The Securities and Exchange Commission (SEC) recently published a revised set of proposals in an attempt to bring further resiliency and transparency to the money market fund (MMF) industry. What does this mean for investors and fund managers and how will the European legislators react? Mark Stockley, Head of International Cash Sales at BlackRock Investment Management, considers the implications for all stakeholders.
Head of International Cash Sales
What is the state-of-play with money market fund (MMF) regulation, especially with regards to proposals made by the Securities and Exchange Commission (SEC)?
In the world of MMFs, the cardinal sin is ‘breaking the buck’. If the fund’s market-based value drops below the consensus $/£/€1 stable share price (known as constant net asset value (CNAV)) investors can lose value – and faith – in their investment.
The last time this happened, in September 2008, the potential contagion was halted when the US Treasury stepped in to provide support for the ailing fund in question, the Reserve Primary Fund. The SEC’s response was to seek reforms to limit the likelihood of a repeat event.
By March 2010, a number of amendments had been published concerning the SEC’s existing MMF Rule 2a-7 (the exemption dating back to the 1980s that allowed MMFs to maintain the stable $1 share price instead of being subject to market fluctuations in the value of the securities held by the fund). The amendments sought to impose stability by reducing credit and liquidity risks within MMF portfolios without, it hoped, stifling the market.
Roll forward to June 2013 and the SEC, having had time to review the effectiveness of its amended rule set, responded by publishing an additional batch of MMF-reforming proposals designed to further protect investors in this $2.9 trillion market. In the words of Mary Jo White, Chair of the SEC, speaking in June 2013: “These proposed reforms should further enhance the resiliency and transparency of this important product, and are significant complements to the other proposals.”
“The MMF space remains a challenging environment both from an investment and a regulatory perspective. Indeed, looking at the challenges by currency, the euro continues to be the most demanding, with shortage of supply, generally low rates and with an increase in provider consolidation.”
Alongside a set of enhanced disclosure requirements, proposals for stronger diversification of portfolios and enhanced stress testing, the latest suggested proposals include two principal alternative reforms that could either be adopted alone or in combination. The first requires a variable net asset value (VNAV) for prime institutional MMFs. Removing the $1 stable share price model, and instead allowing daily share prices of MMFs to fluctuate alongside the market price of securities in the portfolio, is seen as a way of not only increasing investor awareness of MMF risks but also as a method of reducing the likelihood of a run on a fund in times of financial stress.
Where prime institutional funds may currently “penny round” their share price to the nearest whole unit, if the proposals are accepted in their current form they will be expected instead to “basis point round” their share price. This will create a more precise valuation and pricing model for investors, although government, treasury and certain retail MMFs will be exempted from this requirement.
The second alternative allows MMFs to carry on transacting at a stable share price but deploy liquidity fees and redemption gates in times of stress to limit runs. The former proposes that if a fund’s level of weekly liquid assets (typically cash, US Treasury securities, certain other government securities with remaining maturities of 60 days or less, and securities that convert into cash within one week) drops lower than 15% of its total assets, then a 2% liquidity fee may be imposed on all redemptions (unless the fund’s board believes it would be imprudent to do so). A redemption gate is intended as a temporary suspension of redemptions (for no more than 30 days in any 90-day period) to be imposed when a fund reaches a certain level of redemption activity. All MMFs will be required to deliver prompt public disclosure of either action.
Are these new regulations in effect?
At this stage, these are nothing more than proposals – but the required 90-day public comment period is underway and the industry is ramping up for action. The MMF space remains a challenging environment both from an investment and a regulatory perspective. Indeed, looking at the challenges by currency, the euro continues to be the most demanding, with shortage of supply, generally low rates and with an increase in provider consolidation where assets under management (AUM) are moving out of some of the smaller managers whose scale, in terms of distribution, has forced them to withdraw from the euro cash market altogether.
As the MMF industry moves into the period of consultation around the SEC’s proposals, quite a lot can happen. It is now down to sponsors, providers and – importantly – investors to make their opinions known. All things considered, aspects of the new SEC proposals demonstrate a pragmatic approach to market change, and allowing CNAV vehicles to continue, with the ability to apply gates and liquidity fees in certain circumstances, is a thoughtful, well-considered angle to take.
What is BlackRock’s opinion of the proposals?
BlackRock is not supportive of mandatory conversion to variable net asset value (VNAV) because it does not address the key criteria driving the regulation, particularly the run-risk in the market. With the devil very much in the detail of this circa 700-page report there will be nuances therein that interested parties must carefully work through and fully understand before responding. As much as it is now about feedback on what the SEC has proposed, there will be a degree of clarification required.
In general, we support and applaud the steps being taken and will provide clear written feedback on what our thoughts are on the proposal.
Certain clarifications aside, the readiness of the industry to meet the SEC’s proposals is not in question. Once the period of consultation is completed, there will be another period before the final draft is issued, most likely followed by a period of grace for providers to comply with the changes. At this point BlackRock is well positioned to navigate that process.
