Published: November 01, 2014
In August 2014, the Securities and Exchange Commission (SEC) in the United States adopted reforms to Rule 2a7 funds (US money market funds - MMFs) with the aim of reducing systemic risk. Inevitably, these changes have been met with a mixed response, not least due to the uncertainty that will undoubtedly continue until full adoption of the reforms in 2016. In reality, however, are these reforms likely to mark the end of the MMF era, or conversely, given the other market and regulatory changes that are taking place in parallel, are we on the brink of a new phase in the growth of MMFs? As Jim Fuell, J.P.Morgan Asset Management highlights,
“We see two key trends in corporate investment appetite: firstly, the impact of regulation, not only MMF regulation, but wider changes such as Basel III, which in fact creates a tailwind for MMFs; secondly, prolonged low interest rates, particularly in Europe. While companies will not risk assets to avoid negative yield, the convergence of these two issues is prompting treasurers to review their investment policy and consider alternative investments.”
The changes to US MMF regulation impacts on investors in a variety of ways, although these will take effect over the next eighteen months to two years (until October 2016). One of the ‘headline’ changes is the shift from constant net asset value (NAV) to variable NAV. This mandatory shift from constant to variable NAV applies specifically to institutional, non-government MMFs i.e. retail MMFs and government funds are excluded from this requirement. This has valuation, accounting, and operational implications for fund managers, as well as investors. More immediately (i.e., by February 2016) 2a7 funds can no longer be awarded credit ratings from the independent rating agencies. (The removal of external credit ratings from prime money market funds was not included in the final legislation.) The AAA credit rating that MMFs boast is often a major criterion for corporate investors, so many will need to revise their investment policy accordingly to allow for investment in unrated funds, or seek other highly rated investment options. Nick Jones, Head of Sales, Liquidity, EMEA, HSBC Asset Management emphasises,
“Changes to SEC-2a7 regulated fund structures in the US should be viewed by all corporate investors as an opportunity to engage with their global asset manager on the future implications of moving to variable NAV and the wider impact on their global investment policy in other jurisdictions. ”
Jim Fuell, Head of Global Liquidity, EMEA, J.P. Morgan Asset Management comments that while important, the reforms are unlikely to prompt an immediate change in either fund manager or investor behaviour,
“While recent regulatory announcements, such as the changes to 2a7 funds, are a concern for investors, a survey of our clients has indicated most are likely to maintain their existing cash allocation during the course of 2015 given that implementation of the new regulations will largely not take effect until 2016. Even so, investors are still keen to understand the implications and consider what changes to their investment policies may be required.”
Few existing investors in 2a7 funds are likely to push their investment managers to migrate to new-style funds in the short term, bearing in mind that they are already comfortable and familiar with existing funds. Without ‘early mover’ advantage for either fund managers or investors, we would therefore not expect to see considerable activity until closer to the transition deadline in 2016. As Nick Jones, HSBC Asset Management, underlines however, regulatory change will ultimately result in innovation.
“From a bank perspective, regulatory change of this nature will lead to product innovation in fund structures. For example, off balance sheet, we could see new flavours of liquidity fund structures emerge to meet the needs of investors concerned about exposure to daily price fluctuations.”
Given that MMFs are characterised by same-day access to liquidity, and a straightforward investment and redemption process, the transition itself between existing and new funds can be more or less immediate. The primary challenge is therefore to ensure that corporate investment policies permit investment in the new, unrated, constant NAV funds, and that accounting and treasury systems support these funds. These issues will take longer to address than the investment process itself, so investors need to be well-informed and well-prepared to understand and ensure that their policies, processes and systems support the changing profile of funds in which they are investing, or that new investment arrangements are in place.[[[PAGE]]]
Looking beyond the US, a new regulatory framework was also proposed for MMFs in Europe in September 2013 following a period of consultation, but these plans were put on hold earlier in 2014. There is a general expectation that this process will be reinstated, although the timing of this, and the potential length of an adoption period, remains unclear. Bea Rodriguez, Head of EMEA Cash Portfolio Management, BlackRock suggests,
“While we are likely to see changes to MMF regulation in Europe in the future, potentially in line with those recently confirmed in the US, we could see some structural differences in reforms as the US has more retail investors in MMFs compared with Europe which is dominated by institutional investors. However, it is very important to bolster the safety of MMFs through improved stress testing, transparency and diversification – measures that were already in place in the US before the most recent announcements – and with regard to reform in Europe it will be important to take into account local variations, such as the relatively small proportion of government securities that comprise MMFs.”
