Cash & Liquidity Management

Money funds – what next?

Published: Oct 2007

If you are an investor in money funds or considering this well respected type of investment you should read on. Leading experts in the industry share their views in a frank discussion about where the industry is going. Topics discussed include the effects of Basel II, the possibility of formal regulation of money funds in Europe and changes in the rating agencies’ approach to money funds.


Portrait of Joanna Cound

Joanna Cound

MD – Cash Management Group

Portrait of James Finch

James Finch

Head of Liquidity Sales Europe

Portrait of Kathleen Hughes

Kathleen Hughes

VP – Head of Global Cash Sales EMEA

Portrait of Ian Lloyd

Ian Lloyd

Director Sales and Product Management Liquidity Funds

Portrait of Richard Norval

Richard Norval

Head of Global Treasury Fund Sales


Portrait of Richard Parkinson

Richard Parkinson

Managing Director

Richard Parkinson (TT): There’s been a lot of talk about Basel II in the last few years. Where are we on this and how is it going to impact users of money funds?

Joanna Cound (BlackRock): We believe it will have a significant impact on the ability of financial institutions to invest their balance sheet cash in money market funds. I think most of the industry is trying to think through how attractive money market funds will be compared to other asset classes and at what speed the banks will start investing in money market funds.

James Finch (BGI): Yes, that’s a fair comment, I think the thing with Basel II is that there’s still a lot of unknowns in terms of the application of it and how the individual banks themselves are going to adopt it.

Kathleen Hughes (JPMorgan): And even the individual banking commissions in each country don’t yet know how. They’re still being educated, they don’t know what their requirements will be under the two risk rating scenarios that banks can apply.

Parkinson (TT): So basically IMMFA has done its job. The lobbying has worked and you’ve got money funds approved as an investment with a 20% weighting like inter-bank deposits. Now you’re working on the detail of how it’s going to happen, not is it going to happen.

Cound (BlackRock): We’re working on it in two ways. We’re working directly with the underlying clients, but in terms of the regulation, we’ve won the battle at the EU level and now we have to work at the national implementation level – working with the prime regulators on how they’re interpreting the directives and how they’re looking to implement them.

Richard Norval (RBS): There’s a huge process of client and prospect education that we are undertaking. There are two aspects to this. The first is how we put this message across to our clients, that these are attractive investments and how do we get them to accept that at board level so that they can be added to a portfolio of instruments that they’re entitled to use. The second, which is where we’re starting to do even more work, is what do we have to do internally in terms of publication of fund data that we’re not doing at the moment. This is for those banks that want to meet the requirements of the IRB approach1 to risk rating their investment in funds.

Parkinson (TT): I guess this doesn’t bother a corporate investor though does it?

Norval (RBS): To a large extent, this makes funds more attractive to financial institutions and the by-product of that will be larger funds with more liquidity, a wider investor base and therefore more attractiveness to corporates. A corporate shouldn’t worry about getting the detail of the underlying assets in the fund. This is something the banks are going to have to go through simply to get it in the right bit of their balance sheet.

“It will have a very significant impact on the ability of financial institutions to invest their balance sheet cash in money market funds.”

Parkinson (TT): What are the banks going to be using it for? Their day-to-day liquidity? Isn’t that what you call ‘hot money’? Aren’t you going to have a lot of money flowing in and out of the funds?

Norval (RBS): Quite possibly yes. Having spoken in-depth to our money market teams, this isn’t the panacea that we all thought it might be. There are still huge issues, with the fund size, and issues with the cut-off time of the sterling fund. Having a fund that cuts off at one o’clock when your bank is trying to settle up positions at four o’clock in the afternoon, isn’t actually a great deal of help. It simply adds to the tools that the banks have at their disposal, but that doesn’t actually mean that you’re going to get a waterfall of cash flowing into funds as a result. But they do, inherently, become more attractive.

Ian Lloyd (Rabobank): Immediately, it is likely to be the banks with smaller treasury desks and less sophisticated risk systems who will be interested in money funds, as it gives them immediate access to a highly rated product with a low risk weighting. Under the new rules, placing cash with single A and AA banks may have higher risk weightings than a money market fund depending on the duration of the trade. So money market funds are a more viable option. The larger banks are unlikely to use funds in the same way.

Parkinson (TT): There are times when money fund rates are very attractive and there are times when money fund rates may be marginally less attractive. It strikes me that a bank will be very aware of these opportunities and will try to arbitrage the funds.

