Delivered at the 2021 Annual Washington Conference, Institute of International Bankers (via webcast), and published in a two-part series.
Part 1: The dash for cash; Short-Term funding market vulnerabilities; Treasury market functioning.
By Governor Lael Brainard
It has now been one year since the devastating effects of the first wave of the COVID-19 pandemic hit our shores, a year marked by heartbreak and hardship. We look forward to a brighter time ahead, when vaccinations are widespread, the recovery is broad-based and inclusive, and the economy fully springs back to life. But we should not miss the opportunity to distill lessons from the COVID shock and institute reforms so our system is more resilient and better able to withstand a variety of possible shocks in the future, including those emanating from outside the financial system.
The dash for cash
Investor sentiment shifted dramatically in the early days of March 2020 with the realization that COVID would disrupt the entire global economy. Short-term funding markets became severely stressed as market participants reacted to the advent of this low-probability catastrophic event. The abrupt repositioning and repricing of portfolios led to a dash for cash, as even relatively safe Treasury holdings were liquidated, volatility spiked, and spreads in Treasury and offshore dollar funding markets widened sharply. Forceful and timely action by the Federal Reserve and other financial authorities was vital to stabilize markets and restore orderly market functioning.
Although some parts of the financial system that had undergone significant reform in the wake of the Global Financial Crisis remained resilient, the COVID stress test highlighted significant financial vulnerabilities that suggest an agenda for further financial reform. I will briefly comment on these areas of vulnerability as well as areas where earlier reforms led to greater resilience.
Short-Term funding market vulnerabilities
The COVID shock brought to the fore important vulnerabilities in the systemically important short-term funding markets that had previously surfaced in the Global Financial Crisis.
Signs of acute stress were readily apparent in intermediaries and vehicles with structural funding risk, particularly in prime money market funds (MMFs). Indeed, it appears these vulnerabilities had increased, as assets held in prime MMFs doubled in the three years preceding last March. When the COVID shock hit, investors rapidly moved toward cash and the safest, most liquid financial instruments available to them. Over the worst two weeks in mid-March, net redemptions at publicly offered institutional prime MMFs amounted to 30 percent of assets. This rush of outflows as a share of assets was faster than in the run in 2008, and it appears some features of the money funds may have contributed to the severity of the run.
The run-in March forced MMFs to rapidly reduce their commercial paper holdings, which worsened stress in short-term funding markets. Funding costs for borrowers shot up, and the availability of short-term credit at maturities beyond overnight plunged. These markets provide the short-term credit many businesses need to keep operating and meet payrolls. So when short-term funding markets shut down, it can imperil many businesses, too.
For the second time in 12 years, a run on MMFs triggered the need for policy intervention to mitigate the effect on financial conditions and the wider economy. To head off the risk of widespread business failures and layoffs, the Federal Reserve took a number of actions, including announcing the Commercial Paper Funding Facility on March 17 and the Money Market Mutual Fund Liquidity Facility on March 18, 2020. Following the announcement of these facilities, prime MMF redemptions slowed almost immediately, and other measures of stress in short-term funding markets began to ease.
The March 2020 turmoil highlights the need for reforms to reduce the risk of runs on prime money market funds that create stresses in short-term funding markets. The president’s Working Group on Financial Markets has outlined several potential reforms to address this risk, and the Securities and Exchange Commission recently requested comment on these options. If properly calibrated, capital buffers or reforms that address the first-mover advantage to investors that redeem early, such as swing pricing or a minimum balance at risk, could significantly reduce the run risk associated with money funds. Currently, when some investors redeem early, remaining investors bear the costs of the early redemptions.
In contrast, with swing pricing, when a fund’s redemptions rise above a certain level, the investors who are redeeming receive a lower price for their shares, reducing their incentive to run. Similarly, a minimum balance at risk, which would be available for redemption only with a time delay, could provide some protection to investors who do not run by sharing the costs of early redemptions with those who do. Capital buffers can provide dedicated resources within or alongside a fund to absorb losses and reduce the incentive for investors to exit the fund early.
To be sure, domestic money market funds are not the only vulnerable cash-management investment vehicles active in US short-term funding markets. For example, offshore prime money funds, ultrashort bond funds, and other short-term investment funds also experienced stress and heavy redemptions last March. The runs on offshore MMFs that hold dollar-denominated assets like commercial paper underscore the importance of working with international counterparts to increase the resilience of short-term funding markets. We are supporting the work of the Financial Stability Board to assess options for mitigating the vulnerabilities of MMFs globally and report on them later this year.
