HIGH inflation, rising interest rates, banking turmoil – today’s investment landscape comes with a whole new set of challenges.
So where do money market funds stand in this environment? How are investors and money market fund providers responding to the latest market conditions? And could further regulatory reform be on the horizon?
It is no secret that the last three years have brought numerous headwinds, from the beginning of the Covid-19 pandemic in 2020 to soaring inflation and the recent collapse of Silicon Valley Bank (SVB) in the US. All of these have brought challenges for investors. Investment involves making choices under conditions of uncertainty.
While that will never change, there are peaks and troughs of uncertainty. Currently, he says, uncertainty is high. The effects of the rapid pace of interest rate hikes are being felt. A recession could be around the corner. Major banks have had to be rescued. Even the gilt market came briefly unstuck. These are not easy investment conditions.
On the other hand, the increase in interest rates means that investors are benefitting from materially higher yields on their cash holdings compared to the last 10 years. This offers great opportunities for astute investors. But we are noticing on the global landscape flight to quality. Despite market stress in March 2020 and September 2022, money market fund providers functioned as normal. Redemption requests increased, some portfolio security valuations were affected, but money market fund providers successfully preserved capital and provided liquidity. They also maintained their quick ratio of short-term assets to short-term liabilities and all other regulatory-required tests.
More recently, the sudden collapse of Silicon Valley Bank in March 2023 led US investors to re-examine their small and medium sized bank exposures, prompting withdrawals from bank deposits. It also caused reverberations in Europe, leading to volatility in the banking sector, which contributed to the forced merger of Credit Suisse and UBS. As apparent vulnerabilities in the banking sector were exposed, concerned investors turned to money market fund providers as an alternative to the bank deposits, resulting in inflows into money funds.
It is no surprise that during times of stress, we see a flight to quality and the recipient of that flight to quality oftentimes is a money market fund or a fiduciary manager. Global money market fund providers operate under a strict regulatory framework designed to ensure they can provide liquidity when required and manage duration risks prudently through short weighted average maturity restrictions.
Over the past 12 months, amidst rapidly rising interest rates and market uncertainty, money market funds providers have typically shortened duration to be substantially within the weighted average maturity limit, and held much higher levels of overnight and weekly liquidity so as to be well positioned to capture further rate hikes.
Following the period of zero and negative interest rates that preceded the last year in the US, Europe and Japan, investors have typically been more proactive with cash management strategies seeking to take advantage of higher yields. However, navigating the timing and duration of investments has proven difficult, with many investors ending up in investments that are trading below the market rate. More recently, concerns have arisen over concentrated bank deposit holdings and a desire to spread that risk over a number of counterparties.
While market uncertainty remains, globally short-term money market funds continue to be a popular choice for investors as — alongside providing diversification and daily access benefits — they are positioned to minimise volatility and absorb any central bank rate hikes quickly. In a nutshell, money market funds are more popular than ever.
The latest crisis reinforced the value of having one’s cash in a diversified set of banking names and paying for professional money management and credit analysis, which cash investors can access through money market fund providers. The latest aggressive rate hiking cycle across the globe has meant that money market funds are also an attractive relative value investment option as opposed to bank deposits, in addition to their other benefits.
Investors are reacting with a resounding vote of confidence in using money market funds to manage their short-term cash needs. Many money market fund providers are continuing to manage their portfolios conservatively with shorter durations and higher liquidity levels than usual, both to absorb any potential interest rate hikes and to act as a buffer for unexpected market volatility.
Furthermore, where investment priorities are concerned, investors are focused on achieving capital preservation and liquidity, with performance only a tertiary concern. While the events of the last few years have not changed these priorities, investors are showing a slightly stronger preference for capital preservation in the current market. Alongside these three things, diversification is something that is on the minds of most investors. Bank treasurers, economic analysts and researchers agree that lots of investors are questioning their comfort at holding all of their cash at a single institution, particularly with smaller regional banks.
The current global economic environment is putting a stern test on the resilience of regulatory reform. Europe and the US both implemented money market fund reform in the wake of the 2008 financial crisis, during which the Reserve Primary Fund infamously “broke the buck”. Under the rules introduced by the Securities and Exchange Commission (SEC) in 2016, constant net asset value (CNAV) funds were required to switch to a variable net asset value (VNAV) model. The European Money Market Fund Regulation (MMFR) implemented in 2019 took a different direction, introducing a low volatility net asset value (LVNAV) model that would operate alongside VNAV and public debt CNAV funds.
Under the MMFR, funds can also impose liquidity fees, redemption gates and suspension of redemptions if liquidity falls below 30% and daily net redemptions are greater than 10% of the fund’s total assets. Mandatory fees and gates will apply if liquidity is less than 10%. This introduction of prescriptive requirements under the MMFR on liquidity, credit quality, portfolio diversification and weighted average maturity, and transparency made money market funds more resilient. The events of March 2020 acted as the first stress test of money market fund reform and money market funds continued to perform as intended, preserving capital and providing liquidity.
However, one area of MMFR that did not work as intended was the link between minimum liquidity thresholds and the possible imposition of gates and fees. This link created pro-cyclical incentives for investors and investment managers around liquidity buffer levels. There is now widespread agreement on “de-linking” which would enable funds to use their liquidity buffers, as intended, during times of stress.
Meanwhile, another area of focus has been the ability of the low volatility net asset value (LVNAV) to maintain a stable net asset value (NAV). Some regulators have proposed that this ability be removed. To remove the LVNAV fund structure would significantly impact investor choice. We are indeed in financial turmoil and regulators need to be on their toes to prevent a major financial crisis. In developing countries like Zimbabwe, the risk of a huge crisis emanating from a global crisis is high, given banking sector concentration risk. The top three banks in Zimbabwe enjoy more than 40% market share and, as such, there is a need to monitor global financial conditions to limit the pass-through effect.
About the writer: Kaduwo is a researcher and economist. Contact: [email protected] call/whatsapp +263773376128