Use of Derivatives by Registered Investment Companies and Business Development Companies

Federal RegisterDec 21, 2020

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 239, 249, 270, and 274

[Release No. IC-34084; File No. S7-24-15]

RIN 3235-AL60

Use of Derivatives by Registered Investment Companies and Business Development Companies

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

The Securities and Exchange Commission (the “Commission”) is adopting 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 the new rule addresses. In addition, the Commission is adopting new reporting requirements designed to enhance the Commission's ability to effectively oversee funds' use of and compliance with the new rule, and to provide the Commission and the public additional information regarding funds' use of derivatives. Finally, the Commission is adopting amendments under the Investment Company Act to allow leveraged/inverse ETFs that satisfy the rule's conditions to operate without the expense and delay of obtaining an exemptive order. The Commission, accordingly, is rescinding certain exemptive relief that has been granted to these funds and their sponsors.

DATES:

Effective Date:

This rule is effective February 19, 2021.

Compliance Date:

August 19, 2022.

See

Section II.L of the

SUPPLEMENTARY INFORMATION

FOR FURTHER INFORMATION CONTACT:

Blair Burnett, Senior Counsel; Joel Cavanaugh, Senior Counsel; Mykaila DeLesDernier, Senior Counsel, John Lee, Senior Counsel; Amy Miller, Senior Counsel; Amanda Hollander Wagner, Branch Chief; Thoreau A. Bartmann, Senior Special Counsel; or Brian McLaughlin Johnson, Assistant Director, at (202) 551-6792, Investment Company Regulation Office, Division of Investment Management; U.S. Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

SUPPLEMENTARY INFORMATION:

Regulations in 17 CFR 270.18f-4 (“rule 18f-4”) will 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 will 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 rule also permits money market funds (and other funds) to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, subject to conditions.

The Commission is adopting rule 18f-4 under the Investment Company Act, amendments to 17 CFR 270.6c-11 (rule 6c-11), 17 CFR 270.22e-4 (rule 22e-4), and 17 CFR 270.30b1-10 (rule 30b1-10) under the Investment Company Act; amendments to Form N-PORT [referenced in 17 CFR 274.150], Form N-LIQUID (which we are re-titling 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. Investment Company Act Release 10666 and the Status of Derivatives Under Section 18

3. Need for Updated Regulatory Framework

C. Overview of the Final Rule

II. Discussion

A. Scope of Rule 18f-4

B. Derivatives Risk Management Program

1. Program Administration

2. Required Elements of the Program

C. Board Oversight and Reporting

1. Board Approval of the Derivatives Risk Manager

2. Board Reporting

D. Limit on Fund Leverage Risk

1. Use of VaR

2. Relative VaR Test

3. Absolute VaR Test

4. Funds Limited to Certain Investors

5. Choice of Model and Parameters for VaR Test

6. Implementation

E. Limited Derivatives Users

1. Derivatives Exposure

2. Limited Derivatives User Threshold

3. Risk Management

4. Exceedances of the Limited Derivatives User Exception

F. Approach to Leveraged/Inverse Funds

1. Proposed Alternative Requirements for Leveraged/Inverse Funds

2. Treatment of Leveraged/Inverse Funds Under Rule 18f-4

3. Standards of Conduct for Broker-Dealers and Registered Investment Advisers

4. Staff Review of Regulatory Requirements Relating to Complex Financial Products

5. Treatment of Existing Leveraged/Inverse Funds That Seek To Provide Leveraged or Inverse Market Exposure Exceeding 200% of the Return of the Relevant Index

6. Amendments to Rule 6c-11 Under the Investment Company Act and Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs

G. Amendments To Fund Reporting Requirements

1. Amendments to Form N-PORT

2. Amendments to Current Reporting Requirements

3. Amendments to Form N-CEN

H. Reverse Repurchase Agreements

I. Unfunded Commitment Agreements

J. Recordkeeping Provisions

K. Conforming Amendments

1. Form N-PORT and Rule 22e-4

2. Form N-2 (Senior Securities Table)

L. Compliance Date

M. Other Matters

III. Economic Analysis

A. Introduction

B. Economic Baseline

1. Fund Industry Overview

2. Funds' Use of Derivatives and Reverse Repurchase Agreements

3. Current Regulatory Framework for Derivatives

4. Funds' Derivatives Risk Management Practices and Use of VaR Models

5. Leveraged/Inverse Funds

C. Benefits and Costs of the Final 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. Treatment of Existing Leveraged/Inverse Funds That Seek To Provide Leveraged or Inverse Market Exposure Exceeding 200% of the Return of the Relevant Index

6. Amendments to Rule 6c-11 Under the Investment Company Act and Rescission of Exemptive Relief for Leveraged/Inverse ETFs

7. Unfunded Commitment Agreements

8. Recordkeeping

9. Amendments To Fund Reporting Requirements

10. When-Issued and Forward-Settling Transactions

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. Enhanced Disclosure

5. Alternative Treatment for Leveraged/Inverse Funds

IV. Paperwork Reduction Act Analysis

A. Introduction

B. Rule 18f-4

1. Derivatives Risk Management Program

2. Board Oversight and Reporting

3. VaR Remediation

4. Disclosure Requirement for Certain Leveraged/Inverse Funds

5. Disclosure Changes for Money Market Funds

6. Requirements for Limited Derivatives Users

7. Recordkeeping Requirements

8. Rule 18f-4 Total Estimated Burden

C. Rule 6c-11

D. Form N-PORT

E. Form N-RN and Rule 30b1-10

F. Form N-CEN

V. Final Regulatory Flexibility Analysis

A. Need for and Objectives of the Rule and Form Amendments

B. Significant Issues Raised by Public Comments

C. Small Entities Subject to the Final Rule

D. Projected Reporting, Recordkeeping, and Other Compliance Requirements

1. Rule 18f-4

2. Amendments to Forms N-PORT, N-RN, and N-CEN

3. Amendments to Rule 6c-11

E. Agency Action To Minimize Effect on Small Entities

1. Alternative Approaches to Rule 18f-4

2. Alternative Approaches to Amendments to Forms N-PORT, N-LIQUID (N-RN), and N-CEN

3. Alternative Approaches to Rule 6c-11

VI. Statutory Authority

I. Introduction

The Commission is adopting rule 18f-4 under the Investment Company Act to provide an updated, comprehensive approach to the regulation of funds' use of derivatives. This rule, along with amendments that the Commission is adopting to rule 6c-11 and certain forms under the Investment Company Act, will modernize the regulatory framework for funds to reflect the broad ways in which funds' use of derivatives has developed over past decades, and also will address investor protection concerns related to funds' derivatives use. We are committed to designing regulatory programs that reflect the ever-broadening product innovation and investor choice available in today's asset management industry, while also taking into account the risks associated with funds' increasingly complex portfolio composition and operations. The rules we are adopting reflect these considerations, and are also informed by the Commission's ongoing exploration—particularly over the past decade—of the benefits, risks, and costs associated with funds' current practices regarding derivatives.

See, e.g.,

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)] (“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 also

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)] (“2015 Proposing Release”); 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, Investment Company Act Release No. 33704 (Nov. 25, 2019) [85 FR 4446 (Jan. 24, 2020)] (“Proposing Release”). The comment letters on both the 2015 Proposing Release and the Proposing Release (File No. S7-24-15) are available at

https://www.sec.gov/comments/s7-24-15/s72415.shtml.

Under this new framework, funds using derivatives generally will have to adopt a derivatives risk management program that a derivatives risk manager administers and that the fund's board of directors oversees, and comply with an outer limit on fund leverage risk based on value at risk, or “VaR.” Funds that use derivatives only in a limited manner will not be subject to these requirements, but they will have to adopt and implement policies and procedures reasonably designed to manage the fund's derivatives risks. Funds also will be subject to reporting and recordkeeping requirements regarding their derivatives use.

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 through the issuance of “senior securities.”

The Commission and its staff have addressed 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 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 the proposed sales practices rules (

see infra

paragraph following footnote 7) 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 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

footnote 33 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 November 2019, the Commission proposed rule 18f-4, an exemptive rule under the Act designed to address the investor protection purposes and concerns underlying section 18.

The proposal also was designed 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 by replacing the Commission and staff guidance with a codified, consistent regulatory framework. The Commission observed in proposing this rule that, in the absence of Commission rules and guidance that encompass the current broad range of funds' derivatives use, inconsistent industry practices have developed.

The proposal was designed to respond to the concern 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. By standardizing the regulatory framework governing funds' derivatives use, the proposal also was designed to respond to the concern that funds' disparate practices could create an un-level competitive landscape and make it difficult for funds and the Commission

to evaluate funds' compliance with section 18.

See

Proposing Release,

supra

footnote 1. This proposal was a re-proposal of rules that the Commission proposed in 2015 to address funds' derivatives use, which included an earlier version of proposed rule 18f-4.

See

2015 Proposing Release,

supra

footnote 1. In developing the 2019 re-proposal, the Commission considered the approximately 200 comment letters in response to the 2015 proposal, as well as subsequent staff engagement with large and small fund complexes and investor groups.

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/s72415260.pdf

(“2016 DERA Memo”).

See infra

section I.B.3 (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

Proposing Release,

supra

footnote 1, at n.9 and accompanying text (discussing funds that segregate the notional amount of physically-settled futures contracts, and those that segregate only the marked-to-marked obligation in respect of cash-settled futures, and the concern that these practices can result in differing treatment of arguably equivalent products).

The rules that the Commission proposed in 2019 would permit a fund to enter into derivatives transactions, notwithstanding the restrictions under section 18 of the Investment Company Act, subject to certain conditions. These proposed conditions include adopting a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may obtain, based on VaR. Under the proposed rule, a streamlined set of requirements would apply to funds that use derivatives in a limited way. The proposed rule would also permit a fund to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments, subject to conditions tailored to these transactions. The proposal also included new reporting and recordkeeping requirements for funds using derivatives.