Finch (BGI): I think with all our clients it’s just an education process and this is, for us, another client type that is being opened up. You explain how the funds are structured, how to utilise them etc. I think in the majority of cases, we’ve been very pleased in terms of the way in which new clients treat these vehicles – because they know that by coming in and out of the funds on a large scale, they’re potentially damaging the yield for themselves if they want to come back in at a later point.

Hughes (JPMorgan): And the fund providers themselves should set limits in terms of, the actual maximum level of the investment any individual underlying client can make. That inherently is the prevention of having one client coming in and out and skewering the fund return.

“Funds are rated and abide by a code of practice but were relatively unknown by regulators in a number of EU countries. So IMMFA has been working very hard at getting triple-A rated money market funds recognised by regulators.”

Lloyd (Rabobank): Paradoxically, I’ve actually found that it’s our corporate clients who are more sensitive to rates. Our financial institutions client base has been far more stable.

Parkinson (TT): Why is that?

Cound (BlackRock): Because they’re seeking alpha elsewhere. What they’re seeking from their cash is first of all capital preservation, then liquidity coupled with a decent yield. They worry about ten or twenty basis points, not two or three.

Norval (RBS): What’s the point? It really makes a very small impact on an overall basket return.

Parkinson (TT): What has IMMFA (Institutional money market funds Association) been doing recently?

Portrait of Joanna Cound
Joanna Cound

Cound (BlackRock): Well IMMFA has had a very good 12 to 18 months and most of it is on the regulatory side. We’ve talked about Basel II already and then there’s MIFID (the Markets in Financial Instruments Directive), which, for the first time, is opening up client money – an area where money market funds have never been allowed to be used; funds are now the equivalent of bank deposits. Money market funds have also been recognised by CESR’s (The Committee of European Securities Regulators) advice to the European Commission. This is of fundamental importance for corporate investors as well as financial institutions. This means that amortisation has been recognised in UCITS (Undertakings for Collective Investment in Transferable Securities) legislation, which is fundamental to having a stable NAV (Net Asset Value) fund. When the legislation first came out in consultation form, the ability for amortisation was drastically reduced and that would have eradicated the whole of the stable NAV money fund business in Europe in a single stroke.

A potential threat was turned into an opportunity. IMMFA Funds are rated and abide by a code of practice but were relatively unknown by regulators in a number of EU countries. So IMMFA has been working very hard at getting triple-A rated money market funds recognised by regulators. When CESR put out their first consultation paper, we said that what they were proposing would wipe out our industry and so we worked with them, the Irish regulators and others to get amortisation written into UCITS, which now means that our funds are recognised and that straight line amortisation of income is a recognised valuation method throughout Europe. This helps both the clients because they can say yes it’s recognised by regulators, but it also means that a lot of asset managers who are managing enhanced funds for example, can see that rating is now a valuable thing in legislation. So you’re seeing continental European providers starting to rate their funds as well, which is helping the whole of the industry – both AAA-rated funds and enhanced funds.

Lloyd (Rabobank): One of the things I’ve seen when speaking to potential clients in continental Europe is that many are not aware of IMMFA. When explained, it tends to give them a higher level of comfort and differentiates the product a little from the many non-IMMFA providers in the market. IMMFA is made up of 20 or 25 providers of solid, good money market funds who actually meet on a regular basis.

“The by-product of that will be larger funds with more liquidity, a wider investor base and therefore more attractiveness to corporates.”

Cound (BlackRock): All IMMFA member firms adhere to a code of conduct that must be recertified annually and provides more detaield guidance to members on process.

Finch (BGI): Part of the education as we go into the new markets is discussing the best way to reflect money market funds within a corporate treasury policy. Whilst the corporate might currently limit bank deposits per counterparty with a fixed amount, say €100m, when using money funds, they should limit exposure as a percentage of fund size, say 10%. By using a fixed currency limit, you can actually increase risk by forcing yourself to add more and more money market funds as your cash balance increases.

Hughes (JPMorgan): And also the fact that a fund is separate from the provider’s on balance sheet bank deposits. It’s making that distinction that is important.

Parkinson (TT): Isn’t there a danger that you end up with a more grossed-up exposure than you think you have because all the funds are investing in the same underlying assets?

