Q&A: SEC Modernizes Fund Derivatives Rule 18f-4

NOV 10, 2020 | PRACTUS LLP

Q&A: SEC Modernizes Fund Derivatives Rule 18f-4

Authored by Ethan Corey, J. Stephen King, John H. Lively

SEC Adopts Fund Derivatives Rule – Questions & Answers

On October 28, 2020, the US Securities and Exchange Commission (SEC) adopted Rule 18f-4 under the Investment Company Act of 1940 (1940 Act).  The SEC also adopted amendments to its new exchange-traded fund (ETF) rule and to several 1940 Act reporting forms.

1. What types of investment companies does Rule 18f-4 cover?

Most mutual funds, ETFs, registered closed-end funds, and business development companies (BDCs).

2. Do any types of investment companies fall outside the scope of the Rule?

Yes.  Rule 18f-4 does not apply to money market funds and unit investment trusts.

3. Will the Rule apply to all derivatives?  Will the Rule apply to instruments other than derivatives?

Great question!  No, the Rule will not apply to all derivatives.  If a derivative provides economic leverage but does not put at risk an amount greater than a fund’s initial investment, it is not subject to Rule 18f-4.  On the other hand, Rule 18f-4 regulates transactions such as reverse repurchase agreements, unfunded commitment agreements, when-issued transactions and forward settling transactions, all of which can put at risk amounts greater than the initial transaction amount.

4. One of our funds employs derivatives pretty heavily – we’re constantly segregating at least 20% of the fund’s assets to cover its transactions.  What will the Rule require us to do?

Rule 18f-4 will require the fund to: 

  • adopt a written derivatives risk management program; 
  • have a board-designated derivatives risk manager (DRM) 
    • a single DRM cannot be the fund’s portfolio manager; and
    • a group or committee DRM can include a portfolio manager, but the majority of the group or committee cannot consist of the fund’s portfolio managers; 
  • comply with an outer limit on leverage risk based on a value-at-risk metric (VaR)
    •  Generally, the fund will be subject to a relative VaR limit of 200% of the fund’s “designated reference portfolio” (250% if it’s a closed-end fund that has issued preferred stock), which may be 
      • an index that reflects the markets or asset classes in which the fund invests, that wasn’t created or administered by the fund or a fund affiliate and that meets certain other requirements; 
      • the fund’s own securities portfolio (excluding derivatives transactions); or
    • If the fund’s DRM reasonably determines that a designated reference portfolio would not be appropriate for purposes of the relative VaR test, the fund must comply with an absolute VaR of 20% of the fund’s net assets (25% if it’s a closed-end fund that has issued preferred stock); and
  • comply with certain recordkeeping and reporting requirements.

5. What does Rule 18f-4 require with respect to the written derivatives risk management program?

The program must include policies and procedures reasonably designed to manage the fund’s derivatives risks – funds with different risk profiles would need to have policies tailored to their unique risk profiles rather than “one-size-fits-all” policies and procedures.  Required elements of a fund’s program include: 

  • risk identification and assessment of the fund’s derivatives transactions and how they interact with the fund’s other investments; 
  • risk guidelines incorporating quantitative or otherwise measurable criteria, metrics or thresholds related to the fund’s derivatives risks; 
  • weekly or more frequent stress testing and back-testing; 
  • internal reporting and escalation between the fund’s derivatives risk manager and both portfolio management and the fund’s board; and 
  • annual or more frequent program reviews.

6. Most of our funds have limited (or no) derivatives exposure.  Do they need to have a written derivatives management program and comply with the VaR limitations?

Not if a fund’s derivatives exposure is limited to no more than 10% of its net assets.  However, the fund will be required to adopt and implement written policies and procedures reasonably designed to manage its derivatives risks.  

7. I became a lawyer because I don’t have a head for numbers.  I keep on nodding my head when I see these VaR limits, but I’m afraid someone’s going to ask me to explain what VaR actually means.  Can you explain to me what VaR is in language that I can understand?  

