The spotlight on shadow banking

By Business & Finance
31 March 2013
fintech euro money cash

Cormac Commins considers the current debate on regulatory reform of money market funds.

Cormac Commins‘Systemic risk’,‘shadow banking’, and ‘susceptibility to runs on redemptions’ – these are just some of the recurring bywords forming a common thread in the current drive for regulatory overhaul of money market funds (MMFs).

With such venerable institutions as the Financial Stability Board (FSB), IOSCO, the European Commission, ESMA (the European Regulator), the SEC, and the Financial Stability Oversight Committee (FSOC) involved, it feels like regulators on both sides of the Atlantic are on a full-on frontal offensive to reform the global $4.2 trillion MMF industry.
But what is driving this initiative and are we likely to see significant change in the near future?

Since the financial crisis of 2008, G20 leaders and regulators have committed to strengthening the regulation of the financial sector and the supervision of entities which are considered to fall within the arena of shadow banking. Among the possible shadow banking entities identified are MMFs, suggested to be products with deposit-like characteristics, susceptible to runs on redemption, thus posing a systemic risk to the orderly functioning of the financial markets.

Coming under particular focus is one of two species of MMFs, namely constant NAV (CNAV) MMFs. In CNAV funds, the value of a single share in the fund is constant or fixed, for example, at $1. Returns therefore do not come in the form of an increase in the value per share, but rather as dividends paid out in cash or reinvested in additional shares. By contrast, shares of variable NAV (VNAV) MMFs – the second species of MMF – fluctuate with the value of the underlying assets, much in the same way as the share price of a typical mutual fund would.

Regulatory concern with the CNAV model is that maintaining each share at a fixed price may lead investors to believe that the product affords some form of capital guarantee and is akin to a bank deposit. The view is that should any CNAV fund ‘break the buck’ (mark down a share’s value to below $1 due, for example, to an underlying security being written down) this would result in a run on redemptions as investors sought to preserve their capital, forcing funds to liquidate their positions.

Some regulators argue that moving from a CNAV to a VNAV model, permitting the share price to float up or down, would make gains and losses a regular occurrence, as they are in other mutual funds, and alter investor expectations that CNAV MMFs are risk-free, equivalent to cash. Promoters of CNAV funds, which represent approximately 80% of the global MMF market, counter this by pointing out that CNAV MMFs should not be considered to be like bank deposits (they are of course, mutual funds) and that the susceptibility of such products to a run on redemptions applies equally to all other types of mutual funds, including VNAV MMFs.

They also point to the fact that investors still have a desire from an ease of operation perspective for the CNAV model and any mandatory move to a VNAV model, in addition to being operationally challenging or indeed, operationally unworkable, might result in investors diverting funds to other less regulated products.

While some MMF regulatory reforms were introduced in the US in 2010 and in Europe in 2011 – including requirements for greater liquidity within MMFs, higher credit quality of underlying investments, shorter maturity limits of underlying investments – the push is on for more radical reforms. These include the imposition of redemption gates, capital buffers and, what has been described as the nuclear option, mandatory conversion of CNAV funds to VNAV funds. Whether or not the proposed regulatory reform, in particular the mandatory conversion to VNAV, will be introduced in the near term, if at all, is an open question.

In the US, the SEC has very publicly failed to achieve consensus on the shape of reform of US MMFs. Despite the recent announcement that FSOC now take up the baton in the US to drive further MMF regulatory reform, the view is that this will likely not lead to the structural reforms proposed.

The reform of European MMFs, most of which are established as UCITS, is currently part of the consultation which the European Commission has issued on a future framework for UCITS funds, otherwise known as UCITS VI. While any changes to the regulation of European MMFs will most likely be influenced by the 15 recommendations which MMFs should adopt, recently issued by IOSCO (including conversion to VNAV where workable), as no implementation date has yet been set for UCITS VI, it may be some time before any reform of European MMFs will occur.

Whatever happens, however, and irrespective of which direction reform may go, it is important that a global approach is followed so that MMFs on both sides of the Atlantic operate in a consistent manner. To do otherwise would potentially lead to greater investor confusion.

*This article was originally published in Funds Review Ireland 2013.