SEC Proposes Derivative Rules for Registered Investment Companies

Investment Management Update

Date: December 17, 2015

On December 11, 2015, the Securities and Exchange Commission (SEC) voted to propose a new rule governing the use of derivatives by registered investment companies, including mutual funds, closed-end funds and exchange-traded funds (ETFs). The SEC proposed the new rule in light of the growing use of derivatives by funds and the potential risks associated with such instruments. The proposed rule would permit funds that meet the conditions of the rule to enter into derivative transactions notwithstanding the senior security restrictions under Section 18 of the Investment Company Act.


The proposed rule consists of three elements: asset segregation, portfolio limitations and risk management. If adopted, the proposed rule would significantly affect a fund’s ability to engage in derivative transactions, impose additional oversight responsibilities on a fund’s board of directors and would also present additional compliance and reporting requirements.

  1. Asset Segregation. Funds using derivatives must segregate liquid assets (generally, cash and cash equivalents) equal to a mark-to-market amount plus a risk-based amount. The mark-to-market amount is what the fund would pay if it closed a derivative transaction. The risk-based amount is an estimate of what a fund would pay if it closed a derivative under hypothetical stressed market conditions.
  2. Portfolio Limitations. Funds using derivatives may choose between an exposure-based limit and a risk-based limit. The exposure-based limit requires a fund to limit its aggregate exposure to 150 percent of the fund’s net assets. However, “exposure” is measured as the notional amount of a fund’s derivative transactions plus the fund’s financial commitment transactions (such as reverse repurchase agreements and short sales). The risk-based limit requires a fund to limit its aggregate exposure to 300 percent of the fund’s net assets, provided the fund satisfies a risk-based test.
  3. Risk Management. If a fund’s derivatives exceed 50 percent of net assets or are complex derivatives, the fund is required to establish a board-approved formal derivatives risk management program and designate a derivatives risk manager.

The three elements of the proposed rule are discussed in greater detail below.

Asset Segregation

Under the proposed rule, funds would be required to segregate assets equal to the mark-to-market value of a fund’s derivative positions plus a risk-based coverage amount. The risk-based coverage amount would represent a reasonable estimate of the amount a fund would pay if it closed a particular derivative position under stressed conditions. Risk-based coverage determinations would be made in accordance with fund policies and procedures approved by a fund’s board. The proposed rule would allow a fund to net certain derivative positions for the purposes of determining mark-to-market value and risk-based coverage, provided that such positions are subject to a netting agreement.

Currently, funds often use liquid portfolio assets for their asset segregation requirements under Section 18 of the Investment Company Act. Under the proposed rule, funds would be permitted to use only cash or cash equivalents to meet their asset segregation requirements for derivative transactions.

Additionally, the proposed rule would require funds to segregate qualifying assets in an amount equal to the cash or other assets that the fund is obligated to pay or deliver under financial commitment transactions, such as short sales and reverse repurchase agreements. For the purposes of financial commitment transactions, qualifying coverage assets would include cash and assets that are convertible to cash or that will generate cash, equal in amount to the financial commitment obligation, prior to the date on which the fund can be expected to be required to pay such obligation or that have been pledged with respect to the financial commitment obligation and can be expected to satisfy such obligation. Assets used for financial transaction coverage purposes would not be available for coverage of derivative transactions.

Portfolio Limitations

The proposed rule provides for two portfolio testing limitations designed to limit the amount of a fund’s notional exposure. Under the exposure-based test, a fund would be required to limit its aggregate notional exposure to 150 percent of the fund’s net assets. Under the risk-based test, a fund would be allowed to have exposure up to 300 percent of its net assets, provided that it satisfies a test designed to determine whether a fund’s derivative transactions result in a fund portfolio that is subject to less risk than if the fund did not use derivatives. A fund’s board, including a majority of its independent directors, would be required to approve which of the limitation tests would apply to the fund.

In calculating its overall notional exposure, funds would be required to include the amount of the notional exposure of their derivative positions along with any financial commitment transactions, such as short sales and reverse repurchase agreements, and any other senior security transactions such as borrowings. Funds would be permitted under the rule to net any directly offsetting transactions that are the same type of instrument with the same underlying reference asset, maturity and material terms. Funds would be permitted to net directly offsetting positions even if the positions involved different counterparties.

