The Use of Money Market Funds as Collateral Essay

Table of Contents List of Figuresiii List of Tablesiv List of Abbreviationv Abstractvii 1Introduction1 2The Money Market3 2 - The Use of Money Market Funds as Collateral Essay introduction. 1General Description of the Money Market and its Instruments3 2. 2Participants and their Main Activities4 2. 3Trading, Clearing and Settlement6 2. 4Risks and Risk Mitigation7 3Collateral Management9 3. 1General Description of the Collateral Management Function9 3. 2Quality and Risks of Collateral10 3. 3Transaction, Execution and Legal Issues11 3. 4Valuation of Collateral13 3. 5Users and Trends14 4The Role of Collateral in OTC Derivative Transactions16 4.

1General Description of OTC Derivatives16 4. 1. 1Structure and Participants17 4. 2Market Overview18 4. 3Risks and Risk Management21 4. 3. 1Problems with Cash Reinvestment22 4. 4Legal Foundation and Regulation23 5Money Market Funds as Financial Collateral25 5. 1General Description of Money Market Funds25 5. 1. 1Evolution26 5. 1. 2Participants28 5. 2Market Overview30 5. 3Share Valuation and Risks32 5. 4Regulatory Framework34 5. 5MMF Characteristics34 6Criteria to use MMFs as Collateral37 6. 1Regulatory Requirements for Collateral Receiver37 6. 1. 1Impact of Future Regulation42

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6. 2Operational Requirements44 6. 3Preliminary Findings45 7Practical Example47 7. 1Operating Model47 7. 2Performance, Liquidation and Risks50 7. 3Discussion52 8Conclusion54 Referencesv Appendixxiv List of Figures Figure 1: European Benchmark Rates (Percent per Annum)5 Figure 2: The Function of Collateral Management for Market Participants10 Figure 3: Overview Bilateral, Tri-party, and CCP Execution12 Figure 4: Collateral Put Forward in the Eurosystem Credit Operations versus Outstanding Credit in Monetary Policy Operations14 Figure 5: Global OTC Derivative Market18

Figure 6: Growth of Value of Collateral vs. Gross Credit Exposure in Billions of Dollars (estimated)19 Figure 7: Collateral Analysis in OTC Derivative Transactions20 Figure 8: Collateral Levels by Counterparty Type21 Figure 9: Breakdown of UCITS Assets by Category Q1 201125 Figure 10: Worldwide Money Market Funds Net Assets27 Figure 11: Euro Area Investors in MMFs28 Figure 12: Average IMMFA Fund Investment by Client Type29 Figure 13: UCITS Fund Assets Compared to IMMFA Funds in Billion Euros30 Figure 14: Portfolio Composition IMMFA Funds June 201031

Figure 15: Tri-Party Collateral Management without CCP Clearing48 Figure 16: Tri-Party Collateral Management including CCP-Clearing49 Figure 17: European Prime Money Market Funds versus LIBID51 List of Tables Table 1: Standard Money Market Securities3 Table 2: General Product Types in the OTC Derivative Market16 Table 3: Worldwide Money Market Fund Rankings32 Table 4: Overview of applicable regulatory framework37 Table 5: Overview General Collateral Requirements Required by Regulation42 Table 6: Eligibility Results by Collateral Receiver and Regulatory Framework45 List of Abbreviation

ABCPAsset-backed commercial paper AMAsset manager AuMAssets under Management BABankers’ Acceptance BISBank for International Settlements CCPCentral Counterparty CDCertificates of deposits CDSCredit default swap CESRCommittee of European Securities Regulators CGCollateral giver CPCommercial paper CRCollateral receiver CSDCentral Security Depository CURCurrencies DVPDelivery versus Payment ECBEuropean Central Bank EFAMAEuropean Fund and Asset Management Association EMIREuropean Market Infrastructure Regulation EODEnd of Day EONIAEuro Overnight Index Average ESCBEuropean System of Central Banks

EUEuropean Union EURIBOREuro Interbank Offered Rate FOPFree Of Payment FRAForward Rate Agreement GDPGross Domestic Product ICMAInternational Capital Market Association ICSDInternational Central Security Depository IMMFAInternational Money Market Fund Association IRSInterest Rate Swaps ISDAInternational Swap and Derivatives Agreement KYCKnow Your Customer LCLetter of Credit LIBIDLondon Interbank Bid Rate LIBORLondon Interbank Offered Rate MMFMoney Market Fund MROMain Refinancing Operations MTMMark-To-Market NCBNational Central Bank NAVNet Asset Value NSFRNet Stable Funding Ratio OTCOver-the-counter

RepoRepurchase and sales agreement TATransfer Agent UCITSUndertaking for Collective Investment in Transferable Securities Abstract This thesis analyses the possibility to use money market funds (MMFs) as collateral in financial transactions and focuses on over-the counter (OTC) derivative markets in particular. Recent market developments have highlighted the ‘Flight for Security’ of market participants by means of financial collateral. While cash represents the preferred source of collateral in 82% of all OTC derivatives transactions, it needs to be returned with interest to the collateral giver.

At the same time this creates a re-investment risk for the collateral receiver. When accepting MMFs as collateral, collateral receivers are not exposed to any reinvestment risk because the fund offers competitive rates of returns. Compared to their benchmark rates e. g. LIBID, MMFs offer a high stability especially in a falling interest rate environment. Moreover, in case of counterparty default, cash collateral belongs to the liquidation mass, while MMFs are ring-fenced against the defaulter. In addition, MMFs guarantee same-day liquidity and a high safety due to diversification and professional management.

A regulatory review based on the Basel II accord, Solvency I and UCITS-law have found, that in general MMFs are eligible as collateral for banks, funds and insurance companies, but do not qualify as collateral at central bank level according to the ECB-guidelines. Basel II, applicable for banks, requires a high complexity when using MMFs as collateral. Disclosure of fund composition in form of a ‘look through’ and haircut calculation will be the most complex aspects in this context, as funds rarely report such information.

The implementation of Solvency II, applicable for insurer, could solve this information shortage. Insurance companies will require ‘look through’ data of their holdings with asset managers (AMs). As insurance companies are large investors in MMFs, AM are forced to develop an approach to deliver the required ‘look through’ data. Another regulation incentivising MMFs as collateral is the proposed European Market Infrastructure Regulation (EMIR) addressing all standard OTC derivative transactions. EMIR requires approximately USD 644bn additional global collateral.

The arising collateral scarcity creates a high potential for the use of MMFs as alternative collateral asset class. Considering operational requirements, MMFs require an infrastructure that supports same day settlement (T+0) and simultaneous delivery versus payment (DvP) for subscriptions and redemptions. MMFs can be used as collateral if the counterparties execute transactions via a tri-party collateral agent linked with a fund settlement platform, with or without the use of central counterparty (CCP) clearing. Introduction

Since the liquidity failure in 2007 there has been a significant decrease in unsecured cash lending in the European Union and a simultaneous increase in secured cash lending (ECB, 2010:14, 20). Secured financial transactions use financial collateral to reduce the credit risk arising. This current trend towards security emphasises the increased risk aversion and the lowered risk appetite of market participants. Today collateral management has become the most important credit risk mitigation technique, not only in lending markets but also for refinancing operations of the European Central Bank (ECB) and in derivatives markets.

Several regulatory initiatives have been launched to control credit risks. Basel III focuses on capital adequacy and liquidity and the European Market Infrastructure Regulation (EMIR) aims at improving transparency in OTC derivatives transactions and reducing counterparty risk (Dodd, 2004: 2). The data collected from the Bank for International Settlements (BIS) indicate total notional amounts of outstanding over-the-counter (OTC) derivatives of USD 601 trillion by the end of December 2010.

By way of comparison, outstanding amounts are 37 times[1] the size of the EU economy which emphasises the systemic relevance of derivative markets. Collateral and more specifically, its quality will play an important role in complying with the new rules. Derivative instruments such as futures, forwards, options and swaps are derived from underlying assets and are used for hedging and risk management, but also for speculation. Both counterparties bear exposure depending on the market development of the underlying security and are thus exposed to credit risk.

The use of collateral reduces the risk in case of counterparty default as it is exchanged between counterparties and depend on the development of the underlying security. Generally counterparties choose between cash or securities for collateralizing purposes. According to the recent margin survey by the ‘Swaps and Derivatives Association’ (ISDA), cash collateral represents 82% of all collateral that was received in 2010 (ISDA 2010a: 6). While cash collateral offers easy monitoring and fast transfer, it has to be returned with interest.

For that reason, it needs to be reinvested. That in turn creates reinvestment risk if the cash fails to earn the agreed interest (PWC, 2011). A possible way of addressing reinvestment risk is the use of money market funds as collateral instead of cash. Money market funds (MMFs) offer constant liquidity as well as daily dividends, and hence abolish the reinvestment risk involved in using cash collateral. As regards the remaining 18% of securities used as collateral in OTC derivatives transactions, MMFs are not among the securities used so far.

