Money market funds feel force of EU clampdown

New regulations from the European Commission threaten to decimate the Ä1tn money market fund sector in the European Union. The rules, part of the EC’s clampdown on shadow banking, insist on a 3 per cent capital  buffer, broadly equivalent to the prudential measures imposed on actual banks.

The Commission estimates the buffer would simply mean funds would hike their fees from 21 bspts to 30 bspts (0.30 per cent), but the Institutional Money Market Funds Association (IMMFA) argues that the buffer amounts to the de facto abolition of these funds by utterly destroying the business model. It says its members currently retain average fees of 8bspts, which on 300bspt capital produces a return of just 2.67 per cent.

The 3 per cent capital buffer might also  lead to the money market fund provider being deemed to have a 3 per cent economic interest  in the fund if, for example, it receives interest on the capital buffer, so the fund may have to be consolidated on the balance sheet, possibly requiring up to 8 per cent of the fund’s assets under management (the so-called Pillar One haircut) to be injected in the form of CT1 capital.

Most EU constant NAV funds are likely to respond by floating their NAV, like any other fund, but this will make them considerably less attractive to corporate investors who would then face the administrative burden of calculating the tax on any capital gain, when these funds’ primary purpose is merely somewhere to park cash. The constant NAV sector could lose some 50 per cent of its AUM, according to Moody’s report: A Business Model Hangs in the Balance.

The capital buffer could favour bank providers over independent asset managers given the significantly higher cost of capital and return on capital expectations of asset managers. Based on global assets under management, around half the banks with CNAV funds would suffer a reduction in CT1 of more than 1 per cent, with the custodian banks suffering falls of between 2 per cent and 6 per cent, the IMMFA says.

The big winners will be US-based funds, which offer similar attractions but under more lenient rules – for the time being at least. Currently, more than two-thirds of investors in Irish and Luxembourg funds are based outside the EU, and could easily switch. There will be a long lead-in time however as the  reforms require ratification by the European Council and Parliament, which is unlikely  before the  European elections in May.

Many money market fund providers see this regulatory impasse  as a final straw, coming on top of low interest rates which have forced some to waive their investment management fees in recent months. The implications will be most keenly felt by the smaller players, whose senior management must now put a value on the business and make a call.  On the plus side, for committed providers, this is a  highly scalable business, with none of the  issues of liquidity regarding asset purchases seen in equity funds, or much need for additional staff or expenses as the business grows.

The Commission will also propose a series of reforms that cover both the CNAV and VNAV sectors, such as outlawing ratings from rating agencies, and measures to stop funds smoothing returns by using amortised cost accounting.  This could force investors to wait a whole day for redemptions.

Unsurprisingly,  there are broader implications. Money market funds hold around 40 per cent of the short-term debt issued by European banks, a percentage that has been rising recently, which could present challenges for future bond issuers. US money market funds will mop up some of this but they have already nearly doubled their allocations to European banks since June 2012 when a potential eurozone break-up weighed heavily. French banks are currently most in favour.

The new regulations will accelerate the revolution in investor education that has already been building in the sector. Fund managers have been improving their dialogues with customers about the scope for pushing a fund slightly out in the risk spectrum. For example, Pierre Boyer, head of money market at Dexia Asset Management, says that its portfolio’s 30 per cent holdings in short-term bonds and one to two year short-term floating rate notes generates an excess return of 10-15  bspts.

However, money market funds are a sector where there is a huge focus on safety and conservatism and 2007-8 is still in the public’s mind. Six years ago you could not get a consultant to sit down and talk about money market  funds, but that has changed and clients are now asking a lot more questions about the fund manager’s process, and the credit resources, above and beyond their investment policy document.

It had already been a torrid year for euro money market funds, which shed more than a tenth of their assets under management in the first half in the face of low bank lending rates and continued political uncertainty in the eurozone. Twenty-two of the largest euro-denominated funds lost one quarter of their assets under management in the second quarter, which had already fallen to €66.1bn, from €92.7bn a year ago, according to Moody’s.

Some of that was accounted for by investors reaching out to assets with longer maturities and lower credit quality, but, since the chairman of the US Federal Reserve, Ben Bernanke, made comments in June concerning the scaling back of QE, a clear reversal has been materialising as investors once again become nervous about economic stability.

