European money market fund reform arrives

European money market fund (MMF) reform has finally arrived and will herald important changes for corporate treasurers and others that use MMFs to manage liquidity. Investors will face new features and fund types, meaning more complexity, but fundamentally, the changes should be manageable once investors become accustomed to the new landscape.

At a high level, the timing to keep in mind is July 2018 for new funds and January 2019 for existing funds. By those cut-offs new and existing funds, respectively, will need to be in-line with – and authorised – under the reforms. It’s not a long implementation period so understanding the reforms and updating investment policies as needed are important priorities.

Unlike in the US, where over US$1 trillion moved to government-only funds from prime funds when reforms came in last year, we don’t anticipate anything like that shift in Europe. That’s largely a function of the design of the post-reform options in Europe, which is a positive for investors.

Key changes

For corporate treasurers accustomed to constant net asset value (CNAV) funds the key takeaway from the reform is that these funds will no longer exist in their current form. Once reform is effective, there will still be a CNAV option, but, unlike today’s funds, the post-reform CNAV will only be able to invest in government securities. While the credit, market and liquidity risk on these funds will be low, as we saw in the US, it will likely come at a yield cost.

Unlike in the US, variable net asset value (VNAV) funds won’t be the only choice. We estimate that around 10% of investors in Europe already use the short-term version of this fund type and others may consider this option. However, the main focus of fund providers is on a new fund type in Europe: the new Low Volatility Net Asset Value (LVNAV) fund. For end investors, this fund will look and feel very much like today’s prime CNAV funds offering on a conditional basis a stable share price. Fitch’s surveys of investors show that this fund type is most likely to be their preferred option post-reform. It has some important features that investors should appreciate.

Firstly the share price. While these funds will trade at a stable price per share, if the mark-to-market price of the fund trades outside of a +/-20 basis points (bp) corridor then the fund moves to transacting at a variable price. That corridor is tighter than the +/- 50bp corridor on today’s funds, but the same principle applies. In the absence of extreme market shocks or an idiosyncratic credit event, we think it’s unlikely that a fund would move outside this corridor, especially after factoring in the sort of behavioural change we saw from US MMF managers after the US reforms. Post reform in the US, we have seen considerably more conservative portfolio management practices – from an already conservative base.

The second important feature is liquidity. The reforms will set minimum liquidity levels (which include certain “eligible” assets with longer maturities): 10% overnight and 30% weekly. We view this positively as minimum liquidity levels are a core feature of Fitch’s methodology when rating MMFs. Reform also introduces additional liquidity fees and redemption gates in money funds. Note the emphasis on additional: existing European money funds already have fees and gates. What’s new in the reforms is that there are prescriptive conditions, whereas today’s funds can apply fees or gates for a variety of reasons, but they are typically at the discretion of fund boards of directors.

Under the reforms, if certain liquidity thresholds are breached then the board of directors is obliged to take action. Specifically, if a fund’s weekly liquidity falls below 30% and there is a simultaneous net outflow of more than 10% then the board of directors must consider applying a fee or redemption gate. However, if weekly liquidity continues to be drained from the fund, and falls below 10% then the fund is obliged to apply a fee or gate. Even in this mandatory condition the board still has discretion over whether a liquidity fee (of up to 3%) or a full redemption gate is in the investors’ best interest.

In our view, the risk of a mandatory fee or gate being imposed is unlikely. We looked back over five years of data on weekly liquidity levels across the entire universe of European CNAV funds and could not find a single instance of fund liquidity falling below 10%. Clearly highly-rated funds run high liquidity levels, but on the other hand the fact that liquidity levels never dipped too low tells us that fund managers have been managing in and outflows effectively. That’s not to say liquidity couldn’t drop below 10%, but it is surely a remote possibility. Especially if we factor in that, like in the US, there will likely be more conservative portfolio management practices. Post-reform in the US, prime fund managers raised weekly liquidity to an average of 40-50%.

The probability of a discretionary action from the board of directors is, on the face of it, higher. But it’s also a joint probability event, which, all else being equal, is lower than either of the two events in isolation. Based on our data, we estimate a probability of about seven basis points of a fund experiencing a net outflow of 10% at the same time that weekly liquidity has dropped below 30% on any given day. If we factor in managers holding increased liquidity levels, that probability is going to be even lower.

Notwithstanding their remote likelihood, Fitch believes that the presence of fees and gates tied to liquidity levels will inevitably force more focus on fund liquidity management and governance practices by investors and managers. Fitch’s money fund rating criteria has always assessed a MMF’s ability to meet the dual objectives of principal preservation and timely liquidity by limiting credit, market and liquidity risk. We think this is what investors expect, especially from AAAmmf rated funds.

However, we would highlight to investors that there are fundamental rating criteria difference between Fitch and some other global rating agencies whose criteria speaks primarily to principal preservation with liquidity more of a qualitative consideration. In fact, according to one competitor’s rating approach, a fund could still be rated AAA despite throwing up a gate (up to five business days) or imposing a redemption fee – denying investors immediate access to their money. Under Fitch’s criteria, a gated fund cannot be rated a AAAmmf fund.

Conclusion

With European MMF reforms due in January 2019 for existing funds, conversion to the new format means that there is only limited time to update investment policies. There will be complexities with the new fund types and fund features which our interactive investor tool, “European Money Market Fund Reform Made Easy”, highlights.

There is now more emphasis on liquidity than ever before. While we don’t see fees and gates as an overarching investor concern in Europe, the focus on liquidity will increase for investors and managers, and will remain a key focus for Fitch when rating funds.

– The author will be among the speakers participating in a Fitch-hosted teleconference on European MMF reform on July 20. For further details and to register as a participant, click here.

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