A New Resilience
In September 2008, the money market fund (MMF) industry across the globe was shaken to its core. On 16 September , the Reserve Primary Fund – a US MMF (MMF) with over US$60bn invested – announced that the net asset value (NAV) of a share in the fund had fallen below the US$1 mark; this fund had ‘broken the buck’. For only the second time in the near 40-year history of the product, investors experienced a capital loss.
After years of ever-increasing investment, MMFs were hit by sudden, and in some instances, dramatic redemption activities as investors moved cash to the most secure instruments available – government backed securities. What was once seen as a safe haven was suddenly being questioned as investors sought certainty that no capital loss would arise from their investments.
Given the almost complete absence of liquidity in the money markets and the systemic importance of the industry as buyers of money market instruments, the US government took decisive action to prevent the failing of the US money market. A guarantee was provided to investors already in MMFs, thereby preventing further redemptions, and a facility was announced to enable the funds to access liquidity. This would allow them to continue to make longer-term investments to instigate greater activity in the money markets. Following these actions, the US MMF industry soon experienced net inflows, reaching record levels of almost US$4 trillion in early 2009.
In Europe, no such support was forthcoming. And whilst the German and Luxembourg governments made statements of support for domestic MMF industries in mid-October, no mechanisms to facilitate the provision of assistance to such funds were announced. However, no European funds broke the buck, and with some exceptions, all funds remained open to receive investment and process redemptions. One of the few funds that closed was managed by Lehman Brothers. Their fund was obliged to shut down due to headline risk associated with the parent entity and not any impairment of underlying assets. All investors in this fund received a return of principal without loss.
The events which unfolded in the MMF industry in September and October 2008 have since resulted in increased attention from regulatory authorities across the globe. The objectives of stability and confidence in financial markets, and consumer protection, have attributed to the questions being asked regarding the regulatory regime applicable to the MMF industry.
Comments have been forthcoming from a variety of sources. These have included the suggestion of capital regulation for MMFs – like a ‘shadow’ bank (from the Group of Thirty body of leading financiers), and the potential for compensation for the loss of capital (from the European Commission). In essence, the product is now at a crossroads. With regulators seeking to act to ensure financial stability and limit the propensity for losses to arise, the industry is faced with the challenge of responding to the regulatory calls while continuing to be able to provide a product which meets the needs of investors.
The MMF industry on both sides of the Atlantic has responded to this challenge. In the US, the Investment Company Institute (ICI) – the trade association representing the mutual funds industry – quickly formed a MMF working group in late 2008. This group published its recommendations for the industry in March 2009, which included actions the industry should take as well as proposals for regulatory amendments which should be implemented by the Securities and Exchange Commission (SEC).
The following key recommendations were made by the ICI working group:
• To improve portfolio liquidity, a MMF should hold as a minimum daily liquidity of 5% of net assets, and a minimum of 20% of net assets in securities accessible within seven days.
• The maximum weighted average maturity (WAM) should be reduced from 90 days to 75 days, in order to provide additional protection against interest rate risk. A new ‘spread’ WAM should be introduced, which is calculated using the final legal maturity of all instruments in the portfolio. This is designed to limit the effect of changes in interest rate spreads, and should be set at a maximum of 120 days.
•MMFs should implement ‘know your client’ procedures to understand the expected redemption practices and liquidity needs of investors, or if such information is not available, mitigate possible adverse effects from any such unpredictability.
• MMFs should review and, if appropriate, revise the risk disclosure they provide to investors and markets to ensure adequate information is provided, with monthly disclosure of portfolio holdings.
• A non-public reporting regime should be implemented to facilitate the provision of information to an appropriate government entity to allow adequate and effective oversight of financial markets.
However, these industry recommendations are just that: recommendations. The report of the ICI is currently being considered by the SEC as it determines the regulatory response to the events of 2008. The formal proposals of the SEC regarding amendments to rule 2a-7 (the specific regulation of US MMFs) are expected in June 2009, and whilst no detail has yet been forthcoming, the SEC has to-date stated that proposed enhancements will be made to the rules governing the credit quality, maturity and liquidity provisions of rule 2a-7. In addition, the SEC has stated that it is considering more fundamental changes to protect investors that include both a floating NAV and a US$10 NAV.
