EC Regulation For Money Market Funds May Have Unintended Consequences

EC Regulation For Money Market Funds May Have Unintended Consequences
Primary Credit Analysts: Francoise Nichols, Paris (33) 1-4420-7345; [email protected] Andrew Paranthoiene, London (44) 20-7176-8416; [email protected] Joel C Friedman, New York (1) 212-438-5043; [email protected] Secondary Contacts: Guyna G Johnson, Chicago (1) 312-233-7008; [email protected] Emelyne Uchiyama, London (44) 20-7176-8414; [email protected]
Table Of Contents
Money Market Funds: An Overview The EC Proposals: An Evaluation Possible Impact Of The EC Reform Proposals For MMFs Standard & Poor's Perspective: Data Show Rated MMFs Have Played A Positive Role In Stressed Markets Conclusion Appendix A: ESMA Definitions Of Money Market Funds Appendix B: Summary Of The Main Reform Proposals Appendix C: Summary Of S&P's 'AAAm' Principal Stability Fund Ratings Notes Related Research And Criteria
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT
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On Sept. 4, 2013, the European Commission (EC) released its regulatory proposals to reform money market funds (MMFs) domiciled or sold in Europe. The EC states its aim is to standardize investment parameters for MMFs and mitigate the potential systemic risk they might pose to the wider European financial system. The regulation, if approved by the European parliament and by the European Union's (EU's) finance ministers (ECOFIN Council), would become mandatory across all EU member states and supersede the guidelines on MMFs of ESMA, the European Securities and Markets Authority (adopted in 2010 by ESMA's predecessor, the Committee of European Securities Regulators, CESR). Standard & Poor's Ratings Services supports a regulatory environment that promotes increased transparency, enhanced liquidity, and safety for the European money market fund industry. In our view, if well calibrated, the proposals could reduce risk in the European MMF industry, especially by enforcing harmonized rules that apply to the entire European money market fund industry. Until 2011, when ESMA's guidelines on a common definition of European money market funds were effective, MMFs in Europe took very diverse approaches to investment, depending on their country of registration. Overview We believe proposals by the European Commission to regulate money market funds would enhance risk management for most fund operators and investors. We nevertheless consider that some elements of the current proposals may inadvertently make it more difficult for funds to manage risks effectively, add to running costs, and deter investors. In particular, the proposed ban on ratings on money market funds by credit rating agencies would reduce information for market participants and may curtail investor confidence by removing an independent third-party opinion on credit quality and invested principal. We believe that promoting the ability of money market funds to halt redemptions in times of market stress, a measure which is not part of the EC proposals, could be effective in protecting an MMF from mass investors' redemptions.
In our view, however, if the regulation is adopted in its current form, the overall size of the European MMF industry may shrink. Changes to certain fundamental features of these funds, such as a constant share price (with beneficial tax treatment) and same-day liquidity may cause some investors to move all or part of their investments out of the sector. Furthermore, the money fund industry could further consolidate to the detriment of smaller MMF providers. It could also lead to the emergence of a small number of very large MMFs, posing potentially new systemic risks. The regulation could also have other unintended consequences, in our view. The proposed ban on MMFs seeking credit ratings would reduce information available to market participants by removing an independent third-party opinion on a fund's credit quality, and consequently may be detrimental to investor confidence. We also question whether barring fund managers from using credit ratings on a fund's assets, even as complementary opinions to inform their investment
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decision, would enhance the quality of their asset allocation. We believe that other market-based approaches that are not part of the proposals are also worthy of consideration. These include giving MMFs the ability to halt investor redemptions at times of market stress, since this measure could serve the interests of all shareholders and help mitigate run risks. Given the importance of these issues and strong market interest in the proposed regulations, below we provide: An overview of money market funds, their role and investors; An examination of the development of the European money market fund industry; An analysis of the EC's proposals and the potential impact on various industry stakeholders; and Standard & Poor's perspective on the European money market industry.
Money Market Funds: An Overview

What are money market funds?
A money market fund is a mutual fund which aims typically to provide investors with a diversified cash management tool for short-term cash allocation. MMFs endeavor to offer capital safeguarding (preservation) and daily access (liquidity), with a rate of return commensurate with cash market conditions. Much like any mutual fund, fund shares or units can generally be bought or sold at any time, and the return of principal is not guaranteed.
What is the role of money market funds in the capital markets?

Through their underlying investments in short-duration debt securities, MMFs provide short-term financing to a wide variety of borrowers, including financial institutions, governments and government related entities, and corporations. This type of financing can help meet banks' and corporations' needs for short-term financing as well as for the funding of some public projects.
Who are the investors in money market funds?

MMF investors or shareholders are typically classified as either institutional or retail. Institutional investors come from a wide variety of industries, including telecommunications, utilities, the public sector, food & beverage, manufacturing, retail, education, charities, and construction. Institutions utilizing MMFs include pension funds, insurers, sovereign wealth funds, and other governmental entities. The retail investor base individually, or through third-party financial advisors, utilizes MMFs to represent the cash component of their investment or saving portfolios.
What are the EC's objectives in regulating European MMFs?

The EC considers MMFs to be prime participants of the "shadow banking system" together with other non-bank financial intermediaries such as finance companies, credit hedge funds, private equity funds, and exchange-traded funds, as well as certain products such as credit derivatives and structured investments, and security lending activities (repos). As such, the regulatory proposals are part of the EC's broader mandate to limit the potential future negative impact of shadow banking on the European financial system as a whole. EC definitions consider shadow banking to be "credit intermediation that involves entities and activities that are outside the regular banking system," or entities "that are not regulated like banks yet engage in bank-like activities". In 2011, the Financial Stability Board (FSB) estimated that shadow banking equated to approximately 51 trillion, or
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about 25%-30% of the entire financial system. Currently, European MMFs represent nearly 1 trillion, or about 2% of the estimated 51 trillion total.
How has the European money market fund industry developed?