For certain derivative positions, an adjusted notional amount would be used to determine a fund’s exposure. First, notional amounts for derivatives that provide a return based on the leveraged performance of the underlying asset would be multiplied by the applicable leverage factor. Accordingly, a total return swap with a notional amount of $1,000,000 that is structured to provide a return equal to three times the return of an equity index would have an adjusted notional amount of $3,000,000.

Second, a “look through” would be used for derivative transactions for which the underlying reference asset is a managed account or entity operated primarily to invest or trade in derivative instruments, or an index that reflects the performance of a managed account or entity. In such cases, a fund’s notional exposure would be a pro rata portion of the aggregate notional amount of the derivative instruments entered into by the underlying reference vehicle. The aggregate notional amount of the underlying reference vehicle would need to be calculated in accordance with the proposed rule. Examples of such underlying reference vehicles could include hedge funds, managed futures funds and leveraged ETFs.

Third, certain derivatives deemed to be “complex derivative transactions” under the rule would be subject to specific calculations of their notional amounts. For the purposes of the rule, a “complex derivative transaction” is any derivative transaction where payment (1) is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction or (2) is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price. Examples of derivatives that are dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction include barrier options and Asian options. An example of a non-linear derivative would be a variance swap. For such complex derivative transactions, the notional amount would be equal to the aggregate notional amount(s) of other derivatives, excluding other complex derivatives, reasonably estimated to offset substantially all of the market risk of the complex derivative transactions at the time the fund enters into the transaction.

A fund would be able to satisfy the risk-based test if the value at risk (VaR) of its full portfolio is less than the VaR of its securities portfolio after the fund enters into any derivative, financial commitment or other senior securities transaction. VaR is a measure of the estimated potential losses on a particular instrument or portfolio, expressed as a positive amount in U.S. dollars, over a specified time horizon and at a given confidence level. Because there are various VaR models used to calculate risk, the proposed rule would allow a fund flexibility in selecting a VaR model, provided that the model meets certain minimum requirements. Specifically, a VaR model would be required to:

  1. take into account all significant and identifiable risk factors associated with a fund’s investments;
  2. use a minimum 99 percent confidence interval;
  3. use a time horizon of not less than 10 but not more than 20 trading days; and
  4. if using a historical VaR model, use a minimum of three years of historical data.

Once a fund selects its VaR model (if choosing to meet the risk-based test), the fund must apply its VaR model consistently in calculating the VaR of its full portfolio and its securities portfolio.

Risk Management

The proposed rule would also require funds that engage in more than a limited amount of derivative transactions, or that use complex derivatives, to establish a risk management program that includes policies and procedures designed to assess and manage the risks associated with a fund’s use of derivatives. Funds that exceed a 50 percent notional derivatives exposure threshold or that engage in complex derivative transactions, as defined by the rule, would be required to implement risk management programs.

At a minimum, a fund’s derivatives risk policies and procedures would be reasonably designed to:

  1. assess the risks associated with a fund’s derivative transactions, including an evaluation of leverage, market counterparty liquidity, operational and other relevant risks;
  2. manage the risks of the fund’s derivative transactions by monitoring the derivative transactions and informing the portfolio managers or board of directors regarding material risks;
  3. reasonably segregate the functions of the risk management program from the portfolio management of the fund; and
  4. periodically (but at least annually) review and update the program.

A fund’s board, including a majority of its independent directors, would be required to approve the risk management program, any material changes to the program and the fund’s designation of the fund’s derivative risk manager (who cannot be a portfolio manager of the fund). The board would also be required to review reports that assess the adequacy and effectiveness of the risk management program at least quarterly.

Recordkeeping and Reporting

The proposed rule seeks to amend previously proposed Form N-PORT and Form N-CEN. Amendments to N-PORT would require a fund that is required to have a derivatives risk management program to disclose additional risk metrics related to its use of certain derivatives. Amendments to Form N-CEN would require a fund to disclose whether it relied on the rule during the reporting period and the portfolio limitation applicable to the fund.


Comments on the proposed reforms are due 90 days after the Proposing Release is published in the Federal Register.


For more information, please contact:

Andrew J. Davalla

Donald S. Mendelsohn

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