[Federal Register Volume 85, Number 16 (Friday, January 24, 2020)]
[Proposed Rules]
[Pages 4446-4567]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-00040]
[[Page 4445]]
Vol. 85
Friday,
No. 16
January 24, 2020
Part III
Securities and Exchange Commission
-----------------------------------------------------------------------
17 CFR Parts 239, 240, 249, et al.
Use of Derivatives by Registered Investment Companies and Business
Development Companies; Required Due Diligence by Broker-Dealers and
Registered Investment Advisers Regarding Retail Customers' Transactions
in Certain Leveraged/Inverse Investment Vehicles; Proposed Rule
Federal Register / Vol. 85 , No. 16 / Friday, January 24, 2020 /
Proposed Rules
[[Page 4446]]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 239, 240, 249, 270, 274 and 275
[Release No. 34-87607; IA-5413; IC-33704; File No. S7-24-15]
RIN 3235-AL60
Use of Derivatives by Registered Investment Companies and
Business Development Companies; Required Due Diligence by Broker-
Dealers and Registered Investment Advisers Regarding Retail Customers'
Transactions in Certain Leveraged/Inverse Investment Vehicles
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
-----------------------------------------------------------------------
SUMMARY: The Securities and Exchange Commission (the ``Commission'') is
re-proposing rule 18f-4, a new exemptive rule under the Investment
Company Act of 1940 (the ``Investment Company Act'') designed to
address the investor protection purposes and concerns underlying
section 18 of the Act and to provide an updated and more comprehensive
approach to the regulation of funds' use of derivatives and the other
transactions addressed in the proposed rule. The Commission is also
proposing new rule 15l-2 under the Securities Exchange Act of 1934 (the
``Exchange Act'') and new rule 211(h)-1 under the Investment Advisers
Act of 1940 (``Advisers Act'') (collectively, the ``sales practices
rules''). In addition, the Commission is proposing new reporting
requirements and amendments to Form N-PORT, Form N-LIQUID (which we
propose to be re-titled as ``Form N-RN''), and Form N-CEN, which are
designed to enhance the Commission's ability to effectively oversee
funds' use of and compliance with the proposed rules, and for the
Commission and the public to have greater insight into the impact that
funds' use of derivatives would have on their portfolios. Finally, the
Commission is proposing to amend rule 6c-11 under the Investment
Company Act to allow certain leveraged/inverse ETFs that satisfy the
rule's conditions to operate without the expense and delay of obtaining
an exemptive order.
DATES: Comments should be submitted on or before March 24, 2020.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (http://www.sec.gov/rules/proposed.shtml); or
Send an email to [email protected]. Please include
File No. S7-24-15 on the subject line.
Paper Comments
Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number S7-24-15. This file number
should be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method of submission. The Commission will post all
comments on the Commission's website (http://www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and
printing in the Commission's Public Reference Room, 100 F Street NE,
Washington, DC 20549, on official business days between the hours of
10:00 a.m. and 3:00 p.m. All comments received will be posted without
change. Persons submitting comments are cautioned that we do not redact
or edit personal identifying information from comment submissions. You
should submit only information that you wish to make publicly
available.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: Asaf Barouk, Attorney-Adviser; Joel
Cavanaugh, Senior Counsel; John Lee, Senior Counsel; Sirimal Mukerjee,
Senior Counsel; Amanda Hollander Wagner, Branch Chief; Thoreau
Bartmann, Senior Special Counsel; or Brian McLaughlin Johnson,
Assistant Director, at (202) 551-6792, Investment Company Regulation
Office, Division of Investment Management; and with respect to proposed
rule 15l-2, Kelly Shoop, Senior Counsel; or Lourdes Gonzalez, Assistant
Chief Counsel; Office of Chief Counsel, Division of Trading and
Markets; Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549-1090.
SUPPLEMENTARY INFORMATION: Proposed rule 18f-4 would apply to mutual
funds (other than money market funds), exchange-traded funds
(``ETFs''), registered closed-end funds, and companies that have
elected to be treated as business development companies (``BDCs'')
under the Investment Company Act (collectively, ``funds''). It would
permit these funds to enter into derivatives transactions and certain
other transactions, notwithstanding the restrictions under sections 18
and 61 of the Investment Company Act, provided that the funds comply
with the conditions of the rule. The proposed sales practices rules
would require a broker, dealer, or investment adviser that is
registered with (or required to be registered with) the Commission to
exercise due diligence in approving a retail customer's or client's
account to buy or sell shares of certain ``leveraged/inverse investment
vehicles'' before accepting an order from, or placing an order for, the
customer or client to engage in these transactions.
The Commission is proposing for public comment 17 CFR 270.18f-4
(new rule 18f-4) under the Investment Company Act, 17 CFR 240.15l-2
(new rule 15l-2) under the Exchange Act, 17 CFR 275.211(h)-1 (new rule
211(h)-1) under the Advisers Act; amendments to 17 CFR 270.6c-11 (rule
6c-11) under the Investment Company Act; amendments to Form N-PORT
[referenced in 17 CFR 274.150], Form N-LIQUID (which we propose to re-
title as ``Form N-RN'') [referenced in 17 CFR 274.223], Form N-CEN
[referenced in 17 CFR 274.101], and Form N-2 [referenced in 17 CFR
274.11a-1] under the Investment Company Act.
Table of Contents
I. Introduction
A. Overview of Funds' Use of Derivatives
B. Derivatives and the Senior Securities Restrictions of the
Investment Company Act
1. Requirements of Section 18
2. Evolution of Commission and Staff Consideration of Section 18
Restrictions as Applied to Funds' Use of Derivatives
3. Need for Updated Regulatory Framework
C. Overview of the Proposal
II. Discussion
A. Scope of Proposed Rule 18f-4
1. Funds Permitted To Rely on Proposed Rule 18f-4
2. Derivatives Transactions Permitted Under Proposed Rule 18f-4
B. Derivatives Risk Management Program
1. Summary
2. Program Administration
3. Required Elements of the Program
C. Board Oversight and Reporting
1. Board Approval of the Derivatives Risk Manager
2. Board Reporting
D. Proposed Limit on Fund Leverage Risk
[[Page 4447]]
1. Use of VaR
2. Relative VaR Test
3. Absolute VaR Test
4. Choice of Model and Parameters for VaR Test
5. Implementation
6. Other Regulatory Approaches to Limiting Fund Leverage Risk
E. Limited Derivatives Users
1. Exposure-Based Exception
2. Currency Hedging Exception
3. Risk Management
F. Asset Segregation
G. Alternative Requirements for Certain Leveraged/Inverse Funds
and Proposed Sales Practices Rules for Certain Leveraged/Inverse
Investment Vehicles
1. Background on Proposed Approach to Certain Leveraged/Inverse
Funds
2. Proposed Sales Practices Rules for Leveraged/Inverse
Investment Vehicles
3. Alternative Provision for Leveraged/Inverse Funds Under
Proposed Rule 18f-4
4. Proposed Amendments to Rule 6c-11 Under the Investment
Company Act and Proposed Rescission of Exemptive Relief for
Leveraged/Inverse ETFs
H. Amendments to Fund Reporting Requirements
1. Amendments to Form N-PORT
2. Amendments to Current Reporting Requirements
3. Amendments to Form N-CEN
4. BDC Reporting
I. Reverse Repurchase Agreements
J. Unfunded Commitment Agreements
K. Recordkeeping Provisions
L. Transition Periods
M. Conforming Amendments
III. Economic Analysis
A. Introduction
B. Economic Baseline
1. Fund Industry Overview
2. Funds' Use of Derivatives
3. Current Regulatory Framework for Derivatives
4. Funds' Derivatives Risk Management Practices and Use of VaR
Models
5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse
Funds
C. Benefits and Costs of the Proposed Rules and Amendments
1. Derivatives Risk Management Program and Board Oversight and
Reporting
2. VaR-Based Limit on Fund Leverage Risk
3. Limited Derivatives Users
4. Reverse Repurchase Agreements and Similar Financing
Transactions
5. Alternative Requirements for Certain Leveraged/Inverse Funds
and Proposed Sales Practices Rules for Certain Leveraged/Inverse
Investment Vehicles
6. Proposed Amendments to Rule 6c-11 Under the Investment
Company Act and Proposed Rescission of Exemptive Relief for
Leveraged/Inverse ETFs
7. Unfunded Commitment Agreements
8. Recordkeeping
9. Amendments to Fund Reporting Requirements
10. Money Market Funds
D. Effects on Efficiency, Competition, and Capital Formation
1. Efficiency
2. Competition
3. Capital Formation
E. Reasonable Alternatives
1. Alternative Implementations of the VaR Tests
2. Alternatives to the VaR Tests
3. Stress Testing Frequency
4. Alternative Exposure Limits for Leveraged/Inverse Funds
5. No Sales Practices Rules and No Separate Exposure Limit for
Leveraged/Inverse Funds
6. Enhanced Disclosure
F. Request for Comments
IV. Paperwork Reduction Act Analysis
A. Introduction
B. Proposed Rule 18f-4
1. Derivatives Risk Management Program
2. Board Oversight and Reporting
3. Disclosure Requirement Associated With Limit on Fund Leverage
Risk
4. Disclosure Requirement for Leveraged/Inverse Funds
5. Disclosure Changes for Money Market Funds
6. Policies and Procedures for Limited Derivatives Users
7. Recordkeeping Requirements
8. Proposed Rule 18f-4 Total Estimated Burden
C. Proposed Rule 15l-2: Sales Practices Rule for Broker-Dealers
1. Due Diligence and Account Approval
2. Policies and Procedures
3. Recordkeeping
4. Proposed Rule 15l-2 Total Estimated Burden
D. Proposed Rule 211(h)-1: Sales Practices for Registered
Investment Advisers
1. Due Diligence and Account Approval
2. Policies and Procedures
3. Recordkeeping
4. Proposed Rule 211(h)-1 Total Estimated Burden
E. Rule 6c-11
F. Form N-PORT
G. Form N-RN
H. Form N-CEN
I. Request for Comments
V. Initial Regulatory Flexbility Analysis
A. Reasons for and Objectives of the Proposed Actions
B. Legal Basis
C. Small Entities Subject to Proposed Rules
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. Proposed Rule 18f-4
2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
3. Proposed Sales Practices Rules
4. Proposed Amendments to Rule 6c-11
E. Duplicative, Overlapping, or Conflicting Federal Rules
F. Significant Alternatives
1. Proposed Rule 18f-4
2. Proposed Sales Practices Rules
3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
4. Rule 6c-11
G. Request for Comment
VI. Consideration of Impact on the Economy
VII. Statutory Authority
VIII. Appendix A
IX. Appendix B
I. Introduction
The fund industry has grown and evolved substantially in past
decades in response to various factors, including investor demand,
technological developments, and an increase in domestic and
international investment opportunities, both retail and
institutional.\1\ Funds today follow a broad variety of investment
strategies and provide diverse investment opportunities for fund
investors, including retail investors. As funds' strategies have become
increasingly diverse, funds' use of derivatives has grown in both
volume and complexity over the past several decades.\2\ Derivatives may
be broadly described as instruments or contracts whose value is based
upon, or derived from, some other asset or metric.\3\ Funds use
derivatives for a variety of purposes. For example, funds use
derivatives to seek higher returns through increased investment
exposure, to hedge risks in their investment portfolios, or to obtain
exposure to particular investments or markets more efficiently than may
be
[[Page 4448]]
possible through direct investments.\4\ At the same time, derivatives
can introduce certain new risks and heighten certain risks to a fund
and its investors. These risks can arise from, for example, leverage,
liquidity, markets, operations, legal matters (e.g., contract
enforceability), and counterparties.
---------------------------------------------------------------------------
\1\ For example, the investment company industry consisted of
more than 3,500 investment companies, and held over $1.3 trillion in
assets, as of the end of 1991. See SEC Division of Investment
Management, Protecting Investors: A Half Century of Investment
Company Regulation (1992), available at https://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf. The assets held by
U.S.-registered investment companies grew to approximately $7.1
trillion as of the end of 1999, and from then until the end of 2018
grew over 200%, to approximately $21.4 trillion. See Investment
Company Institute, 2018 Investment Company Fact Book at 32,
available at https://www.icifactbook.org/deployedfiles/FactBook/Site%20Properties/pdf/2019/2019_factbook.pdf . Similarly, the number
of mutual funds, registered closed-end funds, and ETFs grew from
7,970, 512, and 30 (respectively) as of the end of 1999, to 9,599,
506, and 2,057 (respectively) as of the end of 2018. See id. at 50.
The diversity of fund strategies has also increased over time,
including, more recently, the introduction of funds pursuing so-
called ``alternative strategies'' (which tend to use derivatives
more than other fund types). See Daniel Deli, Paul Hanouna, Christof
Stahel, Yue Tang & William Yost, Use of Derivatives by Registered
Investment Companies, Division of Economic and Risk Analysis (2015),
available at http://www.sec.gov/dera/staffpapers/white-papers/derivatives12-2015.pdf (``DERA White Paper'').
\2\ See Use of Derivatives by Registered Investment Companies
and Business Development Companies, Investment Company Act Release
No. 31933 (Dec. 11, 2015) [80 FR 80883 (Dec. 28, 2015)], at n.6 and
accompanying text (``2015 Proposing Release'').
\3\ The asset or metric on which the derivative's value is
based, or from which its value is derived, is commonly referred to
as the ``reference asset,'' ``underlying asset,'' or ``underlier.''
See id. at n.3 and accompanying text (citing Use of Derivatives by
Investment Companies under the Investment Company Act of 1940,
Investment Company Act Release No. 29776 (Aug. 31, 2011) [76 FR
55237 (Sept. 7, 2011)], at n.3 (``2011 Concept Release'')). The
comment letters on the 2011 Concept Release (File No. S7-33-11) are
available at https://www.sec.gov/comments/s7-33-11/s73311.shtml.
\4\ See, e.g., My Nguyen, Using Financial Derivatives to Hedge
Against Currency Risk, Arcada University of Applied Sciences (2012).
---------------------------------------------------------------------------
Funds using derivatives must consider requirements under the
Investment Company Act of 1940.\5\ These include sections 18 and 61 of
the Investment Company Act, which limit a fund's ability to obtain
leverage or incur obligations to persons other than the fund's common
shareholders through the issuance of ``senior securities.'' \6\ As we
discuss more fully in this release, as derivatives markets have
expanded and funds have increased their use of derivatives, the
Commission and its staff have issued guidance addressing the use of
specific derivatives instruments and practices, and other financial
instruments, under section 18. In determining how they will comply with
section 18, we understand that funds consider this Commission and staff
guidance, as well as staff no-action letters and the practices that
other funds disclose in their registration statements.\7\
---------------------------------------------------------------------------
\5\ 15 U.S.C. 80a (the ``Investment Company Act,'' or the
``Act''). Except in connection with our discussion of proposed rule
15l-2 under the Securities Exchange Act of 1934 and proposed rule
211(h)-1 under the Advisers Act or as otherwise noted, all
references to statutory sections are to the Investment Company Act,
and all references to rules under the Investment Company Act,
including proposed rule 18f-4, will be to title 17, part 270 of the
Code of Federal Regulations, 17 CFR part 270.
\6\ See infra section I.B.1. Funds using derivatives must also
comply with all other applicable statutory and regulatory
requirements, such as other federal securities law provisions, the
Internal Revenue Code, Regulation T of the Federal Reserve Board,
and the rules and regulations of the Commodity Futures Trading
Commission (the ``CFTC''). See also Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act, Public Law 111-203, 124
Stat. 1376 (2010) (the ``Dodd-Frank Act''), available at http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.
Section 61 of the Investment Company Act makes section 18 of the
Act applicable to BDCs, with certain modifications. See infra note
32 and accompanying text. Except as otherwise noted, or unless the
context dictates otherwise, references in this release to section 18
of the Act should be read to refer also to section 61 with respect
to BDCs.
\7\ Any staff guidance or no-action letters discussed in this
release represent the views of the staff of the Division of
Investment Management. They are not a rule, regulation, or statement
of the Commission. Furthermore, the Commission has neither approved
nor disapproved their content. Staff guidance has no legal force or
effect; it does not alter or amend applicable law; and it creates no
new or additional obligations for any person.
---------------------------------------------------------------------------
In the absence of Commission rules and guidance that address the
current broad range of funds' derivatives use, inconsistent industry
practices have developed.\8\ We are concerned that certain of these
practices may not address investor protection concerns that underlie
section 18's limitations on funds' issuance of senior securities.
Specifically, certain fund practices can heighten leverage-related
risks, such as the risk of potentially significant losses and increased
fund volatility, that section 18 is designed to address. We are also
concerned that funds' disparate practices could create an un-level
competitive landscape and make it difficult for funds and our staff to
evaluate funds' compliance with section 18.\9\
---------------------------------------------------------------------------
\8\ See infra section I.B.2.b (discussing the asset segregation
practices funds have developed to ``cover'' their derivatives
positions, which vary based on the type of derivatives transaction
and with respect to the types of assets that funds segregate to
cover their derivatives positions).
\9\ See, e.g., Comment Letter of the Investment Company
Institute on the 2011 Concept Release (Nov. 7, 2011) (File No. S7-
33-11) at n.19 (``ICI Concept Release Comment Letter'') (noting that
funds segregate the notional amount of physically-settled futures
contracts, while some funds disclose that they segregate only the
marked-to-marked obligation in respect of cash-settled futures and
agreeing with the concern reflected in the 2011 Concept Release that
this ``results in differing treatment of arguably equivalent
products'').
---------------------------------------------------------------------------
To address these concerns, in 2015 the Commission proposed new rule
18f-4 under the Investment Company Act, which would have permitted a
fund to enter into derivatives transactions and ``financial commitment
transactions,'' subject to certain conditions.\10\ We received
approximately 200 comment letters in response to the 2015 proposal.\11\
In developing this re-proposal we considered those comment letters, as
well as subsequent staff engagement with large and small fund complexes
and investor groups.\12\
---------------------------------------------------------------------------
\10\ For purposes of this release, we will refer to the version
of rule 18f-4 that the Commission proposed in the 2015 Proposing
Release as the ``2015 proposed rule.'' We will generally refer to
rule 18f-4 as we propose it here as the ``proposed rule.''
The 2015 proposed rule included four principal elements for
funds entering into derivatives transactions: (1) A requirement to
comply with one of two alternative portfolio limitations designed to
limit the amount of leverage a fund may obtain through derivatives
and other senior securities transactions; (2) asset segregation for
derivatives transactions, designed to enable a fund to meet its
derivatives-related obligations; (3) a derivatives risk management
program requirement for funds that engage in more than limited
derivatives transactions or that use complex derivatives; and (4)
reporting requirements regarding a fund's derivatives usage.
The 2015 proposed rule included different requirements for
derivatives transactions and ``financial commitment transactions''
(collectively, reverse repurchase agreements, short sale borrowings,
or any firm or standby commitment agreement or similar agreement).
Rule 18f-4 as we propose it here does not separately define
``financial commitment transactions,'' although the proposed rule
does address--either directly or indirectly--all of the types of
transactions that composed that defined term in the 2015 proposed
rule. See infra section II.
\11\ The comment letters on the 2015 proposed rule (File No. S7-
24-15) are available at https://www.sec.gov/comments/s7-24-15/s72415.shtml.
\12\ See also Division of Economic and Risk Analysis, Memorandum
re: Risk Adjustment and Haircut Schedules (Nov. 1, 2016), available
at https://www.sec.gov/comments/s7-24-15/s72415-260.pdf (``2016 DERA
Memo'').
---------------------------------------------------------------------------
We are re-proposing rule 18f-4, which is designed to address the
investor protection purposes and concerns underlying section 18 and to
provide an updated and more comprehensive approach to the regulation of
funds' use of derivatives transactions and certain other transactions.
The proposed rule would permit funds to enter into these transactions,
notwithstanding the restrictions under section 18 of the Investment
Company Act, provided that they comply with the conditions of the rule.
The proposed rule's conditions are designed to require funds to manage
the risks associated with their use of derivatives and to limit fund
leverage risk consistent with the investor protection purposes
underlying section 18. Our proposal also includes requirements designed
to address specific risks posed by certain registered investment
companies and exchange-listed commodity- or currency-based trusts or
funds that obtain leveraged or inverse exposure to an underlying index,
generally on a daily basis.\13\ The proposal also addresses funds' use
of reverse repurchase agreements and similar transactions and certain
so-called ``unfunded commitments.'' Finally, we propose to amend rule
6c-11 under the Investment Company Act to allow certain leveraged/
inverse ETFs that satisfy that rule's conditions to operate without the
expense and delay of obtaining an exemptive order. Together, the rules
we are proposing are designed to promote funds' ability to continue to
use derivatives in a broad variety of ways that serve investors, while
responding to the concerns underlying section 18 of the Investment
Company Act and promoting a more
[[Page 4449]]
modern and comprehensive framework for regulating funds' use of
derivatives and the other transactions addressed in the proposed rule.
---------------------------------------------------------------------------
\13\ As discussed in more detail in section II.G, the proposed
sales practices rules would cover transactions in ``leveraged/
inverse investment vehicles,'' which include registered investment
companies and certain exchange-listed commodity- or currency-based
trusts or funds 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. For purposes of this release,
we refer to leveraged, inverse, and leveraged inverse investment
vehicles collectively as ``leveraged/inverse.''
---------------------------------------------------------------------------
A. Overview of Funds' Use of Derivatives
Funds today use a variety of derivatives. These derivatives can
reference a range of assets or metrics, such as: Stocks, bonds,
currencies, interest rates, market indexes, currency exchange rates, or
other assets or interests. Examples of derivatives that funds commonly
use include forwards, futures, swaps, and options. Derivatives are
often characterized as either exchange-traded or over-the-counter
(``OTC'').\14\
---------------------------------------------------------------------------
\14\ Exchange-traded derivatives--such as futures, certain
options, and options on futures--are standardized contracts traded
on regulated exchanges. See 2015 Proposing Release, supra note 2, at
nn.10-13 and accompanying text. OTC derivatives--such as certain
swaps, non-exchange-traded options, and combination products such as
swaptions and forward swaps--are contracts that parties negotiate
and enter into outside of an organized exchange. See id. at nn.14-16
and accompanying text. Unlike exchange-traded derivatives, OTC
derivatives may be significantly customized and may not be cleared
by a central clearing organization. Title VII of the Dodd-Frank Act
provides a comprehensive framework for the regulation of the OTC
swaps market. See supra note 6.
---------------------------------------------------------------------------
A common characteristic of most derivatives is that they involve
leverage or the potential for leverage. The Commission has stated that
``[l]everage exists when an investor achieves the right to a return on
a capital base that exceeds the investment which he has personally
contributed to the entity or instrument achieving a return.'' \15\ Many
fund derivatives transactions, such as futures, swaps, and written
options, involve leverage or the potential for leverage because they
enable the fund to magnify its gains and losses compared to the fund's
investment, while also obligating the fund to make a payment or deliver
assets to a counterparty under specified conditions.\16\ Other
derivatives transactions, such as purchased call options, provide the
economic equivalent of leverage because they can magnify the fund's
exposure beyond its investment but do not impose a payment obligation
on the fund beyond its investment.\17\
---------------------------------------------------------------------------
\15\ See Securities Trading Practices of Registered Investment
Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979)
[44 FR 25128 (Apr. 27, 1979)], at n.5 (``Release 10666'').
\16\ The leverage created by such an arrangement is sometimes
referred to as ``indebtedness leverage.'' See 2015 Proposing
Release, supra note 2, at n.21 (citing 2011 Concept Release, supra
note 3, at n.31).
\17\ This type of leverage is sometimes referred to as
``economic leverage.'' See id. at n.22 (citing 2011 Concept Release,
supra note 3, at n.32).
---------------------------------------------------------------------------
Funds use derivatives both to obtain investment exposures as part
of their investment strategies and to manage risk. A fund may use
derivatives to gain, maintain, or reduce exposure to a market, sector,
or security more quickly, and with lower transaction costs and
portfolio disruption, than investing directly in the underlying
securities.\18\ A fund also may use derivatives to obtain exposure to
reference assets for which it may be difficult or impractical for the
fund to make a direct investment, such as commodities.\19\ With respect
to risk management, funds may employ derivatives to hedge interest
rate, currency, credit, and other risks, as well as to hedge portfolio
exposures.\20\
---------------------------------------------------------------------------
\18\ See, e.g., id. at n.24 and accompanying text (citing 2011
Concept Release, supra note 3, at section I).
\19\ See, e.g., Comment Letter of Stone Ridge Asset Management
LLC (Mar. 28, 2016) (``[I]t is not possible for AVRPX [a Stone Ridge
fund] to trade many of the physical assets underlying the
derivatives included in our portfolio--Stone Ridge does not maintain
facilities to store oil or live hogs, for example.''); Comment
Letter of Vanguard (Mar. 28, 2016) (``Vanguard Comment Letter'')
(stating that a fund may use a derivative, such as commodity
futures, when it is impractical to take delivery of physical
commodities).
\20\ See 2015 Proposing Release, supra note 2, at n.25 and
accompanying text; see also 2011 Concept Release, supra note 3, at
section I.B.
---------------------------------------------------------------------------
At the same time, a fund's derivatives use may entail risks
relating to, for example, leverage, markets, operations, liquidity
(particularly with respect to complex OTC derivatives), and
counterparties, as well as legal risks.\21\ A fund's investment
adviser, therefore, must manage (and the board of directors oversee)
the fund's derivatives use, consistent with the fund's investment
objectives, policies, restrictions, and risk profile. Furthermore, a
fund's investment adviser and board of directors must bear in mind the
requirements of section 18 of the Investment Company Act, as well as
the Act's other requirements, when considering the use of derivatives.
---------------------------------------------------------------------------
\21\ See 2015 Proposing Release, supra note 2, at n.26 and
accompanying text (citing 2011 Concept Release, supra note 3, at
n.34).
---------------------------------------------------------------------------
Section 18 is designed to limit the leverage a fund can obtain or
incur through the issuance of senior securities. Although the leverage
limitations in section 18 apply regardless of whether the relevant fund
actually experiences significant losses, several recent examples
involving significant losses illustrate how a fund's use of derivatives
may raise the investor protection concerns underlying section 18. The
2015 proposal discussed several circumstances in which substantial and
rapid losses resulted from a fund's investment in derivatives.\22\ For
example, one of these cases shows that further losses can result when a
fund's portfolio securities decline in value at the same time that the
fund is required to make additional payments under its derivatives
contracts.\23\
---------------------------------------------------------------------------
\22\ See 2015 Proposing Release, supra note 2, at section
II.D.1.d. (discussing, among other things, the following settled
actions: In the Matter of OppenheimerFunds, Inc. and
OppenheimerFunds Distributor, Inc., Investment Company Act Release
No. 30099 (June 6, 2012) (settled action) (``OppenheimerFunds
Settled Action'') (involving two mutual funds that suffered losses
driven primarily by their exposure to certain commercial mortgage-
backed securities, obtained mainly through total return swaps); In
the Matter of Claymore Advisors, LLC, Investment Company Act Release
No. 30308 (Dec. 19, 2012) and In the Matter of Fiduciary Asset
Management, LLC, Investment Company Act Release No. 30309 (Dec. 19,
2012) (settled actions) (involving a registered closed-end fund that
pursued an investment strategy involving written out-of-the-money
put options and short variance swaps, which led to substantial
losses for the fund); In the Matter of UBS Willow Management L.L.C.
and UBS Fund Advisor L.L.C., Investment Company Act Release No.
31869 (Oct. 16, 2015) (settled action) (involving a registered
closed-end fund that incurred significant losses due in part to
large losses on the fund's credit default swap portfolio)).
See also In the Matter of Team Financial Asset Management, LLC,
Team Financial Managers, Inc., and James L. Dailey, Investment
Company Act Release No. 32951 (Dec. 22, 2017) (settled action)
(involving a mutual fund incurring substantial losses arising out of
speculative derivatives instruments, including losing $34.67 million
in 2013 from trading in derivatives such as futures, options, and
currency contracts); In the Matter of Mohammed Riad and Kevin
Timothy Swanson, Investment Company Act Release No. 33338 (Dec. 21,
2018) (settled action) (involving a registered closed-end fund
incurring substantial losses resulting from the implementation of a
new derivatives trading strategy); In the Matter of Top Fund
Management, Inc. and Barry C. Ziskin, Investment Company Act Release
No. 30315 (Dec. 21, 2012) (settled action) (involving a mutual fund
engaged in a strategy of buying options for speculative purposes
contrary to its stated investment policy, which permitted options
trading for hedging purposes, losing about 69% of its assets as a
result of this activity before liquidating).
\23\ See OppenheimerFunds Settled Action, supra note 22.
---------------------------------------------------------------------------
Similarly, last year the LJM Preservation and Growth Fund
liquidated after sustaining considerable losses (with its net asset
value declining approximately 80% in two days) when market volatility
spiked. The fund's principal investment strategy involved purchasing
and selling call and put options on the Standard & Poor's (``S&P'') 500
Futures Index.\24\ S&P 500 options prices are determined in part by
market volatility, and a volatility spike in early February 2018 caused
the fund to incur significant losses. The fund closed to new
investments on February 7, 2018 and announced on February 27,
[[Page 4450]]
2018 that it would liquidate its assets and dissolve on March 29,
2018.\25\
---------------------------------------------------------------------------
\24\ See Prospectus, LJM Preservation and Growth Fund (Feb. 28,
2017), available at https://www.sec.gov/Archives/edgar/data/1552947/000158064217001225/ljm485b.htm.
\25\ See Supplement to the Prospectus dated Feb. 28, 2017, LJM
Preservation and Growth Fund (Feb. 27, 2018), available at https://www.sec.gov/Archives/edgar/data/1552947/000158064218001068/ljm497.htm.
---------------------------------------------------------------------------
The losses suffered by this fund and in the other examples we
discuss above are extreme. Funds rarely suffer such large and rapid
losses. We note these examples to illustrate the rapid and extensive
losses that can result from a fund's investments in derivatives absent
effective derivatives risk management. In contrast, there are many
other instances in which funds, by employing derivatives, have avoided
losses, increased returns, and lowered risk.
B. Derivatives and the Senior Securities Restrictions of the Investment
Company Act
1. Requirements of Section 18
Section 18 of the Investment Company Act imposes various limits on
the capital structure of funds, including, in part, by restricting the
ability of funds to issue ``senior securities.'' Protecting investors
against the potentially adverse effects of a fund's issuance of senior
securities, and in particular the risks associated with excessive
leverage of investment companies, is a core purpose of the Investment
Company Act.\26\ ``Senior security'' is defined, in part, as ``any
bond, debenture, note, or similar obligation or instrument constituting
a security and evidencing indebtedness.'' \27\
---------------------------------------------------------------------------
\26\ See, e.g., sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of
the Investment Company Act; see also Provisions Of The Proposed Bill
Related To Capital Structure (Sections 18, 19(B), And 21(C)),
Introduced by L.M.C Smith, Associate Counsel, Investment Trust
Study, Securities and Exchange Commission, Hearings on S.3580 Before
a Subcommittee of the Senate Committee on Banking and Currency, 76th
Congress, 3rd session (1940), at 1028 (``Senate Hearings'')
(``Because of the leverage influence, a substantial swing of the
securities market is likely to deprive the common stock of a
leverage investment company of both its asset and market value. . .
. [H]ad investment companies been simple structure companies
exclusively, a very substantial part of the losses sustained by
investors in the common stock would have been avoided.'').
\27\ See section 18(g) of the Investment Company Act. The
definition of ``senior security'' in section 18(g) also includes
``any stock of a class having priority over any other class as to
the distribution of assets or payment of dividends'' and excludes
certain limited temporary borrowings.
---------------------------------------------------------------------------
Congress' concerns underlying the limits in section 18 focused on:
(1) Excessive borrowing and the issuance of excessive amounts of senior
securities by funds when these activities increase unduly the
speculative character of funds' junior securities; (2) funds operating
without adequate assets and reserves; and (3) potential abuse of the
purchasers of senior securities.\28\ To address these concerns, section
18 prohibits an open-end fund from issuing or selling any ``senior
security,'' other than borrowing from a bank (subject to a requirement
to maintain 300% ``asset coverage'').\29\ Section 18 similarly
prohibits a closed-end fund from issuing or selling any ``senior
security [that] represents an indebtedness'' unless it has at least
300% ``asset coverage,'' although closed-end funds' ability to issue
senior securities representing indebtedness is not limited to bank
borrowings.\30\ Closed-end funds also may issue senior securities that
are a stock, subject to the limitations of section 18.\31\ The
Investment Company Act also subjects BDCs to the limitations of section
18 to the same extent as registered closed-end funds, except the
applicable asset coverage amount for any senior security representing
indebtedness is 200% (and can be decreased to 150% under certain
circumstances).\32\
---------------------------------------------------------------------------
\28\ For discussion of the excessive borrowing concern, see
section 1(b)(7) of the Investment Company Act; Release 10666, supra
note 15, at n.8; see also Senate Hearings, supra note 26, at 1028
(``The Commission believes that it has been clearly shown that it is
the leverage aspect of the senior-junior capital structure in
investment companies . . . which may be held accountable for a large
part of the losses which have been suffered by the investor who
purchases the common stock of a leverage company.'').
For discussion of concerns regarding funds operating without
adequate assets and reserves, see section 1(b)(8) of the Investment
Company Act; Release 10666, supra note 15, at n.8.
For discussion of, among other things, potential abuse of the
purchasers of senior securities, see Senate Hearings, supra note 26,
at 265-78; see also Mutual Funds and Derivative Instruments,
Division of Investment Management Memorandum transmitted by Chairman
Levitt to Representatives Markey and Fields (Sept. 26, 1994), at 23,
available at http://www.sec.gov/news/studies/deriv.txt (``1994
Letter to Congress'') (describing practices in the 1920s and 1930s
that gave rise to section 18's limits on leverage).
\29\ See section 18(f)(1) of the Investment Company Act. ``Asset
coverage'' of a class of senior securities representing indebtedness
of an issuer generally is defined in section 18(h) of the Investment
Company Act as ``the ratio which the value of the total assets of
such issuer, less all liabilities and indebtedness not represented
by senior securities, bears to the aggregate amount of senior
securities representing indebtedness of such issuer.'' Take, for
example, an open-end fund with $100 in assets and with no
liabilities or senior securities outstanding. The fund could, while
maintaining the required coverage of 300% of the value of its
assets, borrow an additional $50 from a bank. The $50 in borrowings
would represent one-third of the fund's $150 in total assets,
measured after the borrowing (or 50% of the fund's $100 net assets).
\30\ See section 18(a)(1) of the Investment Company Act.
\31\ See section 18(a)(2) of the Investment Company Act. If a
closed-end fund issues or sells a class of senior securities that is
a stock, it must have an asset coverage of at least 200% immediately
after such issuance or sale. Id.
\32\ See section 61(a)(1) of the Investment Company Act. BDCs,
like registered closed-end funds, also may issue a senior security
that is a stock (e.g., preferred stock), subject to limitations in
section 18. See sections 18(a)(2) and 61(a)(1) of the Investment
Company Act. In 2018, Congress passed the Small Business Credit
Availability Act, which, among other things, modified the statutory
asset coverage requirements applicable to BDCs (permitting BDCs that
meet certain specified conditions to elect to decrease their
effective asset coverage requirement from 200% to 150%). See section
802 of the Small Business Credit Availability Act, Public Law 115-
141, 132 Stat. 348 (2018).
---------------------------------------------------------------------------
2. Evolution of Commission and Staff Consideration of Section 18
Restrictions as Applied to Funds' Use of Derivatives
a. Investment Company Act Release 10666
In a 1979 General Statement of Policy (Release 10666), the
Commission considered the application of section 18's restrictions on
the issuance of senior securities to reverse repurchase agreements,
firm commitment agreements, and standby commitment agreements.\33\ The
Commission concluded that these agreements fall within the ``functional
meaning of the term `evidence of indebtedness' for purposes of Section
18 of the Investment Company Act,'' noting ``the unique legislative
purposes and policies underlying Section 18 of the Act.'' \34\ The
Commission stated in Release 10666 that, for purposes of section 18,
``evidence of indebtedness'' would include ``all contractual
obligations to pay in the future for consideration presently
received.'' The Commission recognized that, while section 18 would
generally prohibit open-end funds' use of reverse repurchase
agreements, firm commitment agreements, and standby commitment
agreements, the Commission nonetheless permitted funds to use these and
similar arrangements subject to the constraints that Release 10666
describes.
---------------------------------------------------------------------------
\33\ See Release 10666, supra note 15.
\34\ See id.
---------------------------------------------------------------------------
These constraints relied on funds' use of ``segregated accounts''
to ``cover'' senior securities, which ``if properly created and
maintained, would limit the investment company's risk of loss.'' \35\
The Commission also stated that the segregated account functions as ``a
practical limit on the amount of leverage which the investment company
may undertake and on the potential increase in the speculative
character of its outstanding common stock'' and that it ``[would]
assure the availability of adequate funds to meet the obligations
arising from such activities.'' \36\ The
[[Page 4451]]
Commission stated that its expressed views were not limited to the
particular trading practices discussed, but that the Commission sought
to address the implications of comparable trading practices that could
similarly affect funds' capital structures.\37\
---------------------------------------------------------------------------
\35\ See 2015 Proposing Release, supra note 2, at nn.45-47 and
accompanying text (discussing Release 10666's discussion of
segregated accounts).
\36\ See Release 10666, supra note 15, at 25132; see also 2015
Proposing Release, supra note 2, at n.48 and accompanying text.
\37\ See 2015 Proposing Release, supra note 2, at nn.49-50 and
accompanying text.
---------------------------------------------------------------------------
We continue to view the transactions described in Release 10666 as
falling within the functional meaning of the term ``evidence of
indebtedness,'' for purposes of section 18.\38\ The trading practices
that Release 10666 describes, as well as short sales of securities for
which the staff initially developed the segregated account approach
that the Commission applied in Release 10666, all impose on a fund a
contractual obligation under which the fund is or may be required to
pay or deliver assets in the future to a counterparty. These
transactions therefore involve the issuance of a senior security for
purposes of section 18.\39\
---------------------------------------------------------------------------
\38\ See Release 10666, supra note 15, at ``The Agreements as
Securities'' discussion. The Investment Company Act's definition of
the term ``security'' is broader than the term's definition in other
federal securities laws. See 2015 Proposing Release, supra note 2,
at n.61. Compare section 2(a)(36) of the Investment Company Act with
sections 2(a)(1) and 2A of the Securities Act of 1933 (15 U.S.C. 77a
et seq.) (``Securities Act'') and sections 3(a)(10) and 3A of the
Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) (``Exchange
Act''). See also 2011 Concept Release, supra note 3, at n.57 and
accompanying text (explaining that the Commission has interpreted
the term ``security'' in light of the policies and purposes
underlying the Investment Company Act).
\39\ See Release 10666, supra note 15, at ``The Agreements as
Securities'' discussion; see also section 18(g) (defining the term
``senior security,'' in part, as ``any bond, debenture, note, or
similar obligation or instrument constituting a security and
evidencing indebtedness'').
The Commission received several comments on the 2015 proposal
that objected to the Commission treating derivatives and financial
commitment transactions as involving senior securities where a fund
has ``appropriately'' covered its obligations under those
transactions. These comments generally argued that this approach is
not consistent with the Commission's views in Release 10666 and that
funds have for many years addressed senior security concerns raised
by these transactions by segregating assets or engaging in
offsetting, or ``cover,'' transactions that take into account
Release 10666 and staff guidance. See, e.g., Comment Letter of the
American Action Forum (Mar. 25, 2016) (``AAF Comment Letter'');
Comment Letter of Financial Services Roundtable (Mar. 28, 2016)
(``FSR Comment Letter''); Comment Letter of Franklin Resources, Inc.
(Mar. 28, 2016) (``Franklin Resources Comment Letter''); Comment
Letter of Dechert LLP (Mar. 28, 2016) (``Dechert Comment Letter'').
Whether a transaction involves the issuance of a senior security
will depend on whether that transaction involves a senior security
within the meaning of section 18(g). A fund's segregation of assets,
although one way to address policy concerns underlying section 18 as
the Commission described in Release 10666, does not, itself, affect
the legal question of whether a fund has issued a senior security.
---------------------------------------------------------------------------
We apply the same analysis to all derivatives transactions that
create future payment obligations. This is the case where the fund has
a contractual obligation to pay or deliver cash or other assets to a
counterparty in the future, either during the life of the instrument or
at maturity or early termination.\40\ As was the case for trading
practices that Release 10666 describes, where the fund has entered into
a derivatives transaction and has such a future payment obligation, we
believe that such a transaction involves an evidence of indebtedness
that is a senior security for purposes of section 18.\41\
---------------------------------------------------------------------------
\40\ These payments--which may include payments of cash, or
delivery of other assets--may occur as margin, as settlement
payments, or otherwise.
\41\ As the Commission explained in Release 10666, we believe
that an evidence of indebtedness, for purposes of section 18,
includes not only a firm and un-contingent obligation, but also a
contingent obligation, such as a standby commitment or a ``put'' (or
call) option sold by a fund. See Release 10666, supra note 15, at
``Standby Commitment Agreements'' discussion. We understand it has
been asserted that a contingent obligation that a standby commitment
or similar agreement creates does not involve a senior security
under section 18, unless and until generally accepted accounting
principles (``GAAP'') would require the fund to recognize the
contingent obligation as a liability on the fund's financial
statements. The treatment of derivatives transactions under GAAP,
including whether the derivatives transaction constitutes a
liability for financial statement purposes at any given time or the
extent of the liability for that purpose, is not determinative with
respect to whether the derivatives transaction involves the issuance
of a senior security under section 18. This is consistent with the
Commission's analysis of a fund's obligation, and the corresponding
segregated asset amounts, under the trading practices that Release
10666 describes. See id.
---------------------------------------------------------------------------
The express scope of section 18 supports this interpretation.
Section 18 defines the term ``senior security'' broadly to include
instruments and transactions that other provisions of the federal
securities laws might not otherwise consider to be securities.\42\ For
example, section 18(f)(1) generally prohibits an open-end fund from
issuing or selling any senior security ``except [that the fund] shall
be permitted to borrow from any bank.'' \43\ This statutory permission
to engage in a specific borrowing makes clear that such borrowings are
senior securities, which otherwise section 18 would prohibit absent
this specific permission.\44\
---------------------------------------------------------------------------
\42\ Consistent with Release 10666, and as the Commission stated
in the 2015 Proposing Release, we are only expressing our views in
this release concerning the scope of the term ``senior security'' in
section 18 of the Investment Company Act. See also section 12(a) of
the Investment Company Act (prohibiting funds from engaging in short
sales in contravention of Commission rules or orders).
\43\ Section 18(c)(2) similarly treats all promissory notes or
evidences of indebtedness issued in consideration of any loan as
senior securities except as section 18 otherwise specifically
provides.
\44\ The Commission similarly observed in Release 10666 that
section 18(f)(1), ``by implication, treats all borrowings as senior
securities,'' and that ``[s]ection 18(f)(1) of the Act prohibits
such borrowings unless entered into with banks and only if there is
300% asset coverage on all borrowings of the investment company.''
See Release 10666, supra note 15, at ``Reverse Repurchase
Agreements'' discussion.
---------------------------------------------------------------------------
This interpretation also is consistent with the fundamental policy
and purposes underlying the Investment Company Act expressed in
sections 1(b)(7) and 1(b)(8) of the Act.\45\ These respectively declare
that ``the national public interest and the interest of investors are
adversely affected'' when funds ``by excessive borrowing and the
issuance of excessive amounts of senior securities increase unduly the
speculative character'' of securities issued to common shareholders and
when funds ``operate without adequate assets or reserves.'' The
Commission emphasized these concerns in Release 10666, and we continue
to believe that the prohibitions and restrictions under the senior
security provisions of section 18 should ``function as a practical
limit on the amount of leverage which the investment company may
undertake and on the potential increase in the speculative character of
its outstanding common stock'' and that funds should not ``operate
without adequate assets or reserves.'' \46\ Funds' use of derivatives,
like the trading practices the Commission addressed in Release 10666,
may raise the undue speculation and asset sufficiency concerns in
section 1(b).\47\ First, funds' obtaining
[[Page 4452]]
leverage (or potential for leverage) through derivatives may raise the
Investment Company Act's undue speculation concern because a fund may
experience gains and losses that substantially exceed the fund's
investment, and also may incur a conditional or unconditional
obligation to make a payment or deliver assets to a counterparty.\48\
Not viewing derivatives that impose a future payment obligation on the
fund as involving senior securities, subject to appropriate limits
under section 18, would frustrate the concerns underlying section
18.\49\
---------------------------------------------------------------------------
\45\ The Commission received several comments on the 2015
proposal asserting that the provisions in section 1(b) of the
Investment Company Act do not, themselves, provide us authority to
regulate senior securities transactions. See, e.g., AAF Comment
Letter; Franklin Resources Comment Letter; Comment Letter of the
Securities Industry and Financial Markets Association (Mar. 28,
2016) (``SIFMA Comment Letter'').
The fundamental statutory policy and purposes underlying the
Investment Company Act, as expressed in section 1(b) of the Act,
inform our interpretation of the scope of the term ``senior
security'' in section 18, as we discuss in the paragraph
accompanying this note (and separately inform our consideration of
appropriate conditions for the exemption that proposed rule 18f-4
provides, as we discuss in sections II.B-II.G infra). The authority
under which we are proposing rules today is set forth in section VII
of this release and includes, among other provisions, section 6(c)
of the Act.
\46\ See Release 10666, supra note 15, at ``Segregated Account''
discussion.
\47\ As the Commission stated in Release 10666, leveraging an
investment company's portfolio through the issuance of senior
securities ``magnifies the potential for gain or loss on monies
invested and therefore results in an increase in the speculative
character of the investment company's outstanding securities'' and
``leveraging without any significant limitation'' was identified
``as one of the major abuses of investment companies prior to the
passage of the Act by Congress.'' Id.
\48\ See, e.g., The Report of the Task Force on Investment
Company Use of Derivatives and Leverage, Committee on Federal
Regulation of Securities, ABA Section of Business Law (July 6,
2010), at 8 (``2010 ABA Derivatives Report'') (stating that
``[f]utures contracts, forward contracts, written options and swaps
can produce a leveraging effect on a fund's portfolio'' because
``for a relatively small up-front payment made by a fund (or no up-
front payment, in the case with many swaps and written options), the
fund contractually obligates itself to one or more potential future
payments until the contract terminates or expires''; noting, for
example, that an ``[interest rate] swap presents the possibility
that the fund will be required to make payments out of its assets''
and that ``[t]he same possibility exists when a fund writes puts and
calls, purchases short and long futures and forwards, and buys or
sells credit protection through [credit default swaps]'').
\49\ One commenter on the 2011 Concept Release made this point
directly. See Comment Letter of Stephen A. Keen on the 2011 Concept
Release (Nov. 8, 2011) (File No. S7-33-11), at 3 (``Keen Concept
Release Comment Letter'') (``If permitted without limitation,
derivative contracts can pose all of the concerns that section 18
was intended to address with respect to borrowings and the issuance
of senior securities by investment companies.''); see also, e.g.,
ICI Concept Release Comment Letter, at 8 (``The Act is thus designed
to regulate the degree to which a fund issues any form of debt--
including contractual obligations that could require a fund to make
payments in the future.''). The Commission similarly noted in
Release 10666 that, given the potential for reverse repurchase
agreements to be used for leveraging and their ability to magnify
the risk of investing in a fund, ``one of the important policies
underlying section 18 would be rendered substantially nugatory'' if
funds' use of reverse repurchase agreements were not subject to
limitation. See 2015 Proposing Release, supra note 2, at text
preceding n.76.
---------------------------------------------------------------------------
Second, with respect to the Investment Company Act's asset
sufficiency concern, a fund's use of derivatives with future payment
obligations also may raise concerns regarding the fund's ability to
meet those obligations. Many fund derivatives investments, such as
futures contracts, swaps, and written options, pose a risk of loss that
can result in payment obligations owed to the fund's
counterparties.\50\ Losses on derivatives therefore can result in
counterparty payment obligations that directly affect the capital
structure of a fund and the relative rights of the fund's
counterparties and shareholders. These losses and payment obligations
also can force a fund's adviser to sell the fund's investments to meet
its obligations. When a fund uses derivatives to leverage its
portfolio, this can amplify the risk of a fund having to sell its
investments, potentially generating additional losses for the fund.\51\
In an extreme situation, a fund could default on its payment
obligations.\52\
---------------------------------------------------------------------------
\50\ Some derivatives transactions, like physically-settled
futures and forwards, can require the fund to deliver the underlying
reference assets regardless of whether the fund experiences losses
on the transaction.
\51\ See, e.g., Markus K. Brunnermeier & Lasse Heje Pedersen,
Market Liquidity and Funding Liquidity, 22 The Review of Financial
Studies 6, 2201-2238 (June 2009), available at https://
www.princeton.edu/~markus/research/papers/liquidity.pdf (providing
both empirical support as well as a theoretical foundation for how
short-term leverage obtained through borrowings or derivative
positions can result in funds and other financial intermediaries
becoming vulnerable to tighter funding conditions and increased
margins, specifically during economic downturns (as in the recent
financial crisis), thus potentially increasing the need for the fund
or intermediary to de-lever and sell portfolio assets at a loss).
\52\ See 2015 Proposing Release, supra note 2, at n.80.
---------------------------------------------------------------------------
b. Market and Industry Developments Following Release 10666
Following the issuance of Release 10666, Commission staff issued
more than thirty no-action letters to funds concerning the maintenance
of segregated accounts or otherwise ``covering'' their obligations in
connection with various transactions otherwise restricted by section
18.\53\ In these letters (issued primarily in the 1970s through 1990s)
and through other staff guidance, Commission staff has addressed
questions--generally on an instrument-by-instrument basis--regarding
the application of the Commission's statements in Release 10666 to
various types of derivatives and other transactions.
---------------------------------------------------------------------------
\53\ See id. at n.51 and accompanying text (citing 2011 Concept
Release, supra note 3, at section I).
---------------------------------------------------------------------------
Funds have developed certain general asset segregation practices to
cover their derivatives positions, based at least in part on the
staff's no-action letters and guidance. Practices vary based on the
type of derivatives transaction. For certain derivatives, funds
generally segregate an amount equal to the full amount of the fund's
potential obligation under the contract, or the full market value of
the underlying reference asset for the derivative (``notional amount
segregation'').\54\ For certain cash-settled derivatives, funds often
segregate an amount equal to the fund's daily mark-to-market liability,
if any (``mark-to-market segregation'').\55\
---------------------------------------------------------------------------
\54\ See id. at nn.54-55 and accompanying text.
\55\ See id. at nn.56-58, 96-98 and accompanying text (stating
that funds initially applied the mark-to-market approach to
segregation to specific types of transactions addressed through
guidance by our staff (interest rate swaps, cash-settled futures,
non-deliverable forwards), but that funds now apply mark-to-market
segregation to a wider range of cash-settled instruments, with our
staff observing that some funds appear to apply the mark-to-market
approach to any derivative that is cash settled).
---------------------------------------------------------------------------
Similarly, funds use different practices regarding the types of
assets that they segregate to cover their derivatives positions.
Release 10666 states that the assets eligible to be included in
segregated accounts should be ``liquid assets'' such as cash, U.S.
government securities, or other appropriate high-grade debt
obligations.\56\ However, a subsequent staff no-action letter stated
that the staff would not recommend enforcement action if a fund were to
segregate any liquid asset, including equity securities and non-
investment grade debt securities, to cover its senior securities-
related obligations.\57\
---------------------------------------------------------------------------
\56\ See id. at n.47 and accompanying text.
\57\ See id. at n.59 and accompanying text (citing Merrill Lynch
Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996),
available at https://www.sec.gov/divisions/investment/imseniorsecurities/merrilllynch070196.pdf).
---------------------------------------------------------------------------
As a result of these asset segregation practices, funds'
derivatives use--and thus funds' potential leverage through derivatives
transactions--does not appear to be subject to a practical limit as the
Commission contemplated in Release 10666. Funds' mark-to-market
liability often does not reflect the full investment exposure
associated with their derivatives positions.\58\ As a result, a fund
that segregates only the mark-to-market liability could theoretically
incur virtually unlimited investment leverage.\59\
---------------------------------------------------------------------------
\58\ For example, for derivatives where there is no loss in a
given day, a fund applying the mark-to-market approach might not
segregate any assets. This may be the case, for example, because the
derivative is currently in a gain position, or because the
derivative has a market value of zero (as will generally be the case
at the inception of a transaction). The fund may, however, still be
required to post collateral to comply with other regulatory or
contractual requirements.
\59\ See, e.g., Comment Letter of Ropes & Gray LLC on the
Concept Release (Nov. 7, 2011) (File No. S7-33-11), at 4 (stating
that ``[o]f course, in many cases [a fund's daily mark-to-market
liability, if any] will not fully reflect the ultimate investment
exposure associated with the swap position'' and that, ``[a]s a
result, a fund that segregates only the market-to-market liability
could theoretically incur virtually unlimited investment leverage
using cash-settled swaps''); Keen Concept Release Comment Letter, at
20 (stating that the mark-to-market approach, as applied to cash
settled swaps, ``imposes no effective control over the amount of
investment leverage created by these swaps, and leaves it to the
market to limit the amount of leverage a fund may use'').
---------------------------------------------------------------------------
These current asset segregation practices also may not assure the
[[Page 4453]]
availability of adequate assets to meet funds' derivatives obligations,
as the Commission contemplated in Release 10666. A fund using the mark-
to-market approach could segregate assets that only reflect the losses
(and corresponding potential payment obligations) that the fund would
then incur as a result of transaction termination. This practice
provides no assurances that future losses will not exceed the value of
the segregated assets or the value of all assets then available to meet
the payment obligations resulting from such losses.\60\ We also
recognize that when a fund segregates any liquid asset, rather than the
more narrow range of high-quality assets the Commission described in
Release 10666, the segregated assets may be more likely to decline in
value at the same time as the fund experiences losses on its
derivatives.\61\ In this case, or when a fund's derivatives payment
obligations are substantial relative to the fund's liquid assets, the
fund may be forced to sell portfolio securities to meet its derivatives
payment obligations. These forced sales could occur during stressed
market conditions, including at times when prudent management could
advise against such liquidation.\62\
---------------------------------------------------------------------------
\60\ A fund's mark-to-market liability on any particular day, if
any, could be substantially smaller than the fund's ultimate
obligations under a derivative. See 2015 Proposing Release, supra
note 2, at n.113.
\61\ See id. at n.115.
\62\ The Commission noted in Release 10666 that ``in an extreme
case an investment company which has segregated all its liquid
assets might be forced to sell non-segregated portfolio securities
to meet its obligations upon shareholder requests for redemption.
Such forced sales could cause an investment company to sell
securities which it wanted to retain or to realize gains or losses
which it did not originally intend.'' See Release 10666, supra note
15, at ``Segregated Account'' discussion.
---------------------------------------------------------------------------
3. Need for Updated Regulatory Framework
As the Commission observed in the 2015 proposal and for the reasons
discussed above, we continue to be concerned that funds' current
practices regarding derivatives use may not address the undue
speculation and asset sufficiency concerns underlying section 18.\63\
Additionally, as recent events demonstrate, a fund's derivatives use
may involve risks that can result in significant losses to a fund.\64\
Accordingly, we continue to believe that it is appropriate for funds to
address these risks and considerations relating to their derivatives
use. Nevertheless, we also recognize the valuable role derivatives can
play in helping funds to achieve their objectives efficiently or manage
their investment risks.
---------------------------------------------------------------------------
\63\ See 2015 Proposing Release, supra note 2, at sections
II.D.1.b and II.D.1.c; see also supra paragraphs accompanying notes
58-62.
\64\ See supra paragraph accompanying notes 22-25.
---------------------------------------------------------------------------
We therefore believe funds that significantly use derivatives
should adopt and implement formalized programs to manage the risks
derivatives may pose. In addition, a more modern framework for
regulating funds' derivatives use would respond to our concern that
funds today are not subject to a practical limit on potential leverage
that they may obtain through derivatives transactions. The risk
management program requirement and limit on fund leverage risk we are
proposing are designed to address these considerations, in turn.
A comprehensive approach to regulating funds' derivatives use also
would help address potential adverse results from funds' current,
disparate asset segregation practices. The development of staff
guidance and industry practice on an instrument-by-instrument basis,
together with growth in the volume and complexity of derivatives
markets over past decades, has resulted in situations in which
different funds may treat the same kind of derivative differently,
based on their own view of our staff's guidance or observation of
industry practice. This may unfairly disadvantage some funds.\65\ The
lack of comprehensive guidance also makes it difficult for funds and
our staff to evaluate and inspect for funds' compliance with section 18
of the Investment Company Act. Moreover, where there is no specific
guidance, or where the application of existing guidance is unclear or
applied inconsistently, funds may take approaches that involve an
extensive use of derivatives and may not address the purposes and
concerns underlying section 18.
---------------------------------------------------------------------------
\65\ See, e.g., Comment Letter of Davis Polk on the 2011 Concept
Release (Nov. 11, 2011), at 1-2 (stating that ``funds and their
sponsors may interpret the available guidance differently, even when
applying it to the same instruments, which may unfairly disadvantage
some funds''); see also Comment Letter of Federated Investors, Inc.
(Mar. 23, 2016) (``Federated Comment Letter''); Comment Letter of
Salient Partners, L.P. (Mar. 25, 2016) (``Salient Comment Letter).
---------------------------------------------------------------------------
C. Overview of the Proposal
Our proposal consists of three parts. Proposed rule 18f-4 is
designed to provide an updated, comprehensive approach to the
regulation of funds' use of derivatives and the other transactions that
the proposed rule addresses. The proposed sales practices rules are
designed to address investor protection concerns with respect to
leveraged/inverse funds by requiring broker-dealers and investment
advisers to exercise due diligence on retail investors before approving
retail investor accounts to invest in leveraged/inverse funds. The
proposed amendments to Forms N-PORT, N-LIQUID (which we propose to re-
title as ``Form N-RN''), and N-CEN are designed to enhance the
Commission's ability to oversee funds' use of and compliance with the
proposed rules, and for the Commission and the public to have greater
insight into the impact that funds' use of derivatives would have on
their portfolios.
Proposed rule 18f-4 would permit a fund to enter into derivatives
transactions, notwithstanding the prohibitions and restrictions on the
issuance of senior securities under section 18 of the Investment
Company Act, subject to the following conditions: \66\
---------------------------------------------------------------------------
\66\ See proposed rule 18f-4(b) and (d). Proposed rule 18f-4(b)
would provide an exemption for funds' derivatives transactions from
sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company
Act. See supra section I.B.1 of this release (providing an overview
of the requirements of section 18). Because the proposed conditions
are designed to provide a tailored set of requirements for
derivatives transactions, the proposed rule would also provide that
a fund's derivatives transactions would not be considered for
purposes of computing asset coverage under section 18(h). Applying
section 18(h) asset coverage to a fund's derivatives transactions
appears unnecessary in light of the tailored restrictions we are
proposing. See also infra section II.M.
---------------------------------------------------------------------------
Derivatives risk management program.\67\ The proposed rule
would generally require a fund to adopt a written derivatives risk
management program with risk guidelines that must cover certain
elements, but that otherwise would be tailored based on how the fund's
use of derivatives may affect its investment portfolio and overall risk
profile. The program also would have to include stress testing,
backtesting, internal reporting and escalation, and program review
elements. The program would institute a standardized risk management
framework for funds that engage in more than a limited amount of
derivatives transactions, while allowing principles-based tailoring to
the fund's particular risks. We believe that a formalized derivatives
risk management program is critical to appropriate derivatives risk
management and is foundational to providing exemptive relief under
section 18.
---------------------------------------------------------------------------
\67\ See proposed rule 18f-4(c)(1); infra section II.A.2.
---------------------------------------------------------------------------
Limit on fund leverage risk.\68\ The proposed rule would
generally require funds when engaging in derivatives
[[Page 4454]]
transactions to comply with an outer limit on fund leverage risk based
on value at risk, or ``VaR.'' This outer limit would be based on a
relative VaR test that compares the fund's VaR to the VaR of a
``designated reference index'' for that fund. If the fund's derivatives
risk manager is unable to identify an appropriate designated reference
index, the fund would be required to comply with an absolute VaR test.
These proposed requirements are designed to limit fund leverage risk
consistent with the investor protection purposes underlying section 18
and to complement the proposed risk management program. Because VaR is
a commonly-known and broadly-used industry metric that enables risk to
be measured in a reasonably comparable and consistent manner across the
diverse instruments that may be included in a fund's portfolio, the
proposed VaR-based limit is designed to address leverage risk for a
variety of fund strategies.
---------------------------------------------------------------------------
\68\ See proposed rule 18f-4(c)(2); infra section II.D.
---------------------------------------------------------------------------
Board oversight and reporting.\69\ The proposed rule would
require a fund's board of directors to approve the fund's designation
of a derivatives risk manager, who would be responsible for
administering the fund's derivatives risk management program. The
fund's derivatives risk manager would have to report to the fund's
board on the derivatives risk management program's implementation and
effectiveness and the results of the fund's stress testing. The
derivatives risk manager would have a direct reporting line to the
fund's board. We believe requiring a fund's derivatives risk manager to
be responsible for the day-to-day administration of the fund's program,
subject to board oversight, is consistent with the way we understand
many funds currently manage derivatives risks and is key to
appropriately managing these risks.
---------------------------------------------------------------------------
\69\ See proposed rule 18f-4(c)(5); infra section II.C.
---------------------------------------------------------------------------
Exception for limited derivatives users.\70\ The proposed
rule would except limited derivatives users from the derivatives risk
management program requirement and the VaR-based limit on fund leverage
risk. This proposed exception would be available to a fund that either
limits its derivatives exposure to 10% of its net assets or uses
derivatives transactions solely to hedge certain currency risks and, in
either case, that also adopts and implements policies and procedures
reasonably designed to manage the fund's derivatives risks. Requiring a
derivatives risk management program that includes all of the program
elements specified in the rule for funds that use derivatives only in a
limited way could potentially require these funds to incur costs and
bear compliance burdens that are disproportionate to the resulting
benefits.
---------------------------------------------------------------------------
\70\ See proposed rule 18f-4(c)(3); infra section II.E.
---------------------------------------------------------------------------
Alternative requirements for certain leveraged/inverse
funds.\71\ The proposed rule would provide an exception from the limit
on fund leverage risk for certain leveraged/inverse funds in light of
the additional safeguards provided by the proposed requirements under
the sales practices rules that broker-dealers and investment advisers
exercise due diligence on retail investors before approving the
investors' accounts to invest in these funds.\72\ The conditions of
this exception are designed to address the investor protection concerns
that underlie section 18 of the Investment Company Act, while
preserving choice for investors the investment adviser or broker-dealer
reasonably believes have such financial knowledge and experience that
they may reasonably be expected to be capable of evaluating the risk of
these funds.
---------------------------------------------------------------------------
\71\ See proposed rule 18f-4(c)(4); infra section II.G.
\72\ In our discussion in this release of the entities subject
to the proposed sales practices rules, we use ``broker-dealer'' to
refer to a broker-dealer that is registered with, or required to
register with, the Commission. Similarly, we use ``investment
adviser'' to refer to an investment adviser that is registered with,
or required to register with, the Commission.
---------------------------------------------------------------------------
Recordkeeping.\73\ The proposed rule would require a fund
to adhere to recordkeeping requirements that are designed to provide
the Commission's staff, and the fund's board of directors and
compliance personnel, the ability to evaluate the fund's compliance
with the proposed rule's requirements.
---------------------------------------------------------------------------
\73\ See proposed rule 18f-4(c)(6); infra section II.K.
---------------------------------------------------------------------------
Proposed rule 18f-4 would also permit funds to enter into reverse
repurchase agreements and similar financing transactions, as well as
``unfunded commitments'' to make certain loans or investments, subject
to conditions tailored to these transactions.\74\ A fund would be
permitted to engage in reverse repurchase agreements and similar
financing transactions so long as they meet the asset coverage
requirements under section 18. If the fund also borrows from a bank or
issues bonds, for example, these senior securities as well as the
reverse repurchase agreement would be required to comply with the asset
coverage requirements under the Investment Company Act. This approach
would provide the same asset coverage requirements under section 18 for
reverse repurchase agreements and similar financing transactions, bank
borrowings, and other borrowings permitted under the Investment Company
Act. A fund would be permitted to enter into unfunded commitment
agreements if the fund reasonably believes that its assets will allow
the fund to meet its obligations under these agreements. This approach
recognizes that, while unfunded commitment agreements do raise the risk
that a fund may be unable to meet its obligations under these
transactions, such unfunded commitments do not generally involve the
leverage and other risks associated with derivatives transactions.
---------------------------------------------------------------------------
\74\ See proposed rule 18f-4(d) and (e); infra sections II.I and
II.J.
---------------------------------------------------------------------------
The proposed sales practices rules are designed to address certain
specific considerations raised by certain leveraged/inverse funds and
listed commodity pools that obtain leveraged or inverse exposure to an
underlying index, on a periodic (generally, daily) basis.\75\ These
rules would require broker-dealers and investment advisers to exercise
due diligence in determining whether to approve a retail customer or
client's account to buy or sell these products. A broker-dealer or
adviser could only approve the account if it had a reasonable basis to
believe that the customer or client is capable of evaluating the risk
associated with these products. In this regard, the proposed sales
practices rules would complement the leveraged/inverse funds exception
from proposed rule 18f-4's limit on leverage risk by subjecting broker-
dealers or advisers to the proposed sales practices rules' due
diligence and approval requirements.
---------------------------------------------------------------------------
\75\ See infra note 327 and accompanying text (defining ``listed
commodity pools'').
---------------------------------------------------------------------------
In connection with proposed rules 15l-2, 211(h)-1, and 18f-4, we
are proposing amendments to rule 6c-11 under the Investment Company
Act. Rule 6c-11 generally permits ETFs to operate without obtaining a
Commission exemptive order, subject to certain conditions.\76\ The rule
currently excludes leveraged/inverse ETFs from relying on the rule,
however, to allow the Commission to consider the section 18 issues
raised by these funds' investment strategies as part of a broader
consideration of derivatives use by registered funds and BDCs.\77\ As
part of this further consideration, we are
[[Page 4455]]
proposing to remove this provision and permit leveraged/inverse ETFs to
rely on rule 6c-11 because the proposed sales practices rules and rule
18f-4 are designed to address these issues. In this regard, we are also
proposing to rescind the exemptive orders previously issued to the
sponsors of leveraged/inverse ETFs. Amending rule 6c-11 and rescinding
these exemptive orders would promote a level playing field by allowing
any sponsor (in addition to the sponsors currently granted exemptive
orders) to form and launch a leveraged/inverse ETF subject to the
conditions in rule 6c-11 and proposed rule 18f-4, with transactions in
the fund subject to the proposed sales practices rules.
---------------------------------------------------------------------------
\76\ See generally Exchange-Traded Funds, Investment Company Act
Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct. 24, 2019)]
(``ETFs Adopting Release'').
\77\ See id. at nn.72-74 and accompanying text.
---------------------------------------------------------------------------
The proposed amendments to Forms N-PORT, N-LIQUID, and N-CEN would
require a fund to provide information regarding: (1) The fund's
exposure to derivatives; (2) the fund's VaR (and, if applicable, the
fund's designated reference index) and backtesting results; (3) VaR
test breaches, to be reported to the Commission in a non-public current
report; and (4) certain identifying information about the fund (e.g.,
whether the fund is a limited derivatives user that is excepted from
certain of the proposed requirements, or whether the fund is a
``leveraged/inverse fund'').
Finally, in view of our proposal for an updated, comprehensive
approach to the regulation of funds' derivative use, we are proposing
to rescind Release 10666. In addition, staff in the Division of
Investment Management is reviewing certain of its no-action letters and
other guidance addressing derivatives transactions and other
transactions covered by proposed rule 18f-4 to determine which letters
and other staff guidance, or portions thereof, should be withdrawn in
connection with any adoption of this proposal. Upon the adoption of any
final rule, some of these letters and other staff guidance, or portions
thereof, would be moot, superseded, or otherwise inconsistent with the
final rule and, therefore, would be withdrawn. We would expect to
provide funds a one-year transition period while they prepare to come
into compliance with rule 18f-4 before Release 10666 is withdrawn.
II. Discussion
A. Scope of Proposed Rule 18f-4
1. Funds Permitted To Rely on Proposed Rule 18f-4
The proposed rule would apply to a ``fund,'' defined as a
registered open-end or closed-end company or a BDC, including any
separate series thereof. The rule would therefore apply to mutual
funds, ETFs, registered closed-end funds, and BDCs. The proposed rule's
definition of a ``fund'' would, however, exclude money market funds
regulated under rule 2a-7 under the Investment Company Act (``money
market funds''). Under rule 2a-7, money market funds seek to maintain a
stable share price or limit principal volatility by limiting their
investments to short-term, high-quality debt securities that fluctuate
very little in value under normal market conditions. As a result of
these and other requirements in rule 2a-7, we believe that money market
funds currently do not typically engage in derivatives transactions or
the other transactions permitted by rule 18f-4.\78\ We believe that
these transactions would generally be inconsistent with a money market
fund maintaining a stable share price or limiting principal volatility,
and especially if used to leverage the fund's portfolio.\79\ We
therefore believe that excluding money market funds from the scope of
the proposed rule is appropriate.
---------------------------------------------------------------------------
\78\ See infra note 583.
\79\ See Money Market Fund Reform; Amendments to Form PF,
Investment Company Act Release No. 31166 (July 23, 2014) [79 FR
47735 (Aug. 14, 2014)] (discussing (1) retail and government money
market funds, which seek to maintain a stable net asset value per
share and (2) institutional non-government money market funds whose
net asset value fluctuates, but still must stress test their ability
to minimize principal volatility given that ``commenters pointed out
investors in floating NAV funds will continue to expect a relatively
stable NAV'').
---------------------------------------------------------------------------
Section 18 applies only to open-end or closed-end companies, i.e.,
to management investment companies. Proposed rule 18f-4 therefore also
would not apply to unit investment trusts (``UITs'') because they are
not management investment companies. In addition, as the Commission has
noted, derivatives transactions generally require a significant degree
of management, and a UIT engaging in derivatives transactions therefore
may not meet the Investment Company Act requirements applicable to
UITs.\80\
---------------------------------------------------------------------------
\80\ See section 4(2) of the Investment Company Act; see also
Custody Of Investment Company Assets with Futures Commission
Merchants And Commodity Clearing Organizations, Investment Company
Act Release No. 22389 (Dec. 11, 1996), at n.18 (explaining that UIT
portfolios are generally unmanaged). See also ETFs Adopting Release,
supra note 76, at n.42.
---------------------------------------------------------------------------
We request comment on all aspects of the proposed rule's definition
of the term ``fund,'' including the following items.
1. The proposed definition excludes money market funds. Should we
include money market funds in the definition? Why or why not?
2. Do money market funds currently engage in any transactions that
might qualify as derivatives transactions under the rule or any of the
other transactions permitted by the rule? For example, do money market
funds engage in reverse repurchase agreements, ``to be announced''
dollar rolls, or ``when issued'' transactions? If so, which
transactions, to what extent, and for what purpose? For example, do
money market funds engage in reverse repurchase agreements for
liquidity management purposes but not to leverage the fund's portfolio?
If so, what effects would the proposed rule have on money market funds'
liquidity management if they are excluded from the rule's scope as
proposed? To the extent money market funds engage in any of the
transactions that the proposed rule would permit, how do money market
funds analyze them under rule 2a-7?
3. Should we permit money market funds to engage in some of the
transactions that the rule would permit? If so, which transactions and
why, and how would the transactions be consistent with rule 2a-7? If we
were to include money market funds in the rule, or permit them to
engage in specific types of transactions, should the rule provide
specific conditions tailored to money market funds entering into those
transactions? What kinds of conditions and why? Should they be
permitted to engage in all (or certain types) of derivatives
transactions, or reverse repurchase or similar financing transactions,
for liquidity management or other purposes that do not leverage the
fund's portfolio? If money market funds were permitted to rely on the
rule for any transactions, should those transactions be limited in
scale? For example, should that limit be the same as the proposed
approach for limited derivatives users that limit the extent of their
derivatives exposure, as discussed below in section II.E.1? Would even
such limited use be consistent with funds that seek to maintain a
stable share price or limit principal volatility?
4. If we were to include money market funds in the scope of rule
18f-4, should we revise Form N-MFP so that money market funds filing
reports on the form could select among the list of investment
categories set forth in Item C.6 of Form N-MFP derivatives and the
other transactions addressed in the proposed rule 18f-4? \81\ Why or
why not?
---------------------------------------------------------------------------
\81\ See infra note 583.
---------------------------------------------------------------------------
2. Derivatives Transactions Permitted Under Proposed Rule 18f-4
The proposed rule would permit funds to enter into derivatives
[[Page 4456]]
transactions, subject to the rule's conditions. The proposed rule would
define the term ``derivatives transaction'' to mean: (1) Any swap,
security-based swap, futures contract, forward contract, option, any
combination of the foregoing, or any similar instrument (``derivatives
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, whether as margin or
settlement payment or otherwise; and (2) any short sale borrowing.\82\
---------------------------------------------------------------------------
\82\ Proposed rule 18f-4(a). The 2015 proposal similarly defined
a derivatives transaction as including enumerated derivatives
instruments ``under which the 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, whether as a margin
or settlement payment or otherwise.'' 2015 proposed rule 18f-
4(c)(2). Most commenters did not address the proposed definition of
the term ``derivatives transaction,'' although those commenters who
did address the definition generally supported it. Some commenters
more generally supported the view, or sought confirmation, that a
derivative does not involve the issuance of a senior security if it
does not impose an obligation under which the fund is or may be
required to make a future payment (e.g., a standard purchased
option). See, e.g., Comment Letter of The Options Clearing
Corporation (Mar. 25, 2016); Comment Letter of Investment Adviser
Association (Mar. 28, 2016) (``IAA Comment Letter''); FSR Comment
Letter.
---------------------------------------------------------------------------
The first prong of this proposed definition is designed to describe
those derivatives transactions that involve the issuance of a senior
security, because they involve a contractual future payment
obligation.\83\ When a fund engages in these transactions, the fund
will have an obligation (or potential obligation) to make payments or
deliver assets to the fund's counterparty. This prong of the definition
incorporates a list of derivatives instruments that, together with the
proposed inclusion in the definition of ``any similar instrument,''
covers the types of derivatives that funds currently use and that the
requirements of section 18 would restrict. This list is designed to be
sufficiently comprehensive to include derivatives that may be developed
in the future. We believe that this approach is clearer than a more
principles-based definition of the term ``derivatives transaction,''
such as defining this term as an instrument or contract whose value is
based upon, or derived from, some other asset or metric.
---------------------------------------------------------------------------
\83\ See supra note 27 and accompanying text, and text following
note 34 (together, noting that ``senior security'' is defined in
part as ``any . . . similar obligation or instrument constituting a
security and evidencing indebtedness,'' and that the Commission has
previously stated that, for purposes of section 18, ``evidence of
indebtedness'' would include ``all contractual obligations to pay in
the future for consideration presently received''); see also infra
notes 85-87 (recognizing that not every derivative instrument will
involve the issuance of a senior security).
---------------------------------------------------------------------------
This prong of the definition also provides that a derivatives
instrument, for purposes of the proposed rule, must involve a future
payment obligation.\84\ This aspect of the definition recognizes that
not every derivatives instrument imposes an obligation that may require
the fund to make a future payment, and therefore not every derivatives
instrument will involve the issuance of a senior security.\85\ A
derivative that does not impose any future payment obligation on a fund
generally resembles a securities investment that is not a senior
security, in that it may lose value but will not require the fund to
make any payments in the future.\86\ Whether a transaction involves the
issuance of a senior security will depend on the nature of the
transaction. The label that a fund or its counterparty assigns to the
transaction is not determinative.\87\
---------------------------------------------------------------------------
\84\ Under the proposed rule, a derivatives instrument is one
where the 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, whether as margin or settlement
payment or otherwise.''
\85\ See 2015 Proposing Release, supra note 2, at paragraph
accompanying nn.82-83. A fund that purchases a standard option
traded on an exchange, for example, generally will make a non-
refundable premium payment to obtain the right to acquire (or sell)
securities under the option. However, the option purchaser generally
will not have any subsequent obligation to deliver cash or assets to
the counterparty unless the fund chooses to exercise the option.
\86\ See id. at n.82.
\87\ For example, the Commission received a comment on the 2015
proposal addressing a type of total return swap, asserting that
``[t]he Swap operates in a manner similar to a purchased option or
structure, in that the fund's losses under the Swap cannot exceed
the amount posted to its tri-party custodian agreement for purposes
of entering into the Swap,'' and that, in the commenter's view, the
swap should be ``afforded the same treatment as a purchased option
or structured note'' because ``[a]lthough the Swap involves interim
payments through the potential posting of margin from the custodial
account, the payment obligations cannot exceed the [amount posted
for purposes of entering into the Swap].'' See Comment Letter of
Dearborn Capital Management (Mar. 24, 2016) (``Dearborn Comment
Letter''). Unlike a fund's payment of a one-time non-refundable
premium in connection with a standard purchased option or a fund's
purchase of a structured note, this transaction appears to involve a
fund obligation to make interim payments of fund assets posted as
margin or collateral to the fund's counterparty during the life of
the transaction in response to market value changes of the
underlying reference asset, as this commenter described. The fund
also must deposit additional margin or collateral to maintain the
position if the fund's losses deplete the assets that the fund
posted to initiate the transaction; if a fund effectively pursues
its strategy through such a swap, or a small number of these swaps,
the fund may as a practical matter be required to continue
reestablishing the trade or refunding the collateral account in
order to continue to offer the fund's strategy. The transaction
therefore appears to involve the issuance of a senior security as
the fund may be required to make future payments.
See also infra section II.J (discussing the characterization of
``unfunded commitment'' agreements for purposes of the proposed
rule, and as senior securities).
---------------------------------------------------------------------------
Unlike the 2015 proposal, this proposal does not include references
to, or a definition of, ``financial commitment transaction'' in
addition to the proposed definition of ``derivatives transaction.'' The
2015 proposal defined a ``financial commitment transaction'' as any
reverse repurchase agreement, short sale borrowing, or any firm or
standby commitment agreement or similar agreement.\88\ Because our
proposal addresses funds' use of reverse repurchase agreements and
unfunded commitment agreements separately from funds' use of
derivatives, the proposed definition of ``derivatives transaction''
does not include reverse repurchase agreements and unfunded commitment
agreements.\89\
---------------------------------------------------------------------------
\88\ See 2015 Proposing Release, supra note 2, at section
III.A.2; 2015 proposed rule 18f-4(c)(4); see also supra note 10.
\89\ See infra section II.I.
---------------------------------------------------------------------------
Short sale borrowings, however, are included in the second prong of
the proposed definition of ``derivatives transaction.'' We appreciate
that short sales of securities do not involve derivatives instruments
such as swaps, futures, and options. The value of a short position is,
however, derived from the price of another asset, i.e., the asset sold
short. A short sale of a security provides the same economic exposure
as a derivatives instrument, like a future or swap, that provides short
exposure to the same security. The proposed rule therefore treats short
sale borrowings and derivatives instruments identically for purposes of
funds' reliance on the rule's exemption.\90\
---------------------------------------------------------------------------
\90\ See proposed rule 18f-4(b).
---------------------------------------------------------------------------
While this proposal does not specifically list firm or standby
commitment agreements in the definition of ``derivatives transaction,''
we interpret the definitional phrase ``or any similar instrument'' to
include these agreements. A firm commitment agreement has the same
economic characteristics as a forward contract.\91\ Similarly, a
standby commitment agreement has the same economic characteristics as
an option contract, and the Commission has previously stated that such
an agreement is economically equivalent to the issuance
[[Page 4457]]
of a put option.\92\ To the extent that a fund engages in transactions
similar to firm or standby commitment agreements, they may fall within
the ``any similar instrument'' definitional language, depending on the
facts and circumstances.\93\
---------------------------------------------------------------------------
\91\ Indeed, the Commission noted in Release 10666 that a firm
commitment is known by other names such as a ``forward contract.''
See Release 10666, supra note 15, at nn.10-12 and accompanying text.
\92\ See id. at ``Standby Commitment Agreements'' (``The standby
commitment agreement is a delayed delivery agreement in which the
investment company contractually binds itself to accept delivery of
a Ginnie Mae with a stated price and fixed yield upon the exercise
of an option held by the other party to the agreement at a stated
future date. . . . The Commission believes that the standby
commitment agreement involves, in economic reality, the issuance and
sale by the investment company of a `put.' '').
\93\ See, e.g., infra paragraph accompanying notes 419-420
(discussing agreements that would not qualify for the proposed
rule's treatment of unfunded commitment agreements because they are
functionally similar to derivatives transactions).
---------------------------------------------------------------------------
We request comment on all aspects of the proposed rule's definition
of the term ``derivatives transaction,'' including the following items.
5. Is the definition of ``derivatives transaction'' sufficiently
clear? Are there additional types of derivatives instruments, or other
transactions, that we should include or exclude? Adding additional
transactions to the definition would permit a fund to engage in those
transactions by complying with the proposed rule, rather than section
18. Are there transactions that we should exclude from the definition
so that funds must comply with the limits of section 18 (to the extent
permitted under section 18) with respect to these transactions, rather
than the proposed rule's conditions?
6. The proposed rule's definition of the term ``derivatives
transaction'' is designed to describe those derivatives transactions
that would involve the issuance of a senior security. Do commenters
agree that derivatives transactions that involve obligations to make a
payment or deliver assets involve the issuance of a senior security
under section 18 of the Act? Does the rule effectively describe all of
the types of derivatives transactions that would involve the issuance
of a senior security? Conversely, are there any types of transactions
that are included in the proposed definition of ``derivatives
transaction'' that should not be considered to involve the issuance of
a senior security? If so, which types of transactions and why?
7. Is it appropriate that the proposed rule's definition of
``derivatives transaction'' incorporates a list of derivatives
instruments plus ``any similar instrument,'' rather than a principles-
based definition, such as an instrument or contract whose value is
based upon, or derived from, some other asset or metric? Why or why
not? Is the reference to ``any similar instrument'' in the proposed
definition sufficiently clear to address transactions that may be
developed in the future? If not, how should we modify the rule to
provide additional clarity?
8. Should the proposed definition of ``derivatives transaction''
include short sale borrowings? Would this approach cause any confusion
because short sales are not typically understood as derivatives
instruments? If the latter, what alternative approach would be
preferable?
9. Should we specifically list firm or standby commitments in the
proposed definition of ``derivatives transaction''? Would funds
understand the phrase ``or any similar instrument'' in the proposed
definition to include these agreements? Do funds currently use the
terms ``firm commitment agreement'' or ``standby commitment agreement''
to describe any of their transactions?
10. Are there any transactions similar to firm or standby
commitments that we should specifically address, either in the proposed
definition of ``derivatives transaction'' or otherwise as guidance? Are
there any other types of transactions that the Commission should
address--either in the proposed definition or as guidance--as
transactions that fall within the ``any similar instrument''
definitional language?
B. Derivatives Risk Management Program
1. Summary
Fund investments in derivatives transactions can pose a variety of
risks, and poor risk management can cause significant harm to funds and
their investors. Derivatives can raise potential risks such as market,
counterparty, leverage, liquidity, and operational risk. Although many
of these risks are not limited to derivatives, the complexity and
character of certain derivatives--such as their multiple contingencies
and optionality, path dependency, and non-linearity--may heighten these
risks.\94\ Even simple derivatives without multiple contingencies and
optionality, for example, can present additional risks beyond a fund's
investment in the underlying reference assets, such as the risk that a
fund must have margin-eligible assets on hand to meet margin or
collateral calls. We also recognize the valuable role derivatives can
play in helping funds to achieve their objectives efficiently or manage
their investment risks.
---------------------------------------------------------------------------
\94\ See European Securities and Markets Authority (formerly
Committee of European Securities Regulators), Guidelines on Risk
Measurement and the Calculation of Global Exposure and Counterparty
Risk for UCITS, CESR/10-788 (July 28, 2010), at 12, available at
https://www.esma.europa.eu/sites/default/files/library/2015/11/10_788.pdf (``CESR Global Guidelines'').
---------------------------------------------------------------------------
An investment adviser of a fund that uses derivatives therefore
should manage this use to ensure alignment with the fund's investment
objectives, policies, and restrictions, its risk profile, and relevant
regulatory requirements. In addition, a fund's board of directors is
responsible for overseeing the fund's activities and the adviser's
management of risks, including any derivatives risks.\95\ Given the
dramatic growth in the volume and complexity of the derivatives markets
over the past two decades, and the increased use of derivatives by
certain funds and their related risks, we believe that requiring funds
that are users of derivatives (other than limited derivatives users) to
have a formalized risk management program with certain specified
elements (a ``program'') supports exempting these transactions from
section 18.
---------------------------------------------------------------------------
\95\ See, e.g., Interpretive Matters Concerning Independent
Directors of Investment Companies, Investment Company Act Release
No. 24083 (Oct. 14, 1999) [64 FR 59877 (Nov. 3, 1999)]; Role of
Independent Directors of Investment Companies, Investment Company
Act Release No. 24816 (Jan. 2, 2001) [66 FR 3733 (Jan. 16, 2001)];
Independent Directors Council, Fund Board Oversight of Risk
Management (Sept. 2011), available at http://www.ici.org/pdf/pub_11_oversight_risk.pdf (``2011 IDC Report'').
---------------------------------------------------------------------------
Under the proposed program requirement, a fund would have to adopt
and implement a written derivatives risk management program, which
would include policies and procedures reasonably designed to manage the
fund's derivatives risks.\96\ A fund's risk management program should
take into the account the way the fund uses derivatives, whether to
increase investment exposures in ways that increase portfolio risks or,
conversely, to reduce portfolio risks or facilitate efficient portfolio
management.\97\
---------------------------------------------------------------------------
\96\ Proposed rule 18f-4(c)(1).
\97\ See supra note 4 and accompanying text; infra section
II.B.3.a.
---------------------------------------------------------------------------
The program requirement is designed to result in a program with
elements that are tailored to the particular types of derivatives that
the fund uses and their related risks, as well as how those derivatives
impact the fund's investment portfolio and strategy. The proposal would
require a fund's program to include the following elements:
Risk identification and assessment.\98\ The program would
have to provide for the identification and assessment of a fund's
derivatives risks,
[[Page 4458]]
which would take into account the fund's derivatives transactions and
other investments.
---------------------------------------------------------------------------
\98\ Proposed rule 18f-4(c)(1)(i); see also infra section
II.B.3.a.
---------------------------------------------------------------------------
Risk guidelines.\99\ The program would have to provide for
the establishment, maintenance, and enforcement of investment, risk
management, or related guidelines that provide for quantitative or
otherwise measurable criteria, metrics, or thresholds related to a
fund's derivatives risks.
---------------------------------------------------------------------------
\99\ Proposed rule 18f-4(c)(1)(ii); see also infra section
II.B.3.b.
---------------------------------------------------------------------------
Stress testing.\100\ The program would have to provide for
stress testing of derivatives risks to evaluate potential losses to a
fund's portfolio under stressed conditions.
---------------------------------------------------------------------------
\100\ Proposed rule 18f-4(c)(1)(iii); see also infra section
II.B.3.c.
---------------------------------------------------------------------------
Backtesting.\101\ The program would have to provide for
backtesting of the VaR calculation model that the fund uses under the
proposed rule.
---------------------------------------------------------------------------
\101\ Proposed rule 18f-4(c)(1)(iv); see also infra section
II.B.3.d.
---------------------------------------------------------------------------
Internal reporting and escalation.\102\ The program would
have to provide for the reporting of certain matters relating to a
fund's derivatives use to the fund's portfolio management and board of
directors.
---------------------------------------------------------------------------
\102\ Proposed rule 18f-4(c)(1)(v); see also infra section
II.B.3.e.
---------------------------------------------------------------------------
Periodic review of the program.\103\ A fund's derivatives
risk manager would be required to periodically review the program, at
least annually, to evaluate the program's effectiveness and to reflect
changes in risk over time.
---------------------------------------------------------------------------
\103\ Proposed rule 18f-4(c)(1)(vi); see also infra section
II.B.3.f.
The proposed program requirement is drawn from existing fund best
practices. We believe it would enhance practices for funds that have
not already implemented a derivatives risk management program, while
building off practices of funds that already have one in place.\104\
---------------------------------------------------------------------------
\104\ See, e.g., Aviva Comment Letter (discussing the
implementation of formalized derivatives risk management programs);
Vanguard Comment Letter.
---------------------------------------------------------------------------
Most commenters generally supported the 2015 proposal's derivatives
risk management program requirement, which had many similar
foundational elements to those of the program we are proposing here.
These commenters stated that the use of derivatives transactions by a
fund should be subject to a comprehensive and appropriate written risk
management program, which would benefit investors.\105\ Our proposal
includes elements from the 2015 proposal's derivatives risk management
program framework, and adds elements that take into account our
analysis of the comments we received.
---------------------------------------------------------------------------
\105\ See, e.g., Comment Letter of AFG-French Asset Management
Association (Mar. 25, 2016) (``AFG Comment Letter''); Comment Letter
of American Beacon Advisors (Mar. 28, 2016) (``American Beacon
Comment Letter''); Comment Letter of AQR Capital Management (Mar.
28, 2016) (``AQR Comment Letter''); Federated Comment Letter;
Comment Letter of Fidelity (Mar. 28, 2016) (``Fidelity Comment
Letter''); Comment Letter of AFL-CIO (Mar. 28, 2016); Comment Letter
of Alternative Investment Management Association (Mar. 28, 2016)
(``AIMA Comment Letter''); Comment Letter of Aviva (Mar. 28, 2016)
(``Aviva Comment Letter''); Comment Letter of BlackRock (Mar. 28,
2016) (``BlackRock Comment Letter''); Comment Letter of Capital
Research and Management Company (Mar. 28, 2016) (``CRMC Comment
Letter'').
---------------------------------------------------------------------------
2. Program Administration
The proposed rule would require a fund adviser's officer or
officers to serve as the fund's derivatives risk manager.\106\ This
requirement is designed to centralize derivatives risk management and
to promote accountability. The designation of the derivatives risk
manager must be approved by the fund's board of directors, and the
derivatives risk manager must have direct communication with the fund's
board of directors. Allowing multiple officers of the fund's adviser
(including any sub-advisers) to serve as the fund's derivatives risk
manager is designed to allow funds with differing sizes, organizational
structures, or investment strategies to more effectively tailor the
programs to their operations.\107\ We understand that many advisers
today involve committees or groups of officers in the vetting and
analysis of portfolio risk and other types of risk.\108\ Although the
proposed rule would not permit a third party to serve as a fund's
derivatives risk manager, the derivatives risk manager could obtain
assistance from third parties in administering the program. For
example, third parties could provide data relevant to the
administration of a fund's program or other analysis that may inform
the fund's derivatives risk management.
---------------------------------------------------------------------------
\106\ Proposed rule 18f-4(a).
\107\ The term ``adviser'' as used in this release and rule 18f-
4 generally refers to any person, including a sub-adviser, that is
an ``investment adviser'' of an investment company as that term is
defined in section 2(a)(20) of the Investment Company Act.
\108\ See, e.g., IAA Comment Letter.
---------------------------------------------------------------------------
The proposed rule would also require that the fund's derivatives
risk manager have relevant experience regarding derivatives risk
management.\109\ This requirement is designed to reflect the potential
complex and unique risks that derivatives can pose to funds and promote
the selection of a derivatives risk manager who is well-positioned to
manage these risks. As discussed below, under the proposed rule, a
fund's board must approve the designation of the fund's derivatives
risk manager, taking into account the derivatives risk manager's
relevant experience regarding derivatives risk management.\110\
---------------------------------------------------------------------------
\109\ Proposed rule 18f-4(a).
\110\ See infra section II.C.1.
---------------------------------------------------------------------------
The proposed rule would require a fund to reasonably segregate the
functions of the program from its portfolio management.\111\
Segregating derivatives risk management from portfolio management is
designed to promote objective and independent identification,
assessment, and management of the risks associated with derivatives
use. Accordingly, this element is designed to enhance the
accountability of the derivatives risk manager and other risk
management personnel and, therefore, to enhance the program's
effectiveness.\112\ We understand that funds today often segregate risk
management from portfolio management. Many have observed that
independent oversight of derivatives activities by compliance and
internal audit functions is valuable.\113\ Because a fund may
compensate its portfolio management personnel in part based on the
returns of the fund, the incentives of portfolio managers may not
always be consistent with the restrictions that a risk management
program would impose. Keeping the functions separate in the context of
derivatives risk management should help mitigate the possibility that
these competing incentives diminish the program's effectiveness.
---------------------------------------------------------------------------
\111\ Proposed rule 18f-4(c)(1).
\112\ See, e.g., Comptroller of the Currency Administrator of
National Banks, Risk Management of Financial Derivatives:
Comptroller's Handbook (Jan. 1997), at 9 (discussing the importance
of independent risk management functions in the banking context).
\113\ See, e.g., Kenneth K. Marshall, Internal Control and
Derivatives, The CPA Journal (Oct. 1995), available at http://archives.cpajournal.com/1995/OCT95/f461095.htm.
