On 4th September, the European Commission (EC) released its long-awaited proposals for increasing money market fund (MMF) regulation. Just two weeks later, the Securities and Exchange Commission (SEC) closed its consultation with industry players. On both sides of the Atlantic, it appears that the writing is on the wall for constant net asset value (CNAV) funds.
Regulators internationally have been keen to increase control over money market funds (MMFs), which many consider to be part of the shadow banking system, since the financial crisis of 2007/8. The whole purpose is to address financial instability, and the proposals that have emerged from the Securities and Exchange Commission (SEC) earlier this year and more recently the European Commission (EC) must be put in the same context as the Liquidity Coverage Ratio (LCR) of Basel III, which puts constraints on banks to ensure that they adequately manage their liquidity.
However, now that both proposals are on the table, it is clear to see that these two jurisdictions are taking diverging paths to achieve the same end.
What has become clear is that the US regulators listened to the industry and have adopted an important second alternative to MMF reform. The SEC proposals tabled in June 2013 suggested two options:
Variable net asset value (VNAV):
Investors will buy and sell shares using the actual net asset value, not a stable $1.00 share price. Fund managers all say this can only be done on a T+1 basis, which is a following day settlement.
Constant net asset value (CNAV):
Fund managers may continue to provide CNAV funds providing there is provision for liquidity fees and the funds are permitted to impose redemption gates at times of stress.
This second alternative is a real breakthrough for the industry, following much more restrictive suggestions. Many in the industry credit lobbying and thoughtful briefing papers by HSBC as being the catalyst for this new alternative. Jonathan Curry, Global CIO Liquidity at HSBC Global Asset Management, who is also chair of the Europe-based International Money Market Funds Association (IMMFA), told Treasury Today: “We are pleased to see that the valuable part that liquidity fees can play in protecting investors and reducing ‘run’ risks has been recognised by the SEC as a potential part of the reform process in the US.”
However, not all corporate treasurers are supportive of gates and fees. In a comment published on the SEC website, Gregg Murphey, Manager Global Treasury, Novelis Inc., argues that this proposal will “bring into question one of the greatest strengths of a prime MMF – liquidity”. He goes on to say: “A fund who imposes a fee or withholds redemption would sink faster than a fund that breaks the buck under current regulations, which means the tool for the funds would be ineffective. In addition, cause runs could occur on funds, when news events about an issuer would cause holders to quickly sell their shares before everyone else does, trying to avoid the gate and or fee. In the current world, news events about individual issuers doesn’t cause the level of panic that will be present when gates close and fees are imposed.”
He believes that the proposed changes will discourage his company from participating in MMFs, and as a result funds will be smaller on an ongoing basis, “so it will be more likely that redemptions will push funds into a crisis position”. David Dohnalek, Vice President of Finance and Treasurer, The Boeing Company, echoed Murphey’s concerns in his contribution to the consultation process.
Meanwhile, back in Europe…
The news on the other side of the Atlantic is not as positive. EU legislators have, after extensive lobbying, adopted what are being described by the MMF industry as draconian rules. What you think of the rules depends on your perspective: finance ministers from France and Germany lobbied regulators to scrap CNAV funds, but there are many corporates who like the product and will be sorry to see it go. But go it will in its present form if the new EU regulation is adopted.
Whether or not the new legislation will get passed is where the industry is currently hanging its hopes. It is important to note that the regulation represents the EC’s proposed initiating legislation and it must pass through the European law-making procedure involving the European Parliament and European Council before it can become new European law. This is likely to be delayed as a result of the European elections to be held in May next year.
Once in effect, funds must submit an application for authorisation as an MMF to their regulators within six months evidencing compliance with the regulation. The regulation is conceived as leaving no scope for additional ‘gold-plating’, or different implementation, at national levels.
Many in the industry hope that, as happened in the US, a change of political personnel will result in the proposed legislation losing its sponsors and fading away. They are also encouraged in this view since Paul Tucker, Deputy Governor at the Bank of England (BoE), who was a major advocate of stringent MMF reform, left the bank after failing to get the job as Governor. But it is far from clear why new regulators would back off from the proposed regulation. The proposals have been made with much references to public engagement and co-ordination with International Organisation of Securities Commissions (IOSCO), the Financial Stability Board (FSB) and the European Systemic Risk Board (ESRB).
There is also concern over regulatory arbitrage, but there are restrictions on Europe-based fund investors switching to US funds and issues about repatriation of funds becoming taxable in the US for US multinationals. In other words, some monies might find efficient ways to get into US funds but most will stay invested in Europe in some form. Going offshore (ex-EU) is not practical as the selling rules and regulations would preclude the funds being effectively sold to European investors. In addition companies are not likely to want to be seen investing in offshore locations which might lead to accusations of tax avoidance, whether justified or not.
In short, the European CNAV institutional MMF industry has a big problem on its hands. The Institutional Money Market Fund Association (IMMFA) has summarised the key issues, starting with what it describes as overarching issues.
Three percent capital buffer
The current EC proposal is that each fund has a NAV buffer of at least 3% in cash. This is the single most important issue the industry has with the EU regulations. The idea that capital will be injected into funds in this way is a non-starter for some thinly-capitalised fund management companies – they simply do not have enough capital to be able to do this. Investment and commercial banks who have more capital believe that it is impossible to provide an adequate return on any capital that was so used. There is evidence to support this. Fund managers have been giving up or minimising fees to prevent the returns on funds going negative with short-term interest rates close to zero. It is hard to see how any the additional return required on capital could be earned.
