Commercial Paper: A Primer
February 12, 2025
Commercial banks were first hesitant to adopt a subscription-based revenue model. This is because it was widely believed that such a revenue model would lead to a drop in revenue for the banks and hence would be unsustainable in the long run. However, over the years, several studies have been conducted. The results of the […]
In the previous article, we have already studied that all bankruptcies are not involuntary. In many cases, the shareholders and/or the management of the company make a conscious decision to file for bankruptcy. This happens because the benefits that may accrue as a result of filing bankruptcy are greater than the loss of reputation and […]
In the previous articles, we have discussed that the money market has various sub-sections. One of the most important sub-markets is the commercial paper market. The commercial paper market accounts for a sizeable amount of funds that flow through the money market. In this article, we will have a closer look at the details of […]
The freely floating currency system may have its advantages and disadvantages. However, it has fundamentally changed the way we look at currencies. In doing so, it has created one major obstacle. We now compare currencies with one another to check if they have gained or lost value. This way of measurement is bizarre to say […]
Liquidity can be defined as the ability of a firm to make good its short term obligations. Most businesses function on credit. Hence to run a business firms have to both extend credit as well as ensure that they receive credit as well. Liquidity ratios measure the relationship between the amounts of short term capital […]
The money market is interlinked with other markets such as the stock market and the bond market. As such, if there is turbulence in the money market, it often quickly spirals to other areas of the economy as well. This has already been in the 2008 global crisis.
The liquidity crisis which greatly exacerbated the negative financial conditions which were prevailing after the Lehman crisis was a great example for the world. Regulators across the world have realized that if there is a run on the money market, then the spillover effect of these runs is felt far beyond the money market.
In this article, we will have a closer look at what money market reforms have been undertaken and how they impact the investors.
Regulators have realized over the years that money markets are remarkably stable most of the time. However, this can change relatively quickly during a crisis. This is because of the fact that securities worth trillions of dollars are traded in the money market. However, almost all of these securities can be redeemed on demand. Hence, there is always a possibility that large and sudden withdrawals can drain the system. This is akin to a run on the bank and hence is called a run on the money market fund.
Regulators realized that the valuation of money market securities dropped rapidly whenever such a run took place. This is the reason that they came up with a set of rules which would help prevent the run. Also, if the run did happen, it would help minimize the loss.
The following money market reforms have taken place in the United States.
This meant that whenever an investor wanted to withdraw their funds, they could easily encash their NAV’s in the shortest period of time. However, the reforms have now mandated all money market funds to adopt a floating NAV system. All funds have also been asked to publish prices up to 4 decimal points. It is likely that there will be a slight change in the prices. This is done in order to delay the process of taking money out of the market.
The NAV calculation takes a certain amount of time. Hence, it is no longer possible for companies to instantaneously allow investors to withdraw money from money market funds. The settlement process takes a few hours and sometimes may even spill over to the next day. This ends up delaying the redemption of units from the money market.
Floating NAV’s also means that the valuation of money market holdings held by investors will change over time. These updated values will have to be periodically reported on the balance sheet following the mark to market accounting.
For example, the rules mandate that if a lot of investors are simultaneously withdrawing their money, then the money market fund needs to impose a 2% withdrawal fee. The purpose of this additional transaction cost is to deter investors. However, even after the imposition of the fee, if the withdrawals do not stop and cross a certain threshold, then the withdrawals can be completely suspended. This can be done as many as ten times within a ninety-day period.
Regulators want to closely monitor money market funds and their liquidity position. This is the reason that these details need to be disclosed to investors as well as to the regulator. Also, the regulators have made it mandatory to follow certain guidelines related to the diversification of the overall portfolio.
Money market funds are now required to routinely undertake stress tests and take necessary actions in order to mitigate any shortcomings that such tests might highlight.
The fact of the matter is that the nature of the money market, as well as money market funds, has undergone a sea of change after the regulations have been put into place.
Investors should be aware that their redemption options may get suspended or delayed in certain conditions. This obviously has a negative impact on liquidity which is an important feature for any money market fund.
Your email address will not be published. Required fields are marked *