Liquidity lowdown: Regulation changes?

There are two exceptional events in recent history that money market fund (MMF) managers will find hard to forget.

In 2020, the Covid pandemic was felt through financial markets with large parts of the economy coming under huge pressure. Investors turned to safe assets which pushed up the price of those assets. The so-called ‘dash for cash’ emerged and investors began to sell their assets in the search for liquidity. Sterling Denominated MMFs saw outflows of around £25bn, or 11% of their total assets, leaving fund managers in an uncomfortable position, with three Low Volatility Net Asset Value Funds (LVNAVs) seeing outflows of over 20% of their assets between 11-20 March 2020. Two years later, a failed budget from former Chancellor of the Exchequer Kwasi Kwarteng sent gilt yields temporarily soaring. MMFs are typically large holders of Liability Investment Driven (LDI) collateral money, and the rapid drive up in yields meant that MMFs faced significant redemptions as LDI funds had to pay out margin on long-dated derivative positions.

Whilst MMFs were not at the root of these financial woes, the pressure felt in markets ultimately filtered down into MMFs, and their resilience in very stressed scenarios has since been called into question. The Financial Conduct Authority (FCA) are currently consulting on the reform of MMFs in the UK. Various changes have been proposed, including, but not limited to, raising the daily liquidity requirement to 15%, and the weekly liquidity requirement to 50% as well as ‘delinking’, which is removing the 30% red line where there was the potential for funds to apply fees and gates. The new rules are meant to address vulnerabilities identified in 2020 ‘dash for cash’ and other times of market stress. They are also intended to mitigate risks to wider financial stability and reduce the need for support from the central bank, whilst maintaining cash management services that meet the needs of investors. There are only a small number of MMFs domiciled in the UK, but offshore funds distributed into the UK are likely to be affected by any changes to overseas fund regimes, so there is plenty of potential change in the pipeline, and a lot for investors to process. However change takes time, and even if the changes go ahead it is unlikely we will see anything materialise before the second half of the year.

In markets, we have seen one-year Certificates of Deposit (CDs) gain 15 basis points on average since the start of the month whilst three-month CDs remain largely unchanged. This time last month, the market was expecting a bank base rate of around 4.00% by year end 2024. Today, that has shifted to 4.50%, with the first rate cut not expected until August 2024. Inflation has fallen significantly since its peak in July 2023, but there are still risks to the upside from services inflation and continued disruptions in the shipping industry. The Bank of England (BoE) are keen to see more evidence that inflation will continue to fall back its 2.00% target before beginning the cycle of rate cuts. However, annualised growth in 2024 is expected to look more encouraging, and this may contribute to the BoE’s nervousness at cutting rates too soon, especially with the potential for real income and consumer demand to grow. Nonetheless, rate cut expectation have shifted back, at least for now.

Currently, we see particular value in treasury bills (T-bill) when compared to CDs. The spread an investor should expect to receive on a six-month CD is currently around 22 basis points over SONIA. This spread compensates you for taking additional credit risk over a risk-free T-bill. Currently, that spread remains stubbornly low, at just 14 basis points, making CDs look expensive relative to T-bills. Why would an investor want to invest their money into an instrument yielding eight basis points lower than what is deemed ‘fair value’, when historic spreads lie so much higher? However, it is likely, that with the advent of the new regulations, demand for CDs will be curtailed as MMF’s are forced into holding a higher amount of shorter dated assets to meet the increased minimum liquidity requirements. We believe this will cause CDs to cheapen in response, and for the spread to T-bills to widen – which in turn will attract more investors to the CD market as issuers may be forced to offer better rates to investors.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.