Key Point to Note:
ESMA publishes its final report on the review of the MMFR which the European Commission must now have regard to in its review of the MMFR. ESMA's key recommendations include (i) A decoupling of regulatory thresholds from suspensions/ gates/redemption fees to limit liquidity stress for LVNAV and CNAV funds; (ii) Removing the possibility to use amortised costs (and stable NAV pricing) for LVNAVs; and (iii) Amendments of the Daily liquidity asset ratios (DLAs)/Weekly liquidity asset ratios (WLAs) applicable to VNAV and LVNAV MMFs
On 14 February 2022 the European Securities and Markets Authority ("ESMA") published its final report on its opinion on the review of the Money Markey Fund Regulation (2017/1131) (the "MMFR"), (the "Final Report"). The European Commission must now have regard to this Final Report in its review of the MMFR which is required to be completed by 21 July 2022.
Following on from the consultation paper issued by ESMA on 26 March 2021 (the "Consultation Paper"), the Final Report outlines ESMA's proposals with respect to the review of the MMFR. As readers will be aware, a number of EU Money Market Funds ("MMFs") experienced liquidity issues and other challenges as a result of the COVID-19 crisis in March 2020, which resulted in large redemptions from investors and a severe deterioration of liquidity of money market instruments on the asset side. According to ESMA, this was particularly the case for some of the Low Volatility Net Asset Value MMFs ("LVNAVs") in US dollars and some Variable Net Asset Value MMFs ("VNAV") in Euro, as both were exposed to money market instruments issued by financial institutions and in particular commercial paper and certificates of deposit which suffered the greatest deterioration in liquidity during March 2020. Although no EU MMF suspended redemptions or used liquidity fees on redemptions or redemptions gates as a result of the crisis, ESMA notes that the recommendations outlined within the Final Report considers the lessons learnt during the COVID-19 crisis.
The recommendations put forward by ESMA in the Final Report include the following:
Reforms aimed at addressing threshold effects for constant NAV MMFs ("CNAVs") and LVNAVs
(i) A decoupling of regulatory thresholds from suspensions/gates/redemption fees to limit liquidity stress for LVNAV and CNAV funds
Following on from strong support by respondents to both the ESMA and the Financial Stability Board consultation reports, ESMA suggests the removal of Article 34 of the MMFR which provides for the possibility of certain liquidity management measures being implemented such as liquidity fees, redemption gates or the suspension of redemptions if the weekly liquid assets ("WLA") ratio of a CNAV MMF or LVNAV MMF falls below 30% and the net daily redemptions on a single working day exceed 10% of total assets. ESMA noted that the rationale for the removal of Article 34 is to avoid what is known as "first mover advantage" whereby investors redeem from the MMF when the WLA ratio declines towards 30%, in order to avoid being subject to the relevant liquidity management measures. It is expected that this recommendation will be broadly welcomed by MMF managers in light of the flexibility it will provide.
(ii) Removing the possibility to use amortised costs (and stable NAV pricing) for LVNAVs
In possibly its most significant recommendation it is Final Report, ESMA has proposed that no private debt MMFs should be able to use the amortised costs method, irrespective of the base or assets they hold which would mean a ban of the amortised costs method for LVNAVs. Under the MMFR, LVNAV MMFs are allowed to use the amortised cost valuation method to value certain assets and need to keep their NAV as calculated using the amortised cost method for certain assets within a collar range of 20 bps as compared to the NAV using entirely the mark-to-market/model valuation method. When this collar is breached, LVNAV MMFs need to use mark-to-market/model valuation for all of their assets. Consequently, the use of the amortised cost valuation method is fundamental in order for LVNAV MMFs to be able to offer a stable NAV to investors.
According to ESMA, the use of the amortised cost method can make LVNAVs prone to first mover advantage and the likelihood of a 'run on the fund', as investors can redeem from the LVNAV MMF at values of the underlying assets that do not necessarily reflect at all times the market valuations of those assets. ESMA noted that it is not suggested to fully remove LVNAVs, as was previously proposed in the Consultation Paper, and they could still offer a marked-to-market/model NAV (albeit with higher liquidity requirements as referred to in paragraph (iv) below) which would be less volatile than VNAVs. Nonetheless, this recommendation will come as a major blow to MMF managers offering LVNAV products on the basis that, if implemented, it will prohibit those funds issuing and redeeming shares at a stable NAV.
Reforms aimed at addressing liquidity related issues
(iii) Imposing an obligation on the MMFs to have at least one liquidity management tool ("LMT") available to them and activation of these liquidity management tools by the manager of the MMF
ESMA has proposed that all MMFs should have in place at least one LMT (i.e., anti-dilution levies / liquidity fees / swing pricing) to ensure that investors effectively bear the cost of their redemptions. ESMA noted that the recommendation, along with preventing the dilution of remaining investors following redemptions, would also likely reduce redemption requests in stressed marked conditions. The flexibility afforded to managers as to the type of LMT is likely to be received positively by managers. In order to harmonise the use of such LMTs by managers of MMFs, ESMA suggests a Commission delegated act specifying the circumstances under which these LMTs will be used.
