When money market fund (MMF) reform came into force for US and European markets (2016 and 2019 respectively), it was part of the ongoing response to the global financial crisis of 2007/08. In keeping with the perceived general need for systemic stability in financial services, banks have undergone a huge regulatory overhaul, notably around capitalisation. This is intended to help them withstand the worst effects of another crisis. It was natural that the reformers would focus next on the so-called ‘shadow-banking’ sector, of which money markets are a systemically important component.
A run on a MMF would create widespread contagion. Because Investors in a constant net asset value (CNAV) fund expected to get out that same £1 they put in, with interest; there was this inherent belief that the fund would be bailed out by its sponsor should there be a default. This bail-out was never guaranteed in writing. It seemed some parties on both sides of the agreement had forgotten that cash is not a risk-free asset. Regulators deemed this to be unacceptable and acted accordingly with reform.
The reform of money markets was lobbied for by key participants, including Aviva Investors. We had already changed our CNAV fund to VNAV (variable net asset value) in 2008, believing that CNAV was no longer a suitable model for our clients. Indeed, with assets fluctuating in value – floating rate notes were especially volatile during the financial crisis – the risk of realised losses (or even defaults) was real. Action was required.
The efficacy of the regulatory response is yet to be tested by market failure. However, a key element – the low volatility net asset value (LVNAV) fund, which saw Aviva Investors become the earliest adopter amongst established funds – incorporates a mechanism ensuring such funds remain open in times of extreme stress.
LVNAV funds have 20bps collar. If the fund moves up or down by more than this, it has to re-price and switch to a floating or variable net asset value. This is a conservative collar compared to CNAV’s 50bps. Even so, the simple facts speak for themselves: in the most stressed moments, a fund deviating by more than 20bps is incredibly rare. With LVNAV’s mechanism ensuring no closure is necessary, a run on a stressed fund is all but ruled out.
Furthermore, regulators have established strict guidelines on managing money market liquidity risk. Similar to the banking sector’s rules on capital adequacy that ensure robustness even in a liquidity crisis, MMF rules ensure funds have sufficient daily and weekly liquidity to meet investor redemptions.
For investor comfort, this may have been over-engineered. For LVNAV funds, daily liquidity must be at least 10%, and weekly liquidity must be at least 30%. Most short-term MMFs operate with 20% daily liquidity and around 35% weekly liquidity. To put this into context, redemptions in MMFs above 5% are incredibly rare, even in times of stress. The global financial crisis saw depositors queuing outside Northern Rock to retrieve their savings. This loss of confidence didn’t happen to Money Market Funds, as diversified pools of cash.
That the regulations have thrown light on the money market sector should be seen as a positive outcome. Prompted by the changes, investors are now asking more probing questions. At Aviva Investors, we can help them better understand how the market works and, as a result, manage their own risks more judiciously.
We know that some potential investors are averse to credit risk, choosing to invest most of their cash directly with their banks. Whilst bank regulation reduces the chance of default for systemically important financial institutions, this model does not provide risk-informed diversification.
For investors wishing to diversify risk away from bank-concentrated cash placements, we can explain how MMFs are a comparable platform. Indeed, they provide same-day liquidity, with robust safety mechanisms, in much the same way a bank deposit does, and possibly with enhanced yields too.
Additionally, new MMF regulations stipulate strict criteria for investment managers in terms of their credit quality assessments, performed by an independent team of credit experts. Clients don’t always have the resources available to manage such deep market analysis. So MMFs effectively create an inexpensive way for investors to leverage the fund manager credit expertise and diversify away from the concentration risk associated with a bank deposit.
With Aviva Investors, and other fund managers, committed to integrating environmental, social and governance (ESG) themes into our funds, there is a clear commitment to helping clients who may lack the resources to screen investments in this space too.
MMF regulations have come at a time when the financial sector needs more clarity and security. The market has responded positively, helping to build investor confidence in what was, frankly, already a robust proposition.