Photographer: Jasper Juinen/Bloomberg

Brexit - Won't Somebody Think of the Money Markets?

A gauge of stress in the financial system has remained relatively immune to Brexit risk - so far.

U.K. voters seeking to gauge the impact of a potential 'Brexit' on the economy could be forgiven for not having turned their minds to the money markets - yet.

While the spread between the interbank lending rate known as Libor and the overnight indexed swap rate (OIS) — a traditional measure of stress in the financial system — has been oscillating recently, much of the movement has been attributed to changing expectations about the timing of the Federal Reserve's next interest rate hike. But don't discount the potential impact of a 'Brexit' vote on money markets just yet, says Barclays Plc Strategist Joe Abate.

Source: Bloomberg

"The June 23 vote could quickly supplant Fed expectations as catalysts for moving Libor higher and Libor-OIS wider," he writes. "The connection between the outcome of the EU Referendum and short-term dollar unsecured financing rates rests on the behavior of investors in money market funds."

Indeed it does. As Barclays points out, both British and EU financial institutions tap money market funds for significant sums of dollar financing. At the end of April, these institutions were raising $650 billion this way, of which $215 billion was secured financing against collateral in the so-called repurchase, or repo, market. The remaining chunk of unsecured financing accounts for an impressive 38 percent of total prime money market fund assets.

The worry here is that flighty money funds abruptly cut off their lending to U.K. financials as they seek to avoid a repeat of the 2008 financial crisis, when one prominent fund — the Reserve Primary Fund — "broke the buck" after its net asset value (NAV) dipped below $1. The shock fall in the value of its securities sparked an investor stampede, and a subsequent cash crunch as money market funds shrunk their exposures.

When it comes to gauging the behavior of these funds in a Brexit scenario, money market-watchers have a handy parallel in the form of the euro zone debt crisis that roiled markets back in 2010 and 2011. Prime funds quickly retreated from unsecured lending to EU institutions and fled for the relatively safer hills of bank deposits and government-only money market funds. 

As Barclays points out, by the end of 2011, prime fund balances had fallen 13 percent — or almost $200 billion — and the spread between three-month Libor and OIS widened 35 basis points to reach 50 basis points. Academic research dubbed this the "quiet run" and noted that the retreat of flighty money market funds from financing the region had "transmitted distress across firms" in the euro zone by cutting back on dollar funding precisely when it was needed.

To date, however, there's been little sign of a Brexit-sparked quiet-run repeat. While 2011 worries were marked by significant concerns over the prospect of euro area banks defaulting, few see this as a risk for British financial institutions in the event of U.K. departure from the EU, especially in light of the Bank of England's recent expansion of its liquidity facilities. Meanwhile, U.K. banks have been gobbling up dollars through a new Fed program to pay interest on excess reserve balances (IOER), helping to strengthen their balance sheets and firmly enmeshing them in the U.S. central bank's monetary policy toolkit.

"Foreign-related institutions hold approximately $1.1 trillion in cash, up from their May 2011 level of $870 billion. Most of these balances are held on deposit at the Federal Reserve earning IOER," writes Abate. "While we cannot determine exactly for what EU banks use the $450 billion in cash raised from money funds, our sense, given the short average tenor of these borrowings (currently 20 days), is that a fair portion is used to arb[itrage] the Fed’s IOER rate and finance short-term investments and activities. A sharp withdrawal of short-term dollar funding, together with a corresponding increase in borrowing rates, might induce some of these banks to trim their enormous cash buffers at the Fed."

Even without the potential impact of a Brexit, money market funds have some larger concerns to fret about.

Come mid-October, they'll be required to float their NAVs, adopt liquidity fees and install redemption gates. It's part of an overhaul aimed at preventing a repeat of the 2008 financial crisis, but one that hasn't been welcomed by money fund investors who are used to viewing the funds as safe havens. That alone could cause Libor-OIS to jump to over 30 basis points as investors withdraw their money, Abate says.

For money market funds, it could literally be Brexit and Bust.

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