Impacts of Money Market Reform Understanding how change to prime money market funds may affect your cash investment strategies Barry Harbison North American Head of Liquidity Product June 2016 For institutional and financial advisor use only. Not for further distribution.
Table of Contents Executive Summary...3 Changes to Rule 2a-7 to be introduced in 2016...4 Understanding market-based NAVs...6 Variable NAV (VNAV) analysis...7 Weekly Liquid Assets...10 Conclusion...12 Appendix...14 Important Information...16 2
Executive summary Enhanced money market fund regulation, in the form of an amendment to Rule 2a-7of the Investment Company Act of 1940, is due to come into effect in 2016. With less than six months to go until the more structural changes are implemented, it is time to address in some detail how these changes will impact institutional investors in prime money market funds. HSBC Global Asset Management (HSBC) believes that the value proposition of prime money market funds persists despite these changes, and that prime funds will continue to be an important cash management option for large corporate and institutional investors. We believe that investors should use the remaining time to fully understand the new regulations and how they will impact their cash investment strategies from October 2016 onwards. About the author Barry Harbison, North American Head of Liquidity Product Barry Harbison is North America Head of Liquidity Product and has been working in the industry since 2006. Prior to joining HSBC in 2008, Barry worked as an attorney at A&L Goodbody Solicitors (Dublin, Ireland) where he specialized in advising a variety of mutual funds. He holds a LL.B. (Hons) Bachelor of Laws from Queens University in Belfast, Northern Ireland. 3
Changes to Rule 2a-7 to be introduced in 2016 Changes to Rule 2a-7 that came into effect in April 2016 were largely focused on ensuring money market fund investors have access to relevant information for evaluating a fund s risk levels. This information will become increasingly important to investors in money market funds as the last of the regulatory changes come into effect in October 2016. The following data is now disclosed on a daily basis on a money market fund s public website: Daily & weekly liquid assets The portion of a fund s assets that mature overnight and within the next 5 business days. This is a key metric of a fund s liquidity and ability to meet redemptions. The SEC requires money market funds to maintain daily liquid assets of at least 10% and weekly liquid assets of at least 30%. Daily market-based NAVs Daily disclosure of the mark to market net asset value (NAV) will now become standard across the money market fund industry. This will allow investors to monitor how much the NAV of a prime money market fund fluctuates. Net shareholder flows Money market funds must disclose the level of net inflows or outflows each dealing day. This helps investors assess the shareholder trading activity of a fund and how that impacts the liquid assets of that fund. Sponsor support Money market funds must disclose all instances where the sponsor has provided financial support to the fund over a preceding 6-month period. Enhanced stress testing of money market funds was also introduced in April 2016 to provide detailed and consistent analysis to a fund s board of directors to demonstrate how the fund and its underlying investments might react to certain stress scenarios. The amended rules with an implementation deadline of October 2016 will result in structural changes to how money market funds operate. Prime institutional money market funds will be required to publish and trade on a market-based NAV rounded to the fourth decimal point, otherwise known as a floating NAV. Market based NAVs are not a new phenomenon. Money market funds have always had to calculate a market based NAV. As part of changes to Rule 2a-7 which came into effect in 2010, money market funds were obliged to report these NAVs to the SEC and publish them with a 60-day lag. 4
Money market funds have previously been able to trade at a stable NAV as long as they met the requirements of Rule 2a-7 permitting the fund to use amortized cost to value its assets and rounding the NAV to the nearest two decimal places. With Rule 2a-7 amended to remove these measures, a prime money market fund being sold to institutional investors will have to transact at its market based NAV by October 2016. In stressed market scenarios, money market funds will be able to impose liquidity fees and/or redemption gates to protect existing investors. This will be compulsory for prime money market funds, and other money market funds may opt in. A liquidity fee is a fee which can be charged to investors redeeming from a money market fund during a period when that fund is under stress to ensure that the costs of obtaining that liquidity are paid for by the redeeming investor and not by investors who remain within the fund. As remaining investors are protected from the impact of redemptions, they have less incentive to redeem and may choose to remain invested until liquidity fees are no longer imposed by the fund. This reduces the likelihood of a run on a fund and as such reduces the need for a money market fund s board to implement a redemption gate. A redemption gate describes an emergency power where a fund s board may restrict redemptions from a money market fund with the aim of stopping a run on that fund during a period where the fund is under stress. The power to impose liquidity fees or redemption gates lies with a fund s independent board of trustees and relies on their determination that imposing such fees or gates is in the best interests of the fund and its shareholders. The fund s board may set a liquidity fee of up to 2% should a fund s weekly liquid assets drop below 30%. If the fund s weekly liquid assets fall below 10%, the board must impose a liquidity fee of 1% unless it determines that the liquidity fee is not in the best interests of the fund s shareholders. The fund s board may set a redemption gate should the fund s weekly liquid assets drop below 30%, if the board believes the gate is in the best interests of a fund and its shareholders. Gates can stay in place for a maximum of 10 consecutive business days, and a maximum of 10 business days in any 90-day period. 5
