Liquidity restrictions on investors, like the redemption gates and liquidity fees introduced in the 2016 money market fund (MMF) reform, are meant to improve financial stability during a crisis. However, by comparing the latest outflow episode due to COVID-19 to those in 2008 and 2011, this column finds evidence that these liquidity restrictions might have exacerbated the run on prime MMFs in this episode. Such severe outflows amid frozen short-term funding markets led the Federal Reserve to intervene with the Money Market Mutual Fund Liquidity Facility (MMLF). By providing ‘liquidity of last resort’, the MMLF successfully stopped the run on prime MMFs and gradually stabilised conditions in short-term funding markets.
Money market funds (MMFs) are an important source of short-term funding for governments, corporations, and banks (Hanson et al. 2015) and play a notable role in the monetary policy transmission as part of the shadow banking system (Xiao 2020). The resilience of the MMF industry has profound implications for the stability of the financial system. In the aftermath of the 2007-09 financial crisis, the Securities and Exchange Commission (SEC) introduced a set of reforms to address the vulnerabilities of the money funds which were exposed during the crisis.1 In particular, the 2016 MMF reform introduced new liquidity rules for prime MMFs, which are major investors in the commercial paper (CP) and negotiable certificates of deposit (CDs) markets. This reform allows prime MMFs to impose redemption gates and liquidity fees on their investors once their liquidity buffers, namely weekly liquid assets (WLA) that could be converted into cash within a week, fall below 30% of total assets.
The intention of such reforms is to endow MMFs with tools to stop investor runs on their own. Their proponents, including then-SEC Chair Mary Jo White, argued that redemption gates and liquidity fees would “mitigate [the run] risk and the potential impact for investors and markets.” However, their critics noted that the possibility of MMFs introducing gates and fees can incentivise investors to run preemptively before such liquidity restrictions are imposed. For example, SEC Commissioner Kara Stein suggested that allowing funds to impose gates and fees “could actually increase an investor’s incentive to redeem,” especially in a crisis.
The COVID-19 crisis provides the first major event to empirically study the impact of the contingent liquidity restrictions introduced by the 2016 MMF reform on the stability of the MMF industry. In late February 2020, with increasing COVID-19 cases in the US and Europe, capital markets started to experience turmoil (e.g. Ramelli and Wagner 2020). By mid-March, yield spreads on various short-term funding securities, including CP and CDs, had surged to levels last seen during the 2008 financial crisis (Figure 1). Amid the broad risk-off sentiment, investors started to run on prime MMFs. Within two weeks from 9 March 2020, $96 billion (about 30% of assets under management) were withdrawn from institutional prime MMFs.
Figure 1 Yield spreads on 1-month CP & CD (in basis points)
In a recent paper (Li et al. 2020), we study the anatomy of the run on institutional prime MMFs during the COVID-19 crisis to understand how contingent redemption gates and liquidity fees might have changed money funds’ run risk. We start by comparing the run during the COVID-19 crisis to the previous two prominent MMF runs, namely the run surrounding the September 2008 Lehman bankruptcy and the euro area sovereign debt crisis run in the summer of 2011. The COVID-19 and 2008 runs are remarkably similar in terms of speed and intensity, with institutional prime funds losing more than 30% of assets in about 20 days (Figure 2), while the 2011 run is relatively milder and more gradual.
Figure 2 Cumulative changes in institutional prime MMF AUMs
We find that fund outflows were highly sensitive to fund liquidity holdings during the 2020 crisis (i.e. funds with low WLA experienced larger outflows), but such a relationship was absent in either the 2008 or 2011 crisis. More interestingly, when we split funds into high (top quartile), middle, and low (bottom quartile) WLA groups, we find greater flow sensitivity to WLA among low-WLA funds in 2020. In other words, the flow sensitivity to fund liquidity is greater for lower-liquidity funds only after the 2016 MMF reform allowed for the imposition of gates and fees. These findings suggest that the contingent liquidity restrictions might have exacerbated the run during the 2020 COVID-19 crisis.2
Figure 3 Runs on institutional prime MMFs by WLA level
The run on prime MMFs led them to hoard liquidity and refrain from investing in instruments with maturities longer than one week, putting further pressure on the already strained CP and CD markets. In response to the precarious conditions in money markets, the Federal Reserve intervened with the Money Market Mutual Fund Liquidity Facility (MMLF).3 The MMLF enabled MMFs to liquidate some of their assets to meet redemptions and increased their confidence in investing in longer-tenor securities.4 We find that the MMLF was effective at stemming outflows from MMFs. During the two weeks following the launch of the MMLF on 23 March 2020, institutional prime funds’ daily flows rebounded by about 2 percentage points on average. Funds with lower WLA experienced a stronger rebound in flows, suggesting that the facility was especially beneficial to less-liquid funds. Furthermore, we use the security-level holdings of MMFs and examine whether the recovery in fund flows was stronger for funds that held more MMLF-eligible assets. As expected, we find that prime funds with more MMLF-eligible holdings experienced a larger rebound in flows after the MMLF was launched. Taken together, our analyses lend strong support to the view that the MMLF helped stabilise the MMF industry during the COVID-19 crisis.
In addition to stopping MMF runs, we also identify stability-enhancing effects of the MMLF on short-term funding markets. First, we exploit the differential eligibility requirements on credit ratings to evaluate the MMLF impact. Only instruments with the highest ratings are eligible under the MMLF, while other facilities also accept those with lower ratings. Consistent with a stabilising effect of the MMLF, we find that the improvements in market conditions were concentrated among top rated instruments. Second, we show that instruments that were more heavily held by prime MMFs before the crisis experienced larger reductions in yield spreads and greater issuance volume during the post-MMLF period. Finally, given the pricing terms of the MMLF, only securities with yields greater than 125 basis points (bps) were economical for banks to pledge at the facility. We confirm that the rebound in issuance volume after the implementation of the MMLF was concentrated among those securities.
The recent COVID-19 crisis highlighted that ex-ante liquidity restrictions might not achieve the goal of creating a system immune from runs. Given the notable role of MMFs in the short-term funding markets and in the shadow banking system, more research and collaborative regulatory efforts are warranted to enhance the stability of the industry.
Authors’ note: The views expressed here are those of the authors and do not necessarily reflect those of the Board of Governors or the Federal Reserve System.
Xiao, K (2020), “Monetary transmission through shadow banks”, Review of Financial Studies 33(6): 2379–2420.
1 There had been active discussion on the MMF reforms after the financial crisis. For example, Hanson et al. (2015) evaluate various reform proposals and recommend requiring MMFs to hold capital buffers. Notably, they also argue that redemption gates could exacerbate runs on MMFs.
2 The 2016 MMF reform also required institutional prime MMFs to transact at a floating net asset value (NAV). However, we do not find evidence that lower floating NAVs drive additional outflows during the Covid-19 crisis. While funds’ floating NAVs saw some declines during the crisis, they were never near the “breaking the buck” threshold.
3 Various government and regulator interventions around the globe were announced around the same time. See, for example, Baldwin and Weder di Maruro (2020).
4 Under the MMLF, banks could purchase high-quality CP and CDs from MMFs and pledge those assets at the MMLF as collateral for a cash loan for the whole life of the security. Economically, this is similar to banks selling the assets that they bought from MMFs to the Federal Reserve.