Money market funds in the 21st century
Sept. 5, 2014
Below is the second in a series of articles on coming changes in monetary policy. Click here here here for Ion Dan’s earlier comments on the U.S. Federal Reserve’s path toward normalizing monetary policy.
As we continue to explore how monetary policy will be conducted in the years ahead, it is important to highlight current regulatory issues in money market funds and repo markets and how they interplay with interest rate normalizationinterest rate normalizationinterest rate normalization. (A repo, also known as a repurchase agreement, is an agreement in which a seller, having sold a security to a buyer, agrees to buy the security from said buyer at an agreed upon date and price.)
Starting with money market funds, we first look at asset flows over the last 25 years. Assets steadily grew throughout the 1990s during both easing and tightening cycles, reflecting an overall higher rate of return during that period. More recently, flows have been more responsive to the level of rates, with outflows occurring during easing cycles (2003 and 2008), and inflows during rate hikes (2004).
Source: Investment Company Institute and Bloomberg
This July, the SEC voted in favor of money fund reforms, which require institutional prime funds to float their net asset values (NAVs) and can impose redemption gates and liquidity fees. On the other hand, government money funds that invest in U.S. Treasurys and Agencies will be exempt.
Chart 2 shows a breakdown of money market fund assets. Of the total $2.5 trillion, about half is in government funds and the rest in prime funds. Of the latter, retail funds will be exempt but about two-thirds of those (roughly $850 billion) will be subject to floating NAV.
Chart 2: Money market fund assets are about evenly split between government and prime funds.
Gov't/Agency assets (all exempt)
Prime fund assets
Source: Investment Company Institute and Bloomberg
Over the near term, given negligible differences between yields on prime and government funds, asset-allocation flows should favor government funds and bank deposits. This implies less demand for commercial paper and non-traditional repo (the realm of prime funds), and a surge in demand for T-bills, agency discounts, and general collateral repo. This would be more relevant under a scenario in which the trend in money market fund flows observed during the 2004 cycle reoccurs.
It would reinforce bank liquidity and cause further dislocations in the repo markets, as government funds prefer repo loans to the Fed for counterparty and collateral availability. In our view, this is why the Fed is now trying to limit the scope of the reverse repo facility (RRF). However, if the size of the RRF is too small when the hiking cycle starts, the effective funds rate could trade below the RRF rate, putting the Fed’s credibility at risk.
It is important to also consider the implications of the new bank liquidity rules of Basel III.* Under the liquidity coverage ratio requirement (LCR), banks need a minimum of 100% of high-quality assets (cash and liquid assets) to meet expected cash outflows over a 30-day stressed scenario. In October 2013, the Fed staff estimated that shortfall at $200 billion.
We believe two potential scenarios could unfold:
- Outflows in prime funds favor banks in the form of corporate term deposits. This may:
- Limit inflows into exempt government funds and improve the liquidity profile of banks by increasing the LCR denominator.
- Satisfy the Fed as an effective macro prudential mechanism, shrinking the footprint of money market funds and moving banks to more stable/diversified funding.
- Outflows in prime funds favor exempt government funds. This may:
- Lead to further growth in exempt funds and increased demand for government securities.
- Put pressure on banks to meet LCR requirements by transforming asset mix and potentially lead to market dislocations that could complicate the Fed’s strategy.
A word on the repo markets
Next, we want to make a few comments on recent developments in the repo markets, where securities dealers source short-term funding, using their portfolio of securities as collateral in repurchase agreements with cash investors. This large and opaque market is a critical component that helps keep finance and trading moving, representing the largest source of borrowing for broker/dealers.
During the 2008 crisis, this market turned treacherous when mistrust led to the seizure of the market. The Fed had to backstop repo lending to prevent a systemic failure. The 2010 Dodd-Frank Act made it more difficult for the central bank to take similar actions in the future and along with Basel III international regulatory agreements addressed the systemic risk imposed by repo markets.
Under Basel III, beginning in 2015, large banks will be required to report supplementary leverage ratios (SLR). In July 2013, the Fed, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) released an enhanced supplementary leverage ratio, which required a tougher 5% minimum Tier 1 SLR for U.S. bank holding companies and a 6% minimum for insured depositories. Under SLR, a bank will be required to hold $5 or $6 of capital for every $100 of assets, independent of the riskiness of the asset. This lowers the return on leveraged capital for securities (especially repo, which is at the lower end of the return spectrum) and increases it for riskier investments such as loans.
More recently, some Fed officials suggested that the SEC should consider imposing higher capital requirements on broker/dealers that are not owned by banks and would not fall under the regulation of the Fed, further limiting the usage of short-term repo.
Source: Goldman Sachs Research
We believe banks will not wait until 2015 to begin implementation. Players have started reducing their footprint in repo markets, cutting back significantly in the first half of this year. The Fed’s introduction of the reverse repo facility and the money market reforms mentioned above should lead to further shrinking, in our opinion.
On a more micro level, it is important for us to highlight the impact on market liquidity. Until the most recent SLR proposal, banks' quarterly SLR was calculated as the average SLR at the end of the three months during the quarter. This in turn put pressure on the repo market at the end of each month as banks pulled back from the market, manifesting itself in higher costs, as repo rates on months’ ends have been higher on average than intramonth rates.
In May 2014, Goldman Sachs published a report calculating repo rates on the last day of the month, as a ratio of the average repo rate intramonth, showing a consistent pattern of higher repo rates at the end of months.
These spikes in month-end repo rates correspond with increased usage of the Fed’s facility around the same time, a sign of constrained liquidity.
Source: Goldman Sachs Research
As the repo market is constrained, the ability of dealers to warehouse inventory shrinks and liquidity suffers. Additionally, investors on the buy side that operate using leverage via the repo markets may also suffer, as their ability to obtain that leverage, store liquidity, and take short positions is diminished. This can lead to less liquid markets and wider bid-ask spreads, especially in times of stress.
The outcomes and market implications of recent regulation, and how we view these changes in light of the Fed normalizing rates, remain highly uncertain due to the complex relationship between all the moving parts. This cloudy picture continues to make the Fed’s exit a high-stakes balancing act. As we noted in our recent commentary recent commentary recent commentary on normalizing monetary policy, however, the risks that this process could present in the coming years further highlight the importance of the research-intensive, fundamental investment process that we undertake at Delaware Investments. We believe our rigorous security selection process can help us find suitable individual securities to make up a portfolio regardless of any potential market turbulence.
*Basel III is a set of regulatory measures devised by the Basel Committee on Banking Supervision, a committee established by the central banks of the Group of Ten countries. The measures aim to increase stability within financial markets, largely by improving the banking sector's ability to absorb shocks to global financial systems.
The views expressed represent the Manager's assessment of the market environment as of August 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
The Fund may also be subject to prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although money market funds seek to preserve the value of an investment at $1.00 per share, it is possible to lose money by investing in them.