(iv) Amendments of the Daily liquidity asset ratios (DLAs)/Weekly liquidity asset ratios (WLAs) applicable to VNAV and LVNAV MMFs as well as amending the pool of eligible assets (including public debt assets) which can be used to satisfy the liquidity ratios
ESMA notes that any amendments to the MMFR should help ensure that MMFs are better prepared for periods of increased redemption requests without destabilising the underlying money markets. As such, ESMA has recommended in the context of short term VNAV MMFs and standard VNAV MMFs higher levels of daily and weekly liquidity ratios, along with the possibility of short term VNAV MMFs holding public debt assets to meet weekly liquidity ratios, in order to ensure greater liquidity and reduced risk to the MMF.
With respect to LVNAVs, ESMA is of the view that no additional liquidity requirements should apply to LVNAVs, since the DLA/WLAs for these MMFs are already higher than for VNAVs, and these funds also already have the possibility to meet the WLA ratio with certain public debt assets, under the MMFR.
(v) Inclusion/reinforcement of the possibility to temporarily use liquidity buffers in times of stress
In light of the difficulties faced by MMFs during the COVID-19 crisis in March 2020, ESMA has recommended that it should be possible for the liquidity requirements set out in Article 24 (setting out portfolio rules for short-term MMFs) and Article 25 (setting out portfolio rules for standard MMFs) of the MMFR to be temporarily relaxed in times of stressed market conditions. ESMA has however noted that the release / relaxing of the liquidity requirements should not be activated by authorities on their own initiative as there is a risk that, in relaxing the requirements, the authorities will trigger the crisis which it is trying to contain. In this regard, ESMA suggests a Commission delegated act specifying the stress market circumstances under which the relevant liquidity requirements may be relaxed, as well as the conditions under which the limits can be relaxed.
Complementary/crisis preparedness reforms aimed at enhancing the MMF resilience as a whole
(vi) Enhancement of MMF reporting requirements
ESMA has suggested that more frequent reporting (i.e., daily for key indicators) in stressed marked circumstances would improve authorities' understanding of the risk posed by MMFs and allow for mitigation policy actions to be adopted. In this regard, ESMA has suggested the key indicators comprise the following points subject to any additional key indicators considered necessary and justified by competent authorities:
- portfolio indicators such as the Total Assets, NAV, WAM, WAL;
- in the case of Public debt CNAV and LVNAV MMFs, the mark to market/model NAV;
- subscription and redemption activity (inflows and outflows); and
- daily and weekly maturing assets.
As to what constitutes stressed market circumstances, ESMA suggests that the Commission specify this in a delegated act. In addition, ESMA suggests that it develop draft implementing technical standards to establish:
- the data standards and formats for the information to be reported;
- the methods and arrangements for reporting; and
- the template and content of such reports, to include all the key indicator information.
Finally in normal market conditions, ESMA has recommended that the frequency of reporting should also be raised from quarterly to monthly for MMFs whose assets under management exceed EUR 100 million, and from annually to quarterly for MMFs whose assets under management do not exceed EUR 100 million.
While it remains to be seen how this will be implemented, this proposal is not something which is likely to create controversy amongst MMF managers.
(vii) Enhancement of the MMF stress testing framework
ESMA notes that the current requirements with respect to stress testing are provided under both Article 28 and Article 37 of the MMFR and are complemented by the ESMA Guidelines on MMF stress tests which are updated on an annual basis. A key issue which ESMA raised in this respect is that while individual MMFs might be able to be resilient to an adverse scenario when considered in isolation, this might not be the case when all MMFs face a shock at the same time (i.e., the COVID-19 crisis in March 2020). Additionally, ESMA notes that Article 28(6) of the MMFR requires that the report sent to National Competent Authorities ("NCAs") which contains the corrective measures the manager of an MMF will take where the results of a stress test show vulnerabilities of a specific MMF is also sent to ESMA. However, ESMA is of the view that the coordination mechanism between the NCA and ESMA in this respect needs addressing. In that vein, ESMA has recommended that Article 28 is amended to specify that ESMA would, together with the NCA, receive directly from the manager the report mentioned in Article 28(5) of the MMFR. Additionally, it recommends that the hypothetical macro systemic shocks affecting the economy as a whole as specified in Article 28(1) (f) of the MMFR include, where relevant, the behaviour of other market participants.
(viii) Clarifications around the requirements applicable to external (sponsor) support
ESMA has suggested adding the clarifications introduced in the ESMA Statement on external support published in July 2020 to Article 35 of the MMFR, thereby putting this guidance as regards what amounts to external support onto a statutory footing.
(ix) New disclosure requirements on ratings of MMFs
ESMA suggests making it mandatory for MMFs to disclose that they have a MMF rating as well as the main features of that rating. However, as MMF prospectuses would not be updated every time features of the rating or the rating methodology change, ESMA has proposed that it should be specified within those documents that an update is required only where there is a material change to the rating / rating methodology. In this regard, ESMA has suggested that the Commission adopt a delegated act specifying what be understood as a material change.
Following receipt of the Final Report, the European Commission will now review the adequacy of the MMFR. The updates outlined above will be of significant importance to all MMF managers but particularly those managers of LVNAV MMFs in light of the proposed prohibition on the use of amortised cost in those products and the knock-on effect of the inability of those funds to issue and redeem shares at a stable NAV. It remains to be seen whether all of these recommendations will be accepted by the European Commission under its review but to the extent they are, there will naturally be a lead-in time before they come into force in light of the amendments needed to the MMFR which will give managers time to assess their options.
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