Breaking the Buck and the Introduction of Greater Liquidity Requirements

Introduction

Money market funds (MMFs) are an important part of the European and global investment fund landscape and perform an essential role as a cash management and liquidity tool. They are a type of collective investment fund where households, corporate treasurers or insurance companies can obtain a relatively safe and short-term investment for surplus cash. They have preservation of capital and liquidity as their primary objectives.

However, during the 2008 financial crisis, their liquidity and stability was challenged. During this period, there were examples where MMFs were “breaking-the-buck” and could not always maintain their promise to redeem immediately and to preserve capital value. Breaking the buck is an American term which occurs when the net asset value (NAV) of a money market fund falls below $1. This may happen when the money market fund’s investment income does not cover operating expenses or investment losses.

Risks

The impact of MMF failings could trigger potentially broader macroeconomic consequences throughout the financial system, including:

The loss of investor confidence leads to substantial and sudden redemption requests;
The large redemption requests force MMFs to sell some of their investment assets in a declining market, exacerbating the problem;
Money market issuers then face severe funding difficulties if the markets for new issuance of commercial paper and other money market instruments dry up;
This leads to contagion within the short-term funding market;
This result in direct and major difficulties in the financing of financial institutions, corporations and governments, and thus the economy;
Panic could also spread into sponsors’ other businesses

Despite MMFs offering a low-risk investment, it must be remembered that they are not guaranteed or risk free. In the US, the Reserve Primary Fund broke the buck in 2008 when the fund had a $785 million allocation to short-term loans issued by Lehman Brothers which became worthless when Lehman filed for bankruptcy.

Closer to home, in the United Kingdom, Standard Life’s sterling money market fund suffered loss through investments in asset-backed securities linked to the mortgage market – it was reported that although this fund was advertised as a cash fund, it had less than a fifth of the fund invested in cash.

Recently, COVID-19 has put huge pressure on the liquidity of global financial markets, including the liquidity of money market funds. Money Market Funds usually hold their assets until maturity, however, due to the high level of redemption, funds had to sell their assets before maturity, which proved difficult due to the lack of buyers.

To combat this liquidity risk, on the 18th March, the U.S. Federal Reserve stepped in to aid the situation with the establishment of the Money Market Mutual Fund Liquidity Facility (MMLF). The MMLF provides loans to eligible financial institutions to purchase eligible securities from money market funds (MMFs). It was essential for the market’s health and allowed the money market funds to sell eligible securities maintaining liquidity.

Money Market Liquidity Requirements

Following the 2008 financial crisis, regulators in both the US and EU reassessed the systemic risk that MMFs had on the wider financial system.

US SEC Rule 2a-7

In the United States, money market funds are regulated under rule 2a-7 of the Investment Company Act of 1940. After the events of the 2008 financial crisis, in March 2010, the SEC adopted a number of amendments to rule 2a-7. The amendments were introduced to make MMFs more resilient and amongst other things, reduce liquidity risk.

The rules include provisions in respect of:

Portfolio Maturity
Portfolio Quality
Portfolio Diversification
Portfolio Liquidity
Portfolio Reporting
Periodic stress testing

EU MMF Regulations

Similarly, in the EU, the MMF Regulation, Regulation (EU) 2017/1131 introduces rules regarding the operation of MMFs, intended to make MMFs more resilient and to limit the risk of contagion.

The MMF Regulation includes a broad range of requirements which support liquidity, including requirements in relation to:

Classification of MMF as (i) Public Debt CNAV MMF, (ii) Low Volatility NAV (LVNAV) MMF or (iii) Variable NAV (VNAV) MMF
Eligible assets
Portfolio diversification
Liquidity
Credit quality assessment
Risk management
Valuation
An escalation process for the application of liquidity fees and gating mechanisms in the case of the Public Debt CNAV and LVNAV MMF
Prohibition on external support
Disclosures and new regulatory reporting obligations

Additionally, the MMF Regulation requires the MMF to have sound stress testing processes in place to identify possible events or future changes in economic conditions which could have unfavourable effects on the MMF. The Stress test scenarios shall at least take into consideration hypothetical:

Changes in the level of liquidity of the assets held
Changes in the level of credit risk of the assets (credit events and rating events)
Movements of the interest rates and exchange rates
Levels of redemption
Widening or narrowing of spreads among indices
Macro systemic shocks affecting the economy

The reporting obligations for MMFs are due to be submitted in September 2020 for both Q1 & Q2.

Our automated liquidity risk management solution is designed to meet international requirements in respect of liquidity risk management and liquidity stress testing. It is a holistic solution which embeds liquidity risk management into the product governance, throughout the product lifecycle. For EU MMF reporting our solution includes: