Europe lacks standard regulation specifically governing money market funds, comparable to Rule 2a-7 of the U. S. Securities and Exchange Commission. European money market funds therefore may differ across jurisdictions, exhibiting at times a much wider investment scope than their U.S. equivalents.
Recently, however, the Irish Financial Services Regulatory Authority (IFSRA) issued a guidance note with the intention of achieving greater harmony across Dublin-domiciled offshore money market funds. Essentially, the IFSRA has set new requirements for money market funds' investment scope, ratings, and asset manager expertise, and has clarified permitted valuation techniques. The IFSRA took into account rating agencies' fund rating criteria to elaborate its guidance, amounting to an endorsement of those ratings and guidelines.
Standard & Poor's Ratings Services sees the harmonization of Dublin-based money market funds as an important step toward ensuring the safety of these funds' invested principal and liquidity. At the same time, it should help rebuild investor confidence through better transparency. Given the amount of uncertainty and confusion surrounding this asset class as a whole, with certain cash and enhanced cash funds recording negative performance over recent months, we believe that the new Irish regulatory framework for money market funds is a model that other European regulators may decide to consider.
Restoring investor confidence is particularly important now, with European money market funds recording significant growth in assets under management (AUM). Supported by investors' increased risk aversion, AUM rose from €911 billion on Dec. 31, 2007, to $1,040 billion on Sept. 30, 2008, as reported by the European Fund Asset Management Association (EFAMA).
Standard & Poor's is monitoring regulatory developments globally that could affect the way we rate funds. We provide principal stability fund ratings for money market funds and fund credit quality and volatility ratings for enhanced cash and bond funds on more than 850 investment funds globally. In Europe, Standard & Poor's has assigned 'AAAm' principal stability fund ratings to more than 130 funds, representing assets of approximately €405 billion as of Oct. 31, 2008. The majority of European and offshore money market funds Standard & Poor's rates are domiciled in the Republic of Ireland (Dublin) and in the Grand Duchy of Luxembourg (Luxembourg) (see chart 1). These two European offshore asset management hubs have developed expertise in providing financial services, in particular to the funds industry.
Irish Regulator Clarifies Scope And Valuation Method For Dublin-Domiciled Money Market Funds
In August 2008, The IFSRA published Guidance Note 1/08 defining the scope of money market funds, as well as how they should value their underlying assets, reflecting the Committee of European Securities Regulators' (CESR) guidelines on asset valuation. The purpose of this guidance note is to establish the conditions under which a new collective investment scheme (CIS), in other words a mutual fund, which proposes to establish itself as a money market fund can use the amortized cost valuation methodology to price its portfolio's securities.
The IFSRA guidance note states that money market funds which can follow this methodology are restricted to:
Money market funds that have obtained a 'AAA' rating from a nationally recognized statistical rating agency (NRSRO), or
Funds whose management company is engaged or has been engaged in the management of a 'AAA' rated money market fund.
In addition, The Irish regulator outlines a number of conditions for using the methodology that reflect Standard and Poor's existing 'AAAm' principal stability fund rating criteria, in terms of credit quality and maturity constraints.
The new regulation requires money market funds to invest in very liquid instruments with high credit quality, which have an initial and remaining maturity not exceeding 397 days. In addition, the weighted average maturity (WAM) should be maintained below 60 days. The money market funds that use the amortized cost valuation method to value their underlying assets should be marked to market weekly to help highlight any discrepancies between the market value and the amortized cost value. In addition, the note requires that the fund should carry a daily mark-to-market value of its portfolio when the net asset value (NAV) deviates by more than 30 basis points (bps) from the mark-to-market NAV. The Irish regulator also stipulates that money market funds carry out monthly portfolio analysis incorporating stress testing to examine portfolio returns under various market scenarios.
Prior to the new regulation, the Irish regulator had set out valuation guidelines in its Guidance Note 1/00 applicable to UCITS (Undertaking for Collective Investment in Transferable Securities) and non-UCITS CIS, stipulating that money market funds may value securities maturing within 15 months on an amortized cost basis. The regulator has amended Guidance Note 1/00 to reflect the new rules allowing existing money market funds to use amortized cost as an alternative method of valuation in accordance with Guidance Note 1/08. The Irish regulator also clarifies that non-money-market funds that invest in money market instruments with a residual maturity of three months or less may also use the amortized cost valuation to price these assets, providing that the assets are not sensitive to credit and market risks. The Irish regulator thereby limits the use of the amortized cost method to funds strictly invested in very liquid money market securities of high credit quality.
As a result, money market funds valued in the past on an amortized cost basis while invested in securities that do not comply with the conditions outlined in the new regulation are now prohibited from using the amortized cost method and should use mark-to-market valuation. Existing money market funds that are not rated by an NRSRO must comply with the new requirements for eligible assets, maturity limits, and credit quality standards to be able to use the amortized cost method.
Lehman Brothers Default Further Tightens Liquidity
The default of Lehman Brothers Holdings Inc. in September 2008 caused liquidity for money market instruments--already tight since the start of the credit crunch in August 2007--to further decline. This additional market stress resulted in central bank support and government actions to protect money market funds.
In conjunction with these events, the Irish regulator decided in October 2008 to allow money market funds to suspend the monitoring of the mark-to-market valuation of certain money market instruments for securities with a residual maturity of three months or less. Although this exceptional measure is temporary and subject to certain conditions, it does help boost the value of short-dated "buy to hold" securities. (For more on how this action would impact Standard and Poor's 'AAAm' rated principal stability funds, see "Amortized Cost Pricing in Rated Money Market Funds," published Oct. 15, 2008, on RatingsDirect.)
