by Hristo Dilov
The Money Market Fund (MMF) Regulation poses some of the latest operational hurdles faced by the asset-management industry in Europe in 2020. In this blog post, we discuss the key takeaways from the MMF framework, as well as the economic and geopolitical risks that could interfere with implementation of the regulation.
For starters, MMF Regulation (MMFR)[1] builds upon the existing Collective Investment in Transferable Securities (UCITS)[2] Directive, known as UCITS V, and the Alternative Investment Fund (AIF) Managers Directive, referred to as AIFMD[3]. Funds covered under these two directives, which carry the MMF designation (or other terms with MMF characteristics), fall under the scope of the MMFR. On top of this, the applicable rules of management, marketing and cross-border provision of services (i.e., the country of domicile is different from the Member State the fund is being marketed in) within the European Union will be dependent on whether the MMF is an AIF or UCITS.
The new regulation aims to minimize systemic threats from the MMF operations or contagion channels from widespread investor withdrawals. These were structural issues identified as leading causes of the sudden lending contraction and the drying up of market liquidity during the financial crisis of 2008. That said, let us see how the MMFR plans to address the vulnerabilities associated with the MMF industry.
Under Article 37 of the MMFR, the European Securities and Markets Authority (ESMA) finalized the “Implementing Technical Standards (ITS)”[4].This document lays out the new transparency reporting template, which the MMF managers will be required to file periodically with the National Competent Authorities (NCAs) from the end of Q1 2020 onwards. As per the new transparency requirements, funds with assets under management (AUM) in excess of EUR 100 million must report on a quarterly basis, otherwise the reporting is annual. From an operational standpoint, the new template will require MMF managers to revise the way they source their investment holdings data and develop new systems to ensure reliable submissions to the NCAs.
In terms of governance, MMFs will be prohibited from receiving financial support from external sponsors to maintain their liquidity levels and stability. They will also need to tailor their business models and indicate whether the fund is of standard or of short-term nature. The former MMF can offer slightly higher than money market returns and can hold assets with extended maturity. In addition, under circumstances of severe market stress, public debt Constant Net Asset Value (CNAV) MMFs and low volatility NAV (LVNAV) funds will have to establish provisions of liquidity fees and redemption gates. This measure aims to increase investor protection and prevent the “first mover advantage” in cases where investors collectively decide to pull their capital away from the MMF. However, these extra frictions added to the MMF product might induce investors to switch to the more liquid exchange-traded funds (ETFs), which are traded like ordinary securities and do not impose lock-in periods.
MMFs will face stricter portfolio composition rules, which require maintaining a minimum level of liquid assets that mature or can be settled either daily or weekly. Examples include treasury and local authority bills, certificates of deposits, commercial paper, banker’s acceptance and medium- to short-term notes. Further, the banking industry is currently required to hold enough High-Quality Liquid Assets (HQLA) to achieve a liquidity coverage ratio (LCR) of at least 100% under Basel III[5]. As one might notice, both regulatory frameworks in tandem artificially increase the demand for the most liquid assets. This can inflate the asset prices and cause more instruments entering the negative-yield universe. Consequently, MMFs might experience strains on their profitability potential. The benchmark regulation[6]might create additional uncertainty on how the profit of MMFs is calculated in the first place.
A consistently low interest rate environment could potentially encourage asset managers to embark on greater risks to increase their expected returns. This so called “search for yield” could tilt investors’ preferences towards assets with lower liquidity, longer maturity or poor credit quality. Hence, easy financial conditions could build up systemic vulnerabilities in certain sectors of the financial system—concerns voiced in the recent reports by the International Monetary Fund (IMF)[7] and ESMA[8]. To mitigate excessive risk taking, ESMA restricted MMFs’ ability to engage in complex financial engineering to artificially boost the funds’ yield via synthetic products. For example, the investments in securitisations and asset-backed commercial paper (ABCP) are each limited to 15% of the MMF’s AUM (transparent and standardised (STS) securitisations limit stands slightly higher at 20%)[9]. Further, up to 10% of the fund’s assets can be invested in repurchase agreements[10]. However, MMFs are not allowed to engage in securities lending and borrowing (SLB) transactions and can use derivatives solely for hedging[11]. The lower bound on profitability packed with restricted investment flexibility could pose further challenges to the MMFs’ ongoing concerns. The environment might worsen for MMFs if the global central banks follow the example set by the Federal Reserve’s emergency rate cut in response to the coronavirus (COVID-19) outbreak.
