[Federal Register Volume 85, Number 245 (Monday, December 21, 2020)]
[Rules and Regulations]
[Pages 83162-83298]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-24781]
[[Page 83161]]
Vol. 85
Monday,
No. 245
December 21, 2020
Part II
Securities and Exchange Commission
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17 CFR Parts 239, 249, 270, et al.
Use of Derivatives by Registered Investment Companies and Business
Development Companies; Final Rule
Federal Register / Vol. 85, No. 245 / Monday, December 21, 2020 /
Rules and Regulations
[[Page 83162]]
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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.
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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
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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.\1\
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\1\ 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.
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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.\2\ 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.'' \3\ 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.\4\
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\2\ 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.
\3\ 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.
\4\ 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.
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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.\5\ 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.\6\ 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
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to evaluate funds' compliance with section 18.\7\
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\5\ 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'').
\6\ 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).
\7\ 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).
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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'').\8\
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.
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\8\ 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.''
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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.\9\ 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.\10\ 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).\11\
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\9\ 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'').
\10\ See infra footnotes 125, 287 and accompanying text.
\11\ See, e.g., infra footnotes 579-584 and accompanying text.
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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.\12\ 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.
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\12\ 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 15l-2(d); proposed rule 211(h)-1(d). In this release
we refer to these trusts or funds collectively as listed commodity
pools.
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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'').\13\
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\13\ 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.
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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.'' \14\ 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.\15\ Other
derivatives transactions, such as
[[Page 83165]]
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.\16\
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\14\ 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'').
\15\ The leverage created by such an arrangement is sometimes
referred to as ``indebtedness leverage.'' See Proposing Release,
supra footnote 1, at n.16.
\16\ This type of leverage is sometimes referred to as
``economic leverage.'' See id. at n.17.
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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.\17\ 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.\18\ 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.\19\ 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).\20\
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\17\ See id. at n.18; see also, e.g., ICI Comment Letter;
Comment Letter of SIFMA, Asset Management Group (Apr. 21, 2020)
(``SIFMA AMG Comment Letter'').
\18\ See Proposing Release, supra footnote 1, at n.19; see also
ICI Comment Letter.
\19\ See Proposing Release, supra footnote 1, at n.20; see also
infra sections II.E.2.b and II.E.2.c.
\20\ See Proposing Release, supra footnote 1, at n.21.
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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.\21\ 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.
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\21\ 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).
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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.\22\ 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.\23\ Certain leveraged/inverse
ETFs changed their investment objectives and strategies during this
period.\24\ 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.\25\ Some commenters suggested changes
to certain aspects of proposed rule 18f-4 that reflect their
experiences with this market volatility.\26\ The rules we are adopting
here take these considerations into account.
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\22\ 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).
\23\ 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).
\24\ 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.
\25\ 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, e.g., PIMCO: Taxonomy of
Crisis, presentation to Commission's Asset Management Advisory
Committee on May 27, 2020, available at https://www.sec.gov/files/marc-seidner-pimco.pdf.
\26\ See, e.g., AQR Comment Letter I; BlackRock Comment Letter;
Comment Letter of Capital Research and Management Company (Apr. 21,
2020) (``Capital Group Comment Letter'').
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[[Page 83166]]
B. Derivatives and the Senior Securities Restrictions of the Investment
Company Act
1. Requirements of Section 18
Section 18 of the Investment Company Act imposes various limits on
the capital structure of funds, including, in part, by restricting the
ability of funds to issue ``senior securities.'' Protecting investors
against the potentially adverse effects of a fund's issuance of senior
securities, and in particular the risks associated with excessive
leverage of investment companies, is a core purpose of the Investment
Company Act.\27\ ``Senior security'' is defined, in part, as ``any
bond, debenture, note, or similar obligation or instrument constituting
a security and evidencing indebtedness.'' \28\
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\27\ See, e.g., sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of
the Investment Company Act; see also Provisions Of The Proposed Bill
Related To Capital Structure (Sections 18, 19(B), And 21(C)),
Introduced by L.M.C Smith, Associate Counsel, Investment Trust
Study, Securities and Exchange Commission, Hearings on S.3580 Before
a Subcommittee of the Senate Committee on Banking and Currency, 76th
Congress, 3rd session (1940), at 1028 (``Senate Hearings''); see
also Proposing Release, supra footnote 1, at n.26.
\28\ 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.
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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.\29\ 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'').\30\ 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.\31\ 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).\32\ 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).\33\
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\29\ 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).
\30\ 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).
\31\ See section 18(a)(1) of the Investment Company Act.
\32\ See section 18(a)(2) of the Investment Company Act.
\33\ 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).
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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).\34\ 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.'' \35\ 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.'' \36\ 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.
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\34\ See Release 10666, supra footnote 14.
\35\ See Proposing Release, supra footnote 1, at n.34 and
accompanying and following text.
\36\ See id.
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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.'' \37\
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.'' \38\ 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.\39\
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\37\ See Proposing Release, supra footnote 1, at n.35 and
accompanying text.
\38\ See id. at n.36 and accompanying text.
\39\ 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.''
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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.\40\ These transactions
therefore involve the issuance of a senior security for purposes of
section 18.\41\
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\40\ See id. at n.38 and accompanying text.
\41\ 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'').
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[[Page 83167]]
We also continue to apply the same analysis to all derivatives
transactions that create future payment obligations.\42\ 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.\43\
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\42\ 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.
\43\ 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).
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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.'' \44\ 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.' '' \45\
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.\46\
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\44\ 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'').
\45\ 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'').
\46\ 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.
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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.\47\ 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.\48\ 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.'' \49\ 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.\50\
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\47\ See Proposing Release, supra footnote 1, at paragraph
accompanying nn.42-44.
\48\ 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).
\49\ 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.
\50\ 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.\51\ 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.'' \52\
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\51\ 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.
\52\ See Release 10666, supra footnote 14, at ``Segregated
Account'' discussion.
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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).\53\ First, funds'
obtaining leverage (or potential for leverage) through
[[Page 83168]]
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.\54\ 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.\55\ Some commenters mentioned undue
speculation concerns underlying section 18 and discussed ways in which
the Commission's 2019 proposal would address these concerns.\56\
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\53\ 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.
\54\ 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]'').
\55\ One commenter on the 2011 Concept Release made this point
directly. See Comment Letter of Stephen A. Keen on the 2011 Concept
Release (Nov. 8, 2011) (File No. S7-33-11), at 3 (``Keen Concept
Release Comment Letter'') (``If permitted without limitation,
derivative contracts can pose all of the concerns that section 18
was intended to address with respect to borrowings and the issuance
of senior securities by investment companies.''); see also, e.g.,
Comment Letter of the Investment Company Institute on the 2011
Concept Release (Nov. 7, 2011) (File No. S7-33-11) (``ICI Concept
Release Comment Letter''), at 8 (``The Act is thus designed to
regulate the degree to which a fund issues any form of debt--
including contractual obligations that could require a fund to make
payments in the future.''). The Commission similarly noted in
Release 10666 that, given the potential for reverse repurchase
agreements to be used for leveraging and their ability to magnify
the risk of investing in a fund, ``one of the important policies
underlying section 18 would be rendered substantially nugatory'' if
funds' use of reverse repurchase agreements were not subject to
limitation. See Proposing Release, supra footnote 1, n.49.
\56\ See, e.g., AQR Comment Letter I (``For a fund engaging in
significant or complex derivative usage, the key to curbing
excessive borrowing and undue speculation lies in implementing an
effective risk management program.''); Capital Group Comment Letter
(``We believe the Proposal is an effective way to address the
investor protection concerns underlying Section 18 of the Investment
Company Act of 1940 . . . In particular, we believe that creating
leverage limits that constrain economic risk, coupled with a
derivatives risk management program, is a better way to constrain
leverage and prevent undue speculation by funds than limits based on
the aggregate gross notional exposure of a fund's derivative
transactions, as proposed in 2015.''); Comment Letter of Consumer
Federation of America (Mar. 30, 2020) (``CFA Comment Letter'')
(``Congress' findings and declaration of policy underlying Section
18 make clear that Congress was concerned with the potential for
investment companies, through excessive borrowing, to engage in
undue speculation and operate without sufficient assets to cover
potential losses . . . While Section 18 does not explicitly refer to
funds' use of derivatives, the concerns are the same.''); ICI
Comment Letter (``We fully support the Commission's goal of
addressing the investor protection concerns underlying Section 18 of
the Investment Company Act of 1940, and the reproposed rule is an
effective way to achieve that goal. In particular, the leverage
limits coupled with elements of the derivatives risk management
program, including required stress testing, will restrict the amount
of exposure to economic risk that a fund could take when investing
in derivatives. Creating leverage limits that confine economic risk
is a far better way to addresses Section 18's ``undue speculation''
concerns than limits based solely on the aggregate gross notional
exposure (``GNE'') of a fund's derivatives transactions, as proposed
in 2015.'').
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Second, with respect to the Investment Company Act's asset
sufficiency concern, a fund's use of derivatives with future payment
obligations also may raise concerns regarding the fund's ability to
meet those obligations. Many fund derivatives investments, such as
futures contracts, swaps, and written options, pose a risk of loss that
can result in payment obligations owed to the fund's
counterparties.\57\ Losses on derivatives therefore can result in
counterparty payment obligations that directly affect the capital
structure of a fund and the relative rights of the fund's
counterparties and shareholders. These losses and payment obligations
also can force a fund's adviser to sell the fund's investments to meet
its obligations. When a fund uses derivatives to leverage its
portfolio, this can amplify the risk of a fund having to sell its
investments, potentially generating additional losses for the fund.\58\
In an extreme situation, a fund could default on its payment
obligations.\59\ Some commenters mentioned asset sufficiency concerns
underlying section 18 and discussed ways in which the Commission's 2019
proposal would address these concerns.\60\
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\57\ Some derivatives transactions, like physically-settled
futures and forwards, can require the fund to deliver the underlying
reference assets regardless of whether the fund experiences losses
on the transaction.
\58\ See, e.g., Markus K. Brunnermeier & Lasse Heje Pedersen,
Market Liquidity and Funding Liquidity, 22 The Review of Financial
Studies 6, 2201-2238 (June 2009), available at https://
www.princeton.edu/~markus/research/papers/liquidity.pdf (providing
both empirical support as well as a theoretical foundation for how
short-term leverage obtained through borrowings or derivative
positions can result in funds and other financial intermediaries
becoming vulnerable to tighter funding conditions and increased
margins, specifically during economic downturns (as in the recent
financial crisis), thus potentially increasing the need for the fund
or intermediary to de-lever and sell portfolio assets at a loss).
\59\ See ICI Concept Release Comment Letter, supra footnote 55,
at 11 (noting that, ``[h]ypothetically, in an extreme scenario, a
fund that used derivatives heavily and segregated most of its liquid
assets to cover its obligation on a pure mark-to-market basis could
potentially find itself with insufficient liquid assets to cover its
derivative positions''); 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).
\60\ 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.'').
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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.\61\
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.'' \62\ 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.\63\
Moreover, derivatives transactions as defined in the final rule
generally involve a
[[Page 83169]]
synthetic borrowing, in that they provide a market exposure exceeding
the fund's investment while also involving a future payment
obligation.\64\
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\61\ See supra footnote 39.
\62\ See Release 10666, supra footnote 14, at nn.10-12 and
accompanying text, and at ``Standby Commitment Agreements.''
\63\ See e.g. John C. Hull, Options, Futures, and Other
Derivatives, Prentice Hall, 7th Edition (2008) at 161.
\64\ 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).
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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.\65\ 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.\66\ Funds also segregate a broader range of
assets to cover their derivatives positions than those the Commission
identified in Release 10666.\67\
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\65\ 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.
\66\ 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).
\67\ 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).
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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.\68\ As a result, a fund
that segregates only the mark-to-market liability could theoretically
incur virtually unlimited investment leverage.\69\
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\68\ 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.
\69\ 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.'').
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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.\70\ 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.\71\
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\70\ 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).
\71\ See id. at n.62 and accompanying text.
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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.\72\ Additionally, a fund's derivatives use may involve
risks that can result in significant losses to a fund.\73\ 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.
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\72\ See Proposing Release, supra footnote 1, at n.63 and
accompanying text; see also supra footnotes 56 and 60 and
accompanying text (discussing, respectively, commenters' statements
regarding undue speculation and asset sufficiency concerns
underlying section 18 and their discussion of ways in which the
Commission's 2019 proposal would address these concerns).
\73\ See supra paragraph accompanying footnote 21.
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We therefore are requiring funds that use derivatives in a more
than limited way to adopt and implement formalized programs, which must
cover certain elements but otherwise will be tailored to manage the
risks that funds' derivatives use may pose. In addition, the framework
we are adopting addresses our concern that funds today are not subject
to a practical limit on potential leverage that they may obtain through
derivatives transactions.
We believe that a comprehensive approach to regulating funds'
derivatives use also will help address potential adverse results from
funds' current, disparate asset segregation practices. The development
of staff guidance and industry practice on an instrument-by-instrument
basis, together with growth in the volume and complexity of derivatives
markets over past decades, has resulted in situations in which
different funds may treat the same kind of derivative differently,
based on their own view of our staff's guidance or observation of
industry practice. This may unfairly disadvantage some funds.\74\
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\74\ See Proposing Release, supra footnote 1, at n.65 and
accompanying text.
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The lack of comprehensive guidance also makes it difficult for
funds and our staff to evaluate and inspect for funds' compliance with
section 18 of the Investment Company Act. Moreover, where there is no
specific guidance, or where the application of existing guidance is
unclear or applied inconsistently, funds may take approaches that
involve an extensive use of derivatives and may not address the
purposes and concerns underlying section 18. The new framework that we
are adopting will replace the current, multi-part guidance framework
with a unitary rule. This will level-set the regulation of funds'
derivatives use in light of the breadth of fund strategies and the
variety of ways that funds use derivatives today.
C. Overview of the Final Rule
We are adopting rule 18f-4 to provide an updated, comprehensive
approach to the regulation of funds' use of derivatives and certain
other
[[Page 83170]]
transactions that the rule addresses. The amendments we are adopting to
Forms N-PORT, N-LIQUID (which we are re-titling as ``Form N-RN''), and
N-CEN will enhance the Commission's ability to oversee funds' use of
and compliance with the rules, and will provide the Commission, fund
investors, and other market participants additional information
regarding funds' use of derivatives.
Rule 18f-4 will permit a fund to enter into derivatives
transactions, notwithstanding the prohibitions and restrictions on the
issuance of senior securities under section 18 of the Investment
Company Act, subject to the following conditions.\75\ These conditions
are designed to address the undue speculation and asset sufficiency
concerns underlying section 18, and they support the Commission's
conclusion that the exemptions that the rule provides are in the public
interest and consistent with the protection of investors and the
purposes fairly intended by the policy and provisions of the Act.
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\75\ See rule 18f-4(b) and (d). Rule 18f-4(b) provides an
exemption for funds' derivatives transactions from sections
18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company Act. See
supra section I.B.1 of this release (providing an overview of the
requirements of section 18). Because the conditions provide a
tailored set of requirements for derivatives transactions, the rule
also provides that a fund's derivatives transactions will not be
considered for purposes of computing asset coverage under section
18(h). See infra section II.K.
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Derivatives risk management program. The rule will
generally require a fund to adopt a written derivatives risk management
program with risk guidelines that must cover certain elements, but that
will otherwise be tailored based on how the fund's use of derivatives
may affect its investment portfolio and overall risk profile. The
program also will include stress testing, backtesting, internal
reporting and escalation, and program review elements. The program will
institute a standardized risk management framework for funds that
engage in more than a limited amount of derivatives transactions, while
allowing principles-based tailoring to the fund's particular risks. The
program requirement that we are adopting retains the same framework and
elements as the proposed program requirement.
Limit on fund leverage risk. The rule will generally
require funds when engaging in derivatives transactions to comply with
an outer limit on fund leverage risk based on VaR. This outer limit is
based on a relative VaR test that compares the fund's VaR to the VaR of
a ``designated reference portfolio'' for that fund. Under the final
rule, a fund generally can use either an index that meets certain
requirements, or the fund's own securities portfolio (excluding
derivatives transactions), as its designated reference portfolio. If
the fund's derivatives risk manager reasonably determines that a
designated reference portfolio would not provide an appropriate
reference portfolio for purposes of the relative VaR test, the fund
would be required to comply with an absolute VaR test. In light of our
consideration of comments received, the requirements we are adopting
incorporate certain changes to the proposed VaR test. These include
permitting a fund to use its securities portfolio as the reference
portfolio for purposes of the relative VaR test (instead of requiring a
fund to compare its VaR against the VaR of a designated index for the
relative VaR test), and increasing the relative and absolute VaR limits
from 150% and 15% to 200% and 20%, respectively.
Board oversight and reporting. The rule will require a
fund's board of directors to approve the fund's designation of a
derivatives risk manager, who will be responsible for administering the
fund's derivatives risk management program. The fund's derivatives risk
manager will have to report to the fund's board on the derivatives risk
management program's implementation and effectiveness and the results
of the fund's stress testing. The derivatives risk manager will have a
direct reporting line to the fund's board. We are adopting these
requirements substantially as proposed, with minor changes to clarify
the requirements and conform to changes in other rule provisions.
Exception for limited derivatives users. The rule will
except limited derivatives users from the derivatives risk management
program requirement, the VaR-based limit on fund leverage risk, and the
related board oversight and reporting requirements, provided that the
fund adopts and implements written policies and procedures reasonably
designed to manage the fund's derivatives risks. This exception will be
available to a fund that limits its derivatives exposure to 10% of its
net assets. In a change from the proposal, in calculating derivatives
exposure to determine eligibility for the exception, a fund will be
permitted to exclude derivatives transactions that it uses to hedge
certain currency and interest rate risks. The exception also includes,
in a change from the proposal, provisions for a fund with derivatives
exposure that exceeds the 10% threshold. If the fund does not reduce
its exposure within five business days, the fund's adviser must provide
a written report to the fund's board informing it whether the adviser
intends to reduce the exposure promptly, but within no more than 30
days, or put in place a derivatives risk management program and comply
with the VaR-based limit on fund leverage risk as soon as reasonably
practicable.
Alternative requirements for certain leveraged/inverse
funds. After considering comments on the proposed sales practices
rules, we have determined not to adopt them at this time. Leveraged/
inverse funds instead will generally be subject to rule 18f-4 like
other funds, including the requirement to comply with the VaR-based
limit on fund leverage risk. This will effectively limit leveraged/
inverse funds' targeted daily return to 200% of the return (or inverse
of the return) of the fund's underlying index. The final rule also
provides an exception from the VaR-based limit for leveraged/inverse
funds in operation as of October 28, 2020 that seek an investment
return above 200% of the return (or inverse of the return) of the
fund's underlying index and satisfy certain conditions and the other
requirements of rule 18f-4. The conditions to this exception are
designed to allow these funds to continue to operate in their current
form, but prohibit them from changing their index or increasing the
amount of their leveraged or inverse market exposure. We believe that
the enhanced standard of conduct for broker-dealers under Regulation
Best Interest and the fiduciary obligations of registered investment
advisers help address some of the sales practice concerns that
leveraged/inverse funds and listed commodity pools following the same
strategies may raise, in the context of recommended transactions and
transactions occurring in an advisory relationship. To help ensure that
our regulatory framework addresses all potential investor protection
concerns associated with complex financial products, including those
that use leveraged/inverse strategies and those that are available to
investors who do not receive either recommendations subject to
Regulation Best Interest or investment advice subject to an adviser's
fiduciary obligation, we have directed the staff to begin a review.
This review will assess the effectiveness of the existing regulatory
requirements in protecting investors--particularly those with self-
directed accounts--who invest in leveraged/inverse products and other
complex investment products.
Recordkeeping. The final rule will require a fund to
adhere to recordkeeping requirements that are designed to provide the
Commission,
[[Page 83171]]
and the fund's board of directors and compliance personnel, the ability
to evaluate the fund's compliance with the rule's requirements. We are
adopting these provisions largely as proposed, with certain conforming
changes in light of modifications to other aspects of the final rule.
Final rule 18f-4 also will permit funds to enter into reverse
repurchase agreements and similar financing transactions, as well as
``unfunded commitments'' to make certain loans or investments, subject
to conditions tailored to these transactions. Under the final rule, a
fund is permitted to engage in reverse repurchase agreements and
similar financing transactions so long as they meet the asset coverage
requirements under section 18. If the fund also borrows from a bank or
issues bonds, for example, these senior securities as well as the
reverse repurchase agreement would be required to comply with the asset
coverage requirements under the Investment Company Act. This approach
would provide the same asset coverage requirements under section 18 for
reverse repurchase agreements and similar financing transactions, bank
borrowings, and other borrowings permitted under the Investment Company
Act. In a change from the proposal, a fund also will be permitted to
enter into these transactions by electing to treat them as derivatives
transactions under the final rule. This alternative approach will
permit funds to apply a consistent set of requirements to its
derivatives transactions and any reverse repurchase agreements or
similar financing transactions.
A fund will be permitted to enter into unfunded commitment
agreements under the final rule if the fund reasonably believes that
its assets will allow the fund to meet its obligations under these
agreements, as proposed. This approach recognizes that, while unfunded
commitment agreements may raise the risk that a fund may be unable to
meet its obligations under these transactions, such unfunded
commitments do not generally involve the leverage and other risks
associated with derivatives transactions.
In a change from the proposal, the final rule also includes a new
provision that will permit funds, as well as money market funds, to
invest in securities on a when-issued or forward-settling basis, or
with a non-standard settlement cycle, subject to conditions. Money
market funds, for example, will continue to be able to invest in when-
issued U.S. Treasury securities under this provision notwithstanding
that these investments trade on a forward basis involving a temporary
delay between the transaction's trade date and settlement date.
The amendments we are adopting to Forms N-PORT, N-LIQUID, and N-CEN
will require each fund to provide information regarding its compliance
with rule 18f-4. This information includes: (1) Certain identifying
information about the fund (e.g., identifying the provisions of rule
18f-4 that the fund is relying on to engage in derivatives transactions
and the other transactions that the rule addresses); (2) as applicable,
information regarding a fund's VaR and designated reference portfolio,
and VaR backtesting results; (3) VaR test breaches, to be reported to
the Commission in a non-public current report; and (4) for a fund that
is operating as a limited derivatives user, information about the
fund's derivatives exposure and the number of business days that its
derivatives exposure exceeded 10% of its net assets. We are adopting
these amendments largely as proposed, with certain modifications, such
as streamlining the VaR information and exposure information that
certain funds would provide, and requiring additional information about
funds operating as limited derivatives users that exceed the 10%
threshold. We also are making certain of these data elements non-public
in response to comments.
In connection with our adoption of rule 18f-4, we are also adopting
amendments to rule 6c-11 under the Investment Company Act. Rule 6c-11
generally permits ETFs to operate without obtaining a Commission
exemptive order, subject to certain conditions.\76\ When the Commission
adopted rule 6c-11, the rule prohibited leveraged/inverse ETFs from
relying on the rule, to allow the Commission to consider the section 18
issues raised by these funds' investment strategies as part of a
broader consideration of derivatives use by registered funds and
BDCs.\77\ As part of this further consideration, and in connection with
the adoption of rule 18f-4, we are modifying this provision to permit
leveraged/inverse ETFs to rely on rule 6c-11 if they comply with all
applicable provisions of rule 18f-4. This will permit new leveraged/
inverse funds that can satisfy the requirements of rule 18f-4 to come
to market under rule 6c-11 without first being required to receive a
separate ETF exemptive order. We also are rescinding exemptive orders
the Commission previously issued to sponsors of leveraged/inverse funds
permitting these funds to operate as ETFs, as these orders will be
superseded. Amending rule 6c-11 and rescinding these exemptive orders
will help promote a more level playing field by allowing any sponsor
(in addition to the sponsors currently granted exemptive orders) to
form and launch a leveraged/inverse ETF subject to the conditions in
rule 6c-11 and rule 18f-4.
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\76\ See generally Exchange-Traded Funds, Investment Company Act
Release No. 33646 (Sept. 25, 2019) [84 FR 57162 (Oct. 24, 2019)]
(``ETFs Adopting Release'').
\77\ See id. at nn.72-74 and accompanying text.
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Finally, in view of the updated, comprehensive approach to the
regulation of funds' derivative use that the final rules provide, we
are rescinding Release 10666. In addition, staff in the Division of
Investment Management has reviewed certain of its no-action letters and
other guidance addressing derivatives transactions and other
transactions covered by rule 18f-4 to determine which letters and staff
guidance, or portions thereof, should be withdrawn in connection with
our adoption of the final rules. As discussed in section II.L below,
some of these letters and staff guidance, or portions thereof, are
moot, superseded, or otherwise inconsistent with the final rule and,
therefore, will be withdrawn. We are providing funds an eighteen-month
transition period while they prepare to come into compliance with rule
18f-4 before Release 10666 is withdrawn.
II. Discussion
A. Scope of Rule 18f-4
As proposed, the rule will apply to a ``fund,'' defined as a
registered open-end or closed-end company or a BDC, including any
separate series thereof.\78\ The rule will therefore apply to mutual
funds, ETFs, registered closed-end funds, and BDCs.\79\ The rule's
definition of a ``fund'' excludes money market funds regulated under
rule 2a-7 under
[[Page 83172]]
the Investment Company Act (``money market funds''), as proposed.\80\
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\78\ See rule 18f-4(a); see also proposed rule 18f-4(a).
\79\ 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.
\80\ See rule 18f-4(a); see also proposed rule 18f-4(a).
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Commenters generally supported the scope of funds that are
permitted to rely on the proposed rule.\81\ 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.\82\ 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.\83\ 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.
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\81\ 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'').
\82\ 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'').
\83\ 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'').
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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.\84\
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\84\ 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.).
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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.\85\ 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.
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\85\ 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).
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This prong of the definition also provides that a derivatives
instrument, for purposes of the rule, must involve a future payment
obligation.\86\ 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.\87\ 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.\88\ 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.\89\
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\86\ 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.''
\87\ 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.
\88\ See 2015 Proposing Release, supra footnote 1, at paragraph
accompanying n.82.
\89\ 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 infra section II.I (discussing the
characterization of ``unfunded commitment'' agreements for purposes
of the rule, and as senior securities).
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A few commenters suggested that the Commission further revise the
definition of a derivatives transaction to address situations where
several derivatives instruments considered together, or a derivatives
instrument and a securities position, in commenters' view did not
involve the same risks as the derivatives transactions considered
[[Page 83173]]
in isolation. For example, commenters urged that the definition exclude
purchased option spread transactions because commenters asserted that
the options together would not create a fund payment obligation that
will exceed the payment potential of a purchased option involved in the
transaction.\90\ Commenters also suggested that the scope of the rule
should exclude written covered calls, which involves a fund selling a
call option where the fund agrees to deliver an asset already held by
the fund if the option is exercised.\91\ Because the fund holds the
asset underlying the option, commenters asserted that the leverage risk
of the option is eliminated.\92\
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\90\ See Comment Letter of CBOE Vest Financial LLC (Mar. 24,
2020) (``CBOE Vest Comment Letter'') (stating that a ``purchased-
options-spread position is entered by buying and selling an equal
number of options of the same class (i.e., options on the same
underlying security), same options style (i.e., either only
exercisable at expiration or exercisable at times prior to expiry),
and same expiration date, but with different strike prices''); see
also Guggenheim Comment Letter.
\91\ 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'').
\92\ Refinitiv Comment Letter.
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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.\93\ 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.\94\ 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.
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\93\ Id. (requesting that FX forwards, FX swaps, non-deliverable
forwards involving FX, and FX options be excluded from the scope of
the rule).
\94\ See 2015 Proposing Release, supra footnote 1, at paragraph
accompanying n.239.
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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.\95\ 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.
---------------------------------------------------------------------------
\95\ See rule 18f-4(b).
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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.\96\ The final rule's
definition of ``derivatives transaction'' therefore includes a
conforming change to reflect the final rule's treatment of these
transactions.
---------------------------------------------------------------------------
\96\ 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.\97\
Similarly, the Commission has previously stated that a standby
commitment agreement is economically equivalent to the issuance of a
put option.\98\ 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.\99\
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\97\ 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.
\98\ See id. at ``Standby Commitment Agreements.''
\99\ 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
[[Page 83174]]
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.
[[Page 83175]]
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
[[Page 83176]]
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
[[Page 83177]]
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
[[Page 83178]]
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.
[[Page 83179]]
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\
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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,
[[Page 83180]]
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 them in view of its investment portfolio and
the fund's disclosure to investors. For example, a fund could consider
establishing corresponding investment size controls or lists of
approved transactions across the fund.\190\ A fund generally should
consider whether to implement appropriate monitoring mechanisms
designed to allow the fund to abide by the guidelines, including the
guidelines' quantitative metrics.
---------------------------------------------------------------------------
\189\ See, e.g., Comprehensive Risk Management of OTC
Derivatives, supra footnote 177; Statement on best practices for
managing risk in derivatives transactions, supra footnote 175; 2008
IDC Report, supra footnote 172.
\190\ A fund could also consider establishing an approved list
of specific derivatives instruments or strategies that may be used,
as well as a list of persons authorized to engage in the
transactions on behalf of the fund. A fund could consider providing
new instruments (or instruments newly used by the fund) additional
scrutiny. See, e.g., MFDF Guidance, supra footnote 187, at 8.
---------------------------------------------------------------------------
c. Stress Testing
A fund's program must provide for stress testing to evaluate
potential losses to the fund's portfolio.\191\ We are adopting this
requirement as proposed.\192\ Specifically, the fund's stress tests
must evaluate potential losses in response to extreme but plausible
market changes or changes in market risk factors that would have a
significant adverse effect on the fund's portfolio.\193\ The stress
tests must take into account correlations of market risk factors and
resulting payments to derivatives counterparties. Finally, the
frequency with which stress testing is conducted must take into account
the fund's strategy and investments and current market conditions,
provided that stress tests must be conducted no less frequently than
weekly.
---------------------------------------------------------------------------
\191\ Rule 18f-4(c)(1)(iii).
\192\ See proposed rule 18f-4(c)(1)(iii).
\193\ The rule requires a fund that is required to establish a
derivatives risk management program to stress test its portfolio,
that is, all of the fund's investments, and not just the fund's
derivatives transactions. Rule 18f-4(c)(1)(iii).
---------------------------------------------------------------------------
Many commenters expressed general support for the proposed stress
testing requirement.\194\ They stated, for example, that stress testing
provides funds with valuable information regarding potentially extreme
market conditions that the rule's VaR test may not capture.\195\ We
agree, and we continue to believe that stress testing is an important
component to a fund's derivatives risk management
[[Page 83181]]
program.\196\ We believe stress testing is an important tool to
evaluate different drivers of derivatives risks, including non-linear
derivatives risks that may be understated by metrics or analyses that
do not focus on periods of stress. We also continue to believe that
stress testing will serve as an important complement to the VaR-based
limit on fund leverage risk, as well as any VaR testing under the
fund's risk guidelines.
---------------------------------------------------------------------------
\194\ See, e.g., Dechert Comment Letter I; Fidelity Comment
Letter; J.P. Morgan Comment Letter; Better Markets Comment Letter;
Invesco Comment Letter; Morningstar Comment Letter; AQR Comment
Letter I; SIFMA AMG Comment Letter.
\195\ See, e.g., Dechert Comment Letter I; J.P. Morgan Comment
Letter.
\196\ The Commission also has required certain types of funds to
conduct stress tests or otherwise consider the effect of stressed
market conditions on their portfolios. See rule 2a-7 under the
Investment Company Act; see also rule 22e-4 under the Investment
Company Act (requiring a fund subject to the rule to assess its
liquidity risk by considering, for example, its investment strategy
and portfolio investment liquidity under reasonably foreseeable
stressed conditions).
---------------------------------------------------------------------------
Commenters generally agreed with the proposed approach not to
require stress tests to include certain identified market risk factors.
One commenter stated that the stress testing requirement took the
``right approach by not prescribing specific stress testing scenarios,
magnitudes, or types of simulations.'' \197\ We continue to believe
that a principles-based approach to stress testing allows funds to
tailor their simulations to a fund's particular relevant risk
factors.\198\
---------------------------------------------------------------------------
\197\ J.P. Morgan Comment Letter.
\198\ See Proposing Release, supra footnote 1, at paragraphs
accompanying nn.138-144.
---------------------------------------------------------------------------
As proposed, the rule requires that stress tests take into account
correlations of market risk factors and resulting payments to
derivatives counterparties.\199\ One commenter requested clarification
regarding the scope of ``correlations of market risk factors.'' \200\
The commenter stated that there were many factors beyond the six
factors that the Proposing Release identified--liquidity, volatility,
yield curve shifts, sector movements, or changes in the price of the
underlying reference security or asset--that could be considered for
stress testing. As discussed in the proposal, these requirements are
designed to promote stress tests that produce results that are valuable
in appropriately managing derivatives risks by focusing the testing on
extreme events that may provide actionable information to inform a
fund's derivatives risk management. We agree with the commenter that
there are factors other than the six specific factors provided as an
example in the Proposing Release that could be considered for stress
testing. For example, stress testing could also take into account
interest rates, credit spreads, volatility, and foreign exchange
rates.\201\ The specific factors to consider in a particular stress
test may vary from fund to fund and will require judgment by fund risk
professionals in designing stress tests. The rule's principles-based
approach to stress testing will provide flexibility to enable those
professionals to exercise their judgment in designing and implementing
the stress tests required by the rule.
---------------------------------------------------------------------------
\199\ See rule 18f-4(c)(1)(iii).
\200\ ICI Comment Letter.
\201\ See Refinitiv Comment Letter.
---------------------------------------------------------------------------
In terms of the frequency of stress testing, comments were mixed.
Some commenters specifically stated their support for the proposed
weekly stress testing requirement. For example, some acknowledged that
the proposed timing requirement is consistent with many funds' current
practice.\202\ Several commenters, however, supported decreasing the
frequency of the stress testing requirement.\203\ Some specifically
suggested a monthly stress testing requirement.\204\ Alternatively,
rather than specifying the frequency of stress tests in the rule, some
commenters preferred that the derivatives risk manager be given the
discretion to determine the appropriate frequency.\205\ Commenters
urging less frequent stress testing stated that weekly stress tests are
too burdensome, particularly during times of low market stress.\206\
One commenter contended that weekly stress testing would not be
necessary given the overlay of the rule's VaR-based limit on fund
leverage risk.\207\
---------------------------------------------------------------------------
\202\ J.P. Morgan Comment Letter; Better Markets Comment Letter.
\203\ Dechert Comment Letter I; Fidelity Comment Letter, at 13;
T. Rowe Price Comment Letter; ICI Comment Letter; SIFMA AMG Comment
Letter; Comment Letter of PIMCO (Apr. 30, 2020) (``PIMCO Comment
Letter''); ABA Comment Letter (advocating that the stress testing
requirement for UCITs should be used).
\204\ Dechert Comment Letter I; Fidelity Comment Letter; T. Rowe
Price Comment Letter; ICI Comment Letter; SIFMA AMG Comment Letter;
PIMCO Comment Letter.
\205\ Dechert I Comment Letter; Fidelity Comment Letter; T. Rowe
Price Comment Letter; ICI Comment Letter; SIFMA AMG Comment Letter;
PIMCO Comment Letter; ISDA Comment Letter.
\206\ See Dechert Comment Letter I; ICI Comment Letter (stating
that, particularly in periods of low market stress, weekly stress
testing is not generally necessary and that monthly stress testing
would allow a fund to observe trends and changes over time without
sacrificing its ability to assess in a timely manner its risk of
potential loss).
\207\ ICI Comment Letter.
---------------------------------------------------------------------------
We continue to believe that weekly stress testing is an important
risk management tool. During periods of stress, returns, correlations,
and volatilities tend to change dramatically over a very short period
of time.\208\ These and other variables also can change quickly outside
of periods of overall market stress or as stressed conditions begin to
materialize. Monthly stress testing may not be frequent enough to
observe these trends or to identify risks that may arise or become more
acute if market conditions were to change quickly. Weekly or more
frequent stress testing may be particularly useful during times of
unexpected or unprecedented market stress. Monthly stress testing may
not provide a fund's derivatives risk manager adequate and timely
insight into the fund's derivatives risk, particularly where the fund
has a high portfolio turnover.
---------------------------------------------------------------------------
\208\ See supra footnote 23 and accompanying text.
---------------------------------------------------------------------------
We believe that the minimum weekly stress testing frequency
balances the attendant costs of establishing a stress testing program
with the benefits of frequent testing.\209\ While a fund must run
stress tests on a weekly basis, the scope of stress testing may vary.
Funds may, for example, conduct more-detailed scenario analyses on a
less-frequent basis--such as the monthly frequency suggested by some
commenters-while conducting more-focused weekly stress tests under rule
18f-4.
---------------------------------------------------------------------------
\209\ See infra section III.C.1. We recognize that the costs
associated with stress testing may increase with the frequency of
conducting such tests. We understand, however, that once a fund
initially implements a stress testing framework, subsequent stress
tests could be automated and, as a result, be less costly.
In establishing the frequency of stress testing, a fund must
take into account the fund's strategy and market conditions. See
rule 18f-4(c)(2). For example, a fund whose strategy involves a high
portfolio turnover might determine to conduct stress testing more
frequently than a fund with a more static portfolio. A fund
similarly might conduct more-frequent stress tests in response to
increases in market stress. In determining this minimum frequency,
we also took into account that this requirement would only apply to
funds that do not qualify for the limited derivatives user exception
because they use derivatives in a more limited way.
---------------------------------------------------------------------------
In response to commenters that stated that weekly stress testing
would not be necessary when complemented by VaR limits, losses under
stressed conditions--or ``tail risks''--would not be reflected in VaR
analyses that are not calibrated to a period of market stress and that
do not estimate losses that occur on the trading days with the highest
losses.\210\ Requiring funds to stress test their portfolios would
provide information regarding these ``tail risks'' that VaR and other
analyses may miss. Stress testing allows funds to tailor the
hypothetical scenario to the needs of a particular fund. VaR, in
contrast, is based on historical data. The rule's VaR test is intended
as an outer limit on fund leverage risk. Stress testing may
[[Page 83182]]
identify risks that may not result in a VaR breach, yet may not be
appropriate in light of the fund's investment strategy. We continue to
believe that stress testing and VaR limits are complementary and
important tools to help funds manage their derivatives risk.
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\210\ The rule does not require a fund to implement a stressed
VaR test. See infra section II.D.1.
---------------------------------------------------------------------------
d. Backtesting
The rule will require a fund to backtest the results of the VaR
calculation model used by the fund in connection with the relative VaR
or absolute VaR test, as applicable, as part of the program.\211\ As
proposed, the backtesting requirement will require that the fund
compare its actual gain or loss for each business day with the VaR the
fund had calculated for that day, and identify as an exception any
instance in which the fund experiences a loss exceeding the
corresponding VaR calculation's estimated loss. In a modification from
the proposal, the rule will permit a fund to perform this analysis on a
weekly instead of a daily basis, comparing the fund's daily gain and
loss to the estimated VaR for each business day in the week. This
requirement is designed to require a fund to monitor the effectiveness
of its VaR model.\212\
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\211\ See rule 18f-4(c)(1)(iv).
\212\ As we explained in the Proposing Release, if 10 or more
exceptions are generated in a year from backtesting that is
conducted using a 99% confidence level and over a one-day time
horizon, and assuming 250 trading days in a year, it is
statistically likely that such exceptions are a result of a VaR
model that is not accurately estimating VaR. See, e.g., Philippe
Jorion, Value at Risk: The New Benchmark for Managing Financial Risk
(3d ed. 2006), at 149-150; see also rule 15c3-1e under the Exchange
Act (requiring backtesting of VaR models and the use of a
multiplication factor based on the number of backtesting
exceptions).
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Commenters indicated general support for the backtesting
requirement but provided mixed views regarding the frequency of
backtesting.\213\ Several commenters noted that they currently use
backtesting as an effective tool in their risk management
framework.\214\ We continue to believe that backtesting is important
for funds to monitor the effectiveness of their VaR models. The
backtesting requirements we are adopting will assist a fund in
confirming the appropriateness of its model and related assumptions and
help identify when a fund should consider model adjustments.
---------------------------------------------------------------------------
\213\ See, e.g., J.P. Morgan Comment Letter; AQR Comment Letter
I; Morningstar Comment Letter.
\214\ See, e.g., J.P. Morgan Comment Letter; MFDF Comment Letter
(observing that stress testing and backtesting are critical for the
operation of the rule).
---------------------------------------------------------------------------
Several commenters, however, supported decreasing the frequency of
backtesting from the proposed daily requirement. Some commenters
supported a weekly requirement.\215\ Several other commenters supported
a monthly requirement, with some of these commenters identifying
compliance efficiencies that could result for advisers to UCITS funds,
which conduct backtesting on a monthly basis.\216\ Commenters urging
less frequent than daily backtesting stated that a less frequent
backtesting requirement in the final rule would serve as a baseline,
while permitting the derivatives risk manager to adjust the frequency
based on the particular needs of the fund.\217\ In supporting weekly
backtesting, one commenter stated that it would allow a retroactive
comparison of the VaR measure for each business day without incurring
the costs and burdens of daily testing.\218\ Several commenters went on
to say that backtesting should be looked at on a longer time horizon so
that the data is analyzed in the context of more than one day's
results.\219\ Additionally, commenters stated that daily testing does
not provide enough data on its own for model validation to allow a
derivatives risk manager to adjust a fund's VaR model, and therefore
the rule should incorporate a less-frequent backtesting
requirement.\220\ For example, in order to alter a VaR model, some
commenters stated that in addition to backtesting, the fund must
consider market trends, risk factors assessed by the risk team, a
formal review by the model risk governance committee and approval by a
risk forum.\221\ In light of these critiques, commenters stated that
the value of daily backtesting is not justified by the costs and
burdens of implementing the requirement.\222\
---------------------------------------------------------------------------
\215\ Fidelity Comment Letter; PIMCO Comment Letter.
\216\ Dechert Comment Letter I; T. Rowe Price Comment Letter;
ICI Comment Letter; SIFMA AMG Comment Letter; see also CESR's
Guidelines on Risk Measurement and the Calculation of Global
Exposure and Counterparty Risk for UCITS (July 28, 2010) (``UCITS
Guidelines'') Section 3.6.4, available at https://www.fsc.gi/uploads/legacy/download/ucits/CESR-10-788.pdf.
\217\ Dechert Comment Letter I; T. Rowe Price Comment Letter;
SIFMA AMG Comment Letter.
\218\ PIMCO Comment Letter.
\219\ PIMCO Comment Letter; Dechert Comment Letter I (``VaR
backtesting could provide more meaningful results if smoothed by a
longer period of data points.'').
\220\ Dechert Comment Letter I; J.P. Morgan Comment Letter; ICI
Comment Letter; PIMCO Comment Letter.
\221\ J.P. Morgan Comment Letter; ICI Comment Letter.
\222\ See, e.g., Dechert Comment Letter I; PIMCO Comment Letter.
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In considering these comments, we agree that daily backtesting may
not be necessary for funds to gather the information needed in order
for a fund to readily and efficiently adjust or calibrate its VaR
calculation model. We are therefore requiring funds to conduct
backtesting on a weekly, rather than a daily, basis (taking into
account the fund's gain and loss on each business day that occurred
during the weekly backtesting period).\223\ This will ensure that funds
collect backtesting data for each business day, while also providing
funds with the added flexibility of only running the test weekly. We
believe this requirement addresses commenters' concerns while still
ensuring that funds gather necessary data for VaR data calibration and
derivatives risk management and conduct backtesting analyses to analyze
the VaR model's effectiveness at least weekly.
---------------------------------------------------------------------------
\223\ Rule 18f-4(c)(1)(iv).
---------------------------------------------------------------------------
We have not, however, revised the rule to provide for monthly
backtesting as some commenters suggested. Although the costs of weekly
backtesting will likely be marginally higher than the costs of less-
frequent backtesting, we believe that any additional costs associated
with a weekly backtesting requirement will be limited because a fund
will be required to calculate its portfolio VaR each business day to
satisfy the limits on fund leverage risk.\224\ We believe the limited
additional costs for weekly backtesting relative to monthly testing are
justified by the benefits of providing more-recent information
regarding the effectiveness of a fund's VaR model. We therefore are
requiring weekly backtesting to provide derivatives risk managers more-
current information regarding the effectiveness of the fund's VaR
model, in line with the requirement under the final rule for weekly
stress testing.
---------------------------------------------------------------------------
\224\ See infra section III.C.1.
---------------------------------------------------------------------------
Under the final rule, the derivatives risk manager may alter the
frequency of backtesting, so long as the frequency is no less frequent
than weekly.\225\ While backtesting may not provide the only
information that a derivatives risk manager should take into account
when adjusting a fund's VaR model, we believe it is an important tool
for funds to use in validating and adjusting a fund's VaR model. The
derivatives risk management program may incorporate additional elements
that the derivatives risk manager may find important when assessing
whether the fund's VaR model should be adjusted. Market trends,
additional risk factors, formal reviews by a model risk governance
committee, and approval by a risk forum may be factors that a
derivatives risk manager
[[Page 83183]]
would choose to incorporate into the derivatives risk management
program.
---------------------------------------------------------------------------
\225\ Rule 18f-4(c)(1)(iv).
---------------------------------------------------------------------------
e. Internal Reporting and Escalation
The final rule will require a fund's derivatives risk management
program to address internal reporting and escalation. Specifically, the
program must identify the circumstances under which persons responsible
for portfolio management will be informed regarding the operation of
the program, including guidelines exceedances and the results of the
fund's stress testing.\226\ The final rule also specifies that a fund's
derivatives risk manager must also directly inform the fund's board, as
appropriate, of material risks arising from the fund's derivatives use,
including risks that exceedances of the guidelines and results of the
fund's stress tests indicate.\227\ We are adopting these requirements
as proposed.
---------------------------------------------------------------------------
\226\ Rule 18f-4(c)(1)(v)(A).
\227\ Rule 18f-4(c)(1)(v)(B). For example, an unexpected risk
may arise due to a sudden market event, such as a downgrade of an
investment bank that is a substantial derivatives counterparty to
the fund.
---------------------------------------------------------------------------
The internal reporting and escalation requirements will require
communication between a fund's risk management and portfolio management
regarding the operation of the program. We continue to believe that
these lines of communication are a key part of derivatives risk
management.\228\ Providing portfolio managers with the insight of a
fund's derivatives risk manager is designed to inform portfolio
managers' execution of the fund's strategy and recognize that portfolio
managers will generally be responsible for transactions that could
mitigate or address derivatives risks as they arise. The rule also will
require communication between a fund's derivatives risk manager and its
board, as appropriate. We understand that funds today often have a
dialogue between risk professionals and fund boards. Requiring a
dialogue between a fund's derivatives risk manager and the fund's board
provides the fund's board with key information to facilitate its
oversight function.
---------------------------------------------------------------------------
\228\ See 2011 IDC Report, supra footnote 124.
---------------------------------------------------------------------------
No commenters opposed the proposed requirements, and the Commission
received one comment supporting the proposed internal reporting and
escalation requirements. This commenter appreciated that the proposed
rule for reporting and escalation requirements did not prescribe
criteria or thresholds for discussion or escalation.\229\ We agree that
the internal reporting and escalation program requirement should be
principles-based. In light of the breadth of funds' differing
strategies and the variety of ways in which we anticipate funds will
manage their derivatives risks, we believe that funds should have
flexibility when implementing this program requirement.
---------------------------------------------------------------------------
\229\ J.P. Morgan Comment Letter. But see Comment Letter of
North American Securities Administrators Association, Inc. (Mar. 27,
2020) (``NASAA Comment Letter'') (while not clearly addressing the
escalation requirement, urging that the Commission require immediate
board reporting when a fund ``exceeds the maximum [VaR] threshold
during backtesting''). Because a fund is expected to experience a
given number of backtesting exceedances, we do not believe it would
be appropriate to require a derivatives risk manager to report every
such exceedance to a fund's board. See also infra footnotes 282-283
and accompanying text.
---------------------------------------------------------------------------
Several commenters requested clarification regarding what the
particular standard for escalating material risks should be under the
rule. While the rule requires the derivatives risk manager to inform
portfolio managers in a timely manner of material risks arising from
the fund's derivatives transactions, the derivatives risk manager has
flexibility to inform the board about these material risks ``as
appropriate.'' Some commenters urged the Commission to adopt backstops
to ensure that funds do not set reporting and escalation standards too
low, potentially leading to the escalation of day-to-day issues or
over-reporting.\230\ One commenter stated that the derivatives risk
manager should not have discretion regarding which material risks
should be escalated to the board, and that all material risks should be
escalated.\231\ Another commenter stated that the derivatives risk
manager should determine escalation based on a good faith
determination.\232\ Some commenters stated that exceedances should only
be reported when they are material and not remediated promptly
(suggesting within five business days) unless the results show material
weaknesses.\233\ This commenter went on to state that the reporting and
escalation requirements should be tailored based on the fund's size,
sophistication, and needs.\234\ One commenter urged that that the
Commission permit funds' boards to work with derivatives risk managers
to establish policies and procedures outlining under what circumstances
such risks should be communicated.\235\ Another commenter, while
broadly supporting a derivatives risk manager's ability to communicate
material risks directly to the board, similarly stated that the board
should work together with the derivatives risk manager to define the
circumstances under which the manager would communicate an issue to the
fund board.\236\
---------------------------------------------------------------------------
\230\ CFA Comment Letter; ABA Comment Letter; J.P. Morgan
Comment Letter.
\231\ Morningstar Comment Letter.
\232\ NYC Bar Comment Letter.
\233\ SIFMA AMG Comment Letter.
\234\ Id.
\235\ Dechert Comment Letter I.
\236\ MFDF Comment Letter.
---------------------------------------------------------------------------
We continue to believe that the derivatives risk manager should
have discretion to determine, as appropriate, when and what material
risks escalated to the fund's portfolio management also should be
escalated to the board of directors. We believe that a fund's
derivatives risk manager is best positioned to determine when it is
appropriate to inform the fund's portfolio management and board of
material risks. The final rule provides flexibility for the derivatives
risk manager to calibrate the escalation framework to suit the needs of
the fund and to avoid the over-reporting concern some commenters
identified. We agree that the escalation requirements for the fund
should be tailored based on the fund's size, sophistication, and needs
and believe that these would be appropriate factors for the derivatives
risk manager to consider in establishing the fund's escalation
requirements.\237\ In addition, the rule does not limit a board's
ability to engage with the derivatives risk manager on the
circumstances under which risks will be communicated to the board. This
engagement may help a derivatives risk manager develop an understanding
of risks that the board would find most salient, or important to raise
outside of a regularly scheduled board meeting.\238\
---------------------------------------------------------------------------
\237\ See SIFMA AMG Comment Letter.
\238\ The final rule also requires a fund's derivatives risk
manager to provide certain reports to the fund's board at a
frequency determined by the board. Rule 18f-4(c)(3)(iii).
---------------------------------------------------------------------------
f. Periodic Review of the Program
The final rule requires a fund's derivatives risk manager to review
the program at least annually to evaluate the program's effectiveness
and to reflect changes in the fund's derivatives risks over time.\239\
The review applies to the overall program, including each of the
specific program elements discussed above. The periodic review must
include a review of the fund's VaR calculation model and any designated
reference portfolio to evaluate whether it remains appropriate. We did
not receive any comments on this requirement and are adopting it as
proposed apart from conforming
[[Page 83184]]
changes to reflect modifications to the final rule's relative VaR test.
---------------------------------------------------------------------------
\239\ Rule 18f-4(c)(1)(vi).
---------------------------------------------------------------------------
We continue to believe that the periodic review of a fund's program
and VaR calculation model is necessary to determine whether the fund is
appropriately addressing its derivatives risks. A fund's derivatives
risk manager, as a result of the review, could determine whether the
fund should update its program, its VaR calculation model, or any
designated reference portfolio.\240\ The rule does not prescribe review
procedures or incorporate specific developments that a derivatives risk
manager must consider as part of its review. We believe a derivatives
risk manager generally should implement periodic review procedures for
evaluating regulatory, market-wide, and fund-specific developments
affecting the fund's program so that it is well positioned to evaluate
the program's effectiveness.
---------------------------------------------------------------------------
\240\ The periodic review requirement applies to a fund's
designated reference portfolio, rather than a designated reference
index as proposed, because the final rule permits a fund to use
either a designated index or its securities portfolio as the fund's
reference portfolio for the relative VaR test, subject to
conditions.
---------------------------------------------------------------------------
We believe that a fund should conduct this review on at least an
annual basis, because derivatives and fund leverage risks, and the
means by which funds evaluate such risks, can change. The rule requires
at least an annual review so that there would be a recurring dialogue
between a fund's derivatives risk manager and its board regarding the
implementation of the program and its effectiveness. This frequency
also mirrors the minimum period in which the fund's derivatives risk
manager would be required to provide a written report on the
effectiveness of the program to the board. A fund's derivatives risk
manager could, however, determine that more frequent reviews are
appropriate based on the fund's particular derivatives risks, the
fund's policies and procedures implementing the program, market
conditions, or other facts and circumstances.\241\
---------------------------------------------------------------------------
\241\ See also rule 18f-4(c)(2)(iii)(A) (requiring, for a fund
that is not in compliance with the applicable VaR test within five
business days, the derivatives risk manager to report to the fund's
board of directors and explain how and by when (i.e., number of
business days) the derivatives risk manager reasonably expects that
the fund will come back into compliance).
---------------------------------------------------------------------------
C. Board Oversight and Reporting
The final rule will require: (1) A fund's board of directors to
approve the designation of the fund's derivatives risk manager; and (2)
the derivatives risk manager to provide regular written reports to the
board regarding the program's implementation and effectiveness, and
analyzing exceedances of the fund's guidelines and the results of the
fund's stress testing.\242\ We are adopting these requirements with
some modifications from the proposal, as we describe in more detail
below.
---------------------------------------------------------------------------
\242\ Rule 18f-4(c)(3).
---------------------------------------------------------------------------
The final rule's requirements regarding board oversight and
reporting are designed to further facilitate the board's oversight of
the fund's derivatives risk management. We believe that directors
should understand the program and the derivatives risks it is designed
to manage as well as participate in determining who should administer
the program. They also should ask questions and seek relevant
information regarding the adequacy of the program and the effectiveness
of its implementation. Therefore, we believe that the board should
inquire about material risks arising from the fund's derivatives
transactions and follow up regarding the steps the fund has taken to
address such risks and any change in those risks over time. To
facilitate the board's oversight, the rule will require the fund's
derivatives risk manager to provide reports to the board.
The Commission received many comments, as discussed throughout this
section, regarding the role of the board in overseeing a fund's
derivatives risk management program. In addition to the comments on the
specific requirements of the rule regarding board approval of the
derivatives risk manager and regarding board reports, the Commission
received comments regarding the role of the board more broadly.
Specifically, commenters requested that the Commission provide guidance
reiterating that the board's role is one of oversight and that the
board members may exercise their reasonable business judgment in
overseeing a fund's program.\243\ We believe the role of the board
under the rule is one of general oversight, and consistent with that
obligation, we expect that directors will exercise their reasonable
business judgment in overseeing the program on behalf of the fund's
investors.\244\
---------------------------------------------------------------------------
\243\ See, e.g., Dechert Comment Letter I; Invesco Comment
Letter; T. Rowe Price Comment Letter; MFDF Comment Letter; ICI
Comment Letter. Commenters discussed the board's role under other of
the Commission's rules--in particular, rule 22e-4 and rule 38a-1--in
making observations and suggestions about the board's oversight role
in the context of funds' derivatives risk management. See SIFMA AMG
Comment Letter; BlackRock Comment Letter; Capital Group Comment
Letter.
Commenters also requested that the Commission clarify that the
board's role does not exceed standards under state law, standards in
Release 10666, rule 22e-4, and rule 38a-1. See Dechert Comment
Letter I; ICI Comment Letter; SIFMA AMG Comment Letter.
\244\ See Investment Company Liquidity Risk Management Programs,
Investment Company Act Release No. 32315 (Oct. 13, 2016) [81 FR
82142 (Nov. 18, 2016)], at section III.H.
---------------------------------------------------------------------------
We continue to believe that the board should view oversight as an
iterative process. Several commenters expressed concern over the use of
the word ``iterative'' when describing the oversight role of the
board.\245\ These commenters suggested that this word implies that the
Commission expects the board to act in a management capacity, similar
to the derivatives risk manager. The use of the word ``iterative'' is
not intended to imply that the board is responsible for the day-to-day
management of the fund's derivatives risk, but is instead intended to
clarify that the board's oversight role requires regular engagement
with the derivatives risk management program rather than a one-time
assessment. We continue to believe that the board's role should be an
active one that involves inquiry into material risks arising from the
fund's derivatives transactions and follow-up regarding the steps the
fund has taken to address such risks, including as those risks may
change over time. Effective board oversight depends on the board
receiving sufficient information on a regular basis to remain abreast
of the specific derivatives risks that the fund faces. Boards should
request follow-up information when appropriate and take reasonable
steps to see that matters identified are addressed. Whether a board
requests follow-up information, however, will depend on the facts and
circumstances. As one commenter noted, ``[d]epending on the
circumstances, regular follow-up may or may not be necessary, as the
reports provided to the board may already contain sufficient
information, or the matter may have been resolved.'' \246\
---------------------------------------------------------------------------
\245\ ICI Comment Letter; IDC Comment Letter; Capital Group
Comment Letter.
\246\ IDC Comment Letter.
---------------------------------------------------------------------------
A fund's board also will be responsible for overseeing a fund's
compliance with rule 18f-4. Rule 38a-1 under the Investment Company Act
requires a fund's board, including a majority of its independent
directors, to approve policies and procedures reasonably designed to
prevent violation of the federal securities laws by the fund and its
service providers.\247\ Rule 38a-
[[Page 83185]]
1 provides for oversight of compliance by the fund's adviser and other
service providers through which the fund conducts its activities. Rule
38a-1 would encompass a fund's compliance obligations with respect to
rule 18f-4.
---------------------------------------------------------------------------
\247\ See rule 38a-1 under the Investment Company Act;
Compliance Programs of Investment Companies and Investment Advisers,
Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR
74714 (Dec. 24, 2003)] (``Compliance Program Release'') (discussing
the adoption and implementation of policies and procedures required
under rule 38a-1).
---------------------------------------------------------------------------
1. Board Approval of the Derivatives Risk Manager
The rule requires a fund's board, including a majority of directors
who are not interested persons of the fund, to approve the designation
of the fund's derivatives risk manager.\248\ We are adopting this
provision with one modification from the proposal, as discussed
below.\249\
---------------------------------------------------------------------------
\248\ Rule 18f-4(c)(3)(i).
\249\ Proposed rule 18f-4(c)(5)(i).
---------------------------------------------------------------------------
Some commenters expressed concern regarding the role of the board
in selecting the derivatives risk manager. Several commenters stated
that the fund's adviser--and not its board--should select the
derivatives risk manager.\250\ Similarly, some commenters stated that
requiring the board to select the derivatives risk manager is a
management function that should be outside the scope of board
responsibilities.\251\ Commenters stated that the selection process for
approving a specific person or persons to serve as the derivatives risk
manager would be unduly burdensome for the board.\252\ On the other
hand, one commenter stated that the proposed approval requirement was
among several responsible measures in the proposal, but expressed
concern that the proposal would not ensure appropriate independence of
the derivatives risk manager.\253\
---------------------------------------------------------------------------
\250\ Dechert Comment Letter I; MFDF Comment Letter; T. Rowe
Price Comment Letter; SIFMA AMG Comment Letter; ABA Comment Letter.
\251\ IDC Comment Letter; T. Rowe Price Comment Letter.
\252\ Dechert Comment Letter I; IDC Comment Letter.
\253\ Better Markets Comment Letter.
---------------------------------------------------------------------------
We continue to believe that requiring the board to designate the
derivatives risk manager is important to establish the foundation for
an effective relationship and line of communication between a fund's
board and its derivatives risk manager.\254\ While the derivatives risk
manager is responsible for administering the fund's derivatives risk
management program, we believe it is important that the board, in its
oversight role, remains engaged with the program by designating a
qualified derivatives risk manager who will have a direct reporting
line to the board. We believe that a fund's board, in its oversight
role, is well-positioned to consider a prospective derivatives risk
manager based on all the facts and circumstances relevant to the fund
in considering whether to approve the derivatives risk manager's
designation, including the derivatives risks particular to the fund.
---------------------------------------------------------------------------
\254\ Cf. rules 22e-4 and 38a-1 under the Investment Company
Act.
---------------------------------------------------------------------------
In response to commenters who suggested that the adviser to the
fund is in the best position to evaluate a candidate, we agree that the
adviser could play a role in putting forward derivatives risk manager
candidates for the board's consideration.\255\ The final rule requires
that the board approve the designation of the fund's derivatives risk
manager but does not preclude the adviser from participating in the
selection process. We anticipate that boards generally would request
that the adviser carry out due diligence on appropriate candidates and
articulate the qualifications of the candidate(s) that the adviser puts
forward to the board.\256\ The adviser to the fund could, for example,
nominate potential candidates, review resumes, conduct initial
interviews, and articulate the adviser's view of the candidate. We
acknowledge that the selection of the derivatives risk manager has
attendant burdens, but nevertheless think it appropriate that the final
rule require the board to exercise oversight by designating the
derivatives risk manager.
---------------------------------------------------------------------------
\255\ MFDF Comment Letter; T. Rowe Price Comment Letter; see
also supra section II.B.1 (discussing the selection of the
derivatives risk manager).
\256\ See J.P. Morgan Comment Letter; Dechert Comment Letter I;
MFDF Comment Letter; ABA Comment Letter.
---------------------------------------------------------------------------
Comments on the proposed requirement that the fund's board consider
relevant experience in managing derivatives risk when selecting the
derivatives risk manager were mixed. Some commenters expressed support
for this proposed requirement.\257\ In contrast, several commenters
stated that the board should not be required to take into account the
relevant experience of managing derivatives risk.\258\ One commenter
stated that if the board is responsible for selecting the derivatives
risk manager, the board should have flexibility in determining what
experience it believes is relevant.\259\
---------------------------------------------------------------------------
\257\ J.P. Morgan Comment Letter; NYC Bar Comment Letter.
\258\ Dechert Comment Letter I; Fidelity Comment Letter; ICI
Comment Letter; IDC Comment Letter.
\259\ MFDF Comment Letter. Some commenters also requested
additional clarity about what experience would be considered
``relevant'' in the context of selecting a derivatives risk manager.
See supra paragraph accompanying footnotes 157-158.
---------------------------------------------------------------------------
After considering comments, we are removing the specific
requirement in the proposal that the fund's board ``tak[e] into account
the derivatives risk manager's relevant experience regarding the
management of derivatives risk'' when approving the designation of the
derivatives risk manager. The definition of ``derivatives risk
manager'' requires the person fulfilling the role to have ``relevant
experience regarding the management of derivatives risk.'' \260\ We
believe that a fund board's consideration of a candidate to serve as a
derivatives risk manager necessarily would take into account the
candidate's experience, among all other relevant factors, and that a
specific requirement in the final rule requiring the board to take the
candidate's experience into account is unnecessary.
---------------------------------------------------------------------------
\260\ Rule 18f-4(a).
---------------------------------------------------------------------------
2. Board Reporting
The rule will require the derivatives risk manager to provide a
written report on the effectiveness of the program to the board at
least annually and also to provide regular written reports at a
frequency determined by the board.\261\ This requirement is designed to
facilitate the board's oversight role, including its role under rule
38a-1.\262\ As discussed below, we are adopting these reporting
obligations with some modifications from the proposal.
---------------------------------------------------------------------------
\261\ Rule 18f-4(c)(3)(ii) and (iii).
\262\ See Compliance Program Release, supra footnote 247, at
n.33 and accompanying text.
---------------------------------------------------------------------------
The Commission received many comments regarding the type and amount
of information that is required to be submitted to boards under the
board reporting obligations. Specifically, commenters stated their
concern that the amount of information that the derivatives risk
manager would submit to the board under the proposal may shift the
board's role from one of oversight to day-to-day risk management.\263\
Some commenters similarly stated their concern that the proposed rule
suggests that board members should have a more substantive knowledge of
derivatives risks than is reasonable to expect for board members
serving in an oversight capacity.\264\
---------------------------------------------------------------------------
\263\ Dechert Comment Letter I; T. Rowe Price Comment Letter;
MFDF Comment Letter; ICI Comment Letter; SIFMA AMG Comment Letter;
ABA Comment Letter.
\264\ ICI Comment Letter; ProShares Comment Letter; ABA Comment
Letter.
---------------------------------------------------------------------------
We agree with commenters that the board's role is distinct from
that of the derivatives risk manager and is not one that requires the
board to be involved in the day-to-day management of the fund. It is
the derivatives risk manager, not the board, that is responsible for
having
[[Page 83186]]
sufficient derivatives experience to administer the derivatives risk
management program. The final rule does not place day-to-day
responsibility for the fund's derivatives risk management on a fund's
board. Board oversight should not, however, be a passive activity. We
continue to believe that the board reporting requirements, discussed
below, are important to facilitate the board's oversight role. In order
for the board members to fulfil their oversight role--and in light of
the fact that funds required to establish a program use derivatives
more extensively--we believe that it is critically important for a
board to be informed of certain derivatives risks faced by the fund.
Consistent with that view, we believe that directors should understand
the program and the derivatives risks it is designed to manage. They
also should ask questions and seek relevant information regarding the
adequacy of the program and the effectiveness of its implementation.
The board reporting requirements are designed to equip board members
with the information they need to provide effective oversight,
including their oversight responsibilities under rule 38a-1.
Reporting on Program Implementation and Effectiveness
The rule will require a fund's derivatives risk manager to provide
to the fund's board, on or before the implementation of the program and
at least annually thereafter, a written report providing a
representation that the program is reasonably designed to manage the
fund's derivatives risks and to incorporate the required elements of
the program.\265\ The report must include the basis for the derivatives
risk manager's representation along with such information as may be
reasonably necessary to evaluate the adequacy of the fund's program and
the effectiveness of its implementation. The representation may be
based on the derivatives risk manager's reasonable belief after due
inquiry. A derivatives risk manager, for example, could form its
reasonable belief based on an assessment of the program and taking into
account input from fund personnel, including the fund's portfolio
management, or data that third parties provide. Additionally, the
written report must include, as applicable, the fund's derivatives risk
manager's basis for the approval of the designated reference portfolio
(or any change in the designated reference portfolio) used under the
relative VaR test; or an explanation of the basis for the derivatives
risk manager's determination that a designated reference portfolio
would not provide an appropriate reference portfolio for purposes of
the relative VaR test such that the fund relied on the absolute VaR
test instead.\266\ These requirements are designed to provide a fund's
board with information about the effectiveness and implementation of
the program so that the board may appropriately exercise its oversight
responsibilities, including its role under rule 38a-1. We are adopting
these requirements substantially as proposed, with some modifications
as discussed below.
---------------------------------------------------------------------------
\265\ Rule 18f-4(c)(3)(ii).
\266\ See infra section II.D.2.b.
---------------------------------------------------------------------------
Commenters generally supported the derivatives risk manager
providing to the fund's board, on or before implementation of the
program, and at least annually thereafter, an annual report regarding
the program's design.\267\ One commenter specifically supported the
requirement that the derivatives risk manager determine whether the
program is operating effectively.\268\ Several commenters, however,
suggested modifications to this proposed reporting requirement,
expressing concern about the requirement for the derivatives risk
manager to make affirmative representations regarding the program due
to the burden this would impose.\269\ For example, one commenter stated
that the reporting requirement should be replaced by a written report,
provided at least annually, that addresses operations, adequacy and
effectiveness of implementation, and discloses any material changes to
the program.\270\
---------------------------------------------------------------------------
\267\ See, e.g., J.P. Morgan Comment Letter; ICI Comment Letter;
Invesco Comment Letter.
\268\ MFDF Comment Letter.
\269\ Dechert Comment Letter I; Invesco Comment Letter; T. Rowe
Price Comment Letter; MFDF Comment Letter.
\270\ Invesco Comment Letter.
---------------------------------------------------------------------------
We continue to believe that a derivatives risk manager's
affirmative representation that the program is reasonably designed to
manage the fund's derivatives risks, incorporating each of the program
elements that rule 18f-4 requires, is appropriate to provide the board
with the information they need to understand the effectiveness and
content of the derivatives risk program. The final rule includes this
requirement--rather than a requirement that the board approve the
derivatives risk management program, for example--because we believe
that the derivatives risk manager, rather than the board, is best
positioned to make the determinations underlying the affirmative
representations. Requiring the derivatives risk manager to include the
information in a board report will also reinforce that the fund and its
adviser are responsible for derivatives risk management while the
board's responsibility is to oversee this activity.\271\
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\271\ One commenter stated that the rule should not require or
suggest through an affirmative representation obligation that the
derivatives risk manager is certifying or guaranteeing the
effectiveness of a fund's program to manage derivatives risks, even
if subject to a reasonableness standard and based upon due inquiry.
See Invesco Comment Letter. The rule does not require or suggest any
such certification or guarantee.
---------------------------------------------------------------------------
One commenter expressed concern regarding the requirement that the
board report include ``such information as may be reasonably necessary
to evaluate the adequacy of the fund's program and the effectiveness of
its implementation.'' \272\ The commenter supported the rule not
requiring the board to make these specific findings and was concerned
that this reporting requirement could imply a board obligation to make
the findings. This reporting requirement applies to the content of the
board reports and is designed to facilitate the board's oversight role,
including its role under rule 38a-1. This requirement does not imply
any obligation for a board to make any particular findings.
---------------------------------------------------------------------------
\272\ MFDF Comment Letter.
---------------------------------------------------------------------------
One commenter who supported the proposed requirement that the
written report provide the basis for the derivatives risk manager's
selection of the designated index also suggested that the board report
include the basis for any change in the index.\273\ We agree that the
basis for a change in a designated reference portfolio that the fund
uses in complying with the relative VaR test may be just as important
to understanding the operation of the relative VaR test as the basis
for a designated reference portfolio's initial approval.\274\
Accordingly, in a clarifying change from the proposal, the derivatives
risk manager will also be required to include in the report the basis
for any change in the designated reference portfolio as well as the
basis for the approval of a designated
[[Page 83187]]
reference portfolio.\275\ The derivatives risk manager's approval of a
particular designated reference portfolio or approval of a change in
that portfolio, or a determination that a designated reference
portfolio would not provide an appropriate reference portfolio for
purposes of the relative VaR test, can affect the amount of leverage
risk a fund may obtain under the final rule. We therefore believe it is
important that a fund's board have sufficient information to oversee
this aspect of the fund's derivatives risk management.
---------------------------------------------------------------------------
\273\ Invesco Comment Letter; see also infra footnote 319
(discussing the use of the proposed term ``designated reference
index'' and the final rule's definition of ``designated index,'' and
stating that, for consistency with the final rule, we discuss
comments received about the designated reference index as comments
about the designated index).
\274\ This could include either a change from one designated
index to another, or a determination to change from using a
designated index to using the fund's own securities portfolio in
complying with the relative VaR test (or, vice versa, a change from
using the fund's securities portfolio to using a designated index).
See infra section II.D.2.b.
\275\ The final rule also refers to a fund's designated
reference portfolio, rather than its designated reference index as
proposed, because the final rule permits a fund to use either a
designated index or its securities portfolio as the fund's reference
portfolio for the relative VaR test, subject to conditions.
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Regular Board Reporting
The rule requires a fund's derivatives risk manager to provide to
the fund's board, at a frequency determined by the board, written
reports analyzing exceedances of the fund's risk guidelines and the
results of the fund's stress tests and backtesting.\276\ These reports
must include information reasonably necessary for the board to evaluate
the fund's response to exceedances and the results of the fund's stress
testing. We are adopting this provision with some modification from the
proposal, as discussed below. Requiring the derivatives risk manager to
provide information about how the fund performed relative to these
measures and at a board-determined frequency is designed to provide the
board with timely information to facilitate its oversight of the fund
and the operation of the program.
---------------------------------------------------------------------------
\276\ Rule 18f-4(c)(3)(iii).
---------------------------------------------------------------------------
The Commission received several comments expressing general support
for the proposed requirement that the derivatives risk manager provide
regular reports to the board.\277\ Commenters expressed concerns,
however, regarding both the frequency of board reporting and the detail
required to be included in each report. Specifically, one commenter
stated that the Commission's rules should require only an annual report
and allow the board and the derivatives risk manager to determine the
content and format of the report.\278\
---------------------------------------------------------------------------
\277\ See e.g. J.P. Morgan Comment Letter; ICI Comment Letter;
Invesco Comment Letter; MFDF Comment Letter.
\278\ ICI Comment Letter.
---------------------------------------------------------------------------
We are adopting as proposed the requirement that the derivatives
risk manager provide reports to the board at a frequency determined by
the board. This aspect of the rule will provide the board with
discretion in setting the frequency of reporting. We believe it is
important that the board determines for itself how frequently it will
receive these reports. This flexibility will permit boards to tailor
their oversight to funds' particular facts and circumstances. We also
understand that many fund advisers today provide regular reports to
fund boards, often in connection with quarterly board meetings,
regarding a fund's use of derivatives and their effects on a fund's
portfolio, among other information.
Commenters expressed concern regarding the amount of detail that
should be included in board reports, with many requesting clarification
that the regular board reporting include summaries of guidelines
exceedances, stress testing, and backtesting (as opposed to a greater
degree of detail). For example, one commenter noted that receiving the
results of stress testing and backtesting in summary form are
``critical for the operation of the rule.'' \279\ Several commenters
suggested the board reports provide executive summaries.\280\
Commenters stated that executive summaries would ensure that boards are
not overly inundated with details and technical determinations.\281\
Some commenters specifically supported a rule that does not require
every stress testing or backtesting exceedance be reported to the
board, preferring the use of summaries instead.\282\
---------------------------------------------------------------------------
\279\ MFDF Comment Letter.
\280\ Dechert Comment Letter I; T. Rowe Price Comment Letter;
ICI Comment Letter; IDC Comment Letter; Capital Group Comment
Letter.
\281\ See, e.g., ICI Comment Letter.
\282\ J.P. Morgan Comment Letter; T. Rowe Price Comment Letter;
ICI Comment Letter; IDC Comment Letter; Capital Group Comment
Letter; Dechert Comment Letter I.
---------------------------------------------------------------------------
In a change from the proposal, and to clarify the scope of this
reporting obligation in the rule in response to commenters' concerns,
the rule we are adopting does not specify the board must receive a
report of ``any'' exceedances of the risk guidelines.\283\ This change
is designed to clarify that the derivatives risk manager need not
report every single exceedance to the board. Instead, the reports to
the board must include an analysis of exceedances that occurred during
the period covered by the report, as well as stress testing and
backtesting conducted during the period. The written report reflecting
this analysis could be in summary form, rather than an itemization of
each exceedance, stress test, or backtest exception. As the Commission
stated in the Proposing Release, and as clarified by our changes in the
final rule, a simple listing of exceedances and stress testing and
backtesting results without context, in contrast to an analysis of
these matters, would provide less useful information for a fund's board
and would not satisfy the requirement that the reports include such
information as may be reasonably necessary for the board of directors
to evaluate the fund's response to exceedances and the results of the
fund's stress testing.
---------------------------------------------------------------------------
\283\ See rule 18f-4(c)(3)(iii); see also proposed rule 18f-
4(c)(5)(iii).
---------------------------------------------------------------------------
D. Limit on Fund Leverage Risk
Consistent with the proposal, the final rule will generally require
funds relying on the rule when engaging in derivatives transactions to
comply with a VaR-based limit on fund leverage risk.\284\ This outer
limit is based on a relative VaR test that compares the fund's VaR to
the VaR of a ``designated reference portfolio.'' A fund can use an
index that meets certain requirements or its own investments, excluding
derivatives transactions, as its designated reference portfolio. If the
fund's derivatives risk manager reasonably determines that a designated
reference portfolio would not provide an appropriate reference
portfolio for purposes of the relative VaR test, the fund will be
required to comply with an absolute VaR test.\285\ A fund will satisfy
the relative VaR test if its portfolio VaR does not exceed 200% of the
VaR of its designated reference portfolio and will satisfy the absolute
VaR test if its portfolio VaR does not exceed 20% of the value of the
fund's net assets. The final rule also provides relative and absolute
VaR limits of 250% and 25%, respectively, for closed-end funds that
have issued to investors and have outstanding shares of a senior
security that is a stock.\286\ We discuss each aspect of the limit on
fund leverage risk below.
---------------------------------------------------------------------------
\284\ See rule 18f-4(c)(2); see also proposed rule 18f-4(c)(2).
\285\ The final rule provides an exception from the rule's VaR
test for limited derivatives users. See infra section II.E. In a
change from the proposal, the final rule does not provide an
exception for funds that met the proposed sales practices rule's
definition of a leveraged/inverse investment vehicle. See infra
section II.F.
\286\ In this release, we refer to shares of a class of senior
security that is a stock as ``preferred stock.''
---------------------------------------------------------------------------
1. Use of VaR
VaR is an estimate of an instrument's or portfolio's potential
losses over a given time horizon and at a specified confidence level.
VaR will not provide, and is not intended to provide, an estimate of an
instrument's or portfolio's maximum loss amount. For example, if a
fund's VaR calculated at a 99% confidence level was $100, this means
[[Page 83188]]
the fund's VaR model estimates that, 99% of the time, the fund would
not be expected to lose more than $100. However, 1% of the time, the
fund would be expected to lose more than $100, and VaR does not
estimate the extent of this loss.
Many commenters expressed support for the use of VaR as the rule's
means of providing an outside limit on fund leverage risk.\287\
Commenters identified benefits of using VaR in the rule, including many
of the benefits the Commission identified in the Proposing
Release.\288\ For example, commenters observed that VaR enables risk to
be measured in a reasonably comparable and consistent manner across
diverse types of instruments and provides an adequate overall
indication of market risk.\289\ One commenter highlighted VaR as an
analytic metric with broad utilization across the financial services
sector.\290\ Others stated more generally that VaR is time tested and a
familiar risk-analytics tool.\291\
---------------------------------------------------------------------------
\287\ See, e.g., ICI Comment Letter; BlackRock Comment Letter;
Fidelity Comment Letter; Comment Letter of Franklin Resources, Inc.
(Apr. 23, 2020) (``Franklin Comment Letter''); J.P. Morgan Comment
Letter; SIFMA AMG Comment Letter; Comment Letter of the Managed
Funds Association and Alternative Investment Management Association
(Apr. 30, 2020) (``MFA Comment Letter''); Comment Letter of Eaton
Vance Corp. (May 1, 2020) (``Eaton Vance Comment Letter''); Putnam
Comment Letter; Vanguard Comment Letter.
\288\ See Proposing Release, supra footnote 1, at section II.D.1
for a discussion of the benefits of VaR in the context of proposed
rule 18f-4.
\289\ See, e.g., ICI Comment Letter; BlackRock Comment Letter;
J.P. Morgan Comment Letter.
\290\ See Franklin Comment Letter.
\291\ See Franklin Comment Letter; Vanguard Comment Letter;
Chamber Comment Letter. As the Commission observed in the Proposing
Release, VaR calculation tools are widely available, and many
advisers that enter into derivatives transactions--and particularly
those that would not qualify as limited derivatives users--already
use risk management or portfolio management platforms that include
VaR capability. See Proposing Release, supra footnote 1, at nn.180-
181 and accompanying text.
---------------------------------------------------------------------------
The Commission recognized in the Proposing Release that VaR is not
itself a leverage measure.\292\ But a VaR test, and especially one that
compares a fund's VaR to an unleveraged reference portfolio that
reflects the markets or asset classes in which the fund invests, can be
used to analyze whether a fund is using derivatives transactions to
leverage the fund's portfolio, magnifying its potential for losses and
significant payment obligations of fund assets to derivatives
counterparties. At the same time, VaR tests can also be used to analyze
whether a fund is using derivatives with effects other than leveraging
the fund's portfolio that may be less likely to raise the concerns
underlying section 18. For example, fixed-income funds use a range of
derivatives instruments, including credit default swaps, interest rate
swaps, swaptions, futures, and currency forwards. These funds often use
these derivatives in part to seek to mitigate the risks associated with
a fund's bond investments or to achieve particular risk targets, such
as a specified duration. If a fund were using derivatives extensively,
but had either a low VaR or a VaR that did not substantially exceed the
VaR of an appropriate benchmark, this would indicate that the fund's
derivatives were not substantially leveraging the fund's portfolio. One
commenter similarly stated that VaR provides helpful information on
whether a fund is using derivatives transactions to leverage its
portfolio and can be used to analyze whether a fund is using
derivatives for other purposes, like hedging its portfolio
investments.\293\
---------------------------------------------------------------------------
\292\ See Proposing Release, supra footnote 1, at section
II.D.1.
