With the EU Parliament’s approval of the new money market fund rules last month, asset managers should prepare for the new money market landscape in Europe.
On 4 April, the EU Parliament approved the final Money Market Fund Regulation. The rules are designed to mitigate the perceived systemic risk posed by money market funds and make them less susceptible to liquidity runs. Initially proposed in late 2013, much of the debate around money market fund reform was on the appropriateness of the CNAV (constant NAV) fund. A CNAV fund’s price is kept at a constant value, typically one currency unit (e.g. dollar, krone, euro, etc.). Policymakers felt that CNAV funds gave a false sense of security to investors and increased their susceptibility to a liquidity crisis in the event of significant investor redemptions. To combat this issue, the original proposal called for CNAV funds to maintain a capital buffer of 3% of the fund’s total assets. This was widely criticized by the industry as impractical and eventually was dropped in subsequent proposals.
The debate about the rules has been very contentious and there have been some key changes in the final rules from the proposals last summer. The most noticeable change is the removal of the Retail CNAV fund, which would have been available to charities, non-profit organizations, public authorities, and public foundations. In its place, the LVNAV fund (The Low Volatility Net Asset Value) fund was resurrected. Gone too is the proposed CNAV fund specifically for non-EU investors.
For the industry, the final result is a bit of a mixed bag. The final rules are certainly an improvement over the original proposals but there is disappointment that the Retail CNAV fund didn’t make the final cut. However, the industry did welcome the expansion of eligible assets for the Public Debt CNAV beyond EU public debt to include “securities issued by central banks and other prescribed international financial institutions” (e.g. US Treasuries). There is also some residual disappointment that the CNAV fund is largely constrained to just public debt. However, given the final rules in the US, this was hardly a surprise.
Alignment with the US Rules
In the end, the EU rules align closely with the US money market fund rules that went live last autumn. Similar to the US rules, the final EU rules only allow CNAV funds to exist under requirements-namely, that at least 99.5% of their assets are in EU or non-EU government securities and securities issued by central banks or other prescribed international financial institutions. All other money market funds must be VNAV (variable NAV) funds, where the price is allowed to fluctuate.
Where the EU rules differ from the US rules is that a new category of fund has been created: the LVNAV fund. LVNAV funds are allowed to offer a CNAV fund that invests in more than government debt under very strict conditions. These conditions include a strict portfolio fluctuation ban. LVNAV will be able to retain a CNAV as long as shares do not deviate from the actual NAV by more than 20 basis points. Currently, CNAV funds are permitted to deviate by 50 basis points. LVNAVs must also adhere to strict liquidity rules on assets; at least 10% of its assets must be daily maturing assets and at least 30% of its assets must be weekly maturing assets.
While the LVNAV seems like an attractive opportunity, there’s a catch. The LVNAV rules have a “sunset clause” that directs the LVNAV structure be phased out in five years and all funds convert to either Public Debt CNAV or VNAV funds. However, there is a chance the LVNAV’s lifespan could be extended. The rules direct the EU Commission to review the LVNAV in four years to determine if the LVNAV is a suitable alternative to the Public Debt CNAV.
Given the uncertainty of the long-term prospects for the LVNAV structure, it seems likely that the LVNAV funds will be used primarily as a transitional structure for asset managers who have funds that do not qualify as Public Debt CNAV funds and who do not want to immediately shift to VNAV funds. It should be noted that this is largely the policy goal of the LVNAV fund. The EU wants to avoid what happened in the US, where leading up to the new rules there was a significant cash flow from prime to government money market funds. The LVNAV is designed to offer a smoother transition to the new world.
Redemption Fees and Gates Are Required
Beyond the CNAV issue, both Public Debt CNAV and LVNAV funds must have provisions for redemption fees or gates that must be deployed if a fund suffers significant outflows. The redemption fees or gates, which either apply additional charges or limit redemptions, are designed to stem any potential liquidity issues. Asset managers are also forbidden from supporting money market funds in times of distress to ensure that the NAV remains constant, which will explicitly allow CNAV and LVNAV funds to “break the buck” in the future.
Preparing for the New Age
Now that the rules are finalized, asset managers can begin to prepare for the new European money market landscape. Managers should now review their existing CNAV funds to see if they adhere to the new rules. If not, a decision will need to be made to alter their funds to comply with the new rules, use the LVNAV fund as a transition plan, or transfer to a VNAV structure.
The new rules take effect 12 months from publication in the Official Journal of the European Union, which means that any new money market fund launched in mid-2018 will have to adhere to the new rules. Existing money market funds are given 18 months to comply with the new rules, marking the end of 2018 as the full dawn of the new age of EU money market funds.