"The Big Sort": Time To Think About Your Money Market Fund

In late July, threemonth LIBOR reached its highest level since the Financial Crisis, as the cost of financing between banks exceeded 75 basis points for 90-day loans between banks. This happened exactly 90 days ahead of a deadline for the implementation of Money Market Fund Reforms, a project on which the United States Securities and Exchange Commission has been working since the $65 billion Reserve Primary Fund “broke the buck” in September 2008.

The reforms, to be implemented on October 14, will require institutional prime money market funds that invest less than 99.5% of their assets in US government securities to report a floating NAV. The new regulations will also allow money market funds to add redemption fees and even to impose gates on redemptions during periods of stress.

This event means that money market fund investors have a choice to make – accept the risks of a floating NAV (and potential higher yields) or move into funds that invest primarily in government securities. Now is the right time for investors to take a look at how they are handling their cash assets, an issue they have taken for granted.

These new regulations mean that funds seeking extra yield by investing in commercial paper will need to increase transparency and more clearly disclose their daily returns, some of which will almost certainly be negative. Investors seeking safety in a steady $1 NAV will have to forego prime money market funds, which invest in commercial paper, in favor of government money market funds that invest in government bonds.

In addition, the risk of fees and/or gates means that investors in money market funds cannot be certain they will be able to withdraw their money when needed. Investors may expect that the risk of gates is particularly high in times of financial stress, exactly when they are likely to need liquidity the most.

The intention of new regulations is to add stability to the money market system. The Reserve Fund’s breaking of the buck led to frantic outflows from money markets that ended only when the US government took the extraordinary step of guaranteeing all money markets.By lessening the chances of a panic, the goal of regulation is to make prime money market funds a moreappealing choice for investors.

Since regulations were announced, however, the apparent effect has been not to increase, but instead to decrease, demand for prime funds.Since November, assets in prime funds have fallen by nearly 1/3, from roughly $1.5 trillion to $1 trillion. In 2016 alone,prime funds have seen outflows of $378 billion, while government funds have increased by $509 billion, a trend that appears to be continuing.

Money market fund watchers call this “The Big Sort,” and so far it is being attributed to changes being made by fund managers.Firms that run large money market funds have liquidated funds or converted prime funds into government funds in anticipation of changing demand in response to new regulations.

The speed of “The Big Sort” has accelerated as the implementation deadline approaches, and it now appears to be shifting from conversions made by fund managers to decisions made by investors. The major investors inprime funds are corporate treasurers investing short term cash. These large investors seem unwilling (at current yields) to take on the risk of a floating NAV, possible redemption fees, or gates. As the implementation of the new regulations approaches, the assets of prime funds have fallen to their lowest level since 1999.

As assets shift from prime to government funds, funding costs for banks and other commercial paper users have increased. With fewer assets in prime funds, these funds’ demand for commercial paperhave fallen in tandem. About half of commercial paper issuers are financial companies, particularly non-U.S. banks, but large global industrial companies like Toyota, Honeywell, and Chevron also rely on corporate paper to meet their funding needs. Non-financial corporate cash is about $1.6 trillion, according to Fed data. But it is estimated that $1.2 trillion cannot be repatriated without generating a large tax bill. Therefore funding in the commercial paper market is important despite the appearance of cash-rich corporates.

The new regulations are akin to the Federal Reserve raising rates. Indeed, some observers believe that the Fed is constrained from raising rates until after the regulations go fully into effect and the impact on capital availability can be assessed.

Already, for example, companies are finding it hard to borrow at 90-day maturities. As part of the reforms, prime funds are required to hold at least 30% of their assets in securities that are convertible to cash within 5 business days or otherwise put in place either liquidity fees or redemption gates. Many prime funds have lowered the weighted average maturities of their assets in recent months, reducing the supply of dollars available at three-month maturities.

The effects of the new regulations are becoming evident in Japan, as supported by a seemingly minor action the Bank of Japan (BoJ) took at its most recent meeting.

In July, the BoJ largely underwhelmed markets by increasing monetary stimulus far less than expectations.The one unexpected move, however, was the BoJ’s decision to increase its program to lend US dollars to Japanese banks. This facility is funded by the BoJ’s swap line with the Federal Reserve.The BoJ borrows dollars from the Federal Reserve and then on-lends those dollars to Japanese institutions in need of dollar funding.

We see a likely link between this announcement and the money market reforms occurring in the United States, which are tightening dollar funding rates for private sector institutions. The amounts drawn under the Fed-BoJ swap have been quite small, leading one to question why a doubling of this facility, from $12 to $24 billion, is necessary.

A deeper examination of the issuers of commercial paper offers a strong clue.Foreign financial institutions constitute the largest group within the commercial paper market.With mostly illiquid assets on their balance sheets, these institutions have few good alternatives to the commercial paper market as a means of accessing dollar funding. Were commercial paper funding not available to them, they would otherwise have to access far more expensive long-term debt.Thus, the new BoJ facility is likely a backstop intended to prevent these and other Japanese financial institutions from experiencing a shock should commercial paper demand fall further.

There is also, as in all significant regulatory changes, the possibility of a mistake that temporarily destabilizes the system. Should a large prime fund manager underestimate redemptions and break the buck by selling commercial paper at a loss, the headlines could potentially spook investors in other markets who do not focus their attention on the money market universe.

Regulatory changes are likely to affect hedge funds, as well.As funding becomes tighter in commercial paper markets, hedge funds may find future funding to be less reliable and more expensive. Banks around the world are rethinking their capital-intensive businesses and are shrinking lower margin businesses that are balance sheet intensive.Traditional cash prime brokerage is one such low margin, balance sheet-intensive business, as are repo desks and delta one arbitrage products, all of which are common means of hedge fund leverage.

In short, investors have a choice to make when it comes to managing cash holdings. The collective result of those choices could have profound implications for the global economy.

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