RegTech Intelligence 
JWG analysis.
Following the financial crisis, regulators were concerned about the risks of shadow banking, including Money Market Funds (MMFs). The European Parliament is still discussing the regulation which the European Commission issued on 4 September 2013 and it’s likely that a revised draft will be released.
This article answers 5 key questions about the proposed regulation.
1. What is a MMF?
A MMF is a mutual fund that invests in short-term debt. This includes money market instruments, issued by banks, governments or corporations*, which include treasury bills, commercial papers or certificates of deposit. MMFs within the EU hold approximately €1 trillion worth of short-term debt.
2. How does the MMF industry work?
Any authorised asset management company, either via Undertakings for Collective Investment in Transferable Securities (UCITS) or Alternative Investment Fund Managers Directive (AIFMD), needs to obtain a separate permit to offer a MMF. This is granted by the relevant competent authority, once it has established compliance with the MMF regulation. Most MMF managers do not tend to manage just one single fund, but have a portfolio of several. Any single manager can, therefore, be managing a portfolio valued up to €120 billion.
MMFs are invested in mainly by corporate treasurers who wish to hold large amounts of cash on a short-term basis and do not want to put this into one single bank deposit account. Investing in MMFs provides a high degree of liquidity, diversification and stability of value which is combined with a market-based yield.
In Europe, corporate treasurers can decide to invest either in Constant Net Asset Value (CNAV) funds or Variable Net Asset Value (VNAV) funds with the two models being chosen in roughly equal proportion.
3. What are the reasons for implementation?
The financial crisis revealed that MMFs, although relatively stable investment vehicles, can pose a systemic risk. This is not only due to their size but also their interconnectedness with both the banking sector and corporate and government finance.
Regulators in Europe have implemented a set of regulations for MMFs that they believe will reduce ‘run’ risk and the knock on impact to the broader financial system of a ‘run’ from MMFs. Such a run played a significant role in the 2008 financial crisis and must be prevented from reprising this. The proposal aims at creating stable platform which investors – both in Europe and internationally – can trust to manage their cash.
4. What changes are being proposed?
The proposed regulation is very comprehensive and includes 44 different sub-regulations, representing a heightened oversight by regulators in Europe.
The main sub regulations include:
- CNAV funds must convert to floating NAV or hold a 3% capital buffer. This will not go into effect immediately but instead be built over 3 years at a rate of 1% per year
- The introduction of minimum liquidity requirements. This will be at 10% overnight and then 20% within one week
- The obligation to maintain a ‘know your client’ policy. This is starting to become increasingly important in the financial regulation world
- Prohibition on all use of amortised cost accounting
- Highly prescriptive credit process. This is important so that a crisis does not happen again, as in 2008, in the money market fund sector
- MMFs being prohibited from paying for, or soliciting, a fund rating. This, in turn, will keep the market more straightforward for investors
- Sponsor support is prohibited, unless approved by the appropriate regulator. This will only occur if they believe the support will reduce systemic risk.
5. What potential implications could arise?
The anticipated regulation poses a number of implications for investors in MMFs.
The first is the conversion to floating NAV because of the small level of volatility in the yield of the fund. Also, the investor must determine the tax treatment of a floating NAV MMF with their accountants.
The second is MMF ratings. MMF providers will not be able to pay for their MMFs to be rated. If firms don’t want to pay for the rating of any MMF they invest in (assuming this is even an option available to them by the rating agencies), they may need to update their investment policies if these reference the requirement for a MMF to be rated.
The third potential implication is the development of a treasury system. The regulatory change may require development of treasury systems to manage investment in a floating NAV MMF.
Furthermore, regulations will also require MMF providers, custodians, administrators and European regulators to adapt to these changes as they are implemented.
* These financial instruments are appropriate for a MMF as long as their residual maturity does not exceed 397 days (short-term MMF) or two years (standard MMF).