Keynote Address — 2019 ICI Securities Law Developments Conference
Dec. 3, 2019
Good Morning. Thank you Susan [Olson], and thank you all for the opportunity to come back and update you on the Division’s work.
I recently came across a September Compliance Minute Podcast, titled: Where Have you Gone, Dalia Blass? In the podcast, Mr. Todd Cipperman wanted an update on initiatives that I had announced last March, including the exchange-traded funds (ETF) final rule and the proposed updates to the investment adviser advertising and solicitation rules. I enjoyed listening to the podcast because it reminded me of how much work we undertook and also how much we achieved.
The accomplishments of Division staff over the last year truly have been amazing. We took across the finish line the ETF rule and the standards of conduct rulemaking for brokers and investment advisers. And to name just a few others, proposals on investment adviser advertising and solicitation, derivatives, variable annuity disclosure, fund of funds, and securities offering reform.
And that is just on the rulemaking front. Based on the Division’s recommendations, the Commission also issued the first exemptive orders for a new model of actively managed ETFs. We continued our board outreach and investor experience initiatives and launched a new initiative reaching out to smaller advisers. These initiatives started with outreach but have already resulted in several completed projects. For example, the recently issued guidance for use of proxy advisory firms and the new feedback form for smaller advisers that was included in the advertising and derivatives proposals. On the international front, we issued an extension of the MiFID II no-action letter, and we addressed questions on the use of Client Commission Arrangements (CCAs).
We have accomplished much over the last year – more than I can cover today. However, we are already looking forward to what comes next. This morning, I would like to talk about fund innovation, the derivatives proposal, affiliated securities lending, and a few updates to the fund disclosure regime.
Before diving in, let me remind you that I am speaking today only for myself and not for the Commission, the Commissioners, or the staff.
The Division is focused on facilitating fund innovation so that investors will have more options when selecting their investments. At the same time, even new products need established protections, particularly when the products will be marketed to retail investors. This balancing act is not always easy.
I want to focus today on two recent examples of working through that balance with fund sponsors who actively engaged with the staff. First, yesterday’s registration of a closed-end interval fund that will invest in bitcoin futures. And, second, a new model of actively managed ETFs.
Digital Assets and Related Investments
As staff, we welcome and value constructive industry engagement regarding new products and novel investment strategies. A prime example of such engagement involves registered funds seeking to invest substantially in digital assets and related investments.
Last year, I issued a public letter calling on the fund industry to engage in a dialogue on the investor protection and substantive issues presented by such investments. Issues identified in the letter focused on valuation, custody, liquidity, the efficiency of the arbitrage mechanism for ETFs, and potential manipulation in the digital asset markets. My letter called for funds seeking to invest substantially in digital assets to grapple with these questions before filing a registration statement.
I, and my staff, greatly appreciate the responses we have received. The industry took the letter seriously, recognized there were open questions, and responded with thoughtful and constructive input.
As a result of this engagement, we are at the point that a registered closed-end interval fund with a bitcoin futures strategy is preparing to launch. To reach this point, the fund first responded to each of the issues identified in the staff letter.
For example, on valuation, this fund expects to generally value its bitcoin futures holdings at daily settlement prices reflected on a CFTC-registered futures exchange, consistent with the principles of the Investment Company Act of 1940 and U.S. GAAP.
With respect to custody, the fund will invest in cash-settled futures and so will not face the challenges presented by direct holdings of digital assets.
Structured as a closed-end interval fund, the fund will not offer daily redemptions and will not be subject to potentially large, unexpected liquidity demands over short periods. And as an unlisted fund, its pricing will not depend on an efficient arbitrage mechanism and the willingness of market makers to make markets in a fund pursuing a digital asset strategy.
The fund also has taken steps to address issues related to potential manipulation in the digital asset markets. This includes prominent risk disclosures, offering the product only through registered investment advisers, and limiting the size and future growth of the fund, with an initial cap of $25 million.
No investment products are absolutely risk-free. This can be particularly true with novel and previously-untested investment strategies. Investors should proceed with caution, ask questions, and consider their risk tolerance before investing.
Speaking of innovation, it has been a truly transformational year for ETFs. The big headline is the Commission’s adoption of the new ETF rule. By creating a level playing field for the vast majority of ETFs today, the rule will facilitate greater competition and innovation in the ETF marketplace, supporting greater choice for investors.