Jim Fuell, J.P. Morgan Asset Management advises,
“It is important not to pre-empt regulators’ decisions in Europe. Clearly they are well aware of the changes that have been announced in the US, and it is highly likely that changes will happen in Europe too, but the specifics are by no means certain. For example, one of the focus areas in the US was the move from constant NAV to variable NAV funds for certain fund types. While this is a significant shift, impacting around a third of constant NAV assets, the effect of a similar change in Europe on institutional prime funds would be far more considerable, which the regulators will be looking at.”
While there is no reason why the current and medium-term regulatory environment for MMFs in Europe should jeopardise their use by corporate investors, a major issue is whether wider regulatory and economic conditions could prompt more, rather then less interest in MMFs.
While discussions on potential MMF regulation in Europe are largely academic, and US 2a7 fund reforms are known and specific in their scope, Basel III, and specifically the liquidity coverage ratio, has far wider reaching implications for corporate cash investment. This situation is exacerbated further by the prolonged period of low interest rates, with negative interest rates in Europe. As Bea Rodriguez, BlackRock describes,
“Looking beyond specific MMF regulation, Basel III will have a huge impact on the structure of the money markets, both in terms of reduced supply and changes to instrument terms. For example, banks will have little interest in deposits of less than three months’ maturity, and secondary market liquidity will also be impacted.”
These issues are more compelling than potential uncertainty in MMF regulations, so rather than seeing a decline in MMF investment, the opposite is the case, at least for as long as rates remain above zero, as Bea Rodriguez, BlackRock continues,
“MMFs are currently a beneficiary of this [regulatory impact], and we are seeing a growth in assets under management. This is partly the result of regulatory uncertainty, but also economic uncertainty, so MMFs’ diversification, high-quality assets and same-day liquidity are proving attractive to investors.”
With banks far less inclined to accept short-term (under 90-day) deposits from corporate investors, treasurers will need to find alternative means of securing same-day access to liquidity to meet their working capital needs. This may be through structures offered by the banks, funds, or the capital markets. As Nick Jones, HSBC Asset Management comments,
“New regulations such as Basel III and the liquidity coverage ratio are already starting to drive new types of deposit structures that are more attractive to the bank’s funding profile and less attractive to institutional depositors.”
The question is what proportion of corporate cash needs to be affected by these changes, i.e., how much cash should be held in short-term investments? Treasurers who are able to segment their cash, so that same-day access to liquidity is only required for a portion of their cash, will experience far less of an impact of changes such as Basel III than those who cannot. Segmenting cash is also an important means of avoiding the effect of negative interest rates, by taking advantage of better rates further along the yield curve. As Bea Rodriguez, BlackRock explains,
“The negative interest rate environment has significant implications for corporate treasurers. So far, we have seen only government funds slipping into negative yield, but once prime funds are affected we are likely to see some rotation into other instrument classes. However, repos and government bills are also now in negative rates and custody banks are starting to change their charging policies. While not every customer will see an immediate impact, there are certainly some that will be affected.” [[[PAGE]]]
Consequently, with both regulatory and economic challenges set to have a major impact on treasurers in the year ahead, treasurers need to take action now to realign their investment policies to the new situation. Bea Rodriguez continues,
“Investors have a range of priorities when reviewing their investment strategies given the macroeconomic situation and low interest rates. The need to manage risk remains an essential requirement, but they are often looking to find ways to capture yield, typically beyond a 60-day weighted average maturity to take advantage of a dislocation in the yield curve.”
