The price of liquidity: CD rates charged by money market funds Matthew D. Whitledge, Drew B. Winters ⇑ Area of Finance, Rawls College of Business, Texas Tech University, United States article info Article history: Received 24 June 2014 Accepted 26 January 2015 Available online 31 January 2015 JEL Classifications: G19 G21 G23 Keywords: Liquidity CDs Money market funds abstract We examine the cost of liquidity in rates on CDs purchased by money market funds (MMFs). We find no evidence that rates vary directly with the size of CDs. However, we do find that large MMFs receive higher rates on large CDs than small MMFs. This suggests banks pay for (potential) liquidity. Ó 2015 Elsevier B.V. All rights reserved. 1. Introduction Liquidity is a fundamental concept in finance. In the equity mar- ket microstructure literature there are two basic branches of liq- uidity research. One is the need/ability to trade immediately. 1 The other is non-informed/liquidity motivated trades. Both are cost- ly. We contribute to research on the cost of liquidity trades. O’Hara (1997) notes a natural role for large (block) trades is meeting liquidity needs (p. 242). O’Hara’s insight explains the interest in upstairs markets in equities. Madhavan and Cheng (1997) describe the upstairs market as a block market where tra- ders must clearly signal that the trading is liquidity motivated. Keim and Madhavan (1996) show that the cost of upstairs market liquidity trading increases with the size of the block. Equity markets trade ownership claims. Money markets trade liquidity (Kidwell et al. (2003, p. 163)). Certificates of Deposit (CDs) are money market securities. Additionally, the typical unit size of negotiable CDs is $1 million (Blackwell et al., 2007, p. 72). However, CDs vary in size and can be issued in amounts of hun- dreds of millions of dollars. Thus, the CD market provides a natural environment for examining whether the cost of liquidity always increases in transaction size. 2 Money market funds (MMFs) regularly receive funds from investors and the MMFs place these funds in money market secu- rities. One of the MMFs’ choices is CDs. Both the MMFs buying the CDs and the banks selling the CDs have ongoing needs in this mar- ket and thus are regular participants. Large banks which sell CDs have a regular need to borrow funds in this market to meet loan demand. MMFs which buy CDs (lend) have an ongoing need to place funds given the short maturity of their assets and investor initiated fund flows. 3 The repeated game nature of the transactions suggests the potential for the development of relationships as in Kane and Malkiel (1965). With the repeated game nature of the CD market between large banks and MMFs the cost of liquidity has two dimensions: the cost of liquidity in a specific transaction and the cost of potential liquidity of selling CDs to large MMFs. We have access to monthly portfolio holdings of MMFs from January 2011 through June of 2012 from which we collect all CDs held by Prime MMFs. 4 The sample period spans the European debt crisis in the summer of 2011 and the CDs are purchased from large banks. Our sample follows the financial crisis but includes the European debt crisis, so we begin our analysis by examining how the CD market is functioning during this period. We find that EU banks pay higher rates and that banks with strong relationships with MMFs pay lower rates, which suggests that borrower http://dx.doi.org/10.1016/j.jbankfin.2015.01.016 0378-4266/Ó 2015 Elsevier B.V. All rights reserved. ⇑ Corresponding author. E-mail addresses: matthew.whitledge@ttu.edu (M.D. Whitledge), drew.win- ters@ttu.edu (D.B. Winters). 1 See, Werner (2003) as an example of this branch of literature. 2 Examining CD rates relative to the size of the CD is similar to Amihud’s (2002) illiquidity measure. 3 In our sample, MMFs have average subscriptions (redemptions) of 55.1% (59.6%) each month. Further, the average fund has a Weighted Average Maturity (WAM) of its assets of 36.5 days. 4 MMF categories are: Treasury, Agency, Prime, Single State and other Tax Exempt funds. Only Prime MMFs regularly invest in CDs. Journal of Banking & Finance 54 (2015) 104–114 Contents lists available at ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf