Investors at the gates: MMF reforms fail the Covid test

After MMF rescues return, regulators urged to rethink rules on gates and sponsor support

  • In March, the Federal Reserve was forced to set up an emergency liquidity facility for prime money market funds.
  • BNY Mellon and Goldman Sachs also purchased assets from affiliated funds to help them meet redemptions.
  • Reforms introduced in 2014 with the aim of preventing runs on prime MMFs may have contributed to the redemption pressure in March.
  • Market participants are now urging the Securities and Exchange Commission to eliminate gates and exit fees for prime MMFs. Some want the rules rewritten to encourage sponsor support.
  • One former regulator argues prime funds pose an inherent systemic risk and should be subject to prudential regulations, including bank-style capital requirements.
  • Others say prime funds should have access to clearly defined central bank support mechanisms.

In mid-March, as major US cities were being put on lockdown, the sponsors of some prime money market funds were desperately trying to avoid doing the same to investors.

Over the course of three days, from March 18 to 20, BNY Mellon and Goldman Sachs bought $4 billion of assets from MMFs overseen by their asset management arms, which were seeing heavy outflows. Such inter-affiliate bailouts face barriers under post-crisis rules. But this was done with the full blessing of regulators.

The US Federal Reserve and Securities and Exchange Commission eased rules on transactions with affiliates, giving banks the green light to provide liquidity support to their MMFs (see box: How regulators facilitated BNY and Goldman’s interventions)

The interventions were necessary in part because the Fed botched the roll-out of its money market mutual fund liquidity facility (MMLF) on March 18. The initial term sheet for the facility only authorised purchases of “unsecured commercial paper that is issued by a US issuer”. Prime MMFs – including the BNY and Goldman funds – mostly hold foreign commercial paper (CP).

Regulatory filings show the assets purchased by BNY Mellon and Goldman consisted entirely of CP issued by foreign banks. “Those types of securities that BNY and Goldman bought out of the funds’ portfolios were not eligible for the Fed’s facility at the time,” says Greg Fayvilevich, senior director and head of North American fund ratings at Fitch Ratings.

Within days, the inter-affiliate tango became largely irrelevant as the Fed came in with a full orchestra. On March 23, the MMLF was authorised to purchase a wider range of securities, including certificates of deposit and CP issued by the US branches of foreign banks. Banks’ exposures to the facility were also exempted from capital requirements.

“That was where the driver for the bottom of the market came from,” says a portfolio manager at one prime MMF. “The Fed facility gave any money market fund investor or portfolio manager the knowledge that there was liquidity in the marketplace being generated through the Fed programme. That liquidity gave confidence to the market.”

None of this, of course, was supposed to happen. After the run on the Reserve Primary Fund in 2008, the SEC introduced a raft of new rules in 2010 and 2014 that were designed to avoid a repeat. Far from solving the problem, the reforms may have exacerbated the run on prime MMFs in March and worsened dislocations in the short-term funding markets. The Fed’s heavy-handed intervention suggests prudential regulators have little faith in them.     

The Fed facility gave any money market fund investor or portfolio manager the knowledge that there was liquidity in the marketplace being generated through the Fed programme
Portfolio manager at one prime MMF

Many market participants now see the 2014 rules as unfinished business that the regulator must attend to. “After this is all over, the regulators need to go back and look at the 2014 rules and see whether they contributed to the solution or created a problem. I think it is incumbent on them to do that and to draw conclusions from that,” says a former official at the SEC’s investment management division.

More fundamental questions are also being asked about the systemic risks posed by prime MMFs and the private and public support mechanisms available to them. Some argue the onus should be on sponsors to backstop their funds and that the regulators should make it easier for them to do so. Others see a permanent role for the Fed as a liquidity provider of last resort for prime MMFs.

“Each time we get one of these crises, the sustainability of MMFs as MMFs – rather than as a deposit that the government has to guarantee and provide liquidity to through the Fed window – that tension manifests itself,” says the former SEC official.

Gate crashers

Much of the criticism of the SEC centres on changes the agency made to rule 2a-7 of the Investment Company Act in 2014. The reforms dealt with prime institutional MMFs, which invest in highly rated financial and non-financial CP, certificates of deposit and repurchase (repo) agreements. These daily dealing funds face heightened liquidity risks because their investors tend to have large, concentrated holdings.  

Since 2010, prime MMFs have had to report the level of assets that matured or could be easily sold within a week – essentially bonds issued by the Treasury or Federal agencies.