In addition, earlier this year the Commission authorized the first new actively managed ETF model since 2008. And just last month, the Commission published notices of intent to approve another four new actively managed ETF models. These models are sometimes referred to as “non-transparent ETFs” because they will not publish their portfolio holdings every day. Many active managers have generally been reluctant to embrace the model of daily transparency out of concerns that their proprietary trading strategies might be exposed. As a result, growth in active ETFs has been slow relative to the broader ETF market.
Under the relief, these ETFs would provide information to the market without exposing their daily portfolio decisions. Each of these models would pursue a somewhat different way of shielding the manager’s strategy but at the same time is designed to provide sufficient information about the portfolio’s value to facilitate arbitrage. Importantly, because these products are novel, the orders that have been issued contain a number of safeguards to help protect investors and inform them about their unique features.
Reaching these milestones does not mean that the Division’s work on ETFs is over. We are continuing to review other proposals for new ETF models that are currently before us, and I encourage all of you to keep coming to us with your ideas on how to provide investors with more choice.
Modernization of Regulations
Let’s move from innovation to modernization. Modernizing old rules is one of the Division’s major themes. We are pursuing this on a number of fronts, most recently, on funds’ use of derivatives and affiliated securities lending.
Funds Use of Derivatives
I believe that it is critical to update and modernize regulatory regimes that are out of step with current markets. As derivatives markets have expanded and diversified, funds have looked to a patchwork of instrument-by-instrument guidance and no-action positions.
This approach has resulted in a lack of clarity and enabled inconsistent industry practices. Even worse, it may benefit certain market participants over others. I believe, for a practice and market that is so important, we need a robust and evergreen regulatory framework. So, in an important step forward, last week, the Commission unanimously voted to propose a comprehensive rulemaking addressing fund use of derivatives and leveraged funds.
The proposal would require funds to adopt a risk management program, designate a risk manager, and comply with a VaR-based limit on leverage risk. The program would have to include risk guidelines as well as stress testing, backtesting, internal reporting, escalation, and program review elements. The proposal provides an exception for limited derivatives users and an alternative leverage limit requirement for leveraged or inverse funds. To address retail purchases of leveraged and inverse funds and certain other leveraged vehicles, the proposal includes new sales practice rules under the Exchange Act and the Advisers Act. Finally, in light of how the proposal addresses these funds, it also would amend rule 6c-11, the recently adopted ETF rule, to allow leveraged or inverse ETFs to rely on that rule.
Let me leave you with a few thoughts and questions for your consideration on four aspects of the proposal.
- First, in recommending the proposal, the staff sought to align the board’s role with its duty to oversee other aspects of the management and operations of a fund. The proposal relies on the existing framework of rule 38a-1 and, to further address the potentially unique oversight challenges presented by derivatives, requires board approval of a qualified derivatives risk manager. This manager must provide regular written reports to the board that address the program’s implementation and effectiveness. Rather than a data dump, this reporting would focus on key events, like when the fund exceeds its risk metrics, as well key analyses, like stress tests and backtests. This is a central aspect of the proposal, and I would like to see feedback. Does the proposal effectively leverage and empower the board? Does it provide boards with the information and tools they need to appropriately oversee derivatives use by a fund? Are there any needed enhancements?
- Second, the proposal includes a VaR-based limit on leverage risk. We developed this data-driven limit with help from the Division of Economic and Risk Analysis. The proposal recognizes that the VaR approach, on its own, has shortcomings. That is why the VaR test is a complement to other elements of the risk management program, not a standalone risk management tool. The proposed rule would also require a fund to establish risk guidelines and to stress test its portfolio. Further, a fund would have to consider its counterparty and liquidity risks. I believe that effective risk management, in the real world, never relies on a single measure or approach, and we developed the proposal to reflect that. Does the program establish an effective limit on leverage risk? Does it address the potential limitations of the VaR test? Are there other tests or measures that we should consider?
- Third, the proposal does not include an asset segregation requirement, which is a feature of the current instrument-by-instrument regime. Fund asset segregation practices have developed such that a fund’s derivatives use—and its potential leverage obtained through derivatives—appear to be subject to little in the way of practical limits. There are also several operational complexities with asset segregation—from how such requirements would apply to cleared transactions to whether coverage assets should be subject to “haircuts” based on the relative volatility of different asset classes. The proposed derivatives risk management program and VaR-based limit on leverage risk, along with the proposed rule’s requirements regarding board oversight and reporting, are designed to require a fund to manage all of the risks associated with its derivatives use. As a result, the proposal does not include a separate asset segregation requirement. But I want to hear from you – are there benefits to maintaining a separate asset segregation requirement?
