The journey to implementation for the EU's money market fund (MMF) regulation started over a decade ago, following the global financial crisis, when regulators reassessed the systemic risk that MMFs had on the wider financial system (see chart 1). Given that the industry has demonstrated good retention of assets under management, the response from investors suggests that the actual transition has been relatively low-key. The next hurdle is in July 2022, when the European Commission (EC) is scheduled to publish a review of two of the three short-term MMF categories introduced in the legislation.

Following the 2007 disruptions and failures of short-term fixed income funds, some labelled as "dynamic" MMFs, the EU decided to remedy its lack of common legislation for MMFs. It drafted regulations aimed at increasing transparency and harmonization, enhancing liquidity, and protecting MMF investors, while curtailing the potential for troubled funds to trigger systemic risk.

CESR introduced two common definitions in 2010 with many investment guidelines very similar to those of S&P Global Ratings, for example, weighted-average maturity and final maturity limits, minimum level of credit quality, stress testing, and diversification.

The EU published its MMF regulation in June 2017, with an effective date of Jan. 21, 2019 applicable to most existing EU-domiciled funds. Regulatory compliance with the new rule was later extended to March 21, 2019 for a few euro-denominated MMFs. Implementing the new regulation had no rating impact on rated MMFs.

EU MMF Regulatory Metrics Are Similar To Ours

The EU's guidelines introduced three categories of short-term MMFs (ST MMFs) and one category of standard MMFs. Table 1 shows their respective requirements.

Table 1

We assign our fund ratings to approximately 600 funds globally under our principal stability fund rating (PSFR) and fund credit quality (FCQ) and fund volatility ratings (FVR) methodology. These criteria are used for funds in the three short-term MMF categories and the standard MMF category. Metrics considered include the minimum standards of credit quality, diversification, net asset value (NAV) deviation, weighted-average life, and cure periods. Our MMF criteria guidelines are mostly within those of the regulation and we apply monthly stress tests.

The Reform Triggered A Shift Among Rated MMFs

Before the reform, 4% of the EU-domiciled MMFs we rated were standard MMFs--the rest were short-term MMFs. By March 31, 2019, this had changed, so that:

• 70% of our rated MMFs were low volatility NAV (LVNAV);
• 15% were short-term VNAV (ST VNAV);
• 11% were public debt constant NAV (CNAV); and
• 4% were standard VNAV.

While some asset managers have launched new MMFs to complete their product ranges, others have split their core funds. We have rated 18 new MMFs since the EU published its MMF regulations in June 2017. Most of these newly rated funds were ST VNAV funds, followed by public debt CNAV and LVNAV MMFs in equal numbers.

We attribute the popularity of ST VNAV funds, in part, to the "sunset" clause in the EU MMF reform regulation. This clause requires the EC to review the safety and adequacy of the public debt CNAV and LVNAV fund categories by July 21, 2022. These fund types use amortized cost accounting valuations. If the review views them unfavorably, the EC could decide to withdraw these fund types. Therefore, some fund sponsors have elected to launch ST VNAV funds instead, as a pre-emptive tactic and to develop the fund's track record, because ST VNAV funds will not be part of the review.

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The U.S. And EU Markets Have Diverged

The period since the reforms were implemented has seen sharp differences emerge between Europe and the U.S. In the U.S., MMF investors shied away from liquidity fees and redemption gates, which are less familiar concepts. EU investors were less sensitive to these risk management tools because they are used in the EU-regulated mutual funds known as Undertakings for Collective Investments in Transferable Securities funds (UCITS).

Many U.S. investors transitioned from "prime" credit MMFs into public debt CNAV funds, which invest primarily in government debt. U.S. institutional investors seem to have chosen government MMFs because this fund type was the only structure that provided a constant NAV. By contrast, in the EU, investors in rated funds favored the LVNAV fund structure over public debt CNAV and ST VNAV funds.

LVNAV funds are complementary for the market

The LVNAV fund category in Europe is a hybrid between a traditional CNAV (which offers a constant NAV, for example, $1.00, £1.00, or €1.00 per share or unit) and a VNAV fund. A VNAV fund uses a full mark-to-market approach to the valuation of securities. In the past, short-term MMFs used amortized cost accounting to value securities that had maturities of up to three months and for many CNAV MMFs, the entire portfolio was valued using amortized cost. LVNAV funds take a more-conservative approach; securities in an LVNAV fund can only be valued using amortized cost accounting if they mature in 75 days or less. The LVNAV fund is thus a hybrid that uses a more conservative pricing method.