I’ll try.  Under Rule 18f-4, the term “value-at-risk” or “VaR” means “an estimate of potential losses on an instrument or portfolio, expressed as a percentage of the value of the portfolio’s assets (or net assets when computing a fund’s VaR), over a specified time horizon and at a given confidence level.  Any VaR model used by a fund for purposes of determining the fund’s compliance with the relative VaR test or the absolute VaR test must: (1) take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments, including, as applicable: (i) equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk; (ii) material risks arising from the non-linear price characteristics of a fund’s investments, including options and positions with embedded optionality; and (iii) the sensitivity of the market value of the fund’s investments to changes in volatility; (2) use a 99% confidence level and a time horizon of 20 trading days; and (3) be based on at least three years of historical market data.”

What is this getting at?  For starters, the amount at risk on an investment that doesn’t involve leverage would be the amount of an investment.  For example, if you took $100 out of your bank account and bought a share of common stock, your amount at risk would be $100 – the maximum amount you could lose would be $100.  By contrast, if you sold short that share of stock (you didn’t own it, but borrowed it), the amount you would have at risk would be unlimited in theory, as the price of the stock could rise.  Next, while the amount at risk on two different investments may be the same, the chance that an investor may lose money on the investments may be different.  For example, the risk of loss on U.S. government debt that matures in a month is much lower than the risk of loss on a speculative investment in a start-up company with no customers.  

The Rule’s definition of VaR attempts to put some parameters on the amount at risk, to distinguish between transactions that create more risk and those that create less risk.  For example, VaR compares how the fund’s investments have changed in value relative to volatility changes.  It also examines what happens to the value of options and instruments that have option-like characteristics when the value of the underlying investment changes.  And it sets a time frame of 20 trading days, requires a 99% confidence level and mandates that risk assessments must be based upon at least three years of historical market data.

8. What will the Rule require in the way of fund board oversight and reporting?

The Rule will require that a fund’s board (including a majority of independent board members) approve the designation of the fund’s DRM.  The Rule will also require that the DRM provide the board with regular written reports addressing the derivative risk management program’s implementation and effectiveness, and analyzing any time the fund’s guidelines have been exceeded, along with the results of the fund’s stress testing and back-testing.  The DRM’s report to the fund’s board must also include, as applicable:

  • the risk manager’s rationale for approving the particular designated reference portfolio (or the basis for any change in the designated reference portfolio) used under the relative VaR test; or
  • an explanation of why the DRM determined that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test such that the fund relied on the absolute VaR test instead.

9. We operate a fund of funds that invests in funds that engage in derivatives transactions, but the fund of funds itself does not.  Must the fund of funds comply with 18f-4?

No.  But if the fund of funds directly engages in derivatives transactions beyond 10% of its net assets (in addition to holding shares of underlying funds), the fund of funds is required under the Rule to calculate its own VaR.  In these circumstances the fund of funds may use the historic returns of the underlying funds in calculating the fund of funds’ VaR.

10. Wasn’t the SEC planning to separately regulate leveraged and inverse funds?

The SEC proposed to adopt special sales practice rules governing sales of leveraged and inverse funds by broker-dealers and investment advisers.  However, the SEC decided not to adopt them, but apply Rule 18f-4, including its leverage limits, to leveraged and inverse funds.  Leveraged and/or inverse funds currently in operation that are designed to utilize leverage in a manner that would exceed the Rule’s limitations may continue to operate at their current leverage limits, subject to certain conditions.

Investment advisers that recommend leveraged and inverse funds to their customers must still meet their fiduciary obligations.  Broker-dealers that recommend that their retail customers purchase leveraged or inverse funds must comply with new Regulation Best Interest.  

11. What about leveraged/inverse ETFs? 

  • The SEC will permit them to rely upon new Rule 6c-11 – they will no longer need to seek individual exemptive orders – as long as they comply with Rule 18f-4.  The SEC is also rescinding exemptive relief previously granted to existing leveraged/inverse ETFs.
  • Certain existing leveraged/inverse funds seek an investment return above 200% of the return (or inverse of the return) of the fund’s underlying index.  Those funds generally would not be able to satisfy the limit on fund leverage risk included in Rule 18f-4 unless they significantly changed their investment strategies.  Consequently, Rule 18f-4 includes a provision permitting these existing leveraged/inverse funds to continue operating at their current leverage levels, as long as they comply with the other provisions of Rule 18f-4 and meet certain additional requirements.

12. What’s going to happen to 10666 and all those no-action letters?  Will our funds need to continue to segregate assets?

