The European Commission has released a Proposal for a Regulation on Money Market Funds.

The draft Regulation can be regarded as the culmination of reforms recommended for money market funds by IOSCO, the ESRB and the FSB. However, it is important to note that three of the reforms that were most aggressively pursued by these bodies, i.e. the mandatory conversion of short term CNAV MMFs to VNAV MMFs, a ban on sponsor support and the limited use for valuation of the amortised cost method, have not been adopted by the Commission in its draft Regulation.     

The draft Regulation breaks MMFs into two categories: (i) short term MMFs; and (ii) standard MMFs, and thus duplicates the approach followed in CESR’s Guidelines on a Common Definition of Money Market Funds.

The provisions of the draft Regulation are summarised below.

Portfolio Construction

Eligible Assets

Under the draft Regulation a MMF is permitted, subject to certain conditions, to invest in one or more of the following categories of financial assets:

• Money market instruments
• Deposits with credit institutions
• Financial derivative instruments
• Reverse repurchase agreements

On the other hand, a MMF may not may not invest in any other assets, engage in short selling of money market instruments, gain exposure to equities or commodities, enter into securities lending or securities borrowing agreements, enter into repurchase agreements or borrow or lend cash, as these asset classes and practices would undermine the liquidity profile of a MMF.

Additional eligibility requirements for each of the categories of financial assets referred to above are set out in the draft Regulation.  For example, issuers of the money market instruments must have been awarded one of the two highest internal rating grades according to the internal procedures to be established by the manager of a MMF for assessing the credit quality of money market instruments (see ‘Credit Quality of Money Market Instruments’ below).

Maturity of Investments

A MMF must ensure that:

• At least 10% of its portfolio shall be comprised of daily maturing assets
• At least 20% of its portfolio shall be comprised of weekly maturing assets

Short Term MMFs

The draft Regulation requires that a short term MMF has a weighted average maturity (WAM) of no more than 60 days and a weighted average life (WAL) of no more than 120 days. These provisions are not a departure from the existing requirements applicable to short term MMFs. However, it is worth noting that the draft Regulation does not include the existing requirement that the investments of short term MMFs should be limited to securities or instruments with a residual maturity until the legal redemption date of less than or equal to 397 days.

Standard MMFs

The draft Regulation requires that a standard MMF has a WAM of no more than 6 months and a WAL of no more than 12 months. These provisions are not a departure from the existing requirements applicable to standard MMFs. However, it is worth noting that the draft Regulation does not include the existing requirements that: (a) the investments of standard MMFs should be limited to securities or instruments with a residual maturity until the legal redemption date of less than or equal to 2 years, provided that the time remaining until the next interest reset date is less than or equal to 397 days; and (b) floating rate securities must reset to a money market rate or index.

Investment Limits

Short Term MMFs

Under the draft Regulation, a short term MMF would not be permitted to invest more than 5%of its assets in:

• Money market instruments issued by the same body (currently 10%)
• Deposits made with the same credit institution (currently 20%)

The aggregate amount of cash provided to the same counterparty pursuant to reverse repurchase agreements entered into by a short term MMF may not exceed 20% of its assets.

In addition, a short term MMF may not combine, where this would lead to investment of more than 10% of its assets in a single body, any of the following:

• Investments in money market instruments issued by that body
• Deposits made with that body
• OTC financial derivative instruments giving counterparty risk exposure to that body

Standard MMFs

Under the draft Regulation, a standard MMF may not invest more than 10% of its assets in money market instruments issued by the same body (accordingly no change has been made to the current limit applicable to standard MMFs).

The aggregate amount of cash provided to the same counterparty pursuant to reverse repurchase agreements entered into by a standard MMF may not exceed 20% of its assets.

In addition, a standard MMF may not combine, where this would lead to investment of more than 15% of its assets in a single body, any of the following:

• Investments in money market instruments issued by that body
• Deposits made with that body
• OTC financial derivative instruments giving counterparty risk exposure to that body

Operational Policies and Procedures

Credit Quality of Money Market Instruments (Article 16)

The draft Regulation contains detailed provisions around the prudent and rigorous internal procedures that should be put in place by the manager of a MMF for assessing the credit quality of money market instruments, taking into account the issuer of the instrument and the characteristics of the instrument itself.  The assessment methodologies shall be subject to validation by the manager based on historical experience and empirical evidence, including back testing.

The draft Regulation also requires that the manager of a MMF assigns an internal rating to each issuer of a money market instrument in which a MMF intends to invest. The structure of the internal rating system must comply with all of the following requirements:

(a) It should be based on a single rating scale which exclusively reflects quantification of the credit risk of the issuer. The rating scale should have six grades for non-defaulted issuers and one for defaulted issuers.

(b)  There should be a clear relationship between issuer grades reflecting the credit risk of an issuer and the rating criteria used to distinguish that level of credit risk.

(c)  It should take into account the short-term nature of money market instruments.

Know Your Customer

Article 24 of the draft Regulation provides that the manager of a MMF must establish, implement and apply procedures and exercise all due diligence to identify the number of investors in a MMF, their needs and behaviour, and the amount of their holdings with a view to correctly anticipating the effect of concurrent redemptions by several investors.  The manager of a MMF must ensure that the value of the shares held by a single investor does not exceed at any time the value of daily maturing assets and that redemption by an investor does not materially impact the liquidity profile of the MMF. 

Stress Testing

The draft Regulation provides (at Article 25) that the manager of a MMF must put in place sound stress testing processes that allow for the identification of possible events or future changes in the economic conditions that could have unfavourable effects on the MMF. 

