The U.S. Treasury's Office of Financial Research published its "OFR 2022 Annual Report to Congress" Thursday, which analyzes threats to the financial stability of the U.S. and contains several sections relating to money market funds. Under "Financial Markets and Liquidity, Short-term Funding," they write, "Short-term funding markets support core functions of the financial system, providing liquidity to borrowers and allowing corporations, financial firms, and other investors to meet immediate and near-term cash needs. Consequently, disruptions in funding markets can present serious financial stability risks since they jeopardize institutions' ability to roll over their existing short-term funding obligations and meet pending expenditures."

The report explains, "Funding markets are relatively stable, but market liquidity remains fragile. Market volatility and the impact of Federal Reserve interest rate increases are magnified in short-term markets. First, a protracted period of low interest rates and the Federal Reserve's quantitative easing facilitated risk taking. Second, investors may have taken market liquidity and low price volatility for granted and underestimated the speed and pace of interest rate increases. Third, the market remains vulnerable to liquidity and maturity transformation mismatches for banks and nonbanks. Fourth, there is heightened uncertainty related to the Federal Reserve's monetary policy and its impact on growth, inflation, market sentiment, and market liquidity."

It tells us, "Before the 2007-09 financial crisis, the Federal Reserve primarily controlled the policy rate in the interbank market by adjusting the supply of reserves in the banking system. Since the crisis, U.S. monetary policy has been implemented in an environment with ample reserves, reducing the interbank market's importance for banks' funding. `Now, the Federal Reserve instead pays interest on reserve balances (IORB) to influence banks' overnight rates. Additionally, to broaden support for the floor of overnight rates, the Federal Reserve uses the Overnight Reverse Repo Facility (ON RRP) to support a floor on short-term rates by providing an alternative investment for nonbank financial institutions such as money market funds (MMFs) and government-sponsored enterprises (GSEs). In the ON RRP operation, the Federal Reserve borrows cash overnight at a specified rate from counterparties, secured by collateral from the central bank's Treasury securities portfolio."

The OFR says, "The ON RRP level is very high at $2.4 trillion as of September 30, 2022, an increase of $846.4 billion since the start of 2022. For comparison, during 2020 and the pre-pandemic period, its peak daily usage was $400 billion. Bank reserves dropped 30.1% to $3.0 trillion (as of September 28, 2022) since December 2021, when they reached a high of around $4.3 trillion, but are still regarded as ample. Traditionally, ON RRP usage tends to spike around month- and quarter-end reporting dates when some banks shrink their balance sheets, limiting overnight investment options for cash-rich money market participants. Additionally, GSEs' investment in the ON RRP tends to follow intra-month calendar effects. However, Treasury collateral scarcity and elevated demand for overnight investments pushed rates on private sector overnight repurchase agreements below the ON RRP award rate.... As a result, eligible money market participants invested substantially in the ON RRP, with prime and government MMFs accounting for up to 92% of the total lending to the ON RRP."

The report continues, "Broadly speaking, MMFs comprise a substantial source of short-term funding, given their need to invest large cash balances and to hold mostly short-term investments. The OFR Money Market Fund Monitor shows that total U.S. MMFs' assets under management have hovered around $5 trillion since the early days of the COVID-19 pandemic in 2020. In anticipation of interest rate increases in 2022, MMFs sharply reduced their portfolio holdings' weighted average maturities (WAMs).... MMFs are incentivized to shorten their portfolio WAMs because rate hikes lead to mark-to-market losses on existing security holdings. Shortening the WAM allows MMF managers to reduce losses and increase holdings of newly issued securities with higher yields."

Discussing "Money Market Funds," the OFR tells us, "Money market funds (MMFs) are generally perceived to offer the preservation of capital and liquidity in normal market environments. They are viewed as an alternative to bank deposits and used as a cash management tool by investors. However, MMFs shares are not cash equivalents to the extent that they invest in certain securities that cannot be easily liquidated at par in all markets. They also do not carry the same protections as cash equivalents. Some assets held by MMFs have limited secondary market liquidity and are often held to maturity. The limited liquidity of many money market instruments creates a first-mover advantage that generates run risk whenever investors believe conditions are deteriorating, which can exacerbate moves in asset prices."

They comment, "Banks, particularly foreign-owned banks (FOBs), are large funding recipients of prime and government funds. On average, 60% of credit provided by prime funds and 20% provided by government funds was to FOBs since 2016.... This creates cross-border vulnerabilities, where shocks in both directions can quickly transmit stress across jurisdictions. A related vulnerability is that government MMFs often enter into repurchase agreements with non-U.S. counterparties and purchase Federal Home Loan Bank System debt, exposing MMFs to cross-border and counterparty risks."

The report states, "In December 2021, the SEC proposed amendments to certain rules that govern money market funds under the Investment Company Act of 1940 (Release No. IC-34441). The proposed amendments are intended to improve money market fund resilience and transparency while preserving the core attributes of money market funds. If adopted as-is, the proposed amendments would: 1. Remove the ability of MMFs to impose liquidity fees and redemption gates when they fall below certain liquidity levels; 2. Require swing pricing specifically for institutional prime and tax-exempt MMFs when the funds experience net redemptions, so that redeeming investors bear the liquidity consequences; and 3. Increase the minimum liquidity requirements applicable to money market funds to provide a more substantial buffer for rapid redemptions."

It adds, "While the proposed rules bolster liquidity and shift the liquidity costs of redemptions to redeeming investors, the proposals may not discourage outflows in the tail scenarios that prompted the proposed rules. First, though increasing the liquidity requirements would better position funds to meet redemptions, the lessons from March 2020 may underestimate future risk without similar interventions from the Federal Reserve and the U.S. Treasury. Second, swing pricing may not avert run risk if investors preemptively redeem to benefit from disposing of their shares at the initial net asset value (NAV). This is because that NAV does not reflect the costs of the managers having to potentially sell additional assets at discounted prices to meet additional redemptions. Similar to the fears of redemption rates, MMFs investors may be concerned about absorbing the costs of a fund manager's sudden forced sales. They may preemptively decide to try and sell first—in the process, creating a feedback loop. Third, certain types of MMFs, such as government funds and select retail funds, are exempt from some proposed requirements. However, these types of funds are still susceptible to interest rate, duration, and credit risks and, in turn, to run risk.... And lastly, as noted in the 2020 OFR Annual Report, sponsor support is commonly used to prevent runs, but there is no certainty about the availability or magnitude of sponsor support in future stress periods. This lack of certainty may generate incentives for fund investors to run."

Finally, the OFR says, "In addition, the 2021 OFR Annual Report noted that other cash alternative funds also experienced heavy outflows, contributing to the stress in the funding markets in March 2020. This included dollar-denominated offshore MMFs, bank-managed short-term investment funds (STIFs), local-government investment pools (LGIPs), private liquidity funds, and ultra-short corporate bond mutual funds. These funds serve a similar purpose as MMFs but are subject to varying degrees of regulatory oversight and portfolio transparency. Arguably, investors in these products are inclined to run when markets are under severe stress."

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