The global outbreak of COVID-19 in March triggered the deepest and most sudden economic downturn since World War II. As financial markets tumbled, fear and a precipitous decline in economic activity unleashed a dash for cash.
This dash for cash created significant strains in the short-term markets, as well as major movements in money market funds (MMFs). The balance of US dollar government MMFs — a safe haven for cash — surged by $862 billion during March. On the other hand, USD institutional prime funds experienced heavy redemptions and extraordinary net asset value (NAV) moves, despite credit fundamentals that remained strong. (In Europe, USD low-volatility NAV funds also saw significant outflows and NAV movements; for an analysis, see COVID-19 and the Future of LVNAV Funds).
Figure 1 : Total Government MMF AUM
During the heightened market volatility, two large US MMF sponsors purchased assets from their funds to provide support, and since March three others have closed their prime funds. These events have caused a buzz, leading market participants to ask, what is the future of the 50-year-old prime fund industry? Regulators are posing questions as well. In September, Securities and Exchange Commission Chairman Jay Clayton said, “There’s no doubt that we need to re-examine the  reforms,” which established the provisions that came under stress in March.
In this paper, we review the COVID-era volatility and discuss lessons drawn from it. We also address possible modifications that regulators may consider. In summary, we believe that these events were an important test of post-Global Financial Crisis (GFC) money market reforms. While in some ways the reforms made prime funds fairer and safer, in others they appear to have fueled a destabilizing feedback loop, or even induced investor panic, potentially justifying further adjustments to the reforms.
Heavy US Dollar Fund Outflows
The outflows from USD institutional prime MMFs were sudden and deep, albeit short-lived. For the first two weeks of March, these funds experienced modest net increases in assets.
Then for the week ending March 18, assets under management (AUM) dropped by about 20% ($66 billion), followed by another 12% ($30 billion) the week ending March 25. The following week AUM remained stable, and for the seven weeks thereafter, AUM increased by approximately 2–6% each week. Overall, institutional prime AUM dropped by $96 in March, compared to $354 billion during September 2008, the worst month of the GFC.
Figure 2 : Institutional Prime MMF AUM
Unlike during the GFC, the COVID-19 era rush to redeem was not driven by any real credit risk to the underlying assets. During the March COVID-19 downturn, banks’ capital reserves were strong, and short-term credit conditions for other prime-fund counterparties (such as highly rated corporations) had not materially changed. Despite the sudden downturn across the financial markets, the risk of default in short-term assets held by prime funds remained very remote. Moreover, in accordance with the requirement to hold at least 30% in weekly liquidity and 10% in daily liquidity, all 41 institutional prime funds were able to meet redemption demands. The two sponsors that provided liquidity to their funds did so not necessarily to meet redemptions, but rather to ensure that fund liquidity remained well above the regulatory thresholds. In fact, during March, weekly liquid assets (WLA) in institutional prime MMFs was higher by about 5%, at roughly 45% WLA on average.
What triggered the sharp outflows? It appears that there were two main causes. First, we believe that many investors were driven by legacy fear and memories of the GFC, regardless of the varying factors between the two events. The fact that redemptions in US dollar funds were far higher than in other currencies supports this view.
Second, investors were concerned over the liquidity requirements and what that might mean for potential gates or fees. As background, since 2016 institutional prime funds have had the option to impose liquidity fees and gates should WLA fall below 30%. The 30% threshold was intended to provide a significant buffer to ensure that funds could meet redemptions, even under extraordinary pressure. By making the gates and fees optional, they are best seen as precautionary — not a solid guard rail that would be damaging if struck, but more akin to a line of cones providing a wide safety buffer adjacent to the guard rail.
Given how important it is for institutional investors to be able to access cash, portfolio managers have been careful to keep liquidity far from that line of cones — typically above 40%. A prime fund with 40% weekly liquidity would be prepared to redeem 40% of its AUM with ease, simply by allowing certain assets to mature and/or by selling highly liquid treasury assets.
Figure 3 : Weekly MMF Liquidity
But amid stronger-than-usual redemptions, WLA levels in a handful of funds dropped to the 30–35% range (Figure 3). Strained conditions in the short-term markets — particularly in selling commercial deposits (CDs) and commercial paper — made it challenging, if not impossible, for portfolio managers to sell assets and raise liquidity. Once funds dropped below 35% weekly liquidity, investors took note. Many received automated emails from institutional money fund portals, alerting them when a fund had breached 35%. As word spread, some saw the 30% weekly liquidity level not as a guard rail or line of cones, but rather as a third rail. These investors redeemed en masse, prompting others to do the same.
