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Regulatory Watch

Cash Managers Await Word on Reverse Distribution for Euro MMFs

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May 03, 2018

Negative rates mean LVNAV funds in euros “untenable” if share cancellation not allowed

Fri Reg and Accting - Law BooksCash investment managers this month are waiting to hear if European regulators will stick with their opposition to so-called “reverse distribution mechanisms” (RDMs) in money market funds (MMFs). Investors may hear something in the next week, according to some sources. The issue is critical because RDMs allow euro-denominated MMFs to operate in a negative yield environment but maintain a stable net asset value (NAV) and pay dividends. To do this, the funds cancel some shares held by investors.

An investment manager considering low-volatility NAV funds (LVNAV)—one of the structures allowed under new European money market rules that go into full effect next year—brought up the issue of reverse distribution at a recent meeting of NeuGroup’s Treasury Investment Managers’ Peer Group sponsored by BlackRock. BlackRock is among the firms that started offering RDMs when short-term rates in Europe turned negative in 2014.

Roger Merritt, global head of the funds ratings group at Fitch, said “a lot of treasurers found the LVNAV structure attractive” because in low volatility environments they resemble stable value NAV funds. And while that may remain true in areas with positive yields, Mr. Merritt said the structure will be “untenable” if European regulators bar reverse distribution in areas with negative rates. That’s because LVNAV funds that deviate from 1.00 by more than 20 basis points will resemble variable funds, opening the door to liquidity fees and redemption gates under certain circumstances.

Mr. Merritt said MNCs with euro-denominated cash assets may have to consider options that require changes to investment policy guidelines that are already in flux because of European money market reform. He said some investors may end up putting cash in variable funds or bank accounts, noting the latter option will require having the “proper counterparty risk controls in place.”

Of course, the issue would be moot if negative rates turn positive. A recent Fitch report says the firm “forecasts a eurozone policy rate of 50bps by end-2019. This development is significant: should short-term rates stabilize at positive levels then euro LVNAV funds may become a possibility. With sustainable positive yields, euro LVNAV funds would not need to use the share cancellation or reverse distribution mechanisms that are currently subject to regulatory uncertainty.”

That uncertainty and fear turned up a notch this year when the European Commission sent a letter to the European Securities and Markets Authority (ESMA) confirming that reverse distribution or cancellation of fund units is not "compatible with the new regulation.” But the final word has not yet been heard on the issue, with one BlackRock executive telling NeuGroup members that regulators are still “fighting it out in Brussels.” Stay tuned.

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