While money market funds have attracted regulatory attention on both sides of the Atlantic since the financial crisis, in Europe, the industry has had a more fundamental issue to tackle: defining for the first time what can and cannot be called a money market fund. In the United States, the legal framework for the money fund industry is relatively straightforward: Such funds are defined and regulated by Rule 2a-7 of the Investment Company Act of 1940. That said, Rule 2a-7 has had to keep up with the times.
When Lehman Brothers fell in September 2008, the Reserve Primary Fund’s exposure to the bank led the money market fund to write off $785 million in Lehman debt—and consequently to “break the buck,” as its net asset value (NAV) fell below the crucial $1 per share to 97 cents. A brief run on U.S. money market funds followed, and many other funds had to be supported by their sponsors.
In order to make money market funds more robust, the Securities and Exchange Commission has made a number of changes to Rule 2a-7 since 2008, including reducing the maximum weighted average maturity (WAM) from 90 days to 60 days and introducing a weighted average life (WAL) restriction of 120 days, as well as minimum liquidity requirements.
The European money fund industry has been working on similar changes, but it has also faced a more fundamental issue. Historically in Europe, there has not been any definition of what constitutes a money market fund. In fact, there is no pan-European regulator of money market funds. Money market funds in Europe fall under European Union legislation, Undertakings for Collective Investment in Transferable Securities (UCITS), which applies to investment funds in general terms but does not specifically mention money market funds.
In the absence of a regulator, the money fund industry founded a London-based trade group, the Institutional Money Market Funds Association (IMMFA), in 2000. Its members, triple-A-rated European money funds, are required to comply with a Code of Practice broadly based on Rule 2a-7. However, aside from IMMFA funds, since there’s no clear definition of what constitutes a money market fund, a wide range of different types of funds have been available under this heading.
“The European money market fund landscape is split between a wide range of products, from stable and secure short-term money market funds up to relatively high-risk enhanced funds, which are more difficult to understand and which have longer tenors—and also potentially much higher yields,” says Jarno Timmerman, chief dealer for AkzoNobel, a Dutch paints and coatings company with $19.8 billion in 2010 revenue. “That all makes it less transparent when you are asking, ‘What kind of fund did I really invest in?’”
At the height of the financial crisis, contradictory patterns emerged as investors scrambled to make sure that their funds were in the safest possible place. In late 2008, no investment could definitively be identified as safe. For many investors, including AkzoNobel, the diversification offered by money market funds was attractive at a time when the spotlight was firmly on bank counterparty risk. Timmerman says the events of 2008 only underlined the benefits of money market funds. “If you have certain funds invested in these money market funds, and you see a risk position in those funds and you would like to redeem fully, what then is your alternative?” he asks. “You will still need to do bilateral investments with banks and you have full counterparty risk on these, whereas if you stay with the money market funds, the risk is diversified.”
As investors flocked to park their funds in the safe haven that money market funds represented, the funds’ assets under management grew. IMMFA funds had 408 billion euros in assets under management at the end of 2008, compared with 336 billion euros in August 2007.
For others, however, the crisis emphasized the shortcomings of money market funds rather than their benefits. Virgin Media, a U.K.-based entertainment and communications company with $5.2 billion in 2010 revenue, used money market funds prior to the financial crisis. However, as James Marshall, assistant treasurer for operations, explains, “We had always been concerned that the reporting for what is a relatively complicated product was quite vague compared to standard bank deposits. We therefore made the decision to stop using these because the information we were getting was insufficient for our needs.”
Virgin Media was not the only company to withdraw from money market funds, and the 2008 crisis pointed out one of the major drawbacks of the lack of a regulatory definition. Given the wide range of funds included in the category, there was concern in the market that if one of the riskier products encountered problems, investors in the more conservative products might view all money market funds as similarly risky and withdraw funds accordingly.
In 2009, this concern was underlined in a report prepared for the European Commission by a panel led by Jacques de Larosière, former governor of the Banque de France, that identified the need for “a common EU definition of money market funds, and a stricter codification of the assets in which they can invest in order to limit exposure to credit, market and liquidity risks.”
This call was taken up by the Committee of European Securities Regulators (CESR), which in 2010 put out guidelines for defining European money market funds. The guidelines, which take effect July 1 for new funds and Dec. 31 for existing funds, for the first time place restrictions on the type of fund that can be described as a money market fund. (Meanwhile, the CESR has been superseded by the European Securities and Markets Authority (ESMA).)
