Liquidity Funds Pass the Stress Test

The tightness in credit that has starved the world's financial markets of liquidity has severely impacted certain types of money market funds. For instance, many enhanced yield and dynamic funds that invested in longer-term securities seeking higher total returns, have hit trouble. The experience of other money market funds, however, has been very different.

The money market funds operated by members of the Institutional Money Market Funds Association (IMMFA) have a different investment model and different targets. Since the sub-prime crisis in the US that has cramped up credit markets, IMMFA members' Qualifying Money Market Funds (QMMFs) have been able to consistently deliver liquidity at a time when this has become the most important commodity in the world's financial markets. It is no surprise, therefore, that they are attracting even more investment than before the crisis.

"Our members' funds have seen record growth in Euro terms. Despite a few funds having had credit difficulties that needed sponsor support, money has been pouring in. Amidst the turmoil they have proven that they can continue to produce what very few funds can – high levels of liquidity," says Donald Aiken, chair of IMMFA.

IMMFA, established in 2000, is the trade association for providers of triple-A-rated QMMFs. It now has 37 members and covers almost every major provider outside the US.

As of June 2008, funds under management stood at €411.6bn, as a result of growth exceeding 35% in the last year. So, what is it that makes IMMFA members' funds so different?

"Our funds are simple products," states Aiken. "They buy high-quality money market instruments that repay at parity with the intention of holding them until maturity. This means that to achieve this they must maintain strong liquidity by having a high proportion of assets maturing on a day-to-day basis."

As a result of this investment policy, IMMFA members are not required to price their funds on a mark-to-market basis, as is the case with other types of money market fund, but instead price their assets on a straight line amortised accounting basis. They do regularly mark-to-market their assets as a secondary check but do not automatically have to sell them in response to reaching pre-set variance limits. This gives these funds some protection in general market turmoil conditions.

A long-term view of liquidity

The asset distribution within IMMFA members' funds is now more conservative than when the current financial crisis hit last summer. The unique characteristics of these funds mean that they can quickly vary their asset allocation in response to the needs of their investors. Typical holdings comprise overnight deposits (27%), certificates of deposit (24%), commercial paper including ABCP (35%) and floating rate notes (14%).

If additional liquidity is needed a fund can rapidly increase its proportion of overnight deposits from maturing assets. As a result, the amount of certificates of deposit and commercial paper it holds, including ABCP, will naturally fall. Furthermore, IMMFA members have been working hard to find other ways to enhance liquidity provision in their funds.

This drive for additional liquidity is not a knee-jerk reaction to the turmoil in financial markets, but part of the long-term development efforts among funds that prioritise predictability, transparency and investor confidence.

"Liquidity is the theme in the market now, but it is not new for us. It has been our focus for the last two years. Our product is all about confidence, as people can take their money out at any time," says Aiken. "Other money market funds hit problems during the turmoil because they couldn’t liquidate, except at fire sale prices, but we don't have that problem. We were already looking at ways to increase liquidity before the crisis hit."

In fact, enhancing liquidity is one of four key strands to IMMFA's development efforts, all of which have been accelerated by the financial crisis. Its drive to enhance transparency of information by providing more regular updates on fund performance with a shorter time lag has been stepped up, and is important if, as IMMFA predicts, banks turn in greater numbers to liquidity funds. Another key project is enhancing the use of repo, by putting the shares investors have bought on Euroclear to bring more flexibility to their use.

Among Aiken's key goals now is to show the market that this drive to innovate in the pursuit of liquidity is not the result of any run on IMMFA members' funds since the credit crisis began, but a projection of the fundamental principles on which the funds are based. The problem he sees IMMFA members facing, however, is that their funds are all too often lumped together with enhanced yield and other money market fund structures with different goals, and which respond in a different way to changes in market conditions. Aiken wants clarity and he believes the move towards common definitions to delineate liquidity funds from their yield-chasing cousins will be an important step forward in the development of the market.

Tackling terminology

Some money market funds that chase yield have grabbed the headlines as they hit the mire of the liquidity crisis, but while these may be referenced in the same terms as IMMFA members' funds they have very different investment objectives and often use a wider range of investment instruments, including structured products (such as asset-backed securities), derivatives and non-investment grade securities.

Aiken is not criticising these investment structures per se, but is keen to highlight that they behave very differently to the IMMFA members' funds that have performed well over the last year, hence his desire for common definitions. He notes that misunderstandings have arisen because of this lack of clarity, notably in August 2007, when IMMFA funds increased the proportion of overnight deposits compared to commercial paper. Some mistook this for an investor hit on the funds, whereas in reality the funds were increasing their liquidity.

"There have never been any runs on the funds during the crisis," states Aiken unequivocally. The current lack of clearly defined terminology has also had repercussions at regulatory level, though progress has been made over the years.

"The IMMFA was set up because the lack of standard definitions and naming conventions had led to unintentional prejudice. For instance, under Europe's old Capital Adequacy Directive for banks, our funds were five times more expensive in capital terms than the interbank market. The Capital Requirements Directive has now created a level playing field and in the UK the funds are also recognised as an intraday liquidity investment – but in Europe the term 'money market fund' covers a wide range of funds, including those seeking enhanced yield. Because of the crisis it is time for a pan-European definition to clarify the different funds," adds Aiken.

Perhaps the diverging performance of different fund types in response to turbulence in financial markets will add momentum to the effort to draft new definitions.

"Out of every bad thing comes something good. The financial crisis has focused minds on finding common ground and common solutions, and there is progress on the definitions because of it. More importantly, it was a real situation stress test for our products, and they appear to have passed it," he remarks.

When corporates have a better idea of what they are buying and which money market funds suit their specific needs, IMMFA members expect to see growth in investment accelerate even further.