Money market funds have seen significant changes in recent years – and more is to come. Following the introduction of regulatory reforms prompted by the financial crisis, the volatility caused by the onset of the COVID-19 pandemic has once again triggered calls for change, with various proposals currently under consideration. At the same time, money market funds are facing additional challenges as a result of continuing low interest rates – and the growing focus on incorporating ESG into the investment process is also shaping the development of the sector. With that in mind, let’s take a closer look at how money markets have fared during the crisis, and the factors that are likely to affect the direction of travel going forward.
From regulatory reform to a ‘dash for cash’
Regulatory change has long been a theme in the world of money market funds. In the US, the 2008-2009 financial crisis saw the Reserve Primary Fund ‘breaking the buck’, with the resulting run on money market funds prompting significant regulatory change. In Europe, the focus of money market fund reform included replacing constant net asset value (CNAV) funds with low volatility net asset value (LVNAV) funds. In the US, meanwhile, CNAV funds were required to move to a variable net asset value (VNAV) model. In addition, both sides of the Atlantic introduced the ability to impose liquidity fees and redemption gates if liquidity falls below a certain threshold.
These measures were intended to make money market funds more robust in the event of another crisis – a goal that was severely tested in early 2020, when the beginning of the pandemic brought considerable volatility. The US saw outflows of US$125bn from prime MMFs in March 2020, which prompted the Fed to step in with the creation of the Money Market Mutual Fund Liquidity Facility (MMLF). European funds, likewise, experienced significant outflow pressures.
Laurie Brignac, Chief Investment Officer and Head of Invesco Global Liquidity, recalls the uncertainty that arose during the critical timeframe from February to the end of April 2020: “As economies began shutting down, we saw a ‘dash for cash’ as people and corporations sought to hold as much cash as possible amid the uncertainty that reigned at that time.”
Initially, says Brignac, “we were wondering if we would see large inflows into money market funds since they are generally the ‘flight to quality’ vehicle of choice for many investors. By the time we started seeing outflows from money market funds and they sought to raise additional liquidity, dealer balance sheets were already quite clogged with other securities. It was a very tough time.” Following central bank interventions, she adds, “markets did start to function more normally as they gained confidence that the central banks stood ready to provide support as needed.”
Gauging the next steps
In the wake of these challenges, regulators are once again reviewing existing money market fund regulations to explore whether further action is needed. For one thing, concerns have been raised that some of the measures introduced by recent reforms may have had unintended consequences, particularly the use of redemption gates and liquidity fees to prevent redemptions if weekly liquid assets (WLA) fall below 30% of the fund’s total assets. Preliminary research published by the Fed suggested that “the expectation that other investors will withdraw money and drive WLA below the 30% threshold may incentivise them to run pre-emptively before such liquidity restrictions are imposed.”
In December, the President’s Working Group on Financial Markets in the US released a report on money market funds, exploring the impact of the crisis and setting out potential reform options – albeit without endorsing any particular course of action. The Financial Stability Board (FSB) published a consultation report in June 2021, while the European Securities and Markets Authority (ESMA) ran a consultation between 26th March and 30th June 2021 looking at potential areas of reform.
The types of reform under discussion are wide ranging. According to Invesco’s Brignac, potential money market reforms fall into four distinct categories:
The operation and structure of liquidity buffers. “For example, policy makers are considering removing the regulatory tie between portfolio liquidity and the potential application of fees and gates,” says Brignac.
Product changes. Brignac notes that one proposal under discussion is “requiring money market funds to adopt a floating net asset value (NAV) structure, versus a constant NAV, to remove perceived regulatory ‘bright lines’ for investors – such as the liquidity buffer – and to reduce a perceived ‘first-mover advantage’ for investors seeking to redeem at par during periods of market stress.”
Bank-like reforms. This could include introducing an additional capital buffer alongside existing liquidity buffers within funds, or mandating membership in a liquidity exchange bank. “We suggest policy makers reconsider the appropriateness of applying bank-like reforms to money market funds, not only because money market funds are not banks, but because they could undermine the vital role money market funds play in channelling liquidity to the real economy,” comments Brignac.
