An agenda for the Federal Reserve’s review of its monetary policy framework


An agenda for the Federal Reserve’s review of its monetary policy framework



US money market reforms: The gain isn’t worth the pain

SEC seal

Next month the new rules of the Securities and Exchange Commission (SEC) will become effective for money market funds (MM funds).

Most importantly, MM funds with any assets from institutional shareholders – e.g., corporations, pension plans and insurance companies – will no longer maintain a constant net asset value per share of $1. Instead, the net asset value of institutional MM funds will fluctuate on a daily basis – for example, 99.8 cents per share on one day, and $1.01 per share on the next.

The new SEC rules apply to institutional MM funds investing in short-term debt of cities and states – called “municipal” MM funds. The new rules also apply to institutional MM funds investing primarily in short-term debt of banks and top-rated companies – called “prime” MM funds.

However, the new rules do not apply to institutional “government “ funds — investing almost all their assets in short-term debt issued by the US Treasury or federal agencies, loans backed by such debt or cash.

The prospect of these SEC rules has already led to billions of institutional assets moving out of municipal MM funds and prime MM funds into government MM funds.

As a result, the interest rates on the short-term borrowings (90 days or less ) of most banks, top rated companies, state and city governments have risen sharply. Will these hikes in borrowing costs be outweighed by the putative benefits of these rules – reducing the potential for systemic risk from institutional MM funds?

Here’s the background.

Historically, the SEC allowed all types of money market funds generally to maintain a net asset value of $1 per share through a series of accounting interpretations. This constant price of $1 per share appealed to investors and helped the institutional MM industry grow to close to $2tn in assets.

However, during the financial crisis of 2008, the net asset value of one institutional Prime MM fund dropped below $1 per share ( “broke the buck”) because of its losses on Lehman paper. In the month or so after this event, institutional investors heavily redeemed their shares not only of this MM fund but also of other prime MM Funds.

In response, the SEC decided that the shares of institutional prime and municipal MM funds should always trade at prices reflecting their precise current value, rather than a constant value of $1 per share. The SEC also directed the boards of all institutional and retail MM funds, except for Government MM funds, to impose liquidity fees or temporary gates if these funds were low on cash and heavy on shareholder redemptions.

In anticipation of these SEC rules, the assets of institutional prime MM funds dropped from $875bn at the end of 2015 to $511bn at the end of last month. At the same time, the assets of institutional Municipal MM funds dropped from $70bn to $33bn. By contrast, the assets of institutional Government MM funds rose from $875bn to $1.25tn in the same time period.

What are the implications of these huge shifts in assets of institutional MM funds?

First, there has been a sharp spike in the costs of short-term borrowings by US banks—which are typically based on LIBOR ( the London Interbank Offered Rate ). The three-month dollar rate for LIBOR rose to 0.8 per cent in August, 2016 from 0.3 per cent a year before. Higher borrowing rates for banks mean in turn higher rates charged by banks to their loan customers.

Second, the costs of short-term borrowing by highly rated non-financial companies such as Alcoa or IBM tripled in less than one year. The average interest rate on 60-day commercial paper issued by AA-rated non-financial companies was 0.13 per cent in 2015 versus 0.41 per cent in 2016 to date, according to the Federal Reserve.

Third, the short-term funding costs of cities and states have spiked with the big decline in institutional Municipal MM funds. For example, Idaho’s short-term borrowing rates for $500mn in seasonal advances to school districts climbed from 0.29 per cent to 0.72 per cent in June of this year – costing the state an incremental $2m.

While the SEC recognised that its rules would lead to somewhat increased borrowing costs, it believed that these were justified by the reduced systemic risks of moving institutional MM funds from constant to variable net asset values (NAVs).

Yet, between the summers of 2007 and 2008, assets of French MM funds that already had variable pricing plunged by over 60 per cent. An EU study by HSBC concluded that “we cannot find any evidence for the argument that there are substantial differences … ..which cause constant NAV funds to be more prone to run risk than variable NAV funds.”

So in 2017, the SEC should re-consider its new rules on institutional MM funds in light of the actual rise in borrowing costs for banks, companies and local governments as well as the actual impact of variable NAVs on redemption rates by institutions.

Pozen was executive chairman of MFS Investment Management and, before 2002, served in various positions at Fidelity Investments. Fidelity manages a large array of money market mutual funds. He did not receive financial support from any firm or person for this article, and he currently is not an officer, director or board member of any organization with an interest in this piece.