Money Market Funds: Navigating a Course Through the Market Storm

In the final week of June, a collection of treasurers, fund managers and regulators gathered in the Jurys Hotel in London for the Money Fund Forum 2008, organised by IBC Global Conferences. And what a 12 months there has been to take stock of in the money market fund (MMF) sector. Following the sub-prime mortgage crisis and the liquidity crunch that followed, MMFs have been tested by the extreme market conditions and come under increased scrutiny from investment managers.

Donald Aiken, chairman of the International Money Market Funds Association (IMMFA), was chairman of the Forum and began proceedings by mentioning this – what a difference a year makes! Previously benign markets have suffered great turbulence, inter-bank lending has broken down, and yet MMFs in Europe have seen significant growth, maintaining year-on-year growth patterns by being up 42% from June 2007. The reason that IMMFA’s Aiken offered for MMFs retaining their popularity is because of the liquidity they offer, which is a crucial asset in a liquidity crisis. For example, when analysing the breakdown of MMF portfolio composition, Aiken noted that bank deposits increased from 15% to 31% in the portfolio mix when the crunch bit because of the liquidity they offer. There has also been extra growth in the take up of certificates of deposit (CDs).

The hold-to-maturity nature of MMFs has boosted their popularity, as well as their ability to generate liquidity in just a few days. MMF portfolios should only contain quality assets that redeem at par at maturity and there is no automatic requirement to sell individual assets at certain levels. Overall, Aiken suggested that, because of these factors, investors regard MMFs as a safe-haven during market turmoil situations.

Despite the positive aspects of MMFs, there are, of course, still lessons to be learned from the market crisis. One of the main lessons that came through in almost all of the sessions at the Forum was the need for clear industry definitions on what can be called a MMF. As IMMFA’s Aiken pointed out, not all cash fund structures are the same and some funds, for example in the enhanced cash area, have been hit hard in the market turmoil due to their portfolio mix. A strong definition, particularly in Europe, would help boost investor confidence.

Other lessons to be learned from the turmoil include the importance of strong liquidity in cash fund structures – this is what has kept MMFs in the spotlight and is certainly something that all cash fund structures should look at. Also, sophisticated investors should not rely solely on assessments from credit rating agencies, just because a fund has been rated AAA does not mean it is immune from risk. As such, the widespread use of portfolio stress-testing and scenario modeling should be encouraged as risk management tools. IMMFA’s Aiken suggested that the’lender-of-last-resort’ liquidity provision should be widened to cover capital markets and not just banks (for example, the share repo capability) and pointed out that there’s a need for greater transparency in the portfolio and pricing approach. Above all, it is vital to ensure that the right products are sold to the right clients – this has not always happened in the past and this has caught out some managers in the past year.

Away from his prepared presentation, Aiken told the delegates that he is “getting worked up” about what may be in store for MMFs. The product is successfully working in the worst possible markets in 70 years, yet at the moment central banks and regulators are panicking and talking about MMFs as being liquidity arbitrage… “make of that what you will,” he hinted. The pendulum is swinging and regulatory scrutiny is set to increase – another reason why the industry needs to agree upon clear definitions.

IMMFA Priorities in 2008

  1. Achieve a pan-European definition of MMFs.
  2. Undertake a European research taxonomy study on MMFs.
  3. Enhance liquidity provision to support the acceptance of MMFs as liquidity/collateral asset (mainly through the use of repo).
  4. Implementation of a revised Code of Practice.
  5. Seek increased dialogue with fund directors.

Corporate Treasury Interest in MMFs

One of the most interesting sessions at the Forum was presented by François Masquelier and Johan Claudot from the treasury department of international telecoms company, RTL Group. Masquelier is also chairman of the European Association of Corporate Treasurers (EACT) and the focus of the presentation looked at the corporate treasurer’s perspective on using MMFs. Masquelier explained how treasurers are managing unprecedented levels of surplus cash and are faced with the dilemma of how to make use of this cash as effectively as possible while ensuring liquidity… but without incurring excessive exposure to market and credit risks.

As the economic and regulatory environment changes, selecting the most appropriate investment products to manage primary liquidity has become more complex for treasurers, who are increasingly looking for an alternative to traditional bank deposits. To fill this void, the evolution of the money market industry, combined with regulatory changes, has made MMFs an important tool in a treasury alternative investment portfolio.

Another reason for treasurers following a cautious investment strategy comes from the sub-prime crisis. Some corporates were not adequately informed about what they were investing in and, in light of this, MMFs represent a cautious investment strategy. They have many characteristics of bank deposit accounts and offer a high level of security. Events of the last 12 months have meant that the investor focus in MFFs has completely changed: over the last 18 months the thirst for yield has been superceded by a strong desire for investment security, followed by a requirement for liquidity.

RTL’s Claudot made the good point that, as soon as the sub-prime crisis occurred, there was a lot of scrutiny on what treasury was investing in from their management. This ties in with the previously mentioned theme of the Forum – the need for a better definition of MMFs. This will lead to a better understanding among corporates who are investing in the MMF area and, even more importantly, for their bosses who may read some troubling headlines in the financial media but lack a clear appreciation of the subtleties of the various cash fund structures.

The EACT’s Position on the Definition of MMFs

  • There needs to be a stricter definition of MMFs (quality assured), tending towards a treasury-style MMF definition (as in the US).
  • More transparency, clarity and security within markets (in line with EU aims).
  • Clearer rules for’cash and cash equivalent’ classification.

