We wrote earlier this month on the U.K. Financial Conduct Authority's new consultation paper entitled, "Updating the regime for Money Market Funds." Today, we quote from the full paper on "Why we are consulting." The FCA explains, "This consultation sets out proposals to enhance the resilience of Money Market Funds (MMFs) domiciled in the UK, addressing vulnerabilities identified in the 2020 'dash for cash' and other times of market stress. We want there to be an effective market in MMFs. The proposals are intended to mitigate risks to wider financial stability and reduce the need for central bank support in the future, whilst maintaining cash management services that meet the needs of investors. The consultation also forms part of the Government's delivery of the Smarter Regulatory Framework (SRF) for financial services, replacing retained European Union (EU) law (REUL) with an approach to regulation tailored to the UK." (Note: Thanks again to those of you attended our Money Fund University in Jersey City earlier this week! Attendees and Crane Data subscribers may access the materials via our "Money Fund University 2023 Download Center.")
They tell us, "HM Treasury expects to lay a Statutory Instrument (SI) before Parliament which will replace UK Money Market Fund Regulation (UK MMFR) with provisions in new legislation which will set an overall framework for MMF regulation more suited to the needs of the UK market. Correspondingly, this consultation proposes new FCA Handbook rules to replace the provisions to be deleted from legislation. HM Treasury is publishing the draft SI and policy note at the same time as this consultation and the two documents should be read in conjunction with each other."
The paper says, "MMFs are a type of open-ended investment fund (OEF) used in many jurisdictions. MMFs are considered to be low-risk investments that give investors a way to diversify credit risk and a place to hold their assets, while aiming to yield a return in line with short-term money market rates. MMFs are an important cash management vehicle for investors to manage short-term liquidity and meet margin calls. There are few alternatives for larger corporate and financial institutions that meet their needs."
It continues, "Investments in an MMF are, however, not guaranteed. MMFs offer daily redemptions on demand, often with same day settlement, despite many of the assets that they invest in having a longer maturity and an illiquid secondary market. This creates a 'liquidity mismatch', with MMFs undertaking 'liquidity transformation' and can also lead to a first mover advantage -- an incentive for investors to redeem ahead of others. If heightened redemptions at one fund lead to redemptions in other funds, this can amplify the original liquidity stress."
The FCA writes, "MMFs are subject to regulation that places limits on the amount of liquidity transformation they can undertake, and that requires MMFs to hold minimum amounts of short-term liquidity, to promote MMFs' ability to meet redemption demands. Over the last few years there have been several instances where the resilience of MMFs has been tested: In March 2020, financial markets globally reacted to the unexpected effect on economic activity of the Covid pandemic and the public health measures that were introduced. This shock catalysed an abrupt and extreme dash for cash. MMFs came under severe strain as investors withdrew money to meet obligations elsewhere such as collateral calls, and out of fear of not being able to redeem at a future date. This in turn increased the pressure on MMFs, increasing the risk they would be unable to meet investors' redemption demands."
They tell us, "If multiple MMFs used by UK investors had suspended in March 2020 -- restricting investor access to cash -- there could have been a significant threat to wider UK financial stability; In late 2022, a rapid and unprecedented increase in UK gilt yields exposed vulnerabilities in Liability-Driven Investment (LDI) funds in which many pension schemes invest. This led to a spiral of collateral calls and forced gilt sales that risked further market dysfunction and a material risk to UK financial stability. Some MMFs saw a rapid wave of withdrawals as investors sought to raise cash including for collateral calls, followed by strong inflows in the period immediately following the market disruptions as investors rebuilt their short-term liquidity."
The FCA paper states, "Work internationally on addressing MMF vulnerabilities has been led by the Financial Stability Board (FSB). This follows on from international reforms to MMFs after the global financial crisis, when vulnerabilities in MMFs were also exposed. In October 2021, the FSB published its Final Report on possible policy proposals to enhance MMF resilience. Many of the FSB's policy options aim to enhance resilience through reducing the likelihood of destabilising redemptions by reducing liquidity transformation (for example by increasing MMF liquidity), imposing on redeeming investors the cost of their redemptions, absorbing losses, or reducing threshold effects. This consultation takes forward FSB proposals in a UK context."
