Speech by SEC Staff:
Remarks Before the Practising Law Institute's Investment Management Institute 2010
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, New York
April 8, 2010
Good morning and thank you for that kind introduction. It is a pleasure to speak with you today about our work in the Division of Investment Management; particularly now, as it is one of the most exciting periods in financial regulatory reform in decades (although Paul and Barry, you both certainly had your share of interesting events during your tenures). Before I begin, it is my obligation to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
This year, not only is Congress considering comprehensive legislation that could impact even the most fundamental aspects of how our financial markets are governed, but we also saw last week the Supreme Court deliver a landmark decision concerning the regulation of investment companies. You just don't see that every day (I guess thankfully, although in this case, it was gratifying to see the Court affirm a long-held approach regarding fund Boards' review of advisory fees).
Much of the activity we are seeing now regarding financial regulation of course stems from the turmoil in our financial markets over the past few years. One result of working in the aftermath of these events is that we are trying to craft a regulatory regime with a view towards preventing or otherwise mitigating further problems - problems that we may not even be aware of today. Rather than reacting to a singular event, our regulatory goal in the Division of Investment Management, in many areas, is to try and create a more dynamic regulatory scheme - one that will be effective in increasing investor protection even as the investment company landscape continues to change and evolve at a rapid pace. In addition to adopting a forward-looking approach in the Division's initiatives, we are also faced with new aspects of regulation. For example, as our markets have become more complex and intertwined, we must consider the effect of certain risks, although not new but certainly more pervasive - such as systemic risks - as an important element when seeking to achieve our mission of investor protection, maintaining fair, orderly and efficient markets and facilitating capital formation.
II. Sophisticated Products
One area that exemplifies my concerns regarding market complexity and the need to address a rapidly changing market is in regard to derivatives. I have, for some time, made no secret of my concerns regarding funds' use of derivatives and my belief that these instruments, while affording the opportunity for efficient portfolio management and risk mitigation, also can present potentially significant additional risk as well as raise issues of investor protection. As funds' investments in these instruments are increasing, and the spectrum of derivative instruments available continuously broadening, this morning I would like to reiterate my concerns and update you on how the Division is looking at this issue.
In the past two decades, the investment company marketplace has been significantly reshaped by the use of derivative instruments. During this period, investment companies have moved from relatively modest participation in derivatives transactions limited to hedging or other risk management purposes to a broad range of strategies that rely upon derivatives as a substitute for conventional securities. Mutual funds that mimic hedge fund strategies, typically involving derivative products, have become commonplace. New categories of investment companies have emerged: absolute return funds, commodity return funds, alternative investment funds, long-short funds and leveraged and inverse index funds, among others.
It is also not uncommon for investment companies with traditional investment objectives to obtain synthetic market exposure through derivative products, such as credit default swaps, rather than invest directly in the underlying "cash" market. The embrace of derivatives by investment companies may be most dramatically illustrated by funds, such as leveraged ETFs, which are designed for the singular purpose of achieving a leveraged return through the use of derivatives, in most cases to a degree not possible using traditional investments.
These developments present challenges in giving effect both to the literal terms of the Investment Company Act as well as two of its underlying purposes 1) to address the speculative character of shareholders interests arising from excessive borrowing or the issuance of excessive amounts of senior securities and 2) to assure full disclosure of investment strategies and risks. The 1940 Act truly contemplated a different world. Engrained in the Act, and assumed until not that long ago, is that investment companies were investing in a market of stocks, bonds and similar securities. It also approaches many areas such as concentration and diversification, to name but two, based on the amount of money invested, rather than the degree of exposure the fund has undertaken. That of course is not always the case now. With so many derivative instruments available to enhance an investment strategy, a fund's manager can design a portfolio in a multitude of ways to create different exposures that are unrelated to the amount of money invested and are not necessarily reflective of the types of instruments the fund holds. It is to assess and respond to this challenge that the Division has undertaken to review derivatives activities of investment companies and the implications of those activities for the regulatory framework.