\293\ See ICI Comment Letter.
---------------------------------------------------------------------------
While we believe there are significant benefits to using a VaR-
based limit on fund leverage risk, we recognize, and the Commission
discussed in the Proposing Release, risk literature critiques of VaR
(especially since the 2007-2009 financial crisis).\294\ Commenters
highlighted concerns with one common critique of VaR: That it does not
reflect the size of losses that may occur on the trading days during
which the greatest losses occur--sometimes referred to as ``tail
risks.'' \295\ A related critique is that VaR calculations may
underestimate the risk of loss under stressed market conditions.\296\
These critiques often arise in the context of discussing risk managers'
use of additional risk tools to address VaR's shortcomings.
---------------------------------------------------------------------------
\294\ See Proposing Release, supra footnote 1, at nn.182-187 and
accompanying paragraph; Chris Downing, Ananth Madhavan, Alex Ulitsky
& Ajit Singh, Portfolio Construction and Tail Risk, 42 The Journal
of Portfolio Management 1, 85-102 (Fall 2015), available at https://jpm.iijournals.com/content/42/1/85 (``for especially fat-tailed
return distributions the VaR threshold value might appear to be low,
but the actual amount of value at risk is high because VaR does not
measure the mass of distribution beyond the threshold value'').
\295\ See, e.g., Better Markets Comment Letter; CFA Comment
Letter; Proposing Release, supra footnote 1, at n.182 and
accompanying text.
With respect to VaR, the ``tail'' refers to the observations in
a probability distribution curve that are outside the specified
confidence level. ``Tail risk'' describes the concern that losses
outside the confidence level may be extreme.
\296\ See Proposing Release, supra footnote 1, at n.183 and
accompanying text.
---------------------------------------------------------------------------
We continue to believe that tests based on VaR are appropriate
means to limit fund leverage risk as part of rule 18f-4. As the
Commission explained in the Proposing Release, the VaR tests in rule
18f-4 are designed to provide a metric that can help assess the extent
to which a fund's derivatives transactions raise concerns underlying
section 18, but we do not believe they should be the sole component of
a derivatives risk management program.\297\ We do not intend to
encourage risk managers to over-rely on VaR as a stand-alone risk
management tool.\298\ Instead, the final rule requires a fund to
establish risk guidelines and to stress test its portfolio as part of
its derivatives risk management program in part because of concerns
that VaR as a risk management tool may not adequately reflect tail
risks. A fund that adopts a derivatives risk management program under
the rule also will have to consider other risks that VaR does not
capture (such as counterparty risk and liquidity risk) as part of its
derivatives risk management program.\299\ We believe that the final
rule's derivatives risk management program provides an effective
complement to the VaR tests and, in particular, that the stress testing
component of the program will require funds to evaluate the ``tail
risks'' that VaR by its nature does not capture. A fund's compliance
with its VaR test would satisfy the final rule's outside limit on fund
leverage risk but is not a substitute for an effective derivatives risk
management program. A fund's derivatives risk management program is
designed to complement the applicable VaR test as well as the fund's
other risk management activities, such as compliance with rule 22e-4
for funds subject to that rule.
---------------------------------------------------------------------------
\297\ See supra section II.B.2.
\298\ See, e.g., James O'Brien & Pawel J. Szerszen, An
Evaluation of Bank VaR Measures for Market Risk During and Before
the Financial Crisis, Federal Reserve Board Staff Working Paper
2014-21 (Mar. 7, 2014), available at https://www.federalreserve.gov/pubs/feds/2014/201421/201421pap.pdf (``Criticism of banks' VaR
measures became vociferous during the financial crisis as the banks'
risk measures appeared to give little forewarning of the loss
potential and the high frequency and level of realized losses during
the crisis period.''); see also Pablo Triana, VaR: The Number That
Killed Us, Futures Magazine (Dec. 1, 2010), available at http://www.futuresmag.com/2010/11/30/var-number-killed-us (stating that
``in mid-2007, the VaR of the big Wall Street firms was relatively
quite low, reflecting the fact that the immediate past had been
dominated by uninterrupted good times and negligible volatility'').
\299\ One commenter similarly stated that the VaR tests will be
particularly beneficial when used in conjunction with elements of
the derivatives risk management program, including stress testing,
backtesting, and risk guidelines. See BlackRock Comment Letter.
---------------------------------------------------------------------------
We also recognize that there are circumstances where VaR tests may
potentially under- or overstate a
[[Page 83189]]
particular fund's leverage risk, which may be particularly restrictive
for certain funds in idiosyncratic circumstances.\300\ A fund that
believes an alternative means of estimating and limiting its leverage
risk would be more effective in accomplishing the Commission's stated
goals in adopting the final rule given these idiosyncratic
circumstances, including addressing the concerns underlying section 18,
may raise such issues via the exemptive application process. The
exemptive application process would allow the Commission to consider,
for example, the details of the fund's derivatives risk management
program; the particular circumstances under which the fund believes the
final rule's VaR tests may under- or overstate the fund's leverage
risk; and alternate means of appropriately limiting that leverage risk
under such circumstances.
---------------------------------------------------------------------------
\300\ See, e.g., Gary Strumeyer, The Capital Markets: Evolution
of the Financial Ecosystem (2017), at 100.
---------------------------------------------------------------------------
Several commenters suggested alternatives to the proposed VaR test
in light of the fact that VaR does not measure ``tail'' risks. One
commenter stated that using VaR as the means of limiting fund leverage
risk may create incentives for fund managers to take excessive risks by
engaging in derivatives strategies that are ``extremely risky under
certain conditions but [the conditions are] highly unlikely to occur.''
\301\ A few commenters suggested requiring funds to measure expected
shortfall or stressed VaR, in addition to complying with the applicable
proposed VaR-based tests, to address this incentive.\302\ Although we
are not adopting a requirement that funds use stressed VaR or expected
shortfall, funds may incorporate these methodologies into their
derivatives risk management programs. Stressed VaR refers to a VaR
model that is calibrated to a period of market stress. A stressed VaR
approach would address some of the VaR test critiques related to tail
risk and underestimating expected losses during stressed conditions.
Calibrating VaR to a period of market stress, however, can pose
quantitative challenges by requiring funds to identify a stress period
with a full set of risk factors for which historical data is available.
We believe that the stress testing required as part of a fund's
derivatives risk management program provides an effective means to
analyze stressed market conditions without raising the quantitative
challenges that would apply if the final rule were to require VaR tests
that incorporate stressed VaR calculations that the fund conducts each
trading day.
---------------------------------------------------------------------------
\301\ See CFA Comment Letter.
\302\ See Better Markets Comment Letter; CFA Comment Letter; see
also infra paragraphs between text accompanying footnotes 300 and
303 (discussing expected shortfall and stressed VaR).
---------------------------------------------------------------------------
Expected shortfall analysis is similar to VaR, but accounts for
tail risk by taking the average of the potential losses beyond the
specified confidence level. For example, if a fund's VaR at a 99%
confidence level is $100, the fund's expected shortfall would be the
average of the potential losses in the 1% ``tail,'' which are the
losses that exceed $100. Because there are fewer observations in the
tail, however, there is an inherent difficulty in estimating the
distribution of larger losses. As a result, expected shortfall analysis
generally is more sensitive to extreme outlier losses than VaR
calculations because expected shortfall is based on an average of a
small number of observations that are in the tail. This heightened
sensitivity could be disruptive to a fund's portfolio management in the
context of the final rule because it could result in large changes in a
fund's expected shortfall as outlier losses enter and exit the
observations that are in the tail or that are used to model the tail's
distribution. For all of these reasons, we are adopting an outside
limit on fund leverage risk using VaR, which is commonly used and does
not present the same quantitative challenges associated with stressed
VaR and expected shortfall, complemented by elements in the final
rule's derivatives risk management program requirement designed to
address VaR's limitations.
In addition to concerns about tail risks, one commenter expressed
support for limiting fund leverage risk by adopting an exposure-based
limit that tracks the approach proposed by the Commission in 2015.\303\
This approach would limit the amount of a fund's derivatives use based
on the derivatives' gross notional amounts. A limitation based on gross
notional amounts would not differentiate between derivatives
transactions that have the same notional amount, but whose underlying
reference assets differ and entail potentially very different risks. A
fund could have a high amount of gross notional exposure without a
commensurately high level of risk. Many commenters opposed using a
fund's gross notional amounts as a means of providing an outside limit
on fund leverage risk.\304\
---------------------------------------------------------------------------
\303\ See CFA Comment Letter; see also 2015 Proposing Release,
supra footnote 1.
\304\ See, e.g., ICI Comment Letter; Invesco Comment Letter; T.
Rowe Price Comment Letter; Capital Group Comment Letter; AQR Comment
Letter I.
---------------------------------------------------------------------------
After considering comments, we continue to believe that a VaR-based
approach is a better means of limiting fund leverage risk because,
unlike notional amounts which do not measure risk or leverage, VaR
enables risk to be measured in a reasonably comparable and consistent
manner, as well as other benefits highlighted by the Commission and
many commenters discussed above. We believe that the risk-based
approach in the final rule, which relies on VaR, stress testing, and
overall risk management, effectively will address concerns about fund
leverage risk underlying section 18, while also allowing funds to
continue to use derivatives for a variety of purposes. We recognize
that an exposure-based approach can be useful, and that it can be a
more straightforward calculation. The final rule includes such an
approach as means of identifying limited derivatives users as discussed
in section II.E below.
In addition and as proposed, we are not adopting a general asset
segregation requirement to complement the rule's VaR-based limit on
fund leverage risk.\305\ The Commission and staff have historically
taken the position that a fund may appropriately manage risks that
section 18 is designed to address if the fund ``covers'' its
obligations in connection with various transactions by maintaining
``segregated accounts.'' \306\ Two commenters suggested that we add an
asset segregation requirement to the final rule as a means of
providing: (1) An additional limit on fund leverage risk with respect
to a fund's use of derivatives transactions; and (2) a specific
requirement that funds have adequate assets to cover derivatives-
related obligations.\307\ Many commenters, however, did not support an
additional asset segregation requirement, and several of these
commenters stated that an asset segregation regime may not be an
effective means of addressing undue speculation concerns.\308\ For
example, one commenter stated that, under the current asset segregation
approach, a fund may obtain ``a significant degree of
[[Page 83190]]
leverage.'' \309\ Another commenter stated that disparate asset
segregation practices may create potential adverse results and would
not require funds to ``holistically assess and manage the several risks
associated with derivatives transactions, including market and
counterparty risks.'' \310\ One commenter stated that rather than an
asset segregation requirement, a formalized risk management program is
``foundational to any effective regulation'' and ``the key to curbing
excessive borrowing and undue speculation.'' \311\
---------------------------------------------------------------------------
\305\ See infra sections II.H, II.I (discussing specific asset
segregation comments received relating to reverse repurchase
agreements and unfunded commitment agreements).
\306\ See supra section I.B.2; see also Proposing Release, supra
footnote 1, at section II.F. The Commission included an asset
segregation requirement in the 2015 proposal. See 2015 Proposing
Release, supra footnote 1, at section III.C.
\307\ See Better Markets Comment Letter; CFA Comment Letter.
\308\ See, e.g., AQR Comment Letter I; J.P. Morgan Comment
Letter; Invesco Comment Letter; PIMCO Comment Letter.
\309\ See J.P. Morgan Comment Letter.
\310\ See Invesco Comment Letter; see also PIMCO Comment Letter.
The Commission similarly observed in the Proposing Release that
funds' disparate practices under the current approach could create
an un-level competitive landscape and make it difficult for funds
and Commission staff to evaluate funds' compliance with section 18.
See Proposing Release, supra footnote 1, at section I.B.3. We
continue to make these observations in this release. See supra
footnote 7 and accompanying text.
\311\ See AQR Comment Letter I.
---------------------------------------------------------------------------
After considering comments, we continue to believe that a general
asset segregation requirement is not necessary in light of the final
rule's requirements, including the requirements that funds must
establish derivatives risk management programs and comply with the VaR-
based limit on fund leverage risk. A fund relying on rule 18f-4 will be
required to adopt and implement a written derivatives risk management
program that, among other things, will require the fund to: Identify
and assess its derivatives risks; put in place guidelines to manage
these risks; stress test the fund's portfolio at least weekly; and
escalate material risks to the fund's portfolio managers and, as
appropriate, the board of directors.\312\ These requirements are
designed to require a fund to manage all of the risks associated with
its derivatives transactions, including the risk that a fund may be
required to sell its investments to generate cash to pay derivatives
counterparties. Moreover, a fund's stress testing must specifically
take into account the fund's payments to derivatives counterparties,
and the rule's VaR-based limit on leverage risk is designed to limit a
fund's leverage risk and therefore the potential for payments to
derivatives counterparties.
---------------------------------------------------------------------------
\312\ Rule 18f-4(c)(1). Funds that rely on the limited
derivatives user exception similarly would be required to manage the
risks associated with their more limited use of derivatives. See
infra section II.E.
---------------------------------------------------------------------------
2. Relative VaR Test
The relative VaR test will require a fund to calculate the VaR of
the fund's portfolio and compare it to the VaR of a ``designated
reference portfolio.'' \313\ We are adopting the relative VaR test as
proposed with certain modifications discussed below, including the
modification to permit a fund to use as its reference portfolio for the
VaR test either an index that meets certain requirements (a
``designated index'') or the fund's own investments, excluding
derivatives transactions (the fund's ``securities portfolio'').\314\ A
fund's designated reference portfolio is designed to create a baseline
VaR that functions as the VaR of a fund's unleveraged portfolio. To the
extent a fund entered into derivatives to leverage its portfolio, the
relative VaR test is designed to identify this leveraging effect. If a
fund is using derivatives and its VaR exceeds that of the designated
reference portfolio, this difference may be attributable to leverage
risk.
---------------------------------------------------------------------------
\313\ See rule 18f-4(a) (defining the term ``relative VaR
test'').
\314\ See rule 18f 4(a) (defining the term ``relative VaR
test,'' ``designated reference portfolio,'' and ``securities
portfolio'').
---------------------------------------------------------------------------
a. Relative VaR as the Default VaR Test
The final rule, consistent with the proposal, uses the relative VaR
test as the default test. Specifically, the final rule requires a fund
to comply with the relative VaR test unless the fund's derivatives risk
manager reasonably determines that a designated reference portfolio
would not provide an appropriate reference portfolio for purposes of
the relative VaR test, taking into account the fund's investments,
investment objectives, and strategy.\315\ A fund that does not apply
the relative VaR test must comply with the absolute VaR test.\316\
---------------------------------------------------------------------------
\315\ See rule 18f-4(c)(2).
\316\ See id.
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Some commenters recommended that the final rule not provide a
relative VaR test as the default means of limiting fund leverage risk
and instead permit a fund to choose to comply with either the relative
VaR test or the absolute VaR test.\317\ Some of these commenters were
concerned that a relative VaR test default would create ambiguity about
the circumstances under which a fund appropriately could use the
absolute VaR test.\318\ For example, some commenters stated that the
proposal is unclear on what it means for a derivatives risk manager to
be ``unable to identify'' an appropriate designated index, which could
create compliance challenges or differing regulatory determinations for
different funds.\319\ Some commenters similarly were concerned that
this aspect of the proposed rule would raise questions for derivatives
risk managers about their process of searching for potential indexes
(e.g., the extent to which the derivatives risk manager would need to
search for potentially appropriate indexes before determining that the
fund would rely on the absolute VaR test).\320\ Some commenters stated
that either the relative or the absolute VaR tests would protect
investors.\321\ Other commenters did not object to the proposed rule's
relative VaR test default but urged that the Commission provide
additional clarity regarding the kinds of funds that appropriately
would rely on the absolute VaR test under the rule.\322\ For example,
commenters identified various fund strategies for which they believed
the absolute VaR test should be appropriate under the final rule,
including market-neutral funds, multi-alternative funds/non-correlated
strategy funds, long-short funds, managed futures funds, and funds that
invest in unique asset classes that may not have a broad-based
index.\323\
---------------------------------------------------------------------------
\317\ See, e.g., AQR Comment Letter I; MFA Comment Letter;
BlackRock Comment Letter; Vanguard Comment Letter.
\318\ See, e.g., AQR Comment Letter I; NYC Bar Comment Letter;
PIMCO Comment Letter.
\319\ See, e.g., Putnam Comment Letter; PIMCO Comment Letter;
Dechert Comment Letter I.
As discussed in section II.D.2.b.i below, we are renaming the
proposed term ``designated reference index'' as ``designated index''
in the final rule. For consistency with the final rule, we discuss
comments received about the designated reference index as comments
about the designated index.
\320\ See Dechert Comment Letter I; ICI Comment Letter; NYC Bar
Comment Letter.
\321\ See Dechert Comment Letter I; PIMCO Comment Letter.
\322\ See, e.g., ICI Comment Letter; J.P. Morgan Comment Letter.
\323\ See, e.g., ICI Comment Letter; J.P. Morgan Comment Letter;
Invesco Comment Letter.
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After considering comments, we are adopting a relative VaR test as
the default means of limiting fund leverage risk because we believe it
resembles the way that section 18 limits a fund's leverage risk. Some
commenters disagreed with this assertion in the Proposing Release
because, for example, VaR measures risk--including non-leverage-related
variables--while section 18 limits the amount of a fund's
borrowings.\324\ We recognize that a relative VaR test differs from the
asset coverage requirements in section 18. Section 18, however, limits
the extent to which a fund can potentially increase its market exposure
through leveraging by issuing senior securities, but it does not
directly limit a fund's level of risk or volatility. For example, a
fund that invests in less-volatile securities and borrows the maximum
amount permitted by section 18 and uses the
[[Page 83191]]
borrowings to leverage the fund's portfolio may not be as volatile as a
completely unleveraged fund that invests in more-volatile securities.
In other words, section 18, like the relative VaR test, limits a fund's
potential leverage on a relative rather than absolute basis. We
designed the relative VaR test likewise to limit the extent to which a
fund increases its market risk by leveraging its portfolio through
derivatives, while not restricting a fund's ability to use derivatives
for other purposes. For example, if a derivatives transaction reduces
(or does not substantially increase) a fund's VaR relative to the VaR
of the designated reference portfolio, the transaction would not be
restricted by the relative VaR test.
---------------------------------------------------------------------------
\324\ See, e.g., Dechert Comment Letter I; PIMCO Comment Letter;
MFA Comment Letter.
---------------------------------------------------------------------------
We believe that allowing a fund to use the absolute VaR test may be
inconsistent with investors' expectations where there is an appropriate
reference portfolio for purposes of the relative VaR test. For example,
a fund that invests in short-term fixed-income securities would have a
relatively low level of volatility. The fund's investors could
reasonably expect that the fund might exhibit a degree of volatility
that is broadly consistent with the volatility of the markets or asset
classes in which the fund invests, as represented by the fund's
designated reference portfolio. This fund's designated reference
portfolio would be composed of short-term fixed income securities, and
could, for example, have a VaR of 4%. If the fund were permitted to
rely on the absolute VaR test, however, the fund could substantially
leverage its portfolio five times its designated reference portfolio's
VaR to achieve a level of volatility that substantially exceeds the
volatility associated with short-term fixed income securities. Although
commenters urged that a fund could address investor expectation
concerns regarding a fund's leverage risk through disclosure,\325\
section 18 limits a fund's ability to obtain leverage through the
issuance of senior securities and operates independently of a fund's
disclosure. Investors therefore may reasonably expect that a fund will
not be highly leveraged. The fixed-income fund in this example, in
contrast, would be highly leveraged and the fund's disclosing that risk
would not address the leverage risks that section 18 addresses or that
the VaR test is designed to limit.
---------------------------------------------------------------------------
\325\ See, e.g., Dechert Comment Letter I; PIMCO Comment Letter.
---------------------------------------------------------------------------
We recognize, however, that the proposed rule's reference to a
derivatives risk manager being unable ``to identify'' a designated
index that is appropriate for the fund raised questions about the
diligence a derivatives risk manager was expected to undertake in
considering potential indexes.\326\ As noted above, the final rule
requires a fund to comply with the relative VaR test unless the fund's
derivatives risk manager reasonably determines that a designated
reference portfolio would not provide an appropriate reference
portfolio for purposes of the relative VaR test, taking into account
the fund's investments, investment objectives, and strategy. This
modification from the proposal is designed to make clear that this
provision involves a derivatives risk manager's determination after
reasonable inquiry and analysis regarding the feasibility of applying a
relative VaR test to a fund and the appropriate reference portfolio for
that purpose. We believe the final rule provides greater clarity on
this point than the proposed rule's reference to an index that is
``appropriate'' for the fund.
---------------------------------------------------------------------------
\326\ See, e.g., Dechert Comment Letter I; ICI Comment Letter;
SIFMA AMG Comment Letter; T. Rowe Price Comment Letter.
---------------------------------------------------------------------------
We believe that the modification also should address the concern
expressed by a commenter that the proposed provision could have created
confusion concerning ``whether a derivatives risk manager must in all
cases undertake an analysis of how a designated index might work for a
fund even where that derivatives risk manager clearly knows that
absolute VaR is the most appropriate test.'' \327\ For example, some
funds may make frequent changes to how they allocate their assets
across a varying set of markets and asset classes, where a different,
appropriate unleveraged index might be available for each allocation
but the appropriate unleveraged index would change frequently.
Switching the fund's designated index frequently could be impractical
and support a determination that a designated index would not provide
an appropriate reference portfolio for purposes of the relative VaR
test. Whether the fund's securities portfolio would provide an
appropriate reference portfolio would depend on the facts and
circumstances and could change from time to time. For example, a fund
obtaining its investment exposure through both cash-market investments
and derivatives transactions may find that, by excluding its derivative
transactions, the fund's securities portfolio does not reflect the
overall markets or asset classes in which the fund invests both
directly and indirectly through derivatives transactions. The fund is
subject to the absolute VaR test if the fund's derivatives risk manager
reasonably determines that neither a designated index nor the fund's
securities portfolio would provide an appropriate reference portfolio
for purposes of the relative VaR test, taking into account the fund's
investments, investment objectives, and strategy.
---------------------------------------------------------------------------
\327\ See AQR Comment Letter I.
---------------------------------------------------------------------------
As another example, the derivatives risk manager for a long/short
or market neutral fund may determine that, although an index is
available that reflects the markets or asset classes in which the fund
invests, the funds' strategies do not involve the kind of risk that is
associated with the market risk of the index, and the index therefore
does not provide an appropriate reference portfolio for purposes of the
relative VaR test. As in the prior example, the fund's securities
portfolio may not reflect the overall markets or asset classes in which
the fund invests or involve the kind of market risk associated with the
fund's strategy. The fund, for example, may obtain its long exposure
through cash-market investments in securities and its short exposure
through derivatives transactions.\328\ A final example, which the
Commission discussed in the proposal, is that some multi-strategy funds
manage their portfolios based on target volatilities but implement a
variety of investment strategies, making it difficult to identify a
single index (even a blended index) that would be appropriate.\329\ The
fund's securities portfolio also may not reflect the markets or asset
classes in which the fund invests if, for example, the fund pursues
certain strategies through investments in derivatives transactions and
others through cash-market investments in securities. As some
commenters noted, a variety of factors may bear on whether a designated
reference portfolio would be appropriate for purposes of the relative
VaR test, including a fund's investment strategy.\330\
---------------------------------------------------------------------------
\328\ The fund in this example also could obtain both its long
and short exposure through derivatives transactions, with its
securities portfolio consisting primarily of cash and cash
equivalents. As we observed in the Proposing Release, this would not
provide an appropriate comparison for a relative VaR test because
the VaR of the cash and cash equivalents would be very low and would
not provide a reference level of risk associated with the fund's
strategy.
\329\ See Proposing Release, supra footnote 1, at section
II.D.3.
\330\ See, e.g., J.P. Morgan Comment Letter (including factors
such as ``fund composition by security selection, asset class,
region, duration or market capitalization, consistency of investment
approach over time, internal or disclosed constraints, and ability
to materially deviate from its primary investment strategy'');
Putnam Comment Letter (including factors such as ``differences in
constituents and risk profiles'' between the fund's portfolio and
benchmark indexes).
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[[Page 83192]]
b. Designated Reference Portfolio
The final rule's relative VaR test compares the fund's VaR to the
VaR of a designated reference portfolio. Under the rule, a designated
reference portfolio is either a designated index or the fund's
securities portfolio, which we discuss in turn below.
i. Designated Index
We are adopting the definition of a ``designated index'' with
certain modifications from the proposed definition of a ``designated
reference index'' discussed below. We are renaming the proposed
definition to ``designated index'' to differentiate it more clearly
from the final rule's definition of a ``designated reference
portfolio.'' The final rule will define a ``designated index'' as an
unleveraged index that is approved by the derivatives risk manager for
purposes of the relative VaR test, and that reflects the markets or
asset classes in which the fund invests.\331\ The definition also will
require that the designated index not be an index that is administered
by an organization that is an affiliated person of the fund, its
investment adviser, or principal underwriter, or created at the request
of the fund or its investment adviser, unless the index is widely
recognized and used (a ``prohibited index'').\332\ In a change from the
proposal, the designated index is not required to be an ``appropriate
broad-based securities market index'' or an ``additional index'' as
defined in Item 27 of Form N-1A or Item 24 of Form N-2.\333\ We are
making this change in light of the fact that the final rule will not
require a fund to disclose its designated index in the annual report,
together with a presentation of the fund's performance relative to the
designated index.\334\ We discuss each of the elements of the final
definition of the term ``designated index'' below.
---------------------------------------------------------------------------
\331\ See rule 18f-4(a) (defining the term ``designated
index''). Under the final rule, a designated index is an index
``approved,'' rather than ``selected,'' by the derivatives risk
manager as proposed. As one commenter observed in recommending this
modification, advisory personnel may recommend an index to the
derivatives risk manager based on their market expertise and
knowledge of the fund's investment strategy and seek the derivatives
risk manager's approval. See J.P. Morgan Comment Letter.
\332\ Furthermore, for a blended index, none of the indexes that
compose the blended index may be administered by an organization
that is an affiliated person of the fund, its investment adviser, or
principal underwriter, or created at the request of the fund or its
investment adviser, unless the index is widely recognized and used.
See rule 18f-4(a).
\333\ See rule 18f-4(a); proposed rule 18f-4(a); see also
Instructions 5 and 6 to Item 27(b)(7)(ii) of Form N-1A (discussing
the terms ``appropriate broad-based securities market index'' and
``additional index''); Instruction 4 to Item 24 of Form N-2
(discussing the terms ``appropriate broad-based securities market
index'' and ``additional index'').
\334\ See rule 18f-4(c)(2)(iv).
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An Unleveraged Index
As proposed, a fund's designated index must be unleveraged. This
requirement is designed to provide an appropriate baseline against
which to measure a fund's portfolio VaR for purposes of assessing the
fund's leverage risk. Conducting a VaR test using a designated index
that itself is leveraged would distort the leverage-limiting purpose of
the VaR comparison by inflating the volatility of the index that serves
as the reference portfolio for the relative VaR test. For example, an
equity fund might select as its designated index an index that tracks a
basket of large-cap U.S. listed equity securities such as the S&P 500.
But the fund could not select an index that is leveraged, such as an
index that tracks 200% of the performance of the S&P 500.
A few commenters requested clarification regarding when an index
would be ``leveraged.'' \335\ These commenters urged that an index
should be considered leveraged if it seeks to provide a multiple of
returns, but not solely because it includes derivatives instruments.
Commenters identified certain commodity indexes and currency-hedged
equity indexes as examples of indexes that commenters believed were
unleveraged, notwithstanding that the indexes included derivatives
instruments.\336\ We agree that whether a particular index is
``leveraged'' would depend on the economic characteristics of the
index's constituents, and not just on whether some or all of the
constituents are derivatives. An index would be leveraged if, for
example, the derivatives included in the index multiply the returns of
the index or index constituents, as suggested by these commenters.
---------------------------------------------------------------------------
\335\ See, e.g., BlackRock Comment Letter; Invesco Comment
Letter; PIMCO Comment Letter.
\336\ See id.
---------------------------------------------------------------------------
Reflects the Markets or Asset Classes in Which the Fund Invests
As the Commission discussed in the proposal, the requirement that
the designated index reflect the markets or asset classes in which the
fund invests is designed to provide an appropriate baseline for the
relative VaR test.\337\ A few commenters raised concerns about
scenarios in which a fund may invest in markets and asset classes that
are reflected in an index, but the index would not provide an
appropriate point of comparison for a relative VaR test because it did
not reflect the fund's investment strategy.\338\ These commenters
therefore suggested that the Commission revise the definition to
reference the fund's investment strategy, either in lieu of or in
addition to the markets or asset classes in which the fund invests.
---------------------------------------------------------------------------
\337\ See Proposing Release, supra footnote 1, at section
II.D.2.
\338\ See Franklin Comment Letter; Dechert Comment Letter I; ICI
Comment Letter; Invesco Comment Letter.
---------------------------------------------------------------------------
We have not made this suggested modification because we believe
that the concerns raised by commenters are addressed by the
modifications discussed above concerning the derivatives risk manager's
reasonable determination that a designated index would not provide an
appropriate reference portfolio for purposes of the relative VaR test,
which includes taking into account the fund's investment strategy. As
discussed above in the context of an example involving a long/short or
market neutral fund, a fund's derivatives risk manager may determine
that, although an index is available that reflects the markets or asset
classes in which the fund invests, the funds' strategies do not involve
the kind of risk that is associated with the market risk of the index,
and the index therefore does not provide an appropriate reference
portfolio for purposes of the relative VaR test. We believe this
modification clarifies that a fund's investment strategy is relevant
even if an index reflects the markets or asset classes in which the
fund invests.
Prohibited Indexes
We are adopting, as proposed, the requirement that a fund's
designated index is not a prohibited index. Accordingly, unless it is
widely recognized and used, the designated index must not be an index
administered by an organization that is an affiliated person of the
fund, its investment adviser, or its principal underwriter, or created
at the request of the fund or its investment adviser.\339\
[[Page 83193]]
This provision is designed to prevent an actively managed fund from
using an index for the purpose of obtaining additional fund leverage
risk. In a change from the proposal discussed further below,
notwithstanding this requirement, a fund with the investment objective
to track the performance (including a leveraged multiple or inverse
multiple) of an unleveraged index must use the unleveraged index it is
tracking as its designated reference portfolio.\340\
---------------------------------------------------------------------------
\339\ See rule 18f-4(a); see also proposed rule 18f-4(a). This
``widely recognized and used'' standard has historically been used
to permit a fund to employ affiliated-administered indexes for
disclosure purposes, when the use of such indexes otherwise would
not be permitted. See Instructions 5 and 6 to Item 27(b)(7)(ii) of
Form N-1A and Instruction 4 to Item 24 of Form N-2 (discussing the
terms ``appropriate broad-based securities market index'' and
``additional index'').
\340\ In this release we refer to funds that do not have the
investment objective to track the performance (including a leveraged
multiple or inverse multiple) of an unleveraged index as ``actively
managed.''
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A few commenters suggested that we allow funds to use indexes that
would be prohibited by the proposed provision.\341\ One commenter
suggested that the rule permit an unaffiliated index created at the
request of the fund or its investment adviser to be a designated index
on the basis that the index provider, in its sole discretion,
determines the composition of the index, the rebalance protocols of the
index, the weightings of the securities and other instruments in the
index, and any updates to the methodology.\342\ Similarly, another
commenter stated that the proposed prohibited indexes need not present
a conflict in the management of the index, as index providers develop
and maintain the index methodology independently as their own
intellectual property.\343\ This commenter suggested the final rule
could require the proposed prohibited indexes to comply with principles
developed by the International Organization of Securities Commissions
and that an index administrator could disclose its policies and
procedures with respect to index design and disclose any material
conflicts of interest. Another commenter raised concerns that if
prohibited indexes are excluded under the rule, a fund may be forced to
use a more ``broad-based'' index that does not closely mirror the
fund's investment program.\344\ This in turn could result in the
relative VaR test failing to properly measure the contribution of
derivatives to that fund's overall investment exposure, making the VaR
test inappropriately restrictive or permissive.\345\ On the other hand,
one commenter stated that prohibited indexes do not solve this concern
because of the administrative and cost burdens associated with bespoke
indexes, including index creation, maintenance, and oversight.\346\
---------------------------------------------------------------------------
\341\ See, e.g., BlackRock Comment Letter; Morningstar Comment
Letter; Nuveen Comment Letter.
\342\ See BlackRock Comment Letter.
\343\ See Morningstar Comment Letter.
\344\ See Nuveen Comment Letter.
\345\ Id.
\346\ See Comment Letter of Dechert LLP (July 6, 2020)
(``Dechert Comment Letter III'').
---------------------------------------------------------------------------
The final rule provides flexibility for actively managed funds in
identifying designated indexes. As proposed, it permits a fund to use a
blended index as its designated index, provided that each constituent
index meets the rule's requirements.\347\ This provision is designed to
provide a fund flexibility to blend indexes to create a designated
index that is more closely tailored to the fund's investment program.
Solely for the purpose of complying with the relative VaR test, we
would not view a designated index blended by the fund's investment
adviser as a prohibited index if each of the constituent indexes meets
the rule's requirements for a designated index.\348\ The final rule
also seeks to address potential differences in the composition of a
designated index and a fund's portfolio by raising the level of the
relative VaR test, as discussed in more detail below. The final rule,
with these modifications, is designed to provide funds flexibility in
selecting a designated index, while making it less likely that indexes
permissible under the final rule will be designed with the intent of
permitting a fund to incur additional leverage-related risk.
---------------------------------------------------------------------------
\347\ See rule 18f-4(a); proposed rule 18f-4(a). Under the rule,
the composition of a blended index is limited to indexes and the
rule does not permit a fund to blend one or more indexes and its
securities portfolio.
\348\ A few commenters sought clarification regarding indexes
blended by a fund's adviser. See, e.g., BlackRock Comment Letter;
Fidelity Comment Letter; PIMCO Comment Letter. One commenter also
sought guidance regarding the circumstances under which a fund could
determine to change the composition of a blended index. See PIMCO
Comment Letter. The final rule does not limit a fund's ability to
change its designated index, including a blended index. Any
designated index used by a fund, however, is subject to the
requirements in the final rule and related reporting requirements.
For example, the derivatives risk manager as part of its periodic
review of the program will evaluate the appropriateness of the
designated index, and if the derivatives risk manager approves a
different designated index, it must report the basis for the change
and approval of the new designated index in its written report to
the board.
---------------------------------------------------------------------------
For all of these reasons, we are not modifying the proposed rule to
permit funds to use the prohibited indexes suggested by some
commenters. Although commenters suggested additional restrictions
discussed above to attempt to address concerns regarding the potential
for funds to obtain additional fund leverage risk inconsistent with the
rule, we believe that the final rule provides sufficient flexibility
for funds to identify appropriate designated indexes without
introducing the ``gaming'' and oversight concerns associated with
prohibited indexes.\349\
---------------------------------------------------------------------------
\349\ One of the commenters suggesting additional restrictions
raised the concern that not allowing funds to use a prohibited index
unless it is widely recognized and used ``could entrench incumbents,
further concentrating monopoly power in the index business, and
prevent funds from finding an appropriate derivatives reference
index.'' Morningstar Comment Letter. This requirement is not
intended to favor incumbents and the ``widely recognized'' qualifier
is derived from current disclosure requirements. See supra footnote
339. The ``widely recognized'' qualifier does not apply to indexes
generally under the final rule. That qualifier only applies if the
index is administered by an organization that is an affiliated
person of the fund, its investment adviser, or principal
underwriter, or created at the request of the fund or its investment
adviser, in light of the potential gaming concerns discussed above.
In addition, as discussed below, an index-tracking fund will use its
index as the fund's designated index, even if that index otherwise
would be a prohibited index.
---------------------------------------------------------------------------
In a change from the proposal, the final rule provides that, if the
fund's investment objective is to track the performance (including a
leverage multiple or inverse multiple) of an unleveraged index, the
fund must use that index as its designated reference portfolio, even if
the index otherwise would be a prohibited index that would not be
permitted under the rule.\350\ Although the limitations on prohibited
indexes generally are designed to address concerns about indexes
created for the purpose of permitting a fund to incur additional
leverage-related risks, these ``gaming'' concerns are not present where
the fund's investment objective is to track an unleveraged index. We
also agree with the commenters who observed that, where a fund tracks
an index, that index will provide the most appropriate reference
portfolio for a relative VaR test, regardless of whether the index
would otherwise be an impermissible prohibited index under the
rule.\351\
---------------------------------------------------------------------------
\350\ See rule 18f-4(a) (defining the term ``designated
reference portfolio''); proposed rule 18f-4(a).
\351\ See, e.g., BlackRock Comment Letter; Dechert Comment
Letter I; ICI Comment Letter.
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Proposed Index Disclosure Requirement in the Fund's Annual Report
In a change from the proposal, the final rule will not require that
a fund publicly disclose the designated index in the fund's annual
report.\352\ The proposed rule would have required an open-end fund and
a registered closed-end fund to disclose the fund's designated index in
the fund's annual report as the fund's ``appropriate broad-based
securities market index'' or an
[[Page 83194]]
``additional index'' in the context of the fund's performance
disclosure.\353\ The proposed rule similarly would have required a BDC
to disclose its designated index in its annual report filed on Form 10-
K. The Commission proposed this requirement to promote the fund's
selection of an appropriate index that reflects the fund's portfolio
risks and its investor expectations.
---------------------------------------------------------------------------
\352\ See rule 18f-4(a); proposed rule 18f-4(a); proposed rule
18f-4(c)(2)(iv).
\353\ See proposed rule 18f-4(c)(2)(iv).
---------------------------------------------------------------------------
After further consideration, we are not adopting this requirement.
Disclosing the fund's designated index in the fund's annual report
could make the annual report disclosure less effective in serving its
primary purpose of showing the investor how his or her fund performed
relative to the market. This would not be consistent with our goal of
promoting concise fund disclosure to highlight key information to
investors, as reflected in the Commission's recent proposal to the
disclosure framework for open-end funds.\354\ In addition, no commenter
suggested that disclosing a fund's designated index would be effective
in promoting the selection of appropriate indexes.\355\ Moreover, to
the extent scrutiny of a fund's performance relative to its designated
index would serve this purpose, a fund's designated index will remain
publicly available on Form N-PORT. Financial professionals, including
research analysts, can still consider and compare a fund's performance
with the performance of its designated index and in that way provide a
secondary ``check'' on funds' designated indexes.
---------------------------------------------------------------------------
\354\ See Tailored Shareholder Reports, Treatment of Annual
Prospectus Updates for Existing Investors, and Improved Fee and Risk
Disclosure for Mutual Funds and Exchange-Traded Funds; Fee
Information in Investment Company Advertisements, Investment Company
Act Release No. 33963 (Aug. 5, 2020). We also are not requiring that
a fund disclose in its annual report certain additional information
related to a fund's adherence to risk metrics, as one commenter
suggested, because we similarly do not believe this information
would be consistent with our goal of promoting concise fund
disclosure to highlight key information to investors. See NASAA
Comment Letter; see also infra section II.G.1.b.
\355\ One commenter supported the proposed disclosure
requirement generally but did not state that it would be effective
in promoting the selection of appropriate indexes. See NASAA Comment
Letter. Several commenters stated that there should not be a
presumption that a fund's performance benchmark will be its
designated index. See, e.g., AQR Comment Letter I; Dechert Comment
Letter I; ICI Comment Letter; Invesco Comment Letter. We agree, and
we believe that the decision not to require a fund to include its
designated index in the context of its performance disclosure helps
to clarify this. However, as discussed above, an index-tracking fund
that tracks an unleveraged index must use that index as its
designated reference portfolio.
---------------------------------------------------------------------------
We also believe that the final rule includes appropriate incentives
to promote the fund's selection of an appropriate index that reflects
the fund's portfolio risks and its investors' expectations. First, the
rule requires the derivatives risk manager to approve the designated
index and to review it periodically. Second, the board of directors
will receive a written report providing the derivatives risk manager's
basis for approving the fund's designated index or a change to that
index. Third, the fund will disclose its designated index to the
Commission on Form N-PORT, which will be publicly available for the
third month of each fund's quarter.
ii. Securities Portfolio
In a change from the proposal, an actively managed fund can use its
securities portfolio as the reference portfolio for the relative VaR
test. A fund's securities portfolio, as defined in the final rule, is
the fund's portfolio of securities and other investments, excluding any
derivatives transactions, subject to certain additional requirements
discussed below. This provision is limited to actively managed funds
because, as discussed above, an index-tracking fund must use the index
it tracks as its designated reference portfolio.
In the Proposing Release the Commission requested comment on
whether to permit funds to compare their VaRs to their ``securities
VaR,'' that is, the VaR of the fund's portfolio of securities and other
investments, but excluding any derivatives transactions.\356\ This is
similar to an approach the Commission proposed in 2015.\357\ In not
proposing this approach in 2019, the Commission stated that it would
not be appropriate for all funds, identifying in particular funds that
invest extensively in derivatives and hold primarily cash and cash
equivalents and derivatives.
---------------------------------------------------------------------------
\356\ See Proposing Release, supra footnote 1, at n.205 and
accompanying discussion.
\357\ See 2015 Proposing Release, supra footnote 1.
---------------------------------------------------------------------------
One commenter urged the Commission to adopt this approach as an
option that funds could use instead of a relative VaR test that
requires a comparison using a designated index.\358\ The commenter
recommended that a fund compute the VaR of its actual portfolio of
securities and other investments, but excluding any derivatives
transactions, consistent with the Commission's request for comment. The
commenter stated that this approach would help to address instances
where the fund's portfolio differed from its designated index, with the
fund's own investments serving as a better representation of the fund's
unleveraged portfolio for purposes of the relative VaR test. Similar to
provisions applicable to the designated index approach, the commenter
recommended a fund's use of its securities portfolio be subject to
formalized procedures. For example, the commenter suggested that a
fund's use of a securities portfolio (or designated index) would be
addressed in the fund's derivatives risk management program, which
requires the derivatives risk manager to periodically review--and
report to the board regarding--a fund's designated reference portfolio.
Other commenters, although not recommending this approach specifically,
identified challenges funds could face where the fund's VaR deviates
from the VaR of the fund's benchmark index due to security selection
rather than leveraging.\359\
---------------------------------------------------------------------------
\358\ See Invesco Comment Letter.
\359\ We discuss these comments in more detail in section
II.D.2.c.i.
---------------------------------------------------------------------------
After considering these comments, we have determined to permit
actively managed funds to use their ``securities portfolio'' for
purposes of the relative VaR test. A fund's securities portfolio will
be the fund's portfolio of securities and other investments, excluding
any derivatives transactions. Excluding the fund's derivatives
transactions is designed to provide an unleveraged reference portfolio,
akin to a designated index, to measure potential leverage risk
introduced by the fund's derivatives transactions. The final rule also
provides that the securities portfolio is approved by the derivatives
risk manager for purposes of the relative VaR test and reflects the
markets or asset classes in which the fund invests (i.e., the markets
or asset classes in which the fund invests directly through securities
and other investments and indirectly through derivatives transactions).
The requirement that the fund's securities portfolio reflects the
markets or asset classes in which the fund invests is designed to
provide an appropriate baseline for the relative VaR test, consistent
with the same requirement applicable to designated indexes.\360\ Absent
this requirement, a fund could, for example, invest in a small number
of highly-volatile securities that are not representative of the fund's
overall investments for the purpose of obtaining a higher amount of
leverage risk. Finally, the final rule includes provisions designed to
promote a fund's appropriate use of the securities portfolio approach
that are analogous to the requirements for funds' use of designated
indexes. These requirements
[[Page 83195]]
include periodic review by the fund's derivatives risk manager and
board reporting.\361\
---------------------------------------------------------------------------
\360\ See supra footnote 337 and accompanying text.
\361\ See rule 18f-4(c)(1)(vi) (requiring periodic review); rule
18f-4(c)(3)(ii) (requiring a written report to the board providing
the basis for the derivatives risk manager's approval); item
B.10.b.i on Form N-PORT (requiring a fund to report on Form N-PORT
that it is using its securities portfolio for purposes of the
relative VaR test).
---------------------------------------------------------------------------
These requirements, taken together, are designed to produce a
reference portfolio that, like a designated index, creates a baseline
VaR that functions as the VaR of a fund's unleveraged portfolio for
purposes of the relative VaR test. Allowing a fund to use its
securities portfolio may allow funds to use a VaR reference portfolio
that is more tailored to the fund's investments than an index, or allow
the fund to avoid the expense associated with blending or licensing an
index just for purposes of the final rule's relative VaR test.
The final rule does not require that a fund ``scale down'' the VaR
of its securities portfolio if the fund also has issued senior security
debt not represented by the fund's derivatives transactions, as a
commenter recommended.\362\ We do not believe this specific adjustment
is necessary in order for a fund's securities portfolio to represent an
unleveraged reference portfolio. This is because the final rule
provides that VaR must be expressed as a percentage of the value of the
relevant portfolio--the scale of the fund's securities portfolio, even
if increased by borrowings, would not change the portfolio's VaR when
expressed as a percentage.\363\ The final rule includes a clarifying
edit to make clear that a fund's VaR is measured as a percentage of the
value of the fund's net assets, whereas the VaR of a fund's securities
portfolio (or designated index) is measured as a percentage of the
value of the portfolio.\364\
---------------------------------------------------------------------------
\362\ See Invesco Comment Letter.
\363\ Take, for example, a fund with $100 to invest that borrows
$50 and invests its then-$150 in total assets in a portfolio that
replicates the S&P 500. If the S&P's VaR is 10%, the fund's
securities portfolio would likewise have a VaR of 10%, regardless of
the size of the portfolio as a result of borrowing, just as if the
fund had used the S&P 500 as its designated index. The fund's own
VaR would be 150% of the S&P 500 VaR because the fund's estimated
losses would be measured relative to the fund's $100 net asset
value, rather than the fund's total assets of $150.
\364\ See rule 18f-4 (a) (defining the term ``value-at-risk or
VaR'').
---------------------------------------------------------------------------
c. 200% and 250% Limits Under Relative VaR Test
Under the final rule a fund's VaR must not exceed 200% of the VaR
of the fund's designated reference portfolio, unless the fund is a
closed-end company that has then-outstanding shares of a preferred
stock issued to investors.\365\ For such closed-end funds, the VaR must
not exceed 250% of the VaR of the fund's designated reference
portfolio. This requirement is modified from the proposal, which would
have limited a fund's VaR, including a closed-end fund's VaR, to 150%
of the VaR of the fund's designated index.\366\
---------------------------------------------------------------------------
\365\ See rule 18f-4(a) (defining the term ``relative VaR
test''). A ``closed-end company'' means any management company other
than an open-end company, and thus includes both registered closed-
end funds and BDCs.
\366\ See proposed rule 18f-4(a).
---------------------------------------------------------------------------
i. 200% Limit
In proposing a 150% relative VaR limit, the Commission first
considered the extent to which a fund could borrow in compliance with
the requirements of section 18.\367\ For example, a mutual fund with
$100 in assets and no liabilities or senior securities outstanding
could borrow an additional $50 from a bank. With the additional $50 in
bank borrowings, the mutual fund could invest $150 in securities based
on $100 of net assets. This fund's VaR would be approximately 150% of
the VaR of the fund's designated index if the fund used the borrowings
to leverage its portfolio by investing in securities consistent with
the fund's strategy. The proposed 150% relative VaR limit was designed
to limit a fund's leverage risk related to derivatives transactions in
a way that is effectively similar to the way that section 18 limits a
registered open- or closed-end fund's ability to borrow from a bank (or
issue other senior securities representing indebtedness for registered
closed-end funds) subject to the 300% asset coverage requirement in
section 18. The proposed limit also was designed to recognize that,
while a fund could achieve certain levels of market exposure through
borrowings permitted under section 18, it may be more efficient to
obtain those exposures through derivatives transactions. In the
proposal, the Commission requested comment on the appropriate relative
VaR test limit, including specifically requesting comment on a 200%
relative VaR test limit, and discussed the 200% relative VaR limit
applicable to UCITS funds.
---------------------------------------------------------------------------
\367\ See Proposing Release, supra footnote 1, at section
II.D.2.b.
---------------------------------------------------------------------------
Many commenters urged the Commission to raise the relative VaR
limit from 150% to 200% of a fund's designated index.\368\ These
commenters stated that this modification would be appropriate to
address factors other than a fund's use of derivatives that could cause
a fund's VaR to exceed the VaR of a designated index.\369\ For example,
some commenters stated that a fund's security selection will influence
a fund's relative VaR calculation.\370\ Commenters stated that the
proposed VaR test could be particularly restrictive for actively-
managed fixed-income funds.\371\ These commenters stated that an
actively-managed fixed-income fund will have an expected amount of
tracking error against a low-volatility benchmark based on the fund's
security selection and concentration levels. Differences between a
fund's portfolio and its reference portfolio--rather than leveraging
with derivatives--could cause a fund's VaR to exceed the VaR of its
designated reference portfolio.
---------------------------------------------------------------------------
\368\ See, e.g., Capital Group Comment Letter; ISDA Comment
Letter; Dechert Comment Letter I; ICI Comment Letter; ABA Comment
Letter; BlackRock Comment Letter; Chamber Comment Letter; Franklin
Comment Letter; J.P. Morgan Comment Letter; Eaton Vance Comment
Letter; PIMCO Comment Letter; Putnam Comment Letter; T. Rowe Price
Comment Letter; Vanguard Comment Letter.
\369\ See, e.g., Capital Group Comment Letter; Franklin Comment
Letter; J.P. Morgan Comment Letter.
\370\ See, e.g., Dechert Comment Letter I; T. Rowe Price Comment
Letter; MFA Comment Letter; SIFMA AMG Comment Letter.
\371\ See AQR Comment Letter I; SIFMA AMG Comment Letter;
Invesco Comment Letter; Dechert Comment Letter III.
---------------------------------------------------------------------------
Several commenters suggested that setting the relative VaR limit to
150% as an analogy to the 300% asset coverage requirement for bank
borrowings under section 18 is inappropriate because the restriction on
bank borrowings isolates leverage related to bank borrowings, whereas a
VaR test measures risk from non-derivative instruments and is affected
by variables other than leverage risk introduced by a fund's use of
derivatives.\372\ Some of these commenters provided examples of funds
that do not use derivatives but have VaRs exceeding the VaR of their
respective indexes, including, as examples, funds with portfolio VaRs
equal to 120% or more of their index VaR.\373\ While supporting the use
of VaR as a means of limiting fund leverage risk, these commenters
urged that an incrementally higher VaR limit would be needed to account
for the inherent imprecision in using VaR to identify potential
leverage relative to a fund's index's VaR.
---------------------------------------------------------------------------
\372\ See, e.g., Dechert Comment Letter I; ICI Comment Letter.
\373\ See Nuveen Comment Letter; SIFMA AMG Comment Letter.
---------------------------------------------------------------------------
Commenters also stated that firms would likely set internal VaR
thresholds that are lower than the rule would prescribe because of the
proposed board and SEC reporting requirements for VaR
[[Page 83196]]
exceedances.\374\ As one commenter observed ``fund managers for years
managed portfolio risks against internal risk tolerance limits using
VaR-based metrics, among other tools.'' \375\ This is consistent with
the design of rule 18f-4, which uses VaR as an outer limit on fund
leverage risk for any fund using derivatives transactions that is
unable to rely on the limited derivatives user exception. Because the
final rule's VaR tests provide an outer limit on fund leverage risk for
funds generally, and given the wide range of fund strategies, we expect
that many funds will use derivatives transactions in such a manner that
their fund's VaR generally is not at or approaching this limit. A
fund's derivatives risk management program could incorporate internal
VaR thresholds lower than the rule's VaR-based outer limit, as
described by commenters, that in conjunction with the other program
elements are tailored to appropriately manage a fund's particular
derivatives risks.
---------------------------------------------------------------------------
\374\ See T. Rowe Price Comment Letter; Dechert Comment Letter
I; J.P. Morgan Comment Letter; SIFMA AMG Comment Letter.
\375\ See Vanguard Comment Letter.
---------------------------------------------------------------------------
Many commenters also observed that raising the relative VaR limit
to 200% would match the 200% relative VaR limit in the UCITS framework
and provide compliance and operational efficiencies.\376\ Some
commenters stated that more closely aligning with the UCITS framework
would permit global fund complexes to streamline their risk management
programs and VaR testing across jurisdictions because these firms could
rely on existing risk management tools and VaR testing already in use
to satisfy UCITS requirements.\377\ Two commenters stated that these
efficiencies may benefit investors due to lower compliance costs.\378\
Two other commenters stated that raising the relative VaR limit to
align with UCITS' VaR limits would create operational efficiencies
because fund complexes that seek to create similar investment programs
could use similar portfolio and risk management for U.S. funds and
UCITS funds.\379\ Commenters also emphasized that the UCITS framework
is an existing regime that they believe provides effective investor
protections.\380\
---------------------------------------------------------------------------
\376\ See NYC Bar Comment Letter; BlackRock Comment Letter;
Dechert Comment Letter I.
\377\ See ABA Comment Letter; BlackRock Comment Letter; Eaton
Vance Comment Letter.
\378\ See Capital Group Comment Letter; SIFMA Comment Letter.
\379\ See PIMCO Comment Letter; Franklin Comment Letter.
\380\ See, e.g., ABA Comment Letter; BlackRock Comment Letter;
Eaton Vance Comment Letter.
---------------------------------------------------------------------------
After considering comments, we have determined to increase the
relative VaR test's outer limit on fund leverage risk from 150% to 200%
(with additional modifications for certain closed-end funds discussed
below).\381\ We believe that a relative VaR test that first considers
the extent to which a fund could borrow in compliance with the
requirements of section 18 is appropriate. We recognize, however, that
VaR is not itself a leverage measure and factors other than derivatives
and leverage can cause a fund's VaR to exceed the VaR of its designated
reference portfolio, such as a fund's security selection.\382\ Where a
fund uses its securities portfolio, the fund's securities investments
will reflect the markets or asset classes in which the fund invests.
However, there still may be differences between the VaR of the fund's
securities portfolio and the VaR of its total portfolio that relate to
differences in risks associated with specific securities versus
derivatives investments, rather than leverage risk. A fund, for
example, might obtain investment exposure to a number of issuers--in
some cases through direct investments in the issuer's securities and in
other cases indirectly through derivatives transactions referencing the
issuer's securities. The derivatives transactions could result in the
fund's VaR exceeding the VaR of the fund's securities portfolio, not
necessarily because of any leveraging associated with the derivatives
transactions, but because of the issuer-specific risk associated with
the derivatives transactions' underlying reference assets. Adopting a
200% relative VaR limit decreases the likelihood that security
selection and the additional risks VaR measures beyond leverage risk
would cause a fund to come out of compliance with the relative VaR
test. We also believe that raising the relative VaR test limit to 200%
is consistent with the VaR tests providing an appropriate outer bound
on fund leverage risk, complemented by a derivatives risk management
program tailored to the fund.
---------------------------------------------------------------------------
\381\ See rule 18f-4(a).
\382\ Moreover, as discussed above, the final rule generally
does not permit funds to use prohibited indexes as their designated
indexes to address the potential for funds to construct indexes for
the purpose of increasing potential fund leverage risk. This
limitation may, however, increase the likelihood that security
selection--rather than derivatives and leverage--may cause the
fund's VaR to exceed the VaR of its designated index. This is
because an unleveraged broad-based index may include a broader range
of securities than those held by the fund.
---------------------------------------------------------------------------
The 200% relative VaR limit also may provide compliance and
operational efficiencies. We recognize that many advisers to U.S. funds
using derivatives transactions also advise, or may have affiliates that
advise, UCITS funds that comply with UCITS requirements. Providing a
degree of consistency between the final rule and UCITS requirements
therefore may provide the compliance and operational efficiencies
identified by commenters, including by facilitating advisers' ability
to offer similar strategies in the United States and Europe. This may
benefit investors by facilitating investor choice and reducing costs
(to the extent these efficiencies result in cost savings that are
passed on to investors).
Two commenters suggested that the Commission modify the relative
VaR test such that a fund would satisfy the test if its VaR did not
exceed the greater of: (1) 200% of the VaR of the designated index; or
(2) 10% of the fund's net asset value.\383\ These commenters stated
that this approach would acknowledge that the absolute level of risk-
taking by some funds is low and would not represent undue speculation
in the commenters' view, while providing an alternative means of
providing these funds flexibility where their portfolio composition
deviates from the composition of their designated indexes.
---------------------------------------------------------------------------
\383\ See AQR Comment Letter I; Dechert Comment Letter III
(suggesting also an alternate version of this 10% formulation: The
fund's portfolio does not exceed the lesser of 300% of the VaR of
the designated index or 10% of the fund's net asset value).
---------------------------------------------------------------------------
We have not incorporated these suggestions into the final rule
because we believe that modifications we have made to the final rule
should help to address commenters' concerns about the relative VaR
test. For example, we are increasing the relative VaR levels from the
proposal and modifying the remediation provision, among other
changes.\384\ In addition, we are permitting actively managed funds to
use their securities portfolio, where appropriate, which will allow
these funds to use their own non-derivatives investments as the
reference portfolio for the relative VaR test. Also, the suggested
absolute VaR level of 10% included in these suggestions may permit
substantial leverage for funds that invest in less-volatile securities.
For example, a low-volatility bond fund and its designated index could
each have a VaR of 1.5%, where under a 10% absolute VaR provision, the
fund could leverage its portfolio almost seven times
[[Page 83197]]
its designated index's VaR to substantially exceed the volatility
associated with the low-volatility securities in its portfolio.
Although one of these commenters suggested that a 10% absolute VaR
limit could be capped at 300% of the VaR of its designated index, for
all the reasons discussed above, we believe the relative VaR test limit
should be 200%.
---------------------------------------------------------------------------
\384\ See supra section II.D.2.c (discussing relative VaR test
limits); infra sections II.D.3 (discussing absolute VaR test
limits), II.D.6.b (discussing remediation provisions).
---------------------------------------------------------------------------
ii. 250% Limit
The Commission considered proposing different relative VaR tests
for different types of investment companies, tied to the asset coverage
requirements applicable to registered open-end funds, registered
closed-end funds, and BDCs.\385\ The Commission did not propose a
higher VaR limit for registered closed-end funds because, although
these funds are permitted to issue preferred stock and open-end funds
are not, registered closed-end funds' senior securities representing
indebtedness are subject to the same 300% asset coverage requirements
applicable to open-end funds.
---------------------------------------------------------------------------
\385\ See Proposing Release, supra footnote 1, at text
accompanying n.210.
---------------------------------------------------------------------------
In response to the proposal's requests for comment, several
commenters urged the Commission to provide closed-end funds with a
higher relative VaR limit than open-end funds under the rule.\386\
These commenters generally reasoned that a higher VaR limit is
appropriate for closed-end funds in consideration of the equity-based
structural leverage that closed-end funds--and not open-end funds--can
obtain through the issuance of preferred stock permitted under section
18 of the Investment Company Act.
---------------------------------------------------------------------------
\386\ See PIMCO Comment Letter; Calamos Comment Letter; NYC Bar
Comment Letter; Dechert Comment Letter I; ICI Comment Letter;
Invesco Comment Letter; Nuveen Comment Letter; Eaton Vance Comment
Letter; Comment Letter of Kramer Levin Naftalis Frankel LLP (Mar.
24, 2020) (``Kramer Levin Comment Letter'').
---------------------------------------------------------------------------
Some commenters raised the concern that a closed-end fund that has
outstanding preferred stock, before entering into any derivatives
transactions, would have a higher starting VaR attributable to the
structural leverage obtained through the issuance of preferred
stock.\387\ Using the example of a fund with $100 in assets and no
liabilities or senior securities outstanding, a registered closed-end
fund could only borrow $50 through senior securities representing
indebtedness, the same amount an open-end fund could borrow from a
bank, but would be permitted also to issue an additional $50 in
preferred stock. If the closed-end fund raised $50 in preferred stock
and invested it in securities, the fund's VaR could potentially equal
the proposed 150% relative VaR limit before the fund entered into any
derivatives transactions.
---------------------------------------------------------------------------
\387\ See ICI Comment Letter; SIFMA AMG Comment Letter; Invesco
Comment Letter; Nuveen Comment Letter.
---------------------------------------------------------------------------
Commenters offered a number of methods to provide closed-end funds
with a higher VaR limit.\388\ For example, commenters suggested that
the rule could provide an increase for closed-end funds' relative VaR
limit based on the amount of structural leverage that a closed-end fund
obtained, either based on the disclosed amount of structural leverage
or the liquidation preference of any issued and then-outstanding
preferred stock.\389\ Other commenters suggested that the rule could
provide a relative VaR limit specific to closed-end funds that is
higher than the relative VaR limit applicable to open-end funds, with
most of these commenters suggesting that a provision specific to
closed-end funds reflect the addition of 50% to the relative VaR limit
applicable to open-end funds (i.e., 250% of the VaR of its designated
index for closed-end funds to reflect their ability to obtain equity-
based leverage).\390\
---------------------------------------------------------------------------
\388\ See Calamos Comment Letter; Dechert Comment Letter I; ICI
Comment Letter; Invesco Comment Letter; NYC Bar Comment Letter;
PIMCO Comment Letter; SIFMA AMG Comment Letter; Nuveen Comment
Letter.
\389\ See, e.g., Dechert Comment Letter I; Invesco Comment
Letter; PIMCO Comment Letter; Nuveen Comment Letter; Calamos Comment
Letter; ICI Comment Letter; SIFMA AMG Comment Letter. Commenters
suggested a few different ways to effectuate these suggestions,
including a preferred stock multiplier that a closed-end fund could
apply to the relative VaR limit or to the underlying designated
index. See, e.g., ICI Comment Letter; Invesco Comment Letter; Nuveen
Comment Letter.
\390\ See Dechert Comment Letter I; NYC Bar Comment Letter;
Nuveen Comment Letter; Invesco Comment Letter (recommending an
approach that includes a 50% maximum in additional relative VaR
limit for closed-end funds). A few commenters provided, as examples,
closed-end funds with higher relative VaR limits than what the
Commission proposed, which is consistent with the 250% relative VaR
limit supported by other commenters. See, e.g., ICI Comment Letter;
PIMCO Comment Letter; see also SIFMA AMG Comment Letter (suggesting
raising the relative VaR limit applicable to open-end funds by 25%
for closed-end funds and BDCs); Nuveen Comment Letter (suggesting
also 225% relative VaR limit for closed-end funds).
---------------------------------------------------------------------------
After considering these comments, we are modifying the proposed
rule's relative VaR test to include a clause providing a higher VaR
limit of 250% of the VaR of a fund's designated reference portfolio for
a closed-end fund with outstanding preferred stock. This modification
is designed to address the concern, raised by commenters, that
providing the same relative VaR limit for open-end funds and closed-end
funds does not take into account that closed-end funds may have a
higher VaR because of their issuance of preferred stock before entering
into any derivatives transactions. Absent a modification in these
circumstances, a closed-end fund could potentially have no or limited
flexibility to enter into derivatives transactions under the rule. For
example, if a closed-end fund with $100 in assets and no liabilities or
senior securities outstanding then raised $100 in preferred stock and
invested it in securities, the fund's VaR could potentially equal the
200% relative VaR limit before the fund entered into any derivatives
transactions.
Increasing the relative VaR test from the 200% relative VaR limit
applicable to funds generally under the rule, to the 250% relative VaR
limit for closed-end funds with equity-based leverage, is designed to
reflect those funds' ability to use equity-based leverage under the
Investment Company Act. Adding an additional 50% to the relative VaR
limit is designed to reflect the additional extent to which closed-end
funds are permitted to obtain equity-based leverage under the
Investment Company Act. For example, a closed-end fund, like a mutual
fund, with $100 in assets and no liabilities or senior securities
outstanding could borrow $50 from a bank. A closed-end fund, unlike a
mutual fund, could also raise an additional $50 by issuing preferred
stock.
We also believe that, because the Investment Company Act permits
closed-end funds to obtain greater leverage than open-end funds, and
many closed-end funds take advantage of this flexibility, investors may
expect closed-end funds to exhibit a greater degree of leverage risk.
We believe these factors support higher VaR limits on fund leverage
risk for closed-end funds with equity-based leverage in recognition
that the VaR tests are designed to provide an outer bound on fund
leverage risk.\391\ This provision is designed to provide incrementally
higher VaR limits only for closed-end funds that raise capital by
issuing preferred stock to investors in the ordinary course of pursuing
their investment strategy. If a closed-end fund does not obtain equity-
based structural leverage, however, the fund would be subject to the
same 200% relative VaR limit as other funds.
---------------------------------------------------------------------------
\391\ See, e.g., Nuveen Comment Letter; Invesco Comment Letter;
NYC Bar Comment Letter.
---------------------------------------------------------------------------
We considered the alternative approaches suggested by commenters
that would adjust a closed-end fund's relative VaR limit based on the
extent to
[[Page 83198]]
which the closed-end fund had preferred stock outstanding (or based on
the disclosed intended amount of such issuances). These approaches
would result in a relative VaR limit that would be more closely tied to
the amount of a closed-end fund's issuance of preferred stock. These
approaches, however, would introduce certain compliance and regulatory
challenges. For example, approaches based on the percentage of a fund's
net asset value represented by preferred stock would result in a fund's
relative VaR limit changing each day, which could raise compliance
challenges.\392\ Although one commenter suggested using an approach
that considers a fund's intended issuance of preferred stock to address
this concern, that approach also could raise compliance and regulatory
concerns by basing a leverage risk limit on a fund's intended
characteristics.\393\ This could raise questions about the appropriate
limit for a fund where the fund's actual structural leverage differs
from a purported or intended level, particularly if those differences
persist for a long period of time.
---------------------------------------------------------------------------
\392\ See ICI Comment Letter.
\393\ See id.
---------------------------------------------------------------------------
Although the final rule's provision for equity-based leverage is
available to both registered closed-end funds and BDCs, we are not
adopting a separate higher leverage limit for BDCs specifically.
Although some commenters urged that their suggestions for registered
closed-end funds also should apply to BDCs, commenters did not suggest
that the rule should provide higher VaR limits for BDCs than for
registered closed-end funds.\394\
---------------------------------------------------------------------------
\394\ See NYC Bar Comment Letter; SIFMA AMG Comment Letter;
Nuveen Comment Letter.
---------------------------------------------------------------------------
As discussed in the proposal, the Investment Company Act provides
greater flexibility for BDCs to issue senior securities.\395\ BDCs,
however, generally do not use derivatives or do so only to a limited
extent. In the proposal, the Commission explained that to help evaluate
the extent to which BDCs use derivatives, the staff sampled 48 of the
current 99 BDCs by reviewing their most recent financial statements
filed with the Commission.\396\ As discussed in the proposal, based on
this analysis the Commission believed that most BDCs either would not
use derivatives or would rely on the exception for limited derivatives
users. Commission staff updated this analysis by reviewing the most
recent financial statements that the same previously-sampled 48 BDCs
(or their successor funds) filed with the Commission.\397\ The staff's
sample included both BDCs with shares listed on an exchange and BDCs
whose shares are not listed. The sampled BDCs' net assets ranged from
$27 million to $6.6 billion. Of the 48 sampled, 59.1% did not report
any derivatives holdings, and a further 31.8% reported using
derivatives with gross notional amounts below 10% of net assets.\398\
We therefore believe that most BDCs either would not use derivatives or
would rely on the exception for limited derivatives users.
---------------------------------------------------------------------------
\395\ See Proposing Release, supra footnote 1, at section
II.D.2.
\396\ See id.
\397\ As of July 2020, there were 99 BDCs.
\398\ See infra footnote 512 and accompanying paragraph
(discussing BDCs that use derivatives and would qualify as limited
derivatives users).
---------------------------------------------------------------------------
In addition, the greater flexibility for BDCs to issue senior
securities allows them to provide additional equity or debt financing
to the ``eligible portfolio companies'' in which BDCs are required to
invest at least 70% of their total assets. Derivatives transactions, in
contrast, generally will not have similar capital formation benefits
for portfolio companies unless the fund's counterparty makes an
investment in the underlying reference assets equal to the notional
amount of the derivatives transaction. Allowing BDCs to leverage their
portfolios with derivatives to a greater extent than other closed-end
funds therefore would not appear to further the capital formation
benefits that underlie BDCs' ability to obtain additional leverage
under the Investment Company Act. We also understand that, even when
BDCs do use derivatives more extensively, derivatives generally do not
play as significant of a role in implementing the BDCs' strategies, as
compared to many other types of funds that use derivatives extensively.
BDCs' ``eligible portfolio companies'' investment requirement may limit
the role that derivatives can play in a BDC's portfolio relative to
other kinds of funds that would generally execute their strategies
primarily through derivatives transactions (e.g., a managed futures
fund). The final rule does not restrict a fund from issuing senior
securities subject to the limits in section 18 to the full extent
permitted by the Investment Company Act.\399\
---------------------------------------------------------------------------
\399\ For purposes of calculating asset coverage, as defined in
section 18(h), BDCs have used derivatives transactions' notional
amounts, less any posted cash collateral, as the ``amount of senior
securities representing indebtedness'' associated with the
transactions. We believe this approach--and not the transactions'
market values--represents the ``amount of senior securities
representing indebtedness'' for purposes of this calculation. These
issues do not tend to arise with respect to open-end funds and
registered closed-end funds. Open-end funds cannot enter into
derivatives transactions under section 18, absent relief from that
section's requirements, because section 18 limits open-end funds'
senior securities to bank borrowings. Section 18(c) also limits a
registered closed-end fund's ability to enter into derivatives
transactions absent such relief.
---------------------------------------------------------------------------
3. Absolute VaR Test
Under the final rule, a fund complying with the absolute VaR test
will satisfy the test if its VaR does not exceed 20% of the value of
the fund's net assets, unless the fund is a closed-end fund that has
then-outstanding preferred stock.\400\ For such closed-end funds, the
VaR must not exceed 25% of the value of the fund's net assets.\401\
This is a modification from the proposed rule, which would have limited
a fund's VaR to 15% of the value of its net assets.\402\
---------------------------------------------------------------------------
\400\ See rule 18f-4(a) (defining the term ``absolute VaR
test'').
\401\ See id.
\402\ See proposed rule 18f-4(a).
---------------------------------------------------------------------------
In proposing a 15% absolute VaR limit, the Commission considered
the comparison of a fund complying with the absolute VaR test and a
fund complying with the relative VaR test. In the proposal, the
Commission explained that for funds that rely on the absolute VaR test
a 15% absolute VaR limit would provide approximately comparable
treatment with funds that rely on the relative VaR test and use the S&P
500 as their designated index during periods where the S&P 500's VaR is
approximately equal to the historical mean. In the proposal, the
Commission requested comment on the appropriate absolute VaR test
limit, including specifically requesting comment on a 20% absolute VaR
test limit, and discussed the 20% absolute VaR limit applicable to
UCITS funds.\403\
---------------------------------------------------------------------------
\403\ See Proposing Release, supra footnote 1, at section
II.D.3.
---------------------------------------------------------------------------
Many commenters urged the Commission to raise the absolute VaR
limit from 15% to 20% of a fund's net assets.\404\ In urging the
Commission to raise the relative VaR limit from 150% to 200%,
commenters also urged a parallel increase in the absolute VaR limit
from 15% to 20%.\405\ They stated that this would be consistent with
the analysis in the Proposing Release if, as commenters suggested, the
Commission were to increase the relative VaR test to 200%.
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\404\ See Capital Group Comment Letter; ISDA Comment Letter;
Dechert Comment Letter I; ICI Comment Letter; AQR Comment Letter I;
ABA Comment Letter; BlackRock Comment Letter; Chamber Comment
Letter; Franklin Comment Letter; J.P. Morgan Comment Letter; Eaton
Vance Comment Letter; PIMCO Comment Letter; Putnam Comment Letter;
T. Rowe Price Comment Letter; Vanguard Comment Letter.
\405\ See, e.g., Invesco Comment Letter; MFA Comment Letter; T.
Rowe Price Comment Letter.
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[[Page 83199]]
A number of commenters agreed with the Commission's stated view in
the Proposing Release that the VaR tests would serve as an outside
limit on fund leverage risk, which would be consistent with the
Commission's estimates that only a small number of funds, if any, would
have to adjust their portfolios to comply with the VaR-based test.\406\
Commenters stated, however, that more funds would fail a 15% absolute
VaR limit than the Commission contemplated in the Proposing Release,
which commenters suggested indicates that the proposed 15% absolute VaR
limit would not function as an outside limit on fund leverage risk as
intended.\407\ Commenters suggested that a higher absolute VaR limit of
20% would more effectively achieve the Commission's goal of imposing an
outside limit on fund leverage risk and would allow a fund's
derivatives risk management program to provide day-to-day constraints
on fund risk instead of the proposed absolute VaR limit.\408\
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\406\ See, e.g., ICI Comment Letter; AQR Comment Letter I;
Invesco Comment Letter.
\407\ See, e.g., ICI Comment Letter (providing survey data
showing that during periods of stressed market conditions, about one
in four survey respondents indicated that their fund would breach an
absolute VaR limit of 15%); BlackRock Comment Letter (stating that
during March 2020 market volatility related to the COVID-19 global
health pandemic, most of its funds would have remained under a 20%
absolute VaR limit, but some would have breached a 15% absolute VaR
limit); see also Proposing Release, supra footnote 1, at n.516 and
accompanying paragraph.
\408\ See, e.g., AQR Comment Letter II; ISDA Comment Letter;
SIFMA AMG Comment Letter; T. Rowe Comment Letter.
---------------------------------------------------------------------------
To support its urging the Commission to raise the absolute VaR
limit to 20%, one commenter analyzed the VaR of the S&P 500 as the
risk-based reference point for setting the absolute VaR limit and
highlighted that the S&P 500 itself would breach a 15% absolute VaR
limit for specific periods of time.\409\ The commenter noted that the
S&P 500 would continue to breach the proposed 15% limit for a nearly
three-year period, including after the volatility of the index came
back down to typical historical levels following the 2008-2009
financial crisis. The commenter also observed the magnitude of the S&P
500's breach of the proposed 15% limit, stating that a fund taking risk
equivalent to the S&P 500 would need to reduce its risk by 32% to
comply with the proposed 15% VaR limit and would need to do this two
years after the 2008-2009 crisis.
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\409\ See AQR Comment Letter I (stating that other widely-known
benchmarks composed of small market capitalization stocks that are
more volatile than the S&P 500, such as the Russell 2000, would be
in breach more often than the S&P 500, supporting the
appropriateness of raising the absolute VaR limit to 20%); see also
J.P. Morgan Comment Letter (supporting an absolute VaR limit of 20%
and suggesting that the S&P 500 volatility since inception as used
in the Commission staff's analysis is less relevant than the more
recent market conditions that reflect increases in market volatility
since the 1980s); MFA Comment Letter.
---------------------------------------------------------------------------
Other commenters stated that raising the absolute VaR limit to 20%
would be consistent with the UCITS framework.\410\ Commenters suggested
that providing a 20% absolute VaR limit in rule 18f-4 would result in
compliance and operational efficiencies for advisers to both UCITS
funds and funds subject to rule 18f-4.
---------------------------------------------------------------------------
\410\ See, e.g., ABA Comment Letter; BlackRock Comment Letter;
Eaton Vance Comment Letter.
---------------------------------------------------------------------------
After considering comments, we are adopting an absolute VaR limit
of 20% of a fund's net assets. The 20% absolute VaR limit is based on
the same analysis that the Commission used to propose a 15% absolute
VaR limit, as we continue to believe it is an appropriate basis to set
this limit, and adjusts the absolute VaR limit to 20% in light of the
increases we are adopting to the proposed relative VaR limit. For
example, under the final rule, a fund that uses the S&P 500 as its
benchmark index, as many funds do, would be permitted to have a VaR
equal to 200% of the VaR of the S&P 500 if the fund uses that index as
its designated index.\411\ Setting the level of loss in the absolute
VaR test at 20% of a fund's net assets would therefore provide
approximately comparable treatment for funds that rely on the absolute
VaR test and funds that rely on the relative VaR test with a 200% limit
and use the S&P 500 as their designated index during periods where the
S&P 500's VaR is approximately equal to the historical mean. Moreover,
we recognize there are some regulatory and compliance efficiencies in
setting the absolute VaR limit at 20% because some fund complexes have
existing regulatory and compliance infrastructures for UCITS funds that
comply with a 20% absolute VaR limit.\412\
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\411\ The Division of Economic and Risk Analysis (``DERA'')
staff analyzed the S&P 500 because funds often select broad-based
large capitalization equities indexes such as the S&P 500 for
performance comparison purposes, including funds that are not broad-
based large capitalization equity funds. This is based on staff
experience and analysis of data obtained from Morningstar. Many
investors may therefore understand the risk inherent in these
indexes as the level of risk inherent in the markets generally.
DERA staff calculated the VaR of the S&P 500, using the
parameters specified in this rule over various time periods. DERA
staff's calculation of the S&P 500's VaR since inception, for
example, produced a mean VaR of approximately 10.5%, although the
VaR of the S&P 500 varied over time.
DERA staff calculated descriptive statistics for the VaR of the
S&P 500 using Morningstar data from March 4, 1957 to June 30, 2020,
based on daily VaR calculations, each using three years of prior
return data and calculated using historical simulation at a 99%
confidence level for a 20-day horizon using overlapping
observations.
\412\ As discussed in section II.D.2.c.i above, we recognize
that many advisers to U.S. funds using derivatives transactions also
advise, or may have affiliates that advise, UCITS funds that comply
with UCITS requirements. Providing a degree of consistency between
the final rule and UCITS requirements therefore may provide the
compliance and operational efficiencies identified by commenters,
including by facilitating advisers' ability to offer similar
strategies in the United States and Europe.
---------------------------------------------------------------------------
We also are modifying the proposed rule to provide a higher
absolute VaR test limit of 25% of the fund's net assets in the case of
a closed-end fund with then-outstanding shares of preferred stock. This
reflects the parallel clause we added to the definition of the term
``relative VaR test.'' We are increasing the absolute VaR limit for
certain closed-end funds for the same reasons we are increasing the
relative VaR limit for these funds.\413\
---------------------------------------------------------------------------
\413\ See supra section II.D.2.c.ii (discussing the 250%
relative VaR limit for closed-end funds that have shares of
preferred stock outstanding).
---------------------------------------------------------------------------
One commenter also suggested that the Commission modify the
absolute VaR test to provide that a fund complies if it does not exceed
either: (1) The absolute VaR limit, which the commenter urged be at
least 20%; or (2) 150% of the then-current VaR of the S&P 500.\414\ The
effect of this suggestion, if we incorporated it into the final rule
(which, as adopted, includes a 200% relative VaR limit), would always
permit a fund to have a portfolio VaR of 20% or less of the fund's net
assets. Moreover, this suggestion would permit a fund to increase its
portfolio VaR beyond this level to 200% of the S&P 500's VaR, if the
fund's portfolio VaR were to exceed 20%. This suggested approach would
therefore allow a fund's permissible VaR to increase in times when
market volatility increases and this increase is reflected in the S&P
500's VaR.
---------------------------------------------------------------------------
\414\ See AQR Comment Letter I. The commenter raised concerns
that in particular funds pursuing a volatility-targeting strategy
would be adversely affected by the absolute VaR test under the
proposal because of the counter-cyclical investment nature of these
funds, which the commenter suggested may be addressed by this
modification. The commenter also suggested an alternative method of
calculating VaR to address these concerns, which we discuss below in
section II.D.5.
---------------------------------------------------------------------------
We are not including this suggested approach in the final rule. In
determining the level of the absolute VaR test, we have used the mean
VaR of S&P 500 as a reference point for this analysis to represent the
level of risk that investors may understand as inherent in the markets
generally. If a fund is relying on the absolute VaR test,
[[Page 83200]]
it is because its derivatives risk manager reasonably determined that a
designated reference portfolio would not provide an appropriate
reference portfolio for purposes of the relative VaR test. It would be
inconsistent with the rule's framework to include a provision that
effectively uses the S&P 500 as a fund's designated index regardless of
the fund's investments and only during periods where this relative VaR
approach permits a fund's VaR to exceed 20%, but not during other
market conditions. This approach also could result in a fund being
permitted to take on substantial additional risk--and potentially
substantially additional leverage depending on the fund's investments--
in periods when market risks already are elevated.
The relative VaR test is designed to address concerns about
compliance with the VaR test during stressed periods because, although
the fund's VaR may increase during these periods, the VaR of the fund's
designated reference portfolio would be expected to increase as well. A
fund can rely on the relative VaR test if the fund's designated
reference portfolio reflects the markets or asset classes in which the
fund invests and meets the rule's other requirements. This is true even
if the fund's strategy is focused on an absolute return rather than a
level of return relative to an index or market. We believe such a
portfolio would provide a more appropriate reference portfolio for a
fund's relative VaR test than prescribing the S&P 500 in all cases.
