In a recent paper published by the European Securities and Markets Authority (ESMA), researchers show how the use of amortized cost and liquidity requirements can create challenges for money market funds (MMFs) exposed to instruments with limited liquidity. In particular, in times of stress, MMFs face difficulties in selling assets to meet redemptions while complying with regulatory requirements.
Using data on EU Low Volatility Net Asset Value LVNAV MMFs and US Prime MMFs, they use a model to assess the impact of policy reform on the resilience of MMFs. Overall, they find that changing required liquidity requirements has limited effects on the resilience of funds.
In contrast, increasing the NAV deviation and at the limit removing the use of amortized cost have a large effect on the maximum amount of redemptions a fund can meet. Relatedly, introducing countercyclical liquidity buffers can foster resilience by providing additional flexibility to MMFs in times of stress. Finally, improving the liquidity of underlying markets has also a significant impact on the resilience of MMFs.
The framework outlined in this paper can be used by Authorities when considering regulatory options for MMFs and to perform reverse stress testing, e.g. estimating the size of the shocks above which MMFs would not be able to comply with regulations. This can be done at the individual fund level (for supervisory purposes for example) but also at sector-wide level. The model can be used to estimate what would be the liquidation of assets performed by MMFs to meet a given amount of redemptions and assess whether short-term markets would be able to absorb such amounts of sales.
The analysis can also be extended to other type of open-ended funds. Since investors flows tend to be related to past performance, large changes in NAV are likely to lead to redemptions. Therefore, the NAV constraint can be used to model behavioural factors (rather than regulatory requirements) from investors. Relatedly, while open-ended funds do not have liquidity requirements, managers might want to maintain some levels of highly liquid assets in their portfolio, which could be modelled through the WLA constraint.