The European MMF industry originated in France in the 1980s, as a by-product to French banking regulation that restrained banks from paying investors interest on deposits. Thus, by pooling a collection of short-term investments, French money market funds were able to provide daily liquidity and pay returns that banks could not. With the development of the euro, the next big shift in the growth of assets under management occurred as U.S. asset managers began to replicate their money market product offerings in Europe by domiciling in Ireland and Luxembourg during the 1990s. Today, according to the Investment Company Institute's 2013 Worldwide Mutual Fund Assets And Flows second-quarter publication, the money market industry in Europe equates to 945 billion and 28% of the total global money market industry (see note 1). In Europe, 89% of the money market industry is domiciled in the following three countries: France (35%), Ireland (28%), and Luxembourg (26%). Other jurisdictions offering money market funds include Germany, Italy, Finland, and the U.K. In terms of currency splits, we have referred to the level of assets across all Standard & Poor's-rated Europe-domiciled funds. The majority is in U.S. dollars (54%), sterling (28%), and euros (17%), while the remaining 1% of assets is in Australian dollars, Singapore dollars, Canadian dollars, and Japanese yen. A key distinguishing characteristic of European MMFs is their valuation methodology. Commonly referred to as CNAV (constant net asset value) or VNAV (variable net asset value) structures, these two approaches are the source of much debate. A CNAV MMF seeks to maintain an unchanging NAV (for example, $1, 1, or 1 per share) at all times. It uses amortized cost accounting to value all of its assets. A VNAV MMF generally uses mark-to-market accounting to value its underlying assets. This means that actual market prices are used to value the fund's assets. Standard & Poor's rates 123 money market funds domiciled throughout France, Ireland, and Luxembourg, as well as those registered in Switzerland, the U.K., and Germany, with assets totaling approximately 495 billion. As a proportion of the overall European industry, Standard & Poor's-rated MMFs have increased their representation from 24% of total assets invested in June 2006 to 52% in June 2013 (based on the European Fund and Asset Managers Association, EFAMA, and published statistics). The pattern of growth shows assets managed by Standard & Poor's-rated funds have increased more than the overall market since March 2006 (see chart 1). In our view, the pattern of European MMF growth reflects how investors have historically managed market risk by adjusting their investment strategies over time to reflect credit concerns, liquidity needs, and interest rate movements. Indeed, given the short-term nature of the investments made, we observe that these MMFs have historically been far more nimble in addressing and adapting to risk in the markets than other types of funds.
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Chart 1
The EC Proposals: An Evaluation

The EC proposes to supplement both its Undertaking for Collective Investment in Transferable Securities (UCITS) Directive and Alternative Investment Fund Managers (AIFM) Directive by establishing a universal regulatory framework applicable to MMFs domiciled or distributed in the EU. The stated intended benefits are strengthened stability and greater product harmonization for European MMFs. Key tenets of the proposed regulations include: Enhancement of risk management and transparency; Reduction of eligible assets for all European MMFs; The adoption of internal credit assessment and relinquishment of the use of credit ratings for selecting MMF assets; A prohibition on money market fund ratings provided by credit rating agencies; and Conversion to VNAV structure for all European MMFs or the enforcement of a 3% capital buffer for CNAV MMFs.
Enhancement Of Risk Management And Transparency

The EC proposes that MMFs and their managers enhance their risk management by increasing portfolio diversification and liquidity requirements, conducting stress testing of their funds, and having a better understanding of their
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shareholders. Standard & Poor's considers each aspect of this part of the proposals both prudent and fundamentally important. First, in our view, diversification is a key element of fixed-income investing and minimizing risk in a portfolio. Undertaken pragmatically, it helps ensure liquidity when it is needed and mitigates the effect of market risk. However, this could curtail the MMF manager's ability to concentrate the MMF portfolio on fewer well-known issuers. The proposed liquidity requirements would require European MMFs to maintain at least 10% of assets that mature overnight and 20% that mature within one week. Under Standard & Poor's principal stability fund rating (PSFR) criteria, we do not specify minimum liquidity guidelines because we instead focus on fund managers' ability to manage their own liquidity and take into account their shareholders' cash flows. MMFs have very different investor profiles, and managers of MMFs should understand their investor needs as part of a focused risk management approach. While this measure would enhance an MMF's liquidity in case of a moderate level of unexpected redemptions, it would not necessarily be adapted to all MMFs, in our view. We consider stress testing as a key element of risk management and it has been part of our rating analysis of MMFs since 1994. Stress testing for MMFs became more prevalent as a standard practice following the pressure exerted on fund NAVs during the 2007-2009 global financial crisis after conducting mark-to-market pricing for their portfolios. As such, we support this important proposed measure, even though it could increase operational costs. In our view, a rigorous stress-testing program would be beneficial for MMFs because market uncertainty can appear at inopportune times. By knowing the limits of the portfolio, the MMF is more likely to be able to manage uncertain circumstances. The "know your customer" proposal within the EC regulations is not only a valuable attempt to increase transparency but also an important means to gauge a fund's asset flows. Indeed, many rated MMFs have undertaken extra due diligence to know their investors and understand their redemption patterns with the use of cash flow calendars as an aid to preparing fund portfolios. We consider measures aiming to increase awareness in this regard as positive because they should help MMFs maintain proper liquidity and meet future stress-related redemptions.
Reduction Of Eligible Assets For European MMFs

