Published: November 01, 2013
Regulators that govern the money fund industry globally are on the verge of finalising significant changes that will fundamentally alter many of the attributes cash investors have come to value. These changes will place corporate treasurers, one of the larger investor segments in money market funds (MMFs), in the potentially uncomfortable position of having to think differently about cash; namely that cash is indeed an asset class that requires risk-focused due diligence and that they will need to evaluate alternatives more proactively.
While investor demand for greater transparency and regulatory changes since the 2008 crisis have strengthened the resiliency of MMFs, looming further reform for both the money markets and financial industry is very likely to alter the range and characteristics of both money market funds and direct instruments alike. This new reality will require treasurers to consider an increasingly dynamic model to match their firm’s unique investment objectives. Traditional overarching goals such as principal preservation, liquidity, and investment performance, while still critical, will need to be prioritised according to the specific requirements of clearly defined investment tranches. As the capital markets evolve and adjust by offering a greater variety of products, increased customisation and transparency, so too must treasurers adapt. By properly segmenting portfolios, staying aligned with changing products, and partnering with well-resourced, experienced advisors, they can properly optimise their cash investments.
The burden for treasurers becomes even higher when regulatory efforts to reduce reliance on credit rating agencies are considered. Historically, most treasurers leveraged internal resources and third party credit ratings to select a small basket of short-term investments including government bills, bank deposits and triple-A rated MMFs. This was a straightforward approach from an accounting perspective and relatively inexpensive. In this model MMFs provided high liquidity, wide diversification, and essentially represented a partial outsourcing of risk management for the organisation.
Simplicity, especially if at the expense of vigilance, comes at a price, as some MMF investors unfortunately discovered during the 2008 financial crisis. Today’s treasury investor is at a crossroad where the one-size-fits-all money fund of the past may no longer fulfill all of treasury’s needs going forward. In order to implement a more tailored approach, cash investors must overcome the costs (both direct and indirect) of operational, accounting and risk management changes that a more nuanced strategy requires.
Regulators’ concerns over the potential systemic risks posed by MMFs have grown since the 2008 financial crisis and have been incorporated in the broader regulatory debate with respect to the ‘shadow banking system’. While the broad term includes entities such as hedge funds, structured investment vehicles (SIVs), ETFs and Private Equity funds, the money market fund industry is a large and, in some regulators’ view, systemically relevant part of this shadow banking system.
Given various risk profiles and structures within the shadow banking system, investors often rely on third party rating agencies to assess risk characteristics and overall suitability. Money funds often utilise credit rating firm opinions to help promote their products as the ratings criteria seek to establish a standard for evaluation. The financial crisis, however, brought the overreliance on ratings into question for failing to anticipate the collapse of Lehman Brothers, as well as for investor losses related to ratings-based financial products, such SIVs and auction rate securities.
With these weaknesses exposed, the idea of being able to rely on third party ratings as a means to outsource risk management took a substantial blow. This was exacerbated when the Reserve Primary Fund ‘broke the buck’ due to portfolio losses, mostly on debt issued by Lehman Brothers. That immediately led to heavy redemptions from prime money funds, with outflows of $300m, or 14% of the assets, according to US Securities and Exchange Commission (SEC) estimates.[1] A main pillar supporting longstanding corporate cash investment strategies had now been dramatically shaken.
On both sides of the Atlantic, regulators have pursued money fund reforms designed to avoid a repeat of the 2008 crisis. In the US, legislators inserted a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that required regulators to strip ratings out of their rules to whatever extent possible. As a result, fund managers may not rely on ratings for the securities they select, and the quality and depth of their credit research capabilities becomes paramount. Similarly, the SEC implemented new MMF regulations in 2010 and a new proposal for further reform, released in June 2013, contemplates two alternatives. The new proposal is extensive in scope, but in summary, alternative one, if adopted, would require institutional prime MMFs to transact at a variable net asset value (vNAV). Prime constant net asset value funds (cNAV) with limited liquidity provisions would still be allowed for retail investors. The second alternative introduces the potential for redemption gates and/or liquidity fees for prime cNAV funds should they breach a prescribed liquidity buffer. Those funds that invest solely in US Treasury, government and agency paper would not experience any changes under either alternative. The SEC is also considering any combination of the two alternatives and is accepting public comments until mid-September.
