A leaked document seen by EuroWeek all but confirms that the European Commission will propose that money market funds hold a capital buffer equivalent to 3% of total assets. The new rule would apply to constant net asset value funds (CNAVs) — those with a fixed share price.
The latest proposals allow for a three year phase-in period that was not present when an earlier version of the document appeared in May. Even so, the CNAV industry is understandably concerned.
Even a year ago, when the EC made requests for comment on potential changes to regulation, CNAV providers warned that a 3% capital buffer would kill the sector. A manager paying for the buffer would see its profits wiped out; asking investors to take the hit would eradicate their yields.
Both circumstances would be amplified in a low interest rate environment. Unfortunately, that's exactly what Europe is in right now.
Shift to floating?
It may be that the EC wants to push the money fund industry towards variable, or floating, NAVs. There would be some logic behind that, albeit flawed.
Critics of CNAV money funds argue that the structure gives the impression that investor capital will be protected — much like a bank account with deposit protection. A fund’s share price dropping below its set price — “breaking the buck”, in the US industry’s parlance — can lead to investors rushing to redeem their shares, lest they end up with a loss.
But a more sensible route than a shift to floating NAVs would be to better ensure that investors are aware of the risks involved. The EC has taken steps in this direction. It has, for instance, banned the sponsors of CNAV funds from providing them with external support — although it should also have applied this to variable NAV products, which under the proposals can receive support in “exceptional circumstances”.
Perceived sponsor support can affect investors’ risk assessment. Getting rid of that support outright should encourage better decision-making.
The EC is correct, however, to remove third party ratings from funds. Confusion often arises due to the different criteria used by the different ratings agencies. Fitch Ratings gauges the likelihood of sponsor support when rating funds, for instance — something that further reinforces an incorrect expectation of protection.
Those changes and others — such as fees or gates to penalise redemptions at times of stress — would help reduce some of the concerns about the money fund industry generally, and not just those that carry a fixed share price.
If the EC is determined to remove CNAV funds altogether, it should take a lead from US regulators. The US Securities and Exchange Commission outlined proposals in June to either shift the industry to VNAVs or to introduce redemption fees during exceptional circumstances. Either or both could be introduced.
Enforcing VNAV would be a seismic shift in the US, where the overwhelming majority of money funds are CNAV. In Europe, the split is roughly 50/50.
If the EC firmly believes that an industry-wide shift to VNAVs is the surest way to avoid runs and is able to get the political support it needs, then there is little the industry will be able to do to stop it.
But if that is indeed what it wants, it should come out and say it. Forcing an industry to change its way of doing business by starving it of the conditions it needs to thrive is a tactic that creates uncertainty. Ultimately, that helps no one.