Certain registered investment companies that seek to provide leveraged or inverse exposure to an underlying index—including leveraged/inverse ETFs—would not have been subject to the limit on fund leverage risk under the 2019 proposal but instead would be subject to alternative requirements. The 2019 proposal provided that sales of these funds also would be subject to new sales practices rules for brokers, dealers, and investment advisers that are registered with the Commission (collectively, the “proposed sales practices rules”).

Finally, the proposal would amend rule 6c-11 under the Investment Company Act to allow leveraged/inverse ETFs that satisfy that rule's conditions to operate without the expense and delay of obtaining an exemptive order.

As discussed in more detail in section II.G, the proposed sales practices rules would have covered 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.”

The Commission received approximately 6,100 comment letters in response to the 2019 proposal. Of these comment letters, approximately 70 addressed proposed rule 18f-4, and the balance addressed the proposed sales practices rules. The majority of commenters who discussed proposed rule 18f-4 supported the Commission acting to provide an updated and more comprehensive approach to the regulation of funds' use of derivatives.

Commenters generally supported the proposal's derivatives risk management program requirement and use of VaR to provide a limit on fund leverage risk, while suggesting certain modifications.

Many commenters, however, expressed concerns with the proposed sales practices rules, and urged the Commission not to adopt these proposed rules (or to adopt alternative requirements designed to address the investor protection concerns underlying the proposed sales practices rules).

See, e.g.,

Comment Letter of the American Bar Association (May 2, 2020) (“ABA Comment Letter”); Comment Letter of Better Markets (Mar. 24, 2020) (“Better Markets Comment Letter”); Comment Letter of the U.S. Chamber of Commerce (“Chamber Comment Letter”); Comment Letter of Investment Company Institute (Apr. 20, 2020) (“ICI Comment Letter”); Comment Letter of New York City Bar (May 1, 2020) (“NYC Bar Comment Letter”).

See infra

footnotes 125, 287 and accompanying text.

See, e.g., infra

footnotes 579-584 and accompanying text.

After consideration of the comments received, we are adopting rule 18f-4, with certain modifications. The final rule retains each of the elements of the proposed rule, as we continue to believe that these requirements provide important investor protections. We have, however, made modifications to the proposed rule to address the comments the Commission received. We are also adopting, with certain modifications, the proposed new reporting and recordkeeping requirements, as well as the proposed amendments to rule 6c-11. We are not, however, adopting the proposed sales practices rules. Instead, leveraged/inverse funds will generally be subject to rule 18f-4, like other funds that use derivatives. The enhanced standard of conduct for broker-dealers under Regulation Best Interest and the fiduciary obligations of registered investment advisers also apply to broker-dealer recommendations and advice from investment advisers in connection with leveraged/inverse funds, as well as with respect to the listed commodity pools following the same strategies that would have been subject to the proposed sales practices rules.

In addition, we have directed the staff to review the effectiveness of the existing regulatory requirements in protecting investors who invest in leveraged/inverse funds and other complex investment products.

See

Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 86031 (June 5, 2019) [84 FR 33318 (July 12, 2019)] (“Regulation Best Interest Adopting Release”). The proposed sales practices rules would have applied to certain exchange-listed commodity- or currency-based trusts or funds.

See

proposed rule 15

-2(d); proposed rule 211(h)-1(d). In this release we refer to these trusts or funds collectively as listed commodity pools.

A. Overview of Funds' Use of Derivatives

As we discussed in the Proposing Release, 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. 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

Proposing Release,

supra

footnote 1, at n.14 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

footnote 3.

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

Proposing Release,

supra

footnote 1, at n.16.

This type of leverage is sometimes referred to as “economic leverage.”

See id.

at n.17.

The Proposing Release considered, and commenters also discussed, how 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 currency, interest rate, credit, and other risks, as well as to hedge portfolio exposures.

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 (

e.g.,

contract enforceability).

See id.

at n.18;

see also

ICI Comment Letter.

See

Proposing Release,

supra

footnote 1, at n.20;

see also infra

sections II.E.2.b and II.E.2.c.

See

Proposing Release,

supra

footnote 1, at n.21.

Section 18 is designed to limit the leverage a fund can obtain or incur through the issuance of senior securities. The Proposing Release discussed recent examples involving significant fund losses, which illustrate how a fund's use of derivatives may raise the investor protection concerns underlying section 18.

While the losses suffered in the examples discussed in the 2019 proposal are extreme, and funds rarely suffer such large and rapid losses, these examples 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.

See

Proposing Release,

supra

footnote 1, at nn.22-23 and accompanying text (discussing 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); 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); 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); 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); In the Matter of Mohammed Riad and Kevin Timothy Swanson, Investment Company Act Release No. 33338 (Dec. 21, 2018) (settled action); In the Matter of Top Fund Management, Inc. and Barry C. Ziskin, Investment Company Act Release No. 30315 (Dec. 21, 2012) (settled action)).

The Proposing Release also discussed the 2018 liquidation of the LJM Preservation and Growth Fund, which occurred after the fund—whose investment strategy involved purchasing and selling call and put options on the Standard & Poor's (“S&P”) 500 Futures Index—sustained considerable losses in connection with a market volatility spike in February 2018.

See id.

at nn.24-25 and accompanying text.

Following the issuance of the Proposing Release, an additional settled action similarly illustrates substantial and rapid losses resulting from a fund's investment in derivatives.

See

In the Matter of Catalyst Capital Advisors, LLC and Jerry Szilagyi, Investment Advisers Act Release No. 5436 (Jan. 27, 2020) (settled action) (involving a mutual fund that advises and invests primarily in options on S&P 500 index futures contracts incurring losses of 20% of its net asset value—more than $700 million—during the period December 2016 through February 2017).

The 2020 outbreak of coronavirus disease 2019 (COVID-19) and related effects on markets similarly have highlighted the importance of funds' derivatives risk management. Our staff has considered, and multiple commenters also discussed, the impact of COVID-19 both on funds' current derivatives risk management, as well as considerations relating to the Commission's 2019 proposal in light of market events stemming from this health crisis. The market volatility that followed the onset of this health crisis resulted in disruptions and challenges across asset classes.

In the context of derivatives, this volatility resulted in trading, liquidity, and pricing disruptions, valuation challenges, counterparty issues, and issues relating to derivatives' underlying assets, all of which emphasize the significance of robust derivatives risk management.

Certain leveraged/inverse ETFs changed their investment objectives and strategies during this period.

On the other hand, commenters observed that the recent market volatility has shown the importance for funds to be able to use derivatives both to hedge risk and the flexibility to respond to quickly-changing market demands.

Some commenters suggested changes to certain aspects of proposed rule 18f-4 that reflect their experiences with this market volatility.

The rules we are adopting here take these considerations into account.

See, e.g.,

Comment Letter of AQR Capital Management, LLC (Apr. 21, 2020) (“AQR Comment Letter I”) (observing “extremely high levels of market volatility driven by the COVID-19 pandemic”); Comment Letter of AQR Capital Management, LLC (Sept. 29, 2020) (“AQR Comment Letter II”) (discussing the impact and investment returns for certain alternative strategy funds at the onset of stressed market conditions related to the COVID-19 global health pandemic);

see also

ISDA COVID-19 Updates (July, 30, 2020),

available at https://www.isda.org/2020/03/13/covid-19-isda-update/

(providing updates on trading suspensions and regulatory emergency relief relating to COVID-19).

See, e.g.,

ISDA and Greenwich Associates, The Impact of COVID-19 and Government Intervention on Swaps Market Liquidity (Q2 2020),

available at https://www.isda.org/a/YfbTE/The-Impact-of-COVID-19-on-Swaps-Market-Liquidity.pdf

; CFTC, COVID-19 Commission Action,

available at https://www.cftc.gov/coronavirus

(discussing CFTC actions designed to help facilitate orderly trading and liquidity in the U.S. derivatives markets in response to the COVID-19 pandemic); CFTC Letter No. 20-17, Staff Advisory on Risk Management and Market Integrity Under Current Market Conditions (May 13, 2020),

available at https://www.cftc.gov/coronavirus

(advisory issued to remind certain CFTC-regulated market participants that they are expected to prepare for the possibility that certain contracts may continue to experience “extreme market volatility, low liquidity and possibly negative pricing”); Derivatives close-outs: COVID-19—Challenges to the valuation of derivatives upon early termination, FTI Consulting (June 2020),

available at https://www.fticonsulting.com/~/media/Files/emea—files/insights/articles/2020/jun/covid-19-derivatives-close-outs-crisis.pdf

; COVID-19 Update: The Impact of COVID-19 on Financial Contracts, The National Law Review Vol. X, Number 111 (Apr. 20, 2020) (discussing market volatility arising from the restrictions imposed to reduce the risk of spread of COVID-19, the impact of this volatility on existing contractual relationships, and illustrating practical issues that a counterparty to a financial contract might take into account using, as an example, a derivative transaction).

In particular, one of the two ETF sponsors that currently relies on exemptive relief from the Commission permitting them to operate leveraged/inverse ETFs changed the objectives of a number of its funds, while also closing a number of its funds.

See

“Direxion Changes Objectives of Ten Leveraged Funds to Address Extreme Market Conditions, While Also Closing Eight Funds Due to Limited Interest Since Launch” (Mar. 24, 2020),

available at https://www.direxion.com/uploads/Change-in-Investment-Objectives-and-Strategies-of-Ten-Daily-Leveraged-and-Daily-Inverse-Leveraged-Funds.pdf

(“Direxion Press Release”);

see also infra

footnote 821 and accompanying text.

See, e.g.,

Comment Letter of BlackRock, Inc. (Apr. 22, 2020) (“BlackRock Comment Letter”); Comment Letter of International Swaps and Derivatives Association, Inc. (Apr. 24, 2020) (“ISDA Comment Letter”);

see also

Proposing Release,

supra

footnote 1, at n.26.

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.

As discussed in the Proposing Release, 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 or sell senior securities that are a stock, subject to the limitations of section 18 (including that these funds must have asset coverage of at least 200% immediately after such issuance or sale).

