Governance of Money Market Funds
by David Rothon, IMMFA Director
When investors place cash in a money market fund, they understand that the objectives of the fund are the provision of security and liquidity. There are several investment risks which the fund manager must navigate in order to achieve these objectives, but other than investment restrictions, what arrangements exist in order to ensure that a money market fund continues to operate on a daily basis? We explore below the key governance provisions within money market funds which help them to function consistently without any problems.
Regulation, regulation, regulation
Financial regulation has evolved over many years to become an industry in itself. However, the development of financial regulation shows no signs of slowing, with increasing appetite for more detailed rules to be imposed on all entities operating within the financial services arena. Funds are firmly caught by existing regulatory obligations; these rules are designed to deliver investor protection, market confidence and financial stability.
After July 2011, any fund based in Europe which refers to itself as a money market fund will have to adhere to specific investment parameters.
Detailed rules have been imposed on funds throughout Europe for some years, and the internal compliance team of the fund manager will monitor these rules to ensure the fund is compliant. However, it is only this year that we will see the introduction of a regulatory definition of a money market fund in Europe. After July 2011, any fund based in Europe which refers to itself as a money market fund will have to adhere to specific investment parameters. If a fund does not adhere to these, it cannot call itself a money market fund. This regulatory definition should provide clarity to investors by restricting the universe of funds which may call themselves a money market fund.
For the funds represented by the Institutional Money Market Funds Association (IMMFA), the pan-European regulatory definition is unlikely to result in any significant changes. These funds are all required to hold a triple-A rating from one or more of the independent credit rating agencies – specifically Fitch Ratings, Moody’s Investors Service or Standard & Poor’s. The attainment of a triple-A rating is an indication that the awarding credit rating agency believes that there is limited risk of a loss of either capital or liquidity associated with that fund. By holding a triple-A rating, the funds must adhere to higher standards than those imposed by the new regulatory definition. In addition, all IMMFA funds follow the IMMFA Code of Practice. This Code is designed to deliver best practice standards in the management and operation of a money market fund, adding a further level of investment restrictions upon IMMFA funds. The IMMFA Code addresses the key risks to which a money market fund may become exposed: interest rate risk, liquidity risk and credit risk.
The combined requirements of European fund regulation, a triple-A rating and the IMMFA Code of Practice deliver stringent requirements and a robust set of criteria within which an IMMFA fund must operate. Although these requirements are rigid, they are further enhanced by specific obligations associated with the structure of the funds.
All IMMFA funds operate in accordance with European fund legislation. Under this legislation, the assets of a fund must be separately identifiable and held by an independent depository, effectively ring-fencing them from the assets of the fund manager. If there is an issue with the solvency of the fund management company, there should in practice be no adverse impact upon the investment within the money market fund. A simple transfer of the investment management mandate to another fund manager would ensure that the investors continue to benefit from investment in a money market fund. This process should place nothing more than an administrative requirement upon the investors.
As well as providing a mechanism to prevent the transmission of risk from the manager to the fund, the existence of an independent depository provides a further level of governance. In accordance with European fund legislation, the independent depository is required to monitor the fund’s compliance with the legislative obligations imposed upon the fund. As part of this monitoring, reporting will be provided to the fund’s board of directors to ensure appropriate action is taken when necessary. Furthermore, the depository will only carry out the instructions of a fund manager where those instructions conform to the relevant obligations imposed upon the fund. The depository therefore provides effective, independent oversight of the fund’s activities, and has direct access to the fund’s board of directors. These directors have a specific responsibility which further enhances the governance arrangements associated with a money market fund.
Shareholders’ best interests
Funds are normally set up as companies, and are separate entities from the fund manager. When set up as a company, the fund will have a board of directors. This board must include independent directors – someone who has no association with the fund manager or other related entities. This delivers independence in the decision- making process of the fund. Each director of the fund, whether independent or not, has a fiduciary responsibility to the shareholders in the fund. This requires the directors to ensure that the actions they take are at all times in the best interests of those shareholders.
The governments for a money market fund are broadly comparible irrespective of the location in which the fund is set up.
The board of directors will meet periodically, and will formally assess on an annual basis whether to reappoint the fund manager to manage the assets of the fund. As part of this decision, the board will consider a variety of matters including the fee structure and financial statements of the fund. The board will also be responsible for agreeing the investment objectives and policies of the fund. After this ‘mandate’ is finalised, all investment activities of the fund must adhere to this, and the mandate may only be changed with the approval of shareholders.
These fiduciary responsibilities provide an effective mechanism which delivers further independence and an overriding obligation to act in the best interests of the shareholders. This should provide reassurance to investors that their interests are at all times being represented, and that the fundamental basis on which the fund operates – its investment mandate – can only be changed with their collective consent.