The Case for Central Bank Liquidity Facilities for Institutional Money Market Funds in the Offshore Market
This paper sets out the case for the creation of liquidity facilities at the Bank of England and the European Central Bank, to provide emergency liquidity support for institutional money market funds. It has been prepared by the Institutional Money Market Fund Association (IMMFA), the trade association that represents the sponsors of Triple-A rated money market funds domiciled in Dublin, Luxembourg and the Channel Islands. Further information about IMMFA, its activities, its members and the products they manage can be found at: www.immfa.org
In the past year the scale of dislocation within the Euro and Sterling wholesale money markets has been unprecedented. While many asset markets have experienced high levels of volatility and significant price falls, the money markets have suffered from a dramatic loss of liquidity. Markets that are normally highly liquid, with narrow bid-offer spreads across a range of short-term investment instruments, have become highly illiquid, with poor (and sometime no) price discovery.
End investors have become highly risk-averse and intermediaries - including the managers of money market funds (MMFs) - have responded by holding an unusually large amount of money in overnight deposits. In turn, this has led to further dysfunction within the markets as the LIBOR curve has steepened sharply and many banks and financial institutions have found it difficult to manage their net funding positions in the wholesale markets.
These problems are familiar to market participants, including regulators and central bankers. In the past few weeks several actions have been undertaken to restore confidence, primarily through injections of liquidity into the money markets via central bank repurchase operations and through the provision of new capital to the major banks. However there are some additional steps, which, if taken, would contribute to an improved infrastructure for the effective functioning of the money markets. These steps would ease the continuing liquidity problems in the Sterling and Euro money markets, as well as helping to mitigate the risk of repetition of the current problems. In addition they would ensure that the offshore money markets keep step with emerging best practice in the domestic US dollar markets.
This paper is organised as follows. Section 1 sets out the background to the growth of Institutional MMFs in Europe over the past fifteen years; Section 2 explains the benefits that these funds have delivered, to managers, to end investors, to borrowers and to the overall operation of the wholesale money markets; Section 3 describes the problems faced by MMFs and their sponsors due to the dislocation in the money markets; Section 4 proposes the creation of liquidity facilities for MMFs at central banks, thereby providing a solution to the current problems; Section 5 outlines some brief conclusions.
 Background: the growth of the offshore MMF industry
Money Market Funds were invented in the US in the early 1970s and were initially targeted at the retail market. As their popularity grew they were brought under the regulatory oversight of the Securities and Exchange Commission (SEC). The SEC standardised the investment guidelines regarding credit, liquidity, duration and operational risks under Regulation 2-a7. Data compiled by the Investment Company Institute (ICI) suggest that assets under management in domestic US MMFs grew from $76bn at the end of 1980 to $3,536bn at the end of October 2008. This equates to an annual growth rate of just over 15%, every year for the past 30 years.
While MMFs remain an attractive investment vehicle for retail investors in the US, they have increasingly become the short-term investment vehicle of choice for institutional market participants. Today, 64% of US MMF assets (i.e. $2,260bn) are in institutional as opposed to retail funds. The ICI estimates that over 30% of US business's short-term assets are managed in MMFs, up from only 9% in 1993. Further, the rapid expansion of the US Commercial Paper (CP) market over the same period has reflected the ability of MMF managers to direct short-term liquidity directly to corporate issuers.
The first MMFs in the offshore market (that is, the market outside of the US domestic market) date back to the 1980s, and once again the initial product offering was aimed at the retail market. However, from the mid-1990s MMF products aimed at the institutional market were developed, often domiciled in Dublin or Luxembourg for tax reasons. These funds were offered in US$ for offshore dollar investors, in Sterling and, following the creation of the single currency, in Euro. In the absence of a single regulatory authority to provide oversight to these funds, the providers of offshore MMF settled on the idea of a Triple-A rating for their funds, to distinguish them from other products.
In 1995 the assets under management of institutional MMFs in the offshore market were less than $1bn. By October 2008 that amount had grown to $626bn, an annual growth rate of around 64% every year for the past 13 years. The relative proportions of this market, by currency, are US$ - 57%, Sterling - 25%, and Euro - 18%.
