LONDON (Reuters) - Any European Central Bank move to cut interest rates below zero could deal a further blow to money market funds already struggling in a low rate environment, raising risks to the wider financial system.
Money market funds help grease the wheels of the financial system, providing an important source of short-term funds for banks and companies and offering investors an alternative to banks as a place to park their cash.
But the industry has been shrinking since the financial crisis. Aggregated assets held by euro zone money funds fell to just 929 billion euros at the end of March from 1 trillion euros in 2011, according to the ECB.
Not only have they suffered outflows after some funds with risky investments made a loss in 2008-9, ultra-low interest rates mean they are struggling to give decent returns. If rates go negative, the industry’s contraction is likely to accelerate.
“When you look at the cost of running cash, with negative interest rates you will end up with a negative rate of return. Then that approach in managing your cash balance (with money funds) becomes invalid,” said Ashok Shah, chief investment officer at London & Capital.
Further bad news for money markets funds would have a ripple effect on the broader financial system, especially given their close ties with wholesale funding markets.
Such funds are typically buyers of commercial paper or certificates of deposit - very short-term, highly liquid securities issued by banks or companies - which they also lend out for a fee in the securities repurchase, or repo, market.
“The impact on the banking system is obviously negative,” Shah added. “We care about money market funds because they supply liquidity into the banking system. They are a conduit to make money go around the system.”
ECB President Mario Draghi shocked investors earlier this month when he said the euro zone’s central bank was “technically ready” to cut its deposit rate into negative territory, although ECB policymakers are divided on the policy.
A deposit rate of less than zero would effectively mean the ECB charges banks to hold their money securely overnight.
Euro zone-domiciled money funds tracked by Thomson Reuters Lipper suffered net outflows of 18 billion euros in the six months to April, with their five-year outflows hitting 179 billion euros.
Regarded as an alternative to bank deposits, money funds have been seen as a safe investment as they aim to maintain a stable net asset value - typically $1 - and never to lose money.
But the crisis has undermined faith in the funds, which unlike bank deposits, offer no guarantee.
U.S. money manager Reserve Primary Fund, which invested in commercial paper issued by Lehman Brothers, “broke the buck” in Sept 2008, with its net asset value per share falling below $1.
In Europe, Standard Life suffered a loss on one of its money market funds in 2009 by investing in asset-backed securities linked to the mortgage market.
Responding to these incidents, new EU rules may force about half of euro money market funds to set aside a chunk of cash and prevent a run in rocky markets.
But the proposed buffer requirement, amounting to 3 percent of total asset value, would be operationally costly for funds.
A shrinking money market fund industry has a ripple effect in the repo market, whose liquidity affects trading in cash government bonds. Market makers in the government bond market turn to the repo market to borrow bonds which they sell in the secondary market, thus supplying liquidity there.
Euro-denominated money funds rated by Fitch have more than a quarter of their assets in repo and other lending that requires collateral such as asset-backed commercial paper.
Indeed, the International Capital Markets Association estimates the European repo market shrank as much as 11.9 percent in the year to June 2012, with the total value of outstanding repo contracts at 5.611 trillion euros.
JP Morgan strategist Nikolaos Panigirtzoglou says falling repo liquidity could prompt those who supply collateral to withdraw, making it hard for repo players to trade in the cash bond market, impairing liquidity there too.
“Money market funds are significant investors in the repo market. Repo markets are important because they effectively infuse liquidity in cash bond markets. For the market to function properly you need buyers and sellers - a two-way market,” he said.
Volatile moves in the repo and government bond market are also causing troubles beyond the euro zone.
The Bank of Japan was forced to intervene in the market earlier this month, injecting 2.8 trillion yen ($27.60 billion)to stem a rout in government bond prices that caused a spike in benchmark yields to a one-year high of 0.920 percent.
JP Morgan estimates that a 100 basis point shift in Japanese bond yield curve would cause a loss of 3 trillion yen for major Japanese banks, or 10 percent of tier 1 capital.
“(Falling liquidity means) market moves could thus be bigger and we could have more frequent volatility spikes triggered by self-reinforcing selling by commercial banks,” Panigirtzoglou said.
Additional reporting by Joel Dimmock; Editing by Catherine Evans