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).

See

Proposing Release,

supra

footnote 1, at n.28 and accompanying text (citing to discussion of each of these enumerated concerns in certain Investment Company Act provisions, Release 10666,

supra

footnote 14, and Senate Hearings,

supra

footnote 27).

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.

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. Investment Company Act Release 10666 and the Status of Derivatives Under Section 18

Investment Company Act Release 10666

As discussed in the Proposing Release, the Commission considered the application of section 18's restrictions on the issuance of senior securities to certain transactions—reverse repurchase agreements, firm commitment agreements, and standby commitment agreements—in a 1979 General Statement of Policy (Release 10666).

The Proposing Release discussed the Commission's conclusion that these agreements fall within the “functional meaning of the term `evidence of indebtedness' for purposes of Section 18 of the Investment Company 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, Release 10666 nonetheless permitted funds to use these and similar arrangements subject to certain constraints.

See

Release 10666,

supra

footnote 14.

See

Proposing Release,

supra

footnote 1, at n.34 and accompanying and following text.

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, emphasizing that Release 10666 discussed certain securities trading practices as examples and that the Commission sought to address the implications of all comparable trading practices that could similarly affect funds' capital structures.

See

Proposing Release,

supra

footnote 1, at n.35 and accompanying text.

See id.

at n.36 and accompanying text.

See id.

at n.37 and accompanying text. The Commission in Release 10666 stated that although it was expressing its views about the particular trading practices discussed in that release, its views were not limited to those trading practices, in that the Commission sought to “address generally the possible economic effects and legal implications of all comparable trading practices which may affect the capital structure of investment companies in a manner analogous to the securities trading practices specifically discussed in Release 10666.”

Transactions Involving Senior Securities for Purposes of Section 18

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. These transactions, as well as short sales of securities for which the staff initially developed the segregated account approach, 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 id.

at n.38 and accompanying text.

See id.

at n.38 and accompanying text (citing Release 10666,

supra

footnote 14, at “The

Agreements as Securities” discussion and noting that the Investment Company Act's definition of the term “security” is broader than the term's definition in other federal securities laws);

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”).

We also continue to apply the same analysis to all derivatives transactions that create future payment obligations.

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.

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

See

Proposing Release,

supra

footnote 1, at n.41 and accompanying text (stating that, as the Commission explained in Release 10666, the Commission continues to 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).

Most commenters were silent on the Commission's interpretation. Some commenters, however, raised questions about whether all of the transactions covered in the rule's definition of “derivatives transaction” involve senior securities. For example, some of these commenters stated that derivatives such as swaps, options, and futures are not generally structured as “borrowings” and therefore questioned whether these derivatives represent “indebtedness.”

One of these commenters stated that the reverse repurchase agreements, firm commitment agreements, and standby commitment agreements that Release 10666 addresses “can fairly be characterized as `evidence of indebtedness,' ” but questioned whether those types of arrangements are derivatives “in today's parlance” and stated that Release 10666's discussion of those arrangements does not indicate that “today's derivatives—swaps, options, futures—represent `indebtedness.' ”

Certain commenters also questioned whether a fund “issues” senior securities when it engages in derivatives transactions, and some furthermore expressed the view that derivatives transactions do not involve senior securities under section 18.

See, e.g.,

Comment Letter of Nuveen Funds Advisors, LLC (Apr. 1, 2020) (“Nuveen Comment Letter”); Comment Letter of Rafferty Asset Management and Rafferty Capital Markets, LLC, including on behalf of the separate series of Direxion Funds and Direxion Shares ETF Trust (Mar. 31, 2020) (“Direxion Comment Letter”); Comment Letter of ProShares (Mar. 28, 2016) (“ProShares Comment Letter”).

See

Nuveen Comment Letter;

see also

Direxion Comment Letter (stating that total return swap contracts should not qualify as “evidencing indebtedness” because they are not the type of long-term debt securities issued by a fund that Congress intended to be considered part of the fund's capital structure and thus subject to regulation under section 18, and stating also that the exception in section 18(f) for bank borrowings does not imply that all borrowings constitute “senior securities”); ProShares Comment Letter (arguing that derivatives such as options and futures are not “evidence of indebtedness”).

See, e.g.,

Comment Letter of James Angel, Associate Professor of Finance Georgetown University (Feb. 24, 2020); Comment Letter of Competitive Enterprise Institute (Apr. 30, 2020); Direxion Comment Letter; ProShares Comment Letter.

As discussed in the Proposing Release, we continue to believe that the express scope of section 18, and the broad definition of the term “senior security” in section 18, support the interpretation that a derivatives transaction that creates a future payment obligation involves an evidence of indebtedness that is a senior security for purposes of section 18.

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.

See

Proposing Release,

supra

footnote 1, at paragraph accompanying nn.42-44.

Consistent with Release 10666, and as the Commission stated in the Proposing Release (as well as 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

footnote 14, at “Reverse Repurchase Agreements” discussion.

In addition to continuing to believe that section 18's scope supports the interpretation that a derivatives transaction creating a future payment obligation involves an evidence of indebtedness that is a senior security for purposes of section 18, we continue to believe that this interpretation 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.”

Several commenters discussed the Commission's authority to adopt rules based on the policy considerations reflected in section 1 of the Act.

See, e.g.,

Direxion Comment Letter; ProShares Comment Letter. The authority under which we are adopting rules today is set forth in section VI of this release and includes, among other provisions, section 6(c) of the Act. That section provides that “The Commission, by rules and regulations upon its own motion, or by order upon application, may conditionally or unconditionally exempt any person, security, or transactions . . . from any provision or provisions of this title or of any rule or regulation thereunder, if and to the extent that such exemption is necessary or appropriate in the public interest and consistent with the protection of investors . . . .” As discussed in the paragraph accompanying this footnote, the fundamental statutory policy and purposes underlying the Investment Company Act, as expressed in section 1(b) of the Act, continue to inform our interpretation of the scope of the term “senior security” in section 18. This also separately informs our consideration of appropriate conditions for the exemption that rule 18f-4 provides, as we discuss in sections II.B-II.F

infra.

See

Release 10666,

supra

footnote 14, at “Segregated Account” discussion.

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.

Some commenters mentioned undue speculation concerns underlying section 18 and discussed ways in which the Commission's 2019 proposal would address these concerns.

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

Aditum Comment Letter (discussing asset sufficiency concerns in the context of unfunded commitment agreements and the recent market disruption associated with COVID-19).

See, e.g.,

Better Markets Comment Letter; Comment Letter of CBOE (May 1, 2020) (“CBOE Comment Letter”); Comment Letter of Dechert LLP (Mar. 24, 2020) (“Dechert Comment Letter I”); Comment Letter of Invesco, Ltd. (Mar. 24, 2020) (“Invesco Comment Letter”) (“Invesco agrees with the Commission that registered funds using derivatives transactions should be subject to a regulatory framework that requires them and their advisers to manage attendant risks, including the risk of leverage that implicates the “undue speculation” and “asset sufficiency” concerns expressed in Sections 1(b)(7) and 1(b)(8), respectively, of the Investment Company Act . . . We believe the Proposed Rule will aptly address the investor protection purposes and concerns that underlie Section 18 . . .”); Comment Letter of Vanguard Group, Inc. (Apr. 23, 2020) (“Vanguard Comment Letter”) (“We agree with the Commission's assessment that the proposed requirements for a derivatives risk management program, including VaR and stress testing, would appropriately address the asset sufficiency concerns underlying Section 18 with respect to derivatives use.”).

Applying rule 18f-4 to derivatives transactions—including swaps, options, and futures—also is consistent with the Commission's views in Release 10666. As discussed above, in Release 10666, the Commission stated that its expressed views were not limited to the particular trading practices discussed, emphasizing that Release 10666 discussed certain securities trading practices as examples and that the Commission sought to address the implications of all comparable trading practices that could similarly affect funds' capital structures.

The Commission observed in Release 10666 that firm commitment agreements are also known as forward contracts, and that standby commitment agreements involve, in economic reality, the issuance and sale by the investment company of a “put.”

Both forward and futures contracts involve the agreement to buy or sell an underlying reference asset at a set price in the future, and a swap contract is structurally the equivalent of a series of forward contracts.

Moreover, derivatives transactions as defined in the final rule generally involve a

synthetic borrowing, in that they provide a market exposure exceeding the fund's investment while also involving a future payment obligation.

See supra

footnote 39.

See

Release 10666,

supra

footnote 14, at nn.10-12 and accompanying text, and at “Standby Commitment Agreements.”

See e.g.

John C. Hull,

Options, Futures, and Other Derivatives,

Prentice Hall, 7th Edition (2008) at 161.

For example, one commenter on the 2011 Concept Release observed that “a fund's purchase of an equity total return swap produces an exposure and economic return substantially equal to the exposure and economic return a fund could achieve by borrowing money from the counterparty in order to purchase the equities that are reference assets.” Comment Letter of BlackRock on the 2011 Concept Release (Nov. 4, 2011) (File No. S7-33-11).

3. Need for Updated Regulatory Framework

Market and Industry Developments Following Release 10666

Following Release 10666, Commission staff issued more than thirty no-action letters to funds concerning the maintenance of segregated accounts or otherwise “covering” their obligations in connection with various transactions otherwise restricted by section 18.

Funds have developed certain general asset segregation practices to cover their derivatives positions, considering at least in part the staff's no-action letters and guidance, which vary based on the type of derivatives transaction.

Funds also segregate a broader range of assets to cover their derivatives positions than those the Commission identified in Release 10666.

See

Proposing Release,

supra

footnote 1, at paragraph accompanying n.53 (stating that, in these letters and through other staff guidance, staff addressed questions regarding the application of Release 10666 to various types of derivatives and other transactions);

see also

Concept Release,

supra

footnote 1, at section I.

