Money Market Funds: Safe Until They Aren’t

Money market funds are a type of mutual fund that invests in short-term and highly liquid financial assets. Along with providing a relatively safe and short-term place to hold cash, money markets serve an important role in the economy by providing short-term funding for the government and corporations.

As of July 2021, money market funds held over $4.5 trillion in assets, making them a large player in the financial system. Although they are considered safe compared to some other financial assets, money market funds have a history of meltdowns when panic sets into the market.

Money Market Meltdowns

In 2008, the Reserve Fund, the largest money market at the time, was forced to shut down and liquidate its assets after the collapse of the Lehman Brothers prompted worried investors to pull their money out of the fund. Although the fund held less than 1.5% of its assets in Lehman Brothers’ commercial paper, investors feared the same fate for other companies in the fund.

Investors who were not able to pull their money out fast enough took heavy losses. This was the first time since they were created a couple of decades prior that investors began to question the safety of money market funds.

A similar event occurred at the onset of the Covid market crash in March of 2020 when U.S investors rushed to take money out of prime money market funds that invest in short-term commercial paper and move it over to exclusively government money funds.

In March of 2020, assets in prime funds fell from $791 billion to $652 billion by the end of the month as money rushed to the safety of government-backed debt. This caused a short-term spike in corporate borrowing costs due to their loss of funding in the money market.

Now more than 7 months into 2021, we are still seeing issues with money market funds as more and more money is headed towards government debt-backed funds and away from prime funds that are exposed to commercial paper.

Are Current Regulations Enough?

Since the first issues arose in 2008, the SEC has introduced regulation and oversight to try and prevent these situations from happening in the future.

These regulations included a floating net asset value, temporary withdrawal limits called “redemption gates”, and creating the Money Market Mutual Fund Liquidity Facility in 2020 to help money market funds meet the demand for redemptions without having to sell its assets.

But ever since the scare in March of 2020, regulators are pushing for even more regulation and oversight to further try and prevent future issues. Some suggestions include removing a rule requiring U.S funds to hold 30% of assets in assets that have a maturity of less than one week and allowing funds to trade out unwanted commercial paper through the Fed’s discount window at any time.

Even if further reforms were introduced, money market funds may still be riskier than they are implied to be as financial institutions increasingly opt-out of parking their cash in prime and other money funds that are exposed to corporate debt, in favor of funds invested in debt backed by the full faith and credit of the U.S. Government.

Falling Demand and the Future

Demand for corporate debt exposure has fallen enough for large fund managers like Vanguard to reduce fees and investment minimums for its prime fund investors to try and lure investors back in.

What was once thought of as a safe haven for short-term cash, has turned out to be quite the opposite in the eyes of investors.

If investors do not want exposure to corporate debt, they must have a negative outlook for these businesses and the economy. If this is the case, instead of providing a safe place to hold short-term cash, money markets may provide insight into what is to come for the economy.

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