Since its inception nearly 40 years ago, the global money market fund (MMF) industry has witnessed phenomenal growth, currently holding over US$4 trillion in assets under management.
The landscape within which MMFs operate has already witnessed material changes over recent months. Proactive actions by the industry, combined with regulatory amendments, have delivered a product that is now better able to provide investors with security and liquidity. However, there are several potential amendments that could have a deeper impact on the MMF industry. And with all this change occurring, the need for ongoing investor education has become increasingly important.
The European Context
In Europe, the key recent change has been the advent of the first pan-European regulatory definition of an MMF. Following the work of two trade associations – the Institutional Money Market Funds Association (IMMFA) and the European Fund and Asset Management Association (EFAMA) – the Committee of European Securities Regulators (CESR) issued guidelines on what constitutes an MMF in May 2010. National regulators must implement these guidelines by July 2011. After this date, only funds that comply with the guidelines and that have capital security as their principal objective will be capable of referring to themselves as an MMF. This is a very positive step, providing necessary clarity to investors over the nature of their investment.
The CESR guidelines incorporate a number of investment parameters with which funds must comply. These parameters are designed to address the risks that an MMF may become exposed to, covering credit risk, interest rate risk and operational risk.
Also in Europe, IMMFA – which represents triple-A rated MMFs – implemented amendments to its code of practice. This code is a voluntary standard that IMMFA members agree to comply with, and is designed to deliver best practice standards for the management and operation of MMFs. The IMMFA code of practice addresses additional areas not covered by the CESR guidelines, most notably liquidity risk, and provides supplemental guidance on managing operational risk.
The US Market
The regulation of MMFs in the US was first established in 1983 via Rule 2a-7 of the Investment Company Act 1940. In May 2010, the Securities and Exchange Commission (SEC) implemented amendments to this rule. As with the CESR guidelines, the SEC changes addressed the major sources of risk to which an MMF could become exposed.
There is now increased consistency between the regulatory environments for MMFs in Europe and the US. Although there is no single global definition, the role of the credit rating agencies is helping facilitate a global model by imposing cross-border standards. Many MMFs seek to maintain a triple-A MMF rating. This rating, determined by the credit rating agencies, provides investors with an independent opinion on the ability of the fund to preserve capital and provide liquidity. Funds must respect parameters imposed by the rating agencies in order to achieve a triple-A rating. These criteria again address the key risks within an MMF, and do not differ by location. Consequently, funds operating in different locations but holding the same triple-A rating will be managed to the same standards.
The changes made across the globe to the management and operation of an MMF have all been undertaken with the objective of delivering a more resilient product. To this end, these changes are beneficial for all involved in the industry, most importantly the investors. The product must now continue to evolve to address a number of forthcoming challenges.
Possible Structural Changes
The revised product should be more resilient. Additional risk mitigants have been introduced to better enable the funds to provide capital security and liquidity to investors. However, the changes made to date have only been the first phase. The industry and its regulators continue to consider whether structural changes are necessary to further improve the product.
The intention of any further changes will be to provide additional, holistic risk mitigants that address the role played by MMFs within the wider financial system. Structural changes currently being considered include the conversion to a variable net asset value (VNAV, as opposed to the constant net asset value, or CNAV, operated by IMMFA and US MMFs), and the creation of a third-party liquidity resource that funds could access in stressed markets.
The principal difference between CNAV and VNAV MMFs is the accounting technique used to value assets. In a CNAV fund, all assets are valued on an amortised cost basis, allowing the fund to maintain a constant value of, for example, £1. In a VNAV fund, amortisation may only be used for assets that have less than 90 days to maturity, with all other assets being valued on a mark-to-market basis. The net asset value of these funds will vary over time as market values of the assets move.
The US MMF industry operates exclusively on a CNAV basis, while in Europe both CNAV and VNAV funds exist, the split being approximately 33% and 67% respectively. Conversion to VNAV could alert investors to movements in value, potentially reducing the possibility of redemption requests being received should value decline. Whereas it should be possible for fund managers to address the operational issues relatively easily, given that VNAV funds exist, the bigger challenge may be the cultural shift needed for investors in US and IMMFA funds to accept such a revision. Investors unwilling to make this change could potentially look to other short-term cash management solutions.
