Cash & Liquidity ManagementInvestment & FundingEconomyThe Future of Money Market Funds

The Future of Money Market Funds

A substantial proportion of European corporate investors are already using money market funds for their surplus cash management, and with various structural and regulatory changes coming into force over the next year, Europe’s use of money market funds could be on course to grow to a size nearer that of the US market sooner rather than later. So what makes European money market funds the instrument of choice for liquidity cash?

What are Money Market Funds?

Money market funds managed by Institutional Money Market Funds Association (IMMFA) members are triple-A-rated European domiciled mutual funds that invest in short-term debt instruments. Typically, such funds are authorised as undertakings for the collective investment of transferable securities (UCITS) with the objective of investing in a diversified portfolio of short-term money market instruments. They provide the traditional benefits of pooled investments and are managed within rigid and transparent guidelines, notably those set by independent ratings agencies, which restrict the asset range (e.g. credit quality, type and currency), counterparty risk and choice of custodian.

There are two fundamentally different styles of money market funds currently operating in Europe, both of which meet the needs of their specific investors. These are often referred to as ‘investment-style’ money market funds and ‘treasury-style’ institutional money market funds. ‘Investment-style’ money market funds have been available in Europe for over 30 years and have the primary investment objective to achieve an ‘all-in-return’ (i.e. combined capital plus income) and have similar characteristics to short-dated bond funds. ‘Treasury-style’ institutional money market funds, such as those managed by IMMFA members, were only introduced to Europe in the mid-1990s. They have proved very popular with liquidity cash managers due to their main investment objective of capital preservation.

Treasury-style funds operate on an almost identical basis to funds regulated in the US by the Securities and Exchange Commission (SEC) under rule 2a-7 of the Investment Company Act 1940 (2a7 funds). These funds have operated in the US since the early 1970s and have been regulated there for more than two decades. One key difference is that, whereas the weighted average maturity (WAM) under 2a-7 is 90 days, European funds operate to a more stringent WAM of 60 days.

From an investor’s perspective, triple-A-rated money market funds compete in the same space as bank accounts as they provide daily liquidity and a constant face value of the investment (i.e. EUR1 in, EUR1 out plus yield). There are two basic choices of ‘treasury-style’ money market funds: either constant net asset value or accumulating net asset value funds. As the name suggests, constant net asset value funds tend to operate on a stable price per share basis (that is EUR1.00 per share in and EUR1.00 per share out). Income in the fund is accrued daily and can either be paid out to the investor, or used to purchase more units in the fund, at the end of each month. On the other hand, while accumulating net asset value funds operate under the same investment guidelines as constant net asset value funds, income is distributed daily and is reflected by an increase in the value of the fund shares.

The market for these funds in Europe is large and growing, and provides an important service to institutional clients. Total assets under management of IMMFA members’ funds have grown to over US$300bn as of August 2006 from circa $50bn in 2000. This compares to US$2.171 trillion in the US. At the current growth rate, commentators have suggested that the European market could become comparable to the US within the next five years.

One of the main drivers behind this recent growth has been the significant increase in corporate demand throughout Europe over the past few years. Substantial markets for triple-A-rated money market funds already exist in the UK, Germany and Italy and increasingly in France and Spain. The market is forecast to double in the next three to five years, with growth continuing to accelerate in Europe as a result of the implementation of the Capital Requirements Directive (CRD). This is likely to result in banks becoming direct investors in money market funds.

Money Market Funds v Bank Accounts

What are the main characteristics of money market funds? The key point to note is that money market funds operate in a similar way to bank deposits and therefore provide a competitive alternative to such accounts. As mentioned earlier, where ‘treasury-style’ funds are unique is that they operate on a constant net asset value (CNAV) per share basis (EUR1.00 in, EUR1.00 out and operate within a maximum divergence limit between their amortised cost and market valuation of 0.5%). In addition, money market funds offer same day liquidity. Typically, there will be a cut off time for accessing the funds, usually between 12pm and 2pm depending on the fund and the currency in question. For example, dollar funds – due to the time zone advantages of Europe – tend to be a little later than sterling and euro.

Where IMMFA member funds have an advantage over bank deposits is that they are all triple-A-rated, while there are relatively few triple-A-rated banks available to depositors. With typical money market funds holding up to 100 different assets, they also offer a much broader diversification of risk than can be offered by banks. Fund providers undertake extensive ongoing credit research and control at a level, and within a timescale, that only the very largest investment banks are likely to be able to replicate. They also provide an extra layer of security as the funds themselves are ring fenced and held ‘in trust’ by a third party trustee or custodian rather than being exposed to a bank’s balance sheet.

