11 September 2013

Fitch comments on EC's proposed regulatory changes to MMFs

Certain aspects of the regulation should make MMFs less risky through enhanced liquidity and diversification, consistent with the practices adopted by conservative funds. As a way to mitigate the risk of investor runs on MMF, the EC also proposes a move to full variable-NAV (VNAV) on most funds. The focus on investor runs is understandable, given the maturity transformation embedded in MMFs and the high level of redemptions historically observed in certain MMFs.

The proposal is part of a broader regulatory review of shadow banking activities. It will apply to all funds established, managed or marketed in Europe as MMFs and governed by the Collective Investment in Transferable Securities (UCITS) Directive or Alternative Investment Fund (AIFM) directive. The proposal will have to be approved by the European Council and Parliament, which could be a protracted and uncertain process.

The proposed diversification and liquidity limits provide additional safety to European MMFs relative to existing guidelines and are also consistent with industry practice and MMF regulation in the US under Rule 2a-7. Additionally, the proposal restricts the use of leverage and derivatives, requires that MMFs put in place a robust process for stress testing and investor base monitoring, and places restrictions on eligible repo collateral.

A key element of the proposal disallows the use of amortised cost valuation and a constant NAV (CNAV) for MMFs, unless the fund establishes a 3 per cent cash capital buffer available to absorb losses. While a 3 per cent capital buffer would provide a material cushion against losses, it also imposes a significant additional cost to an MMF or its sponsor. As a result, it is likely to result in most MMFs adopting the VNAV framework overall in a low rate environment.

The move to full VNAV accounting is designed to reduce the so-called 'first mover' advantage of early redemptions that some believe creates systemic risk. Whether it would accomplish this goal or not continues to be debated. It is likely that pro-cyclicality caused by sudden, large-scale redemption activity will remain a risk. In front of a minor mark-to-market NAV decline, investors may conclude that a fund is experiencing difficulties and pre-emptively sell, forcing the fund to dispose of assets, which would lead to more downward price volatility.

In Fitch's view, redemption risk is influenced by parameters other than valuation. Fitch's research finds that excluding funds only invested in treasuries, French VNAV funds and euro-denominated CNAV were confronted with somewhat similar redemption pressure in 2008. Approximately 20 per cent of the 100 largest French MMFs suffered monthly outflows of more than 20 per cent of assets in September or October 2008. In comparison, around 30 per cent of euro-denominated CNAV funds suffered similar outflows.

It is possible that certain managers, particularly those that benefit from a low cost of capital, may decide to offer CNAV funds with the 3 per cent buffer in combination with VNAV funds. These CNAV funds essentially would be "bank-type" products that are structurally safer - at a cost - and continue to provide diversification and liquidity.

A move to full VNAV may reduce the products' attractiveness for a number of investors and have implications for MMF operations (eg.pricing or same day liquidity) and the broader markets. The ultimate impact would only be known over time, should the proposal be adopted. Many larger investors in Europe may ultimately adapt to the new market paradigm, assuming it offers the same security, liquidity and transparency. With record cash to invest and low demand from banks for short-term wholesale deposits, larger investors may have little choice but to continue using MMFs, even under the new framework. Moreover, the acceptance of VNAV MMFs varies by country within Europe and as many as a fifth of MMF investors use both CNAV and VNAV according to Fitch's European Treasurer Survey 2013.

By contrast, many less sophisticated and smaller CNAV investors may determine that the required changes to their internal processes are disproportionately expensive and abandon MMFs as a cash management tool. Fitch's treasurer survey shows that a move to VNAV would make the product less attractive as it would lose its simple tax and accounting treatment, and potentially daily liquidity. 50 per cent of CNAV investors interviewed by Fitch cite their simple tax and accounting treatment as strength.

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© Fitch, Inc.