UK: Money Market Funds And Shadow Banking - Cash Buffers, Transparency And The Long Road Ahead

Last Updated: 25 September 2013
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017


On September 4, the EU Commission published a proposal on a Regulation for Money Market Funds (MMF) and a communication outlining its wider shadow banking work.

This briefing note provides a short industry context, followed by a summary of the Commission's key proposals.

The MMF Regulation is intended to address the risk that investor "runs" could affect the stability of the sponsor, the wider financial sector and ultimately the real economy. It is also intended to protect investors by reducing the potential disadvantages for late redeemers, particularly in stressed market conditions. The proposal will have a significant impact on MMFs, as well as their investors and those who use MMFs for funding purposes. As near final drafts of the document were widely circulated before their official release, the content is largely expected. However, the Commission has softened its stance in relation to exposure to securitisation and collateral. There are three important elements of the proposal. First, the Regulation proposes the introduction of a 3% cash buffer for Constant Net Asset Value (CNAV) MMFs. This will reduce the profitability of these types of funds and push up fees for investors. Second, the Regulation proposes rules on what MMFs can invest in and what activities they can perform, restricting the type of collateral that can be used in reverse repurchase (repo) agreements and banning MMFs from engaging in certain securities financing transactions (SFTs). Third, there are proposed rules on risk management, valuation and transparency. Notably, neither MMFs nor their managers will be permitted to request ratings from credit rating agencies.

The Commission's communication provides a 'roadmap' for its shadow banking work. Much of the work relates to transparency and data collection, with the Commission calling for a regular quantitative monitoring exercise and highlighting the transparency benefits of existing initiatives. In this respect the Commission is supportive of the Legal Entity Identifier (LEI), and will consider the possibility of transposing the LEI into EU law. Other notable items include a possible extension of scope for prudential banking regulation to a broader range of institutions, a delay of proposals for non-bank resolution until 2014, as well as a further delay to the long-awaited proposals on securities law to 2014.

Industry context

According to the European Systemic Risk Board (ESRB), EU MMFs manage around €1 trillion in assets, of which over 40% are accounted for by CNAV funds. The industry is heavily concentrated in France, Ireland and Luxembourg, with CNAV funds split between Ireland and Luxembourg at two-thirds and one-third of the total, respectively. Due to their high liquidity and relatively stable value, MMFs attract both retail and institutional investors, and are often used as an efficient way to achieve diversified cash management. They also provide an important source of short-term funding for financial institutions, corporates and governments. According to the Commission, MMFs hold 38% of short-term debt issued by the banking sector. Due to their "systemic interconnectedness" with the banking sector and wider economy, MMFs have increasingly been in the regulatory spotlight. Reform of the sector has been a priority under the umbrella of 'shadow banking', which can broadly be defined as credit intermediation taking place outside the regular (and regulated) banking system.

Under the aegis of the G20, the Financial Stability Board (FSB) has been pursuing a wide-ranging programme for reform of the shadow banking sector, addressing the following five workstreams: (i) the interaction of banks with non-banks; (ii) MMFs (including policy recommendations by the International Organization of Securities Commissions (IOSCO)); (iii) 'other' shadow banking entities, such as exchange traded funds (ETFs) and credit hedge funds; (iv) securitisation; and (v) SFTs such as repo agreements. Several substantial documents on this work are expected to be endorsed this week by the G20 Leaders in St Petersburg.

It is in this international context that the Commission has proposed the Regulation on MMFs and a communication on the broader shadow banking agenda in the EU, outlining work done to date and further work to come. These follow on from a March 2012 Green Paper on shadow banking, a consultation on a revision to the Undertakings for Collective Investment in Transferable Securities Directive (UCITS VI) in July 2012 in which MMFs were covered, as well as a set of recommendations issued by the ESRB in December 2012. The United States has also been developing proposals to address MMFs for some time, and the SEC finally published its proposals in June 2013. The SEC put forward two alternative reforms, which may be adopted alone or in combination. One of these would require all prime institutional MMFs to adopt floating NAV, while the other would allow them to continue to use constant NAV, but would require liquidity fees and redemption gates during stress periods.

The proposed MMF Regulation is broadly in line with the IOSCO principles. While the Commission states that ESRB recommendations have been "largely reflected" in the proposed Regulation, it has not taken forward the ESRB recommendation to ban CNAV MMFs outright.

An overview of the MMF Regulation

The below table provides an overview of the MMF proposals.

