Regulators are worried about money market funds
Money market funds have long been sold as a safe place to stash cash. But they aren’t without risk, particularly as we move into an increasingly volatile market.
We have shared our insights on certain asset class risks related to money market funds (MMFs) in a past post. However, recent quarters have seen a great deal of activity related to these vehicles and it’s time to take another look.
Price risks of money market funds
The price risk of MMFs is also known as “breaking the buck” because MMFs typically trade at a stable net asset value (NAV) of $1.00 per share. There are two potential risks related to this, and sometimes they both arise at the same time:
- The MMF has made poor investment choices and some of its holdings have dropped materially in value, so the overall fund is now worth less than $1.00.
- There is a run on MMFs—in other words, MMF investors in large numbers want to turn their MMF investments into cash. The MMFs are then forced to sell instruments in large quantities in the open market. If there are not enough buyers, the prices will drop.
The second example is particularly relevant given the March 2023 stampede into money markets.
At around the same time as this was happening, Treasury secretary Janet Yellen remarked in a speech that, “If there is any place where the vulnerabilities of the system to runs and fire sales have been clear-cut, it is money market funds.”
Liquidity risks of money market funds
In July 2023, the SEC imposed a new rule (Bloomberg story) which allows MMFs to charge liquidity fees at their own discretion when outflows happen, and impose liquidity fees on certain types of MMFs when daily redemptions exceed 5% of net assets. Those types of MMFs are institutional prime and institutional tax-exempt funds. According to MMF sponsors themselves, this is likely to increase volatility and reduce the attractiveness of these vehicles.
Furthermore, liquid asset requirements will increase. This means costs will increase, yields will decrease and, when everyone is trying to convert their MMF holding into cash, price stability will be hampered.
This is clearly important as we’re now witnessing another spike in flows that resembles activity around the dot com boom, the financial crisis, and the COVID-19 dislocation.
What do regulators say about money market funds?
Although many of these risks are generally poorly understood, they are certainly not new to regulators. For example, Money Market Funds and Systemic Risk (Fed, 2012) discusses these dangers:
- NAV rounding to the nearest cent
- How portfolios become less liquid during sell-offs
- Fund sponsors (eg, Blackrock) providing financial support to artificially keep NAV at $1.00 over 100 times in 2008 alone
- That new rules aren’t enough, reinforced by then-SEC Chair Mary Schapiro
The Fed followed 10 years later in Money Market Fund Vulnerabilities: A Global Perspective (Fed, 2022), in which it noted: “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.” (emphasis ours)
The Fed’s report identified price and value risks:
- Susceptibility to runs due to either sudden or heavy redemptions
- Credit risk in the underlying assets
- Large institutional investors have more extreme swings in cash needs, and front-run during riskier periods
- Accelerated redemptions as MMFs reach certain monitoring thresholds, such as a quick drop in liquid assets, NAV rounding below rounding thresholds
It also commented on liquidity and market risks:
- Underlying presumed liquid assets “lose” their liquid characteristics
- Lack of liquidity: eg, investors who requested redemptions from one fund in September 2008 had to wait several years before receiving their cash
- High similarity in MMF portfolios means that when one fund becomes unstable, this can easily result in contagion among other funds
- A high percentage of MMF assets must be rolled overnight, and an instability in that market will immediately translate to the funds
- Cross-border financing of MMF portfolios creates additional failure points
The report discussed heavy MMF mark-to-market losses during 2007-08, such as losses in a single fund leading to 29 other US funds breaking the buck absent sponsor support. Worryingly, it identified significant MMF instability during 2011, 2014, 2016, and 2020, which turned out to be worse than 2008.
Most recently, the Financial Stability Board, which has an international mandate, has decided the challenges surrounding MMFs are important enough to work through a thematic peer review for publication by the end of 2023.
If MMFs are risky, what should you do?
Our investment experience drives our fundamental view that the long run is better served by focusing on low risk and high liquidity first. Today, that choice doesn’t have to come at the expense of high yield. At Mayfair, we hold your cash at FDIC-insured banks to provide both safety and liquidity, without sacrificing excellent yield.