Should Asset Segregation Do Double Duty?

I've been discussing comments on the SEC's proposed Rule 18f-4 in light of the SEC's initial regulation of derivatives in Release No. IC-10666 ("Release 10666"). As explained in my first post, the objectives of the proposed rule include limiting the "speculative character" of funds that use derivatives and assuring they have sufficient assets to cover their obligations. Release 10666 used one means, asset segregation, to achieve both ends. Several comment letters appear to question whether this approach is still tenable. Asset Segregation under Release 10666 For both firm and standby commitments (that is, futures, forwards and written puts), Release 10666 required segregation of "liquid assets equal in value to the purchase price due on the settlement date." "Liquid assets" included "cash, U.S. government securities or other appropriate high grade debt obligations." A commitment to deliver a security not held by the fund would be a short sale, requiring segregation "equal to the difference between (a) the market value of the securities sold short at the time they were sold short and (b) any cash or U.S. government securities required to be deposited as collateral … in connection with the short sale …." Release No. IC-7221, cited in footnote 15 of Release 10666. Hitting Both Birds "Liquid assets" as defined by Release 10666 were low volatility assets—at least as compared to publicly traded stocks. By requiring segregation of the full purchase price or market value of the underlying asset, Release 10666 forced a fund using derivatives to devote part of its portfolio to low volatility assets. The more a fund used derivatives (which might increase its speculative character), the more low volatility assets the fund must hold (which would dampen its speculative character). Insofar as the segregated assets were liquid, the fund could sell them to raise the cash required to pay the purchase price or acquire the asset underlying the derivative. Thus, segregation also created a reserve from which the fund could meet its obligations with respect to derivatives. Still Trying to Do Double Duty Proposed Rule 18f-4 would limit a fund's exposure to senior securities transactions. "Senior security transactions" include derivative transactions, financial commitment transactions, traditional borrowings and (for closed-end funds) preferred stock. A fund's exposure to senior security transactions would be limited to either 150% or 300% of its net assets. A fund could exceed the 150% limit only if its use of derivatives reduced its value-at-risk.

[T]hese portfolio limitations are designed primarily to address the undue speculation concern expressed in section 1(b)(7) by imposing an overall limit on the amount of exposure to underlying reference assets, and potential leverage, that a fund would be able to obtain through derivatives and other senior securities transactions.

This requirement is designed to address the asset sufficiency concern reflected in section 1(b)(8) of the Act… [and also] help to address the undue speculation concern reflected in section 1(b)(7) ….