Understanding market-based NAVs New rules mean the NAV per share is likely to fluctuate A market-based NAV is simply an alternative way to reflect the underlying value of a money market fund s portfolio of securities. It represents the value of each share in a money market fund should the fund sell its underlying assets at that point in time. As the NAV is calculated using a market-based price for each underlying asset, any price movement in these assets changes the NAV per share of the fund, which creates the floating NAV. Some examples of events that can impact the market based price of a fund s underlying assets: Interest rate changes Credit spread changes Significant inflows or outflows from a fund Defaults or rating downgrades in the underlying securities Given the high credit quality and short average maturity in the underlying investments of money market funds, market-based NAVs are generally not expected to fluctuate significantly. However, it is important for investors to understand that selling shares at a different NAV will result in a gain or a loss. The IRS has issued guidance aimed at simplifying tax reporting for investors trading into and out of money market funds with floating NAVs. This guidance allows investors to measure net gains and net losses in a floating NAV money market fund in aggregate over a period of time which the investor can select. This means that gains and losses can be tracked in aggregate over a time period rather than tracking individual transactions. The guidance also exempts redemptions in variable NAV money market funds from wash sale rules. This means an investor in a 2a-7 floating NAV money market fund does not have to recognize a loss on a sale of shares in the fund if they acquire substantially identical stock or securities within a period beginning 30 days before and ending 30 days after the date of the sale. IRS and Treasury Guidance Money market fund investors should consult with their accountants and tax advisors to understand how these changes will impact their cash investments. 6
Variable NAV (VNAV) analysis HSBC has analyzed market data from January 2001 through January 2016 to better understand how often the NAV of four hypothetical prime money market portfolios could potentially decline. We considered how different factors, such as restricting portfolio maturities and investors holding the shares for longer periods of time would impact the frequency of negative returns. Our baseline portfolio applies HSBC s internal liquidity investment guidelines, known as LIIGs. In this baseline scenario, the hypothetical portfolio has securities with a range of maturities out to the maximum permitted maturity of one year. It includes instruments with laddered maturities: overnight, one week, one month, 3 months, 6 months and 12 months. This baseline portfolio can be considered to have the maximum risk permitted within the LIIGs and should therefore produce a worst case scenario or the highest possible NAV fluctuation. Given that these were hypothetical portfolios, we did not apply any active investment management decisions so that the investment constraints were consistent throughout the examined period. (This differs, of course, from an actively managed money market fund where the investment adviser can adjust investment constraints based on market conditions, as long as the fund remains in line with regulatory guidelines and its prospectus.) Our hypothetical portfolios also took into account the portfolio return when determining how long it would take for an NAV to recover from a previous day s decline. As such, a portfolio s recovery time from a decline in the NAV is longer in periods of low interest rates than in periods of higher rates. 7
Frequency of NAV declines Figure 1 shows the frequency of negative returns in each of the hypothetical portfolios over the period January 2001-January 2016. It demonstrates that reducing the maximum maturity of the securities in a portfolio has a significant impact on the frequency of NAV declines. Figure 1. Daily NAV declines of hypothetical money market portfolios 8.24% 4.86% 1.91% 0.48% Source: HSBC Global Asset Management. January 2001 January 2016. See important additional information on hypothetical performance. It is also worth noting that Figure 1 takes into account all daily NAV declines over the period. If an investor should hold shares for at least one week, the frequency of NAV declines decreases substantially as shown in Figure 2. Figure 2. Weekly NAV declines of hypothetical money market portfolios 3.00% 1.55% 0.69% 0.00% Source: HSBC Global Asset Management. January 2001 January 2016. See important additional information on hypothetical performance. 8
