Treasury Today Country Profiles in association with Citi

MMFs: under the bonnet

Fragment of an engine

This section will commence with an introduction to the main types of MMF before moving on to consider the business model and the various aspects which influence the running of a MMF, its structure and its asset holdings. The following five areas will be examined:

  • Core fund types.

  • MMF Holdings.

  • Management and control.

  • Governance and regulation.

  • Investment strategies and the impact of negative rates.

Core fund types

Descriptions of fund types exist elsewhere in this Handbook, however as a recap, there are a few core Money Market Fund (MMF) types that will be of interest to treasurers.

  • A prime money fund is one that generally invests in CDs, TDs, commercial paper, reverse repurchase agreements, floating/variable rate debt and government securities.

  • A government money fund is one that invests at least 99.5% of its total assets in cash, government securities, and/or reverse repurchase agreements that are collateralised by cash or government securities.

  • Institutional money funds have high minimum investment, low expense share classes that are marketed to corporates, governments, or fiduciaries (acting on another party’s behalf). They are often set up so that money is swept to them overnight from a company’s main operating accounts. Large corporates (national and international) with multiple accounts and banks may sweep funds to a MMF.

MMF holdings

Before we look at the portfolio restrictions imposed by regulators and credit ratings agencies, let’s first consider the types of investments made by funds.

To summarise, MMFs will only invest in high-grade short-term money market instruments. These are investments that have a maximum term to maturity of no more than 13 months (or a loss probability profile equivalent to that of a AAA 13-month security) or, in the case of variable rate securities, an interest reset period of less than 13 months. The overall maturity of the profile is limited by restrictions applied to the ‘WAM’ (weighted average maturity) and ‘WAL’ (weighted average life) by the ratings agencies, by operation of IMMFA’s Code of Practice and, in practical terms, by funds’ own liquidity requirements.

The short-term securities MMFs invest in comprise mainly of the following instruments, provided that they have a good credit rating:

  • Certificates of deposit (CD).

  • Commercial paper (CP).

  • Reverse repurchase agreements (Repo).

  • Short-term debt issued by government entities.

  • Short-term bonds issued by private issuers.

While all types of MMFs tend to invest in high-quality short-term instruments, we have seen a not insignificant shift in the asset composition of many prime MMFs in recent years. This shift is often attributed to the diminishing pool of investable securities and the interest rate environment. Chart 1 shows the average portfolio mix for euro denominated MMFs. Although the securities of financial institutions continue to represent the bulk of fund’s holdings, allocation to financials has declined, falling to 67% in Q414 to 59% in Q415. Meanwhile, allocation to non-financial corporate securities – especially US investment companies – has increased marginally, growing by 5% in 2015.

Chart 1: Average portfolio asset mix
Chart 1: Average portfolio asset mix

Source: Fitch

Bank deposits/term deposits

Bank deposits were the first form of investment made by MMFs. By spreading the investment of monies amongst a number of banks, the fund offers diversity of counterparty risk. Every fund must maintain liquidity invested in overnight deposits or call accounts to meet investor redemptions but will also make fixed-term (up to seven days) deposits with banks. The trend has been towards increased bank placements to reinforce funds’ overnight to seven-day liquidity.

Certificates of deposit (CD)

Negotiable certificates of deposit, or CDs, are short-term, actively traded instruments issued by banks or other financial institutions. These are usually issued in a $100,000 minimum (or equivalent currency) unit and trade in wholesale market clips of no less than $5m. They are a highly liquid form of investment generally with a fixed rate of return. Typically yielding marginally less than the equivalent bank deposit at the time of issue, they can sometimes be bought in the secondary market at superior yield and, structurally, they offer better liquidity than time deposits. Holdings by funds of CDs have risen considerably since the market dislocation of 2007 – 2009 and are often relied upon by funds as a source of secondary liquidity.

Bankers’ acceptances (mainly US)

Bankers’ acceptances (BAs) are short-term notes guaranteed by commercial banks as part of a trade transaction. With structural changes on the horizon and a growing shortage of investible assets, trade-backed issuance (and issuance programmes backed by such) could become a more significant feature in coming years.

Medium-term notes (MTNs) issued by banks

Do not be misled by the category ‘medium term’ – we are dealing here with MTNs that will be part way through their life and have a short enough residual maturity to be bought by the funds.

There is however an interesting quirk in that the maturity restriction of 13 months allows funds to buy paper with an expiry of more than one year, which is classified by the borrower as medium-term debt at the time of issue.

Commercial paper (CP)

CP can be secured or unsecured. It is short-term corporate and bank debt with a maturity of 364 days or less. This can include asset-backed debt instruments issued by special purpose vehicles investing in some form of asset such as trade receivables, credit card receivables or mortgage backed securities. This type of CP, known as asset-backed CP or ABCP, is allowed by the rating agencies and, until recently, had constituted as much as 20% to 25% of a typical MMF portfolio; currently, sector weighted average offshore US money fund holdings of ABCP range from 26% in GBP and USD portfolios to just over 51 in US dollars/euro portfolios.

Much of the ABCP issuance had been issued by structured investment vehicles, bank conduits and other programmes, many of which have now been brought back onto the originating banks’ balance sheets so as to restore a firm link between the securitised debt instrument and the originators. There is a difference of opinion in the industry about ABCP. Some fund managers avoid it as they regard ABCP as a less liquid investment that is difficult to analyse. Others with a greater depth of analytical resource regard this type of paper as offering an attractive yield. Funds investing in such paper would typically need to have an exhaustive and highly specialised credit research capability to support the holdings and to have a liquidity management function that is capable of dealing with somewhat fickle secondary market demand.