Redemptions were much larger in certain funds. When redemptions peaked on March 18, funds with between 30% and 35% weekly liquidity saw outflows totaling 10% of AUM, twice the rate of funds holding weekly liquidity over 35%. Finally, the redemptions began to ease when the Federal Reserve established a range of emergency lending facilities, including the Money Market Mutual Fund Liquidity Facility (MMLF), which enabled MMFs to sell eligible assets to the Fed, effectively relieving the tightness in the short-term market.2
A key takeaway from this episode is that despite the strong redemptions, the funds satisfied investors’ liquidity, needs. Of 41 funds, only one breached the 30% weekly liquidity level. It did so for only one day, falling to 27.4% weekly liquidity. The funds whose liquidity had fallen below 35% still held ample liquidity — 33% on average, totaling nearly $23 billion — and no funds exercised the option to impose gates or fees. Instead, they were able to handle the redemption activity and maintain liquidity levels. The bottom
line: the 30% liquidity buffer may have helped keep the funds liquid, but the
threat of gates and fees appeared to have fueled redemptions. It is evident
the intention of the rule was counterproductive, and raises the question of
whether liquidity gates and redemption fees should be decoupled from required liquidity levels.
Another key takeaway concerns floating NAVs, a required feature of institutional prime funds since October 2016. Floating NAVs were implemented to counteract asset runs fueled by a “stealing of liquidity,” where worried investors rush to redeem before prices fall, unduly stressing funds and penalizing those who remain. During March 2020, some funds lost more than 20 basis points (bps) (although they may have started from elevated levels, above 1.0000). Some dropped by as much as 10bps in a single day (e.g. 1.0000 to 0.9990).
Figure 4: Institutional Prime MMF Net Asset Value
Investors who redeemed shares under these conditions did so at a loss. If they had held their investments, they would not have incurred these losses, as all funds’ NAVs recovered or even surpassed early March levels within a month or two. In other words, in March institutional prime funds’ floating NAVs essentially worked as intended, reversing the traditional firstmover advantage of asset runs. The declining NAVs penalized those who sold, rather than those who recognized that credit conditions remained sound and held their shares.
Lastly, we must consider the role the Fed’s Money Market Liquidity Facility played in stabilizing prime money market fund outflows. The facility absorbed approximately one third of the total prime MMF outflows (~$50 billion of ~$150 billion) and was seen as critical tool in stabilizing market conditions. Although this program was one of over a dozen programs the Fed launched during this period of stress, the direct benefit it had on US registered prime MMFs cannot be underestimated.
Looking back at March 2020 we ask: what were the key drivers and causes behind the prime money market fund turmoil? There are two main issues for regulators and market participants to consider. First, to what extent did the prime MMF liquidity rules drive redemptions? We concur with the view expressed by the Investment Company Institute (ICI) — which conducted an in-depth analysis of the volatility, showing that prime funds held ample liquidity to meet investor redemptions and that fear of gates and fees played a pivotal role in driving outflows.3
Second, what should (or will) be done to address this? We don’t expect regulators to soften the liquidity rule. After all, despite the volatility it could be argued that the rule effectively ensured that funds could meet redemptions. A response could be for regulators to examine the liquidity conditions in the front end of the market and ask, why was it so hard to sell commercial paper and CDs during this period? Why did the whole fixed income market see such poor liquidity? Addressing these questions could solve the broader challenges that forced the Fed not only to backstop MMFs, but also to unleash massive quantitative easing.
Aside from that, there are several options for further de-risking of prime funds that are under consideration. Durations could be shortened from the current limits (60 days weighted average maturity and 120 days weighted average life). The liquidity requirements could be boosted above 10% daily liquidity and 30% weekly liquidity, perhaps to 20% and 40%, respectively. A minimum proportion of US Treasury Bills could be required. Or fund sponsors could be required to provide capital to supplement liquidity during a crisis.
While the merits of these options should be further examined, a more pertinent consideration should be how to enable MMFs to draw upon their liquidity to manage shareholder activity in times of stress. As the rule is written, when an MMF’s WLA drops below 30% the fund’s board must consider the option of imposing a gate or fee; investors face no immediate threat of restricted access to their cash. Yet the March events suggest that if WLA drops below 35% or 30%, investors believe the likelihood of a gate or fee rises dramatically, driving them to exit the fund. This resulted in the counterintuitive outcome whereby a fund effectively could not utilize its liquidity.
Many of these ideas have been considered in the past, and will likely be considered again. But how much is too much before the regulators should eliminate prime funds altogether? Our view is that despite the turmoil and the investor perception regarding gates and fees, the March events demonstrated that the new measures in place since 2016 helped although there is clearly scope for making improvements.
Prime money market funds serve a key function in the economy. They offer a yield enhancement over government money market funds while providing the safety and liquidity needed for cash investments. They also create demand for short-term funding for banks and corporations that rely on such funding. They will and should continue to facilitate this function. Although prime MMFs faced liquidity management challenges during the March 2020 market crisis, the previous decade’s reforms, while imperfect, helped make them more liquid. Regulators will need to consider the unintended consequences of these reforms and determine how they can be improved. This presents an opportunity for regulators and market participants to cooperate in further improving the industry.
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