European Money Market Funds - A Primer for Investors - Part 2

1The first part of this report European Money Market Funds A Primer for Investors: Questions and Answers Part 1, dated 8 March 2010 is available at fitchratings.com. While Part 1 focused on the key attributes of money market funds and ratings assigned by Fitch Ratings, this second part of the report addresses more technical questions.

1. In what types of instruments is a money market fund typically invested?Money market funds (MMFs) invest in fixed-income assets that are short-term at issuance known as money market instruments or long-term assets that are getting close to their maturity date. Typically, the remaining maturity of the instruments in MMFs is shorter than a year. Certain funds, those defined as quasi cash products, also focus on one- to three-year papers, but Fitch considers these as short-term bond funds, and does not rate them on the MMF rating scale.

Instruments in MMFs can be classified according to:

their tradability on a secondary market; and

the existence (or not) of a collateralisation, in which case investors have recourse to some assets in the event of the counterpartys/issuers default. The instrument is then known as being secured.

The most commonly encountered assets are classified in the ST Instrument Matrix table.

The Asset Class Breakdown of the Offshore Universe of AAA-Rated Funds graph shows the evolution of the average allocation by instruments. As shown, approximately one-third of portfolios consist of non-tradable assets, deposits and repos, albeit concentrated in overnight and short-term maturities.

European Money Market Funds A Primer for Investors >Questions and Answers Part 2

ST Instrument MatrixSecured Unsecured

Tradable Asset-backedcommercialpaper(ABCP) asset-backednotes(MTNsorFRNs)

Treasurybills certificatesofdeposit(CD) corporatecommercialpapers(CPs)andfloatingratenotes(FRNs)

Nontradable Repurchaseagreements(repos) Cashaccounts timedeposits(TD)

Source:Fitch

0%10%20%30%40%50%60%70%80%90%

100%

Sep09

Oct09

Nov09

Dec09

Jan10

Feb10

Mar10

Apr10

May10

Jun10

Jul10

Aug10

Sep10

Treasury Govt Other Repos TD CD CP FRN

Asset Class Breakdown of the Offshore Universe of AAA-Rated Funds

Source: iMoneyNet

22. What are the main distinguishing features of these instruments?The instruments used by MMFs differ in many respects, and this has implications for operations, portfolio construction and monitoring. For example, certain instruments such as certificates of deposits or commercial papers are traded via broker-dealers; others, such as repurchase agreements (repos) are negotiated directly with the counterparty. In addition, MMF holdings could be fixed-rate instruments or floating-rate instruments.

Non tradable instrumentsDeposits or term deposits: money deposited at a banking institution earning interest. The deposit can either be an overnight or time/term deposit where the term of the investment is fixed (from two days to a few months). Cash is generally not accessible for the fixed period agreed. Early withdrawal may be possible on payment of a penalty fee, but this often depends on the relationship with the institution. Account and deposit holders are senior to the unsecured creditors of the bank.

Call accounts: these are deposit accounts without a fixed maturity date. Investors are offered preferential interest rates on the understanding/expectation that a certain level of investment will be maintained for the period. The investor can call or withdraw the money at any time. A minimum credit balance may be required to maintain the account at a given rate. These investments are treated as overnight when the agreement explicitly permits withdrawal of funds at any time, without provisions. Call accounts are becoming increasingly popular as MMFs are keen to maintain greater levels of overnight liquidity. Their higher level of interest compared with deposits make them more attractive investments.

Repos (also known as sale and repurchase agreements): these are financial transactions which comprise a sale of securities together with an agreement for the seller to buy back the securities at a later date. Typically, MMFs act as the buyer of the collateral rather than the seller. The collateral that MMFs accept generally comprises highly rated and liquid securities such as government bonds. Generally, the value of the collateral (the securities being temporarily sold) will exceed loan value (typically 2% overcollateralisation for government securities); when the value of the collateral diminishes, the borrowing party must contribute additional collateral.

Repos can be bi-party (directly between the lender and borrower) or tri-party, with a custodian bank or clearing organisation acting as an intermediary between the two parties. Most repos are bi-party in Europe, unlike in the US. MMFs normally execute repos on overnight basis. This includes open repos, which give both parties the right to terminate the agreement on a daily basis. Term repos with maturities ranging from two days to typically one week are also used occasionally, as are putable term repos. Cash is not accessible for the fixed period agreed. Early withdrawal may be possible on payment of a penalty fee see also Fitchs US Money Market Funds: Repurchase Agreement Practicesreport, dated 4 October 2010.