It comments, "Many sterling denominated MMFs are domiciled outside the UK -- around 90% of total assets under management (AUM) in sterling MMFs are in MMFs domiciled in the EU. The Government SI being published alongside this CP sets out the Government's Overseas MMF Regime which will enable approved MMFs to market into the UK provided they apply to the FCA for recognition under either section 271A of FSMA (where applicable) or section 272 of FSMA, or notify the FCA under the UK's National Private Placement Regime. Irrespective of any designations under this regime, we consider it appropriate for the FCA to propose rules in this CP for UK MMFs that will support financial stability, investor protection and growth."
The introduction then says, "This work should be considered part of broader international efforts to address vulnerabilities and increase the resilience of MMFs, ensuring consistently high standards in the international financial system.... The UK authorities are looking to: Strengthen the resilience of MMFs and the financial system in supporting the UK economy and its international competitiveness; Reduce the need for future extraordinary central bank interventions of the kind that occurred in March 2020; Support the provision of sustainable and robust cash management financial services that meet the needs of investors including at times of financial stress."
The FCA tells us, "This consultation was preceded by Discussion Paper DP22/1 on the Resilience of Money Market Funds (DP22/1), in which we gathered feedback on the FSB policy options, seeking to understand how best to support financial stability in a UK context through enhancing the resilience of MMFs. The Bank of England's Financial Policy Committee (FPC) has also developed its view on how the risks are best addressed. Feedback to DP22/1 supports our analysis that our aim should be to mitigate and reduce risk associated with MMFs rather than restrict their operations. This is because the measures necessary to eliminate risk would prevent MMFs either being able to operate effectively or to provide the features such as same day settlement and a high degree of NAV per unit stability that are most valued by MMF investors. This would reduce the use of MMFs and move demand for cash management products and risk to other parts of the financial markets which may not necessarily have the capacity to absorb it."
They add, "The proposals in this consultation, prepared in close cooperation with the Bank of England and HM Treasury, prioritise strengthening the existing regulatory regime for MMFs while maintaining the broad current MMF operating model. The proposals increase MMF resilience principally by ensuring MMFs have usable liquidity sufficient to endure severe but plausible redemption stresses. The proposals include: A significant increase in the minimum liquid asset requirement for all MMFs, raising daily liquid assets (DLA) and weekly liquid assets (WLA) levels to 15% and 50% of their assets respectively. We also modify the assets eligible for WLA for Variable NAV (VNAV) MMFs; and The removal of the regulatory link between liquidity levels in MMFs that have the ability to offer subscriptions and redemptions at a constant Net Asset Value (NAV) (so-called 'stable NAV MMFs') and the need for the manager to consider or impose tools such as liquidity fees or redemption gates. This is known as 'delinking' and is intended to make those MMFs’ liquidity buffers more usable. Other enhancements include: Enhanced 'know your customer' (KYC) requirements: strengthened and broadened KYC requirements on MMF investor concentration; Enhanced stress testing for stable NAV MMFs; and Enhanced operational resilience for stable NAV MMFs."
Finally, they write, "We have considered other policy measures set out in DP22/1 but not adopted them -- either because they would prevent MMFs from being able to support the needs of investors -- or because we consider there to be more proportionate ways of achieving our desired outcomes. Policy measures not adopted include: Changing or removing stable NAV operation for the current stable NAV MMFs, so these MMFs would be no longer permitted to deal at a constant NAV; and Making changes to how MMFs currently operate in order to impose on redeeming investors the true cost of their redemptions in the absence of MMFs selling assets and crystallising losses. However, we are consulting on a requirement for all MMFs to have at least one Liquidity Management Tool (LMT) available for use when the fund is still trading if needed, and for all managers to have the ability to suspend their MMFs, with such tools to be deployed at the manager's discretion.... We welcome feedback on our proposals by 8 March 2024 using the details on the Contents page. We will consider all feedback, and subject to the responses received we will look to publish a final policy statement and final Handbook rules in line with HM Treasury's finalised SI."