The definition takes a two-tier approach, in contrast to U.S. regulations. The reason is clear: While the U.S. definition was introduced in 1983, much earlier in the development of the money market fund industry, the European definition is being overlaid onto an existing and diverse array of money market funds. “It’s a difficult task to come up with a definition to cover everything from kitemark AAA-rated products all the way through to domestic continental European funds, which are variable NAV, extended duration and able to invest in a slightly broader mix of assets,” says Marcus Littler, director of institutional liquidity sales at BNY Mellon. “Short of making everyone toe the line and bringing in one overarching definition, CESR has had to split it out.” (A kitemark is a U.K. symbol showing a product meets certain standards.)
The CESR definition identifies two distinct types of funds: short-term money market funds and money market funds. The more conservative of the two categories, the short-term money market fund, has a maximum WAM of 60 days and a maximum WAL of 120 days, in line with 2a-7 and IMMFA’s Code of Practice. In contrast, a money market fund has a maximum WAM of six months and a maximum WAL of 12 months. For both categories, the guidelines specify—among other things—specific disclosure to highlight the difference between money market funds and bank deposits.
The introduction of a definition has been broadly welcomed by the industry as removing much of the ambiguity that had previously existed. “The real benefit is that certain essentially short-duration bond funds, which were describing themselves as money market funds, are now not allowed to do so,” says IMMFA chairman Travis Barker. “The second thing that’s good is that the definition establishes certain minimum standards.”
However, as Barker points out, the definitions are not without their shortcomings: “The definition does remain quite high level. So there’s all sorts of detail which in our opinion is missing from the definition, which would be needed for a truly robust definition,” he says. “For example, in relation to liquidity requirements—in other words, requiring a fund to hold a certain proportion of assets in cash overnight or maturing within a week, to ensure that there’s lots of liquidity in the fund—that’s not specified in the CESR/ESMA definition.”
Barker also points out that the guidelines’ naming conventions are not as clear as they could have been. “The overall category is called a money market fund, and there are two subcategories: short-term money market fund and money market fund,” he says. “The first problem is that if you give a subcategory the same name as the overall category, that’s a recipe for confusion. The second issue is that these subcategories are essentially the wrong way round. What CESR is calling a short-term money market fund is the standard variety of money market funds globally.”
Rather than bringing harmonization, the new definitions therefore introduce some degree of conflict with global standards: A money market fund under 2a-7—or indeed under IMMFA’s Code of Practice—would be classified as a short-term money market fund under CESR. By the same token, CESR’s money market fund subcategory includes some enhanced funds that would not be classified as money market funds under 2a-7 or by IMMFA.
Despite the shortcomings of the CESR definition, introducing some basic parameters does go some way toward meeting the original objectives of preventing riskier funds from being classified as money market funds and providing more clarity for investors. “With harmonization of terms across the industry, making the product more regulated, there’s more comfort to be had as a treasurer if you know that they are all playing by the same rules,” comments Marshall.
Indeed, after halting its use of money market funds during the crisis, Virgin Media has since revisited the topic, although this has more to do with improvements on the reporting side than any regulatory developments. “We’re now back in the saddle, and we do use money market funds again,” Marshall says. “There has been a major shake-up in terms of the amount of material we get on a monthly basis, and the reporting is much better now. I like the flexibility that money market funds offer us, and the 13:30 [GMT] cut-off time is useful. We also get a slightly better yield using these compared to time deposits.”
The changes taking place in the oversight of European money market funds are not limited to the quest for a definition. IMMFA has updated its Code of Practice and is set to make a further raft of changes in June. In addition to the changes it made to match Rule 2a-7 in 2010, including the introduction of liquidity requirements, IMMFA is set to reconsider how the code is enforced. “One of the challenges we have by relying on an industry code, rather than legal regulation, is the question of how investors in the product can be sure that the code is being applied,” says Barker. “After all, IMMFA isn’t a regulator. We are proposing to create a mechanism so that investors can be confident that there is proper third-party oversight.”
Looking forward, there is a sense that more regulation is coming for the European money fund industry, as in the United States. “I daresay the European regulators are contemplating shifting their attention from the banking sector to the shadow banking sector,” says BNY Mellon’s Littler. “The industry is now anticipating a period of oversight, with attention focusing on the character of these products and on whether they could be classified in the same way as other banking operations.”
While the CESR definitions clearly go some way toward addressing the issues the industry is facing, the expectation is that this is only the latest chapter in the story. “What CESR has done is very helpful; it definitely represents progress—but it doesn’t represent the final word on the matter,” says Barker. “It’s hard to be sure of the time frame, but I think there will be further developments here.”
Read about how companies are using portals to monitor their short-term investments in Checking Funds’ Ingredients.