OREANDA-NEWS. The UK's vote to leave the EU may create material medium-term challenges for sterling-denominated money market funds (MMFs) in terms of regulation and the supply of high-quality short-term debt, Fitch Ratings says. In the near term, however, money funds have been relatively stable with no material referendum-related flows following the vote.

Adverse funding conditions for non-UK issuers could have a significant impact on supply for sterling MMFs. If swap rates are unattractive, non-UK issuers may reduce funding in sterling. Non-UK banks have been highly active sterling issuers, led by French, Japanese and Australian banks (representing 12.5%, 10.4% and 8.5%, respectively, of Fitch-rated sterling MMF exposures). A reduction in their market presence could severely impair sterling funds' ability to construct highly rated, diversified portfolios. The already low yields at these funds would probably come under further pressure as exposure to sovereign debt would rise.

This effect could be mitigated where banks fund local UK operations in the sterling market, rather than as part of a global programme. However, demand for sterling funding of local operations may fall if banks shift operations out of the UK into the EU.

The universe of UK issuers for sterling money funds is limited since many UK banks have short-term ratings below the minimum level required by the funds. Average exposure to UK banks across the Fitch-rated sterling MMF portfolio was only 6.5% as of mid-June. These banks' ratings are resilient to a moderate deterioration in the operating environment and the UK sovereign rating is not a constraining factor for any UK bank ratings. But if material adverse developments did affect UK bank ratings, this could further reduce supply for MMFs.

Brexit also poses considerable uncertainty for the presence and role of offshore funds in the UK. The vast majority of sterling money funds are either domiciled in Luxembourg or Ireland. It is uncertain whether they will be able to continue passporting (access enabled by EU regulation) into the UK following an eventual departure from the EU.

The key challenge funds face in the short term is the management of overnight and one-week liquidity in the event of material outflows. Sterling money funds had overnight liquidity of 32% and one-week liquidity of 42% on average as at mid-June. This was high relative to typical levels and to our criteria for a 'AAAmmf' rating of 10% minimum in securities maturing overnight and 30% maturing within one week. Overnight liquidity in particular, increased from 27% at end-May. We actively monitor liquidity risk as a core element of our rating criteria.

Flows in Fitch-rated sterling-denominated funds were muted during the week running up to the vote. We have not detected any unusual outflows since and, if anything, we expect to see some near-term inflows as part of the wider safe-haven seeking activity. This could increase overnight liquidity until this new money is invested. On the other hand, month-, quarter - and year-ends typically see outflows as part of routine corporate activity, which may offset safe-haven-seeking inflows.

Funds with high levels of overnight and one-week liquidity face the imminent challenge of re-investing as assets rapidly mature. Quarter-ends typically see materially reduced supply, which may challenge funds' ability to diversify effectively. Government supply will be an important factor in mitigating any supply constraints.