Described by one participant as "the bit of the business that used to be boring but isn’t any more", the funds, also known as liquidity funds, have benefited from many recent events, contrived and otherwise. Consequently, they could now be poised for quite a substantial acceleration in growth.
"The size of the European liquidity fund market has gone up 500 times in a decade," says Chris Oulton, chief executive of Prime Rate, a new venture that is offering the first UK registered triple-A-rated liquidity fund. "With the levels of cash out there, it hasn’t even started."
Oulton has had a front-row seat for the various developments of the past 10 years, having started in money market funds in 1998. At that time, there were several barriers to the growth of money market funds. In the UK, the Permitted Investment Act of 1990 prevented local authorities from investing in anything classed as equity, as shares in a money market fund were. Banks and other financial institutions were likewise impeded by the 100% risk weighting attached to equities.
Times change
In 2001, Oulton and others founded the Institutional Money Markets Funds Association, for the purpose of providing consistency, transparency and standardization to the liquidity fund market. It also began lobbying governments. In 2003, the UK government changed the Permitted Investment Act to allow the public sector to invest in triple-A rated liquidity funds. The Committee for European Securities Regulation allowed financial intermediaries to invest in the funds in 2006, while under Basle II, money market funds were given a 20% risk weighting. With the type of advanced treatment the big funds can offer, specifically in terms of transparency and access to funds, that risk weighting can fall to zero. Liquidity funds suddenly became both more attractive and far easier to invest in.
And on top of all of that, a monumental credit crunch hit the world’s financial markets. Instead of pursuing yield, investors began frantically seeking security and liquidity, the primary objectives of a money market fund. Bank ratings are falling, and various regulatory measures are making it harder for banks to recycle their liquidity baskets. "The regulatory regime is making investment into liquidity funds very attractive from a capital point of view, while at the same time making it ever more onerous for banks to lend to each other," explains Oulton. "The evergreen nature of a well-managed liquidity fund means that banks can now use them for balance sheet assets with the double benefit of covering their liquidity requirements."
So the timing is fortuitous for Prime Rate’s new fund. Luck came also in the form of a venture partner, Matrix Group. For a 50/50 split with Oulton, Matrix bankrolled the venture with a two-year funding agreement. Prime Rate has been given space in Matrix’s London offices, and access to more than 130 of its employees. The two companies share a compliance officer, a financial director and a financial controller. Prime Rate also benefits from the seniority of its own team. All seven members are specialists in the industry, and have many years’ experience, as does Oulton. This is important. It could be argued that spreads had contracted too far before the crunch. Now, the dispersion of returns between the best and the worst funds is greater, at around 30 basis points by some estimates. Those with a high level of experience and expertise will benefit. Once again, skills are a prime factor.
Tailor made
Prime Rate is not the only company to recognize the potential of liquidity funds. JPMorgan has launched its own, called the Euro Government Liquidity Fund. The portfolio will consist mainly of European government securities. It will take no exposure to currency risk, make no use of derivatives, and will be closely managed to limit the effects of market events such as changes in interest rates. JPMorgan is one of the biggest money market fund managers in the world. The US liquidity fund market is vast, at nearly $3 trillion; it was around $1 trillion in 1998. JPMorgan is bringing its liquidity fund management skills to the blossoming European market.
There are other funds, and their common theme is safety. With an emphasis on avoiding volatility and maintaining liquidity, rather than maximizing yield, liquidity funds are tailor-made for poor credit conditions. With the credit environment widely expected to deteriorate further, it could be a happy New Year for European money market fund managers. In the US, the liquidity fund market grew as a solution to credit uncertainty, and the same thing is happening in Europe. Early bookbuilding for Prime Rate’s fund suggests that its target of having $10 billion under management in three years’ time could be rather conservative.