- Finally, together with the proposed risk management program and sales practice rules, the Commission also proposed to allow leveraged and inverse ETFs to rely on the final ETF rule. Do the conditions of proposed rule 18f-4, combined with the proposed sales practice rules, appropriately address the unique risks presented by such funds? Is it appropriate to allow current and new sponsors of leveraged or inverse ETFs to rely on the final ETF rule?
With that, I look forward to hearing commenters’ thoughts on this rulemaking.
Affiliated Securities Lending
As we work to modernize asset management regulation, we need to tackle, in particular, areas where market participants are treated differently. An important example, and current priority, is affiliated securities lending. Earlier this year we formed a team to focus on this topic because its relevance has only grown over the years given the increasingly competitive environment for fees and performance.
Advisers may be using related revenue to boost returns or to reduce the impact of expenses. To support the efficiency of their lending programs, funds generally use a securities lending agent, and the agent may be an affiliate. They pay the lending agents in a variety of ways, including on a fee-for-service basis or by sharing the revenue from securities lending. Funds that pay an affiliated agent with a share of revenue must obtain exemptive relief from the Commission.
As many of you know, the Commission last issued an exemptive order with this relief in 2004. The result is that some funds have relief and others that would like it do not. We are reviewing securities lending, in part, to seek ways to address this divide. To do that, however, we have to confront potential conflicts of interest and abuses raised by such arrangements.
In this regard, we welcome ideas on qualitative and quantitative conditions to address these potential conflicts and abuses. For example, we welcome your thoughts on some preliminary areas we are exploring:
- On the overall structure of the securities lending program, how can advisers and boards consider the appropriateness of the program on a fund-by-fund, asset class, and complex-wide basis?
- Rather than allowing a fund to use an affiliated lending agent for its entire program, should we explore conditions that require a mix of affiliated and unaffiliated agents? For example, should the Commission permit the use of affiliated agents only if limited to a certain percentage of the securities loaned? Could this help support competition, transparency and benchmarking?
- What are the current best practices on conflict assessment and management?
- Do advisers and boards have access to independent information about the performance of their securities lending agent? Are there additional disclosures that would improve the mix of information so that funds and boards are better informed in selecting lending agents?
We understand the importance of a level playing field in affiliated securities lending. Any constructive input you can provide in this area will help us work toward this goal.
Before closing, I would like to return to the topic that is at the heart of our Investor Experience Initiative – fund disclosure. As you know, as our next major step in advancing this Initiative, we are actively working on a recommendation for streamlining the shareholder report. However, that is not our only focus. Two other areas that are front and center include fund fees and foreign index risk disclosures.
In response to the request for comment on how to improve fund disclosures, investors told us that fee disclosures need attention. They find fee disclosure confusing and full of legal jargon. If I may summarize my takeaway, investors are looking for disclosure to answer a simple question: how much of my money is working for me?
The staff is considering ways to update fee disclosure so that it answers this question. For one thing, our current requirements are not keeping up with changing market practices. Every few days I read another article about funds that have cut their fees and zero-fee funds. While real reductions in costs are good news for investors, I cannot help but ask a couple of questions:
- First, are cuts in one place being made up in another?
- Second, can an ordinary investor figure that out? Can an investor looking at the fee table answer my simple question – how much of my money is working for me?
Transparency of fees and expenses is not the end of the story. If funds are relying on revenue sources not reflected in the fee table, does that implicate fund marketing rules? For example, under rule 156 under the Securities Act a statement could be misleading in “the absence of explanations, qualifications, limitations or other statements necessary or appropriate to make [the] statement not misleading.” With that in mind, are funds that advertise zero-fees, for example, considering whether explanations and qualifications are needed? We are asking these question, and I would encourage you to do so as well.
Disclosure Issues for Funds Tracking Foreign Indices
In addition to newer disclosure issues, like those concerning zero-fee funds, we also continue our focus on perennial concerns, like improving risk disclosures. You have heard me talk about the importance of risk disclosure before, and the Division recently published suggestions for improving these disclosures. There continues to be room for improvement, and an example that comes to mind is funds that track indices with significant exposure to emerging and frontier markets. These funds face unique risk disclosure considerations.
In some foreign markets, less information is publicly available. These markets may also involve less oversight of compliance with regulatory and reporting requirements. As a result, there may be heightened risks associated with the adequacy and reliability of the information index providers use when constructing their indices. There also may be a marked difference in the rights and remedies available to the fund against index constituents located in emerging and frontier markets compared to those available in the United States.
As such, I believe that a fund should ask and answer the following:
- What are the risks in using unreliable or outdated information when assessing if a constituent should be included in an index?