As a result of current market conditions, 'AAAm' money market funds have adopted a very conservative investment strategy, investing in highly liquid assets, and holding in their portfolios primarily certificates of deposit, commercial paper, time deposits, overnight repurchase agreements, government treasuries, and, to a lesser extent, floating rate notes. Depending on the type of investments and the maturity of the instruments, administrators of 'AAAm' rated Dublin-domiciled offshore money market funds use different valuation approaches as outlined in the table below.
Valuation Approaches For Irish 'AAAm' Rated Money Market Funds
Instrument type
Amortized cost method
Market (broker/vendor) prices
Par value
Asset-backed commercial paper
X
X
Certificate of deposit
X
X
Commercial paper
Maturity less than 397 days
X
X
Maturity greater than 397 days
X
Corporate bonds-floating rate notes
Maturity less than 397 days
X
X
Maturity greater than 397 days
X
Government bonds
X
Mutual funds
X
Overnight repurchase agreements
X
Time deposits
X
Liquidity Crisis Raises Concerns About Asset Valuation
The asset valuation methodology chosen by a fund is outlined in its prospectus and must comply with the valuation guidelines of the fund's regulator. Due to the liquidity crisis, regulators have issued guidance about how to value securities in illiquid markets. Some fund sponsors have questioned the fair value provided by market prices as they have seen fund values fall.
CESR guidelines
CESR guidelines, which constitute the common principles of all European financial services regulatory authorities concerning asset valuation in UCITS, have been adopted by the respective European regulators, including very recently by the Irish regulator, as reflected in Guidance Note 1/08. These guidelines stipulate that the amortized cost valuation method can be used to assess the value of a money market instrument as long as it does not result in a material discrepancy between the market value and the value calculated according to the amortized cost method.
Due to the liquidity crisis that has prevailed in the money market, especially after the collapse of Lehman Brothers, CESR has published a guidance note on the "fair valuation" technique for assets in illiquid or inactive markets. This guidance note stipulates that considering current illiquid market conditions, the fair value of securities with a residual maturity of three months or less should be derived by using the amortized cost method. When there is an active market, CESR recommends using market prices to determine the fair value.
Amortized cost valuation
Under the amortized cost valuation methodology, a security is valued based on its initial cost, with interest accrued on a linear basis until maturity of the security. European funds may also be valued on an adjusted amortizing basis. In this case, the cost of the security is adjusted of any premium or discount as of a given date.
The amortized cost method does not reflect the impact of fluctuating interest rates, credit spreads, or credit ratings and does not take into account the unrealized gains or losses on that security, thus preventing the fund's NAV from experiencing any market volatility. When pricing is linear across all securities and maturities, investors left in the fund may be penalized if unrealized losses are not reflected in the portfolio valuation, in particular if redemptions from the fund occur.
Mark-to-market valuation
Mark-to-market valuation, also called market valuation, means that securities that are held in a portfolio are priced at their current market value. When undertaken in normal market conditions, mark-to-market valuation has the benefit of reflecting current market sentiment on a security's price, taking into account the possibility of further credit deterioration and liquidity risk. Therefore this approach provides a more meaningful assessment of the fund's NAV and likely impact of further price volatility. Furthermore, the mark-to-market value is fairer to all investors in funds facing important redemptions.
The money market turmoil has raised concerns about the valuation of securities in money market funds where trading has ceased and there exists no market, as some funds have invested in assets that have become illiquid. Some fund sponsors have challenged the "fair value" usually provided by market prices, as they have seen their funds' NAV fall in the aftermath of the Lehman Brothers default. (For our view on the liquidity squeeze in the short-term credit market, see "Money Market Funds Tackle 'Exuberant Irrationality'," published Sept. 30, 2008.)
Irish Regulation Should Not Affect 'AAAm' Rated Funds
The Irish regulator's latest guidance note on the scope and the valuation of money market funds has no specific impact on 'AAAm' rated funds. Using similar methodology to that laid out in the guidance note regarding eligible assets, maturity constraints, credit quality prescriptions, and valuation, the Dublin-domiciled money market funds that Standard & Poor's rates 'AAAm' fulfill the Irish regulator's latest requirements for money market funds.
Nevertheless, the guidance brings further clarity and transparency for money market fund investors, by providing a stricter and more conservative framework for Irish money market funds than what prevailed previously.
The accuracy of valuation for money market fund assets has become critical in the current environment, as investors seek to scrutinize and understand the techniques used to value money market fund holdings. We believe that when liquidity returns to the markets, and administrators adopt best practices, a greater harmonization in valuation practices will be achieved among European and offshore money market funds.
Analytic services provided by Standard & Poor's Ratings Services (Ratings Services) are the result of separate activities designed to preserve the independence and objectivity of ratings opinions. The credit ratings and observations contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Accordingly, any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision. Ratings are based on information received by Ratings Services. Other divisions of Standard & Poor's may have information that is not available to Ratings Services. Standard & Poor's has established policies and procedures to maintain the confidentiality of non-public information received during the ratings process.
Ratings Services receives compensation for its ratings. Such compensation is normally paid either by the issuers of such securities or third parties participating in marketing the securities. While Standard & Poor's reserves the right to disseminate the rating, it receives no payment for doing so, except for subscriptions to its publications. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.
