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September 13, 2017
Money market funds in the euro area managed assets worth EUR 1.16 trillion in mid-2017. Low interest rates did not hamper the impressive growth by EUR 260 billion during the past three years. But new EU regulation taking effect in 2018 will impose stricter rules on fund managers. However, the measured regulation will probably not cause a major restructuring of the euro area market, in contrast to the reshuffling seen in response to the US money market fund reform. In the future, Brexit could lead to competition for non-EUR denominated money market fund business between the EU and the UK. [more]
EU Monitor Global financial markets *The author thanks Julia Breuing for her valuable research assistance. In the past three years, European money market funds (MMFs) have grown by an impressive EUR 260 bn to EUR 1.16 trillion in invested assets. MMFs have attracted large inflows, which have particularly gone into non-euro assets benefiting from rising USD yields. In addition, the appreciation of the dollar has led to higher assets under management (AuM) measured in euro. Yields on euro assets have been low or even negative but in line with alternative money market investments. EU regulation issued in June 2017 and taking effect in 2018 aims at bolstering MMFs against financial distress. It introduces tighter rules on portfolio diversification, liquidity and transparency. Sponsor support is explicitly prohibited. Newly introduced MMF categories are likely to accommodate current investor preferences as regards accounting methods (variable or constant net asset value) as well as investment objectives (public or private debt) without triggering major market changes. By contrast, the US MMF reform of October 2016 led to fundamental adjustments in the market. USD 1 trillion have been shifted from prime to government MMFs, driven by prevailing investor preferences for constant net asset valuation and lighter regulation on fees and redemption gates. A “hard Brexit” could trigger a repatriation of GBP-denominated and UK-focused MMFs with approximately EUR 213 bn in AuM. Furthermore, a proprietary UK regulation similar to old EU rules could spark regulatory competition for the offshore USD MMF market. Currently, euro area MMFs manage EUR 326 bn in USD-denominated assets. USD- and GBP-denominated funds are predominantly domiciled in Ireland and Luxembourg. Author Heike Mai* +49 69 910-31444 heike.mai@db.com Editor Jan Schildbach Deutsche Bank AG Deutsche Bank Research Frankfurt am Main Germany E-mail: marketing.dbr@db.com Fax: +49 69 910-31877 www.dbresearch.com DB Research Management Stefan Schneider September 13, 2017 New EU money market fund regulation: Will growth continue? -1 0 1 2 3 4 5 6 7 0 200 400 600 800 1,000 1,200 1,400 06 08 10 12 14 16 EUR USD GBP Unknown EUR LIBOR USD LIBOR GBP LIBOR Sources: ECB, WEFA, Deutsche Bank Research Euro area MMFs attractive despite low interest rates Assets of euro area MMFs in EUR bn (left); 3 - month LIBOR in % (right ) MMF assets by denomination Q2 17 Annotation: Due to statistical reclassifications, AuM were reduced by about EUR 194 bn between Q2 2011 and Q1 2012, and increased by EUR 69 bn in Q1 2014. 3-month LIBOR New EU money market fund regulation 2 | September 13, 2017 EU Monitor In June, the EU issued a new regulation on money market funds (MMFs) which will be phased in over the coming 18 months. 1 While acknowledging the importance of MMFs for short-term finance, legislators aim to mitigate the risks which MMFs can pose to financial stability in times of crisis. Regulation comes at a time when euro area MMFs, which more or less represent the total EU MMF industry, have long recovered from the decline experienced after the financial crisis. In the past three years, assets under management (AuM) have grown by EUR 260 bn to EUR 1,158 bn at the end of Q2 2017. European MMFs have grown despite low interest rates Net inflows of EUR 208 bn accounted for most of the increase in AuM during the past three years. Investors from outside the euro area bought MMF shares worth EUR 105 bn. It can be assumed that these investors mostly placed USD or GBP funds. With increasing short-term USD rates and thus positive returns of USD- denominated MMFs, inflows in this segment are no surprise. However, euro area investors also invested EUR 94 bn (net) of fresh money despite low and even negative euro money market rates. 