Trying to Get Two Wrongs to Make a Right

MMFR is designed to make money market funds liquid and secure and EMIR is designed to ensure that FDI collateral is liquid and secure. In an ideal world, they would agree as to what "liquid and secure" means, but things aren’t so simple. Barry O'Connor (Matheson) and Tom McGrath (Blackrock) discuss some of the challenges around the question of what is considered highly liquid and low risk.

In ideal world, different pieces of legislation and regulation would be aligned and would cross-refer to each other, knitted together as a coherent whole. Of course, realities like the political legislative negotiation process or questions of timing mean that this ideal does not always come to pass. There are many examples of this in the financial services space and, in the money market fund segment alone, there is more than one. But as technology advances promise greater efficiencies and resiliency in the market, one example of legislative mis-alignment stands out more than others, preventing market participants from benefiting fully from those advances.

One piece of legislation, MMFR1, has made European money market funds more resilient, more stable, more liquid, and lower risk than ever – since 2019, we've seen Covid, the UK Gilt crisis and the Russian invasion of Ukraine rock financial markets, and yet not a single European money market fund failed to meet its obligations to investors or to comply with legislative requirements. Another piece of legislation, EMIR2, obliges counterparties to OTC derivative transactions to exchange collateral that is highly liquid and low risk.

In an ideal world, EMIR would simply say that public debt constant net asset value money market funds authorised under MMFR are acceptable forms of collateral. Of course, it doesn’t say that. Instead, for non-centrally cleared OTC derivatives for example, it says that units in UCITS are acceptable as collateral where, amongst other things, the UCITS is limited to investing in cash and low risk debt securities3.

MMFR does permit money market funds to invest in cash and low risk debt securities, but it also allows money market funds to make use of reverse repurchase agreements, where they post cash and receive low risk government debt securities back as collateral. Such collateral, if held directly, would carry a zero-risk rating. Therefore, reverse repurchase agreements are considered to be amongst the highest quality, lowest risk transactions available to a money market fund and yet it would seem EMIR considers them to render money market funds as ineligible EMIR collateral. We say "seem" because you could make arguments the other way – that you should "look through" the reverse repurchase agreement to the underlying collateral, for example – but such arguments are not watertight and do not have universal acceptance. And so EMIR and MMFR are not aligned on the question of what counts as highly liquid and low risk.

The impact of this legislative mis-alignment shouldn’t be underestimated. When market participants who use money market funds to manage their cash (ie, most market participants) need to post margin for their derivative transactions, they often have to redeem from the money market fund and pass the cash to the counterparty.

ESMA and others have found that this type of behaviour was a significant driver of money market fund flows during stressed periods (Covid, UK gilt crisis). To meet the redemptions, the money market funds have to withdraw from activity in the short-term markets but the cash eventually finds its way to an OTC counterparty who then needs to either place that cash with a money market fund or invest it directly in the short-term markets. This round-about route creates needless additional stress on a short-term financing eco-system that is already facing pressures on cash needs from external sources such as the impact of Covid. If legislation was aligned, and counterparties and CCPs could easily accept money market units as collateral, it would significantly increase the resiliency of the short-term financing eco-system.

At the same time, technologies like permissioned blockchain between trusted parties promises to greatly enhance the efficiency of collateral exchange, with near-instant transfers. BlackRock and Barclays recently completed a test collateral transfer of tokenised money market fund units, using JPMorgan’s Onyx platform. But that was a test between two willing early adopters. In the absence of legislative alignment or at least clarity of regulatory interpretation, mass adoption of that type of frictionless, efficient and resilient collateral exchange is difficult to foresee. It is not likely that EMIR will be updated to tackle this in the short term (it is in fact in the process of being updated, with EMIR 3.0, but this type of change is not included) and the baton falls to bodies like ESMA and the Central Bank to confirm an interpretation of EMIR that money market funds (even with reverse repo investments) are highly liquid and low risk and therefore acceptable as collateral.