European money market fund reform

Read this article to understand:

• The implications of MMF reforms for investors in Europe and the UK
• The likely impact on MMF structures
• The timeline of the proposed reforms

European money market fund (MMF) reform is progressing. The bottom line for MMF investors: potentially significant change is coming.

While certain milestones have been met, much work remains before the new rules are finally published. And even after they are, there is likely to be an implementation period, allowing market participants time to adapt.

However, because of the significance of some of the proposals, cash investors should review their policies now to ensure they have a future-fit set of funds authorised and available.

Why are we here?

The current European MMF regulation was scheduled for a five-year review by June 2022. The market dislocation in March 2020 will have contributed materially to the extent of this review, explaining why it is continuing past the original deadline.

The economic and market impacts of the COVID-19 pandemic in early 2020 meant many MMFs experienced significant outflows. For example, some insurers faced significantly increased margin requirements on swaps, while some corporates’ cashflow needs increased dramatically (the hospitality sector being a case in point).¹ This sparked concern among European policymakers about the potential systemic risk posed by MMFs and their resilience.

We believe such concerns are unfounded. While MMFs were affected by market stress in March 2020, they were not the cause. In fact, in relative terms, MMFs were considerably more resilient than they were during the Global Financial Crisis. They passed the acid test: unlike in 2008, no MMF suspended redemptions in 2020.

MMFs certainly faced challenges, some relating to the structure and functioning of the current regulations. But while there is a case for change, we would argue some proposed changes go beyond what is needed.

In the absence of material changes to market structure (in particular, reforms supporting the tradability of money market instruments), rule changes to MMFs alone will likely increase complexity and costs for investors while not necessarily resolving the issues experienced in March 2020. Nevertheless, such changes seem likely and investors should be prepared.

What happens next?

The consultations are done, proposals have been made and we are now into the decision-making phase. Also known as “trialogue”, this constitutes a negotiation between the three key decision-making bodies in Europe: the European Parliament, Council of the European Union and the European Commission (EC).

Precisely how long the process will take is unclear. The timeline will undoubtedly be influenced by other legislative priorities and the interests of relevant constituencies. The current (six-monthly rotating) presidency of the Council is held by the Czech Republic, which lacks a material domestic MMF industry. The presidency in the next rotation (which begins in January 2023) will be held by France, which has a large domestic MMF industry.

The EC concluded its consultation on MMF reforms in May.² The information gathered will be factored into the Commission’s position in the trialogue process; proposals from the European Systemic Risk Board (ESRB, in January 2022)³ and the European Securities and Markets Authority (ESMA, in February 2022)⁴ will be considered by all participants in the process. ESMA consulted on MMF reforms in 2021;⁵ we responded to the consultation⁶ and contributed to the Institutional Money Market Fund Association’s response.

International developments may also influence the debate in Europe. Following a consultation, the Financial Stability Board (FSB) published policy recommendations for MMFs in October 2021;⁷ these drew on work⁸ by the International Organisation of Securities Commissions (of which ESMA is a member). The US, the world’s largest MMF domicile, is also moving ahead with reforms: the Securities and Exchanges Commission (SEC) proposed changes to domestic MMF regulation last December.⁹

Ultimately, European policymakers will chart their own course, but they will be aware of the US and international recommendations. Given the US is slightly ahead of Europe in terms of timing, decisions there could influence the European process (the final US rules were not yet available at the time of writing.

What are the current European proposals?

The proposed reforms are summarised in the table at the end of this article. The most material change would affect Low Volatility Net Asset Value (LVNAV) MMFs. If enacted, this will radically change the structure of such funds by removing the ability to price at a stable net asset value (NAV). In our view, this would materially diminish the utility of this fund type for most investors – a particularly significant development given LVNAVs represent the largest segment of the European MMF universe (see Figure 1).