With EUR 1,141bn net assets currently under management (EFAMA, 2011a), MMFs could be a valid alternative to cash, government securities and other categories of traditional collateral. The combination of a well-established UCITS (Undertakings for Collective Investment in Transferable Securities) regulatory framework, high capital preservation and strong liquidity profile explain their attractiveness as a way of controlling counterparty risk. This thesis aims to analyse the possibility of the establishment of money market funds as an alternative to traditional asset classes used as collateral, particularly in OTC derivatives transactions.

The International Money Market Funds Association (IMMFA) which represents the European triple-A MMF industry will play an important role in this analysis as IMMFA MMFs present high quality products and are likely to qualify as collateral. In general this analysis focuses on the European market; however market data regarding OTC derivative transactions are produced only by frequent ISDA margin surveys as transactions occur over the counter and are rarely reported. As financial transactions increasingly blur, worldwide figures are used to facilitate a complete view.

All currencies (CUR) if not specified, are US- Dollars (USD), Euro (EUR) or Pounds Sterling (GBP). This thesis proceeds first with a general description of the money market, explaining the borrowing and lending activities of the main participants, and briefly documents the latest market developments regarding security. It then moves on to explain the overall collateral function and describes the trends in the use of collateral. The following part focuses on the role of collateral in OTC derivative transactions and outlines the issues with cash collateral.

Then, the eligibility of MMFs as financial collateral is assessed through a comprehensive regulatory review based on European regulation and to some extent Luxembourg law. In addition, the eligibility analysis determines and evaluates operational requirements. Finally, this thesis provides a practical example, designing a possible operating model for MMF collateral in OTC derivative transactions and concludes with some general observations and the outlook for future development. The Money Market 1 General Description of the Money Market and its Instruments

Financial markets are commonly classified by the maturity structure of their securities. Distinctions can be made between the money- and the capital market. The latter term deals with longer-term funds such as bonds, whereas the money market refers to short-term borrowing and lending with maturities of one year or less. The need for the money market arises because receipts and expenditures of capital do not coincide. Every additional amount of money involves opportunity costs meaning foregone interests, which could have been achieved by investing it in another way.

Thus, financial and non-financial organizations as well as governments seek to hold only the minimum amount of money needed for their daily operations (Madura, 2009: 2-4). According to Marcia Stigum (1990: 3), the money market consists of three characteristics: it is a ‘collection of markets with close interrelationships’, it involves a ‘varied cast of participants’, and it can be seen as a ‘wholesale market’, because ‘the trades are big and the people making them are almost always dealing for the account of some substantial institution’.

The variety of markets is summarized in this table: Table 1: Standard Money Market Securities [pic] Sources: Own illustration, data based on Burton, 2009: 241; Cook, 1998: 3; Investopia, 2011 As well as the standard securities illustrated, there are other money market instruments such as money market funds (MMFs) and money market derivatives. MMFs invest in standard money market securities, while money market derivatives are financial products the values of which are derived from the price of a particular money market instrument, also referred as the underlying instrument.

Money market derivatives take the form of futures, forwards, options and swaps. They are used by money market participants to help limit risk, but they are also used for speculation purposes to increase returns. Forwards and the majority of swaps are traded over the counter (OTC), which means that they are negotiated between two parties and are not traded on exchange like futures or options. Investment in exchange-traded derivatives can be done by institutional and private individuals; although OTC traded types are generally only viable for institutional investors.

All in all, investment in money market instruments can be done either, through direct investment which requires a high investment because of the minimum denominations, or through, indirect investment meaning the purchase of money market funds’ shares (Riche, 2011). 2 Participants and their Main Activities Central banks, national and local governments, foreign and domestic banks, financial intermediaries, such as insurance and investment companies, and corporations of all types are the main participants in the money market. Participants with cash shortages issue certain money market instruments (cp.

Table 1) on the primary market to raise short-term funds, whereas participants with cash surpluses obtain interest by investing in those money market instruments. Because of active secondary market trading, money market instruments can be sold before maturity. This enables investors to liquidate money market instruments very quickly in the event of a cash demand (Cook 1993: 1; Stigum; 1990: 3). European Central Bank (ECB) The ECB, as a key player in the European money market, sets out to maintain price stability. In order to do so, it manages the growth of the money supply and influences interest rates.

Open market operations, standing facilities and minimum reserve requirements for credit institutions are the main monetary instruments in this context[2]. Its most important activity as a participant in the money market is the ‘Main refinancing operations’ in which the ECB provides liquidity to commercial banks through so-called reverse transactions. Reverse transactions are executed in the form of repurchase agreements with a full transfer of ownership for an agreed duration and a re-transfer on maturity or in the form of a collateralized loan.

The enforceability over the assets provided as loan remains with the lender in case the debtor cannot fulfil its obligations (ECB, 2011a: 19, b). Commercial Banks Next to the ECB, banks also play an important role. Through the ECB’s standing facilities, banks can either borrow (marginal lending facility) overnight liquidity against collateral; or make overnight deposits (deposit facility), both with national central banks. Short-term borrowing takes place either with the ECB through reverse transactions or business to business through repurchase and sales agreements (repos).

Reverse transactions and repos are quite similar. In order to borrow cash, securities are sold with a simultaneous agreement to buy them back later at an agreed date. Moreover banks issue certificates of deposits (CDs). Such certificates serve as evidence that a certain amount has been deposited. On defined maturity it will be redeemed with interest. As well as borrowing and lending, banks may also act as counterparties or dealers in over-the-counter (OTC) interest rate derivatives transactions (Cook, 1998: 2-3; ECB, 2011a: 11).

As mentioned earlier, banks also lend or borrow funds also between each other in the interbank market. The benchmark rate at which prime banks lend to each other is the EURIBOR (Euro Interbank Offered Rate) for daily interbank term deposits, or the LIBOR (London Interbank Offered Rate) in the short-term international interbank market. Another very popular rate is EONIA (Euro Overnight Index Average) which represents a weighted average index for Euro-denominated lending in the unsecured market. Figure- 2 shows the development of those three benchmark rates.

Because of very low ECB key interest rates, benchmark rates interbank lending also declined significantly in 2009. However, since the end of 2010-, interbank rates have generally increased, which is a step towards normality on the money market. Figure 1: European Benchmark Rates (Percent per Annum) [pic] Source: Own illustration, data based on Global rates, 2011 National Governments Not only the ECB and commercial banks but also national and local governments issue large amounts of debt to raise funds. Treasury bills (T-bills) have a maturity of less than one year and represent the largest outstanding volume in the money market.

Because of their high liquidity, T-bills are very actively traded on the secondary market. As these instruments are issued by governments to raise funds, most of the time they benefit from tax exemptions and low credit risk as T-bills are generally backed by the countries’ ‘full faith’ of credit (Cook, 1993: 4, 75-76). Non-Financial Organizations The treasuries of large companies or organizations also invest their cash surplus in money market instruments and borrow funds if needed. That is done through the issue of unsecured short term debt instruments, i.

e. commercial papers that are sold in the money market. For non-financial organizations involved in international trade, Banker’s acceptances (BA) and letters of credit (LC) offer further possible ways of raising funds on the money market (Van Horne 2008: 239; Cook 1993: 4). Money Market Funds (MMF) MMFs are financial instruments and part of the fund industry. They are run by financial intermediaries that purchase large amounts of money market instruments with the money from many large or small, individual or institutional investors.

By investing in a money market fund share, investors benefit from the large size of the fund, which offers professional management, a high level of diversification and daily liquidity (Burton, 2010: 240; Corrigan A. , 1984: 6). Overall MMFs are important participants in the money market as they provide short-term funding to banks and other financial institutions. For their investors MMFs offer a high level of safety and liquidity, on account of the short maturity of their underlying assets (CESR, 2009: 3). 3 Trading, Clearing and Settlement Most money market instruments are traded over- the- counter and rarely on organized exchanges.

The money market is mainly considered a single market because of the activities of its intermediaries such as brokers and dealers. Brokers bring together sellers and buyers by acting as counterparty for both. They sell securities against commission and ensure anonymity between sellers and buyers. In contrast to dealers, they do not invest own money in the securities they sell. Most of the time dealers are also brokers (e. g. Investment banking and brokerage firms) because they can act as agent or as principal. If a dealer acts as agent, he does not risk his own money and receives only a fee for selling securities just like a broker.

On the other hand, acting as principal the dealer invests own money in the securities that he is selling and acts as direct counterparty. To finance those investments, dealers generally use repos. Dealers are also called market makers if they take the risk of holding large volumes of securities in order to facilitate trade by quoting buy and sell prices for money market instruments. Those trading activities are the reason why there is a secondary market which enables money market instruments to be sold prior maturity (Cook, 1993: 5; Francis, 2000:1; Stigum 1990: 424-425, 436-439).

Every trade conducted on the secondary market involves a process that concludes the transaction. When money market instruments are traded some kind of exchange between the two parties has to take place. This can be cash for the purchase or sale of a money market instrument or the netted outcome of more transactions. Loader (2002: 2) defines clearing as ? the preparation through matching, recording and processing of instructions of a transaction for settlement? , whereas settlement consists in ? the exchange of cash or assets in return for other assets or cash and transference of the ownership of those assets and cash?.

