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

Federal RegisterJan 24, 2020

Ask Donna

What actually matters in this document.

Text

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 15

-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

rule-comments@sec.gov

. 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 15

-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 240.15

-2 (new rule 15

-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

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.

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.

Derivatives may be broadly described as instruments or contracts whose value is based upon, or derived from, some other asset or metric.

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

possible through direct investments.

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.

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”).

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”).

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

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.

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.”

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.

15 U.S.C. 80a (the “Investment Company Act,” or the “Act”). Except in connection with our discussion of proposed rule 15

-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.

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.

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.

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.

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).

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.

We received approximately 200 comment letters in response to the 2015 proposal.

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.

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.

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

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.

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

modern and comprehensive framework for regulating funds' use of derivatives and the other transactions addressed in the proposed rule.

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”).

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.”

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.

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.

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”).

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).

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.

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.

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.

See, e.g., id.

at n.24 and accompanying text (citing 2011 Concept Release,

supra

note 3, at section I).

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).

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.

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.

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.

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.

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).

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.

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,

2018 that it would liquidate its assets and dissolve on March 29, 2018.

See

Prospectus, LJM Preservation and Growth Fund (Feb. 28, 2017),

available at https://www.sec.gov/Archives/edgar/data/1552947/000158064217001225/ljm485b.htm

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.

“Senior security” is defined, in part, as “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.”

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.”).

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.

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”).

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.

Closed-end funds also may issue senior securities that are a stock, subject to the limitations of section 18.

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).

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).

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).

See

section 18(a)(1) of the Investment Company Act.

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.

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.

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.”

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.

See

Release 10666,

supra

note 15.

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.”

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.”

The

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.

See

2015 Proposing Release,

supra

note 2, at nn.45-47 and accompanying text (discussing Release 10666's discussion of segregated accounts).

See

Release 10666,

supra

note 15, at 25132;

see also

2015 Proposing Release,

supra

note 2, at n.48 and accompanying text.

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.

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.

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).

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.

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.

These payments—which may include payments of cash, or delivery of other assets—may occur as margin, as settlement payments, or otherwise.

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.

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.”

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.

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).

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.

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.

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.”

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).

First, funds' obtaining

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.

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.

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.

See

Release 10666,

supra

note 15, at “Segregated Account” discussion.

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.

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]”).

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

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:

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

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?

Why or why not?

See infra

note 583.

2. Derivatives Transactions Permitted Under Proposed Rule 18f-4

The proposed rule would permit funds to enter into derivatives

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.

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.

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.

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.

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.

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.

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.

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.”

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.

See id.

at n.82.

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.B.3.a.

•

Risk guidelines.

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.

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

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

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

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

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

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

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

See, e.g.,

Raimonda Martinkutė-Kaulienė,

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

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,

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

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

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

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

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

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

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.,

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.

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

This text is long and has been trimmed here. Open the source document for the complete record.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.