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SEC Releases Economic Analysis on Proposed Rule Limiting Derivatives for Registered Funds
Practical Law Legal Update w-004-3739 (Approx. 4 pages)
SEC Releases Economic Analysis on Proposed Rule Limiting Derivatives for Registered Funds
by Practical Law Finance
| Published on 03 Nov 2016 • USA (National/Federal) |
The SEC released an additional economic analysis on proposed SEC Rule 18f-4, issued in December 2015, which would limit the use of derivatives by SEC-registered investment companies (RICs), including mutual funds and ETFs.
On November 1, 2016, the SEC's Division of Economic and Risk Analysis (DERA) published an additional economic analysis on proposed SEC Rule 18f-4, issued in December 2015, which would limit the use of derivatives by SEC registered investment companies (RICs), including mutual funds and ETFs (see Legal Update, SEC Proposes Limited Use of Derivatives by Registered Funds).
This analysis is in addition to an SEC white paper referred by the SEC throughout the proposed rule. The additional analysis was issued in response to public comment submitted on the proposed rule.
The proposed rule would allow RICs to enter into derivatives transactions provided they comply with one of two portfolio-limitation regimes. RICs are funds that include:
- Mutual funds.
- Exchange-traded funds (ETFs).
- Closed-end funds.
- Business development companies (BDCs).
Under the proposed rule, RICs that enter into derivatives transactions would be subject to certain limitations and enhanced regulation. These limitations include certain risk-management measures, including:
- Compliance with one of two portfolio limitation regimes that limits the amount of leverage the fund may obtain through derivatives transactions. For details on the different regimes, see Legal Update, SEC Proposes Limited Use of Derivatives by Registered Funds.
- A requirement to maintain an asset-segregation program for each derivatives transaction, where an amount of certain segregated assets (generally cash or cash equivalents), referred to as "qualifying coverage assets," with a value equal to the sum of a mark-to-market coverage amount and a risk-based coverage amount, are held in order to enable the fund to meet its obligations under its derivatives transactions. For more information on the mark-to-market and risk-based coverage amounts under the proposed rule, see Legal Update, SEC Proposes Limited Use of Derivatives by Registered Funds.
- A requirement to establish a formalized derivatives risk management program (DRMP).
Public comments were submitted on the proposed rule and addressed alternatives to these risk-management options. Comments included suggestions that:
- Funds should be permitted to maintain certain liquid assets other than cash or cash equivalents as qualifying coverage assets, subject to appropriate haircuts.
- Risk-adjustment and haircut schedules for the qualifying coverage assets should be derived from standardized schedules used for other regulatory purposes.
Commenters suggested using the same methodology used to derive the margin schedules for uncleared swaps to calculate risk for purposes of the proposed rule. The additional economic analysis conducted by the SEC on the proposed rule evaluates these suggested schedules for purposes of risk-adjustment alternatives for RICs and provides analysis on:
- The existing standardized risk-adjustment schedules of the US prudential bank regulators, the CFTC, and the Bank for International Settlements (BIS), used to calculate margin requirements for uncleared swaps, and how these schedules could be used to derive risk-based adjustments for purposes of proposed Rule 18f-4. These existing schedules can be found in:
- the final CFTC margin rules, at section 23.154(c) (see Practice Note, The Dodd-Frank Act: Margin Posting and Collection Rules for Uncleared Swaps: Final CFTC Margin Rules); and
- the BIS margin requirements for non-centrally cleared derivatives, at Appendix A.
- How these standardized margin schedules would relate to the risks of the following asset classes when used for risk-assessments for the purposes of Proposed Rule 18f-4:
- interest rate derivatives;
- credit derivatives, including corporate debt and credit default swaps (CDS); and
- currency derivatives.
- Haircut schedules for qualifying coverage assets.
- Risk analyses for crisis periods.
The SEC does not express a view regarding the results of the analysis, and invites further public comment on the analysis, which may be submitted here.
For more information on the proposed rule, see Legal Update, SEC Proposes Limited Use of Derivatives by Registered Funds.