Modernizing the Regulatory Framework for Funds’ Use of Derivatives

Good morning. This is an open meeting of the U.S. Securities and Exchange Commission, under the Government in the Sunshine Act.

Today, we are considering a new rule to provide an updated and comprehensive regulatory framework for the use of derivatives by registered investment funds, including mutual funds and exchange traded funds (ETFs). I have spoken before on the importance of modernization—ensuring that the implementation of our time-tested, long term investor-oriented regulatory structure keeps pace with today’s marketplace—to the Commission’s mission and our markets more generally.[1]  I have no doubt that this commitment to modernization, which flows through the 4,500-strong SEC staff, greatly enhanced our ability and the ability of market participants more generally to both absorb and respond to the market and operational stresses caused by the COVID-19 pandemic.

The recommendation before us today is another outstanding example of reforms that modernize our rules for the benefit of investors.  Today’s recommendation recognizes that fund investment strategies and techniques have evolved, and will continue to evolve, in response to broader market and technological developments.  That recognition is just the first step.  To soundly modernize, the Commission must question how best to move forward.  Has enough time passed, and has enough changed, such that a fresh look is appropriate? Are there already Commission rules that address the concerns at hand, and if so are the market changes sufficiently discrete such that a new tailoring of existing rules will be more effective? Or, is it some combination of new requirements, tailoring of existing requirements, and codifying best practices that will produce the best practical results for our long term investors? Here, the Commission and its staff have investigated those questions in detail, including through the proposing release issued last November.[2]  This most recent investigation benefited from a number of related efforts over the last decade, including detailed comments we received in response to our December 2015 proposal.[3]  In particular, certain commenters argued that that proposal’s use of notional amounts was an ineffective way to identify and manage the types of risks that section 18 of the Investment Company Act is designed to limit.  That approach could have both restricted funds from using derivatives in prudent ways that benefit investors, while at the same time failing to address the kind of speculative leverage risks section 18 was designed to limit.  Importantly, as we move forward, we can take comfort from the fact that today’s recommendation benefits from a high-level of engagement, with over 6,000 commenters providing their views on the Commission’s 2019 proposal.

A further discussion of the background to this recommendation is illuminating.  It is beyond question that the Commission’s current regulatory approach to the use of derivatives by registered funds is overdue for improvement and modernization.  As a threshold matter, the current approach is both outdated and unclear.  The framework rests on a Commission statement issued in 1979, over forty years ago.[4]  Since then, the framework has developed through a combination of Commission guidance as well as staff no-action letters and staff guidance, which in many cases vary based on the specific type of derivatives transaction at issue.[5]  This approach may have made a certain amount of sense at the outset, and in a different era, but the use of derivatives by institutional investors has increased substantially and changed dramatically in character in the past forty years.  Just as relevant to the actions we consider today, this piecemeal approach has contributed to significant uncertainty as to how funds should treat their obligations under certain derivatives transactions for regulatory purposes, both generally and when considered in the context of the facts and circumstances of an individual transaction and fund.  This type of uncertainty is costly.  It causes some funds to refrain from wholly-appropriate transactions that are beneficial to investors, yet also allows funds to pursue transactions that are at least arguably consistent with specific Commission and staff guidance but that may not be consistent with principles of investor protection and other prudential considerations embedded in the Investment Company Act.  In addition, the combination of this approach and dramatic market change has driven disparate and inconsistent practices among similarly situated funds and, as a result, assertions of an un-level playing field and concerns about such asymmetries leading to an erosion of the principles underlying the Commission’s 1979 statement and self-imposed prudential safeguards.  The uncertainty associated with the current approach has oversight and enforcement consequences as well.  In certain circumstances, it limits our ability—and the ability of individual funds and advisers—to evaluate compliance with section 18 of the Investment Company Act.