The process of clearing has to be performed by a designated function, also called a clearing house. Central securities depositories (CSDs) or international central securities depositories (ICSD) hold securities on behalf of their members to speed up the process of clearing and settlement (Loader 2002: 2-4). Euroclear, Clearstream and DTC are examples of CSDs. One settlement method is delivery versus payment (DVP). It makes sure that cash and security settle at the same time through links on both sides of a transaction.

Hence settlement risk is reduced, as this process requires both cash and security to be available on both sides. If no cash is involved at the point of exchange, settlement is carried out free of payment (FOP). Most of the time market participants use settlement agents to facilitate the transfer of cash and securities (Davenport, 2003: 27-28). 4 Risks and Risk Mitigation The daily volume and the high value of transactions carried out on the money market create a high potential for various types of risks. Operational risk may occur through a breakdown of the computer systems and may lead to settlement delays.

The temporary unavailability of required funds is considered as liquidity risk and also causes settlement delays (Cook, 1993: 183-184). Besides the risks arising from secondary market trading, all participants investing in money market securities face the risk that their investment will not be as much as anticipated. As money market securities mature within twelve months or less, they are rarely subject to interest rate risk. That is the risk of interest rates’ moving unfavourably, which may lead to a major loss in value of an investment. So rather than the investment’s just losing some value the issuer of the security could default.

That would result in a loss of the entire investment and is called credit, default or counterparty risk. Participants themselves decide how much risk they are willing to accept, depending on whether a transaction is secured or unsecured. Unsecured lending and borrowing exposes a lender to the highest degree of default risk, but at the same time lenders can earn higher yields. In contrast to the unsecured market, participants in the secured market are exposed to a much smaller credit risk because of the use of financial collateral. This can be liquidated to cover the loss in the event of default (Madura, 2009: 130).

In general trading activities in financial markets have grown significantly in recent decades according to the ‘Bank for International Settlements’ (BIS) and thus have increased transaction volume and risk exposure. With this trend the need for efficient risk mitigation techniques has grown. Not only trading activities, but also the numbers of global participants have been growing, resulting in new types of counterparties which at the same time increase credit risk. In general market participants have become more sensitive with regard to the risks they are taking (BIS 2001: 6).

According to recent studies by the ECB the unsecured cash lending and borrowing market has declined continuously over the last couple of years, whereas the secured market recovered over the same period[3]. This current trend towards security by means of collateral has arisen mainly because of the liquidity failure in 2007 and repercussions of the financial crisis. The subsequent market disturbances led to increasing risk aversion, lowered the risk appetite of its market participants, and sharply increased the demand for security in form of collateral (ECB, 2010: 13-20).

Collateral Management Whereas the preceding section explained the increase in collateralization, this chapter focuses on current trends in the use of collateral in more detail. In addition it provides the reader with general facts and determines essential qualitative characteristics that have to be considered for the efficient use of collateral. 1 General Description of the Collateral Management Function Collateral management is a credit risk mitigation process intended to secure financial transactions. In order to limit credit exposure, collateral is taken as security.

This has been popular for centuries in money lending, pawn-broking and since the 19th century, also in real-estate financing. In the last fifteen to twenty years, however, the process of collateral management has constantly evolved, thanks to new technologies, competitive pressure and increased counterparty risk from the use of derivatives, securitization and high leverages. Today, the types of assets most commonly used as collateral are cash, government securities, corporate bonds, equities, etc. Accordingly, collateral must fulfil certain characteristics to cover a potential loss in the event of counterparty default.

Harding (2002: 3) defines collateral as ? legally watertight, valuable liquid property supporting a risk. It has to be legally watertight in order to enforce it, to be valuable as to be worth something, to be liquid so one can sell it in case of default and to be subject to property rights to own and control it. ‘ In addition, collateral has to be easily transferable. As well as mitigating risk, collateralization also reduces the amount of economic capital required under Basel II regulations. The requirement of less capital encourages more trade and in turn leads to a higher level of liquidity on the markets.

In addition collateralization improves competiveness and may offer access to more complex and higher-risk trades (Harding, 2002: 3; Financial-education, 2011). According to the Finadium/-SunGard survey (2010: 5), 39% of the participants reported that risk mitigation was still their main purpose. The majority (54%) noted that collateral management should be used for risk mitigation with the potential for revenues. Revenues can be achieved through further investments or the re-use of assets, which is also called re-hypothecation. Overall pure revenue generation (7%) plays a subordinate role in the collateral management function (cp.

figure 2, next page). Figure 2: The Function of Collateral Management for Market Participants [pic] Source: Own illustration, data based on Finadium/ SunGard, 2010: 5 2 Quality and Risks of Collateral The quality of collateral is crucial for its use as an efficient risk-mitigation tool. ISDA (2010b: 46) therefore proposes further considerations regarding collateral quality, addressing its ability to cover possible losses in the event of default. Consequently, preferred collateral consists of liquid assets without any or with lowest credit risk.

The price of assets used as collateral should be easy to determine, preferably through external market data sources such as Bloomberg or Reuters. These external data reduce disputes in margin calculation by the counterparties. That is why some counterparties use tri-party collateral agents for collateral valuation purposes. Market participants should also consider the volatility of the assets. The risk of unfavourable changes in prices affects the value of the collateral assets. If the assets have to be liquidated in the event of default, the price obtained may not be close to the initial value.

Another factor influencing this price is liquidity. Sufficient liquidity is essential if the collateral asset is to be sold at a reasonable price and within a reasonable time. In addition, collateral asset issuer’s good credit standing influences the level of security for the collateral receiver (CR), also called issuer risk. For example, if the organization issuing a corporate bond becomes subject to credit distress or defaults, the corporate bond used as collateral loses its value. Additional risks occur, if the collateral is not amenable to easy and cost efficient custody and settlement.

The reduced settlement and custody efficiency increases operational as well as potential settlement risk because of long settlement cycles and local depository operating times. In addition, ISDA suggests considering correlation and concentration of the collateral asset. Correlation risk arises if the collateral received correlates highly with the credit quality of the counterparty providing the collateral, whereas concentration risk addresses collateral which is highly concentrated to any issuer, country, sector etc. Overall legal aspects regarding the creation and perfection of security interest have to be considered, too.

As a result, criteria that define collateral quality can be summarized as follows: • Volatility and liquidity • Credit quality • Custody and settlement efficiency • Valuation and transparency • Correlation and concentration • Interest perfection Because collateral transforms credit risk into operational and residual risk, it becomes very important to select the assets used as collateral by means of the criteria described. Operational risk covers all mistakes conditioned by human or technical errors that may lead to e. g. , a shortfall in protection.

Residual risk may occur in the time between margin calls, meaning the demand of additional collateral due to increased exposure, and the counterparty default. Moreover residual risk may also occur due to a decrease in value of collateral between receiving it and using it to cover the loss in case of default and over-collateralization due to inaccurate valuation. The management of those risks is an expensive process including costs for proper documentation and monitoring, administration and technology (ISDA, 2010b: 6, 46). 3 Transaction, Execution and Legal Issues

In secured financial transactions between two counterparties, the lender delivers cash or securities against collateral to the borrower. The borrower is called the collateral giver (CG), whereas the lender who receives the collateral is referred to as the collateral receiver (CR). The provision of collateral takes place either by: • Transfer of title method, where the full ownership is transferred from collateral giver to collateral receiver; • or by pledging through the transfer of possession, where the full ownership remains with the collateral giver (European commission, 2010: 3).

In addition, there are three different possible ways of carrying out the collateral management process (cp. figure 3). The first is bilateral execution between the collateral receiver and the collateral giver. This requires a large back office team, as all administrative tasks remain with the two parties. Bilateral execution can be problematic and fraught with risks and challenges because of the highly manual and people-dependent process (Fundamentals, 2011a: 20). Figure 3: Overview Bilateral, Tri-party, and CCP Execution [pic]

Source: Own illustration, data based on Clearstream, 2010: 1 Another possibility is tri-party execution. Some custodian banks have added this service to their business. Customers benefit from the existing banking relationship, a developed technology, and the coverage of markets related to custody business. Some tri-party agents have established themselves as an alternative to custody banks. They undertake administrative tasks and offer the latest real-time processing and communication systems which help to reduce operational risk.

Overall agent intermediaries provide a central service to manage, hold and clear collateral by bringing together different counterparties (Financial-education, 2011; Faulkner, 2006: 19). Another growing trend is towards central counterparty (CCP) – based transactions. A CCP acts as legal counterparty for the collateral giver and the collateral receiver. The collateral giver and the collateral receiver are therefore no longer direct counterparties. This ensures anonymity between the collateral receiver and the collateral giver (ECB, 2010c: 24). CCPs make information available to the market and to regulators.

Consequently, the use of a CCP improves the management of the counterparty risk, allows multilateral netting[4] of exposures and payments, and increases transparency (BIS, 2009: 46). Collateral is used throughout the EU to manage credit risk. However, each Member State has its own jurisdiction. That is why legal rules vary among the Member States. This is very difficult for participants in the European financial market. Participants have to consider all the legal requirements for each country they do business in, which rules in a very complex and expensive process.