---------------------------------------------------------------------------
Separation of functions creates important checks and balances, and
funds could institute this proposed requirement through a variety of
methods, such as independent reporting chains, oversight arrangements,
or separate monitoring systems and personnel. The proposed rule would
require reasonable segregation of functions, rather than taking a more
prescriptive approach, such as requiring funds to implement strict
protocols regarding communications between specific fund personnel, to
allow funds to structure their risk management and portfolio management
functions in ways that are tailored to each fund's facts and
circumstances, including the size and
[[Page 4459]]
resources of the fund's adviser. In this regard, the reasonable
segregation requirement is not meant to indicate that the derivatives
risk manager and portfolio management must be subject to a
communications ``firewall.'' We recognize the important perspective and
insight regarding the fund's use of derivatives that the portfolio
manager can provide and generally understand that the fund's
derivatives risk manager would work with the fund's portfolio
management in implementing the program requirement.
For similar reasons, the proposed rule would also prohibit the
derivatives risk manager position from being filled solely by the
fund's portfolio manager, if a single fund officer serves in the
position.\114\ The proposed rule also would prohibit a majority of the
officers who compose the derivatives risk manager position from being
portfolio managers, if multiple fund officers serve in the position.
---------------------------------------------------------------------------
\114\ Proposed rule 18f-4(a).
---------------------------------------------------------------------------
Commenters generally supported the 2015 proposal's requirement that
a fund's derivatives risk management program be administered by a
derivatives risk manager and that the fund's derivatives risk
management be segregated from the fund's portfolio management.\115\
Commenters did, however, express concern about the 2015 proposal's
requirement that there be a single derivatives risk manager and urged
that the Commission permit a fund's portfolio managers to provide some
input into the fund's derivatives risk management function.\116\ This
re-proposal addresses these concerns by permitting a group or committee
to serve as a fund's derivatives risk manager, a portion of whom could
be portfolio managers.
---------------------------------------------------------------------------
\115\ See, e.g., BlackRock Comment Letter.
\116\ See, e.g., BlackRock Comment Letter; Comment Letter of
Morningstar (Mar. 28, 2016) (``Morningstar Comment Letter'');
Comment Letter of the Investment Company Institute (Mar. 28, 2016)
(``ICI Comment Letter I''); Comment Letter of WisdomTree (Mar. 28,
2016).
---------------------------------------------------------------------------
We request comment on the proposed requirements that a fund's
derivatives risk manager administer the fund's program, and that the
derivatives risk management function be reasonably segregated from the
fund's portfolio management.
11. Is the proposed definition of ``derivatives risk manager''
sufficiently clear? Why or why not? Should the rule, as proposed,
require that a fund's derivatives risk manager be an officer or
officers of the fund's adviser, and would this requirement further the
goals of centralizing derivatives risk management and promoting
accountability? Why or why not? Should the rule, as proposed, permit a
fund's derivatives risk manager to be an officer or officers of the
fund's sub-advisers? Why or why not? If so, should the rule require
that at least one of the officers be an officer of the adviser or
otherwise limit the number of sub-adviser officers? Why or why not?
Would a fund's program be more effective if we required the derivatives
risk manager to be a single individual? Why or why not? If so, should
this individual be required to be an officer of a fund's adviser?
12. Should the rule, as proposed, require that a fund's derivatives
risk manager have relevant experience regarding derivatives risk
management? Why or why not? Is the proposed requirement that the
derivatives risk manager have ``relevant experience regarding the
management of derivatives risk'' sufficiently clear? Would this raise
questions about whether portfolio management experience, or experience
outside of formal derivatives risk management, would suffice for
purposes of the rule? Should the rule, instead, require that a fund's
derivatives risk manager simply have ``relevant experience''? Should
the rule specify that the derivatives risk manager must have relevant
experience as determined by the fund's board, to allow a board to
determine the experience that would be appropriate? Or should the rule
identify specific qualifications, training, or experience of a fund's
derivatives risk manager? Why or why not? If so, what should they be
and why?
13. Should the rule, as proposed, require a fund to segregate
derivatives risk management functions from portfolio management? Why or
why not? If we were not to require independence between a fund's
derivatives risk manager and the fund's portfolio managers, how could
we ensure that a fund's portfolio management personnel, who may have
conflicting incentives, do not unduly influence the fund's program
management?
14. Should we provide any additional clarification regarding the
proposed reasonable segregation requirement? If so, what changes should
we make? Should we add any specific requirements? For example, should
we limit the extent to which fund risk management personnel can be
compensated in part based on fund performance?
15. Is our understanding that many funds already segregate
functions correct? If so, how and why do current approaches differ from
the proposed rule's requirement to segregate functions?
16. Are there other ways to facilitate objective and independent
risk assessment of portfolio strategies that we should consider? If so,
what are they and how would these alternatives be more effective than
the proposed rule's requirement to reasonably segregate functions?
17. Rule 22e-4 under the Investment Company Act, similar to the
proposed rule, requires certain funds to implement a risk management
program. In particular, rule 22e-4 requires person(s) designated to
administer a fund's liquidity risk management program to be the fund's
investment adviser, officer, or officers (which may not be solely
portfolio managers of the fund) (the ``liquidity risk manager'').
Should we amend rule 22e-4 to more closely align the definition of
``liquidity risk manager'' with the proposed definition of
``derivatives risk manager'' by prohibiting a fund's adviser from
serving as a liquidity risk manager? Why or why not? Conversely, should
we align the standard for derivatives risk manager with the liquidity
risk manager standard under rule 22e-4?
18. Would the proposed derivatives risk manager requirement raise
any particular challenges for funds with smaller advisers and, if so,
what could we do to help mitigate these challenges? For example, should
we modify the rule to permit funds to authorize the use of third
parties not employed by the adviser to administer the program and, if
so, under what conditions? Why or why not? Would allowing third parties
to act as derivatives risk managers enhance the program by allowing
specialized personnel to administer the program or detract from it by
allowing for a derivatives risk manager who may not be as focused on
the specific risks of the particular fund or as accountable to its
board? Would the proposed requirement that a fund reasonably segregate
derivatives risk management from portfolio management pose particular
challenges for funds with smaller advisers? If so, how and why, and
would additional guidance on this proposed requirement or changes to
the proposed rule be useful? Conversely, would this proposed
requirement (which does not prescribe how funds must segregate
functions) provide appropriate flexibility for funds with smaller
advisers?
19. Rule 38a-1(c) under the Investment Company Act prohibits
officers, directors, and employees of the fund and its adviser from,
among other things, coercing or unduly influencing a fund's chief
compliance officer in the
[[Page 4460]]
performance of his or her duties. Should we include such a prohibition
on unduly influencing a fund's derivatives risk manager in the proposed
rule? Why or why not?
20. Should we include any other program administration
requirements? If so, what? For example, should we include a requirement
for training staff responsible for day-to-day management of the
program, or for portfolio managers, senior management, and any
personnel whose functions may include engaging in, or managing the risk
of, derivatives transactions? If we require such training, should that
involve setting minimum qualifications for staff responsible for
carrying out the requirements of the program? Why or why not? Should we
require training and education with respect to any new derivatives
instruments that a fund may trade? Why or why not? Should we require a
new instrument review committee?
3. Required Elements of the Program
a. Risk Identification and Assessment
The proposed program requirement would require a fund to identify
and assess its derivatives risks in order to manage these risks.\117\
It would require that the fund's identification and assessment take
into account the fund's other investments as well as its derivatives
transactions. An appropriate assessment of derivatives risks generally
involves assessing how a fund's derivatives may interact with the
fund's other investments or whether the fund's derivatives have the
effect of helping the fund manage risks. For example, the risks
associated with a currency forward would differ if a fund is using the
forward to hedge the fund's exposure to currency risk associated with a
fund investment denominated in a foreign currency or, conversely, to
take a speculative position on the relative price movements of two
currencies. We believe that by assessing its derivatives use
holistically, a fund will be better positioned to implement a
derivatives risk management program that does not over- or understate
the risks its derivatives use may pose. Accordingly, we believe that
this approach would result in a more-tailored derivatives risk
management program.
---------------------------------------------------------------------------
\117\ Proposed rule 18f-4(c)(1)(i).
---------------------------------------------------------------------------
The proposed rule would define the derivatives risks that must be
identified and managed to include leverage, market, counterparty,
liquidity, operational, and legal risks, as well as any other risks the
derivatives risk manager deems material.\118\ In the context of a
fund's derivatives transactions:
---------------------------------------------------------------------------
\118\ Proposed rule 18f-4(a). In the case of funds that are
limited derivatives users under the proposed rule, the definition
would include any other risks that the fund's investment adviser (as
opposed to the fund's derivatives risk manager) deems material,
because a fund that is a limited derivatives user would be exempt
from the requirement to adopt a derivatives risk management program
(and therefore also exempt from the requirement to have a
derivatives risk manager). See infra section II.E.
---------------------------------------------------------------------------
Leverage risk generally refers to the risk that
derivatives transactions can magnify the fund's gains and losses; \119\
---------------------------------------------------------------------------
\119\ See, e.g., Independent Directors Council, Board Oversight
of Derivatives Task Force Report (July 2008), at 12 (``2008 IDC
Report'').
---------------------------------------------------------------------------
Market risk generally refers to risk from potential
adverse market movements in relation to the fund's derivatives
positions, or the risk that markets could experience a change in
volatility that adversely impacts fund returns and the fund's
obligations and exposures; \120\
---------------------------------------------------------------------------
\120\ Funds should consider market risk together with leverage
risk because leveraged exposures can magnify such impacts. See,
e.g., NAPF, Derivatives and Risk Management Made Simple (Dec. 2013),
available at https://www.jpmorgan.com/cm/BlobServer/is_napfms2013.pdf?blobkey=id&blobwhere=1320663533358&blobheader=application/pdf&blobheadername1=Cache-Control&blobheadervalue1=private&blobcol=urldata&blobtable=MungoBlobs
.
---------------------------------------------------------------------------
Counterparty risk generally refers to the risk that a
counterparty on a derivatives transaction may not be willing or able to
perform its obligations under the derivatives contract, and the related
risks of having concentrated exposure to such a counterparty; \121\
---------------------------------------------------------------------------
\121\ See, e.g., Nils Beier, et al., Getting to Grips with
Counterparty Risk, McKinsey Working Papers on Risk, Number 20 (June
2010).
---------------------------------------------------------------------------
Liquidity risk generally refers to risk involving the
liquidity demands that derivatives can create to make payments of
margin, collateral, or settlement payments to counterparties;
Operational risk generally refers to risk related to
potential operational issues, including documentation issues,
settlement issues, systems failures, inadequate controls, and human
error; \122\ and
---------------------------------------------------------------------------
\122\ See, e.g., 2008 IDC Report, supra note 119; RMA, Statement
on best practices for managing risk in derivatives transactions
(2004) (``Statement on best practices for managing risk in
derivatives transactions''), available at http://www.rmahq.org/securities-lending/best-practices.
---------------------------------------------------------------------------
Legal risk generally refers to insufficient documentation,
insufficient capacity or authority of counterparty, or legality or
enforceability of a contract.\123\
---------------------------------------------------------------------------
\123\ See, e.g., Raimonda Martinkut[edot]-Kaulien[edot], Risk
Factors in Derivatives Markets, 2 Entrepreneurial Business and
Economics Review 4 (2014); Capital, Margin, and Segregation
Requirements for Security-Based Swap Dealers and Major Security-
Based Swap Participants and Capital and Segregation Requirements for
Broker-Dealers, Exchange Act Release No. 86175 (June 21, 2019), 84
FR 43872 (Aug. 22, 2019), n.1055 (``Capital Margin Release'')
(``Market participants face risks associated with the financial and
legal ability of counterparties to perform under the terms of
specific transactions''); see also Office of the Comptroller of the
Currency, Risk Management of Financial Derivatives, Comptroller's
Handbook (Jan. 1997) (narrative), (Feb. 1998) (procedures).
Because derivatives contracts that are traded over the counter
are not standardized, they bear a certain amount of legal risk in
that poor draftsmanship, changes in laws, or other reasons may cause
the contract to not be legally enforceable against the counterparty.
See, e.g., Comprehensive Risk Management of OTC Derivatives, supra
note 124. For example, some netting agreements or qualified
financial contracts contain so-called ``walkaway'' clauses, such as
provisions that, under certain circumstances, suspend, condition, or
extinguish a party's payment obligation under the contract. These
provisions would not be enforceable where the Federal Deposit
Insurance Act is applicable. See 12 U.S.C 1821(e)(8)(G). As another
example, many derivatives contracts and prime brokerage agreements
that hedge funds and other counterparties had entered into with
Lehman Brothers included cross-netting that allowed for payments
owed to and from different Lehman affiliates to be offset against
each other, and cross-liens that granted security interests to all
Lehman affiliates (rather than only the specific Lehman entity
entering into a particular transaction). In 2011, the U.S.
Bankruptcy Court for the Southern District of New York held that
cross-affiliate netting provisions in an ISDA swap agreement were
unenforceable against a debtor in bankruptcy. In the Matter of
Lehman Brothers Inc., Bankr. Case No. 08-01420 (JPM) (SIPA), 458
B.R. 134, 1135-137 (Bankr. S.D.N.Y. Oct. 4, 2011).
We believe these risks are common to most derivatives
transactions.\124\
---------------------------------------------------------------------------
\124\ See Numerix, Comprehensive Risk Management of OTC
Derivatives; A Tricky Endeavor (July 16, 2013), available at http://www.numerix.com/comprehensive-risk-management-otc-derivatives-tricky-endeavor (``Comprehensive Risk Management of OTC
Derivatives''); Statement on best practices for managing risk in
derivatives transactions, supra note 122; 2008 IDC Report, supra
note 119; Lawrence Metzger, Derivatives Danger: internal auditors
can play a role in reigning in the complex risks associated with
financial instruments, FSA Times (2011), available at http://www.theiia.org/fsa/2011-features/derivatives-danger (``FSA Times
Derivatives Dangers''). See also 17 CFR 240.15c3-4(a) (``An OTC
derivatives dealer shall establish, document, and maintain a system
of internal risk management controls to assist it in managing the
risks associated with its business activities, including market,
credit, leverage, liquidity, legal, and operational risks.'').
Nonbank security-based swap dealers and broker-dealers authorized to
use internal models to compute net capital also are subject to rule
15c3-4. See Capital Margin Release, supra note 123.
---------------------------------------------------------------------------
The proposed rule would not limit a fund's identification and
assessment of derivatives risks to only those specified in the rule.
The proposed definition of the term ``derivatives risks'' includes any
other risks a fund's derivatives risk manager deems material.\125\ Some
derivatives transactions could pose certain idiosyncratic risks. For
example,
[[Page 4461]]
some derivatives transactions could pose a risk that a complex OTC
derivative could fail to produce the expected result (e.g., because
historical correlations change or unexpected merger events occur) or
pose a political risk (e.g., events that affect currencies).
---------------------------------------------------------------------------
\125\ See supra note 118.
---------------------------------------------------------------------------
Commenters to the 2015 proposal generally supported its requirement
that a fund engage in a process of identifying and evaluating the
potential risks posed by its derivatives transactions.\126\
---------------------------------------------------------------------------
\126\ See, e.g., ICI Comment Letter I; Comment Letter of the
Consumer Federation of America (Mar. 28, 2016) (``CFA Comment
Letter'').
---------------------------------------------------------------------------
We request comment on all aspects of the proposed requirement to
identify and assess a fund's derivatives risks, as well as the proposed
definition of the term ``derivatives risks.''
21. Is the proposed definition of ``derivatives risks''
sufficiently clear? Why or why not?
22. Are the categories of risks that we have identified in the
proposed rule appropriate? Why or why not? Should we remove any of the
identified risk categories? If so, what categories should be removed,
and why? Should we add any other specified categories of risks that
should be addressed? If so, what additional categories and why? Should
we provide further guidance regarding the assessment of any of these
risks? If so, what should the guidance be, and why?
23. Do commenters believe the proposed approach with respect to
risk identification and assessment is appropriate? Why or why not?
24. Do funds currently assess the risks associated with their
derivatives transactions by taking into account both their derivatives
transactions and other investments? If so, how do they perform this
assessment? Are there certain derivatives transactions whose risks do
not involve an assessment of other investments in a fund's portfolio?
If so, which derivatives transactions, and why?
25. Should we require policies and procedures to include an
assessment of particular risks based on an evaluation of certain
identified risk categories as proposed? If not, why?
b. Risk Guidelines
The proposed rule would require a fund's program to provide for the
establishment, maintenance, and enforcement of investment, risk
management, or related guidelines that provide for quantitative or
otherwise measurable criteria, metrics, or thresholds of the fund's
derivatives risks (the ``guidelines'').\127\ The guidelines would be
required to specify levels of the given criterion, metric, or threshold
that a fund does not normally expect to exceed and the measures to be
taken if they are exceeded. The proposed guidelines requirement is
designed to address the derivatives risks that a fund would be required
to monitor routinely as part of its program, and to help the fund
identify when it should respond to changes in those risks. We
understand that many funds today have established risk management
guidelines, with varying degrees of specificity.
---------------------------------------------------------------------------
\127\ Proposed rule 18f-4(c)(1)(ii).
---------------------------------------------------------------------------
The proposed rule would not impose specific risk limits for these
guidelines. It would, however, require a fund to adopt guidelines that
provide for quantitative thresholds that the fund determines to be
appropriate and that are most pertinent to its investment portfolio,
and that the fund reasonably determines are consistent with its risk
disclosure.\128\ Requiring a fund to establish discrete metrics to
monitor its derivatives risks would require the fund and its
derivatives risk manager to measure changes in its risks regularly, and
this in turn is designed to lead to more timely steps to manage these
risks. Moreover, requiring a fund to identify its response when these
metrics have been exceeded would provide the fund's derivatives risk
manager with a clear basis from which to determine whether to involve
other persons, such as the fund's portfolio management or board of
directors, in addressing derivatives risks appropriately.\129\
---------------------------------------------------------------------------
\128\ See, e.g., Mutual Fund Directors Forum, Risk Principles
for Fund Directors: Practical Guidance for Fund Directors on
Effective Risk Management Oversight (Apr. 2010), available at http://www.mfdf.org/images/Newsroom/Risk_Principles_6.pdf (``MFDF
Guidance'').
\129\ See proposed rule 18f-4(c)(1)(v); see also infra section
II.B.3.e.
---------------------------------------------------------------------------
Funds may use a variety of approaches in developing guidelines that
comply with the proposed rule.\130\ This would draw on the risk
identification element of the program and the scope and objectives of
the fund's use of derivatives. A fund could use quantitative metrics
that it determines would allow it to monitor and manage its particular
derivatives risks most appropriately. We understand that today funds
use a variety of quantitative models or methodologies to measure the
risks associated with the derivatives transactions. With respect to
market risk, we understand that funds commonly use VaR, stress testing,
or horizon analysis. Concentration risk metrics are also being used in
connection with monitoring counterparty risk (e.g., requiring specific
credit committee approval for transactions with a notional exposure in
excess of a specified amount, aggregated with other outstanding
positions with the same of affiliated counterparties). In addition,
liquidity models have been designed to address liquidity risks over
specified periods (e.g., models identifying margin outlay requirements
over a specified period under specified volatility scenarios).
---------------------------------------------------------------------------
\130\ See, e.g., Comprehensive Risk Management of OTC
Derivatives, supra note 124; Statement on best practices for
managing risk in derivatives transactions, supra note 122; 2008 IDC
Report, supra note 119.
---------------------------------------------------------------------------
In developing the guidelines, a fund generally should consider how
to implement them in view of its investment portfolio and the fund's
disclosure to investors. For example, a fund may wish to consider
establishing corresponding investment size controls or lists of
approved transactions across the fund.\131\ A fund generally should
consider whether to implement appropriate monitoring mechanisms
designed to allow the fund to abide by the guidelines, including their
quantitative metrics.
---------------------------------------------------------------------------
\131\ A fund could also consider establishing an ``approved
list'' of specific derivatives instruments or strategies that may be
used, as well as a list of persons authorized to engage in the
transactions on behalf of the fund. A fund may wish to provide new
instruments (or instruments newly used by the fund) additional
scrutiny. See, e.g., MFDF Guidance, supra note 128, at 8.
---------------------------------------------------------------------------
While the 2015 proposal did not require funds to adopt risk
guidelines, commenters on the 2015 proposal generally supported the
concept of a requirement that a fund adopt and implement policies and
procedures reasonably designed to manage the risks of its derivatives
transactions, including by monitoring whether those risks continue to
be consistent with any investment guidelines established by the fund or
the fund's investment adviser.\132\
---------------------------------------------------------------------------
\132\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter;
ICI Comment Letter I.
---------------------------------------------------------------------------
We request comment on the proposed rule's guidelines requirement.
26. Should we require, as proposed, a fund's program to provide for
the establishment, maintenance, and enforcement of investment, risk
management, or related guidelines? Why or why not? Should we require,
as proposed, that the guidelines provide for quantitative or otherwise
measurable criteria, metrics, or thresholds of the fund's derivatives
risks? Why or why not? If not, is there an alternative program element
that would be more appropriate in promoting effective derivatives risk
management? Should we prescribe particular tools or
[[Page 4462]]
approaches that funds must use to manage specific risks related to
their use of derivatives? For example, should we require funds to
manage derivatives' liquidity risks by maintaining highly liquid assets
to cover potential future losses and other liquidity demands?
27. Should we require a specific number or range of numbers of
guidelines that a fund should establish? For example, should we require
a fund to establish a minimum of 2, 3, 4, or more different guidelines
to cover a range of different risks? Why or why not?
28. Do funds currently adopt, and monitor compliance with, such
guidelines? If so, do these guidelines provide for quantitative or
otherwise measurable criteria, metrics, or thresholds of the funds'
derivatives risks? If so, what criteria, metrics, or thresholds are
provided for? Should we require that funds use specific risk management
tools? If so, what tools should we require?
29. Should we specify a menu of guideline categories that all funds
should use to promote consistency in risk management among funds? For
example, should we identify certain commonly-used types of guidelines
such as VaR, notional amounts, and duration, and require funds to
choose among those commonly-used types? If we were to do so, which
metrics should we allow funds to use? Would such a menu become stale as
new risk measurement tools are developed?
30. Should we require, as proposed, that the guidelines specify set
levels of a given criterion, metric, or threshold that the fund does
not generally expect to exceed? Why or why not? If so, how would these
levels be set or calculated? Should we instead set maximum levels for
certain guidelines a fund would not exceed?
31. Should we require that a fund publicly disclose the guidelines
it uses and the quantitative levels selected? If so, where (for
example, in the fund's prospectus, website, or on Form N-PORT or N-
CEN)? Should we instead require that funds confidentially report to us
the guidelines they use and the quantitative levels selected? If so, on
what form should they report this information?
32. Should we require, as proposed, that the guidelines identify
measures to be taken when the fund exceeds a criterion, metric, or
threshold in the fund's guidelines? Why or why not?
33. Should we require any form of public disclosure or confidential
reporting to us if a fund were to exceed its risk guidelines? Would
such reporting or disclosure result in funds setting guidelines that
are so restrictive or lax that they would be unlikely to be useful as a
monitoring and risk management tool?
34. Should the rule require the guidelines to provide for other
elements? If so, what elements and why?
c. Stress Testing
The proposed rule would require a fund's program to provide for
stress testing to evaluate potential losses to the fund's
portfolio.\133\ We understand that, as a derivatives risk management
tool, stress testing is effective at measuring different drivers of
derivatives risks, including non-linear derivatives risks that may be
understated by metrics or analyses that do not focus on periods of
stress. Stress testing is an important tool routinely used in other
areas of the financial markets and in other regulatory regimes, and we
understand that funds engaging in derivatives transactions have
increasingly used stress testing as a risk management tool over the
past decade.\134\ The Commission has also required certain types of
funds to conduct stress tests or otherwise consider the effect of
stressed market conditions on their portfolios.\135\ We believe that
requiring a fund to stress test its portfolio would help the fund
better manage its derivatives risks and facilitate board oversight.
---------------------------------------------------------------------------
\133\ Proposed rule 18f-4(c)(1)(iii); see also infra section
II.D.6.a (discussing an alternative to the proposed limit on fund
leverage risk that would rely on a stress testing framework). The
proposed rule would require a fund that is required to establish a
derivatives risk mangement program to stress test its portfolio,
that is, all of the fund's investments, and not just the fund's
derivatives transactions.
\134\ See, e.g., Comment Letter of Investment Company Institute
(Oct. 8, 2019) (``ICI Comment Letter III'') (stating that, based on
a survey of member firms, many funds perform ex ante stress
testing).
\135\ See rule 2a-7 under the Investment Company Act [17 CFR
270.2a-7]; see also rule 22e-4 under the Investment Company Act [17
CFR 270.22e-4] (requiring a fund subject to the rule to assess its
liquidity risk by considering, for example, its investment strategy
and portfolio investment liquidity under reasonably foreseeable
stressed conditions).
---------------------------------------------------------------------------
We also believe that stress testing would serve as an important
complement to the proposed VaR-based limit on fund leverage risk, as
well as any VaR testing under the fund's risk guidelines.\136\ During
periods of stress, returns, correlations, and volatilities tend to
change dramatically over a very short period of time. Losses under
stressed conditions--or ``tail risks''--would not be reflected in VaR
analyses that are not calibrated to a period of market stress and that
do not estimate losses that occur on the trading days with the highest
losses.\137\ Requiring funds to stress test their portfolios would
provide information regarding these ``tail risks'' that VaR and other
analyses may miss.
---------------------------------------------------------------------------
\136\ See proposed rule 18f-4(c)(2); infra section II.D.
\137\ The proposed rule would not require a fund to implement a
stressed VaR test. See infra section II.D.1.
---------------------------------------------------------------------------
Under the proposed rule, the fund's stress tests would be required
to evaluate potential losses to the fund's portfolio in response to
extreme but plausible market changes or changes in market risk factors
that would have a significant adverse effect on the fund's
portfolio.\138\ The stress tests also would have to take into account
correlations of market risk factors and resulting payments to
derivatives counterparties.\139\ We believe that these requirements
would promote stress tests that produce results that are valuable in
appropriately managing derivatives risks by focusing the testing on
extreme events that may provide actionable information to inform a
fund's derivatives risk management.\140\ We understand that funds
commonly consider the following market risk factors: liquidity,
volatility, yield curve shifts, sector movements, or changes in the
price of the underlying reference security or asset.\141\ In addition,
we believe it is important for a fund's stress testing to take into
account payments to counterparties, as losses can result when the
fund's portfolio securities decline in value at the same time that the
fund is required to make additional payments under its derivatives
contracts.\142\
---------------------------------------------------------------------------
\138\ Proposed rule 18f-4(c)(1)(iii).
\139\ Id.
\140\ Krishan Mohan Nagpal, Designing Stress Scenarios for
Portfolios, 19 Risk Management 323 (2017).
\141\ See, e.g., ICI Comment Letter I; Thomas Breuer, et al.,
How to Find Plausible, Severe, and Useful Stress Scenarios,
International Journal of Central Banking 205 (Sept. 2009).
\142\ See OppenheimerFunds Settled Action, supra note 22.
---------------------------------------------------------------------------
To inform a fund's derivatives risk management effectively, a fund
should stress test its portfolio with a frequency that would best
position the derivative risk manager to appropriately administer, and
the board to appropriately oversee, a fund's derivatives risk
management, taking into account the frequency of change in the fund's
investments and market conditions. The proposed rule, therefore, would
permit a fund to determine the frequency of stress tests, provided that
the fund must conduct stress testing at least weekly. In establishing
such frequency, a fund
[[Page 4463]]
must take into account the fund's strategy and investments and current
market conditions. For example, a fund whose strategy involves a high
portfolio turnover might determine to conduct stress testing more
frequently than a fund with a more static portfolio. A fund similarly
might conduct more frequent stress tests in response to increases in
market stress. The minimum weekly stress testing frequency is designed
to balance the potential benefits of relatively frequent stress testing
with the burdens of administering stress testing.\143\ We also
considered a less frequent requirement, such as monthly stress testing.
A less frequent requirement, however, may fail to provide a fund's
derivatives risk manager adequate and timely insight into the fund's
derivatives risk, particularly where the fund has a high portfolio
turnover. In determining this minimum frequency, we also took into
account that this requirement would only apply to funds that do not
qualify for the limited derivatives user exception because they use
derivatives in more than a limited way. In addition, in view of the
proposed rule's internal reporting and periodic review requirements,
the weekly stress testing minimum would provide a fund's derivatives
risk manager and board with multiple sets of stress testing results,
which would allow them to observe trends and how the results may change
over time.\144\
---------------------------------------------------------------------------
\143\ We recognize that the costs associated with stress testing
may increase with the frequency of conducting such tests. We
understand, however, that once a fund initially implements a stress
testing framework, subsequent stress tests could be automated and,
as a result, be less costly.
\144\ See infra sections II.B.3.e and II.C.
---------------------------------------------------------------------------
Although the 2015 proposal's risk management program did not
include a stress testing requirement, some commenters stated that
stress testing would serve as an important component of derivatives
risk management and recommended that the Commission require a fund's
designated risk manager to perform stress testing and report the
results to the fund's board.\145\
---------------------------------------------------------------------------
\145\ See, e.g., Comment Letter of Blackstone Alternative
Investment Advisors LLC (Mar. 28, 2016) (``Blackstone Comment
Letter''); Comment Letter of Invesco Management Group, Inc. (Mar.
28, 2016) (``Invesco Comment Letter''); see also ICI Comment Letter
III.
---------------------------------------------------------------------------
We request comment on the proposed rule's stress testing
requirement.
35. Should we require, as proposed, that funds conduct stress
testing as part of the program requirement? Why or why not? How, if at
all, would stress testing serve as a complement for other risk
measurement tools, such as VaR? What does stress testing capture as
part of derivatives risk management that other tools do not, and why?
36. Should the rule require funds to conduct a particular type of
stress testing? If so, what type, and what should the required elements
be? For example, should the rule require funds to conduct scenario
analysis?
37. Should the rule identify specific stress events to be applied?
Should any required stress events vary based on the primary risks of
particular funds?
38. Do funds currently conduct stress testing? If so, what types of
stress testing, for what purposes, and how does the stress testing that
funds currently conduct differ from the proposed rule's requirement?
39. For funds that currently conduct stress testing, how frequently
do they conduct it? Daily, weekly, or monthly? Why? Does it depend on
the type of stress testing? On the investment objective or strategy of
a fund? With what minimum frequency should the rule require stress
testing be conducted? For example, instead of weekly tests should we
require daily tests? Conversely should we allow longer periods of time
between tests, such as monthly, or quarterly? Why? Should we require
more frequent testing for funds with some investment objectives or
strategies than other funds? If so, for which objectives or strategies
should we require more frequent testing?
40. Is the proposed rule's reference to ``extreme but plausible
market changes or changes in market risk factors'' sufficiently clear?
Should we identify more quantitative changes, such as the worst change
in a specific risk factor seen in the last 10, 20, or 50 years? Is the
proposed rule's reference to ``significant adverse effect''
sufficiently clear? Should we instead identify quantitative levels of
NAV change, such as a drop of 20, 30, or 50% of the fund's NAV?
41. Should we require stress tests to include certain identified
market risk factors such as changes in interest rates or spreads,
market volatility, market liquidity, or other market factors? If so,
which market risk factors should we identify, and why? If we were to
identify certain market risk factors to be tested, should we require a
fund to take action (such as reporting to its board or to the
Commission, or reducing its derivatives usage) if a stress test were to
show that one of these factors would result in the fund losing a
certain percentage of its NAV? If so, what level of NAV, what types of
risk factors, and what types of action should we consider?
42. Should we require, as proposed, that funds take into account
their strategy, investments, and current market conditions in
considering the appropriate frequency for a fund's stress tests? Why or
why not? Should we require, as proposed, that funds to take into
account correlations of market risk factors and payments to derivatives
counterparties as part of the fund's stress tests? Why or why not?
Would any additional guidance help funds to better understand, and more
consistently conduct, the stress tests that the proposed rule would
require?
43. We discuss and request comment below on the proposed rule's
requirements to provide information to a fund's board of directors,
including the derivatives risk manager's analysis of a fund's stress
testing. In addition to providing this information to the board, should
we require funds to disclose stress test results to investors or report
them confidentially to us? If so, what information should be disclosed
or reported?
d. Backtesting
The proposed rule would require a fund to backtest the results of
the VaR calculation model used by the fund in connection with the
relative VaR or absolute VaR test, as applicable, as part of the
program.\146\ This proposed requirement is designed to require a fund
to monitor the effectiveness of its VaR model. It would assist a fund
in confirming the appropriateness of its model and related assumptions
and help identify when funds should consider model adjustments.\147\ We
are proposing this requirement in light of the central role that VaR
plays in the proposed VaR-based limit on leverage risk. This also is
consistent with the comments we received on the 2015 proposal
suggesting that we require backtesting, which we had not included in
that proposal.\148\
---------------------------------------------------------------------------
\146\ See proposed rule 18f-4(c)(1)(iv).
\147\ Some commenters on the 2015 proposal suggested that the
Commission require backtesting of a fund's VaR calculation models.
See, e.g., Blackstone Comment Letter; Comment Letter of Investment
Company Institute (Sept. 27, 2016) (``ICI Comment Letter II'');
Aviva Comment Letter; Comment Letter of the Global Association of
Risk Professionals (Mar. 21, 2016) (``GARP Comment Letter'').
\148\ See, e.g., Blackstone Comment Letter; ICI Comment Letter
II; Aviva Comment Letter; GARP Comment Letter.
---------------------------------------------------------------------------
Specifically, the proposed backtesting requirement provides that,
each business day, the fund must compare its actual gain or loss for
that business day with the VaR the fund had calculated for that day.
For purposes of the backtesting requirement, the VaR would be estimated
over a one-trading day time horizon. For example, on Monday at the
[[Page 4464]]
end of the trading day, a fund would analyze whether the gain or loss
it experienced that day exceeds the VaR calculated for that day. In
this backtesting example, the fund could calculate the VaR for Monday
on Friday evening (after Friday trading closes) or Monday morning
(before Monday trading begins). The fund would have to identify as an
exception any instance in which the fund experiences a loss exceeding
the corresponding VaR calculation's estimated loss. This approach is
generally consistent with the practice of firms that use internal
models to compute regulatory capital and other regulatory
approaches.\149\ Because the proposed rule would require that the
fund's backtest be conducted using a 99% confidence level and over a
one-day time horizon, and assuming 250 trading days in a year, a fund
would be expected to experience a backtesting exception approximately
2.5 times a year, or 1% of the 250 trading days.\150\ If the fund were
consistently to experience backtesting exceptions more (or less)
frequently, this could suggest that the fund's VaR model may not be
effectively taking into account and incorporating all significant,
identifiable market risk factors associated with a fund's investments,
as required by the proposed rule.\151\
---------------------------------------------------------------------------
\149\ See, e.g., rule 15c3-1e under the Exchange Act [17 CFR
240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1) (``On the last
business day of each quarter, the broker or dealer must identify the
number of backtesting exceptions of the VaR model, that is, the
number of business days in the past 250 business days, or other
period as may be appropriate for the first year of its use, for
which the actual net trading loss, if any, exceeds the corresponding
VaR measure.''); CESR Global Guidelines, supra note 94 (``The UCITS
should carry out the back testing program at least on a monthly
basis, subject to always performing retroactively the comparison for
each business day,'' i.e., ``provid[ing] for each business day a
comparison of the one-day value-at-risk measure generated by the
UCITS model for the UCITS' end-of-day positions to the one-day
change of the UCITS' portfolio value by the end of the subsequent
business day''); see also infra note 152 (discussing frequency
variations for backtesting requirements).
\150\ The proposed backtesting requirement would be based on a
one-day time horizon. See infra section II.D.4 (discussing the
proposed VaR model requirements that would be based on a twenty-day
time horizon).
\151\ If 10 or more exceptions are generated in a year from
backtesting that is conducted using a 99% confidence level and over
a one-day time horizon, and assuming 250 trading days in a year, it
is statistically likely that such exceptions are a result of a VaR
model that is not accurately estimating VaR. See, e.g., Philippe
Jorion, Value at Risk: The New Benchmark for Managing Financial Risk
(3d ed. 2006), at 149-150 (``Jorion''). See also rule 15c3-1e under
the Exchange Act (requiring backtesting of VaR models and the use of
a multiplication factor based on the number of backtesting
exceptions).
---------------------------------------------------------------------------
The proposed rule would require funds to conduct a backtest each
day so that a fund and its derivatives risk manager could more readily
and efficiently adjust or calibrate its VaR calculation model and,
therefore, could more effectively manage the risks associated with its
derivatives use. We understand that some funds perform these
calculations less frequently than daily.\152\ We are proposing a daily
backtesting requirement because market risk factors and fund
investments are dynamic, which might result in frequent changes to the
accuracy and effectiveness of a VaR model and calculations using the
model. Some commenters on the 2015 proposal supported a backtesting
requirement with a daily frequency.\153\ We also believe that the
additional costs associated with a daily backtesting requirement would
be limited because a fund would be required to calculate its portfolio
VaR each business day to satisfy the proposed limits on fund leverage
discussed in section II.D of this release.
---------------------------------------------------------------------------
\152\ See, e.g., CESR Global Guidelines, supra note 94 (``The
UCITS should carry out the back testing program at least on a
monthly basis, subject to always performing retroactively the
comparison for each business day,'' i.e., ``provid[ing] for each
business day a comparison of the one-day value-at-risk measure
generated by the UCITS model for the UCITS' end-of-day positions to
the one-day change of the UCITS' portfolio value by the end of the
subsequent business day''); Blackstone Comment Letter (suggesting
monthly backtests); Aviva Comment Letter (recommending reporting to
the Commission on a semi-annual basis if a fund experienced a
certain number of backtest exceptions). Cf. rule 15c3-1e under the
Exchange Act [17 CFR 240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1)
(``On the last business day of each quarter, the broker or dealer
must identify the number of backtesting exceptions of the VaR model,
that is, the number of business days in the past 250 business days,
or other period as may be appropriate for the first year of its use,
for which the actual net trading loss, if any, exceeds the
corresponding VaR measure.'').
\153\ See, e.g., GARP Comment Letter; Aviva Comment Letter; ICI
Comment Letter II.
---------------------------------------------------------------------------
We request comment on the proposed backtesting requirement.
44. Is the proposed requirement that a fund backtest its VaR model
each business day appropriate? Why or why not? Would less-frequent
backtesting be sufficient? Is backtesting an effective tool to promote
derivatives risk management and VaR model accuracy? Why or why not?
45. Should the rule specify the number of exceedances, or the
number of consecutive days without an exceedance, that would require
VaR model calibration? Why or why not?
46. How often do funds that currently use VaR backtest their VaR
models and why? Should the backtesting requirement be less frequent?
For example, should we require a fund to perform backtests weekly,
monthly, or quarterly, in each case considering the one-day value
change for each trading day in the period? Please explain.
47. For funds that currently backtest their VaR models, how often
and for what reasons do funds recalibrate their VaR models? Are certain
market risk factors or investment types particularly prone to requiring
VaR model recalibrations (as well as backtesting)?
e. Internal Reporting and Escalation
The proposed rule would require communication between a fund's risk
management and portfolio management regarding the operation of the
program.\154\ We believe these lines of communication are a key part of
derivatives risk management.\155\ Providing portfolio managers with the
insight of a fund's derivatives risk manager is designed to inform
portfolio managers' execution of the fund's strategy and recognize that
portfolio managers will generally be responsible for transactions that
could mitigate or address derivatives risks as they arise. The proposed
rule also would require communication between a fund's derivatives risk
manager and its board, as appropriate. We understand that funds today
often have a dialogue between risk professionals and fund boards.
Requiring a dialogue between a fund's derivatives risk manager and the
fund's board would provide the fund's board with key information to
facilitate its oversight function.
---------------------------------------------------------------------------
\154\ Proposed rule 18f-4(c)(1)(v).
\155\ See 2011 IDC Report, supra note 95.
---------------------------------------------------------------------------
To provide flexibility for funds to communicate among these groups
as they deem appropriate and taking into account funds' own facts and
circumstances, the proposed rule would require a fund's program to
identify the circumstances under which a fund must communicate with its
portfolio management about the fund's derivatives risk management,
including its program's operation.\156\ A fund's program, in addition,
could require that the fund's derivatives risk manager inform the
fund's portfolio management, for example, by meeting with the fund's
portfolio management on a regular and frequent basis, or require that
the fund's portfolio management is notified of the fund's exceedances
or stress tests through software designed to provide automated updates.
---------------------------------------------------------------------------
\156\ Proposed rule 18f-4(c)(1)(v)(A).
---------------------------------------------------------------------------
The proposed rule would also require a fund's derivatives risk
manager to communicate material risks to the fund's portfolio
management and, as appropriate, its board of directors.\157\
Specifically, the rule would require the
[[Page 4465]]
derivatives risk manager to inform, in a timely manner, persons
responsible for the fund's portfolio management--and the fund's board
of directors, as appropriate--of material risks arising from the fund's
derivatives transactions.\158\ The proposed rule would not require a
fund's derivatives risk manager to escalate these risks to the fund's
board automatically, but would require that the derivatives risk
manager directly inform the fund's board of directors regarding these
material risks if the manager determines board escalation to be
appropriate. A fund's derivatives risk manager, for example, could
determine to inform the fund's adviser's senior officers of material
derivatives risks after informing the fund's portfolio management, and
before informing the fund's board. As another example, a fund's
derivatives risk manager could determine that it would be appropriate
to communicate certain material derivatives risks (for example, those
that put more than a certain percentage of the fund's assets at
imminent risk) to the board at the same time it informs the fund's
portfolio management. We believe that a fund's derivatives risk manager
is best positioned to determine when to appropriately inform the fund's
portfolio management and board of material risks.
---------------------------------------------------------------------------
\157\ Proposed rule 18f-4(c)(1)(v)(B).
\158\ Id.
---------------------------------------------------------------------------
The proposed rule would require that these material risks include
any material risks identified by the fund's guideline exceedances or
stress testing. For example, an unexpected risk may arise due to a
sudden market event, such as a downgrade of a large investment bank
that is a substantial derivatives counterparty to the fund. This
requirement is designed to inform portfolio managers of material risks
identified by a fund's derivatives risk management function so that
portfolio managers can take them into account in managing the fund's
portfolio and address or mitigate them as appropriate. It also would
facilitate board oversight by empowering the derivatives risk manager
to escalate a material risk directly to the fund's board where
appropriate. Requiring that a fund's derivatives risk manager have this
direct line of communication with the board regarding material risks
arising from the fund's derivatives transactions is designed to foster
an open and effective dialogue among the derivatives risk manager and
the board.
We request comment on the internal reporting and escalation
elements of the proposed program requirement.
48. Are the proposed internal reporting and escalation requirements
appropriate? Why or why not? Should the rule describe the circumstances
under which a fund must inform its portfolio management regarding the
operation of the program, including any exceedances of its guidelines
and the results of its stress tests? Why or why not? If so, what should
the circumstances be and why? Should the rule require a fund to report
to others at the fund or its adviser (e.g., the fund's chief compliance
officer)? If so, who should a fund report to and why?
49. Should we prescribe the types of internal reporting information
that persons responsible for a fund's portfolio management or the
fund's board should receive, and the means by which these persons
receive such information? Why or why not? If so, what should we
prescribe and why?
50. Are the proposed requirements to escalate material risks to the
fund's portfolio management (and, as appropriate, the fund's board of
directors) appropriate? Why or why not? Should these material risks
include risks identified by the fund's guideline exceedances or stress
testing? Why or why not? Should a fund's derivatives risk manager be
required to report all material derivatives risks to the fund's board,
as well as to its portfolio management? Why or why not?
51. Should the rule, as proposed, permit a fund to determine what
risks arising from its derivatives transactions are material to the
fund, for purposes of the proposed escalation requirement? Why or why
not? If so, should the rule specifically require a fund's derivatives
risk manager to make this determination?
52. Should the rule require the means by which internal reporting
and/or material risk escalation occur? For example, should the rule
specify that certain communications must be in writing? Why or why not?
53. Should the rule require a fund's derivatives risk manager to
inform the fund's portfolio management regarding the operation of the
program on a regular basis? Why or why not? If so, what should the
frequency be and why?
54. Should the rule require a fund to report material risks to us?
Why or why not? If so, what should a fund report and how should it be
reported? For example, should a fund be required to report material
exceedances to its guidelines? Why or why not? Should such a report be
confidential?
55. Should the rule permit a fund to determine whether the material
risk warrants informing the fund's board? Why or why not? If so, which
person or persons at the fund or its adviser should be responsible for
that determination? Should a fund's board always be informed of
material risks regarding the fund's derivatives use? Why or why not? If
so, under what circumstances and frequency should the board be
informed, and why?
56. Should we require that a fund's derivatives risk manager be
permitted to communicate directly with the fund's board of directors?
If not, how should we otherwise address the concern that a board may
not receive the derivatives risk manager's independent risk assessments
if the derivatives risk manager is not empowered to communicate
directly with the board?
f. Periodic Review of the Program
The proposed rule would require a fund's derivatives risk manager
to review the program at least annually to evaluate the program's
effectiveness and to reflect changes in the fund's derivatives risks
over time.\159\ The review would apply to the overall program,
including each of the specific program elements discussed above.
---------------------------------------------------------------------------
\159\ Proposed rule 18f-4(c)(1)(vi).
---------------------------------------------------------------------------
The periodic review would also cover the VaR model a fund uses to
comply with the proposed VaR-based limit on fund leverage risk and
related matters. As discussed below, the proposed rule would require a
fund to comply with a relative or absolute VaR test.\160\ For the
relative VaR test, the fund would compare its VaR to a ``designated
reference index,'' as defined in the rule and selected by the fund's
derivatives risk manager. The proposed periodic review would therefore
include the VaR calculation model that the fund used in connection with
either of the proposed VaR tests (including the fund's backtesting of
the model) and any designated reference index that the derivatives risk
manager selected, to evaluate whether the calculation model and
designated reference index remain appropriate.
---------------------------------------------------------------------------
\160\ See proposed rule 18f-4(c)(2); infra section II.D.
---------------------------------------------------------------------------
We believe that the periodic review of a fund's program and VaR
calculation model is necessary to determine whether the fund is
appropriately addressing its derivatives risks. A fund's derivatives
risk manager, as a result of the review, could determine whether the
fund should update its program, its VaR calculation model, or any
designated reference index. Commenters on the 2015 proposal generally
supported a similar proposed requirement that a fund review and
[[Page 4466]]
update its derivatives risk management program at least annually.\161\
---------------------------------------------------------------------------
\161\ See, e.g., Vanguard Comment Letter.
---------------------------------------------------------------------------
The proposed rule would not prescribe review procedures or
incorporate specific developments that a derivatives risk manager must
consider as part of its review. We believe a derivatives risk manager
generally should implement periodic review procedures for evaluating
regulatory, market-wide, and fund-specific developments affecting the
fund's program so that it is well positioned to evaluate the program's
effectiveness.
We believe that a fund should review its program, VaR calculation
model, and designated reference index on at least an annual basis,
because derivatives and fund leverage risks, and the means by which
funds evaluate such risks, can change. The proposed rule would require
at least an annual review so that there would be a recurring dialogue
between a fund's derivatives risk manager and its board regarding the
implementation of the program and its effectiveness. This frequency
also mirrors the minimum period in which the fund's derivatives risk
manager would be required to provide a written report on the
effectiveness of the program to the board.\162\ A fund's derivatives
risk manager could, however, determine that more frequent reviews are
appropriate based on the fund's particular derivatives risks, the
fund's policies and procedures implementing the program, market
conditions, or other facts and circumstances.\163\
---------------------------------------------------------------------------
\162\ See infra section II.C.2.
\163\ See also proposed rule 18f-4(c)(2)(iii)(A) (requiring, for
a fund that is not in compliance with the applicable VaR test within
three business days, the derivatives risk manager to report to the
fund's board of directors and explain how and by when (i.e., number
of business days) the derivatives risk manager reasonably expects
that the fund will come back into compliance).
---------------------------------------------------------------------------
We request comment on the proposed rule's periodic review
requirement.
57. Should the rule, as proposed, specifically require that a
fund's derivatives risk manager periodically review the program's
effectiveness, including the program's VaR calculation model and any
designated reference index? Why or why not?
58. Should the rule, as proposed, require this review to take place
at least annually, or should it require a more frequent review, such as
quarterly? Should we, instead, not prescribe a minimum frequency for
the periodic review? Why or why not?
59. Are there certain review procedures that the proposed rule
should require and/or on which the Commission should provide guidance?
If so, what are they? For example, should the periodic review involve
board input? Should the Commission provide any additional guidance on
regulatory, market-wide, and fund-specific developments that a fund's
review procedures might cover? Why or why not? If so, how?
60. Should the rule, as proposed, specifically require that other
program elements be periodically reviewed? Why or why not? If so, which
elements and why, and should they be reviewed with the same frequency?
C. Board Oversight and Reporting
The proposed rule would require: (1) A fund's board of directors to
approve the designation of the fund's derivatives risk manager and (2)
the derivatives risk manager to provide regular written reports to the
board regarding the program's implementation and effectiveness, and
describing any exceedances of the fund's guidelines and the results of
the fund's stress testing.\164\ Requiring a fund's derivatives risk
manager approved by the fund's board and with relevant experience as
determined by the fund's board to be responsible for the day-to-day
administration of the fund's program, subject to board oversight, is
consistent with the way we believe many funds currently manage
derivatives risks.\165\ It is also consistent with a board's duty to
oversee other aspects of the management and operations of a fund.
---------------------------------------------------------------------------
\164\ Proposed rule 18f-4(c)(5). The board could designate a
committee of directors to receive the report.
\165\ See, e.g., Comment Letter of the Independent Directors
Council (June 22, 2016) (providing views regarding the appropriate
oversight role of fund directors).
---------------------------------------------------------------------------
The proposed rule's requirements regarding board oversight and
reporting are designed to further facilitate the board's oversight of
the fund's derivatives risk management.\166\ Board oversight should not
be a passive activity. Consistent with that view, we believe that
directors should understand the program and the derivatives risks it is
designed to manage as well as participate in determining who should
administer the program. They also should ask questions and seek
relevant information regarding the adequacy of the program and the
effectiveness of its implementation. The board should view oversight as
an iterative process. Therefore, the board should inquire about
material risks arising from the fund's derivatives transactions and
follow up regarding the steps the fund has taken to address such risks,
including as those risks may change over time. To facilitate the
board's oversight, the proposed rule, as discussed below, would require
the fund's derivatives risk manager to provide reports to the board.
---------------------------------------------------------------------------
\166\ Many commenters to the 2015 proposal expressed the view
that the appropriate role of the board in the context of funds'
derivatives risk management is one of oversight. See, e.g., Comment
Letter of Mutual Fund Directors Forum (Mar. 28, 2016) (stating it
has long taken the position that boards and independent trustees
have an important role to play in overseeing the risks associated
with funds' use of derivatives, including the manner in which those
risks are managed); see also Comment Letter of the Independent
Directors Council (Mar. 28, 2016) (``IDC Comment Letter'');
Morningstar Comment Letter.
---------------------------------------------------------------------------
A fund's board would also be responsible for overseeing a fund's
compliance with proposed rule 18f-4. Rule 38a-1 under the Investment
Company Act requires a fund's board, including a majority of its
independent directors, to approve policies and procedures reasonably
designed to prevent violation of the federal securities laws by the
fund and its service providers.\167\ Rule 38a-1 provides for oversight
of compliance by the fund's adviser and other service providers through
which the fund conducts its activities. Rule 38a-1 would encompass a
fund's compliance obligations with respect to proposed rule 18f-4.
---------------------------------------------------------------------------
\167\ See rule 38a-1 under the Investment Company Act;
Compliance Programs of Investment Companies and Investment Advisers,
Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR
74714 (Dec. 24, 2003)] (discussing the adoption and implementation
of policies and procedures required under rule 38-1) (``Compliance
Program Release'').
---------------------------------------------------------------------------
1. Board Approval of the Derivatives Risk Manager
The proposed rule would require a fund's board to approve the
designation of the fund's derivatives risk manager, taking into account
the derivatives risk manager's relevant experience regarding the
management of derivatives risk.\168\ This requirement is designed to
establish the foundation for an effective relationship and line of
communication between a fund's board and its derivatives risk manager,
and to ensure that the board receives information it needs to approve
the designation.\169\ The requirement that the board consider the
derivatives risk manager's relevant experience is designed to provide
flexibility for a fund's board to take into account a derivatives risk
manager's specific experience, rather than the rule taking a more
prescriptive approach in identifying a specific amount or type of
experience that a derivatives risk
[[Page 4467]]
manager must have. Detailing a derivatives risk manager's required
experience in the rule would not be practical, given the numerous ways
in which a person could obtain experience with derivatives or risk
management. Any specification in the rule of the specific experience
required to serve as a derivatives risk manager likely would be over-
or under-inclusive and would not take into account the way that any
particular fund uses derivatives. We believe that a fund's board, in
its oversight role, is best-positioned to consider a prospective
derivatives risk manager's experience based on all the facts and
circumstances relevant to the fund in considering whether to approve
the derivatives risk manager's designation.
---------------------------------------------------------------------------
\168\ Proposed rule 18f-4(c)(5)(i).
\169\ Cf. rules 22e-4 and 38a-1 under the Investment Company
Act.
---------------------------------------------------------------------------
Commenters on the 2015 proposal generally supported a requirement
that the board approve a fund's derivatives risk manager, although some
of these commenters objected to the proposed requirement that only a
single individual could serve in that role. These commenters asserted
that requiring the board to approve a single individual as the
derivatives risk manager would have required the board to participate
too closely in the management function of the fund.\170\ This re-
proposal, in contrast, would permit a fund's board to approve the
designation of a single individual or group of individuals, subject to
the other proposed requirements about who may serve as a derivatives
risk manager.
---------------------------------------------------------------------------
\170\ See, e.g., Comment Letter of Guggenheim (Mar. 28, 2016)
(``Guggenheim Comment Letter''); Dechert Comment Letter; IDC Comment
Letter; American Beacon Comment Letter; Fidelity Comment Letter; IAA
Comment Letter; ICI Comment Letter I; Invesco Comment Letter.
---------------------------------------------------------------------------
We request comment on the proposed requirement that a fund's board
approve the designation of the fund's derivatives risk manager.
61. Should we require, as proposed, that a fund's board approve the
designation of the fund's derivatives risk manager? Why or why not? Are
there any specific requirements we should include with respect to the
derivatives risk manager's relationship with the board? For example,
should we require the board to meet with the derivatives risk manager
in executive session? Should we also require the derivatives risk
manager to be removable only by the fund's board? Should we require the
derivatives risk manager's compensation be approved by the board, like
a fund's chief compliance officer? If so, why? Would such a requirement
pose undue burdens on fund boards or place the board in an
inappropriate role? If so, why?
62. Should the rule permit a board committee to approve the
designation of the derivatives risk manager, rather than the full board
(and a majority of directors who are not interested persons of the
fund) as proposed? Why or why not? If so, should there be any
requirements or guidance with respect to such a board committee (e.g.,
composition or responsibilities)?
63. Should the rule, as proposed, require that a fund's board in
approving the fund's derivatives risk manager, take into account the
derivatives risk manager's relevant experience regarding the management
of derivatives risk? Why or why not? Would a fund's board, in approving
the designation of the fund's derivatives risk manager, only approve
individuals with relevant experience even without this express
requirement? Is the proposed requirement that a fund's board must take
into account the derivatives risk manager's ``relevant experience
regarding the management of derivatives risk'' sufficiently clear?
Would this raise questions for a fund's board about whether portfolio
management experience, or experience outside of formal derivatives risk
management, would suffice for purposes of the rule? Should the rule,
instead, require that a fund's board take into account the derivatives
risk manager's ``relevant experience''? Or should the rule identify
specific qualifications or experience of a fund's derivatives risk
manager that the fund's board must consider? Why or why not? If so,
what should they be and why?
64. Should we require a fund's board, or a committee thereof, to
approve the derivatives risk management program or any material changes
to the program? Why or why not? If so, should we require that the
committee have a majority that are disinterested? Would such an
approval requirement promote greater board engagement and oversight? Do
a fund's derivatives use and related derivatives risks present matters
for which it would be appropriate to require the fund's board, or
committee thereof, to approve the program or any material changes to
the program? Why or why not?
2. Board Reporting
The proposed rule would require the derivatives risk manager to
provide a written report on the effectiveness of the program to the
board at least annually and also to provide regular written reports at
a frequency determined by the board. This requirement is designed to
facilitate the board's oversight role, including its role under rule
38a-1.\171\
---------------------------------------------------------------------------
\171\ See Compliance Program Release, supra note 166, at n.33
and accompanying text.
---------------------------------------------------------------------------
Many commenters to the 2015 proposal did not support the proposal's
requirement that the board approve material changes to the program.
Many commenters did state, however, that a fund's board of directors
should be provided with notices of changes to the policies and
procedures implementing the derivatives risk management program and
that the fund's derivatives risk manager should provide the board with
a written report describing the adequacy of the derivatives risk
management program and the effectiveness of its implementation and the
results of the fund's stress testing.\172\
---------------------------------------------------------------------------
\172\ See, e.g., BlackRock Comment Letter; Vanguard Comment
Letter.
---------------------------------------------------------------------------
Reporting on Program Implementation and Effectiveness
The proposed rule would require a fund's derivatives risk manager
to provide to the fund's board, on or before the implementation of the
program and at least annually thereafter, a written report providing a
representation that the program is reasonably designed to manage the
fund's derivatives risks and to incorporate the required elements of
the program as well as the basis for the representation.\173\ This
requirement, as discussed below, is designed to provide a fund's board
with information about the effectiveness and implementation of the
program so that the board may appropriately exercise its oversight
responsibilities, including its role under rule 38a-1.
---------------------------------------------------------------------------
\173\ Proposed rule 18f-4(c)(5)(ii).
---------------------------------------------------------------------------
To facilitate the board's oversight, the proposed rule would
require the written report to include the basis for the derivatives
risk manager's representation along with such information as may be
reasonably necessary to evaluate the adequacy of the fund's program and
the effectiveness of its implementation. In addition, the
representation may be based on the derivatives risk manager's
reasonable belief after due inquiry. A derivatives risk manager, for
example, could form its reasonable belief based on an assessment of the
program and taking into account input from fund personnel, including
the fund's portfolio management, or from third parties. We propose to
require that the derivatives risk manager include this representation
and its basis, because we believe the derivatives risk manager--rather
than the board--is best positioned to make this determination.
Requiring the
[[Page 4468]]
derivatives risk manager to include the information in a board report
would also reinforce that the fund and its adviser are responsible for
derivatives risk management while the board's responsibility is to
oversee this activity. Reports following the initial implementation of
the program must also address the effectiveness of the program. This
requirement is designed to provide the board with appropriate and
useful information so it can exercise its judgment in overseeing the
program, and in light of its role under rule 38a-1.
The proposed rule would also require the written report to include
a fund's derivatives risk manager's basis for the selection of the
designated reference index used under the proposed relative VaR test
or, if applicable, an explanation of why the derivatives risk manager
was unable to identify a designated reference index appropriate for the
fund such that the fund relied on the proposed absolute VaR test
instead. The derivatives risk manager's selection of a particular
designated reference index, or conclusion that one is not available,
can affect the amount of leverage risk a fund may obtain under the
proposed rule.\174\ We therefore believe it is important that a fund's
board have sufficient information to oversee this activity.
---------------------------------------------------------------------------
\174\ See infra section II.D.2.b. The proposed rule would not
limit a derivatives risk manager from receiving input from the
fund's portfolio managers or others regarding the fund's designated
reference index.
---------------------------------------------------------------------------
Regular Board Reporting
The proposed rule would require a fund's derivatives risk manager
to provide to the fund's board, at a frequency determined by the board,
a written report analyzing any exceedances of the fund's risk
guidelines and the results of the fund's stress tests and
backtesting.\175\ Requiring the derivatives risk manager to provide
information about how the fund performed relative to these measures and
at a board-determined frequency is designed to provide the board with
timely information to facilitate its oversight of the fund and the
operation of the program. The program's guidelines and stress testing
requirements are designed to address a fund's particular derivatives
risks and are areas the fund should routinely monitor. The program's
backtesting requirement is designed to require a fund to monitor the
effectiveness of the fund's VaR model, which plays a central role in
the proposed VaR-based limit on fund leverage risk. Therefore, we
believe that a board overseeing a fund's derivatives risk management
should receive regular reporting regarding the derivatives risk
manager's analysis of guideline exceedances and the results of stress
testing and backtesting. We also understand that many fund advisers
today provide regular reports to fund boards, often in connection with
quarterly board meetings, regarding a fund's use of derivatives and
their effects on a fund's portfolio, among other information.
---------------------------------------------------------------------------
\175\ Proposed rule 18f-4(c)(5)(iii); see also proposed rule
18f-4(c)(1)(ii)-(iv); see also supra sections II.B.3.b, II.B.3.c,
and II.B.3.d.
---------------------------------------------------------------------------
Accordingly, the proposed rule would require that the report
include the derivatives risk manager's analysis of any exceedances and
stress testing and backtesting results, and to include such information
as may be reasonably necessary for the board to evaluate the fund's
response to any exceedances and the stress testing and backtesting
results. This requirement is designed to provide the board with
information in a format, and with appropriate context, that would
facilitate the board's understanding of the information. A simple
listing of exceedances and stress testing and backtesting results
without context, in contrast, would provide less useful information for
a fund's board and would not satisfy this proposed requirement.
Under the proposed regular board reporting requirement, a fund's
board would determine the frequency of this written report. Boards
should be allowed flexibility in determining the frequency of reporting
so that they can tailor their oversight to their funds' particular
facts and circumstances.
We request comment on the proposed board reporting requirements.
65. Are the proposed requirements for the fund's derivatives risk
manager to provide written reports to the fund's board on the program's
implementation and effectiveness appropriate? Why or why not? Should
the board receive a written report on or before the implementation of
the program? Why or why not? Should we modify the proposed rule to
require funds to provide boards reports with greater frequency than
annually? Why or why not?
66. Is the proposed representation that the derivatives risk
manager would have to make in the report appropriate? Why or why not?
What should the representation entail, and why? Should we provide
guidance as to what the representation should look like? Why or why
not? Would the representation be helpful for a fund's board in
exercising its oversight responsibilities? Why or why not? What effect,
if any, would the representation have on a fund's derivatives risk
management apart from the board's oversight of such risk management?
67. Would the responsibilities the proposed rule allocates to a
fund's derivatives risk manager affect a fund's ability to hire or
retain a derivatives risk manager? If so, how?
68. Is the proposed requirement for the written report to include
the basis for the derivatives risk manager's representation along with
information to evaluate the program's adequacy and effectiveness,
appropriate? Why or why not? Should the rule require specific
information in the written report? Why or why not? If so, what
information and why? Should the rule, as proposed, permit the
representation to be based on the derivatives risk manager's reasonable
belief after due inquiry? Why or why not? Should we provide more
guidance regarding the basis for the representation? If so, what should
we provide? For example, should we provide guidance regarding the types
of information on which a fund's derivatives risk manager may base this
representation? Why or why not? Is the reference to due inquiry
appropriate in this context? Is the reference sufficiently clear?
69. Should the rule require the written report to include a fund's
derivatives risk manager's basis for the selection of the designated
reference index or, if applicable, an explanation of why the
derivatives risk manager was unable to identify a designated reference
index appropriate for the fund? Why or why not? Should the rule require
the written report to identify and explain any difference between the
selected index and any indices that are used for performance
comparisons in the fund's registration statement and shareholder
reports? Why or why not?
70. Should the rule require a fund's derivatives risk manager to
provide a written report regarding any exceedances to thresholds
provided for in the fund's guidelines? Why or why not? Should the rule
require a fund's derivatives risk manager to provide a written report
regarding the results of the stress tests and backtests? Why or why
not?
71. Should the rule require that a fund's derivatives risk manager
report to the board? Why or why not? If not, should the fund determine
who should report to the board, and why? Should the rule permit the
derivatives risk manager to delegate its reporting obligations under
the rule to other officers or employees of the adviser? Why or why not?
If so, to whom should they be able to delegate these obligations?
[[Page 4469]]
72. Should the rule permit a fund's board to determine the
frequency with which it receives the written report? Why or why not? Or
should the rule require that the derivatives risk manager provide the
written report with a certain frequency? Why or why not? If so, what
frequency should the rule require, and why? Should the rule permit a
fund's derivatives risk manager to determine to report to the board
sooner than the frequency determined by the board if appropriate? Why
or why not?
73. Should the rule require that the written report include such
information as may be reasonably necessary for the board to evaluate a
fund's response to any exceedances and the results of the fund's stress
testing? Why or why not? What information may be reasonably necessary
for the board's evaluation? Should the rule require certain information
to be provided in the written report? Why or why not? If so, what
information should be required to be provided?
74. Should the rule require the report to be written? Why or why
not? Should the rule require that the derivatives risk manager prepare
the written report? Why or why not?
75. Would the approach provided by the proposed rule's board
oversight provisions appropriately provide the board the ability to
oversee a fund's derivatives risk management? Why or why not? Does the
proposed rule provide an appropriate balance between the board's role
of general oversight and the fund's roles of day-to-day risk management
and portfolio management? Why or why not?
76. Should the board be required to approve the program, including
initially, and any material changes to the program? Why or why not?
What is current industry practice with respect to the board's oversight
of a fund's derivatives risk management?
D. Proposed Limit on Fund Leverage Risk
The proposed rule would also generally require funds relying on the
rule when engaging in derivatives transactions to comply with a VaR-
based limit on fund leverage risk. This outer limit would be based on a
relative VaR test that compares the fund's VaR to the VaR of a
``designated reference index.'' If the fund's derivatives risk manager
is unable to identify an appropriate designated reference index, the
fund would be required to comply with an absolute VaR test.\176\
---------------------------------------------------------------------------
\176\ A fund that is a leveraged/inverse investment vehicle, as
defined in the proposed sales practices rules, would not be required
to comply with the proposed VaR-based limit on fund leverage risk.
Broker-dealers and investment advisers would be required to approve
retail investors' accounts to purchase or sell shares in these
funds. See infra section II.G (discussing leveraged/inverse
investment vehicles). The proposed rule also would provide an
exception from the proposed VaR tests for funds that use derivatives
to a limited extent or only to hedge currency risks. See infra
sections II.E and II.G (discussing the proposed rule's provisions
regarding limited derivatives users and leveraged/inverse funds
covered by the sales practices rules).
---------------------------------------------------------------------------
1. Use of VaR
VaR is an estimate of an instrument or portfolio's potential losses
over a given time horizon and at a specified confidence level. VaR will
not provide, and is not intended to provide, an estimate of an
instrument or portfolio's maximum loss amount. For example, if a fund's
VaR calculated at a 99% confidence level was $100, this means the
fund's VaR model estimates that, 99% of the time, the fund would not be
expected to lose more than $100. However, 1% of the time, the fund
would be expected to lose more than $100, and VaR does not estimate the
extent of this loss.
We propose to use VaR tests to limit fund leverage risk associated
with derivatives because VaR generally enables risk to be measured in a
reasonably comparable and consistent manner across diverse types of
instruments that may be included in a fund's portfolio. One benefit of
the proposed VaR-based approach is that different funds could, and
would be required to, tailor their VaR models to incorporate and
reflect the risk characteristics of their fund's particular
investments.\177\ VaR is a commonly-known and broadly-used industry
metric that integrates the market risk associated with different
instruments into a single number that provides an overall indication of
market risk, including the market risk associated with the fund's
derivatives transactions.\178\ We recognize that funds use many other
risk analytic metrics suited to particular financial instrument
categories.\179\ Given the diverse portfolios of many funds, these more
category-specific risk metrics may be less suitable for establishing a
proposed limit on fund leverage risk that is applied more generally.
---------------------------------------------------------------------------
\177\ See infra section II.D.4 (discussing the choice of model
and parameters for the VaR test).
\178\ See Kevin Dowd, An Introduction to Market Risk Measurement
(Oct. 2002), at 10 (``Dowd'') (VaR ``provides a common consistent
measure of risk across different positions and risk factors. It
enables us to measure the risk associated with a fixed-income
position, say, in a way that is comparable to and consistent with a
measure of the risk associated with equity positions''); see also
Jorion, supra note 151, at 159 (stating that VaR ``explicitly
accounts for leverage and portfolio diversification and provides a
simple, single measure of risk based on current positions'').
\179\ See Jorion, supra note 151. For example, risk measures for
government bonds can include duration, convexity and term-structure
models; for corporate bonds, ratings and default models; for stocks,
volatility, correlations and beta; for options, delta, gamma and
vega; and for foreign exchange, target zones and spreads. Certain
funds are required to report on Form N-PORT some of these metrics,
such as portfolio-level duration (DV01 and SDV01) and position-level
delta. See Investment Company Reporting Modernization, Investment
Company Act Release No. 32314 (Oct. 13, 2016) [81 FR 81870 (Nov. 18,
2016)] (``Investment Company Reporting Modernization Adopting
Release'').
---------------------------------------------------------------------------
We recognize that VaR is not itself a leverage measure. But a VaR
test, and especially one that compares a fund's VaR to an unleveraged
index that reflects the markets or asset classes in which the fund
invests, can be used to analyze whether a fund is using derivatives
transactions to leverage the fund's portfolio, magnifying its potential
for losses and significant payment obligations of fund assets to
derivatives counterparties. At the same time, VaR tests can also be
used to analyze whether a fund is using derivatives with effects other
than leveraging the fund's portfolio that may be less likely to raise
the concerns underlying section 18. For example, fixed-income funds use
a range of derivatives instruments, including credit default swaps,
interest rate swaps, swaptions, futures, and currency forwards. These
funds often use these derivatives in part to seek to mitigate the risks
associated with a fund's bond investments or to achieve particular risk
targets, such as a specified duration. If a fund were using derivatives
extensively, but had either a low VaR or a VaR that did not
substantially exceed the VaR of an appropriate benchmark, this would
indicate that the fund's derivatives were not substantially leveraging
the fund's portfolio.
We also understand that VaR calculation tools are widely available,
and many advisers that enter into derivatives transactions already use
risk management or portfolio management platforms that include VaR
capability.\180\ Advisers to the funds that
[[Page 4470]]
use derivatives transactions more extensively may be particularly
likely to already use risk management or portfolio management platforms
that include VaR capability, as compared to advisers to the funds that
are within the scope of the proposed provision for limited derivatives
users and that would not be subject to the proposed VaR tests.\181\
---------------------------------------------------------------------------
\180\ See, e.g., ICI Comment Letter III (``73 percent of
respondents [to an Investment Company Institute survey of its member
firms] use both some form of VaR and stress testing as derivatives
risk management tools.)''; Comment Letter of OppenheimerFunds (Mar.
28, 2016) (``Oppenheimer Comment Letter''); Federated Comment
Letter; Franklin Resources Comment Letter; see also Christopher L.
Culp, Merton H. Miller & Andres M. P. Neves, Value at Risk: Uses and
Abuses, 10 Journal of Applied Corporate Finance 26 (Jan. 1998) (VaR
is ``used regularly by nonfinancial corporations, pension plans and
mutual funds, clearing organizations, brokers and futures commission
merchants, and insurers.''). Moreover, the proposed relative VaR
test is similar to a relative VaR approach that applies to UCITS
under European guidelines. See infra section II.D.6.c (discussing
the UCITS approach).
\181\ See, e.g., ICI Comment Letter III.
---------------------------------------------------------------------------
While we believe there are significant benefits to using the
proposed VaR-based limit on fund leverage risk, we recognize risk
literature critiques of VaR (especially since the 2007-2009 financial
crisis). One common critique of VaR is that it does not reflect the
size of losses that may occur on the trading days during which the
greatest losses occur--sometimes referred to as ``tail risks.'' \182\ A
related critique is that VaR calculations may underestimate the risk of
loss under stressed market conditions.\183\ These critiques often arise
in the context of discussing risk managers' use of additional risk
tools to address VaR's shortcomings. Our proposed VaR tests are
designed to provide a metric that can help assess the extent to which a
fund's derivatives transactions raise concerns underlying section 18,
but we do not believe they should be the sole component of a
derivatives risk management program.\184\ We do not intend to encourage
risk managers to over-rely on VaR as a stand-alone risk management
tool.\185\ Instead, as discussed above, the proposed rule would require
a fund to establish risk guidelines and to stress test its portfolio as
part of its risk management program in part because of concerns that
VaR as a risk management tool may not adequately reflect tail
risks.\186\ We also recognize that a fund's use of derivatives
transactions may pose other risks (such as counterparty risk and
liquidity risk) that VaR does not capture. A fund that adopts a
derivatives risk management program under the proposed rule would have
to consider these risks as part of its derivatives risk management
program.\187\
---------------------------------------------------------------------------
\182\ See Chris Downing, Ananth Madhavan, Alex Ulitsky & Ajit
Singh, Portfolio Construction and Tail Risk, 42 The Journal of
Portfolio Management 1, 85-102 (Fall 2015), available at https://jpm.iijournals.com/content/42/1/85 (``for especially fat-tailed
return distributions the VaR threshold value might appear to be low,
but the actual amount of value at risk is high because VaR does not
measure the mass of distribution beyond the threshold value'').
With respect to VaR, the ``tail'' refers to the observations in
a probability distribution curve that are outside the specified
confidence level. ``Tail risk'' describes the concern that losses
outside the confidence level may be extreme.
\183\ See Jorion, supra note 151, at 357 (VaR ``quantif[ies]
potential losses under `normal' market conditions, where normal is
defined by the confidence level, typically 99 percent. . . . In
practice, [VaR] measures based on recent historical data can fail to
identify extreme unusual situations that could cause severe
losses.'').
\184\ See supra section II.B.3.
\185\ See, e.g., James O'Brien & Pawel J. Szerszen, An
Evaluation of Bank VaR Measures for Market Risk During and Before
the Financial Crisis, Federal Reserve Board Staff Working Paper
2014-21 (Mar. 7, 2014), available at https://www.federalreserve.gov/pubs/feds/2014/201421/201421pap.pdf (``Criticism of banks' VaR
measures became vociferous during the financial crisis as the banks'
risk measures appeared to give little forewarning of the loss
potential and the high frequency and level of realized losses during
the crisis period.''); see also Pablo Triana, VaR: The Number That
Killed Us, Futures Magazine (Dec. 1, 2010), available at http://www.futuresmag.com/2010/11/30/var-number-killed-us (stating that
``in mid-2007, the VaR of the big Wall Street firms was relatively
quite low, reflecting the fact that the immediate past had been
dominated by uninterrupted good times and negligible volatility'').
\186\ See supra section II.B.3.b.
\187\ See supra section II.B.3.a.
---------------------------------------------------------------------------
We also considered proposing tests based on stressed VaR, expected
shortfall, or both. Stressed VaR refers to a VaR model that is
calibrated to a period of market stress. A stressed VaR approach would
address some of the VaR test critiques related to tail risk and
underestimating expected losses during stressed conditions. Calibrating
VaR to a period of market stress, however, can pose quantitative
challenges by requiring funds to identify a stress period with a full
set of risk factors for which historical data is available. Expected
shortfall analysis is similar to VaR, but accounts for tail risk by
taking the average of the potential losses beyond the specified
confidence level. For example, if a fund's VaR at a 99% confidence
level is $100, the fund's expected shortfall would be the average of
the potential losses in the 1% ``tail.'' Because there are fewer
observations in the tail, however, there is an inherent difficulty in
estimating the expected value of larger losses. Expected shortfall
analysis also could involve potentially greater sensitivity to extreme
outlier losses because it is based on an average of a smaller number of
observations that are in the tail. Taking these considerations into
account, we are proposing tests based on VaR, which is commonly used
and does not present all of the quantitative challenges associated with
stressed VaR and expected shortfall, complemented by elements in the
proposed risk management program designed to address VaR's limitations.
We request comment on the proposed definition of VaR, the proposed
use of VaR as a means to limit funds' leverage risk, as well as
alternative VaR-based methodologies (stressed VaR and expected
shortfall). We also request comment and discuss alternatives to VaR and
VaR-based methodologies in section II.D.6 below.
77. Is the proposed definition of the term ``VaR'' appropriate? Why
or why not? If not, how should we define it?
78. Is a VaR-based test an appropriate way to limit funds' leverage
risk? Why or why not? Do commenters agree with our observations
regarding VaR's characteristics and its critiques? Do commenters
believe that the proposed derivatives risk management program
requirement would help to address VaR's limitations? Please explain.
79. Should we change the rule to require stressed VaR, either as
part of the program's stress testing requirement or as part of the
limit on fund leverage risk? If so, how should we implement a stressed
VaR requirement? Should the rule provide, for example, that the
historical data used to calculate VaR must include a period of market
stress? What VaR model requirements should we include if the rule
required stressed VaR? Please describe in detail. Are there any other
corresponding changes we should make to the proposed VaR model
requirements or proposed VaR tests if we used stressed VaR? Why or why
not?
80. Should we change the rule to require expected shortfall or
stressed expected shortfall, either as part of the program's stress
testing requirement or as part of the limit on fund leverage risk? If
so, how should we implement this element? What VaR model requirements
should we include if the rule required expected shortfall or stressed
expected shortfall? Please describe in detail. Are there any other
corresponding changes we should make to the proposed VaR model
requirements or proposed VaR tests if we were to require expected
shortfall or stressed expected shortfall? Why or why not?
81. Are there risk metrics or measurements other than VaR that
similarly can be applied to a wide breadth of fund strategy types and
investments and used to limit fund leverage risk? Please explain.
82. Should we use VaR as the only methodology to establish an
outside limit on funds' leverage risk in rule 18f-4? We discuss below
additional alternatives to VaR for this purpose. Should we include in
rule 18f-4 some combination of the proposed VaR tests and the
alternatives discussed in that section, and provide flexibility to
funds to comply with the approach that they believe is most appropriate
based on their strategies and investments? If so,
[[Page 4471]]
which approaches should we include in the rule and why?
2. Relative VaR Test
The proposed relative VaR test would require a fund to calculate
the VaR of the fund's portfolio and compare it to the VaR of a
``designated reference index.'' As discussed in more detail below, a
fund's designated reference index must be unleveraged and reflect the
markets or asset classes in which the fund invests, among other
requirements. This index is designed to create a baseline VaR that
approximates the VaR of a fund's unleveraged portfolio. To the extent a
fund entered into derivatives to leverage its portfolio, the relative
VaR test is designed to identify this leveraging effect. If a fund is
using derivatives and its VaR exceeds that of the designated reference
index, this difference may be attributable to leverage risk.
A fund would be required to comply with the relative VaR test
unless a designated reference index is unavailable. We propose a
relative VaR test as the default means of limiting fund leverage risk
because it resembles the way that section 18 limits a fund's leverage
risk. Section 18 limits the extent to which a fund can potentially
increase its market exposure through leveraging by issuing senior
securities, but it does not directly limit a fund's level of risk or
volatility. For example, a fund that invests in less-volatile
securities and leverages itself to the maximum extent may not be as
volatile as a completely unleveraged fund that invests in more-volatile
securities. The proposed relative VaR test likewise is designed to
limit the extent to which a fund increases its market risk by
leveraging its portfolio through derivatives, while not restricting a
fund's ability to use derivatives for other purposes. For example, if a
derivatives transaction reduces (or does not substantially increase) a
fund's VaR relative to the VaR of the designated reference index, the
transaction would not be restricted by the relative VaR test.
In addition, allowing funds to rely on the proposed absolute VaR
test may be inconsistent with investors' expectations where a
designated reference index is available. For example, a fund that
invests in short-term fixed income securities would have a relatively
low level of volatility. The fund's investors could reasonably expect
that the fund might exhibit a degree of volatility that is broadly
consistent with the volatility of the markets or asset classes in which
the fund invests, as represented by the fund's designated reference
index. This fund's designated reference index would be composed of
short-term fixed income securities, and could, for example, have a VaR
of 4%. If the fund were permitted to rely on the absolute VaR test,
however, the fund could substantially leverage its portfolio almost
four times its designated reference index's VaR to achieve a level of
volatility that substantially exceeds the volatility associated with
fixed-income securities.
a. Designated Reference Index
A fund would satisfy the proposed relative VaR test if the VaR of
its entire portfolio does not exceed 150% of the VaR of its designated
reference index.\188\ The proposed rule would define a ``designated
reference index'' as an unleveraged index that is selected by the
derivatives risk manager, and that reflects the markets or asset
classes in which the fund invests.\189\ The proposed definition also
would require that the designated reference index not be administered
by an organization that is an affiliated person of the fund, its
investment adviser, or principal underwriter, or created at the request
of the fund or its investment adviser, unless the index is widely
recognized and used.\190\ Additionally, the designated reference index
must either be an ``appropriate broad-based securities market index''
or an ``additional index'' as defined in Item 27 of Form N-1A.\191\ A
fund would have to disclose its designated reference index in the
annual report, together with a presentation of the fund's performance
relative to the designated reference index.\192\
---------------------------------------------------------------------------
\188\ See proposed rule 18f-4(a) (defining the term ``relative
VaR test''); proposed rule 18f-4(c)(2)(i); infra section II.D.2.b
(discussing the 150% limit under the relative VaR test).
\189\ See proposed rule 18f-4(a) (defining the term ``designated
reference index'').
\190\ Furthermore, for a blended index, none of the indexes that
compose the blended index may be administered by an organization
that is an affiliated person of the fund, its investment adviser, or
principal underwriter, or created at the request of the fund or its
investment adviser, unless the index is widely recognized and used.
See id.
\191\ See proposed rule 18f-4(a) (defining the term ``designated
reference index''); see also Instructions 5 and 6 to Item
27(b)(7)(ii) of Form N-1A (discussing the terms ``appropriate broad-
based securities market index'' and ``additional index'').
\192\ See proposed rule 18f-4(c)(2)(iv).
---------------------------------------------------------------------------
The requirement that the designated reference index reflect the
markets or asset classes in which the fund invests is designed to
provide an appropriate baseline for the relative VaR test. Because of
this requirement, differences between the fund's VaR and the VaR of the
designated reference index are more likely to represent leverage than
other factors, like differences between the securities in the fund's
portfolio and those in the index, as compared to a relative VaR test
that compares the fund's VaR to an index that does not reflect the
markets or asset classes in which the fund invests.\193\ Take, for
example, a fund that invests primarily in S&P 500 index options and
uses that index as its designated reference index. Differences between
the fund's VaR and the VaR of the S&P 500 would be more likely
attributable to the leverage risk associated with the options than, for
example, if the fund were permitted to use an index that did not
reflect the markets or assets classes in which the fund invests, such
as an index of small capitalization stocks in this example. The
derivatives risk manager could select a designated reference index that
is a blended index under the proposed rule (assuming that the blended
index meets the proposed requirements for a designated reference
index), which would give some flexibility in identifying or
constructing a designated reference index that provides an appropriate
baseline for the relative VaR test.\194\ For example, the derivatives
risk manager of a balanced fund may determine that a blended index of
an unleveraged equity index and an unleveraged fixed income index would
be an appropriate designated reference index.
---------------------------------------------------------------------------
\193\ To the extent a fund discloses in its annual report an
``appropriate broad-based securities market index'' that does not
reflect the markets or asset classes in which the fund invests, such
a fund may satisfy the performance disclosure requirements of Form
N-1A, but it would not satisfy the proposed designated reference
index requirement. For example, a fund that pursues its strategy
primarily through commodity futures contracts could select the S&P
500 to satisfy its performance disclosure requirement under Form N-
1A, but such an index would not satisfy the proposed designated
reference index requirement because a commodity fund would not
invest in stocks included in the S&P 500 or large cap stocks
generally.
\194\ If the derivatives risk manager selects a designated
reference index that is a blended index, the designated reference
index would have to be disclosed as an ``additional index'' (as
opposed to an ``appropriate broad-based securities market index'')
as defined in the instruction to Item 27 in Form N-1A. Form N-1A
defines the term ``appropriate broad-based securities market index''
to mean an index ``that is administered by an organization that is
not an affiliated person of the [f]und, its investment adviser, or
principal underwriter, unless the index is widely recognized and
used.'' See Instruction 5 to Item 27(b)(7)(ii) of Form N-1A. A
blended index that is administered by the fund's investment adviser,
for example, would therefore not qualify as an ``appropriate broad-
based securities market index.''
---------------------------------------------------------------------------
The requirement that the designated reference index be an
unleveraged index also is designed to provide an appropriate baseline
against which to measure a fund's portfolio VaR for
[[Page 4472]]
purposes of assessing the fund's leverage risk. Conducting a VaR test
on a designated reference index that itself is leveraged would distort
the leverage-limiting purpose of the VaR comparison by inflating the
volatility of the index that serves as the reference portfolio for the
relative VaR test. For example, an equity fund might select as its
designated reference index an index that tracks a basket of large-cap
U.S. listed equity securities such as the S&P 500. But the fund could
not select an index that is leveraged, such as an index that tracks
200% of the performance of the S&P 500. A relative VaR test based on
this index would effectively permit additional leveraging inconsistent
with the Investment Company Act.\195\
---------------------------------------------------------------------------
\195\ See supra section I.B.1. But see infra section II.G
(discussing leveraged/inverse funds covered by the proposed sales
practices rules).
---------------------------------------------------------------------------
Our proposal would prohibit the designated reference index from
being an index administered by an organization that is an affiliated
person of the fund, its investment adviser, or its principal
underwriter, or created at the request of the fund or its investment
adviser. This proposed prohibition would not, however, extend to
indexes that are ``widely recognized and used.'' \196\ We believe that
the indexes permissible under the proposed rule would be less likely to
be designed with the intent of permitting a fund to incur additional
leverage-related risk.
---------------------------------------------------------------------------
\196\ See proposed rule 18f-4(a) (defining the term ``designated
reference index''). This ``widely recognized and used'' standard has
historically been used to permit a fund to employ affiliated-
administered indexes for disclosure purposes, when the use of such
indexes otherwise would not be permitted. See supra note 193.
---------------------------------------------------------------------------
The proposed rule would require that a fund publicly disclose to
its investors in its annual reports the designated reference index. An
open-end fund would have to disclose its designated reference index in
the fund's annual report as the fund's ``appropriate broad-based
securities market index'' or an ``additional index'' that Form N-1A
describes in the context of the annual report performance presentation
requirements.\197\ Form N-2, on the other hand, does not require
closed-end funds to disclose a benchmark index for comparing a fund's
performance. Nevertheless, some closed-end funds choose to disclose a
benchmark index in their annual reports to shareholders. Under the
proposed rule, a closed-end fund seeking to satisfy the relative VaR
test would have to disclose the fund's designated reference index in
its annual report together with a presentation of the fund's
performance.\198\ In proposing this approach, we considered the role of
investor expectations in selecting funds that correspond to investors'
desired level of investment risk.\199\ We believe that investors could
reasonably expect that their fund might exhibit a degree of volatility
that is broadly consistent with the volatility of the markets or asset
classes in which the fund invests, as represented by the fund's
designated reference index. Requiring a fund to select a designated
reference index that it publicly discloses would promote the fund's
selection of an appropriate index that reflects the fund's portfolio
risks and its investor expectations.
---------------------------------------------------------------------------
\197\ See proposed rule 18f-4(c)(2)(iv); Item 27(b)(7)(ii) of
Form N-1A.
See also Instructions to Items 4 and 27(b)(7)(ii) of Form N-1A.
Form N-1A provides that ``New Funds,'' as defined in the form, are
not required to disclose an appropriate broad-based securities
market index and the fund's performance in the annual report because
of the fund's limited operating history. See Instruction 6 to Item 3
of Form N-1A (defining a ``New Fund'' to mean a ``Fund that does not
include in Form N-1A financial statements reporting operating
results or that includes financial statements for the Fund's initial
fiscal year reporting operating results for a period of 6 months or
less''). For the same reason, the proposed rule would provide that a
fund would not be required to disclose its designated reference
index in the fund's annual report if the fund is a ``New Fund,'' or
would meet that definition if it were filing on Form N-1A, at the
time the fund files its annual report. See proposed rule 18f-
4(c)(2)(iv).
\198\ See proposed rule 18f-4(c)(2)(iv).
\199\ To the extent a fund's use of derivatives transactions is
part of its principal investment strategy or is a principal risk, it
is required to be disclosed as such in the fund's prospectus. See
Item 4 of Form N-1A; Item 8 of Form N-2.
---------------------------------------------------------------------------
Some registered closed-end funds currently elect to provide a
Management's Discussion of Fund Performance (``MDFP'') in their annual
reports.\200\ These registered closed-end funds could disclose their
performance relative to the performance of the designated reference
index in the fund's MDFP. BDCs that are publicly traded must disclose,
in their annual reports filed on Form 10-K, a line graph comparing the
yearly percentage change in fund share price with the return of a broad
equity market index.\201\ A publicly-traded BDC could choose to include
its designated reference index in this line graph disclosure.
---------------------------------------------------------------------------
\200\ The Commission recently proposed to amend Form N-2 to
require registered closed-end funds to include MDFP disclosure in
their annual reports. See Securities Offering Reform for Closed-End
Investment Companies, Investment Company Act Release No. 33427 (Mar.
20, 2019) [84 FR 14448 (Apr. 10, 2019)], at 14471-72 (``Securities
Offering Reform Proposing Release'').
\201\ 17 CFR 229.201(e)(1)(i).
---------------------------------------------------------------------------
We recognize the concern that funds could have the incentive to
select an inappropriate designated reference index composed of more
volatile securities to allow the fund to obtain more leverage risk
under the relative VaR test. The proposed rule includes three
provisions designed to address this concern. In addition to requiring
that the designated reference index reflect the markets or asset
classes in which the fund invests, and that the index not be
administered by certain affiliated persons or created at the request of
the fund or its investment adviser, as described above, the proposed
rule would require: (1) The derivatives risk manager to select the
designated reference index and to periodically review it; (2) the fund
to disclose the designated reference index, relative to its
performance, in its annual report, creating the disincentive for a fund
to present performance that may be significantly lower than, or not
related to, the disclosed index; and (3) the board of directors to
receive a written report providing the derivatives risk manager's basis
for selecting the designated reference index.\202\ These requirements,
collectively, are designed to require funds to use designated reference
indexes that provide an appropriate baseline for the relative VaR test
and to prohibit funds from, instead, selecting indexes solely for the
purpose of maximizing the fund's permissible leverage risk under the
proposed rule.
---------------------------------------------------------------------------
\202\ See proposed rule 18f-4(a), (c)(1)(vi), (c)(2)(iii),
(c)(5)(ii)-(iii); see also supra sections II.B.3.f, II.C.2.
---------------------------------------------------------------------------
We recognize that some (but not all) popular benchmark indexes
charge funds a licensing fee for their inclusion in fund prospectuses
and annual reports. Funds could incur licensing fees if their
derivatives risk managers select a designated reference index whose
provider charges such a fee and the fund is not already using the
index. We are nevertheless proposing this disclosure requirement
because the relative VaR test's ability to limit a fund's leverage risk
is directly tied to the appropriateness of its designated reference
index. This disclosure requirement is designed to address concerns
about inappropriate indexes, as discussed above, by creating the
disincentive for a fund to select an inappropriate index because the
fund would have to disclose its performance against that index in its
annual report and likely would not want to present performance that is
significantly lower than, or not related to, the disclosed index.\203\
At the same time, the proposed rule provides funds flexibility to use
any index that meets the proposed requirements. The proposed rule would
provide this flexibility in light of the conditions discussed above
[[Page 4473]]
designed to require that a fund use a designated reference index that
is appropriate for the relative VaR test.
---------------------------------------------------------------------------
\203\ See supra note 201 and accompanying paragraph.
---------------------------------------------------------------------------
The 2015 Proposing Release also included a risk-based portfolio
limit based on VaR.\204\ The 2015 proposal provided that a fund would
satisfy its risk-based portfolio limit condition if a fund's full
portfolio VaR was less than the fund's ``securities VaR'' (i.e., the
VaR of the fund's portfolio of securities and other investments, but
excluding any derivatives transactions).\205\ Our proposal, however,
differs from the 2015 proposal in that the proposed relative VaR test
compares the fund's VaR to the VaR of the fund's designated reference
index, rather than the fund's ``securities VaR.'' This is because some
funds that use derivatives extensively hold primarily cash, cash
equivalents, and derivatives. These funds' ``securities VaRs'' would be
based primarily on the fund's cash and cash equivalents. As some
commenters on the 2015 proposal noted, this would not provide an
appropriate comparison for a relative VaR test because the VaR of the
cash and cash equivalents would be very low and would not provide a
reference level of risk associated with the fund's strategy.\206\
---------------------------------------------------------------------------
\204\ See 2015 Proposing Release, supra note 2, at section
III.B.2.
\205\ Under that proposal, a fund that satisfied this VaR test
was also required to limit its aggregate exposure--including
derivatives exposure--to 300% of the fund's net assets. See id.
\206\ See, e.g., AlphaSimplex Comment Letter; AQR Comment
Letter; ICI Comment Letter I.
---------------------------------------------------------------------------
We request comment on the proposed requirements regarding the
selection and disclosure of a designated reference index for purposes
of compliance with the proposed relative VaR test.
83. Is the proposed definition of the term ``designated reference
index'' appropriate? Why or why not? Should the Commission provide
additional guidance, or requirements in the proposed rule, addressing
when an index reflects the markets or asset classes in which a fund
invests? Are there particular types of indexes that would not be
appropriate as a designated reference index? Why or why not? If so,
what types of indexes and why would they be inappropriate for this
purpose?
84. Should the rule require that the designated reference index be
an unleveraged index? Should the rule specify with greater
particularity what constitutes an unleveraged index? Please explain.
Alternatively, should the Commission provide guidance on when an index
will be ``leveraged''?
