C-NAV to V-NAV: what would a rule change mean?

With rumblings afoot across the pond about a move from constant net asset value money market funds to ones with a variable net asset value, we asked two leading fund managers to explain the underlying issues and assess the potential impact on local authority wholesale depositors. 

Taking part in the questionnaire were James Bevan, CIO, CCLA and Dennis Gepp, CIO, Federated Prime Rate Capital Management LLP 

Room151: Why is the SEC proposing to move money market funds (MMFs) from a constant to a variable net-asset-value?

James Bevan: It is clear that there has been confusion in the market place as to whether money market funds were in fact a form of bank account, with capital underwritten by the operator. Given the confusion, the EC went through a process of consultation to “increase understanding of what shadow banking actually is and does, and what regulation or supervision may be appropriate.” The EC have listed the entities and activities which may be identified as part of the shadow banking system – and MMFs are at the top of the list.

The challenge is that either funds must convert from a CNAV (constant net asset value) to a VNAV (variable net asset value) or introduce a varying list of controls and support measures which may be called upon. Such measures may include holding back shareholders’ funds; increasing the capital held by the provider/sponsor firm of MMFs; possible insurance to mitigate credit risk, or a reserve set-up which is funded by reducing the daily yield paid to shareholders.

The SEC hopes that by forming a distinction between CNAV and VNAV funds, investors will have a clearer understanding as to the nature of the risk they run in depositing with a MMF.

Dennis Gepp: The SEC has not to date proposed to amend its rules in order to move MMFs from a constant or stable net asset value (NAV) to a variable NAV. The SEC Chairman and certain members of the SEC Staff have, however, discussed that as a possibility. Proposal of a change to the current rule requires an affirmative vote by three of the five sitting SEC Commissioners to seek public comment on the proposed change. After that, public comment is required, and an analysis of the comments and an economic assessment of the rule change is required to be conducted, followed by a second affirmative vote by a majority of the SEC Commissioners to adopt a rule amendment. The process of adopting a rule, even after it is proposed, can take many months, and agencies sometimes decide not to adopt a rule in final form, based on comments and data gathered after a rule is proposed.

The current MMF rule permits the use of a stable net asset value by MMFs that meet the stringent requirements of the rule. These include: maintenance of 10% overnight liquidity and 30% or more 7-day liquidity as a percentage of assets, 60-day or shorter weighted average maturity, stringent transparency, credit quality and diversification requirements, as well as publication of “shadow pricing” of the shares at a floating NAV based on market values of the portfolio. There is also a requirement to consider departing from stable value pricing or close the fund if the amortized cost departs by 1/2 cent or more per share from the floating NAV.

Those advocating the proposed change suggest various reasons why it would be beneficial. These include a view that the use of a stable net asset value makes MMFs vulnerable to “runs” by withdrawing investors, although the empirical data from the performance of fixed and floating NAV funds during the 2008 financial crisis does not appear to support that assertion. Additionally, even though there are prominent disclosures in MMF offering documents and marketing literature stating that they may lose value and are not guaranteed, the SEC Chairman has said that a continuously floating NAV will help educate investors that MMF shares can lose value.

It is worth noting that normally the “shadow price” per share calculated and disclosed by MMFs using mark-to-market portfolio asset values (essentially a floating NAV disclosed in arrears to investors under US rules) is either exactly the same as the stable NAV of a dollar per share or within a few one-hundredths of a cent per share of that price, although occasionally in very stressed situations the “shadow price” may vary one or two tenths of a cent from a dollar. In the forty-year history of MMFs, only two MMFs failed to fully repay investors at a stable NAV of $1/share. One of those MMFs that “broke the buck” paid investors 96 cents per share, and the other repaid investors over 99 cents per share, at no cost to U.S. taxpayers.

Room151: Why does it matter to us in the UK?

James Bevan: The shift in the rules adds complexity, will carry costs for MMFs seeking to be classed as CNAVs which will affect returns for investors, and may mis-lead as the real nature of risk. After all, the choice of counterparties is much more complex and demanding than whether a fund is formally designated CNAV or VNAF, both types of funds will clearly be run with the practical intention of retaining constant net asset value. Even after designation, question marks must remain as to whether CNAV funds will actually protect NAV in the event of a material crisis in global banking and markets. The result is that informed choice will remain a key requirement for investors.

Dennis Gepp: Constant net asset value (CNAV) pricing for shares of MMFs makes them more useful than floating NAV MMFs in a variety of consumer and business processes in the UK. The CNAV allows for same day settlement of purchases and redemptions of MMF shares. This is a key benefit to investors, allowing them to manage their cash balances more effectively, and also permits the use of MMFs to hold cash balances in securities brokerage accounts and other arrangements where customer cash is needed to settle transactions as they occur on a daily basis. VNAV funds settle one day later, because the market price information needed to value VNAV MMF shares is not available until after the market closes. VNAV Funds therefore are not as useful to hold cash as CNAV MMFs.

A change in U.S. requirements for MMFs may cause a change in standards in the UK and elsewhere in the world where many money funds maintain a stable NAV, and may cause regulators in other countries to impose similar standards requiring use of floating NAV.

Room151: What will the impact be on the money market fund industry?

James Bevan: History shows that through the global financial crisis in 2007-08 investors redeemed from some CNAV funds but not from others, and from some VNAV funds but not from others. The reality is that investors did not redeem because of the pricing structure of money funds, but because of concerns about the credit quality of their portfolios. Yet MMFs must now choose whether they should be CNAV or VNAV, and if they chose the former, they must face increased costs, and by extension offer lower returns than otherwise would be the case. Of course the money market fund industry and indeed all industry participants should welcome the efforts of regulators to address the risks and realities of financial crisis. But this approach may turn out to be misleading and unhelpful against the goals of delivering transparency and clarity of choice for investors.

Dennis Gepp: A variety of U.S. consumer groups, state and local government representatives, corporate treasurers, money fund sponsors, academics, and others have submitted comments to the SEC urging the SEC not to abandon the stable NAV for MMFs and making the point that a change from the current stable NAV (daily $1/share pricing) to a continuously floating NAV will make MMFs much less useful to retail and institutional investors and result in a significant shrinkage of the MMF industry.  This, in turn, will in the view of many commentators, reduce funding available to business and state and local governments whose short-term notes are owned by MMFs.

Room151: Should local authority investors be concerned?

James Bevan: Local authority investors should be focused on the nature and scale of the risks they face. It follows that local authority investors should seek to understand how their fund managers seek to control risk whilst adding value against an inter-bank benchmark. There can be no substitute for detailed and ongoing due diligence by and of the manager – and any reliance on labels may prove to be a trap for the unwary.

Dennis Gepp: Yes. A change in U.S. requirements for MMFs may cause a change in standards in the UK and elsewhere in the world where many money funds maintain a constant NAV, and may cause regulators in other countries to impose similar standards requiring use of floating NAV.   This could mean that Local Authorities may no longer be able to benefit from the diversification and economies of scale that a CNAV fund offers or have access to funds offering same day settlement for their cash.