On Friday, December 11, as previously announced, the SEC voted to propose a new rule regarding the use of derivatives by mutual funds, closed-end funds, ETFs, and business development companies. Since as far back as the 1990s under Chairman Aurthur Levitt, the SEC has been concerned about the multitude of risks derivatives can raise for funds, including risks related to leverage and liquidity. But, with the dramatic growth in the volume and complexity of the derivatives markets over the past two decades and the increased use of derivatives by certain funds, the risks to funds and the associated investor protection concerns are now significantly greater.
Mutual funds invest in a variety of derivatives for a wide range of purposes, including to increase leverage to boost returns, gain access to certain markets, achieve greater transaction efficiency, and hedge interest rate, credit, and other risks. However, the 1940 Act regulatory scheme governing what derivatives mutual funds may use, as well as how and the extent to which they use them has not kept up with funds' investment and risk management strategies. Nor has it kept up with the wide array of derivatives developed in the marketplace and the risks associated with their use.
The 420-page proposal is a recognition that the existing framework under the Investment Company Act (the “Act”) is outdated, and with this proposal the SEC is seeking to bring regulation of funds’ use of derivatives into the 21st Century. According to Chairman Mary Jo White, the “proposal is designed to modernize the regulation of funds’ use of derivatives and safeguard both investors and our financial system.” This new rule is intended to address those concerns at least in part by requiring funds to monitor and manage derivatives-related risks and to provide limits on their use.
New Rule 18-f4
The proposal includes a new rule 18f-4, which is intended to address the SEC’s investor protection concerns underlying the existing regulatory framework and to provide an updated and more comprehensive approach to the regulation of funds’ use of derivatives transactions. Proposed rule 18f-4 provides a safe harbor by which funds may enter into derivatives and financial commitment transactions, notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18 of the Act, provided that the fund complies with one of two alternative portfolio limitations designed to curtail the amount of leverage the fund may obtain through derivatives and certain other transactions, segregates assets to manage liquidity risks, and institutes a derivative risk management program.
The two alternative portfolio leverage limitations are:
- Exposure-Based Portfolio Limit: A fund would be required to limit its aggregate exposure to 150 percent of the fund’s net assets. A fund’s “exposure” generally would be calculated as the aggregate notional amount of its derivatives transactions, together with its obligations under financial commitment transactions and certain other transactions.
- Risk-Based Portfolio Limit: A fund would be permitted to obtain exposure up to 300 percent of the fund’s net assets, provided that the fund satisfies a risk-based test (based on value-at-risk). This test is designed to determine whether the fund’s derivatives transactions, in aggregate, result in a fund portfolio that is subject to less market risk than if the fund did not use derivatives.
Liquidity Risk Management and “Financial Commitment Transactions"
A key aspect of the the proposal’s modernization of the regulation of funds’ use of derivatives also addresses funds’ use of certain financial commitment transactions, such as reverse repurchase agreements and short sales, by allowing funds to enter into these transactions provided they segregate certain assets to cover their obligations under such transactions. Funds wishing to enter into derivatives transactions, including financial commitment transactions, would be required to manage the liquidity risks associated with their derivatives transactions by segregating certain assets in an amount designed to enable the fund to meet its obligations, including under stressed conditions. A fund would be required to segregate cash and cash equivalents equal to the sum of two amounts:
- Mark-to-Market Coverage Amount: A fund would be required to segregate assets equal to the amount that the fund would pay if the fund exited the derivatives transaction at the time of the determination.
- Risk-Based Coverage Amount: A fund also would be required to segregate an additional risk-based coverage amount representing a reasonable estimate of the potential amount the fund would pay if the fund exited the derivatives transaction under stressed conditions.
Derivatives Risk Management
While all funds engaging in any derivatives transactions would be required under the proposed rules to create a formalized derivatives risk management program, a fund that engages in more than a limited amount of derivatives transactions or that uses complex derivatives would also be required to engage a qualified derivatives risk manager. This risk program as well as the appointment of derivatives risk manager would have to be approved by the fund’s board of directors.
A Dissenting Vote
The proposal was approved by a 3 to 1 vote, with Commissioner Piwowar dissenting. While still expressing “strong support for Commission action in this area,” Commissioner Piwowar stated that there was no need for a new, 150 percent cap on leverage because the SEC’s collateral requirements already limit how much exposure a fund can have to derivatives. In addition, Piwowar felt that this proposal was issued prematurely, and that the Commission should wait to review data received from its reporting modernization and liquidity risk management proposals before moving forward with the derivatives reforms. He also stressed that work remains to be done on the Dodd-Frank Act mandate to regulate the over-the-counter derivatives marketplace, and this work should be completed before imposing new restrictions on funds’ use of derivatives:
"[T]he Proposing Release we are voting on today repeatedly states that the new rule is necessary, in part, because of the dramatic growth in the volume and complexity of the derivatives markets over the past two decades. The release also notes that funds’ use of complex over-the-counter derivatives in particular entail risks. However, other regulatory action is already seeking to address some of these issues. Title VII of the Dodd-Frank Act established a new oversight regime for the over-the-counter derivatives marketplace. The Title VII framework is designed to reduce risk, increase transparency, and promote market integrity within the financial system. Both the Commission and Commodity Futures Trading Commission (“CFTC”) are currently working to implement this new mandate. While the CFTC has completed its rulemakings, the Commission has still not adopted the bulk of its rules under Title VII. The notion of good government suggests that we first complete the Title VII rulemakings and study the rules’ effectiveness before proposing comprehensive new requirements governing funds’ use of derivatives."
These rules, if adopted, could have significant effects on ETFs which rely on derivatives like forwards, futures, options, and swaps to meet or beat their index. These funds, which will either have to curb their use of derivatives or build larger cash buffers to comply with the proposed rules, will no doubt be amongst the most vocal commenters on the proposal.
Comments on the proposal will be due 90 days after publication of the the release in the Federal Register.
 Under current SEC rules, funds may pledge almost any type of liquid security as collateral to cover just the daily gain or loss for many types of derivatives contracts, creating the risk that a fund’s collateral could decline in market value at the same time it realizes losses on derivatives.
 The proposal defines “financial commitment transaction” as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement. Current SEC guidance treats these kinds of transactions as “senior securities” under Section 18 of the Act, and generally prohibits their use by mutual funds.