The SEC will rescind Release No. 10666 as well as many of its no-action letters and staff guidance.  The SEC believes that asset segregation is unnecessary in light of the Rule’s requirements, including the requirements that funds establish derivatives risk management programs and comply with the VaR-based limit on fund leverage risk.

13. What Forms has the SEC amended?  What has changed?

  • Form N-PORT:  
    • Limited Derivatives Users A Fund must report (as a percentage of the fund’s net asset value): 
      • the fund’s derivatives exposure; and 
      • the fund’s derivatives exposure attributable to currency or interest rate derivatives entered into for hedging purposes.  

If a Limited Derivatives User had derivatives exposure > 10% of the fund’s net assets during the reporting period, and failed to cure it within the five-business-day remediation period permitted under Rule 18f-4, it must report the number of business days beyond the five-business-day remediation period that its derivatives exposure exceeded 10% of net assets.

    • Funds Subject to Outer limit on Leverage Risk.  A fund must report:
      • its median daily VaR for the reporting period (not publicly available);
      • the name of its designated index or a statement that the fund used its securities portfolio as its designated reference portfolio (publicly available); 
      • the index identifier (if applicable) (publicly available); 
      • the fund’s median daily VaR Ratio for the reporting period (not publicly available); and
      • the number of exceptions that the fund identified as a result of the back-testing of its VaR calculation model (not publicly available).  
    • Form N-LIQUID (to be renamed Form N-RN):  if a fund is subject to the relative VaR test, and the VaR of its portfolio exceeds 200% (or 250% if the fund is a closed-end fund for which the higher threshold is applicable) of the VaR of its designated reference portfolio for five business days, the fund must file a non-public report on Form N-RN, identifying:
      • the dates on which the fund’s portfolio VaR exceeded 200% (or 250%, as applicable) of the VaR of the designated reference portfolio; 
      • the fund’s portfolio VaR for each of these days; 
      • the VaR of the designated reference portfolio for each of these days; 
      • the designated index or statement that the fund used its securities portfolio as its designated reference portfolio; and 
      • the index identifier, if applicable.  

The fund also must also file a report on Form N-RN when it is back in compliance with its applicable VaR test, indicating the dates on which the fund’s VaR exceeded the limit and the current VaR of the fund’s portfolio.  

Similarly, if a fund is subject to the absolute VaR test, and its absolute VaR exceeds 20% (or 25%, as applicable) of the fund’s net asset value for five business days, the fund will be required to file a comparable report on Form N-RN and a report when the fund is back in compliance.

    • Form N-CEN.  A fund must identify whether it relied on Rule 18f-4 during the reporting period.  A fund must also identify whether it: 
      • is a limited derivatives user; 
      • is a leveraged/inverse fund; 
      • has entered into reverse repurchase agreements or similar financing transactions; 
      • has entered into unfunded commitment agreements; and 
      • is relying on the provision of the Rule that addresses investment in when-issued and forward-settling securities.  
    • Form N-2.  A closed-end fund relying on Rule 18f-4 does not need to report derivatives transactions and unfunded commitment agreements in Form N-2’s senior securities table.

14. What additional records must a fund keep? For how long? 

Rule 18f-4 will require a fund to keep the following records for 5 years, to the extent applicable:  

  • records relating to the fund’s derivatives risk management program; 
  • records relating to the designation of the fund’s derivatives risk manager and any written reports provided to the board of directors; 
  • records relating to the fund’s determination of its VaR and any VaR calculation models; 
  • if the fund is a limited derivatives user, the fund’s written record of its policies and procedures designed to manage its derivatives risk; 
  • records relating to the basis for the fund’s belief regarding its ability to meet its obligations with respect to each unfunded commitment agreement entered into; and
  • if a fund enters into reverse repurchase agreements or similar financial transactions, records documenting whether a fund is complying with the asset coverage requirements of Section 18 of the 1940 Act or is treating them as derivatives transactions under Rule 18f-4.

15. When will this all take effect?  

60 days after publication in the Federal Register.  The compliance date will be 18 months after the effective date.  

16. The Release is 458 pages.  Who should we talk to if we have further questions?

Please contact Steve King, Ethan Corey, or the Practus attorney with whom you deal regularly with questions.

The Authors
Ethan Corey
Read Full Bio
J. Stephen King
Read Full Bio
John H. Lively
Read Full Bio

Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.

Search Icon