Offshore MMFs invest in a wide variety of money market assets including time deposits, certificates of deposit, commercial paper, repurchase agreements, Treasury Bills and short dated fixed and floating-rate notes. The funds that are represented by IMMFA are characterised by strict limits on the final maturities of the assets, the weighted average maturity of the overall portfolio, the credit quality of the individual assets and of the overall portfolio. Each MMF will have a Triple-A rating from at least one of the major credit rating agencies. Details of these limits are set out in the IMMFA Code of Practice, agreed by all members in February 2003, which can be found at the IMMFA website.
As in the United States, offshore MMFs have become important conduits for liquidity management. They provide a convenient, low-cost vehicle for institutions with short-term liquidity to invest, and they provide a ready source of funding for banks and corporations with short-term funding needs. Although their relative importance in the Sterling and Euro markets is not yet as great as their importance to the US domestic market, the influence of MMFs has grown significantly in recent years. As the next section suggests, this growth has been of considerable benefit to a wide range of participants in the offshore money markets.
 Benefits: How MMFs have contributed to improvements in liquidity management in the wholesale markets
To give a comprehensive account of the benefits of MMFs requires consideration of four different sets of market participants. First the sponsors and managers of MMFs, second investors who use MMFs to manage their short-term liquidity, third borrowers who raise short-term liquidity by selling assets to MMFs, and finally the central banks and regulatory authorities who have an interest in the maintenance of well-ordered and efficient markets.
[2a] Benefits to sponsors and managers
Prior to the development of the offshore MMF industry the management of cash assets by investment management firms in the UK and Europe was amateurish and haphazard. Cash was not managed as a separate asset class, but as a residual that arose from other investment activity in the equity and fixed income markets. Often it was simply invested in short dated bank deposits and certificates of deposit, with each client's cash managed in a small segregated account. Credit analysis was perfunctory and often depended upon advice from market intermediaries, namely money-brokers. The management of cash was routinely delegated to the most junior person on the fixed income team, or on the trading desk.
The arrival of offshore MMFs allowed investment firms to treat cash as an asset class in its own right and cash management as a separate business with its own economic value to the firm. Pooling cash from multiple segregated funds into one large fund per currency allowed for the benefits of scale to be applied to the cash business. MMFs grew to sufficient size to allow for modern portfolio management methods to be applied to them: credit, duration, liquidity and operational risk could all by managed more efficiently. In addition, growing fund size allowed cash managers to buy assets in larger size, giving them greater influence in the sourcing and pricing of new issuance.
As cash management become more professional it attracted higher calibre portfolio managers, credit analysts and business managers. The quantity and quality of people involved in the management of cash at the larger investment firms increased significantly. The entry of US firms - with a long track record of professional cash management in their domestic market - into the offshore cash markets also accelerated this process. As MMFs grew in size and profitability, investment firms were able to invest in better technology for risk and operations management, leading to shorter settlement times and automated confirmation processing.
Over a fifteen-year period - from the early 1990s to the present - cash management was transformed from a sleepy backwater into a highly sophisticated and competitive market place. Investment firms could manage their overall business risks better, since revenues from cash management are not linked to rises or falls in equity markets, and could offer a better service to their clients, many of whom welcomed the opportunity to outsource their cash management (see next section). However, these benefits depended upon the shared understanding that MMFs are an investment product: that is, the investment risks lay with the investors (the principals) and not with the fund managers or their sponsors (the agents).
[2b] Benefits to investors
The rapid growth in size of offshore MMFs reflects the significant benefits they offer to investors as compared with previous cash management arrangements. Some of the money that has flowed into MMFs came from cash that investment firms already controlled - the cash held in balanced mandates, or cash held as collateral against loaned securities or derivative positions. However a substantial proportion of the growth in the size of MMFs has come from investors who once managed their own short-term cash but who now prefer to outsource their cash management activities to investment firms. These investors include corporate treasuries, insurance companies, local authorities, charities, universities, sovereign wealth funds, hedge funds, and investment firms who lack their own specialist cash management capabilities.
The benefits of outsourcing have been widely embraced by investors in the UK, continental Europe and, increasingly, throughout the global offshore marketplace. They include access to specialist credit analysis and portfolio management skills; the benefits of scale and diversification that are achieved by investment in a large pooled fund; and the ability to reduce costs by outsourcing. One of the first groups to embrace the offshore MMF product were the treasury departments of large, international corporations, many of whom had knowledge of MMFs from their US operations. This group is generally more sophisticated and cost-conscious than other cash managers; but where they led others followed.
