Deutsche Bank AG: New EU money market fund regulation: Will growth continue?

Tickers: DB
EU Monitor

Global financial markets

Top Company Interviews

Microsoft Corporation
Intel Corporation
Pfizer, Inc.
General Electric Company
Wal-Mart Stores, Inc.
September 13, 2017

New EU money market fund regulation: Will growth continue?

Author Heike Mai*

+49 69 910-31444

heike.mai@db.com

Editor

Jan Schildbach

Deutsche Bank AG Deutsche Bank Research Frankfurt am Main Germany

E-mail: marketing.dbr@db.com Fax: +49 69 910-31877

www.dbresearch.com

DB Research Management Stefan Schneider

*The author thanks Julia Breuing for her valuable research assistance.

In the past three years, European money market funds (MMFs) have grown by an impressive EUR 260 bn to EUR 1.16 trillion in invested assets. MMFs have attracted large inflows, which have particularly gone into non-euro assets benefiting from rising USD yields. In addition, the appreciation of the dollar has led to higher assets under management (AuM) measured in euro. Yields on euro assets have been low or even negative but in line with alternative money market investments.

EU regulation issued in June 2017 and taking effect in 2018 aims at bolstering MMFs against financial distress. It introduces tighter rules on portfolio diversification, liquidity and transparency. Sponsor support is explicitly prohibited. Newly introduced MMF categories are likely to accommodate current investor preferences as regards accounting methods (variable or constant net asset value) as well as investment objectives (public or private debt) without triggering major market changes.

By contrast, the US MMF reform of October 2016 led to fundamental adjustments in the market. USD 1 trillion have been shifted from prime to government MMFs, driven by prevailing investor preferences for constant net asset valuation and lighter regulation on fees and redemption gates.

A "hard Brexit" could trigger a repatriation of GBP-denominated and UK-focused MMFs with approximately EUR 213 bn in AuM. Furthermore, a proprietary UK regulation similar to old EU rules could spark regulatory competition for the offshore USD MMF market. Currently, euro area MMFs manage EUR 326 bn in USD-denominated assets. USD- and GBP-denominated funds are predominantly domiciled in Ireland and Luxembourg.

Euro area MMFs attractive despite low interest rates

Assets of euro area MMFs in EUR bn (left); 3-month LIBOR in % (right)

1,400 7

1,200 6

1,000 5

4

800

3

600

2

400 1

200 0

0 -1

06 08 10 12 14 16

Q2 17

MMF assets by denomination

3-month LIBOR

EUR USD

GBP Unknown

EUR LIBOR USD LIBOR GBP LIBOR

Annotation: Due to statistical reclassifications, AuM were reduced by about EUR 194 bn between Q2 2011 and Q1 2012, and increased by EUR 69 bn in Q1 2014.

Sources: ECB, W EFA, Deutsche Bank Research

Net inflows in past three years 1

EUR bn per quarter, Q3 2014 - Q2 2017 50

40

30

20

10

-

In June, the EU issued a new regulation on money market funds (MMFs) which will be phased in over the coming 18 months.1While acknowledging the importance of MMFs for short-term finance, legislators aim to mitigate the risks which MMFs can pose to financial stability in times of crisis. Regulation comes at a time when euro area MMFs, which more or less represent the total EU MMF industry, have long recovered from the decline experienced after the financial crisis. In the past three years, assets under management (AuM) have grown by EUR 260 bn to EUR 1,158 bn at the end of Q2 2017.