The EC proposes to curtail certain asset types currently utilized by MMFs. For instance, investments in shares of other MMFs of the same classification would no longer be a permitted investment. Additionally, regulations would place limitations on eligible asset-backed commercial paper types (ABCP) backed by auto loans and leases, residential mortgage loans, and credit card receivables. Lastly, restrictions would be imposed on the collateral type of reverse repurchase agreements (repo) combined with a maximum permitted exposure to repo counterparties. Standard & Poor's understands the importance of requesting funds not to deviate from what should be liquid and appropriate investments for funds that attempt to meet daily liquidity needs. Asset types and classes considered "outliers" can have potentially damaging effects in meeting those liquidity needs. However, the limitations proposed could in our view negatively influence a fund's ability to properly manage risk and liquidity, thereby making the management of these funds more challenging. In times of stress, limited investment options could exacerbate the problem of meeting investor redemptions because MMFs would be forced to maintain similar portfolios and instruments.
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As observed during the financial crisis, stresses transcended through different investment sectors at different moments. First, sub-prime mortgages were affected, then structured investment vehicle securities, followed by major investment banks (Bear Sterns and Lehman Brothers), and then finally governments. In each of these different sectors, market liquidity was uncertain for high-quality short-dated assets. When combined with redemption requests, MMFs were forced to sell assets into a market with limited liquidity. Therefore, in our view, MMFs that focus on capital preservation need more available investment options rather than fewer to promote increased market liquidity.
The Adoption Of An Internal Credit Assessment And Relinquishment Of The Use Of Credit Ratings For Selecting MMF Assets
The EC proposes that MMF managers adopt a uniform internal credit rating assessment system to select their investments and relinquish the use of external credit rating agencies in selecting portfolio assets. Under this proposal, both short-term and standard money market funds (see Appendix A) in the EU would invest in eligible money market instruments that have been awarded one of the two highest internal credit quality categories by the asset manager. We understand that this proposal aims to foster the development of credit assessment capabilities and would remove independent credit rating references from ESMA's guidelines on MMFs. We support the EC's intent, which is to reduce mechanistic reliance on ratings and to encourage MMF asset managers to do their own credit analysis. The recent financial crisis highlighted that a lack of transparent information was a significant contributor to systemic risk. In our view, a sound investment process leverages various sources of market information available. However, requiring fund managers to ignore market information such as external credit ratings might undermine the goal to achieve the best possible asset allocation. In addition, we believe the implementation of an internal credit assessment may lead managers to examine and invest in a much narrower range of assets because they might not have the capacity to replicate the coverage of credit rating agencies. This would reduce diversification and potentially increase risk. The detrimental by-product to investors may also be reduced transparency on the actual credit risk of the underlying fund investments. As an alternative to using external credit ratings to determine eligible assets, the EC is proposing that MMF providers should use an internal credit assessment methodology defined by the regulator. The proposal is intended to provide a prescriptive rating assessment framework to reduce divergence in interpretation and potentially implementation, as a substitute for common usage of globally comparable external ratings. For instance, the proposals prescribe that MMFs would invest in the top two credit quality categories. However, they do not clarify whether an asset should be sold or retained if it falls below the official minimum credit quality threshold after it has been purchased. In addition, it is unclear whether the proposed framework would be applied uniformly by all asset managers. If it is, how would the new system avoid cliff effects and herd behavior in case of credit deterioration of an issuer? This could inadvertently create the type of market stress and investors' mass redemptions from MMFs, which we believe runs contrary to the proposal's intent. Larger European MMF providers, which are better equipped in terms of credit research capabilities, would likely benefit if the current EC proposals were adopted. Investors would likely favor larger players, given the reduced transparency and the lack of published portfolio holding information. In the absence of regulatory requirements imposing frequent mandatory disclosures, asset managers may not voluntarily reveal to the wider market their MMF's asset allocation, since this would be derived from their internal credit analysis and investment process. Investors could
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seek reassurance--perhaps unwittingly--in the strength of an asset manager's analytical resources. This, in turn, could foster greater market concentration among the larger MMF providers and diminish competition.
A Prohibition On Money Market Fund Ratings Provided By Credit Rating Agencies