The board of directors of the manager of the MMF must (a) determine the frequency with which stress tests are conducted; (b) examine an extensive report containing the results of the stress testing; and (c) amend any action plan if necessary and approve the final action plan.

NAV Buffer

A significant new development for MMF regulation is the introduction of a so-called “NAV buffer” for CNAV MMFs. 

3%

The draft Regulation requires that CNAV MMFs shall establish and maintain a NAV buffer amounting at all times to at least 3% of the total value of the CNAV MMF’s assets.  The NAV buffer may only be used to cover differences between the CNAV MMF’s constant NAV per share and the CNAV MMF’s NAV per share.  It is worth noting that the amounts in the NAV buffer may not be included in the calculation of the NAV or constant NAV of the CNAV MMF. Furthermore, the NAV buffer must be composed only of cash and be held in a protected reserve account opened with a credit institution in the name and on behalf of the MMF. 

Under the draft Regulation, a MMF must file a detailed plan with the Central Bank specifying the methodology governing the use of the NAV buffer.  The Central Bank must be satisfied with this plan, with the MMF’s arrangements to replenish the NAV buffer and with the financial strength of the entity expected to fund this replenishment.  The articles of association of the MMF must also be updated to provide for the NAV buffer.

Use of the NAV Buffer

Each MMF must establish and implement an escalation procedure which ensures that any negative difference between the constant NAV per share and the NAV per share is considered by persons competent to act for the MMF in a timely manner. The draft Regulation contains requirements regarding the content and characteristics of the escalation procedure. 

Significantly, the draft Regulation provides that when the NAV buffer has not been replenished and for one month the amount of the NAV buffer stays below 3% by 10 basis points the MMF shall automatically cease to be a CNAV MMF and is prohibited from using the amortised cost or rounding methods. In that event, the investors must be informed immediately.

External Support

A MMF must not receive external support (other than in the form of a NAV buffer, in accordance with the draft Regulation). The draft Regulation precludes direct or indirect support offered by a third party that is intended for, or in effect would result in, guaranteeing the liquidity of an MMF or stabilising the NAV per share of the MMF. External support is described as including:

• Cash injections from a third party
• Purchase by a third party of shares of the MMF in order to provide liquidity
• Issuance by a third party of any kind of explicit or implicit guarantee, warranty or letter of support for the benefit of the MMF
• Any action by a third party, the direct or indirect objective of which is to maintain the liquidity profile and NAV per share of the MMF

It is not clear from the draft Regulation whether the seeding of a sub-fund, during its initial offer period, would constitute sponsor support. We will ensure that this lack of clarity is raised in the IFIA’s response to the Commission on the draft Regulation.

Phasing in of NAV Buffer

The draft Regulation provides for the gradual introduction of the requirement to maintain a 3% NAV buffer. It states that an existing UCITS that meets the criteria for the definition of a CNAV MMF shall establish a NAV buffer of at least:

• 1% of the total value of the CNAV MMF’s assets, within one year from the entry into force of the draft Regulation
• 2% of the total value of the CNAV MMF’s assets, within two years from the entry into force of the draft Regulation
• 3% of the total value of the CNAV MMF’s assets, within three years from the date of entry into force of the draft Regulation

Use of the terms ‘money market fund’ and ‘MMF’

The draft Regulation provides that, following implementation of the Regulation, a UCITS may only use the designation ‘money market fund’ or ‘MMF’ in relation to itself or the shares it issues where the UCITS has been authorised in accordance with the Regulation.

Identification of MMF as a Short-term MMF, Standard MMF or CNAV MMF

A MMF must indicate clearly whether it is a short-term or a standard MMF, and whether it is a CNAV MMF, in any external or internal document, report, statement, advertisement, letter or any other written evidence issued by it or its manager, addressed to or intended for distribution to prospective investors, unit-holders, shareholders or competent authorities of the MMF or its manager.

Transitional Provisions

An existing MMF must submit, within six months following the date of entry into force of the Regulation, an application to its competent authority, together with all documents and evidence necessary to demonstrate compliance with the Regulation.

The competent authority must assess, within two months of receiving the application, whether the MMF is compliant with the Regulation and immediately notify its decision to the MMF.

Anticipated Implementation Date

The draft Regulation will now pass to the European Parliament for approval and then to the Council of the EU. The Commission has advised that it could potentially be agreed over the course of 2014, in which case, it is expected that it would then be directly applicable throughout the EU towards the end of 2014.

Industry Reaction

IMMFA

The secretary general of IMMFA has stated that IMMFA will engage with the UK treasury and treasuries in other EU member states, members of the European parliament and investor groups as part of its campaign against those proposals in the draft Regulation that it sees as prejudicial to CNAV MMFs, particularly the NAV buffer. IMMFA has called the proposals “ill-considered”, adding that they will “effectively mandate a conversion to variable NAV MMFs”.

Irish Funds Industry Association (IFIA)

The IFIA is calling on the EU to implement a consistent global response to money market funds reform rather than pursue an agenda that will create significant cross border arbitrage between the US and the EU despite the fact there is no material difference between money markets in the US and EU.

“Having different rules for money market funds in the US and the EU is neither consistent nor effective. The EU proposal for a 3% capital buffer must be reconsidered on that basis” said Kevin Murphy, Chairman of the IFIA.

The IFIA MMF Task Force is currently preparing a response to the Commission’s Proposal.

Contributed by Niall Crowley