Because foremost among the issues presented by fund use of derivatives is leverage, and its implications for investors, fund managers and the markets, the Division's review includes looking at current practices involving derivatives and determining whether they are consistent with the policies and purposes underlying the Investment Company Act and its regulations. In particular, we are looking at whether methods to obtain leverage are consistent with leverage restrictions embodied in Section 18 as well as the concerns expressed in section 1(b) of the Act. For example, certain practices may allow a fund to obtain market exposures well beyond that which the Act explicitly allows through the use of derivatives and the use of various structures and offshore or special purpose vehicles. Are there practices that might violate section 48 of the Act where funds are indirectly obtaining leverage and other exposures through the use of derivatives that they are precluded from obtaining directly? This is just one question of many in this area that we are looking at.
In addition to leverage issues previously mentioned, we are also looking at the appropriate way to address concentration and diversification requirements where derivative instruments are utilized. As an initial matter, how should we measure the derivative instrument itself for such purposes? It would seem that simply utilizing the amount invested in the derivative instrument would underestimate the exposures and risks in many cases and using notional amounts may at times overstate them. Furthermore, utilizing derivative instruments introduces another dimension to the equation, in addition to the exposure sought from the derivative instrument, the fund frequently has now exposed the fund to the credit and other risks associated with the issuing of the derivative instrument and its issuer.
One example of the challenges being presented is the following extreme case. Assume a diversified fund purchases derivative instruments providing exposure to the performance of Issuer "A" common stock from a diversified group of issuers. Is the fund diversified as the instruments it owns are from a diversified group or is it non-diversified as its performance and risks are driven principally by what happens with Issuer "A" common stock? While I can posit other examples, I believe you can clearly see that the issues are much more complex than when the fund just invested directly in Issuer "A" common stock.
Thinking about how interconnected our markets can be daunting. For this reason, the Division is also looking at how funds are addressing risk in this area and asking whether funds that rely heavily on the use of derivatives, particularly those that seek leveraged returns, have appropriate expertise and maintain robust risk management systems and procedures in light of their investments. In addition, the Division is looking at how fund derivative investments are being regulated and overseen. Do existing regulations sufficiently address whether funds' procedures for pricing and liquidity determinations of their derivatives holdings are appropriate and do the current disclosure requirements adequately address the risks created by derivatives? Has the Commission provided adequate guidance on how much leverage is permissible, how it should be measured and "covered" for purposes of the Act?
As we examine the market environment with respect to funds' use of derivatives, the Division staff is deferring consideration of exemptive requests to operate ETFs that intend to use significant amounts of derivatives. We are doing this to be sure that the regulatory protections for investors in these products are keeping up with the increasing complexity of the derivative instruments these types of ETFs use. We also look forward to learning of the recommendations of the ABA Task Force on Investment Company Use of Derivatives and Leverage. That Task Force is looking at how the Commission can improve regulations and regulatory guidance in this area.
In addition, the staff, in its review, is looking at whether boards of directors are providing sufficient oversight of the use of derivatives by funds and how the Commission might assist directors in this important area. As we are refining the appropriate regulatory framework for derivatives usage by funds, effective Board oversight in this area, in the meantime, is critically important. As funds' use of derivatives presents concerns and risks on many levels, fund boards' oversight of the use of these instruments by advisers also requires a multi-faceted approach, an approach that not only considers the more obvious risks these instruments present - such as market, liquidity, leverage, counterparty, legal and structure risks - but some less obvious risks as well. For example, certain derivative-based investment products, such as collateralized debt obligations, collateralized mortgage obligations and swaps are potentially difficult to price, directors should ensure that the fund's procedures to price such securities are appropriate. Does the fund have the necessary expertise (other than the portfolio manager) to understand the impact on the fund's portfolio of the derivatives and to properly determine their price and liquidity?
As I have mentioned in the past, with the advent of such complexity in our markets, and the increased use of derivatives by funds, I believe oversight of derivatives can not be business as usual. In the current financial environment, it is becoming increasingly apparent that the more traditional approaches to risk, while important, are not enough. Losses to the fund and its shareholders can result from a complicated mix of events, making it more difficult to predict or model expected outcomes. With derivatives, the necessity of a robust, non-traditional analysis is clear.
As regulators, we need to do our part as we examine this area. Our goal with respect to derivatives is not simply to react to recent market events, but rather, through thoughtful examination of each facet involved in funds' use of derivatives, to develop a complete picture of the current landscape in this area and develop an appropriate regulatory approach. We cannot do this in isolation. In addition to the work of the ABA, we hope to engage market and other regulatory experts, academics and investor advocates in our review. In this way, my hope is that we can develop an appropriate regulatory framework for the proper use of derivatives by funds. I admit this will be a big project, but considering the stakes involved, I believe it is crucial that we do it quickly and that we get it right.
