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News December 21, 2015 Issue

SEC’s Proposed Derivatives Rule Seeks to Limit Fund Use of Leverage

Mutual funds and other funds that invest in derivatives are in a new ballgame.

The SEC’s proposed derivatives rule would place new risk management caps on the use of these financial instruments by mutual funds, ETFs, closed-end funds and business development companies. The result will be a lot of additional work for firms managing such funds, particularly if the funds are heavily invested in derivatives. Some advisers and fund managers may ask themselves if the effort required by the proposed new rule is worth it and may choose to lessen their reliance on derivatives.

The "proposal is designed to modernize the regulation of funds’ use of derivatives and safeguard both investors and our financial system," said SEC chair Mary Jo White. "Derivatives can raise risks for a fund, including risks related to leverage, so it is important to require funds to monitor and manage derivatives-related risks and to provide limits on their use."

"A clear intent of the proposed rule is to limit the use of derivatives," said Morgan Lewis partner John McGuire, who predicted "a huge outcry from the industry in opposition" to the proposal, which will be in a 90-day comment period once published in the Federal Register.

The SEC’s proposed derivatives rule is one of a series of regulations planned or already proposed for asset managers. Other rules include the agency’s September proposed liquidity management rule, new reporting requirements for certain types of funds, and expected 2016 proposed rules that would require stress testing by large advisers and funds, as well as transition plans for advisers.

Advisers and funds "are beginning to feel the exhaustion" from the onslaught of proposed new asset management rules, said Willkie Farr partner James Burns. "The SEC has proposed a wide array of requirements in these rules that have led advisers and funds to raise a lot of questions about what these rules mean to them." Funds will now, in addition to looking at the earlier proposed rules, have to determine just how the proposed derivatives rule will affect them, he said. "It is not just their number, but their potential interplay that is daunting."

Behind the SEC’s push for increased regulation in these areas lies the perceived push from organizations such as the Financial Stability Oversight Council for prudential regulation of the asset management industry. Opponents of prudential regulation, the SEC among them, are concerned that such regulation would lead to advisers and funds being regulated much in the way banks currently are. The agency also wants to head off any encroachment within its regulatory sphere by other regulators.

What’s in the rule

The proposed rule, offered by the Commission after a 4-to-1 vote, would, if adopted, create a new Investment Company Act exemptive rule, 18f-4, under the Act’s Section 18. That section limits the ability of funds to borrow money or otherwise issue "senior securities." However, as commissioner Michael Piwowar noted in his dissent, since funds have been relying on SEC guidance to invest in derivatives and related instruments for decades, the proposed rule will not in practice be an exemptive one, but a rule limiting a fund’s ability to
employ current practices.

Specifically, the proposed rule would put in place three requirements affecting a fund’s use of derivatives: portfolio limitations on derivatives transactions, asset segregation for derivatives transactions, and a derivatives risk management program for certain funds.

Portfolio limitations for derivatives transactions

Funds would be required to comply with one of two alternative portfolio limitations "designed to limit the amount of leverage the funds may obtain through derivatives and certain other transactions."

  • Exposure-based portfolio limit. Under this  option, a fund would be required to limit its aggregate exposure to 150 percent of the fund’s net assets. "Exposure" would be calculated as the aggregate notional amount of the fund’s derivatives transactions, together with its obligations under financial commitment transactions and certain other transactions
  • Risk-based portfolio limit. When this option is chosen, a fund would be permitted to obtain exposure up to 300 percent of its net assets, but only after satisfying a risk-based test, based on value-at-risk. The test would seek to determine whether the aggregate value of the fund’s derivatives transactions would result in a fund portfolio subject to less market risk than it would have if the fund did not use derivatives.

Asset segregation for derivatives transactions

Funds would be required to manage the risks associated with derivatives by segregating certain assets, typically cash and cash equivalents, equal to the sum of the following two amounts:

  • Mark-to-market coverage amount. A fund would be required to segregate assets equal to the amount that the fund would pay if the fund exited the derivatives transaction at the time of the determination.
  • Risk-based coverage amount. In addition to the mark-to-market coverage amount, a fund would be required to segregate a risk-based coverage amount representing "a reasonable estimate of the potential amount the fund would pay if the fund exited the
    derivatives transaction under stressed conditions," the SEC said.

Derivatives risk management program

This requirement would pertain only to funds that "engage in more than limited derivatives transactions" or that "use complex derivatives," the agency said. Such funds, it said, would have to establish a "formalized derivatives risk management program" that would include certain components that would be administered by a designated derivatives risk manager. In addition, a fund’s board of directors would be required to approve and review the program and approve the derivatives risk manager.

Disclosure and reporting requirements

Separately from the proposed rule, the SEC said it will consider proposing amendments to two new reporting forms that were proposed by the agency this past May.

The first would amend proposed Form N-PORT, which requires registered funds other than money market funds to provide portfolio-wide and position level holdings data each month. The SEC said it is considering requiring funds with a derivatives risk management program to "disclose additional metrics related to a fund’s use of certain derivatives" on the form.

The second would amend proposed Form N-CEN, which requires registered funds to annually report certain census-type information. The possible amendment would require that a fund disclose whether it relied on the proposed derivatives rule during the reporting period, and the particular portfolio limitation it chose.

Piwowar’s dissent

Piwowar noted that he supported some parts of the proposed rule, such as the asset segregation requirements, which he described as a time-tested method to mitigate risk. However, he added, "I cannot, at this time, support the other rule requirements," and said he had two main reasons for his dissent.

The first was that the proposed asset segregation requirements may themselves "function as a leverage limit on funds and ensure that funds have the ability to meet their obligations arising from derivatives," he said."

Piwowar’s second reason for dissenting was tied to the timing of the derivatives rule proposal. The Commission should wait to determine the impact of other recently proposed asset management rules, such as the proposed reporting requirement rule and the proposed rule on liquidity, that have yet to be adopted, before proceeding with the derivatives proposal, he said.