Following years of negotiation, European money market fund reform is close to being finalised. The new rules differ significantly from the changes already introduced by regulators in the US – so will European funds avoid the considerable outflows seen in US last year?
An end is in sight for European money market fund (MMF) reform, with the regulation set to enter into force in the coming weeks. While funds will not be required to comply with the new rules until late 2018 or early 2019, fund providers are preparing to adopt the new structures. So what do treasurers need to know about the types of fund that will be available in the future?
History of MMF reform
The impetus for the new regulation dates back to the financial crisis. The failure of Lehman Brothers in September 2008 resulted in the Reserve Primary Fund ‘breaking the buck’, meaning that the fund’s net asset value fell below US$1 per share. This prompted a run on US money market funds – and, in the longer term, a regulatory drive to make money market funds on both sides of the Atlantic more robust.
In the US, this resulted in a programme of reform led by the Securities and Exchange Commission (SEC). The new rules, which came into effect on 14th October 2016, require funds to adopt a variable net asset value (VNAV) model, meaning that the value of the investment fluctuates with market conditions rather than being fixed at US$1 per share.
Other changes include the ability to funds to impose liquidity fees and/or redemption gates during times of stress, thereby discouraging or preventing investors from making redemptions at such times:
Liquidity fees of up to 2% can be imposed at the discretion of the board if the percentage of a fund’s assets that can be liquidated within one week falls below 30%. If the fund’s weekly liquidity falls below 10%, the board is required to impose a 1% redemption fee, unless the board votes otherwise in the fund’s best interests. Liquidity fees are automatically lifted if weekly liquidity reaches or exceeds 30%.
Redemption gates are also being introduced which can temporarily prevent redemptions for up to ten business days in a 90-day period if weekly liquid assets fall below 30% of the fund’s total assets.
At the same time, US prime funds are required to disclose certain information on their websites, including their daily and weekly liquid assets as well as details of any fees and gates that have been imposed.
Following the announcement of the new rules, significant outflows took place in the US, with US$1trn reportedly flowing out of prime money market funds and into government funds. This was backed up by the 2017 J.P. Morgan Asset Management 2017 Investment PeerViewSM survey, which found that only 37% of US-based investors were invested in a prime money market fund, compared to 63% in 2015.
However, as investors have become familiar with the new rules there are signs that cash has begun to return to prime funds. Half of the US-based investors surveyed by J.P. Morgan Asset Management said that their comfort level with floating NAV funds and fees/gates would be the most important factor affecting their decision to move assets back into prime funds.
MMF reform in Europe
While the same events may have set in motion money market fund reform in both the US and Europe, there are some important differences between the approaches taken by regulators.
The story so far
The European Commission issued a proposal for new money market fund regulation as long ago as September 2013. Lengthy negotiations followed, and the final rules were agreed by the European Commission, European Parliament and European Council on 14th November 2016.
The text of the regulation is expected to be published in the Official Journal of the European Union in the coming weeks. The regulation will enter into force 20 days later and will apply 12 months after the date of entry into force. The European Commission will then review the regulation within five years after the regulation enters into force and will, among other things, evaluate the impact of the regulation on investors.
In the meantime, the European Securities and Markets Authorities (ESMA) has published a consultation paper on the new regulation, covering areas such as draft technical advice, draft implementing technical standards and guidelines. Stakeholders have been asked to provide feedback on the proposals by 7th August.
“Whilst all MMFs will, under the new regulation, face some change, the most significant element for corporate treasurers will be the changes occurring to existing Constant Net Asset Value (CNAV) money market funds,” observes James Finch, Head of Liquidity Management, EMEA at UBS. “This category of money market fund has in recent years seen significant usage by corporate treasurers as a cash management tool. Under the new regulation, it will be replaced by two new categories, defined as Public Debt CNAV and Low Volatility NAV (LVNAV) MMFs.”
“At this stage, LVNAV is expected to be a likely choice for many clients and is being viewed by investors as the option most akin to short-term CNAV money market funds.”
Jim Fuell, Managing Director, Head of Global Liquidity Sales, International, J.P. Morgan Asset Management
Under the new rules, three types of short-term money market fund will be available in Europe:
VNAV MMFs, which calculate NAV using mark-to-market or mark-to-model prices. At least 15% of a fund’s assets will need to consist of weekly maturing assets, and 7.5% will need to consist of daily maturing assets.