2 But cash-rich investors which need to hold short-term liquidity do not have many alternatives. For companies, interest rates on bank deposits are still slightly positive on average, but individual investors are facing negative deposit rates. Moreover, prudential regulation (NSFR 3 ) lets banks shy away from large wholesale sight deposits. Not least, MMFs still offer investors liquidity and risk reduction through portfolio diversification. Admittedly, the growth in AuM has not only been due to net inflows. Over half of euro area MMFs’ assets are invested in instruments denominated in USD, GBP or other currencies. Thus, exchange rate fluctuations impact the AuM when measured in EUR. Based on a back-of-the-envelope calculation, the EUR depreciation against the USD in the past three years has inflated the EUR value of USD assets by about EUR 53 bn. But the opposite development vis-à-vis the GBP has reduced the FX inflation of total assets to EUR 30 bn. As there were no statistical reclassifications, asset revaluations may be the reason for the remaining increase in AuM. On the asset side, euro area MMFs have invested most of the net inflows in debt issued by non-residents (EUR 159 bn), and only EUR 46 bn in debt issued by euro area residents. Given that resident investors had placed EUR 94 bn, MMFs channelled about half of this money to non-resident debtors. These figures also suggest that EUR-denominated MMFs have invested to some degree in higher- yielding USD or GBP assets, as issuer residency and debt currency are usually “the same”. However, the currency of investments can only be roughly estimated due to a lack of comprehensive data. EU regulation introduces new MMF categories The new EU regulation aims at ensuring the liquidity of MMFs in order to protect investors and to prevent contagion of the wider financial system in case a fund gets into difficulties. Tighter rules on portfolio diversification and enhanced liquidity requirements for all MMFs will strengthen their ability to always and fully meet investors’ redemption requests. Sponsor support for ailing MMFs will be explicitly forbidden. 1 Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on money market funds. 2 EUR 9 bn of inflows cannot be allocated geographically. 3 Basel Committee on Banking Supervision (2014). Basel III: the net stable funding ratio. BIS, October 2014. The NSFR is part of the pending capital requirements reform for which the EU legislative process started in November 2016. -40 -30 -20 -10 - 10 20 30 40 50 Flows from non-euro area investors Flows from euro area investors Total flows Net inflows in past three years 1 EUR bn per quarter, Q3 2014 - Q2 2017 Sources: ECB, Deutsche Bank Research 2014 2015 2016 2017 - 50 100 150 200 250 Asset flows Liabilities flows No geographical allocation Outside euro area Euro area More money received from residents than invested in debt issued by residents 2 Net flows of euro area MMFs in EUR bn, accumulated in Q3 2014 - Q2 2017 Sources: ECB, Deutsche Bank Research (money invested in... ) (money received from... ) New EU money market fund regulation 3 | September 13, 2017 EU Monitor According to existing and still effective ESMA guidelines 4 , MMFs can be standard or short-term. Portfolio requirements (e.g. maximum asset maturity) are stricter for short-term than for standard MMFs. From a market perspective, however, the distinction between variable and constant net asset value is more important. MMFs displaying a variable (fluctuating) share price calculate the entire fund’s net asset value based on mark- to-market or mark-to-model pricing. The share price is then calculated by dividing this net asset value by the number of shares outstanding. Variable net asset value (VNAV) funds can be set up as either standard or short-term MMFs. Both VNAV types will also be allowed under the new legal regime. Constant net asset value (CNAV) funds are able to display a steady share price (usually EUR/USD/GBP 1) because they value their portfolio based on amortised cost accounting. Amortised cost accounting is only allowed for short-term MMFs. Regulators are particularly wary of CNAV funds because investors expect them to always maintain a stable price per share. A sudden devaluation can thus easily trigger an investor run. Therefore, CNAV MMFs as they exist today will no longer be allowed. This affects about 55% of all euro area MMF assets. But as many investors prefer CNAV funds due to their easy handling, for accounting and tax reasons, the EU regulation provides for two new, close substitutes: low volatility NAV funds and public debt CNAV funds. LVNAV (low volatility net asset value) MMFs will be allowed to use amortised cost accounting – the