Better late than never

Read this article to understand:

• Why the European Commission believes current regulation has been effective during market stresses
• The likelihood of changes to the regulation
• Whether recent reforms in the US could influence the thinking of European regulators

One year after it was due, the European Commission on July 20 published its long-awaited assessment report on the functioning of the European money market fund (MMF) regulation.¹

The report concludes the regulation works: MMFs “passed” the recent market stress events. This means the existing safeguards in the regulation, including fund types, work. This augurs well for the continued viability of the low volatility net asset value (LVNAV) MMF type.

The report also supports de-linking redemption gates and liquidity fees from weekly liquid assets, a known investor sensitivity.

The report raises the intriguing possibility that there will be no change to the current MMF regulation. Conceivably, the changes the report suggests could be achieved via other regulations. If there are to be changes, we think it is unlikely they can be agreed in the current European parliamentary term (to 2024).

The main conclusions

The overall tone of the European Commission’s assessment report was constructive. The report finds the MMF regulation enacted in 2017 largely worked, successfully navigating several periods of market stress since implementation.

The review takes into consideration both the stress period of March 2020 (particularly acute for US dollar MMFs) and September 2022 (acute for sterling MMFs).² In our view, the report speaks to continuity of the current regulatory framework – and current fund structures – rather than wholesale change.

We see two possible scenarios for MMF reform following on from the publication of the report. The first is one of modest reform to the current regulation, albeit with significant time before implementation. The alternative scenario is that there is no reform.

We think the first scenario is the more likely, although do not discount the possibility of there being no change. The report is, after all, clear the regulation is working as intended. However, it also identifies sensitivities, above all, the link between weekly liquid assets and redemption gates / liquidity fees.

1. Delinking gates and fees from weekly liquidity

The report supports removing the link between weekly liquid assets and LVNAVs needing to apply a redemption gate or liquidity fee. It is worth noting no European MMF has ever suspended redemptions under the current regulation and the protections against this outcome are high.

As it currently stands, an LVNAV must consider applying a gate (temporary suspension of redemptions) or liquidity fee (charged to exiting investors) if weekly liquid assets fall below 30 per cent and the fund experiences a same day net outflow of over ten per cent.

Figure 1: Gates and fees

Source: Aviva Investors, 2023; European MMF Regulation 2017.

Ultimately, the fund’s board of directors decides on the most appropriate course of action – the link is not automatic. Investors have nonetheless been concerned funds could impose a gate as a result. The report voicing support for removing this link is a clear positive for investors because of the uncertainty resulting from the current set-up.

2. Support for LVNAV

The report also considers pricing. It judges amortised cost pricing is appropriate in certain circumstances for LVNAVs and constant net asset value (CNAV) MMFs. With amortised cost pricing enabled, this suggests there is some support at the European Commission for LVNAVs continuing to be able to offer stable pricing. Other European bodies have argued against this, however (see below). 

3. Market structure

Lastly, the report makes two potentially significant additional observations. First, it suggests allowing MMFs to access deposit facilities with central banks. This would be like the structure in the US, where MMFs can enter overnight reverse repurchase agreements with the Federal Reserve. This facility has been actively and successfully used by US MMFs. In stressed market conditions, access to such a facility should be highly positive for European MMFs.

Second, the report calls for a review of the functioning of the short-term market more broadly, recognising MMFs are creatures of their environment. Rule changes just for MMFs will not necessarily be as effective as they could be if not accompanied by changes to the environment in which they operate.

A good example of market functioning is the settlement cycle of commercial paper (CP). In the US, funds buy overnight CP that settles T+0 as well as using the Fed reverse repo facility and term deposits. In contrast, the T+2 settlement cycle typical in Europe means overnight CP is not widely used. Secondary market liquidity also needs to be looked at as there is an overreliance on bank balance sheets, which can, in times of stress, be reduced (see the European Commission report).³

The legislative cycle is the key determinant of reform timing

The assessment report is a material step forwards for the reform process in Europe. But it is only a diagnostic report. Actual reforms remain some way off. We remain of the view there will be reforms to the European MMF regulation, although we do also see a case that there could be no reform (see below).⁴ Assuming reforms proceed, they are unlikely in the term of the current European Parliament (until June 2024), but the likelihood is evidently greater than it was before the report was published.

For reforms to proceed, the relevant European bodies – the Commission, Parliament and Presidency – need to formalise their respective positions. The Commission’s report will clearly feature in the determination of positions, as will the views aired by the European Securities and Markets Association (ESMA) and European Systemic Risk Board (ESRB). International activity, such as the recently enacted reforms in the US, could also play a role, at least as a reference point.

Having reached their respective positions, a “trialogue” process would commence, whereby the Parliament, Commission, and Council of the EU (Spain has the rotating presidency until December 2023, followed by Belgium) negotiate and agree a final position. This is, ultimately, a political process. There are, therefore, significant uncertainties as to the final agreement.

The time available to finalise positions and complete the trialogue process is short and decreasing rapidly. The current European Parliament’s term is coming to an end. Elections will take place from June 6 to 9 next year.⁵ Attention will increasingly turn to the candidates and their policies as the elections approach, decreasing the likelihood of major policy decisions. Simultaneously, the desire to push decisions to the next elected body will increase. All European politicians face re-election and subsequently need to agree the new EU Commission President (currently Ursula von der Leyen, Germany).