RTL’s Masquelier brought up the issue of MMF portals and the effect these may have on the corporate-to-bank relationship, pointing out that corporates are keen to maintain good relationships with all of their banks. Even though corporates are cash-rich, they want to “share the cake.” Claudot echoed this as well, saying that the key issue for treasurers is to maintain their relationships with the banks. With his EACT hat on, Masquelier set out the association’s position on MMF portals, by stating that they believe they are required – there’s a need for automation and STP with treasury management systems (TMS) and MMF portals offer this in the investment field. The EACT has no preference over which platform treasury departments should use, pointing out that if there is open competition, the best portals will succeed, which can only be a positive for treasury. Masquelier stated that he thinks MMF portals will soon be seen as best practice and a necessity, particularly for internal control reasons.

MMFs and the Sub-prime Crisis: Lessons from a Crisis

With ratings agencies hitting the headlines in financial media for their problems over the liquidity crunch, it was good to hear from a representative from the sector at the Forum. Kathryn Kerle, a vice president at Moody’s Investor Services, focused her presentation on lessons from the sub-crisis. Kerle was keen to point out that the theme was not’lessons learned’, because she thought that, at this moment, they have not been learned and that it may still take some time before the industry takes on board the lessons of the past 12 months.

Kerle stated that the money markets are starting to recover from the events of the last 12 months, but the crisis is not yet over. MMFs have performed well so far, thanks to widespread financial support from parents, continued investor confidence and changed investment strategies on the part of management firms. The same, however, can not be said for enhanced cash funds, which have suffered badly from the liquidity crisis. US enhanced cash funds have been particularly hard hit.

One of the key ratings issues at the moment is that the industry is at the beginning of a cycle of downgrading credit quality. The speculative default rate is on the rise – this was at 1% in January 2008, 2% in June 2008, and Moody’s predicts that it will reach as high as 5% in June 2009. Moody’s itself has been downgrading across extendible asset-backed commercial paper (ABCP), ABCP/structured investment vehicles (SIVs) and corporate obligations. Kerle advised that investment managers should watch the ‘TED spread’ – the difference between the three-month T-bill (T) interest rate and three-month Eurodollars (ED) contract as represented by LIBOR. ABCP spreads are still elevated above LIBOR, so maybe there is trouble still to come for the market.

A major change in the money markets that Moody’s Kerle outlined involved sponsor support of funds. Before the crisis, there were no instances of sponsor support in a Moody’s-rated European MMF, but during the crisis there have been numerous instances, particularly in purchases, credit support agreements, letters of credit and total return swaps. As mentioned in other sessions, Kerle pointed out that enhanced cash funds have performed poorly – in these cases, management firms have absorbed the losses in their entirety; or these losses have been passed on to investors.

Shifts and trends

Analysing the past 12 months, Moody’s Kerle noted that assets under management (AUM) in European money markets is increasing. The decline of ABCP in MMF portfolios, due to lack of confidence in SIVs, has been offset by investments in deposits and a significant increase in repo and an increase in corporate exposures. She described this as a’flight to quality’ – as investors are nervous in the current climate, they are not comfortable in speculating on risky/untried investment instruments, rather preferring the security offered by’gold standard’ instruments. ABCP has been replaced by CDs in MMFs across all the denominations, US dollar, euro and sterling. Again it is worth noting that sponsor support has helped keep afloat some funds that are invested in SIVs.

Another market development has been an emergence of the first European treasury-style MMFs. There are indications of increased interest in reverse repo as an asset class in euro and sterling MMFs. Reverse repo refers a purchase that is a cash transaction while the return sale is a forward transaction occurring at a future date.

Outlook for European MMFs – A Ratings Agency Perspective

Moody’s Kerle offered Forum delegates her view on the outlook for MMFs in Europe, from both an investment and strategic perspective.

Investment outlook for European MMFs:
  • Reduced exposure to structured securities.
  • Higher exposure to financial institutions.
  • Higher levels of liquidity.
  • Increased investment on the part of’prime’ funds in reverse repo.
  • Shift in some assets to treasury-style funds in the short-term.
Strategic outlook for European MMFs:
  • Likely avoidance of’breaking the buck’ in this cycle.
  • Re-examination of economics of fund business.
  • Increased operating costs/expense ratios.
  • Consolidation accounting issues (FASB 140) and potential implications for parental financial support in the US – there are also potential accounting issues with income smoothing in Europe.
  • Improved shareholder communications/disclosure.
  • Further industry consolidation and concentration.
  • Improved credit research and analysis/risk management.

Future Developments in MMFs

At the Forum, IMMFA’s Aiken offered his vision of the direction he sees the MMF industry taking over the next 12 months. As mentioned throughout the Forum, there is a need for MMFs to be clearly defined, and Aiken sees the use of the name’money market fund’ in Europe becoming restricted to certain types of cash funds.

There has been a growing acceptance from regulators and investors of funds offered by IMMFA members by countries throughout Europe and Aiken sees this continuing, thanks to the liquidity they offer. Indeed, he suggested that IMMFA members’ funds will become widely used for prudential liquidity purposes by European banks and building societies. He also sees significant growth in the use of IMMFA members’ funds for client money and collateral cash management purposes.

As MMF growth continues, they are likely to attract even more scrutiny and interest. Therefore, most investment funds will need to provide investors with information on stress testing and scenario model results. There will also be greater corporate governance responsibilities placed on fund directors.

Despite some of the negative connotations associated with enhanced yield cash funds and their poor performance in the face of the liquidity crisis, Aiken believes that there is still a role for this type of fund going forward. He suggested that a new generation of enhanced yield cash funds is likely to emerge, with stronger liquidity credentials.

The overall message from Money Fund Forum 2008 was that of’back to basics’. MMFs have done well to maintain their growth rate in Europe, but this growth should not be taken for granted. The MMF industry needs to build on what it continues to do well, but just as importantly it has to learn from the challenges it has faced over the past 12 months in order to maintain its position as the treasurer’s short-term investment instrument of choice.


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Mark Carney Bank of England