Public debt CNAV MMFs, which maintain a constant NAV and must invest at least 99.5% of their assets in public debt.
Low Volatility Net Asset Value (LVNAV) MMFs.
In addition, there will be one category for standard MMFs, the Standard VNAV MMF.
As Jim Fuell, Managing Director, Head of Global Liquidity Sales, International at J.P. Morgan Asset Management, notes, “At this stage, LVNAV is expected to be a likely choice for many clients and is being viewed by investors as the option most akin to short-term CNAV money market funds.”
LVNAV funds will be able to use amortised cost accounting for assets which have a residual maturity of up to 75 days, with mark-to-market or mark-to-model valuations required for longer dated instruments. Funds can issue shares at a price equal to the fund’s CNAV per unit or share as long as the constant NAV does not deviate from the actual NAV by more than 20 basis points.
At the same time, funds will be required to maintain minimum weekly liquidity of 30%. If liquidity falls below 30% and daily net redemptions exceed 10% of the fund’s total assets, measures may be put in place including liquidity fees, redemption gates and suspension of redemptions. If weekly liquidity falls below 10%, mandatory fees and gates will apply. As with the other categories of MMF, sponsor support is prohibited under the new rules.
Response from fund providers
Fund providers have welcomed the changes. “It has taken a long time to get to this point, but the reforms are generally prudent and sensible,” says Jonathan Curry, Global Chief Investment Officer, Liquidity at HSBC Global Asset Management. “From the outset, we’ve had some very clear views on what we thought the reform should focus on, and a decent number of those have made it into the final reform in Europe, such as the prohibition on sponsor support and the use of liquidity fees and redemption gates.”
Fuell is similarly positive about the new regulation. “While the finalisation of the rules is still in progress, there’s been a degree of greater certainty,” he says, noting that the greater certainty sheds light on two important elements of the new regulations. “For one thing, the proposed new regulations offer new optionality which will allow money market funds to continue offering investors the advantages they already enjoy,” he observes.
“In addition, the new regulations bring together elements of oversight which have previously been afforded not just by the previous regulations, but also by industry codes of practice, rating agency requirements and prudent practices within individual asset management firms. The new regulations we think therefore provide clarity, consistency and more certainty for investors.”
A key question is whether the new rules could result in an exodus of cash similar to that seen in the US. As Finch points out, “Whenever change is introduced to a product that not only has a loyal following but some would argue didn’t require significant amendment, the initial view is often that the outcome will be sub-optimal.” However, he points out that since many of the reforms are already in use within existing CNAV MMFs through UCITS and ESMA guidelines, external rating agency restrictions and adherence to the Institutional Money Market Fund Associations (IMMFA) code of practice, “I don’t see why the new regulation will make MMFs less attractive.”
The difference in approach between US and European regulators may be key when it comes to the impact on investor behaviour. “Europe hasn’t followed the approach that the United States took, which was to require prime CNAV funds to convert to VNAV,” says Curry. “That’s likely to lead to quite different outcomes to what we’ve seen in the US, where a significant majority of investors in prime CNAV funds have switched to government CNAV funds and treasury CNAV funds.”
Fuell concurs: “We are not expecting to see the same significant movement of money market fund flows that we saw in the US following their regulatory reform.”
Adopting the new rules
For fund providers, a key question will be whether to create new funds or convert existing CNAV funds to the new models. In the first instance, it is likely that many will opt for the latter. “We will look to convert our existing funds,” says Natalie Cross, Client Portfolio Manager at Invesco. “Looking forwards, once the regulations go live, as clients get more comfortable with the different fund types we will then look to see if there is room in the market to consider different products.”
“We will need to do some back testing and scenario testing to find out what sort of situation would lead you to invoke the 20 basis point collar. But to be honest, we’re already operating under a similar regime on our S&P rated fund(s) where, to be consistent with a AAA rating, the fund NAV should not deviate by more than an amount quite similar to the proposed new regulations.”