Sponsor support. Brignac says that in the EU, regulators are considering whether existing rules should be strengthened to ensure the prohibition of sponsor support is absolutely clear – “while in the US, policy makers are considering introducing a framework governing sponsor support to clarify the risks borne by money market funds and their sponsors.”
Whichever types of reform are ultimately chosen, it seems likely that money market funds will once again see significant changes in the coming years – and as Aidan Shevlin, Head International Liquidity Fund Management at J.P. Morgan Asset Management notes, any period of change will create uncertainty. “Tighter guidelines should improve liquidity and security, but will also likely impact returns,” he comments. “Meanwhile, any accounting changes will require internal adjustments to accommodate.”
Low interest rates
Regulatory reform is not the only factor currently weighing on money market funds. Another challenge is the continuing issue of low interest rates, particularly given the high levels of cash currently held by many companies. “Following the outbreak of COVID-19, most companies significantly increased their cash balances,” says Jonathan Curry, Global CIO Liquidity at HSBC Asset Management. “While some sectors have had to use portions of that cash, many others continue to hold balances that are much higher than their previous levels.”
Low interest rates continue to present another challenge for investors when it comes to earning a return on that cash. “Globally, central banks have pinned base rates at record lows while markets are awash with liquidity, further depressing market driven yields,” comments Shevlin. “Returns on many money-market instruments remain close to zero (in the US, UK, Australia, etc) or below zero (in the EU). Meanwhile, banks and financial institutions, caught between excess liquidity and tighter rules, are reluctant to accept additional time deposits.” Shevlin notes that this has created significant challenges for corporate treasurers, who are still seeking to invest higher than average cash balances.
Against this backdrop, Curry says he has seen increased interest from corporate treasurers for ultra-short duration fixed income investment strategies that take limited interest rate and credit risk to improve yield. “These strategies can be a useful tool for corporate treasurers in a range of global currencies, but it’s important to ensure that an investor weighs the risks against the opportunity for increased return,” he observes.
Shevlin adds that a combination of diversification and step out strategies “should allow corporate treasurers to get fully invested and achieve a more competitive yield, while retaining a focus on security and liquidity.” He also emphasises the value of good cash forecasting, which can allow cash to be segmented into operating, reserve and strategic cash categories – “allowing for different investment strategies to increase returns without significantly expanding risk.”
MMFs and ESG
Beyond the impact of the COVID-19 crisis and the challenges associated with a low interest rate environment, a further factor affecting the development of money market funds is the growing focus on ESG and sustainability. As HSBC Asset Management’s Curry observes: “We have seen a sharp increase in interest from corporate treasurers seeking to align their investment activities with their company’s sustainability objectives.”
A number of factors are driving this focus on ESG and sustainability, as Shevlin points out. “ESG considerations have rapidly emerged as a crucial challenge, especially as extreme weather events and the growing importance of equality have heightened consumers’ and companies’ awareness of these issues,” he comments. “This implies that ESG factors are an increasingly important part of investing and the due diligence process.”
As such, Shevlin says that treasurers are progressively seeking to incorporate ESG into their cash management and liquidity fund selection process. “Regulators and central banks are also considering incorporating these factors, with the EU setting early standards through the introduction of SFDR Article 6 and 8 funds classification system, while the European Central Bank is planning to establish ESG rules and is tilting its purchases towards green investments,” he adds. “Across Asia, local regulators are also debating how to include and improve environment standards, with Hong Kong, Singapore and Taiwan all recently announcing ESG-related rules.”
In this environment, Shevlin says a key focus for investors should be on understanding how ESG is incorporated into credit analysis and the security selection process. “If the credit analyst believes that the ESG factors are material and may impact issuer risks, the analysis will be reflected in the analyst’s credit opinion,” he says. “The ability to incorporate this analysis into the investment process and portfolio implementation is also important.”
The way forward?
There’s no doubt that the crisis has brought some additional challenges for money market funds – and with regulatory reform once again on the horizon, treasurers will need to be prepared for any future changes. In the meantime, money market funds still fulfil a valuable function for treasurers seeking to manage their short-term investments. As Curry points out, “Money market funds continued to play an important role in helping companies around the world manage these elevated cash balances through challenging economic and interest rate environments in 2020 and 2021.”