Money Market Fund Reform Increases Dollar Funding Cost

September 1, 2016

Money Market Fund Reform Increases Dollar Funding Cost Photo

The Money Market Fund (MMF) reforms taking effect on October 14 impact approximately $2.7 trillion in money market mutual funds. Prior to the effective date, many prime money market funds are converting to government money market funds.

Prime money market funds are the major short-term funding source for many banks, so the shrinking of prime money market funds will mean higher dollar funding cost for banks. Now, we are seeing higher commercial paper (CP) and LIBOR rates. According to Fitch’s report, the percentage of the commercial paper market that is bought by prime funds has slumped to 19.6% from 30.2%. Commercial paper is an especially important funding source for foreign banks, which are highly dependent on CP to raise dollars to fund their portfolio of dollar assets.

Japanese banks are some of the most dependent on prime MMF’s for U.S. dollar (USD) funding. With less USD funding from prime MMFs, Japanese banks will have to either issue cheaper short-term commercial paper or exchange Japanese yen (JPY) for USD. A powerful financial tool banks can use to raise foreign currency funding is cross currency basis swaps, which are a floating exchange derivative to exchange the interest rate payments and notional amounts in two different currencies. Take Japanese banks for example, they would pay 3 month USD LIBOR and receive the 3 month deposit rates in JPY plus the cross currency basis swaps spread to enter into the trades. We’re seeing 3 month JPY-USD basis swap turning more negative dramatically since June, indicating a rising cost of borrowing USD with JPY. From these market dynamics, lending USD to Japanese counterparties in exchange for JPY becomes attractive.

Key Takeaway:

Commercial paper is trading cheap due to the shrinking market of prime MMFs. Lending U.S. dollars to the counterparties which rely heavily on the MMF for dollar funding is attractive.

Tags: Chart of the Week | Yen | Reform | Money market funds (MMF) | Commercial paper (CP) | Cross currency swaps

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