Published: August 01, 2009
The market turmoil which commenced in the summer of 2007 has resulted in the worst global financial crisis since the 1930s. Money market funds (MMFs) have not escaped this turmoil, and increasing attention has been directed towards the product from both investors and regulatory bodies. The global size of the industry now amounts to over USD 5tr, the vast majority of which is invested in the US. However, while the US market has a clear definition of what constitutes a money market fund, which has resulted in the development of a huge and systemically important industry, the market in Europe has never developed a widely accepted definition. This has resulted in a more fragmented industry in which a variety of products are referred to in this way, but operate within different parameters.
MMFs originated in the United States in the early 1970s as a result of Regulation Q. Introduced in 1933 by the Glass-Steagall Act, Regulation Q is the Federal Reserve Board regulation that placed a limit on the interest rate that banks could pay, including a rate of zero on demand deposits. MMFs developed as a result of this; as they are not considered as a demand deposit, they are able to reap competitive interest rates for investors. Their success resulted in amendments being made to the Investment Company Act 1940, which instigated direct regulation of this fund type through Rule 2a-7 of the Securities & Exchange Commission (SEC). Following the implementation of this rule in 1983, no fund type has been permitted to promote itself as a “money market fund” in the US unless it complies with the requirements of SEC Rule 2a-7.
This rule applies strict criteria to MMFs, generating a product which both retail and institutional investors in the US recognise and utilise. The success of the product is such that nearly USD 4tr is currently invested in it.
In order to qualify as a MMF, the product must:
This very specific piece of regulation has allowed an industry to develop. The investors using the product have a complete understanding of the nature of the product. Investors recognise that a MMF seeks to provide capital security and liquidity, and also maintain a constant net asset value. Such is the clarity of that understanding that the product is heavily utilised by both retail and institutional investors, with the split between the two being approximately 35% retail and 65% institutional.
Outside of the US, there are a small number of sizeable markets for MMFs, albeit that the total of funds under management still remains relatively small when compared with the US industry.
Within Europe, MMFs initially developed in France in the early 1980s. Following a change in regulation in 1981, which restricted the yields payable on time deposits, commercial banks began offering MMFs as a viable alternative to cash investors. The French MMF industry, which seeks to offer products whose principal purpose is to provide capital security, now manages approximately €450bn of assets.
In contrast to the US market, all MMFs in France provide a variable net asset value, albeit that the funds are managed with the intention of providing an asset value which only increases. The MMF industry in France has developed without reliance upon a rating for the fund.
There are two principal types of MMF authorised by the French regulator, the Autorité des marchés financiers (the AMF): Fonds Monétaire Euro (Eurozone MMFs) or Fonds Monétaire à vocation internationale (International MMFs). In addition, there is a so-called “dynamic” or “enhanced” MMF sector, albeit that these are not recognised as MMFs by the AMF.
The two fund types designated as MMFs by the AMF are required to adhere to some criteria, but are not subject to the same level of investment restrictions as those in operation in the US:
These funds generally invest in instruments with a maturity of less than three months, and not exceeding one year. For those instruments with a maturity of three months or less, the manager may utilise an amortised cost rather than the market value.
The “dynamic” or “enhanced” sector is not subject to specific regulation by the AMF, and consequently has no qualitative or quantitative limits applicable to the funds. It is generally accepted that such funds concentrate on performance, but also seek to provide an element of capital security.
Whilst the US and French MMF industries may broadly have the same objectives, the limited quantitative criteria of the French model allows material differences to arise between the two industries. [[[PAGE]]]
The European version of the US money market fund did not appear until the mid 1990s, and was initially developed by the European subsidiaries of various US banks and investment companies. These funds initially developed in only two locations, Ireland and Luxembourg, but have since begun to expand into other localities. There is however no specific European regulation covering only these MMFs, but all European funds that are equivalent to the US version operate in accordance with the UCITS directive.
In the absence of any regulation equivalent to rule 2a-7, this European industry formed a specific trade body to represent the interests of this product – the Institutional Money Market Funds Association (IMMFA). In an attempt to instil best practice standards across the membership, the IMMFA Code of Practice was developed in 2002. The Code is a self-certified standard to which all members adhere, and includes quantitative limits and qualitative standards with which the funds should comply. This Code requires all members’ funds to have achieved a triple-A rating from one or more of the credit rating agencies. The combination of the triple-A rating (and the monitoring conducted by the rating agencies), the UCITS directive and the IMMFA Code of Practice provide the investment parameters within which these funds operate.