4. Funds Limited to Certain Investors
The final rule does not provide an exemption from the rule's VaR-
based limit for funds that limit their investors to ``qualified
clients,'' as defined in rule 205-3 under the Advisers Act, and/or are
sold exclusively to ``qualified clients,'' ``accredited investors,'' or
``qualified purchasers.'' \415\ A few commenters urged the Commission
to exempt closed-end funds that limit their investor base in this way
from the rule's VaR limits.\416\ One of these commenters urged that,
instead of being subject to the VaR tests, these funds should be
permitted to set and disclose limits of their own choosing.\417\
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\415\ An ``accredited investor'' is defined in rules 215 and
501(a) under the Securities Act of 1933 and is intended to identify
``investors that have sufficient knowledge and expertise to
participate in investment opportunities that do not have the
rigorous disclosure and procedural requirements, and related
investor protections, provided by registration under the Securities
Act of 1933.'' See, e.g., Amending the ``Accredited Investor''
Definition, Securities Act Release No. 10824 (Aug. 26, 2020) [85 FR
64234 (Oct. 9, 2020)].
A ``qualified purchaser'' is defined in section 2(a)(51) of the
Investment Company Act and includes natural persons who own not less
than $5 million in investments, family-owned companies that own not
less than $5 million in investments, certain trusts, and persons,
acting for their own accounts or the accounts of other qualified
purchasers, who in the aggregate own and invest on a discretionary
basis, not less than $25 million in investments (e.g., institutional
investors). See id. at n.8.
\416\ Some of these commenters recommended an exemption from the
VaR tests for closed-end funds that limit their investors to
qualified clients. See Comment Letter of Dechert LLP (Mar. 24, 2020)
(``Dechert Comment Letter II''); Kramer Levin Comment Letter. Other
commenters urged exemptions more broadly for closed-end funds sold
exclusively to accredited investors, qualified purchasers, or
qualified clients. See NYC Bar Comment Letter; ABA Comment Letter.
\417\ See ABA Comment Letter.
---------------------------------------------------------------------------
Commenters asserted that complying with the VaR-based limit on fund
leverage risk would negatively affect how these funds operate and the
investment strategies they can pursue.\418\ Commenters asserted that
because their investors are sophisticated, with the ability to
understand the risks associated with a fund obtaining significant
derivatives exposure, the funds should not be subject to VaR testing
because these investors do not require the same investor protections as
other registered funds.\419\ Commenters urged that failing to provide
these funds an exemption would encourage their investors to move to
private funds, losing investor protections that the Investment Company
Act provides.\420\
---------------------------------------------------------------------------
\418\ See Dechert Comment Letter II (stating that compliance
with the rule ``could significantly and negatively impact investment
performance and create unnecessary costs for investors [of qualified
client funds]''); Kramer Levin Comment Letter.
\419\ See Kramer Levin Comment Letter (stating that ``[u]nlike
mutual funds, [closed-end funds that limit their investors to
``qualified clients''] are only offered to sophisticated, high net
worth investors (with a $2.1 million net worth minimum), who not
only certify as to their financial wherewithal but also acknowledge
all of the risks involved in investing in such [funds]''); Dechert
Comment Letter II; contra CFA Comment Letter at 9 (stating that that
these ``exotic-hedge fund like strategies that use extensive
leverage . . . . are more appropriately reserved for the
unregistered space where, at least in theory, investors are
sophisticated, can withstand losses resulting from risky strategies,
and are able to access information that would enable them to make
informed investment decisions'').
\420\ See ABA Comment Letter; Dechert Comment Letter II; Kramer
Levin Comment Letter.
---------------------------------------------------------------------------
The final rule does not provide an exemption for these funds from
the rule's VaR test. To the extent a fund that limits its investor base
as described by these commenters is able to qualify for the exclusions
from the investment company definition in sections 3(c)(1) or 3(c)(7),
the fund can operate as a private fund under those exclusions and will
not be subject to section 18.\421\ Private funds can pursue complex
derivatives strategies with significant leverage. Where a fund is
registered under the Investment Company Act (or regulated under the Act
in the case of BDCs), however, the fund remains subject to all
applicable provisions of the Act and its rules, notwithstanding its
investor base.\422\ The Investment Company Act's requirements for
registered investment companies and BDCs generally do not vary based on
the nature of the fund's investors.
---------------------------------------------------------------------------
\421\ Section 3(c)(1) of the Investment Company Act excludes
from the definition of ``investment company'' any issuer whose
outstanding securities (other than short-term paper) are
beneficially owned by not more than 100 persons, and which is not
making and does not presently propose to make a public offering of
its securities. Section 3(c)(7) of the Investment Company Act
excludes from the definition of ``investment company'' any issuer
whose outstanding securities are owned exclusively by persons who,
at the time of acquisition of such securities, are ``qualified
purchasers,'' and which is not making and does not at that time
propose to make a public offering of its securities.
\422\ The final rule does include modifications to the proposed
VaR tests, including commenter suggestions to raise the VaR limits
from the proposed levels. See Kramer Levin Comment Letter
(recommending that closed-end funds under the rule be subject, as
applicable, to a limit of 200% relative VaR or 20% absolute VaR). We
also modified the proposed rule to take account of closed-ends'
funds ability to issue preferred stock by providing these funds a
higher VaR limit. We believe these and other modifications to the
final rule should help to address the concerns commenters raised
about the final rule's impact on the funds' strategies.
---------------------------------------------------------------------------
5. Choice of Model and Parameters for VaR Test
We are adopting the VaR model and parameters for the VaR test as
proposed. The final rule will require a VaR model to take into account
and incorporate certain market risk factors associated with a fund's
investments and provide parameters for the VaR calculation's confidence
level, time horizon, and historical market data. The final rule also
will not require a fund to use the same VaR model for calculating its
portfolio's VaR and the VaR of its designated reference portfolio. We
discuss each of these requirements below in addition to certain VaR
calculation considerations raised by commenters.
Risk Factors and Methodologies
As proposed, the final rule will require that any VaR model a fund
uses for purposes of the relative or absolute VaR test take into
account and incorporate all significant, identifiable market risk
factors associated with a fund's investments.\423\ The rule includes a
non-exhaustive list of common market
[[Page 83201]]
risk factors that a fund must account for in its VaR model, if
applicable. These market risk factors are: (1) Equity price risk,
interest rate risk, credit spread risk, foreign currency risk and
commodity price risk; (2) material risks arising from the nonlinear
price characteristics of a fund's investments, including options and
positions with embedded optionality; and (3) the sensitivity of the
market value of the fund's investments to changes in volatility.\424\
VaR models are often categorized according to three modeling methods--
historical simulation, Monte Carlo simulation, or parametric
models.\425\ Each method has certain benefits and drawbacks, which may
make a particular method more or less suitable, depending on a fund's
strategy, investments and other factors. In particular, some VaR
methodologies may not adequately incorporate all of the material risks
inherent in particular investments, or all material risks arising from
the nonlinear price characteristics of certain derivatives.\426\ By
specifying certain parameters but not prescribing particular VaR
models, the final rule is designed to allow each fund to use a VaR
model that is appropriate for the fund's investments. The commenters
who addressed this provision supported it.\427\
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\423\ See rule 18f-4(a) (defining the term ``value-at-risk'' or
``VaR'' in the final rule); proposed rule 18f-4(a) (defining the
term ``value-at-risk'' or ``VaR'' in the proposed rule).
\424\ See id.
\425\ Historical simulation models rely on past observed
historical returns to estimate VaR. Historical VaR involves taking a
fund's current portfolio, subjecting it to changes in the relevant
market risk factors observed over a prior historical period, and
constructing a distribution of hypothetical profits and losses. The
resulting VaR is then determined by looking at the largest (100
minus the confidence level) percent of losses in the resulting
distribution.
Monte Carlo simulation uses a random number generator to produce
a large number (often tens of thousands) of hypothetical changes in
market values that simulate changes in market factors. These outputs
are then used to construct a distribution of hypothetical profits
and losses on the fund's current portfolio, from which the resulting
VaR is ascertained by looking at the largest (100 minus the
confidence level) percent of losses in the resulting distribution.
Parametric methods for calculating VaR rely on estimates of key
parameters (such as the mean returns, standard deviations of
returns, and correlations among the returns of the instruments in a
fund's portfolio) to create a hypothetical statistical distribution
of returns for a fund, and use statistical methods to calculate VaR
at a given confidence level.
See Proposing Release, supra footnote 1, at n.227.
\426\ For example, some parametric methodologies may be more
likely to yield misleading VaR estimates for assets or portfolios
that exhibit non-linear returns, due, for example, to the presence
of options or instruments that have embedded optionality (such as
callable or convertible bonds). See, e.g., Thomas J. Linsmeier &
Neil D. Pearson, Value at Risk, 56 Journal of Financial Analysts 2
(Mar.-Apr. 2000) (``Linsmeier & Pearson'') (stating that historical
and Monte Carlo simulation ``work well regardless of the presence of
options and option-like instruments in the portfolio. In contrast,
the standard [parametric] delta-normal method works well for
instruments and portfolios with little option content but not as
well as the two simulation methods when options and option-like
instruments are significant in the portfolio.'').
\427\ See J.P. Morgan Comment Letter; BlackRock Comment Letter;
Franklin Comment Letter.
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Confidence Level and Time Horizon
As proposed, the final rule requires a fund's VaR model to use a
99% confidence level and a time horizon of 20 trading days.\428\ VaR
models that use relatively high confidence levels and longer time
horizons--as the final rule parameters reflect--result in a focus on
more-``extreme'' but less-frequent losses. This is because a fund's VaR
model will be based on a distribution of returns, where a higher
confidence level would go further into the tail of the distribution
(i.e., more-``extreme'' but less-frequent losses) and a longer time
horizon would result in larger losses in the distribution (i.e., losses
have the potential to be larger over twenty days than over, for
example, one day). The VaR tests in the final rule, as proposed, are
designed to measure, and seek to limit the severity of, these less-
frequent but larger losses.
---------------------------------------------------------------------------
\428\ See rule 18f-4(a); proposed rule 18f-4(a).
---------------------------------------------------------------------------
Many commenters provided general support for a 99% confidence level
for the rule's VaR test.\429\ Several commenters that supported this
parameter suggested providing guidance regarding confidence interval
rescaling, specifically from a 95% confidence level to a 99% confidence
level.\430\ Under this approach, a fund would first compute its VaR at
a 95% confidence level, which will involve more observations because
this approach looks to losses in 5% of the distribution rather than 1%.
The fund would then use the statistical relationship of the normal
distribution between the 99th percentile and the 95th percentile, using
the ratio of their respective Z-scores, in calculating a fund's VaR
consistent with the VaR model and parameters requirements under the
rule.\431\
---------------------------------------------------------------------------
\429\ See, e.g., J.P. Morgan Comment Letter; AQR Comment Letter
I; BlackRock Comment Letter; Dechert Comment Letter I; ICI Comment
Letter; Invesco Comment Letter; SIFMA AMG Comment Letter. But see
ISDA Comment Letter (suggesting the rule permit a fund to determine
its own confidence level from 95% to 99% for purposes of the rule's
VaR test).
\430\ See AQR Comment Letter I; BlackRock Comment Letter;
Dechert Comment Letter I; ICI Comment Letter; Invesco Comment
Letter; SIFMA AMG Comment Letter.
\431\ The Z-scores for these confidence levels are: (1) The
value of the 99th percentile minus the population mean and (2) the
value of the 95th percentile minus the population mean, both divided
by the population standard deviation.
---------------------------------------------------------------------------
Commenters stated that this approach would produce more stable
results because the VaR calculation would be based on a larger number
of observations. For example, one commenter stated that while there are
benefits to selecting a 99% confidence level, one of the tradeoffs is
that being so far into the ``tail'' of the distribution of returns for
VaR calculations implies an inherently imprecise, unstable, and
unnecessarily sensitive metric of risk.\432\ The commenter stated that,
for example, if a fund calculated a 3-year VaR with 20-day non-
overlapping periods, the 99% VaR is based on less than one observation.
Rescaling a VaR calculated at a 95% confidence to a 99% confidence
level would address the effects of having a limited number of
observations.\433\ Two commenters similarly stated that permitting
rescaling from a 95% confidence level to a 99% confidence level is
useful as another means for obtaining additional observations, when
compared to increasing the number of observations by using overlapping
periods, because it better addresses concerns with small sample bias in
estimating VaR at higher confidence levels.\434\ One commenter stated
that this confidence level scaling would ensure that the VaR outputs
are appropriately representative and take into account unusual
volatility periods, and in this commenter's view, ensure greater
reliability of the model outputs.\435\ A few commenters stated that
this also would align with other regulatory regimes, creating
regulatory compliance efficiencies for funds complying with the
rule.\436\ Commenters also supported the Commission's statement in the
Proposing Release that funds could scale a one-day VaR calculation to a
20-day calculation for purposes of the rule under appropriate
circumstances and urged that permitting confidence level scaling would
likewise be appropriate. With respect to the proposed time horizon of
20 trading days, the Commission received one comment that supported the
proposed parameter and another that did not object to it and noted that
this and other parameters generally are in line with UCITS
requirements.\437\
---------------------------------------------------------------------------
\432\ See AQR Comment Letter I.
\433\ See id.
\434\ See ICI Comment Letter; Invesco Comment Letter.
\435\ See SIFMA AMG Comment Letter.
\436\ See BlackRock Comment Letter; Dechert Comment Letter I;
ICI Comment Letter.
\437\ See J.P. Morgan Comment Letter; ICI Comment Letter.
---------------------------------------------------------------------------
We agree with commenters that it is a commonly used technique in
performing VaR calculations to determine a 99% confidence level VaR
[[Page 83202]]
by rescaling a calculation initially performed at a 95% confidence
level. Like the time-scaling technique the Commission discussed in the
proposal, it may be beneficial in that it would allow a fund's VaR
calculation to take into account additional observations while still
complying with the final rule's VaR tests calibrated to a 99%
confidence level and a time horizon of 20 trading days.\438\ We believe
that both approaches are appropriate for purposes of the final rule.
---------------------------------------------------------------------------
\438\ See Proposing Release, supra footnote 1, at n.230.
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Historical Market Data
We are adopting the requirement, as proposed, that the fund's
chosen VaR model must be based on at least three years of historical
market data. As discussed in the proposal, we understand that the
availability of data is a key consideration when calculating VaR, and
that the length of the data observation period may significantly
influence the results of a VaR calculation. When proposing this
requirement, the Commission recognized that a shorter observation
period means that each observation will have a greater influence on the
result of the VaR calculation (as compared to a longer observation
period), such that periods of unusually high or low volatility could
result in unusually high or low VaR estimates.\439\ Longer observation
periods, however, can lead to data collection problems, if sufficient
historical data is not available.\440\
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\439\ See Linsmeier & Pearson, supra footnote 426 (stating that,
because historical simulation relies directly on historical data, a
danger is that the price and rate changes in the last 100 (or 500 or
1,000) days might not be typical. For example, if by chance the last
100 days were a period of low volatility in market rates and prices,
the VaR computed through historical simulation would understate the
risk in the portfolio).
\440\ See Proposing Release, supra footnote 1, at n.178 and
accompanying text (citing Kevin Dowd, An Introduction to Market Risk
Measurement (Oct. 2002) at 68 (stating that ``[a] long sample period
can lead to data collection problems. This is a particular concern
with new or emerging market instruments, where long runs of
historical data don't exist and are not necessarily easy to
proxy'').
---------------------------------------------------------------------------
The Commission received a few comments on this aspect of the
proposal. One commenter suggested that the rule should require at a
minimum five years of historical data rather than the proposed three
years of historical data requirement.\441\ This commenter stated that
five years would be more representative of market conditions, but not
so long as to mute the effects of extreme market events. Another
commenter, however, stated that it supported the proposed three years
of historical data requirement.\442\ Another commenter expressly stated
that it did not object to the proposed three-year historical data
requirement.\443\
---------------------------------------------------------------------------
\441\ See Better Markets Comment Letter. This commenter also
suggested stressed VaR, as discussed above (suggesting that the
historical data include a one-year period of extreme but plausible
market conditions). See supra section II.D.1.
\442\ See J.P. Morgan Comment Letter.
\443\ See ICI Comment Letter.
---------------------------------------------------------------------------
We are not persuaded to extend the requirement, as suggested by one
commenter, to at least five years of historical data.\444\ Funds with
newer or novel investment exposures, for example, may experience
challenges in collecting this data set. The rule's historical market
data requirement is designed to permit a fund to base its VaR estimates
on a meaningful number of observations, while also recognizing that
requiring a longer period could make it difficult for a fund to obtain
sufficient data to estimate VaR for the instruments in its
portfolio.\445\ We believe requiring a fund's chosen VaR model to be
based on at least three years of historical market data strikes an
appropriate balance.\446\ Derivatives risk managers can base their VaR
calculations on additional historical data if they choose.
---------------------------------------------------------------------------
\444\ See Better Markets Comment Letter.
\445\ See Michael Minnich, Perspectives On Interest Rate Risk
Management For Money Managers And Traders (Frank Fabozzi, ed.)
(1998) (stating that for historical simulation, ``[l]onger periods
of data have a richer return distribution while shorter periods
allow the VAR to react more quickly to changing market events'' and
that ``[t]hree to five years of historical data are typical''); see
also Darryll Hendricks, Evaluation of Value-at-Risk Models Using
Historical Data, FRBNY Economic Policy Review (Apr. 1996) (finding
that, when using historical VaR, ``[e]xtreme [confidence level]
percentiles such as the 95th and particularly the 99th are very
difficult to estimate accurately with small samples'' and that the
complete dependence of historical VaR models on historical
observation data ``to estimate these percentiles directly is one
rationale for using long observation periods'').
\446\ The three-year data requirement applies to all VaR
calculations under the rule, as proposed, rather than only
historical simulation as the Commission proposed in 2015. All VaR
models--not just historical simulation--rely on historical data. The
Commission received no comments on this aspect of the proposal.
---------------------------------------------------------------------------
VaR Models for the Fund's Portfolio and Its Designated Reference
Portfolio
The final rule, as proposed, does not require a fund to apply its
VaR model consistently (i.e., the same VaR model applied in the same
way) when calculating (1) the VaR of its portfolio and (2) the VaR of
its designated reference portfolio. The rule will, however, require
that VaR calculations comply with the same VaR definition under the
rule and its specified model requirements.
As proposed, we have determined not to adopt a model consistency
requirement because it could prevent funds from using less-costly
approaches. For example, under the final rule's approach, in many cases
a fund could calculate the VaR of a designated index based on the index
levels over time without having to obtain more-detailed information
about the index constituents. A fund also may obtain the VaR from a
third-party vendor instead of analyzing it in-house. A model
consistency requirement could preclude these approaches, however,
because a fund might not be able apply the same approach to its
portfolio.\447\ Commenters supported this approach.\448\ We believe
similar considerations apply to funds using their securities portfolios
in lieu of a designated index. For example, such a fund may have a
securities portfolio composed solely of listed equities securities
while also writing options or entering into other derivatives
transactions with non-linear returns. A simpler VaR model may be
appropriate to calculate the VaR of the fund's securities portfolio,
and a comparatively more complex VaR model could be more appropriate
for calculating the VaR of the fund's total portfolio that includes the
fund's derivatives transactions.
---------------------------------------------------------------------------
\447\ For example, if a fund invested significantly in options,
it generally would not be appropriate to use certain parametric VaR
models. The fund might instead use Monte Carlo simulation, which is
more computationally intensive and takes more time to perform. A
model consistency requirement would require the fund to apply the
same Monte Carlo simulation model to its unleveraged designated
index or securities portfolio, for which a parametric or other
simpler and less costly VaR model might be appropriate.
\448\ See BlackRock Comment Letter; Franklin Comment Letter
(stating its support for the proposed VaR model calculation
flexibility and noting that it is supported by the Commission's
discussion in the proposal regarding index licensing fees).
---------------------------------------------------------------------------
Other VaR Calculation Considerations
Funds of funds. One commenter requested guidance on how the VaR
tests should be applied to investments by a fund that invests in other
registered investment companies (``underlying funds'').\449\ This
commenter observed that calculating VaR based on the acquiring fund's
holdings can be challenging because an acquiring fund's adviser may not
have daily transparency into the holdings of underlying funds.
Accordingly, the commenter suggested we confirm that a fund need only
comply with the rule if the fund itself directly engages in derivatives
transactions and need not look through to the holdings of underlying
funds. The commenter also sought confirmation
[[Page 83203]]
that, when an acquiring fund does enter into derivatives transactions
and also holds shares of underlying funds, that the acquiring fund may
calculate its VaR by taking into account the historic return of the
acquiring fund rather than determining the acquiring fund's VaR based
on the aggregate VaR of the underlying funds.
---------------------------------------------------------------------------
\449\ See Fidelity Comment Letter.
---------------------------------------------------------------------------
We agree that, in general, an acquiring fund that does not use
derivatives transactions would not be required to comply with the final
rule or to look through to an underlying registered investment company
or BDC's use of derivatives transactions for purposes of determining
the acquiring fund's derivatives exposure. These underlying funds,
themselves, will be subject to rule 18f-4 with respect to their
investments in derivatives.\450\ If a fund enters into derivatives
transactions indirectly through controlled foreign corporations, these
derivatives transactions are treated as direct investments of the fund
for regulatory and other purposes, including for purposes of section 18
and therefore for rule 18f-4.
---------------------------------------------------------------------------
\450\ However, section 48(a) of the Act provides that it shall
be unlawful for any person, directly or indirectly, to cause to be
done any act or thing through or by means of any other person which
it would be unlawful for such person to do under the provisions of
the Investment Company Act or any rule, regulation, or order
thereunder. This provision prevents a fund from investing through a
registered investment company or BDC, or a private fund or other
pooled investment vehicle, as a means of directly or indirectly
causing to be done any act or thing through or by means of any other
person which it would be unlawful under section 18 and the final
rule for the acquiring fund to do directly.
---------------------------------------------------------------------------
When an acquiring fund does engage in derivatives transactions
beyond the 10% limited derivatives user threshold and also holds shares
of underlying funds, the acquiring fund will be required under the rule
to calculate its own VaR. In these circumstance we believe that it
would be sufficient for the acquiring fund to use the historic returns
of the underlying funds when determining the acquiring fund's VaR, in
recognition of the compliance challenges associated with obtaining
daily transparency into the holdings of the underlying funds. We do not
believe it would be appropriate, however, for the acquiring fund (or
any other fund under the rule) to use its own historic return for
calculating VaR. The acquiring fund will have information about its own
direct investments and can calculate its VaR taking these investments
into account rather than looking to the fund's historic return, which
will include return information that may be based on investments that
differ from those in the fund's current portfolio.
Volatility-targeting funds. One commenter suggested that the
Commission permit different VaR parameters for funds that target a
constant volatility or volatility range (``volatility-targeting
funds'').\451\ Such funds generally will increase the size of their
positions when market risks are lower and decrease the size of their
positions when market risks are higher. The commenter expressed
concerns about applying a VaR test to such funds, particularly in
periods of low volatility that follow high-volatility periods. In this
case, the fund would increase the size of its position because of the
low volatility in the market but, when calculating the fund's VaR,
effectively would be simulating how the fund's current portfolio would
perform during the past high-volatility period. The commenter believed
that this would not measure effectively the fund's risk because during
the prior high-volatility periods simulated in the VaR model, the
fund's positions would have been smaller than in its current portfolio
because volatility was higher.
---------------------------------------------------------------------------
\451\ See AQR Comment Letter I.
---------------------------------------------------------------------------
The commenter urged that the final rule permit this fund's
derivatives risk manager to use a VaR model that, in simulating the
fund's performance over the look-back period, would reflect the way in
which the fund would change its position sizes based on the fund's
publicly-disclosed investment strategy.\452\ The commenter explained
that this alternative VaR model adjusts historical returns data by
considering the ex-ante volatility of the holdings on each day in the
lookback window and scaling those returns to reflect the target
volatility of the fund. The commenter acknowledged that this VaR model
modification would not be appropriate for all funds and could be
misused by funds that do not effect these strategies during high
volatility market conditions, but suggested the Commission could
address such concerns by providing guidance that this methodology would
be limited to only those funds that have an explicit strategy of
targeting a specific volatility level or range that is disclosed as a
principal investment strategy.
---------------------------------------------------------------------------
\452\ The commenter also suggested a modification to the
absolute VaR test designed to address concerns for volatility-
targeting funds as discussed at supra footnote 414 and accompanying
text.
---------------------------------------------------------------------------
We recognize that the VaR of a fund's current portfolio is based on
past trading conditions and that this can affect volatility-targeting
funds as this commenter discussed. Where these high-volatility periods
are in the VaR lookback period and market volatility currently is low,
VaR may limit the size of the fund's positions. We have not, however,
modified the proposed rule to permit the alternative method suggested.
The VaR test is designed to measure the leverage risk in a fund's
portfolio. The suggested method appears to measure the risk in the
fund's strategy. It also assumes that the fund effectively achieves the
targeted volatility each day, which may not be the case. In addition,
allowing a fund to adjust historical returns when measuring the current
leverage risk in a fund's portfolio would appear to introduce
``gaming'' concerns that we do not believe can be fully addressed by
limiting such a method to only those funds that have an explicit
strategy of targeting a specific volatility level or range that is
disclosed as a principal investment strategy. We have, however,
incorporated a number of other modifications suggested by the commenter
to other aspects of the rule that may help to address the concerns the
commenter expressed.\453\
---------------------------------------------------------------------------
\453\ See, e.g., supra sections II.D.2.c, II.D.3, II.D.4
(discussing raising VaR limits and confidence level re-scaling).
---------------------------------------------------------------------------
6. Implementation
a. Testing Frequency
Under the final rule, a fund must determine its compliance with the
applicable VaR test at least once each business day, as proposed.\454\
Although we believe that funds will calculate their VaRs at a
consistent time each day, which would generally be either in the
mornings before markets open or in the evenings after markets close,
the rule does not require one at the exclusion of the other.
---------------------------------------------------------------------------
\454\ Rule 18f-4(c)(2)(ii).
---------------------------------------------------------------------------
The Commission proposed a daily testing frequency because, if this
testing requirement were less frequent, a fund could satisfy the
condition only on business days requiring a VaR test and modify its
trading strategy to circumvent the purpose of the test on other
business days. Testing each business day also reflects the potential
for market risk factors associated with a fund's investments to change
quickly. The Commission received one comment on this aspect of the
rule, which supported it, and we are adopting it as proposed.\455\
---------------------------------------------------------------------------
\455\ See J.P. Morgan Comment Letter.
---------------------------------------------------------------------------
b. Remediation
If a fund determines that it is not in compliance with the
applicable VaR test, then under the rule a fund must
[[Page 83204]]
come back into compliance promptly after such determination, in a
manner that is in the best interests of the fund and its
shareholders.\456\ If the fund is not in compliance within five
business days:
---------------------------------------------------------------------------
\456\ See rule 18f-4(c)(2)(ii).
---------------------------------------------------------------------------
The derivatives risk manager must provide a written report
to the fund's board of directors and explain how and by when (i.e., the
number of business days) the derivatives risk manager reasonably
expects that the fund will come back into compliance; \457\
---------------------------------------------------------------------------
\457\ The final rule clarifies that this report must be in
writing. See rule 18f-4(c)(2)(iii)(A); proposed rule 18f-
4(c)(2)(iii)(A). The Commission did not receive comment on whether
this reporting requirement must be in writing.
---------------------------------------------------------------------------
The derivatives risk manager must analyze the
circumstances that caused the fund to be out of compliance for more
than five business days and update any program elements as appropriate
to address those circumstances; \458\ and
---------------------------------------------------------------------------
\458\ See rule 18f-4(c)(2)(iii)(B).
---------------------------------------------------------------------------
The derivatives risk manager must provide a written report
within thirty calendar days of the exceedance to the fund's board of
directors explaining how the fund came back into compliance and the
results of the derivatives risk manager's analysis of the circumstances
that caused the fund to be out of compliance for more than five
business days and any updates to the program elements.\459\
---------------------------------------------------------------------------
\459\ See rule 18f-4(c)(2)(iii)(C).
If the fund remains out of compliance with the applicable VaR test at
that time, the derivatives risk manager's written report must update
the report explaining how and by when he or she reasonably expects the
fund will come back into compliance, and the derivatives risk manager
must update the board of directors on the fund's progress in coming
back into compliance at regularly scheduled intervals at a frequency
determined by the board.\460\
---------------------------------------------------------------------------
\460\ See id.; see also infra section II.G.2 (discussing the
requirement to submit a confidential report to the Commission if the
fund is out of compliance with the applicable VaR test for five
business days).
---------------------------------------------------------------------------
The proposed rule would have required the derivatives risk manager
to satisfy the additional reporting and analysis requirements if the
fund was out of compliance for three consecutive business days.\461\
Additionally, the proposed rule would have prohibited a fund from
entering into any derivatives transactions (other than derivatives
transactions that, individually or in the aggregate, are designed to
reduce the fund's VaR) until the fund has been back in compliance with
the applicable VaR test for three consecutive business days (the
``proposed derivatives entry restriction''), among other
requirements.\462\ The Commission requested comment in the Proposing
Release on whether the remediation provision would exacerbate fund or
market instability and harm investors.\463\ The Commission also
requested comment on whether there was a more-effective means for the
remediation provision to balance investor protection concerns regarding
compliance with the VaR-based limit on fund leverage risk and not
forcing asset sales or unwinding transactions.
---------------------------------------------------------------------------
\461\ See proposed rule 18f-4(c)(2)(iii).
\462\ See proposed rule 18f-4(c)(2)(iii)(A) through (C).
\463\ See Proposing Release, supra footnote 1, at section
II.D.5.b.
---------------------------------------------------------------------------
Many commenters urged the Commission to extend the remediation
period from three business days to five business days or seven calendar
days.\464\ These commenters suggested that the proposed three business
days is too short to ensure an orderly process of getting back into
compliance.\465\ In particular, commenters raised concerns that during
periods of high market volatility and dislocation, funds would engage
in sales and other actions to get back into compliance with the VaR
test that may have adverse effects on a fund and its shareholders.\466\
Moreover, some commenters pointed out that a five-business-day
remediation period would align better with respect to over-the-counter
derivatives contracts' termination provisions that, based on industry
market practices, are often set at seven calendar days.\467\
---------------------------------------------------------------------------
\464\ See, e.g., AQR Comment Letter I; Capital Group Comment
Letter; Dechert Comment Letter I; ICI Comment Letter; Franklin
Comment Letter; Putnam Comment Letter; SIFMA AMG Comment Letter; see
also ISDA Comment Letter (suggesting seven business days); Dechert
Comment Letter III (suggesting ten business days in light of
concerns relating to funds fire selling assets to avoid VaR test
compliance issues that may trigger reporting requirements to the
Commission).
\465\ See, e.g., Franklin Comment Letter; Putnam Comment Letter;
T. Rowe Price Comment Letter.
\466\ See, e.g., AQR Comment Letter I; Capital Group Comment
Letter; ICI Comment Letter.
\467\ See, e.g., Dechert Comment Letter I; ICI Comment Letter;
MFA Comment Letter.
---------------------------------------------------------------------------
Commenters similarly urged that the Commission eliminate or modify
the proposed derivatives entry restriction.\468\ Commenters urged that
this restriction could be disruptive to a fund's execution of its
strategy and could adversely affect a fund and its shareholders.\469\
Several commenters urged that it should be eliminated because the other
provisions requiring reporting to the fund's board of directors and to
the Commission under the rule provide sufficient incentives for funds
to come back into compliance promptly with the rule's VaR test.\470\ A
few commenters also expressed concerns with the proposed derivatives
entry restriction because of the challenges with predicting whether a
new derivatives transaction will be VaR reducing.\471\
---------------------------------------------------------------------------
\468\ See, e.g., AQR Comment Letter I; Capital Group Comment
Letter; Dechert Comment Letter I; ICI Comment Letter; Franklin
Comment Letter; Putnam Comment Letter; SIFMA AMG Comment Letter;
Dechert Comment Letter III.
\469\ See, e.g., AQR Comment Letter I; Franklin Comment Letter;
ISDA Comment Letter.
\470\ See, e.g., SIFMA AMG Comment Letter; Nuveen Comment
Letter; Putnam Comment Letter. But see CFA Comment Letter (stating
that the proposed remediation provisions did not have enough
incentives for funds to comply with the rule's VaR-based test).
\471\ See, e.g., Franklin Comment Letter; Dechert Comment Letter
I; ICI Comment Letter (suggesting that the implication is that a
fund must engage in pre-trade monitoring). But see J.P. Morgan
Comment Letter (suggesting pre-trade documentation by the portfolio
management team of the intended impact of the derivatives
transaction should satisfy this proposed requirement).
---------------------------------------------------------------------------
After considering comments, we are making several modifications
from the proposal. We are extending from three business days to five
business days the time period during which a fund may be out of
compliance with its VaR test without being required to report to the
fund's board and confidentially to the Commission.\472\ We appreciate
that investigating a VaR breach and taking steps to remediate it may
take more time than reducing a fund's outstanding bank borrowings,
which was the basis for the three-day period at proposal.
---------------------------------------------------------------------------
\472\ Under the rule, a fund that is not in compliance within
five business days also will be required to file a report to the
Commission on Form N-RN. See rule 18f-4(c)(7); infra section II.H.2.
---------------------------------------------------------------------------
We also are modifying the rule to provide that a fund out of
compliance with its VaR test must reduce its VaR promptly, in a manner
that is in the best interests of the fund and its shareholders, which
may exceed this five-business day period. Although a fund remaining out
of compliance with the applicable VaR test raises investor protection
concerns related to fund leverage risk, if the rule were to force a
fund to exit derivatives transactions immediately or at the end of the
five-day period, this could result in greater harm to investors. For
example, it could require the fund to realize trading losses that could
have been avoided under a more-flexible approach. Requiring the fund to
come back into compliance promptly, in a manner that is in the best
interests of the fund and its shareholders, is designed to require a
[[Page 83205]]
fund to reduce its VaR promptly but without requiring the fund to
engage in deeply discounted transactions (sometimes known as ``fire
sales'') or otherwise incur trading losses that reasonably might be
avoided while coming back into compliance in a deliberate manner that
is in the best interests of the fund and its shareholders.\473\
---------------------------------------------------------------------------
\473\ Cf. Dechert Comment Letter III (suggesting that the final
rule require a fund to reduce risk in the best interest of investors
and in line with an adviser's fiduciary responsibilities).
---------------------------------------------------------------------------
If a fund does not come back into compliance within five business
days, the remediation provision requires the fund to satisfy three
additional requirements. First, the derivatives risk manager must
provide a written report to the fund's board of directors and explain
how and by when (i.e., the number of business days) the derivatives
risk manager reasonably expects that the fund will come back into
compliance.\474\ A few commenters expressed general support for this
remediation provision because it incentivizes funds to stay in
compliance or come back into compliance with the applicable VaR
limit.\475\ However, one commenter suggested eliminating the proposed
board reporting prong of the remediation provision and replacing it
with a rule requiring funds out of compliance with the VaR-based test
to ``reduce risk in the best interest of investors and in line with an
adviser's fiduciary responsibilities.'' \476\
---------------------------------------------------------------------------
\474\ Rule 18f-4(c)(2)(iii)(A).
\475\ See, e.g., T. Rowe Price Comment Letter; AQR Comment
Letter I.
\476\ See, e.g., Dechert Comment Letter III.
---------------------------------------------------------------------------
After considering the comments received, we are adopting this
requirement as proposed other than the change from three to five
business days discussed above and a modification to require that the
board report be in writing. This requirement is designed to facilitate
the fund coming back into compliance promptly by requiring the
derivatives risk manager to develop a specific remediation course of
action and to facilitate the board's oversight by requiring the
derivatives risk manager to report this information to the board.
Second, the derivatives risk manager must analyze the circumstances
that caused the fund to be out of compliance for more than five
business days and update any program elements as appropriate to address
those circumstances.\477\ Commenters did not address this aspect of the
remediation provision. We are adopting this provision as proposed,
other than a conforming change from three to five business days
discussed above. This provision is designed to address any deficiencies
in the fund's program, which the fund's inability to come back into
compliance with the applicable VaR test within five business days may
suggest exist.
---------------------------------------------------------------------------
\477\ Proposed rule 18f-4(c)(2)(iii)(B).
---------------------------------------------------------------------------
Third, the derivatives risk manager, in a change from the proposal,
must provide a written report within thirty calendar days of the
exceedance (i.e., thirty calendar days of the fund's determination that
it is out of compliance with its applicable VaR test) to the fund's
board of directors explaining: (1) How the fund came back into
compliance; (2) the results of the derivatives risk manager's analysis
of the circumstances that caused the fund to be out of compliance for
more than five business days; and (3) any updates to the program
elements. Under the rule, if the fund remains out of compliance with
the applicable VaR test at that time, the derivatives risk manager's
written report must update the report that explained how and by when he
or she reasonably expects the fund will come back into compliance, and
the derivatives risk manager must update the board of directors on the
fund's progress in coming back into compliance at regularly scheduled
intervals at a frequency determined by the board.
In the proposal, the Commission requested comment on whether the
remediation provision should include any changes that would distinguish
funds that have more frequent or longer periods of non-compliance with
the VaR test from other funds and potentially subject them to
additional remediation provisions.\478\ A few commenters addressed this
concern.\479\ For example, one commenter stated that because of the
proposed reporting requirements to the Commission and the fund's board
of directors, any fund that has more frequent or longer periods of non-
compliance would ``immediately stand apart as an outlier'' and the
fund's board and the Commission staff could address it.\480\ Another
commenter stated that it would be unlikely a fund would intentionally
exceed the VaR limits for a specific period because of the burdens and
``potentially costly and embarrassing consequences'' of exceeding the
VaR limit beyond the remediation period.\481\ A commenter also stated
that in lieu of the proposed restriction that may address this concern,
the Commission ``has many other tools'' that can address these types of
funds including requiring reporting to the fund's board of
directors.\482\
---------------------------------------------------------------------------
\478\ See Proposing Release, supra footnote 1, at section
II.D.5.b.
\479\ See, e.g., MFA Comment Letter; ISDA Comment Letter; AQR
Comment Letter I.
\480\ See AQR Comment Letter I.
\481\ See ISDA Comment Letter; but see CFA Comment Letter.
\482\ See MFA Comment Letter.
---------------------------------------------------------------------------
After considering the comments received, we are adopting this new
written reporting requirement. This provision is designed to facilitate
appropriate board engagement and oversight when a fund is out of
compliance with its VaR test. The rule provides for this follow-up
within thirty calendar days because we anticipate that funds generally
would have mitigated VaR breaches by that time and would be in a
position to report to the board regarding the process.
For funds that are out of compliance beyond that time period, by
requiring the derivatives risk manager to update the initial board
report, the rule is designed to facilitate appropriate board oversight
and incentivize compliance with the rule's VaR-based fund leverage risk
limit. For the same reasons, the rule requires the fund's board of
directors to determine regularly scheduled intervals to meet with the
derivatives risk manager until the fund has come back into compliance
with its VaR-based test. If a fund is repeatedly out of compliance with
its applicable VaR test for more than five business days, we would
expect the fund and its board of directors to reconsider whether the
fund's derivatives risk management program is appropriately designed
and operating effectively.
Finally, we are eliminating the proposed restrictions on a fund's
ability to enter into derivatives transactions while out of compliance
with the VaR test. We appreciate the concerns commenters raised about
the negative effects this could have on a fund's ability to pursue its
strategy, to the potential detriment of shareholders. We also believe
that the requirement that the fund report to the fund's board and the
Commission when a fund's VaR exceeds the limits in its VaR test for
five business days, as well as the other aspects of the remediation
provisions, will create a strong incentive for funds to come back into
compliance without the need for the final rule to limit a fund's
investment activities in ways that could be detrimental to
shareholders. We do not believe that additional mandatory Commission
reporting is necessary because Commission staff can determine whether
and how to follow up with a fund after receiving an initial report on
Form N-RN. The fund also must report confidentially to the Commission
on Form N-RN once it
[[Page 83206]]
comes back into compliance. This allows the Commission to monitor the
length of time that a fund has been out of compliance and the fund's
progress in coming back into compliance. We expect that this monitoring
would include staff outreach to a fund concerning its remediation plans
where the fund has remained out of compliance for a longer period of
time.
Many commenters supported the Form N-RN reporting requirement as an
appropriate adjunct to the rule's remediation provision, facilitating
regulatory monitoring by the Commission.\483\ One commenter, however,
suggested removing the Form N-RN reporting requirement due to fund
sensitivities regarding having to immediately report to the
Commission.\484\ This commenter expressed concern that to avoid this
reporting requirement a fund may engage in ``fire sales'' during
stressed market conditions that may contribute to additional systemic
risk from portfolio managers selling into a volatile market and
realizing losses during a period where transaction costs may be higher.
---------------------------------------------------------------------------
\483\ See, e.g., J.P. Morgan Comment Letter; Dechert Comment
Letter I; ICI Comment Letter; Invesco Comment Letter; SIFMA AMG
Comment Letter; Nuveen Comment Letter. But see ISDA Comment Letter
(suggesting that the board reporting requirement under the proposed
remediation provision is sufficient and SEC reporting on Form N-RN
is not necessary).
\484\ See Dechert Comment Letter III (suggesting that some of
the proposed Form N-RN reporting information could be required on
Form N-PORT, which would provide this information to the Commission
on a more time delayed basis). Although this commenter stated that
it ``would eliminate the SEC reporting requirement on Form N-RN and
the board reporting requirement immediately post a [VaR] limit
breach,'' the commenter's concern appeared focused on filing Form N-
RN because the commenter later observed in its letter that ``[i]t is
the immediate SEC posting [on Form N-RN], not the [b]oard reporting
requirement, which creates the sense of urgency and may cause forced
selling not in the best interest of the fund.''
---------------------------------------------------------------------------
After considering comments, the final rule, consistent with the
proposal, will require a fund that is not in compliance with the
applicable VaR test within five business days after determining it is
out of compliance to report this to the Commission on Form N-RN.\485\
We believe this requirement is important for facilitating appropriate
regulatory oversight of fund leverage risk and compliance with the
rule. This requirement is designed to provide the Commission with
current information regarding potential increased risks and stress
events (as opposed to delayed reporting on Form N-PORT), as discussed
in more detail below.\486\ We have modified the rule expressly to
require a fund that is promptly coming back into compliance with the
applicable VaR test to do so in a manner that is in the best interests
of the fund and its shareholders. A fund engaging in ``fire sales'' to
avoid filing a report on Form N-RN would violate the final rule.
---------------------------------------------------------------------------
\485\ See infra section II.G.2 (discussing Form N-RN disclosure
reporting requirements).
\486\ Id.
---------------------------------------------------------------------------
E. Limited Derivatives Users
Consistent with the proposal, rule 18f-4 includes an exception from
the rule's requirements to adopt a derivatives risk management program,
comply with the VaR-based limit on fund leverage risk, and comply with
the related board oversight and reporting provisions for funds that use
derivatives in a limited manner (collectively, the ``VaR and program
requirements'').\487\ Requiring funds that use derivatives only in a
limited way to comply with these requirements could potentially require
funds (and therefore their shareholders) to incur costs and bear
compliance burdens that may be disproportionate to the resulting
benefits.\488\ We recognize that the risks and potential effect of
derivatives transactions on a fund's portfolio generally increase as
the fund's level of derivatives usage increases and when a fund uses
derivatives for speculative purposes. The rule's limited derivatives
user exception is designed to provide an objective standard to identify
funds that use derivatives in a limited manner.
---------------------------------------------------------------------------
\487\ One commenter observed that if a limited derivatives user
is exempt from the rule's requirements to establish a derivatives
risk management program and comply with the VaR-based limit on fund
leverage risk, it seems implicit that the fund also would be exempt
from the related board oversight and reporting requirements that are
only relevant to funds that are required to establish a derivatives
risk management program. See NYC Bar Comment Letter. The final rule
clarifies this point by expressly providing that a limited
derivatives user is not subject to the related board oversight and
reporting requirements in rule 18f-4. See rule 18f-4(c)(4)(i).
\488\ The cost burden concern extends to smaller funds as well,
which could experience an even more disproportionate cost than
larger funds.
---------------------------------------------------------------------------
Commenters supported the proposed limited derivatives user
exception, and we are adopting it with certain modifications in
response to comments.\489\ Under the final rule, the exception will be
available to a fund that limits its derivatives exposure to 10% of its
net assets. A fund may exclude from the 10% threshold derivatives
transactions that are used to hedge certain currency and/or interest
rate risks and positions closed out with the same counterparty.\490\ A
fund that relies on the exception will be required to adopt policies
and procedures that are reasonably designed to manage its derivatives
risks.\491\ The rule also contains remediation provisions to address
instances in which a fund exceeds the 10% threshold.\492\ We discuss
each element of the exception below.
---------------------------------------------------------------------------
\489\ See, e.g., ICI Comment Letter; Comment Letter of Gateway
Investment Advisers, LLC (Mar. 24, 2020) (``Gateway Comment
Letter''); SIFMA AMG Comment Letter; Comment Letter of TPG Specialty
Lending (Apr. 2, 2020) (``TPG Comment Letter''); T. Rowe Price
Comment Letter.
\490\ See rule 18f-4(c)(4).
\491\ See rule 18f-4(c)(4)(i).
\492\ See rule 18f-4(c)(4)(ii).
---------------------------------------------------------------------------
1. Derivatives Exposure
The final rule defines the term ``derivatives exposure'' to mean
the sum of: (1) The gross notional amounts of a fund's derivatives
transactions such as futures, swaps, and options; and (2) in the case
of short sale borrowings, the value of any asset sold short.\493\ We
are adopting this aspect of the rule as proposed, except with a
modification clarifying that derivatives instruments that do not
involve future payment obligations--and therefore are not a
``derivatives transaction'' under the rule--are not included in a
fund's derivatives exposure.\494\ Further, although commenters seemed
to assume that derivatives exposure was to be calculated on a gross
basis in the proposed rule, the final rule expressly requires
derivatives exposure to be based on ``gross'' notional amounts.\495\
This is designed to make clear that a fund's derivatives exposure must
include the sum of the absolute values of the notional amounts of the
fund's derivatives transactions, rather than a figure based on
calculations that net long and short positions. In addition, because
the final rule permits a fund to treat reverse repurchase agreements or
similar financing transactions as derivatives transactions under
certain circumstances, a fund treating these transactions as
derivatives transactions also must include in its derivatives exposure
the proceeds that the fund received but has not yet repaid or returned,
or for which the associated liability has not been extinguished, in
connection with each such transaction.\496\ The derivatives exposure
definition is designed to provide a measure of the market exposure
associated with a limited derivative user's derivatives transactions.
---------------------------------------------------------------------------
\493\ See rule 18f-4(a).
\494\ See rule 18f-4(a).
\495\ Id.
\496\ See rule 18f-4(a); see also rule 18f-4(d)(1)(ii); Item
B.9.e of Form N-PORT.
---------------------------------------------------------------------------
Using gross notional amounts to measure market exposure could be
[[Page 83207]]
viewed as a relatively blunt measurement, as discussed in the Proposing
Release.\497\ The derivatives exposure threshold in the limited
derivatives user exception, however, is not designed to provide a
precise measure of a fund's market exposure or to serve as a risk
measure. Rather it is designed to serve as an efficient way to identify
funds that use derivatives in a limited way. Commenters supported
permitting the inclusion of an exception from the VaR and program
requirements for funds that engage in derivatives transactions to a
limited extent, based on a fund's derivatives exposure.\498\
---------------------------------------------------------------------------
\497\ See Proposing Release supra footnote 1, at 149.
\498\ See, e.g., Comment Letter of the Options Clearing
Corporation (Apr. 15, 2020) (``OCC Comment Letter''); T. Rowe Price
Comment Letter.
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a. Adjustments for Interest Rate Derivatives and Options
Like the proposed rule, the final rule permits funds to make two
adjustments designed to address certain limitations associated with
notional measures of market exposure. The commenters who addressed
these adjustments supported them.\499\ Specifically, the first
adjustment permits a fund to convert the notional amount of interest
rate derivatives to 10-year bond equivalents, and the second adjustment
permits a fund to delta adjust the notional amounts of options
contracts.\500\ Converting interest rate derivatives to 10-year bond
equivalents will provide for greater comparability of the notional
amounts of different interest rate derivatives that provide similar
exposure to changes in interest rates but that have different
unadjusted notional amounts. Absent this adjustment, short-term
interest rate derivatives in particular can produce large unadjusted
notional amounts that may not correspond to large exposures to interest
rate changes. Permitting funds to convert these and other interest rate
derivatives to 10-year bond equivalents is designed to result in
adjusted notional amounts that better represent a fund's exposure to
interest rate changes. Similarly, permitting delta adjusting of options
is designed to provide for a more tailored notional amount that better
reflects the exposure that an option creates to the underlying
reference asset. Further, providing these adjustments also would be
efficient for some funds because the adjustments are consistent with
the reporting requirements in Form PF and Form ADV.\501\
---------------------------------------------------------------------------
\499\ See OCC Comment Letter (stating that ``allowing a fund to
delta-adjust the notional amount of a listed options contract allows
the fund to get a more accurate picture of its exposure to the
underlying security or index''); see also ISDA Comment Letter.
\500\ Delta refers to the ratio of change in the value of an
option to the change in value of the asset into which the option is
convertible. A fund would delta adjust an option by multiplying the
option's unadjusted notional amount by the option's delta.
\501\ See, e.g., General Instruction 15 to Form PF; Item B.30 of
Section 2b of Form PF; Glossary of Terms, Gross Notional Value of
Form ADV; Schedule D of Part 1A of Form ADV.
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b. Closed-Out Derivatives Positions
Several commenters stated that the rule should allow for netting of
offsetting derivatives transactions when calculating a fund's
derivatives exposure.\502\ They asserted that permitting a fund to
calculate its derivatives exposure by netting offsetting derivatives
positions is necessary to more accurately identify the fund's market
exposure through derivatives.\503\ Commenters stated that a derivatives
transaction previously executed by a fund is often exited through the
fund's execution of an identical but offsetting transaction and that
this process is a useful tool in controlling a fund's derivatives
exposure.\504\ Some commenters favored incorporating a broad use of
netting, for instance, allowing netting of offsetting derivatives
holdings with different counterparties.\505\ Other commenters suggested
that the rule should allow for netting only for offsetting transactions
with the same counterparty.\506\
---------------------------------------------------------------------------
\502\ See, e.g., Angel Oak Comment Letter; Dechert Comment
Letter I; Guggenheim Comment Letter; T. Rowe Price Comment Letter.
\503\ See, e.g., Guggenheim Comment Letter; ICI Comment Letter;
Invesco Comment Letter; ISDA Comment Letter; Angel Oak Comment
Letter; Dechert Comment Letter I.
\504\ See, e.g., T. Rowe Price Comment Letter; Invesco Comment
Letter; Guggenheim Comment Letter.
\505\ See, e.g., ICI Comment Letter; Invesco Comment Letter.
\506\ Guggenheim Comment Letter; SIFMA AMG Comment Letter.
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We recognize that, in certain circumstances, funds seeking to exit
a derivatives position may enter into a directly offsetting position to
eliminate the fund's market exposure. Accordingly, we are modifying the
proposed ``derivatives exposure'' definition in the final rule to allow
a fund to exclude from its derivatives exposure any closed-out
positions. These positions must be closed out with the same
counterparty and must result in no credit or market exposure to the
fund.\507\
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\507\ Rule 18f-4(a). In addition, the final rule's approach to
offsetting positions is consistent with the way advisers report
derivatives exposures on Form PF, which may provide some
efficiencies where these advisers also manage funds that are limited
derivatives users.
---------------------------------------------------------------------------
The final rule does not, however, permit a fund to exclude offset
positions across different counterparties. This could result in the
fund having a large volume of open derivatives positions subject to
their own margin and other requirements with various counterparties.
For example, when a fund must make margin or collateral payments on a
derivatives transaction to one counterparty, and has not yet received
payments from an offsetting transaction from a different counterparty,
the fund might have to sell investments to raise cash for these
purposes. This could result from differences in the timing of required
payments, effects of margin thresholds or minimum transfer amounts for
the exchange of margin or collateral, or other reasons. These
transactions could involve a scale of derivatives positions and related
operational and counterparty risks that we believe should be managed as
part of a fund's derivatives risk management program.
2. Limited Derivatives User Threshold
A fund will qualify as a limited derivatives user under the rule if
its derivatives exposure does not exceed 10% of its net assets. As
discussed in more detail above, a fund's derivatives exposure is based
primarily on the gross notional amounts of a fund's derivatives
transactions such as futures, swaps, and options, subject to certain
adjustments. In addition, and in a change from the proposal, the final
rule permits a fund to exclude certain currency and interest rate
hedges from the 10% threshold. This threshold is designed to provide an
objective standard to identify funds that use derivatives in a limited
manner.
a. 10% Derivatives Exposure Threshold
The Commission proposed a 10% derivatives exposure threshold based
in part on staff analysis of funds' practices regarding derivatives use
based on Form N-PORT filings. Specifically, DERA staff's analysis in
connection with the proposal showed that 78% of funds had adjusted
notional amounts below 10% of NAV; 80% of funds had adjusted notional
amounts below 15% of NAV; 81% of funds had adjusted notional amounts
below 20% of NAV; and 82% of funds had adjusted notional amounts below
25% of NAV.\508\ One commenter conducted a survey of funds' derivatives
[[Page 83208]]
exposure and found similar results.\509\ Although BDCs are not required
to file reports on Form N-PORT, our staff separately analyzed a
sampling of 48 BDCs and found that of the sampled BDCs, 54% did not
report any derivatives holdings and a further 29% reported using
derivatives with gross notional amounts below 10% of net assets.\510\
Commenters did not provide alternative data regarding the extent to
which BDCs use derivatives in the context of the limited derivatives
user exception.
---------------------------------------------------------------------------
\508\ See Proposing Release supra footnote 1, at 151 (citing
data based on Form N-PORT filings from September 2019). These
figures, as well as the updated figures provided below, include
funds that did not report any derivatives transactions.
\509\ See ICI Comment Letter (asserting that ``75 percent of
respondents (3,940 out of 5,228 funds) indicated that, as of
December 31, 2019, they would have qualified as limited derivative
users'').
\510\ See Proposing Release supra footnote 1, at 151-52.
---------------------------------------------------------------------------
The 10% threshold the Commission proposed took these findings into
account, including the Commission's observation that setting the
threshold at 10%, 15%, 20%, or 25%, for example, seemed likely to
result in nearly the same percentages of funds qualifying for the
exception. Since the proposal, DERA staff updated their analysis of
funds' use of derivatives based on September 2020 Form N-PORT filings.
The results of the updated analysis are similar to the findings at
proposal, with the updated analysis reflecting that 79% of funds had
adjusted notional amounts below 10% of NAV; 81% of funds had adjusted
notional amounts below 15% of NAV; 82% of funds had adjusted notional
amounts below 20% of NAV; and 83% of funds had adjusted notional
amounts below 25% of NAV. Similarly, our staff updated their analysis
of the use of derivatives by BDCs. Of the 48 BDCs sampled at proposal
(or their successor funds), updated data reflects that 59.1% did not
report any derivatives holdings, and a further 31.8% reported using
derivatives with gross notional amounts below 10% of net assets. Four
of the BDCs sampled used derivatives more extensively, when measured on
a gross notional basis, mainly due to their use of currency forwards
and/or interest rate swaps. However, as proposed, the final rule
permits a fund to convert the notional amount of interest rate
derivatives to 10-year bond equivalents.\511\ Further, as discussed in
more detail below, and in a change from the proposal, a fund may
exclude currency and interest rate derivatives from the 10% derivatives
exposure threshold if these transactions meet certain criteria for
hedging under the final rule. Most commenters generally supported the
limited derivatives user exception but did not comment specifically on
the proposed 10% threshold. One commenter, however, suggested that a
fund with derivatives exposure up to 20% or 25% of net assets should be
permitted to rely on this exception absent data indicating harm would
result from a higher threshold.\512\ This commenter stated that
distressed or volatile market conditions could make it difficult for
funds to consistently maintain a derivatives exposure of less than 10%.
---------------------------------------------------------------------------
\511\ See rule 18f-4(a); see also supra section II.E.1.a. Our
staff did not have access to sufficient information to adjust the
notional amounts of the BDCs' interest rate derivatives.
\512\ See ISDA Comment Letter.
---------------------------------------------------------------------------
We are adopting the proposed 10% derivatives exposure threshold
rather than a higher figure, like 25%, because we believe the 10%
exposure level is likely to result in nearly the same percentage of
funds qualifying for the exception based on current practices. The 10%
threshold will provide greater investor protections than a 25%
threshold, for example, without a materially greater compliance burden
on funds, since only 4% more funds would be subject to the derivatives
risk management program at the 25% threshold. Further, we believe that
a fund that maintains derivatives exposure at 10% or below is using
derivatives in a limited manner, whereas a fund that has derivatives
exposure near 20% or 25% of its net assets is more likely to present
risks that we believe should be managed as part of a derivatives risk
management program. For instance, we believe that it is important that
a fund with derivatives exposure near 20% or 25% is subject to the
periodic stress testing requirement of the derivatives risk management
program.\513\ For example, although the final rule permits a fund to
delta adjust options because we believe this provides for a more
tailored notional amount, delta-adjusting options also creates the risk
that the size of a fund's investment exposure can increase quickly as
market conditions change, including in times of stress. The final
rule's stress testing requirement will result in the fund manager
developing a more complete understanding of the fund's potential losses
during distressed or volatile market conditions, such as those related
to the recent COVID-19 global health pandemic.
---------------------------------------------------------------------------
\513\ See infra section II.B.2.c (discussing the stress testing
requirements of the derivatives risk management program).
---------------------------------------------------------------------------
b. The 10% Derivatives Exposure Threshold Excludes Certain Hedging
Transactions
In a modification of the proposal, the final rule allows a fund to
exclude certain hedging transactions from the 10% derivatives exposure
threshold. The proposed rule, in contrast, included two mutually-
exclusive bases for relying on the limited derivatives user exception.
The first prong of the proposed exception would have excluded funds
when their derivatives exposure is less than 10% of net assets. The
second prong would have excluded funds that limited their derivatives
use solely to certain currency hedging transactions. The Commission
observed that using currency derivatives solely to hedge currency risk
does not raise the policy concerns underlying section 18.
Commenters urged the Commission to combine the proposed exposure-
based and currency hedging exceptions by allowing a fund to exclude
currency hedges from the derivatives exposure calculation.\514\
Commenters stated that requiring a limited derivatives user to choose
between these exceptions could require funds that use derivatives in a
limited way nevertheless to incur the costs and compliance burdens of
complying with the VaR and program requirements.\515\ For example,
several commenters were concerned that, under the proposal, a fund with
currency derivatives exposure exceeding 10% of the fund's net assets
would be unable to use a single derivative for any other purpose while
remaining a limited derivatives user.\516\ The fund would have to
either leave its foreign-currency denominated investments unhedged or,
if it hedged its currency risk, forgo even a limited use of non-
currency hedging derivatives.\517\ Commenters also stated that, because
they believed that currency hedging derivatives permitted in the
proposed exception do not raise section 18 policy concerns, excluding
currency hedging derivatives from the 10% derivatives exposure
threshold would not raise additional risks that need to be managed
under a derivatives risk management program.\518\
---------------------------------------------------------------------------
\514\ See, e.g., ICI Comment Letter; Dechert Comment Letter I;
TPG Comment Letter.
\515\ See, e.g., ICI Comment Letter; Calamos Comment Letter.
\516\ See, e.g., ICI Comment Letter; T. Rowe Price Comment
Letter; TPG Comment Letter.
\517\ Dechert Comment Letter I; ICI Comment Letter (stating that
this ``is inefficient and likely detrimental to a fund's returns and
could create more risk for the fund'').
\518\ See, e.g., Vanguard Comment Letter; ICI Comment Letter.
---------------------------------------------------------------------------
Several commenters also suggested broadening the scope of the
exclusion to
[[Page 83209]]
include interest rate hedging that corresponds directly to a specific
cash-market instrument held by the fund.\519\ Some commenters stated
that they routinely enter into fixed-to-floating interest rate swaps
(or vice versa) and that these transactions are matched to the notional
amount and maturity of a specific security in the fund's
portfolio.\520\ These commenters asserted that such matched interest
rate hedging is conceptually the same as the currency hedging that the
proposed exception would permit because the transactions are easily
identified as a hedge, offset a single risk (interest rate risk), and
are tied to a specific instrument in a fund's portfolio.\521\
---------------------------------------------------------------------------
\519\ See, e.g., SIFMA AMG Comment Letter; ISDA Comment Letter.
\520\ See, e.g., SIFMA AMG Comment Letter; TPG Comment Letter.
\521\ See, e.g., Guggenheim Comment Letter; TPG Comment Letter.
---------------------------------------------------------------------------
After considering comments, we are permitting funds to exclude
certain currency and interest rate hedges from the 10% derivatives
exposure threshold, in the final rule.\522\ While distinguishing most
hedging transactions from leveraged or speculative derivatives
transactions is challenging, the rule limits this exclusion to interest
rate or currency hedging transactions directly matched to particular
investments held by the fund, or the principal amount of borrowings by
the fund. We believe these currency and interest rate derivatives are
appropriate for limited derivatives users because they will predictably
and mechanically provide the anticipated hedging exposure without
giving rise to basis risks or other potentially complex risks that
should be managed as part of a derivatives risk management program.
---------------------------------------------------------------------------
\522\ See rule 18f-4(c)(4)(i)(B).
---------------------------------------------------------------------------
Accordingly, under the final rule a fund may exclude currency and
interest rate derivatives used to hedge the respective currency and
interest rate risks associated with specific equity or fixed-income
investments held by the fund or borrowings by the fund. In the case of
currency hedges, the equity or fixed-income investments being hedged
must be foreign-currency-denominated. These derivatives must be entered
into and maintained by the fund for hedging purposes. The notional
amounts of such derivatives may not exceed the value of the hedged
instruments (or the par value thereof, in the case of fixed-income
investments, or the principal amount, in the case of borrowings) by
more than 10%. These requirements are substantially similar to the
proposal's currency hedging exception, except the proposal provided
that the derivative's notional amount could not exceed the value of the
hedged investment by more than a ``negligible amount'' instead of
10%.\523\
---------------------------------------------------------------------------
\523\ See proposed rule 18f-4(c)(3).
---------------------------------------------------------------------------
Several commenters urged that we replace a ``negligible amount''
with a fixed numerical value to provide greater clarity and facilitate
compliance.\524\ Many commenters suggested that a 10% numerical value
would be consistent with the limited derivatives user exception's 10%
derivatives exposure threshold.\525\ Commenters stated that there are
situations, such as shareholder redemptions or fluctuations in the
market value of a hedged investment, that can temporarily cause the
notional amounts of the hedges to exceed the value of the hedged
investments by more than a negligible amount.\526\
---------------------------------------------------------------------------
\524\ See, e.g., BlackRock Comment Letter; Dechert Comment
Letter I.
\525\ See, e.g., BlackRock Comment Letter; ICI Comment Letter.
\526\ See Invesco Comment Letter.
---------------------------------------------------------------------------
After considering these comments, we have modified the proposal to
replace ``negligible amount'' with a 10% threshold in the final rule.
We are not taking the position that this threshold reflects a
negligible amount. Rather, this change is designed to provide an
unambiguous numerical value to facilitate compliance. Setting the level
at 10%, as opposed to a lower value like 5% or 3%, also will avoid
funds frequently trading (and incurring the attendant costs) to resize
their hedges in response to small changes in value of the hedged
investments. If the notional amount of a derivatives transaction
exceeds the value of the hedged investments by more than 10%, however,
it will no longer qualify as a hedge under the limited derivatives user
exception.
One commenter urged that the final rule refer simply to foreign-
currency denominated ``investments,'' rather than ``foreign-currency-
denominated equity or fixed-income investments.'' \527\ The commenter
stated that certain investments, such as foreign currency itself, may
not constitute an equity or fixed-income investment. We have not made
this modification because we understand, based on our staff's analysis
of Form N-PORT filings, that funds rarely hold foreign currency in such
significant amounts, and for an extended period, that they would hedge
this currency risk. Moreover, we believe that a rule that refers
specifically to ``equity or fixed-income investments'' is appropriate
because, absent this limitation, a fund could enter into derivatives
transactions to hedge the risks associated with other derivatives
transactions. We view using derivatives to hedge the risks of a fund's
cash-market investments, in contrast, as more consistent with
``limited'' derivatives use.
---------------------------------------------------------------------------
\527\ Invesco Comment Letter. This commenter also asserted that,
although denominated in U.S. dollars, investors in American
depositary receipts (``ADRs'') are exposed to currency risk
equivalent to that incurred by investing directly in the foreign
security held in the ADR and that it would therefore be appropriate
to ``look through'' the ADR to the underlying foreign security for
purposes of identifying currency hedges under the rule. We agree.
---------------------------------------------------------------------------
c. Certain Suggested Transactions Not Excluded From the 10% Derivatives
Exposure Threshold
We have not further expanded the limited derivatives user exception
as some commenters urged to include additional hedging or other
transactions. We understand that certain other derivatives strategies
could mitigate funds' portfolio risks. The exception is not meant to
provide parameters for hedging generally or to provide a comprehensive
list of transactions that may pose more limited or defined risks. The
final rule's limited derivatives user exception, however, is designed
to provide an objective standard to identify funds that use derivatives
in a limited manner and help facilitate compliance with the rule.\528\
Unlike the currency and interest rate hedges discussed above, other
transactions commenters suggested may not always predictably and
mechanically provide the anticipated hedging exposure without giving
rise to basis risks or many other potentially complex risks that we
believe should be managed as part of a derivatives risk management
program. Moreover, if we were to permit funds to engage in some or all
of these transactions, as some commenters suggested, that could result
in a fund obtaining derivatives exposure up to the 10% threshold while
also engaging in a range of other transactions. We do not believe this
would represent a limited use of derivatives that should be exempted
from the rule's derivatives
[[Page 83210]]
risk management program and VaR requirements. We discuss commenters'
specific suggestions below.
---------------------------------------------------------------------------
\528\ The challenges of distinguishing between hedging and
speculative activity have been considered in numerous regulatory and
financial contexts. For example, the exemption for certain risk-
mitigating hedging activities from the prohibition on proprietary
trading by banking entities in the rules implementing section 13 of
the Bank Holding Company Act (commonly known as the ``Volcker
Rule''). See Prohibitions and Restrictions on Proprietary Trading
and Certain Interests in, and Relationships With, Hedge Funds and
Private Equity Funds, Release No. BHCA-1 (Dec. 10, 2013) 79 FR 5536
(Jan. 31, 2014), at 5629, 5627. The complexity of distinguishing
hedging from speculation in this context is notable because the
exemption is designed for entities that would not otherwise be
engaged in speculative activity.
---------------------------------------------------------------------------
Some commenters stated that certain derivatives transactions used
for hedging purposes but not directly matched to a particular
instrument in the fund's portfolio should be excluded from a fund's 10%
derivatives exposure threshold. For instance, a few commenters
requested an exclusion for duration hedging, which is used primarily by
fixed-income funds to manage their exposure to interest rate
fluctuations.\529\ We are not including duration hedging and similar
transactions in the rule because, in contrast to the currency and
interest rate hedging permitted under the exclusion, duration hedging
is not directly matched to a particular instrument in a fund's
portfolio, but rather seeks to modify a portfolio's general interest
rate exposure. Duration hedging can involve more complex hedging
activities than the hedging transactions permitted under the final
rule, which are tied to specific securities held by the fund. Duration
hedging therefore can require a degree of sophistication to implement
and manage.\530\ For these reasons, we believe that a fund that engages
in these transactions, to a sufficient degree, should address these
transactions as part of the fund's derivatives risk management program
and in its compliance with the final rule's VaR requirements.
---------------------------------------------------------------------------
\529\ For example, if a portfolio has a duration of five
(meaning that for every 1% increase in interest rates, the value of
the portfolio will decline by 5%), interest rate derivatives could
be used to reduce that sensitivity to a lower rate (for example, 2%
or 3%). See Guggenheim Comment Letter; see also SIFMA AMG Comment
Letter.
\530\ See, e.g., Robert Daigler, Mark Copper, A Futures
Duration-Convexity Hedging Method, 33 The Financial Review 61 (1998)
(discussing the limitations and complexities of duration hedging).
---------------------------------------------------------------------------
Further, several commenters requested that purchased single-name
credit default swaps be excluded.\531\ Commenters asserted that these
swaps are used to hedge a single risk factor, credit risks.\532\
Although these derivatives transactions may be tied to a particular
reference asset held by the fund, we are not excluding these
transactions from a fund's 10% derivatives exposure threshold. Market
value changes in the fund's investment in the reference asset may not
be offset precisely by changes in value of, or payment amounts under,
the credit default swap. Further, credit default swaps are typically
administered and governed by procedures and documents established by
the International Swaps and Derivatives Association (``ISDA''), a third
party separate from the parties to the transaction. The ISDA procedures
may determine whether the issuer has experienced a credit event that
triggers a payment from the seller of protection. These determinations
will affect whether a fund receives a payment from the protection
seller in the event of a possible credit event. The specific credit
events for a given credit default swap also can affect the swap's value
or its payment amount and, accordingly, can introduce basis risk
between the swap and an investment held by the fund. These mismatches
can occur particularly if the fund holds a security issued by the
entity referenced in the credit default swap but not the exact
reference obligation used by the relevant ISDA procedure. A credit
default swap therefore will not always predictably and mechanically
provide the anticipated hedging exposure without giving rise to basis
risks or other risks that, if incurred in sufficient size, should be
managed as part of a derivatives risk management program.
---------------------------------------------------------------------------
\531\ See, e.g., ICI Comment Letter, ISDA Comment Letter; SIFMA
AMG Comment Letter.
\532\ See, e.g., SIFMA AMG Comment Letter; see also Guggenheim
Comment Letter.
---------------------------------------------------------------------------
Separately, one commenter asserted that after the initial premium,
a purchased single-name credit default swap only obligates a fund to
pay a regularly-scheduled coupon at a rate fixed on trade date.\533\
The commenter urged treating this transaction as an unfunded commitment
agreement under the rule. We are not taking this approach. We believe
that purchased single-name credit default swaps are derivatives
instruments and are distinguishable from unfunded commitment
agreements. For example, they involve investment risks during the life
of the transaction as the value of the swap changes as perceptions of
the credit risk of the entity that the swap references change.\534\
Credit default swaps, including purchased credit default swaps, provide
the ability to take unfunded positions in an issuer's credit risk with
a future payment obligation that can create leverage and other
risks.\535\ We therefore are not excluding purchased credit default
swaps from a fund's 10% derivatives exposure threshold the final rule.
---------------------------------------------------------------------------
\533\ See Guggenheim Comment Letter (further stating that if
``the reference issuer fails during the term of the trade, an
auction settlement process will unfold pursuant to which the fund
will receive a cash payment equal to the difference (if greater than
zero) between the par value of the reference issuer's debt and the
auction-determined price of such debt'').
\534\ See footnote 751 and accompanying text for further
discussion of the differences between derivatives transactions and
unfunded commitment agreements.
\535\ See, e.g., In the Matter of UBS Willow Management L.L.C.
and UBS Fund Advisor L.L.C., Investment Company Act Release No.
31869 (Oct. 16, 2015) (settled action) (involving a registered
closed-end fund that incurred significant losses due in part to
large losses on the fund's purchased credit default swap portfolio).
---------------------------------------------------------------------------
Additionally, commenters suggested that covered call options and
certain purchased option spreads should be excluded from a fund's 10%
derivatives exposure threshold.\536\ Commenters asserted that for these
transactions, the potential future payment obligation is fully covered
either by shares the fund already owns, in the case of a covered call
option, or by offsetting purchased options, in the case of a purchased
option spread.\537\ Although these transactions have a defined risk
tied to an investment held by the fund, they may be used for
speculative purposes, which makes it difficult to categorically
classify these derivatives transactions as hedges. Further, we do not
believe that it is appropriate or feasible for the limited derivatives
user exception to identify all derivatives instruments or combinations
of derivatives instruments that may mitigate a defined risk in the fund
or a fund position considered in isolation. We therefore have not
modified the rule as these commenters suggested.
---------------------------------------------------------------------------
\536\ See, e.g., Dechert Comment Letter I; Franklin Templeton
Comment Letter; ICI Comment Letter.
\537\ See Franklin Templeton Comment Letter.
---------------------------------------------------------------------------
Similarly, one commenter expressed the view that the Commission
should exclude any derivatives transactions from the 10% derivatives
exposure threshold if a fund earmarks liquid assets equal to the
derivatives' full notional obligations.\538\ The commenter suggested
that this approach would allow funds to engage in hedging transactions
while keeping fund leverage ratios low, at 200% or below. The approach
suggested by the commenter would allow a fund to engage in a
potentially significant amount of derivatives transactions while
remaining a limited derivatives user. Although these transactions may
be ``unelaborate'' in some cases, as described by the commenter,\539\
these transactions could be used to leverage a fund's portfolio and
could be used to introduce significant risk. We believe that funds
engaging in such a level of derivatives activity should comply with the
VaR and program requirements. We therefore have not modified the rule
as the commenter suggested.
---------------------------------------------------------------------------
\538\ Keen Comment Letter.
\539\ Id.
---------------------------------------------------------------------------
One commenter also requested that the exclusion include synthetic
positions where a fund holds cash with
[[Page 83211]]
a value equal to the notional amount of derivatives held by the fund,
less any posted margin.\540\ This commenter asserted that a fund's use
of synthetic derivatives should be excluded because they do not create
leverage. We understand that funds may use derivatives to create
synthetic positions to replicate a cash-market exposure in a given
security or group of securities. However, based on Commission staff's
experience, we understand that there could be events that cause these
synthetic positions to behave differently than the equivalent cash-
market position. For instance, an equity swap may contain a complex
merger event or potential adjustment event where the consequences
diverge from the desired consequences available to a cash-market
investor. For example, a swap contract may terminate upon a valid
tender offer for the underlying stock. A swap dealer also may terminate
a transaction due to the dealer's inability to continue to hedge its
market exposure under the swap or due to increased hedging costs. These
kinds of events could lead to an early termination of a synthetic
position prior to the desired liquidation of the related cash-market
investment. Further, the ability to adjust a fund's position in such a
swap may be more limited than its adjustment of cash-market
investments.
---------------------------------------------------------------------------
\540\ Fidelity Comment Letter (stating that these synthetic
positions are ``routinely used by funds to fully invest shareholder
funds where access to a particular market may be limited at any
given time, or to manage large flows into a fund'').
---------------------------------------------------------------------------
Moreover, although we believe that a derivatives transaction's
notional amount is an appropriate means of measuring derivatives
exposure for purposes of the limited derivatives user exception, the
notional amount is not a risk measure and may not appropriately reflect
the derivative's market exposure in all cases, such as with respect to
certain complex derivatives.\541\ This commenter's suggestion would
permit a fund to obtain substantially more derivatives exposure than
permitted under the 10% threshold--with exposure theoretically up to
100% of the fund's net assets--increasing the likelihood that the fund
could incur substantial derivatives risks without establishing a
derivatives risk management program or complying with the rule's VaR
test requirements. We do not believe this would be a sufficiently
limited use of derivatives that it should not be subject to those
requirements. For these reasons we are not excluding synthetic
positions from the 10% derivatives exposure threshold in the exception.
---------------------------------------------------------------------------
\541\ See, e.g., 2015 Proposing Release, supra footnote 1, at
n.175 and accompanying discussion.
---------------------------------------------------------------------------
One commenter suggested calculating each derivatives transaction's
impact on VaR as an alternative method for identifying hedging
transactions that a fund would exclude from its 10% derivatives
exposure threshold. If the incremental VaR calculation is negative, the
derivatives transaction reduces the fund's risk profile and should
therefore be deemed to fall within the hedging-based exclusion.\542\ As
we discuss above, VaR can be used to analyze whether a fund is using
derivatives transactions to leverage the fund's portfolio. VaR is just
one risk management tool, however, and we believe that it is more
effective if supplemented with other measures.\543\ This commenter's
suggestion could involve funds taking on substantial derivatives
exposure based on VaR calculations without complying with the other
aspects of the rule, like stress testing, that are designed to
complement VaR. This is because an approach based solely on VaR could
identify derivatives transactions as reducing a fund's risk based on
historical correlations that could break down, including in periods of
market stress or the trading days during which the greatest losses
occur (i.e., the ``tail risks'' that VaR does not measure).
---------------------------------------------------------------------------
\542\ Angel Oak Comment Letter (stating that the ``risk of [the]
overall portfolio should be reduced after the hedging transactions
are executed'').
\543\ See supra section II.D.1, at footnotes 297-299 and the
accompanying paragraph.
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Finally, one commenter urged that we expand the limited derivatives
user exception to exclude commodity hedging from a fund's derivatives
exposure.\544\ Funds typically do not invest directly in commodities,
however, and this suggestion could, for example, involve funds hedging
the exposure created from investments in commodity derivatives with
other commodity derivatives. We recognize that the parties to certain
commodity derivatives transactions (like commodity futures and options
on those futures) may view these transactions as hedged in that they
may be delta neutral.\545\ If these positions remain delta neutral,
losses on one of the positions will be offset by gains on the other.
However, these transactions continue to pose risks that may be
significant. For instance, as certain factors change over time, such as
the price of the underlying asset and/or the interest rate, the
underlying delta can change quickly, introducing risk that will no
longer be offset by the other position. Accordingly, we believe these
transactions, if incurred in sufficient size, should be addressed
through the rule's derivatives risk management program and VaR test
requirements.
---------------------------------------------------------------------------
\544\ See Guggenheim Comment Letter.
\545\ As an example, if a fund sells a put option on natural gas
futures and also sells those same futures contracts, and the amount
of the sold futures contracts equals the delta of the sold option,
these positions will be ``delta neutral.''
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3. Risk Management
A fund relying on the limited derivatives user exception, as
proposed, will be required to manage the risks associated with its
derivatives transactions by adopting and implementing written policies
and procedures that are reasonably designed to manage the fund's
derivatives risks.\546\ The requirement that funds relying on the
exception manage their derivatives risks recognizes that even a limited
use of derivatives can present risks that a fund should manage.
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\546\ See rule 18f-4(c)(4)(i)(A). We are adopting the definition
of derivatives risks as proposed, including the requirement that, in
addition to the enumerated risks, a fund's derivatives risks include
any other risks a fund's investment adviser deems material in the
case of a limited derivatives user. See supra section II.B.2.a
(discussing the derivatives risks definition).
---------------------------------------------------------------------------
For example, a fund that uses derivatives to hedge currency risks
would not be introducing leverage risk, but could still introduce other
risks, including counterparty risk and a risk of selling investments to
meet margin calls. As another example, certain derivatives, and
particularly derivatives with non-linear or path-dependent returns, may
pose risks that require monitoring even when the derivatives' delta-
adjusted notional amount represents a small portion of net asset value.
In such case, because of the non-linear payout profiles associated with
put and call options, changes in the value of the option's underlying
reference asset can increase the option's delta, and thus a fund's
derivatives exposure from the option. An options transaction that
represents a small percentage of a fund's net asset value can rapidly
increase to a larger percentage.
The policies and procedures that a fund relying on the limited
derivatives user exception adopts should be tailored to the extent and
nature of the fund's derivatives use. For example, a fund that uses
derivatives only occasionally and for a limited purpose, such as to
equitize cash, is likely to have limited policies and procedures
commensurate with this limited use. A fund that uses more complex
derivatives with derivatives exposure approaching 10% of net asset
value, in contrast, should
[[Page 83212]]
have more extensive policies and procedures.
Commenters generally supported the proposed requirement that a fund
relying on the limited derivatives user exception should adopt and
implement written policies and procedures reasonably designed to manage
the funds' derivatives risks.\547\ One commenter requested that the
Commission provide further guidance on the contents of these required
policies and procedures.\548\ This commenter specifically requested
additional clarity on the minimum frequency of testing for continued
compliance with the exception.
---------------------------------------------------------------------------
\547\ See, e.g., Gateway Comment Letter; Franklin Comment
Letter.
\548\ See SIFMA AMG Comment Letter.
---------------------------------------------------------------------------
The final rule is designed to require a fund relying on the limited
derivatives user exception to manage all risks associated with its
derivatives transactions. Moreover, this approach allows funds to scale
their policies and procedures to address the different strategies funds
may pursue, the different level of derivatives exposure they may seek
(so long as they remain below the 10% derivatives exposure threshold),
and the different risks associated with their derivatives transactions.
In contrast, although a more prescriptive approach regarding a fund's
policies and procedures, such as a minimum frequency of testing as one
commenter suggested, would provide clearer guidelines to facilitate
compliance, this approach may be over- or under-inclusive considering
the breadth of funds' use of derivatives and the derivatives'
particular risks.
