The Importance of Definition

Money market funds were first created in the US in the early 1970s, as a result of regulation limiting the interest payable on bank deposits. These funds rapidly grew into a prominent sector, as they responded to investor demand for more competitive rates of return. In addition, money market funds provided security and liquidity, as well as simplified accounting through their constant net asset value (NAV).

Amendments were soon made to the 1940 Investment Company Act, the US mutual funds legislation, in order to include money market funds. This resulted in the development of Rule 2a-7 of the Securities & Exchange Commission (SEC), directly regulating money market funds in the US. Since the introduction of this Rule in 1983, the US money market fund industry has grown by over 20 times to approximately $3.7tn.

The development of money market funds in Europe

Money market funds in Europe developed slightly later than in the US, but for similar reasons. The first European money market funds appeared in France in the early 1980s, following regulatory restrictions on interest payable on deposit accounts. Unlike the US, French money market funds operate with a variable NAV, although they are broadly managed with the objective of providing a constantly increasing NAV. A small part of the market consists of ‘dynamic’ money market funds, which frequently seek to obtain additional yield by investing a minority percentage in riskier assets such as alternatives and credit instruments.

Smaller but more bespoke industries have also developed in other jurisdictions. The German money market fund industry (with around €75bn invested) is predominantly retail oriented, and these funds are defined by the core objective of performing in line with a money market benchmark. The strategies operated in order to achieve this performance may vary beyond investment in money market instruments. Industries of a similar nature have also developed in Italy (around €60bn) and Spain (around €30bn).

In the UK, both the investment management and life assurance industries provide money market funds. These funds must invest at least 95% of assets in money market instruments, loosely defined as cash or near cash. On average, these funds have placed a slightly greater emphasis on achieving yield than the French variable NAV funds.

Impact of the liquidity crisis

The European money market fund industry therefore includes several fund types. These funds may have varying objectives, or simply a different emphasis on the same objectives of capital preservation, liquidity and yield. Consequently, the national industries across Europe are not necessarily directly comparable, even though all of their funds share the same label of ‘money market funds’.

Despite this diversity, the European money market fund industries operated independently and without issue until the events across financial services in September 2008. With the net asset value of The Reserve’s money market fund in the US dropping below par and the suspension of several European dynamic money market funds, investors became concerned about the variety of products referred to as money market funds.

In some instances, shareholders withdrew monies because of fears over the security of their investment. Although these fears were generally unfounded, this action was taken at a time when the solidity of financial services firms was under extreme scrutiny. As each redemption request was received, the absence of market liquidity made processing more difficult, thereby putting downward pressure on prices and generating pro-cyclical risk.

The US authorities quickly implemented a number of specific actions to aid their money market fund industry. These, together with the broader and coordinated actions of governments across the globe, proved sufficient to placate any concerns of investors in money market funds.

The events experienced by the European money market fund industry in autumn 2008 were sufficient to warrant calls for action. The De Larosière report on the future of European financial regulation and supervision identified the need for 1) a common EU definition of a money market fund and 2) a stricter codification of the assets in which they can invest, in order to limit exposure to credit, market and liquidity risks.

Working towards a common definition?

Following the publication of the De Larosière report in February 2009, specific action has been taken in two European jurisdictions. The French regulator (L’Authorité des Marchés Financiers, or AMF) has issued a consultation on proposals strongly limiting the duration, credit and market risk of money market funds. The Spanish regulator (the Comisión Nacional del Mercado de Valores, or CNMV) has already put in place similar legislation. Other individual regulators may similarly follow suit, and the insurance trade body in the UK (Association of British Insurers, or ABI) recently consulted on proposed modifications to its money market sector classification.

However, there has not as yet been any proposal for pan- European regulation which would define money market funds, as there is in the United States with Rule 2a-7. In the absence of such, the European Fund and Asset Management Association (EFAMA) and the IMMFA have commenced work to agree a pan-European definition of a money market fund. This definition will impose quantitative restrictions on money market funds in order to limit their exposure to credit, market and liquidity risk. This is a significant enhancement when compared to the current situation.

Investor benefit

Prudent cash management is now more important than ever before, and money market funds provide a viable means of obtaining both security and liquidity. Investors in all money market funds, irrespective of the type, obtain the benefits of pooled investment: participation in a more diverse and high quality portfolio than they could otherwise obtain individually. Money market funds also have the protections accorded by the UCITS Directive, including assets held by a separate custodian and the services of an independent auditor.

The implementation of an industry definition of a money market fund will provide additional tangible benefits to investors. This definition should further clarify the type of fund that an investor is purchasing, and ensure that there is consistency across funds of the same type. As such, investors should be able to more easily understand the nature of the fund in which they have invested and compare like with like.

Given the breadth of choice available in the European money market fund industry, all investors should be able to identify products which are consistent with their objectives and risk appetite, and fulfil their cash management needs. The provision of a pan-European definition of a money market fund will facilitate this choice for investors and should therefore help improve the cash management activity.