From the November 2011 issue of Treasury & Risk magazine

The Future of Money Funds

Can constant NAV funds survive the latest wave of regulatory changes?

Money-market funds (MMFs) have had no shortage of attention since 2008, when the Reserve Primary fund broke the buck in the wake of Lehman’s collapse, leading to a run on money funds in the United States. That led to a steady flow of regulatory initiatives around the globe that affected money-market funds: Amendments to Rule 2a-7 reduced maturity limits and increased the liquidity of U.S. money funds, while the London-based industry association, the Institutional Money Market Funds Association (IMMFA), updated its own Code of Practice along similar lines. Meanwhile ratings agency Moody’s Investors Service updated its rating methodologies for money funds.

While many in the industry feel these changes have bolstered the resilience of money-market funds and addressed the issues highlighted by the financial crisis, there is much more to come. The full impact of Basel III, which requires banks to issue longer-term paper, has yet to play out for the money fund industry. Solvency II, the revised capital adequacy regime for insurers in Europe, and the International Accounting Standards Board’s financial statement presentation project could both have adverse implications for money funds. Meanwhile the U.S. President’s Working Group on Financial Markets and the U.K.’s Financial Stability Board have initiatives in motion that could have significant consequences for funds.

Some question whether the regulatory changes will kill off this type of fund—at least the stable or constant net asset value (CNAV) flavor of money-market fund, which maintains a constant share price of $1 (or £1, or €1). While floating or variable net asset value (VNAV) funds are common in mainland Europe, the money-market-funds industry in the U.S. and U.K. is predominantly made up of CNAV funds.

It is this very feature—the constant NAV—that attracted much regulatory attention in the past year. Repeatedly the question has been asked: Should CNAV funds continue to exist?

In 2010, the President’s Working Group on Financial Markets released its long-awaited report on the options available for reforming money-market funds. It found that while the Securities and Exchange Commission’s amended rules increased the resilience of the funds and reduced their risks, more still needed to be done to lower the risk of a run on money funds in the future. The report proposed eight different options, including eliminating CNAV funds in favor of VNAV; distributing large redemptions in kind rather than in cash; offering fund investors insurance; and regulating CNAV funds as special-purpose banks.

In July, the Financial Stability Oversight Council set up by the Dodd-Frank Act to monitor the stability of the financial system issued its first annual report. Among other things, it recommends that the SEC continue to explore ways to further reform the money fund industry and specifically mentions three options: implementing mandatory VNAV, introducing capital buffers to absorb losses in CNAV funds and establishing deterrents to investor redemption.

Hot on the heels of those recommendations, across the Atlantic the U.K.’s Financial Stability Board announced in September that its Shadow Banking Task Force has set up five different work streams to determine whether further regulatory action is needed in specific areas, including money-market funds. Again, the prospect of abolishing CNAV funds in favor of VNAV is likely to be under consideration.

 “This will be the equivalent of the President’s Working Group in the U.S.,” says Jennifer Gillespie, head of money markets at Legal & General Investment Management in the U.K. “It will be asking whether we can come up with sufficient regulations or guidance to allow money-market funds to continue as constant NAV funds or whether there can no longer be constant NAV funds—that really is the question out there.”

Why do regulators object to the concept of the CNAV fund? In operational terms, there is little difference between CNAV and VNAV funds. “From a fund manager’s perspective, managing a fund with constant NAV or mark-to-market makes no difference—I’m not going to change the way I manage the fund, I’m not going to make different credit decisions,” Gillespie says. “The difference is all from the investor’s perspective. They like the constant NAV—it sits on their balance sheet as £1 and has a yield that gets attached with it.”

The opposing school of thought goes as follows: By its nature, the constant NAV masks the fact that the value of the fund may go up or down. With a VNAV fund, investors understand that the value will fluctuate and are less likely to make redemptions during periods of market stress.

