Money Market Mutual Funds: A Financial Stability Case Study
Updated March 24, 2020
Money Market Mutual Funds: A Financial Stability Case Study
A money market mutual fund (MMF) is a mutual fund that
Financial Stability Considerations
under Securities and Exchange Commission (SEC) Rule 2a-
Threats to financial stability, or systemic risk, can be
7 can invest only in high-quality, short-term debt securities,
viewed in different ways (e.g., spillover, contagion, and
such as U.S. Treasury bills or commercial paper (a type of
negative feedback loops). They largely relate to the
corporate debt). MMFs are commonly considered as safe
transmission of risks from one event to broadly affect the
alternatives to bank deposits, although they are not
confidence and functioning of the financial system as a
federally insured like bank deposits. However, this
whole. MMFs pose financial stability concerns because
perceived-to-be-safe financial instrument triggered major
they demonstrated during the 2008 market events that they
market disruptions in 2008 that accelerated the 2007-2009
were susceptible to sudden large redemptions (runs),
financial crisis. At the time, the Treasury Department and
causing dislocation in short-term funding markets. Share
the Fed developed multiple intervention tools. As the 2020
redemption is the MMF feature that is often discussed
coronavirus-induced market stress continues, some of the
under the context of runs.
same tools are being reconsidered. The Fed reintroduced its
MMF facility. The Coronavirus Aid, Relief, and Economic
Redemptions at Per Share Net Asset Value
Security Act of 2020 (S. 3548) also proposes to permit a
Share redemption allows MMF investors to exit their
Treasury Department guarantee program for temporary use
investment positions by selling their shares back to the fund
during the coronavirus (COVID-19) outbreak.
on demand. Investors redeem MMF shares at per share net
asset value (NAV), meaning the value of a fund’s assets
MMFs and the 2007-2009 Financial Crisis
minus liabilities. Prior to the 2007-2009 crisis, MMFs
On September 15, 2008, Lehman Brothers Holdings Inc., an
generally maintained a stable NAV at $1.00 per share,
investment bank, filed for bankruptcy. The next day, one
paying dividends as their value rises, thus closely
prominent MMF—the Reserve Primary Fund—saw its per
mimicking the features of a bank deposit. If its stable NAV
share price fall from $1.00 to $0.97 after writing off its
drops below $1.00, which rarely occurs, although it
Lehman debt. This event triggered an array of market
occurred in 2008, it is said that the MMF “broke the buck.”
reactions, including investors’ redemptions of more than
MMFs are susceptible to runs because investors have an
$250 billion throughout the MMF industry within a few
incentive to redeem shares before others do when there is a
days of the bankruptcy. The consequences of these actions
perception that the fund could suffer a loss. Thus when the
were potentially so dire to U.S. financial stability that the
Reserve Primary Fund broke the buck, MMF investors
government ultimately intervened:
elsewhere also rushed to exit their positions, spreading fear
that MMFs, and even the broader financial system, were
The Treasury Department provided explicit temporary
vulnerable, regardless of whether actual losses occurred.
deposit insurance to all MMF investors. Over its life, the
program guaranteed more than $3 trillion in deposits
Post-Crisis Reforms
and earned $1.2 billion in insurance coverage fees, but
MMFs are regulated primarily under the Investment
no guaranteed funds failed. Treasury announced this
Company Act of 1940 (P.L. 76-768) and Rule 2a-7
program without seeking specific congressional
pursuant to the act. To mitigate MMFs’ systemic risk, the
authorization, justifying the program on the grounds that
SEC reformed Rule 2a-7 in a multi-year process:
guaranteeing MMFs would protect the value of the
dollar. After the fact, Congress addressed the guarantee
February 2010—SEC adopted certain Rule 2a-7
in the Emergency Economic Stabilization Act (P.L. 110-
amendments to strengthen MMF liquidity.
343), reimbursing the exchange stability fund (ESF) that
March 2011—SEC proposed rules to eliminate certain
backed the guarantee, but also forbidding the future use
references to credit ratings in MMF reforms. The rules were
of the ESF to provide such a guarantee.
re-proposed in July 2014 and adopted in September 2015.
The Federal Reserve System also established multiple
June 2013—SEC proposed rules to convert institutional
emergency liquidity facilities under its statutory
prime and institutional municipal MMFs to floating NAV.
authority invoked by “unusual and exigent
March 2014—SEC issued multiple MMF economic studies
circumstances” in September and October of 2008 to
to solicit public comments.
provide a backstop to MMFs and commercial paper as
part of a broader crisis response. These programs
July 2014—SEC finalized the 2014 MMF reform.
expired without loss between late 2009 and early 2010.
October 2016—SEC MMF reform became effective.