One of the reasons ABCP can yield slightly more than corporate CP is that corporate investors are less often seen as buyers of this type of paper. They find the complex structures difficult to analyse. This leaves the market to the professional fund managers, who analyse the structure of each ABCP issue and can more readily assess the strength or weakness of the underlying assets.

ABCP had been a rapidly developing market in Europe. Until the market fall-out in 2007, volumes had been growing and the sector had not experienced the same deterioration in credit quality that has been seen in some other parts of the CP market. Since 2007, market demand for ABCP has waned and, whilst funds have not been buying as actively, certain types of issuance remain established as an important part of European MMF portfolios, particularly in euro.

Floating and variable rate notes

Other forms of corporate debt can also be purchased. In the case of variable or floating rate notes, the rating agencies will allow the maturity for WAM purposes to be the date of the next interest rate reset. The final legal maturity can be as much as two years or more depending on the rating agency and the precise nature of the instrument.

Floating and variable rate notes have a slightly more volatile market price reflecting changes in issuer credit spreads and in market liquidity generally but they can offer significantly better yields. Some fund managers avoid or restrict investments in these instruments. Others have decided that the nature of their funds (and the characteristics of their shareholder bases) enables them to make more use of these investments. These funds may have a very stable core of investor balances or more predictable withdrawal patterns. Thus they can invest a greater proportion of their fund in such instruments.

Corporate bonds and notes

As with bank medium-term notes, we are dealing here with instruments that will be part way through their life and have a short enough maturity to be bought by the funds. This category can include asset-backed securities of various forms but very little of this paper is generally suitable for MMFs by virtue of residual credit maturity or of market illiquidity.

Government securities or securities guaranteed by government or other supranational organisations

Unless the fund restricts itself to government securities, these investments are sparingly used as the yield is not as attractive. That said, the banking crisis has encouraged some of the funds to embark upon a general risk reduction exercise by incorporating government securities investment into their prime funds.

Examples of funds that are currently favouring higher-than-sector-average holdings of governments currently are BNY Mellon, HSBC, Northern Trust, Deutsche Bank, State Street, Insight, RBS and BNP Paribas.

In addition, some fund providers have established discrete sub-funds that are designed to invest exclusively in OECD government obligations or in assets (eg repo) collateralised by such securities.

‘Reverse’ repo agreements

Reverse repurchase agreements, which we shall refer to generically as ‘repos’, are short-term (often overnight) investment agreements. An investor (lender) agrees to purchase certain securities from the borrower and the borrower promises to repurchase the securities at a specified future date. The difference between the simultaneously negotiated prices is the investor’s return, the ‘interest’ earned.

Repos economically constitute a fully collateralised loan to a bank or securities trader. These arrangements are carefully monitored by the ratings agencies and restrictions are placed on the securities and the counterparties.

Tri-party repos, where the counterparty’s custodian bank still holds the securities but holds them to the order of the investing fund, are allowed. This is useful when a fund would like to invest late in the trading day when it is too late to get the securities transferred to the fund managers own custodian bank.

Conventional repos

Occasionally and very exceptionally a fund may use a conventional repo as a funding mechanism to obtain liquidity until an investment matures.

The rating agencies do not always allow this form of borrowing. Any other borrowing is also strictly limited by Undertakings for Collective Investment in Transferable Securities (UCITS) regulatory regime and credit ratings requirements so that there is no portfolio leverage in the funds.


No speculative positions are allowed, so derivatives of any form can be rare. Fund prospectuses may permit the use of derivatives for the purpose of efficient portfolio management but in many cases internal policies prohibit their use. That said, some funds will routinely utilise derivatives in order to manage fund duration and actively to rebalance the book. Again, understanding whether and how derivatives are used is important for any prospective investor.

MMFs rarely invest in a different currency asset but this would be allowed if the investment was fully hedged back to the currency of the fund. The hedge must always match the investment; there must be no mismatch. This is not always easy to achieve and the cost may offset any gains that are made by investing in another currency. Some funds are using this when they lack scale in a currency (say euro) but have much larger amounts in another currency say sterling or US dollars.

Fund management and control

MMFs are run by asset management companies which are either bank-sponsored (as indeed most are – nine out of the ten biggest EU MMF managers are sponsored by commercial banks) or independent. Almost 40% of short-term debt issued by the banking sector is held by MMFs.

To offer a MMF in the US or Europe, any authorised asset management company will either be subject to SEC’s Rule 2a-7 under the Investment Company Act of 1940 in the US, or be licenced under the UCITS directive or the Alternative Investment Fund Managers Directive (AIFMD) rulings.

Investors are mostly corporate treasurers who need to invest large amounts of cash on a short-term basis and who seek either to gain more yield than they might from a bank deposit account or who seek diversification of their short-term portfolio.

With preservation of capital and the provision of liquidity as their primary objectives, MMFs play safe. As we have seen, the securities in MMFs are of very high quality and have only a very short time to maturity, thereby minimising movements in the NAV. Matters such as credit quality, portfolio construction and fund management come to the fore when ratings are considered.

Credit quality, says IMMFA, is evaluated by looking both at assets individually and in aggregate. For individual assets, the type, credit quality and tenor are relevant characteristics. Credit ratings agencies (CRAs) will also challenge portfolio construction by analytical review which typically includes stress testing. The CRAs are also concerned with the strength of the operational framework upon which fund management is based.

Fund administrator and custodian

Fund administration covers all the activities carried out to support the process of running a MMF. Often some or all of these activities are outsourced by the fund manager to the fund’s custodian bank. The specific activities a fund administrator is responsible for include:

  • Fund accounting services.

  • Valuation of the portfolio and pricing of the shares.

  • Distribution of income.

  • Contract settlements.

  • Record keeping.

