SEC Proposes New Derivatives Rules for Registered Funds and Business Development Companies

The Securities and Exchange Commission today voted to propose a new rule designed to enhance the regulation of the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds (ETFs) and closed-end funds, as well as business development companies.  The proposed rule would limit funds’ use of derivatives and require them to put risk management measures in place which would result in better investor protections.

“Today’s proposal is designed to modernize the regulation of funds’ use of derivatives and safeguard both investors and our financial system,” said SEC Chair Mary Jo White.  “Derivatives can raise risks for a fund, including risks related to leverage, so it is important to require funds to monitor and manage derivatives-related risks and to provide limits on their use.”  

The Investment Company Act limits the ability of funds to engage in transactions that involve potential future payment obligations, including derivatives such as forwards, futures, swaps and written options.  The proposed rule would permit funds to enter into these derivatives transactions, provided that they comply with certain conditions.  

Under the proposed rule, a fund would be required to comply with one of two alternative portfolio limitations designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions. 

A fund would also have to manage the risks associated with their derivatives transactions by segregating certain assets in an amount designed to enable the fund to meet its obligations, including under stressed conditions.

A fund that engages in more than a limited amount of derivatives transactions or that uses complex derivatives would be required to establish a formalized derivatives risk management program.

The proposed reforms would also address funds’ use of certain financial commitment transactions, such as reverse repurchase agreements and short sales, by requiring funds to segregate certain assets to cover their obligations under such transactions.

The proposal will be published on the Commission’s website and in the Federal Register.  The comment period for the proposal will be 90 days after publication in the Federal Register.

#  #  #

FACT SHEET

Use of Derivatives by Registered Investment Companies and Business Development Companies

SEC Open Meeting

December 11, 2015

Action

The Commission will consider whether to propose a new rule designed to provide a modernized, more comprehensive approach to the regulation of funds’ use of derivatives.  The proposed rule would place restrictions on funds, such as mutual funds and exchange-traded funds (ETFs) that would limit their use of derivatives and require funds to put in place risk management measures resulting in better protection for investors.

Highlights of the Proposal

Requirements for Derivatives

Portfolio Limitations for Derivatives Transactions

Under the proposed rule, a fund would be required to comply with one of two alternative portfolio limitations designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions. 

• Exposure-Based Portfolio Limit: Under the exposure-based portfolio limit, a fund would be required to limit its aggregate exposure to 150 percent of the fund’s net assets.  A fund’s “exposure” generally would be calculated as the aggregate notional amount of its derivatives transactions, together with its obligations under financial commitment transactions and certain other transactions. 

• Risk-Based Portfolio Limit: Under the risk-based portfolio limit, a fund would be permitted to obtain exposure up to 300 percent of the fund’s net assets, provided that the fund satisfies a risk-based test (based on value-at-risk).  This test is designed to determine whether the fund’s derivatives transactions, in aggregate, result in a fund portfolio that is subject to less market risk than if the fund did not use derivatives.      

Asset Segregation for Derivatives Transactions    

A fund would be required to manage the risks associated with derivatives by segregating certain assets (generally cash and cash equivalents) equal to the sum of two amounts. 

• Mark-to-Market Coverage Amount:  A fund would be required to segregate assets equal to the amount that the fund would pay if the fund exited the derivatives transaction at the time of the determination.  

• Risk-Based Coverage Amount:  A fund also would be required to segregate an additional risk-based coverage amount representing a reasonable estimate of the potential amount the fund would pay if the fund exited the derivatives transaction under stressed conditions.

Derivatives Risk Management Program

Funds that engage in more than limited derivatives transactions or use complex derivatives would be required to establish a formalized derivatives risk management program consisting of certain components administered by a designated derivatives risk manager.  The fund’s board of directors would be required to approve and review the derivatives risk management program and approve the derivatives risk manager. 

These formalized risk management program requirements would be in addition to certain requirements related to derivatives risk management that would apply to every fund that enters into derivatives transactions in reliance on the rule. 

Requirements for Financial Commitment Transactions

A fund that enters into financial commitment transactions would be required to segregate assets with a value equal to the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under those transactions.    

Disclosure and Reporting

The Commission will also consider whether to propose amendments to two reporting forms the Commission proposed in May 2015, Form N-PORT and Form N-CEN. 

Proposed Form N-PORT 

Form N-PORT would require registered funds other than money market funds to provide portfolio-wide and position-level holdings data to the Commission on a monthly basis.  The proposal would amend the form to require a fund that is required to have a derivatives risk management program to disclose additional risk metrics related to a fund’s use of certain derivatives.

Proposed Form N-CEN

Form N-CEN would require registered funds to annually report certain census-type information to the Commission.  The proposal would amend the form to require that a fund disclose whether it relied on the proposed rule during the reporting period and the particular portfolio limitation applicable to the fund.

Derivatives White Paper

The proposal refers to a white paper prepared by the SEC’s Division of Economic and Risk Analysis (DERA) staff entitled, “Use of Derivatives by Registered Investment Companies.”   Granular information on the extent to which funds currently use derivatives is not  generally available.  The paper analyzes the use of derivatives by a random sample generated by DERA of 10 percent of all registered funds.  The paper presents data on their derivatives positions, financial commitment transactions, and certain other transactions. 

 The paper reports that some funds use derivatives extensively, with notional exposures ranging up to approximately 950% of net assets, while most funds either do not use derivatives or do not use a substantial amount.  The paper also presents  figures showing that since 2010 some fund investment categories that make greater use of derivatives have received a disproportionately large share of inflows. 

The white paper will be available on www.sec.gov. 

Background

The ability of funds to borrow money or otherwise issue “senior securities” is limited under Section 18 of the Investment Company Act.  A core purpose of the Investment Company Act is the protection of investors against potential adverse effects of a fund’s leveraging its assets by issuing senior securities. 

Certain derivatives transactions (e.g., forwards, futures, swaps and written options), as well as financial commitment transactions (e.g., reverse repurchase agreements, short sale borrowings, or firm or standby commitment agreements or similar agreements) impose on a fund an obligation to pay money or deliver assets to the fund’s counterparty, which implicates section 18.  The Commission’s proposed derivatives framework would be an exemptive rule under section 18.   

What’s Next

If approved for publication by the Commission, the proposal will be published on the Commission’s website and in the Federal Register.  The comment period for the proposal will be 90 days after publication in the Federal Register.