This EC proposal states that "the MMF or the manager of the MMF shall not solicit or finance a credit rating agency for rating the MMF". The EC's intent is to ensure that the risk management of the MMF is not biased by short-term decisions influenced by the possible rating of the MMF. In addition, the EC proposal considers that the risk of a fund rating downgrade could lead to a run on a MMF, which in turn could lead to mass redemptions from the MMF industry and financial market dislocation. Standard & Poor's disagrees with the assertion that a fund rating action would lead to systemic run risk through the MMF industry, and provides key analysis through recent examples below. As previously stated, we understand that MMFs have been classified as part of the "shadow banking" industry by regulators because their size and influence in the capital markets can swing funding levels for institutions rapidly. A prime example is the notable reduction in MMF funding for European institutions, particularly French banks, during summer 2011. Based on our information, this was caused not by a fund rating action, but by a reassessment by U.S. asset managers of the economic risks within the eurozone (European Economic and Monetary Union), who withdrew investments from the region. There have been very few MMF rating downgrades at the fund rating level over the past 30 years. One of the most recent European fund rating actions, which was outlined in a prominent response to the EC consultation on the European MMF reform, occurred in December 2011. But in our view, this example does not illustrate the alleged potential systemic effect of MMF rating actions. Another credit rating agency (Fitch Ratings) placed it highest fund rating assigned to the U.K.-based MMF, Prime Rate Sterling Liquidity Fund, on rating watch negative (see note 2). The rating action was related to Fitch's specific criteria on sponsor support, which forms part of its fund rating analysis. Following this rating action, the fund encountered significant redemptions over a three-week period (from Dec. 5 to Dec. 26, 2011) representing over 50% cumulative outflows, as the fund's net assets dropped from 2.52 billion to 1.18 billion. However, it is worth noting that there was no contagion among other sterling-denominated MMFs leading to a systemic run throughout the money market industry. This remained an isolated event. Key statistics recorded during this time indicate that total assets under management of Standard & Poor's-rated sterling money market funds actually increased by 11.2% during this period. As further background to this example, this MMF was also rated 'AAAm' by Standard & Poor's. The fund was able to maintain its principal value at all time and met all its redemptions requests in a timely manner, due to the high credit quality and liquidity of its underlying assets. Standard & Poor's does not factor in sponsor's support in its rating analysis and our 'AAAm' rating remained unaffected because the fund was managed in accordance with our criteria over that period. Subsequently, this MMF gradually regained the level of its managed assets in the first half of 2012, following the December 2011 announcement that its management company would be acquired by Federated Investors Inc. It is Standard & Poor's view that many of the troubled "money market funds" referenced in the EC's Impact
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Assessment (Annex 5.1) to illustrate the consequences of the financial crisis were actually not money market funds. In fact, these funds are more likely to be referred to as "absolute return bond funds" or "enhanced cash funds" and not the traditional low-risk high-liquidity money market funds which are being assessed as part of this regulatory reform. In fact, these types of funds would be excluded from this reform. For example, the fund Axa IM US Libor Plus Strategy had 100% of its portfolio invested in asset-backed securities. Even before our 2011 MMF criteria revision, longer-dated residential mortgage-backed securities and asset-backed security structures were not eligible investments under our criteria applicable to rated MMFs, since our opinion was that these were less liquid assets for money market funds. In our view, if adopted, the proposed rating ban could reduce transparency and increase uncertainty about the creditworthiness of an MMF's investments. Despite global regulators' intentions to reduce reliance on external credit ratings, many investors still have internal provisions regarding minimum credit quality standards for their investments in rated securities or in rated money market funds. Removing external credit ratings as an independent benchmark would make it more difficult for investors to conduct global comparisons of the credit quality of money market funds. Furthermore, as a result of this proposed prohibition, EU MMF providers would be unable to use and refer to independent credit quality benchmarks, which are internationally recognized and comparable. It would deprive money market asset managers and their investors alike from independent forward-looking opinions on relative credit risk. Investors could be left to rely on what funds publish, and fund selection could be based on past performance, where the best-performing MMF could be the one taking the greatest risk. In our opinion, MMF ratings can foster a more conservative approach to risk management. As an illustration, Standard & Poor's 'AAAm' rated MMFs' underlying investments consist exclusively of short-term securities rated 'A-1' or 'A-1+'. This means, for instance, that from January 2009, Greek government debt was no longer an eligible investment under our 'AAAm' rating criteria. In accordance with our criteria, however, 'AAAm' rated MMFs were generally able to retain until maturity any short-term Greek government securities they held, if such investments had taken place prior to the Standard & Poor's downgrade of the short-term rating on Greece to 'A-2' from 'A-1'. This was three years before Standard & Poor's sovereign rating on Greece was lowered to 'SD' (selective default). We believe that the EC's proposed rules could lead to increased credit risk in European MMFs because they place no limit on the exposure MMFs can maintain to the debt issued by a European sovereign irrespective of its credit quality. In particular, instruments issued by or guaranteed by EU sovereigns and agencies are not subject to a minimum diversification or credit assessment threshold, which could create a risk in light of the volatility and wide divergence of the creditworthiness of certain European sovereign issuers over recent years and the ongoing difficult economic conditions in Europe.
Conversion To VNAV Structure For All European MMFs Or Enforcement Of A 3% Capital Buffer For CNAV MMFs
The EC reform proposes that all European MMFs move to a VNAV structure, and requires that, going forward, all MMFs use daily mark-to-market prices to value all of their underlying assets. The proposed conversion to a VNAV structure is aimed at stemming investor runs during stressed market conditions. According to the EC, CNAV MMFs in particular would be most vulnerable to runs, as investors would attempt to attain a first-mover advantage. Alternatively, if a CNAV MMF chooses not to convert to a VNAV structure, the fund would be required under the
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proposed rules to maintain a capital buffer of at least 3% as a backstop or reserve to protect against potential losses. We agree that the principle of implementing a capital buffer could provide adequate protection to investors in the instance of a single underlying issuer default. In one topical example, investors in the U.S.-domiciled Reserve Primary Fund recovered 99% of their initial value following the default of a Lehman Brothers investment, equivalent to 1.2% of the fund's assets. In this extraordinary circumstance, the 3% capital buffer proposed by the commission would have provided sufficient protection. However, if a fund utilizes the full 5% issuer diversification limit and is faced with an issuer's default representing 5% of its assets, the 3% capital buffer may not be enough to cover the losses encountered. Managers of CNAV MMFs may consider the proposed capital buffer introduction prohibitive and uneconomical, in our view, particularly in the current very low interest rate environment. The cost of funding such a buffer may have to be passed to investors through higher management fees, since operating expenses to run such funds would likely increase as a result. In addition, the implementation of a capital buffer in CNAV MMFs could support investors' perception that CNAV MMFs are "guaranteed" investment products. Regarding CNAV versus VNAV MMF valuation techniques, Standard & Poor's does not support one model in particular, since we rate MMFs using either valuation type. If enforced, however, the conversion to a full mark-to-market valuation for all VNAV MMFs could present operational valuation challenges, with the current same-day liquidity feature of MMFs. This would in particular rule out the current use by a large majority of VNAV MMFs, notably in France, of amortized cost accounting to evaluate their short-term securities maturing within three months. All MMFs' assets, irrespective of their maturity, would have to be priced on a mark-to-market basis, even if there are few or no market transactions to adequately price these assets. Furthermore, if MMFs' share price exhibited volatility from one day to the next, they could be less attractive to investors. Over the past five years of market instability, we have found significant distinctions between the pricing methodologies of amortized cost and mark-to-market. Although mark-to-market valuation is generally perceived as the more transparent pricing methodology, we observed in the few MMFs that truly fully adhered to mark-to-market pricing methodology to value their entire portfolio that it led to greater volatility in the funds' net asset value since security valuations did not reflect their true and fair value during periods of market stress. We note also that the call for the introduction of mark-to-market pricing is not without its skeptics. For example, Mr. Mark Carney (in his role as Governor of the Bank of Canada, now Governor of the Bank of England) has questioned the "combination of the relative novelty of fair value accounting and extremely volatile markets" (see note 3). Furthermore, our view is that the conversion to a mark-to-market valuation or the implementation of a capital buffer will not fully safeguard CNAV or VNAV MMFs from investor runs, especially when such runs are caused by a mass risk aversion to the financial sector, by concern with the MMF management, or uncertainty on the credit quality or liquidity of the fund's underlying assets.
Possible Impact Of The EC Reform Proposals For MMFs
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Implications for asset managers: Smaller players could be forced out of the market
In our opinion, the proposed MMF reforms may reduce the overall size of the European MMF industry. European CNAV MMF providers represent 40%-45% of the European MMF assets and they could suffer considerable economic and operational costs as a result of the conversion to VNAV. In particular, they might be susceptible to losing assets to time deposits or CNAV MMFs domiciled in less regulated jurisdictions outside the EU, since some investors may not be willing to invest in VNAV MMFs due to the tax treatment of these MMFs. The fund-servicing industry in Luxembourg and Ireland, which provides services to the large majority of the CNAV MMFs, could also be severely affected by the regulation. In addition, the proposals are likely to lead to greater industry consolidation because of increased regulatory costs from funding a capital buffer and establishing an internal rating process. This could force existing MMF providers to exit the market. In one recent example of industry consolidation, Goldman Sachs Asset Management announced it will acquire the money market business of RBS Asset Management. The move toward greater industry consolidation, could in turn, lead to less competition. Furthermore, with fewer players, the average size of MMFs may become larger and systematically more important.
Implications for investors: Higher investment costs and reduced transparency

