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Europeans hope to avoid outflows as new money market rules loom

Most investors now have policies in place that allow them to buy constant NAV funds, said Dennis Gepp of Federated Investors (UK) LLP.

Regulatory changes to money market funds in Europe are expected to carry fewer implications for investors and managers than similar reforms did for their U.S. counterparts, but asset owners still need to adjust their policies, observers said.

One key task before July 21, when the new pan-European law comes into force, will be for European investors to change their investment policies to include new categories of money market funds, such as instruments with a variable, or floating, net asset value. These funds have been disliked by many investors in the past because of concerns about liquidity fees during more volatile market periods. Investors globally instead have preferred constant net asset value funds. But under the new regulations, those no longer will be available for prime money market funds.

In the U.S., $1.2 trillion worth of investments left prime money market funds when a 2016 reform required them to have a floating NAV.

To avoid this outcome on the Continent, the European Commission has allowed another type of money market fund, called low-volatility NAV funds. These funds would trade similarly to the constant NAV funds as long as certain criteria are met. However, they would convert into a variable NAV money market fund under certain circumstances. For this reason, sources said, investors need to allow variable NAV funds in their policies.

Most investors now have policies in place that allow them to buy constant NAV funds, without any mention of floating-value funds, said Dennis Gepp, senior vice president, managing director and chief investment officer, cash, at Federated Investors (FII) (UK) LLP in London.

And while the low-volatility NAV funds have the ability "to quote a constant price in normal circumstances, the market suggests to clients that they broaden the policies to ensure they can invest in all (other) products," Mr. Gepp said. Federated managed $265.2 billion in money market funds as of Dec. 31.

As long as the low-volatility fund's net asset value does not deviate by more than 20 basis points, the fund would trade similarly to a constant NAV fund. However, should minimum weekly liquidity fall below 30% and daily net redemptions exceed 10% of the fund's total assets, liquidity fees and redemption gates would be applied, turning these low-volatility funds into variable NAV ones.

The European Commission's goal was to give investors better protection and the market more liquidity to handle small swings in volatility.

But sources fear the low-volatility NAV model will not completely shield investors from liquidity fees.

"For investors explicitly picking a LVNAV fund, one potential issue could come from the 0.2% pricing collar. In the most extreme cases, this could lead to fees or gates being applied," said Craig Inches, head of short rates and cash at Royal London Asset Management in London.

A survey of investors by State Street Corp. (STT) last month showed more than half of respondents expect to change investment policy to allow investment in variable NAV money market funds.

Sources also expect that investors won't be ditching money market funds after the reform is enacted because the vehicles have become too important in accessing short-term liquidity, capital preservation and preservation of initial principal invested.

"For us, it doesn't really matter if a CNAV money market fund transforms into a LVNAV or VNAV fund as long as the liquidity is there. As long as funds will be triple-A rated, as well as if the liquidity remains sufficient, there is no reason to abandon the use of these funds," said Meng-Lei Wu, senior investment manager, treasury trading and commodities at PGGM, the manager of the €185 billion ($230 billion) Pensioenfonds Zorg en Welzijn in Zeist, Netherlands. He declined to disclose how much PGGM has in money market funds.

Money managers said the demand for money market funds is expected to continue in Europe as there are few alternatives, particularly for obtaining short-term funding.

"Secure, liquid products for short-term cash are few and far between," said Federated Investors' Mr. Gepp. "Banks increasingly are trying to restrict the growth of short-term cash on their balance sheets, mainly as a result of Basel III rules, so I continue to believe that money market funds are the best option available for (a) transitory case."

Kathleen Hughes, managing director and head of global liquidity sales and European institutional sales at Goldman Sachs Asset Management in London, agreed.

"Although all European-domiciled money market funds are changing to some degree following new regulation, we anticipate many institutional investors, including pension funds, will continue to utilize money market funds as a core part of their cash management strategy," Ms. Hughes said. Goldman Sachs has $270 billion in money market funds.

Monitoring volatility

To assist institutional investors with the move to variable NAV funds, money managers and custodians have boosted systems that will help them monitor the behavior of instruments with variable NAVs in stressed market conditions in an attempt to reduce any impact from volatility.

Still, regulators have left the money managers in the dark about some issues crucial to providers of money market funds, sources said. And while large pension funds like PGGM that have their own cash management systems might not be immediately affected by the new rules, smaller plans will have to rely on managers' ability to distribute money market funds in Europe.

One key issue for managers is recognizing the impact of negative interest rates on variable NAV funds. Previously, constant NAV funds paid dividends during periods of negative interest rates. Although investors and managers can wait until 2020 to fully transition existing strategies under the new rules, it appears the European Commission alongside pan-European markets regulator European Securities and Markets Authority have banned this so-called reverse distribution under the new regulation, sources said.

Last month, the European Commission sent a letter to the ESMA confirming that reverse distribution or cancellation of fund units is not "compatible with the new regulation," which means that in negative interest rate environments investors will not benefit from canceled investors' units to account for a negative yield.

Sources said that while the U.S. reform was seen to have disrupted the money market industry, the European transition remains on course to be a much more seamless process that will benefit investors staying invested in money market funds. Mr. Gepp said the U.S. reform might have gone so far as to have pushed U.S. investors to seek regulatory arbitrage through European subsidiaries that bought dollar-denominated European money market funds.

Another issue affecting distribution and, therefore, liquidity, is Brexit.

Since the 2016 U.K. vote to leave the European Union, managers offering short-term money market funds in Europe have seen inflows of capital. According to Moody's Investors Service, in the week immediately following the vote, 1.7 billion ($2.4 billion) flowed into sterling money market funds, €2 billion into euro-denominated money market funds and $24 billion into offshore U.S. dollar money market funds. But a hard Brexit outcome means U.K.-based managers lose the ability to distribute money market funds in the European Union unless they are registered in Dublin or Luxembourg.

Royal London Asset Management's Mr. Inches said: "Despite the steady progress of the (money market) legislation, actually implementing the changes is still a fair way off. It'll be 2020 before the market is fully up to speed."

Royal London has 3.4 billion in money market funds.