Under the new EU money market funds regulation, the risk profiles and reporting requirements around different types of money market funds have changed. Deutsche Bank Corporate Trust experts David Contino and Puneet Anand explore the implications
Insurance-linked securities (ILS) fund managers and ILS debt issuers should be aware of the implications of the recently implemented Money Market Funds (MMFs) regulation and some may need to change their investment strategies as a result.
That is the warning from David Contino, director, client service head for the Corporate Trust Escrow and ILS services businesses at Deutsche Bank. Contino notes that many ILS funds, as well as ILS debt issuers, may be unaware of some of the implications of the new regulation, especially as it applies to the way they may invest the collateral used in ILS deals.
The MMFs regulation has applied since July 2018 for new MMFs and will apply from January 2019 for existing ones to allow them to adapt.
The regulation provides for the three categories of MMF in the EU: MMFs with variable net asset value (VNAV), whereby the funds can be either short-term MMFs or standard money market; MMFs with constant net asset value (CNAV) and invested in public debt up to 99.5 percent without any special conditions relating to the credit quality of the securities or the domiciliation of their issuers; and MMFs with low volatility net asset value (LVNAV).
Funds with CNAV and those with LVNAV can only be short-term MMFs. Managers are strictly supervised: they must calculate a ‘shadow NAV’ and implement specific stress tests or even procedures for NAV suspension under certain conditions.
Contino explains that the regulation is designed to provide better protections around MMFs, preserving the stability of the EU markets.
“If there is an issue with MMFs it should be contained to that market,” he says. “It provides transparency to the market around what assets a fund can hold through the requirement for reporting on stress testing and internal quality assessments, all designed to prevent a potential liquidity crisis.”
He adds that one implication of the regulation is that some CNAV funds could be reclassified as LVNAV or VNAV funds.
"It provides transparency to the market around what assets a fund can hold."
David Contino, Corporate Trust expert, Deutsche Bank
This is significant for ILS funds and ILS debt issuers because they usually invest the collateral they hold in MMFs. While ILS investors may be comfortable taking on insurance risks and cat risk in particular, they may not be aware of the latent risk inherent in this process. “They need to be aware of where that money ends up,” he says.
Under the new regulation, CNAV funds as they are today will no longer exist and while public debt CNAV and LVNAV funds offer relatively close substitutes, the reform offers ILS funds and ILS debt issuers an opportunity to review their strategy around which MMFs they use, Contino says.
Puneet Anand, vice president covering MMFs for Corporate Trust at Deutsche Bank, echoes that sentiment, adding that while most investors will notice little difference—particularly as many of the guidelines formalised under the reform are already required by the rating agencies and liquidity-saving measures were already a feature of the UCITS regime—it is important investors understand differences introduced by the regulation.
Investors should seek to understand when a liquidity fee or redemption gate might occur; what the threshold is for a public debt CNAV and LVNAV fund to trade at a CNAV; and how the fund’s portfolio may change.
Anand says that many ILS funds and ILS debt issuers invest in US domestic MMFs, and may not need to change this strategy. But those who invest in offshore funds, designed to invest in treasury notes only with no repurchase agreement (repo), could be compelled to change because these funds may be forced to introduce the use of repo to meet overnight liquidity limits.
“Some funds prefer to use offshore treasury funds without repo and that may need to change going forward,” he says, explaining that, unlike SEC Rule 2a-7 in the US, which allows US treasuries to be treated as daily maturing assets for portfolio liquidity requirements, the EU MMF regulation will permit these securities to count towards weekly liquid assets only under certain limits and conditions.
Contino adds that clients in Europe will need to look at individual transactions and consider the basis on which the investment choices have been agreed. They may also want to seek an audit opinion on cash equivalent status.
“They need to be clear about what they have decided to do and why,” he says. “There may be scenarios where they are investing in a very specific way and they need to consider how comfortable they are accepting the changes to the MMFs.
“There are no rights or wrongs; ultimately the regulation seeks to provide investors greater protections, but education is certainly required.”
David Contino is director, client service head for Corporate Trust’s Escrow and ILS business at Deutsche Bank.
Puneet Anand, CFA, is a vice president covering MMFs at Deutsche Bank.
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