The bottom line: New global money market reforms and pandemic lessons

Laurie: It has been a very interesting year and a half. One of the key elements from that critical timeframe from February to the end of April 2020 was that there was so much uncertainty. There was uncertainty about shutting down, specifically for our clients, and more broadly, for the global economy. As economies began shutting down, we saw a “dash for cash” as people and corporations sought to hold as much cash as possible amid the uncertainty that reigned at that time. 

When you look at the timeline of events, the market disruptions really began in the long-term equity and fixed income markets at the end of February. There were redemptions out of many investment products preceding outflows from money market funds. As a matter of fact, we were wondering if we would see large inflows into money market funds since they are generally the “flight to quality” vehicle of choice for many investors. By the time we started seeing outflows from money market funds and they sought to raise additional liquidity, dealer balance sheets were already quite clogged with other securities. It was a very tough time.

Looking back, the central banks were very responsive, especially the Fed, compared to their interventions in 2008. Granted, the response didn’t feel very fast as every market was dislocated. But following the central bank interventions, whether it was the Fed, the European Central Bank or Bank of England, markets did start to function more normally as they gained confidence that the central banks stood ready to provide support as needed. 

And where are we today? The markets feel much healthier and are functioning normally. Money market funds are still holding a lot of cash and liquidity, with assets near or at historic highs, as investors haven’t yet put their excess cash to work, but we expect this to happen as economies begin to reopen and normalize. 

Laurie: The central bank interventions were important because, as economies shut down, so did market liquidity. We watched this in real time as Asia shut down first, followed by continental Europe, the UK and then the US. As we started to see the severity of COVID-19 and what it was going to mean for individuals and businesses, we saw markets begin to seize up and a huge surge in demand for dollars. The Fed and other central banks were very proactive in their responses as they tried to stay ahead of market volatility, liquidity conditions and investor concerns. 

When you consider the central bank actions that were very successful in 2008, and their roll-out again in 2020, a lot had changed in the intervening period. The way that banks and broker dealers operate in the market now, regulations, the size of the money market fund industry globally and the types of money market funds; they have all changed. One aspect that was very different this time around was that, as the central banks were pulling levers and using old tools, the markets weren’t reacting in the same ways they had in the past. This meant that there was somewhat of a learning curve for the regulators. 

Another difference was that the central banks were very targeted in their interventions. They started with a commercial paper facility, then, at least in the US, there was a facility for money market funds. There was already a primary dealer credit facility, and the Fed created a municipal facility, one for structured markets, main street lending facilities and others. They were very targeted rather than simply throwing dollars at the problem and expecting things to sort themselves out. 

In terms of whether the central banks could have been a bit more synched up, I believe so. As we know, this is a global economy, and we have global decision makers and global banks. Therefore, as much as the regulators can ensure that there is consistency and certainty in markets and currencies across the board, this does lead to better functioning markets.

Michael: Yes, as Laurie alluded to, the issues faced in March and April last year were very much global issues. With policy makers and supervisors now considering whether recent money market reforms have contributed to a more resilient financial market ecosystem, we are pleased that this work is being led at an international level by the Financial Stability Board (FSB), which seeks to promote international financial stability by coordinating national financial authorities and international standard-setting bodies as they work toward developing strong regulatory, supervisory and other financial sector policies. 

The FSB has set out a road map for reform, which we and others in the industry are following very closely. The FSB is currently consulting publicly on potential money market reforms and will publish final recommendations for national financial authorities in October. Additionally, as contributors to the FSB work, national financial authorities have already undertaken preparatory initiatives in respect of their local jurisdictions. For instance, in the US, the President’s Working Group on Financial Markets published a report in December last year providing options for policy reform in the money market fund space. 

The European Securities and Markets Authority (ESMA) recently consulted on the effectiveness of the European Union’s money market fund regulation ahead of a planned review in 2022. Finally, the Bank of England and the Financial Conduct Authority recently published the conclusions of a joint survey into the resilience of open-ended funds more broadly, including some proposals to strengthen the regulatory framework governing money market funds. Given the significant international focus on progressing money market fund reforms, we are engaging with the regulatory community globally on an ongoing basis, ensuring that in each discussion the interests of our clients are represented at each level of the policy debate.

