Lecture 8 Asset Management Regulation PDF

Lecture 8 Asset management regulation Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the Europe...

Lecture 8 Asset management regulation Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the European Commission.  Agenda Definition and trends in asset management The UCITS opt-in framework The AIFMD default framework Shadow banking and Money Market Funds (case study) Other asset management frameworks © Valiante Diego – 2  Asset management © Valiante Diego – 3  Asset management Two main categories of portfolio management service Investment PM service Allocation Individual portfolio management Individual portfolio (discretionary/segregated (segregated) mandate) Retail and institutional Investor Collective portfolio management Units of investment funds (Collective Investment in collective portfolio Scheme) © Valiante Diego – 4  Individual portfolio management (segregated mandates) © Valiante Diego – 5  Individual portfolio management services “‘Portfolio management’ means managing portfolios in accordance with mandates given by clients on a discretionary client-by-client basis where such portfolios include one or more financial instruments” (MiFID 2, Article 4.1(8)) Individual portfolio management is an investment service regulated under MiFID 2. Key characteristics a. Broker allowed to buy and sell securities without client’s consent and based on a client-to-client mandate (discretionary service in portfolio composition) b. But in line with his/her investment goals c. Investors retain ownership of the assets in the portfolio d. Ban on inducements under MiFID 2 (remuneration control) Pros – Asset diversification – Potential for alpha returns (if fund managers do possess superior skill at choosing undervalued assets) Cons – Expensive – Alignment of interests (principal-agent relationship) © Valiante Diego – 6  Key requirements No inducements from third parties – Including research (so unbundling) – Only ‘minor non-monetary’ benefits Asset segregation from other clients Appropriateness and suitability tests (art. 25 MiFID) are required Appropriateness test Suitability test Source: PWC © Valiante Diego – 7  Collective portfolio management (collective investment schemes) © Valiante Diego – 8 © Valiante Diego – 9 Source: EFAMA © Valiante Diego – 10 Source: EFAMA © Valiante Diego – 11 Source: EFAMA © Valiante Diego – 12  Market fragmentation – average size (in EURmn) and number of mutual funds at end 2017 Source: 2018 ECMI Stats Package © Valiante Diego – 13  Collective investment schemes (CIS) or investment funds CISs or investment funds provide portfolios of assets in which individuals can invest by receiving ‘shares’ of that portfolio (so called ‘units of investment funds’) They are very attractive for their liquidity transformation function, which aims to generate returns. The price of an investment fund share or unit of investment funds is called Net Asset Value (NAV), which is 𝑴𝒂𝒓𝒌𝒆𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝑵𝑨𝑽 = 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 © Valiante Diego – 14  Collective portfolio management services Key features of Collective Investment Schemes (CISs): a. Do not have a general commercial or industrial purpose; b. Pooled capital raised from investors with a view to generating a pooled return for those investors; c. Allow unit holders or shareholders of the undertaking no day-to-day discretion or control. d. Operate under a ‘defined investment policy’ Determined and fixed in a document, investment guidelines, etc Pros – Stewardship in governance – Capital allocation & asset diversification – Address behavioural weaknesses – Lower costs than direct trading Cons – Not suitable for high net worth investors (indirect trading costs) – Herding behaviours and interconnection © Valiante Diego – 15  Investment Funds Investment/pension funds’ balance sheet – Structured as a corporate entity in which investors buy shares or ‘units’ – Funds are typically invested in other financial assets, but they can also hold real assets (e.g. infrastructure or real estate funds). © Valiante Diego – 16  Investment Funds Open-ended vs closed-ended funds – ‘Open-ended’ means that the numbers of shares issued by the investment company is not fixed and varies with investors’ redemption at any time. Many of these units of funds are actually listed on exchanges and traded daily. – ‘Closed-ended’ instead means that numbers of shares are fixed, i.e. redemption is not allowed (unless under specific conditions), but of course units can be sold to other investors with open market sales. The rise of investment funds is a triumph for the portfolio theory – Diversification improves risk-adjusted returns – Broader portfolio and greater diversification – Research that adds value in highly efficient markets is too expensive and is best spread across a wide-ranging portfolio © Valiante Diego – 17  Taxonomy of fund management structures © Valiante Diego – 18 Source: De Manuel et al. (2012)  Asset management – Key vulnerabilities (FSB) Liquidity mismatch (e.g. fixed income funds) between fund investments and redemption terms (open-ended funds) – Generating run and contagion risks Leverage within funds (often synthetic, via financial derivatives) – Feedback loop with liquidity mismatch Herding behavior in stressed conditions – Spurious herding of retail fund managers as a consequence of changes in benchmark index composition (rebalancing). Securities lending operations – Fire sale of securities following counterparty failure and sharp fall in price – Erroneous collateral valuation – More procyclical system as available financial resources linked linked to fluctuating asset value – Re-hypothecation of encumbered assets (with knock-on effects) © Valiante Diego – 19  Regulatory rationale Three main rationales for intervention 1. Investor protection (e.g. agency costs between investors and asset managers leading to extraction of benefits through trading practices or fraudulent diversion of assets) 2. Promote long-term market-based savings by households (better hedging against market risk; e.g. passive investment). 3. Financial stability (public good) Some CISs structure can operate as forms of shadow banks (see next slides) a. Money Market Funds (MMFs), which can be a UCITS or an alternative investment fund, can have a funding structure with deposit-like characteristics Potential issue: systemic risk (herd behaviours) and investor protection b. Fixed income Exchange Traded Funds (ETFs), open-ended listed on exchanges, offer maturity/liquidity transformation as well as expose to hidden counterparty risk © Valiante Diego – 20  Regulatory strategies Key intervention tools: – Rules on product structuring and governance (e.g. eligible assets, issuer concentration and leverage limits) – Rules on risk management (e.g. risk management function [liquidity and redemptions]) – Conduct of business rules (e.g. conflicts of interest) and – Rules on disclosure to investors (e.g. transparency obligations, pre- contractual product disclosure with KIID) © Valiante Diego – 21  The UCITS framework (product-based regulation) © Valiante Diego – 22  Undertakings for Collective Investment in Transferable Securities (UCITS) Scope: Collective investment in transferable securities and/or other ‘liquid financial assets’ (art. 50.1) of capital raised from the public, operating under the principle of risk-spreading (no control over the entity in which it invests) The ‘retail’ (open-end) investment fund (always redeemable or tradable) – Vs closed-end funds (only tradable by open market sales) First version of the Directive was adopted in 1985 – It lays down uniform rules on investment funds, allowing the cross- border offer of investment funds regulated at EU level. – Also reviewed post-crisis (2009 and 2014 reviews) including rules on depositary liability, remuneration policies, admin sanctions. Example of product-based regulation (restricting choice to avoid to make mistakes) © Valiante Diego – 23  Key risks of product-based regulation Obsolescence. Continuous evolution in markets means product rules can quickly become outdated. Such changes can play against both product attractiveness in terms of exposures and returns, as well as their security, given the emergence of risks that regulation did not initially control for. Regulatory license. The use of a particularly favourable legal regime for a financial product or service, is useful in promoting participation in financial markets, but it reduces the incentives of agents to adhere to ethical and professional principles and induces a species of ‘moral licensing’. Partial representativeness. A single product regulation cannot cater for all products without becoming obscure or fragmented, e.g. product proliferation in UCITS. Partial representativeness also means that product rules may distort the optimum allocation of savings by investors. © Valiante Diego – 24  Legal nature and investment limits (or risk spreading rules) Whether or not there is an investment management company, three key functions/tasks must be provided: 1. Capital raising from unit holders; 2. Managing assets and