European Money Market Funds: COVID-19 and the Future of LVNAV Funds
Although both short-term and standard money market funds (MMFs) faced challenges during the March 2020 market crisis, the recent reforms, while imperfect, helped make Low Volatility Net Asset Value (LVNAV) funds safer and more liquid. Holistic consideration needs to be given to various elements, in order to ensure that MMFs can continue to play their important role in short-term market.
In March 2020, the pandemic triggered substantial volatility across the global financial system, including in short-term markets. As we address in this paper, this volatility presented acute challenges for Europe’s most highly subscribed institutional money market fund (MMF) structure: the low-volatility net asset value (LVNAV) fund. The COVID-era volatility was the first serious test of LVNAV funds, which were launched following the implementation of Europe’s money fund reform in 2019, and it raised important issues for regulators and market participants alike.
An LVNAV fund is popular with investors largely because funds are permitted to trade their shares at a constant 1.00 price, provided that the mark-to-market NAV remains within a 20 basis points (bps) collar of 1.0000 (i.e. 0.9980 to 1.0020). In the event the NAV breaches the collar, the fund must move to a full mark-to-market valuation until it recovers.
In March, the sudden and unprecedented demand for market liquidity precipitated significant redemption pressure on MMFs. In Europe, LVNAV funds denominated in U.S. dollars were the hardest hit, losing 30% of their AUM ($92 billion) in the period between March 6th and 27th (Figure 1), thereby presenting a high-stakes balancing act for portfolio managers. Under EU regulations, when weekly liquidity in an LVNAV fund falls below 30%, the fund’s board must consider imposing liquidity fees and/or gates. To avoid this, portfolio managers sold longer-dated assets to boost fund liquidity. In fact, many funds sought not just to keep their liquidity above
the minimum threshold but to boost it to elevated levels. The weekly liquidity of some funds exceeded 60% and remained there, waiting for the market to normalize.
Figure 1 : AUM of USD LVNAV and Public Debt CNAV Funds
This scramble for liquidity occurred amid markets that had become extremely illiquid. In some cases, funds sold assets at a loss, which drove down mark-to-market NAVs. This resulted in a small number of funds approaching the 20bps collar, that would have compelled them to float their share price at or below 0.9980. It is important to emphasize that the regulatory liquidity threshold created a liquidity paradox for these funds. To
assuage investor concerns over the potential imposition of fees or gates, portfolio managers viewed the threshold as an effective floor that could not be passed through. Thus they aggressively sold assets to maintain and, in many cases substantively exceed, the minimum regulatory requirements. This was counterproductive, an unintended consequence of the liquidity rule.
Further complicating matters for funds domiciled in Dublin or Luxembourg was a lack of immediate and direct central-bank liquidity support. In the U.S. the Federal Reserve provided liquidity to domestically registered MMFs through the MMLF, although this excluded foreign funds. While the ECB and the BOE also provided market liquidity through various facilities, including asset purchase programs, their construction and associated conditions meant they could not be meaningfully accessed by MMFs.
Notwithstanding the extremely challenging market conditions, all investor redemptions were met in full, no LVNAV fund imposed fees/gates (despite some funds seeing their weekly liquidity falling below 30% for short periods of time) nor did any fund breach the 20bps collar.
Sterling and Euro Stability vs. Dollar Volatility
LVNAV funds denominated in EUR and GBP behaved differently from USD funds during the March turmoil. Net redemptions for the month were more muted, although fund flows were elevated. During the first two weeks, EUR LVNAV AUM was up 15% (€13 billion), before outflows in the third week of 15% (€15 billion). By the first week of April, flows had reversed again, and AUM was up 9% (€8 billion; Figure 2). Similarly, GBP LVNAV AUM was up 4% (£8.7 billion) in the first two weeks of March, only to drop by 7% in the third week, before rising by 7% in the last week (Figure 3).
Figure 2 : AUM of EUR LVNAV Funds
Figure 3 : AUM of GBP LVNAV Funds
In contrast to USD LVNAV funds, trading patterns suggest that sterling and euro redemptions were primarily driven by investors’ real liquidity needs (for example, covering payroll amid the collapse in economic activity and meeting margin calls) rather than by concerns over whether MMFs would be able to accommodate redemptions.
We also note that at least one LVNAV fund in each currency fell below the 30% threshold that mandates board consideration of gates and fees, and numerous other funds came close to the threshold. Despite this, sterling and euro fund investors did not exhibit a strong rush to exit. In contrast, in the U.S. the fact that various prime funds merely approached the 30% threshold — only one fell below it, and only for a single day — was a major driver of redemptions.
There are several possible explanations for why USD investors behaved differently from EUR and GBP investors. First, USD redemptions largely mirrored U.S.-based prime funds, and may have been stoked by a similar flight to safety based on memories of the GFC (see COVID-19 and the Future of Prime Funds). Second, in contrast to sterling and euros, dollar investments in Europe offered a safer, readily available alternative — the government or public-debt constant NAV (CNAV) funds — without negative yields. Indeed, USD CNAV funds gained 47% of their AUM ($61
billion) during the same period. Finally, with regard to gates and fees, while these tools have long been a feature of the European mutual fund framework, their continued stigma within US-registered funds may have resulted in USD investors being more sensitive to their potential use.
As is typical with European legislation, the EU Money Market Funds Regulation will be subject to a periodic review in 2022, although this could be initiated sooner, and we expect the performance of the sector during the March 2020 volatility to be an important consideration. Regardless of timing, addressing the challenges observed during the peak of the market turmoil will not be a simple undertaking. For Institutional Investors the LVNAV remains the most popular MMF structure in Europe, with AUM being significantly greater than short-term VNAV funds, Europe’s other prime-like short-term MMF structure. This is likely the result of investor appreciation for these funds’ use of amortized-cost accounting, thereby maintaining a constant NAV. Yet the risk, in distressed markets, that heavy redemptions can cause NAV stress is unlikely to be ignored by policymakers.
There is no easy fix and, furthermore, effective reform must consider both
underlying market structure issues and MMF-specific issues. Liquidity conditions were unambiguously the root cause of the problems in March. Regulators can take steps to reduce the potential for future distress by examining the behavior of the short-term markets under severe stress and identifying ways to ease market liquidity. Central banks could also provide coordinated actions to ease liquidity strains in cross-jurisdictional markets, similar to the measures taken to ease dollar-demand stresses in the foreign exchange market. Finally, regarding MMFs specifically, regulators may also allow for a tool less blunt than gates and fees as a first step in preserving MMF liquidity; one option would be to separate the minimum liquidity requirements from the level or prevailing conditions at which the board may impose a redemption fee or liquidity gate.
Short-term money market funds serve a key function in the economy. They offer both scale and yield enhancement over sovereign money market funds, while providing the safety and liquidity needed for cash investments. They create demand for short-term funding for banks and corporations that rely on such funding. They will and should continue to play this function. Although both short-term and standard MMFs faced challenges during the March 2020 market crisis, the recent reforms, while imperfect, helped make LVNAV funds safer and more liquid. It is clear that the challenges faced by MMFs were in part driven by market structure issues, including the unintended consequences of post-GFC reforms, as well as by provisions included in MMF reforms which may not have operated as intended. Regulators now need to holistically consider these various elements, in order to ensure that MMFs can continue to play their important role in short-term market. This presents an opportunity for regulators and market participants to cooperate in further improving the industry.
1 In late February, just prior to the COVID volatility, LVNAV funds had AUM of about $700 billion, compared to $85 billion for the other short-term money fund category, variable NAV funds. The third category, Standard VNAV, is similar to a short-term bond fund, with longer WAM and WAL and lower expectations for immediate access to liquidity.
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