After the volatility that rocked UK markets in recent weeks, Alastair Sewell reflects on how this impacted money market funds and what’s next.

Read this article to understand:

  • Why money market funds have been able to withstand two severe market events, in March 2020 and September 2022
  • How much stress MMFs could endure and current positioning
  • Whether recent volatility could influence regulation

The dust is beginning to settle after the market stress of late September and early October. Now is the time to pause, take stock of what happened and consider what happens next. One clear takeaway stands out:

Money market funds (MMFs) successfully navigated two recent periods of severe market stress: nothing happened, twice1

MMFs passed the “acid test”: they remained open and continued trading throughout the March 2020 and September 2022 stress periods, delivering on their objectives of providing investors with timely liquidity and preserving capital. This contrasts with the financial crisis of 2008, when several MMFs were forced to suspend redemptions.

This reflects positively on MMF managers’ capabilities in managing actively through periods of stress and the structural safeguards built into regulation.

In this article, we address the six key questions investors want answers to with respect to the recent turmoil and looking ahead.

1. What caused the market issues?

The root causes of the March 2020 and September 2022 market stresses were different. March 2020 was an exogenous shock (COVID-19 triggered a dash-for-cash); the September 2022 stress was, well, self-inflicted, avoidable, chaotic… the list goes on, but, again, resulted in another dash-for-cash.

Both periods were comparable in that government bonds came under pressure. Indeed, the Financial Stability Board2 (FSB) recently discussed how “… changes in core government bond markets over the past decade may have made them more prone to liquidity imbalances in times of stress”.

The FSB has proposed policy initiatives to improve market liquidity and resilience. While we hope these will achieve their aims, we also know banking regulation is unlikely to change in Europe, which may limit the full potential impact of the changes. The end result: we need to learn to live with periods of volatility.

Recent events have highlighted cash is not a vanilla asset class; active management is key to ensure preservation of principal, timely provision of liquidity and, of course, yield. As the market environment remains febrile, overreaching for yield could, however, entail significant risk.

2. Where were the specific pressures for MMFs?

We would argue the pressure was not the market events themselves (although clearly the market was severely dislocated), it was the structural rigidities in MMF regulation. Or, to put it another way, the ability of MMFs to cope with market stress would have been much greater had they not been constrained by certain tests required by applicable regulations.

March 2020

MMFs suffered substantial outflows in March 2020. They sold securities into severely dislocated markets to raise liquidity to meet the outflows. This put pressure on two key MMF tests (or MMF structural rigidities): the minimum liquidity test and the mark-to-market test. Neither was breached. Nonetheless, fund managers responded by selling additional securities to maintain liquidity test compliance, contributing to the stress.

The turmoil was short-lived, although MMFs remained conservatively positioned for a prolonged period afterwards.

Figure 1: Peak-trough aggregate outflows in LVNAVs (per cent)
  March 2020 September 2022
GBP -8 -5
USD -14  
EUR -15  
Source: iMoneyNet, Fitch Ratings, November 2022

September/October 2022

UK assets – gilts in particular – were at the epicentre of the recent turbulence. This time, MMFs did not actually suffer material outflows, although many were forced to re-position portfolios to prepare for potential outflows.

Industry wide portfolio maturities were very short going into the period

Instead, the pressure was primarily on funds’ mark-to-market net asset values (MTM NAVs). MTM NAV deviations had widened throughout 2022 due to rate rises. Market volatility in September 2022 caused those deviations to widen further. Despite this, no fund breached the mark-to-market test, reflecting the fact that industry wide portfolio maturities were short going into the period. Prudent positioning pre-event helped MMFs navigate the stress.

Within days, MTM NAV deviations were reverting towards zero.

Figure 2: The liquidity and mark-to-market tests

The liquidity test

If a Low Volatility Net Asset Value (LVNAV) MMF’s weekly liquid assets fall below 30 per cent and the fund experiences a same day net outflow of ten per cent or more, it must consider (i.e. it has total discretion over the appropriate action to take to best serve investors’ interests):

  • Doing nothing
  • Applying a liquidity fee
  • Temporarily suspending redemptions

The mark-to-market test

If a LVNAV’s MTM NAV per share deviates by more than +/-20 basis points from its stable price (usually 1.000), it must temporarily move to variable pricing until the MTM NAV moves back with the 20-basis point collar. The rationale for setting the collar at 20 basis points is unclear.

The fact remains, however, that an LVNAV could in theory breach either of these tests. As neither has ever been breached,  we do not know with certainty how investors would react. We have a diverse investor base and good insight into our investors’ needs. We believe some investors would be more sensitive than others to a test breach and would react differently.

We prepare ourselves for any eventuality. We have up-to-date operational processes to deal with the unlikely event of a test breach. These processes operationalise the actions set out in the MMF regulation. We are confident in our processes: our fund board and management company have strong oversight and our service providers to the fund – accounts and transfer agents - are well-versed in what to do. This would mitigate operational risk in a theoretical breach scenario.

More fundamentally, our policies are anchored on progressively increasing liquidity as MTM-deviation increases. The end result is that if we ever got to the point of breach, our funds would be highly liquid and able to meet subsequent redemption requests.

3. How much stress could MMFs endure now?

We believe MMFs could endure substantial market stress before risking a breach of the LVNAV MTM NAV test. Most sterling MMFs’ MTM NAVs have small deviations from their stable price per share at present3, reflecting the effects of rate rises through the year and the recent volatility. Equally, however, MTM NAVs are converging back towards 1.0000 across the board.

We run periodic stress tests both on regulation and bespoke scenarios

We run periodic stress tests both on regulatory and bespoke scenarios. These are based on current market values, themselves factoring in upcoming market-expected rate movements.

