The credit and banking crisis has had a significant impact on money market funds (“MMF”), bringing a conservative investment product into the spotlight and prompting a number of regulatory changes in both the United States (“US”) and Europe.
Until September 2008, MMF were considered a safe if somewhat prosaic investment product, but that month the net asset value (“NAV”) of the U.S. Reserve Primary MMF fell below US $1 per share (“broke the buck”) due to its overexposure to Lehman debt securities which resulted in the fund being unable to meet redemption requests. This event triggered an immediate run on MMF resulting in the withdrawal of approximately $300 billion during one week that September. These unprecedented events attaching to an investment product perceived as safe and low risk alarmed investors and regulators alike and gave rise to demands for a greater degree of product integrity and transparency. To address these concerns the U.S. Securities and Exchange Commission (“SEC”) and, in Europe, the Institutional Money Market Funds Association (“IMMFA”), European Fund and Asset Management Association ("EFAMA"), and the Committee of European Securities Regulators (“CESR”), have introduced or proposed reforms which, the MMF industry anticipates, will also facilitate the growth and development of the product. In this article Barry Lynch and Fidelma Walshe examine these initiatives.
In Europe, there is no single piece of legislation comparable with the SEC’s Rule 2a-7, and a broader array of funds can be termed MMF, ranging from the highly conservative IMMFA style funds which are consistent with the 2a-7 Rules, to enhanced cash and short term bond funds. Those European MMF which are harmonised under the UCITS Directive can “passport” into other European member states without seeking authorisation in each jurisdiction. Since 2000, IMMFA has represented promoters and service providers of triple-A rated, constant and accumulating NAV MMF domiciled in Europe, and its members include the majority of major providers of MMF outside the US. IMMFA’s stated aim is to ensure the delivery to investors of a high quality product by promoting best practice additional to legal and regulatory requirements and, to this end, in 2002 introduced its Code of Practice to establish European industry standards in the absence of any comparable Rule 2a-7 regulation.
In July 2009, EFAMA and IMMFA issued an industry recommendation for a European classification and definition of MMF. This followed recommendations made in the De Larosiere Report in February 2009 that there be a common EU definition of MMF and a stricter codification of the assets in which they can invest to limit exposure to credit, market and liquidity risks. In October 2009, CESR issued a consultation paper proposing a common definition of European MMF, with the key purpose of improving investor protection. CESR proposed a two-tiered approach to the definition of European MMF broadly in line with the EFAMA and IMMFA recommendations. CESR’s definitions will apply to UCITS MMF, but with a recommendation that the same approach is followed at national level for non-UCITS MMF. In both cases, specific disclosure will be required to draw attention to the differences between MMF and bank deposits. The consultation closed on 31 December 2009, and it is anticipated that CESR will publish its guidelines on a common definition by the end of April 2010.
In December 2009, in another European move to enhance the product, IMMFA published its revised Code of Practice, modified to provide additional protection to investors through improved standards for maturity, credit quality, liquidity and disclosure. The move mirrors CESR’s current proposals with the object of ensuring the product’s resilience and the delivery of its principal objectives of capital security and liquidity.
The IMMFA guidelines stipulate that to ensure liquidity to meet redemption requests MMF must hold at least 5 per cent of their net assets in overnight securities and 20 per cent in securities maturing within five days. Further, MMF must have a weighted average maturity of not more than 60 days, while individual securities must have a final maturity of 397 days, except where issued or specifically guaranteed by a Government. The final legal maturity for Government and Government-guaranteed securities should not exceed two years. IMMFA has also moved to tighten up credit quality by stipulating that the weighted average final maturity of securities held by a MMF should not exceed 120 days, except where the MMF can exercise a put option. The revised code was introduced on January 1, 2010 and provides a transitional period of 12 months at the end of which IMMFA members must have implemented the revised provisions.
On 23 February 2010, the SEC issued details of various amendments to Rule 2a-7 under the Investment Company Act of 1940. The amendments made to Rule 2a-7 reflect the reforms proposed by the Investment Company Institute in its “Report of the Money Market Working Group,” released in March 2009.
The Rule 2a-7 amendments go to issues of portfolio quality, maturity and liquidity designed to increase the resilience of MMF to economic stresses, with additional disclosure to investors and the SEC. They also require an MMF’s board to adopt procedures for periodic stress testing of the portfolio’s ability to maintain a stable net asset value under certain scenarios. The effective date for the rule amendments is May 5, 2010, with implementation of the principal changes by the current year end.
Under the SEC Rule changes MMF will be required to maintain a holding of sufficiently liquid securities to meet reasonably foreseeable redemption requests. The final rule requires taxable MMF to hold at least 10 per cent of their assets in cash, demand deposits, U.S. Treasury securities, or assets readily convertible into cash within one day. All MMF are required to maintain at least 30 per cent of their assets in cash, demand deposits, U.S. Treasury securities, agency discount notes with remaining maturities of 60 days or less, or assets readily convertible into cash within five days. Further, MMF are prohibited from acquiring illiquid securities (i.e. those which cannot be sold or disposed of within seven days at approximately the ascribed value) if, at the time acquired, the MMF would have more than 5 per cent of its total assets invested in such securities. The new regulations also stipulate that an MMF’s board must designate at least four nationally recognized statistical rating organizations (“NRSROs”) that the MMF will use in determining whether the security is an eligible security, a rated security, a first tier security and a second tier security. The ability of a MMF to invest in second tier securities, being those eligible securities which, if rated, have received other than the highest short-term debt rating or, if unrated, have been determined by the MMF’s directors to be of corresponding quality, has also been limited by the Rule 2a-7 amendments which reduce the permitted percentage of such securities to 3 per cent from 5 per cent of total assets, the permitted concentration of a single issuer of such securities to 0.5 per cent from the greater of 1 per cent or $1 million, and prohibit a MMF from acquiring any second tier security with a remaining maturity in excess of 45 days.
The Rule changes also require MMF to provide enhanced monthly portfolio information on their websites and, under new Rule 30b1-7, to the SEC.
In addition, the SEC has indicated that there is likely to be a second round of changes, but did not set a specific timeframe for those to be announced. While the SEC did not take action to prohibit use of the amortized cost method and maintenance of a stable $1.00 per share NAV, and thereby allow MMF NAVs to float according to market value, this is still under review despite strong opposition from the industry.
MMF are an important source of liquidity for corporations, financial entities and institutions, and represent a large and critical segment of global financial products with, in December 2009, total investments of approximately $5.5 trillion. The aim of the current US and Europe initiatives is to enhance the quality and transparency of the product to meet the investor expectations which were so eroded by the 2008 upheavals. In doing so, these regulatory changes will, it is anticipated, facilitate the further global development of the industry.