Published: August 01, 2011
Following the worst financial crisis in recent history, the global money market funds industry has come under heightened scrutiny. The events of 2008, including the historic ‘breaking of the buck’ by the Reserve Primary Fund in September of that year, brought to light both idiosyncratic (fund-specific) and systemic (industry-wide) risks associated with money market funds, and gave rise to several reform measures designed to enhance the stability of the industry. For example, in the US the Securities and Exchange Commission (SEC) Rule 2a-7 reforms for money market funds, which took effect in May 2010, enhanced oversight and transparency in the US money market funds industry by expanding disclosure requirements and imposing tighter restrictions on the portfolio maturity, credit quality and liquidity guidelines of money market funds. Similar changes have been made to the industry framework for European money market funds through the Institutional Money Markets Fund Association (IMMFA), the European Federation of Asset Management Associations (EFAMA), and the Commission of European Securities Regulators (CESR – now ESMA).
In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law in July 2010, subsequently instructed the SEC to make certain additional changes to money market fund regulations. One recent proposal resulting from this mandate addresses the use of Nationally Recognized Statistical Rating Organizations (NRSRO) ratings by fund advisors.
While no specific regulation regarding credit rating agencies has been enacted in the European Union, the European Commission conducted a public consultation earlier in 2011 which sought input from investors, market participants, regulators and other stakeholders around the “potential risks from over-reliance on credit rating by financial markets participants”. At the time of writing, the Commission is still considering what actions, if any, will be taken with regard to the use of credit rating agencies references in financial markets.
As such, we believe that this subject is an important topic for international investors to be aware of, given the global nature of the constant net asset value (CNAV) money market funds industry and the fact that European-based CNAV money market funds often seek to hold credit ratings reflecting their conservative investment policies. In fact IMMFA specifically states its objective in issuing its Code of Practice as “…promoting best practice in the management and operation of triple-A rated money market funds”.
We think that ratings provide useful screen for advirsors and enable comparisons across funds by investors.
In this note we focus on the SEC proposal and while we agree that all money market fund advisors must conduct independent credit research, we do not support the proposed elimination of NRSRO references. In our view, ratings provide a useful screen for advisors performing their own credit assessments and enable investors to compare different money market fund products.
We also take the opportunity to outline a framework for fundamental credit analysis and the key principles which we think should govern an approach to credit evaluation. In our belief, a strong risk framework is created through independent research but augmented through use of external information such as ratings.
Section 939A of the Dodd-Frank Act directs the SEC, along with other US federal agencies, to review regulations that rely on credit ratings as a standard of measurement. The legislation further requires them to eliminate references to ratings as a standard of creditworthiness and to substitute alternate standards of creditworthiness.
Although BlackRock agrees that all money market fund advisors must conduct independent credit research, we do not support the proposed elimination of NRSRO references in these rules and disclosure forms. As stated above, we think that ratings provide a useful screen for advisors and enable comparisons across funds by investors. We believe Rule 2a-7 should continue to permit money market fund boards or their delegates to consider NRSRO ratings along with other factors as a minimum credit quality standard. BlackRock supports the assumption embedded in Section 939 of the Dodd-Frank Act that NRSRO ratings should not be the sole determinant of whether a particular security should be included in a money market fund portfolio.
Under current Rule 2a-7, a fund is required to limit its investments to those securities that its board or its delegate determines present minimal credit risks. This determination must be based on factors in addition to NRSRO ratings. We believe it is essential that a board or its delegate make an informed and independent assessment of the creditworthiness of each issuer and security – not only prior to purchase, but on an ongoing basis for those securities held in the portfolio. In our view, a NRSRO rating provides a useful preliminary filter. [[[PAGE]]]
Removal of the NRSRO requirement could have the opposite of the intended effect, as it could permit a money market fund to purchase a security that would not meet the minimum threshold created by the current rating requirements. This would cause a divergence in the quality of securities held by different funds which could be difficult for investors to discern.
Th EC still considering what actoins, if any, will be taken with regard to the use of credit rating agencies references in financial markets.
In our view, the removal of references to ratings on these forms would harm money market fund investors. For example, many current and potential investors in money market funds have investment guidelines which limit their holdings to instruments which carry ratings from NRSROs or funds which invest primarily in such instruments. These investors include pensions, foundations, endowments, insurance companies, and corporate treasurers.
References to ratings on disclosure forms help these investors evaluate money market fund portfolios and compare competing money market fund products. Within the current market there is no comparable alternative data available to investors – as such ratings references should remain a key component of investors’ understanding of the risks associated in investing in money market funds combined with a thorough understanding of a fund sponsor’s risk philosophy.
BlackRock and its predecessor companies have been involved in the management of money market funds since 1973. Today BlackRock is one of the largest cash management providers in the world, managing a total of $257bn in US and European-domiciled money market funds. BlackRock money market funds do not seek to offer the highest yield; we believe they have grown because we have earned our clients’ trust through multiple interest rate cycles and a wide range of market events by making safety of principal and liquidity our highest priorities.
BlackRock’s investment philosophy emphasises a commitment to fundamental research and independent credit evaluation. Our research team follows a rigorous process when assessing the creditworthiness of a security. In order to develop a formal view, we conduct both quantitative analyses of corporate capital structures and qualitative assessments of management and industry positioning. BlackRock has also developed proprietary tools that support the research process. For example, Galileo™, our global research database, allows analysts to share, store and access information and insights across asset classes and locations. GPLive™, our risk monitor, enables portfolio managers to view issuer exposure across portfolios on a real-time basis.
While we support the need for independent credit research, we do not believe all references to NRSRO ratings should be eliminated. We maintain that money market fund advisors should not rely on a security’s NRSRO rating, but instead should consider ratings as preliminary screens in an independent credit review. In fact, the elimination of references to ratings may inadvertently result in the creation of new risks for money market fund investors, as lower quality securities may be deemed creditworthy by advisors. In addition, we believe the disclosure of ratings on portfolio holdings is helpful to investors.
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