European Money Market Fund Reform A long time in the making February 2017 For Professional Clients Only
Executive summary After many years of debate the finishing line for the new European money market fund ( MMF ) regulation is in touching distance. In this paper we summarise the key aspects of the regulation that still has three hurdles to clear before becoming official, although we do not expect any of these hurdles to be clipped and are confident that what we outline in this paper will be the final regulation. The regulation is extremely granular, as well as having been through a number of different proposals in recent years from the main European bodies. The simplest way to explain what are now expected to be the final rules is to break it down into two parts; structural changes to the industry and changes to the risk profile of MMFs. Here we will tackle structural changes first. We believe the Low Volatility NAV or LVNAV funds are a credible alternative to Prime CNAV funds Existing MMFs will have to comply with the new regulation within 18-months. Based on our current projections this takes us to Q4 2018 HSBC Liquidity Internal Investment Guidelines are already roughly equivalent to the new regulation In terms of risk profile and ability to manage assets, not much will change in HSBC AMG Liquidity funds Many existing HSBC Global Asset Management internal investment guidelines are more conservative than the proposed regulations Relative returns to other short term cash investments such as deposits should be consistent with past experience European MMF regulation is different in a number of key areas to that implemented in the USA. We do not expect the initial structural shift from Prime to Government MMFs seen in the US. This regulation is likely to concentrate further the MMF industry into a smaller number of committed players with scale; The regulation is complex, requires a lot of resources (credit analysts, risk monitoring, client analysis, etc ) and put new responsibilities in terms of Governance on a Fund s Board of Directors (= FMC for FCPs) We believe this new regulation will create a better level playing field in the industry More focus and onus are put on local regulators The devil is in the details though, particularly as far as the mark to market pricing determination is concern 2
Structural changes to the industry driven by the new MMF regulation By far the more significant changes that are coming out of the new regulation are the structural changes that it creates for the MMF industry. The key structural changes are outlined below: 1. A new type of MMF is born the Low Volatility NAV ( LVNAV ) Structure before regulation Structure post regulation Risk profile Constant NAV full amortised cost accounting Public debt Constant NAV full amortised cost accounting Short term MMF only Variable NAV partial amortised cost accounting and partial mark-to-market LVNAV partial amortised cost accounting VNAV full mark to market Short term MMF only Short term and Standard MMF The creation of the LVNAV MMF is a key part of the European regulation and, in our opinion, is an effort by European regulators to ensure that an MMF that invests primarily in non-government debt is in a form that many investors will find attractive while addressing regulators key concerns surrounding MMFs. This hybrid solution is a primary difference between the evolution of regulators plans in Europe versus the US (where no such compromise exists in between CNAV Government and VNAV Prime funds). We believe that LVNAV MMFs will attract a significant proportion of the cash invested in today s Prime Constant NAV ( CNAV ) MMFs, in part as we believe investors will value those features similar to existing CNAV prime funds that many use today. 2. Credit ratings for MMFs will remain The European Commission s original proposal in September 2013 to prohibit the sponsor of a MMF soliciting or paying for a credit rating for a MMF was a major area of concern for investors in AAA rated MMFs. The good news for investors is that this proposal will not form part of the final regulation and fund sponsors will continue to be able to offer MMFs that have a credit rating from one or more of the three main credit rating agencies. 3. External support of a MMF is prohibited The provision of support by the sponsor or a third party is explicitly prohibited in the new regulation. While there is no prohibition of support in regulation today in practice the probability of a sponsor providing support has changed post the 2008 credit crisis. Changes to accounting rules and new regulation in other parts of financial services means the cost of providing support today has risen significantly and is likely to be financially prohibitive. We are pleased to see this explicit prohibition of external support in regulation as the current situation can lead to ambiguity about who owns the risk of investing in a MMF. Liquidity fees and redemption gates apply to public debt CNAV and LVNAV MMFs. 4. Liquidity fees and redemption gates apply to public debt CNAV and LVNAV MMFs The probability of liquidity fees and redemption gates forming part of the final regulation has been high for a number of years. In fact the majority of CNAV MMFs today have some form of liquidity fee and redemption gate provision. The feature therefore is not new to investors and have been discussed with investors for a number of years as part of the broader debate on MMF regulation. 3