85. Are there other considerations that would present challenges
for funds in light of the proposed requirement to select a designated
reference index for purposes of the proposed relative VaR test
requirement? If so, what?
86. To what extent do funds expect that the requirement to disclose
the designated reference index would result in additional licensing
fees? Please explain. What consequences would such charges create?
87. Should we change the proposed definition of the term
``designated reference index'' to no longer track in part the
definition of an ``appropriate broad-based securities market index'' in
Form N-1A (Instruction 5 of Item 27(b)(7)) and allow a derivatives risk
manager to select an index administered by an affiliated person of the
fund, its investment adviser, or principal underwriter? Should we
change the proposed definition to allow a derivatives risk manager to
select an index created at the request of the fund or its investment
adviser? Is it appropriate to exclude such indexes from the definition
of ``designated reference index,'' and is it appropriate that widely
recognized and used indexes be carved out from this exclusion, as
proposed? Would the proposed exclusion help ensure the selection of
indexes that are appropriately designed to create a baseline VaR that
approximates the VaR of a fund's unleveraged portfolio? Please explain.
Would allowing funds to use indexes that would fall within the proposed
exclusion raise concerns that the indexes would not be appropriate,
or--if the Commission were to permit the use of such indexes--would the
rule's other proposed conditions designed to address this concern work
equally well for all indexes? If the Commission were to permit the use
of indexes that would fall within the proposed exclusion, would any
additional limits on the use of these indexes be appropriate? If so,
what limits and why?
88. If we were to further limit or restrict the types of indexes
that a fund could select as its designated reference index under the
proposed rule, what additional limits would be appropriate? Should we,
for example, provide that a fund's designated reference index must meet
the definition of an ``appropriate broad-based securities market
index'' as defined in Form N-1A? Should we require that the index be
widely recognized and used?
89. Similar to UCITS guidelines, should the proposed definition
specifically require that the risk profile of the designated reference
index be consistent with the fund's investment objectives and policies,
as well as investment limits? \207\ Why or why not?
---------------------------------------------------------------------------
\207\ See infra section II.D.6.c (discussing the UCITS
framework).
---------------------------------------------------------------------------
90. Should the rule require funds to disclose their designated
reference indexes in their annual reports to shareholders, as proposed?
Should such disclosure also appear in the fund's prospectus? What
reasons, if any, should the designated reference index not be an index
a fund includes as part of its performance disclosure? Please explain.
Should a fund be required to specify that the index it includes in its
performance disclosure is the fund's designated reference index, which
has been selected for purposes of the fund's compliance with rule 18f-
4? If so, what other information or explanations should a fund also
have to include (if any), in order to best promote investor
understanding of how the fund's designated reference index affects the
fund's ability to use leverage, and how this in turn affects the risks
associated with an investment in the fund? For example, should a fund
also be required to disclose the index's historical (e.g., 1-year)
average VaR? What accompanying narrative disclosure would help
investors best understand the significance of this information? Would
this disclosure be useful to supplement the VaR information that a fund
would be required to disclose on Form N-PORT under the proposal?
91. Should the rule permit a fund to compare its portfolio VaR to
its ``securities VaR'' for purposes of the rule's relative VaR test, as
provided for in the 2015 proposed rule, in addition to its designated
reference index? \208\ Why or why not? If the relative VaR test
permitted a fund to compare its porfolio's VaR against its designated
reference index or its ``securities VaR,'' would funds prefer to use
their ``securities VaRs''? If so, why? In what circumstances or what
fund strategies would ``securities VaR'' be a more or equally
appropriate baseline for funds calculating their relative VaR? What
benefits or drawbacks are there with respect to this approach? Please
explain.
---------------------------------------------------------------------------
\208\ See supra note 204 and accompanying text.
---------------------------------------------------------------------------
92. For a registered closed-end fund, is the proposed requirement
that it must disclose its designated reference index in its annual
report together with a presentation of the fund's performance
appropriate? Why or why not? What challenges, if any, would the
proposed disclosure requirement have for closed-end funds that do not
currently disclose their performance relative to a benchmark index in
their annual reports? Please explain.
[[Page 4474]]
93. For a registered closed-end fund, should we prescribe in rule
18f-4 or Form N-2 where in the fund's annual report it must disclose
its designated reference index? Why or why not?
94. What challenges, if any, would a BDC have in disclosing its
designated reference index together with its performance in the BDC's
annual report? Please explain.
95. Should we also amend Forms N-1A and/or N-2 to require a fund
relying on rule 18f-4 and subject to the relative VaR test to disclose
its performance relative to the performance of its designated reference
index? Would it be helpful to have this requirement both in rule 18f-4
and in the registration forms?
96. What changes should we make to the rule in light of the concern
that a fund could have an incentive to select an inappropriate
designated reference index to obtain more leverage risk? Is the
proposed requirement that the derivatives risk manager select the
designated reference index useful for this purpose? Is the proposed
requirement that the designated reference index be an appropriate
broad-based securities index or an additional index effective for this
purpose? Is the proposed requirement that the fund disclose the
designated reference index relative to its performance in the annual
report useful for this purpose? Is the proposed requirement that the
board of directors receive a written report from the derivatives risk
manager about the basis for the designated reference index subject to
periodic review useful for this purpose? Please explain.
b. 150% Limit Under Proposed Relative VaR Test
We are proposing that a fund's VaR must not exceed 150% of the VaR
of the fund's designated reference index.\209\ In proposing a 150%
limit, we first considered the extent to which a fund could borrow in
compliance with the requirements of section 18. For example, a mutual
fund with $100 in assets and no liabilities or senior securities
outstanding could borrow an additional $50 from a bank. With the
additional $50 in bank borrowings, the mutual fund could invest $150 in
securities based on $100 of net assets. This fund's VaR would be
approximately 150% of the VaR of the fund's designated reference index.
The proposed 150% limit would therefore effectively limit a fund's
leverage risk related to derivatives transactions similar to the way
that section 18 limits a registered open- or closed-end fund's ability
to borrow from a bank (or issue other senior securities representing
indebtedness for registered closed-end funds) subject to section 18's
300% asset coverage requirement. We recognize that while a fund could
achieve certain levels of market exposure through borrowings permitted
under section 18, it may be more efficient to obtain those exposures
through derivatives transactions. Allowing a fund to have a VaR that is
150% of its designated reference index, rather than a higher or lower
relative VaR, is designed to provide what we believe is an appropriate
degree of flexibility for funds to use derivatives.
---------------------------------------------------------------------------
\209\ See proposed rule 18f-4(a) (defining the term ``relative
VaR test'').
---------------------------------------------------------------------------
We considered proposing different relative VaR tests for different
types of investment companies, tied to the asset coverage requirements
applicable to registered open-end funds, registered closed-end funds,
and BDCs.\210\ Registered closed-end funds, like open-end funds, are
only permitted to issue senior securities representing indebtedness
under section 18 subject to a 300% asset coverage requirement, although
closed-end funds' indebtedness is not limited to bank borrowings.\211\
Using the example above, a registered closed-end fund with $100 in
assets likewise could only borrow $50. Although registered closed-end
funds also are permitted to issue senior securities that are
stocks,\212\ proposed rule 18f-4 is focused on the indebtedness
leverage that derivatives transactions create. We do not believe that a
registered closed-end fund's ability to issue preferred stock, for
example, suggests that registered closed-end funds should be permitted
to obtain additional indebtedness leverage through derivatives
transactions.
---------------------------------------------------------------------------
\210\ See supra notes 29-32 and accompanying paragraph
(discussing asset coverage requirements for different investment
company types).
\211\ See supra note 30 and accompanying text.
\212\ See supra note 31 and accompanying text.
---------------------------------------------------------------------------
The Investment Company Act also provides greater flexibility for
BDCs to issue senior securities. BDCs, however, generally do not use
derivatives or do so only to a limited extent. To help evaluate the
extent to which BDCs use derivatives, our staff sampled 48 of the
current 99 BDCs by reviewing their most recent financial statements
filed with the Commission. The staff's sample included both BDCs with
shares listed on an exchange and BDCs whose shares are not listed. The
sampled BDCs' net assets ranged from $32 million to $7.4 billion. Of
the 48 sampled, 54% did not report any derivatives holdings, and a
further 29% reported using derivatives with gross notional amounts
below 10% of net assets. A few BDCs used derivatives more extensively,
when measured on a gross notional basis, mainly due to interest rate
swaps--which likely would have lower adjusted notional amounts if they
were converted to ten-year bond equivalents, as the proposed rule would
permit.\213\ Finally, two of the sampled BDCs used total return swaps
to gain a substantial portion of their exposure. We therefore believe
that most BDCs either would not use derivatives or would rely on the
exception for limited derivatives users.\214\
---------------------------------------------------------------------------
\213\ Our staff did not have access to sufficient information to
adjust the notional amounts of the BDCs' interest rate derivatives
or options. Some of the 17% of the sampled BDCs with gross notional
amounts exceeding 10% of net assets likely would have lower notional
amounts after applying these adjustments.
\214\ See infra section II.E (discussing the proposed exception
for limited derivatives users).
---------------------------------------------------------------------------
In addition, the greater flexibility for BDCs to issue senior
securities allows them to provide additional equity or debt financing
to the ``eligible portfolio companies'' in which BDCs are required to
invest at least 70% of their total assets. Derivatives transactions, in
contrast, generally will not have similar capital formation benefits
for portfolio companies unless the fund's counterparty makes an
investment in the underlying reference assets equal to the notional
amount of the derivatives transaction. Allowing BDCs to leverage their
portfolios with derivatives to a greater extent than other funds
therefore would not appear to further the capital formation benefits
that underlie BDCs' ability to obtain additional leverage under the
Investment Company Act. We also understand that, even when BDCs do use
derivatives more extensively, derivatives generally do not play as
significant of a role in implementing the BDC's strategy, as compared
to many other types of funds that use derivatives extensively. BDCs are
required under the Investment Company Act to invest at least 70% of
their total assets in ``eligible portfolio companies,'' which may limit
the role that derivatives can play in a BDC's portfolio relative to
other kinds of funds that would generally execute their strategies
primarily through derivatives transactions (e.g., a managed futures
fund). For these reasons, and to provide a consistent framework
regarding funds' use of derivatives, we believe that it is appropriate
to set a single limit on fund leverage risk under the proposed rule for
derivatives transactions. The proposed rule would not restrict a fund
from issuing senior securities subject to the limits in section 18 to
the full extent
[[Page 4475]]
permitted by the Investment Company Act.\215\
---------------------------------------------------------------------------
\215\ For purposes of calculating asset coverage, as defined in
section 18(h), BDCs have used derivatives transactions' notional
amounts, less any posted cash collateral, as the ``amount of senior
securities representing indebtedness'' associated with the
transactions. We believe this approach--and not the transactions'
market values--represents the ``amount of senior securities
representing indebtedness'' for purposes of this calculation. Open-
end funds cannot enter into derivatives transactions under section
18, absent relief from that section's requirements, because section
18 limits open-end funds' senior securities to bank borrowings.
Section 18(c) also limits a registered closed-end fund's ability to
enter into derivatives transactions absent such relief.
---------------------------------------------------------------------------
We request comment on the following aspects of the proposed
relative VaR test.
97. Is the proposed relative VaR test requirement appropriate? Why
or why not? As proposed, should funds be required to comply with a
relative VaR test, rather than an absolute VaR test, except where a
designated reference index is unavailable?
98. Should the limit in the proposed relative VaR test be lower or
higher than 150% of the VaR of the designated reference index, and if
so why? For example, the relative VaR test applicable to UCITS funds
allows a UCITS fund to have a relative VaR up to 200% of the VaR of the
relevant index.\216\ Should rule 18f-4 similarly permit a fund to have
a VaR up to 200% of the VaR of its designated reference index? If so,
how should the rule incorporate investor protection provisions
consistent with section 18? Conversely, should the relative VaR test be
set at a lower level, such as 125% of the VaR of the designated
reference index? If so, why?
---------------------------------------------------------------------------
\216\ See infra section II.D.6.c (discussing the UCITS
framework); see also ICI Comment Letter III (suggesting that a
Commission rule limiting the use of derivatives by registered
investment companies allow funds to use either ex ante stress
testing or UCITS VaR for that purpose).
---------------------------------------------------------------------------
99. Should the proposed relative VaR test incorporate different
leverage limit levels according to fund type and corresponding to the
asset coverage requirements under the Investment Company Act? Why or
why not and how?
100. Are there any challenges in calculating the VaR of the
designated reference index? If so, would certain types of funds
particularly encounter these challenges, and if so which ones? How
should we address any challenges?
101. Are there any fund-type specific challenges to open-end funds,
registered closed-end funds, or BDCs complying with the VaR-based limit
on fund leverage risk? For example, would registered closed-end funds
or BDCs encounter any unique challenges in calculating VaR because of
the nature of their investments? If so, what kinds of challenges and
how should we address them? Please also explain specifically the nature
of any challenges given that a number of financial institutions such as
banks and UCITS funds calculate VaR for regulatory purposes, and these
institutions' portfolios hold a wide range of assets.
3. Absolute VaR Test
We recognize that, for some funds, the derivatives risk manager may
be unable to identify an appropriate designated reference index. For
example, some multi-strategy funds manage their portfolios based on
target volatilities but implement a variety of investment strategies,
making it difficult to identify a single index (even a blended index)
that would be appropriate. If a derivatives risk manager is unable to
identify an appropriate designated reference index, a fund relying on
the proposed rule would be required to comply with the absolute VaR
test.\217\
---------------------------------------------------------------------------
\217\ See supra note 173 and accompanying text (discussing the
proposed requirement for the fund's derivatives risk manager to
provide written reports to the fund's board of directors that must
include, among other things, the derivatives risk manager's basis
for the selection of the designated reference index or, if
applicable, an explanation of why the derivatives risk manager was
unable to identify a designated reference index appropriate for the
fund); infra notes 425-426 and accompanying text (discussing
proposed recordkeeping requirements for such written reports
provided to the fund's board).
---------------------------------------------------------------------------
To comply with the proposed absolute VaR test, the VaR of the
fund's portfolio must not exceed 15% of the value of the fund's net
assets. In proposing an absolute VaR test of 15% of a fund's net
assets, we considered the comparison of a fund complying with the
absolute VaR test and a fund complying with the relative VaR test. A
fund that uses the S&P 500 as its benchmark index, as many funds do,
would be permitted to have a VaR equal to 150% of the VaR of the S&P
500 if the fund also used that index as its designated reference index.
The Division of Economic and Risk Analysis (``DERA'') staff calculated
the VaR of the S&P 500, using the parameters specified in this proposed
rule over various time periods. DERA staff's calculation of the S&P
500's VaR since inception, for example, produced a mean VaR of
approximately 10.4%, although the VaR of the S&P 500 varied over
time.\218\ Setting the level of loss in the proposed absolute VaR test
at 15% of a fund's net assets would therefore provide approximately
comparable treatment for funds that rely on the absolute VaR test and
funds that rely on the relative VaR test and use the S&P 500 as their
designated reference index during periods where the S&P 500's VaR is
approximately equal to the historical mean.
---------------------------------------------------------------------------
\218\ DERA staff calculated descriptive statistics for the VaR
of the S&P 500 using Morningstar data from March 4, 1957 to June 28,
2019, based on daily VaR calculations, each using three years of
prior return data and calculated using historical simulation at a
99% confidence level for a 20-day horizon using overlapping
observations.
---------------------------------------------------------------------------
DERA staff analyzed the S&P 500 because funds often select broad-
based large capitalization equities indexes such as the S&P 500 for
performance comparison purposes, including funds that are not broad-
based large capitalization equity funds.\219\ Many investors may
therefore understand the risk inherent in these indexes as the level of
risk inherent in the markets generally.\220\ An absolute VaR test set
to approximate, or not substantially exceed, this level of risk would
therefore often approximate the level of risk that investors may
understand, and frequently choose to undertake, through investments in
funds. We are proposing a single absolute VaR limit that would apply to
open-end funds and registered closed-end funds and BDCs for the same
reasons we are proposing that all funds relying on the relative VaR
test must limit their VaR to 150% of the VaR of their designated
reference index.\221\
---------------------------------------------------------------------------
\219\ This is based on staff experience and analysis of data
obtained from Morningstar.
\220\ Some commenters to the 2015 proposal also expressed the
view that the S&P 500 Index is an appropriate risk-based reference
point because it is widely used with a risk profile that is well
understood and commonly acceptable to investors. See, e.g., AQR
Comment Letter; Comment Letter of Millburn Ridgefield Corporation
(Mar. 28, 2016).
\221\ See supra section II.D.2.b.
---------------------------------------------------------------------------
The proposed absolute VaR test is also broadly consistent with the
European Union regulatory framework that that applies to UCITS
funds.\222\ Advisers that manage (or have affiliates that manage) UCITS
funds may derive some efficiencies from reasonably comparable
requirements across jurisdictions.\223\ Commenters to the 2015 proposal
also generally supported an absolute VaR test.\224\
---------------------------------------------------------------------------
\222\ See CESR Global Guidelines, supra note 94, at 26. The
absolute VaR test for UCITS funds is similar to the proposed
absolute VaR test in rule 18f-4, although it sets a 20% limit for
UCITS funds, rather than 15% as we propose in rule 18f-4.
\223\ See, e.g., ICI Comment Letter III (stating that, in
response to the Investment Company Institute's survey, ``45 percent
of respondents indicated that it would be only slightly burdensome
to implement a UCITS VaR test that used the same parameters as
prescribed for UCITS. An additional 34 percent reported that it
would be moderately burdensome.'').
\224\ See, e.g., ICI Comment Letter I; Franklin Resources
Comment Letter; SIFMA Comment Letter; Comment Letter of T. Rowe
Price Associates, Inc. (Mar. 28, 2016) (``T. Rowe Price Comment
Letter'').
---------------------------------------------------------------------------
[[Page 4476]]
We request comment on the proposed absolute VaR test requirement.
102. Is the proposed absolute VaR test requirement appropriate? Are
we correct that in some cases a fund's derivatives risk manager may be
unable to identify an appropriate designated reference index? Why or
why not? What are examples of funds that would likely use the absolute
VaR test because a derivatives risk manager would be unable to identify
an appropriate designated reference index? Is it appropriate for these
funds to use an absolute VaR test? Why or why not?
103. Should we provide additional guidance on the circumstances
under which a fund's derivatives risk manager would be ``unable'' to
identify an appropriate index? If so, what guidance should we provide?
Should the rule include a different standard than the inability to
identify a designated reference index for funds to be able to use the
absolute VaR test instead of the relative VaR test? If so, what
standard and why? For example, should we identify certain types of fund
strategies that may not typically have appropriate reference indexes or
for which absolute VaR would otherwise be appropriate? If so, which
fund strategies, and how would we keep any list of fund strategies
current over time?
104. Should the proposed absolute VaR test include a limit other
than 15% of the fund's net assets? Please explain. For example, should
it be 12, 18, 20, or 25%? If so, which limit, and why? Would funds
using the absolute VaR test manage their VaRs to a certain amount below
the limit the Commission sets? If so, to what extent and should we take
this into account in determining the appropriate limit under this test?
Should we look to different market data in determining an appropriate
level of absolute VaR? Which other sources, and why would they be
appropriate?
105. For funds that use an absolute VaR test as part of their risk
management practices, do risk managers set internal absolute VaR
limits, and if so, at what level and why? For funds that currently use
both absolute VaR and relative VaR, are the internal limits set at
comparable levels? Why or why not? Please describe each internal level
set with respect to these two VaR tests. Do certain fund types or
strategies more commonly use either absolute VaR or relative VaR for
risk management purposes? If so, why?
106. Should the rule include both a relative and absolute VaR test,
as proposed, or should it include only a relative VaR test or an
absolute VaR test? Why, and which test should the rule include? Should
it use a different VaR-based test? If so, which one?
107. Should the rule permit funds to choose which VaR test to
comply with regardless of the derivatives risk manager's ability or
inability to identify a designated reference index? If so, would this
be consistent with investor expectations and section 18?
4. Choice of Model and Parameters for VaR Test
The proposed rule would require that any VaR model a fund uses for
purposes of the relative or absolute VaR test take into account and
incorporate all significant, identifiable market risk factors
associated with a fund's investments.\225\ The proposed rule includes a
non-exhaustive list of common market risk factors that a fund must
account for in its VaR model, if applicable. These market risk factors
are: (1) Equity price risk, interest rate risk, credit spread risk,
foreign currency risk and commodity price risk; (2) material risks
arising from the nonlinear price characteristics of a fund's
investments, including options and positions with embedded optionality;
and (3) the sensitivity of the market value of the fund's investments
to changes in volatility.\226\ VaR models are often categorized
according to three modeling methods--historical simulation, Monte Carlo
simulation, or parametric models.\227\ Each method has certain benefits
and drawbacks, which may make a particular method more or less
suitable, depending on a fund's strategy, investments and other
factors. In particular, some VaR methodologies may not adequately
incorporate all of the material risks inherent in particular
investments, or all material risks arising from the nonlinear price
characteristics of certain derivatives.\228\ We believe it should be
the responsibility of the derivatives risk manager to choose the
appropriate VaR model for the fund's portfolio, and the proposed
requirement is designed to allow funds to use a VaR model that is
appropriate for the fund's investments. Commenters that addressed the
same proposed requirement for VaR models in the 2015 proposal generally
supported it.\229\
---------------------------------------------------------------------------
\225\ See proposed rule 18f-4(a) (defining the term ``value-at-
risk'' or ``VaR'').
\226\ See id.
\227\ Historical simulation models rely on past observed
historical returns to estimate VaR. Historical VaR involves taking a
fund's current portfolio, subjecting it to changes in the relevant
market risk factors observed over a prior historical period, and
constructing a distribution of hypothetical profits and losses. The
resulting VaR is then determined by looking at the largest (100
minus the confidence level) percent of losses in the resulting
distribution.
Monte Carlo simulation uses a random number generator to produce
a large number (often tens of thousands) of hypothetical changes in
market values that simulate changes in market factors. These outputs
are then used to construct a distribution of hypothetical profits
and losses on the fund's current portfolio, from which the resulting
VaR is ascertained by looking at the largest (100 minus the
confidence level) percent of losses in the resulting distribution.
Parametric methods for calculating VaR rely on estimates of key
parameters (such as the mean returns, standard deviations of
returns, and correlations among the returns of the instruments in a
fund's portfolio) to create a hypothetical statistical distribution
of returns for a fund, and use statistical methods to calculate VaR
at a given confidence level.
See, e.g., Dowd, supra note 177; see also Thomas J. Linsmeier &
Neil D. Pearson, Value at Risk, 56 Journal of Financial Analysts 2
(Mar.-Apr. 2000) (``Linsmeier & Pearson'').
\228\ For example, some parametric methodologies may be more
likely to yield misleading VaR estimates for assets or portfolios
that exhibit non-linear returns, due, for example, to the presence
of options or instruments that have embedded optionality (such as
callable or convertible bonds). See, e.g., Linsmeier & Pearson,
supra note 226 (stating that historical and Monte Carlo simulation
``work well regardless of the presence of options and option-like
instruments in the portfolio. In contrast, the standard [parametric]
delta-normal method works well for instruments and portfolios with
little option content but not as well as the two simulation methods
when options and option-like instruments are significant in the
portfolio.'').
\229\ See, e.g., Oppenheimer Comment Letter; CFA Comment Letter.
---------------------------------------------------------------------------
The proposed rule also requires that a fund's VaR model use a 99%
confidence level and a time horizon of 20 trading days.\230\ We
understand that market participants currently using VaR most commonly
use 95% or 99% confidence levels and often use time horizons of 10 or
20 days. The proposed confidence level and time horizon requirements
also are similar to those in other VaR-based regulatory schemes.\231\
[[Page 4477]]
VaR models that use relatively high confidence levels and longer time
horizons--as the proposed rule parameters reflect--result in a focus on
more-``extreme'' but less-frequent losses. We propose relatively high
confidence level and longer time horizon requirements so that the VaR
model is designed to measure, and seek to limit the severity of, these
less-frequent but larger losses. This is because a fund's VaR model
would be based on a distribution of returns, where a higher confidence
level would go further into the tail of the distribution (i.e., more-
``extreme'' but less-frequent losses) and a longer time horizon would
result in larger losses in the distribution (i.e., losses have the
potential to be larger over twenty days when compared, for example, to
over one day).
---------------------------------------------------------------------------
\230\ See proposed rule 18f-4(a) (defining the term ``value-at-
risk'' or ``VaR'').
We recognize that many market participants today also may
calculate VaR over a one-day time horizon. See also supra section
II.B.3.d (the proposed rule would require calculating a fund's one-
day VaR as part of the proposed backtesting requirement). A VaR
calculation based on a one-day time horizon can be scaled to a 20-
day time horizon. For example, a common VaR model time-scaling
technique is to multiply the one-day VaR by the square root of the
designated time period (i.e., for the proposed rule it would be the
square root of 20). But for funds with returns that are not
identically and independently normally distributed, simple time-
scaling techniques may be inaccurate. If this inaccuracy results in
meaningful underestimation of VaR, this simple time-scaling
technique would be inappropriate.
\231\ See, e.g., CESR Global Guidelines, supra note 94
(providing default VaR calculation standards that require funds that
use the relative VaR or absolute VaR approach to calculate VaR using
a ``one-tailed confidence interval of 99%''); rule 15c3-1e under the
Exchange Act [17 CFR 240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1)
(requiring VaR models to use ``a 99 percent, one-tailed confidence
level with price changes equivalent to a ten business-day movement
in rates and prices''). See also the Basel Committee on Banking
Supervision, Amendment To The Capital Accord To Incorporate Market
Risks (Jan. 1996), available at https://www.bis.org/publ/bcbs24.pdf
(contemplating banks' use of internal models for measuring market
risk based on a 10-day time horizon); CESR Global Guidelines, supra
note 94 (specifying generally a 20-day time horizon as a
quantitative requirement when calculating VaR for risk measurement
and the calculation of global exposure and counterparty risk for
UCITS).
---------------------------------------------------------------------------
In proposing a higher confidence level and longer time horizon, we
considered whether this would result in a VaR model based on fewer data
points in comparison to lower confidence levels and shorter time
horizons. However, we understand that a longer trading day horizon only
results in reduced data points if the fund uses historical simulation
and measures historical losses using non-overlapping periods, which our
proposal would not require. For example, a fund measuring non-
overlapping twenty-day periods, assuming 250 trading days in a year,
would expect approximately 12 or 13 data points (250 trading days/20-
day time horizons). But if the fund measured the twenty-day periods on
a rolling and overlapping basis, it could expect as many as 250 data
points where each data point captures the return over the trailing 20
trading days. A fund could use either a non-overlapping or overlapping
approach under the proposed rule.
The 2015 proposal similarly specified the particular confidence
level and time horizon parameters that funds would use in their VaR
models for purposes of the proposed risk-based portfolio limit. These
parameters were a 99% confidence level and a time horizon range of not
less than 10 and not more than 20 trading days.\232\ Comments were
mixed but generally supported a confidence level in the range of 95% to
99%.\233\ Rather than a time horizon range providing funds discretion
to select the number of trading days for which to compute their VaR
models, some commenters suggested that the rule should specify a
particular number of days.\234\ Because our proposal, unlike the 2015
proposal, includes an absolute VaR test, our proposed VaR model
parameters reflect commenter suggestions by proposing a confidence
level within the generally supported range and proposing a specific VaR
model time horizon rather than a range of permissible time horizons.
---------------------------------------------------------------------------
\232\ 2015 Proposing Release, supra note 2, at section
III.B.2.b.
\233\ See, e.g., AQR Comment Letter; ICI Comment Letter II.
\234\ See, e.g., Morningstar Comment Letter; AIMA Comment
Letter; AQR Comment Letter; ICI Comment Letter II.
---------------------------------------------------------------------------
In addition to specifying the confidence level and time horizon
that a fund's VaR model would use, we are also proposing that the
fund's chosen VaR model must be based on at least three years of
historical market data. We understand that the availability of data is
a key consideration when calculating VaR, and that the length of the
data observation period may significantly influence the results of a
VaR calculation. For example, a shorter observation period means that
each observation will have a greater influence on the result of the VaR
calculation (as compared to a longer observation period), such that
periods of unusually high or low volatility could result in unusually
high or low VaR estimates.\235\ Longer observation periods, however,
can lead to data collection problems, if sufficient historical data is
not available.\236\ We believe requiring a fund's chosen VaR model to
be based on at least three years of historical market data strikes an
appropriate balance.
---------------------------------------------------------------------------
\235\ See Linsmeier & Pearson, supra note 226 (stating that,
because historical simulation relies directly on historical data, a
danger is that the price and rate changes in the last 100 (or 500 or
1,000) days might not be typical. For example, if by chance the last
100 days were a period of low volatility in market rates and prices,
the VAR computed through historical simulation would understate the
risk in the portfolio).
\236\ See Dowd, supra note 177 (stating that ``[a] long sample
period can lead to data collection problems. This is a particular
concern with new or emerging market instruments, where long runs of
historical data don't exist and are not necessarily easy to
proxy'').
---------------------------------------------------------------------------
The proposed historical market data requirement would permit a fund
to base its VaR estimates on a meaningful number of observations, while
also recognizing the concern that requiring a longer historical period
could make it difficult for a fund to obtain sufficient historical data
to estimate VaR for the instruments in its portfolio.\237\ The 2015
proposal would have required three years of market data for funds using
historical simulation (but did not require three years of market data
for VaR models based on Monte Carlo simulation or parametric
methods).\238\ A number of commenters supported our approach in the
2015 proposal to require three years of market data for funds using
historical simulation.\239\ However, some commenters suggested that the
rule should require a longer period of historical market data.\240\ As
discussed above, we believe that three years strikes an appropriate
balance. We also are proposing to require funds to use three years of
market data for all VaR calculations under the proposed rule--rather
than only historical simulation as in the 2015 proposal. We believe
this is appropriate because all methods for calculating VaR--not just
historical simulation--rely on historical data.
---------------------------------------------------------------------------
\237\ See Michael Minnich, Perspectives On Interest Rate Risk
Management For Money Managers And Traders (Frank Fabozzi, ed.)
(1998) (stating that for historical simulation, ``[l]onger periods
of data have a richer return distribution while shorter periods
allow the VAR to react more quickly to changing market events'' and
that ``[t]hree to five years of historical data are typical''); see
also Darryll Hendricks, Evaluation of Value-at-Risk Models Using
Historical Data, FRBNY Economic Policy Review (Apr. 1996) (finding
that, when using historical VaR, ``[e]xtreme [confidence level]
percentiles such as the 95th and particularly the 99th are very
difficult to estimate accurately with small samples'' and that the
complete dependence of historical VaR models on historical
observation data ``to estimate these percentiles directly is one
rationale for using long observation periods'').
\238\ See 2015 Proposing Release, supra note 2, at section
III.B.2.b; see also supra note 177 (discussing historical
simulation, Monte Carlo simulation, and parametric methods).
\239\ See, e.g., Comment Letter of Abbey Capital (Mar. 28,
2016); AIMA Comment Letter; Comment Letter of Aspect Capital Limited
(Mar. 28, 2016); Comment Letter of Intercontinental Exchange (Apr.
15, 2016).
\240\ See, e.g., materials attached to the memorandum included
in the comment file concerning a meeting between representatives of
AlphaSimplex Group LLC and members of the staff of the Division of
Investment Management (July 8, 2016); AQR Comment Letter.
---------------------------------------------------------------------------
Unlike the 2015 proposal, the proposed rule does not require a fund
to apply its VaR model consistently (i.e., the same VaR model applied
in the same way) when calculating the VaR of its portfolio and the VaR
of its designated reference index.\241\ The proposed rule would,
however, require that VaR calculations comply with the same proposed
VaR definition and its specified model requirements.\242\ Our proposal
does not include the 2015
[[Page 4478]]
proposal's model consistency requirement because if the proposed rule
required funds to apply the same VaR model to its portfolio and the
designated reference index, it could prevent funds from using less-
costly approaches. For example, under the proposed approach, in many
cases a fund could calculate the VaR of a designated reference index
based on the index levels over time without having to obtain access to
more-detailed information about the index constituents. A fund also
would have the flexibility to obtain the VaR from a third-party vendor
instead of analyzing it in-house. A model consistency requirement could
preclude these approaches, however, because a fund might not be able
apply the same approach to its portfolio. For example, if a fund
invested significantly in options, it generally would not be
appropriate to use certain parametric VaR models.\243\ The fund might
instead use Monte Carlo simulation, which is more computationally
intensive and takes more time to perform. A model consistency
requirement would require the fund to apply the same Monte Carlo
simulation model to its unleveraged designated reference index, for
which a parametric or other simpler and less costly VaR model might be
appropriate.
---------------------------------------------------------------------------
\241\ See 2015 Proposing Release, supra note 2, at section
III.B.2.b.
\242\ See infra section II.D.4 (discussing the proposed VaR
model requirements).
\243\ See supra note 227 (explaining that some parametric
methodologies may be more likely to yield misleading VaR estimates
for assets or portfolios that exhibit non-linear returns, due, for
example, to the presence of options or instruments that have
embedded optionality).
---------------------------------------------------------------------------
Although requiring a fund to apply the same VaR model to its
portfolio and the designated reference index could result in a more
precise comparison of the two values, we do not believe that the
additional precision is necessary for the relative VaR test to identify
where funds' use of derivatives is more likely to raise the concerns
underlying section 18 because the proposed rule would provide certain
common parameters for all VaR calculations under the rule. Because a
fund's designated reference index must be unleveraged, we believe it is
generally unlikely that different VaR models calibrated to these common
parameters would produce substantially different results for a fund's
designated reference index. Additionally, the derivatives risk manager
would be responsible for administering and maintaining the derivatives
risk management program, which includes the integrity of the VaR test.
On balance, we believe the proposed approach would not materially
diminish the efficacy of the proposed relative VaR test while
permitting less-costly approaches for funds.
We request comment on the proposed requirements regarding a fund's
choice of VaR model, and the required parameters for a VaR model that
funds would use under the proposed rule.
108. Should the rule specify a particular VaR model(s) that funds
must use (i.e., a historical simulation, Monte Carlo simulation, or
parametric methodology)? If so, which methodology (or methodologies)
and why?
109. Is the proposed requirement that a fund's VaR model
incorporate all significant, identifiable market risk factors
associated with a fund's investments appropriate? Why or why not?
110. The proposed rule would provide a non-exhaustive list of risk
factors that may be relevant in light of a fund's strategy and
investments. Should the final rule include this non-exhaustive list of
risk factors? Are risk factors included in the proposed list
appropriate? Should we include any additional risk factors to this
list? If so, which ones and why?
111. The proposed rule would require a fund to use a 99% confidence
level for its VaR model. Is the proposed confidence level appropriate?
Should the rule include a different confidence level? If so, which
level and why, and if not, why not?
112. The proposed rule would require a fund to use a time horizon
of 20 trading days for its VaR model. Is the proposed time horizon
appropriate? Should the rule include a different time horizon? If so,
which time horizon and why, and if not, why not?
113. The proposed rule would require a fund to use at least three
years of historical market data for its VaR model. Is the historical
market data requirement appropriate? Should the rule set forth a
different length of time for requiring historical market data? Should
the requirement be limited to funds using historical simulation? Would
funds experience challenges in identifying sufficient data for
particular types of investments? If so, which types of investments and
how should the rule address these challenges? Please explain.
114. The proposed rule does not include any requirement for third-
party validation of a fund's chosen VaR model, either at inception or
upon material changes, to confirm that the model is structurally sound
and adequately captures all material risks.\244\ Should we require
third-party validation? Why or why not?
---------------------------------------------------------------------------
\244\ The Global Exposure Guidelines applicable to UCITS'
requires such validation. See CESR Global Guidelines, supra note 94.
---------------------------------------------------------------------------
115. Should the rule require a fund's board to approve the VaR
model and any material changes to the model? Why or why not?
116. Should the final rule also include a requirement that a fund
that uses the relative VaR test apply the same VaR model when
calculating the fund's portfolio and the VaR of the designated
reference portfolio? Would the requirement to apply the same VaR model
to the fund's portfolio and the designated reference portfolio address
any concerns that funds could inappropriately manipulate the results of
VaR testing under the proposed rule's requirements? What additional
cost, if any, would such a requirement impose on funds? Are there other
ways that we could prevent such manipulations? To what extent would
this requirement promote additional precision in the relative VaR test
and would any additional precision increase the efficacy of the test in
limiting fund leverage risk? Please explain.
5. Implementation
a. Testing Frequency
The proposed rule would require a fund to determine its compliance
with the applicable VaR test at least once each business day.\245\
Although we believe that funds would calculate their VaRs at a
consistent time each day, which would generally be either in the
mornings before markets open or in the evenings after markets close, we
do not propose to require one at the exclusion of the other, to allow
funds to conduct their VaR tests at the time that is most efficient
based on each fund's facts and circumstances. We considered proposing
that funds determine compliance with the proposed VaR test at the time
of, or immediately after, entering into a derivatives transaction. We
recognize, however, that conducting a VaR test on a trade-by-trade
basis could present operational challenges for some funds and could
limit the fund's choice of VaR modeling. For example, we believe that
most funds would be unable to perform computationally-intensive Monte
Carlo simulations so frequently based on computing resources and
compliance costs. Requiring this VaR calculation each day, in contrast,
would provide funds flexibility to use VaR models they believe to be
appropriate while also providing for fairly frequent calculations. The
2015 proposal included a testing frequency of
[[Page 4479]]
immediately after entering into any senior securities transactions, but
many commenters raised concerns about operational complexity related to
transaction-by-transaction testing, and instead generally suggested a
daily testing frequency.\246\
---------------------------------------------------------------------------
\245\ Proposed rule 18f-4(c)(2)(ii).
\246\ See, e.g., ICI Comment Letter I; Franklin Resources
Comment Letter; SIFMA Comment Letter; AIMA Comment Letter; BlackRock
Comment Letter.
---------------------------------------------------------------------------
We believe that determining compliance with the VaR test less
frequently than each business day would not be consistent with the
purpose of a condition to limit fund leverage risk. Section 18 sets
forth certain fund leverage risk protections that are fundamental to
protecting investors. If this testing requirement were less frequent
than each business day, then a fund could satisfy the condition only on
business days requiring a VaR test and modify its trading strategy to
circumvent the purpose of the test on other business days.
Additionally, we believe that testing each business day is appropriate
in light of the potential for market risk factors associated with a
fund's investments to change quickly.
We request comment on the proposed frequency of conducting the
relative or absolute VaR test.
117. Is the proposed required frequency for conducting the VaR test
appropriate? Should the rule require a fund to conduct the required VaR
test more frequently or less frequently, such as--respectively--either
before or after each transaction, multiple times throughout the day, or
on a weekly basis? Why or why not? Should the required frequency vary
depending on fund type or whether the fund is conducting an absolute
VaR test or relative VaR test? Please explain.
118. Should the rule require funds to conduct the test at the same
time each day? If so, why? What compliance or operational challenges,
if any, would funds have to conduct the test at the same time each day?
Would the absence of such a requirement allow funds to ``game'' the
test?
b. Remediation
If a fund determines that it is not in compliance with the
applicable proposed VaR test, then under our proposal a fund must come
back into compliance promptly and within no more than three business
days after such determination.\247\ If the fund is not in compliance
within three business days, then: (1) The derivatives risk manager must
report to the fund's board of directors and explain how and by when
(i.e., the number of business days) the derivatives risk manager
reasonably expects that the fund will come back into compliance; (2)
the derivatives risk manager must analyze the circumstances that caused
the fund to be out of compliance for more than three business days and
update any program elements as appropriate to address those
circumstances; and (3) the fund may not enter into derivatives
transactions (other than derivatives transactions that, individually or
in the aggregate, are designed to reduce the fund's VaR) until the fund
has been back in compliance with the applicable VaR test for three
consecutive business days and satisfied the board reporting requirement
and program analysis and update requirements.\248\
---------------------------------------------------------------------------
\247\ See proposed rule 18f-4(c)(2)(ii).
\248\ See proposed rule 18f-4(c)(2)(iii); see also infra section
II.H.2 (discussing the proposed requirement to submit a confidential
report to the Commission if the fund is out of compliance with the
applicable proposed VaR test for three business days).
---------------------------------------------------------------------------
The proposed three-business-day remediation provision is designed
to provide funds with some flexibility in coming back into compliance
with the applicable proposed VaR tests. It reflects our view that it
would be inappropriate for a fund to purposefully exceed the VaR-based
limit on fund leverage risk, but allows funds to take reasonable steps
to come back into compliance without harming fund investors. The three-
business-day period is designed to provide an appropriate time period
to permit remediation efforts because it balances investor protections
related to fund leverage risk and potential harm to a fund if it were
required to sell assets or unwind transactions even more quickly. This
remediation approach is similar to the remediation approach that
section 18 of the Investment Company Act provides for asset coverage
compliance with respect to bank borrowings, which also includes a
three-day period to come back into compliance.\249\
---------------------------------------------------------------------------
\249\ Section 18(f)(1) of the Investment Company Act.
---------------------------------------------------------------------------
If the fund does not come back into compliance within three
business days, the proposed rule would not require the fund to exit its
derivatives transactions or make other portfolio adjustments.\250\
Although a fund remaining out of compliance with the applicable VaR
test raises investor protection concerns related to fund leverage risk,
if the proposed rule were to force a fund to exit derivatives
transactions immediately at the end of the three-day period, this could
harm investors, for example, by requiring the fund to realize trading
losses that could have been avoided under a more-flexible approach. The
proposed remediation provision reflects the balancing of these multiple
investor protection concerns.
---------------------------------------------------------------------------
\250\ Under the proposed rule, a fund that is not in compliance
within three business days also would be required to file a report
to the Commission on proposed Form N-RN. See proposed rule 18f-
4(c)(7); infra section II.H.2.
---------------------------------------------------------------------------
Instead of requiring a fund to come back into compliance under
these circumstances immediately, the fund must satisfy three
requirements before it can enter into derivatives transactions other
than those designed to reduce the fund's VaR. First, the derivatives
risk manager must report to the fund's board of directors and explain
how and by when (i.e., the number of business days) the derivatives
risk manager reasonably expects that the fund will come back into
compliance.\251\ This requirement is designed to facilitate the fund
coming back into compliance promptly by requiring the derivatives risk
manager to develop a specific course of action to come back into
compliance and to facilitate the board's oversight by requiring the
derivatives risk manager to report this information to the board.
---------------------------------------------------------------------------
\251\ Proposed rule 18f-4(c)(2)(iii)(A).
---------------------------------------------------------------------------
Second, the derivatives risk manager must analyze the circumstances
that caused the fund to be out of compliance for more than three
business days and update any program elements as appropriate to address
those circumstances.\252\ That the fund was unable to come back into
compliance with the applicable VaR test within three business days may
suggest there are deficiencies in the fund's program. This requires the
derivatives risk manager to analyze and update any program elements as
appropriate before the fund is able to enter into derivatives
transactions other than those designed to reduce VaR.
---------------------------------------------------------------------------
\252\ Proposed rule 18f-4(c)(2)(iii)(B).
---------------------------------------------------------------------------
Finally, a fund may not enter into derivatives transactions (other
than those designed to reduce the fund's VaR) until the fund has been
back in compliance with the applicable VaR test for at least three
consecutive business days and has satisfied the applicable board
reporting and program analysis and update requirements.\253\ If the
proposed rule were to permit a fund that is out of compliance with the
limit on fund leverage risk to comply for just one day before entering
into derivatives transactions that would increase the fund's market
risk, this could potentially lead to some funds having persistently
high levels of leverage risk
[[Page 4480]]
beyond that permitted by the applicable VaR test.
---------------------------------------------------------------------------
\253\ Proposed rule 18f-4(c)(2)(iii)(C).
---------------------------------------------------------------------------
We request comment on the proposed remediation requirement for a
fund that is out of compliance with the applicable VaR test.
119. Is the proposed three-business-day remediation provision
appropriate? Could such a limited remediation period exacerbate fund or
market instability and harm investors? Should the rule require a longer
or shorter period, such as one or seven days? Why or why not, and if
so, what should the alternative remediation period be? In light of the
balancing of investor protection concerns (fund compliance with the
VaR-based limit on fund leverage risk and not forcing asset sales or
unwinding transactions to comply), is there a more-effective means to
structure a remediation provision that balances these concerns? If so,
how?
120. Should we change the rule's remediation provision to include
an escalating provision that requires longer periods of compliance
based on the number of three-day (or more) periods that a fund has been
out of compliance? If so, how should we structure such a provision?
121. Should we change the rule to factor in the aggregate number of
days in a trailing year that a fund has been out of compliance? What
additional remediation consequences should a fund address before
entering into derivatives transactions (other than those designed to
reduce the fund's VaR)? Please explain.
122. Should the remediation provision provide further or different
limitations for a fund that continuously goes in and out of compliance
with its VaR test? For example, should the rule provide that such a
fund is not permitted to rely on the proposed rule indefinitely or for
a set period of time? How should a rule define ``continuously going in
and out of compliance''? Should such a fund be subject to a lower VaR
requirement? If so, what level of VaR and why? How long should the fund
remain subject to any lower VaR requirement? Should the fund be subject
to limits on its derivatives exposure?
123. Should the remediation provision, as proposed, require the
derivatives risk manager to report to the fund's board of directors
that the fund has been out of compliance with the VaR-based limit for
more than three consecutive business days? Why or why not? Should the
derivatives risk manager be required to explain how the fund will come
back into compliance promptly and by when? Should we change the rule to
require such a fund to take certain specific actions? Should we change
the rule to require fund compliance within a specific time period? If
so, how should we change the rule and why?
124. Should the remediation provision, as proposed, require the
derivatives risk manager to analyze the circumstances for the fund
being out of compliance for more than three business days? Should we
change the rule to require specific program updates? Should we change
the rule to require a complete program review and update? What
challenges would such a remediation requirement impose on funds? What
are the benefits of specifying program updates? Under what
circumstances, if any, would a fund be out of compliance for more than
three business days and not have risk management program elements to
update? Please explain.
6. Other Regulatory Approaches To Limiting Fund Leverage Risk
a. Stress Testing
In addition to our proposal to require stress testing as a
derivatives risk management program element, we considered a stress
testing requirement as a means to limit fund leverage risk in lieu of,
or in addition to, the proposed VaR tests. We understand that many
funds that use derivatives transactions already conduct stress tests
for purposes of risk management.\254\
---------------------------------------------------------------------------
\254\ See, e.g., ICI Comment Letter III. While we do not propose
to require stress testing as a means for limiting a fund's leverage
risk, as discussed above, one element of the proposed program
requires stress testing for risk management purposes. See supra
section II.B.3.c.
---------------------------------------------------------------------------
For example, we considered proposing a single-factor stress test
requirement that would enumerate a limited number of shocks,
corresponding to different asset classes in which funds commonly
invest, and specify the required shock levels for each asset class.
Similar to Form PF, the rule could categorize stress testing shocks
based on market factors such as equity prices, risk-free interest
rates, credit spreads, currency rates, commodity prices, option implied
volatilities, default rates for asset-backed securities, and default
rates for corporate bonds and credit-default swaps.\255\ The rule could
also include an ``other,'' general category for which the corresponding
shock level would be a specific or otherwise determinable factor based
on extreme but plausible market conditions determined by the
derivatives risk manager. A fund would ``fail'' this stress test if one
of the prescribed shocks would cause the fund to experience a level of
loss that we would specify.
---------------------------------------------------------------------------
\255\ Question 42 on Form PF requires some private fund advisers
to report the impact on the fund's portfolio from specified changes
to the identified market factors.
---------------------------------------------------------------------------
We could, for example, specify the shock levels for each market
factor based on a certain number of standard deviations from the mean
of historical distributions of returns for that factor, such as three
or four standard deviations, as a means of establishing standardized
shock levels.\256\ We could then specify that a fund fails the stress
test if any such shock leads to a loss of a certain percentage of the
fund's net assets over a single trading day or series of trading days,
such as 20% over one trading day. We could determine these metrics
based on how funds that do not engage in derivatives, but that have
borrowed up to and in compliance with the requirements of section 18,
would perform against the stress test. For example, the stress test
outer limit could be based on a fund that is not using derivatives but
has invested $150 in securities based on $100 of net assets and $50 in
bank borrowings. To be consistent with section 18, a fund that uses
derivatives and conducts a stress test resulting in losses greater than
the stress test losses of this hypothetical bank-borrowing-leveraged
fund would fail the single-factor stress test.
---------------------------------------------------------------------------
\256\ If normally distributed, shock levels based on historical
returns of a market factor that is three standard deviations from
the mean of that market factor would correspond to approximately a
99.7% confidence level.
---------------------------------------------------------------------------
This approach would have the benefit of setting forth a
comparatively simple-to-conduct test that a broad variety of funds
could apply. The challenges of a single-factor stress testing
requirement, however, include identifying an appropriate universe of
market risk factors for the broad universe of derivatives in which
funds invest and strategies they follow, setting the appropriate level
of each shock for each factor, and determining the level of losses that
would result in a fund ``failing'' the test. Making these
determinations would be particularly challenging in a rule that would
apply to all funds. Any prescribed shocks and related values could
become stale over time and necessarily would not include all of the
relevant risk factors for each fund. As funds continue to innovate,
there could be funds for which no prescribed shock would be relevant.
An approach that looks at a fund's losses in response to changes in a
single market risk factor also may not effectively take into account
correlations among market risk factors under stressed market
conditions. Stress testing is useful as a risk management tool because
it
[[Page 4481]]
provides a framework for advisers to consider a range of potential
scenarios tailored to each fund and refined over time. Its benefits as
a limit of fund leverage risk may not be fully realized, however, by
single-factor stress testing that includes static values that a rule
specifies.\257\
---------------------------------------------------------------------------
\257\ We recognize that these concerns do not apply to all uses
of single-factor stress testing. For example, money market fund
stress testing does not raise similar concerns in part because of
money market funds' common strategies and limited universe of
investment holdings. See rule 2a-7(g)(8) under the Investment
Company Act (requiring periodic stress testing).
---------------------------------------------------------------------------
We also considered requiring a multi-factor stress test based on
scenario analysis. Rather than a fund applying a single-factor shock to
each relevant asset class, this approach would require funds to create
a stress test model that takes into account multiple asset classes
simultaneously, which a fund would have to identify to tailor the
stress test to its fund. The fund would then run numerous scenarios
against the model, shocking the multiple asset classes identified,
based on a high number of iterations and permutations akin to a Monte
Carlo simulation. A multi-factor stress test would result in a matrix
or range of estimated potential losses during stressed market
conditions because each scenario permutation would create one estimated
potential loss calculation. The benefits of multi-factor stress testing
include tailoring the stress test to the investment and risk
characteristics of a fund's portfolio, which may result in more
meaningful derivatives risk management. But in considering a multi-
factor stress testing requirement, we would have to consider whether
such a framework, if highly particularized, would permit enough long-
term flexibility as an applicable regulatory limit on fund leverage
risk. For example, the multi-factor stress test could identify specific
correlations and assumptions that funds should reflect in their stress
tests based on their strategies and investments, or identify specific
historical market events to run as scenarios against their stress test
model. In addition, if we were to propose a principles-based multi-
factor stress testing requirement that would rely on funds to tailor
their stress tests, it would present regulatory challenges in
determining whether funds were adhering to a limit on fund leverage
risk consistent with section 18.
Finally, our proposed VaR-based limit on fund leverage risk, as
opposed to stress testing, may better align with section 18's investor
protection goals concerning the level of risk in a registered fund.
This is because the limitations in section 18 apply under both normal
and stressed market conditions.\258\ For these reasons, as well as the
regulatory design challenges of specifying the universe of asset class
shocks and setting their corresponding levels, we are proposing a VaR-
based limit on fund leverage risk instead of a stress testing approach
to limiting fund leverage risk.
---------------------------------------------------------------------------
\258\ See supra section I.B.1.
---------------------------------------------------------------------------
We request comment on stress testing as a means to limit funds'
leverage risk.
125. In addition to our proposed stress testing requirement as part
of the derivatives risk management program, should the rule require
stress testing as a means to limit fund leverage risk in lieu of or in
addition to the VaR-based limit on fund leverage risk? Why or why not?
Is a stress test an effective means to limit a fund's leverage risk?
Please explain. If we were to include a stress testing requirement in
addition to a VaR-based limit on fund leverage risk, should we require
a fund to comply with both requirements, or should we allow a fund to
choose one or the other? If we were to allow funds to comply with
either approach, would that result in inconsistent limits across funds
and would that be appropriate if so?
126. To measure and/or limit fund leverage risk, do funds currently
use VaR tests, stress tests or both? If a fund uses VaR tests but not
stress tests (or vice versa), did the fund consider using the other
approach as a means to measure and limit its leverage risk? Why or why
not?
127. If funds use both VaR tests and stress tests to measure and/or
limit fund leverage risk, why do they use both tests? Are there certain
fund types or strategies that are better suited for VaR or for stress
testing? If so, which ones and why?
128. Should the limit of fund leverage risk focus on normal market
conditions, stressed market conditions, or both? Please explain.
129. Should the rule require a single-factor stress test as an
alternative to the proposed VaR-based limit on fund leverage risk? If
so, what single-factor shocks should the test require? What would the
corresponding shock levels be for each factor? Are the example single-
factor shocks discussed above appropriate? Please explain. How
frequently and on what basis, if at all, do commenters anticipate that
the Commission would need to amend a rule that incorporated the
enumerated shocks and their corresponding levels?
130. What number of standard deviations from the mean of historical
distributions of returns should the single-factor shock levels for each
market risk factor be? Would three standard deviations or four standard
deviations be appropriate? How should the rule define a failed stress
test? Would a loss expressed as a percentage of the fund's net assets
over a single trading day or series of trading days be appropriate?
What percentage and over what period would be appropriate? Would 20%
over one trading day be appropriate? How frequently, if at all, do
commenters anticipate that the Commission would need to amend the rule
to revise the specified loss level?
131. Should the rule require a multi-factor stress test as an
alternative to the proposed VaR-based limit on fund leverage risk? If
so, how might the rule include a multi-factor stress testing
requirement that permits adequate flexibility and tailoring but could
also promote comparability and regulatory consistency in setting a
leverage risk limit?
132. Should the single-factor or multi-factor stress testing
methods be required as part of the proposed program's stress testing
requirement? If so, which one and why?
b. Asset Segregation
We considered applying an asset segregation approach to derivatives
transactions, similar to asset segregation under Release 10666, as a
tool to limit funds' leverage-related risks.\259\ Under this approach,
we could require a fund engaging in derivatives transactions to
segregate cash and cash equivalents equal in value to the full amount
of the conditional and unconditional obligations incurred by the fund
(also referred to as ``notional amount segregation''). We could allow
funds to segregate additional types of assets beyond cash and cash
equivalents subject to prescribed haircuts based on the assets'
volatilities. The 2016 DERA Memo, for example, analyzed different risk-
based ``haircuts'' that could apply to a broader range of assets.\260\
Allowing a broader range of segregated assets would have the effect of
allowing funds to take on additional leverage because it would increase
a fund's ability to obtain market exposure through a combination of
cash, market securities investments, and derivatives transactions.
Allowing funds to segregate a broader range of assets, even if subject
to haircuts, also may not effectively address all of the section 18
concerns underlying an asset segregation requirement. For example, if
[[Page 4482]]
a fund must raise cash to pay a derivatives counterparty by selling a
segregated security with unrealized trading losses, then the fund still
would realize trading losses on the sale of the security regardless of
whether the fund applied haircuts to the value of the security when
determining the amount of its segregated assets. The haircuts therefore
could help to prevent a fund from defaulting on its derivatives
transactions obligations, but may not prevent a fund from realizing
trading losses to meet those obligations.
---------------------------------------------------------------------------
\259\ We separately discuss below our consideration of asset
segregation as a complement to the proposed limitations on fund
leverage risk. See infra section II.F.
\260\ See, e.g., 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------
Notional amount segregation, although generally an effective way to
limit leverage risk, is a non-risk-sensitive and often more restrictive
approach to limiting potential leverage risk as compared to the
proposed VaR tests. Notional amount segregation could limit funds'
ability to engage in derivatives transactions that may not raise the
concerns underlying section 18. For example, if a fund had segregated
all available qualifying assets, it would not be permitted to enter
into a derivatives transaction that would reduce portfolio risk. The
proposed VaR tests would not constrain such a transaction because it
would reduce the fund's VaR.
We also considered proposing an approach that would require funds
to segregate liquid assets in an amount equal to the fund's daily mark-
to-market liability plus a ``cushion amount'' designed to address
potential future losses. Requiring funds to segregate liquid assets
would indirectly limit a fund's leverage risk because each derivatives
transaction and segregation of liquid assets would limit the net assets
available for segregation to support additional derivatives. This
approach would require segregating a smaller amount of liquid assets
than the notional amount segregation approach.\261\ In light of the
smaller amount of segregated assets, we could provide that only a
specified percentage of a fund's assets can be segregated. We could
provide, for example, that a fund's segregated amount cannot exceed
one-third of its total assets or one-half of its net assets because
this is the maximum amount that an open-end fund can owe a bank under
section 18.
---------------------------------------------------------------------------
\261\ See 2010 ABA Derivatives Report (recommending a risk-
adjusted segregated amounts approach); 2011 Concept Release, supra
note 3, at sections II.B.2, II.C.2 (citing and requesting comment on
the 2010 ABA Derivatives Report approach).
---------------------------------------------------------------------------
This approach, however, would raise compliance complexities and may
not be as effective as the proposed VaR tests in limiting fund leverage
risk. For example, under this approach we would have to define the
risk-based ``cushion amount'' funds would segregate. We could define
this amount as we proposed in 2015: A reasonable estimate of the
potential amount payable by the fund if the fund were to exit the
derivatives transaction under stressed conditions.\262\ Some commenters
suggested determining these amounts could raise compliance
challenges.\263\ Another approach would be to use the amount of
required initial margin, for transactions subject to regulatory initial
margin requirements. Not all derivatives transactions are subject to
initial margin requirements, however, and these requirements generally
vary based on the type of derivatives instrument. An approach that were
to allow a fund to have more leverage when trading futures as compared
to swaps, for example, would not seem consistent with the concerns
underlying section 18.
---------------------------------------------------------------------------
\262\ See 2015 proposed rule 18f-4(c)(9).
\263\ We discuss these challenges in more detail below in
section II.F. See also, e.g., AAF Comment Letter; Angel; Comment
Letter of James J. Angel, Ph.D., CFA (Mar. 28, 2016).
---------------------------------------------------------------------------
Requiring funds to segregate liquid assets in an amount equal to
the fund's daily mark-to-market liability plus a ``cushion amount''
therefore could introduce unnecessary complexity and compliance costs
and may not result in an effective limit on fund leverage. We believe
that the proposed VaR-based tests would be a more direct and effective
method of limiting fund leverage risk consistent with section 18.
We request comment on asset segregation as an alternative or
complement to VaR.
133. Should the rule require asset segregation in lieu of or in
addition to the proposed VaR-based limit on fund leverage risk? Is
asset segregation equally effective or more effective than the proposed
VaR tests in limiting a fund's leverage risk? Why or why not?
134. Are there certain fund types or strategies for which an asset
segregation approach would be more effective or appropriate for
limiting a fund's leverage risk? Which ones and why?
135. Should the proposed rule require notional amount segregation?
What challenges, if any, would funds have with complying with notional
amount segregation? Would this be an effective means to limit a fund's
leverage risk? If so, how? Please describe.
136. Should the proposed rule require an asset segregation risk-
based approach based on the fund's daily mark-to-market liability and
``cushion amount''? Please explain why or why not. If so, how should
funds calculate the risk-based cushions? Should we use the approach in
the 2015 proposal for risk-based coverage amounts? Would funds
encounter challenges in determining stressed conditions for purposes of
that analysis? Would that approach lead to consistent segregated
amounts across funds for the same or similar investments? Why or why
not? Could we provide for greater consistency by prescribing a
standardized schedule for computing these amounts based on the
volatility of the underlying reference assets? What values should we
prescribe? Rather than the approach in the 2015 proposal, should we use
the amounts posted to satisfy regulatory margin requirements? Would it
be appropriate for different instruments that provide the same economic
exposure (e.g., futures and swaps that reference the same index) to
have different segregated amounts? Under this approach, how should
funds calculate risk-based cushions for transactions that are not
subject to regulatory initial margin requirements?
137. Should we use the risk-based cushion amount approach to
indirectly limit leverage risk? If so, should we provide that a fund's
segregated amount cannot exceed one-third of its total assets, one-half
of its net assets, or some other percentage of a fund's total or net
assets? Would such an approach be sufficiently risk-sensitive and
dynamic? If we were to use such an approach, how should we address
derivatives transactions that may require little or no margin or
collateral to be posted?
138. Are there other reasons that the proposed rule should include
asset segregation? Should the derivatives risk management program
specify asset segregation requirements? Would market practices
adequately address asset coverage concerns? If not, why?
139. We included an asset segregation requirement as part of the
2015 proposal designed in part to address the asset sufficiency related
concerns underlying section 18. Would an asset segregation requirement
help to address fund leverage risk and complement the proposed VaR
tests? If so, what type of asset sufficiency test?
c. Exposure-Based Test
We considered an exposure-based approach for limiting fund leverage
risk. For example, we could design an exposure-based approach that
permits a fund to enter into derivatives transactions so long as its
derivatives exposure does not exceed a specified percentage of the
fund's net assets, such as 50%. This would be similar to an exposure-
based test under the European
[[Page 4483]]
Union guidelines that apply to UCITS funds.\264\
---------------------------------------------------------------------------
\264\ CESR (now known as the European Securities and Markets
Authority (``ESMA'')) issued its Guidelines on Risk Measurement and
the Calculation of Global Exposure and Counterparty Risk for UCITS
(``Global Exposure Guidelines'') in 2010, addressing the
implementation of the European Commission's 2009 revised UCITS
Directive (``2009 Directive''). See CESR Global Guidelines, supra
note 94, at 9.
A UCITS fund may, instead of complying with the European
Union's VaR-based test, satisfy a ``commitment approach.'' The
commitment approach provides that a UCITS fund is in compliance with
the leverage limits under the guidelines if its derivatives notional
amounts (taking into account netting and hedging) do not exceed 100%
of the fund's net asset value. See 2009 Directive.
---------------------------------------------------------------------------
A fund's ``derivatives exposure'' could be defined as in proposed
rule 18f-4.\265\ A similar approach would be to provide that the sum of
a fund's derivatives exposure and the value of its other investments
cannot exceed 150% of the fund's net asset value. This latter approach,
and particularly if cash and cash equivalents were not included in the
calculation, would allow a fund to achieve the level of market exposure
permitted for an open-end fund under section 18 using any combination
of derivatives and other investments.\266\
---------------------------------------------------------------------------
\265\ Proposed rule 18f-4(a) (defining derivatives exposure to
mean the sum of the notional amounts of the fund's derivatives
instruments and, in the case of short sale borrowings, the value of
the asset sold short. In determining derivatives exposure a fund may
convert the notional amount of interest rate derivatives to 10-year
bond equivalents and delta adjust the notional amounts of options
contracts).
\266\ This approach would exclude cash and cash equivalents
because they do not meaningfully contribute to a fund's market
exposure.
---------------------------------------------------------------------------
This alternative approach would recognize that for most types of
derivatives, the notional amount generally serves as a measure of the
fund's economic exposure to the underlying reference asset or metric.
It also would provide a simple approach because a fund would just add
the relevant values rather than having to perform VaR tests.
An exposure-based test does have certain limitations. One drawback
to this alternative approach is that a derivative's notional amount
does not reflect the way in which the fund uses the derivative and is
not a risk measurement. For this reason, an exposure-based approach may
be viewed as a relatively blunt measurement. It would not differentiate
between derivatives transactions having the same notional amount but
different underlying reference assets with potentially very different
risks.
There are adjustments to notional amounts available that may better
reflect the risk associated with derivatives transactions. One way to
attempt to address these drawbacks would be to define the circumstances
under which funds could subtract the exposure associated with
``hedging'' and ``netting'' transactions from a fund's derivatives
exposure. This would be similar to the ``commitment method'' applicable
to UCITS funds.\267\ Defining these kinds of transactions can be
challenging. For example, determining whether transactions are
``hedges'' can involve an analysis of historical correlations and
predicting future price movements of related instruments or underlying
reference assets, among other things. Historical correlations also can
break down in times of market stress.\268\
---------------------------------------------------------------------------
\267\ See, e.g., CESR Global Guidelines, supra note 94, at 13-14
(defining netting as ``combinations of trades on financial
derivative instruments and/or security positions which refer to the
same underlying asset, irrespective--in the case of financial
derivative instruments--of the contracts' due date; and where the
trades on financial derivative instruments and/or security positions
are concluded with the sole aim of eliminating the risks linked to
positions taken through the other financial derivative instruments
and/or security positions'' and hedging as ``combinations of trades
on financial derivative instruments and/or security positions which
do not necessarily refer to the same underlying asset and where the
trades on financial derivative instruments and/or security positions
are concluded with the sole aim of offsetting risks linked to
positions taken through the other financial derivative instruments
and/or security positions'').
\268\ In times of extreme market stress, price correlations
between asset classes frequently break down. See Mico Loretan &
William B. English, Evaluating ``Correlation Breakdowns'' During
Periods of Market Volatility, Federal Reserve System International
Finance Working Paper No. 658 (Feb. 2000), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=231857 (``[I]n periods
of heightened market volatility correlations between asset returns
can differ substantially from those seen in quieter markets. The
problem of `correlation breakdown' during periods of greater
volatility is well known.''). During periods of stressed conditions,
correlations between asset classes with historically weak or inverse
correlations may change significantly. See Whitney Kisling, Greed
Beats Fear With Stock-Bond Correlation Falling, Bloomberg (Nov. 22,
2010) (stating that the 30-day correlation between S&P 500 prices
and 10-year Treasury yields showed equity and bond markets,
typically inversely correlated markets, moving in lockstep after the
2008 financial crisis); see also A Review of Financial Market Events
in Autumn 1998, Bank for International Settlements, Committee on the
Global Financial System (1999), available at http://www.bis.org/publ/cgfs12.htm (during the Russian financial crisis in August 1998
the average correlation between five-day changes in yield spreads
for 26 instruments in 10 economies rose from 11% in the first half
of 1998 to 37% during the height of the crisis).
---------------------------------------------------------------------------
Another potential way to modify an exposure-based test would be to
adjust the notional amounts that contribute to a fund's derivatives
exposure based on the volatility of their underlying reference assets.
Some commenters on the 2015 proposal suggested we take this approach,
and DERA staff prepared an analysis of commenters' suggestions.\269\
This would make an exposure-based test more risk-sensitive, but would
not provide the more-comprehensive analysis of portfolio risk that VaR
provides. An exposure-based test, even with these various adjustments
to notional amounts for purposes of calculating a fund's derivatives
exposure, still would be a relatively blunt measurement. For example,
this approach could limit certain fund strategies that rely on
derivatives more extensively but that do not seek to take on
significant leverage risk.
---------------------------------------------------------------------------
\269\ See 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------
While we do not propose an exposure-based test element as a means
for limiting all funds' leverage risk, we are proposing an exposure-
based test for limited derivatives users (as discussed below).\270\
---------------------------------------------------------------------------
\270\ See proposed rule 18f-4(c)(3).
---------------------------------------------------------------------------
We request comment on an exposure-based test as a means to limit
funds' leverage risk.
140. Should the rule incorporate an exposure-based approach in
addition to, or in lieu of, the proposed VaR-based limit on fund
leverage risk? If so, what derivatives exposure amount should this
approach permit? For example, should we modify the proposed rule so
that a fund would not be required to satisfy either VaR test if the
fund limited its derivatives exposure, as defined for purposes of the
limited derivatives user exception discussed below, to 50% of a fund's
net assets? Should an exposure-based approach focus on a fund's overall
gross market exposure and be based on the sum of the fund's derivatives
exposure and the value of its other investments, less any cash and cash
equivalents? If so, should a fund's gross market exposure be limited to
150% of net assets to allow a fund to achieve the level of market
exposure permitted for an open-end fund under section 18 using any
combination of derivatives and other investments? Would any of these
approaches to implementing an exposure-based limit on fund leverage
risk effectively address the potential leverage associated with a
fund's derivatives transactions? If so, would funds find it more cost
effective or otherwise preferable to have the option to comply with an
exposure-based test in lieu of the proposed VaR tests? Please explain.
141. If the rule were to incorporate an exposure-based approach,
should we permit funds to make netting and hedging adjustments when
calculating their derivatives exposures? If so, why? How should we
define permissible
[[Page 4484]]
netting and hedging transactions? If we permit netting and hedging to
be incorporated into the exposure calculation, should the rule include
third-party verification to test whether a fund's netting and hedging
calculations were reasonable and appropriate? What other provisions
could achieve these concerns with netting and hedging? Please describe.
142. If the rule were to incorporate an exposure-based approach,
should we permit funds to make risk-sensitive adjustments as discussed
in the 2016 DERA Memo? If so, why? How should we define the permissible
risk-adjusted notional amounts? If we permit these adjustments to be
incorporated into the exposure calculation, should the rule include
third-party verification to test whether a fund's adjustments were
reasonable and appropriate? What other provisions could achieve these
concerns with risk-adjusted notional amounts? Please describe.
143. Are there certain fund types or strategies where an exposure-
based test would be more appropriate? If so, which ones and why? Would
these fund types or strategies have difficulty conducting either a
relative VaR test or absolute VaR test? If so, why would an exposure-
based test be less challenging to conduct than a VaR-based test?
144. What challenges, if any, would funds have in conducting an
exposure-based test? How could an exposure-based test rule account for
these challenges?
145. Do funds currently conduct exposure-based tests as a means of
measuring and limiting a fund's leverage risk? If so, which ones and
why? Are these exposure-based tests in place of or in addition to VaR-
based tests or other risk measurements? Should the rule be modified to
require both, and what benefits do funds find when running an exposure-
based test and VaR-based test and comparing results? Would these
additional compliance burdens result in a more-accurate limit on fund
leverage risk? If so, how much so, and what would the additional
compliance burdens be?
146. In what ways is the proposed approach to limiting leverage
risk superior or inferior to the current regulatory approach or
alternative approaches, including the stress testing, asset segregation
and exposure-based alternatives discussed herein?
E. Limited Derivatives Users
We are proposing an exception from the proposed rule's risk
management program requirement and VaR-based limit on fund leverage
risk for funds that use derivatives in a limited manner. Requiring
funds that use derivatives only in a limited way to adopt a derivatives
risk management program that includes all of the proposed program
elements could potentially require funds (and therefore their
shareholders) to incur costs and bear compliance burdens that may be
disproportionate to the resulting benefits.\271\ We recognize that the
risks and potential impact of derivatives transactions on a fund's
portfolio generally increase as the fund's level of derivatives usage
increases and when funds use derivatives for speculative purposes.
---------------------------------------------------------------------------
\271\ The cost burden concern extends to smaller funds as well,
which could experience an even more disproportionate cost than
larger funds. See infra sections III.C.3and V.D.1.c.
---------------------------------------------------------------------------
The proposed exception would cover two alternative types of limited
derivatives use. It would be available to a fund that either limits its
derivatives exposure to 10% of its net assets, or that uses derivatives
transactions solely to hedge certain currency risks.\272\ A fund that
relies on the proposed exception would also be required to adopt
policies and procedures that are reasonably designed to manage its
derivatives risks.\273\ We believe that the risks and potential impact
of these funds' derivatives use may not be as significant, compared to
those of funds that do not qualify for the exception, and that a
principles-based policies and procedures requirement would
appropriately address these risks. We discuss and request comment on
each of the elements of this proposed exception below.
---------------------------------------------------------------------------
\272\ See proposed rule 18f-4(c)(3)(i)-(ii); see also infra
sections II.E.1 and II.E.2 (discussing the specific requirements for
funds relying on either alternative of the proposed exception).
\273\ See proposed rule 18f-4(c)(3).
---------------------------------------------------------------------------
1. Exposure-Based Exception
Under one alternative set of conditions, a fund would be permitted
to rely on the limited derivatives user exception if its derivatives
exposure does not exceed 10% of its net assets. The proposed rule would
generally define the term ``derivatives exposure'' to mean the sum of
the notional amounts of the fund's derivatives instruments and, for
short sale borrowings, the value of any asset sold short.\274\ This
definition is designed to provide a measure of the market exposure
associated with a fund's derivatives transactions entered into in
reliance on proposed rule 18f-4.\275\
---------------------------------------------------------------------------
\274\ See proposed rule 18f-4(a) (defining the term
``derivatives exposure'').
\275\ Id.
---------------------------------------------------------------------------
We recognize that using notional amounts as a measure of market
exposure could be viewed as a relatively blunt measurement in that
different derivatives transactions having the same notional amount but
different underlying reference assets--for example, an interest rate
swap and a credit default swap having the same notional amount--may
expose a fund to very different potential investment risks and
potential payment obligations. The derivatives exposure threshold in
the limited derivatives user exception, however, is not designed to
provide a precise measure of a fund's market exposure or to serve as a
risk measure, but rather to serve as an efficient way to identify funds
that use derivatives in a limited way.
The proposed definition of ``derivatives exposure'' would, however,
include two adjustments designed to address certain limitations
associated with measures of market exposure that use derivatives'
notional amounts without adjustments. Specifically, the proposed rule
would permit a fund to convert the notional amount of interest rate
derivatives to 10-year bond equivalents and delta adjust the notional
amounts of options contracts.\276\ Converting interest rate derivatives
to 10-year bond equivalents would provide for greater comparability of
the notional amounts of different interest rate derivatives that
provide similar exposure to changes in interest rates but that have
different unadjusted notional amount. In addition, absent this
adjustment, short-term interest rate derivatives in particular can
produce large unadjusted notional amounts that may not correspond to
large exposures to interest rate changes.\277\ Permitting funds to
convert these and other interest rate derivatives to 10-year bond
equivalents is designed to result in adjusted notional amounts that
better represent a fund's exposure to interest rate changes. Similarly,
permitting delta adjusting of options is designed to provide for a more
tailored notional amount that better reflects the exposure that an
option creates to the underlying reference asset.
---------------------------------------------------------------------------
\276\ Id. Delta refers to the ratio of change in the value of an
option to the change in value of the asset into which the option is
convertible. A fund would delta adjust an option by multiplying the
option's unadjusted notional amount by the option's delta.
\277\ Id.
---------------------------------------------------------------------------
These adjustments are therefore designed to provide for more
tailored notional amounts that better reflect the exposure that a
derivative creates to the underlying reference asset. Providing these
adjustments also would be efficient for funds because the adjustments
are consistent with the
[[Page 4485]]
reporting requirements in Form PF and Form ADV.\278\ We do not believe
additional adjustments are necessary for purposes of identifying
limited derivatives users. For example, commenters on the 2015 proposal
suggested an approach to adjusting notional amounts based on the
volatility of the underlying reference assets, and DERA staff analyzed
these suggestions.\279\ We believe, however, that whether a fund is
using derivatives in a limited way for purposes of the limited
derivatives user exception should not depend on the volatility of the
underlying reference assets, but rather on the extent to which a fund
uses derivatives to implement its investment strategy.
---------------------------------------------------------------------------
\278\ See, e.g., General Instruction 15 to Form PF; Item B.30 of
Section 2b of Form PF; Glossary of Terms, Gross Notional Value of
Form ADV; Schedule D of Part 1A of Form ADV.
\279\ See 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------
The proposed 10% derivatives exposure condition represents a
threshold that is designed to exclude funds from the program
requirement and the VaR-based limit on fund leverage risk when their
derivatives exposure is relatively limited. This proposed threshold is
based in part on staff analysis of funds' practices regarding
derivatives use. Specifically, DERA staff analyzed funds' use of
derivatives based on Form N-PORT filings as of September 2019. As
discussed in more detail in section III, these filings covered mutual
funds, ETFs, registered closed-end funds, and variable annuity separate
accounts registered as management investment companies. Based on this
analysis, 59% of funds report no derivatives holdings and 14% of funds
report derivatives holdings with gross notional amounts above 50% of
NAV.
DERA staff also analyzed the levels of these funds' derivatives
exposure after adjusting interest rate derivatives and options, as
permitted under the proposed rule. Taking these adjustments into
account, DERA staff's analysis showed that 78% of funds have adjusted
notional amounts below 10% of NAV; 80% of funds have adjusted notional
amounts below 15% of NAV; 81% of funds have adjusted notional amounts
below 20% of NAV; and 82% of funds have adjusted notional amounts below
25% of NAV. Although BDCs are not required to file reports on Form N-
PORT, our staff separately analyzed a sampling of BDCs, finding that of
the sampled BDCs, 54% did not report any derivatives holdings and a
further 29% reported using derivatives with gross notional amounts
below 10% of net assets.\280\
---------------------------------------------------------------------------
\280\ See infra section III.B.2. As noted above, our staff did
not have sufficient information to adjust the notional amounts of
the BDCs' interest rate derivatives or options. Some of the 17% of
the sampled BDCs with gross notional amounts exceeding 10% of net
assets likely would have lower notional amounts after applying these
adjustments.
---------------------------------------------------------------------------
We recognize that not all funds are currently required to file
reports on Form N-PORT.\281\ It appears, however, that funds' use of
derivatives reflected in the Form N-PORT data is generally consistent
with that in the representative sample studied in the White Paper
prepared in connection with the 2015 proposal, entitled ``Use of
Derivatives by Investment Companies.'' \282\ For example, DERA staff
compared the percentages of funds in both data sets that reported no
derivatives and the percentage with gross notional amounts less than
50% of net assets. These figures were comparable, suggesting that the
Form N-PORT data provides a representative sample of current funds, and
not just the set of funds currently required to file reports on Form N-
PORT.\283\ Taking these results into account, we are proposing to
permit a fund to operate as a limited derivatives user if its
derivatives exposure is below 10% of net assets. DERA staff analysis
suggests that most funds either do not use derivatives or do so to a
more limited extent, and that setting the derivatives exposure
threshold for the limited user exception at 10%, 15%, 20%, or 25%, for
example, would result in nearly the same percentages of funds
qualifying for the exception. We therefore are proposing a lower
threshold of 10% because the lower threshold would result in nearly the
same percentage of funds qualifying for the exception based on current
practices while potentially providing greater investor protections in
the future by requiring funds that exceed the lower 10% threshold to
establish a program and comply with the VaR-based limit on fund
leverage risk.
---------------------------------------------------------------------------
\281\ Larger fund groups--funds that together with other
investment companies in the same ``group of related investment
companies'' have net assets of $1 billion or more as of the end of
the most recent fiscal year of the fund--currently are required to
file reports on N-PORT. Smaller fund groups must begin to file
reports on Form N-PORT by April 30, 2020. While only larger fund
groups are currently required to file reports on Form N-PORT,
existing filings nevertheless covered 89% of funds representing 94%
of assets. See infra note 457 and accompanying text.
\282\ DERA White Paper, supra note 1; see also ICI Comment
Letter III (regarding a survey related to funds' use of derivatives
sent to its member firms, the Investment Company Institute stated
``The survey was distributed to smaller fund complex members, yet
relatively few responses were received from these smaller fund
members. Based on anecdotal conversations with staff at these member
complexes, the smaller fund firms described no to minimal use of
derivatives.'').
\283\ Specifically, the DERA White Paper observes that 68% of
funds held no derivatives and 89% of funds had gross notional
amounts less than 50% of net assets. See DERA White Paper, supra
note 1. The respective figures from the N-PORT data were 59% and 86%
of funds.
---------------------------------------------------------------------------
The 2015 proposal also included an exception from that proposal's
risk management program requirement for funds: (1) Whose notional
derivatives exposure does not exceed 50% of net assets; and (2) that do
not enter into ``complex derivatives transactions,'' defined in that
proposal to include certain path-dependent and non-linear
transactions.\284\ The 2015 proposal permitted funds to use delta-
adjusted notional amounts for options but did not provide an adjustment
for interest rate derivatives.
---------------------------------------------------------------------------
\284\ Specifically, the 2015 proposal defined the term ``complex
derivatives transaction'' to mean any derivatives transaction for
which the amount payable by either party upon settlement date,
maturity or exercise: (1) Is dependent on the value of the
underlying reference asset at multiple points in time during the
term of the transaction; or (2) is a non-linear function of the
value of the underlying reference asset, other than due to
optionality arising from a single strike price. 2015 proposed rule
18f-4(c)(1).
---------------------------------------------------------------------------
We are proposing a 10% derivatives exposure threshold that takes
into account certain adjustments rather than a higher figure, like the
50% threshold we proposed in 2015 that did not include adjustments for
interest rate derivatives, because we believe this approach would more
effectively identify funds whose derivatives may be effectively managed
without a fund needing to establish a derivatives risk management
program that includes all of the proposed program elements. A fund with
derivatives exposure equal to 50% of net assets, for example, would be
at risk of substantial losses, notwithstanding that an open-end fund
could borrow an amount equal to 50% of its net assets from a bank.\285\
Conversely, if a fund were entering into interest rate derivatives--and
especially short-term interest rate derivatives--those transactions'
unadjusted notional amounts could cause a fund to exceed the threshold
we proposed in 2015 even though the fund's derivatives risks could be
less significant than those of
[[Page 4486]]
other funds that would qualify for the exception. The approach the
Commission proposed in 2015 therefore could have permitted some funds
to rely on the exception while still taking on significant derivatives
risks, while disqualifying other funds whose derivatives transactions
may have posed less-significant risks but that had high unadjusted
notional amounts. Here, our proposal is designed to address these
concerns by proposing a lower derivatives exposure threshold while also
allowing funds to adjust interest rate derivatives' notional amounts
because the unadjusted values may be more likely to overstate a fund's
market exposure.
---------------------------------------------------------------------------
\285\ See, e.g., CFA Comment Letter (stating that the commenter
did not believe it was ``appropriate that a fund with 40 or 45
percent notional exposure should be viewed as having a limited
amount of exposure obviating the requirement for that fund to
implement a formal risk management program'' and that ``Section 18's
limit reflects a congressional determination on the level of
exposure funds may not exceed; it does not reflect the level of
exposure at which funds should begin to establish formal risk
management practices'').
---------------------------------------------------------------------------
We also are not proposing to prohibit funds relying on the
exception from entering into complex derivatives transactions as we
proposed in 2015 because, as discussed in more detail below, we are
proposing to require that limited derivatives users manage all of the
risks associated with their derivatives transactions, including any
complex derivatives transactions. In addition, if these or other
complex or exotic derivatives were to embed multiple forms of
optionality or other non-linearities such that the fund could not
reliably compute the transaction's notional amount, the fund would not
be able to confirm that its derivatives exposure is below 10% of the
fund's net assets and therefore would not be able to rely on the
limited derivatives user exception. Finally, if these complex
derivatives transactions were to cause a fund's derivatives exposure to
exceed 10% of the fund's net assets--or the fund were to exceed the
limit for any other reason--the fund would have to reduce its
derivatives exposure promptly or establish a derivatives risk
management program and comply with the VaR-based limit on fund leverage
risk as soon as reasonably practicable.
We also considered an alternative approach to identifying funds
that use derivatives in a limited way based on a fund's disclosure.
Specifically, we considered providing that a fund would be a limited
derivatives user if its principal investment strategies disclosed in
its prospectus do not involve the use of derivatives.\286\ A fund that
does not identify the use of derivatives in its principal investment
strategies should generally be using derivatives less extensively than
a fund that does include the use of derivatives as a principal
investment strategy. This approach would provide some efficiencies for
funds because they already are required to make this disclosure.\287\
---------------------------------------------------------------------------
\286\ See, e.g., ICI Comment Letter III (stating that an
appropriate threshold for limited derivatives users could be whether
a fund listed derivatives in its prospectus as a principal
investment strategy). Form N-1A requires an open-end fund to
disclose its principal investment strategies, including the
particular type or types of securities in which the fund principally
invests or will invest. See Item 9 of Form N-1A. Form N-1A also
provides, in part, that ``[i]n determining what is a principal
investment strategy, consider, among other things, the amount of the
Fund's assets expected to be committed to the strategy, the amount
of the Fund's assets expected to be placed at risk by the strategy,
and the likelihood of the Fund's losing some or all of those assets
from implementing the strategy.'' See Instruction 2 to Item 9 of
Form N-1A. Form N-2 requires a closed-end fund to concisely describe
the fund's investment objectives and policies that will constitute
its principal portfolio emphasis, including the types of securities
in which the fund invests or will invest principally. See Item 8 of
Form N-2. The instructions to this item direct the fund to briefly
describe the significant investment practices or techniques that the
fund employs or intends to employ with several examples, including
examples related to derivatives transactions.
\287\ See ICI Comment Letter III (stating that 92% of the firms
surveyed indicated that their firms have funds that list derivatives
as a principal investment strategy in their prospectus).
---------------------------------------------------------------------------
This approach would, however, have certain drawbacks. For example,
whether a fund's use of derivatives is a principal investment strategy
is a facts-and-circumstances-based analysis. Funds that may appear
broadly similar could provide different disclosures, leading to less
consistency in the application of the derivatives risk management
program requirement and in the application of the VaR-based limit on
leverage risk.
Taking these considerations into account, we are proposing to look
at a uniform metric of a fund's derivatives exposure, rather than at
the more fact-specific question of whether a fund views the use of
derivatives as a principal investment strategy. We believe the proposed
approach should result in more-consistent determinations by funds and
would be more appropriate in determining whether a fund should qualify
for the limited derivatives user exception.
We request comment on the proposed exposure-based exception.
147. Is it appropriate to permit funds to rely on the limited
derivatives user exception if their derivatives exposure does not
exceed 10% of their net assets? Why or why not? Should we lower or
raise the proposed derivatives exposure threshold, for example to 5% or
to 15%? Why or why not? Should we lower it to a de minimis amount, such
as 1% or 3%, and provide that a fund with derivatives exposure below
these levels is not required to adopt policies and procedures designed
to manage derivatives risk? Should the threshold vary based on whether
a fund is an open-end fund, registered closed-end fund, or BDC? If so,
why, and which levels would be appropriate for each kind of fund?
148. The derivatives exposure of certain types of transactions may
be difficult to calculate or may change rapidly, which may make it
difficult for a fund to consistently comply with the limited
derivatives user exception. Should we provide that a fund relying on
the limited derivatives user exception may not enter into complex or
exotic derivatives transactions, whose risks may not be fully reflected
in their notional amounts? If so, what kinds of complex or exotic
transactions? For example, should we provide that a fund relying on the
exception may not enter into complex derivatives transactions, as
defined in the 2015 proposal? Should we only permit a fund to have a
more-limited amount of derivatives exposure associated with these
transactions, such as 1% or 5% of net assets? Why or why not?
149. Should we prescribe how a fund must calculate its notional
amounts, or is that term in the proposed rule sufficiently clear? If we
should prescribe the calculation, what should we prescribe? For
example, in 2015 the Commission proposed to define a derivatives
transaction's notional amount to mean, among other things: (1) The
market value of an equivalent position in the underlying reference
asset for the derivatives transaction (expressed as a positive amount
for both long and short positions); or (2) the principal amount on
which payment obligations under the derivatives transaction are
calculated. Should we include this definition in rule 18f-4? The 2015
proposal also included specific provisions for calculating a
derivatives transaction's notional amount for: (1) Derivatives that
provide a return based on the leveraged performance of a reference
asset; and (2) derivatives transactions for which the reference asset
is a managed account or entity formed or operated primarily for the
purpose of investing in or trading derivatives transactions, or an
index that reflects the performance of such a managed account or
entity.\288\ Should we include either or both of these provisions in
rule 18f-4? Why or why not? Would funds calculate their notional
amounts consistently with these provisions even if they were not
included in the rule text because the calculations would be consistent
with the way market participants determine
[[Page 4487]]
derivatives transactions' notional amounts?
---------------------------------------------------------------------------
\288\ See 2015 Proposing Release, supra 2, at n.158 and
accompanying text.
---------------------------------------------------------------------------
150. Would funds be able to calculate notional amounts for complex
derivatives and, if so, would they reflect the market risk in the
transactions? Why or why? If we permit funds to enter into complex
derivatives transactions as defined in the 2015 proposal while relying
on the limited derivatives user exception, should we require that funds
calculate these transactions' notional amounts as the Commission
proposed in 2015? That proposal would have provided that the notional
amount of a complex derivatives transaction would be the aggregate
notional amounts of derivatives transactions (excluding complex
derivatives transactions) reasonably estimated to offset substantially
all of the market risk of the complex derivatives transaction.
151. For purposes of determining a fund's derivatives exposure,
should the proposed rule treat differently derivatives that create
synthetic positions where the fund holds cash and cash equivalents with
a value equal to the derivative's notional amount less any posted
margin? These transactions may not leverage the fund's portfolio
because of the fund's holding cash and cash equivalents equal to the
notional amount of the derivatives transaction less any posted margin,
rather than investing in additional securities or making other
investments. Take, for example, a fund with $100 that posts $20 of
initial margin to initiate a long position in a swap contract
referencing a market index. If the fund posted cash and cash
equivalents as initial margin and maintains the remaining $80 in cash
and cash equivalents as well, the fund would have a market exposure
that would be similar to having invested the fund's $100 in the stocks
composing the index. Such a transaction could, however, present other
risks, such as counterparty risk. Because these synthetic transactions
may not leverage a fund's portfolio, should we permit a fund to exclude
these transactions from its derivatives exposure? Conversely, because
they can raise other risks, such as counterparty risks, should they be
included in derivatives exposure as proposed?
152. Should the rule define limited derivatives users using an
alternative methodology other than the proposed threshold tied to
derivatives exposure (or, as discussed below, for funds that use
derivatives to hedge currency risks)? Why or why not? For example,
should the limited derivatives user exception be defined to include
funds that do not disclose the use of derivatives as a principal
investment strategy in their prospectuses? Would this disclosure-based
exception threshold be over- or under-inclusive? Would it lead to less
consistency in the requirement to establish a derivatives risk
management program and comply with a VaR-based limit on leverage risk
and potentially create uncertainty for funds as to when they would
qualify for the limited user exception? Why or why not? If this could
lead to less consistency, would any additional instructions in funds'
registration forms, regarding what a fund should disclose as a
principal investment strategy in its prospectus, help mitigate this
concern, and if so, what should those instructions be? Is it
appropriate to tie an exception to the derivatives risk management
program requirement and VaR-based limit on fund leverage risk to a
prospectus disclosure requirement? Why or why not?
153. Should the condition that a limited derivatives user's
derivatives exposure not exceed 10% of the fund's net assets address
exceedances and remediation? Why or why not? For example, as noted
above, if a fund's derivatives exposure were to exceed 10% of the
fund's net assets, the fund would have to promptly reduce its
derivatives exposure or establish a derivatives risk management program
and comply with the VaR-based limit on fund leverage risk as soon as
reasonably practicable. Should we provide in rule 18f-4 specific time
periods for these actions and, if so, which time periods would be
appropriate? As an alternative way to address temporary exceedances,
should the rule provide that a fund will be a limited derivatives user
if it adopts a policy providing that, under normal circumstances, the
fund's derivatives exposure will not exceed 10% of the fund's net
assets? If so, what should be considered ``normal circumstances''?
Would this standard be too subjective such that funds would have
substantial derivatives exposures while still qualifying as limited
derivatives users? Rather than a policy referring to ``normal
circumstances,'' should we require a fund to disclose in its prospectus
that it does not expect its derivatives exposure to exceed 10% of the
fund's net assets? Should this disclosure also appear in the fund's
annual report?
154. Should we prohibit a fund whose derivatives exposure
repeatedly exceeds 10% of net assets from relying on the exception
again for a period of time? For example, if a fund were to exceed this
limit more than two or three times in a year, should we provide that
the fund cannot rely on the limited derivatives user exception for one
or two years?
155. In calculating derivatives exposure, should we permit a fund
to convert the notional amount of interest rate derivatives to 10-year
bond equivalents and delta adjust the notional amounts of options
contracts, as proposed? Would delta adjusting options raise the concern
that a fund's delta-adjusted options exposure would be small, allowing
a fund to avoid establishing a program, but could quickly grow in
response to large price changes in the option's reference asset? How
should we address this concern? Should we permit additional
adjustments? Why or why not? If so, what additional adjustments should
we permit? For example, should we permit funds to adjust notional
amounts based on the volatility of the underlying reference assets? Why
or why not?
156. The proposed rule provides that, for a fund to operate as a
limited derivatives user under the exposure-based prong, the fund's
derivatives exposure must not exceed 10% of net assets. The rule does
not, however, prescribe the frequency with which funds must calculate
their derivatives exposure to evaluate their compliance. Should we
require that a fund calculate its notional amounts daily, or at some
other specified frequency? Are there other requirements we should
specify regarding a fund's calculation of its derivatives exposure? If
so, what are they, and why would these other requirements more
accurately address a fund's derivatives exposure?