- What if the issue is not just the quality of the information but that the index provider has access to partial or very limited information?
- What are the limitations, if any, in assessing the index provider’s due diligence process?
- What are the limitations, if any, to the rights and remedies available to the fund?
Each of these questions points to potential risks to the reliability of index data, index construction, and index computation. Each of these can meaningfully affect fund performance. As a result, and also keeping in mind the potential effect on the rights and remedies available to the fund, the staff has heightened its review of these disclosures.
I know that I have covered a lot this morning. The services that asset managers and fund sponsors provide are critical to investors, our markets, and our economy. As a result, it is important that we continue our work to modernize our rules to provide better safeguards together with choice and opportunity to investors. The Division has sought to be transparent about its agenda to facilitate public input. For example the Commission’s short term Regulatory Flexibility Act Agenda reflects the rulemaking initiatives we reasonably expect to complete over the 12 month period. Further, we use opportunities such as today’s conference to share other policy areas that we have identified as potentially in need of modifications. I believe this transparent approach facilitates constructive engagement and, in turn, helps move our initiatives forward.
On that note, a number of my colleagues will participate on panels later today and will talk about other matters the Division is engaged on. Melissa Gainor and Brian Johnson will join the Regulatory Developments panel. Daniele Marchesani and Parisa Haghshenas will participate in the discussion on the SEC’s role in fostering fund innovation. Finally, Samantha Brutlag will join the discussion on ESG investing while Michael Spratt will join the panel on benchmark reform.
Thank you again for inviting me to speak this morning, and I hope that you enjoy the rest of the conference.
 I would also like to thank David Bartels, Matthew Cook, Brent Fields, Brian Johnson, Michael Kosoff, Andrea Ottomanelli Magovern, Jennifer McHugh, DeCarlo McLaren, Jean E. Minarick, Sirimal Mukerjee, Susan Nash, Trace W. Rakestraw, Penelope W. Saltzman, Christian Sandoe, Sarah ten Siethoff, Tara Varghese, Kay-Mario Vobis, Amanda Wagner, and Sumeera Younis for their assistance in preparing these remarks.
 Todd Cipperman, Compliance Minute Podcast: Where Have you Gone, Dalia Blass? (Sept. 13, 2019) available at https://cipperman.com/2019/09/13/compliance-minute-podcast-where-have-you-gone-dalia-blass/.
 The Securities and Exchange Commission (“SEC” or “Commission”) disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
 Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings (Jan. 18, 2018), available at https://www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm. Public responses to the staff’s letter are available at https://www.sec.gov/investment/fund-innovation-cryptocurrency-related-holdings.
 Of course, like any other registered fund, the Commission has not approved or disapproved the securities issued by the fund or determined that its prospectus is accurate or complete. Any representation to the contrary is a criminal offense. See rule 481(b)(1) under the Securities Act of 1933 (requiring a legend to this effect on the outside front cover page of each prospectus).
 See Blue Tractor ETF Trust and Blue Tractor Group, LLC, Investment Company Act Release No. 33682 (Nov. 14, 2019), https://www.sec.gov/rules/ic/2019/ic-33682.pdf; Fidelity Beach Street Trust, et al., Investment Company Act Release No. 33683 (Nov. 14, 2019), https://www.sec.gov/rules/ic/2019/ic-33683.pdf; Natixis ETF Trust II, et al., Investment Company Act Release No. 33684 (Nov. 14, 2019), https://www.sec.gov/rules/ic/2019/ic-33684.pdf; T. Rowe Price Associates, Inc. and T. Rowe Price Equity Series, Inc., Investment Company Act Release No. 33685 (Nov. 14, 2019), https://www.sec.gov/rules/ic/2019/ic-33685.pdf.
 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. 33704 (Nov. 25, 2019) at nn.182-183 and accompanying text available at https://www.sec.gov/rules/proposed/2019/34-87607.pdf.
 Section 17(d) of the Investment Company Act of 1940 and rule 17d-1 thereunder prohibit an affiliated person of a registered investment company, or an affiliated person of such a person, acting as principal, from participating in any joint enterprise or arrangement in which that investment company is a participant, unless the SEC has issued an order exempting the arrangement.
 Notes from the Chairman: Fees, Costs and Taxes (Apr. 25, 2019) available at https://www.youtube.com/watch?v=iUu9M8rRpys#action=share.
 Improving Principal Risks Disclosure; ADI 2019-08 available at https://www.sec.gov/investment/accounting-and-disclosure-information/principal-risks/adi-2019-08-improving-principal-risks-disclosure