Amid a time of great upheaval, this section will look at what the future holds for the short-term investment environment in Europe and the US. Will ‘lower for longer’ interest rates in Europe turn into lower forever? Will MMF reform drive corporate investors into new liquidity products? And as they continue to respond to market pressures and far-reaching regulatory reforms, will the banks ever be the same again?
State of the money markets
In recent years the global economy has faced many headwinds: the flaring of geopolitical tensions in Eastern Europe and the Middle East, the slowdown in China and, not to mention, the UK vote to leave the European Union (EU). In this uncertain environment, corporates across the globe have understandably cut back on investment and built up their cash reserves.
Having deteriorated considerably in the wake of the financial crisis, money market conditions generally remain challenging. Post-crisis, the markets have had to adapt as a result of accommodative monetary policies and the introduction of regulatory reforms designed to improve the resilience of the global financial system. The result has been a combination of historically low yields, and a decline in liquidity that has hit fixed income markets particularly hard.
In the US, at least, the outlook is looking somewhat more positive. The Federal Reserve began unwinding its quantitative easing programme in 2014, before raising the interest rate in December 2015, to 0.25%. In Europe, however, yields remain deep in negative territory. Driven by the European Central Bank (ECB) commitment to monetary easing, yields on 99% of all Eurozone sovereign debt with a maturity of less than one year are negative. Overall, the universe of negative yielding government debt reached $12trn in the aftermath of the UK’s decision to leave the EU.
Amid tensions between reduced supply of and rising demand for liquidity, conditions in the money market do not seem likely to pick up in the near future. In terms of demand, primary bond issuance has grown considerably in recent years. Meanwhile, at the supply end of the equation, adjusting to new regulation, especially the ongoing implementation of the Basel III accords, remains a high priority for banks and dealers who have responded by lowering market-making capacity.
Finally, as they endeavour to comply with the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), banks are increasingly looking to become less reliant on wholesale short-dated funding as a source of finance. This has translated to a reduction in the supply of short-dated issuance and further pressure on the yield at the short-end of the curve.
MMF regulation
Regulators in the US and Europe responded to the events of the 2008 financial crisis, which saw the $62.5bn Reserve Primary Fund break the buck, by introducing reforms in 2010. These were followed up by the Securities and Exchange Commission (SEC) and European Commission (EC) both publishing new regulatory proposals for MMFs in 2013. Three years on since those proposals were first tabled, the new regulatory environment is beginning to take shape in the US. While progress has been made in the EU, meanwhile, the final rules are still being negotiated.
The US: a new dawn
New enhanced MMF regulation came into effect in the US in 2016, with the long awaited implementation of amendments to Rule 2a-7 of the Investment Company Act of 1940.
Already we are beginning to get a sense of the extent to which the industry will be reshaped by the new rules. With institutional prime MMFs prohibited under the new regulation from preserving the value of their investments at $1 a share and being permitted to impose fees and gates, there were noticeable outflows from prime ahead of full implementation of the regulation in October 2016. A significant portion of the liquidity that left prime funds ended up in government MMFs which, under the provisions of the new regulation are able to maintain a stable NAV. As a result of this shift in investor preference, government MMFs eclipsed prime funds for the first time in February 2016.
The shift in assets under management (AUM) from prime to government MMFs witnessed in advance of the rule change was driven by two factors. Speaking in July 2015, Roger Merritt, Managing Director, Fitch Ratings, said that much of the outflows seen earlier in the year could be accounted for by fund complexes proactively converting their prime funds to government funds in anticipation of that product being in greater demand from institutional investors in the new regime. But as the implementation date drew ever closer, investors also began to migrate. “We have seen some obvious small but steady outflow from prime funds over the last three to four weeks,” said Merritt. “Most people think that will continue and, perhaps, accelerate going into the third quarter.”
But the shift into government funds may be only an ephemeral feature of the new regulatory landscape. Not all prime funds are choosing to convert into government funds, and some asset managers, like HSBC Global Asset Management, are adamant that there will continue to be demand for prime products amongst institutional investors now they have been converted to VNAV. Some, perhaps, will be surprised at how little volatility there is in VNAV funds. Analysis of market data performed by HSBC GAM to consider how four hypothetical MMF portfolios would have performed between January 2001 through to January 2016 found only negligible NAV movements in the funds.
“I think a lot of investors would agree with the idea that we are putting forward that there is still value in these products,” says Barry Harbison, North American Head of Liquidity Product, HSBC GAM. “Our analysis shows that the NAV is not likely to move as much as some previously considered,” he says. “Even in that worst-case scenario, in which we considered taking the maximum duration permitted across the entire period we analysed, the average price fall was still around a basis point.”
