In September 2008, the global credit markets were in complete disarray. Corporations were scrambling to fund their day-to-day operations, LIBOR was on the rise every morning, credit default rates on recently pristine institutions soared… and all that happened before Lehman Brothers declared bankruptcy.
Lehman’s filing kicked off a full assault on similarly structured investment banks and money market mutual funds invested in Lehman paper. The Reserve Primary, with total assets of US$64.8bn, held US$785m in Lehman commercial paper. It announced that it was seeking financing options to remove the bad debt from its fund, but had yet to find a solution. This fuelled a run on the Reserve and the industry.
In the weeks to come, huge outflows cascaded across the industry, followed by massive inflows into mostly treasury and government funds. This flight to quality actually propelled US money market fund (MMF) assets to a record high of nearly US$3.9 trillion toward the end of 2008, before settling around US$3.7 trillion. Never before had the relatively quiet MMF industry witnessed such volatility.
Source: ICI, Crane Data
As depicted in the graph above, courtesy of Crane Data, the popularity of US MMFs actually grew from pre-crisis levels, even in the current, ultra-low-rate environment. With US$2.8 trillion in assets and more than 30 million shareholders, these funds clearly provide an essential source of short-term funding to corporations, broker-dealers, banks and governments, while remaining an important asset class to investors due to their security, liquidity and competitive yield.
According to the AFP 2010 Liquidity Survey, MMFs were second only to bank deposits in asset allocation, and three times more widely held than the next, most popular investment option. Bank deposits and MMFs, at 41.5% and at 25.1% respectively, made up two-thirds of all short-term investments.
Source: ICI, Crane Data
Since their genesis in the late 1970s, MMFs have grown dramatically. They currently represent more than one quarter of the total short-term cash market. However, the events of 2008 made it clear that there was still room for improvement to help ensure that MMFs continue to meet the needs of investors in today’s environment.
Responding to the Crisis
In response to the crisis, and to aid the industry’s recovery, the US Securities and Exchange Commission (SEC) announced some major changes to Rule 2a-7 of the Investment Company Act of 1940. Rule 2a-7 governs all US MMFs and, among other things, dictates into which securities the funds can or cannot invest.
The intent of these new changes, many of which already have been implemented, is to improve the funds’ liquidity and credit quality, while increasing industry transparency. Similar improvements also have been implemented by non-US domiciled MMFs. Although they operate outside the jurisdiction of the SEC, it is clear that these vital industry participants continue to gain momentum in satisfying the changing needs of their funds’ shareholders.
Because it operates one of the only fully direct and transparent global money market trading portals, SunGard has witnessed these changes first-hand. SunGard’s platform assets have grown dramatically post-crisis as investors moved from more opaque bank portals toward direct, transparent, fully disclosed technology solutions. Using a direct portal can help eliminate the added counterparty risk introduced by an omnibus platform, and supports a more direct relationship with the fund. This gives investors open access to their cash – even if an issue existed with their bank portal provider.
This type of one-to-one relationship completely coincides with the SEC’s new requirement for fund companies to “know their investors.” It also enables assessment of the funds’ potential exposures to a particular type of investor or industry, aiding in the performance of stress tests on the portfolio. Increased visibility benefits all industry participants by helping fund companies make more informed investment decisions regarding cash forecasting, maturity management and liquidity – which ultimately impacts the fund’s yield.
To further promote transparency and visibility, funds now disclose their portfolio holdings monthly (at a minimum) on their websites. Many fund companies make holdings information available even more frequently. In December 2010, funds also will begin disclosing shadow net asset values (NAV) to the public on a 60-day delay.
Some other important changes designed to improve funds’ liquidity and credit quality were recently mandated by the SEC and implemented by the funds. Those changes include the following:
- Funds now maintain a minimum of 10% of fund assets overnight, and 30% in one week to help meet possible redemption demand.
- The weighted average maturity (WAM) was shortened from 90 to 60 days, with the intent to make the funds shorter and more liquid – WAM, also known as ‘average effective maturity’, is the weighted average of the time until all maturities on mortgages in a mortgage-backed security (MBS).
- The weighted average life (WAL) is now limited to 120 days – Similar to WAM, WAL is a measure of the portfolio’s term that takes into account the final maturity date on reset issues.
- Illiquid securities can no longer be more than 5% of the total fund holdings, and second-tier securities are now limited to just 3%, helping to reduce the funds’ exposure to these asset classes.
Using Technology to Improve Transparency and Efficiency
The use of new technology, such as money market trading portals, also has helped support the MMF recovery. Pre-crisis customers wanted straight-through processing (STP) into treasury management systems (TMS), increased efficiency, and aggregation of fund providers. They also sought solutions that could help them reduce trade errors and create operational efficiencies.
Though all these benefits are still very valuable, implementations today are more about leveraging the right tools to help maintain investment policy compliance, assess counterparty risk and creating an auditable investment process. Technology platforms help companies achieve these goals online from multiple locations around the globe.
Recently, many portal providers have improved their risk management and compliance capabilities. Specifically, new investment company compliance controls are built into these portals that can be used to help ensure a cash manager remains within the company’s investment policy guidelines. Corporations can enter dollar limits per fund or rules based on a percentage of the fund’s total assets under management (AUM). These rules and limits can be rolled up to the parent level or remain unique to specific subsidiaries. In addition to the pre-trade compliance validations, investors can set alerts to be notified if an event has pushed them out-of-compliance post-trade, perhaps caused by a decline in a fund’s assets, for example.
There also are additional controls in place regarding user access and entitlements. Not only can a corporation use their system to control which accounts an individual can view or trade on, but they can track and report on those permissions, as well as respond quickly to an auditor’s request. The trading workflow can be set up to allow for ‘dual control’ regarding executions on transactions, for example. In these cases, one individual has the authority to submit an order, which kicks off a notice for another individual or individuals with approval authority to go online and approve or deny the transaction, if necessary. These solutions can also be deployed globally, allowing customers to access their portal from multiple jurisdictions around the world and centralise all money market trading activity in one auditable and secure location.
Reporting also has improved dramatically to meet growing client demand for more transparency and access to data, and to comply with requests from auditors and senior management. Enhancements such as portfolio ‘x-rays’ into the underlying holdings of MMFs help to aggregate and identify potential exposure to specific issuers, industries and countries. With the recent development of the European debt crisis, these particular types of enhancements have become extremely popular.
Laying a Foundation for a Better Future
The MMF industry made some significant changes over the past several years, clearly emerging stronger. Technology enhancements are the result of collaborative efforts between shareholders, regulators, fund manufacturers and distributors, as well as many other, interested parties. Like most aspects of the economy post-crisis, the road to recovery has had its bumps along the way. The recovery of MMFs is no different. Looking back and comparing the pre-crisis industry to the one today, it is evident that the improvements and innovations deployed recently have laid a foundation for a better future.
The outcome of all these efforts is a more liquid, transparent and efficiently automated marketplace that is poised for global expansion and the next step in its natural evolution. These efforts have helped to craft a future where money market mutual funds continue to be valuable to both investors and issuers in the short-term cash management space and beyond.
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