Mr. Aidan Carrigan:

This is a technical regulatory proposal, so I will rely on my colleagues from the Central Bank of Ireland to assist in some explanations. It is important to note that much of the legislative reform programme on European banking union has now been completed. This banking union work is designed to address the risks posed to financial stability by the banking system. However, banking is just one part of the picture regarding credit intermediation. A substantial and growing element of credit is provided by the so-called shadow banking system which facilitates the provision of credit to business through the markets as an alternative to bank funding. As we near the conclusion of the new banking union framework, attention in Europe and across the world is now turning to the large shadow banking regulatory agenda.

Shadow banking is a broad term which covers a range of activities in the area of non-bank credit intermediation. It is important to note that shadow banking activities, which include securitisation, securities lending and repurchase transactions, constitute an important source of finance for financial entities. It includes entities which raise funding with deposit-like characteristics, perform maturity or liquidity transformations, allow credit risk transfer and use direct or indirect leverage. It is broadly accepted that shadow banking needs to be regulated because of its size, its close links to the regulated banking sector and the potential systemic risks that it poses. There is already some regulation of the shadow banking sector through the existing undertakings for collective investment in transferable securities, UCITS, directive, the alternative investment fund managers directive, and other EU legislation. However, some would argue that this provides only partial regulation and further measures are required.

It is in this context that the European Commission has brought forward its proposal to enhance the regulation of money market funds, which constitute possibly one of the most prominent sectors of shadow banking.
Money market funds are collective investment schemes which bring together demand and offer short-term money. They act as an important source of short-term financing for financial institutions, corporates and governments. To corporate treasurers, money market funds offer a short-term cash management tool that provides a high degree of liquidity. They are mainly used by corporations seeking to invest their excess cash for a short period, for example, until a major expenditure such as payroll is due. In Europe they are generally established as undertakings for collective investment in transferable securities, UCITS, under the UCITS directive and thus have a passport which allows for their sale across the European economic area, EEA. However, they can also be established under national laws of member states and fall within the scope of the alternative investment fund managers directive. As UCITS, they comply with European Securities and Markets Authority guidelines on money market funds.
There are two types of money market fund: those of which the net asset value - that is, the value of the assets held by the fund - is allowed to float, the variable net asset value, VNAV, fund, and those of which the net asset value does not float, namely, the constant net asset value, CNAV, fund. A CNAV fund seeks to maintain a stable €1 per share through the amortisation - or writing down - of any loss or gain in value over the life of the asset, rather than valuing at the market price on a daily basis. This kind of fund holds a particular attraction for corporate treasurers beyond its usually limited yield. The stability in the price of the fund allows for investments to be treated as similar to bank deposits in corporate accounts. By contrast, a VNAV fund is priced according to the market value of its assets at a particular point and thus its value floats in accordance with the markets for its underlying assets. It would not be correct to say it would be a straightforward matter to require all CNAV funds to convert to VNAV funds. There is evidence that most CNAV investors would leave money market funds altogether, rather than redirect their funds into VNAV money market funds.
The intention behind the money market funds regulations is to deal with the perceived risk of runs on the funds. In summary, the regulations propose the following measures: that money market funds will be required to have at least 10% of their portfolio in assets which mature within one day and another 20% which mature within one week; they may only invest in money market instruments, deposits with credit institutions, financial derivative instruments and reverse repurchase agreements; they will not be permitted to invest more than 5% of assets in money market instruments issued by the same body or 5% of its assets in deposits made with the same credit institution; they may not solicit or finance an external credit rating; they must identify the number of investors in the MMF, their needs and behaviour and the amount of their holdings; they must put in place sound stress testing processes for the fund; and CNAV funds must have a 3% a capital buffer or convert to a VNAV fund. In broad terms, these are the additional regulations being proposed by the European Commission.
The total money market funds sector in Europe amounts to some €1.3 trillion in funds. This is shared between VNAV and CNAV funds. CNAV funds are favoured by US investors and the Irish funds industry hosts up to €300 billion worth. The question, therefore, of a specific regime for the regulation of CNAV funds is of particular interest to Ireland. As structured, the proposals for the added regulation of CNAV funds pose a risk to the future of the CNAV funds sector of the Irish funds industry. We have been advised by the European Commission that the additional requirement for a CNAV buffer arises from a perception that these funds are riskier. It is argued that the apparently fixed price of an investment in a CNAV fund lulls investors into a false sense of security and that there is a market perception that the value of these funds is guaranteed. In the event that assets depreciate, the fear is that the investment manager will no longer be able to hold the net asset value steady and that investors might not get €1 or $1 back for each €1 or $1 they put in. When that happens, the CNAV fund is said to have broken the buck, so to speak. Such events are rare and seen as dramatic and could be a cause of market instability. The Commission's intention is to require buffers which would require investment managers to place aside a percentage of the value of the CNAV fund to act as a safety net in times when the fund's assets devalue to such an extent that there is a risk of the buck being broken.
We agree fully that shadow banking needs to be robustly regulated and that the risks to financial stability arising from such banking are recognised and addressed. There is no room for complacency in markets regulation. We support the general approach taken in the European Commission's regulations and are keen to play a full part in the debate on all elements. We will engage in the debate on each of the measures I outlined. The Department of Finance will approach the forthcoming Council working parties in a constructive and open-minded manner and with the hope of securing a proportionate approach to the regulation of both CNAV and VNAV funds.
Members might recall that in the European Parliament recently there were mixed views on the approach to the capital buffer for CNAV funds, with many MEPs arguing, in particular, that the potential negative impact on the industry was not fully understood. This resulted in consideration of the regulations being postponed until the election of the new Parliament. We will be highlighting this concern at the Council and encouraging a greater focus on and assessment of the consequences of this proposal. In particular, we will be making the point that the 3% capital buffer for CNAV funds is seen by many as excessive and potentially dangerous. In the context of a product which operates on very tight margins and at a time when interest rates are at an all-time low, the cost of funding a 3% buffer could render these funds uneconomic. Should this occur, it would amount to an effective ban on CNAV funds. Commissioner Daniel M. Gallagher of the US Securities and Exchange Commission, SEC, made this point well last year when, at an open meeting of that organisation, he stated:

