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SEC Proposes Limited Use of Derivatives by Registered Funds
Practical Law Legal Update w-001-0726 (Approx. 4 pages)
SEC Proposes Limited Use of Derivatives by Registered Funds
by Practical Law Finance
| Published on 16 Dec 2015 • USA (National/Federal) |
The SEC proposed a new rule which would allow SEC-registered investment companies (RICs) to enter into derivatives transactions provided they comply with one of two portfolio-limitation regimes.
On December 11, 2015, the SEC announced proposed rule 18f-4, designed to permit limited use of derivatives by SEC-registered investment companies (RICs), which are funds that include:
- Mutual funds.
- Exchange-traded funds.
- Closed-end funds.
- Business development companies (BDCs).
Section 18 of the Investment Company Act of 1940 (ICA) generally prohibits these funds from obtaining leverage through the issuance of senior securities (defined as "any bond, debenture, note or similar obligation or instrument constituting a security and evidencing indebtedness" (15 U.S.C. § 80a-18(g)) or otherwise incurring obligations to persons other than the fund's common shareholders. The SEC has historically viewed derivatives as "senior securities" for the purposes of section 18, as they create future payment obligations. RICs have therefore been prohibited from engaging in derivatives transactions.
However, the proposed rule would permit RICs to participate in derivatives and "financial commitment transactions" (defined as reverse repurchase agreements, short sale borrowings or any firm or standby commitment agreement), provided they comply with one of two portfolio-limitation regimes.
The SEC also proposed conforming changes to Proposed Form N-PORT and Proposed Form N-CEN (which were first proposed in May 2015 and later supplemented in September 2015).
Proposed Treatment of Fund Derivatives
Under the proposed rule, in order to engage in derivative transactions, RICs would be required to:
- Adhere to one of the two following proposed portfolio-limitation regimes:
- an exposure-based portfolio limit on the fund's aggregate exposure equal to 150% of the fund’s net assets (exposure is defined as the aggregate notional amount of a fund's derivatives transactions plus its total payment or delivery obligations under financial commitment transactions and other transactions involving "senior securities" under section 18); or
- a risk-based portfolio limit on the fund's aggregate exposure equal to 300% of the fund's net assets provided the fund satisfies a risk-based test designed to determine whether, in the aggregate, the fund's derivatives activities make the fund less of a market risk that it would be had the fund not used derivatives).
- Maintain an asset segregation program for each derivatives transaction, under which assets (generally cash or cash equivalents) with a value equal to the sum of the following must be held in segregated accounts:
- a mark-to-market coverage amount (equal to the amount the fund would pay if it exited the derivatives transaction, with provisions to offset this amount by the value of any variation margin collateral posted to it by its counterparty in connection with the transaction); and
- a risk-based coverage amount (equal to a reasonable estimate of the potential amount payable by the fund if it exited the derivatives transaction under stressed conditions, taking into account the fund's policies and procedures, with provisions to offset this amount by the value of any initial margin collateral posted to it by its counterparty in connection with the transaction).
- Establish a derivatives risk management program (DRMP) – for funds that engage in an amount of derivatives transactions that exceeds 50% in notional amount of the fund's net asset value or use complex derivatives transactions that are dependent on the value of the reference asset at multiple times during the term of the transaction or which are based on non-linear functions of the value of the reference asset (other than due to optionality arising from a single strike price). The DRMP must be designed to:
- asses the risks associated with derivatives transactions (evaluation of potential leverage, market, counterparty, liquidity, and operational risks);
- manage those risks by actively monitoring the fund's use of derivative transactions and designate an employee or officer to monitor, subject to the oversight of the fund's board;
- reasonably separate the monitoring functions of the program from the fund’s portfolio management; and
- review and update the program at least once a year.
Other Aspects of the Proposal
The proposed rule also addresses a fund's use of financial commitment transactions. Funds that engage in these transactions must:
- Maintain qualifying coverage assets equal in value to the amount of cash (or other assets) the fund is obligated (conditionally or unconditionally) to pay or deliver under each of these transactions.
- Establish policies and procedures, by its board of directors to ensure compliance with the above.
Other aspects of the proposed rule include:
- Recordkeeping requirements documenting:
- the fund's portfolio limitation regime selection;
- the fund's ongoing compliance with the proposed rule; and
- where applicable, the fund's records related to the DRMP.
- Amending Proposed Form N-PORT to account for funds that implement a DRMP under the proposed rule by providing the gamma (which measures the sensitivity of the delta (changes in the underlying instrument)) and vega (which measures an option contract's price change in relation to a one percent change in the volatility of the reference asset) for options transactions.
- Amending Proposed Form N-CEN to require funds that rely on the proposed rule to identify which portfolio-limitation regime it is using.
Throughout its proposal, the SEC refers to a white paper by the Division of Economic and Risk Analysis, which is available here.
Public comment on the proposed rule are due on March 28, 2016, 90 days after publication of the proposed rule in the Federal Register. Comments should be addressed to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC, 20549. Comments also may be submitted via the Federal eRulemaking Portal at www.regulations.gov. All comments should refer to File Number S7-24-15.