basis for a stable share price – for assets with a residual maturity of up to 75 days. 5 Furthermore, the constant asset price must not deviate by more than 10 basis points from the mark-to-market price of that asset. Public debt CNAV funds are another option. These MMFs will be restricted as regards their portfolio: they will have to hold at least 99.5% of their assets in public debt, reverse repos secured with public debt, or cash. But they will be allowed to stick to amortised cost accounting and stable share prices. Both LVNAV and public debt CNAV funds will be subject to mandatory liquidity fees or a suspension of redemptions if the share of weekly maturing assets in the portfolio falls below 10%. If suspensions are put in place on more than 15 days within a 90-day period, an LVNAV or public debt CNAV fund will be converted into a VNAV MMF. By contrast, VNAV funds are “only” subject to the UCITS regime, which puts the introduction of measures like liquidity fees or redemption gates at the discretion of the fund management board. 4 ESMA 2014/1103 Opinion. Review of the CESR guidelines on a Common Definition of European Money Market Funds, 22 August 2014. 5 The maximum residual maturity of an individual instrument is 397 days, but if the residual maturity exceeds 75 days, the instrument has to be valued mark-to-market. CNAV funds, EUR 640 bn, 55% France, EUR 360 bn, 31% Luxembourg and other EA, EUR 158 bn, 14% VNAV funds, EUR 518 bn, 45% Euro area MMF market: divided between CNAV and VNAV 3 Assets under management, estimation for mid-2017 Sources: ECB, IMMFA, Deutsche Bank Research Annotation: MMFs domiciled in France, Ireland and Luxembourg account for 98% of euro area MMFs' total assets. CNAV funds are predominantly domiciled in Ireland and Luxembourg. New EU money market fund regulation 4 | September 13, 2017 EU Monitor Impact of EU regulation The new EU regulation forces investors and fund managers to reconsider their investment strategies and will certainly cause adjustments in the market. Nevertheless, the cautious reform is unlikely to disrupt the EU MMF market or to trigger substantial outflows from the sector as a whole. On the one hand, investors in VNAV MMFs (EUR 518 bn, 45% of the market) will see no fundamental changes due to the new regulation. However, standard VNAV funds (approximately EUR 341 bn, 30% 6 ) may have to shorten the maturity of their portfolios due to the introduction of minimum requirements for daily and weekly liquidity. On the other hand, CNAV MMFs as they exist today will disappear, which means that assets of approximately EUR 640 bn will have to be reallocated. But investors are offered relatively close substitutes with the introduction of public debt and LVNAV funds. The new type of public debt CNAV MMF will be the closest alternative for today’s investors in CNAV funds focused on government debt. Admittedly, only 7% (EUR 85 bn) of euro area MMF assets are currently invested in such funds. 6 Estimation based on figures of the ECB, Association Française de la Gestion financière (AFG), Commission de Surveillance du Secteur Financier (CSSF). MMF categories defined by new EU regulation 4 Standard Short-term Low volatility Public debt VNAV VNAV NAV CNAV Accounting method Mark-to-market Mark-to-market Amortised cost for assets with residual maturity of 75 days max. Amortised cost Eligible assets Money market instruments Money market instruments Money market instruments Public debt, reverse repos, cash Mandatory liquidity fees/redemption gates No No Yes Yes Maximum residual maturity of a money market instrument until legal redemption 2 years 397 days 397 days (mark- to-market valuation if over 75 days) 397 days Maximum weighted average maturity* (WAM) of portfolio 6 months 60 days 60 days 60 days Maximum weighted average life* (WAL) of portfolio 12 months 120 days 120 days 120 days Minimum of daily maturing assets 7.5% 7.5% 10% 10% Minimum of weekly maturing assets 15% 15% 30% 30% * When calculating WAM, maturity is defined as the time remaining until the next interest rate reset date. When calculating WAL, however, the life of a floating rate instrument is the time left until it has to be redeemed. Sources: Regulation (EU) 2017/1131, Deutsche Bank Research New EU money market fund regulation 5 | September 13, 2017 EU Monitor Almost half of all euro area MMF assets are invested in prime CNAV funds (i.e. focus on private debt). At first sight, investors in this segment seem to face a more pronounced change in the regulatory regime, as the current setup will not be possible any more. However, no