Long-term pain from short-term funds
Changes to the regulation of US money market funds see non-US banks scramble to replace money market liquidity
On October 14 2016, changes to the Securities and Exchange Commission rules governing money market funds came into effect. The news may have come as little surprise to the market, which had been given two years to adjust to the new regulatory environment, but one thing is for sure: the cost of liquidity for those needing to fund in US dollars has increased. It is an important change, and one that has already affected business models, funding strategies, and client relationships within the banking sector.
The full extent of the implications, however, has yet to be revealed.
In 2014, the SEC approved regulatory changes to prime MMFs as it moved to counteract the potential for a run on liquidity along the lines of that which almost brought the short-term lending markets to a standstill during the height of the financial crisis. In 2008, exposure to Lehman Brothers pushed the value of a MMF share below US$1 for the first time. It wrecked the perception of MMFs being a solid, safe investment vehicle for cash management and led to a widespread withdrawal of money from the sector.
The repercussions of a severe loss in confidence in the money markets were clear once again in 2011, when European banks felt the pinch due to their exposure to the eurozone crisis. Among those hardest hit were banks (including the French banks) with not only Europe-wide exposure to potential government defaults but business models built on a bias for short-term financing to support longer-term lending in, for instance, commodity-related and infrastructure markets.
The new regulations are an attempt by the SEC to stem the type of flows that can devastate short-term financing options.
Following the deviation from a dollar share price, regulators were keen that investment into prime funds should reflect the net asset value of exposure to the underlying investments. They were also keen that institutions, with the systems in place to react more efficiently to volatility than retail investors, were not in a situation to profit from early withdrawal of funds at the expense of their retail co-investors. As well as introducing floating NAVs, liquidity fees and suspension gates were also imposed.
“The changes eliminate the first-mover advantage,” said Andrew Paranthoiene, director of fund ratings at S&P. “And a move to a floating NAV is a better reflection of the valuation of the underlying portfolio.”
The new rules do not apply to retail money market funds or to government funds, however, which continue to benefit from the constant US$1 per share valuation and no restrictions on withdrawals.
Time to adapt
The long lead-up to the October deadline gave the market plenty of time to adapt. The reaction was, perhaps, predictable – and logical: investors moved cash out of prime funds and into government funds and that withdrawal of ready cash in the system led to an increase in short-term money market rates. The magnitude of the moves, however, was more of a surprise.
According to the Investment Company Institute, up to September 2016, the new rules for money market funds had “induced a drop in the assets of prime and tax-exempt money market funds of US$910bn since January 2015 and a roughly comparable US$872bn rise in the assets of government money market funds”. The momentum behind the switch into government funds (and out of prime) continued into October.
“The flows out of the prime funds were much larger than expected due to an underestimation of the magnitude of the impact on sweep accounts,” said Michael Cloherty, head of US interest rate strategy at RBC Capital Markets.
Sweep accounts transfer excess cash into other avenues in an attempt to earn a little more yield. It is naturally conservative money and fears of any potential gating in funds was a significant problem for those flows.
“The need for liquidity was reflected in the weighted average maturity of investments in prime funds moving as short as eight days versus a more normal 40 days,” said Cloherty.
In essence, the amount of cash being managed has barely changed but it has been managed away from prime funds investing in corporate and, most frequently, bank instruments into government funds with the result that liquidity for non-government borrowers has become more expensive.
In the run up to the reforms being introduced, short-term interest rates had already begun to rise in anticipation of the US Federal Reserve starting out on its move towards tighter monetary policy. But there was a notable jump in rates some three months before October as banks moved into the market in order to refinance outstanding obligations.
Over the course of 2016, three-month US dollar Libor rose steadily from just over 0.6% in January to 0.65% at the beginning of July. By the beginning of October, three-month US dollar Libor was closing in on a rate of 0.86% and it has continued to gradually trade higher.
Even though some of this price development has been driven by expectations of a move by the Fed, there has clearly been a gap opening up between returns from investing in Treasury-backed paper and the cost of borrowing for the rest of the global dollar-based economy.
“The money market reforms come with a cost, but that cost is more in terms of the price of accessing money rather than in terms of a reduction in market liquidity,” said Paranthoiene. “It is a structural change to the market.”
And it is a structural change that has been well flagged, giving time for borrowers to deleverage, adapt business models and adjust the level of dependence to a pool of liquidity previously afforded by the prime funds.
“Banks in general have decreased their reliance on short-term funding,” said Nicolas Malaterre, senior director of bank ratings at S&P. “In the US, they have access to dollars from other sources, such as their deposit base. Non-US banks may also have access to dollars through their own deposit base but they have also been looking at alternatives.”
Non-US banks have been scouring the world for other sources of funding. The options pursued include an expansion of the deposit base, and charming corporates and institutions into extending deposits with attractive interest rates. They have also looked further out the curve to the senior unsecured debt markets by issuing bonds. And there have also been signs of funding being sourced in home markets and then swapped into dollars.
“Starved of attractive short-term US dollar-based funding, these institutions have to convert foreign funding into dollars, using cross-currency swaps,” said Dierk Brandenburg, a senior sovereign analyst at Fidelity. “The strong demand for cross-currency swaps from these currencies … has pushed the basis wider and the premium for US dollar funding higher.”
The practice has led to sharp swings in the basis, which has implications not only for institutional short-term financing but also for investors.
There are limits to the levels of liquidity that can be tapped in local currency to support dollar funding, limits to how far liabilities can be termed out the curve, and limits to the price paid on deposits. At some point, there is little alternative to visiting the short-term dollar markets in order to finance the everyday business of banks and their customers. Those visits have become more expensive, however, and higher funding costs bring with them issues that need to be addressed.
“There is the question as to what part of the price increase can and has to be absorbed internally or needs to be passed on.” said Thomas Einramhof, global head of short-term funding at Rabobank.
If the relationship with the client is broad and covers a variety of asset classes then the costs can more easily be accommodated among other operations within the institution. Nevertheless, at the margin, difficult decisions may have to be made as to whether banks can support certain relationships. Those banks with access to onshore US dollar funding certainly appear to be at an advantage but as to how great that advantage will be – and what that implies – is yet to be revealed.
S&P expects that non-US banks will not overly suffer from the regulatory changes. But there are differing levels of reliance on the money markets and that can be seen in the prices posted at the Libor fixings.
“If you look at the historical Libor submission rates then you’ll see that it was the Japanese banks that posted the highest rates on average, then the Europeans and then the US banks,” said Steve Kang, a strategist at Citigroup.
While the flow of investors out of prime funds into government funds has been impressive and price movements in Libor and the basis have been significant, the market is in the early days of assessing the long-term impact of the changes.
“You have to look at the asset and liability composition of the entire balance sheet and the dependency on short-term [dollar] funding,” said Einramhof. ”The more diversified your liabilities, the easier it is to absorb changes in the liability availability and potentially higher prices for certain funding.
“And don’t forget, this is all being played out at historically low interest rates. It will be interesting to see what happens to the spread between money market rates and government funds – and investor flows – when absolute rates start to rise.”