The big question confronting corporate treasurers now that the regulation has taken effect is whether the additional yield available in prime funds offsets the various challenges posed to them by the new rules. Already the additional liquidity that migrated into government funds over the course of 2016, has lifted demand for short-dated treasury bills which has, in turn, weighed on yield. For those in a position to tolerate a floating NAV and the potentiality of fees and gates in stress scenarios, there will be incremental yield in prime MMFs that investors can capture.
But treasury systems may well need to be updated, and investment policies recognising only CNAV MMFs amended (however, asset managers say it is more common for investment policies to refer to 2a-7 MMFs, meaning no such update would be required). Ultimately, the decision around whether to switch to a government MMF or prime will come down to investment objectives. “MMF reform in the US represents a sea change in terms of corporate cash management,” says Fitch’s Merritt. “Treasurers had a product before in the form of the prime CNAV MMF that essentially met all their objectives. Now such a product won’t really exist, and so they will have to sacrifice something going forward.”
Europe: nearing the finish line
Though the EU began drafting its new rules at broadly the same time as the SEC, procedural differences between the two regulators has meant that progress in Europe has been less expedient than in the US.
In June 2016, the Council of the EU agreed its position on MMF regulation, building upon both the original proposal of EC, and the position of the European Parliament (EP). This latest text retained some notable aspects of the EP’s position. The text proposes that CNAV MMFs can continue to operate only by investing in public debt or – as proposed by the EP – by converting to a new, still hypothetical product, called a Low Volatility (LVNAV) MMF. Whereas the EP’s text included a five-year ‘sunset clause’ for LVNAV MMFs, the Council instead proposed an open-ended review of the product within five years. Also in accordance with the EP, the Council chose not to back the EC’s widely criticised proposal of a 3% capital buffer for CNAV MMFs.
The Council’s compromise proposal was largely welcomed by the asset management industry. “The concept of the LVNAV retains many of the key attributes that compel corporates to use CNAV MMFs today,” says Beccy Milchem, Director, Head of International Corporate Cash Sales at BlackRock. “In essence, the look-and-feel of the product is quite similar to what corporates are used to in the stable NAV world, with daily liquidity and an AAA rating. We certainly feel it is a good proposition.”
The final trialogue negotiation between the Council, EC and EP remains ongoing at the time of writing. Should the LVNAV proposal survive in its current form, Blackrock say they would entertain the idea of including it in their line up to offer clients, along with government CNAV MMFs and VNAV MMFs. Other asset managers are also of the opinion that the LVNAV now looks like an appealing proposition. “It is structured in a way that I think will be attractive to many investors in CNAV prime funds today without being a CNAV MMF,” says Jonathan Curry, Global Chief Investment Officer, Liquidity, with HSBC Global Asset Management. “If it is implemented in the form that has been proposed by the Council then I would say there is a strong possibility that we would look to establish one in Europe.”
However, it would be mistaken to conclude, just because aspects of the Council’s proposal line up with the EP text, that those proposals will be included in the final text negotiated in trialogue. After all, a common agreement still needs to be found between the three positions. The elephant in the room is that the EP wants a sunset clause applied to LVNAV MMFs, a provision opposed by much of the asset management industry. But as Carey Evans, Director, Public Policy at BlackRock, explains, that raises the question of what the EP will receive in order to give up that position.
“If you started this discussion on the premise that you did not want CNAV MMFs persisting, then ruling out government CNAV MMFs altogether might seem like a more politically-attractive trade,” he says. “Whereas our opinion would be that a workable government CNAV MMFs should be off limits in the discussion on the LVNAV.”
The rules regarding liquidity management have also yet to be resolved to the industry’s satisfaction. The current set of rules around how funds must hold liquidity has been deemed too prescriptive by asset managers who say they require more flexibility to actively manage liquidity.
“Maintaining high levels of liquidity is a key challenge for money funds, and a prerequisite for achieving a AAAmmf rating,” says Alastair Sewell, Regional Head of Fitch Ratings’ Fund and Asset Manager Group for EMEA and APAC. “The liquidity profile of government funds is typically stronger than that of ‘prime’ funds, by virtue of the fact that they predominately comprise of government securities. But with banking regulation having an impact on the availability of short-term funding, the ability of prime funds (investing primarily in non-government securities) to maintain high levels of liquidity and to diversify effectively could be a challenge in the future.”
