September 26, 2022

Ready by Michael Grill, Luis Molestina Vivar, Christian Mücke, Charles O’Donnell, Seán O’Sullivan, Michael Wedow, Moritz Weis and Christian Weistroffer

This text assesses proposed reforms to the Cash Market Funds (MMF) Regulation[1] to boost the resilience of the sector. Particularly, the article gives a rationale for requiring non-public debt MMFs to carry increased ranges of liquid belongings, of which a component must be public debt, and considers the design and calibration of such a requirement. The article additionally proposes that the impediments to the usage of liquidity buffers must be eliminated and authorities ought to have a job in releasing these buffers. Lastly, whereas the removing of a secure internet asset worth (NAV) for low-volatility MMFs would scale back cliff results, we argue that this may not be needed if liquidity necessities for these non-public debt MMFs are sufficiently strengthened.

1 Introduction

MMFs fulfil a twin financial perform, specifically liquidity administration for buyers and the supply of short-term funding for monetary establishments, non-financial firms and governments. MMFs carry out a central perform for the monetary system by bringing collectively the demand for and provide of short-term funding. By investing in a portfolio of short-term debt and providing each day liquidity, MMFs allow buyers to retailer liquidity and handle their money wants, whereas on the similar time they contribute to the short-term financing of banks and different firms within the wider financial system.

This twin financial perform could make non-public debt MMFs susceptible below confused market circumstances, and the related systemic danger was highlighted through the coronavirus (COVID‑19) market turmoil in March 2020. Following the onset of the COVID‑19 disaster in Europe in early 2020, private debt MMFs skilled vital outflows ensuing from liquidity pressures, flight-to-safety issues, and varied different components (see, for instance, Capotă et al., 2021; ESMA, 2021).[2] These MMFs got here below stress and needed to cut back their holdings of personal debt belongings, compromising their means to concurrently present money administration companies to buyers and short-term funding to banks and non-financial firms (NFCs). These dangers have been examined and documented by the Monetary Stability Board (FSB) in its suggestions on MMFs and have been mentioned within the Eurosystem’s response to the European Securities and Markets Authority (ESMA) session on the regulatory framework for MMFs within the EU.[3]

This text assesses doable MMF reform proposals to boost the resilience of MMFs by focusing on liquidity mismatch and makes the case for a compulsory public debt quota alongside different measures. The article highlights the necessity for personal debt MMFs to strengthen their liquidity place, together with by means of the introduction of a public debt buffer. The article additionally discusses the function authorities ought to play in the usage of liquidity administration instruments and the discharge of liquidity buffers. Lastly, the article considers whether or not the secure NAV for low-volatility internet asset worth (LVNAV) funds must be eliminated.

2 Liquidity necessities and the inclusion of a compulsory public debt quota

Non-public debt MMFs proved notably susceptible through the COVID-19 market turmoil in March 2020 as a result of liquidity mismatch between their belongings and liabilities. Throughout the disaster, these MMFs skilled exceptionally massive outflows and confronted difficulties in elevating money at brief discover. Throughout regular occasions, MMFs can depend on maturing belongings to handle liquidity and meet investor redemptions. During times of stress, nonetheless, they might be susceptible owing to the disparity between the comparatively low market liquidity of lots of their belongings and the power of buyers to redeem MMF shares every day. Specifically, when attempting to satisfy massive redemptions, MMFs might face extreme difficulties in off-loading business paper (CP) and certificates of deposits (CDs), for which there’s little to no secondary market buying and selling.

