The ins and outs of Europe’s new money market fund proposal, and how it compares to the US
On September 4 2013, the European Commission released its 'Proposal for a Regulation of the European Parliament and of the Council on Money Market Funds' (Regulation). In the accompanying press release, the Commission noted the following in relation to money market funds (MMFs or Funds): "Because of the systemic interconnectedness of MMFs with the banking sector and with corporates and governments, their operation has been at the core of international work on shadow banking."
This makes it timely to compare and contrast the Regulation with the corresponding regulation in the US – rule 2a-7 under the US Investment Company Act (Rule 2a-7).
MMFs provide short-term financing to financial institutions, corporates and governments. They are also a short-term investment alternative to bank deposits. MMF investments are considered to have attributes similar to bank deposits, including instant access to liquidity and stable value. The accounting and valuation rules applicable to most MMFs support stable valuations and redemptions by relying on an amortised cost method of accounting, rather than mark-to-market valuations. But as MMFs are investment funds, not bank deposits, the value of their assets may become subject to market risks affecting both their ease of redemption and stable net asset value. During the financial crisis, many MMFs faced large redemption requests. The increased regulation of the sector, both in the EU and US, has been prompted by those events and is expressly intended to improve MMFs' stability and liquidity so they can withstand significant withdrawal requests.
|Nancy Prior, Fidelity|
"The gates and fees proposal directly addresses the SEC concern of stopping or slowing down redemptions from funds"
It also prohibits MMFs from: investing in any other assets; short-selling money market instruments; taking direct or indirect exposure to equity or commodities; entering into securities holding agreements, securities borrowing agreements, repurchase agreements, or other agreements which would encumber the MMF's assets; and, borrowing and lending cash.
The Regulation provides specific criteria for the permitted investment classes.
Money market instruments must be transferable securities admitted or intended to be admitted to a regulated market. They must have a residual maturity and legal maturity at issuance of 397 days or less, and the issuer of the instrument (other than instruments issued or guaranteed by specified governmental entities) must have one of the two highest rating grades determined in accordance with the Regulation. If the instrument carries exposure to a securitisation, it must meet the criteria for an eligible securitisation (see below). Standard MMFs may invest in instruments having a residual maturity of two years or less, as long as the yield is adjusted in line with market conditions every 397 days or less.
Deposits with credit institutions must be repayable on demand or withdrawable at any time, mature in no more than 12 months, and be with a credit institution registered in the EU or another country subject to equivalent prudential rules.
Financial derivative instruments must be with respect to interest rates, foreign exchange rates, currencies or indices representing one of those categories. Their sole purpose must be to hedge duration and exchange risks inherent in the Fund's other investments. In the case of over-the-counter (OTC) derivatives, the hedge must be with certain regulated counterparties, subject to reliable and verifiable daily valuation, and capable of being sold, liquidated or closed at any time.
Reverse repurchase agreements must be terminable by the MMF upon a maximum of two working days' notice, and be supported by assets (which must be money market instruments other than securitisations, meeting the criteria under the Regulation) with a market value at all times equal to the amount of cash given out by the MMF. Those assets need to be included in calculations of diversification and concentration limits under the Regulation. Assets supporting the reverse repurchase agreement may also include certain assets issued or guaranteed by specified governmental entities. The Commission may adopt by delegated acts further quantitative and qualitative liquidity requirements applicable for some of the governmental assets.
Diversification and concentration
The Regulation sets out detailed diversification requirements, and subjects Funds to the following limits:
- no more than five percent of assets issued by a single issuer can be held with a single credit institution or in deposits with the same credit institution;
- no more than 10% of assets can be invested in exposures to securitisations;
- no more than five pecent of assets in risk exposure to a single OTC derivatives counterparty;
- no more than 10% of assets in a combination of money market instruments issued by a single body, deposits with that body, and risk exposure to OTC derivatives with that body; and
- no more than 20% of its assets in an aggregate amount of cash provided to the same counterparty in reverse repurchase agreements.
Companies that are in the same group for the purposes of consolidated accounts (as determined by specified rules) are treated as a single body. An MMF's competent authority may authorise the Fund to invest up to 100% of its assets in money market instruments issued or guaranteed by specified governmental entities. In addition, an MMF may not hold more than 10% of the money market instruments issued by a single body (excluding instruments issued or guaranteed by specified governmental entities).
|The US approach to MMFs|
There are concerns that proposed changes to the regulation of US MMFs could significantly disrupt the market and cause a flight to other products.
