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A recurring shortage of overnight deposit and repo facilities around year-end will leave European money market funds increasingly dependent on custodian banks for managing their liquidity, which will come at a cost to fund yields, Fitch Ratings says.
Supply from the banking sector has been declining for the last three years due to regulations that discourage them from taking on short-term deposits and repos. But the shortage is particularly acute at year-end, when banks report their liquidity coverage ratios. Our discussions with MMF managers suggest this year-end may be the toughest yet and many money market funds are therefore likely to leave large sums un-invested with their custodian banks.
The fees for this service are likely to be high. One manager said they would have to pay 100 basis points on euro funds deposited at their custodian, compared to the overnight Euribor rate of minus 0.35% as of mid-December 2016. Money may only be left with custodian banks for a short time, but the associated cost will further reduce the already ultra-low yields generated by these funds.
European money funds can keep up to 20% of their assets un-invested with a custodian bank under the UCITS fund regulation framework. Fitch's rating criteria recognise that custody cash balances may temporarily increase to high levels. But the money is ring-fenced under the UCITS V directive and the funds are therefore not directly exposed to the credit risk of the custodian bank.
Money funds will take other steps to offset the shortage in year-end bank supply, including increasing their allocation to sovereigns, supranationals and agencies (SSAs). The high credit quality and liquidity of the SSA sector means this shift is likely to be positive for money funds' credit profiles. Managers will also attempt to buy longer-dated money market securities to see them through the year-end, but their availability may also be limited and pricing for those available may be unattractive.
These challenges will be greatest for euro- and sterling-denominated funds. Dollar-denominated European funds should have a much smoother ride because of the recent US money fund reforms, which drove a massive shift out of prime and into government funds. This has shaken up the supply-demand dynamics for short-term non-government debt and means year-end shortages should be less severe.
