The money market fund market is a central part of the US economy — Americans have roughly $5 trillion invested in money market funds (MMF). The Securities and Exchange Commission (SEC) proposes new regulations to prevent investors from fleeing MMF instruments during financial crises such as the recessions in 2008 and 2020. Interest rates were set to near zero, leading to concern that many money market funds would “break the buck” and persistently dip below $1 net asset value (NAV). As a result, these funds could not meet redemption requests. Although many retail primes and tax-exempt money market funds experienced declining market based prices in March 2020, only one retail tax-exempt fund reported a price below $0.9975.
Nevertheless, fears of declining NAV led to heavy redemptions by investors. When this occurred, many funds were forced to liquidate, and the Federal Reserve (FED) was forced to backstop the funds to prevent financial collapse. Special facilities created by the FED slowed outflows from vulnerable funds. These effects exposed the fragility of money market funds under stress and provoked the SEC to revaluate its regulations on the market.
Money market funds aren’t regulated like deposits at banks and therefore are at higher risk for runs. After the 2008 crisis, the SEC created new rules to tighten the amount and type of securities that could be invested by imposing new credit quality, maturity, and liquidity standards and increasing the transparency of these funds. These “liquidity buffers” ensured that funds could endure high redemptions while the market became illiquid. The total assets in money market funds increased after this regulation was implemented, possibly because the market became much less risky after the new law. Prime Money Market Funds dropped significantly, and government funds expanded. Currently, Prime and Tax-exempt funds represent about 20% of the total funds; these two types of funds experienced significant outflows at the start of the pandemic in March 2020.
Total Investments of US Money Market Funds
Sources: SEC Form N-MFP2, OFR Analysis, Accessed at https://www.financialresearch.gov/money-market-funds/us-mmfs-investments-by-fund-category/
New rules proposed would prevent runs by investors on the most-vulnerable money-market funds — prime and tax-exempt money-market funds — and thus strengthen the resiliency of the funds. So, after substantial reform following the 2008 crisis, why do we need additional reform? SEC Chairman Gary Gensler says that despite robust reform, there is evidence that investors made a “dash for cash” at the beginning of the pandemic, which disrupts the money market funds markets requiring the federal reserve to step in. The proposed amendments would increase liquidity requirements, remove provisions that permit or require a money market fund to impose liquidity fees or to suspend redemptions when a fund’s liquidity gets too low, and require institutional prime and institutional tax-exempt money market funds to implement swing pricing policies. Further, the proposal would increase the transparency of the funds.
Net Flows from Prime and Government Money Market Funds and Funding Market Spreads
What risks will the new regulations mitigate? The issue in the money market fund today is that when there is a crisis, investors’ demand for cash skyrockets. Money market funds meet this redemption by selling the most liquid assets. This leaves the funds holding only their least liquid assets. Under current regulation, the price of the shares in the fund doesn’t reflect the associated costs with less liquid assets as they lose value in a recession. The last investor to redeem shares will lose money as their shares become significantly diluted. Thus, investors are incentivized to be the first to redeem shares with the current regime. To correct this adverse incentive, the SEC proposes that share prices be adjusted by a swing factor when they have net redemptions. The factor would take into account associated transaction costs and the market price of selling a part of the funds that represent the liquidity ratio of the profile, rather than just the most liquid assets. Who Benefits from these changes? Swing pricing benefits the investors who do not redeem their shares and ensures that the price of shares more accurately represents the value. Who is harmed by the changes? Daily pricing is costly to asset managers and potentially impossible. The main attraction for using money market funds to that investors can withdraw cash at any time. Swing pricing would add barriers to withdraw by requiring some redeeming investors to pay the liquidity costs of their redemptions.
Swing pricing mitigates first-mover advantage risk in funds and incentives investors to slow down and spread-out redemptions to reduce transaction costs. However, swing pricing does not address investors’ tendency to pre-emptively take advantage of changing market conditions such as those at the start of the pandemic. In such cases, other anti-dilution measures should be considered. Swing pricing is somewhat automated, but it requires oversight of asset managers and regulators. Therefore, to get effective pricing, SEC should steer away from mandating specific swing pricing models less they create inefficiencies in the market.
