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European MMFs in increased regulatory peril

The European Banking Authority (EBA) has launched a public consultation on draft regulatory technical standards (RTS) setting out criteria for the identification of shadow banking entities for the purposes of reporting large exposures. The consultation runs until 26 October 2021.

Entities that offer banking services and perform banking activities as defined in the draft RTS but are not regulated and are not being supervised in accordance with any of the acts that form the regulated framework are identified as shadow banking entities.

An EBA statement says that considering the characteristics of funds regulated under the Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive and the Alternative Investment Fund Managers (AIFM) Directive, special provisions are included in the draft RTS. Specifically, in view of what the statement describes as "the severe liquidity issues that affected money market funds (MMFs) during the COVID-19 crisis" as well as the ongoing discussions at EU and international level to strengthen their regulation, MMFs are identified as shadow banking entities in the RTS.

In Europe, classifying MMFs as shadow banking instruments will effectively mean that banks and other financial services providers with exposure to MMFs that have been regulated through UCITS and AIFM must now comply with Capital Requirements Directive IV (CRD4) and its requirements around capital exposure limits and risk reporting. This includes credit risk, contagion risk, liquidity risk, and operational risk elements.

The draft RTS also considers the situation of entities established in third countries and provides for a treatment that distinguishes between banks and other entities.

Comments to this consultation can be sent to the EBA via its website, and the deadline for the submission of comments is 26 October 2021. A public hearing will also take place, via conference call, on 29 September 2021.

Legal basis and background

Providing the legal basis for its changes, the EBA cited Article 394(2) of the Capital Requirements Regulation (CRR), as amended by Regulation (EU) 2019/876, “institutions shall report the following information to their competent authorities in relation to their 10 largest exposures to institutions on a consolidated basis, as well as their 10 largest exposures to shadow banking entities which carry out banking activities outside the regulated framework on a consolidated basis, including large exposures exempted from the application of Article 395(1) […]”

Article 394(4) of the CRR mandates the EBA “to develop draft regulatory technical standards to specify the criteria for the identification of shadow banking entities referred to in paragraph 2. In developing those draft regulatory technical standards, EBA shall take into account international developments and internationally agreed standards on shadow banking and shall consider whether (a) the relation with an individual entity or a group of entities may carry risks to the institution's solvency or liquidity position; (b) entities that are subject to solvency or liquidity requirements similar to those imposed by this Regulation and Directive 2013/36/EU should be entirely or partially excluded from the obligation to be reported referred to in paragraph 2 on shadow banking entities.”

While developing the draft RTS, the EBA has relied as far as possible on the guidelines on limits on exposures to shadow banking (EBA/GL/2015/20), yet having due regard to international developments in shadow banking and taking into account the lack of third-country equivalence for institutions in certain jurisdictions.

The European Securities and Markets Authority (ESMA) ran a consultation on EU Money Market Fund Regulation from 26 March to 30 June this year. The review was developed in the context of Article 46 of the MMF Regulation, which provides that “[b]y 21 July 2022, the Commission shall review the adequacy of this Regulation from a prudential and economic point of view, following consultations with ESMA”. ESMA is expected to publish its opinion on the review of the MMF Regulation in the second half of 2021.

Quantifying the performance of MMFs

Back in April 2021, CTMfile published a report from independent portal provider of MMFs, ICD, which examined whether there had been a run on MMFs when COVID first hit. 

Based on trading data from ICD, the redemption from prime MMFs due to the impacts of COVID-19 in March 2020 was an orderly rotation out of the asset class rather than a 'run' on these investment products, as characterised by the Securities Exchange Commission (SEC). 

ICD provided these trading insights to the SEC’s Request for Comment on Potential Money Market Fund Reform Measures in President’s Working Group Report (PWG) File No. S7-01-21 earlier this month.

According to ICD Data analysis of 378 companies trading prime MMFs on ICD Portal between 2 March and 8 April 2020, outflows were spread evenly over a five business-day period from 13-19 March last year. Even at the lowest point of the crisis on 23 March, 30% of ICD’s client base invested in prime MMFs either increased or maintained their positions. Furthermore, of the 70% of ICD clients that reduced their prime MMF holdings, 43% still retained some of their investment positions. 

"ICD believes that the exit from prime MMFs in March 2020 was triggered by the concern over fees and gates, not from a fundamental flaw with the instruments themselves," Tory Hazard, chief executive officer of ICD, wrote to the SEC at the time.

Indeed, the ICD statement recommended that only the removal of the tie between MMF liquidity and fee and gate thresholds will further fortify these instruments. "Any further actions will significantly diminish the effectiveness of these products," Hazard commented.

It appears that regulation in the MMF space could be set to tighten once again. If banks and financial service providers are required to, for example, hold a greater percentage of liquidity to underwrite such funds, the terms and costs of such investment instruments could prove less than favourable for corporates that want to invest their excess cash in a place that traditionally has offered some yield while still being highly liquid. This would be something of a blow to treasurers that are already dealing with long-term low or even negative interest rates when trying to place short-term cash investments.

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