Published: January 01, 2010
The upheaval in the money market fund sector during the past 18 months has prompted a number of proposed regulatory changes in the United States, United Kingdom and Europe. Although designed to enhance the safety and transparency of these investments, the proposed changes are also likely to cause institutional investors to rethink their approach to investing in money market funds.
Investors have demanded a higher level of transparency to understand the underlying risks with a fund.
Money market funds have long been considered a bastion of safety, even during times of financial crisis. That changed last September, however, when the net asset value (NAV) of a US money market fund fell below US$1 per share and the fund couldn’t meet redemption requests.
The unprecedented events of last year serve as a reminder that money market funds do carry investment risk and that investors can lose money. “Investors have demanded a higher level of transparency to understand the underlying risks with a fund,” says David Rothon, global fixed income product specialist at Northern Trust, London.
Money market funds represent a large and critical segment of the financial world. According to Crane Data, money market fund assets have grown to about US$3.6tr at the end of 2009 from about US$1.8tr at the beginning of this decade.
“The money market sector has proven to be important to a well-functioning financial system,” says Peter Yi, director of money markets at Northern Trust. “It’s the grease that allows the wheels of the financial system to turn. That’s why the credit freeze within this sector was one catalyst to a broader credit crunch,” he notes.
In the United States, Rule 2a-7 of the Investment Company Act of 1940 governs money market funds. The rule was amended in the 1990s and worked effectively for about a decade, but faltered under the recent market turmoil, says Bradford Adams, senior product manager, Northern Trust. In fact, the Reserve Primary Fund actually was operating within 2a-7 when it ran into trouble. “That highlighted the fact that 2a-7 was inadequate for the challenges money market funds faced,” Adams says.
To remedy this, the US Securities and Exchange Commission (SEC) is considering changes to the regulations, and has received proposals from several groups, including the Investment Company Institute (ICI). The main objective of any regulatory changes would be to manage systemic risk. Currently, about 40 million investors hold registered money market products. When significant redemptions occur, the liquidity in the system is unable to accommodate them, which means sales take place into a distressed market. The proposals are intended to mitigate that. “In general, we’re looking at the proposals with optimism,” Yi says. “They’re ultimately good for the industry and will strengthen it.”
Several of the proposed changes concern the maturities of the securities within money market funds. One of these changes would reduce the weighted average maturity (WAM) of a fund’s portfolio from 90 to 60 days. By convention, WAM measures maturity based on interest-rate reset. So a floating-rate note with an interest rate that changes each month is considered to have a WAM of one month, not the time to the final maturity, which could be as much as a year longer.
Another proposal would cap the weighted average final maturity (WAFM) of a portfolio at 120 days; no current regulation limits this. The WAFM measures the assets based on final maturity and this change would limit funds’ ability to invest in long-term floating-rate securities.
Several other proposals focus on liquidity. One requires institutional money market funds to maintain at least 10% of their holdings in securities that mature within one day and 30% in securities that mature within one week. The current version of Rule 2a-7 contains no liquidity requirements. Interestingly, the ICI is proposing a slightly different version of this change and suggests that funds keep 5% of their portfolio in securities that mature within one day and 20% in securities with maturities of up to a week.
In another proposed change, money market funds would be restricted to only A1/P1, or the highest quality, securities. This proposal has a good chance of moving forward, Adams says: “It’s important to note, however, that such a change wouldn’t have prevented the Reserve Primary Fund from breaking the buck. Lehman Brothers was an A-rated issuer until the day it filed for bankruptcy. Allowing funds to invest in A2/P2 securities enables them to diversify away from financial sector issuers, which account for more than half of A1/P1 securities. An argument can be made for continuing to allow A2/P2 securities in money market funds because it tends to help diversification more than it lowers credit quality.”[[[PAGE]]]
A proposal that has generated controversy is the recommendation to move from fixed to floating share prices. “There’s an intellectual appeal to a variable net asset value,” Adams says. However, this change would create a host of other concerns. As a starting point, money market funds are currently classified as cash in most companies’ balance sheets. If a move to a floating NAV is enacted, they would have to be classified as short-term investments. In addition, such a shift would create gains and losses on every trade, creating a tremendous amount of accounting work, thereby reducing the appeal of money market funds to the corporate community.
Yi notes Northern Trust already operates within the proposed framework, focusing first on principal preservation, then liquidity and then yield while also emphasising credit research and risk management. “Where we will see real benefits from these proposals is by continuing to be a leader within a stronger and more stable industry,” he says.
Going forward, investors will want to consider several aspects of a money market fund before investing in it. First, assess the strength of the fund organisation, along with its investment process and governance.
To determine this, investors need to focus on the process a company uses to evaluate investments and assess risk. “Until recently, some investors paid little attention to this, treating money market funds like commodities with a sole focus on yield,” says Steve Everett, director of balance sheet and operating assets. “Higher rates usually indicate a greater level of risk. It’s important that investors understand that yield can be a good thing, but it can also be a red flag,” he adds. “Investors should also verify that the fund has the technical tools to readily evaluate its holdings and risks to make informed decisions. Its systems should provide frequent and robust reports,” Yi says. “In addition, a fund should be able to adopt any proposals that are enacted without wavering in its overall investment philosophy and process,” he adds. “The fund family should have the resources to support more stringent reporting requirements that promote greater transparency and disclosures.”
Some modifications to money market fund regulations are also likely in the United Kingdom and Europe, says Rothon. He says the Institutional Money Market Funds Association (IMMFA), a trade association representing the European triple-A rated money market funds industry, has formulated several proposals.
IMMFA, working with the European Fund and Asset Management Association (EFAMA) developed some common definitions of money market funds, which hadn’t existed in Europe.
Several other proposals are similar to, or the same, as those being discussed in the United States. One is a liquidity policy, which states that funds would have to hold at least 5% of their assets in securities that mature within one day, and 20% in investments that mature within one week. Another proposal would require more disclosure of the percent of the fund’s assets held by the top 10% of shareholders, as well as the holdings within the fund. All of these make up a ‘code of practice’ to which funds would have to adhere. Existing funds, however, would likely be ‘grandfathered in’ over a period of time, Rothon says.
Together, the proposed changes highlight a trend toward greater transparency and product integrity. “In the future, a fund that takes on more risk will be distinguished from a safer fund with lower return,” Rothon says. “The days of dialing up the risk on a AAA-rated fund in order to boost yield are over. The goal of the proposals is to make sure that 2a-7 or IMMFA funds provide the seal of quality investors expect from a money market fund.”
With thanks to Peter YI, Director of Money Markets, Bradford Adams, Senior Product Manager, and Steve Everett, Director of Balance Sheet and Operating Assets, Northern Trust.
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