Money Market Funds: A liquid asset in volatile markets

Normally, the summer is a time for relaxation and enjoyment... but not the summer of 2007!! The fallout and repercussions of the turmoil in financial markets continue, and as yet, there is no light at the end of the tunnel. However, we at the Institutional Money Market Funds Association (IMMFA) continue to have a positive outlook.

Not all money market funds have escaped unscathed from the turmoil which has been affecting global economies since last summer, but it is important here to draw the distinction between the different types of money market funds that are available. Some funds are managed with the primary objective of producing an enhanced yield for investors whilst still offering an element of capital security and liquidity. For other money market funds, the yield is of secondary importance when compared with the primary twin objectives of preservation of capital and access to that capital upon demand.

It is important to draw the distinction between the different types of money market funds that are available.

IMMFA only represents the latter style of money market fund - these funds are often referred to as ‘liquidity funds’, ‘treasury-style money market funds’, and now increasingly as ‘422 Funds’ (after the relevant asset valuation section of the CESR guidance associated with the Eligible Assets Directive). Irrespective of the nomenclature for these funds, the reality of the situation is that there are significant differences in the way these funds are managed when compared against the ‘enhanced’ - or ‘investment-style’ money market funds. For this reason, IMMFA fully supports a move to a pan-European definition of a money market fund, similar to that in operation in the US under SEC rule 2a-7.

The impact of the market turmoil on money market funds depends upon the type of money market fund in question. Let me start with ‘enhanced’ money market funds, which have received more press coverage and attention, albeit sometimes without any distinction between fund types being made. These funds are designed to provide the investor with a headline rate of return, whilst also offering security and liquidity. Increasing use had been made of structured products - such as asset backed securities (ABS) - to provide additional yield to these portfolios. Some of these funds achieved a triple-A rating from one or more of the independent credit rating agencies. Irrespective of any triple-A rating, the susceptibility to market volatility and liquidity tightening was not evident in benign markets. Consequently, investors were prepared to accept a notional increase in risk in return for a more attractive yield.

At the onset of the turmoil, the liquidity risk in these funds became immediately apparent. Difficulties in valuing assets occurred when secondary markets disappeared, and with ‘forced-sales’ into illiquid markets, these funds were increasingly subject to significant reductions in fund values. In some notable instances, parental support was sought or the fund was simply wound up.

The success of 422 funds

In contrast, 422 Funds have generally performed very well. Funds under management have increased to record highs, both in Europe and in the equivalent US fund type. In Europe, funds reached €393 billion at the end of March 2008, an increase of over €75 billion since June 2007.

The success of 422 Funds is in no small part due to the investment structures of these funds. Regulatory obligations require the funds to have a weighted average maturity (WAM) for interest risk-management purposes of no more than 60 days, and to purchase no instrument which has a fixed interest - or interest reset period - of more than 397 days. These funds are therefore all short-term in nature, with most funds operating with a WAM of approximately 40 days. At the onset of the financial turbulence, fund managers were able to respond quickly to the crisis by changing the composition of the assets within the fund to build up a strong supply of daily liquidity. With a regular supply of maturing assets, this was achieved without having to resort to any ‘forced-selling’.

The underlying portfolios could then be quickly altered to ensure the principal objectives of preservation of capital and liquidity continued to be met at all times. In recognition of the growing nervousness of investors as the crisis deepened, 422 Funds simply increased the proportion of assets held on overnight deposit, or as certificates of deposit, to ensure the ability to liquidate investments same-day was retained for all investors.

Another key differentiator for these funds is their ability to value assets on an amortised basis. Whilst other funds can utilise this methodology for components of the portfolio, it is only 422 Funds which can value both the fund and all underlying components on this basis (as governed by the Eligible Assets Directive and associated CESR guidance). Using this methodology, the asset value is extrapolated on a straight-line basis from the purchase price at a premium or discount to par to the price at maturity of par. Regular comparisons with the mark-to-market price are made at fund and instrument level, with escalation procedures in operation to ensure material differences are acted upon. However, the directors of the fund have discretion over the action which should be taken upon any divergence in the two pricing methodologies, provided the relevant individuals make the decisions which should be in the best interests of investors in all instances. [[[PAGE]]]

Consequently, it is the intention of a 422 Fund manager to hold all instruments to maturity. This neither creates valuation difficulties, nor the need to seek forced sales of assets in illiquid markets. 422 Funds have been able to avoid the volatility which has been associated with other funds, especially other money market and hedge funds. This stability has been rewarded by the significant influx of funds, taking investment to record levels during the turmoil.

