GLOBAL - The upcoming regulations in both Europe and the US for OTC derivatives will create a "significant" increase in demand for liquid, high-quality government securities resulting therefore in lower returns for the funds mandated to invest in these securities, a new report has warned. 

According to a study published by Moody's Investors Service, the Dodd-Frank Act in the US and the European Market Infrastructure Regulation (EMIR) in Europe - expected to come into effect before year-end - will lead to an increased demand of high rated government bonds, which receive the most favourable regulatory capital treatment and are eligible as collateral to meet initial margin calls under central clearing requirements.

Similarly, central counterparties (CCPs) often forego initial margins and sometimes waive collateralisation of current exposures for certain types of counterparties, including sovereigns and non-financial companies.

Such increased demand for government securities would likely exert further downward pressure on bond yields, coming in the wake of several sovereigns already seeing their borrowing costs falling into negative territory, Moody'swent on to say.

The downward pressure on yields could, in turn, lead bond funds to shift their asset allocation into riskier, lower credit-quality investments to seek higher yields, as they did in the first half of this year.

Another measure undertaken by bond funds with fewer constraints could lead portfolio managers to "slide down the credit curve" in the view to generate marginally higher yields within permitted investment parameters, according to the report.

This would compromise the overall credit quality of the bond fund's portfolio, Moody's warned.

Additionally, some liquidity constraints may arise in the future as the assets provided for the initial margin to CCPs could be immobilised because they are held in segregated custodian accounts that do not permit re-use of the securities.

"This could have the effect of removing the securities from the market for a prolonged period, potentially harming overall market liquidity," Moody's said.

The rating agency nonetheless conceded that the fact that market participants have started to adapt to the new rules has enabled the market to avoid any potential shock.

"The combination of central clearing and margins for uncleared trades on the demand for eligible collateral could have posed a significant shock to the market if they had been implemented over a shorter timeframe," Moody's said.

"However, market participants have begun to adapt to the new rules, albeit slowly, in anticipation of their full implementation at the end of the year."

The anticipated preparation of market players has therefore led to a $500bn (€401bn) raise in reported collateral use from 2010-11 alone, according to data from the International Swaps and Derivatives Association (ISDA).

"When the new rules finally become effective, the market could still see the demand for eligible collateral rising further, which will maintain downwards pressure on the yields of government securities," Moody's concluded.

See the September issue of IPE for a special report on OTC swaps regulation