These concepts—uncertainty of regulation, asymmetry in application, and resulting limitations on oversight and enforcement—are well known to regulators.  Here, it is appropriate to discuss them in more detail particularly in light of the significant evolution in both the derivatives market and the investment management market over the past four decades.  This evolution includes the development of various fund types and investment strategies, including strategies responding to broader market developments, as well as the dramatic growth in the volume and complexity of the derivatives markets over the past few decades. For example, since 1991 the fund industry has approximately tripled the number of investment companies and has roughly 20 times more assets under management, with this year over 13,000 investment companies holding over $27 trillion in assets.  As the size of the fund industry has increased, so too has the variety of fund strategies available to investors.  Investors today have a number of choices, ranging from passively managed funds linked to an index, to funds pursuing alternative investment strategies, as just two examples.  Derivatives, when appropriately risk managed, can be an important part of executing a variety of investment strategies.  This evolution, the over-arching obligation to the best interests of investors, and ever-present competition, have required registered funds to pursue the use of derivatives in various circumstances that were beyond any reasonable expectation in 1979, or 1999 for that matter. 

A fund’s use of derivatives implicates a key aspect of the Investment Company Act—section 18.  That section is a bedrock principle in the Act and we are not changing it.  It is its implementation that we need to monitor and modernize.  Section 18 limits a fund’s ability to obtain leverage or incur obligations through the issuance of “senior securities.”  In my words, that means the fund’s ability to take on debt or other obligations that are senior to—e.g., must be paid back in advance of—the fund’s obligations to its investors.  Protecting fund investors against the potentially adverse effects of a fund’s issuance of senior securities in inappropriate amounts or with inappropriate terms and, in particular, the risks associated with excessive fund leverage, is a core purpose of the Act. 

In many circumstances, derivatives involve “senior securities.”  Just as a fund can add leverage by issuing debt, so can a fund add leverage by engaging in derivatives transactions that create future payment obligations.  For example, a fund that has $100 in assets invested in an index might borrow $50 to invest in the same index.  If the same fund, having $100 invested in an index, were to enter into a total return swap with a notional amount of $50 on the same index, the fund’s risk and return profile is the same for all intents and purposes, including under section 18.  In this respect, both the borrowing and the total return swap amplify the potential benefits and risks of the fund, including gains, losses and volatility, and both practices raise the asset sufficiency and undue speculation concerns that section 18 was designed to address.  In addressing these risks, our approach should not allow form to override substance.  In fact, for the reasons of regulatory consistency, efficacy, effectiveness and efficiency I mentioned earlier, our regulations should address funds taking on leverage through “senior securities” regardless of the specific form those securities take.   

Achieving this goal, however, requires an understanding of how derivatives can be different from other ways that funds can leverage their portfolios through cash borrowings.  For example, beyond increasing exposure generally across a portfolio, funds may use derivatives to obtain (or reduce) specific investment exposures as part of their investment strategies, at times more quickly and with lower transaction costs or portfolio disruption than if they had invested directly in (or sold) the underlying securities.  Funds also may use derivatives to hedge their portfolio exposures or to hedge currency, interest rate and other risks.  Further, they may use additional derivatives to unwind or adjust exposures or hedges previously put in place using derivatives.  In these ways, among others, derivatives have proven useful to funds in the face of wider market developments, and in certain cases can strengthen funds’ ability to compete.  The resulting return enhancements and cost savings should inure to the benefit of investors, particularly where there is transparent competition among funds.  However, we cannot lose sight of the fact that, regardless of their principal purpose, derivatives can and often do create the type of exposure, including the risk of significant losses to fund investors, that the section 18 restriction on “senior securities” was intended to limit. 

So, our task is to continue to permit funds to use derivatives in a manner that best serves the investment objectives of the fund (including its liquidity and risk management polices) while addressing the concerns underlying section 18; and to do so in a manner that provides clarity and consistency.  In my view, Director Blass and her staff in the Division of Investment Management, with assistance from across the Commission, including from our Division of Economic and Risk Analysis, have done just that.

Today’s recommendation takes into account all of these considerations and recognizes that funds’ use of derivatives will and should continue, but in accordance with an overarching regulatory framework that appropriately protects investors and addresses the concerns underlying section 18.  As my colleagues will explain in more detail, this framework features new rule 18f-4, which has several components, some of which I will highlight.