IMMFA also makes the point that if the capital required (estimated at €14 billion) was withdrawn from the banking markets, it would, because of bank leverage, result in €200-250 billion being withdrawn from the European economy. Of course, it could be said that if the returns were adequate the capital would be found. The point is that insisting that CNAV funds have 3% capital destroys the business model and there is no evidence that we have seen to believe any fund provider believes it can do this and make anything like adequate returns.
Time for transition
The IMMFA then goes on to say that the implementation time for any changes set at six months is totally inadequate. Meanwhile, behind the scenes the mangers are looking at what is involved in moving to VNAV funds and what other options there might be.
Category A issues
The IMMFA then goes on to describe what it calls “Category A” issues.
Valuation – use of amortised cost accounting
The industry uses straight-line amortised cost accounting to value short-term investments. This is not mark-to-market, but the industry points out there is no liquid secondary market price for many short-term investments and thus no reliable pricing. Regulators want the industry to find a solution.
The IMMFA says: “In the absence of traded or quoted prices, amortised cost accounting is a pragmatic way to evaluate the fair value of money market instruments. Amortised cost accounting is widely used in the EU, is compliant with the Undertakings for Collective Investment in Transferable Securities (UCITS) and has been accepted by the Financial Accounting Standards Board (FASB) as being compliant with Generally Accepted Accounting Principles (GAAP). It is also used in the financial statements of banks to value loans and certain other assets. MMFs are not outliers in their use of amortised cost accounting.”
Asset-backed commercial paper
The narrow description of ‘securitisations’ affects the funds’ ability to invest in many types of asset-backed commercial paper (ABCP). IMMFA says this “has potential to hamper this funding stream to the wider economy”. In practical terms, it also reduces the eligible investments managers would like to use in order to earn some slight additional yield.
Reverse repo collateral/diversification
The regulation proposes rules on what MMFs can invest in and what activities they can perform, restricting the type of collateral that can be used in reverse repurchase (repo) agreements and banning funds from engaging in certain securities financing transactions (SFTs).
Definition of liquidity requirements
Certain levels of daily/weekly liquidity are prescribed in order for funds to satisfy investor redemptions. CNAV funds will be obliged to hold at least 10% of their assets in instruments that mature on a daily basis and an additional 20% of assets that mature within a week.
Prescriptive credit process
The proposed regulation has set requirements for a consistent prescribed credit process across all funds designed to prevent credit arbitrage between the funds.
Ban on fund level ratings
Finally, there is an issue that will affect investors in particular – a ban of fund ratings by credit rating agencies. This will remove the AAA fund rating which is the cornerstone on which most investors base their investment policies. Fund managers expect this proposal in itself to lead to many investors walking away from this form of investment.
The IMMFA then goes on to list other ‘issues’ which are as follows:
Application of the regulation
The way the regulation is worded potentially creates a higher risk of liability on the manager than any other type of investment product.
Valuation of assets
The regulation talks about assets being priced on the “more prudent side of bid and offer”. The lack of a secondary market in many short-term securities which are all being held to maturity makes this impossible.
Shares in MMFs are not themselves classifies as an eligible asset, thus preventing any master feeder structures.
There is an inconsistency in the drafting that places limits on one type of investments and not another. In summary, it could be said the industry does not like the EC proposals.
Call to action
Lobbying is continuing apace, but it may be too late. The proposed regulation is not open to public consultation – yet many are attempting to influence regulators/legislators through diverse channels. For example, Richard Raeburn, Chair of the European Association of Corporate Treasurers (EACT), wrote a letter to the Financial Times on 6th September, calling into question the bar on the provision of external ratings. This stance was backed up by a letter from Mark Hannam, Independent Director at the IMMFA.
The IMMFA is working together with the Association of Corporate Treasurers (ACT) to ensure that the corporate voice is heard. Each member of the IMMFA will also be reaching out to its investors to get involved in the debate.
Susan Hindle Barone, Secretary General of IMMFA, recommends pointing out directly to local MEPs, as well as representatives from the BoE and the Treasury, how damaging these proposals could be. “We are encouraging anyone who cares about this to make their voices heard, whichever avenue that takes,” she says. “We are trying to explain that this has a real impact on the broader economy and we struggle to get that message through.”
The UK and Irish governments have been very vocal in their opposition to the proposed regulations. The French and German governments, on the other hand, support the legislation and want a ban on CNAV funds. Many German corporates invest in CNAV funds, whereas French corporates tend not to.
We live in an environment when regulation of the financial services industry is seen to be a good thing. It is hard to see why EU regulators would back away from legislation that has been proposed after ‘extensive consultation’ regardless of the consequences, both intended and unintended. One legal observer pondered that this was just an intermediate solution before a complete ban.
In the short term, CNAV funds will wait to see what the regulators do and, in the meantime, manage all the other challenges they are experiencing – low interest rates, flat yield curves and lack of short-term investments.
In the longer-term, the CNAV fund industry may disappear or shrink dramatically. In a subsequent article we will look at how VNAV funds might work in practice and what alternative forms of investment might startto find favour with corporate investors.