Money Market Funds: A Financial Dinosaur - Who Uses Money Markets Today, and Why?

Money market funds were at one time a reasonable way to maintain liquidity while providing reasonable interest on your cash. However, today’s money market funds are returning a staggeringly low 0.01% annually. That means every $10,000 invested returns just a single dollar annually.

Why would people still invest in money markets? They cannot keep up with even today’s relatively low inflation and provide a slightly better return than stuffing your money under your mattress. Is there a valid reason to hold money markets (besides a less lumpy mattress)?

Somebody must think so, because there are still approximately $2.6 trillion held in money market funds. Institutions hold many money market funds, but there is still a significant amount held by individual investors.

Security is not the issue either. Unlike bank deposits, money market funds are not FDIC-insured. Thus, there is nothing preventing a “run” on mutual funds that are sinking… or, are perceived to be sinking. That is exactly what happened in September 2008, as a side effect of the Lehman Brothers bankruptcy.

The Reserve Primary fund lost approximately $785 million in Lehman Brothers debt. The $62 billion fund would have easily been able to handle the loss, but spooked investors reacted by running on the fund and removing $40 billion from the fund within two days. Soon the fund’s value dropped below $1.00 per share (a condition known as “breaking the buck”), and panic spread to other funds as a result. A total of $300 billion was removed from collective money market holdings in that week.

This could have caused a complete collapse without government intervention. The Fed took action through loaning banks the funds required to soak up the assets removed from money markets, and the Treasury Department guaranteed a $1 net asset value (NAV) on a temporary basis until the system could right itself.

The issue was addressed in the Dodd-Frank legislation, as well as with SEC reforms in 2010 and new ones proposed this year. The SEC’s final rule for the second round of reforms was adopted in July, but will not take effect until 2016.

These reforms address the potential holdings a money market fund can have, and how the NAV is handled (floating for some funds, fixed with potential fees and redemption gates to others). Funds are also required to post certain fund information on a regular basis to improve transparency.

However, the SEC regulations do not guarantee preventing a run on money market funds, and Dodd-Frank prohibits the Treasury and/or the Fed from bailing them out in the future and dragging taxpayer funds into the mess.

In the near term, there really isn’t much reason to hold a money market fund. You may be better served with the safety of a traditional bank or credit union account, or perhaps an online savings account where the lack of branch overhead allows the bank to provide you with at least some reasonable interest return on your money.

Are money market funds truly a financial dinosaur, to be dug up and examined centuries from now by financial archaeologists? Or are they just suffering from an extended long run of extraordinarily low returns?

Money market funds are probably not dying in the near future, since interest rates will eventually rise when the economy fully recovers. However, they are going to have to evolve to have a usable future niche in investments, and the collective regulations of the SEC and Dodd-Frank will dictate the path of their evolution.

If they are regulated too closely, they provide no advantage over a traditional bank account, and if regulated too loosely, they have the potential of creating another run similar to 2008. Regulation will likely determine whether they evolve in a useful way, or end up in the tar pits of financial history.