Money market funds (MMFs), particularly sterling Low Volatility Net Asset Value (LVNAV) funds, are popular short-term cash management tools for local authority treasurers and have long been a feature of Arlingclose’s advice. It doesn’t seem like long ago that we were last talking to clients about reforms to MMF regulation, but time flies and it has been five years since the introduction of the EU Money Market Fund Regulation that aimed to address issues identified as a result of the 2008 financial crisis. As such, a regulatory review is due and we noted last year (see here) that further rule changes could be on the horizon, driven by the market stresses experienced in March 2020 with the onset of the Covid-19 pandemic.
Some MMFs faced significant liquidity issues during this period, with large redemptions from investors amid a deterioration in liquidity of the money market instruments in which they invest. Internationally, regulators and associated bodies have been assessing the situation faced by MMFs during this crisis and considering the policy options to address the issues observed, and potentially further enhance the previous MMF reform.
From a European perspective (with most sterling LVNAV MMFs being domiciled in the EU), definitive regulatory proposals are not yet known, but we are approaching an important stage. Regulatory change tends to be a convoluted process and there are several bodies involved in Europe. So far, the European Central Bank, European Systemic Risk Board (ESRB) and European Securities and Markets Authority (ESMA) have conducted reviews of the current EU regulation and lessons from the Covid-19 related market turmoil and published their opinions, recommendations, and proposals for reform of the MMF regulatory framework.
Broadly speaking, they believe that further reform is needed to enhance the resilience of MMFs, improve the overall stability of financial markets by reducing the risk of liquidity stress and address remaining systemic risks in the MMF sector.
Their recommendations are not completely aligned but there are common themes. The most notable suggestions include:
This means it would no longer be possible for LVNAV funds to offer a stable NAV. LVNAV funds are currently able to maintain a constant £1.00 NAV per share by using amortised cost valuation for some assets, rather than reflecting the market pricing of all assets. The NAV must stay within a 20bps ‘collar’ for this to be maintained, which is now viewed as a potential ‘cliff edge’ that exposes MMFs to a risk of first-mover advantage given investors can redeem at a value which may not reflect the underlying value of the assets.
Currently MMFs must consider imposing liquidity fees/gates if their Weekly Liquid Assets (WLA) falls below certain thresholds. This might create an additional risk of first-mover advantage because as liquidity levels decline towards the regulatory threshold, investors have an incentive to pre-emptively withdraw cash to avoid being subject to redemption fees and gates.
None of the ECB, ESRB or ESMA have the final say or lay down the legislation needed for regulatory changes so the next step is for the European Commission to undertake a review of the adequacy of the current regulation, taking on board the feedback and recommendations from these organisations. This process has already started, including a public consultation, launched in mid-April, open to both the MMF industry and MMF investors. It is expected that the Commission will then issue its proposals by 21st July 2022 which kick-starts the formal legislative process.
This may well be a lengthy undertaking, as the Commission’s proposals will then be both reviewed and voted on by the European Parliament and European Council, before finally a ‘Trilogue’ of all three bodies is held to agree the final reforms. The proposals could be amended, or indeed rejected, at any stage, so there will be significant uncertainty around the final changes and new rules well beyond July.
It’s expected that new rules would not be introduced until at least late 2023, but more likely 2024 or beyond, given the usually slow legislative process and the likelihood of an implementation period.
The MMFs we have spoken to recently seem to be supportive of the decoupling of liquidity thresholds and fees/gates, but views are mixed when it comes to the idea of LVNAV funds becoming VNAV. Indeed, ESMA noted in its proposal that most respondents to its own consultation were against the removal of CNAV and LVNAV, so it seems likely the European Commission will receive similar feedback. A move away from the current LVNAV structure may result in significant changes for the EU MMF landscape given LVNAV funds make up around 46% of the EU MMF industry. ESMA stated that it has not assessed the impact of this on investors and financial stability, and it will do this following adoption.
In terms of local authority investors in MMFs, we don’t think a conversion to VNAV should remove the appeal of MMFs as liquidity management tools, but there would be some implications for the way in which funds are accounted for. At this stage, given we are some way off knowing what any rule changes are, let alone them actually being implemented, we will stay in ‘wait and see’ mode. We will, of course, keep clients informed as the regulatory process progresses.