major adjustments will be necessary for a current prime CNAV fund to convert into an LVNAV fund, because the requirements for the average liquidity of the portfolio (WAL, WAM) will remain unchanged. Only individual instruments with residual maturities of between 75 and 397 days will need to be exchanged for instruments maturing within 75 days. Such asset reallocations will probably be limited in size, though, because CNAV funds currently manage their portfolios with WAL (WAM) values well below the allowed 120 (60) days. The resulting effect on returns will depend on the yield curve. Overall, where investors are subject to tax and accounting regimes which favour constant share prices, LVNAV funds look like a workable alternative. Market reaction to US money market fund reform In the US, the new rules for MMFs adopted by the Securities and Exchange Commission (SEC) already came into force on 14 October 2016. The US MMF industry, which had been entirely CNAV-based, had to introduce fluctuating share prices for prime and municipal MMFs directed at institutional investors. 7 Moreover, all prime and municipal MMFs must now feature a system of liquidity fees and redemption gates which can – but do not have to be – implemented by the fund board in the best interest of the fund and its shareholders in times of financial distress. However, government MMFs are exempted from these new requirements. As a result, even though the volume of USD 2.7 trillion in assets managed by US MMFs did not change significantly, the market experienced a tremendous reshuffling. During the course of 2016, about USD 1 trillion were shifted from prime and municipal funds into government MMFs, namely agency MMFs, a riskier and higher yielding sub-segment of government MMFs. 8 The reason for the shift to government funds might simply have been the preference for the familiar status quo instead of the new regime, as government MMFs were least changed by the reform. This is somewhat surprising, though, given that US authorities and fund managers had taken legal and operational measures to make the handling of VNAV MMFs as easy as that of CNAV MMFs for investors. On the regulatory side, the SEC clarified in 2014 that investments in VNAV funds will be treated as cash equivalents under US GAAP. In July 2016, the US Internal Revenue Service (IRS) issued rules putting VNAV funds on par with CNAV funds as regards tax and reporting. On the technical side, the industry has upgraded infrastructure for VNAV funds to match the operational service level that CNAV fund clients are used to, e.g. same-day cash settlement and multiple settlement cycles per day. However, the legal and operational uncertainties around VNAV funds – the aforementioned IRS rule was published only three months before the new MMF framework took effect – may have delayed decision-making in favour of VNAV funds on the investor side. Internal processes like treasury management systems and investment policies need to be adjusted to handle VNAV funds. Backed by legal clarity, investors may possibly come back to prime MMFs in the future, not least because they offer higher yields. Indeed, in 2017 (until August), prime MMFs 7 Municipal MMFs invest in state and local debt and are tax-exempt. For an overview of the US MMF market and reform project, please see Mai, Heike (2015). Money Market Funds – an economic perspective, Deutsche Bank Research, February 2015. 8 See e.g. Cipriani, Marco, Gabriele La Spada and Philip Mulder (2017). Investors’ Appetite for Money-Like Assets: The Money Market Fund Industry after the 2014 Regulatory Reform, Federal Reserve Bank of New York Staff Reports, no. 816, June 2017. Government CNAV funds, EUR 85 bn, 7% Prime CNAV funds, EUR 554 bn, 48% Short-term VNAV funds, EUR 85 bn, 7% Standard VNAV funds, EUR 341 bn, 30% VNAV funds not allocated, EUR 92 bn, 8% Detailed segments of euro area MMF market 5 Estimation for mid-2017 Sources: Association Française de la Gestion financière, Commission de Surveillance du Secteur Financier, ECB, IMMFA, Deutsche Bank Research 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 07 08 09 10 11 12 13 14 15 16 17 Government MMFs Prime MMFs Municipal MMFs Share of government MMFs (%) US reform 2016: huge reallocation from prime to government MMFs 6 AuM in USD trillion (left), share in total industry in % (right) Sources: ICI, Deutsche Bank Research New EU money market fund regulation 6 | September 13, 2017 EU Monitor did gain some ground (USD 65 bn) while government MMFs lost AuM of USD 57 bn. A second, more structural and thus lasting factor for the