Money Market Funds: A Reflection on How the Market Has Changed
by Joseph W. Sarbinowski, Managing Director, Global Head of Liquidity & Sara L. Flour, Managing Director, Liquidity Specialist, Global Client Group, Deutsche Asset & Wealth Management
The proverb ‘The more things change, the more they stay the same’ (plus ça change, plus c’est la même chose in its original French form) might be aptly applied to the money market fund industries of the United States and Europe. For example, despite the flurry of rule changes by both regulators and rating agencies over this period with the likelihood of more on the horizon, the structure of these products remain substantially the same operationally—namely stable net asset value (NAV) and utilisation of amortised cost accounting. These key attributes have led to huge growth in this segment over the last decade on both sides of the Atlantic. And from an investor’s perspective, these funds remain as widely utilised today as in 2007, providing professional management, ease of use from an accounting and operational angle, and late-in-the-day, same-day access to liquidity and markets.
However, there has been a clear evolution in the money market fund industry with changes driven by both regulatory mandates and market dynamics. As a result, many underlying characteristics of prime money market funds now have a distinctly different profile from those they had nearly a decade ago. Regulators and industry associations globally have been particularly focused on enhancements that could reduce money market funds’ susceptibility to risk during times of market turmoil. Many of the regulatory changes so far have been focused on funds’ investment strategy, while other changes have enhanced oversight and investor transparency. With the global fund industry now poised to receive further potential regulatory changes from the Securities and Exchange Commission (SEC) and from the European Union’s (EU’s) European System of Financial Supervision (ESFS), it is important to understand the impact on these strategies.
In order to improve overall liquidity, regulatory changes established minimum thresholds for daily and weekly maturities that could provide cash to support investor redemptions. Before the financial crisis, some funds had been able to keep less than 10% of their portfolio maturing within a week, enabling them to enhance yield by sacrificing liquidity. Currently, with the mandate of 10% on an overnight basis, and at least 30% on a weekly basis, there is very little competitive yield advantage available to be captured in that part of the portfolio any longer. Perhaps less broadly known are some of the changes that have been made by the major ratings agencies related to their monitoring of money funds. With specific guidelines in place to earn an Aaa-mf or AAAm rating from Moody’s or Standard & Poor’s, funds undergo even more detailed scrutiny. For example, based on the concentration assets from the largest three investors in a fund, Moody’s can require even higher levels of overnight and weekly liquidity than regulations set forth. This goal of this requirement is to customise the potential liquidity needs of a fund, based on the potential redemption risk of their largest shareholders.
These standardised liquidity requirements have provided more consistent maturity profiles across fund complexes, and serve well to buffer potential cash flow needs, but this has come at a cost. With short-term rates remaining at historic lows, portfolio managers are challenged to find yield in securities that meet these liquidity requirements. And with nearly a third of the total money market fund industry’s assets needing to be invested in this range, this extraordinary demand keeps downward pressure on yields as well.
In order to meet these liquidity goals, money market fund portfolio managers have turned to a few different approaches that were much less commonly used prior to the financial crisis. For example, in US domestic funds, there is a noticeably higher allocation to variable-rate demand notes (VRDNs) which, as tax-exempt instruments, were more commonly seen before only in the municipal money market funds. These notes have structural conditions that can provide daily or weekly liquidity that meet the regulatory requirements. Since VRDNs are often supported by letters of credit from highly rated financial institutions, they also provides access to the banking sector for names that may not otherwise like to issue short- term obligations.
Challenges for MMF managers
The challenges faced by the global banking industry in meeting the capital requirements under the Basel III standards certainly contribute to challenges for money market fund managers. As mentioned above, many banks are reluctant to take on short-term deposits or obligations since they carry unfavorable capital charges. The cost for banks to capitalise short-term obligations, particularly those under 30 days, makes them unattractive to offer and again limits potential yield or even available supply. While bank exposure is still typically the largest allocation in prime funds, there are noticeable changes in investment profile since before the credit crisis. For example, back in 2007, US prime funds averaged only 7% in exposure to foreign bank obligations, whereas now in 2014, that exposure is in excess of 26%, according to iMoneyNet. Such changes have been driven both by market conditions and investor demand. For example, while certain that the highest quality banks aren’t seeking short-term deposits, and some have been downgraded below credit-ratings eligibility, there are still a wide variety of banks to work with around the world. However, since many investors still have concerns about selective markets, such as in peripheral Europe, managers must look further afield to place deposits. So, instead of seeing exposure to Ireland, Iceland, Spain and Greece, it is now more common to see bank names from China or Chile instead.
Money fund investments in structured securities have certainly seen notable changes over the past decade. Think back to 2006 and 2007, which were the heyday years for structured credit, not all of which survived the crisis. Then, it was common to see structured investment vehicles (SIVs) in portfolio holdings, and asset-backed commercial paper (ABCP) programmes were ubiquitous, and not all of the best quality. Today, only those structures that have been time tested from high quality issuers have survived. Supply has dwindled dramatically. (At its peak in 2007, globally the ABCP/SIVs market was $1,480 bn. Today, the SIV market is essentially dead while the ABCP market has shrunk to approximately $300 bn. ) But those that remain generally provide good access to diversified cash flow receivables such as credit cards and auto loans. Even the US Treasury has entered the ABCP market with its programme backed by student loan payment receivables. So investors generally have fewer concerns now about exposure to ABCP in their money market funds.
Use of repurchase agreements (repo) as a structure for liquidity and yield continues to be seen in funds as before. But as with ABCP, the types of repo have subtly changed, with varying risk profiles. Before the credit crisis, repo was normally used only as an overnight liquidity alternative, usually backed by US Treasury or government agency securities as collateral. Now, however, the variety of collateral that is seen has expanded to include other investment-grade bonds, mortgage-backed securities, distressed debt and equities. Distinguishing between high-quality and high-risk collateral still remains a difficult matter for investors to address. Notably, the Federal Reserve (Fed) has recently joined the market as a counterparty for repurchase agreements. The Fed limits access based on portfolio size, so certain of the larger funds that meet a specific threshold may now take advantage of this programme. With the rate levels set by the Fed rather than by market conditions, these repurchase agreements are becoming increasingly attractive while also providing strong credit quality. Since many believe the Fed intends to use this programme as a tool in setting monetary policy, yields on these overnight repurchase agreements may be some of the earliest movers toward higher levels in the coming months and quarters.