Regulators' effort to stamp out risk in the $2.6 trillion U.S.money-fund industry is creating unintended ripple effects acrossfinancial markets, with far-reaching consequences for companies andinvestors.

Far less cash than anticipated has returned to thehigher-yielding slice of the money fund world after the overhaulthat took effect in October led to a $1 trillion exodus from whatare known as prime funds. Such funds had been the principal buyersof the commercial paper that companies and both foreign anddomestic banks have sold for decades to obtain short-term U.S.dollar-denominated financing.

By squelching demand from prime funds, the rules causedcommercial paper rates to rise relative to those of othermoney-market securities. Rates are now at the highest levels sincethe financial crisis, causing borrowers to seek new sources offunding like the short-term securities lending market. Investorsare also feeling the pinch — most money funds are stuck withTreasury bills offering paltry rates. What's more, the massiveshift toward funds that can only buy the safest U.S. debt hascreated the potential for a bottleneck if Congress is unable toresolve long-simmering disputes related to the nation's debtceiling.

“The biggest losers are financial institutions,” said AnthonyCarfang, a Chicago-based managing director at Treasury Strategies,a consultant for corporations and financial services providers.“U.S. financials and nonfinancials have also been hurt. There arevery few U.S. corporations getting funding from prime funds.”

The commercial paper market is a shadow of its former self, withforeign financial issuance up only about $20 billion since Novemberas overseas institutions gravitate to high-quality, short-termgovernment assets to secure U.S. dollar funding. Non-U.S. bankslost $555 billion of U.S. dollar funding from prime funds sinceDecember 2015, according to the Bank for International Settlements'Quarterly Review published March 6.

The number of AA-rated financial commercial paper issues withmaturities longer than 80 days has plummeted. Six issuers tappedthe market March 29, compared with as many as 95 a day in March2016, Federal Reserve data show.

“We're in the middle of a long-term shakeup of dollar-fundingmarkets,” said Blake Gwinn, a U.S. rates strategistwith NatWest Markets. “We're moving from a regime that lasteda decade or so and finding our footing for the next 10 to 20years.”

The catalyst is U.S. regulatory efforts to prevent a repeat ofthe run on money market funds that took place during the 2008financial crisis, when the $62.5 billion Reserve Primary Fund hadto “break the buck” due to losses on debt issued by Lehman BrothersHoldings. That caused a panic among investors in other funds, whowent on to yank about $200 billion in about two days, nearlyfreezing credit markets.

The changes included institutional prime funds abandoningthe long-held tradition of having asset values locked at $1 pershare. Holdings in prime funds fell to a record low of $373 billionafter the reforms went into effect in October, ICI data show. Sincethe implementation deadline, total prime fund assets have onlyrebounded by about $25 billion. Most of the prime outflows ended upin government-only funds, which were exempt from the changes.

Among foreign institutions, Japanese banks' exposure to primefunds fell to $44.9 billion in February from $174.6 billion inOctober 2014, while French banks' exposure dropped to $62.1 billionfrom $165.2 billion, Securities and Exchange Commission data show.Prime funds slashed U.S. bank holdings to $53.9 billion from $233.2billion.

As an alternative, non-U.S. banks have gained about $140 billionof funding via repurchase agreements with government money funds,according to the BIS. Ninety-day commercial paper rates are about1%, compared with 0.9% for similar maturity repos.

“There are other investors out there who are willing to buy bankpaper — especially as spreads and rates overall have gone up a bit”given the Fed tightening, said Oskar Rogg, head of Treasury for theAmericas at Credit Agricole CIB in New York. “Other counterparties,using other vehicles like separately managed accounts and offshorefunds, have been willing to provide funding to banks.”

While the SEC changes have reduced the odds of a repeat of a2008-style credit-induced crisis, other unintended risks havesurfaced, such as the concentration of money in government funds.Any startling event, such as another fight over extending thenation's borrowing capacity, could serve as a trigger fordisruptive moves out of the sector.

“Wherever you have those big dollars moving around, theythemselves are a risk,” said Peter Crane, president of Crane Data.“You put a bunch of 800-pound gorillas in a room, and if all of asudden everyone wants to get out, they are going to break down awall.”

One silver lining for prime funds is the widening gap betweenyields on the two types of funds, which could eventually lure backmore cash.

But even if some money returns, it will only be a fraction ofwhat was lost, because some investors, including sweep accounts,are required to place their cash in money funds with a constant netasset value. Other fund companies, such as Fidelity Investments,which converted its institutional prime money markets togovernment-only, are unlikely to revert.

“The $1 trillion that left will not all come back,” Carfangsaid. “Not all of it can come back.”

Bloomberg News

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