See

Proposing Release,

supra

footnote 1, at paragraph accompanying n.54 (discussing funds' practices for segregating an amount equal to the full amount of the fund's potential obligation under the contract, or the full market value of the underlying reference asset for the derivative (“notional amount segregation”) for certain derivatives, and funds practices for segregating an amount equal to the fund's daily mark-to-market liability, if any (“mark-to-market segregation”) for certain cash settled-derivatives).

See id.

at paragraph accompanying nn.56-57 (discussing Release 10666's statement that assets eligible to be included in segregated accounts should be “liquid assets” such as cash, U.S. government securities, or other appropriate high-grade debt obligations, and a subsequent staff no-action letter stating that the staff would not recommend enforcement action if a fund were to segregate any liquid asset, including equity securities and non-investment grade debt securities);

see also

Merrill Lynch Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996).

As a result of these asset segregation practices, funds' derivatives use—and thus funds' potential leverage through derivatives transactions—does not appear to be subject to a practical limit as the Commission contemplated in Release 10666. Funds' mark-to-market liability often does not reflect the full investment exposure associated with their derivatives positions.

As a result, a fund that segregates only the mark-to-market liability could theoretically incur virtually unlimited investment leverage.

For example, for derivatives where there is no loss in a given day, a fund applying the mark-to-market approach might not segregate any assets. This may be the case, for example, because the derivative is currently in a gain position, or because the derivative has a market value of zero (as will generally be the case at the inception of a transaction). The fund may, however, still be required to post collateral to comply with other regulatory or contractual requirements.

See

Proposing Release,

supra

footnote 1, at n.59;

see also

BlackRock Comment Letter (“We agree with the Commission's view that the use of derivatives should not be unlimited or unregulated.”); Comment Letter of J.P. Morgan Asset Management (Mar. 24, 2020) (“J.P. Morgan Comment Letter”) (“Evolving market practices, together with staff guidance over the years, have enabled funds to segregate large portions of their portfolios, while using mark-to-market exposure amounts for many instruments. This approach to asset segregation could result in a fund obtaining a significant degree of leverage.”).

Furthermore, as discussed in the Proposing Release, funds' current asset segregation practices also may not assure the availability of adequate assets to meet funds' derivatives obligations, on account of both the amount and types of assets that funds may segregate.

When a fund's derivatives payment obligations are substantial relative to the fund's liquid assets, the fund may be forced to sell portfolio securities to meet its derivatives payment obligations. These forced sales could occur during stressed market conditions, including at times when prudent management could advise against such liquidation.

See

Proposing Release,

supra

footnote 1, at nn.60-62 and accompanying text (discussing: (1) Funds' segregation of assets that only reflect losses that would occur as a result of transaction termination; and (2) funds' practices of segregating any liquid asset, rather than the more narrow range of high-quality assets that the Commission described in Release 10666).

See id.

at n.62 and accompanying text.

Regulatory Framework To Address Concerns Underlying Section 18 in Light of Current Fund Practices

As a result of market and industry developments over the past four decades, funds' current practices regarding derivatives use may not address the undue speculation and asset sufficiency concerns underlying section 18.

Additionally, a fund's derivatives use may involve risks that can result in significant losses to a fund.

Accordingly, we continue to believe that it is appropriate for funds to address these risks and considerations relating to their derivatives use. Nevertheless, we also recognize the valuable role derivatives can play in helping funds to achieve their objectives efficiently or manage their investment risks.

See

Proposing Release,

supra

footnote 1, at n.63 and accompanying text;

see also

proposed rule 18f-4(a).

Section 18 of the Investment Company Act applies only to open-end or closed-end companies (

i.e.,

management investment companies). Rule 18f-4 therefore will not apply to unit investment trusts (“UITs”) because they are not management investment companies. As the Commission has noted, derivatives transactions generally require a significant degree of management, and a UIT engaging in derivatives transactions therefore may not meet the Investment Company Act requirements applicable to UITs.

See

section 4(2) of the Investment Company Act;

see also

Custody Of Investment Company Assets with Futures Commission Merchants And Commodity Clearing Organizations, Investment Company Act Release No. 22389 (Dec. 11, 1996), at n.18 (explaining that UIT portfolios are generally unmanaged).

See also

ETFs Adopting Release,

supra

footnote 76, at n.42.

See

rule 18f-4(a);

see also

proposed rule 18f-4(a).

Commenters generally supported the scope of funds that are permitted to rely on the proposed rule.

Some commenters also specifically expressed support for excluding money market funds from the full scope of rule 18f-4 because money market funds do not typically engage in derivatives transactions.

Under rule 2a-7, money market funds seek to maintain a stable share price or limit principal volatility by limiting their investments to short-term, high-quality debt securities that fluctuate very little in value under normal market conditions. As a result of these and other requirements in rule 2a-7, money market funds do not enter into derivatives such as futures, swaps, and options. These instruments are not eligible securities in which money market funds are permitted to invest under rule 2a-7. We also believe that entering into these transactions would be inconsistent with a money market fund maintaining a stable share price or limiting principal volatility, especially if the money market fund were to use derivatives to leverage the fund's portfolio.

We therefore continue to believe that generally excluding money market funds from the full scope of the rule is appropriate. As discussed in more detail below, we are, however, including a targeted provision in the final rule that permits funds (including money market funds) to continue to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle.

See, e.g.,

Dechert Comment Letter I; Comment Letter of Fidelity Investments (Mar. 24, 2020) (“Fidelity Comment Letter”); Comment Letter of T. Rowe Price (Apr. 14, 2020) (“T. Rowe Price Comment Letter”).

See, e.g.,

Fidelity Comment Letter; J.P. Morgan Comment Letter; SIFMA AMG Comment Letter; Comment Letter of Stephen A. Keen (Aug. 11, 2020) (“Keen Comment Letter”).

See

Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014) [79 FR 47735 (Aug. 14, 2014)] (discussing: (1) Retail and government money market funds, which seek to maintain a stable net asset value per share; and (2) institutional non-government money market funds whose net asset value fluctuates, but nevertheless seek to minimize principal volatility given that, as “commenters pointed out[,] investors in floating NAV funds will continue to expect a relatively stable NAV”).

The final rule will permit funds to enter into derivatives transactions, subject to the rule's conditions. The rule defines 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; (2) any short sale borrowing; and (3) reverse repurchase agreements and similar financing transactions, for those funds that choose to treat these transactions as derivatives transactions under the rule.

See

rule 18f-4(a);

see also infra

section II.H (discussing the provision in the final rule that provides an option for funds to manage reverse repurchase agreements and similar financing transactions under the asset coverage provisions of section 18 applicable to bank borrowings. If a fund does not choose to use this option, then reverse repurchase agreements and similar financing transactions would instead be derivatives transactions under the final rule.).

The first prong of this definition is designed to describe those derivatives transactions that involve the issuance of a senior security, because they involve a contractual future payment obligation.

This prong of the definition incorporates a list of derivatives instruments that, together with “any similar instrument,” covers the types of derivatives that funds currently use and that section 18 would restrict because they impose on the fund a contractual obligation (or potential obligation) to make payments or deliver assets to the fund's counterparty. This list is designed to be sufficiently comprehensive to include derivatives that may be developed in the future.

See supra

footnotes 28, 36 and accompanying text (together, observing 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

footnotes 86-87 (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 rule, must involve a future payment obligation.

This aspect of the definition recognizes that not every derivatives instrument imposes such an obligation, and therefore not every derivatives instrument will involve the issuance of a senior security. 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 but generally will not have any subsequent obligation to deliver cash or assets to the counterparty unless the fund chooses to exercise the option.

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 it 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 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

footnote 1, at paragraph accompanying nn.82-83. A few commenters suggested we address these purchased options specifically in rule 18f-4.

See

Comment Letter of Guggenheim Investments (Apr. 27, 2020) (“Guggenheim Comment Letter”);

see also

CBOE Comment Letter. We do not believe that further revisions to address these comments are necessary, however, because rule 18f-4's definition of a derivatives transaction is limited to derivatives instruments that involve a future payment obligation.

See

2015 Proposing Release,

supra

footnote 1, at paragraph accompanying 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). 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

Guggenheim Comment Letter.

See

Comment Letter of Refinitiv US SEF LLC (Mar. 24, 2020) (“Refinitiv Comment Letter”);

see also

CBOE Vest Comment Letter (stating that “[a]lthough sold call options in isolation do expose the fund to a potential future obligation, that obligation will be entirely offset by the position in the underlying security”).

Refinitiv Comment Letter.

Each of these examples, however, involves derivatives transactions that involve future payment obligations. We do not believe it would be appropriate or feasible to identify in rule 18f-4 combinations of derivatives instruments or other investments that, together, may involve less risk or different risks than the constituent transactions considered in isolation. We believe these kinds of relationships are appropriate to assess as part of a fund's derivatives risk management, but do not support excluding the kinds of transactions commenters identified from the rule's derivatives transaction definition.

Additionally, a commenter urged the Commission to exclude certain foreign exchange derivatives instruments from the scope of transactions covered by the rule because the commenter believes that these instruments have limited exposure to market fluctuations and do not introduce section 18 leverage concerns.

However, funds may use foreign currency derivatives to take speculative positions on the relationships between different currencies just as funds may use derivatives to obtain exposures to other rates or metrics or changes in asset prices.

Therefore, we do not believe that there is a principled basis to treat foreign currency derivatives, such as foreign currency forwards and swaps, differently than other derivatives that involve a potential future payment obligation and are encompassed within the rule's “derivatives transaction” definition.

Id.

(requesting that FX forwards, FX swaps, non-deliverable forwards involving FX, and FX options be excluded from the scope of the rule).

See

2015 Proposing Release,

supra

footnote 1, at paragraph accompanying n.239.

Short sale borrowings are included in the second prong of the rule's definition of “derivatives transaction.” We appreciate that short sales of securities do not involve derivatives instruments such as swaps, futures, and options. The value of a short position is, however, derived from the price of another asset,

i.e.,

the asset sold short. A short sale of a security provides the same economic exposure as a derivatives instrument, like a future or swap, that provides short exposure to the same security. The rule therefore treats short sale borrowings and derivatives instruments identically for purposes of funds' reliance on the rule's exemption.

