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September 2011

All issues

Editorial

What exactly is a money market fund?

These are all creative and sensible solutions but they will all need to be paid for.

We return this month to the subject of money funds. The money fund industry is in turmoil as it deals with regulatory proposals. These proposals originated in the US, but they are being closely followed by European regulators, and they will dramatically change the financial dynamics of the money fund industry.

What exactly is a money fund though? A money fund is, in reality, an investment product but stable net asset value money funds are often seen as more of a banking product. Money funds offering a stable net asset value are seen by most corporates as an attractive alternative to bank deposits. They are sold as such by the fund providers. Invest a dollar or a euro and that is what you get back with some accrued interest (although technically this interest is investment income). The important point is that a stable net asset value money fund looks like and acts like a bank deposit.

But it isn’t. You are not making a deposit with a bank. You are investing in a fund which has no capital other than the funds that have been invested. There is just an investment manager (who may be a bank) managing the fund. Managing it very well and managing the fund within very tight parameters but not guaranteeing the value of the fund. This should not be a cause for alarm, however, as the underlying value of the assets should and usually does stay very stable. What happens in normal circumstances is that the underlying value of the assets just varies a few basis points around the nominal value of the investors’ funds. The variations are so small that they simply do not matter.

Unfortunately the regulators will no longer accept this argument. During the financial crisis several funds were supported by their managers and the regulators are seeking more clarity. The regulator’s position could be summarised as saying to the fund managers, “Either explicitly support the fund and put it on your balance sheet or make it clear to investors that, in a crisis, the net asset value may fall below par”.

The industry has responded with a variety of solutions including various forms of capital, subordinated shares, buffers and other forms of support1. These are all creative and sensible solutions but they will all need to be paid for. At a time of very low interest rates the margins in the business have already come under pressure. The investor will end up paying for whatever solution is pursued. The commercial risk is that the yield on money funds will end up being much less competitive.

The regulators will not give up on this. The risk they are asking the industry to address is easy to identify and they cannot be seen to be ignoring it. The fact that money funds performed comparatively strongly in the recent financial crisis is not enough. The regulators see it as a black and white issue. If a money fund is a banking product offering stable value, it needs tangible support. If it is an investment product it cannot be described as offering a stable net asset value.

Inevitably, as fund managers address this risk, the funds will end up being less commercially attractive to both the investors and the managers. The question is whether the stable net asset value money fund industry will be regulated out of existence, which would be a shame.