OREANDA-NEWS. US money market fund reforms that take effect from 14 October will help improve diversification and boost yields for US dollar-denominated MMFs in Europe, Fitch Ratings says. This will drive further divergence with euro-denominated funds, where yields are still negative.

The new US regime requires the net asset value of institutional prime funds, which hold corporate and bank debt, to be allowed to float freely and allows for the introduction of withdrawal fees or redemption suspensions (gates) when liquidity, a key part of Fitch's rating criteria, drops below certain thresholds. Most MMF investors want to be able to withdraw their money at par at any time, so this has driven a significant shift away from US prime MMFs into government MMFs that solely invest in treasuries and other government securities. Government MMFs are allowed to continue operating with a constant net asset value and do not face the risk of liquidity fees or gates.

Around USD949bn has moved out of prime US MMFs and USD1.02trn has been pumped into government MMFs in the last 12 months.

The knock-on effect of the big drop in demand for short-term corporate and bank debt is a rise in short-term borrowing costs for these issuers. This will help support yields for US dollar-denominated money market funds domiciled in Europe, as these can continue to buy prime securities discarded by US MMFs. The one-year US dollar LIBOR rate had risen to 1.56% at end-September from 1.17% at the start of the year and the overnight rate edged up to 0.42% from 0.37%. In contrast, the one-year EURIBOR rate dropped to -0.06% from 0.06% in early 2016.

The shrinking of the US prime MMF sector should also help improve diversification for Europe-domiciled US dollar funds as issuers that have accessed onshore dollar funding increasingly look offshore. Canadian, Australian and Japanese banks are among the issuers that may target Europe-domiciled US dollar MMFs for their short-term dollar funding to replace MMF funding sources lost in the US.

We do not expect significant inflows into Europe-domiciled dollar MMFs from investors switching out of onshore dollar MMFs because of tax and accounting constraints on the ability of large corporate investors to move money offshore.

In the longer term, European authorities are planning to introduce their own MMF reforms along the same lines as the US changes. This could further shake up demand for short-term dollar and euro corporate and bank debt. But we expect the impact of any reform to be smaller than in the US because the current European plans, if enacted, include a new intermediate fund structure that would still be able to hold non-government debt and that investors accustomed to constant net asset value funds may be more comfortable with. Liquidity fees and withdrawal gates would also apply to government constant net asset value funds under the European proposals, which might make these funds less attractive to investors.