It remains too early to determine the final format of the future regulatory regime in the US for the MMF industry. While opinion and comment remain divided amongst market participants on the final outcome, it appears certain that whatever shape the future regime takes, it will prove beneficial to investors. All parties are committed to providing a more robust product with greater limitation of the risk which may be included within the fund’s portfolio. Such an outcome would be undeniably beneficial for investors.
In Europe, there has been less regulatory comment on the product, as there is an absence of any specific product regulation similar to SEC rule 2a-7 in the US. Generally speaking, there are two types of funds in Europe: constant NAV funds, which resemble the US 2a-7 funds, and variable NAV funds, which are managed with the intention of providing an asset value which only increases. The former type of funds, as represented by the Institutional MMFs Association (IMMFA), has formed a working party to consider the future structure of the product.
At present, IMMFA operates a code of practice to which all members adhere. This code establishes qualitative and quantitative criteria with which the fund must comply. The MMFs represented by the IMMFA membership must also have achieved a triple-A rating and be authorised under the UCITS directive. This combination implements a set of investment parameters within which the funds must operate.
The key parameters of the Code of Practice are:
• The fund should maintain a WAM of not more than 60 days (which is notably more restrictive than the US, which operates with a 90-day maximum).
• The fund may invest in no instrument that has a maturity, or interest reset period, of more than 397 days. Where a floating rate instrument is purchased, the final maturity must not exceed two years.
• The funds should conduct a weekly comparison of the amortised cost valuation of the underlying instruments and the portfolio with the mark-to-market value, and operate escalation procedures for dealing with any material variance between the two values. These escalation procedures exist to ensure the directors of the fund are informed at an appropriate juncture in order that they can act in the best interests of shareholders.
The IMMFA Code of Practice defers to the requirements of the rating agencies with respect to the diversification and credit quality requirements which are imposed. In general however, the diversification requirements are more stringent than contained within the UCITS directive, and the credit quality requirements are comparable with those within rule 2a-7 in the US. The funds that are included within the IMMFA membership are therefore broadly similar to the US version.
The IMMFA working party is considering amendments to the code of practice that will enhance the resilience of the product. While IMMFA has yet to publish final recommendations, these are likely to include proposals on liquidity, portfolio maturity and increased disclosure, and should be broadly consistent with those made by the ICI. In addition, IMMFA is considering ways through which members of the Association may demonstrate compliance with the obligations contained therein in order to allow the IMMFA Code of Practice to operate as a market standard.
The rating agencies are also considering revising the rating criteria which are applied to MMFs. Whilst there are some technical differences in the criteria of the three principal agencies, all proposals look to impose tighter investment parameters on triple-A rated MMFs.
Within the broader MMFs universe, the market turmoil which commenced in the summer of 2007 and intensified in autumn 2008 has highlighted the need for a clear pan-European definition of a MMF. In the De Larosière report, submitted to the European Commission, a specific recommendation is made for such a definition to be implemented. The industry has recognised this. Led by the IMMFA and the European Fund and Asset Management Association (EFAMA), a working group has been formed to develop a definition which members of the asset management industry should adhere to for the marketing of funds.
It is therefore unequivocally clear that all parties are committed to improving the resilience of MMFs. All indications suggest that in the future the product will be subject to additional restrictions – whether on the instruments which may be purchased or on the risks which the portfolio may include. While there may not be a consensus on how this can be achieved, whatever mechanism is eventually utilised will likely result in a favourable outcome for the end investor. The revised product should be even more adept at providing capital security and liquidity in all markets and at all times.
In conclusion, the benefits of the product, and the reason why investment should be considered, remain as true now as before the credit crunch had even begun to materialise. Indeed, in light of the market turmoil which has been experienced, the objectives of a MMF are arguably the priorities which many investors seek more than anything: capital security and liquidity.