Draft EU Money Market Fund Regulation: Initial Assessment
On 4 September 2013 the draft "Proposal for a Regulation of the European Parliament and of the Council on Money Market Funds" (the "Draft Regulation") was officially released by the European Commission (the "Commission"). This follows its unofficial release in April 2013.
The Draft Regulation contains a radical set of new regulatory measures that will apply to European money market funds ("MMFs"), both in the context of UCITS and also funds within the scope of the Alternative Investment Fund Management Directive 2011/61/EU ("AIFMD").
Among the measures, and perhaps the most significant, is the proposal to require MMFs that operate with a constant net asset value ("CNAV") to establish and maintain a capital buffer of at least 3% of the total value of the money market fund’s assets. The only amendments that have been made to the unofficially released version in this regard is that the 3% buffer will be re-assessed three years following the implementation of the Draft Regulation and also the introduction of a three year ramp-up period for the phased introduction of the buffer.
Below is a high level initial assessment of this capital buffer proposal and other key elements contained in the Draft Regulation.
The Draft Regulation follows a report and recommendations on MMFs issued on 18 February 2013 by the European Systemic Risk Board ("ESRB"). That report called for proposals to be made by the European Commission. However, it is noteworthy that the measures in the Draft Regulation do not follow the recommendations contained in that report.
MMFs have also been under recent scrutiny from the US Securities and Exchange Commission ("SEC") (which published proposals in June 2013) as well as the Financial Stability Board ("FSB") and the International Organization of Securities Commissions ("IOSCO").
The theme across each of these reviews has been that MMFs were of systemic importance but have not been sufficiently addressed by current regulations.
In presenting the Draft Regulation, the European Commission maintains that because of the systemic connection of MMFs and the banking sector and with corporate and government finance, the Commission considers that the operation of MMFs "has been at the core of the international work on shadow banking".
In the context of UCITS, the Draft Regulation expands upon the ESMA "Guidelines on a common definition of European money market funds" issued on 19 May 2010 and builds upon the existing regulatory framework established through Directive 2009/65/EC (the "UCITS IV Directive"). In a non-UCITS context, the Draft Regulation overlays the regulatory framework for alternative investment funds ("AIF") within the scope of AIFMD. Therefore, funds falling under the scope of the Draft Regulation will have to comply with the additional layer of specific MMF rules in addition to their core regulation.
(a) Eligible Assets
The Draft Regulation states that MMFs shall only invest in the following categories of assets:
• money market instruments;
• deposits with eligible credit institutions (on demand or less than 12 month maturity);
• financial derivative instruments (only to hedge duration and exchange rate risks);
• reverse repurchase agreements (with a maximum close out facility of two working days).
Of note regarding money market instruments, among the eligibility conditions outlined is the requirement that each MMF must internally assess each money market instrument and assign it a credit rating – with six grades for instruments of non-defaulting issuers. The MMF will then only be permitted to invest in money market instruments assigned the first or second grade on its internal rating scale.
The Draft Regulation also contains a detailed list of investment restrictions for MMFs. In summary, MMFs shall be prohibited from short-selling money market instruments, taking direct or indirect exposure to equity or commodities, entering into securities lending agreements or securities borrowing agreements or borrowing and lending cash.
(b) Diversification and Concentration
The Draft Regulation contains detailed rules on the diversification of eligible investments that each MMF has to respect, such as a:
• 5% issuer limit for money market instruments;
• 5% limit on deposits with a single credit institution;
• 10% aggregate limit in terms of securitisation exposure; and
• 10% aggregate limit in terms of issuer exposure.
These restrictions are waived for sovereign issues of certain countries and public bodies subject to six issues/30% per issue limits.
(c) Portfolio Maturity
The portfolio of an MMF (other than a extended maturity MMF defined as a "Standard MMF" in the Draft Regulation) must have a weighted average maturity ("WAM") of no more than 60 days and a weighted average life ("WAL") of no more than 120 days.