[O]ur economists believe that in order to act as a bulwark against default risk or run risk, a buffer would have to be so large that it would not be economical for money market funds to continue to operate. And, conversely, if the buffer was small enough to be economical, then it would provide no protection against events like the ones experienced in 2008. This is not news.

We will also be reflecting concerns that the effective ban on CNAV funds might damage both the funds industry and European markets generally. The European Systemic Risk Board acknowledged this in its report on the regulation of money market funds. It stated, in the context of the possible imposition of more onerous conditions on CNAV funds, that:

[T]here could be a sudden outflow from European CNAV funds to other jurisdictions or alternative products. The consequences of this happening could result in a serious impact on the pricing and availability of short-term funding for European borrowers, in particular banks.

Europe hosts some €400 billion in CNAV money market funds. If CNAV funds were effectively prohibited, this could have the effect of driving much of this funding out of the European banking system or distort liquidity in unpredictable ways which could include a withdrawal of liquidity from all other banks and a movement of liquidity outside the European Union. Demand for European short-term paper could easily be undermined. At a time when the European Union is trying to broaden sources of funding for Europe’s businesses and, in particular, SMEs we must be very careful that we do not accidentally frustrate those attempts here through an overly narrow focus on regulation.
While there are risks associated with the creation of large buffers, there are alternative measures put forward to mitigate run risks and these can apply to all open-ended funds. Such measures include liquidity fees and redemption gates to prevent runs on either VNAV or CNAV funds. Liquidity fees would require a fund of which the liquid assets fall below a given percentage of its total assets to impose a fee on all redemptions to act as a disincentive to redemptions, while redemption gates would permit a fund to restrict or suspend redemptions for a period if it came under particular stress. We will be supporting these as better alternatives to the buffer approach to CNAV funds in the Council negotiations.

We will also be pointing to continuing developments in the United States where the Securities and Exchange Commission is advanced in its deliberations on how best to approach the regulation of money market funds. It is examining several approaches, but it has already made it clear that it sees capital buffers as the least effective way to achieve the goal of mitigating run risk in money market funds. The financial markets are global and both the United States and the European Union have repeatedly stated the regulation of these markets should be co-ordinated. It is important that we try to co-ordinate the EU-US approach to the regulation of these funds.

The introduction of differing rules across jurisdictions may result in the intentions of one set of legislators or regulators being frustrated, or result in unintended consequences, amplified by the international market for money market funds. A case in point is the actions taken by the Federal Reserve in 2008 when it introduced support mechanisms which eased pressures on US money market funds and improved the liquidity position of such funds but separately affected European money market funds which did not have similar support mechanisms. We will, therefore, seek to align developments in Europe with those in the United States.

The Department of Finance has been consulting a range of stakeholder interests on this issue. We have also been in contact with the European Commission and other member states. It is clear to us that while some differences of view remain on how best to enhance the regulation of money market funds, there is a growing appreciation of the concerns we are raising about the proposed approach to CNAV funds.

Our objective is to achieve enhanced regulation of money market funds as a first step towards the harmonisation of the regulation of Europe’s shadow banking sector. Within this broader objective, we are seeking to achieve an outcome to the Council working party deliberations that ensures proper, effective and proportionate regulation of both types of money market funds so as to allow the safe development and growth of this market sector in Ireland and elsewhere in Europe.