4. Exceedances of the Limited Derivatives User Exception
In the Proposing Release, the Commission stated that if a fund's
derivatives exposure were to exceed the 10% threshold for any reason,
the fund would have to reduce its derivatives exposure promptly or
establish a derivatives risk management program and comply with the
VaR-based limit on fund leverage risk as soon as reasonably
practicable.\549\ The Commission also requested comment on whether the
rule should otherwise address exceedances and remediation.
---------------------------------------------------------------------------
\549\ See Proposing Release supra footnote 1, at 155.
---------------------------------------------------------------------------
Many commenters requested further clarity on issues related to
exceedances and remediation of the exception in the final rule,
including to prevent confusion and divergent practices.\550\ As
discussed in more detail below, commenters sought additional clarity
and made suggestions regarding cases where a fund's derivatives
exposure were to exceed the 10% threshold temporarily, as well as cases
where a fund exceeded the derivatives exposure threshold and determined
to come into compliance with the VaR and program requirements rather
than reduce the fund's derivatives exposure.
---------------------------------------------------------------------------
\550\ See, e.g., BlackRock Comment Letter; Nuveen Comment
Letter; Invesco Comment Letter; Dechert Comment Letter I; see also
ICI Comment Letter (urging that further confusion could result
without clear guidance in situations in which the Commission's exam
staff questions whether a fund's remediation activities were
timely).
---------------------------------------------------------------------------
To address commenters' concerns, we have determined to modify the
final rule to address exceedances of the 10% derivatives exposure
threshold. The final rule includes two alternative paths for
remediation. If a fund's derivatives exposure exceeds the 10%
derivatives exposure threshold for five business days, the fund's
investment adviser must provide a written report to the fund's board of
directors informing it whether the investment adviser intends either
to: (1) Promptly, but within no more than thirty calendar days of the
exceedance, reduce the fund's derivatives exposure to be in compliance
with the 10% threshold (``temporary exceedance''); or (2) establish a
derivatives risk management program, comply with the VaR-based limit on
fund leverage risk, and comply with the related board oversight and
reporting requirements as soon as reasonably practicable (``derivatives
risk management program adoption'').\551\ In either case the fund's
next filing on Form N-PORT must specify the number of business days, in
excess of the five-business-day period that the final rule provides for
remediation, that the fund's derivatives exposure exceeded 10% of its
net assets during the applicable reporting period.\552\
---------------------------------------------------------------------------
\551\ See rule 18f-4(c)(4)(ii). A fund with derivatives exposure
exceeding the 10% threshold that complies with the remediation
provision and other requirements of rule 18f-4 applicable to a
limited derivatives user will still qualify as a limited derivatives
user. Under these circumstances the fund's derivatives transactions
therefore will not affect a fund's computation of asset coverage, a
concern that one commenter raised. See Calamos Comment Letter. This
is because the final rule provides that a fund's derivatives
transactions entered into in compliance with the rule will not be
considered for purposes of computing asset coverage under section
18(h). See rule 18f-4(b).
\552\ See section II.G.1.a. For example, if a fund relying on
the limited derivatives user exception were to determine, on the
evening of Monday, June 1, that its derivatives exposure exceeded
10% of its net assets, and this exceedance were to persist through
Tuesday (June 2), Wednesday (June 3), Thursday (June 4), Friday
(June 5), Monday (June 8), and Tuesday (June 9), the fund would
specify on its next Form N-PORT filing that it had exceeded the 10%
derivatives exposure threshold for 1 day (because five business days
following the determination on June 1 is June 8, and the fund is
required to report the number of business days in excess of the
five-business-day remediation period, therefore the fund will only
report the exceedance on Tuesday, June 9). Information provided in
response to this new Form N-PORT reporting item will not be made
public.
---------------------------------------------------------------------------
The two paths that the final rule permits for remediation are
designed to balance providing a clear framework for addressing
exceedances that persist beyond five business days with investor
protection concerns related to fund leverage risk and potential harm to
a fund if it were required to sell assets or exit positions quickly to
remain a limited derivatives user. We discuss each of the two paths for
remediation below.
a. Temporary Exceedance
Several commenters who addressed temporary exceedances urged that
we provide greater clarity by including in the final rule a specific
cure period for a fund to remediate a breach.\553\ A commenter also
urged us to consider including an exception for temporary exceedances
that result from certain ``routine'' fund events, such as large
redemptions and fund rebalancings.\554\ This commenter suggested that
the investment adviser would determine the appropriate duration of the
fund's exceedance based on the fund's risk guidelines and market
convention.
---------------------------------------------------------------------------
\553\ See ICI Comment Letter (requesting a 14-calendar-day cure
period for a temporary breach, stating that such cure period ``is a
sufficient and reasonable period of time for funds to unwind, close
out, or terminate such transactions in order to come back into
compliance with the exception''); see also Invesco Comment Letter
(requesting a 7-calendar-day cure period); SIFMA AMG Comment Letter
(requesting a 5-business-day cure period).
\554\ Fidelity Comment Letter.
---------------------------------------------------------------------------
After considering comments, we are providing an initial five-
business-day period for a fund to address any temporary exceedance of
the threshold.\555\ We recognize that there can be circumstances that
could cause a fund's derivatives exposure temporarily to exceed the 10%
threshold. These might include circumstances that are consistent with
the fund generally using derivatives in a limited way, for example, a
decrease in the fund's net asset value while its derivatives' notional
amounts remain relatively constant. This could happen more frequently
during periods of volatile market conditions. The five-business-day
remediation period is designed to provide funds with some flexibility
in coming back into compliance with the limited derivatives user
exception without triggering an obligation to inform the fund's board
of directors or a Form N-PORT reporting requirement.
[[Page 83213]]
This time period is consistent with the time period that the final rule
permits for a fund to come back into compliance with the VaR test
before the fund reports a breach to its board and the Commission.
---------------------------------------------------------------------------
\555\ See rule 18f-4(c)(4)(ii).
---------------------------------------------------------------------------
This provision also provides some flexibility for a fund that
cannot reduce its exposure within five business days in a manner that
is in the best interests of the fund and its shareholders.\556\ For
example, a fund with derivatives exposure that exceeds the 10%
threshold because of rebalancing activities as identified by one
commenter would have flexibility either to reduce derivatives exposure
below 10% within five business days, or to take more time to reduce
exposure (up to thirty calendar days of the fund's determination that
it is out of compliance with the 10% threshold) if the adviser reports
to the fund's board.\557\
---------------------------------------------------------------------------
\556\ See Fidelity Comment Letter (identifying certain events
that could cause a fund's derivatives exposure to exceed the 10%
threshold temporarily).
\557\ Id.
---------------------------------------------------------------------------
Although this provision provides flexibility, if a fund were to
exceed the 10% threshold repeatedly, and particularly if those
exceedances occurred over a long period of time and did not occur in
connection with extreme market events that may cause rapid and
significant changes in a fund's net asset value, the fund would not
appear to be using derivatives in a limited manner. In order for a
fund's compliance policies and procedures under rule 38a-1 to be
reasonably designed to achieve compliance with the final rule, they
should be designed to prevent such repeated exceedances. The fund's
policies and procedures likewise should be reasonably designed
generally to address the fund's compliance with the 10% threshold and
support the fund's reliance on the exclusion.
b. Derivatives Risk Management Program Adoption
The alternate path will require a fund to establish a derivatives
risk management program and comply with the related requirements as
soon as reasonably practicable. Commenters requested greater clarity of
the meaning of ``reasonably practicable'' in the Proposing Release's
discussion of the timing to establish a derivatives risk management
program and comply with the rule's VaR requirements after an
exceedance.\558\ Some commenters requested that we provide a particular
remediation period to allow a fund to implement a derivatives risk
management program.\559\ One commenter suggested that instead of
providing more definitive regulatory guidance, the Commission should
provide assurances that it will not second-guess reasonable actions and
interpretations.\560\
---------------------------------------------------------------------------
\558\ See, e.g., BlackRock Comment Letter; Dechert Comment
Letter I; SIFMA AMG Comment Letter.
\559\ See ICI Comment Letter (requesting a 90-calendar-day
period); see also SIFMA AMG Comment Letter (requesting a 60-
calendar-day period); T. Rowe Price Comment Letter (requesting a 45-
calendar-day period).
\560\ Dechert Comment Letter I.
---------------------------------------------------------------------------
We understand that there are practical considerations that would
prevent a fund that is no longer a limited derivatives user from coming
into immediate compliance with the VaR and program requirements.
Compliance with the rule requires a fund to adopt a written derivatives
risk management program that a board-approved derivatives risk manager
administers. The program includes mandatory stress testing,
backtesting, internal reporting and escalation, and program review
elements, among other requirements. We recognize that some funds may be
able to comply with the VaR and program requirements relatively
quickly. Their ability to comply quickly would vary based on a variety
of factors, including the complexity of a fund's derivatives use. Other
funds may require additional time. For these reasons, the final rule
provides, as the Commission stated in the proposal, that a fund
transitioning from a limited derivatives user to full compliance with
the rule's other requirements must do so as soon as reasonably
practicable.\561\ We continue to believe this standard is more
appropriate than specifying in the rule the specific time periods
commenters suggested or some other period. Any prescribed period might
provide more or less time than a particular fund may need.
---------------------------------------------------------------------------
\561\ A fund transitioning from a limited derivatives user to
full compliance with the rule's other requirements may be able to
reduce its exposure below the 10% threshold. If the fund were able
to resume operating below the 10% threshold as a limited derivatives
user, the fund could do so rather than finalizing the fund's
derivatives risk management program and complying with the rule's
VaR test. As noted above, however, if a fund were to exceed the 10%
threshold repeatedly, and particularly if those exceedances occurred
over a long period of time and did not occur in connection with
extreme market events that may cause rapid and significant changes
in a fund's net asset value, the fund would not appear to be using
derivatives in a limited manner. See supra discussion following
footnote 557.
---------------------------------------------------------------------------
F. Approach to Leveraged/Inverse Funds
Proposed rule 18f-4 included an alternative set of requirements for
leveraged/inverse funds. Under the proposal, a leveraged/inverse fund
would not have been required to comply with rule 18f-4's VaR-based
leverage risk limit if: (1) Transactions in the fund's shares would be
subject to the proposed sales practices rules, discussed below; (2) the
fund limited the investment results it seeks to 300% of the return (or
inverse of the return) of the underlying index; and (3) the fund
disclosed in its prospectus that it was not subject to rule 18f-4's
leverage risk limit.\562\ As discussed in more detail below, after
considering comments, we are not adopting the proposed sales practices
rules or the proposed exception from the VaR-based limit on leverage
risk that was predicated on those rules. Leveraged/inverse funds will
be subject to all of the provisions of rule 18f-4, including the
relative VaR test. Rule 18f-4 will provide, however, an exception from
the VaR test requirement for leveraged/inverse funds in operation as of
October 28, 2020 that seek an investment result above 200% of the
return (or inverse of the return) of an underlying index and satisfy
certain additional conditions.
---------------------------------------------------------------------------
\562\ See Proposing Release, supra footnote 1, at section
II.G.3.
---------------------------------------------------------------------------
1. Proposed Alternative Requirements for Leveraged/Inverse Funds
As the Commission stated in the Proposing Release, leveraged/
inverse funds present unique considerations. In contrast to other funds
that use derivatives as part of their broader investment strategy, the
strategy of a leveraged/inverse fund is predicated on the use of
derivatives to amplify the returns (or to correspond to the inverse of
the returns) of an underlying index by a specified multiple.\563\
---------------------------------------------------------------------------
\563\ Proposing Release, supra footnote 1, at section II.G.1.
The term ``multiple'' as used in rule 18f-4 has the same meaning as
in rule 6c-11. See ETFs Adopting Release, supra footnote 76, at
section II.A.3. As such, leveraged/inverse funds that seek returns
over a predetermined time period that are not evenly divisible by
100 (e.g., 150% of the performance of an index), or that seek
returns within a specified range of an index's performance (e.g.,
200% to 300% of an index's performance or -200% to -300% of an
index's performance), are ``leveraged/inverse funds'' for the
purposes of rule 18f-4.
---------------------------------------------------------------------------
Leveraged/inverse funds also rebalance their portfolios on a daily
(or other predetermined) basis in order to maintain a constant leverage
ratio. This reset, and the effects of compounding, can result in
performance over longer holding periods that differs significantly from
the leveraged or inverse performance of the underlying reference index
over those longer holding periods.\564\ This effect can be more
[[Page 83214]]
pronounced in volatile markets.\565\ As a result, buy-and-hold
investors in a leveraged/inverse fund who have an intermediate or long-
term time horizon--and who may not evaluate their portfolios
frequently--may experience large and unexpected losses or otherwise
experience returns that are different from what they anticipated.\566\
---------------------------------------------------------------------------
\564\ For example, as a result of compounding, a leveraged/
inverse fund can outperform a simple multiple of its index's returns
over several days of consistently positive returns, or underperform
a simple multiple of its index's returns over several days of
volatile returns.
\565\ See supra footnotes 23-26 and accompanying text
(discussing effects of market volatility caused by COVID-19 pandemic
on issues related to funds' use of derivatives). See also FINRA
Regulatory Notice 09-31, Non-Traditional ETFs-FINRA Reminds Firms of
Sales Practice Obligations Relating to Leveraged and Inverse
Exchange-Traded Funds (June 2009) (``FINRA Regulatory Notice 09-
31'') (``Using a two-day example, if the index goes from 100 to
close at 101 on the first day and back down to close at 100 on the
next day, the two-day return of an inverse ETF will be different
than if the index had moved up to close at 110 the first day but
then back down to close at 100 on the next day. In the first case
with low volatility, the inverse ETF loses 0.02 percent; but in the
more volatile scenario the inverse ETF loses 1.82 percent. The
effects of mathematical compounding can grow significantly over
time, leading to scenarios such as those noted above.'').
\566\ See Regulation Best Interest Adopting Release, supra
footnote 12, at discussion following n.597 (stating leveraged and
inverse exchange-traded products ``may not be in the best interest
of a retail customer absent an identified, short-term, customer-
specific trading objective''); see also FINRA Regulatory Notice 09-
31, supra footnote 565 (reminding member firms of their sales
practice obligations relating to leveraged/inverse ETFs and stating
that leveraged/inverse ETFs are typically not suitable for retail
investors who plan to hold these products for more than one trading
session); see also Fiduciary Interpretation, infra footnote 564
(stating that ``leveraged exchange-traded products are designed
primarily as short-term trading tools for sophisticated investors .
. . [and] require daily monitoring . . . .''); Securities Litigation
and Consulting Group, Leveraged ETFs, Holding Periods and Investment
Shortfalls (2010), at 13 (``The percentage of investors that we
estimate hold [leveraged/inverse ETFs] longer than a month is quite
striking.''); ETFs Adopting Release, supra footnote 76, at n.78
(discussing comment letters submitted by Consumer Federation of
America (urging the Commission to consider additional investor
protection requirements for leveraged/inverse ETFs) and by Nasdaq
(stating that ``there is significant investor confusion regarding
existing leveraged/inverse ETFs' daily investment horizon'')).
---------------------------------------------------------------------------
As discussed in the Proposing Release, the Commission's Office of
Investor Education and Advocacy and FINRA have issued alerts in the
past decade to highlight issues investors should consider when
investing in leveraged/inverse funds.\567\ In addition, some commenters
on the 2015 proposal indicated that at least some segment of investors
may hold leveraged/inverse funds for long periods of time, which can
lead to significant losses under certain circumstances.\568\ FINRA has
sanctioned a number of brokerage firms for making unsuitable sales of
leveraged/inverse ETFs.\569\ More recently, the Commission has brought
enforcement actions against investment advisers for, among other
things, soliciting advisory clients to purchase leveraged/inverse ETFs
for their retirement accounts with long-term time horizons, and holding
those securities in the client accounts for months or years.\570\
---------------------------------------------------------------------------
\567\ SEC Investor Alert and Bulletins, Leveraged and Inverse
ETFs: Specialized Products with Extra Risks for Buy-and-Hold
Investors (Aug. 1, 2009), available at http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm. This investor alert, jointly issued by
SEC staff and FINRA, followed FINRA's June 2009 alert, which raised
concerns about retail investors holding leveraged/inverse ETFs over
periods of time longer than one day. See FINRA Regulatory Notice 09-
31, supra footnote 565.
\568\ See, e.g., Comment Letter of the Consumer Federation of
America (Mar. 28, 2016) (``There is evidence that suggests investors
are incorrectly using certain alternative investments that use
derivatives extensively. For example, despite the fact that double
and triple leveraged ETFs are short-term trading vehicles that are
not meant to be held longer than one day, a significant number of
shares are held for several days, if not weeks.''). But cf. Comment
Letter of Rafferty Asset Management (Mar. 28, 2016) (asserting that
there is no evidence that investors do not understand the leveraged/
inverse ETF product, citing, for example, an analysis of eight of
its leveraged/inverse ETFs between May 1, 2009 and July 31, 2015,
and finding an average implied holding period ranging from 1.18 days
to 4.03 days and suggesting, therefore, that investors understand
the products are designed for active trading). We note, however,
that the analysis relied upon in the Comment Letter of Rafferty
Asset Management did not analyze shareholder-level trading activity
or provide any information on the distribution of shareholder
holding periods.
\569\ See FINRA News Release, FINRA Sanctions Four Firms $9.1
Million for Sales of Leveraged and Inverse Exchange-Traded Funds
(May 1, 2012), available at https://www.finra.org/newsroom/2012/finra-sanctions-four-firms-91-million-sales-leveraged-and-inverse-exchange-traded; FINRA News Release, FINRA Orders Stifel, Nicolaus
and Century Securities to Pay Fines and Restitution Totaling More
Than $1 Million for Unsuitable Sales of Leveraged and Inverse ETFs,
and Related Supervisory Deficiencies (Jan. 9, 2014), available at
https://www.finra.org/newsroom/2014/finra-orders-stifel-nicolaus-and-century-securities-pay-fines-and-restitution-totaling; FINRA
News Release, FINRA Sanctions Oppenheimer & Co. $2.9 Million for
Unsuitable Sales of Non-Traditional ETFs and Related Supervisory
Failures (June 8, 2016), available at http://www.finra.org/newsroom/2016/finra-sanctions-oppenheimer-co-29-million-unsuitable-sales-non-traditional-etfs. See also ProEquities, Inc., FINRA Letter of
Acceptance, Waiver and Consent (``AWC'') No. 2014039418801 (Aug. 8,
2016), available at http://disciplinaryactions.finra.org/Search/ViewDocument/66461; Citigroup Global Markets Inc., FINRA Letter of
AWC No. 20090191134 (May, 1, 2012), available at http://disciplinaryactions.finra.org/Search/ViewDocument/31714. See also
Regulation Best Interest Adopting Release, supra footnote 12, at
paragraph accompanying nn.593-98.
See also, e.g., SEC. v. Hallas, No 1:17-cv-2999 (S.D.N.Y. Sept.
27, 2017) (default judgement); In the Matter of Demetrios Hallas,
SEC. Release No. 1358 (Feb. 22, 2019) (initial decision), Exchange
Act Release No 85926 (May 23, 2019) (final decision) (involving a
former registered representative of registered broker-dealers
purchasing and selling leveraged ETFs and exchange-traded notes for
customer accounts while knowingly or recklessly disregarding that
they were unsuitable for these customers, in violation of section
17(a) of the Securities Act and section 10(b) and rule 10b-5
thereunder of the Exchange Act).
\570\ See, e.g., In the Matter of Wells Fargo Clearing Services,
LLC, et al., Investment Advisers Act Release No. 5451 (Feb. 27,
2020) (settled action); In the Matter of Morgan Stanley Smith
Barney, LLC, Investment Advisers Act Release No. 4649 (Feb. 14,
2017) (settled action).
---------------------------------------------------------------------------
The proposal, as well as market volatility following the onset of
COVID-19, each elicited feedback from investors in leveraged/inverse
funds. As discussed below, the Commission received many comments on the
proposal from individual investors asserting they understand the risks
involved in these funds,\571\ as well as some comments suggesting that
retail investors do not understand the unique risks of leveraged/
inverse funds.\572\ The Commission's Office of Investor Education and
Advocacy has received complaints and other communications from
investors following the onset of the market volatility related to
COVID-19 expressing concerns that these funds did not behave as these
investors had expected, with some of these investors experiencing
significant losses. Furthermore, several leveraged/inverse funds with
3x leverage or inverse multiples recently reduced their leverage
multiples to 2x due to the increased market volatility caused by COVID-
19.\573\
---------------------------------------------------------------------------
\571\ See, e.g., Comment Letter of Kerry Copple (Apr. 17, 2020);
Comment Letter of Praveen Lobo (Apr. 7, 2020); Comment Letter of
Arlene Hellman (Mar. 25, 2020); Comment Letter of Sean Ward (Apr.
27, 2020); Comment Letter of Stephen Cecchini (Apr. 22, 2020).
\572\ See, e.g., Comment Letter of Steve Woeste (Mar. 17, 2020);
Comment Letter of James Reichl (Mar. 17, 2020); Comment Letter of
Steven Bell (Mar. 18, 2020); Comment Letter of Richard Herber (Mar.
17, 2020); Comment Letter of Daniel P. Smith (Jan. 29, 2020).
\573\ See, e.g., Direxion Press Release, supra footnote 24; see
also paragraph accompanying supra footnotes 23-26 (discussing
effects of COVID-19 related volatility on funds' use of
derivatives).
---------------------------------------------------------------------------
As the Commission recognized in the Proposing Release, most
leveraged/inverse funds provide leveraged or inverse market exposure
that exceeds 150% of the return or inverse return of the relevant
index.\574\ Such funds would not have been able to comply with the
proposed limitation on leverage risk under rule 18f-4 because they
would not have been able to satisfy the proposed relative VaR test, and
would not have been eligible to use the proposed absolute VaR test. As
such, requiring these funds to comply with the proposed limit on
leverage risk
[[Page 83215]]
effectively would have precluded sponsors from offering the funds in
their current form.
---------------------------------------------------------------------------
\574\ See Proposing Release, supra footnote 1, at nn.317-318 and
accompanying text.
---------------------------------------------------------------------------
The Commission proposed a set of alternative requirements for
leveraged/inverse funds that, if satisfied, would have excepted such
funds from the leverage risk limit in proposed rule 18f-4. These
proposed alternative requirements were designed to address the investor
protection concerns that underlie section 18 of the Investment Company
Act, in part, by helping to ensure that retail investors in leveraged/
inverse funds are limited to those investors who are capable of
evaluating the risks these products present. They also would have
limited the amount of leverage that leveraged/inverse funds subject to
rule 18f-4 can obtain to 300% of the return (or inverse of the return)
of the underlying index.
Proposed rule 15l-2 under the Exchange Act and rule 211(h)-1 under
the Advisers Act would have required broker-dealers and investment
advisers, respectively, to exercise due diligence on retail investors
before approving retail investor accounts to invest in ``leveraged/
inverse investment vehicles.'' As defined in the proposed sales
practices rules, leveraged/inverse investment vehicles include
leveraged/inverse funds and certain exchange-listed commodity- or
currency-based trusts or funds that use a similar leveraged/inverse
strategy.\575\
---------------------------------------------------------------------------
\575\ See Proposing Release, supra footnote 1, at section
II.G.2.
---------------------------------------------------------------------------
The proposed due diligence requirements provided that a broker-
dealer or investment adviser must exercise due diligence to ascertain
the essential facts relative to the retail investor, his or her
financial situation, and investment objectives before approving his or
her account to invest in leveraged/inverse investment vehicles. This
requirement would have required the broker-dealer or investment adviser
to seek to obtain certain information about the retail investor,
including, at a minimum, information about his or her financial status
(e.g., employment status, income, and net worth (including liquid net
worth)); and information about his or her investment objectives
generally and his or her anticipated investments in, and experience
with, leveraged/inverse investment vehicles (e.g., general investment
objectives, percentage of liquid net worth intended for investment in
leveraged/inverse investment vehicles, and investment experience and
knowledge).
The proposed due diligence requirement was designed to provide the
broker-dealer or investment adviser with a comprehensive picture of the
retail investor on which to evaluate whether the retail investor has
the financial knowledge and experience to be reasonably expected to be
capable of evaluating the risks of buying and selling leveraged/inverse
investment vehicles.\576\
---------------------------------------------------------------------------
\576\ In addition, the proposed sales practices rules would have
required broker-dealers and investment advisers to adopt and
implement written policies and procedures addressing compliance with
the applicable sales practices rule, and would have required broker-
dealers and investment advisers to retain certain records arising
from the due diligence and account approval requirements. See
Proposing Release, supra footnote 1, at sections II.G.2.b-c.
---------------------------------------------------------------------------
The proposed sales practices rules were generally modeled after
current FINRA options account approval requirements for broker-dealers,
in part based on the Commission's belief that leveraged/inverse
investment vehicles, when held over longer periods of time, may have
certain similarities to options.\577\ Under the FINRA rules for
options, a broker-dealer may not accept a customer's options order
unless the broker-dealer has approved the customer's account for
options trading.\578\ This account-approval requirement applies to all
customers who wish to trade options, including self-directed investors
who do not receive advice or recommendations from the broker-dealer.
---------------------------------------------------------------------------
\577\ See, e.g., FINRA rule 2360(b)(16)-(17) (requiring firm
approval, diligence and recordkeeping for options accounts); see
also Proposing Release, supra footnote 1, at nn.325-327 and
accompanying text.
\578\ FINRA rule 2360(b)(16).
---------------------------------------------------------------------------
The Commission received significant comment on the proposed
alternative requirements for leveraged/inverse funds. Most commenters
categorically opposed the adoption of the proposed sales practices
rules. These commenters provided numerous reasons for their opposition,
including:
The proposed sales practices rules would restrict investor
choice because retail investors who wish to invest or continue to
invest in leveraged/inverse investment products, including investors
who understand their unique risks, might not be approved for trading in
those products by a broker-dealer or investment adviser.\579\
---------------------------------------------------------------------------
\579\ See, e.g., Comment Letter of Nathaniel Reynolds (Apr. 28,
2020); Comment Letter of Steve Ludwig (Apr. 22, 2020); Comment
Letter of Jesse Underwood (Apr. 17, 2000); Comment Letter of Angie
Hall (Apr. 17, 2020); Comment Letter of Barbara Kalib (Mar. 22,
2020).
---------------------------------------------------------------------------
The proposed sales practices rules would provide few
additional protections for investors because their requirements are
duplicative of existing Commission requirements for the activities of
broker-dealers and investment advisers in the recommended transaction
context, including rule 15l-1 under the Exchange Act (``Regulation Best
Interest'') and investment advisers' fiduciary obligations to their
clients.\580\
---------------------------------------------------------------------------
\580\ See, e.g., Comment Letter of TD Ameritrade (May 4, 2020)
(``TD Ameritrade Comment Letter''); SIFMA Comment Letter. See also
Regulation Best Interest Adopting Release, supra footnote 12;
Commission Interpretation Regarding Standard of Conduct for
Investment Advisers, Investment Advisers Act Release No. 5248 (June
5, 2019) [84 FR 33669 (July 12, 2019)] (``Fiduciary
Interpretation'').
---------------------------------------------------------------------------
The Commission should not address the investor protection
concerns underlying section 18 of the Investment Company Act by
imposing sales practice requirements on financial intermediaries rather
than placing requirements on leveraged/inverse funds themselves.\581\
---------------------------------------------------------------------------
\581\ See Direxion Comment Letter; see also Comment Letter of
Charles Schwab & Co., Inc. (Mar. 24, 2020) (``Schwab Comment
Letter'').
---------------------------------------------------------------------------
The operational burden and expense of implementing the due
diligence and account approval requirements, as well as the potential
legal liability arising from the performance of those requirements,
could cause broker-dealers and investment advisers simply to stop
offering leveraged/inverse investment vehicles to retail investors,
causing harm to leveraged/inverse fund sponsors and restricting
investor choice.\582\
---------------------------------------------------------------------------
\582\ See, e.g., Comment Letter of Americans for Limited
Government (Mar. 24, 2020) (``Americans for Limited Government
Comment Letter''); SIFMA Comment Letter; Direxion Comment Letter;
ProShares Comment Letter; Schwab Comment Letter.
---------------------------------------------------------------------------
The FINRA options account-approval framework is not well
suited as a model for leveraged/inverse investment vehicles because
options trading strategies are significantly more complex and have
significantly more risk, including the risk that an investor could lose
more than the amount invested, than investments in leveraged/inverse
investment vehicles.\583\
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\583\ See, e.g., Schwab Comment Letter; SIFMA Comment Letter.
Several commenters stated that the FINRA options rule, unlike the
proposed sales practices rules, applies only to transactions for
which there is a broker-dealer recommendation. See, e.g., Direxion
Comment Letter. Although the proposed sales practice rules
incorporated one element from the FINRA rule that applies to
recommended options transactions, FINRA rule 2360(b)(19), the FINRA
rule on which the proposed sales practices rules principally were
based, rule 2360(b)(16), applies regardless of whether the broker-
dealer has made a recommendation.
---------------------------------------------------------------------------
The proposed sales practices rules, because they would
apply to only two categories of leveraged/inverse products--leveraged/
inverse funds and
[[Page 83216]]
listed commodity pools that use leveraged/inverse strategies--would not
sufficiently advance the Commission's investor protection goals.
Exchange-traded notes (``ETNs''), for example, would not be subject to
the proposed sales practices rules, but can use leveraged/inverse
strategies with a nearly identical risk/return profile to leveraged/
inverse investment vehicles, and can present additional risks,
including the risk of issuer default. Accordingly, the proposed sales
practices rules, if adopted, could cause: (1) Sponsors of leveraged/
inverse investment vehicles to offer leveraged/inverse strategies as
ETNs rather than funds or listed commodity pools; and (2) retail
investors to seek out leveraged/inverse strategies through ETNs or
other products that would not be subject to the requirements of the
proposed sales practices rules.\584\
---------------------------------------------------------------------------
\584\ See, e.g., Direxion Comment Letter; Comment Letter of Mark
J. Flannery, Ph.D. (Mar. 31, 2020) (``Flannery Comment Letter'').
---------------------------------------------------------------------------
Commenters questioned whether the proposed sales practices
rules regulate ``sales practices'' and therefore the Commission's
authority to promulgate the proposed rules.\585\
---------------------------------------------------------------------------
\585\ See, e.g., Direxion Comment Letter; ProShares Comment
Letter; Comment Letter of Virtu Financial (Apr. 24, 2020).
---------------------------------------------------------------------------
Some commenters expressed support for the proposed sales practices
rules on the basis that additional investor protections are warranted
in light of the unique characteristics and risks of leveraged/inverse
investment vehicles.\586\ In addition, several commenters stated that
many retail investors do not understand the risks associated with
investing in leveraged/inverse investment vehicles.\587\
---------------------------------------------------------------------------
\586\ See, e.g., Herber Comment Letter; Comment Letter of Tom
Antony (Apr. 9, 2020); Comment Letter of Thomas Garman (Mar. 6,
2020); Comment Letter of Patrick Oberman (Feb. 20, 2020); NASAA
Comment Letter. One commenter supported the sales practices rules as
proposed, but suggested that the Commission not amend rule 6c-11 to
include leveraged/inverse funds within that rule's scope (as
proposed), without first implementing additional identification and
categorization requirements for exchange-traded products generally.
See BlackRock Comment Letter (also discussed at infra footnote 618
and accompanying text).
\587\ See supra footnote 572.
---------------------------------------------------------------------------
Several commenters recommended alternatives to the proposed sales
practices rules that they believed would address investor protection
concerns associated with leveraged/inverse funds. Commenters suggested
that we should place additional disclosure-based requirements on
intermediaries offering leveraged/inverse investment vehicles to retail
investors, rather than due diligence and account approval
requirements.\588\ Some commenters suggested we require broker-dealers
to: (1) Provide their self-directed customers with short, plain-English
disclosures of the potential risks of trading leveraged/inverse
investment vehicles, both at the point of sale and periodically
thereafter; and (2) require such customers to provide an
acknowledgement of receipt of these disclosures.\589\ Another commenter
suggested that we require broker-dealers and investment advisers to
adopt and implement policies and procedures designed to protect
investors in leveraged/inverse investment vehicles.\590\ This commenter
stated that such policies and procedures could include, among other
things, procedures for reviewing purchases of leveraged/inverse
investment vehicles and monitoring accounts that hold positions in
leveraged/inverse investment vehicles for extended time periods.
---------------------------------------------------------------------------
\588\ See, e.g., Direxion Comment Letter; Schwab Comment Letter.
\589\ See, e.g., Schwab Comment Letter; TD Ameritrade Comment
Letter; see also NASAA Comment Letter.
\590\ See Comment Letter of Cambridge Investment Research, Inc.
(May 1, 2020) (``Cambridge Investment Research Comment Letter'').
---------------------------------------------------------------------------
Commenters also suggested that we allow leveraged/inverse funds
with a stated target multiple that is equal to or below the VaR-based
limit on leveraged risk in rule 18f-4 (e.g., a fund that seeks 100%
inverse exposure to the relevant index) to comply with all the
requirements of rule 18f-4, including the VaR-based risk limitation,
rather than requiring broker-dealers or investment advisers to comply
with the proposed sales practices rules with respect to transactions in
these funds. According to these commenters, leveraged/inverse funds
that do not exceed the VaR-based risk limit (and thus would not require
an exception to the VaR limit) should not be subject to the proposed
sales practices rules.\591\
---------------------------------------------------------------------------
\591\ See, e.g., Direxion Comment Letter; ProShares Comment
Letter. See also Comment Letter of Innovator Capital Management (May
8, 2020) (``Innovator Comment Letter'').
---------------------------------------------------------------------------
2. Treatment of Leveraged/Inverse Funds Under Rule 18f-4
After considering the comments discussed above, we have determined
not to adopt the proposed sales practices rules or the proposed
exception from the leverage risk limit that was predicated on broker-
dealers' and investment advisers' compliance with the sales practices
rules. Leveraged/inverse funds, like funds generally, will be required
to comply with the VaR-based limit on fund leverage risk in rule 18f-4,
as adopted, with the exception of certain existing funds discussed in
section II.F.3 below.
We recognize, as commenters suggested, that our proposal to address
the investor protection concerns underlying section 18 by placing
requirements on the activities of broker-dealers and investment
advisers that offer leveraged/inverse funds, rather than on the
leveraged/inverse funds themselves, presents unique challenges. These
challenges include, as commenters stated, that broker-dealers and
investment advisers would be required to carry out new due diligence
requirements designed to address concerns under section 18, and that
section 18 does not apply to the broker-dealers and investment advisers
that would be subject to those new requirements.\592\ We also recognize
that many leveraged/inverse funds can comply with final rule 18f-4,
particularly given the adjustments to the relative VaR test. We believe
the approach we are adopting addresses many of the concerns raised by
commenters regarding the proposed sales practices rules. We believe the
final approach will preserve meaningful choice for investors by
permitting a substantial number of leveraged/inverse funds to continue
to operate under rule 18f-4, subject to the rule's requirements.
---------------------------------------------------------------------------
\592\ Some commenters also expressed the concern that a
leveraged/inverse fund sponsor would not be able to ensure that a
broker-dealer or investment adviser complied with the sales
practices rules. See, e.g., Direxion Comment Letter. The alternative
requirements in proposed rule 18f-4 would have applied to leveraged/
inverse funds that were within the scope of the proposed sales
practices rules. Broker-dealers and investment advisers would have
been responsible for their own compliance with the sales practices
rules.
---------------------------------------------------------------------------
Leveraged/inverse funds generally will be subject to the
requirements of rule 18f-4 on the same basis as other funds that are
subject to that rule, including the VaR-based leverage risk limit.\593\
Leveraged/inverse funds, because they provide a leveraged return of an
index, will be subject to the rule's relative VaR and, under the rule,
a leveraged/inverse fund must use the index it tracks as its designated
reference portfolio.\594\ For a leveraged/inverse fund that seeks,
directly or indirectly, to provide investment returns that correspond
to 200% of the performance or inverse performance of an index, we
recognize that there may
[[Page 83217]]
be minor deviations between the VaR of the fund and 200% of the VaR of
its designated index. These are attributable to financing costs
embedded in the fund's derivatives and valuation differences between
the fund's portfolio and the index it tracks.\595\ These minor
differences would be expected to cause a fund's VaR to exceed 200% of
the VaR of its designated index by a de minimis amount from time to
time where the fund is seeking to provide investment exposure equal to
200% of the return, or inverse of the return, of an index. We would not
view these de minimis deviations by a leveraged/inverse fund as
exceedances of the relative VaR test under these circumstances because
they do not reflect an increase in the fund's leveraged or inverse
market exposure. Therefore, we would not view these deviations, alone,
as giving rise to the remediation requirements in rule 18f-4 for funds
that are not in compliance with the VaR test, or the requirements for
funds to file Form N-RN to report information about VaR test breaches
to the Commission.
---------------------------------------------------------------------------
\593\ The Commission considered and requested comment on this
alternative in section III.E.5 of the Proposing Release.
\594\ As discussed above, if a fund's investment objective is to
track the performance of an unleveraged index--as we understand to
be the case for leveraged/inverse funds--the fund will be required
under the final rule to use that index as the fund's designated
reference portfolio. See supra section II.D.2.b.
\595\ See, e.g., ProShares Comment Letter.
---------------------------------------------------------------------------
In addition, where a fund's investment strategy is to provide the
inverse performance, or a multiple of the inverse performance, of an
index, we anticipate the fund would calculate the VaR of the index
based upon the index's inverse performance for purposes of the relative
VaR test. This is because, for inverse funds, the potential for losses
that VaR seeks to measure is driven by the potential for increases in
the index.
3. Standards of Conduct for Broker-Dealers and Registered Investment
Advisers
Although the final rules we are adopting will not include the
proposed sales practices rules, we agree with commenters that, in the
context of recommended transactions, certain of the investor protection
concerns the Commission articulated in the Proposing Release regarding
leveraged/inverse investment vehicles are addressed by the best
interest standard of conduct for broker-dealers under Regulation Best
Interest. Further, in the context of advisory relationships, the
fiduciary obligations of investment advisers, as the Commission
discussed in the Fiduciary Interpretation, address many of the same
concerns. The best interest standard of conduct for broker-dealers and
the fiduciary obligations of investment advisers apply to transactions
in all exchange-traded products where the transaction is recommended by
a broker-dealer or pursuant to the advice of an investment adviser.
These include transactions in leveraged/inverse funds and listed
commodity pools that the proposed sales practices rules covered, as
well as transactions in products such as ETNs that the proposed rules
did not address.
The Commission's adoption of Regulation Best Interest enhanced the
standard of conduct for broker-dealers beyond the then-existing
suitability obligations by requiring broker-dealers to act in the best
interest of a retail customer when recommending a securities
transaction or investment strategy involving securities to a retail
customer.\596\ To meet this best interest standard, a broker-dealer
must, among other things, satisfy its care obligation. The care
obligation requires the broker dealer to exercise reasonable diligence,
care, and skill to understand the potential risks, rewards, and costs
associated with the recommendation, and have a reasonable basis to
believe that the recommendation could be in the best interest of at
least some retail customers. This requirement is especially important
where broker-dealers recommend products that are particularly complex
or risky, including leveraged/inverse funds and other products that
follow a similar leveraged or inverse strategy. Broker-dealers
recommending such products should understand that leveraged/inverse
products that are reset daily may not be suitable for, and as a
consequence also not in the best interest of, retail customers who plan
to hold them for longer than one trading session, particularly in
volatile markets. A broker-dealer cannot establish a reasonable basis
to recommend leveraged/inverse products to retail customers without
understanding the terms, features, and risks of these products.\597\
The care obligation also requires a broker-dealer to have a reasonable
basis to believe that a recommendation provided to a retail customer is
in the customer's best interest. Leveraged/inverse products may not be
in the best interest of a retail customer absent an identified, short-
term, customer-specific trading objective.
---------------------------------------------------------------------------
\596\ Regulation Best Interest Adopting Release, supra footnote
12.
\597\ Id. at nn.593-597 and accompanying text.
---------------------------------------------------------------------------
Similarly, as the Commission stated in the Fiduciary
Interpretation, a reasonable belief that investment advice is in the
best interest of a client requires that an adviser conduct a reasonable
investigation into the investment sufficient not to base its advice on
materially inaccurate or incomplete information. An investment adviser
also must have a reasonable belief that the advice it provides is in
the best interest of the client based on the client's investment
objectives.\598\ Complex products, such as leveraged/inverse products
that are designed primarily as short-term trading tools for
sophisticated investors, may not be in the best interest of a retail
client absent an identified, short-term, client-specific trading
objective.\599\ Moreover, to the extent that such products are in the
best interest of a retail client initially, they would require daily
monitoring by the adviser.
---------------------------------------------------------------------------
\598\ See Fiduciary Interpretation, supra footnote 580.
\599\ Id. at n.39 and accompanying text.
---------------------------------------------------------------------------
To satisfy their respective obligations in making recommendations
or giving investment advice to retail investors, broker-dealers and
investment advisers need to ascertain certain information about their
customer or client, which can include the same kinds of information the
Commission proposed that firms would collect under the sales practices
rules' due diligence requirement.\600\ Broker-dealers must develop an
investment profile for a retail customer based on the customer's age,
other investments, financial situation and needs, tax status,
investment objectives, investment experience, investment time horizon,
liquidity needs, risk tolerance, and any other information the retail
customer may disclose to the broker-dealer.\601\ Similarly, investment
advisers are required to develop a reasonable understanding of a retail
client's objectives, which should, at a minimum, include a reasonable
inquiry into the client's financial situation, level of financial
sophistication, investment experience, and financial goals.\602\
---------------------------------------------------------------------------
\600\ The proposed sales practices rules would have required
broker-dealers and investment advisers to seek to obtain information
about the retail investor, including, at a minimum, his or her
investment objectives (e.g., safety of principal, income, growth,
trading profits, speculation) and time horizon; employment status
(name of employer, self-employed or retired); estimated annual
income from all sources; estimated net worth (exclusive of family
residence); estimated liquid net worth (cash, liquid securities,
other); percentage of the customer's estimated liquid net worth that
he or she intends to invest in leveraged/inverse investment
vehicles; and investment experience and knowledge (e.g., number of
years, size, frequency and type of transactions) regarding
leveraged/inverse investment vehicles, options, stocks and bonds,
commodities, and other financial instruments. See Proposing Release,
supra footnote 1, at n.333 and accompanying text.
\601\ See Regulation Best Interest Adopting Release, supra
footnote 12, at paragraph (a)(2).
\602\ See Fiduciary Interpretation, supra footnote 580, at
section II.B.1.
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[[Page 83218]]
4. Staff Review of Regulatory Requirements Relating to Complex
Financial Products
We recognize that while Regulation Best Interest applies to all
exchange-traded products, including products that the proposed sales
practices rules did not cover, it applies only where a broker-dealer
recommends a transaction or an investment strategy involving securities
to a retail customer. Similarly, rule 18f-4 does not address the
universe of potential investor protection issues related to
transactions in complex products, as it applies only to registered
investment companies and business development companies, and its
requirements for leveraged/inverse funds specifically address the
section 18 concerns that these funds raise. As such, neither Regulation
Best Interest nor rule 18f-4 applies where a retail investor with a
self-directed account invests in ETNs or other complex financial
products that use leveraged/inverse strategies with a nearly identical
risk/return profile to leveraged/inverse funds or in other complex
investment products.
Accordingly, we have directed the staff to review the effectiveness
of the existing regulatory requirements in protecting investors--
particularly those with self-directed accounts--who invest in
leveraged/inverse products and other complex investment products.\603\
Based on this review, the staff will make recommendations to the
Commission for potential new rulemakings, guidance, or other policy
actions, if appropriate. As part of this review, the staff will
consider whether the Commission's promulgation of any additional
requirements for these products may be effective in helping to promote
retail investor understanding of these products' unique characteristics
and risks. The staff may consider requirements that include, among
other things, additional obligations for broker-dealers and investment
advisers relating to leveraged/inverse investment vehicles and other
complex products, as well as the alternatives to the proposed sales
practices rules that commenters recommended, including: (1) Point-of-
sale disclosure; and (2) policies and procedures tailored to the risks
of leveraged/inverse investment vehicles and other complex
products.\604\
---------------------------------------------------------------------------
\603\ See Joint Statement Regarding Complex Financial Products
and Retail Investors (Oct. 28, 2020), available at https://www.sec.gov/news/public-statement/clayton-blass-hinman-redfearn-complex-financial-products-2020-10-28.
\604\ See supra footnotes 588-590 and accompanying text
(discussing alternative approaches proposed by commenters).
---------------------------------------------------------------------------
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
Under the relative VaR test with a 200% limit, as adopted,
leveraged/inverse funds that seek to provide leveraged or inverse
market exposure exceeding 200% of the return or inverse return of the
relevant index (``over-200% leveraged/inverse funds'') generally could
not satisfy the limit on fund leverage risk in rule 18f-4. As such,
over-200% leveraged/inverse funds in operation today would have to
significantly change their investment strategies if they were required
to comply with rule 18f-4's relative VaR test. While we believe that it
is important to continue to consider these funds in light of investor
protection concerns, and the staff review that we discuss above will
assess these funds in addition to other complex investment products, we
believe that these concerns would most appropriately be addressed
holistically as a result of any Commission action that may result from
the staff review.
Accordingly, rule 18f-4 includes a provision permitting over-200%
leveraged/inverse funds to continue operating at their current leverage
levels, provided they comply with all the provisions of rule 18f-4
other than the VaR-based limit on fund leverage risk and meet certain
additional requirements, as discussed below. This provision recognizes
the unique circumstances facing these funds, which have existed for
years under Commission exemptive orders prior to our reconsideration of
our regulatory approach regarding fund derivative use under section 18
and our adoption of a new approach for such regulation under rule 18f-
4. Given this history and in light of the staff review discussed above,
we have determined to allow these existing funds to continue but
subject to further constraints and a limitation to funds currently in
operation because of the section 18 concerns that these highly
leveraged funds present.\605\ Because the final rule limits this
treatment to those over-200% leveraged/inverse funds that are currently
in operation, absent a different regulatory approach following the
staff review that might permit additional over-200% leveraged/inverse
funds, the number of these funds may decrease over time, to the extent
that fund sponsors remove existing funds from the market or reduce
their leverage multiples.\606\
---------------------------------------------------------------------------
\605\ See rule 18f-4(c)(5). In addition, under rule 18f-4(a),
``fund'' is defined, in part, to mean a registered open-end or
closed-end company or a business development company, including any
separate series thereof.
\606\ See infra section III.C.5. (discussion in the Economic
Analysis section about, among other things, the potential market
effects of the Commission's approach with respect to over-200%
leveraged/inverse funds).
We understand that there are approximately 70 over-200%
leveraged/inverse funds currently in operation. These funds
represent approximately 0.07% of the total assets held by funds and
business development companies subject to rule 18f-4. See infra
section III.B.
---------------------------------------------------------------------------
The final rule's approach to these funds is limited to a leveraged/
inverse fund that cannot comply with rule 18f-4's limit on fund
leverage risk and that, as of October 28, 2020, is: (1) In operation;
(2) has outstanding shares issued in one or more public offerings to
investors; and (3) discloses in its prospectus a leverage multiple or
inverse multiple that exceeds 200% of the performance or the inverse of
the performance of the underlying index.\607\ A leveraged/inverse fund
that can comply with rule 18f-4's limit on leverage risk because, for
example, it rebalances its portfolios less frequently than daily or
subsequently reduces its disclosed leverage or inverse multiple to 200%
or less, will not qualify for the exception from the leverage risk
limit and will be required to comply with all the provisions of rule
18f-4.
---------------------------------------------------------------------------
\607\ See rule 18f-4(c)(5)(i).
---------------------------------------------------------------------------
Rule 18f-4 provides that an over-200% leveraged/inverse fund
relying on this exception may not change the underlying market index or
increase the level of leveraged or inverse market exposure the fund
seeks, directly or indirectly, to provide.\608\ The Commission's
exemptive orders for leveraged/inverse ETFs contemplate those funds
seeking investment results corresponding to a multiple of the return
(or inverse of the return) of an underlying index that does not exceed
300%, and thus no funds with an over-300% leverage multiple or inverse
multiple currently exist. We are therefore not adopting the proposed
requirement that leveraged/inverse funds must not seek or obtain,
directly or indirectly, investment results exceeding 300% of the return
(or inverse of the return) of the underlying index.\609\
---------------------------------------------------------------------------
\608\ See rule 18f-4(c)(5)(ii).
\609\ See Proposing Release, supra footnote 1, at nn.349-350 and
accompanying text.
---------------------------------------------------------------------------
We also are requiring existing over-200% leveraged/inverse funds to
disclose in their prospectuses that they are not subject to the
condition of rule 18f-4 limiting fund leverage risk.\610\ Under the
final rule requirement, the
[[Page 83219]]
prospectus disclosure that over-200% leveraged/inverse funds will
provide is identical to the prospectus disclosure that all leveraged/
inverse funds would have been required to provide under the
proposal.\611\ The proposed prospectus disclosure requirement was
designed to provide investors and the market with clarity that
leveraged/inverse funds (due to the proposed sales practices rules)
were not subject to rule 18f-4's limit on fund leverage risk.\612\ We
are not requiring all leveraged/inverse funds to provide this
disclosure, as the Commission proposed, because leveraged/inverse funds
other than the existing over-200% leveraged/inverse funds will be
required to comply with the final rule's limit on fund leverage risk.
We continue to believe that such a disclosure for over-200% leveraged/
inverse funds is appropriate, particularly because we have determined
not to adopt the proposed sales practices rules at this time.
---------------------------------------------------------------------------
\610\ See rule 18f-4(c)(5)(iii).
\611\ See proposed rule 18f-4(c)(4)(ii).
\612\ The Commission received one comment questioning our
proposal to require all leveraged/inverse funds, as defined in the
Proposing Release, to disclose in their prospectuses that they are
not subject to the leverage risk limit. See Direxion Comment Letter.
Because we are not adopting the sales practices rules, we believe
that the adoption of this disclosure requirement remains
appropriate.
---------------------------------------------------------------------------
6. Amendments to Rule 6c-11 Under the Investment Company Act and
Proposed Rescission of Exemptive Relief for Leveraged/Inverse ETFs
We are amending rule 6c-11 to include leveraged/inverse ETFs within
the scope of that rule, provided that they comply with the applicable
provisions of rule 18f-4. Rule 6c-11 permits ETFs that satisfy certain
conditions to operate without obtaining an exemptive order from the
Commission.\613\ As discussed in the Proposing Release, rule 6c-11
includes a provision excluding leveraged/inverse ETFs from the scope of
ETFs that may rely on that rule.\614\ Leveraged/inverse ETFs,
therefore, currently rely on their Commission exemptive orders. In
adopting rule 6c-11, the Commission stated that the particular section
18 concerns raised by leveraged/inverse ETFs' use of derivatives
distinguish those funds from the other ETFs permitted to rely on that
rule, and that those section 18 concerns would be more appropriately
addressed in a rulemaking addressing the use of derivatives by funds
more broadly.\615\ The Commission further stated that leveraged/inverse
ETFs are similar in structure and operation to the other types of ETFs
that are within the scope of rule 6c-11.\616\
---------------------------------------------------------------------------
\613\ See ETFs Adopting Release, supra footnote 76.
\614\ See rule 6c-11(c)(4).
\615\ See ETFs Adopting Release, supra footnote 76, at nn.72-75
and accompanying text.
\616\ See id. at text following n.86. In addition, one sponsor
of leveraged/inverse ETFs has stated that its ETFs would prefer to
rely on rule 6c-11 over their exemptive orders and that leveraged/
inverse ETFs would be able to comply with rule 6c-11 because they
are structured and operated in the same manner as other ETFs that
fall within the scope of that rule. See id. at n.83 and accompanying
text.
---------------------------------------------------------------------------
The Commission proposed to amend rule 6c-11 to remove the provision
excluding leveraged/inverse ETFs from the scope of ETFs that may rely
on that rule. Two commenters expressed support for the proposal.\617\
One commenter, however, stated that the Commission should not do so
without first implementing a system for the categorization and
identification of exchange-traded products (``ETPs'').\618\ The
Commission has previously addressed the implementation of an ETP naming
system in the ETFs Adopting Release, and, as stated in that release, we
encourage ETP market participants to continue engaging with their
investors, with each other, and with the Commission on these
issues.\619\
---------------------------------------------------------------------------
\617\ See, e.g., Direxion Comment Letter; ProShares Comment
Letter.
\618\ See BlackRock Comment Letter.
\619\ ETFs Adopting Release, supra footnote 76, at n.406 and
accompanying and following paragraphs.
---------------------------------------------------------------------------
Because leveraged/inverse ETFs are similar in structure and
operation to the other types of ETFs that are within the scope of rule
6c-11, we believe it is appropriate to permit leveraged/inverse funds
to rely on rule 6c-11 when they satisfy the applicable conditions in
rule 18f-4 as adopted. In addition, to provide greater clarity to
investors and the market regarding the conditions we are placing on
leveraged/inverse ETFs under rules 18f-4 and 6c-11, we are amending
rule 6c-11 to require a leveraged/inverse ETF to comply with the
applicable provisions of rule 18f-4 to operate as an ETF under rule 6c-
11.\620\
---------------------------------------------------------------------------
\620\ In addition, in 2019 the Commission issued an order
granting an exemption from certain provisions of the Exchange Act
and the rules thereunder to broker-dealers and certain other
persons, as applicable, that engage in certain transactions with
ETFs relying on rule 6c-11, subject to certain conditions. See Order
Granting a Conditional Exemption from Exchange Act Section 11(d)(1)
and Exchange Act Rules 10b-10; 15c1-5; 15c1-6; and 14e-5 for Certain
Exchange Traded Funds, Exchange Act Release No. 87110 (Sept. 25,
2019) [84 FR 57089 (Oct. 24, 2019)] (``ETF Exchange Act Order'').
These exemptions will apply to transactions in the securities of
leveraged/inverse ETFs that rely on rule 6c-11, provided the
conditions of the ETF Exchange Act Order are satisfied.
---------------------------------------------------------------------------
Because the amendments to rule 6c-11 will permit a leveraged/
inverse ETF to rely on that rule rather than its exemptive order, we
are rescinding the exemptive orders the Commission has previously
issued to leveraged/inverse ETFs, as proposed.\621\ We believe that
amending rule 6c-11 and rescinding these exemptive orders will help
promote a more level playing field and greater competition by allowing
any sponsor to form and launch a leveraged/inverse ETF whose target
multiple is equal to or less than 200% of its reference portfolio,
subject to the conditions in rules 6c-11 and 18f-4. We are rescinding
the exemptive orders provided to leveraged/inverse ETFs on the
compliance date for rule 18f-4, in eighteen months.\622\ We believe
that providing an eighteen-month period for existing leveraged/inverse
ETFs also will provide time for them to prepare to comply with rule 6c-
11 rather than their exemptive orders, and will provide the staff with
time to conduct its review of leveraged/inverse and other complex
products, as discussed above, and to provide a recommendation to the
Commission.\623\
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\621\ We did not receive any comments directly supporting or
opposing our proposal to rescind the Commission exemptive orders to
leveraged/inverse ETFs.
\622\ See infra section II.L.
\623\ See ETFs Adopting Release, supra footnote 76, at text
following n.451.
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G. Amendments To Fund Reporting Requirements
We are adopting, with certain modifications from the proposal,
amendments to the reporting requirements for funds that will rely on
new rule 18f-4--in particular, amendments to Forms N-PORT, N-LIQUID
(which we will re-title as ``Form N-RN,'' to reflect that funds will
use this form to file risk notices with the Commission and not solely
reports related to rule 22e-4), and Form N-CEN.\624\ These amendments
are designed to enhance the Commission's ability to oversee funds' use
of and compliance with the new rule effectively, and to provide the
Commission and the public additional information regarding funds' use
of derivatives.\625\
---------------------------------------------------------------------------
\624\ 17 CFR 274.150; 17 CFR 274.223; and 17 CFR 249.330 and 17
CFR 274.101.
\625\ The funds that will rely on rule 18f-4 (other than BDCs)
generally are subject to the reporting requirements of Form N-PORT.
All registered management investment companies, other than
registered money market funds and small business investment
companies, are required to electronically file with the Commission,
on a quarterly basis, monthly portfolio investment information on
Form N-PORT, as of the end of each month. See Investment Company
Reporting Modernization, Investment Company Act Release No. 32314
(Oct. 13, 2016) [81 FR 81870 (Nov. 18, 2016)] (``Reporting
Modernization Adopting Release''), and Investment Company Act
Release No. 32936 (Dec. 8, 2017) [82 FR 58731 (Dec. 14, 2017)]
(modifying approach to the requirement to submit reports on Form N-
PORT).
Certain information that funds will report on Form N-PORT will
be publicly available. For these data elements, only information
that funds report for the third month of each fund's fiscal quarter
on Form N-PORT will be publicly available (60 days after the end of
the fiscal quarter). See Amendments to the Timing Requirements for
Filing Reports on Form N-PORT, Investment Company Act Release No.
33384 (Feb. 27, 2019) [84 FR 7980 (Mar. 6, 2019)].
Currently, only open-end funds that are not regulated as money
market funds under rule 2a-7 under the Investment Company Act are
required to file current reports on Form N-LIQUID, under section
30(b) of the Investment Company Act and rule 30b1-10 under the Act.
See Investment Company Liquidity Risk Management Programs,
Investment Company Act Release No. 32315 (Oct. 13, 2016) [81 FR
82142 (Nov. 18, 2016)], at section III.L.2 (``Liquidity Adopting
Release''). We are amending Form N-LIQUID (newly-retitled Form N-RN)
and rule 30b1-10, and adopting rule 18f-4(c)(7) to add new VaR-
related items to the form, and to extend the requirement to file
current reports with respect to these new items to any fund
(including registered open-end funds, registered closed-end funds,
and BDCs) that relies on rule 18f-4 and that is subject to the
rule's limit on leverage risk.
The funds that will rely on rule 18f-4 (other than BDCs)
generally are subject to the reporting requirements of Form N-CEN.
Specifically, all registered investment companies (excluding face
amount certificate companies) are required to file annual reports on
Form N-CEN. See Reporting Modernization Adopting Release.
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[[Page 83220]]
Most commenters generally supported, or stated they did not object
to, requiring funds to report to the Commission the information that
the proposal would require about their derivatives use.\626\ One
commenter broadly opposed the new reporting requirements, in general,
because they ``could introduce a substantial additional reporting
burden for funds, particularly in the context of volatile market
conditions.'' \627\ No other commenter opposed the proposed reporting
requirements in the aggregate. We continue to believe that the new
reporting requirements will allow the Commission to identify and
monitor industry trends, as well as risks associated with funds'
investments in derivatives (including by requiring current, non-public
reporting to the Commission when certain significant events related to
a fund's leverage risk occur). The amendments will aid the Commission
in evaluating the activities of investment companies in order to better
carry out its regulatory functions. Accordingly, we are adopting,
consistent with the proposal, the requirements to report the specified
information to the Commission on Forms N-PORT, N-RN, and N-CEN, with
certain modifications discussed below.
---------------------------------------------------------------------------
\626\ See, e.g., J.P. Morgan Comment Letter; AQR Comment Letter
I; Fidelity Comment Letter; Capital Group Comment Letter; SIFMA AMG
Comment Letter.
\627\ ISDA Comment Letter.
---------------------------------------------------------------------------
Commenters had mixed views regarding the public availability of
certain information that funds would provide in response to the
proposed reporting requirements. As discussed in more detail below,
after considering these comments we are making certain of these data
elements non-public, while making other information publicly available
as proposed.
1. Amendments to Form N-PORT
We are adopting amendments to Form N-PORT to add new items to Part
B (``Information About the Fund''), and revise some of the form's
General Instructions.\628\ As proposed, these amendments would have
required all funds to report information about their derivatives
exposure, as well as VaR information (as applicable) on Form N-PORT.
However, the amendments we are adopting incorporate several changes
from the proposal:
---------------------------------------------------------------------------
\628\ See General Instructions E (Definitions) and F (Public
Availability) to Form N-PORT.
---------------------------------------------------------------------------
While the proposal would have required all funds to report
their aggregate derivatives exposure, under the final rules only a fund
that relies on the limited derivatives exception in rule 18f-4 will be
required to report this information.\629\ A limited derivatives user
will also be required to break out certain aspects of its derivatives
exposure (e.g., exposure from currency and interest rate derivatives
that hedge related risks), and report the number of business days (in
excess of the five-business-day remediation period provided in rule
18f-4) that derivatives exposure exceeded 10% of its net assets, to
assist the Commission in monitoring compliance with the limited
derivatives user exception.\630\
---------------------------------------------------------------------------
\629\ Item B.9 of Form N-PORT.
\630\ Id.
---------------------------------------------------------------------------
We are tailoring the VaR-related information we are
requiring funds to report to include the VaR-related information that
we believe most effectively portrays a fund's use of derivatives.\631\
---------------------------------------------------------------------------
\631\ See Item B.10 of Form N-PORT; see also infra footnote 673
and accompanying paragraph.
---------------------------------------------------------------------------
Finally, we are modifying the proposed requirement to make
all information reported in response to the new N-PORT items publicly
available. In a change from the proposal, information about a limited
derivatives user's derivatives exposure, as well as a fund's median
daily VaR, median VaR ratio and VaR backtesting exceptions, will be
confidentially reported to the Commission and not publicly
disclosed.\632\ Information about the fund's designated reference
portfolio will be made publicly available, as proposed.
---------------------------------------------------------------------------
\632\ See General Instruction F (Public Availability) to Form N-
PORT.
---------------------------------------------------------------------------
We discuss all of these changes in more detail below.
a. Derivatives Exposure
We are amending Form N-PORT to include a new reporting item for
certain funds' derivatives exposure.\633\ While the proposal would have
required all funds to report their derivatives exposure, the final
amendments we are adopting will require only a fund that relies on the
limited derivatives user exception in rule 18f-4 to report derivatives
exposure information.\634\ A fund that relies on this exception will
have to report: (1) Its derivatives exposure; (2) its exposure from
currency derivatives that hedge currency risks; and (3) its exposure
from interest rate derivatives that hedge interest rate risks. Such a
fund also will have to report the number of business days, if any, in
excess of the five-business-day remediation period that final rule 18f-
4 provides, that the fund's derivatives exposure exceeded 10 percent of
its net assets during the reporting period. These reporting
requirements are designed to provide information to the Commission to
further its ability to monitor compliance with the limited derivatives
user exception.
---------------------------------------------------------------------------
\633\ Item B.9 of Form N-PORT; see also amendments to General
Instruction E to Form N-PORT (adding a new definition for
``derivatives exposure,'' as defined in rule 18f-4(a)). A fund's
derivatives exposure, which is expressed as a percentage of the
fund's net assets, is computed in U.S. dollars.
\634\ See proposed Item B.9 of Form N-PORT.
---------------------------------------------------------------------------
No commenters specifically supported the Commission's proposal to
require a fund to report its derivatives exposure data on Form N-
PORT.\635\ Likewise, no commenters specifically opposed this reporting
requirement.\636\ However, some commenters stated that public
disclosure of a fund's aggregate derivatives exposure would not serve
investor protection purposes because such information could be
misleading and would be unnecessary, as individual portfolio holdings
data already provide similar but more useful
[[Page 83221]]
information.\637\ We agree that the proposed derivatives exposure
reporting requirement would not have permitted investors or other
market participants to determine the purposes for which a fund uses
derivatives, including whether derivatives are being used for hedging
purposes. We also recognize that funds currently publicly disclose
information regarding their derivatives positions on Form N-PORT and
elsewhere.\638\ In light of these considerations, we are not adopting
the requirement for all funds to report derivatives exposure on Form N-
PORT. However, because the limited derivatives user exception in final
rule 18f-4 will require funds relying on the exception to limit their
derivatives exposure to 10% or less of the value of their net assets,
we are adopting a derivatives exposure reporting requirement for these
funds to facilitate the Commission's ability to monitor compliance with
the exception.\639\
---------------------------------------------------------------------------
\635\ Some commenters generally agreed with, or did not object
to, reporting the proposed derivatives information to the
Commission, but did not specifically support the derivatives
exposure reporting item. See ICI Comment Letter; J.P. Morgan Comment
Letter; Putnam Comment Letter.
\636\ Although one commenter broadly objected to all new
reporting requirements, it did not discuss or object to any specific
requirements. See ISDA Comment Letter.
\637\ See, e.g., ICI Comment Letter; Putnam Comment Letter.
\638\ See infra footnote 654 and accompanying text.
\639\ See Proposing Release, supra footnote 1, n.364 and
accompanying text. As proposed, a fund also will have to indicate
whether it is a limited derivatives user on Form N-CEN. See infra
section II.G.3.
---------------------------------------------------------------------------
The specific exposure information we are requiring funds to report
reflects this regulatory purpose. While the proposal would have
required a fund to provide its exposure from derivatives instruments
and exposure from short sales separately, as distinct reporting items,
we are not requiring limited derivatives users to break out these
separate components of exposure.\640\ We can perform our oversight
function without requiring funds to separately report their exposure
from derivatives instruments and shorts sales.\641\ Conversely, because
the final rule will permit a fund that relies on the limited
derivatives user exception to exclude certain currency and interest
rate hedging transactions from the 10% derivatives exposure threshold
associated with the exception, we are adopting corresponding reporting
requirements that will require funds to separately report the levels of
exposure they have obtained from these currency and interest rate
hedging transactions. This information will help support our ability to
monitor funds' reliance on the exception. For each of the reporting
items we are adopting, a fund will be required to provide its exposure
as a percentage of the fund's net asset value as of the end of the
reporting period.\642\
---------------------------------------------------------------------------
\640\ See proposed Items B.9.a.i (exposure from derivative
instruments that involve future payment obligations) and B.9.a.ii
(exposure from short sales).
\641\ See supra footnote 633.
\642\ Item B.9; see also General Instruction A to Form N-PORT.
---------------------------------------------------------------------------
One commenter recommended allowing a fund to report derivatives
exposure based on either a net notional basis (e.g., allowing netting
of long and short positions) or mark-to-market basis, stating that
either of these methods provides a more accurate measure of the fund's
derivatives exposure.\643\ These suggestions, however, would result in
funds reporting derivatives exposure figures that deviate from the
manner in which funds are required to calculate derivatives exposure
under rule 18f-4. As a result, this would limit the Commission's
ability to monitor funds' use of derivatives for oversight purposes.
Accordingly, we are not making the requested change, and the final
amendments to Form N-PORT will require a fund that is a limited
derivatives user to report its derivatives exposure on a gross notional
basis, as proposed.\644\
---------------------------------------------------------------------------
\643\ Fidelity Comment Letter.
\644\ Item B.9.a.; see also rule 18f-4(a) (defining
``derivatives exposure'').
---------------------------------------------------------------------------
In a change from the proposal, we are also adopting a requirement
for funds that are limited derivatives users to report certain
information regarding times during which these funds' derivatives
exposure exceeds 10% of their net assets.\645\ Final rule 18f-4
includes remediation provisions that address circumstances in which
funds that are relying on the limited derivatives user exception have
derivatives exposure that exceeds 10% of their net assets.\646\ These
provisions incorporate a five-business-day period for the fund to
reduce its exposure before it must provide a written report to the
fund's board of directors on the fund's plan to reduce its exposure. If
a fund relying on that exception has derivatives exposure exceeding 10%
of the fund's net assets, and this exceedance persists beyond the five-
business-day period that rule 18f-4 provides for remediation, the fund
will have to report the number of business days (beyond the five-
business-day period) that its derivatives exposure exceeded 10% of net
assets during the reporting period. This information also is designed
to assist the Commission in monitoring compliance with the limited
derivatives user exception.
---------------------------------------------------------------------------
\645\ See Item B.9.d of Form N-PORT.
\646\ See rule 18f-4(c)(4); supra section III.E.4.
---------------------------------------------------------------------------
In another change, derivatives exposure information reported in
response to Item B.9 of Form N-PORT will not be made publicly
available, as had been proposed.\647\ The majority of commenters that
addressed this aspect of the proposal urged the Commission to make this
information non-public.\648\ Other commenters supported (or stated they
did not oppose) public disclosure of derivatives exposure, but did not
provide detailed justification for this support.\649\
---------------------------------------------------------------------------
\647\ Proposing Release supra footnote 1, at n.363 and
accompanying text.
\648\ See, e.g., Dechert Comment Letter I; Invesco Comment
Letter; ICI Comment Letter; AQR Comment Letter I; Capital Group
Comment Letter.
\649\ J.P. Morgan Comment Letter; SIFMA AMG Comment Letter; T.
Rowe Comment Letter.
---------------------------------------------------------------------------
Commenters that opposed public disclosure of a fund's gross
notional derivatives exposure expressed concern that this information
could confuse or mislead investors who may not understand the relevance
of or context for the data.\650\ One commenter stated that
``derivatives exposure'' would include notional amounts of transactions
that investors may not traditionally consider to be ``derivatives.''
\651\ Several commenters stated that public disclosure of this
information could cause some investors or third-party analysts to
incorrectly gauge the riskiness of (and amount of leverage used by)
funds, particularly since Form N-PORT is not designed to include
qualitative information that could provide context for the data.\652\
Commenters also asserted that publicly disclosing this information
would not be necessary to provide additional transparency to investors
and other market participants because funds already publicly disclose
information about their derivatives positions.\653\ In particular,
several commenters observed that: (1) Funds currently report their full
portfolio schedules on Form N-PORT in a structured data format; (2) a
fund's financial statements contain a variety of derivatives-related
information (including notional amount information organized by
category of derivative instrument); and (3) some funds provide
disclosure about their use of derivatives in shareholder reports.\654\
Some commenters also stated that public disclosure of derivatives
exposure amounts, even if disclosed on a delayed basis, could reveal
proprietary
[[Page 83222]]
information to fund competitors.\655\ Two commenters stated that the
delayed public availability of exposure information that funds report,
while protective of funds, may limit its utility to investors.\656\
---------------------------------------------------------------------------
\650\ See, e.g., Capital Group Comment Letter; Eaton Vance
Comment Letter; MFA Comment Letter; PIMCO Comment Letter.
\651\ Dechert Comment Letter I.
\652\ See, e.g., Invesco Comment Letter; ICI Comment Letter;
Putnam Comment Letter.
\653\ See, e.g., ICI Comment Letter; AQR Comment Letter I;
Capital Group Comment Letter; Invesco Comment Letter.
\654\ Dechert Comment Letter I; Invesco Comment Letter; T. Rowe
Comment Letter.
\655\ Dechert Comment Letter I; ICI Comment Letter; MFA Comment
Letter.
\656\ Dechert Comment Letter I; MFA/AIMA Comment Letter.
---------------------------------------------------------------------------
We are not requiring derivatives exposure information to be
publicly available. Section 45(a) requires information in reports filed
with the Commission pursuant to the Investment Company Act to be made
public unless we find that public disclosure is neither necessary nor
appropriate in the public interest or for the protection of
investors.\657\ Because we are not, as proposed, requiring all funds to
report derivatives exposure information, but are instead imposing the
requirement only on funds that are limited derivatives users, making
this information public is unlikely to provide the market-wide insight
into the levels of funds' derivatives exposure to investors and other
market participants we had initially anticipated.\658\ Moreover, making
the derivatives exposure data that funds that are limited derivatives
users must report publicly available could cause investors to believe
that these reporting funds (which do not use derivatives extensively or
largely use them for limited hedging purposes), are riskier than funds
that use derivatives to a greater extent but are not required to report
their exposure information. In light of commenters' concerns, and given
the regulatory purpose of the reporting requirement we are adopting, we
find that public disclosure of this information is neither necessary
nor appropriate in the public interest or for the protection of
investors.
---------------------------------------------------------------------------
\657\ Section 45(a) of the Investment Company Act.
\658\ Proposing Release supra footnote 1, footnote 363 and
accompanying text.
---------------------------------------------------------------------------
b. VaR Information
Form N-PORT will include a new reporting item related to the VaR
tests we are adopting, with certain modifications from the proposal
discussed below.\659\ As proposed, the new disclosure item will apply
to funds that are subject to the VaR-based limit on fund leverage risk
during the relevant reporting period.
---------------------------------------------------------------------------
\659\ Item B.10 of Form N-PORT.
---------------------------------------------------------------------------
With the exception of one commenter that broadly opposed all new
proposed reporting requirements on the grounds that they increase
burdens on funds, no commenter opposed providing the proposed VaR
information to the Commission on Form N-PORT.\660\ Multiple commenters,
however, opposed making certain information reported in response to the
proposed VaR disclosure items publicly available.\661\
---------------------------------------------------------------------------
\660\ See ISDA Comment Letter.
\661\ See, e.g., ISDA Comment Letter; Dechert Comment Letter I;
ICI Comment Letter; AQR Comment Letter I; BlackRock Comment Letter.
---------------------------------------------------------------------------
Median VaR and Designated Reference Portfolio Information
Funds will report their median daily VaR for the monthly reporting
period, as proposed. Also as proposed, a fund subject to the relative
VaR test during the reporting period will report, as applicable, the
name of the fund's designated index and its index identifier. This item
reflects a conforming change from the proposal, in light of
modifications to the proposed relative VaR test, to require a statement
that the fund's designated reference portfolio is the fund's securities
portfolio, if applicable. Funds also will report their median daily VaR
ratio for the reporting period, as the proposal would have
required.\662\ The requirement for a fund to report median daily VaR
(and, for a fund that is subject to the relative VaR test, the fund's
median VaR ratio) is designed to help the Commission assess compliance
with the rule.\663\ These data points will also facilitate the
Commission's monitoring efforts. For example, these data points can be
used to identify changes in a fund's VaR over time, and trends
involving a single fund or group of funds regarding their VaRs. The
requirement that a fund report information about its designated
reference portfolio is designed to help analyze whether funds are using
designated reference portfolios that meet the rule's requirements, and
to assess any trends in the designated reference portfolios that funds
select.
---------------------------------------------------------------------------
\662\ In a conforming change to reflect modifications we are
making to proposed rule 18f-4, this reporting item describes a
fund's median VaR ratio as a percentage of the VaR of the fund's
designated reference portfolio instead of as a percentage of the VaR
of the fund's designated reference index (as proposed).
\663\ See Proposing Release, supra footnote 1, at section
II.H.1.b.
---------------------------------------------------------------------------
Although several commenters supported (or generally did not oppose)
public reporting about a fund's designated index on Form N-PORT,\664\
commenters largely objected to making information reported in response
to the proposed VaR disclosure items publicly available.\665\ Many
commenters expressed concern that, while the Commission may expect and
understand divergence across VaR models, VaR is a complex measure that
many investors do not have the expertise or experience to
understand.\666\ One commenter stated that because investors trying to
compare funds may misunderstand VaR information, funds could be
incentivized to report data designed to appear less risky.\667\
Although the proposed VaR information would have been made publicly
available on a delayed basis, several commenters stated that publicly
disclosing VaR information could reveal proprietary information about a
fund's risk management tools.\668\ Some generally questioned the
investor protection benefits of making VaR data public.\669\
---------------------------------------------------------------------------
\664\ Putnam Comment Letter; SIFMA AMG Comment Letter; Invesco
Comment Letter.
\665\ See supra footnote 661.
\666\ See, e.g., Dechert Comment Letter I; Invesco Comment
Letter; ICI Comment Letter; AQR Comment Letter I; J.P. Morgan
Comment Letter.
\667\ Eaton Vance Comment Letter.
\668\ Dechert Comment Letter I; MFA/AIMA Comment Letter.
\669\ Dechert Comment Letter I; J.P. Morgan Comment Letter.
---------------------------------------------------------------------------
After considering these comments, we are making two modifications
to the proposal. First, we are not requiring a fund's median VaR
information (its median VaR, and its median VaR ratio for funds subject
to the relative VaR test) to be publicly available, as had been
proposed.\670\ While we recognize that this information could help some
market participants assess the effect of derivatives use on funds that
have similar strategies but different VaRs, many investors may not have
the expertise or experience to understand VaR and could misinterpret
VaR figures, especially when comparing funds. Moreover, sophisticated
investors and other market participants who may be less likely to
misinterpret VaR figures can analyze a fund's portfolio holdings, which
are publicly available in a structured data format on Form N-PORT, to
roughly estimate a fund's VaR.\671\ Taking all of these considerations
into account, we find that public disclosure of this information is
neither necessary nor appropriate in the public interest or for the
protection of investors.\672\ We are, however, requiring information
about a fund's designated reference portfolio to be made publicly
available, as proposed. Commenters did not object to making
[[Page 83223]]
this information publicly available, and to the extent that investors
and other market participants wish to compare a fund's performance
relative to the performance of its designated index, the information
regarding a fund's designated reference portfolio will facilitate this
analysis.
---------------------------------------------------------------------------
\670\ See General Instruction F of Form N-PORT (stating that the
SEC does not intend to make public the information reported with
respect to a fund's median daily VaR (Item B.10.a) and Median VaR
Ratio (Item B.10.b.iii)).
\671\ Cf. Dechert Comment Letter I; Invesco Comment Letter; T.
Rowe Comment Letter.
\672\ See supra footnote 657.
---------------------------------------------------------------------------
Second, while the proposal would have required funds to report
their highest daily VaR (and for funds that use the relative VaR test,
their highest daily VaR ratio) and these measures' corresponding dates,
the Form N-PORT amendments that we are adopting do not include this
requirement.\673\ After considering comments, we believe that a fund's
median VaR data more effectively portrays a fund's use of derivatives
than the highest VaR figures. The median VaR data will be based on
multiple inputs, whereas the high VaR figures would represent the
fund's VaR on a single day during the period, which could have been an
outlier that is not reflective of fund's typical VaR levels. Although
information about a fund's highest VaR or VaR ratio also could
facilitate monitoring by the Commission for compliance with the final
rule, we believe that the requirement for funds to report VaR breaches
on Form N-RN will provide sufficient information for this purpose. In
addition, the elimination of these proposed reporting items will offset
the burdens associated with new Form N-PORT reporting items that we
believe provide higher information value, such as a fund's median daily
VaR and median daily VaR ratio.
---------------------------------------------------------------------------
\673\ Proposed Items B.10.a, b, and d.iii-iv of Form N-PORT.
---------------------------------------------------------------------------
Backtesting Results
As proposed, a fund will have to report the number of exceptions it
identified during the reporting period arising from backtesting the
fund's VaR calculation model.\674\ This requirement is designed to help
analyze whether a fund's VaR model is effectively taking into account
and incorporating all significant, identifiable market risk factors
associated with a fund's investments, and will assist the Commission in
monitoring funds' compliance with the VaR tests.
---------------------------------------------------------------------------
\674\ Item B.10.c of Form N-PORT; see also Proposing Release,
supra footnote 1, at n.370.
---------------------------------------------------------------------------
While the Commission proposed that this backtesting information
would be publicly available, many commenters opposed making this
information public due to concerns that investors would misunderstand
or ascribe inappropriate significance to the backtesting
exceptions.\675\ These commenters suggested that investors might think
a fund that reports backtesting exceptions is not complying with its
leverage limits, or presents more compliance and leverage risk than it
actually does.\676\ The Proposing Release stated that funds would be
expected to experience backtesting exceptions approximately 2.5 times a
year and that more (or fewer) exceptions could suggest issues with the
VaR model. Commenters expressed concern that while backtesting
exceptions would not necessarily warrant investor concern, an investor
may not have the experience or relevant background to understand
this.\677\ Some commenters suggested that public disclosure of the
backtesting exceptions might confuse investors about the risks
associated with a fund's use of derivatives unless a detailed
contextual explanation regarding the fund's choice and application of
its VaR limit were also provided, which Form N-PORT is not designed to
provide.\678\
---------------------------------------------------------------------------
\675\ See, e.g., Dechert Comment Letter I; ICI Comment Letter;
BlackRock Comment Letter; Eaton Vance Comment Letter; MFA Comment
Letter.
\676\ See, e.g., Dechert Comment Letter I; MFA Comment Letter.
\677\ See Proposing Release, supra footnote 1, at n.150 and
accompanying text; see also BlackRock Comment Letter; Capital Group
Comment Letter; ICI Comment Letter.
\678\ Capital Group Comment Letter; BlackRock Comment Letter;
Eaton Vance Comment Letter.
---------------------------------------------------------------------------
In a change from the proposal, and after consideration of these
comments, we are not requiring the number of a fund's backtesting
exceptions to be made publicly available.\679\ This reporting
requirement is designed to allow the Commission to assess the adequacy
of a fund's VaR model. Taking into account the concerns commenters
raised and the purpose of this reporting requirement, we believe that
public disclosure of this information is neither necessary nor
appropriate in the public interest or for the protection of investors
---------------------------------------------------------------------------
\679\ See General Instruction F to Form N-PORT.
