2012 will live long in the memory of the money markets. Already struggling to make returns in the low interest rate environment, they saw bank supply dry up after the European Central Banks long term refinancing operations in December 2011 and February 2012 offered an alternative source of short term funding.
Then, in July, the ECB reduced its deposit rate to zero, sending levels plunging. Money funds particularly government-only funds were faced with the real prospect of negative returns.
Some closed to new money. Some shut entirely. Some managers, such as JP Morgan, made moves to create a new "flex" share class to avoid losing their 1-a-share constant net asset value.
"Government-only euro denominated funds have suffered the most," says Deborah Cunningham, chief investment officer, global money markets, at Federated Investments, which has around $265bn of assets under management in money market products. "They have been buying German and French treasury bills but when the ECB lowered its deposit rate to zero in July, a lot of governments started financing at less than zero."
Barclays predicts that if the low rate persists, there would be a 10%-20% drop in overall ECP outstandings.
"It was a transformational year in terms of how issuers, investors and dealers behave," says Kieran Davis, head of European short-term credit trading at Barclays. "You could carve the year up into before July and after. What weve gone through over the past few months will shape how we behave over the next few years."
Investors, desperate for yield, looked down the maturity curve. That allowed many top rated issuers to complete funding targets early, leaving the latter part of the year devoid of deals. While some may have hoped the cut would force funds to invest in periphery Eurozone debt which had been widely shunned by money market funds as the Eurozone debt crisis unfolded that would be to misunderstand the nature of the money fund business.
"The odd Irish, Spanish or Italian credit has placed deals but its not yet the start of a trend," says Ian Bedford, director, syndicate at Royal Bank of Scotland. "The money markets are binary you can either buy or you cant. There are a lot of ratings notches to go and a lot of trust to rebuild."
With most of those periphery issuers rated below A-1/P-1, triple-A rated money market funds could not buy them in any great number.
One option for managers is to launch riskier funds that would be able to buy larger volumes of A-2/P-2 rated securities. However, this may not solve the problem of ultra-low yields in the long term.
"The creation of more A2/P2 funds could be a possibility," says Federateds Cunningham. "But the supply of those lower rated but high quality names is limited, so if there was a lot of demand all of a sudden the yield spreads would tighten quickly."
Money funds, particularly in the US, felt pressure from regulators over the course of 2012.
Securities and Exchange Commission chair Mary Schapiro was keen to introduce new reforms to avoid a repeat of the Reserve Primary Funds breaking the buck following the Lehman Brothers bankruptcy in 2008. A fund breaks the buck when it is unable to maintain a constant net asset value of $1. That constant NAV is seen as a critical aspect of money funds ability to provide preservation of capital. In the Reserve Primary Funds case, its exposure to Lehman Brothers debt caused its NAV to drop below $1, leading to a surge in client redemptions.
The industry was vehemently opposed to Schapiros proposals, which included floating NAVs, capital requirements or restrictions on investors ability to withdraw funds.
Participants argued that these measures would nullify money funds attraction to investors. They also said that rules introduced in 2010 on credit quality and liquidity had been sufficient to deal with the problems of 2008.
Commissioners voted 3-2 against introducing any of the reforms in August. Schapiro announced she was leaving the organisation late in 2012.
However, the US Financial Stability Oversight Council has taken up the baton much to the chagrin of the industry.
"We all want to advance the debate over how to make money market funds more resilient in the face of financial crisis," says Dan Waters, managing director of the Investment Company Institutes ICI Global, which represents global investment funds.
"Unfortunately, the latest action by the FSOC fails to do so. The Council apparently is proposing to send back to the SEC the very same concepts that a majority of the Commissions members declined to move forward on. "
The Financial Stability Board has also issued recommendations on money fund reform as part of its work on increasing transparency in the so-called shadow banking sector. However, it has missed its intended aim, according to Waters.
"The FSB report includes some recommendations that could provide additional safeguards without destroying the fundamental characteristics that have made money market funds so valuable in the economy," says Waters.
"However, the report unfortunately fails to include any recommendations that would improve the transparency of money market fund portfolio holdings for the benefit of investors and regulators."
Waters is also concerned that the FSBs attempt to harmonise regulations in different jurisdictions could be damaging.
"We are always concerned about imposing a one size fits all set of regulations, predicated on a bank model," he says. "This is not sensible and does not reflect a global approach. Money market fund regulations vary widely between jurisdictions."
One major concern is the differences between the US industry and the European industry. Constant NAV is used by the overwhelming majority of US funds, while in Europe there is a mix of both constant and floating NAV.
But some have welcomed the global approach.
"The global regulatory approach is our preference as it is less confusing for investors," says Federateds Cunningham. "There are global investors that invest in domestic products in the US with subsidiaries that invest through us on an offshore basis outside the US. To have different rules is ripe for confusion. We like the idea of a common approach as long as its not the wrong one."
Shrinking universeSome money fund managers have looked at other jurisdictions for yield (see separate story on page 93). Others are returning to asset backed CP, which offers a yield pick-up over financial and corporate paper.
Funds have warmed to the asset class again after it blew up during the financial crisis of 2007/08.
"Investors that remained post-crisis were reluctant to have long dated ABCP on their books, largely because their clients were nervous as there was ongoing reticence about structured products in general," says Alex Wickens, senior analyst on Moodys structured finance team in London. "As time goes by and there are no new bad headlines, end investors are becoming more comfortable with ABCP. That means they can look to have a slightly longer exposure, giving them more yield."
However, the supply side of the equation could still be problematic. "The optimistic view is that ABCP outstandings will show a slight increase but more probably the change will be broadly flat," says Wickens. "Some issuers are very active and putting on new deals but other issuers are reigning back a bit or reviewing the whole product."
The main near term concern for money market funds is the possibility of a negative ECB deposit rate.
"Money funds initial reaction when the ECB eased rates was to lengthen duration, re-evaluate their approved lists and look to secured debt as an alternative source," says Barclays Davis. "A central banker should be pretty happy with that outcome. But there has to be a tipping point where you get diminishing marginal returns on that strategy. Would a negative deposit rate provide a further seismic shift in investor behaviour? I dont think the money fund community can react quickly enough to what would be an exponential decrease in supply in the front end."
Federateds Cunningham adds: "A negative deposit rate would be a problem and be a lot more challenging than the zero rate. Taking rates to zero hasnt had a great effect from an economic perspective so the likelihood of going negative is probably less than half. If it was temporary, maybe a couple of months, funds could deal with it. If the outlook is pervasive for years then a lot of managers will exit the market."
There is a worry from some in the money fund industry that politicians reliance on short term measures will lead to negative long term effects. Some participants have voiced concern that funds are being told to be more liquid and hold shorter term debt, while at the same time banks are being asked to lengthen the duration of their funding.
"Its really contradictory and in that sense is driving us apart," says Menno van Eijk, senior investment manager at ING Investment Management. "The longer politicians rely on temporary solutions, workarounds and the required legislation is finalised the more difficult it will be to return to what we had a few years back."
The unintended consequences of regulatory tweaking and interest rate experimentation will remain the biggest fears for funds."Whats clear is that money market funds play a key role in the economy and to investors around the globe, holding $4.6tr worldwide," says ICI Globals Waters. "Regulators are intent on making further regulatory changes to these funds, but, as they consider options, it is critical that they preserve the utility of these funds in the economy and to investors."