Money Market Funds in the US and Europe: Converging Markets
In recent months, faced with persistent uncertainty about the path of interest rates as well as volatility in equity markets, investors have looked to money market funds for safety, liquidity and yield. According to the Investment Company Institute (ICI), June 2006 continued to see outflows from equity and bond mutual funds alike, into money market funds. Assets invested in US money funds rose by 1.6%, or US$27bn, to US$1.77 trillion. Even in Europe, where money market funds are much less widely used, offshore money market funds grew by over US$25m from March to June 2006, to US$342bn.
Indeed, the appeal of money market funds (MMFs) is well known in the US, where the MMF industry has grown astronomically since the early 1990s. However, the market for triple-A money market funds in Europe is still in its infancy. In the US, money market funds were created out of necessity – banks in the US were unable to meet the short-term investment needs of institutional clients in the early 1970s. The political and economic environment did not help either. But the new fund vehicles climbed in popularity, so the need for regulation became clear. In 1983, the SEC issued a new set of regulations known as SEC Rule 2a-7, within the framework of the 1940 Investment Company Act. As money market fund assets grew to over $1 trillion during the 1990s, rule 2a-7 was ameneded to allow different weighted average maturity limits for differently rated funds.
Rule 2a-7 laid out very strict parameters for the types of investments, credit, operational and maturity risk money market funds could take. In turn, the main credit rating agencies set up a process whereby they could calibrate the level of risk in each fund. Today in the US, money market funds, ranging from strictly regulated triple-A-rated 2a-7 funds to enhanced yield funds – which can take more credit risk and more duration risk without sacrificing liquidity – are the instrument of choice for corporate treasurers and pension funds alike. A typical triple-A money market fund is an overnight to three-month liquidity fund. It invests in first-tier (A-1+ or A-1 short term rating) commercial paper, repurchase agreements, CDs, short corporates, agency notes and corporate floaters. It maintains a weighted average maturity of 60 days or less and restricts investments to 397 days in final maturity (up to 18 months for government or agency floaters), and targets an overnight or weekly index (overnight or one week Libor) for returns. In investor circles, these funds are dubbed ‘plain vanilla’, seen as the closest one can get to a risk free fund.
Triple-A funds have nowhere near the same status in European corporate treasurer circles. The majority of these investors continue to opt for traditional bank time deposits. Until the early 1990s, the European banking system was stronger than the US system and distribution was more effective, albeit in a smaller market. Therefore, the investor’s best interest was in approaching banks directly for time deposits. In the days of higher credit quality, this was a sound practice. However, the 1990s saw a wave of bank consolidation in Europe, shrinking the available market for portfolio diversification. In addition, the decade saw a slow but steady decline in bank credit quality. With hardly one true triple-A-rated bank left in Europe, investing in bank deposits is no longer on the same level with buying a triple-A money market fund.
Despite the implicit guarantee in a triple-A-rated fund, corporate treasurers in Europe have been slow to take the plunge. The only exception is the French money market, where corporate treasurers have invested in money market funds since the 1980s due to regulations that prohibited banks from paying interest on deposit accounts.
However, on a pan-European scale, the lack of a single regulatory framework complicates the task of defining a money market fund, let alone promoting it. Consider a triple-A-rated fund, which provides a high-quality, diversified and liquid parking spot for operational cash, from overnight to three months, targeting a return around overnight Libor. The opposite extreme in money market funds, an enhanced yield or short duration bond fund, may hold a larger proportion of asset-backed, mortgage-backed securities or corporate floaters. Yet both are called money market funds in Europe.
Defining the product is a relatively straightforward obstacle to overcome, but a second barrier to creating a pan-European standard is the disparate regulatory environments between countries. UCITS III European regulations for Sicavs, as well as Basel II regulations, do seek to mitigate this, but to this day a fund domiciled in France, for example, may not be exactly tailored to German investors. This is a legacy problem from the days before the euro; fund providers can take their own initiative to tailor their offerings to appeal to a range of European countries. For example, Fortis Investments’ Paris-based euro money markets team manages EUR20bn in pure liquidity funds to enhanced yield funds. Although the range was originally created for the French money market, the company recently adapted its offerings to meet German and Dutch regulatory requirements.
Nonetheless, ad hoc efforts are only a partial solution. Clearly, the lack of a regulatory framework bars triple-A money market funds from growing to the same size and stature as the US market. The Institutional Money Market Funds Association (IMMFA), established in 2000, has become the de facto standard setter for pan-European triple-A money market funds, and has lobbied to implement a regulatory framework for European money funds.
Nonetheless, most European treasurers continue to prefer time deposits as the ‘mattress’ of choice for investing working capital or strategic cash. Compared to the diversification, quality and liquidity of money market funds, time deposits seem suboptimal. It is true that when cash flows are certain, liquidity is a secondary consideration and the idea of investing directly in the balance sheet of a single bank is a viable option, investing in time deposits makes sense. Indeed, time deposits may offer a slightly better rate than a money market fund for a set time frame. But the trade-off between the two is asymmetric. In addition, corporate treasurers must set and monitor limits in terms of credit quality, counterparty concentration and diversification. All of these tasks imply a significant investment in time and money – difficult to justify given consolidation and declining credit quality among banks, and the daily liquidity, safety and competitive yields of money market funds. They are at least as safe if not safer than time deposits. However, some corporate treasurers may be unwilling to relinquish control of the portfolio holdings. To this end, many funds allow corporate treasurers to have access to fund holdings and duration positioning in order to foster transparency in addition to that ensured by Triple-A rating requirements.
In conclusion, it is clear that in some cases time deposits are a good solution to invest working capital. But in order to meet their own cash management objectives of liquidity, diversification and safety, with a competitive yield, the attractiveness of money market funds is clear for corporate treasurers: time freed up from forecasting cash flows and overseeing position sizes can be better spent on value added activities.