Client Alert: SEC proposes derivatives usage rules for registered investment companies and business development companies

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On December 11, 2015, the Securities and Exchange Commission (SEC) proposed new rules and amendments for mutual funds, exchange-traded funds, and closed-end funds regarding derivatives transactions.1 Proposed Rule 18f-4 is an exemption from parts of Section 18 that would allow funds to use derivatives if they comply with certain requirements, which include two distinct leverage limitations, enhanced asset segregation requirements, and can include a derivatives risk management program. The Release2 notes that derivatives usage by funds has risen greatly with purposes including risk management, equitizing cash for quick exposure, and leverage.3 The SEC believes that the Proposed Rule will reduce risk, strengthen investor protection, and increase transparency around derivatives usage by funds.

Portfolio leverage limitations

The Proposed Rule offers two leverage limitations. The first, simpler limitation is 150% aggregate derivatives exposure, along with other transactions, of the fund’s net assets, where exposure is the total notional amount of the derivatives transactions.4 The second limitation allows a fund to exceed 150% and go up to 300% derivatives exposure if the fund can show that its portfolio is subject to less market risk because of the derivatives transaction via a test based on value-at-risk (“VaR”).5 The purpose of these limitations is to ensure that a fund is not so levered that it is unable to meet its obligations to its investors during times of market stress.

150% Limit

The 150% limitation is measured by aggregating derivatives transactions, financial commitment transactions6, and other senior security transactions.7 The derivatives transactions are valued in their notional amounts.8 The Release posits that the notional amount is the most accurate measure of economic exposure, is used by other regulators, and is generally easily ascertainable.9 The SEC also provides a table of common derivatives and how to calculate their notional value.10 In most cases, the notional amount of funds’ derivatives alone is adequate. However, the SEC acknowledges that “in some cases, the notional amount for a derivatives transaction may not produce a measure of exposure that we [the SEC] believe would be appropriate for purposes of the Proposed Rule’s exposure limitations.”11

The Proposed Rule has three provisions for certain derivatives which would adjust the notional exposure when considering the 150% threshold12:

1. Derivatives transactions that provide a return based on the leveraged performance of an underlying reference asset would require the notional amount to be multiplied by the applicable leverage factor13

2. Derivatives transactions that reference an asset that is a managed account or an entity that has a primary purpose of investing or trading derivatives will require a “look-through” to that underlying account or entity14

3. Complex derivatives transactions require specific, different calculation methods than simple derivatives. The Proposed Rule defines a complex derivative transaction as: one where the amount payable by either party upon settlement date, maturity, or exercise is dependent on the value of the underlying reference asset at multiple points in time or is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price.15 Importantly, the Proposed Rule specifically excludes standard put or call options from the definition of complex derivatives transactions. The Proposed Rule’s method for calculating the notional amount for complex derivatives transactions is to aggregate the notional amount of other, non-complex derivatives transactions, that would be required to offset “substantially all” of the market of the complex derivatives transaction at the time it was entered.16

In addition to the adjustments to notional amount, the Proposed Rule allows for netting of directly offsetting derivatives transactions. The transactions must have the same reference asset maturity and other material terms.17 Although the Proposed Rule allows for this netting, the Release states that the purpose of the derivatives transactions does not alter its calculated exposure. This includes derivatives used for hedging purposes.18

300% Risk-based limit

A fund can opt to have a 300% derivatives notional limitation if it is able to demonstrate compliance with a VaR-based test in the Proposed Rule.19 The SEC believes that this alternative gives funds an opportunity to continue greater levels of derivatives usage if the purpose is to reduce market risk. In short, the VaR test requires a fund’s full portfolio VaR to be less than the fund’s securities VaR immediately after the fund enters into any senior securities transaction.20 The Release goes into great detail describing each step of the test, the rationale behind its design, and acknowledges issues that have been raised with VaR for risk management.

