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Dissenting Statement at Open Meeting on Use of Derivatives by Registered Investment Companies and Business Development Companies

Commissioner Michael S. Piwowar

Dec. 11, 2015

Thank you, Chair White. Today, we are considering a proposed new exemptive rule that addresses the use of derivatives and financial commitment transactions by registered investment companies and business development companies (collectively, “funds”). This proposal is the third in a series of initiatives aimed at ensuring that the Commission’s regulatory program fully addresses the increasingly complex portfolio composition and operations of the asset management industry.

Let me begin by stating my strong support for Commission action in this area. For too long now the fund community has been left to navigate the complex world of derivatives without clear guidance from the Commission on the use of such products. Given the absence of specific current direction from the Commission, funds’ derivatives use is guided by a 1979 Commission General Statement of Policy (Release 10666),[1] more than 30 staff no-action letters, and other informal staff guidance issued on an instrument-by-instrument basis. Without diminishing the good work staff has done to address issues in this evolving market, it is imperative that the Commission step forward and provide a clear framework for fund activities in this space.

As we undertake this effort, however, the Commission must not forget that the current situation is one mostly of its own making. Funds have been engaging in derivatives transactions and pursuing related investment objectives and strategies for decades based on the guidance provided by their regulator, and, while the proposed rule we are considering today is referred to as an “exemptive rule,” it actually would restrict funds’ current practices.[2] The Commission, therefore, has an obligation to ensure that all proposed changes to the existing framework are based on clearly identified justifications for action. Moreover, any changes must also rely on the best available information about their likely economic consequences on funds and investors.

Compliance with this basic obligation requires that the Commission not propose any changes to the existing framework unless they are both based on high quality analyses of comprehensive data, and take into consideration other recent regulatory actions impacting the use of derivatives by funds. Unfortunately, some of the recommendations under consideration today fail this basic standard. This failure means that I cannot, at this time, support all of the proposed recommendations.

Before discussing the problematic portions of the recommendation, I will first turn to the part I do support, the proposed asset segregation requirements. Asset segregation has long been a part of fund risk management, including with respect to derivatives transaction obligations, and is the current approach the Commission uses to regulate funds’ derivatives transactions. The asset segregation approach was originally implemented by the Commission in Release 10666, which required a fund to maintain a segregated account with its custodian that contained liquid assets, such as cash, U.S. government securities, or other appropriate high-grade debt obligations, equal to the indebtedness incurred by the fund.[3] The Commission reasoned that such an approach would limit the amount of leverage incurred by funds and assure that funds are able to meet their obligations under their derivatives transactions.[4]

Since that time staff has issues a series of no-action letters and other informal guidance applying the asset segregation approach to derivatives transactions on an instrument-by-instrument basis. The cumulative effect of this staff guidance has been to considerably loosen the asset segregation requirements from how they were originally intended to apply.

The most significant change is that funds no longer segregate assets for all of their derivatives transactions in an amount equal to their potential obligations under their contracts or the full market value of the underlying reference assets. Instead, funds generally engage in so-called “mark-to-market segregation,” segregating an amount equal to the fund’s daily mark-to-market liability, if any, for derivatives that are required to be net cash settled.[5] Some funds even apply mark-to-market segregation to any derivative that is cash settled.[6] Additionally, funds now can segregate on their books any liquid asset, including equity securities and non-investment grade debt securities, and cover their derivatives positions with offsetting derivatives positions.[7]

It is clear that the mark-to-market segregation approach has strayed far from the Commission’s original asset segregation approach and does not provide the investor protections articulated by the Commission in Release 10666. One particular shortcoming in the current mark-to-market segregation approach is that it does not take into account a fund’s potential obligations under its derivatives transactions. This omission has resulted in some funds having highly leveraged investment exposures that are substantially in excess of the fund’s net assets, which may lead to unacceptable risks for investors in such funds.

Today’s proposal addresses the inadequacies of the current market practices by requiring a fund to segregate only cash and cash equivalents to cover not only mark-to-market liability, but also a reasonable estimate of the potential future liabilities. These potential future liabilities would be determined in accordance with policies and procedures approved by the fund’s board (including a majority of the independent directors) to reflect an amount payable by the fund if the fund were to exit each derivatives transaction under stressed conditions. In addition, the rule generally would not permit a fund to cover its derivatives positions with offsetting positions and would limit the total amount of a fund’s segregated assets to no more than the fund’s net assets.

These new requirements should serve as a functional leverage limit on funds as well as ensure funds’ ability to meet their obligations arising from their derivatives usage, consistent with the original intent of the asset segregation approach specified by the Commission in Release 10666.[8] The proposed rule text, in fact, expressly requires a fund to “manage[ ] the risks associated with its derivatives transactions by maintaining qualifying coverage assets.”[9] Thus, it is clear that the segregated asset requirements are designed to address both limits on a fund’s use of leverage and a fund’s ability to meet its derivative obligations.

