Bank Deposits Versus Money Market Funds

The cash manager’s primary role is to maximize the safety, liquidity and yield of their cash holdings. By placing a deposit with a bank, it must be recognized that the depositor becomes an unsecured creditor, and should that bank fail, then that deposit is 100% at risk.

It is clearly not best practice therefore to place all your money at risk with just one bank. Consequently the prudent cash manager spreads his/her short-term liquidity across several bank counterparts. Counterparty lists are drawn up with the size of the limit assigned reflecting the credit quality of the bank in question. This in itself means by utilizing the deposit market in this way then the cash manager will only ever meet two of the three primary roles; the better rated the bank, the lower rate likely to be paid and vice versa.

Money market funds, on the other hand, meet all three requirements, and hence why they have become best practice for the day-to-day management of short-term liquidity.

Safety — Funds are triple-A rated
Liquidity — Same day access to cash replicates a call account structure
Yield — Although the fund operates like a call account, the weighted average maturity can be as long as 60 days. This enables the fund to generally outperform short-term inter-bank rates

Money market funds have a distinct risk difference from a normal bank deposit. Below are examples that show the differences in approaches to investment risk.

Approach

An investor who has made a direct deposit with a bank has a 100% risk concentration with that particular institution. If that banking institution were to become financially distressed, there is a material risk of principal loss for all of its creditors, including depositors. Further, insolvency proceedings for banking institutions can be lengthy, with a wide range of potential outcomes. At minimum, the uncertainly with regard to ultimate principal recovery on an investor’s deposit, and the loss of potential earned interest during the period of insolvency proceedings, are scenarios that cash investors do not want to consider.

The high-profile failure of 4 US banks in the spring of 2023 serves as a good example of concentrated deposit risk. The uninsured depositors of the these institutions quickly withdrew their cash and created irreparable funding stress. The failure of these banks was a clear reminder of the risk in concentrated exposures.

Risk Analysis

a) Money market funds have a diverse investor base, including:

• Financial Institutions
• Pension Funds
• Corporate
• Charities
• Local Authorities

The result of this diverse investor base is that each investor type has very different cash flow requirements and where one investor may redeem from the fund the other subscribes thus creating a netting effect. This construct, along with specific guidelines that require minimum amounts of liquidity in the fund make the investments appropriate for same day cash needs.

b) Investments made into the fund are paid to the Custodian for the fund acts independently from the distributor and investment manager and in essence ring fences the assets of the fund from the distributor and Investment Manager.

c) The investment manager is responsible for the investment decisions and dealing of the fund assets. They have a wealth of experience and has built a sophisticated and research driven fund management team totally dedicated to manage the assets within strict and transparent guidelines.

d) The fund specification is the guidelines in which the portfolio managers are allowed to operate and stipulates the permitted asset types. The fund is allowed to invest into the following:

• Term Deposits
• Certificates of Deposit
• Commercial Paper
• Bonds
• Floating Rate Notes
• Government Securities
• Reverse Repo

The fund is managed to ensure that it maintains its AAA-ratings from at least two of the three major rating agencies.

e) The fund specification allows only the investment into investment grade securities. They have a large dedicated credit risk research team that constantly monitors the liquidity of issues and importantly the fundamental credit quality of every single issue held within the fund. They set our own internal ratings and the portfolio managers adhere to this buy list ensuring that they are proactive and not reactive, not reliant on the rating agencies.

f) Money market funds tend not to invest more than 10% of the funds total asset holdings with any one counterparty. We operate within these parameters by working to a <5% counterparty limit. In turn this restricts any individual investors, underlying exposure (assuming that investor represents no more than 10% of the total value of the fund) to any individual counterparty to less than ½%.

Constant/Stable NAV Funds

There are two fund types that can use amortized cost accounting and calculate their NAV at a stable 1.00. These are, first, European domiciled and governed by UCITS rules; they are CNAV (sovereign debt) or LVNAV (credit debt). Two, US domiciled SEC registered government or treasury funds. Clients of these funds can subscribe or redeem at 1.00 assuming the fund’s underlying value does not deviate from its allowable limits.

Rating Always Maintained

In order to achieve a AAA-rating the fund must adhere to the strict and transparent guidelines imposed by the rating agencies. The AAA-rating is the guiding principle by which they manage the fund.

The rating guidelines covers all three primary types of risk inherent in money market funds, namely:

• Credit
• Market
• Operational

Credit risk addresses the probability of a security held within the fund defaults and generates a loss to the fund.

Rating agencies therefore restrict what assets a fund can purchase and the quantity of such assets. It also stipulates diversification requirements and certain concentration requirements that are more conservative than regulatory requirements. Moody’s therefore restrict what assets a fund can purchase and the quality of such assets. It also stipulates diversification requirements with a fund generally unable to invest more than 10% with any one counterpart. The fund is also a registered money market fund that adds to the diversification requirements on top of those imposed by the rating agencies.

Market risk addresses the funds sensitivity to changing market conditions. Rules governing the weighted average maturity of the portfolio, (restricted to a maximum of 60 days) and weighted average life (restricted to a maximum of 120 days) are imposed. The liquidity of the assets within the fund and diversification as well as the effects of dilution is all covered. Independent verification also monitors the market risk within the fund with all assets held marked to market daily to ensure that the fund’s actual net asset value per share does not deviate materially from £1/€1/1$, and to ensure action if such deviation exists. Operational risks look at the fund management capabilities as well as the service providers. It is vital that the Fund is managed in a way consistent with its published objectives and policies.