Our stress tests indicate that our Sterling Liquidity Fund could accommodate significant outflows and significant rate movements above and beyond the rate movements already priced by the market, without exceeding the LVNAV MTM NAV test range.

4. How are MMFs positioned now?

Liquid and short! Liquidity levels are high across the industry and our funds are no exception. This provides two key benefits:

  1. We are positioned to re-deploy into higher-yielding assets as rates rise
  2. We are able to meet any outflows

The high level of liquidity, in combination with relatively high floating-rate exposure, means our portfolio-weighted average maturity is low. The floating-rate note exposure will contribute positively to yield as rates rise, in combination with our ability to redeploy liquid assets into higher-yielding exposures.

5. Could recent events influence MMF regulation?

Updated regulations for European MMFs are overdue: reform proposals were due in July 2022 but are evidently being delayed. Recent events in the sterling market will factor into the regulatory debate, although how this changes regulators’ views is not yet clear.

It will take some time for regulators and other authorities to assess events

We do, however, know it will take some time for regulators and other authorities to assess events. In an ironic twist of timing, the European Central Bank (ECB) published a report4 on the effects of the March 2020 COVID-related stress on MMFs just as MMFs were dealing with the latest market stress.

Looking ahead, we can draw two, contradictory, conclusions on how recent market events will feed into regulatory developments:

  1. The timeframe for updating the MMF regulation will now extend: authorities will need additional time to understand the episode and factor lessons learned into final rules
  2. The timeframe for updating the MMF regulation will now shorten: authorities will see the recent stress as motivation to implement reforms sooner

We think the first conclusion is marginally more likely. After all, the last round of reforms, which were implemented in response to the 2008 financial crisis-related stress, were only implemented in full in 2019, 11 years later. If this is the case, political developments could become relevant. European parliamentary elections are held every five years, with the next in May 2024. If the MMF reforms are not agreed before then, further delays may follow to accommodate the new political situation.

On the other hand, multiple commentators are suggesting final rules for US MMFs could come out this quarter. This, as well as recent events, may spur the European authorities into action.

Stress testing an interim step

Irrespective of the pace of regulatory development, we think it likely that the European Securities and Markets Authority (ESMA) will implement additional stress-testing requirements for MMFs.

It is likely ESMA will implement additional stress-testing requirements for MMFs

ESMA states it will update stress-testing requirements annually, although the last update5 was in December 2020. That included several changes to reflect the March 2020 experience, notably with increased severity of redemption scenarios.

For further background on MMF regulation and the potential direction of travel, please read our earlier article (written before the recent market stress): European money market fund reform: Preparing for change.6

6. What’s the outlook for yields?

We anticipate multiple interest-rate rises from the Bank of England in the coming months, as it seeks to bring inflation back to target. While the actual movement at any given rate-setting meeting is uncertain, the direction of travel is clear. MMF yields, which have increased steadily this year, will rise as rate rises feed through to fund yields.

Figure 3: Market-implied policy rate (per cent)
Source: Bloomberg World Interest Rate Probability, November 3, 2022
Investors can take comfort from the fact MMFs have again survived, and should thrive in the current rising-rate environment

We are actively managing our portfolio exposures with a focus on near-term developments and longer-term risks and opportunities. This means we need to have sufficient liquidity to meet redemption requests and be able to re-deploy into attractive opportunities benefitting from higher yields, while positioning the portfolio for year-end. Year-ends can be challenging periods for MMFs as they are typically characterised by supply limitations.

For funds with excessively high levels of liquidity, the year-end period will present acute challenges. We have actively positioned our liquidity to optimally manage the fund’s risk profile, now and looking ahead to year-end.

Time for MMFs to thrive

Investors, fund managers, and, importantly, regulators, are acutely aware of the recent period of market stress. Nothing adverse has now happened to MMFs, twice, but we were certainly all glued to our seats by the turbulence. This period will undoubtedly factor into the regulatory developments, but the timing is uncertain. We would lean towards new rules being delayed.

Investors can take comfort from the fact MMFs have again survived and should thrive in the current rising-rate environment. As for what’s next, we’ll take care of the first part and let Maya Angelou take care of the rest:

My mission in life is not merely to survive, but to thrive; and to do so with some passion, some compassion, some humour, and some style

Key risks

The value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested.

Investments in money market instruments such as short-term bank debt the market prices/value can rise as well as fall on a daily basis. Their values are affected by changes in interest rates, inflation and any decline in creditworthiness of the issuer.

Investments are not guaranteed, an investment in a Money Market Fund is different from an investment in deposits and can fluctuate in price meaning you may not get back the original amount you invested. This investment does not rely on external support for guaranteeing liquidity or stabilising the NAV per unit or share. The risk of loss of the principal is to be borne by the investor.

References

  1. Paraphrasing Vivian Mercier’s 1956 review of the play Waiting for Godot: “[Samuel Beckett] has achieved a theoretical impossibility – a play in which nothing happens, that yet keeps audiences glued to their seats. What's more, since the second act is a subtly different reprise of the first, he has written a play in which nothing happens, twice.
  2. ‘Liquidity in core government bond markets’, Financial Stability Board, October 20, 2022
  3. Data as of November 3, 2022
  4. Laura-Dona Capotă, et al., ‘Working paper series: Is the EU Money Market Fund Regulation fit for purpose? Lessons from the Covid-19 turmoil’, European Central Bank, October 2022
  5. ‘ESMA updates guidelines on stress tests for Money Market Funds’, European Securities and Markets Authority, December 16, 2020
  6. Alastair Sewell, ‘European money market fund reform: Preparing for change’, Aviva Investors, September 15, 2022

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