shift into government funds has probably been the exemption from fees and gates provisions. Boards of prime and municipal MMFs now have the option to impose liquidity fees or redemption gates. Therefore, money invested in such funds is no longer perceived as fully liquid. Before the reform, the board of an MMF was already allowed to suspend redemptions, but the fund had to be liquidated as a consequence, which was a high hurdle. Still, with the new rule, it remains to be seen if and how fund boards will work with these discretionary powers in critical situations and how market practices will evolve. In Europe, the introduction of mandatory liquidity saving measures will probably have a lesser effect than in the US, as investors already face the “threat” of similar – albeit discretionary – action under the existing UCITS regime. Furthermore, to benefit from the least restrictive European rules on fees and gates, investors would have to shift towards VNAV funds, which in turn would require operational adjustments. As regards the mere preference for constant net asset value accounting, this does not require a reallocation to public debt like in the US, as LVNAV funds can become “home” to current investments in prime CNAV MMFs. Next thing to watch: Brexit EU regulation will change the framework of the European MMF market, but it is not poised to cause a fundamental restructuring. Brexit could trigger substantial changes, though. Of course, the future relation between the EU and the UK cannot be foreseen at this point in time. The EU MMF regulation applies to any money market fund “established, managed or marketed in the Union”. In case of a “hard Brexit”, it may well be that MMFs which are essentially British and which are currently almost all domiciled in Ireland will be “repatriated”. “Essentially British” means MMFs run by asset management companies in the UK, or MMFs whose investors are predominantly UK residents. Currently, UK investors hold 45% of CNAV fund shares; 9 90% of GBP-denominated assets are managed by MMFs domiciled in Ireland. An exodus of such “British” MMFs could reduce the total size of the EU MMF market by more than EUR 200 bn. In addition, the EUR 300 bn-plus market for USD-denominated European MMFs could change considerably. They are so far predominantly domiciled in Ireland (EUR 192 bn, 59% of USD assets managed by euro area MMFs) or Luxembourg (over EUR 110 bn, 35%) and mostly operate as CNAV funds. Following Brexit, it cannot be ruled out that the UK could establish a proprietary regime for MMFs similar to the old EU rules. In such a case, regulatory competition for the offshore USD MMF market could evolve. Heike Mai (+49 69 910-31444, heike.mai@db.com) 9 IMMFA, assets under management as at the end of 2016, retrieved August 2017, https://www.immfa.org/market-statistics/immfa-aum.html EU Monitor Our publications can be accessed, free of charge, on our website www.dbresearch.com You can also register there to receive our publications regularly by E-mail. Ordering address for the print version: Deutsche Bank Research Marketing 60262 Frankfurt am Main Fax: +49 69 910-31877 E-mail: marketing.dbr@db.com Available faster by E-mail: marketing.dbr@db.com * New EU money market fund regulation: Will growth continue? .......................................... September 13, 2017 * Where do European banks stand? 10 years after the start of the financial crisis ............... August 29, 2017 * Robo-advice – a true innovation in asset management ..................................................... August 10, 2017 * Large or small? How to measure bank size .................... April 25, 2017 * Who is afraid of populists? ...........................................March 23, 2017 * Synthetic securitisation: Making a silent comeback ....................................... February 21, 2017 * Coping with mixed feelings: What future for European trade policy? ..................... January 24, 2017 * Rising income inequality: do not draw the obvious conclusions .................................. December 7, 2016 * Cash, freedom and crime: Use and impact of cash in a world going digital ............................... November 23, 2016 * Think Local: What Brexit would mean for regional and cohesion policies in Europe ......... September 30, 2016 * Start-ups and their financing in Europe: Out of the woods with Capital Markets Union ........ September 29, 2016 © Copyright 2017. Deutsche Bank AG, Deutsche Bank Research, 60262 Frankfurt am Main, Germany. All rights reserved. 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