The legal differences with regards to bankruptcy legislation may be problematic. This legislation ensures that all creditors are treated fairly. The purpose remains the same, but the definition differs from one Member States to another. There are also differences in the procedure a creditor must follow if the other party cannot fulfil its obligations. Those procedures are called perfection requirements and are intended to prevent illegal benefits. In addition, the timing allowed in the liquidation of collateral varies from immediate liquidation to the obligation to wait several months.

An additional rule renders these issues even more complex. That rule is the ‘lex rei sitae’ rule which specifies that the location of the collateral determines the law. As book-entry securities can be moved around easily, it is often very difficult to determine the exact location (ECB, 2001: 2). 4 Valuation of Collateral The fast and correct valuation of collateral is an essential part of the collateral management process. Eligible collateral must be easily transferable into real economic value (e. g. in the event of default) to serve as security in a trade.

This value is traditionally calculated at the end of each day (EOD) after the market closes. The valuation is done by either the collateral giver, the collateral receiver, both of them, or by a third party collateral agent. The most common way of determining the collateral value is the mark-to-market (MTM) method. It is used for very standard (vanilla) trades with many comparable market prices available. This MTM value is reduced by a valuation percentage also called haircut, to protect the collateral receiver from drops in the MTM collateral value.

EOD determination ensures an adequate value of collateral during the entire life of a deal. A margin call is made, if collateral declines in its value. The owning counterparty (e. g. in an OTC derivative transaction) is asked to deliver additional collateral until the collateral value again equals the value of the trade (Financial-education, 2011). 5 Users and Trends Financial institutions such as banks, asset managers and insurance companies, and also dealers and mutual funds, use collateral mainly in three areas of their activities: • Sales and repurchase agreements (Repos); • Securities lending[5];

• OTC derivatives transactions. In addition to the three areas mentioned, central banks use collateral in their refinancing operations to protect against counterparty risk. In general all ECB liquidity-providing operations are fully collateralized as required by Article- 18. 1 of the Statute of the European System of Central Banks (ESCB, 2011: 6). To be eligible for the ECB’s credit operations, collateral needs to fulfil a defined set of criteria published and assessed by the ECB. Currently the total amount of eligible collateral for the Eurosystem’s credit operations equals EUR 14 trillion.

The largest share is central government debt with a value of EUR 5. 8 trillion, followed by uncovered bank bonds with EUR 1. 5 trillion[6] (ECB, 2011c: 98; ECB, 2011a: 46-49). Figure 4: Collateral Put Forward in the Eurosystem Credit Operations versus Outstanding Credit in Monetary Policy Operations [pic] Source: ECB, 2011c: 98 The average value of collateral put forward in the EU slightly decreased from EUR 2,034bn in 2009 to EUR 2,010bn in 2010 (cp. figure 4, previous page). What is remarkable is the significant increase of collateral put forward in the period between 2007 and 2009.

That increase arose mainly because of the financial crisis and the market turbulence involved, which obliged counterparties to submit large additional amounts of collateral. In addition, the outstanding credit also declined in 2010, which indicates lower liquidity needs. The comparison of both, total collateral put forward and outstanding credits in monetary policy operations shows a large amount of collateral that has not been used to cover those credits of the ECB. This fact leads to the conclusion that the Eurosystem does not have to fear the risk of a possible shortage of ECB eligible collateral (ECB, 2011c: 98; ECB, 2010a: 103).

Overall two areas are most important for the supply of collateral, namely securities markets for fixed-income and equity and the debt market for securities issued by corporations, financial institutions and governments (BIS, 2001: 7-8). Government securities have been the preferred source of collateral for repos[7] (40. 6%) and reverse transactions (41%) as the ‘government backing’ represents a very low risk for the lender. With regard to the collateral analysis of repos, ICMA (2010: 17) reports in its main survey a remarkable increase in German government bonds to 24. 3% and the UK to 11. 6%.

In contrast Greek collateral remains at a low level with 0. 5%. The trend in the choice of collateral is currently towards securities issued by countries unaffected by fiscal difficulties. Market participants seek security. As current credit ratings show, more than 90% of collateral in tri-party repos is rated at least A[8] or better. (ICMA, 2010: 18). Consequently the pool of accepted eligible collateral that fall outside the scope of the ECB eligible assets for refinancing operations is shrinking because of the fiscal difficulties of various EU-countries as reflected by their credit ratings.

The Role of Collateral in OTC Derivative Transactions The financial crisis has highlighted the systemic relevance of OTC derivatives as the market is defined by a small number of financial institutions but large risk exposures and emphasized the importance of efficient counterparty risk mitigation in OTC derivatives transactions. Consequently, current regulatory initiatives such as the European Market Infrastructure Regulation (EMIR) are under way, intended to improve transparency, safety and the resilience of OTC derivatives markets (ECB, 2009: 5).

The following section provides a general description of the OTC derivatives market, including market size, structure and characteristics, as well as main participants and, in addition, regulatory implications. In particular this chapter analyses risks and outlines possible weaknesses associated with the predominant use of cash collateral and hence argues in favour of substituting cash or respectively the establishment of an alternative asset class alongside cash collateral. 1 General Description of OTC Derivatives Derivatives are financial contracts whose value is ‘derived’ from the value, price, index or event of the underlying asset.

Derivative contracts are fulfilled at a future point in time depending on the underlying instrument. They are often traded over the counter (OTC) as counterparties themselves decide on the terms and conditions of the contract to meet their specific needs. That is why derivatives contracts may take various customized forms. General products traded in the OTC derivative market are interest rate swaps (IRS), OTC equity derivatives, credit default swaps (CDS) and OTC foreign exchange derivatives as illustrated in Table 2 (ECB, 2009: 7).

Table 2: General Product Types in the OTC Derivative Market [pic] Source: Own illustration, data based on ECB, 2009: 7-10 1 Structure and Participants Derivatives in general are traded in two different types of markets. First, the exchange market which traditionally trades futures and options, ran by brokers and second, the OTC market. OTC derivatives markets can be grouped in three categories[9]: • the dealer market, also called bilateral market • the electronically brokered market; • the proprietary trading platform market.

Traditionally dealers acting as market makers represent bilateral trading. Only the counterparties involved in the trade observe prices at the time of the execution. This is because dealers maintain bid and offer quotes. Prices are negotiated usually over the telephone or via electronic bulletin boards[10] either end-user-to-dealer or dealer-to-dealer. For the purpose of risk mitigation both counterparties post collateral on mark-to-market changes in the value of the underlying asset covered in the contract.

An alternative to the dealer market is the electronically brokered market which operates similar to the exchange market and automatically matches bid and offer quotes. The operator of the electronic platform acts only as broker and hence does not act as counterparty for any trade. By contrast if the platform adopts a clearing house it also bears the credit risk arising from the trades. The last category, i. e. the proprietary electronic dealer or trading platform market, is a hybrid form of the two previous categories.

The dealer posts bids and offers and other market participants are able only to observe such quotes and execution prices. This practise is called one-way multilateral. It is one-way, because the dealer acts as counterparty for all trades, exclusively posts quotes and is exposed to credit risk (ECB, 2009: 7-8; Dodd, 2002: 2). Overall the main participants in OTC derivatives markets are the market-making dealers. Large commercial or investment banks, security houses and also large mutual funds, pension funds, hedge funds and insurance companies act as dealers in OTC derivatives markets (ECB, 2009: 12).

The buying-side of OTC derivatives encompasses almost everyone such as ‘corporations of every variety, particularly heavy consumers of energy products, municipalities of every variety, and of course, hedge funds’ (Worldpress, 2009). As dealers act as counterparty in OTC derivatives trades, they are exposed to credit or counterparty risk. The general market practice in dealer-to-dealer transactions and also in end-user-to-dealer transactions has been to post collateral on a daily mark-to-market basis to cover the relevant spread.

This process of risk mitigation by means of collateral can be conducted on a bilateral basis or through outsourcing to a tri-party collateral agent as well as though the use of a central counterparty (CCP). CCPs act as large capitalized hubs through which trades are channelled and netted against each other. Examples of CCPs are Eurex Clearing AG for equity derivatives, CDS’s too for certain types of repo transactions, CLS for foreign exchange derivatives settlement and LCH. Clearnet S. A. for CDS’s (ECB, 2009: 5-6). 2 Market Overview

Over the decade to June 2007 the OTC derivatives market experienced significant growth. As figure 5 indicates, it grew from USD 95,199bn to USD 595,340bn in 2007. In contrast to that development, the market declined until mid-2008, falling by 13. 8%. The current OTC derivatives market reached USD 601,048bn at the end of 2010, as measured in notional amounts outstanding. Figure 5: Global OTC Derivative Market [pic] Source: Own illustration, data based on BIS, 2011a:8 The figure also illustrates the OTC market segments in 2009 and 2010.

The largest share represents interest rate contracts with USD 465,260bn followed by foreign exchange contracts with USD 29,898bn in 2010, whereas equity-linked contracts (USD 5,635bn) and commodity contracts (USD 2,922bn) have the smallest shares. The development of OTC market segments in 2010 highlights a further increase of interest rate and foreign exchange derivatives as well as a decrease of CDS’s by 8% (BIS, 2011a: 8). As regards the development of exposure in the OTC derivative market, the BIS report a gross credit exposure of USD 3,378bn at the end of 2010 (cp. figure 6).

