Why European Money Fund Reforms Will Differ from the US
No trillion dollar question for European Money Funds.
Nearly seven years after talks started, European money fund reform has finally been agreed upon. The new rules, which we should see in force by the end of 2018, look superficially similar, but on closer examination, really quite different to the approach recently adopted in the US. We explain why these changes and differences matter, and offer some views on how investors can prepare themselves.
Money fund reform in the US, completed in October 2016, has led to a staggering USD1 trillion flowing from “prime” funds — that is, funds which invest the majority of their assets in non-government and non-treasury securities — into government-only funds. The attraction of these funds was two-fold:
First, government funds in the US were allowed to retain a stable unit value per share (allowing operationally simple cash management), which has been the industry norm over the last 30 years, whereas prime funds had to move to a floating unit value per share (susceptible to price fluctuation).
Second, the US rules introduced liquidity fees and redemption gates in certain scenarios for prime funds. These are mechanisms designed to either charge investors for withdrawing money from the funds or temporarily halt withdrawals in their entirety in certain stress scenarios.
We surveyed institutional investors on their thoughts on European money fund reform at a recent investor-only event. Our investor audience told us they have concerns with floating net asset values per share and with potential liquidity fees and redemption gates.
Perhaps European investors are anchoring their views on the recent US experience? However, there are some important differences with the US in the European approach which they may not appreciate. The European reforms provide for a brand new (money) fund type which is not available in the US — the low volatility net asset value fund (or LVNAV fund in the alphabet soup terminology of European money fund reform). These funds will offer investors the combination of “prime” assets, that is, the ability to buy non-government securities, and an effective stable unit value per share.
In many ways, the investor experience of these funds will be similar to the existing prime funds in Europe. As such, investors clearly see these funds as a preferred option post-reform. In comparison with the US, this is an important development as it may mitigate a structural shift of assets into government-only funds. The fact that fees and gates will also apply to government funds in Europe (in direct contrast with the US) will also be a mitigating factor even if the construction of these funds makes the imposition of fees and gates a remote possibility.
On the surface, LVNAV funds appeal to investors. However, there are some important factors investors should consider
First, these funds will offer a stable unit value per share. However, it is possible that these funds convert to a floating or variable unit value per share in more stressful scenarios. Specifically, if the market-to-market price of an LVNAV fund strays 20 b.p. away from its stable value, then it is forced to convert to a floating NAV fund. Absent some large exogenous shock, we think this outcome is unlikely. In all likelihood, managers of these funds will adopt even more conservative portfolio management practices to mitigate not only the risk of the mark-to-market price moving out of the corridor but also investor perceptions of that risk.
Second, they come with the potential for gates and fees. Fees and gates were a significant issue in the US. In Europe, fees and gates may be less of a concern. Under Europe’s UCITs rules, funds already have a smorgasbord of extraordinary liquidity management tools available to them ranging from delayed redemptions through fees, gates and even payment-in-kind in some scenarios. Nonetheless, the prominence of fees and gates in the reform debate may still be a headline issue. In practical terms, the European rules define a specific threshold at which a fund’s board of directors must consider applying a fee or gate, followed by a second threshold at which the fund must apply a fee or gate, both tied to available weekly liquidity (30% and 10% respectively). The fact that the fee or gate is discretionary at the first threshold means we can expect more investor interest in fund board composition and processes. That being said, we anticipate that fund providers will up the conservatism of their liquidity management in these products to avoid either threshold in their entirety. Even more than now, liquidity management is going to be critical to funds in a post-reform world where there will be a heightened focus on a funds’ proximity to the new regulatory thresholds.
Coupled with the yield cost which will come with the conservative fund management strategies needed for such funds, this presents a rather formidable challenge for the market. That said, investors may still see such funds as preferable to the alternatives.
One intriguing possibility is whether we see funds that invest in lower quality or peripheral European sovereign debt. The new reform rules make it a possibility provided the issuers achieve a “favourable” credit assessment, to use the Council’s exact phrase. Whether we see such funds or not, we do still expect a plethora of fund launches — notably LVNAV funds — over the coming months as fund providers prepare for European money fund reform.
Changes to the landscape of money funds and liquidity products are clearly on the horizon. So what can investor do and why is it important to prepare? At the very least, they can prepare themselves by understanding the rule changes and what this means for cash management options. They can also proactively review their investment guidelines and dialogue with internal stakeholders to make sure they are ‘fit for purpose’ for what lies ahead.