Other proposals include increasing the share of assets that are cash equivalents or mature within one day or a week significantly. In addition, the SEC is considering repealing legislation put in place after 2008 that enabled money market funds to impose fees or temporarily suspend redemptions if liquidity was drying up. This initially was set to prevent runs on money market funds, but evidence suggests that this led investors to pull out when weekly-liquid assets approached 30% — the threshold when funds can start suspension. Indeed, there is evidence that this threshold contributed to heavy redemptions in the 2020 recession as outflows increased significantly when funds approached 30% weekly asset liquidity. So, it is possible that fees and gates exacerbated runs on non-government funds.
The events in the money market fund market in March of 2020 prove that fund’s structure is inadequate to protect investors from runs on non-government funds. Investors’ redemption requests skyrocketed despite the drought of the liquidity in underlying assets. This behavior put the money market under significant stress, and without intervention from the FED, could have caused an economic collapse. Removing previous gates and fees that proved ineffective is a critical step in the right direction by the SEC. However, further protection and prevention are required.
Is swing pricing the most effective solution? Swing pricing effectively reduces redemptions in a crisis and helps funds better retain capital. On the other hand, swing pricing is costly and complicated to implement. It also takes away crucial attractive features of money-market funds, such as withdrawing funds quickly and easily. A less-costly alternative is partial swing pricing, such as mandating asset managers to estimate the daily net flow and apply a swing factor if above/below a threshold. Another pricing solution could be using dual pricing so that there is one price for buying shares and one for selling if redemption.
All in all, the current regime of banking and money markets only works if the FED is the lender of last resort. Runs in the money-market fund are possible and, under economic stress, runs almost guaranteed to occur because of the structure of the funds. Swing pricing and other alternative pricing measures effectively prevent heavy outflows in times of financial stress but make funds less attractive by adding barriers to withdrawal in booms. A non-pricing solution to mitigate this risk would be to let asset managers have an option to slow down redemptions through fees or suspension when they suspect a fear-based run. However, managers have no way of parsing out speculative requests from fundamental needs for cash would be a way to know. One suggestion for prevention could be to let shareholders pay a fee to prioritize redemption or keep normal shares. If a run occurred, the return from the priority accounts would be higher than the normal, and vis-versa if no run occurred. Thus, if enough investors opted into priority accounts, this would signal a run, and asset managers could act accordingly to slow redemptions.
References
Anadu, K., & Sanders, S. (2021). Money Market Mutual Funds: Runs, Emergency Liquidity Facilities, and Potential Reforms. Emergency Liquidity Facilities, and Potential Reforms
BlackRock (2021). Policy Spotlight: Swing pricing – Raising the Bar. https://www.blackrock.com/corporate/literature/whitepaper/spotlight-swing-pricing-raising-the-bar-september-2021.pdf
Haltom, R., & Sultanum, B. (2018). Preventing Bank Runs. Richmond Federal Reserve Bank, https://www.richmondfed.org//media/RichmondFedOrg/publications/research/economic_brief/2018/pdf/eb_18-03.pdf
Kashyap, A., Kohn, D., & Wessel, D. (2021) What is Swing Pricing. Brookings Institute, https://www.brookings.edu/blog/up-front/2021/08/03/what-is-swing-pricing/
Kiernan, Paul (2021). SEC Floats Rules to Shore up Money Markets, Curb Insider Trading. The Wall Street Journal, https://www.wsj.com/articles/sec-floats-money-market-fund-rules-to-deter-investor-runs-11639579017.
Money Market Fund Statistics (2021). Form N-MFP Data, period ending July 2021. Securities and Exchange Commission, https://www.sec.gov/files/mmf-statistics-2021-07.pdf.
Securities And Exchange Commission (2021). Proposed Rule: Money Market Fund Reforms. Release No. IC-34441; File No. S7-22-21. https://www.sec.gov/rules/proposed/2021/ic-34441.pdf