We also have the summer holidays with which to contend. The last plenary session of the European Parliament took place July 13, with no more sessions until September.⁶

Putting all this together, there is little time to agree final policy in the current political term. That said, the fact the US published reforms for US MMFs recently (in July 2023, see below) will increase pressure on Europe to act.

Past precedent suggests there will be an implementation period once any reforms are signed into law. The last set of reforms had an 18-month implementation period. In the US, the most recent set of reforms have an implementation period of just 60 days.

The alternative scenario: no reform

The EC’s report states that the reform is working “as is”. One could conclude no changes are needed. Equally, however, the report highlights sensitivities. We believe there is a route through which the key sensitivity – the link between weekly liquid assets and gates/ fees – could be addressed without necessarily re-opening the regulation.

Most money market funds are Undertakings for Collective Investment in Transferable Securities (UCITS). The UCITS directive is currently under review.⁷ This review includes assessment of how UCITS manage liquidity.

It is conceivable the review of UCITS regulation could bring additional clarity on how fund providers should approach the steps specified in the MMF regulation when liquidity falls below a given threshold. This could reduce investor sensitivity to the current set-up, by bringing clarity on the outcomes that would be pursued.

In this scenario, the MMF regulation could effectively stay “as is”.

Comparing the assessment report with existing policy proposals

The purpose of the EC report was not to provide policy proposals. Therefore, the comparison with actual proposals from ESMA and the ESRB is not entirely valid. Nonetheless, it provides some reference points.

Firstly, the European Commission is clear much of the existing regulation is working. This contrasts with both ESMA and the ESRB, which propose meaningful changes. The European Commission is silent on the future of LVNAV, but clear that existing safeguards (including the use of amortised cost) are working. On the other hand, ESMA and the ESRB propose changes of such magnitude to the LVNAV structure that it would, frankly, become untenable.

The European Commission recognises changes to LVNAVs would have wide-ranging implications for investors. Indeed, ESMA’s 2021 survey of the European MMF industry (the most recent official numbers) showed LVNAVs accounted for 46 per cent of the industry’s assets at the end of 2021, followed by VNAVs (short-term and standard) at 42 per cent.⁸

The ESRB published policy proposals in January 2022 and ESMA a month later.^9,10 At an international level, the Financial Stability Board (FSB) published policy proposals in 2021, broadly supporting the need for the removal of threshold effects (aka delinking gates and fees from weekly liquidity), increased liquidity and liquidity management tools (LMTs, among other points).¹¹

Meanwhile, over in the US

The SEC published reforms for US onshore MMFs on July 12.¹² The changes are material, but equally, allow the industry to continue more or less as is. While Europe and the US will undoubtedly chart their own courses, the decisions made in the US may well factor into the thinking in Europe, not least given the sheer size of the US market (over $5 trillion at the end of June).¹³

• Liquidity increases: Minimum level of liquid assets increases to 25 per cent daily and 50 per cent weekly for prime funds, from ten per cent and 30 per cent respectively. All else being equal, a higher liquidity requirement will imply lower yields.¹⁴
• Gates and fees removed: US MMFs will no longer be able to temporarily suspend redemptions, nor will there be any tie between the level of weekly liquid assets and liquidity fees. This was a key issue for many investors because they were concerned if liquidity fell below the required threshold, the fund would have to suspend redemptions. The removal of this link is positive and may well lead to investors allocating more to prime funds.
• Liquidity fees: A new provision requires institutional funds to charge liquidity fees when net daily redemptions exceed five per cent of total assets. There is some optionality around this, however.
• Short implementation timeframe: Most of the reforms will become effective 60 days after the rules are published in the Federal Register. Some reporting requirements will not become effective for almost a year, however. This implementation timeframe is materially shorter than the two-year implementation time at the last round of reform.

These reforms were broadly expected.¹⁵ Importantly for both the industry and investors, two items did not make the final rule set:

• No swing pricing: There had been considerable debate in the run-up to the reforms on swing pricing (where a fund’s price varies depending on the cost of subscriptions and redemptions). Industry participants viewed swing pricing as unworkable for MMFs as it would have effectively precluded daily dealing.
• Constant pricing remains for government and Treasury funds: There had been discussion of all funds moving to variable pricing, but the new rules allow government and Treasury funds to continue offering stable pricing. As a reminder, all US prime funds were forced to move to variable pricing in 2016, when the 2014 reforms became effective.

Key takeaways

• The publication of the European Commission’s assessment report is a significant step forward in the European MMF reform process. In combination with the recent publication of final reforms by the US, the pressure on Europe to act is growing.
• We think there will be changes to the European MMF regulation, although we do not rule out the possibility of no changes.
• We can’t rule out an agreement on European MMF reform being agreed in this European Parliament, but the clock is ticking. Even if reforms can be agreed, we would anticipate an implementation period, meaning investors will have time to react.
• The broadly constructive tone of the European Commission’s diagnostic report augurs well for the status quo and, importantly, the continuation of the LVNAV fund type. However, the political process still has some way to go.

We will update our investors as new information comes available.