We consider the development of the LVNAV fund structure as positive because it enabled traditional CNAV MMF investors to continue to invest in a fund that provided a constant share or unit price of 1.00, as long as the fund did not breach the various NAV or liquidity triggers. EU institutional investors such as corporate treasurers and pension funds place a high value on the ability to transact at a constant unit or share price of 1.00 for cash management purposes. In their view, this outweighs the risk of liquidity fees or redemption gates.

In addition, LVNAV funds offer asset managers greater diversity in terms of asset class and credit quality. Where public debt CNAV funds can only invest in government or government-related entity debt, LVNAV funds are more flexible and can invest in a wider range of credit securities.

Finally, the LVNAV fund category has proved quite versatile. Investors can choose a distributing (constant NAV) or accumulating (variable NAV) share LVNAV fund. Because of the EU's ban on reverse distribution mechanisms (RDMs), investors in euro-denominated short-term MMFs could no longer invest in a fund that provided a constant share or unit price of €1.00. However, many of these investors were able to participate in an LVNAV fund via a de-accumulating share class, which accommodates the current negative interest rates in Europe. The NAV per share is variable and declines from a high value, for example, €100, €1,000, or €10,000.

When interest rates eventually turn positive in Europe, and provided the LVNAV fund type continues to exist, these investors should be able to migrate back into a distributing share class valued at €1.00 per share. Since the regulation's effective date (March 21, 2019), we understand that most traditional CNAV short-term MMF investors have remained invested in a fund that has similar features to a CNAV fund.

Stable Net Asset Trends Suggest A Successful Regulatory Transition

During the past year, net assets have not significantly changed, indicating that the transition to the new regulation has gone relatively smoothly.

In January 2019, when the regulators announced their decision to ban RDM under the reform, they allowed fund sponsors two months to comply with the new regulation (see "EU-Domiciled Money Market Funds Still Scrambling For Regulatory Approval Following Reforms," published on Jan. 21, 2019). Investors in short-term euro-denominated MMFs (ST EUR MMFs) would have to migrate to a de-accumulating share class from a distributing share class. At the time, net assets for rated ST EUR MMFs saw a 15%-20% decline compared with the end of 2018. It was not yet clear how much of this decline was due to the ban on RDM, and how much to other cyclical and operational factors.

As of March 29, 2019, net assets for rated ST EUR MMFs had rebounded to -9% compared with year-end 2018 (to €83.3 billion from €91.8 billion). This indicates the importance and continued demand for ST EUR MMF products after the reforms, despite the negative yields in Europe.

Longer-term trends show a more-complex picture

Over the past five years, we have seen a mixed picture among the three major currencies--euro, sterling, and U.S. dollars. While net assets held in rated short-term MMFs denominated in sterling and U.S. dollars have trended higher, net assets in euro-denominated MMFs came under pressure as a result of negative yields and were therefore typically flat. We also saw a sharp increase in the number of U.S. dollar- and euro-denominated short-term MMFs, causing the average fund size to shrink. Meanwhile, the number of sterling-denominated short-term MMFs has been relatively stable, but it saw an increase in net assets due to organic growth and market appreciation.

The large increase in the number of rated short-term MMFs denominated in euros suggests that investors' interest in investing in a pooled structure and diversified investment product has not waned. In our view, investor demand for short-term MMFs may also have been supported by banks seeking to avoid holding large amounts of short-term cash on their balance sheet, as such liabilities may incur a costly capital charge.

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Concentration among the rated U.S. dollar- and euro-denominated short-term MMFs domiciled in Europe has clearly declined over the past five years since the end of March 2014. Net assets held by the five largest funds in these currencies, as a proportion of total net assets, have fallen by 10%-20%. By contrast, the top five fund concentration for sterling-denominated short-term MMFs has stayed flat, partly as a result of the growth in net assets.

This suggests that investors and fund sponsors have embraced the new regulation and the demand for these products has not abated. The division of short-term MMF assets into the three fund categories has also helped to reduce fund concentration among our rated ST MMFs. The relatively lower average fund size and top fund concentrations should help to reduce any systemic risk in the market.

Not All Regulated ST MMFs Are The Same

The new regulations provide a good risk framework and greater transparency and the MMF industry has become more homogeneous. Nevertheless, we still see some differences in approach and the industry faces new challenges.

