The writer is an associate professor of finance at the University of Chicago Booth School of Business
There is a love-hate relationship between the US Federal Reserve, regulators and money market funds, a $5tn industry at the heart of short-term funding, shadow banking, monetary policy, and the dollar-centric international financial system.
Broadly speaking, there are two types of money market funds in the US: prime and government funds. Prime funds can lend to all sectors of the economy with or without collateral. Government funds are only allowed to hold Treasury securities or lend to other sectors against Treasury collateral.
Prime funds have long been viewed as a source of vulnerability, while government funds have been viewed as a source of strength. But the bad kid might be getting too much blame and the good kid too much credit.
Lately, prime funds are back on the regulatory hot seat and potentially face additional reforms for their role in the money market turmoil of March 2020. Big investor outflows from such funds at the time left managers rushing to sell assets, reprising some of the dynamics seen in the financial crisis.
Meanwhile, the largest money market funds, mostly government funds, now lend the Fed several hundred billion dollars daily ($790bn on Tuesday) to finance the central bank’s bond buying programme.
First, on the “bad kid”, the old model of prime funds gave investors a false sense of security by allowing them to redeem shares at face value on demand even though the investment vehicles had risky portfolios of assets.
However, the US money market fund reform implemented in 2016 made prime fund shares significantly less “money-like” by allowing their net asset value to fluctuate instead of being pegged at $1. The reforms also introduced restrictions on redemptions during times of stress and explicit fees.
As a result, prime funds contracted their footprint significantly. Before the Covid pandemic hit, institutional prime funds had $600bn of assets under management, compared with assets of $1.7tn in 2015. In contrast, government funds grew from $1tn in 2015 to $4tn today.
Perhaps even more importantly, large global banks, primary borrowers from the prime funds, have transformed the use of these funding vehicles, as a recent research paper I wrote with Alyssa Anderson and Bernd Schlusche shows.
New global Basel III regulations have prompted banks to use prime funding less to finance illiquid assets such as loans. Instead, it is used more for financing liquid asset positions. These include risk free arbitrages like borrowing overnight from the private money markets and parking it with the Fed.
This transformation of the role of the prime funding has made global banks less vulnerable to runs on prime funds.
On the other hand, the growth of the “good kid” — government funds — as a more important pillar to the Fed monetary policy framework has not been all rosy.
Since the turn of the year, short-term funding markets face a list of forces that push rates towards the negative territory, including $1tn cash released by the US Treasury to pay for various Covid economic relief programmes. Demand for a current low supply of treasury bills also pushes prices up and yields down.
By setting the interest rate on the money funds’ lending to the Fed at 0.05 per cent, the central sets a floor for rates. If the Fed is paying those yields, funds are unlikely to want to lend to private borrowers at lower rates. So government funds happily lend the cash to the Fed, directly recycling the cash created by asset buying by the central bank.
This way the Fed can continue its asset purchases even if large banks appear to be running out of balance sheet space to absorb additional cash created by the continued asset purchases.
However, one additional dollar cash recycled by the money market fund to the Fed means one dollar less available to the banks. With government funds offering 0.05 per cent, banks have to cut fees or increase returns on their deposits to compete for funds.
And if money market funds compete away stable deposits that have more favourable regulatory treatments for the banks than other sources of funding, the appetite of banks for lending might be reduced.
All this represents a big shift. The unsecured short-term funding market historically backed by prime funds will not disappear, but instead will likely be intermediated between more opaque money lenders and borrowers. Government funds are likely to continue to grow. Only the Fed and the US Treasury can satiate their asset growth demand going forward.
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