MMFs: A Regulatory Concerto?

by Helen Sanders, Editor

There have been few times in recent decades where the closing weeks of the year have brought such uncertainty and controversy as the dying song of 2010. While the potential fortunes of the euro and risk of contagion in the European debt markets continue across Europe and Basel III are amongst the most pertinent issues for treasurers, another issue worthy of consideration is changing regulation in the money market fund (MMF) industry.

Why MMFs, why now?

MMFs are discussed regularly in the treasury media, so why raise this topic at a time when there are so many other challenges? While treasurers have many issues to consider in the present discordant environment, one is the security of cash. Leaving cash in with a bank in a vulnerable country could be considered careless at the least. Government securities, the traditional bastion of investment security, are no longer seen to be ‘risk free’. Consequently, a diversified approach to investment would seem to be essential, but few treasuries have the resources or appetite to construct an investment portfolio that provides the security and access to liquidity that they require. While no instrument is ‘risk-free’ the diversified collection of high-risk assets that comprise a AAA-rated MMF should prove increasingly attractive, illustrated by the continuing growth of these instruments in Europe.

While treasurers have many issues to consider in the present discordant environment, one is the security of cash.

Since Lehman Bros collapsed, and the Prime Reserve Fund ‘broke the buck’ in September 2008, regulatory changes to MMFs have been widely expected and anticipated, and individual associations such as IMMFA have already updated their Code of Practice. As Kathleen Hughes, Co-Head of Global Liquidity Distribution, Goldman Sachs Asset Management (GSAM) explains,

“Today’s challenges and uncertainties in the MMF industry continue to be largely caused by the regulatory changes we see in the United States and Europe. Tightening Rule 2a-7 is positive for investors and fund managers alike by creating a level playing field. In Europe, we see CESR defining MMFs in Europe more clearly, which again is positive for investors.”

Some of these changes have now taken effect, such as in the United States, and European guidelines have also been published. So what are the potential outcomes of these changes, and what other issues are influencing the MMF market today? In many respects, new regulatory stipulations have been received positively, not least because they create a level playing field for fund managers, and investors can have greater confidence in the fund in which they are investing. This is not to say, however, that a fund in which a company is already investing will necessarily need to change, particularly IMMFA AAA-rated MMFs which effectively demonstrate the characteristics of a Short-Term Money Market Fund according to the CESR definition.

In the United States, many of the new and amended requirements for the 2a-7 fund (figure 2) are already in effect, with the remaining provisions due by end 2010. In Europe, CESR (Committee of European Securities Regulators) has published new guidelines which will take effect in 2011 (figure 3). Fund managers and investors alike recognise the need for greater transparency as well as management of risk, and many individual fund managers, and associations such as IMMFA had already enhanced transparency over the fund portfolio. Kathleen Hughes, GSAM describes:

“Fund transparency continues to be important to investors. In Europe, MMFs already provided 60-day WAM and WAL, which are effective ways of measuring fund risk. In addition, portfolio holdings must also be made available to investors through a website. For IMMFA funds, managers also have a policy for investor concentration and the maturity profile of the portfolio.”Colin Cookson, Head of Liquidity - Business Development, Aviva Investors agrees,

“We pre-empted the demand for greater transparency over funds, and for nearly two years have provided a weekly breakdown of the portfolio, a daily mark to market valuation plus WAM and WAL calculations.”

The CNAV – VNAV debate

Fund managers and investors alike recognise the need for greater transparency as well as management of risk.

While many of these changes are positive, one major cause of controversy is that while constant net asset value (CNAV) funds form the backbone of today’s AAA-rated MMF industry, only certain types of funds will be able to be valued in this way in the future, in favour of variable net asset value (VNAV).  Specifically, as described in figure 3, European money market funds will be designated either as Short-Term MMFs or Money Market Funds. Short-Term MMFs can be constant NAV (as with today’s IMMFA AAA-rated MMFs) but other types of Money Market Fund such as some of today’s continental MMFs, must be VNAV. In some countries, such as the Czech Republic, few if any existing funds will be able to adhere to these restrictions. While ultimately this may be positive in terms of investment security and transparency, in the short term, investor choice and opportunities for investment may be limited.

Kathleen Hughes, GSAM emphasises that both CNAV and VNAV funds have their place,

“The value of IMMFA-style, AAA-rated CNAV MMFs is well-accepted, in addition to the potential advantages of VNAV funds, particularly for retail investors with a different risk profile to the institutional investors who are currently attracted to CNAV funds.”

[[[PAGE]]]

Others are concerned that the CNAV fund will ultimately need to migrate to VNAV in the future. Justin Meadows, Chief Executive, MyTreasury says,

“IMMFA-style funds remain a flagship product, offering institutional investors both security and liquidity. These will continue to be an attractive product unless investment managers are forced to move away from CNAV products by the regulators.”

IMMFA-style funds remain a flagship product, offering institutional investors both security and liquidity. 

However, he continues,

“It may be argued that VNAV funds are more transparent than CNAV, as individual asset values are reflected in the fund; furthermore, while a CNAV fund would break the buck if the value varies by +/- 50 basis points from the par value, this would not happen in the case of a VNAV fund.”

