Cash & Liquidity ManagementInvestment & FundingEconomyUS Money Market Funds: A Regulatory Success Story

US Money Market Funds: A Regulatory Success Story

US money market mutual funds have been a fabulous success story, growing from nothing to over $2.3 trillion over a mere 26 years. To mirror the success of the US market, Europe should amend its UCITS regulations to pursue the adoption of US-style quality, maturity, and diversity in its money fund guidelines. Furthermore, fund providers, investors, and regulators worldwide should seek to standardize the definition of ‘money market fund’. Corporate treasurers, institutional investors, and local retail investors would all benefit from the introduction of a safe, standardized, high-yielding investment option and low-cost funding alternative to markets dominated by traditional banking.

History and Growth of Money Market Funds in US

The first US money market mutual fund, The Reserve Fund, was launched in 1970. The concept was to introduce a way for smaller investors to participate in the Treasury and money markets, and to allow an exemption to mutual funds ‘mark-to-market’ everyday pricing of securities in order to allow a $1 stable share price. While the share price is not guaranteed, there has been only one instance of a US money fund ‘breaking-the-buck’ or dropping below $1 a share, and this was a tiny (<$100m) fund liquidated for $0.96 a share. No individual investor has ever lost money in a US money fund.

Money market funds owe much of their success to the growth of mutual funds overall in the US. Mutual funds, based on the Dutch, English and Scottish pooled trust investments from the 1700s and 1800s, which represent over $10 trillion in assets, have become the dominant means of investing for both individuals and institutions in the US. Over half of US households now own mutual funds, and mutual funds represent over 20% of all household financial assets (up from 7% in 1990). The growth of stock and bond funds has fuelled growth in money funds, and vice versa. Their extreme diversity, professional management, pooled costs, and low barriers to investment have made mutual funds a raging success story in the US.

Money market funds succeeded due to a regulatory statute that prohibited banks from paying competitive interest rates on savings deposits (Regulation Q). They also benefited from excellent timing – around the time of their introduction in the 1970s, short-term interest rates spiked up to almost 20%, and stock and bond investors sought shelter from market turmoil. By 1981 and 1982, they had gained enough mass (over $200bn) to merit status as a separate asset class, and regulations governing money market mutual funds – Rule 2a-7 of the Investment Company Act of 1940 – were introduced.

The 1980s and 1990s saw an explosion in money fund assets (see chart below). US money funds grew fivefold during the 1980s, from under $100bn in 1980 to just under $500bn in 1990, and grew almost fourfold during the 1990s, to $1.85 trillion in 2000. During 2001, money funds took in an astounding $440bn (23.8%) to almost $2.3 trillion, primarily on the strength of institutional assets attempting to delay the effect of the year’s interest rate cuts. Assets declined modestly from 2002-2004 as rates approached record lows, but have rallied back to just below their previous record highs over the past two years.

Chart 1: Total US Money Market Mutual Funds Assets Since 1976

A Review of Rule 2a-7 of the Investment Company Act of 1940

The regulations governing money market funds in the US have helped the growth of the asset class by assuring investors of their integrity and by policing the class from rogue providers. Money funds and mutual funds are regulated by the Securities and Exchange Commission (SEC), which oversees all securities markets through mandates from the US Congress.

Rule 2a-7, named for the section and paragraphs of the text, is also known as the quality, maturity, and diversity guidelines governing money funds. In brief, a fund may only call itself a ‘money market’ fund and use the ‘amortized cost’ method of accounting (vs. funds’ normal ‘mark-to-market’ – this flat-lines interest income from discount securities) if it abides by the following (abbreviated) tenets:

  • Quality: Securities must be ‘First Tier’ (A-1, P-1, F-1, the equivalent of AA or AAA).
  • Maturity: The portfolio weighted average maturity (WAM) must be 90 days or less, and individual securities must be shorter than 13 months.
  • Diversity: A fund may only hold a maximum of 5% per issuer.

Note that these are simplified for the sake of brevity. The entire text of Rule 2a-7 may be found at: https://www.law.uc.edu/CCL/InvCoRls/rule2a-7.html.

As we mentioned, Rule 2a-7 was introduced in 1983 and amended in 1991. It was amended again in 1996. In 1991, the maximum WAM (weighed average maturity) for funds was reduced from 120 to 90 days, and in 1996 regulations for ‘looking through’ asset-backed securities in order to determine diversity levels were implemented. While no changes are currently pending, the Rule’s ability to respond to changes in the marketplace is one of the reasons behind its success.