The final 2014 reforms required these funds to convert from fixed to floating net asset value (NAV) and to report assets daily at fair market value rather than at amortised cost. The move to floating NAVs was meant to eliminate the risk of these funds “breaking the buck” – the catalyst for the run on Reserve Primary in 2008.

But the 2014 rules went further, mandating fund boards to consider imposing redemption fees or gates if the weekly liquidity bucket dropped below 30%. This change was not included in a consultation a year earlier, and caught MMF managers by surprise.  

The effect of all these rules is to increase the tension and pressure on corporate treasurers to get funded every day
Thomas Deas, National Association of Corporate Treasurers

“Most of the industry didn’t think it was a good idea,” says Stephen Keen, a lawyer at Perkins Coie and former general counsel at Federated Investors, one of the largest managers of MMFs in the US. He calls it a “belt and suspenders” approach that was unnecessary. “There was no benefit to it.”

If a prime fund had a fixed NAV and valued its assets at amortised cost, the ability to temporarily gate investors might afford the manager the time needed to take out impaired assets, or to find a way to merge funds to maintain a stable NAV. “But if the fund is already floating in value, it is difficult to see what you would be doing,” says Keen.  

The Covid crisis revealed the downside of the 30% weekly threshold for gates and fees. As clients withdrew money, prime funds tried to sell longer-dated paper to keep their weekly liquidity buckets as large as possible. But when redemptions intensified, they were forced to eat into shorter-dated holdings, and the bucket began to shrink – falling below 30% for some prime MMFs (see figure 1).

 

 

The portfolio manager at the prime MMF says that far from reducing systemic liquidity risks, the 30% threshold has front-loaded them. “I am all for transparency, but investors started setting up automated reminders: please let me know when the fund gets below 35% weekly liquidity, then they run to a government money fund. But if everybody runs, it creates problems,” he says.

A research bulletin produced by three staff from the Bank for International Settlements (BIS) in May found cumulative outflows of more than $150 billion from US prime funds during March.

Even worse, the weekly liquidity rule may have added to the stress in short-term funding markets. As prime MMFs tried to stay above the 30% weekly liquidity threshold, their appetite for longer maturity paper fell sharply. This meant corporates were forced to roll over more of their CP funding at overnight tenors, when they would have preferred something longer.

“The effect of all these rules is to increase the tension and pressure on corporate treasurers to get funded every day. It has forced them to have shorter and shorter maturities – I think just in March, 90% of the CP [issued] was less than a week. The maturities have come in, it just makes the fuse that much shorter,” says Thomas Deas, chairman of the National Association of Corporate Treasurers.

Dalia Blass
Dalia Blass

Little wonder then that some are now calling for the SEC to completely rethink the 30% weekly liquidity threshold for gates and fees. Members of the SEC’s asset management advisory committee (Amac) urged a review of that element of the rules at a meeting on May 27.

“What we have done in investors’ minds is replace the old notion of ‘breaking the buck’ with a new tripwire in the market that seemed to be an issue that concerned a lot of investors,” Joseph Lynagh, a fund manager at T. Rowe Price, told the Amac meeting. “If you went back to 2008, if you had 30% of your fund in liquid assets, you would have been very happy. Yet in this new environment, it’s a cause for concern on the part of managers.”

The SEC declined to comment for this article.

At the Amac meeting, Dalia Blass, head of the SEC’s investment management division, acknowledged Lynagh’s point but also noted his observation that funds were holding more liquid assets as a result of the 30% threshold – and were therefore safer.

“Is there a pro and a con that should be balanced out?” Blass asked.

Sponsored runs

The events of March have also revived the debate about the systemic risk posed by prime MMFs and the merits of sponsors providing liquidity support for their affiliates’ funds – which in turn fund the operations of other banks. 

Jill Fisch, a professor of business law at the University of Pennsylvania, wrote a paper in 2015 arguing that far from being discouraged, sponsor support for MMFs should be encouraged or even enforced. Today, she says regulators have “underappreciated the value of having a viable and incentivised sponsor who would be willing to step in.”

“The SEC has been pro-active in stepping up to provide no-action relief. But it seems kind of odd that you have to ask for permission, when this seems like a very practical way of dealing with a short-term liquidity issue,” says Fisch.

Scott Bauguess
Scott Bauguess

“If investors are not in fear, they are not going to run, and you don’t have a problem. It accomplishes essentially the same thing as a government bailout or bank deposit insurance, but at a much lower societal or taxpayer cost.”