The issue is not that there will be no repositories for corporate cash, simply that different instruments may be required than in the past. For example, Jim Fuell, J.P. Morgan Asset Management emphasises that funds are already available to help treasurers to achieve an uplift in yield.
“As a global liquidity business, J.P. Morgan Asset Management offers a wide range of funds to meet the varying needs of our customers. For example, some investors are keen to take advantage of opportunities further along the yield curve than MMFs are able to invest.”
The first step in this review and realignment process is effective cash flow forecasting. This in turn allows treasurers to segment cash into funds required for working capital (short term), core (medium term) and strategic (long term). Nick Jones, HSBC Asset Management highlights,
“Investors of cash will need to improve their cash visibility and forecasting accuracy to achieve proper segmentation of their cash balances in an effort to deploy investments more efficiently in each segment, from operating, non operating and core/ strategic segments.”
Bea Rodriguez, BlackRock concurs,
“What is important for all investors, whatever their risk appetite, is to be able to segment cash more effectively, which requires accurate cash flow forecasting. By doing so, treasurers can be more precise in determining what portion of cash is required immediately and the portion for which same-day liquidity is less important.”
Some corporations will decide that cash for which same-day or short-term liquidity is not required (i.e., core and strategic cash) can be invested in the longer-term deposits that are more attractive to banks, and therefore will offer better returns, in addition to a wider range of capital market instruments or funds.
Having established how cash can be segmented, treasurers and investment committees can then review their investment policy with more confidence. Nick Jones, HSBC Asset Management, indicates that a number of treasurers are already embarking on this process,
“We are seeing treasurers of some of the largest US multinationals plan ahead with their global relationship banks and in-house asset managers to address the expected changes in MMF reform and Basel III, all of which could mean a significant change to global investment policy”
While different companies will have various drivers for reviewing and implementing greater consistency in their global investment policies, Bea Rodriguez, BlackRock emphasises that the negative interest rate environment, as well as global regulatory changes, are driving this behaviour, rather than simply MMF reforms in the US,
“These trends are mostly driven by conditions in the Eurozone, while the investment situation in the US is more stable. US corporations that have developed an investment strategy in the US are now looking at how they can adapt these strategies to the European environment.”
Reviewing investment policies does not necessarily mark a change in risk appetite, although some companies may take the opportunity to relax some of their more stringent risk requirements that were introduced subsequent to the global financial crisis. Equally, others will become more conservative in their policies. In most cases, treasurers that have already started to review their investment approach are engaged in redefining corporate policy to reflect a regulatory and economic landscape that may be quite different from the situation in which investment policies were originally conceived.
Although it may only be a minority of treasurers who have yet embarked on an investment policy review, every company that holds surplus cash will need to do so, even if surpluses are only held for short periods as part of the working capital cycle. Deposits are pivotal to many companies’ current investment strategy. According to the J.P. Morgan Global Liquidity Investment PeerViewSM 2014, 50% of corporate cash globally is currently invested in bank deposits. The emphasis on deposits is particularly pronounced in Asia Pacific (where Basel III is just as relevant as North America and Europe), with 68% of cash held in deposits, partly as the MMF industry is less mature. Even in US, the world’s largest market for MMFs, only 34% of cash is held in MMFs.[[[PAGE]]]
The shift in bank appetite for corporate deposits therefore requires a major change in treasurers’ behaviour. The same report illustrates, however, a lack of awareness amongst companies of all sizes of the implications of Basel III. For example, well over 50% of survey respondents indicated that they expected their investment in bank deposits to remain the same in 2015. A sizeable number said that deposits would become more important, particularly in the US, presumably reflecting the potential impact of MMF regulation without taking into account the impact of Basel III.
