Regulation Almost Destroyed Money Market Funds, But Cash Management Needs Kept Them Alive
Extensive regulatory overhaul in October 2016 changed the money market fund (MMF) industry considerably, especially for institutional clients. Nonetheless, MMFs continue to be an important cash management tool for institutions even though MMF asset allocations are now much more restricted and quantitative restrictions are in place to preserve their ability to redeem shares at a constant share price.
Key regulatory changes were threefold. First, institutional prime MMFs must float their net asset value, abandoning their signature feature of a constant share price. Second, institutional prime MMFs must adopt a system of redemption gates and fees to ensure sufficient liquidity. Third, government and retail MMFs are exempt from the floating NAV requirement and from redemption fees and gates.
Following the October 2016 reforms, institutional investors made significant changes to their MMF investments. They faced a choice of shifting their investments to government MMFs (offering a stable share price), or remaining invested in higher yielding prime funds (now with a floating share price). Institutional depositors overwhelmingly favored retaining a constant share price even if returns were lower: institutional prime funds lost almost 74 percent of their net assets to government funds, and partly to retail prime funds. This reallocation shows that immediate liquidity at par dominates slightly higher returns when it comes to the needs of institutional investors’ cash management.
Immediate liquidity at a constant share price is an essential characteristic of a cash management tool. However, this price stability may induce investor complacency by introducing the incorrect notion that underlying assets held by a money market fund are risk-free. This distortion can induce destabilizing runs in times of extreme financial stress. By allowing the share price of MMFs to vary, new regulations have highlighted the fact that shares in prime MMFs are not risk-free. This change in regulation led to a $1 trillion reallocation from prime to government funds, thereby reducing the risk of runs caused by the false sense of security of a guaranteed fixed share price when market conditions become volatile.
Fees and gates, the second pillar of the new MMF regulations, may stem runs temporarily. However, they may induce attempts to circumvent the restrictions and could make a liquidity crunch worse by cutting off investors from accessing their liquid assets just when liquidity is scarce. Only institutional prime MMFs remain subject to the rules on gates and fees. However, regulators may extend these quantitative restrictions on withdrawals to mutual funds more broadly. Such a regulatory shift might create preemptive runs, as the option to suspend convertibility introduces potential restrictions on investors’ access to their assets in times of stress. In other words, investors might withdraw their investments if the likelihood of redemption restrictions increases substantially. The almost-disappearance of institutional prime funds is an indication of the importance investors place on having reliable access to their assets.
In our recent Milken Institute Viewpoint, we describe the MMF’s new asset allocations and their impact on different markets. The reallocation of $1 trillion from prime to government MMFs had a substantial impact on the choice of financial instruments companies use to borrow. As prime funds were withdrawing from commercial paper and deposits, banks increased their borrowings from Federal Home Loan Banks (FHLBs) as a substitute. These collateralized loans from FHLBs to banks, called advances, are ultimately funded by issuing Agency debt held by government MMFs.
We believe that regulatory changes in the money market and to related channels of short-term financing should act as a reminder that regulatory pressure on one part of financial markets has repercussions throughout the entire financial system—leading to unexpected adaptation by market participants. Such changes may not be finished. To cite Fed vice chair Fischer, “[w]hile the current configuration of money markets reveals a reduced financial stability risk […] this configuration may not yet represent the final equilibrium.”