Figure 1. European MMFs by assets under management

Source: Lipper, Fitch Ratings, June 2022

Other potential reforms of note include changes to redemption gates and swing pricing, as follows:

Redemption gates

• It appears probable the link between weekly liquidity levels and trigger thresholds for redemption suspensions (aka “gates”) will be removed
• This relationship was a particular concern in March 2020 as investors became concerned some funds could hit gating triggers. Current LVNAV rules state if an LVNAV’s weekly liquidity falls below 30 per cent and there is a same day net outflow in excess of ten per cent, the fund’s governance body must consider applying a redemption gate or liquidity fee
• The experience of March 2020 showed many investors assume a fund’s governance function will decide to apply a fee or gate, whereas it is in fact a discretionary decision that must be taken in line with fiduciary responsibility.¹⁰ Some funds’ weekly liquidity (briefly) dipped below 30 per cent during this period,¹¹ but none suspended redemptions. (Aviva Investors’ LVNAV MMFs’ weekly liquidity remained well above 30 per cent throughout this period)

Swing pricing

• A commonly used tool by many mutual funds, allowing a fund to adjust its dealing price in response to material inflow or outflow activity
• In longer-term funds, it can be an effective measure for navigating periods of heightened volatility and redemption activity. However, it requires a complex set of calculations to implement and is therefore unsuited to daily-dealing funds, let alone intra-day dealing funds such as MMFs
• We believe an anti-dilution levy (akin to the liquidity fee option already available in the European MMF regulation) is a much more effective tool, although the conservatism of our management practices makes this a purely theoretical discussion from our perspective

What happens next?

There is likely to be an extended period before the final rules become effective. First, the trialogue process must conclude and the EC must publish its final rules. There will then be an implementation period. This could potentially last a long time.

The last set of reforms were published in June 2017, with final full implementation not taking place until January 2019. Even then, a technicality meant some funds were not required to implement until March 2019. Similarly, in the US, 27 months elapsed between the new rules being determined (July 2014) and implemented (October 2016) in the last major regulation update.

However, precedent shows some elements of regulation may take effect sooner than others, and there may be differences in treatment between new and existing funds. For example, in the current MMF regulation, certain provisions came into force almost immediately, whereas others became effective after a year or two, with an extension. This means reform implementation is unlikely before late 2024, if past experience is any guide.

How does this affect investors?

If, and it’s a big if – nothing is certain until the final rules are published – there are material changes to MMFs, and LVNAVs in particular, investors need to ensure their liquidity investment policy can accommodate the new regulations.

Given the most consequential changes are likely to impact LVNAVs, investors should explore whether to add variable asset value (VNAV) MMFs to their policy, if not already available.

An important consideration for many investors is cash equivalence. While this is evidently a topic for individual investors to address with their auditors, there are relevant precedents. In France, all MMFs, including VNAVs, are classified as cash equivalent.¹² Similarly, in the US, the SEC classifies “prime” MMFs, which have variable NAV, as cash equivalents (“cash items”).¹³

Revisions to cash investment policies should also consider cash optimisation.

We will continue to monitor developments and provide further updates as clarity emerges on the final regulation and timelines. Our fund range will be updated as needed.

UK regulation and equivalence

Most European MMFs are domiciled in the European Union and sold into the UK. For example, our liquidity fund range is domiciled in Ireland and available to UK investors.

The UK’s Financial Conduct Authority (FCA), in conjunction with the Bank of England, is considering changes to UK MMF regulation.

The FCA published a discussion paper in May 2022, with a comment period running to July 2022.¹⁴ The UK proposals align closely with the Financial Stability Board's recommendations, including the removal of the ability of MMFs to transact at a stable NAV. Given the detail of the discussion paper and commentary from relevant officials (see for example Andrew Bailey’s speech in May 2021)¹⁵ we think it unlikely UK-domiciled MMFs will have material differences to EU MMFs in future.

The most important factor will remain equivalence – the rules governing how EU funds are sold into the UK (the Overseas Fund Regime).¹⁶

Time to act

MMF reform is coming. The likely implementation date in 2024 may seem like a long way off, but investors should start thinking now about how their cash investment policies may need to change, and the processes and timelines that go into making those changes.

More broadly, reforms provide an opportunity to assess current cash investment practices to ensure they are future-fit in terms of regulation and consider whether cash can be optimised for greater efficiency.