Money Fund Reform: Calling All Treasury Cash Managers
by Joe Sarbinowski, Global Head of Liquidity Management, Global Client Group, Deutsche Asset & Wealth Management
Regulators that govern the money fund industry globally are on the verge of finalising significant changes that will fundamentally alter many of the attributes cash investors have come to value. These changes will place corporate treasurers, one of the larger investor segments in money market funds (MMFs), in the potentially uncomfortable position of having to think differently about cash; namely that cash is indeed an asset class that requires risk-focused due diligence and that they will need to evaluate alternatives more proactively.
While investor demand for greater transparency and regulatory changes since the 2008 crisis have strengthened the resiliency of MMFs, looming further reform for both the money markets and financial industry is very likely to alter the range and characteristics of both money market funds and direct instruments alike. This new reality will require treasurers to consider an increasingly dynamic model to match their firm’s unique investment objectives. Traditional overarching goals such as principal preservation, liquidity, and investment performance, while still critical, will need to be prioritised according to the specific requirements of clearly defined investment tranches. As the capital markets evolve and adjust by offering a greater variety of products, increased customisation and transparency, so too must treasurers adapt. By properly segmenting portfolios, staying aligned with changing products, and partnering with well-resourced, experienced advisors, they can properly optimise their cash investments.
The burden for treasurers becomes even higher when regulatory efforts to reduce reliance on credit rating agencies are considered. Historically, most treasurers leveraged internal resources and third party credit ratings to select a small basket of short-term investments including government bills, bank deposits and triple-A rated MMFs. This was a straightforward approach from an accounting perspective and relatively inexpensive. In this model MMFs provided high liquidity, wide diversification, and essentially represented a partial outsourcing of risk management for the organisation.
Simplicity, especially if at the expense of vigilance, comes at a price, as some MMF investors unfortunately discovered during the 2008 financial crisis. Today’s treasury investor is at a crossroad where the one-size-fits-all money fund of the past may no longer fulfill all of treasury’s needs going forward. In order to implement a more tailored approach, cash investors must overcome the costs (both direct and indirect) of operational, accounting and risk management changes that a more nuanced strategy requires.
Regulators’ concerns over the potential systemic risks posed by MMFs have grown since the 2008 financial crisis and have been incorporated in the broader regulatory debate with respect to the ‘shadow banking system’. While the broad term includes entities such as hedge funds, structured investment vehicles (SIVs), ETFs and Private Equity funds, the money market fund industry is a large and, in some regulators’ view, systemically relevant part of this shadow banking system.
Given various risk profiles and structures within the shadow banking system, investors often rely on third party rating agencies to assess risk characteristics and overall suitability. Money funds often utilise credit rating firm opinions to help promote their products as the ratings criteria seek to establish a standard for evaluation. The financial crisis, however, brought the overreliance on ratings into question for failing to anticipate the collapse of Lehman Brothers, as well as for investor losses related to ratings-based financial products, such SIVs and auction rate securities.
With these weaknesses exposed, the idea of being able to rely on third party ratings as a means to outsource risk management took a substantial blow. This was exacerbated when the Reserve Primary Fund ‘broke the buck’ due to portfolio losses, mostly on debt issued by Lehman Brothers. That immediately led to heavy redemptions from prime money funds, with outflows of $300m, or 14% of the assets, according to US Securities and Exchange Commission (SEC) estimates. A main pillar supporting longstanding corporate cash investment strategies had now been dramatically shaken.
On both sides of the Atlantic, regulators have pursued money fund reforms designed to avoid a repeat of the 2008 crisis. In the US, legislators inserted a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that required regulators to strip ratings out of their rules to whatever extent possible. As a result, fund managers may not rely on ratings for the securities they select, and the quality and depth of their credit research capabilities becomes paramount. Similarly, the SEC implemented new MMF regulations in 2010 and a new proposal for further reform, released in June 2013, contemplates two alternatives. The new proposal is extensive in scope, but in summary, alternative one, if adopted, would require institutional prime MMFs to transact at a variable net asset value (vNAV). Prime constant net asset value funds (cNAV) with limited liquidity provisions would still be allowed for retail investors. The second alternative introduces the potential for redemption gates and/or liquidity fees for prime cNAV funds should they breach a prescribed liquidity buffer. Those funds that invest solely in US Treasury, government and agency paper would not experience any changes under either alternative. The SEC is also considering any combination of the two alternatives and is accepting public comments until mid-September.
Meanwhile, EU regulators released proposed regulations on money funds on September 4 2013. The rules are meant to bolster the resiliency of money market funds in time of stress including some similar to those adopted by the US SEC in 2010. Notably, they would require a 3% capital cushion for cNAV funds and would eliminate fund managers’ overreliance on rating agencies. The EU states that their primary concerns relate to ‘run on the fund’ risk when money funds value their assets at amortied cost to maintain a cNAV but the market value of the underlying investments dseclines, potentially creating an incentive for investors to pull their funds during times of market stress to avoid potential loss of principal or liquidity.
Regardless of the final outcome, it is clear that global regulators are converging toward a more comprehensive regulatory framework for MMFs and corporate treasury teams need to prepare for this new paradigm.