Some differences in the amount of short-term liquidity held

We would expect EU MMFs to hold a reasonable buffer (approximately 5%) above any portfolio liquidity metric, to avoid the potential reputational risk of failing an enforced regulatory metric. Both U.S. and EU regulators have set overnight and weekly liquidity limits. For example, U.S. fund managers are required to hold at least 30% of the fund's assets in weekly liquid assets (that is, highly liquid assets that could be converted to cash within five business days). We are seeing divergence among funds about how much liquidity to hold.

The managers of our U.S.-domiciled rated funds typically hold between 40%-50% in weekly liquid assets. Given that many of the regulated short-term MMFs in the U.S. are government debt MMFs, we believe this high level of one-week liquidity may be due to the nature of the investments.

We have found that one-week liquidity at European funds is generally lower, although of course, it's still early days for the new regulations. On average, our rated public debt and LVNAV MMFs in Europe are holding 38.3% in weekly liquidity for euro-denominated short-term MMFs, 35.89% for sterling-denominated, and 44.83% for U.S. dollar-denominated, as of March 29, 2019.

Holding more short-term assets can mitigate certain market risks, but will have the knock-on effect of compressing yields. Given the overnight and weekly liquidity requirements prescribed in the regulation, we anticipate that the weighted-average maturity of some funds will trend lower over the short term. Once interest rates are trending upward, we would expect opportunistic plays (for example, MMFs buying one-year floating-rate notes) to offset the yield compression created by daily and weekly liquidity levels.

Higher liquidity requirements may also present fund managers with another problem: a lack of bank counterparties. Our recent conversations with our rated sponsors suggest that managers are contemplating adding more bank counterparties to ensure that they have access to sufficient overnight and weekly liquidity. Generally, to comply with the short-term liquidity requirements, managers are likely to invest in bank deposits and reverse repurchase (repos) securities with banks. The alternatives are short-term bonds, the supply and availability of which is not as regular, or treasury bills, which typically have lower yields but greater liquidity and availability. We anticipate that the new regulation could lead to portfolios that are more concentrated in the banking sector.

Fund managers can no longer rely on external assessments of a security's credit quality

The new regulation requires asset managers to conduct their own internal credit assessments, preventing any overreliance on credit ratings provided by rating agencies. Depending on the asset manager, we could see significant differences in the assessment of a specific investment's credit risk. For example, depending on a manager's internal credit assessment, public debt from EU sovereigns that S&P Global Ratings rates less highly may be included in a portfolio. As always, it will be important for investors to verify the type and credit quality of the underlying fund assets.

The new regulation imposes compliance with various guidelines and risk measures, but is not a substitute for fund ratings. For example, we carry out weekly or monthly surveillance to detect any issues early, while the newly regulated funds will report to regulators only quarterly.

For each of our rating criteria metrics, we have cure periods in place. The more important the breach, the shorter the cure period. We could place a fund rating on CreditWatch if there is an imminent danger to the NAV. We would lower the fund rating only if the fund remained in breach of our criteria following the cure period or is no longer expected to be in line with criteria.

Higher hurdles for the smaller asset manager

The barriers to entry are much higher now because of the new requirements, which include conducting an internal credit assessment, managing liquidity and NAV properly, reporting quarterly, undergoing biannual stress testing, and identifying the underlying clients in a fund. In addition, fund managers require additional risk and compliance resources to monitor compliance with these guidelines.

This is a concern for smaller asset managers. For example, smaller asset managers that lack a fully staffed credit research department or large funds may have difficulty entering and competing in the newly regulated market. For asset managers in the U.K., the outcome of the Brexit negotiations may impose further costs and disruption. Economies of scale will be of more importance, as managers seek to offset these additional costs. This will give larger asset managers an advantage and could prompt further consolidation among the smaller fund groups.

The Story Has Not Yet Ended

The new regulation is not yet finalized. The EC is expected to undertake a review of the EU MMF regulation by July 21, 2022. It will present a report on the feasibility of establishing an 80% EU public debt quota for public debt CNAV MMFs. The report will also include the EC's assessment of whether the LVNAV MMF model has become an appropriate alternative to non-EU public debt CNAV MMFs.

Given how many historical CNAV and ST VNAV MMF investors have moved into the public debt CNAV and the LVNAV fund categories, it will be difficult to eliminate any of these fund categories. We will have to see if the three years before the review provide sufficient data for a full and detailed analysis.