The U.S. Securities and Exchange Commission (SEC) has implemented significant regulatory updates to its derivatives rule. Learn more about them – and what they mean for your fund portfolio.
The past few years have seen an array of efforts from the SEC to improve transparency and streamline regulatory requirements. A key element in that effort is Rule 18f-4 (the “Rule”), which provides “an updated, comprehensive approach to the regulation of funds’ use of derivatives,” while enhancing investor protections.
The Rule applies to registered investment companies, including the following, and allows these entities to enter into derivative transactions in excess of the Section 18 limits, subject to certain requirements:
- Mutual funds (other than money market funds that operate under Rule 2a-7 under the Investment Company Act of 1940, as amended)
- Exchange-traded funds
- Closed-end funds
- Business development companies
The key requirements include adoption of a derivatives risk management program (“Program”) and limits on the amount of leverage-related risk a fund may hold based on the amount of value-at-risk (VaR).
At U. S. Bank, our Global Fund Services team has the experience and expertise to assist clients with all compliance obligations. Below, we’ll present a general overview of the Rule.
What’s new?
The new Rule imposes measurable limits on the overall portfolio exposure of affected funds and requires them to have a formal risk management program. Funds with derivatives exposure of less than 10% of their net assets (excluding certain currency and interest rate hedging transactions) are considered “limited derivatives users.” This group, while exempt from the majority of the Rule’s requirements, is still affected.
The following questions and answers apply to funds above the 10% threshold.
What are considered “derivative transactions” for the purposes of this Rule?
- Any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (a “derivatives instrument”), under which a fund is or may be required to make any payment or delivery of cash or other assets (i.e., the issuance of a senior security because the transaction involves a contractual future payment obligation).
- Any short sale borrowing.
- Reverse repurchase agreements and similar financing transactions, for those funds that choose to treat these transactions as derivatives transactions under the Rule.
What are the Rule’s major conditions?
- Limitations on a fund’s leverage risk, implemented by monitoring VaR testing.
- Adoption of a derivatives risk management program (Program).
- Oversight by the fund’s board of directors/trustees (Board).
What is required for a compliant Program?
- Appointment of a derivatives risk manager (DRM), who must be an officer (or officers) of the fund’s investment adviser.
- The DRM will administer the Program and have a direct reporting line to the Board.
- Establishment, maintenance and enforcement of risk guidelines; formalizing risk identification, guidelines, and assessment that provide for the measurable criteria, metrics, or thresholds related to a fund’s derivatives risks.
- Implementation of stress testing to evaluate a fund’s potential losses under stressed conditions, as well as backtesting of the VaR calculation model that the fund uses.
- Provisions for internal reporting and escalation of certain matters to a fund’s Board.
What is required under the Rule to address risk?
- Implementation of VaR calculations is required, which estimate a fund’s potential losses over a given time period at a set confidence level.
- By default, the Rule requires a “relative VaR test” that compares the fund’s VaR to the VaR of a “designated reference portfolio.” However, an “absolute VaR test” may be used instead if a fund’s DRM reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for the purpose of the relative VaR test.
- VaR testing must be performed daily, at a consistent time, and any result in violation of established risk limitations must be addressed promptly.
- Weekly stress testing must be performed to evaluate potential losses to the fund’s portfolio.
- Weekly backtesting is also required. A fund must compare its actual gain or loss for each business day with the applicable VaR.
Qualifying for the exception
The regulatory framework for derivatives provides a streamlined path to compliance for funds whose derivatives exposure falls below a specified threshold. Funds meeting this exception, known as “limited derivatives users,” will not be required to establish a derivatives risk management program or implement value-at-risk (VaR) testing.
The SEC estimates in the Rule’s adopting release that a significant number of funds will qualify for the limited derivatives user exception. The SEC expects that many funds with exposure below the threshold of 10% of net assets will choose to maintain that level, while some funds over the threshold may decide to reduce their exposure in order to qualify for the exception.
What is necessary to qualify for the limited derivatives user exception?
A fund must have derivatives exposure that is no more than 10% of its net assets and is generally permitted to exclude from its calculations derivatives transactions that are used to hedge currency and interest rate risks. If currency hedges are excluded, the equity or fixed-income investments being hedged must be foreign-currency denominated – and the notional amounts of such derivatives may not exceed the value of the hedged instruments by more than 10%.
How is “derivatives exposure” defined by the Rule?
Derivatives exposure is defined as the sum of the following:
- The gross notional amounts of a fund’s derivatives transactions such as futures, swaps, and options.
- The value of any asset sold short in the case of short-sale borrowings.
For purposes of calculating derivatives exposure (and therefore, whether a fund qualifies for the exception), derivatives instruments that don’t involve a payment obligation aren’t included in a fund’s derivatives exposure.
What other adjustments and exclusions are permitted under the Rule in calculating eligibility for limited derivatives user status?
In order to address the limitations associated with notional measures of market exposure, funds may make these adjustments:
- Convert the notional amount of interest rate derivatives to 10-year bond equivalents.
- Delta-adjust the notional amount of options contracts.
- Exclude any closed-out positions from its derivatives exposure.
However, positions must be closed out with the same counterparty and must result in no credit or market exposure to the fund.
If a fund qualifies for the limited derivatives user exception, what obligations does it have under the Rule?
Limited derivatives users must adopt and implement written policies and procedures that are reasonably designed to manage the fund’s derivatives risks. The SEC in its adopting release describes it this way:
“The policies and procedures that a fund relying on the limited derivatives user exception adopts should be tailored to the extent and nature of the fund’s derivatives use. For example, a fund that uses derivatives only occasionally and for a limited purpose, such as to equitize cash, is likely to have limited policies and procedures commensurate with this limited use. A fund that uses more complex derivatives with derivatives exposure approaching 10% of net asset value, in contrast, should have more extensive policies and procedures.”