Extent of NAV decline and time to recover After considering how often the NAV per share of the hypothetical portfolios decreased over the period, we examined how much the NAV declined and how long it took to recover from that decline (factoring in the yield as well as an increase in value). Figure 3. Time to recover from daily NAV declines Risk Profile Maximum price fall Average price fall Average days to recover price fall Max with current LIIGs 14bp 1bp 2.86 days Max 6-month maturity 11bp 1bp 2.82 days Max 3-month maturity 6bp 1bp 2.96 days Max 1-month maturity 2bp 0.5bp 1.94 days Source: HSBC Global Asset Management. January 2001 January 2016. See important additional information on hypothetical performance. In Figure 3 we show daily NAV declines and the average time it took the NAV of each hypothetical portfolio to recover the decline in NAV. Limiting the maximum maturity of the portfolios reduced the extent of the largest daily NAV decline; however, as Figure 4 shows, limiting maturities typically reduces the return on that portfolio over time, which effectively increases the time it takes to recover a NAV decline. Figure 4. Limiting maturities reduces returns Return profile: Annualized 3-month returns Full period Pre-Aug 07 Aug 07 Oct 09 Post Oct 09 Max with current LIIGs 1.91% 3.01% 3.23% 0.32% Max 6-month maturity 1.88% 3.00% 3.17% 0.29% Max 3-month maturity 1.84% 2.99% 3.02% 0.25% Max 1-month maturity 1.76% 2.97% 2.68% 0.20% Source: HSBC Global Asset Management. January 2001 January 2016. See important additional information on hypothetical performance. Summary Our analysis has shown that there were some movements in the market-based NAVs of a hypothetical prime institutional money market portfolio over the 15 year period, January 2001 January 2016. The magnitude of these movements and the time it took to recover these NAV declines were both reduced, in some cases significantly, by reducing the maximum maturity of the portfolio. The frequency of the NAV declines was also reduced by the length of time an investor held shares in the portfolio. Investors considering investing in prime institutional money market funds with floating NAVs should consider the risk parameters of these funds and the length of time they expect to hold shares in these funds. Each of these factors can affect how often the investor may have to potentially sell shares at a lower NAV than at purchase. 9
Weekly Liquid Assets A new metric for measuring liquidity risk in money market funds The SEC introduced changes to Rule 2a-7 in 2010, in response to the impacts of the Lehman Brothers bankruptcy and the subsequent failure of the Reserve Primary Fund in October 2008. These changes were broadly welcomed by the money market fund industry as they codified many enhancements money market fund providers had already made to their funds since 2008. In releasing its 2014 changes to Rule 2a-7, the SEC noted that the 2010 changes had made money market funds more resilient in the face of challenges they had encountered since then, challenges such as the European debt crisis in 2011 and the US debt ceiling issues. The 2010 rule changes imposed new standards for the maturity, credit quality and liquidity of the underlying investments of a money market fund. The rules on liquidity introduced in 2010 are an important starting point when considering the impact of the changes to money market fund regulation due to take effect in October 2016, particularly in terms of imposing liquidity fees or restricting redemptions. Since 2010, money market funds have been subject to the following minimum liquidity requirements: 10% of a fund s assets must mature within one business day (i.e., overnight). This can include Treasuries, cash or instruments maturing the next day 30% of a fund s assets must mature within the next 5 business days (known as weekly liquid assets ). This can also include Treasuries, cash, certain government securities and instruments maturing within the next 5 business days A money market fund can drop below the regulatory requirement to hold 30% of a fund in weekly liquid assets on a passive basis, typically caused by unexpected fund redemptions. In these circumstances, a passive breach could be cured by any combination of: fund inflows, allowing instruments beyond one week maturity to mature, or selling fund assets in the secondary market 10
All money market funds have been required to publicly report overnight and weekly liquid asset levels for the prior 6 months from April 2016 onwards. With a fund s weekly liquid asset levels becoming the trigger for the fund board to consider imposing liquidity fees and redemption gates, we will likely see increased investor focus on this metric. It is important to bear in mind the two separate triggers that allow a money market fund board to consider implementing liquidity fees or redemption gates: Investors in money market funds should not necessarily interpret a drop below the 30% weekly liquid asset level as an absolute trigger point for a fund to impose a liquidity fee. 30% weekly liquid assets. When liquidity levels drop below 30%, the board may decide to implement a liquidity fee or limit redemptions if they think it is in the best interests of the fund and its shareholders. In practice, crossing the 30% weekly liquid asset level does not in and of itself indicate a liquidity issue in a money market fund. 10% weekly liquid assets. If liquidity levels drop below 10%, a fund board must implement a liquidity fee unless they determine that this is not in the best interests of the fund and its shareholders. Bearing in mind that a money market fund is required to have 10% of its assets maturing overnight, a drop in weekly liquid assets to 10% would represent a drastic reduction in a fund s natural liquid assets and would indicate that a fund has sustained significant levels of outflows likely coupled with the inability to sell assets in the secondary market. In a release explaining the changes to Rule 2a-7, the SEC stated that it chose not to set a single trigger point for imposing a liquidity fee because this could induce investors to redeem pre-emptively from a money market fund when it approached that level. Investors in money market funds should not necessarily interpret a drop below the 30% weekly liquid asset level as an absolute trigger point for a fund to impose a liquidity fee. 11
