US MMFs, which peaked at $4.1 trillion in 2007, according to data provided by Sifma, were a key source of funding for banks off-balance-sheet securitization activities and suffered from dramatic investor runs in the wake of the Lehman Brothers bankruptcy.
In addition to short-term senior unsecured debt issued by governments and investment-grade corporates, money-market investors, including thousands of corporate and public sector treasurers, had become regular buyers of asset-backed commercial paper (ABCP), or short-dated debt linked to assets including other asset-backed securities (ABS), residential mortgages, commercial loans, CDOs and other credit derivatives.
With $1.2 trillion invested in ABCP by 2008, money markets were a key conduit for systemic risk between the US subprime mortgage market, credit derivatives and the real economy during the crisis.
The money market funds reform proposal represents the European Commissions first legislative action on shadow banking, says Conor Foley, a Brussels-based lobbyist advising asset managers.
The proposal follows a series of recommendations by the G20 in response to the financial crisis and particular concerns about runs on MMFs and the systemic risk effects that could impact real-economy funding.
Although an earlier Commission draft prohibited money markets from taking any exposure to ABS and securitized products, the proposal permits limited investment in the asset class, where the underlying exposure or pool of exposures consists exclusively of liquid and high-credit quality corporate debt that has a legal or residual maturity at issuance of 397 days or less.
Other proposed restrictions on money-market investments include outright prohibitions on short-selling money-market instruments, any kind of exposure to equities or commodities via derivatives, a ban on activity that would encumber fund assets and borrowing and lending cash.
MMFs could continue to trade derivatives, but only for hedging interest rate and FX risk, and must limit activities to regulated traded venues.
The Commissions proposals are the latest episode in a broader regulatory move to address structural problems in an asset class that had long been considered as a cash-equivalent for the purpose of corporate liquidity management.
In 2010, the SEC adopted an amendment to Rule 2a-7 of the US Investment Company Act 1940 imposing investment restrictions on US managers, and the Committee of European Securities Regulators issued similar guidelines for the sector in the same year.
However, market risk dynamics have achieved a substantial reduction in MMF outstandings since the crisis. The US market has almost halved, falling to $2.4 trillion in the first quarter of this year according to Sifma, while the relatively smaller European market has shrunk to 485 billion from a peak of 855 billion in 2008.
Yet MMFs remain a crucial asset class for many investors and continue to attract inflows, especially when other asset classes suffer. Indeed, MMF flows have remained volatile since the primary reserve fund broke the buck. For example, European MMFs attracted 1.1 billion of new capital in July 2013, after suffering 40 billion of outflows the previous month.
Overall, the European MMF sector has lost 54.4 billion of investor capital in 2013, according to the European Fund and Asset Management Association.
While the proposals are intended to support the cash-like properties of the asset class and protect MMF liquidity, fund managers say rules requiring European constant net asset value (CNAV) funds to hold a 3% capital buffer will effectively kill that asset class.
According to the Institutional Money Market Funds Association (IMMFA), the regulatory focus on CNAV funds and their pledge to maintain a share price of at least 1/$1/£1 misses the point.
We reject the assertion that there is a greater degree of systemic risk inherent in constant NAV money market funds, says Susan Hindle Barone, secretary general of IMMFA. The European Commission has not demonstrated that CNAV funds are more susceptible to run-risk than VNAV [variable net asset value] funds and the discrimination between these two accounting techniques is unjustified.
Despite the lack of hard evidence linking MMF investment behaviour to the investor runs and subsequent global liquidity crisis in 2008/9, European Commission members are lining up for an opportunity to get stuck into shadow banking.
Indeed, Brussels lobbyists suggest that the active interest of a group of Belgian, Dutch, German, Greek and British legislators are showing an active interest in shadow banking might accelerate the legislative process, which typically takes 14 to 16 weeks.
There are a number of factors which may prompt the EU institutions to attempt to hurry the legislative review, including a potentially distracted Greek presidency, the May 2014 European elections and the end of term of the current College of Commissioners in October 2014, says lobbyist Foley.
A rush to conclude the legislative review would present significant risks for fund managers, investors and institutions reliant on the money markets for funding.