High inflation, rising interest rates, banking turmoil – today’s investment landscape comes with a whole new set of challenges. So where do money market funds stand in this environment? How are investors and MMF providers responding to the latest market conditions? And could further regulatory reform be on the horizon?
It’s no secret that the last three years have brought numerous headwinds, from the beginning of the COVID-19 pandemic in 2020 to soaring inflation and the recent collapse of Silicon Valley Bank (SVB). All of these have brought challenges for investors.
“Investment involves making choices under conditions of uncertainty,” says Alastair Sewell, Liquidity Investment Strategist at Aviva Investors. “While that will never change, there are peaks and troughs of uncertainty.” Currently, he says, uncertainty is high: “The effects of the rapid pace of interest rate hikes are being felt. A recession could be around the corner. Major banks have had to be rescued. Even the gilt market came briefly unstuck. These are not easy investment conditions.”
On the other hand, notes Sewell, the increase in rates mean that investors are benefitting from materially higher yields on their cash holdings compared to the last ten years. “This offers great opportunities for astute investors,” he adds.
Flight to quality
So how have money market funds (MMFs) fared during the recent turbulence? Despite market stress in March 2020 and September 2022, says Sewell, “MMFs functioned as normal. Redemption requests increased, some portfolio security valuations were affected, but MMFs successfully preserved capital and provided liquidity. They also maintained their ‘quick’ ratio of short-term assets to short-term liabilities and all other regulatory-required tests.” (While the quick ratio does not feature in MMF regulation, notes Sewell, “the concept is applicable.”)
More recently, the sudden collapse of SVB in March 2023 led US investors to re-examine their small and medium sized bank exposures, prompting withdrawals from bank deposits. It also caused reverberations in Europe, leading to volatility in the banking sector, which contributed to the forced merger of Credit Suisse and UBS. “As apparent vulnerabilities in the banking sector were exposed, concerned investors turned to MMFs as an alternative to the bank deposits, resulting in inflows into money funds,” says Veronica Iommi, Secretary General of the Institutional Money Market Funds Association (IMMFA).
Indeed, Iommi points out that the IMMFA MMF industry in Europe experienced inflows during March 2023, “which is a testament to their being perceived as a safe haven in times of crisis.”
“It’s no surprise that during times of stress, we see a flight to quality – and the recipient of that flight to quality oftentimes is a money market fund or a fiduciary manager,” comments Jim Fuell, Head of Global Liquidity Sales, International at J.P. Morgan Asset Management. “We’ve certainly seen a significant flight to money market funds in the US, where there’s a substantial platform of government-style MMFs – and we’ve seen some of that in Europe as well.”
In the US, more than US$286bn flowed into MMFs in March, according to data provider EPFR.
Impact of current market conditions on investors and MMF providers
Beccy Milchem, Head of EMEA Cash Management, BlackRock:
“MMFs operate under a strict regulatory framework designed to ensure they can provide liquidity when required and manage duration risks prudently through short weighted average maturity (WAM) restrictions. Over the past 12 months, amidst rapidly rising interest rates and market uncertainty, MMFs have typically shortened duration to be substantially within the WAM limit, and held much higher levels of overnight and weekly liquidity so as to be well positioned to capture further rate hikes.
“Following the period of zero and negative interest rates that preceded the last year, investors have typically been more proactive with cash management strategies seeking to take advantage of higher yields. However, navigating the timing and duration of investments has proven difficult, with many investors ending up in investments that are trading below the market rate. More recently, concerns have arisen over concentrated bank deposit holdings and a desire to spread that risk over a number of counterparties.
“While market uncertainty remains, short term MMFs continue to be a popular choice for investors as alongside providing diversification and daily access benefits, they are positioned to minimise volatility and absorb any central bank rate hikes quickly.”
Kim Hochfeld, Global Head of Cash, State Street Global Advisors and Chair of IMMFA:
“In a nutshell, MMFs are more popular than ever. The latest crisis reinforced the value of having one’s cash in a diversified set of banking names and paying for professional money management and credit analysis, which cash investors can access through an MMF. The latest aggressive rate hiking cycle across the globe has meant that MMFs are also an attractive relative value investment option as opposed to bank deposits, in addition to their other benefits.
“Investors are reacting with a resounding vote of confidence in using MMFs to manage their short-term cash needs. Many MMF providers are continuing to manage their portfolios conservatively with shorter durations and higher liquidity levels than usual, both to absorb any potential interest rate hikes and to act as a buffer for unexpected market volatility.”
Seeking diversification and liquidity
Where investment priorities are concerned, Fuell says that treasurers have always been focused on achieving capital preservation and liquidity, with performance only a tertiary concern. While the events of the last few years haven’t changed these priorities, he observes that treasurers are showing a slightly stronger preference for capital preservation in the current market. “Alongside these three things, diversification is something that is on the minds of treasurers these days,” he adds. “We’ve seen a lot of clients in the US questioning their comfort at holding all of their cash at a single institution, particularly with smaller regional banks.”
Hugo Parry-Wingfield, EMEA Head of Liquidity Investment Specialists at HSBC Global Asset Management, likewise notes that treasurers have become more focused on diversification following recent events. “That’s an entirely logical thing to do,” he says. “One of the important benefits of MMFs is that they can offer a very high level of diversification through a single investment vehicle – typically our MMFs have exposure to 50 or 60 issuers. It’s pretty hard to replicate that scale and breadth of diversification.”
