Cash equivalents for EU investors

Cash equivalents
In the investment world, we speak of cash as a collection of short-term investment instruments that are highly liquid and easily converted into ready cash. These investments make up the money markets. The short-term nature of all money market instruments means that they rapidly adjust to changes in short term interest rates. Cash includes familiar bank instruments such as transaction and savings accounts, as well as short term bank certificates of deposit (CDs). Cash also includes a number of marketable liquid securities bought and sold on the money markets. These securities include treasury bills, institutional large bank CDs, commercial paper, bankers acceptances, and repos. Short term municipal securities are held by tax-exempt money funds. Cash investments are held by investors for a number of reasons, primarily as liquid emergency reserves and for funding obligations due in the short to intermediate term.

There are some differences between the various cash instruments in the different world regions. The US system is undoubtedly the most developed and offers the greatest number of options to the retail investor. In non US regions the picture is quite different and varied. In this section we will look at the options available and their relevance to the retail investor in the EU.

The assets available for retail investors in the EU as alternatives to bank deposit accounts require careful consideration before any decision to invest is made, some of these assets are not widely available for retail investors such as money market funds, and advice from a qualified and certified adviser should be sought. Although generally these investment assets such as money market funds, short term bonds and ultra short term bonds have reduced risk levels over other assets such as equities and long term bonds, they retain capital loss risks.

The purchase of cash equivalents such as certificates of deposit or short term bonds is assumed to take the form of a purchase of the equivalent fund, i.e. a short term bond fund etc. The direct purchase of these assets is not considered here.

Bank accounts
It is not the purpose of this article to discuss the various bank account solutions that are available to EU investors. The different jurisdictions (28 nations) and the various banking systems across the EU are too disparate to be described here, a separate study will need to be carried out which may best be based upon a country by country approach. However it is worth noting that the deposit guarantee system in the EU is not comprehensive and for investors with larger sums held in cash the bank guarantee system is inadequate especially where a lower risk level is desired. See note below on deposit guarantee system for EU which will lead investors to seek alternatives.

US Deposit Guarantee System
In the US the FDIC (Federal Deposit Insurance Corporation ) system operates so as to provide a significant protection to ordinary investors for their deposits. The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.

EU Deposit Guarantee System
In the EU there is a similar system which however is much less generous and is confined to participating banks providing a €100,000 deposit guarantee per depositor per bank. This situation results in significant deposit risks for an EU retail investor who wishes to hold readily accessible and secure "cash" amounts over €100,000. The Deposit Guarantee Schemes (DGS) reimburse a limited amount to compensate depositors whose bank has failed. A fundamental principle underlying DGS is that they are funded entirely by banks, and that no taxpayer funds are used.

Under EU rules, deposit guarantee schemes seek to:


 * protect depositors' savings by guaranteeing deposits of up to €100,000
 * help prevent the mass withdrawal of deposits in the case of bank failure, which can create financial instability

In 2014, the EU adopted Directive 2014/49/EU. It requires EU countries to introduce laws setting up at least 1 DGS that all banks must join. EU countries must


 * ensure a harmonised level of protection for depositors
 * produce lists of the types of deposits that are protected

Cyprus "haircut"
The degree of deposit protection is dependent upon the regulations introduced on a country by country basis within the EU. The threat to investors deposits in EU country banks is not theoretical, in the period of 2012 - 2014 in Cyprus The ‘Troika’ of creditors agreed the final deposit levy on Cypriot accounts was to be 47.5% for shareholders, bondholders, and depositors with more than €100,000 in the two largest Cypriot banks. The "Troika" is the European Commission (EC), the European Central Bank (ECB) and the International Monetary Fund (IMF).

The levies placed on large depositors were used as equity to recapitalize the bank, following a decision reached in March 2013 as part of the bailout package for Cyprus.

As a condition for receiving a $13 billion (€10 billion) bailout package, Cyprus was forced by Troika lenders to sponsor a portion of their bailout, which they raised by levying shareholders, bondholders, and depositors with more than €100,000 in accounts. Therefore for investors wanting to hold substantial cash amounts for whatever reason, it is essential to manage the cash instruments so as to avoid deposit compromise.

Money markets
The money market is where financial instruments with high liquidity and very short maturities are traded. It is used by participants as a means for borrowing and lending in the short term, with maturities that usually range from overnight to just under a year. Among the most common money market instruments are eurodollar deposits, negotiable certificates of deposit (CDs), banker's acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).

Money market transactions are wholesale, meaning that they are for large denominations and take place between financial institutions and companies rather than individuals. Money market funds offer individuals the opportunity to invest smaller amounts in these assets.

