RegTech Intelligence 
By: Conor Foley & Umar Ahmed.
New EC proposals raise risks for fund managers and investors relying on EU Money Markets.
Overview
This memo summarises key provisions of the Commission proposal for a Regulation of the European Parliament and of the Council on money market funds (MMFR) and next steps in the legislative review process.1
1. Key point summary
(1) If adopted, the Commission proposal would permit MMFs to only invest in money market instruments, bank deposits, certain financial derivatives instruments and reverse repo agreements as defined in the text.
(2) MMFs would be prohibited from investing directly or indirectly in equities, equity derivatives, commodities and commodity derivatives. MMFs would also be prohibited from entering into securities lending, securities borrowing or repo agreements.
(3) CNAV MMFs would be required to establish and maintain a cash buffer equal to at least 3% of total value of assets.2 NAV buffers would be held in segregated accounts and would only be used to compensate the difference between CNAV per unit and ‘real’ value per unit.
(4) Fund managers would be required to calculate NAV per unit for each MMF, whether CNAV or other, daily on a mark-to-market or mark-to-model basis.
(5) The proposed legislation would require that MMFs be comprised of at least 10% of daily maturing assets and at least 20% of weekly maturing assets.
2. Main provisions of the Commission proposal
The MMFR proposal represents the European Commission’s first legislative action on ‘shadow banking’. The proposal follows a series of recommendations by the G20 in response to the financial crisis and particular concerns about runs on MMFs and the systemic risk effects that could impact ‘real economy’ funding. Reforms of rules for MMFs to date include the 2010 amendments to Rule 2a-7 of the US Investment Company Act 1940 that concern MMFs and the 2010 (ex) CESR guidelines for EU MMFs.3
Further international guidance emerged in October 2012 with the publication of IOSCO’s Final Report on policy recommendations for MMFs.4 Although there are no obvious EU MMF failures driving reform, the Commission has decided to propose legislation in line with international efforts to enhance the safety and stability of MMFs and to reduce the likelihood of runs.
Following adoption and publication, the proposal will be subject to a review by the EU’s Council of Ministers and the European Parliament under the ordinary legislative procedure. It remains to be seen whether the legislation will be formally adopted before the 2014 European Parliament election and the appointment of the new College of Commissioners (see section 3 below).
The Commission proposal appears to diverge significantly from the 2010 CESR guidelines on European money market funds in a number of key areas. As a Regulation the rules would be directly applicable across all EU Member States. Key provisions are summarised below –
(1) Investment restrictions – eligible assets (Article 8 – 13)
Article 8 MMFR would add significant investment restrictions for MMFs over and above the 2010 CESR guidelines. If adopted, the proposal would only allow MMFs to invest in one or more of the following categories of financial assets, with each being further restricted under Articles 8-11:
(a) money market instruments;
(b) deposits with credit institutions;
(c) financial derivative instruments;
(d) reverse repurchase agreements.
An earlier Commission draft prohibited taking exposure to securitisation. The published proposal allows for securitisations where the underlying exposure or pool of exposures consists exclusively of liquid and high credit quality corporate debt that has a legal or residual maturity at issuance of 397 days or less.
MMFs would be prohibited from:
(a) short-selling money market instruments;
(b) taking direct or indirect exposure to equity or commodities, including via derivatives, certificates representing them, indices or any others means or instruments;
(c) entering into securities lending agreements or securities borrowing agreements, and repurchase agreements, or any other agreement that would encumber the assets of the MMF; and
(d) borrowing and lending cash.
Under Article 12 MMFR, MMFs would only be allowed to invest in ‘financial derivative instruments’ traded on a regulated market or OTC and used for hedging purposes where the underlying consists of interest rates, foreign exchange rates, currencies or indices representing one of these categories. OTC derivatives would be subject to reliable and verifiable valuation on a daily basis and the MFF must be able to sell, liquidate or close them by an offsetting transaction at any time.
Article 13 MMFR specifies eligibility requirements for reverse repurchase agreements (RRPs). In order to be eligible for investment, the MMF must be able to terminate the agreement at any time with a maximum notice of 48 hours. The value of the assets received under the agreement must be at least equal to the value of the cash given out. In addition, the assets of the RRP must be money market instruments compliant with the requirements above and may not be sold, reinvested, pledged or otherwise transferred.