III. Money Market Funds
Now I would like to spend a few minutes talking about money market funds. As you know, the Commission recently amended rule 2a-7 to make money market funds more resilient. The new rules, which are being phased in over the next few months, will further limit the ability of money market funds to assume risks, by lowering the maximum average weighted maturity of fund portfolios, further limiting a fund's ability to invest in "second tier securities" and, for the first time, requiring money market funds to maintain a significant portion of their assets in highly liquid securities. If a fund does break the buck, the rules allow for funds to suspend redemptions so that the portfolio can be liquidated in an orderly manner. The Commission has announced a second phase of rulemaking, which I expect will commence later this year.
Now that credit markets are no longer frozen and a sense of normalcy has returned to the money markets, some might question why the Commission needs to take any further steps in this area. The answer is fundamental. While the new rules effectively reduce the risk in money market funds and strengthen them, thus making it less likely that another fund will "break the buck" and protecting shareholders' interests in the event that happens, the events of the fall of 2008 showed that money market funds are susceptible to runs, particularly by institutional investors. The regulatory framework under which money market funds operate can be made to more effectively deal with that fundamental risk.
For obvious reasons, reducing the susceptibility of money market funds to runs has become an important policy objective, not just for us within the walls of the SEC, but at the Treasury Department and the Federal Reserve as well. The events of the fall of 2008 precipitated a massive intervention with respect to money market funds that many in the government would not like to see repeated. The President's Working Group has been tasked with examining alternatives to addressing systemic risk in money market funds and will issue a report on the subject. The report is expected to discuss advantages and disadvantages of different policy options. We can look forward to a robust public discussion following its release.
One idea for a private liquidity bank would provide a liquidity source that funds could tap after exhausting their own internal liquidity. This facility would operate to augment the recent rule changes with respect to liquidity, but it would not prevent funds from breaking the dollar and thus would not fully resolve systemic risk concerns. Institutional investors would still have an incentive to run if the marked to market value of a money market fund is below a dollar. At its core, I would anticipate that phase two of money market reform will among other things be about seeking to lower that incentive.
I think we can all agree that money market funds economically are critically important and provide a great service to investors, as well as to the corporations and municipalities that rely on money market funds to provide short term funding. However, in my opinion, we cannot afford to ignore the lessons of 2008, and must further address the liquidity and systemic risk that money market funds present. Just because the government came to the rescue once, does not mean it will continue to do so whenever called upon, particularly if the industry appears to neither appreciate nor engage in finding possible solutions to deal with the fundamental nature of these risks.
IV. Collective Investment Trusts
Before I end this morning and we move on to the first panel, I briefly want to mention one investment practice that I am increasingly concerned about. And that is the use of collective investment trust platforms. In these platforms, although consisting of pooled trust accounts operated by a trust company or bank, each fund in the collective trust may be managed by an outside adviser that will also be responsible for marketing and distribution. Although these trusts have been around for decades, albeit previously with more limited availability, they are now being used to a much greater extent, particularly for retirement funds. According to one source, assets managed in this manner have risen from $783 billion in 1999 to $1 trillion at the end of the second quarter of 2009.
Collective investment trusts are regulated by the banking agencies, and may rely on an exclusion from registration under the Investment Company Act. The premise underlying this exclusion is that banks exercise full investment authority over the pooled assets, among other things. As collective investment trusts become more popular and their structures more varied, the Division is looking at whether, under certain conditions, this exemption is properly relied upon and consistent with the Act and whether it denies investors appropriate protections. For example, are banks operating merely in custodial or similar capacity while providing a place for an adviser to simply place pension plan assets of its clients? As we learn more about the structure and operation of these platforms, we will be considering this and other issues and whether there may be a need for any regulatory recommendations.
Thank you very much for listening this morning. As I had mentioned, it is a very exciting time to be working in this area of regulation. PLI has put together a terrific program over the next two days, with the panels exploring in depth a number of the potentially significant reforms that we are seeing in Congress and at the Commission. I hope you enjoy what I am certain will be very interesting and lively discussions of the issues and impact of these historic changes. Thank you again.