investors and fund managers during the COVID-19 turmoil. First, we test whether investors redeem more strongly from funds which hold less liquid portfolio assets during the stress period. In response to large redemptions, private debt MMFs may be forced to sell assets at a discount to accommodate those redemptions. However, the secondary market liquidity for commercial papers and certificates of deposit usually depends on the willingness of the issuing banks to buy back their own paper, which can be hampered in a stress scenario. Investors may anticipate this and redeem more strongly from funds which invest in less liquid assets, as these assets are harder to sell in a stress scenario. Next, we focus on certain rules under the EU MMF Regulation to further explain investor behaviour. LVNAV funds are required to switch from a stable to a variable NAV if they breach a certain valuation threshold. Since investors value MMFs for their stable NAV, under a second hypothesis, we test whether LVNAVs face higher outflows if they approach their regulatory threshold for a stable NAV. Third, funds with liquidity buffers below a certain regulatory threshold are required to consider liquidity gates or similar measures to improve their liquidity management. Since this can restrict investor redemptions, we test whether funds with lower liquidity buffers (and higher risk of employing liquidity management tools) face stronger outflows in crisis times. Fourth, we look at the behaviour of fund managers who may be anticipating investor responsiveness to the fund’s liquidity level. We study if funds with low liquidity levels are reluctant to use their liquidity buffers when facing redemptions in an attempt to avoid further outflows."
The paper adds, "Our empirical tests are based on a large and granular dataset containing fund-level information from Crane Data, with daily observations of EU MMFs between January 2019 and May 2020. The sample covers around 70% of the EU MMF sector. This allows us to run our regressions at a high frequency and take a detailed look at the fast-moving developments in the MMF sector around the COVID-19 shock. The data also enables us to control for a wide array of potentially confounding factors such as past returns, past volatility of returns, fund age and size, fund currency, as well as portfolio illiquidity. In addition, all our regressions include fund and time fixed effects to capture additional factors which we cannot control for directly. Furthermore, we cluster standard errors at a fund level to account for heteroskedasticity and autocorrelation across observations."
Finally, they write, "Our results identify three key vulnerabilities in the EU MMF sector. First, investment in private debt assets exposes MMFs to heightened risk of outflows during stress. We find that investors in MMFs investing in less liquid assets redeem more strongly than other investors during the COVID-19 turmoil. Second, LVNAV funds are particularly vulnerable to liquidity shocks as they invest in non-public debt assets while offering a stable NAV. During crisis periods, outflows are around 1.8-2.4 percentage points larger for LVNAV funds that were close to the lower valuation threshold on the previous day, relative to other LVNAV funds. The prospect of breaching the regulatory NAV limit may have incentivised outflows among some LVNAV investors during the March 2020 turmoil. Third, although some LVNAV funds experienced large outflows, fund managers did not draw down on their weekly liquid assets to the same extent, suggesting low levels of buffer usability. According to the MMF Regulation (MMFR), a breach of liquidity requirements can lead LVNAV and CNAV MMFs to consider applying extraordinary measures, which may incentivise investors to redeem early. We find that investors redeem more strongly from MMFs with lower liquidity buffers than from funds with larger buffers. At the same time, we find that funds with lower levels of weekly liquidity buffers use their buffers less than funds with higher buffers, suggesting a preference for those funds to sell other (often less liquid) assets, possibly to avoid getting too close or falling below the regulatory threshold. These findings point to fragilities in the EU MMF sector and underline the need for enhanced MMF regulation. The remainder of this paper is structured as follows. Section 2 reviews the literature on MMF vulnerabilities and the regulatory framework. Section 3 develops the hypotheses. Section 4 describes the dataset, while section 5 presents the analysis and empirical findings. Section 6 concludes."
