The European Commission has issued a proposal for a Regulation on Money Market Funds (the “Regulation”). The publication of the Regulation follows increased regulatory scrutiny of money market funds (“MMFs”) at both an international and European level as part of the general review of shadow banking activities by the Financial Stability Board (“FSB”) and the Commission. The proposed reforms of MMFs are of particular interest to the Irish funds industry, which had assets of €295 billion in MMFs as at December 2012, representing 24% of the assets of all Irish domiciled funds.
The Regulation provides for uniform rules applicable to MMFs established, managed and / or marketed in the European Union. The Regulation prescribes permissible investment policies, with rules on eligible assets, diversification, concentration and credit quality of investment assets. It also sets out requirements relating to the valuation of MMF assets and the calculation of net asset value (“NAV”). Most controversially, it introduces a 3% capital buffer which will apply to all constant net asset value (“Legal and Regulatory Update European Commission publishes proposed regulation on money market funds”) funds marketed in Europe. The rules apply to all MMFs, whether they are UCITS or alternative investment funds (“AIFs”) under the AIFMD. Some of the key provisions are discussed further below.
CNAV funds, employing amortised cost valuation and offering a stable subscription and redemption price, will be permitted to maintain this accounting methodology on the condition that they build up appropriate cash reserves. These CNAV funds must establish and maintain at all times a buffer amounting to at least 3% of the total value of their assets, to be built up through a three-year transition. This “NAV buffer” is designed to absorb day-to-day fluctuations in the value of a CNAV MMF’s assets and is intended to ensure that sponsors are prepared should their MMFs require external support. The NAV buffer must be kept in a segregated reserve account in an EU credit institution or a credit institution in a third country subject to equivalent prudential rules to EU law and must be comprised solely of cash. By the third year of the Regulation’s application, the Commission is required to review the operation of the NAV buffer. The Commission is also required to consider the application of the buffer to CNAV MMF that concentrate their portfolios on debt issued or guaranteed by member states.
CNAV funds may only receive external support through the NAV buffer. Variable NAV MMFs are prohibited from receiving external support, however national regulators may allow external support in exceptional cases where the maintenance of financial stability may justify the grant of sponsor support.
Four categories of eligible assets are set out in the Regulation: money market instruments; deposits with credit institutions; financial derivatives; and reverse repurchase agreements. The Regulation introduces enhanced diversification requirements for MMFs which go further than the requirements currently applicable to MMFs structured as UCITS.
The Regulation also provides that an MMF may not engage in short selling of money market instruments; gain exposure to equities or commodities; enter into securities lending or securities borrowing agreements; enter into repurchase agreements; or borrow or lend cash. These limits based on the Commission’s view that these asset classes and practices would undermine the liquidity profile of the MMF.
In terms of credit quality of money market instruments, managers of MMFs must establish internal assessment procedures, based on an internal rating system provided for by the Regulation, for assessing credit quality. In this regard, the Regulation contains prescriptive requirements that do not allow managers to devise their own credit assessment process, nor acknowledge long-standing practices. MMFs are prohibited from soliciting or financing an external credit rating.
Common standards are introduced with a view to increasing the liquidity of MMFs and to ensure the stability of their structure, including uniform rules to ensure a minimum level of daily and weekly liquid assets. “Know your customer” policies will be required to ensure a better understanding of the MMF’s investor base and to anticipate redemption cycles. These measures, in combination with the requirement to invest in high quality and well diversified assets of good credit quality, are designed to ensure that the liquidity of the MMF is adequate to meet investors’ redemption requests.
MMFs are an extremely important product for those seeking low risk, liquid and well diversified means of holding cash. While some of the measures in the Regulation, including minimum liquidity requirements, are welcome as a means to strengthen this product and minimise systemic risk, other measures, such as the NAV buffer, are potentially very damaging for the industry. As a result of the ongoing ultra-low interest rate environment, many MMF managers are already waiving advisory fees and reimbursing fund expenses or earning net fees measured in single basis points. The imposition of a 3% capital buffer would in effect mean that many MMFs could no longer exist. It is extremely disappointing that the European Commission has introduced this proposed capital buffer in circumstances where the US SEC has chosen to focus on liquidity and transparency to protect investors and the market. This divergence of approach between the two largest MMF markets is not in the best interest of the industry or investors.
It is also questionable whether service providers will be able to support the onerous requirements regarding daily calculations and daily top-ups or withdrawals relating to the maintenance of the NAV buffer. Prohibiting MMFs from receiving a rating from a credit rating agency removes a level of third party oversight and transparency which is of benefit to shareholders.
The Regulation represents the Commission’s proposed initiating legislation in this area, and it must pass through the European law-making procedure involving the input of the European Parliament and European Council before it can become new European law. It is anticipated that consideration by the European Parliament may be delayed as a result of the European elections to be held in May next year however. Once in effect, existing UCITS and AIFs that are MMFs must submit an application for authorisation as an MMF to their regulators within six months evidencing compliance with the Regulation. The Regulation is stated to be conceived as leaving no scope for additional 'gold-plating' at national level.
We will be contacting individual clients directly to discuss the possible impact on their funds.
Shadow banking communication
The publication of the Regulation was accompanied by the publication of the European Commission’s communication on shadow banking, which outlines a number of other priorities in respect of which the Commission also intends to take initiative, such as increasing transparency of the shadow banking sector; introducing an enhanced framework for certain investment funds; reducing the risks associated with securities financing transactions; strengthening the prudential banking framework in order to limitcontagion; and promoting greater supervision of the shadow banking sector. It is also worth noting that the G20 is due to approve a package of policy recommendations on shadow banking drawn up by the FSB at its summit in Russia this week.
The Regulation may be accessed here: Proposed Regulation on Money Market Funds.
The communication on shadow banking bay be accessed here: Communication on Shadow Banking.