Tradable instrumentsTreasury bills: these are short-term debt obligations issued by a sovereign that mature in one year or less. They are sold by auction at a discount from face value and are considered to be the least risky of all short term investments, albeit also perhaps the lowest yielding, when issued by AAA-rated sovereigns. The risk associated with the security is the risk of default of the government.

Certificates of deposit: like a deposit, certificates of deposit have a set maturity date and pay a fixed return (except for floating rate CDs issued with over one year maturities) at maturity. CDs are traded through brokers and active secondary market exists, though its liquidity can vary by name and over time.

CP: these are short-term unsecured promissory notes with a fixed maturity of less than a year. CP is usually sold at a discount from face value and is issued by banks and large corporations. CP programmes are used to finance short-term debt obligations (for example, payrolls, inventories and receivables) and maturing paper is usually repaid by funds raised through issuing new paper. Like CDs, CP is traded through brokers and a secondary market exists, though its liquidity can vary by name and over time.

Asset-backed CP (ABCP): this is CP that is collateralised by trade receivables or other financial assets such as auto loans, credit card facilities or securities. ABCP is issued under a programme (or conduit), by bankruptcy-remote special-purpose vehicles (SPVs) established by a sponsoring bank or non-banking organisation. ABCP programmes may be fully or partially supported with respect to credit by the sponsor or other support providers and all

European Money Market Funds A Primer for Investors

3programmes feature a 100% backstop liquidity facility, which could be utilised should the programme be unable to issue new CP. The maturity at issuance is typically between 90 days and 180 days. For more information, see Fitchs ABCP in European Money Market Funds: What Investors Need to Know report, published on 6 July 2009.

Corporate floating-rate notes (FRNs): these are bonds issued by financial and non-financial corporations offering a variable coupon benchmarked to a short-term reference rate like LIBOR or EURIBOR and with final maturities ranging from one to five years. FRNs coupon rates are typically reset quarterly, although there could be monthly or semi-annual resets. FRNs exhibit low sensitivity to interest rate moves and a shorter reset period will react more quickly to any changes in interest rates than will a longer reset. FRNs are traded via securities dealers who are also supporting the FRN secondary market. They are purchased by MMFs when maturity is short typically at under 13 months at issuance, or after several years in secondary market.

Asset-backed FRNs: these are secured FRNs issued by structured finance SPVs, backed by financial assets, such as mortgages, loans or receivables. ABS and MBS programmes issue debts with differing levels of seniority (tranches) and the whole debt issuance benefit from credit enhancement in the form of equity and other subordinated loss-absorbing tranches. Mortgage-backed FRNs are also subject to amortisation risk, whereby the speed at which underlying mortgages repay capital (and subsequently the instruments market price) can vary depending on market conditions. Secondary market liquidity for ABS and MBS has structurally declined since 2007, and therefore these products represent marginal exposures in MMFs.

The Short-Term Assets Outstanding table below summarises instruments outstanding amounts in various currencies.

3. In what circumstances may an MMF lose capital? What are the implications for investors?MMF investors expect their capital to be preserved. Nevertheless, MMF assets are not risk-free and, in spite of their very conservative nature, capital can be lost, mainly in three instances:

rapid credit deterioration/default for example, in the case of a counterparty or issuer going bankrupt very quickly: eg, Lehman Brothers failure in 2008, or Parmalats in 2003 or WorldComs in 2002;

crystallised market losses for instance, in the case of asset sell-off (because of redemptions that cannot be met with cash and asset roll off) occurring in illiquid markets or when market liquidity dries up; and

specifically in the case of variable Net Asset Value (see Part 1 of the Q&A) funds when an investor redeems its shares with a Net Asset Value that has gone down for mark-to-market reasons and realises a loss. If no loss is realised in the portfolio at that time or subsequently, the loss incurred by the investor would indeed be a wealth transfer to remaining investors.

There have only been a few examples over the last 25 years of MMFs experiencing an actual loss, and these have been limited to just a few percentage points. In many instances, capital losses have been supported by the fund sponsor through various forms, but there is no legal obligation to do so.

4. In what circumstances may an MMF not be able to provide shareholders liquidity? What are the implications for investors?MMFs offer daily liquidity at par typically with same-day settlement. When facing massive unexpected redemptions, the fund board may decide to suspend redemptions to avoid market losses as described above (see question 3) and to ensure all investors are treated equally. Depending on the jurisdiction and the context, the reopening of a fund or its liquidation may take a few days to a few months and investors may have to wait that long to get their money back. As per Fitchs rating definitions (and consistent with most investors), an investor not receiving its money back in time would be considered a failure, despite the funds legal right to do so.

