We assess the effectiveness of the EU’s regulatory framework from a financial stability perspective and draw three important lessons.
The turmoil seen in March 2020 highlighted key vulnerabilities in the money market fund (MMF) sector. We assess the effectiveness of the EU’s regulatory framework from a financial stability perspective and draw three important lessons. First, investment in non-public debt assets exposes MMFs to increased liquidity risk, highlighting the vulnerability from liquidity mismatch between MMF assets and liabilities. Second, low-volatility net asset value (LVNAV) funds are particularly vulnerable to liquidity shocks, given that they invest in non-public debt assets while offering a stable value to their investors. Third, MMFs seem reluctant to draw down on their liquidity buffers during periods of stress, which is amplified by threshold effects associated with breaching the liquidity requirements. Overall, our findings point to fragilities in the EU MMF sector which underline the case for a strengthened regulatory framework. Sensible policy options include removing threshold effects and enhancing the liquidity risk profile of private debt MMFs, for instance by increasing their liquidity buffers while ensuring that the buffers are usable during periods of stress.
Introduction
MMFs are primarily used by investors to store liquidity and manage their cash needs. By investing in short-maturity debt, MMFs also provide short-term funding for financial institutions, corporations, and governments. In this sense, MMFs play a crucial role in the financial system as intermediaries between demand and supply of short-term funding.
The global financial crisis of 2008 highlighted key vulnerabilities in the MMF sector with the potential to amplify risks in the wider financial system. In 2012, the International Organization of Securities Commissions identified several factors that make MMFs vulnerable to investor runs. These include first-mover advantages and a disconnect between the risks that MMF investors perceive and existing credit, interest rate, and liquidity risk (International Organization of Securities Commissions, 2012).
In 2017, EU legislators adopted the EU Money Market Fund Regulation.
1 The new regulatory framework aimed at improving the resilience of the European money market fund sector while maintaining MMFs’ ability to provide short-term funding to banks and the real economy. The new framework devised three main regulatory types of MMFs and introduced new rules regarding their portfolio compositions:
- Constant net asset value (CNAV) funds maintain a stable value per share, if the gap between the stable and marked-to-market NAV is lower than 50 basis points. They are required to invest mainly in public debt.
- Low volatility net asset value (LVNAV) funds are permitted to invest in a broader range of assets, including commercial paper and certificates of deposit. They trade at a stable value, as long as the gap between the stable and marked-to-market NAV is lower than 20 basis points.
- Variable net asset value (VNAV) funds can invest in the same range of assets as LVNAV funds, but trade at a marked-to-market NAV. There are two types of VNAV funds, with a shorter and a longer maturity profile.
The MMF Regulation also introduced new liquidity requirements. CNAV and LVNAV funds face the same requirements in terms of daily and weekly liquid assets. If their weekly liquid assets fall below a certain threshold, these funds may need to consider applying liquidity fees or temporary redemption suspensions. VNAV funds have lower liquidity requirements and do not need to consider liquidity management tools if they breach the weekly liquid asset threshold.
Following the onset of the COVID‑19 crisis in early 2020, private debt MMFs experienced significant outflows resulting in exceptional challenges for managing liquidity. While the level of stress stabilised following central bank policy actions, the episode exposed vulnerabilities in the sector arising from liquidity mismatch between MMFs’ assets and liabilities.
This policy brief summarises the findings of a recent analysis which assesses the effectiveness of the EU’s regulatory framework from a financial stability perspective (Capotă et al., 2022). By investigating the behaviour of investors and fund managers during the COVID-19 market turmoil in March 2020, this policy brief highlights fragilities in the European MMF sector and calls for strengthening the regulatory framework for private debt MMFs in the EU....
By Laura-Dona Capotă (University of Orléans), Michael Grill (European Central Bank), Luis Molestina Vivar (European Central Bank), Niklas Schmitz (University of Cambridge), and Christian Weistroffer (European Central Bank)
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