OTC derivative transactions bear a higher risk as there is no open market to assess the value of the trade, estimates the exposure, or make a quick liquidation possible (Chorofas, 2008: 59). Consequently the use of collateral in OTC derivatives transactions is important if credit risk is to be limited. The risk of loss is generated by the volatility of the underlying exposure and this amount varies daily. Thus, the amount of the collateral also changes according to the value of the underlying asset (Davenport, 2003: 3). Figure 6 compares the value of collateral with the gross credit exposure.

ISDA, representing worldwide participants in the derivatives industry, estimates in its 2010 Margin Survey USD 2,934bn of collateral in circulation. There had been a remarkable increase of collateral since 1999 with a significant peak in 2008. The on-going decline of collateral since 2009 mainly has it roots in a return to ‘more normal’ interest rates, credit spreads and counterparty exposure. Figure 6: Growth of Value of Collateral vs. Gross Credit Exposure in Billions of Dollars (estimated) [pic] Sources: Own illustration, data based on ISDA Margin Survey, 2010a: 4; BIS, 2011a: 8

Comparing the USD 3,578bn gross credit exposure reported by BIS with the USD 2,934bn collateral in circulation, it can be inferred that uncollateralized exposures at the end of 2010 came to about USD 644bn. In addition, ISDA indicates that approximately 70% of all OTC derivatives transactions are collateralized (ISDA, 2010a:10). Although cash has to be reinvested, it is the predominant source (82%) of collateral in OTC derivatives transactions. Cash in the form of USD followed by EUR represents the largest share. Government securities with a share of 10%, are the second preferred asset class in OTC derivatives transactions (cp.

figure 7), where government securities issued in the EU are in greater demand than securities from the US, followed by Japanese securities (ISDA, 2010a: 5-6). Figure 7: Collateral Analysis in OTC Derivative Transactions [pic] Sources: Own illustration, data based on ISDA Margin Survey, 2010: 6 93% of all credit derivatives are collateralized followed by equity (71%) and fixed income derivatives (70%). Foreign exchange derivatives contracts form the smallest share of collateral user representing 51% (ISDA, 2010a: 5-6, 10) In addition, ISDA also investigates different levels of collateralization with regard to the counterparty type.

As figure 8 (next page) illustrates, hedge fund exposures tend to be the most highly collateralized of all types of counterparty exposures, exceeding even 100% of net exposure. The second highest collateral level is represented by mutual funds, followed by banks and dealers, whereas non-financial organizations and governments belong to the lowest levels of collateralization in OTC derivative transactions. Figure 8: Collateral Levels by Counterparty Type [pic] Sources: Own illustration, data based on ISDA Margin Survey 2011: 14

With regard to re-hypothecation, meaning the re-use of collateral, 44% of all respondents and 93% of all dealers responded to the ISDA Margin Survey (2010a: 8) that they re-use the collateral received. Cash collateral is for re-investment in new securities, re-lending, or as collateral in other derivatives transactions. 3 Risks and Risk Management In general, OTC derivatives markets are of systemic relevance because of the large volumes and a comparatively small number of participants. As mentioned earlier, the main activity in OTC derivatives markets takes place between market-making dealers and large financial institutions.

The disruption of one single participant is therefore easily transmitted to the others. In addition, as links between the different institutions blur, it is very difficult to investigate which institution ultimately holds the risk exposure. This lack of transparency in turn leads to shortcomings in risk management as the real exposure is unknown. Another frequently discussed source of risk is the lack of sufficient post trade-infrastructure development in accordance with the exponential growth of OTC derivatives markets in recent years.

Most of the transactions are cleared and settled bilaterally in a non-standardised form that requires a high degree of manual intervention and thus involves an equally high degree of operational risk (ECB, 2009: 12). Risks Connected with Collateral Credit risk mitigation through the use of collateral involves adding other types of risk in exchange for a reduced credit risk. Credit risk is transformed into market price, liquidity, operational and legal risks as explained in the previous chapter. The extent to which collateral takers (CT) are able to reduce the loss in the event of counterparty default depends on their overall risk management.

Consequently CTs prefer collateral that moves in line with the value of the exposure and maintains or even increases its value in the event of default. As with collateral analysis, cash and government securities are the preferred source of collateral in OTC derivatives transactions. The reason is that their value is very often not related to the creditworthiness of the collateral providing counterparty. Moreover, cash and government securities provide additional protection in times of market stress when prices increase for very liquid and risk-free assets.

This explains the very low share of equity or corporate bonds as collateral in OTC derivatives transactions. Due to higher and variable price volatility as well as low liquidity, it is more difficult to assess the real net exposure after taking collateral. Consequently, in order to manage this uncertainty a higher haircut needs to be applied. This means that the value of the asset taken as collateral is reduced by a certain amount, providing the CT with additional credit protection. The greater the haircut applied, the greater the costs of using the lower-quality collateral to the collateral giver.

That explains why most of the collateral givers tend to use cash and government securities in OTC derivatives transactions (BIS, 2001: 18, 21, 23). However, government securities and cash come with collateral related issues, too. Government securities such as bonds (and other types of bonds not issued by a government) bear a high valuation risk as their credit quality depends on the decision of the major American rating institutions (e. g. S&P, Moody’s etc. ). According a down-graded bond-rating will hurt the CT by making its collateral increasingly illiquid and thus less valuable in case of default (Curtis, 2010).

1 Problems with Cash Reinvestment In contrast to bonds which allocate interests, cash faces a reinvestment risk as it needs to be returned with a certain amount of interest earned (as agreed by the counterparties) at the end of the transaction. Consequently, the collateral receiver aims to reinvest the cash at a higher rate than the interest earned from the borrower to generate a positive delta by the end of the transaction. However, high revenues imply higher credit risk which makes cash re-investment very risky (Kreischer Miller, 2010: 5).

The receiver of cash collateral has two options to reinvest the cash, either by himself or through the use of the services offered by professional money managers. If a money manger reinvests the cash collateral, the collateral receiver faces a ‘re-risk’. That risk is associated with the lack of transparency the risks accepted by the money manager (Fabozzi, 1997: 199). Even through cash collateral is very popular among market participants because it offers the ‘inherent property of fungibility’ (ISDA, 2010c: 11). This favoured characteristic is at the same time a serious issue, too.

That is because cash collateral delivered to a CT or its custodian is effectively an unsecured claim on the CT, as it is difficult to segregate the cash on the balance sheet of the holder efficiently. This issue arises for traditional or ‘pure’ custodians as they ‘cannot track the interest on cash collateral on their traditional custodian legacy systems’ (SIFMA, 2007:2). This issue can be resolved only if the cash collateral is held with a third-party custodian in a segregated account. However, that assumes that the cash is not invested or re-used in another way and thus does not earn any interest.

If third-party custodians also offer the investment of segregated cash accounts, they invest only in low-yielding investments. As a possible solution to this problem, the custodian could invest the cash in a predefined set of instruments which most of the time should include money market fund shares. Under these circumstances, it is not clear if the CT has a security interest in the cash or in the money market fund shares. It might therefore be preferable to deliver the collateral directly in the form of a MMF (ISDA, 2010c:11).

Consequently, the following chapters first analyse, MMFs in general, then analyse in detail their possible use as collateral in general and particularly in OTC derivatives transactions. 4 Legal Foundation and Regulation The legal foundation supporting collateralization is the ISDA Master Agreement and the ISDA Credit Support Arrangement (CSA). Master agreements published by the International Swap and Derivatives Association (ISDA) aim to set common industry standards for OTC derivatives transactions and are compiled in a single agreement.

It consists of a set of complex documents, emphasizing the legal terms and conditions of the contract, including payments, termination of transactions, and collateral-related matters. Additional commercial terms that are subject to a certain transaction are set out in a confirmation that also forms a part of the Master Agreement (ISDA, 2010b: 9; Benhamou, 2010: 1). In addition, the provision of collateral with respect to different laws is covered by the ISDA credit support agreements (CDA). They cover the New York CDA and the English CDA (ISDA, 2010b: 17).

ISDA reports 171,879 collateral agreements by the end of 2010 in the OTC derivatives markets, of which 92% are ISDA agreements. 83% of all agreements are conducted on a bilateral basis, which constitutes an increase of 8% compared to the previous year (ISDA 2010a: 1). As already mentioned, the OTC derivatives markets have been predominantly unregulated as most transactions are neither standardised nor exchange traded and reported but rather agreed between and aligned to the needs of its counterparties, making it hard for policymakers or regulators to intervene.

However, the risks of the OTC derivatives transactions including the lack of transparency were highlighted by the 2008 financial crisis through the collapse of Lehman Bothers, the near collapse of Bear Sterns and the bailout of the American International Group (AIG). Consequently, the G20 leaders agreed on the European Market Infrastructure Regulation (EMIR)[11], which requires all standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms and cleared through central counterparties by the end of 2012.