At the very least, treasurers will need to accept, and convince their boards to accept, negative returns on cash, and/or to shift a higher proportion of cash into MMFs to continue to allow access to same-day liquidity. For those that choose, or are able to continue with a deposit-based strategy, despite unattractive commercial conditions, the potential for additional credit rating downgrades will also reduce the number of banks in which many corporate treasurers are authorised to invest. Bea Rodriguez, BlackRock comments,
“Although banks are in a better place than they have been in the past, as each country puts in place resolution plans on how bank failures would be handled, the removal of sovereign agency uplift of senior unsecured ratings will have an impact on cash investment decision-making. This could result in downgrades to ratings of low A or even BBB which will make it even more difficult for investors to place excess liquidity. This may result in greater demand for government debt, but this will largely depend on where rates go.”
Many treasurers will therefore need to seek complementary investment solutions, although as Bea Rodriguez, BlackRock continues, this is not without challenges,
“Some will structure repos in-house, reflecting the increase in corporate demand for repos which is helpful for the market. This does not work for all corporates, as it takes time and specific expertise to set up master repo agreements. Others are looking at unrated liquidity funds to find yield, but this is difficult in practice without compromising liquidity and risk objectives. Offshore bond funds are becoming more popular in some markets, particularly France, amongst corporate investors that are able to accept higher levels of risk for portions of their cash. This is an important area of growth for BlackRock and we anticipate greater interest in the future for this type of fund. At the other end of the spectrum, government funds are becoming more popular amongst some investors, or they are leaving cash with their custodians if they are not being charged to do so. Finally, separately managed accounts are becoming more important, and again, we see this as a growing area.”
Separately managed accounts have been steadily growing in popularity amongst larger corporates in particular in recent years, although asset managers are increasingly able to willing to manage smaller fund sizes. Jim Fuell, J.P. Morgan Asset Management notes,
“We are seeing greater interest in separately managed accounts, although these are not strictly an asset class but rather a vehicle to deliver on a company’s investment policy using a specific strategy rather than ‘off the shelf’ fund.”
For global corporations in particular, one of the most important objectives, and challenges, is to establish a global investment approach to reflect the company’s risk appetite, policies and procedures consistently. Given the variations that exist across markets, this can be complex and require significant support from investment managers, particularly where large cash balances are not repatriated, resulting in the need for investments in multiple currencies and jurisdictions. Nick Jones, HSBC Asset Management, suggests that MMFs can be particularly valuable in this situation, particularly where cash is ‘trapped’ in more highly regulated countries or in non-convertible currencies,
“As globalisation continues, it becomes more important for treasurers to comply with global investment policies in all parts of the world. Having access to efficient, robust off-balance sheet MMF type investment solutions in countries where cash repatriation is still restricted helps treasurers to keep within investment policy guidelines and free up bank counterparty limits for use in other parts of the world.”
While the availability of appropriate repositories of cash investment is a key consideration, treasury departments also need to ensure they have the people in place to understand, analyse, compare and manage a changing investment portfolio, or who can engage proactively with asset managers where investment is outsourced. Jim Fuell, J.P. Morgan Asset Management highlights the increasing depth of investment skills and experience amongst large multinationals in particular, to equip them to manage cash more effectively in a changing environment,
“Inevitably, the more cash that a company has, the more competence it needs to have to manage this appropriately. For example, we have seen the development of sophisticated asset management skills amongst large US multinational customers far beyond those of five years ago. This trend is now extending to European businesses, which is a very valuable development as it equips companies to explore a wider range of investment solutions.”
The investment landscape over the next 18-24 months will be radically different from that of today. However, at this stage it appears that, far from the death of MMFs, these funds in their current and revised form are likely to fulfill an important, and possibly greater role as a vehicle for managing short-term cash in the future. Rather, it is short-term bank deposits that are likely to be a casualty, which is more serious for many corporations. To minimise the impact of the combined effects of regulatory change and low interest rates, treasurers need to be looking at how best to manage not only working capital, but core and strategic cash too, to avoid the erosion of value, whilst preserving capital and ensuring appropriate access to liquidity.
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