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Opening Statement on Use of Derivatives by Registered Investment Companies and Business Development Companies

Oct. 28, 2020

Thank you, Mr. Chairman. In 2015, when this rule was first proposed, someone could have designed a derivatives contract to shift the risk of the rule’s adoption: in exchange for periodic payments, the seller of derivatives rule protection would pay out big if the rule got adopted. The buyer of this protection would have made periodic payments over the years. The parties would have exchanged collateral during the course of the contract to reflect the changing likelihood that the rule would get adopted. There might have been a market for such a derivatives contract because, in the words of one commenter in response to the 2015 rule proposal: “The proposed rule would severely restrict investment companies’ use of derivatives and thereby limit investors’ investment opportunities while imposing significant new compliance and other obligations on the directors and risk managers of such funds.” [1] In hindsight, however, purchasers of such a derivatives contract could have done without it since today’s rule is a great improvement over its problematic 2015 forerunner.

My little example illustrates that derivatives are a risk management tool that also carry risks and obligations for both sides of the transaction. Today’s rule seeks to ensure that funds use derivatives with due regard for those risks and obligations. I support the rule for its broadly sensible approach born of an understanding that funds use derivatives for important purposes and that to stop them from doing so would be harmful to investors.

Derivatives enable funds to manage risk and efficiently gain investment exposure. It is not surprising then that currently up to forty percent of funds report derivatives holdings.[2] It is also not surprising that the Commission wanted to adopt a comprehensive approach to govern funds’ derivatives use. Although I continue to believe that Section 18 provides an awkward basis for today’s rule and that a simple derivatives-risk-management program requirement together with advisers’ existing fiduciary duties would have sufficed, Rule 18f-4 will replace the current informal guidance patchwork with a clear and comprehensive regulatory structure for funds’ use of derivatives. Among other things, the rule will require certain funds to adopt written derivatives risk management programs, impose outer limits on a fund’s leverage risk based on a value at risk (VaR) calculation, impose additional board oversight responsibilities, and specify detailed reporting requirements. Rule 18f-4 also incorporates an exception for funds that are limited derivatives users and creates a narrow exception for certain leveraged/inverse exchange-traded funds (ETFs).

The final rule addresses a number of important concerns that commenters raised. For example, of the more than 6,000 comment letters that came in on this proposal, all but seventy addressed the proposed sales practices rule for leveraged/inverse ETFs. Largely as a result of those comments, this merit regulation component of the proposal is not part of the final rule. I welcome the passing of the proposed sales practices rule and am pleased to see that rule 18f-4 preserves an investor’s opportunity to invest in 200 percent leveraged/inverse products. With respect to 300 percent ETFs, however, the rule simply codifies the existing duopoly by prohibiting new entrants, rather than allowing competitors to come in on the same terms as the existing providers. I understand that there are investor protection concerns and that some believe disclosure is insufficient to address them, but this approach to dealing with thorny questions of investor protection and investor opportunity is less than ideal.

Another aspect of today’s recommendation that sets an unwelcome precedent is the devolution of duties to fund boards that more properly belong with the adviser. Rule 18f-4 requires the board to approve the designation of the fund’s derivatives risk manager. To echo some commenters, personnel decisions should be left with the adviser. The Independent Directors Council, for example, explained:

[R]equiring the board to approve the designation of specific personnel—and to evaluate the relevant experience of a candidate—draws them too far into the management function. It also clouds the reporting lines for those personnel and, importantly, creates yet another reporting relationship of this type with the board with siloed reporting protocols. The resulting potential for inefficient workstreams can be counter effective in the oversight of a fund’s investment risks, including derivatives risks. [3]

Not only would I have left the task of choosing a derivatives risk manager to the adviser, I also would have given the adviser the flexibility to outsource the role.

More generally, I join the many commenters who were supportive of a principles-based approach to derivatives risk management in lieu of more prescriptive measures. The final rule relies in many places on a principles-based approach, such as the risk identification and assessment requirement that informs the development of a fund’s derivatives risk management program. We should have taken other opportunities to recognize the diversity of knowledge and differences across fund strategies by further empowering funds and advisers to tailor how they manage and monitor derivatives-related risk.

Despite my concerns, there is much to commend this rule, both in its general approach and in its specifics. I appreciate, for instance, the commonsense exception from the rule’s coverage for funds that limit their derivative exposures to 10 percent of their net assets. In addition, in response to some commenters who, using the volatile markets of last spring as a highly informative analytical canvas, urged us to rethink the proposed relative and absolute VaR limits, the rule increases them from 150 percent and 15 percent to 200 percent and 20 percent, respectively. Also welcome is the revision to the proposed reporting obligations for a fund that exceeds its VaR limit. Relatedly, I am glad to see the extension of the remediation period, the removal of the proposed prohibition on derivatives transactions for funds that go above their VaR limit, and the elimination of the proposed restrictions on a fund’s ability to enter into derivatives transactions while out of compliance. The final rule appropriately provides funds flexibility to manage through stressed markets without an arbitrary regulatory hammer hanging over them threatening harm to funds, fund shareholders, and the broader markets.

So, the bottom line is that, thanks to the hardworking staff that crafted today’s recommendation, funds should not need to shift the risk of this rule. IM’s Miller-Lee-DeLesDernier-Cavanaugh-Burnett-Wagner-Bartmann-Johnson-ten Siethoff-Blass team worked with colleagues across the Commission, including staff from the Divisions of Economic and Risk Analysis and Trading and Markets, and the Office of General Counsel. All of us benefited greatly from their efforts and the invaluable insights from the many thoughtful commenters on our proposal.

[1] Letter from the American Action Forum,, at 1.

[2] This figure is based on a review of Commission filings reported in the Adopting Release.

[3] Letter from the Independent Directors Council,, at 5.

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