Commenters did not address the treatment of short sale borrowings in the proposal's definition of “derivatives transactions,” and we are adopting it as proposed.

See

rule 18f-4(b).

The third prong of the definition reflects the final rule's treatment of reverse repurchase agreements and similar financing transactions. In a change from the proposal and as discussed further in section II.H below, a fund may either elect to treat reverse repurchase agreements and similar financing transactions as derivatives transactions under the rule or elect to subject such transactions to the asset coverage requirements of section 18.

The final rule's definition of “derivatives transaction” therefore includes a conforming change to reflect the final rule's treatment of these transactions.

See

rule 18f-4(d);

see also infra

section II.H. Similarly, because rule 18f-4 addresses funds' use of unfunded commitment agreements separately from funds' use of derivatives, the definition of “derivatives transaction” does not include unfunded commitment agreements.

See infra

section II.J.

The final rule, like the proposed rule, does not specifically list firm or standby commitment agreements in the definition of “derivatives transaction.” However, as the Proposing Release discussed, we interpret the definitional phrase “or any similar instrument” to include these agreements. A firm commitment agreement has the same economic characteristics as a forward contract.

Similarly, the Commission has previously stated that a standby commitment agreement is economically equivalent to the issuance of a put option.

To the extent that a fund engages in transactions similar to firm or standby commitment agreements, they may fall within the “any similar instrument” definitional language, depending on the facts and circumstances.

Indeed, the Commission stated in Release 10666 that a firm commitment is known by other names such as a “forward contract.”

See

Release 10666,

supra

footnote 14, at nn.10-12 and accompanying text.

See id.

at “Standby Commitment Agreements.”

For example, a fund that enters into a binding commitment to make a loan or purchase a note upon demand by the borrower, with stated principal and term and a fixed interest rate, would appear to have entered into an agreement that is similar to a standby commitment agreement or a written put option. This transaction would expose the fund to investment risk during the life of the transaction because the value of the fund's commitment agreement will change as interest rates change. Such an agreement thus would fall within the rule's definition of “derivatives transaction.”

Several commenters urged the Commission to exclude certain firm and standby commitment agreements from the scope of the rule or to subject them to different conditions.

100

Many commenters urged that money market funds, in particular, engage in these transactions and urged that the Commission clearly permit money market funds to continue to do so.

101

In particular, these commenters identified transactions that trade on a when-issued basis, or that involve a settlement cycle that exceeds the “T+2” settlement cycle applicable to most securities transactions but that nonetheless settle within a short period of time. Commenters urged that these transactions limit the ability of funds to leverage their portfolios where the delay between trade date and settlement date is short, this delay is a result of the manner in which the securities are customarily issued or traded, and the fund intends to physically settle the transaction.

102

Commenters explained that funds engage in these transactions to purchase the underlying securities rather than as a means of obtaining an unfunded investment exposure to the underlying security that may be effectively used by funds to leverage their portfolios.

103

Further, commenters stated that the use of when-issued U.S. Treasury securities transactions is an important tool to enhance transparency and pricing stability in the U.S. Treasury market, and subjecting the use

of these transactions to the rule could diminish their use and negatively impact the short-term fixed income market.

104

100

See, e.g.,

ICI Comment Letter; Invesco Comment Letter; SIFMA AMG Comment Letter.

101

See, e.g.,

ICI Comment Letter; Fidelity Comment Letter; T. Rowe Price Comment Letter.

102

See

SIFMA AMG Comment Letter;

see also

Keen Comment Letter.

103

See, e.g.,

ICI Comment Letter; Invesco Comment Letter; SIFMA AMG Comment Letter.

104

See

SIFMA AMG Comment Letter. Investments in when-issued securities enable market participants to contract for the purchase and sale of a new security before the security has been issued. The most common type of when-issued trading involves U.S. Treasury securities. For example, on Monday, October 19th, the U.S. Treasury may announce that it will hold an auction of a specified quantity of new U.S. Treasury bills on Wednesday, October 21st with the securities being issued on Monday, October 25th. Following the announcement, market participants may begin to trade the new security on a when-issued basis. Settlement of the securities purchased on a when-issued basis as well as those purchased at auction will occur on the issue date.

We agree with commenters that the potential for leveraging is limited in these transactions, particularly because of the short period of time between trade date and settlement date and the fund's intention to physically settle the transaction rather than to engage in an offsetting transaction. Accordingly, we have included a provision in the final rule that allows funds to invest in securities on a when-issued or forward-settling basis, or with a non-standard settlement cycle, and the transaction will be deemed not to involve a senior security (“delayed-settlement securities provision”).

105

While the final rule generally excludes money market funds from its scope, the scope of the rule's delayed-settlement securities provision includes money market funds, as well as the other funds to which the rule applies. This provision is subject to two conditions.

105

Rule 18f-4(f).

First, as some commenters suggested, the fund must intend to settle the transaction physically.

106

Physical settlement may occur electronically through the Depository Trust Company or other electronic platforms. This condition distinguishes these investments from bond forwards and other derivatives transactions where a fund commonly intends to execute an offsetting transaction rather than to actually purchase (or sell) the security. The provision is designed to permit funds to invest in the underlying security rather than to obtain unfunded investment exposure to the underlying security beyond the limited period of time between trade and settlement date.

107

106

SIFMA AMG Comment Letter; Fidelity Comment Letter. The discussion in this release regarding this condition and any future interpretation of this condition do not apply to the exclusion from the swap and security-based swap definitions for security forwards.

See

section 1a(47)(B)(ii) of the Commodity Exchange Act, 7 U.S.C. 1a(47)(B)(ii) (excluding from the swap and security-based swap definitions “any sale of a . . . security for deferred shipment or delivery, so long as the transaction is intended to be physically settled”).

107

Commenters suggested that the final rule also require that these transactions involve a defined delivery obligation, to distinguish these investments from the kinds of instruments included in the derivatives transaction definition.

See

Invesco Comment Letter; ICI Comment Letter; SIFMA AMG Comment Letter. Many derivatives transactions, however, such as forwards and futures contracts, involve a delivery obligation fixed at trade date. We therefore do not believe this condition is useful to distinguish when-issued and similar securities, and believe that the requirement that the fund intend to physically settle the transaction will serve to distinguish a fund's intent to invest in the underlying securities from a fund engaging in derivatives transactions.

Second, the transactions must settle within 35 days. Commenters addressing the short-term nature of these transactions offered differing suggestions for the permissible length of their settlement period.

108

Some commenters simply urged that we permit transactions with a “relatively short” delay between trade date and settlement date without specifying a particular number of days, while other commenters suggested a more precise 35-day period between trade date and settlement for a threshold.

109

The final rule's 35-day settlement threshold reflects our view that securities that trade on a when-issued or forward-settling basis, or with a non-standard settlement cycle that have a settlement cycle of 35 days or less, more closely resemble regular-way securities transactions that are not covered by the rule rather than forwards and similar transactions that involve a greater potential for leveraging.

110

108

See, e.g.,

Invesco Comment Letter; ICI Comment Letter; Fidelity Comment Letter; SIFMA AMG Comment Letter.

109

See, e.g.,

Invesco Comment Letter; ICI Comment Letter; Fidelity Comment Letter; SIFMA AMG Comment Letter; Keen Comment Letter.

110

As one commenter observed, this 35-day period is consistent with the threshold under Regulation T, which provides that a transaction that settles in T+35 or sooner and has an extended settlement date due to the mechanics of the transaction, is not an extension of credit under the rule.

See

SIFMA AMG Comment Letter;

see also

Regulation T, Section 220.8(b)(2).

We are not subjecting these transactions to an asset segregation requirement, as some commenters suggested, because we believe the conditions discussed above render that additional requirement unnecessary.

111

Because funds will be required to intend to settle these transactions physically, funds must have sufficient assets to meet that obligation regardless of any separate asset segregation requirement in the final rule.

111

See, e.g.,

SIFMA AMG Comment Letter; Dechert Comment Letter I; Keen Comment Letter.

Commenters separately recommended that we provide an asset segregation approach for firm and standby commitment agreements generally.

112

For example, some commenters recommended a specific provision to address securities transactions that settle within a short period of time, similar to the delayed-settlement securities provision in the final rule.

113

These commenters also urged that the Commission should permit funds the option of adopting an alternative asset segregation regime for when-issued securities, to-be-announced investments (“TBAs”), dollar rolls, and bond forwards, that have characteristics that would make them ineligible for such a provision, such as delays between trade date and settlement date that do not settle within a short period of time.

114

Commenters asserted that any risks associated with these firm and standby commitment agreements can be appropriately managed by requiring funds to maintain assets sufficient to cover the obligations of the transactions, similar to the approach the Commission proposed for these transactions in 2015.

115

112

See, e.g.,

Dechert Comment Letter I; ICI Comment Letter; Comment Letter of Calamos Investments LLC (May 1, 2020) (“Calamos Comment Letter”).

113

ICI Comment Letter; Calamos Comment Letter; Dechert Comment Letter I.

114

See

ICI Comment Letter; Calamos Comment Letter;

see also

Dechert Comment Letter I (urging that, for purposes of the limited derivatives user exception, firm and standby commitment agreements should be excluded from a fund's derivatives exposure threshold if a fund segregates liquid assets sufficient to cover such obligations).

115

See

ICI Comment Letter;

see also

2015 Proposing Release

supra

footnote 1, at section III.C.

Where these firm and standby commitment agreements and similar transactions do not satisfy the conditions in the delayed-settlement securities provision, we do not see a basis to differentiate the transactions from other instruments included in the derivatives transactions definition. For example, this suggested approach would treat a bond forward differently than an equity or currency forward. Moreover, we understand that funds typically settle forward contracts in cash, by an offsetting transaction, or by “rolling” the exposure via subsequent transactions. Therefore, bond forward contracts, and other transactions identified by commenters, could involve many of the same kinds of risks as other transactions that are considered derivatives transactions under the rule, such as futures contracts. We believe it is appropriate for the final rule to provide a consistent set of requirements for funds engaging in transactions that present the same kinds of risks rather than providing separate requirements for economically similar transactions.

