Global regulatory bodies have confirmed that a review of money market fund (MMF) regulation is underway – and there could be changes. Regulatory change could be material to the sector. However, at Fitch Ratings we don’t expect changes to be imminent: the last set of regulatory changes were implemented in 2016, eight years after the 2008 financial crisis. The Financial Stability Board (FSB) has indicated that it expects to make regulatory proposals by the end of 2021, and the scheduled five-year review of European MMF regulation is due in 2022. This means that there should be time to adapt.
The FSB stated on 17 November that it will “make policy proposals, in light of the March experience, to enhance MMF resilience including with respect to the underlying short-term funding markets”. Specifically, it identifies “liquidity risks, core functions and aspects of the structure or regulations in non-government MMFs which experienced large outflows” as areas for investigation. The International Organization of Securities Commissions (IOSCO) added on 20 November, that it will review “the broader ecosystem and the functioning of the money markets”.
Market stress in March 2020 was acute, with significant redemptions from funds, material price volatility and severe limitations on MMFs’ ability to sell securities. Institutional prime funds in the US and US dollar-denominated low-volatility net asset value (LVNAV) MMFs in Europe experienced the most stress. No MMF suspended redemptions in 2020, however, unlike in 2008.
We believe there are four primary areas of potential regulatory attention, although we cannot predict the probability of regulatory change, nor which particular proposal (if any) is likely to be adopted:
- Outright bans: The effect of an outright regulatory ban on the types of MMF that experienced more acute stress in March 2020, from Fitch’s perspective, would be limited – we would withdraw ratings as funds closed. A ban on some fund types could reduce the amount of short-term wholesale funding MMFs provide to banks, corporations and other entities. It would also reduce the cash investment choices currently available to investors.
- Fees and gates: Regulatory changes that decreased the likelihood of an MMF applying a fee or gate would help stabilise ratings, by reducing the ‘cliff risk’ effect of the imposition of a fee or gate on ratings. A recent Securities and Exchange Commission (SEC) study found that outflows increased as MMFs approached weekly liquidity trigger points even though regulatory requirements and precedents show that a gate or fee is neither required nor automatic if a trigger point is hit.
- Increased liquidity requirements: Objective minimum liquidity requirements increase MMFs’ resilience, all else equal. Increased minimum regulatory liquidity requirements could also increase rating headroom at a given rating level. That said, certain MMFs’ preference in March 2020 to sell longer-dated assets rather than to use available weekly liquidity assets, for fear of adverse investor reaction, shows that these buffers are not functioning entirely as intended. Regulators may therefore consider increases to minimum liquidity requirements, particularly in connection with trigger points for fees and gates.
- Changes to fund structures: European LVNAV MMFs can offer stable pricing to investors provided the fund’s mark-to-market (MTM) NAV remains within 20bp of 1.0000 (or equivalent stable NAV point). We believe that a breach of the lower bound of the LVNAV MMF collar would further exacerbate redemptions. However, this outcome is untested and therefore unknown. If the breach did cause further redemptions, redemption pressure would increase at a time at which the fund was already under stress. Any regulatory change that materially increased the likelihood that funds could breach a NAV collar is therefore likely to result in heightened downside rating sensitivity for in-scope funds, because of the potential for such events triggering significant redemptions.
While these potential changes could affect MMFs themselves, there are also market structure dynamics which can affect MMFs. Both IOSCO and the FSB have pointed to a broader review of the functioning of the short-term markets. Materially reduced commercial paper liquidity in March 2020 constrained MMFs’ trading ability. In particular, issuers and dealers were unwilling, or unable, to buy back commercial paper at fair value. Restrictions on their ability to execute trades exacerbated stress in MMFs.
Accordingly, any market structure changes that improve the incentives for dealers to continue intermediating in short-term markets during stress periods could be beneficial for secondary market liquidity as well as for MMFs’ ability to sell securities, if needed, to meet redemption requests. These developments, if realised, would be relevant to Fitch’s rating analysis because we rate MMFs according to their ability to both preserve principal and provide timely liquidity.
- FSB: Holistic Review of the March Market Turmoil, 17 November 2020
- IOSCO: Money Market Funds during the March-April Episode, 20 November 2020
- SEC: U.S. Credit Markets – Interconnectedness and the Effects of the COVID-19 Economic Shock, October 2020