The main types of MMFs are (1) municipal, also referred to
as tax-exempt, which invest in national or state municipal
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Money Market Mutual Funds: A Financial Stability Case Study
securities that are free of national or state income tax; (2)
Figure 1. Net Assets of Money Market Funds
government, which invest in securities backed by the
($Tril ions, Data as of July 31, 2019)
creditworthiness of the U.S. government; and (3) prime,
which include investments in corporate debt, certificates of
deposit, and repurchase agreements. The main types of
MMFs are then further divided into those held by individual
investors (retail) or those held by organizations
(institutional). The 2014 MMF regulation affects different
MMF types in different ways:
Institutional prime and institutional municipal MMFs
are required to float their NAV from stable value to
reflect the actual market value of the fund more closely.
All government and retail MMFs may continue to use
Source: CRS based on SEC MMF Statistics.
stable NAV.
MMFs’ boards now may impose redemption fees (up to
Between July 2015 and July 2019, government MMFs,
2%) and redemption gates (up to 10 business days) for
which were not affected by the NAV reform, increased
all nongovernment MMFs. These barriers to withdrawal
from $0.5 trillion to $1.7 trillion. Municipal retail and
are expected to discourage runs.
institutional MMFs combined fell to $141 billion (a 45%
decline) and prime retail and institutional MMFs combined
In addition, the SEC reform required new macro-prudential
fell from $1.7 trillion to $1.0 trillion (a 40% decline). But
stress tests similar to those more commonly used in
there are also signs of gradual volume recovery. Short-term
banking. Stress testing as a systemic risk mitigation tool
funding markets are complex and sensitive to interest rate
generally refers to a forward-looking quantitative
movements. Other factors could also influence this trend
evaluation of the impact of stressful economic and financial
irrespective of the MMF reforms.
market conditions. As part of the SEC’s 2014 MMF reform,
MMFs are required to stress test their ability to maintain
Policy Debates
weekly liquid assets of at least 10% and to minimize
Policy discussions continued after the 2014 reform,
principal volatility in response to several SEC-defined
especially about whether the MMFs’ NAV should be
hypothetical stress scenarios including (1) increases in the
floating or stable. For example, the Consumer Financial
level of short-term interest rates, (2) the downgrade or
Choice and Capital Markets Protection Act of 2019 (S. 733)
default of particular portfolio security positions, and (3) the
would require the SEC to reverse the floating NAV back to
widening of spreads in various sectors.
a stable NAV for the affected MMFs.
This SEC stress testing is separate from the stress testing
Many proponents of floating NAV believe the floating
required for certain asset management firms as part of the
NAV could (1) reduce the investors’ incentive to runs in
2010 Dodd-Frank Wall Street Reform and Consumer
distressed markets because of the difference between the
Protection Act (P.L. 111-203, Dodd-Frank). The Dodd-
stable value and the actual market value; (2) allow investors
Frank stress tests are to include baseline and severely
to better understand a fund’s price movements and market
adverse scenarios, and testing results must be reported to
fluctuations; and (3) remove the implicit guarantee of zero
the SEC and the Federal Reserve Board. The SEC has not
investor losses through the stable value that could lead to
yet implemented the Dodd-Frank stress testing
unrealistic expectations of safety. Opponents believe that
requirements for asset managers.
floating NAV does not solve the issue of investors’
incentive to run. For example, one academic research article
Since the 2014 reform, certain MMFs that converted to
concludes that European MMFs that offer similar structures
floating NAV—institutional municipal and institutional
to floating NAV did not experience significant reduction in
prime MMFs—appear to have seen overall net assets
run propensity during market distress compared with stable
decline. However, because MMFs began to identify
NAV. In addition, providing floating NAV requires
themselves as institutional or retail only in October 2016,
calculation time and business model changes that could
the data are not definitive (see Figure 1).
raise costs and slow market operations. The opponents also
point to the volume decline of the affected MMFs since the
reform as an example of a shrinking MMF market that may
raise working capital costs for certain business operations
and municipalities. Others argue that because the MMF
reform has been fully implemented since 2016, it makes
sense to thoroughly study the effectiveness and impact of
the reform before considering changes.
Regarding stress testing, a 2017 Treasury report rejected the
use of prudential stress testing on investment companies,
contending that the MMF reform stress testing requirements
already “satisfy the spirit of” the Dodd-Frank’s stress
testing requirements. In the 116th Congress, the Alleviating
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Money Market Mutual Funds: A Financial Stability Case Study
Stress Test Burden to Help Investors Act (H.R. 3987)
from widespread market fears instead of the size of the
would exempt nonbanks from certain Dodd-Frank stress
actual losses alone, thus making the exact place and
test requirements. There are also others who support stress
condition of the next financial crisis unpredictable.
tests as important for mitigating systemic risk.
Eva Su, Analyst in Financial Economics
As illustrated by this case study, unexpected market events
and seemingly safe financial instruments could, at times,
IF11320
trigger financial instability. Such instability could originate
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