Since the fallout of the 2008 Financial Crisis, Cash Investors have been waiting for a “new normal” environment, which would replace the recent period of zero yields and uncertain regulatory reforms. The past five years have proven to be an interim “healing” timeframe where monetary policy from the Federal Reserve and evolving sanctions from regulators focused on the improvement of financial institutions’ capital structures. The consequences for institutional investors were highly uncertain risk/return characteristics for cash and liquidity investments. Reforms resulted in an improved financial system, but left investors with fewer compelling opportunities for managing growing cash balances. The first wave of clarity came in 2010 for providers of cash investments. Added safeguards were put in place to regulate Money Market Funds (MMFs), and the banking industry incorporated the global financial regulations of Basel III, specifically addressing capital requirements. Although the future became a bit clearer for financial institutions, institutional investors still had to wait for a next wave of reforms to begin understanding the ramifications for them. That wave came in 2012 when the FDIC Transaction Account Guarantee (TAG) program expired, eliminating the unlimited insurance covering non-interest bearing accounts. The outcome of this expiration was additional risk for institutional cash investors. By the end of 2012 it became clearer that the paradigm of managing liquidity was changing significantly.
In July 2014, the Securities and Exchange Commission (SEC) finalized substantial reforms to the rules governing MMF’s which will directly affect large institutional investors in these programs. The most significant change for investors is that Institutional Prime MMFs must float their market-based net asset values (NAV), replacing the historic stable $1 unit value with a four digit floating NAV. Also, the Institutional Prime MMFs may impose a liquidity fee for redemption, or gate redemptions, if liquidity assets within the portfolio fall below a certain level. These changes scheduled for October 2016 alter the attractiveness of Institutional Prime MMFs drastically, questioning the future viability of this large segment of the liquidity markets. As we get closer to the change date of October 2016, providers (financial institutions) are beginning to offer their vision of liquidity options that may address new reforms and the “new normal” in liquidity management.
Cash and Daily Liquidity
Presently, the largest programs offering daily liquidity to institutions are Institutional Prime MMFs. The upcoming changes will have investors rethink their use of these programs for daily needs as a floating NAV and possible gates or liquidity fees will likely be unacceptable for most. Institutional investors wanting to maintain an absolute stable principal value will be limited to using bank demand accounts and government MMFs. An additional wrinkle to this new world is that bank deposits have some risk due to the expiration of the TAG program. Going forward investors will need to incorporate greater risk oversight to the selection and management of their bank deposit relationship. Commonfund strongly advises that cash investors consider a financial institution’s Deposit rating as well as its Senior Long Term Debt rating before choosing a provider for their needed daily liquidity. Also, larger banks affected by Basel III will find large deposit relationships more expensive due to their new capital requirements. Consequently, these financial institutions are beginning to charge for cash balances in demand accounts. This trend will lead to large cash investors moving or sweeping liquidity to government MMFs as they will still transact at a stable $1 NAV. Stronger demand for these MMFs will drive already low yields lower, and may keep these yields low even with the expected upcoming interest rate hikes by the Federal Reserve. Thus, our view of the new normal is that investors may have to pay for daily liquidity, or at least accept extremely low yields for the foreseeable future to maintain absolute safety of principal within cash balances.
If it’s not needed for cash…..
Providers are cautiously preparing for a widespread dispersion of assets previously held in Institutional Prime MMFs. The ability of providers to minimize risk through credit diversification within a stable $1 fund will go away next year. Expectations are varied as to what happens to the existing $1.5 Trillion in Institutional Prime MMFs. Liquidity assets that truly need absolute safety in principal may move to government MMFs, further increasing the demand for these low yielding programs. Some investors may rethink their need for a stable $1 NAV and move assets to programs that encompass some risks. Over the next year, investors will be introduced and reintroduced to several liquidity “short duration” options. These options will include less than 60 day maturity fixed income programs, Floating NAV Prime MMFs, Enhanced Floating NAV Prime funds, Ultra Short fixed income programs, Short Duration fixed income programs, Institutional Credit programs, Limited Duration programs, and so forth. Obviously, not all of these programs are appropriate for all liquidity investors. In fact, the providers of these programs are hard pressed to predict which of these programs will attract assets and which will be ignored by investors.
So, where does that leave liquidity investors?
There is no need to panic as investors have a year and a half to formulate strategies and execute needed operating asset portfolio changes. However, it is an appropriate time to formulate or amend current liquidity/operating asset policies and reevaluate needed liquidity levels of cash. Policies should include language regarding the selection and oversight of bank demand deposit accounts as well as investment program oversight. Some attention should be paid to what is really needed in cash/liquidity at any time and what assets can be segmented by time horizon. A sound updated policy along with cash flow forecasts will help investors clearly understand their unique needs for operating assets, as well as navigate the new world of operating asset investments.