Boutique cash manager Capital Advisors Group published a paper entitled, "The New Money Fund Reality," which discusses changes in the money market environment over the past five years since Money Fund Reform was passed in 2014. The "Abstract" explains, "The 2014 money market fund reform brought forth drastic change to the corporate cash management landscape, significantly impacting investors, issuers and fund sponsors. While there is little doubt that money market funds are more resilient following the implementation of the reform's higher credit, liquidity, transparency, and oversight standards, it also had some unanticipated side-effects."
It continues, "Changes in the utility of MMFs, particularly prime funds, and concurrent changes in investor perceptions of these instruments, led to a large-scale migration in assets from prime to government funds. Resulting changes in the demand dynamics of the short-term debt markets may have had unintended consequences for fund manager incentives. Three years after the reform's implementation, we believe it is worthwhile to evaluate the reform's regulatory outcomes against the backdrop of its original intentions. Following the recent completion of the European Union's MMF reform, the opportunity to compare and contrast differences in outcomes can also add value to the discussion -- especially given the two regulators' differing approaches. While there is strong evidence that the reform hit close to its mark, we note that there may still be room for improvement."
Capital Advisors' "Introduction" tells us, "Money market funds, since their inception, have provided investors with a deposit-like option for parking idle cash. Through careful risk management and the use of book value accounting, they aimed to offer a dollar-in dollar-out utility to investors at market rates. But the financial crisis of 2008 and the collapse of Lehman Brothers demonstrated that this model was unsustainable. Investor panic following the Reserve Primary Fund 'breaking the buck' led to collective runs on prime money market funds (MMFs) which disrupted the short-term funding markets and risked impacting the rest of the financial system. The severity of the shock necessitated government intervention to contain the panic and return short-term markets to operation. This experience spurred calls for regulatory reform to fortify the MMF industry."
It says, "The SEC enacted its first round of reforms in 2010, where it pushed MMFs to increase transparency, reduce the average maturity of their holdings and boost liquidity. While this improved the risk profile of prime MMF portfolios, the European sovereign debt crisis that soon followed showed that significant run risk was still present. US MMFs with European bank exposures experienced substantial outflows, which in turn impacted short-term funding conditions. This indicated that the recently implemented reforms had missed their mark."
The paper explains, "In 2014, the SEC announced changes to the original 2010 reforms that went on to more radically change the face of the MMF industry. Notably, in seeking to reduce run incentives for investors during periods of stress, this reform changed the deposit-like nature of prime and municipal MMFs by introducing a variable NAV (net asset value) and the possibility of redemption limitations should certain liquidity barriers be breached. In this paper, we examine how the new 2a-7 reform has impacted the money market landscape, focusing on prime MMFs which were most heavily affected. We review recent literature and evaluate the extent to which the reform has been successful in meeting regulators' goals of safer portfolios with a lower probability of runs. We then briefly compare and contrast the outcomes of the US MMF reform with those of its European counterpart and conclude with a look at current challenges facing cash investors."
CAG Research Analyst Spyros Qendro writes, "Prime funds have long served as a reliable source of short-term funding for corporations. The large asset migration from prime to government during the implementation period of the MMF reform presented a funding challenge for short-term borrowers, as demand shifted from the private sector to government and government-sponsored issuers. Market participants expressed concerns over potential spikes in funding costs from short-term volatility, as well as longer-term funding availability due to the structural change in the market.... However, these concerns were somewhat overblown."
He comments, "The European approach to MMF reform provides an interesting point for comparison of policy impacts on the state of the industry. Formally concluded on March 21st, the reform carries some similarities to its US counterpart in terms of higher liquidity requirements and the potential imposition of fees and gates on withdrawals, though the EU version requires that be the case for constant net asset value (CNAV) funds also. The reform also contains some differences, such as the explicit prohibition of external support for MMFs."
The piece states, "Perhaps most notably, it spelled the creation of a third type of MMF, the limited variability NAV (LVNAV) fund, which acts as a compromise between the variable NAV (VNAV) and constant NAV (CNAV) funds of the US. LVNAV funds maintain a stable share-value as long as the underlying NAV is within a 0.20% band of their currency unit. On the other hand, if the NAV breaks that band, the fund converts to a variable NAV. This implies that LVNAV funds would behave as CNAV funds in a low volatility environment but could convert to VNAV funds during periods of stress. The similarity of this vehicle to the previous status quo for prime funds in Europe has been viewed positively by investors. Following the reform, the majority of prime assets ... landed in LVNAV funds."
It tells us, "In this environment, flows appear to have been driven by perceived confidence in managers' ability to maintain the LVNAV fund's CNAV-like utility. As such, there are management incentives to ensure the funds remain within the 0.20% band that enables them to resemble CNAV funds.... The retention of prime MMFs deposit-like utility through the LVNAV vehicle prevented the type of outflows seen in the US. At the same time, LVNAV portfolios can be expected to be safer than the pre-reform CNAV prime funds from a credit and liquidity standpoint.... [H]ow it performs during periods of market stress remains to be seen. It is not impossible that given the popularity of LVNAV funds, a period of market stress could result in lumpy flows and potential funding disruption at a time when it would be least desirable."
Capital Advisors also writes, "While the dust following the reform's implementation has mostly settled, the new money fund landscape has yet to be tested. To add to the observations made in the previous sections of this paper, we see certain risks on the horizon that may present challenges for cash investors."
They state, "The MMF reform has by design raised the importance of due diligence for cash investors. By decreasing the deposit-likeness of prime MMFs, there are now fewer options for capturing market yields while also limiting the risk of principal losses. For prime investors, credit research and monitoring needs are now greater, given the closer link between portfolio quality and value preservation. Investing in prime funds today requires greater research capabilities, which may not be available to all investors.... While government funds have retained their utility as sweep vehicles for overnight liquidity, the reform's stricter maturity and liquidity requirements have also limited their yield advantage over bank deposits. In this context, direct purchases or separately managed accounts (SMAs) can be a viable option for investors seeking solutions customized to their risk and return goals. By managing a portfolio to an individual mandate, investors can outsource credit research costs while achieving individualized liquidity and retaining the opportunity to exploit market inefficiencies."
The paper concludes, "In this whitepaper, we examined some of the second order effects of the 2016 money fund reform, its overall impact on funding markets, how it compares to its European counterpart, and the extent to which it met regulators' goals of improving industry resilience. We reviewed research showing that the introduction of fees and gates and a floating NAV changed investors' perception of prime MMFs, creating incentives for fund managers to take on more credit risk. The asset migration from prime to government, combined with the rise in demand for riskier assets, resulted in changes in the demand dynamics of short-term funding markets which were mitigated by greater involvement of the FHLB system and offshore funds in funding intermediation. This outcome increases the dependency of large domestic financial institutions on FHLB's status and creates some sensitivity for highly rated domestic corporations to foreign operating environments."
It adds, "Lastly, we conclude that the US MMF reform of 2014 did indeed improve the resilience of the MMF industry by strengthening liquidity and making investors' exposure to fund portfolios explicit in the case of prime funds. However, the accompanying risk-taking incentives work counter to the reform's original intentions.... At the same time, changes to fund compensation structure to focus on creating and sustaining long-term sponsor shareholder value might be a step in the right direction. While the utility of MMFs has become less universal post-reform, cash investors may benefit from evaluating alternative cash management strategies that can better align with their liquidity needs, credit risk tolerance and yield requirements."