Lloyd (Rabobank): This issue came up with a client we saw recently who is just changing the whole structure of their treasury operations. They were interested in creating a fund of money market funds for their internal cash and they wanted to use at least eight providers. Firstly, we suggested they look at the IMMFA providers. We also consulted the rating agencies to see if rating a fund of money market fund was viable. They said this is very difficult because funds tend to buy the same investments and the client could become extremely exposed to one particular underlying issue within the portfolio. So we advised them against adding more than about five different providers and even then it is going to be difficult to look through and see the potential exposures – even if we start providing portfolio holdings lists.

Parkinson (TT): Can we talk some more about regulation of money funds. You’ve all been saying that various pieces of legislation are coming and you’ve lobbied and made sure they are money fund friendly, but what about actual regulation of money funds? Where are we on that?

Cound (BlackRock): We’ve drafted a consultation paper that we’ve discussed with regulators in Ireland and Luxembourg. Now we’re in the process of setting up meetings with a range of other regulators to try and find out what their views are; what the pros and cons are and then we’ll take it from there. So we’re in the midst of considering whether we should move to local regulation or not at the moment.

Lloyd (Rabobank): I think there is now more appetite from the fund providers to accept a regulation that gives us a 2a-7 style badge that we can use. Not that I’ve come across a huge number of corporates who think it really matters, but if it can be done without compromising your investment policy, without comprising the way in which you manage your funds, then there is a grudging acceptance within the money fund providers community, because it ticks a lot of boxes that might be in somebody’s treasury policy.

Cound (BlackRock): All the lobbying was a phenomenal amount of work, but definitely worth it!

Hughes (JPMorgan): Yes, the improvement is more on the lobbying side than on the corporate treasury side – we’ve never run across a corporate treasurer that said, ‘oh I can’t buy this fund because you know there’s not a 2a-7 badge on the fund’.

Finch (BGI): I think the other overlay is that the providers themselves should self regulate in terms of the actual policies and procedures they have in-house. That’s the final link in the chain really. So you have rating agencies, the UCITS Directive, the prospectus and then the individual policies which each fund manager should be adhering to.

Parkinson (TT): But the real independent teeth in all that is the rating agencies. What are they doing, what changes are we going to see with the rating agencies?

Hughes (JPMorgan): Well, we’ve seen more funds that have traditionally been unrated seeking AAA ratings – that’s one trend. Another is that they’re always looking at new securities. One of these is extendable notes and CP (Commercial Paper). It’s a big market in the US, it’s very liquid and it’s proven. It’s less developed over here, but I think it’s a chicken and egg problem & as it won’t become a bigger market until you know more funds are buying these instruments. So I think Moodys recognises it in the US, it’s a proven market and I think we’ll see it become more significant here.

Parkinson (TT): Now let’s define what we’re talking about here, we’re talking about instruments that, at the borrowers request, can be extended for a further period?

Hughes (JPMorgan): Yes and the investors can put it back or they can extend it. It’s usually issued with maybe a five year plan maturity and the first maturity is 13 months so to be suitable for the funds that can invest in 13 months paper. We’re looking at how that fits the Moody’s matrix right now, but it’s only going to be a very small percentage of the portfolio, so we’re not talking about a large amount of money piling in.

Portrait of Richard Norval
Richard Norval

Norval (RBS): I think a lot of the funds are approaching a common view. Previously having more than one ratings agency could well have cost you some yield. That’s because the rating agencies view your funds fundamentally quite differently, depending on which rating agency you were rated by. However, my instinct is that there is a degree of convergence about rating agencies’ views on how a fund should be rated.

Cound (BlackRock): S&P and Moody’s had differing views on money market funds and their investment in ABS (Asset-Backed Securities). Moody’s allowed funds to invest up to 10% of the portfolio in ABS with a four-year average life, whereas S&P rules stated a two-year legal final date.

Lloyd (Rabobank): That was a difference on yield, a few basis points of performance.

Cound (BlackRock): And then Moody’s went through a very large consultation process and they’ve now amended it, where they have introduced an ABS matrix, which depends on various things: whether the security is AA or AAA rated, what type of instrument it is and how long it’s going out – based on that you can put in different percentages. So, this way of evaluating the ‘risk’ of a fund has become stricter.

Norval (RBS): So there’s been a move towards increasing the number of ratings agencies that rate your funds.

Parkinson (TT): Ian, you are only rated by S&P?

Lloyd (Rabobank): We haven’t had any specific requests for ratings from any other agencies. If we get a request we will consider adding another rating agency.

Cound (BlackRock): S&P is more restrictive on ABS, but it’s more flexible in other areas.