Conclusion The value proposition of money market funds remains intact Money market funds have proven popular with corporate and institutional investors because they aim to provide safety, liquidity and a competitive money market return. While the current changes in regulation may cause investors to think carefully before including money market funds as one of their cash investment solutions, it is important to consider the changes in context. Transacting at a market-based NAV does not make a prime institutional money market fund an outlier in the world of cash investment options. All other shortterm securities that investors may consider for their cash management needs, (including commercial paper or Treasuries), have a market-based price that fluctuates over time, assuming the instrument is not held to maturity. After October 2016, bank deposit products, such as time deposits, will be the only cash investment option to have a fixed value. However, in many instances, even here there are costs to breaking a deposit before maturity in the same way that there is a cost to sell a security. The introduction of floating NAVs and the ability to implement liquidity fees or redemption gates is not expected to prevent money market funds from being considered as cash equivalent under US Generally Accepted Accounting Principles ( US GAAP ). In its release of the final rule amending Rule 2a-7, the SEC confirmed that the Commission s position continues to be that, under normal circumstances, an investment in a money market fund that has the ability to impose a fee or a gate under Rule 2a-7(c)(2) qualifies as cash equivalent for the purposes of US GAAP. IRS guidance is expected to remove some of the anticipated burden placed on investors in floating NAV money market funds. As set out above, trading into and out of a money market fund with a floating NAV can create gains and losses for investors. Guidance issued by the IRS seeks to reduce the record keeping burden for investors as well as exempting trades in a money market fund from existing wash sale rules. 12
Despite the evolving regulatory landscape, money market funds will continue to play an important role for cash investors seeking a diversified investment product aimed at providing safety, liquidity and a competitive money market return. Investors should take care to fully evaluate how the new rules will impact their cash investments before deciding whether to continue to use prime institutional money market funds post October 2016. We believe that money market fund investors should use the time between now and October 2016 to: Understand the regulatory changes Consider how the changes impact your current and future cash investment strategy Update your investment guidelines, where necessary Communicate the changes within your organization and determine your cash investment strategy from October 2016 onwards HSBC firmly believes that prime money market funds will continue to be an important cash investment solution despite the changes we have highlighted. If we can be of any help to you in navigating these regulatory changes, please do not hesitate to contact us. Contact us Take the next step To learn more about how HSBC can help you better manage liquidity in today s evolving global economy, please contact your HSBC client services team. For more information, please contact us: Americas T: +1 (1) 212 525 5750 E: global.liquidity@us.hsbc.com For more information on our capabilities go to www.globalliquidity.hsbc.com 13
Appendix Questions to help money market fund investors navigate the evolving world of money market funds We have compiled a list of questions which an investor should consider in light of the changes to money market fund regulation in 2016. Impact on your investment policy Do you plan to use prime money market funds post-reform? Does your investment policy permit you to use floating NAV money market funds? Do you plan to use different cash management products (e.g., separately managed accounts) as a result of the changes in money market fund regulation? If so, does your investment policy currently permit the use of these products? Liquidity Needs Investors using prime institutional money market funds after October 2016 will need to consider a fund s operational processes in detail to ensure that the fund continues to meet their liquidity needs. As subscription and redemption trades in these funds will be transacted at an NAV struck after the trade is placed, the time it takes to strike the NAV and settle the trades will impact the frequency of intra-day redemptions in prime money market funds and it will extend the time it takes to process redemption wires. At present, many fund sponsors plan to offer prime institutional money market funds with multiple NAV strikes per day. This will allow the funds to settle redemption trades within a set time frame after that NAV has been struck, providing investors with the same day liquidity they value from current money market funds. However, given the complexity of calculating a market-based NAV under the new rules, prime institutional money market funds are likely to have fewer intra-day settlement windows throughout a trading day than they have at present. What time of day do you typically trade? At what time of day do you require redemption proceeds to be paid? How soon after you have placed a trade do you expect to receive redemption proceeds? Do you ever have late day trading requirements? 14