While I support the proposed rule’s asset segregation requirements, I cannot, at this time, support the other rule requirements. The center piece of the proposed rule is the imposition of a limit on the amount of leverage a fund may obtain through derivatives transactions and other senior securities transactions. The proposal includes a limit of 150% of a fund’s net assets for most funds, and a limit of 300% of a fund’s net assets for funds where the derivatives transactions, in aggregate, result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives. The rule also would require funds to establish a derivatives risk management program administered by a designated risk manager, with an exception for funds that engage in only a limited amount of derivatives transactions and that do not use certain complex derivatives transactions.

I have two main reasons for not supporting these new requirements. First, as I just mentioned, the proposed asset segregation requirements should function as a leverage limit on funds and ensure that funds have the ability to meet their obligations arising from derivatives. Therefore, absent data indicating that a separate specified leverage limit is warranted there is no justification for imposing any additional requirements or burdens on funds. This is particularly the case given that our current guidance to funds concerning their derivatives transactions rests solely on asset segregation.

Second, the timing of today’s proposal, other than the proposed asset segregation requirements, is not appropriate given other recently proposed or adopted rules that address derivatives or funds’ use of derivatives. Many of these rules will either have a direct impact on the risks of derivatives positions held by funds, or will provide us with data that could be used to better understand how we should regulate this market. Two such recent rulemakings are the Investment Company Reporting Modernization Proposal[10] and the Open-End Fund Liquidity Risk Management Programs Proposal.[11]

The Investment Company Reporting Modernization Proposal included proposed new Form N-PORT, which would require almost all funds to report information about their monthly portfolio holdings to the Commission in a structured data format. Form N-PORT would include extensive information on a fund’s derivatives investments.[12] Part of the rationale for this data gathering proposal was that the Commission and investors are not always able to accurately assess funds’ derivatives investments and the exposures they create, which is important to understanding funds’ investment strategies, use of leverage, and risk of loss. The data collected under that proposal would bear directly on issues of leverage and risk that are at the heart of today’s recommendation.[13]

Thus, I strongly believe that the Commission should first adopt the Investment Company Reporting Modernization Proposal before proposing a new leverage limit on funds. Adoption of that proposal would provide investors and the Commission with a much better understanding of funds’ derivatives use and exposures, which should address many of the concerns regarding funds use of derivatives for leveraging purposes. In addition, it would provide the Commission with much needed data that can be analyzed, in accordance with our current guidance on economic analysis in rulemakings,[14] to determine whether there is any need to further limit funds’ use of derivatives. If the data supported further limits, it could then be used to determine what such limits should be in a thoughtful, empirically driven manner.

Perhaps we should take our own words from the Investment Company Reporting Modernization Proposal to heart, as we clearly indicated that the data gathered under that proposal would help us better understand the derivatives risks faced by funds, and that understanding these risks “will help our staff better understand and monitor risks and trends in the fund industry as a whole, facilitating our informed regulation of the fund industry.”[15]

The Commission should also adopt the Liquidity Risk Management Program Proposal before proposing a leverage limit or a specific derivatives risk management program for funds. The Liquidity Risk Management Program Proposal would require open-end funds (other than money market funds) to, among other things, classify their derivatives investments into one of six categories based on the number of days within which a fund’s position would be convertible to cash. The proposal would also require funds to specifically consider the liquidity of derivatives instruments when making these liquidity classification determinations. The proposal would further require funds to assess their liquidity risk, including the potential effects of the use of borrowings and derivatives on their liquidity risk. As part of their liquidity risk management programs required under the rule, funds would have to set a three-day liquid asset minimum requirement. In setting the liquid asset minimum, funds would have to consider their use of derivatives.[16] If adopted, these requirements could reduce the risks associated with a fund’s use of derivatives by ensuring that funds account for their derivatives exposures in formulating and implementing their liquidity risk management programs.

Finally, the Proposing Release we are voting on today repeatedly states that the new rule is necessary, in part, because of the dramatic growth in the volume and complexity of the derivatives markets over the past two decades.[17] The release also notes that funds’ use of complex over-the-counter derivatives in particular entail risks.[18] However, other regulatory action is already seeking to address some of these issues. Title VII of the Dodd-Frank Act[19] established a new oversight regime for the over-the-counter derivatives marketplace. The Title VII framework is designed to reduce risk, increase transparency, and promote market integrity within the financial system.[20] Both the Commission and Commodity Futures Trading Commission (“CFTC”) are currently working to implement this new mandate. While the CFTC has completed its rulemakings, the Commission has still not adopted the bulk of its rules under Title VII. The notion of good government suggests that we first complete the Title VII rulemakings and study the rules’ effectiveness before proposing comprehensive new requirements governing funds’ use of derivatives.