Paradoxically, those organizations with the most to benefit from outsourcing - those who lack access to sophisticated investment skills and who lack the resources to pay for state-of-the-art risk management technology - have been the slowest to take advantage of the opportunities afforded by offshore MMFs. It is noteworthy that many local authorities, universities and charities have chosen not to make use of MMFs, relying instead on an in-house investment function that is often heavily reliant for advice on consultants and money-brokers. It is also noteworthy that is it precisely this sector who have suffered over the past few months from imprudent investments in foreign banks.
In short, the advent of offshore MMFs has led to far greater professionalism in the management of cash assets by investment firms, a benefit which has been welcomed by many investors including large corporations and other sophisticated investment mangers such as hedge funds. Some of those investor groups that have been slow to take advantage of the benefits of MMFs have found themselves seriously disadvantaged in recent months, as their lack ability to make sound credit judgements has proved expensive.
[2c] Benefits to borrowers
While the advantages of MMFs to sponsors and investors are evident, it is also the case that many borrowers have benefited from the growth of the offshore MMF sector. For corporate borrowers, the US experience has been replicated in Europe: as MMFs have grown in size so too the volume of commercial paper (CP) issuance has grown, making it easier for corporate borrowers to fund their short-term activities. Rather than borrow directly from banks, corporate treasurers have been able to use bank trading-desks to sell their short-term debt to MMFs. In addition MMFs have proved to be active buyers of secondary CP, making it easier for a liquid secondary market to develop for this asset class.
Banks with short-term funding needs have also benefited from the activities of MMFs. Rather than the time consuming (and therefore expensive) process of gathering a large number of small, short-term deposits from a disparate range of wholesale investors, banks are now able to borrow in large size and at various maturities from MMFs. The ability of MMFs to gather assets into large pools and to invest at a range of maturities provides banks with an easier source of cash for short-term borrowing. In addition the first step of the maturity transformation process is now increasingly managed by MMFs, which offer daily liquidity to investors but which lend to banks out to one-year, thereby reducing the burden on bank balance sheets.
MMFs have also become active in the repurchase and reverse repurchase markets, improving their liquidity for other market participants. They have also been one of the main sources of demand for asset-backed CP, which allowed for the development for a market in short-dated securitised paper in the offshore markets.
As with any structural change in the financial marketplace, there have been losers as well as winners. The role of money brokers in directing cash from unsophisticated investors has been greatly reduced and the cost of raising cash has probably risen, at the margin, for some borrowers, because MMF managers have been able to demand appropriate price differentiation for credit risk. However, to the extent that cash markets are now more transparent, more efficient and more professional, this is a general benefit to borrowers who are now able to get better information on their true cost of funding.
[2d] Benefits to regulators
For those charged with regulatory oversight for the money markets, the offshore MMF industry has brought two significant benefits. First, the money markets are now much more transparent. It is clear where the large pools of money are, who is responsible for managing them, and under what investment guidelines they are being managed. Previously it was almost impossible to gather data on the investors, their goals, their risk management policies, and the resources that they were devoting to their work. Now these areas are much better understood and the sponsors of MMFs provide much more information on what they do and how they do it.
IMMFA, the trade association for the offshore money market industry, has played in important role in the standardisation of information and in making this information easily accessible to investors and to regulatory authorities. It also acts as a focal point for discussions between the leading investment firms on issues affecting the Sterling and Euro money markets. The ability of regulators to monitor emerging trends in the money markets and to canvas opinions of market participants has therefore increased.
Second, the level of professionalism in the money markets is much higher. As MMFs have become successful and profitable businesses, so their sponsors have become more willing to invest in them: there are now more and better people working in the money markets, with more and better technology to work with, than was the case fifteen years ago. While this improvement in professionalism is most obviously a benefit to investors (many of whom are now paying lower fees for better cash management) it is also of benefit to regulators, who have an interest in the money markets working as efficiently as possible.
Neither the Sterling money market nor the Euro money market can yet compete with the domestic US dollar market with regard to size, liquidity and transparency. But the qualitative gap between the offshore markets and the domestic US market has narrowed dramatically in the past fifteen years, largely owing to the development of the offshore MMF industry.