MMFs’ reluctance to attract down their weekly liquid asset (WLA) holdings in March 2020 contributed to a disorderly unwinding of their positions in much less liquid belongings, comparable to financial institution CDs. Fund managers might have tried to keep away from giving destructive alerts probably related to a discount of liquidity buffers for worry of triggering additional outflows. The ensuing dislocations in cash markets created dangers for the graceful transmission of financial coverage and the financing of the actual financial system, and required distinctive central financial institution interventions to avert much more extreme stress and contagion.[4] These central financial institution interventions helped to revive the functioning of key market segments, comparable to monetary and non-financial CP, thereby stopping a procyclical tightening of financing circumstances, whereas additionally serving to to ease liquidity tensions for MMFs.[5]

Increased and extra usable liquidity buffers, together with a part of public debt holdings, could be notably efficient in lowering dangers related to liquidity mismatch in non-public debt MMFs. To protect the money administration perform of MMFs, it will be significant that MMFs can cope with massive and sudden outflows below stress. Making certain that liquidity buffers are usable in a disaster is useful on this respect.[6] On the similar time, given the low market liquidity of most non-public debt belongings and the comparatively lengthy lead time of weekly maturing belongings, you will need to diversify liquidity sources alongside eradicating impediments to the usage of liquidity buffers. Requiring MMFs to carry public debt is thus extremely complementary to current liquidity necessities, provided that public debt usually has excessive market liquidity even when it isn’t about to mature.

A compulsory public debt holding would assist to diversify liquidity sources past the idea of weekly maturing belongings. A minimal share of public debt as a part of the broader liquidity buffer would assist to make sure that MMFs have a broader vary of liquidity sources at their disposal to satisfy elevated redemption requests. Provided that public debt markets are considerably extra liquid and deeper than CP and CD markets, funds would be capable of promote public debt extra simply and with a cheaper price impression in nearly all circumstances, together with in periods of stress.[7] Because of this, relying on the kind of shock and market circumstances, fund managers would be capable of draw on a broader vary of belongings to satisfy redemption requests, slightly than counting on proceeds from maturing belongings or promoting different non-public debt belongings. The weighted common maturities of funds wouldn’t be altered, as the present necessities could be maintained.[8]

The calibration of a public debt requirement wants to contemplate doable prices and constraints, whereas aiming to strengthen the resilience of MMFs. The calibration of a minimal public debt quota must be excessive sufficient to extend MMFs’ total liquidity buffers, however not so excessive that it might have an extreme footprint in underlying public debt markets or unduly cut back MMF returns. It is usually essential that such a quota is necessary, since MMFs’ (voluntarily held) public debt holdings presently are inclined to fluctuate over time, as seen after the March 2020 market turmoil when fund managers in non-public debt MMFs first elevated their public debt holdings after which lowered them once more. A compulsory quota would assist be sure that non-public debt funds have ample shock-absorbing capability to satisfy massive and sudden outflows below a variety of various stresses, thereby considerably enhancing MMF resilience.

The emergence of a brand new stress channel between MMFs and sovereigns can be unlikely for a number of causes. First, there is no such thing as a bail-out expectation for MMFs and due to this fact no market notion of contingent liabilities for sovereigns. Second, there’s proof that MMFs presently maintain diversified sovereign debt portfolios centered on probably the most liquid issuers, limiting their publicity to emphasize in anybody nation. Lastly, the MMF footprint in short-term public debt markets would solely improve by a small quantity and stay comparatively contained. Given the excessive liquidity of public debt in most circumstances, there ought to, due to this fact, not usually be a major value impression when MMFs get rid of belongings in an episode of stress.

Desk 1 reveals a instructed calibration which might improve the liquidity necessities of each VNAV and LVNAV MMFs relative to current necessities within the EU.[9] Underneath the proposed calibration, liquidity could be strengthened each by rising WLA from present minimums and by introducing a compulsory public debt requirement.[10] Given their secure worth, it’s applicable to demand increased liquidity from LVNAV funds than from different non-public debt MMFs. This could assist help the function of LVNAV funds as a money administration car and low-volatility different to different kinds of non-public debt MMFs. The proposed ranges for LVNAV funds in Desk 1 are primarily based on the presumption that their secure worth is maintained. If the secure NAV have been to be eliminated, it might be essential to evaluate whether or not a brand new low-volatility NAV class could be wanted alongside different kinds of VNAV funds.

Desk 1

Potential calibration for total liquidity


Notes: The proposed ranges for LVNAV presume that the secure worth won’t be eliminated.

