Bank of England Governor Andrew Bailey spoke yesterday on "Taking our second chance to make MMFs more resilient," at a virtual meeting of ISDA, the International Swaps and Derivatives Association. Bailey says, "You may be relieved to hear that I am not going to talk about Libor today.... Instead, I am going to speak about another important part of our current work and a priority for the global Financial Stability Board (FSB), namely Money Market Funds (MMFs). The FSB analysed last March's so-called 'dash for cash' in their 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 we saw in that episode.... MMFs were one of the issues at the top of that list. MMFs also played a role in amplifying the stress we saw during the Global Financial Crisis, so this is the second time they have proven not to be sufficiently resilient. I plan, therefore, to set out my views today on the reforms required to solve these issues. We are committed to working with others internationally, through the FSB, to avoid history repeating itself yet again." (Note: Register here for our next webinar, "Handicapping Money Fund Reforms," next Thursday, May 20, from 2-3pm EDT.)
The speech, which likely won't go over well with U.S. investors and money fund providers, gives some background and lessons from March 2020, then discusses "Reforms to make MMFs more resilient." Bailey explains, "It is clear from experience that money market funds as currently structured may often be perceived as cash-like, but cannot make good on this expectation in a sufficiently wide range of market conditions, and so can contribute to stress in short-term funding markets. The objective must be to improve the resilience and functioning of MMFs to protect the stability of the financial system. In doing so, it is also important to recognise that the reforms after the financial crisis did not tackle this issue conclusively. I should note that the remaining vulnerabilities in non-bank finance are perhaps the exception, as on the whole the post-crisis reforms have left a financial system that has stood up well to the acute stress of the Covid period."
He continues, "In order to create a framework for reforms, it is important to set out clearly the principles that should shape the changes. The following principles -- while not intended as prescriptive rules – are I think helpful in this respect: [1] As a general principle for all funds -- investment and money market -- redemption terms should be aligned with the underlying liquidity of assets. [2] 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. [3] Money market funds should not hold less liquid assets on a scale that would make them more suitable to be traditional investment funds. [4] Money market funds should not be designed with regulatory thresholds or cliff-edges which create adverse incentives and amplify first-mover advantage behaviour. [5] Reforms should improve the ability of funds to support short-term funding markets, including by making them more resilient."
Bailey elaborates, "These principles may sound obvious; indeed, I hope they do. But I would emphasise that they are not obvious in the sense that the current landscape is some way from meeting these principles. I think there are three big picture changes which follow from these principles, and should form the basis of the necessary reforms. I will set out each of them, and then discuss the issues that arise from them."
He says, "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."
He continues, "Money-market funds are a cash management instrument, so it may seem odd that the meaning of cash-like as a term has not been well defined. The resultant ambiguity may have seemed convenient as a means to stretch the boundary of the definition to allow less liquid instruments in, but when a stress event like the dash for cash happens, the flaw is badly exposed and financial stability is in jeopardy. The authorities then have to intervene in scale to restore well-functioning markets, but that should not be the accepted way to run the system."
Bailey asks, "So, what reforms are required to establish money market funds as cash-like without ambiguity? The first thing to say is that no single reform will solve things on its own. We must identify a coherent package of reforms that address the current vulnerabilities in the money market fund sector. It is easiest to describe three broad approaches to illustrate the potential options available that could deliver this objective. These are intentionally somewhat stylistic, to draw out the trade-offs we face in addressing these issues."
He speculates, "First, at one extreme, asset holdings could be limited to government instruments. Given the low risk and liquid nature of these instruments, run risk would be materially reduced. The existing size of the sterling T-bill and gilt repo markets may, however, limit the extent to which this solution would be achievable in sufficient scale to meet the needs of sterling investors, at least in the near term. And this would of course also have significant implications for the funding of banks."
Bailey explains, "Second, at the other extreme, the liquidity mismatch could be removed by making funds non-daily dealing -- i.e. not cash on demand. This would require a term notice period. Such a fund would be somewhat like a term deposit with no break clause. This would fundamentally change the potential uses for which MMFs could be held, and so would also have repercussions for the demand for other instruments, such as bank deposits, the implications of which would require further consideration."
He says, "Third, there may be a middle option whereby a combination of measures are used to reduce the risks to a sufficiently low level. We have a menu of options to choose from. For instance, a limit could be introduced on the percentage of assets a money market fund could hold in non-government instruments, to reduce the holding of less liquid assets. This could be combined with making sure funds are structured as variable net asset value, albeit with this asset mix the variability of the value in the fund should be lessened. And we would need to ensure the absence of regulatory cliff-edges, so that funds could be more confident to release their cash buffers in times of stress to meet withdrawals. Run risk would be reduced but not eliminated, and it would be more likely that in a stress funds could sell a so-called vertical (representative) slice of their assets. This is important for an agency-form collective investment structure. There may though still be some first mover advantage to exit in this structure, so great care would be needed to design it in a way which doesn't fall foul of the familiar issues missed by the post financial crisis reforms."
The Governor adds, "Each of the three options I have just outlined may not be mutually exclusive. Properly differentiated, there may be a role for funds of each of these types, to suit the needs of the diverse set of existing MMF investors. We may end up with some MMFs becoming more cash-like and some less cash-like, but we need to avoid the muddy middle."
Finally, Bailey tells the ISDA gathering, "In conclusion, we are very much in the world of having a second chance to deal with the issue of how to structure money market funds consistent with their role. The FSB will shortly be consulting on what reforms would be most appropriate. 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. 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."