I look forward to the comments on today’s proposal. I am particularly interested on comments on the proposed asset segregation requirements. Would funds be able to continue to operate if they had to comply with the new segregation requirements? How effective would the proposed asset segregation changes be in serving as a leverage limit on funds? Are there alternative asset segregation changes that would work better? Supporting data would be greatly appreciated.

In closing, I want to thank the staff for the incredible amount of work they put into today’s proposal. Derivatives are extremely complex financial transactions, and the current regulatory framework for funds’ use of derivatives is only slightly less complicated. The staff expertly navigated through these many complexities and drafted a release that explains derivatives and their use by funds under the Act in a way that is easy to follow and understand. Despite my inability to support all of the recommendations at this time, I commend their work.

I have no questions.

[1] Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 10, 1979) (“Release 10666”).

[2] The Commission acknowledges in its economic analysis in the proposing release that the economic baseline for the analysis is the current industry practice established in light of Commission and staff positions that funds rely upon. See Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 31933 (Dec. 11, 2015) (“Proposing Release”) at section IV.B.

[3] Although Release 10666 specifically addressed reverse repurchase agreements, firm commitment agreements, and standby commitment agreements, the Commission stated that the release was “intended to address generally the possible economic effects and legal implications of all comparable trading practices which may affect the capital structure of investment companies in a manner analogous to the securities trading practices specifically discussed herein.”

[4] See Release 10666 at discussion in “Segregated Account” section, which suggests that asset segregation provides the same protections afforded by the restrictions on senior securities in Section 18 because if a fund “properly segregates assets, the segregated account will function as a practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock. Additionally, such accounts will assure the availability of adequate funds to meet the obligations arising from such activities.”

[5] See, e.g., Response Letter from Morgan Stanley Emerging Markets Domestic Debt Fund, Inc. to Comment Letter from the Division of Investment Management (Mar. 21, 2007) at Comment 29, available at; Response Letter from Morgan Stanley Select Dimensions Investment Series to Comment Letter from the Division of Investment Management (Apr. 12, 2007) at Comment 2, available at; Response Letter from Nationwide Mutual Funds to Comment Letter from the Division of Investment Management (Mar. 24, 2014) at Comment 16, available at

[6] See Proposing Release at nn.56-58 and accompanying text.

[7] See, e.g., Dreyfus Strategic Investing and Dreyfus Strategic Income, SEC Staff No-Action Letter (June 22, 1987); Merrill Lynch Asset Management, L.P., SEC Staff No-Action Letter (Jul. 2, 1996) ; Dear Chief Financial Officer Letter from Lawrence A. Friend, Chief Accountant, Division of Investment Management (Nov. 7, 1997), available at

[8] The rule would not require a fund to segregate assets equal to the full notional amount of each derivative because, as the Commission notes in the Proposing Release, “[t]he notional amount of a derivatives transaction does not necessarily equal, and often will exceed, the amount of cash or other assets that a fund ultimately would likely be required to pay or deliver under the derivatives transaction.” See Proposing Release at section III.A.1.

[9] Proposed rule 18f-4(a)(2).

[10] Investment Company Reporting Modernization, Investment Company Act Release No. 31610 (May 20, 2015) [80 FR 33590 (June 12, 2015)] (“Investment Company Reporting Modernization Proposal”).

[11] Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Investment Company Act Release No. 31835 (Sept. 22, 2015) [80 FR 62274 (Oct. 15, 2015)] (“Liquidity Risk Management Program Proposal”).

[12] The proposal also included amendments to Regulation S-X making similar changes to the reporting regime for derivatives disclosure in fund financial statements. See Investment Company Reporting Modernization Proposal at section II.A.2.g.iv.

[13] The Commission stated that the Investment Company Reporting Modernization Proposal is intended “to increase transparency into funds’ derivatives investments by requiring funds to disclose certain characteristics and terms of derivatives that are important to understand the payoff profile of a fund’s investment in such contracts, as well as the exposures they create or hedge in the fund.” See Investment Company Reporting Modernization Proposal at section II.A.2.g.iv. Additionally, in today’s Proposing Release the Commission suggests that the proposed additional derivatives information could have been useful in considering today’s proposed rule. See Proposing Release at n. 313.

[14] See Current Guidance on Economic Analysis in SEC Rulemaking (Mar. 6, 2012) available at

[15] See Investment Company Reporting Modernization Proposal at section II.A (emphasis added).

[16] See proposed rule 22e-4(b)((iv)(A)-(B) in Liquidity Risk Management Program Proposal

[17] See Proposing Release at section I, section II.D.1.a, section III, section III.D (as justification for requiring derivatives risk management programs), section IV.A, section V.A, and section VI.A.

[18] See id. at text accompanying n.26.

[19] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 (2010).

[20] See Proposing Release at text accompanying n.18.

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