Potential issues include fund leverage, diversification, portfolio concentration and valuation.

The Securities and Exchange Commission has kicked its probe of derivatives use by mutual funds into high gear, issuing a concept release and requesting comments on a wide range of issues relevant to the use of derivatives by funds.

These include potential issues for fund leverage, diversification, exposure to securities-related issues, portfolio concentration, and valuation.

The SEC has been conducting a review of derivatives by funds under the Investment Company Act since early 2010, during which time it has explored current market practices involving derivatives are consistent with provisions of the Investment Company Act, and whether funds that rely substantially upon derivatives, particularly those that seek to provide leveraged returns, have adequate risk management procedures in place.

It’s also examining whether existing rules sufficiently address procedures for a fund’s pricing and liquidity determination regarding its derivatives holdings, and whether funds’ derivative activities should be subject to special reporting requirements.

While acknowledging that the use of derivatives by funds is not a new phenomenon, the SEC says that it’s an opportune time to examine their use given the risks associated with the derivative instruments underlying many funds.

A fund that invests in derivatives must take into account various provisions of the Investment Company Act, including leverage limitations, which govern the extent to which a fund may issue senior securities.

A fund’s use of derivatives may also raise issues under the Act’s provisions governing diversification, concentration, investing in securities-related issuers, valuation, and accounting and financial statement reporting.

The SEC and CFTC are deep into the process of implementing rules to implement provisions under the Dodd-Frank Act related to OTC derivatives, including execution, clearing, and reporting.

While the SECs review of derivatives use by mutual funds appears to be taking place in parallel with its Dodd-Frank work, questions are bound to arise over whether the two projects will intersect.

“The SEC focus on whether derivatives can be used to acquire leverage also coincides with a separate, global initiative to expand the regulatory perimeter to the shadow banking sector,” Barbara Matthews, managing director at BCM International Regulatory Analytics, told Markets Media. “It also coincides with regulatory and risk management efforts to limit the amount of leverage provided by some funds to the European banking sector.”

The Investment Company Institute has weighed in on the Commodities Futures Trading Commission’s opposed rules regarding the appropriate model for protecting margin collateral posted by customers for cleared swaps transactions.

In a letter sent in August, the ICI said it favors a model known as “legally separate but operationally commingled, or LSOC, as the most appropriate model. It also said that a “full physical segregation model” would potentially provide maximum protection for customer collateral, and is the most consistent with current OTC market practice where funds post initial margin for OTC swap transactions in individual, segregated accounts at third-party custodians.

However, the ICI noted, the full physical segregation model would likely entail significant operational and infrastructure costs, including the establishment of multiple customer accounts at each clearing organization, FCM, and settlement bank, across all asset classes. Hence, it favored the LSCO model.

Eurex Clearing’s Individual Clearing model enables full legal and operational segregation of all assets (positions and margin collateral) for its non-clearing members (clients with trading admission) at the clearing house level.

Through the service, Eurex Clearing aims to fulfill the planned regulatory requirements as specified in the published draft versions of European Market Infrastructure Regulation.

The Eurex service will be offered in addition to the existing Eurex Clearing model. Eurex Clearing will also launch an Omnibus Model, offering segregation of client assets in an omnibus account with higher operational efficiency and flexibility for the clearing member.