By Barb Shegog
New regulations will force companies to look for new ways to manage their cash in the time-honored fashion of maintaining liquidity, safety and a decent yield.
The changing landscape of financial regulation has led many investors to wonder how the liquidity in the short-duration fixed-income market will ultimately be affected.
On top of the changing regulations, the market is also shifting into a rising-rate environment where shorter-dated fixed income will be in much greater demand. Is the combination of increased regulation reducing market supply and a market that has increasing demand going to lead to a short-term liquidity crisis?
Regulation Impacting Supply
In 2014 the SEC the released new rules for money market funds (MMFs), and by October of 2016, MMFs will have a whole new way of operating. Although the investment universe for prime money market funds will not change, regulations restricting average maturity and requiring 30 percent of the fund to have weekly liquidity will likely change the demand for very short fixed-income paper. Another significant regulatory change is prime money market funds moving to a variable net asset value or VNAV.
The draw for money market funds of course has always been the stable NAV, whereby investments are carried at book value and do not fluctuate. Investors can only guess what impact this might have on the marketplace. Will a floating NAV encourage prime MMF managers to be more conservative and invest in shorter securities that have less interest-rate fluctuations?
While trying to figure out the eventual impact and possible chaos that the new regs will bring, many cash managers are looking into other cash-like offerings from the likes of PIMCO, BlackRock and Legg Mason. Other options include corporate investors transitioning to separate accounts. Meanwhile, government funds will not be subject to the floating NAV, which brings up several more questions, such as where will the government liquidity come from? BlackRock recently expressed this concern: “Given the limited supply of short-dated government securities and the substantial contraction of the repurchase agreement markets, we are concerned about the potential for shortages in CNAV government funds,” BlackRock wrote in a letter to investors.
There are more questions than answers at this point but with the implementation date about a year and a half away, there is no question that the demand in the liquid short market will change.
The Unintended Consequences of Basel III
Meanwhile the SEC rule changes aren’t the only issue challenging short-term cash management. Treasurers also must deal with the side effects of Basel III’s impact on banks.
“Basel III has altered the bank’s business model requiring increased capital and has pushed banks to issue more longer-dated securities,” says Rena Walsh, head of money markets at Fischer Francis Trees & Watts (FFTW). “New bank liquidity requirements will permanently alter bank behavior in the overnight markets, regardless of monetary policy stance.”
In summary, the Basel III rules require banks to hold higher capital levels and adhere to stringent liquidity coverage ratio (LCR). The LCR requires banks to hold enough capital in high-quality liquid securities to fund 100 percent of their projected outflows over a 30-day period. Additionally, banks are required to hold a certain amount of high-quality liquid assets (HQLA) based on expected cash outflows. For the usual outflow projections for retail deposits, banks are required to hold HQLA equal to 3 percent of stable retail deposits. These requirements provide a disincentive for banks to hold overnight-unsecured financings. Investors responsible for corporate cash portfolios are concerned about the decrease in supply around bank deposits. Bank deposits for some short-term investors have been a core of their investment portfolio.
“Clearly regulation is shrinking the supply of eligible investments in the short-term market,” says Ms. Walsh. Although it is hard to determine if demand could change, investors should assume the supply dynamics will change in the short-term market.
Pinch point
The Basel III regulations are eroding the supply of overnight liquidity and money market fund regulations will increase the demand of very short-dated liquid options. These two regulation changes on top of a highly anticipated US interest rate increase (again increasing the demand for short liquid paper) will make investing in the very short term fixed-income market challenging.