marketing of UCITS; 3. Holding assets (by a depository; typically an ICSD). UCITS can be created under: – Contract law (no legal personality, but common funds held by an investment company); No control over the investment management company (units are not shares of the company) – A trust; or – An investment company (e.g. French SICAV or Italian SGR) Art. 1(5)): – The Member States shall prohibit UCITS which are subject to this Directive from transforming themselves into collective investment undertakings which are not covered by this Directive. © Valiante Diego – 25  Redemption Units of UCITS are redeemable on request and can be repurchased (closed-ended are excluded; art. 84 UCITS Dir.2009/65). – To protect retail investors from liquidity risks. Redemption shall take place at Net Asset Value (NAV) 𝑴𝒂𝒓𝒌𝒆𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝑵𝑨𝑽 = 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 © Valiante Diego – 26  Eligible assets UCITS can only invest in ‘eligible assets’ – Transferable securities; and – ‘other liquid financial instruments’ (set out in article 50), incl. money market instruments admitted to trading on a MiFID II regulated market (also units of closed-ended funds traded on RM) BUT ALSO financial derivative instruments on RM and OTC (with specific conditions, like type of underlying assets, verifiable daily valuation and possibility to close-out with offsetting transaction at fair value at any time) UCITS V, Dir 2009/65, (artt. 50-55) also includes investment restrictions, including: – No more than 10% in transferable securities and money-market instruments that are not eligible or in other CIS investments – Only property investments if essential for the direct pursuit of the business – No exposure to a single body greater than 20% of its assets (5% if OTC derivative transaction) – Leverage restrictions apply, with no more than 10% of NAV for financial borrowing, and through financial derivatives up to 100% of NAV. © Valiante Diego – 27  Key Investor Information Document (KIID) The UCITS investment or management company has to publish a a short document (together with the Prospectus) that summaries key characteristics (costs, past performance, risk, etc) of the UCITS fund. – Objective: going beyond the ‘caveat emptor’ even more boldly than the past (simplified prospectus) Not to exceed 2 pages of A4-sized paper Standardised or synthetic risk indicators scoring (from 1 to 7) Comparable data on ongoing charges for easier shopping around Easy to read, concise and non-technical language – Must be ‘fair, clear and not misleading’ The KIID is not approved by NCAs – But no liability for the UCITS company – It can be passported in English © Valiante Diego – 28  Depository liability © Valiante Diego – 29  The key role of depositories institutions The Man who knew Bernie Madoff’s $65 bn Ponzi Scheme https://www.youtube.com/watch?v=s68FR1MXT8Q © Valiante Diego – 30  Depositary liability (UCITS V plus CSDR) A depository, which is usually a CSD: – Holds UCITS assets in custody – Oversees compliance – Act independently and solely in the interest of the unit-holders – Cannot be the management company of the fund After Bernie Madoff’s Ponzi Scheme, a depositary liability for non- market risks was introduced – Objective: to make sure money is actually invested (e.g. matching cash invested and underlying assets to limit misuse of feeder-master fund structures, like in the Madoff case) – It also includes safekeeping (like record-keeping of derivatives contracts) and oversight duties (such as monitoring of cash accounts) – Also for sub-custodian’s failures (raising cross-border issues) © Valiante Diego – 31  Depositary liability (UCITS V plus CSDR) Regulation (EU) 2016/438 (CSDR) also addresses non-market risks related to the depositaries’ activities, such as: – safekeeping of UCITS assets; – oversight duties (e.g. checking that UCITS investments are consistent with their investment strategies as described in their rules and offering documents or ensuring that UCITS do not breach their investment restrictions); and – the liability for the assets. CSDR also includes due diligence requirements for insolvency protection of UCITS assets and independence requirements for managers and custodians of UCITS. © Valiante Diego – 32  Depositary liability (UCITS V plus CSDR) Source: De Manuel et al. 2012 © Valiante Diego – 33  Other key UCITS requirements (for info) Rules for the management company (authorization, remuneration policies, operational requirements, etc) – a genuine European passport for UCITS management companies, which