European MMFs have grown despite low interest rates

-10

-20

-30

-40

2014 2015 2016 2017

Flows from non-euro area investors Flows from euro area investors Total flows

Net inflows of EUR 208 bn accounted for most of the increase in AuM during the past three years. Investors from outside the euro area bought MMF shares worth EUR 105 bn. It can be assumed that these investors mostly placed USD or GBP funds. With increasing short-term USD rates and thus positive returns of USD- denominated MMFs, inflows in this segment are no surprise. However, euro area investors also invested EUR 94 bn (net) of fresh money despite low and even negative euro money market rates.2But cash-rich investors which need to hold short-term liquidity do not have many alternatives. For companies, interest rates on bank deposits are still slightly positive on average, but individual investors are facing negative deposit rates. Moreover, prudential regulation (NSFR3) lets banks

Sources: ECB, Deutsche Bank Research

More money received from residents

than invested in debt issued by residents 2

Net flows of euro area MMFs in EUR bn, accumulated in Q3 2014 - Q2 2017

250

200

150

100

50

-

Asset flows Liabilities flows

shy away from large wholesale sight deposits. Not least, MMFs still offer investors liquidity and risk reduction through portfolio diversification.

Admittedly, the growth in AuM has not only been due to net inflows. Over half of euro area MMFs' assets are invested in instruments denominated in USD, GBP or other currencies. Thus, exchange rate fluctuations impact the AuM when measured in EUR. Based on a back-of-the-envelope calculation, the EUR depreciation against the USD in the past three years has inflated the EUR value of USD assets by about EUR 53 bn. But the opposite development vis-à-vis the GBP has reduced the FX inflation of total assets to EUR 30 bn. As there were no statistical reclassifications, asset revaluations may be the reason for the remaining increase in AuM.

On the asset side, euro area MMFs have invested most of the net inflows in debt issued by non-residents (EUR 159 bn), and only EUR 46 bn in debt issued by euro area residents. Given that resident investors had placed EUR 94 bn, MMFs channelled about half of this money to non-resident debtors. These figures also suggest that EUR-denominated MMFs have invested to some degree in higher- yielding USD or GBP assets, as issuer residency and debt currency are usually "the same". However, the currency of investments can only be roughly estimated

(money invested in... )

(money received from... )

due to a lack of comprehensive data.

No geographical allocation Outside euro area

Euro area

Sources: ECB, Deutsche Bank Research

EU regulation introduces new MMF categories

The new EU regulation aims at ensuring the liquidity of MMFs in order to protect investors and to prevent contagion of the wider financial system in case a fund gets into difficulties. Tighter rules on portfolio diversification and enhanced liquidity requirements for all MMFs will strengthen their ability to always and fully meet investors' redemption requests. Sponsor support for ailing MMFs will be explicitly forbidden.

1 Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on money market funds.

2 EUR 9 bn of inflows cannot be allocated geographically.

3 Basel Committee on Banking Supervision (2014). Basel III: the net stable funding ratio. BIS, October 2014. The NSFR is part of the pending capital requirements reform for which the EU legislative process started in November 2016.

Euro area MMF market: divided between CNAV and VNAV 3

Assets under management, estimation for mid-2017

France,

According to existing and still effective ESMA guidelines4, MMFs can be standard or short-term. Portfolio requirements (e.g. maximum asset maturity) are stricter for short-term than for standard MMFs.

From a market perspective, however, the distinction between variable and constant net asset value is more important. MMFs displaying a variable (fluctuating) share price calculate the entire fund's net asset value based on mark- to-market or mark-to-model pricing. The share price is then calculated by dividing this net asset value by the number of shares outstanding. Variable net asset value (VNAV) funds can be set up as either standard or short-term MMFs. Both VNAV types will also be allowed under the new legal regime.

Constant net asset value (CNAV) funds are able to display a steady share price (usually EUR/USD/GBP 1) because they value their portfolio based on amortised cost accounting. Amortised cost accounting is only allowed for short-term MMFs.

CNAV funds, EUR 640 bn,

55%

VNAV funds, EUR 518 bn,

45%

EUR 360 bn,

31%

Luxembourg and other EA, EUR 158 bn,

14%

Regulators are particularly wary of CNAV funds because investors expect them to always maintain a stable price per share. A sudden devaluation can thus easily trigger an investor run. Therefore, CNAV MMFs as they exist today will no longer be allowed. This affects about 55% of all euro area MMF assets. But as many investors prefer CNAV funds due to their easy handling, for accounting and tax reasons, the EU regulation provides for two new, close substitutes: low volatility

Annotation: MMFs domiciled in France, Ireland and Luxembourg account for 98% of euro area MMFs' total assets. CNAV funds are predominantly domiciled in Ireland and Luxembourg.