157. Should we permit a fund to adjust its derivatives exposure for
purposes of the proposed exception to account for certain netting and
hedging transactions? \289\ Why or why not? If so, how should we define
netting and hedging transactions for this purpose? How should we
prescribe in rule 18f-4 the circumstances under which different
derivatives--and particularly derivatives with different reference
assets--should be treated as hedged or offsetting? If the rule were to
permit funds to exclude hedging or netting transactions from their
derivatives exposure, should we require funds to maintain records
concerning these transactions to help our staff and fund compliance
personnel evaluate if the transactions reasonably could be viewed as
hedging or netting? If so, what information should those records
reflect? For example, the regulations under section 13 of the Bank
Holding Company Act, commonly known as the Volcker Rule, require
certain banking entities to maintain certain
[[Page 4488]]
documentation relating to hedging strategies, including positions and
techniques.\290\ Should the proposed rule take this or a similar
approach? As another example, should we require funds to identify both
the asset being hedged or netted and the derivatives transaction used
to hedge or net that asset? How should we consider the risk that the
historical correlations underlying an adviser's view that assets will
have inverse price correlations can break down in times of market
stress? How could a standard in the rule be reasonably objective such
that funds and our staff could confirm a fund's compliance? Should we
permit funds to account for netting but not hedging or vice versa? Why
or why not? Would the compliance burden to calculate netting and
hedging transactions for purposes of such adjustments justify the
benefits of permitting these adjustments? Why or why not? What other
challenges could funds face in accounting for netting and hedging
transactions that could increase the costs associated with this
exercise, or that could negatively affect a fund's ability to assess
its derivatives exposure accurately? Could these challenges be
mitigated in any way? If so, how?
---------------------------------------------------------------------------
\289\ See paragraph accompanying supra notes 266-267.
\290\ See 17 CFR 255.5(c).
---------------------------------------------------------------------------
158. Should we specify in the rule that a fund calculating its
derivatives exposure may net any directly-offsetting derivatives
transactions that are the same type of instrument and have the same
underlying reference asset, maturity and other material terms, as we
proposed in 2015? Why or why not?
159. In determining a fund's derivatives exposure, or the level of
derivatives exposure a fund may obtain while remaining a limited
derivatives user, should we consider other types of investments, like
structured notes, that have return profiles that are similar to many
derivatives instruments? Take, for example, a fund with derivatives
exposure exceeding the proposed 10% threshold by 2% that reallocates
that 2% of its net asset value from a derivatives instrument to a
structured note with a similar return profile. The fund would be a
limited derivatives user on the basis that its derivatives exposure was
below the threshold, but would present a similar risk profile to its
prior portfolio that exceeded the threshold. Are there circumstances
where we should require the fund in this example to include the value
of the structured note (or similar investment) in determining its
derivatives exposure? If so, which circumstances and what kinds of
instruments should be included? As another alternative, should we
provide that, when funds that invest in derivatives also invest in
structured notes or similar investments, they should be subject to a
lower threshold of derivatives exposure to remain a limited derivatives
user? If so, what lower level would be appropriate?
2. Currency Hedging Exception
Under the second alternative set of conditions, a fund could rely
on the limited derivatives user exception if it limits its use of
derivatives transactions to currency derivatives for hedging purposes
as specified in the proposed rule.\291\ Under this exception, a fund
could only use currency derivatives to hedge currency risk associated
with specific foreign-currency-denominated equity or fixed-income
investments in the fund's portfolio. In addition, the notional amount
of the currency derivatives the fund holds could not exceed the value
of the instruments denominated in the foreign currency by more than a
negligible amount.\292\
---------------------------------------------------------------------------
\291\ See proposed rule 18f-4(c)(3)(ii).
\292\ Id.
---------------------------------------------------------------------------
The proposed currency hedging exception reflects our view that
using currency derivatives solely to hedge currency risk does not raise
the policy concerns underlying section 18. While distinguishing most
hedging transactions from leveraged or speculative transactions is
challenging, we believe that the currency hedging described in the
proposed rule is definable because it involves a single risk factor
(currency risk) and requires that the derivatives instrument must be
tied to specific hedged investments (foreign-currency-denominated
securities held by the fund).\293\ Although we recognize that most
funds that use derivatives do not use them solely to hedge currency
risks, these currency hedges are not intended to leverage the fund's
portfolio, and conversely could mitigate potential losses.\294\
---------------------------------------------------------------------------
\293\ Many hedges are imperfect, which makes it difficult to
distinguish purported hedges from leveraged or speculative
exposures. See 2015 Proposing Release, supra 2, at n.238 and
accompanying text.
\294\ See infra section III.C.3 (discussing the number of funds
whose current derivatives transactions practices would qualify them
for the currency hedging exception).
---------------------------------------------------------------------------
We also recognize that certain funds hedge all of the foreign
currency risk associated with their foreign securities investments. A
fund that invests all or substantially all of its assets in foreign
securities and currency derivatives to hedge currency risks associated
with the foreign securities necessarily would have derivatives exposure
exceeding 10% of net asset value. This is because such a fund could
have derivatives exposure up to approximately 100% of the fund's net
assets to hedge the risks associated with all of its foreign security
investments. We therefore are proposing a separate basis for the
limited derivatives user exception for currency hedging because certain
funds that hedge currency risks would be unable to qualify for the
exposure-based limited derivatives user exception discussed above.
Rather than proposing two alternative bases to qualify for the
limited derivatives user exception, we considered permitting a fund to
qualify as a limited derivatives user if its derivatives exposure does
not exceed 10% of net assets, excluding any currency hedges as
discussed above. We are not taking this combined approach, however, to
preclude a fund that is operating as a limited derivatives user from
engaging in a broad range of derivatives transactions that may raise
risks that we believe should be managed through a derivatives
management program and subject to the proposed VaR-based limit on fund
leverage risk.
We request comment on the proposed currency hedging exception.
160. Is the proposed currency risk hedging exception appropriate?
Why or why not? Should we modify the proposed exception in any way? Why
or why not? For example, should we limit the derivatives exposure of a
fund that relies on the currency hedging exception, and if so, what
should be that exposure threshold? Should we prescribe the kinds of
currency derivatives that a fund may use while relying on the
exception? If so, which derivatives should be permitted and which
should be prohibited and why? Should the rule refer to other foreign-
currency-denominated assets in addition to equity or fixed-income
investments? For example, do funds hedge holdings of foreign currencies
themselves in addition to foreign-currency-denominated investments?
161. Are there other types of derivatives that funds use that are
less likely to raise the policy concerns underlying section 18? If so,
which derivatives, and how do funds use them? For instance, we are
aware that funds use interest rate derivatives to hedge interest rate
risk arising from fixed income investments in their portfolios. Should
we modify the proposed hedging-based exception to also include interest
rate derivatives that funds use for hedging purposes? Why or why not?
If so, what challenges could funds encounter in identifying interest
rate derivatives that are used for hedging purposes (instead of for
speculation or to accomplish
[[Page 4489]]
leveraging)? How could we define interest rate hedging in rule 18f-4 in
a way that would allow hedging transactions while not permitting
transactions that simply are speculating on the direction of interest
rates? How could conditions in the rule help identify interest rate
derivatives that funds use for ``true'' hedging? For example, should we
require that any interest rate derivative that is treated as a hedge be
tied to specific fixed-income securities or groups of specific fixed-
income securities in the fund's portfolio? This would be analogous to
the proposed nexus between a fund's currency derivatives and the fund's
hedged foreign-currency-denominated investments. Should we similarly
allow a fund to treat as a hedging transaction an interest rate
derivative that converts a fund's fixed rate borrowings to floating
rate borrowings or vice versa? To what extent do funds engage in these
transactions? For funds that do engage in these transactions, how large
are the notional amounts of these transactions, in ten-year bond
equivalents, as a percentage of the fund's net assets?
162. Should the rule address what happens if a fund using currency
derivatives exceeds the notional amount of the value of the instruments
denominated in a foreign currency by more than a negligible amount? If
so, how should we address exceedances? Should we provide further
guidance on what a negligible amount would be? For example, should we
provide guidance or provide in rule 18f-4 that exceedances of 1% or 2%,
for example, would be negligible?
163. Should we permit funds that rely on the first alternative set
of limited derivatives user conditions (limiting their derivatives
exposure to 10% of net assets) to deduct the notional amounts of their
currency derivatives used for hedging purposes when calculating their
derivatives exposure for purposes of the proposed exception? Why or why
not? Should we allow funds to rely on both exceptions at the same time,
instead of the exceptions being alternatives? If the exceptions were
combined, could that result in funds relying on the limited derivatives
user exception developing larger and potentially more complex
derivatives portfolios that that may raise risks more appropriately
managed through a derivatives management program and subject to the
proposed VaR-based limit on fund leverage risk? Why or why not?
3. Risk Management
A fund relying on the limited derivatives user exception would be
required to manage the risks associated with its derivatives
transactions by adopting and implementing policies and procedures that
are reasonably designed to manage the fund's derivatives risks.\295\
The requirement that funds relying on the exception manage their
derivatives risks recognizes that even a limited use of derivatives can
present risks that should be managed.
---------------------------------------------------------------------------
\295\ See proposed rule 18f-4(c)(3); see also proposed rule 18f-
4(a) (definition of ``derivatives risks'') and supra note 118 and
accompanying text (discussing the proposed definition of
``derivatives risks'').
---------------------------------------------------------------------------
For example, a fund that uses derivatives solely to hedge currency
risks would not be introducing leverage risk, but could still introduce
other risks, including counterparty risk and the risk that a fund could
be required to sell its investments to meet margin calls. As another
example, certain derivatives, and particularly derivatives with non-
linear or path-dependent returns, may pose risks that require
monitoring even when the derivatives represent a small portion of net
asset value. For example, because of the non-linear payout profiles
associated with put and call options, changes in the value of the
option's underlying reference asset can increase the option's delta,
and thus the extent of the fund's derivatives exposure from the option.
An options transaction that represented a small percentage of a fund's
net asset value can rapidly increase to a larger percentage.
The proposed rule would require funds relying on the limited
derivatives user exception to adopt and implement policies and
procedures reasonably designed to manage the funds' derivatives risks.
Because they would be reasonably designed to address each fund's
derivatives risks, these policies and procedures would reflect the
extent and nature of a fund's use of derivatives within the parameters
provided in the exception. For example, a fund that uses derivatives
only occasionally and for a limited purpose, such as to equitize cash,
could have limited policies and procedures commensurate with this
limited use. A fund that uses more complex derivatives with derivatives
exposure approaching 10% of net asset value, in contrast, would need to
have policies and procedures tailored to the risks these derivatives
could present. These policies and procedures could be more extensive
and could include elements similar to those required under the proposed
derivatives risk management program.
The 2015 proposal would have required funds relying on that
proposal's exception to the derivatives risk management program
requirement to manage derivatives risks by determining (and maintaining
certain assets to cover) a ``risk-based coverage amount'' associated
with the fund's derivatives. This amount represented an estimate of the
amount the fund would expect to pay to exit the derivatives transaction
under stressed conditions.
The approach we are proposing here is designed to require a fund
relying on the limited derivatives user exception to manage all of the
risks associated with its derivatives transactions, and not just the
risks that an asset segregation requirement could address.\296\
Moreover, our proposal is designed to limit derivatives risks by
limiting the extent to which a fund can use derivatives while relying
on the exception. As discussed above, the 2015 proposal would have
permitted funds to obtain substantially greater derivatives exposure--
up to 50% of net assets--without establishing a derivatives risk
management program. On balance, we believe that the proposed bases for
the limited derivatives user exception, together with the requirement
that a fund manage any risks its limited use of derivatives presents,
would provide both important investor protections and flexibility for
funds to use derivatives in a way that is consistent with the policy
concerns underlying section 18.
---------------------------------------------------------------------------
\296\ We discuss the limitations of an asset segregation
requirement in section II.F below.
---------------------------------------------------------------------------
We request comment on the proposed requirement that a fund relying
on the limited derivatives user exception manage the risks associated
with its derivatives transactions by adopting policies and procedures
that are reasonably designed to manage its derivatives risks.
164. Is it appropriate to require funds relying on the limited
derivatives user exception to adopt policies and procedures that are
reasonably designed to manage their derivatives risks, in lieu of
requiring such a fund to adopt a derivatives risk management program
that includes all of the proposed program elements and comply with the
proposed VaR-based limit on fund leverage risk? Would this requirement
effectively address the risks entailed by the levels and types of
derivatives use in which a fund that qualifies for the proposed
exception might engage?
165. Alternatively, should funds eligible for the proposed limited
derivatives user exception be subject to a tailored version of the
proposed program requirement (e.g., a program requirement that would
specify only certain elements, such as risk identification and
assessment, establishing risk guidelines, stress
[[Page 4490]]
testing, etc.)? If so, if so what should this entail?
166. Either in addition to or in lieu of policies and procedures
reasonably designed to manage a fund's derivatives risk, should we
require funds relying on the limited derivatives user exception to
comply with an asset segregation requirement? Should we use the same
approach we proposed in 2015? Should we use that approach but allow
funds to segregate a broader range of assets, such as the assets with
corresponding haircuts analyzed in the 2016 DERA Memo?
167. Should we require limited derivatives users to publicly
disclose that they are limited derivatives users in their prospectus,
annual report, or on their website? If so, should we require any
particular disclosure to enhance investors' understanding of, for
example: (1) The risks of investing in a fund that qualifies as a
limited derivatives user under the proposed rule, or (2) such a fund's
derivatives risk management practices?
F. Asset Segregation
The Commission and staff have historically taken the position that
a fund may appropriately manage the risks that section 18 is designed
to address if the fund ``covers'' its obligations in connection with
various transactions by maintaining ``segregated accounts.'' \297\
Funds' practices regarding the amount of ``cover'' they segregate, and
the assets available for segregation, have evolved over time. In
addition, different funds have applied those practices in varying ways
to derivatives transactions with comparable economic exposures.
Moreover, regulatory and contractual margin requirements have developed
significantly since the adoption of Release 10666.
---------------------------------------------------------------------------
\297\ See supra section I.B.2.
---------------------------------------------------------------------------
The 2015 proposal drew on the Commission's historical approach--and
sought to primarily address the Investment Company Act's asset
sufficiency concern--by including an asset segregation requirement as
part of the 2015 proposed rule.\298\ Under the Commission's 2015
proposed approach, a fund relying on the proposed rule, in addition to
complying with one of two portfolio limitations, would have had to
maintain an amount of ``qualifying coverage assets'' designed to enable
a fund to meet its derivatives-related obligations. Under the 2015
proposed rule, a fund would not have been required to segregate a
derivative's full notional amount, but instead would have had to
segregate qualifying coverage assets (generally cash and cash
equivalents) equal to the sum of two amounts: (1) The amount that would
be payable by the fund if the fund were to exit the derivatives
transaction at the time of determination (the ``mark-to-market coverage
amount''), and (2) a reasonable estimate of the potential amount
payable by the fund if the fund were to exit the derivatives
transaction under stressed conditions (the ``risk-based coverage
amount'').\299\
---------------------------------------------------------------------------
\298\ See 2015 Proposing Release supra note 2, at section III.C.
\299\ See id. at section III.C.2 (discussing the composition of
qualifying coverage assets as either: (1) Cash and cash equivalents,
or (2) with respect to any derivatives transaction under which the
fund may satisfy its obligations under the transaction by delivering
a particular asset, that particular asset).
---------------------------------------------------------------------------
Although commenters generally supported the overarching framework
of the 2015 proposed rule's asset segregation requirement, they
identified several operational complexities. For example, commenters
stated that additional clarity was necessary for funds to determine
risk-based coverage amounts, including how funds should determine
stressed conditions for this purpose.\300\ Commenters also raised
questions about how funds could reduce segregated amounts to account
for posted initial or variation margin and, more generally, how rule
provisions governing coverage amounts would apply to cleared
transactions (as opposed to OTC transactions covered by netting
agreements).\301\ A number of commenters also expressed concerns about
the proposed requirement that funds generally segregate cash and cash
equivalents.\302\ Commenters suggested alternatives to this proposed
requirement, including allowing funds to segregate a broader range of
assets subject to ``haircuts'' prescribed by the Commission based on
the relative volatility of different asset classes.\303\
---------------------------------------------------------------------------
\300\ See, e.g., ICI Comment Letter I; BlackRock Comment Letter;
Dechert Comment Letter; FSR Comment Letter; Guggenheim Comment
Letter.
\301\ See, e.g., SIFMA Comment Letter (stating that ``[i]n
practice, variation margin and initial margin are often calculated
in the aggregate, on a net basis, rather than separately'' and
recommending that funds ``be able to get credit for both initial and
variation margin posted on a net basis . . .'' rather than limiting
the type of coverage amount against which initial or variation
margin may be credited); BlackRock Comment Letter (stating that
initial and variation margin are used for cleared and OTC
derivatives transactions by the clearinghouse and counterparties,
respectively, when a derivatives transaction is exited and that
distinguishing between the uses of the two types of margin will
introduce complexity given that both forms of margin are available
to cover potential obligations under derivatives in the event of a
party's default).
\302\ See, e.g., AIMA Comment Letter; AQR Comment Letter;
BlackRock Comment Letter; Dechert Comment Letter; Comment Letter of
Eaton Vance Management (Mar. 28, 2016) (``Eaton Vance Comment
Letter''); Guggenheim Comment Letter; Comment Letter of JPMorgan
(Mar. 28, 2016); Oppenheimer Comment Letter; PIMCO Comment Letter.
\303\ See, e.g., Dechert Comment Letter; Eaton Vance Comment
Letter; IAA Comment Letter; SIFMA Comment Letter, Guggenheim Comment
Letter.
---------------------------------------------------------------------------
Our proposal does not include a specific asset segregation
requirement because we do not believe that an asset segregation
requirement is necessary in light of the proposed rule's requirements,
including the requirements that funds establish risk management
programs and comply with the proposed VaR-based limit on fund leverage
risk. As discussed in more detail above, a fund relying on proposed
rule 18f-4 would be required to adopt and implement a written
derivatives risk management program that, among other things, would
require the fund to: Identify and assess its derivatives risks; put in
place guidelines to manage these risks; stress test the fund's
portfolio at least weekly; and escalate material risks to the fund's
portfolio managers and, as appropriate, the board of directors.\304\
These proposed requirements are designed to require a fund to manage
all of the risks associated with its derivatives transactions. These
include--but are not limited to--the risk that a fund may be required
to sell its investments to generate cash to pay derivatives
counterparties, which the 2015 proposal's asset segregation was
designed to address.
---------------------------------------------------------------------------
\304\ Proposed rule 18f-4(c)(1). Funds that rely on the limited
derivatives user exception also would be required to manage the
risks associated with their more limited use of derivatives. See
supra section II.E.
---------------------------------------------------------------------------
Moreover, the proposed rule would require that a fund's stress
testing for purposes of its derivatives management program specifically
take into account the fund's payments to derivatives counterparties
that could result from losses in stressed conditions. Rather than
require a fund to evaluate the amounts it would pay to exit derivatives
transactions under stressed conditions on a transaction-by-transaction
basis as in the 2015 proposal,\305\ our proposal would require funds to
conduct portfolio-wide stress tests, taking into account potential
payments to counterparties. Although counterparties often require funds
to post margin or collateral for individual transactions (or groups of
transactions) in order to cover potential loss exposure, the proposed
[[Page 4491]]
rule's stress testing requirement is designed to provide a portfolio-
wide assessment of how the fund may respond to stressed conditions and
any resulting payment obligations. This portfolio-wide assessment also
would be buttressed by the other provisions in the risk management
program and the proposed VaR-based limit on fund leverage risk, which
are designed to limit a fund's leverage risk and therefore the
potential for payments to derivatives counterparties. The 2015
proposal's derivatives risk management program, in contrast, did not
include such a portfolio-wide assessment. We believe that the proposed
rule's requirements, in their totality, would appropriately address the
asset sufficiency risks underlying section 18.
---------------------------------------------------------------------------
\305\ In the 2015 proposal, funds were required to determine
qualifying coverage assets on a transaction-by-transaction basis,
with the exception that funds could determine the amount of
qualifying coverage assets on a net basis for derivatives
transactions covered by netting agreements. See 2015 proposed rule
18f-4(c)(6) and (9).
---------------------------------------------------------------------------
A separate asset segregation requirement, in contrast, may be less
effective. As derivatives markets evolve, questions may arise about the
amount (and composition) of assets that funds must segregate for novel
types of transactions. Although the Commission in 2015 sought to take a
principles-based approach to the amount of assets that funds would
segregate, many commenters asserted that additional clarity would be
necessary to administer this approach. It would be difficult in this
context for the Commission to specify the amount of assets that funds
should segregate on a transaction-by-transaction basis and to keep any
specific requirements current as markets develop. And a principles-
based approach to asset segregation, if it does not provide sufficient
clarity, may contribute to the kinds of divergent asset segregation
practices that exist today, which in turn have led to situations in
which funds are not subject to a practical limit on potential leverage
that they may obtain through derivatives transactions.\306\ By building
on current risk management practices and techniques, including VaR and
stress testing, the proposed rule is designed to provide a framework
that we believe funds can apply to a broad variety of fund types and
derivatives uses without our having to specify the operational details
that an asset segregation requirement would entail.
---------------------------------------------------------------------------
\306\ See supra sections I.B.2 and I.B.3.
---------------------------------------------------------------------------
We request comment on our proposal not to include a specific asset
segregation requirement.
168. Do commenters believe that the proposed rule's requirements
discussed above, in their totality, would appropriately address the
asset sufficiency risks underlying section 18? If not and commenters
believe rule 18f-4 should include an asset segregation requirement,
what should that requirement entail? What added benefits would an asset
segregation requirement provide that the current proposed rule
requirements would not?
169. Should we require funds relying on the limited derivatives
user exposure-based exception to segregate assets for purposes of the
exception? Why or why not? Would an asset segregation requirement for
such limited derivatives users obviate any need for a policies and
procedures requirement? Why or why not?
170. Commenters in the 2015 release requested further clarity about
the Commission's 2015 proposal to require a principles-based asset
segregation regime. What aspect of that proposal required further
clarity and why?
G. Alternative Requirements for Certain Leveraged/Inverse Funds and
Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment
Vehicles
1. Background on Proposed Approach to Certain Leveraged/Inverse Funds
Proposed rule 18f-4 would include an alternative approach for
certain funds that seek to provide leveraged or inverse exposure to an
underlying index, generally on a daily basis. This alternative approach
would be available for a registered investment company that is a
``leveraged/inverse investment vehicle,'' as that term is defined in
proposed Exchange Act rule 15l-2 and proposed Advisers Act rule 211(h)-
1 (which we refer to collectively as the proposed ``sales practices
rules,'' as noted above). As discussed below, the proposed sales
practices rules would require broker-dealers and investment advisers to
engage in due diligence before accepting or placing an order for a
customer or client that is a natural person (``retail investor'') to
trade a leveraged/inverse investment vehicle, or approving a retail
investor's account for such trading. The definition of the term
``leveraged/inverse investment vehicle'' in the proposed sales
practices rules would include certain entities 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.\307\ The
entities included in the proposed scope of the sales practices rules
would include registered investment companies and certain exchange-
listed commodity- or currency-based trusts or funds. In this release,
we refer to the registered investment companies covered by the proposed
sales practices rules as ``leveraged/inverse funds'' (which in turn
would be subject to the proposed alternative approach under rule 18f-
4). We use the proposed sales practices rules' defined term
``leveraged/inverse investment vehicle'' to refer to both such
leveraged/inverse funds and to the exchange-listed commodity- or
currency-based trusts or funds covered by those rules.
---------------------------------------------------------------------------
\307\ See proposed rules 15l-2(d) and 211(h)-1(d) (defining the
term ``leveraged/inverse investment vehicle''); see also, e.g., ETFs
Adopting Release, supra note 76, at section II.A.3; rule 6c-11(c)(3)
under the Investment Company Act.
---------------------------------------------------------------------------
Leveraged/inverse funds, which today are structured primarily as
leveraged/inverse ETFs, seek to amplify the returns of an underlying
index by a specified multiple or to profit from a decline in the value
of their underlying index over a predetermined period of time using
financial derivatives.\308\ These funds reset periodically and are
designed to hedge against or profit from short-term market movements
without using margin, and, as such, are generally intended as short-
term trading tools.\309\ To achieve their targeted returns, leveraged/
inverse funds use derivatives extensively. In contrast to other funds
that use derivatives as part of their broader investment strategy,
leveraged/inverse funds' strategies (and use of derivatives) are
predicated on leverage. Accordingly, leveraged/inverse funds raise the
issues that section 18 of the
[[Page 4492]]
Investment Company Act is designed to address.
---------------------------------------------------------------------------
\308\ See infra section III.B for baseline statistics regarding
leveraged/inverse ETFs and mutual funds. Leveraged/inverse ETFs
operate under Commission orders providing exemptive relief from
certain provisions of the Investment Company Act. These orders,
however, do not provide exemptive relief from section 18 of the
Investment Company Act. Rather, like other funds that use derivative
investments, leveraged/inverse ETFs rely upon Release 10666 and
operate consistent with the conditions in staff no-action letters
and other staff guidance on derivatives transactions. See infra
section II.L (discussing our proposal to rescind Release 10666, and
stating that staff in the Division of Investment Management is
reviewing certain of its no-action letters and other guidance to
determine which letters and other staff guidance should be withdrawn
in connection with any adoption of this proposal).
The Commission recently adopted rule 6c-11 under the Investment
Company Act to permit ETFs that satisfy certain conditions to
operate without obtaining an exemptive order from the Commission.
Rule 6c-11 includes a provision excluding leveraged/inverse ETFs
from the scope of that rule. See infra section II.G.4 (discussing
proposed amendments to rule 6c-11 and proposed rescission of
exemptive orders issued to leveraged/inverse ETFs).
\309\ See Commission Interpretation Regarding Standard of
Conduct for Investment Advisers, Investment Advisers Act Release No.
5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)], at text preceding
n.39 (``Fiduciary Interpretation'').
---------------------------------------------------------------------------
Leveraged/inverse funds and certain commodity pools following the
same strategy also present unique considerations because they rebalance
their portfolios on a daily (or other predetermined) basis in order to
maintain a constant leverage ratio. This reset, and the effects of
compounding, can result in performance over longer holding periods that
differs significantly from the leveraged or inverse performance of the
underlying reference index over those longer holding periods.\310\ This
effect can be more pronounced in volatile markets.\311\ As a result,
buy-and-hold investors in a leveraged/inverse fund who have an
intermediate or long-term time horizon--and who may not evaluate their
portfolios frequently--may experience large and unexpected losses or
otherwise experience returns that are different from what they
anticipated.\312\
---------------------------------------------------------------------------
\310\ For example, as a result of compounding, a leveraged/
inverse fund can outperform a simple multiple of its index's returns
over several days of consistently positive returns, or underperform
a simple multiple of its index's returns over several days of
volatile returns.
\311\ See FINRA Regulatory Notice 09-31, Non-Traditional ETFs--
FINRA Reminds Firms of Sales Practice Obligations Relating to
Leveraged and Inverse Exchange-Traded Funds (June 2009) (``FINRA
Regulatory Notice 09-31'') (``Using a two-day example, if the index
goes from 100 to close at 101 on the first day and back down to
close at 100 on the next day, the two-day return of an inverse ETF
will be different than if the index had moved up to close at 110 the
first day but then back down to close at 100 on the next day. In the
first case with low volatility, the inverse ETF loses 0.02 percent;
but in the more volatile scenario the inverse ETF loses 1.82
percent. The effects of mathematical compounding can grow
significantly over time, leading to scenarios such as those noted
above.'').
\312\ See id. (reminding member firms of their sales practice
obligations relating to leveraged/inverse ETFs and stating that
leveraged/inverse ETFs are typically not suitable for retail
investors who plan to hold these products for more than one trading
session). See also Fiduciary Interpretation, supra note 308 (stating
that ``leveraged exchange-traded products are designed primarily as
short-term trading tools for sophisticated investors . . . [and]
require daily monitoring . . . .''); Securities Litigation and
Consulting Group, Leveraged ETFs, Holding Periods and Investment
Shortfalls, (2010), at 13 (``The percentage of investors that we
estimate hold [leveraged/inverse ETFs] longer than a month is quite
striking.''); ETFs Adopting Release, supra note 76, at n.78
(discussing comment letters submitted by Consumer Federation of
America (urging the Commission to consider additional investor
protection requirements for leveraged/inverse ETFs) and by Nasdaq
(stating that ``there is significant investor confusion regarding
existing leveraged/inverse ETFs' daily investment horizon'')).
---------------------------------------------------------------------------
The Commission's Office of Investor Education and Advocacy and
FINRA have issued alerts in the past decade to highlight issues
investors should consider when investing in leveraged/inverse
funds.\313\ In addition, some commenters to the 2015 proposal indicated
that at least some segment of investors may hold leveraged/inverse
funds for long periods of time, which can lead to significant losses
under certain circumstances.\314\ FINRA has sanctioned a number of
brokerage firms for making unsuitable sales of leveraged/inverse
ETFs.\315\ More recently, the Commission has brought enforcement
actions against investment advisers for, among other things, soliciting
advisory clients to purchase leveraged/inverse ETFs for their
retirement accounts with long-term time horizons, and holding those
securities in the client accounts for months or years.\316\
---------------------------------------------------------------------------
\313\ SEC Investor Alert and Bulletins, Leveraged and Inverse
ETFs: Specialized Products with Extra Risks for Buy-and-Hold
Investors (Aug. 1, 2009), available at http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm. This investor alert, jointly issued by
SEC staff and FINRA, followed FINRA's June 2009 alert, which raised
concerns about retail investors holding leveraged/inverse ETFs over
periods of time longer than one day. See FINRA Regulatory Notice 9-
31, supra note 310.
\314\ See, e.g., CFA Comment Letter (``There is evidence that
suggests investors are incorrectly using certain alternative
investments that use derivatives extensively. For example, despite
the fact that double and triple leveraged ETFs are short-term
trading vehicles that are not meant to be held longer than one day,
a significant number of shares are held for several days, if not
weeks.''). But cf. Comment Letter of Rafferty Asset Management (Mar.
28, 2016) (asserting that there is no evidence that investors do not
understand the leveraged/inverse ETF product, citing, for example,
an analysis of eight of its leveraged/inverse ETFs between May 1,
2009 and July 31, 2015, and finding an average implied holding
period ranging from 1.18 days to 4.03 days and suggesting,
therefore, that investors understand the products are designed for
active trading). We note, however, that the analysis relied upon in
the Comment Letter of Rafferty Asset Management did not analyze
shareholder-level trading activity or provide any information on the
distribution of shareholder holding periods.
\315\ See FINRA News Release, FINRA Sanctions Four Firms $9.1
Million for Sales of Leveraged and Inverse Exchange-Traded Funds
(May 1, 2012), available at https://www.finra.org/newsroom/2012/finra-sanctions-four-firms-91-million-sales-leveraged-and-inverse-exchange-traded; FINRA News Release, FINRA Orders Stifel, Nicolaus
and Century Securities to Pay Fines and Restitution Totaling More
Than $1 Million for Unsuitable Sales of Leveraged and Inverse ETFs,
and Related Supervisory Deficiencies (Jan. 9, 2014), available at
https://www.finra.org/newsroom/2014/finra-orders-stifel-nicolaus-and-century-securities-pay-fines-and-restitution-totaling; FINRA
News Release, FINRA Sanctions Oppenheimer & Co. $2.9 Million for
Unsuitable Sales of Non-Traditional ETFs and Related Supervisory
Failures (June 8, 2016), available at http://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-million-unsuitable-sales-non-traditional-etfs. See also ProEquities, Inc., FINRA Letter of
Acceptance, Waiver and Consent (``AWC'') No. 2014039418801 (Aug. 8,
2016), available at http://disciplinaryactions.finra.org/Search/ViewDocument/66461; Citigroup Global Markets Inc., FINRA Letter of
AWC No. 20090191134 (May, 1, 2012), available at http://disciplinaryactions.finra.org/Search/ViewDocument/31714. See also
Regulation Best Interest: The Broker-Dealer Standard of Conduct,
Exchange Act Release No. 86031 (June 5, 2019) [84 FR 33318 (July 12,
2019)], at paragraph accompanying nn.593-98 (``Regulation Best
Interest: The Broker-Dealer Standard of Conduct''). See also, e.g.,
SEC. v. Hallas, No 1:17-cv-2999 (S.D.N.Y. Sept. 27, 2017) (default
judgement); In the Matter of Demetrios Hallas, SEC. Release No. 1358
(Feb. 22, 2019) (initial decision), Exchange Act Release No 85926
(May 23, 2019) (final decision) (involving a former registered
representative of registered broker-dealers purchasing and selling
leveraged ETFs and exchange-traded notes for customer accounts while
knowingly or recklessly disregarding that they were unsuitable for
these customers, in violation of section 17(a) of the Securities Act
and section 10(b) and rule 10b-5 thereunder of the Exchange Act).
\316\ See, e.g., In the Matter of Morgan Stanley Smith Barney,
LLC, Investment Advisers Act Release No. 4649 (Feb. 14, 2017)
(settled action).
---------------------------------------------------------------------------
Most leveraged/inverse funds could not satisfy the limit on fund
leverage risk in proposed rule 18f-4 because they provide leveraged or
inverse market exposure exceeding 150% of the return or inverse return
of the relevant index.\317\ These funds therefore would fail the
relative VaR test and would not be eligible to use the absolute VaR
test.\318\ Requiring these funds to comply with the proposed VaR tests
therefore effectively would preclude sponsors from offering the funds
in their current form. Investors who are capable of evaluating these
funds' characteristics and their unique risks, however, may want to use
them to meet specific short-term or other investment goals. We
therefore are proposing a set of alternative requirements for
leveraged/inverse funds designed to address the investor protection
concerns that underlie section 18 of the Investment Company Act, while
preserving choice for these investors. These requirements, discussed
below, are designed to help ensure that retail investors in leveraged/
inverse investment vehicles are limited to those who are capable of
evaluating the risks these products present. They also would limit the
amount of leverage that leveraged/inverse funds subject to rule 18f-4
can obtain to their current levels.
---------------------------------------------------------------------------
\317\ See supra section II.D (discussing the proposed VaR-based
limit on fund leverage risk).
\318\ See supra section II.D (discussing relative and absolute
VaR tests under proposed rule 18f-4). In addition, we understand
that even if leveraged/inverse funds were to apply the proposed
absolute VaR test, many of those funds also would fail that test.
---------------------------------------------------------------------------
2. Proposed Sales Practices Rules for Leveraged/Inverse Investment
Vehicles
As a complement to proposed rule 18f-4, we are proposing sales
practices rules under the rulemaking authority provided in Exchange Act
section 15(l)(2) and Advisers Act section
[[Page 4493]]
211(h).\319\ The proposed sales practices rules would require broker-
dealers and investment advisers to exercise due diligence on retail
investors before approving retail investor accounts to invest in
leveraged/inverse investment vehicles. Specifically, proposed rule 15l-
2 under the Exchange Act would require a broker-dealer (or any
associated person of the broker-dealer) to exercise due diligence to
ascertain certain essential facts about a customer who is a retail
investor before accepting the customer's order to buy or sell shares of
a leveraged/inverse investment vehicle, or approving the customer's
account to engage in those transactions.\320\ Similarly, proposed rule
211(h)-1 under the Advisers Act would require an investment adviser (or
any supervised person of the investment adviser) to exercise due
diligence to ascertain the same set of essential facts about a client
who is a retail investor before placing an order for that client's
account to buy or sell shares of a leveraged/inverse investment
vehicle, or approving the client's account to engage in those
transactions.\321\ Under both of the proposed sales practices rules, a
firm could approve the retail investor's account to buy or sell shares
of leveraged/inverse investment vehicles only if the firm had a
reasonable basis to believe that the investor is capable of evaluating
the risks associated with these products.
---------------------------------------------------------------------------
\319\ These provisions provide the Commission with authority to
``where appropriate, promulgate rules prohibiting or restricting
certain sales practices, conflicts of interest, and compensation
schemes for brokers, dealers, and investment advisers that the
Commission deems contrary to the public interest and the protection
of investors.''
\320\ Proposed rule 15l-2(a). In this release, the term
``firm,'' which collectively refers to Commission-registered broker-
dealers and investment advisers, also includes associated persons of
such broker-dealers.
\321\ Proposed rule 211(h)-1(a). In this release, the term
``firm,'' which collectively refers to Commission-registered broker-
dealers and investment advisers, also includes supervised persons of
such investment advisers.
---------------------------------------------------------------------------
The proposed sales practices rules are designed to establish a
single, uniform set of enhanced due diligence and approval requirements
for broker-dealers and investment advisers with respect to retail
investors that engage in leveraged/inverse investment vehicle
transactions, including transactions where no recommendation or
investment advice is provided by a firm. These rules therefore would
apply the same due diligence requirements to both broker-dealers and
investment advisers.\322\ They are designed to help ensure that
investors in these funds are limited to those who are capable of
evaluating their characteristics--including that the funds would not be
subject to all of the leverage-related requirements applicable to
registered investment companies generally--and the unique risks they
present. Compliance with the proposed rules would not supplant or by
itself satisfy other broker-dealer or investment adviser obligations,
such as a broker-dealer's obligations under Regulation Best Interest or
an investment adviser's fiduciary duty under the Advisers Act.\323\
---------------------------------------------------------------------------
\322\ Although we expect that the proposed sales practices rules
would cover a significant percentage of the retail investors who
invest in leveraged/inverse investment vehicles, we recognize that
not every purchase or sale of a leveraged/inverse investment vehicle
will involve a customer or client of a Commission-registered broker-
dealer or investment adviser that would be subject to the proposed
sales practices rules.
\323\ See Regulation Best Interest: The Broker-Dealer Standard
of Conduct, supra note 314 (discussing broker-dealer obligations
when providing a recommendation to a retail customer of any
securities transaction or investment strategy involving securities
based on the customer's investment profile); Fiduciary
Interpretation, supra note 308 (discussing an investment adviser's
fiduciary duty to its client, and stating that as fiduciaries,
investment advisers owe their clients duties of care and loyalty).
---------------------------------------------------------------------------
The approval and due diligence requirements under the proposed
rules are modeled after current FINRA options account approval
requirements for broker-dealers.\324\ Under the FINRA rules governing
options, a broker-dealer may not accept a customer's options order
unless the broker-dealer has approved the customer's account for
options trading.\325\ Similarly, the proposed sales practices rules
would require that a firm approve a retail investor's account before
the retail investor may invest in leveraged/inverse investment
vehicles. As such, the proposed sales practices rules, like the FINRA
rule, would not require firms to evaluate retail investors' eligibility
to transact in these products on a transaction-by-transaction basis. We
have generally modeled the proposed rules after the FINRA options
account framework in part because leveraged/inverse investment
vehicles, when held over longer periods of time, may have certain
similarities to options.\326\ The options account approval requirements
also represent a current framework that can be used in connection with
complex products generally.\327\ This approach may provide some
efficiencies and reduced compliance costs for broker-dealers that
already have compliance procedures in place for approving options
accounts, although we recognize that these efficiencies and reduced
compliance costs would not apply to investment advisers that are not
dually registered as, or affiliated with, broker-dealers subject to
FINRA rules.
---------------------------------------------------------------------------
\324\ See, e.g., FINRA rule 2360(b)(16), (17) (requiring for
options accounts, firm approval, diligence and recordkeeping).
\325\ FINRA rule 2360(b)(16). The same requirements apply for
transactions in index warrants, currency index warrants, and
currency warrants. See FINRA rules 2352 and 2353. Similar
requirements apply for transactions in security futures. See FINRA
rule 2370(b)(16) (requiring broker-dealer approval and diligence
regarding the opening of accounts to trade security futures).
\326\ For example, both leveraged/inverse investment vehicles
and options provide exposure that is economically equivalent to a
dynamically rebalanced inverse or leveraged position in an
underlying asset. As a result, both have return characteristics that
are more complex than those of the underlying asset, particularly as
a leveraged/inverse investment vehicle's leverage multiple and/or
holding period increase. See infra section III.B.5.
\327\ See FINRA Regulatory Notice 12-03 (providing, among other
things, that FINRA members ``should consider prohibiting their sales
force from recommending the purchase of some complex products to
retail investors whose accounts have not been approved for options
trading'').
---------------------------------------------------------------------------
a. Definition of Leveraged/Inverse Investment Vehicle
The proposed sales practices rules would define a ``leveraged/
inverse investment vehicle'' to mean a registered investment company or
an exchange-listed commodity- or currency-based trust or fund (a
``listed commodity pool''), that seeks, 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.\328\ Although the scope of this
definition extends beyond just ETFs (as defined in rule 6c-11), this
definition otherwise is substantively identical to the provision in
rule 6c-11 excluding leveraged/inverse ETFs from the scope of that
rule. The substantive requirements in the proposed definition in the
sales practices rules have the same meaning as the provision in rule
6c-11.\329\
---------------------------------------------------------------------------
\328\ See proposed rule 15l-2(d) and proposed rule 211(h)-1(d).
\329\ See rule 6c-11(c)(4) (providing that scope of rule 6c-11
does not include ETFs 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.''). See also ETFs
Adopting Release, supra note 76, at section II.A.3 (discussing rule
6c-11(c)(4)).
---------------------------------------------------------------------------
We believe it is appropriate for the scope of the proposed sales
practices rules to include leveraged/inverse funds as well as listed
commodity pools that follow a similar leveraged or inverse
[[Page 4494]]
strategy. The same investor protection concerns regarding aligning
firms' transaction practices with investors' capability of evaluating
the risks of these trading tools apply to this broader category of
leveraged/inverse investment vehicles, and not just leveraged/inverse
funds specifically.\330\ Indeed, we understand that leveraged/inverse
funds and listed commodity pools following the same strategy can have
virtually identical investment portfolios. Applying the proposed rule
to all leveraged/inverse investment vehicles, as defined in the
proposed rules, would avoid potential regulatory arbitrage that could
result if we were to place different requirements on these products.
---------------------------------------------------------------------------
\330\ The definition of commodity- or currency-based trusts or
funds that we propose to include in the leveraged/inverse investment
vehicle definition tracks a definition recently provided by Congress
in the Fair Access to Investment Research Act of 2017, Public Law
115-66, 131 Stat. 1196 (2017) (the ``FAIR Act''), which we
understand includes the kinds of commodity pools that generally
pursue leveraged or inverse investment strategies. Our proposed
definition differs from the FAIR Act definition because it would not
include a trust or fund that holds only commodities or currencies
and does not hold derivatives. Because we believe that trusts or
funds that seek to provide a leveraged or inverse return of an index
generally would use derivatives to do so, we do not believe it is
necessary to include trusts or funds that do not hold derivatives in
the proposed definition in the sales practices rules.
---------------------------------------------------------------------------
We request comment on the definition of the term ``leveraged/
inverse investment vehicle'' in the proposed sales practices rules.
171. Is the scope of the proposed definition of the term
``leveraged/inverse investment vehicle'' appropriate? The definition
includes a fund that seeks to provide investment returns that have an
inverse relationship to the performance of a market index. Do
commenters agree that this is appropriate? Should the definition
instead only include an inverse fund that seeks investment returns that
exceed the inverse performance of a market index by a specified
multiple (e.g., -1.5 or lower)? Why or why not? The definition also
includes a fund that seeks to provide performance results ``over a
predetermined period of time.'' Do commenters agree that this is
appropriate? Generally, the extent to which a fund's performance can be
expected to deviate from the multiple or inverse multiple of the
performance of its index when held over longer periods is larger for
funds that track a multiple or inverse multiple of the performance of
an index over shorter time intervals, as those funds typically
rebalance their portfolios more frequently. Should we specify a time
period in the definition and, if so, what time period would be
appropriate? For example, should the definition only include a fund
that seeks investment returns that correspond to a multiple or inverse
multiple of an index over a fixed period of time that is less than a
year, a quarter, or a month? Please explain.
172. Do commenters agree with our proposal to include listed
commodity pools within the definition? Are we correct that the
similarities between the investment strategies and return profiles of
listed commodity pools and other leveraged/inverse investment vehicles,
such as leveraged/inverse ETFs, warrant including listed commodity
pools within the scope of this definition?
173. Are there other types of investments or products that we
should include in the leveraged/inverse investment vehicle definition?
For example, should we include exchange-traded notes within the scope
of the proposed sales practices rules if they have the same or similar
return profile as the leveraged/inverse funds and listed commodity
pools included in the proposed definition? \331\ Are there additional
complex financial products, such as those discussed in FINRA Regulatory
Notice 12-03 (including, among others, certain structured or asset-
backed notes, unlisted REITs, securitized products, and products that
offer exposure to stock market volatility), that commenters believe
should be subject to the due diligence and account approval
requirements that we are proposing for leveraged/inverse investment
vehicles? \332\
---------------------------------------------------------------------------
\331\ The Commission also recently brought and settled an
enforcement action against a dually-registered broker-dealer/
investment adviser, certain of its supervisory personnel, and one of
its registered representatives arising out of that representative's
recommending that his customers buy and hold leveraged and inverse
exchange-traded funds and exchange traded notes (including
allegations that the registered representative recommended that his
customers hold a triple-leveraged exchange-traded note for longer
than the one-day holding period set forth in the product's
prospectus). See In the Matter of Cadaret Grant, et al., Exchange
Act Release No. 84074 (Sept. 11, 2018) (alleging, among other
things, a violation of section 206(4) of the Advisers Act and rule
206(4)-7 thereunder and failure to supervise) (settled action). See
In the Matter of Cadaret Grant, et al., Exchange Act Release No.
84074 (Sept. 11, 2018) (settled action).
\332\ See FINRA Regulatory Notice 12-03, supra note 326.
---------------------------------------------------------------------------
b. Required Approval and Due Diligence in Opening Accounts
Under the proposed sales practices rules, no firm may accept an
order from or place an order for a retail investor to buy or sell
shares of a leveraged/inverse investment vehicle, or approve such a
retail investor's account to engage in those transactions, unless the
firm has complied with certain conditions. Specifically, the proposed
rules would require the firm to (1) approve the retail investor's
account for buying and selling shares of leveraged/inverse investment
vehicles pursuant to a due diligence requirement; and (2) adopt and
implement policies and procedures reasonably designed to achieve
compliance with the proposed rules.
The proposed due diligence requirement provides that a firm must
exercise due diligence to ascertain the essential facts relative to the
retail investor, his or her financial situation, and investment
objectives. A firm must seek to obtain, at a minimum, certain
information about its retail investor's:
Investment objectives (e.g., safety of principal, income,
growth, trading profits, speculation) and time horizon;
employment status (name of employer, self-employed or
retired);
estimated annual income from all sources;
estimated net worth (exclusive of family residence);
estimated liquid net worth (cash, liquid securities,
other);
percentage of the retail investor's liquid net worth that
he or she intends to invest in leveraged/inverse investment vehicles;
and
investment experience and knowledge (e.g., number of
years, size, frequency and type of transactions) regarding leveraged/
inverse investment vehicles, options, stocks and bonds, commodities,
and other financial instruments.\333\
---------------------------------------------------------------------------
\333\ See proposed rule 15l-2(b)(2). For joint accounts, the
firm must seek to obtain the information for all participants in
joint retail investor accounts.
Based on its evaluation of this information, the firm would be required
specifically to approve or disapprove the retail investor's account for
buying or selling shares of leveraged/inverse investment vehicles. If
the firm approves the account, the approval must be in writing.
Under the proposed rules, to provide this approval a firm must have
a reasonable basis for believing that the retail investor has the
financial knowledge and experience to be reasonably expected to be
capable of evaluating the risks of buying and selling leveraged/inverse
investment vehicles. We are not proposing a bright-line test for this
determination. Rather, the determination would be based on all of the
relevant facts and circumstances.
The information that a firm would collect includes information
about the retail investor's financial status (e.g.,
[[Page 4495]]
employment status, income, and net worth (including liquid net worth));
and information about his or her investment objectives generally and
his or her anticipated investments in, and experience with, leveraged/
inverse investment vehicles (e.g., general investment objectives,
percentage of liquid net worth intended for investment in leveraged/
inverse investment vehicles, and investment experience and knowledge).
This information is designed to provide a comprehensive picture of the
retail investor to allow a firm to evaluate whether the retail investor
has the financial knowledge and experience to be reasonably expected to
be capable of evaluating the risks of buying and selling leveraged/
inverse investment vehicles.
While not required under the proposed rules, firms could consider
establishing multiple levels of account approvals for a retail investor
seeking to trade leveraged/inverse investment vehicles. We understand
that broker-dealers set different levels of options account approval
depending on the customer's trading experience and financial
sophistication.\334\ Similarly, a firm may determine that certain
leveraged/inverse investment vehicles (e.g., those with lower leverage
multiples or that invest in less-volatile asset classes) are more
appropriate for a lower level of account approval, while other types of
leveraged/inverse investment vehicles may be more appropriate for a
higher level of account approval. Any such approaches generally should
be addressed in the policies and procedures that the proposed sales
practices rules would require a firm to adopt and implement.\335\
---------------------------------------------------------------------------
\334\ These increasing levels generally track the riskiness of
the product or trading strategy; for example, the initial option
account approval may permit covered call writing of equity options
but higher account approvals would be needed for writing uncovered
index options.
\335\ See proposed rules 15l-2(a) and 211(h)-1(a).
---------------------------------------------------------------------------
The proposed rules' scope with respect to a firm's customer or
client is limited to ``a natural person'' or ``the legal representative
of a natural person.'' \336\ The rules include all natural persons--
including high-net worth individuals--to provide the related investor
protections to all natural persons. The proposed rules require firms to
seek to obtain and to consider information related to a retail
investor's net worth as part of their consideration of whether to
approve the investor's account for trading in leveraged/inverse
investment vehicles. We interpret ``legal representative'' of a natural
person to mean non-professional legal representatives of a natural
person.\337\ This interpretation would exclude institutions and certain
professional fiduciaries, but it would include certain legal entities
such as trusts that represent the assets of a natural person.\338\ This
interpretation is designed to provide the protections of the sales
practices rules where non-professional persons are acting on behalf of
natural persons, but where such professional persons are not regulated
financial services industry professionals retained by natural persons
to exercise independent professional judgment.\339\
---------------------------------------------------------------------------
\336\ See proposed rules 15l-2(a) and 211(h)-1(a).
\337\ See, e.g., Form CRS Relationship Summary, Exchange Act
Release No. 34-86032 (June 5, 2019) [84 FR 33492 (July 12, 2019)]
(``Form CRS Release''), at n.629 and accompanying text.
\338\ See Form CRS Release, supra note 336, at nn.645-647 and
accompanying text (clarifying interpretation of ``legal
representative'' of a natural person to cover only non-professional
legal representatives (e.g., a non-professional trustee that
represents the assets of a natural person and similar
representatives such as executors, conservators, and persons holding
a power of attorney for a natural person)); Regulation Best
Interest: The Broker-Dealer Standard of Conduct, supra note 314, at
n.237 and accompanying text (defining ``retail customer'').
\339\ See Form CRS Release, supra note 336, at nn.645-647 and
accompanying text.
---------------------------------------------------------------------------
In addition, we are proposing to specify in the sales practices
rules that, although the rules would apply to transactions by broker-
dealers and investment advisers for retail investors--including those
investors who have existing accounts before the rules' compliance
date--the sales practices rules would not apply to a position in a
leveraged/inverse investment vehicle established before the rules'
compliance date. This provision is designed to allow existing investors
in leveraged/inverse investment vehicles with open investments as of
the rules' compliance date to sell their holdings (or to purchase
leveraged/inverse investment vehicles to close out short positions in
the leveraged/inverse investment vehicle) without the additional steps
we propose to require for their broker-dealer or investment adviser to
determine whether to approve the retail investor's account to trade in
these products.\340\ Absent this provision, the sales practices rules
could prevent or delay a retail investor's ability to close or reduce a
position in a leveraged/inverse investment vehicle that he or she
entered into before firms were required to comply with the rules.
---------------------------------------------------------------------------
\340\ This provision is designed to allow a retail investor to
exit a legacy position in a leveraged/inverse investment vehicle, as
discussed above, and does not reflect any view on whether any
recommendation for these legacy positions was suitable when made.
---------------------------------------------------------------------------
We also do not believe it would be appropriate to apply the sales
practices rules only to retail accounts established after the rules'
compliance date, because the investor protection concerns underlying
the rules would apply equally to pre-existing retail investor accounts.
Accordingly, the proposed rules would make clear that, even if a retail
investor had already been trading leveraged/inverse investment
vehicles, a firm would have to satisfy the due diligence and account
approval requirements for that investor's account before the investor
could make additional investments in leveraged/inverse investment
vehicles.\341\
---------------------------------------------------------------------------
\341\ As discussed above, this evaluation would take into
account, among other things, the investor's experience with
leveraged/inverse investment vehicles. See, e.g., proposed rules
211(h)-1(b)(2) and 15l-2(b)(2).
---------------------------------------------------------------------------
The proposed sales practices rules also would require firms to
adopt and implement written policies and procedures addressing
compliance with the applicable sales practices rule.\342\ We are not
proposing to impose specific requirements for these policies and
procedures, provided that they are reasonably designed to achieve
compliance with the applicable sales practices rule, including the due
diligence and account approval requirements. This requirement, together
with the proposed recordkeeping requirements discussed below, is
designed to provide comparable policies and procedures and
recordkeeping requirements for both broker-dealers and investment
advisers.
---------------------------------------------------------------------------
\342\ See proposed rule 15l-2(a); proposed rule 211(h)-1(a).
---------------------------------------------------------------------------
We request comment on the proposed approval and due diligence
requirements for approving retail investors' accounts to trade in
shares of leveraged/inverse investment vehicles.
174. Is modeling these rules on FINRA's options rule the
appropriate approach? Why or why not?
175. Should the proposed sales practices rules apply to Commission-
registered broker-dealers and investment advisers? Why or why not? What
challenges, if any, would broker-dealers or investment advisers face
complying with the proposed rules, and what compliance burdens would
the proposed rules create for broker-dealers and investment advisers?
Would compliance burdens be substantially different for investment
advisers than for broker-dealers (for example, because of any
compliance efficiencies that might result to the extent broker-dealers
are already complying with FINRA's
[[Page 4496]]
rules for approving options accounts), or vice versa? Should we apply
proposed Advisers Act rule 211(h)-1 to investment advisers that are
registered with one or more states but not registered with the
Commission? Why or why not? Should the proposed rule for investment
advisers apply equally to advisers with discretionary authority and
with non-discretionary authority over client accounts? If the sales
practices rule for investment advisers applies to both discretionary
and non-discretionary advisory accounts, should we apply different due
diligence and account approval requirements based on whether an account
is discretionary or non-discretionary? Should the proposed sales
practices rules apply to investment advisers, in light of their
fiduciary duties to their clients? Why or why not? Should the sales
practices rules apply to a broker-dealer if the broker-dealer does not
effect transactions in leveraged investment vehicles for retail
investors other than transactions resulting from recommendations that
are subject to Regulation Best Interest? Why or why not?
176. Should the proposed rules apply to transactions in leveraged/
inverse investment vehicles that are directed by a retail investor
without any recommendation or advice from a broker-dealer or investment
adviser? Why or why not?
177. Should the proposed rules apply on a transaction-by-
transaction basis rather than requiring an initial account approval to
transact in leveraged/inverse investment vehicles? Why or why not?
178. As proposed, the sales practices rules would require that a
firm could provide account approval only if the firm has a reasonable
basis for believing that the investor has such knowledge and experience
in financial matters that he or she may reasonably be expected to be
capable of evaluating the risks of buying and selling leveraged/inverse
investment vehicles. Is this account approval standard appropriate? Why
or why not? If not, what should the account approval standard be?
Should it be tied instead, for example, to an investor's ability to
absorb losses, and if so how should a firm assess this?
179. Is the investor information that the proposed rules would
require firms to seek to obtain under the rules' due diligence
requirements appropriate, and would this information effectively assist
in forming a reasonable basis for assessing the investor's knowledge
and experience in financial matters as required under the proposed
account approval standard? Why or why not? What modifications, if any,
should we make to the information items that the proposed rules would
require a firm to seek to obtain? Are there any information items that
we should remove from the proposed list, or any additional information
items that we should include? For example, instead of tracking
generally the information elements set forth under FINRA's option rule,
should the proposed rules track generally the information set forth in
the definition of ``retail customer investment profile'' under
Regulation Best Interest (i.e., ``age, other investments, financial
situation and needs, tax status, investment objectives, investment
experience, investment time horizon, liquidity needs, risk tolerance,
and any other information the retail customer may disclose to the
broker, dealer, or a natural person who is an associated person of a
broker or dealer'')? As proposed, should the rules require firms to
seek to obtain the percentage of the investments that the retail
investor intends to invest in leveraged/inverse investment vehicles?
Why or why not?
180. Should the sales practices rules require firms to obtain the
specified information, rather than to seek to obtain it? Would a firm
be able to form a reasonable basis for believing that a retail investor
has such knowledge and experience in financial matters that he or she
may reasonably be expected to be capable of evaluating the risks of
buying and selling leveraged/inverse investment vehicles if the retail
investor provides some, but not all, of the information specified in
the sales practices rules?
181. What special procedures, if any, do firms currently undertake
in permitting or not permitting retail investors to trade in leveraged/
inverse investment vehicles? At account opening? With respect to
specific transactions? With respect to concentration limits? Do firms
already have approval processes in place designed to evaluate whether
their retail investors are reasonably expected to be capable of
evaluating the risks of buying and selling leveraged/inverse investment
vehicles? If so, do firms distinguish between types of vehicles or
trading strategies? Do these practices differ between broker-dealers
and investment advisers? If so, please explain the differences.
182. What special procedures, if any, do firms currently undertake
in permitting or not permitting retail investors to trade in other
types of complex products? Please explain in detail, including products
to which such procedures apply and what the approval process entails.
183. The proposed sales practices rules would require that firms'
approvals of retail investors' accounts for buying or selling shares of
leveraged/inverse investment vehicles be in writing. The proposed rules
would not require account disapprovals to be in writing. Should we
require account disapprovals also to be in writing? Would such a
requirement raise any practical concerns, or other concerns, for firms?
In other investor approval contexts, do firms currently put both their
approvals and disapprovals in writing?
184. How do broker-dealers apply the options eligibility
requirement with respect to clients of investment advisers, if at all,
when those advisers submit orders on behalf of their clients? Do
broker-dealer practices differ with respect to orders submitted by
other types of intermediaries? Please explain.
185. How do broker-dealers currently analyze the information they
collect under FINRA rule 2360? Which data elements do broker-dealers
find most important and which elements are less important? What
standards do broker-dealers apply in determining whether to approve a
customer's account on the basis of the information collected?
186. Should the proposed rules require firms to provide specific
disclosure as part of the approval process, similar to the options
disclosure document that must be provided under FINRA rule 2360? If so,
what information should it contain? Should the rules require that
receipt of such disclosure be acknowledged?
187. Should the rules require firms to provide retail investors a
short, plain-English disclosure generally describing the risks
associated with leveraged/inverse investment vehicles as part of the
proposed account approval process? For example, before a firm approves
a retail investor's account for buying and selling shares of a
leveraged/inverse investment vehicle, should the rules require a firm
to incorporate and distill into a short disclosure the specific risk
factors associated with leveraged/inverse investment vehicles (such as
the risks related to compounding and other risks that leveraged/inverse
funds disclose in their prospectuses)?
188. Should the rules apply to all customers or clients, and not
just natural persons? Should they apply to a different subset of
customers or clients and, if so, which ones and why? If the rule were
to apply to all customers or clients, including institutional accounts,
what changes should we make to the information that firms must collect
or to the basis upon which a firm would approve or disapprove the
account? Are
[[Page 4497]]
there distinctions between institutional investors and natural persons
that invest in leveraged/inverse investment vehicles that we should
consider? For example, do commenters have data or information on the
percentage of leveraged investment vehicles' investors who are natural
persons, and how natural persons use these investment products (e.g.,
how long do these investors hold the products)?
189. As discussed above, we understand that certain purchases or
sales of leveraged/inverse investment vehicles do not involve a
customer or client of a broker-dealer or investment adviser that would
be subject to the proposed sales practices rules.\343\ Should the
proposed rules apply to these transactions? For example, should the
proposed sales practices rule for broker-dealers apply to a mutual fund
principal underwriter's transactions with any retail investor who is
purchasing fund shares directly from the fund?
---------------------------------------------------------------------------
\343\ See supra note 321.
---------------------------------------------------------------------------
190. Should the sales practices rules include different account-
approval conditions for different types of leveraged/inverse investment
vehicles? For example, should the rules include different conditions
for investment vehicles that seek to exceed the performance of a market
index by a specified multiple, versus those that provide returns that
have an inverse relationship to the performance of a market index?
Should the rules include different levels of account approval, such as
heightened requirements for investors to transact in leveraged/inverse
investment vehicles with higher leverage multiples or that invest in
more volatile asset classes? Similarly, should the rules include
different levels of account-approval conditions based on a retail
investor's trading experience and financial sophistication?
191. Do commenters agree that we should apply the sales practices
rules to all retail investors, including those who have opened accounts
with an investment adviser or broker-dealer before the rules'
compliance date? Should the sales practices rules include exceptions
from the due diligence and account approval requirements for retail
investors that have already traded in leveraged/inverse investment
vehicles as of the rules' compliance date? Should the sales practices
rules provide exceptions for retail investors who meet established
criteria, such as retail investors who are accredited investors? Why or
why not?
192. The proposed rules also would not apply to, and therefore
would not restrict a retail investor's ability to close or reduce, a
position in a leveraged/inverse investment vehicle established before
the rules' compliance date. Do commenters agree that this is
appropriate? Are there modifications we should make to the rules so
that they would not impede an investor's ability to close or reduce an
existing position in a leveraged/inverse investment vehicle? Which
modifications and why? Alternatively, should the sales practices rules
apply to retail investors with positions in leveraged/inverse
investment vehicles established before the rules' compliance date even
if they do not seek to make additional purchases or sales of leveraged
investment vehicles? If so, how would firms comply, in practice, with
the due diligence and account approval requirements for these
investors?
193. Do commenters agree with the proposed policies and procedures
requirement? Should the rule provide specific requirements for firms'
policies and procedures relating to compliance with the sales practices
rules?
c. Recordkeeping
Under the proposed sales practices rules, a firm would have to
maintain a written record of the investor information that it obtained
under the rules' due diligence requirements, the firm's written
approval of the retail investor's account for buying and selling shares
of leveraged/inverse investment vehicles, and the versions of the
firm's policies and procedures that it adopted under the proposed rules
that were in place when it approved or disapproved the account. We
propose that firms be required to retain these records for a period of
not less than six years (the first two years in an easily accessible
place) after the date of the closing of the investor's account.\344\ We
believe that it is appropriate for the proposed rules to include a
recordkeeping provision to facilitate compliance, and regulatory
oversight of a firm's compliance, with the rules. Also, because an
investor account that was approved to trade in leveraged/inverse
investment vehicles could remain open with a firm for more than six
years, we believe it is appropriate to require that records be
preserved for a minimum of six years after the closing of the account,
rather than six years after the creation of the records.\345\ We
believe that this recordkeeping requirement would provide sufficient
investor protection and, because it is generally consistent with
recordkeeping requirements for broker-dealers and investment advisers,
would not impose overly burdensome recordkeeping costs.\346\
---------------------------------------------------------------------------
\344\ See proposed rules 15l-2(c) and 211(h)-1(c).
\345\ This is consistent with other Commission recordkeeping
requirements relating to investor account documentation. See, e.g.,
rule 17a-4(c) under the Exchange Act (requiring broker-dealers to
preserve for a period of not less than six years after the closing
of any customer's account any account cards or records relating to
the terms and conditions with respect to the opening and maintenance
of the account).
\346\ See, e.g., id.; see also rule 204-2(e)(1) under the
Investment Advisers Act (requiring investment advisers to preserve
certain records in an easily accessible place for a period of not
less than five years from the end of the fiscal year during which
the last entry was made on such record, the first two years in an
appropriate office of the investment adviser). While we recognize
that our existing recordkeeping requirements generally require
broker-dealers to preserve records for six years and investment
advisers for five years, we believe it would be appropriate for the
recordkeeping requirements under the proposed sales practices rule
to be consistent, in part because many broker-dealers and investment
advisers are dual-registered, and thus are proposing a six-year
period for both rules.
---------------------------------------------------------------------------
We request comment on the recordkeeping requirement in the proposed
sales practices rules:
194. Is the proposed recordkeeping requirement appropriate? Why or
why not?
195. What changes, if any, should we make to this proposed
requirement (e.g., by modifying the types of records that a firm would
have to keep)?
196. Does our proposal to apply the same recordkeeping requirement
to both broker-dealers and investment advisers raise any specific
recordkeeping concerns for either broker-dealers or investment advisers
(e.g., do investment advisers believe it would be particularly
burdensome to comply with a six-year recordkeeping period)? Should the
proposed rules include different requirements for broker-dealers and
investment advisers?
197. Is the proposed duration of the recordkeeping provision,
including the proposed requirement that the records be maintained for a
minimum of six years after the closing of the investor's account,
appropriate? Does using the closing of the investor's account as the
starting point for the recordkeeping period raise any practical
difficulties for firms? Should we lengthen or shorten the required
recordkeeping periods? Why or why not?
3. Alternative Provision for Leveraged/Inverse Funds Under Proposed
Rule 18f-4
Under proposed rule 18f-4, a fund would not have to comply with the
proposed VaR-based leverage risk limit if it: (1) Meets the definition
of a ``leveraged/inverse investment vehicle'' in the proposed sales
practices rules; (2) limits the investment results it seeks to
[[Page 4498]]
300% of the return (or inverse of the return) of the underlying index;
and (3) discloses in its prospectus that it is not subject to proposed
rule 18f-4's limit on fund leverage risk. We refer to this set of
proposed conditions collectively as the ``alternative provision for
leveraged/inverse funds.'' A leveraged/inverse fund that satisfies
these conditions still would be required to satisfy all of the
additional conditions in proposed rule 18f-4 other than the VaR tests,
including the proposed conditions requiring a derivatives risk
management program, board oversight and reporting, and
recordkeeping.\347\
---------------------------------------------------------------------------
\347\ See proposed rule 18f-4(c)(1), (5)-(6).
---------------------------------------------------------------------------
First, the alternative provision for leveraged/inverse funds
requires that a leveraged/inverse fund be a ``leveraged/inverse
investment vehicle'' as defined in the proposed sales practices
rules.\348\ As discussed above, the proposed sales practices rules are
designed to help ensure that investors in leveraged/inverse investment
vehicles are limited to those who are capable of evaluating their
general characteristics and the unique risks they present.
---------------------------------------------------------------------------
\348\ See proposed rule 18f-4(c)(4)(i); proposed rules 15l-2(d)
and 211(h)-1(d) (defining the term ``leveraged/inverse investment
vehicle'').
---------------------------------------------------------------------------
Second, the alternative provision for leveraged/inverse funds would
limit a leveraged/inverse fund's market exposure by providing that the
fund must not seek or obtain, directly or indirectly, investment
results exceeding 300% of the return (or inverse of the return) of the
underlying index.\349\ This limitation reflects the highest leverage
level currently permitted by our exemptive orders for leveraged/inverse
ETFs.\350\ It therefore reflects the maximum amount of leverage in
these funds with which investors and other market participants are
familiar. To permit leveraged/inverse funds to use a higher level of
leverage would heighten the investor protection concerns these funds
present, notwithstanding their more limited investor base.\351\
Moreover, allowing leveraged/inverse funds to increase their leverage
beyond current levels would result in a non-linear increase in the
extent of leveraged/inverse funds' rebalancing activity, which may have
adverse effects on the markets for the constituent securities as
discussed in more detail in sections III.D.1 and III.E.4. For these
reasons, and because the Commission does not have experience with
leveraged/inverse funds that seek returns above 300% of the return (or
inverse of the return) of the underlying index, we are not proposing to
permit higher levels of leveraged market exposure for leveraged/inverse
funds in this rule.
---------------------------------------------------------------------------
\349\ See proposed rule 18f-4(c)(4)(iii).
\350\ See ETFs Adopting Release, supra note 76, at n.75 and
accompanying text.
\351\ See also section III.C.5.
---------------------------------------------------------------------------
Third, the alternative provision for leveraged/inverse funds would
require a leveraged/inverse fund to disclose in its prospectus that it
is not subject to the condition of proposed rule 18f-4 limiting fund
leverage risk.\352\ This requirement is designed to provide investors
and the market with information to clarify that leveraged/inverse
funds--which as discussed above, use derivatives extensively--are not
subject to rule 18f-4's limit on fund leverage risk.
---------------------------------------------------------------------------
\352\ See proposed rule 18f-4(c)(4)(ii).
---------------------------------------------------------------------------
We request comment on the proposed alternative provision for
leveraged/inverse funds.
198. Should the rule include an alternative set of requirements for
leveraged/inverse funds? Should leveraged/inverse funds instead be
required to meet the proposed requirements for all funds that use
derivatives, including the VaR-based limit on fund leverage risk? If
commenters agree that we should permit leveraged/inverse ETFs to rely
on rule 18f-4 based on an alternative set of requirements, are there
additional conditions--either relating to these funds' derivatives risk
management or otherwise--that we should consider requiring those funds
to satisfy? To what extent would additional limitations or restrictions
on leveraged investment vehicles' advertising or marketing materials
help to address the investor protection concerns discussed above?
199. Does our proposal to include within the scope of the rule only
leveraged/inverse funds that are covered by the proposed sales
practices rules, along with the conditions comprising the alternative
provision for leveraged/inverse funds, address the investor protection
concerns related to leveraged/inverse funds?
200. If leveraged/inverse funds operate pursuant to the proposed
alternative provision, should they nonetheless be subject to other
requirements in the proposed rule (e.g., the proposed risk management
program requirement, board oversight and reporting requirement, and
recordkeeping requirement)?
201. Should leveraged/inverse funds relying on the alternative
provision be required to disclose in their prospectuses that the fund
is not subject to the proposed VaR-based limit on fund leverage risk,
as proposed? If so, what would be the most appropriate method of
disclosure? In addition to requiring this disclosure under rule 18f-4,
should we also include this requirement in Form N-1A? Would it aid
practitioners for a leveraged/inverse fund's registration form to
specify this requirement?
202. Should a leveraged/inverse fund relying on rule 18f-4 be
required to limit the investment results it seeks or obtains to 300% of
the return (or inverse of the return) of the underlying index? Would
some other threshold be more appropriate? Should the threshold be
higher, such as 400%, or lower, such as 150% or 200%?
203. Any registered investment company that operates as a
leveraged/inverse fund would be eligible to comply with the proposed
alternative provision for leveraged/inverse funds in rule 18f-4. Should
we limit the scope of leveraged/inverse funds eligible for this
provision to open-end funds, including ETFs?
4. Proposed Amendments to Rule 6c-11 Under the Investment Company Act
and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs
Earlier this year, the Commission adopted rule 6c-11, which permits
ETFs that satisfy certain conditions to operate without obtaining an
exemptive order from the Commission.\353\ Rule 6c-11 includes a
provision excluding leveraged/inverse ETFs from the scope of ETFs that
may rely on that rule.\354\ Leveraged/inverse ETFs, therefore, continue
to rely on their Commission exemptive orders. In adopting rule 6c-11,
the Commission stated that the particular section 18 concerns raised by
leveraged/inverse ETFs' use of derivatives distinguish those funds from
the other ETFs permitted to rely on that rule, and that those section
18 concerns would be more appropriately addressed in a rulemaking
addressing the use of derivatives by funds more broadly.\355\ The
Commission further stated that leveraged/inverse ETFs are similar in
structure and operation to the other types of ETFs that are within the
scope of rule 6c-11.\356\ The rules we are proposing, rule 18f-4 under
the
[[Page 4499]]
Investment Company Act and the sales practices rules under the Exchange
Act and the Advisers Act, would create an updated and more
comprehensive regulatory framework for the use of derivatives by funds,
including provisions specifically applicable to leveraged/inverse ETFs.
Accordingly, we propose to amend rule 6c-11 to remove the provision
excluding leveraged/inverse ETFs from the scope of that rule one year
following the publication of the final amendments in the Federal
Register.
---------------------------------------------------------------------------
\353\ See ETFs Adopting Release, supra note 76.
\354\ See rule 6c-11(c)(4).
\355\ See ETFs Adopting Release, supra note 76, at nn.72-75 and
accompanying text.
\356\ See id. at text following n.86. In addition, one sponsor
of leveraged/inverse ETFs has stated that its ETFs would prefer to
rely on rule 6c-11 over their exemptive orders and that leveraged/
inverse ETFs would be able to comply with rule 6c-11 because they
are structured and operated in the same manner as other ETFs that
fall within the scope of that rule. See id. at n.83 and accompanying
text.
---------------------------------------------------------------------------
In addition, because the proposed amendments to rule 6c-11 would
permit leveraged/inverse ETFs to rely on that rule rather than their
exemptive orders, we are proposing to rescind the exemptive orders we
have previously issued to leveraged/inverse ETFs. The exemptive relief
granted to leveraged/inverse ETFs has resulted in an uneven playing
field among market participants because the Commission has permitted
only three ETF sponsors to operate leveraged/inverse ETFs and has not
granted any exemptive relief for leveraged/inverse ETFs since
2009.\357\ We believe that amending rule 6c-11 and rescinding these
exemptive orders would promote a more level playing field and greater
competition by allowing any sponsor to form and launch a leveraged/
inverse ETF subject to the conditions in rules 6c-11 and proposed rule
18f-4, with transactions in the funds subject to the proposed sales
practices rules. We propose to rescind these exemptive orders on the
effective date of the proposed amendments to rule 6c-11 (one year
following the publication of the final rule amendments in the Federal
Register), to coincide with the compliance date for the sales practices
rules and to allow time for broker-dealers and investment advisers to
make any adjustments necessary to comply with the proposed sales
practices rules. Providing a one-year period for existing leveraged/
inverse ETFs also would provide time for them to prepare to comply with
rule 6c-11 rather than their exemptive orders.\358\
---------------------------------------------------------------------------
\357\ There are currently two ETF sponsors that rely upon this
exemptive relief today. See supra note 307 and accompanying text;
infra note 473 and accompanying text. We also discuss below in
section III.E alternative approaches for leveraged/inverse funds,
including an approach under which the Commission would rescind the
exemptive orders issued to leveraged/inverse ETF sponsors, permit
leveraged/inverse funds to operate under rule 6c-11, but require
leveraged/inverse funds to comply with rule 18f-4's VaR-based limit
on fund leverage risk in lieu of adopting the proposed sales
practices rules.
\358\ See ETFs Adopting Release, supra note 76, at text
following n.451.
---------------------------------------------------------------------------
We request comment on the proposed amendments to rule 6c-11 and
rescission of leveraged/inverse ETF exemptive orders.
204. If leveraged/inverse funds are permitted to rely on rule 18f-
4, should the Commission amend rule 6c-11 to permit leveraged/inverse
funds to operate under that rule, as proposed? Do the requirements of
proposed rule 18f-4, together with the proposed sales practices rules,
adequately address the section 18 concerns relating to leveraged/
inverse funds? Are there are other concerns regarding leveraged/inverse
funds that we should consider in determining whether to allow such
funds to rely on rule 6c-11?
205. In addition, do commenters agree with our proposal to rescind
the existing leveraged/inverse ETF exemptive relief in view of our
proposed treatment of leveraged/inverse funds under rule 18f-4 and
proposed amendments to rule 6c-11? Are there other approaches to the
existing leveraged/inverse ETF exemptive relief that we should consider
in view of proposed rule 18f-4 and the proposed sales practices rules?
H. Amendments to Fund Reporting Requirements
We are proposing amendments to the reporting requirements for funds
that would rely on proposed rule 18f-4--in particular, amendments to
Forms N-PORT, N-LIQUID (which we propose to re-title as ``Form N-RN''),
and N-CEN.\359\ These proposed amendments are designed to enhance the
Commission's ability to oversee funds' use of and compliance with the
proposed rules effectively, and for the Commission and the public to
have greater insight into the impact that funds' use of derivatives
would have on their portfolios.\360\ They would allow the Commission
and others to identify and monitor industry trends, as well as risks
associated with funds' investments in derivatives (including by
requiring current, non-public reporting to the Commission when certain
significant events related to a fund's leverage risk occur). The
proposed amendments also would aid the Commission in evaluating the
activities of investment companies in order to better carry out its
regulatory functions.
---------------------------------------------------------------------------
\359\ 17 CFR 274.150; 17 CFR 274.223; and 17 CFR 249.330 and 17
CFR 274.101.
\360\ The funds that would rely on proposed rule 18f-4 other
than BDCs generally are subject to reporting requirements on Form N-
PORT. All registered management investment companies, other than
registered money market funds and small business investment
companies, are (or will be) required to electronically file with the
Commission, on a quarterly basis, monthly portfolio investment
information on Form N-PORT, as of the end of each month. See
Investment Company Reporting Modernization Adopting Release, supra
note 178. As of April 30, 2019, larger fund groups (defined as
having $1 billion or more in net assets) have begun submitting
reports on Form N-PORT for the period ending March 31, 2019. Smaller
fund groups (less than $1 billion in net assets) will begin
submitting reports on Form N-PORT by April 30, 2020. See Investment
Company Reporting Modernization, Investment Company Act Release No.
32936 (Dec. 8, 2017) [82 FR 58731 (Dec. 14, 2017)]. Only information
reported for the third month of each fund's fiscal quarter on Form
N-PORT will be publicly available (60 days after the end of the
fiscal quarter). See Amendments to the Timing Requirements for
Filing Reports on Form N-PORT, Investment Company Act Release No.
33384 (Feb. 27, 2019) [84 FR 7980 (Mar. 6, 2019)].
Currently, only open-end funds that are not regulated as money
market funds under rule 2a-7 under the Investment Company Act are
required to file current reports on Form N-LIQUID, under section
30(b) of the Investment Company Act and rule 30b1-10 under the Act.
See Investment Company Liquidity Risk Management Programs,
Investment Company Act Release No. 32315 (Oct. 13, 2016) [81 FR
82142 (Nov. 18, 2016)], at section III.L.2 (``Liquidity Adopting
Release''). Our proposal, including proposed amendments to Form N-
LIQUID, rule 30b1-10 and proposed rule 18f-4(c)(7), would add new
VaR-related items to the form, and would extend the requirement to
file current reports with respect to these new items to any fund
(including registered open-end funds, registered closed-end funds,
and BDCs) that relies on rule 18f-4 and that is subject to the
rule's limit on leverage risk.
The funds that would rely on proposed rule 18f-4 other than BDCs
generally are subject to reporting requirements on Form N-CEN.
Specifically, all registered investment companies, including money
market funds but excluding face amount certificate companies, are
currently required to file annual reports on Form N-CEN. See
Investment Company Reporting Modernization Adopting Release, supra
note 178. Form N-CEN requires these funds to report census-type
information including reports on whether a fund relied upon certain
enumerated rules under the Investment Company Act during the
reporting period. See, e.g., Item C.7 of Form N-CEN.
---------------------------------------------------------------------------
1. Amendments to Form N-PORT
We are proposing to amend Form N-PORT to add new items to Part B
(``Information About the Fund''), as well as to make certain amendments
to the form's General Instructions.
a. Derivatives Exposure
We are proposing to amend Form N-PORT to include a new reporting
item on funds' derivatives exposure.\361\ A fund would be required to
provide its derivatives exposure as of the end of the reporting
period.\362\ This information
[[Page 4500]]
would be publicly available for the third month of each fund's quarter
and would provide market-wide insight into the levels of funds'
derivatives exposure to the Commission, its staff, and market
participants.\363\ It also would allow the Commission and its staff to
oversee and monitor compliance with the proposed rule's exception for
limited derivatives users.\364\
---------------------------------------------------------------------------
\361\ See proposed Item B.9 of Form N-PORT; see also proposed
amendments to General Instruction E to Form N-PORT (adding a new
definition for ``derivatives exposure,'' as defined in proposed rule
18f-4(a),which would permit a fund to convert the notional amounts
of interest rate derivatives to 10-year bond equivalents and delta
adjust the notional amounts of options contracts).
\362\ See proposed Item B.9 of Form N-PORT. Just as the proposed
definition of ``derivatives transaction'' in rule 18f-4 includes
derivatives instruments as well as short sale borrowings, Form N-
PORT would require a fund to report exposure associated with
derivatives instruments and short sales.
The proposed requirement to report derivatives exposure at the
end of the reporting period reflects the form's requirement to
report information about funds' portfolio holdings as of the last
business day, or last calendar day, of each month. See General
Instruction A to Form N-PORT. While we are proposing that funds
report their highest daily VaR and median daily VaR during the
reporting period (see infra section II.H.1.b), we are not also
proposing that funds report their highest daily derivatives exposure
(or median daily derivatives exposure) during the reporting period.
This is because proposed rule 18f-4 requires daily calculation of a
fund's VaR but does not require a fund to calculate its derivatives
exposure daily.
\363\ We are not proposing to amend General Instruction F to
Form N-PORT, which specifies the information that funds report on
Form N-PORT that the Commission does not make publicly available.
While the information for the first two months of a fund's
quarter would be non-public, the information for the third month of
a fund's quarter would be publicly available. See supra note 359.
\364\ Under this proposal, a fund would have to indicate whether
it is a limited derivatives user on Form N-CEN. See infra section
II.H.3.
---------------------------------------------------------------------------
We seek comment on the Commission's proposed amendments to Form N-
PORT requiring reporting of derivatives exposure:
206. Is the proposed requirement that funds report their
derivatives exposure on Form N-PORT appropriate? Why or why not? Should
we modify the proposed derivatives exposure reporting item in any way?
If so, how should we modify this reporting item?
207. Our proposal would make public the information that a fund
would report in response to the new derivatives exposure Form N-PORT
item. Is there any reason why this information should not be publicly
available?
208. Should we require this reporting only from certain funds--for
example, those that qualify either as limited derivatives users or
leveraged/inverse funds under proposed rule 18f-4--during the reporting
period?
209. Should we require funds to report metrics tied to their daily
notional amount calculation on Form N-PORT (for example, a fund's
highest daily derivatives exposure during the reporting period and the
date of its highest exposure, and its median daily derivatives exposure
during the reporting period)? Should we only require funds to report
these types of metrics if we were also to modify proposed rule 18f-4 to
require funds to calculate their notional amounts daily? Would this
type of reporting requirement help to mitigate any potential ``window
dressing'' concerns about funds' reporting of their derivatives
exposure, and/or provide additional beneficial transparency with
respect to any particular type of funds (for example, leveraged/inverse
funds)? If so, would these benefits outweigh related costs?
b. VaR Information
We are also proposing to amend Form N-PORT to include a new
reporting item related to the proposed VaR tests.\365\ Information that
a fund would report under this new reporting item would be made public
for the third month of each fund's quarter.\366\ The proposed item
would apply to funds that were subject to the proposed VaR-based limit
on fund leverage risk during the reporting period.
---------------------------------------------------------------------------
\365\ See proposed Item B.10 of Form N-PORT. Proposed item B.10
would require that a fund provide the applicable VaR information in
accordance with proposed rule 18f-4(c)(2)(ii), which requires a fund
to determine compliance with its applicable VaR test at least once
each business day.
\366\ See supra note 362. While the information for the first
two months of a fund's quarter would be non-public, the information
for the third month of a fund's quarter would be publicly available.
See supra note 359.
---------------------------------------------------------------------------
Funds that are subject to the new VaR-related N-PORT item would
have to report their highest daily VaR during the reporting period and
its corresponding date, as well as their median daily VaR for the
monthly reporting period.\367\ Funds subject to the relative VaR test
during the reporting period would report the name of the fund's
designated reference index, and index identifier.\368\ These funds also
would have to report the fund's highest daily VaR ratio (that is, the
value of the fund's portfolio VaR divided by the VaR of the designated
reference index) during the reporting period and its corresponding
date, as well as the fund's median daily VaR ratio for the reporting
period.\369\
---------------------------------------------------------------------------
\367\ See proposed Items B.10.a.-c of Form N-PORT. The proposed
form amendments would require each of the reported metrics to be
determined in accordance with the requirement under proposed rule
18f-4 to determine the fund's compliance with the applicable VaR
test at least once each business day.
\368\ See proposed Item B.10.d.i.-ii of Form N-PORT.
\369\ See proposed Item B.10.d.iii.-v of Form N-PORT.
---------------------------------------------------------------------------
The proposed requirement for a fund to report highest daily VaR
(and, for a fund that is subject to the relative VaR test, information
about the fund's VaR ratio) is designed to help assess compliance with
the proposed rule. These requirements, and the proposed requirement for
a fund to report its median daily VaR (and, for a fund that is subject
to the relative VaR test, the median VaR ratio) are designed to help
identify changes in a fund's VaR over time, and to help identify trends
involving a single fund or group of funds regarding their VaRs. The
proposed requirement that a fund report information about its
designated reference index is designed to help analyze whether funds
are using designated reference indexes that meet the rule's
requirements, and also to assess any trends in the designated reference
indexes that funds select.
A fund also would have to report the number of exceptions the fund
identified during the reporting period arising from backtesting the
fund's VaR calculation model.\370\ This proposed requirement is
designed to help analyze whether a fund's VaR model is effectively
taking into account and incorporating all significant, identifiable
market risk factors associated with a fund's investments, as required
by the proposed rule.\371\ This information would assist in monitoring
for compliance with the proposed VaR tests and also would provide high-
level information to market participants, as well as researchers and
analysts, to help evaluate the extent to which funds' VaR models, used
as part of the proposed VaR tests, are operating effectively. Because
this information would be made publicly available on a delayed basis,
and would not provide details about backtesting exceptions other than
the number of exceptions, we do not believe that this proposed
reporting requirement would produce adverse effects such that the
reported information should be made non-public.\372\
---------------------------------------------------------------------------
\370\ See proposed Item B.10.e of Form N-PORT; see also supra
section II.B.3.d (discussing proposed backtesting requirement); ICI
Comment Letter II (discussing UCITS funds being similarly required
to report to their primary regulator, on a semi-annual basis, the
number of VaR breaks that exceed a specified threshold (a VaR break
occurs when the actual one-day loss exceeds that day's VaR), and
recommending the Commission require funds to report the number of
VaR breaks and the dates on which they occurred).
\371\ See supra note 151.
\372\ See supra notes 362, 365. But see infra section II.H.2
(discussing adverse effects that might arise from the real-time
public reporting of a fund's VaR test breaches under the proposed
amendments to Form N-LIQUID).
Information reported for the third month of each fund's fiscal
quarter on Form N-PORT will be made publicly available 60 days after
the end of the fiscal quarter. See supra note 359.
---------------------------------------------------------------------------
We seek comment on the Commission's proposed amendments to
[[Page 4501]]
Form N-PORT requiring reporting of VaR information:
210. Are the proposed requirements that funds report VaR
information on Form N-PORT, and each of the elements that a fund would
have to report under this requirement, appropriate? Why or why not?
Should we modify the proposed VaR information reporting item in any
way? If so, how should we modify this reporting item?
211. Our proposal would make public all of the information that a
fund would report in response to the new VaR information item on Form
N-PORT. Is there any reason why this information should not be publicly
available? For example, would making this information public lead to
harm arising from investor confusion, adverse competitive effects, or
for any other reason? If we require that this reported information be
made public, is there additional information we should require funds to
report to provide contextualization or mitigate any adverse effects
that could arise from public disclosure? Should we make non-public some
of these disclosures (e.g., portfolio VaR or a fund's designated
reference index, or information about backtesting results) but not
others? If so, which ones should we make non-public and why?
212. Would any of the proposed N-PORT reporting requirements be
more appropriately structured as Form N-CEN reporting requirements, or
items to be reported on a current basis on Form N-RN?
213. Is there any additional information related to funds'
derivatives exposure or derivatives risk management that we should
require funds to report on Form N-PORT? What information and why, and
should this reported information be made public?
2. Amendments to Current Reporting Requirements
We are also proposing current reporting requirements for funds that
are relying on proposed rule 18f-4. We are proposing to re-title Form
N-LIQUID as Form N-RN and to amend this form to include new reporting
events for funds that are subject to the proposed VaR-based limit on
fund leverage risk.\373\ These funds would be required to determine
their compliance with the applicable VaR test on at least a daily
basis.\374\ We are proposing to require these funds to file Form N-RN
to report information about VaR test breaches under certain
circumstances. Proposed rule 18f-4 would require a fund that has
determined that it is not in compliance with the applicable VaR test to
come back into compliance promptly and within no more than three
business days after such determination.\375\ We are therefore proposing
that a fund that determines that it is out of compliance with the VaR
test and has not come back into compliance within three business days
after such determination would file a report on Form N-RN providing
certain information regarding its VaR test breaches.\376\
---------------------------------------------------------------------------
\373\ See proposed Parts E-G of Form N-RN.
\374\ See supra section II.D; see also proposed rule 18f-
4(c)(2).
\375\ See supra section II.D.5.b.
\376\ See proposed Parts E and F of Form N-RN.
---------------------------------------------------------------------------
If the portfolio VaR of a fund subject to the relative VaR test
were to exceed 150% of the VaR of its designated reference index for
three business days, we are proposing to require that such a fund
report: (1) The dates on which the fund portfolio's VaR exceeded 150%
of the VaR of its designated reference index; (2) the VaR of its
portfolio for each of these days; (3) the VaR of its designated
reference index for each of these days; (4) the name of the designated
reference index; and (5) the index identifier.\377\ A fund would have
to report this information within one business day following the third
business day after the fund has determined that its portfolio VaR
exceeds 150% of its designated reference index VaR.\378\ Such a fund
also would have to file a report on Form N-RN when it is back in
compliance with the relative VaR test.\379\
---------------------------------------------------------------------------
\377\ See proposed Part E of Form N-RN.
\378\ For example, if the fund were to determine, on the evening
of Monday, June 1, that its portfolio VaR exceeded 150% of the
fund's designated reference index VaR, and this exceedance were to
persist through Tuesday (June 2), Wednesday (June 3), and Thursday
(June 4), the fund would file Form N-RN on Friday, June 5 (because 3
business days following the determination on June 1 is June 4, and 1
business day following June 4 is June 5). If the exceedance were to
still persist on June 5 (the date that the fund would file Form N-
RN), the fund's report on Form N-RN would provide the required
information elements for June 1, 2, 3, 4, and 5.
\379\ See proposed Part G of Form N-RN. The report would include
the dates on which the fund was not in compliance with the VaR test,
and the current VaR of the fund's portfolio on the date the fund
files the report. See also proposed rule 18f-4(c)(2)(iii) (providing
that a fund must meet specific requirements to be back in
compliance).
---------------------------------------------------------------------------
If the portfolio VaR of a fund subject to the absolute VaR test
were to exceed 15% of the value of the fund's net assets for three
business days, we are proposing to require that such a fund report: (1)
The dates the on which the fund portfolio's VaR exceeded 15% of the
value of its net assets; (2) the VaR of its portfolio for each of these
days; and (3) the value of the fund's net assets for each of these
days.\380\ A fund would have to report this information within one
business day following the third business day that the fund determined
that its portfolio VaR exceeds 15% of the value of its net assets. Such
a fund also would have to file a report on Form N-RN when it is back in
compliance with the absolute VaR test.\381\
---------------------------------------------------------------------------
\380\ See proposed Part F of Form N-RN.
\381\ See supra note 378.
---------------------------------------------------------------------------
The data points, collectively, would aid the Commission in
assessing funds' compliance with the VaR tests. In addition, the
information would provide staff the ability to assess how long a fund
is precluded from entering into derivatives transactions as a
consequence of its lack of compliance with its VaR test.
Currently, only registered open-end funds (excluding money market
funds) are required to file reports on Form N-LIQUID.\382\ We are
proposing to amend this form, as well as rule 30b1-10 under the
Investment Company Act, to reflect the proposed 18f-4 requirement that
all funds that are subject to the relative VaR test or absolute VaR
test file current reports regarding VaR test breaches under the
circumstances that Form N-RN specifies.\383\ The scope of funds that
would be subject to the new VaR test breach current reporting
requirements would thus include registered open-end funds as well as
registered closed-end funds and BDCs. In addition to extending the
scope of funds required to respond to Form N-LIQUID, we are proposing
to amend the general instructions to the form to reflect the expanded
scope and application.\384\
---------------------------------------------------------------------------
\382\ See General Instruction A.(1) to Form N-LIQUID; see also
rule 30b1-10 [17 CFR 270.30b1-10].
\383\ See proposed Form N-RN; see also proposed amendments to
rule 30b1-10 under the Investment Company Act, and proposed rule
18f-4(c)(7) (requiring a fund that experiences an event specified in
the parts of Form N-RN titled ``Relative VaR Test Breaches,''
``Absolute VaR Test Breaches,'' or ``Compliance with VaR Test'' to
file with the Commission a report on Form N-RN within the period and
according to the instructions specified in that form).
\384\ See, e.g., proposed General Instruction A.(1) to Form N-RN
(amending the defined term ``registrant''); proposed General
Instruction A.(2) to Form N-RN (amending the submission requirement
to clarify application to the new VaR-test-breach-related items);
proposed General Instruction A.(3) to Form N-RN (clarifying that
only open-end funds required to comply with rule 22e-4 under the
Investment Company Act would be required to respond to events
occurring in Parts B-D, as applicable, while funds required to
comply with the limit on fund leverage risk in proposed rule 18f-4
would be required to respond to events specified in proposed Parts
E-G, as applicable); and proposed General Instruction F to Form N-RN
(clarifying that the terms used in proposed Parts E-G, unless
otherwise specified, would have the same meaning as the terms in
proposed rule 18f-4).
