Testing the water

The FCA presents two major proposals for MMFs, one of which we welcome. There are also several other policy proposals. Most of them are modest and, we would say, sensible changes which could benefit liquidity funds.

It is also worth highlighting some options the FCA has chosen not to pursue. Chief among these is the decision not to materially change regulations around the LVNAV fund. This MMF type is valued by investors and, despite noises to the contrary from some quarters, the fact the FCA has concluded this fund type is viable and resilient is a positive for investors.

Delinking

The FCA is proposing to sever the link between weekly liquid assets and a fund having to consider applying a liquidity management tool. This is a real positive.

An unintended consequence of the current MMF regulation is the perceived link between weekly liquid assets and a fund having to consider applying an extraordinary liquidity management technique. This could include as extreme an action as suspending redemptions on the fund, commonly known as “gating”. In  fact, gating is, and always has been, a low-probability outcome.

Given the uncertainty of potential outcomes under the current regulation, investors have tended to assume a worst-case scenario – that the fund would be suspended. In other words, the link between weekly liquid assets and a potential fund suspension became a “red line” in the regulation. Certainly unintended, but a red line nonetheless.

In our view, the FCA’s proposal to remove the link between weekly liquid assets and potential fund suspensions is an unambiguous positive. This proposal also has downstream positive effects. There is academic evidence that redemptions from some (mostly USD-denominated) funds accelerated as liquidity levels reduced towards the red line point of 30 per cent. It follows, then, that if there is no red line, redemptions shouldn’t accelerate. Granted, redemptions might still accelerate at very low levels of liquidity, but in the absence of an arbitrary marker, you shouldn’t get an arbitrary acceleration in flows. We think this change will make MMFs inherently more resilient than they already are.

Increased weekly liquidity

The FCA also proposes increased daily and weekly liquid assets: an increase to 50 per cent for weekly liquid assets and to 15 per cent for daily liquid assets. That compares with levels of 30 per cent and ten per cent respectively today. We focus here on weekly liquid assets, as that is the material change.

The industry consensus is that the increase in the weekly liquid asset requirement is too high, for three main reasons. First, worst-case outflows have been well below 50 per cent. In fact, the worst case any sterling fund has ever experienced was -30 per cent over a week, and that was in a small fund with a history of volatile flows. The attentive reader will notice that is exactly the amount of weekly liquidity MMFs have to carry today. Said fund excluded, worst-case flows are clustered in the low 20s.

The second point concerns security sales. The FCA’s underlying modelling assumes securities cannot be sold. While industry participants will all agree that secondary-market trading conditions can deteriorate, most agree that some securities can be sold, if needed, even in the most extreme market conditions. Indeed, this view is embedded in the MMF regulation itself, with certain assets considered “eligible” for weekly liquidity, even if they have longer maturities. From the consultation it seems the FCA will continue to view certain assets as “eligible” for liquidity purposes.

The evidence backs up the view certain assets can and will trade through difficult market conditions. For starters, we know some funds were buying securities throughout the March 2020 (COVID-triggered) stress period. How do we know? Because we were an active buyer at the time. Unlike many funds, we did not experience outflows; on the contrary, our assets were stable and we were more than happy to acquire from our peers high-quality assets at attractive prices.

In September 2022, we did have to sell some securities. We were able to do so with minimal price impact. When we look at other funds in the industry we see more evidence of security sales. For example, we have identified some funds with asset declines which could not be explained by changes in their weekly liquid asset levels alone. This implies they must have sold securities, as otherwise there would have been a like-for-like decline in total assets and weekly liquid assets.

Third, there are the practicalities of the matter. Banking regulation means banks are less willing to show balance sheet at certain times of year: quarter-ends and year-ends in particular. This makes it harder for MMFs to deploy very short-dated cash into bank deposits at these times. Turnover in the repurchase agreement, or repo, marketplace also slows at these times. This takes out another channel MMFs could use to deploy liquidity. Without that the only real option is the government bill market. Unfortunately, more liquidity would be required here – issuance volumes just aren’t high enough and are variable over the year. In other words, more liquidity might be achievable some of the time, but would be extremely challenging at certain times of year. Don’t forget: 50 per cent liquidity is £110 billion based on current total assets. That is a significant sum to be rolled every week.

The FCA does suggest some changes which may help with the practicalities. For example, the FCA proposes allowing MMFs to enter into slightly longer repo contracts. That could help, but only at the margins. Far more significant would be the creation of a Bank of England facility to absorb (we stress: absorb, not provide) excess liquidity. While this is theoretical at the moment, if it were implemented along the lines of the facility which already exists for MMFs in the US it could help with the practicalities of deploying significant levels of liquidity. There is a lot of ground to be covered before such a facility could be established in the UK, though.

