Defining suitable cash investments
Defining which instruments are truly cash equivalents, and which cash investments are most suitable, are among the most difficult tasks for modern cash investors.
Help is on hand from regulators, who play an increasingly important role in defining cash investment instruments and structures. Nevertheless, due diligence is still vital if cash investors are to seek out the most effective cash investments for their own needs and circumstances.
Money market fund regulation
Globally, cash investors look to regulators to define and clarify suitable cash investment instruments and structures, particularly in the US, Europe and China given the size and systemic importance of the liquidity industry. Regulations in other countries and jurisdictions may be less detailed.
Since the global financial crisis, money market fund guidelines have been tightened to demand higher levels of liquidity, impose tighter investment limits and require increased diversification. These rules have helped reduce the likelihood that funds will suffer losses, albeit at the expense of lower potential returns.
Regulations vary from prescriptive, listing specific approved and unapproved instruments, to abstract, outlining key sources of investment risk and limits to mitigate them. Regardless of the regulator’s philosophy, the ultimate goals remain the same: to ensure adequate liquidity and minimise the probability of losses.
What is “breaking the buck” and why is it important?
- Subscriptions and redemptions to a money market fund occur at $1 per share (no capital gains or losses are realised).
- To ensure all redemptions can be paid at $1 per share, the mark-to-market value of the portfolio should be extremely close to the amortised value of the portfolio at all times. The acceptable range for US, European and Chinese stable NAV money market funds is +/- 50 basis points (bps) +/- 20 bps, and +/- 50 bps, respectively.
- The deviation from the mark-to-market value of the portfolio beyond which regulators and the rating agencies deem redemptions to no longer be paid at $1 per share is known as “breaking the buck.”
Global comparison of regulatory guidelines
Money market fund regulation continues to evolve, incorporating lessons learned from periods of volatility. Regulators also consider financial market changes, local market characteristics and international developments when creating new guidelines. Notably, over the past decade, regulatory gaps between different country and regional guidelines have been narrowing.
| GUIDELINE | US - SEC RULE 2A-7 | EU – ESMA SHORT-TERM MMF | CHINA – CSRC MMF |
|---|---|---|---|
| Product structure | CNAV: government, retail VNAV: institutional prime, municipal |
CNAV: government LVNAV: credit VNAV: government, credit | CNAV VNAV |
| Max WAM | WAM 60 days/WAL 120 days | WAM 60 days/WAL 120 days | WAM 120 days/WAL 240 days |
| Max maturity | Fixed 397 days FRN/VRN non-US government: 397 days | 397 days | Bonds: 397 days TD and repo: one year FRN: Max 20% if tenor > 397 days |
| Min credit rating | Must present minimal credit risks to the fund as determined by the fund’s board | Must present minimal credit risks to the fund | Long term: AA+ (domestic ratings) Max 10% of below AAA-rated issuers (2% per issuer) Approval required for below AA+ rated banks, term deposits (TD) or negotiable certificates of deposit (NCD) |
| Diversification/concentration | Issuer Concentration: max 5% | Max 5% per issuer Rule 5/10/40: positions between 5% and 10% must not in aggregate exceed 40% | Max 30% (excluding redeemable TD) 20% per bank with custody license 5% per bank without custody license Max 10% per bank’s net assets |
| Repo (lend collateral) / Reverse Repo (lend cash) | Repo: not allowed Reverse repo: max 5% per counterparty; no limit per counterparty if fully collateralized by U.S. Treasuries, U.S. government agency securities or cash | Repo: max 10% Reverse repo: max 15% per counterparty; collateral must be money market eligible securities; max maturity of two business days | Repo: max 20% Reverse repo: max 40% per issuer |
| lliquid securities | Max 5%1 | n/a | Max 10% in TD and repo with maturities >10 days |
| Portfolio liquidity | Min 10% daily 2/min 30% weekly 3 Tax-free MMF exempt from daily liquidity | CNAV: Min 10% daily/min 30% weekly 4 LVNAV: Min 10% daily/min 30% weekly 4 VNAV: Min 7.5% daily/min 15% weekly 5 | Min 5% daily 6 Min 10% weekly 7 |
Source: J.P. Morgan Asset Management, Securities and Exchange Commission (SEC), European Securities and Markets Authority (ESMA), and China Securities Regulatory Commission (CSRC). As of 31 December 2020. 1 Illiquid securities include repos and depos >seven days. 2 Assets must be in cash, US Treasury securities, or securities that convert into cash within one day. 3 Assets must be in cash, US Treasury securities, certain other government securities with remaining maturity of 60 days or less, or securities that convert into cash within five business days. 4 17.5% of weekly liquid assets can be US Treasuries or certain other foreign government positions with 190 days or less to maturity. 5 7.5% of assets outside of the weekly maturity bucket can be counted toward weekly liquid assets. 6 Assets must be in cash, government bonds, People’s Bank of China bills, policy bank bonds. 7 Assets must be in cash, government bonds, PBoC bills, policy bank bonds or securities with remaining maturity of five days or less.