---------------------------------------------------------------------------
[[Page 4502]]
We are proposing to require funds to provide this information in a
current report because we believe that the Commission should be
notified promptly when a fund is out of compliance with the proposed
VaR-based limit on fund leverage risk, which in turn we believe could
indicate that a fund is experiencing heightened risks as a result of
the fund's use of derivatives transactions. VaR test breaches could
indicate that a fund is using derivatives transactions to leverage the
fund's portfolio, magnifying its potential for losses and significant
payments of fund assets to derivatives counterparties. Such breaches
also could indicate market events that are drivers of potential
derivatives risks or other risks across the fund industry. Either of
these scenarios--increased fund-specific risks, or market events that
affect funds' risks broadly--may, depending on the facts and
circumstances, require attention by the Commission. The proposed
current reporting requirement is designed to provide the Commission
current information regarding potential increased risks and stress
events (as opposed to a requirement to report the same or similar
information later, for example on Form N-PORT).\385\ The one-business-
day time-frame for submitting a report on Form N-RN regarding a fund's
VaR test breaches is designed to provide an appropriately early
notification to the Commission of potential heightened risks, while at
the same time providing sufficient time for a fund to compile and file
its report on Form N-RN. This time-frame is also consistent with the
current required timing for reporting other events on Form N-
LIQUID.\386\
---------------------------------------------------------------------------
\385\ See supra section II.H.1.b.
\386\ See General Instruction A of Form N-LIQUID.
---------------------------------------------------------------------------
We are cognizant that certain adverse effects might arise from
real-time public reporting of a fund's VaR test breaches. For example,
publicly disclosing this information could lead to investor confusion.
Investors might mistakenly assume that a fund that breached the
applicable VaR test actually had suffered substantial losses or that
substantial losses necessarily were imminent. Investors might also
believe that a fund's failing the VaR test suggests a sudden increase
in fund risk when, in some cases, a fund can fail a VaR test--and
especially an absolute VaR test--due to changes in market volatility
generally. Investors also might believe that a fund's real-time
reporting of a VaR test breach necessarily meant that the fund was not
complying with applicable regulations. Information about VaR breaches
would therefore provide important information to the Commission and its
staff for regulatory purposes but could confuse investors and lead them
and other market participants to make incorrect assumptions about a
fund's relative riskiness. This could have potential adverse effects
for funds if investors redeem or sell fund shares as a result. Other
market participants also could react to real-time reporting of VaR
breaches in ways that could adversely affect funds. For example, if
market participants knew on a real-time basis that a fund had breached
the applicable VaR test, market participants might seek to anticipate
the trading activity the fund might undertake to come back into
compliance and engage in predatory trading that could adversely affect
the fund. Accordingly, we are proposing to make funds' reports on Form
N-RN regarding VaR test breaches (like their reports on this form
regarding liquidity-related items) non-public, because we preliminarily
believe that public disclosure of this information is neither necessary
nor appropriate in the public interest or for the protection of
investors.\387\
---------------------------------------------------------------------------
\387\ See proposed General Instruction A.(1) to Form N-RN; see
also section 45(a) of the Investment Company Act (requiring
information in reports filed with the Commission pursuant to the
Investment Company Act to be made available to the public, unless we
find that public disclosure is neither necessary nor appropriate in
the public interest or for the protection of investors).
---------------------------------------------------------------------------
We seek comment on the Commission's proposed amendments to Form N-
LIQUID requiring reporting of certain information regarding a fund's
VaR test breaches:
214. Is the proposed new current reporting requirement for funds
that are subject to the VaR-based limit on fund leverage risk
appropriate? Why or why not? If not, how should the scope of the
proposed current reporting requirement be modified? Should we require
additional current reporting requirements for funds to report other
derivatives-risk-related information? For example, should funds that
are limited derivatives users pursuant to the proposed exposure-based
exception be required to file current reports if their derivatives
exposure were to exceed 10% of their net assets? \388\ Should we
require a fund to file a current report if it identifies a certain
number of exceptions as a result of backtesting its VaR calculation
model, and if so, what circumstances should trigger the requirement to
file a current report? \389\
---------------------------------------------------------------------------
\388\ See supra section II.E.1.
\389\ See supra section II.B.3.d (discussing backtesting
requirements in proposed rule 18f-4); see also supra section
II.H.1.b (discussing proposed requirement to report backtesting
results on Form N-PORT).
---------------------------------------------------------------------------
215. Is each of the pieces of information that we propose a fund
would include in a report about a VaR test breach on proposed Form N-RN
appropriate? Why or why not? Should we modify the required information
in any way?
216. For a fund that is out of compliance with the VaR test, and is
unable to come back into compliance within three business days after
its initial determination, the proposed current reporting requirement
would require that fund to file a report on Form N-RN providing certain
information regarding its VaR test breaches. Is the proposed three-
business-day current reporting requirement appropriate? Why or why not?
Should the rule require a shorter or longer period, such as one or
seven days, before prompting a current reporting requirement? Which
time period would be appropriate and why?
217. We are proposing that a fund's reports regarding VaR test
breaches on Form N-RN would not be made public. Would there be a
benefit to publicly reporting this information, and would it be
appropriate to make these disclosures public? Why or why not? Should we
make public some of these disclosures but not others? If so, which ones
should we make public and why?
218. As an alternative or an addition to the proposed current
reporting requirement, should we require funds to report information
regarding VaR test breaches on Form N-PORT? Why or why not? If so,
should we make public this information reported on Form N-PORT?
219. Should we modify the proposed current reporting requirement to
require reporting by certain types of funds and not others? If so which
types of funds, and why? For example, should we require BDCs also to
report the information that we are proposing them to report on Form N-
RN on Form 8-K? Why or why not?
220. As an alternative to amending Form N-LIQUID to require current
reporting on VaR test breaches, should we provide a new, separate
current reporting form for funds to use to report VaR test breaches
(and/or any other current reporting items relating to their derivatives
risk management programs under proposed rule 18f-4)? Why or why not?
3. Amendments to Form N-CEN
Form N-CEN currently includes an item that requires a fund to
indicate--in a manner similar to ``checking a
[[Page 4503]]
box''--whether the fund has relied on certain Investment Company Act
rules during the reporting period.\390\ We are proposing amendments to
this item to require a fund to identify whether it relied on proposed
rule 18f-4 during the reporting period.\391\ We are also proposing
amendments to require a fund to identify whether it relied on any of
the exceptions from various requirements under the proposed rule,
specifically:
---------------------------------------------------------------------------
\390\ See Item C.7 of Form N-CEN.
\391\ See proposed Item C.7.l of Form N-CEN.
---------------------------------------------------------------------------
Whether the fund is a limited derivatives user excepted
from the proposed rule's program requirement, under either the proposed
exception for funds that limit their derivatives exposure to 10% of
their net assets or under the exception for funds that limit their
derivatives use to certain currency hedging; \392\ or
---------------------------------------------------------------------------
\392\ See proposed Item C.7.l.i.-ii of Form N-CEN; see also
supra section II.E.
---------------------------------------------------------------------------
Whether the fund is a leveraged/inverse fund covered by
the proposed sales practices rules that, under proposed rule 18f-4,
would be excepted from the proposed limit on fund leverage risk.\393\
---------------------------------------------------------------------------
\393\ See proposed Item C.7.l.iii of Form N-CEN; see also supra
section II.G.
---------------------------------------------------------------------------
Finally, a fund would have to identify whether it has entered into
reverse repurchase agreements or similar financing transactions, or
unfunded commitment agreements, as provided under the proposed
rule.\394\ This information would assist the Commission and staff with
our oversight functions by allowing us to identify which funds were
excepted from certain of the proposed rule's provisions or relied on
the rule's provisions regarding reverse repurchase agreements and
unfunded commitment agreements.
---------------------------------------------------------------------------
\394\ See proposed Item C.7.l.iv-v of Form N-CEN; see also infra
sections II.I and II.J.
---------------------------------------------------------------------------
We seek comment on the Commission's proposed amendments to Form N-
CEN:
221. Should we require, as proposed, that funds identify that they
relied on rule 18f-4, including whether they are limited derivatives
users that are excepted from the proposed program requirement? Why or
why not?
222. Should we require, as proposed, that funds identify that they
are leveraged/inverse funds that are excepted from the proposed limit
on fund leverage risk? Why or why not?
223. Should we require, as proposed, that funds identify that they
entered into reverse repurchase agreements or similar financing
transactions, or unfunded commitment agreements? Why or why not?
224. Are there other means that funds use to disclose or report
information (e.g., prospectus or annual report disclosure in addition
to the other disclosure requirements in this proposal) that would be
more appropriate for reporting any of the information that the proposed
amendments to Form N-CEN would require? Should any of the disclosures
required in the proposed amendments to Form N-PORT above be made on
Form N-CEN? Why or why not?
4. BDC Reporting
BDCs do not file reports on Form N-CEN or Form N-PORT. We
considered proposing to require that BDCs provide the new information
that we propose registered funds report on Form N-CEN, and the new
information regarding derivatives exposure and VaR that we propose to
require funds to report on Form N-PORT, in their annual reports on Form
10-K. BDCs, however, generally do not enter into derivatives
transactions or do so to a limited extent.\395\ We therefore believe
that most BDCs that enter into derivatives transactions would qualify
for the limited derivatives user exception (which would make the
proposed VaR reporting items on Form N-PORT inapplicable to BDCs). In
addition, and as noted above, we understand that even when BDCs do use
derivatives more extensively, derivatives generally do not play as
significant of a role in implementing the BDC's strategy, as compared
to many other types of funds that use derivatives extensively. BDCs are
required under the Investment Company Act to invest at least 70% of
their total assets in ``eligible portfolio companies,'' which may limit
the role that derivatives can play in a BDC's portfolio relative to
other kinds of funds that would generally execute their strategies
primarily through derivatives transactions (e.g., a managed futures
fund). BDCs that would not qualify as limited derivatives users under
the proposed rule also would be subject to the proposed new requirement
to file current reports regarding VaR test breaches on Form N-RN.\396\
Taking these factors into account, we are not proposing additional
reporting requirements for BDCs because we believe that the reporting
framework we are proposing for BDCs adequately addresses the
Commission's ability to monitor BDCs' compliance with the proposed
rules, as well as any competitive disparities that could result from
disparate reporting requirements among funds that rely on proposed rule
18f-4.\397\
---------------------------------------------------------------------------
\395\ See supra section II.D.2.b.
\396\ See supra section II.H.2.
\397\ We have separately proposed to require BDCs to tag their
financial statements using Inline XBRL, a structured, machine-
readable format, which would provide structured data about BDCs'
derivatives and other investments. See Securities Offering Reform
Proposing Release, supra note 199, at section II.H.1. In addition,
BDCs are currently required to disclose certain information about
their exposures to market risks, including risks that may arise as a
result of their derivatives-related activity. See, e.g., Items 303
and 305 of Regulation S-K [17 CFR 229.303 and 229.305].
See also infra section III.D.2 (discussing, among other things,
potential competitive effects resulting from BDCs not being subject
to the proposed additional reporting requirements on Form N-PORT and
Form N-CEN).
---------------------------------------------------------------------------
We seek comment on the Commission's proposal to not require BDCs to
report on Forms N-PORT or N-CEN:
225. Should we require BDCs to report any of the same information
on Form 10-K (or elsewhere, such as in a BDC's prospectus) that we are
proposing to require registered investment companies to report on Forms
N-CEN and N-PORT? Why or why not? Should we require, for example, that
a BDC report its derivatives exposure, whether it is a limited
derivatives user, and/or its designated reference index (if
applicable)? If so, where? If a BDC uses derivatives and does not
qualify as a limited derivatives user, should it have to report
information about its derivatives exposure and portfolio VaR on Form N-
PORT (or elsewhere)?
226. Should we require BDCs to report on Form 10-K or elsewhere
whether they have relied on the rule's provision regarding reverse
repurchase agreements and similar financing transactions or unfunded
commitment agreements?
I. Reverse Repurchase Agreements
Funds may engage in certain transactions that may involve senior
securities primarily as a means of obtaining financing. For example,
open-end funds are permitted to borrow money from a bank, provided they
maintain a 300% asset coverage ratio.\398\ Another common method of
obtaining financing is through the use of reverse repurchase
agreements. In a reverse repurchase agreement, a fund transfers a
security to another party in return for a percentage of the value of
the security. At an agreed-upon future date, the fund repurchases the
transferred security by paying an amount equal to the proceeds of the
initial sale transaction plus interest.\399\ A reverse repurchase
[[Page 4504]]
agreement is economically equivalent to a secured borrowing.\400\
---------------------------------------------------------------------------
\398\ See section 18(f)(1) of the Investment Company Act.
\399\ See Release 10666, supra note 15, at ``Reverse Repurchase
Agreements'' discussion (stating that a reverse repurchase agreement
may not have an agreed-upon repurchase date, and in that case the
agreement would be treated as if it were reestablished each day).
\400\ See, e.g., Office of Financial Research, Reference Guide
to U.S. Repo and Securities Lending Markets (Sept. 9, 2015),
available at https://www.financialresearch.gov/working-papers/files/OFRwp-2015-17_Reference-Guide-to-U.S.-Repo-and-Securities-Lending-Markets.pdf.
---------------------------------------------------------------------------
We believe that reverse repurchase agreements and other similar
financing transactions that have the effect of allowing a fund to
obtain additional cash that can be used for investment purposes or to
finance fund assets should be treated for section 18 purposes like a
bank borrowing or other borrowing, as they achieve effectively
identical results. Accordingly, we are proposing that a fund may engage
in reverse repurchase agreements and other similar financing
transactions so long as they are subject to the relevant asset coverage
requirements of section 18.\401\ For example, this would have the
effect of permitting an open-end fund to obtain financing by borrowing
from a bank, engaging in a reverse repurchase agreement, or any
combination thereof, so long as all sources of financing are included
when calculating the fund's asset coverage ratio.\402\
---------------------------------------------------------------------------
\401\ Proposed rule 18f-4(d). Among other things, section 18
prescribes the required amount of asset coverage for a fund's senior
securities and provides certain consequences for a fund that fails
to maintain this amount. See, e.g., section 18(a) (restrictions on
dividend issuance). This provision in rule 18f-4 would not provide
any exemptions from the requirements of section 61 for BDCs because
that section does not limit a BDC's ability to engage in reverse
repurchase or similar transactions in parity with other senior
security transactions permitted under that section.
\402\ Section 18 states that certain borrowings that are made
for temporary purposes (less than 60 days) and that do not exceed 5%
of the total assets of the issuer at the time when the loan is made
(temporary loans) are not senior securities for purposes of certain
paragraphs in section 18. As we noted in Release 10666, reverse
repurchase agreements and similar financing transactions could be
designed to appear to fall within the temporary loans exception, and
then could be ``rolled-over,'' perhaps indefinitely, with such
short-term transactions being entered into, closed out, and later
re-entered. If substantially similar financing arrangements were
being ``rolled over'' in any manner for a total period of 60 days or
more, we would treat the later transactions as renewals of the
earlier ones, and all such transactions would fall outside the
exclusion for temporary loans.
---------------------------------------------------------------------------
Reverse repurchase agreements and similar financing transactions
are not treated as derivatives transactions under the proposed rule
because they have the economic effects of a secured borrowing, and thus
more closely resemble bank borrowings with a known repayment obligation
rather than the more-uncertain payment obligations of many derivatives.
However, such transactions can have the effect of introducing leverage
into a fund's portfolio if the fund were to use the proceeds of the
financing transaction to purchase additional investments. In addition,
such transactions impose a requirement to return assets at the
termination of the agreement, which can raise section 18 asset
sufficiency concerns to the extent the fund needs to sell less-liquid
securities at a loss to obtain the necessary assets.
Reverse repurchase agreements and similar financing transactions
would not be included in calculating a fund's derivatives exposure
under the limited derivatives user provisions of the proposed rule.
However, if a fund did not qualify as a limited derivatives user due to
its other investment activity, any portfolio leveraging effect of
reverse repurchase agreements or similar financing transactions would
be included and restricted through the proposed VaR-based limit on fund
leverage risk. This is because the proposed VaR tests estimate a fund's
risk of loss taking into account all of its investments, including the
proceeds of reverse repurchase agreements and similar investments the
fund purchased with those proceeds.
Securities lending arrangements are structurally similar to reverse
repurchase agreements in that, in both cases, a fund transfers a
portfolio security to a counterparty in exchange for cash (or other
assets). Although these arrangements are structurally similar, under
our proposal we would not view a fund's obligation to return securities
lending collateral as a ``similar financing transaction'' in the
circumstances discussed below. In the 2015 Proposing Release, we sought
comment on whether rule 18f-4 should address funds' compliance with
section 18 in connection with securities lending.\403\ Commenters
stated that the staff's current guidance on securities lending forms
the basis for funds' securities lending practices and effectively
addresses the senior securities implications of securities lending, and
thus securities lending practices need not be addressed in the final
rule.\404\
---------------------------------------------------------------------------
\403\ 2015 Proposing Release, supra note 2, at paragraph
accompanying n.149.
\404\ See, e.g., ICI Comment Letter I; Guggenheim Comment
Letter; SIFMA Comment Letter; Comment Letter of the Risk Management
Association (Mar. 28, 2016). Staff guidance on Securities Lending by
U.S. Open-End and Closed-End Investment Companies (Feb. 27, 2014),
available at https://www.sec.gov/divisions/investment/securities-lending-open-closed-end-investment-companies.htm (providing guidance
on certain no-action letters that funds consider when engaging in
securities lending and summarizing areas those letters address,
including limitations on the amount that may be lent and
collateralization for such loans).
---------------------------------------------------------------------------
Currently, funds that engage in securities lending typically
reinvest cash collateral in highly liquid, short-term investments, such
as money market funds or other cash or cash equivalents, and funds
generally do not sell or otherwise use non-cash collateral to leverage
the fund's portfolio.\405\ We believe a fund that engages in securities
lending under these circumstances is limited in its ability to use
securities lending transactions to increase leverage in its portfolio.
Accordingly, the proposed rule does not treat a fund's obligation to
return securities lending collateral as a financing transaction similar
to a reverse repurchase agreement, so long as the obligation relates to
an agreement under which a fund engages in securities lending, the fund
does not sell or otherwise use non-cash collateral received for loaned
securities to leverage the fund's portfolio, and the fund invests cash
collateral solely in cash or cash equivalents. If a fund were to engage
in securities lending and to invest the cash collateral in securities
other than cash or cash equivalents, this may result in leveraging of
the fund's portfolio, and we believe this activity would be a ``similar
financing transaction'' and should thus be included when calculating a
funds asset coverage ratio.
---------------------------------------------------------------------------
\405\ See ICI, Securities Lending by Mutual Funds, ETFs, and
Closed-End Funds: The Basics (Sept. 14, 2014), available at https://www.ici.org/viewpoints/view_14_sec_lending_01 (``[T]he collateral
that funds can accept from borrowers must be highly liquid, such as
cash, government securities, or bank letters of credit. U.S.
regulated funds typically demand cash collateral. . . . In practice,
U.S. regulated funds most often invest cash collateral in money
market funds.''); SIFMA, Master Securities Lending Agreement,
section 4.2 (2000), available at https://www.sifma.org/wp-content/uploads/2017/08/MSLA_Master-Securities-Loan-Agreement-2000-Version.pdf (generally limiting lenders from re-hypothecating non-
cash collateral).
---------------------------------------------------------------------------
We believe that a fund's obligation with respect to a ``tender
option bond'' (``TOB'') financing may be similar to a reverse
repurchase agreement in some circumstances. One commenter on the 2015
proposal explained that TOB financings are economically similar to
reverse repurchase agreements because a fund employing a TOB trust has
in effect used the underlying bond as collateral to secure a borrowing
analogous to a fund's use of a security to secure a reverse repurchase
agreement.\406\ We believe that determining whether a TOB is a similar
financing transaction as a reverse repurchase agreement would depend on
the facts and circumstances. To the
[[Page 4505]]
extent a fund concludes that there are economic similarities between a
TOB financing and a reverse repurchase agreement, the fund should treat
obligations with respect to the TOB financing as a similar financing
transaction under the proposed rule.
---------------------------------------------------------------------------
\406\ See SIFMA Comment Letter.
---------------------------------------------------------------------------
We request comment on our proposed approach to reverse repurchase
agreements and similar financing transactions under the proposed rule.
227. As proposed, should we treat reverse repurchase agreements and
similar financing transactions as economically equivalent to bank
borrowings under section 18, and subject them to the same asset
coverage requirements? Why or why not?
228. Should we not combine reverse repurchase agreements with bank
borrowing and other senior securities under the provision, and instead
treat them separately but with the same limit? For example, should we
allow a fund to borrow from a bank subject to the 300% asset coverage
limit and also separately use reverse repurchase agreements up to a
300% asset coverage limit?
229. Should we instead treat such reverse repurchase agreements and
similar financing transactions as derivatives transactions under the
proposed rule? Would this have any disparate effects on certain types
of funds?
230. Is there a way to distinguish reverse repurchase agreements
and similar financing transactions that funds use to leverage their
portfolios from instances in which funds use those transactions for
other purposes? If so, should we treat such transactions engaged in for
leveraging purposes differently than transactions engaged in for other
purposes?
231. Should we include securities lending transactions as a similar
financing transaction (regardless of how the proceeds are invested)
under the proposed provision? Why or why not? Should we define in rule
18f-4 the circumstances under which securities lending would not be
treated as a similar financing transaction?
232. Are there other types of transactions that we should identify
and treat as similar financing transactions to reverse repurchase
agreements that we have not identified above? What are they and why
should they be treated accordingly?
J. Unfunded Commitment Agreements
Under unfunded commitment agreements, a fund commits, conditionally
or unconditionally, to make a loan to a company or to invest equity in
a company in the future.\407\ They include capital commitments to a
private fund requiring investors to fund capital contributions or to
purchase shares upon delivery of a drawdown notice. The proposed rule
would therefore define an unfunded commitment agreement to mean a
contract that is not a derivatives transaction, under which a fund
commits, conditionally or unconditionally, to make a loan to a company
or to invest equity in a company in the future, including by making a
capital commitment to a private fund that can be drawn at the
discretion of the fund's general partner.\408\
---------------------------------------------------------------------------
\407\ We understand that the types of funds that enter into
unfunded commitment agreements typically include BDCs and registered
closed-end funds.
\408\ Proposed rule 18f-4(a).
---------------------------------------------------------------------------
The Commission's 2015 proposal would have treated these agreements
as ``financial commitment transactions.'' As a result, a fund's
obligations under the agreements could not exceed the fund's net asset
value.\409\ Commenters on the 2015 proposal identified characteristics
of these agreements that they believed distinguished unfunded
commitments from the derivatives transactions and financial commitment
transactions covered by that proposal, which are also covered by re-
proposed rule 18f-4.\410\ First, commenters stated that a fund often
does not expect to lend or invest up to the full amount committed.
Second, commenters stated that a fund's obligation to lend is commonly
subject to conditions, such as a borrower's obligation to meet certain
financial metrics and performance benchmarks, which are not typically
present under the types of agreements that the Commission described in
Release 10666.\411\ Commenters also asserted that unfunded commitment
agreements do not give rise to the risks that Release 10666 identified
and do not have a leveraging effect on the fund's portfolio because
they do not present an opportunity for the fund to realize gains or
losses between the date of the fund's commitment and its subsequent
investment when the other party to the agreement calls the
commitment.\412\ These commenters contrasted firm and standby
commitment agreements, under which a fund commits itself to purchase a
security with a stated price and fixed yield without condition or upon
the counterparty's demand.\413\ They argued that the firm and standby
commitment agreements that Release 10666 describes expose the fund to
investment risk during the life of the transaction, because the value
of the fund's commitment agreement will change as interest rates
change.
---------------------------------------------------------------------------
\409\ See 2015 proposed rule 18f-4(c)(4) (defining ``financial
commitment transactions''); 2015 proposed rule 18f-4(b) (permitting
funds to engage in financial commitment transactions if the fund
maintains qualifying coverage assets with a value equal to at least
the fund's aggregate financial commitment obligations); 2015
proposed rule 18f-4(c)(5) (defining a fund's ``financial commitment
obligations,'' in part, to mean ``the amount of cash or other assets
that the fund is conditionally or unconditionally obligated to pay
or deliver under a financial commitment transaction).
\410\ Specifically, these commenters generally compared unfunded
commitment agreements to firm and standby commitment agreements
(which we would in turn interpret the phrase ``or any similar
instrument'' in proposed rule 18f-4's definition of ``derivatives
transaction'' to include, see supra note 91 and accompanying
paragraph). See, e.g., Letter of Ares Capital Corporation (Mar. 28,
2016) (``Ares Comment Letter''); Comment Letter of the Small
Business Investor Alliance (Mar. 28, 2016) (``SBIA Comment
Letter''); Comment Letter of the Center for Capital Markets
Competitiveness, U.S. Chamber of Commerce (Mar. 28, 2016); Comment
Letter of Skadden, Arps, Slate, Meagher & Flom LLP (Mar. 28, 2016)
(``Skadden Comment Letter''); Dechert Comment Letter; Private Equity
Growth Capital Council (Mar. 28, 2016) (``PEGCC Comment Letter'').
\411\ See, e.g., SBIA Comment Letter; Comment Letter of Hercules
Capital (Mar. 29, 2016); see also, e.g., Skadden Comment Letter
(contingent loan commitments typically have ``funding conditions
that excuse the BDC from funding if the borrower does not continue
to satisfy various representations, financial and non-financial
metrics and performance conditions . . . [and] cannot result in
substantial risk of loss prior to funding because the BDC is not
required to fund the loan if the borrower's credit or financial
position degenerates meaningfully.'').
\412\ See, e.g., PEGCC Comment Letter (distinguishing the
agreements that Release 10666 discusses because, while the value of
the fund's limited partnership interest may fluctuate based on the
amount of capital it invests in the private fund, the fund has no
profit or loss on the unfunded commitment); Ares Comment Letter
(stating that, in general, unfunded loan commitments do not reflect
a bet on interest rate movements because the yields for unfunded
loan commitments are determined as a spread over a prevailing market
interest rate); see also Altegris Comment Letter (explaining that
unfunded commitment agreements do not have a potential for
``pyramiding'' because--in contrast to a reverse repurchase
agreement--a fund ``receives nothing from the underlying private
equity funds in return for its capital commitments and, as a result,
its gross assets remain unchanged.'').
\413\ See, e.g., SBIA Comment Letter; see also Altegris Comment
Letter; Ares Comment Letter; Comment Letter of Dechert (Feb. 7,
2016); Skadden Comment Letter.
---------------------------------------------------------------------------
We agree that these factors distinguish unfunded commitment
agreements from the derivatives transactions covered by proposed rule
18f-4. The derivatives transactions covered by proposed rule 18f-4--
including the firm and standby commitment agreements the Commission
described in Release 10666--expose the fund to investment risk during
the life of the transaction. Derivatives transactions therefore can be
used to leverage a fund's portfolio by enabling a fund to magnify its
gains and
[[Page 4506]]
losses compared to the fund's investment, while also obligating the
fund to make a payment to a counterparty. Based on the characteristics
of unfunded commitment agreements commenters described, which we
understand are typical of these agreements, we do not believe that such
unfunded commitment agreements are undertaken to leverage a fund's
portfolio. For example, if the yield for an unfunded loan commitment is
determined as a spread over a prevailing market interest rate, the
agreement creates a risk that the fund would not have liquid assets to
fund the loan, but the agreement would not reflect a speculative
position on the direction of interest rates.\414\ We therefore do not
believe that such unfunded commitment agreements generally raise the
Investment Company Act's concerns regarding the risks of undue
speculation.\415\
---------------------------------------------------------------------------
\414\ Cf. Release 10666, supra note 15, at n.12 (``Commitments
to purchase securities whose yields are determined on the date of
delivery with reference to prevailing market interest rates are not
intended to be included in this general statement of policy. Such
commitments neither create nor shift the risk associated with
interest rate changes in the marketplace, and in economic reality
have no discernible potential for leverage.'').
\415\ See supra notes 45-47 and accompanying text.
---------------------------------------------------------------------------
Depending on the facts and circumstances, however, an unfunded
commitment agreement could raise the asset sufficiency concerns
underlying the Investment Company Act.\416\ A fund could be required to
liquidate other assets to obtain the cash needed to satisfy its
obligation under an unfunded commitment agreement if the fund did not
have cash on hand to meet its obligation to provide a committed loan or
make a committed equity investment. If the fund is unable to meet its
obligations, the fund would be subject to default remedies available to
its counterparty. For example, if a fund fails to fulfill its
commitments to invest in a private fund when called to do so, the fund
could be subject to the remedies specified in the limited partnership
agreement (or similar document) relating to that private fund. These
remedies can have the practical effect of forfeiture of some or all of
the fund's investment in the private fund.\417\ In these and other
circumstances a fund's investors could be harmed if the fund is unable
to meet its obligations under an unfunded commitment agreement.
---------------------------------------------------------------------------
\416\ See id.
\417\ See, e.g., Phyllis A. Schwartz & Stephanie R. Breslow,
Private Equity Funds: Formation and Operation (June 2015 ed.), at 2-
34 (remedies private equity funds may apply in event of investor
default include, among other things, the right to charge high
interest on late payments, the right to force a sale of the
defaulting investor's interest, the right to continue to charge
losses and expenses to defaulting investors while cutting off their
interest in future profits, and the right to take any other action
permitted at law or in equity).
---------------------------------------------------------------------------
Because unfunded commitment agreements can raise the asset
sufficiency concern underlying section 18, but generally do not raise
the undue speculation concern associated with derivatives transactions
(and reverse repurchase agreements and similar financing transactions),
we are proposing to permit a fund to enter into unfunded commitment
agreements if it reasonably believes, at the time it enters into such
an agreement, that it will have sufficient cash and cash equivalents to
meet its obligations with respect to all of its unfunded commitment
agreements, in each case as they come due.\418\ While a fund should
consider its unique facts and circumstances to have such a reasonable
belief, the proposed rule would prescribe certain specific factors that
a fund must take into account.\419\
---------------------------------------------------------------------------
\418\ See proposed rule 18f-4(e)(1). Because this proposed
condition is designed to provide an approach tailored to unfunded
commitment agreements, the proposed rule would also provide that
these transactions would not be considered for purposes of computing
asset coverage under section 18(h). As with our approach to
derivatives transactions, applying section 18(h) asset coverage to
these transactions appears unnecessary in light of the tailored
requirement we are proposing. See supra note 66.
\419\ The proposed rule would also require the fund to make and
maintain records documenting the basis for this belief. See proposed
rule 18f-4(e)(2); see also infra section II.K.
---------------------------------------------------------------------------
First, the proposed rule would require a fund to take into account
its reasonable expectations with respect to other obligations
(including any obligation with respect to senior securities or
redemptions). This is because other obligations can place competing
demands on cash a fund otherwise might intend to use to fund an
unfunded commitment agreement. Second, the proposed rule would provide
that a fund may not take into account cash that may become available
from the sale or disposition of any investment at a price that deviates
significantly from the market value of those investments. This
provision is designed to address the risk that a fund could suffer
losses by selling assets to raise cash to fund an unfunded commitment
agreement, ultimately having an adverse impact on the fund's investors.
Finally, the proposed rule would provide that a fund may not consider
cash that may become available from issuing additional equity. Whether
a fund would be able to raise capital in the future and the amount of
any additional capital would depend on a variety of factors, including
future market conditions, that we believe are too speculative to
support a fund's reasonable belief that it could fund an unfunded
commitment with the proceeds from future sales of the fund's
securities. The proposed rule would not preclude a fund from
considering the issuance of debt to support a reasonable belief that it
could fund an unfunded commitment, as we understand that funds often
satisfy their obligations under unfunded commitments through
borrowings. Moreover, such borrowings by funds would be limited by
section 18's asset coverage requirements, which would limit the extent
to which a fund's belief regarding its ability to borrow would allow
the fund to enter into unfunded commitment agreements.
To have a reasonable belief, a fund therefore could consider, for
example, its strategy, its assets' liquidity, its borrowing capacity
under existing committed lines of credit, and the contractual
provisions of its unfunded commitment agreements. A fund with unfunded
loan commitments, for instance, could evaluate the likelihood that
different potential borrowers would meet contractual ``milestones''
that the borrowers would have to satisfy as a condition to the
obligation to fund a loan, as well as the amount of the anticipated
borrowing. The fund's historical experience with comparable obligations
should inform this analysis. Whether a fund has a reasonable belief
also could be informed by a fund's assessment of the likeliness that
subsequent developments could impair the fund's ability to have
sufficient cash and cash equivalents to meet its unfunded commitment
obligations.
This proposed approach for unfunded commitment agreements reflects
the staff's experience in reviewing and commenting on fund registration
statements, which have disclosure regarding the funds' unfunded
commitments. These funds have generally represented, in substance, that
they reasonably believe that their assets will provide adequate cover
to allow them to satisfy all of their unfunded investment commitments,
without taking into account any projected securities offerings. In
their responses to staff comments, funds also have provided a general
explanation as to the process by which they reached this reasonable
belief.
Finally, the proposed rule would provide that an agreement that
meets the rule's definition of a derivatives transaction is not an
unfunded
[[Page 4507]]
commitment.\420\ This is because the proposed rule's treatment of
unfunded commitments is predicated on these agreements having
characteristics that distinguish them from the derivatives transactions
covered by the proposed rule, as discussed above. Because the proposed
definition of the term ``derivatives transaction'' includes any
instrument that is similar to certain listed derivatives instruments, a
contract that is functionally similar to a listed derivatives
instrument would be a derivatives transaction and therefore would not
qualify for the proposed rule's treatment of unfunded commitment
agreements.\421\ For example, a fund that enters into a binding
commitment to make a loan or purchase a note upon demand by the
borrower, with stated principal and term and a fixed interest rate,
would appear to have entered into an agreement that is similar to a
standby commitment agreement or a written put option.\422\ This
transaction would expose the fund to investment risk during the life of
the transaction because the value of the fund's commitment agreement
will change as interest rates change. Such an agreement thus would fall
within the proposed rule's definition of ``derivatives transaction''
and would not be an unfunded commitment agreement under the proposed
rule.
---------------------------------------------------------------------------
\420\ See proposed rule 18f-4(a) (defining the term ``unfunded
commitment agreement'').
\421\ See supra section II.A (discussing proposed definition of
``derivatives transaction'').
\422\ See supra paragraph accompanying notes 408-412 (discussing
factors distinguishing unfunded commitment agreements from the
derivatives transactions covered by proposed rule 18f-4).
---------------------------------------------------------------------------
We request comment on our proposed approach to unfunded commitment
agreements.
233. Are unfunded commitment agreements distinguishable from
derivatives transactions? Can funds use unfunded commitment agreements
for speculation or to accomplish leveraging? If so, how? What types of
funds enter into unfunded commitment agreements, and for what purposes?
234. Does funds' use of unfunded commitment agreements raise the
undue speculation and/or the assets sufficiency concerns underlying
section 18 of the Investment Company Act? Why or why not?
235. Is the proposed approach to unfunded commitment agreements
appropriate? Would the proposed approach appropriately address any
asset sufficiency concerns that funds' use of unfunded commitment
agreements might entail? Why or why not?
236. Is the proposed requirement that a fund must have a
``reasonable belief'' regarding its ability to meet its unfunded
commitment obligations, at the time it enters into an unfunded
commitment agreement, appropriate? Should the rule instead, or also,
require a fund to reassess whether this belief remains reasonable at
various points during the period of the unfunded commitment agreement?
237. Are the rule's provisions regarding the factors that a fund
must consider in determining whether it has the required ``reasonable
belief'' appropriate? Why or why not? Are they sufficiently clear?
Should we specify other factors that a fund could consider? Should the
rule provide, for example, that a fund may consider potential
borrowings only to the extent the fund has committed lines of credit or
other committed borrowing capacity? If so, how should we define
``committed'' for this purpose?
238. Under the proposed rule, a fund's reasonable belief that it
has sufficient cash to satisfy its unfunded commitments may not be
based on cash that may become available from issuing additional equity.
Do commenters agree that a fund's ability to raise capital in the
future, and the amount of any such additional capital, are based on
factors that are too speculative to support a fund's reasonable belief
that it could use that capital to fund an unfunded commitment? Are
there circumstances in which a fund can expect to raise capital in the
future, such as expected inflows from retirement plan platforms, that
would not raise the same concerns about supporting a reasonable belief
under the proposed rule? Should the rule permit a fund to consider such
additional capital as a basis for forming a reasonable belief?
239. Should the rule otherwise limit funds' use of unfunded
commitment agreements? If so, how? For example, should the rule specify
that funds' unfunded commitment agreements, in the aggregate, may not
exceed the fund's net asset value? Or should we adopt different
requirements for unfunded commitment agreements for different types of
funds, based on their ability to borrow money under the Investment
Company Act? \423\ Should the rule limit the agreements' counterparties
or otherwise restrict the agreements' terms in any way? If so, how?
Should we adopt different requirements for unfunded loan commitments,
which generally will be contingent upon a borrower meeting certain
``milestones,'' as compared to commitments to invest in a private fund
due upon demand by the fund's adviser? If so, which requirements should
apply to each type of transaction and why?
---------------------------------------------------------------------------
\423\ See supra notes 29-32 and accompanying text.
---------------------------------------------------------------------------
240. Should the rule instead treat all--or a specified subset of--
unfunded commitment agreements in the same way that it treats
derivatives transactions? If a subset of these agreements, should the
rule specify that certain characteristics of these agreements are
indicative that these agreements are ``similar instruments'' in the
proposed rule's definition of ``derivatives transaction''? Should a
fund that enters into unfunded commitment agreements, but that
otherwise does not use derivatives (or that limits its derivatives
exposure, either as the proposed rule specifies in the limited
derivative user provisions or otherwise) be subject to the proposed
VaR-based limit on fund leverage risk? Should such a fund be exempt
from any of the proposed rule's other requirements, and if so, which
ones and why?
241. Is the proposed definition of ``unfunded commitment
agreement'' clear and appropriate? If not, how should the Commission
modify it? Should the Commission clarify any aspect of the definition
(e.g., should the Commission further define or provide guidance
regarding agreements that involve a commitment to ``make a loan to a
company'' or to ``invest equity in a company in the future'')? Would
funds experience any challenges in practice differentiating between
unfunded commitments, on the one hand, and firm or standby commitment
agreements or other transactions included in the definition of
``derivatives transaction,'' on the other? If so, how should the
Commission provide additional clarity?
242. Are there other types of transactions that we should identify
and treat as similar to unfunded commitment agreements? What are they
and why should they be treated accordingly? Are there any transactions
that may be viewed as firm or standby commitment agreements, but that
commenters believe should be given the same treatment as unfunded
commitments under the proposed rule? What kinds of transactions and
why?
243. Would any adverse market effects result from the proposed
treatment of unfunded commitment agreements? For example, would the
proposal lead funds to restructure transactions as unfunded commitment
agreements, and if so would this adversely affect investor protection?
Would any modifications to the proposed rule, or additional
[[Page 4508]]
Commission guidance, help mitigate potential adverse market effects?
K. Recordkeeping Provisions
Proposed rule 18f-4 also includes certain recordkeeping
requirements. These proposed requirements are designed to provide our
staff, and a fund's compliance personnel, the ability to evaluate the
fund's compliance with the proposed rule's requirements.
First, the proposed rule would require the fund to maintain certain
records documenting the fund's derivatives risk management program.
Specifically, for a fund subject to the proposed rule's program
requirements, the proposed rule would require the fund to maintain a
written record of its policies and procedures that are designed to
manage the fund's derivatives risks.\424\ The proposed rule would also
require a fund to maintain a written record of the results of any
stress testing of its portfolio, results of any VaR test backtesting it
conducts, records documenting any internal reporting or escalation of
material risks under the program, and records documenting any periodic
reviews of the program.\425\ These records would allow our staff to
understand a fund's derivatives risk management program and how the
fund administered it.
---------------------------------------------------------------------------
\424\ Proposed rule 18f-4(c)(6)(i)(A); see also supra section
II.B.3.
Under proposed rule 18f-4(c)(4), leveraged/inverse funds would
be subject to the proposed rule's derivatives risk management
program requirement. Such funds would therefore also be subject to
the program-related recordkeeping provisions of the proposed rule.
\425\ Proposed rule 18f-4(c)(6)(i)(A).
---------------------------------------------------------------------------
Second, the proposed rule would require funds to keep records of
any materials provided to the fund's board of directors in connection
with approving the designation of the derivatives risk manager.\426\
The proposed rule would also require a fund to keep records of any
written reports provided to the board of directors relating to the
program, and any written reports provided to the board that the rule
would require regarding the fund's non-compliance with the applicable
VaR test.\427\ These records would help our staff to understand what
was provided to the fund's board while overseeing the fund's program.
---------------------------------------------------------------------------
\426\ Proposed rule 18f-4(c)(6)(i)(B); see also supra section
II.C.
\427\ Id.; see also supra section II.D.5.b.
---------------------------------------------------------------------------
Third, for a fund that is required to comply with the proposed VaR-
based limit on fund leverage risk, the fund would have to maintain
records documenting the fund's determination of: The VaR of its
portfolio; the VaR of the fund's designated reference index, as
applicable; the fund's VaR ratio (the value of the VaR of the fund's
portfolio divided by the VaR of the designated reference index), as
applicable; and any updates to any VaR calculation models used by the
fund, as well as the basis for any material changes made to those
models.\428\ These records would provide information on the operation
of a fund's VaR test and, for example, would allow our staff to better
understand how a fund (and funds generally) implement the proposed VaR
tests.
---------------------------------------------------------------------------
\428\ Proposed rule 18f-4(c)(6)(i)(C); see also supra section
II.K.
---------------------------------------------------------------------------
Fourth, the proposed rule would require a fund that is a limited
derivatives user to maintain a written record of its policies and
procedures that are reasonably designed to manage its derivatives
risk.\429\ These records would help our staff to understand what
policies and procedures that a limited derivatives user has adopted and
implemented to address the risks associated with its use of
derivatives.
---------------------------------------------------------------------------
\429\ Proposed rule 18f-4(c)(6)(i)(D); see also supra section
II.K.
---------------------------------------------------------------------------
Fifth, the proposed rule would require a fund that enters into
unfunded commitment agreements to maintain a record documenting the
basis for the fund's belief regarding the sufficiency of its cash and
cash equivalents to meet its obligations with respect to its unfunded
commitment agreements.\430\ A fund must make such a record each time it
enters into such an agreement.\431\ These records would allow our staff
to understand and evaluate funds' determinations regarding their
ability to meet their obligations under their unfunded commitment
agreements.
---------------------------------------------------------------------------
\430\ Proposed rule 18f-4(e)(2); see also supra section II.K.
\431\ Id.
---------------------------------------------------------------------------
Finally, the proposed rule would require funds to maintain the
required records for a period of five years.\432\ In particular, a fund
must retain a copy of its written policies and procedures under the
rule that are currently in effect, or were in effect at any time within
the past five years, in an easily accessible place.\433\ In addition, a
fund would have to maintain all other records and materials that the
rule would require the fund to keep for at least five years (the first
two years in an easily accessible place).\434\ The proposed five-year
retention period is consistent with the period provided in rule 38a-
1(d) and rule 22e-4 under the Investment Company Act. We believe
consistency in these retention periods is appropriate because funds
currently have compliance-program-related recordkeeping procedures in
place incorporating a five-year retention period, which we believe
would lessen the proposed new recordkeeping compliance burden to funds,
compared to choosing a different, longer retention period.
---------------------------------------------------------------------------
\432\ Proposed rule 18f-4(c)(6)(ii); proposed rule 18f-4(e)(2).
\433\ Proposed rule 18f-4(c)(6)(ii)(A); see also supra notes 423
and 428 and accompanying text. The retention requirement would apply
to both funds that are required to implement a derivatives risk
management program and funds that are limited derivatives users
under proposed rule 18f-4(c)(3).
\434\ Proposed rule 18f-4(c)(6)(ii)(B); proposed rule 18f-
4(e)(2).
---------------------------------------------------------------------------
We request comment on the proposed rule's recordkeeping
requirements.
244. Are the proposed recordkeeping provisions appropriate? Are
there any other records relating to a fund's derivatives transactions
that a fund should be required to maintain? For example, should we also
require a fund to maintain written records relating to any action the
fund took after exceeding a risk guideline (or any internal reporting
that occurred following the exceedance of a risk guideline)? \435\ Or,
as another example, should we include a provision in the proposed rule
that would require a fund that enters into reverse repurchase
agreements under proposed rule 18f-4(d) to maintain records documenting
the fund's compliance with the applicable asset coverage requirement of
section 18? Why or why not? The proposed rule would require a fund to
maintain records of the VaR of its portfolio, the VaR of its designated
reference index (as applicable), and its VaR ratio. To what extent
would the requirement to maintain records of the fund's VaR ratio
involve burdens in addition to the requirement to maintain the fund's
VaR and the VaR of the designated reference index?
---------------------------------------------------------------------------
\435\ See, e.g., proposed rule 18f-4(c)(1)(ii), proposed rule
18f-4(c)(1)(v)(A).
---------------------------------------------------------------------------
245. Are there feasible alternatives to the proposed recordkeeping
requirements that would minimize recordkeeping burdens, including the
costs of maintaining the required records, while promoting the goals of
providing the Commission and its staff, and a fund's compliance
personnel, sufficient information to understand: (1) A fund's
derivatives risk management program and how the fund had administered
it, (2) how a fund's board oversees the program, (3) the administration
and effectiveness of a fund's VaR test, (4) how a limited derivatives
user's policies and procedures are designed to address the risks
associated with its use of derivatives, and (5) the basis for a fund's
determination regarding the sufficiency
[[Page 4509]]
of its cash to meet its obligations with respect to unfunded commitment
agreements?
246. Are the record retention time periods that we have proposed
appropriate? Should we require records to be maintained for a longer or
shorter period? If so, for how long?
L. Transition Periods
In view of our proposal for an updated, comprehensive approach to
the regulation of funds' derivatives use, we are proposing to rescind
Release 10666.\436\ In addition, staff in the Division of Investment
Management is reviewing its no-action letters and other guidance
addressing derivatives transactions and other transactions covered by
proposed rule 18f-4 to determine which letters and other staff
guidance, or portions thereof, should be withdrawn in connection with
any adoption of this proposal. Upon the adoption of any final rule,
some of these letters and other staff guidance, or portions thereof,
would be moot, superseded, or otherwise inconsistent with the final
rule and, therefore, would be withdrawn. If interested parties believe
that additional letters or other staff guidance, or portions thereof,
should be withdrawn, they should identify the letter or guidance, state
why it is relevant to the proposed rule, how it or any specific portion
thereof should be treated, and the reason therefor. The staff review
would include, but would not necessarily be limited to, all of the
staff no-action letters and other staff guidance listed below,
including our staff's position regarding TOBs.\437\
---------------------------------------------------------------------------
\436\ See supra section I.C.
\437\ See Investment Management Staff Issues of Interest,
available at https://www.sec.gov/divisions/investment/issues-of-interest.shtml#tobfinancing; see also Registered Investment Company
Use of Senior Securities--Select Bibliography, available at https://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm.
Dreyfus Strategic Investing & Dreyfus Strategic Income (pub.
avail. June 22, 1987)
Merrill Lynch Asset Management, L.P. (pub. avail. July 2,
1996)
Robertson Stephens Investment Trust (pub. avail. Aug. 24,
1995)
Claremont Capital Corp (pub. avail. Sept. 16, 1979)
Emerald Mgt. Co. (pub. avail. Jan. 21, 1978)
Sanford C. Bernstein (pub. avail. June 25, 1990)
Hutton Options Trading, L.P. (pub. avail. Feb. 2, 1989)
Prudential-Bache IncomeVertible Plus Fund (pub. avail. Nov.
20, 1985)
State Street Income Fund, State Street Balanced Fund (pub.
avail. Oct. 21, 1985)
New England Life Government Securities Trust (pub. avail.
Sept. 26, 1985)
Putnam Option Income Trust II (pub. avail. Sept. 23, 1985)
Thomson McKinnon Government Securities Fund (pub. avail. Sept.
23, 1985)
GMO Core Trust (pub. avail. Aug. 19, 1985)
Bartlett Capital Trust (pub. avail. Aug. 19, 1985)
Continental Option Income Plus Fund (pub. avail. Aug. 12,
1985)
Colonial High Yield Securities Trust, Colonial Enhanced
Mortgage Trust (pub. avail. July 25, 1985)
Putnam High Income Government Trust (pub. avail. June 3, 1985)
Bartlett Management Trust (pub. avail. May 17, 1985)
Drexel Series Trust--Government Securities Series (pub. avail.
Apr. 25, 1985)
Koenig Tax Advantaged Liquidity Fund (pub. avail. Mar. 27,
1985)
Colonial Tax-Managed Trust (pub. avail. Dec. 31, 1984)
Monitrend Fund (pub. avail. Nov. 14, 1984)
Pilot Fund (pub. avail. Sept. 14, 1984)
Colonial Government Securities Plus Trust (pub. avail. June
15, 1984)
Z-Seven Fund (pub. avail. May 21, 1984)
Pension Hedge Fund (pub. avail. Jan. 20, 1984)
Steinroe Bond Fund (pub. avail. Jan. 17, 1984)
IDS Bond Fund (pub. avail. Apr. 11, 1983)
Safeco Municipal Bond, Inc (pub. avail. Nov. 26, 1982)
``Dear Chief Financial Officer'' Letter, from Lawrence A.
Friend, Chief Accountant, Division of Investment Management (pub.
avail. Nov. 7, 1997)
Accordingly, following a one-year transition period to provide time
for funds to prepare to come into compliance with the new rule, funds
could only enter into derivatives transactions, reverse repurchase
agreements and similar financing transactions, and unfunded commitments
to the extent permitted by, and consistent with the requirements of,
proposed rule 18f-4 or section 18. At that time, Release 10666 would be
rescinded and, as determined appropriate in connection with the staff's
review of no-action letters and other staff guidance described in this
release, staff no-action letters and other staff guidance, or portions
thereof, would be withdrawn.
We similarly propose to provide a one-year compliance period for
the sales practices rules to provide time for broker-dealers and
investment advisers to bring their operations into conformity with the
new rule. We also propose a one-year delay to the effective date of the
amendments to rule 6c-11, which would permit leveraged/inverse ETFs to
rely on that rule, and to rescind the exemptive orders we have provided
to leveraged/inverse ETF sponsors on the effective date of the
amendments to rule 6c-11.
We propose that each of the transition periods discussed in this
section would run from the date of the publication of any final rule in
the Federal Register. Accordingly, one year after that date: (1) Any
fund that enters into the transactions permitted by rule 18f-4 would do
so relying on that rule; (2) broker-dealers and investment advisers
would be required to comply with the sales practices rules; and (3)
leveraged/inverse ETFs could operate under rule 6c-11 and the current
leveraged/inverse ETF sponsors' orders would be rescinded.
We request comment on these transition periods.
247. Do commenters agree that a one-year transition period to
provide time for funds to prepare to come into compliance with proposed
rule 18f-4 is appropriate? Should the period be shorter or longer?
248. Should we adopt tiered transition periods for smaller
entities? For example, should we provide an additional 6 months for
smaller entities (or some other shorter or longer period) in any
transition period that we provide? Should the transition period be the
same for all funds that rely on proposed rule 18f-4 (for example 12
months after any adoption of proposed rule 18f-4, or any shorter or
longer period)?
249. Is the proposed one-year compliance period for the sales
practices rules appropriate? Why or why not? Is a longer or shorter
compliance period necessary to allow investment advisers and broker-
dealers to comply with the proposed sales practices rules? Why or why
not? If we provide small and large funds a tiered transition period to
comply with proposed rule 18f-4, should we similarly implement a tiered
compliance period for investment advisers and broker-dealers to comply
with the proposed sales practices rules? Why or why not?
250. Would our proposal to rescind the current leveraged/inverse
ETF sponsors' exemptive orders on the delayed effective date of the
amendments to rule 6c-11 provide sufficient time for the leveraged/
inverse
[[Page 4510]]
ETF sponsors to transition to rule 6c-11?
M. Conforming Amendments
Form N-2 requires a closed-end fund to disclose a senior securities
table with certain information about any senior securities it has
issued.\438\ Outstanding senior securities may bear on the likelihood,
frequency, and size of distributions from the fund to its investors
because section 18 prohibits distributions when a closed-end fund does
not have the asset coverage required under that section. Proposed rule
18f-4 would provide that a fund's derivatives transactions and unfunded
commitments entered into under the proposed rule would not be
considered for purposes of computing section 18 asset coverage.\439\
These transactions therefore would not affect a fund's ability under
section 18 to make distributions to investors. Registered closed-end
funds are already required to disclose extensive information about
their derivatives transactions on Form N-PORT. In light of this
treatment under proposed rule 18f-4 and the information that is already
available regarding registered closed-end funds' derivatives
transactions, we are proposing to amend Form N-2 to provide that funds
relying on proposed rule 18f-4 would not be required to include their
derivatives transactions and unfunded commitment agreements in the
senior securities table on Form N-2.\440\ Commenters on the 2015
proposal that addressed this topic supported such a conforming
amendment with respect to asset coverage calculations and
disclosure.\441\
---------------------------------------------------------------------------
\438\ See Item 4.3 of Form N-2.
\439\ See proposed rule 18f-4(b).
\440\ See proposed amendment to Instruction 2 of Item 4.3 of
Form N-2.
\441\ See, e.g., Ares Comment Letter; ICI Comment Letter I.
---------------------------------------------------------------------------
We request comment on the proposed conforming amendment to Form N-
2, and other conforming amendments that commenters suggest would be
necessary or appropriate.
251. Is the proposed conforming amendment appropriate? We have not
proposed to exclude reverse repurchase agreements and similar financing
transactions from the senior securities table in Form N-2 because these
transactions may bear on the likelihood, frequency, and size of
distributions from a fund to its investors. Do commenters agree that
this is appropriate? Why or why not? If commenters do not believe that
these transactions should be included in the senior securities table,
what other disclosure would be appropriate?
252. Rule 22e-4 requires funds subject to the rule, in classifying
the liquidity of their portfolios and in determining whether a fund
primarily holds highly liquid investments, to take into account the
fund's highly liquid investments that it has ``segregated'' to cover
certain less liquid investments.\442\ Proposed rule 18f-4, however,
does not include an asset segregation requirement, and would supersede
Release 10666 and related staff guidance. Should we remove any
references in rule 22e-4 to ``segregated'' assets (while retaining rule
22e-4's references to assets pledged to satisfy margin requirements)?
Is there any other basis on which funds ``segregate'' assets that would
warrant our retaining these references?
---------------------------------------------------------------------------
\442\ See rule 22e-4(b)(1)(ii)(C); rule 22e-4(b)(1)(iii)(B). A
fund would also have to take into account the percentage of its
highly liquid investments that it has pledged to satisfy margin
requirements. See id.
---------------------------------------------------------------------------
253. Are there other conforming amendments to any of our other
rules or forms that we should make? If so, what rules or forms should
be amended and why?
III. Economic Analysis
We are mindful of the costs imposed by, and the benefits obtained
from, our rules. Section 3(f) of the Exchange Act and section 2(c) of
the Investment Company Act state that when the Commission is engaging
in rulemaking under such titles and is required to consider or
determine whether the action is necessary or appropriate in (or, with
respect to the Investment Company Act, consistent with) the public
interest, the Commission shall consider whether the action will promote
efficiency, competition, and capital formation, in addition to the
protection of investors. Further, section 23(a)(2) of the Exchange Act
requires the Commission to consider, among other matters, the impact
such rules would have on competition and states that the Commission
shall not adopt any rule that would impose a burden on competition not
necessary or appropriate in furtherance of the purposes of the Exchange
Act. The following analysis considers, in detail, the potential
economic effects that may result from the proposed rule, including the
benefits and costs to investors and other market participants as well
as the broader implications of the proposal for efficiency,
competition, and capital formation.
A. Introduction
Funds today use a variety of derivatives, referencing a range of
assets or metrics. Funds use derivatives both to obtain investment
exposure as part of their investment strategies and to manage risks. A
fund may use derivatives to gain, maintain, or reduce exposure to a
market, sector, or security more quickly, or to obtain exposure to a
reference asset for which it may be difficult or impractical for the
fund to make a direct investment. A fund may use derivatives to hedge
interest rate, currency, credit, and other risks, as well as to hedge
portfolio exposures.\443\ As funds' strategies have become increasingly
diverse, funds' use of derivatives has grown in both volume and
complexity over the past several decades. At the same time, a fund's
derivatives use may entail risks relating to, for example, leverage,
markets, operations, liquidity, and counterparties, as well as legal
risks.\444\
---------------------------------------------------------------------------
\443\ See supra section I.A.
\444\ See, e.g., supra notes 16-17 and accompanying text.
---------------------------------------------------------------------------
Section 18 of the Investment Company Act is designed to limit the
leverage a fund can obtain through the issuance of senior
securities.\445\ As discussed above, a fund's derivatives use may raise
the investor protections concerns underlying section 18. In addition,
funds' asset segregation practices have developed such that funds'
derivatives use--and thus funds' potential leverage through derivatives
transactions--does not appear to be subject to a practical limit as the
Commission contemplated in Release 10666. Accordingly, we continue to
be concerned that certain fund asset segregation practices may not
address the concerns underlying section 18.\446\
---------------------------------------------------------------------------
\445\ See supra section I.B.1.
\446\ See supra sections I.B.3.
---------------------------------------------------------------------------
Proposed rule 18f-4 is designed to provide an updated,
comprehensive approach to the regulation of funds' use of derivatives
and certain other transactions. The proposed rule would permit a fund,
subject to certain conditions, to enter into derivatives or other
transactions, notwithstanding the prohibitions and restrictions on the
issuance of senior securities under section 18 of the Investment
Company Act. We believe that the proposed rule's requirements,
including the derivatives risk management program requirement and VaR-
based limit on fund leverage risk, would benefit investors by
mitigating derivatives-related risks, including those that may lead to
unanticipated and potentially significant losses for investors.
Certain funds use derivatives in a limited manner, which we believe
presents a lower degree of risk or
[[Page 4511]]
potential impact and generally a lower degree of leverage than
permitted under section 18. The proposed rule would provide an
exception from the proposed derivative risk management program
requirement and VaR-based limit on fund leverage risk for these limited
derivatives users. Instead, the proposed rule would require a fund
relying on this exception to adopt policies and procedures that are
reasonably designed to manage its derivatives risks. Funds with limited
derivatives exposure and funds that use derivatives transactions solely
to hedge certain currency risk would therefore not be required to incur
costs and bear compliance burdens that may be disproportionate to the
resulting benefits, while still being required to manage the risks
their limited use of derivatives may present.\447\
---------------------------------------------------------------------------
\447\ See supra sections I.C and II.E.
---------------------------------------------------------------------------
The proposed rule would also provide an exception from the VaR-
based limit on fund leverage risk for certain leveraged/inverse funds
in light of the requirements under the proposed sales practices rules
that broker-dealers and investment advisers exercise due diligence in
approving the accounts of retail investors to invest in these funds,
and other conditions for these funds that proposed rule 18f-4
includes.\448\ This would allow these funds, which generally could not
currently satisfy the proposed VaR-based limit on fund leverage risk,
to continue offering their current strategies. The proposed sales
practices rules' due diligence and account approval requirements also
would apply to accounts of investors in certain exchange-listed
commodity- or currency-based trusts or funds, which are not investment
companies subject to section 18 but present similar investor protection
concerns. We believe the proposed sales practices rules would enhance
investor protection by helping to ensure that investors in these funds
are limited to those who are capable of evaluating their
characteristics--including that the funds would not be subject to all
of the leverage-related requirements applicable to registered
investment companies generally--and the unique risks they present.
---------------------------------------------------------------------------
\448\ See supra section II.G.
---------------------------------------------------------------------------
Proposed rule 18f-4 also contains requirements for funds' use of
certain senior securities that are not derivatives. Specifically, the
proposed rule would permit reverse repurchase agreements and other
similar financing transactions if they comply with the asset coverage
requirements of section 18; this approach would align the treatment of
reverse repurchase agreements and similar financing transactions, for
section 18 purposes, with the treatment of bank borrowings and other
senior securities transactions subject to section 18's asset coverage
requirements.\449\ In addition, the proposed rule would permit a fund
to enter into unfunded commitment agreements if it reasonably believes,
at the time it enters into such an agreement, that it will have
sufficient cash and cash equivalents to meet its obligations with
respect to all of its unfunded commitment agreements.\450\ This
requirement is designed to address the concern that a fund may
experience losses as a result of having insufficient assets to meet its
obligations with respect to these transactions, and we believe that the
requirement would benefit investors by mitigating such losses or other
adverse effects if a fund is unable to satisfy an unfunded commitment
agreement.\451\
---------------------------------------------------------------------------
\449\ Similar financing transactions may include securities
lending arrangements and TOBs, depending on the particular facts and
circumstances of the individual transaction. See supra section II.I.
\450\ See supra section II.J.
\451\ We believe that the proposed treatment of unfunded
commitment transactions is consistent with general market practices.
Therefore, we believe that the proposed requirements for both types
of senior securities would not have significant economic effects
when measured against this baseline.
---------------------------------------------------------------------------
This proposal also includes certain recordkeeping requirements and
reporting requirements for funds that use derivatives.\452\ We expect
that the proposed recordkeeping requirements would benefit investors by
facilitating fund compliance with the proposed rule and our staff's
review of funds' compliance. In addition, we expect that the proposed
amendments to Forms N-PORT, N-CEN, and N-RN would further benefit
investors by enhancing the Commission's and the public's understanding
of the impact of funds' use of derivatives on fund portfolios, and by
facilitating the Commission's ability to oversee funds' use of
derivatives and compliance with the proposed rules.\453\
---------------------------------------------------------------------------
\452\ See supra sections II.C and II.H.
\453\ Because leveraged/inverse funds would not be subject to
the proposed VaR-based limit on fund leverage risk, these funds
would not be subject to the related proposed reporting requirements
on Forms N-PORT and N-RN. Leveraged/inverse funds would, however, be
subject to the proposed new reporting requirements on funds'
derivatives exposure on form N-PORT as well as to the proposed new
requirements on Form N-CEN.
---------------------------------------------------------------------------
B. Economic Baseline
1. Fund Industry Overview
The fund industry has grown and evolved substantially in past
decades in response to various factors, including investor demand,
technological developments, and an increase in domestic and
international investment opportunities, both retail and
institutional.\454\ As of September 2019, there were 9,788 mutual funds
(excluding money market funds) with $21,333 billion in total net
assets, 1,910 ETFs organized as an open-end fund or as a share-class of
an open-end fund with $3,081 billion in total net assets, 664
registered closed-end funds with 294 billion in total net assets, and
13 variable annuity separate accounts registered as management
investment companies on Form N-3 with $224 billion in total net assets.
There also were 413 money market funds with $3,392 billion in total net
assets.\455\ Finally, as of June 2019, there were 99 BDCs with $63
billion in total net assets.\456\
---------------------------------------------------------------------------
\454\ See supra note 1.
\455\ Estimates of the number of registered investment companies
and their total net assets are based on a staff analysis of Form N-
CEN filings as of September 5, 2019. For open-end funds that have
mutual fund and ETF share classes, we count each type of share class
as a separate fund and use data from Morningstar to determine the
amount of total net assets reported on Form N-CEN attributable to
the ETF share class. Money market funds are excluded from the scope
of proposed rule 18f-4 but may experience economic effects as a
result of being excluded from the rule's scope. We therefore report
their number and net assets separately from those of other mutual
funds.
\456\ Estimates of the number of BDCs and their net assets are
based on a staff analysis of Form 10-K and Form 10-Q filings as of
June 30, 2019. Our estimate includes BDCs that may be delinquent or
have filed extensions for their filings, and it excludes 6 wholly-
owned subsidiaries of other BDCs.
---------------------------------------------------------------------------
2. Funds' Use of Derivatives
DERA staff analyzed funds' use of derivatives based on Form N-PORT
filings as of September 2019. The filings covered 9,074 mutual funds
with $19,590 billion in total net assets, 1,711 ETFs with $3,317
billion in total net assets, 565 registered closed-end funds with $327
billion in net assets, and 13 variable annuity separate accounts
registered as management investment companies with $219 billion in
total net assets.\457\ While only larger fund groups are currently
required to file reports on Form N-PORT, existing filings nevertheless
covered 89% of funds representing 94% of assets.\458\
---------------------------------------------------------------------------
\457\ The analysis is based on each registrant's latest Form N-
PORT filing as of September 23, 2019. Money market funds are
excluded from the analysis; they do not file monthly reports on Form
N-PORT and are excluded from the scope of proposed rule 18f-4. For
open-end funds that have mutual fund and ETF share classes, we count
each type of share class as a separate fund and use data from
Morningstar to determine the amount of total net assets reported on
Form N-PORT attributable to the ETF share class.
\458\ See supra note 280.
---------------------------------------------------------------------------
[[Page 4512]]
Based on this analysis, 59% of funds reported no derivatives
holdings, and a further 27% of funds reported using derivatives with
gross notional amounts below 50% of net assets. These results are
comparable to and consistent with the findings of the DERA White Paper,
which studied a random sample of 10% of funds in 2014.\459\
---------------------------------------------------------------------------
\459\ See DERA White Paper, supra note 1.
---------------------------------------------------------------------------
BDCs do not file Form N-PORT. To help evaluate the extent to which
BDCs use derivatives, our staff reviewed the most recent financial
statements of 48 of the current 99 BDCs as of September 2019.\460\
Based on this analysis, we observe that most BDCs do not use
derivatives extensively. Of the sampled BDCs, 54% did not report any
derivatives holdings, and a further 29% reported using derivatives with
gross notional amounts below 10% of net assets.
---------------------------------------------------------------------------
\460\ See supra note 279 and accompanying text.
---------------------------------------------------------------------------
3. Current Regulatory Framework for Derivatives
Funds have developed certain general asset segregation practices to
``cover'' their derivatives positions, consistent with the conditions
in staff no-action letters and guidance.\461\ However, staff has
observed that practices vary based on the type of derivatives
transaction, and that funds use different practices regarding the types
of assets that they segregate to cover their derivatives positions. For
purposes of establishing the baseline, we assume that funds generally
segregate sufficient assets to at least cover any mark-to-market
liabilities on the funds' derivatives transactions, with some funds
segregating more assets for certain types of derivatives transactions
(sufficient to cover the full notional amount of the transaction or an
amount between the transaction's full notional amount and any mark-to-
market liability).\462\ As the mark-to-market liability of a derivative
can be much smaller than the full investment exposure associated with
the position, funds' current use of the mark-to-market asset
segregation approach, and funds' segregation of any liquid asset, do
not appear to place a practical limit on their use of derivatives.\463\
---------------------------------------------------------------------------
\461\ See supra section II.B.2.b.
\462\ See supra notes 54-55 and accompanying text.
\463\ See supra section I.B.2.b.
---------------------------------------------------------------------------
4. Funds' Derivatives Risk Management Practices and Use of VaR Models
There is currently no requirement for funds that use derivatives to
have a formalized derivatives risk management program. However, we
understand that advisers to many funds whose investment strategies
entail the use of derivatives, including leveraged/inverse funds,
already assess and manage risks associated with their derivatives
transactions to varying extents. In addition, we understand that funds
engaging in derivatives transactions have increasingly used stress
testing as a risk management tool over the past decade.\464\
---------------------------------------------------------------------------
\464\ See also supra note 145 and accompanying text.
---------------------------------------------------------------------------
We also understand that VaR calculation tools are widely available,
and many advisers that enter into derivatives transactions already use
risk management or portfolio management platforms that include VaR
tools.\465\ Advisers to funds that use derivatives more extensively may
be particularly likely to currently use risk management or portfolio
management platforms that include VaR capability. Moreover, advisers
that manage (or that have affiliates that manage) UCITS funds may
already be familiar with using VaR models in connection with European
guidelines.\466\ One commenter submitted the results of a survey based
on responses from 24 fund complexes with $13.8 trillion in assets.\467\
The results of this survey indicate that 73% of respondents used some
form of both VaR and stress testing as derivatives risk management
tools.
---------------------------------------------------------------------------
\465\ See also supra note 179.
\466\ See supra note 221 and accompanying text.
\467\ See ICI Comment Letter III. The commenter also indicated
that the surveyed ICI member firms accounted for 67% of mutual fund
and ETF assets as of June 2019 and that survey responses were
submitted by firms ``whose assets under management spanned the
spectrum from small to very large.'' However, these representations
alone do not provide sufficient information about whether the
surveyed firms were representative of all mutual funds and ETFs in
terms of the exact distribution of specific characteristics, such as
firm size or type of investment strategy.
---------------------------------------------------------------------------
5. Leveraged/Inverse Investment Vehicles and Leveraged/Inverse Funds
Leveraged/inverse investment vehicles, as defined in the proposed
sales practices rules, include leveraged/inverse funds and certain
exchange-listed commodity- or currency-based trusts or funds.
Currently, there are 164 leveraged/inverse ETFs with $33.9 billion in
total net assets; 105 leveraged/inverse mutual funds with $4.9 billion
in total net assets; and 17 exchange-listed commodity- or currency-
based trusts or funds with $1.2 billion in total net assets.\468\
---------------------------------------------------------------------------
\468\ Estimates of the number of leveraged/inverse mutual funds
and leveraged/inverse ETFs and their total net assets are based on a
staff analysis of Form N-CEN filings as of September 5, 2019.
Estimates of the number of exchange-listed commodity- or currency-
based trusts or funds and their total net assets are based on
Bloomberg data as of September 20, 2019.
---------------------------------------------------------------------------
Leveraged/inverse investment vehicles generally target a daily
return (or a return over another predetermined time period) that is a
multiple, inverse, or inverse multiple of the return of an underlying
index; however over longer holding periods, the realized leverage
multiple of the returns of an investment in a leveraged/inverse
investment vehicle relative to the returns of its underlying index can
vary substantially from the vehicle's daily leverage multiple.
In addition, the returns of leveraged/inverse investment vehicles
over longer holding periods share certain features with the returns of
holding an option.\469\ For example, a call option on an index with a
strike price that is much higher than the current index price (i.e.,
the option is significantly ``out of the money'') is likely to expire
worthless. If the option expires worthless, an investor that holds the
option until expiry receives no payoff in exchange for their initial
investment (the option premium) and therefore experiences a return of -
100%. Holding all other factors fixed, the likelihood of this outcome
increases with the strike price of the option, and the option is priced
accordingly--options that are further out of the money, all else equal,
will have lower premiums. At the same time, on the rare occasions when
the index price exceeds the strike price at expiration, the investor
will earn a high return on his or her initial investment because the
initial price paid for a call option is lower when the strike price is
higher. While the payoff to holding a leveraged/inverse investment
vehicle over long periods generally lacks this strict discontinuous
nature (expiring either in the money or out of the money), it is
nevertheless similar to that of an option in the sense that, as the
vehicle's leverage multiple or investor's holding period increases, the
likelihood of experiencing a loss increases (analogous to the option
expiring out of the money) while gains, when they do occur, tend to be
larger (analogous to the option expiring in the money).\470\
---------------------------------------------------------------------------
\469\ For a technical analysis of the similarities between the
returns of leveraged/inverse ETFs over longer holding periods and
the returns of holding an option, see Division of Economic and Risk
Analysis, Economics Note: The Distribution of Leveraged ETF Returns
(Nov. 2019), available at https://www.sec.gov/files/DERA_LETF_Economics_Note_Nov2019.pdf. The results of that analysis
also apply more generally to other types of leveraged/inverse
investment vehicles.
\470\ In statistical terms, the option returns and returns of
holding leveraged/inverse investment vehicles over longer holding
periods both exhibit positive skewness.
---------------------------------------------------------------------------
[[Page 4513]]
To achieve the stated leverage multiple, most leveraged/inverse
investment vehicles rebalance their exposure to the underlying index
daily.\471\ This is also similar to options, whose payoffs can be
replicated by trading dynamically in the underlying asset and a low-
risk bond. For example, call options are economically equivalent to
holding a long position in the underlying asset and a short position in
a low-risk bond.\472\ Both leveraged/inverse investment vehicles and
options are therefore economically equivalent to a dynamically
rebalanced leveraged/inverse or inverse leveraged/inverse position in
the underlying asset or reference index.\473\
---------------------------------------------------------------------------
\471\ Leveraged/inverse investment vehicles that track the
returns of an underlying index over time periods that are longer
than one day rebalance their portfolios at the end of each such
period. Leveraged/inverse investment vehicles use derivatives to
achieve their targeted returns.
\472\ Conversely, put options are economically equivalent to
holding a short position in the underlying and a long position in a
low-risk bond--their replicating portfolio consists of an inverse
leveraged position in the underlying.
\473\ Option replication portfolios need to be rebalanced
continuously throughout the day as the price of the underlying asset
changes. While the implied rebalancing happens continuously during
the trading day for options, leveraged/inverse investment vehicles
perform rebalancing trades in the underlying less frequently (daily
for most leveraged/inverse investment vehicles).
---------------------------------------------------------------------------
The majority of assets held in leveraged/inverse funds are held in
leveraged/inverse ETFs. There are currently two ETF sponsors that rely
upon exemptive relief from the Commission that permits them to operate
leveraged/inverse ETFs.\474\ Since 2009, the Commission has not granted
leveraged/inverse exemptive relief to any additional sponsors. In
addition, leveraged/inverse ETFs are currently excluded from the scope
of rule 6c-11, which the Commission adopted earlier this year and which
allows ETFs satisfying certain conditions to operate without obtaining
an exemptive order from the Commission.\475\
---------------------------------------------------------------------------
\474\ See supra notes 307 and 356. The exemptive orders of the
two sponsors that operate leveraged/inverse ETFs permit these
sponsors to launch additional funds under the terms and conditions
of those orders.
\475\ See supra notes 352-353 and accompanying text.
---------------------------------------------------------------------------
Retail investors predominantly purchase and sell shares of
leveraged/inverse investment vehicles through broker-dealers and
investment advisers.\476\ To the extent that broker-dealers or
investment advisers recommend leveraged/inverse investment vehicles to
their customers or clients, they should have processes in place to
satisfy their obligations to make only suitable recommendations or
provide best interest advice, respectively.\477\ For example, the basis
for an investment adviser's reasonable understanding generally would
include, for retail clients of investment advisers, a reasonable
inquiry into the client's financial situation, level of financial
sophistication, investment experience, and financial goals.\478\ When
an adviser is assessing whether complex or high-risk products--such as
leveraged/inverse funds--are in a retail client's best interest, the
adviser should generally apply heightened scrutiny to whether such
investments fall within the retail client's risk tolerance and
objectives.\479\ Broker-dealers also will be required to comply with
Regulation Best Interest beginning on June 30, 2020.\480\ Broker-
dealers complying with Regulation Best Interest will have to exercise
reasonable diligence, care, and skill when making a recommendation to a
retail customer, including by understanding potential risks, rewards,
and costs associated with a recommendation in light of the customer's
investment profile.\481\
---------------------------------------------------------------------------
\476\ See supra note 321.
\477\ Following the June 30, 2020 compliance date for Regulation
Best Interest, broker-dealers will have to provide recommendations
in the best interest of their retail customers. See Regulation Best
Interest: The Broker-Dealer Standard of Conduct, supra note 308.
\478\ See, e.g., Fiduciary Interpretation, supra note 308, at
text preceding n.36.
\479\ See id. at text preceding n.39. The Commission further
stated in the Fiduciary Interpretation that leveraged/inverse funds
and other complex products ``may not be in the best interest of a
retail client absent an identified, short-term, client-specific
trading objective and, to the extent that such products are in the
best interest of a retail client initially, they would require daily
monitoring by the adviser.'' See id.
\480\ See Regulation Best Interest: The Broker-Dealer Standard
of Conduct, supra note 305.
\481\ See id. at section II.C.2.
---------------------------------------------------------------------------
C. Benefits and Costs of the Proposed Rules and Amendments
The Commission is sensitive to the economic effects that may result
from the proposed rules and rule and form amendments, including
benefits and costs. Where possible, we have attempted to quantify the
likely economic effects; however, we are unable to quantify certain
economic effects because we lack the information necessary to provide
reasonable estimates. In some cases, it is difficult to predict how
market participants would act under the conditions of the proposed
rules. For example, we are unable to predict whether the proposed
derivatives risk management program requirement and VaR-based limit on
fund leverage risk may make investors more or less likely to invest in
funds that would be subject to these requirements or the degree to
which these requirements may affect the use of derivatives by these
funds. Nevertheless, as described more fully below, we are providing
both a qualitative assessment and quantified estimate of the economic
effects, including the initial and ongoing costs of the additional
reporting requirements, where feasible.
Direct costs incurred by funds discussed below may, to some extent,
be absorbed by the fund's investment adviser or be passed on to
investors in the form of increased management fees. The share of these
costs borne by funds, their advisers, and investors depends on multiple
factors, including the nature of competition between advisers, and
investors' relative sensitivity to changes in fund fees, the joint
effects of which are particularly challenging to predict due to the
number of assumptions that the Commission would need to make.
1. Derivatives Risk Management Program and Board Oversight and
Reporting
Proposed rule 18f-4 would require funds that enter into derivatives
transactions and are not limited derivatives users to adopt and
implement a derivatives risk management program. The program would
provide for the establishment of risk guidelines that must include
certain elements, but that are otherwise tailored based on how the
fund's use of derivatives may affect its investment portfolio and
overall risk profile. The program also would have to include stress
testing, backtesting, internal reporting and escalation, and program
review elements. The proposed rule would require a fund's board of
directors to approve the fund's designation of a derivatives risk
manager, who would be responsible for administering the derivatives
risk management program. The fund's derivatives risk manager would have
to report to the fund's board on the derivatives risk management
program's implementation and effectiveness and the results of the
fund's stress testing and backtesting.
We understand that advisers to many funds whose investment
strategies entail the use of derivatives already assess and manage
risks associated with their derivatives transactions.\482\ However,
proposed rule 18f-4's requirement that funds establish written
derivatives risk management programs would create a standardized
framework for funds'
[[Page 4514]]
derivatives risk management by requiring each fund's program to include
all of the proposed program elements. To the extent that the resulting
risk management activities are more comprehensive than funds' current
practices, this may result in more-effective risk management across
funds. While the adoption of a derivatives risk management program
requirement may not eliminate all derivatives-related risks, including
that investors could experience large, unexpected losses from funds'
use of derivatives, we expect that investors would benefit from a
decrease in leverage-related risks.
---------------------------------------------------------------------------
\482\ See supra section III.B.4.
---------------------------------------------------------------------------
Some funds may reduce or otherwise alter their use of derivatives
transactions to respond to risks identified after adopting and
implementing their risk management programs. In particular, we expect
that funds currently utilizing risk management practices that are not
tailored to their use of derivatives may decide to make such changes to
their portfolios.\483\
---------------------------------------------------------------------------
\483\ As a consequence of reducing risk, such funds may earn
reduced returns.
---------------------------------------------------------------------------
The proposed rule would require a fund to reasonably segregate the
functions of its derivatives risk management program from those of its
portfolio management.\484\ This segregation requirement is designed to
enhance the program's effectiveness by promoting the objective and
independent identification and assessment of derivatives risk.\485\
Segregating the functions of a fund's derivatives risk management
program from those of its portfolio management may also mitigate the
risks of competing incentives between a fund's portfolio managers and
its investors.\486\
---------------------------------------------------------------------------
\484\ See supra section II.B.2.
\485\ See supra note 112 and accompanying text. While some
portfolio managers may find it burdensome to collaborate with a
derivatives risk manager, to the extent that portfolio managers
already consider the impact of trades on the fund's portfolio risk,
we believe that having the involvement of a derivatives risk manager
may typically make a portfolio manager's tasks more rather than less
efficient.
\486\ For example, portfolio managers of actively-managed funds
that are underperforming competing funds may have an incentive to
increase risk exposures through use of derivatives in an effort to
increase returns. This behavior may result in a fund also increasing
risk beyond investor expectations. (For theoretical motivation of
such behaviors see, e.g., Keith C. Brown, W.V. Harlow, & Laura T.
Starks, Of Tournaments and Temptations: An Analysis of Managerial
Incentives in the Mutual Fund Industry, 51 Journal of Finance 85
(1996), available at https://www.onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1996.tb05203.x; Judith Chevalier & Glenn
Ellison, Risk-Taking by Mutual Funds as a Response to Incentives,
105 Journal of Political Economy 1167 (1997), available at https://www.jstor.org/stable/10.1086/516389?seq=1#metadata_info_tab_contents).
---------------------------------------------------------------------------
Finally, to the extent that the periodic stress testing and
backtesting requirements of the proposed derivatives risk management
program result in fund managers developing a more complete
understanding of the risks associated with their use of derivatives, we
expect that funds and their investors will benefit from improved risk
management.\487\ Such benefits would be in addition to benefits derived
from the proposed VaR-based limit on fund leverage risk discussed
below.\488\ VaR analysis, while yielding a simple yet general measure
of a fund's portfolio risk, does not provide a complete picture of a
fund's financial risk exposures.\489\ Complementing VaR analysis with
stress testing would provide a more complete understanding of the
fund's potential losses under different sets of market conditions. For
example, simulating potential stressed market conditions not reflected
in historical correlations between fund returns and asset prices
observed in normal markets may provide derivatives risk managers with
important information pertaining to derivatives risks in stressed
environments.\490\ By incorporating the potential impact of future
economic outcomes and market volatility in its stress test analysis, a
fund may be able to analyze future potential swings in its portfolio
that may impact the fund's long-term performance. This forward-looking
aspect of stress testing would supplement the proposed rule's VaR
analysis requirement, which would rely on historical data.
---------------------------------------------------------------------------
\487\ See supra sections II.B.3.c and II.B.3.d; see also supra
section II.C.2 (discussing the proposed requirements that a fund's
derivatives risk manager provide to the fund's board: (1) A written
report, at least annually, providing a representation that the
program is reasonably designed to manage the fund's derivatives
risks and to incorporate the required elements of the program
(including a review of the VaR calculation model used by the fund
under proposed rule 18f-4(c)(2), and the backtesting required by
proposed rule 18f-4(c)(1)(iv)); and (2) a written report, at the
frequency determined by the board, regarding any exceedances of the
fund's risk guidelines and the results of the fund's stress tests).
\488\ See infra section III.C.2.
\489\ See id.
\490\ See supra section II.B.3.c (proposed rule 18f-4 would
require the program to provide for stress testing to ``evaluate
potential losses to the fund's portfolio in response to extreme but
plausible market changes or changes in market risk factors that
would have a significant adverse effect on the fund's portfolio,
taking into account correlations of market risk factors as
appropriate and resulting payments to derivatives counterparties'').
---------------------------------------------------------------------------
In addition, requiring that a fund backtest the results of its VaR
analysis each business day would assist funds in examining the
effectiveness of the fund's VaR model. The proposed rule would require
that, each business day, the fund compare its actual gain or loss for
that business day with the fund's VaR calculated for that day.\491\
This comparison would help identify days where the fund's portfolio
losses exceed the VaR calculated for that day, as well as systematic
over- or under-estimation of VaR suggesting that the fund may not be
accurately measuring all significant, identifiable market risk
factors.\492\
---------------------------------------------------------------------------
\491\ See supra section II.B.3.d.
\492\ See supra notes 150-151 and accompanying text.
---------------------------------------------------------------------------
Proposed rule 18f-4 would also require that a fund's board of
directors approve the designation of the fund's derivatives risk
manager, taking into account the derivatives risk manager's relevant
experience.\493\ We anticipate that this requirement, along with the
derivatives risk manager's direct reporting line to the board, would
result in effective communication between the board and the derivatives
risk manager that would enhance oversight of the program to the benefit
of the fund and its investors.
---------------------------------------------------------------------------
\493\ See supra section II.C.1.
---------------------------------------------------------------------------
Proposed rule 18f-4 would require that the derivatives risk manager
provide the fund's board a written report at least once a year on the
program's effectiveness as well as regular written reports at a
frequency determined by the board that analyze exceedances of the
fund's risk guidelines and present the results of the fund's stress
tests and backtests.\494\ The proposed board reporting requirements may
facilitate the board's oversight of the fund and the operation of the
derivatives risk management program, to the extent the fund does not
have such regular reporting mechanisms already in place. In the event
the derivatives risk manager encounters material risks that need to be
escalated to the fund's board, the proposed provision that the
derivatives risk manager may directly inform the board of these risks
in a timely manner as appropriate may help prevent delays in resolving
such risks.
---------------------------------------------------------------------------
\494\ See supra section II.C.2.
---------------------------------------------------------------------------
Funds today employ a range of different practices, with varying
levels of comprehensiveness and sophistication, for managing the risks
associated with their use of derivatives.\495\ We expect that
compliance costs associated with the proposed derivatives risk
management program requirement would vary based on the fund's current
risk management practices, as well as the fund's characteristics,
including in particular
[[Page 4515]]
the fund's investment strategy, and the nature and type of derivatives
transactions used by the fund.
---------------------------------------------------------------------------
\495\ See supra section III.B.4.
---------------------------------------------------------------------------
We understand that VaR models are widely used in the industry and
that backtesting is commonly performed in conjunction with VaR
analyses. As a result, we believe that many funds that would be
required to establish derivatives risk management programs already have
VaR models with backtesting in place. Moreover, the proposed rule's
derivatives risk management program requirements, including stress
testing and backtesting requirements are, generally, high-level and
principles-based. As a result, it is likely that many funds' current
risk management practices may already be in line with many of the
proposed rule's derivatives risk management program requirements or
could be readily conformed without material change. Thus, the costs of
adjusting funds current' practices and procedures to comply with the
parallel requirements of proposed rule 18f-4 may be minimal for such
funds.
Certain costs of the proposed derivatives risk management program
may be fixed, while other costs may vary with the size and complexity
of the fund and its portfolio allocation. For instance, costs
associated with purchasing certain third-party data used in the
program's stress tests may not vary much across funds. On the other
hand, certain third-party services may vary in terms of costs based on
the portfolio positions to be analyzed. Further, the extent to which a
cost corresponding to the program is fixed or variable may also depend
on the third-party service provider.
Larger funds or funds that are part of a large fund complex may
incur higher costs in absolute terms but find it less costly, per
dollar managed, to establish and administer a derivatives risk
management program relative to a smaller fund or a fund that is part of
a smaller fund complex. For example, larger funds may have to allocate
a smaller portion of existing resources for the program, and fund
complexes may realize economies of scale in developing and implementing
derivatives risk management programs for several funds.\496\
---------------------------------------------------------------------------
\496\ Although we believe that many funds have existing risk
officers whose role extends to managing derivatives risks, we note
that some funds, and in particular smaller funds or those that are
part of a smaller fund complex, may not have existing personnel
capable of fulfilling the responsibilities of the derivatives risk
manager, or may choose to hire a new employee or employees to
fulfill this role, rather than assigning that responsibility to a
current employee or officer of the fund or the fund's investment
adviser. We expect that a fund that would hire new employees would
likely incur larger costs compared to a fund that has existing
employees that could serve as a fund's derivatives risk manager.
---------------------------------------------------------------------------
For funds that do not already have a derivatives risk management
program in place that could be readily adapted to meet the proposed
rule's requirements without significant additional cost, we estimate
that the one-time costs to establish and implement a derivatives risk
management program would range from $70,000 to $500,000 per fund,
depending on the particular facts and circumstances, including whether
a fund is part of a larger fund complex and therefore may benefit from
economies of scale. These estimated costs are attributable to the
following activities: (1) Developing risk guidelines and processes for
stress testing, backtesting, internal reporting and escalation, and
program review; (2) integrating and implementing the guidelines and
processes described above; and (3) preparing training materials and
administering training sessions for staff in affected areas.
For funds that do not already have a derivatives risk management
program in place that could be readily adapted to meet the proposed
rule's requirements without significant additional cost, based on our
understanding, we estimate that the ongoing annual program-related
costs that a fund would incur range from 65% to 75% of the one-time
costs to establish and implement a derivatives risk management program.
Thus, a fund would incur ongoing annual costs that range from $45,500
to $375,000.\497\ These estimated costs are attributable to the
following activities: (1) Assessing, monitoring, and managing the risks
associated with the fund's derivatives transactions; (2) periodically
reviewing and updating (A) the program including any models or
measurement tools (including any VaR calculation models) to evaluate
the program's effectiveness and to reflect changes in risk over time,
and (B) any designated reference index to evaluate its appropriateness;
(3) providing written reports to the fund's board on the derivatives
risk management program's implementation and effectiveness and the
results of the fund's stress testing; and (4) additional staff
training.
---------------------------------------------------------------------------
\497\ This estimate is based on the following calculations: 0.65
x $70,000 = $45,500; 0.75 x $500,000 = $375,000.
---------------------------------------------------------------------------
Under the proposed rule, a fund that is a limited derivatives user
would not be required to establish a derivatives risk management
program.\498\ Based on an analysis of Form N-PORT filings, as well as
financial statements filed with the Commission by BDCs, we estimate
that about 22% of funds that would be subject to the proposed rule, or
2,693 funds total, would be required to implement a risk management
program.\499\ As many funds belong to a fund complex and are likely to
experience economies of scale, we expect that the lower end of the
estimated range of costs ($70,000 in one-time costs; $45,500 in annual
costs) better reflects the total costs likely to be incurred by those
funds.\500\ In addition, we believe that many funds already have a
derivatives risk management program in place that could be readily
adapted to meet the proposed rule's requirements without significant
additional cost.\501\ However, as we do not have data to determine how
many funds already have a program in place that would substantially
satisfy the proposed rule's requirements, we over-inclusively assume
that all funds would incur a cost associated with this requirement.
Based on these assumptions, we provide an upper-end estimate for total
industry cost in the first year of $311,041,500.\502\
---------------------------------------------------------------------------
\498\ The estimates of the one-time and ongoing costs described
in this section include the costs associated with determining
whether a fund is a limited derivatives user.
\499\ We estimate that about 22% of all funds that would be
subject to the proposed rule hold some derivatives and would not
qualify as a limited derivatives user under the proposed rule.
\500\ A fund that uses derivatives in a complex manner, has
existing risk management practices that are not commensurate with
such use of derivatives, and may have to hire additional personnel
to fulfill the role of derivatives risk manager would be
particularly likely to experience costs at the upper end of this
range.
\501\ One commenter indicated that implementing stress testing,
which would be one of the required elements of the proposed
derivatives risk management program, would be only slightly
burdensome for 27% of respondents to a survey of ICI member firms
and would be moderately burdensome for an additional 50% of
respondents. See ICI Comment Letter III; see also supra note 466.
\502\ This estimate is based on the following calculation: 2,693
funds x ($70,000 + $45,500) = $311,041,500.
---------------------------------------------------------------------------
2. VaR-Based Limit on Fund Leverage Risk
The proposed rule would generally impose a VaR-based limit on fund
leverage risk on funds relying on the rule to engage in derivatives
transactions.\503\ This outer limit would be based on a relative VaR
test or, if the fund's derivatives risk manager is unable to identify
an appropriate designated reference index, an absolute VaR test. In
either case a fund would apply the test at least once each business
day. The proposed rule would include an exception from the limit on
[[Page 4516]]
fund leverage risk for limited derivatives users and also certain funds
that are ``leveraged/inverse investment vehicles,'' as defined in the
proposed sales practices rules.\504\
---------------------------------------------------------------------------
\503\ See supra section II.D.
\504\ See supra sections II.E and II.G.3.
---------------------------------------------------------------------------
The proposed relative VaR test would limit a fund's VaR to 150% of
the VaR of the fund's designated reference index.\505\ The designated
reference index would have to be unleveraged and reflect the markets or
asset classes in which the fund invests.\506\ Therefore, the relative
VaR test restricts the incremental risk associated with a fund's
portfolio relative to a similar but unleveraged investment strategy. In
this sense, the relative VaR test restricts the degree to which a fund
can use derivatives to leverage its portfolio.
---------------------------------------------------------------------------
\505\ See supra section II.D.2.
\506\ See supra section II.D.2.a. The proposed definition of
``designated reference index'' also includes other requirements, as
discussed above. See id. For example, a designated reference index
could not be administered by an organization that is an affiliated
person of the fund, its investment adviser, or principal
underwriter, or created at the request of the fund or its investment
adviser, unless the index is widely recognized and used.
---------------------------------------------------------------------------
We recognize that the derivatives risk managers of some funds may
not be able to identify an appropriate designated reference index.\507\
As these funds would not be able to comply with the proposed relative
VaR test, the proposed rule would require these funds to comply with
the proposed absolute VaR test instead.\508\ To comply with the
absolute VaR test, the VaR of the fund's portfolio must not exceed 15%
of the value of the fund's net assets. The level of loss in the
proposed absolute VaR test would provide approximately comparable
treatment for funds that rely on the absolute VaR test and funds that
rely on the relative VaR test and use the S&P 500 as their designated
reference index during periods where the S&P 500's VaR is approximately
equal to the historical mean.\509\
---------------------------------------------------------------------------
\507\ See supra section II.D.3.
\508\ Whether a fund complies with the proposed relative or
absolute VaR test would depend on whether the fund's derivatives
risk manager would be able to identify a designated reference index
that is appropriate for the fund taking into account the fund's
investments, investment objectives, and strategy. See id. We
therefore anticipate that industry norms that reflect the
availability of an appropriate designated reference index would
develop under which funds with similar strategies would generally
comply with the same type of VaR test (that is, either the proposed
relative VaR test or the proposed absolute VaR test).
\509\ See supra section II.D.3.
---------------------------------------------------------------------------
One common critique of VaR is that it does not reflect the
conditional distribution of losses beyond the specified confidence
level.\510\ In other words, the proposed VaR tests would not capture
the size and relative frequency of losses in the ``tail'' of the
distribution of losses beyond the measured confidence level.\511\ As a
result, two funds with the same VaR level could differ significantly in
the magnitude and relative frequency of extreme losses, even though the
probability of a VaR breach would be the same for the two funds. To
demonstrate this limitation of VaR, we construct a simplified portfolio
with an equity investment that also achieves leverage through
derivatives. By varying the type of derivatives included in the
portfolio, we illustrate that the tail risk varies significantly across
portfolios with equal VaR.
