With markets well into late cycle, cash, or Money Market Funds (MMFs), are increasingly being considered as part of asset allocation decisions, given their primary objectives to provide a high degree of liquidity alongside preservation of capital, and yield, a tertiary consideration. Investors must therefore familiarise themselves with the regulatory reform driven changes to MMFs in recent years including the October 2016 US Money Market Reform and European Money Market Reform in 2019. We may be familiar with the terms constant net asset value (NAV) fund or variable NAV fund, but what is a low volatility NAV fund and how does it work? Focusing on the recent European reform, we’ll explore what the new regulations really mean for investors and how that experience will compare to what happened in the US.
Brief background to European Reform
European Money Market Regulation came into effect on July 21st 2018 for new funds, and existing, in-scope funds were required to submit an application for authorisation to the relevant authority by January 21st 2019 for conversion to the new rules shortly thereafter. Some asset managers converted before this final deadline, including JPMorgan Asset Management which moved on December 3rd 2018. Prior to reform, the European constant net asset value (NAV) universe had €635bn AUM as at June 1st 2018 and AUM has grown to €657bn as at March 22nd 2019 , showing that the market has not experienced any displacement of assets during the reform implementation.
Optionality in the market
The new European regulations introduce optionality into the money market space with 2 classifications of MMF and 3 structural options. MMFs can be classified as Short-term MMFs (akin to the existing conservative investment restrictions under the ESMA Short–Term Money Market Fund definition, including a maximum WAM of 60 days and maximum WAL of 120 days) or Standard MMFs (reflect the existing ESMA Money Market Fund definition, including a maximum WAM of 6 months and maximum WAL of one year).
Furthermore MMFs can be structured as one of the following:
Public Debt Constant NAV MMFs (CNAV) which can retain a stable NAV but must invest 99.5% of their assets into government debt instruments, reverse repos collateralised with government debt, and cash
Low Volatility NAV MMFs (LVNAV) can maintain a constant dealing NAV if certain criteria are met, including that the market NAV of the fund does not deviate from the dealing NAV by more than 20 basis points
Variable NAV MMFs (VNAV) price their assets using market pricing and therefore offer a fluctuating dealing NAV
Reverse Distribution Mechanism
Reverse Distribution Mechanism (RDM) is a share cancellation mechanism that allowed for prevailing market negative yields to be passed to investors while still maintaining a stable NAV and had been utilised by Euro currency MMFs while short term EUR rates remained in negative territory. The European Commission expressed opinion in letters dated January 2018 and October 2018 that share cancellation mechanisms are not compatible with MMF Regulation. To that end, European MMFs ceased to use RDM prior to March 21st 2019.
CNAV and LVNAV need to hold a minimum 10% in Daily Liquid Assets (DLA), and 30% in Weekly Liquid Assets (WLA), while the VNAV funds need to hold 7.5% and 15% respectively.
In order to ensure compliance with weekly liquidity thresholds the regulations have introduced a double-lock test on CNAVs and LVNAVs structures, whereby if both a fund’s WLA falls below 30% and the fund experiences a net redemption of greater than 10% on the same day, then the board may choose to apply one of more of 4 options, 1. Take no action, 2. Charge liquidity fees on redemptions 3. Implement redemption gates 4. Suspend redemptions for up to 15 working days. If WLA falls below 10% then the board shall apply one of more of 1. Liquidity fees on redemptions 2. Suspend redemptions for up to 15 working days.
In reality, prospectuses in Europe, have for many years included the ability to impose a gate or a fee and the introduction of the double-lock test as the first threshold, after which the board can still choose not to impose gates or fees, gives investors a clearer understanding of the circumstances in which these mechanisms can be invoked.
How have clients reacted to the changes?
In Europe the majority of clients previously invested in Government CNAV funds transitioned to the new Public Debt CNAV funds. Client who were invested in Non-Government or “Prime” CNAV funds generally moved to the new LVNAV structure. There was little displacement of assets during fund platform conversions and this benign transition differed to US Money Market Reform when, just ahead of the October 2016 conversion date, we saw the migration of assets out of Prime MMFs into Government MMFs (chart 1) and a widening of 3month LIBOR (chart 2) as Prime funds anticipated these outflows and built cash. The reason we saw this behaviour from US clients was because under the new US regulations, Government funds would remain as CNAV but, in contrast to Europe, they would not be subject to provisions to impose gates or fees. Prime funds on the other hand had to convert to a fully mark-to-market VNAV structure and could be subject to gates and fees.
In summary, European Money Market Reform introduces optionality for investors in the short term space and although some fund structures are changing, these features are already familiar to investors and the transition has been as smooth as anticipated.