Stress Testing in Money Market Funds

From the previous articles, we already know that money markets form an integral part of the overall financial system. Also because of their large volumes and high ratio of demand deposits, the money market funds are always at the risk of a run. It is for this reason that the Securities and Exchange Commission has made it mandatory for money market funds to conduct periodic stress tests. This helps safeguard the interests of investors as well as of the entire financial system in general.

In this article, we will have a closer look at the details of the stress testing process in money market mutual funds.

Why Do Money Market Funds Need to be Stress Tested?

Money market funds need to be stress-tested since they face a lot of different types of pressures. Some of these have been listed below:

1. It is possible that the short-term interest rates may increase. This could cause stress in money market funds since empirically an increase in interest rates is highly correlated with a fall in the net asset value of the funds.

2. It is also possible that a market-wide correction of interest rate has not taken place. Instead, the correction has taken place only for a certain company since it has faced a downgrade or a negative credit event. If a money market fund holds a significant portion of its income in these assets, then it can be negatively impacted.

3. It is also possible that the credit spreads for only a certain type of securities begin to rise. In this case, also the value of the money market securities is negatively impacted

4. It is also possible that the shareholder redemptions might suddenly increase either on its own or in combination with any of the factors mentioned above

How is Stress Testing Conducted?

1. The stress tests for interest rate changes are done by simulating an environment in which the interest rate is considered to be changed. The stress testing team has to carefully construct a variety of plausible scenarios. Based on empirical evidence, they then need to map the impact on money market securities. This is done using sophisticated software which understands the underlying trend and is able to make predictions.

   Another important outcome of the exercise is that the interest rate can be identified at which the money market fund might start facing solvency issues. This helps the management to continuously monitor their solvency in the light of the latest information

2. Just like the interest rate shock, stress tests are also designed in order to gauge the impact of redemption shocks on the overall financial health of the money market fund. The stress test aims at understanding how the financial health of the money market fund will behave at various levels of redemption.

   The impact at different levels is mapped in order to understand the point where such redemptions will lead to the insolvency of the fund. This analysis is used by money market funds to determine when the rights to redeem funds needs to be suspended

3. At first, the stress testing is done using a single variable such as interest rates or redemption rates. However, finally, the stress testing team needs to combine the impact of all the different factors in order to gauge the level at which the fund’s financial health is likely to be affected. This is because in the marketplace the factors do not work in isolation. Instead, the combination of all these factors is what causes the prices of money market securities to change.

Impact of Stress Testing

The fact of the matter is that stress testing was used by many sponsors and financial corporations in the money market.

It was always a best practice for the sponsors to be aware of how the changes in the external environment will impact the value of the portfolio. However, now, this best practice is no longer voluntary. Instead, it is mandatory for all money market funds to conduct these tests because:

1. The money market is the first market to be negatively affected by the external environment. Most financial crises originate in the money market first and then spread further. Hence, from a regulator’s point of view, if the crisis can be detected as well as prevented at this stage, then the monetary impact to other investment markets can be minimized.

2. Stress testing ensures that investors and all stakeholders are prepared for any financial duress. Hence, even if assets have to be liquidated, it is done in a planned and phased manner. The main purpose of stress testing these funds is to prevent a run on the money locked in money market securities.

The bottom line is that stress testing in money markets is not only required from a regulatory point of view but is also desired by investors. This is the reason that the practice has been quickly adopted by all players in the money market.