---------------------------------------------------------------------------
\510\ See supra note 181 and accompanying text.
\511\ The term ``relative frequency'' here refers to the
frequency of loss outcomes in the tail of the distribution relative
to other loss outcomes that are also in the tail of the
distribution. This relative frequency of the loss outcomes together
with the magnitude of the associated losses describe the conditional
distribution of losses in the tail of the distribution.
---------------------------------------------------------------------------
The details of the strategy are as follows. Assume a fund has
initial assets of $100 in cash. On day t, the manager of the portfolio
achieves the additional leverage by writing $ X worth of put options,
and then invests the proceeds from the sale of the options and the
initial cash balance, i.e., $(100 + X), into the S&P 500 index.\512\
For simplicity, we further assume that the underlying asset of the
shorted put options is also the S&P 500 index, so that the fund's
designated reference index is the S&P 500. The maturity of the put
option is assumed to be one month, and the price of the S&P on day t is
normalized to $100. On day t + 1, the manager buys back the put options
and realizes the returns of the strategy. The one-day gross return of
the fund can be described mathematically as
[GRAPHIC] [TIFF OMITTED] TP24JA20.000
where RM is the gross one-day return of the S&P 500 index, and Rput =
P(t + 1)/P(t) is the gross one-day return of the put option, with the
price of the put option at time t denoted by P(t). The return of the
put option depends on the return of the underlying sset, and the money-
ness of the put--the lower the strike price, the more out-of-the-money
is the put. In our exercise, we look at three options with three
different strike prices, ranging from more out-of-the-money to at-the-
money. The strike prices, denoted by K, are equal to K = 92%, K = 96%,
and K = 100%, of the current level of the S&P 500 index
respectively.\513\ Assuming the portfolio manager wants to achieve as
much leverage as possible with each of the three options, while still
abiding by the proposed limit set by the relative VaR level of 150% at
a 99% confidence level, we calculate the amount of puts she would
short, the expected returns of the three portfolios, and the relative
VaR for confidence levels of 95%, 99%, and 99.9%. In our calculation,
the model is calibrated to approximately match the historical return
distribution of the S&P 500. Returns are assumed to be normally
distributed (for simplicity) with an annualized mean return of 6% and
an annual standard deviation of roughly 16%. The latter implies a daily
standard deviation of 1%. For simplicity, the risk-free rate is assumed
to be zero. The results are in Table 1.
---------------------------------------------------------------------------
\512\ This strategy could be implemented by either investing in
the constituent securities of the S&P 500 directly or, for example,
by investing in an ETF that tracks the S&P 500 index.
\513\ Given the historical volatility of the S&P 500--
approximately 16% annually, or 1% daily--an 8% daily drop in the
price is an 8 standard deviation event. Therefore, an option with a
strike price of 92% of the current value of the S&P 500 index could
be considered a deep out-of-the-money option.
Table 1--Portfolio Composition, Returns and VAR Levels
----------------------------------------------------------------------------------------------------------------
K = 92% K = 96% K = 100%
Portfolio Portfolio Portfolio
----------------------------------------------------------------------------------------------------------------
Portfolio Weight................................................ -0.58% -0.93% -1.54%
Number of Contracts............................................. -9.92 -2.05 -0.84
Fund Expected Return............................................ 6.68% 7.00% 7.30%
Fund Relative VaR (99%)......................................... 1.49 1.49 1.49
Fund Relative VaR (99.9%)....................................... 2.14 2.07 2.03
----------------------------------------------------------------------------------------------------------------
[[Page 4517]]
Relative VaR levels are identical and no greater than 150% for all
three portfolios at the 99% confidence level and, as expected, for each
portfolio relative VaR is higher for higher confidence levels. However,
this example illustrates that relative VaR varies across these
portfolio for confidence levels above 99%. The fund writing the more
out-of-the-money option (K = 92%) is riskier in the tail of the S&P 500
return distribution (when the S&P 500 drops over the one-day period)
than the fund writing the at-the-money option (K = 100%), but the
relative VaR level at the 99% confidence level does not reflect this
difference.
Figure 1 shows the daily return profile of the three portfolios as
a function of daily returns to the S&P 500 index. Along the x-axis are
daily returns to the S&P 500 index, ranging from -8% to +8%. The dotted
line represents the daily return profile of a portfolio that tracks 1.5
times the returns of the S&P 500 index. The figure shows that the
degree of tail risk differs across portfolios. While the returns to all
portfolios are equal at the 150% relative VaR limit at a 99% confidence
level, returns beyond the 150% relative VaR limit are lower for
portfolios that write puts that are further out-of-the-money.
BILLING CODE 8011-01-P
[[Page 4518]]
[GRAPHIC] [TIFF OMITTED] TP24JA20.001
BILLING CODE 8011-01-C
We also considered the effect that a decline in the S&P 500 over
three consecutive days would have on the fund that is short the put
options with a K = 92% strike price considered above. The proposed rule
requires that a fund determine its compliance with the applicable VaR
test at least once each business day. In computing three-day returns
for the fund, we assume that, as the fund exceeds the relative
[[Page 4519]]
VaR test each business day, the fund rebalances its portfolio, at the
beginning of each day, to bring the fund back into compliance with the
150% relative VaR limit. The solid line in Figure 2 shows the three-day
cumulative return of the fund as a function of the per-day returns of
the S&P 500 on the x-axis, which is assumed to be the same for three
consecutive days. The dashed curve in Figure 2 shows the corresponding
first-day returns of the portfolio for comparison, which are the same
as those denoted by the solid line in Figure 1. The figure shows that
the three-day cumulative returns shown by the solid curve (in Figure 2)
are less than three times the single-day losses shown by the dashed
curve. This is a result of the daily rebalancing of the portfolio,
which, in this example, reduces the incremental downside risk over
time.
As discussed in more detail above, the proposed VaR tests are
designed to address the concerns underlying section 18, but they are
not a substitute for a fully-developed derivatives risk management
program.\514\ Recognizing VaR's limitations, the proposed rule also
would require the fund to adopt and implement a derivatives risk
management program that, among other things, would require the fund to
establish risk guidelines and to stress test its portfolio in part
because of concerns that VaR as a risk management tool may not
adequately reflect tail risks.
---------------------------------------------------------------------------
\514\ See supra note 183 and accompanying text.
---------------------------------------------------------------------------
DERA staff analyzed the VaR levels of the portfolios of all funds
that would be subject to the proposed rule and of certain benchmark
indexes as of December 2018 in order to estimate how many of the funds
that would be subject to the proposed VaR-based limit on fund leverage
risk currently operate in exceedance of that limit.\515\ This analysis
identified only six funds that would be subject to the proposed limit
that DERA staff estimated may fail the relative VaR test. In the case
of these six funds, DERA staff calculated the relative VaR test using
the primary benchmark disclosed in the funds' prospectuses. To the
extent that these funds' derivatives risk managers were to determine
that a different index would be more appropriate for purposes of
computing the relative VaR test or that no appropriate designated
reference index were available, some or all of these funds could be
compliant with the VaR-based limit on fund leverage risk either under
the relative VaR test with a more appropriate index or under the
absolute VaR test.\516\ As a result, we estimate that there would only
be a very small number of funds, if any, that would have to adjust
their portfolios in order to comply with the VaR-based limit on fund
leverage risk. This is consistent with the VaR-based limit on fund
leverage risk functioning as an outer bound on fund leverage risk.
---------------------------------------------------------------------------
\515\ This analysis is based on Morningstar data as of December
31, 2018. DERA staff computed the VaR of each fund and that of a
reference index using historical simulation from three years of
prior daily return data. Staff generally computed the relative VaR
test based on a fund's primary prospectus benchmark. In cases where
historical return data for the primary prospectus benchmark was not
available or where the primary prospectus benchmark did not appear
to capture the markets or asset classes in which a fund invests,
DERA staff instead used a broad-based unleveraged index that
captures a fund's markets or asset classes or a broad-based U.S.
equity index.
\516\ Based on our analysis, we estimate that only one of the
six funds that we identified may fail the proposed relative VaR test
would also fail the proposed absolute VaR test.
---------------------------------------------------------------------------
To the extent that there are funds that would have to adjust their
portfolios to comply with the VaR-based limit on fund leverage risk,
these funds would incur associated trading costs. If there were a fund
that would have to adjust its portfolio so significantly that it could
no longer pursue its investment strategy, such a fund may also lose
investors or, if it chooses to cease operating, incur costs associated
with unwinding the fund.
In addition, funds could be required to adjust their portfolios to
comply in the future and, if so, would incur associated trading costs.
For example, as market conditions change, a fund's VaR could exceed the
proposed limits, especially if a fund relies on the absolute VaR test.
The proposed VaR tests also would eliminate the flexibility that funds
currently have to leverage their portfolios to a greater extent than
the proposed VaR tests would permit. Although funds currently may not
be exercising this flexibility, they may nevertheless value the ability
to so increase leverage in the future. While, on the one hand, the
proposed VaR tests impose costs on funds by restricting the strategies
they may employ, the proposed limit on fund leverage risk would benefit
fund investors, to the extent that it would prevent these investors
from experiencing unexpected losses from a fund's increased risk
exposure that are prevented by the proposed VaR-based limit on fund
leverage risk.
By establishing a bright-line limit on the amount of leverage risk
that a fund can take on using derivatives, the proposed rule may make
some funds and their advisers more comfortable with using derivatives.
As a result, some funds that currently invest in derivatives to an
extent that would result in the fund's VaR being below the proposed
limit may react by increasing the extent of their derivatives usage.
The proposed requirement could also indirectly result in changing
the amount of investments in funds. On the one hand, the proposed rule
could attract additional investment, if investors become more
comfortable with funds' general level of riskiness as a result of
funds' compliance with an outside limit on fund leverage risk. On the
other hand, to the extent that investors currently expect funds to
limit their risk to levels below those which the proposed limits would
produce (which investors could observe from the required VaR reporting
requirements on form N-PORT for funds other than limited derivatives
users and leveraged/inverse funds), or investors see funds' general
level of riskiness increasing after funds come into compliance with the
proposed limits, the proposed limits may result in investors re-
evaluating how much risk they are willing to take and reducing their
investments in funds. Due to a lack of data regarding current investor
expectations about fund risk, however, we are unable to predict which
of the two effects would more likely dominate the other.
As the proposed requirements would prevent funds from offering
investment strategies that exceed the proposed outer limit on fund
leverage risk, those investors who prefer to invest in such funds
because they value the increased potential for gains that is generally
associated with riskier investment strategies may see their investment
opportunities restricted by the proposed rules. As a result, such
investors may instead invest in alternative investment vehicles,
exchange-traded notes, or structured products, which can provide
leveraged market exposure but would not be subject to the VaR-based
limit on fund leverage risk of rule 18f-4.\517\ Alternatively, such
investors, particularly institutional ones, may instead borrow
themselves or trade on margin to achieve leverage.
---------------------------------------------------------------------------
\517\ See supra section III.C.5.
---------------------------------------------------------------------------
Funds that would be subject to the proposed VaR-based limit on fund
leverage risk would incur the cost of determining their compliance with
the applicable VaR test at least once each business day. Part of these
costs would be associated with obtaining the necessary data required
for the VaR calculation. Funds implementing the relative VaR test would
likely incur larger data costs compared to funds implementing the
absolute VaR test, as
[[Page 4520]]
the absolute VaR test would require funds to obtain data only for the
VaR calculation for the fund's portfolio, whereas the relative VaR test
also would require funds to obtain data for the VaR calculation for
their designated reference index. In addition, some index providers may
charge licensing fees to funds for including indexes in their
disclosure documents or for access to information about the index's
constituent securities and weightings.\518\
---------------------------------------------------------------------------
\518\ We understand that industry practices around licensing
indexes for regulatory purposes vary widely, with some providers not
charging any fees and others charging fees in excess of $10,000 per
year.
---------------------------------------------------------------------------
Funds that do not already have systems to perform the proposed VaR
calculations in place would also incur the costs associated with
setting up these systems or updating existing systems.\519\ Both the
data costs and the systems costs would likely be larger for funds that
use multiple types of derivatives, use derivatives more extensively, or
otherwise have more complicated derivatives portfolios, compared to
funds with less complicated derivatives portfolios.
---------------------------------------------------------------------------
\519\ One commenter indicated that implementing a UCITS VaR test
would be only slightly burdensome for 45% of respondents to a survey
of ICI member firms and would be moderately burdensome for an
additional 34% of respondents. The commenter also indicated that
respondents commonly reported that the burden would increase, in
some cases very substantially, if a VaR test has different
parameters or is more prescriptive than UCITS VaR. See ICI Comment
Letter III; see also supra note 451. As the requirements of the
proposed VaR test are generally consistent with existing market
practice, including that of UCITs funds, the results of this survey
therefore support our view that many funds would likely experience
efficiencies in implementing the proposed VaR test.
---------------------------------------------------------------------------
Larger funds or funds that are part of a large fund complex may
incur higher costs in absolute terms but find it less costly, per
dollar managed, to perform VaR tests relative to a smaller fund or a
fund that is part of a smaller fund complex. For example, larger funds
may have to allocate a smaller portion of existing resources for the
VaR test and fund complexes may realize economies of scale in
implementing systems to compute VaR. In particular, the costs
associated with implementing or updating systems to calculate VaR would
likely only be incurred once at the level of a fund complex, as such
systems can be used to perform VaR tests for all funds in the complex
that are subject to the VaR test requirement. Similarly, larger fund
complexes may incur lower costs associated with purchasing data per
fund, to the extent that the VaR calculations for multiple funds in the
complex partially or completely require the same data.
Under the proposed rule, a fund that holds derivatives that is
either a limited derivatives user or a leveraged/inverse fund that
complies with the alternative requirements for leveraged/inverse
investment vehicles would not be subject to the proposed VaR-based
limit on fund leverage risk. Based on an analysis of Form N-PORT
filings and financial statements filed with the Commission by BDCs, we
estimate that about 19% of funds that would be subject to the proposed
rule, or 2,424 funds total, would be required to implement VaR
tests.\520\ We estimate that the incremental annual cost associated
with the VaR test would range from $5,000 to $100,000 per fund,
depending on the particular facts and circumstances, including whether
the fund currently computes VaR; whether the fund is implementing the
relative or absolute VaR test; and whether a fund that is part of a
larger complex may be able to realize economies of scale. Funds that
currently already compute VaR would be particularly likely to
experience costs at the very low end of this range. Assuming that the
midpoint of this range reflects the cost to the average fund subject to
the VaR requirement, we estimate a total additional annual industry
cost of $127,260,000.\521\
---------------------------------------------------------------------------
\520\ We estimate that about 19% of all funds that would be
subject to the proposed rule hold some derivatives, would not
qualify as a limited derivatives user, and are not a leveraged/
inverse fund that could comply with the alternative requirements for
leveraged/inverse investment vehicles.
\521\ This estimate is based on the following calculation: 2,424
funds x 0.5 x ($5,000 + $100,000) = $127,260,000. Some funds may
find it more cost effective to restrict their use of derivatives in
order to be able to rely on the proposed rule's exception for
limited derivatives users compared to complying with the proposed
VaR-based limit on fund leverage risk. See supra section II.E; infra
section III.C.3. As we do not have data that would allow us to
quantify the costs and benefits that define the tradeoff for any
particular fund of changing its use of derivatives in order to
qualify for the limited user exception, we are unable to quantify
how many funds would make this choice.
---------------------------------------------------------------------------
In addition, a fund that today or in the future may operate in a
manner that would result in the fund's portfolio VaR being just under
the proposed limit on fund leverage risk may need to alter its
portfolio during periods of increased market volatility in order to
avoid falling out of compliance with the proposed limit. We would
expect such a scenario to be more likely for a fund that would rely on
the absolute VaR test, because the relative VaR test would allow a fund
to operate with a higher portfolio VaR when the VaR of its designated
reference index increases.
A fund that were to eliminate some of its leverage risk associated
with derivatives in order to comply with the proposed VaR-based limit
on leverage risk might do so through unwinding or hedging its
derivatives transactions or through some other means. These portfolio
adjustments may be costly, particularly in conditions of market stress
and reduced liquidity. The proposed rule would, however, give a fund
the flexibility to mitigate these potential costs by not requiring the
fund to exit positions or change its portfolio if it is out of
compliance with the VaR test. Instead, the rule would provide that, if
a fund has been out of compliance with the applicable VaR test for more
than three business days, then: (1) The derivatives risk manager must
report to the fund's board of directors and explain how and by when
(i.e., the number of business days) the derivatives risk manager
reasonably expects that the fund will come back into compliance; \522\
(2) the derivatives risk manager must analyze the circumstances that
caused the fund to be out of compliance for more than three business
days and update any program elements as appropriate to address those
circumstances; and (3) the fund may not enter into derivatives
transactions other than derivatives transactions that, individually or
in the aggregate, are designed to reduce the fund's VaR, until the fund
has been back in compliance with the applicable VaR test for three
consecutive business days and satisfied the board reporting requirement
and program analysis and update requirements.\523\ These provisions of
the proposed rule collectively would provide some flexibility for a
fund that is out of compliance with the VaR test to make any portfolio
adjustments, which may allow funds to avoid some of the costs that
otherwise could result from forced changes in the fund's portfolio.
---------------------------------------------------------------------------
\522\ Proposed rule 18f-4(c)(2)(iii)(A). See also infra section
II.H.2 (discussing a report to the Commission regarding the fund
being out of compliance with the applicable proposed VaR test for
three business days).
\523\ See proposed rule 18f-4(c)(2)(iii).
---------------------------------------------------------------------------
3. Limited Derivatives Users
Proposed rule 18f-4 includes an exception from the proposed risk
management program requirement and VaR-based limit on fund leverage
risk for limited derivatives users.\524\ The proposed exception would
be available for a fund that either limits its derivatives exposure to
10% of its net assets or uses derivatives transactions solely to hedge
certain currency risks and that also adopts and implements policies and
procedures reasonably
[[Page 4521]]
designed to manage the fund's derivative risks. We expect that the
risks and potential impact of these funds' derivatives use may not be
as significant, compared to those of funds that do not qualify for the
exception.\525\ Therefore, we believe that a principles-based policies
and procedures requirement would appropriately address these risks.
---------------------------------------------------------------------------
\524\ See supra section II.E.
\525\ See supra note 270 and accompanying and immediately-
following text.
---------------------------------------------------------------------------
We believe that investors in funds that use derivatives in a
limited manner would benefit from the proposed requirement, which we
anticipate would reduce, but not eliminate, the frequency and severity
of derivatives-related losses for such funds. In addition, to the
extent that the proposed framework is more comprehensive than funds'
current practices, the proposed requirement may result in more
effective risk management across funds and increased fund industry
stability.
For funds that do not already have policies and procedures in place
that could be readily adapted to meet the proposed rule's requirements
without significant additional cost, we estimate that the one-time
costs would range from $1,000 to $100,000 per fund, depending on the
particular facts and circumstances, including whether a fund is part of
a larger fund complex; the extent to which the fund uses derivatives
within the parameters of the limited user exception, including whether
the fund uses more complex derivatives; and the fund's current
derivatives risk management practices. These estimated costs are
attributable to the following activities: (1) Assessing whether a fund
is a limited derivatives user; (2) developing policies and procedures
reasonably designed to manage a fund's derivatives risks; (3)
integrating and implementing the policies and procedures; and (4)
preparing training materials and administering training sessions for
staff in affected areas.
For funds that do not already have policies and procedures in place
that could be readily adapted to meet the proposed rule's requirements
without significant additional cost, we estimate that the ongoing
annual costs that a fund that is a limited derivatives user would incur
range from 65% to 75% of the one-time costs to establish and implement
the policies and procedures. Thus, a fund would incur ongoing annual
costs that range from $650 to $75,000.\526\ These estimated costs are
attributable to the following activities: (1) Assessing, monitoring,
and managing the risks associated with the fund's derivatives
transactions; (2) periodically reviewing and updating a fund's policies
and procedures; and (3) additional staff training.
---------------------------------------------------------------------------
\526\ This estimate is based on the following calculations: 0.65
x $1,000 = $650; 0.75 x $100,000 = $75,000.
---------------------------------------------------------------------------
Based on an analysis of Form N-PORT filings, as well as financial
statements filed with the Commission by BDCs, we estimate that about
19% of funds that would be subject to the proposed rule, or 2,398 funds
total, would qualify as limited derivatives users. Almost all of these
funds would be able to rely on the exposure-based exception. While some
funds, about 1%, could rely on both the exposure-based exception and
the currency hedging exception, only a fraction of 1% of funds would
qualify as limited derivatives users solely based on the currency
hedging exception.
As many funds belong to a fund complex and are likely to experience
economies of scale, we expect that the lower end of the estimated range
of costs ($1,000 in one-time costs; $650 in annual costs) better
reflects the total costs likely to be incurred by many funds. In
addition, we believe that many funds already have policies and
procedures in place that could be readily adapted to meet the proposed
rule's requirements without significant additional cost. However, as we
do not have data to determine how many funds already have such policies
and procedures in place that would substantially satisfy the proposed
rule's requirements, we assume that all funds would incur a cost
associated with this requirement. Based on these assumptions, we over-
inclusively estimate a lower bound for the total industry cost in the
first year of $751,773.\527\
---------------------------------------------------------------------------
\527\ This estimate is based on the following calculation: 2,398
funds x 0.19 x ($1,000 + $650) = $751,773. This cost estimate
assumes that none of the funds that currently do not hold any
derivatives would choose to establish and implement policies and
procedures reasonably designed to manage the fund's derivatives
risks in anticipation of a future limited use of derivatives.
Notwithstanding this assumption, we acknowledge some funds that
currently do not use derivatives may still choose to establish and
implement such policies and procedures prophylactically in order to
preserve the flexibility to engage in a limited use of derivatives
on short notice.
---------------------------------------------------------------------------
Some funds may change how they use derivatives in order to qualify
for the limited derivatives user exception and thereby avoid the
potentially increased compliance cost associated with the proposed
derivatives risk management program and VaR-based limit on fund
leverage risk. Specifically, a fund with derivatives exposure just
below 10% of its net assets may forego taking on additional derivatives
positions, or a fund with derivatives exposure just above 10% of its
net assets may close out some existing derivatives positions.
Similarly, a fund that uses derivatives to hedge certain currency risks
may forego or eliminate its use of derivatives for other purposes. As a
result, the proposed exception for limited derivatives users may reduce
the extent to which some funds use derivatives.\528\
---------------------------------------------------------------------------
\528\ As we do not have data that would allow us to quantify the
costs and benefits that define the tradeoff for any particular fund
of changing its use of derivatives in order to qualify for the
limited user exception, we are unable to quantify how many funds
would make this choice.
---------------------------------------------------------------------------
4. Reverse Repurchase Agreements and Similar Financing Transactions
The proposed rule would allow funds to engage in reverse repurchase
agreements and other similar financing transactions. However, as these
transactions achieve economically identical results to other secured
loans, the proposed rule would require that they be treated the same as
bank borrowings and other borrowings under section 18. The proposal
would therefore require a fund to combine any bank borrowings or other
borrowings and reverse repurchase agreements when assessing compliance
with the relevant asset coverage requirements of section 18.\529\
---------------------------------------------------------------------------
\529\ See supra section II.I.
---------------------------------------------------------------------------
Today, funds rely on the asset segregation approach that Release
10666 describes with respect to reverse repurchase agreements, which
funds may view as separate from the limitations established on bank
borrowings (and other senior securities that are evidence of
indebtedness) by the asset coverage requirements of section 18.\530\ As
a result, the degree to which funds could engage in reverse repurchase
agreements may differ under the proposed rule from the baseline. A fund
that engages solely in reverse repurchase agreements, or solely in bank
borrowings (for example), would be unaffected by the proposed
requirement.\531\ However, to the extent that a fund engages in both
reverse repurchase agreements and bank borrowings (or similar
transactions), because we believe these transactions are economically
equivalent, they would be combined for purposes of analyzing whether a
fund is in compliance with section 18's asset
[[Page 4522]]
coverage requirement. This may have the effect of limiting the overall
scale of these transactions under the proposed requirement compared to
the baseline, to the extent that funds today separately analyze their
asset coverage requirements with respect to reverse repurchase
agreements under Release 10666 and bank borrowings and similar senior
securities under section 18.
---------------------------------------------------------------------------
\530\ See supra section I.B.2.a.
\531\ For example, an open-end fund with no other senior
securities outstanding could borrow an amount equivalent to 50% of
its net assets using reverse repurchase agreements or bank
borrowings under the baseline.
---------------------------------------------------------------------------
DERA staff analyzed funds' use of reverse repurchase agreements and
borrowings using Form N-PORT filings as well as financial statements
filed with the Commission by BDCs. Based on our analysis of Form N-PORT
filings, we estimate that about 0.36% of funds that would be subject to
the proposed rule, or 45 funds total, used these transactions in
combined amounts that exceeded the asset coverage requirement.\532\
These funds would have to adjust their use of reverse repurchase
agreements, similar financing transactions, or borrowings in order to
comply with the proposed rule and may incur associated transactions
costs.
---------------------------------------------------------------------------
\532\ In our review of form N-PORT filings, we observed that
several of the funds that used reverse repurchase agreements and
similar financing transactions (bank borrowings and similar
securities) in combined amounts that exceeded 50% of net assets
already exceeded the 50% limit for either repurchase agreements,
similar financing transactions (bank borrowings and similar
securities, or both, when considered separately. In our review of
financial statements filed by the Commission by BDCs, we observed
that no BDCs exceeded the asset coverage requirement.
---------------------------------------------------------------------------
In addition, under the proposed rule, if a fund did not qualify as
a limited derivatives user due to its other investment activity, any
portfolio leveraging effect of reverse repurchase agreements, similar
financing transactions, and borrowings would also be restricted
indirectly through the VaR-based limit on fund leverage risk. As a
result, a fund could be restricted through the VaR-based limit on fund
leverage risk from investing the proceeds of borrowings through reverse
repurchase agreements to the full extent otherwise permitted by the
asset coverage requirements in section 18 if the fund did not qualify
as a limited derivatives user.
5. Alternative Requirements for Certain Leveraged/Inverse Funds and
Proposed Sales Practices Rules for Certain Leveraged/Inverse Investment
Vehicles
The proposed sales practices rules would require a broker-dealer or
investment adviser to (1) exercise due diligence in approving a retail
investor's account to buy or sell shares of leveraged/inverse
investment vehicles before accepting an order from, or placing an order
for, such an investor to engage in these transactions; and (2) adopt
and implement policies and procedures reasonably designed to achieve
compliance with the proposed rules.\533\ Additionally, a leveraged/
inverse fund that meets the definition of a ``leveraged/inverse
investment vehicle'' in the proposed sales practices rules would not
have to comply with the VaR-based leverage risk limit under proposed
rule 18f-4, provided the fund limits the investment results it seeks to
300% of the return (or inverse of the return) of the underlying index
and discloses in its prospectus that it is not subject to the proposed
VaR-based limit on fund leverage risk.\534\
---------------------------------------------------------------------------
\533\ See supra section II.G.2. The proposed sales practices
rules define ``leveraged/inverse investment vehicle'' to mean a
registered investment company or an exchange-listed commodity- or
currency-based trust or fund that seeks, 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. See proposed
rules 15l-2(d) and 211(h)-1(d).
\534\ See supra section II.G.3. A leveraged/inverse fund that
meets these requirements still would be required to satisfy all of
the conditions in proposed rule 18f-4 other than the proposed VaR-
based limit on fund leverage risk, including the proposed conditions
requiring a derivatives risk management program, board oversight and
reporting, and recordkeeping.
---------------------------------------------------------------------------
These due diligence and approval requirements are designed to
address potential investor protection concerns with respect to
leveraged/inverse investment vehicles by subjecting retail investors to
specific due diligence and account approval requirements by broker-
dealers and investment advisers. The proposed rules also are designed
to help to ensure that investors in these funds are limited to those
who are capable of evaluating their characteristics--including that the
funds would not be subject to all of the leverage-related requirements
applicable to registered investment companies generally--and the unique
risks they present. There is a body of academic literature providing
empirical evidence that retail investors may not fully understand the
risks inherent in their investment decisions and not fully understand
the effects of compounding returns over time.\535\ Retail investors
could face additional burdens in investing in leveraged/inverse
investment vehicles, to the extent that they do not currently possess
the requisite capability of evaluating the risks of these products to
satisfy the approval requirements implemented by broker-dealers and
investment advisers in connection with the proposed rules' due
diligence and account approval obligations. However, we expect such
retail investors would benefit from the proposed requirement, which we
believe would help to ensure that investors in these funds are limited
to those who are capable of evaluating the characteristics and unique
risks of these products.\536\ We acknowledge that these benefits may be
reduced, to the extent that they overlap with the effects of investment
advisers' or broker-dealers' existing requirements or practices related
to a retail investors' suitability for investments in these produces as
discussed in section III.B.5 above.
---------------------------------------------------------------------------
\535\ See, e.g., Annamaria Lusardi & Olivia S. Mitchell, The
Economic Importance of Financial Literacy: Theory and Evidence, 52
Journal of Economic Literature 5 (2014), available athttps://
www.aeaweb.org/articles?id=10.1257/jel.52.1.5, which provides a
literature review of recent survey-based work indicating that many
retail investors have limited financial literacy and, for example,
do not always understand the compounding of returns, which may
directly apply in the context of the daily compounding feature of
leveraged/inverse ETFs. The literature does not address retail
investor's inattention to investment risk or the unique dynamics of
compounding of daily returns in the context of leveraged/inverse
ETFs or other leveraged/inverse investment vehicles specifically,
but studies investor inattention to financial products more
generally.
\536\ The sales practices rules would not apply to a position in
a leveraged/inverse investment vehicle established before the rules'
compliance date. See supra note 339 and associated text. As a
result, investors with such existing positions would only be
affected by the proposed sales practices rules if they seek to
increase an existing or add a new position in a leveraged/inverse
investment vehicle.
---------------------------------------------------------------------------
Since the alternative provision for leveraged/inverse funds under
proposed rule 18f-4 includes a requirement that a leveraged/inverse
fund disclose in its prospectus that it is not subject to the proposed
limit on fund leverage risk, both investors and the market would
benefit from transparency regarding which funds are exempt from rule
18f-4's limit on fund leverage fund risk. Some investors may value this
information to the extent that it helps them make better-informed
choices between funds.
The costs that broker-dealers and investment advisers may incur as
a result of the proposed sales practices rules would vary depending on
the firm. For example, as the proposed requirements are generally
modeled after the options account requirements, broker-dealers that
already have compliance procedures in place for approving options
accounts would likely have reduced compliance costs.\537\ In addition,
some broker-dealers and investment advisers may incur costs associated
with training
[[Page 4523]]
customer-facing personnel and supervisory review of account approval
decisions. Investment advisers' and broker-dealers' existing processes,
as discussed above in section III.B.5, may reduce the costs that the
proposed sales practices rules otherwise would involve to the extent
that investment advisers or broker-dealers can build on existing
processes in complying with the proposed sales practices rules.
---------------------------------------------------------------------------
\537\ These efficiencies and the resulting reduced compliance
costs would not apply to investment advisers that are not also
registered broker-dealers because they are not subject to FINRA
rules.
---------------------------------------------------------------------------
Broker-dealers and investment advisers would incur costs associated
with the proposed sales practices rules. We estimate that one-time
costs for a broker-dealer or investment adviser related to the due
diligence and account approval requirements would range from $7,749 to
$12,915 \538\ and that one-time costs related to drafting the
associated policies and procedures would range from $1,367 to
$2,278.\539\ Thus, we estimate total one-time costs for a broker-dealer
or investment adviser would range from $9,116 to $15,193.\540\
---------------------------------------------------------------------------
\538\ This estimated range is based on the following
calculations: (6 hours x $365 (compliance attorney) + 9 hours x $284
(senior systems analyst) + 12 hours x $331 (senior programmer)) =
($2,190 + $2,556 + $3,972) = $8,718 for development and
implementation of online client questionnaire; (3 hours x $365
(compliance attorney) + 3 hour x $70 (compliance clerk)) = $1,305
for customer due diligence; and 1 hour x $309 (compliance manager) =
$309 for evaluation of client information for account approval/
disapproval for a total of $10,332. Assuming a range of +/-25%
around the average total of $10,332 gives a range for one-time costs
from $10,332 x 75% = $7,749 to $10,332 x 125% = $12,915.
\539\ This estimated range is based on the following
calculations: (3 hours x $309 (senior manager) + 1 hour x $365
(compliance attorney) + 1 hour x $530 (chief compliance officer)) =
($927 + $365 + $530) = $1,822 for establishing and implementing rule
15l-2 policies and procedures. Assuming a range of +/-25% around the
average total of $1,822 gives a range for one-time costs from $1,822
x 75% = $1,366.50 to $1,822 x 125% = $2,277.50.
\540\ This estimated range is based on the following
calculations: $7,749 + $1,366.50 = $9,115.50 for the minimum of the
cost range and $12,915 + $2,277.50 = $15,192.50 for the maximum of
the cost range.
---------------------------------------------------------------------------
In addition, we estimate that ongoing costs for a broker-dealer or
investment adviser related to the due diligence and account approval
requirements would range from $1,211 to $2,018 per year,\541\ that
ongoing costs related to the associated policies and procedures
requirement would range from $903 to $1,505 per year,\542\ and that
ongoing costs related to the associated recordkeeping requirements
would range from $157 to $393 per year.\543\ Thus, we estimate that
total ongoing costs for a broker-dealer or investment adviser would
range from $2,271 to $3,915 per year.\544\
---------------------------------------------------------------------------
\541\ This estimated range is based on the following
calculations: (3 hours x $365 (compliance attorney) + 3 hour x $70
(compliance clerk)) = $1,305 per year for customer due diligence;
and 1 hour x $309 (compliance manager) = $309 per year for
evaluation of client information for account approval/disapproval
for a total of $1,614 per year. Assuming a range of +/-25% around
the average total of $1,614 per year gives a range for ongoing costs
from $1,614 x 75% = $1,210.50 per year to $1,614 x 125% = $2,017.50
per year.
\542\ This estimated range is based on the following
calculations: (1 hour x $309 (senior manager) + 1 hour x $365
(compliance attorney) + 1 hour x $530 (chief compliance officer)) =
$1,204 per year for reviewing and updating rule 15l-2 policies and
procedures. Assuming a range of +/-25% around the average total of
$1,204 per year gives a range for ongoing costs from $1,204 x 75% =
$903 per year to $1,204 x 125% = $1,505 per year.
\543\ This estimated range is based on the following
calculations: (1 hour x $62 (general clerk) + 1 hour x $95 (senior
computer operator)) = $157 per year for the minimum of the cost
range and (2.5 hours x $62 (general clerk) + 2.5 hours x $95 (senior
computer operator) = ($155 + $237.50)) = $392.50 per year for the
maximum of the cost range.
\544\ This estimated range is based on the following
calculations: ($1,210.50 + $903 + $157) = $2,270.50 per year for the
minimum of the cost range and ($2,017.50 + $1,505 + $392.50) =
$3,915 per year for the maximum of the cost range.
---------------------------------------------------------------------------
As of December 2018, there were 2,766 broker-dealers that reported
some sales to retail customer investors.\545\ We estimate that 700 of
these broker dealers with retail customer accounts (approximately 25%)
have retail customer accounts that invest in leveraged/inverse
investment vehicles. Our staff further estimates that 715,000 existing
customer accounts with such broker-dealers would require account
approval for trading in leveraged/inverse investment vehicles and that
10,000 new customer accounts opened each year would require such
approval.\546\
---------------------------------------------------------------------------
\545\ Our estimate of the number of broker-dealers with retail
customers are based on data obtained from Form BD and Form BR as of
December 31, 2018.
\546\ The number of broker-dealers that have retail client
accounts that invest in leveraged/inverse investment vehicles as
well as the numbers of existing and new customer accounts with these
broker-dealers that would require approval for trading in these
products are based on staff experience, as we do not have data that
would allow us to determine these numbers more precisely.
---------------------------------------------------------------------------
In addition, as of December 2018, there were 8,235 investment
advisers registered with the Commission having some portion of their
business dedicated to retail investors, including either individual
high net worth clients or individual non-high net worth clients.\547\
We estimate that 2,000 of these investment advisers with retail client
accounts (approximately 25%) have retail client accounts that invest in
leveraged/inverse investment vehicles. Wefurther estimate that 715,000
existing customer accounts with such investment advisers would require
account approval for trading in leveraged/inverse investment vehicles,
and that 10,000 new customer accounts opened each year would require
such approval.\548\
---------------------------------------------------------------------------
\547\ Our estimate of the number of investment advisers with
retail accounts are based on data obtained from responses to Item
5.D of Form ADV as of December 31, 2018.
\548\ The number of investment advisors that have retail client
accounts that invest in leveraged/inverse investment vehicles as
well as the numbers of existing and new customer accounts with these
investment advisers that would require approval for trading in these
products are based on staff experience, as we do not have data that
would allow us to determine these numbers more precisely.
---------------------------------------------------------------------------
To the extent that many broker-dealers already have compliance
procedures in place for approving options accounts, which is a common
industry practice, these broker-dealers would likely have reduced costs
associated with the proposed requirements of the sales practices rules.
Thus, we estimate that many broker-dealers would incur one-time and
ongoing costs that are closer to the low end of the provided ranges,
while broker-dealers that cannot take advantage of such efficiencies
and many investment advisors would likely experience costs closer to
the high end of the provided ranges.\549\ We estimate that the total
industry cost for the proposed requirements of the sales practice rule
in the first year for both broker-dealers and investment advisers would
equal $2,377,503,800, which is based on the midpoint of the sum of the
ranges for both one-time and ongoing costs.\550\ Some broker-dealers
and investment advisers may decide to pass
[[Page 4524]]
these compliance costs on to their customers.\551\
---------------------------------------------------------------------------
\549\ See supra notes 514 and 518.
\550\ This estimate is based on the following calculations: (700
broker-dealers + 2,000 registered investment advisers having retail
customer accounts that invest in leveraged/inverse investment
vehicles) x ($8,718 + $1,822)) = $28,458,000 + ((2 x 715,000)
existing customer accounts with broker-dealers and registered
investment advisers requiring account approval for trading in
leveraged/inverse investment vehicles) x ($1,305 + $309) =
$2,308,020,000 for total one-time industry costs to broker-dealers
and investment advisers of $2,336,478,000; and ((2 x 10,000) new
customer accounts requiring account approval for trading in
leveraged/inverse investment vehicles) x ($1,305 + $309) =
$32,280,000 + (700 broker-dealers + 2,000 registered investment
advisers having retail customer accounts that invest in leveraged/
inverse investment vehicles) x $1,204) = $3,250,800 + (10,000 new
customer accounts requiring account approval for trading in
leveraged/inverse investment vehicles) x ($157 (broker-dealer
recordkeeping costs) + $392.50 (investment adviser recordkeeping
costs)) = $5,495,000 for total ongoing annual industry costs to
broker-dealers and investment advisers of $41,025,800 per year.
Total industry cost for proposed requirements of sales practice rule
in the first year is $2,336,478,000 + $41,025,800 = $2,377,503,800,
which is consistent with being the midpoint of the sum of the ranges
for both one-time and ongoing costs discussed in preceding
calculations.
\551\ The share of these costs passed on to investors by
investment advisers or broker-dealers would depend on multiple
factors, including the nature of competition between investment
advisers and broker-dealers as well as investors' relative
sensitivity to changes in fees, the joint effects of which are
inherently impossible to predict. Some broker-dealers offer
transactions in certain leveraged/inverse investment vehicles, such
as some leveraged/inverse ETFs, without charging commissions. In
these cases, broker-dealers may pass on some of the compliance costs
associated with the proposed requirements by charging some amount of
commission on these trades.
---------------------------------------------------------------------------
In addition, some leveraged/inverse investment vehicles may lose
existing or potential investors as a result of some retail investors
not being approved by their broker-dealer or investment adviser to
transact in leveraged/inverse investment vehicles or some retail
investors being deterred by the time costs and delay introduced by the
account-opening procedures. Broker-dealers or investment advisers with
a larger fraction of retail customers or clients that can no longer
transact in leveraged/inverse investment vehicles as a result of the
proposed sales practices rules may experience larger declines in their
customer or client base and associated reductions in profits.\552\
---------------------------------------------------------------------------
\552\ Any such reduction in a broker-dealer's or investment
adviser's customer base may be offset to the extent that clients
transact in other products with the same broker dealer or investment
adviser instead.
---------------------------------------------------------------------------
It is our understanding that no funds that would meet the
definition of a ``leveraged/inverse investment vehicle,'' and that seek
returns above 300% of the return (or inverse of the return) of the
underlying index, currently exist. Therefore we do not expect any costs
associated with existing funds having to alter their investment
strategies or business practices to comply with proposed rule 18f-4's
alternative requirements for leveraged/inverse funds.
Requiring a leveraged/inverse fund covered by the proposed sales
practices rules to limit its exposure to 300% of the return (or inverse
of the return) of the underlying index while preventing a fund that
does not qualify as a leveraged/inverse investment vehicle from
offering investment strategies that exceed the proposed outer limit on
fund leverage risk may also have competitive effects, which we discuss
in section III.B.5 below. As an alternative to the proposed exposure
limit for leveraged/inverse funds, we also discuss the effects of
conditioning the exemption for leveraged/inverse funds on compliance
with a higher or lower exposure limit in section III.D.1 below.
6. Proposed Amendments to Rule 6c-11 Under the Investment Company Act
and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs
Existing leveraged/inverse ETFs rely on exemptive relief, which the
Commission has not granted to a leveraged/inverse ETF sponsor since
2009. We are proposing to amend rule 6c-11 to remove the provision
excluding leveraged/inverse ETFs from its scope, which would permit
fund sponsors to operate a leveraged/inverse ETF under that rule and
without obtaining an exemptive order.
The proposed amendments to rule 6c-11 would benefit any fund
sponsors seeking to launch leveraged/inverse ETFs that did not obtain
the required exemptive relief due to the Commission's moratorium on
granting such relief as well as fund sponsors seeking to launch
leveraged/inverse ETFs in the future. A fund sponsor planning to seek
exemptive relief from the Commission to form and operate a leveraged/
inverse ETF would also no longer incur the cost associated with
applying for an exemptive order.\553\ To the extent that the amendments
result in new leveraged/inverse ETFs coming to market, the industry-
wide assets under management of leveraged/inverse ETFs could increase
and investors that would be eligible under the proposed sales practices
rules to invest in leveraged/inverse ETFs could benefit from an
increase in investment choices.\554\
---------------------------------------------------------------------------
\553\ In the ETFs Adopting Release, we estimated that the direct
cost of a typical fund's application for ETF relief (associated
with, for example, legal fees) is approximately $100,000. As
exemptive applications for leveraged/inverse ETFs are significantly
more complex than those of the average fund, we estimate that the
direct costs of an application for leveraged/inverse ETF relief
would amount to approximately $250,000. See ETFs Adopting Release,
supra note 76, at nn.537-539 and accompanying text.
\554\ The increase in assets under management among leveraged/
inverse ETFs could be attenuated, to the extent that proposed rule
15l-2's and 211(h)-1's due diligence requirements would lead to a
reduction in the number of investors that invest in these funds. See
infra section III.C.5.
---------------------------------------------------------------------------
Because our proposed amendments to rule 6c-11 would permit
leveraged/inverse ETFs to rely on that rule, we also are proposing to
rescind the exemptive orders the Commission has previously granted to
leveraged/inverse ETFs. As a result, existing and future leveraged/
inverse ETFs would operate under a consistent regulatory framework. We
believe that the costs to leveraged/inverse ETFs associated with
rescinding their existing exemptive relief would be minimal, as we
anticipate that all existing leveraged/inverse ETFs would be able to
continue operating with only minor adjustments, other than being
required to comply with the requirements in rule 6c-11 for additional
website disclosures and basket asset policies and procedures.\555\
---------------------------------------------------------------------------
\555\ In this section as well as in section III.D below, we have
accounted for the costs and benefits to leveraged/inverse ETFs as a
result of the removal of the current exclusion of these funds from
rule 6c-11. We believe that the additional considerations the
Commission analyzed in the ETFs Adopting Release for ETFs other than
leveraged/inverse ETFs that were included in the scope of rule 6c-11
at adoption would apply substantially similarly to leveraged/inverse
ETFs. See ETFs Adopting Release, supra note 76.
---------------------------------------------------------------------------
Additional economic considerations that the proposed treatment of
leveraged/inverse ETFs presents with regards to efficiency and
competition are discussed below in section III.D.
7. Unfunded Commitment Agreements
The proposed rule would permit a fund to enter into unfunded
commitment agreements if it reasonably believes, at the time it enters
into such an agreement, that it will have sufficient cash and cash
equivalents to meet its obligations with respect to all of its unfunded
commitment agreements, in each case as they come due.\556\ While a fund
should consider its unique facts and circumstances, the proposed rule
would prescribe certain specific factors that a fund must take into
account in having such a reasonable belief. We believe that the
proposed requirements are consistent with current market practices,
based on the staff's experience in reviewing and commenting on fund
registration statements, which have disclosure regarding their unfunded
commitments, as well as representations funds have made to the
staff.\557\ As a result, we do not believe that the rule's treatment of
unfunded commitment agreements represents a change from the baseline,
although we acknowledge that there may be some variation in the
specific factors that funds consider today, as well as the potential
for some variation between those factors and those prescribed in the
proposed rule. Because we believe that the proposed approach is
consistent with general market practices and we do not have specific
granular information to identify differences in funds' current
practices relative to the proposed rule, we believe this proposed
requirement would not lead to significant economic effects.
---------------------------------------------------------------------------
\556\ See supra section II.J.
\557\ See supra discussion in paragraph preceding note 419.
---------------------------------------------------------------------------
8. Recordkeeping
Proposed rule 18f-4 includes certain recordkeeping
requirements.\558\ Specifically, the proposed rule would
[[Page 4525]]
require a fund to maintain certain records documenting its derivatives
risk management program's written policies and procedures, along with
its stress test results, VaR backtesting results, internal reporting or
escalation of material risks under the program, and reviews of the
program.\559\ It would also require a fund to maintain records of any
materials provided to the fund's board of directors in connection with
approving the designation of the derivatives risk manager and any
written reports relating to the derivatives risk management
program.\560\ A fund that would be required to comply with the proposed
VaR test would also have to maintain records documenting the
determination of: Its portfolio's VaR; its designated reference index
VaR, as applicable; its VaR ratio (the value of the VaR of the Fund's
portfolio divided by the VaR of the designated reference index), as
applicable; and any updates to any of its VaR calculation models and
the basis for any material changes to its VaR models.\561\ A fund that
would be a limited derivatives user under the proposed rule would have
to maintain a written record of its policies and procedures that are
reasonably designed to manage derivatives risks.\562\ Finally, a fund
engaging in unfunded commitment agreements would be required to
maintain records documenting the sufficiency of its funds to meet its
obligations with respect to all unfunded commitment agreements.\563\
---------------------------------------------------------------------------
\558\ See supra section II.K.
\559\ See proposed rule 18f-4(c)(i)(A).
\560\ See proposed rule 18f-4(c)(6)(i)(B).
\561\ See proposed rule 18f-4(c)(6)(i)(C).
\562\ See proposed rule 18f-4(c)(6)(i)(D).
\563\ See proposed rule 18f-4(c)(6)(i)(E).
---------------------------------------------------------------------------
We believe that these proposed requirements would increase the
effectiveness of the Commission's oversight of the fund industry, which
will, in turn, benefit investors. Further, the requirement to keep
records documenting the derivatives risk management program, including
records documenting periodic review of the program and reports provided
to the board of directors relating to the program, would help our staff
evaluate a fund's compliance with the proposed derivatives risk
management program requirements. We anticipate that these recordkeeping
requirements would generally not impose a large additional burden on
funds, as most funds would likely choose to keep such records, even
absent the proposed requirement to do so, in order to support their
ongoing administration of the proposed derivatives risk management
program and their compliance with the associated requirements.
As discussed below in section IV.B.7, our estimated average one-
time and ongoing annual costs associated with the recordkeeping
requirements take into account the fact that certain funds can rely on
the proposed rule's limited derivatives user exception and may incur
less extensive recordkeeping costs relative to those funds which may
not rely on this exception. Of the estimated 5,091 funds that would be
subject to the recordkeeping requirements, we estimate that 2,398 funds
would be limited derivatives users. Assuming that both one-time and
ongoing annual recordkeeping costs for limited derivatives users are
90% of those for funds that would not qualify as limited derivatives
users, we estimate that, on average, each fund that could not rely on
the limited user exception would incur a one-time cost of $2,047 \564\
and an ongoing cost of $330 per year \565\ and each fund that could
rely on the exception would incur, a one-time cost of $1,842 \566\ and
an ongoing cost of $297 per year.\567\ We thus estimate that the total
industry cost for this requirement in the first year would equal
$11,529,656.\568\
---------------------------------------------------------------------------
\564\ This estimate is based on the following derivations and
calculations: 1.5 hours x $62 (general clerk)/((2,398/5,091) x 90% +
((5,091-2,398)/5,091)) = $97.60; and 1.5 hours x $95 (senior
computer operator)/((2,398/5,091) x 90% + ((5,091-2,398)/5,091)) =
$149.54 for a total of $97.60 + $149.54 + ($1,800 for initial
external cost burden) = $2,047.14, where (2,398/5,091) is the share
of funds that are limited derivatives users and (5,091-2,398)/5,091)
is the share of funds that are not limited derivatives users.
\565\ This estimate is based on the following derivations and
calculations: 2 hours x $62 (general clerk)/((2,398/5,091) x 90% +
((5,091-2,398)/5,091)) = $130.13; and 2 hours x $95 (senior computer
operator)/((2,398/5,091) x 90% + ((5,091-2,398)/5,091)) = $199.39
for a total of $130.13 + $199.39 = $329.52, where (2,398/5,091) is
the share of funds that are limited derivatives users and (5,091-
2,398)/5,091) is the share of funds that are not limited derivatives
users.
\566\ This estimate is based on the following calculations:
$2,047.14 x 90% = $1,842.43.
\567\ This estimate is based on the following calculations:
$329.52 x 90% = $296.57.
\568\ This estimate is based on the following calculations:
(5,091-2,398 = 2,693 funds which cannot rely on the limited
derivatives user exception) x ($2,047.14 + $329.52) = $6,400,347.32;
and (2,398 funds which can rely on the limited derivatives user
exception) x ($1,842.43 + $296.57) = $5,129,309.17 for a total of
$11,529,656.48.
---------------------------------------------------------------------------
9. Amendments to Fund Reporting Requirements
a. Form N-PORT and Form N-CEN
We are proposing to amend Form N-PORT to include a new reporting
item on funds' derivatives exposure, which would be publicly available
for the third month of each fund's quarter.\569\ In addition, we are
proposing amendments that would require funds that are subject to the
proposed VaR-based limit on fund leverage risk to report certain
information related to their VaR.\570\ We are also proposing to amend
Form N-CEN to require a fund to identify (1) whether it is a limited
derivatives user (either under the proposed exception for funds that
limit their derivatives exposure to 10% of their net assets or under
the exception for funds that limit their derivatives use to certain
currency hedging); (2) whether it is a leveraged/inverse investment
vehicle as defined in proposed sales practices rules; and (3) whether
it has entered into reverse repurchase agreements or similar financing
transactions, or unfunded commitment agreements.\571\ These additional
reporting requirements would not apply to BDCs, which do not file
reports on Form N-CEN or Form N-PORT.\572\
---------------------------------------------------------------------------
\569\ See supra section II.H.1. While the information for the
first two months of a fund's quarter would be non-public, the
information for the third month of a fund's quarter would be
publicly available. See supra note 359.
\570\ Specifically, this information would include: (1) The
fund's highest daily VaR during the reporting period and its
corresponding date; and (2) the fund's median daily VaR for the
reporting period. Funds subject to the relative VaR test during the
reporting period also would have to report: (1) The name of the
fund's designated reference index; (2) the index identifier; (3) the
fund's highest daily VaR ratio during the reporting period and its
corresponding date; and (4) the fund's median daily VaR ratio for
the reporting period. Finally, all funds that are subject to the
proposed limit on fund leverage risk also would have to report the
number of exceptions that the fund identified as a result of the
backtesting of its VaR calculation model. See id.
\571\ We believe that many of these proposed new reporting items
would be inapplicable to most BDCs. See supra section II.H.3.
\572\ See supra section II.H.4.
---------------------------------------------------------------------------
To the extent that measures of derivatives exposure, and the other
information that we would require funds to report on Forms N-PORT and
N-CEN, are not currently available, the proposed requirements that
funds make such information available periodically on these forms would
improve the ability of the Commission to oversee reporting funds. It
also would allow the Commission and its staff to oversee and monitor
reporting funds' compliance with the proposed rule and help identify
trends in reporting funds' use of derivatives, portfolio VaRs, and
their choice of designated reference indexes. The expanded reporting
also would increase the ability of the Commission staff to identify
trends in investment strategies and fund products in reporting funds as
well as industry outliers.\573\
---------------------------------------------------------------------------
\573\ The structuring of the information in Form N-PORT would
improve the ability of Commission staff to compile and aggregate
information across all reporting funds, and to analyze individual
funds or a group of funds, and would increase the overall efficiency
of staff in analyzing the information.
---------------------------------------------------------------------------
[[Page 4526]]
Investors, third-party information providers, and other potential
users would also experience benefits from the proposed amendments to
Forms N-PORT and N-CEN. Investors and other potential users would have
disclosure of additional information that is not currently available in
any filings. We believe that the structured data format of this
information in Forms N-PORT and N-CEN would allow investors and other
potential users to more efficiently analyze portfolio investment
information. The additional information, as well as the structure of
that information, would increase the transparency of a fund's
investment strategies and allow more efficient assessment of reporting
funds' potential leverage-related risks.
The amendments to Forms N-PORT and N-CEN would also benefit
investors, to the extent that they use the information, to better
differentiate funds that are not limited derivatives users or
leveraged/inverse funds based on their derivatives usage. For example,
investors would be able to more efficiently identify the extent to
which such funds use derivatives as part of their investment
strategies. Investors, and in particular individual investors, could
also indirectly benefit from the additional information in amended
Forms N-PORT and N-CEN to the extent that third-party information
providers and other interested parties obtain, aggregate, provide,
analyze and report on the information. Investors could also indirectly
benefit from the additional information in amended Forms N-PORT and N-
CEN to the extent that other entities, including investment advisers
and broker-dealers, utilize the information to help investors make more
informed investment decisions related to funds that provide this
information.
As discussed below in section IV.F, our estimated average one-time
and ongoing annual costs associated with the amendments to Forms N-PORT
take into account the fact that certain funds that are not subject to
the proposed VaR-based limit on fund leverage risk in proposed rule
18f-4 would not have to report certain VaR-related information and may
incur less extensive reporting costs relative to those funds subject to
the limit, which are required to report such VaR-related disclosure
information. Of the estimated 5,091 funds that would be subject to the
exposure-related disclosure requirement, we estimate that 2,424 funds
would also be subject to the VaR-related disclosure requirements. We
estimate that, on average, each fund that is not subject to the VaR-
related disclosure requirement would incur a one-time cost of $6,982
\574\ and an ongoing cost of $2,088 per year \575\ and each fund that
is subject to the VaR-related disclosure requirement would incur a one-
time cost of $8,374 \576\ and an ongoing cost of $4,176 per year.\577\
We thus estimate that the total industry cost for this reporting
requirement in the first year would equal $54,610,890.\578\
---------------------------------------------------------------------------
\574\ This estimate is based on the following derivations and
calculations: (2 hours x $365 (compliance attorney) + 2 hours x $331
(senior programmer) + ($5,590 for initial external cost burden)) =
$6,982 to comply with the new N-PORT requirements of derivatives
exposure information in the first reporting quarter of the fiscal
year.
\575\ This estimate is based on the following derivations and
calculations: (3 hours x $365 (compliance attorney) + 3 hours x $331
(senior programmer)) = $2,088 per year to comply with the new N-PORT
requirements of derivatives exposure information in the final three
reporting quarters of the fiscal year.
\576\ This estimate is based on the following derivations and
calculations: (4 hours x $365 (compliance attorney) + 4 hours x $331
(senior programmer) + ($5,590 for initial external cost burden)) =
$8,374 to comply with the new N-PORT requirements of derivatives
exposure and VaR-related information in the first reporting quarter
of the fiscal year.
\577\ This estimate is based on the following derivations and
calculations: (6 hours x $365 (compliance attorney) + 6 hours x $331
(senior programmer)) = $4,176 to comply with the new N-PORT
requirements of derivatives exposure and VaR-related information in
the final three reporting quarters of the fiscal year.
\578\ This estimate is based on the following calculations:
(5,091-2,424 = 2,667 funds which are not subject to the VaR-related
disclosure agreements) x ($6,982 + $2,088) = $24,189,690; and (2,424
funds which are subject to the VaR-related disclosure agreements) x
($8,374 + $4,176) = $30,421,200 for a total of ($24,189,690 +
$30,421,200) = $54,610,890.
---------------------------------------------------------------------------
As discussed below in section IV.H, we estimate that the average
ongoing annual cost for a registered fund to prepare amendments to Form
N-CEN is $6.96 per year.\579\ We thus estimate that the total industry
cost for all registered funds associated with this reporting
requirement in the first year is $86,130.\580\
---------------------------------------------------------------------------
\579\ This estimate is based on the following derivations and
calculations: 0.01 hour x $365 (compliance attorney) + 0.01 hour x
$331 (senior programmer) = $3.65 + $3.31 = $6.96 per year.
\580\ This estimate is based on the following derivations and
calculations: (12,375 registered funds required to prepare a report
on Form N-CEN as amended) x $6.96 = $86,130.
---------------------------------------------------------------------------
b. Amendments to Current Reporting Requirements
We are also proposing current reporting requirements for funds that
are relying on proposed rule 18f-4 and subject to the proposed VaR-
based limit on fund leverage risk. Specifically, a fund that is out of
compliance with the VaR test for more than three business days would be
required to file a non-public report on Form N-RN providing certain
information regarding its VaR test breaches and a fund will also be
required to file a report when it is back in compliance with its
applicable VaR test.\581\
---------------------------------------------------------------------------
\581\ See supra section II.H.2.
---------------------------------------------------------------------------
We anticipate that the enhanced current reporting requirements
could produce significant benefits. For example, when a fund is out of
compliance with the proposed VaR-based limit on fund leverage risk,
this may indicate that a fund is experiencing heightened risks as a
result of a fund's use of derivatives transactions. Such breaches also
could indicate market events that are drivers of potential derivatives
risks across the fund industry and therefore complement other sources
of information related to such market events for the Commission. As a
result, we believe that the proposed current reporting requirement
would increase the effectiveness of the Commission's oversight of the
fund industry by providing the Commission and staff with current
information regarding potential increased risks and stress events,
which in turn would benefit investors.
As discussed below in section IV.G, our estimated average cost
burdens associated with the amendments to Form N-RN are based on the
assumption that, of the estimated 2,424 funds that would be required to
comply with either of the VaR tests, the Commission would receive
approximately 30 filings per year in response to each of the new VaR-
related items proposed to be included in Form N-RN, as amended. We
estimate such funds would incur an average cost of $3.49 per year on a
per-fund basis \582\ to prepare amended Form N-RN. Thus, the estimated
total industry cost for this reporting requirement in the first year
for funds required to comply with either of the VaR tests is
$8,460.\583\
---------------------------------------------------------------------------
\582\ This estimate is based on the following derivations and
calculations: 0.005 hour x $365 (compliance attorney) + 0.005 hour x
$331 (senior programmer) = $1.83 + $1.66 = $3.49 per year on a per-
fund basis.
\583\ This estimate is based on the following derivations and
calculations: (30 filings per year fractionalized across the 2,424
funds per year required to comply with either of the VaR tests) x
$3.49 = $8,460.
---------------------------------------------------------------------------
We do not believe there would be any potential indirect costs
associated with filing Form N-RN, such as spillover effects or the
potential for investor flight due to a VaR test breach (to the extent
that investors would leave a fund if they believed a fund's VaR test
breaches
[[Page 4527]]
indicate that a fund has a risk profile that is inconsistent with their
investment goals and risk tolerance), because Form N-RN filings would
not be publicly disclosed. Because the Form N-RN filing requirements
would be triggered by events that are part of a fund's proposed
requirement to determine compliance with the applicable VaR test at
least daily, any monitoring costs associated with Form N-RN are
included in our estimates of the compliance costs for rule 18f-4 above.
10. Money Market Funds
Money market funds are excluded from the scope of proposed rule
18f-4. As we are proposing to rescind Release 10666, however, money
market funds would not be able to enter into transactions covered by
proposed rule 18f-4, including derivatives transactions and reverse
repurchase agreements. As discussed above in section II.A.1, we believe
that money market funds currently do not typically engage in
derivatives transactions or the other transactions permitted by rule
18f-4.\584\ However, to the extent that there are money market funds
that do engage in such transactions to increase the efficiency of their
portfolio management, these funds would bear the costs associated with
losing any such efficiencies.
---------------------------------------------------------------------------
\584\ Money market funds file monthly reports on Form N-MFP and
disclose schedules of portfolio securities held on the form. For
each security held, Form N-MFP requires money market funds to
disclose the investment category most closely identifying the
instrument held from a list of investment categories. See Item C.6
of Form N-MFP. However, the form does not contemplate nor include
data element categories for transactions covered by proposed rule
18f-4, including derivatives transactions and reverse repurchase
agreements. We therefore do not estimate the extent to which money
market funds currently rely on these transactions.
---------------------------------------------------------------------------
However, we believe any costs to money market funds that may
currently enter into transactions covered by proposed rule 18f-4 would
likely be small. Specifically, as discussed above in section II.A.1, we
believe that these transactions would generally be inconsistent with a
money market fund maintaining a stable share price or limiting
principal volatility, and especially if used to leverage the fund's
portfolio. Therefore, we do not believe that any fund that may
currently engage in these transactions would use them as an integral
part of its investment strategy.
D. Effects on Efficiency, Competition, and Capital Formation
This section evaluates the impact of the proposed rules and
amendments on efficiency, competition, and capital formation. However,
we are unable to quantify the effects on efficiency, competition, and
capital formation because we lack the information necessary to provide
a reasonable estimate. For example, we are unable to predict how the
proposed rules, amendments, and form amendments would change investors'
propensity to invest in funds and ultimately affect capital formation.
Therefore, much of the discussion below is qualitative in nature,
although where possible we attempt to describe the direction of the
economic effects.
1. Efficiency
Proposed rule 18f-4 in conjunction with the proposed rescission of
Release 10666 may make derivatives use more efficient for certain
funds, particularly for those funds that would qualify as limited
derivatives users. Specifically, funds' current asset segregation
practices may provide a disincentive to use derivatives for which
notional amount segregation is the practice, even if such derivatives
would otherwise provide a lower-cost method of achieving desired
exposures than purchasing the underlying reference asset directly. For
example, a fund seeking to sell credit default swaps to take a position
in an issuer's credit risk may currently choose not to do so because of
the large notional amounts that the fund would segregate for that
specific derivatives position. The proposed rule therefore could
increase efficiency by mitigating current incentives for funds to avoid
use of certain derivatives (even if foregoing the use of those
derivatives would entail cost and operational efficiencies).
In addition, the proposed rules and amendments may change the
degree to which some funds choose to use derivatives generally or the
degree to which funds use certain derivatives over others.\585\ Changes
in the degree to which certain derivatives are used by funds could
affect the liquidity and price efficiency of these derivatives.
Although unaddressed in the academic literature, we expect an increase
in the use of derivatives to correspond to an increase in derivatives
market liquidity as more derivatives contracts may be easily bought or
sold in markets in a given period, as well as an increase in price
efficiency since information regarding underlying securities (and other
factors that affect derivatives prices) may be better reflected in the
prices of derivative contracts.
---------------------------------------------------------------------------
\585\ Specifically, (1) as discussed in the previous paragraph,
funds may transact in more notional-value based derivatives as a
result of removing the incentive distortion of notional- vs. market-
value asset segregation under funds' current asset segregation
practices; (2) new potential funds may reduce their use of
derivatives transactions to satisfy the proposed VaR-based limit on
fund leverage risk (see supra section III.C.2); (3) existing funds
may change their use of derivatives transactions to respond to risks
identified after adopting and implementing their risk management
programs (see supra section III.C.1); and (4) both existing and new
potential funds may increase their use of derivatives transactions
as a result of the exemptive rule's bright-line limits on leverage
risk (see supra section III.C.2). Overall, the effect of the
proposed rules and amendments on funds use of derivatives
transactions is ambiguous and depends on the type of derivatives
transaction.
---------------------------------------------------------------------------
Changes in the degree to which certain derivatives are used could
also affect the pricing efficiency and liquidity of securities
underlying these derivatives and those of related securities. For
example, one paper provides evidence that the introduction of credit
default swap contracts decreases the liquidity and price efficiency of
the equity security of the issuer referenced in the swap.\586\
Conversely, the paper also observes that the introduction of exchange-
traded stock option contracts improves the liquidity and price
efficiency of the underlying stocks.
---------------------------------------------------------------------------
\586\ This paper analyzed NYSE-listed firms and observed that,
all else equal, equity markets become less liquid and equity prices
become less efficient when single-name credit default swap contracts
are introduced, while the opposite results hold when equity options
are listed on exchanges. Ekkehart Boehmer, Sudheer Chava, & Heather
E. Tookes, Related Securities and Equity Market Quality: The Case of
CDS, 50 Journal of Financial and Quantitative Analysis 509 (2015),
available at https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/related-securities-and-equity-market-quality-the-case-of-cds/08DE66A250F9950FA486AE818D5E0341. The latter result, that traded
equity options are associated with more liquid and efficient equity
prices, is consistent with several other academic papers. See, e.g.,
Charles Cao, Zhiwu Chen, & John M. Griffin, Informational Content of
Option Volume Prior to Takeovers, 78 Journal of Business 1073
(2005), as well as Jun Pan & Allen M. Poteshman, The Information in
Option Volume for Future Stock Prices, 19 Review of Financial
Studies 871 (2006). The effects described in the literature are
based on studies of the introduction of derivative securities and
may therefore apply differently to changes in the trading volume of
derivatives securities that may occur as a result of the proposed
rule.
---------------------------------------------------------------------------
The proposed VaR-based limit on fund leverage risk would also
establish a bright-line limit on the amount of leverage that a fund can
take on using derivatives.\587\ To the extent that funds are more
comfortable with managing their derivatives exposures to a clear
outside limit, the proposed rule could improve the efficiency of fund's
portfolio risk management practices.
---------------------------------------------------------------------------
\587\ See supra section III.C.2.
---------------------------------------------------------------------------
In addition, the recordkeeping elements of proposed rule 18f-4
would facilitate more efficient evaluation of
[[Page 4528]]
compliance with the rule while also providing the Commission with
information that may be useful in assessing market risks associated
with derivative products. Moreover, the proposed amendments to fund's
current reporting requirements could facilitate the Commission's
oversight of funds subject to proposed rule 18f-4 with fewer resources,
thus making its supervision more efficient.\588\
---------------------------------------------------------------------------
\588\ See supra section III.C.8.
---------------------------------------------------------------------------
The amendments to Forms N-PORT and N-CEN would allow investors, to
the extent that they use the information, to better differentiate funds
that are not limited derivatives users or leveraged/inverse funds based
on their derivatives usage.\589\ As a result, investors would be able
to more efficiently identify the extent to which such funds use
derivatives as part of their investment strategies, allowing them to
make better-informed investment decisions.
---------------------------------------------------------------------------
\589\ See supra section III.C.9.a.
---------------------------------------------------------------------------
The proposed sales practices rules could also reduce investments in
leveraged/inverse investment vehicles, to the extent that some retail
investors would not be approved by their broker-dealer or investment
adviser to transact in leveraged/inverse investment vehicles or to the
extent that some retail investors would be deterred by the time costs
and delay introduced by the account-opening procedures.\590\ The
proposed amendments to rule 6c-11, however, would likely outweigh these
effects in the case of leveraged/inverse ETFs and lead to an overall
increase in the number and assets under management for these types of
funds.
---------------------------------------------------------------------------
\590\ See supra section III.B.5.
---------------------------------------------------------------------------
To the extent that the proposed rules would lead to a reduction in
investment in leveraged/inverse commodity- or currency-based trusts or
funds, the liquidity of these products may decline as a result.
Conversely, to the extent that the proposed rules would lead to an
overall increase in investments in leveraged/inverse ETFs, the
liquidity of these funds may increase as a result. The likely increase
in the number, and assets under management, of leveraged/inverse ETFs
as a result of the proposed amendments to rule 6c-11 may affect the
quality of the markets for underlying securities and derivatives.
Specifically, the academic literature to date provides some evidence,
albeit inconclusive, that leveraged/inverse ETFs' rebalancing activity
may have an impact on the price and volatility of the constituent
assets that make up the ETFs. For example, one paper empirically tests
whether the rebalancing activity of leveraged/inverse ETFs impacts the
price and price volatility of underlying stocks.\591\ The authors find
a positive association, suggesting that rebalancing demand may affect
the price and price volatility of component stocks, and may reduce the
degree to which prices reflect fundamental value of the component
stocks. As leveraged/inverse ETFs commonly use derivatives to rebalance
their portfolios, similar effects could also extend to underlying
derivatives, although we are not aware of any academic literature that
has examined the effects of leveraged/inverse ETFs' rebalancing
activity on derivatives markets. Conversely, another paper argues that
the existing literature that studies the effect of leveraged/inverse
ETFs' rebalancing activity on the constituent asset prices does not
control for the effect of the creation and redemption transactions
(i.e., fund flows) by authorized participants.\592\ The paper presents
evidence that positively leveraged/inverse ETFs tend to have capital
flows in the opposite direction of the underlying index, and inverse
leveraged/inverse ETFs tend to have capital flows in the same direction
as the underlying index, suggesting that investor behavior may
attenuate the effect of leveraged/inverse ETFs' rebalancing activity on
the prices of underlying securities and derivatives.\593\
---------------------------------------------------------------------------
\591\ See Qing Bai, Shaun A. Bond & Brian Hatch, The Impact of
Leveraged and Inverse ETFs on Underlying Real Estate Returns, 43
Real Estate Economics 37 (2015).
\592\ See Ivan T. Ivanov & Stephen Lenkey, Are Concerns About
Leveraged ETFs Overblown?, FEDS Working Paper No. 2014-106 (2014).
\593\ The literature we are aware of focuses on leveraged/
inverse ETFs and does not study similar effects of leveraged/inverse
mutual funds, although both types of funds generally engage in
similar rebalancing activity. To the extent that similar effects may
be attributable to leveraged/inverse mutual funds and that any
increase in leveraged/inverse ETF assets would be (at least
partially) offset by a decrease in leveraged/inverse mutual fund
assets, this may ameliorate the overall effect on the price and
volatility of constituent assets.
---------------------------------------------------------------------------
2. Competition
Certain aspects of the proposed rules and amendments may have an
impact on competition. Certain of these potential competitive effects
result from the proposed rule imposing differential costs on different
funds. Specifically, (1) large fund complexes may find it less costly
to comply per fund with the new requirements of proposed rule 18f-4;
\594\ (2) funds that would qualify as limited derivatives users would
generally incur lower compliance costs associated with the rule than
funds that would not qualify for this exception; \595\ (3) funds that
would comply with the relative VaR test would generally incur higher
compliance costs than those that would comply with the absolute VaR
test; (4) BDCs are not subject to the additional reporting requirements
on Forms N-CEN or N-PORT and would therefore not incur the increased
compliance costs that would be imposed on filers of these forms; and
(5) leveraged/inverse funds are not subject to several of the
additional reporting requirements on Forms N-CEN or N-PORT and would
therefore incur a reduced additional burden compared to other funds
that are not limited users of derivatives.\596\ To the extent that
investors believe that the funds that would incur lower compliance
burdens and the funds that would incur a higher compliance burden under
the rule are substitutes, the rule would result in a competitive
advantage for funds with the lower compliance burden to the extent that
a lower burden makes such funds materially less costly to operate.
---------------------------------------------------------------------------
\594\ See supra section III.C.2.
\595\ See supra section III.C.3.
\596\ See supra section III.C.2.
---------------------------------------------------------------------------
To the extent that the proposed sales practices rules' due
diligence and account approval requirements limit certain customers or
clients from buying or selling shares of certain leveraged/inverse
investment vehicles, such investors may instead opt to invest in
another product with a similar risk profile that is not subject to
those requirements.\597\ Thus, the proposed sales practices rules may
generate substitution spillover effects that increase competition
between leveraged/inverse investment vehicles within the scope of the
rule and other products outside the scope of the rule that provide
similar exposures.
---------------------------------------------------------------------------
\597\ Some investors that are not approved to buy or sell
leveraged/inverse investment vehicles may opt to move their capital
into exchange-traded notes or other products with a similar risk
profile. Conversely, some investors may transact in leveraged/
inverse investment vehicles without involving a broker-dealer or
investment adviser that would be subject to the proposed sales
practices rules, although this is uncommon. See supra note 321.
---------------------------------------------------------------------------
Similarly, broker-dealers and investment advisers with a larger
fraction of retail customers or clients that can no longer transact in
leveraged/inverse investment vehicles as a result of the proposed sales
practices rules' due diligence and account approval requirements may
experience larger declines in their customer or client base.\598\ As a
result, broker-dealers and investment advisers that would see a larger
reduction in customers or clients may be at a competitive disadvantage
[[Page 4529]]
compared to broker-dealers and investment advisers that would see only
a smaller reduction in customers or clients or no reduction at all.
---------------------------------------------------------------------------
\598\ Any such reduction in a broker-dealer's or investment
adviser's customer base may be offset to the extent that clients
transact in other products with the same broker dealer or investment
adviser instead. See supra section III.C.5.
---------------------------------------------------------------------------
The Commission has not provided exemptive relief to new prospective
sponsors of leveraged/inverse ETFs since 2009.\599\ The proposed
amendments to rule 6c-11 would allow other leveraged/inverse ETFs to
enter the leveraged/inverse ETF market, likely leading to more
competition among leveraged/inverse ETFs and between leveraged/inverse
ETFs and other products that investors may perceive as substitutes,
such as leveraged/inverse mutual funds. This increase in competition
could be significant, as the leveraged/inverse ETF market is very
concentrated; currently, only two fund sponsors operate leveraged/
inverse ETFs.\600\ In addition, fees for leveraged/inverse ETFs and
substitute products, such as leveraged/inverse mutual funds, could fall
as a result of any such increase in competition.
---------------------------------------------------------------------------
\599\ See supra text following note 473.
\600\ The increase in competition among leveraged/inverse ETFs
could be attenuated, to the extent that proposed rule 15l-2's and
211(h)-1's due diligence requirements would limit the number of
investors that invest in these funds. See supra section III.C.5.
---------------------------------------------------------------------------
3. Capital Formation
Certain aspects of the proposed rules and amendments may have an
impact on capital formation. Certain of these effects may arise from a
change in investors' propensity to invest in funds. On the one hand,
investors may be more inclined to invest in funds as a result of
increased investor protection arising from any decrease in leverage-
related risks. On the other hand, some investors may reduce their
investments in certain funds that may increase their use of derivatives
in light of the bright-line VaR-based limit on fund leverage risk.\601\
Additionally, some investors may re-evaluate their desire to invest in
funds generally as a result of the increased disclosure requirements,
with some investors deciding to invest more and other investors
deciding to invest less. While we are unable to determine whether the
proposed rules and amendments would lead to an overall increase or
decrease in fund assets, to the extent the overall fund assets change,
this may have an effect on capital formation.
---------------------------------------------------------------------------
\601\ See supra section III.C.2.
---------------------------------------------------------------------------
The proposed rule may also decrease the use of reverse repurchase
agreements, similar financing transactions, or borrowings by some
funds, or reduce some funds' ability to invest the borrowings obtained
through reverse repurchase agreements.\602\ To the extent that this
restricts a fund's ability to obtain financing to invest in debt or
equity securities, capital formation may be reduced.
---------------------------------------------------------------------------
\602\ See supra section III.C.4.
---------------------------------------------------------------------------
In addition, the proposed sales practices rules may reduce capital
formation in asset markets directly connected with covered leveraged/
inverse investment vehicles. By restricting the accounts of customers
or clients seeking to buy or sell shares of a leveraged/inverse
investment vehicle, the proposed rules may produce net capital outflows
from retail investors. However, the size of this effect would depend on
the number of retail investors that would no longer be approved to buy
or sell shares of leveraged/inverse investment vehicles and any other
investments these retail investors would make in lieu of investing in
leveraged/inverse investment vehicles.
E. Reasonable Alternatives
1. Alternative Implementations of the VaR Tests
a. Different Confidence Level or Time Horizon
Proposed rule 18f-4 would require that a fund's VaR model use a 99%
confidence level and a time horizon of 20 trading days.\603\ We could
alternatively require a different confidence level and/or a different
time horizon for the VaR test.
---------------------------------------------------------------------------
\603\ See supra section II.D.4.
---------------------------------------------------------------------------
As discussed above in section II.D.4, market participants
calculating VaR most commonly use 95% or 99% confidence levels and
often use time horizons of 10 or 20 days. The proposed VaR parameters
therefore represent a confidence level and time horizon at the high end
of what is commonly used. Compared to requiring a lower confidence
level and a shorter time horizon, the proposed parameters result in a
VaR test that is designed to measure, and therefore limit the severity
of, less frequent but larger losses. The cost of calculating VaR does
not vary based on how the model is parametrized, meaning the proposed
confidence level and time horizon would not lead to larger compliance
costs for funds compared to the alternatives we considered. A lower
confidence level or shorter time horizon may be less effective at
placing a VaR-based outer limit on fund leverage risk associated with
larger losses and would not result in cost savings for funds.
b. Absolute VaR Test Only
To establish an outer limit for a fund's leverage risk, the
proposed rule would generally require a fund engaging in derivatives
transactions to comply with a relative VaR test; the fund could instead
comply with an absolute VaR test only if the derivatives risk manager
is unable to identify an appropriate designated reference index for the
fund. As an alternative, we could require all funds that would be
subject to the proposed VaR-based limit on fund leverage risk to comply
with an absolute VaR test.
Use of an absolute VaR test would be less costly for some funds
that would be required to comply with the relative VaR test under the
proposed rule, including because the relative VaR test may require some
funds to pay licensing costs associated with the use of the reference
index.\604\ In addition, use of an absolute VaR test would reduce the
compliance challenge for fund risk managers who have difficulty
identifying a designated reference index; however, this benefit would
be limited for funds that have an existing or easy-to-identify
benchmark.
---------------------------------------------------------------------------
\604\ See supra section III.C.2.
---------------------------------------------------------------------------
On the other hand, the absolute VaR test is a static measure of
fund risk in the sense that the implied limit on a fund's VaR will not
change with the VaR of its designated reference index. The absolute VaR
test is therefore less suited for measuring leverage risk and limiting
the degree to which a fund can use derivatives to leverage its
portfolio, as measuring leverage inherently requires comparing a fund's
risk exposure to that of an unleveraged point of reference.\605\ An
additional implication of this aspect of an absolute VaR test is that a
fund may fall out of compliance with an absolute VaR test just because
the market it invest in becomes more volatile even though the degree of
leverage in the fund's portfolio may not have changed. Overall, we
believe that permitting funds to rely on an absolute VaR test only in
those instances when a designated reference index is unavailable is
justified.
---------------------------------------------------------------------------
\605\ Id.
---------------------------------------------------------------------------
c. Choice of Absolute or Relative VaR Tests
As another alternative, we could allow derivatives risk managers to
choose between an absolute and a relative VaR limit, depending on their
preferences and without regard to whether a designated reference index
is available. Such an alternative would offer derivatives risk managers
more flexibility than the proposed rule and
[[Page 4530]]
could reduce compliance costs for funds, to the extent that derivatives
risk managers would choose the VaR test that is cheaper to implement
for their particular fund. However, this alternative may result in less
uniformity in the outer limit on funds' leverage risk across the
industry, as individual derivatives risk managers would have the
ability to choose between VaR-based tests that could provide for
different limits on fund leverage risk. Funds that invest in assets
with a low VaR, for example, could obtain significantly more leverage
under an absolute VaR test because the VaR of the fund's designated
reference index would be low; as a result, investors in these funds
would be less protected from leverage-related risks compared to the
proposed rule.
d. Optional Relative VaR Test Using a Fund's ``Securities VaR''
As another alternative, we could allow funds relying on the
relative VaR test to compare the fund's VaR to its ``securities VaR''
(i.e., the VaR of the fund's portfolio of securities and other
investments, but excluding any derivatives transactions), rather than
the VaR of the fund's designated reference index, depending on the
derivatives risk manager's preferences and without regard to whether a
designated reference index is available.\606\
---------------------------------------------------------------------------
\606\ The 2015 Proposing Release also included a risk-based
portfolio limit based on VaR, which provided that a fund would
satisfy its risk-based portfolio limit condition if a fund's full
portfolio VaR was less than the fund's ``securities VaR.'' See 2015
Proposing Release, supra note 2, at section III.B.2.
---------------------------------------------------------------------------
While such an alternative would offer derivatives risk managers
more flexibility than the proposed rule, we believe that it would not
be easier to implement or lead to cost savings for a significant number
of funds. Conversely, the alternative VaR test based on a fund's
``securities VaR'' would provide an incentive for some funds to invest
in volatile, riskier securities that would increase the fund's
``securities VaR,'' thereby reducing the test's effectiveness at
limiting fund leverage risk. As a result, investors in these funds
would be less protected from leverage-related risks compared to the
proposed rule.
e. Third-Party Validation of a Fund's VaR Model
The proposed rule does not require third-party validation of a
fund's chosen VaR model. As an alternative, we could require that a
fund obtain third-party validation of its VaR model, either at
inception or in connection with any material changes to the model, to
independently confirm that the model is structurally sound and
adequately captures all material risks.\607\ While such a requirement
could help ensure funds' compliance with the proposed VaR-based limit
on fund leverage risk, this incremental benefit may not justify the
potentially significant additional costs to funds associated with
third-party validation of the fund's VaR model.\608\
---------------------------------------------------------------------------
\607\ See also supra note 243.
\608\ We note that the UCITS regime requires third-party
validation of funds' VaR models; as a result, these additional costs
could be mitigated for fund that are part of a complex that also
includes UCITS funds. See supra note 243.
---------------------------------------------------------------------------
2. Alternatives to the VaR Tests
a. Stress Testing
As an alternative to the proposed VaR-based limit on fund leverage
risk, we could require a stress testing approach. As discussed above in
section II.D.6.a, we understand that many funds that use derivatives
transactions already conduct stress testing for purposes of risk
management. However, we do not believe that a stress testing approach
would impose significantly lower costs on funds compared to a VaR-based
approach, with the exception of those funds that already conduct stress
testing but not VaR testing.\609\
---------------------------------------------------------------------------
\609\ See also ICI Comment Letter III (stating that, ``depending
on the type of fund managed and whether the fund currently employs
the test for risk management purposes, some respondents viewed a
stress loss test as being more burdensome to implement, while others
viewed a VaR test as being more burdensome to implement.'').
---------------------------------------------------------------------------
In addition, as also discussed in section II.D.6.a above, it would
be challenging for the Commission to specify a set of asset class
shocks, their corresponding shock levels, and, in the case of multi-
factor stress testing, assumptions about the correlations of the
shocks, in a manner that applies to all funds and does not become stale
over time. While we could also prescribe a principles-based stress
testing requirement, we believe that the flexibility such an approach
would give to individual funds over how to implement the test would
render it less effective than the proposed VaR test at establishing an
outer limit on fund leverage risk.
Finally, stress testing generally focuses on a narrower and more
remote range of extreme loss events compared to VaR analysis. As a
result, a limit on fund leverage risk based on stress testing would
likely be less effective at limiting fund leverage risk during more
normal conditions and protecting investors from unexpected losses
resulting from less extreme scenarios.
b. Asset Segregation
As another alternative, we could require an asset segregation
approach in lieu of the proposed VaR-based limit on fund leverage risk.
For example, we could consider an approach similar to the Commission's
position in Release 10666, under which a fund engaging in derivatives
transactions would segregate cash and cash equivalents equal in value
to the full amount of the conditional and unconditional obligations
incurred by the fund (also referred to as ``notional amount
segregation''). Such an approach could also permit a fund to segregate
a broader range of assets, subject to haircuts.\610\ Alternatively, we
could require funds to segregate liquid assets in an amount equal to
the fund's daily mark-to-market liability plus a ``cushion amount''
designed to address potential future losses.
---------------------------------------------------------------------------
\610\ The 2016 DERA Memo, for example, analyzed different risk-
based ``haircuts'' that could apply to a broader range of assets.
See, e.g., 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------
As discussed above in section II.D.6.b, we believe that asset
segregation approaches have several drawbacks as a means for limiting
fund leverage risk, compared to the proposed VaR tests. For example,
notional amount segregation is not risk-sensitive and could restrict
derivatives transactions that would reduce portfolio risk. Similarly,
segregation of liquid assets in an amount equal to the fund's daily
mark-to-market liability plus a ``cushion amount'' would be difficult
to implement in a manner that is applied uniformly across all funds and
types of derivatives. In addition, asset segregation approaches raise
certain compliance complexities that may not make them significantly
less costly to implement for funds than the proposed VaR tests.\611\
---------------------------------------------------------------------------
\611\ See supra section II.D.6.b.
---------------------------------------------------------------------------
In conjunction with the proposed VaR-based limit, we could also
require a fund relying on the proposed rule to maintain an amount of
``qualifying coverage assets'' designed to enable a fund to meet its
derivatives-related obligations. As discussed above, we believe that
the proposed rule's requirements, including the requirements that funds
establish risk management programs and comply with the proposed VaR-
based limit on fund leverage risk, would address the risk that a fund
may be required to realize trading losses by selling its investments to
generate cash to pay derivatives counterparties.
[[Page 4531]]
c. Exposure-Based Test
We alternatively considered proposing an exposure-based approach
for limiting fund leverage risk in lieu of the proposed VaR test. An
exposure-based test could limit a fund's derivatives exposure, as
defined in the proposed rule, to a specified percentage of the fund's
net assets. For example, we considered proposing that a fund limit its
derivatives exposure to 50% of net assets. This would allow a fund to
add to its portfolio an amount of derivatives exposure equal to the
amount that an open-end fund could borrow from a bank. A similar
approach would be to provide that the sum of a fund's derivatives
exposure and the value of its other investments cannot exceed 150% of
its net asset value. This latter approach, and particularly if cash and
cash equivalents were not included in the calculation, would allow a
fund to achieve the level of market exposure permitted for an open-end
fund under section 18 using any combination of derivatives and other
investments.
While an exposure-based test may be simpler and therefore less
costly to implement for the typical fund than the proposed VaR tests,
an exposure-based test has certain limitations compared to VaR tests,
as discussed in detail in section above. One limitation is that
measuring derivatives exposure based on notional amounts would not
reflect how derivatives are used in a portfolio, whether to hedge or
gain leverage, nor would it differentiate derivatives with different
risk profiles. Various adjustments to the notional amount are available
that may better reflect the risk associated with the derivatives
transactions, although even with these adjustments the measure would
remain relatively blunt. For example, an exposure-based limit could
significantly limit certain strategies that rely on derivatives more
extensively but that do not seek to take on significant leverage risk.
Some of the limitations of an exposure-based approach could be
addressed, however, if rule 18f-4 were to provide an exposure-based
test as an optional alternative to the proposed VaR tests, rather than
as the sole means of limiting fund leverage risk. Under this second
alternative, funds with less complex portfolios might choose to rely on
an exposure-based test because it would be simpler and impose lower
compliance costs than the proposed VaR tests. Furthermore, if we
provided that the sum of a fund's derivatives exposure and the value of
its other investments cannot exceed 150% of its net asset value, funds
below this threshold would generally also pass the proposed relative
VaR test.\612\ Conversely, funds with more complex portfolios that rely
on derivatives more extensively but that do not seek to take on
significant leverage risk might choose to rely on the proposed VaR
test. As the proposed rule would already except limited derivatives
users from the VaR-based limit on fund leverage risk, however, we do
not believe that also giving funds the option of relying on an
exposure-based limit on fund leverage risk would be necessary or that
it would significantly reduce the compliance burden associated with the
rule.
---------------------------------------------------------------------------
\612\ A fund that limited the sum of its derivatives exposure
and the value of its other investments to 150% of its net asset
value would generally also pass the proposed relative VaR test,
provided that derivatives notionals are either not adjusted or only
adjusted for delta in the case of options.
---------------------------------------------------------------------------
3. Stress Testing Frequency
Proposed rule 18f-4 would require funds that enter into derivatives
transactions and are not limited derivatives users to adopt and
implement a derivatives risk management program that includes stress
testing, among other elements. The proposed rule would permit a fund to
determine the frequency of stress tests, provided that the fund must
conduct stress testing at least weekly.
As an alternative to the weekly requirement, we considered both
shorter and longer minimum stress testing frequencies. On the one hand,
more frequent stress testing would reflect changes in risk for fund
strategies that involve frequent and significant portfolio turnover. In
addition, more frequent stress testing may reflect increases in market
stress in a timelier manner. On the other hand, given the forward-
looking nature of stress testing, we expect that most funds would take
foreseeable changes in market conditions and portfolio composition into
account when conducting stress testing. In addition, more frequent
stress testing may impose an increased cost burden on funds, although
we would expect any additional cost burden to be small, to the extent
that funds perform stress testing in an automated manner. Overall, we
preliminarily believe that the proposed minimum weekly stress testing
appropriately balances the anticipated benefits of relatively frequent
stress testing against the burdens of administering stress testing.
Another alternative would be to permit a fund to determine its own
stress testing frequency without the proposed rule prescribing a
minimum stress testing frequency. This approach would provide maximum
flexibility to funds regarding the frequency of their stress tests, and
would reduce compliance costs for funds that determine that stress
testing less frequently than weekly is warranted in light of their own
particular facts and circumstances. However, allowing funds to
individually determine the frequency with which stress tests are
conducted could result in some funds stress testing their portfolios
too infrequently to provide timely information to the fund's
derivatives risk manager and board. Taking these considerations into
account, we are proposing to require weekly stress tests, rather than
less frequent testing, to provide for consistent and reasonably
frequent stress testing by all funds that would be required to
establish a derivatives risk management program.
4. Alternative Exposure Limits for Leveraged/Inverse Funds
A fund that meets the definition of a ``leveraged/inverse
investment vehicle'' in the proposed sales practices rules would not
have to comply with the VaR-based leverage risk limit under proposed
rule 18f-4, provided the fund limits the investment results it seeks to
300% of the return (or inverse of the return) of the underlying index
and discloses in its prospectus that it is not subject to the proposed
limit on fund leverage risk.\613\ Alternatively, we could condition the
exemption on compliance with a higher or lower exposure limit.
---------------------------------------------------------------------------
\613\ See supra section II.G.3.
---------------------------------------------------------------------------
Over longer holding periods, the realized leverage multiple of the
returns of an investment in a leveraged/inverse fund relative to the
returns of its underlying index can vary substantially from the fund's
daily leverage multiple.\614\ All else equal, this effect becomes
stronger as the fund's leverage multiple increases. The extent of a
leveraged/inverse fund's rebalancing activity likewise increases as the
fund's leverage multiple increases.\615\ Therefore, the effects of
leveraged/inverse funds' rebalancing activity on the constituent asset
prices may be heightened if a significant number of leveraged/inverse
funds were to increase their leverage beyond the levels currently
observed in markets and,
[[Page 4532]]
conversely, could be diminished if a significant number of leveraged/
inverse funds were to reduce their leverage below current levels.
---------------------------------------------------------------------------
\614\ See supra section III.B.5.
\615\ The rebalancing demand of a leveraged/inverse fund is a
function of the fund's assets, the realized return of its reference
index, and is proportional to the term , where denotes the fund's
leverage multiple. (See, e.g., Minder Cheng & Ananth Madhavan, The
dynamics of leveraged/inverse and inverse exchange-traded funds, 7
Journal of Investment Management 4 (2009).) As a result, increasing
a fund's leverage multiple increases its rebalancing demand more
than linearly.
---------------------------------------------------------------------------
While permitting a higher exposure limit may benefit fund sponsors
to the extent that some sponsors would bring funds with higher leverage
multiples to market, we are concerned that a higher exposure limit
would heighten the investor protection concerns these funds present.
Conversely, limiting leveraged/inverse funds' exposure could reduce the
concerns these funds present, but could reduce investor choice relative
to the baseline given that leveraged/inverse funds today operate with
levels of leverage up to the exposure limit we propose. Allowing funds
to continue to obtain this level of leverage, subject to the additional
requirements in proposed rule 18f-4 and in light of the proposed sales
practices rules, is designed to address the investor protection
concerns that underlie section 18, while preserving choice for retail
investors who are capable of evaluating their characteristics and
unique risks. For these reasons, and because the Commission does not
have experience with leveraged/inverse funds that seek returns above
300% of the return (or inverse of the return) of the underlying index,
we are not proposing to permit higher levels of leveraged/inverse
market exposure for leveraged/inverse funds in this rule. We also are
not proposing a lower exposure limit for these funds in light of the
investor protections that we believe proposed rule 18f-4 and the sales
practices rules would provide.\616\
---------------------------------------------------------------------------
\616\ See supra section II.G.3.
