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Stress Testing and the Money Market Funds Industry
by Mark Stockley, Managing Director and Head of International Cash Sales, BlackRock
The term ‘stress test’ can be applied to many scenarios where managing risk is critical – assessing cardiac health, evaluating structural stability in buildings or measuring the financial strength of banks. Depending on its application, stress testing can be quite simple and focused on measuring the impact of one key factor or variable, or it may be very complex, combining the effects of multiple influences or factors on an underlying subject.
Today stress testing has become an integral component of global banking regulators’ assessment of the strength of the broad financial services industry as well as that of individual banks. One of the most notable applications in recent years took place in mid-2009, shortly after the height of the 2007-2009 credit crisis, when the Federal Reserve conducted stress tests of the leading US banks to assess their levels of capital and ability to withstand further shocks in the economy. Fast forward to mid-2011 and European Union regulators are planning to conduct a range of tests to understand the capital strength of the major European banks.
While stress testing has proved important and topical for the global banking industry, it has also increased in visibility and importance for the global money market funds industry. However, for many of the world’s leading asset managers stress testing is not a new concept and has been an established practice within the risk management framework supporting their money market funds for some time.
What has changed is the more recent requirement from regulators and industry groups for stress testing to be a key feature of the risk-monitoring framework maintained for a money market fund by its investment adviser. For European-based international liquidity funds, the Institutional Money Market Funds Association (IMMFA) maintains a self-regulatory Code of Practice which among other recommended best practices suggests that member firms undertake regular stress testing of their portfolios. Within changes introduced in 2010 to rule 2a-7 under the Investment Company Act of 1940, the legal framework governing US-registered money market funds, the US Securities and Exchange Commission has mandated that money market funds adopt procedures to provide for periodic stress testing of their portfolios and reporting to the funds’ boards of directors on the results of such testing.
In this article we discuss the importance of stress testing to the money market funds industry, highlight a number of the key risks that stress testing helps to mitigate and briefly describe a number of the reports and practices implemented by the BlackRock Cash Management business.
Why is stress testing important for Money Market Funds?
One of the defining features of money market funds managed according to Rule 2a-7 in the US, and the majority of funds following the IMMFA Code of Practice in Europe is their stable or constant net asset value (NAV) per share. This feature allows investors, whether corporations, governments, financial institutions or individuals, to receive the benefits that money market funds can provide (e.g., principal stability, liquidity, underlying security diversification, exposure to asset management expertise and resources and accounting simplicity) while investing in a vehicle that seldom experiences fluctuations in its quoted NAV.
Stress testing has become an integral component of global banking regulators' assessment of the strength and the broad financial services industry and that of individual banks.
To maintain their constant NAV, money market funds value portfolio securities at their acquisition cost adjusted for amortisation of premium or accretion of discount. This is known as amortised cost accounting. Money market funds are permitted to use this valuation method due to the short-dated, diversified, high quality and liquid nature of their underlying investments. In addition, money market funds that use the amortised cost method are generally required to calculate a separate NAV—often called the ‘mark-to-market’ (MTM) or ‘shadow’ NAV—which is based on available market quotations for the funds’ portfolio securities plus undistributed realised gains and losses. There are typically very small daily market price movements experienced by the securities in a money market fund’s portfolio.
Money market funds managed according to Rule 2a-7 or stable NAV funds following the IMMFA Code of Practice follow similar rules: as long as the mark-to-market NAV is within one-half of one percent of one share or the unit of a fund’s reference currency (between 0.995 and 1.005) of the NAV calculated using the amortised cost method, a money market fund is permitted to continue using amortised cost accounting and to conduct purchases and redemptions of its shares at 1.00 per share. In the event that the mark-to-market NAV deviates from the money market fund’s amortised cost price per share by more than one-half of one percent of one share or unit per share (commonly referred to as ‘breaking the buck’), the fund is required to consider promptly what action should be taken, which may include suspending the use of amortised cost accounting.
At a broad level, mark-to-market NAV movements for money market funds are typically caused by changes in certain factors, including levels and direction of interest rates, prevailing economic conditions, credit conditions affecting individual issuers and investor purchase and redemption activity within the money market fund. Stress testing is critical for money market funds in that it models a fund’s ability to maintain a stable net asset value per share when faced with hypothetical changes in one or more of these factors.
How testing mitigates key risks
Testing helps to monitor both the overall portfolio impact from changes at the macro or economy-wide level and the impact of specific market conditions or events on individual portfolio securities. Examples of events that could impact a money market fund include: a change in short-term interest rates, an increase in shareholder redemptions, a downgrade or default of certain portfolio securities, and the widening or narrowing of credit spreads. Stress tests are typically conducted on a regular basis and are modified as underlying market conditions change. The stress tests applied to money market funds typically monitor several key risks:
Interest rate risk: the risk to a money market fund’s NAV from interest rate changes or parallel and non-parallel shifts in the yield curve.