Money market funds and the commercial paper markets were at the heart of the financial crisis. In the fall of 2008, money market funds experienced massive withdrawals after one fund (the Reserve Primary Fund) reduced the value of depositors’ accounts after getting caught as Lehman went under holding significant amounts of Lehman short-term debt (other money market funds also lost money but were bailed out by their institutional sponsors). In response to this drain on funds for investing in short-term commercial paper, the Federal Reserve stepped forward and insured all money market funds.
The SEC has just issued some new rules for money market funds intended to limit their vulnerability. But while these changes may make investors in money market funds happy, from the perspective of systemic risk, the rules work in different directions—one of the rules actually increase systemic risk rather than reducing it. First, there are several seemingly reasonable restrictions: funds must hold at least 30% of their assets in cash and government securities of less than 60 days to maturity, funds cannot invest more than 5% of their funds in “illiquid” assets (with the very strange definition of illiquid that they cannot be sold within 7 days at carrying value (in what state of the world?)), funds cannot invest more that 3% of assets in second-tier securities, and funds cannot invest more than 0.5% of assets in the securities of one entity.
But there are also a set of rules that reduce the maturity of what money market funds can hold: second tier securities must mature in 45 days or less rather than a year, the weighted average life maturity of the funds holdings must be less than 120 days and the average maturity less than 60 days.
How will markets respond? Firms will provide more very short-term securities so that they can borrow from money market mutual funds. This makes the system more unstable, as it increases maturity mismatch and encourages firms to borrow even more short term! Ugh.