A Way Forward?
by Travis Barker, Outgoing Chairman, Institutional Money Market Funds Association
The MMF industry has overwhelmingly rejected regulatory reforms based on the premise that MMFs are shadow banks, or that would require CNAV funds to adopt a VNAV. Instead, the industry has endorsed regulatory reforms that focus on managing liquidity risk. What regulatory reforms are supported by the industry? What regulatory reforms remain contentious? And how is this debate likely to resolve itself?
What regulatory reforms are supported by the industry?
There is broad support within the MMF industry for the following narrative about the events of 2008.
MMFs provide a simple but valuable intermediation service between lenders and borrowers in the short-term debt markets. They are used, in particular, by corporate treasurers whose cash assets are generally in excess of the amount guaranteed by deposit insurance schemes. To that extent, investors are exposed to credit risk when they make deposits, and manage that risk by diversifying deposits between creditworthy banks. But there are constraints on the level of diversification that investors can achieve on their own, in particular because they don’t have the expertise to assess creditworthiness across a large number of issuers. Therefore they use MMFs which – like other collective investment schemes – can provide higher levels of diversification than investors could achieve individually, and can employ specialist credit analysts through economies of scale.
Prime MMFs invest substantially all of their assets in high-quality, low duration fixed income instruments issued by banks, businesses and governments. In September 2008, a series of headline events undermined investor confidence in the solvency of the global banking system. That caused some US investors to switch their investment from prime MMFs to treasury and government MMFs (which invest in US Treasury Bills and other government agency securities): a classic ‘flight to quality’.
US MMF investors were not the only party to lose confidence in the global banking system: banks lost confidence in one another! Consequently, the interbank market and secondary market for money market instruments essentially closed, which made it increasingly difficult for MMFs to sell assets to raise cash to make redemption payments. The flight came to an end when the US Treasury Temporary Guarantee Programme effectively made prime MMFs ‘as good as’ treasury MMFs and made further switching unnecessary.
Non-US investors didn’t react so strongly, and therefore redemptions from non-US MMFs were less severe. Nevertheless, to generalise from the experience of US MFs in 2008: a loss of confidence in the banking system may cause some investors to ‘fly to quality’, including switching their investments from prime to treasury MMFs. The only credible way of stopping that flight to quality is to restore confidence in the banking system, and quickly. In the intervening period and in the absence of a functioning secondary market, the primary objective of MMF reform should be to ensure that funds have sufficient natural liquidity to meet redemption payments.
Therefore, there is broad support within the MMF industry – including IMMFA – for the following regulatory reforms:
- MMFs should be subject to minimum liquidity requirements, in order to be able to make redemption payments without relying on secondary market liquidity. For example, IMMFA’s Code of Practice requires MMFs to hold at least 10% of their assets in overnight cash, and 20% in assets that mature within one week. These should be made a regulatory requirement.
- MMFs should be required to ‘know their clients’, in order to enable them to monitor subscription/redemption cycles and manage risks arising from shareholder concentration. Such measures may need to be accompanied by requirements on intermediaries to disclose the identity of underlying investors to MMFs. For example, IMMFA’s Code of Practice requires MMFs to adopt a liquidity policy which addresses concentration risk, including any concentrations arising within shareholders or sector-specific issuance. This should be made a regulatory requirement.
What regulatory reforms remain contentious?
Some regulators have taken the narrative further. They have observed that, insofar as a loss of confidence in the banking system may cause a switch from prime to treasury MMFs, then the funding provided by prime funds to the banking system would necessarily decrease; but in those circumstances, reduced funding would further undermine confidence in the banking system. Therefore, they recommend that MMF reform should not merely focus on ensuring that funds have sufficient liquidity to meet redemption payments, but also should actively disincentivise investors from redeeming.