To limit the volatility of cash outflows, certain funds, depending on the jurisdiction, impose liquidity gates which pre-specify limits on same-day withdrawal requests

Short-Term Assets Outstanding (estimated outstanding Q210)(trn) EUR GBP USDTimedeposits 3.8 1.5 1.3Repos 0.4 0.3 2.5Treasurybills 0.7 0.07 1.9Certificateofdeposits 0.3 0.1 0.3Commercialpapers 0.3 0.05 1.0FRNs 3.2 0.6 2.3

Source:Fitch,Eurostat,BIS,Euroclear,Fed,ECB,BoE


4from a single shareholder or from all shareholders. Such limits help impose discipline on large investors, discouraging them from holding excessive concentrations of cash with any single fund and accurately forecasting their cash flow needs to remain relatively stable in the fund. Gates can smoothen a big redemption flow over several days, but are only a partial answer and may not be sufficient to prevent a full-blown liquidity run in stressed times.

5. Mitigating risks of credit events in MMFTo limit risk of default and rating migration in portfolios, MMFs typically invest in highly rated securities/issuers with a minimum level of rating from one of the Nationally Recognised Statistical Rating Organisations (NRSROs). As per Fitchs rating criteria, assets in AAAmmf-rated funds carry a rating of F1 (or equivalent) and above (under the short-term ratings scale) or A- and above (under the long-term ratings scale). On average, Fitch-rated MMFs hold a majority of F1+-rated assets. At fund rating levels below AAAmmf, investments in F2 assets (typically rated BBB+/BBB) are eligible but limited to short tenors and for modest overall amounts, given lower liquidity.

The Fitch Financial Institutions Transition Rates Across the Major Rating Categories table shows the degree of security and stability over one year for financial institutions by rating level. For example, ratings on average for AA-rated financial institutions remained unchanged in 92% of cases over 12 months. Defaults of AA-rated financial institutions have been historically close to zero. The proportion of defaults or near defaults (D and CCC to C category) become non-negligible at BBB and lower levels, which is consistent with an F1/A- rating threshold in highly rated MMF and calls for shorter tenors of F2 assets in funds rated below AAAmmf.

Importantly, limits on maturities also play a role in mitigating credit risk for MMFs, even for highly rated paper. Default risk increases and visibility on issuers creditworthiness diminishes with time to maturity, and MMFs generally hold portfolios with weighted average maturities well under one year. For example, a financial institution may have the support of its state until a certain date or a non-financial corporate may have a sufficient cash cushion to meet all its obligations in the forthcoming months, which, in both cases, means sound creditworthiness over the short term.

Beyond ratings from recognised rating agencies, an MMF benefits from credit research processes at investment management organisations. Credit research teams typically review eligible investment lists ensuring that counterparty/issuer ratings, exposure limits and maximum tenors are of appropriate levels. Active research also allows funds to see credit events that may be forming on the horizon and exit these at risk positions (for example, in 2008, with certain banks, in 2010, with certain sovereign exposures).

Diversification is also a strong mitigant to credit risk (at least in terms of loss severity given a fund failure), and a clear differentiating factor of MMFs versus direct investments by investors with few counterparties. Smaller holding positions mean lower losses in case of defaults and more flexibility to sell in case of rating migration. Fitch-rated MMFs typically invest across 30 to 60 counterparties. Any single corporate issuer exposure under Fitchs AAAmmf criteria is 5% or less of the portfolio with an exception for F1+ issuers, in which MMFs could concentrate up to 10% provided such investments are limited in tenor to seven days.

Fitch Financial Institutions Transition Rates Across the Major Rating CategoriesAverage Annual: 19902009 (%) AAA AA A BBB BB B CCC to C D TotalAAA 94.77 5.23 0 0 0 0 0 0 100AA 0.11 91.85 7.73 0.21 0.03 0.03 0 0.05 100A 0.03 3.22 91.36 4.48 0.63 0.08 0.05 0.14 100BBB 0 0.52 5.49 89.39 3.32 0.68 0.33 0.27 100BB 0 0.17 0.26 9.67 76.86 8.03 2.94 2.07 100B 0 0 0.25 0.62 10.92 82.38 4.47 1.36 100CCCtoC 0 0 0 0 0 24.14 54.02 21.84 100

Source:Fitch.


5In benign environments, the number of counterparties is also influenced by the breadth of issuance and the managers search for yield opportunities. By contrast, during periods of financial stress (like 2008), the preservation of capital becomes the main concern for managers who tend to concentrate portfolios in fewer better quality names.

