Money market funds: Why their appeal is set to endure as rates fall

Money market funds offer a range of advantages for use as collateral in financial transactions. Their appeal may expand if proposed regulatory changes are implemented.

Money market funds (MMFs) in general, and government and Treasury MMFs in particular, are high-quality, actively managed investments that typically hold low-risk securities such as Treasury bills and other government-issued bonds, and in some cases, repurchase agreements (repo) backed by these instruments. These funds are usually run in a way that ensures they have a stable or constant net asset value (CNAV) of USD 1 per share, and they offer investors a high level of liquidity and safety of principal.

Treasury and government MMFs offer a range of advantages for use as collateral in financial transactions:

When assets are used as collateral in financial transactions, they are normally subject to a haircut – a percentage discount on their market value that reflects the risk inherent in the asset. Counterparties typically apply a 2% haircut to MMFs when they are used as collateral, a rate that reflects their relatively low risk levels.

By contrast, haircuts on 30-year Treasury bills used as collateral are currently around 6%, while the discounts applied to riskier securities, such as corporate bonds, are likely to be even steeper and are frequently as high as 20%. As an example, USD 1 million of collateral would require an MMF holding of USD 1,020,400 (assuming a 2% haircut), but USD 1,063,800 of 30-year Treasury bills (6% haircut) or USD 1,250,000 of corporate bonds at a 20% haircut. While securities with shorter maturity dates than noted above may have lower haircuts, they still require monitoring and rebalancing due to changes in market value, whereas MMF haircuts remain constant.

Managing a MMF position as collateral is also significantly easier than with other eligible assets. CNAV MMFs are not subject to daily value fluctuations, so there is no need for investors to engage in constant repricing and ongoing management of their positions, as might be the case with bonds or repo. There is no need to constantly trade in securities or roll over positions (as with repo), or to have to trade in securities for delivery. MMFs can be traded down to the penny, so a single transaction is all that is needed – no multiple buys or sells, or dealing with odd lots. As such, MMFs can be considered a viable solution for investors who are looking to reduce the administrative burden attached to collateral management.

The ability of MMF managers to adjust the duration – the interest-rate sensitivity – by adjusting the weighted average maturity (WAM) of the portfolio can deliver benefits when rates are rising as well as falling. During periods when rates are rising, as was the case for much of 2022 and 2023, the MMF can reduce its WAM to as little as one or two days in order to maximise yields. The same holds true for a falling rate environment by extending the WAM out at far as 60 days. Being able to raise, maintain, or capture yields as rates change while also maintaining a stable NAV level is a key benefit of MMFs.

The use of repo in MMFs enables these vehicles to accommodate late-day purchases, including large purchases that Treasury-only funds are unable to facilitate. This results in later cutoff times for MMFs that use repo, something that offers significantly greater flexibility for investors looking to use such funds as margin collateral.

Plans to relax rules on the use of MMFs as collateral

In mid-2023, the Commodities Futures Trading Commission (CFTC) announced plans to broaden the type of MMFs that could be used as initial margin collateral in derivatives trading. The regulator said it wanted to end the ban on MMFs that use repo and other forms of securities lending from being used as initial margin collateral in commodity futures transactions.

These changes are set to increase the appeal of the asset class even further. As interest rates on both sides of the Atlantic have risen to their highest levels in 15 years, inflows into MMFs have increased: figures published at the start of 2024¹ showed that MMF assets in the US rose by USD 1.1 trillion in 2023 to reach a total of USD 6 trillion.

At present, shares in MMFs that hold repo can be used as eligible collateral on cleared derivatives positions that involve regulated intermediaries, but not on non-cleared positions where no central clearing house is involved. The CFTC opened a market consultation on the issue that closed in October 2023, and its results are expected to be published at some point in 2024. If approved, government and Treasury funds, most of which currently invest in repo, may become eligible collateral for non-cleared positions. Under the current regulation, only a few MMFs would qualify as eligible collateral. Increasing the number of MMFs whose securities qualify as eligible collateral may promote more efficient collateral management practices, and reduce the potential concentration of collateral in the few MMFs that qualify under the current regulations.

In addition, allowing MMFs to use repo would more closely align the CTFC with its global counterparts, most of which currently allow for funds using repo as eligible collateral for their markets. For firms with multinational domains, this development is likely to provide a broader and more simplified solution.

Whatever the outcome of the CFCT’s proposals, MMFs offer a wide range of advantages to market participants looking for collateral for initial margin trading and other forms of risk-management transactions. These benefits should see their popularity endure across the market cycle, even in a falling interest-rate environment.

¹https://www.reuters.com/markets/money-market-funds-keep-growing-despite-expected-fed-cuts-jpmorgan-strategists-2024-01-25/