Scott Bauguess, a former deputy director in the risk analysis division of the SEC and now an associate professor at the University of Texas, agrees with this. He regards BNY and Goldman’s interventions as a positive outcome.

“I think this is markets functioning well,” says Bauguess. “Sponsors have reputational risk… If they’re offering a product that’s about to fail, then they will seek permission to step in and keep the fund from failing.”

Views on this are mixed. Jane Heinrichs, associate general counsel at the Investment Company Institute, notes that the SEC moved quickly to permit sponsor support when it was needed. The ICI wrote to the agency on March 19 seeking assurance that banks that purchased assets from affiliated MMFs at market value (rather than amortised cost) would not face enforcement actions. The SEC issued a no-action letter the same day.

“The SEC showed that, under those kind of circumstances they can act quickly, and they did. It was basically a turnaround of 12 hours from start to finish – they saw the need, they saw that it would be good for everybody involved, and they put it together,” says Heinrichs.

Jane Heinrichs
Jane Heinrichs

Some bank-sponsored MMF operators are more explicit in asking for the no-action relief to be codified. “The industry would like to see more of a formalised approach, not to have to wait for when there is an issue like this for it to come into effect – to have it ready to go for when it is needed,” says a source at one bank-affiliated prime fund manager.

Mark Cabana, head of US short rates strategy at Bank of America Securities, says sponsor support can be helpful, but it is not “failsafe”. (BofA sold its affiliated money market fund business to BlackRock in 2015.) While large banks and fund giants such as BlackRock and Fidelity have the resources to step in when their funds get into trouble, the MMF business is only as strong as its weakest link.

“That is a real issue we were hearing from some portfolio managers: they might have been comfortable with their own liquidity position, but they were worried about their peers,” says Cabana. “We are talking about a run – all it takes is one fund, one headline saying a prime fund has imposed a gate, to really catalyse that run.” 

Call the Feds

This may be why the Fed set up the MMLF without waiting for any prime funds to use the crisis management tools – gates and fees – that were prescribed by the SEC in 2014.

“Would there be contagion, would other funds fail, would there be a run and how would that disrupt markets?” says Bauguess. “[The Fed] likely stepped in because they didn’t want to see what the cost of funds failing would be. They didn’t want to know the answer to that question.”

This is why some former regulators and analysts consider prime MMFs to be a systemic risk that still hasn’t been adequately regulated. After 2008, Fed officials pushed for bank-style capital or reserve buffers for prime MMFs. The SEC ruled that out at the time, but the idea seems likely to receive a second airing.

“The public is again backstopping MMFs, so clearly more structural reforms are necessary,” says Gregg Gelzinis, senior policy analyst at the Center for American Progress. “They still look and act like bank accounts, but without deposit insurance coverage or prudential regulation and supervision.”

The former SEC official does not think sponsor support alone is the answer, as this simply transfers risk from prime MMF to bank balance sheets. The Basel Committee on Banking Supervision tried to establish capital requirements for this phenomenon, which it termed step-in risk – a bank taking on exposures from a fund for reputational reasons, even when it has no legal obligation to do so.

The public is again backstopping MMFs, so clearly more structural reforms are necessary
Gregg Gelzinis, Center for American Progress

“From the bank regulators’ point of view, it looks like these banks have an unfunded liability on their balance sheet that is not reserved against, that is not taken into consideration in terms of capital requirements,” says the former SEC official.

The Basel Committee was unable to reach consensus on capital requirements for step-in risk and settled for supervisory guidance only. Even this has not yet been integrated into the US prudential framework, and the former SEC official sees reserve requirements for the MMFs themselves as the only way forward.

The trouble is, in the current environment of very low yields, a reserve requirement could wipe out prime MMFs altogether. “How do you set aside however many basis points it would be to build a reserve within the MMF? You would have a negative yield because the yields were so low; you couldn’t take a slice out of that small pie to build any kind of a reserve fund,” says Deas at the National Association of Corporate Treasurers.

A reserve requirement would be a death warrant for MMFs and the companies that rely on them for short-term funding. The CP market could not survive without them, says Deas.

Mark Cabana
Mark Cabana

BofA’s Cabana agrees with that assessment. He estimates that prime funds constitute around 25% of the CP investor base. “Unless the regulators want to limit the ability for a corporate to raise short-term cash for a few months at a time, then I struggle to see how prime funds should be eradicated, and I don’t think they will be – they provide a useful function,” says Cabana.