The comment period for the SEC's MMF proposal closed on September 17. The main issue under contention is whether the $1 per share rule should be replaced with a floating net asset value (NAV) or liquidity fees and temporary gates. While industry players with large investor bases have generally supported a liquidity fees and gates regulation, those with larger retail bases have favoured a floating NAV.
According to Dechert's Steve Cohen, a floating NAV requirement will likely shrink the institutional money market fund space. "If the SEC adopts the fees and gates proposal without a floating NAV requirement, assets in the industry will not decrease as much, but it could have an effect on some corporate treasuries who may consider alternative investments," he says.
Stable versus floating NAVs
The proposal to float the NAV represents a substantial change. It would mean the end of the $1 in – $1 out guarantee that has been so attractive to investors looking to maintain their principal.
"From what I understand, the number one priority for an institutional investor is the stability of principal," says Cohen. "To the extent that a stable value is removed from MMFs, these investors will likely decide to invest in other products with stable value features or invest in government money market funds."
It wouldn't be a surprise if these investors did move their cash to bank deposits, he adds.
The SEC hopes by making investors aware of changes to the NAV they will be less likely to pull out when it fluctuates. Nancy Prior, president of Money Markets for Fidelity, suggests the same result was achievable through disclosures.
"In our view the gates and fees proposal directly addresses the SEC concern of stopping or slowing down redemptions from funds, as opposed to the floating NAV," she says. "There is no data that a floating NAV would stop or slow redemptions from a fund."
A floating NAV may create problems of its own. Until now taxation has not been a real issue. But a fluctuating NAV creates the possibility of capital gains being realised.
"The IRS has considered steps to help preserve some of the attractive tax attributes of these investments, including with respect to the potential application of the 'wash sale' tax rules," says Jeremy Smith partner at Ropes & Gray. "But there's substantial doubt as to whether all of the tax issues that arise from a floating net asset value will be addressed, especially for large institutional investors in prime money funds," he adds.
Fees and gates
The market's largest players see the gates and fees option as easier and cheaper to implement. This involves the creation of triggers to prevent or slow the withdrawal of redemptions. Under this proposal, if a fund's liquid assets dropped by 15% within one week, it would trigger either a two percent fee to make redemptions or a gate on the fund entirely.
The possibility that the regulations could create classes of investors – those who were able to make redemptions before the liquidity fee kicked in and those that were not – is concerning for some. "In my experience, boards get very concerned when there's the potential for similarly-situated shareholders to be treated differently," says Smith.
"There may be reluctance by some to impose liquidity fees and gates that might not apply to shareholders on one day, but that would apply to other shareholders of the same fund on the next day," he adds. "It's possible this aspect of the proposed rules may just lead to more fund liquidations."
Funds excluded from regulation
Government, treasury and retail funds would be excluded from the floating NAV change. Retail funds would need to limit redemptions to $1 million a day per shareholder. But there are questions about investors' ability access their money. This sparked suggestions in comment letters that retail investors be defined as having a social security number.
Municipal MMFs are missing from this list of exempt funds. It's possible they could fall into the retail exemption, but without being specifically exempt they will be a less attractive product, shrinking the asset base.
With the comment period only just completed and the extraordinary number of comments letter submitted, no one in the industry is prepared to say definitively what a potential rule would look like. The largest players are forming contingency plans and evaluating the costs the rules might impose.
"I could imagine the largest industry participants being the biggest winners because the cost of entry and the cost of maintaining these products will increase significantly," says Smith. "Although it can be a painful business now given the interest rate environment, when interest rates go up, the largest players may be the few left standing and may capture even more of the market for these investments."
Internal assessment and ratings
The Regulation also requires MMFs to establish, implement and apply assessment procedures for determining the credit quality of money market instruments based on an internal rating system. Both the internal assessment procedures and internal rating system must satisfy detailed requirements set out in the Regulation. The Commission is authorised to adopt delegated acts providing further detail to both the assessment procedure and rating system requirements.
The Regulation distinguishes between short-term MMFs and standard MMFs and requires each Fund to meet the following portfolio requirements at all times:
- weighted average maturity (WAM) of 60 days or less for short-term MMFs, and six months or less for standard MMFs;
- weighted average life (WAL) of 120 days or less for short-term MMFs, and 12 months or less for standard MMFs;
- at least 10% of its assets comprised of daily maturing assets; and
- at least 20% of its assets comprised of weekly maturing assets.
A standard MMF may invest up to 10% of its assets in money market instruments issued by a single body. This goes up to 15% where such investments are a combination of money market instruments issued by that body, deposits with that body and counterparty risk exposure to that body – provided that these investments are disclosed to investors in the MMF.