---------------------------------------------------------------------------
2. Amendments to Current Reporting Requirements
We are adopting new current reporting requirements for certain
funds that are relying on rule 18f-4. Specifically, we are re-titling
Form N-LIQUID as Form N-RN and amending this form to include new
reporting events for funds that are subject to the VaR-based limit on
fund leverage risk.\680\ These funds will be required to determine
their compliance with the applicable VaR test on at least a daily
basis.\681\ We are requiring these funds to file Form N-RN to report
information about VaR test breaches under certain circumstances. We are
adopting these requirements substantially as proposed, with conforming
amendments to reflect changes to the modified VaR requirements that we
adopting.
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\680\ See Parts E-G of Form N-RN.
\681\ Rule 18f-4(c)(2).
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If the portfolio VaR of a fund subject to the relative VaR test
exceeds, as applicable, 200% or 250% of the VaR of its designated
reference portfolio for five business days, we are requiring that such
a fund report: (1) The dates on which the fund portfolio's VaR exceeded
200% or 250% of the VaR of its designated reference portfolio; (2) the
VaR of the fund's portfolio for each of these days; (3) the VaR of its
designated reference portfolio for each of these days; (4) as
applicable, either the name of the designated index, or a statement
that the fund's designated reference portfolio is its securities
portfolio; and (5) as applicable, the index identifier for the fund's
designated index.\682\ A fund will have to report this information
within one business day following the fifth business day after the fund
has determined that its portfolio VaR exceeds, as applicable, 200% or
250% of its designated reference portfolio VaR.\683\ Such a fund also
will then have to file a second report on Form N-RN when it is back in
compliance with the relative VaR test.\684\
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\682\ See Part E of Form N-RN. This requirement reflects
conforming changes to parallel the VaR limits that we are adopting
as part of final rule 18f-4. See supra sections II.D.2.c. and
II.D.3. This requirement also reflects a conforming change to
reflect the final time-frame for VaR test remediation (five business
days as opposed to three business days, as proposed) that we are
adopting. See supra footnote 460 and accompanying text.
\683\ For example, if the fund were to determine, on the evening
of Monday, June 1, that its portfolio VaR exceeded 200% of the
fund's designated reference portfolio VaR, and this exceedance were
to persist through Tuesday (June 2), Wednesday (June 3), Thursday
(June 4), Friday (June 5), and Monday (June 8), the fund would file
Form N-RN on Tuesday, June 9 (because five business days following
the determination on June 1 is June 8, and 1 business day following
June 8 is June 9). If the exceedance were to still persist on June 9
(the date that the fund would file Form N-RN), the fund's report on
Form N-RN would provide the required information elements for June
1, 2, 3, 4, 5, 8 and 9.
\684\ See Part G of Form N-RN. The report will include the dates
on which the fund was not in compliance with the VaR test, and the
current VaR of the fund's portfolio on the date the fund files the
report.
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Similarly, if the portfolio VaR of a fund subject to the absolute
VaR test were to exceed, as applicable, 20% or 25% of the value of the
fund's net assets for five business days, we are requiring that such a
fund report: (1) The dates on which the fund portfolio's VaR exceeded
20% or 25% of the value of its net assets; (2) the VaR of the fund's
portfolio for each of these days; and (3)
[[Page 83224]]
the value of the fund's net assets for each of these days.\685\ Such a
fund will have to report this information within the same time frame as
would be required under the parallel reporting requirements for funds
that are subject to the relative VaR test, and also will have to file a
report on Form N-RN when it is back in compliance with the absolute VaR
test.\686\
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\685\ See Part F of Form N-RN. This requirement reflects
conforming changes to parallel proposed requirements to reflect the
VaR limits that we are adopting as part of final rule 18f-4. See
proposed Part F of Form N-RN; see also supra footnote 402 and
accompanying text. This requirement also reflects a conforming
change to the proposed requirement to reflect the final time-frame
for VaR test remediation that we are adopting (five business days as
opposed to three business days, as proposed). See supra footnote 460
and accompanying text.
\686\ A fund may provide explanatory information about any
information reported in response to the form's items. See Part H of
Form N-RN.
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Currently, only registered open-end funds (excluding money market
funds) are required to file reports on Form N-LIQUID (to be re-titled
as Form N-RN).\687\ As proposed, we are requiring all funds that are
subject to rule 18f-4's limit on fund leverage risk to file current
reports on Form N-RN regarding VaR test breaches.\688\ The scope of
funds that will be subject to the new VaR test breach current reporting
requirements of Form N-RN will thus include registered open-end funds,
as well as registered closed-end funds and BDCs. In addition to
extending the scope of funds required to respond to Form N-RN, we are
amending the general instructions to the form to reflect the expanded
scope and application, as proposed.\689\
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\687\ See General Instruction A.(1) to Form N-LIQUID; see also
rule 30b1-10 [17 CFR 270.30b1-10].
\688\ See Form N-RN; see also rule 30b1-10 under the Investment
Company Act (amended to extend current reporting requirements to
registered closed-end funds), and rule 18f-4(c)(7) (requiring all
funds that rely on rule 18f-4 and that are subject to its limit on
fund leverage risk, which experience an event specified in the parts
of Form N-RN titled ``Relative VaR Test Breaches,'' ``Absolute VaR
Test Breaches,'' or ``Compliance with VaR Test,'' to file with the
Commission a report on Form N-RN within the period and according to
the instructions specified in that form).
Because BDCs are regulated, not registered, under the Investment
Company Act, they are not subject to rule 30b1-10. A BDC is only
required to file on Form N-RN if it elects to rely on rule 18f-4 to
enter into derivative transactions, and the BDC experiences an event
that rule 18f-4(c)(7) specifies requires a filing on Form N-RN.
\689\ See, e.g., General Instruction A.(1) to Form N-RN (amended
to specify that the defined term ``registrant'' also includes
registered closed-end funds and BDCs); General Instruction A.(2) to
Form N-RN (amended to extend the scope of application to the new
VaR-test-breach-related Items E-G); General Instruction A.(3) to
Form N-RN (added to specify that only open-end funds required to
comply with rule 22e-4 under the Investment Company Act must report
events described in Parts B-D, as applicable, while all funds that
rely on rule 18f-4 subject to compliance with rule 18f-4(c)(2)'s
limit on fund leverage risk must report events described in Parts E-
G, as applicable); and General Instruction F to Form N-RN (amended
to specify that the terms used in Parts E-G have the same meaning as
in rule 18f-4).
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Many commenters expressed general support for the proposed Form N-
RN reporting requirements as an appropriate adjunct to the rule's
remediation provisions, facilitating regulatory monitoring by the
Commission.\690\ Conversely, one commenter broadly opposed any new
reporting requirements, including on Form N-RN.\691\ This commenter
stated that the proposed requirements in the aggregate could introduce
a substantial additional reporting burden for funds, particularly in
the context of volatile market conditions, and that given the board
reporting requirements under the proposed remediation provision,
imposing additional reporting requirements is unnecessary. Another
commenter recommended that the Commission either eliminate the proposed
Form N-RN reporting requirement and instead include the proposed Form
N-RN reporting items on Form N-PORT, or extend the remediation period
within which a fund must come back into compliance with its VaR to ten
business days.\692\ While acknowledging the Commission's need for
transparency and information, particularly during times of market
stress, this commenter expressed concern that some funds could engage
in asset sales to avoid triggering the Form N-RN filing
requirement.\693\
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\690\ See, e.g., J.P. Morgan Comment Letter; ICI Comment Letter;
Invesco Comment Letter; SIFMA AMG Comment Letter; Nuveen Comment
Letter.
\691\ ISDA Comment Letter.
\692\ Dechert Comment Letter III.
\693\ Id.; see also supra footnote 484.
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We continue to believe that the amendments to current reporting
requirements will be important for the Commission to assess funds'
compliance with the VaR tests and to monitor the effects of market
stress on funds' leverage risk.\694\ We are requiring funds to provide
this information in a current report because we believe that the
Commission should be notified promptly when a fund is out of compliance
with the VaR-based limit on fund leverage risk, which could indicate
that a fund is experiencing heightened risks as a result of the fund's
use of derivatives transactions. VaR test breaches could indicate that
a fund is using derivatives transactions to leverage the fund's
portfolio, magnifying its potential for losses and significant payments
of fund assets to derivatives counterparties. Such breaches also could
indicate market events that are drivers of potential derivatives risks
or other risks across the fund industry. Either of these scenarios--
increased fund-specific risks, or market events that affect funds'
risks broadly--may, depending on the facts and circumstances, require
attention by the Commission. Relying on reporting to the fund's board
alone and without a report to the Commission, as one commenter
suggested, would not further these objectives.
---------------------------------------------------------------------------
\694\ See Proposing Release supra footnote 1, at section II.H.2.
---------------------------------------------------------------------------
The new current reporting requirement is designed to provide the
Commission with current information regarding potential increased risks
and stress events (as opposed to delayed reporting on Form N-PORT). The
one-business-day time frame for this Form N-RN reporting--after a fund
has been out of compliance with the VaR test for five business days--is
designed to provide an appropriately early notification to the
Commission of potential heightened risks, while at the same time
providing sufficient time for a fund to compile and file its report on
Form N-RN. This time frame is also consistent with the current required
timing for reporting other events on current Form N-LIQUID.\695\ A fund
that breached its VaR test and has filed an initial report on Form N-RN
is not required to file additional reports while it is working to come
back into compliance because the requirement that a fund file a report
when it comes back into compliance allows the Commission to monitor the
length of time that a fund is out of compliance. However, we expect
that Commission staff will engage with the fund about its plans to come
back into compliance, among other monitoring activities, as discussed
above.\696\ Although one commenter suggested that a requirement to file
a current report could ``create[ ] [a] sense of urgency and may cause
forced selling not in the best interest of the fund,'' because a fund
that is promptly coming back into compliance with the applicable VaR
test must do so in a manner that is in the best interests of the fund
and its shareholders, a fund engaging in ``fire sales'' to avoid filing
a report on Form N-RN would violate the final rule.\697\
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\695\ See General Instruction A of current Form N-LIQUID (to be
re-titled as Form N-RN).
\696\ See supra section II.D.6.b.
\697\ See Dechert Comment Letter III; see also rule 18f-
4(2)(c)(ii); supra section II.D.6.b.
---------------------------------------------------------------------------
As proposed, funds' reports on Form N-RN regarding VaR test
breaches (like their reports on this form regarding
[[Page 83225]]
liquidity-related items) will be non-public, because we believe that
public disclosure of this information is neither necessary nor
appropriate in the public interest or for the protection of
investors.\698\ Information about VaR breaches that funds report on
Form N-RN will provide important information to the Commission for
regulatory purposes. Public disclosure is not required for these
regulatory purposes, and we believe that adverse effects might arise
from real-time public disclosure of a fund's VaR test breaches. For
example, publicly disclosing this information could confuse investors
and lead them and other market participants to make incorrect
assumptions about whether a fund has suffered losses (or will
imminently suffer losses) or about a fund's relative riskiness. This
could have potential adverse effects for funds if investors redeem or
sell fund shares as a result, and funds' remaining investors could be
adversely affected as well. The only commenter to address this aspect
of the proposal agreed that VaR information disclosed on Form N-RN
should not be made public.\699\ No commenters opposed the Commission's
proposal to make VaR information reported on Form N-RN non-public.
---------------------------------------------------------------------------
\698\ See General Instruction A.(1) to Form N-RN; see also
section 45(a) of the Investment Company Act.
\699\ AQR Comment Letter I.
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3. Amendments to Form N-CEN
Form N-CEN currently includes an item that requires a fund to
indicate--in a manner similar to ``checking a box''--whether the fund
has relied on certain Investment Company Act rules during the reporting
period.\700\ As proposed, we are amending this item to require a fund
to identify whether it relied on rule 18f-4 during the reporting
period.\701\ We are also adopting amendments, largely as proposed,
requiring a fund to identify whether it relied on any of the exceptions
from various requirements under the rule, specifically:
---------------------------------------------------------------------------
\700\ See Item C.7 of Form N-CEN.
\701\ See Item C.7.n of Form N-CEN.
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Whether the fund is a limited derivatives user excepted
from the rule's program requirement and VaR-based limit on fund
leverage risk; \702\ or
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\702\ See Item C.7.n.i of Form N-CEN.
---------------------------------------------------------------------------
Whether the fund is a leveraged/inverse fund that will be
excepted from the limit on fund leverage risk.\703\
---------------------------------------------------------------------------
\703\ See Item C.7.n.ii of Form N-CEN. This requirement reflects
conforming changes to remove references to the proposed sales
practices rules, which we are not adopting, and instead reference
the provision in the final rule addressing leveraged/inverse funds.
See rule 18f-4(c)(5).
---------------------------------------------------------------------------
In addition, as proposed, a fund will have to identify whether it
has entered into reverse repurchase agreements or similar financing
transactions pursuant to the rule. In a change from the proposal, a
fund must identify whether it entered into such transactions either
under: (1) The provision of rule 18f-4 that requires compliance with
section 18's asset coverage requirements; or (2) the provision that
allows funds to treat these transactions as derivatives transactions
for all purposes under the final rule.\704\ As proposed, a fund also
will have to identify whether it has entered into unfunded commitment
agreements under rule 18f-4.\705\ Finally, we are including a new
reporting item designed to conform to other changes being adopted in
final rule 18f-4 that will require a fund to identify whether it is
relying on the provision of rule 18f-4 that addresses investments in
securities on a when-issued or forward-settling basis, or with a non-
standard settlement cycle.\706\ This information will assist the
Commission with its oversight functions by allowing Commission staff to
identify which funds were excepted from certain of the rule's
provisions or relied on the rule's provisions regarding reverse
repurchase agreements, unfunded commitment agreements, or funds'
investment in when-issued, forward-settling, and non-standard
settlement cycle securities. All new information reported on Form N-CEN
pursuant to this rulemaking will be publicly available, as proposed.
---------------------------------------------------------------------------
\704\ See Items C.7.n.iii-iv of Form N-CEN. These requirements
reflect conforming changes to the proposed item to create two
separate reporting items, so a fund that enters into reverse
repurchase agreements or similar financing transactions under final
rule 18f-4 must identify the specific provision on which it is
relying, i.e., rule 18f-4(d)(1)(i) or rule 18f-4(d)(1)(ii).
\705\ See Item C.7.n.v of Form N-CEN.
\706\ See Item C.7.n.vi of Form N-CEN. This reporting item
corresponds with new rule 18f-4(f), which addresses investments in
when-issued and forward-settling securities.
In a change from the proposal, we are modifying Part A of Form
N-CEN (General Information) to include fields for a registrant's
name, and series name, if applicable. This change is designed to
facilitate the filing and review process.
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With the exception of one commenter that broadly opposed any new
form reporting requirements, including reporting on Form N-CEN, the
Commission received no comments opposing the proposed reporting
requirements on Form N-CEN.\707\ One commenter suggested that the
Commission amend Form N-CEN to include a new reporting item requiring a
fund to affirmatively identify whether it has adopted and implemented a
derivatives risk management program and is subject to a VaR-based limit
on leverage risk under rule 18f-4.\708\ We believe that the requirement
we are adopting for a fund to indicate on Form N-CEN that it is relying
on rule 18f-4 effectuates this recommendation. One commenter supported
making the new Form N-CEN disclosures publicly-available, and no
commenters opposed public availability of the new disclosures.\709\
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\707\ ISDA Comment Letter.
\708\ Invesco Comment Letter.
\709\ J.P. Morgan Comment Letter.
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H. Reverse Repurchase Agreements
As proposed, rule 18f-4 will permit funds to enter into reverse
repurchase agreements or similar financing transactions so long as they
meet the relevant asset coverage requirements of section 18.\710\
However, in a change from the proposal, the final rule also will allow
funds the option to treat reverse repurchase agreements or similar
financing transactions as derivatives transactions, rather than
including such transactions in the fund's asset coverage
calculations.\711\ This change is designed to provide a fund
flexibility to choose the approach that is best suited to its
investment strategy or operational needs, while still addressing
section 18's asset sufficiency and leverage concerns.\712\
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\710\ Rule 18f-4(d)(1)(i). Among other things, section 18
prescribes the required amount of asset coverage for a fund's senior
securities, and provides certain consequences for a fund that fails
to maintain this amount. See, e.g., section 18(a) (restrictions on
dividend issuance).
\711\ Rule 18f-4(d)(1)(ii).
\712\ Rule 18f-4(d) does not provide any exemptions from the
requirements of section 61 for BDCs because that section does not
limit a BDC's ability to engage in reverse repurchase or similar
transactions in parity with other senior security transactions
permitted under that section, and we do not believe that BDCs use
reverse repurchase agreements or similar financing transactions to
such an extent that they would seek or require the additional
flexibility to treat these transactions as derivatives transactions
under the final rule.
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As discussed in the Proposing Release, funds may engage in certain
transactions that may involve senior securities primarily as a means of
obtaining financing.\713\ A common method of obtaining financing is
through the use of reverse repurchase agreements,\714\ which are
economically
[[Page 83226]]
equivalent to secured borrowings.\715\ Accordingly, the Commission
proposed to allow a fund to enter into reverse repurchase agreements
and similar financing transactions if it treats them as economically
equivalent to bank borrowings or other indebtedness subject to the full
asset coverage requirements of section 18, and combines the aggregate
amount of indebtedness associated with reverse repurchase agreements
and other similar financing transactions with bank borrowings and other
senior securities representing indebtedness when calculating compliance
with section 18's asset coverage ratios.\716\
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\713\ For example, open-end funds are permitted to borrow money
from a bank, provided they maintain a 300% asset coverage ratio. See
section 18(f)(1) of the Investment Company Act.
\714\ In a reverse repurchase agreement, a fund transfers a
security to another party in return for a percentage of the value of
the security. At an agreed-upon future date, the fund repurchases
the transferred security by paying an amount equal to the proceeds
of the initial sale transaction plus interest. See Release 10666,
supra footnote 14, at ``Reverse Repurchase Agreements'' discussion
(stating that a reverse repurchase agreement may not have an agreed-
upon repurchase date, and in that case the agreement would be
treated as if it were reestablished each day).
\715\ See, e.g., Office of Financial Research, Reference Guide
to U.S. Repo and Securities Lending Markets (Sept. 9, 2015),
available at https://www.financialresearch.gov/working-papers/files/OFRwp-2015-17_Reference-Guide-to-U.S.-Repo-and-Securities-Lending-Markets.pdf.
\716\ Proposed rule 18f-4(d).
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Commenters generally agreed that reverse repurchase agreements are
economically a form of secured borrowing.\717\ Nevertheless, some
commenters urged that we provide additional flexibility for funds to
engage in these transactions because subjecting them to the Act's asset
coverage requirements as proposed would limit a fund's use of reverse
repurchase agreements and similar financing transactions relative to
current levels permitted under Release 10666.\718\ Several commenters
stated that reverse repurchase agreements are often simpler and less
expensive to enter into than other borrowings, and have bankruptcy
benefits.\719\ One commenter was concerned that it would be
operationally challenging to include reverse repurchases when
calculating compliance with the 300% asset coverage test because the
transactions are so quickly entered and exited.\720\ Some commenters
also suggested that the proposed approach would unnecessarily hamper
the investment strategies of certain funds, with two commenters
focusing on closed-end funds in particular.\721\
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\717\ See, e.g., Nuveen Comment Letter; Guggenheim Comment
Letter.
\718\ See, e.g., NYC Bar Comment Letter; ICI Comment Letter;
BlackRock Comment Letter; Guggenheim Comment Letter; PIMCO Comment
Letter.
Under the approach established in Release 10666, a fund could
enter into reverse repurchase agreements so long as it segregated
assets equal to the fund's repurchase obligations, or effectively up
to a 200% asset coverage ratio. Under the proposal, reverse
repurchase agreements would be combined with other borrowings,
subject to a total asset coverage limit of 300% in the case of open-
end funds. This would have the effect of reducing the maximum amount
that a fund could borrow using reverse repurchase agreements
relative to the approach under Release 10666.
\719\ See, e.g., Dechert Comment Letter I; Guggenheim Comment
Letter; ICI Comment Letter.
\720\ See, e.g., Guggenheim Comment Letter.
\721\ See, e.g., ICI Comment Letter; Blackrock Comment Letter;
PIMCO Comment Letter.
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Commenters suggested alternatives to the Commission's proposed
treatment of reverse repurchase agreements. They generally agreed that
the current regulation of reverse repurchase agreements under an asset
segregation framework has been effective.\722\ A number of commenters
recommended retaining the current regulatory framework under which
funds segregate liquid assets in connection with reverse repurchase
agreements rather than complying with section 18's asset coverage
requirements.\723\ Commenters also suggested allowing funds the option
to use either the current asset segregation approach, or the proposed
approach to requiring compliance with section 18's asset coverage
requirements for reverse repurchase agreements.\724\ Several commenters
recommended that we adopt a modified asset segregation approach that
limits segregated assets to assets classified as highly or moderately
liquid under rule 22e-4.\725\ Another commenter suggested that if we do
not retain the existing asset segregation framework, we should allow
funds to treat reverse repurchase agreements as derivatives
transactions under the final rule.\726\ One commenter also observed
that a fund could create exactly the same economics of a reverse
repurchase agreement with a total return swap, which is treated as a
derivatives transaction under the rule.\727\
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\722\ See, e.g., ICI Comment Letter; NYC Bar Comment Letter.
\723\ See, e.g., NYC Bar Comment Letter, Guggenheim Comment
Letter; Dechert Comment Letter I; BlackRock Comment Letter; SIFMA
AMG Comment Letter.
\724\ See, e.g., Guggenheim Comment Letter; Dechert Comment
Letter I; SIFMA AMG Comment Letter; PIMCO Comment Letter.
\725\ See, e.g., ICI Comment Letter; BlackRock Comment Letter;
Guggenheim Comment Letter; PIMCO Comment Letter; SIFMA AMG Comment
Letter.
\726\ NYC Bar Comment Letter. The Commission requested comment
regarding whether to treat reverse repurchase agreements and similar
financing transactions as derivatives transactions in the Proposing
Release.
\727\ Nuveen Comment Letter.
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Reverse repurchase agreements and other similar financing
transactions have the effect of allowing a fund to obtain additional
cash that can be used for investment purposes or to finance fund
assets. As such, they achieve effectively identical results to a bank
borrowing or other borrowing.\728\ Accordingly, we believe it is
appropriate to allow funds to engage in these transactions to the same
degree as borrowings under the Act, and to treat them equally. For
example, this would have the effect of permitting an open-end fund to
obtain financing by borrowing from a bank, engaging in a reverse
repurchase agreement, or any combination thereof, so long as all
sources of financing are included when calculating the fund's asset
coverage ratio.\729\ The final rule therefore will allow funds to use
reverse repurchase agreements up to the Act's limits on borrowings
without incurring the costs and burdens of instituting a derivatives
risk management program under the final rule.\730\
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\728\ Another example of a similar financing transaction for
purposes of this provision would be a fund's purchase of a security
on margin.
\729\ Section 18 states that certain borrowings that are made
for temporary purposes (less than 60 days) and that do not exceed 5%
of the total assets of the issuer at the time when the loan is made
(temporary loans) are not senior securities for purposes of certain
paragraphs in section 18. As the Commission noted in Release 10666,
reverse repurchase agreements and similar financing transactions
could be designed to appear to fall within the temporary loans
exception, and then could be ``rolled-over,'' perhaps indefinitely,
with such short-term transactions being entered into, closed out,
and later re-entered. If substantially similar financing
arrangements were being ``rolled over'' in any manner for a total
period of 60 days or more, we would treat the later transactions as
renewals of the earlier ones, and all such transactions would fall
outside the exclusion for temporary loans.
\730\ Under this asset coverage option, reverse repurchase
agreements and similar financing transactions will not be included
in calculating a fund's derivatives exposure under the limited
derivatives user provisions of the final rule. However, if a fund
does not qualify as a limited derivatives user due to its other
investment activity, any portfolio leveraging effect of reverse
repurchase agreements or similar financing transactions will be
included and restricted through the VaR-based limit on fund leverage
risk. This is because the VaR tests estimate a fund's risk of loss
taking into account all of its investments, including the proceeds
of reverse repurchase agreements and investments the fund purchased
with those proceeds.
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We are also persuaded that reverse repurchase agreements and
similar financing transactions, like derivatives transactions, may
provide an efficient and cost-effective form of financing or leverage.
When a fund engages in these transactions to borrow beyond what the Act
allows under section 18, however, we believe that the same concerns
that prompted our adoption of the derivatives risk management program
requirement and other conditions of rule 18f-4 may arise. We also
appreciate that other types of transactions that would qualify as
derivatives transactions under the proposed rule, such as total return
swaps, can achieve economically similar results to reverse
[[Page 83227]]
repurchase agreements. That is, a 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--including through a reverse repurchase agreement--in
order to purchase the swap's reference assets. While reverse repurchase
agreements may not be traditionally seen as ``derivatives,'' they were
one of the specific types of transactions that were addressed in
Release 10666, in light of the leverage and asset sufficiency concerns
they may raise. We believe that as part of our re-evaluation of our
regulatory scheme with respect to derivatives and similar transactions,
we should address the concerns raised by fund use of reverse repurchase
agreements in a consistent manner as those posed by derivatives
transactions under the rule when a fund engages in these transitions
beyond the Act's asset coverage requirements for borrowings.
Accordingly, the final rule will allow a fund that does not wish to
avail itself of the asset coverage treatment of reverse repurchase
agreements, to instead choose to treat them as a derivatives
transaction for all purposes under the final rule.\731\ In other words,
a fund can either choose to limit its reverse repurchase and other
similar financing transaction activity to the applicable asset coverage
limit of the Act for senior securities representing indebtedness, or it
may instead treat them as derivative transactions.\732\ A fund's
election will apply to all of its reverse repurchase agreements or
similar financing transactions so that all such transactions are
subject to a consistent treatment under the final rule.\733\ For
example a fund may not elect to treat reverse repurchase agreements as
derivatives transactions under the final rule, while at the same time
electing to treat similar financing transactions, such as Tender Offer
Bond (``TOB'') financings, like bank borrowings under the final rule's
asset coverage option. Such mixing and matching of transaction types
would not be consistent with the final rule.
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\731\ Rule 18f-4(a) (definition of derivatives transaction).
\732\ A fund could choose to treat its reverse repurchase
agreements as borrowings under the option we are adopting, and also
engage in a limited amount of derivatives use under the limited
derivatives user exception.
\733\ Rule 18f-4(d)(1)(i) and (ii).
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We recognize that such transactions could have the effect of
introducing leverage into a fund's portfolio if the fund were to use
the proceeds of the financing transaction to purchase additional
investments. In addition, such transactions impose a requirement to
return assets at the termination of the agreement, which can raise
section 18 asset sufficiency concerns to the extent the fund needs to
sell less-liquid securities at a loss to obtain the necessary assets.
However, we believe that the derivatives risk management program
requirement we are adopting in rule 18f-4 is designed to address these
concerns. The leverage risks introduced by the use of reverse
repurchase agreements will be identified through the funds' VaR
calculations and managed through the program. Similarly, any asset
sufficiency concerns should be addressed as a liquidity risk or other
derivatives risk under the program. Accordingly, the final rule would
allow funds to treat reverse repurchase agreements as derivatives
transactions if they choose to do so and comply with the other
requirements of the final rule.
Allowing a fund to treat reverse repurchase agreements as
derivatives transactions will provide additional flexibility for funds
to enter into these agreements. This is because, under the final rule,
a fund is permitted to have a portfolio VaR up to 200% of the VaR of
the fund's designated reference portfolio or up to 20% for funds
relying on the absolute VaR test (with higher limits for closed-end
funds). Under our historical approach to asset segregation for these
transactions, a fund could incur obligations under these transactions
equal to 100% of the fund's net assets, after which all of the fund's
assets would have been segregated. The approach we are taking under the
final rule would provide reasonably comparable flexibility where a fund
relies on the relative VaR test because the fund could treat reverse
repurchase agreements as derivatives transactions and would be able to
use them to increase the fund's VaR up to approximately 200% of the VaR
of the fund's designated reference portfolio by reinvesting the reverse
repurchase agreement borrowings in the fund's strategy.
The final rule will also require a fund to memorialize on its books
and records which option it is using to manage its reverse repurchase
agreements and similar financing transactions, and maintain that record
for five years.\734\ These records will provide supporting detail for a
fund's corresponding Form N-CEN ``check-the-box'' representation
regarding the rule provision upon which it relied in entering into
reverse repurchase agreements and similar financing transactions.\735\
We believe it is appropriate to require such a record to ensure that
our examiners can identify and verify which option the fund is using
for these transactions.
---------------------------------------------------------------------------
\734\ Rule 18f-4(d)(2).
\735\ See supra footnote 704.
---------------------------------------------------------------------------
The required records also could preserve more-granular detail than
the corresponding Form N-CEN representation, depending on the
circumstances. For example, if a fund were to switch between the two
options multiple times throughout one year, these actions would be
memorialized in the fund's books and records, but would not appear on
Form N-CEN, which registered funds file annually. We believe that if a
fund were to switch between the two options on a dynamic or frequent
basis, this may indicate that the fund has not effectively evaluated
the appropriate approach. In addition, such frequent switching may
indicate gaming or create other evasion concerns. However, a fund could
reasonably decide to switch between options if circumstances change or
it otherwise reevaluates how it should best treat such transactions. In
such a case, this recordkeeping provision requires the fund to maintain
a record of its original choice and its switch to the other option for
the appropriate period.
As noted above, some commenters suggested that we retain an asset
segregation approach for reverse repurchase agreements and similar
financing transactions, similar to the approach that the Commission
proposed for these and certain other transactions in 2015. We are not
persuaded that we should adopt such a separate and distinct approach
for reverse repurchase agreements. As part of this rulemaking process,
we are engaging in a holistic re-evaluation of our approach to
regulating derivatives and similar transactions. As discussed
previously, while asset segregation, depending on the assets
segregated, can address the asset sufficiency and leverage concerns of
the Act, we generally believe that when a fund exceeds the leverage
limits contemplated by the Act, such concerns are more appropriately
managed through a derivatives risk management program and other rule
18f-4 requirements. We do not believe that establishing an asset
segregation regime for a limited subset of transactions, such as
reverse repurchase agreements, is necessary. Moreover, providing
separate and distinct regimes for bank borrowings and other
transactions subject to the Act's asset coverage requirements,
derivatives transactions under the final rule, and an asset
[[Page 83228]]
segregation requirement for reverse repurchase agreements and similar
financing transactions would increase the likelihood that funds
engaging in economically similar transactions would be subject to
disparate regulatory requirements. Accordingly, in light of the
approach we are adopting here, we do not believe that providing a
separate asset segregation regime for reverse repurchase agreements and
similar financing transactions is appropriate.
Some commenters requested that we provide different limits for
reverse repurchase agreements or similar financing transactions for
closed-end funds in light of the lower asset coverage ratio the Act
allows for the issuance of preferred stock.\736\ While the Act provides
a lower asset coverage ratio for such purposes, we believe that
permitting closed-end funds the option to treat such transactions as
derivatives transactions should address this issue. Under the final
rule, closed-end funds can choose to engage in reverse repurchase
agreements and similar financing transactions to the same extent as
derivative transactions, which would allow them to use reverse
repurchase agreement to the same degree or higher than would be
permitted under the 200% asset coverage requirement for preferred stock
in the Act.
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\736\ See, e.g., Nuveen Comment Letter; PIMCO Comment Letter.
These commenters noted that unlike open-end funds, which are subject
to a 300% asset coverage requirement for debt, which is the only
form of leverage that such funds are permitted to use, registered
closed-end funds and BDCs can also obtain equity-based leverage by
selling preferred stock, which are subject to lower asset coverage
requirements. These commenters asserted that closed-end funds should
be allowed to treat reverse repurchase agreements and TOB Residuals
for purposes of section 18 as a form of senior security representing
stock subject to a 200% asset coverage requirement. Under section
18, whether a senior security involves equity or debt for purposes
of that section does not depend on whether the fund entering into
the transaction is an open-end or closed-end fund. We believe the
final rule should take the same approach.
---------------------------------------------------------------------------
Several commenters sought clarification on whether certain types of
transactions (such as TOB financings) are ``similar financing
transactions'' to reverse repurchase agreements and thus would be
subject to the proposed asset coverage limit.\737\ We believe that TOB
financings are economically similar to reverse repurchase agreements,
and therefore are ``similar financing transactions'' under the final
rule, where a fund engages in a TOB financing (as opposed to purchasing
an ``inverse floater'' issued by a TOB trust in the secondary market).
In a TOB financing, similar to a reverse repurchase agreement, a fund
transfers a bond to a TOB trust that, in turn, issues floating rate
securities to money market funds and other investors, often called
``floaters,'' and transfers to the fund the residual interest in the
trust (an ``inverse floater'') and the proceeds of the sale of the
floating rate securities. The fund typically uses the cash proceeds
from the sale of the floating rate securities to purchase additional
portfolio securities. As one commenter on the 2015 proposal observed, a
fund employing a TOB trust has in effect used the underlying bond as
collateral to secure a borrowing analogous to a fund's use of a
security to secure a reverse repurchase agreement.\738\
---------------------------------------------------------------------------
\737\ See, e.g., SIFMA AMG Comment Letter; Putnam Comment
Letter.
\738\ See Proposing Release, supra footnote 1, at n.406 (citing
the Comment Letter of the Securities Industry and Financial Markets
Association (Mar. 28, 2016)).
---------------------------------------------------------------------------
Some commenters urged that the final rule should distinguish
between ``recourse'' and ``non-recourse'' TOB financings.\739\ Under a
``recourse'' TOB financing, the fund holding the inverse floater is
obligated to increase its investment in the TOB trust to either provide
an additional cushion to the holder of the floaters or allow the
liquidity provider to redeem some or all of the outstanding floaters,
or make payments to a financial institution providing liquidity to the
holders of the floaters. In a non-recourse TOB financing, the fund
would not have a legal obligation to provide additional assets to the
TOB trust or payments to liquidity providers.\740\ We do not believe
that this distinction supports different treatment under section 18 or
the final rule. We also note that GAAP does not support such a
distinction.\741\ In both a recourse and non-recourse TOB financing,
the fund effectively is engaging in a leveraging transaction and
receiving the proceeds from the sale of the floaters, which the fund
can use to make further investments. Although the inverse floater,
itself, may represent an equity interest in the TOB trust, we believe
TOB financings involve a borrowing by the fund regardless of whether
the holders of the floaters would look to the fund or some other party
if the income produced by the bond deposited in the TOB trust or
proceeds realized upon the bond's sale is insufficient to repay them.
---------------------------------------------------------------------------
\739\ See, e.g., SIFMA AMG Comment Letter.
\740\ SIFMA AMG Comment Letter; Nuveen Comment Letter.
\741\ See, e.g., FASB Accounting Standards Codification
Transfers and Servicing (Topic 860) (``ASC 860 Transfers and
Servicing''). ASC 860 Transfers and Servicing, which applies to
transfers and servicing of financial assets, provides guidance on
the accounting for a transfer of financial assets as a sale to third
parties and the use of financial assets as collateral in secured
borrowings. Transactions related to TOB financings, including the
initial transfer of the bond into the TOB trust and subsequent
issuance of synthetic floaters, generally should be evaluated
pursuant to ASC 860 to determine whether the transaction is a
secured borrowing or a sale.
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Securities lending arrangements are structurally similar to reverse
repurchase agreements in that, in both cases, a fund transfers a
portfolio security to a counterparty in exchange for cash (or other
assets).\742\ Nevertheless, the Commission stated in the Proposing
Release that it would not view a fund's obligation to return securities
lending collateral as a ``similar financing transaction'' if the fund
reinvests cash collateral in cash or cash equivalents (such as money
market funds), and the fund does not sell or otherwise use non-cash
collateral to leverage its portfolio.\743\ The Commission also stated
that a fund that engages in securities lending under these
circumstances is limited in its ability to use securities lending
transactions to increase leverage in its portfolio.\744\
---------------------------------------------------------------------------
\742\ In the 2015 Proposing Release, the Commission sought
comment on whether rule 18f-4 should address funds' compliance with
section 18 in connection with securities lending, to which
commenters responded that the staff's current guidance on securities
lending forms the basis for funds' securities lending practices and
effectively addresses the senior securities implications of
securities lending, and thus securities lending practices need not
be addressed in the final rule. See, e.g., Comment Letter of the
Investment Company Institute (Mar. 28, 2016); Comment Letter of
Guggenheim (Mar. 28, 2016); Comment Letter of the Securities
Industry and Financial Markets Association (Mar. 28, 2016); Comment
Letter of the Risk Management Association (Mar. 28, 2016); see also
Staff Guidance on Securities Lending by U.S. Open-End and Closed-End
Investment Companies (Feb. 27, 2014), available at https://www.sec.gov/divisions/investment/securities-lending-open-closed-end-investment-companies.htm (providing guidance on certain no-action
letters that funds consider when engaging in securities lending and
summarizing areas those letters address, including limitations on
the amount that may be lent and collateralization for such loans).
\743\ See Proposing Release supra footnote 1, at nn.403-405 and
accompanying text.
\744\ Id.
---------------------------------------------------------------------------
The commenters who addressed this issue agreed that securities
lending transactions should not be treated as reverse repurchase
agreements or similar transactions under the final rule under these
circumstances.\745\ However, some of these commenters requested that we
expand the types of assets in which funds can invest the securities
lending proceeds beyond cash and cash equivalents.\746\ Commenters also
requested that we clarify what
[[Page 83229]]
instruments would qualify as cash or cash equivalents.\747\
---------------------------------------------------------------------------
\745\ See, e.g., ICI Comment Letter; BlackRock Comment Letter;
Dechert Comment Letter I; SIFMA AMG Comment Letter.
\746\ See, e.g., ICI Comment Letter; BlackRock Comment Letter.
\747\ See, e.g., Putnam Comment Letter; SIFMA AMG Comment
Letter.
---------------------------------------------------------------------------
We do not agree with commenters' suggestions that we expand the
types of collateral in which a fund may reinvest its proceeds beyond
cash and cash equivalents without treating the arrangements as reverse
repurchase agreements or similar financing transactions under the final
rule. If a fund were to engage in securities lending and to invest the
cash collateral in securities other than cash or cash equivalents, this
may result in leveraging of the fund's portfolio. Accordingly, we
believe this activity would be a ``similar financing transaction''
under the final rule. The Commission has previously stated that
``[c]urrent U.S. generally accepted accounting principles define cash
equivalents as short-term, highly liquid investments that are readily
convertible to known amounts of cash and that are so near their
maturity that they present insignificant risk of changes in value
because of changes in interest rates.'' \748\ The Commission has also
stated that items commonly considered to be cash equivalents include
certain Treasury bills, agency securities, bank deposits, commercial
paper, and shares of money market funds.\749\
---------------------------------------------------------------------------
\748\ See 2015 Proposing Release, supra footnote 1, at n.367 and
accompanying text.
\749\ See id., at n.368 and accompanying text.
---------------------------------------------------------------------------
I. Unfunded Commitment Agreements
As proposed, rule 18f-4 will permit a fund to enter into unfunded
commitment agreements to make certain loans or investments if the fund
reasonably believes, at the time it enters into such agreement, that it
will have sufficient cash and cash equivalents to meet its obligations
with respect to its unfunded commitment agreements.\750\ This approach
recognizes that while entering into unfunded commitment agreements may
raise the risk that a fund may be unable to meet its obligations under
these transactions, unfunded commitments do not generally involve the
leverage and other risks associated with derivatives transactions.
---------------------------------------------------------------------------
\750\ Rule 18f-4(e)(1).
---------------------------------------------------------------------------
When a fund enters into an unfunded commitment agreement, the fund
commits, conditionally or unconditionally, to make a loan to a company
or to invest equity in a company in the future.\751\ They include
capital commitments to a private fund requiring investors to fund
capital contributions or to purchase shares upon delivery of a drawdown
notice. As proposed, the final rule will define an unfunded commitment
agreement to mean a contract that is not a derivatives transaction,
under which a fund commits, conditionally or unconditionally, to make a
loan to a company or to invest equity in a company in the future,
including by making a capital commitment to a private fund that can be
drawn at the discretion of the fund's general partner.\752\ The
exclusion of derivatives transactions from this definition is
predicated on our understanding that unfunded commitment agreements
have certain characteristics that distinguish them from derivatives
transactions.\753\
---------------------------------------------------------------------------
\751\ Proposing Release supra footnote 1, at section II.J. The
types of funds that enter into unfunded commitment agreements
typically include BDCs and registered closed-end funds. Certain
types of open-end funds, such as floating rate funds and bank loan
funds, also enter into unfunded commitment agreements, although to a
lesser extent. We estimate that approximately 989 of 11,616 (8.5%)
open-end funds, 205 of 678 (30%) closed-end funds, and 100% of BDCs
entered into unfunded commitments in 2019. See infra footnote 1033.
\752\ Rule 18f-4(a).
As discussed in the Proposing Release, commenters on the 2015
Proposal identified characteristics of unfunded commitment
agreements that they believed distinguished them from derivatives
transactions: (1) A fund often does not expect to lend or invest up
to the full amount committed; (2) a fund's obligation to lend is
commonly subject to conditions, such as a borrower's obligation to
meet certain financial metrics and performance benchmarks, which are
not typically present under the types of agreements that the
Commission described in Release 10666; and (3) unfunded commitment
agreements do not give rise to the risks that Release 10666
identified and do not have a leveraging effect on the fund's
portfolio because they do not present an opportunity for the fund to
realize gains or losses between the date of the fund's commitment
and its subsequent investment when the other party to the agreement
calls the commitment. See Proposing Release supra footnote 1, at
nn.410-412 and accompanying text.
\753\ See id. at n.413 and accompanying text.
---------------------------------------------------------------------------
We continue to believe that unfunded commitment agreements are
distinguishable from the derivatives transactions covered by rule 18f-
4. Based on characteristics that we understand are typical of unfunded
commitment agreements, we do not believe that funds enter into these
agreements to leverage a fund's portfolio, or that they generally raise
the Investment Company Act's concerns regarding the risks of undue
speculation.\754\ Two commenters agreed that unfunded commitments are
distinguishable from derivative transactions.\755\ Commenters also
agreed that unfunded commitments do not give rise to the type of
leverage risk that section 18 was meant to regulate.\756\ Two
commenters expressly supported the proposed definition of ``unfunded
commitment agreement.'' \757\ One commenter stated that the proposed
definition may not clearly demarcate the difference between unfunded
commitment agreements and derivatives transactions in all cases, but
offered no suggestions regarding how to revise the definition to
address this concern.\758\ We are adopting the definition of ``unfunded
commitment agreement'' as proposed.
---------------------------------------------------------------------------
\754\ Id.
\755\ ABA Comment Letter; Aditum Comment Letter.
\756\ ABA Comment Letter; NYC Bar Comment Letter; Aditum Comment
Letter.
\757\ Aditum Comment Letter; ICI Comment Letter.
\758\ Keen Comment Letter.
---------------------------------------------------------------------------
We believe that unfunded commitment agreements can raise the asset
sufficiency concerns underlying the Investment Company Act, depending
on the facts and circumstances. No commenters opposed this view, and
one commenter agreed, stating that ``[e]xcessive unfunded commitments,
even made or acquired as the result of careful planning, may engender
asset sufficiency concerns, particularly in the context of a market
distortion.'' \759\ We are therefore adopting, as proposed, an approach
that will permit a fund to enter into unfunded commitment agreements if
it reasonably believes, at the time it enters into such an agreement,
that it will have sufficient cash and cash equivalents to meet its
obligations with respect to its unfunded commitment agreements, in each
case as they come due.\760\
---------------------------------------------------------------------------
\759\ Aditum Comment Letter.
\760\ See rule 18f-4(e)(1). Because this condition is designed
to provide an approach tailored to unfunded commitment agreements,
the final rule also provides that these transactions will not be
considered for purposes of computing asset coverage under section
18(h).
---------------------------------------------------------------------------
A fund should consider its unique facts and circumstances in
forming such a reasonable belief. As proposed, the final rule
prescribes certain specific factors that a fund must take into
account.\761\ Specifically:
---------------------------------------------------------------------------
\761\ Rule 18f-4(e)(1). The final rule requires the fund to make
and maintain records documenting the basis for this belief, as
proposed. See rule 18f-4(e)(2).
---------------------------------------------------------------------------
A fund must take into account its reasonable expectations
with respect to other obligations, including any obligation with
respect to senior securities or redemptions. This factor reflects that
other obligations can place competing demands on cash a fund otherwise
might intend to use to fund an unfunded commitment agreement.
A fund may not take into account cash that may become
available from the sale or disposition of any investment at a price
that deviates significantly from
[[Page 83230]]
the market value of those investments. This provision is designed to
address the risk that a fund could suffer losses by selling assets to
raise cash to fund an unfunded commitment agreement, ultimately having
an adverse impact on the fund's investors.
A fund may not consider cash that may become available
from issuing additional equity. We believe that a fund's ability to
raise capital in the future depends on a variety of factors that are
too speculative to support a fund's reasonable belief that it could
fund an unfunded commitment agreement with the proceeds from future
sales of securities issued by the fund, as discussed below.
The final rule will not preclude a fund from considering the
issuance of debt (e.g., borrowings from financial institutions, or the
issuance of debt securities) to support a reasonable belief that it
could cover an unfunded commitment, as proposed.\762\ We understand
that funds often satisfy their obligations under unfunded commitments
through borrowings, which are limited by section 18's asset coverage
requirements. These asset coverage requirements, in turn, affect the
extent to which a fund may form a reasonable belief regarding its
ability to borrow, and likewise, to enter into unfunded commitment
agreements.
---------------------------------------------------------------------------
\762\ Proposing Release, supra footnote 1, at section II.J.
---------------------------------------------------------------------------
To have a reasonable belief, a fund could consider, for example,
its strategy, its assets' liquidity, its borrowing capacity under
existing committed lines of credit, and the contractual provisions of
its unfunded commitment agreements. A fund with unfunded loan
commitments, for instance, could evaluate the likelihood that different
potential borrowers would meet contractual ``milestones'' that the
borrowers would have to satisfy as a condition to the obligation to
fund a loan, as well as the amount of the anticipated borrowing. The
fund's historical experience with comparable obligations should inform
this analysis. Whether a fund has a reasonable belief also could be
informed by a fund's assessment of the likelihood that subsequent
market or other events could impair the fund's ability to have
sufficient cash and cash equivalents to meet its unfunded commitment
obligations. One commenter confirmed that the proposed approach
conforms with current industry practice for BDCs and other regulated
funds.\763\
---------------------------------------------------------------------------
\763\ ABA Comment Letter (``BDCs and other regulated funds that
enter into unfunded commitments generally represent to the staff
during the review of their registration statements that they believe
their assets will provide adequate cover to satisfy unfunded
commitments when due. In other words, funds have experience
complying with the reasonable belief requirement under the Proposed
Rules.'').
---------------------------------------------------------------------------
The commenters that addressed this aspect of the proposal broadly
supported requiring a ``reasonable belief'' determination in connection
with unfunded commitment agreements as set forth in the proposed
rule.\764\ Two commenters recommended that the final rule treat
unfunded commitments in the same manner as the proposed rule.\765\ One
stated that the ``reasonable belief'' factors ``are appropriate and
will provide additional clarity for how a fund should handle
determining whether or not it should enter into unfunded commitment
agreements going forward.'' \766\ Conversely, two commenters
recommended changing certain aspects of the proposed factors, with one
seeking greater flexibility, and the other advocating for more
restrictive criteria.
---------------------------------------------------------------------------
\764\ ABA Comment Letter; ICI Comment Letter, NYC Bar Comment
Letter, Aditum Comment Letter.
\765\ ICI Comment Letter; ABA Comment Letter.
\766\ ABA Comment Letter.
---------------------------------------------------------------------------
The commenter advocating for additional flexibility suggested that,
instead of being required to consider the proposed specified factors,
funds be permitted to determine their own factors to consider when
making a ``reasonable belief'' determination with respect to asset
sufficiency.\767\ This commenter stated that a more flexible approach
would allow a fund to consider its unique facts and circumstances, and
the Commission's exam staff could review a fund's records to assess
what factors a fund considered when entering into unfunded commitment
transactions. We believe the approach we are adopting provides this
flexibility. While a fund must take into account the specified factors
and prohibitions, it may consider any other factors it deems relevant
for purposes of forming a reasonable belief as to its asset
sufficiency. This commenter also suggested that in making an asset
sufficiency determination, a fund should be permitted to consider its
ability to raise cash by issuing equity securities, in addition to
debt. We continue to believe, as the Commission discussed in the
proposal, that a fund's future ability to raise cash by issuing equity
would depend on a variety of factors, including future market
conditions, that are too speculative to support a reasonable belief
that a fund could cover its unfunded commitments with the proceeds from
future sales of the fund's securities.\768\ Thus, the final rule
precludes a fund that is making an asset sufficiency determination from
taking into account cash that may become available from issuing
additional equity, as proposed.
---------------------------------------------------------------------------
\767\ NYC Bar Comment Letter.
\768\ Proposing Release, supra footnote 1, at section II.J.
Because an exchange-traded closed-fund can only sell shares if its
share price is above NAV, its ability to issue equity is more
limited (and thus, we believe more speculative) than its ability to
issues debt or access a line of credit. See section 23(b) of the
Investment Company Act (generally prohibiting a registered closed
end fund or BDC from issuing its shares at a price below the fund's
current net asset value (``NAV'') without shareholder approval).
---------------------------------------------------------------------------
Conversely, another commenter urged the Commission to enhance or
expand the specified factors to provide additional protections to
investors.\769\ This commenter recommended that a fund making an asset
sufficiency determination be precluded from considering the
availability of any additional capital (including debt) because its
ability to satisfy its unfunded commitments is likely to be most
impaired during a market distortion, when it should least expect
additional fund subscriptions or the availability of borrowed funds. We
are not adopting this suggested approach. Borrowings may be an
important way for funds to obtain cash to fund an unfunded commitment
agreement. Closed-end funds that hold less liquid assets, for example,
may rely on lending facilities rather than selling assets or holding
cash. Moreover, although the final rule does not preclude a fund from
considering its ability to borrow to satisfy unfunded commitments, a
fund's reasonable belief would be based on all of the facts and
circumstances, including whether the fund would reasonably expect to be
able to access financing in a particular case.
---------------------------------------------------------------------------
\769\ See Aditum Comment Letter.
---------------------------------------------------------------------------
This commenter also suggested requiring a fund to reassess whether
its ``reasonable belief'' remains reasonable at various points during
the period of the unfunded commitment agreement.\770\ We are not
adopting this approach. Under the final rule, a fund must reassess its
asset sufficiency before entering into any additional unfunded
commitment agreements, when such information would be most relevant to
such a determination. Requiring a fund to reassess its asset
sufficiency after entering into a contract would be of limited use
because regardless of the outcome, the fund would still be bound by the
terms of the contract. Finally, this commenter urged that given the
potential impact of a market distortion on a fund's ability to meet its
unfunded commitments and the negative impact
[[Page 83231]]
that a failure to meet these commitments would have on its investors, a
fund's ability to enter into unfunded commitments should be subject to
a ``well-defined limitation.'' We are not adopting this approach, as
the extent to which unfunded commitment agreements could raise asset
sufficiency concerns depends on funds' facts and circumstances. We do
not believe that an across-the-board limitation is appropriate in light
of this, or is necessary given the protections our adopted approach
will provide.
---------------------------------------------------------------------------
\770\ Aditum Comment Letter.
---------------------------------------------------------------------------
J. Recordkeeping Provisions
We are adopting, consistent with the proposal, certain
recordkeeping requirements.\771\ We did not receive comments on the
proposed recordkeeping provisions. We are making certain conforming
changes to the proposed recordkeeping provisions in light of changes to
other aspects of the final rule, which we discuss below. The final
recordkeeping requirements are designed to provide our staff, and a
fund's compliance personnel, the ability to evaluate the fund's
compliance with the rule's requirements.
---------------------------------------------------------------------------
\771\ See rule 18f-4(c)(6); see also proposed rule 18f-4(c)(6).
---------------------------------------------------------------------------
First, as proposed, the rule will require the fund to maintain
certain records documenting the fund's derivatives risk management
program. Specifically, for a fund subject to the rule's program
requirements, the rule requires the fund to maintain a written record
of its policies and procedures that are designed to manage the fund's
derivatives risks. The rule also requires a fund to maintain a written
record of the results of any stress testing of its portfolio, the
results of any VaR test backtesting it conducts, any internal reporting
or escalation of material risks under the program, and any periodic
reviews of the program.
Second, as proposed, the rule will require funds to keep records of
any materials provided to the fund's board of directors in connection
with approving the designation of the derivatives risk manager. The
rule also will require a fund to keep records of any written reports
provided to the board of directors relating to the program, and any
written reports provided to the board that the rule requires regarding
the fund's non-compliance with the applicable VaR test, as proposed. We
also are making a new conforming change in light of a change to the
rule's remediation provision for a fund that is out of compliance with
its applicable VaR test. The final rule includes a new reporting
requirement providing that the derivatives risk manager, within thirty
calendar days of the exceedance, must provide a written report to the
fund's board of directors explaining how the fund came back into
compliance and the results of the derivatives risk manager's analysis
of the circumstances that caused the fund to be out of compliance for
more than five business days and any updates to the program
elements.\772\ As part of this new reporting provision, if the fund
remains out of compliance with the applicable VaR test at that time,
the derivatives risk manager's written report must update the report
previously provided to the fund's board of directors and explain how
and by when he or she reasonably expects that the fund will come back
into compliance. These reports will be covered by the final
recordkeeping requirements.
---------------------------------------------------------------------------
\772\ Rule 18f-4(c)(2)(iii)(C).
---------------------------------------------------------------------------
Third, as proposed, for a fund that is required to comply with the
VaR-based limit on fund leverage risk, the fund will have to maintain
records documenting the fund's determination of: The VaR of its
portfolio; the VaR of the fund's designated reference portfolio, as
applicable; the fund's VaR ratio (the value of the VaR of the fund's
portfolio divided by the VaR of the designated reference portfolio), as
applicable; and any updates to any VaR calculation models used by the
fund, as well as the basis for any material changes made to those
models.
Fourth, generally as proposed, the rule will require a fund that is
a limited derivatives user to maintain a written record of its policies
and procedures that are reasonably designed to manage its derivatives
risk. We are updating the cross reference cite in the recordkeeping
provision to reflect the new paragraph number for the limited
derivatives users' policies and procedures requirement. We also are
making a new conforming change in light of the rule's limited
derivatives user provision requiring written reports to the board of
directors for fund exceedances of the limited derivatives user
exception's 10% derivatives exposure threshold. These reports will be
covered by the final recordkeeping requirements.
Fifth, as proposed, the rule will require a fund that enters into
unfunded commitment agreements to maintain a record documenting the
basis for the fund's basis for its reasonable belief regarding the
sufficiency of its cash and cash equivalents to meet its obligations
with respect to its unfunded commitment agreements.\773\ A fund must
make such a record each time it enters into such an agreement.
---------------------------------------------------------------------------
\773\ Rule 18f-4(e)(2).
---------------------------------------------------------------------------
Sixth, the final recordkeeping requirement includes a new
conforming change in light of the final rule providing two separate
treatment options for a fund that enters into a reverse repurchase
agreement or similar financing transaction. Under this new
recordkeeping requirement, the fund must maintain a written record
documenting whether the fund is treating these transactions, as set
forth in the rule, under (1) an asset coverage requirements approach or
(2) a derivatives transactions treatment approach.\774\
---------------------------------------------------------------------------
\774\ Rule 18f-4(d)(2).
---------------------------------------------------------------------------
Finally, the rule will require funds to maintain the required
records for a period of five years.\775\ In particular, a fund must
retain a copy of its written policies and procedures under the rule
that are currently in effect, or were in effect at any time within the
past five years, in an easily accessible place.\776\ In addition, a
fund will have to maintain all other records and materials that the
rule would require the fund to keep for at least five years (the first
two years in an easily accessible place).\777\
---------------------------------------------------------------------------
\775\ Rule 18f-4(c)(6)(ii); rule 18f-4(d)(2); rule 18f-4(e)(2).
\776\ Rule 18f-4(c)(6)(ii)(A). The retention requirement will
apply to both funds that are required to implement a derivatives
risk management program and funds that are limited derivatives users
under rule 18f-4(c)(4).
\777\ Rule 18f-4(c)(6)(ii)(B); rule 18f-4(d)(2); rule 18f-
4(e)(2).
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K. Conforming Amendments
1. Form N-PORT and Rule 22e-4
In change from the proposal, and in response to comments, we are
amending rule 22e-4 and a related reporting requirement on Form N-PORT
to remove references to assets ``segregated to cover'' derivatives
transactions.\778\ These are references to assets segregated in
accordance with Release 10666 and related staff guidance, which are
being rescinded in connection with the final rule. The final rule does
not include an asset segregation requirement, and these references
therefore are moot and superseded. Although the Commission did not
propose to amend rule 22e-4 or the related reporting requirement in
Form N-PORT, the Proposing Release
[[Page 83232]]
included requests for comment regarding whether references to
``segregated'' assets in rule 22e-4 should be removed, and whether the
Commission should make any other conforming amendments to its rules or
forms. Commenters who responded to these requests for comment urged the
Commission to remove these references from rule 22e-4, and some
commenters also suggested removing the parallel references in a related
reporting requirement in Form N-PORT.\779\
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\778\ We are removing these references from, and making
conforming changes to, paragraph (b)(1)(ii)(C) of rule 22e-4 and the
related note to this paragraph; paragraph (b)(iii)(B) of rule 22e-4;
and Item B.8 of Form N-PORT. We also are amending these provisions
to refer to ``collateral,'' in addition to ``margin,'' and adding an
instruction to Item B.8 of Form N-PORT regarding the calculation
required by that item. These amendments are designed to make these
provisions clearer and do not reflect any changes in the underlying
requirements.
\779\ Putnam Comment Letter; Invesco Comment Letter; Vanguard
Comment Letter; ICI Comment Letter.
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One commenter also stated that the current Form N-PORT description
of ``derivatives transactions'' is not consistent with the Proposed
Rule's definition, ``which includes transactions not customarily
considered `derivatives' (e.g., TBAs).'' \780\ The commenter
recommended that the Commission undertake a review of affected public
disclosures to evaluate whether an existing and commonly used
definition of derivatives transactions should be used for purposes of
the revised Form N-PORT reporting to avoid investor confusion and
administrative cost associated with differing definitions.
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\780\ Fidelity Comment Letter.
---------------------------------------------------------------------------
We recognize that the final rule's ``derivatives transaction''
definition includes some instruments not generally described as
``derivatives,'' and also excludes other instruments commonly
understood as derivatives where they do not involve a future payment
obligation. Accordingly, we are amending Form N-PORT's general
instructions to make clear that the term ``derivatives transactions''
has the same meaning as in rule 18f-4 solely with respect to N-PORT
items that relate specifically to the rule.\781\
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\781\ General Instruction E of Form N-PORT.
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2. Form N-2 (Senior Securities Table)
As proposed, we are amending Form N-2 to provide that funds relying
on rule 18f-4 will not be required to include their derivatives
transactions and unfunded commitment agreements in the senior
securities table on Form N-2.\782\ This amendment conforms Form N-2's
senior securities table to the provisions of the final rule that
provide that a fund's derivatives transactions and unfunded commitment
agreements entered into in compliance with the rule will not be
considered for purposes of computing asset coverage under section
18(h). We believe that applying section 18's asset coverage
requirements to these transactions is unnecessary in light of rule 18f-
4's specific requirements tailored to address these transactions. We
are adopting these provisions as proposed.
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\782\ See amendment to Instruction 2 of Item 4.3 of Form N-2;
proposed amendment to Instruction 2 of Item 4.3 of Form N-2. This
amendment will apply to registration statements on a prospective
basis. Accordingly, the amendment does not require funds to modify
information provided for periods before a fund begins to rely on the
final rule.
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One commenter suggested the Commission clarify how a fund should
``not consider'' derivatives transactions for purposes of calculating
asset coverage under section 18(h), in light of the proposed provision
providing that derivatives transactions entered into under the proposed
rule will not be considered for purposes of computing asset coverage
under section 18(h).\783\ The commenter asked, for example, if a fund
should include the assets and liabilities associated with a written
option in the calculation, or the gains and losses associated with the
option's premium. We believe a fund would ``not consider'' a
derivatives transaction for purposes of calculating asset coverage, and
accordingly for disclosure in the senior securities table, by not
including the derivatives transaction or any component of the
derivatives transaction in the calculation. We do not believe that this
provision in the final rule requires the fund to track gains and losses
associated with the fund's investment of options' premium, margin, or
collateral received in connection with the fund's derivatives
transactions.
---------------------------------------------------------------------------
\783\ See Comment Letter of Ernst Young LLP (Mar. 24, 2020).
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L. Compliance Date
The Commission is providing a transition period to give funds
sufficient time to comply with the provisions of rule 18f-4 and the
related reporting requirements.\784\ Specifically, we are adopting a
compliance date for rule 18f-4 and the related amendments in this
release that is eighteen months following the effective date. We
believe that an eighteen-month compliance period provides sufficient
time for all funds to come into compliance with the rule and the
related reporting requirements. Accordingly, we are also rescinding
Release 10666, effective August 19, 2022.\785\ In addition, staff in
the Division of Investment Management has reviewed its no-action
letters and other guidance addressing derivatives transactions and
other transactions covered by proposed rule 18f-4 to determine which
letters and other staff guidance, or portions thereof, should be
withdrawn in connection with the final rule. This review included, but
was not limited to, the staff no-action letters and other guidance
identified in the Proposing Release. Some of these letters and other
staff guidance, or portions thereof, will be moot, superseded, or
otherwise inconsistent with the final rule and, therefore, will be
withdrawn by the staff, effective upon the rescission of Release
10666.\786\
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\784\ The ``related reporting requirements'' include the
amendments to fund reporting requirements discussed in section II.G,
as well as the amendments to rule 30b1-10.
\785\ See supra section I.C.
\786\ We also intend, after appropriate notice and opportunity
for hearing, to rescind orders we have granted to funds providing
exemptive relief from section 18(f) relating to investments in
certain futures contracts, related options and/or options on stock
indices that is superseded by or otherwise inconsistent with rule
18f-4. Based on staff review of filings on Form N-CEN, no fund is
relying on these exemptive orders.
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Commenters urged the Commission to provide more time beyond the
one-year transition period we discussed in the Proposing Release,
generally suggesting an eighteen-month or two-year period to provide
time for funds to prepare to comply with the rule's requirements.\787\
In particular, commenters stated that a one-year transition period
would not provide sufficient time to implement the derivatives risk
management program and the VaR limit, and to designate a qualified
derivatives risk manager.\788\ Delaying the rescission of Release 10666
and the staff's rescission of its no-action letters and other guidance
for eighteen months is designed to provide additional time for funds to
prepare to transition their current approaches and come into compliance
with the final rule and the related reporting requirements.
---------------------------------------------------------------------------
\787\ See e.g. Invesco Comment Letter; Fidelity Comment Letter;
Dechert Comment Letter I; Capital Group Comment Letter.
\788\ See e.g. Dechert Comment Letter I; Fidelity Comment
Letter; Invesco Comment Letter.
---------------------------------------------------------------------------
A fund may rely on rule 18f-4 after its effective date but before
the compliance date, provided that the fund satisfies the rule's
conditions.\789\ To promote regulatory consistency, however, any fund
that elects to rely on rule 18f-4 prior to the date when Release 10666
is rescinded may rely only on rule 18f-4, and not also consider Release
10666, staff no-action letters, or other staff guidance in determining
how it will comply with section 18 with respect to its use of
derivatives and the other transactions that rule 18f-4 addresses. In
addition, rule 18f-4 provides that, if a fund
[[Page 83233]]
experiences a reportable event on Form N-RN, the fund must file with
the Commission a report on Form N-RN within the period and according to
the instructions specified in that form.\790\ Until the Commission
staff completes the process of updating current Form N-LIQUID on EDGAR
to reflect the amendments we have adopted, including retitling the form
as ``Form N-RN,'' a fund relying on rule 18f-4 may satisfy the
requirement to file a report on Form N-RN by including information that
Form N-RN requires in a report on Form N-LIQUID filed on EDGAR. A fund
may contact Commission staff with any questions regarding this filing
process.
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\789\ Similarly, leveraged/inverse funds will be able to rely on
rule 6c-11 once rule 18f-4 is effective and the leveraged/inverse
funds comply with its conditions. In addition, we are rescinding the
exemptive orders provided to leveraged/inverse ETFs on the
compliance date for rule 18f-4. See supra footnote 622 and
accompanying text.
\790\ Rule 18f-4(c)(7).
---------------------------------------------------------------------------
Because the reporting requirements we are adopting will enhance the
Commission's ability to oversee funds' use of and compliance with rule
18f-4 effectively, we are requiring a fund that relies on rule 18f-4
prior to the rule's compliance date also to comply with the amendments
we are adopting to Form N-PORT and Form N-CEN, as applicable, once
these updated forms are available for filing on EDGAR. We appreciate
that funds will not be able to comply with these new reporting
requirements until Commission staff completes the process of updating
these amended forms for filing on EDGAR. Therefore, until this updating
process is complete, a fund may elect to rely on rule 18f-4 prior to
the rule's compliance date without also complying with these reporting
requirements. Commission staff will issue a notice to the public when
the updated forms are available for filing on EDGAR.
M. Other Matters
Pursuant to the Congressional Review Act,\791\ the Office of
Information and Regulatory Affairs has designated this rule a ``major
rule,'' as defined by 5 U.S.C. 804(2). If any of the provisions of
these rules, or the application thereof to any person or circumstance,
is held to be invalid, such invalidity shall not affect other
provisions or application of such provisions to other persons or
circumstances that can be given effect without the invalid provision or
application.
---------------------------------------------------------------------------
\791\ 5 U.S.C. 801 et seq.
---------------------------------------------------------------------------
III. Economic Analysis
We are mindful of the costs imposed by, and the benefits obtained
from, our rules. Section 2(c) of the Investment Company Act provides
that when the Commission is engaging in rulemaking under the Act and is
required to consider or determine whether an action is consistent with
the public interest, the Commission shall also consider whether the
action will promote efficiency, competition, and capital formation, in
addition to the protection of investors. The following analysis
considers, in detail, the potential economic effects that may result
from the final rules, including the benefits and costs to investors and
other market participants as well as the broader implications of the
final rules for efficiency, competition, and capital formation.
A. Introduction
Funds today use a variety of derivatives, both to obtain investment
exposure as part of their investment strategies and to manage risks. A
fund may use derivatives to gain, maintain, or reduce exposure to a
market, sector, or security more quickly, or to obtain exposure to a
reference asset for which it may be difficult or impractical for the
fund to make a direct investment. A fund may use derivatives to hedge
interest rate, currency, credit, and other risks, as well as to hedge
portfolio exposures.\792\ As funds' strategies have become increasingly
diverse over the past several decades, funds' use of derivatives has
grown in both volume and complexity. At the same time, a fund's
derivatives use may entail risks relating to, for example, leverage,
markets, operations, liquidity, and counterparties, as well as legal
risks.\793\
---------------------------------------------------------------------------
\792\ See supra section I.A.
\793\ See, e.g., supra footnotes 15-16 and accompanying text.
---------------------------------------------------------------------------
Section 18 of the Investment Company Act is designed to limit the
leverage a fund can obtain through the issuance of senior
securities.\794\ As discussed above, a fund's derivatives use may raise
the investor protections concerns underlying section 18. In addition,
funds' asset segregation practices have developed such that funds'
derivatives use--and thus funds' potential leverage through derivatives
transactions--does not appear to be subject to a practical limit as the
Commission contemplated in Release 10666.
---------------------------------------------------------------------------
\794\ See supra section I.B.1.
---------------------------------------------------------------------------
Rule 18f-4 is designed to provide an updated, comprehensive
approach to the regulation of funds' use of derivatives and certain
other transactions. The final rule will permit a fund, subject to
certain conditions, to enter into derivatives or other transactions,
notwithstanding the prohibitions and restrictions on the issuance of
senior securities under section 18 of the Investment Company Act. We
believe that the final rule's requirements, including the derivatives
risk management program requirement and VaR-based limit on fund
leverage risk, will benefit investors by mitigating derivatives-related
risks, including those that may lead to unanticipated and potentially
significant losses for investors.
Certain funds use derivatives in a limited manner, which we believe
presents a lower degree of risk or potential impact and generally a
lower degree of leverage than permitted under section 18. The final
rule will provide an exception from the derivatives risk management
program requirement and VaR-based limit on fund leverage risk and the
related board oversight and reporting provisions (collectively, the
``VaR and program requirements,'' as noted above) for these limited
derivatives users. Instead, the final rule will require a fund relying
on this exception to adopt policies and procedures that are reasonably
designed to manage its derivatives risks. Funds with limited
derivatives exposure will therefore not be required to incur costs and
bear compliance burdens that may be disproportionate to the resulting
benefits, while still being required to manage the risks their limited
use of derivatives may present.\795\
---------------------------------------------------------------------------
\795\ See supra sections I.C and II.E.
---------------------------------------------------------------------------
Leveraged/inverse funds generally will be subject to the
requirements of rule 18f-4 on the same basis as other funds subject to
that rule, including the VaR-based leverage risk limit.\796\ The rule
will, however, provide an exception from the VaR-based limit on fund
leverage risk for leveraged/inverse funds currently in operation that
seek to provide leveraged or inverse market exposure exceeding 200% of
the return or inverse return of the relevant index. The conditions to
this exception are designed to allow these funds to continue to operate
in their current form, but prohibit them from changing their index or
increasing the amount of their leveraged or inverse market exposure.
---------------------------------------------------------------------------
\796\ The enhanced standard of conduct for broker-dealers under
Regulation Best Interest and the fiduciary obligations of registered
investment advisers also will apply in the context of recommended
transactions and transactions occurring in an advisory relationship
with respect to these funds and the listed commodity pools that
would have been subject to the proposed sales practices rules.
---------------------------------------------------------------------------
Rule 18f-4 also contains requirements for funds' use of certain
senior securities that are not derivatives. Specifically, the final
rule permits a fund to either choose to limit its reverse repurchase
and other similar financing transaction
[[Page 83234]]
activity to the applicable asset coverage limit of the Act for senior
securities representing indebtedness, as proposed, or a fund may
instead treat them as derivatives transactions. This approach reflects
that reverse repurchase agreements and similar financing transactions
can be used to introduce leverage into a fund's portfolio just like
other forms of borrowings, or derivatives.\797\
---------------------------------------------------------------------------
\797\ Similar financing transactions may include securities
lending arrangements and TOBs, depending on the particular facts and
circumstances of the individual transaction. See supra section II.H.
---------------------------------------------------------------------------
In addition, the final rule will permit a fund to enter into
unfunded commitment agreements if it reasonably believes, at the time
it enters into such an agreement, that it will have sufficient cash and
cash equivalents to meet its obligations with respect to its unfunded
commitment agreements.\798\ This requirement is designed to address the
concern that a fund may experience losses as a result of having
insufficient assets to meet its obligations with respect to these
transactions, and we believe that the requirement will benefit
investors by mitigating such losses or other adverse effects if a fund
is unable to satisfy an unfunded commitment agreement.\799\
---------------------------------------------------------------------------
\798\ See supra section II.I.
\799\ We believe that the treatment of unfunded commitment
transactions is consistent with general market practices. Therefore,
we believe that the requirements for these transactions will not
have significant economic effects when measured against this
baseline.
---------------------------------------------------------------------------
The final rule also includes a provision that will allow funds, as
well as money market funds, to invest in securities on a when-issued or
forward-settling basis, or with a non-standard settlement cycle,
subject to certain conditions.\800\ This provision reflects our view
that these short-term transactions generally do not raise the concerns
about fund leverage risk underlying section 18.
---------------------------------------------------------------------------
\800\ See supra section II.A.
---------------------------------------------------------------------------
This rule also includes certain recordkeeping requirements and
reporting requirements for funds that use derivatives.\801\ We expect
that the recordkeeping requirements will benefit investors by
facilitating fund compliance with the final rule and our staff's review
of funds' compliance. In addition, we expect that the amendments we are
adopting to Forms N-PORT, N-CEN, and N-LIQUID (which is being re-titled
as Form N-RN) will further benefit investors primarily by enhancing the
Commission's understanding of the impact of funds' use of derivatives
on fund portfolios, and by facilitating the Commission's ability to
oversee funds' use of derivatives and compliance with the final
rules.\802\
---------------------------------------------------------------------------
\801\ See supra sections II.C and II.G.
\802\ Because existing leveraged/inverse funds with a stated
target multiple that is equal to or below the VaR-based limit on
leveraged risk in rule 18f-4 will be subject to the VaR-based limit
on fund leverage risk, these funds will be subject to the related
reporting requirements on Forms N-PORT and N-RN. Conversely,
existing leveraged/inverse funds that seek to provide leveraged or
inverse market exposure exceeding 200% of the return of the relevant
index will not be subject to the condition of rule 18f-4 limiting
fund leverage risk and thus not subject to the related reporting
requirements on Forms N-PORT and N-RN. However, such funds will have
to disclose this exemption in their prospectuses. All leveraged/
inverse funds will also be subject to the new requirements on Form
N-CEN.
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B. Economic Baseline
1. Fund Industry Overview
The fund industry has grown and evolved substantially in past
decades in response to various factors, including investor demand,
technological developments, and an increase in domestic and
international investment opportunities, both retail and
institutional.\803\ As of July 2020, there were 10,092 mutual funds
(excluding money market funds) with $19,528 billion in total net
assets, 2,142 ETFs organized as an open-end fund or as a share-class of
an open-end fund with $3,462 billion in total net assets, 666
registered closed-end funds with $307 billion in total net assets, and
13 variable annuity separate accounts registered as management
investment companies on Form N-3 with $216 billion in total net assets.
There also were 420 money market funds with $3,881 billion in total net
assets.\804\ Finally, as of July 2020, there were 99 BDCs with $58
billion in total net assets.\805\
---------------------------------------------------------------------------
\803\ See Proposing Release, supra footnote 1, at n.1.
\804\ Estimates of the number of registered investment companies
and their total net assets are based on a staff analysis of Form N-
CEN filings as of July 8, 2020. For open-end funds that have mutual
fund and ETF share classes, which only one fund sponsor currently
operates, we count each type of share class as a separate fund and
use data from Morningstar to determine the amount of total net
assets reported on Form N-CEN attributable to the ETF share class.
Money market funds generally are excluded from the scope of rule
18f-4, but may rely on the provision in the rule for investments in
when-issued and similar securities. We therefore report their number
and net assets separately from those of other mutual funds.
\805\ Estimates of the number of BDCs and their net assets are
based on a staff analysis of Form 10-K and Form 10-Q filings as of
July 30, 2020. Our estimate includes BDCs that may be delinquent or
have filed extensions for their filings, and it excludes 6 wholly-
owned subsidiaries of other BDCs.
---------------------------------------------------------------------------
2. Funds' Use of Derivatives and Reverse Repurchase Agreements
DERA staff analyzed funds' use of derivatives and reverse
repurchase agreements based on Form N-PORT filings as of September
2020. The filings covered 9,700 mutual funds with $17,059 billion in
total net assets, 1,973 ETFs with $3,252 billion in total net assets,
672 registered closed-end funds with $276 billion in net assets, and 13
variable annuity separate accounts registered as management investment
companies with $179 billion in total net assets.\806\
---------------------------------------------------------------------------
\806\ The analysis is based on each registrant's latest Form N-
PORT filing as of September 15, 2020. Money market funds are
excluded from the analysis; they do not file monthly reports on Form
N-PORT and generally are excluded from the scope of rule 18f-4. For
open-end funds that have mutual fund and ETF share classes, we count
each type of share class as a separate fund and use data from
Morningstar to determine the amount of total net assets reported on
Form N-PORT attributable to the ETF share class.
---------------------------------------------------------------------------
Based on this analysis, 60% of funds reported no derivatives
holdings, and a further 26% of funds reported using derivatives with
gross notional amounts below 50% of net assets. These results are
comparable to and consistent with the findings of a white paper
prepared by DERA staff that studied a random sample of 10% of funds in
2015.\807\ The 14% of funds that reported derivatives holdings at or
above 50% of net assets reported combined net assets of $1,886 billion,
which represented 8% of fund industry net assets. One percent of funds
reported entering into reverse repurchase agreements.
---------------------------------------------------------------------------
\807\ See Daniel Deli, Paul Hanouna, Christof Stahel, Yue Tang &
William Yost, Use of Derivatives by Registered Investment Companies,
Division of Economic and Risk Analysis (2015), available at https://www.sec.gov/dera/staff-papers/white-papers/derivatives12-2015.pdf.
---------------------------------------------------------------------------
BDCs do not file Form N-PORT. To help evaluate the extent to which
BDCs use derivatives, our staff reviewed the most recent financial
statements of 48 of the current 99 BDCs as of July 2020.\808\ Based on
this analysis, we observe that most BDCs do not use derivatives
extensively. Of the sampled BDCs, 59.1% did not report any derivatives
holdings, and a further 31.8% reported using derivatives with gross
notional amounts below 10% of net assets. We do not believe that BDCs
use reverse repurchase agreements to a significant extent.\809\
---------------------------------------------------------------------------
\808\ See supra footnote 397 and accompanying text.
\809\ See also supra footnote 712 (stating our belief that BDCs
do not use reverse repurchase agreements and bank borrowings (or
similar transactions) in combined amounts that exceed 50% of NAV).
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[[Page 83235]]
3. Current Regulatory Framework for Derivatives
Funds generally 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.\810\ However,
as discussed in the proposal, practices vary based on the type of
derivatives transaction, and funds use different practices regarding
the types of assets that they segregate to cover their derivatives
positions. For purposes of establishing the baseline, we assume that
funds generally segregate sufficient assets to at least cover any mark-
to-market liabilities on the funds' derivatives transactions, with some
funds segregating more assets for certain types of derivatives
transactions (sufficient to cover the full notional amount of the
transaction or an amount between the transaction's full notional amount
and any mark-to-market liability).\811\ The mark-to-market liability of
a derivative can be much smaller than the full investment exposure
associated with the position. As a result, funds' current asset
segregation practices do not appear to place a practical limit on their
use of derivatives: A fund that segregates only the mark-to-market
liability could theoretically incur virtually unlimited investment
leverage.\812\ Moreover, funds' current asset segregation practices 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.
---------------------------------------------------------------------------
\810\ See supra section II.B.1.
\811\ See Proposing Release, supra footnote 1, at n.54-55 and
accompanying text.
\812\ See supra section I.B.2; footnote 69 and accompanying
text.
---------------------------------------------------------------------------
4. Funds' Derivatives Risk Management Practices and Use of VaR Models
There is currently no requirement for funds that use derivatives to
have a formalized derivatives risk management program. However, we
understand that advisers to many funds whose investment strategies
entail the use of derivatives already assess and manage risks
associated with their derivatives transactions to varying extents.\813\
In addition, we understand that funds engaging in derivatives
transactions have increasingly used stress testing as a risk management
tool over the past decade.\814\
---------------------------------------------------------------------------
\813\ See, e.g., AQR Comment Letter I, at 4.
\814\ See supra footnote 194.
---------------------------------------------------------------------------
We also understand that VaR calculation tools are widely available,
and many advisers that enter into derivatives transactions already use
risk management or portfolio management platforms that include VaR
tools.\815\ Advisers to funds that use derivatives more extensively may
be particularly likely currently to use risk management or portfolio
management platforms that include VaR capability. Moreover, advisers
that manage (or that have affiliates that manage) UCITS funds may
already be familiar with using VaR models in connection with European
guidelines.\816\ One commenter submitted the results of a survey based
on responses from 24 fund complexes with $13.8 trillion in assets.\817\
The results of this survey indicate that 73% of respondents used some
form of both VaR and stress testing as derivatives risk management
tools. Other commenters also observed that VaR is commonly used.\818\
---------------------------------------------------------------------------
\815\ See Proposing Release, supra footnote 1, at n.180.
\816\ See e.g., ABA Comment Letter; Blackrock Comment Letter;
Dechert Comment Letter I; Vanguard Comment Letter. Based on a staff
analysis of Form ADV and Form N-CEN filings received through July
31, 2020, there were approximately 190 registered investment
advisers that are registered with a EU financial regulatory
authority and that are reported as the investment adviser, or sub-
adviser, for a registered fund. This estimate may not capture
instances where a U.S. registered investment adviser and a EU
registered investment adviser are affiliated but separate legal
entities.
\817\ See Comment Letter of Investment Company Institute (Oct.
8, 2019) (``2019 ICI Comment Letter''). The commenter also indicated
that the surveyed ICI member firms accounted for 67% of mutual fund
and ETF assets as of June 2019 and that survey responses were
submitted by firms ``whose assets under management spanned the
spectrum from small to very large.'' However, these representations
alone do not provide sufficient information about whether the
surveyed firms were representative of all mutual funds and ETFs in
terms of the exact distribution of specific characteristics, such as
firm size or type of investment strategy.
