The reverse distribution mechanism (RDM), the facility that has allowed money market funds to maintain a constant net asset value (NAV) in times of low or negative interest rate environments will be disallowed for EU money market funds from March 21st, and as a result, the NAV of these funds may fall below 1 from then onwards. EY’s Kieran Daly discusses these developments in Finance Dublin.
The application date for money market fund reform has come and gone and the industry is bedding down the new reality. However, the transition is not over yet and there is still some work to do. The industry continues to grapple with the key issues, which will have a huge bearing on how money market funds operate in the future.
The main hurdle to overcome is around the reverse distribution mechanism (RDM). This is the facility that has allowed money market funds to maintain the constant net asset value (NAV) in times of low or negative interest rate environments. The EC has taken the view that this mechanism is not in line with money market fund reform regulations. The debate around RDM, which continued over the course of 2018, concluded before Christmas.
The outcome was one that results in a fundamental change to how money market funds operate. RDM is no longer allowed as a mechanism to maintain the constant NAV. This will change how these funds operate, and as a result, will require changes to operations for both the service providers to these funds, as well as investors, who are used to constant NAV money market funds.
Given the timing of the conclusion relative to the implementation date of 21 January 2019, the CBI issued a joint statement with the CSSF in Luxembourg, whereby they have given the industry up to 21 March to discontinue the practice of RDM.
The impact of RDM will be greatest on EUR denominated public debt constant NAV funds (“CNAV funds”). We continue to live in a low EUR interest rate environment, and as a result, the NAV of these funds may fall below 1 from 21 March onwards. The industry continues to develop their plans as to how to make this work operationally and as to how to educate investors of the coming change.
However, we are in a time of rising interest rates, and as rates rise, the necessity to deploy such a mechanism reduces. These funds will earn more income, and therefore should be able to cover the running costs of the funds, reducing the risk of running a net loss on a daily basis. For USD and GBP denominated funds, where rates have already risen, investment managers have more scope to manage their new CNAV funds in such a way that avoids the use of RDM, while maintaining the constant NAV of 1.
As interest rates in Europe rise over the medium term to a more long term rate, that will also be the case of EUR CNAV funds.
In addition to the new CNAV fund, the new regulations do provide a number of product options for investment managers, including the low volatility NAV (LVNAV) fund and the variable NAV (VNAV) fund. The LVNAV fund is an interesting concept, where it blends features from both the CNAV and the VNAV fund options. This is proving quite popular amongst investment managers, thanks to its ability for investors to trade at the constant NAV, once certain conditions are met.
The variable NAV fund provides the greatest level of flexibility. However, it has historically accounted for a small number of Irish money market funds, and requires the biggest change in terms of operating model. However, once investors are happy to choose a VNAV fund, it gives the greatest flexibility to investment managers and therefore could deliver higher returns for investors.
These regulations have resulted in big changes for the industry, and there are still more changes to come. In reality, although the regulations are now in place, we will see a period of implementation, where investment managers and service providers will continue to monitor and adopt their model.
And given that these regulations have brought about so much change, it is important that the industry looks at the opportunities that this could bring and focuses on making Irish money market funds the vehicles of choice for European investors into the future.
This article first appeared in the March 2019 edition of Finance Dublin.