In addition, OTC derivatives contracts have to be reported to trade depositories (EMIR, 2011: 1). As a result of EMIR all OTC derivative transactions are forced to use adequate collateral as CCPs generally require an initial margin in the form of collateral from its participants. This would imply a significant increase in the need for collateral, as 30% additional transactions would need to be collateralized. To cover outstanding credit exposure, approximately USD 644bn collateral would be required.

This additional value of collateral could be absorbed by means of the establishment of a new collateral asset class in the form of money market funds. That is why the following chapter analyses the possible use of money market funds as collateral, and considers regulatory and operational, but also general requirements. Money Market Funds as Financial Collateral This chapter focuses on the eligibility analysis of MMFs with respect to their use as financial collateral. To begin with, it is important to understand the financial instrument and to gain an insight into the European money market fund industry and its legal framework.

Consequently, this part begins with a general description of MMFs and clarifies the corresponding asset class and the regulatory framework, before moving on to an assessment of the specific characteristics of MMFs in terms of qualitative source of collateral. 1 General Description of Money Market Funds Money market funds are characterized as collective investment schemes that pool together the money invested by various individual investors and invest it in money market securities according to their investment strategies and objectives (Rothwell, 2007: 340).

Investors benefit from professional management, cost savings due to scale effects, diversification and efficient risk-return profiles (HM Revenue & Customs, 2010). A MMF is a special form of a mutual fund. A mutual fund is an ‘open-ended management company that establishes a portfolio of securities and then continually issues new shares and redeems already outstanding shares representing ownership in the portfolio’ (Hall, 2011: 15). Figure 9: Breakdown of UCITS Assets by Category Q1 2011 [pic]

Sources: Own illustration, data based on Efama, 2011b: 8 In Europe (cp. figure 9) most collective investment schemes are established in accordance with the UCITS (Undertakings for Collective Investment in Transferable Securities) directive. It sets a regulatory framework for cross-border distribution at a European level. UCITS funds are open ended funds, which are freely transferable and can be sold worldwide. UCITS funds have a restrictive investment policy and hence a high investor protection (EC, 2010a: 2).

The ECB defines money market funds as ‘Collective Investment Undertakings of which the units are, in terms of liquidity, close substitutes for deposits and which primarily invest in money market instruments and/or in money market funds shares/units and/or in other transferable debt instruments with a residual maturity of up to and including one year, and/or in bank deposits, and/or which pursue a rate of return that approaches the interest rates of money market instruments’ (CESR, 2009: 4). Overall, MMFs can be classified according to the following criteria:

• Taxable and tax- exempt MMFs • Institutional and retail MMFs • Stable and floating MMFs • Prime and treasury MMFs Taxable MMFs invest in bank obligations such as CD, in corporate debt and in other debentures traded between institutions whereby non-taxable MMFs invest in securities which are tax-exempt such as bonds or municipal notes (Hall, 2011: 44-45). Institutional MMFs require a high minimum investment. That is why individual investors primarily invest in retail MMFs as the minimum investment is lower.

Whether a funds share class is stable or floating depends on the calculation of the net asset value (NAV). This will be elaborated in the following chapter taking into account the specific risks of MMFs. MMFs can also be divided into prime and treasury funds. The latter invests in government debt only, whereas prime MMFs can invest in all money market securities. 1 Evolution Originally MMFs were designed for single investors which could not invest in money market securities directly, because of the high minimum denominations of money market debt securities.

By investing in a MMF instead, private investors benefit from diversification, because MMFs are large and therefore able to spread their investments over a large number of securities. The financial vehicle did not exist before 1972. One of the first MMFs was established in the U. S. and was named ‘The Reserve Fund’. This MMF created a loophole around Regulation Q in the U. S. This regulation limited the interest rates banks were allowed to pay on deposits. By investing in a MMF instead of using deposit accounts, single investors were able to obtain much higher interest rates (e. g. an average of 10. 29% for U.

S. MMFs in 1979 compared to average 5% for savings deposits) in the past. In 1981 U. S. MMF yields reached their peak earning more than 17% dividends for their shareholders whereas savings deposits had been permitted to yield 5. 25% (Donoghue, 1980: 67; Federal Reserve Bank, 1981:2). In contrast, regulations in Europe have always encouraged investors to use banks rather than MMFs (Corrigan 1984: 2, 6-7; Stigum, 1990: 1176). MMFs had been introduced some years later in Europe. France and Luxembourg were the first European countries introducing MMFs, mainly to speed up post-crisis recovery in the early 1980s.

The French government issued large amounts of short-term debt which was offered as tax-free investment to individuals through MMFs. Further MMFs were introduced to European investors through U. S. subsidiaries in Europe. Germany was the last country to introduce MMFs. Until 1994 the Bundesbank was able to prevent such competition for the German banking community (Baklanova, 2011: 9-10, 12). Figure 10: Worldwide Money Market Funds Net Assets [pic] Source: Own illustration, data based on ICI, 2010 In total, MMFs had grown constantly since their inception in the early 1970s.

At their peak in 2008, worldwide MMFs accounted for almost one third of the fund industry. As figure 10 illustrates, at the end of 2010, worldwide net MMF asset stood at USD 4,531bn according to the Investment Company Institute (ICI, 2011). MMFs are experiencing difficult times because of very low short-term interest rates. Key interest rates stood unchanged at 1% during the last two years, resulting in average IMMFA MMFs yields in 2010 of 0. 059% and 0. 028%. Consequently, many investors decided to shift their investments in MMFs into other asset classes in order to gain better returns.

In total UCITS MMFs suffered from a decline to approximately EUR 154bn in net sales (excluding Ireland) in 2010. The competition came mainly from banks that tried to strengthen their balance sheets by increasing the share of deposits. In the first quarter of 2011 the ECB slightly increased interest rates by 0. 25%. This increase positively affected UCITS MMFs, which experienced reduced net outflows of EUR 9bn in the first quarter of 2011(Efama, 2011a: 2; Efama, 2011b: 2, 7). The different historical development in Europe led to a broad diversity of European MMFs and thus different levels of acceptance (Baklanova, 2011: 12).

That is why the total number of assets has always been at a much lower level in Europe than in the U. S (Stigum, 1990: 1177). A first attempt to harmonize European MMFs was undertaken by the International Money Market Fund Association (IMMFA). IMMFA was established in 2000 with the aim of lobbying for regulatory changes, offering only high quality products to investors and educating the market. IMMFA represents the European triple-A MMF industry. In 2003 IMMFA’s ‘Code of Practice’ was published. It provides harmonized guidelines for portfolio management and operational aspects to its members (IMMFA, 2011: 6; IMMFA, 2011c).

2 Participants Over time, two major customer segments have emerged. The first segment represents retail or private investors which use MMFs in addition to their savings or deposit accounts. The second group is institutional investors. Figure 11 illustrates the distribution of European investors in MMFs. The majority (62%) of European investors in MMFs are institutional investors such as non-financial corporations, insurance corporations and pension funds as well as other institutional sectors. The remaining 38% are the retail investors which includes private households and non-profit institutions.

Figure 11: Euro Area Investors in MMFs [pic] Source: Own illustration, data based on ECB, 2011d In contrast average IMMFA fund investments by client type as illustrated in figure 12 show a much lower proportion of private investors. Approximately 94% of all investors in IMMFA MMFs are institutional ones. The largest share consists of corporations. Corporations can buy their shares directly or indirectly through intermediaries. Many treasuries of large companies have ‘outsourced’ cash management operations through the use of MMFs.

In addition they benefit from diversification, professional management, daily liquidity, safety and money market returns. Besides providing daily cash management, MMFs are very often a ‘parking place’ for cash until a better investment is found. However, when short-term interest rates are rising, MMFs are a better investment than bonds or stock, as MMFs invest in short-term debt securities and are therefore able to capture higher interest rates as soon as they are available (Macey, 2011: 8-9). Figure 12: Average IMMFA Fund Investment by Client Type [pic] Source: Own illustration, data based on IMMFA 2011a: 1

In general funds are created by fund promoters. The request to launch a specific fund in most cases comes from financial institutions such as banks, wealth managers or insurance companies. The creator of a fund, the fund promoter will search for partners and specialists to launch, to manage and to distribute the fund. In Luxembourg UCITS regulated funds must be set up with the Commission de Surveillance du Sector Financier (CSSF), the financial supervisory agency. Following its accreditation, the fund can be distributed to investors through different channels such as banks, independent intermediaries and asset managers.

The fund promoter will appoint a Transfer Agent (TA), which receives the orders for subscriptions (purchase of shares) and redemptions (sale of shares) and maintains the fund register of shareholders. Further general examples of participants in the running of a fund are custodian banks which safeguard the assets, the fund manager, which manages the fund’s assets, the fund accountant, and the domiciliation agent, which is responsible for administrative management and acts as official contact person liaising with regulatory issues (Alfi, 2011). 2 Market Overview The MMF market can be divided between Europe and the U.