Ultimately both mechanisms are designed to protect investors. Liquidity fees allow a MMF to manage a severe liquidity event ensuring that the cost or providing liquidity is borne by any investor that redeems rather than those that remain in the fund. This also means that any investor that wants to remain invested in the fund is not incentivised to follow redeeming investors in the fear that they will pay the cost of providing the liquidity if they remain. The regulation requires a MMF to follow a specific process in the event of significant redemption activity. Specifically, if the proportion of assets that mature within one week falls below 30% and the daily net redemptions on a single business day exceed 10% of total assets the Board of Directors of the MMF must make an assessment, taking into account the best interest of shareholders, whether to apply a liquidity fee or redemption gate. In addition, if the proportion of assets maturing within one week falls below 10% then the Board of Directors must apply a liquidity fee and / or a redemption gate for up to 15 days. A comparison of the investment constraints in the new MMF regulation To quantify the new investment constraints in the MMF regulation we show the key constraints compared to HSBC Global Asset Management s own internal investment guidelines and the Standard and Poors Principal Stability MMF constraints for a AAA rated MMF. Here we show the new regulatory constraints for an LVNAV as this is the closest comparison to the Prime MMFs we offer today. 1Source: Institutional Money Market Fund Association 2Standard2 and Poors, February 2017 In practice what is an LVNAV MMF? An LVNAV MMF has some similarities and some important differences to today s Prime CNAV MMFs. An LVNAV MMF is intended to invest primarily in credit (bank, agency and corporate), follow many of the same key investment constraints and price to two decimal places as today s Prime CNAV MMFs do. The fact an LVNAV MMF will be able to price to two decimal places is an important one. It is the fact that CNAV MMFs today use two decimal place pricing that means that a CNAV MMF would break the buck if its shadow NAV (the at least weekly markto-market of the assets) is at or below 0.9950 or is at or above 1.0050 i.e. if the shadow price moves by + or 0.50%. The important difference with an LVNAV is that the MMF regulation stipulates that if the daily price is + or 0.20% then the fund must switch to four decimal places pricing and thus the price would move. The collar is fixed by regulation rather than being arithmetic, and is narrower. 4
Primary risk constraints Risk constraint New regulation short term LVNAV HSBC Global Asset Management internal guidelines Standard and Poors principal stability fund constraints (AAAm) WAM maximum 60 days 60 days 60 days WAL maximum 120 days 90 days 90 days Individual asset maximum 397 days 397 days 397 days Overnight liquidity minimum 10% 20% Not applicable 1 week liquidity minimum 30% 30% Not applicable Diversification constraints Diversification constraint New regulation short term LVNAV HSBC Global Asset Management internal guidelines Standard and Poors principal stability fund constraints Per counterparty group (all above exposure) maximum 15% 5% banks (10% overnight only certain banks) 10% agencies 2% corporates 15% except for AA- or better rated banks Per counterparty group (reverse repo) maximum 15% 25% overnight 10% 2-5 business days 5% 5-30 business days 25% overnight* 10% 2-5 business days 5% > 5 business days Asset Backed Commercial Paper total exposure maximum 15% 30% Not applicable Public debt per issuer maximum 100% 100% Eurozone < A** rated 35% 100% AA or higher 50% AA- or below The tables above show a sample of the investment constraints. There are many more constraints not shown here but we have chosen some of the most important ones to illustrate. We have also identified where the current HSBC Global Asset Management internal investment guidelines are more (highlighted in green) or less (highlighted in red) conservative than the new regulation for short term LVNAV MMFs. In essence our existing guidelines already meet or exceed the requirements of the forthcoming regulations in most areas, and where not will be easily adapted to do so. The regulation also covers areas such as the credit assessment process, transparency to investors and to regulators, stress testing and know your customer policies. *A-1 short term rated counterparties ** A star is HSBC Global Asset Management highest internal credit rating 5
Europe has taken a different approach to the US in the regulation of MMFs in two key areas There are many similarities between the new sets of MMF regulation in the US and Europe. However, with both sets of regulation being very granular we will again focus on the key differences. There are two key factors that we believe are important to highlight. Firstly, the Securities and Exchange Commission s ( SEC ) 2a-7 regulation prohibited the investment in CNAV Prime MMFs by institutional investors. This type of MMF is now only available to retail investors. Institutional investors in the US have the choice of CNAV Government and Treasury funds or VNAV Prime funds. This is a significant difference with Europe where institutional (and retail) investors will have access to the LVNAV Prime MMFs as well as CNAV Public Debt MMFs. Secondly, while both sets