In addition, firms face a conundrum when placing money with banks – if the cash is deposited with the largest banks there is a risk that exposure will be concentrated, if it is placed with smaller banks, however, the risk rating is likely to be of a lower quality.

Investing in money market funds provides a low risk and fully diversified alternative. The funds are extremely low risk due to their triple-A rated nature, which demands a number of stringent controls to ensure that such funds lie at the very low end of the risk spectrum.  Finally, earnings from the fund are transparent and are available on public sources so that the investor can always track the yields.

Why the Current Interest in Money Market Funds?

Most corporate treasurers have long been aware of the advantages of money market funds, but interest is increasing from financial firms as a result of the impending implementation of the CRD. The CRD initiates the biggest change to European banking regulation in almost two decades and sets the basis for the capital treatment of banks. Based on the Basel II capital accord and the three-pillar approach, the CRD sets out rules for calculating risk-sensitive minimum capital requirements for banking organisations (the ‘first pillar’), reinforced by requirements on banks to assess the adequacy of their capital and requires supervisors to review such assessments (the ‘second pillar’) and market discipline is strengthened by the ‘third pillar’ which enhances transparency in banks’ financial reporting.

For money market funds, the CRD creates a level playing field for the industry and enables the funds to be treated on the same basis as bank deposits. For the first pillar, the CRD permits banks to choose between two methods to measure risk – the relatively straightforward standardised approach which is based on credit ratings and the more complex ‘advanced’ internal risk based approach (IRB), which allows banks to use their internal rating systems to measure risk.

Under the standardized approach, with triple-A-rated money market funds having the highest rating, they are placed at the highest level (or credit quality step) and therefore attract the lowest risk weighting. The relevant risk weight for such funds is 20%, which importantly, is the same weighting as for an interbank deposit placed with a triple-A- or double-A-rated bank. Similar considerations apply with regard to the advanced approach. Thus, the CRD provides a level playing field between triple-A-rated money market funds and interbank deposits within the same credit quality step. The CRD is expected to significantly improve the market for triple-A-rated money market funds among banks and more and more financial institutions will consider using money market funds as part of their liquidity management processes. The implementation date for the CRD is 1 January 2007, so these factors will be coming into play in the very near future.

The past 12 months have seen a number of positive structural and regulatory changes in the institutional money market funds arena. In particular, there has been recognition of the importance of such funds at the European Commission level with the publication of the Markets in Financial Instruments Directive (MiFID). Due for implementation in 2007, MiFID explicitly recognises the security of the money market funds industry by making provisions for client money to be invested in triple-A-rated funds for the first time, a break away from the traditional bank deposits which are currently used. Earlier this year, the Committee of European Securities Regulators (CESR) explicitly recognised ‘treasury-style’ institutional money market funds in its advice to the European Commission.

Away from the regulatory front, the past few years have seen a number of structural changes, namely the reduction of the number of bank counterparts as a result of mergers and the perceived downshift in bank credit. Such developments have, therefore, made triple-A-rated money market funds significantly more attractive, with more financial institutions than ever expressing an interest following the CRD.

Conclusion

What does the future hold for the industry? 2006 has seen resurgence in funds under management of IMMFA members, which have experienced growth of around 20% over the past 12 months alone with every likelihood that this will continue. In the pipeline is a major directive for European insurers, Solvency II, which is expected to be published in 2007. This is anticipated to have a similar impact for insurers as the CRD is having on banks and with potentially significant interest in funds from the insurance sector, the future certainly looks positive for money market funds.

Comments are closed.

Subscribe to get your daily business insights

Whitepapers & Resources

2021 Transaction Banking Services Survey
Banking

2021 Transaction Banking Services Survey

2y
CGI Transaction Banking Survey 2020

CGI Transaction Banking Survey 2020

4y
TIS Sanction Screening Survey Report
Payments

TIS Sanction Screening Survey Report

5y
Enhancing your strategic position: Digitalization in Treasury
Payments

Enhancing your strategic position: Digitalization in Treasury

5y
Netting: An Immersive Guide to Global Reconciliation

Netting: An Immersive Guide to Global Reconciliation

5y