Michael: We view potential money market fund reforms in four distinct categories. The first is the operation and structure of liquidity buffers. For example, policy makers are considering removing the regulatory tie between portfolio liquidity and the potential application of fees and gates. There is a view that this tie can incentivize investors to pre-emptively redeem their positions if money market funds move toward the liquidity buffer threshold. We would support the removal of this tie. 

The second area of potential money market reform relates to product changes. One proposal being discussed is requiring money market funds to adopt a floating net asset value (NAV) structure, versus a constant NAV, to remove perceived regulatory “bright lines” for investors – such as the liquidity buffer – and to reduce a perceived “first-mover advantage” for investors seeking to redeem at par during periods of market stress. Policymakers are also considering the potential effectiveness of introducing measures such as swing pricing or imposing a “minimum balance at risk” policy on money market funds that would prevent a small fraction of an investors’ balance from being redeemed immediately. However, we question whether reforming the structure of money market funds in these ways would directly address the fundamental underlying market liquidity issues that Laurie described. 

The third area of reform that policy makers and regulators are considering are bank-like reforms, such as introducing an additional capital buffer in addition to existing liquidity buffers  within funds, or mandating membership in a liquidity exchange bank. We suggest policy makers reconsider the appropriateness of applying bank-like reforms to money market funds, not only because money market funds are not banks, but because they could undermine the vital role money market funds play in channeling liquidity to the real economy. Such reforms could further constrain fund operations in an already challenging, low interest rate environment. 

Finally, policy makers are taking a closer look at rules governing external or “sponsor” support. In the European Union, regulators are considering whether existing rules should be strengthened to ensure that the prohibition of sponsor support is absolutely clear, while in the US, policy makers are considering introducing a framework governing sponsor support to clarify the risks borne by money market funds and their sponsors. 

From our perspective, proposals that make the rules clearer and more robust in this regard are always welcome. Looking ahead, beyond the clear need for international cooperation in the area of money market reform, what is most important for us is that policy makers take a holistic approach to reviewing how short-term money markets operate, including underlying financial market infrastructures, rather than seeing another round of money market fund reform as a solution to all of the issues faced in the market last year. We very much look forward to continuing to contribute to the debate in this regard, as policy makers bring forward concrete proposals for reform in the coming months.

Marques Mercier: At the June Federal Open Market Committee (FOMC) meeting, the Fed appropriately increased the administered rates of Interest on Excess Reserves (IOER) and the Fed Reverse Repurchase Program (RRP) by five basis points each, to 15 basis points and five basis points, respectively. This was done to mitigate the downward pressure on short-term interest rates created by the supply-demand imbalance resulting from the high demand for short-term US Treasury bills amid dwindling bill supply. 

The steep decline in Treasury bill supply combined with faster growth in the supply of reserves caused overnight rates to trade at the lower bound of the federal funds target range of 0.0%. Usage of the RRP, which is an effective tool to help keep the effective federal funds rate from falling below the target range set by the FOMC, soared to an all-time high level of participation at the end of June. Eligible counterparties utilized the Fed facility to invest over quarter-end, which is typical during periods when supply in the funding markets is limited due to dealer balance sheet management. 

After the FOMC’s adjustment to the administered rates (IOER and RRP), overnight tri-party Treasury repurchase rates traded on average at 0.05%, maintaining a tight spread to the Fed’s lower bound on the back of heightened demand from money market funds. The surge in government money market fund assets in the first half of 2021 has contributed to excess demand of short-term US Treasuries. The technical adjustment by the FOMC was very helpful in preventing the threat of a sustained negative Treasury bill curve and in supporting overnight funding rates across the money fund industry above 0.0%. We are optimistic that the US debt ceiling resolution will occur before extraordinary measures are exhausted and we anticipate that net positive Treasury bill supply in the fourth quarter of this year will help further stabilize short-term interest rates.