The Journal of Banking & Finance published a paper written by Michel Baes, ESMA's Antoine Bouveret and Eric Schaanning titled, "Money Market Funds Vulnerabilities and Systemic Liquidity Crises." The Abstract explains, "Despite regulatory reforms, Money Market Funds (MMFs) experienced severe stress in March 2020, following large redemptions and dislocations in short term markets. We provide a model showing the trade-offs between liquidity and capital preservation services offered by MMFs. We show that in a crisis, MMFs cannot provide liquidity and capital preservation to investors at the same time. As a result, investors have an incentive to run pre-emptively. We calibrate our model on data from USD MMFs and find that most funds would have been unable to meet redemptions above 30% mid-March 2020. Unless short-term funding markets are made resilient in times of stress, MMFs will face similar challenges during future liquidity crises."
The paper's "Introduction" states, "Money Market Funds (MMFs) are used by investors as cash management vehicles. MMFs perform two key functions: they provide on-demand liquidity, and they seek to preserve capital for investors -- that is, they aim to maintain the value of the original investment and avoid losses. These features make MMFs particularly attractive to institutional investors. However, MMFs vulnerabilities emerge from the liquidity and maturity transformation they perform: they offer daily redemptions to investors while investing in instruments of longer maturity and of varying degrees of liquidity."
It says, "MMF fragilities arise because they do not provide limits on the quantity of liquidity available to investors (all fund shares can be redeemed), and do not provide a price for liquidity (the share price is constant or subject to very low variations). These features create incentives for investors to redeem early, especially when anticipating that a fund might become unable to meet redemptions without losses."
The piece continues, "While other open-ended funds also perform liquidity transformation (Gold stein et al., 2017), MMFs are more vulnerable because they are used as a primary source of liquidity, and are expected to maintain a stable NAV. In the aftermath of the Global Financial Crisis, regulatory reforms in the US and Europe sought to make MMFs more resilient. The regulatory framework was tightened to reduce credit risk and maturity transformation, and explicit liquidity requirements were introduced. However, the March 2020 episode revealed that these changes did not resolve the core tension between liquidity provision and capital preservation (FSB (2020), Anadu et al. (2022))."
It tells us, "In this article, we study the inherent trade-off between the liquidity and capital preservation services MMFs offer. We develop a stylized model that shows that MMFs cannot deliver both simultaneously during a crisis. When liquidity in underlying markets dries up, redeeming investors can impose losses on remaining investors, prompting pre-emptive redemptions. This dynamic creates a run risk similar to that described by Diamond and Dybvig (1983), but it arises from the interplay between price stability and unrestricted liquidity."
The authors state, "We calibrate the model using data from US Prime MMFs in the lead-up to the March 2020 'dash for cash' episode. Our analysis shows that most funds would have been unable to meet redemptions above 30% of their net asset value without violating capital preservation -- consistent with observed stress and the need for central bank intervention. We extend the analysis to European USD MMFs and find comparable vulnerabilities."
They add, "Finally, we apply the framework to assess potential regulatory reforms and their impact on the resilience of MMFs. We explore measures such as the move to a floating net asset value (NAV), higher liquidity requirements and countercyclical liquidity buffers. We quantify how these reforms affect the trade-off between liquidity and capital preservation, and discuss their implications for financial stability. Overall, our findings suggest that unless the resilience of short-term funding markets is improved, MMFs will continue to face destabilizing run risk in future crises."
The paper also explains, "Our work relates to several strands of the literature. On the theoretical side, classic models of runs (Diamond and Dybvig, 1983; Chen et al., 2010) highlight the risks of liquidity transformation. Hanson et al. (2015) compare the fragilities of banks and market-based intermediaries, showing how fire sales and liquidity needs create negative externalities in shadow banking. Our key contribution to this strand of literature is to model how the interactions between price and liquidity constraints, asset liquidity and investor redemptions determine the resilience of MMFs."
It continues, "On the empirical side, several papers have documented the run on MMFs observed during the Global Financial Crisis of 2007-2008 and the March 2020 episode. During the former, runs, and sponsor support were widespread (Pedersen, 2009; McCabe, 2010; Chernenko and Sunderam, 2014). More recent studies show that US Prime MMFs which were more likely to use fees and gates (due to lower liquid assets) experienced higher outflows in March 2020 than funds with higher liquidity buffers (Li et al., 2021; Cipriani and La Spada, 2020). European MMFs showed similar patterns, particularly among Low Volatility Net Asset Value (LVNAV) funds with limited liquid assets (Dunne and Giuliana, 2021)."
The paper then states, "Finally, our results contribute to the discussion of regulatory reforms and their impact. McCabe et al. (2013) and Cipriani et al. (2014) analyze how liquidity fees, gates, and floating NAVs may influence run incentives. Allen and Winters (2020) and Fricke et al. (2024) document how regulatory changes reshaped fund flows, shifting assets between fund types and jurisdictions. We contribute to this discussion by providing a quantitative model to assess how specific reforms affect MMF resilience."
The Introduction adds, "The remainder of the paper is organized as follows: Section 2 discusses MMF fragilities, Section 3 outlines a stylized model to illustrate the liquidity/capital preservation conundrum for MMFs, Section 4 applies the model to data on European and US MMFs, Section 5 discusses regulatory reforms and macroprudential considerations and Section 6 concludes."
The work concludes, "We have shown how MMFs vulnerabilities crystallize during liquidity crises. In times of stress, funds are unable to provide capital preservation and liquidity services to investors. Using data on EU and US MMFs, we calibrate our model and show that during the COVID-19 crisis, MMFs ability to meet redemptions was very low, at around 30% of NAV. A range of regulatory reforms can be considered, and the most effective relate to those that relax the price deviation and reduce liquidity transformation performed by MMFs. Such reforms can improve the resilience of MMFs. However, unless investors' behavior changes and short-term funding markets are made more resilient in times of stress, MMFs will continue to face acute challenges during liquidity crises."