will allow a management company located in one EU country to manage funds in other EU countries; Mergers of UCITS in other countries allowed (previous approval); Marketing of UCITS in other countries, e.g. by simplifying administrative procedures, disclosure of local marketing rules etc Distribution of UCITS at point of sale is typically regulated under MiFID No possibility to grant loans or guarantees © Valiante Diego – 34  Exchange-Traded Funds (ETFs) © Valiante Diego – 35  Other types of UCITS – Exchange-Traded Funds First developed and marketed in 1990s Lower fees than traditional investment funds, due to public trading that is cheaper than fund redemption They could be closed-ended, but they are not because the open-ended structure ensures the match between ETF prices and net asset value (NAV). – Market price cannot diverge much from NAV, because an arbitrageur would buy units and ask for redemption. ETFs typically mimic a return of given assets – They are the main vehicle for passive investments. – Main objective is to minimise tracking errors. © Valiante Diego – 36  Physical ETF UCITS manager ETF Securities Cash/returns (creation units) Securities Market Markets Maker Cash ETF (shares) Cash Exchange Secondary market ETF (shares) Cash Investor © Valiante Diego – 37  Synthetic ETF I NDEX UCITS manager RE TURN SWAP ETF Funded or unfunded Cash Collateral (creation units) Authorised Counterparty CASH participant ETF Cash Cash Securities (shares) Exchange Secondary market Markets ETF (shares) Cash Investor © Valiante Diego – 38  Transparency for Packaged Retail Investment Products (PRIPs) © Valiante Diego – 39  General transparency regulation for fund-like structures Packaged Retail and Insurance-based Investment Products (PRIIPs) → Regulation EU n. 1286/2014 – Packaged Retail (PRIIP)→ “means an investment, including instruments issued by special purpose vehicles [..] where [..] the amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or to the performance of one or more assets which are not directly purchased by the retail investor” (art.4.1) – Insurance-based product → “means an insurance product which offers a maturity or surrender value and where that maturity or surrender value is wholly or partially exposed, directly or indirectly, to market fluctuations” (art.4.2) They include investment funds (incl. UCITS), insurance-based investment products (insurance wrappers), derivatives, retail- structured securities and structured-term deposits (structured products are investments with a pre-set formula for calculating returns and a pre-set formula for calculating risk). – Plain vanilla corporate bond with ’make-whole clause (with an anticipated NPV repayment of future capital and interests)? It’s pre-contractual information disclosure via a standardised form. © Valiante Diego – 40  General transparency regulation for fund-like structures – The producer of a ‘packaged’ investment product intended to be sold to retail investors has to provide a PRIIP KID concerning the product (different from UCITS KIID) and review it on ongoing basis. – Distributors obliged to provide access to it ex ante. – KID, max 3 A4 pages, includes info on 1. The risk and reward profile of the financial product 2. A summary risk indicator 3. The possible maximum loss of invested capital; and 4. Appropriate performance scenarios of the product (future scenarios and no past performance) → ‘reduction-in-yield’ © Valiante Diego – 41  An example of PRIIP KID We went from a backward performance UCITS KIID (no longer required, but it can be published anyway) to a forward-looking one (PRIIP KID). An example of PRIIP KID is here. Many funds’ boards still produce a backward looking document, like the KIID. See, for instance here. © Valiante Diego – 42  EU-labelled fund regulations (for info) European Long Term Investment Funds – ELTIF (EU Reg 2015/760) – Vehicle specialised in long-term investments (at least 70% in eligible assets, incl. equity, bonds, loans) Doesn’t engage in short selling, securitise lending, commodities trading and has strict limitations on leverage and derivatives – No redemption before end of its life (but there are exceptions) – For retail, suitability test and mandatory investment advice (plus no more than – Banks get lower capital charges to invest in ELTIFs – Needs to publish Prospectus and PRIIPS KID – It has a passport European Venture Capital Funds – EuVECA (EU Reg 2013/345) – Sub-category of AIFs – Invest in eligible assets (at least 70% in equity, loans to portfolio company, where the company is a non-financial undertaking, unlisted