Statement on Regulation of Funds' Use of Derivatives
Oct. 28, 2020
I am grateful to the staff of the Division of Investment Management (the “Division”) for their years of work developing the recommendation we are considering today: to adopt rules governing the ways funds use derivatives in their investment portfolios. I would also like to extend my thanks to our staff in the Division of Economic and Risk Analysis, the Office of the General Counsel, and all others at the agency who contributed to this effort.
I. ACHIEVING BALANCE TO SERVE INVESTORS
Derivatives are essential financial tools in today’s markets. They enable portfolio managers of registered investment companies and business development companies (“funds”) to manage and hedge risk, enhance portfolio liquidity, efficiently gain or reduce exposure to certain asset classes, reduce transaction costs and volatility, increase yield, and otherwise assist in portfolio management. If funds were prohibited from using derivatives, investors would incur higher costs and greater risks in seeking to obtain the same market exposure.
Throughout the rulemaking process, we have endeavored to find a balance. On one hand, we aim to require careful risk management by funds that use products such as equity options, credit default swaps, and index futures, which can be complex on their own and particularly so in combination with one another. On the other hand, it is important to recognize that advisers need to exercise a degree of flexibility in order to responsibly manage their portfolios and pursue investment strategies that investors demand and benefit from.
In 2019, the Commission proposed a multi-prong approach: requiring funds to implement a principles-based risk management program that could address the bespoke risks and objectives of each fund, while imposing an overall outer limit on leverage that would apply to all funds. The proposal also included a more limited regime for funds that qualified as limited derivatives users, since their relatively minimal use of derivatives posed less risk to investors. Commenters provided specific and detailed feedback, including recent data, on almost every aspect of this proposal. Much of this feedback was derived from practical experience in executing trading strategies as well as carrying out risk management.
I appreciate the Division’s efforts to assimilate all of the information we received and make adjustments to the proposed rules where it was clear that doing so would better strike the balance for which we have been striving. I believe the final product is thoughtfully crafted and tailored to achieving the goals of this rulemaking.
II. ASSESSING OUR REGULATORY APPROACH TO COMPLEX PRODUCTS
I am pleased to see that this final recommendation does not include the proposed sales practice rules that would have applied only to leveraged and inverse, or “geared,” ETFs. I believe that, to the greatest extent possible, the Commission should maintain a consistent regulatory approach to the products we oversee. Instead, these proposed rules would have introduced a new layer of regulation applicable to only a narrow subset of securities products.
The release notes that our staff will continue to consider whether our current securities laws and rules are adequate to protect investors who may purchase geared ETFs. However, I appreciate that this study will not be limited only to such products. Instead, it will also include consideration of other complex products.
To further this effort, Chairman Clayton and the directors of our rulemaking divisions have published a Joint Statement Regarding Complex Financial Products and Retail Investors, which includes a request for public comment. I appreciate the thoughtful discussion in this document about the different regulatory regimes that currently apply to several different types of products available to investors, such as those governed by the Securities Act of 1933 versus those governed by the Investment Company Act of 1940. I also appreciate that the request for comment focuses on those investors, who are not advised by financial professionals—that is, those who may not receive the protections offered by Regulation Best Interest and the Investment Advisers Act’s fiduciary duty.
The request for comment asks for general feedback, but I would like to pose three specific questions that I believe would greatly inform the Commission’s study of these issues:
- What types of products should fall into the category of “complex?” Can commenters identify specific attributes that such products have in common? As we consider whether to impose different or additional investor protections in connection with the issuance, purchase, or sale of complex products, these questions can help us determine, to the extent appropriate, the scope of products to which such regulation should apply.
- What best practices have distributors of complex products developed and implemented in order to preempt, prevent, or address investor complaints? For example, have firms instituted their own classification systems, point-of-sale disclosures, or checks on investors’ ability to transact such products? If so, I am interested in how such practices were developed and why firms chose to implement some over others. I am also interested in whether firms may have come to develop different measures, based on the preferences or characteristics of the particular customers they serve.
- Finally, I am eager to hear from actual individual investors about their experiences, including what surprises they have encountered in transacting or attempting to transact complex products. What types of measures do these investors believe would best protect them and allow them access to investment opportunities?
I will conclude with a few notes of thanks. Thank you, in advance, to all who take the time to write in response to the request for comment. Thank you also to all of the commenters, who wrote in and met with us over the past several years, as we developed our proposals to regulate funds’ use of derivatives. Your practical insight was invaluable in creating this final product.
Finally, let me reiterate my sincere thanks to the agency’s staff. In particular, I commend Dalia Blass, Sarah ten Siethoff, Brian Johnson, Thoreau Bartmann, Amanda Wagner, Blair Burnett, Joel Cavanaugh, Mykaila DeLesDernier, John Lee, Amy Miller, Tim Husson, Tim Dulaney, Ned Rubenstein, Penelope Saltzman, Dennis Sullivan, Jacquelyn Rivas, Chyhe Becker, Malou Huth, Hari Phatak, Alex Schiller, Christian Jauregui, Mi Wu, Adam Large, Meridith Mitchell, Natalie Shioji, Cathy Ahn, Bob Bagnall, William (Brooks) Shirey, and Emily Parise. This rulemaking is the product of many years’ study and hard work, and it could not have been accomplished without your patience, perseverance, and dedication.
 See Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles, Investment Company Act Release No. 337-4 (Nov. 26, 2019) (“Re-Proposing Release”), at Section II.G.
 See also Commissioner Hester M. Peirce and Commissioner Elad L. Roisman, “Statement on the Re-Proposal to Regulate Funds' Use of Derivatives as Well as Certain Sales Practices” (Nov. 26, 2019), https://www.sec.gov/news/public-statement/roisman-peirce-statement-funds-derivatives-sales-practices.
 Chairman Jay Clayton; Dalia Blass, Director, Division of Investment Management; William Hinman, Director, Division of Corporation Finance; Brett Redfearn, Director, Division of Trading and Markets, “Joint Statement Regarding Complex Financial Products and Retail Investors” (Oct. 28, 2020), https://www.sec.gov/news/public-statement/clayton-blass-hinman-redfearn-complex-financial-products-2020-10-28 .