The implementation of a 3% capital buffer on CNAV MMFs would in our view compensate an investor if the fund's NAV deviated significantly from par, and would provide an additional safety net for investors otherwise. However, CNAV MMF investors could be subject to higher operation costs appended to the fund if the fund sponsors are required to maintain the capital buffer. Potentially, investors may look for lower-cost liquidity management alternatives, such as time deposits, treasuries, or less transparent fixed-income funds. While pan-European regulations could establish a homogenous framework, in our opinion a ban on the use of credit or fund ratings will reduce transparency and deprive investors from a tool helping them to make relative comparisons regarding investment decisions.
Implications for European funding: A shrinking MMF industry

If CNAV MMF investors were to pursue alternative investment options, it could lead to a reduction in funding to financial institutions, sovereign governments, and nonfinancial institutions. However, we expect the shortfall would have a limited impact, given the relative small share in the overall funding to the economy provided by European MMFs. For instance, eurozone financial institutions' overall funding represented close to 29 trillion as of September 2013, according to ECB data, and the share of this overall funding provided by European money market funds was 477 billion, representing only 1.6%. If the European MMF industry was to shrink, liquidity for high-quality short-term securities could also be diminished. In addition, the funding sources of financial institutions, sovereigns, and nonfinancial corporations could as a result be less diversified.
Standard & Poor's Perspective: Data Show Rated MMFs Have Played A Positive Role In Stressed Markets
Standard & Poor's has assigned MMF ratings since 1983 using its principal stability fund rating (PSFR) criteria (for details see Appendix C, table 4). Our rating criteria, coupled with a comprehensive weekly analytical surveillance

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process, have provided investors with an independent opinion on the credit quality of their invested principal. From the onset, our PSFR criteria determined a 60-day weighted-average maturity (WAM) metric for its highest money market fund rating ('AAAm') to limit exposure to principal losses due to credit risk. The Securities and Exchange Commission changed its WAM guidelines to 60 days from 90 days in 2010, and ESMA also introduced a 60-day WAM in the same year. Outside of the quantitative requirements, there are several qualitative components that form part of our rating assessment, and understanding the strengths and weaknesses of fund management is an essential component. Our management assessment considers the experience and track record in portfolio management, operating policies, risk preferences, credibility and commitment to oversight policies, and the thoroughness of internal controls. One concern of the regulators is that MMFs are required to sell positions in order to maintain their fund rating. When Standard & Poor's revised its criteria for MMFs in 2011, we established "cure periods" for times when a fund breaches a quantitative criteria threshold. In instances where a security is downgraded to a short-term rating of 'A-2', the cure periods for investments downgraded below 'A-1' would apply and take into account the affected investment's exposure percentage and maturity. For example, where the downgraded investment represented a 0.5% exposure of the fund, the cure period to roll off (mature) would be up to a 397 days. Although they have a 30-year operating history, true growth of European MMFs wasn't witnessed until 2006. As an illustration, euro-denominated MMFs rated by Standard & Poor's expanded from 49 billion in January 2006 to a peak of 161 billion in August 2011. Leading up to this peak, euro-denominated rated MMFs experienced tremendous growth. For every month of negative monthly asset flows, two months of positive asset flows occurred (see chart 2). However, shortly after that, assets under management started to fall. Indeed, asset levels within 'AAAm' rated funds have dropped by 50% since August 2011. Today, the largest euro-denominated money market fund rated by Standard & Poor's--the BlackRock sponsored Institutional Cash Series PLC - Institutional Euro Liquidity Fund--is approximately 14 billion. The average size across 30 'AAAm' rated funds is 2.7 billion.