To avoid any influence by credit ratings, MMFs may not solicit or finance the receipt of a rating by a credit rating agency. To help anticipate or manage redemption requests, MMFs must comply on an ongoing basis with so-called know your customer (KYC) procedures. In addition, Funds will be required to apply stress testing processes that are intended to help them identify 'possible events or future changes in economic conditions that could have unfavourable effects on the MMF', and to take actions when vulnerabilities are identified. The European Securities and Markets Authority (Esma) is to issue guidelines for common parameters of the stress test scenarios.
Valuation rules and CNAV funds
The Regulation specifies standards for valuing MMF assets. Assets are to be valued at least on a daily basis using mark-to-market whenever possible, or otherwise marked-to-model. A special category of MMFs designated as Constant Net Asset Value MMFs (CNAV MMFs) may use the amortised cost method for valuation, so long as the CNAV MMF complies with a detailed set of rules. CNAV MMFs must be short-term MMFs, and must maintain a capital buffer of at least three percent of the total value of its assets in a cash reserve account. CNAV MMFs would be allowed to accumulate the reserve over a three-year period in one percent increments per year. If the required cash reserve falls below certain levels, or the difference between the constant net asset value for a MMF and its actual net asset value exceeds certain thresholds, the CNAV MMF will cease being a CNAV MMF.
To avoid or limit potential systemic contagion arising from MMFs, the Regulation will allow Funds to receive external support only in exceptional circumstances determined by a competent authority. CNAV MMFs may not receive external support under any circumstances and must rely only on their capital buffer.
The introductory statements to the Regulation note that asset-backed commercial paper (ABCP) should be an eligible money market instrument, but that it is subject to additional requirements 'due to the fact that during the crisis certain securitisations were particularly unstable'. An earlier version of the proposed rule had excluded securitisations and ABCP as eligible money market instruments. The Regulation allows investments in ABCP only if the underlying exposure or pool of exposures consists exclusively of high quality corporate debt, and liquidity where the underlying exposures have a legal maturity at issuance or a residual maturity of 397 days or less. The introductory statements specifically exclude from the underlying exposures equipment leases and other consumer payment obligations. Esma is to develop technical standards specifying the conditions and circumstances under which the conditions applicable to underlying exposures meet the credit quality and liquidity requirements.
Comparison to US regulation
While many of the rules proposed by the Regulation substantively correspond to equivalent rules in the US – either proposed or in effect – there are also substantial differences. The Regulation and Rule 2a-7 use different terminology and methods for determining compliance with the risk management rules relating to the asset liquidity of a US MMF and EU short-term MMF. However the substantive principles are virtually identical: 60 days WAM, 120 day WAL, 10% minimum daily maturing assets, and 20% (30% under Rule 2a-7) minimum weekly maturing assets. Similarly, although the US rules have a more detailed framework for determining diversification requirements, both rules establish a five percent limit on exposure to a single issuer. Like the Regulation, a proposal in the US would expand the scope of the diversification rules so that the five percent limit applied to both an issuer and its affiliates. The same US proposal would treat sponsors of ABCP programmes as guarantors, thereby aggregating the relevant ABCP programme with other exposures to the issuer and its affiliates for the purpose of a 10% diversification rule applicable to guarantees.
"The most significant differences between the two sets of rules relate to ABCP and capital buffers for CNAV MMFs"
The US rules are not as prescriptive as the Regulation in terms of the types of assets in which a MMF may invest, or the terms which must apply to internal assessment procedures and internal rating systems. In an unusual twist, the US rules continue to be one of the few instances in which a regulated entity (the MMF) is required to rely on and take account of ratings by credit rating agencies (although removal of credit ratings from these rules remains a regulatory goal). In contrast, the Regulation requires MMFs to develop and rely on internal rating systems to be developed in accordance with further guidance to be provided by the Commission.
The most significant differences between the two sets of rules relate to ABCP and the requirement of capital buffers for CNAV MMFs. As worded, the Regulation would effectively prohibit MMFs from investing in existing ABCP, and it is highly unlikely that ABCP issuers would be able to unravel their portfolios to meet the requirements under the Regulation. Although the US has considered requiring capital buffers (albeit ranging from one to three percent of assets) for MMFs, its existing rule proposals contemplate other alternatives to mitigate liquidity runs on MMFs. The proposal for capital buffers under the Regulation is likely to make affected MMFs an unattractive investment due to the drag on return arising from holding the buffer.
The Regulation will now pass to the European Parliament and the Council of the EU for consideration, with agreement likely during 2014.
By Hogan Lovells partner Dennis Dillon, senior associate Sally Simmonds, and professional support lawyer Isobel Wright in London