24 November 2021

SUERF: Did liquidity limits amplify money market fund redemptions during the COVID crisis?

Regulation of Money Market Funds (MMFs) in the EU requires some categories of MMFs to consider applying liquidity management tools if they breach a minimum “weekly” liquidity requirement. Anticipation of the application of such tools is a plausible amplifier of run risks.

 Using Irish, Luxembourgish and UK MMF data, we assess whether proximity to liquidity thresholds explains differences in redemptions both at the start of the COVID-19 crisis and in the following months. We assess this effect for MMFs subject to and exempt from the liquidity regulation. The evidence shows that out flows can be robustly associated with proximity to minimum liquidity requirements in the peak of the crisis for funds required to consider suspending redemptions if breaches occur. In the post-crisis phase the redemption-liquidity relationship does not appear to be specifically related to mandated consideration of the suspension of redemptions. The evidence supports consideration of countercyclical liquidity requirements or buffers that are more usable in times of stress.

The unintended consequences of financial regulations often only come to light in the next significant crisis. The negative impact of COVID-19 on non-bank intermediation and, in general, financial markets can largely be understood in relation to its shocks on economic fundamentals.1 But there is also theoretical and empirical evidence showing that the impact of negative economic shocks on financial markets could be amplified by certain financial regulations introduced specifically to minimise such adverse reactions.2 In many ways, the COVID-19 pandemic provides a testing ground for regulations that were designed with the best of intentions following the Global Financial Crisis (GFC). Despite the aim of those initiatives being to improve systemic resilience, fears that some post-GFC regulatory initiatives may have contributed to destabilising behaviours deserve to be assessed.

In this brief we outline the results of research uncovering regulation-driven amplification in the Money Market Fund (MMF) sector. This emerged during March of 2020, when the intermediation of short term funding by MMFs to banks and non-financial corporations was significantly impaired. The importance of such intermediation by MMFs is evident from the fact that their large and abrupt redemptions in March 2020 ($ 200 billion in key MMF subsectors) were a key reason behind the approval of extraordinary purchase programs by central banks in the EU, US and UK.3

Regulators expected the post-GFC measures to mitigate rather than exacerbate run-risks of MMFs. Liquidity requirements were introduced in the major MMF jurisdictions (EU, US and UK, for instance) specifically to prevent a damaging repetition of 2008’s fire sales by MMFs. Regulators introduced larger liquidity requirements so that funds would be more prepared to withstand large and persistent outflows in a crisis. The new framework also involved requirements on funds to impose (or consider imposing) limits to redemptions (i.e., Liquidity Management Tools, or LMTs) when MMFs breached liquidity requirements. This linkage between liquidity breaches and LMTs was expected to give comfort to investors so that, in a crisis, they would not be induced to redeem their holdings (adding to stresses). In the US, the then-SEC Chair, Mary Jo White, argued that this would “mitigate risk and the potential impact for investors and markets.” However, the perception of a linkage between liquidity and redemption limits may explain why some funds experienced elevated redemption pressures at the onset of the COVID-19 pandemic. This potential side-effect is the main theme of the evidence presented in this brief.

The research discussed in this brief focuses on the effects of the rule that links liquidity breaches to redemption limits in the EU, but similar effects are present in the US. The EU regulation (i.e., Article 34 of the MMF Regulation of 2017) differs somewhat from that in the US. Rather than mandating LMTs when liquidity thresholds are breached, it requires some categories of MMFs to consider applying LMTs if they breach a minimum weekly liquidity requirement and simultaneously experience daily outflows larger than 10% of net asset value (NAV).4 The categories subject to the EU rule are Low-Volatility NAV funds (LVNAV) and Public-Debt Constant NAV funds (PDCNAV). Variable NAV funds (VNAV) are exempt from it.

Comparing the cumulative outflows from funds subject to and exempt from the regulation around the onset of the COVID crisis provides initial evidence of a regulation side-effect. Descriptive evidence on European MMF data shows that assets under management of LVNAVs (those investing in USD assets) decreased significantly more than that of similarly focused VNAVs during the peak of the COVID crisis. This result is unrelated to the asset holding profiles of the two groups....

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