CESR published guidelines on a common definition for money market funds in May 2010 (the Guidelines) which have been broadly welcomed as a significant advance in achieving a harmonised definition of the term money market fund (MMF) and thus ensuring greater investor protection. Historically the term Money Market Fund has traditionally covered a very broad range of investment funds which in turn created risks for investors who may not have fully understood the type of assets in which the funds invested. In addition, the strategies of some funds may not always have been consistent with the generally accepted concept of money market funds as some invested in relatively liquid, short term investments.
The aim of the Guidelines is to improve investor protection by setting out criteria to be applied by any fund that wishes to market itself as a money market fund. It is intended that the Guidelines be reflected in the revised Notices and Guidance Notes soon to be issued by the Central Bank of Ireland (the Central Bank). This memorandum is being prepared in advance of the publication of those Notices and Guidance Notes with a view to assessing how the Guidelines will impact on Irish regulated money market funds, and in particular, changes that may be required to the fund documentation.
What types of funds do the Guidelines apply to?
The Guidelines apply to both UCITS and non-UCITS funds which label or market themselves as money market funds.
What do money market funds need to do?
- Firstly, the money market funds need to identify whether they are to be categorised as a Money Market Fund or a Short Term Money Market Fund. This categorisation must be stated in the prospectus for the fund and in the key investor information document where the fund is a UCITS fund.
- Money market funds must provide investors with appropriate information on the risk and reward profile of the fund so as to enable investors to identify any specific risks linked to the investment strategy of the fund.
In practice, the majority of Irish authorised money market funds are constant NAV money market funds and we would expect that these would be categorised as Short Term Money Market Funds - under the Guidelines only Short Term Money Market Funds can have a constant NAV.
Short Term Money Market Funds
In order to be classified as a Short Term Money Market Fund the fund must:-
1. Have the primary investment objective of maintaining the principle of the fund and aim to provide a return in line with money market rates.
This should not be an issue for constant NAV funds as all would have a similar objective.
2. Invest in money market instruments which comply with the criteria for money market instruments as set out in the UCITS Directive or deposits with credit institutions. Non-UCITS money market funds must ensure that the liquidity and valuation of the portfolio is assessed on an equivalent basis.
Most Irish authorised money market funds are UCITS and accordingly would already comply with this requirement.
3. Ensure the money market instruments in which it invests are of high quality as determined by the management company . In making its determination the management company must take into account a range of factors including but not limited to:-
(a) the credit quality of the instrument;
(b) the nature of the asset class represented by the instrument;
(c) for structured financial instruments the operational counterparty risk inherent within the structured financial transaction; and
(d) the liquidity profile.
Most money market funds disclose a credit quality requirement in their investment policy. Also, it is typically a requirement of the rating agency that the investments of the money market fund have a certain credit quality.
4. For the purposes of point 3 (a) consider a money market instrument not to be of high quality unless it has been awarded one of the two highest available short term credit ratings by each recognised credit rating agency that has rated the instrument or if the instrument is not rated is of an equivalent quality as determined by the management company’s internal rating process.
While the investment manager of the fund will need to reflect this requirement in its own internal procedures, some sub-fund supplements may need to be amended if they provide for something to the contrary.
5. Limit investment in securities to those with a residual maturity until the legal redemption date of less than or equal to 397 days.
This is already a requirement of the Central Bank’s Guidance Note 1/08 (the Guidance Note). However, the Guidance Note also permits investment in longer dated securities which undergo regular yield adjustments at least every 397 days. Accordingly, there does appear to be a mis match between the Guidelines and the Guidance Note as the Guidelines seem to disregard the interest re-set dates and focuses on the legal redemption date. It is possible that some Irish authorised money market funds are permitted to invest in securities with a residual maturity of more than 397 days but that undergo interest rate resets at least every 397 days. Such funds will have to adjust their portfolios if they have such investments, unless the Central Bank takes a flexible approach to this requirement – see below for details on transitional arrangements. It is also worth noting that the IMMFA Code of Practice (the IMMFA Code) states that the limit of a final legal maturity of 397 days can be extended to 2 years for government or government guaranteed securities, which also conflicts with the Guidelines.
6. Provide daily NAV and price calculation and daily subscription and redemption of units. A non-UCITS money market fund marketed solely to employee saving schemes and to specific categories of investor that are subject to divestment restrictions may provide weekly subscription and redemption opportunities to investors in accordance with its home state regulations.
Almost all money market funds have daily dealing.
7. Ensure its portfolio has a Weighted Average Maturity (WAM) of no more than 60 days.
This is already provided for in the Guidance Note.