A custodian, meanwhile, is a financial institution responsible for the safekeeping of a MMF’s assets. Most custodians also offer a range of other services. These include:

  • Ensuring that subscriptions and redemptions are performed in accordance with the law and constitutional documents.

  • Ensuring that a fund’s income is applied in accordance with constitutional documents.

  • Carrying out the instructions of the management company – unless these are in conflict with constitutional documents.

Because funds are normally set up as corporate entities in their own right – separate from the fund manager itself – they will have their own Board of Directors. The directorship has a fiduciary responsibility to the fund’s shareholders, with the best interests of its shareholders as top priority. The directors will also oversee the fund manager’s activities and the relationship with stakeholders such as the depositary and fund the administrator (whose task it is to run the fund on a day-to-day basis), the latter of which may be outsourced to the fund’s custodian bank (which, as the name suggests, safeguard’s the fund’s assets).

The makeup of the Board is such that it often and purposefully has little or no association with the fund manager, ensuring independence. Periodic Board meetings are required at which operational matters such as the fee structure and financial statements are considered, as are investment objectives and fund policies (referred to as the mandate) which steers all fund activities (and which can only be changed with shareholder agreement). The Board will also decide on the reappointment of the fund manager.

Chart 2: Fund governance – who does what
Chart 2: Fund governance – who does what

Source: J.P. Morgan Asset Management

Outsourced back office operations

A fund provider does not have to establish its own administrative operation in, for instance, Dublin but if the funds are registered in a certain jurisdiction this means they must be administered from there. Most of the fund providers outsource the administration and custodian arrangements to third-party providers of these services.

There are a number of providers of administrative and custodial services. They include Bank of New York Mellon, State Street, HSBC, J.P. Morgan, BNP Paribas and Northern Trust.

The extent to which back, middle and even front office functions are outsourced varies from fund to fund. This may mean that you will not be talking to the fund provider when placing your investment or when calling funds back. This has no practical effect on an investor if an efficient outsourcing arrangement is in place.

Some fund managers have their own client-servicing staff and investors do not have any contact with the organisations running the funds ‘behind the scenes’.

While the use of a limited number of back office providers does mean that there is some concentration of operational risk given that several funds may all use the same administrator and custodian banks, the same concentration of resources has enabled centres such as Dublin to create an impressive fund servicing infrastructure with local expertise.

Private labelling and outsourcing

Not all those providing funds are actually in the business of running them. Outsourcing can be taken to its logical conclusion if a bank or other financial intermediary ‘private labels’ a fund provided by another provider or sells shares in another provider’s fund. There are a number of ways in which this outsourcing can be achieved, the most common of which is white labelling.

White labelling/private labelling

White labelling (also described as private labelling or outsourcing), is when an intermediary with relative strength in distribution among its client base sells another manager’s fund. Numerous examples exist where fund sponsors have deliberately chosen a neutral name for their funds to encourage distribution (ie sales) by third parties; one would be Invesco with its ‘short-term investment company’ style. These third parties may badge the funds as if they were their own fund or they may simply sell the neutrally named fund on the best-of-breed principle under a distribution agreement.

In all of these cases, the management fee is shared between the organisation selling the fund to the investor (often described as the distributor or sub-distributor) and the organisation actually managing and running the fund.

There are many of these arrangements and they make sense. A lot of the costs of running a fund are fixed costs which fall as a percentage as the fund grows in size. Larger funds achieve significant economies of scale that make them less costly to run and allow the fund to be profitable even if the fees are shared between two parties.

In some cases, the fund provider will establish a new share class for funds distributed by a third party. This share class may have higher fees. With some careful questions (and close reading of the prospectus), an investor can ensure that any such arrangement is disclosed. In such circumstances, investors should make sure that they are not being put into a share class with a higher fee than could be obtained if they had a direct investment relationship with the fund provider.

Blue labelling (uncommon)

A ‘blue label’ arrangement arises when a bank or other financial intermediary sells its own fund which is managed by a third party. The fund is a separate fund, which will be separately branded, but is run by someone else for a fee.

It may make sense for a new entrant to the business to get another fund provider to run its fund in the early stages. One major bank provider outsourced the entire fund management process to another fund manager in the first months while it grew in size and scale; this enabled the bank to keep operating costs down in the early stages.

Master/feeder structures

Some funds offer a feeder fund structure outside the jurisdiction of the main (or master) fund so as to take advantage of tax rules or to enable investors to conform with accounting and share pricing conventions or to aggregate meaningful volumes in an operationally efficient manner. A feeder fund would invest exclusively in the master fund so portfolio exposures should be identical to direct investment in the master fund but, structurally (ie legally and operationally) and economically (ie fee pricing), there can be issues for investors.

Front office administration and systems capability

Most fund providers retain responsibility for selling (attracting new investors), client relationship management and servicing and investment management.

Every fund has to carefully monitor its investments, its liquidity, the average maturity of its portfolio and its yield. Every day, investors are withdrawing and investing funds, investments are maturing and there are new investments to be made.

The capabilities and level of automation in fund managers’ offices varies. Some use spreadsheets, others use fund management systems that are not really designed for MMFs. Some have systems specially designed for MMFs. Some have real-time systems updating as transactions are entered and others are designed periodically to recalculate the positions and the important ratios.

Fund managers with fully automated systems will be able to manage their funds more effectively and produce data such as the yield being generated much more quickly. This can be an indication of how seriously the manager takes client service.

This may not matter to most investors but ultimately systems efficiency equals more profit and/or lower fees. As more data becomes available over the web, the speed at which fund managers can supply this data will also become more apparent.

Elements such as operating procedures, risk management and internal controls of the manager, including disaster recovery, are core to the understanding of this. But the administrator, custodian and trustee and their practices, policies and controls are also scrutinised.

