Bond funds could be squeezed by new financial reforms

Move to increase transparency means that traders will have to put up more capital on margin

Jul 19, 2010 @ 9:10 am

Fixed-income fund managers likely will face heightened margin requirements when trading privately negotiated derivatives under the new financial services reform bill.

The bill, which was passed by the Senate yesterday, requires that privately negotiated derivatives — such as credit default swaps — be traded on a central clearinghouse or exchange to provide transparency on pricing to investors. As a result, those that trade these derivatives such as fixed-income fund managers will be forced to put up more capital on margin, said Matthew K. Kerfoot, an attorney at Dechert LLP.

“Often banks today would take the view that it’s a mutual fund, so they don’t have to post collateral” in these transactions, he said.

However, with a centralized exchange, funds will be required to meet a standard margin requirement.

“The bottom line is that there could be heightened margin requirements, which would mean less risk and [lower] returns on the funds,” Mr. Kerfoot said.

Additionally, the creation of the exchange might limit liquidity and availability of these derivatives and thus could end up raising the costs, he said.

“The costs involved in putting a trade on an exchange will be substantial, and having a limited number of counterparties on an exchange may have the ironic effect of increasing costs and at the same time decreasing liquidity,” Mr. Kerfoot said.

Attorneys are talking to fund clients about this possibility but said that it is too early to tell how it will be resolved.

“It could affect returns,” said Barry Barbash, a partner in the law firm Willkie Farr & Gallagher LLP and a former director of the Securities and Exchange Commission's Division of Investment Management. “I think it’s more of an operational issue that will require changing up some systems.”

If the new rules do diminish returns of fixed-income funds, “at least there will be transparency,” said Jane Stafford, a principal at Stafford Law Firm LLC.

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