Money Market Fund-amentals
Institutional Money Market Funds Association
The market turmoil which commenced in the summer of 2007 has resulted in the worst global financial crisis since the 1930s. Money market funds (MMFs) have not escaped this turmoil, and increasing attention has been directed towards the product from both investors and regulatory bodies. The global size of the industry now amounts to over USD 5tr, the vast majority of which is invested in the US. However, while the US market has a clear definition of what constitutes a money market fund, which has resulted in the development of a huge and systemically important industry, the market in Europe has never developed a widely accepted definition. This has resulted in a more fragmented industry in which a variety of products are referred to in this way, but operate within different parameters.
Money market funds in the US
MMFs originated in the United States in the early 1970s as a result of Regulation Q. Introduced in 1933 by the Glass-Steagall Act, Regulation Q is the Federal Reserve Board regulation that placed a limit on the interest rate that banks could pay, including a rate of zero on demand deposits. MMFs developed as a result of this; as they are not considered as a demand deposit, they are able to reap competitive interest rates for investors. Their success resulted in amendments being made to the Investment Company Act 1940, which instigated direct regulation of this fund type through Rule 2a-7 of the Securities & Exchange Commission (SEC). Following the implementation of this rule in 1983, no fund type has been permitted to promote itself as a “money market fund” in the US unless it complies with the requirements of SEC Rule 2a-7.
This rule applies strict criteria to MMFs, generating a product which both retail and institutional investors in the US recognise and utilise. The success of the product is such that nearly USD 4tr is currently invested in it.
In order to qualify as a MMF, the product must:
- seek to maintain a stable net asset value, either through the amortised cost method or the penny-rounding method;
- only invest in securities with a residual maturity of less than 397 days;
- maintain a weighted average maturity of not more than 90 days;
- purchase only assets which represent minimal credit risk. Such assets should only be those which have achieved the highest short-term rating from one of the credit rating agencies or are of comparable quality. A fund may also invest up to 5% in assets which have achieved the second highest short-term rating; and
- achieve diversification by generally investing not more than 5% with a single issuer.
This very specific piece of regulation has allowed an industry to develop. The investors using the product have a complete understanding of the nature of the product. Investors recognise that a MMF seeks to provide capital security and liquidity, and also maintain a constant net asset value. Such is the clarity of that understanding that the product is heavily utilised by both retail and institutional investors, with the split between the two being approximately 35% retail and 65% institutional.
Outside of the US, there are a small number of sizeable markets for MMFs, albeit that the total of funds under management still remains relatively small when compared with the US industry.
Within Europe, MMFs initially developed in France in the early 1980s. Following a change in regulation in 1981, which restricted the yields payable on time deposits, commercial banks began offering MMFs as a viable alternative to cash investors. The French MMF industry, which seeks to offer products whose principal purpose is to provide capital security, now manages approximately €450bn of assets.
In contrast to the US market, all MMFs in France provide a variable net asset value, albeit that the funds are managed with the intention of providing an asset value which only increases. The MMF industry in France has developed without reliance upon a rating for the fund.
There are two principal types of MMF authorised by the French regulator, the Autorité des marchés financiers (the AMF): Fonds Monétaire Euro (Eurozone MMFs) or Fonds Monétaire à vocation internationale (International MMFs). In addition, there is a so-called “dynamic” or “enhanced” MMF sector, albeit that these are not recognised as MMFs by the AMF.
The two fund types designated as MMFs by the AMF are required to adhere to some criteria, but are not subject to the same level of investment restrictions as those in operation in the US:
- the fund must be managed with limited interest rate risk;
- the fund may not be exposed to equity; and
- if the fund is exposed to risks other than interest/exchange rate risk, and in particular credit and liquidity risks, the fund’s documentation must clearly disclose those risks.
These funds generally invest in instruments with a maturity of less than three months, and not exceeding one year. For those instruments with a maturity of three months or less, the manager may utilise an amortised cost rather than the market value.
The “dynamic” or “enhanced” sector is not subject to specific regulation by the AMF, and consequently has no qualitative or quantitative limits applicable to the funds. It is generally accepted that such funds concentrate on performance, but also seek to provide an element of capital security.
Whilst the US and French MMF industries may broadly have the same objectives, the limited quantitative criteria of the French model allows material differences to arise between the two industries.