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Fidelity Investments has announced plans to convert up to $125 billion-worth of prime US money market funds (MMFs) into government-only funds – a move that is a direct consequence of the new SEC regulations covering this business that were announced in July.
The move is significant not only because of the numbers involved but because the asset manager is making the move 18 months before the SEC’s deadline of October 2016.
If other prime MMF managers decide to do the same, there could be worrying implications for the non-government short-term funding markets.
“This industry is fairly concentrated and if any other large managers follow suit and make changes it will be significant,” Joseph Abate, money market strategist at Barclays in New York, tells Euromoney.
Other large players in this market include JPMorgan, BlackRock, Federated Investors, Vanguard, Charles Schwab and Goldman Sachs Asset Management.
The liquidity mismatch between prime MMFs, which offer daily liquidity, and many of the assets in which they invest has been one of the more worrying consequences of the global hunt for yield. It was also the impetus behind the SEC’s new rules.
From October next year, MMFs must hold at least 99.5% of total portfolio assets in cash or government securities and repos collateralized by such instruments to be exempt from new regulations imposing fees and gates on such funds in times of stress. The rules are designed to slow deposit runs and reduce systemic risk.
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Fidelity Investments therefore plans to convert its $112.72 billion Fidelity Cash Reserves fund – the largest prime MMF in the business – into a government fund. It will be renamed Fidelity Government Cash Reserves fund after the conversion, which should be complete by the fourth quarter of this year.
Another two funds are also slated for conversion: the $12.29 billion Fidelity MMT/Retirement MMP and the $2.66 billion Fidelity VIP MMP. They will be respectively renamed the FMMT Retirement Government Money Market II Portfolio and VIP Government Money Market Portfolio.
The conversion of the three funds is subject to a proxy vote in May.
“Many investors have told us that they want access to money market mutual funds with a stable NAV that will not be subject to liquidity fees or redemption gates,” stated Fidelity when news of the conversion became public. It says the move is in shareholders’ interests because the new rules could limit daily access to the fund.
Of the $125 billion in the three Fidelity funds, only 22% is currently invested in government fund-eligible assets, according to BAML. That means $97 billion (78%) now invested in CDs, CP, non-government repo and other instruments will need to be rolled into government holdings. Of this, $9 billion is bank CP, $2 billion non-financial CP and $15 billion non-government repo.
Fidelity is a huge player in this space: the non-government repo holdings in these funds account for around 16% of the $90 billion in non-government collateral repo held by US MMFs. Barclays’ analysts estimate the three funds will now need an additional $35 billion in agency debt and $43 billion in treasury debt to meet their new mandates.
Puzzling aspect
One puzzling aspect of the move is why Fidelity has decided to act so early, deciding to change fund mandates rather than wait for signs of investors moving from prime and muni funds into government funds.
With credit spreads on non-government funds as low as they are, the returns are simply not attractive enough versus government funds for investors to take the risk of fees and gates – the market has therefore been anticipating a move by investors out of prime funds for some time.
“Firms make more money by managing a prime fund than a government fund, but this is a volume business and it is better to run a larger fund even if it pays lower fees,” Barclays’ Abate observes.
However, this exodus from prime funds has yet to happen on any significant scale.
"The process of seeking shareholder approval to change the funds' mandates will take time, and the MMFs in question have large credit holdings that will need to be disinvested, mainly via letting assets mature," explains Brian Smedley, director US rates research at Bank of America Merrill Lynch in New York. "Even so, Fidelity, as a market leader in the MMF space, has taken a proactive step in response to investor feedback. They want to reassure investors well ahead of the SEC's October 2016 deadline in order to minimise the risk of assets potentially moving away from the firm."
Fidelity's status as a brokerage firm will also have weighed its decision. "What makes Fidelity different is that they are brokerage firm that offers mutual funds, which in some cases manage brokerage sweep cash. Some other large MMF players are simply mutual fund companies that don't have the sweep element that apparently factored into Fidelity's decision," says Smedley.
Another significant player in the MMF space that is also a brokerage firm is Charles Schwab. This need for mutual funds to manage cash sweep could perhaps incentivise that firm to follow Fidelity's lead sooner rather than later.
The non-government money market industry is enormous: US prime MMFs manage $1.7 trillion of assets, $927 billion of which are institutional and $513 billion retail. These funds generally hold 60% of their assets in bank-issued CP and CDs, so large-scale mandate changes will hit the short-term bank funding market hard.
The expectation is that while that treasury repo and the overnight RRP rate will narrow as a result of Fidelity’s move, unsecured funding costs for the banks will rise. This has particularly serious implications for non-US banks, as they are far greater users of this market than their US counterparts, which have ready access to cheap deposits.
Indeed, less than 10% of the $97 billion in short-term unsecured bank paper held by the three Fidelity funds marked for conversion was issued by US institutions. "Prime MMFs have ramped up their holdings of CDs issued by non-US banks in recent years," Smedley says. "But for many of the banks this borrowing has been opportunistic. Top-tier non-US banks can issue Yankee CDs at 10bp to 15bp and hold the cash at the Federal Reserve, which pays 25bp on reserves. Unlike US banks, foreign banks don't pay FDIC insurance on that cash, so it's a more attractive proposition for them. This has been a big motivating factor for increased bank issuance, and means that for these issuers decreased MMF demand should be manageable, albeit costly.”
Banks will, however, now have to replace longer term funding either with retail deposits or through other prime institutional funds.
“I would expect to see the bulk of the rate increase on the bank funding side in two- or three-month or longer paper,” says Abate. “Banks might, therefore, use this as an opportunity to term out their funding.”
The reduced demand for and consequent increased cost of short-term bank paper and non-traditional repo will be of concern to the banks as they need these instruments to comply with NSFR rules under Basel III.
It is not only the banks that will be hit by the SEC's move. "MMFs are big lenders to both US and foreign broker dealers," says Smedley. "New regulations require dealers to extend the tenor of their repo funding while MMF holdings are being pushed shorter. Prime funds have been an important source of repo funding for non-government collateral, but going forward they will be less able to play that role as their AUMs shrink. Dealers will likely find alternative funding sources to be more expensive, and they will pass on these higher costs to their customers."
However, as with so much in the US market, the extent of the impact on bank funding costs will depend on the extent and timing of any rate rises.
If rates do rise, then the returns on offer from prime institutional funds might become sufficient for investors to stick with them rather than switch to government funds, because the return for the risk of fees and gates will be worth it. But the industry will, nevertheless, become a shadow of its former self. "I don't think that the prime fund universe will disappear, but it will shrink, with funding from this investor base becoming be more expensive for issuers as a result,"says Bank of America Merrill Lynch's Smedley.
