The Securities and Exchange Commission has announced that it will hold hearings on December 11 to “consider whether to propose a new rule and amendments to certain proposed forms related to the use of derivatives by registered investment companies and business development companies.” This move is not unexpected as the SEC has long been concerned with how funds’ use of derivatives might affect compliance with leverage restrictions, and raise issues with fund portfolio diversification, concentration, and valuation. In 2011, the SEC issued a concept release seeking input on these very issues.
The Investment Company Act of 1940 and SEC rules permit mutual funds to use derivatives for a number of purposes including: seeking higher returns through increased investment exposures; hedging interest rate, credit, currency, and other risks; accessing particular markets; and to take advantage of transaction efficiencies. Derivatives carry with them, however, risks associated with leverage, illiquidity, and counterparties. The dramatic growth in the volume and complexity of the derivatives markets over the past two decades coupled with the increased use of derivatives by certain funds has raised concerns that the existing regulatory framework governing funds’ use of derivatives may not sufficiently address the risks associated with these instruments, and consequently may not provide adequate investor protections.
Last December, Chairman Mary Jo White announced that these new rule proposals were in the works, saying: "Derivatives can pose a separate set of risks. The use of derivatives by registered funds has grown significantly in recent years, and many funds are using derivatives in increasingly complex ways. While funds often use derivatives to manage risks or to more efficiently adjust exposure to a market, sector or security, these instruments also frequently result in leveraged investment exposures and potential future obligations that can create risks for the funds."
“[T]he staff is considering whether broad risk management programs should be required for mutual funds and ETFs to address the risks related to their liquidity and derivatives use, as well as measures to ensure the Commission’s comprehensive oversight of those programs. The staff is also reviewing options for specific requirements, such as updated liquidity standards, disclosures of liquidity risks, or measures to appropriately limit the leverage created by a fund’s use of derivatives.”