First, the rule requires funds that use derivatives in a more than limited manner to put in place derivatives risk management programs.  A fund’s program must be administered by a derivatives risk manager appointed by the fund’s board and have elements tailored to the particular fund’s derivatives transactions and their related risks.  These elements include risk guidelines, stress testing, backtesting, and internal reporting requirements. This risk management program requirement draws on funds’ current best practices in many cases.    

Second, the rule imposes an outer limit on fund leverage risk based on value at risk, or “VaR.”  This outer limit is based on a relative VaR test that compares the fund’s VaR to the VaR of a designated reference portfolio: either an index that meets certain requirements or the fund’s own unleveraged securities portfolio.  Under certain circumstances, the outer limit would be based on an absolute VaR test, calculated as a percentage of the fund’s net asset value.  While open-end funds would be subject to relative and absolute VaR limits of 200% and 20%, respectively, closed-end funds would be subject to higher limits under certain circumstances, in light of statutory differences in permissible borrowings for these funds. 

Third, the rule imposes specific reporting and recordkeeping requirements to allow the Commission to monitor and evaluate a fund’s compliance with the rule’s requirements.  This information would complement the existing reporting that is already available to the Commission and facilitate the Commission’s identification and monitoring of industry trends, as well as risks associated with funds’ derivatives transactions.

Importantly, and I must emphasize this point, the new rule is not a siloed, stand-alone requirement.  This new framework for ensuring that the use of derivatives is consistent with the Act would be part of a fund’s overall management of portfolio risk and would supplement—but would not supplant—a fund’s other risk management activities, such as a fund’s liquidity risk management program and other regulatory requirements. 

Today’s recommendation would apply these new requirements to all funds that use derivatives in a more than limited manner, including so-called leverage/inverse funds.  These are funds or other investment vehicles that seek, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time.  Leverage/inverse funds and other complex investment products raise particular investor protection concerns, particularly with respect to retail investors who invest in such products of their own accord and without the regulatory protections provided when those investments are made pursuant to a recommendation by a broker-dealer or advice from an investment adviser.  Accordingly, today’s recommendation directs the staff to review the effectiveness of existing regulatory requirements in protecting investors who invest in leveraged/inverse products and other complex investment products.  This staff review is designed to produce recommendations for future Commission rulemakings or other policy actions.  In this vein, today I joined staff in issuing a statement regarding the purchase and use of leveraged/inverse funds and other complex products by retail investors.[6]  While the matters discussed in that statement are different from and extend beyond the use of derivatives, today’s recommendation will undoubtedly enhance our investor protection efforts with respect to investment companies that invest in derivatives, including those that follow more complex strategies.

In closing, I applaud the staff for today’s recommendation, which is a fantastic achievement.  Your work here successfully takes into account the myriad considerations I mentioned earlier, as well as the significant volume of Commission and staff guidance that has accumulated over the years, as well as the impressive feedback that we received in response to both our most recent proposal and to the Commission and staff efforts to modernize this space over the last decade.  This recommendation is thoughtful and sophisticated, yet consistent with our long-standing principles and pragmatic in its implementation.  Thank you for your outstanding work.

In particular, I would like to acknowledge the following staff members for their contribution to this rulemaking effort:

• From the Division of Investment Management: Dalia Blass, Sarah ten Siethoff, Brian McLaughlin 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, and Jacquelyn Rivas.
• From the Division of Economic and Risk Analysis: Chyhe Becker, Malou Huth, Hari Phatak, Alex Schiller, Christian Jauregui, Mi Wu, and Adam Large.
• From the Office of the General Counsel: Meridith Mitchell, Natalie Shioji, Cathy Ahn, Bob Bagnall, William (Brooks) Shirey, and Emily Parise.

I will now turn it over to Dalia Blass, Director of the Division of Investment Management, for the staff’s presentation of their recommendation.  Hari Phatak, Associate Director in the Division of Economic and Risk Analysis, will then summarize his views on the potential economic effects of this proposal.  Following the staff’s presentations, I’ll ask Commissioner Peirce, Commissioner Roisman, Commissioner Lee and Commissioner Crenshaw for any remarks.