MMFs are important intermediaries in the financial system, providing investors with capital security and liquidity, sourced by investing in a variety of corporate and financial debt instruments. Consequently, MMFs provide an important service to the entities from which they purchase securities. In illiquid markets, it is important that this service continues, thereby facilitating the operation of the broader money markets. The industry is proactively involved in discussing setting up a third-party liquidity resource for stressed market conditions. Such a facility would provide benefits to the financial system, though it could significantly alter the operation and economics of an MMF.
In the US, the President’s Working Group on Financial Markets has been tasked with considering these structural changes, while in Europe, IMMFA has instigated a debate among its membership on how these issues may be addressed. Investors should view these debates as a further positive indicator that the industry is maturing and improving. A more robust product that can function in all market environments will provide investors with a more attractive proposition when seeking to place short-cash cash balances.
Amendments to the Basel Framework
As well as possible structural changes to the product, the MMF industry is likely to be impacted by the amendments to the banking system currently being considered. The Basel framework dictates the global standard of prudential regulation that applies to banks; this is currently being revised. These revisions may have both direct and indirect consequences for the MMF industry.
Of principal interest to the MMF industry is the proposal that banking groups which manage a CNAV MMF should hold liquid assets (primarily cash and government debt) against any such exposure. Holding liquid assets against any CNAV money market funds managed within the group would be a significant change for the industry, fundamentally altering the cost of running such an MMF. As such, the Basel debate is being closely monitored and could result in a number of banking groups questioning whether they continue to operate such funds once these revisions are implemented in 2012.
A presumably unintended consequence of the Basel revisions is the potential change in the availability of those securities held by MMF. The Basel proposals will encourage banks to obtain more stable and long-term funding. This change would occur at a time when MMFs, as buyers of bank debt, are being required by the CESR guidelines to reduce average maturities and limit exposure to securities which have a legal final maturity of 397 days or less. The potential exists for a mismatch between the supply and demand of short-term bank debt. Recognising the potential implications of implementing the Basel framework as proposed, the Group of Twenty Finance Ministers and Central Bank Governors (G20) have confirmed that a full quantitative study will be performed before any implementation, with some aspects of the proposals – whether revised or not – unlikely to be effective before 2018.
Education, Education, Education
With all of these changes and potential alterations, investor education assumes increasing importance. MMFs are designed to provide security of capital and same-day liquidity, not to generate yield. Any yield provided should be viewed as a by-product of the investment strategy rather than as an investment objective. Investors primarily interested in generating returns on their cash investment should not use an MMF; however, investors wishing to place short-term cash surpluses in a secure and liquid manner should use an MMF. The CESR guidelines will help minimise investor confusion by limiting the scope of what may be referred to as an MMF.
Yet there remains a need to provide further education on the product and to allow investors to make informed decisions on where short-term cash surpluses should be placed. An appreciation of the risks to which these funds may become exposed and the methods of mitigating those risks should also be provided.
IMMFA is proactively addressing this challenge. Firstly, additional materials have been published on its website that are designed to assist investors in further understanding the workings of a money market fund. Secondly, IMMFA is developing briefings for investor associations, aimed at providing generic information about the product and its operation. Finally, and to complement these generic materials, all IMMFA funds must publicly disclose a variety of data, including average maturity, liquidity profile and fund composition. This data is intended to provide investors with a means to assess risk, while also facilitating easy comparison between competing funds. IMMFA is also reviewing whether additional information should be publicly disclosed by its members to further benefit investors.
Rising to the Challenge
The MMF industry is at a crossroads, as it has improved the resilience of the product but may still need to evolve further. Based upon the proactive involvement of the industry and its willingness to response to different environments, there is every reason to consider that the industry will rise to meet these challenges.
Assets in the MMFs represented by IMMFA have increased by 44% over the past three years. Growth of this amount over this period is a clear indication of the comfort with which investors view this product. MMFs provide investors with a necessary service; a short-term cash management solution provided by experienced professionals will always be required. By tightening the investment parameters within which funds may operate, the product has strengthened its ability to deliver security and liquidity to investors.
The biggest challenge facing the MMF industry is to make sure that it continues to deliver these two objectives in light of the ongoing evolution of the financial services industry. Given the volume of cash invested in MMFs, there are a large number of investors interested in such an outcome. Investors should be reassured that MMFs will rise to this challenge and continue to offer a valuable solution to invest short-term cash balances.
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