Bob Plaze, the assistant director of the SEC’s division of investment management, explains how the SEC views money market funds: “On the whole, we’re very pleased with how 2a-7 is working. I think the amendments that were adopted in 1991 achieved their purpose.” The assets have grown from $200bn since the introduction of Rule 2a-7 in 1983, to $500bn at the time of the 1991 amendments, to $2.3 trillion currently. Money funds must also answer to the National Association of Securities Dealers (NASD), which says funds must publish their most recent seven-day current yield (simple) alongside any other performance figures.

Not Just for Consumers: Institutions Adopt Money Funds

In the US, in Europe, and now in Asia, corporations, bank trusts, investment managers, hedge funds and other financial institutions, government entities and ultra high net worth individuals have all become big users of money market mutual funds. The US-based Association of Financial Professionals (AFP) estimates that 80% of US companies allow the use of money funds, and about 25% of US corporate short-term assets are invested in money funds. European and Asian numbers are likely to be a fraction of these totals, but they could eventually approach US levels. A recent survey by gtnews and SEB found that 51% of respondents used money market mutual funds compared to 24% who used direct money market instruments; 58% used bank deposits.

Competitive yields have always been the biggest selling point of money funds. But their extreme safety, diversity and liquidity, expert management, especially in this age of ‘outsourcing’ and complicated securities, and convenience have made funds staples of the investment world. Demand from multinational companies, which are attempting to transfer ‘best practices’ across operating units, is also a factor in driving demand.

Ratings Not Regulations: Money Funds in Europe

European, or ‘offshore’, money funds have grown nicely over the past decade, but the lack of a clear regulatory framework and the lack of standardized terminology have clearly slowed the acceptance of the asset class in some countries. The UCITS and country-specific regulations don’t specifically address ‘money market funds’, so providers have looked to the ratings agencies – Fitch, Moody’s, S&P – to fill the void. Triple-A ratings have helped reassure investors, but they don’t have the teeth of a regulator.

While US-style money market funds have had success converting the UK and Ireland to their merits, the rest of Europe has been more difficult. The term ‘money market fund’ means different things to different countries and investors in Europe, and the acceptance of mutual funds in general has been much tougher than foreseen. While we expect money funds to continue gaining market share among the very largest of investors, it is likely to be at a much slower pace than providers had hoped. It appears that mutual funds in general may never gain critical mass in Europe, as the UCITS process and regulatory standardization initiatives move at a painfully slow pace.

The Institutional Money Market Funds Association (IMMFA) and others are attempting to address these issues, but a broader, UCITS-targeted effort will be needed if providers have any chance of ever rivaling the US market in size. Nonetheless, the largest providers – JPMorgan, Goldman Sachs, Western (Citi), Barclays, BlackRock, Dreyfus, etc. – and the largest customers – corporations in particular – have been using Dublin-based dollar, euro and sterling money funds extensively.

Following the US Model: Money Funds in Asia

Asia, in contrast to Europe, is moving forward in adopting stable value money funds with stringent investment guidelines. Japan, China, Singapore, India, Australia, and Taiwan all have embryonic or nascent ‘US-style’ domestic money fund businesses, and most also allow investment in Dublin-based US dollar, euro or sterling money funds by companies headquartered or located in their countries.

Japan, which had a class of ‘money management funds’ get burned by longer-maturity investments, is now returning to a 2a-7-like regime, and China appears to be adopting the US approach fully. JPMorgan recently launched the first AAA-rated RMB currency fund available to its multinational client base. While Europe got started in the money fund business earlier, Asia appears to be making up for lost time.

Towards a Worldwide Standard for Money Market Funds

Funds have generated hundreds of billions of dollars in interest income for their investors, and they’ve opened up new avenues of funding for large companies throughout the world. As the success of the money fund business in Dublin and in parts of Asia has shown, adopting and offering US style money market funds is something investors large and small will enthusiastically embrace.

So we urge investors, providers, and regulators to consider a Rule 2a-7 for Europe. The quality, maturity, and diversity regulations have proven to be robust and flexible enough to protect the $1 a share price, while other less stringent regimes have proven to be downright perilous. Where cash is concerned, investors need more than a rating. They need the protection of regulators.

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