With the collateral shortage expected to balloon into the trillions over the next couple of months, the Fed appears unconcerned. Every night, approximately $700-800 billion in cash is loaned to the Fed in exchange for Treasury securities to pull all of this excess cash out of the financial system to provide the necessary collateral. Upon closer inspection, the Fed is bailing out the money market funds due to a 2016 SEC rule.
In 2016, the Securities and Exchange Commission (SEC) implemented Rule 2a-7 to make money market funds safer. The rule required money market funds to increase their liquidity, stability, and the credit ratings of their holdings. In short, it required money market funds to invest in short-term Treasury Bills.
From an outside perspective, requiring money market mutual funds to limit their investments to high-quality, short-term Treasury securities created a new buyer for the ever-growing mountain of U.S. government debt. Those who have money in a money market fund are unknowingly funding the U.S. government.
Through regulation of the financial services industry, policymakers can create a persistent and continuous demand for U.S. government debt. The problem with most of these regulations is the highest quality collateral is short-term Treasury Bills, which there is an insufficient amount of.
As the collateral shortage persists due to the flood of money that entered the financial system from the repeated fiscal stimulus packages, the demand for pristine collateral in the form of Treasury Bills has increased. Since the U.S. Treasury, led by former Fed Chair Janet Yellen, is unwilling to issue enough T-Bills to satisfy demand, the Fed is being forced to bail out the financial system.
Recently the Fed increased the interest rate it pays on overnight loans from zero percent to five basis points, or 0.05%. The Fed did this to encourage money market funds, which are all subject to SEC Rule 2a-7, to sell or roll-off their T-Bills holdings and park their mountain of cash in the Fed’s overnight Reverse Repurchase Program (RRP) facility.
Through the use of its overnight RRP, the Fed is bailing out the money market funds who all are subject to the SEC Rule 2a-7, suggesting the Fed is indirectly bailing out the SEC. Soon, all money in money market funds may be backed entirely by the Fed.
There are no apparent negative implications of money market funds relying on the Fed’s overnight RRP facility. The risk of a large and persistent collateral shortage is it puts downward pressure on Treasury yields which leads to tighter financial conditions. When financial conditions tighten too much, risk assets crash as bond prices soar.