As might be expected, regular CRA inspections are vital to ensure a MMF is working. Funds are required to have at least 10% of their assets maturing the next business day and at least 20% maturing within five business days. Overall the weighted average life (WAL) or final maturity of the portfolio is not allowed to exceed 120 days. To make sure they are always in compliance with the ratings criteria – as well as regulations like Rule 2a-7 – fund managers will stagger the maturities of the holdings in the fund, so that a steady cash flow can be achieved with some securities being paid off each day.

The consequence of these requirements is that each fund has a relatively high investment rate. The ratings agencies monitor the maintenance of quality through regular reporting requirements and dialogue with fund managers. Ratings are also subject to annual review which involves on-site meetings with fund managers.

MMF ratings: need to know

The rating agencies keep their ratings methodologies and criteria under constant review as addressed in more detail later. However, it is important to note that the ratings are fund ratings; they are not equivalent to long-term debt or sovereign ratings and should be viewed as opinions on the investment quality of shares issued by a fund in accordance with its stated objectives.

The safest funds are rated Aaa-mf by Moody’s, AAAm by Standard & Poor’s and AAAmmf by Fitch. The suffixes and subscripts are very important as they indicate that these are MMF ratings, not bond fund ratings and that the principal value should be stable. The debate continues regarding the notation used for the fund ratings with some arguing for a move away from the AAA tag as a means of achieving greater distinction from debt ratings.

In an interview with Treasury Today, Fitch Ratings explain that a MMF credit rating is different from other types of credit rating. “It’s really a liquidity rating,” says Roger Merritt, Managing Director at Fitch Ratings. “Most credit ratings speak to credit quality and credit quality alone, but a MMF rating from Fitch also speaks to a fund’s ability to return whatever principle principal is invested and in a timely fashion.”

Investment basics

Under the strict guidelines set down by the rating agencies, fund managers are very limited with respect to investment strategy.

Core and cash

Most fund managers divide the fund into two:

  1. Core investment cash which is fairly stable.

  2. Short-term cash which is needed for liquidity.

Short-term cash is invested for a maximum of, say, seven days. Core investment cash can be invested longer but the portfolio must stay within the 60-day WAM and other WAL restrictions that are imposed by the rating agencies, regulators and trade bodies.

Yield curves

The main reason for investing longer is that a greater variety of investments are available and also the yield curve may be positive, reflecting higher interest rate expectations in the future, wider credit spreads for longer maturity assets and/or (usually temporarily) reduced asset liquidity. In other words, the longer you invest your money, the greater the return achieved. Currently, a considerable term liquidity premium (ie assured funding for an issuer) is available to any investor willing to commit cash beyond short maturities and yield curves are relatively steep out to one year.

A positive yield curve means that if you plot a graph for interest rates over time the resulting yield curve slopes upwards as the period gets longer. Every basis point can matter to a MMF. In a stable market, the difference between the best and the worst performing funds can be less than 10bp; currently, the difference between maximum and minimum gross yields (ie before fees) ranges from 7bp in USD to 17bp in EUR.

However, following the failure of Lehman Brothers in September 2008, money fund returns diverged significantly (well over 3% pa at the peak in US dollars and sterling) reflecting very different investment strategies and portfolio allocations. It is also worth noting here that, given differences in credit policies and limits maintained by different funds, the yield curves (perhaps better defined as the yield ‘opportunity’ curves) can be perceived very differently by individual fund providers.

Unfortunately, a positive yield curve is fine in theory but in reality the curve may not be positive. It may be flat, or inverted, or some combination of all three at various times.

When the yield curve is flat or inverted, longer-term rates are lower than short-term rates. Investors are expecting a reduction in prevailing interest rates. Then it becomes more difficult for funds to earn enough to meet their fees and still offer a competitive return. In these circumstances, a typical response would be for the fund manager to shorten the investment book thereby reducing the time that legacy assets would impact returns.

A flat yield curve is not sufficient reason for a fund manager to keep all the investments short. Rates may drop, for example, in which case investments of 90 days or more can start providing a yield enhancement to the whole portfolio.

As with euro short-term rates presently, official interest rates can be negative as a means of encouraging spending and economic growth and of avoiding the onset of deflation. The market typically responds with lower short-term market rates and a steepening in the yield curve thereby increasing the ‘price’ of liquidity and underscoring in the process the true value of accurate cash forecasting and liquidity planning.

Fees/total expense ratios (TER)

In the main, the costs of distribution/sales, administration, custody and fund administration are all included in a single fee, the annual management fee, which is deducted from funds’ returns prior to distribution to shareholders. In some cases, however, these external servicing costs (eg admin and custody) may be charged to shareholders separately from a fund manager’s annual management charge. Direct fund operating costs, such as audit fees, bank charges, listing fees, rating agency fees etc, are normally charged within the fund, although fund providers may also absorb such costs in their management fee.

The TER of a fund is the total expense burden expressed as a percentage of NAV taking into account all management charges and external costs. Competition has kept fees at fairly low levels, typically between ten basis points per annum (bppa) and 20 bppa for corporate and institutional investors, depending upon circumstances. Furthermore, in the past few years, low short-term interest rates in euro and US dollar have resulted in the application of fee waivers so as to avoid net returns becoming negative.

Amortised earnings

An important feature of the earnings accrual is that funds are allowed to value their investments on an amortised cost basis. This enables the fund to value the investment on a yield to maturity basis adding the investment income in a straight line during the period of the investment. This smoothes the performance of the fund over time.

Marking fund NAV (net asset value) to market prices

Because income is recorded in this way, the book value may not be exactly the same as the market value. Market value will fluctuate according to prevailing interest rates and market sentiment towards the issuer.

