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Responding to European Money Market Fund reform: a portfolio manager’s perspective

At long last, European Money Market Fund reform is almost upon us. But don’t wait until the ink has dried; start looking at your policies and approaches now, say BlackRock experts, Beccy Milchem, Head of Corporate Sales and Eric Hiatt, Director, Portfolio Manager.

Portrait of Beccy Milchem

Beccy Milchem

Head of Corporate Sales
Portrait of Eric Hiatt

Eric Hiatt

Director, Portfolio Manager

For treasurers, it is time to prepare for European Money Market Fund (MMF) reform. The European Commission’s proposals now have an implementation date for new funds of mid-2018, with existing funds on a 19th January 2019 deadline. However, the new rules may have an earlier impact on the existing major European sectors of variable and constant net asset value MMFs (VNAVs and CNAVs).

Whilst most corporate investors can expect minimal short-term impact from the changes, industry consensus says the wise investor will begin working with their asset managers now on forming a clear response. “With the two dates in mind, we are using this period to educate all of our clients,” confirms Beccy Milchem, Head of Corporate Sales, BlackRock. “We are cautioning that although we have a 2019 final implementation date, we think a lot of funds will migrate before then. It is worth being prepared ahead of that.”

Start now

BlackRock believes it is prudent to plan a transition to the new rules during Q4 2018. It is being mindful that not only is the final date right at the start of 2019, but also that this date is sufficiently close to year-end as to apply an unnecessary challenge to managing liquidity.

The aim of this preparatory period for corporates should be to confirm full awareness of LVNAV’s features, and to ensure investment policies and all stakeholders are ready for the changes when they come into effect, says Milchem. This means kicking-off internal conversations with investment committees and Boards, around updating investment policies.

Mindful of the fact that these often only get looked at once a year, they should certainly be tabled for the next available review. But Milchem adds that investors should also start dialogue with external auditors and other stakeholders who might have input on the choice of response, both to the possible changing shape of their funds, and to any operational impact this might have. “Have these conversations sooner rather than later so that if you do unearth any questions, you have time to address them.”

Market impasse – the same but different

The US$2.7trn US domiciled MMF market faced up to its ‘2a-7 reforms’ back in October 2016. This saw a shift away from a prime fund’s ability to maintain its investment value at US$1 a share, towards a price that moves with the market. Government funds in the US have been allowed to maintain their constant net asset value pricing.

US and EU reforms bear some similarities but European reform for MMFs domiciled predominantly in Ireland and Luxembourg will see the introduction of Low Volatility NAV (LVNAV) funds. These, Milchem explains, are a “hybrid” composition that nestle between CNAV Government funds, priced to two decimal places, and the VNAV funds that deploy mark-to-market or mark-to-model pricing to four decimal places. The aim of LVNAV funds is to provide many of the attributes that make CNAV attractive to corporate investors, in particular the utility of a constant net asset value as long as certain tolerances are met, but with the added safety net sought by the EU lawmakers. Hiatt believes that the addition of the LVNAV category will see a more uniform migration rather than the shift in investor preferences we witnessed during the US reforms.

“We think LVNAV are a good compromise strategy,” Milchem comments. “In the US, there were two ends of the spectrum, which is why we saw that huge shift; in Europe, we will have more structural uniformity in terms of where the asset flow goes because LVNAV is similar to what investors have been used to.”

The rate environment in Europe may also help frame investor decisions, says Eric Hiatt, Director, Portfolio Manager at BlackRock. It is unclear to what extent this may take place but, in the US, there is an ongoing conversation around what spread differential is required for a Government fund investor to consider a move back to prime. The difference in USD is currently around 35bps and BlackRock has seen some assets return to Prime as a result, however with short-term EUR Government rates deeply negative and GBP Government funds currently close to zero, investors in these currencies are likely to be more mindful of the gap. The proposition around reform is different in the EU but Hiatt says fund managers will be paying particularly close attention to client considerations in their discussions around the ‘fund structure versus income’ debate.

