Liquidity Lowdown: Defining liquidity in money market funds

Money market funds (MMFs) are often judged by a simple set of headline metrics. Daily and weekly liquidity percentages are a core regulatory requirement and are monitored daily.

While they are an important safeguard for investors and provide a useful snapshot, they don’t always tell the full story. The liquidity of the underlying assets can behave very differently when markets become stressed.

Under money market regulation, daily and weekly liquidity are defined by asset type and maturity. Cash, overnight repos and securities maturing within a certain timeframe are classified as liquid, regardless of how they might trade in more difficult conditions. On paper, a fund may therefore report comfortably high liquidity levels, yet those figures assume those assets can always be sold at short notice and importantly, at or near their fair value. Experience suggests this assumption does not always hold true.

In periods of market stress, assets issued by weaker or lower quality credits can quickly become illiquid, as there is a natural tendency for buyers of secondary paper to steer towards quality.

In periods of market stress, assets issued by weaker or lower quality credits can quickly become illiquid, as there is a natural tendency for buyers of secondary paper to steer towards quality. When investor confidence deteriorates, bid ask spreads can widen, secondary market depth deteriorates, and the willingness of dealers to intermediate risk diminishes. An asset that appears liquid under regulatory definitions may, in practice, be difficult to sell without a material price discount.

Credit quality plays a central role here. In normal market conditions, the distinction between stronger and weaker issuers is evident. But during stress events, those distinctions become even more apparent. The result is that assets which may have been purchased to enhance yield during normal market conditions, can become difficult to sell when liquidity is genuinely needed. Even where credit quality exists, there is sometimes no strong secondary market for certain asset types. Asset Backed Commercial Paper (ABCP) as an example, can offer attractive yields, but sacrificing valuable liquidity for a minimal increase in overall yield can be inconsistent with the core purpose of an MMF.

We believe that governance and ESG considerations can also affect liquidity in stressed markets. Issuers with weaker governance standards or poor ESG credentials may find themselves particularly exposed if adverse news emerges. Market perception can change very quickly, and even where credit fundamentals are strong, reputational risk alone can be enough to negatively affect secondary market liquidity.

This is where headline liquidity metrics can be slightly misleading. A fund holding a large proportion of such assets may report high daily and weekly liquidity on paper but discover that real world liquidity is far less reliable when required. By contrast, a fund reporting lower regulatory liquidity may, in practice, be holding assets that are much more attractive for dealers and other MMFs to buy at fair rates.

Secured exposures, sovereign-linked issuers and high-quality bank paper tend to demonstrate this. Even if maturities are slightly longer, the ability sell high quality assets provides more meaningful liquidity to MMFs in practice. In other words, real liquidity is not just about how soon an asset matures, but how confidently and efficiently it can be converted into cash in different economic conditions.

Liquidity should not be assessed solely through reported percentages. A deeper understanding of underlying asset quality, issuer behaviour, governance standards and secondary market dynamics is key to understanding how a MMF will behave when put under pressure. Funds constructed with an emphasis on quality and diversification may appear more conservative on paper, but can prove more robust when liquidity is needed most.

Ultimately, MMFs are designed to provide stability and confidence, particularly during periods of uncertainty. High liquidity numbers can be reassuring, but they are not a guarantee. True liquidity only becomes apparent under pressure, and history has shown that what looks liquid in calm markets may behave very differently when conditions change.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. 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.