The inconstant constant
Regulation threatens the existence of Constant Net Asset Value money market funds. David Turner asks if investors will miss them
The money market fund industry is warning that a series of proposals from an alphabet soup of regulators and executive bodies – all designed to prevent a panic-induced run on money market funds that might destabilise the financial system – could force the shutdown of a certain type of widely used money market fund known as the Constant Net Asset Value (CNAV) fund, leaving a hole in investors’ cash management.
Susan Hindle Barone, London-based secretary-general of the Institutional Money Market Funds Association (IMMFA), the trade body for CNAV funds, argues in particular that the European Commission’s proposal for a capital buffer of 3% would mean a forced conversion from CNAV to Variable Net Asset Value (VNAV) for “virtually all of the €457bn worth of CNAV funds run by our 22 members”.
The trigger for this concern about CNAV funds was the 2008 declaration by the Reserve Primary Fund in the US that it could no longer redeem shares at the customary $1 each. The event was prompted by the collapse of Lehman Brothers, which suddenly destroyed the value of Lehman securities held by the fund. This fall in redemption value was not supposed to happen. The Reserve Primary Fund was a Constant Net Asset Value fund – meaning that the value at which shares could be redeemed was supposed to stay at $1 all the time.
This was a feat achieved primarily by investing in ‘safe’ securities whose NAV fluctuated very little. CNAV fund providers also keep NAVs stable by using amortisation to value securities – progressively and predictably changing the value of securities over time as they near maturity – rather than market prices. They argue that amortisation is a fairer method than market pricing because the securities are generally held to maturity rather than being sold into the market. This method comes unstuck, however, if a security in the portfolio looks set to default – leaving the fund with insufficient assets to redeem shares at $1 or €1.
It is primarily CNAV funds that are in the gun-sights of regulators and legislators. They argue that a CNAV fund is, at least under current rules, inherently more dangerous to the financial system – precisely because of the certainty attached to its redemption value. Regulators say that if the fixed share price value is suddenly withdrawn, a panic among investors in the fund is more likely to ensue than if they were investing in VNAV funds, whose shares’ redemption value fluctuates moderately from day to day.
When it comes to European funds, the proposals generating the most fear in the industry are those emanating from the European Commission. This is because of the Commission’s role as an executive body – in contrast, the other proposals have been made by international regulatory bodies with the power merely to recommend rather than to initiate proposed legislation.
The Commission’s proposals finally appeared on 4 September 2013 after a number of delays. The most striking proposal is that CNAV funds must establish and maintain at all times a buffer amounting to at least 3% of the total value of their assets, to be built up through a three-year transition, which could be used to provide the money necessary to boost the redemption value of CNAV shares to $1 in the event of a crisis that destroyed the value of CNAV fund investments.
The key problem this poses is the resulting difficulty for money managers in maintaining enough of a margin on the fund’s investments to pay for their fees. Hindle Barone argues that the buffer would destroy the economic viability of these products – especially right now, when market interest rates are so low that money market professionals cannot even eke out returns in excess of 10 basis points in CNAV funds.
Jonathan Curry, chief investment officer for global liquidity at HSBC in London, also opposes capital buffers. Curry instead advocates a series of reforms to sustain confidence in CNAV funds. These include minimum liquidity requirements that compel funds to keep 10% of assets in securities that can be liquidated overnight, and 30% in securities that can be liquidated within one week.
The European Commission’s proposals are not, in fact, the most severe. The International Organization of Securities Commissions (IOSCO) recommends that regulators “should require, where workable, a conversion to floating/variable NAV” – a recommendation endorsed by the Financial Stability Board, the Basel-based body that recommends reforms to finance ministers and central banks. The European Systemic Risk Board, chaired by the president of the European Central Bank, advocates a “mandatory move” to VNAV. Of course, critics of the European Commission proposals argue that the 3% capital buffer, because it will make CNAV unviable, effectively amounts to much the same thing.
What would the investing world miss if CNAV funds became extinct?
Hindle Barone asserts that CNAV funds offer advantages not granted by VNAV funds. Notably, “investors can sweep money in and out without having to worry about recording any capital gain or loss from a change in the shares’ value”, she points out, that being one reason why CNAV funds make life “very easy from a tax and accounting perspective”. She says some investors have told her that, if CNAV funds disappeared, instead of switching to VNAVs they would simply put money in the bank, or take up the “riskier and lumpier” option of buying short-dated paper for themselves – riskier and lumpier because few would be able to achieve the same diversification as money market funds.
On the other hand, Bruce Tuckman, clinical professor of finance at the NYU Stern School of Business and senior fellow at the Center for Financial Stability, concludes that since there is “huge” global demand for “deposit-like assets” such as CNAV funds, “if money market funds are made unappealing, the market will find some other structure to satisfy this demand and the next run will happen through that structure”. He cites, as an example, the growth of managed accounts provided by banks that allow institutional investors to choose whatever levels of rate, credit, and liquidity risk they desire.
Regulators may see that as a victory – at least the provision of bank account-like products will have been forced back into entities regulated as banks. But it is at least arguable that the result will have been the killing-off of a widely used investment vehicle, without killing off the associated systemic risk.