Money market funds: the end for stable NAV?

Robin Creswell is Managing Principal at Payden & Rygel Global Ltd

Speaking at the Local Authority Treasurers Investment Forum provided an opportunity to poll attendees on their ownership of money market funds.  Of around 120 delegates attending, some 95% confirmed they were invested in money market funds, of the remaining 5% just 2% had no intention of adding these funds to their TMS.  An informal sampling later suggested that whilst approximately 30% now permit variable net asset value (VNAV) funds in their TMS, close to 100% of money market fund investments were held in constant net asset value funds (CNAV) which form a key plank of treasury strategy.

It came as a surprise to many to hear of the latest draft legislation from Brussels released in September which proposes new regulations which may in effect bring to an end CNAV funds or potentially make them much more costly.  The measure weighing most heavily on the sector is a proposal that fund managers or the sponsors of money market funds set aside capital within their company balance sheets amounting to 3% of the value of the money market funds they manage. To be clear, this is not a liquidity buffer held inside the fund comprised of investor assets but cash the sponsor must find, to be held in a non interest bearing account to provide for a potential shortfall in the net asset value.

Banks would either have to find additional new capital or divert it from other potentially more remunerative areas of their business.  Money market funds are notoriously low margin or no margin vehicles which are often provided to complete a suite of client services.  If the cost of holding reserve capital cannot be passed on to the funds, banks and fund managers will most likely close their funds of float the NAV and some have already done so.  Fund managers without substantial capital or parent backing would have no means of providing the required capital and would have to either close or sell their funds.

Estimates of the cost to fund shareholders of the new measure vary between 15 and 20 basis points annually depending on the sponsor’s cost of capital, with lower rated banks paying more.  The highest quality sterling money market funds today yield some 10 basis points or less, net of fees.  An addition load of 15 or 20 basis points would ensure these funds produced a negative return of 5 to 15 basis points annually.

Money managers have already begun to adapt to the changing environment even before news of the potential capital requirement was raised.  In the early part of the year US dollar and Euro managers began approaching investors in their funds to approve special resolutions first to float their NAVs and then to re-impose full fees which had been reduced or suspended as interest rates fell in the vain hope of maintaining the viability of the funds for investors until interest rates moved higher.  In fact with the medium to longer term outlook for interest rates suggesting a lower for longer interest rate environment, a number of US dollar and Euro funds are no longer viable and have either closed or moved to variable net asset value.

THE POLICY MOTIVATION AND WHY IT WON’T GO AWAY

Governments and policy makers are determined that tax payers should not underwrite the shadow banking sector, as they describe it, any longer.  However in order to make aspiration a reality and to avoid the public outcry of not supporting the sector, governments need to create effective tools to deliver the policy. This legislation is that tool and the policy very effectively delegates more of the risk and more of the underwriting to managers, promoters and investors.  The message now may be – If you want CNAV, here it is, here are the new rules and there’s a cost. If you don’t want CNAV here’s the alternative, but don’t expect the government, the taxpayer or the sponsor to have any moral or legal obligation to support your fund in the future.  It’s important this message sinks in; governments are not going to stand behind these funds in future and sponsors will have little or no motivation to do so either.

MONEY MARKET FUNDS IN CONTEXT

It is estimated £1 trillion is in invested in UK and continental European money market funds, a part of this is corporate cash, the largest investors, where in the UK alone cash held on company balance sheets is now estimated to be sufficient to pay all the dividends of the FTSE 100 companies for the next three years.  However these large numbers represent just 15% of the European funds industry and perhaps as little as 5% of industry revenues, some think these funds are a net drag on company profits.  So there may not be much appetite to defend the status quo, despite initial protests, especially if in the great board game of Brussels the cost of a “win” here amounts to a “loss” somewhere else.

France, Luxembourg and Ireland comprise 95% of the market which also gives this an interesting dynamic; Ireland appears keen to maintain the status but it may be that the French sponsors are in favour of the new rules. In France there is already a predominance of VNAV funds (50% or more) and sponsors of these funds felt obliged to prop up and subsidise fund values during the liquidity squeeze to preserve their reputations and their businesses.  Fund subsidies were costly, some £5 billion was used to prop up funds and this legislation is being seen by some as an opportunity to rid them of any obligation to stand behind their funds in future.

THE CRUCIAL ROLE OF MONEY MARKET FUNDS

Legislation will need to take account of the crucial role money market funds play in the capital markets and may prove a mitigating role in the legislative process.

25% of short term debt issued by EU Governments is purchased by these funds as is 28% of short term debt issued by banks.  Key users of the funds for this purpose are Germany, Britain and France.  Governments and banks depend in part on these funds as a low cost flexible source of funding and it is not clear what would replace this source were it disrupted. Capital markets cannot afford a wholesale move out of CNAV funds and for the smooth running of these markets to continue acceptable regulations will need to be found.

A TIMETABLE FOR CHANGE

In September 2012, The EU undertook general consultation on the topic with industry participants.  Earlier this year, March 2013 an “Impact Assessment” was undertaken which concluded that there was a need for an “adequate” buffer to back up a funds “promise” to redeem investors at a constant price.  In September the European Commission published the “New Rules for Money Market Funds Proposed” document, containing details of the proposed 3% buffer.  Looking forward to March 2014 the Commission must have EU member states and the EU Parliament give approval to legislation before the spring elections and ahead of the parliamentary recess.  If this timetable is adhered to implementation will take place in 2015 or early 2016

Potentially the most likely outcome is a choice between costly CNAV funds and less costly VNAV funds. As the legislation firms up it will become clear what those costs will be.  For some the absolute of a CNAV fund will outweigh all other considerations.  But in an income constrained, revenue limited world, for most, the smart option, as we see it, will be to make a break-even analysis between the costs and the benefits relative to specific needs.  The message today must be, prepare for VNAV (it will be a close cousin of its neighbor CNAV) and be ready to evaluate between the two.  Prepare also for advising your members who will need to understand what is coming, and prepare to adapt TMSs, accounting policies and systems.