Heralding a New Era for European Money Market Funds

 

By Jason Straker, Head of Client Portfolio Management, EMEA, Global Liquidity, J. P. Morgan Asset Management

More than three years since they were first proposed, new regulations for the money market fund (MMF) industry in Europe are now in their final stages. While technical fine tuning of the text may still occur, we do not expect substantive changes and the implementation will likely take effect in late 2018. The clock has now started for investors in European MMFs to begin reviewing and understanding the different fund types that will be available, and to determine whether they will need to amend investment and accounting policies, systems and processes to take account of these changes. This article outlines some of the key changes for corporate investors, and some of the important issues they should be considering. Given the regulatory changes impacting corporate investors, specifically Basel III, it is also important that the issue of MMF reform not simply be viewed in isolation. 

Introducing the LVNAV fund

While they follow the MMF reforms which were implemented in the United States, the expected European regulations take a different approach which ultimately offers greater optionality for investors. One of the ‘headlines’ under the new regulations is that short-term MMFs that invest in government debt will be permitted to continue to use a Constant Net Asset Value (CNAV). Alongside this, the regulation introduces a new style of a Low Volatility Net Asset Value (LVNAV) fund. The LVNAV fund will effectively operate as a CNAV fund, provided that it operates within certain constraints (see Box 1). In brief, the LVNAV fund will have the following features:

• A tighter portfolio fluctuation band than existing CNAV funds i.e. no more than 20 basis points from the actual Net Asset Value (NAV), compared with 50 basis points currently used by CNAV funds.
  
  
• A diversified portfolio with stringent concentration requirements to reduce risk, and assets described more precisely and subject to strict conditions.
  
  
• Limited use of the amortised accounting method for the valuation of assets (up to 75 days; thereafter mark-to-market will apply).
  
  
• Strict daily and weekly liquidity requirements to fulfil potential redemption requests.
  
  
• Increased transparency to ensure investors and regulators have access to comprehensive information more quickly.

The LVNAV fund will be quoted to two decimal places, therefore effectively resembling a CNAV fund. However, due to the nature of the fund there is, of course, the possibility that the value could move away from a stable NAV. Consequently, it is important for corporate investors to understand the investment manager’s expectations and approach in managing this fund. 

Gates and fees

While not new to most European MMF’s, another important feature expected within the new rules is the inclusion of gates and fees for government debt CNAV and LVNAV funds. A form of these were also introduced under the revised US MMF regulations last year, and are designed to limit redemptions either by applying fees or controlling outflows in the event that liquidity levels fall below certain levels i.e. if a fund falls below 30% of assets under management in weekly liquidity and a daily net outflow of 10%. However, as the process is well-defined, fund providers will not permit funds to approach these trigger levels. This could potentially have a drag on yield, but most existing AAA rated CNAV funds are currently managing to achieve similar liquidity levels.

 
Lessons learned

It is worth reiterating that the US rules are quite different to the proposed European rules, and therefore that the decisions taken by clients in the US will not necessarily be replicated in Europe. However, the benefit of introducing these regulations after those in the United States is that both investors and MMF providers can still learn lessons from the US experience. For example, although there was a long transition period, many investors did not switch to new funds until close to the October 2016 deadline. This created difficulties for some treasurers who had not previously discussed and evaluated the changes internally or made the necessary changes to policies, accounting practices and systems.

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With many investors switching funds close to the deadline, a large movement of capital took place over a short time horizon. This resulted in rising short-term yields, illustrated by the increase in Libor and the widening gap between prime and government fund yields[1]. In response, and to manage large redemptions, MMF providers increased cash levels in funds which resulted in a lower average maturity and lower yield, which served to close the gap between prime and government funds. After the new regulation transition period, investment levels in prime funds then returned to a normal level, and the yield differential between prime and government funds returned, exacerbated by the spike in Libor. The outcome of this was that some investors who had previously switched from prime to government funds in response to the new regulations decided to switch back to prime funds to take advantage of the higher yield.

 
Planning ahead

With the optionality afforded by the European MMF regulatory proposals, a similar shift to CNAV government debt funds in Europe is not anticipated. Also, the European MMF market is smaller than the US – approximately USD1tr across multiple currencies and markets compared with USD2.7tr in the US[2] Furthermore, many European investors are already familiar with VNAV funds, as domestic funds such as SICAV in France are already valued on this basis. However, treasurers need to prepare, as follows:

1. Understand the new regulations. First, treasurers need to explore the detail of the regulations, including the new LVNAV fund, and decide whether existing short-term or standard VNAV funds, the LVNAV or government CNAV are most closely aligned with their risk and return appetite. 
   
   
2. Engage in internal discussions. Treasurers need to prepare the ground internally, ensuring that board and/ or treasury committee are aware of the new regulations and its implications. There may also be changes required to the investment policy, processes and systems, which can take time to implement.
   
   
3. Clarify the balance of risk/ return. Based on the experience of US investors, it is worth deciding what the yield differential would be to switch from the fund type that the company generally prefers into higher yielding fund, and what the conditions of this might be.

 Although the introduction of new European MMF regulations will create change, which inevitably brings some uncertainty, they are likely to create less impact than comparable regulations in the US. For existing short-term MMF investors, the CNAV government debt and LVNAV options bring with them a level of familiarity. The alternative of a short-term VNAV MMF presents a third option with which many investors are already familiar. While gates and fees were an issue for many US investors, treasurers in Europe are more accustomed to these tools being in place . However, although the changes may be less significant, treasurers need to work with their fund providers to understand, communicate and prepare for these regulations to avoid disruption to their cash investment decision-making and operations.  

Notes
1 Source: iMoneynet, as at 31 October 2016.
2 Source: iMoneynet, as at 31 March 2017.