Money Market Reforms

The money market is interlinked with other markets such as the stock market and the bond market. As such, if there is turbulence in the money market, it often quickly spirals to other areas of the economy as well. This has already been in the 2008 global crisis.

The liquidity crisis which greatly exacerbated the negative financial conditions which were prevailing after the Lehman crisis was a great example for the world. Regulators across the world have realized that if there is a run on the money market, then the spillover effect of these runs is felt far beyond the money market.

In this article, we will have a closer look at what money market reforms have been undertaken and how they impact the investors.

Why Were Reforms Required?

Regulators have realized over the years that money markets are remarkably stable most of the time. However, this can change relatively quickly during a crisis. This is because of the fact that securities worth trillions of dollars are traded in the money market. However, almost all of these securities can be redeemed on demand. Hence, there is always a possibility that large and sudden withdrawals can drain the system. This is akin to a run on the bank and hence is called a run on the money market fund.

Regulators realized that the valuation of money market securities dropped rapidly whenever such a run took place. This is the reason that they came up with a set of rules which would help prevent the run. Also, if the run did happen, it would help minimize the loss.

What are the Money Market Reforms?

The following money market reforms have taken place in the United States.

  1. Floating NAV: Earlier, the money market funds followed a stable NAV system. This is because the underlying instruments in which money markets invest funds are very stable. Hence, their value does not fluctuate very often. As a result, funds used stable NAVs of $1 each.

    This meant that whenever an investor wanted to withdraw their funds, they could easily encash their NAV’s in the shortest period of time. However, the reforms have now mandated all money market funds to adopt a floating NAV system. All funds have also been asked to publish prices up to 4 decimal points. It is likely that there will be a slight change in the prices. This is done in order to delay the process of taking money out of the market.

    The NAV calculation takes a certain amount of time. Hence, it is no longer possible for companies to instantaneously allow investors to withdraw money from money market funds. The settlement process takes a few hours and sometimes may even spill over to the next day. This ends up delaying the redemption of units from the money market.

    Floating NAV’s also means that the valuation of money market holdings held by investors will change over time. These updated values will have to be periodically reported on the balance sheet following the mark to market accounting.

  2. Fees and Gates: The new rules have been created in such a way that during the normal course of business, investors can easily divest their funds and obtain cash. However, if there is a run on the money market fund, then withdrawal becomes much more difficult.

    For example, the rules mandate that if a lot of investors are simultaneously withdrawing their money, then the money market fund needs to impose a 2% withdrawal fee. The purpose of this additional transaction cost is to deter investors. However, even after the imposition of the fee, if the withdrawals do not stop and cross a certain threshold, then the withdrawals can be completely suspended. This can be done as many as ten times within a ninety-day period.

  3. Increased Diversification and Disclosure: Up until now, money market funds were not required to disclose a lot of details to the regulators. However, that has changed with this reform.

    Regulators want to closely monitor money market funds and their liquidity position. This is the reason that these details need to be disclosed to investors as well as to the regulator. Also, the regulators have made it mandatory to follow certain guidelines related to the diversification of the overall portfolio.

  4. Stress Testing: The new reforms are trying to bring in best practices from the banking industry into the money market. This is because just like the banking industry, the money market also has a lot of demand deposits. Therefore, regulators want to ensure that even in the worse of scenarios, the money market has enough resources to not be insolvent.

    Money market funds are now required to routinely undertake stress tests and take necessary actions in order to mitigate any shortcomings that such tests might highlight.

The fact of the matter is that the nature of the money market, as well as money market funds, has undergone a sea of change after the regulations have been put into place.

Investors should be aware that their redemption options may get suspended or delayed in certain conditions. This obviously has a negative impact on liquidity which is an important feature for any money market fund.

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