With us, when we carried out analysis on this with our client base, we wondered whether we should go for one, or if we should go for two or even three! We talked to our clients and it was just short of 50% who said they needed dual-rated funds owing to their investment policies.

Hughes (JPMorgan): A lot of corporates do require that and there are certain clients who require Fitch as well. If it’s important to the client, it makes sense economically.

Finch (BGI): I think it’s just as important that the individual managers themselves have a credit process, so that they’re not taking the views of the rating agencies as the holy grail and they’re doing their own due diligence on the underlying instruments that are being put into the portfolio. I think sometimes our whole market is maybe doing itself a slight disservice by talking about these funds as a commoditised product which can be selected simply on a fund rating. What we should do, is actively encourage clients to spend more time understanding the investment process and how much effort we put into credit analysis. You can find broad differences between money market funds by how much resource they have dedicated to it. Credit agencies should not be the sole provider of influence with regards to the instruments in a portfolio.

Cound (BlackRock): Not all providers of money market funds have internal credit analysts. The credit analysts produce approved lists that are more conservative and reduce significantly the universe of securities the fund manager can invest in. Practically everyone around this table would be able to say that of any security downgraded, we pulled it off our approved list months before the rating agency action.

“This is exactly why an investor should understand the provider, the credit research process and how their approved list is derived.”

Norval (RBS): I think with the larger providers, you won’t find that level of differentiation, but I think what it comes to is the understanding of what the actual management of these underlying funds is.

Another topic which we should probably talk about is portals. An area of interest for corporates is as you remove the level of dialogue between the corporate and the underlying asset manager – ie by trading through a portal – you can have a tendency to reduce that level of conversation on that very important topic. That’s a key point where I see that with investor education you may lose that level of dialogue, because you’re not speaking to the client!

Portrait of Ian Lloyd
Ian Lloyd

Lloyd (Rabobank): There’s a whole bunch of assets that we could comfortably purchase and maintain the fund’s AAA rating, but these don’t pass the strict criteria set out by our credit research department.

Norval (RBS): There’s a couple of providers who would buy those particular instruments.

Lloyd (Rabobank): This is exactly why an investor should understand the provider, the credit research process and how their approved list is derived – and the process around an issuer being added or removed.

Parkinson (TT): But there’s an underlying premise here that therefore the other ones are riskier?

Lloyd (Rabobank): I think a lot of corporate investors look at the name that’s standing behind the fund. A lot of corporate clients will want to take comfort in the size of the organisation and the standing of the organisation that’s promoting that fund.

Parkinson (TT): What’s going on in the portal’s space?

Finch (BGI): It’s a function of what’s happened already across FX and depo markets. The clients want simplicity and they want to be able to access a number of providers in a straightforward way.

Cound (BlackRock): Trading via portals has become very popular in the US and is becoming increasingly popular over here. It’s much, much smaller at present, but we would expect it to go the same way.

Norval (RBS): It’s only ever going to appeal to a certain slice of the clients, those who are comfortable dealing online, comfortable dealing with a third-party potentially between themselves and the final fund providers. I think it’s funny that the portal providers are literally telling me primarily that corporate clients may use two or three funds. My feeling is that ultimately, they will have more success with financial institutions who could be dealing on behalf of 20 or 30 different counterparties, where actually them being able to log on to a site and place and invest on behalf of the 20 or 30 accounts that you’re managing does genuinely save you time. If you’re a corporate and you’re dealing with one or two funds consistently and you place money once a week, then right now, is a portal going to bring you a great deal of advantage?

“The term ‘enhanced’, can really be anything. All of our enhanced funds have diff erent benchmarks, diff erent guidelines etc.”

Hughes (JPMorgan): And portals are all different. Some come in through an omnibus relationship so you don’t know who the underlying client is and for a corporate client that’s sometimes not attractive. They want their bank to know that they’re actually using the funds, having monies in the funds, placing monies in the funds. So whether its disclosed or undisclosed can make a difference as well.

Finch (BGI): We’re on a select number of underlying portals and it’s on the back of client requests. I think that’s the important point – just listening to the underlying clients and helping them facilitate how they want to trade. Certain clients want a direct relationship and some clients want to trade through portals. If you provide a number of options, that can only be good for the clients – it just gives them choice.

Parkinson (TT): Is IMMFA going to do something in this space?

Cound (BlackRock): It’s not been discussed yet.

Parkinson (TT): Enhanced funds, super funds, whatever you want to call them, what’s going on in this space?

