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Investment Management

Brexit Clouds Europe's MMF Reform Prospects

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July 01, 2016

European MMF reform approaches important stage but Brexit adds uncertainty.

EU FlagThe European money market fund (MMF) reform effort has made recent strides forward, but the United Kingdom’s June Brexit vote means there’s no time for dilly dallying or risk the initiative falling by the wayside.

The European Union (EU) actually took up MMF reform before the US, which will place new restrictions on prime MMFs starting in October. However, instituting regulations across all 28 member countries is a laborious process, often hindered when the EU’s revolving six-month presidency is occupied by a member with other priorities.

“The process is in many ways more complex than the US system, because they have to get so many countries to agree to the changes,” said Jerry Klein, head of Treasury Partners’ corporate cash management group.

Since the start of the year through June, the EU Presidency has been held by the Netherlands, which has made MMF reform a priority. So far, Europe’s major economic powers, including Germany, France, the UK and Ireland all back the general thrust of the proposed changes, and they’re seeking to garner the remaining members’ support.

Two of the EU’s three rulemaking bodies, the EU Commission and the Council of Ministers, have issued draft versions of the MMF regulations, and the European Parliament is anticipated to issue its version by autumn, said Stephen Baseby, associate policy and technical director at the Association of Corporate Treasurers. A “trialogue” discussion will follow, in which the parties hammer out a compromise, he added, and given the fixed timeframe to implement the rules they could become effective by the start of 2019.

Mr. Baseby noted that the drafts have many of the same components, which closely resemble the US’s new regulations. The EU’s constant NAV (CNAV) funds would house government bonds, similar to government-only MMFs in the US that also have a fixed NAV. Variable NAV (VNAV) MMFs already exist in Europe, primarily domiciled in France, and they will be able to continue to operate as such.

The drafts also create a sort of hybrid, called the low volatility NAV (LVNAV) fund, which can use the same amortized cost method as CNAV funds. However, they must maintain a residual maturity of up to 75 days and the underlying value of their assets cannot vary by more than 20 basis points from the value according to the amortized cost accounting method. In those instances, the fund would effectively flip to VNAV.

“Even though its NAV could go up or down, the likelihood of that occurring would be very slight—only a major market trauma, which is what governments would like to see put in place,” Many of the funds only see a one- to two-basis-point deviation daily, so the thought of 20 is far away,” James Greenway, director of business development at Institutional Cash Distributors.

There are still significant details to be worked out, however. For example, the European Parliament had sought to phase out CNAV funds, which make up half of the $1.14 trillion European MMF market, by requiring them to convert to VNAV when the rule becomes effective. That position is opposed by jurisdictions where many such funds are housed, including the UK, Ireland and Luxembourg. The European Parliament has also sought a five-year “sunset” clause on LVNAVs.

The Dutch Presidency and a subgroup of the European Parliament’s Council on Money Market Funds have issued a compromise draft aimed at making outstanding issues more palatable. “The most recent adaptation of the legislation came out in April, and it set the ground rules for what they see as the best solution,” said Mr. Greenway.

The Presidency’s proposal would give CNAV funds two years to switch to lower risk public debt would face a review in five years instead of lapsing.

A significant change from earlier drafts, Mr. Greenway said, is giving the fund provider the ability to implement its own internal ratings; it will then have to provide full transparency to clients who pay for the services of credit rating agencies to rate its fund. The EU previously wanted to exclude those ratings, given the cloud over the agencies in the wake of the financial crisis starting in 2008. Funds will also be allowed to develop their own rating systems.

The Presidency draft describes gates and fees that resemble US rules. If liquid assets fall below 30% of total assets, the fund’s board can choose from several options. It can impose liquidity fees of up to 2% on redemptions or institute redemption gates that limit the number of shares in CNAV or LVNAV MMFs to be redeemed in a trading day to a maximum 10% of shares for up to 15 days. The board can also suspend redemptions for up to 15 days, or it can take no immediate action.

European MMF reform is progressing as the funds’ popularity has grown since the financial crisis and the advent of Basel III, which makes demand deposits much less attractive for banks to hold. Corporate treasuries in Europe are now finding it extremely difficult to place short-term cash even with the strongest relationship banks, Mr. Greenway said, resulting in much more interest in MMFs and separately managed accounts (SMAs).

“The importance of money market funds is likely to increase over the next two years,” Mr. Greenway said. But the Brexit vote June 23 may throw a wrench into the drawn out MMF reform process. The Netherland’s Presidency term expires at the end of June, and Slovakia and Malta, not anticipated to prioritize MMF reform, will take the next two slots. Any momentum lost during their reign could be recaptured when the United Kingdom, a strong proponent of the MMF market, is scheduled to fill the role at the start of July 2017. Post-Brexit, however, the UK’s role in such rule making is unclear. In addition, majorities in at least eight EU countries, including heavy hitters such as France and Germany, wants referendums on whether to remain in the union, according to a recent poll by Ipsos Mori.

“With the recent Brexit vote and the impact of the UK on the union, priorities will no doubt change again,” Mr. Greenway said. “That’s still evolving, but there is potential for the EU to push this legislation through sooner, perhaps by the end of 2016 or first quarter of 2017. There will be pressure from all EU institutions to show that the political inclinations of member states is status quo post the UK referendum.”

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