“The taper increases the prospect of greater volatility in emerging markets and currencies in the coming months which is likely to generate inflows into money markets and cash, until the economic climate comes back to a more conservative risk profile,”  says Mr Boyer.

 “The likely scenario of an increase in interest rates, although  at a moderate pace, in the US and  its spillover effect in other countries changes investors’ asset allocation and has made these funds more appealing,” adds Luigi Fallanca,  investment fund manager at Eurizon Capital. “In fact in this context, they tend to shift their preferences from a medium to long-term horizon to a very short one parking their cash and  waiting for the market to reach the desirable or expected level of interest rate to reallocate their bets.”

Return to normal

But the trickle back  can also be seen as a progression to a normal business environment where money market funds are being used in a classical way.

“Globally speaking the situation has changed,” says Patrick Siméon, head of money markets at Amundi. “Since the second quarter there has been a reversal of a long-term trend  for market outflows. There are many explanations: corporates are using their cash for reducing debt, and we also see some corporate customers parking cash in money market funds while waiting for corporate opportunities such as mergers and acquisitions. There is also greater competition from bonds while insurers searching for return are shifting to other  assets.”

The volatility of inflows and outflows has made asset managers look hard at their customer base, sometimes declining subscriptions if, for example, it is a hedge fund waiting to invest or a large corporate treasurer.

For investors too, money market funds are one sector where the profile and commitment of other fund holders are critical. Some fund managers, such as Amundi, limit clients to holding a maximum 10 per cent of the fund, while others such as AZ Fund Management make a selling point of putting no size limit for entering and exiting the product.

It is an area where bigger is definitely better and broad diversification is a big plus. “Our clients find the opportunity to diversify the counterparties and the instruments particularly valuable, avoiding the risk of concentrating their savings with just one bank as it’s often the case and to adapt the investment horizon to their changing needs, from overnight to one year duration with attractive and competitive rate of return, especially when compared to other market alternatives available in Italy,” says Andrea Aliberti, general manager and chief investment officer at AZ Fund Management

 “In terms of credit analysis, internal buy side research plays a vital role given that the universe of investible issues continues to diminish as a result of downgrades and increased regulation,” says Leonardo Brenna, senior portfolio manager at UBS Global Asset Management. This resource allows him to broaden his investable universe into less well-known names, as opposed to only the largest, most common names.

Mr Brenna adds that money market funds, despite the historically low yield environment, still play an important role from a diversification perspective within the context of  asset allocation. “They are important building blocks but what you hold will depend (entirely) on your view on fixed interest and risk appetite,” he says.  

Safety first

“The primary reason we use money market funds is to place cash in secure and liquid funds, and  as such performance takes a secondary role to the security of these funds for our clients and investors,” says Oliver Gregson, managing director at Barclays Wealth.

“As a result, to ensure we select the most secure money market funds we undertake both operational and investment due diligence, looking at the quality of the credit analysts and portfolio managers and preferring larger funds of £1bn / $1bn / €1bn minimum, which can better meet redemptions and also offer diversity by holder,” he explains.

“We are looking for a range of corporate treasuries, pensions, private individuals, charities etc as they will have different redemption patterns providing more stability to the fund,” adds Mr Gregson.  He also looks for credit quality, preferring funds with an S&P AAAm/Moody’s Aaa-mf rating which are the highest awarded and  demonstrate “an extremely strong capacity to maintain principal stability and to limit exposure to principal losses due to credit, market and/or liquidity risks”.

Regarding the European Commission’s new framework for money market funds, as part of the suite of existing and planned measures to mitigate the risks of financial instability through entities that could be described as shadow banks, Mr Gregson says that the high level of AUM concentration in the money market fund market makes some of these funds very large and therefore potentially systemically relevant.

“This capital buffer is likely to have a meaningful impact,” he expains. “The variable NAV is fine for us, but the cash buffer is likely to reduce the overall rate. In our view this might make some funds unsustainable especially in the exceptionally low interest rate environment. We will learn more in time.”

Bank Julius Baer largely eschews the sector for more flexible funds. “There hasn’t been much interest in money market funds over the last couple of years because returns after fees were very low in this market environment,” says Patrick Roefs, head of fund offering at Bank Julius Baer in Zurich.

“Therefore a strong selling point for money market funds is hard to make. We rather propose to invest in absolute return oriented products with better risk/return characteristics.”