There are several steps corporate treasurers will need to make in preparation ahead of implementation. First and foremost, asset managers are encouraging treasurers to review investment policies on a more frequent basis and introduce a greater degree of flexibility into such documents. It would also be advisable for treasurers to begin familiarising themselves with the three different structures on the table. Each will have different implications from a yield and an operational perspective, and it makes sense for treasurers to get an understanding of these before change becomes mandatory.
Brexit: a game changer?
It is also important to note that the trialogue negotiations are taking place in the context of a highly politicised environment following the ‘Brexit’ vote in the UK.
Indeed, the final outcome of the negotiation could be contingent upon how the politics of Brexit play out as the negotiations proceed. For example, Nina Gill, the lawmaker responsible for overseeing the regulation in the EP is a UK MEP. Understandably, this has raised a few questions in Brussels in the wake of the EU referendum result in the UK.
“The politics of Brexit will almost certainly come into play somehow,” says BlackRock’s Evans. “The UK has been a very strong voice at the negotiating table to date, and the loss of influence will undoubtedly be felt. Equally, UK MEPs have played a very central role, and prolonged uncertainty over their position in the Parliament and within their political groups may change the dynamic of the trilogues discussions considerably.” Some in Brussels have predicted that legislative negotiations featuring so-called ‘third country issues’ (access to the Single Market by firms in non-EU countries) could become politically-charged and difficult to progress until the direction of the Brexit negotiations become clearer. While the MMFR does not have obvious third country issues, the concept of a government CNAV MMF, as it is constituted in the EP text, is restricted to only EU currencies – a classification that may not capture sterling in the future. While this restriction is not present in the Council text, it could become more politically charged depending on the political dynamics of Brexit.
The pivotal moment could come when the UK finally triggers Article 50 of the Lisbon Treaty, thereby officially beginning exit negotiations with the EU. At that point, there would obviously be legitimate reasons to ask UK MEPs like Gill to stand down from negotiation, given that they would be negotiating rules that, in theory, the UK would not itself be implementing.
Aside from the political implications, the impact of Brexit on MMFs in the near term is less of a concern. In fact, given the higher risk aversion resulting from the referendum result has led to some corporate capital investments being postponed, low-risk, highly liquid investment products such as MMFs have seen increased asset inflows in the weeks following the referendum. Offshore MMFs denominated in US dollars have, for instance, attracted $24bn since the Brexit vote.
In the long run, the outcome of discussions between the UK and the EU could in the medium to long-term have some quite profound implications for the MMF industry, particularly for the large numbers of sterling money funds currently domiciled in Ireland.
“I think a lot is going to depend on whether there will be continued passporting for MMFs into Europe,” says Dennis Gepp, Federated Investors’ Managing Director and CIO, Cash. Federated Investors is in a slightly different position than some of its peers in the IMMFA universe that have their sterling MMFs domiciled in Dublin and Luxembourg, Gepp explains. “They may have difficulty putting their products from Europe back in the UK,” he says. “We are in the opposite position. The question for us is whether we will be able to distribute our Sterling products into Europe. But given that the vast majority of our sterling clients are UK-based I would say it is not such a major issue for us.”
As it currently stands it remains, however, very unclear what implications Brexit will have for the UK’s participation in the passporting scheme. There are, for instance, already a number of non-EU funds that are using the UCITS scheme to market their funds in the EU.
The banks
Regulatory pressures remain
Although much progress has been made over recent years, implementation of the Basel III accord is still ongoing. Some banks have taken a more proactive approach to implementation: the LCR for instance, only has a deadline of 2016 for 65% adherence, and full implementation of the regulatory framework will not be completed until 2019.
Nevertheless, in January 2014 European and US banks started to report under the new regulations and some banks are choosing to follow the rules sooner than required. Already this is having an impact on the banks’ appetite for certain types of deposits. This is because under the LCR, banks are required to maintain sufficient high quality liquid assets (HQLA) buffers to ensure they can meet their liquidity needs in a 30-day stress scenario. As a result, the benefits of non-operating deposits for banks often no longer outweigh the associated costs.
Given that deposits categorised as non-operating have become less attractive to the banks under the LCR, the Basel III framework has played a part in driving cash off balance sheets and into alternative investment vehicles, such as MMFs and Separately Managed Accounts (SMAs), for instance. Even those deposits that do meet the Basel III criteria for operating cash balances could be considered to be an “operating excess balance” and unattractive, therefore, to the bank to hold.