The former SEC official is not so sure. Funding non-financial corporates is no longer the main business of prime MMFs. The BIS bulletin found that, as of February 2020, around 77% of prime money fund holdings consisted of unsecured paper issued by banks, or repo transactions with financial institutions. 

“The big participants in this market used to be industrial companies borrowing for short-term needs, but now basically they are financial institutions, the banks,” says the former SEC official. Which is why MMFs should be subject to similar prudential standards as banks, he argues.

Those in the industry draw a different conclusion from this. If prime funds are a vital source of wholesale funding for the financial sector, then shouldn’t they be entitled to Fed support, the same as banks? The prime fund portfolio manager says this may be the price to pay for tougher bank regulation since 2008, which has reduced the capacity of broker-dealers to hold CP and repo inventory.

“Maybe that’s the new normal – because there are stricter capital and leverage rules for banks, then the central banks have to play a more frequent role in the market place as an intermediator of credit when there are crises,” he says.

BofA’s Cabana also supports the idea of Fed liquidity facilities for prime funds. These could be activated based on “whatever thresholds of liquidity metrics and price movements you want to create” as a signal of stress that needs to be addressed by an official market-maker of last resort.

This may sound like a self-serving argument coming from those working at – or sourcing funding from – prime MMFs. But some in the official sector are thinking the same way.

As the BIS’s May bulletin on the MMF crisis notes, the genie is already out of the bottle. “The central bank balance sheet (once again) acted as an important buffer, accommodating demand for safety coming from the non-bank sector in the Covid-19 crisis,” the authors write. “This raises broader questions about the systemic benefits and costs of facilitating access to safe central bank liabilities for a wider set of players.”
 

How regulators facilitated BNY and Goldman’s interventions

When the US Federal Reserve announced the launch of its money market mutual fund facility (MMLF) on March 18, the initial term sheet precluded purchases of commercial paper (CP) from foreign issuers.

That left many prime MMFs out in the cold. Data from the Office for Financial Research shows more than 66% of US prime fund assets at the end of February 2020 were exposures to foreign issuers.

It wasn’t until March 23 that the Fed issued an updated term sheet clarifying that the MMLF could purchase CP issued by the US branches of foreign banks.

Regulatory filings show the assets purchased by BNY Mellon and Goldman from their affiliated MMFs consisted entirely of CP issued by foreign banks. BNY made its purchases on March 18 and 19 and Goldman on March 19 and 20 – before the Fed made clear that foreign issuer CP could be used as collateral for the MMLF.

To do so, the banks had to jump through some regulatory hoops.

Section 23A of the Federal Reserve Act and the Fed’s regulation W limit a bank’s exposure to its affiliates to 10% of capital for a single affiliate, and 20% for all affiliates. On March 17, the Fed published an exemption letter effectively raising these limits to 200% of capital, provided the assets are investment grade and are purchased only to cover net redemptions from affiliated funds.

Section 23A had very different implications for the two banks, because their capital bases are very different sizes. According to Risk Quantum research, Goldman’s end-2019 Common Equity Tier 1 capital of $79 billion was more than four times larger than BNY’s.

That means Goldman’s asset purchases, totalling $1.85 billion, were equivalent to just 2.3% of its capital, well below the Section 23A limit. But BNY’s purchases of assets worth $2.15 billion from the Dreyfus prime fund exceeded the previous limit, at 11.6%.

The US Securities and Exchange Commission also had to get involved. The Fed’s rules require that any asset purchases from an affiliate must be made “at fair market value”. But section 17a-9 of the Investment Company Act (ICA) specifies that affiliates should buy assets from a money market fund at the higher of market value or amortised cost, to ensure value is protected for end-investors.

In the volatile market conditions of March 2020, amortised cost was clearly the higher valuation. BNY’s purchases from the Dreyfus fund on March 18 were made at amortised cost to comply with the ICA. The booking of the trades was split across two different parts of the group – the Fed-regulated bank holding company (BNY Mellon Corporation) and a separate legal entity – likely an effort to comply with the Fed rules, according to lawyers not directly involved in the matter.

On March 19, the SEC issued a no-action letter allowing affiliates to purchase assets from MMFs at market value rather than amortised cost.

Goldman’s purchases on March 19 and 20 were both made at market value, after the SEC’s no-action letter. This means the interventions by the two banks were technically different: Goldman simply purchased assets at market value to enable its funds to meet redemptions, while BNY potentially underpinned the value of the Dreyfus fund by buying assets at amortised cost.

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