\818\ See, e.g., supra footnotes 287-291 and accompanying text.
---------------------------------------------------------------------------
5. Leveraged/Inverse Funds
Leveraged/inverse investment funds generally target a daily return
(or a return over another predetermined time period) that is a
multiple, inverse, or inverse multiple of the return of an underlying
index; however over longer holding periods, the realized leverage
multiple of the returns of an investment in a leveraged/inverse
investment vehicle relative to the returns of its underlying index can
vary substantially from the vehicle's daily leverage multiple. To
achieve the stated leverage multiple, most leveraged/inverse investment
funds rebalance their exposure to the underlying index daily.\819\
---------------------------------------------------------------------------
\819\ Leveraged/inverse funds that track the returns of an
underlying index over time periods that are longer than one day
rebalance their portfolios at the end of each such period.
Leveraged/inverse funds use derivatives to achieve their targeted
returns.
---------------------------------------------------------------------------
Currently, there are 172 leveraged/inverse ETFs with $33.4 billion
in total net assets and 120 leveraged/inverse mutual funds with $4.6
billion in total net assets. Of these funds, 70 leveraged/inverse ETFs
with $15.7 billion in total net assets and none of the leveraged/
inverse mutual funds currently seek to provide leveraged or inverse
market exposure exceeding 200% of the return or inverse return of the
relevant index.\820\
---------------------------------------------------------------------------
\820\ Estimates of the number of leveraged/inverse mutual funds
and leveraged/inverse ETFs and their total net assets are based on a
staff analysis of Form N-CEN filings as of July 7, 2020 and are
based on fund's responses to item C.3.c of the form. Information
about the market exposure funds seek to provide is based on a staff
review of funds' summary prospectuses and takes into account that
several leveraged/inverse funds that sought to provide 300%
leveraged or inverse market exposure recently reduced their target
exposures to 200% due to the increased market volatility caused by
COVID-19. See also supra footnote 24 and accompanying text.
---------------------------------------------------------------------------
Two ETF sponsors currently rely upon exemptive relief from the
Commission that permits them to operate leveraged/inverse ETFs.\821\
Since 2009, the Commission has not granted leveraged/inverse ETF
exemptive relief to any additional sponsors. In addition, leveraged/
inverse ETFs are currently excluded from the scope of rule 6c-11, which
the Commission adopted in 2019 and allows ETFs satisfying certain
conditions to operate without obtaining an exemptive order from the
Commission.\822\ While certain exchange-listed commodity- or currency-
based trusts or funds that are not registered investment companies also
have strategies that are similar to leveraged/inverse funds, and other
investments like certain exchange-traded notes may provide a similar
investment exposure, the final rules' provisions for leveraged/inverse
funds address only registered investment companies with these
strategies.
---------------------------------------------------------------------------
\821\ See Proposing Release, supra footnote 1, at nn.307 and
356. The exemptive orders of the two sponsors that operate
leveraged/inverse ETFs permit these sponsors to launch additional
funds under the terms and conditions of those orders.
\822\ See supra footnotes 613-614 and accompanying text.
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C. Benefits and Costs of the Final Rules and Amendments
The Commission is sensitive to the economic effects that may result
from the final rules and form amendments, including benefits and costs.
Where possible, we have attempted to quantify the likely economic
effects; however, we are unable to quantify certain economic effects
because we lack the information
[[Page 83236]]
necessary to provide reasonable estimates. In some cases, it is
difficult to predict how market participants will act under the
conditions of the final rules. For example, we are unable to predict
whether the derivatives risk management program requirement and VaR-
based limit on fund leverage risk may make investors more or less
likely to invest in funds that would be subject to these requirements
or the degree to which these requirements may affect the use of
derivatives by these funds. Nevertheless, as described more fully
below, we are providing both a qualitative assessment and quantified
estimate of the economic effects, including the initial and ongoing
costs of the additional reporting requirements, where feasible.
Direct costs that funds will incur, as discussed below, may to some
extent be absorbed by a fund's investment adviser or be passed on to a
fund's investors in the form of increased fees and expenses.\823\ The
share of these costs borne by funds, their advisers, and investors
depends on multiple factors, including the nature of competition
between advisers, and investors' relative sensitivity to changes in
fund fees, the joint effects of which are particularly challenging to
predict due to the number of assumptions that the Commission would need
to make.
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\823\ Several commenters stated that a fund may pass on some of
the costs associated with the rule's requirements to its investors.
See Dechert Comment Letter I; Dechert Comment Letter II; ICI Comment
Letter; Vanguard Comment Letter.
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1. Derivatives Risk Management Program and Board Oversight and
Reporting
Rule 18f-4 will require funds that enter into derivatives
transactions and are not limited derivatives users to adopt and
implement a derivatives risk management program. The program will have
to include risk guidelines, stress testing, backtesting, internal
reporting and escalation, and program review elements. The final rule
will require a fund's board of directors to approve the fund's
designation of a derivatives risk manager, who will be responsible for
administering the derivatives risk management program.\824\ The fund's
derivatives risk manager will have to report to the fund's board on the
derivatives risk management program's implementation and effectiveness
and the results of the fund's stress testing and backtesting.\825\
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\824\ See supra section II.C.1. for a discussion of the final
rule's requirements for board approval of the derivatives risk
manager and the comments we received on the proposal.
\825\ See supra section II.C.2. for a discussion of the final
rule's board reporting requirements and the comments we received on
the proposal.
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We understand that advisers to many funds whose investment
strategies entail the use of derivatives already assess and manage
risks associated with their derivatives transactions.\826\ However,
rule 18f-4's requirement that funds establish written derivatives risk
management programs will create a standardized framework for funds'
derivatives risk management by requiring each fund's program to include
all of the rule's program elements. To the extent that the resulting
risk management activities are more comprehensive than funds' current
practices, this may result in more effective risk management across
funds. While the adoption of a derivatives risk management program
requirement may not eliminate all derivatives-related risks, including
that investors could experience large, unexpected losses from funds'
use of derivatives, we expect that investors may benefit from a
decrease in leverage-related risks.
---------------------------------------------------------------------------
\826\ See supra section III.B.4. See also Blackrock Comment
Letter; ICI Comment Letter; and J.P. Morgan Comment Letter.
---------------------------------------------------------------------------
Some funds may reduce or otherwise alter their use of derivatives
transactions to respond to risks identified after adopting and
implementing their derivatives risk management programs. In particular,
we expect that funds currently utilizing risk management practices that
are not tailored to their use of derivatives may decide to make such
changes to their portfolios.\827\
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\827\ As a consequence of reducing risk, such funds may earn
reduced returns.
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Rule 18f-4 will require a fund to reasonably segregate the
functions of its derivatives risk management program from those of its
portfolio management.\828\ This segregation requirement is designed to
enhance the program's effectiveness by promoting the objective and
independent identification and assessment of derivatives risk.\829\
Segregating the functions of a fund's derivatives risk management
program from those of its portfolio management may also mitigate the
risks posed by competing incentives between a fund's portfolio managers
and its investors.\830\
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\828\ See supra section II.B.1.
\829\ In addition, while some portfolio managers may find it
burdensome to collaborate with a derivatives risk manager, to the
extent that portfolio managers already consider the impact of trades
on the fund's portfolio risk, we believe that having the involvement
of a derivatives risk manager may typically make a portfolio
manager's tasks more rather than less efficient.
\830\ For example, portfolio managers of actively-managed funds
that are underperforming competing funds may have an incentive to
increase risk exposures through use of derivatives in an effort to
increase returns. This behavior may result in a fund also increasing
risk beyond investor expectations. See also SIFMA AMG Comment
Letter; ABA Comment Letter. (For theoretical motivation of such
behaviors see, e.g., Keith C. Brown, W.V. Harlow, & Laura T. Starks,
Of Tournaments and Temptations: An Analysis of Managerial Incentives
in the Mutual Fund Industry, 51 J. FIN. 85 (1996), available at
https://www.onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1996.tb05203.x; Judith Chevalier & Glenn Ellison, Risk-Taking
by Mutual Funds as a Response to Incentives, 105 J. POL. ECON. 1167
(1997), available at https://www.jstor.org/stable/10.1086/516389?seq=1#metadata_info_tab_contents).
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Finally, to the extent that the periodic stress testing and
backtesting requirements of the derivatives risk management program
result in fund managers developing a more complete understanding of the
risks associated with their use of derivatives, we expect that funds
and their investors will benefit from improved risk management.\831\
Such benefits will be in addition to benefits derived from the VaR-
based limit on fund leverage risk discussed below.\832\ VaR analysis,
while yielding a simple yet general measure of a fund's portfolio risk,
does not provide a complete picture of a fund's financial risk
exposures.\833\ Complementing VaR analysis with stress testing will
provide a more complete understanding of the fund's potential losses
under different sets of market conditions. For example, simulating
potential stressed market conditions not reflected in historical
correlations between fund returns and asset prices observed in normal
markets may provide derivatives risk managers with important
information pertaining to derivatives risks in stressed
environments.\834\ By incorporating the potential impact of future
economic outcomes and market volatility in its stress test analysis, a
fund may be able
[[Page 83237]]
to analyze future potential swings in its portfolio that may impact the
fund's long-term performance. Recent episodes of market volatility
related to the COVID-19 global health pandemic have highlighted the
importance of analyzing such future potential swings in a fund's
portfolio. This forward-looking aspect of stress testing will
supplement the final rule's VaR analysis requirement, which will rely
on historical data.
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\831\ See supra sections II.B.2.c and II.B.2.d; see also supra
section II.C.2 (discussing the requirements that a fund's
derivatives risk manager provide to the fund's board: (1) A written
report, at least annually, providing a representation that the
program is reasonably designed to manage the fund's derivatives
risks and to incorporate the required elements of the program; and
(2) a written report, at the frequency determined by the board,
analyzing exceedances of the fund's risk guidelines and the results
of the fund's stress tests and backtesting).
\832\ See infra section III.C.2.
\833\ See id.
\834\ See supra section II.B.2.c (rule 18f-4 will require the
program to provide for stress testing to ``evaluate potential losses
to the fund's portfolio in response to extreme but plausible market
changes or changes in market risk factors that would have a
significant adverse effect on the fund's portfolio, taking into
account correlations of market risk factors as appropriate and
resulting payments to derivatives counterparties'').
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In addition, the final rule will require that a fund backtest the
results of its VaR analysis no less frequently than weekly, which will
assist funds in examining the effectiveness of the fund's VaR model.
The final rule will require that, for each weekly backtesting period,
the fund compare its actual gains or losses on each business day during
the weekly period, with the fund's VaR calculated for each business day
during the same weekly period.\835\ The weekly comparison will help
identify days where the fund's portfolio losses exceed the VaR
calculated for each day during the week, as well as systematic over- or
under-estimation of VaR, which would suggest that the fund may not be
accurately measuring all significant, identifiable market risk
factors.\836\
---------------------------------------------------------------------------
\835\ See supra section II.B.2.d.
\836\ See supra footnote 212; see also supra section II.B.2.d
for a discussion of comments the Commission received on the proposed
backtesting requirement.
---------------------------------------------------------------------------
Commenters stated that weekly backtesting would be associated with
reduced burdens compared to the more frequent daily backtesting
requirement we proposed.\837\ We have not reduced our estimates from
the Proposing Release of one-time and ongoing program-related costs as
a result of the decreased backtesting frequency, however.\838\
Therefore, the cost estimates we provide below may overstate the costs
of the final rule's backtesting requirement.\839\
---------------------------------------------------------------------------
\837\ See supra footnote 222 and associated text.
\838\ See Proposing Release, supra footnote 1, at section
III.C.1.
\839\ We anticipate that any cost savings compared to the
proposal as a result of the decreased backtesting frequency will be
small, as the development and implementation of processes for
backtesting likely have a significant fixed-cost component.
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Rule 18f-4 will also require that a fund's board of directors
approve the designation of the fund's derivatives risk manager.\840\ We
anticipate that this requirement, along with the derivatives risk
manager's direct reporting line to the board, will result in effective
communication between the board and the derivatives risk manager that
will enhance oversight of the program to the benefit of the fund and
its investors.
---------------------------------------------------------------------------
\840\ See supra section II.C.1.
---------------------------------------------------------------------------
Rule 18f-4 will require that the derivatives risk manager provide
the fund's board a written report at least once a year on the program's
effectiveness as well as regular written reports at a frequency
determined by the board that analyze exceedances of the fund's risk
guidelines and the results of the fund's stress tests and
backtests.\841\ The board reporting requirements may facilitate the
board's oversight of the fund and the operation of the derivatives risk
management program, to the extent the fund does not have such regular
reporting mechanisms already in place. In the event the derivatives
risk manager encounters material risks that need to be escalated to the
fund's board, the rule's provision that the derivatives risk manager
must directly inform the board of these risks in a timely manner as
appropriate may help prevent delays in resolving such risks.
---------------------------------------------------------------------------
\841\ See id.
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Funds today employ a range of different practices, with varying
levels of comprehensiveness and sophistication, for managing the risks
associated with their use of derivatives.\842\ We expect that
compliance costs associated with the derivatives risk management
program requirement will vary based on the fund's current risk
management practices, as well as the fund's characteristics, including
in particular the fund's investment strategy, and the nature and type
of derivatives transactions used by the fund.
---------------------------------------------------------------------------
\842\ See supra section III.B.4.
---------------------------------------------------------------------------
We understand that VaR models are widely used in the industry and
that backtesting is commonly performed in conjunction with VaR
analyses. As a result, we believe that many funds that will be required
to establish derivatives risk management programs already have VaR
models with backtesting in place. Moreover, the final rule's
derivatives risk management program requirements, including stress
testing and backtesting requirements are, generally, high-level and
principles-based. As a result, as one commenter acknowledged, many
funds' current risk management practices may already be in line with
many of the rule's derivatives risk management program requirements or
could be readily conformed without material change.\843\ Thus, the
costs of adjusting funds current' practices and procedures to comply
with the parallel requirements of final rule 18f-4 may be minimal for
such funds.
---------------------------------------------------------------------------
\843\ See Blackrock Comment Letter, at 8.
---------------------------------------------------------------------------
Certain costs of the rule's derivatives risk management program may
be fixed, while other costs may vary with the size and complexity of
the fund and its portfolio allocation. For instance, costs associated
with purchasing certain third-party data used in the program's stress
tests may not vary much across funds. On the other hand, certain third-
party services may vary in terms of costs based on the portfolio
positions to be analyzed. Further, the extent to which a cost
corresponding to the program is fixed or variable may also depend on
the third-party service provider.
Larger funds or funds that are part of a large fund complex may
incur higher costs in absolute terms but find it less costly, per
dollar managed, to establish and administer a derivatives risk
management program relative to a smaller fund or a fund that is part of
a smaller fund complex. For example, larger funds may have to allocate
a smaller portion of existing resources for the program, and fund
complexes may realize economies of scale in developing and implementing
derivatives risk management programs for several funds. In addition,
smaller funds or those that are part of a smaller fund complex may find
it more costly to appoint a derivatives risk manager, because they (1)
may not have existing officers of the fund's investment advisers who
are capable of fulfilling the responsibilities of the derivatives risk
manager; (2) may have existing officers of the fund's investment
advisers who are capable of fulfilling the responsibilities of the
derivatives risk manager but may be overburdened with other existing
responsibilities within the fund; or (3) may choose to hire a new
officer or promote a current employee to fulfill this role.
We estimate that the one-time costs to establish and implement a
derivatives risk management program will range from $150,000 to
$500,000 per fund, depending on the particular facts and circumstances,
including whether a fund is part of a larger fund complex and therefore
may benefit from economies of scale.\844\ These estimated
[[Page 83238]]
costs are attributable to the following activities: (1) Assessing
whether a fund is subject to the derivatives risk management program
requirement; (2) analyzing the fund's current practices relative to the
final rule's requirements; (3) developing risk guidelines and processes
for stress testing, backtesting, internal reporting and escalation, and
program review; (4) integrating and implementing the guidelines and
processes described above; (5) preparing training materials and
administering training sessions for staff in affected areas; \845\ (6)
recruiting and hiring a derivatives risks manager, to the extent the
fund is unable to consider an existing officer of the investment
adviser that is equipped with the appropriate and relevant experience
necessary to be selected for the role of derivatives risk manager; and
(7) approval by the board of the fund's derivatives risk manager.\846\
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\844\ We believe that the low end of this range is reflective of
a fund that already has policies and procedures in place that could
be readily adapted to meet the final rule's requirements. Such a
fund would nevertheless incur costs associated with analyzing its
current practices relative to the final rule's requirements and
determining whether it is subject to the derivatives risk management
program; some funds may also incur costs associated with analyzing
whether and how they could modify their derivatives exposure in
order to qualify as a limited derivatives user. We increased our
estimate of the low end of this range compared to the proposal to
account for these costs as well as to account for comments we
received suggesting that the implementation of the program may be
more burdensome than the Commission estimated at proposal and
comments suggesting that requiring the fund's board of directors to
approve the designation of the fund's derivatives risk manager would
place increased burdens on the fund's board of directors. See
Dechert Comment Letter I; IDC Comment Letter; see also supra
sections II.C.1 and II.B. This increased estimate also takes into
account our assumption that a number of funds and their boards may
wish to employ outside legal services in connection with adopting
and implementing the fund's derivatives risk management program as
well as approving the derivatives risk manager. See infra sections
IV.B.1, IV.B.2.
\845\ See also ProShares Comment Letter (stating that
``employees will need to read and be trained on the policies and
procedures.'')
\846\ A fund that selects an existing officer of its investment
adviser for the role of derivatives risk manager may incur costs
associated with recruiting and hiring an additional officer to
assume some or all of the tasks that previously were allocated to
the officer who is selected as derivatives risk manager.
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We estimate that the ongoing annual program-related costs that a
fund will incur range from 65% to 75% of the one-time costs to
establish and implement a derivatives risk management program. Thus, a
fund will incur ongoing annual costs that range from $97,500 to
$375,000.\847\ These estimated costs are attributable to the following
activities: (1) Assessing, monitoring, and managing the risks
associated with the fund's derivatives transactions; (2) periodically
reviewing and updating (A) the program including any models or
measurement tools (including any VaR calculation models) to evaluate
the program's effectiveness and to reflect changes in risk over time,
and (B) the appropriateness of any designated reference portfolio; (3)
providing written reports to the fund's board; (4) additional staff
training; and (5) the derivatives risk manager's base salary and
compensation, to the extent a fund is unable to consider an existing
officer of the investment adviser that is equipped with the appropriate
and relevant experience necessary to be selected for the role of
derivatives risk manager. Under the final rule, a fund that is a
limited derivatives user will not be required to establish a
derivatives risk management program.\848\ Based on an analysis of Form
N-PORT filings, as well as financial statements filed with the
Commission by BDCs, we estimate that about 21% of funds, or 2,766 funds
total, will be required to implement a derivatives risk management
program.\849\ As many funds belong to a fund complex and are likely to
experience economies of scale, we expect that the lower end of the
estimated range of costs ($150,000 in one-time costs; $97,500 in annual
costs) better reflects the total costs likely to be incurred by those
funds.\850\ In addition, we believe that many funds already have a
derivatives risk management program in place that could be readily
adapted (and also already have personnel on staff who could serve as
derivatives risk manager) to meet the final rule's requirements without
significant additional cost.\851\ However, as we do not have data to
determine how many funds already have a program in place that will
substantially satisfy the final rule's requirements, and commenters did
not provide any such data, we over-inclusively assume that all funds
that will be required to establish a derivatives risk management
program will incur a cost associated with this requirement. Based on
these assumptions, we provide an upper-end estimate for total industry
cost in the first year of $684,585,000.\852\
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\847\ This estimate is based on the following calculations: 0.65
x $150,000 = $97,500; 0.75 x $500,000 = $375,000.
\848\ The estimates of the one-time and ongoing costs described
in this section include the costs associated with determining
whether a fund is subject to the rule's VaR and program
requirements.
\849\ We estimate that about 21% of funds hold some derivatives
and will not qualify as a limited derivatives user under the final
rule.
\850\ A fund that uses derivatives in a complex manner, has
existing risk management practices that are not commensurate with
such use of derivatives, and may have to hire additional personnel
to fulfill the role of derivatives risk manager will be particularly
likely to experience costs at the upper end of this range.
\851\ Prior to the proposal, one commenter indicated that
implementing stress testing, which would be one of the required
elements of the proposed derivatives risk management program, would
be only slightly burdensome for 27% of respondents to a survey of
ICI member firms and would be moderately burdensome for an
additional 50% of respondents. See Proposing Release, supra footnote
1, at n.501.
\852\ This estimate is based on the following calculation: 2,766
funds x ($150,000 + $97,500) = $684,585,000.
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2. VaR-Based Limit on Fund Leverage Risk
The final rule will generally impose a VaR-based limit on fund
leverage risk on funds relying on the rule to engage in derivatives
transactions.\853\ This outer limit is based on a relative VaR test
that compares the fund's VaR to the VaR of a ``designated reference
portfolio.'' If the fund's derivatives risk manager reasonably
determines that a designated reference portfolio would not provide an
appropriate reference portfolio for purposes of the relative VaR test,
the fund will be required to comply with an absolute VaR test.\854\ In
either case a fund will apply the test at least once each business day.
---------------------------------------------------------------------------
\853\ See supra section II.D.
\854\ The final rule provides an exception from the rule's VaR
test for limited derivatives users. See supra section II.E.
---------------------------------------------------------------------------
The relative VaR test will limit a fund's VaR to 200% of the VaR of
the fund's designated reference portfolio, unless the fund is a closed-
end fund that has then-outstanding shares of a preferred stock issued
to investors. For such closed-end funds, the VaR must not exceed 250%
of the VaR of the fund's designated reference portfolio.\855\ The
designated reference portfolio will have to be unleveraged--an
unleveraged designated index or the fund's securities portfolio--and
reflect the markets or asset classes in which the fund invests.\856\ By
comparing the VaR of a fund's portfolio to that of an unleveraged
reference portfolio, the relative VaR test restricts the incremental
risk associated with a fund's portfolio relative to a similar but
unleveraged investment strategy. In this sense, the relative VaR test
restricts the degree to which a fund can use derivatives to leverage
its portfolio.
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\855\ See supra section II.D.2 for a discussion of the comments
we received and the data commenters provided on the relative VaR
limit we proposed.
\856\ See supra section II.D.2.b. The final rule's definition of
``designated index'' also includes other requirements, as discussed
above. See id. For example, a designated index cannot be
administered by an organization that is an affiliated person of the
fund, its investment adviser, or principal underwriter, or created
at the request of the fund or its investment adviser, unless the
index is widely recognized and used.
---------------------------------------------------------------------------
The final rule will permit a fund to rely on the absolute VaR test
only if the fund's derivatives risk manager reasonably determines that
a designated reference portfolio would not provide an appropriate
reference portfolio for purposes of the relative VaR test. To
[[Page 83239]]
comply with the absolute VaR test, the VaR of the fund's portfolio must
not exceed 20% of the value of the fund's net assets, unless the fund
is a closed-end fund that has then-outstanding preferred stock. For
such closed-end funds, the VaR must not exceed 25% of the value of the
fund's net assets.\857\
---------------------------------------------------------------------------
\857\ See supra section II.D.2.
---------------------------------------------------------------------------
The 20% absolute VaR limit is based on DERA staff analysis that
calculated the VaR of the S&P 500 since inception that the Commission
used to propose a 15% absolute VaR limit, adjusted consistent with the
final rule's increases to the proposed relative VaR limit.\858\ Under
the final rule, for example, a fund that uses the S&P 500 as its
benchmark index would be permitted to have a VaR equal to 200% of the
VaR of the S&P 500 if the fund also uses that index as its designated
reference portfolio. The 20% absolute VaR test limit would therefore
provide approximately comparable treatment for funds that rely on the
absolute VaR test and funds that rely on the relative VaR test with a
200% limit and use the S&P 500 as their designated reference portfolio
during periods where the S&P 500's VaR is approximately equal to the
historical mean.\859\
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\858\ See supra section II.D.3 for a discussion of the comments
we received and the data commenters provided on the absolute VaR
limit we proposed.
\859\ DERA staff analyzed the historical returns of the S&P 500
index since inception. Computing VaR based on historical simulation
using the parameters specified in the final rule, we find that the
S&P 500's VaR had an average VaR of approximately 10.5%. The VaR of
the index varied over time, with a minimum of approximately 4.1%
attained for much of the first quarter of 1994 and a maximum of
approximately 22.9% attained from late 1987 through the third
quarter of 1990.
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One common critique of VaR is that it does not reflect the
conditional distribution of losses beyond the specified confidence
level.\860\ In other words, the VaR tests will not capture the size and
relative frequency of losses in the ``tail'' of the distribution of
losses beyond the measured confidence level.\861\ As a result, two
funds with the same VaR level could differ significantly in the
magnitude and relative frequency of extreme losses, even though the
probability of a VaR breach would be the same for the two funds. The
Proposing Release contained a set of example calculations, based on a
simplified portfolio, that illustrate this point.\862\
---------------------------------------------------------------------------
\860\ See supra footnote 295 and accompanying text.
\861\ The term ``relative frequency'' here refers to the
frequency of loss outcomes in the tail of the distribution relative
to other loss outcomes that are also in the tail of the
distribution. This relative frequency of the loss outcomes together
with the magnitude of the associated losses describe the conditional
distribution of losses in the tail of the distribution.
\862\ See Proposing Release, supra footnote 1, at section
IV.C.2.
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As discussed in more detail above, the VaR tests are designed to
address the concerns underlying section 18, but they are not a
substitute for a fully-developed derivatives risk management
program.\863\ Recognizing VaR's limitations, the final rule will also
require the fund to adopt and implement a derivatives risk management
program that, among other things, will require the fund to establish
risk guidelines and to stress test its portfolio in part because of
concerns that VaR as a risk management tool may not adequately reflect
tail risks.
---------------------------------------------------------------------------
\863\ See supra footnote 297 and accompanying text.
---------------------------------------------------------------------------
Below is an analysis using benchmark and other data that is an
effort to produce estimates of how many funds (out of the 2,696) that
we estimate will be subject to the final rule's VaR-based limit on fund
leverage risk would have operated in exceedance of such limit.\864\ The
analysis supporting these estimates relies on various assumptions that
limit the applicability of the estimates to the population of funds
subject to the final rule. More specifically, the analysis is limited
in the following ways: (1) The estimated VaR is based on funds'
historical portfolio and benchmark returns throughout the look-back
period, rather than returns of the funds' current portfolio and
composition of the benchmark index at the end of the look-back period,
as will be required of funds under the final rule, (2) the calculations
do not take into account the VaR of funds' securities portfolios,
because we do not have historical data regarding the returns of those
portfolios, and (3) the calculations generally assume that funds will
use their primary prospectus benchmarks for purposes of the relative
VaR test, even though the final rule permits them to use a different
index or their own securities portfolio. Accordingly, the estimates
approximate the effects of the final rule's VaR limits using the
available information, and that approximation, as discussed below, may
not reflect the actual manner in which the limits apply to funds under
the final rule.
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\864\ This analysis is based on Morningstar data with three-year
look-back periods ending in December 31, 2018 and June 30, 2020.
DERA staff computed the VaR of each fund and that of the related
index using historical simulation from three years of prior daily
return data. Staff generally computed the relative VaR test based on
a fund's primary prospectus benchmark. In cases where historical
return data for the primary prospectus benchmark was not available
or where the primary prospectus benchmark did not appear to capture
the markets or asset classes in which a fund invests, DERA staff
instead used a broad-based unleveraged index that captures a fund's
markets or asset classes or a broad-based U.S. equity index.
---------------------------------------------------------------------------
The analysis estimates VaR based on the historical returns of fund
portfolios and benchmark indexes because it would be impractical for
staff to estimate VaR based on the exact composition, as of the end of
the look-back period, for every fund's portfolio and benchmark index.
As a result, the VaR estimates we derive reflect changes to the
composition of funds' portfolios and the benchmark indexes throughout
the look-back period rather than just at the end of the look-back
period.\865\ Funds computing their own VaRs, in contrast, would analyze
their current portfolios and benchmark indexes, if applicable, at the
time of calculation, taking into consideration at least three years of
historical market data. We also were not able to evaluate VaR levels of
funds' securities portfolios because we do not have historical data
regarding the returns of funds' securities portfolios, as defined in
the final rule.
---------------------------------------------------------------------------
\865\ For example, our methodology would under-estimate VaR for
volatility-targeting funds in a period of low volatility that was
preceded by a period of higher volatility earlier in the look-back
period. This is because these funds increase the size of their
positions when market risks are lower in order to target a constant
level or range of volatility. See also supra footnote 451 and
accompanying text.
---------------------------------------------------------------------------
We analyzed the effects of the final rule's VaR limits for two
three-year lookback periods: The first ending on December 31, 2018 and
the second ending on June 30, 2020. The former period is the period we
analyzed in the Proposing Release and reflects a relatively calm market
environment.\866\ The latter period is more recent and includes parts
of the more volatile market environment following the onset of COVID-
19.
---------------------------------------------------------------------------
\866\ See Proposing Release, supra footnote 1, at section
III.C.2.
---------------------------------------------------------------------------
For the three-year period ending on December 31, 2018, we did not
estimate that any funds would fail the relative VaR test from the pool
of funds that would have been subject to the VaR-based limit.\867\ For
the three-year period ending on June 30, 2020, which included a period
of significantly heightened market volatility, our analysis yields an
estimate of 383 funds that may fail the relative VaR test from the pool
of funds that will be subject to the VaR-based limit.\868\ None of the
383 funds are closed-end funds that have outstanding shares of
preferred stock
[[Page 83240]]
and thus are subject to the higher 250% relative-VaR based limit.\869\
Differences between the composition of the benchmarks and the funds'
portfolios--together with heightened market volatility during the
lookback period--likely contributed to some funds being estimated to
fail the VaR tests. In addition, this estimate is limited by the
information available to the Commission, which generally compared the
funds' VaRs to the VaRs of the funds' primary prospectus
benchmarks.\870\ To the extent that these funds' derivatives risk
managers would have determined that the fund's securities portfolio or
an index other than the disclosed benchmark would have been more
appropriate for purposes of computing the relative VaR test, some of
these funds could have satisfied the relative VaR test. Conversely, if
the indexes selected by the funds, or their securities portfolios, had
lower volatility than the index selected here, funds that are estimated
to have passed the relative VaR test may not ultimately satisfy that
test under the final rule.
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\867\ In the Proposing Release we identified six funds that
would have failed the relative VaR test at the lower 150% limit we
proposed. See id.
\868\ For the purposes of this analysis, we assumed that all
leveraged/inverse funds with exposures up to 200% will be able to
satisfy the relative VaR test.
\869\ We identified one closed-end fund that has outstanding
shares of preferred stock that is subject to the VaR-based limit
with a relative VaR level that exceeds 200% but not 250%. Thus, this
fund would not be able to satisfy the relative VaR test absent the
higher limit for closed-end funds that have outstanding shares of
preferred stock.
\870\ See supra footnote 858.
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In addition, some of these funds could have applied the absolute
VaR test if the funds' derivatives risk managers reasonably determined
that a designated reference portfolio would not provide an appropriate
reference portfolio for purposes of the relative VaR test. Most of the
funds with VaRs exceeding 200% of the relevant index VaR (351 of 383)
had portfolio VaRs below the final rule's 20% absolute VaR limit.
Conversely, we recognize that some funds that are estimated to pass the
relative VaR test could have applied the absolute VaR test and may not
have satisfied that test.\871\
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\871\ DERA staff also examined funds' absolute VaR levels in
isolation as a result of the volatile market environment following
the onset of COVID-19. Specifically, we observe that 396 funds that
we estimated would satisfy the relative VaR test had absolute VaR
levels above 20% for the three-year lookback period ending on June
30, 2020. However, we believe this observation is of limited value
in estimating the impact of the absolute VaR test. First, because
the relative VaR test is the default test under the final rule, we
do not believe that this observation is indicative of the number of
funds that will not be able to satisfy the rule's VaR-based limit on
fund leverage risk because they rely on the absolute VaR test.
Second, because we lack the information necessary to identify the
subset of funds that are likely to rely on the absolute VaR test
under the rule, it is not clear that this observation is
representative of the likelihood that such funds would exceed the
absolute VaR limit.
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One commenter provided the results from a survey that asked
respondents to evaluate whether they would anticipate relying on the
proposed absolute or relative VaR test and whether they would satisfy
their applicable test, assuming various alternative specifications of
limits for these tests.\872\ The commenter reported that 0.9% of funds
that indicated that they use derivatives and do not qualify as a
limited derivatives user (under the proposed definition) would not have
been able to satisfy their applicable VaR test at the end of 2019 using
a 200% limit for the relative VaR test and a 20% limit for the absolute
VaR test. Using the staff estimate of the number of funds that will be
subject to the VaR-based test under the final rule, this result implies
that 24 funds would have failed their applicable VaR test.\873\ The
commenter also asked respondents to evaluate their VaR levels during a
stressed market period, and reported that 1.8% of funds would have
failed their applicable VaR test (using assumed 200% and 20% levels for
the relative VaR test and absolute VaR test, respectively).\874\ Using
the staff estimate of the number of funds that we estimate will be
subject to the VaR-based test under the final rule, this result implies
that 49 funds would have failed their applicable VaR test.\875\ We
believe that these survey-based results of the proposed VaR-based tests
using a 200% limit for the relative VaR test and a 20% limit for the
absolute VaR test help inform an assessment of the final rule's likely
effects and complement the staff's own analysis of the VaR-based tests
under the final rule.
---------------------------------------------------------------------------
\872\ See ICI Comment Letter.
\873\ This number is based on the following calculation: 2,696
funds x 0.9% = 24 funds.
\874\ The commenter indicated that the survey did not specify a
specific stressed period but that the majority of respondents
included the global financial crisis. See ICI Comment Letter.
\875\ This number is based on the following calculation: 2,696
funds x 1.8% = 49 funds.
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Two commenters stated that the VaR-based limit on fund leverage
risk would not benefit investors, because only a relatively small
number of funds will have to adjust their portfolios in order to comply
with the VaR based limit on leverage risk.\876\ However, we believe
that the VaR-based limit on fund leverage risk will benefit investors
by establishing an outer bound on fund leverage risk, which will
prevent funds from using strategies that expose investors to a degree
of fund leverage risk that is inconsistent with the investor protection
concerns of section 18.
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\876\ See ProShares Comment Letter and Direxion Comment Letter.
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Funds that will have to adjust their portfolios to comply with the
VaR-based limit on fund leverage risk will incur associated trading
costs. If a fund has to adjust its portfolio so significantly that it
could no longer pursue its investment strategy, such a fund may also
lose investors or, if it chooses to cease operating, incur costs
associated with unwinding the fund.
In addition, funds could be required to adjust their portfolios to
comply in the future and, if so, will incur associated trading costs.
For example, as market conditions change, a fund's VaR could exceed the
VaR-based limit, especially if a fund relies on the absolute VaR test.
The final rule's VaR tests also will eliminate the flexibility that
funds currently have to leverage their portfolios to a greater extent
than the VaR tests permit. Although funds currently may not be
exercising this flexibility, they may nevertheless value the ability to
increase leverage beyond the rule's VaR-based limit. While, on the one
hand, the VaR-based tests impose costs on funds by restricting the
strategies they can employ, the limit on fund leverage risk will
benefit fund investors, to the extent that it prevents these investors
from experiencing losses from a fund's increased risk exposure that is
prohibited by the VaR-based limit on fund leverage risk.
By establishing a bright-line limit on the amount of leverage risk
that a fund can take on using derivatives, the final rule may make some
funds and their advisers more comfortable with using derivatives. As a
result, some funds that currently use derivatives to an extent that
will result in the fund's VaR being below the limit may react by
increasing the extent of their derivatives usage.
The requirement could also indirectly result in changing the amount
of investments in funds. On the one hand, the final rule could attract
additional investment, if investors become more comfortable with funds'
general level of riskiness as a result of funds' compliance with an
outside limit on fund leverage risk. On the other hand, to the extent
that investors currently expect funds to limit their risk to levels
below those which the limits will produce, or to the extent that the
rule's bright-line limit on the amount of leverage risk leads some
funds to increase their derivatives usage, the limits may result in
investors re-evaluating how much risk they are willing to take and
reducing their investments in funds. Due to a lack of data regarding
current investor expectations about fund risk, however,
[[Page 83241]]
we are unable to predict which of the two effects will more likely
dominate the other.
As the requirements will prevent funds that are subject to the
outer limit on fund leverage risk from offering investment strategies
that exceed the outer limit, those investors who prefer to invest in
such funds because they value the increased potential for gains that is
generally associated with riskier investment strategies may see their
investment opportunities restricted by the final rules.\877\ As a
result, such investors may instead invest in alternative products that
can provide leveraged market exposure but will not be subject to the
VaR-based limit on fund leverage risk of rule 18f-4 and incur any
transactions costs associated with changing their investments.\878\
Examples of such alternative products include existing leveraged/
inverse funds with exposures exceeding 200%, as well as products that
are not registered investment companies, such as alternative investment
vehicles (including the listed commodity pools that would have been
subject to the proposed sales practices rules), exchange-traded notes
(``ETNs''), and structured products.\879\ Some of these alternatives
may present additional risks. For example, some investors could choose
to invest in ETNs, which are subject to issuer default. Alternatively,
such investors, particularly institutional ones, may instead borrow
themselves or trade on margin to achieve leverage.
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\877\ See also ProShares Comment Letter (mentioning a
``reduction of investment opportunities for investors'' as a result
of the VaR-based test.)
\878\ See also ProShares Comment Letter (mentioning ``costs
incurred if [investors] switched to alternative investment vehicles
[from funds that cannot satisfy the VaR-based test].'')
\879\ As part of the staff review discussed above, the staff
will review the effectiveness of the existing regulatory
requirements in protecting investors who invest in leveraged/inverse
products and other complex investment products. See supra section
II.F.4.
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Funds that will be subject to the VaR-based limit on fund leverage
risk will incur the cost of determining their compliance with the
applicable VaR test at least once each business day. Part of these
costs will be associated with obtaining the necessary data required for
the VaR calculation, to the extent that a fund does not already have
this data available. Funds implementing the relative VaR test and using
a designated index as the reference portfolio will likely incur larger
data costs compared to funds implementing the absolute VaR test, as the
absolute VaR test will require funds to obtain data only for the VaR
calculation for the fund's portfolio, whereas the relative VaR test in
this case also will require funds to obtain data for the VaR
calculation for their designated index. In addition, some index
providers may charge licensing fees to funds for including indexes in
their regulatory documents or for access to information about the
index's constituent securities and weightings.\880\ Funds may avoid
these index-related costs by using their securities portfolio. That
approach may, however, involve some operational burdens in that it
would require a fund to be able to identify and exclude the fund's
derivatives transactions, as defined in the rule, in order to calculate
the VaR of the fund's securities and other investments.
---------------------------------------------------------------------------
\880\ We understand that industry practices around licensing
indexes for regulatory purposes vary widely, with some providers not
charging any fees and others charging fees in excess of $10,000 per
year.
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Funds that do not already have systems to perform the VaR
calculations in place will also incur the costs associated with setting
up these systems or updating existing systems.\881\ Both the data costs
and the systems costs will likely be larger for funds that use multiple
types of derivatives, use derivatives more extensively, or otherwise
have more complicated derivatives portfolios, compared to funds with
less complicated derivatives portfolios.
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\881\ In advance of the proposal, one commenter indicated that
implementing a UCITS VaR test will be only slightly burdensome for
45% of respondents to a survey of ICI member firms and would be
moderately burdensome for an additional 34% of respondents. The
commenter also indicated that respondents commonly reported that the
burden will increase, in some cases very substantially, if a VaR
test has different parameters or is more prescriptive than UCITS
VaR. See 2019 ICI Comment Letter. As the requirements of the VaR
test in the final rule are generally consistent with existing market
practice, including that of UCITs funds, the results of this survey
therefore support our view that many funds will likely experience
efficiencies in implementing the VaR test.
---------------------------------------------------------------------------
Larger funds or funds that are part of a large fund complex may
incur higher costs in absolute terms but find it less costly, per
dollar managed, to perform VaR tests relative to a smaller fund or a
fund that is part of a smaller fund complex. For example, larger funds
may have to allocate a smaller portion of existing resources for the
VaR test and fund complexes may realize economies of scale in
implementing systems to compute VaR. In particular, the costs
associated with implementing or updating systems to calculate VaR will
likely only be incurred once at the level of a fund complex, as such
systems can be used to perform VaR tests for all funds in the complex
that are subject to the VaR test requirement. Similarly, larger fund
complexes may incur lower costs associated with purchasing data on a
per-fund basis, to the extent that the VaR calculations for multiple
funds in the complex partially or completely require the same data. For
these reasons, smaller funds or funds that are not part of a large fund
complex may be particularly likely to find it more economical to rely
on a third-party vendor to calculate VaR compared to incurring the
associated systems and data costs directly.
Under the final rule, a fund that holds derivatives that is not a
limited derivatives user will generally be subject to the VaR-based
limit on fund leverage risk.\882\ Based on an analysis of Form N-PORT
filings and financial statements filed with the Commission by BDCs, we
estimate that about 21% of funds, or 2,696 funds total, will be
required to implement VaR tests. We estimate that the incremental
annual cost associated with the VaR test will range from $5,000 to
$100,000 per fund, depending on the particular facts and circumstances,
including whether the fund currently computes VaR; whether the fund is
implementing the relative or absolute VaR test; and whether a fund that
is part of a larger complex may be able to realize economies of scale
or compliance efficiencies with UCITS requirements.\883\ Funds that
currently already compute VaR, and especially funds that are managed by
an adviser (or are managed by an affiliate of an adviser) that manages
UCITS funds, will be particularly likely to experience costs at the
very low end of this range.\884\ Assuming that the midpoint of this
range reflects the cost to the average fund subject to the VaR
requirement, we
[[Page 83242]]
estimate a total additional annual industry cost of $141,540,000.\885\
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\882\ The final rule will permit leveraged/inverse funds in
operation today that seek investment results in excess of the 200%
leverage risk limit, and that cannot comply with the relative VaR
test, to continue operating at their current leverage levels,
provided they meet certain requirements. See supra section II.F.5.
\883\ One commenter criticized our estimates for the incremental
annual cost associated with the VaR test, and pointed out that our
estimates are lower than the estimated range of $60,000 to $180,000
per fund that the Commission provided in the 2015 Proposing Release.
See ProShares Comment Letter. The commenter did not, however,
provide data to inform more precise cost estimates. Conversely,
other commenters said that many advisers that use derivatives
already use risk management platforms that include VaR tools,
indicating that many funds may experience lower marginal costs than
we estimated in 2015. See supra footnotes 729-732 and accompanying
text. We are therefore not revising the cost estimates we provided
in the Proposing Release.
\884\ We estimate that there are 190 registered investment
advisers that are registered with a EU financial regulatory
authority and that are reported as the investment adviser, or sub-
adviser, for a registered fund. See supra footnote 816.
\885\ This estimate is based on the following calculation: 2,696
funds x 0.5 x ($5,000 + $100,000) = $141,540,000. Some funds may
find it more cost effective to restrict their use of derivatives in
order to be able to rely on the final rule's exception for limited
derivatives users compared to complying with the VaR-based limit on
fund leverage risk. See supra section II.E; infra section III.C.3.
As in the proposal, we do not have data that would allow us to
quantify the costs and benefits that define the tradeoff for any
particular fund of changing its use of derivatives in order to
qualify for the limited derivatives user exception, and commenters
did not provide any such data. Thus, we are still unable to quantify
how many funds would make this choice.
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In addition, a fund that currently operates in a manner that could
result in the fund's portfolio VaR being just under the final rule's
limit on fund leverage risk may need to alter its portfolio during
periods of increased market volatility in order to avoid falling out of
compliance with this limit. We expect such a scenario to be more likely
for a fund that will rely on the absolute VaR test, because the
relative VaR test will allow a fund to operate with a higher portfolio
VaR when the VaR of its designated reference portfolio increases.
A fund that determines to eliminate some of its leverage risk
associated with derivatives in order to comply with the VaR-based limit
on leverage risk might do so through unwinding or hedging its
derivatives transactions or through some other means. These portfolio
adjustments may be costly, particularly in conditions of market stress
and reduced liquidity, such as the recent experience during COVID-19.
The final rule will, however, give a fund the flexibility to mitigate
these potential costs by not requiring the fund to exit positions or
change its portfolio if it is out of compliance with its VaR test. If a
fund determines that it is not in compliance with the applicable VaR
test, the final rule provides that a fund must come back into
compliance promptly after such determination, in a manner that is in
the best interests of the fund and its shareholders.\886\ If the fund
is not in compliance within five business days, the rule requires the
derivatives risk manager to report to the fund's board of directors
certain specified information about the fund coming back into
compliance, as well as requiring him or her to analyze the
circumstances that caused the fund to be out of compliance and update
as appropriate program elements to address those circumstances. If the
fund remains out of compliance with the applicable VaR test for thirty
calendar days since the exceedance, the derivatives risk manager's
written report must update the initial report to the board explaining
how and by when he or she reasonably expects the fund will come back
into compliance, and the derivatives risk manager must update the board
of directors on the fund's progress in coming back into compliance at
regularly scheduled intervals at a frequency determined by the
board.\887\ These provisions of the final rule collectively provide
some flexibility for a fund that is out of compliance with the VaR test
to make any portfolio adjustments. The final rule expressly requires a
fund's prompt coming back into compliance with its applicable VaR test
to be in a manner that is in the best interests of the fund and its
shareholders. This provision recognizes the investor protection
concerns arising from the harm and costs to funds and their
shareholders if funds were forced to exit derivatives transactions
immediately or at the end of the five-day period. Under this more
flexible approach, funds will have the ability to avoid some of the
costs that otherwise could result from a fund being forced to exit its
derivatives transactions within a short timeframe.
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\886\ See rule 18f-4(c)(2)(ii).
\887\ See rule 18f-4(c)(2)(iii); see also supra section II.G.2
(discussing the requirement to submit a confidential report to the
Commission if the fund is out of compliance with the applicable VaR
test for five business days).
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3. Limited Derivatives Users
Rule 18f-4 includes an exception from the VaR-based limit on fund
leverage risk and program requirements for limited derivatives
users.\888\ The exception will be available for a fund that limits its
derivatives exposure to 10% of its net assets, excluding for this
purpose derivative transactions that are used to hedge certain currency
and/or interest rate risks. The final rule also provides certain
adjustments for interest rate derivatives and options, in computing
derivatives exposure, and permits funds to exclude positions closed out
with the same counterparty. A fund relying on the exception is required
to adopt and implement policies and procedures reasonably designed to
manage the fund's derivatives risks.\889\
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\888\ See supra section II.E for a discussion of the comments we
received on the proposed limited derivatives user exception and for
a discussion of the final rule's exclusions of certain hedging
transactions and offsetting of closed-out derivatives positions.
\889\ See supra section II.E.4 for a discussion of the final
rule's two alternative paths for remediation if a fund's derivatives
exposure exceeds the 10% derivatives exposure threshold for five
business days.
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We expect that the risks and potential impact of these funds'
derivatives use may not be as significant, compared to those of funds
that do not qualify for the exception.\890\ Therefore, we believe that
a principles-based policies and procedures requirement would
appropriately address these risks. We believe that investors in funds
that use derivatives in a limited manner will benefit from the
requirement, which we anticipate will reduce, but not eliminate, the
frequency and severity of derivatives-related losses for such funds. In
addition, to the extent that the final rule's framework is more
comprehensive than funds' current practices, the requirement may result
in more effective risk management across funds and increased fund
industry stability.
---------------------------------------------------------------------------
\890\ See supra footnote 488 and accompanying and immediately-
following text.
---------------------------------------------------------------------------
We estimate that the one-time costs would range from $15,000 to
$100,000 per fund, depending on the particular facts and circumstances,
including whether a fund is part of a larger fund complex; the extent
to which the fund uses derivatives within the parameters of the limited
derivatives user exception, including whether the fund uses more
complex derivatives; and the fund's current derivatives risk management
practices.\891\ These estimated costs are attributable to the following
activities: (1) Assessing whether a fund is a limited derivatives user,
which may include determining whether a fund's derivatives positions
are used to hedge certain currency and/or interest rate risks or are
closed out with the same counterparty; (2) analyzing the fund's current
practices relative to the final rule's requirements; (3) developing
policies and procedures reasonably designed to manage a fund's
derivatives risks; (4) integrating and implementing the policies and
procedures; and (5) preparing training materials and administering
training sessions for staff in affected areas.
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\891\ We believe that the low end of this range is reflective of
a fund that already has policies and procedures in place that could
be readily adapted to meet the final rule's requirements. Such a
fund would nevertheless incur costs associated with analyzing its
current practices relative to the final rule's requirements and
determining whether it could qualify as a limited derivatives user.
We increased our estimate of the low end of this range compared to
the proposal to account for this cost as well as to account for the
potential that funds may implement additional policies and
procedures related to the changes we have incorporated into the
final rule to address exceedances of the 10% derivatives exposure
threshold. This increased estimate also takes into account our
assumption that a number of funds that qualify as limited
derivatives users may wish to employ outside legal services in
connection with adopting and implementing policies and procedures
reasonably designed to manage their derivatives risks. See infra
section IV.B.6.
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[[Page 83243]]
We estimate that the ongoing annual costs that a fund that is a
limited derivatives user will incur range from 65% to 75% of the one-
time costs associated with these requirements. Thus, we estimate that a
fund will incur ongoing annual costs that range from $9,750 to
$75,000.\892\ These estimated costs are attributable to the following
activities: (1) Assessing, monitoring, and managing the risks
associated with the fund's derivatives transactions; (2) periodically
reviewing and updating a fund's policies and procedures; (3) additional
staff training; and (4) preparing a written report to the fund's board
if a fund exceeds the 10% derivatives exposure threshold and does not
reduce its exposure within five business days.
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\892\ This estimate is based on the following calculations: 0.65
x $15,000 = $9,750; 0.75 x $100,000 = $75,000.
---------------------------------------------------------------------------
Based on an analysis of Form N-PORT filings, as well as financial
statements filed with the Commission by BDCs, we estimate that about
19% of funds, or 2,437 funds total, will qualify as limited derivatives
users.
Because many funds belong to a fund complex and are likely to
experience economies of scale, we expect that the lower end of the
estimated range of costs ($15,000 in one-time costs; $9,750 in annual
costs) better reflects the total costs likely to be incurred by many
funds. In addition, commenters suggested that many funds already have
policies and procedures in place to manage certain risks associated
with their derivatives transactions.\893\ We believe that these
policies and procedures could be readily adapted to meet the final
rule's requirements without significant additional cost. However, we do
not have data to determine how many funds already have such policies
and procedures in place that will substantially satisfy the final
rule's requirements, and commenters did not provide any such data. All
funds that seek to qualify as limited derivatives users also will need
to evaluate both the final rule and their current policies and
procedures to identify any needed modifications. We therefore assume
that all funds that seek to qualify as limited derivatives users will
incur a cost associated with this requirement. Based on these
assumptions, we estimate the total industry cost in the first year of
$60,315,750, but we believe that this estimate is likely over-inclusive
for the reasons stated above.\894\
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\893\ See Fidelity Comment Letter; IAA Comment Letter.
\894\ This estimate is based on the following calculation: 2,437
funds x ($15,000 + $9,750) = $60,315,750. This cost estimate assumes
that none of the funds that currently do not hold any derivatives
will choose to establish and implement policies and procedures
reasonably designed to manage the fund's derivatives risks in
anticipation of a future limited use of derivatives. Notwithstanding
this assumption, we acknowledge some funds that currently do not use
derivatives may still choose to establish and implement such
policies and procedures prophylactically in order to preserve the
flexibility to engage in a limited use of derivatives on short
notice.
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Some funds may change how they use derivatives in order to qualify
for the limited derivatives user exception and thereby avoid the
potentially increased compliance cost associated with the final rule's
VaR and program requirements. For example, a fund with derivatives
exposure just below 10% of its net assets may forego taking on
additional derivatives positions, while a fund with derivatives
exposure just above 10% of its net assets might close out some existing
derivatives positions. As a result, the final rule's exception for
limited derivatives users may reduce the extent to which some funds use
derivatives.\895\
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\895\ As we do not have data that allow us to quantify the costs
and benefits that define the tradeoff for any particular fund of
changing its use of derivatives in order to qualify for the limited
derivatives user exception, and commenters did not provide any such
data, we are unable to estimate how many funds will make this
choice.
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4. Reverse Repurchase Agreements and Similar Financing Transactions
Reverse repurchase agreements and similar financing transactions
represent secured loans, which can be used to introduce leverage into a
fund's portfolio just like other forms of borrowings, or derivatives.
Accordingly, the final rule permits a fund to either choose to limit
its reverse repurchase and other similar financing transaction activity
to the applicable asset coverage limit of the Act for senior securities
representing indebtedness, or a fund may instead treat them as
derivative transactions. A fund's election will apply to all of its
reverse repurchase agreements and similar financing transactions so
that all such transactions are subject to a consistent treatment under
the final rule.\896\
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\896\ Rule 18f-4(d)(1)(i) and (ii).
---------------------------------------------------------------------------
Today, funds rely on the asset segregation approach that Release
10666 describes with respect to reverse repurchase agreements, which
funds may view as separate from the limitations established on bank
borrowings (and other senior securities that are evidence of
indebtedness) by the asset coverage requirements of section 18.\897\ As
a result, the degree to which funds can engage in reverse repurchase
agreements under the final rule may differ from the baseline.
---------------------------------------------------------------------------
\897\ See supra section II.H.
---------------------------------------------------------------------------
A fund that engages in both reverse repurchase agreements and bank
borrowings (or similar transactions), in excess of the asset coverage
requirements of section 18, may be affected by the rule's requirements.
If such a fund chose to treat its reverse repurchase and other similar
financing transaction activity under the applicable asset coverage
limit of the Act for senior securities representing indebtedness, the
fund would be required to reduce the size of its activity to satisfy
this limit. Conversely, such a fund could choose to treat its reverse
repurchase and other similar financing transaction activity as
derivatives for all purposes of the final rule. Whether and how this
election would affect a fund would depend on the amount of other
derivatives and the degree to which the fund engages in reverse
repurchase agreements and similar financing transactions. This election
could cause a fund that otherwise did not engage in any derivatives
transactions to be required to adopt and implement policies and
procedures reasonably designed to manage the fund's derivatives risks
in order to qualify as a limited derivatives user (assuming that the
fund's use of reverse repurchase agreements and similar financing
transactions was limited to 10% of its net assets).\898\ Similarly, a
fund that otherwise could qualify as a limited derivatives user
(because it otherwise engaged in only a limited amount of derivatives
transactions) may no longer be able to rely on this exception to the
final rule's VaR and program requirements.
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\898\ As discussed further below in this section, we did not
identify any funds that used reverse repurchase agreements and bank
borrowings in combined amounts that exceed the asset coverage
requirement that also did not otherwise hold any derivatives.
Nevertheless, this fact pattern could affect some funds in the
future.
---------------------------------------------------------------------------
To the extent that funds today separately analyze their asset
coverage requirements with respect to reverse repurchase agreements
under Release 10666 and bank borrowings and similar senior securities
under section 18, the treatment of reverse repurchase agreements under
the final rule could have the effect of limiting the overall scale of
these transactions. In addition, if a fund does not qualify as a
limited derivatives user due to its other investment activity or its
treatment of reverse repurchase agreements and similar financing
transactions as derivatives, any portfolio leveraging effect of reverse
repurchase agreements, similar financing transactions, and
[[Page 83244]]
borrowings will also be restricted indirectly through the VaR-based
limit on fund leverage risk. As a result, a fund could be restricted
through the VaR-based limit on fund leverage risk from investing the
proceeds of borrowings through reverse repurchase agreements to the
full extent otherwise permitted by the asset coverage requirements in
section 18 if the fund does not qualify as a limited derivatives user.
DERA staff analyzed funds' use of reverse repurchase agreements and
borrowings using Form N-PORT filings as well as financial statements
filed with the Commission by BDCs. Based on the staff's analysis of
Form N-PORT filings, we estimate that about 0.27% of funds, or 35 funds
total, used these transactions in combined amounts that exceeded the
asset coverage requirement.\899\ All of these funds also otherwise
engaged in derivatives transactions, but only one of them would no
longer qualify as a limited derivatives user if it elected to treat its
reverse repurchase transactions as derivatives for all purposes of the
final rule.\900\
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\899\ In our review of form N-PORT filings, we observed that
several of the funds that used reverse repurchase agreements and
similar financing transactions (bank borrowings and similar
securities) in combined amounts that exceeded 50% of net assets
already exceeded the 50% limit for either repurchase agreements,
similar financing transactions (bank borrowings and similar
securities, or both, when considered separately. In our review of
financial statements filed by the Commission by BDCs, we observed
that no BDCs exceeded the asset coverage requirement.
\900\ For purposes of our analysis in other parts of the
economic analysis (specifically, sections III.C.1-III.C.3), we
assumed that this fund would not qualify for the limited derivatives
user exception.
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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
Rule 18f-4 permits existing leveraged/inverse funds that cannot
satisfy the final rule's relative VaR test and that seek to provide
leveraged or inverse market exposure exceeding 200% of the return or
inverse return of the relevant index as of October 28, 2020 to continue
operating, provided they meet certain requirements. This exception is
limited to funds currently in operation, and would therefore not apply
to any new funds.
Because the final rule limits this provision to funds currently in
operation, the number of funds with exposure above 200% may fall over
time, to the extent that fund sponsors remove existing funds from the
market. This may particularly affect funds that are less popular or
become less popular with investors over time. For the same reason, the
final rule may limit the growth (or lead to a decline) of assets
managed by leveraged/inverse funds with a market exposure above these
limits over time. At the same time, because leveraged/inverse funds
that are already in operation today will be permitted to continue
operating at their current exposure levels and because fund sponsors
will likely be hesitant to remove funds relying on the exception from
the market (because the exception applies only to funds currently in
operation), the final rule is not likely to have a significant
immediate effect on the number of these funds and the size of the
assets they manage.
Any reduction in the variety (including future variety) of
leveraged/inverse funds with exposures exceeding 200% will affect
investors. While investors generally benefit from increased investment
opportunities, the effects on any particular investor also depend on
how well an investor is able to evaluate the characteristics and risks
of leveraged/inverse funds, particularly those with exposures exceeding
200%. On the one hand, there is a body of academic literature that
provides empirical evidence that some retail investors may not fully
understand the risks inherent in their investment decisions and not
fully understand the effects of compounding.\901\ In addition, the
Commission received some comments on the proposal suggesting that
retail investors do not understand the unique risks of leveraged/
inverse funds.\902\ On the other hand, we also received a large number
of comments from individual investors asserting they understand the
risks involved in these funds.\903\
---------------------------------------------------------------------------
\901\ See, e.g., Annamaria Lusardi & Olivia S. Mitchell, The
Economic Importance of Financial Literacy: Theory and Evidence, 52
J. Econ. Literature 5 (2014), available at https://www.aeaweb.org/articles?id=10.1257/jel.52.1.5, which reviews a body of recent
survey-based work indicating that many retail investors have limited
financial literacy. As the Commission pointed out in the Proposing
Release, this literature studies investor inattention to financial
products generally and does not specifically examine retail
investors' understanding of leveraged/inverse funds. Two commenters
stated that the arguments provided in the Proposing Release do not
represent evidence that investors misunderstand the risks of
leveraged/inverse funds. See Comment Letter of Chester Spatt, Ph.D.
(Mar. 31, 2020); Flannery Comment Letter. One of those commenters
specifically raised the limitations of this literature. See Flannery
Comment Letter. We continue to believe that this literature may be
informative of investors' understanding of leveraged/inverse funds,
as it includes an examination of investors' understanding of
interest compounding, which may directly apply in the context of the
(generally) daily compounding feature of leveraged/inverse funds.
\902\ See supra footnote 572 and accompanying text.
\903\ See supra footnote 571 and accompanying text. See also
Flannery Comment Letter, supra footnote 901 (finding a negative
historical relationship between the returns of some leveraged/
inverse funds and subsequent changes in outstanding shares and
arguing that this relationship is consistent with some investors
using leveraged/inverse funds for short-term trading strategies).
---------------------------------------------------------------------------
The final rule's treatment of leveraged/inverse funds with
exposures above 200% could benefit some investors, to the extent that
the rule has the effect of reducing the number of investors in these
funds who are not capable of evaluating the risks they pose. These
benefits would be limited, however, to the extent that they overlap
with the effects of current requirements that apply to investment
advisers or broker-dealers, including the best interest standard of
conduct for broker-dealers under Regulation Best Interest and the
fiduciary obligations of investment advisers.\904\ Conversely, the
final rule may impose a cost on those investors who are capable of
evaluating the risks these funds pose, by limiting the investment
opportunities available to those investors.\905\
---------------------------------------------------------------------------
\904\ See supra section II.F.2.
\905\ See, e.g., Flannery Comment Letter, supra footnote 901
(stating that an investor may rationally hold a leveraged/inverse
fund for multi-day holding periods and that leveraged/inverse funds
provide a cost-efficient means of achieving investors' objectives).
---------------------------------------------------------------------------
The final rule also includes a requirement that a fund that seeks
to provide leveraged or inverse market exposure exceeding 200% of the
return or inverse return of the relevant index disclose in its
prospectus that it is not subject to the final rule's limit on fund
leverage risk. We believe that this requirement may benefit investors
and the market, by providing transparency regarding which funds are
exempt from rule 18f-4's limit on fund leverage fund risk.
As discussed below in section IV.B.4, rule 18f-4 requires an over-
200% leveraged/inverse fund currently in operation to disclose in its
prospectus that it is not subject to the VaR-based limits on fund
leverage risks. We estimate that the total industry cost associated
with this disclosure requirement in the first year will be
$71,400.\906\
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\906\ The burdens associated with this estimate are all
paperwork-related burdens, and thus they are also estimated in the
Paperwork Reduction Act Analysis section of this release. See infra
section IV.B.4. The estimate is based on the following calculations:
First, we calculate the one-time cost to an over-200% leveraged/
inverse fund for the disclosure, to be 1.5 hours x $312 (compliance
manager) + 1.5 hours x $368 (compliance attorney) = $468 + $552 =
$1,020 per year. The total industry cost to over-200% leveraged/
inverse funds, in the first year, is (70 over-200% leveraged/inverse
funds) x $1,020 = $71,400.
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[[Page 83245]]
6. Amendments to Rule 6c-11 Under the Investment Company Act and
Rescission of Exemptive Relief for Leveraged/Inverse ETFs
Existing leveraged/inverse ETFs rely on exemptive relief, which the
Commission has not granted to a leveraged/inverse ETF sponsor since
2009. We are amending the provision in rule 6c-11 that excludes
leveraged/inverse ETFs from its scope to allow a leveraged/inverse ETF
to operate under rule 6c-11 if the fund complies with the applicable
requirements of rule 18f-4. As a result, fund sponsors will be
permitted to operate a leveraged/inverse ETF subject to the conditions
in rules 6c-11 and 18f-4 without obtaining an exemptive order.
The amendments to rule 6c-11 will benefit any fund sponsors seeking
to launch leveraged/inverse ETFs whose target multiple is equal to or
less than 200% of its reference index that did not obtain the required
exemptive relief due to the Commission's moratorium on granting such
relief. A fund sponsor planning to seek exemptive relief from the
Commission to form and operate a leveraged/inverse ETF that could
operate under rules 6c-11 and 18f-4 will also no longer incur the cost
associated with applying for an exemptive order.\907\ To the extent
that the amendments result in new leveraged/inverse ETFs with exposures
not exceeding 200% coming to market, the industry-wide assets under
management of such leveraged/inverse ETFs could increase and investors
who are able to evaluate the risks they pose could benefit from an
increase in investment choices. Conversely, the amendment may also have
the effect of increasing the number of investors in these funds who may
not be capable of evaluating the risks they pose.\908\
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\907\ In the ETFs Adopting Release, we estimated that the direct
cost of a typical fund's application for ETF relief (associated
with, for example, legal fees) is approximately $100,000. As
exemptive applications for leveraged/inverse ETFs are significantly
more complex than those of the average fund, we estimate that the
direct costs of an application for leveraged/inverse ETF relief
amounts to approximately $250,000. See ETFs Adopting Release, supra
footnote 76, at nn.537-539 and accompanying text.
\908\ See supra section III.C.5 for a discussion of investors'
understanding of leveraged/inverse funds and the comments we
received on this topic in the context of leveraged/inverse funds
with exposures exceeding 200%, for which the effects of these fund's
unique characteristics are more pronounced due to the higher levels
of exposure they seek to provide.
---------------------------------------------------------------------------
Because our amendments to rule 6c-11 will permit leveraged/inverse
ETFs to rely on that rule, we also are rescinding the exemptive orders
the Commission has previously granted to sponsors of leveraged/inverse
ETFs. As a result, existing and future leveraged/inverse ETFs will
operate under a consistent regulatory framework with respect to the
relief necessary to operate as an ETF. We believe that the costs to
leveraged/inverse ETFs of complying with the conditions of rule 6c-11
instead of those contained in their exemptive orders will be minimal
(other than the costs of complying with rule 18f-4, which we discuss
separately), as we anticipate that all existing leveraged/inverse ETFs
will be able to continue operating as they do currently, while also
being required to comply with rule 6c-11's requirements for additional
website disclosures and basket asset policies and procedures.\909\
While we do anticipate that these funds will incur costs from having to
comply with the applicable provisions of rule 18f-4, as referenced in
the amendments to rule 6c-11, we estimate these costs in the
subsections of this section III.C that discuss the costs and benefits
of rule 18f-4. Sponsors of leveraged/inverse ETFs with existing
exemptive orders describing exposures exceeding 200% will no longer be
able to launch additional leveraged/inverse ETFs with exposures
exceeding this limit. The economic effects of this restriction are
discussed above.\910\ Additional economic considerations that the
treatment of leveraged/inverse ETFs presents with regards to efficiency
and competition are discussed below in section III.D.
---------------------------------------------------------------------------
\909\ In this section as well as in section III.D below, we have
accounted for the costs and benefits to leveraged/inverse ETFs as a
result of the removal of the current exclusion of these funds from
rule 6c-11. We believe that the additional considerations the
Commission analyzed in the ETFs Adopting Release for ETFs other than
leveraged/inverse ETFs that were included in the scope of rule 6c-11
at adoption apply substantially similarly to leveraged/inverse ETFs.
See ETFs Adopting Release, supra footnote 76.
\910\ See infra section III.C.5.
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7. Unfunded Commitment Agreements
Rule 18f-4 will permit a fund to enter into unfunded commitment
agreements to make certain loans or investments if it reasonably
believes, at the time it enters into such an agreement, that it will
have sufficient cash and cash equivalents to meet its obligations with
respect to its unfunded commitment agreements, in each case as they
come due.\911\ While a fund should consider its unique facts and
circumstances, the final rule will prescribe certain specific factors
that a fund must take into account in having such a reasonable belief.
---------------------------------------------------------------------------
\911\ See supra section II.I.
---------------------------------------------------------------------------
We continue to believe that the final rule's requirements are
consistent with current industry practice.\912\ As a result, we do not
believe that the rule's treatment of unfunded commitment agreements
represents a change from the baseline, although we acknowledge that
there may be some variation in the specific factors that funds consider
today, as well as the potential for some variation between those
factors and those prescribed in the final rule. Because we believe that
the final rule's approach is consistent with general industry
practices, we believe this requirement will not lead to significant
economic effects.\913\
---------------------------------------------------------------------------
\912\ See supra footnote 763 and accompanying text.
\913\ See supra footnote 763 and accompanying text.
---------------------------------------------------------------------------
8. Recordkeeping
Rule 18f-4 includes certain recordkeeping requirements.\914\
Specifically, the final rule will require a fund to maintain certain
records documenting its derivatives risk management program's written
policies and procedures, along with its portfolio's stress test
results, VaR backtesting results, any internal reporting or escalation
of material risks under the program, and periodic reviews of the
program.\915\ It will also require a fund to maintain records of any
materials provided to the fund's board of directors in connection with
approving the designation of the derivatives risk manager and any
written reports relating to the derivatives risk management
program.\916\
---------------------------------------------------------------------------
\914\ See supra section II.J.
\915\ Rule 18f-4(c)(i)(A).
\916\ Rule 18f-4(c)(6)(i)(B).
---------------------------------------------------------------------------
A fund that will be required to comply with the VaR-based limit on
fund leverage risk will also have to maintain records documenting the
determination of: Its portfolio's VaR; the VaR of its designated
reference portfolio, as applicable; its VaR ratio (the value of the VaR
of the Fund's portfolio divided by the VaR of the designated reference
portfolio), as applicable; and any updates to any of its VaR
calculation models and the basis for any material changes to its VaR
models.\917\ The rule also will require a fund to keep records of any
written reports provided to the board that the rule requires regarding
the fund's non-compliance with the applicable VaR
[[Page 83246]]
test.\918\A fund that will be a limited derivatives user under the
final rule will have to maintain a written record of its policies and
procedures that are reasonably designed to manage derivatives risks, as
well any written reports to the fund's board regarding the fund's
exceeding the exception's 10% derivatives exposure threshold.\919\ In
light of the final rule providing two separate treatment options for a
fund that enters into a reverse repurchase agreement or similar
financing transactions, a fund must also maintain a written record
documenting whether the fund is treating these transactions, as set
forth in the rule, under (1) an asset coverage requirements approach or
(2) a derivatives transactions treatment approach.\920\ Finally, a fund
engaging in unfunded commitment agreements will be required to maintain
records documenting the basis for its reasonable belief regarding the
sufficiency of its cash and cash equivalents to meet its obligations
with respect to each unfunded commitment agreement, with such a record
made each time it enters such an agreement.\921\ Rule 18f-4 will
require funds to maintain required records for a period of five years
(the first two years in an easily accessible place).\922\
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\917\ Rule 18f-4(c)(6)(i)(C).
\918\ Rule 18f-4(c)(6)(i)(B).
\919\ Rule 18f-4(c)(6)(i)(D).
\920\ Rule 18f-4(d)(2).
\921\ See rule 18f-4(e)(2).
\922\ See rule 18f-4(c)(6)(ii); rule 18f-4(d)(2); rule 18f-
4(e)(2).
---------------------------------------------------------------------------
We believe that these requirements will increase the effectiveness
of the Commission's oversight of the fund industry, which will, in
turn, benefit investors. Further, the requirement to keep records
documenting the derivatives risk management program, including records
documenting periodic review of the program and written reports provided
to the board of directors relating to the program, will help our staff
evaluate a fund's compliance with the derivatives risk management
program requirements. We anticipate that these recordkeeping
requirements will generally not impose a large additional burden on
funds, as most funds would likely choose to keep such records, even
absent the requirement to do so, in order to support their ongoing
administration of the derivatives risk management program and their
compliance with the associated requirements.
As discussed below in section IV.B.7, our estimated average one-
time and ongoing annual costs associated with the recordkeeping
requirements take into account the fact that some funds, such as those
that can rely on the final rule's limited derivatives user exception,
may incur less extensive recordkeeping costs relative to other funds
that use derivatives, or the other transactions that rule 18f-4
addresses, more substantially. We estimate that the total industry cost
for the final rule's recordkeeping requirement in the first year will
equal $53,012,728.\923\
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\923\ The burdens associated with this estimate are all
paperwork-related burdens, and thus they are also estimated in the
Paperwork Reduction Act Analysis section of this release. See infra
section IV.B.7.The total industry cost estimate is then based on the
following calculations: First, 9 hours x $63 (general clerk) = $567,
9 hours x $96 (senior computer operator) = $864, and 9 hours x $368
(compliance attorney) = $3,312, for a total of $567 + $864 + $3,312
+ ($1,800 for initial external cost burden) = $6,543, which is the
one-time cost per non-limited derivatives user fund for establishing
recordkeeping policies and procedures for derivatives risk
management program and VaR requirements; Second, 16 hours x $63
(general clerk) = $1,008, 16 hours x $96 (senior computer operator)
= $1,536, and 16 hours x $368 (compliance attorney) = $5,888, for a
total of $1,008 + $1,536 + $5,888 = $8,432, which is the annual
ongoing recordkeeping cost per non-limited derivatives user fund for
derivatives risk management program and VaR requirements; Third, 1.5
hours x $63 (general clerk) = $95, 1.5 hours x $96 (senior computer
operator) = $144, and 1.5 hours x $368 (compliance attorney) = $552,
for a total of $95 + $144 + $552 + ($1,800 for initial external cost
burden) = $2,591, which is the one-time cost per limited derivatives
user fund for establishing recordkeeping policies and procedures;
Fourth, 2 hours x $63 (general clerk) = $126, 2 hours x $96 (senior
computer operator) = $192, and 2 hours x $368 (compliance attorney)
= $736, for a total of $126 + $192 + $736 = $1,054, which is the
annual ongoing recordkeeping cost per limited derivatives user fund
or a fund engaging in unfunded commitment agreements; Fifth, 1.5
hours x $63 (general clerk) = $95, 1.5 hours x $96 (senior computer
operator) = $144, and 1.5 hours x $368 (compliance attorney) = $552,
for a total of $95 + $144 + $552 = $791, which is the one-time cost
per fund engaging in unfunded commitment agreements or reverse
repurchase agreements for establishing recordkeeping policies and
procedures; Lastly, 1 hour x $63 (general clerk) = $63, 1 hour x $96
(senior computer operator) = $96, and 1 hour x $368 (compliance
attorney) = $368, for a total of $63 + $96 + $368 = $527, which is
the annual ongoing recordkeeping cost per fund engaging in reverse
repurchase agreements; Total industry costs associated with
recordkeeping requirements are estimated as: (2,766 funds which
cannot rely on the limited derivatives user exception) x ($6,543 +
$8,432) = $41,420,850; (2,437 funds which can rely on the limited
derivatives user exception) x ($2,591 + $1,054) = $8,882,865; (1,339
funds engaging in unfunded commitment agreements) x ($791 + $1,054)
= $2,470,455; (181 funds engaging in reverse repurchase agreements)
x ($791 + $527) = $238,558 for a total of $53,012,728.
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9. Amendments To Fund Reporting Requirements
a. Form N-PORT and Form N-CEN
We are amending Form N-PORT to include a new reporting item on
limited derivatives users' derivatives exposure, which will be non-
public because we are collecting this information for regulatory
purposes.\924\ This new item requires a limited derivatives user to
report: (1) The fund's derivatives exposure; and (2) the fund's
derivatives exposure attributable to currency or interest rate
derivatives entered into and maintained by the fund for hedging
purposes. Furthermore, if a fund relying on that exception has
derivatives exposure exceeding 10% of the fund's net assets, and this
exceedance persists beyond the five-business-day period that the final
rule provides for remediation, the fund will have to report the number
of business days beyond the five-business-day remediation period that
its derivatives exposure exceeded 10% of net assets.\925\ In addition,
we are adopting a new Form N-PORT reporting item related to the VaR
tests we are adopting, in which funds that are subject to the final
rule's VaR-based limit on fund leverage risk will have to report
certain information related to their VaR.\926\
---------------------------------------------------------------------------
\924\ See supra section II.G.1.a.
\925\ Id.
\926\ Specifically, this information will include the fund's
median daily VaR for the reporting period. Funds subject to the
relative VaR test during the reporting period also will have to
report: (1) The name of the fund's designated index or a statement
that the fund used its securities portfolio as its designated
reference portfolio; (2) the index identifier; and (3) the fund's
median daily VaR Ratio for the reporting period. Finally, all funds
that are subject to the limit on fund leverage risk also will have
to report the number of exceptions that the fund identified as a
result of the backtesting of its VaR calculation model. Information
about a fund's designated index will be made publicly available, but
not a fund's median daily VaR, median daily VaR ratio, and
backtesting information. See supra section II.G.1.b.
---------------------------------------------------------------------------
We also are amending Form N-CEN to require a fund relying on the
final rule to identify that it is relying on the rule in the first
instance, as well as: (1) Whether it is a limited derivatives user
excepted from the rule's program requirement and VaR tests; (2) whether
it is a leveraged/inverse fund as defined in the rule; (3) whether it
has entered into reverse repurchase agreements or similar financing
transactions, either under the provision of rule 18f-4 that requires a
fund to comply with the asset coverage requirements of section 18 or
under the provision that requires a fund to treat such transactions as
derivative transactions under the final rule; (4) whether it has
entered into unfunded commitment agreements under rule 18f-4; and (5)
whether it is relying on the provision of rule 18f-4 that addresses
investment in when-issued and forward-settling securities. All new
information reported in Form N-CEN pursuant to this rulemaking will be
made publicly available. These additional reporting requirements will
not apply to BDCs,
[[Page 83247]]
which do not file reports on Form N-CEN or Form N-PORT.\927\
---------------------------------------------------------------------------
\927\ See supra footnote 625.
---------------------------------------------------------------------------
To the extent that the information that we will require funds to
report on Forms N-PORT and N-CEN is not currently available, the
requirements that funds make such information available periodically on
these forms will improve the ability of the Commission to oversee
reporting funds. It also will allow the Commission and its staff to
oversee and monitor reporting funds' compliance with the final rule and
help identify trends in reporting funds' use of derivatives. The
expanded reporting also will increase the ability of the Commission
staff to identify trends in investment strategies and fund products in
reporting funds as well as industry outliers.\928\
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\928\ The structuring of the information in Form N-PORT will
improve the ability of Commission staff to compile and aggregate
information across all reporting funds, and to analyze individual
funds or a group of funds, and will increase the overall efficiency
of staff in analyzing the information.
---------------------------------------------------------------------------
Investors, third-party information providers, and other potential
users may also experience benefits from the amendments to Forms N-PORT
(that relate to information that will be publicly available) and N-CEN,
as they will require the disclosure of additional information that is
not currently available elsewhere and that may allow the users of this
data to better differentiate funds.
As discussed below in section IV.D, our estimated average one-time
and ongoing annual costs associated with the amendments to Forms N-PORT
take into account the fact that only certain funds--those that rely on
the limited derivatives user exception, and those that are subject to
the VaR-based limit on fund leverage risk in final rule 18f-4--will
incur these costs. We estimate that the total industry cost for these
new Form N-PORT reporting requirements in the first year will equal
$18,033,889.\929\ We also estimate that the total industry cost for all
registered funds associated with these new Form N-CEN reporting
requirements in the first year will equal $775,570.\930\
---------------------------------------------------------------------------
\929\ The burdens associated with this estimate are all
paperwork-related burdens, and thus they are also estimated in the
Paperwork Reduction Act Analysis section of this release. See infra
section IV.D. The total industry estimate is based on the following
calculations: First, (2 hours x $368 (compliance attorney) + 2 hours
x $334 (senior programmer) = $1,404), which is the average, one-time
cost per limited derivatives user to comply with the new N-PORT
requirements of derivatives exposure information in the first
reporting quarter of the fiscal year; Second, (3 hours x $368
(compliance attorney) + 3 hours x $334 (senior programmer) = $2,106
per year), which is the ongoing cost per limited derivatives user to
comply with the new N-PORT requirements of derivatives exposure
information in the final three reporting quarters of the fiscal
year; Third, (2 hours x $368 (compliance attorney) + 2 hours x $334
(senior programmer) = $1,404), which is the average, one-time cost
per fund to comply with the new N-PORT requirements of VaR-related
information in the first reporting quarter of the fiscal year;
Fourth, (3 hours x $368 (compliance attorney) + 3 hours x $334
(senior programmer) = $2,106 per year), which is the ongoing cost
per fund to comply with the new N-PORT requirements of VaR-related
information in the final three reporting quarters of the fiscal
year; Lastly, (0.01 hours x $368 (compliance attorney) + 0.01 hours
x $334 (senior programmer) = $7), which is the ongoing cost per
limited derivatives that reports exceedances of 10% derivatives
exposure threshold in the fiscal year. The total industry cost for
these reporting requirements in the first year is: ((2,437
registered funds that are limited derivatives users and required to
provide information about their derivatives exposure and exceedances
of the 10% threshold on N-PORT) x ($1,404 + $2,106 + $7) =
$8,570,929) + (2,696 registered funds subject to the VaR-based limit
on fund leverage risk in rule 18f-4 x ($1,404 + $2,106) =
$9,462,960) = $18,033,889.
\930\ The burdens associated with this estimate are all
paperwork-related burdens, and thus they are also estimated in the
Paperwork Reduction Act Analysis section of this release. See infra
section IV.F. The estimate is based on the following calculations:
First, we calculate the ongoing annual cost for a registered fund
required to prepare amendments to Form N-CEN, which is 0.2 hours x
$368 (compliance attorney) + 0.2 hours x $334 (senior programmer) =
$73.6 + $66.8 = $140.4 per year; Lastly, the total industry cost for
all registered funds associated with this reporting requirement in
the first year is (5,524 registered funds required to prepare a
report on Form N-CEN as amended) x $140.4 = $775,570.