  • Address the risk that investor "runs" could affect the stability of the sponsor, the wider financial sector, and ultimately the real economy.
  • Protect investors by reducing the disadvantages for late redeemers, especially with respect to redemptions in stressed market conditions.
Who is affected?
  • MMFs established, managed or marketed in the EU, as well as UCITS and Alternative Investment Funds (AIF) that have the "characteristics" of MMFs, will need to comply with the Regulation.
  • Investors in MMFs.
  • Firms that rely on MMFs for funding purposes.
Key proposals
  • Rules related to the scope of the Regulation and authorisation of MMFs.
  • Requirements for CNAV MMFs, in particular the introduction of a 3% NAV buffer.
  • Investment policy rules, covering eligible assets, diversification, concentration and internal procedures to access the credit quality of investments.
  • Risk management measures aimed at ensuring adequate MMF liquidity, including thorough "know your customer" and stress testing requirements, as well as a restriction on MMFs soliciting or financing external credit ratings.
  • Valuation rules, in particular that MMFs should mark to market wherever possible, with only CNAV MMFs permitted to use the amortised cost method.
  • Transparency rules, including on disclosure to investors and reporting to competent authorities.
  • Rules setting out when MMFs can receive external support.
What's next?
  • The proposal will now pass to the European Parliament and Council for negotiation and adoption.

A look at the key MMF proposals


The proposed Regulation will apply to MMFs established, managed or marketed in the EU. This includes UCITS and AIFs that that have the "characteristics" of MMFs, such that they invest in short term assets and have the objectives of offering returns in line with money market rates and/or preserving the value of the investment. The majority of MMFs in the EU operate under the UCITS Directive and the remaining MMFs should be operating, as of July 2013, under the Alternative Investment Fund Managers Directive (AIFMD). MMF Managers will continue to be regulated under either UCITS or AIFMD, but will also need to comply with additional rules under the MMF Regulation. Rules related to the authorisation of MMFs are proposed, with UCITS or AIFs only allowed to use the MMF designation, or imply they are MMFs, if they are authorised in accordance with the MMF Regulation.


The most significant requirements in the proposal relate to CNAV MMFs. These are MMFs where the accounting methodology permits a stable face value, such as at 1€, $ or £. CNAV MMFs will be required to establish and maintain a "NAV buffer" of at least 3% of the total value of their assets, with notification to competent authorities and the European Securities and Markets Authority (ESMA) if the buffer falls below this by a specified amount. CNAV MMFs that fail to maintain the buffer must vary the NAV and cease to be CNAV MMFs. According to the Commission's Impact Assessment, "if all managers decide to build up a buffer, the initial amount of the capital to be raised will amount to around €14 billion in Europe". The NAV buffer can only be used to cover differences between the CNAV MMF's constant NAV per unit or share and its NAV per unit or share, or "real" value. It must not be included in the calculation of the NAV or constant NAV and must be held in cash in a separate and protected reserve account opened with a credit institution (which meets certain requirements). The intention is that an agreed "entity", for example this could be the sponsor or MMF manager (although the text does not specify), will establish and replenish the buffer. However, questions remain about the mechanics of how the buffer will work in practice.

In introducing the buffer, the Commission is seeking to address the risk of CNAV MMFs coming under pressure and failing to maintain a stable price, leading to investor runs. This so-called "breaking the buck" occurred in the US in 2008 to the Reserve Primary Fund following the collapse of Lehman Brothers and sparked increased regulatory focus on the risks posed by these types of funds. The introduction of the buffer is likely to significantly impact the MMF market. Concerns exist that for a low margin product like an MMF, the buffer will call into question the economic viability of CNAV MMFs for some providers and lead to a reduction in supply. While the Commission states that the buffer will benefit investors by insulating them against losses, it will also push the cost up to investors, with the Commission putting the increase in management fees at between nine and 30 basis points annually. Investors, including firms that use MMFs for cash management purposes, will need to think carefully about where they put their money in future.

Investment policies

The proposal sets out what MMFs can invest in, as well as activities they cannot undertake. MMFs will only be permitted to invest in money market instruments, deposits with credit institutions, financial derivative instruments and reverse repo agreements that meet certain requirements. In an apparent softening of the Commission's approach, money market instruments that take exposure to securitisation, for example Asset Backed Commercial Paper, will be considered eligible investments provided they meet certain requirements. In order for a reverse repo agreement to be eligible for inclusion in the MMF's portfolio, the MMF will need to have the right to terminate the agreement at any time upon a notice of two working days. The assets received as part of the agreement will need to be money market instruments which meet certain requirements, such as on credit quality and maturity. Again in an apparent softening of the Commission's stance, certain high quality central authority or central bank debt instruments will also be eligible as collateral for reverse repos. MMFs would only be allowed to invest in financial derivative instruments used for hedging interest rate and currency risk where the underlying instruments are interest rates, exchange currencies or indices representing these categories.

Under the proposals, MMFs will not be permitted to: short-sell money market instruments; gain direct or indirect exposure to equities or commodities; enter into securities lending, borrowing or repo agreements; or borrow or lend cash. The proposal also sets out rules related to portfolio diversification and concentration. MMF managers will be required to have a documented "internal assessment procedure" to assess the credit quality of money market instruments that it intends to invest in. This should be "prudent" and "rigorous", based on an internal rating system and methodologies, meeting other requirements, and subject to appropriate governance.

