In part one of our Fund Liquidity blog series, we identified fund liquidity management as a current central tenet of global policymaker policy. It’s the first time that the regulatory spotlight seems to shine with greatest intensity in Europe, where European Securities and Markets Authority (ESMA) have recently published two significant papers on the topic of fund liquidity management. The first related specifically to E.U. Money Market Funds, and the second outlines ESMA’s findings from its detailed study of the UCITS liquidity landscape.
Here in part 2, we focus on European Money Market Funds.
E.U. Money Market Fund Regulation – Legislative Review
We previously highlighted that in the United States, the Securities and Exchange Commission has moved to reframe it’s money market fund rules through a public consultation where they outline ten possible revisions to the regime. Some of the most significant revisions include doing away with stable NAV funds once and for all, imposition of mandatory “capital buffers” to deal with significant redemptions and down markets, and creation of a “emergency insurance fund” paid into in the good times, which could be drawn down to fund redemptions in the bad times.
Money market funds (in Europe and further afield) form a large and important sub-set of the overall E.U. fund landscape and act as a cash management and liquidity tool for a wide range of investors ranging from corporate treasurers, governments, down to retail investors. It’s also inevitable that money market funds come under regulatory scrutiny in the wake of large market volatility event. Global policymaking bodies ranging from International Organization of Securities Commissions (IOSCO) to the Financial Stability Board (FSB), the Securities and Exchange Commission (SEC) have each already weighed in, and now it’s ESMA’s turn.
The ESMA consultation has much in common with the SEC’s in terms of the most consequential reforms and issues that emerged from review of the March data. It acknowledges once more that overall, the funds were largely resilient to the impacts of the market conditions and investor redemptions were met, with no EUMMF having to suspend, apply liquidity fees, or gate their funds as the COVID-19 pandemic struck upending market stability. However, they also observe high levels of outflows in stressed market conditions which helped to highlight certain vulnerabilities in the framework.
EUMMFs have a large footprint and high concentration of ownership in the securities they invest in and they tend to invest in the same or similar securities. The corporate commercial paper (CP) market for example, is heavily concentrated in money market funds. Globally, the CP market is often largely made up of money market fund investment. Adding to the concentration risk is that funds (U.S. & E.U.) tend to invest in the same or very similar securities, resulting in a high degree of portfolio overlap and usually a lot of correlation in terms of market risk. Also, secondary market activity is usually very low since money market securities are normally bought to hold to maturity. These factors together make for a naturally shallow liquidity pool in stressed market conditions and make MMFs particularly vulnerable to symmetric shocks. These overall vulnerabilities lead ESMA to suggest four distinct enhancements for considerations:
1. Changes to the liability side
ESMA identify in much the same way as the SEC have that the prescribed regulatory thresholds relating to NAV deviations or Weekly Liquid Asset (WLA) thresholds often have the unintended consequence of pushing investors to redeem as a fund nears thresholds, which might automatically trigger imposition of a liquidity fee or gating of redemptions. These hard-coded, quantitative regulatory thresholds therefore may result in “equal and opposite” outcomes by increasing redemptions in stressed periods when they were designed to dissuade “dash for cash” redemption pressures. Also, it is interesting that ESMA’s assessment of the March 2020 data indicates that certain funds were reluctant to sell off their most liquid, shortest duration assets, even in the face of high redemption levels for fear of breaching their WLA levels. They might have absorbed losses on the sale other assets, again the exact opposite of the intended outcome.
The other big idea is to demand the application of liquidity management tools such as swing pricing and/or anti-dilution and redemption fees on a mandatory, rather than elective basis.
2. Changes on the asset side
The current rules always require EUMMFs to maintain a fixed level of liquid assets within portfolios, usually a daily and weekly liquid asset amount expressed as a percentage of total net assets. The rigid fixed thresholds are an area ESMA suggests could be more flexible and recognize market dynamics through more exact and risk sensitive modelling. ESMA puts forward a proposed recalibration of the minimum liquidity buffers. The buffers may be based on the funds own liquidity stress testing outputs and might see a greater role for the regulator in working with the fund to calibrate an appropriately flexible buffer thresholds in the best interest of its investors.
3. Reform Types of Funds Available
Perhaps the most consequential proposal is the suggestion for alterations of fund types. Like in the U.S., the elimination of stable NAV MMFs is proffered. The suggestion may be quite radical, considering ESMA opens the consultation by reaffirming that there were no NAV suspensions or gating required last March. ESMA proposes to remove constant net asset value (CNAV) money market funds and limited-volatility funds (LNAV funds) as product options. They also ask for consideration of Public Debt Constant NAV funds and Low Volatility NAV funds to convert to Variable NAV funds.
4. Reforms that are external to MMFs themselves
ESMA asks whether the role of EUMMF sponsor should be modified. Currently, sponsor support is explicitly prohibited for EUMMFs but again, ESMA asks whether greater flexibility and nuance to this prescribed rule is required to reflect market realities more accurately.
In addition, ESMA asks for feedback on changes relating to fund ratings, disclosure of investor categories, stress testing, and the setting up of a liquidity exchange facility (LEF). The LEF to funded by the EUMFs themselves, or asset managers which would act as a central source of liquidity or credit to funds in need at time of crisis. This would mean the creation of a centralized and pre-funded facility for EUMMFs to transact with during a crisis, instead of government and central bank interventions. A similar idea has been proposed in the U.S. consultation. Detractors of the idea will suggest it will make EUMMFs commercially unattractive to all, except the biggest bank owned EUMMFs.
It is clear that policymakers would like industry to be more self-sufficient in managing future crises, so industry feedback to that point specifically will be worth watching. Check back on the blog on Friday for part three, where we will focus on the findings contained in ESMAs report on UCITS fund liquidity management following its common supervisory action conducted last year.