Use of Derivatives by Registered Investment Companies and Business Development Companies: A Small Entity Compliance Guide
Feb. 4, 2021
This compliance guide is divided into the following parts:
- Who is covered by rule 18f-4?
- What exemptive relief does the rule provide, and what are the rule’s conditions?
- How are reverse repurchase agreements or similar financing transactions, and unfunded commitment agreements treated under rule 18f-4?
- What are the reporting requirements?
- What about leveraged or inverse ETFs?
- Effective and compliance dates
- Other resources
- Contacting the Commission
On October 28, 2020, the Securities and Exchange Commission (the “Commission”) adopted new rule 18f-4 under the Investment Company Act of 1940 (the “Act”), as well as additional rule and form amendments, that together are designed to provide an updated, comprehensive approach to the regulation of funds’ use of derivatives and certain other transactions. In connection with these new rules, the Commission amended rule 6c-11 under the Act to allow leveraged or inverse exchange-traded funds (“ETFs”) to operate without obtaining an exemptive order. Finally, the Commission adopted new reporting requirements and amendments to Forms N-PORT, N-LIQUID (to be re-titled as “Form N-RN”), and N-CEN.
Who is covered by rule 18f-4?
New rule 18f-4 permits mutual funds (other than money market funds), ETFs, registered closed-end funds, and business development companies (collectively, “funds”) to enter into derivatives transactions and certain other transactions notwithstanding the restrictions under section 18 of the Act.
What exemptive relief does the rule provide, and what are the rule’s conditions?
The Act limits funds’ ability to engage in transactions that involve potential future payment obligations, including obligations under derivatives such as forwards, futures, swaps and written options. The new rule permits funds to enter into these transactions if they comply with certain conditions designed to address the undue speculation and asset sufficiency concerns underlying section 18, described below.
Derivatives risk management program. The new rule generally requires a fund to adopt and implement a written derivatives risk management program. The program will institute a standardized risk management framework for funds, while also permitting principles-based tailoring to the fund’s particular derivatives risks. “Derivatives risks” include leverage, market, counterparty, liquidity, operational, and legal risks. The program must include risk guidelines, stress testing, backtesting (see more on this below in the discussion of the required limit of fund leverage risk), internal reporting and escalation, and program review elements.
- Risk guidelines. The program must include risk guidelines—including establishing, maintaining, and enforcing these guidelines. These include investment, risk management, or related guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds related to a fund’s derivatives risks.
- Stress testing. The program must include stress testing of the fund’s portfolio to evaluate potential losses under stressed conditions.
- Internal reporting and escalation. Certain matters relating to a fund’s derivatives use would have to be reported to the fund’s portfolio management and board of directors. For example, the program would specify when the derivatives risk manager must inform (1) the fund’s portfolio managers about guideline exceedances and stress testing results and (2) the fund’s board directly about material risks arising from the fund’s derivatives use.
- Periodic review of the program. The derivatives risk manager is required to review the program at least annually, to evaluate the program’s effectiveness and to reflect changes in risk over time.
A derivatives risk manager approved by the fund’s board will administer the program. This person must be an officer or officers of the fund’s investment adviser, and may not be a portfolio manager of the fund. The fund’s derivatives risk manager will have to report to the fund’s board on the derivatives risk management program’s implementation and effectiveness to facilitate the board’s oversight role. The derivatives risk manager must have a direct reporting line to the fund’s board. The rule requires the derivatives risk manager to provide to the fund’s board certain written reports regarding the program.
Limit on fund leverage risk. A fund relying on the rule generally must comply with an outer limit on fund leverage risk based on value-at-risk, or “VaR.” This outer limit is based on a relative VaR test that compares the fund’s VaR to the VaR of its “designated reference portfolio.” If the fund’s derivatives risk manager reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test, the fund would be required to comply with an absolute VaR test.
- How would a fund comply with the relative VaR test?
- Relative VaR limit. The fund’s VaR must not exceed 200% of the VaR of the fund’s designated reference portfolio. For closed-end funds with then-outstanding shares of preferred stock, the VaR must not exceed 250% of the VaR of the fund’s designated reference portfolio.
- Using a designated index as the designated reference portfolio. A fund may use a “designated index” as its designed reference portfolio. This is an unleveraged index that is approved by the derivatives risk manager for purposes of the relative VaR test, and that reflects the markets or asset classes in which the fund invests. The rule prohibits funds from selecting certain indexes such as an index administered by an affiliate (unless it is widely recognized and used), as their designated index. Blended indexes are permitted so long as each constituent index meets the rule’s requirements. A fund that tracks an unleveraged index must use that index as the fund’s designated reference portfolio.
- Using the fund’s securities portfolio as the designated reference portfolio. A fund also may use its own portfolio of securities and other investments, excluding any derivatives transactions, as its designated reference portfolio. The derivatives risk manager must approve the securities portfolio for purposes of the relative VaR test, and it must reflect the markets or asset classes in which the fund invests.
- How would a fund comply with the absolute VaR test? The fund’s VaR must not exceed 20% of the value of the fund’s net assets. For closed-end funds with then-outstanding shares of preferred stock, the VaR must not exceed 25% of the value of the fund’s net assets.
- What VaR model parameters does a fund have to use? The fund’s VaR model must take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments. The rule provides a non-exhaustive list of common market risk factors that a fund must account for in its VaR model. Additionally, the VaR model must use a 99% confidence level and a time horizon of 20 trading days, and be based on at least three years of historical market data.