---------------------------------------------------------------------------
5. No Sales Practices Rules and No Separate Exposure Limit for
Leveraged/Inverse Funds
The proposed rules would require a leveraged/inverse fund that
meets the definition of a ``leveraged/inverse investment vehicle'' to
limit its investment results to 300% of the return (or inverse of the
return) of the underlying index and would require a broker-dealer or
investment adviser to exercise due diligence in approving a retail
investor's account to buy or sell shares of leveraged/inverse
investment vehicles, as well as implement policies and procedures
reasonably designed to achieve compliance with the proposed rules.\617\
In lieu of the proposed sales practices rules and associated exception
from the VaR-based limit on fund leverage risk, we could alternatively
require leveraged/inverse funds to comply with the proposed relative
VaR test.
---------------------------------------------------------------------------
\617\ See supra sections II.G.3 and II.G.2.
---------------------------------------------------------------------------
Existing leveraged/inverse ETFs and mutual funds generally could
comply with the proposed relative VaR test only if they restricted the
investment results they seek to 150% of the return (or inverse of the
return) of the underlying index. Therefore, under this alternative,
leveraged/inverse funds that seek investment results in excess of this
limit would either have to significantly change their investment
strategy or liquidate. Given that existing fund sponsors frequently
offer leveraged/inverse funds with various target multiples referencing
the same index, we would expect that this alternative would reduce the
number of leveraged/inverse funds.
Compared to the proposal, this alternative would also restrict
choice for investors that prefer to invest in leveraged/inverse funds
that pursue investment results in excess of 150% of the return (or
inverse of the return) of the underlying index and who would satisfy
the due diligence and approval requirements adopted by their broker-
dealer or investment adviser in connection with the proposed rule.
At the same time, the alternative could result in increased
investor protection for investors in these funds compared to the
proposal. While investors' access to leveraged/inverse funds would not
be subject to the proposed sales practice rules under this alternative
(and investment advisers and broker-dealers would not incur the
associated compliance costs), these funds would be required to limit
their exposure to 150% of the return (or inverse of the return) of the
underlying index, thereby reducing the potential consequences for
leveraged/inverse fund investors who are not capable of evaluating
their return characteristics and ameliorating the associated investor
protection concerns. Conversely, the alternative would reduce
protection for investors in leveraged/inverse commodity- and currency-
based trusts or funds, as those funds would be subject to neither the
150% exposure limit nor the proposed sales practices rules.
Finally, because leveraged/inverse funds would no longer be able to
offer exposures above 150% of the return (or inverse of the return) of
the underlying index, the alternative may ameliorate the concerns
associated with the rebalancing activity of leveraged/inverse ETFs,
which decreases with the targeted leverage multiple of these
funds.\618\ As discussed above in section D.1, however, while the
literature observes that leveraged/inverse ETFs' rebalancing activity
may have an adverse impact on the prices and volatility of the
constituent assets that make up leveraged/inverse ETFs, the literature,
overall, is not definitive.
---------------------------------------------------------------------------
\618\ See supra sections III.D.1 and III.E.4. While the
literature focuses on leveraged/inverse ETFs, the results may apply
similarly to leveraged/inverse mutual funds.
---------------------------------------------------------------------------
Overall, we believe that preserving investor choice justifies
providing leveraged/inverse funds an exemption from the proposed VaR-
based limit on fund leverage risk, particularly in light of the
proposed sales practices rules, which we believe would help to ensure
that investors in these funds are limited to those who are capable of
evaluating the characteristics and risks of these products.\619\
---------------------------------------------------------------------------
\619\ See also supra note 535.
---------------------------------------------------------------------------
6. Enhanced Disclosure
As an alternative to the requirements in rule 18f-4, such as the
proposed derivatives risk management program and the VaR-based limit on
fund leverage risk, we could consider addressing the risks associated
with funds' use of derivatives through enhanced disclosures to
investors with respect to a fund's use of derivatives and the resulting
derivatives-related risks.\620\ While an approach focused on enhanced
disclosures could result in greater fund investment flexibility, such
an approach may be less effective than the proposed rule in addressing
the purposes and concerns underlying section 18 of the Investment
Company Act. Section 18 itself imposes a specific limit on the amount
of senior securities that a fund may issue, regardless of the level of
risk introduced or the disclosure that a fund provides regarding those
risks. Absent additional requirements to limit leverage or potential
leverage, requiring enhancement to derivatives disclosure alone would
not appear to provide any limit on the amount of leverage a fund may
obtain. Indeed, the degree to which funds use derivatives varies widely
between funds. As a result, an approach focused solely on enhanced
disclosure requirements may not provide a sufficient basis for an
exemption from the requirements of section 18 of the Investment Company
Act.
---------------------------------------------------------------------------
\620\ See, e.g., Comment Letter of the Fixed Income Market
Structure Advisory Committee on proposed rule 6c-11 under the
Investment Company Act (Oct. 29, 2018) (recommending that the
Commission consider future rulemaking regarding ``leveraged ETP''
investor disclosure requirements).
---------------------------------------------------------------------------
[[Page 4533]]
F. Request for Comments
The Commission requests comment on all aspects of this initial
economic analysis, including whether the analysis has: (1) Identified
all benefits and costs, including all effects on efficiency,
competition, and capital formation; (2) given due consideration to each
benefit and cost, including each effect on efficiency, competition, and
capital formation; and (3) identified and considered reasonable
alternatives to the proposed new rules and rule amendments. We request
and encourage any interested person to submit comments regarding the
proposed rules, our analysis of the potential effects of the proposed
rules and proposed amendments, and other matters that may have an
effect on the proposed rules. We request that commenters identify
sources of data and information as well as provide data and information
to assist us in analyzing the economic consequences of the proposed
rules and proposed amendments. We also are interested in comments on
the qualitative benefits and costs we have identified and any benefits
and costs we may have overlooked. In addition to our general request
for comments on the economic analysis associated with the proposed
rules and proposed amendments, we request specific comment on certain
aspects of the proposal:
254. Are we correct that many funds already have a derivatives risk
management program in place that could be readily adapted to meet the
proposed rule's requirements without significant additional cost? If
so, for how many funds would this be true?
255. The proposed rule does not include any requirement for third-
party validation of a fund's chosen VaR model, either at inception or
upon material changes, to confirm that the model is structurally sound
and adequately captures all material risks.\621\ How costly would such
a requirement be to funds? What would the benefits of such a
requirement be?
---------------------------------------------------------------------------
\621\ See also supra note 243.
---------------------------------------------------------------------------
256. Are we correct that many funds that use derivatives in a
limited manner already have in place policies and procedures that are
reasonably designed to address their derivatives that could be readily
adapted to meet the proposed rule's requirements without significant
additional cost? If so, for how many funds would this be true?
257. How many broker-dealers provide customers the ability to buy
or sell interests in leveraged/inverse investment vehicles? How many
investment advisers place orders to buy or sell leveraged/inverse
investment vehicles for their advisory clients? How many retail
investor accounts with broker-dealers and investment advisers trade
leveraged/inverse investment vehicles?
258. How many current investors in leveraged/inverse investment
vehicles would likely not be approved to buy or sell these products
under the proposed sales practices rules' due diligence and account
approval requirements?
259. If we provided that the sum of a fund's derivatives exposure
and the value of its other investments cannot exceed 150% of its net
asset value, funds below this threshold would generally also pass the
proposed relative VaR test. How many funds would be likely to rely on
such an exposure-based test if exempted funds that satisfied this limit
from the proposed VaR tests?
IV. Paperwork Reduction Act Analysis
A. Introduction
Proposed rule 18f-4, proposed rule 15l-2, and proposed rule 211(h)-
1 would result in new ``collection of information'' requirements within
the meaning of the Paperwork Reduction Act of 1995 (``PRA'').\622\ In
addition, the proposed amendments to rule 6c-11 under the Investment
Company Act, as well as to Forms N-PORT, Form N-LIQUID (which would be
renamed Form N-RN), and N-CEN would affect the collection of
information burden under those rules and forms.\623\
---------------------------------------------------------------------------
\622\ 44 U.S.C. 3501-3520.
\623\ We do not believe that the proposed conforming amendment
to Form N-2, to reflect a clarification that funds do not have to
disclose in their senior securities table the derivatives
transactions and unfunded commitment agreements entered into in
reliance on proposed rule 18f-4, makes any new substantive
recordkeeping or information collection within the meaning of the
PRA. Accordingly, we do not revise any burden and cost estimates in
connection with this proposed amendment.
---------------------------------------------------------------------------
The titles for the existing collections of information are: ``Form
N-PORT'' (OMB Control No. 3235-0731); ``Form N-LIQUID'' (OMB Control
No. 3235-0754); ``Form N-CEN'' (OMB Control No. 3235-0730); and ``Rule
6c-11 under the Investment Company Act of 1940, Exchange-traded funds''
(OMB Control No. xxxx-xxxx). The titles for the new collections of
information would be: ``Rule 18f-4 under the Investment Company Act of
1940, Use of Derivatives by Registered Investment Companies and
Business Development Companies,'' ``Rule 15l-2 under the Securities
Exchange Act of 1934, Broker and Dealer Sales Practices for Leveraged/
Inverse Investment Vehicles,'' and ``Rule 211(h)-1 under the Investment
Advisers Act of 1940, Investment Adviser Sales Practices for Leveraged/
Inverse Investment Vehicles.'' The Commission is submitting these
collections of information to the Office of Management and Budget
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11. An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless it displays
a currently-valid control number.
The Commission published notice soliciting comments on the
collection of information requirements in the 2015 Proposing Release
and submitted the proposed collections of information to OMB for review
and approval in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11.\624\ The Commission received comments on the 2015 proposal's
collection of information burden regarding the 2015 proposal's trade-
by-trade determination of compliance with portfolio limits.\625\ These
comments were considered but did not form the basis of our burden
estimates because we do not propose a trade-by-trade determination of
compliance with the proposed VaR-based tests.
---------------------------------------------------------------------------
\624\ See 2015 Proposing Release, supra note 2.
\625\ See, e.g., Vanguard Comment Letter; Invesco Comment
Letter; see also supra note 245 and accompanying text.
---------------------------------------------------------------------------
We discuss below the collection of information burdens associated
with proposed rule 18f-4, proposed rule 15l-2, proposed rule 211(h)-1,
as well as proposed amendments to rule 6c-11 and Forms N-PORT, N-
LIQUID, and N-CEN.
B. Proposed Rule 18f-4
Proposed rule 18f-4 would permit a fund to enter into derivatives
transactions, notwithstanding the prohibitions and restrictions on the
issuance of senior securities under section 18 of the Investment
Company Act.
Proposed rule 18f-4 would generally require a fund that relies on
the rule to enter into derivatives transactions to: Adopt a derivatives
risk management program; have its board of directors approve the fund's
designation of a derivatives risk manager and receive direct reports
from the derivatives risk manager about the derivatives risk management
program; and require a fund to comply with a VaR-based test designed to
limit a fund's leverage risk consistent with the investor protection
purposes underlying section 18.
[[Page 4534]]
Proposed rule 18f-4 includes an exception from the risk management
program requirement and limit on fund leverage risk if a fund is a
``limited derivatives user'' that either limits its derivatives
exposure to 10% of its net assets or it uses derivatives transactions
solely to hedge certain currency risks. A fund relying on the proposed
exception would be required to adopt policies and procedures that are
reasonably designed to manage its derivatives risks. Proposed rule 18f-
4 also includes alternative requirements for a leveraged/inverse fund
not subject to the proposed VaR-based leverage risk limit, if such a
fund: (1) Meets the definition of a ``leveraged/inverse investment
vehicle'' in the proposed sales practices rules; (2) limits the
investment results it seeks to 300% of the return (or inverse of the
return) of the underlying index; and (3) discloses in its prospectus
that it is not subject to proposed rule 18f-4's limit on fund leverage
risk.\626\ Proposed rule 18f-4 also would require a fund to adhere to
certain recordkeeping requirements that are designed to provide the
Commission's staff, and the fund's board of directors and compliance
personnel, the ability to evaluate the fund's compliance with the
proposed rule's requirements.
---------------------------------------------------------------------------
\626\ See proposed rule 18f-4(c)(4); supra section II.G.3.
---------------------------------------------------------------------------
The respondents to proposed rule 18f-4 would be registered open-
and closed-end management investment companies and BDCs.\627\ We
estimate that 5,091 funds would likely rely on rule 18f-4.\628\
Compliance with proposed rule 18f-4 would be mandatory for all funds
that seek to engage in derivatives transactions in reliance on the
rule, which would otherwise be subject to the restrictions of section
18. To the extent that records required to be created and maintained by
funds under the rule are provided to the Commission in connection with
examinations or investigations, such information would be kept
confidential subject to the provisions of applicable law.
---------------------------------------------------------------------------
\627\ See proposed rule 18f-4(a) (defining ``fund'').
\628\ See supra notes 467, 498 and accompanying text, and
paragraph following note 525 (2,693 funds that would be subject to
the proposed derivatives risk management program and limit on fund
leverage risk requirements + 2,398 funds relying on the limited
derivatives user exception and complying with the related limited
derivatives user requirements).
The Commission's estimates of the relevant wage rates in the
tables below are based on salary information for the securities
industry compiled by the Securities Industry and Financial Markets
Association's Office Salaries in the Securities Industry 2013. The
estimated wage figures are modified by Commission staff to account
for an 1,800-hour work-year and multiplied by 2.93 to account for
bonuses, firm size, employee benefits, overhead, and adjusted to
account for the effects of inflation. See Securities Industry and
Financial Markets Association, Report on Management & Professional
Earnings in the Securities Industry 2013 (``SIFMA Report'').
---------------------------------------------------------------------------
1. Derivatives Risk Management Program
Proposed rule 18f-4 would require certain funds relying on the rule
to adopt and implement a written derivatives risk management program,
which would include policies and procedures reasonably designed to
manage the fund's derivatives risks. The proposal would require a
fund's program to include the following elements: (1) Risk
identification and assessment; (2) risk guidelines; (3) stress testing;
(4) backtesting; (5) internal reporting and escalation; and (6)
periodic review of the program.\629\ Under the proposed rule, the
derivatives risk manager is responsible for administering the
derivatives risk management program and its policies and procedures.
Certain funds relying on the proposed rule would not be subject to the
program requirement.\630\ We estimate that 2,693 funds would likely be
subject to the program requirement.\631\ Below we estimate the initial
and annual ongoing burdens associated with initial documentation of the
program, and any revision (and related documentation) of the
derivatives risk management program arising from the periodic review of
the program. In addition to the initial burden to document the program,
including policies and procedures reasonably designed to manage the
fund's derivatives risks, we estimate that a fund relying on the
proposed rule would have an ongoing burden associated with the proposed
periodic review requirements to evaluate the program's effectiveness
and to reflect changes in the fund's derivatives risks over time. Below
we estimate the initial and annual ongoing burdens associated with
documentation and any review and revision of funds' programs including
their policies and procedures.
---------------------------------------------------------------------------
\629\ See proposed rule 18f-4(c)(1)(i)-(vi); supra section
II.A.2 (discussing the proposed derivatives risk management program
requirement).
\630\ A fund that is a limited derivatives user would not be
required to comply with the proposed program requirement. Funds that
are limited derivatives users would be required to adopt policies
and procedures that are reasonably designed to manage its
derivatives risks. See proposed rule 18f-4(c)(3); infra section
IV.B.6 (discussing limited derivatives users).
\631\ See supra notes 498, 627 and accompanying text.
---------------------------------------------------------------------------
Table 2 below summarizes the proposed PRA initial and ongoing
annual burden estimates associated with the derivatives risk management
program requirement under proposed rule 18f-4. We do not estimate that
there will be any initial or ongoing external costs associated with the
derivatives risk management program requirement.
Table 2--Derivatives Risk Management Program PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \2\ Internal time
hours hours \1\ costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Written derivatives risk management 12 4 x $357 (derivatives risk $1,428
program development. manager).
12 4 x $466 (assistant 1,864
general counsel).
12 4 x $365 (compliance 1,460
attorney).
Periodic review and revisions of 0 2 x $357 (derivatives risk 714
the program. manager).
0 2 x $466 (assistant 932
general counsel).
0 2 x $365 (compliance 730
attorney).
----------------------------------------------------------------------------
Total annual burden per fund... .............. 18 ...................... 7,128
Number of funds............ .............. x 2,693 ...................... x 2,693
----------------------------------------------------------------------------
[[Page 4535]]
Total annual burden............ .............. 48,474 ...................... 19,195,704
----------------------------------------------------------------------------------------------------------------
Notes:
1. For ``Written Derivatives Risk Management Program Development,'' these estimates include initial burden
estimates annualized over a three-year period.
2. See supra note 627.
2. Board Oversight and Reporting
The proposed rule would require: (1) A fund's board of directors to
approve the designation of the fund's derivatives risk manager,\632\
(2) the derivatives risk manager to provide written reports to the
board regarding the program's implementation and effectiveness,\633\
and (3) the derivatives risk manager to provide written reports
describing any exceedances of the fund's guidelines and the results of
the fund's stress testing and backtesting.\634\ We estimate that 2,693
funds would be subject to these requirements.\635\
---------------------------------------------------------------------------
\632\ See proposed rule 18f-4(c)(5)(i); supra section II.C
(discussing the proposed board oversight and reporting
requirements).
\633\ See proposed rule 18f-4(c)(5)(ii); supra section II.C.
\634\ See proposed rule 18f-4(c)(5)(iii); supra section II.C.
Burdens associated with reports to the fund's board of directors of
material risks arising from the fund's derivatives transactions, as
described in proposed rule 18f-4(c)(1)(v), are discussed above in
supra section IV.B.1.
\635\ See supra notes 498, 627 and accompanying text.
---------------------------------------------------------------------------
Table 3 below summarizes the proposed PRA initial and ongoing
annual burden estimates associated with the board oversight and
reporting requirements under proposed rule 18f-4. We do not estimate
that there will be any initial or ongoing external costs associated
with the board oversight and reporting requirements.
Table 3--Board Oversight and Reporting PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \2\ Internal time
hours hours \1\ costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Approving the designation of the 3 1 x $17,860 (combined rate $17,860
derivatives risk manager. for 4 directors) \2\.
Derivatives risk manager written .............. 8 x $357 (derivatives risk 2,856
reports \3\. manager).
.............. 1 x $17,860 (combined rate 17,860
for 4 directors).
----------------------------------------------------------------------------
Total annual burden per fund... .............. 10 ...................... 11,786
Number of funds............ .............. x 2,693 ...................... x 2,693
----------------------------------------------------------------------------
Total annual burden............ .............. 26,930 ...................... 31,739,698
----------------------------------------------------------------------------------------------------------------
Notes:
1. For ``Approving the Designation of the Derivatives Risk Manager,'' this estimate includes initial burden
estimates annualized over a three-year period.
2. See supra notes 627.
3. See supra notes 631-632 and accompanying text.
3. Disclosure Requirement Associated With Limit on Fund Leverage Risk
The proposed rule would also generally require funds relying on the
rule to comply with an outer limit on fund leverage risk based on VaR.
This outer limit would be based on a relative VaR test that compares
the fund's VaR to the VaR of a ``designated reference index.'' If the
fund's derivatives risk manager is unable to identify an appropriate
designated reference index, the fund would be required to comply with
an absolute VaR test.\636\ Under the proposed rule, a fund must
disclose its designated reference index in its annual report.\637\ We
estimate that 2,424 funds would be subject to this disclosure
requirement.\638\
---------------------------------------------------------------------------
\636\ The collections of information burdens for disclosure
requirements associated with the proposed limit on fund leverage
risk are reflected in the PRA for proposed rule 18f-4 and not in the
funds' applicable disclosure forms because the burden arises from
the proposed rule. The Paperwork Reduction Act analysis for the
funds' applicable disclosure forms will not reflect the collections
of information burdens for disclosure requirements associated with
the proposed limit on fund leverage risk.
A fund that is a leveraged/inverse investment vehicle, as
defined in the proposed sales practices rules, would not be required
to comply with the proposed VaR-based limit on fund leverage risk.
Broker-dealers and investment advisers would be required to approve
retail investors' accounts to purchase or sell shares in these
funds. See infra sections IV.C and IV.D (discussing leveraged/
inverse investment vehicles and leveraged/inverse funds covered by
the sales practices rules). The proposed rule also would provide an
exception from the proposed VaR tests for funds that use derivatives
to a limited extent or only to hedge currency risks. See infra
sections IV.B.5 (discussing the proposed rule's provisions regarding
limited derivatives users).
VaR test burdens related to recordkeeping and reporting are
reflected in the recordkeeping section below, and also in the Forms
N-PORT, N-CURRENT, and N-CEN burdens discussed below. See infra
sections IV.F, IV.G, and IV.H.
\637\ See proposed rule 18f-4(c)(2)(iv).
\638\ See supra notes 519-520 and accompanying text.
---------------------------------------------------------------------------
Table 4 below summarizes the proposed PRA initial and ongoing
annual burden estimates associated with the disclosure requirement
associated with the proposed limit on fund leverage risk. We do not
estimate that there will be any paperwork-related initial or ongoing
external costs associated with this proposed disclosure requirement.
[[Page 4536]]
Table 4--Disclosure Requirement Associated With Limit on Fund Leverage Risk PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \1\ Internal time
hours hours costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Disclosure of designated reference 0 .5 x $309 (compliance $154.50
index. manager).
0 .5 x 365 (compliance 182.50
attorney).
----------------------------------------------------------------------------
Total annual burden per fund... .............. 1 hour ...................... 337
Number of funds............ .............. x 2,424 ...................... x 2,424
----------------------------------------------------------------------------
Total annual burden............ .............. 2,424 ...................... 816,888
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627.
4. Disclosure Requirement for Leveraged/Inverse Funds
Under the proposed rule, a fund would not have to comply with the
proposed VaR-based leverage risk limit if it: (1) Meets the definition
of a ``leveraged/inverse investment vehicle'' in the proposed sales
practices rules; (2) limits the investment results it seeks to 300% of
the return (or inverse of the return) of the underlying index; and (3)
discloses in its prospectus that it is not subject to proposed rule
18f-4's limit on fund leverage risk.\639\ We estimate that 269 funds
would be subject to the proposed prospectus disclosure requirement for
leveraged/inverse funds.\640\
---------------------------------------------------------------------------
\639\ See proposed rule 18f-4(c)(4); supra section II.G
(discussing the alternative requirements for leveraged/inverse
funds).
\640\ See supra note 467 and accompanying text (164 leveraged/
inverse ETFs + 105 leveraged mutual funds).
---------------------------------------------------------------------------
Table 5 below summarizes the proposed PRA initial and ongoing
annual burden estimates associated with the disclosure requirement in
the proposed rule's alternative provision for leveraged/inverse funds.
We do not estimate that there will be any initial or ongoing external
costs associated with this proposed disclosure requirement.
Table 5--Disclosure Requirement Associated With Leveraged/Inverse Funds PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \1\ Internal time
hours hours costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Leveraged/inverse fund prospectus 0 .25 x $309 (compliance $77
disclosure. manager).
0 .25 x 365 (compliance 91
attorney).
----------------------------------------------------------------------------
Total annual burden per fund... .............. 1 ...................... 168
Number of funds............ .............. x 269 ...................... x 269
----------------------------------------------------------------------------
Total annual burden............ .............. 269 ...................... 45,192
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627.
5. Disclosure Changes for Money Market Funds
Money market funds are excluded from the scope of the rule and
could not rely on proposed rule 18f-4 to enter into derivatives
transactions or other transactions addressed in the proposed rule.\641\
To the extent a money market fund currently discloses in its prospectus
that it may use any of these transactions--even if it is not currently
entering into these transactions--money market funds would be subject
to the burdens associated with making disclosure changes to their
prospectuses. We estimate that 413 funds could be subject to such
disclosure changes on account of money market funds' exclusion from the
proposed rule.\642\
---------------------------------------------------------------------------
\641\ See proposed rule 18f-4(a) (defining the term ``Fund'' to
``. . . not include a registered open-end company that is regulated
as a money market fund''); supra section II.A.1 (discussing the
exclusion of money market funds from the scope of the proposed
rule).
\642\ See supra note 454 and accompanying text. This likely
overestimates the total number of funds subject to these disclosure
changes, because we believe that money market funds currently do not
typically engage in derivatives transactions or the other
transactions addressed by proposed rule 18f-4. See supra section
II.A.1.
---------------------------------------------------------------------------
Table 6 below summarizes the proposed PRA initial and ongoing
annual burden estimates associated with disclosure changes that money
market funds could make because of their exclusion from proposed rule
18f-4.\643\ We do not estimate that there will be any initial or
ongoing external costs associated with this disclosure change
requirement.
---------------------------------------------------------------------------
\643\ These per-fund burden estimates likely overestimate the
total burden associated with these disclosure changes. See supra
note 641.
[[Page 4537]]
Table 6--Disclosure Changes for Money Market Funds PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \1\ Internal time
hours hours costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Money market prospectus disclosure .75 .25 x $309 (compliance $77
changes. manager).
.75 .25 x $365 (compliance 91
attorney).
----------------------------------------------------------------------------
Total annual burden per fund... .............. .5 ...................... 168
Number of funds............ .............. x 413 ...................... x 413
----------------------------------------------------------------------------
Total annual burden............ .............. 207 ...................... 69,384
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627.
6. Policies and Procedures for Limited Derivatives Users
Proposed rule 18f-4 would require funds relying on the limited
derivatives user provisions to adopt and implement written policies and
procedures reasonably designed to manage the fund's derivatives
risks.\644\ Only funds that limit their derivatives exposure to 10% of
their net assets or that use derivatives transactions solely to hedge
certain currency risks would be permitted to rely on these provisions.
We estimate that 2,398 funds would be subject to the limited
derivatives users requirements.\645\ In addition to the initial burden
to document the policies and procedures, we estimate that limited
derivatives users would have an ongoing burden associated with any
review and revisions to its policies and procedures to ensure that they
are ``reasonably designed'' to manage the fund's derivatives risks.
Below we estimate the initial and annual ongoing burdens associated
with documentation and any review and revision of the limited
derivatives users' policies and procedures.
---------------------------------------------------------------------------
\644\ See proposed rule 18f-4(c)(3); supra section II.E
(discussing the proposed policies and procedures requirement for
limited derivatives users).
\645\ See supra paragraph following note 525.
---------------------------------------------------------------------------
Table 7 below summarizes the proposed PRA initial and ongoing
annual burden estimates associated with the policies and procedures
requirement for limited derivatives users under proposed rule 18f-4. We
do not estimate that there will be any initial or ongoing external
costs associated with the policies and procedures requirement for
limited derivatives users.
Table 7--Policies and Procedures for Limited Derivatives Users PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \2\ Internal time
hours hours \1\ costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Written policies and procedures.... 3 1 x $329 (senior manager) $329
\ 4\.
3 1 x $365 (compliance 365
attorney) \ 4\.
Review of policies and procedures.. 0 .25 $329 (senior manager) 82.25
\4\.
0 .25 $365 (compliance 91.25
attorney) \4\.
----------------------------------------------------------------------------
Total annual burden per fund... .............. 2.5 ...................... 867.50
Number of funds............ .............. x 2,398 ...................... x 2,398
----------------------------------------------------------------------------
Total annual burden............ .............. 5,995 ...................... 2,080,265
----------------------------------------------------------------------------------------------------------------
Notes:
1. For ``Written Policies and Procedures,'' these estimates include initial burden estimates annualized over a
three-year period.
2. See supra note 627.
7. Recordkeeping Requirements
Proposed rule 18f-4 would require a fund to maintain certain
records documenting its derivatives risk management program's written
policies and procedures, along with its stress test results, VaR
backtesting results, internal reporting or escalation of material risks
under the program, and reviews of the program.\646\ The proposed rule
would also require a fund to maintain records of any materials provided
to the fund's board of directors in connection with approving the
designation of the derivatives risk manager and any written reports
relating to the derivatives risk management program.\647\ A fund that
is required to comply with the proposed VaR test would also have to
maintain records documenting the determination of: Its portfolio VaR;
the VaR of its designated
[[Page 4538]]
reference indexes, as applicable; its VaR ratio (the value of the VaR
of the Fund's portfolio divided by the VaR of the designated reference
index), as applicable; and any updates to any of its VaR calculation
model and the basis for any material changes to its VaR model.\648\ A
fund that is a limited derivatives users under the proposed rule would
have to maintain a written record of its policies and procedures that
are reasonably designed to manage derivatives risks.\649\ A fund
engaging in unfunded commitment agreements would be required to
maintain records documenting the sufficiency of its funds to meet its
obligations with respect to all unfunded commitment agreements.\650\
---------------------------------------------------------------------------
\646\ See proposed rule 18f-4(c)(6)(i)(A); supra section II.K
(discussing the proposed recordkeeping requirements).
\647\ See proposed rule 18f-4(c)(6)(i)(B).
\648\ See proposed rule 18f-4(c)(6)(i)(C).
\649\ See proposed rule 18f-4(c)(6)(i)(D).
\650\ See proposed rule 18f-4(e)(2).
---------------------------------------------------------------------------
We estimate that 5,091 funds would be subject to the recordkeeping
requirements.\651\ Below we estimate the average initial and ongoing
annual burdens associated with the recordkeeping requirements. This
average takes into account that some funds such as limited derivatives
users may have less extensive recordkeeping burdens than other funds
that use derivatives more substantially.
---------------------------------------------------------------------------
\651\ See supra notes 467, 498 and accompanying text, and
paragraph following note 525 (2,693 funds that would be subject to
the proposed derivatives risk management program and limit on fund
leverage risk requirements + 2,398 funds relying on the limited
derivatives user exception and complying with the related limited
derivatives user requirements).
---------------------------------------------------------------------------
Table 8 below summarizes the proposed PRA estimates associated with
the recordkeeping requirements in rule 18f-4.
Table 8--Recordkeeping PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal Internal Initial Annual
initial burden annual burden Wage rate \2\ Internal time external cost external cost
hours hours \1\ costs burden burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Establishing recordkeeping policies and 1.5 .5 $62 (general clerk)....... $31 $1,800 $600
procedures.
1.5 .5 $95 (senior computer 47.50 .............. ..............
operator).
Recordkeeping.......................... 0 2 x 62 (general clerk)........ 31 0 0
0 2 x $95 (senior computer 47.50 .............. ..............
operator).
----------------------------------------------------------------------------------------------------------------
Total annual burden per fund....... .............. 5 .......................... 157 .............. 600
Number of funds................ .............. x 5,091 .......................... x 5,091 .............. 5,091
----------------------------------------------------------------------------------------------------------------
Total annual burden................ .............. 25,455 .......................... 799,287 .............. 3,054,600
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. For ``Establishing Recordkeeping Policies and Procedures,'' these estimates include initial burden estimates annualized over a three-year period.
2. See supra note 627.
8. Proposed Rule 18f-4 Total Estimated Burden
As summarized in Table 9 below, we estimate that the total hour
burdens and time costs associated with proposed rule 18f-4, including
the burden associated with documenting the derivatives risk management
program, board oversight and reporting, disclosure requirements
associated with the proposed VaR tests, disclosure requirements
associated with the alternative requirements for leveraged/inverse
funds, policies and procedures development for limited derivatives
users, and recordkeeping, amortized over three years, would result in
an average aggregate annual burden of 109,754 hours and an average
aggregate annual monetized time cost of $54,761,797. We also estimate
that, amortized over three years, there would be external costs of
$3,054,600 associated with this collection of information. Therefore,
each fund that relies on the rule would incur an average annual burden
of approximately 20.56 hours, at an average annual monetized time cost
of approximately $10,757, and an external cost of $600 to comply with
proposed rule 18f-4.\652\
---------------------------------------------------------------------------
\652\ These per-fund burden estimates likely overestimate the
total burden of proposed rule 18f-4 because not all funds (e.g.,
limited derivatives users) would incur the various burdens set forth
in the table.
Table 9--Proposed Rule 18f-4 Total PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal
Internal hour burden time External cost
burden cost burden
----------------------------------------------------------------------------------------------------------------
Derivatives risk management program............................. 48,474 $19,195,704 $0
Board oversight and reporting................................... 26,930 31,739,698 0
Disclosure requirement associated with limit on fund leverage 2,424 816,888 0
risk...........................................................
Disclosure requirement associated with alternative requirements 269 45,192 0
for leveraged/inverse funds....................................
Disclosure changes for money market funds....................... 207 69,384 0
Policies and procedures for limited derivatives users........... 5,995 2,080,265 0
Recordkeeping requirements...................................... 25,455 799,287 3,054,600
-----------------------------------------------
Total annual burden......................................... 109,754 54,746,418 3,054,600
Number of funds......................................... / 5,091 / 5,091 / 5,091
-----------------------------------------------
Average annual burden per fund.............................. 20.56 10,754 600
----------------------------------------------------------------------------------------------------------------
[[Page 4539]]
C. Proposed Rule 15l-2: Sales Practices Rule for Broker-Dealers
Proposed rule 15l-2 would impose burdens on registered broker-
dealers relating to investments in leveraged/inverse investment
vehicles by their retail customers.\653\ The proposed rule is designed
to address investor protection concerns relating to leveraged/inverse
investment vehicles by helping to ensure that retail investors in these
products are capable of evaluating their characteristics and the unique
risks they present. The collections of information under proposed rule
15l-2, discussed below, would assist the Commission with its
accounting, auditing and oversight functions. The respondents to the
proposed rule would be broker-dealers registered under the Exchange Act
with retail customers that transact in leveraged/inverse investment
vehicles. Compliance with proposed rule 15l-2 would be mandatory for
all such broker-dealers. To the extent that records required to be
created and maintained by broker-dealers under the proposed rule are
provided to the Commission in connection with examinations or
investigations, such information would be kept confidential subject to
the provisions of applicable law.
---------------------------------------------------------------------------
\653\ Specifically, the proposed sales practices rules (proposed
rule 15l-2, as well as proposed rule 211(h)-1 under the Advisers
Act), would require broker-dealers and investment advisers to engage
in due diligence before accepting or placing an order for a retail
investor to trade a leveraged/inverse investment vehicle or
approving an investor's account for such trading. See supra section
II.G.2.
---------------------------------------------------------------------------
We estimate that, as of December 31, 2018, there were approximately
2,766 broker-dealers registered with the Commission that reported some
sales to retail customer investors.\654\ We further estimate that 700
of those broker dealers with retail customer accounts (approximately
25%) have retail customer accounts that invest in leveraged/inverse
investment vehicles.
---------------------------------------------------------------------------
\654\ Our estimates relating to retail sales by broker-dealers
are based on data obtained from Form BD and Form BR. See also supra
note 543 and accompanying text.
---------------------------------------------------------------------------
1. Due Diligence and Account Approval
Under proposed rule 15l-2, before accepting an order from a
customer that is a natural person (or the legal representative of a
natural person) to buy or sell shares of a leveraged/inverse investment
vehicle, or approve such a customer's account to engage in those
transactions, the broker-dealer must approve the customer's account to
engage in those transactions in accordance with the proposed rule.\655\
To make this determination, the broker-dealer must exercise due
diligence to ascertain certain facts about the customer, his or her
financial situation, and investment objectives. To comply with this due
diligence requirement, the broker-dealer must seek to obtain certain
information described in the proposed rule. This proposed rule is
modeled, in large part, after the FINRA rule requiring due diligence
and account approval for retail investors to trade in options. Based on
our understanding of how broker-dealers comply with the FINRA options
account requirements, we believe that a common way for broker-dealers
to comply with this due diligence obligation would be to utilize in-
house legal and compliance counsel, as well as in-house computer and
website specialists, to create an online form for customers to provide
the required information for approval of their accounts to trade in
leveraged/inverse investment vehicles. We also believe that a portion
of the due diligence would be performed by individuals associated with
a broker-dealer or by telephone or in-person meetings with investors.
Based on our understanding of current broker-dealer practices, we do
not believe there would be any initial or ongoing external costs
associated with the proposed broker-dealer due diligence requirement.
---------------------------------------------------------------------------
\655\ See supra section II.G.2.b.
---------------------------------------------------------------------------
Currently, there are 105 leveraged/inverse mutual funds, 164
leveraged/inverse ETFs, and 17 exchange-listed commodity- or currency-
based trusts or funds that meet the definition of ``leveraged/inverse
investment vehicle'' under the proposed rule.\656\ Accordingly, there
are 286 leveraged/inverse investment vehicles in total for which a
broker-dealer would be required to approve a retail customer's account
before the customer could transact in the shares of those vehicles.
Based on our experience with broker-dealers and leveraged/inverse
investment vehicles, we estimate that each of these leveraged/inverse
investment vehicles is held by approximately 2,500 separate retail
investor accounts held by registered broker dealers, for a total of
715,000 existing accounts requiring approval to trade in leveraged/
inverse investment vehicles. We further estimate that approximately
10,000 new retail accounts will be opened each year requiring approval
to trade in leveraged/inverse investment vehicles.\657\
---------------------------------------------------------------------------
\656\ See supra note 467 and accompanying text.
\657\ See supra note 545 and accompanying text.
---------------------------------------------------------------------------
Table 10 below summarizes our initial and ongoing PRA burden
estimates associated with the due diligence and account approval
requirements in proposed rule 15l-2. Based on our understanding of
current broker-dealer practices, we do not estimate that there will be
any initial or ongoing external costs associated with the proposed due
diligence and account approval requirements.
Table 10--Proposed Rule 15l-2 Due Diligence and Account Approval PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal Internal Initial Annual
initial annual burden Wage rate \2\ Internal time external cost external cost
burden hours hours \1\ costs burden burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Development and implementation of 6 2 x $365 (compliance attorney) $730 .............. ..............
customer due diligence.
9 3 x 284 (senior systems 852 .............. ..............
analyst).
12 4 x 331 (senior programmer)... 1,324 .............. ..............
Annual burden per broker-dealer........ .............. 9 .......................... 2,906 .............. ..............
Estimated number of affected broker- .............. 700 .......................... 700 .............. ..............
dealers.
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
Total burden (I)................... .............. 6,300 .......................... 2,034,200 .............. ..............
----------------------------------------------------------------------------------------------------------------
Customer due diligence................. 3 1 x 365 (compliance attorney). 365 .............. ..............
3 1 hour x 70 (compliance clerk)..... 70 .............. ..............
Evaluation of customer information for 1 .33 x $309 (compliance manager). 101.97 .............. ..............
account approval/disapproval.
[[Page 4540]]
Total annual burden per customer 7 2.33 .......................... 536.97 .............. ..............
account.
Estimated number of affected customer .............. \3\ x .......................... x 248,333.33 x 248,333.33 x 248,333.33
accounts. 248,333.33
----------------------------------------------------------------------------------------------------------------
Total burden (II).................. .............. 578,616.66 .......................... $133,347,548 .............. ..............
----------------------------------------------------------------------------------------------------------------
Total annual burden (I + II)....... .............. 584,916.66 .......................... 135,381,748 $0 $0
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.
3. We estimate that 715,000 existing customer accounts with broker-dealers would require the proposed rule 15l-2 account approval for trading in
leveraged/inverse investment vehicles, and that 10,000 new customer accounts opened each year would require such approval. Accordingly, we believe
that over a three-year period, a total of 745,000 accounts will require approval, which when annualized over a three-year period, equals 248,333.33
accounts per year.
2. Policies and Procedures
Proposed rule 15l-2 requires broker-dealers to adopt and implement
policies and procedures reasonably designed to achieve compliance with
the proposed rule's provisions.\658\ We believe that broker-dealers
likely would establish these policies and procedures by adjusting their
current systems for implementing and enforcing compliance policies and
procedures. While broker-dealers already have policies and procedures
in place to address compliance with other Commission rules (among other
obligations), they would need to update their existing policies and
procedures to account for rule 15l-2. To comply with this obligation,
we believe that broker-dealers would use in-house legal and compliance
counsel to update their existing policies and procedures to account for
the requirements of rule 15l-2. For purposes of these PRA estimates, we
assume that broker-dealers would review the policies and procedures
that they would adopt under proposed rule 15l-2 annually (for example,
to assess whether the policies and procedures continue to be
``reasonably designed'' to achieve compliance with the proposed rule).
We therefore have estimated initial and ongoing burdens associated with
the proposed policies and procedures requirement. As discussed above,
we estimate that approximately 700 broker dealers have retail customer
accounts that invest in leveraged/inverse investment vehicles. We do
not estimate that there will be any initial or ongoing external costs
associated with the proposed policies and procedures requirement.
---------------------------------------------------------------------------
\658\ See supra section II.G.2.b.
---------------------------------------------------------------------------
Table 11 below summarizes our initial and ongoing annual PRA burden
estimates associated with the policies and procedures requirement in
proposed rule 15l-2.
Table 11--Proposed Rule 15l-2 Policies and Procedures PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \2\ Internal time
hours hours \1\ costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Establishing and implementing rule 3 1 x $309 (compliance $309.00
15l-2 policies and procedures. manager).
1 0.33 x 365 (compliance $20.45
attorney).
1 0.33 x 530 (chief compliance 174.90
officer).
Reviewing and updating rule 15l-2 .............. 1 x 309 (compliance 309.00
policies and procedures. manager).
.............. 1 x 365 (compliance 365.00
attorney).
.............. 1 x 530 (chief compliance 530.00
officer).
Total annual burden per broker- .............. 4.66 ...................... 1,808.35
dealer.
Number of affected broker-dealers.. .............. x 700 ...................... x 700
----------------------------------------------------------------------------
Total annual burden............ .............. 3,262 ...................... 1,265,845
----------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.
3. Recordkeeping
Under proposed rule 15l-2, a broker-dealer would have to maintain a
written record of the information that it obtained under the rule 15l-2
due diligence requirement and its written approval of the customer's
account, as well as the firm's policies and procedures, for a period of
not less than six years (the first two years in an easily accessible
place) after the date of the closing of the client's account.\659\ To
comply with this obligation, we believe that broker-dealers would use
in-house personnel to compile and maintain the relevant records. We do
not estimate that there will be any initial or ongoing external costs
associated with this requirement.
---------------------------------------------------------------------------
\659\ See supra section II.G.2.c.
---------------------------------------------------------------------------
Table 12 below summarizes our PRA initial and onging annual burden
estimates associated with the recordkeeping requirement in proposed
rule 15l-2.
[[Page 4541]]
Table 12--Proposed Rule 15l-2 Recordkeeping PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial annual burden Wage rate \1\ Internal time
burden hours hours costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Recordkeeping...................... 0 1 x $62 (general clerk)... $62
----------------------------------------------------------------------------------------------------------------
0 1 x $95 (senior computer 95
operator).
Total annual burden per broker- 0 2 ...................... 157
dealer.
Number of affected broker-dealers.. x 700 x 700 ...................... x 700
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
Total annual burden............ 0 1,400 ...................... 109,900
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627.
4. Proposed Rule 15l-2 Total Estimated Burden
As summarized in Table 13 below, we estimate that the total hour
burdens and time costs associated with proposed rule 15l-2, including
the burden associated with the due diligence and account approval
requirement, the policies and procedures requirement, and the
recordkeeping requirement, would result in an average aggregate annual
burden of 589,578.66 hours and an average aggregate time cost of
$136,757,493. Therefore, each broker-dealer would incur an annual
burden of approximately 842.26 hours, at an average time cost of
approximately $195,367.85, to comply with proposed rule 15l-2.
Table 13--Proposed Rule 15l-2 Total PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden time External cost
burden hours cost burden
----------------------------------------------------------------------------------------------------------------
Due diligence and account approval.............................. 584,916.66 $135,381,748 $0
Policies and procedures......................................... 3,262 1,265,845 0
Recordkeeping................................................... 1,400 109,900 0
Total annual burden......................................... 589,578.66 136,757,493 0
-----------------------------------------------
Number of affected broker-dealers....................... / 700 / 700 / 700
-----------------------------------------------
Average annual burden per affected broker-dealer............ 842.26 195,367.85 0
----------------------------------------------------------------------------------------------------------------
D. Proposed Rule 211(h)-1: Sales Practices for Registered Investment
Advisers
Proposed 211(h)-1 would impose burdens on registered investment
advisers relating to investments in leveraged/inverse investment
vehicles by their retail clients.\660\ Proposed rule 211(h)-1 is
designed to address investor protection concerns relating to leveraged/
inverse investment vehicles by helping to ensure that retail investors
in these products are capable of evaluating their characteristics and
the unique risks they present. The Commission also believes that the
collections of information under proposed rule 211(h)-1, discussed
below, would assist the Commission with its accounting, auditing and
oversight functions.
---------------------------------------------------------------------------
\660\ See supra note 652.
---------------------------------------------------------------------------
The respondents to the proposed rule would be investment advisers
registered under the Advisers Act that place orders for retail clients
to invest in leveraged/inverse investment vehicles. Compliance with
proposed rule 211(h)-1 would be mandatory for all such investment
advisers. To the extent that records required to be created and
maintained by investment advisers under the proposed rule are provided
to the Commission in connection with examinations or investigations,
such information would be kept confidential subject to the provisions
of applicable law.
We estimate that, as of December 31, 2018, approximately 8,235
investment advisers registered with the Commission have some portion of
their business dedicated to retail investors, including either
individual high net worth clients or individual non-high net worth
clients.\661\ Based on our experience with registered investment
advisers, we further estimate that 2,000 of these investment advisers
with retail client accounts (approximately 25%) have retail client
accounts that invest in leveraged/inverse investment vehicles. As such,
the investment advisers for those client accounts would be subject to
the requirements of proposed rule 211(h)-1.\662\
---------------------------------------------------------------------------
\661\ Based on responses to Item 5.D of Form ADV.
\662\ See supra note 547 and accompanying paragraph.
---------------------------------------------------------------------------
1. Due Diligence and Account Approval
Under proposed rule 211(h)-1, before placing an order for the
account of a client that is a natural person (or the legal
representative of a natural person) to buy or sell shares of a
leveraged/inverse investment vehicle, or approving such a client's
account to engage in those transactions, the investment adviser must
approve the client's account to engage in those transactions in
accordance with the proposed rule.\663\ To make this determination, the
adviser must exercise due diligence to ascertain certain facts about
the client, his or her financial situation, and investment objectives.
To
[[Page 4542]]
comply with this due diligence requirement, the investment adviser must
seek to obtain certain information described in the proposed rule.
Based on our understanding of how broker-dealers comply with the FINRA
options account requirements, as discussed above (which we assume, for
purposes of this PRA estimate, that investment advisers could model
their compliance programs after), we believe that investment advisers
likely would comply with this due diligence obligation by utilizing in-
house legal and compliance counsel, as well as in-house computer and
website specialists, to create an online form for clients to complete
with the required information for approval of their accounts to trade
in leveraged/inverse investment vehicles.\664\ We also believe that a
portion of the due diligence would be performed by individuals
associated with an investment adviser by telephone or in-person
meetings with investors.
---------------------------------------------------------------------------
\663\ See proposed rule 211(h)-1; supra section II.G.2.
\664\ See supra paragraph accompanying note 654.
---------------------------------------------------------------------------
Currently, there are 105 leveraged/inverse mutual funds, 164
leveraged/inverse ETFs, and 17 exchange-listed commodity- or currency-
based trusts or funds that meet the definition of ``leveraged/inverse
investment vehicle'' under the proposed rule.\665\ Accordingly, there
are 286 leveraged/inverse investment vehicles in total for which an
investment adviser would be required to approve a retail client's
account before the client could transact in the shares those vehicles.
Based on our experience with registered investment advisers, we
estimate that each of these leveraged/inverse investment vehicles is
held by approximately 2,500 separate retail investor accounts held by
investment advisers, for a total of 715,000 existing accounts requiring
approval to trade in leveraged/inverse investment vehicles. Based on
our experience, we further estimate that approximately 10,000 new
retail accounts will be opened each year requiring approval to trade in
leveraged/inverse investment vehicles.\666\
---------------------------------------------------------------------------
\665\ See supra note 467 and accompanying text.
\666\ See supra note 547 and accompanying text.
---------------------------------------------------------------------------
Table 14 below summarizes our initial and ongoing PRA burden
estimates associated with the due diligence requirement in proposed
rule 211(h)-1. We do not estimate that there will be any initial or
ongoing external costs associated with the proposed due diligence and
approval requirements.
Table 14--Proposed Rule 211(h)-1 Due Diligence and Account Approval PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal Internal Initial Annual
initial burden annual burden Wage rate \2\ Internal time external cost external cost
hours hours \1\ costs burden burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Development and implementation of 6 2 x $365 (compliance attorney) $730 $0 $0
client due diligence.
9 3 x $284 (senior systems 852 .............. ..............
analyst).
12 4 x $331 (senior programmer).. 1,324 .............. ..............
Annual burden per investment adviser... .............. 9 .......................... 2,906 .............. ..............
Estimated number of affected investment .............. 2,000 .......................... 2,000 .............. ..............
advisers.
----------------------------------------------------------------------------------------------------------------
Total burden (I)................... .............. 18,000 .......................... 5,812,000 .............. ..............
Client due diligence................... 3 1 x $365 (compliance attorney) 365 .............. ..............
3 1 x $70 (compliance clerk).... 70 .............. ..............
Evaluation of client information for 1 .33 $309 (compliance manager). 101.97 .............. ..............
account approval/disapproval.
Total annual burden per client account. 7 2.33 .......................... 536.97 .............. ..............
Estimated number of affected client \3\ x x 248,333.33 .............. ..............
accounts. 248,333.33
----------------------------------------------------------------------------------------------------------------
Total burden (II).................. .............. 578,616.66 .......................... 133,347,548 .............. ..............
----------------------------------------------------------------------------------------------------------------
Total annual burden (I + II)....... .............. 596,616.66 .......................... 139,159,548 0 0
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.
3. We estimate that 715,000 existing client accounts with registered investment advisers would require the proposed rule 211(h)-1 account approval for
trading in leveraged/inverse investment vehicles, and that 10,000 new client accounts opened each year would require such approval. Accordingly, we
believe that over a three-year period, a total of 745,000 client accounts would require approval, which when annualized over a three-year period, is
248,333.33 accounts per year.
2. Policies and Procedures
Proposed rule 211(h)-1 requires investment advisers to adopt and
implement policies and procedures reasonably designed to achieve
compliance with the proposed rule's provisions.\667\ We believe that
investment advisers likely would establish these policies and
procedures by adjusting their current systems for implementing and
enforcing compliance policies and procedures. While investment advisers
already have policies and procedures in place to address compliance
with other Commission rules (among other obligations), they would need
to update their existing policies and procedures to account for rule
211(h)-1. To comply with this obligation, we believe that investment
advisers would use in-house legal and compliance counsel to update
their existing policies and procedures to account for the requirements
of rule 211(h)-1. For purposes of these PRA estimates, we assume that
investment advisers would review the policies and procedures that they
would adopt under proposed rule 211(h)-1 annually (for example, to
assess whether the policies and procedures continue to be ``reasonably
designed'' to achieve compliance with the proposed rule, and in
compliance with Advisers Act rule 206(4)-7(b)). We therefore have
estimated initial and ongoing burdens associated with the proposed
policies and procedures requirement. We do not estimate that there will
be any initial or
[[Page 4543]]
ongoing external costs associated with the proposed policies and
procedures requirement.
---------------------------------------------------------------------------
\667\ See supra section II.G.2.b.
---------------------------------------------------------------------------
Table 15 below summarizes our PRA estimates associated with the
policies and procedures requirement in proposed rule 211(h)-1.
Table 15--Proposed Rule 211(h)-1 Policies and Procedures PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \2\ Internal time
hours hours \1\ costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Establishing and implementing rule 3 1 hour x $309 (compliance $309
211(h)-1 policies and procedures. manager).
1 0.33 x $365 (compliance 120.45
attorney).
1 0.33 x $530 (chief compliance 174.90
officer).
Reviewing and updating rule 211(h)- .............. 1 $309 (compliance 309
1 policies and procedures. manager).
1 $365 (compliance 365
attorney).
1 $530 (chief compliance 530
officer).
Total annual burden per investment .............. 4.66 ...................... 1,808.35
adviser.
Number of affected investment .............. x 2,000 ...................... x 2,000
advisers.
----------------------------------------------------------------------------
Total annual burden............ .............. 9,320 ...................... 3,616,700
----------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.
3. Recordkeeping
Under the proposed rule, a registered investment adviser would have
to maintain a written record of the information that it obtained under
the rule 211(h)-1 due diligence requirement and its written approval of
the client's account for buying or selling shares of leveraged/inverse
investment vehicles, as well as the firm's policies and procedures, for
a period of not less than six years (the first two years in an easily
accessible place) after the date of the closing of the client's
account.\668\ To comply with this obligation, we believe that
investment advisers would use in-house personnel to compile and
maintain the relevant records. We do not estimate that there will be
any initial or ongoing external costs associated with this requirement.
---------------------------------------------------------------------------
\668\ See supra section II.G.2.c.
---------------------------------------------------------------------------
Table 16 below summarizes our PRA estimates associated with the
recordkeeping requirement in proposed rule 211(h)-1.
Table 16--Proposed Rule 211(h)-1 Recordkeeping PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \2\ Internal time
hours hours \1\ costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Recordkeeping...................... 0 2.5 x $62 (general clerk)... $155
0 2.5 x $95 (senior computer 237.50
operator).
Total annual burden per investment 0 5 ...................... 392.50
adviser.
Number of affected investment x 2,000 x 2,000 ...................... x 2,000
advisers.
----------------------------------------------------------------------------
Total annual burden............ 0 10,000 ...................... 785,000
----------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627.
4. Proposed Rule 211(h)-1 Total Estimated Burden
As summarized in Table 17 below, we estimate that the total hour
burdens and time costs associated with proposed rule 211(h)-1,
including the burden associated with the due diligence and account
approval requirement, the policies and procedures requirement, and the
recordkeeping requirement, would result in an average aggregate annual
burden of 615,936.66 hours and an average aggregate time cost of
$143,561,248. Therefore, each investment adviser would incur an annual
burden of approximately 307.97 hours, at an average time cost of
approximately $71,780.62 to comply with proposed rule 211(h)-1.
[[Page 4544]]
Table 17--Proposed Rule 211(h)-1 Total Estimated PRA Burden
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden burden time External cost
hours cost burden
----------------------------------------------------------------------------------------------------------------
Due diligence and account approval.............................. 596,616.66 $139,159,548 $0
Policies and procedures......................................... 9,320 3,616,700 0
Recordkeeping................................................... 10,000 785,000 0
-----------------------------------------------
Total annual burden......................................... 615,936.66 143,561,248 0
Number of affected investment advisers.................. / 2,000 / 2,000 / 2,000
-----------------------------------------------
Average annual burden per investment adviser................ 307.97 71,780.62 0
----------------------------------------------------------------------------------------------------------------
E. Rule 6c-11
We recently adopted rule 6c-11, which permits ETFs that satisfy
certain conditions to operate without first obtaining an exemptive
order from the Commission.\669\ The rule is designed to create a
consistent, transparent, and efficient regulatory framework for such
ETFs and facilitate greater competition and innovation among ETFs. Rule
6c-11 includes a provision excluding leveraged/inverse ETFs from the
scope of ETFs that may rely on that rule. To promote a level playing
field among ETFs, and in view of the other conditions we are proposing
to place on leveraged/inverse ETFs under proposed rule 18f-4 and on
transactions in leveraged/inverse ETFs' securities under proposed rule
15l-2 and 211(h)-1, we are proposing to amend rule 6c-11 to permit
leveraged/inverse ETFs to rely on that rule. Because we believe this
proposed amendment would increase the number of funds relying on rule
6c-11, we are updating the PRA analysis for rule 6c-11 to account for
any burden increases that would result from this increase in
respondents to that rule. We are not updating the rule 6c-11 PRA
analysis in any other respect.
---------------------------------------------------------------------------
\669\ See supra notes 352-355 and accompanying text.
---------------------------------------------------------------------------
Rule 6c-11 requires an ETF to disclose certain information on its
website, to maintain certain records, and to adopt and implement
certain written policies and procedures. The purpose of these
collections of information is to provide useful information to
investors who purchase and sell ETF shares in secondary markets and to
allow the Commission to better monitor reliance on rule 6c-11 and will
assist the Commission with its accounting, auditing and oversight
functions.
The respondents to rule 6c-11 will be ETFs registered as open-end
management investment companies other than share class ETFs and non-
transparent ETFs. This collection will not be mandatory, but will be
necessary for those ETFs seeking to operate without individual
exemptive orders, including all ETFs whose existing exemptive orders
will be rescinded. Information provided to the Commission in connection
with staff examinations or investigations will be kept confidential
subject to the provisions of applicable law.
Under current PRA estimates, 1,735 ETFs would be subject to these
requirements. The current PRA estimates for rule 6c-11 include 74,466.2
total internal burden hours, $24,771,740.10 in internal time costs, and
$1,735,000 in external time costs.
We continue to believe that the current annual burden and cost
estimates for rule 6c-11 are appropriate, but estimate that the
proposed amendment to rule 6c-11 would result in an increase in the
number of respondents. Specifically, we estimate that an additional 164
ETFs (all leveraged/inverse ETFs) would rely on rule 6c-11, resulting
in an increase in the number of respondents to 1,899 ETFs.\670\ Table
18 below summarizes these revisions to the estimated annual responses,
burden hours, and burden-hour costs based on the proposed amendment to
rule 6c-11.
---------------------------------------------------------------------------
\670\ See supra note 467 and accompanying text.
Table 18--Rule 6c-11 PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Previously Updated Previously Updated
estimated estimated Previously Updated estimated estimated estimated
annual annual estimated annual annual internal annual annual
internal hour internal hour internal burden time burden cost external cost external cost
burden \1\ burden \2\ time cost burden burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Website disclosure................................ 33,398.75 36,555.75 $10,717,945.15 $11,731,053.51 $1,735,000 $1,899,000
Recordkeeping..................................... 8,675 9,495 680,987.50 745,357.50 0 0
Policies and procedures........................... 32,392.45 35,454.33 13,372,807.45 14,636,865.33 0 0
-----------------------------------------------------------------------------------------------------
Total annual burden........................... 74,466.2 81,505.08 24,771,740.10 27,113,276.34 1,735,000 1,899,000
Number of affected ETFs................... / 1,735 / 1,899 / 1,735 / 1,899 / 1,735 / 1,899
-----------------------------------------------------------------------------------------------------
Average annual burden per ETF................. 42.92 42.92 14,277.66 14,277.66 1,000 1,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. The previously estimated burdens and costs in this table are based on an estimate of 1,735 ETFs relying on rule 6c-11.
2. The updated estimated burdens and costs in this table are based on an estimate of 164 leveraged/inverse ETFs that would rely on rule 6c-11 pursuant
to the proposed amendment to that rule, for a total estimate of 1,899 ETFs that would rely on rule 6c-11.
[[Page 4545]]
F. Form N-PORT
We are proposing to amend Form N-PORT to add new items to Part B
(``Information About the Fund''), as well as to make certain amendments
to the form's General Instructions.
Form N-PORT, as amended, would require funds to provide information
about their derivatives exposure.\671\ We estimate that 5,091 funds
would be subject to this exposure-related disclosure requirement.\672\
---------------------------------------------------------------------------
\671\ See proposed Item B.9 of Form N-PORT; supra section
II.H.1.a.
\672\ See supra notes 467, 498 and accompanying text, and
paragraph following note 525 (2,693 funds that would be subject to
the proposed derivatives risk management program and limit on fund
leverage risk requirements + 2,398 funds relying on the limited
derivatives user exception and complying with the related limited
derivatives user requirements).
---------------------------------------------------------------------------
In addition, funds that are subject to the limit on fund leverage
risk in proposed rule 18f-4 would have to report certain VaR-related
information, including: (1) The fund's highest daily VaR during the
reporting period and its corresponding date; and (2) the fund's median
daily VaR for the reporting period. Funds subject to the relative VaR
test during the reporting period also would have to report: (1) The
name of the fund's designated reference index, (2) the index
identifier, (3) the fund's highest daily VaR ratio during the reporting
period and its corresponding date; and (4) the fund's median daily VaR
ratio for the reporting period.\673\ Finally, all funds that are
subject to the proposed limit on fund leverage risk also would have to
report the number of exceptions that the fund identified as a result of
the backtesting of its VaR calculation model.\674\ We estimate that
2,424 funds would be subject to these VaR-related disclosure
requirements.\675\
---------------------------------------------------------------------------
\673\ See proposed Item B.10 of Form N-Port; supra section
II.H.1.b.
\674\ See id.
\675\ See supra paragraph following note 525.
---------------------------------------------------------------------------
Preparing reports on Form N-Port is mandatory for all management
investment companies (other than money market funds and small business
investment companies) and UITs that operate as ETFs and is a collection
of information under the PRA. The information required by Form N-Port
must be data-tagged in XML format. Responses to the reporting
requirements will be kept confidential, subject to the provisions of
applicable law, for reports filed with respect to the first two months
of each quarter; the third month of the quarter will not be kept
confidential, but made public sixty days after the quarter end. Form N-
Port is designed to assist the Commission its regulatory, disclosure
review, inspection, and policymaking roles, and to help investors and
other market participants better assess different fund products.\676\
---------------------------------------------------------------------------
\676\ The specific purposes for each of the new proposed
reporting items are discussed in section II.H.1 supra.
---------------------------------------------------------------------------
Based on current PRA estimates, we estimate that funds prepare and
file their reports on Form N-Port either by (1) licensing a software
solution and preparing and filing the reports in house, or (2)
retaining a service provider to provide data aggregation, validation
and/or filing services as part of the preparation and filing of reports
on behalf of the fund. We estimate that 35% of funds subject to the
proposed N-Port filing requirements would license a software solution
and file reports on Form N-Port in house, and the remainder would
retain a service provider to file reports on behalf of the fund.
Table 19 below summarizes our PRA initial and ongoing annual burden
estimates associated with the proposed amendments to Form N-Port.
Table 19--Form N-PORT PRA Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internal Internal Initial Annual
initial burden annual burden Wage rate \2\ Internal time external cost external cost
hours hours \1\ costs burden burden
--------------------------------------------------------------------------------------------------------------------------------------------------------
Proposed Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Report derivatives exposure information 2 \3\ 4.33 x $365 (compliance attorney) $1,580 .............. ..............
2 4.33 x $331 (senior programmer).. 1,433 .............. ..............
----------------------------------------------------------------------------------------------------------------
Total new burden for derivatives .............. 8.66 .......................... 3,013 .............. ..............
exposure information.
Number of funds for derivatives x 5,091 x 5,091
exposure information.
----------------------------------------------------------------------------------------------------------------
Total new annual burden for .............. 44,088 .......................... 15,339,183 .............. ..............
derivatives exposure information
(I).
--------------------------------------------------------------------------------------------------------------------------------------------------------
Report VaR-related information......... 2 4.33 x $365 (compliance attorney) 1,580 $5,490 $4,210
2 4.33 x $331 (senior programmer).. 1,433 .............. ..............
----------------------------------------------------------------------------------------------------------------
Total new burden for VaR-related .............. 8.66 .......................... 3,013 .............. ..............
information.
Number of funds for VaR-related x 2,424 x 2,424
information.
----------------------------------------------------------------------------------------------------------------
[[Page 4546]]
Total new annual burden for VaR- .............. 20,992 .......................... 7,303,512 .............. ..............
related information (II).
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total new annual burden (I + II)... .............. 65,080 .......................... 22,642,695 .............. \4\ 21,433,110
Current burden estimates............... .............. 1,803,826 .......................... .............. .............. 103,776,240
----------------------------------------------------------------------------------------------------------------
Revised burden estimates........... .............. 1,868,906 .......................... .............. .............. 125,209,350
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:
1. Includes initial burden estimates annualized over a three-year period.
2. See supra note 627. These PRA estimates assume that the same types of professionals would be involved in the proposed reporting requirements that we
believe otherwise would be involved in preparing and filing reports on Form N-PORT.
3. This estimate assumes that, annually after the initial 2 hours to comply with the new N-PORT requirements, each of a compliance attorney and a senior
programmer would incur 1 burden hours per filing associated with the new reporting requirements. The estimate of 4.33 hours is based on the following
calculation: ((2 hours for the first filing x 1 = 2) + (3 additional filings in year 1 x 1 hour for each of the additional 3 filings in year 1 = 3) +
(4 filings in years 2 and 3 x 1 hour per filing x 2 years) = 8)/3 = 4.33.
4. This estimate is based on the following calculation: $4,210 (average costs for funds reporting the proposed information on Form N-PORT) * 5,091 funds
(which includes funds reporting derivative exposure information and VaR-related information).
G. Form N-RN
We are proposing to amend Form N-LIQUID (which we propose to re-
title as ``Form N-RN'') to add new current reporting requirements for
funds subject to the proposed VaR-based limit on fund leverage risk
pursuant to proposed rule 18f-4.\677\ Specifically, a fund that
determines that it is out of compliance with the VaR test and has not
come back into compliance within three business days after such
determination would have to file a non-public report on Form N-RN
providing certain information regarding its VaR test breaches.\678\ If
the portfolio VaR of a fund subject to the relative VaR test were to
exceed 150% of the VaR of its designated reference index for three
business days, a fund would have to report: (1) The dates on which the
fund portfolio's VaR exceeded 150% of the VaR of its designated
reference index; (2) the VaR of its portfolio for each of these days;
(3) the VaR of its designated reference index for each of these days;
(4) the name of the designated reference index; and (5) the index
identifier. If the portfolio VaR of a fund subject to the absolute VaR
test were to exceed 10% of the value of the fund's net assets for three
business days, a fund would have to report: (1) The dates on which the
fund portfolio's VaR exceeded 10% of the value of its net assets; (2)
the VaR of its portfolio for each of these days; and (3) the value of
the fund's net assets for each of these days.
---------------------------------------------------------------------------
\677\ See supra section II.H.2.
\678\ This requirement would be implemented through the proposed
amendments to rule 30b1-10 under the Investment Company Act, and
proposed rule 18f-4(c)(7). For purposes of this PRA analysis, the
burden associated with the proposed amendments to rule 30b1-10 and
proposed rule 18f-4(c)(7) is included in the collection of
information requirements for Form N-RN.
---------------------------------------------------------------------------
In addition, if a fund that has filed Part E or Part F of Form N-RN
to report it has breached its applicable VaR test, has come back into
compliance with either the relative VaR test or the absolute VaR test,
as applicable, it must file a report on Form N-RN to indicate
that.\679\ Specifically, a fund must report the dates on which its
portfolio VaR exceeded, as applicable, 150% of the VaR of its
designated reference index (if the fund is subject to the relative VaR
test under proposed rule 18f-4(c)(2)(i)) or exceeded 15% of the value
of its net assets (if the fund is subject to the absolute VaR test
under proposed rule 18f-4(c)(2)(ii)).\680\ Furthermore, a fund must
also report the current VaR of its portfolio.\681\
---------------------------------------------------------------------------
\679\ See proposed Part G of Form N-RN.
\680\ Id.
\681\ Id.
---------------------------------------------------------------------------
A fund would have to report information for either VaR test breach,
within one business day following the third business day after the fund
has determined that its portfolio VaR exceeds either of the VaR test
thresholds, as applicable. Similarly, a fund that has come back into
compliance with its applicable VaR test would have to file such a
report within one business day. We estimate that 2,424 funds per year
would be required to comply with either of the VaR tests, and the
Commission would receive approximately 30 filing(s) per year in
response to each of the new VaR-related items that we proposed to
include on Form N-RN, as amended.\682\
---------------------------------------------------------------------------
\682\ This estimate is similar to the Commission's estimates of
the number of reports that funds, in the aggregate, would submit
annually in response to the liquidity-related items of Form N-
LIQUID. See Liquidity Adopting Release, supra note 359, at nn.1281-
1283 and accompanying paragraph. See also supra paragraph following
note 525.
---------------------------------------------------------------------------
Under the proposed amendments to Form N-RN, preparing a report on
this form would be mandatory for any fund that is out of compliance
with its applicable VaR test for more than three business days, as
described above, and for any fund that has come back into compliance
with its applicable VaR test. A report on Form N-RN is a collection of
information under the PRA. The VaR test breach information provided on
Form N-RN, as well as the information a fund provides when it has come
back into compliance, would enable the Commission to receive
information on events that could impact funds' leverage-related risk
more uniformly and efficiently and would enhance the Commission's
oversight of funds when significant fund and/or market events occur.
The Commission would be able to use the newly required information that
funds would provide on Form N-RN in its regulatory, disclosure review,
inspection, and policymaking roles. Responses to the reporting
requirements and this collection of information would be kept
confidential, subject to provisions of applicable law.
Table 20 below summarizes our PRA initial and ongoing annual burden
estimates associated with the proposed amendments to funds' current
reporting requirement. Staff estimates there will
[[Page 4547]]
be no external costs associated with this collection of information. We
further assume similar hourly and cost burdens, as well as similar
response rates, for responses to either a breach of the absolute VaR
test or the relative VaR test.
Table 20--Form N-RN PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \1\ Internal time
hours hours costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Relative or absolute VaR test breach 0 \2\ 0.005 x $365 $1.83
reports................................... (compliance
attorney)
0 0.005 x $331 (senior 1.66
programmer)
--------------------------------------------------------------------
Total new annual burden per fund....... .............. 0.01 .............. 3.49
Number of funds.................... x 2,424 x 2,424
--------------------------------------------------------------------
Total new annual burden................ .............. 24 .............. 8,460
Current burden estimates................... .............. 941 .............. ..............
--------------------------------------------------------------------
Revised burden estimates............... .............. 965 .............. ..............
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627. These PRA estimates assume that the same types of professionals would be involved in the
proposed reporting requirements that we believe otherwise would be involved in preparing and filing reports on
Form N-LIQUID.
2. This estimate is based on the assumption that, of the 2,424 funds that would be required to comply with
either of the VaR tests, on average the Commission would receive 30 reports regarding a relative or absolute
VaR test breach and that compliance attorney and senior programmer would each spend 30 minutes as part of
preparing and submitting this report.
H. Form N-CEN
We are proposing to amend Form N-CEN to require a fund to identify
whether it relied on proposed rule 18f-4 during the reporting
period.\683\ Form N-CEN is a structured form that requires registered
funds to provide census-type information to the Commission on an annual
basis. The proposed amendments also would require a fund to identify
whether it relied on any of the exemptions from various requirements
under the proposed rule, specifically: (1) Whether the fund is a
limited derivatives user excepted from the proposed rule's program
requirement, under either of the proposed exception's alternatives
(either a funds that limits its derivatives exposure to 10% of its net
assets, or a fund that uses derivatives transactions solely to hedge
certain currency risks); or (2) whether it is a leveraged/inverse
investment fund covered by the proposed sales practices rules that,
under proposed rule 18f-4, would be excepted from the proposed limit on
fund leverage risk. Finally, a fund would have to identify whether it
has entered into reverse repurchase agreements or similar financing
transactions, or unfunded commitment agreements, as provided under the
proposed rule.
---------------------------------------------------------------------------
\683\ See supra section II.H.3.
---------------------------------------------------------------------------
Preparing a report on Form N-CEN, as amended, would be mandatory
for all registered funds. Responses would not be kept confidential. We
estimate that 12,375 funds would be subject to these disclosure
requirements.\684\
---------------------------------------------------------------------------
\684\ See supra section III.B.1 (9,788 mutual funds + 1,910 ETFs
organized as an open-end fund or as a share-class of an open-end
fund + 664 registered closed-end funds + 13 variable annuity
separate accounts registered as management investment companies on
Form N-3).
---------------------------------------------------------------------------
The purpose of Form N-CEN is to satisfy the filing and disclosure
requirements of section 30 of the Investment Company Act, and of
amended rule 30a-1 thereunder. The information required to be filed
with the Commission assures the public availability of the information
and is designed to facilitate the Commission's oversight of registered
funds and its ability to monitor trends and risks.
Table 21 below summarizes our PRA initial and ongoing annual burden
estimates associated with the proposed amendments to Form N-CEN based
on current Form N-CEN practices and burdens associated with minor
amendments to the form. Staff estimates there will be no external costs
associated with this collection of information.
Table 21--Form N-CEN PRA Estimates
----------------------------------------------------------------------------------------------------------------
Internal Internal
initial burden annual burden Wage rate \1\ Internal time
hours hours costs
----------------------------------------------------------------------------------------------------------------
Proposed Estimates
----------------------------------------------------------------------------------------------------------------
Reporting derivatives-related fund 0 0.01 x $365 (compliance $3.7
census information. attorney).
0 0.01 x $331 (senior 3.3
programmer).
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
Total new annual burden per .............. 0.02 ...................... 7
fund.
Number of funds.................... x 12,375 x 12,375
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
[[Page 4548]]
Total new annual burden........ .............. 248 ...................... 86,625
Current burden estimates........... .............. 74,425 ...................... ..............
rrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr
Revised burden estimates....... .............. 74,673 ...................... ..............
----------------------------------------------------------------------------------------------------------------
Notes:
1. See supra note 627. These PRA estimates assume that the same types of professionals would be involved in the
proposed reporting requirements that we believe otherwise would be involved in preparing and filing reports on
Form N-CEN.
2. This estimate assumes each fund reporting on Form N-CEN would spend 1 to 2 minutes reporting these new data
elements.
I. Request for Comments
We request comment on whether these estimates are reasonable.
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments
in order to: (1) Evaluate whether the proposed collections of
information are necessary for the proper performance of the functions
of the Commission, including whether the information will have
practical utility; (2) evaluate the accuracy of the Commission's
estimate of the burden of the proposed collections of information; (3)
determine whether there are ways to enhance the quality, utility, and
clarity of the information to be collected; and (4) determine whether
there are ways to minimize the burden of the collections of information
on those who are to respond, including through the use of automated
collection techniques or other forms of information technology.
Persons wishing to submit comments on the collection of information
requirements of the proposed rules and amendments should direct them to
the OMB, Attention Desk Officer for the Securities and Exchange
Commission, Office of Information and Regulatory Affairs, Washington,
DC 20503, and should send a copy to, Vanessa Countryman, Secretary,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549-1090, with reference to File No. S7-24-15. OMB is required to
make a decision concerning the collections of information between 30
and 60 days after publication of this release; therefore a comment to
OMB is best assured of having its full effect if OMB receives it within
30 days after publication of this release. Requests for materials
submitted to OMB by the Commission with regard to these collections of
information should be in writing, refer to File No. S7-24-15, and be
submitted to the Securities and Exchange Commission, Office of FOIA
Services, 100 F Street NE, Washington, DC 20549-2736.
V. Initial Regulatory Flexbility Analysis
This Initial Regulatory Flexibility Analysis has been prepared in
accordance with section 3 of the Regulatory Flexibility Act.\685\ It
relates to proposed rules 18f-4, 15l-2, 211(h)-1, and proposed
amendments to Forms N-PORT, N-LIQUID (which we propose to re-title as
``Form N-RN''), and N-CEN.\686\
---------------------------------------------------------------------------
\685\ 5 U.S.C. 603.
\686\ As discussed above, the proposed conforming amendment to
Form N-2 does not change the Form N-2 collection of information. See
supra note 622. We also do not believe there to be any reporting,
recordkeeping, or compliance burden associated with this proposed
conforming amendment.
---------------------------------------------------------------------------
A. Reasons for and Objectives of the Proposed Actions
The Commission is proposing new rules 18f-4, 211(h)-1, and 15l-2,
amendments to rule 6c-11, as well as amendments to Forms N-PORT, N-
LIQUID, and N-CEN. These proposed rules, and proposed rule and form
amendments, are designed to address the investor protection purposes
and concerns underlying section 18 of the Investment Company Act and to
provide an updated and more comprehensive approach to the regulation of
funds' use of derivatives and the other transactions covered by
proposed rule 18f-4.\687\
---------------------------------------------------------------------------
\687\ See supra section I.B (discussing the requirements of
section 18, and as well as Congress' concerns underlying the limits
of section 18).
---------------------------------------------------------------------------
Proposed rule 18f-4 is designed to provide an updated,
comprehensive approach to the regulation of funds' use of derivatives
and certain other transactions, generally through the implementation of
a derivatives risk management program, limits on fund leverage risk,
board oversight and reporting, and related recordkeeping
requirements.\688\ The proposed sales practices rules are designed to
address certain specific considerations raised by certain leveraged/
inverse investment vehicles by requiring registered broker-dealers and
investment advisers to satisfy due diligence and account approval
requirements.\689\ Finally, the proposed amendments to Forms N-PORT, N-
LIQUID, and N-CEN are designed to enhance the Commission's ability to
effectively oversee the use by funds, broker-dealers and investment
advisers of the proposed rules and to provide the Commission and the
public with greater insight into the impact that funds' use of
derivatives may have on their portfolios.\690\
---------------------------------------------------------------------------
\688\ See supra section II.A.2.
\689\ See supra section II.G.
\690\ See supra section II.H.
---------------------------------------------------------------------------
All of these requirements are discussed in detail in section II of
this release. The costs and burdens of these requirements on small
funds, investment advisers, and broker-dealers are discussed below as
well as above in our Economic Analysis and Paperwork Reduction Act
Analysis, which discuss the applicable costs and burdens on all funds,
investment advisers, and broker-dealers.\691\
---------------------------------------------------------------------------
\691\ See supra sections III and IV. These sections also discuss
the professional skills that we believe compliance with the proposed
rules, and proposed rule and form amendments would entail.
---------------------------------------------------------------------------
B. Legal Basis
The Commission is proposing new rule 18f-4 under the authority set
forth in sections 6(c), 12(a), 18, 31(a), 38(a), and 61 of the
Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 80a-12(a), 80a-18,
80a-30(a), 80a-37(a), and 80a-60]. The Commission is proposing
amendments to rule 6c-11 under the authority set forth in sections
6(c), 22(c), and 38(a) of the Investment Company Act [15 U.S.C. 80a-
6(c), 22(c), and 80a-37(a)]. The Commission is proposing new rule 15l-2
under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F,
17, 23(a), and 36 of the Securities Exchange Act of 1934 [15 U.S.C.
78c, 78c(b), 78c-5, 78j, 78o(l), 78o-10, 78q, 78w(a), and 78mm]. The
Commission is proposing new rule 211(h)-1 under the authority set forth
in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment
Advisers Act of 1940 [15 U.S.C. 80b-6, 80b-6a, 80b-8, 80b-11(a), and
80b-11(h)]. The Commission is
[[Page 4549]]
proposing amendments to Form N-PORT, Form N-LIQUID (which we propose to
re-title as ``Form N-RN''), Form N-CEN, and Form N-2 under the
authority set forth in sections 8, 18, 30, and 38 of the Investment
Company Act of 1940 [15 U.S.C. 80a-8, 80a-18, 80a-29, 80a-37, 80a-63],
sections 6, 7(a), 10 and 19(a) of the Securities Act of 1933 [15 U.S.C.
77f, 77g(a), 77j, 77s(a)], and sections 10, 13, 15, 23, and 35A of the
Exchange Act [15 U.S.C. 78j, 78m, 78o, 78w, and 78ll].
C. Small Entities Subject to Proposed Rules
For purposes of Commission rulemaking in connection with the
Regulatory Flexibility Act, an investment company is a small entity if,
together with other investment companies in the same group of related
investment companies, it has net assets of $50 million or less as of
the end of its most recent fiscal year (a ``small fund'').\692\
Commission staff estimates that, as of June 2019, approximately 42
registered open-end mutual funds, 8 registered ETFs, 33 registered
closed-end funds, and 16 BDCs (collectively, 99 funds) are small
entities.\693\
---------------------------------------------------------------------------
\692\ See rule 0-10(a) under the Investment Company Act [17 CFR
270.0-10(a)].
\693\ This estimate is derived an analysis of data obtained from
Morningstar Direct as well as data reported to the Commission for
the period ending June 2019.
---------------------------------------------------------------------------
For purposes of Commission rulemaking in connection with the
Regulatory Flexibility Act, a broker-dealer is a small entity if it:
(1) Had total capital (net worth plus subordinated liabilities) of less
than $500,000 on the date in the prior fiscal year as of which its
audited financial statements were prepared pursuant to rule 17a-5(d)
under the Exchange Act, or, if not required to file such statements,
had total capital (net worth plus subordinated liabilities) of less
than $500,000 on the last business day of the preceding fiscal year (or
in the time that it has been in business, if shorter); and (2) it is
not affiliated with any person (other than a natural person) that is
not a small business or small organization.\694\ Commission staff
estimates that, as of June 30, 2019, there are approximately 942
broker-dealers that may be considered small entities.\695\
---------------------------------------------------------------------------
\694\ See rule 0-10(c)(1)-(2) under the Exchange Act [17 CFR
240.0-10(c)(1)(2)].
\695\ This estimate is derived from an analysis of data for the
period ending June 30, 2019 obtained from Financial and Operational
Combined Uniform Single (FOCUS) Reports that broker-dealers
generally are required to file with the Commission and/or SROs
pursuant to rule 17a-5 under the Exchange Act [17 CFR 240.17a-5].
---------------------------------------------------------------------------
Under Commission rules, and for the purposes of the Advisers Act
and the Regulatory Flexibility Act, a registered investment adviser
generally is a small entity if it: (1) Has assets under management
having a total value of less than $25 million; (2) did not have total
assets of $5 million or more on the last day of the most recent fiscal
year; and (3) does not control, is not controlled by, and is not under
common control with another investment adviser that has assets under
management of $25 million or more, or any person (other than a natural
person) that had total assets of $5 million or more on the last day of
its most recent fiscal year.\696\ We believe that proposed rule 211(h)-
1 would not affect most investment advisers that are small entities
(``small advisers''). Many small advisers would not be affected because
they are registered with one or more state securities authorities and
not with the Commission. Under section 203A of the Advisers Act, many
small advisers are prohibited from registering with the Commission and
are regulated by state regulators.\697\ Of those advisers that are
registered with the Commission, we estimate based on IARD data that as
of June 30, 2019, approximately 470 SEC-registered investment advisers
are small entities under the RFA.\698\ Of these, we estimate that 171
registered investment advisers are small entities that provide advice
to individual clients.\699\
---------------------------------------------------------------------------
\696\ See rule 0-7(a) under the Advisers Act [17 CFR 275.0-
7(a)].
\697\ 15 U.S.C. 80b-3a.
\698\ Based on SEC registered investment adviser responses to
Item 12 of Form ADV.
\699\ Based on SEC-registered investment adviser responses to
Items 5.D.(1)(a)-(b), 5.D.(3)(a)-(b), 5.F and 12 of Form ADV. These
responses indicate that: The investment adviser has clients that are
high net worth individuals and/or individuals other than high net
worth individuals; the investment adviser has regulatory assets
under management attributable to clients that are high net worth
individuals and/or individuals other than high net worth
individuals; and that the investment adviser is a small entity.
Firms that are registered as a broker-dealer and an investment
adviser are counted in both the total number of small investment
advisers and small broker-dealers that would be subject to the new
requirements. We believe that counting these firms twice is
appropriate because of any additional burdens of complying with the
rules with respect to both their advisory and brokerage businesses.
---------------------------------------------------------------------------
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. Proposed Rule 18f-4
a. Derivatives Risk Management Program, and Board Oversight and
Reporting
Proposed rule 18f-4 would generally require a fund relying on the
rule--including small entities, but not including funds that are
limited derivatives users--to adopt and implement a derivatives risk
management program.\700\ This risk management program would include
policies and procedures reasonably designed to assess and manage the
risks of the fund's derivatives transactions.\701\ The program
requirement is designed to permit a fund to tailor the program's
elements to the particular types of derivatives that the fund uses and
related risks, as well as how those derivatives impact the fund's
investment portfolio and strategy. The proposal would require a fund's
program to include the following elements: (1) Risk identification and
assessment; (2) risk guidelines; (3) stress testing; (4) backtesting;
(5) internal reporting and escalation; and (6) periodic review of the
program. The proposed rule also would require: (1) A fund's board of
directors to approve the designation of the fund's derivatives risk
manager and (2) the derivatives risk manager to provide written reports
to the board regarding the program's implementation and effectiveness,
including describing any exceedances of the fund's guidelines and the
results of the fund's stress testing and backtesting.\702\
---------------------------------------------------------------------------
\700\ See supra section II.A.2; proposed rule 18f-4(c)(1).
\701\ See proposed rule 18f-4(a).
\702\ See supra sections II.C and III.C.1.
---------------------------------------------------------------------------
As discussed above, we estimate that the one-time operational costs
necessary to establish and implement a derivatives risk management
program would range from $70,000 to $500,000 per fund, depending on the
particular facts and circumstances and current derivatives risk
management practices of the fund.\703\ We also estimate that each fund
would incur ongoing program-related costs that range from 65% to 75% of
the one-time costs necessary to establish and implement a derivatives
risk management program.\704\ Thus, we estimate that a fund would incur
ongoing annual costs associated with proposed rule 18f-4 that would
range from $45,500 to $375,000.\705\ We estimate that approximately 22%
of funds would be required to implement a derivatives risk management
program, including board oversight.\706\ We
[[Page 4550]]
similarly estimate--applying to small funds the same estimated
percentage of funds that would implement a derivatives risk management
program--that approximately 22% of small funds (approximately 22 small
funds) would establish a derivatives risk management program.\707\
---------------------------------------------------------------------------
\703\ See supra section III.C.1. This section, along with
sections IV.B.1 and IV.B.2, also discusses the professional skills
that we believe compliance with this aspect of the proposal would
entail.
\704\ Id.
\705\ Id.
\706\ These are funds that would not be considered limited
derivatives users under the proposed rule. See supra sections II.E,
III.C.1, IV.B.1 and IV.B.2; infra section V.D.1.c.
\707\ See supra sections III.C.1 and V.C. We estimate that there
are 99 small funds that meet the small entity definition. See supra
note 692 and accompanying text. 99 small funds x 22% = approximately
22 funds that are small entities.
---------------------------------------------------------------------------
There are different factors that would affect whether a smaller
fund incurs program-related costs that are on the higher or lower end
of the estimated range. For example, we would expect that smaller
funds--and more specifically, smaller funds that are not part of a fund
complex--may not have existing personnel capable of fulfilling the
responsibilities of the proposed derivatives risk manager, or may
choose to hire a derivatives risk manager rather than assigning that
responsibility to a current officer (or officers) of the fund's
investment adviser who is not a portfolio manager. Also, while we would
expect larger funds or funds that are part of a large fund complex to
incur higher program-related costs in absolute terms relative to a
smaller fund or a fund that is part of a smaller fund complex, we would
expect a smaller fund to find it more costly, per dollar managed, to
comply with the proposed program requirement because it would not be
able to benefit from a larger fund complex's economies of scale.\708\
---------------------------------------------------------------------------
\708\ See supra section III.C.1.
---------------------------------------------------------------------------
b. Limit on Fund Leverage Risk
Proposed rule 18f-4 would also generally require a fund relying on
the rule--including small entities, but not including funds that are
limited derivatives users or that are certain leveraged/inverse funds
that the rule describes--to comply with an outer limit on fund leverage
risk based on VaR.\709\ This outer limit would be based on a relative
VaR test that compares the fund's VaR to the VaR of a designated
reference index. If the fund's derivatives risk manager is unable to
identify an appropriate designated reference index, the fund would be
required to comply with an absolute VaR test.\710\ Under the proposed
rule, a fund must disclose its designated reference index in its annual
report.\711\ This proposed requirement is designed to limit fund
leverage risk consistent with the investor protection purposes
underlying section 18.
---------------------------------------------------------------------------
\709\ See supra sections II.D, II.E, and II.G.
\710\ See supra sections II.D.2, II.D.3.
\711\ Proposed rule 18f-4(c)(2)(iv).
---------------------------------------------------------------------------
As discussed above, we estimate that the one-time operational costs
necessary to establish and implement a VaR calculation model consistent
with the proposed limit on fund leverage risk would range from $5,000
to $100,000 per fund, depending on the particular facts and
circumstances and current derivatives risk management practices of the
fund.\712\ We estimate that approximately 19% of funds would be
required to comply with the proposed limit on fund leverage risk.\713\
We similarly estimate--applying to small funds the same estimated
percentage of funds overall that would comply with this requirement--
that approximately 19% of small funds (approximately 19 small funds)
would be required to comply with the proposed limit on fund leverage
risk.\714\
---------------------------------------------------------------------------
\712\ See supra section III.C.2. This section, along with
section IV.B.3, also discusses the professional skills that we
believe compliance with this aspect of the proposal would entail.
\713\ See supra section III.C.2. This estimate excludes both:
(1) Limited derivatives users, and (2) funds that are leveraged/
inverse investment vehicles under the proposed sales practices
rules. Id.; see also supra sections II.E, II.G, III.C.2, III.C.3,
III.C.5, and IV.B.3; infra section V.D.1.c.
\714\ See supra sections III.C.2 and V.C. We estimate that there
are 99 small funds that meet the small entity definition. See supra
note 692 and accompanying text. 99 small entities x 19% =
approximately 19 funds that are small entities.
---------------------------------------------------------------------------
There are multiple factors that could affect whether the costs that
smaller funds would incur in complying with the proposed limit on fund
leverage risk would be on the lower versus higher end of this estimated
range. To the extent that funds (including smaller funds) have already
established and implemented portfolio VaR testing practices and
procedures, these funds would incur fewer costs relative to those funds
that have not already established and implemented VaR-based analysis in
their risk management. If as a result of fewer resources, a smaller
fund, and more specifically a smaller fund not part of a fund complex,
hired a third-party vendor to comply with the VaR-based limit on fund
leverage risk, this could increase costs of complying with the proposed
limit for those funds. Finally, costs would vary based on factors such
as whether the fund uses multiple types of derivatives or uses
derivatives more extensively, whether the fund would be implementing
the absolute VaR test versus the relative VaR test, and whether (for a
fund that uses the relative VaR test) the fund uses a designated
reference index for which the index provider charges a licensing
fee.\715\
---------------------------------------------------------------------------
\715\ See supra note 202 and accompanying paragraph; note 517
and accompanying sentence.
---------------------------------------------------------------------------
c. Requirements for Limited Derivatives Users
Proposed rule 18f-4 includes an exception from the proposed rule's
risk management program requirement and limit on fund leverage risk for
``limited derivatives users.'' \716\ The proposed exception would be
available to a fund that either limits its derivatives exposure to 10%
of its net assets, or that uses derivatives transactions solely to
hedge certain currency risks. Any fund that relies on the proposed
exception--small funds as well as large funds--would also be required
to adopt policies and procedures that are reasonably designed to manage
its derivatives risks. We expect that the risks and potential impact of
these funds' derivatives use may not be as significant, compared to
those of funds that do not qualify for the exception, and that a
principles-based policies and procedures requirement would
appropriately address these risks. These ``reasonably designed''
policies and procedures would have a scope that that reflects the
extent and nature of a fund's use of derivatives within the parameters
that the proposed exception provides.
---------------------------------------------------------------------------
\716\ See supra section II.E; proposed rule 18f-4(c)(3)(i)-(ii).
---------------------------------------------------------------------------
As discussed above, we estimate that the one-time costs to
establish and implement policies and procedures reasonably designed to
manage a fund's derivative risks would range from $1,000 to $100,000
per fund, depending on the particular facts and circumstances and
current derivatives risk management practices of the fund.\717\ We also
estimate that the ongoing annual costs that a fund that is a limited
derivatives user would incur range from 65% to 75% of the one-time
costs to establish and implement the policies and procedures. Thus, we
estimate that a fund would incur ongoing annual costs associated with
the proposed limited derivatives user exception that would range from
$650 to $75,000.\718\ We anticipate that larger funds that are limited
derivatives users--or limited derivatives user funds that are part of a
large fund complex--would likely experience economies of scale in
complying with the proposed requirements for limited derivatives users
that smaller funds would not
[[Page 4551]]
necessarily experience.\719\ Thus, smaller funds that are limited
derivatives users could incur costs on the higher end of the estimated
range. However, a smaller fund whose derivatives use is limited could
benefit from the proposed limited derivatives user exception, because
it would not be required to adopt a derivatives risk management program
(including all of the proposed program elements), and therefore such a
fund could potentially avoid incurring costs and bearing compliance
burdens that may be disproportionate to any benefits.\720\
---------------------------------------------------------------------------
\717\ See supra section III.C.3 (discussing the one-time range
of costs for implementing the limited derivatives user requirements
under proposed rule18f-4 and the variables impacting a fund
incurring costs at the lower or higher end of the estimated cost
range). This section, along with section IV.B.6, also discusses the
professional skills that we believe compliance with this aspect of
the proposal would entail.
\718\ Id.
\719\ See supra note 707 and accompanying text.
\720\ See supra section II.E.
---------------------------------------------------------------------------
We estimate that approximately 19% of funds that use derivatives
would qualify for the limited derivatives user exception.\721\ We would
expect some small funds to fall within the proposed limited derivatives
user exception.\722\ However, not all small funds that use derivatives
would necessarily qualify as limited derivatives users. We estimate--
applying to small funds the same estimated percentage of funds overall
that would qualify as limited derivatives users--that approximately 19%
of small funds that use derivatives (approximately 19 small funds)
would comply with the proposed requirements for limited derivatives
users under the proposed rule.\723\
---------------------------------------------------------------------------
\721\ Id. This estimate excludes both: (1) Funds that would
comply with the derivatives risk management program, and (2) funds
that would be leveraged/inverse investment vehicles under proposed
rule 15l-2. See also supra sections II.A.2, II.E, II.G, III.C.1,
III.C.3, III.C.5, IV.B.4, and V.D.1.a.
\722\ Id.; see also supra section III.C.3.
\723\ Id.; see also supra sections III.C.3 and V.C. We estimate
that there are 99 small funds that meet the small entity definition.
See supra note 692 and accompanying text. 99 small entities x 19% =
approximately 19 funds that are small entities.