or listed on SMEs growth markets) – Not marketable to retail European Social Entrepreneurship Funds – EuSEF (EU Reg 2013/346) – Sub-category of AIFs (less than EUR 500mn and run also by AIF managers) – Invest in eligible assets (at least 70% in ‘social businesses’) Unlisted company that has ‘positive social impacts’ as objective of its articles of association, statutes, etc and re-use profits for such activities – Marketable to retail investors , but with standardised key information disclosure © Valiante Diego – 43  Regulations for pension funds (for info) Institution for Occupation Retirement Provision (IORP II) – EU Directive 2016/2341 – Occupational pensions are private, normally pre-funded, supplementary pension plans linked to an employment relationship. More specifically, IORP “means an institution, irrespective of its legal form, operating on a funded basis, [..] for the purpose of providing retirement benefits in the context of an occupational activity on the basis of an agreement or a contract agreed: a. individually or collectively between the employer(s) and the employee(s) or their respective representatives, or b. with self-employed persons, individually or collectively, in compliance with the law of the home and host Member States, and which carries out activities directly arising therefrom – Objective: high-level of protection for pensioners, while preserving efficient investments – Minimum harmonisation in three areas: a. Prudential requirements b. Investment rules and efficient management of savings (including risk management requirements) a. E.g. IORPs to appoint one or more depositaries for the safe-keeping of assets and oversight duties where members and beneficiaries fully bear the investment risk c. Measures to facilitate cross-border IORPs’ activity © Valiante Diego – 44  Regulations for pension funds (for info) Pan-European Personal Pension Product (PEPP) → EU Reg 2019/1238 – A ’personal pension product’ is a non-statutory and non-occupational product, which is a contract established voluntarily to provide long-term capital accumulation to provide income for retirement. (art. 2.1) – Product rules on design and manufacturing of this product under an EU label. – No specific investment restrictions, but principles to act as a ‘prudent’ investor – Anybody can save in PEPP, but only some can offer it (e.g. insurers, asset managers, banks) – Disclosure of fees and costs via a KID (pre-contractual), plus annual benefit statement (ongoing) – Key characteristics: ’Basic’ PEPP (safe product as default option [mandatory to be offered by the PEPP manufacturer and switch can happen only after 5 years minimum], with cost and fees capped at 1% and ‘protected’ capital [either with guarantees or risk mitigation techniques]) Cross-border portability (with sub-accounts for each country) Disclosure on how sustainability risks are taken into account © Valiante Diego – 45  Alternative Fund Managers Directive (AIFMD) © Valiante Diego – 46  Scope and exemptions Scope: Capture most non-UCITS CISs to bring more transparency among hedge funds and private equity funds, among others. It does not capture family offices, sovereign wealth funds, pension funds etc. Mandate comes from the G20 in Washington: – All financial markets, products and participants are regulated or subject to oversight, as appropriate to their circumstances This is the default framework for managers of investment funds – UCITS is an ‘opt-in’ product-based framework – Compared to UCITS, this framework does not regulate the fund, but the fund manager. The standard framework is accompanied by a lighter de minimis regime that applies to: – AIFMs managing portfolios of AIFs, whose AuM (including leveraged assets) are below EUR 100 mn – AIFMs managing portfolios of AIFs, whose AuM (excluding leverage and no redemption rights for at least 5 years) are below EUR 500 mn The light touch regime only involves a registration-based system (but no passport right across the EU) © Valiante Diego – 47  Alternative Fund Managers Directive (AIFMD) Leveraged funds. The directive introduces specific requirements with regard to leverage, i.e. the use of debt to finance investment. Competent authorities have the right to set limits to leverage in order to ensure the stability of the financial system (art. 25 AIFMD). Private equity funds. Where an AIF acquires control of a non- listed company (except for SMEs) or an issuer, the AIFM is subject to the anti-asset stripping provisions. For a period of 2 years, the AIFM must act against any distribution, capital reduction, share redemption