Paul Mueller, Senior Portfolio Manager, Invesco Fixed Income
It is worth noting that in practice, many fund providers already follow many of the guidelines that will be formalised under the new regulation. “We will need to do some back testing and scenario testing to find out what sort of situation would lead you to invoke the 20 basis point collar,” says Paul Mueller, Senior Portfolio Manager at Invesco Fixed Income. “But to be honest, we’re already operating under a similar regime on our S&P rated fund(s) where, to be consistent with a AAA rating, the fund NAV should not deviate by more than an amount quite similar to the proposed new regulations.”
Other areas of the regulation are likewise in line with the practices already used by some providers. As Mueller explains, “The new rules put in different guidelines on liquidity, but we already operate under those liquidity requirements. There are slight differences in that you can only hold a certain amount of government securities in your liquidity bucket, but I don’t think that will impact us. There is also more formalisation with fees and gates, which is slightly different – but again, we already have discretion within our prospectus to impose a gate, and many prospectuses have the same. So there isn’t much that is new, but some things are being highlighted more formally.”
Impact on investment policies
The 2017 J.P. Morgan Asset Management 2017 Investment PeerViewSM survey found that 58% of respondents in Europe were considering making changes to their investment policies in the next six to 12 months in light of regulatory changes.
The survey also asked respondents about their preference in terms of the different money market fund structures which will be available in Europe under the new regulation. Twenty nine percent of respondents favoured LVNAV funds compared to 24% who cited VNAV funds. However, 44% stated that they needed more time and/or information before making a decision.
For treasurers, there is still some time before the new funds will become available. “It will be the beginning of 2019 before existing funds need to comply with the new regulation, and there will be a 12-month implementation process for any new funds, taking the date for these funds to comply to June 2018,” says Curry. “That said, we are encouraging investors not to leave this to the last minute – we recognise that treasury teams are very busy, but we are encouraging clients to start formulating their views as soon as possible and start the necessary approval processes. In this way, treasurers can ensure they are in a position to respond as and when new funds are created.”
As such, fund managers are taking steps to keep their investors up to date about the new regulations. Fuell says that J.P. Morgan Asset Management is taking a proactive approach in communicating with investors. “We’re taking the discussion to them,” he explains. “We have a dedicated reform resource centre on our website where we have posted various articles and insight pieces. Meanwhile, our sales team is actively talking to clients about the regulatory reform.”
Curry notes that HSBC Global Asset Management has been very active for the last seven years in terms of keeping investors informed about the debate in Europe. “Since we’ve had more certainty about what the final reforms are going to be, we’ve had a process of engagement with our investors in a number of different formats, including one-to-one meetings, conferences and client events,” he adds.
While much attention has been focused on the new LVNAV funds, it is worth noting that treasurers may choose to explore the opportunities presented by other categories of money market fund under the new rules. “What I do anticipate is corporate treasurers taking a closer look at VNAV MMFs, looking to use these in combination with the new LVNAV MMFs to create a blended portfolio,” says UBS’ Finch. “Whilst this approach has often been discussed, it’s not really been widely implemented among treasures. One of the reason being that providers with a large corporate client base have focused more heavily on the CNAV category with limited VNAV fund options.”
Given the new reforms, Finch says he wouldn’t be surprised to see those providers launching new VNAV MMFs. “At UBS AM, we have managed both CNAV and VNAV MMFs in multiple currencies for many years and we see this as a particular advantage in light of the new regulations,” he adds.
The big picture
Finally, it is important to note that the new rules are being introduced at a time when other factors are also affecting the short-term investment landscape, such as low/negative interest rates and the impact of Basel III on banks deposits. As such, any decisions about investment strategies will need to be made with the big picture in mind.
“Treasurers have seen the evolution of banking regulation and the impact of what banks are able to offer compared to several years ago,” says Fuell. “They will be factoring this into the decisions they will have to make in a couple of years’ time.”
With that in mind, providers remain optimistic that money market funds will continue to meet treasurers’ needs once the new structures come into effect. “While the changes may seem quite dramatic on paper, what the regulations have brought about is a coping mechanism for funds to be able to continue operating in times of market stress,” concludes Invesco’s Cross. “Those going down the LVNAV route should continue to operate in a similar manner as they currently do as they used to, which means there will hopefully not be too much disruption to the industry.”