The Financial Sevices Team discuss recent developments in Money Market Funds and their regulation.
On 23 July 2014, the United States Securities and Exchange Commission (SEC) published its Money Market Fund (MMF) Reform Rules (the US MMF Rules). The US MMF Rules are the product of lengthy discussions on US MMF reform which started out in the dark days following the 2008 financial crisis due to the perceived systemic stability risks associated with MMFs and in particular constant NAV (CNAV) MMFs. The US MMF Rules set out a new regulatory framework within which MMF promoters in the United States will need to operate.
In Europe, policy makers and industry stakeholders have since 2008, been involved in a similar discussion regarding proposed EU reform of the regulation of MMFs. What started out as a global discussion on how best to regulate MMFs, a structure most commentators agree to be of great importance for institutions seeking to access short term liquidity, has now fragmented. Due to the different demographic of MMF investor profiles between the US and the EU, there is now the potential for regulatory arbitrage to cause major difficulties for European CNAV MMFs.
The European Position
On 22 May 2014, the European Central Bank (the ECB) issued an opinion on the proposed EU Regulation of MMFs (the Proposed Regulation).
The Proposed Regulation was published by the European Commission in September 2013. For more information on its content, please see the LK Shields' article 'EC Proposes Regulation on Money Market Funds' published in February 2014.
Progress towards implementation of the Proposed Regulation has slowed, with the European Parliament's Committee on Economic and Monetary Affairs (ECON) deciding in March 2014 to postpone a vote on the measure until the new European Parliament is installed in the autumn.
The ECB Opinion is thus timely, and it will be interesting to see what impact it has on the shape and content of the Proposed Regulation when the European Parliament resumes its consideration of the matter. The European Parliament's revised text will then form the basis of trilogue discussions between the Commission, the Council and the Parliament to reach agreement on the final rules.
The ECB Opinion analyses aspects of the Proposed Regulation but stops short of commenting on the amendments to the Proposed Regulation suggested by ECON in its report published in November 2013.
The ECB Opinion supports several aspects of the Proposed Regulation, while also highlighting a number of areas which warrant further consideration.
The following are the key points of the ECB's Opinion: -
- The ECB notes the importance of achieving "substantial convergence at international level" in order to avoid the regulatory arbitrage which has the potential to arise were there to be different MMF regulatory regimes in the most important MMF markets; the EU and the United States.
- In relation to the controversial proposal that all CNAV MMFs hold a NAV buffer of 3%, the ECB notes that the proposal runs contrary to the recommendations of the European Systemic Risk Board and notes that were such a provision to be introduced, the European Commission would be mandated to review the adequacy of the rules three years after the implementation of the Proposed Regulation.
The ECB highlights what it sees as two weaknesses with the NAV buffer proposal;
- the fact that the NAV buffer is not proposed to be risk-based, i.e. that for MMFs needing to build up or replenish the buffer, there may be an incentive for such MMFs to take increased risks in their investment policies; and
- the short period of time within which it is proposed the NAV buffer would need to be replenished were the buffer to fall below 3%.
- The ECB welcomes the provisions of the Proposed Regulation which would govern the circumstances in which MMFs may receive external support. The majority of MMFs are sponsored by banks and historically have relied on the implicit support of sponsors to support the CNAV offered to investors. Under the Proposed Regulation, CNAV MMFs would be able to receive support only through the NAV buffer. MMFs other than CNAV MMFs would only be able to receive support in "exceptional circumstances" with the prior agreement of the MMF's competent authority, and where applicable, the prudential regulator of its sponsor. The ECB thus highlighted the need for sponsors to receive reports from MMFs within their group which would enable them to alert the relevant authorities were the need for external support to arise.
The ECB also highlights the need for coordination at EU level in order to achieve consistency in the application by competent authorities of those provisions of the Proposed Regulation which govern external support and which are inherently subjective. In particular the ECB points out that: -
- different competent authorities may have differing interpretations of what constitutes "exceptional circumstances";and
- a conflict may arise when competent authorities are required to take measures for the stability of an MMF which may negatively impact the stability of that MMF's parent credit institution.
- The Proposed Regulation would prohibit MMFs from obtaining external credit ratings. The ECB expressed its support for reducing reliance on external credit rating agencies but noted that the internal rating models of MMFs may produce similar credit assessments to those of rating agencies. The ECB also highlighted the need for rules governing conflicts of interest when MMFs compile ratings internally.