Given the short-term nature of the investment, there should be very little difference in the values that emerge between book and market values (unless the issuer encounters credit problems or markets become illiquid). Nonetheless, the difference needs to be monitored. In the US, funds are now required to publish daily NAV, so that investors can monitor how much the NAV of a prime fund fluctuates. As part of the changes to Rule 2a-7 introduced in 2010, funds were obliged to report monthly ‘shadow NAVs’ to four decimal places to the SEC and publish them with a 60-day lag.

Driven by the requirements of the rating agencies and regulators, the industry regards a deviation from par of more than a half of one percent as unacceptable. In other words, the mark-to-market value of a fund must stay within 99.5% to 100.5% of the amortised (or book) value of the fund. The ratings agencies expect a fund manager to take action before a fund gets anywhere near this and all funds have escalation procedures in place ensuring that remedial action is taken well before the limit is reached. Anything outside of this is described as ‘breaking the buck’.

As a result, fund managers are expected to run the liquidity profile of the fund in such a way that any slight variations in market value versus book (ie accrued) value do not affect the net asset value of the fund nor put an investor’s principal at risk.

The difference between mark-to-market and book values is regularly monitored (at least weekly in stable market conditions). Fund managers all have escalation policies in place that dictate action to be taken at various trigger points if the market value and book value start moving apart.

One illustration of how tightly funds must be managed is the following position stated in March 2009 by Standard & Poor’s: “When the marked-to-market NAV of a ‘AAAm’ rated fund drops below 0.9985, we contact fund management to discuss cause(s) of the decline and activities/meetings occurring at fund management and/or Board level, and we request daily pricing/NAV reporting. If the marked-to-market NAV drops below 0.9980, we will put the fund on CreditWatch with negative implications for the time the NAV remains below 0.9980, and we will adjust the rating to ‘AAm’ if the NAV drops below 0.9975”.

Amortising realised gains and losses

The effect of the accrual of income is that earnings are smoothed but there is still a remote possibility of realising an unrecognised loss (or gain) if the market value decreases (or increases) and the holding is sold. If held to maturity, there should be no difference in the values providing there is no default. Funds do realise gains and losses on investments from time to time. The issue that then arises is how to account for the difference.

This is described in the industry as a ‘grey area’ and is the subject of much discussion behind the scenes. Regardless of whether there is a gain or a loss it can cause the daily return to be very erratic if it is all accounted for in the performance of a fund on a single day.

Most funds ‘drip’ any gains or losses into the daily performance of the fund over time. They limit the impact on the daily return to a few basis points per day and, under IMMFA’s Code, ensure that any realised adjustment is smoothed on a consistent basis and in a timely manner. Limiting this to three basis points per day was described as acceptable by one of the ratings agencies.

Amortisation of a loss over the life of an investment might be acceptable for a single holding but in an actively traded portfolio it could result in a growing amount of unamortised losses and seriously misrepresent the true value of the fund.

To avoid ‘completely’ the potential problems associated with realised losses, safety conscious investors should seek MMFs and advisors that follow very conservative investment practices, designed to maximise share price stability and portfolio liquidity. If this aspect worries you, ask the fund manager what their policy is on this issue. Furthermore, persistent volatility in daily published fund yields should also be questioned.

Tax treatment of the income

The funds pay income gross of withholding or any other taxes. Tax treatment in the UK has been that investment in a MMF is deemed to be a loan relationship under the Finance Act 1996 and income is taxed as interest earnings.

According to the fund providers, most other countries will treat the income in a similar way but some countries apply a tax to income from foreign investments. The accumulating nature of net asset value (ANAV) shares may delay the timing of the tax for some investors and make these a more attractive form of shareholding in certain circumstances. As always, investors would be well advised to seek professional advice on such matters.

Accounting treatment as ‘cash equivalent’

IMMFA considers that treasury style funds conforming to the definition of qualifying MMFs meet the IAS 7 qualification criteria and should be considered as ‘cash equivalent’. However, it urges corporations to confirm this with the reporting entity concerned for compliance with internal accounting policies and with the relevant external auditor. Against a backdrop of regulatory change, there is a debate as to whether a VNAV fund can also qualify as cash equivalent. In the US, it is expected that a floating NAV MMF would continue to be treated as cash equivalent under GAAP.

Guidance has recently been issued by the Internal Revenue Service (IRS) with the aim of simplifying tax reporting for investors. This guidance allows for net gains and losses to be measured and tracked over a period of time (chosen by the investor), rather than requiring that this be done for individual transactions. The guidance also exempts investors in VNAV funds from wash sale rules, meaning if they acquire “substantially identical stock or securities” from a sale of fund shares, investors are not required to recognise a loss on that sale within a period of 30 days after the date of the transaction.


Oversight and governance are applied to MMFs to ensure quality and control. The rules around this tend to be much the same regardless of jurisdiction, although domestic variables may apply. All IMMFA MMFs, for example, operate not only in accordance with the IMMFA Code of Practice (which establishes best practice standards relating to the management and operation of the fund) but also in line with the requirements of the UCITS Directive and the guidelines of the European securities regulator, the European Securities and Markets Authority (ESMA).

IMMFA guidelines

The Institutional Money Market Funds Association (IMMFA) Code of Practice contains very explicit recommendations on valuing funds. In particular, it states that:

  • Funds must be marked-to-market at not less than weekly intervals.

  • Fund managers must have escalation procedures in place for occasions when the mark-to-market value of the fund and of individual securities held varies from the book-value by more than a marginal amount. The necessary procedure is further defined as being referred by the fund administrator to the fund manager, to senior management of the investment manager and to the directors or trustees of the fund according to the level of variation.