The intricacies of CNAV and VNAV may make little difference from a day-to-day perspective, but the accounting for these funds differs, and potential local tax regulations will vary (see figure 1). Some fund managers, and their investors, have already embraced VNAV funds. As Colin Cookson, Head of Liquidity - Business Development, Aviva Investors explains,

“We introduced VNAV funds approximately two years ago as we wanted to provide investors with greater transparency over the actual value of the fund.We concluded that CNAV funds’ theoretical market value of 1.000 can be misleading to investors. In addition, investors in CNAV funds often do so under the false impression, or hope, that such funds are guaranteed by the fund provider.  This is clearly not the case.We took the view that by moving to a VNAV structure, whilst still having the stated objective of maintaining a stable NAV of 1.000 and publishing a mark to market valuation daily, investors would benefit from greater transparency and be reassured as to the underlying value of our fund on a daily basis. Providers of CNAV Funds rarely (if ever) tell investors the mark-to-market value of the fund’s portfolio. The move to VNAV has also ensured that we focus on managing our main Liquidity Funds in a conservative, highly liquid style, avoiding those instruments with potentially volatile pricing. Since we moved to VNAV in 2008, we have consistently maintained a stable NAV of 1.000.”

Colin Cookson, Aviva continues,

“To some extent, the move towards VNAV funds would return the MMF industry back to what it originally intended: i.e. to provide a highly secure, diversified and liquid investment. Before the crisis, some fund managers started to try and differentiate themselves through chasing increased yield, but to the detriment of security, and contrary to the purpose of these funds. To maintain a stable VNAV it is essential to avoid risk and instruments with volatile pricing.” [[[PAGE]]]

Picking up the tempo

Some investors are starting to seek opportunities to enhance their yield.

So if today’s AAA-rated MMFs fulfil the requirements of Short-Term MMFs, what opportunities do new types of funds offer for investors? In a low interest rate environment, yield has been a low priority; however, although security of cash remains key to investment decisions, some investors are starting to seek opportunities to enhance their yield, particularly if they do not need same-day liquidity on all of their cash. Colin Cookson, Aviva, gives an example,

“In addition to our Sterling Government and Sterling and Euro Liquidity funds, we also have two slightly enhanced Sterling funds with different risk and return profiles. We are finding that some investors are now seeking a more dynamic approach to cash investment, by using a blend of the various funds we have available to match their investment strategy - our Dynamic Liquidity Solution.”

He concludes, however, 

“While funds may need to adapt in the future, the need for a secure, diversified, liquid fund that enables investors to outsource their credit analysis of counter-parties and cash investment, will remain. Potentially, we may see a more diverse range of funds with different risk and reward profiles.”

Justin Meadows, MyTreasury also sees the new regulation as an opportunity for the emergence of new funds, without jeopardising the integrity or reliability of AAA-rated MMFs, or Short-Term Money Market Funds. He explains,

“In their search for yield, investors are seeking more bespoke products with the opportunity for an enhanced yield. It is highly unlikely that such funds would be CNAV even if allowed by regulation.”

Although regulatory movements have already been relatively significant, there is still likely to be a coda, as Kathleen Hughes, GSAM outlines,

“There may be more regulation to come, with the publication of the President’s Working Group’s Money Market Funds Report in October 2010, and further guidance from CESR. It is then up to individual regulatory bodies to impose their own definitions in local regulation. In addition, IMMFA has already revised its code of practice for members, which is closely aligned with Rule 2a-7 in the US on material issues such as the data points used for measuring risk in funds.”

One of the factors causing most concern in the industry, as Colin Cookson, Aviva highlights, is a potential change in the way that credit rating agencies treat MMFs,

“The suggestion by certain rating agencies to assess and include the fund sponsor’s willingness and ability to support a fund in crisis as part of a fund rating is causing significant concern within the industry. In our view, this would reinforce the false impression that such funds are guaranteed. This could well force providers of CNAV funds to hold them on balance sheet, which would have capital allocation implications. Indeed, this may also be the direction that regulators may drive providers of CNAV funds. The impact would be significant - it would no longer be economic to provide CNAV funds.”

[[[PAGE]]]

This is likely to be a longer-term issue, however, and involves a number of ‘what ifs’. The reality is, as Kathleen Hughes, GSAM summarises,

“MMFs continue to be popular and in Europe their use is expanding. While some investors are seeking alternative or complementary investment products, institutional investors such as corporate treasurers continue to recognise their benefits.”

Where the amount of cash is too large to keep under the mattress, MMFs arguably offer the best combination of security and liquidity available to investors.As new funds emerge, the opportunity for yield is also likely to increase further, but as ever, corporate treasurers need to be clear about what they are investing in, and continue to manage their counterparty and concentration risk. In addition to standardising the composition and management of funds, new regulations assist in this by ensuring full transparency.While the MMF industry will continue to evolve, synchronisation across jurisdictions is likely to continue, providing investors with a harmonious investment experience.