S. , both sharing approximately 90% of the global MMF market, whereas Europe’s share forms one third of that. Within Europe the largest country is France (37%) followed by Luxembourg (25%) and Ireland (24%), holding more than three-quarters of MMF domiciliation (ICI 2011, IMMFA 2011: 5). Figure 13: UCITS Fund Assets Compared to IMMFA Funds in Billion Euros [pic] Sources: Own illustration, data based on Efama, 2011a; IMMFA, 2011b: 6 European UCITS MMF net assets (including Ireland) reached EUR 1,141bn in the first quarter of 2011, which represents a small decrease compared to EUR

1,182bn at the end of 2010 (cp. figure 13). IMMFA MMFs grown continuously representing 39% of the European MMFs in 2010. Approximately two thirds of all MMFs domiciled in Europe have a stable NAV, whereas one third has a fluctuating one (Efama, 2011a; IMMFA, 2011b: 6). MMFs invest into a broad range of money market instruments as described in chapter 2. IMMFA MMFs reported the following composition for June 2010 as illustrated in figure 14. With almost one-third of assets CDs represent the largest share, followed by Commercial Papers (CPs) and Asset Backed Commercial Papers (ABCPs).

This portfolio composition had changed significantly since 2005. At the end of 2005 CP and ABCP with (43%) and FRAs (24%) represented the largest shares. That shift in portfolio composition occurred mainly due to the decline of the ABCP market. The downturn in the U. S. real estate market led most investors to avoid ABCPs during the 2008 financial crisis and also afterwards (IMMFA, 2011b: 8). Figure 14: Portfolio Composition IMMFA Funds June 2010 [pic] Sources: Own illustration, data based on IMMFA, 2011b: 7

Looking at the players involved, JP Morgan is the largest institutional MMF provider followed by Black Rock and Fidelity as illustrated in Table 3 (next page). It is not surprising that the two largest MMF providers are U. S. fund promoters as the U. S. market is by far the largest. Almost all MMF providers offer MMFs in different currencies. The most common denominations are US Dollars, Pound Sterling and Euro. Table 3 also shows the differences described in the minimum investment between institutional and retail share classes. Lower yields might be explained through the specific investment strategy of the MMF.

MMFs investing in government securities are generally tax- exempt and most of the times earn lower yields. Investing in non-government debt such as CPs involves greater risks and will consequently obtain higher dividends for the MMF shareholders. Table 3: Worldwide Money Market Fund Rankings [pic] [pic] Sources: Own illustration, data based on i MoneyNet, 2011a, b 3 Share Valuation and Risks The value of a share in a mutual fund is called ‘Net Asset Value’ (NAV). It is the net value of all underlying assets divided by the number of shares outstanding.

The NAV therefore represents the price at which an investor can buy or sell the fund (Haslem, 2003: 3) When it comes to the net asset value (NAV) calculation of MMFs, a distinction is made between floating and stable NAV. A floating MMF marks its assets to market each day, whereas the stable NAV tries to maintain typically CUR 1,00 per share. Mark-to market accounting requires the MMF to reflect all changes in the value of its underlying securities on a daily basis. However, if the fund fails to update changes of its underlying securities, it will be either over- or undervalued.

In contrast, the stable NAV provides the following benefits to the investor: • tax convenience; • accounting simplicity; • operational convenience (ICI, 2010: 8). The most common method used to maintain a stable NAV is the amortized cost method. The precondition of this method is that MMF portfolio managers plan to hold each debt security till it matures and the full principal is paid back. Underlying securities are valued at acquisition cost and all interest earned is accrued constantly over the remaining maturity. The MMF declares this interest as daily dividends to its shareholders and is therefore able

to maintain a stable NAV. (Birdthistle, 2010: 1155-1156, Macey, 2011:7). MMFs are exposed to a broad range of risks that may cause the NAV to fall below or to exceed CUR 1. 00. For example an upward adjustment in the securities’ interest rates might reduce the value of the portfolio or assets held by the MMF. In addition, if the average maturity of the fund’s assets increases, it is likely that the NAV will vary, too. Despite the possibility of the NAV’s exceeding CUR 1. 00, the main danger is that the NAV may fall below its stable value (Macey, 2011: 8).

In order to limit liquidity risk; MMFs are required to hold minimum liquidity buffers. Just like any other participant in the money market, MMFs are also exposed to credit risk. However, as already mentioned, MMFs are large and able to diversify their investments to minimize the impact of credit risk. (Crouhy, 2006: 325). If the NAV of a MMF drops below CUR 1. 00, the fund said to ‘break the buck’. This failure happened only twice during 40 years history of MMFs. In 1994, the Community Bankers U. S. Government Fund was the first MMF which dropped below its stable USD 1. 00 value and returned 90 cents to its shareholders (Evans, 2007).

In 2008, the oldest U. S. MMF, the ‘Reserve Primary Fund’, broke the buck. The MMF had invested USD 785m in Lehman Brothers commercial papers. After Lehman Brothers went bankrupt it had to write off this investment and the shares dropped below USD 1. 00 and stood at 96 cents. Investors wanted to redeem shares, but the MMF could not comply with such a high number of redemptions; it had to introduce a seven-day block on large withdrawals and the Federal Government had to step in (Conaway, 2008). Those two incidents showed that MMFs are neither risk free, nor insured against losses.

Indeed, MMFs manage high quality and low risk debt securities and are characterized by their conservatism, but their promotion as ‘safe harbour’ and cash equivalents must be questioned (Birdthistle, 2010: 1159). Generally speaking, there is no guarantee that a MMF will actually maintain a stable share price. There is always the risk of losing some of the money invested, as with investments in equity or bonds directly. Even though losses in MMFs are rare, they are possible. As the yield depends on interests accrued by the underlying securities, dividends are variable and not known in advance to the investor.

Furthermore, MMFs are subject to inflation. MMFs offer lower return than riskier investments such as equity. That is why investors should always benchmark MMF- returns and risk profiles according other asset classes. 4 Regulatory Framework European MMFs generally fall under European Union legislation, the directive on Undertakings for Collective Investment in Transferable Securities (UCITS). UCITS funds are considered as robust and well-regulated product. However the UCITS directive does not define the scope of MMFs, nor does it mention MMFs specifically.

As previously described, the money market industry has established an association called IMMFA which represents the European triple-A rated industry. Members have to comply with the ‘Code of Practice’ that is based on Rule 2a-7. This rule of the Investment Company Act of 1940 defines and regulates MMFs in the U. S. The absence of a definition of MMFs in Europe-, has led to a wide range of different types of funds calling themselves MMFs. As 2008 showed, no investment should ever be considered safe. At the end of 2008 compared with August 2007, IMMFA MMFs have seen a significant growth in AuM.

The increase of more than EUR 72bn reflects investors need for transparency, clear, defined definitions and practice (EC, 2010a; IMMFA, 2010c). The Committee of European Securities Regulators (CESR) finally established guidelines for the definition of European money market funds which were implemented in July 2010. For the first time these guidelines have introduced restrictions on the type of fund that can be called MMF. CESR’s definition distinguishes between short-term money market funds with a weighted average maturity (WAM) of 60 days and money market funds with a WAM of 6 months (CESR 2009: 2).

The introduction of a definition was broadly welcomed by market participants and led to the positive side effect that short term bond funds were not allowed to call themselves MMFs anymore. Next to valuable benefits, experts regret that the definition lacks minimum liquidity standards that a fund needs to maintain overnight or on a weekly basis. In addition, the categorization and its terminology create some conflict with global standards. For example, a MMF under Rule 2a-7 or the IMMFA is considered a short-term MMF under CESR.

Market participants also call for a harmonization of terms across the industry (Treasury and Risk, 2011). 5 MMF Characteristics This part aims to summarize the characteristics of MMFs that have been mentioned in preceding sections. In chapter 3, eligible collateral was defined as ? legally watertight, valuable liquid property supporting a risk? (Harding 2002: 3). It was mentioned that MMFs can be liquidated at any time without any penalty for the investor. Due to the possibility of fast liquidation, investors can redeem shares at any point in time to convert shares into cash.

Consequently, MMFs provide investors with a continuous availability of their invested cash. This is possible because of a minimum liquidity that a fund is required to maintain. In addition to that, MMFs are easy to value as they are generally trying to keep a stable value. Floating MMFs calculate and publish their daily net asset value based on the current market value of their underlying securities. As a result, floating MMFs too can also be liquidated at any time. In addition, a MMF has to invest in high-quality short-term debt securities in accordance with its definition.

Because of that fact, it is possible for the MMF not only to maintain a stable NAV, but also to be classified as a very safe investment. MMFs offer a very good credit quality as they represent a minimum credit quality of A+[12] (IMMFA, 2010: 1). This high level of safety is also supported by the broad diversification of the underlying securities in which the MMF invests. Owned by the large size of a MMF and its various underlying securities, mistakes in some investments do not have serious consequences with regard to the stable NAV. The main goals of MMFs are not only safety but also capital preservation.

Consequently, in this context the investment yield is a secondary goal. The fund distributes (dividends paid out daily or monthly) or accumulates (dividends added to value of fund units) dividends at competitive money market rates to or for its investors (IMMFA website, 2011). Another characteristic not only of MMFs but also of funds in general is the clear possession right. As soon as an investor acquires some shares in a fund, he becomes a shareholder of the fund, which involves clear possession and enforceability rights, making the fund ‘legally waterproof’ as required by definition.