8. Ensure its portfolio has a Weighted Average Life (WAL) of no more than 120 days.
This is not currently a requirement of the Central Bank. It is however a requirement under the IMMFA Code. This requirement may also result in some adjustments to the portfolio of Short Term Money Market Funds. Funds may wish to disclose this requirement in the prospectus (and the Central Bank may require it) but some funds may prefer to have it as a policy of the investment manager but not necessarily disclosed in the prospectus.
9. When calculating the WAL for securities, including structured financial instruments, base the maturity calculation on the residual maturity until the legal redemption of the instruments. However, when a financial instrument embeds a put option the exercise date of the put option may be used instead of the legal residual maturity only if the following conditions are fulfilled at all times:-
- The put option can be freely exercised by the management company at its exercise date;
- The strike price of the put option remains close to the expected value of the instrument at the next exercise date; and
- The investment strategy of the UCITS imply that there is a high probability that the option will be exercised at the next exercise date.
This requirement in our view is not necessarily something that needs to be included in the prospectus for the Short Term Money Market Fund but will need to be complied with at all times by the relevant investment manager and may result in some adjustment to the portfolios of Short Term Money Market Funds.
10. Take into account for both the WAL and WAM calculations, the impact of financial derivative instruments, deposits and efficient portfolio management techniques.
Again, this may not impact on the actual prospectus for the funds but will need to be complied with.
11. Not take direct or indirect exposure to equities or commodities including via derivatives and only use derivatives in line with the money market investment strategy of the fund. Derivatives which give exposure to foreign exchange may only be used for hedging purposes. Investment in non-base currency securities is allowed provided the currency exposure is fully hedged.
Money market funds would not typically have exposure to equities or commodities so most money market funds should find it easy to comply with this prohibition. Also, money market funds typically only use derivatives for currency hedging and the use of derivatives is restricted by the rating agency that rate the money market funds.
12. Limit investment in other collective investment undertakings to those which comply with the definition of Short Term Money Market Funds.
This could be included as an investment restriction in the prospectus for the relevant money market fund although it would be unusual to make such investments.
13. Have either a constant or fluctuating Net Asset Value
It is important to note here that a Short Term Money Market Fund is the only type of money market fund which is permitted to have a constant Net Asset Value.
What must a Money Market Fund comply with?
A Money Market Fund must comply with paragraphs 1, 2, 3, 4, 6, 9, 10 and 11 above. In addition to those requirements a Money Market Fund:-
1. May, as an exception to the requirement of point 4 above, hold sovereign issuance of at least investment grade quality. Sovereign issuance should be understood as money market instruments issued or guaranteed by central, regional or local authority or central bank of a Member State, the European Central Bank, the European Union or the European Investment Bank.
2. Must have a fluctuating Net Asset Value.
3. Must limit investment in securities to those with a residual maturity until the legal redemption date of less than or equal to two years provided the time remaining until the next interest rate reset date is less than or equal to 397 days. Floating rate securities should reset to a money market rate or index.
4. Must ensure the portfolio has a WAM of no more than six months.
5. Must ensure its portfolio has a WAL of no more than twelve months.
6. Must limit investment in other collective investment undertakings to those which comply with the definition of Short Term Money Market Fund or a money market fund.
It should be noted that most of the requirements that apply to Short Term Money Market Funds also apply to Money Market Funds and accordingly the changes to fund documents outlined above need to be considered for Money Market Funds also. More changes are likely in our view to be needed to prospectuses and possibly the portfolios of Money Market Funds to reflect these requirements. The main difference being the maturity of the instruments in which they can invest and the requirement to have a variable Net Asset Value.
Impact of Guidelines on Articles of Association
It is unlikely that the articles of money market funds will require amendment to reflect the Guidelines. To the extent that the valuation provisions in the articles reflect the Guidance Note, these provisions should be reviewed to ensure no changes need to be made.
When must money market funds comply with these provisions?
The Guidelines enter into force on 1 July 2011. Money market funds created after 1 July 2011 will have to comply with the Guidelines immediately. Money market funds in existence on 1 July 2011 must comply from that date with the requirements in respect of any new investment made on or after 1 July 2011. However, in respect of all investments acquired prior to 1 July 2011, such funds are allowed a six month transitional period until 31 December 2011 to comply with the Guidelines. The Guidelines require all funds that intend to operate as money market funds under the Guidelines to reflect this in their documentation from 1 July 2011 and funds that do not intend to conform i.e. those that will cease to call themselves money market funds should make this clear in their documentation from 1 July 2011.
It should be noted that the foregoing comments are made in the absence of any guidance from the Central Bank which at the time of writing is due very shortly.