 Problems: How recent market events have impacted the offshore MMF industry
Managers of MMFs have at all time to take account of four very different types of risk: operational risk (such as trade settlement for securities and order management for clients), performance risk (particularly if the shape of the yield curve changes unexpectedly), credit risk (if a borrower defaults on their loan or if there is a market wide rise in credit spreads) and liquidity risk (the inability to meet client redemption requests). In normal markets the first three of these risks are to the fore. They require the application of sound portfolio management skills together with sound operational procedures. Liquidity risk is normally easy to manage because money market assets can be sold quickly to fund redemption demands from clients. Even unexpectedly high requests for cash can usually be met within two days.
However, the past few months have been anything other than normal for the money markets. As concerns about the state of the US housing market spread, first mortgage-backed securities, then asset-backed securities more generally, and then a significant proportion of more traditional money market instruments have became illiquid. Investors are not able properly to assess the value of the assets they own and as a consequence they are not able to judge the fair value of their portfolios. In the absence of a market consensus on fair pricing, trading in many types of assets is completely drying up. The money markets - often regarded as the most liquid of markets - are now illiquid.
MMF managers face two problems. First it is very difficult to know how to price the assets they hold in their funds, and thus to assure their investors that the fund's daily published value is sound. Even if all the short dated assets are "money good" - that is to say, it is almost certain that the borrower will repay the whole amount on the agreed date - it is still not clear how they should be fairly valued at present. Despite high levels of confidence with regard to the creditworthiness of their assets, managers know that there are few (if any) buyers to whom the assets could be sold if liquidity is required.
Second, given the well-publicised uncertainties about the market there is a growing nervousness amongst investors, some of whom have decided to withdraw their money from MMFs. Other investors, for example securities lenders and hedge funds, have reduced their cash holdings as a consequence of adjusting other trading positions, in response to market turbulence. Thirdly, many market counterparties, such as commercial banks and investment banks, are shrinking balance sheet positions as quickly as possible and have significantly reduced appetite for holding secondary money market investments on their own books, even for a matter of a few days or weeks. In other words, just at the time when it has became impossible for managers to rely on secondary market liquidity for pricing or trading, investor demand, both for price transparency and for assurances about access to liquidity, have risen.
Different MMF managers are responding to these problems in different ways, depending on the scale of their funds, the behaviour of their investors, and their ability to secure financial support from their sponsors. In a number of cases MMF sponsors have stepped in to provide liquidity to their funds, generally by buying assets from the fund to generate the liquidity necessary to meet client redemption demands. Sponsors have taken the view that maintaining client confidence in their MMFs is of paramount importance, even at the cost of using their own balance sheets, albeit temporarily, to generate liquidity.
It should be noted that these recent problems are different, both in nature and in scale, from previous actions by MMF sponsors to support their products. In the past there have been a number of cases - both in the US domestic markets and in the offshore markets - where sponsors have bought assets out of their own funds at par, to avoid their investors from suffering a credit loss. In these cases, the Funds in question lent money to borrowers that were unable or unwilling to repay them. Their Funds would have recorded a loss of value to all investors had the sponsor not stepped in to absorb the losses for themselves. These were credit events: failures of credit analysis and control. The sponsor paid for their own portfolio manager's mistakes.
However, as described above, what is currently happening is that some sponsors are stepping in to provide liquidity to their own funds because assets simply cannot be sold into the secondary market. In the absence of market liquidity, sponsors have used their own balance sheets to buy-out asset holdings in order to provide liquidity for client redemption. These are liquidity events, not credit events; and consequently sponsors are paying the price for systemic market disruption rather than for any mistakes on the part of their own MMF managers.
In response to this current and continuing market dislocation a number of MMF sponsors are reviewing the business case for remaining players in the offshore MMF business. At a time when other critical demands are being made upon their balance sheets, the requirement to provide temporary finance for their MMFs has been a significant inconvenience. In some cases the sums involved have been billions of US dollars. In effect, MMF sponsors have become lenders of last resort to their own funds in order to avoid reputational damage for their brand, and to try to avoid the likely contagion effects that would result if they were to deny liquidity to their investors.