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Chart 2
Nevertheless, while asset levels have fallen, we believe the credit quality of those funds has not. Standard & Poor's rated euro-denominated MMFs have an average credit quality of 70% exposure to 'A-1+' names and a weighted-average maturity of 35 days, with 20% of their portfolio maturing in one day. We therefore consider that the pull-back from the peak of assets under management is a consequence of low interest rates, negative yields, and regulatory uncertainty rather than MMFs being unwanted or distrusted by investors. We believe highly rated MMFs have played a positive role during various stressful moments in the markets (see chart 3). As risk aversion rose because of the surrounding crisis, investors flowed into highly rated MMFs, which they viewed as investment vehicles offering high credit quality, low market risk, and transparency. By attracting assets, these funds were able to provide additional funding at such critical periods, enhancing the liquidity of the short-term debt market at a time when the interbank market was at a standstill. The funds' portfolio managers responded accordingly by increasing their investment in high credit-quality names outside the eurozone or systemically important banks within it. The credit quality trend below 'A-1+' replicates the positive inflows in times of pressure, where in order to protect their investors' interest, money market funds avoided the eurozone's stressed and less creditworthy banking industry.

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Chart 3
In other words, during a moment of stress in the financial markets, European MMFs were often the first stop in the credit management hierarchy for investors, and MMF portfolio managers reacted accordingly by increasing the overall credit quality of their funds as inflows arrived. Post crisis, we have observed a decline in the allocation to 'A-1+' names, partly due to a diminishing investment universe, but also to compensate for the low remuneration of these issuers with the highest short-term rating in a prolonged low interest rate environment. In the future, MMFs seeking higher yields may decrease the credit quality of their underlying assets, leading to a potentially more aggressive portfolio composition. If performance once again is to become a key determinant of investing practices, then it is possible that there could be an exploitation of the proposed EC diversification rules to help drive performance. For instance, the current EC MMF reform proposals do not set any limits on exposures to lower rated EU member state sovereign issuers, allowing asset managers to take more credit risk than currently allowed under ESMA's guidelines. We observed these investment practices in late 2008-2009, as certain money market funds were exposed to the debt of Greece and other peripheral EU countries, before the roll-out of the ESMA guidelines on MMFs.

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Case study: Lehman Brothers Liquidity Funds

We consider that the events surrounding the Irish-domiciled Lehman Brothers Liquidity Funds also highlight that MMFs can provide investor protection in times of stress, and reduce potential systemic risk to the financial system in the event of a MMF's run. Following the default of Lehman Brothers in September 2008, the two MMFs managed by Lehman Brothers Asset Management in London suffered significantly. The funds suffered large-scale redemptions and ultimately closed because they were managed by the asset management subsidiary of the defaulted entity. We observed that even though MMF assets were segregated from the bankruptcy proceedings, investors still fled the funds. The quality of invested assets remained high--with an average 89% exposure to 'A-1+' investments--and the NAVs of both funds remained well above any 'break the buck' threshold (when the net asset value of a money market fund falls below 0.9950 of its par value; see tables 1 and 2 and chart 4). At the time, the fund directors took the pragmatic step of halting redemptions and offered in-specie transfers (a pro-rata allocation of securities) rather than cash. In our view, these actions were the most effective to enable each investor to be treated equally and curtail the negative impact of run risk on these funds. It is important to highlight that investors were fully reimbursed for their investment despite the liquidation process. Although not currently a feature of the proposal, we feel that approved use and investor acceptance of halting redemptions and in-specie transfers is an important element that MMFs--small and large--can use to prevent run risk during times of market stress. Halting redemptions allows the fund to "breathe" for a moment, by generating cash from maturing assets. Once enough cash is raised, investors can then be allocated cash through pro-rata transfers without diluting the value of remaining shareholder investments. An in-specie transfer is the process of transferring assets to the investor in their current form rather than receiving cash, basically receiving a slice of the invested pie rather than the proceeds of selling the pie. For an MMF encountering reduced liquidity, we believe outsourcing market risk to outgoing investors is a more prudent method of safeguarding the remaining investors. Although potentially operationally challenging, we think a regulatory-approved market-defined process could be a key measure in protecting a fund from run risk. In our view, the use of such a facility would help to achieve the regulators' objectives in safeguarding the entire fund, and not just the shares of those who exit first.
Table 1
Lehman Sterling Liquidity Fund Key Statistics

Portfolio date Net assets (mil. ) < 7-day liquidity (%) 'A-1+' exposure (%) Net asset value () Sept. 12, 2008 Sept. 19, 2008 Sept. 26, 2008 Oct. 3, 2008 Oct. 10, 2008 Oct. 17, 2008 251 146 58 58 58 58 39.0 42.0 37.0 54.0 64.0 67.0 85.0 93.0 89.0 89.0 97.0 93.0 0.999757 0.999495 0.99941 0.999423 0.999424 0.999418
Table 2
Lehman Euro Liquidity Fund Key Statistics

Portfolio date Net assets (mil. ) < 7-day liquidity (%) 'A-1+' exposure (%) Net asset value () Sept. 12, 2008 1,508 28.0 85.0 0.99991

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Table 2
Lehman Euro Liquidity Fund Key Statistics (cont.)

