In spite of a lack of detailed, accessible data, press reports and anecdotal evidence suggest that the use of derivatives is on the rise among investment companies that are registered under the Investment Company Act of 1940. Enforced and regulated by the Securities and Exchange Commission, this is the legislation defining the responsibilities and limitations of those entities — such as open-end mutual funds, closed-end funds, and unit investment trusts — that offer investment products to the public.
Given today’s widespread concerns about the risk exposure associated with derivatives, their possible increased use by investment companies has naturally raised apprehension among regulators. Specifically, regulators worry that extensive use of derivatives can lead to higher risks relating to leverage, the ability to meet future obligations, and concerns that funds may not be carrying sufficient liquid assets to compensate for potential future losses.
In response to these concerns, and citing a white paper prepared by staff members of its Division of Economic and Risk Analysis, the Securities and Exchange Commission (SEC) voted at the end of last year to propose a new rule that would place tighter restrictions on registered investment companies’ use of derivatives. The aim of such a rule, according to the SEC, is to modernize the regulation of derivatives use among funds and to safeguard both investors and the financial system overall. Below are some of the key elements of the proposed new rule:
Portfolio Limitations for Derivatives Transactions
The rule specifies two alternative portfolio limitations that are designed to restrict how much leverage a fund would be permitted to obtain through derivatives and certain other transactions.
Under the first option, the exposure-based portfolio limit, a registered fund would need to limit its aggregate exposure to 150 percent of its net assets. In general, “exposure” is calculated as the aggregate notional amount of the derivatives transactions of the fund (“notional amount” being the total value of a leveraged position’s assets), as well as any obligations it may have under financial commitment transactions and any aggregated indebtedness resulting from senior securities transactions.
The other alternative is the risk-based portfolio limit. Here, a fund could increase its aggregate notional derivatives exposure to up to 300 percent of its net assets, but only if its aggregated derivatives transactions reduce the total market risk of the fund’s portfolio as determined by a value-at-risk (VaR) test. In other words, the total VaR of the portfolio with derivatives must be less than the portfolio’s VaR without derivatives.
Asset Segregation for Derivatives Transactions
One method of derivatives risk management required of registered funds by the new SEC rule is the segregation of certain qualifying assets, usually cash or cash equivalents, equal to the sum of two amounts.
The first is the market-to-market coverage amount. A fund would need to segregate assets equal to the amount it would have to pay to close out or exit its derivatives transactions at the time of the determination.
The second is the risk-based coverage amount. A fund would also need to segregate an additional amount for risk-based coverage. In other words, this amount should represent a reasonable estimate of how much the fund would have to pay if it exited the derivatives transaction under stressed conditions.
Derivatives Risk Management Program
This requirements formalizes a kind of in-house approach to derivatives risk management for those registered funds that use complex derivatives, or whose aggregate exposure is over 50 percent of the value of their net assets.
Such funds would need to create a formalized derivatives risk management program meeting these criteria: approved and reviewed by the board, administered by a designated, board-approved derivatives risk manager, and consisting of certain specified components.
Requirements for Financial Commitment Transactions
Any fund entering into financial commitment transactions would need to segregate assets equivalent in value to 100 percent of its cash payment or delivery obligations under these transactions, regardless of whether the obligation is conditional or unconditional.
Disclosure and Reporting
An additional element of the new rule is the possible amendment of two forms — Form N-PORT and Form N-CEN — which were originally proposed by the SEC in May 2015 but which have not yet been finalized.
The current version of Form N-PORT requires all registered funds, except money market funds, to provide monthly portfolio-wide and position-level holdings data to the SEC. The proposed amendment would further require the disclosure of additional risk metrics from those funds that are obligated to have a derivatives risk management program.
Likewise, the current version of form N-CEN, which requires registered funds to report certain census-type information annually to the SEC, would be amended to require that funds disclose whether or not they relied on the proposed new SEC rule during the reporting period, as well as which portfolio limitation applies to their activities.