- What happens if a fund is out of compliance with its VaR test? A fund must determine its compliance with its VaR test at least once each business day. If a fund is not in compliance, then it must come back into compliance promptly, in a manner that is in the best interests of the fund and its shareholders. If the fund is not in compliance within five business days, the derivatives risk manager must provide certain written reports to the fund’s board and analyze the circumstances that caused the fund to be out of compliance and update any program elements as appropriate. For funds that are out of compliance for thirty calendar days, the derivatives risk manager must update the board at regularly scheduled intervals until the fund has come back into compliance.
- How must a fund monitor its VaR calculation model? A fund must “backtest” its VaR model, that is, compare the fund’s actual gain or loss for each business day with the VaR calculated for that day. A fund must identify as an exception any instance in which the fund experiences a loss exceeding the corresponding VaR calculation’s estimated loss.
Exception for limited derivatives users. If a fund is a “limited derivatives user,” it does not have to adopt a derivatives risk management program, adhere to the VaR-based limit on fund leverage risk, or comply with the related board oversight and reporting requirements. To rely on this rule exception, a fund must adopt and implement written policies and procedures reasonably designed to manage its derivatives risks. This exception is only for funds that limit their derivatives exposure to 10% of their net assets.
- Derivatives exposure. Under the rule, “derivatives exposure” is the sum of: (1) the gross notional amounts of a fund’s derivatives transactions such as futures, swaps, and options; and (2) in the case of short sale borrowings, the value of any asset sold short. Funds may exclude certain currency and interest rate hedging transactions.
- Remediation. If a fund exceeds the 10% threshold and does not reduce its exposure within five business days, the fund’s adviser must provide a written report to the fund’s board informing the board whether (1) the adviser intends to reduce the exposure promptly, but within no more than thirty days, or (2) put in place a derivatives risk management program and comply with the VaR-based limit on fund leverage risk as soon as reasonably practicable.
Recordkeeping. The rule includes certain recordkeeping requirements for funds.
How are reverse repurchase agreements or similar financing transactions, and unfunded commitment agreements treated under rule 18f-4?
Reverse Repurchase Agreements. The rule permits a fund to enter into reverse repurchase agreements or similar financing transactions. A fund can choose to limit its reverse repurchase and other similar financing transaction activity to the applicable asset coverage limit under the Act for senior securities representing indebtedness. Or, it may instead treat them as derivative transactions (and therefore a fund would include these when it considers its other derivatives transactions under the rule).
Unfunded Commitment Agreements. The rule permits a fund to enter into unfunded commitment agreements if it reasonably believes, at the time it enters into such an agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to its unfunded commitment agreements as they come due. A fund should consider its unique facts and circumstances in forming such a reasonable belief. The rule prescribes certain specific factors that a fund must take into account.
What are the reporting requirements?
Form N-PORT. Amendments to this form require a fund to report information regarding its derivatives exposure if it is relying on the limited derivatives user exception, and (for applicable funds) information regarding its compliance with the VaR-based limit on leverage risk. Certain of this information will be reported confidentially to the Commission.
Form N-RN (formerly Form N-LIQUID). Amendments to this form require a fund to notify the Commission confidentially when a fund exceeds its applicable VaR limit for five business days. A fund must report this information within one business day (following the fifth business day after its VaR limit exceedance). These funds must file a second report when they are back in compliance.
Form N-CEN. Amendments to this form require funds to check a box to identify whether they relied on rule 18f-4 during the reporting period, including on whether they relied on various specific provisions of the rule.
What about leveraged or inverse ETFs?
Leveraged or inverse funds will generally be subject to rule 18f-4 like other funds, including the requirement to comply with the VaR-based limit on fund leverage risk. The rule includes an exception from the VaR-based limit for leveraged or inverse funds in operation as of October 28, 2020 that seek an investment return above 200% of the return (or inverse of the return) of the fund’s underlying index and satisfy certain conditions and the other requirements of rule 18f-4.
Rule 6c-11 has also been amended to include leveraged and inverse ETFs within the scope of that rule so long as they comply with the applicable rule 18f-4 provisions. Rule 6c-11 permits ETFs that satisfy certain conditions to operate without obtaining an exemptive order from the Commission.
Effective and compliance dates
The rule will be effective February 19, 2021. The Commission has set a compliance date of August 19, 2022 to give funds sufficient time to comply with the provisions of rule 18f-4 and the related reporting requirements.
On August 19, 2022, the 1979 General Statement of Policy (Release 10666) that provided Commission guidance on how funds may engage in certain trading practices in light of the restrictions under section 18 of the Act will be withdrawn. Related staff guidance also will be withdrawn on that date. A fund may rely on rule 18f-4 after the rule’s effective date but before the compliance date, provided the fund satisfies the rule’s applicable conditions and does not also rely on Release 10666 or related Commission or staff guidance.
The adopting release can be found on the Commission’s website at https://www.sec.gov/rules/final/2020/ic-34084.pdf.
The proposing release can be found on the Commission’s website at https://www.sec.gov/rules/proposed/2019/34-87607.pdf.
Contacting the Commission
The Commission’s Division of Investment Management is happy to assist small entities with questions regarding the rule 18f-4. You may submit a question by email to IMOCC@sec.gov. Additionally, you may contact the Division of Investment Management’s Office of Chief Counsel at (202) 551-6825.
 This guide was prepared by the staff of the U.S. Securities and Exchange Commission as a “small entity compliance guide” under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996, as amended. The guide summarizes and explains rules and form amendments adopted by the Commission, but is not a substitute for any rule or form itself. Only the rule or form itself can provide complete and definitive information regarding its requirements.