The delayed-settlement securities provision also applies to money market funds. Commenters urged that the Commission permit money market funds to continue to invest in eligible securities under rule 2a-7, as they do today, even where those investments may involve when-issued securities or securities with a forward-settling convention or a non-standard settlement cycle.

116

Money market funds today segregate assets in connection with these transactions under Release 10666, which we are rescinding. The delayed-settlement securities provision is designed to address commenters' concerns that the proposed rule would have resulted in uncertainty for money market funds that invest in certain when-issued securities or securities with a forward-settling convention or a non-standard settlement cycle. The final rule permits money market funds to continue to engage in these and the other types of transactions covered by the delayed-settlement securities provision.

117

We have not, however, modified the rule to provide an exemption in rule 18f-4 for any eligible security as defined in rule 2a-7, as some commenters recommended.

118

Rule 2a-7 imposes protective conditions on money market funds tailored to these funds' operations, including requirements for a money market fund to maintain a significant amount of liquid assets and invest in assets that meet the rule's credit quality, maturity, and diversification requirements. Rule 2a-7 is not, however, designed to address senior security concerns and its conditions alone do not provide a basis for an exemption from section 18.

116

See, e.g.,

T. Rowe Price Comment Letter; Vanguard Comment Letter; ICI Comment Letter; Dechert Comment Letter I. Several commenters expressed particular concern that the proposed exclusion of money market funds from the scope of the rule would result in uncertainty with respect to the ability of money market funds to continue to invest in when-issued U.S. Treasury securities.

See, e.g.,

ICI Comment Letter; Fidelity Comment Letter; T. Rowe Price Comment Letter.

117

The final rule provides that these transactions are not senior securities, but a money market fund must of course also comply with rule 2a-7 in connection with the investments.

118

See, e.g.,

BlackRock Comment Letter; Keen Comment Letter; T. Rowe Price Comment Letter; Vanguard Comment Letter.

In addition, although a fund or money market fund may invest in TBAs under the delayed-settlement securities provision, we are not excluding TBAs from the scope of the rule generally, as one commenter recommended.

119

The TBA market facilitates the trading of forward-settling mortgage-backed securities by allowing participants to enter into a contract agreeing to purchase mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae at a later date, typically, two or three months from the transaction date.

120

The commenter urged that the Commission reconsider the inclusion of TBAs within the rule's derivatives transaction definition to avoid the possibility of a chilling effect on the market and because these transactions may be subject to margin requirements under FINRA rules.

121

The other commenters who addressed TBAs, however, recommended that we clarify that TBAs are derivatives transactions under the rule.

122

119

See

Fidelity Comment Letter.

120

See

Comment Letter of Putnam Investments (Apr. 1, 2020) (“Putnam Comment Letter”) (stating that “[i]n a TBA trade, the parties agree on six parameters of the securities to be delivered (issuer, maturity, coupon, price, par amount and settlement date), but the actual identity of the securities to be delivered at settlement is not specified [until 48 hours prior to the settlement]”).

121

See

Fidelity Comment Letter. Under amended FINRA Rule 4210, effective March 25, 2021, brokers will be required to collect mark-to-market margin from counterparties engaging in TBA transactions.

122

See, e.g.,

Putnam Comment Letter; SIFMA AMG Comment Letter; ICI Comment Letter;

cf.

Invesco Comment Letter (recommending we permit certain short-term when-issued or forward-settling transactions and observing that the settlement periods for these transactions “are still relatively short compared to TBAs and other forward contracts captured by the Proposed Rule's derivatives transaction definition”).

TBAs and dollar rolls are included in the final rule's derivatives transaction definition because we believe they are forward contracts or “similar instruments.”

123

We recognize the importance of TBAs to the market for forward-settling mortgage-backed securities and the importance of the FINRA margin requirements to the TBA market. However, TBAs, like other forwards and similar instruments can be used to leverage a fund's portfolio by permitting funds to take unfunded positions in the underlying reference assets and involve a potential future payment obligation. The investor protection concerns the final rule is designed to address do not turn on the nature of a derivatives transaction's underlying reference assets. We do not see a basis to differentiate TBAs for purposes of the final rule from other types of transactions included in the derivatives transaction definition, where the fund's TBA investment does not satisfy the conditions of the delayed-settlement securities provision.

123

See, e.g.,

SIFMA AMG Comment Letter. Some of the commenters who sought clarity that TBAs would be derivatives transactions under the final rule also argued that TBAs are not “similar financing transactions” that would be treated like reverse repurchase agreements under the final rule. We agree that TBAs are not reverse repurchase agreements or “similar financing transactions” under the rule.

B. Derivatives Risk Management Program

A fund should manage its derivatives use to ensure alignment with the fund's investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements. In addition, a fund's board of directors is responsible for overseeing the fund's activities and the adviser's management of risks, including any derivatives risks.

124

Given the dramatic growth in the volume and complexity of the derivatives markets over the past two decades, and the increased use of derivatives by certain funds and their related risks, we believe that requiring funds that are users of derivatives (other than limited derivatives users) to have a formalized risk management program with certain specified elements (a “program”) supports exempting these transactions from section 18. A fund's program would be part of an adviser's overall management of portfolio risk and would complement—but would not replace—a fund's other risk management activities, such as a fund's liquidity risk management program adopted under rule 22e-4.

124

See, e.g.,

Interpretive Matters Concerning Independent Directors of Investment Companies, Investment Company Act Release No. 24083 (Oct. 14, 1999) [64 FR 59877 (Nov. 3, 1999)]; Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24816 (Jan. 2, 2001) [66 FR 3733 (Jan. 16, 2001)]; Independent Directors Council,

Fund Board Oversight of Risk Management

(Sept. 2011),

available at

http://www.ici.org/pdf/pub_11_oversight_risk.pdf (“2011 IDC Report”).

As proposed, under the program requirement we are adopting, a fund will have to adopt and implement a written derivatives risk management program that includes policies and procedures reasonably designed to manage the fund's derivatives risks. A derivatives risk manager whom the fund's board approves will be responsible for administering the program. A fund's derivatives risk management program should take into account the way the fund uses derivatives, whether to increase investment exposures in ways that increase portfolio risks or, conversely, to reduce portfolio risks or facilitate efficient portfolio management.

The program requirement is designed to result in a program with elements that are tailored to the particular types of derivatives that the fund uses and their related risks, as well as how those derivatives impact the fund's investment portfolio and strategy. A

fund's program must include the following elements:

•

Program administration.

As proposed, the program will have to be administered by an officer or officers of the fund's investment adviser serving as the fund's derivatives risk manager.

•

Risk identification and assessment.

As proposed, the program will have to provide for the identification and assessment of a fund's derivatives risks, which must take into account the fund's derivatives transactions and other investments.

•

Risk guidelines.

As proposed, the program will 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.

•

Stress testing.

As proposed, the program will have to provide for stress testing of derivatives risks to evaluate potential losses to a fund's portfolio under stressed conditions.

•

Backtesting.

The program will have to provide for backtesting of the VaR calculation model that the fund uses under the rule. We are adopting this requirement largely as proposed, but with a required weekly minimum frequency instead of the proposed daily frequency.

•

Internal reporting and escalation.

The program will 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. We are adopting this requirement largely as proposed, but with conforming amendments to reflect changes we are adopting to the relative VaR test.

•

Periodic review of the program.

A fund's derivatives risk manager will be required to periodically review the program, at least annually, to evaluate the program's effectiveness and to reflect changes in risk over time. We are adopting this requirement largely as proposed, but with conforming amendments to reflect changes we are adopting to the relative VaR test.

The program requirement is drawn from existing fund best practices. We believe it will 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.

Many commenters expressed their broad support for the proposed derivatives risk management program.

125

In particular, commenters highlighted that the proposed rule would permit funds to tailor the derivatives risk management program to the particular unique needs of a fund.

126

One commenter acknowledged that the proposed derivatives risk management program would codify best practices many funds already have in place, including stress testing, backtesting, and other risk management tools.

127

As discussed below, commenters provided specific feedback regarding the individual elements of the program requirement.

125

See e.g.

ICI Comment Letter; Comment Letter of the Investment Adviser Association (Apr. 30, 2020) (“IAA Comment Letter”); Blackrock Comment Letter; AQR Comment Letter I; Comment Letter of the Mutual Fund Directors Forum (Apr. 9, 2020) (“MFDF Comment Letter”); Dechert Comment Letter I.

126

ICI Comment Letter; AQR Comment Letter I; MFDF Comment Letter; J.P. Morgan Comment Letter.

127

Blackrock Comment Letter.

1. Program Administration

The final rule will require an officer or officers of the fund's investment adviser to serve as the fund's derivatives risk manager.

128

The derivatives risk manager may not be a portfolio manager of the fund, and must have relevant experience regarding the management of derivatives risk.

129

We are adopting these requirements specifying what person(s) may be eligible to serve as the derivatives risk manager as proposed.

128

Rule 18f-4(a).

129

See infra

section II.C.1 (discussing the requirement that the board approve the designation of the derivatives risk manager, and stating that because the final definition of “derivatives risk manager” requires the person fulfilling the role to have “relevant experience regarding the management of derivatives risk,” the board's consideration of the designation of the derivatives risk manager would necessarily take into account the candidate's experience, among all other relevant factors).

Persons Eligible To Serve as Derivatives Risk Manager

The proposed rule specified that the derivatives risk manager must be an officer or officers of the fund's investment adviser, and we are adopting this provision as proposed.

130

Many commenters supported allowing multiple officers to serve as the derivatives risk manager, and no commenters suggested that the rule should instead require that a single officer serve in this role.

131

For example, one commenter believed allowing multiple officers would permit the derivatives risk manager to reflect a broader range of expertise.

