SEC Proposes Rules Governing Use of Derivatives
Investment Management Update
Date: January 30, 2020
On November 25, 2019, the Securities and Exchange Commission (SEC) proposed rules to regulate the use of derivatives by mutual funds, exchange-traded funds, registered closed-end funds and business development companies (BDCs) (each a “fund,” and collectively, “funds”) and the sale of leveraged/inverse investment vehicles to retail investors. The SEC proposed a new rule to each the Investment Company Act of 1940, as amended (1940 Act), the Securities Exchange Act of 1934, as amended (Exchange Act) and the Advisers Act of 1940, as amended (Advisers Act).
Re-proposed 1940 Act Rule 18f-4, if enacted, would provide investment companies and BDCs exemptive relief from the restrictions found in 1940 Act Sections 18 and 61, provided they comply with the rule’s conditions. The proposed rule would permit a fund to enter into derivatives transactions notwithstanding the prohibitions and restrictions on the issuance of senior securities found in the 1940 Act, so long as the fund adopts a written derivatives risk management program, implements oversight and reporting requirements, and limits leverage risk.
A fund is not required to comply with Rule 18f-4 if it can comply with either of the following exceptions:
- Exposure-based exception. The fund’s total derivatives exposure does not exceed 10% of its net assets.
- Currency hedging exception. The fund limits its use of derivatives to currency derivatives for hedging purposes.
Written Derivatives Risk Management Program
Under the proposed rule, a fund would have to adopt and implement a written derivatives risk management program overseen by a derivatives risk manager, who would be approved by the fund’s board. The program would be required to include policies and procedures reasonably designed to manage the fund’s derivatives risks, including:
- Risk identification and assessment. The fund must identify and assess its derivatives risk by taking into account its derivatives transactions and other investments. The fund would be required to identify and manage leverage, market, counterparty, liquidity, operational and legal risks as well as any other risks the derivatives risk manager deems material.
- Risk guidelines. The fund must establish, maintain and enforce risk management guidelines that provide for quantitative or otherwise measurable criteria, metrics or other thresholds related to its derivatives risks.
- The guidelines would be required to specify the level of the given criterion, metric or threshold that the fund does not normally expect to exceed and the measures to be taken if it is exceeded.
- The fund would be required to adopt guidelines that provide for quantitative thresholds it determines to be appropriate and pertinent to its investment portfolio and reasonably consistent with its risk disclosures.
- Stress testing. The fund must conduct stress testing to evaluate potential losses to its portfolio under extreme but plausible market changes. Weekly stress testing would be required to take into account correlations of market risk factors and resulting payments to derivatives counterparties.
- Backtesting. The fund must conduct backtesting of its value at risk (VaR) calculation. Each business day, the fund would be required to compare its actual gain or loss with the VaR calculated for that day. Backtesting must be conducted using a 99% confidence level over a one-day time horizon to properly evaluate the fund’s VaR model.
- Internal reporting and escalation. The fund would be required to identify the circumstances under which its derivatives risk manager must communicate with its portfolio management team about the fund’s derivatives risk, including the program’s operation. The risk manager must inform the fund’s board, in a timely manner, of material risks arising from the fund’s use of derivatives, including any risks identified by the fund’s guidelines including exceedances or the results of stress testing.
- Periodic review. The fund’s derivatives risk manager must review and evaluate the program’s effectiveness at least annually. The periodic review would be required to include evaluation of all of the program’s elements, the VaR calculation model and the designated reference index.
Board Oversight and Reporting
The proposed rule places requirements on a fund’s board and its derivatives risk manager:
- Board approval. The fund’s board must approve the designation of the derivatives risk manager, taking into account his/her relevant experience regarding the management of derivatives risk.
- Board reporting. The derivatives risk manager would be required to provide an annual written report on the program’s implementation and effectiveness and also provide regular written reports at a frequency determined by the board.
- Reporting on program implementation and effectiveness. To facilitate oversight, the derivatives risk manager would be required to submit a written report including the basis for his/her representation along with information reasonably necessary to evaluate the program’s adequacy and the effectiveness of its implementation. The report must include the risk manager’s basis for selecting the reference index used on the relative VaR test or an explanation of why the risk manager was unable to identify a designated reference index.
- Regular board reporting. The derivatives risk manager would be required to provide, at a frequency determined by the board, a written report analyzing any exceedances of the fund’s risk guidelines and the results of its stress testing and backtesting. The written report must provide the board information reasonably necessary to evaluate the fund’s response to any exceedances and stress testing and backtesting results.
Leverage Risk Limitations
The proposed rule would require a fund to comply with a VaR-based limit on fund leverage risk. The proposed limit would be based on a relative VaR test that compares the fund’s VaR to that of a “designated reference index,” as described below. If the fund’s derivatives risk manager cannot identify an appropriate designated reference index, the fund would then be required to comply with an absolute VaR test.
Relative VaR test. The fund must comply with the relative VaR test unless a designated reference index is unavailable. The proposed relative VaR test allows the fund to identify its leveraging risk by comparing its relative VaR to a baseline VaR that approximates the VaR of the fund’s unleveraged portfolio.
Designated reference index. The fund may satisfy the proposed relative VaR test so long as the VaR of its entire portfolio does not exceed 150% of the VaR of its designated reference index. The fund must disclose the designated reference index in its annual report. A designated reference index must meet the following requirements:
- It must be an unleveraged index that is selected by the derivatives risk manager.
- It must reflect the markets or asset classes in which the fund invests.
- It cannot be administered by an organization that is an affiliated person of the fund, its adviser or its principal underwriter, or created at the request of its adviser, unless the index is widely recognized and used.
- It must either be an appropriate broad-based securities market index or an additional index as defined in Item 27 of Form N-1A.
