A recent uptick in the three-month US dollar Libor appears to be an unintended consequence of soon to be effective SEC money market fund regulations. Approved in 2014, the regulations intended to make structural and operational reforms to address risks of investor runs in money market funds provided for a two-year implementation period. With that period drawing to a close in October of 2016, prime money funds and their investors have been making strategic moves and investment decisions that are having knock-on effects on Libor.
Ahead of the October 14, 2016 money market rule effective date, the three-month US Dollar Libor rate has increased from 0.66910% on July 11, 2016 to 0.74300% on July 26, 2016, the highest the rate has been in seven years. Analysts attribute this in part to initial shock associated with Brexit. But the rise predates the Brexit vote, and the pattern and continuation of the rate’s rise suggests something more is at play. That “something else” seems to be widespread change to prime money fund portfolios and movement of prime money fund investors into other vehicles.
The new money market fund rule requires that prime institutional money market funds that hold short-term corporate debt have to allow their share prices to fluctuate. In addition, non-government money market funds (prime and municipal) may impose a redemption fee or temporarily halt redemptions if fund liquidity falls below regulatory limits. The prospect of redemption fees has prompted many investors to leave prime funds in favor of funds holding government debt, with more expected to redeem closer to the deadline. At the same time, in order to head off volatility as October 14 approaches, most prime funds are taking steps to reduce their weighted average maturities to ensure they comply with new liquidity thresholds set by the new rules and to deal with expected spikes in redemptions. This foreshortening of maturities for the sake of liquidity has had the effect of driving up Libor in the short-term. This is because prime funds' avoidance of bank term funding has reduced the overall demand for commercial paper, thereby forcing issuers to offer higher rates. With money market funds playing such an important role in the short-term commercial paper market, their buying decisions have an outsized effect on the benchmark rate.
Libor increases traditionally have been seen as warning flags about the health of banks and the financial system. In this instance, however, it seems that the increase is not the result of banks struggling with market conditions, but merely strategic maneuvers by prime funds and investors resulting from regulatory intervention (along with some acute uncertainty resulting from Brexit). The SEC implemented the new rules to "make structural and operational reforms to address risks of investor runs in money market funds, while preserving the benefits of the funds.” It seems, however, that in response, large numbers of prime funds have converted to government funds and large numbers of investors have fled to government funds. It is unclear how that development preserves the benefits of prime funds. In addition, the remaining prime funds have made strategic changes in their portfolios driving up Libor. Higher Libor rates mean mortgages and other consumer loans are more expensive and consumers have less access to credit, which could harm the U.S. and other economies. While the regulations may have made the risk of runs on prime funds less likely, this relative risk reduction has come as at a high price for all of us.