6. Mitigating market risks in MMFMarket risks in MMF may result from:

interest rate risk

spread risk

liquidity risk.

All of these may materialise in market losses for the fund if assets are sold at a discount to the accrued price or if, at a single investor level, the investor redeems his shares of a fund with a mark to market net asset value that went down, therefore crystallising the loss.

To mitigate the risk of market losses MMF managers need to ensure that they can meet redemptions without using secondary markets and that assets market prices do not diverge much from accrued value at any time.

To meet redemptions without using secondary markets, MMFs can rely on:

a cushion of overnight assets (repos, call accounts, cash on demand);

proceeds from maturing assets (ie, the distribution of asset maturities has to be staggered over time);

proceeds from instruments that can be redeemed or called on demand (putable CDs, call accounts, callable repos);

overdraft facilities or lines of credit; or

reverse repos, whereby the fund lends assets against a cash loan, with a third party, an affiliate or another fund (cross-fund operations).

To limit the sensitivity to market price volatility, an MMF limits portfolio weighted average maturity to reset date (WAMr) and weighted average maturity to final date (WAMf) (to contain the influence of spread and interest rate movements) in the portfolio and focuses on highly liquid assets.

7. What happens if a credit/market risk/diversification limit is breached?MMF are subject to regulatory and internal limits, as well as rating agency guidelines. These limits are monitored by various parties: portfolio managers, compliance, internal control and risk management departments of investment managers, administrators and trustees, and rating agencies. Quite often, limits are also hard coded in trading systems to prevent breaches from active trading.

Typically, active breaches will not occur if portfolio managers are well aware of the limits under which the fund operates and if automatic pre and post-trade controls are in place. By contrast, passive breaches may occur more frequently, notably when redemptions temporarily distort portfolio allocation. For example, a portfolio holding 20% of cash, 9.5% of CPs with one issuer and 70.5% of other assets and facing 10% of redemption would breach Fitchs concentration limit as the 9.5% would become 10.6% after the redemption. Likewise, an underlying asset downgrade may breach certain limits, or the merging of two issuing entities may increase a funds single obligor exposure.

In the case of material downgrades, mitigating factors are assessed such as credible and achievable near-term remedial actions proposed by the asset manager, a very short maturity on the affected asset(s), or possibly credit support provided by the fund sponsor.

When confronted with such breaches in rated funds, Fitch evaluates them in the context of the overall portfolio risk taking and the plan for remediation. There is often a reasonable basis for a short grace periods. Very often, breaches can be resolved on a timely basis and in the best interest of shareholders, without any forced selling of the portfolio.

8. What are the risks relating to types and numbers of shareholders in the fund? In general, limits on shareholder concentrations by single shareholder and by type of shareholders, such as source and use of money, industry and geography could be viewed as a positive by Fitch insomuch as it provides diversification of the funds liabilities and limits its redemption risk. A concentrated shareholder base is considered relatively riskier, as the risk of such shareholders acting in synchronised fashion increases. This may lead to massive redemptions. Generally, institutional investors such as


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pension funds or insurance companies and retail investors are viewed as more stable shareholders of MMFs.

When a few single large investors dominate a fund, fund managers are expected to maintain a close relationship with such investors by monitoring their liquidity needs. All the same, Fitch expects MMFs with a relatively high shareholder concentration to offset this risk by allocating a larger share of the funds portfolio in daily liquid assets.

Aside from crisis times, and everything else equal, MMF with very stable investors bases can on average maintain relatively lower cash cushions, which often carry an opportunity cost (ie, overnight rates are generally lower).

9. Is the fund size relevant?A fund size is an important consideration for investors, bearing opportunities and challenges.A bigger fund generally benefits from economy of scale, which includes: better access to the mainstream market as it is N#1 on

dealers lists to place papers and has negotiation power;

capacity to deal with reasonable ticket size (eg, minimum investment amounts for CPs or repos);

more resources in terms of controls, distribution or research;

a broader and more diversified pool of accessible investors; and

more stable cash flows given more granular asset and investor bases.

Conversely, large funds may face the following challenges:

reduced investment flexibility as certain niche markets become less attractive such as small issuances or certain FRNs;

difficulty in selling sizable positions;

hindered investment flexibility; and

a large fund may also become too big to support for its sponsor.

There is no optimal figure, the size having to be put in perspective with other considerations such as the objective of the investor (security versus yield), the nature of sponsor or the investment strategy.

For More InformationFor more information about Fitch Ratings' fund and asset manager offerings, please visit: www.fitchratings.com > Financial Institutions > Fund and Asset Manager Ratings.

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European Money Market Funds - A Primer for Investors - Part 2