Understanding the Changes Coming To Funds

With the new reforms comes a greater focus on the potential implementation of liquidity fees and redemption gates. While gates are not necessarily a new function of the funds, the regulations give boards a specific guideline of when they have the option to implement fees or gates, based on predetermined weekly asset liquidity levels.

Such weekly assets include those with a maturity within seven days, those that have a callable feature due within five days, cash, obligations of the U.S. government, and securities of government agencies maturing within 60 days. If these weekly assets fall below 30% of overall fund assets, the fund's board may impose a fee of up to 2% — should the fee be in the best interest of other shareholders — and they also may impose gates limited to 10 days within any 90-day period. If weekly assets fall below 10%, the fund is required to impose a minimum 1% fee, or up to 2%, but the fund manager has certain discretion to waive the fee, and continues to be able to impose gates limited to 10 days within any 90-day period. Funds will be required to report weekly liquidity percentages to provide transparency to investors if the potential for a fee or gate is on the horizon.

Fees and gates are left up to the fund's discretion and are put in place to prevent runs on the fund and take away any "first mover" advantage. Fees and gates are designed to protect those investors who remain in the fund, by imposing a cost on those who exit the fund. The fees are paid to the fund itself, rather than the fund manager, to compensate shareholders left in the fund. The gates give fund managers a chance to successfully navigate a short-term market stress scenario. Despite the amount of attention given to the fees and gates in this regulation, the majority of funds already have wording in their prospectuses that allow them to deny redemptions or charge a redemption fee, if it is in the best interest of the majority of the shareholders. This regulation standardizes the practice across all prime funds. Even though funds will have the ability to implement gates and fees, many managers will remain extremely cautious, attempting to avoid the reputational risks associated with imposing them.

The Floating NAV Is Changing the Way Corporations View MMFs

The floating net asset value (NAV) poses a significant change in how corporations view prime and municipal institutional MMFs. Historically, MMFs have been treated as stable, fully liquid funds. Going forward, those funds will be required to strike intraday NAVs, to the 4th decimal place, putting investments at risk of potentially losing, or gaining, value of principal. For example, a fund could strike a NAV at 9:00 a.m. for 1.0000, and they could strike again at 12:00 p.m. for 0.9999, which would be a $10,000 loss for every $100MM invested in the fund.

Despite the floating NAV, funds strive to provide stable pricing. As of April 14, 2016, they have been required to provide historical NAVs on a trailing six month basis to show stability, and many funds are choosing to provide even longer history to demonstrate their stability. Funds are also required to run stress testing scenarios to prove fund price stability. Exact timing and number of NAVs per day will differ from fund to fund, the timing of which many funds have already disclosed. Once NAV strike times are established, corporations will need to be cognizant of new processing times when investing and redeeming funds. Because funds have to process and strike multiple NAVs each day, the handling of investments and redemptions could be delayed. Tax implications of floating NAVs may be an additional consideration; consultation with tax professionals is critical.

For companies that require a stable NAV, government and treasury funds will remain a viable option. Government funds will be required to hold 99.5% of their assets in government or equivalent securities, as opposed to the prior limit of 80%. Some prime funds are reclassifying themselves as government/treasury funds so they can continue to offer stable pricing. While these funds will offer a stable NAV, they also will generally have lower yields. For treasurers looking for a yield greater than treasury and government funds, while satisfying capital preservation and liquidity needs, bank earnings credit rate programs and direct securities or bank deposits with tenors of greater than 31 days may help to achieve these goals.

The Impending Shift from Prime Funds to Other Investments

Based on a Citi survey, a total of $200–$400 billion is expected to move from prime funds into other investments, such as treasury and government funds, bank deposits or other securities. As October 2016 approaches, prime funds are expected to shorten their weighted average maturity (WAM) to prepare for any major shifts in the market, which could potentially lower the spread between government and prime funds. If a significant amount of funds convert from prime to government, the yields on government funds could also be depressed, due to the increased demand of applicable securities by the fund families. Citi's survey results indicated that once the spread between prime and government funds reaches 20–40bps, deposits will start to flow back to prime funds.

In response to MMF reform, Citi is making several upgrades to Citi Online Investments, which is a multi-fund family portal that offers investment analytics and new reporting functionality to help ease the burden of the reform. In combination with MMF reform, Basel III, and the anticipated continued rise in USD rates, an increased focus on segmentation of cash into various liquidity buckets will be critical. For longer-dated cash, Citi has released competitive yielding Minimum Maturity Time Deposits, with tenors of 31, 45, 60 and 95 days, with further tenor options to come. Fund managers are also responding with new product offerings, including 7-day and private funds to help ensure compliance with liquidity requirements and/or maintain stable NAVs.

As the MMF reform deadline nears, it is highly recommended that treasurers review and update their investment policies, focusing on wording that may limit certain MMF investments following these regulatory changes. Regardless of regulatory change, best practice would dictate reviewing and updating one's investment policy at least once per year. While many will still consider prime funds a viable investment option, it is important to remember that fees and gates may be imposed, but only as tools to be used in times of extreme market stress. Tools such as these already exist today and are not new to the market. Finally, it's important to note that fund managers will, in all likelihood, act very cautiously when it comes to utilizing these tools because they want to avoid the reputational risk of implementing liquidity fees and gates.

As prime funds shorten their WAM, government and treasury MMFs may prove appealing to conservative investment policies, but they will likely come with lower returns. The upshot is that in today's increased regulatory environment, it is imperative to sit down with your banking/financial, legal and tax partners to determine how your current investment strategy may be affected by new reforms.