Money market funds and the pricing of near-money assets

Summary

Focus

US Treasury bills (T-bills) and repurchase agreements (repos) are among the most important financial instruments in global finance, and US money market funds (MMFs) are key components of both the T-bill and repo market. It remains an open question as to what extent the portfolio allocation of MMFs affects the pricing of these short-term assets, and whether MMFs create interdependencies between the repo and T-bill markets.

Contribution

We develop a theoretical framework to clarify how money market funds affect the pricing of short-term assets through their strategic interactions with each other and with banks. We then provide empirical evidence in support of the theoretical channels. Our results contribute to the literature on the pricing of near-money assets, with implications for the transmission of monetary policy and the role of central bank balance sheets, government debt issuance and repo-based benchmark rates.

Findings

We show that, when MMFs allocate more of their assets under management to the T-bill market, T-bill rates fall and the liquidity premium on T-bills rises. Guided by our theory, we develop an instrumental variable to show that this finding is causal. Using a granular holding-level data set to examine the channels, we show that MMFs internalise their price impact in the T-bill market when they set repo rates and tilt their portfolios towards repos with the Federal Reserve when Treasury market liquidity is low.

Abstract

US money market funds (MMFs) play an important role in short-term markets as large investors of Treasury bills (T-bills) and repurchase agreements (repos). We build a theoretical model in which MMFs strategically interact with banks and each other. These interactions generate interdependencies between repo and T-bill markets, affecting the pricing of these near-money assets. Consistent with the model's predictions, we empirically show that when MMFs allocate more cash to the T-bill market, T-bill rates fall, and the liquidity premium on T-bills rises. To establish causality, we devise instrumental variables guided by our theory. Using a granular holding-level dataset to examine the channels, we show that MMFs internalize their price impact in the T-bill market when they set repo rates and tilt their portfolios towards repos with the Federal Reserve when Treasury market liquidity is low. Our results have implications for the transmission of monetary policy, benchmark rates, and government debt issuance.

JEL classification: E44, G11, G12, G23

Keywords: T-bills, repo, money market funds, near-money assets, liquidity