Systemic Risks in Money Market Funds

Despite new support from Europe for the financial sector, markets are still exposed to one big hidden risk. Potential problems in almost every type of financial institution and security have been tackled, yet a key danger remains. Money market funds seem to have escaped the big financial sector reforms of the past two years. The sector globally could represent as much as US$4 trillion in assets. Yet, these funds involve some of the most vulnerable investors and can conceal risks. They might sound just like bank deposits, but structures are often much more complex. The fixed capital price may give false security.

Money market funds do have an important role in assisting diversification of credit risk exposure and providing short term funding for borrowers. They often help to finance current operations of businesses and national and local governments. Daily liquidity and capital preservation is what differentiates these funds from most other collective investment schemes. There are rules on how these funds are run – but no international consistency.

After the high profile problems of 2008, when one major US money market fund failed to protect capital, there were moves to improve safety and liquidity. But any further attempt to address systemic risks has stalled. Last month, US attempts for further reform were de-railed. This was despite the view of some regulators that the sector is one of the most vulnerable parts of the financial system. There has been no global harmonisation, and the lessons of 2008 simply forgotten. The sector could be an accident waiting to happen.

In the search for yield, some of the least sophisticated investors are drawn into these funds. With negligible interest rates on bank deposits, money market funds promise a solution. They appear to offer capital security, via a constant net asset value (NAV), along with yield pick up. Organisations such as county councils and charities, facing extreme budget pressures, love money market funds. Daily liquidity makes them look much like bank accounts, and typically they appear alongside deposits in annual reports. With the recent halving of short term EURIBOR rates, money market funds certainly have a role. It is little surprise that these funds look like the answer to the prayers of hard-pressed treasurers. But do the buyers understand the risks?

Recently the financial regulators’ group, the International Organisation of Securities Commissions (IOSCO), has highlighted the vulnerability of money market funds to systemic risk. It has made clear it will propose strengthening oversight of the shadow banking system, including money market funds. IOSCO will determine its action on this in October, and then report to the G20 finance ministers in November. But regulators have been meeting resistance from managers of the funds and from politicians. Each country has their own preferred model and solution. France, Ireland and Luxembourg are the locations of most of the funds in Europe, with the US accounting for more than half the industry’s world-wide assets. No-one wants to lose a competitive edge.

Underlying money market funds’ safe, cuddly exterior can be a complex series of trades and instruments to deliver the required yield and stabilise capital. Around the world different models are used, and problems often smoothed over with some sponsor support. While money market funds do not generally employ leverage, they can still be at risk from currency moves or deterioration in bank credit. But some funds are also dependent on the stability of the Euro – a break-up could pose risks for this capital guarantee. Despite the renewed political support for the Euro, fears of a split could resurface. It is these stress events that test the normally resilient structure of the funds.

Managers of the funds themselves do not accept the need for further regulation. They believe that imposing even tougher capital and liquidity requirements could kill the ability to provide yield. And, moving to variable net asset value might spook investors. Yet, a constant NAV risks subsidising redeeming shareholders at the expense of those remaining when losses emerge. Even where funds have a variable net asset value, some of their assets can be held at an amortised cost, rather than marking to market. This could encourage redemption where there are fears over liquidity.

One of the key protections that some funds retain is the ability to suspend or delay redemptions – “gating”. But, buried within prospectuses can be wording that explains that holders should view these as medium to long term assets if that happens. Overnight, they would move to a different place in holders’ accounts and no longer look like deposits. The less sophisticated holders of these funds may not be prepared for this. Some organisations have invested a significant portion of their balance sheet in something they thought was safe.

And, credit risks in portfolios can concentrate. European banks can not only represent key portfolio risks for money market funds, but can also at the same time be important investors in the funds. It is easy to see the potential for contagion risk. The key issue is how investors react under stress, and the liquidity offered when other parts of the market freeze. Solutions could include insurance or capital buffers.

It seems a better understanding is needed by the less sophisticated investors. Bank deposits have been protected up to £85,000 for individuals, with the assumption that bigger depositors can take more pain. But for charities and county councils, involvement in problem areas can ultimately impact thousands of individuals who can least afford it. It is time to ensure treasurers understand the nature of these funds and report them correctly.

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