MMF providers, meanwhile, are taking steps to build up liquidity in light of current market conditions. “Our normal approach is to have high levels of liquidity anyway – we typically maintain thresholds higher than the regulatory minimum, for example, in terms of the weekly liquid assets and daily liquid assets that we need to maintain,” says Parry-Wingfield. “In the current market, we’re maintaining even higher levels of liquidity, and we’ve also been limiting the maximum duration of investments for a period of time.” He adds that this is a “normal prudent step” during times of market disruption.
“On top of that, our investment team and our credit analysts are keeping extremely close to developments and are tracking the bank counterparties that we use,” he says. “In many ways, that’s business as usual – but it’s obviously particularly relevant given recent developments.”
Fuell says that European regulations require at least 10% of a LVNAV/PDCNAV’s [Low Volatility Net Asset Value/Public Debt Constant Net Asset Value] assets to be comprised of overnight maturing assets, and at least 30% to be comprised of weekly maturing assets. “But most funds will be carrying a lot more, and remaining a lot more liquid, given the volatility of the current marketplace. For example, we are currently running in excess of 50% weekly liquidity across a number of our core funds.”
Testing the resilience of regulatory reform
Europe and the US both implemented MMF reform in the wake of the 2008 financial crisis, during which the Reserve Primary Fund infamously ‘broke the buck’. Under the rules introduced by the Securities and Exchange Commission (SEC) in 2016, constant net asset value (CNAV) funds were required to switch to a variable net asset value (VNAV) model. The European Money Market Fund Regulation (MMFR) implemented in 2019 took a different direction, introducing a low volatility net asset value (LVNAV) model that would operate alongside VNAV and public debt CNAV funds.
Under the MMFR, funds can also impose liquidity fees, redemption gates and suspension of redemptions if liquidity falls below 30% and daily net redemptions are greater than 10% of the fund’s total assets. Mandatory fees and gates will apply if liquidity is less than 10%.
In Iommi’s, opinion the introduction of prescriptive requirements under the MMFR on liquidity, credit quality, portfolio diversification and weighted average maturity, and transparency made MMFs more resilient. “The events of March 2020 acted as the first stress test of MMF reform and IMMFA MMFs continued to perform as intended, preserving capital and providing liquidity,” Iommi says.
However, “one area of MMFR that did not work as intended was the link between minimum liquidity thresholds and the possible imposition of gates and fees.” As Iommi explains, this link created procyclical incentives for investors and investment managers around liquidity buffer levels. “There is now widespread agreement on ‘delinking’ which would enable funds to use their liquidity buffers, as intended, during times of stress.”
Meanwhile, another area of focus has been the ability of the LVNAV to maintain a stable NAV, providing that the mark-to-market NAV does not deviate more than 20bps from par. “This ability to trade in and out at par is essential to the utility value of the LVNAV and is helpful for classifying as cash or cash equivalent for accounting purposes,” explains Iommi.
Some regulators have proposed that this ability be removed, thereby creating another variable NAV fund type which may be harder to achieve consistency in the same accounting treatment. But as Iommi points out, “LVNAVs account for approximately 46% of the European MMF market. To remove the LVNAV fund structure would significantly impact investor choice.”
Regulatory review in Europe and the UK
The EU MMFR required the European Commission to review and publish a report on the adequacy of the regulation “from a prudential and economic point of view by summer 2022, including whether changes are to be made to the regime for public debt CNAV MMFs and LVNAV MMFs.” However, the review is ongoing and the report is yet to be published (although expected over the coming months).
“We know that the review has been delayed, as the European Commission wants to ensure that they are looking at all the factors they should be considering – particularly given some of the recent volatility that we saw in the UK last year, and given the banking stress during the last few weeks,” comments Fuell. “We’re supportive of the European Commission’s approach in terms of ensuring they’ve got a comprehensive view of money market funds and how they have weathered this environment.”
The UK is also in the process of reviewing MMF regulation: in May 2022, the Financial Conduct Authority (FCA) and Bank of England published a discussion paper to “gather views to inform the UK’s authorities’ development of MMF reform proposals.”
“Pending the outcome of any potential reforms, we continue with what we have in place today. While it is important to stay abreast of the developments, there is no need to start to consider revising investment policies,” says Iommi. The earliest impact of any relevant changes for treasurers would be in 2025/2026.
In the meantime, she concludes, “IMMFA will continue to engage with regulators and policy makers to articulate the views of investors and other stake holders.”
Alternatives to MMFs
As Parry-Wingfield points out, MMFs are popular with treasurers in part because they offer a high degree of diversification as well as capital preservation and liquidity – “and that is something that’s quite hard to replicate outside of a managed fund.”
The most obvious alternative is to place cash in bank deposits from relationship banks. “But treasurers have to consider diversification when they’re doing that, as recent events have highlighted,” he says.
Larger and more sophisticated treasury teams may purchase instruments such as deposits, commercial paper and repo themselves, although this requires significant in-house expertise. For investors with a longer investment horizon, another option is to use asset management solutions that offer more duration and credit risk, while typically seeking to provide a higher rate of return. “I would say that these are more appropriate as an add-on to a money market fund, as opposed to an alternative,” comments Parry-Wingfield.
Investors may also consider segregated investment mandates that are set up for specific clients with their own investment restrictions. However, as these can be time-consuming and complex to set up, Parry-Wingfield argues that they are “typically better suited to investors with larger cash pools.”
