Understanding A Changing Liquidity Landscape

Understanding A Changing Liquidity Landscape

October 2016

A A A

The 2016 liquidity space is going through a sea change due to a myriad of market and regulatory forces, especially those surrounding short-term products. Here is what investors should know to stay a step ahead.

Sam Schwartzman, Global Head of IMG Cash Solutions, BNY Mellon Markets

There is a current convergence of events occurring in the 2016 liquidity space that is resulting in hundreds of billions of dollars moving from certain short-term investment products to others. These include a number of market and regulatory changes that are having a significant impact on liquidity investing, and the relative value of certain products in 2016 and beyond, such as:

Short-term rates increasing in USD: The increase in short-term rates in late 2015 resulted in “dormant” clients re-examining their liquidity options as product yields began to differentiate more than they had in the recent years’ zero rate environment. Previously, the opportunity cost of not actively managing cash had been low, resulting in many clients choosing to passively manage their cash into one sweep vehicle or not investing their liquidity balances at all. That cost is expected to increase if we continue to move into a higher rate environment, resulting in more active investment of cash, and liquidity balances moving from certain investment vehicles to others.

Money market reform in the US: As a result of the Securities and Exchange Commission’s (SEC) new rules that were effective this fall, many clients have been re-examining their investments into prime and tax-exempt funds. Institutional prime and tax-exempt money market funds became floating-NAV vehicles in October 2016 and now require the ability to impose redemption fees and/or bring down gates preventing any withdrawal activity should the funds’ 7-day liquidity levels fall below 30%. (Retail versions of these funds, defined as funds that exclusively consist of natural persons only, do not need to float their NAVs, though the ability to apply fees and gates, if certain conditions are met, are now required. US Treasury/Government money market funds are also not subject to the floating NAV requirement and may opt in to have the capability to apply fees and gates.) Many money market fund investors utilize the vehicles for cash that they may need immediately in an emergency situation. As a result, the possibility of a gate limiting their ability to access that cash, or a fee, causing them a loss upon redemption, may make prime and tax-exempt money market funds less attractive to these investors and cause them to reduce or eliminate their positions in these funds. In addition, the concept of a floating NAV, resulting in a potential principal loss in a money market fund, may also give some investors pause, resulting in withdrawal activity from institutional prime/tax-exempt money market funds.

Due to these changes, and their impact on the attractiveness of these funds to certain investors, a large amount of balances (hundreds of billions of dollars) has been withdrawn from these funds recently. As expected, many of these balances have been moved to US Treasury/Government money market funds, as floating NAVs will not be a requirement imposed on these funds, and fee/gates are optional.

Basel III-related regulations: Regulations such as the Liquidity Coverage Ratio (LCR) and the Supplementary Leverage Ratio (SLR) are forcing large banks to value short-term deposits differently than they would have historically and, in some instances, to reduce deposit levels to achieve compliance with required regulatory ratios. The LCR is a quantitative liquidity requirement that requires large banks to hold a certain amount of high quality liquid assets (HQLA) to offset outflows that could occur in a stressed environment over a 30-day period. HQLA are expected to be relatively low-yielding as they are considered to be safe and will presumably be subject to inflated demand because of the LCR and other regulations.

As a result, banks are expected to attempt to limit the amount of HQLA they hold on their balance sheets because their expected lower returns potentially limit return on capital. Overnight deposits (as well as deposits with tenors of 30 days and less) are included as outflows subject to certain factors under the LCR. Consequently, it is expected that large banks will not value certain overnight and short-term deposits as highly as they historically would have, as the need to potentially hold some HQLA against these deposits potentially limits return on capital. Given their lower value, it is expected that banks will pay lower relative rates for these deposits, creating an incentive for certain bank depositors to look at other investment vehicles with their liquidity balances.

In addition, the SLR is a new capital ratio that requires compliance in 2018, but it has already begun to be reported by the large banks since 2015. It is expected to result in large banks decreasing their asset base and consequently their offsetting deposit levels, since the minimum SLR is higher than the historical leverage ratio that large insured bank subsidiaries were subject to, and the SLR’s denominator is broader and larger. As a result, in order to decrease their size to comply with the SLR, large banks may encourage certain depositors to move to alternative investment products in 2016.

With the expected impact of these events, and others, liquidity investors will want to educate themselves about the changing dynamics in this space and continue to monitor how this environment impacts the relative attractiveness of different short-term investment products. BNY Mellon is here to offer our experts’ support and guidance as the new realities of the liquidity landscape come into clearer focus.

BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may be used as a generic term to reference the corporation as a whole and/or its various subsidiaries generally. This material and any products and services may be issued or provided under various brand names in various countries by duly authorized and regulated subsidiaries, affiliates, and joint ventures of BNY Mellon, which may include any of the following. The Bank of New York Mellon, at 225 Liberty St, NY, NY USA, 10286, a banking corporation organized pursuant to the laws of the State of New York, and operating in England through its branch at One Canada Square, London E14 5AL, UK, registered in England and Wales with numbers FC005522 and BR000818. The Bank of New York Mellon is supervised and regulated by the New York State Department of Financial Services and the US Federal Reserve and authorized by the Prudential Regulation Authority. The Bank of New York Mellon, London Branch is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. The Bank of New York Mellon SA/NV, a Belgian public limited liability company, with company number 0806.743.159, whose registered office is at 46 Rue Montoyerstraat, B-1000 Brussels, Belgium, authorized and regulated as a significant credit institution by the European Central Bank (ECB), under the prudential supervision of the National Bank of Belgium (NBB) and under the supervision of the Belgian Financial Services and Markets Authority (FSMA) for conduct of business rules, and a subsidiary of The Bank of New York Mellon. The Bank of New York Mellon SA/NV operates in England through its branch at 160 Queen Victoria Street, London EC4V 4LA, UK, registered in England and Wales with numbers FC029379 and BR014361. The Bank of New York Mellon SA/NV (London Branch) is authorized by the ECB and subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority. Details about the extent of our regulation by the Financial Conduct Authority and Prudential Regulation Authority are available from us on request The Bank of New York Mellon SA/NV operating in Ireland through its branch at 4th Floor Hanover Building, Windmill Lane, Dublin 2, Ireland trading as The Bank of New York Mellon SA/NV, Dublin Branch, is authorized by the ECB and is registered with the Companies Registration Office in Ireland No. 907126 & with VAT No. IE 9578054E. The Bank of New York Mellon, Singapore Branch, subject to regulation by the Monetary Authority of Singapore. The Bank of New York Mellon, Hong Kong Branch, subject to regulation by the Hong Kong Monetary Authority and the Securities & Futures Commission of Hong Kong. If this material is distributed in Japan, it is distribute by The Bank of New York Mellon Securities Company Japan Ltd, as intermediary for The Bank of New York Mellon.

Not all products and services are offered in all countries.

The information contained in this material is intended for use by wholesale/professional clients or the equivalent only and is not intended for use by retail clients. If distributed in the UK, this material is a financial promotion.

This material, which may be considered advertising, is for general information purposes only and is not intended to provide legal, tax, accounting, investment, financial or other professional advice on any matter. This material does not constitute a recommendation by BNY Mellon of any kind. Use of our products and services is subject to various regulations and regulatory oversight. You should discuss this material with appropriate advisors in the context of your circumstances before acting in any manner on this material or agreeing to use any of the referenced products or services and make your own independent assessment (based on such advice) as to whether the referenced products or services are appropriate or suitable for you. This material may not be comprehensive or up to date and there is no undertaking as to the accuracy, timeliness, completeness or fitness for a particular purpose of information given. BNY Mellon will not be responsible for updating any information contained within this material and opinions and information contained herein are subject to change without notice. BNY Mellon assumes no direct or consequential liability for any errors in or reliance upon this material.

This material may not be distributed or used for the purpose of providing any referenced products or services or making any offers or solicitations in any jurisdiction or in any circumstances in which such products, services, offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements.

Money market fund shares are not a deposit or obligation of BNY Mellon. Investments in money market funds are not insured, guaranteed, recommended or otherwise endorsed in any way by BNY Mellon, the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, fund shares are subject to investment risk and your investment may lose value. Money market fund yield performance represents past performance, which is no guarantee of future results and investment returns will fluctuate. Before investing, investors should carefully consider the investment objectives, risks, charges, tax impact and expenses of the fund that are explained in each fund’s prospectus. The following factors, among many, could reduce any one fund’s income level and/or share price: interest rates could rise sharply, causing the value of the fund’s investments and its share price to drop; interest rates could drop, thereby reducing the fund’s yield; any of the fund’s holdings could have its credit rating downgraded or could default; and there are risks generally associated with concentrating investments in any one industry. Investments in instruments of non-U.S. issuers are subject to the risks of certain domestic events—such as political upheaval, financial troubles, nationalization (certain assets, entities or sectors) or natural disasters—that may weaken a country’s securities markets. Country risk may be especially high in emerging markets. Such investments may be affected by market risk on a global scale based on responses of certain foreign markets to markets of other countries or global market sectors. Foreign-currency denominated securities are subject to fluctuations in exchange rates that could have an adverse effect on the value or price of, or income derived from, the investment. Investments in foreign instruments are subject to the risk that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates.

Securities instruments and services other than money market mutual funds and off-shore liquidity funds are offered by BNY Mellon Capital Markets, LLC.

All references to dollars are in US dollars unless specified otherwise.

This material may not be reproduced or disseminated in any form without the prior written permission of BNY Mellon. Trademarks, logos and other intellectual property marks belong to their respective owners.

The Bank of New York Mellon, member FDIC.

© 2016 The Bank of New York Mellon Corporation. All rights reserved.