Sept. 19, 2008 Sept. 26, 2008 Oct. 3, 2008 Oct. 10, 2008 Oct. 17, 2008 823 707 707 707 645 34.0 35.0 53.0 59.0 63.0 82.0 79.0 88.0 94.0 93.0 0.99982 0.99982 0.99968 0.99965 0.99974
Chart 4
Conclusion
We welcome the EC's regulatory proposals for MMFs, which we believe, if well-calibrated, could increase transparency, reduce run-risk, develop credit risk analysis, and enhance risk management for those operating and using MMFs. Nevertheless, while we consider some elements of the EC's reform proposals are positive for the overall European MMF industry, we believe others go against the spirit of the objectives of the proposals, and may be detrimental to investment management and investors. For example, we consider that the use of external credit ratings adds transparency in the market, helping establish investors' confidence and investment stability, thereby reducing the risk of fund runs. In our view, the ability of an MMF to halt redemptions and provide in specie transfers--a measure

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which is not currently included in the EC proposals--could lessen the systemic impact of large MMF runs and help prevent a potential dislocation of the short-term liquidity markets. Standard & Poor's looks forward to the forthcoming regulatory discussions, in which all parties can work together for the benefit of the European economy, investors, and businesses that support the smooth-functioning of the capital markets.
Appendix A: ESMA Definitions Of Money Market Funds

The 2010 ESMA guidelines, implemented in 2011, established two MMF classifications: short-term money market funds (STMMF) and money market funds. The EC proposes to rename the latter "Standard Money Market Funds". The two-classifications recognize the distinction between funds that operate a very short weighted-average maturity (WAM) and weighted average life (WAL) and those that operate longer WAM and WAL.
ESMA short-term money market fund (STMMF)

STMMFs have capital preservation as the primary investment objective, and based on ESMA guidelines, are required to: Invest in high-quality money market instruments rated in the two highest short-term credit rating categories or be deemed to be of equivalent quality as determined by the management company's internal rating process. Limit their investment in securities with a residual maturity until the legal redemption date of less than or equal to 397 days. Ensure the portfolio has a WAM of no more than 60 days. Ensure the portfolio has a WAL of no more than 120 days.
ESMA money market fund or standard money market fund

Standard MMFs are considered by ESMA to be more sensitive to interest rate changes. Many of the characteristics found in the ESMA-defined standard money market fund are similar to that of a short-term money market fund with the following exceptions. Under the ESMA definition, a standard money market fund: Has a fluctuating net asset value (VNAV). Limits investment in securities to those with a residual maturity until the legal redemption date of less than or equal to two years. Must ensure its portfolio has a WAM of no more than six months. Must ensure its portfolio has a WAL of no more than 12 months.
Appendix B: Summary Of The Main Reform Proposals

Table 3
Summary Of The EC's Main Reform Proposals For Money Market Funds (MMFs)
Proposals Establishment of a regulatory framework for MMFs in Europe Benefits First Europe-wide regulatory and binding framework governing MMFs Applicable to a wider spectrum of MMFs than the current ESMA guidelines Potential negative effects Framework may prove too rigid and could lack flexibility if future adaptations are required European MMFs may be put at a disadvantage to non-EU MMFs

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Table 3
Summary Of The EC's Main Reform Proposals For Money Market Funds (MMFs) (cont.)
Asset diversification limit of 5% per issuer, with the exemption of EU sovereigns and sovereign agencies Establishment of mandatory liquidity buckets (10% of assets to mature overnight and 20% of assets to mature weekly) Enhances risk-mitigation measure, currently adopted only as best practice by S&P highly rated funds. Enhances MMF liquidity in case of a moderate level of unexpected redemptions Reduced flexibility for MMFs, who currently concentrate on fewer names. May diminish the performance of funds
May not be in the best interest of long-term MMF investors May not match cash flow requirements of underlying investors A reduction of eligible assets for all MMFs (through the exclusion of investments in other MMFs and of certain types of asset-backed commercial paper and reverse repurchase agreements) Mitigates risk of these asset classes Makes MMF management more challenging and reduces investment options in times of stress
Standardizes the risk profile of all EU MMFs, allowing easier MMF comparisons
May result in greater diversification in lesser-known issuers May impact MMF sources of added value, pressuring funds to take more risk to sustain performance MMFs may decide to switch to less regulated domiciles or investment vehicles
Requirements to run regular stress tests
Improves analysis of portfolio risks
Increases operational costs May not be relevant for MMFs invested in high-credit-quality government securities
Move to daily mark-to-market valuation for all VNAV MMFs
Increased transparency of underlying asset values Investors treated more equally in case of MMF runs
May be operationally challenging to implement with the current provision of same-day liquidity Reduced attractiveness of MMF, if the share price exhibits volatility Same-day subscriptions and redemptions unable to be met. Does not protect from MMF run
Implementation of a 3% capital buffer for CNAV MMFs
Capital buffer may provide adequate protection in case of a single-issuer default
Introduces prohibitive costs for CNAV MMF providers Increases investors' perception that CNAV MMFs are a guaranteed product Does not prevent CNAV MMFs from experiencing investor runs
Adoption of an internal rating assessment and discontinued use of credit ratings for selecting MMF assets
Fosters development of credit analysis capability at MMF providers
Lack of global comparability and transparency, leading to creation of systemic risks
Prohibitive implementation cost for some providers Does not prevent MMF from investor runs Increases MMFs' flexibility in terms of investment scope Prohibition on MMF ratings by credit rating agencies Reduces investors' mechanistic reliance on MMF fund ratings Removes a risk management tool for investors. Investors may be left to rely on unregulated fund assessments focused on performance rather than risk Lack of global comparability and transparency, potentially leading to creation of systemic risks