Sources: ECB, IMMFA, Deutsche Bank Research

NAV funds and public debt CNAV funds.

LVNAV (low volatility net asset value) MMFs will be allowed to use amortised cost accounting - the basis for a stable share price - for assets with a residual maturity of up to 75 days.5Furthermore, the constant asset price must not deviate by more than 10 basis points from the mark-to-market price of that asset.

Public debt CNAV funds are another option. These MMFs will be restricted as regards their portfolio: they will have to hold at least 99.5% of their assets in public debt, reverse repos secured with public debt, or cash. But they will be allowed to stick to amortised cost accounting and stable share prices.

Both LVNAV and public debt CNAV funds will be subject to mandatory liquidity fees or a suspension of redemptions if the share of weekly maturing assets in the portfolio falls below 10%. If suspensions are put in place on more than 15 days within a 90-day period, an LVNAV or public debt CNAV fund will be converted into a VNAV MMF. By contrast, VNAV funds are "only" subject to the UCITS regime, which puts the introduction of measures like liquidity fees or redemption gates at the discretion of the fund management board.

4 ESMA 2014/1103 Opinion. Review of the CESR guidelines on a Common Definition of European Money Market Funds, 22 August 2014.

5 The maximum residual maturity of an individual instrument is 397 days, but if the residual maturity exceeds 75 days, the instrument has to be valued mark-to-market.

MMF categories defined by new EU regulation 4

Standard VNAV

Short-term VNAV

Low volatility NAV

Public debt CNAV

Accounting method

Mark-to-market

Mark-to-market

Amortised cost for assets with

Amortised cost

residual maturity of 75 days max.

Eligible assets

Money market instruments

Money market instruments

Money market instruments

Public debt, reverse repos, cash

Mandatory liquidity

No

No

Yes

Yes

fees/redemption gates

Maximum residual maturity of a money

2 years

397 days

397 days (mark- to-market

397 days

market instrument until legal redemption

valuation if over 75 days)

Maximum weighted average maturity* (WAM) of portfolio

6 months

60 days

60 days

60 days

Maximum weighted

12 months

120 days

120 days

120 days

average life* (WAL) of portfolio

Minimum of daily maturing assets

7.5%

7.5%

10%

10%

Minimum of weekly maturing assets

15%

15%

30%

30%

* When calculating WAM, maturity is defined as the time remaining until the next interest rate reset date. When calculating WAL, however, the life of a floating rate instrument is the time left until it has to be redeemed.

Sources: Regulation (EU) 2017/1131, Deutsche Bank Research

Impact of EU regulation

The new EU regulation forces investors and fund managers to reconsider their investment strategies and will certainly cause adjustments in the market. Nevertheless, the cautious reform is unlikely to disrupt the EU MMF market or to trigger substantial outflows from the sector as a whole. On the one hand, investors in VNAV MMFs (EUR 518 bn, 45% of the market) will see no fundamental changes due to the new regulation. However, standard VNAV funds (approximately EUR 341 bn, 30%6) may have to shorten the maturity of their portfolios due to the introduction of minimum requirements for daily and weekly liquidity.

On the other hand, CNAV MMFs as they exist today will disappear, which means that assets of approximately EUR 640 bn will have to be reallocated. But investors are offered relatively close substitutes with the introduction of public debt and LVNAV funds. The new type of public debt CNAV MMF will be the closest alternative for today's investors in CNAV funds focused on government debt. Admittedly, only 7% (EUR 85 bn) of euro area MMF assets are currently invested in such funds.

6 Estimation based on figures of the ECB, Association Française de la Gestion financière (AFG), Commission de Surveillance du Secteur Financier (CSSF).

Deutsche Bank AG published this content on 13 September 2017 and is solely responsible for the information contained herein.
Distributed by Public, unedited and unaltered, on 13 September 2017 21:19:01 UTC.