---------------------------------------------------------------------------
d. Reverse Repurchase Agreements and Unfunded Commitment Agreements
Proposed rule 18f-4 would permit a fund to engage in reverse
repurchase agreements and other similar financing transactions so long
as they are subject to the relevant asset coverage requirements of
section 18.\724\ Because funds are required to rely on the asset
segregation approach in Release 10666, the degree to which funds could
engage in reverse repurchase agreements under the proposal would
generally be the same as under current practice. Therefore we do not
estimate a significant compliance burden--either for small funds that
engage in reverse repurchase agreements or for larger funds--associated
with the proposed provisions regarding reverse repurchase agreements in
rule 18f-4.\725\ For large and small funds subject to the proposed
limit on fund leverage risk, any portfolio leveraging effect of reverse
repurchase agreements or similar financing transactions would be
included and restricted through the proposed VaR-based limits, and
therefore would incrementally affect the costs associated with
complying with these limits.\726\
---------------------------------------------------------------------------
\724\ See supra section II.I.
\725\ See supra section III.C.4.
\726\ See supra section II.I.
---------------------------------------------------------------------------
The proposed rule also includes a provision that codifies an
approach for funds' participation in unfunded commitment agreements in
light of the concerns underlying section 18.\727\ Proposed rule 18f-4
would permit a fund to enter into unfunded commitment agreements if it
reasonably believes, at the time it enters into such agreement, that it
will have sufficient cash and cash equivalents to meet its obligations
with respect to all of its unfunded commitment agreements, in each case
as they come due. The proposed rule would prescribe factors that a fund
must consider in forming such a reasonable belief. If a fund enters
into unfunded comment agreements in compliance with this requirement,
the proposed rule specifies that unfunded commitment agreements will
not be considered for purposes of computing asset coverage, as defined
in section 18(h) of the Investment Company Act. This proposed approach
for unfunded commitment agreements reflects the staff's experience in
reviewing and commenting on fund registration statements, as discussed
above.\728\ We therefore do not expect that the proposed approach would
result in significant costs to small or large funds because we believe
the proposed approach is generally consistent with the current
practices of funds that enter into unfunded commitment agreements.
---------------------------------------------------------------------------
\727\ See supra section II.J.
\728\ See id.
---------------------------------------------------------------------------
e. Recordkeeping
Proposed rule 18f-4 includes certain recordkeeping provisions that
are designed to provide the Commission's staff, and the fund's board of
directors and compliance personnel, the ability to evaluate the fund's
compliance with the proposed rule's requirements.\729\ The proposed
rule would require a fund to maintain certain records documenting its
derivatives risk management program, including a written record of: (1)
Its policies and procedures designed to manage the fund's derivatives
risks, (2) the results of any stress testing of its portfolio, (3) the
results of any VaR test backtesting it conducts, (4) records
documenting any internal reporting or escalation of material risks
under the program, and (5) records documenting any periodic reviews of
the program.\730\
---------------------------------------------------------------------------
\729\ See supra section II.K.
\730\ See proposed rule 18f-4(c)(6)(i)(A).
---------------------------------------------------------------------------
Second, the proposed rule would also require a fund to maintain a
written record of any materials provided to the fund's board of
directors in connection with approving the designation of the
derivatives risk manager. The proposed rule would also require a fund
to keep records of any written reports provided to the board of
directors relating to the program, and any written reports provided to
the board that the rule would require regarding the fund's non-
compliance with the applicable VaR test.\731\
---------------------------------------------------------------------------
\731\ See proposed rule 18f-4(c)(6)(i)(B).
---------------------------------------------------------------------------
Third, a fund that is required to comply with the proposed VaR test
would also have to maintain written records documenting the
determination of: Its portfolio VaR; the VaR of its designated
reference index, as applicable; its VaR ratio (the value of the VaR of
the Fund's portfolio divided by the VaR of the designated reference
index), as applicable; and any updates to the VaR calculation models
used by the fund, as well as the basis for any material changes made to
those models.\732\
---------------------------------------------------------------------------
\732\ See proposed rule 18f-4(c)(6)(i)(C).
---------------------------------------------------------------------------
Fourth, the proposed rule would require a fund that is a limited
derivatives user to maintain a written record of its policies and
procedures that are reasonably designed to manage its derivatives
risks.\733\
---------------------------------------------------------------------------
\733\ See proposed rule 18f-4(c)(6)(i)(D).
---------------------------------------------------------------------------
Finally, a fund that enters into unfunded commitment agreements
would be required to maintain a records documenting the basis for the
fund's belief regarding the sufficiency of its cash and cash
equivalents to meet its obligations with respect to its unfunded
commitment agreements.\734\ A record must be made each time a fund
enters into such an agreement.\735\
---------------------------------------------------------------------------
\734\ See proposed rule 18f-4e)(2); see also supra note 429 and
accompanying text.
\735\ Id.; see also supra note 430 and accompanying text.
---------------------------------------------------------------------------
As discussed above, we estimate that the average one-time
recordkeeping costs for funds that would not qualify as limited
derivatives users would be $2,047 per fund, depending on the particular
facts and circumstances and current derivatives risk management
practices of the fund.\736\ We also
[[Page 4552]]
estimate that such a fund would incur an average ongoing annual
recordkeeping costs of $330.\737\ We further estimate that the one-time
and ongoing annual recordkeeping costs for a limited derivatives user
to be 90% of those for funds that do not qualify as limited derivatives
users.\738\ Thus, for each fund that could rely on the limited
derivatives user exception, we estimate a one-time cost of $1,842 and
an ongoing cost of $297 per year.\739\ To the extent that we estimate
that small funds would be subject to the various provisions of the
proposed rule that would necessitate recordkeeping requirements, as
discussed above, these small funds also would be subject to the
associated proposed recordkeeping requirements. Therefore, we estimate
that: 22% of small funds (approximately 22 small funds) would have to
comply with the program-related recordkeeping requirements and
requirements regarding materials provided to the fund's board; 19% of
small funds (approximately 19 small funds) would have to comply with
requirements to maintain records of compliance with the proposed VaR
test; and 19% of small funds (approximately 19 funds) would have to
comply with the recordkeeping requirements for limited derivatives
users.\740\
---------------------------------------------------------------------------
\736\ See supra section III.C.8. This section, along with
section IV.B.7, also discusses the professional skills that we
believe compliance with this aspect of the proposal would entail.
\737\ Id.
\738\ Id.
\739\ Id.
\740\ See supra sections III.C.1, III.C.2, III.C.3, V.D.1.a,
V.D.1.b, and V.D.1.c.
---------------------------------------------------------------------------
A fund's recordkeeping-related costs will vary, depending on the
provisions of proposed rule 18f-4 that the fund relies on. For example,
funds that are required to adopt derivatives risk management programs,
versus funds that are limited derivatives users under the proposed
rule, would be subject to different recordkeeping requirements.
However, while small funds' recordkeeping burdens would vary based on
the provisions of the proposed rule that a fund relies on, their
recordkeeping burdens would not vary solely because they are small
funds. We do not anticipate that larger funds, or funds that are part
of a large fund complex, would experience any significant economies of
scale related to the proposed recordkeeping requirements.
2. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
a. Proposed Amendments to Form N-PORT
The proposed amendments to Form N-PORT would require funds to
report information about their derivatives exposure, and also--as
applicable for funds that are subject to the proposed rule 18f-4 VaR-
based limit on fund leverage risk--to report certain VaR-related
information.\741\ These proposed amendments would provide market-wide
insight into the levels of reporting funds' derivatives exposure to the
Commission, its staff, and market participants at the specific points
in time covered by the reporting. They also would help the Commission
and its staff assess compliance with proposed rule 18f-4.
---------------------------------------------------------------------------
\741\ See supra section II.H.1; see also proposed Items B.9 and
B.10 of Form N-PORT.
---------------------------------------------------------------------------
All funds that file Form N-PORT would have to provide information
regarding their derivatives exposure on this form. We estimate that 41%
of small funds that file Form N-PORT (approximately 34 small funds) use
derivatives, and thus only these funds would have substantive
information to report in response to this new exposure-related
disclosure requirement.\742\
---------------------------------------------------------------------------
\742\ See supra sections V.C, V.D.1.a, and V.D.1.c. Because BDCs
do not file reports on Form N-PORT, we deduct the number of BDCs
from the total number of small funds that we estimate (99 small
funds-16 BDCs that are small entities = 83 small funds that file
reports on Form N-PORT). See supra note 692 and accompanying text.
We estimate that approximately 22% of funds would be subject to
the proposed rule's derivatives risk management program requirements
and approximately 19% of funds would be subject to either of the
limited derivatives user exceptions, with funds from both groups
subject to reporting requirements on Form N-PORT. See supra notes
706, 720, and accompanying text. Although both of these estimated
percentages include BDCs, we note that the total number of BDCs
relative to the number of registered open- and closed-end funds is
small, and therefore our estimates do not adjust these percentages
to reflect the fact that BDCs do not file Forms N-PORT. See supra
section III.B.1. Therefore, we estimate the total number of small
funds subject to the proposed Form N-PORT requirements as follows:
83 small funds that file reports on Form N-PORT x (22% + 19% = 41%)
= 34 small funds.
---------------------------------------------------------------------------
In addition, funds that are subject to the proposed limit on fund
leverage risk would have to report: (1) The fund's highest daily VaR
during the reporting period and its corresponding date; and (2) the
fund's median daily VaR for the reporting period. Funds subject to the
relative VaR test during the reporting period also would have to
report: (1) The name of the fund's designated reference index, (2) the
index identifier, (3) the fund's highest daily VaR ratio during the
reporting period and its corresponding date; and (4) the fund's median
daily VaR ratio for the reporting period. A fund would be required to
determine its compliance with its applicable VaR test once each
business day.\743\
---------------------------------------------------------------------------
\743\ See supra note 364.
---------------------------------------------------------------------------
All funds that are subject to the proposed limit on fund leverage
risk also would have to report the number of exceptions that the fund
identified as a result of the backtesting of its VaR calculation model.
We estimate that 19% of small funds (approximately 16 small funds)
would be subject to these VaR-related disclosure requirements.\744\
---------------------------------------------------------------------------
\744\ We estimate 83 small funds that file reports on Form N-
PORT. See supra note 741.
We estimate that approximately 19% of funds would be subject to
the proposed limit on fund leverage risk. See supra note 712 and
accompanying text. Although this estimated percentage include BDCs,
we note that the total number of BDCs relative to the number of
registered open- and closed-end funds is small, and therefore our
estimate does not adjust this percentage to reflect the fact that
BDCs do not file Forms N-PORT. See supra section III.B.1. Therefore,
we estimate the total number of small funds that would make VaR-
related disclosures on Form N-PORT as follows: 83 small funds that
file reports on Form N-PORT x 19% = approximately 16 small funds.
---------------------------------------------------------------------------
We estimate that each fund that reports information in response to
the proposed VaR-related disclosure requirements on Form N-PORT would
incur a one-time cost of $2,784 and an ongoing cost of $4,176 per year,
and each fund that is not subject to the VaR-related disclosure
requirement would incur a one-time cost of $1,392 and an ongoing cost
of $2,088 per year.\745\ Notwithstanding the economies of scale
experienced by large versus small funds, we would not expect the costs
of compliance associated with the new Form N-PORT requirements to be
meaningfully different for small versus large funds. The costs of
compliance would vary only based on fund characteristics tied to their
derivatives use. For example, a fund that uses derivatives extensively
would incur more costs to calculate its derivatives exposure than a
fund that does not use derivatives extensively.\746\ And a fund that is
a limited derivatives user, or that otherwise is not subject to the
proposed VaR test, would not incur any costs to comply with the
proposed new VaR-related N-PORT items.\747\
---------------------------------------------------------------------------
\745\ See supra section III.C.9.a.; see also supra section IV.F
(discussing the professional skills that we believe compliance with
this aspect of the proposal would entail).
\746\ See supra note 714.
\747\ See proposed Item B.10 to Form N-PORT.
---------------------------------------------------------------------------
b. Proposed Amendments to Form N-LIQUID
We are proposing to re-title Form N-LIQUID as Form N-RN, and amend
this form to include new reporting events for funds that are subject to
proposed rule 18f-4's limit on fund leverage risk.\748\ The proposed
amendments would require funds subject to the limit on fund leverage
risk to report information
[[Page 4553]]
about VaR test breaches under certain circumstances. These proposed
current reporting requirements are designed to aid the Commission in
assessing funds' compliance with the VaR tests, and to provide staff
the ability to assess how long a fund is precluded from entering into
derivatives transactions as a consequence of its lack of compliance
with its VaR test. We are proposing to require funds to provide this
information in a current report because we believe that the Commission
should be notified promptly when a fund is out of compliance with the
proposed VaR-based limit on fund leverage risk (and also when it has
come back into compliance with its applicable VaR test). We believe
this information could indicate that a fund is experiencing heightened
risks as a result of a fund's use of derivatives transactions, as well
as provide the Commission insight about the duration and severity of
those risks, and whether those heightened risks are fund-specific or
industry-wide.
---------------------------------------------------------------------------
\748\ See supra section II.H.2.
---------------------------------------------------------------------------
As discussed above, we estimate that each fund subject to the
proposed new current reporting requirements would incur an average cost
of $10 per year to prepare amended Form N-RN.\749\ We estimate that
approximately 19 registered open- and closed-end funds, and BDCs, are
small entities that would be required to report VaR test related
information on Form N-RN.\750\ Because the proposed amendments to Form
N-RN would require both large and small funds to report VaR test
breaches, the burden to report is not associated with fund size, and
consequently, we would not expect the costs of compliance with the new
Form N-RN requirements to be meaningfully different for small versus
large funds.
---------------------------------------------------------------------------
\749\ See supra section III.C.9.b; see also supra section IV.G
(discussing the professional skills that we believe compliance with
this aspect of the proposal would entail).
\750\ This estimate is based on an estimate that 16 small
registered open- and closed-end funds would make VaR-related
disclosures on Form N-PORT (see supra note 743 and accompanying
text), plus 3 BDCs (16 total small BDCs (see supra note 692 and
accompanying text) x 19% (our estimate of the percentage of funds
subject to a VaR-based limit on fund leverage risk, see supra note
712 and accompanying text) = approximately 3 BDCs). Thus, 16 small
registered open- and closed-end funds + 3 BDCs = 19 funds.
---------------------------------------------------------------------------
c. Proposed Amendments to Form N-CEN
The proposed amendments to Form N-CEN would require a fund to
identify whether it relied on proposed rule 18f-4 during the reporting
period.\751\ The proposed amendments also would require a fund to
identify whether it relied on any of the exemptions from various
requirements under the proposed rule, specifically: (1) Whether the
fund is a limited derivatives user excepted from the proposed rule's
program requirement, under either of the proposed exception's
alternatives (either a funds that limits its derivatives exposure to
10% of its net assets, or a fund that uses derivatives transactions
solely to hedge certain currency risks); or (2) whether it is a
leveraged/inverse fund covered by the proposed sales practices rules
that, under proposed rule 18f-4, would be excepted from the proposed
limit on fund leverage risk. Finally, a fund would have to identify
whether it has entered into reverse repurchase agreements or similar
financing transactions, or unfunded commitment agreements, as provided
under the proposed rule.\752\ The proposed amendments to Form N-CEN are
designed to assist the Commission and staff with our oversight
functions by allowing us to identify which funds were excepted from
certain of the proposed rule's provisions or relied on the rule's
provisions regarding reverse repurchase agreements and unfunded
commitment agreements.
---------------------------------------------------------------------------
\751\ See supra section II.H.3.
\752\ See proposed Item C.7.l.iv-v of Form N-CEN; see also supra
section II.I and II.J; proposed rule 18f-4(d); and proposed rule
18f-4(e).
---------------------------------------------------------------------------
As discussed above, we estimate that each fund subject to the
proposed new Form N-CEN reporting requirements would incur on average
an ongoing annual cost of $6.96 per year.\753\ We estimate that
approximately 34 registered open- and closed-end funds are small
entities that would be subject to the proposed new Form N-CEN reporting
requirements.\754\ Notwithstanding any economies of scale experienced
by large versus small funds, we would not expect the costs of
compliance with the new Form N-CEN requirements to be meaningfully
different for small versus large funds.
---------------------------------------------------------------------------
\753\ See supra section III.C.9.a; see also supra section IV.H
(discussing the professional skills that we believe compliance with
this aspect of the proposal would entail).
\754\ Because BDCs do not file reports on Form N-CEN, we deduct
the number of BDCs from the total number of small funds that we
estimate (99 small funds - 16 BDCs that are small entities = 83
small funds that file reports on Form N-CEN). See supra note 692 and
accompanying text.
The estimate of 34 funds is based on the percentage of funds we
believe would be subject to the proposed derivatives risk management
program requirement (22% of funds, see supra note 498 and
accompanying text) plus the percentage of funds we believe would
qualify as limited derivatives users (19% of funds, see supra note
720 and accompanying text). We estimate that 83 small funds that
file reports on Form N-CEN (99 total small funds less 16 small BDCs)
x 41% (22% + 19%) = 34 small funds subject to the proposed Form N-
CEN reporting requirements. To the extent that there are funds that
either (1) would not adopt a derivatives risk management program or
(2) would not qualify as limited derivatives user, but that would
rely on the rule's provisions with respect to reverse repurchase
agreements or unfunded commitment agreements, this analysis might
underestimate the number of funds that would be subject to the new
Form N-CEN reporting requirements.
---------------------------------------------------------------------------
3. Proposed Sales Practices Rules
The proposed sales practices rules under the Exchange Act and the
Advisers Act would require a firm to exercise due diligence in
determining whether to approve the account of a retail investor to buy
or sell shares of a leveraged/inverse investment vehicle before
accepting an order from, or placing an order for, the retail investor
to engage in these transactions.\755\ Under the proposed sales
practices rules, no firm may accept an order from or place an order for
a retail investor to buy or sell shares of a leveraged/inverse
investment vehicle, or approve such an investor's account to engage in
those transactions, unless the firm has complied with certain
conditions.
---------------------------------------------------------------------------
\755\ See supra section II.G.1.
---------------------------------------------------------------------------
Specifically, the proposed sales practices rules would require the
firm to: (1) Approve the retail investor's account for buying and
selling shares of leveraged/inverse investment vehicles pursuant to a
due diligence requirement; and (2) adopt and implement policies and
procedures reasonably designed to achieve compliance with the proposed
rules.\756\ The proposed sales practices rules' due diligence
requirements provide that a firm must exercise due diligence to
ascertain the essential facts relative to the retail investor, his or
her financial situation, and investment objectives. A firm must seek to
obtain, at a minimum, certain specified information about the retail
investor. The proposed sales practices rules also include recordkeeping
requirements relating to the information that the firm obtained through
its due diligence, the firm's approval or disapproval of the retail
investor's account for buying and selling shares of leveraged/inverse
investment vehicles (account approvals must be in writing), and the
firm's policies and procedures that it adopted pursuant to those
rules.\757\
---------------------------------------------------------------------------
\756\ See supra section II.G.2.b.
\757\ See supra section II.G.2.c.
---------------------------------------------------------------------------
The proposed sales practices rules are designed to establish a
uniform set of enhanced due diligence and account approval requirements
for all leveraged/inverse investment vehicle transactions, including
transactions where no recommendation or investment advice is provided
by a firm. They also are designed in part to help to ensure that
[[Page 4554]]
investors in these funds are limited to those who understand their
characteristics--including that these funds would not be subject to all
of the leverage-related requirements applicable to registered
investment companies generally--and the unique risks they present.
As discussed above, we estimate that each broker-dealer subject to
proposed rule 15l-2, and each investment adviser subject to proposed
rule 211(h)-1, would incur total one-time costs that would range from
$9,115.50 to $15,192.50 to comply with the proposed rules, and total
ongoing costs that would range from $2,270.50 to $3,915 per year to
comply with the proposed rules.\758\ We estimate that approximately 236
broker-dealers and 43 registered investment advisers are small entities
that would be subject to the proposed sales practices rules.\759\
---------------------------------------------------------------------------
\758\ See supra notes 539 and 543 and accompanying text. This
discussion, along with sections IV.C and IV.D supra, also discusses
the professional skills that we believe compliance with this aspect
of the proposal would entail.
\759\ We estimate there are currently 942 small broker-dealers.
See supra note 694 and accompanying text. We further estimate that
700 broker-dealers (or 25% of all 2,766 broker-dealers registered
with the Commission) have retail customer accounts that invest in
leveraged/inverse investment vehicles. See supra section III.C.5.
Our estimate of 236 broker-dealers is based on the following
calculation: 942 small broker dealers x 25% = approximately 236
small broker-dealers that have retail customer accounts that invest
in leveraged/inverse investment vehicles.
We estimate that there are currently 470 SEC-registered
investment advisers that are small entities. See supra note 697 and
accompanying text. Of these, we estimate that 171 provide advice to
individual clients, and could therefore be subject to the proposed
new sales practices rules under the Advisers Act. See supra note 698
and accompanying text. We further estimate that 2,000 investment
advisers (or approximately 25% of the 8,235 investment advisers that
are registered with the Commission and offer some part of their
business to retail investors) have retail client accounts that
invest in leveraged/inverse investment vehicles. See supra sections
III.C.5 and IV.D. Our estimate of 43 investment advisers is based on
the following calculation: 171 small investment advisers that
provide advice to individual clients x 25% = approximately 43 small
investment advisers that have retail client accounts that invest in
leveraged/inverse investment vehicles.
---------------------------------------------------------------------------
The costs that broker-dealers and investment advisers may incur as
a result of the proposed sales practices rules would vary depending on
the firm and the due diligence requirements that the firm adopts as a
result of the proposed rules' requirements.\760\ We expect that
economies of scale among larger firms could result in cost reductions
for larger firms. Compliance costs could, however, be different across
firms with relatively smaller or larger numbers of retail investors as
customers or clients.\761\
---------------------------------------------------------------------------
\760\ See supra section III.C.5 (discussing costs and benefits
of proposed sales practices rules).
\761\ See supra section II.G.2.b (discussing required approval
and due diligence for retail investors' accounts to trade shares of
leveraged/inverse investment vehicles under the proposed sales
practices rules).
---------------------------------------------------------------------------
4. Proposed Amendments to Rule 6c-11
We are proposing to amend rule 6c-11 to remove the provision
excluding leveraged/inverse ETFs from the scope of that rule and to
newly permit leveraged/inverse ETFs to rely on that rule.\762\ Rule 6c-
11 permits ETFs that satisfy certain conditions to operate without
obtaining an exemptive order from the Commission.\763\ The rule is
designed to create a consistent, transparent, and efficient regulatory
framework for such ETFs and facilitate greater competition and
innovation among ETFs. As a consequence of our proposed amendment to
rule 6c-11, and proposal to rescind the exemptive orders we have
previously issued to leveraged/inverse ETFs, these proposed amendments
would newly permit leveraged/inverse ETFs to come within scope of the
rule's exemptive relief.
---------------------------------------------------------------------------
\762\ See supra section II.G.4.
\763\ Id.
---------------------------------------------------------------------------
Currently, there are 73 leveraged/inverse ETFs.\764\ As a result of
the proposed amendments, we would expect the number of funds relying on
rule 6c-11 to increase, and we estimate that all 73 leveraged/inverse
ETFs would newly seek to use rule 6c-11. We also estimate, for purposes
of this Regulatory Flexibility Act analysis, that approximately 1 of
these leveraged/inverse ETFs would be a small leveraged/inverse ETF
that would seek to rely on rule 6c-11.\765\ We do not estimate our
amendments to rule 6c-11 would change the estimated per-fund cost
burden associated with rule 6c-11, but we do believe the number of
funds using the rule, as a result of our amendment, would now
increase.\766\ The costs associated with complying with rule 6c-11 are
discussed in the ETFs Adopting Release.\767\
---------------------------------------------------------------------------
\764\ See supra note 467.
\765\ This estimate is based on the following calculation: 8
small ETFs/1,190 total ETFs = approximately 0.67% of ETFs that are
small ETFs. See supra sections III.B.1 and V.C. 0.67% of 73
leveraged/inverse ETFs = approximately 1 leveraged/inverse ETF.
\766\ See supra section IV.E.
\767\ See ETFs Adopting Release, supra note 76, at section IV.
---------------------------------------------------------------------------
E. Duplicative, Overlapping, or Conflicting Federal Rules
Commission staff has not identified any federal rules that
duplicate, overlap, or conflict with proposed Investment Company Act
rule 18f-4, proposed Exchange Act rule 15l-2, proposed Advisers Act
rule 211(h)-1, or the proposed amendments to Form N-PORT, Form N-
LIQUID, and Form N-CEN.
We recognize that other broker-dealer or investment adviser
obligations require these entities to engage in due diligence with
respect to transactions they recommend to customers or clients. The
proposed sales practices rules, in contrast, would apply regardless of
whether a broker-dealer or investment adviser recommends that a
customer or client buy or sell leveraged/inverse investment vehicles.
We therefore do not believe that the sales practices rules would
conflict with existing broker-dealer or investment adviser obligations,
and believe that any overlap or duplication should be limited because a
broker-dealer or investment adviser could consider the information it
collects in connection with the sales practices rules in connection
with the due diligence the broker-dealer or investment adviser conducts
in connection with other, existing obligations for recommended
transactions.
F. Significant Alternatives
The Regulatory Flexibility Act directs the Commission to consider
significant alternatives that would accomplish our stated objectives,
while minimizing any significant economic impact on small entities. We
considered the following alternatives for small entities in relation to
our proposal: (1) Exempting funds, broker-dealers, and registered
investment advisers that are small entities from the proposed
reporting, recordkeeping, and other compliance requirements, to account
for resources available to small entities; (2) establishing different
reporting, recordkeeping, and other compliance requirements or
frequency, to account for resources available to small entities; (3)
clarifying, consolidating, or simplifying the compliance requirements
under the proposal for small entities; and (4) using performance rather
than design standards.
1. Proposed Rule 18f-4
We do not believe that exempting small funds from the provisions in
proposed rule 18f-4 would permit us to achieve our stated objectives.
Because proposed rule 18f-4 is an exemptive rule, it would require
funds to comply with new requirements only if they wish to enter into
derivatives or certain other transactions.\768\ Therefore, if a
[[Page 4555]]
small entity does not enter into derivatives or such other transactions
as part of its investment strategy, then the small entity would not be
subject to the provisions of proposed rule 18f-4. In addition, a small
fund whose derivatives use is limited could benefit from the proposed
limited derivatives user exception, because it would not be required to
adopt a derivatives risk management program (including all of the
proposed program elements).
---------------------------------------------------------------------------
\768\ See supra sections II.D.6 and III.E.
---------------------------------------------------------------------------
We estimate that 59% of all funds do not have any exposure to
derivatives or such other transactions.\769\ This estimate indicates
that many funds, including many small funds, would be unaffected by the
proposed rule. However, for small funds that would be affected by our
proposed rule, providing an exemption for them could subject investors
in small funds that invest in derivatives or engage in such other
transactions to a higher degree of risk than investors to large funds
that would be required to comply with the proposed elements of the
rule.
---------------------------------------------------------------------------
\769\ See supra note 458 and accompanying paragraph.
---------------------------------------------------------------------------
The undue speculation concern expressed in section 1(b)(7) of the
Investment Company Act, and the asset sufficiency concern reflected in
section 1(b)(8) of the Act--both of which the proposed rule is designed
to address--apply to both small as well as large funds. As discussed
throughout this release, we believe that the proposed rule would result
in investor protection benefits, and these benefits should apply to
investors in smaller funds as well as investors in larger funds. We
therefore do not believe it would be appropriate to exempt small funds
from the proposed rule's program requirement or VaR-based limit on fund
leverage risk, or to establish different requirements applicable to
funds of different sizes under these provisions to account for
resources available to small entities. We believe that all of the
proposed elements of rule 18f-4 should work together to produce the
anticipated investor protection benefits, and therefore do not believe
it is appropriate to except smaller funds because we believe this would
limit the benefits to investors in such funds.
We also do not believe that it would be appropriate to subject
small funds to different reporting, recordkeeping, and other compliance
requirements or frequency. Similar to the concerns discussed above, if
the proposal included different requirements for small funds, it could
raise investor protection concerns for investors in small funds
including subjecting small fund investors to a higher degree of risk if
the small fund uses derivatives transactions. We also believe that all
fund investors will benefit from enhanced Commission monitoring and
oversight of the fund industry, which we anticipate will result from
the disclosure and reporting requirements.
We do not believe that clarifying, consolidating, or simplifying
the compliance requirements under the proposal for small funds would
permit us to achieve our stated objectives. Again, this approach would
raise investor protection concerns for investors in small funds using
derivatives transactions. However, as discussed above, the proposed
rule contains an exception for limited derivatives users that we
anticipate would subject funds that qualify for this exception to fewer
compliance burdens. We recognize that the risks and potential impact of
derivatives transactions on a fund's portfolio generally increase as
the fund's level of derivatives usage increases and when funds use
derivatives for speculative purposes. Therefore the proposed rule would
entail a less significant compliance burden for funds--including small
funds--that choose to limit their derivatives usage in the manner that
the proposed exception specifies. The proposal, therefore, does include
provisions designed to consider the requirement burdens based on the
fund's use of derivatives (rather than the size of the fund).
The costs associated with proposed rule 18f-4 would vary depending
on the fund's particular circumstances, and thus the proposed rule
could result in different burdens on funds' resources. In particular,
we expect that a fund that pursues an investment strategy that involves
greater derivatives risk may have greater costs associated with its
derivatives risk management program. For example, a fund that qualifies
as a limited derivatives user under the proposed rule would be exempt
from the proposed requirements to adopt and implement a derivatives
risk management program, and to adhere to the proposed rule's VaR-based
limit on fund leverage risk. The costs of compliance with the proposed
rule would vary even for limited derivatives users, as these funds
would be required to adopt policies and procedures that are
``reasonably designed'' to manage their derivatives risks. Thus, to the
extent a fund that is a small entity faces relatively little
derivatives risk, we believe it would incur relatively low costs to
comply with the proposed rule. However, we believe that it is
appropriate to correlate the costs associated with the proposed rule
with the level of derivatives risk facing a fund, and not necessarily
with the fund's size in light of our investor protection objectives.
Finally, with respect to the use of performance rather than design
standards, the proposed rule generally uses performance standards for
all funds relying on the proposed rule, regardless of size. We believe
that providing funds with the flexibility with respect to investment
strategies and use of derivatives transactions is appropriate, as well
as the derivatives risk management program design. However, the
proposed rule also uses design standards with respect to certain
requirements such as complying with the VaR-based limit on fund
leverage risk and the specified program elements in the derivatives
risk management program. For the reasons discussed above, we believe
that this use of design standards is appropriate to address investor
protection concerns, particularly the concerns expressed in sections
1(b)(7), 1(b)(8), and 18 of the Investment Company Act.
2. Proposed Sales Practices Rules
Similarly, we do not believe that exempting any subset of broker-
dealers or registered investment advisers, including those firms that
are small entities, from the provisions in the proposed sales practices
rules would permit us to achieve our stated investor protection
objectives. We also do not believe that it would be desirable to
establish different requirements applicable to firms of different sizes
under the proposed sales practices rules to account for resources
available to small entities, to consolidate or simplify the compliance
requirements under the proposal for small entities, or to use
performance standards rather than design standards for small entities.
We do not believe exempting small broker-dealers and investment
advisers from the proposed sales practices rules would serve the
interest of investors. As we discussed above, leveraged/inverse
investment vehicles present unique considerations, and the proposed
sales practices rules are designed in part to address the investor
protection concerns leveraged/inverse funds present.\770\ The proposed
sales practices rules would permit broker-dealers and investment
advisers to accept or place orders to buy or sell shares of a
``leveraged/inverse investment vehicle'' only for investors that they
have approved for those transactions, based on certain required
[[Page 4556]]
criteria.\771\ Exempting smaller broker-dealer and investment adviser
firms would create a regulatory gap, whereby larger funds would be
required to comply with the proposed sales practices rules' due
diligence requirements to determine whether to approve the account of
retail investor to buy or sell shares of a leveraged/inverse investment
vehicle, and small entities would not need to conduct this same
diligence.
---------------------------------------------------------------------------
\770\ See supra section II.G.
\771\ See proposed rule 15l-2(b).
---------------------------------------------------------------------------
As discussed above, we believe that this limitation on leveraged/
inverse investment vehicles' investor base would help provide that
investors in these vehicles understand the characteristics of these
vehicles and the unique risks they present.\772\ Providing different
requirements or simplifying the requirements for small entities would
dilute these investor protection benefits for customers or clients of
small entities. We do not believe that the investor protection benefits
of the proposed sales practices rules should depend on whether an
investor is transacting through a small or a large firm. Furthermore, a
broker-dealer or investment adviser would have to comply with the
applicable proposed rule's requirements only if it transacts with
retail investors in the shares of leveraged/inverse investment
vehicles.\773\
---------------------------------------------------------------------------
\772\ See supra section II.G.
\773\ We estimate that approximately 236 broker-dealers and 43
registered investment advisers are small entities that would be
subject to the proposed sales practices rules. See supra note 758
and accompanying text.
Broker-dealers and investment advisers that would have to
comply with the proposed sales practices rules also might currently
have processes in place that would provide efficiencies in complying
with the proposed rules. See supra note 536 and accompanying text.
---------------------------------------------------------------------------
Finally, we are not proposing performance standards rather than
design standards for smaller entities. We believe that subjecting
smaller entities to different standards under the proposed rules could
lead to inconsistency in how investors would transact in leveraged/
inverse investment vehicles, depending on whether the investor has a
relationship with a large or small broker-dealer or investment adviser.
This would be inconsistent with the regulatory and investor protections
purposes of the proposed rules and could subject investors who interact
with small firms to a higher degree of risk than investors who interact
with larger firms. It could also circumvent the proposed rules' ability
to establish a uniform set of enhanced due diligence and approval
requirements for all leveraged/inverse investment vehicle transactions,
and to address the investor protection concerns underlying section 18
for leveraged/inverse funds by limiting their investor base.
3. Proposed Amendments to Forms N-PORT, N-LIQUID, and N-CEN
We do not believe that the interests of investors would be served
by exempting funds that are small entities from the proposed disclosure
and reporting requirements. We believe that the form amendments are
necessary to help identify and provide the Commission, staff,
investors, and other market participants timely information about funds
that comply with proposed rule 18f-4, and to realize the anticipated
benefits of the proposed reporting requirements.\774\ Exempting small
funds from coverage under all or any part of the proposed form
amendments could compromise the effectiveness of the required
disclosures, which the Commission believes would not be consistent with
its goals of industry oversight and investor protection. We believe
that all fund investors, including investors in small funds, would
benefit from disclosure and reporting requirements that would permit
them to make investment choices that better match their risk
tolerances. We also believe that all fund investors would benefit from
enhanced Commission monitoring and oversight of the fund industry,
which we anticipate would result from the proposed disclosure and
reporting requirements.
---------------------------------------------------------------------------
\774\ See supra section III.C.9.
---------------------------------------------------------------------------
For similar reasons, we do not believe that the interests of
investors would be served by establishing different reporting,
recordkeeping, or other compliance requirements for small funds. We
considered providing small funds simplified compliance or disclosure
requirements. However, we believe this too would subject investors in
small funds that invest in derivatives to a higher degree of risk and
information asymmetry than investors to large funds that would be
required to comply with the proposed disclosure requirements. We also
note that registered open- and closed-end management investment
companies, including those that are small entities, have already
updated their systems and have established internal processes to
prepare, validate, and file reports on Forms N-PORT and N-CEN (or will
do so shortly).\775\ For funds that will be required to file reports on
Form N-RN, the vast majority of them are open-end funds, which already
are required to submit the form upon specified events. With respect to
the additional registered closed-end funds and BDCs newly required to
file reports on Form N-RN, we do not believe they would need more time
to comply with the new reporting requirements, given the limited set of
reporting requirements they would be subject to and the relatively low
burden we estimate of filing reports on Form N-RN.
---------------------------------------------------------------------------
\775\ See supra note 359 (discussing, among other things, Form
N-PORT compliance dates and noting that the funds that would rely on
proposed rule 18f-4 (if adopted) other than BDCs generally are
subject to reporting requirements on Form N-CEN); see also
Investment Report Modernization Adopting Release supra note 178, at
section II.H.
---------------------------------------------------------------------------
We also do not believe that the interests of investors would be
served by clarifying, consolidating, or simplifying the compliance
requirements under the proposal for small funds. Small funds are as
vulnerable to the same potential risks associated with their
derivatives use as larger funds are, and therefore we believe that
simplifying or consolidating the proposed reporting requirements for
small funds would not allow us to meet our stated objectives. Moreover,
we believe many of the proposed disclosure requirements involve minimal
burden. For example, the Form N-CEN ``checking a box'' reporting
requirement is completed on an annual basis.
Finally, we did not prescribe performance standards rather than
design standards for small funds because we believe this too could
diminish the ability of the proposed rules to achieve their intended
regulatory purpose by creating inconsistent reporting requirements
between small and large funds, and weakening the benefits of the
proposed reporting requirement for investors in small funds.
4. Rule 6c-11
Rule 6c-11 is designed to modernize the regulatory framework for
ETFs and to create a consistent, transparent, and efficient regulatory
framework.\776\ The Commission's full Regulatory Flexibility Act
Analysis regarding rule 6c-11, including analysis of significant
alternatives, appears in the 2019 ETFs Adopting Release and the 2018
ETFs Proposing Release.\777\ Our analysis of alternatives for small
leveraged/inverse ETFs here is consistent with the Commission's
analysis of alternatives for small ETFs in those releases.
---------------------------------------------------------------------------
\776\ See ETFs Adopting Release, supra note 76, at section I.
\777\ See id. at section VI; see also Exchange-Traded Funds,
Investment Company Act Release No. 10515 (June 28, 2018) [83 FR
37332 (July 31, 2018)] (``ETFs Proposing Release''), at section V.
---------------------------------------------------------------------------
[[Page 4557]]
We do not believe that permitting or requiring different treatment
for any subset of leveraged/inverse ETFs, including small leveraged/
inverse ETFs, under the proposed amendments to rule 6c-11, and the
rule's related recordkeeping, disclosure and reporting requirements,
would permit us to achieve our stated objectives. Similarly, we do not
believe that we can establish simplified or consolidated compliance
requirements for small leveraged/inverse ETFs under the proposed
amendments to rule 6c-11 without compromising our objectives. The
Commission discussed the bases for this determination (with respect to
ETFs other than leveraged/inverse ETFs) in more detail in the ETFs
Proposing Release and the ETFs Adopting Release, and we are extending
that analysis to leveraged/inverse ETFs in this Initial Regulatory
Flexibility Act Analysis. In addition, we do not believe it would be
appropriate to exempt small leveraged/inverse ETFs from the proposed
amendments to rule 6c-11 (or to establish different disclosure,
reporting, or recordkeeping requirements, or simplified or consolidated
compliance requirements under rule 6c-11 for these entities) because of
the particular risks that leveraged/inverse ETFs may present.\778\ We
also do not think it would be appropriate to establish different
requirements under rule 6c-11 for small leveraged/inverse ETFs, which
could produce a competitive advantage for these funds compared to
larger leveraged/inverse ETFs (and compared to other ETFs that rely on
the rule). This would conflict with our goals of creating a consistent,
transparent, and efficient regulatory framework for ETFs and to
facilitate greater competition and innovation among ETFs.
---------------------------------------------------------------------------
\778\ See supra section II.G.1.
---------------------------------------------------------------------------
G. Request for Comment
The Commission requests comments regarding this analysis. We
request comment on the number of small entities that would be subject
to our proposal and whether our proposal would have any effects that
have not been discussed. We request that commenters describe the nature
of any effects on small entities subject to our proposal and provide
empirical data to support the nature and extent of such effects. We
also request comment on the estimated compliance burdens of our
proposal and how they would affect small entities.
VI. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996 (``SBREFA''), the Commission must advise OMB whether a
proposed regulation constitutes a ``major'' rule. Under SBREFA, a rule
is considered ``major'' where, if adopted, it results in or is likely
to result in:
An annual effect on the economy of $100 million or more;
A major increase in costs or prices for consumers or
individual industries; or
Significant adverse effects on competition, investment, or
innovation.
We request comment on whether our proposal would be a ``major
rule'' for purposes of SBREFA. We solicit comment and empirical data
on:
The potential effect on the U.S. economy on an annual
basis;
Any potential increase in costs or prices for consumers or
individual industries; and
Any potential effect on competition, investment, or
innovation.
Commenters are requested to provide empirical data and other
factual support for their views to the extent possible.
VII. Statutory Authority
The Commission is proposing new rule 18f-4 under the authority set
forth in sections 6(c), 12(a), 18, 31(a), 38(a), and 61 of the
Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 80a-12(a), 80a-18,
80a-30(a), 80a-37(a), and 80a-60]. The Commission is proposing
amendments to rule 6c-11 under the authority set forth in sections
6(c), 22(c), and 38(a) of the Investment Company Act [15 U.S.C. 80a-
6(c), 22(c), and 80a-37(a)]. The Commission is proposing new rule 15l-2
under the authority set forth in sections 3, 3(b), 3E, 10, 15(l), 15F,
17, 23(a), and 36 of the Securities Exchange Act of 1934 [15 U.S.C.
78c, 78c(b), 78c-5, 78j, 78o(l), 78o-10, 78q, 78w(a), and 78mm]. The
Commission is proposing new rule 211(h)-1 under the authority set forth
in sections 206, 206A, 208, 211(a), and 211(h), and of the Investment
Advisers Act of 1940 [15 U.S.C. 80b-6, 80b-6a, 80b-8, 80b-11(a), and
80b-11(h)]. The Commission is proposing amendments to Form N-PORT, Form
N-LIQUID (which we propose to re-title as ``Form N-RN''), Form N-CEN,
and Form N-2 under the authority set forth in sections 8, 18, 30, and
38 of the Investment Company Act of 1940 [15 U.S.C. 80a-8, 80a-18, 80a-
29, 80a-37, 80a-63], sections 6, 7(a), 10 and 19(a) of the Securities
Act of 1933 [15 U.S.C. 77f, 77g(a), 77j, 77s(a)], and sections 10, 13,
15, 23, and 35A of the Exchange Act [15 U.S.C. 78j, 78m, 78o, 78w, and
78ll].
Text of Rules and Forms
List of Subjects
17 CFR Parts 240 and 249
Brokers, Fraud, Reporting and recordkeeping requirements,
Securities.
17 CFR Parts 270 and 274
Investment companies, Reporting and recordkeeping requirements,
Securities.
17 CFR Part 275
Reporting and recordkeeping requirements, Securities.
For the reasons set out in the preamble, title 17, chapter II of
the Code of Federal Regulations is proposed to be amended as follows:
* * * * *
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
0
1. The authority citation for part 240 is amended by adding a
subauthority for Section 240.15l-2 to read as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm,
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et
seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C.
1350; Pub. L. 111-203, 939A, 124 Stat. 1376 (2010); and Pub. L. 112-
106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted.
* * * * *
Section 240.15l-2 is also issued under Pub. L. 111-203, sec.
913, 124 Stat. 1376, 1827 (2010).
* * * * *
0
2. Section 240-15l-2 is added to read as follows:
Sec. 240.15l-2 Broker and dealer sales practices for leveraged/
inverse investment vehicles.
(a) Required approval of customer account. No broker or dealer
registered or required to be registered under the Securities Exchange
Act of 1934, or any associated person of the broker or dealer, may
accept an order from a customer that is a natural person (or the legal
representative of a natural person) to buy or sell shares of a
leveraged/inverse investment vehicle unless the broker or dealer has
approved such a customer's account to engage in those transactions and
has adopted and implemented policies and procedures reasonably designed
to achieve compliance with this section. Any
[[Page 4558]]
approval of a customer's account for buying or selling leveraged/
inverse investment vehicles must be effected as provided in paragraph
(b).
(b) Diligence in approving accounts. (1) In determining whether to
approve a customer's account to buy or sell leveraged/inverse
investment vehicles, the broker or dealer must exercise due diligence
to ascertain the essential facts relative to the customer, his or her
financial situation, and investment objectives, including, at a
minimum, the information specified in paragraph (b)(2) of this section
(and must seek to obtain information for all participants in a joint
account). Based upon this information, the broker or dealer must
specifically approve or disapprove the customer's account for buying
and selling shares of leveraged/inverse investment vehicles. An
approval of a customer account must be in writing. A broker or dealer
may provide this approval if the broker or dealer has a reasonable
basis for believing that the customer has such knowledge and experience
in financial matters that he or she may reasonably be expected to be
capable of evaluating the risks of buying and selling leveraged/inverse
investment vehicles.
(2) A broker or dealer must seek to obtain the following
information at a minimum regarding the customer:
(i) Investment objectives (e.g., safety of principal, income,
growth, trading profits, speculation) and time horizon;
(ii) Employment status (name of employer, self-employed or
retired);
(iii) Estimated annual income from all sources;
(iv) Estimated net worth (exclusive of family residence);
(v) Estimated liquid net worth (cash, liquid securities, other);
(vi) Percentage of the customer's estimated liquid net worth that
he or she intends to invest in leveraged/inverse investment vehicles;
and
(vii) Investment experience and knowledge (e.g., number of years,
size, frequency and type of transactions) regarding leveraged/inverse
investment vehicles, options, stocks and bonds, commodities, and other
financial instruments.
(c) Recordkeeping. A broker or dealer must maintain a written
record of the information that it obtained under paragraph (b) of this
section and, if applicable, its written approval of the customer's
account, as well as the versions of the firm's policies and procedures
required under paragraph (a) that were in place when it approved or
disapproved the customer's account, for a period of not less than six
years (the first two years in an easily accessible place) after the
date of the closing of the customer's account.
(d) Definitions. For purposes of this section:
Associated person of the broker dealer means any partner, officer,
director, or branch manager of such broker or dealer (or any person
occupying a similar status or performing similar functions), any person
directly or indirectly controlling, controlled by, or under common
control with such broker or dealer, or any employee of such broker or
dealer, except that any person associated with a broker or dealer whose
functions are solely clerical or ministerial shall not be included in
the meaning of such term for purposes of section 15(b) of the Exchange
Act (other than paragraph (6) thereof).
Commodity- or Currency-Based Trust or Fund means a trust or other
person:
(1) Issuing securities in an offering registered under the
Securities Act of 1933 (15 U.S.C. 77a et seq.) and which class of
securities is listed for trading on a national securities exchange;
(2) The assets of which consist primarily of derivative instruments
that reference commodities or currencies, or interests in the
foregoing; and
(3) That provides in its registration statement under the
Securities Act of 1933 (15 U.S.C. 77a et seq.) that a class of its
securities are purchased or redeemed, subject to conditions or
limitations, for a ratable share of its assets.
Leveraged/inverse investment vehicle means a registered investment
company (including any separate series thereof), or commodity- or
currency-based trust or fund, that seeks, 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.
(e) Transition. This section applies to all customers of the broker
or dealer, including customers who have opened accounts with the broker
or dealer before the compliance date for this section, provided that
this section does not apply to, and therefore will not restrict a
customer's ability to close or reduce, a position in a leveraged/
inverse investment vehicle that a customer established before the
compliance date of this section.
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
0
3. The authority citation for part 270 continues to read, in part, as
follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39,
and Pub. L. 111-203, sec. 939A, 124 Stat. 1376 (2010), unless
otherwise noted.
* * * * *
Section 270.6c-11 is also issued under 15 U.S.C. 80a-6(c) and
80a-37(a).
* * * * *
Sec. 270.6c-11 [Amended]
0
4. Amend Sec. 270.6c-11 by removing paragraph (c)(4).
0
5. Section 270.18f-4 is added to read as follows:
Sec. 270.18f-4 Exemption from the requirements of section 18 and
section 61 for certain senior securities transactions.
(a) Definitions. For purposes of this section:
Absolute VaR test means that the VaR of the fund's portfolio does
not exceed 15% of the value of the fund's net assets.
Derivatives exposure means the sum of the notional amounts of the
fund's derivatives instruments and, in the case of short sale
borrowings, the value of the asset sold short. In determining
derivatives exposure a fund may convert the notional amount of interest
rate derivatives to 10-year bond equivalents and delta adjust the
notional amounts of options contracts.
Derivatives risks means the risks associated with a fund's
derivatives transactions or its use of derivatives transactions,
including leverage, market, counterparty, liquidity, operational, and
legal risks and any other risks the derivatives risk manager (or, in
the case of a fund that is a limited derivatives user as described in
paragraph (c)(3) of this section, the fund's investment adviser) deems
material.
Derivatives risk manager means an officer or officers of the fund's
investment adviser responsible for administering the program and
policies and procedures required by paragraph (c)(1) of this section,
provided that the derivatives risk manager:
(1) May not be a portfolio manager of the fund, or if multiple
officers serve as derivatives risk manager, may not have a majority
composed of portfolio managers of the fund; and
(2) Must have relevant experience regarding the management of
derivatives risk.
Derivatives transaction means:
(1) Any swap, security-based swap, futures contract, forward
contract, option, any combination of the foregoing, or any similar
instrument (``derivatives 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
[[Page 4559]]
or at maturity or early termination, whether as margin or settlement
payment or otherwise; and
(2) Any short sale borrowing.
Designated reference index means an unleveraged index that: (1) Is
selected by the derivatives risk manager and that reflects the markets
or asset classes in which the fund invests; (2) is not administered by
an organization that is an affiliated person of the fund, its
investment adviser, or principal underwriter, or created at the request
of the fund or its investment adviser, unless the index is widely
recognized and used; and (3) is an ``appropriate broad-based securities
market index'' or an ``additional index,'' as defined in the
instruction to Item 27 in Form N-1A [17 CFR 274.11A]. In the case of a
blended index, none of the indexes that compose the blended index may
be administered by an organization that is an affiliated person of the
fund, its investment adviser, or principal underwriter, or created at
the request of the fund or its investment adviser, unless the index is
widely recognized and used.
Fund means a registered open-end or closed-end company or a
business development company, including any separate series thereof,
but does not include a registered open-end company that is regulated as
a money market fund under Sec. 270.2a-7.
Relative VaR test means that the VaR of the fund's portfolio does
not exceed 150% of the VaR of the designated reference index.
Unfunded commitment agreement means a contract that is not a
derivatives transaction, under which a fund commits, conditionally or
unconditionally, to make a loan to a company or to invest equity in a
company in the future, including by making a capital commitment to a
private fund that can be drawn at the discretion of the fund's general
partner.
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 net assets, over a specified time horizon and at a given
confidence level, provided that 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 nonlinear 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.
(b) Derivatives transactions. If a fund satisfies the conditions of
paragraph (c) of this section, the fund may enter into derivatives
transactions, notwithstanding the requirements of sections 18(a)(1),
18(c), 18(f)(1), and 61 of the Investment Company Act (15 U.S.C. 80a-
18(a)(1), 80a-18(c), 80a-18(f)(1), and 80a-60), and derivatives
transactions entered into by the fund in compliance with this section
will not be considered for purposes of computing asset coverage, as
defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a-
18(h)).
(c) Conditions. (1) Derivatives risk management program. The fund
adopts and implements a written derivatives risk management program
(``program''), which must include policies and procedures that are
reasonably designed to manage the fund's derivatives risks and to
reasonably segregate the functions associated with the program from the
portfolio management of the fund. The program must include the
following elements:
(i) Risk identification and assessment. The program must provide
for the identification and assessment of the fund's derivatives risks.
This assessment must take into account the fund's derivatives
transactions and other investments.
(ii) Risk guidelines. The program must provide for the
establishment, maintenance, and enforcement of investment, risk
management, or related guidelines that provide for quantitative or
otherwise measurable criteria, metrics, or thresholds of the fund's
derivatives risks. These guidelines must specify levels of the given
criterion, metric, or threshold that the fund does not normally expect
to exceed, and measures to be taken if they are exceeded.
(iii) Stress testing. The program must provide for stress testing
to evaluate potential losses to the fund's portfolio in response to
extreme but plausible market changes or changes in market risk factors
that would have a significant adverse effect on the fund's portfolio,
taking into account correlations of market risk factors and resulting
payments to derivatives counterparties. The frequency with which the
stress testing under this paragraph is conducted must take into account
the fund's strategy and investments and current market conditions,
provided that these stress tests must be conducted no less frequently
than weekly.
(iv) Backtesting. The program must provide for backtesting of the
results of the VaR calculation model used by the fund in connection
with the relative VaR test or the absolute VaR test by, each business
day, comparing the fund's gain or loss with the corresponding VaR
calculation for that day, estimated over a one-trading day time
horizon, and identifying as an exception any instance in which the fund
experiences a loss exceeding the corresponding VaR calculation's
estimated loss.
(v) Internal reporting and escalation. (A) Internal reporting. The
program must identify the circumstances under which persons responsible
for portfolio management will be informed regarding the operation of
the program, including exceedances of the guidelines specified in
paragraph (c)(1)(ii) of this section and the results of the stress
tests specified in paragraph (c)(1)(iii) of this section.
(B) Escalation of material risks. The derivatives risk manager must
inform in a timely manner persons responsible for portfolio management
of the fund, and also directly inform the fund's board of directors as
appropriate, of material risks arising from the fund's derivatives
transactions, including risks identified by the fund's exceedance of a
criterion, metric, or threshold provided for in the fund's risk
guidelines established under paragraph (c)(1)(ii) of this section or by
the stress testing described in paragraph (c)(1)(iii) of this section.
(vi) Periodic review of the program. The derivatives risk manager
must review the program at least annually to evaluate the program's
effectiveness and to reflect changes in risk over time. The periodic
review must include a review of the VaR calculation model used by the
fund under paragraph (c)(2) of this section (including the backtesting
required by paragraph (c)(1)(iv) of this section) and any designated
reference index to evaluate whether it remains appropriate.
(2) Limit on fund leverage risk. (i) The fund must comply with the
relative VaR test or, if the derivatives risk manager is unable to
identify a designated reference index that is appropriate for the fund
taking into account the fund's investments, investment objectives, and
strategy, the absolute VaR test.
(ii) The fund must determine its compliance with the applicable VaR
test at least once each business day. If the fund determines that it is
not in compliance with the applicable VaR test, the fund must come back
into compliance promptly and within no
[[Page 4560]]
more than three business days after such determination.
(iii) If the fund is not in compliance with the applicable VaR test
within three business days:
(A) The derivatives risk manager must report to the fund's board of
directors and explain how and by when (i.e., number of business days)
the derivatives risk manager reasonably expects that the fund will come
back into compliance;
(B) The derivatives risk manager must analyze the circumstances
that caused the fund to be out of compliance for more than three
business days and update any program elements as appropriate to address
those circumstances; and
(C) The fund may not enter into any derivatives transactions (other
than derivatives transactions that, individually or in the aggregate,
are designed to reduce the fund's VaR) until the fund has been back in
compliance with the applicable VaR test for three consecutive business
days and has satisfied the requirements set forth in paragraphs
(c)(2)(iii)(A) and (B) of this section.
(iv) If the fund is complying with the relative VaR test, an open-
end fund must disclose in its annual report the fund's designated
reference index as the fund's ``appropriate broad-based securities
market index'' or an ``additional index,'' as defined in the
instruction to Item 27 in Form N-1A [17 CFR 274.11A], and a registered
closed-end fund or business development company must disclose its
designated reference index in the annual report, together with a
presentation of the fund's performance relative to the designated
reference index. A fund is not required to include this disclosure in
an annual report if the fund is a ``New Fund,'' as defined in Form N-1A
[17 CFR 274.11A], or would meet that definition if it were filing on
Form N-1A [17 CFR 274.11A], at the time the fund files the annual
report.
(3) Limited derivatives users. A fund is not required to adopt a
program as prescribed in paragraph (c)(1) of this section, or comply
with the limit on fund leverage risk in paragraph (c)(2) of this
section, if the fund adopts and implements policies and procedures
reasonably designed to manage the fund's derivatives risks and:
(i) The fund's derivatives exposure does not exceed 10 percent of
the fund's net assets; or
(ii) The fund limits its use of derivatives transactions to
currency derivatives that hedge the currency risks associated with
specific foreign-currency-denominated equity or fixed-income
investments held by the fund, provided that the currency derivatives
are entered into and maintained by the fund for hedging purposes and
that the notional amounts of such derivatives do not exceed the value
of the hedged instruments denominated in the foreign currency (or the
par value thereof, in the case of fixed-income investments) by more
than a negligible amount.
(4) Leveraged/inverse funds. A fund is not required to comply with
the limit on fund leverage risk in paragraph (c)(2) of this section if:
(i) The fund is a leveraged/inverse investment vehicle as defined
in Sec. 240.15l-2 and Sec. 275.211(h)-1;
(ii) The fund discloses in its prospectus that it is not subject to
the limit on fund leverage risk in paragraph (c)(2) of this section;
and
(iii) The fund does not seek or obtain, directly or indirectly,
investment results exceeding 300% of the return (or inverse of the
return) of the underlying index.
(5) Board oversight and reporting. (i) Approval of the derivatives
risk manager. A fund's board of directors, including a majority of
directors who are not interested persons of the fund, must approve the
designation of the derivatives risk manager, taking into account the
derivatives risk manager's relevant experience regarding the management
of derivatives risk.
(ii) Reporting on program implementation and effectiveness. On or
before the implementation of the program, and at least annually
thereafter, the derivatives risk manager must provide to the board of
directors a written report providing a representation that the program
is reasonably designed to manage the fund's derivatives risks and to
incorporate the elements provided in paragraphs (c)(1)(i) through (vi)
of this section. The representation may be based on the derivatives
risk manager's reasonable belief after due inquiry. The written report
must include the basis for the representation along with such
information as may be reasonably necessary to evaluate the adequacy of
the fund's program and, for reports following the program's initial
implementation, the effectiveness of its implementation. The written
report also must include the derivatives risk manager's basis for the
selection of the designated reference index or, if applicable, an
explanation of why the derivatives risk manager was unable to identify
a designated reference index appropriate for the fund.
(iii) Regular board reporting. The derivatives risk manager must
provide to the board of directors, at a frequency determined by the
board, a written report regarding the derivatives risk manager's
analysis of any exceedances described in paragraph (c)(1)(ii) of this
section, the results of the stress testing conducted under paragraph
(c)(1)(iii) of this section, and the results of the backtesting
conducted under paragraph (c)(1)(iv) of this section since the last
report to the board. Each report under this paragraph must include such
information as may be reasonably necessary for the board of directors
to evaluate the fund's response to any exceedances and the results of
the fund's stress testing.
(6) Recordkeeping. (i) Records to be maintained. A fund must
maintain a written record documenting, as applicable:
(A) The fund's written policies and procedures required by
paragraph (c)(1) of this section, along with:
(1) The results of the fund's stress tests under paragraph
(c)(1)(iii) of this section;
(2) The results of the backtesting conducted under paragraph
(c)(1)(iv) of this section;
(3) Records documenting any internal reporting or escalation of
material risks under paragraph (c)(1)(v)(B) of this section; and
(4) Records documenting the reviews conducted under paragraph
(c)(1)(vi) of this section.
(B) Copies of any materials provided to the board of directors in
connection with its approval of the designation of the derivatives risk
manager, any written reports provided to the board of directors
relating to the program, and any written reports provided to the board
of directors under paragraph (c)(2)(iii)(A) of this section.
(C) Any determination and/or action the fund made under paragraphs
(c)(2)(i)-(ii) of this section, including a fund's determination of:
The VaR of its portfolio; the VaR of the fund's designated reference
index, as applicable; the fund's VaR ratio (the value of the VaR of the
Fund's portfolio divided by the VaR of the designated reference index),
as applicable; and any updates to any VaR calculation models used by
the fund and the basis for any material changes thereto.
(D) If applicable, the fund's written policies and procedures
required by paragraph (c)(3) of this section.
(ii) Retention periods. (A) A fund must maintain a copy of the
written policies and procedures that the fund adopted under paragraphs
(c)(1) or (c)(3) of this section that are in effect, or at any time
within the past five years were in effect, in an easily accessible
place.
[[Page 4561]]
(B) A fund must maintain all records and materials that paragraphs
(c)(6)(i)(A)(1)-(4) and (c)(6)(i)(B)-(D) of this section describe for a
period of not less than five years (the first two years in an easily
accessible place) following each determination, action, or review that
these paragraphs describe.
(7) Current reports. A fund that experiences an event specified in
the parts of Form N-RN [referenced in 17 CFR 274.223] titled ``Relative
VaR Test Breaches,'' ``Absolute VaR Test Breaches,'' or ``Compliance
with VaR Test'' must file with the Commission a report on Form N-RN
within the period and according to the instructions specified in that
form.
(d) Reverse repurchase agreements. A fund may enter into reverse
repurchase agreements or similar financing transactions,
notwithstanding the requirements of sections 18(c), and 18(f)(1) of the
Investment Company Act, if the fund complies with the asset coverage
requirements of section 18 and combines the aggregate amount of
indebtedness associated with the reverse repurchase agreement or
similar financing transaction with the aggregate amount of any other
senior securities representing indebtedness when calculating the asset
coverage ratio.
(e) Unfunded commitment agreements. (1) A fund may enter into an
unfunded commitment agreement, notwithstanding the requirements of
sections 18(a), 18(c), 18(f)(1), and 61 of the Investment Company Act,
if the fund reasonably believes, at the time it enters into such
agreement, that it will have sufficient cash and cash equivalents to
meet its obligations with respect to all of its unfunded commitment
agreements, in each case as they come due. In forming a reasonable
belief, the fund must take into account its reasonable expectations
with respect to other obligations (including any obligation with
respect to senior securities or redemptions), and may not take into
account cash that may become available from the sale or disposition of
any investment at a price that deviates significantly from the market
value of those investments, or from issuing additional equity. Unfunded
commitment agreements entered into by the fund in compliance with this
section will not be considered for purposes of computing asset
coverage, as defined in section 18(h) of the Investment Company Act (15
U.S.C. 80a-18(h)).
(2) For each unfunded commitment agreement that a fund enters into
under paragraph (e)(1) of this section, a fund must document the basis
for its reasonable belief regarding the sufficiency of its cash and
cash equivalents to meet its unfunded commitment agreement obligations,
and maintain a record of this documentation for a period of not less
than five years (the first two years in an easily accessible place)
following the date that the fund entered into the agreement.
0
6. Revise Sec. 270.30b1-10 to read as follows:
Sec. 270.30b1-10 Current report for open-end and closed-end
management investment companies.
Every registered open-end management investment company, or series
thereof, and every registered closed-end management investment company,
but not a fund that is regulated as a money market fund under Sec.
270.2a-7, that experiences an event specified on Form N-RN, must file
with the Commission a current report on Form N-RN within the period and
according to the instructions specified in that form.
PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940
0
7. The general authority for part 274 continues to read as follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m,
78n, 78o(d), 80a-8, 80a-24, 80a-26, 80a-29, and Pub. L. 111-203,
sec. 939A, 124 Stat. 1376 (2010), unless otherwise noted.
* * * * *
0
8. Amend Form N-2 (referenced in Sec. Sec. 239.14 and 274.11a-1) by
revising instruction 2. to sub-item ``3. Senior Securities'' of ``Item
4. Financial Highlights'' to read as follows:
Note: The text of Form N-2 does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form N-2
* * * * *
Item 4. Financial Highlights
* * * * *
3. Senior Securities
* * * * *
Instructions
* * * * *
2. Use the method described in section 18(h) of the 1940 Act [15
U.S.C. 80a-18(h)] to calculate the asset coverage to be set forth in
column (3). However, in lieu of expressing asset coverage in terms of a
ratio, as described in section 18(h), express it for each class of
senior securities in terms of dollar amounts per share (in the case of
preferred stock) or per $1,000 of indebtedness (in the case of senior
indebtedness). A fund should not consider any derivatives transactions,
or any unfunded commitment agreements, that it enters into in
compliance with rule 18f-4 under the Investment Company Act [17 CFR
270.18f-4] for purposes of computing asset coverage.
* * * * *
0
9. Amend Form N-CEN (referenced in Sec. Sec. 249.330 and 274.101) by
adding new Item C.7.l. to read as follows:
Note: The text of Form N-CEN does not, and this amendment will
not, appear in the Code of Federal Regulations.
FORM N-CEN
ANNUAL REPORT FOR REGISTERED INVESTMENT COMPANIES
* * * * *
Item C.7. * * *
l. Rule 18f-4 (17 CFR 270.18f-4): _
i. Is the Fund excepted from the rule 18f-4 (17 CFR 270.18f-4)
program requirement under rule 18f-4(c)(3)(i) (17 CFR 270.18f-
4(c)(3)(i))? __
ii. Is the Fund excepted from the rule 18f-4 (17 CFR 270.18f-4)
program requirement under rule 18f-4(c)(3)(ii) (17 CFR 270.18f-
4(c)(3)(ii))? __
iii. Is the Fund a leveraged/inverse fund covered by rule 15l-2
under the Exchange Act (17 CFR 240.15l-2) or rule 211(h)-1 under the
Investment Advisers Act of 1940 (17 CFR 275.211(h)-1) that, under rule
18f-4(c)(4) (17 CFR 270.18f-4(c)(4)), is excepted from the requirement
to comply with the limit on leverage risk described in rule 18f-4(c)(2)
(17 CFR 270.18f-4(c)(2))? __
iv. Has the Fund entered into any reverse repurchase agreements or
similar financing transactions under rule 18f-4(d) (17 CFR 270.18f-
4(d))? __
v. Has the Fund entered into any unfunded commitment agreements
under rule 18f-4(e) (17 CFR 270.18f-4(e))? __
* * * * *
0
10. Amend Form N-PORT (referenced in Sec. 274.150) by:
0
a. Adding to General Instruction E. ``Definitions'' in alphabetical
order, the following definitions:
0
i. ``Absolute VaR Test'';
0
ii. ``Designated Reference Index'';
0
iii. ``Derivatives Exposure'';
0
iv. ``Relative VaR Test'';
0
v. ``Value-at-risk'';
0
vi. ``VaR Ratio''; and
0
b. Adding Items B.9 and B.10.
The additions read as follows:
[[Page 4562]]
Note: The text of Form N-PORT does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form N-PORT
MONTHLY PORTFOLIO INVESTMENTS REPORT
* * * * *
GENERAL INSTRUCTIONS
* * * * *
E. Definitions
* * * * *
``Absolute VaR Test'' has the meaning defined in rule 18f-4(a) [17 CFR
270.18f-4(a)].
* * * * *
``Derivatives Exposure'' has the meaning defined in rule 18f-4(a) [17
CFR 270.18f-4(a)].
* * * * *
``Designated Reference Index'' has the meaning defined in rule 18f-4(a)
[17 CFR 270.18f-4(a)].
* * * * *
``Relative VaR Test'' has the meaning defined in rule 18f-4(a) [17 CFR
270.18f-4(a)].
* * * * *
``Value-at-risk'' or VaR has the meaning defined in rule 18f-4(a) [17
CFR 270.18f-4(a)].
* * * * *
``VaR Ratio'' means the value of the Fund's portfolio VaR divided by
the VaR of the Designated Reference Index.
* * * * *
PART B. * * *
Item B.9 Derivatives Exposure. Report as a percentage of the Fund's net
asset value:
a. Derivatives Exposure.
i. Exposure from derivatives instruments.
ii. Exposure from short sales.
Item B.10 VaR Information. For Funds subject to the limit on fund
leverage risk in rule 18f-4(c)(2) [17 CFR 270.18f-4(c)(2)], provide the
following information, as determined in accordance with the requirement
under rule 18f-4(c)(2)(ii) to determine the fund's compliance with the
applicable VaR test at least once each business day:
a. Highest daily VaR during the reporting period.
b. Date of highest daily VaR during the reporting period.
c. Median daily VaR during the reporting period.
d. For Funds that were subject to the Relative VaR Test during the
reporting period, provide:
i. Name of the Fund's Designated Reference Index.
ii. Index Identifier for the Fund's Designated Reference Index.
iii. Highest VaR Ratio during the reporting period.
iv. Date of highest VaR Ratio during the reporting period.
v. Median VaR Ratio during the reporting period.
e. Backtesting Results. Number of exceptions that the Fund identified
as a result of its backtesting of its VaR calculation model (as
described in rule 18f-4(c)(1)(iv) [17 CFR 270.18f-4(c)(1)(iv)] during
the reporting period.
* * * * *
0
11. Revise Sec. 274.223, its sectional heading, and Form N-LIQUID
(referenced in Sec. 274.223) and its title to read as follows:
Sec. 274.223 Form N-RN, Current report, open- and closed-end
investment company reporting.
This form shall be used by registered open-end management
investment companies, or series thereof, and closed-end management
investment companies, or series thereof, to file reports pursuant to
Sec. 270.18f-4(c)(7) and Sec. 270.30b1-10 of this chapter.
Note: The text of Form N-RN does not, and this amendment will
not, appear in the Code of Federal Regulations.
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
FORM N-RN
CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT COMPANIES AND
BUSINESS DEVELOPMENT COMPANIES
Form N-RN is to be used by a registered open-end management
investment company or series thereof, but not including a fund that is
regulated as a money market fund under rule 2a-7 under the Act (17 CFR
270.2A-7) (a ``registered open-end fund''), a registered closed-end
management investment company (a ``registered closed-end fund''), or a
closed-end management investment company that has elected to be
regulated as a business development company (a ``business development
company''), to file current reports with the Commission pursuant to
rule 18f-4 and rule 30b1-10 under the Investment Company of 1940 Act
[15 U.S.C. 80a] (``Act'') (17 CFR 270.18f-4; 17 CFR 270.30b1-10). The
Commission may use the information provided on Form N-RN in its
regulatory, disclosure review, inspection, and policymaking roles.
GENERAL INSTRUCTIONS
A. Rules as to Use of Form N-RN
(1) Form N-RN is the reporting form that is to be used for current
reports of registered open-end funds (not including funds that are
regulated as money market funds under rule 2a-7 under the Act),
registered closed-end funds, and business development companies
(together, ``registrants'') required by, as applicable, section 30(b)
of the Act and rule 30b1-10 under the Act, as well as rule 18f-4 under
the Act. The Commission does not intend to make public information
reported on Form N-RN that is identifiable to any particular
registrant, although the Commission may use Form N-RN information in an
enforcement action.
(2) Unless otherwise specified, a report on this Form N-RN is
required to be filed, as applicable, within one business day of the
occurrence of the event specified in Parts B-G of this form. If the
event occurs on a Saturday, Sunday, or holiday on which the Commission
is not open for business, then the one business day period shall begin
to run on, and include, the first business day thereafter.
(3) For registered open-end funds required to comply with rule 22e-
4 under the Investment Company Act [17 CFR 270.22e-4], complete Parts
B-D of this form, as applicable. For registrants that rely on rule 18f-
4 of the Act [17 CFR 270.18f-4], complete Parts E-G of this form, as
applicable.
B. Application of General Rules and Regulations
The General Rules and Regulations under the Act contain certain
general requirements that are applicable to reporting on any form under
the Act. These general requirements should be carefully read and
observed in the preparation and filing of reports on this form, except
that any provision in the form or in these instructions shall be
controlling.
C. Information To Be Included in Report Filed on Form N-RN
Upon the occurrence of the event specified in Parts B-G of Form N-
RN, as applicable, a registrant must file a report on Form N-RN that
includes information in response to each of the items in Part A of the
form, as well as each of the items in the applicable Parts B-G of the
Form.
D. Filing of Form N-RN
A registrant must file Form N-RN in accordance with rule 232.13 of
Regulation S-T (17 CFR part 232). Form N-RN must be filed
electronically using
[[Page 4563]]
the Commission's Electronic Data Gathering, Analysis and Retrieval
System (``EDGAR'').
E. Paperwork Reduction Act Information
A registrant is not required to respond to the collection of
information contained in Form N-RN unless the form displays a currently
valid Office of Management and Budget (``OMB'') control number. Please
direct comments concerning the accuracy of the information collection
burden estimate and any suggestions for reducing the burden to the
Secretary, Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549-1090. The OMB has reviewed this collection of
information under the clearance requirements of 44 U.S.C. 3507.
F. Definitions
(1) References to sections and rules in this Form N-RN are to the
Investment Company Act (15 U.S.C. 80a), unless otherwise indicated.
Terms used in this Form N-RN have the same meaning as in the Investment
Company Act, rule 22e-4 under the Investment Company Act (for Parts B-D
of the Form), or rule 18f-4 under the Investment Company Act (for Part
E-G of the Form), unless otherwise indicated. In addition, as used in
this Form N-RN, the term registrant means the registrant or a separate
series of the registrant, as applicable.
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
FORM N-RN
CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT COMPANIES AND
BUSINESS DEVELOPMENT COMPANIES
PART A. General Information
Item A.1. Report for [mm/dd/yyyy].
Item A.2. CIK Number of registrant.
Item A.3. EDGAR Series Identifier.
Item A.4. Securities Act File Number, if applicable.
Item A.5. Provide the name, email address, and telephone number of the
person authorized to receive information and respond to questions about
this Form N-RN.
PART B. Above 15% Illiquid Investments
If more than 15 percent of the registrant's net assets are, or
become, illiquid investments that are assets as defined in rule 22e-4,
then report the following information:
Item B.1. Date(s) on which the registrant's illiquid investments that
are assets exceeded 15 percent of its net assets.
Item B.2. The current percentage of the registrant's net assets that
are illiquid investments that are assets.
Item B.3. Identification of illiquid investments. For each investment
that is an asset that is held by the registrant that is considered
illiquid, disclose (1) the name of the issuer, the title of the issue
or description of the investment, the CUSIP (if any), and at least one
other identifier, if available (e.g., ISIN, Ticker, or other unique
identifier (if ticker and ISIN are not available)) (indicate the type
of identifier used), and (2) the percentage of the fund's net assets
attributable to that investment.
PART C. At or Below 15% Illiquid Investments
If a registrant that has filed Part B of Form N-RN determines that
its holdings in illiquid investments that are assets have changed to be
less than or equal to 15 percent of the registrant's net assets, then
report the following information:
Item C.1. Date(s) on which the registrant's illiquid investments that
are assets fell to or below 15 percent of net assets.
Item C.2. The current percentage of the registrant's net assets that
are illiquid investments that are assets.
PART D. Assets That Are Highly Liquid Investments Below the Highly
Liquid Investment Minimum
If a registrant's holdings in assets that are highly liquid
investments fall below its highly liquid investment minimum for more
than 7 consecutive calendar days, then report the following
information:
Item D.1. Date(s) on which the registrant's holdings of assets that are
highly liquid investments fell below the fund's highly liquid
investment minimum.
PART E. Relative VaR Test Breaches
If a registrant is subject to the relative VaR test under rule 18f-
4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)], and the fund determines that it
is not in compliance with the relative VaR test and has not come back
into compliance within 3 business days after such determination,
provide:
Item E.1. The dates on which the VaR of the registrant's portfolio
exceeded 150% of the VaR of its designated reference index.
Item E.2. The VaR of the registrant's portfolio on the dates each
exceedance occurred.
Item E.3. The VaR of the registrant's designated reference index on the
dates each exceedance occurred.
Item E.4. The name of the registrant's designated reference index.
Item E.5. The index identifier for the registrant's designated
reference index.
PART F. Absolute VaR Test Breaches
If a registrant is subject to the absolute VaR test under rule 18f-
4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)], and the fund determines that it
is not in compliance with the absolute VaR test and has not come back
into compliance within 3 business days after such determination,
provide:
Item F.1. The dates on which the VaR of the registrant's portfolio
exceeded 15% of the value of the registrant's net assets.
Item F.2. The VaR of the registrant's portfolio on the dates each
exceedance occurred.
Item F.3. The value of the registrant's net assets on the dates each
exceedance occurred.
PART G. Compliance with VaR Test
If a registrant that has filed Part E or Part F of Form N-RN has
come back into compliance with either the relative VaR test or the
absolute VaR test, as applicable, then report the following
information:
Item G.1. Dates on which the VaR of the registrant's portfolio
exceeded, as applicable, 150% of the VaR of its designated reference
index (if the registrant is subject to the relative VaR test under rule
18f-4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)]) or 15% of the value of the
registrant's net assets (if the registrant is subject to the absolute
VaR test under rule 18f-4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)]).
Item G.2. The current VaR of the registrant's portfolio.
PART H. Explanatory Notes (if any)
A registrant may provide any information it believes would be
helpful in understanding the information reported in response to any
Item of this Form.
SIGNATURES
Pursuant to the requirements of the Investment Company Act of 1940, the
registrant has duly caused this report to be signed on its behalf by
the undersigned hereunto duly authorized.
-----------------------------------------------------------------------
[[Page 4564]]
(Registrant)
Date-------------------------------------------------------------------
-----------------------------------------------------------------------
(Signature) *
* Print name and title of the signing officer under his/her signature.
* * * * *
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
0
12. The authority citation for part 275 continues to read, in part, and
the subauthority for Section 275.211h-1 is added to read as follows:
Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless
otherwise noted.
* * * * *
Section 275.211(h)-1 is also issued under sec. 913, Pub. L. 111-
203, 124 Stat. 1827-28 (2010).
* * * * *
0
13. Section 275.211(h)-1 is added to read as follows:
Sec. 275.211(h)-1 Investment adviser sales practices for leveraged/
inverse investment vehicles.
(a) Required approval of client account. No investment adviser
registered or required to be registered under the Advisers Act, or any
supervised person of the investment adviser, may place an order for the
account of an advisory client that is a natural person (or the legal
representative of a natural person) to buy or sell shares of a
leveraged/inverse investment vehicle unless the investment adviser has
approved such a client's account to engage in those transactions and
has adopted and implemented policies and procedures reasonably designed
to achieve compliance with this section. Any approval of a client's
account for buying or selling leveraged/inverse investment vehicles
must be effected as provided in paragraph (b).
(b) Diligence in approving accounts. (1) In determining whether to
approve a client's account to buy or sell leveraged/inverse investment
vehicles, the investment adviser must exercise due diligence to
ascertain the essential facts relative to the client, his or her
financial situation, and investment objectives, including, at a
minimum, the information specified in paragraph (b)(2) of this section
(and must seek to obtain information for all participants in a joint
account). Based upon this information, the investment adviser must
specifically approve or disapprove the client's account for buying and
selling shares of leveraged/inverse investment vehicles. An approval of
a client account must be in writing. An investment adviser may provide
this approval if the investment adviser has a reasonable basis for
believing that the client has such knowledge and experience in
financial matters that he or she may reasonably be expected to be
capable of evaluating the risks of buying and selling leveraged/inverse
investment vehicles.
(2) An investment adviser must seek to obtain the following
information at a minimum regarding the client:
(i) Investment objectives (e.g., safety of principal, income,
growth, trading profits, speculation) and time horizon;
(ii) Employment status (name of employer, self-employed or
retired);
(iii) Estimated annual income from all sources;
(iv) Estimated net worth (exclusive of family residence);
(v) Estimated liquid net worth (cash, liquid securities, other);
(vi) Percentage of the client's estimated liquid net worth that he
or she intends to invest in leveraged/inverse investment vehicles; and
(vii) Investment experience and knowledge (e.g., number of years,
size, frequency and type of transactions) regarding leveraged/inverse
investment vehicles, options, stocks and bonds, commodities, and other
financial instruments.
(c) Recordkeeping. An investment adviser must maintain a written
record of the information that it obtained under paragraph (b) of this
section and, if applicable, its written approval of the client's
account, as well as the versions of the firm's policies and procedures
required under paragraph (a) that were in place when it approved or
disapproved the client's account, for a period of not less than six
years (the first two years in an easily accessible place) after the
date of the closing of the client's account.
(d) Definitions. For purposes of this section:
Commodity- or currency-based trust or fund means a trust or other
person:
(1) Issuing securities in an offering registered under the
Securities Act of 1933 (15 U.S.C. 77a et seq.) and which class of
securities is listed for trading on a national securities exchange;
(2) The assets of which consist primarily of derivative instruments
that reference commodities or currencies, or interests in the
foregoing; and
(3) That provides in its registration statement under the
Securities Act of 1933 (15 U.S.C. 77a et seq.) that a class of its
securities are purchased or redeemed, subject to conditions or
limitations, for a ratable share of its assets.
Leveraged/inverse investment vehicle means a registered investment
company (including any separate series thereof), or commodity- or
currency-based trust or fund, that seeks, 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.
Supervised person means any partner, officer, director (or other
person occupying a similar status or performing similar functions), or
employee of an investment adviser, or other person who provides
investment advice on behalf of the investment adviser.
(e) Transition. This section applies to all clients of the
investment adviser, including clients who have opened accounts with the
investment adviser before the compliance date for this section,
provided that this section does not apply to, and therefore will not
restrict the ability to close or reduce, a client's position in a
leveraged/inverse investment vehicle that a client established before
the compliance date of this section.
By the Commission.
Dated: November 25, 2019.
Eduardo A. Aleman,
Deputy Secretary.
VIII. APPENDIX A
Note: Appendix A will not appear in the Code of Federal
Regulations. Feedback Flier: Funds' Use of Derivatives
We are proposing a new regulatory approach for funds' use of
derivatives. This includes proposed rule 18f-4 under the Investment
Company Act of 1940, a new exemptive rule designed to address the
investor protection purposes and concerns underlying section 18 of
the Act and to provide an updated and more comprehensive approach to
the regulation of funds' use of derivatives. The proposal also
includes certain new proposed reporting requirements relating to
funds' derivatives use. More information about our proposal is
available at https://www.sec.gov/rules/proposed/2019/34-87607.pdf.
We are particularly interested in learning what small funds
think about the requirements of proposed new rule 18f-4 and the
proposed new reporting requirements. Hearing from small funds could
help us learn how the proposed rule and new reporting requirements
would affect these entities, and evaluate how we could address any
unintended consequences resulting from the cost and effort of
regulatory compliance while still promoting investor protection. We
would appreciate your feedback on any or all of the following
questions.
[[Page 4565]]
All of the following questions are optional, including any
questions that ask about identifying information. Please note that
responses to these questions--including any other general
identifying information you provide--will be made public.
Item 1: General Identifying Information
Instructions: At your option, you may include general identifying
information that would help us contextualize your other feedback on
the proposal. This information could include responses to the
following questions, as well as any other general identifying
information you would like to provide. Responses to these items--
like responses to the other items on this Feedback Flier--will be
made public.
a. How big is the fund in terms of net asset value? (This may be
expressed in a range, for example, $40 million-$50 million.)
b. What is/are the principal investment strategy/strategies of the
fund?
c. Does the fund use derivatives transactions (as defined in the
proposed rule) to pursue the fund's principal investment strategy/
strategies? [Y/N]
d. Is the fund part of a fund complex? [Y/N]
e. Please include any additional general identifying information
that you wish to provide, that could add context for your other
feedback on the proposal.
Item 2: Derivatives Risk Management Program
Instructions: If you believe the fund would be required to adopt and
implement a derivatives risk management program under the proposed
rules, please answer the following questions. If you do not believe
so, please proceed to Item 4.
a. The proposed derivatives risk management program requirement
would include the following seven elements. In the following chart,
please indicate which of the proposed program elements you think
would be the most expensive for the fund to implement and which
would be least expensive to implement, by ranking the following
elements from one (1)--most expensive--through seven (7)--least
expensive--using each number only once. If you have any comments
about the factors informing your analysis, please include.
------------------------------------------------------------------------
Rank by cost (1--
Derivatives risk management most expensive; 7--
program elements least expensive) Use Comments
each number once
------------------------------------------------------------------------
(a) Risk identification and
assessment
------------------------------------------------------------------------
(b) Risk guidelines
------------------------------------------------------------------------
(c) Stress testing
------------------------------------------------------------------------
(d) Backtesting
------------------------------------------------------------------------
(e) Internal reporting and
escalation
------------------------------------------------------------------------
(f) Periodic review of the
program
------------------------------------------------------------------------
(g) Board reporting and
oversight
------------------------------------------------------------------------
b. Implementation timing.
(1.) How many months do you think it would take the fund to
adopt and implement a derivatives risk management program (check one
box)?
----------------------------------------------------------------------------------------------------------------
6 months-12 months 12 months-18 months 18 months-24 months >24 months
----------------------------------------------------------------------------------------------------------------
[ ] [ ] [ ] [ ]
----------------------------------------------------------------------------------------------------------------
(2.) If the response above is more than 12 months, what would
help to shorten that time period?
(3.) Please provide any explanatory notes that you would like to
include.
c. Implementation cost.
(1.) Approximately how much do you think it would cost the fund
to implement a derivatives risk management program (in terms of
combined internal and external costs) (check one box)?
----------------------------------------------------------------------------------------------------------------
Estimated cost ($)
-----------------------------------------------------------------------------------------------------------------
$0-$150,000 $150,001-$350,000 $350,001-$500,000 >$500,000
----------------------------------------------------------------------------------------------------------------
[ ] [ ] [ ] [ ]
----------------------------------------------------------------------------------------------------------------
(2.) Please include any explanatory notes that you would like to
provide. These could describe, for example, how a fund that is part
of a fund complex might share these costs, any particular cost
considerations for a fund that uses sub-advisers, or the extent to
which the estimated costs would arise from internal versus external
costs (such as those associated with third-party service providers).
d. To the extent that the fund is a sub-advised fund, would any of
the proposed program elements present any particular challenges for
the fund to implement in light of its advisory structure? If so
please explain.
Item 3: Limit on Fund Leverage Risk
Instructions: The proposed rule would require certain funds to
comply with a limit on fund leverage risk based on value at risk
(``VaR''). The following questions relate to this proposed
requirement.
a. Does the fund currently use VaR testing? [Y/N]
b. Implementation cost.
(1.) If you anticipate that, if the proposed rules were adopted,
the fund would have to comply with the VaR testing requirement,
approximately how much do you think it would cost the fund to
implement the proposed VaR test requirements (in terms of combined
internal and external costs) (check one box)?
[[Page 4566]]
----------------------------------------------------------------------------------------------------------------
Estimated cost ($)
-----------------------------------------------------------------------------------------------------------------
$0-$25,000 $25,001-$50,000 $50,001-$75,000 >$75,000
----------------------------------------------------------------------------------------------------------------
[ ] [ ] [ ] [ ]
----------------------------------------------------------------------------------------------------------------
(2.) Please include any explanatory notes that you would like to
provide. These could describe, for example, how a fund that is part
of a fund complex might share these costs, any particular cost
considerations for a fund that uses sub-advisers, or the extent to
which the estimated costs would arise from internal versus external
costs (such as those associated with third-party service providers).
c. Use of relative VaR test and absolute VaR test.
(1.) Would the fund anticipate that it would use the proposed
relative VaR test or the proposed absolute VaR test (check one box)?
----------------------------------------------------------------------------------------------------------------
Relative VaR test Absolute VaR test
----------------------------------------------------------------------------------------------------------------
[ ] [ ]
----------------------------------------------------------------------------------------------------------------
(2.) If you anticipate that you would use the proposed relative
VaR test, and you already disclose a benchmark index for performance
disclosure, do you anticipate that the index would also qualify as a
designated reference index under the proposed rule? [Y/N]
d. To the extent that the fund is a sub-advised fund, would the
proposed limit on fund leverage risk present any particular
challenges for the fund to implement in light of its advisory
structure? If so please explain.
Item 4: Limited Derivatives Users
Instructions: If you believe the fund would qualify as a limited
derivatives user under the proposed rule, please answer the
following questions. If you do not believe so, please proceed to
question 5.
a. Please state which basis for the proposed limited derivatives
user exception you think the fund would seek to rely on (check one
box):
----------------------------------------------------------------------------------------------------------------
Currency hedging exception (The fund only uses
Exposure-based test (The fund's derivatives exposure derivatives for currency hedging purposes as specified
does not exceed 10% of the fund's net asset value) in the proposed rule)
----------------------------------------------------------------------------------------------------------------
[ ] [ ]
----------------------------------------------------------------------------------------------------------------
b. Should the rule include any other bases for a fund to qualify as
a limited derivatives user? What alternative approach and why?
c. Implementation cost.
(1.) Approximately how much do you think it would cost the fund
to adopt and implement policies and procedures reasonably designed
to manage its derivatives risks (in terms of combined internal and
external costs) (check one box)?
----------------------------------------------------------------------------------------------------------------
Estimated cost ($)
-----------------------------------------------------------------------------------------------------------------
$0-$25,000 $25,001-$50,000 $50,001-$75,000 $75,001-$100,000 >$100,000
----------------------------------------------------------------------------------------------------------------
[ ] [ ] [ ] [ ] [ ]
----------------------------------------------------------------------------------------------------------------
(2.) Please include any explanatory notes that you would like to
provide.
Item 5: Recordkeeping
a. Approximately how much would it cost the fund to comply with the
proposed recordkeeping requirements associated with rule 18f-4 (in
terms of combined internal and external costs)?
b. Should we modify any of the proposed recordkeeping requirements,
and if so, how?
Item 6: Reporting Requirements
a. Approximately how much would it cost the fund to comply with the
proposed new requirements for reporting on Form N-PORT, Form N-CEN,
and Form N-RN (in terms of combined internal and external costs)?
b. Should we modify any of the proposed reporting requirements, and
if so, how?
Item 7: Other Feedback on Proposed Rule 18f-4 and Proposed New
Reporting Requirements
Instructions: Please include any other additional suggestions or
comments about proposed rule 18f-4, and/or the proposed new
reporting requirements, that you would like to provide.
We will post your feedback on our website. Your submission will be
posted without change; we do not redact or edit personal identifying
information from submissions. You should only make submissions that
you wish to make available publicly.
If you are interested in more information on the proposal, or want
to provide feedback on additional questions, click here. Comments
should be received on or before March 24, 2020
Thank You!
Other Ways to Submit Your Feedback
You also can send us feedback in the following ways (include the
file number S7-24-15 in your response):
Print Your Responses and Mail
Secretary, Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549-1090
Print a PDF of Your Responses and Email
Use the printer friendly page and select a PDF printer to create a
file you can email to: [email protected]
Print a Blank Copy of This Flier, Fill it Out, and Mail
Secretary, Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549-1090
IX. APPENDIX B
Note: Appendix B will not appear in the Code of Federal
Regulations. Feedback Flier: Sales Practices Rules for Transacting
in Shares of Leveraged/Inverse Investment Vehicles
We are proposing two new sales practices rules--rule 15l-2 under
the Securities Exchange Act of 1934, and Rule 211(h)-1 under the
Investment Advisers Act of 1940--that would require a broker,
dealer, or
[[Page 4567]]
registered investment adviser to exercise due diligence in approving
a retail customer's or client's account to buy or sell shares of
certain ``leveraged/inverse investment vehicles.'' More information
about our proposal is available at https://www.sec.gov/rules/proposed/2019/34-87607.pdf.
We are particularly interested in learning what small broker-
dealers and investment advisers think about the proposed new sales
practices rules' requirements. Hearing from these smaller firms
could help us learn how our proposed rules would affect them, and
evaluate how we could address any unintended consequences resulting
from the cost and effort of regulatory compliance while still
promoting investor protection. We would appreciate your feedback on
any or all of the following questions.
All of the following questions are optional, including any
questions that ask about identifying information. Please note that
responses to these questions--including any other general
identifying information you provide--will be made public.
Item 1: General Identifying Information
Instructions: At your option, you may include general identifying
information that would help us contextualize your other feedback on
the proposal. This information could include responses to the
following questions, as well as any other general identifying
information you would like to provide. Responses to these items--
like responses to the other items on this Feedback Flier--will be
made public.
a. Is the firm a Commission-registered investment adviser or a
broker-dealer?
b. What is the size of the firm in terms of:
(1.) The number of retail investors (as defined in the release)?
(2.) For Investment Advisers, regulatory assets under
management?
(3.) For broker-dealers, regulatory net capital?
(4.) Other (please specify)?
c. Please include any additional general identifying information
that you wish to provide, that could add context to your other
feedback on the proposal.
d. Does the firm accept orders from or place orders for the accounts
of retail investors to buy or sell shares of leveraged/inverse
investment vehicles (as defined in the proposed sales practices
rules)?
Item 2: Cost To Comply With the Proposed Due Diligence and Account
Approval Requirements
a. What do you expect the cost to your firm would be in order to
comply with these proposed requirements (in terms of combined
internal and external costs)?
(1.) For an investment adviser (check one box):
------------------------------------------------------------------------
Estimated cost ($)
-------------------------------------------------------------------------
$0-$5,000 $5,001-$10,000 >$10,000
------------------------------------------------------------------------
[ ] [ ] [ ]
------------------------------------------------------------------------
(2.) For a broker-dealer (check one box):
------------------------------------------------------------------------
Estimated cost ($)
-------------------------------------------------------------------------
$0-$25,000 $25,001-$50,000 >$50,000
------------------------------------------------------------------------
[ ] [ ] [ ]
------------------------------------------------------------------------
b. Are there any less expensive alternatives to the proposed
requirements you can suggest that would still preserve the proposed
rules' intended investor protection safeguards?
Item 3: Other Feedback on Proposed Sales Practices Rules
Instructions: Please include any other additional suggestions or
comments about the proposed sales practices rules that you would
like to provide.
We will post your feedback on our website. Your submission will be
posted without change; we do not redact or edit personal identifying
information from submissions. You should only make submissions that
you wish to make available publicly.
If you are interested in more information on the proposal, or want
to provide feedback on additional questions, click here. Comments
should be received on or before March 24, 2020.
Thank You!
Other Ways to Submit Your Feedback
You also can send us feedback in the following ways (include the
file number S7-24-15 in your response):
Print Your Responses and Mail
Secretary, Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549-1090
Print a PDF of Your Responses and Email
Use the printer friendly page and select a PDF printer to create a
file you can email to: [email protected]
Print a Blank Copy of This Flier, Fill it Out, and Mail
Secretary, Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549-1090
[FR Doc. 2020-00040 Filed 1-23-20; 8:45 am]
BILLING CODE 8011-01-P