After fifteen years of strong growth, healthy revenues and improved professionalism, the offshore MMF industry now faces a crisis. Without improved confidence with regard to the liquidity of the money markets many sponsors may choose to downsize or close entirely their MMF business. There is widespread concern among MMF managers - a concern that is shared by IMMFA - about the lack of well-developed infrastructure in the Sterling and Euro money markets that can be deployed to deal with this crisis. By contrast, in the domestic US money markets decisive action by the Federal Reserve has provided effective relief from comparable problems.
 Solution: The creation of central bank liquidity facilities for Sterling and Euro MMFs
IMMFA believes that there is a strong case for the establishment by central banks of liquidity facilities for offshore MMFs. This case is made: first, by considering the actions of the Federal Reserve Board in the US domestic market; second, by considering whether the Bank of England and the European Central Bank could and should attempt something similar in the Sterling and Euro markets; and third, by considering which MMFs should be eligible to access such a facility and at what cost.
[4a] The Money Market Investor Funding Facility
On 21 October 2008 the Federal Reserve Board announced the creation of a Money Market Investor Funding Facility (MMIFF) to help provide liquidity for the domestic US money markets. The Federal Reserve will provide secured funding to support a series of special purpose vehicles that will purchase eligible assets with maturities of 90-days or less from US dollar money market funds. It is expected that these special purpose vehicles will be wound down, starting 30 April 2009 although, if problems in the US dollar money markets persist, it is expected that the life of the MMIFF will be extended.
According to the Federal Reserve Board, the aim of the MMIFF is as follows:
The short-term debt markets have been under considerable strain in recent weeks as money market mutual funds and other investors have had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs. By facilitating the sales of money market instruments in the secondary market, the MMIFF should improve the liquidity position of money market investors, thus increasing their ability to meet any further redemption requests and their willingness to invest in money market instruments. Improved money market conditions will enhance the ability of banks and other financial intermediaries to accommodate the credit needs of businesses and households.
In short, this scheme has been designed to counter exactly the same conditions that now also prevail in the offshore money markets.
While it is too early to ascertain the impact of the MMIFF, it is clear that this announcement, together with other actions taken by the Federal Reserve Board and the US government, has helped to improve market sentiment and has helped to restore some semblance of normality to the US dollar money markets. Consider two examples both using data collected by the Federal Reserve Board. First, the yield on 3-month certificates of deposit trading in the secondary market was around 2.80% during the first half of September 2008. The yield spiked up in late September and early October to levels of 4.50% and higher. Subsequent to the Federal Reserve Board's actions this yield has fallen back down to around 3.00% at the end of October.
Second, the seasonally adjusted outstandings of US dollar commercial paper (CP) rose by $100bn in the last week of October, immediately following the Federal Reserve Board's announcement of the MMIFF. This followed four successive weekly falls in out-standings (averaging over $60bn per week), a fall of over $150bn in September, and monthly falls in four of the previous five months. There was a net decline in CP out-standings over the period April to October 2008 of just over $230bn, of which around 70% related to issuance by US financial firms.
It appears, then, that action by the Federal Reserve Board to restore confidence to the money markets, by providing MMFs with a liquidity facility for paper with maturities of 90-days or less, has led to a fall in the cost of funds for 3-month money and, at the same time, a significant increase in issuance of short term debt by financial institutions. While it would be premature to claim that the domestic US money markets are now "back to normal", their health has been significantly improved since the announcement of the MMIFF on 21 October.
[4b] Creating liquidity facilities in Europe
The offshore money markets differ from the domestic US money market in a number of important respects. Most obviously, there is more than one currency, more than one central bank, more than one regulator, and the participants - investors, borrowers and intermediaries - and their investment vehicles are located in a variety of domiciles. These differences make the task of drawing parallels from the domestic US money markets difficult; but not impossible.
In the offshore markets MMFs are offered to institutional investors in US dollars, Sterling and Euro. Since central banks are principally concerned with market developments in the currency for which they have responsibility, IMMFA makes the assumption that the European Central Bank would the be appropriate body to take action to maintain the liquidity of the Euro money market; that the Bank of England would be the appropriate body to take action to maintain the liquidity of the Sterling money market; and that the Federal Reserve Board would be the appropriate body to take action to maintain the liquidity of the offshore US dollar market.
