Commentary

Posts tagged Redemption

Open-end Funds vs. ETFs: Lessons from the COVID Stress Test

COVID-19 posed the most severe stress test for financial markets and institutions since the Great Financial Crisis (GFC) of 2007-09. By some measures, the COVID shock’s peak impact was larger than that of the GFC—both the VIX rose higher and intermediaries’ estimated capital shortfalls were bigger. As a result, the COVID experience provides a natural laboratory for testing the resilience of many parts of the post-GFC financial system.

For example, the March 2020 dysfunction in the corporate bond market highlights the extraordinary fragility of a market that accounts for nearly 60% of the debt and borrowings of the nonfinancial corporate sector. Yield spreads over equivalent Treasuries widened further than at any time since the GFC, with bond prices plunging even for instruments that have little risk of default. (See Liang for an excellent overview.)

In this post, we focus on how, because of the contractual agreement with their shareholders, an extraordinary wave of redemptions created selling pressure on corporate bond mutual funds that almost surely exacerbated the liquidity crisis in the corporate bond market. To foreshadow our conclusions, we urge policymakers to find ways to reduce the gap between the illiquidity of the assets held by corporate bond (and some other) mutual funds and the redemption-on-demand that these funds provide. To reduce systemic fragility, we also urge them—as we did several years ago—to consider encouraging conversion of mutual funds holding illiquid assets into ETFs, which suffered relatively less in the COVID crisis….

Fix Money Funds Now

On September 19, 2008, at the height of the financial crisis, the U.S. Treasury announced that it would guarantee the liabilities of money market mutual funds (MMMFs). And, the Federal Reserve created an emergency facility (“Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”) to finance commercial banks’ purchases of illiquid MMMF assets. These policy actions halted the panic.

That episode drove home what we all knew: MMMFs are vulnerable to runs. Everyone also knew that the Treasury and Fed bailout created enormous moral hazard. Yet, the subsequent regulatory efforts to make MMMFs more resilient and less bank-like have proven to be half-hearted and, in some cases, counterproductive. So, to halt another run in March 2020, the Fed revived its 2008 emergency liquidity facilities.

We hope the second time’s the charm, and that U.S. policymakers will now act decisively to prevent yet another panic that would force yet another MMMF bailout.

In this post, we briefly review key regulatory changes affecting MMMFs over the past decade and their impact during the March 2020 crisis. We then discuss the options for MMMF reform that the President’s Working Group on Financial Markets identifies in their recent report. Our conclusion is that only two or three of the report’s 10 options would materially add to MMMF resilience. The fact that everyone has known about these for years highlights the political challenge of enacting credible reforms.

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Money, Banking, and Financial Markets