132

Commenters also noted that permitting multiple officers to serve as the derivatives risk manager would be consistent with the Investment Company Act rule governing the persons who may serve as administrators of funds' liquidity risk management programs.

133

Commenters urged, however, that the final rule also permit non-officer employees of the adviser to serve as the derivatives risk manager.

134

One commenter stated that allowing employees of the adviser to serve as the derivatives risk manager would provide needed flexibility for boards to approve the designation of the best individuals to serve in the role.

135

Some commenters supported allowing a third-party not affiliated with the adviser to serve as the derivatives risk manager.

136

130

Rule 18f-4(a); proposed rule 18f-4(a). 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.

131

See

J.P. Morgan Comment Letter

;

SIFMA AMG Comment Letter

;

Blackrock Comment Letter; Chamber Comment Letter; T. Rowe Price Comment Letter; ABA Comment Letter.

132

J.P. Morgan Comment Letter.

133

See, e.g.,

J.P. Morgan Comment Letter.

134

Dechert Comment Letter I; Fidelity Comment Letter; SIFMA AMG Comment Letter; Comment Letter of Angel Oak Capital (Apr. 30, 2020) (“Angel Oak Comment Letter”); Capital Group Comment Letter; Chamber Comment Letter.

135

Fidelity Comment Letter; Angel Oak Capital Comment Letter.

136

Comment Letter of Foreside Financial Group, LLC (Apr. 22, 2020) (“Foreside Comment Letter”); NYC Bar Comment Letter.

After considering comments, we have determined to adopt the requirement that the derivatives risk manager must be an officer or officers of the fund's investment adviser as proposed. The person(s) serving in the role of the derivatives risk manager must be able to carry out their responsibilities under the rule, which requires that they administer the derivatives risk management program and policies and procedures in addition to the board reporting requirements.

137

The person(s) serving in this role must have sufficient authority within the investment adviser to carry out these responsibilities. We believe that an officer of the fund's investment adviser would be more likely to have the requisite level of seniority to be effective than a non-officer employee or third-party service provider. We recognize that investment advisers may have personnel who, although not designated as “officers” in accordance with the adviser's corporate bylaws, have a comparable degree of seniority and authority within the organization. Such a person therefore could have a comparable ability to carry out a derivatives risk manager's

responsibilities under the final rule, if the person otherwise met the qualifications for being a derivatives risk manager. In these circumstances, we believe such a person(s) could be treated as an officer, for purposes of the final rule, and serve as a fund's derivatives risk manager if approved by the fund's board. This person, like any other person serving as a fund's derivatives risk manager, would have a direct reporting line to the board.

137

See

rule 18f-4(a); and rule 18f-4(c)(3).

We recognize that employees of the adviser may have relevant derivatives risk management experience that would be helpful to the derivatives risk manager in administering the derivatives risk management program. While employees may not serve as the derivatives risk manager, they may provide support to the person(s) serving in the role. Advisory employees also may carry out derivatives risk management activities as discussed below.

Many commenters also urged the Commission to permit the fund's adviser to serve as the derivatives risk manager.

138

Commenters maintained that, because the board has already considered the quality and expertise of the fund's investment adviser, the adviser is well suited to serve as the derivatives risk manager.

139

Commenters also stated that requiring the board to consider and designate a separate individual(s) to serve as the derivatives risk manager is overly burdensome, compared to permitting the adviser to serve in this role.

140

Commenters stated that the adviser as an entity should serve as the derivatives risk manager, which could then designate its employees to staff the administration of the derivatives risk management program.

141

Commenters also suggested that permitting a fund's adviser to serve as the derivatives risk manager would be appropriate in light of the fact that the Commission's liquidity risk management program rule permits a fund's adviser to serve as the liquidity risk management program administrator.

142

Conversely, some commenters expressly supported the Commission permitting a third party, separate from the adviser, to serve as the derivatives risk manager.

143

138

See, e.g.,

Fidelity Comment Letter; Dechert Comment Letter I; ICI Comment Letter; Comment Letter of Independent Directors Council (Apr. 20, 2020) (“IDC Comment Letter”); SIFMA AMG Comment Letter; BlackRock Comment Letter; Capital Group Comment Letter; Chamber Comment Letter; T. Rowe Price Comment Letter; ABA Comment Letter. One commenter supported the board approving a committee created by the adviser. J.P. Morgan Comment Letter.

139

See

Fidelity Comment Letter; Dechert Comment Letter I; ICI Comment Letter.

140

See

Fidelity Comment Letter; ICI Comment Letter; IDC Comment Letter. For example, one commenter stated that the proposed designation requirement could require extra board meetings, which is costly. Fidelity Comment Letter. Another commenter stated that having extra board meetings associated with designating the derivatives risk manager could delay the appointment of the derivatives risk manager. Fidelity Comment Letter.

141

See

ICI Comment Letter; ABA Comment Letter.

142

Fidelity Comment Letter; Dechert Comment Letter I; ICI Comment Letter; IDC Comment Letter; SIFMA AMG Comment Letter; BlackRock Comment Letter.

143

Foreside Comment Letter; NYC Bar Comment Letter; ABA Comment Letter.

We are not allowing an adviser to serve as the derivatives risk manager under the final rule. We continue to believe that requiring the derivatives risk manager to be one or more natural persons, specifically approved by the board, will promote independence and objectivity in this role. We believe that requiring one or more officers of the adviser to serve in this role, rather than the adviser as an entity or a committee created by the adviser and composed of individuals selected by the adviser from time to time, would promote accountability to the board by creating a direct reporting line between the board and the individual(s) responsible for administering the program.

144

Unlike rule 22e-4, where the board is required to approve a fund's liquidity risk management program that contains certain specific program elements, the board is not required to approve the derivatives risk management program.

145

Instead, the board will engage with the derivatives risk management program through its appointment of the derivatives risk manager, who is responsible for administering the program and reporting to the board on the program's implementation and effectiveness.

144

See

Proposing Release,

supra

footnote 1 (discussing the role of the derivatives risk manager).

145

See infra

section II.C.

See also

rules 22e-4 and 38a-1. Under rule 38a-1, boards will also be responsible for overseeing compliance with rule 18f-4.

See infra

paragraph accompanying footnote 247.

Moreover, any person serving as a fund's derivatives risk manager is responsible for administering the fund's program under rule 18f-4. The rule does not require, however, that the person be responsible for carrying out all activities associated with the fund's derivatives risk management program, and we do not anticipate that the person necessarily would carry out all such activities. For example, the final rule provides that a fund's derivatives risk management program must provide for risk identification and assessment, the establishment of risk guidelines, and stress testing, but does not require that the individual(s) serving as the derivatives risk manager carry out these activities. The derivatives risk manager also could seek inputs that could help inform risk management from third parties that are separate from the adviser, such as third-party service providers, and may reasonably rely on such inputs. The derivatives risk manager therefore may benefit from the expertise and assistance of third-party service providers even though the service provider (or its employees) may not itself serve as the fund's derivatives risk manager.

Commenters expressed concern that, if an individual were to serve in the role, he or she could face personal liability for his or her administration of the program.

146

The final rule, however, does not change the standards that apply in determining whether a person is liable for aiding or abetting or causing a violation of the federal securities laws. We recognize that risk management necessarily involves judgment. That a fund suffers losses does not, itself, mean that a fund's derivatives risk manager acted inappropriately.

146

See, e.g.,

ICI Comment Letter; SIFMA AMG Comment Letter; NYC Bar Comment Letter; Chamber Comment Letter.

Segregation of Derivatives Risk Management Function From Fund's Portfolio Management

The rule will prohibit the derivatives risk manager position from being filled by the fund's portfolio manager, if a single person serves in this position.

147

Similarly, if multiple officers serve as a derivatives risk manager, a majority of these persons may not be composed of portfolio managers. The rule will require a fund to reasonably segregate the functions of the program from its portfolio management.

148

We are adopting each of these requirements as proposed.

147

Rule 18f-4(c)(1).

148

Id.

Several commenters supported the proposed requirement that the derivatives risk manager not be the fund's portfolio manager.

149

While one commenter agreed that portfolio managers should not serve as the derivatives risk manager, the commenter stated that portfolio managers do have expertise the derivatives risk management program may need in order to react to market events.

150

Commenters stated that smaller firms may have more difficulty segregating portfolio management from derivatives risk management due to limited

personnel qualified to serve in these roles.

151

In order to provide flexibility, one commenter suggested that we should permit a fund's derivatives risk manager to be the portfolio manager of a separate fund.

152

149

See

SIFMA AMG Comment Letter; ABA Comment Letter.

150

ABA Comment Letter.

151

ABA Comment Letter; SIFMA AMG Comment Letter.

152

ABA Comment Letter.

We continue to believe that it is important to segregate the portfolio management function from the risk management function. 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 of the derivatives risk manager requirement is designed to enhance the independence of the derivatives risk manager and other risk management personnel and, therefore, to enhance the program's effectiveness.

153

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 derivatives risk management program would impose. Keeping these functions separate in the context of derivatives risk management should help mitigate the possibility that these competing incentives diminish the program's effectiveness.

153

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).

Separation of the derivatives risk management function and the portfolio management function creates important checks and balances. Separation of functions may be established through a variety of methods, such as independent reporting chains, oversight arrangements, or separate monitoring systems and personnel. While we understand that smaller funds may have more limited employee resources, making it more difficult to segregate the portfolio management and derivatives risk management functions, we continue to believe that segregation of these functions is important and funds may need to hire additional personnel.

154

The reasonable segregation requirement is not meant to indicate that the derivatives risk manager and portfolio management must be subject to a communications “firewall.” For example, the internal reporting and escalation requirements we are adopting will require communication between a fund's risk management and portfolio management regarding the operation of the program.

155

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.

154

See infra

III.C.1. In addition, and as proposed, the final rule prohibits a portfolio manager from serving as the derivatives risk manager for funds for which he or she is a portfolio manager, but does not prohibit that person from serving as the derivatives risk manager for other funds.

