Earlier this month, the International Organization of Securities Commissions (IOSCO) released a final report that sets out policy recommendations for the regulation of money market funds (MMFs). The IOSCO Report [available here] is the product of much consultation by IOSCO, including an earlier consultation paper published for comment in April 2012. Staff of the Ontario Securities Commission participated in the working group that developed the consultation paper and the final report. Given the overall goal of IOSCO - to establish internationally agreed standards for the regulation of MMFs - and the OSC's involvement in developing the recommendations, it is useful to not only understand IOSCO's recommendations (and the controversy that certain of those recommendations can be expected to generate), but also to compare them to current Canadian regulation of MMFs.
The recent amendments to National Instrument 81-102 Mutual Funds relating to MMFs, which can be seen as resulting, at least in part, from the OSC's participation in the IOSCO working group, come into force on October 30, 2012.
IOSCO's Principal Concerns about MMFs
IOSCO commenced its work to look into the regulation of MMFs at the request of the Financial Stability Board following the 2008 global financial crisis, during which some MMFs in certain jurisdictions were unable to maintain a constant NAV ("broke the buck"). The chain of events occurring during the height of the crisis, including the run on MMFs, highlighted to regulators the systemic relevance of MMFs. The Financial Stability Board is tasked with strengthening the oversight and regulation of the shadow banking system, and as one of its workstreams, embarked on a review of MMFs on the basis that MMFs perform maturity and liquidity transformation and are important sources of short-term funding, particularly for banks.
In its Report, IOSCO acknowledges the regulatory reforms for MMFs that have already occurred in, for example, the United States and Europe, and upcoming changes to MMF regulation in Canada. IOSCO describes these reforms as "mainly focused on the asset side of funds" and expressly suggests that further reforms are needed. IOSCO's principal concerns relating to MMFs include the following:
- The stable NAV of MMFs - This feature unique to MMFs gives an impression of safety even though MMFs are subject to credit, interest rate and liquidity risk, just like any other mutual fund or collective investment scheme.
- The first mover advantage - Investors who are the first to redeem from a troubled MMF (or one that is subject to market distress) have an advantage in that their redemption prices would be based on the constant NAV; the ultimate cost of any losses would be borne by the investors that remain in the MMF.
- The discrepancy between the NAV published and the value of the assets - Amortized cost accounting is a common method in valuing portfolio assets of MMFs. However, amortized cost may not reflect the true market price of an instrument and may give rise to the risk of mispricing a fund's portfolio assets.
- Reliance on ratings - This reduces managers' diligence in the selection of portfolio investments for the MMFs - and ultimately investors' diligence in deciding to invest in MMFs.
IOSCO's Recommendations
IOSCO's recommendations are intended to address vulnerabilities arising from the liability side, as well as the crucial issue of valuation and the display of a constant NAV. IOSCO's 15 recommendations deal with, among others, valuation, liquidity management, MMFs that offer a stable NAV, the use of ratings and disclosure to investors. The approach that is apparent in many of IOSCO's 15 recommendations is one of "putting in safeguards".
With respect to liquidity management, the purpose of the recommended safeguards is for the MMF to be able to deal with redemptions. Recommended safeguards include having rules in place for large investors (such as imposing a minimum holding period, requiring longer notice periods for large redemptions etc.), having a minimum amount of liquid assets to be able to meet redemption requests, doing stress tests on a regular basis and having in place tools (such as temporary suspensions) to deal with redemption pressures.
With respect to MMFs that offer a stable NAV, IOSCO's recommendation is for such MMFs to convert to a floating NAV - a concept that has generated much controversy and criticism in the United States and Europe. Where such a move is not "workable", IOSCO recommends that MMFs put in safeguards that address the issues noted concerning "first mover advantage". These safeguards should include a mechanism to compensate the day-to-day variations in the value of the assets in the fund's portfolio, and to offset the deviations between the fixed NAV and the market value of the fund's securities. In addition, a mechanism should be put in place to slow down outflows in the event of significant redemption pressures. This could include the imposition of a "liquidity fee" on investors who wish to redeem their securities. The theory behind a liquidity fee is that it would help offset the cost that would be borne by the remaining security holders as a result of the redemptions. It could also help reduce any additional strain on the fund due to the redemptions.
With respect to valuation, IOSCO recommends that MMFs use amortized cost accounting only in limited circumstances and subject to strict conditions. The recommended safeguard comes in the form of third party review to ensure appropriate procedures are in place in the determination of the value of each instrument held in a fund's portfolio.
Traditionally, having portfolio assets that meet certain ratings by credit rating agencies is considered as another safeguard for MMFs and collective investment schemes in general. However, IOSCO suggests that a mechanistic reliance on external ratings is insufficient; rather, the appropriate safeguard is for the responsible entity (such as the fund manager or the portfolio manager) to assess the credit worthiness of the fund's investments and treat external ratings as only one element to be taken into consideration when assessing the quality of an investment.
IOSCO recommends that disclosure be made to investors about an MMF's practices in relation to valuation and the applicable procedures in time of stress (i.e., the safeguards that the fund manager has adopted). In addition, MMF disclosure documents should include specific disclosure drawing investors' attention to the absence of a capital guarantee and the possibility of principal loss.
What can be expected in Canada?
The Canadian Securities Administrators published new restrictions on MMFs in February 2012 through a new section 2.18 of NI 81-102. Section 2.18 will apply to all Canadian MMFs as of October 30, 2012 and principally imposes two new requirements:
- New liquidity provisions requiring a MMF to have at least 5 percent of its assets in cash or readily convertible to cash within one day and 15 percent of its assets in cash or readily convertible to cash within one week.
- A new dollar-weighted average term to maturity limit for the MMF's overall portfolio of 180 days that is to be calculated based on the actual term to maturity of all securities in a MMF portfolio.
These new rules supplement existing regulation, which deals with portfolio composition, permitted investments and disclosure in a MMF's prospectus. The restrictions on portfolio assets for MMFs rely to some extent on ratings assigned by credit rating agencies. For example, an evidence of indebtedness, certain types of permitted "cash equivalents" and certain types of permitted "floating rate evidence of indebtedness" (by virtue of their definitions in NI 81-102) must have an "approved credit rating".
The CSA has acknowledged that NI 81-102 provides for no rules prescribing a MMF's valuation methods or the specific safeguards that must be adopted to protect against the impact of large redemptions on the fund or remaining securityholders. In February 2012, at the time of publication of the final revised rules of NI 81-102, the CSA explained that they did not believe codification of prudent practices was necessary at this time, and suggested that portfolio managers of MMFs should consider appropriate diversification, currency risks, stress testing and monitoring of "shadow" NAV on a regular basis. In addition, the CSA made note of the fact that many MMFs typically monitor the holdings of individual securityholders to assess the risk of large transactions, and often use investor agreements to require specified advance notice for a large redemption. The CSA indicated that they expect such prudent management practices to continue.
Nonetheless, the CSA also explained that they would continue to monitor ongoing regulatory developments impacting MMFs in other global jurisdictions and consider the need for similar changes in Canada. The release of IOSCO's policy recommendations continues the discussion and, depending on the response of other jurisdictions to IOSCO's policy recommendations and market conditions, there may very well be further developments in the regulation of MMFs in Canada at some point in the coming year or two. However, we note that the Canadian MMF marketplace is significantly different from that of the United States and Europe and IOSCO itself has recognized that there are important differences between jurisdictions and that the implementation of its recommendations may vary from country to country.
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