While the Commission has softened its stance on exposure to securitisation and collateral, the restrictions are nevertheless likely to push up demand for eligible assets at a time when there are already a number of initiatives in train that will affect demand for collateral.

Risk management, valuation and transparency

The risk management rules aim to ensure adequate liquidity for MMFs. The Commission has stayed away from introducing specific tools for the temporary suspension of redemptions, but notes that the UCITS and AIFM Directives already have certain provisions related to this. Instead, the Regulation proposes portfolio rules for both "short-term" and "standard" MMFs, setting out the maximum weighted average maturity (WAM) and weighted average life (WAL) that their portfolios should have. There are also requirements for the minimum amount of liquid assets that MMFs should hold that mature daily or weekly. MMF managers will need to comply with "know your customer" rules to help them anticipate large redemptions. Rules for stress testing are also proposed.

As part of a general regulatory trend seeking to reduce reliance on external credit ratings, the MMF or MMF manager will not be able to "solicit or finance" a credit rating agency to rate the MMF under the proposals.

Rules related to the valuation of MMF assets are also proposed, specifying that they should be valued at least on a daily basis and by marking to market "whenever possible". When marking to market is not possible or market data is not of sufficient quality, marking to model can be used. CNAV MMFs may also use the amortised cost method.

Transparency proposals include that MMFs must clearly disclose whether they are "short-term", "standard" or "CNAV" in their communications and in no way suggest that the investment is guaranteed. There are additional disclosure requirements for CNAV MMFs in relation to the "NAV buffer". The Regulation also introduces requirements for reporting to competent authorities.

External support from third parties

The proposals seek to reduce the uncertainty of the discretionary nature of external support, which the Commission believes makes MMFs "even more vulnerable to runs during periods of financial instability". CNAV MMFs will only be able to receive external support through the NAV buffer. Other MMFs will not be allowed to receive external support, except in certain exceptional circumstances permitted by the competent authority which are "justified by systemic implications or adverse market conditions".

Communication on shadow banking

The Commission's communication provides a 'roadmap' for the coming months on its shadow banking work. In large part, the Commission will look to achieve its aims through existing or expected legislation, with targeted supplemental work where the Commission believes it is needed. The multifarious initiatives referenced by the Commission are an indication of how tricky a problem 'shadow banking' is to address. Moreover, although there are prudential elements to the shadow banking agenda, much of the work relates to transparency and data collection, highlighting the continuing difficulties in simply understanding the financial relationships which constitute the marketplace.

Key points from the communication include the following:

  • On the LEI, the Commission says it "will consider the possibility" of a law to transpose the LEI into the EU legal framework.
  • During implementation of the European Market Infrastructure Regulation (EMIR) and future reviews the Commission will "assess the coverage" of entities involved in shadow banking, and will decide whether "supplementary initiatives" are needed.
  • The expected legislative proposal on securities law has been pushed back further to 2014, but the Commission is "closely following" the work of the European Central Bank (ECB) to collect real time data on repo transactions.
  • Within asset management, there will be a "global assessment of the framework in which certain funds can operate", including how they use securities financing transactions.
  • The Commission is "thinking about" extending the scope of prudential banking rules. There will be a "precise assessment" of the application of the definition of 'credit institution' within the EU member states, with the Commission ready to "clarify" the definition if it deems necessary.
  • The forthcoming proposal on non-bank resolution will be limited to Central Counterparties (CCPs), with a communication to be issued on the "policy orientation" for other non-banks, though this work has been pushed back to 2014.
  • Finally, on data, the Commission calls for a regular quantitative assessment of shadow banking, to take place "at least annually".

What's next?

The Commission's MMF proposal will now pass to the European Parliament and to the Council for negotiation and adoption. Timing will be affected by the competing priorities of other initiatives and the potential disruption to proceedings resulting from next year's European Parliament elections and the end of term of the current College of Commissioners. Once the Regulation enters into force, existing MMFs, as well as UCITS or AIFs that share similar characteristics and therefore fall in scope of the Regulation, will have only six months to submit an application to their competition authorities together with all documents and evidence required to demonstrate compliance with the Regulation. CNAV MMFs will have three years to build up their NAV buffer. As a Regulation, the rules will be directly applicable across EU Member States.

Substantial work to address shadow banking remains, both internationally through the FSB and at the European level. There is clearly a strong regulatory will to push reforms through, but some of the proposals are likely to prove controversial with industry, not least of which is yesterday's proposed Regulation for MMFs, against which there is likely to be a concerted lobbying effort. The Commission has not committed to firm deadlines for further proposals to address non-MMF shadow banking issues, noting simply that other measures will follow "as soon as possible." However, with shadow banking to be discussed further at the G20 this week, many industry sectors will need to keep watching this agenda.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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