Money market funds (MMF’s) are cash-like instruments that tend to hold their value through thick and thin. They invest in low risk, low return assets like short-term debt, which is often triple A rated.
What is key to remember is that “cash like” is not the same as cash. Cash is tradable at all times, but “cash-like assets” in bad times can turn extremely illiquid and can be untradeable in periods of financial stress.
The Definition Of Liquidity
An MMF invests in various assets and promises in most cases to keep the net asset value (NAV) at $1. When these assets fall in value, i.e. during the financial crisis, the fund’s NAV can drop below $1 (called in the trade as “breaking the buck”). Unlike individual institutions, they promise to redeem at par, yet are not insured by the federal deposit insurance corporation (FDIC).
Thanks to regulation (total loss absorbing capacity or TLAC), if banks get into trouble, the shareholders, the debtholders and the depositors participate in the losses. In the money market arena, if the fund is forced to break the buck, they are obliged to sell down their assets. Earlier this year, a real estate fund was suspended. The fund is liquid, or if not, it closes.
If central banks and regulators do not want the responsibility of providing liquidity to non-bank entities, they need to explain what is liquid and what is not in different market scenarios, or else the perception will be yet again the financial system has just endured another bailout. Closing funds in a sticky situation are better than letting an MMF go to 30 cents on the dollar. That would cause panic, and the repercussions would be profoundly destabilising.
The Different Issues With Asset Managers
Getting capital to banks in periods of financial stress is easy, whether through repo methods or by purchasing assets they hold. Taking liquidity to non-bank entities, i.e. asset managers cannot be done as easily. Many asset managers or funds in some way are connected to banks, which means a kind of third party repo system can be set up via the commercial bank, from the central bank and into the fund itself.
The problem is that a lot of the larger asset managers are not connected to banks, so what happens then? Buying assets outright is clearly a good option and does not come with the perception of another bailout of yet another large financial institution. Closing the funds is clearly better, but that begs the question of moral hazard, where the fund would then invest in super illiquid high return emerging market debt, where even if liquidity dried up, the fund would be gated immediately.
Constructive ambiguity goes some way to solving the problem. If the fund knew authorities might not gate it and has the potential to fall to 30 cents on the dollar, they might manage liquidity risk better. One size would therefore not fit all and in turn would create an element of mystery, and generate prudence in investment decisions.
2017 should be the year where such a problem is resolved, in addition to sticking a hole in the market vacuum from the counter-productive Volcker rule.