It is interesting that the birth of LVNAV was in part informed by the close involvement of the corporate community, says Milchem. Being consulted around regulatory reform, and offering feedback on what was highly prized in today’s products, has paid dividends. But the regulators were also, to a degree, conscious of the impact of ongoing Basel III changes on banks and their attitude to the short-term investment space.

In pushing corporates off the bank balance-sheet, it created an environment where there was almost nowhere for corporates to place their day-to-day cash. “Regulators wanted to create something that still had the usability factor that was present in the CNAV world, along with much more transparency around the risk, so that end-users can really understand what they are getting into,” says Milchem.

US better than EU?

Is one set of reforms better than the other? It is not easy to make a relative comparison, says Hiatt. “That’s why we are focused on providing attractive solutions, no matter the operating environment. The European landscape certainly offers more choice and we plan to have a full spectrum of products available so that clients can choose the best money market fund for their needs.”

Away from fund reform, US policy-makers have moved target rates up from zero in the past two years. This has been helpful to USD cash investors. At the same time, there has been a steady demand for USD funding by international banks, helping to augment dollar-issuance and thus also helping USD investors, irrespective of US 2a-7 or EU structural change.

However, there are “cross-currents” that should be highlighted, notes Hiatt. Chief amongst these are the liquidity and capital standards for banks that arise from the aforementioned Basel III. “This has fundamentally altered the supply environment for short credit, with banks rationalising exposure to short-term wholesale funding,” he notes, reiterating Milchem’s earlier observation that corporate non-operating deposits are being bounced off bank balance-sheets.

As such, Milchem believes that MMFs of any form – whether the predominant Government funds in the US or Europe’s new LVNAV – will continue to provide “an attractive solution for short-term investing for corporates”, representing an “easy tool for quick diversification of credit and day-to-day liquidity with reasonable yield”.

Table 1: What are the structural impacts to European Money Market Funds?

Short-Term Money Market Funds Standard Money Market Funds
Government (CNAV) Low Volatility NAV (LVNAV) Variable Net Asset Value (VNAV) Standard Variable Net Asset Value (VNAV)
Stable NAV

1

X X
Floating Net Asset Value (FNAV) X

1

Liquidity Fees

2

2

3

3

Redemption Gate

2

2

3

3

WAM (max) 60 days 60 days 60 days 0.50 year
WAL (max) 120 days 120 days 120 days 1.0 year
Maturity (max) 397 days 397 days 397 days Fixed – 397 days
Floating – 2 years
Liquidity requirements – daily liquid assets (min) 10% 10% 7.50% 7.50%
Liquidity requirements – weekly liquid assets (min) 30% 30% 15.00% 15.00%
Pricing – dealing NAV Constant NAV (rounded to 2 decimal places ie nearest penny/cent) Constant NAV (rounded to 2 decimal places ie nearest penny/cent), provided dealing NAV does not deviate from mark-to-market NAV by >20 basis points Variable (rounded to 4 decimal places) Variable (rounded to 4 decimal places)
Reference
  1. The Fund can price to 2 decimal places if the full mark-to-market price does not deviate from 1.00 by more than 20bps, essentially rounding up to 1.00. If the 20bps tolerance is breached the fund will price to 4 decimal places using the full mark-to-market NAV, essentially rounding down to the nearest basis point

  2. If the weekly maturing assets of the fund fall below 30% the manager will inform the board who has the discretion to implement fees and/or gates as deemed appropriate. If the weekly maturing assets of the fund fall below 10% the board must decide which fees and/or gates they deem appropriate to implement

  3. Although fees and or gates are not prescribed for VNAV funds as part of the European Money Market Fund Reform text, they will be required to be included within funds prospectus under UCITS and AIFMD rules, as they currently are.

Two approaches, one platform

The US market, having already reformed, has seen US asset managers with platforms on both sides of the Atlantic leveraging the experience. The operational architecture that sits behind the new 2a-7 reforms can be used in Europe for LVNAV and the short-term VNAV product and BlackRock is currently in close dialogue with the Irish regulator around the appropriate ways to handle multiple NAV strikes, which were developed for the US Prime funds, for the new fund structure in Europe.

