The reform will require prime funds to float their net asset values and impose liquidity fees and gates on investors’ cash.
Although the reform is intended to make prime funds safe from runs, a big part of their appeal is a stable net asset value and easy withdrawals. That is pushing funds to convert to only buy government assets, which means they escape the rule — well over $200bn of prime funds have already made the switch.
More worrying still is the possibility of mass redemptions as investors pull their money out of funds while it remains a simple operation. While this has not yet happened, investors can pull out at any time between now and October 14 without warning.
Funds are positioning themselves for this eventuality by holding paper that matures by October to enable them to fund investor redemptions without selling off assets. Conservative estimates have mooted the possibility of $350bn leaving in a four week period.
A rough estimate in an academic paper indicates that banks obtain around 35% of their wholesale short-term dollar funding from prime money market funds.
If there is a reasonable possibility that the universe of investors on which banks rely for hundreds of billions of short term dollars per year is about to shrink by $500bn-$600bn, that implies a very rapid deleveraging, or extensive new sources of funding.
Australian and Canadian banks are increasing their activity in the European CP market but dollar funding in Europe’s short term market is not cheap. Mitsubishi UFJ has made noises about making greater use of local currencies in its funding process but it seems unlikely that it will be able to find the $45.4bn it sourced in 2012 with this method.
Perhaps banks will simply grit their teeth and pay the extra yield that is likely to be demanded to secure funding from the investors that remain. Perhaps that yield will even be enough to tempt a few investors back from the government funds (although many will not be able to invest in funds with floating NAVs). In any case, there has been remarkably little discussion of the increased cost of funds, and how this will further damage bank profits.
Meanwhile, the US government is taking full advantage of its own regulatory move, and the dramatic growth in its investor base by announcing $250bn of additional T-bills which it will be able to sell at tighter yields, thanks to the influx of prime money.
Perhaps banks could learn from the government’s opportunism. Either way, they need a solution and fast.