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b. Amendments to Current Reporting Requirements
We are also adopting current reporting requirements for funds that
will rely on rule 18f-4 and will be subject to the VaR-based limit on
fund leverage risk. Specifically, if a fund is subject to the relative
VaR test, and the VaR of its portfolio exceeds 200% or 250% (depending
on whether the fund is a closed-end fund for which the higher threshold
is applicable) of the VaR of its designated reference portfolio for
five business days, the fund will be required to file a non-public
report on Form N-RN.\931\ The report must include the following
information: (1) The dates on which the fund's portfolio VaR exceeded
200% or 250% of the VaR of the designated reference portfolio; (2) the
fund portfolio's VaR for each of these days; (3) the VaR of the
designated reference portfolio for each of these days; (4) the
designated index or statement that the fund used its securities
portfolio as its designated reference portfolio; and (5) the index
identifier, if applicable. The fund also will have to file a report on
Form N-RN when it is back in compliance with its applicable VaR
test.\932\ Similarly, if a fund is subject to the absolute VaR test,
and its absolute VaR exceeds 20% or 25% (as applicable) of the fund's
net asset value for five business days, the fund will be required to
file a comparable report on Form N-RN and a report when the fund is
back in compliance.\933\
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\931\ As proposed, we are requiring all funds that are subject
to rule 18f-4's limit on fund leverage risk to file current reports
on Form N-RN regarding VaR test breaches. See also supra footnote
688.
\932\ See supra footnote 682.
\933\ See supra footnote 685.
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We anticipate that the enhanced current reporting requirements
could produce significant benefits. For example, when a fund is out of
compliance with the VaR-based limit on fund leverage risk, this may
indicate that a fund is experiencing heightened risks as a result of a
fund's use of derivatives transactions. Such breaches also could
indicate market events that are drivers of potential derivatives risks
across the fund industry and therefore complement other sources of
information related to such market events for the Commission. As a
result, we believe that the final rule's current reporting requirement
will increase the effectiveness of the Commission's oversight of the
fund industry by providing the Commission with current information
regarding potential increased risks and stress events, which in turn
will benefit investors.\934\
---------------------------------------------------------------------------
\934\ See supra section II.G.2 for a discussion of the comments
we received on the proposed current reporting requirements.
---------------------------------------------------------------------------
As discussed below in section IV.E, our estimated average cost
burdens associated with the amendments to Form N-RN take into account
that only certain funds--those that are out of compliance with the VaR-
based limit on fund leverage risk that Form N-RN describes--will be
required to file reports on Form N-RN, as amended. We estimate that the
total industry cost for this reporting requirement in the first year
will be $77,652.\935\
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\935\ The burdens associated with this estimate are all
paperwork-related burdens, and thus they are also estimated in the
Paperwork Reduction Act Analysis section of this release. See infra
sections IV.E and V.D.2.b. This estimate is based on the assumption
that 27 funds will have to file reports on Form N-RN per year and
corresponds to a cost of $2,876 for each filing fund ($1,438 per
filing, and a fund will have to file two reports per breach
incident: One to report the breach, and one when the fund is back in
compliance with the VaR test ($1,438 x 2 = $2,876)).
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We do not believe there will be any potential indirect costs
associated with filing Form N-RN, such as spillover effects or the
potential for investor flight due to a VaR test breach (to the extent
that investors would leave a fund if they believed a fund's VaR test
breaches indicate that a fund has a risk profile that is inconsistent
with their investment goals and risk tolerance),
[[Page 83248]]
because Form N-RN filings will not be publicly disclosed.\936\ Because
the Form N-RN filing requirements will be triggered by events that are
part of a fund's requirement to determine compliance with the
applicable VaR test at least daily, any monitoring costs associated
with Form N-RN are included in our estimates of the compliance costs
for rule 18f-4 above.
---------------------------------------------------------------------------
\936\ See also supra footnote 697 and accompanying text
(discussing that a fund may not engage in ``fire sales'' to avoid
filing a report on Form N-RN.)
---------------------------------------------------------------------------
10. When-Issued and Forward-Settling Transactions
The final rule includes a provision that will permit funds, as well
as money market funds, to invest in securities on a when-issued or
forward-settling basis, or with a non-standard settlement cycle,
subject to conditions.\937\ This provision reflects our view that the
potential for leveraging is limited in these transactions when they
meet the conditions in this provision. We do not believe that this
provision will result in a significant change in the extent to which
funds and money market funds engage in these transactions. For example,
money market funds will continue to be able to invest in when-issued
U.S. Treasury securities under this provision notwithstanding that
these investments trade on a forward basis involving a temporary delay
between the transaction's trade date and settlement date. We therefore
do not expect these amendments to result in significant costs to funds,
as well as money market funds.\938\
---------------------------------------------------------------------------
\937\ See supra sections I.C. and II.A.
\938\ Money market funds may be required to make certain
disclosure changes to their prospectuses. The burdens associated
with this estimate are all paperwork-related burdens, and thus they
are also estimated in the Paperwork Reduction Act Analysis section
of this release. See infra sections IV.B.5 and IV.B.7. We estimate
that the total industry cost for disclosure changes for money market
funds in the first year would equal $285,600. The estimate is based
on the following calculations: First, we calculate the one-time cost
for disclosure changes for money market funds, which is 3 hours x
$312 (compliance manager) + 3 hours x $368 (compliance attorney) =
$936 + $1,104 = $2,040 per year; The total industry cost for
disclosure changes for money market funds, in the first year, is
(420 registered money market funds) x $2,040 = $856,800.
---------------------------------------------------------------------------
D. Effects on Efficiency, Competition, and Capital Formation
This section evaluates the impact of the final rules on efficiency,
competition, and capital formation. We are unable to quantify these
effects, however, because we lack the information necessary to provide
a reasonable estimate. For example, we are unable to predict how the
final rules will change investors' propensity to invest in funds and
ultimately affect capital formation. Therefore, much of the discussion
below is qualitative in nature, although where possible we attempt to
describe the direction of the economic effects.
1. Efficiency
Rule 18f-4 in conjunction with the rescission of Release 10666 may
make derivatives use more efficient for certain funds, including for
those funds that will qualify as limited derivatives users.
Specifically, funds' current asset segregation practices may provide a
disincentive to use derivatives for which notional amount segregation
is the practice, even if such derivatives would otherwise provide a
lower-cost method of achieving desired exposures than purchasing the
underlying reference asset directly.\939\ For example, a fund seeking
to sell credit default swaps to take a position in an issuer's credit
risk may currently choose not to do so because of the large notional
amounts that the fund would segregate for that specific derivatives
position. The final rule therefore could increase efficiency by
mitigating current incentives for funds to avoid use of certain
derivatives (even if foregoing the use of those derivatives would
entail cost and operational efficiencies).
---------------------------------------------------------------------------
\939\ See supra section III.B.3 (for a description of funds'
current asset segregation practices).
---------------------------------------------------------------------------
In addition, the final rules may change the degree to which some
funds choose to use derivatives generally or the degree to which funds
use certain derivatives over others.\940\ Changes in the degree to
which certain derivatives are used by funds could affect the liquidity
and price efficiency of these derivatives. Although unaddressed in the
academic literature, we expect an increase in the use of derivatives to
correspond to an increase in derivatives market liquidity as more
derivatives contracts may be easily bought or sold in markets in any
given period, as well as an increase in price efficiency since
information regarding underlying securities (and other factors that
affect derivatives prices) may be better reflected in the prices of
derivative contracts.
---------------------------------------------------------------------------
\940\ Specifically, (1) as discussed in the previous paragraph,
funds may transact in more notional-value based derivatives as a
result of removing the incentive distortion of notional- vs. market-
value asset segregation under funds' current asset segregation
practices; (2) new potential funds may reduce their use of
derivatives transactions to satisfy the VaR-based limit on fund
leverage risk (see supra section III.C.2); (3) existing funds may
change their use of derivatives transactions to respond to risks
identified after adopting and implementing their derivatives risk
management programs (see supra section III.C.1); (4) both existing
and new potential funds may increase their use of derivatives
transactions as a result of the exemptive rule's bright-line limits
on leverage risk (see supra section III.C.2); and (5) the use of
derivatives transactions of leveraged/inverse funds with exposure
exceeding 200% may decrease, to the extent that the final rule has
the effect of limiting the growth (or leading to a decline) of
assets managed by these funds over time as a result of limiting
leveraged/funds with exposures above this limit to those currently
in operation (see supra section III.C.5). Overall, the effect of the
final rules on funds use of derivatives transactions is ambiguous
and depends on the type of derivatives transaction.
---------------------------------------------------------------------------
Changes in the degree to which certain derivatives are used could
also affect the pricing efficiency and liquidity of securities
underlying these derivatives and those of related securities. For
example, one paper provides evidence that the introduction of credit
default swap contracts decreases the liquidity and price efficiency of
the equity security of the issuer referenced in the swap.\941\
Conversely, the paper also observes that the introduction of exchange-
traded stock option contracts improves the liquidity and price
efficiency of the underlying stocks.
---------------------------------------------------------------------------
\941\ This paper analyzed NYSE-listed firms and observed that,
all else equal, equity markets become less liquid and equity prices
become less efficient when single-name credit default swap contracts
are introduced, while the opposite results hold when equity options
are listed on exchanges. Ekkehart Boehmer, Sudheer Chava, & Heather
E. Tookes, Related Securities and Equity Market Quality: The Case of
CDS, 50 J. Fin. & Quantitative Analysis 509 (2015), available at
https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/related-securities-and-equity-market-quality-the-case-of-cds/08DE66A250F9950FA486AE818D5E0341. The latter
result, that traded equity options are associated with more liquid
and efficient equity prices, is consistent with several other
academic papers. See, e.g., Charles Cao, Zhiwu Chen, & John M.
Griffin, Informational Content of Option Volume Prior to Takeovers,
78 J. Bus. 1073 (2005), as well as Jun Pan & Allen M. Poteshman, The
Information in Option Volume for Future Stock Prices, 19 Rev. Fin.
Stud. 871 (2006). The effects described in the literature are based
on studies of the introduction of derivative securities and may
therefore apply differently to changes in the trading volume of
derivatives securities that may occur as a result of the final rule.
---------------------------------------------------------------------------
The final rule's VaR-based limit on fund leverage risk will also
establish a bright-line limit on the amount of leverage risk that a
fund can take on using derivatives.\942\ As we stated in the Proposing
Release, to the extent that funds are more comfortable with managing
their derivatives exposures to a clear outside limit, this could
improve the efficiency of funds' portfolio risk management
practices.\943\ One commenter disagreed with this assessment, stating
that a bright-line limit would not improve the efficiency of funds'
portfolio risk management
[[Page 83249]]
practices.\944\ However, the commenter did not provide any data or
evidence that contradicts the possibility that funds may find it more
efficient to manage to clearly defined limits than the current
approach. We therefore continue to believe that some funds may be able
to manage portfolio risk more efficiently in the presence of a clear
outside limit, as compared to the baseline, which provides less clear
and uniform limitations on funds' derivatives use owing to its
development on an instrument-by-instrument basis through a combination
of Commission guidance in Release 10666, staff no-action letters, and
other staff guidance.
---------------------------------------------------------------------------
\942\ See supra section III.C.2.
\943\ See Proposing Release, supra footnote 1, at section
III.D.1.
\944\ See ProShares Comment Letter.
---------------------------------------------------------------------------
In addition, the recordkeeping elements of rule 18f-4 will
facilitate efficient evaluation of compliance with the rule while also
providing the Commission with information that may be useful in
assessing market risks associated with derivatives products. Moreover,
the amendments to fund's current reporting requirements could
facilitate the Commission's oversight of funds subject to rule 18f-4
with fewer resources.\945\
---------------------------------------------------------------------------
\945\ See supra section II.G.2.
---------------------------------------------------------------------------
The amendments to Forms N-PORT and N-CEN will allow investors, to
the extent that they use the information, to better differentiate
between funds based on their derivatives usage.\946\ As a result,
investors will be able to more efficiently evaluate the effects of a
fund's use of derivatives as part of its investment strategies,
allowing them to make better-informed investment decisions.
---------------------------------------------------------------------------
\946\ See supra section III.C.9.a.
---------------------------------------------------------------------------
In addition, the final rules may affect market quality for some of
the investments held by leveraged/inverse ETFs, to the extent that the
rule changes the amount and composition of investments by leveraged/
inverse ETFs as a whole. Specifically, the academic literature to date
provides some evidence, albeit inconclusive, that leveraged/inverse
ETFs' rebalancing activity may have an impact on the price and
volatility of the constituent assets that make up the ETFs. For
example, one paper empirically tests whether the rebalancing activity
of leveraged/inverse ETFs impacts the price and price volatility of
underlying stocks.\947\ The authors find a positive association,
suggesting that rebalancing demand may affect the price and price
volatility of component stocks, and may reduce the degree to which
prices reflect fundamental value of the component stocks. As leveraged/
inverse ETFs commonly use derivatives to rebalance their portfolios,
similar effects could also extend to underlying derivatives, although
we are not aware of any academic literature that has examined the
effects of leveraged/inverse ETFs' rebalancing activity on derivatives
markets. Conversely, another paper argues that the existing literature
that studies the effect of leveraged/inverse ETFs' rebalancing activity
on the constituent asset prices does not control for the effect of the
creation and redemption transactions (i.e., fund flows) by authorized
participants.\948\ The paper presents evidence that positively
leveraged/inverse ETFs tend to have capital flows in the opposite
direction of the underlying index, and inverse leveraged/inverse ETFs
tend to have capital flows in the same direction as the underlying
index, suggesting that investor behavior may attenuate the effect of
leveraged/inverse ETFs' rebalancing activity on the prices of
underlying securities and derivatives.\949\ We are unable to determine,
however, which holdings of leveraged/inverse ETFs are likely to be
positively affected and which may be negatively affected, as we lack
the information necessary to predict the effect that the amendments to
rule 6c-11 and the prohibition on launching new funds with exposures
above 200% that cannot satisfy rule 18f-4's relative VaR test will have
on the size and composition of leveraged/inverse ETFs' portfolios.
---------------------------------------------------------------------------
\947\ See Qing Bai, Shaun A. Bond & Brian Hatch, The Impact of
Leveraged and Inverse ETFs on Underlying Real Estate Returns, 43
Real Estate Econ. 37 (2015).
\948\ See Ivan T. Ivanov & Stephen Lenkey, Are Concerns About
Leveraged ETFs Overblown?, (FEDS, Working Paper No. 2014-106, 2014).
\949\ The literature we are aware of focuses on leveraged/
inverse ETFs and does not study similar effects of leveraged/inverse
mutual funds, although both types of funds generally engage in
similar rebalancing activity. As a result, similar effects may be
attributable to leveraged/inverse mutual funds.
---------------------------------------------------------------------------
2. Competition
Certain aspects of the final rules may have an impact on
competition.\950\ Certain of these potential competitive effects result
from the final rule imposing differential costs on different funds.
Specifically: (1) Large fund complexes may find it less costly to
comply per fund with the new requirements of rule 18f-4 as a whole;
\951\ (2) funds that already have robust derivatives risk management
practices in place and funds whose advisers already employ someone with
the relevant expertise to serve as the fund's derivatives risk manager
may incur lower costs associated with the rule's derivatives risk
management program requirements; \952\ (3) funds that qualify as
limited derivatives users will generally incur lower compliance costs
associated with the rule than funds that will not qualify for this
exception; \953\ (4) unlike leveraged/inverse funds with exposures not
exceeding 200%, leveraged/inverse funds with exposures in excess of
this limit will not be subject to the rule's VaR-based limit on fund
leverage risk and will therefore not incur the increased compliance
costs associated with this requirement; \954\ (5) funds that will
comply with the relative VaR test would generally incur higher
compliance costs than those that will comply with the absolute VaR
test; \955\ and (6) BDCs are not subject to the additional reporting
requirements on Forms N-CEN or N-PORT and will therefore not incur the
increased compliance costs that will be imposed on filers of these
forms.\956\ To the extent that investors believe that the funds that
will incur lower compliance burdens and the funds that will incur
higher compliance burdens under the rule are substitutes, the rule may
result in a competitive advantage for funds with the lower compliance
burden to the extent that a lower burden makes such funds less costly
to operate.
---------------------------------------------------------------------------
\950\ See supra sections III.B.1 and III.B.5 for an overview of
the baseline of the fund industry.
\951\ See supra sections III.C.1 and III.C.2.
\952\ See supra section III.C.1.
\953\ See supra section III.C.3.
\954\ See supra section II.F.5.
\955\ See supra section III.C.2.
\956\ See supra section III.C.9.a.
---------------------------------------------------------------------------
The final rule may also put funds that are subject to the outer
limit on fund leverage risk at a competitive disadvantage compared to
alternative products that can provide leveraged market exposure but
will not be subject to the VaR-based limit on fund leverage risk of
rule 18f-4, such as existing leveraged/inverse funds with exposures
exceeding 200% that satisfy the conditions to the exception from the
VaR-based limit on fund leverage risk for such funds, alternative
investment vehicles (including the listed commodity pools that would
have been subject to the proposed sales practices rules), exchange-
traded notes, and structured products.\957\
---------------------------------------------------------------------------
\957\ See also supra section III.C.2.
---------------------------------------------------------------------------
The Commission has not provided exemptive relief to new prospective
sponsors of leveraged/inverse ETFs since 2009.\958\ The amendments to
rule 6c-11 will allow other leveraged/inverse ETFs with exposures at or
below 200% to enter the leveraged/inverse ETF market, subject to the
conditions in rules 6c-11 and 18f-4, and therefore
[[Page 83250]]
help promote a more level playing field. This will likely lead to more
competition among leveraged/inverse ETFs (primarily among those with
exposures at or below 200%) and between leveraged/inverse ETFs and
other products that investors may perceive as substitutes, such as
leveraged/inverse mutual funds. This increase in competition could be
significant, as the leveraged/inverse ETF market is very concentrated;
currently, only two fund sponsors operate leveraged/inverse ETFs. Fees
for leveraged/inverse ETFs and substitute products, such as leveraged/
inverse mutual funds, could fall as a result of any such increase in
competition.
---------------------------------------------------------------------------
\958\ See supra text following footnote 821.
---------------------------------------------------------------------------
Conversely, the final rule's prohibition on new leveraged/inverse
funds with market exposure above 200% of the return, or inverse return,
of the relevant index may lead to reduced competition among those
funds, to the extent that the provision reduces the number of such
funds over time.\959\ As a result, fees for leveraged/inverse ETFs with
exposures above this limit may rise.\960\
---------------------------------------------------------------------------
\959\ In the period following the onset of the COVID-19 health
crisis, certain leveraged/inverse ETFs changed their investment
objectives and strategies. See supra footnote 24. As a result, the
number of leveraged/inverse ETFs with exposures exceeding 200% was
reduced, which is reflected in our baseline statistics in section
III.B.5.
\960\ Leveraged/inverse funds with exposures above 200% are
currently only offered in the form of ETFs and by two fund sponsors.
We do not expect that the final rule will reduce the number of
sponsors that choose to offer leveraged/inverse ETFs with exposures
above this limit; nor do we believe that the final rule represents a
change from the baseline in terms of the inability of new sponsors
to enter that market, as the Commission has not provided exemptive
relief to new prospective sponsors of leveraged/inverse ETFs since
2009. See supra text following footnote 821.
---------------------------------------------------------------------------
3. Capital Formation
Certain aspects of the final rules may have an impact on capital
formation.\961\ Certain of these effects may arise from a change in
some investors' propensity to invest in funds, depending on their
preferences for taking risk. For example, some investors may be more
inclined to invest in funds as a result of increased investor
protection arising from any decrease in leverage-related risks; or they
may reduce their investments in certain funds that may increase their
use of derivatives in light of the bright-line VaR-based limit on fund
leverage risk.\962\ Additionally, the rule may lead investors to
increase investments in leveraged/inverse funds with exposures up to
200% as a result of any increase in competition for these funds; and
the rule may lead investors to reduce investments in leveraged/inverse
funds that exceed this exposure as a result of any decrease in
competition or reduced investor choice for those funds.\963\ While we
are unable to determine whether the final rules will lead to an overall
increase or decrease in fund assets, to the extent that overall assets
of funds change, this may have an effect on capital formation.
---------------------------------------------------------------------------
\961\ See supra sections III.B.1 and III.B.5 for an overview of
the baseline of the fund industry.
\962\ See supra section III.C.2.
\963\ See supra sections III.C.5 and III.D.2. Any net change of
assets held by leveraged/inverse funds is likely to have a small
effect on capital formation as only positively leveraged funds
typically invest some portion of their assets into securities
whereas inversely leveraged funds typically achieve their exposures
using only derivatives instruments.
---------------------------------------------------------------------------
Rule 18f-4 may also decrease the use of reverse repurchase
agreements, similar financing transactions, or borrowings by some
funds, or reduce some funds' ability to invest the borrowings obtained
through reverse repurchase agreements, although the modifications from
the proposal to provide funds additional flexibility to treat these
investments as derivatives transaction may make any decrease less
likely.\964\ To the extent that this restricts a fund's ability to
obtain financing to invest in debt or equity securities, capital
formation may be reduced.
---------------------------------------------------------------------------
\964\ See supra section III.C.4.
---------------------------------------------------------------------------
E. Reasonable Alternatives
1. Alternative Implementations of the VaR Tests
a. Different Confidence Level or Time Horizon
Rule 18f-4 will require that a fund's VaR model use a 99%
confidence level and a time horizon of 20 trading days.\965\ We could
alternatively require a different confidence level and/or a different
time horizon for the VaR test. As discussed above in section II.D.4,
market participants calculating VaR most commonly use 95% or 99%
confidence levels and often use time horizons of 10 or 20 days. The VaR
parameters in the final rule therefore represent a confidence level and
time horizon at the high end of what is commonly used.
---------------------------------------------------------------------------
\965\ See supra section II.D.4.
---------------------------------------------------------------------------
Compared to requiring a lower confidence level and a shorter time
horizon, the rule's parameters result in a VaR test that is designed to
measure, and therefore limit the severity of, less frequent but larger
losses. However, estimates of VaR at the larger confidence level and
longer time horizon required by the final rule are based on fewer
observations, which reduces the accuracy of the VaR estimate compared
to using a lower confidence level and a shorter time horizon. As
discussed above, we believe certain time- and confidence level scaling
techniques discussed by commenters are appropriate for purposes of the
final rule, which can help reduce the estimation error associated with
VaR calculations and produce more-stable results.\966\
---------------------------------------------------------------------------
\966\ See supra section II.D.5 (for a more detailed discussion
of the effects of time- and confidence level scaling and the
comments we received on the use of these techniques).
---------------------------------------------------------------------------
b. Absolute VaR Test Only
To establish an outer limit for a fund's leverage risk, the final
rule will generally require a fund engaging in derivatives transactions
to comply with a relative VaR test; the fund could instead comply with
an absolute VaR test if the fund's derivatives risk manager reasonably
determines that a designated reference portfolio would not provide an
appropriate reference portfolio for purposes of the relative VaR test.
As an alternative, we considered requiring all funds that will be
subject to the VaR-based limit on fund leverage risk to comply with an
absolute VaR test.
Use of an absolute VaR test would be less costly for some funds
that will be required to comply with the relative VaR test under the
final rule, including because the relative VaR test may require some
funds to pay licensing costs associated with the use of a designated
index.\967\ In addition, use of an absolute VaR test would reduce the
compliance challenge for fund risk managers, who would not have to
consider if a designated reference portfolio would provide an
appropriate reference portfolio for purposes of the relative VaR test.
---------------------------------------------------------------------------
\967\ See supra section III.C.2. A fund that uses its securities
portfolio as its designated reference portfolio would not incur
these costs.
---------------------------------------------------------------------------
On the other hand, the absolute VaR test is a static measure of
fund risk in the sense that the implied limit on a fund's VaR will not
change with the VaR of its designated reference portfolio. The absolute
VaR test is therefore less suited for measuring leverage risk and
limiting the degree to which a fund can use derivatives to leverage its
portfolio, as measuring leverage inherently requires comparing a fund's
risk exposure to that of an unleveraged point of reference.\968\ An
additional implication of this aspect of an absolute VaR test is that a
fund may fall out of compliance with an absolute VaR test just because
the market it invests in becomes more volatile, even
[[Page 83251]]
though the degree of leverage in the fund's portfolio may not have
changed.
---------------------------------------------------------------------------
\968\ Id.
---------------------------------------------------------------------------
c. Choice of Absolute or Relative VaR Tests
As another alternative, we considered allowing derivatives risk
managers to choose between an absolute and a relative VaR limit,
depending on their preferences and without regard to whether a
designated reference portfolio would provide an appropriate reference
portfolio for purposes of the relative VaR test.\969\ Such an
alternative would offer funds more flexibility than the final rule and
could reduce compliance costs for funds, to the extent that derivatives
risk managers would choose the VaR test that is cheaper to implement
for their particular fund. However, this alternative may result in less
uniformity in the outer limit on funds' leverage risk across the
industry, as individual derivatives risk managers would have the
ability to choose between VaR-based tests that could provide for
different limits on fund leverage risk. Funds that invest in assets
with a low VaR, for example, could obtain significantly more leverage
under an absolute VaR test because the VaR of the fund's designated
reference portfolio would be low. In addition, the relative VaR test
resembles the way that section 18 limits a fund's leverage risk.\970\
---------------------------------------------------------------------------
\969\ Several commenters suggested this alternative. See supra
section II.D.2.a.
\970\ See id.
---------------------------------------------------------------------------
We therefore continue to believe that allowing any fund to rely on
the absolute VaR test may be inconsistent with investors' expectations
where a designated reference portfolio would provide an appropriate
reference portfolio for purposes of the relative VaR test.\971\ As a
result, investors in these funds would be less protected from leverage-
related risks compared to the final rule.
---------------------------------------------------------------------------
\971\ See id.
---------------------------------------------------------------------------
d. Third-Party Validation of a Fund's VaR Model
Rule 18f-4 does not require third-party validation of a fund's
chosen VaR model. As an alternative, we considered requiring that a
fund obtain third-party validation of its VaR model, either at
inception or in connection with any material changes to the model, to
independently confirm that the model is structurally sound and
adequately captures all material risks.\972\ While such a requirement
could help ensure funds' compliance with the rule's VaR-based limit on
fund leverage risk, this incremental benefit may not justify the
potentially significant additional costs to funds associated with
third-party validation of the fund's VaR model.\973\
---------------------------------------------------------------------------
\972\ We did not receive any comments on the discussion of this
alternative in the Proposing Release. See Proposing Release, supra
footnote 1, at section III.E.1.e.
\973\ We note that the UCITS regime requires third-party
validation of funds' VaR models; as a result, these additional costs
could be mitigated for fund that are part of a complex that also
includes UCITS funds. See Proposing Release, supra footnote 1, at n.
243.
---------------------------------------------------------------------------
e. Expected Shortfall or Stressed VaR
The final rule establishes an outer limit for a fund's leverage
risk using VaR. Alternatively, we could require funds to comply with a
limit based on stressed VaR or expected shortfall. Compared to the
final rule's VaR test, both methodologies focus on more extreme losses,
but also are associated with quantitative challenges inherent in
estimating tail risk.\974\ Stressed VaR, for example, can pose
quantitative challenges by requiring funds to identify a stress period
with a full set of risk factors for which historical data is available.
Expected shortfall, for example, generally is more sensitive to extreme
outlier losses than VaR calculations because expected shortfall is
based on an average of a small number of observations that are in the
tail. This heightened sensitivity could be disruptive to a fund's
portfolio management in the context of the final rule because it could
result in large changes in a fund's expected shortfall as outlier
losses enter and exit the observations that are in the tail or that are
used to model the tail's distribution.
---------------------------------------------------------------------------
\974\ See supra section II.D.1.
---------------------------------------------------------------------------
A limit on fund leverage risk based on stressed VaR or expected
shortfall also would likely be less effective at limiting fund leverage
risk during normal conditions and protecting investors from losses
resulting from less extreme scenarios. Conversely, the final rule's
outside limit on fund leverage risk using VaR is complemented by
elements in the final rule's derivatives risk management program, such
as the stress testing requirement, designed to address VaR's
limitations, including that VaR does not capture tail risk. Finally, as
VaR is commonly used, we do not believe that stressed VaR or expected
shortfall would be cheaper to implement for funds than the final rule's
VaR-based tests.
f. Funds Limited to Certain Investors
The final rule does not provide an exemption from the rule's VaR-
based limit for funds that limit their investors to ``qualified
clients,'' as defined in rule 205-3 under the Advisers Act, and/or are
sold exclusively to ``qualified clients,'' ``accredited investors,'' or
``qualified purchasers.'' \975\ Some commenters suggested that the
Commission exempt these funds from the rule's VaR limits.\976\
---------------------------------------------------------------------------
\975\ See supra footnote 415.
\976\ See supra footnote 416.
---------------------------------------------------------------------------
We believe that the benefits and costs to investors and funds of
the final rule's VaR-based limit on fund leverage risk, as discussed in
this economic analysis, generally apply similarly across the various
types of funds that will be subject to the final rule.\977\ However,
the investor protection benefits may be attenuated for some more
sophisticated investors, to the extent that these investors would
prefer to invest in fund strategies that will not be possible under the
final rule's VaR limits and that they fully understand the potential
for losses in such funds.\978\ As discussed above, however, to the
extent that a fund limits its investor base as described by these
commenters is able to qualify for the exclusions from the investment
company definition in section 3(c)(1) or 3(c)(7), the fund can operate
as a private fund under those exclusions and will not be subject to
section 18. Where a fund does operate as registered investment company
or BDC, however, we do not believe that the potentially attenuated
benefits to some more sophisticated investors would justify the final
rule exempting funds that limit their investor base from the final
rule's VaR-based limit on fund leverage risk.
---------------------------------------------------------------------------
\977\ See supra section III.C.2.
\978\ Investors that meet certain asset holdings and income
requirements and thus are presumed sophisticated have the ability to
invest in unregistered funds that pursue complex derivatives
strategies with significant leverage, and these funds are not
subject to the requirements of rule 18f-4.
---------------------------------------------------------------------------
g. No Modification of VaR Limits for Certain Closed-End Funds
The final rule provides higher VaR limits for closed-end funds that
have then-outstanding shares of preferred stock issued to investors,
compared to open-end funds. Specifically, the relative VaR limit for
these closed-end funds is increased from 200% to 250% of the VaR of the
fund's designated reference portfolio and the absolute VaR limit is
increased from 20% to 25% of the fund's assets. As an alternative, we
considered requiring all funds that are subject to the relative or
absolute VaR test to adhere to the same limits of 200% of the VaR of
the fund's designated reference portfolio or 20% of the fund's assets,
respectively.
As suggested by commenters, providing the same relative and
absolute VaR limit for open-end funds and closed-end funds does not
incorporate
[[Page 83252]]
the fact that closed-end funds that have preferred stock outstanding
may have a higher starting VaR than open-end funds. That is, even
before entering into any derivatives transactions, such closed-end
fund's VaR could be higher than an open-end fund's VaR attributable to
the structural leverage obtained through the issuance of preferred
stock, which section 18 of the Investment Company Act permits closed-
end funds but not open-end funds to issue.\979\ As a result, investors
may expect closed-end funds to have a higher VaR level. In addition,
some closed-end funds could potentially have no or limited flexibility
to enter into derivatives transactions if we required them comply with
the same VaR limits as open-end funds, which could limit investor
choice and impose costs on such funds.
---------------------------------------------------------------------------
\979\ See supra sections II.D.2.c.ii and II.D.3.
---------------------------------------------------------------------------
2. Alternatives to the VaR Tests
a. Stress Testing
As an alternative to the final rule's VaR-based limit on fund
leverage risk, we considered establishing an outside limit on fund
leverage risk using a stress testing approach. We understand that many
funds that use derivatives transactions already conduct stress testing
for purposes of risk management, and the final rule likewise provides
that funds required to establish a derivatives risk management program
must conduct stress testing.\980\ However, we do not believe that a
stress testing approach would impose significantly lower costs on funds
compared to a VaR-based approach, with the exception of those funds
that already conduct stress testing but not VaR testing.\981\
---------------------------------------------------------------------------
\980\ See also Proposing Release, supra footnote 1, at section
II.D.6.a.
\981\ See also 2019 ICI Comment Letter (stating that,
``depending on the type of fund managed and whether the fund
currently employs the test for risk management purposes, some
respondents viewed a stress loss test as being more burdensome to
implement, while others viewed a VaR test as being more burdensome
to implement.'').
---------------------------------------------------------------------------
It would be challenging for the Commission to specify a set of
asset class shocks, their corresponding shock levels, and, in the case
of multi-factor stress testing, assumptions about the correlations of
the shocks, in a manner that applies to all funds and does not become
stale over time. While we could also prescribe a principles-based
stress testing requirement, we believe that the flexibility such an
approach would give to individual funds over how to implement the test
would render it less effective than the final rule's VaR test at
establishing an outer limit on fund leverage risk.
Finally, stress testing generally focuses on a narrower and more
remote range of extreme loss events compared to VaR analysis. As a
result, a limit on fund leverage risk based on stress testing would
likely be less effective at limiting fund leverage risk during normal
conditions and protecting investors from losses resulting from less
extreme scenarios.
b. Asset Segregation
As another alternative, we considered an asset segregation approach
in lieu of the final rule's VaR-based limit on fund leverage risk. For
example, we considered an approach similar to the Commission's position
in Release 10666, under which a fund engaging in derivatives
transactions would segregate cash and cash equivalents equal in value
to the full amount of the conditional and unconditional obligations
incurred by the fund (also referred to as ``notional amount
segregation'').\982\ Such an approach could also permit a fund to
segregate a broader range of assets, subject to haircuts.\983\
Alternatively, we could require funds to segregate liquid assets in an
amount equal to the fund's daily mark-to-market liability plus a
``cushion amount'' designed to address potential future losses.
---------------------------------------------------------------------------
\982\ See also Direxion Comment Letter (suggesting that the
Commission ``codify existing asset segregation practices'')
\983\ The 2016 DERA Memo, for example, analyzed different risk-
based ``haircuts'' that could apply to a broader range of assets.
See, e.g., 2016 DERA Memo, supra footnote 5.
---------------------------------------------------------------------------
We believe that asset segregation approaches have several drawbacks
as a means for limiting fund leverage risk, compared to the final
rule's VaR tests.\984\ For example, notional amount segregation is not
risk-sensitive and could restrict derivatives transactions that would
reduce portfolio risk. Similarly, segregation of liquid assets in an
amount equal to the fund's daily mark-to-market liability plus a
``cushion amount'' would be difficult to implement in a manner that is
applied uniformly across all funds and types of derivatives. In
addition, asset segregation approaches raise certain compliance
complexities that may not make them significantly less costly to
implement for funds than the VaR tests.\985\
---------------------------------------------------------------------------
\984\ As discussed above, as a result of current 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. See supra section I.B.3. Funds' current asset
segregation practices also may not assure the availability of
adequate assets to meet funds' derivatives obligations. Id. Several
commenters stated that an asset segregation regime may not be an
effective means of addressing undue speculation concerns. See supra
footnote 308 and accompanying text.
\985\ See Proposing Release, supra footnote 1, at section
II.D.6.b.
---------------------------------------------------------------------------
In conjunction with the final rule's VaR-based limit, we also
considered requiring a fund that relies on the final rule to maintain
an amount of ``qualifying coverage assets'' designed to enable a fund
to meet its derivatives-related obligations. However, we believe that
the final rule's requirements, including the requirements that funds
establish derivatives risk management programs and comply with the
rule's VaR-based limit on fund leverage risk, will address the risk
that a fund may be required to realize trading losses by selling its
investments to generate cash to pay derivatives counterparties.\986\
---------------------------------------------------------------------------
\986\ See supra footnote 305 and accompanying text.
---------------------------------------------------------------------------
Some commenters suggested that we adopt narrower asset segregation
approaches with regard to only certain kinds of transactions. For
example, some commenters suggested that we adopt an asset segregation
approach for firm and standby commitment agreements that do not satisfy
the conditions in the delayed-settlement securities provision.\987\
However, these transactions involve many of the same kinds of risks as
other derivatives instruments that are considered derivatives
transactions under the rule and will therefore be included in the final
rule's definition of ``derivatives transactions''. Some commenters also
suggested that we adopt an asset segregation approach for reverse
repurchase agreements.\988\ These transactions can be used to introduce
leverage into a fund's portfolio just like other forms of borrowings,
or derivatives.\989\ Accordingly, the final rule permits a fund either
to limit its reverse repurchase and other similar financing transaction
activity to the applicable asset coverage limit of the Act for senior
securities representing indebtedness, or, instead, to treat them as
derivative transactions. Compared to these alternatives, we believe
that the final rule will protect investors more effectively, because it
provides a consistent set of requirements for funds engaging in
economically similar transactions.
---------------------------------------------------------------------------
\987\ See supra footnote 112 and accompanying text for a
discussion of commenter's suggestions related to this alternative.
\988\ See supra footnotes 722-725 and accompanying text.
\989\ See supra section III.C.4.
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[[Page 83253]]
c. Exposure-Based Test
We alternatively considered an exposure-based approach for limiting
fund leverage risk in lieu of the final rule's VaR test, as one
commenter suggested.\990\ An exposure-based test could limit a fund's
derivatives exposure, as defined in the rule, to a specified percentage
of the fund's net assets. For example, we considered requiring that a
fund limit its derivatives exposure to 50% of net assets, to match the
amount an open-end could borrow from a bank, or 100% of net assets to
match a level of gross market exposure that generally would satisfy the
relative VaR test. A similar approach would be to provide that the sum
of a fund's derivatives exposure and the value of its other investments
cannot exceed 150% or 200% of its net asset value. This latter
approach, and particularly if cash and cash equivalents were not
included in the calculation, would allow a fund to achieve the level of
market exposure permitted for an open-end fund under section 18 using
any combination of derivatives and other investments, or likewise to
achieve a level of gross market exposure that generally would satisfy
the relative VaR test.
---------------------------------------------------------------------------
\990\ See supra footnotes 303-304 and accompanying text for a
discussion of comments we received on using an exposure-based
approach to limiting fund leverage risk.
---------------------------------------------------------------------------
While an exposure-based test may be simpler and therefore less
costly to implement for the typical fund than the VaR tests, an
exposure-based test has certain limitations compared to VaR tests. One
limitation is that measuring derivatives exposure based on notional
amounts would not reflect how derivatives are used in a portfolio,
whether to hedge or gain leverage, nor would it differentiate
derivatives with different risk profiles. Various adjustments to the
notional amount are available that may better reflect the risk
associated with the derivatives transactions, although even with these
adjustments the measure would remain relatively blunt. For example, an
exposure-based limit could significantly limit certain strategies that
rely on derivatives more extensively but that do not seek to take on
significant leverage risk.
Some of the limitations of an exposure-based approach could be
addressed if rule 18f-4 were to provide an exposure-based test as an
optional alternative to the VaR tests, rather than as the sole means of
limiting fund leverage risk. Under this second alternative, funds with
less complex portfolios might choose to rely on an exposure-based test
if this would lead to lower compliance costs than the VaR tests. If we
provided that the sum of a fund's derivatives exposure and the value of
its other investments cannot exceed 200% of its net asset value, funds
below this threshold would generally also pass the relative VaR test.
Conversely, funds with more complex portfolios that rely on derivatives
more extensively but that do not seek to take on significant leverage
risk might choose to rely on the VaR test. As the final rule will
already except limited derivatives users from the VaR-based limit on
fund leverage risk, however, we do not believe that also giving funds
the option of relying on an exposure-based limit on fund leverage risk
would be necessary or that it would significantly reduce the compliance
burden associated with the final rule.
3. Stress Testing Frequency
Rule 18f-4 will require funds that enter into derivatives
transactions and are not limited derivatives users to adopt and
implement a derivatives risk management program that includes stress
testing, among other elements. The final rule will permit a fund to
determine the frequency of stress tests, provided that the fund must
conduct stress testing at least weekly.\991\
---------------------------------------------------------------------------
\991\ See supra section II.B.2.c for a discussion of comments we
received on this aspect of the proposal.
---------------------------------------------------------------------------
As an alternative to the weekly requirement, we considered both
shorter and longer minimum stress testing frequencies.\992\ On the one
hand, more frequent stress testing would reflect changes in risk for
fund strategies that involve frequent and significant portfolio
turnover as well as increases in market stress in a timelier manner
compared to less frequent stress testing. On the other hand, given the
forward-looking nature of stress testing, we expect that most funds
would take foreseeable changes in market conditions and portfolio
composition into account when conducting stress testing. More-frequent
stress testing also may impose an increased cost burden on funds,
compared to less frequent stress testing, although we would expect any
additional cost burden to be small, to the extent that funds perform
stress testing in an automated manner. Overall, we believe that the
final rule's requirement for stress testing at least weekly
appropriately balances the anticipated benefits of relatively frequent
stress testing against the burdens of administering stress testing. In
addition, some commenters said that a weekly stress-testing frequency
is consistent with many fund's current practices.\993\
---------------------------------------------------------------------------
\992\ See supra section II.B.2.c for a discussion of the comment
letters that addressed this aspect of the proposal.
\993\ See J.P. Morgan Comment Letter; Better Markets Comment
Letter.
---------------------------------------------------------------------------
Another alternative would be to permit a fund to determine its own
stress testing frequency without the final rule prescribing a minimum
stress testing frequency. This approach would provide maximum
flexibility to funds regarding the frequency of their stress tests, and
would reduce compliance costs for funds that determine that stress
testing less frequently than weekly is warranted in light of their own
particular facts and circumstances. However, allowing funds
individually to determine the frequency with which stress tests are
conducted could result in some funds stress testing their portfolios
too infrequently to provide timely information to the fund's
derivatives risk manager and board. Taking these considerations into
account, we are requiring weekly stress tests, rather than less-
frequent testing, to provide for consistent and reasonably frequent
stress testing by all funds that will be required to establish a
derivatives risk management program.
4. Enhanced Disclosure
As an alternative to the requirements in rule 18f-4, such as the
derivatives risk management program and the VaR-based limit on fund
leverage risk, we could consider addressing the risks associated with
funds' use of derivatives through enhanced disclosures to investors
with respect to a fund's use of derivatives and the resulting
derivatives-related risks.\994\ While an approach focused on enhanced
disclosures could result in greater fund investment flexibility, we
believe that such an approach would be less effective than the final
rule in addressing the purposes and concerns underlying section 18 of
the Investment Company Act. Section 18 itself imposes a specific limit
on the amount of senior securities that a fund may issue, regardless of
the level of risk introduced or the disclosure that a fund provides
regarding those risks. Absent additional requirements to limit leverage
or potential leverage, requiring enhancement to derivatives disclosure
alone would not appear to provide any limit on the amount of leverage
or leverage risk a fund may obtain. Indeed,
[[Page 83254]]
the degree to which funds use derivatives varies widely between funds.
As a result, an approach focused solely on enhanced disclosure
requirements may not provide a sufficient basis for an exemption from
the requirements of section 18 of the Investment Company Act.
---------------------------------------------------------------------------
\994\ See, e.g., Comment Letter of the Fixed Income Market
Structure Advisory Committee on proposed rule 6c-11 under the
Investment Company Act (Oct. 29, 2018) (recommending that the
Commission consider future rulemaking regarding ``leveraged ETP''
investor disclosure requirements).
---------------------------------------------------------------------------
5. Alternative Treatment for Leveraged/Inverse Funds
Under the final rule, leveraged/inverse funds generally will be
subject to the requirements of rule 18f-4 on the same basis as other
funds that are subject to that rule, including the VaR-based leverage
risk limit. The rule will, however, permit currently operating
leveraged/inverse funds that seek to provide leveraged or inverse
market exposure exceeding 200% of the return or inverse return of the
relevant index that cannot satisfy the VaR-based leverage limit to
continue operating at their current leverage levels, provided they meet
certain requirements.\995\ As an alternative, we could omit the
requirement for leveraged/inverse funds to comply with the VaR-based
leverage limit and instead limit these funds to, for example, obtaining
300% of the performance or inverse performance of the relevant index
and adopt the proposed sales practices rules, which would have required
a broker-dealer or investment adviser to exercise due diligence in
approving a retail investor's account to invest in leveraged/inverse
investment vehicles.\996\
---------------------------------------------------------------------------
\995\ This exception is limited to funds currently in operation,
and would therefore not allow a fund sponsor to launch a new
leveraged/inverse fund that exceeds this exposure limit.
\996\ As defined in the proposed sales practices rules,
leveraged/inverse investment vehicles include leveraged/inverse
funds and certain exchange-listed commodity- or currency-based
trusts or funds that use a similar leveraged/inverse strategy. (See
Proposing Release, supra footnote 1, at section II.G.2.) The
provision of rule 18f-4 that provides an exception from the VaR-
based limit on fund leverage risk for certain leveraged/inverse
funds currently in operation with leverage or inverse multiples
exceeding 200% is only available to such a fund if it does not
increase the level of leveraged or inverse market exposure that it
seeks, directly or indirectly, to provide. This provision
effectively limits these funds from operating with a leverage or
inverse multiple exceeding 300%, as the Commission proposed for
leveraged/inverse funds generally. The alternative considered in
this section also includes such a requirement and therefore does not
differ from the final rule in this respect. The Proposing Release
discussed the effects of alternative exposure limits for leveraged/
inverse funds. (See Proposing Release, supra footnote 1, at section
III.E.4.)
---------------------------------------------------------------------------
All existing leveraged/inverse funds will be able to continue
operating under the final rule; this also would be the case under the
alternative. However, the final rule and the alternative have different
implications for the ability of fund sponsors to offer new leveraged/
inverse funds. While fund sponsors will be able to launch new funds
with exposures up to 200% under the final rule, as they would under the
alternative, the final rule will prevent fund sponsors from offering
new funds with market exposure exceeding 200% that cannot satisfy the
final rule's relative VaR test.
As we discussed in the Proposing Release, broker-dealers and
investment advisers would incur direct compliance costs associated with
implementing due diligence and account approval requirements under the
alternative.\997\ Commenters also expressed concerns regarding
potential legal liability for broker-dealers and investment advisers
associated with implementing the requirements under the proposed sales
practices rules.\998\
---------------------------------------------------------------------------
\997\ See Proposing Release, supra footnote 1, at section
III.C.5.
\998\ See supra footnote 582.
---------------------------------------------------------------------------
The alternative also would impose a burden on investors to access
leveraged/inverse investment vehicles, including on those investors
that understand the risks of these products. Some leveraged/inverse
investment vehicles may lose existing or potential investors as a
result of some retail investors not being approved by their broker-
dealer or investment adviser to transact in leveraged/inverse
investment vehicles.\999\ This could lead to fewer leveraged/inverse
investment vehicles being available to investors who would be approved
to transact in these vehicles and decreased competition among these
products.\1000\ However, the final rule may also lead to a reduction in
investor choice and competition for some leveraged/inverse investment
vehicles. Specifically, because the rule limits the exception from the
final rule's VaR-based limit on fund leverage risk to certain
leveraged/inverse funds currently in operation, the number of
leveraged/inverse funds exceeding this limit may fall under the final
rule.\1001\
---------------------------------------------------------------------------
\999\ See, e.g., Americans for Limited Government Comment
Letter; Direxion Comment Letter; ProShares Comment Letter; Schwab
Comment Letter.
\1000\ See also Flannery Comment Letter, supra footnote 901
(stating that the proposed sales practices rules could lead to
reduced demand for leveraged/inverse funds and make offering them
economically unviable); and Proposing Release, supra footnote 1, at
section III.D.2.
\1001\ See supra sections III.C.5 and III.D.2.
---------------------------------------------------------------------------
The alternative may have increased benefits for investor
protection, to the extent that account approval requirements that are
specific to leveraged/inverse investment vehicles, which are in
addition to advisers' and broker-dealers' existing requirements and
practices, are effective at helping ensure that investors in these
products are limited to those who are capable of evaluating their
risks.\1002\ The proposed sales practices rules would not have covered
all products that offer leveraged or inverse exposures to an index,
however, and some of those substitute products may present additional
risks. For example, as one commenter stated, some investors could
choose to invest in ETNs, which would not have been covered by the
proposed sales practices rules and which are subject to issuer default,
potentially hampering the effectiveness of the alternative to improve
investor protection.\1003\
---------------------------------------------------------------------------
\1002\ Neither Regulation Best Interest nor investment advisers'
fiduciary obligations apply to investments in leveraged/inverse
investment vehicles by self-directed retail investors.
\1003\ See Flannery Comment Letter, supra footnote 901.
---------------------------------------------------------------------------
As another alternative, we considered placing additional
disclosure-based requirements on intermediaries offering leveraged/
inverse investment vehicles to retail investors, as suggested by some
commenters.\1004\ For example, some commenters suggested we require
broker-dealers to: (1) Provide their self-directed customers with
short, plain-English disclosures of the potential risks of trading
leveraged/inverse investment vehicles, both at the point of sale and
periodically thereafter; and (2) require such customers to provide an
acknowledgement of receipt of these disclosures.\1005\ Similar to the
proposed sales practices rules, this alternative could have investor
protection benefits, to the extent that these disclosures would be
effective at helping ensure that investors in these products are
limited to those who are capable of evaluating their risks. At the same
time, this alternative would also impose costs on the intermediaries
that would be required to implement the requirement and would impose a
burden on investors to access leveraged/inverse investment vehicles,
including on those investors that understand the risks of these
products.
---------------------------------------------------------------------------
\1004\ See, e.g., Direxion Comment Letter; Schwab Comment
Letter.
\1005\ See, e.g., Schwab Comment Letter; TD Ameritrade Comment
Letter.
---------------------------------------------------------------------------
As another alternative, we considered requiring all leveraged/
inverse funds to comply with the final rule's VaR-based leverage limit.
Compared to the final rule, this alternative would therefore not permit
any currently operating leveraged/inverse funds that seek to provide
leveraged or inverse market exposure exceeding 200% of the return or
inverse return of the relevant index that cannot satisfy the VaR-based
[[Page 83255]]
leverage limit to continue operating at their current leverage levels.
This alternative would protect investors who may not be capable of
evaluating the risks associated with leveraged/inverse funds that
cannot satisfy the rule's VaR based leverage limit. At the same time,
this alternative would restrict investor choice for investors who are
capable of evaluating the risks associated with these funds and would
impose a cost on these funds by requiring them to either stop operating
or change their investment objectives.
In light of these considerations and the staff review of the
effectiveness of the existing regulatory requirements in protecting
investors in leveraged/inverse and other complex investment products,
we are not adopting the proposed sales practices rules or any of the
other alternatives discussed in this section at this time.
IV. Paperwork Reduction Act Analysis
A. Introduction
Rule 18f-4 will result in new ``collection of information''
requirements within the meaning of the Paperwork Reduction Act of 1995
(``PRA'').\1006\ In addition, the amendments to rules 6c-11 and 30b1-10
under the Investment Company Act, as well as to Forms N-PORT, Form N-
LIQUID (which will be re-titled Form N-RN), and N-CEN will affect the
collection of information burden under those rules and forms.\1007\
---------------------------------------------------------------------------
\1006\ 44 U.S.C. 3501-3520.
\1007\ We do not believe that the final conforming amendment to
Form N-2, to reflect a clarification that funds do not have to
disclose in their senior securities table the derivatives
transactions and unfunded commitment agreements entered into in
reliance on rule 18f-4, makes any new substantive recordkeeping or
information collection within the meaning of the PRA. The Commission
stated this view in the Proposing Release and did not receive any
comments regarding any burden and cost estimates to Form N 2.
Accordingly, we do not revise any burden and cost estimates in
connection with this amendment.
Similarly, we do not believe that the final conforming
amendments to rule 22e-4 and Form N-PORT, to remove references to
assets ``segregated to cover'' derivatives transactions in the rule
and form and to amend the Form N-PORT general instructions to
clarify the term ``derivatives transaction'' in light of the
adoption of rule 18f-4, result in any new substantive recordkeeping
or information collection within the meaning of the PRA.
Accordingly, we do not revise any burden and cost estimates in
connection with these amendments.
---------------------------------------------------------------------------
The titles for the existing collections of information are: ``Form
N-PORT'' (OMB Control No. 3235-0731); ``Rule 30b1-10 and Form N-
LIQUID'' (OMB Control No. 3235-0754); ``Form N-CEN'' (OMB Control No.
3235-0730); and ``Rule 6c-11 under the Investment Company Act of 1940,
Exchange-traded funds'' (OMB Control No. 3235-0764). The title for the
new collection of information will be: ``Rule 18f-4 under the
Investment Company Act of 1940, Use of Derivatives by Registered
Investment Companies and Business Development Companies.'' The
Commission is submitting these collections of information to the Office
of Management and Budget (``OMB'') for review in accordance with 44
U.S.C. 3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor,
and a person is not required to respond to, a collection of information
unless it displays a currently-valid control number.
B. Rule 18f-4
Rule 18f-4 permits a fund to enter into derivatives transactions,
notwithstanding the prohibitions and restrictions on the issuance of
senior securities under section 18 of the Investment Company Act.
A fund that relies on rule 18f-4 to enter into derivatives
transactions generally will be required to: Adopt a derivatives risk
management program; have its board of directors approve the fund's
designation of a derivatives risk manager and receive direct reports
from the derivatives risk manager about the derivatives risk management
program; and comply with a VaR-based test designed to limit a fund's
leverage risk consistent with the investor protection purposes
underlying section 18. Rule 18f-4 includes an exception from the
derivatives risk management program requirement and limit on fund
leverage risk if a fund limits its derivatives exposure to 10% of its
net assets (the fund may exclude from this calculation derivatives
transactions that it uses to hedge certain currency and interest rate
risks). A fund relying on this exception will be required to adopt
policies and procedures that are reasonably designed to manage its
derivatives risks.
Rule 18f-4 also includes an exception from the VaR-based limit on
leverage risk for a leveraged/inverse fund that cannot comply with rule
18f-4's limit on fund leverage risk and that, as of October 28, 2020,
is: (1) In operation, (2) has outstanding shares issued in one or more
public offerings to investors, and (3) discloses in its prospectus that
it has a leverage multiple or inverse multiple that exceeds 200% of the
performance or the inverse of the performance of the underlying index.
A fund relying on this exception must disclose in its prospectus that
it is not subject to rule 18f-4's limit on fund leverage risk.\1008\
Rule 18f-4 also requires a fund to meet certain recordkeeping
requirements that are designed to provide the Commission, and the
fund's board of directors and compliance personnel, the ability to
evaluate the fund's compliance with the rule's requirements. Finally,
rule 18f-4 includes provisions that will permit funds to enter into
reverse repurchase agreements (and similar financing transactions) and
``unfunded commitments'' to make certain loans or investments, and to
invest in securities on a when-issued or forward-settling basis, or
with a non-standard settlement cycle, subject to conditions tailored to
these transactions.
---------------------------------------------------------------------------
\1008\ See rule 18f-4(c)(5)(iii); supra section II.F.2.
---------------------------------------------------------------------------
The purpose of rule 18f-4 is to address the investor protection
purposes and concerns underlying section 18 of the Act and to provide
an updated and more comprehensive approach to the regulation of funds'
use of derivatives and the other transactions addressed in the rule.
The respondents to rule 18f-4 will be registered open- and closed-end
management investment companies and BDCs.\1009\ We estimate that 5,203
funds will likely rely on rule 18f-4.\1010\ Compliance with rule 18f-4
will be mandatory for all funds that seek to engage, in reliance on the
rule, in derivatives transactions and certain other transactions that
the rule addresses, which would otherwise be subject to the
restrictions of section 18. To the extent that records required to be
created and maintained by funds under the rule are provided to the
Commission in connection with examinations or
[[Page 83256]]
investigations, such information will be kept confidential subject to
the provisions of applicable law.
---------------------------------------------------------------------------
\1009\ See rule 18f-4(a) (defining ``fund'').
\1010\ We estimate this number as follows: 2,766 funds that will
be subject to the derivatives risk management program requirement +
2,437 funds relying on the limited derivatives user exception and
complying with the related limited derivatives user requirements =
5,203 funds. See supra text accompanying footnote 849 (estimated
number of funds subject to the derivatives risk management program
requirement), and supra paragraph following footnote 892 (estimated
number of funds that will qualify as limited derivatives users).
The Commission's estimates of the relevant wage rates for
internal time costs in the tables below are based on salary
information for the securities industry compiled by the Securities
Industry and Financial Markets Association's Office Salaries in the
Securities Industry 2013. The estimated wage figures are modified by
Commission staff to account for an 1,800-hour work-year and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits, overhead, and adjusted to account for the effects of
inflation. See Securities Industry and Financial Markets
Association, Report on Management & Professional Earnings in the
Securities Industry 2013 (``SIFMA Report''). These wage figures
differ slightly from the same figures the Commission used in its
estimates in the Proposing Release to account for incremental
inflation effects. The Commission's estimates of the relevant wage
rates for external time costs, such as outside legal services, takes
into account staff experience, a variety of sources including
general information websites, and adjustments for inflation.
---------------------------------------------------------------------------
1. Derivatives Risk Management Program
Rule 18f-4 requires certain funds relying on the rule to adopt and
implement a written derivatives risk management program, which includes
policies and procedures reasonably designed to manage the fund's
derivatives risks and a periodic review requirement.\1011\ We estimate
that 2,766 funds will be subject to the program requirement.\1012\
---------------------------------------------------------------------------
\1011\ See rule 18f-4(c)(1); supra section II.B (discussing the
derivatives risk management program requirements).
\1012\ See supra sentence following footnote 882. A fund that is
a limited derivatives user will not be required to comply with the
program requirement. Funds that are limited derivatives users will
be required to adopt policies and procedures that are reasonably
designed to manage their derivatives risks. See rule 18f-4(c)(4);
infra section IV.B.6 (discussing collections of information related
to limited derivatives users).
---------------------------------------------------------------------------
Table 1 below summarizes the initial and ongoing annual burden
estimates associated with the derivatives risk management program
requirement under rule 18f-4 as adopted. While the Commission did not
receive any comments specifically addressing the estimated PRA burdens
in the Proposing Release associated with the derivatives risk
management program, it did receive comments suggesting that the
implementation of the program, including the associated collections of
information as defined in the PRA, may be more burdensome than the
Commission estimated at proposal.\1013\ As such, we have increased the
annual burden estimates associated with the derivatives risk management
program, as shown in Table 1 below.
---------------------------------------------------------------------------
\1013\ See supra section II.B.
---------------------------------------------------------------------------
BILLING CODE 8011-01-P
[[Page 83257]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.000
[[Page 83258]]
2. Board Oversight and Reporting
Rule 18f-4 requires: (1) A fund's board of directors to approve the
designation of the fund's derivatives risk manager, (2) the derivatives
risk manager to provide certain written reports to the board.\1014\ We
estimate that 2,766 funds will be subject to these requirements.\1015\
---------------------------------------------------------------------------
\1014\ See rule 18f-4(c)(3)(i) through (iii); supra section
II.C. Burdens associated with reports to the fund's board of
directors of material risks arising from the fund's derivatives
transactions, as described in rule 18f-4(c)(1)(v), are discussed
above in supra section IV.B.1.
\1015\ See supra footnotes 849, 1010 and accompanying text.
---------------------------------------------------------------------------
Table 2 below summarizes the initial and ongoing annual burden
estimates associated with the board oversight and reporting
requirements under rule 18f-4. While the Commission did not receive any
comments specifically addressing the estimated PRA burdens in the
Proposing Release associated with the board oversight and reporting
requirements, it did receive comments suggesting that requiring the
fund's board of directors to approve the designation of the fund's
derivatives risk manager would place increased burdens on the fund's
board of directors.\1016\ Accordingly, we have adjusted the proposal's
estimated annual burden hours and total time costs to account for the
potential for increased time burdens on the board of directors and to
reflect the Commission's updated views on typical time burdens
associated with similar board reporting requirements in other
Commission regulations.
---------------------------------------------------------------------------
\1016\ See Dechert Comment Letter I; IDC Comment Letter; see
also supra section II.C.1.
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[[Page 83259]]
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[[Page 83260]]
3. VaR Remediation
Rule 18f-4 requires that if a fund is not in compliance within five
business days, following an exceedance of the VaR-based fund leverage
limit, the derivatives risk manager must provide certain written
reports to the fund's board.\1017\ In contrast, the proposed rule would
have required the derivatives risk manager to notify the fund's board
(and would not have specifically required a written report for such
notification) following the fund being out of compliance with the VaR-
based fund leverage limit for three business days.\1018\
---------------------------------------------------------------------------
\1017\ See rule 18f-4(c)(2)(ii)(A) through (C); supra section
II.D.6.b.
\1018\ See supra section II.D.6.b.
---------------------------------------------------------------------------
Table 3 below summarizes the initial and ongoing annual burden
estimates associated with the VaR-related remediation reports required
under rule 18f-4. For purposes of the PRA analysis, we do not estimate
that there will be any initial or ongoing external costs associated
with the VaR-related remediation requirements.
[[Page 83261]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.002
[[Page 83262]]
4. Disclosure Requirement for Certain Leveraged/Inverse Funds
Under the final rule, an over-200% leveraged/inverse fund currently
in operation will not have to comply with the VaR-based leverage risk
limit. Such a fund is required to disclose in its prospectus that it is
not subject to rule 18f-4's limit on fund leverage risk.\1019\ This
requirement represents a change from the proposal, in which we proposed
to require that all leveraged/inverse funds (i.e., not only those with
a leverage or inverse multiple above 200% of the underlying index)
disclose that they are not subject to the rule's VaR-based leverage
risk limit. As such, whereas in the proposal the Commission estimated
that 269 leveraged/inverse funds would be subject to this prospectus
disclosure requirement, we now estimate that 70 over-200% leveraged/
inverse funds will be subject to this requirement.\1020\
Table 4 below summarizes the initial and ongoing annual burden
estimates associated with the rule's disclosure requirement for over-
200% leveraged/inverse funds. We do not estimate that there will be any
initial or ongoing external costs associated with this disclosure
requirement. The Commission did not receive any comments relating to
the estimated PRA burdens set forth in the Proposing Release associated
with the prospectus disclosure requirement for leveraged/inverse
funds.\1021\ As shown in Table 4 below, we are making a modest increase
to the estimated per-fund burden associated with the prospectus
disclosure requirement for over-200% leveraged/inverse funds to reflect
updated views on the burdens related to similar prospectus disclosure
requirements.
---------------------------------------------------------------------------
\1019\ See rule 18f-4(c)(5)(iii); supra section II.F.
\1020\ See supra paragraph accompanying footnote 819 (estimating
70 leveraged/inverse ETFs (and 0 leveraged/inverse mutual funds)
that currently seek to provide leveraged or inverse market exposure
exceeding 200% of the return or inverse return of the relevant
index).
\1021\ See supra footnote 612 and accompanying text (discussing
comment received on proposed prospectus disclosure requirement
generally).
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[[Page 83263]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.003
[[Page 83264]]
5. Disclosure Changes for Money Market Funds
In a change from the proposal, the final rule includes a provision
that will permit money market funds to invest in securities on a when-
issued or forward-settling basis, or with a non-standard settlement
cycle (``delayed-settlement securities provision''). As in the
proposal, money market funds are excluded from the full scope of the
final rule because they do not typically enter into derivatives
transactions, as defined in the rule.\1022\ To the extent a money
market fund currently discloses in its prospectus that it may enter
into transactions covered by the final rule other than transactions
covered by the delayed-settlement securities provision, money market
funds will be subject to the burdens associated with making disclosure
changes to their prospectuses. We estimate that 420 funds could be
subject to such disclosure changes.\1023\
---------------------------------------------------------------------------
\1022\ See rule 18f-4(a) (defining the term ``Fund'' to ``. .
.not include a registered open-end company that is regulated as a
money market fund'').
\1023\ See supra footnote 804 and accompanying text. This likely
overestimates the total number of funds subject to these disclosure
changes, because we believe that money market funds currently do not
typically engage in derivatives transactions.
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Table 5 below summarizes the initial and ongoing annual burden
estimates associated with disclosure changes that money market funds
could make because of rule 18f-4. For purposes of this PRA analysis, we
do not estimate that there will be any initial or ongoing external
costs associated with this disclosure change requirement. The
Commission did not receive any comments relating to the estimated PRA
burdens set forth in the Proposing Release associated with potential
disclosure changes for money market funds. However, we have adjusted
the proposal's estimated annual burden hours and total time costs to
reflect the Commission's updated views on typical time burdens
associated with similar disclosure requirements in other Commission
regulations.
[[Page 83265]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.004
BILLING CODE 8011-01-C
[[Page 83266]]
6. Requirements for Limited Derivatives Users
Rule 18f-4 will require funds relying on the limited derivatives
user provisions to adopt and implement written policies and procedures
reasonably designed to manage the fund's derivatives risks.\1024\ In
addition to the initial burden to document the policies and procedures,
we estimate that limited derivatives users will have an ongoing burden
associated with any review and revisions to their policies and
procedures to ensure that they are ``reasonably designed'' to manage
the fund's derivatives risks. Rule 18f-4 also requires that the adviser
for any limited derivatives user that exceeds the 10% derivatives
exposure threshold and does not reduce its exposure within five
business days, must provide a written report to the fund's board of
directors informing them whether the adviser intends to reduce the
exposure promptly, but within no more than 30 days of the exceedance,
or put in place a derivatives risk management program and comply with
the VaR-based limit on fund leverage risk as soon as reasonably
practicable.\1025\ We estimate that 2,437 funds will be subject to
these limited derivatives users requirements.\1026\
---------------------------------------------------------------------------
\1024\ See rule 18f-4(c)(4); supra section II.E.3 (discussing
the policies and procedures requirement for limited derivatives
users).
\1025\ See rule 18f-4(c)(4)(ii); supra section II.E.4.
\1026\ See supra paragraph following footnote 892.
---------------------------------------------------------------------------
Table 6 below summarizes the initial and ongoing annual burden
estimates associated with the requirements for limited derivatives
users under rule 18f-4. The Commission did not receive comments
relating to the estimated hour and costs burdens associated with the
preparation and maintenance of a limited derivatives user's policies
and procedures. However, we have increased the proposal's estimated
burden hours and internal and external total time costs to account for
the potential that funds may implement additional policies and
procedures related to the changes we have incorporated into the final
rule to address exceedances of the 10% derivatives exposure threshold.
This increase also reflects the Commission's updated views on typical
time burdens and costs associated with the development of fund risk
management policies and procedures.
Some commenters did state that many funds already have policies and
procedures in place to manage certain risks associated with their
derivatives transactions.\1027\ We do not have data to determine how
many funds currently have written policies and procedures in place that
will satisfy the rule's requirement. However, for purposes of our
estimated hour and costs burden, we assume that all limited derivatives
users will incur a cost associated with this requirement. Accordingly,
our estimate may be over-inclusive, to the extent that it counts funds
that already have in place policies and procedures reasonably designed
to manage the fund's derivatives risks. Our estimate also may be under-
inclusive, to the extent that it does not count funds that do not
currently use derivatives, but that might want to implement policies
and procedures reasonably designed to manage derivatives risks in order
to have future flexibility to engage in derivatives transactions under
the final's rule's limited derivatives user provision.
---------------------------------------------------------------------------
\1027\ See Fidelity Comment Letter; IAA Comment Letter; see also
supra footnote 893 and accompanying paragraph (stating that the
Commission believes that ``these policies and procedures could be
readily adapted to meet the final rule's requirements without
significant additional cost'').
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BILLING CODE 8011-01-P
[[Page 83267]]
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[[Page 83268]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.006
BILLING CODE 8011-01-C
[[Page 83269]]
7. Recordkeeping Requirements
Rule 18f-4 will require a fund that enters into derivatives
transactions to maintain certain records. As proposed, if the fund is
not a limited derivatives user, the fund will be required to maintain
records related to the fund's derivatives risk management program and
the VaR-based limit on fund leverage risk, including records related to
board oversight and reporting (including records of the written
reporting that the rule requires to occur between the derivatives risk
manager and the fund's board when the fund is out of compliance with
the applicable VaR test).\1028\ As a modification to the proposal the
final rule includes further obligations for a fund that is out of
compliance with its applicable VaR test to provide written reports to
the board.\1029\ These additional reports will be covered by the final
recordkeeping requirements.
---------------------------------------------------------------------------
\1028\ See rule 18f-4(c)(6)(i)(A) through (C).
\1029\ See supra footnote 772 and accompanying text.
---------------------------------------------------------------------------
If the fund is a limited derivatives user, the fund will be
required to maintain a written record of its policies and procedures
that are reasonably designed to manage derivatives risks.\1030\ As a
conforming change in the final rule, a limited derivatives user will
also be required to maintain records of written reports provided to the
board upon any exceedance by the fund of the 10% derivatives exposure
threshold, in accordance with the rule.\1031\
---------------------------------------------------------------------------
\1030\ See rule 18f-4(c)(6)(i)(D).
\1031\ Id.
---------------------------------------------------------------------------
Further, in light of the final rule providing two separate
treatment options for a fund that enters into a reverse repurchase
agreement or similar financing transaction, we have conformed the
recordkeeping provision to require that a fund that enters into reverse
repurchase agreements or similar financing transactions to maintain a
written record documenting whether it is complying with the asset
coverage requirements of section 18 with respect to these transactions,
or alternatively whether it is treating these transactions as
derivatives transactions for all purposes under rule 18f-4.
Finally, a fund engaging in unfunded commitment agreements will be
required to maintain records documenting the sufficiency of its cash
and cash equivalents to meet its obligations with respect to each
unfunded commitment agreement.\1032\
---------------------------------------------------------------------------
\1032\ See rule 18f-4(e)(2).
---------------------------------------------------------------------------
We estimate that 5,203 funds will be subject to recordkeeping
requirements under the final rule (although not all funds will be
subject to all of the rule's recordkeeping requirements).\1033\ Below
we estimate the average initial and ongoing annual burdens associated
with the recordkeeping requirements. This average takes into account
that some funds such as limited derivatives users may have less
extensive recordkeeping burdens than other funds that use derivatives,
or the other transactions that final rule 18f-4 addresses, more
substantially.
---------------------------------------------------------------------------
\1033\ We estimate that the number of funds that will be subject
to the recordkeeping requirements includes the number of funds that
we estimate will be required to comply with the derivatives risk
management program requirement (2,766 funds, which number
encompasses the 2,696 funds that we estimate will be subject to the
VaR test requirements) and the number of funds that we estimate will
qualify as limited derivatives users (2,437 funds). See supra
footnote 1010 and sections III.C.1-III.C.3. 2,766 funds + 2,437
funds = 5,203 funds.
Based on staff review of filings on Forms N-PORT and N-CEN for
2019, we estimate that 181 funds, or 1% of all funds subject to the
final rule, will enter into reverse repurchase agreements or similar
financing transactions (excluding BDCs, which we do not believe
enter into such transactions to a significant degree) and will be
subject to the recordkeeping requirements in the final rule. We
further estimate that approximately 8.5% of open-end funds, 30% of
registered closed-end funds, and 100% of BDCs, or 1,339 funds (10%
of all funds subject to the rule) will enter into unfunded
commitments and will incur be subject to the recordkeeping
requirements in the final rule. To prevent over-counting, we are not
adding these numbers of funds that engage in reverse repurchase
agreements and unfunded commitment agreements to the sum of 5,203
funds discussed above, because we assume that these funds generally
either would have to comply with the derivatives risk management
program requirement or would qualify as limited derivatives users.
---------------------------------------------------------------------------
Table 7 below summarizes the proposed PRA estimates associated with
the recordkeeping requirements in rule 18f-4. The Commission did not
receive any comments related to the estimated PRA burdens set forth in
the Proposing Release associated with the rule's recordkeeping
requirements. However, we have adjusted the proposal's estimated annual
burden hours and total time costs, on account of the conforming
modifications to the proposed recordkeeping requirements that we are
adopting, as well as to reflect the Commission's updated views on
typical time burdens and personnel associated with similar
recordkeeping requirements in other Commission regulations.
BILLING CODE 8011-01-P
[[Page 83270]]
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[[Page 83271]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.008
[[Page 83272]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.009
8. Rule 18f-4 Total Estimated Burden
As summarized in Table 8 below, we estimate that the total hour
burdens and time costs associated with rule 18f-4, amortized over three
years, will result in an average aggregate annual burden of 501,275
hours and an average aggregate annual monetized time cost of
$202,443,126. We also estimate that, amortized over three years, there
will be external costs of $22,252,947 associated with this collection
of information. Therefore, each fund that relies on the rule will incur
an average annual burden of approximately 96.34 hours, at an average
annual monetized time cost of approximately $38,909, and an external
cost of $4,277 to comply with rule 18f-4.\1034\
---------------------------------------------------------------------------
\1034\ These per-fund burden estimates likely overestimate the
total burden of rule 18f-4 because not all funds (e.g., limited
derivatives users) would incur the various burdens set forth in the
table.
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[[Page 83273]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.010
C. Rule 6c-11
Rule 6c-11 permits ETFs that satisfy certain conditions to operate
without first obtaining an exemptive order from the Commission.\1035\
We are amending rule 6c-11 to permit leveraged/inverse ETFs to rely on
that rule, provided they satisfy the applicable requirements of rule
18f-4. Because we believe this amendment will increase the number of
funds relying on rule 6c-11, we are updating the PRA analysis for rule
6c-11 to account for the aggregate burden increase that will result
from this increase in respondents to that rule. We are not updating the
rule 6c-11 PRA analysis in any other respect.
---------------------------------------------------------------------------
\1035\ See supra footnotes 613-616 and accompanying text.
---------------------------------------------------------------------------
Rule 6c-11 requires an ETF to disclose certain information on its
publicly-available website, to maintain certain records, and to adopt
and implement certain written policies and procedures. The purpose of
these collections of information is to provide useful information to
investors who purchase and sell ETF shares in secondary markets and to
allow the Commission to better monitor reliance on rule 6c-11 and will
assist the Commission with its accounting, auditing and oversight
functions. Information provided to the Commission in connection with
staff
[[Page 83274]]
examinations or investigations will be kept confidential subject to the
provisions of applicable law.
The respondents to rule 6c-11 will be ETFs registered as open-end
management investment companies other than share class ETFs and non-
transparent ETFs. This collection will not be mandatory, but will be
necessary for those ETFs seeking to operate without individual
exemptive orders, including all ETFs whose existing exemptive orders
will be rescinded.
Under the currently approved PRA estimates, 1,735 ETFs would be
subject to these requirements. The current PRA estimates for rule 6c-11
include 74,466.2 total internal burden hours, $24,771,740.10 in
internal time costs, and $1,735,000 in external time costs.
In the Proposing Release, we estimated that the proposed amendments
to rule 6c-11 would result in an additional 164 leveraged/inverse ETFs
relying on that rule, resulting in an increase in the number of
respondents to 1,899 ETFs. This updated number of respondents resulted
in a total of 81,505.08 burden hours, $27,113,276.34 in internal time
costs, and $1,899,000 in external costs.
We did not receive public comment relating to the PRA estimates for
rule 6c-11 in the Proposing Release. We continue to believe that the
current annual burden and cost estimates for rule 6c-11 are
appropriate, but that the amendments to rule 6c-11 will result in an
increase in the number of respondents. Specifically, we estimate that
an additional 172 ETFs (all leveraged/inverse ETFs) will rely on rule
6c-11, resulting in an increase in the number of respondents to 1,907
ETFs. Table 9 below summarizes these revisions to the estimated annual
responses, burden hours, and burden-hour costs based on the amendments
to rule 6c-11.
[[Page 83275]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.011
[[Page 83276]]
BILLING CODE 8011-01-C
D. Form N-PORT
We are amending Form N-PORT to add new items to Part B
(``Information About the Fund''), as well as to make certain amendments
to the form's General Instructions. Form N-PORT, as amended, will
require funds that are limited derivatives users under final rule 18f-4
to provide information about their derivatives exposure, and
exceedances of their derivatives exposure over 10% of their net
assets.\1036\ It also will require funds that are subject to the limit
on fund leverage risk in rule 18f-4 to provide certain information
about the fund's VaR during the reporting period.\1037\ The final
amendments to Form N-PORT incorporate several modifications from the
proposal: (1) The proposed requirements would have required all funds,
not just limited derivatives users, to report derivatives exposure
information; (2) the proposed requirements did not include the
requirement for funds that are limited derivatives users to report
exceedances of their derivatives exposure over the 10% threshold; and
(3) the final VaR reporting requirements decrease the number of
reported items that the proposal would have required and make certain
VaR-related information non-public. We estimate that 5,133 funds in the
aggregate, consisting of 2,437 limited derivatives users and 2,696
funds that are subject to the VaR-based limit on fund leverage risk,
will be subject to aspects of the Form N-PORT reporting requirements in
the final rule.
---------------------------------------------------------------------------
\1036\ See Item B.9 of Form N-PORT; supra section II.G.1.a.
\1037\ See Item B.10 of Form N-PORT; see supra section II.G.1.b.
---------------------------------------------------------------------------
Preparing reports on Form N-PORT is mandatory for all management
investment companies (other than money market funds and small business
investment companies) and UITs that operate as ETFs and is a collection
of information under the PRA. Responses to the reporting requirements
will be kept confidential, subject to the provisions of applicable law,
for reports filed with respect to the first two months of each quarter.
The information that funds will report regarding limited derivatives
users' derivatives exposure and exceedances of the 10% derivatives
exposure threshold, information about a fund's median daily VaR and
median VaR Ratio, as applicable, and VaR backtesting exceptions will
not be made publicly available. All other responses to the new Form N-
PORT reporting requirements for the third month of the quarter will not
be kept confidential, but made public sixty days after the quarter end.
Form N-PORT is designed to assist the Commission in its regulatory,
disclosure review, inspection, and policymaking roles, and to help
investors and other market participants better assess different fund
products.\1038\
---------------------------------------------------------------------------
\1038\ The specific purposes for each of the new reporting items
are discussed in section II.G.1 supra.
---------------------------------------------------------------------------
Based on current PRA estimates, we estimate that funds prepare and
file their reports on Form N-PORT either by (1) licensing a software
solution and preparing and filing the reports in house, or (2)
retaining a service provider to provide data aggregation, validation
and/or filing services as part of the preparation and filing of reports
on behalf of the fund. We estimate that 35% of funds subject to the N-
PORT filing requirements will license a software solution and file
reports on Form N-PORT in house, and the remainder will retain a
service provider to file reports on behalf of the fund.
Table 10 below summarizes our initial and ongoing annual burden
estimates associated with the amendments to Form N-PORT. One commenter
broadly opposed any new Form N-PORT reporting requirements on the
grounds that they generally increase burdens on funds, but did not
comment on PRA related burdens specifically.\1039\ Otherwise, the
Commission did not receive comments specifically addressing the
estimated burdens associated with the proposed Form N-PORT reporting
requirements. We have adjusted the proposal's estimated annual burden
hours and total time costs, on account of the modifications to the
proposed Form N-PORT requirements that we are adopting.
---------------------------------------------------------------------------
\1039\ ISDA Comment Letter.
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[[Page 83277]]
BILLING CODE 8011-01-P
[GRAPHIC] [TIFF OMITTED] TR21DE20.012
[[Page 83278]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.013
BILLING CODE 8011-01-C
E. Form N-RN and Rule 30b1-10
We are amending Form N-LIQUID (which we are re-titling as ``Form N-
RN'') to add new reporting requirements for funds subject to the VaR-
based limit on fund leverage risk pursuant to rule 18f-4 as well as
conforming amendments to rule 30b1-10.\1040\ We are adopting these
requirements substantially as proposed, with conforming amendments to
reflect changes to the proposed VaR requirements in the final rule.
---------------------------------------------------------------------------
\1040\ See Parts E, F, and G of Form N-RN; see also supra
section II.G.2 (noting that, in addition to registered open-end
funds, the scope of funds that will be subject to the requirements
of Form N-RN will expand to include registered closed-end funds and
BDCs).
---------------------------------------------------------------------------
[[Page 83279]]
A fund that determines that it is out of compliance with the VaR
test and has not come back into compliance within five business days
after such determination will have to file a non-public report on Form
N-RN providing certain information regarding its VaR test
breaches.\1041\ In addition, a fund that has come back into compliance
with either the relative VaR test or the absolute VaR test, as
applicable, must file a report on Form N-RN within one business day to
indicate that. We estimate that 2,696 funds per year will be required
to comply with either of the VaR tests, and the Commission will receive
approximately 54 filing(s) in aggregate per year in response to the new
VaR-related items that we proposed to include on Form N-RN, as
amended.\1042\
---------------------------------------------------------------------------
\1041\ See supra footnote 688. For purposes of this PRA
analysis, the burden associated with the amendments to rule 30b1-10
and rule 18f-4(c)(7) is included in the collection of information
requirements for Form N-RN.