of regulation require some MMFs, public debt CNAV and LVNAV in the case of Europe and Prime Institutional in the case of the US, to have the ability to apply liquidity fees or redemption gates there are again important differences to note. In relation to the event that would require a Board of Directors to determine whether to apply a liquidity fee or redemption gate our interpretation is that the probability of this event occurring would be lower in Europe. In our opinion that is a reasonable view because in practice there has never been a systemic liquidity event for MMFs in Europe and only one idiosyncratic event that we are aware of (to a competitors MMF). And of course investors in Europe are far more familiar with these mechanisms as they have formed part of the toolkit available for many years to managers of MMFS to help them manage in the best interest of all investors. Q2 2015 European Parliament votes through its proposal for MMF reform Next steps and the timeline As mentioned at the start of the paper there are some final steps to take before the regulation is officially adopted into law in Europe. The European Parliament must hold a plenary vote where all Members of the European Parliament are able to vote on the proposed regulation. The Ministers in Council, the finance ministers of the 28 EU governments, also have to sign the new regulation. We expect both these events to take place in the first or second quarter this year. The final stage is for the regulation to be published in the Official Journal of the EU 20 days after which the regulation will come into force. Existing MMFs have 18-months before they are required to comply with the new regulation. An important area where further work is required is to get confirmation that LVNAV and VNAV MMFs will qualify as cash and cash equivalents for reporting purposes. Along with our peers in the industry and the relevant industry associations we will work to ensure that the MMFs qualify as cash and cash equivalents. Our current estimate is that the HSBC Global Liquidity Funds will be required to comply with the new regulation in Q3 or Q4 2018. We will continue to work with you over the coming months to help you evaluate the full implications of the reform for you and to help you with your preparation for discussions with your Treasury risk committees. Q3 2016 Q4 2016 Trilogue takes place European reforms for MMFs announced September 2013 European Commission proposes reforms for MMFs in Europe following a cost/benefit analysis Q4 2015 Q2 2016 European Council proposes position and votes on its proposal for reform of MMFs in Europe Q2 2017 Q4 2018 (estimate) Transition period before final implementation of regulatory requirements 6
Important information For Professional Clients only and should not be distributed to or relied upon by Retail Clients. The material contained herein is for information only and does not constitute legal, tax or investment advice or a recommendation to any reader of this material to buy or sell investments. You must not, therefore, rely on the content of this document when making any investment decisions. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe to any investment. Any views expressed were held at the time of preparation, reflected our understanding of the regulatory environment; and are subject to change without notice. The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. HSBC Global Liquidity Funds plc is an open-ended Investment company with variable capital and segregated liability between sub-funds, which is incorporated under the laws of Ireland and authorised by the Central Bank of Ireland. The company is constituted as an umbrella fund, with segregated liability between sub-funds. UK based investors in HSBC Global Liquidity Funds plc are advised that they may not be afforded some of the protections conveyed by the provisions of the Financial Services and Markets Act 2000. The Company is recognised in the United Kingdom by the Financial Conduct Authority under section 264 of the Act. The shares in HSBC Global Liquidity Funds plc have not been and will not be publicly offered for sale in the United States of America, its territories or possessions and all areas subject to its jurisdiction, or to United States Persons. All applications are made on the basis of the current HSBC Global Liquidity Funds plc Prospectus, Key Investor Information Document, Supplementary Information Document (SID) and most recent annual and semi-annual reports, which can be obtained upon request free of charge from HSBC Global Asset Management (UK) Limited, 8 Canada Square, Canary Wharf, London, E14 5HQ. UK, or the local distributors. Investors and potential investors should read and note the risk warnings in the prospectus and relevant KIID and additionally, in the case of retail clients, the information contained in the supporting SID. It is important to remember that there is no guarantee that a stable net asset value will be maintained. HSBC Global Asset Management (UK) Limited provides information to Institutions, Professional Advisers and their clients on the investment products and services of the HSBC Group. Approved for issue in the UK by HSBC Global Asset Management (UK) Limited, who are authorised and regulated by the Financial Conduct Authority. www.assetmanagement.hsbc.com/uk Copyright HSBC Global Asset Management (UK) Limited 2017. All rights reserved. 7