(2) Investment policy rules (Article 14 – 20)
If adopted, the proposal would place several further restrictions on MMFs with regard to diversification. The proposal would require that a MMF invest no more than 5% of its assets in money market instruments issued by the same issuer or in deposits made with the same credit institution. In addition, the aggregate risk exposure to the same counterparty stemming from OTC derivative contracts shall not exceed 5% of the MMFs assets. Article 14 (4) would also limit the amount of cash provided to the same counterparty in an eligible RRP. Article 14 (5) would set an overall 10% limit on risk exposures to a single counterparty.
(3) Risk management (Articles 21 – 25)
The proposal would expand on the portfolio rules in the 2010 CESR guidelines by requiring that at least 10% of MMF portfolios are comprised of daily maturing assets and at least 20% of portfolios are comprised of weekly maturing assets. In line with the CESR guidelines, short-term MMFs would be required to have a weighted average maturity (WAM) of no more than 60 days and a weighted average life (WAL) of no more than 120 days, with the equivalent rules for standard MMFs set at 6 months and 12 monthly respectively. Fund managers and MMFs would be prohibited from directly or indirectly soliciting a credit rating agency to provide a rating for the MMF. The proposal also sets out procedures for thorough stress testing of MMFs.
(4) Specific requirements for CNAV MMFs (Articles 29 – 37)
The proposal demonstrates the ongoing concern of some EU policy makers with respect to CNAV MMFs. While the proposal does not restrict the use of CNAVs, the proposal would add onerous and specific requirements for CNAVs. Most importantly, CNAVs would be obliged to establish a NAV buffer amounting to a minimum of 3% of the total value of the MMFs assets. This NAV buffer, which shall be composed only of cash and must be held in a segregated account, would be used exclusively in case of subscriptions and redemptions to equalise the difference between the CNAV per unit and the ‘real’ NAV per unit. Article 37 MMFR sets out additional, onerous transparency requirements for CNAVs. The proposal would allow CNAVs to access external support guaranteeing the liquidity of the MMF through the NAV buffer. Three years after entry into force of the Regulation the Commission will review the application of the NAV buffer for CNAV MMFs that concentrate their portfolios on debt issues or guaranteed by the Member States.
3. Next steps
The proposal will now be sent to the Council of Ministers (Member States) and the European Parliament where it will be reviewed and amended under the ordinary legislative procedure. The Lithuanian Presidency of the Council (Q3-Q4 2013) may start substantive discussions on the proposal but it is not yet clear what priority the proposal will receive given the high profile draft legislation still in process. In Council, HB expects the main MMF domiciles (France, Ireland and Luxembourg) to drive early-stage discussions although other Member States where key investors and MMF sponsors are based will also be expected to take an interest.
The European Parliament’s Economic and Monetary Affairs (ECON) committee will lead the legislature’s review of the proposal. It is unclear at this time which political group will be allocated the lead on the proposal. However, several legislators have already shown an interest in ‘shadow banking’ issues, including Said El-Khadraoui (S&D, Belgium), Corien Wortmann-Kool (EPP, Netherlands), Wolf Klinz (ALDE, Germany), Philippe Lamberts (Greens/EFA, Belgium) and Syed Kamall (ECR, United Kingdom). One of these will likely be appointed Rapporteur on the proposal.
First reading agreements on legislative proposals typically take 14-16 months. However, there are a number of factors which may prompt the EU institutions to attempt to hurry the legislative review, including a potentially distracted Greek Presidency (Q1-Q2 2014), the May 2014 European elections and the end of term of the current College of Commissioners in October 2014. A rush to conclude the legislative review would present significant risks for fund managers, investors and institutions reliant on the money markets for funding.
Questions and comments:
Conor Foley
Partner
Hume Brophy
T: +32 (0) 2 234 68 60
M: +32 (0) 472 530 484
E: conor.foley@humebrophy.com
Umar Ahmed
Senior Account Manager
Hume Brophy
T: +32 (0) 2 234 68 60
M: +32 (0) 470 125 595
E: umar.ahmed@humebrophy.com
1 Proposal for a Regulation of the European Parliament and of the Council on Money Market Funds [Link]
2 A constant net asset value (CNAV) MMF maintains an unchanging value NAV per unit or share, where assets are generally valued according to the amortised cost method and/or the NAV is rounded to the nearest percentage point or its equivalent currency term.
3 Committee of European Securities Regulators: Guidelines on a common definition of European money market fund [CESR / 10-049] (19 May 2010) [Link].
4 IOSCO: Final Report on policy recommendations for MMFs [FR07/12] (09 October 2012) [Link].