In addition, the fund segregates the investor’s assets in a separate ring-fenced account (IMMFA 2011d: 5). As a result the defining characteristics of MMFs can be summarized as follows: • easy liquidation; • easy valuation; • good credit quality; • money market returns in form of dividends; • clear possession rights. According to Harding’s abstract definition, MMFs seem to be assets that are eligible collaterals. Nevertheless, the following chapter focuses on a deeper analysis of the described characteristics that define eligible collateral.

Criteria to use MMFs as Collateral This chapter assesses if money market funds can or respectively could be used as collateral to secure financial transactions. For this reason, legal aspects and the impact of regulation, as well as operational requirements have to taken into account. 1 Regulatory Requirements for Collateral Receiver The money market involves a broad range of participants. Mutual funds, National Central Banks (NCBs), commercial banks and insurance companies are the most active players when it comes to collateral management.

Hence, depending on their activities, each market player is governed by different regulatory frameworks. As shown in Table 4, the jurisdiction is driven by the collateral receiver. Table 4: Overview of applicable regulatory framework [pic] Sources: Own illustration Banks Banks are regulated by the current Basel II guidelines released by ‘The Basel Committee of Banking Supervision’. Those guidelines aim to strengthen national banking supervision and risk management for the banking sector. The Basel regulation is most commonly known for its capital requirements. (BIS, 2011b).

A distinction can be made between the standardized (simple) and the comprehensive (internal rating based – IRB) approach. Banks require supervisory approval to use the IRB approach as it relies on well developed internal risk management and requires less regulatory capital (BIS, 2004: 27, 60). Basel II contains a list of eligible financial collateral[13] valid for the standardized approach. This includes cash, gold, debt securities, equities and UCITS funds, as well as mutual funds in general. According to this list, MMFs are eligible collateral if they fulfil the following criteria:

• quote and publish a daily price; • invest exclusively in assets on the list of eligible collateral. The comprehensive approach includes MMFs which invest in equities that are listed on recognized exchanges. In addition, a fund is allowed to use derivative instruments only in order to hedge investments listed as eligible collateral. In addition Basel II requires MMFs to apply the highest haircut applicable to any underlying security in which it invests (BIS, 2004: 31-33). The Basel regulation is always accompanied by the national law of the Member States in which it has to be implemented.

Final details concerning collateral eligibility criteria are established by the country in which the collateral receiver is domiciled. For example Luxembourgish domiciled collateral receiver are governed by the ‘Commission de Surveillance du Secteur Financier’ (CSSF) which is responsible for banking supervision in Luxembourg. The CSSF incorporates the Basel II regulation in its Circular 06/273 (CSSF, 2006: §30). This regulation adds further criteria for MMFs: • no correlation with the credit quality of the counterparty (§18); • not issued by the counterparty or any other related group or entity (§18);

• minimum maturity equals the mitigated risk exposure when applying the standardized approach (§20); • minimum historical data of one year for the calculation of haircuts for application of the comprehensive approach and internal model method (§ 102e). Another CSSF Circular 10/ 475 rules that MMFs are eligible only for the proportion they invest in Basel II eligible assets. Overall, the percentage of non-Basel II eligible assets cannot exceed 10% when the simple approach is applied, whereas the comprehensive approach is subject to that limit.

If MMFs are to be used as collateral, the collateral management policy must contain a conservative definition of the collateral as required by CSSF Circular 09/ 403 (CSSF, 2006, 2009, 2010). In general MMFs fulfil the required criteria. Because the market is liquid, money market funds can be sold quickly. MMFs have been designed to offer constant liquidity. That is why investors can redeem their shares at any moment without penalty. The constant or floating NAV, which is calculated on a daily basis, ensures that the fund can be sold at a robust price.

However, the request to launch a MMF originates most of the time with financial institutions which might be banks, wealth or asset managers etc. They have either manufactured their funds themselves or set up a dedicated fund management company (e. g. Deutsche Bank set up DWS). For collateral management purposes it means that, for example Deutsche Bank, would be able to use DWS MMFs as collateral giver in a financial transaction. That is because MMFs act as independent legal assets. A critical aspect considering MMFs as collateral is eligibility criteria for banks as collateral receiver.

In order to assess whether a MMF invests in Basel II eligible assets, the entire fund composition must be known. Therefore a complete ‘look through’ is required and that will be an operationally intensive and very complex assessment. In order to determine whether a MMF is allowed to invest in non-Basel II eligible assets, the fund prospectus needs to be checked. Banks can accept MMFs as collateral only for the percentage it invests in Basel II eligible assets. Moreover, the haircut calculation is very complex. For example a standard IMMFA MMF invests approximately 7% of all of its assets in derivative instruments such as FRA’s.

According to the Basel II regulation this would mean a reduction of 7% in terms of allowable value of the MMF. In establishing MMFs as a valid alternative to traditional asset classes, the haircut is an important instrument. The higher the haircut, the lower will be the possible acceptance of market participants as the value of the MMF posted, reduced by its haircut, would be disproportionate. All in all, Basel II eligibility criteria ‘look through’ and correlation in general are the most crucial criteria of the regulatory assessment.

UCITS Funds UCITS funds as collateral receiver fall under the EU legislation which encompasses ‘The Committee of European Securities Regulators’ (CESR)[14]. According to CESR 10/ 788 (2010: §1) collateral can be used to reduce counterparty risk if it fulfils the following criteria: • sufficient liquidity; • possibility for daily third-party valuation; • no correlation with the counterparty’s credit quality. In addition, European Commission Directive 2009/ 65 (EC, 2010b) requires sufficient diversification for MMFs being used as collateral.

In addition CSSF regulation distinguishes whether collateral is used in securities lending or in OTC derivative transactions. CSSF 08/ 356 (Section II B) determines criteria for MMFs as collateral that is received by a UCITS fund in the scope of securities lending: • daily NAV; • triple-A credit rating; • no correlation of the issuing entity and the counterparty (CSSF, 2008). MMFs received by a UCITS fund with the aim of reducing credit risk in OTC derivative transactions have to fulfil the following requirements (CSSF 07/ 308, Section III: 2. 3. 2b):

• valued at market price at a frequency equal to the NAV calculation of a UCITS fund; • compliance with the eligibility criteria laid down in CSSF 08/ 356 and CESR 10/ 788. The criteria for UCITS funds with regard to correlation are as strict as Basel II for banks, requiring no correlation between the counterparty’s credit quality and the value of collateral. In contrast, other regulations governing UCITS as collateral receiver is less strict than those for banks. According to the eligibility criteria required for UCITS collateral receiver, IMMFA MMFs would qualify for use as collateral as they offer the required triple-A rating.

Insurance Companies ‘The Committee of European Insurance and Occupational Pensions Supervisors’ (CEIOPS) has adopt legal advice (EC: 2011), also known as Solvency I regulation. CEIOPS DOC 26/09 accepts collateral as a risk mitigation technique (Chapter 3. 2, Section A, Advice 3. 52) and lists the following criteria for MMFs as collateral: • proper documentation of all possible risks arising from the collateral (Chapter 3. 2, Section D, Advice 3. 66); • on-going possibility to enforce the collateral (Chapter 3. 2, Section E, Principle 2, Advice 3. 74-76);

• sufficient liquidity (Chapter 3. 2, Section D, Principle 3, Advice 3. 83); • MMF has to be issued by entities rated better than BBB (Chapter 3. 2, Section D, Principle 4, Advice 3. 85); • no correlation with the counterparty’s credit quality (Chapter 3. 2, Section D, Principle 4, Advice 3. 90). This means for insurance companies that they would be able to accept MMF for collateral purposes. Regulation for insurance companies does not even indicate the nature of collateral that needs to be provided and therefore hypothetically includes all MMFs issued by an entity rated better than BBB.

ECB The European Central Bank defines three types of eligible collateral at central bank level in its ECB guidelines (2008: 11): • debt instruments; • credit claims; • retail mortgage backed debt instruments. During the crisis, central banks also accepted other forms as collateral. However that occurred only on an exceptional basis and central banks have started to retighten their eligibility criteria, again complying with the initial criteria (De Grauwe, 2011: 1-2). Consequently funds in general and MMFs too are not eligible collateral at central bank level.

Overall the different regulatory guidelines for banks, insurance companies and UCITS funds feature several similarities in collateral requirements and thus can be summarized into four fundamental categories as illustrated in Table 5 (next page). Table 5: Overview General Collateral Requirements Required by Regulation [pic] Sources: Own illustration 1 Impact of Future Regulation The latest financial crisis has led to much discussion on how to improve the current financial system with the overall target of avoiding a similar scenario in the future.

Consequently, new regulatory initiatives are being prepared to implement that goal. The most important new regulatory change is the Basel III framework, which must be fully implemented by financial institutions by 2019. Basel III modifies and enhances existing rules of collateralized exposure measurement. The main changes address the quality and quantity of capital and set global liquidity standards. Overall, total capital requirements reach 10. 5% including a fully loss absorbent contingent capital buffer. This may lead to cautious capital management and a limited

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