COVID-19 highlights the limitations of Money Market Funds
The pandemic emergency outbreak, in March 2020, shed a light on some vulnerabilities of money market funds, which have experienced huge outflows and problems in selling their assets to meet investors’ demands. Fortunately, the measures put in place by the Central Banks, in order to support market liquidity, were efficient in controlling possible damage to the system and to investors.
For this reason, ESMA, The European Securities and Markets Authority, has organized a consultation on the matter, looking to assess three main points:
- The liquidity of money markets underlying investment funds
- The role of regulatory obligations
- The role of credit rating agencies in valuing MMFs
Point 1: Liquidity
Money Market Funds (MMFs) have a prime role in private monetary markets. They hold a large share of the outstanding monetary instruments. It is estimated that MMFs account for 50% of all Commercial Papers issued in Euros or Pounds. In February 2020, the sum of the exposures of the biggest MMFs of the United States, the Low Volatility NAV MMFs denominated in Dollars and Variable NAV MMFs, was one third of the whole Commercial Papers Market, a digit that reaches 80% if we consider Commercial Papers issued by financial institutions. This gives an idea of the market concentration.
At the same time, market activity for these instruments is really low, even in periods of calm. This is due to the fact that investors who buy these kinds of securities tend to keep them until the expiry date, resulting in a low level of trade and low liquidity. This resulted in low market absorption capacity in March 2020, when MMFs sold more than $50 billion of financial Commercial Papers, five times the amount of liquid reserves held by funds. Yields recorded an increase of up to 100 basis points.
European markets experienced this phenomenon as well, with an increase of 30 basis points in yields and €18 billion in refunds.
The last matter regarding liquidity is due to the similar issuer exposition of all MMFs. An ESMA study rolled out this year showed how the largest US and European Money Market Funds have overlapped exposures to the same big financial issuers. In times of selling, this results in all funds liquidating the same holdings in the market at the same time, resulting in great difficulty in selling and low liquidity.
Short-term financing markets showed a high degree of vulnerability, a factor that needs to be taken into consideration.
Point 2: Regulatory obligations
The regulatory framework imposes strict compliance on Low Volatility NAV MMFs. The funds have to maintain a Weekly Liquid Assets (WLAs) volume above 30% of the NAV and NAV volatility must be under 20 basis points. The market downturn of March 2020 highlighted how these limitations on Money Market Funds caused serious difficulties in satisfying all these requirements at the same time. By selling their most liquid assets, in order to meet investors refund demands, the WLAs would decrease, breaking the 30% limit. At the same time, funds that have a smaller amount of liquid assets could face a NAV change greater than 20 bps.
In a recent study, ESMA showed how by slightly modifying these requirements (allowing a NAV volatility up to 50bps instead of 20bps) could help MMFs increase their refund ability by 20%. Allowing a higher WLAs would instead provide a negligible benefit.
Another issue relates to fees and costs for requiring a refund in case of a violation of the 30% WLAs limit and an amount of daily requests superior to 10% of the fund assets. Many market operators think that this is an adequate rule, but the Covid crisis highlighted important evidence: institutional investors tend to ask for refunds when the amount of Weekly Liquid Assets gets near to the 30% barrier. This shows how the actual rule could create an incentive, in case of market stress, for institutional investors to exit their investment in order to avoid fees and barriers.
Point 3: Credit Rating Agencies role
Another problem comes from the MMFs habit of receiving a rating from Credit Rating Agencies. These ratings aren’t based on the overall credit rating of the securities held in their portfolio, but describes the ability of the MMFs to preserve capital and maintain a good level of liquidity.
60% of all MMFs in Europe have been assigned a credit rating by an agency. Many funds need this kind of rating as institutional investors have rules that mean they can only invest in MMFs rated by at least two Rating Agencies.
The issue is caused by the methodology behind credit rating attribution: many Credit Rating Agencies give a rating only if the MMF invests in instruments and issuers who have been previously rated by an agency. For this reason, MMFs are often forced to invest in instruments and issuers rated by the same agency. This produces a distortive effect; a rated MMF invests as much as 98% of its NAV in instruments that received a rating by the same rating agencies, while this percentage lowers to 65% for non-rated MMFs. This can cause problems due to the too concentrated market, when there are many refund requests.
For the reasons above, in the consultation ESMA proposes several modifications to the MMFs regulatory framework on which the authority asks for the opinion of the respondents. In particular, it aims to focus on the following points:
- Reforms regarding the liability side of MMFs:
i. Decoupling regulatory thresholds from suspensions/fees to limit liquidity stress
ii. Ask MMFs to use liquidity management tools such as “swing prices”, a technical tool where the operative burden of the refund strategy is translated to holders
- Reforms targeting the asset side of MMFs:
iii.Increasing the liquid reserve requirements, revising and recalibrating them
- Reforms that regard both sides of MMFs:
iv. Elimination of stable NAV MMFs or conversion of LVNAV and CNAV (Constant NAV) in Variable NAV Money Market Funds
In addition, ESMA aims at collecting respondents’ feedback on
- Modifications or specifications on rating standards of MMFs
- The strengthening stress test role for Money Market Funds
- Increasing harmonisation and importance of the regulatory framework about MMFs
- Creating a liquidity exchange facility, funded by MMFs or by their managers, in order to create a centralised source of liquidity/credit during stress periods. This could actually avoid refund and selling spirals for monetary activities.