NAV Volatility Prime money market funds sold to institutional clients will have to transact at a market-based NAV from October 2016 onwards. Our analysis has shown that while the market-based NAV does fluctuate over time, certain factors can reduce the impact of that NAV movement, such as the length of time an investor holds shares in that fund. How often do you typically trade into and out of a money market fund? Do you have a tolerance level for NAV volatility? How will you monitor a fund s NAV to determine if it remains within your tolerance levels? Have you considered the fund s yield when calculating your tolerance levels to NAV volatility? Are your accounting systems able to handle purchases and sales of floating NAV money market funds? Fees and Gates From October 2016 onwards, money market fund boards will have the power to impose liquidity fees and/or to restrict redemptions from the fund in times of stress. That stress is defined in Rule 2a-7 by a decline in the fund s weekly liquid asset levels. A decline below the regulatory minimum of 30% triggers the ability to impose a redemption gate or a liquidity fee. A decline below 10% imposes an obligation for the board of directors to impose a fee or make a determination that a fee is not in the best interests of the fund and its shareholders. Investors will need to pay close attention to a fund s weekly liquid asset levels and understand how that fund s investment adviser typically handles unexpected redemptions or drops in weekly liquid assets. What are the historic weekly liquid asset levels of the funds we are investing in? What causes a fund s weekly liquid assets to drop below 30%? How volatile are the shareholder flows in the prime money market fund? What measures are prime money market funds taking to reduce the impact of unexpected flows? Would you expect a prime money market fund to sell securities in the secondary market to bring weekly liquid asset levels back above 30% or allow liquidity levels to recover naturally? 15
Important Information For institutional investor and financial advisor use only. Not for further distribution. This document is for information only and does not constitute investment advice, a solicitation or a recommendation to buy, sell or subscribe to any investment. It is not intended to provide and should not be relied upon for accounting, legal or tax advice. HSBC Global Asset Management is the marketing name for the asset management businesses of HSBC Holdings Plc. HSBC Global Asset Management (USA) Inc. is an investment adviser registered with the US Securities and Exchange Commission. HSBC Global Asset Management has based this material on information obtained from sources it believes to be reliable but which it has not independently verified. HSBC Global Asset Management and HSBC Group accept no responsibility as to its accuracy or completeness. The views expressed were held at the time of preparation and are subject to change without notice. Forecasts, projections or targets are indicative only and are not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecasts, projections or targets. Past performance is no guarantee of future results. There is no assurance that a portfolio will achieve its investment objective or will work under all market conditions. The value of investments may go down as well as up and you may not get back the amount originally invested. Portfolios may be subject to certain additional risks, which should be considered carefully along with their investment objectives and fees. Hypothetical information presented does not represent actual investment accounts. Results are provided for illustrative purposes only and are no guarantee of future performance. The results do not include the impact of fees, which would lower the returns. No representation is being made that any portfolio has achieved, or will likely achieve the results shown. Any changes to the allocation could have a material impact on the returns set forth. Hypothetical examples have many inherent limitations and are generally prepared with the benefit of hindsight. In addition, there can be sharp differences between hypothetical results and actual results. Keep in mind, factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of hypothetical results, can adversely affect actual results. US persons (both entities and individuals) are subject to US taxation on their worldwide income and may be subject to tax and other filing obligations with respect to their US and non-us accounts. The Foreign Account Tax Compliance Act (FATCA) is a US law designed to prevent the use of non-us accounts or non-us entities to avoid US taxation of income and assets. To meet this objective, FATCA imposes on US and non-us entities certain documentation, due diligence, withholding and reporting requirements with respect to accounts and certain payments. Investors should consult their independent tax advisors about investment tax implications. The contents of this document are confidential and may not be reproduced or further distributed to any person or entity, whether in whole or in part, for any purpose without prior written permission. Copyright 2016. HSBC Global Asset Management (USA) Inc. All rights reserved. Investment Products: ARE NOT A BANK DEPOSIT OR OBLIGATION OF THE BANK OR ANY OF ITS AFFILIATES ARE NOT FDIC INSURED ARE NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY ARE NOT GUARANTEED BY THE BANK OR ANY OF ITS AFFILIATES All decisions regarding the tax implications of your investment (s) should be made in connection with your independent tax adviser. MAY LOSE VALUE 16