Reflecting this new paradigm, results from J.P. Morgan’s Global Liquidity Investment PeerViewSM Study show that almost half (47%) of respondents planning to reduce bank deposits reported that their banks had encouraged them to move non-operating deposits off the banks’ balance sheet. The trend is even more pronounced in the Americas and Europe, where the percentages being encouraged to move cash off the banks’ balance sheet were 63% and 61% respectively.
Ratings: nearing the bottom?
Despite the recent improvement seen in their credit fundamentals, the banks continue to be subject to downward pressure on credit ratings. The trend has resulted in treasurers being left with a smaller panel of banks that meet the criteria set out in treasury investment policies.
In December 2015, eight big US banks were downgraded by Standard & Poor’s, reflecting the credit rating agency’s assessment that the likelihood of state support in a future crisis had diminished. European banks are under even greater ratings pressure. Again noting the decreased likelihood of a government bail-out in a future crisis, both Standard & Poor’s and Moody’s have downgraded major European banks by three to four notches between 2007 – 2013, according to research conducted by J.P. Morgan Asset Management.
The change in thinking around the likelihood of state support largely stems from regulatory change, in particular the EU’s bail-in regime that states bondholders should absorb losses first, making a government bail-out the last resort. Europe’s bail-in regime, which became fully operational in January 2016, has led ratings agencies like Moody’s and Standard & Poor’s to modify their bank rating methodology to reduce levels of government support.
And while credit fundamentals have stabilised for European banks recently as a result of tighter regulation and a modest pick-up in credit demand, the resultant uncertainty of the UK’s vote to leave the EU has fuelled fresh concerns about the banks’ long-term health and sent share prices across Europe plunging. As of August 2016, Moody’s has changed its outlook from stable to negative for eight banks, while Standard & Poor’s has placed the German lender Deutsche Bank’s credit rating on review, citing, amongst other factors, the outcome of the Brexit vote.
Arguably, the downward pressure on bank credit ratings makes the diversification and professional credit expertise offered by MMFs an all the more valuable option to have. The majority of corporates today typically have very slim resources allocated to credit assessment, and Europe’s bail-in regime has had made such assessments even more complex. In such conditions, outsourcing such assessments to a third-party whilst diversifying away from single issuer risk would appear to make a lot of sense.
The corporate investor
As the short-term investment environment continues to evolve, the impetus on corporate treasurers to change their thinking around short-term investments grows ever greater. This process of adaptation appears to be already well underway.
Facing historically low – sometimes negative – yields, treasurers are reconsidering both their appetite for risk and their needs for short-term liquidity as they look to segment cash and allocate some of it to products with longer investment horizons. Whilst the traditional investment objectives of preservation of principle, liquidity and competitive short-term yield remain the same, asset managers are now noticing a change in the way clients define those objectives.
“When we think about preservation of principle, previously I think a lot of corporate treasurers would interpret that as not losing money from one day to the next,” says Jason Straker, Client Portfolio Manager, Global Liquidity Group, J.P. Morgan Asset Management. “I would say that has really evolved so we increasingly see the inclusion of an investment horizon in policies. Instead of merely looking at one day to the next, treasurers are perhaps looking at one, three or six months.”
Reflecting this change in mindset, many treasurers are also considering making updates to their investment policies as they begin to look at alternatives to bank deposits and CNAV MMFs. Products previously unfamiliar to many corporate cash investors, such as VNAV MMFs, repurchase agreements (repo), and short-duration bond funds are a key focus of such reviews. This shift towards less traditional products is reflected in the results of J.P. Morgan’s Global Liquidity PeerViewSM study. The survey reports large increases and decreases planned in the year ahead for every type of cash investment. A quarter of respondents with balance sheets between $500m and $5bn are now considering SMAs, for example, and net increases to these vehicles rose 11% and 10%, respectively, in 2014 and 2015.
“A lot of treasurers are opening up accounts and establishing the ability to use a whole variety of different investment options – even if they don’t necessarily plan on using them initially,” says Straker. “They would like to have the option of, say, trading repo or investing in VNAV MMFs. It really boils down to the risk tolerance objectives, but particularly when thinking about VNAV or short-duration bond funds we would recommend some due diligence so that the treasurer understands how the product is managed. These products need to be looked into a little bit more because one does not get the same level of confidence from the ratings agencies as with AAA-rated MMFs.”
Most investors will continue to invest in CNAV MMFs for as long as they remain available. However, treasurers understand that in both the US and Europe regulation is coming that is going to radically alter their investment options – and now is the time to prepare.