  • Fund managers must have in place formal policies dealing with the treatment of realised gains and losses. They may be spread over time but treatment must be consistent and timely. Any smoothing period of more than one year must be formally approved by the fund’s directors.

  • Valuation procedures must ensure that administrators utilise pricing sources that properly reflect the ‘fair disposal value’ of individual securities held.

Whilst adherence to the Code is a condition of membership of IMMFA, it remains voluntary and IMMFA does not have the resources to undertake close monitoring. Accordingly, investors are encouraged to ask about funds’ valuation and income reporting. IMMFA has worked hard to establish a consensus among its membership in the valuation and recording of assets, treatment of income and enforcement of its guidelines. Regulatory and other changes affecting the sector have also brought these issues into sharp focus and IMMFA is continuously developing its own policies in these areas.

In common with the US regulator’s own revisions, IMMFA has established comprehensive guidelines on such issues as, issuer concentration limits, minimum liquidity standards, a fund’s weighted average life/final maturity (WAL/WAFM), transparency, the suitability of certain instruments, consistency in the recognition of capital gains and losses, the role of credit ratings and periodic portfolio stress testing.

Today one investment manager may make an investment that another thinks is unsuitable. This matters because fund managers want to maximise performance. There is always a tendency for a fund manager to operate at the limit, and the limits have some holes in them that can be exploited. Is it dangerous? Perhaps not, but it does mean that there can be slightly more risk present in one fund compared with another.

Undertakings for collective investments in transferrable securities (UCITS)

UCITS was introduced in Europe in 1985 allowing a harmonised cross-border European regulatory framework for investment vehicles making it possible for collective investment schemes to ‘passport’ across the whole region regardless of country of domicile of the fund.

All UCITS funds must be open-ended, liquid and be in possession of a triple-A rating from one of the ‘Big Three’ independent credit rating agencies (CRAs) – Fitch, Moody’s or S&P. They may be set up as a single fund or umbrella fund. In the latter, a number of discrete sub-funds are covered, each may have a different investment objective and policy. Each sub-fund is then treated as a separate entity and as such all the assets and liabilities within are segregated from other sub-funds. In terms of their management, each separate sub-fund can be allotted to a different investment manager and although restrictions may apply, sub-funds may invest in each other.

UCITS requires assets to be segregated, separately identifiable and held by an independent depository. Ring-fencing investor assets from the fund manager’s in this way adds a strong element of safety to all compliant funds, regardless of the fund manager’s location and indeed solvency (in case of emergency, the funds could easily be transferred to another fund manager). However, the depositary must also meet UCITS requirements in order to operate and the fund manager itself must establish a coherent internal monitoring programme to ensure overall compliance.

The legislation with which the European funds generally seek to comply is UCITS. Funds are approved under European Directive 2009/65/EC Undertakings for Collective Investments in Transferrable Securities (as amended). Approval to be registered as a UCITS is sought and obtained from the regulator in the country of domicile – the Irish Financial Services Regulatory Authority for the Dublin funds, Commission de Surveillance du Secteur Financier for those in Luxembourg and the FCA in the UK.

These regulations include generic diversification limits and concentration limits but they are not MMF specific. The UCITS directive is the same legislation that covers many sorts of OEIC – open ended collective investment companies – including equity and bond funds. The UCITS registration should, at best, be regarded as showing that established finance professionals run the fund but not as any guarantee of stability and safety of the investment.

UCITS rules have been updated since they were first implemented in 1985 and the industry is now subject to the fifth version, UCITS V, which went live in March 2016. The principle enhancements in UCITS IV are three key provisions aimed at improving investor protection.

  • It provides a precise definition of the tasks and liabilities of depositaries for asset safekeeping and independent oversight of the activities of UCITS funds.

  • It provides clear rules on the remuneration of UCITS fund managers. The way managers are paid should not encourage excessive risk-taking and be linked to the long-term interests of investors.

  • It sets out how breaches of UCITS rules should be punished with fines and sanctions.

Main objectives

Whilst the main thrust of recent UCITS enhancements through the adoption of UCITS III, UCITS IV and UCITS V is to assist fund providers in marketing and operating their funds through closer specification and widening of asset eligibility, it is also designed to benefit investors in a number of ways. Simplification and standardisation of the information provided and adoption of uniform standards of regulation are designed to improve investor access to the product across the EU and to improve investor protection generally. They should also facilitate greater competition within the industry and could support consolidation in the money funds sector.

UCITS III widened scope for a fund to use and invest in financial derivative instruments. MMFs typically do not use derivatives as a matter of policy but may include the ability to use such instruments in the prospectus.

Derivatives such as futures and OTC interest rate contracts are routinely used by financial market practitioners to aid efficient portfolio management, as the shape of the portfolio changes in response to share subscriptions and redemptions, and to immunise investment portfolios against adverse interest rate curve changes. Investors should establish with the fund manager precisely its policy on the use of derivatives.

Borrowing powers

The UCITS legislation allows funds to borrow up to 10% of their value for redemption purposes and to manage operational settlements. The prospectus of most funds routinely allows borrowing at these modest levels.

If a fund was to borrow more and reinvest the monies the fund would become leveraged, which is not acceptable in a short-term fund aimed at preserving capital. As a result, the credit rating agencies also forbid borrowing or restrict it to covering very short-term maturity mismatches.

Prospectus, reporting, semi-annual accounts, redemption restrictions

The UCITS legislation does lead to MMFs having long prospectuses and having to produce annual and semi-annual accounts.

The prospectuses can be rather misleading in as much as they are sometimes described as ‘kitchen sink’ documents with everything thrown in, although UCITS III introduced short-form prospectus formats and UCITS IV introduced the Key Investor Information document. The restrictions placed on the fund by the rating agency and the internal investment policies will give a much more accurate idea of what a fund will be doing.

