European money market reform on different path

Impending reforms to European money market fund regulations will likely spare prime funds from the exodus of assets that the U.S. market has seen following SEC reforms, sources said.

Investors have one more month before the changes in the U.S. fully come into force. Those changes aim to reduce the risk of investor runs and require institutional prime funds to transact at a fluctuating net asset value, rather than the current constant net asset value.

But U.S. investment in prime money market funds has fallen by about $338 billion this year through July to $1.23 trillion, according to Securities and Exchange Commission data. Instead, some $339 billion has flown into government money market funds, which remain trading at constant NAV.

Observers expect Europe's incoming reforms will avoid this drain, and critically important, maintain the funds' role in financing the real economy.

Dennis Gepp, senior vice president, managing director and chief investment officer, cash, at Federated Investors (UK) LLP based in London, is “certain” the money market fund reform and its effects will take a very different shape in Europe than in the U.S.

“One consequence (of the U.S. reform) that Europe would like to avoid is to have cash flow out of the prime money market funds into government funds,” Mr. Gepp said.

The European Commission first proposed a regulation on money market funds in September 2013. Constant NAV money market funds, or CNAV funds — which are considered most similar to the U.S. model — will be required to convert into a new low-volatility model, or a LVNAV fund, within 24 months of implementation, according to the European Council's June release.

Such low-volatility funds can retain a constant share price as long as the share value does not deviate from its actual NAV by more than 20 basis points.

Rudolf Siebel, managing director at German Investment Funds Association BVI and chair of European Fund and Asset Management Association money market fund working group, said the EU was under pressure from both Financial Stability Board and International Organization of Securities Commissions to reform these systemically risky instruments.

“IOSCO postulated in 2012 that regulators, where workable, should push for a conversion of CNAV to variable NAV. The European lawmakers share this view in proposing capital buffers on CNAV and offering conversion of CNAV to LVNAV funds,” he said.

Mr. Siebel added that investment funds do not need capital buffers because assets are held separately in trust by the asset manager and do not form part of the manager's balance sheet.

In the consultation period, at industry request, regulators have extended the transition period from constant NAV to the low-volatility NAV model to 24 months after approval, which is expected this year.

European money market funds have risen in recent years — with inflows from short-term bank deposits — thanks to the regulatory effects of Basel III. The sector is likely to benefit even more from pension funds postponing allocations to more traditional but volatile asset classes by choosing to park money in short-term cash funds.

“We have been advised by institutional clients that they are receiving low or negative rates on cash balances held with their banks or custodians,” Craig Inches, head of short rates and cash at Royal London Asset Management based in London, said in an e-mail. “We have been actively working with these clients to deliver a liquid cash alternative via our range of short-dated cash funds.”

According to EFAMA, the money market funds segment has grown to €1.1 trillion ($1.3 trillion) at the end of 2015, from €913 billion in 2013.

The need to keep money in prime funds is particularly acute due to the role this short-term funding market plays in the financing of the real economy.

“Were assets to flow out of money market funds, the funding of the real economy reduces, and Europe certainly wishes to avoid that,” said Mr. Gepp.

Kathleen Hughes, head of European institutional and liquidity sales at Goldman Sachs Asset Management, who is based in London, agreed that with the majority of European money market funds being prime funds, they are “incredibly important to the real economy.”

But some money managers, including Mikael Pacot, head of money market funds at AXA Investment Managers in Paris, said the low-volatility NAV funds and original constant NAV funds are not inherently different.

While the aim is for these new types of funds to replace constant NAVs, the circumstances have changed. Investors now accept the prospect of losing a few basis points per year to park their cash in safe and liquid money market funds, Mr. Pacot said in a telephone interview.

“The ECB's action had an impact on the market and MMFs are no longer losing assets because we have negative yields,” said Mr. Pacot.

While variable NAV funds should survive if the current proposal from the EC is enforced, there is no doubt that constant NAV funds — in their new guise as low-volatility NAVs — would in fact survive in parallel, he added.

While work remains to be done on the reforms, money managers already are looking at the potential impact.

Ms. Hughes said the reform proposals are positive for the money market fund industry in Europe for a number of reasons. “The LVNAV model has addressed the need for greater transparency, higher liquidity and for a different type of product due to the fragmentation of investors in Europe and the breadth of jurisdictions they operate in,” she said.

Mr. Siebel said a few elements of the proposed regulation are unworkable and will be addressed by the trialogue — the European Parliament, European Council and European Commission.

For example, under the draft proposal, the only CNAV money market funds that will be allowed to continue to operate will be those that invest 99.5% of their assets in EU public debt instruments.“ At present the government CNAVs should not be limited to EU public debt because U.S. Treasury money market funds will essentially become prohibited,” Mr. Siebel said.

Money managers won't have long to find out how they will be affected.

Mr. Gepp and Mr. Siebel both expect the new regulation to be finalized this year. “There is a lot of political pressure to close the file,” Mr. Siebel said.