Absolute VaR test. The proposed rule allows the derivatives risk manager to utilize an absolute VaR test in lieu of the relative VaR test when he/she is unable to identify an appropriate designated reference index. Under the proposed absolute VaR test, the VaR of the fund’s portfolio cannot exceed 15% of the value of its net assets.
Choice of Model and Parameters for VaR Test
The proposed rule provides the following requirements for a fund’s VaR model:
- It must incorporate all significant, identifiable market risk factors associated with the fund’s investments, including but not limited to:
- Equity price, interest rate, credit spread, foreign currency and/or commodity price risks
- Material risks arising from the non-linear price characteristics of the fund’s investments
- Sensitivity of the market value of the fund’s investments to changes in volatility
- It must utilize as its modeling method historical simulation, Monte Carlo simulation or parametric models.
- It must have a 99% confidence level over a 20-day time horizon.
- It must be based on three years of historical market data.
The proposed rule would require a fund to determine its compliance with its applicable VaR test at least once each business day. If the fund is not in compliance with its VaR test, it must regain compliance promptly, which is considered to be no more than three business days. If the fund does not regain compliance within three business days:
- The derivatives risk manager must report to the board of trustees and explain how and by when he/she expects the fund to come back into compliance.
- The derivatives risk manager must analyze the circumstances that caused the fund to be out of compliance and update any program elements as appropriate to address those circumstances.
- The fund cannot enter into any derivatives transactions until it has been in compliance with its applicable VaR test for three consecutive business days, satisfied its board reporting requirements and taken the appropriate remedial measures.
Exceptions to Program Requirements
The proposed rule provides exposure-based and currency hedging exceptions to the requirement to adopt a risk management program and comply with the VaR limitations. A fund is not required to adopt a risk management program if it either limits its derivative exposure to 10% of net assets or only uses derivatives to hedge certain currency risks.
Exposure-based exception. The fund would be permitted to rely upon a limited derivatives user exception if its derivatives exposure does not exceed 10% of its net assets. A fund’s derivatives exposure is measured as the sum of the notional amounts of the fund’s derivative instruments and with respect to short sale borrowings, the value of any asset sold short.
Currency hedging exception. Under this exception, the fund could use the currency derivatives user exception only if it limits its use of derivatives transaction to currency derivatives for hedging purposes.
Risk management. A fund relying upon either exception would still be required to manage the risks associated with its derivatives transactions by adopting and implementing policies and procedures reasonably designed to manage such risks. The policies and procedures must be tailored to appropriately address the fund’s use of derivatives.
Alternative Provisions for Leveraged/Inverse Funds
Under proposed Rule 18f-4, leveraged/inverse funds would exempt a fund from the proposed VaR-based leverage limit if it:
- Meets the definition of a leveraged/inverse investment vehicle as defined in the sales practice rules (see below).
- Limits the investment results it seeks to 300% of the return (or inverse of the return) of the underlying index.
- Discloses in its prospectus that it is not subject to the proposed Rule 18f-4 limit on fund leverage risk.
A leveraged/inverse fund that satisfies these conditions would be exempt from the VaR tests but would still be required to have a derivatives risk management program, board oversight and reporting, and to comply with the rule’s recordkeeping requirements.
Sales Practice Rules
In addition to re-proposing Rule 18f-4, the SEC announced that it was proposing two additional rules that regulate the use of inverse and leverage investment vehicles. Proposed Exchange Act Rule 15l-2 and proposed Advisers Act Rule 211h-1 (collectively, the “sales practice rules”), if enacted, would require a broker-dealer or adviser to exercise certain due diligence requirements before approving a retail client’s account to buy or sell shares of leveraged/inverse investment vehicles. Under the sales practice rules, a leveraged/inverse investment vehicle is defined as a registered investment company or an exchange-listed commodity pool or currency-based trust that seeks, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple or to provide investment returns that have an inverse relationship to the performance of a market index over a predetermined period of time. The proposed sales practice rules would require broker-dealers and advisers to conduct due diligence before accepting or placing retail investors’ trades in leveraged/inverse investment vehicles and to have a reasonable basis for believing that a retail investor has the financial knowledge and experience to be able to evaluate the risks of buying and selling leveraged/inverse investment vehicles. The sales practice rules require a broker-dealer or adviser to ascertain certain essential facts about a customer such as:
- Investment objectives (safety of principal, income, growth, trading profits, speculation) and time horizon.
- Employment status (name of employer, self-employed or retired).
- Estimated annual income from all sources.
- Estimated net worth (exclusive of family residence).
- Estimated liquid net worth (cash, liquid securities, other).
- Percentage of the retail investor’s liquid net worth that he/she intends to invest in leveraged/inverse investment vehicles.
- Investment experience and knowledge (number of years; size, frequency and types of transactions) regarding leveraged/inverse investment vehicles, options, stocks and bonds, commodities and other financial instruments.
Based on its evaluation of the above information, the adviser or broker-dealer would be required to approve or deny the investor’s account for buying or selling shares of leveraged/inverse investment vehicles. If the adviser or broker-dealer approves the investment, such approval must be in writing and retained for six years.
The sales practice rules do not propose a bright-line test for determining whether the retail investor can evaluate the risks of buying or selling inverse/leveraged investment vehicles. Rather, the broker-dealer or adviser would base its determination on relevant facts and circumstances and information collected from the retail investor.
Evaluate Compliance Now
The SEC will accept comments for 60 days after the proposed rule is published in the Federal Register. In the meantime, funds should assess their use of derivatives and determine whether they will be able to comply with the proposed limitations. Further, funds, advisers and broker-dealers should consider adopting the policies and procedures necessary to comply with the proposed rules.
FOR MORE INFORMATION
For more information, please contact:
Andrew J. Davalla
Owen J. Pinkerton
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