Money market funds
A Money Market Fund is a type of mutual fund.

MMFs issue shares to investors to finance their activities, offering a high degree of liquidity, diversification and market-based yields.

The value of their shares fluctuates in line with the price of the debt instruments in which they have invested. They have to maintain a high level of asset liquidity to be able to meet daily redemptions by their investors.

There are three types of MMF available in the EU, these are:


 * Treasury bills
 * Commercial papers
 * Certificates of deposit

These MMF's are further categorised by their risk profile into:


 * Public debt constant net asset value
 * Low volatility net asset value
 * Variable net asset value

These funds are managed by asset managers who are either controlled by banks or by independent entities. The expenses associated with these funds can vary widely from asset manager to asset manager. Some funds require entry premia and the expense ratio should be carefully checked in all cases.

The MMF's in the EU are mainly used by institutions and large corporate bodies to place shorter term cash. Individual investors can purchase money market ETF's through online platforms and through financial advisers. A selection of MMF's are shown in the following table:

EU money market regulation changes
The regulatory regime for MMFs is currently undergoing signiﬁcant change due to the implementation of the EU Money Market Fund Regulation (MMFR) which applies from 21 July 2018. Existing MMFs benefit from an 18-month transitional period and are required to comply by 21 January 2019. Under the MMFR, an MMF may be established as:


 * a Public Debt CNAV MMF;


 * a Low Volatility NAV (LVNAV) MMF; or


 * a variable NAV (VNAV) MMF.

The Public Debt CNAV MMF will value assets under the amortised cost accounting methodology and must invest 99.5% of its assets in government backed securities.

The LVNAV is permitted to use amortised cost accounting to value assets that have a residual maturity up to 75 days, while other assets must be valued at mark-to-market/mark-to-model. The LVNAV may display a stable share price per unit/share as long as this does not deviate by more than 20 bps from the price per unit/share as calculated under the mark-to-market/mark-to-model methodology.

Alternatives to money market funds for EU investors
For those EU investors looking for alternative assets with reduced levels of risk to hold cash, there are alternatives that may be appropriate other than bank deposit accounts and money market funds. This approach may be salient for retail investors who wish to reduce their risk exposure and at the same time to avoid any possibility of capital loss through bank haircuts. In addition the use of these assets can be part of an investors process of holding capital prior to investing. Short term bonds and ultra short term bonds may be worthwhile evaluating albeit there are risks attached to holding these assets which could lead to loss of capital. There are a number of considerations when contemplating investing in short term or ultra short term bonds:


 * Home currency and hedging
 * Sterling investors may consider gilts preferable
 * Tax status of home country may affect the choice of accumulating or distributing versions if they exist
 * Low return rates of some bonds including negative returns
 * The risk profile of government bonds and corporate bonds
 * Alternative local fund options that may be available in some individual countries
 * Pension fund options where they exist and offer simplicity and tax efficiency

Short term bonds
Investors looking for capital preservation try to focus their portfolio allocations on minimal-risk investment options, including cash, money markets, certificates of deposit (CDs) and bonds. Short-term bonds fall on the safer end of the debt risk spectrum due to their short duration and near-cash status. A shorter duration or maturity date leads to less credit risk and less interest rate risk. The choice of bond will affect the risk level, with government treasuries presenting less risk than corporate bonds. Some short term bond funds that are available to retail investors are listed in the table below:

Ultra short term bonds
Ultra-short term bond funds are bond funds that invest only in fixed-income instruments with very short-term maturities. An ultra-short bond fund will ideally invest in instruments with maturities up to around one year. This investing strategy tends to offer higher yields than money market instruments, with fewer price fluctuations than a typical short-term fund. It is important to note that ultra short term bonds are not money market funds and are not subject to the special regulatory requirements (including maturity and credit quality constraints) designed to enable money market funds to maintain a stable share price.

Ultra-short term bond funds give investors more significant protection against interest rate risk than longer-term bond investments. As noted above ultra short term bonds are normally more risky than money market instruments, this is in part due to the fact that money market funds generally are required to invest in specific assets including government debt, corporate debt, while ultra short term bond managers have a wider remit and are not subject to the same regulations as money market funds.

Suggested suite of cash equivalents for EU retail investors
An EU investor looking to hold a cash equivalent might consider using one or a combination of funds from the above asset categories. The following table shows a short list of possible candidates for a range of cash equivalent funds. Considerations include:


 * Expenses
 * Hedging to home currency
 * Check for "hidden" charges such as exit premia
 * The funds may be negative

These funds are provided by reputable managers and have reasonable expenses without entry or exit premia: