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 their asset allocations are now much more restricted to preserve the feature of a constant share price.
Key regulatory changes were threefold:
- Institutional prime MMFs must float their net asset value, abandoning their signature feature of a constant share price.
- Institutional prime MMFs must adopt a system of redemption gates and fees to ensure sufficient liquidity.
- Government and retail MMFs are exempt from the floating NAV requirement and from redemption fees and gates.
Following the reforms, institutional investors made significant changes to their MMF investments. They faced a choice of shifting their investments to government MMFs (offering a stable shareprice), 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.
As we show in this paper, regulatory changes to MMFs correctly remove unviable promises of immediate liquidity at a constant share price while holding asset portfolios with varying risk exposures. We emphasize the importance of allowing price signals to reveal the impact of changes in the risk environment on asset holdings. We also believe that quantitative restrictions (e.g., withdrawal fees and gates) are counterproductive for preventing runs: they do not aid price discovery, and incentivize investors to circumvent the restrictions to access to their otherwise liquid assets in times of heightened liquidity demand.
In the remainder of the paper, we describe the asset shifting by MMFs as well as the resulting impact on different markets. The second portion of the paper outlines how the approximately $1 trillion that shifted from prime to government MMFs has affected commercial paper and deposits. Before concluding, we provide an overview of the asset reallocation into government funds.