“With the devil very much in the detail of this circa 700-page report there will be nuances therein that interested parties must carefully work through and fully understand before responding. As much as it is now about feedback on what the SEC has proposed, there will be a degree of clarification required.”
Indeed, with the rule changes of 2010 having required greater levels of liquidity and more disclosure, and the industry voluntarily publishing ‘shadow NAVs’, or mark-to-market valuations, on a daily basis (the SEC publishes MMF-reported portfolio holdings and prices on a 60-day delay), some of what is being proposed is already being complied with. And, in the interest of executing “good market practice and business conduct”, institutions such as BlackRock have been doing so for some while.
How will the new proposed regulations impact the investor?
For the investor, as future changes are introduced, they will need to be fully understood and where necessary translated into individual investment guidelines and reporting requirements. Part of the proposal requires funds to be run shorter and more liquid which means, over time, yields may fall. Given the low-rate environment, many investors are in this mode of thinking anyway, but they will need to be more mindful of how they segment their cash. They should be reviewing the kind of ladders put in place and differentiate between working capital that needs to be truly liquid versus that which can be considered more strategic and moved further out the curve, towards slightly longer-duration vehicles where they can get a better yield pick-up.
Being pushed into a VNAV situation will demand a more dramatic reaction with considerations around accounting and tax treatment potentially being more impactful and damaging to the industry and client interests.
With this threat hanging over the industry, through the consultation period investors will become more vocal. Their thoughts will find voice through varying associations, such as the Association of Corporate Treasurers (ACT), European Association of Corporate Treasurers (EACT) and, in the US, the Association for Financial Professionals (AFP), which will be lobbying, as with previous proposals, to have MMFs remain as intact as possible.
“From the industry’s perspective, the best way to reduce risk in these products is to increase diversification, shorten tenors and increase the level of disclosure and transparency on investments. Changing CNAV to VNAV does not reduce run risk caused by systemic issues.”
BlackRock together with industry peers, particularly in the US, will now be considering their individual responses. A co-ordinated industry-level response, with questionnaires being distributed amongst clients to ensure these proposals resonate with the investor-base, will then add to the feedback. The response from clients so far is broadly positive, but this is tempered with the knowledge that the end-point may look markedly different from what is currently being proposed.
What should investors be concerned about?
Investors currently face two main perils. The first is the ongoing tough market conditions. Supply is limited, yield-levels are low and ratings-agency actions can impose restrictions and enforced diversification that may not be in the best interest of the investor. It is a very difficult job at the moment for a manager to put together a high credit-quality portfolio that is suitably liquid and paying a level of return that is attractive. The harsh reality is that if a business is holding truly instant access cash then it is difficult to get paid on that, and therefore it has to look at being smarter at how it segments that working capital.
The second concern is how the European Central Bank (ECB) and the European Commission (EC) propose to handle MMFs through forthcoming legislation – an announcement is expected to be made in July and a consultation paper published.
In April, the EC’s Systemic Risk Board – worried about massive and sudden redemption requests – issued a paper stating its desire for mandatory conversion of all CNAV funds to VNAV, with a demand for a 3% cash buffer for funds to absorb any losses, amounting to around €14.7 billion across the European industry. The paper also proposed that all MMFs should be barred from accepting collateral with a maturity of longer than 397 days to back repo trades. This may just be a means of forcing participants to come up with a better proposal.
From the industry’s perspective, the best way to reduce risk in these products is to increase diversification, shorten tenors and increase the level of disclosure and transparency on investments. Changing CNAV to VNAV does not reduce run risk caused by systemic issues.
Whatever transpires, the conversation between providers and policy-makers must be mindful that a potential situation of “domiciliary arbitrage” – where it is better to launch funds outside of Europe because of the unfavourable regulatory environment – is not the way forward.
Indeed, the most unattractive outcome of the proposals would be for the SEC to deliver a thoughtful solution that is supported by the industry, but with its European counterparts moving in the opposite direction. If the creation of an uneven playing field makes it untenable to offer MMFs within the regulated framework of Europe, providers and investors would be forced to look to other domiciles.
BlackRock strongly hope that there is co-ordination, acknowledgement and recognition of the amount of time and effort that the SEC has taken on this, in terms of cost-benefit analysis and focusing on the specific problems trying to be addressed. It would be disappointing if we come out with anything other than a level regulatory playing field.
How is BlackRock alleviating its customers’ concerns?
BlackRock’s client-base is being kept up to date on developments in the US and in Europe as developments unfold. We are working with existing clients, plus bringing new investors to the product, ensuring that we keep them fully appraised of what is happening from a regulatory perspective. Our clients continue to be comfortable with the BlackRock investment process, its credit, risk management, research and execution.
Furthermore, it is important to keep in mind that if there are proposals in Europe that differ from the US, there is likely to be a fairly lengthy implementation period during which we will amend our product offering as needed and clients can alter their investment activity. Currently, there is no cause for alarm, as our approach has been – and continues to be – one of staying close to our clients, educating them, giving them the confidence in a product continuum and ultimately providing them with more choice.