While all the above are good reasons why more liquidity isn’t the answer, there is precedent – the US Securities and Exchange Commission (SEC) moved to 50 per cent weekly liquid assets in 2023. Clearly the FCA will chart its own course, but the SEC’s view will surely carry some weight.

We think most of the FCA’s proposed changes will bring benefits to investors. They address some issues, frame some interesting potential future developments and remove a major unintended consequence. It’s the liquidity part that may have an adverse outcome for investors.

At one level, it could mean lower yields. By forcing MMFs to invest shorter overall, yields would likely fall. We know investors would not appreciate this change.

The more problematic effect would be at those quarter- and year-end pinch points. We can see some scenarios in which funds would be forced to turn away investment simply because they could not deploy it into the market at the proposed levels of weekly liquid assets – this is not something we ever want to do.

More importantly, if widespread, it could increase investor allocations to banks (but don’t forget, they don’t want anyone’s cash at quarter- or year-ends) and hence, potentially, increase concentration risks or push investors into less-transparent or regulated segments of the financial market. Not a desirable outcome.

The FCA’s consultation could have wide-ranging implications. Nominally, the consultation (which closed on March 8, 2024) focussed on UK-domiciled MMFs. There are few of these: 17 in fact, with around £27 billion of total assets.

The offshore sterling MMF segment is much larger – we estimate around £220 billion at end-January 2024. Most of these funds are domiciled in Ireland or Luxembourg and sold into the UK under the temporary permissions regime. From 2026, this regime is changing, with new rules applying to MMFs being sold into the UK. There is a distinct likelihood that for an offshore fund to be sold into the UK, it will have to comply with the UK rules, as well as the rules applying in the country of origin.

As for Europe, we think the consultation will be closely scrutinised by European regulators. If anything, we think it will likely accelerate Europe’s progress on reviewing the current MMF rules.

Currently, the European Commission (EC) is of the view that changes are not needed to the MMF regulation and that it is working, by and large, as intended, although the EC does recognise that delinking is desirable. With the FCA joining the SEC in calling for major changes, we think this changes the calculus in Europe. The fact of the matter is that MMFs are a substantial EU export to the UK. Or to put it another way, UK entities are major investors in EU MMFs. So, the UK’s views matter.

However, before Europe can do anything, there is the matter of the upcoming European elections, which could be significant in this context. We don’t know who the legislators will be, nor do we know what, if any, changes there may be to key European bodies both within parliament and in the regulatory community. How the landscape shakes out could be significant in the direction of travel on the MMF regulation. The current EU parliament dissolves in May, with the new parliament sworn in thereafter.

One thing on which we are fairly certain is timing. We think the changes implemented by the SEC last year, in combination with the UK’s proposals, will accelerate the timeframe in which Europe looks again at the MMF regulation. We think the European authorities could launch a consultation on reforms early in the new term of the incoming parliament, potentially as early as the first quarter of next year. We would encourage investors to share their views with the FCA to help shape the future regulatory standards.

Our current estimate is that there will not be any material change until 2026 at the earliest. We are basing that estimate on the current temporary permission regime, which is due to expire at the end of 2025 for UCITS MMFs and 2027 for AIF MMFs.

This deadline can potentially be extended, and we expect it will be, as the UK authorities will want to mitigate the risk of any “cliff-edge” effects whereby EU and UK rules deviate materially for some period of time. Our core view is that the UK and EU authorities will work together to implement rule changes at approximately the same time.

The reality is that legislating and implementing rule changes takes time. The last round of EU reforms was agreed in 2017 and finally fully implemented in 2019. These changes were, ultimately, a response to the 2008-’09 global financial crisis.

In the meantime, investors have good reason for cheer. MMF yields remain elevated. With the expected timing of rate cuts being consistently pushed back by the market, there is more and more reason to think that rates will indeed remain higher for longer. We think this will support demand for cash and hence keep MMF assets high.

With inflation falling, and now, in many cases, below the yields available on MMFs, investors have the opportunity to achieve inflation-beating returns for a negligible level of risk. As a fundamental investment “need”, we’d expect this fact to strongly support MMF assets, even as yields do begin to fall.

Indeed, we see this in investor positioning. Our review of listed corporate cash balances shows cash levels are at around prior-year levels. Industry surveys show both private and public market investors are sitting on stable to growing cash balances. Long may it continue.

The regulatory cycle for MMFs is now well underway. The FCA has made its play. Formally speaking, the next step will be rule-making in the UK, but we expect this will take some time, particularly with potential changes coming in Europe. As to Europe, we expect a review of the MMF regulation to start soon in the new parliament’s term.

Our message to investors: watch this space. We’ll keep you informed. In the meantime, enjoy the yield on your MMF investments.

Past performance is not a reliable indicator of future results.