There are two different types of money market funds (MMFs): short-term MMFs and standard MMFs. In EMEA, liquidity funds are overwhelmingly the largest part of the market, so we will focus on them here.
The size of the international money marketfund (IMMFA) universe within EMEA & Asia totals EUR 894 billion (bn), an equivalent split across USD 536bn, EUR 151bn and GBP 225bn1.
The growth of the MMF market has resulted in liquidity funds becoming a structurally important component of the financial institution and corporate short-term funding markets. The cash pooled within liquidity funds is invested in short-term financial instruments and deposits issued by these institutions.
How do liquidity funds work?
Liquidity funds are heavily regulated pooled investment vehicles that look to provide capital preservation and same-day liquidity while delivering competitive cash returns.
They invest in a variety of financial instruments, including overnight deposits, call accounts, short-term deposits, certificates of deposits, commercial paper, Treasury bills, short-dated floating-rate notes, and short-term bonds maturing under 397 days. These instruments are primarily issued by highly rated banks, although some will be issued by investment-grade corporates. All assets must have a minimum A1/P1 or F1 rating (the highest short-term rating by S&P, Moody's and Fitch respectively) and are limited to a maximum maturity of 397 days.
Liquidity funds are typically AAA rated by at least one of the major ratings agencies. This reflects the strong credit diversification found within the funds and highest degree of Liquidity available, with investments spread across multiple (typically over 80) high investment-grade institutions. This strong, well-diversified credit profile contrasts favourably with the alternative strategy of placing cash directly across a small number of banks. Essentially, investors can leverage the credit process, credit analysis and global reach of the fund provider. They can also access the protections offered by the restrictions and controls placed by the rating agencies that funds must meet to maintain an AAA-rating.
Managers can build liquidity ladders, potentially resulting in the fund outperforming the prevailing overnight cash market
European regulations require short-term MMFs to have a minimum of 10% of the fund maturing within one business day and 30% within one week. In practice, liquidity funds will hold a buffer above that regulatory requirement, with typically over 20% maturing overnight and 40% within a week (depending). There are usually hundreds of investors within these pooled liquidity funds. As such, the regulatory minimum is significantly higher than the normal flows experienced in these funds.
Additionally, the assets held at longer maturities within the funds are extremely liquid short-term investments that can be sold on a today+0 or today+1 basis. The maximum weighted-average maturity (WAM) of these funds is restricted to 60 days, while the maximum individual asset maturity is restricted to 397 days. The funds are therefore designed to be extremely liquid at all times.
Competitive cash returns
The maximum WAM and individual asset maturity restrictions provide the opportunity for the portfolio manager to invest a proportion of the fund further along the yield curve where yields might be higher. This allows managers to build and maintain liquidity ladders, potentially resulting in the fund outperforming the prevailing overnight cash market in most investment environments. Liquidity funds therefore offer the opportunity to achieve competitive and stable long-term returns and often comparable to 1W or 1M average bank deposits yet with daily access at all times and no penalty in accordance to the cut-off times.
We believe liquidity funds provide an attractive alternative to other short-term cash management strategies. They have a stronger credit profile, provide immediate liquidity, and can potentially deliver long-term outperformance over the prevailing overnight cash market. By investing in liquidity funds, investors can also leverage the risk and controls, credit process, global reach and investment expertise of the fund provider. The benefits of liquidity funds have been demonstrated over several economic cycles. That’s why the IMMFA universe has evolved and grown from humble beginnings into the EUR 895bn, systemically important market of today.
- IMMFA April 2023 Quarterly Bulletin.