(d) Credit Rating Restriction
The Draft Regulation prohibits an MMF from soliciting or financing an external credit rating.
The Draft Regulation contains provisions outlining how MMFs should value their assets requiring MMFs (other than CNAV MMFs) to value their assets daily using mark-to-market whenever possible and otherwise mark-to-model.
Only CNAV MMFs may value assets using the amortised cost method.
(f) Redemption Monitoring and Stress Testing
Managers of MMFs shall be required to monitor investors in order to “correctly anticipate the effect of concurrent redemptions by several investors” and shall also ensure that "redemption by an investor does not materially impact the liquidity profile of the MMF”.
Liquidity and the quality of assets in the MMF must also be assessed via stress tests on at least an annual basis and measures taken to reinforce liquidity or asset quality where stress testing identifies any vulnerability of the MMF.
(g) External Support
Under the Draft Regulation, CNAV MMFs may only receive support through a specific NAV buffer (as dealt with below) and all other MMFs shall be prohibited from receiving external support. The MMFs competent authority may, in exceptional circumstances (justified by systemic implications or adverse market conditions) allow a MMF (other than a CNAV MMF) to receive external support that is "intended for or in effect would result in guaranteeing the liquidity of the MMF or stabilising the NAV per unit or share".
(h) Specific CNAV Requirements
CNAV MMFs will be required to establish and maintain at all times a capital buffer amounting to at least 3% of the total value of their assets (the "NAV buffer"). The NAV buffer shall be composed of cash and held in a protected reserve account in the name of the CNAV MMF. This reserve account shall be used solely for the benefit of the CNAV MMF and the instances when this account can be debited and credited are set out in detail in the Draft Regulation. The NAV buffer can only be used to compensate the difference between the constant NAV per unit or share and the "real" value of a unit or share.
The NAV buffer should be replenished whenever it falls below 3%. The competent authority (and ESMA) shall be immediately notified when the amount of the NAV buffer decreases by 10 basis points below the 3%.
The recitals of the Draft Regulation also note that competent authority should also have the power to convert a CNAV MMF into a MMF other than a CNAV MMF when it has justifiable reasons demonstrating the incapacity of the CNAV MMF to replenish the buffer within one month.
The Draft Regulation allows a ramp-up period for existing CNAV MMF in relation to the NAV buffer as follows:
(a) 1% of the total value of the CNAV MMF’s assets, within one year from the entry into force of the Draft Regulation;
(b) 2% within two years; and
(c) 3% within three years.
Each CNAV MMF must provide in its constitutional document clear procedures for conversion to a non-CNAV MMF.
NAV Buffer Retained - Commentary
That the NAV buffer has not been removed from the Draft Regulation dashes the hope that the Commission would reassess the unofficial draft released in April 2013, with a view to aligning their proposals with the recent SEC proposals. Notably the SEC proposed requirements on constant NAV funds to apply liquidity fees on withdrawals and withdrawal restrictions in stress periods but did not propose a capital buffer.
The fact that the Commission is maintaining the capital buffer proposal could potentially be as significant and damaging for the EU money market funds industry as earlier feared - and perhaps even more so now it seems the SEC will not be following the same path in the US.
We should mention this remains a legislative proposal and recall that recently a bonus cap proposal, in the context of UCITS V, was defeated in the European Parliament. We certainly expect a strong lobbying effort to emerge against the capital buffer now it is back on the agenda.
Implementation and Transition
As the Draft Regulation is being presented as a regulation (as opposed to a directive), once finalised, it will be directly effective in EU Member States 20 days after its publication in the Official Journal.
There is a transitional period of six months (following the entry into force) for all existing MMFs to comply with the Draft Regulation and, as noted above, a ramp-up period for the phased introduction of the NAV Buffer.
Please find a link to the Draft Regulation here.
If you would like further information on the Draft Regulation or would like to discuss the potential implications for your business please contact your usual Maples and Calder contact.