Money Market Fund reform is on the horizon.
Here is an update.
The landscape for cash investments is changing rapidly. The latest AFP Liquidity survey1 cited bank deposits, Prime and Government Money Market Funds, Treasury Bills and Commercial Paper as the top vehicles among corporations for investing short-term cash.
However, new regulations are redefining the value of cash and the characteristics of some short-term investment vehicles, compelling corporate treasurers to reassess portfolio allocations. Basel III, U.S. stress tests, Money Market Fund reforms and new capital measures for U.S. Global Systemically Important Bank Holding Company (GSIB) are important drivers of this reevaluation.
Basel III defines cash as operating or non-operating based on the certainty of deposits remaining with the bank during a stress scenario. The regulations require banks to establish, justify and report to regulators quantitative measures that classify deposits as operating or non-operating based on their link to the value of client banking transactions.
Specifically, non-operating cash needs to be backed by High Quality Liquid Assets (HQLA) maintained by the bank, which increases the cost of holding non-operating deposits on their balance sheets. (Overview of the impact of Basel III regulations).
As a result, the dynamics of balance sheet management are changing, and banks may not be able to accept all the cash deposits they have previously. This is leading more treasurers to address the issue of where to place non-operating cash.
Money Market Funds (MMFs) have traditionally been used to invest in short- and medium-term debt obligations to achieve improved yields, while diversifying risk and maintaining daily liquidity. And right now they are an alternative for clients with balances deemed as non-operating. But there are upcoming changes to consider.
U.S. regulatory reforms governing money market funds – both those introduced in 2010 and the changes being implemented in 2016 – are designed to provide greater protection to investors, making funds more transparent and secure. A thorough understanding of the new rules will help investors to make informed decisions.
One of the major changes introduced in July 2014, and scheduled to be implemented in October 2016, is the new SEC rule to alter the way Institutional Prime Funds calculate net asset value (NAV). There is currently about $900 billion invested in this category2.
The proposal calls for non-government institutional Money Market Funds to replace the stable NAV, which is calculated using the amortized cost accounting method, in which portfolio securities generally are valued at cost plus any amortization of premium. Under the new rule, a variable net asset value structure (VNAV) that is based on the market value of the funds’ securities must be used for transactions in institutional prime funds.
Money Market Funds have long calculated their market NAV out to four decimals (e.g., $1.0000). Some funds have reported these values on their websites. With the new reforms in 2016, institutional prime MMFs will not only calculate and disclose the market-based NAV out to four decimals, they must transact at this NAV. This means that even small fluctuations could result in gains and losses for shareholders. They may experience a small gain or loss on positions that are sold while the NAV is above or below the $1.0000 threshold. Fluctuations can occur as the result of changes in market interest rates, changes in credit spreads, inflows and outflows of money and rating downgrades.
Under the new SEC rules, if a MMF’s level of weekly liquid assets falls below 30% of total assets, the regulatory minimum, the MMF’s board has the authority to temporarily suspend redemptions (i.e., impose a gate) if it judges that it is in the best interest of the fund. The gate can stay in place for no longer than 10 business days in any 90-day period, but can be lifted earlier.
In addition, the board has the authority to impose a liquidity fee of up to 2% on all redemptions if the level of weekly assets falls below 30%; again, only if the board determines that a fee is in the best interest of the fund. If weekly liquid assets were to fall below 10%, the board is required to impose a 1% liquidity fee, unless the board determines that a fee is not in the best interest of the fund.
It should be noted that Government funds are not required to adopt gates or fees under the new regulations.
Gates and liquidity fees can be powerful tools, enabling MMF boards to provide shareholders with stability and equitable treatment in times of stress. A gate will effectively and definitively stop a run on a MMF, giving its board time to react to the situation at hand.
Will a board always opt to impose a fee or a gate when the level of weekly liquid assets falls below the 30% threshold? Not necessarily. In most cases, the specific situation the fund finds itself in will determine whether the board will choose to impose a gate or fee. MMFs may currently fall below a 30% threshold without experiencing a meaningful liquidity issue. For example, a temporary increase in cash flow volatility may bring the liquidity level to say 29%, but 4-5% of a portfolio may be maturing over the following few weeks. In that case, the fund’s liquidity position would appear to be quite solid.
While bringing additional stability to Prime Funds, these changes may also require changes to a client’s investment policies and systems.
Institutional liquidity investors who may be challenged by floating NAV and/or liquidity gates and fees may find Treasury and Government MMFs increasingly attractive alternatives. Broadly, the short-term Government sector has experienced some supply and demand imbalances over the last several years. As such, questions have been raised as to whether there will be adequate supply of eligible securities for these funds to invest in following final SEC 2a-7 reform implementation. The supply picture, however, appears to be positive following recent developments in the market.
Increased demand for MMFs will come in part from investors moving out of bank deposits. Some of that shift reflects the fact that Basel III standards for bank capital, liquidity and leverage, as discussed, make it less attractive for banks to hold deposits deemed to be non-operating cash; banks have already begun to encourage clients to look for off-balance sheet alternatives.
In addition, some banks may offer automated ways to invest in a variety of MMFs and other instruments per the standing instructions of the customer. This would enable diversification of non-operating cash, for example, invested to a client’s specifications across multiple Money Market Fund options without the need for manual trading.
Placing deposits with a number of banks that do not fall under the GSIB rules may be an alternative, but may require a closer look at counterparty risk and additional resources to monitor cash and obtain appropriate reporting.
Another option would be direct investing outright in Treasuries or Commercial Paper, which would typically require Treasurers to re-evaluate their investment policy and may require additional resources to manually manage these investments.
As a result of regulatory changes, clients may look to new alternatives for investing and may also look to manage cash differently.
Here are some considerations for the changing world of investments:
12015 AFP Liquidity Survey
2Investment Company Institute
Contact your Treasury Services Representative