The desire by investors for safety of principal and liquidity in the uncertainty created by the credit crunch was the reason for the flight to quality, resulting in significant investment in 422 Funds since August 2007. However, in order to ensure this new investment is retained if and when markets become more settled, there is a need to maintain the integrity of the product.

Review of IMMFA Code

The market turmoil has provided the perfect opportunity to conduct a frank review of the IMMFA Code of Practice. Following consultation with the IMMFA membership and other interested parties, IMMFA is reviewing the Code with a view to implementing a revised version based on a small number of principles with underlying guidance indicating how compliance can be achieved.

422 Funds have been able to avoid the volatility which has been associated with other funds, especially other money market and hadge funds.

The integrity of the product will also be tested by the recent regulatory changes which are expected to further increase investment in 422 Funds. The introduction of MiFID in November 2007 allows client money to be placed in a ‘qualifying money market fund’ (a type of money market fund which equates to a 422 Fund). This is the only instrument other than a bank deposit which can hold such money. Recent amendments to the FSA rules now allow investment by banks and building societies in a 422 Fund to be eligible as a liquid asset for prudential liquidity purposes.

The credit crunch has indicated the importance of, and the need for, adequate liquidity at all times. 422 Funds have clearly demonstrated their ability to provide liquidity to investors upon demand in the most challenging of market environments. As such, IMMFA believes that 422 Funds should be included as eligible collateral for liquidity purposes in all European jurisdictions. The amendments which have been made in the UK - at the height of the market turmoil - reflect the robustness of the product, and should be seen as a clear indicator of the acceptance by a key regulator of the ability of the product to provide liquidity in all market conditions.

In addition, IMMFA believes that 422 Funds should be designated as eligible collateral for open market operations with central banks. This would allow credit institutions to utilise 422 Funds in order to gain access to central bank facilities when needed, and would widen the pool of liquid assets which could be used as collateral. The events of the credit crunch have demonstrated the need for wider prudent access to central bank facilities in times of stress, provided that access is controlled through the use of acceptable collateral. 422 Funds have demonstrated their ability to withstand extreme market events whilst continuing to meet their principal objectives of capital security and same-day liquidity. Recognition of this ability could help in a modest way to alleviate any future shortfalls in liquidity provision.

Prior to the onset of the credit and liquidity problems affecting the global financial markets, work was already being considered on making amendments to 422 Funds to enhance the liquidity provision of the product. This enhancement was designed to reduce any volatility which may be introduced to the funds as a result of investment by banks. Whilst the capital requirement placed on banks resulting from the investment in a triple-A rated money market fund had reduced due to the implementation of the Capital Requirements Directive - making investment noticeably more attractive - it was expected that possible sizeable investments and redemptions by banks, often at short notice, could create volatility and an adverse impact on the yield payable to other investors in the fund.

A new share class?

To avoid such volatility and any associated impact on yield, IMMFA is considering whether a new share class could be created that would offer banking investors the ability to repo the shares of the 422 Fund rather than redeem them. This enhancement would continue to allow all investors to have same-day liquidity, irrespective of the size of the demand. Such enhancements should also aid the argument for the use of 422 Funds as a liquid asset for banks within the prudential regimes of pan-European regulators.

The events within financial markets since the summer of 2007 have seen a significant inflow of investment into 422 Funds. The expectation of investors is for these funds to continue to provide capital security and same-day liquidity at all times. The challenge for the industry is to ensure this occurs, whilst maintaining the integrity of the product in light of new investors and new offerings. This can only be achieved through prudent management and an honest self-assessment by the industry of those areas in which further improvements can and should be made.

422 Funds are ideally placed to exploit the need for liquidity provision, and IMMFA firmly believes that should this be achieved, the product will then be lifted to new levels of investment, as well as achieving a place amongst all treasurers as a key component of corporate balance sheet management.