Moody's Investor Service published a "Special Comment" entitled, "Money Market Funds and Regulatory Reform: A Business Model Hangs in the Balance" yesterday, which says, "Recent changes in market dynamics, and particularly low interest rates, constrained asset supply, regulatory scrutiny and evolving investor preferences have begun to transform the liquidity and investment characteristics of money market funds (MMFs). We expect that additional and more substantial regulatory change will provide further protections to MMF investors and reduce systemic risk, but at the same time lead to a reshaping of the industry, as some funds close or consolidate, and some of the smaller MMF managers either exit the business or reassess their business models. In addition, the potential transformation of the traditional constant net asset value (CNAV) MMF product would have a significant impact on the overall liquidity product landscape, investor preferences and industry composition."
The press release announcing the report, titled, "Regulatory reforms will transform MMF industry and drive growth of alternative liquidity products," tells us, "Changes in the money market industry will continue, as regulatory developments coupled with market dynamics force some money market funds (MMFs) to close or consolidate, says Moody's Investors Service in its latest special comment "Money Market Funds and Regulatory Reform: A Business Model Hangs in the Balance.""
Yaron Ernst, Managing Director of Moody's Managed Investments Group, comments, "Low interest rates, constrained asset supply, regulatory scrutiny and evolving investor preferences have already begun to transform the characteristics of money market funds.... Due to the changing product dynamics, we expect industry consolidation to accelerate, combined with a significant impact on the overall liquidity product landscape and investor preferences."
Moody's release explains, "Proposed regulatory reforms in the US and Europe that threaten the traditional constant net asset value (CNAV) structure are one of the three key drivers of the changing MMF landscape, says Moody's. MMFs are also faced with persistently low interest rates that continue to push investors to higher-yielding fund products, further reducing already-slim profits. In addition, the diminishing supply of highly rated investments are forcing managers to develop and launch new products, as the industry changes shape and business models follow suit, says the rating agency."
It continues, "The report lays out three scenarios for the industry, as well as the expected implications for fund managers and investors: (A) Variable net asset value (VNAV) MMFs entirely replace CNAV MMFs -- there is a regulatory prohibition on the CNAV product generally. The probability of this scenario is low in the US and in Europe; (B) Bifurcation of MMFs -- Only government/treasury MMFs are allowed to maintain their CNAV structure, while prime and tax-exempt MMFs can only be VNAV. In Moody's view, this scenario is the most likely in the US, but does not apply in Europe because a separate framework for government funds does not exist; (C) Buffers/Holdbacks - Requirement for capital buffers and/or redemption limits for all CNAV MMFs. This is the most likely scenario in Europe, with moderate probability of implementation in the US."
The Moody's report explains, "The implementation of regulation in the US and Europe is likely to unfold along different timeframes and with different outcomes. Given this, there is the risk that funds suffer an increase in outflows arising from investors shifting their investments across regions to remain invested in a CNAV fund. In the event that Europe is the first to modify the CNAV MMF by imposing buffer provisions or mandating a shift to VNAV, CNAV investors with domiciles outside of the European Union may decide to repatriate some of their cash to the US to remain invested in CNAV MMFs. According to estimates by the European Systemic Risk Board (ESRB), the E433 billion in European CNAV MMFS could see a potential outflow of E257 billion, or 59%. This risk likely is to be mitigated by the aversion of corporate treasurers to creating a tax liability in the shift of offshore cash balances to onshore."
It adds, "In addition, some managers may consider relocating their funds to an offshore domicile, such as the Cayman Islands, to avoid the expected regulations in Europe and/or the US. However, this solution seems temporary in nature, as regulators may act to reduce the benefits of a new fund domicile, either by applying certain restrictions on fund managers, or by imposing unfavorable accounting or tax treatment on investors that invest in these offshore funds. It also remains to be seen what investors' reaction would be to such a change in a fund's domicile."