It’s important to note that funds relying on the limited derivatives use exception must still manage their derivatives risks – even though leverage risk may not be present. There are other risks for a fund to consider, such as counterparty risks and the risk of selling investments to meet a margin call. Therefore, the fund’s policies and procedures should address its compliance with the 10% threshold and continually support the fund’s reliance on the exception.
What happens if a fund relying on the limited derivatives user exception exceeds the 10% threshold?
If a fund’s derivatives exposure exceeds the 10% threshold for five business days, the fund’s investment adviser must provide a written report to the fund’s board of directors, identifying which of two remediation paths is being undertaken. The choices are:
- Treat the exceedance as “temporary,” in which case the exposure level must be returned to compliance “promptly,” but within no more than thirty calendar days.
- Establish a derivatives risk management program and comply with the VaR-based limit on fund leverage risk as soon as “reasonably practicable.”
In either case, the fund’s next Form N-PORT filing must specify the number of business days (after the initial five-day period) that the fund exceeded the 10% threshold.
A fund cannot repeatedly go over 10%, even if it returns to compliance promptly, without calling into question its reliance on the limited derivatives user exception. In order for a fund’s compliance policies and procedures under Rule 38a-1 to be reasonably designed to achieve compliance with the Rule, they should be designed to prevent such repeated exceedances.
Why was Rule 18f-4 adopted?
Rule 18f-4 (the “Rule”) was adopted by the SEC in 2020 for several reasons:
- To address the investor protection purposes and concerns underlying Section 18 of the Investment Company Act of 1940, as amended
- To provide an updated, more comprehensive approach to the regulation of funds’ use of derivatives and other transactions
Below, we’ll explore the details of the rule’s two major conceptual structures: a derivative risk management program and value-at-risk (VaR).
It’s important to note that these requirements don’t apply to funds relying on the “Limited Derivatives User” exception provided in the Rule, designed to minimize the regulatory burden on funds whose derivatives exposure is no more than 10% of its net assets. However, for funds that fall above the 10% threshold, the Rule outlines compliance requirements for the derivatives risk management program including the VaR.
A deeper look at the derivative risk management program
The Program must be designed to align derivatives transactions with the fund’s investment objectives, policies and restrictions, its risk profile and relevant regulatory requirements. The Program must be reasonably designed to manage a fund’s derivatives risk and should take into account the way the fund uses derivatives – whether in a way that increases portfolio risks or conversely, to reduce portfolio risks or facilitate efficient portfolio management.
The Program must provide for the establishment, maintenance and enforcement of investment, risk management and related guidelines that provide for the measurable criteria, metrics or thresholds related to a fund’s derivatives risks (risk guidelines). The risk guidelines must do the following:
- Specify levels of the given metric that a fund does not normally expect to exceed and the measures to be taken if they are exceeded
- Address the risks a fund would be required to routinely monitor as part of its Program
The Program must be administered by an officer or officers of the fund’s investment adviser, who is designated as the derivatives risk manager (DRM). The DRM must be approved by the Board and must inform the Board of any material risks arising from the fund’s derivatives use. These would include risks that are derived when a fund exceeds its guidelines, as well as risks derived by the results of the fund’s stress testing. If the DRM is a single person, that person may not be the fund’s portfolio manager. If multiple officers serve as the DRM, a majority of these persons may not be composed of portfolio managers.
The Program must provide for stress testing to evaluate a fund’s potential losses under stressed conditions. This must involve testing all the fund’s investments, not just the derivative transactions, and it must evaluate potential losses in response to “extreme but plausible” market risk factors that would have a significant adverse effect on the fund’s portfolio. Stress-testing must be performed at least weekly.
The Program must also provide for backtesting to monitor effectiveness of the fund’s VaR model. This too must be performed at least weekly, taking into account the fund’s actual gains or losses on each business day that occurred during the weekly backtesting period.
A deeper look at value-at-risk
VaR is an estimate of a portfolio’s potential losses over a given time horizon at a specified confidence level.
The VaR test must be performed daily, at a consistent time. And if the fund is found to be out of compliance, it must come back into compliance promptly after such determination and in a matter that serves “the best interests of the fund and its shareholders.” If the fund is still not in compliance after five business days, the DRM must report this fact to the Board, and a report must be made to the SEC on Form N-RN (formerly known as Form N-LIQUID).
The default according to Rule 18f-4 is a “relative VaR test” that compares the fund’s VaR to the VaR of a “designated reference portfolio.” There are two options for the designated reference portfolio:
- An index that meets certain requirements
- The fund’s own securities portfolio (excluding derivatives transactions)
An open-end fund will satisfy the relative VaR test if its portfolio VaR does not exceed 200% of the VaR of its designated reference portfolio. The relative VaR limit for a closed-end fund is 250%.
An alternative to the relative VaR test may be used if a fund’s DRM reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for the purpose of the relative VaR test. This “absolute VaR test” will be satisfied if an open-end fund’s portfolio VaR does not exceed 20% of the value of the fund’s net assets. The absolute VaR limits for a closed-end fund is 25%.
Additional requirements provided in the Rule
Rule 18f-4 provides additional information regarding compliance requirements. Topics include:
- Reverse repurchase agreements and similar financing transactions
- Alternatives for certain leveraged/inverse funds
- New recordkeeping obligations
- Changes to reporting requirements, including Forms N-CEN, N-PORT and N-RN
- Board reporting requirements
At U.S. Bank, we’re here to help you with any needs related to Rule 18f-4. Please contact us or reach out to your relationship manager if you have immediate questions about this regulatory framework. To learn more about our other products and solutions, visit usbank.com/globalfundservices.
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