Indeed, BlackRock’s single, global ‘Aladdin’ platform is an operating system for investment managers that supports the entire process, including trading, portfolio management, risk analytics and compliance. Hiatt explains that whilst there are nuances unique to EU reform, BlackRock has spent time planning for and implementing the changes around 2a-7 reform that “lend themselves very well to reform in Europe”.

Within Aladdin, portfolio managers are able to analyse liquidity metrics in real-time. This can run scenario analyses based on shareholder subscriptions and redemptions. The platform also offers enhanced analytic capability, extending to NAV per-share impacts and asset value per-share impacts on portfolio transactions, shareholder activity and security price movements.

Despite BlackRock’s US 2a-7 experience, and the system’s easy translation to European reform, Milchem does not see the sets of portfolios fundamentally being run differently. “This is very much us continuing with the risk management and credit management approach that we have always worked to, but adhering to extra rules and procedures which we have now embedded in our systems.”

Corporate preparations

The changes likely to be seen are therefore not far-removed from what treasurers might experience today, it is simply a new concept that all must now get used to. First and foremost, as mentioned, this requires taking action now, at least discussing ‘new world’ plans, appetite and policy approach.

As part of this programme, securing data from funds could prove essential in making the right decision. Treasurers looking at an LVNAV strategy, for example, should seek data on the liquidity level and the shadow net asset value of the fund. These are the critical data points that allow LVNAV funds to price to ‘one’, explains Milchem. It is also the kind of information that should now start to become available through the MMF portals – it is certainly information that BlackRock is already publishing live to its website in a bid to make sure its clients become familiarised with it in good time.

Investors that are comfortable with the composition of risks in today’s prime funds will find familiarity with the LVNAV structure, notes Hiatt. “It’s also important to recognise that a lot of the conditions that regulators are placing around the new fund structures will see enhanced transparency, which will benefit shareholders, and if a fund chooses to add a rating, investors will also still be able to rely on the independent scrutiny of the rating agencies.”

A useful way to think about regulation

Ultimately, says Hiatt, think of LVNAV as “retaining the investor utility of CNAV but with the capability to round the NAV to ‘one’”. Where in the old CNAV environment, the ‘breaking the buck’ point was 99.50, LVNAV takes that concept and tightens that broad collar to 20bps. As long as a fund stays within a 20bps margin of a stable NAV pricing, rounding it to ‘one’ is fine and a 20bps threshold is tolerable from a portfolio management perspective

And on the matter of fending off runs on a fund – rare though they are – the new formalised rules around gates and fees (they are already in place in European UCITS funds) should be seen as measures designed to protect investors in a stressed environment.

The key differences in new fund guidelines are thus really around the increase in the requisite levels of liquidity, and the revision of diversification and concentration limits that will apply at either the product or institutional level. If there is any yield differential with LVNAV from CNAV Prime funds today, it will be a function of those liquidity standards, and even then, in most circumstances, “not be very meaningful”, notes Hiatt.

Indeed, on a day-to-day basis, the reasons for a corporate using a money market fund will not be subject to drastic change, adds Milchem. However, she continues, one outcome we may see as a result of far wider-ranging market reforms in financial services, is the client becoming more adept at segmenting their cash for different use cases.

If MMF reform does indeed encourage treasurers to look at their investment policies and have a more open view on it, this is an opportunity for them to investigate some of the other solutions available, maybe taking on Standard MMFs with more duration. Having better oversight of cash flow forecasting and being able to segment more effectively has seen BlackRock engage in many more conversations with clients in the US about bespoke investments, she notes.

The wider regulatory environment is making investors become more aware of their needs and the challenges they now face for investing day-to-day cash. As they draw the veil from many more investment solutions, where they previously may have relied heavily upon their banking relationships, they may now see fit to explore a far wider portfolio of possibilities. Some may even outsource credit expertise to an asset manager with substantial resources, leaving treasurers to get on with being treasurers.

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