For decades, money-market mutual funds offered better returns than bank deposits, were just as accessible and seemed just as safe — until they needed a federal bailout at the height of the 2008 financial crisis. That led to reforms meant to make the industry safer, while still allowing users to pursue higher yields, and investors started to drift back. But now the Federal Reserve has driven rates so low that the extra risk hardly seems worth it. That’s creating problems not just for fund managers but for corporations that have long relied on money markets to fund their day-to-day operations.
1. How do money-market funds work?
They’re kind of like banks but not quite. While both take deposits that can be withdrawn at any time, banks use them to make loans that can tie up the money for years. That mismatch historically made bank runs a constant danger since no one wanted to be the last in line to get their money back if an institution was going under. But government-imposed systems of deposit insurance have made runs largely a thing of the past for banks.
2. What does that have to do with money-market funds?
As mutual funds, they also offer investors the right to withdraw their money anytime, but they mitigate their liquidity risks by restricting their investments to short-term, high-quality assets and cash equivalents like Treasuries. Their aura of safety has made money-market funds widely used by everyone from corporate treasurers to households as easily-accessible places to put short-term cash while typically getting better interest than in a bank account. Of the roughly $4 trillion in money-market funds currently, almost $750 billion is in what are known as prime funds that are an important force in the so-called commercial-paper market that’s crucial to the daily functioning of companies and financial firms.
3. What happened in 2008?
Fears about rising credit risks spurred withdrawals in September 2008, and these outflows turned into a run when the Reserve Primary Fund said it expected losses on its holdings of Lehman commercial paper. That pushed the value of the $62.5 billion fund below the stable level of $1 a share — “breaking the buck,” in the industry jargon. A total of $500 billion fled from funds that invested in commercial paper, adding to volatility that spilled across global markets. The Treasury responded by creating a Temporary Guarantee Program to underwrite the share price of any participating fund, while the Fed rolled out support in the form of its Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. After the crisis passed, Congress was keen to head off any future bailout, and regulators set to work on a raft of reforms aimed at safeguarding the industry.
4. What did regulators do?
The rules, which took effect in 2016, aimed to make risks in money-market funds more transparent; their biggest impact was on prime funds. (The other main types are government and municipals, or tax-exempt, funds.) Major changes included separating prime funds into retail and institutional types, with the latter catering to more sophisticated investors. Retail funds could keep using the traditional stable $1 pricing for shares, but institutional funds had to adopt a floating net asset value that would show deviations in price. Regulators also gave managers of all funds the option to impose fees on withdrawals above a certain amount, or establish gates they could lower to temporarily stop outflows if a fund’s assets fell below a certain threshold.
5. How do prime funds work?
Prime money-market funds typically buy certificates of deposits, time deposits and commercial paper, which are IOUs that companies issue to meet their short-term funding needs, such as payrolls. This ability to take credit risk means prime funds can offer more yield than government funds, which are the most conservative, focusing on U.S. Treasuries and repurchase agreements for that debt.
6. What happened this spring?
As social distancing and quarantine measures to curb the pandemic shut down economies and wracked global markets in March, investors again herded out of prime funds, and into the relative safety of “govvies.” Over six weeks, prime funds shed around $150 billion of assets. Perversely, the 2016 overhaul may have exacerbated the flight, as investors were motivated to move early to avoid possible penalties, or getting stuck if a fund’s assets dropped too far. Some managers with parent banks were able get liquidity injections from them — Goldman Sachs bought a total of $1.84 billion from two of its asset management arm’s money-market funds in March.
7. What did that do to markets?
Made a bad situation worse. While prime redemptions were largely absorbed by government funds, they had big ripple effects: Commercial-paper issuance froze in March through April, which in turn contributed to a surge in Libor, a benchmark rate for lending between banks that underpins trillions of dollars of corporate and consumer loans. Once again the Fed stepped in with emergency support, rolling out its Money Market Mutual Fund Liquidity Facility to help them meet demand for redemptions. That solved one problem for funds, even while the Fed was creating another.
8. What’s that?
Prime money-market funds exist because they offer better returns than holding cash or Treasuries. But that’s hard to offer when the Fed is pushing rates down to zero, as it did in March. The Fed’s assurances that the target policy rate will stay put for years to support a full economic recovery signify another stretch in the wilderness for money-market funds. Rock-bottom rates will mean that short-term funds will be able to offer little if any return. But the situation is particularly tough for prime funds, where the main appeal is the dollop of yield they offer investors prepared to take a little credit risk.
9. How has the industry reacted?
Several fund managers including T. Rowe Price Group Inc. and Federated Hermes Inc. have already waived fees they typically charge prime-fund investors in an effort to preserve income for clients. And Vanguard Group — the world’s second-largest asset manager — voluntarily agreed to limit expenses on the investor class of a $125 billion fund that it’s converting to a government-only vehicle after more than 40 years. Northern Trust Corp. and Fidelity Investments recently axed prime funds altogether, and they’re unlikely to be the last to do so, according to Fitch’s Greg Fayvilevich.
10. What’s the fallout from all this?
It’s not great. Barclays rates strategist Joseph Abate assumes the prime-fund industry will be “permanently smaller, because of voluntary exits or regulation changes.” And even if the incumbents stay, regulators armed with this fresh evidence of how commercial-paper markets can evaporate in moments of stress may want to impose limits on how much of it these funds can buy. Prime-fund investments in commercial paper and certificates of deposit have already declined, to 49% in July, from 62% in February, according to Barclays, due in part to a weaker stomach for risk. A shrinking customer base for commercial paper could translate to higher borrowing costs for the thousands of companies that rely on this market. And that in turn could lead to higher, and more volatile, benchmark funding rates.
The Reference Shelf
- A Bloomberg News article on how a liquidity crunch raised questions about money-market funds.
- A piece about the challenges for prime funds in a zero-rate world.
- An article about the Fed’s rapid response to that crunch.
- A New York Fed staff paper on how gates and fees can cause preemptive runs.