The EU Commission today issued its long awaited roadmap for Shadow Banking and Money Market Funds. This follows recommendations from IOSCO, ESRB, FSB, consideration by the G20 leaders summit and considerable debate in both the US and EU on this topic. The Regulation on Money Market Funds is of particular interest. It does not differ significantly from an earlier leaked draft Regulation.
The new materials include;
- a press release on Shadow Banking and proposed new rules for Money Market Funds;
- a communication on Shadow Banking;
- a FAQ list on Shadow Banking;
- a memorandum on Money Market Funds; and
- a draft Regulation on Money Market Funds.
Further materials dedicated to Money Market Funds are available on the EU Commission website.
Key points to note in respect of the draft Regulation on Money Market Funds.
Scope; the draft Regulation covers money market funds (MMFs) that are domiciled or sold in Europe. MMFs are funds, whether UCITS or AIFs under AIFMD, which invest in short term assets and have, as distinct or cumulative objectives, offering returns in line with money market rates or preserving the value of the investment.
Standard and Short-Term MMFs; The draft Regulation has reverted to the ESMA style of categorisation using the terms Short-term MMFs and Standard MMFs. Only Short-term MMFs are permitted to utilise amortised cost valuation methodologies.
Liquidity Management; MMFs will be required to have at least 10% of their portfolio in assets that mature within a day and another 20% that mature within a week. Exposure to a single issuer will be capped at 5% of the MMF's portfolio (in value terms). For standard MMFs (being MMFs which are not Short-Term MMFs), a single issuer may account for 10% of the portfolio.
Capital Buffer/Stability; the draft Regulation requires that constant net asset value MMFs (CNAV MMFs) establish a predefined capital buffer of 3% (or 300 basis points). For existing CNAV MMFs, this will be built up cumulatively over three years at a rate of 1% (or 100 basis points) per year. This buffer will be activated to support stable redemptions in times of decreasing value of the CNAV MMFs investment assets. The amounts in the buffer will not be included in the calculation of the NAV or constant NAV of the CNAV MMF. The buffer must be composed entirely of cash and be held in a protected reserve account opened with a credit institution in the name and on behalf of the CNAV MMF. Crucially, if the NAV buffer falls below the 3% by 10 basis points for a month , the CNAV MMF will automatically cease to be a CNAV MMF and be prohibited from using the amortised cost valuation methods. The mechanism for such automatic conversion is not yet clear.
Eligible Assets; the draft Regulation provides that MMFs may only invest in money market instruments, deposits with credit institutions, financial derivative instruments, reverse repurchase agreements and sets out sets out conditions for each of these types of assets. MMFs will not be able to engage in short selling of money market instruments, gain exposure to equities or commodities (directly or indirectly), enter into securities lending or securities borrowing agreements, or borrow or lend cash. In a change from the earlier leaked Regulation, they will be permitted to engage in securitisation (again subject to conditions).
Investment Restrictions; MMFs will not be permitted to invest more than 5% of assets in money market instruments issued by the same body or 5% of its assets in deposits made with the same credit institution. Moreover, the aggregate amount of cash provided to the same counterparty under reverse repurchase agreements entered into by a MMF may not exceed 20% of assets.
Credit Rating/Quality; the draft Regulation prohibits an MMF from soliciting or financing an external rating and requires that the management of the MMF establish its own rigorous internal procedures for assessing the credit quality of money market instruments.
Know Your Customer; the draft Regulation requires that the manager of a MMF exercise due diligence to identify the number of investors in the MMF, their needs and behaviour and the amount of their holdings, so as to plan for concurrent redemptions by several investors.
Stress Testing; the draft Regulation requires that the manager of a MMF should put in place sound stress testing processes that allow for the identification of possible events or future changes in the economic conditions that could have unfavourable effects on the MMF.
External Support; the draft Regulation sets out that a CNAV MMF may only receive external support by way of the NAV buffer. Other MMFs are prohibited as a rule from receiving external support although regulators may permit this, on an ad hoc basis, in exceptional circumstances justified by systemic implications or adverse market conditions.
Other Provisions; the draft Regulation also contains detailed provisions concerning valuation and transparency.
Regulatory Arbitrage; the EU Commission points out that the aim is to ensure that the potential systemic risks to the financial sector are covered and that the opportunities for regulatory arbitrage are limited in order to strengthen market integrity and increase the confidence of savers and consumers. In this context, it is interesting that the US has not proposed equivalent requirements.
Next Steps; the draft Regulation will now pass to the EU Parliament and the EU Council of Ministers for review and amendment in the normal way. The aim was to have the Regulation implemented in Q4 of 2013 or in early 2014 but we anticipate that the Regulation is not yet in its final form and that significant lobbying is likely, particularly because there will not be a parallel regime in operation in the US.
Key points to note in respect of the future regulation of Shadow Banking
Transparency; increased reporting of detailed, reliable and comprehensive data will be essential to enable regulators to monitor risks in an effective manner and intervene when necessary.
Securities Financing Transactions; (principally securities lending and repurchase transactions). These transactions are seen as contributing to an increase in leverage and strengthening the pro-cyclical nature of the financial system, which then becomes vulnerable to bank runs and sudden deleveraging. The lack of transparency of these markets will also be addressed so as to assist in identifying property rights (who owns what?), monitoring risk concentration and identifying counterparties (who is exposed to who?)
Framework for Interactions with Banks; The high level of interconnectedness between the shadow banking system and the rest of the financial sector, particularly the banking system, is seen as constituting a major source of contagion risk. These risks may be addressed by tightening the prudential rules applied to banks in their operations with unregulated financial entities.
Supervision; Particular attention will be paid to the supervision arrangements of shadow banking entities/activities in order to ensure that specific risks are adequately addressed. Certain areas such as the set-up of resolution tools for non-bank financial institutions and a structural reform of the banking system will be clarified later.
The Commission’s communication is in line with the Financial Stability Board’s recommendations, which will be endorsed by the G20 Leaders in Saint Petersburg on 5-6 September 2013.