The European Commission published the "Proposal for a Regulation of the European Parliament and of the Council on Money Market Funds" (the "Proposed Regulation") on 4 September 2013.
The Proposed Regulation has come about as a result of increased regulatory scrutiny of money market funds (“MMFs”) at both international and European level. The Proposed Regulation follows a review of shadow banking activities by the Financial Stability Board and the EU Commission, together with a report and recommendations on MMFs issued by the European Systemic Risk Board in February 2013.
The Proposed Regulation has been considered by the European Parliament's Committee on Economic and Monetary Affairs ("ECON") and it has issued a report on the Proposed Regulation dated 15 November 2013 (the "ECON Report"). The ECON Report proposes a number of amendments to the Proposed Regulation, the most significant of which are outlined below.
The full European Parliament is scheduled to consider the Proposed Regulation in its plenary session to be held from 14 to 17 April 2014.
The role of MMFs in the so called “shadow banking” sector has come to the forefront following the recent financial crisis. The European Commission, in the explanatory memorandum which prefaces the Proposed Regulation, cites the systemic interconnectedness of MMFs and the failure of local regulators to deal with perceived issues associated with the operation of MMFs as the reason behind the content of the Proposed Regulation.
The Proposed Regulation is designed to focus on the MMF product rather than the fund vehicle. As drafted, the Proposed Regulation requires that collective investment undertakings ("CIUs") be authorised explicitly as MMFs, either as part of the harmonised authorisation procedure for UCITS or using the new harmonised authorisation procedure for AIFs. Only CIUs which comply with the Proposed Regulation may identify themselves as MMFs.
The Proposed Regulation, once finalised, will be directly effective in all EU Member States 20 days after its publication in the Official Journal. There will then be a transitional period of six months for existing MMFs to comply.
The Proposed Regulation provides that only MMFs which establish and maintain at all times a "capital buffer" of 3% of the total value of assets under management may advertise a constant NAV (“CNAV”) per unit or share.
The capital buffer must be composed of cash and held in a protected reserve account in the name of the CNAV MMF. The capital buffer will only be permitted to be used to compensate the difference between the CNAV per unit or share and the "real" value of the unit or share.
The capital buffer will need to be replenished whenever it falls below the 3% threshold. Both the competent authority in the relevant EU Member State and ESMA must be immediately notified when the amount of the NAV buffer decreases by 10 basis points below the 3% buffer threshold.
The recitals of the Proposed Regulation also note that each competent authority should have the power to convert a CNAV MMF into a variable NAV MMF if it has justifiable reasons and can demonstrate the incapacity of the CNAV MMF to replenish the capital buffer within one month. CNAV MMFs must provide clear procedures for conversion to variable NAV MMFs in their constitutional documents.
The Proposed Regulation provides for a "ramp-up" period for existing CNAV MMFs in relation to the capital buffer as follows:
- 1% of the total value of the CNAV MMF’s assets within one year from the entry into force of the Proposed Regulation;
- 2% within two years; and
- 3% within three years.
The Proposed Regulation states that MMFs shall only invest in four categories of financial instruments, namely;
- Money market instruments;
- Deposits with credit institutions;
- Financial derivative instruments (only to hedge duration/exchange risks); and
- Reverse repurchase agreements.
The Proposed Regulation contains further detailed criteria regarding eligible assets.
The Proposed Regulation also contains a detailed list of investment restrictions for MMFs.
In summary, MMFs shall be prohibited from short-selling money market instruments, taking direct or indirect exposure to equity or commodities, entering into securities lending agreements, securities borrowing agreements or borrowing and lending cash.
The Proposed Regulation contains detailed rules on the diversification of eligible investments including:
- 5% issuer limit for money market instruments;
- 5% limit on deposits with a single credit institution;
- 10% aggregate limit in terms of securitisation exposure; and
- 10% aggregate limit in terms of issuer exposure.
These restrictions are waived for sovereign issues of certain countries and public bodies.
