Modern financial markets are a finely woven tapestry of market makers, investment products and vehicles, and investors with diverse expectations and risk appetites.  Holding the whole thing together is a structure of rules and regulations. Altering this intricate weaving is always fraught with risk, and tugging on one thread may unravel another. The Securities and Exchange Commission’s recent liquidity and derivatives rule proposals for mutual funds and ETFs may have set the stage for a major unraveling.  The combination of these two proposals, if implemented as currently written, may unintentionally create conditions that would drive investors from ETFs toward riskier and less well-regulated exchange traded notes (ETNs).  

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.