See supra

footnote 152 and accompanying text.

155

See infra

section II.B.2.e.

Relevant Experience Regarding the Management of Derivatives Risk

The final rule, as proposed, requires a fund's derivatives risk manager to have relevant experience regarding the management of derivatives risk.

156

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.

156

Rule 18f-4(a).

Some commenters requested clarification regarding this requirement. In particular, commenters requested clarification of what “relevant experience” means in the context of selecting a derivatives risk manager.

157

One commenter suggested that “relevant experience” should not require expertise in all types of derivatives risk.

158

The requirement that the derivatives risk manager must have “relevant experience” is designed to provide flexibility such that the person(s) serving in this role may have experience that is relevant in light of the derivatives risks unique to the fund, rather than the rule taking a more prescriptive approach in identifying a specific amount or type of experience that the derivatives risk manager must have. We do not believe it would be practical to detail in our rules the specific experience a derivatives risk manager should hold. We recognize that different funds may appropriately seek out different types of derivatives risk experience from their respective derivatives risk managers, depending on the funds' particular circumstances.

157

Dechert Comment Letter I; ICI Comment Letter; IDC Comment Letter.

158

ABA Comment Letter.

Program Administration in the Context of Sub-Advised Funds

A number of commenters sought clarification about the administration of a fund's derivatives risk management program for sub-advised funds. Commenters supported permitting the derivatives risk manager to delegate certain aspects of the day-to-day management of the derivatives risk management program to the fund's sub-adviser(s).

159

Further, commenters suggested that the derivatives risk manager should develop a program specifying the responsibilities and role of the sub-adviser.

160

One commenter, for example, stated that sub-advisers would provide important support to the derivatives risk manager by identifying and assessing the fund's derivatives risks, to establish, maintain, and enforce certain risk guidelines, and to implement the measures needed if those guidelines are exceeded.

161

Several commenters stated that while the derivatives risk manager should be able to create a role for sub-advisers in the derivatives risk management program, the derivatives risk manager should retain the board reporting responsibilities.

162

159

See, e.g.,

ICI Comment Letter; SIFMA AMG Comment Letter; Capital Group Comment Letter; T. Rowe Price Comment Letter. A number of these commenters noted that the staff of the Commission had provided guidance regarding sub-advisers in the context of rule 22e-4.

160

T. Rowe Price Comment Letter; ICI Comment Letter.

161

ICI Comment Letter.

162

T. Rowe Price Comment Letter; ICI Comment Letter.

The final rule provides flexibility for funds to involve sub-advisers in derivatives risk management. For example, the rule permits a group of individuals to serve as a fund's derivatives risk manager, which could include officers of both the fund's primary adviser and sub-adviser(s).

163

For a fund in which a sub-adviser manages the entirety of the fund's portfolio (as opposed to a portion, or “sleeve” of the fund's assets), the officer(s) of a sub-adviser alone also could serve as a fund's derivatives risk manager, if approved by the fund's board.

164

163

See supra

footnote 129 (explaining that 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);

see also

Proposing Release,

supra

footnote 1, at n. 107.

164

See infra

paragraph accompanying footnote 166 (discussing delegation of risk management activities).

In addition, the final rule does not preclude a derivatives risk manager from delegating to a sub-adviser specific derivatives risk management activities that are not specifically assigned to the derivatives risk manager in the final rule, subject to appropriate oversight.

The derivatives risk manager also may reasonably rely on information provided by sub-advisers in fulfilling his or her responsibilities under the rule. The fund, of course, retains ultimate responsibility for compliance with rule 18f-4, and the derivatives risk manager remains responsible under the rule for the reporting obligations to the board and the administration of the derivatives risk management program.

165

Accordingly, where a fund delegates risk management activities to a sub-adviser, in order to be reasonably designed to manage the fund's derivatives risks and achieve compliance with the rule, the fund's policies and procedures generally should address the oversight of any delegated activities, including the scope of and conditions on activities delegated to a sub-adviser(s), as well as oversight of the sub-adviser(s). The same considerations would apply with respect to any sub-delegates.

165

See

rule 18f-4(a); rule 18f-4(c)(3)(ii) and (iii);

see also infra

section II.C.

For certain elements of the derivatives risk management program, delegation to a sub-adviser that manages a sleeve of a fund's assets generally would not be consistent with the fund's obligations to implement a derivatives risk management program under rule 18f-4. For example, certain elements of the derivatives risk management program (

e.g.,

stress testing) must be evaluated at the portfolio level. We therefore believe that the fund's derivatives risk manager and not the sub-adviser may be better suited in this case—in having a portfolio-level view—to administer these program elements.

166

Sub-advisers managing a portion of the fund's assets, however, may be appropriately positioned to assist the derivatives risk manager by providing information relevant to the derivatives risk management program at a more-granular level. Examples of these areas include risk identification, risk assessment, and monitoring the program's risk guidelines.

166

See infra

section II.B.2.c.

2. Required Elements of the Program

a. Risk Identification and Assessment

We are adopting, as proposed, the requirement that a fund must identify and assess its derivatives risks as part of the derivatives risk management program.

167

This assessment must take into account the fund's derivatives transactions and other investments.

167

See

rule 18f-4(c)(1)(i);

compare with

proposed rule 18f-4(c)(1)(i).

Commenters supported the proposed risk identification and assessment requirement. One commenter expressed support for the flexible, principles-based nature of this program element.

168

Several commenters agreed that the derivatives risk management program should begin with risk identification and assessment.

169

No commenter opposed this requirement.

168

J.P. Morgan Comment Letter.

169

J.P. Morgan Comment Letter; Comment Letter of Morningstar, Inc. (Mar. 24 2020) (“Morningstar Comment Letter”).

We continue to believe that 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.

170

As proposed, the rule defines 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.

171

In the context of a fund's derivatives transactions:

170

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 will result in a more-tailored derivatives risk management program.

See, e.g.,

Proposing Release,

supra

footnote 1, at section II.B.3 (discussing the goal of promoting tailored derivatives risk management programs).

171

Rule 18f-4(a);

see also

proposed rule 18f-4(a). In the case of funds that are limited derivatives users under the rule, the definition will 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;

172

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;

173

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;

174

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;

175

and

175

See, e.g.,

2008 IDC Report,

supra

footnote 172; 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.

176

See

Proposing Release,

supra

footnote 1, at n.123 (providing additional details and examples regarding each of these elements of legal risk, and describing how, 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).

We believe these risks are common to most derivatives transactions.

177

We did not receive any comments regarding the risks that are included in the definition of “derivatives risks” under the rule.

177

See id.

at n.124.

The rule does not limit a fund's identification and assessment of derivatives risks to only those specified in the rule. As proposed, the definition of the term “derivatives risks” that we are adopting includes any other risks a fund's derivatives risk manager deems material. 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). To the extent the derivatives risk manager considers any such idiosyncratic risk to be material,

that risk would be a “derivatives risk” for purposes of the rule.

b. Risk Guidelines

We are adopting, as proposed, the requirement that a fund's program 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”).

178

The guidelines must 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.

179

The 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.

178

Rule 18f-4(c)(1)(ii);

see also

proposed rule 18f-4(c)(1)(ii).

179

Rule 18f-4(c)(1)(ii).

Many commenters supported the proposed risk guidelines requirement, specifically expressing their support for a requirement that does not impose specific limits or guidance for how the risk thresholds should be calculated.

180

One commenter, however, stated that the proposed guidelines should be removed because many risks are not susceptible to quantification.

181

The commenter also stated that, for aspects of the required derivatives risk management program where quantitative measures are likely to be used, such as stress testing and backtesting results, the proposed quantitative guidelines requirement would be duplicative.

182

Several other commenters requested clarification. Specifically, one asked for clarification that non-quantifiable risks may be managed through other practices.

183

Other commenters asked for more detailed criteria for how a fund should define its program's risk guidelines.

184

180

See, e.g.,

J.P. Morgan Comment Letter; Morningstar Comment Letter.

181

ABA Comment Letter.

182

See id.

183

J.P. Morgan Comment Letter.

184

See

Dechert Comment Letter I; ABA Comment Letter.

We continue to believe that risk guidelines are a key component of a fund's derivatives risk management. To manage risks, a fund must identify relevant risks and put in place means to measure them. A fund's risk guidelines are designed to complement, and not duplicate, the stress testing and other aspects of the fund's derivatives risk management program. For example, a fund's risk guidelines would provide information about the fund's portfolio risks in current market conditions, as opposed to the fund's stress testing, which would evaluate the effects of stressed conditions. We recognize, however, that some risks may not be readily quantifiable or measurable and reflected in a risk guideline. For example, certain legal risks may not fit within a quantifiable risk guideline.

185

We agree that one appropriate way to manage these risks is through other practices, such as review and approval procedures for derivatives contracts as suggested by one commenter, consistent with the overall requirement in the final rule that the fund's policies and procedures be reasonably designed to manage the fund's derivatives risks.

186

185

J.P. Morgan Comment Letter.

186

Rule 18f-4(c)(1).

The final rule, as proposed, does not impose specific risk limits for these guidelines, but instead requires a fund to adopt guidelines that provide for quantitative thresholds tailored to the fund. We believe that the quantitative thresholds should be those 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.

187

A fund must establish discrete metrics to monitor its derivatives risks, which will require the fund and its derivatives risk manager to measure changes in the fund's risks regularly, and this in turn is designed to lead to timelier steps to manage these risks. Moreover, a fund must identify its response when these metrics have been exceeded, which should 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.

188

187

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.

188

See

rule 18f-4(c)(1)(v).

Funds may use a variety of approaches in developing guidelines that comply with the rule.

189

This draws on the risk identification element of the program and the scope and objectives of the fund's use of derivatives. The rule will allow a fund to use quantitative metrics that it determines would allow it to monitor and manage its particular derivatives risks most appropriately. In developing the guidelines (and determining whether to change the guidelines), a fund generally should consider how to implement

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