- MMFs play a vital role in intermediation in the money markets, channelling money between investors with available funds, and the credit institutions, corporates, government and municipal bodies who need to borrow funds on a short-term basis at regular intervals. The ECB pointed out the danger that the intermediation role of MMFs in the EU financial system would be reduced due to the combined impact of the Proposed Regulation, Basel III's Liquidity Cover Ratio measures and possible future rules on net stable funding.
- The ECB noted that were some MMFs to exit the market due to regulatory reforms, the resulting market consolidation may cause remaining MMFs to become systemically important.
- The ECB suggested that the start-date of the Proposed Regulation be aligned with the calendar year, i.e. introduced on 1 January, to facilitate ease of implementation.
The points raised by the ECB in relation to the proposed NAV Buffer and the need for substantial convergence at international level are interesting when the new US rules on MMF reform are taken into consideration.
The US Position
The US MMF Rules published by the SEC on 23 July 2014, adopt a new set of MMF regulatory requirements which will force institutional non-government MMFs (MMFs with institutional investors and which do not primarily invest in government debt) to move from a CNAV to a variable net asset value (VNAV). In addition, the US MMF Rules would permit almost all MMFs to impose redemption gates and liquidity fees on investors where liquid assets fall below certain levels. There is also a requirement to charge liquidity fees in times of extreme market stress unless the board of the MMF determines that imposing such a fee would not be in the best interests of the MMF.
It is important to note that institutional non-government MMFs represent only about one-third of all US MMFs. As such, the majority of US MMFs will be able to continue as CNAV MMFs under the new regime.
The US MMF Rules distinguish between MMFs on the basis of the types of investors investing in the MMFs. MMFs with an institutional investor base (which are considered most likely to suffer investor-runs) will be required to use a VNAV, (with an exception made for those institutional MMFs which invest predominantly in government debt).
The EU's MMF reform proposals do not follow the US approach. Instead, the EU rules focus on the liquidity profile of an MMF. Under the Proposed Regulation, only Short-Term MMFs (MMFs holding portfolios of assets with short-term maturities) will be able to use a CNAV. Standard MMFs (those MMFs with a portfolio of assets with a weighted average maturity of between 60 days and 6 months) will be required to use a VNAV.
The EU's stated objective in reforming MMFs is to make them safer, both for investors and for the wider financial system by seeking to reduce the impact of any potential investor run on the MMF. The proposed EU reforms are seeking to achieve this through imposing rules relating to investment policies, eligible assets, diversification, credit quality, and stress-testing. Furthermore, if there was to be a run on a CNAV MMF, the purpose of the proposed reforms is to ensure that MMFs have sufficient liquid assets to enable them to meet investor redemptions, while the NAV buffer provides a backstop to protect investors by acting as a source of funds to compensate redeeming investors for any shortfall between the published CNAV and the actual value of the MMF's net assets. However, the combined costs of complying with the proposed rules and of maintaining a NAV buffer in what is a low-margin industry, throws doubt on the viability of CNAV MMFs in the EU. It is possible that MMFs could choose to convert to VNAV MMFs to avail of a lighter regulatory regime, a scenario which would achieve through the backdoor, what was originally advocated for at the height of the economic crisis; that all MMFs should publish VNAVs.
The European Commission has previously stated that it would not require that all MMFs publish a VNAV because it recognises that many investors prefer to invest in CNAV MMFs and may stop investing in MMFs if CNAV MMFs disappear. Many investors rely on CNAV MMFs due to the straight line accounting treatment of their investments, the certainty the CNAV provides for cash-planning purposes, and because the CNAV facilitates same-day settlement of redemptions.
In contrast to the Proposed Regulation, the US MMF Rules place less of a burden on MMFs and the use of liquidity gates and fees in an attempt to mitigate against both the likelihood and the impact of investor runs by ensuring fairness amongst those shareholders who redeem early and those who do not.
In summary, the MMF regulatory reforms of the US and the proposals in the EU diverge in a number of key areas. The SEC's reform focuses on redemption gates and liquidity fees, which are not a feature of the EU's proposed reforms, while the EU is proposing a NAV buffer for CNAV MMFs, something the SEC ruled out.
As previously noted, the ECB thinks it crucial that differences in MMF regulation in the EU and the US do not create regulatory arbitrage. The EU authorities will need to be very careful of their next steps.