The portfolio limit choice must be approved by the fund’s board of directors, including the majority of non-interested persons of the fund.21 Both portfolio limitations go into effect as soon as the fund enters into any derivatives transaction.22

Asset segregation

The Proposed Rule introduces additional asset segregation requirements for funds that enter into derivatives transactions. There are two pieces to the rule that must be completed each business day. First, the fund must maintain qualifying coverage assets (cash or cash-like instruments) with a value equal to the amount that the fund would have to pay if it were to exit the derivatives transaction (this is known as the mark-to-market coverage amount). Importantly, the Proposed Rule allows this amount to be reduced by the value of any assets that represent variation margin or collateral.23 However, the initial margin would not reduce the required coverage amount for the derivatives transactions.24

Secondly, the fund must maintain an additional cushion amount that represents “a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions.”25 This cushion amount, termed risk-based coverage amount, must be calculated each business day and recorded. There must be board-approved policies and procedures for determining this amount. The Release suggests that a fund include in its method consideration of “the structure, terms, and characteristics of the derivatives transaction and the underlying reference asset.”26 Similar to the mark-to-market coverage amount, the risk-based coverage amount can be reduced by collateral amounts and additionally by the initial margin amount.27 Finally, both of these coverage amounts cannot be greater than the fund’s net assets.28

Derivatives risk management program

A fund that engages in more than a limited amount of derivatives transactions, a threshold of 50% aggregate notional exposure, must establish a derivatives risk management program.29 Funds that do not breach this threshold are still obligated to monitor for compliance with the other parts of the rule. A fund that enters into any complex derivatives transaction must establish the risk management program even if those complex derivatives do not breach the 50% threshold.30 This program must contain the following four elements31:

1. Assessment of risks – policies and procedures to assess derivatives-related issues, such as leverage, market risk, counterparty risk, liquidity risk, and operational risk

2. Management of risks – a system to monitor the aforementioned derivatives- related risks on an ongoing basis to ensure compliance with the portfolio’s guidelines and limits

3. Segregation of functions – the fund should establish policies to ensure the independence of the risk management program and its staff from its portfolio management function

4. Periodic review – there should be adequate review of the program and updates as necessary

The fund must designate an officer of the fund or the investment adviser to implement the policies and procedures around the risk management program; this appointment must be board approved.32 There must be an individual “derivatives risk manager” appointed to be responsible for the program. This person must have sufficient knowledge and understanding of derivatives and their uses. The Release states that this person can be the chief compliance officer, if he/she is qualified.33 The manager must produce a written report on a quarterly basis that must be reviewed by the fund’s board. Any material changes to the program must approved by the board.34


All records related to the derivatives risk management program and the fund’s compliance with the other aspects of the Proposed Rule must be maintained for five years, with the first two years in an easily accessible place.35 There are proposed changes to Form N-PORT and N-CEN that will require greater disclosure related to derivatives and portfolio limitations.36  

Next steps

The comment period for the Proposed Rule is 90 days. The SEC has not proposed any specific dates for compliance, but rather asked for comment about the timing and transition of this rule. Specifically, the SEC is asking for comment about whether there should be tiered compliance dates, similar to the proposed Liquidity Risk rules, or if more time is needed.37

1The proposed rule 18f-4(c)(2) defines “derivatives transaction” as any “swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination.”

2IC-31933, available at

3Page 13 of the Release

4Proposed rule 18f-4(a)(1)

5Page 65 of Release

6Defined as any reverse repurchase agreement, short sale borrowing or any firm or standby commitment agreement or similar agreement (such as an agreement under which a fund has obligated itself, conditionally or unconditionally, to make a loan to a company or to invest equity in a company, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner).

7Page 65 of the Release, 18f-4(a)(1)(i)

8Page 67, 18f-4(c)(7)

9Id 67

10See Page 69 of the Release

11Page 72

12Proposed rule 18f-4(c)(7)(iii)(A)


14Proposed Rule 18f-4(c)(7)(iii)(B)


16Proposed rule 18f-4(c)(7)(iii)(C)

17Proposed Rule 18f-4(c)(3)(i)

18Page 94 of the Release


20Proposed Rule 18f-4(a)(1)(ii)

21Proposed Rule 18f-4(a)(5)(i)

22Page 150 of the Release

23Proposed Rule 18f-4(c)(6)(ii)

24Page 162 of the Release

25Proposed Rule 18f-4(a)(2), (c)(6), (c)(9)

26Page 168-169

27Proposed Rule 18f-4(c)(9)(ii)

28Proposed Rule 18f-4(c)(8)

29Page 193 of the Release

30Page 200 of the Release

31Pages 205-219 of the Release

32Proposed Rule 18f-4(a)(3)(ii)(C)

33Page 222 of the Release

34Page 227

35Proposed Rule 18f-4(a)(6)

36Pages 250-256 of the Release

37Page 261 of the Release

Next steps