Money market funds, risk, and cash

By Felix Salmon
September 3, 2009
Eleanor Laise has the encouraging news this morning that Deutsche Bank is planning to launch a money-market fund whose shares fluctuate in value, rather than being artificially pegged at $1.


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Eleanor Laise has the encouraging news this morning that Deutsche Bank is planning to launch a money-market fund whose shares fluctuate in value, rather than being artificially pegged at $1.

On the face of it, this is a very good idea. Money-market funds are low-risk instruments, but that one phrase hides many different possible meanings, which get unhelpfully elided in the minds of investors. Moving to what’s known as a “floating NAV” (the net asset value goes up and down over the course of each trading day) helps to make some of those distinctions explicit.

Most people intuitively think that “low-risk” means “you can’t lose much money”. In finance, however, “low risk” can also mean “there’s a very low probability that you’ll lose any money at all”. And the problem with $1 money-market funds is that if they “break the buck”, then all hell breaks loose, and investors can end up waiting months to get their money back. It’s classic tail risk.

Wall Street is good at massaging risk in this way: taking risk and shoving it off into the tails. Most triple-A-rated structured products were like that: part of the reason that they offered a big yield pickup was by effectively maximizing the loss given default in the (perceived unlikely) event that a default did occur. Of course, another huge problem with tail risk is that measuring it, ex ante, is pretty much impossible.

So I’m all in favor of a product which has small fluctuations in value every day, thereby helping to reduce the tail risk associated with putting a floor on the fund value.

There are good reasons not to go down this road, however, and if you look at section 8.1 of this report, you’ll find a lot of them. What’s more, there are bad reasons to go down this road, specifically the idea that it’s just nimble-footed regulatory arbitrage:

In a letter to the SEC this week, Deutsche Bank suggested that floating NAV funds have a starting price of $10 a share and that they don’t need to be subject to tighter money-fund rules recently proposed by the SEC.

Rolfe Winkler adds another wrinkle to all this, which is the whole idea of money-market funds being “cash equivalents”. I’m with FASB on this front, in believing that the whole concept of a “cash equivalent” is dangerous and unhelpful. There’s really no such thing as “cash”, beyond folding banknotes — and those literally come with a cost of carry. All other forms of cash carry some kind of counterparty, credit, or interest-rate risk. We should move to a world where those kind of small risks are embraced and understood, rather than being ignored by being lumped into the category of “cash equivalents”.

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Comments
3 comments so far

Taxes can be a problem. If you hold a MM in a taxable account, there are tax consequences if purchase and sales prices are different, which can create real record keeping costs.

Posted by foosion | Report as abusive

With extermently rare exceptions, the value of a floating NAV mmf would not vary throughout the day. The NAV would (could) change once a day — at the end of the trading day. See Investment Company Act rule 22c-1.

Posted by Paul | Report as abusive

I don’t see why money funds were ever permitted to pretend to be something they are not. If they are an investment product such that investors can lose money, then it should be illegal for them to pretend that they have a NAV of $1. The value of an investment fund is what it is — it’s simply illogical to try to bound an investment fund below by some fixed value.

On the other hand, if money funds want to have a NAV of $1, then they are clearly not investment funds. They are making an implicit promise to account holders to return their funds. It is only possible for a money fund to support this promise if it has reserves/capital set aside in case losses exceed the NAV (as was demonstrated by the fund bailouts of 2008).

The ICI wants to continue to have it’s cake and eat it too. Regulators need to recognize that they have allowed the development of a financial product with investments that are inconsistent with the marketing of the product. This situation would be okay if there were money fund failures every one or two years — so the reality of the investment fund attribute of money funds was brought home to investors on a regular basis. In the absence of such market feedback, regulators need to rationalize the money fund market by demanding truth in advertising: If you want to have a fixed NAV, you have to maintain reserves to support your target NAV.

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