Portrait of Kathleen Hughes
Kathleen Hughes

Hughes (JPMorgan): Its a big catch-all term really. I think the one thing to point out is that AAA funds, because of the nature of the rating, all look similar in the sense that they use the same benchmark, the same restrictions. The term ‘enhanced’, can really be anything. All of our enhanced funds have different benchmarks, different guidelines etc. So I think it’s a catch-all term which can mean a variety of different things, but certainly I think they’re gaining in popularity for a bunch of reasons. They’re not cash, they’re really the first step to short-term bond funds. But they do make a nice compliment to AAA funds if you can determine you’ve got some cash that’s got a longer investment horizon and is a bit more stable.

Norval (RBS): If you spoke to 10 clients about what they wanted from an enhanced cash fund, you’d get 10 different answers, you’d get 10 different performance regimes, you’d get 10 different liquidity requirements and you’d get 10 different credit requirements. So in fact, all you can ever do as a provider of an enhanced fund is try and blend something that appeals to most of the client base that you are going to. An enhanced fund is never going to appeal to all of your clients. And the second problem is that at certain points during any interest rate cycle, there is a strong possibility that your enhanced fund is going to be under performing your AAA fund and so morally – and from the point of view of client service – your best advice to your client is actually to redeem from that enhanced fund and place that money to the same-day fund which, is of course, exactly what the fund doesn’t need at that particular point in the cycle – it needs more cash coming in.

Finch (BGI): We’ve seen strong demand from corporate investors for our enhanced funds. These funds are still focused on preservation of capital and are rated –AA or above, so fit with their treasury policy in terms of bank counterparty risk. The main point is that this is a longerterm investment, not a cash fund. There are times in an investment cycle when it will under perform, but over the cycle, you should see a yield benefit from these vehicles. Clients who understand this have been very positive and we’ve seen a tremendous amount of growth from corporate clients in these funds.

Norval (RBS): I think the holy grail for the corporate client is something that gives them a AAA type fund, yield plus 50 basis points for example. There are times in the yield curve environment when it is nigh on impossible to achieve this out performance of a AAA rated fund with minimal additional risk.

Parkinson (TT): Looking to the future, what’s going to be going on?

Norval (RBS): Five years from now I would expect to see less providers than there are at the moment.

Finch (BGI): We will also see further interest from the corporate pension funds due to shifts in the way they invest to match liabilities.

“What we’re seeing now, due to LDI mandates, is a big increase in absolute levels of cash to collateralise the swaps.”

Parkinson (TT): So this in relation to liability driven investment (LDI)?

Cound (BlackRock): Yes, and you need to have something like a money market fund or an enhanced fund to produce the returns for the swap.

Portrait of James Finch
James Finch

Finch (BGI): We’ve always had corporate pensions using money market funds for the 4% to 5% of residual cash in the portfolio, but what we’re seeing now, due to LDI mandates, is a big increase in absolute levels of cash to collateralise the swaps. So a pension fund could see cash levels rise to a very significant level and in this environment, its management becomes a very important consideration.

Hughes (JPMorgan): If you ask a corporate treasurer what their main concern is, on their list is pension under funding, because the rating agencies are putting the liability back on the balance sheet. So it’s inhibiting the corporates ability to raise cash or finance something. So they’re paying big attention to that and increasing their expertise – so in some way we could see a corporate familiar with funds and the use of funds increasing.

Finch (BGI): Also, because of the length of a pension funds time horizon, it lends itself more towards enhanced funds as well.

They’re generally not using money market funds for short-term cash flows, these are long-term multi year ones, so the development of specific LDI cash vehicles or enhanced funds fits squarely in that type of conversation.

Parkinson (TT): Any final comments on where the fund industry is going?

Lloyd (Rabobank): I think you’re going to see some local currency funds emerge. Chinese Yuan and Japanese Yen funds have been set up by a few providers. You will see more providers enter these markets especially Yen as interest rates begin to rise in Japan.

Finch (BGI): One of the important considerations for corporates will be in terms of the liquidity available from these new currency funds. They may offer next day liquidity rather than the same-day if they’re managed out of London, but yes new currencies definitely. In short, wherever there are big pools of cash, you’re going to find new funds emerging. So there’s a theme – new currencies.

Parkinson (TT): Thank you.

  1. Editorial note: IRB risk rating involves looking through the fund ‘wrapper’ and risk rating the underlying investments.

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