The key parameters are:
The IMMFA Code of Practice defers to the requirements of the rating agencies with respect to the diversification and credit quality requirements which are imposed. In general however, the diversification requirements are more stringent than contained within the UCITS directive, and the credit quality requirements are comparable with those within rule 2a-7 in the US. The funds which are included within the IMMFA membership are therefore broadly similar to the US version.
Since the inception of IMMFA in 2000, the total funds under management within members’ money market funds have grown year-on-year, currently standing at approximately €440bn.
In the UK, the investment management and life assurance industries both provide for a money market sector in which funds may report in order to provide peer group comparison. The definitions in both sectors are broadly similar, being based on qualitative statements rather than quantitative limits. For a fund to qualify for either the Investment Management Association (IMA) or Association of British Insurers (ABI) Money Market Sector, the fund must invest at least 95% of assets in money market instruments, loosely defined as cash or near cash (such as bank deposits, certificates of deposit, fixed income securities or floating rate notes).
Bespoke industries have also developed in other locations, including the German money market fund industry. These funds are however more akin to short-term bond funds. There is no regulatory definition and therefore no restrictions on the investment parameters applicable to these funds. They seek to provide capital security and performance in line with a money market benchmark, which is achieved through equity investment, but with the risk hedged to minimise potential for losses.
Again, in the absence of any quantitative limits, these MMFs can be significantly different from the US or IMMFA money market funds, and should not therefore be directly compared. [[[PAGE]]]
The performance of the more sizeable industries shows notable differences since the onset of the credit crunch in the summer of 2007. Using indexed growth in total funds under management, the relative performance of the US, French and IMMFA universes can be compared.
From this it is clear that the experience of MMF investors depends significantly on the type of MMF. This is due to the fact that the funds which report as MMFs have different objectives and risks, and therefore react differently to market events. And with no overarching pan-European regulation, and no consistency in the definitions used either throughout Europe or between Europe and the US, an investor in a MMF in one locality is likely to be influenced by the impact of market events on a MMF in another.
Given the breadth of funds in Europe referred to as MMFs and the absence of any pan-European regulatory definition, there is a significant possibility of investor confusion. The increased attention which has been given to MMFs due to the market turmoil of recent months has only exacerbated the situation by increasing the media coverage of every format and guise of MMFs. This has also occurred at a time when investors are generally more nervous and sceptical about the risks associated with any product.
Furthermore, investment in a MMF comes from a global investor base, with the investor not necessarily based in the same locality as the fund or the manager, or in the region in which the currency is prevalent. Consequently, investors’ understanding may be restricted to an appreciation of only one product; therefore, when there is media coverage of “MMFs”, it is understandable that an investor will equate this to the product type in which he is invested, irrespective of the underlying cause or location.
It is indisputable that the market crisis has highlighted the need for a definitive pan-European definition of a MMF. In the De Larosière report submitted to the European Commission, a specific recommendation is made for such a definition to be implemented. The industry has recognised this. Led by the IMMFA and the European Fund and Asset Management Association (EFAMA), a working group has been formed to develop a definition which members of the asset management industry should adhere to for marketing of funds.
The historic development of the MMF industry in Europe is likely to result in a definition which is broader than in the US. However, by providing a consistent definition that will allow investors to understand the nature of the fund, the outcome should prove beneficial. It should also mitigate the possibility of confusion by removing the potential for investors to compare products with different objectives.
The objectives and therefore risks of the various funds described as MMFs are not necessarily consistent. An investor should not therefore assume that one fund which is referred to as a MMF will exhibit the same risk profile as any other. Indeed, even within the specific definitions, there is sufficient leeway to allow a fund manager to differentiate his product from that of his competitors.
The fund documentation will include details of the risks to which the investor is exposed, but an investor would be advised to speak directly with the fund management company to determine whether the risk appetite of the fund is consistent with that of the investor. The breadth of funds that are available in Europe should ensure that an investor is able to locate at least one which mirrors his investment objectives.
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