Thursday, September 3, 2009

Money market funds, risk and cash

Posted on Reuters by Felix Salmon:

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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