While the financial world’s attention is fixed on the global macro economy, Brexit and, China, something has been going on with USD Libor fixings.

The past couple of weeks have seen a sharp increase in USD Libor fixings and widening in USD Libor (as shown in the chart below) a development at Deutsche Bank blames on incoming US money market regulations, which starts to take effect on 14 October.

What's going on with USD Libor?
What’s going on with USD Libor?

Considering the reliance of the global financial system on dollar funding via US money market funds, and the size of the US money market industry, the wider market implications of these moves should not be underestimated.

Challenges Facing Government Money Market Funds

The US money market industry amounts to $2.7 trillion, around 15% of US nominal GDP and 22% of all mutual fund assets. Institutional money market funds account for about 65% of money market funds.

Incoming regulations push USD Libor higher 

The key elements of the new money market regulations are the requirement of institutional prime funds to float their NAV and the imposition of liquidity fees and redemption gates under certain situations for prime funds. As Deutsche Bank explains:

  • Floating NAV: Institutional prime money market funds will have to float their NAV which requires them to report their NAV to the nearest basis point rather than the nearest percentage point (the fourth decimal place rather than the second decimal place in case of a fund with $1.0000 share price). These funds will also no longer be able to use the amortized cost method for valuing their portfolio securities. Government money market funds and retail money market funds will be exempt from these rules
  • Liquidity fees and redemption gates: Money market funds will be able to apply redemption fees and redemption gates if their “weekly liquid assets” fall below certain threshold levels. Government money market funds, for both institutional and retail clients, are exempt from these redemption fee and gate provisions but could opt for these voluntarily.
  • Compliance dates: The compliance dates for the floating NAV and redemption fee and gate requirements is 14-Oct-2016

These new regulations mainly affect prime funds and as a result, in the run-up to the introduction of the rules, there has been a significant flow of funds from prime to government money market funds.

Sweeping Money Market Fund Reforms Adopted By SEC

The net effect of these changes is that prime money market funds have been reducing their holdings of overseas securities (Commercial paper and Certificates of Deposit).

Deutsche finds that as prime funds have been selling securities to meet redemptions, prime funds have retrenched by reducing holdings of securities issued by non-US issuers while keeping their holdings of US issues broadly unchanged. European issues are the most sold.

Fed Researchers Argue Against SEC Money Market Reforms

The long-term effects of these regulations, however, may be more severe. As the Financial Times and Wall Street Journal report, the sweeping changes could risk upsetting the Federal Reserve’s carefully choreographed tightening cycle while retail investors could now be in for a shock if they try to exit money market funds during a period of market stress.

Of course no mention is made of any libor manipulation which Deutsche Bank was involved with  and paid a massive $2.5 billion fine for (although to be fair the research unit is entirely separate from the unit involved in the scandal), additionally the bank would have to be REALLY dumb to try to manipulate the same product again and then even dumber to write about the topic (although again units are separate but till) some food for thought, especially those into conspiracy theories!