Central banks and governments will naturally take an interest in the activities of investors, borrowers and managers who are domiciled in their jurisdiction, and in the activities of other, non-domiciled participants in cases where they might have a significant impact in the markets over which they have oversight. Nevertheless, IMMFA makes the assumption that as a matter of priority, each central bank will take the lead role in maintaining order in the money markets of the currency for which it has responsibility.
From which it follows that: first, the Federal Reserve Board should urgently consider making Triple-A rated offshore MMFs eligible for the MMIFF scheme, which is currently limited to domestic (2a-7 regulated) MMFs. Second, that the Bank of England and the European Central Bank should both consider the creation of a liquidity facility modelled on the MMIFF, to help to restore liquidity to the Sterling and Euro money markets. Such facilities would be available to a defined set of offshore MMF managers and would provide them with the opportunity to sell short-dated assets with 90-days or less to maturity to create liquidity to manage client redemptions demands.
Access to these liquidity facilities will, of necessity, have to be restricted in some way. Since there is no offshore equivalent to the SEC 2a-7 regulation (that defines a domestic US MMF) access should be restricted instead to the agreed standard within the offshore marketplace, namely the possession of Triple-A rating from a recognized rating agency. This stipulation will have two benefits: first it provides a clear and simple test with regard to access that will avoid lengthy and contentious disputes; second it ensures that the assets that will be offered to the central banks in return for cash will be of a high credit quality, since to secure and to maintain its Triple-A rating an offshore MMF must limit itself to assets of the highest credit quality.
At this point it is appropriate to recall that the purpose of these facilities is to provide liquidity for MMF managers, so that they can better manage client redemption requests and any associated portfolio rebalancing. Central bank liquidity facilities should not be under any obligation to purchase assets that are suffering from credit deterioration, as opposed to illiquid assets for which there is no meaningful secondary market. IMMFA is not seeking to protect its members or their investors from the cost of poor credit decisions. IMMFA is seeking to protect its members and their investors from the cost of systemic liquidity problems in the offshore money markets.
IMMFA is strongly of the opinion that the creation of liquidity facilities in the Sterling and Euro markets will help to restore confidence among investors and managers in these markets. Liquidity facilities will enable managers to raise liquidity by asset sales without paying penal rates, thereby allowing them to manage client redemption requests in a responsible and orderly manner. In turn this will give managers more confidence to move further along the yield curve from overnight deposits out to 90-day paper, and beyond. As with the US domestic market, this will likely result in a reduction in 3-month yields and an increase in CP out-standings.
The present dislocation of the offshore money markets has multiple causes, some of which will take many months to be fully resolved. However, central bank action to provide liquidity to MMFs is one simple and practical step that would likely improve confidence among a range of market participants and would help to return a measure of stability and liquidity to the markets that is currently absent.
Nothing - however useful, however necessary - comes for free. There are two funding models that might be used to pay for liquidity facilities in the offshore markets. The first, modelled on the MMIFF cost structure would be to use the pricing of asset purchases by the liquidity facility to provide a cushion of cash that would cover operational costs. If excess cash is accumulated during the operation of the facility it can be paid back to users, on a pro rata basis, at a later date.
A second model would be for eligible investors to pay an annual fee, based on their assets under management in the relevant MMFs, which would entitle them to access the facility when market conditions proved necessary. Such a fee would act much like an insurance premium, allowing the facility to build up a reserve of cash that would then fund its operations when it was called into play. If, over time, the cash accumulated by the facility was more than necessary to fund its activities, a rebate could be paid to users.
Whichever of these funding options is selected - or perhaps a combination of them -IMMFA believes that market participants should fully cover the costs of the liquidity facility. IMMFA also believes that the purpose of the liquidity facility is to preserve orderly and efficient markets and not to make a profit.
This paper has set out the case for action by the Bank of England and the European Central Bank, to provide support to the offshore MMF industry by the creation of liquidity facilities in Sterling and Euro, similar to the Federal Reserve Board's MMIFF.
IMMFA believes that the growth of the offshore MMF industry in the past 15 years has been of significant benefit to investors, borrowers and regulators within the offshore money markets but that, as a result of recent market dislocation, some (perhaps many) of these benefits are now at risk. Action by the central banks could help to mitigate these risks and, thereby, help to develop the depth, quality and attractiveness of both the Sterling and Euro money markets to investors and borrowers, both nationally and internationally.
IMMFA, November 2008