MMFs are required to reduce their overreliance on credit agencies by developing internal models for evaluating the credit quality of their investments. On 3 March 2020, ESMA published the translated guidelines on the stress test scenarios under the MMF Regulation[12]. To facilitate prudent risk management, MMFs must conduct stress tests at least biannually and share the results with NCAs starting from their Q1 2020 quarterly reporting. Article 28 (1) of the MMF Regulation further requires that stress tests are based on objective criteria and consider the effects of severe (but plausible) scenarios that include hypothetical changes in:
- Liquidity levels of the MMF holdings via the “calibrated discount factor” approach;
- Credit risk, as well as independent exchange-rate and interest-rate shocks applied to MMF portfolios;
- Stressed redemptions levels;
- Widening / narrowing of spreads among indexes to which floating rate securities in the portfolio are tied to; and,
- Macroeconomic shocks to assess the redemption shock impact to the weekly liquid assets and to measure the combined effect of different risk scenarios after redemption.
The redemption stress test is a central piece of the MMF Regulation. It aims to assess MMFs’ ability to meet high redemption pressure from both institutional and retail investors through the application of a reverse liquidity stress test. Additionally, the MMF needs to measure the impact of the net redemption of its two main investors. However, MMFs registered in Luxemburg might find this difficult to implement because the complexity of certain corporate structures can effectively create “Chinese walls”, making the beneficial owners of the fund hardly visible to the portfolio manager. To increase transparency, the Commission de Surveillance du Secteur Financier (CSSF) of Luxemburg adopted the Fourth and the Fifth Anti-Money Laundering (AML) Directives[13], which require public disclosure of the ultimate beneficial owners, who hold more than 25% of a company. Unfortunately, this would not resolve the issue for MMFs with more diluted ownership structures. Such difficulties in the practical implementation of the redemption stress tests can lead to regulatory “gold-plating” (measures going beyond the requirements set by the EU law), or applying less accurate approaches, such as using MMFs’ highest level of historical redemptions as a stress proxy.
Following the United Kingdom’s withdrawal from the EU, the UK Financial Conduct Authority (FCA) will no longer be a member of ESMA’s Board of Supervisors or participate in any of ESMA’s other governance bodies. However, during the transition period between 1 February 2020 and 31 December 2020, the MMFR reporting obligations for UK entities under EU law will apply[14]. It is worth mentioning that one of ESMA’s key priorities for 2020 – 2022 is to continue its efforts into further developing cooperation with third-party countries[15]. Therefore, in the post-Brexit world, the FCA and ESMA could engage in further interactions around issues dealing with equivalence of regulatory frameworks and fund passports.
The new MMF Regulation may seem like a daunting requirement to asset managers, but we are here to help. The Regulatory Reporting Team at Qontigo is driven by market experts, who constantly keep track of new developments in the regulatory space. Our Qontigo Reporting Solutions and Axioma Risk platform provide our clients with a cost-efficient way to address reporting requirements across multiple regulatory regimes globally. Contact us to learn more about how we can help with your regulatory requirements.
[1] Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on money market funds
[2] Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to UCITS
[3] Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers
[4] Final Report: Guidelines on the reporting to competent authorities under Article 37 of the MMF Regulation (ESMA, 2019)
[5] Liquidity Coverage Ratio (LCR) – Executive Summary (BIS, 2018)
[6] Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds
[7] Global Financial Stability Report: Lower for Longer (IMF, 2019)
[8] Trends, Risks and Vulnerabilities (TVR) Report (ESMA, 2020)
[9] Article 11, Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on money market funds
[10] Article 14, Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on money market funds
[11] Article 9, Article 13, Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on money market funds
[12] Guidelines on Stress Test Scenarios Under the MMF Regulation (ESMA, 2020)
[13] Circular CSSF 19/732, Prevention of Money Laundering and Terrorist Financing: Clarifications on the Identification and Verification of the Identity of the Ultimate Beneficial Owner(s) (CSSF, 2019)
[14] Update on Governance and Reporting Obligations Following the UK’s Withdrawal from the EU (ESMA, 2020)
[15] ESMA Strategic Orientation 2020-22 (ESMA, 2020)