The prospectus will also include redemption limits which technically mean that a fund could restrict and, at its discretion, apply a penalty fee on redemptions. In reality this has never been known to happen to a shareholding in a top-rated MMF in the ordinary course of its business. However, it is worth noting that some funds in the US were unable to operate for a number of days after the events of 9/11 and, following the bankruptcy of Lehman Brothers in September 2008, a number of money funds in the US and one in Dublin (Lehman’s own fund) suspended redemptions.

For meaningful rules outside those implemented internally by the funds themselves, we must turn to the rating agencies and to industry codes such as that published by IMMFA. It is these independent organisations that place the real restrictions on what top-rated AAA MMFs can and cannot do. However, recent events illustrate just how important it is that investors very carefully read all the documentation provided to ensure that they understand precisely what guidelines a fund manager may operate under.

Alternative Investment Funds (AIF)

AIFs (Alternative Investment Funds) fall under the Alternative Investment Fund Managers Directive (AIFMD), implemented in July 2013. AIFMD covers all AIFs and provides the organisational, operational, transparency and business conduct guidelines by which fund managers should abide. As a directive it sets out the objective and the 28 Member States must then pass domestic legislation to achieve those aims. In this case it is intended to give a steer on supervisory oversight, an independent depositary, corporate governance, valuations and investor disclosure, with each central bank creating an AIF Rulebook. This combines the objectives of each regulated AIF offering within the AIFMD framework. There are two main types of AIF: Qualifying Investor AIF (QIAIF), and the Retail Investor AIF (RIAIF).

A QIAIF is intended only for professional investors and as it is not subject to investment or borrowing restrictions can be used for the widest range of investment purposes. A RIAIF is subject to less investment and eligible asset restrictions than a UCITS fund but is more restrictive than a QIAIF. As a retail fund product, a RIAIF has no automatic right to passport across the region but may be granted rights on a country by country basis.

US Funds – Rule 2a-7

Rule 2a-7 of the Investment Company Act 1940 was introduced to define and regulate MMFs in the United States in 1983. It has been amended several times as new financial instruments have been introduced and in response to losses and difficulties experienced by some funds. The most recent revisions took effect from May 2010 and were designed to make the money fund proposition more robust against systemic weaknesses that became apparent in the wake of the failure of Lehman Brothers and the subsequent ‘breaking of the buck’ by the Reserve Primary fund.

Further revisions to 2a-7 were agreed in 2014, and were implemented between April and October 2016. The first changes to 2a-7 came into effect in April 2016 and are largely focused on ensuring investors have access to relevant information for evaluating a MMF by requiring funds to disclose the following data on a daily basis:

  • Daily and weekly liquid assets.

  • Daily market-based NAVs.

  • Net shareholder flows.

  • Sponsor support.

The date for implementation of the SEC’s new rules was set for 14th October 2016. From this date onwards all prime institutional MMFs will be required to publish NAVs based on the current assets they hold, which will mean that rather than being allowed to preserve the value of its investments at $1 a share, a fund’s price will fluctuate according to market conditions.

Furthermore, in stressed market scenarios, MMFs will be able to impose liquidity fees and/or redemption gates for the protection of existing investors. Given that the primary purpose of MMFs for the corporate investor is liquidity management, it is this aspect of the SEC’s new rules that most probably has the greatest implications for treasurers.

Liquidity fees can be charged to investors redeeming from an MMF in times of stress, thereby ensuring that the cost of obtaining liquidity is not paid for by the investors choosing to remain in the fund. A redemption gate, meanwhile, is a tool a fund’s board can use to restrict redemptions from a MMF in order to prevent a run on that fund occurring during a stress period.

The fund’s board has the option to impose a liquidity fee of up to 2%, should the fund’s weekly liquid assets drop below 30%. A liquidity fee of 1% must be imposed if the weekly liquid assets of the fund drop below 10%. A redemption gate can be applied for a maximum of ten working days in a 90-day period in circumstances whereby a fund’s weekly liquid assets drop below 30%.


The funds in Europe are sometimes described as 2a-7 funds but this is slightly misleading. Although they claim to follow the 2a-7 rules – and many do – there is no sanction if they do not conform. One of the 2a-7 rules, restricting holdings to no more than 5% of the portfolio, can be taken to 10% in Europe (although IMMFA’s Code is more restrictive).

Until 2011, and despite there being various definitions in separate pieces of European legislation, there had been no single definition of a MMF in Europe (IMMFA itself had sometimes characterised its membership as comprising ‘European 2a-7 style funds’). However, CESR (now known as the European Securities Market Authority or ESMA) published in 2009 new definitions that were adopted in 2010 and implemented in 2011 – that restrict the use of the term ‘money market fund’. Confusingly, ESMA chose to publish advice that required certain other, slightly longer duration funds with a fluctuating NAV, to describe themselves as MMFs. IMMFA and its sister body in Europe, EFAMA, had proposed that the term ‘money market funds’ should be qualified through the addition of one of two prefixes – ‘short-term’ or ‘regular’ – depending upon the type. The net result is that there is still room for confusion and investors have to be sure of what they are buying into.

The industry sometimes describes itself as ‘treasury-style’ using the premise of stable NAV and amortised cost accounting, not ‘investment-style’ which typically will include variable NAV, total-return bond funds. Some providers had also used the shorthand ‘422 fund’ to reflect the status of its funds under Section 4.2 paragraph two of the EU’s Eligible Assets Directive (EAD) that governs investments made by UCITS.

Under the EAD and Market in Financial Instruments Directive (MiFID) that governs investment of certain client monies, investment may be made in a qualifying MMF (QMMF) which is defined as having the following features:

  • Supervision of the competent authority of a Member State on a national basis.