The COVID shock also highlighted the structural vulnerabilities associated with the funding risk of other investment vehicles that offer daily liquidity while investing in less-liquid assets, such as corporate bonds, bank loans, and municipal debt. Funds that invest primarily in corporate bonds saw record outflows in March 2020. These open-end funds held about one-sixth of all outstanding US corporate bonds prior to the crisis. Bond mutual funds, including those specializing in corporate and municipal bonds, had an unprecedented $250 billion in outflows last March, far larger than their outflows at any time during the 2007–09 financial crisis. The associated forced sales of fund assets contributed to a sharp deterioration in fixed-income market liquidity that necessitated additional emergency interventions by the Federal Reserve.
In assessing possible reforms to address this run risk, swing pricing could be helpful, because it reduces the first-mover advantage for running from a fund by imposing a cost when redemptions are high. Swing pricing has been used for more than a decade in European mutual funds, where it has been shown to slow redemptions in stress events. In the United States, mutual funds have not adopted swing pricing, in part because of technical obstacles.
Treasury market functioning
The COVID shock also revealed vulnerabilities in the market for US Treasury securities. The US Treasury market is one of the most important and liquid securities markets in the world, and many companies and investors treat Treasury securities as risk-free assets and expect to be able to sell them quickly to raise money to meet any need for liquidity. Trading conditions deteriorated rapidly in the second week of March as a wide range of investors sought to raise cash by liquidating the Treasury securities they held. Measures of trading costs widened as daily trading volumes for both on- and off-the-run securities surged.
Indicative bid-ask spreads widened by as much as 30-fold for off-the-run securities. Market depth for the on-the-run 10-year Treasury security dropped to about 10 percent of its previous level, and daily volumes spiked to more than $1.2 trillion at one point, roughly four standard deviations above the 2019 average daily trading volume. Stresses were also evident in a breakdown of the usually tight link between Treasury cash and futures prices, with the Treasury cash–futures basis—the difference between prices of Treasury futures contracts and prices of Treasury cash securities eligible for delivery into those futures contracts—widening notably.
Selling pressures were widespread, reflecting sales by foreign official institutions, rebalancing by asset managers, a rapid unwinding of levered positions, and precautionary liquidity raising. Available data suggest that foreign institutions liquidated about $400 billion in Treasury securities in March, with more than half from official institutions and the remainder from private foreign investors, at a time when offshore dollar funding markets also experienced acute stress. Domestic mutual funds sold about $200 billion during the first quarter, selling their less-liquid Treasury securities in order to raise cash to meet investor redemptions. Hedge funds reduced long cash Treasury positions by an estimated $35 billion.
Dealers play a central role in the Treasury market by buying and selling securities and providing financing to investors. Their capacity or willingness to intermediate these flows was strained amid the elevated uncertainty and intense and widespread selling pressure in mid-March. Operational adjustments associated with the rapid move to remote work may also have inhibited intermediation.
The acute stresses in the Treasury market necessitated emergency intervention by the Federal Reserve at an unprecedented scale. The Federal Open Market Committee authorized purchases of Treasury securities and agency mortgage-backed securities (MBS) “in the amounts needed” to support smooth market functioning of these markets.7 Between March 12 and April 15, the Federal Reserve increased its holdings of Treasury securities by about $1.2 trillion and agency MBS by about $200 billion. The Federal Reserve provided overnight and term repurchase agreement (repo) operations to address disruptions in Treasury financing markets. These actions rapidly restored market functioning, and a variety of indicators had returned to pre-COVID levels by the summer.
While the scale and speed of flows associated with the COVID shock are likely pretty far out in the tail of the probability distribution, the crisis highlighted vulnerabilities in the critically important Treasury market that warrant careful analysis. A number of possible reforms have been suggested to strengthen the resilience of the Treasury market. For instance, further improvements in data collection and availability have been recommended to enhance transparency related to market participants, such as broker-dealers and hedge funds.
Some have suggested that the Federal Reserve could provide standing facilities to backstop repos in stress conditions, possibly creating a domestic standing facility or converting the temporary Foreign and International Monetary Authorities (FIMA) Repo Facility to a standing facility. Other possible avenues to explore include the potential for wider access to platforms that promote forms of “all to all” trading less dependent on dealers and, relatedly, greater use of central clearing in Treasury cash markets. These measures involve complex tradeoffs and merit thoughtful analysis in advancing the important goal of ensuring Treasury market resilience.
To be continued … Part 2