The Proposed Regulation contains detailed provisions for the valuation of MMF assets. It requires variable NAV MMFs to value their assets daily using mark-to-market methods whenever possible and otherwise mark-to-model.
Only CNAV MMFs may value assets using the amortised cost methodology.
Under the Proposed Regulation, CNAV MMFs may only receive support through the specific NAV capital buffer (as detailed above). Other MMFs shall be prohibited from receiving external support, i.e. sponsor support, however in exceptional circumstances, the relevant competent authority may allow a MMF other than a CNAV MMF to receive external support.
The Proposed Regulation differentiates between "Short-Term" MMFs and "Standard" MMFs. Portfolios of Short Term MMFs must have a weighted average maturity (“WAM”) of no more than 60 days and a weighted average life (“WAL”) of no more than 120 days. Portfolios of Standard MMFs must have a WAM of no more than 6 months and a WAL of no more than 12 months.
Each MMF must indicate whether it is a short-term or a standard MMF in any internal or external document, report, statement, advertisement, letter or any other written evidence issued by it or its manager, addressed to or intended for distribution to shareholders, prospective investors or competent authorities.
Standard MMFs will not be permitted to operate as CNAV MMFs under the Proposed Regulation.
In order to avoid mechanistic reliance on external ratings, the Proposed Regulation provides that MMFs should establish an internal assessment procedure for assessing the credit quality of MMF investment instruments. These requirements will include the introduction of stress testing processes in order to identify possible changes in economic circumstances which could adversely affect the MMF. Measures must be taken to reinforce liquidity or asset quality where stress testing identifies any vulnerability of the MMF.
Soliciting or financing an external credit rating is prohibited by the Proposed Regulation.
The Proposed Regulation also requires the manager of a MMF to carry out due diligence on investors with the goal of anticipating the effect of concurrent redemptions by a number of investors.
The ECON Report
The most significant amendment proposed by the ECON Report is the conversion of all CNAV MMFs which are established, managed or marketed in the EU to variable NAV MMFs within five years of the entry into force of the Proposed Regulation.
The ECON Report also proposes the following amendments to the Proposed Regulation;
- Restrictions on the use of the amortised cost method for CNAV MMFs;
- The removal of the three year "ramp-up" period in respect of the NAV buffer and instead a requirement that CNAV MMFs be required to establish and maintain the NAV buffer by 31 December 2014;
- A prohibition on CNAV MMFs being offered to retail investors;
- the introduction of a requirement that MMFs must establish and implement remuneration policies and procedures which are consistent with sound and effective risk management and do not encourage risk taking;
- the removal of the prohibition on MMFs soliciting or financing external credit ratings; and
- the introduction of a requirement that MMFs with more than €10 billion of assets shall be supervised directly by ESMA.
Reception and Timing
The Proposed Regulation represents a substantial change to the current regulatory regime applicable to MMFs. In particular, the capital buffer proposal has been the subject of much industry debate and many commentators believe there is still a chance that this requirement will ultimately be dropped from the MMF proposals. The proposal contained in the ECON Report that all CNAV MMFs be converted to variable NAV MMFs is also likely to provoke a strong lobbying effect against it.
The Securities Exchange Commission (the "SEC") in the US has avoided mandating any kind of a capital buffer in its proposed rules on the operation of MMFs, expressing concerns about the economic effect of such a requirement on the MMF industry. Neither did the SEC propose the compulsory conversion of all CNAV MMFs into variable NAV MMFs. Industry lobby groups are advocating a global approach to the regulation of MMFs and argue that lack of consistency between regulation of MMFs in the US and regulation of MMFs in the EU could prove highly damaging to Europe's €1 trillion MMF industry owing to the very real possibility of promoters exploiting the regulatory arbitrage.
According to the Irish Funds Industry Association (the "IFIA”), Irish domiciled MMFs had assets of €273 billion as at August 2013. The IFIA has already issued a press release calling for alignment between EU and US MMF policies and a strong pan European lobbying effort against the proposed capital buffer is expected prior to the Proposed Regulation being considered by the European Parliament in April 2014.