3 The function of authorities within the launch of liquidity buffers and the usage of liquidity administration instruments

Authorities ought to have a job in releasing liquidity buffers and supply steering on the sufficient time for rebuilding them. Such an method might assist to cut back authorized uncertainty and additional nudge fund managers to make use of their buffers if wanted. Three key ideas ought to govern the method to a releasable buffer. First, doable impediments to the usage of buffers must be minimised and asset managers must be inspired to make use of the buffers if wanted. Second, the discharge of buffers must be utilized on the sector degree, i.e. by fund sort and foreign money. The discharge of buffers must be thought of in a market-wide occasion with doable systemic implications, however not on a fund-by-fund foundation to keep away from stigma results. Third, to restrict market fragmentation, ESMA ought to have a robust function in coordinating the motion of nationwide competent authorities once they use their powers to launch buffers.

Whereas liquidity administration instruments may be helpful in lowering first-mover benefit, you will need to be sure that no new cliff results or impediments to the usability of liquidity buffers are created. The implementation of liquidity administration instruments, comparable to swing pricing and anti-dilution levies, may result in new threshold results in which there’s uncertainty surrounding the purpose of implementation and whether or not that is initiated by the fund supervisor or by the competent authority.[11] If linked to the breach of sure liquidity thresholds, this might additionally impair the usability of liquidity buffers. Instruments may additionally improve redemption prices in occasions of stress, which may incentivise buyers to attempt to redeem MMF shares prematurely of the instruments being activated, successfully exacerbating slightly than eradicating the first-mover benefit for buyers.

To maintain fund managers’ incentives aligned with prudent liquidity danger administration, authorities shouldn’t have a job in requiring the usage of liquidity administration instruments. Nevertheless, they may have a job in offering steering on their design and use. Specifically, ESMA must be given a mandate to develop steering on the standards set out by the European Fee on facilitating the overall use of liquidity administration instruments in all market circumstances. The standards also needs to cowl the usage of gates and suspensions.

4 Concerns on eradicating secure NAVs for LVNAV funds

Eradicating the secure worth for LVNAV funds might complement reforms to enhance funds’ liquidity danger profiles. The March 2020 market turmoil highlighted specific vulnerabilities in LVNAV funds, as these funds confronted elevated outflows and buyers turned involved a few breach of the collar across the secure worth.[12] The removing of the secure worth from LVNAV funds would benefit from absolutely eliminating unintended cliff results associated to doable transformations from LVNAV to VNAV funds in durations of stress. Moreover, a variable share value would additionally replicate the underlying asset worth extra precisely, lowering first-mover benefits related to a decline in asset values. Nevertheless, imposing a variable NAV doesn’t deal with vulnerabilities related to liquidity mismatches in non-public debt MMFs extra usually. The removing of the secure NAV of LVNAV funds might thus not be needed, supplied there’s a substantial enchancment within the liquidity danger profile of those funds.

Any removing of the secure NAV of LVNAV MMFs must be a part of a complete package deal aimed toward lowering liquidity dangers in non-public debt MMFs extra broadly.[13] MMF holdings of personal sector debt proved notably susceptible through the interval of market turmoil. This posed a danger to each variable and secure NAV MMFs. Due to this fact, whereas eradicating the secure worth pricing for LVNAV funds might cut back some danger, this measure in isolation wouldn’t be an alternative choice to tackling liquidity dangers by way of enhanced liquidity necessities and better usability of buffers.[14]

5 Conclusion

MMF vulnerabilities must be focused by means of increased ranges of liquid asset holdings, together with a compulsory public debt requirement, and improved usability of liquidity buffers. This text has advocated the introduction of each a compulsory public debt requirement and elevated WLA necessities to boost the shock-absorbing capability of MMFs. As well as, the article additionally means that liquidity buffers should be made extra usable and that authorities ought to have a job in directing their use. However the deployment of liquidity administration instruments ought to stay the duty of fund managers in managing their liquidity place. This package deal of measures ought to considerably improve the resilience of the MMF sector to future shocks and thereby cut back systemic danger. The upcoming assessment of the MMF Regulation by the Fee will current a chance to implement such proposals to the advantage of each the sector and monetary stability.


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