  • Has been given the highest available credit rating by a recognised independent credit rating agency; provides liquidity through same day or next day settlement; has as its primary investment objective either:

    • To maintain the NAV at par (net of earnings).

    • To maintain the NAV at the value of investors’ initial capital plus earnings.

  • Invests exclusively in cash or a portfolio of high quality money market instruments that comply with the definition of money market instruments as recommended in ESMA’s ‘guidelines concerning eligible assets’ and which:

    • As a general rule has a maturity or residual maturity of at most 397 days or regular yield adjustments in line with the above maturity restrictions at asset level.

    • Restricts the weighted average maturity (‘WAM’) of the portfolio to a maximum of 60 days.

    • Has adequate procedures and/or mitigations in place at both portfolio and individual asset level to avoid any discrepancies between the mark-to-market value and the amortised price having a material impact on the price per share.

To address the vulnerabilities MMFs were perceived to have exhibited during the financial crisis, a new regulation for MMFs was put forward by the European Commission (EC) in September 2013. The subsequent negotiation process has persisted, however, for almost three years. At the time of writing, the European Parliament (EP) and European Council of Ministers (EC) have both drafted their own versions of the regulation and the negotiation has entered the ‘trialogue’ stage, the point where the three legislative bodies come together to try to find a compromise deal.

Under the EP proposal which was agreed in 2015, CNAV funds will continue to be permitted, providing they are either designed for retail investors or invest only in European government debt. Most radically, however, an entirely new category of fund is being introduced: Low Volatility (LVNAV). After five years, the proposal states that they should be completely phased out, and for everyone other than retail investors the only CNAV funds on the market will be EU government MMFs.

However, under the version of the regulation agreed by the European Council of Ministers in June 2016 LVNAV authorisations would not automatically lapse after five years. Instead, there would be a review of the rules to see how they affect markets and investors before any further changes. Furthermore, existing CNAV MMFs would have two years to make the changes necessary to comply with the regulation, rather than the nine months originally set out by the European Commission.

How MMFs operate in a negative rate environment

According to Moody’s, most of the asset managers of euro CNAV funds introduced a share class reduction mechanism in 2012 and 2013, allowing them to maintain a €1 NAV per share by reducing the number of shares outstanding in an amount equal to the negative book yield on an overall MMF portfolio. This structural change, it says, enabled asset managers to continue to operate their CNAV MMFs even when their funds started posting net negative yields.

The trading conditions in money markets remain challenging. The fact that money market instruments have ventured into negative yield has seen fund providers acknowledge that investors accrue value from share classes with a stable NAV. As such, they have determined that it is in the best interests of fund shareholders to implement the share-reduction mechanism mentioned above to enable a stable NAV to be maintained on days when the net yield on the fund is negative.

According to asset management firm, BlackRock, when there is a positive net yield, dividends will be accrued normally. When net yield is negative a number of shares with a NAV which equals the amount required to maintain a stable NAV per share may be redeemed. The redeemed shares will be cancelled and the value attributable to those shares will be retained by the fund provider to offset the net negative yield. This will enable the NAV per share to remain stable. Therefore, shareholders would incur a reduction in the number of shares they hold. It was reported (in the Financial Times) that European asset managers were quick to adopt the so-called “flex” mechanisms.

This was not the case when Japan introduced negative rates earlier this year however. The sudden nature of the Bank of Japan’s (BoJ) announcement meant that most MMFs – predominantly a retail instrument in Japan – did not have time to implement the same share reduction mechanisms as seen in Europe. As a consequence of this, and the fact that Japanese regulation prohibits sponsor support of MMFs, many of the country’s funds closed in the wake of the decision.

As corporate treasurers take strategic decisions for the future, surplus cash and cash required for short-term needs must to find a home, thus it is that MMFs remain solidly on the radar. However, the low interest rate environment has led to some investors easing their investment policy constraints. This has translated into a growing appetite for MMFs with longer investment horizons and more flexibility in terms of credit and interest rate duration.

When in September 2014, the European Central Bank (ECB) slashed its key rate to what was then a record low (it has since fallen further), it was clearly trying to fend off the risk of deflation. The move was followed by policy measures aimed at facilitating monetary policy transmission in the form of its quantitative easing (QE) programme, announced the following January. This programme incorporated a broad sweep of securities including Eurozone sovereign debt.

However, it was the ECB’s long-term refinancing operations (LTRO) – and the increase in surplus liquidity in the interbank market that this created – that really seemed to determine short-term interest rate trends going forward. With surplus liquidity in the market it can affect money-market rates: the greater the surplus, the lower the Euro OverNight Index Average (Eonia) rate (calculated as a weighted average of all overnight unsecured lending transactions in the interbank market in euros to give a rate ‘fixing’).

In the wake of ECB intervention, Eonia fixings, have been increasingly volatile of late. Indeed, concerns have been expressed that the banks’ repayments of the original LTRO loans was draining surplus liquidity in the interbank market and putting upward pressure on Eonia fixings.

However, after this period further targeted LTROs were scheduled to take place each quarter, potentially negatively impacting short-term rates because significant liquidity surpluses can force Eonia fixings downwards (even to the ECB deposit facility rate which has been negative since June 2014). Further concerns were raised around the tightening in credit spreads of money market instruments since the summer of 2014, the declining supply of instruments, the effect that Basel III LCR has had on banks in focusing on longer maturities, the notable surplus of corporate cash in some sectors and the downgrades by the ratings agencies of a number of bank, corporate and sovereign issuers. Uncertainty is exacerbated by the fact that corporate cash has swelled (estimated at up to $2trn) and that the MMF regulatory debate in Europe is ongoing.

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