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Table 3
Summary Of The EC's Main Reform Proposals For Money Market Funds (MMFs) (cont.)
Does not prevent MMFs from experiencing investor runs Requirement for funds to know their investor base (such as their cash flow requirements, size, and type) and to match overnight liquidity with their largest shareholder size Increases safety, since MMFs will be better prepared in case of large redemptions May diminish the performance of MMFs with a concentrated shareholder base
Appendix C: Summary Of S&P's 'AAAm' Principal Stability Fund Ratings

Table 4
'AAAm' Principal Stability Fund Ratings Criteria Summary

Credit Quality 50% minimum exposure to securities 'A-1+' &' A-1' <= 5 business days. 50% maximum exposure to securities' A-1' > 5 business days. Final Maturity 397 days maximum final maturity per: Fixed-rate investment Nonsovereign government floating-rate investment Sovereign floating-rate investments rated below 'AA-' Investment with unconditional demand features (i.e., put) providing for liquidity within 397 days with an issuer rated 'A-1'/'A+' or higher. 762 days maximum final maturity per sovereign government (incl. sovereign government related/guaranteed) floating-rate security rated 'AA-' or higher Weighted Average Maturity (WAM) 60 days*
*May be adjusted lower for funds with more volatile shareholder characteristics such as start-up funds or funds with limited operating history, small asset size, a concentrated shareholder base, or a new shareholder base with uncertain liquidity needs. Weighted Average Maturity (Final) 90 days*
*May increase to 120 days if a fund invests in floating-rate sovereigns or government-sponsored entities rated 'AA-' or higher. The maximum WAM is based on a weighted average of the percentage exposure to each type of floating-rate instrument. Diversification 5% exposure per issuer but greater allowance for: Sovereign entities Sovereign government-related entities Overnight bank deposits (incl. uninvested cash) Instruments that are at least 100% collateralized Investments in another rated fund 0.25% deviation (i.e., 0.9975 to 1.0025). Daily mark-to-market pricing if NAV moves more than 0.15% (i.e., below 0.9985 or above 1.0015). A fund may be placed on CreditWatch at a 0.20% deviation (i.e., 0.9980 or 1.0020). Counterparty must be explicitly rated 'A-1' or better. Maximum per rated repo counterparty fully collateralized with traditional collateral: 'A-1+' rated Overnight: 50% 2-5 business days: 10%
NAV Thresholds Counterparty Credit Risk Repo Guidelines

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Table 4
'AAAm' Principal Stability Fund Ratings Criteria Summary (cont.)

>5 business days: 5% Aggregate exposure: 50% 'A-1' rated Overnight: 25% 2-5 business days: 10% >5 business days: 5% Aggregate exposure: 25% 5% maximum per rated repo counterparty with non-traditional collateral
Table 5
Additional Principal Stability Fund Ratings Criteria

Sponsor Assessment Stress Testing The fund rating is based on a funds independent ability to maintain principal stability and does not include a fund sponsors willingness and/or ability to support the funds NAV. However, the rating does include the measures a sponsor takes or has committed to implement within a five-business-day cure period to support the funds NAV or liquidity. Stress tests are required monthly and must show the impact of each of the following scenarios: Parallel interest-rate shifts of +/- 200bp in 25bp increments Asset decreases (i.e., redemptions) of 10%, 15%, 20%, 25% including the percentage of the largest historical five business day net redemptions A downgrade on the largest issuer exposure The widening and narrowing of credit spreads We make available to all rated funds our own stress testing model called the Standard & Poors Ratings Services PSFR Sensitivity Matrix. Illiquid Asset Restrictions Additional Quantitative Criteria Maximum in illiquid/limited liquidity securities: 10%. The includes non-marketable and historically less liquid instruments with maturities > five business days (unless the fund holds an unconditional put providing for liquidity within five business days or an ability to redeem within five business days at no loss of principal) and securities not in funds base currency. Cure periods are applied when there is a breach of a quantitative metric including:
NAV (up to five business days) Diversification (10 business days) 10% illiquid/limited liquidity (10 business days) Overall credit quality (10 business days) Issuer downgrades, cure period depends on exposure: --0 to <0.5% = 397 calendar days --0.5% to 1.0% = 120* calendar days --1.0% to <5.0% = 60* calendar days -->5% = seven calendar days *Regardless of the short-term rating, if the long-term rating is 'BBB+' and on CreditWatch negative or 'BBB' or lower, the cure period drops to seven calendar days. All cure periods are based on a funds NAV remaining within the 0.25% range for 'AAAm'. The qualitative review includes: funds history, investment objectives and strategy, managements investment philosophy, fund management teams depth, experience and adequacy, credit research and analysis, pricing and NAV deviation policy, risk preferences including use of leverage, operating policies, internal controls including fund management oversight and disaster recovery. Weekly portfolio holdings and summary statistics. Annual onsite management review meeting.
Additional Qualitative Criteria Monitoring Frequency

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Notes
1.http://www.ici.org/research/stats/worldwide/ww_06_13 2."Fitch Places Three Prime Rate Money Market Funds on Rating Watch Negative," Fitch press release, issued Dec. 7, 2011. 3.http://www.bankofcanada.ca/2008/03/publications/speeches/addressing-financial-market-turbulence-2/
Related Research And Criteria

Methodology: Principal Stability Fund Ratings, June 8, 2011 A Supervisory Framework For U.S. Shadow Banking Is Progressing Slowly, May 9, 2012

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