Liquidity fund pre-investent due diligence
Equipped with a solid understanding of liquidity products, their risks and the differences between them, treasury professionals and other institutional cash investors can carry out independent due diligence to find the best match of liquidity products to their unique needs and internal guidelines.
Investors should investigate five key areas in the due diligence process: strength and experience of the manager; credit analysis capabilities and investment process; liquidity, investor concentration and access; environmental, social and governance (ESG) considerations; and technology.
Manager strength and experience
Investors should assess the strength of a money market fund manager through careful examination of the manager’s current and historical financial position, as well as considering the manager’s commitment to (and the size of) its liquidity business.
A thorough investigation of the manager’s experience and track record — particularly through volatile markets — is critical in the selection process.
Credit analysis capabilities and investment process
Prospective investors should probe the strength and track record of the credit analysis capabilities and the investment process by asking about the structure, experience and resources of the credit team.
Topics to address include how are funds stress-tested, whether anything in a portfolio has been downgraded or a fund manager has had to buy out any holdings, the underlying investment diversification, if the fund is rated by a Nationally Recognised Statistical Rating Organisation (NRSRO) and what additional internal restrictions beyond the regulatory limits are used.
Liquidity, investor concentration and access
As a key priority, prospective money market fund investors should ask if the fund maintains high levels of overnight liquidity and a strong ladder [HRW(G1] of maturities to meet all potential redemptions, and if there are restrictions to ensure an adequate level of client diversification.
Clients should also inquire if the fund has ever restricted withdrawals. Some additional service and operational considerations that are important include cut-off times, management fees and minimum subscription levels.
Environmental, social and governance (ESG) considerations
Investors seeking to include ESG factors in their liquidity fund selection process may want to look closely at how ESG factors are incorporated into a money market fund’s credit analysis and security selection process.
If the analyst believes that the ESG factors are material and may impact issuer risks, the analysis will be reflected in the analyst’s credit opinion.
At J.P. Morgan Asset Management, ESG risks are systematically considered as part the fundamental company credit and industry analysis. Credit analysts examine all aspects of a company, including how ESG risks and opportunities are currently affecting a company’s cash flows as well as how cash flows may be impacted in the future.
At the sector level, considerations include industry positioning, the regulatory environment, public sentiment, climate considerations, resource usage and secular trends.
Technology
As an organisation's treasury team moves its trading and investment decisions online, a comprehensive, secure and easily-integrated technology platform for liquidity investments has become another important consideration for treasury professionals and cash investors.
On average, global liquidity clients invest in at least three fund providers to ensure they have enough investment options to create a diversified, multi-manager, multi-currency portfolio that meets their liquidity needs.
A strong technology platform will feature the following characteristics:
- EASE OF INVESTING: this includes access to a wide selection of funds, easy trading and helpful functions, such as the ability to view aggregated account information across entire portfolios, conduct in-depth risk analysis, model potential trades and compare available investment options. A provider’s platform should also be able to integrate with a client’s treasury management platform.
- EFFECTIVE CONTROLS: investment policy guidelines can be integrated into a technology platform and warn users in advance when a trade may create a breach.
- OPERATIONAL EFFICIENCY: ability to perform analysis, schedule custom reporting and execute trades both, in real time and in advance. Some platforms can facilitate multiple and more complex trading options, including host-to-host trading, Application Programming Interfaces (API) integration and support for multiple settlement instructions.