Speaking at the ISDA 35th Annual General Meeting last week, Bank of England (BoE) governor Andrew Bailey explained how money market funds (MMFs) magnified some of the economic shocks caused by the Covid 19 pandemic. He also discussed the ways regulators around the world can coordinate to make MMFs more resilient in future.
Bailey noted that the global Financial Stability Board (FSB), had analysed last March’s so-called 'dash for cash' in its Holistic Review published at the end of last year, highlighting a number of vulnerabilities in non-bank finance and setting out some considerations for reforms required to tackle the issues that arose, with MMFs being one of the issues at the top of that list.
Background to the issues posed by MMFs
Following the credit crunch and global financial crisis of 2007-08, considerable work was undertaken to build the resilience of MMFs. In 2012 the International Organization of Securities Commissions (IOSCO) published policy recommendations for the regulation and management of MMFs.
"Many of the reforms that were subsequently implemented have helped improve the resilience of MMFs, however it is clear they did not go far enough in solving the underlying problems," Bailey said. "And in some cases they may have had unintended consequences, such as the introduction of a link between the level of illiquid assets held by a fund and the potential use of tools (such as fees or gates) to manage redemptions during periods of stress. While introduced to manage potentially disruptive outflows, these changes have made funds more sensitive to so-called cliff edge effects - thus increasing an incentive to exit before the gate closes."
Reflecting on the various kinds of investment funds, Bailey noted that most are not meant to be cash-like, in the sense that the promise is to return the fruits of the investment strategy, which may be more or less than the amount invested. Cash-like certainty of value is not part of the contract.
"There are at least two problems which are evident in how this system operates – or possibly two variants of the same problem," Bailey commented. "First, there are instruments which at least in some of their existing forms are neither one thing nor the other – neither properly cash-like nor properly investment-like. Second, there are instruments which are meant to be investment-like but which become regarded as cash-like."
He made the point that there are structural vulnerabilities in the financial system caused by both of these problems in the non-bank world. The dash for cash episode that occurred in March 2020 as a result of the global pandemic was the sort of stress event that nearly caused the problems to crystallise in a big way, and arguably would have done so but for the rapid intervention on a substantial scale by the authorities.
Lessons from the dash for cash episode
"The dash for cash was a broader financial system - and indeed economy wide - phenomenon, driven by the underlying health shock and its economic implications," Bailey pointed out. "Nonetheless, money market funds are an important part of the dash for cash story because they seek to bridge between the desire of investors for immediate liquidity (in other words a cash or deposit-like desire) and the desire of the banks, in which they invest a sizeable part of the funds, for term funding in the form of commercial paper or certificates of deposit. They are therefore carrying out a form of maturity transformation which in times of stress can become prone to runs."
In total, sterling money market funds saw outflows of around £25bn; or 10% of their total assets, in the eight days between 12th and 20th March last year. At first, the outflows were met by running down their holdings of cash, but as the outflows increased, they sought to liquidate some of their bank assets - CDs and CP. But they found that the market for those assets - which typically comes primarily from dealers buying back their own paper - was closed. The dash for cash meant that the tide was flowing fast against them.
As the regulatory system currently works, if MMFs’ liquid asset ratios fall towards prescribed thresholds, and they are unable to top up their liquid assets (cash) through sales, they are able to ‘gate’ or impose fees on investors, in other words decline to provide immediate liquidity. As with banks, the broader danger of this situation - which is a threat to financial stability - is that such a problem in one fund could trigger contagion to other funds, through fear that they might have the same problem, and thus lead to a highly destabilising run on money market funds. These thresholds can, therefore, also affect the behaviour of fund managers, making liquidity buffers not usable in times of stress, for fear this would fuel investors’ desire to run.
Another consequence of the rising demand for cash, and the failure to meet that demand by selling assets, was a sharp rise in money market rates. The rise was sharpest at longer money market-tenors, but there was also a pickup in overnight repo rates.
"This was a particularly serious sign of market dysfunction in what are core markets, and a serious challenge to our ability to implement monetary policy by keeping these rates broadly aligned to the official Bank Rate," explained Bailey. "It resulted in an increase in the cost and reduction in the availability of credit - to the financial system, other companies and households - precisely at the time they needed it most. There was therefore a serious threat to both monetary policy and financial stability, in other words both of the core purposes of a central bank. It was an existential moment."
The BoE took two actions which eased the pressure, and did so quickly. First, on 19 March, the Monetary Policy Committee (MPC) decided to buy gilts in large size and at high speed. At its peak the pace of gilt purchases reached £13.5bn per week, more than twice as fast as in early 2009. Bailey said that the use of this broad monetary policy tool was warranted given the widespread nature of the dash for cash, and the implications of the pandemic for the economic outlook. Other central banks took similar decisions around the same time. This helped to stabilise markets and reversed the dash for cash and thus the flows out of money market funds. Second, the BoE activated its Contingent Term Repo Facility on 24 March, committing to lend unlimited amounts of reserves at close to Bank Rate against a broad range of collateral. Taken together, these operations brought money market rates back to more normal levels. The Federal Reserve in the US also launched a specific liquidity facility aimed at easing the stresses in dollar denominated MMFs.
While these actions tackled the immediate problem, some serious issues that represent a threat to the stability of the financial system were revealed during the episode, which is why Bailey is pitching certain reforms aimed at making MMFs more resilient.
Reforms to make MMFs more resilient
The objective of the proposed reforms is to improve the resilience and functioning of MMFs to protect the stability of the financial system. The fact that this is happening little over a decade since the financial crisis points to the reforms that occurred after that event as failing to tackle this issue conclusively.
In his speech, Bailey set out the following five key principles that should shape the necessary changes to MMFs:
- As a general principle for all funds - investment and money market - redemption terms should be aligned with the underlying liquidity of assets.
- Where investors regard funds as cash-like, they should be made resilient so they can operate as such at all times, which means running minimal maturity mismatch risk.
- Money market funds should not hold less liquid assets on a scale that would make them more suitable to be traditional investment funds.
- Money market funds should not be designed with regulatory thresholds or cliff-edges which create adverse incentives and amplify first-mover advantage behaviour.
- Reforms should improve the ability of funds to support short-term funding markets, including by making them more resilient.
Bailey also outlined what he called three 'big picture changes' which follow from these principles, and should form the basis of the necessary reforms:
"First, we should remove the adverse incentives introduced by the liquidity thresholds related to the use of suspensions, gates and redemption fees. Second, we should simplify the landscape to make clearer the critical distinction between cash-like funds and investment funds. We should remove the ambiguity of intermediate descriptions such as low volatility funds. Third, and to support removing the ambiguity, it will be important to define in an accounting and substantive sense more explicitly what constitutes cash-like. Current guidance leaves a lot of judgement to managers and auditors to make these decisions on a fund by fund basis."
The FSB will shortly be consulting on what reforms would be most appropriate. Bailey noted that the Bank of England remains very supportive of the work being taken forward by the FSB and under the Italian G20 presidency.
"Given the cross-border nature of MMFs, it is important we work together internationally to ensure that we are aligned in our objectives, and adhering to common principles, even if the precise implementation varies a little to reflect the specific nature of each jurisdiction’s markets," Bailey concluded. "The dash for cash provided an unwelcome reminder that the post financial crisis did not finish the job and left a dangerous gap in our exposure to the risk of financial instability. We must finish the task this time."
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