LONDON (Reuters) - Regulation aimed at making the global financial system safer may spell trouble for Europe’s 1 trillion euro (874 billion pound) money market funds sector, where managers are handing assets to bigger rivals, pushing more risk into fewer hands.
The threat of costly red-tape is already forcing consolidation among the largest players in what watchdogs call the ‘shadow banking’ system, a network of loosely regulated private equity, hedge and money funds that together are large enough to topple the global financial system.
Financial regulators argue that this shadow banking sector was a key contributor to the financial crisis.
They want a crackdown on shadow banking, which could compel money market managers — who look after cash for clients seeking alternatives to bank deposits — to hold capital against the money they manage.
This could provide a cushion if these highly liquid funds saw a sudden spike in outflows as happened during the crisis.
Regulators worry that a fire sale of the short-dated AAA debt these funds invest in could spark a new credit crisis.
But providers say the proposal is already driving non-specialists out of the sector and could place undue stress on the balance sheets of managers who choose to stay in.
“Enhanced regulation, particularly the prospect of holding capital, is focussing groups on what is their core and non-core business and whether they can manage existing or create competitive products in this space,” said Mark Stockley, head of international cash at BlackRock (BLK.N).
The new rules would be akin to the new bank capital regime, known as Basel III, that banks are presently grappling with.
The proposals are seen as so demanding by some members of the asset management industry that only super-sized groups or bank-owned managers would be able to cope with it.
Standard Life Investments (SLI) SL.L and Henderson Group HGGH.L, who between them run about 220 billion pounds in assets, both passed up their cash funds to Deutsche Bank Advisors in 2011, citing such hefty regulatory burdens.
“We are a bank and therefore our ability to deal with this kind of banking-style regulation is more aligned,” said Reyer Kooy, head of institutional liquidity management UK & Ireland at Deutsche Bank Advisors (DBKGn.DE), explaining his reasons for the bank’s aggressive growth plans in the cash fund sector.
“This is a business we have a large amount of resource allocated to, and a business we feel very comfortable about growing out,” he added.
Moody’s Investor Service Senior Analyst Dagmar Silva feels Henderson and Standard Life are unlikely to be the last managers who decide to exit the sector rather than comply, echoing worries of managers who say more concentration would hurt investor choice and ramp up liabilities of the biggest players.
“We think there may be others who look to dispose of their liquidity businesses. I think many are seriously assessing those businesses as the capital requirement may outweigh the economic benefits,” she said.
Internationally, Stockley estimates that more than 80 percent of the cash fund assets managed by members of the Institutional Money Market Funds Association are today managed by the sector’s 10 largest providers, up from about 60 percent 10 years ago.
He said BlackRock was also interested in “non-organic growth opportunities” should more providers consider an exit.
Some managers say they fear the heavy-handed regulation may even promote risk-taking in the traditionally ultra-safe sector, as providers look for ways to deliver better returns and offset the costs of hoarding capital against such low-margin business.
“These changes are prompting some money market portfolio managers to take more investment risk...in order to target higher yields,” Pimco’s Head of Short-Term Portfolio Management Jerome Schneider said.
“This may also introduce unintended new risks that aren’t matched by the reward proposition,” he said.
Insurer-backed managers said rapid growth of bank-sponsored providers in a shrinking marketplace undermined a key selling point of money market funds, which were originally designed to help investors avoid holding their all their cash in one place.
“Corporate treasurers may already have deposits with these banking institutions so in essence, this is a doubling up of exposure,” said Jennifer Gillespie, head of money markets at Legal & General Investment Management (LGEN.L).
Regulators’ demands that banks to reduce reliance on short-term funding — a major problem during the financial crisis — have also put the long-term growth of the money market sector in further doubt.
As banks have cut down issuance of short-term debt, managers have been forced to look for alternative assets that meet their tough investment criteria, hampering their efforts to provide diversification.
In addition, the unusually low interest rate environment has put massive downward pressure on returns generated — and fees earned — by these funds, further threatening their viability.
Demand for European-domiciled money market funds in sterling, dollar and euro currencies have plunged since 2009, with the euro class alone shedding 1.8 billion euros of assets in the first quarter of 2011, data from Lipper shows.
“We have been in a very low interest rate environment for many months and some managers have been forced to dramatically waive fees,” said Patrick Simeon, head of money markets at Amundi, the asset manager co-owned by Societe Generale (SOGN.PA) and Credit Agricole (CAGR.PA).
“This is one of the greatest issues the industry has to face at the moment,” Simeon said, pointing out increased competition from higher-yielding savings and liquidity management products.
Additional reporting by Tommy Wilkes. Editing by Jane Merriman