26 January 2022

ECB: Mind the liquidity gap: a discussion of money market fund reform proposals

Money market funds perform a key function for the financial system by linking the short-term funding and cash-management needs of various market participants. Proposals to reform the regulation of these funds and enhance the sector’s resilience are assessed.

This article assesses proposed reforms to the Money Market Funds (MMF) Regulation^[1] to enhance the resilience of the sector. Specifically, the article provides a rationale for requiring private debt MMFs to hold higher levels of liquid assets, of which a part should be public debt, and considers the design and calibration of such a requirement. The article also proposes that the impediments to the use of liquidity buffers should be removed and authorities should have a role in releasing these buffers. Finally, while the removal of a stable net asset value (NAV) for low-volatility MMFs would reduce cliff effects, we argue that this might not be necessary if liquidity requirements for these private debt MMFs are sufficiently strengthened.

1 Introduction

MMFs fulfil a dual economic function, namely liquidity management for investors and the provision of short-term funding for financial institutions, non-financial corporations and governments. MMFs perform a central function for the financial system by bringing together the demand for and supply of short-term funding. By investing in a portfolio of short-term debt and offering daily liquidity, MMFs enable investors to store liquidity and manage their cash needs, while at the same time they contribute to the short-term financing of banks and other companies in the wider economy.

This dual economic function can make private debt MMFs vulnerable under stressed market conditions, and the associated systemic risk was highlighted during the coronavirus (COVID‑19) market turmoil in March 2020. Following the onset of the COVID‑19 crisis in Europe in early 2020, non-public debt MMFs experienced significant outflows resulting from liquidity pressures, flight-to-safety considerations, and various other factors (see, for example, Capotă et al., 2021; ESMA, 2021).^[2] These MMFs came under stress and had to reduce their holdings of private debt assets, compromising their ability to simultaneously provide cash management services to investors and short-term funding to banks and non-financial corporations (NFCs). These risks were examined and documented by the Financial Stability Board (FSB) in its recommendations on MMFs and were discussed in the Eurosystem’s response to the European Securities and Markets Authority (ESMA) consultation on the regulatory framework for MMFs in the EU.^[3]

This article assesses possible MMF reform proposals to enhance the resilience of MMFs by targeting liquidity mismatch and makes the case for a mandatory public debt quota alongside other measures. The article highlights the need for private debt MMFs to strengthen their liquidity position, including through the introduction of a public debt buffer. The article also discusses the role authorities should play in the use of liquidity management tools and the release of liquidity buffers. Finally, the article considers whether the stable NAV for low-volatility net asset value (LVNAV) funds needs to be removed...

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