Speaking at a seminar in 2010, Paul Tucker, deputy governor for financial stability at the Bank of England, outlined some of the objections relating to CNAV funds. “They promise to return to savers, on demand, at least as much as they invest. Just like a bank. And just like a bank, they are subject to runs,” he said. “And if a constant NAV fund’s value goes just a few basis points below par (100 pence in the £1), they effectively have to close, fueling the incentive to run. If this sounds like a bank, it is because it is just like a bank.

 “The Bank of England believes that constant NAV money funds should not exist in their current form,” Tucker continued. “They should become either regulated banks or, alternatively, variable NAV funds that do not offer instant liquidity.”

In light of these comments and the various regulatory proposals, it is easy to see why there is concern in the industry about the future of the CNAV fund. But while regulators see VNAV funds as a solution to some of the product’s perceived shortcomings, not everyone agrees that investors do not comprehend how CNAV funds work.

“What we understand is that investors want to be able to continue to invest in CNAV funds,” says Jonathan Curry, a director at IMMFA and chair of its technical committee. “They understand the product. They understand the risks that are clearly described to them. And I think the evidence of the volume of assets in this type of fund means they are valuable to the end investor.”

A number of money-fund experts say they are far from convinced that moving to a VNAV model will make the product more robust. “Some market observers believe that floating NAV would have alleviated the issues around money-market funds during the last market crisis,” says Tony Wong, senior analyst and head of short term investment grade and municipal research at Invesco. “I believe that’s debatable given the redemption experience of ultra-short bond funds or French floating-NAV money funds during that period.”

“Some regulators have argued that investors in VNAV funds become ‘immunized’ to price movements and so are less liable to panic when markets become dislocated,” Curry adds. “But we see no evidence in support of this argument. Indeed, investors in enhanced VNAV funds redeemed en masse in 2007. We can see no correlation between redemptions and the particular pricing structure of a fund.”

So VNAV funds might not offer any real advantage over their CNAV cousins—and there is a big question mark over how investors in a market worth more than $3 trillion would react if regulators pulled the plug on the CNAV model. As Gillespie points out, investors who use CNAV funds do so because they value the particular characteristics of this type of money fund. Other fund managers agree.

“Most corporate treasuries prefer the transactional benefits of a constant NAV,” Wong says. “There are financial reporting, accounting and tax implications with floating NAV money market funds that could make these funds less attractive. We’ve been hearing from our investors how critically important constant NAV is to them.”

Consequently, there is no guarantee that investors would move from CNAV to VNAV funds if regulators did away with the CNAV variety. “If CNAV funds no longer existed, we wouldn’t be interested in VNAV funds,” says Dmitry Bespalov, treasury manager at Netherlands-based retail group Ahold. “When you have to fair-value everything on a daily or weekly basis, it’s like you’re investing yourself. If CNAV funds disappeared, we would probably end up building our own portfolio and directly participating in the market ourselves. Or we might use a segregated mandate and set up a portfolio with one of the asset managers.”

Many argue that investors would not accept the transition. “The one thing everyone wants in the industry is to maintain a constant NAV,” Gillespie says.

 “If the industry moves away from CNAV funds and VNAV funds become the only solution in the sector, it will kill the industry,” Bespalov says.

Even taking an optimistic view, it is clear a move from CNAV to VNAV would result in some fundamental changes in investor behavior. “There will always be a need for investors to manage cash in a prudent manner focusing on safety and liquidity,” Invesco’s Wong says. “What investment vehicle those assets will be delivered in could change if the market moves to floating NAV—in the U.S., at least, it would materially alter a product we’ve known since the early 1970s.”

Regulators have yet to decide whether or how to regulate the product further and it is still possible that no further action will be taken. “I think if the right people could get in front of regulators, they could make them understand the importance of money market funds,” Gillespie says. “We’ve moved on from a few years ago, added more rules and regulations. We have enough controls in place to meet any requirements.”

For now, the outcome is far from certain. As Wong concludes, “The final chapter of regulatory reform stemming from the financial crisis has yet to be written.”

For a look at how companies are coping with current low rates, read The Hunt for Short-Term Yield. And for a discussion of companies’ efforts to track short-term investment risks, see Self-Policing Money Fund Risks.


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