or acquisition of own shares by the company. Funds and managers located in non-EU countries. Subject to conditions set out in the directive, the ‘passport’ may be extended to non-EU AIFMs and to the marketing of non-EU funds, managed by either EU or non-EU AIFMs. © Valiante Diego – 48  Alternative Fund Managers Directive (AIFMD) Passport. Once an AIFM is authorised in one EU country and complies with the rules of the directive, the AIFM is entitled to manage or market funds to professional investors throughout the EU. – Contrary to UCITS, there is no passporting framework for retail distribution (left to national rules to decide whether to allow it) – MS can also authorize the AIF manager to provide individual portfolio management, investment advice and reception and transmission of orders (MiFID services) In that case, certain MiFID provisions will apply Depositary (in line with UCITS). AIFMs are required to ensure that the funds they manage appoint an independent depositary, for example a bank or investment firm (not an AIFM or a prime broker), that is responsible for overseeing the fund’s activities and ensuring that the fund’s assets are appropriately protected. © Valiante Diego – 49  Alternative Fund Managers Directive (AIFMD) – FOR INFO Risk management and prudential oversight. AIFMs are required to assure the competent authority of the robustness of their internal arrangements with respect to risk management. This includes a requirement to disclose, on a regular basis, the main markets and instruments in which they trade, their principal exposures and their concentrations of risk. Conflicts of interest. Arrangements to prevent, manage and monitor conflicts of interest are key for the Directive. AIFMs cannot invest clients’ assets in AIFs if not approved by clients. Treatment of investors. In order to encourage diligence amongst their investors, AIFMs are required to provide a clear description of their investment policy, including descriptions of the types of assets and the use of leverage. An annual report for each financial year has to be made available to investors on request. © Valiante Diego – 50  Shadow banks © Valiante Diego – 51  The ‘shady’ concept of ‘shadow banks’ The term “shadow bank” was coined by economist Paul McCulley in 2007. – It refers to some ‘nonbank financial institutions’ that engage in what economists call maturity transformation – Commercial banks engage in maturity transformation when they use deposits, which are normally short term, to fund loans that are longer term. – Shadow banks do something similar. They raise (that is, mostly borrow) short-term funds in the money markets and use those funds to buy assets with longer-term maturities. But because they are not subject to traditional bank regulation, they cannot—as banks can—borrow in an emergency from the Federal Reserve (the U.S. central bank) and do not have traditional depositors whose funds are covered by insurance; they are in the “shadows”. “Money market funding of capital market lending” (cit. Mehrling) According to the FSB, – The “shadow banking system” can broadly be described as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. – Some authorities and market participants prefer to use other terms such as “market-based finance” instead of “shadow banking”. © Valiante Diego – 52  Forms of ‘shadow banking’ 1. Funding with deposit-like characteristics – E.g., money market funds – Potential issue: systemic risk (herd behaviours) and investor protection 2. Maturity and liquidity transformation – E.g., ETFs, securitised products – Potential issue: Circumvention of capital regulation and hidden risks 3. Credit risk transfer – E.g., securitised products – Potential issue: Hidden risks and knock-on effects (outside prudential supervision) 4. Using direct/indirect financial leverage – E.g., repos, securities lending, – Potential issue: Systemic impact and knock-on effects © Valiante Diego – 53  We talked about repos – Key characteristics 1. Obligation of the seller to buy back the assets at a different price 2. Obligation of the buyer to give back fungible assets at a future data and at a different price (if on demand is called ‘open repo’) 3. Pricing with ‘haircut’ 4. Transfer of ownership (buy and re-purchase) 5. Temporary use of assets (for buyer) and temporary use of cash (for seller) It acts de facto as a collateralised loan (economic function) Repos are classified as a money-market instrument, and they are usually used to raise short-term capital. © Valiante Diego – 54  Building up leverage via repos A repo transaction © Valiante Diego – 55  Money Market Funds (MMFs) Case Study © Valiante Diego – 56  Case Study - Money Market Funds (MMFs) Money market funds (MMFs) are funds that invest in short- term maturities such as commercial papers or mostly ‘safe assets’ (such as short-term govies), offering redemption to investors at either a constant (CNAV) or (scarcely) variable NAV (because of the portfolio composition). Usually redemption is nearly immediate (next day transfer). MMFs came to the attention of policy-makers during the crisis, as one important form of shadow banking In effect, MMFs are funds with deposit-like characteristics, so could be considered a substitute of bank deposits (but without the same guarantees that a bank deposit can offer) – Stable NAV US MMFs created serious issues of run in the US and led to US Treasury intervention to stop redemptions when they broke the buck ($ par) © Valiante Diego – 57  Case Study - Money Market Funds (MMFs) MMFs can be supported by ‘sponsor’ banks (guarantee), but the presence of a guarantee in the first place may lead people to run for redemption if a crisis hit for fear of not being able to redeem at CNAV. When there is a crisis, even if the fund might not be affected as much, the lack of coordination among units holders may lead to a run to redeem for the fear of the guarantee not being able to hold the ‘buck’ if others do redeem (value at par; 1$ in, at least $1 out). → Sunspot run-like © Valiante Diego – 58  Case study - Money Market Funds (MMFs) Some countries regulate the permissible maturity of the assets and some others regulate the average maturity, while some have no restrictions. – Generally, little or no leverage is permitted. Most of EU MMFs take the form of UCITS (60% or more; source EFAMA) or AIFs The EU introduced a specific Regulation n. 2017/1131 identifies three types of MMFs: 1. a VNAV MMF (assets and liabilities are valued at mark-to-market [fair value valuation] or market-to-model or both); 2. a public debt CNAV MMF (assets and liabilities are valued with amortised cost method [which is nominal value, plus/minus repayment of principal or interest]); and 3. a LVNAV MMF (assets and liabilities are valued with mark-to-market pr mark-to-model unless maturity below 75 days and difference with MTM method not more than 10 basis points [0.1%]). © Valiante Diego – 59  Case study - Run on money market funds The Regulation n. 2017/1131 key requirements include: 1. Strict investment policies – Money market instruments are transferable instruments normally dealt in on the money market (with maturity not exceeding 2 years) and include treasury and local authority bills, certificates of deposits, commercial papers, bankers' acceptances, and medium- or short-term notes. – MMFs are prohibited to invest in assets other than short-term assets but they can invest in repos, reverse repos, deposits not over 12 months, units/shares of other MMFs, among others. – Securitisations and asset-backed commercial paper (ABCPs), should be considered to be eligible to a limit of 15 % of MMF’s assets (20% if STS securitisation). – A (public debt) CNAV MMFs can only invest in money market instruments guaranteed by governments or supranational organisations or repos backed by these instruments or cash. Plus other requirements about concentration of exposure) 2. No more than 10% invested in MM instrument from a single entity 3. At least 10% invested in daily maturing assets (1 day termination) or cash © Valiante Diego – 60  Other examples of shadow banking activities Hedge funds doing reverse repos – Short-term securities lending Money Market Funds (MM[M]F) with fix NAV – Bank deposit-like tool Finance companies sell commercial papers to give credit to households – Short-term unsecured lending (credit cards, etc) Short-selling – Borrowing of shares of a company from an existing owner through his broker, sells those borrowed shares at the current market price, and pockets the cash to rebuy shares at later stage to be given back to the broker (plus dividend payments and fees) – Securities lending (secured lending-like) © Valiante Diego – 61  Recommended readings FSB report on asset management vulnerabilities (see lecture 1) Armour J., D. Awrey, P. Davies, L. Enriques, J. N. Gordon, C. Mayer and J. Payne, Principles of Financial Regulation, OUP (Chapter 20 and 22) Additional readings – For more on Madoff’s scheme and the use of feeder-master fund structures https://www.businessinsider.com/2009/1/how-madoff-feeder-funds- wiped-out-investors © Valiante Diego – 62  Diego Valiante LEIF Master Programme [email protected] www.unibo.it