Meanwhile, EU regulators released proposed regulations on money funds on September 4 2013. The rules are meant to bolster the resiliency of money market funds in time of stress including some similar to those adopted by the US SEC in 2010. Notably, they would require a 3% capital cushion for cNAV funds and would eliminate fund managers’ overreliance on rating agencies.[2] The EU states that their primary concerns relate to ‘run on the fund’ risk when money funds value their assets at amortied cost to maintain a cNAV but the market value of the underlying investments dseclines, potentially creating an incentive for investors to pull their funds during times of market stress to avoid potential loss of principal or liquidity.[3]
Regardless of the final outcome, it is clear that global regulators are converging toward a more comprehensive regulatory framework for MMFs and corporate treasury teams need to prepare for this new paradigm.[[[PAGE]]]
Acknowledging that change in MMFs and the short term-markets is inevitable, there are ways for treasurers to meet the challenges. Some treasury teams are already well positioned to support additional due diligence and risk management functions in-house. A number of treasurers have offset the additional cost of increasing their risk management acumen by becoming the in-house source of expertise for other departments, for example, by doing credit reviews of supply chain members or customers. Treasury can also leverage its existing relationships with fund managers. By tactically outsourcing mandates, treasury executives gain access to valuable insights and resources which supplement their internal efforts.
For balance sheet investments, companies traditionally have segmented cash into different investment tiers (i.e., Liquidity, Strategic, Core), depending on the company’s expected liquidity needs. In the new environment, these tiers will need to be more granular and nuanced, with varying products used to meet the goals within each tranche. Within the liquidity tier, a corporate treasurer would often select money market funds together with overnight bank deposits to meet the daily liquidity needs of those assets. Now, however, within the same tier and with the same risk profile, it is possible that certain assets would be more suitable in cNAV fund, while others may be better fit for a vNAV product. For example, if there are gates and/or fees on a cNAV fund that could be implemented during times of market stress, assets that have mandatory outflow dates could have their liquidity at risk. It would be appropriate, therefore, to also have assets in a vNAV strategy that may offer improved access to ready liquidity at market pricing. Similarly, for more strategic or core balances, longer-term or predictable cash needs can be diversified into a combination of vNAV funds and customised separate portfolios to complement any self-managed component.
Separate accounts should be designed to achieve specific corporate goals, whether to balance an existing exposure, improve diversification, or to take advantage of investment opportunities from which money funds are barred. Taking the model further, companies with significant cash pools can think more creatively about how they invest by establishing private investment funds investing in their own trade receivables, thereby leveraging available cash balances to finance other divisions within the organisation.
As the money market industry prepares for the future, corporate treasurers will play an important part in shaping the final outcome. As both issuers and investors, the strategic decisions they make with respect to the topics highlighted above will influence virtually every facet of their roles. Investment returns, financing costs, liquidity, risk management, accounting, and tax decisions will all be impacted by how their organisations weigh the trade-offs among priorities in this changing landscape. Identifying, evaluating, and implementing change will take more effort than simply signing off on a triple-A rated stable NAV fund. While the transition may be uncomfortable, inaction is not an option and the time for planning is now. As an extension of the corporate treasury team, investment managers should be poised to work closely with their clients to align the new range of alternatives available into a comprehensive investment strategy. Proactive treasurers can benefit from those partnerships as they embrace the new investment landscape to come.
Notes
1 SEC Money Fund Reform “Fact Sheet”, June 5, 2013, http://ftp.sec.gov/news/press/2013/2013-101.htm
2 EC draft regulations on MMFs, September 4, 2013
3 European Commission Green Paper on Shadow Banking, March 19, 2012, http://ec.europa.eu/internal_market/bank/docs/shadow/green-paper_en.pdf
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