\1042\ The estimate at proposal was 30 filings in aggregate per
year. See Proposing Release, supra footnote 1, at n.682 and
accompanying text. However, in a modification from the calculation
at proposal, the final PRA analysis increases this total by
approximately 75% to 54 filings in aggregate per year.
---------------------------------------------------------------------------
Pursuant to the amendments to Form N-RN, preparing a report on this
form will be mandatory for any fund that is out of compliance with its
applicable VaR test for more than five business days, and for any fund
that has come back into compliance with its applicable VaR test. A
report on Form N-RN is a collection of information under the PRA. The
VaR test breach information provided on Form N-RN, as well as the
information a fund provides when it has come back into compliance, will
enable the Commission to receive information on events that could
impact funds' leverage-related risk more uniformly and efficiently and
will enhance the Commission's oversight of funds when significant fund
and/or market events occur. The Commission will be able to use the
newly required information that funds will provide on Form N-RN in its
regulatory, disclosure review, inspection, and policymaking roles.
Responses to the reporting requirements and this collection of
information will be kept confidential, subject to provisions of
applicable law.
Table 11 below summarizes our initial and ongoing annual burden
estimates associated with preparing current reports in connection with
the amendments we are adopting to funds' current reporting
requirements. Staff estimates there will be no external costs
associated with this collection of information. We further assume
similar hourly and cost burdens, as well as similar response rates, for
responses to either a breach of the absolute VaR test or the relative
VaR test. Our assumptions furthermore take into account that the
information that funds must report on Form N-RN regarding a VaR test
breach includes data that will be available to funds in connection with
their compliance with rule 18f-4, and therefore funds will not need to
obtain or compile this information anew when they prepare reports on
Form N-RN. Several commenters expressed that the proposed rule would
result in more breaches of the VaR limits than estimated by the
Commission at proposal.\1043\ Although the final rule provides
incremental higher VaR limits than proposed, we have increased the
number of funds that we expect to be subject to the VaR-related items
on Form N-RN to reflect the potential that there could be more VaR
limit breaches than we had initially estimated. We have also adjusted
the proposal's estimated annual burden hours and total time costs to
reflect the Commission's updated views on typical time burdens
associated with similar reporting requirements.
---------------------------------------------------------------------------
\1043\ See supra sections II.D.2 and II.D.3 (discussing requests
from commenters to raise both the relative VaR and absolute VaR
limits in the proposal).
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BILLING CODE 8011-01-P
[[Page 83280]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.014
F. Form N-CEN
Form N-CEN is a structured form that requires registered funds to
provide census-type information to the Commission on an annual basis.
We are amending Form N-CEN to require a fund to identify whether it
relied on rule 18f-4 during the reporting period and whether the fund
has relied on certain provisions of the rule, substantially as
proposed.\1044\ In a modification from the proposal, we also are
amending Form N-CEN to require a fund to identify whether it has
invested in securities on a when-issued or forward-settling basis, or
with a non-standard settlement cycle, in reliance on the final rule.
---------------------------------------------------------------------------
\1044\ See supra section II.G.3.
---------------------------------------------------------------------------
[[Page 83281]]
Preparing a report on Form N-CEN, as amended, will be mandatory for
all registered funds, including money market funds. Responses will not
be kept confidential. We estimate that 5,524 funds will be subject to
the amendments to the Form N-CEN reporting requirements.\1045\
---------------------------------------------------------------------------
\1045\ We estimate that the number of funds that will be subject
to the amendments to the Form N-CEN reporting requirements includes
the number of funds that we estimate will be required to comply with
the derivatives risk management program requirement (2,766 funds),
plus the number of funds that we estimate will qualify as limited
derivatives users (2,437 funds), plus the number of money market
funds (420 funds), minus BDCs, which are not required to report on
Form N-CEN (99 BDCs). 2,766 + 2,437 + 420-99 = 5,524.
---------------------------------------------------------------------------
The purpose of Form N-CEN is to satisfy the filing and disclosure
requirements of section 30 of the Investment Company Act, and of
amended rule 30a-1 thereunder. The information required to be filed
with the Commission assures the public availability of the information
and is designed to facilitate the Commission's oversight of registered
funds and its ability to monitor trends and risks.
Table 12 below summarizes our initial and ongoing annual burden
estimates associated with the amendments to Form N-CEN based on current
Form N-CEN practices and burdens associated with minor amendments to
the form. Staff estimates there will be no external costs associated
with this collection of information. One commenter broadly opposed any
new Form N-CEN reporting requirements on the grounds that they
generally increase burdens on funds, but did not comment on PRA related
burdens specifically.\1046\ We have adjusted the proposal's estimated
annual burden hours and total time costs, on account of the additions
to the proposed Form N-CEN requirements that we are adopting and the
Commission's updated views on typical time burdens associated with
similar reporting requirements.
---------------------------------------------------------------------------
\1046\ ISDA Comment Letter.
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[[Page 83282]]
[GRAPHIC] [TIFF OMITTED] TR21DE20.015
BILLING CODE 8011-01-C
V. Final Regulatory Flexibility Analysis
The Commission has prepared the following Final Regulatory
Flexibility Analysis (``FRFA'') in accordance with section 604 of the
Regulatory Flexibility Act (``RFA'').\1047\ It relates to new rule 18f-
4 and the final amendments to Forms N-PORT, N-LIQUID (re-titled ``Form
N-RN''), and N-CEN.\1048\ An
[[Page 83283]]
Initial Regulatory Flexibility Analysis (``IRFA'') was prepared in
accordance with the RFA and included in the Proposing Release.\1049\
---------------------------------------------------------------------------
\1047\ 5 U.S.C. 604.
\1048\ As discussed above, we do not believe the conforming
amendments to Form N-2 (clarifying that funds do not have to
disclose in their senior securities table the derivatives
transactions and unfunded commitment agreements entered into in
reliance on rule 18f-4) or rule 22e-4 and Form N-PORT (removing
references to assets ``segregated to cover'' rendered obsolete by
rule 18f-4) result in any new reporting, recordkeeping, or
compliance burdens. See supra footnote 1007.
Similarly, we do not believe the conforming amendment to rule
30b1-10 (adding registered closed-end funds to the scope of this
rule, reflecting the requirement in final rule 18f-4 for all funds
that experience certain VaR breach events to report information
about these events confidentially to the Commission on Form N-RN)
result in any new reporting, recordkeeping, or compliance burdens.
See supra footnote 1007.
\1049\ See Proposing Release supra footnote 1, at section VI.
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A. Need for and Objectives of the Rule and Form Amendments
The Commission is adopting new rule 18f-4, as well as amendments to
rule 6c-11, and Forms N-PORT, N-LIQUID (re-titled N-RN), and N-CEN.
This final rule, and final rule amendments, are designed to address the
investor protection purposes and concerns underlying section 18 of the
Investment Company Act and to provide an updated and more comprehensive
approach to the regulation of funds' use of derivatives and the other
transactions covered by rule 18f-4.\1050\
---------------------------------------------------------------------------
\1050\ See supra section I.B (discussing the requirements of
section 18, and as well as Congress' concerns underlying the limits
of section 18). Other transactions specified in the rule include
reverse repurchase agreements and similar financing transactions,
unfunded commitments, and when-issued, forward-settling, and non-
standard settlement cycle securities.
---------------------------------------------------------------------------
Rule 18f-4 is designed to provide an updated, comprehensive
approach to the regulation of funds' use of derivatives and certain
other transactions, generally through the implementation of a
derivatives risk management program, limits on fund leverage risk,
board oversight and reporting, and related recordkeeping
requirements.\1051\ The amendments to Forms N-PORT, N-LIQUID (re-titled
N-RN), and N-CEN will enhance the Commission's ability to effectively
oversee funds' use of the rule and provide the Commission and the
public with additional information regarding funds' use of
derivatives.\1052\ All of these requirements are discussed in detail in
section II of this release. The costs and burdens of these requirements
on small funds are discussed below, as well as above in our Economic
Analysis and Paperwork Reduction Act Analysis, which discuss the
applicable costs and burdens on funds.\1053\
---------------------------------------------------------------------------
\1051\ See supra section II.A.
\1052\ See supra section II.G.
\1053\ See supra sections III and IV.
---------------------------------------------------------------------------
B. Significant Issues Raised by Public Comments
In the Proposing Release, we requested comment on every aspect of
the IRFA, including the number of small entities that would be affected
by the proposed rule and form amendments, the existence or nature of
the potential impact of the proposals on small entities discussed in
the analysis, and how to quantify the impact of the proposed
amendments. We also requested comment on the proposed compliance
burdens and the effect these burdens would have on smaller entities.
Although we did not receive comments specifically addressing the
IRFA, some commenters noted the impact of certain aspects of proposed
rule 18f-4 on smaller funds.\1054\ Commenters in particular expressed
concern that the proposed requirements concerning the appointment of a
derivatives risk manager could adversely affect smaller funds. One
commenter that urged the Commission to permit the fund's adviser to
serve as the derivatives risk manager, instead of requiring the board
to consider and select an individual to serve in this role, cited
unspecified cost burdens, particularly for smaller funds, associated
with the proposed approach.\1055\ Another commenter generally supported
the proposed requirement for an individual to serve as the derivatives
risk manager, but expressed concern ``that the specificity of the
requirements could hamstring smaller and mid-sized investment managers
in particular whose key personnel often carry out multiple
responsibilities.'' \1056\ Similarly, one commenter stated that smaller
firms may have significant difficulty complying with the proposed
requirement that a fund's derivatives risk management functions be
reasonably segregated from the fund's portfolio management functions
because ``the portfolio managers may be the principal employees
possessing the essential derivatives experience and hiring a person to
be a separate [derivatives risk manager] may not be economical (and may
not represent full time employment).'' \1057\
---------------------------------------------------------------------------
\1054\ See, e.g., IDC Comment Letter; SIFMA AMG Comment Letter;
ABA Comment Letter; NYC Bar Comment Letter; Dechert Comment Letter
I. We did not receive any comments discussing the impact of
amendments to rules 6c-11, 22e-4 or 30b1-10 on smaller funds.
\1055\ IDC Comment Letter; see also supra section II.B.1.
\1056\ SIFMA AMG Comment Letter.
\1057\ ABA Comment Letter.
---------------------------------------------------------------------------
In addition to discussing the derivatives risk manager requirement
in particular, commenters observed that the proposed rule's
requirements as a whole could adversely affect smaller funds. One
commenter described the impact of the rule's requirements generally on
smaller funds, stating that like larger fund complexes, ``smaller fund
complexes may need to significantly increase the financial and human
capital resources to meet the detailed requirements under the Proposed
Rule,'' and ``[f]und complexes of all sizes may need to draft licensing
agreements and engage in due diligence regarding the capabilities of
potential vendors.'' \1058\ Another commenter urged us to broadly
exempt from the rule funds sold exclusively to accredited investors,
qualified purchasers, or qualified clients, stating that ``a small
advisory organization that offers a closed-end fund or BDC to
Qualifying Investors, as an extension of its sponsorship of private
funds, may not have the resources to hire and maintain separate risk
personnel, including a [derivatives risk manager], or develop and
maintain a [derivatives risk management program].'' \1059\ Several
commenters that recommended extending the transition period for all
funds beyond the one-year period we proposed noted a longer timeframe
could be particularly beneficial to smaller funds. One commenter stated
that ``certain smaller and midsize investment advisers that serve as
subadvisers to registered funds would benefit from more time to meet
these implementation challenges.'' \1060\ Similarly, another commenter
suggested that a longer transition period would be useful for smaller
funds with limited resources that may need to hire additional personnel
or redirect current resources in order to comply with the new
requirements.\1061\
---------------------------------------------------------------------------
\1058\ Dechert Comment Letter I.
\1059\ NYC Bar Comment Letter.
\1060\ ICI Comment Letter.
\1061\ Dechert Comment Letter I.
---------------------------------------------------------------------------
After considering the comments we received, we are adopting the
proposed rule and form amendments, with certain modifications intended
to reduce many of the operational challenges commenters identified. For
example, we are adopting certain changes to the proposal that will be
cost-reducing to all funds, including small funds, such as requiring
weekly backtesting, instead of daily, as proposed.\1062\ This release
also clarifies that the final rule provides flexibility for the fund's
derivatives risk manager to rely on others, such as employees of the
fund's adviser, in carrying out activities associated with
[[Page 83284]]
the fund's derivatives risk management.\1063\ We believe that this
flexibility will benefit all funds, including smaller funds. We also
believe there will be certain compliance efficiencies associated with
raising the relative and absolute VaR limits to 200% and 20%,
respectively, which match the VaR limits in the UCITS framework, and
could benefit small funds with an adviser that also manages UCITS
funds.\1064\ While the proposal would have required all funds to report
their derivatives exposure, the final amendments we are adopting will
require only a fund that relies on the limited derivatives exception in
rule 18f-4 to report its derivatives exposure on Form N-PORT, which
will reduce reporting burdens on any smaller funds that do not rely on
the exception.\1065\ In addition, we are adopting an eighteen-month
transition period, instead of the proposed one-year transition period,
which provides more time for all funds, including smaller funds, to
comply with the new requirements.\1066\
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\1062\ See supra section II.B.2.d.
\1063\ See supra section II.B.1.
\1064\ See supra footnote 376.
\1065\ See supra section II.G.1.b.
\1066\ See supra section II.L.
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C. Small Entities Subject to the Final Rule
An investment company is a small entity if, together with other
investment companies in the same group of related investment companies,
it has net assets of $50 million or less as of the end of its most
recent fiscal year.\1067\ Commission staff estimates that, as of June
2020, approximately 40 registered mutual funds, 8 registered ETFs, 26
registered closed-end funds, and 12 BDCs (collectively, 86 funds) were
small entities.\1068\
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\1067\ Rule 0-10(a) under the Investment Company Act [17 CFR
270.0-10(a)]. Recognizing the growth in assets under management in
investment companies since rule 0-10(a) was adopted, the Commission
plans to revisit the definition of a small entity in rule 0-10(a).
\1068\ This estimate is derived from an analysis of data
obtained from Morningstar Direct as well as data reported to the
Commission for the period ending June 2020. This estimate of small
entities include one money market fund, which has net assets of less
than $100,000.
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D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
The new rule and form amendments will impact current reporting,
recordkeeping and other compliance requirements for funds, including
those considered to be small entities.
1. Rule 18f-4
a. Derivatives Risk Management Program, and Board Oversight and
Reporting
Rule 18f-4 will generally require a fund relying on the rule when
engaging in derivatives transactions--including small entities, but not
funds that are limited derivatives users--to adopt and implement a
derivatives risk management program.\1069\ This derivatives risk
management program will include policies and procedures reasonably
designed to assess and manage the risks of the fund's derivatives
transactions. The program requirement is designed to permit a fund to
tailor the program's elements to the particular types of derivatives
that the fund uses and related risks, as well as how those derivatives
impact the fund's investment portfolio and strategy. The final rule
will require a fund's program to include the following elements: (1)
Risk identification and assessment; (2) risk guidelines; (3) stress
testing; (4) backtesting; (5) internal reporting and escalation; and
(6) periodic review of the program. The final rule also will require:
(1) A fund's board of directors to approve the designation of the
fund's derivatives risk manager and (2) the derivatives risk manager to
provide written reports to the board regarding the program's
implementation and effectiveness.\1070\
---------------------------------------------------------------------------
\1069\ See supra section II.B; see also rule 18f-4(c)(1).
\1070\ See supra sections II.C and III.C.1.
---------------------------------------------------------------------------
As discussed above, we estimate that the one-time operational costs
necessary to establish and implement a derivatives risk management
program will range from $150,000 to $500,000 per fund, depending on the
particular facts and circumstances and current derivatives risk
management practices of the fund.\1071\ We also estimate that each fund
will incur ongoing program-related costs that range from 65% to 75% of
the one-time costs necessary to establish and implement a derivatives
risk management program, or approximately $97,500 to $375,000.\1072\ We
estimate that approximately 21% of funds will be required to implement
a derivatives risk management program, including board oversight.\1073\
We therefore similarly estimate that approximately 21% of small funds,
or approximately 18 small funds, will establish a derivatives risk
management program.\1074\
---------------------------------------------------------------------------
\1071\ See supra section III.C.1. This section, along with
sections IV.B.1 and IV.B.2, also discusses the professional skills
that we believe compliance with this aspect of the final rule will
entail.
\1072\ See supra footnote 847.
\1073\ See supra footnote 849 and accompanying text (estimating
that 21% of funds, or 2,766 funds total, will be required to
implement a derivatives risk management program). These are funds
that hold some derivatives and will not qualify as a limited
derivatives user under the final rule.
\1074\ We estimate that there are 86 small funds that meet the
small entity definition. See supra footnote 1068 and accompanying
text. 86 small funds x 21% = approximately 18 funds that are small
entities that will be required to implement a derivatives risk
management program.
---------------------------------------------------------------------------
There are different factors that will affect whether a smaller fund
incurs program-related costs that are on the higher or lower end of the
estimated range. For example, we would expect that smaller funds that
are not part of a fund complex--or their advisers--may not have
existing personnel capable of fulfilling the responsibilities of the
derivatives risk manager. Some smaller funds may have more limited
employee resources, making it more difficult to segregate the portfolio
management and derivatives risk management function. In addition, some
smaller entities may choose to hire a derivatives risk manager rather
than assigning that responsibility to a current officer or officers of
the fund's investment adviser who is not a portfolio manager and has
the requisite experience. Also, while we would expect larger funds or
funds that are part of a large fund complex to incur higher program-
related costs in absolute terms relative to a smaller fund or a fund
that is part of a smaller fund complex, a smaller fund may find it more
costly, per dollar managed, to comply with the derivatives risk
management program requirement because it will not be able to benefit
from a larger fund complex's economies of scale.\1075\
---------------------------------------------------------------------------
\1075\ See supra section III.C.1.
---------------------------------------------------------------------------
b. Limit on Fund Leverage Risk
Rule 18f-4 will generally require a fund relying on the rule to
engage in derivatives transactions to comply with an outer limit on
fund leverage risk based on VaR.\1076\ This requirement is applicable
to small entities, except for those that are limited derivatives users
or that are leveraged/inverse funds that cannot comply with the VaR
limit and meet other conditions, as the rule describes. This outer
limit is based on a relative VaR test that compares the fund's VaR to
the VaR of a designated reference portfolio. If the fund's derivatives
risk manager reasonably determines that a designated reference
portfolio would not provide an appropriate reference portfolio for
purposes of the relative VaR test, the fund will be required to comply
with an absolute VaR test. In either case, a fund must apply the test
at least once each
[[Page 83285]]
business day. This requirement is designed to limit fund leverage risk
consistent with the investor protection purposes underlying section 18.
---------------------------------------------------------------------------
\1076\ See supra sections II.D, II.E, and II.F.
---------------------------------------------------------------------------
As discussed above, we estimate that the one-time operational costs
necessary to establish and implement a VaR calculation model consistent
with the limit on fund leverage risk will range from $5,000 to $100,000
per fund, depending on the particular facts and circumstances and
current derivatives risk management practices of the fund.\1077\ We
estimate that approximately 21% of funds will be required to comply
with the limit on fund leverage risk.\1078\ We therefore similarly
estimate that approximately 21% of small funds, or approximately 18
small funds, will be required to comply with the limit on fund leverage
risk.\1079\
---------------------------------------------------------------------------
\1077\ See supra section III.C.2. This section also discusses
the professional skills that we believe compliance with this aspect
of the final rule will entail.
\1078\ See supra text following footnote 857 (estimating that
21% of funds, or 2,696 funds total, will be required to implement
VaR tests). This estimate excludes both: (1) Limited derivatives
users, and (2) funds that are leveraged/inverse funds that cannot
comply with the VaR limit and meet other conditions, as the rule
describes.
\1079\ We estimate that there are 86 small funds that meet the
small entity definition. See supra footnote 1068 and accompanying
text. 86 small funds x 21% = approximately 18 funds that are small
entities that will be subject to a VaR test.
---------------------------------------------------------------------------
There are multiple factors that could affect whether the costs that
smaller funds will incur in complying with the limit on fund leverage
risk will be on the lower versus higher end of this estimated range. To
the extent that funds (including smaller funds) have already
established and implemented portfolio VaR testing practices and
procedures, these funds will incur fewer costs relative to those funds
that have not already established and implemented VaR-based analysis in
their risk management. As a result of fewer resources, a smaller fund,
and more specifically a smaller fund not part of a fund complex, may be
particularly likely to hire a third-party vendor to comply with the
VaR-based limit on fund leverage risk, which could increase costs of
complying with the limit for those funds. Finally, costs will vary
based on factors such as whether the fund uses multiple types of
derivatives or uses derivatives more extensively, whether the fund
implements the absolute VaR test versus the relative VaR test, and
whether (for a fund that uses the relative VaR test) the fund uses a
designated reference portfolio for which the index provider charges a
licensing fee.\1080\
---------------------------------------------------------------------------
\1080\ See supra footnote 880 and accompanying paragraph.
---------------------------------------------------------------------------
c. Requirements for Limited Derivatives Users
Rule 18f-4 includes an exception from the rule's derivatives risk
management program requirement and limit on fund leverage risk for
``limited derivatives users.'' \1081\ The exception is available to a
fund that limits its derivatives exposure to 10% of its net assets,
excluding derivatives transactions used to hedge certain currency and/
or interest rate risks. A fund that relies on the exception--small
funds as well as large funds--will also be required to adopt policies
and procedures that are reasonably designed to manage its derivatives
risks. In a change from the proposal, the final rule provides two
alternative paths for remediation for limited derivatives users that
are out of compliance with the 10% derivatives exposure threshold
requirement.\1082\ We believe that the risks and potential impact of
these funds' derivatives use may not be as significant, compared to
those of funds that do not qualify for the exception, and that a
principles-based policies and procedures requirement will appropriately
address these risks. These ``reasonably designed'' policies and
procedures will have a scope that that reflects the extent and nature
of a fund's use of derivatives within the parameters that the exception
provides.
---------------------------------------------------------------------------
\1081\ See supra section II.E; rule 18f-4(c)(4).
\1082\ See supra section II.E.4.
---------------------------------------------------------------------------
As discussed above, we estimate that the one-time costs to
establish and implement policies and procedures reasonably designed to
manage a fund's derivatives risks will range from $15,000 to $100,000
per fund, depending on the particular facts and circumstances and
current derivatives risk management practices of the fund.\1083\ We
also estimate that the ongoing annual costs that a fund that is a
limited derivatives user will incur range from 65% to 75% of the one-
time costs to establish and implement the policies and procedures.
Thus, we estimate that a fund will incur ongoing annual costs
associated with the limited derivatives user exception that will range
from $9,750 to $75,000.\1084\ We anticipate that larger funds that are
limited derivatives users--or limited derivatives user funds that are
part of a large fund complex--will likely experience economies of scale
in complying with the requirements for limited derivatives users that
smaller funds will not necessarily experience.\1085\ Thus, smaller
funds that are limited derivatives users could incur costs on the
higher end of the estimated range. However, a smaller fund whose
derivatives use is limited could benefit from the limited derivatives
user exception because it will not be required to adopt a derivatives
risk management program (including all of the program elements).\1086\
---------------------------------------------------------------------------
\1083\ See supra section III.C.3 (discussing the one-time range
of costs for implementing the limited derivatives user requirements
under rule 18f-4 and the variables impacting a fund incurring costs
at the lower or higher end of the estimated cost range). This
section, along with section IV.B.6, also discusses the professional
skills that we believe compliance with this aspect of the rule will
entail.
\1084\ See supra footnote 892.
\1085\ See supra footnote 1075 and accompanying text.
\1086\ See supra section II.E.
---------------------------------------------------------------------------
We estimate that approximately 19% of funds will qualify for the
limited derivatives user exception.\1087\ We would expect some small
funds to fall within the limited derivatives user exception.\1088\
However, not all small funds that use derivatives will necessarily
qualify as limited derivatives users. We estimate--applying to small
funds the same estimated percentage of funds overall that will qualify
as limited derivatives users--that approximately 19% of small funds
(approximately 16 small funds) will qualify for the limited derivatives
user exception under the final rule.\1089\
---------------------------------------------------------------------------
\1087\ See supra paragraph following footnote 892 (estimating
that 19% of funds, or 2,437 funds total, will qualify as limited
derivatives users). This estimate excludes funds that will comply
with the derivatives risk management program. See also supra
sections II.F, III.C.1, III.C.3, III.C.5, IV.B.3, and V.D.1.a.
\1088\ Id.
\1089\ Id. We estimate that there are 86 small funds that meet
the small entity definition. See supra footnote 1068 and
accompanying text. 86 small funds x 19% = approximately 16 funds
that are small entities that will qualify for the limited
derivatives user exception.
---------------------------------------------------------------------------
d. Reverse Repurchase Agreements
Rule 18f-4 will permit a fund to engage in reverse repurchase
agreements and other similar financing transactions so long as they
either are subject to the relevant asset coverage requirements of
section 18 for senior securities representing indebtedness, or treated
as derivative transactions for all purposes under the rule.\1090\ A
fund's election will apply to all of its reverse repurchase agreements
and similar financing transactions, and therefore all of a fund's such
transactions will be subject to consistent treatment under the final
rule.\1091\
---------------------------------------------------------------------------
\1090\ See supra section II.H.
\1091\ Rule 18f-4(d)(1)(i) and (ii).
---------------------------------------------------------------------------
[[Page 83286]]
Today, funds rely on the asset segregation approach that Release
10666 describes with respect to reverse repurchase agreements, which
funds may view as separate from the limitations established on bank
borrowings (and other senior securities that are evidence of
indebtedness) by the asset coverage requirements of section 18. To the
extent that funds elect to rely on the asset coverage requirements of
section 18 with respect to their reverse repurchase agreements and
similar financing transactions, these funds will have to take these
transactions into account in monitoring their compliance with the asset
coverage requirements of section 18. Alternatively, to the extent that
a fund chooses to treat its reverse repurchase and other similar
financing transaction activity as derivatives for all purposes of the
final rule, the fund must adopt and implement policies and procedures
reasonably designed to manage the fund's derivatives risks in order to
qualify as a limited derivatives user (assuming that the fund's use of
reverse repurchase agreements and similar financing transactions, in
addition to its derivatives exposure, was limited to 10% of its net
assets). If such a fund's use of reverse repurchase agreements and
similar financing transactions, in addition to derivatives exposure
associated with the fund's other derivatives transactions, exceeds 10%
of its net assets, the fund must adopt a derivatives risk management
program and comply with the VaR-based limit on fund leverage risk.
We estimate that about 0.27% of all funds, excluding BDCs, will
enter into these transactions in amounts that exceed the asset coverage
requirements.\1092\ If these funds choose not to adjust their use of
reverse repurchase agreements, similar financing transactions, or
borrowings in order to comply with the asset coverage requirements,
these funds will have to qualify as a limited derivatives user under
the final rule (and adopt the policies and procedures that the limited
derivatives user exception requires) or else be subject to the final
rule's VaR and program requirements. We similarly estimate--applying to
small funds the same estimated percentage of funds that will engage in
reverse repurchase agreements or similar financing activities--that no
small funds will engage in these transactions in combined amounts that
exceed the asset coverage requirement.\1093\ We therefore do not
estimate a cost burden to small funds associated with the provisions
regarding reverse repurchase agreements in rule 18f-4.
---------------------------------------------------------------------------
\1092\ See supra footnote 1033.
\1093\ We estimate that there are 86 small funds that meet the
small entity definition. See supra footnote 1068 and accompanying
text. 86 small funds x 0.27% = 0 (rounded for convenience).
---------------------------------------------------------------------------
e. Unfunded Commitment Agreements
The rule also addresses funds' participation in unfunded commitment
agreements. The approach in the final rule recognizes that while
entering into unfunded commitment agreements may raise the risk that a
fund may be unable to meet its obligations under these transactions,
unfunded commitments do not generally involve the leverage and other
risks associated with derivatives transactions.\1094\ Rule 18f-4 will
permit a fund to enter into unfunded commitment agreements if it
reasonably believes, at the time it enters into such agreement, that it
will have sufficient cash and cash equivalents to meet its obligations
with respect to each of its unfunded commitment agreements, in each
case as they come due. The rule prescribes factors that a fund must
consider in forming such a reasonable belief. If a fund enters into
unfunded commitment agreements in compliance with this requirement, the
rule specifies that unfunded commitment agreements will not be
considered for purposes of computing asset coverage, as defined in
section 18(h) of the Investment Company Act. This approach for unfunded
commitment agreements reflects current industry practice, as discussed
above.\1095\ We therefore do not expect that this provision in rule
18f-4 will result in significant costs to small (or large) funds.
---------------------------------------------------------------------------
\1094\ See supra section II.I.
\1095\ See id.
---------------------------------------------------------------------------
f. When-Issued, Forward-Settling, and Non-Standard Settlement Cycle
Securities Transactions
In a change from the proposal, the final rule also includes a new
provision that will permit funds, as well as money market funds, to
invest in securities on a when-issued or forward-settling basis, or
with a non-standard settlement cycle, and the transactions will be
deemed not to involve a senior security subject to certain
conditions.\1096\ This provision will permit funds and money market
funds, including smaller entities, to invest in securities on a when-
issued basis under rule 18f-4 notwithstanding that these investments
trade on a forward basis involving a temporary delay between the
transaction's trade date and settlement date. We do not believe that
this approach will result in a significant change in the extent to
which funds and money market funds engage in these transactions. We
therefore do not expect these amendments to result in significant costs
to small (or large) funds.
---------------------------------------------------------------------------
\1096\ See supra section II.A.
---------------------------------------------------------------------------
g. Recordkeeping
Rule 18f-4 includes certain recordkeeping provisions that are
designed to provide the Commission, and the fund's board of directors
and compliance personnel, the ability to evaluate the fund's compliance
with the final rule's requirements.\1097\
---------------------------------------------------------------------------
\1097\ See supra section II.J.
---------------------------------------------------------------------------
First, the rule will require a fund to maintain certain records
documenting its derivatives risk management program, including a
written record of: (1) Its policies and procedures designed to manage
the fund's derivatives risks, (2) the results of any stress testing of
its portfolio, (3) the results of any VaR test backtesting it conducts,
(4) records documenting any internal reporting or escalation of
material risks under the program, and (5) records documenting any
periodic reviews of the program.\1098\
---------------------------------------------------------------------------
\1098\ Rule 18f-4(c)(6)(i)(A).
---------------------------------------------------------------------------
Second, the rule will also require a fund to maintain a written
record of any materials provided to the fund's board of directors in
connection with approving the designation of the derivatives risk
manager. The rule also requires a fund to keep records of any written
reports provided to the board of directors relating to the program, and
any written reports provided to the board that the rule requires
regarding the fund's non-compliance with the applicable VaR test.\1099\
---------------------------------------------------------------------------
\1099\ Rule 18f-4(c)(6)(i)(B).
---------------------------------------------------------------------------
Third, a fund that is required to comply with the VaR test also has
to maintain written records documenting the determination of: Its
portfolio VaR; the VaR of its designated reference portfolio, as
applicable; its VaR ratio (the value of the VaR of the fund's portfolio
divided by the VaR of the designated reference portfolio), as
applicable; and any updates to the VaR calculation models used by the
fund, as well as the basis for any material changes made to those
models.\1100\
---------------------------------------------------------------------------
\1100\ Rule 18f-4(c)(6)(i)(C).
---------------------------------------------------------------------------
Fourth, the rule requires a fund that is a limited derivatives user
to maintain a written record of its policies and procedures that are
reasonably designed to manage its derivatives risks.\1101\
---------------------------------------------------------------------------
\1101\ Rule 18f-4(c)(6)(i)(D).
---------------------------------------------------------------------------
Fifth, a fund that enters into unfunded commitment agreements will
be required to maintain a record documenting the basis for the fund's
[[Page 83287]]
belief regarding the sufficiency of its cash and cash equivalents to
meet its obligations with respect to its unfunded commitment
agreements.\1102\ A record must be made each time a fund enters into
such an agreement.
---------------------------------------------------------------------------
\1102\ Rule 18f-4(e)(2).
---------------------------------------------------------------------------
Sixth, the rule requires a fund that enters into reverse repurchase
agreements or similar financing transactions to maintain a record
documenting whether it is complying with the asset coverage
requirements of section 18 with respect to these transactions, or
alternatively whether it is treating these transactions as derivatives
transactions for all purposes under the rule.\1103\
---------------------------------------------------------------------------
\1103\ Rule 18f-4(d)(2).
---------------------------------------------------------------------------
Finally, funds must maintain the required records for a period of
five years.\1104\
---------------------------------------------------------------------------
\1104\ Rule 18f-4(c)(6)(ii); rule 18f-4(d)(2); rule 18f-4(e)(2).
---------------------------------------------------------------------------
As reflected above, we estimate that the average annual
recordkeeping costs for funds that will not qualify as limited
derivatives users (that is, recordkeeping costs associated with the
program and VaR requirements) will be $10,613 per fund, depending on
the particular facts and circumstances and current derivatives risk
management practices of the fund.\1105\ We separately estimate that the
average annual recordkeeping costs for a limited derivatives user will
be $1,917.50.\1106\
---------------------------------------------------------------------------
\1105\ See supra section IV.B.7. The components of this estimate
include average annual estimates of $10,013 internal cost and $600
average annual external cost per fund ($10,013 + $600 = $10,613).
This section also discusses the professional skills that we believe
compliance with this aspect of the rule will entail.
\1106\ Id. The components of this estimate include average
annual estimates of $1,317.50 internal cost and $600 average annual
external cost per fund ($1,317.50 + $600 = $1,917.50).
---------------------------------------------------------------------------
To the extent that we estimate that small funds will be subject to
the various provisions of the rule that will necessitate recordkeeping
requirements, as discussed above, these small funds also will be
subject to the associated recordkeeping requirements. Therefore, we
estimate that: 21% of small funds (approximately 18 small funds) will
have to comply with the program-related recordkeeping requirements and
requirements regarding materials provided to the fund's board; 21% of
small funds (approximately 18 small funds) will have to comply with
requirements to maintain records of compliance with the VaR test; and
19% of small funds (approximately 16 funds) will have to comply with
the recordkeeping requirements for limited derivatives users.\1107\
---------------------------------------------------------------------------
\1107\ See supra sections III.C.1, III.C.2, III.C.3, V.D.1.a,
V.D.1.b, and V.D.1.c.
---------------------------------------------------------------------------
In addition, we estimate that 1% of small funds (approximately 1
small fund) will use reverse repurchase agreements or similar financing
agreements and be required to comply with the recordkeeping
requirements associated with this aspect of the rule.\1108\ We further
estimate that the average annual recordkeeping cost for each fund--
large or small--that chooses to enter into reverse repurchase
agreements or similar financing transactions is $790.50 to document how
the fund elects treat these transactions for all purposes under the
rule (i.e., either subject to section 18's asset coverage requirements,
or treated as derivatives transactions).\1109\
---------------------------------------------------------------------------
\1108\ We estimate that 1% of all funds subject to the final
rule (excluding BDCs), will enter into such transactions. See supra
footnote 1033. Applying the same percentage, we estimate that 1
small fund will use reverse repurchase agreements or similar
financing transactions ((86 small funds-12 small BDCs) = 74 small
funds x 1% = 1 (rounded for convenience).
\1109\ See supra section IV.B.7.
---------------------------------------------------------------------------
Finally, we estimate that 10% of small funds, or 9 small funds,
will enter into at least one unfunded commitment agreement annually,
thus triggering the requisite recordkeeping requirements.\1110\ We also
estimate an average annual cost of $1,317.50 for a fund to create and
maintain a record documenting its ``reasonable belief'' regarding its
ability to meet its obligations with respect to each unfunded
commitment agreement, each time it enters such an agreement.\1111\
---------------------------------------------------------------------------
\1110\ We believe the final rule's approach to unfunded
commitments is generally consistent with the current practices of
funds that enter into unfunded commitments. See supra section II.I.
Based on our staff's review of fund filings, we estimate that 1,339
funds (approximately 10% of all funds subject to the rule) entered
into an unfunded commitment agreement as of December 2019, see supra
footnote 1033, and 9 small funds (10% of 86 small funds) did
likewise.
\1111\ See supra section IV.B.7.
---------------------------------------------------------------------------
A fund's recordkeeping-related costs will vary, depending on the
provisions of rule 18f-4 that the fund relies on. For example, funds
that are required to adopt derivatives risk management programs, versus
funds that are limited derivatives users under the rule, will be
subject to different recordkeeping requirements. However, while small
funds' recordkeeping burdens will vary based on the provisions of the
rule that a fund relies on, their recordkeeping burdens will not vary
solely because they are small funds. We do not anticipate that larger
funds, or funds that are part of a large fund complex, will experience
any significant economies of scale related to the final rule's
additional recordkeeping requirements.
2. Amendments to Forms N-PORT, N-RN, and N-CEN
a. Amendments to Form N-PORT
The amendments to Form N-PORT will require limited derivatives
users to report information about their derivatives exposure, and
also--as applicable for funds that are subject to the rule 18f-4 VaR-
based limit on fund leverage risk--to report certain VaR-related
information.\1112\ These amendments will help the Commission assess
compliance with rule 18f-4.
---------------------------------------------------------------------------
\1112\ See supra section II.G.1; see also Items B.9 and B.10 of
Form N-PORT.
---------------------------------------------------------------------------
Under the final rule, limited derivatives users that file Form N-
PORT will have to provide information regarding their derivatives
exposure on this form, specifically: (1) The fund's aggregate
derivatives exposure; and (2) the fund's derivatives exposure
attributable to currency or interest rate derivatives entered into and
maintained by the fund for hedging purposes. In addition, if a limited
derivatives user has derivatives exposure exceeding 10% of the fund's
net assets, and this exceedance persists beyond the five-business-day
period that the final rule provides for remediation, the fund will have
to report the number of business days beyond the five-business-day
remediation period that its derivatives exposure exceeded 10% of net
assets. We estimate that 19% of small funds that file Form N-PORT
(approximately 14 small funds) are limited derivatives users that will
report information in response to this new exposure-related disclosure
requirement.\1113\ In addition, funds that are subject to the limit on
fund leverage risk will have to report certain VaR-related information
for the reporting period. We estimate that 21% of small funds
(approximately 16 small funds) will be subject to these VaR-related
disclosure requirements.\1114\
---------------------------------------------------------------------------
\1113\ See supra sections V.C, V.D.1.a, and V.D.1.c. Because
BDCs do not file reports on Form N-PORT, we deducted BDCs from our
estimate of small Form N-PORT filers (86 small funds-12 small BDCs =
74 small funds that file reports on Form N-PORT). See supra footnote
1068 and accompanying text.
We estimate that approximately 19% of funds will qualify for the
limited derivatives user exception. See supra footnote 1087 and
accompanying text. Although this estimated percentage includes BDCs,
because the total number of BDCs relative to the number of
registered open- and closed-end funds is small, so we did not adjust
our estimated percentage to reflect the fact that BDCs do not file
Forms N-PORT. See supra section III.B.1. Therefore, we estimate the
total number of small funds subject to this Form N-PORT requirement
as follows: 74 small funds that file reports on Form N-PORT x 19% =
approximately 14 small funds.
\1114\ We estimate that 74 small funds file reports on Form N-
PORT. See supra footnote 1113. We estimate that approximately 21% of
funds will be subject to the proposed limit on fund leverage risk.
See supra section III.C.2. Although this estimated percentage
includes BDCs, we note that the total number of BDCs relative to the
number of registered open- and closed-end funds is small, and
therefore our estimate does not adjust this percentage to reflect
the fact that BDCs do not file Form N-PORT. See supra section
III.B.1. Therefore, we estimate the total number of small funds that
will make VaR-related disclosures on Form N-PORT as follows: 74
small funds that file reports on Form N-PORT x 21% = approximately
16 small funds.
Under the final rule, funds that choose not to adjust their use
of reverse repurchase agreements, similar financing transactions, or
borrowings to comply with section 18's asset coverage requirements
must treat such transactions as derivatives and either qualify as a
limited derivatives user or be subject to the VaR tests and program
requirements. We do not estimate any small funds will use these
transactions in combined amounts that exceed the asset coverage
requirement, and accordingly do not expect this requirement to
substantively affect our estimate regarding the number of smaller
funds that are likely to report VaR-related information on Form N-
PORT.
---------------------------------------------------------------------------
[[Page 83288]]
We estimate that each fund that reports information in response to
the VaR-related disclosure requirements on Form N-PORT will incur an
average cost of $3,951 per year.\1115\ We also estimate that limited
derivatives users reporting information in response to the requirement
to report derivatives exposure, including the number of business days
its derivatives exposure exceeds 10% of net assets, will incur a cost
of $3,958 per year.\1116\ Notwithstanding the economies of scale
experienced by large versus small funds, we would not expect the costs
of compliance associated with the new Form N-PORT requirements to be
meaningfully different for small versus large funds. The costs of
compliance will vary only based on fund characteristics tied to their
derivatives use. For example, a limited derivatives user that uses
derivatives more extensively (while still under the 10% threshold) will
incur more costs to calculate its derivatives exposure than a limited
derivatives user that uses derivatives to a more limited degree. And a
fund that is a limited derivatives user, or that otherwise is not
subject to the VaR test, will not incur any costs to comply with the
new VaR-related N-PORT items. Similarly, a fund that is a limited
derivatives user will report derivatives exposure, but if it does not
exceed the 10% threshold, will not incur costs to report exceedances.
---------------------------------------------------------------------------
\1115\ See supra section IV.D. The components of this $3,951
estimate include average annual estimates of $3,039 internal cost
and $912 average annual external cost per fund ($3,039 + $912 =
$3,951).
\1116\ See supra section IV.D. The components of this $3,958
estimate include average annual estimates of $3,039 internal cost
(to report exposure information), $7.02 internal cost (to report
exceedance-related information), and $912 average annual external
cost per fund ($3,039 + $7.02 + $912 = approximately $3,958).
---------------------------------------------------------------------------
b. Amendments to Current Reporting Requirements
We are re-titling Form N-LIQUID as Form N-RN, and amending this
form to include new reporting events for funds that are subject to rule
18f-4's limit on fund leverage risk.\1117\ We are adopting these
amendments in light of final rule 18f-4's requirement for funds to file
current reports on Form N-RN about VaR test breaches under certain
circumstances, as well as conforming amendments to rule 30b1-10.\1118\
These current reporting requirements are designed to aid the Commission
in assessing funds' compliance with the VaR tests. We are requiring
funds to provide this information in a current report because we
believe that the Commission should be notified promptly when a fund is
out of compliance with the VaR-based limit on fund leverage risk (and
also when it has come back into compliance with its applicable VaR
test). We believe this information could indicate that a fund is
experiencing heightened risks as a result of a fund's use of
derivatives transactions, as well as provide the Commission insight
about the duration and severity of those risks, and whether those
heightened risks are fund-specific or industry-wide.
---------------------------------------------------------------------------
\1117\ See supra section II.G.3.
\1118\ See rule 18f-4(c)(7); see also rule 30b1-10.
---------------------------------------------------------------------------
We estimate that each report that a fund will file in response to
the new VaR-related reporting requirements of Form N-RN will entail
costs of approximately $1,438.\1119\ Furthermore, because each report
that a fund files initially reporting a VaR test breach must be
accompanied by a second report when the fund comes back into compliance
with the VaR test, each VaR test breach that requires a report will
entail costs of two times the estimated cost for filing a single report
($1,438 x 2 = $2,876). We estimate that approximately 18 small funds
will be required to comply with the limit on fund leverage risk and may
report VaR test related information on Form N-RN.\1120\ However, we
also estimate that only 1% of funds that must comply with the leverage
limit will file Form N-RN each year because they breached the relative
or absolute VaR test, and applying the same percentage, estimate that
that no small fund will file the form.\1121\ Regardless, because the
amendments to Form N-RN will require both large and small funds to
report VaR test breaches, the burden to report is not associated with
fund size, and consequently, we would not expect the costs of
compliance with the new Form N-RN requirements to be meaningfully
different for small versus large funds.
---------------------------------------------------------------------------
\1119\ See supra section IV.E. The components of this $1,438
estimate include 3 hours of compliance attorney time ($368) and 1
hour of senior programmer time ($334) ((3 x $368 = $1,104) + (1 x
$334 = $334) = $1,438).
\1120\ See supra footnote 1079 and accompanying text (estimating
that 21% of small funds, or 18 small funds, will be subject to a
VaR-based limit on fund leverage risk). We therefore similarly
estimate that the same percentage and number of small funds may be
required to report VaR-related information on Form N-RN.
\1121\ See supra section IV.E. Calculated as follows: 18 small
funds subject to the VaR-based limit x 1% = 0 (rounded for
convenience).
---------------------------------------------------------------------------
c. Amendments to Form N-CEN
The amendments to Form N-CEN will require a fund to identify
whether it relied on rule 18f-4 during the reporting period.\1122\ The
amendments also require a fund to identify whether it relied on any of
the exemptions from various requirements under the rule, specifically
whether it: (1) Is a limited derivatives user; (2) is a leveraged/
inverse fund as defined in the rule that is excepted from the
requirement to comply with the VaR-based limit on fund leverage risk;
(3) has entered into reverse repurchase agreements or similar financing
transactions in reliance either on the rule provision that requires
compliance with section 18's asset coverage requirements, or the
provision that treats such transactions as derivative transactions
under the final rule; (4) has entered into unfunded commitment
agreements; or (5) has invested in a security on a when-issued or
forward-settling basis, or with a non-standard settlement cycle.\1123\
The amendments to Form N-CEN are designed to assist the Commission with
its oversight functions by allowing it to identify which funds were
excepted from, or relied on, certain of the rule's provisions.
---------------------------------------------------------------------------
\1122\ See supra section II.G.3; see also Item C.7.n of Form N-
CEN.
\1123\ See Item C.7.n.i-vi of Form N-CEN; see also rule 18f-
4(c)(4); (c)(5); (d)(i); (d)(ii); (e); and (f).
---------------------------------------------------------------------------
We estimate that each fund subject to the new Form N-CEN reporting
requirements will incur additional paperwork-related burdens associated
with responding to the new form items that average $140.40 per year on
a per-fund basis.\1124\ We estimate that approximately 31 registered
open- and closed-end funds are small entities that will be subject to
the new Form N-CEN reporting requirements.\1125\
[[Page 83289]]
Notwithstanding any economies of scale experienced by large versus
small funds, we do not expect the costs of compliance with the new Form
N-CEN requirements to be meaningfully different for small versus large
funds.
---------------------------------------------------------------------------
\1124\ See supra section IV.F.
\1125\ Because BDCs do not file reports on Form N-CEN, we deduct
the number of BDCs from the total number of small funds that we
estimate (86 small funds-12 BDCs that are small entities = 74 small
funds that file reports on Form N-CEN). See supra footnote 1068 and
accompanying text.
The estimate of 31 funds is based on the percentage of funds we
believe will be subject to the derivatives risk management program
requirement (21% of funds, see supra footnote 849 and accompanying
text, which encompasses the percentage of funds that we estimate
will be subject to the VaR test requirements) plus the percentage of
funds we believe will qualify as limited derivatives users (19% of
funds, see supra footnote 1087 and accompanying text). We assume
generally that funds that will enter into reverse repurchase
agreements or similar financing transactions, and unfunded
commitments either would have to comply with the derivatives risk
management program or would qualify as a limited derivatives user.
See supra footnote 1033. In addition, we include money market funds
in this estimate, as they may report their reliance on rule 18f-4's
provisions for when-issued and forward-settling transactions on Form
N-CEN.
We therefore estimate that approximately 30 small funds that
file reports on Form N-CEN ((86 total small funds less 12 small BDCs
= 74 small funds) x 40% (21% + 19%) = approximately 30 small funds)
+ 1 small money market fund = 31 small funds subject to the new Form
N-CEN reporting requirements.
---------------------------------------------------------------------------
3. Amendments to Rule 6c-11
We are amending the provision in rule 6c-11 excluding leveraged/
inverse ETFs from the scope of that rule so that a leveraged/inverse
ETF may rely on that rule if the fund complies with the applicable
requirements of rule 18f-4.\1126\ Rule 6c-11 permits ETFs that satisfy
certain conditions to operate without obtaining an exemptive order from
the Commission.\1127\ The rule is designed to create a consistent,
transparent, and efficient regulatory framework for such ETFs and
facilitate greater competition and innovation among ETFs. As a
consequence of our amendment to rule 6c-11, and our rescission of the
exemptive orders we previously issued to leveraged/inverse ETFs, the
amendment to rule 6c-11 will newly permit leveraged/inverse ETFs to
come within scope of the rule's exemptive relief. As a result, fund
sponsors will be allowed to operate a leveraged/inverse ETF subject to
the conditions in rules 6c-11 and 18f-4 without obtaining an exemptive
order.
---------------------------------------------------------------------------
\1126\ See supra section II.F.6.
\1127\ Id.
---------------------------------------------------------------------------
Currently, there are 172 leveraged/inverse ETFs.\1128\ As a result
of the amendments, we expect the number of funds relying on rule 6c-11
to increase, and all 172 leveraged/inverse ETFs will rely on rule 6c-
11. However, Commission staff estimates that none of these leveraged/
inverse ETFs is a small entity.\1129\ In addition, we do not estimate
our amendments to rule 6c-11 will change the estimated per-fund cost
burden associated with rule 6c-11. The costs associated with complying
with rule 6c-11 are discussed in the ETFs Adopting Release.\1130\
---------------------------------------------------------------------------
\1128\ See supra footnote 820 and accompanying paragraph.
\1129\ Id.
\1130\ See ETFs Adopting Release, supra footnote 76, at sections
IV-VI.
---------------------------------------------------------------------------
E. Agency Action To Minimize Effect on Small Entities
The RFA directs the Commission to consider significant alternatives
that would accomplish our stated objectives, while minimizing any
significant economic impact on small entities. We considered the
following alternatives for small entities in relation to the adopted
regulations: (1) Exempting funds that are small entities from the
reporting, recordkeeping, and other compliance requirements, to account
for resources available to small entities; (2) establishing different
reporting, recordkeeping, and other compliance requirements or
frequency, to account for resources available to small entities; (3)
consolidating or simplifying the compliance requirements under the
proposal for small entities; and (4) using performance rather than
design standards.
1. Alternative Approaches to Rule 18f-4
We do not believe that exempting small funds from the provisions in
rule 18f-4 would permit us to achieve our stated objectives. Because
rule 18f-4 is an exemptive rule, it will require funds to comply with
new requirements only if they wish to enter into derivatives or certain
other transactions.\1131\ Therefore, if a small entity does not enter
into derivatives or such other transactions as part of its investment
strategy, then the small entity will not be subject to the provisions
of rule 18f-4. In addition, a small fund whose derivatives use is
limited could benefit from the limited derivatives user exception
because it will not be required to adopt a derivatives risk management
program (including all of the program elements). Although smaller funds
that are limited derivatives users will still have to adopt policies
and procedures that are reasonably designed to manage their derivatives
risks, the estimated costs associated with this requirement are
expected to be significantly lower than the cost of adopting a full
derivatives risk management program.\1132\ Thus, we estimate that small
funds that rely on the exception will not have to incur a signification
portion of the costs associated with new rule 18f-4.
---------------------------------------------------------------------------
\1131\ See supra sections II.A and III.E.
\1132\ See supra sections III.C.1 and IV.B.1 (Derivatives Risk
Management Program) and III.C.3 and IV.B.6 (Requirements for Limited
Derivatives Users) for a discussion of estimated costs associated
with these elements of the rule.
---------------------------------------------------------------------------
We estimate that 60% of all funds do not have any exposure to
derivatives or such other transactions.\1133\ This estimate indicates
that many funds, including many small funds, will be unaffected by the
final rule. However, for small funds that are affected by our rule,
providing an exemption for them could subject investors in small funds
that engage in derivatives transactions (or other transactions that the
rule covers) to a higher degree of risk than investors to large funds
that will be required to comply with the elements of the rule.
---------------------------------------------------------------------------
\1133\ See supra footnote 807 and accompanying paragraph.
---------------------------------------------------------------------------
The undue speculation concern expressed in section 1(b)(7) of the
Investment Company Act, and the asset sufficiency concern reflected in
section 1(b)(8) of the Act--both of which the rule is designed to
address--apply to both small as well as large funds. As discussed
throughout this release, we believe that the rule will result in
investor protection benefits, and these benefits should apply to
investors in smaller funds as well as investors in larger funds. We
therefore do not believe it would be appropriate to exempt small funds
from the rule's program requirement or VaR-based limit on fund leverage
risk, or to establish different requirements applicable to funds of
different sizes under these provisions to account for resources
available to small entities. We believe that all of the elements of
rule 18f-4 should work together to produce the anticipated investor
protection benefits, and therefore do not believe it is appropriate to
except smaller funds because we believe this would limit the benefits
to investors in such funds.
We also do not believe that it would be appropriate to subject
small funds to different reporting, recordkeeping, and other compliance
requirements or frequency. Similar to the concerns discussed above, if
the rule included different requirements for small funds, it could
raise investor protection concerns for investors in small funds,
including subjecting small fund investors to a higher degree of risk.
We also believe that all fund investors will benefit from enhanced
Commission monitoring and oversight of the fund
[[Page 83290]]
industry, which we anticipate will result from the disclosure and
reporting requirements.
We do not believe that consolidating or simplifying the compliance
requirements under the rule for small funds would permit us to achieve
our stated objectives. Again, this approach would raise investor
protection concerns for investors in small funds using derivatives and
the other transactions that the final rule addresses.\1134\ However, as
discussed above, the rule contains an exception for limited derivatives
users that we anticipate will subject funds that qualify for this
exception to fewer compliance burdens. We recognize that the risks and
potential impact of derivatives transactions on a fund's portfolio
generally increase as the fund's level of derivatives usage increases
and when funds use derivatives for speculative purposes. Therefore the
rule will entail a less significant compliance burden for funds--
including small funds--that choose to limit their derivatives usage in
the manner that the exception specifies. The final rule, therefore,
includes provisions designed to consider the requirement burdens based
on the fund's use of derivatives (rather than the size of the fund).
---------------------------------------------------------------------------
\1134\ See, e.g., rules 18f-4(d) (reverse repurchase agreements
and similar financing transactions); (e) (unfunded commitments); and
(f) (when-issued, forward-settling, and non-standard settlement
cycle securities).
---------------------------------------------------------------------------
The costs associated with rule 18f-4 will vary depending on the
fund's particular circumstances, and thus the rule could result in
different burdens on funds' resources. In particular, we expect that a
fund that pursues an investment strategy that involves greater
derivatives risk may have greater costs associated with its derivatives
risk management program. For example, a fund that qualifies as a
limited derivatives user under the rule will be exempt from the
requirements to adopt and implement a derivatives risk management
program, to adhere to the rule's VaR-based limit on fund leverage risk,
and to comply with related board oversight and reporting provisions.
The costs of compliance with the rule will vary even for limited
derivatives users, as these funds will be required to adopt policies
and procedures that are ``reasonably designed'' to manage their
derivatives risks. Thus, to the extent a fund that is a small entity
faces relatively little derivatives risk, we believe it will incur
relatively low costs to comply with the rule. However, we believe that
it is appropriate to correlate the costs associated with the rule with
the level of derivatives risk facing a fund, and not necessarily with
the fund's size in light of our investor protection objectives.
Finally, with respect to the use of performance rather than design
standards, the rule generally uses performance standards for all funds
relying on the rule, regardless of size. We believe that providing
funds with the flexibility with respect to investment strategies and
use of derivatives transactions is appropriate, as well as the
derivatives risk management program design. However, the rule also uses
design standards with respect to certain requirements such as complying
with the VaR-based limit on fund leverage risk and the specified
program elements in the derivatives risk management program. For the
reasons discussed above, we believe that this use of design standards
is appropriate to address investor protection concerns, particularly
the concerns expressed in sections 1(b)(7), 1(b)(8), and 18 of the
Investment Company Act.
2. Alternative Approaches to Amendments to Forms N-PORT, N-LIQUID (N-
RN), and N-CEN
We do not believe that the interests of investors would be served
by exempting funds that are small entities from the reporting
requirements. We believe that the form amendments are necessary to help
identify and provide the Commission timely information about funds that
comply with rule 18f-4.\1135\ Exempting small funds from coverage under
all or any part of the form amendments could compromise the
effectiveness of the reporting requirements, which the Commission
believes would not be consistent with its goals of industry oversight
and investor protection. We believe that fund investors will benefit
from enhanced Commission monitoring and oversight of the fund industry,
which we anticipate will result from the new reporting requirements.
---------------------------------------------------------------------------
\1135\ See supra section III.C.9.
---------------------------------------------------------------------------
For similar reasons, although we considered establishing different
reporting requirements for small funds, we believe this would subject
investors in small funds that enter into derivatives transactions to a
higher degree of risk and information asymmetry than investors to large
funds that will be required to comply with the new reporting
requirements for which the reported information will be publicly
available. We also note that registered open- and closed-end management
investment companies, including those that are small entities, have
already updated their systems and have established internal processes
to prepare, validate, and file reports on Forms N-PORT and N-CEN.\1136\
For funds that will be required to file reports on Form N-RN pursuant
to rules 18f-4 and 30b1-10, the vast majority of them are open-end
funds, which already are required to submit the form upon specified
events. With respect to the additional registered closed-end funds and
BDCs newly required to file reports on Form N-RN, we do not believe
they will need more time than other types of funds to comply with the
new reporting requirements, given the limited set of reporting
requirements they will be subject to and the relatively low burden we
estimate of filing reports on Form N-RN.
---------------------------------------------------------------------------
\1136\ See supra footnote 625 (noting that the funds that will
rely on rule 18f-4, other than BDCs, generally are subject to
reporting requirements of Forms N-PORT and N-CEN); see also
Reporting Modernization Adopting Release, Release No. 32936 (Dec. 8,
2017) [82 FR 58731 (Dec. 14, 2017)] (requiring larger registered
fund groups to submit reports on Form N-PORT by April 30, 2019, and
smaller fund groups to submit reports on Form N-PORT by April 30,
2020).
---------------------------------------------------------------------------
We also do not believe that the interests of investors would be
served by consolidating or simplifying the reporting requirements under
the final rule for small funds. Small funds are as vulnerable to the
same potential risks associated with their derivatives use as larger
funds are, and therefore we believe that simplifying or consolidating
the reporting requirements for small funds would not allow us to meet
our stated objectives. Moreover, we believe many of the reporting
requirements involve minimal burden. For example, the Form N-CEN
``checking a box'' reporting requirement is completed on an annual
basis.
Finally, we did not prescribe performance standards rather than
design standards for small funds because we believe this too could
diminish the ability of the new rules to achieve their intended
regulatory purpose by creating inconsistent reporting requirements
between small and large funds, and weakening the benefits of the
reporting requirement for investors in small funds.
3. Alternative Approaches to Rule 6c-11
Rule 6c-11 is designed to modernize the regulatory framework for
ETFs and to create a consistent, transparent, and efficient regulatory
framework.\1137\ The Commission's full Regulatory Flexibility Act
Analysis regarding rule 6c-11, including analysis of significant
alternatives, appears in the 2019 ETFs
[[Page 83291]]
Adopting Release.\1138\ This analysis of alternatives for small
leveraged/inverse ETFs here is consistent with the Commission's
analysis of alternatives for small ETFs in that release.
---------------------------------------------------------------------------
\1137\ See ETFs Adopting Release, supra footnote 76, at section
I.
\1138\ See id. at section VI.
---------------------------------------------------------------------------
We do not believe that permitting or requiring different treatment
for any subset of leveraged/inverse ETFs, including small leveraged/
inverse ETFs, under the amendments to rule 6c-11, and the rule's
related recordkeeping, disclosure and reporting requirements, will
permit us to achieve our stated objectives. Similarly, we do not
believe that we can establish simplified or consolidated compliance
requirements for small leveraged/inverse ETFs under the amendments to
rule 6c-11 without compromising our objectives. The Commission
discussed the bases for this determination (with respect to ETFs other
than leveraged/inverse ETFs) in more detail in the ETFs Adopting
Release, and we are extending that analysis to leveraged/inverse ETFs
in this FRFA.
VI. Statutory Authority
The Commission is adopting new rule 18f-4 under the authority set
forth in sections 6(c), 12(a), 18, 31(a), 38(a), and 61 of the
Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 80a-12(a), 80a-18,
80a-30(a), 80a-37(a), and 80a-60]. The Commission is adopting
amendments to rule 6c-11 under the authority set forth in sections
6(c), 22(c), and 38(a) of the Investment Company Act [15 U.S.C. 80a-
6(c), 22(c), and 80a-37(a)]. The Commission is adopting amendments to
rule 22e-4 under the authority set forth in 22(c), 22(e), 34(b) and
38(a) of the Investment Company Act [15 U.S.C. 80a-22(c), 80a-22(e),
80a-35(b), and 80a-37(a)], the Investment Advisers Act, particularly,
section 206(4) thereof [15 U.S.C. 80b-6(4)], the Exchange Act,
particularly section 10(b) thereof [15 U.S.C. 78a et seq.], the
Securities Act, particularly section 17(a) thereof [15 U.S.C. 77a et
seq.]. The Commission is adopting amendments to rule 30b1-10 under the
authority set forth in sections 22(c), 22(e), 34(b) and 38(a) of the
Investment Company Act [15 U.S.C. 80a-22(c), 80a-22(e), 80a-35(b), and
80a-37(a)], the Investment Advisers Act, particularly, section 206(4)
thereof [15 U.S.C. 80b-6(4)], the Exchange Act, particularly section
10(b) thereof [15 U.S.C. 78a et seq.], the Securities Act, particularly
section 17(a) thereof [15 U.S.C. 77a et seq.]. The Commission is
adopting amendments to Form N-PORT, Form N-LIQUID (re-titled ``Form N-
RN''), Form N-CEN, and Form N-2 under the authority set forth in
sections 6(c), 8, 18, 30, and 38 of the Investment Company Act of 1940
[15 U.S.C. 80a-8, 80a-18, 80a-29, 80a-37, 80a-63], sections 6, 7(a), 10
and 19(a) of the Securities Act of 1933 [15 U.S.C. 77f, 77g(a), 77j,
77s(a)], and sections 10, 13, 15, 23, and 35A of the Exchange Act [15
U.S.C. 78j, 78m, 78o, 78w, and 78ll].
List of Subjects
17 CFR Part 239
Reporting and recordkeeping requirements, Securities.
17 CFR Part 249
Brokers, Fraud, Reporting and recordkeeping requirements,
Securities.
17 CFR Parts 270 and 274
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Rules and Form Amendments
For the reasons set out in the preamble the Commission amends title
17, chapter II of the Code of Federal Regulations as follows:
PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933
0
1. The authority citation for part 239 continues to read, in part, as
follows:
Authority: 15 U.S.C. 77c, 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3,
77sss, 78c, 78 l, 78m,78n, 78o(d), 78o-7 note, 78u-5, 78w(a), 78ll,
78mm, 80a-2(a), 80a-3, 80a-8, 80a-9, 80a-10, 80a-13, 80a-24, 80a-26,
80a-29, 80a-30, and 80a-37; and sec. 107, Pub. L. 112-106, 126 Stat.
312, unless otherwise noted.
* * * * *
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
0
2. The authority citation for part 249 continues to read, in part, as
follows:
Authority: 15 U.S.C. 78a et seq. and 7201 et seq.; 12 U.S.C.
5461 et seq.; 18 U.S.C. 1350; Sec. 953(b), Pub. L. 111-203, 124
Stat. 1904; Sec. 102(a)(3), Pub. L. 112-106, 126 Stat. 309 (2012);
Sec. 107, Pub. L. 112-106, 126 Stat. 313 (2012), and Sec. 72001,
Pub. L. 114-94, 129 Stat. 1312 (2015), unless otherwise noted.
* * * * *
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
0
3. The authority citation for part 270 continues to read, in part, as
follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39,
and Pub. L. 111-203, sec. 939A, 124 Stat. 1376 (2010), unless
otherwise noted.
* * * * *
Section 270.6c-11 is also issued under 15 U.S.C. 80a-6(c) and
80a-37(a).
* * * * *
0
4. Amend Sec. 270.6c-11 by revising paragraph (c)(4) to read as
follows:
Sec. 270.6c-11 Exchange traded-funds.
* * * * *
(c) * * *
(4) An exchange-traded fund that seeks, directly or indirectly, to
provide investment returns that correspond to the performance of a
market index by a specified multiple, or to provide investment returns
that have an inverse relationship to the performance of a market index,
over a predetermined period of time, must comply with all applicable
provisions of Sec. 270.18f-4.
* * * * *
0
5. Section 270.18f-4 is added to read as follows:
Sec. 270.18f-4 Exemption from the requirements of section 18 and
section 61 for certain senior securities transactions.
(a) Definitions. For purposes of this section:
Absolute VaR test means that the VaR of the fund's portfolio does
not exceed 20% of the value of the fund's net assets, or in the case of
a closed-end company that has issued to investors and has then
outstanding shares of a class of senior security that is a stock, that
the VaR of the fund's portfolio does not exceed 25% of the value of the
fund's net assets.
Derivatives exposure means the sum of the gross notional amounts of
the fund's derivatives transactions described in paragraph (1) of the
definition of the term ``derivatives transaction'' of this section, and
in the case of short sale borrowings, the value of the assets sold
short. If a fund's derivatives transactions include reverse repurchase
agreements or similar financing transactions under paragraph (d)(1)(ii)
of this section, the fund's derivatives exposure also includes, for
each transaction, the proceeds received but not yet repaid or returned,
or for which the associated liability has not been extinguished, in
connection with the transaction. In determining derivatives exposure a
fund may convert the notional amount of interest rate derivatives to
10-year bond equivalents and delta adjust the notional amounts of
options contracts and exclude any closed-out positions, if those
positions were closed out with the same counterparty and result in no
credit or market exposure to the fund.
Derivatives risk manager means an officer or officers of the fund's
investment adviser responsible for administering the program and
policies
[[Page 83292]]
and procedures required by paragraph (c)(1) of this section, provided
that the derivatives risk manager:
(1) May not be a portfolio manager of the fund, or if multiple
officers serve as derivatives risk manager, may not have a majority
composed of portfolio managers of the fund; and
(2) Must have relevant experience regarding the management of
derivatives risk.
Derivatives risks means the risks associated with a fund's
derivatives transactions or its use of derivatives transactions,
including leverage, market, counterparty, liquidity, operational, and
legal risks and any other risks the derivatives risk manager (or, in
the case of a fund that is a limited derivatives user as described in
paragraph (c)(4) of this section, the fund's investment adviser) deems
material.
Derivatives transaction means:
(1) Any swap, security-based swap, futures contract, forward
contract, option, any combination of the foregoing, or any similar
instrument (``derivatives instrument''), under which a fund is or may
be required to make any payment or delivery of cash or other assets
during the life of the instrument or at maturity or early termination,
whether as margin or settlement payment or otherwise;
(2) Any short sale borrowing; and
(3) If a fund relies on paragraph (d)(1)(ii) of this section, any
reverse repurchase agreement or similar financing transaction.
Designated index means an unleveraged index that is approved by the
derivatives risk manager for purposes of the relative VaR test and that
reflects the markets or asset classes in which the fund invests and is
not administered by an organization that is an affiliated person of the
fund, its investment adviser, or principal underwriter, or created at
the request of the fund or its investment adviser, unless the index is
widely recognized and used. In the case of a blended index, none of the
indexes that compose the blended index may be administered by an
organization that is an affiliated person of the fund, its investment
adviser, or principal underwriter, or created at the request of the
fund or its investment adviser, unless the index is widely recognized
and used.
Designated reference portfolio means a designated index or the
fund's securities portfolio. Notwithstanding paragraph (2) of the
definition of designated index of this section, if the fund's
investment objective is to track the performance (including a leverage
multiple or inverse multiple) of an unleveraged index, the fund must
use that index as its designated reference portfolio.
Fund means a registered open-end or closed-end company or a
business development company, including any separate series thereof,
but does not include a registered open-end company that is regulated as
a money market fund under Sec. 270.2a-7.
Leveraged/inverse fund means a fund that seeks, directly or
indirectly, to provide investment returns that correspond to the
performance of a market index by a specified multiple (``leverage
multiple''), or to provide investment returns that have an inverse
relationship to the performance of a market index (``inverse
multiple''), over a predetermined period of time.
Relative VaR test means that the VaR of the fund's portfolio does
not exceed 200% of the VaR of the designated reference portfolio, or in
the case of a closed-end company that has issued to investors and has
then outstanding shares of a class of senior security that is a stock,
that the VaR of the fund's portfolio does not exceed 250% of the VaR of
the designated reference portfolio.
Securities portfolio means the fund's portfolio of securities and
other investments, excluding any derivatives transactions, that is
approved by the derivatives risk manager for purposes of the relative
VaR test, provided that the fund's securities portfolio reflects the
markets or asset classes in which the fund invests (i.e., the markets
or asset classes in which the fund invests directly through securities
and other investments and indirectly through derivatives transactions).
Unfunded commitment agreement means a contract that is not a
derivatives transaction, under which a fund commits, conditionally or
unconditionally, to make a loan to a company or to invest equity in a
company in the future, including by making a capital commitment to a
private fund that can be drawn at the discretion of the fund's general
partner.
Value-at-risk or VaR means an estimate of potential losses on an
instrument or portfolio, expressed as a percentage of the value of the
portfolio's assets (or net assets when computing a fund's VaR), over a
specified time horizon and at a given confidence level, provided that
any VaR model used by a fund for purposes of determining the fund's
compliance with the relative VaR test or the absolute VaR test must:
(1) Take into account and incorporate all significant, identifiable
market risk factors associated with a fund's investments, including, as
applicable:
(i) Equity price risk, interest rate risk, credit spread risk,
foreign currency risk and commodity price risk;
(ii) Material risks arising from the nonlinear price
characteristics of a fund's investments, including options and
positions with embedded optionality; and
(iii) The sensitivity of the market value of the fund's investments
to changes in volatility;
(2) Use a 99% confidence level and a time horizon of 20 trading
days; and
(3) Be based on at least three years of historical market data.
(b) Derivatives transactions. If a fund satisfies the conditions of
paragraph (c) of this section, the fund may enter into derivatives
transactions, notwithstanding the requirements of sections 18(a)(1),
18(c), 18(f)(1), and 61 of the Investment Company Act (15 U.S.C. 80a-
18(a)(1), 80a-18(c), 80a-18(f)(1), and 80a-60), and derivatives
transactions entered into by the fund in compliance with this section
will not be considered for purposes of computing asset coverage, as
defined in section 18(h) of the Investment Company Act (15 U.S.C. 80a-
18(h)).
(c) Conditions--(1) Derivatives risk management program. The fund
adopts and implements a written derivatives risk management program
(``program''), which must include policies and procedures that are
reasonably designed to manage the fund's derivatives risks and to
reasonably segregate the functions associated with the program from the
portfolio management of the fund. The program must include the
following elements:
(i) Risk identification and assessment. The program must provide
for the identification and assessment of the fund's derivatives risks.
This assessment must take into account the fund's derivatives
transactions and other investments.
(ii) Risk guidelines. The program must provide for the
establishment, maintenance, and enforcement of investment, risk
management, or related guidelines that provide for quantitative or
otherwise measurable criteria, metrics, or thresholds of the fund's
derivatives risks. These guidelines must specify levels of the given
criterion, metric, or threshold that the fund does not normally expect
to exceed, and measures to be taken if they are exceeded.
(iii) Stress testing. The program must provide for stress testing
to evaluate potential losses to the fund's portfolio in response to
extreme but plausible market changes or changes in market risk factors
that would have a significant adverse effect on the fund's portfolio,
[[Page 83293]]
taking into account correlations of market risk factors and resulting
payments to derivatives counterparties. The frequency with which the
stress testing under this paragraph is conducted must take into account
the fund's strategy and investments and current market conditions,
provided that these stress tests must be conducted no less frequently
than weekly.
(iv) Backtesting. The program must provide for backtesting to be
conducted no less frequently than weekly, of the results of the VaR
calculation model used by the fund in connection with the relative VaR
test or the absolute VaR test by comparing the fund's gain or loss that
occurred on each business day during the backtesting period with the
corresponding VaR calculation for that day, estimated over a one-
trading day time horizon, and identifying as an exception any instance
in which the fund experiences a loss exceeding the corresponding VaR
calculation's estimated loss.
(v) Internal reporting and escalation--(A) Internal reporting. The
program must identify the circumstances under which persons responsible
for portfolio management will be informed regarding the operation of
the program, including exceedances of the guidelines specified in
paragraph (c)(1)(ii) of this section and the results of the stress
tests specified in paragraph (c)(1)(iii) of this section.
(B) Escalation of material risks. The derivatives risk manager must
inform in a timely manner persons responsible for portfolio management
of the fund, and also directly inform the fund's board of directors as
appropriate, of material risks arising from the fund's derivatives
transactions, including risks identified by the fund's exceedance of a
criterion, metric, or threshold provided for in the fund's risk
guidelines established under paragraph (c)(1)(ii) of this section or by
the stress testing described in paragraph (c)(1)(iii) of this section.
(vi) Periodic review of the program. The derivatives risk manager
must review the program at least annually to evaluate the program's
effectiveness and to reflect changes in risk over time. The periodic
review must include a review of the VaR calculation model used by the
fund under paragraph (c)(2) of this section (including the backtesting
required by paragraph (c)(1)(iv) of this section) and any designated
reference portfolio to evaluate whether it remains appropriate.
(2) Limit on fund leverage risk. (i) The fund must comply with the
relative VaR test unless the derivatives risk manager reasonably
determines that a designated reference portfolio would not provide an
appropriate reference portfolio for purposes of the relative VaR test,
taking into account the fund's investments, investment objectives, and
strategy. A fund that does not apply the relative VaR test must comply
with the absolute VaR test.
(ii) The fund must determine its compliance with the applicable VaR
test at least once each business day. If the fund determines that it is
not in compliance with the applicable VaR test, the fund must come back
into compliance promptly after such determination, in a manner that is
in the best interests of the fund and its shareholders.
(iii) If the fund is not in compliance with the applicable VaR test
within five business days:
(A) The derivatives risk manager must provide a written report to
the fund's board of directors and explain how and by when (i.e., number
of business days) the derivatives risk manager reasonably expects that
the fund will come back into compliance;
(B) The derivatives risk manager must analyze the circumstances
that caused the fund to be out of compliance for more than five
business days and update any program elements as appropriate to address
those circumstances; and
(C) The derivatives risk manager must provide a written report
within thirty calendar days of the exceedance to the fund's board of
directors explaining how the fund came back into compliance and the
results of the analysis and updates required under paragraph
(c)(2)(iii)(B) of this section. If the fund remains out of compliance
with the applicable VaR test at that time, the derivatives risk
manager's written report must update the report previously provided
under paragraph (c)(2)(iii)(A) of this section and the derivatives risk
manager must update the board of directors on the fund's progress in
coming back into compliance at regularly scheduled intervals at a
frequency determined by the board.
(3) Board oversight and reporting--(i) Approval of the derivatives
risk manager. A fund's board of directors, including a majority of
directors who are not interested persons of the fund, must approve the
designation of the derivatives risk manager.
(ii) Reporting on program implementation and effectiveness. On or
before the implementation of the program, and at least annually
thereafter, the derivatives risk manager must provide to the board of
directors a written report providing a representation that the program
is reasonably designed to manage the fund's derivatives risks and to
incorporate the elements provided in paragraphs (c)(1)(i) through (vi)
of this section. The representation may be based on the derivatives
risk manager's reasonable belief after due inquiry. The written report
must include the basis for the representation along with such
information as may be reasonably necessary to evaluate the adequacy of
the fund's program and, for reports following the program's initial
implementation, the effectiveness of its implementation. The written
report also must include, as applicable, the derivatives risk manager's
basis for the approval of any designated reference portfolio or any
change in the designated reference portfolio during the period covered
by the report; or an explanation of the basis for the derivatives risk
manager's determination that a designated reference portfolio would not
provide an appropriate reference portfolio for purposes of the relative
VaR test.
(iii) Regular board reporting. The derivatives risk manager must
provide to the board of directors, at a frequency determined by the
board, a written report regarding the derivatives risk manager's
analysis of exceedances described in paragraph (c)(1)(ii) of this
section, the results of the stress testing conducted under paragraph
(c)(1)(iii) of this section, and the results of the backtesting
conducted under paragraph (c)(1)(iv) of this section since the last
report to the board. Each report under this paragraph must include such
information as may be reasonably necessary for the board of directors
to evaluate the fund's response to exceedances and the results of the
fund's stress testing.
(4) Limited derivatives users. (i) A fund is not required to adopt
a program as prescribed in paragraph (c)(1) of this section, comply
with the limit on fund leverage risk in paragraph (c)(2) of this
section, or comply with the board oversight and reporting requirements
as prescribed in paragraph (c)(3) of this section, if:
(A) The fund adopts and implements written policies and procedures
reasonably designed to manage the fund's derivatives risk; and
(B) The fund's derivatives exposure does not exceed 10 percent of
the fund's net assets, excluding, for this purpose, currency or
interest rate derivatives that hedge currency or interest rate risks
associated with one or more specific equity or fixed-income investments
held by the fund (which must be foreign-currency-denominated in the
case of currency derivatives), or the fund's borrowings, provided that
the currency
[[Page 83294]]
or interest rate derivatives are entered into and maintained by the
fund for hedging purposes and that the notional amounts of such
derivatives do not exceed the value of the hedged investments (or the
par value thereof, in the case of fixed-income investments, or the
principal amount, in the case of borrowing) by more than 10 percent.
(ii) If a fund's derivatives exposure exceeds 10 percent of its net
assets, as calculated in accordance with paragraph (c)(4)(i)(B) of this
section, and the fund is not in compliance with that paragraph within
five business days, the fund's investment adviser must provide a
written report to the fund's board of directors informing them whether
the investment adviser intends either:
(A) To reduce the fund's derivatives exposure to less than 10
percent of the fund's net assets promptly, but within no more than
thirty calendar days of the exceedance, in a manner that is in the best
interests of the fund and its shareholders; or
(B) For the fund to establish a program as prescribed in paragraph
(c)(1) of this section, comply with the limit on fund leverage risk in
paragraph (c)(2) of this section, and comply with the board oversight
and reporting requirements as prescribed in paragraph (c)(3) of this
section, as soon as reasonably practicable.
(5) Leveraged/inverse funds. A leveraged/inverse fund that cannot
comply with the limit on fund leverage risk in paragraph (c) of this
section is not required to comply with the limit on fund leverage risk
if, in addition to complying with all other applicable requirements of
this section:
(i) As of October 28, 2020, the fund is in operation; has
outstanding shares issued in one or more public offerings to investors;
and discloses in its prospectus a leverage multiple or inverse multiple
that exceeds 200% of the performance or the inverse of the performance
of the underlying index;
(ii) The fund does not change the underlying market index or
increase the level of leveraged or inverse market exposure the fund
seeks, directly or indirectly, to provide; and
(iii) The fund discloses in its prospectus that it is not subject
to the limit on fund leverage risk in paragraph (c)(2) of this section.
(6) Recordkeeping--(i) Records to be maintained. A fund must
maintain a written record documenting, as applicable:
(A) The fund's written policies and procedures required by
paragraph (c)(1) of this section, along with:
(1) The results of the fund's stress tests under paragraph
(c)(1)(iii) of this section;
(2) The results of the backtesting conducted under paragraph
(c)(1)(iv) of this section;
(3) Records documenting any internal reporting or escalation of
material risks under paragraph (c)(1)(v)(B) of this section; and
(4) Records documenting the reviews conducted under paragraph
(c)(1)(vi) of this section.
(B) Copies of any materials provided to the board of directors in
connection with its approval of the designation of the derivatives risk
manager, any written reports provided to the board of directors
relating to the program, and any written reports provided to the board
of directors under paragraphs (c)(2)(iii)(A) and (C) of this section.
(C) Any determination and/or action the fund made under paragraphs
(c)(2)(i) and (ii) of this section, including a fund's determination
of: The VaR of its portfolio; the VaR of the fund's designated
reference portfolio, as applicable; the fund's VaR ratio (the value of
the VaR of the fund's portfolio divided by the VaR of the designated
reference portfolio), as applicable; and any updates to any VaR
calculation models used by the fund and the basis for any material
changes thereto.
(D) If applicable, the fund's written policies and procedures
required by paragraph (c)(4) of this section, along with copies of any
written reports provided to the board of directors under paragraph
(c)(4)(ii) of this section.
(ii) Retention periods. (A) A fund must maintain a copy of the
written policies and procedures that the fund adopted under paragraph
(c)(1) or (4) of this section that are in effect, or at any time within
the past five years were in effect, in an easily accessible place.
(B) A fund must maintain all records and materials that paragraphs
(c)(6)(i)(A)(1) through (4) and (c)(6)(i)(B) through (D) of this
section describe for a period of not less than five years (the first
two years in an easily accessible place) following each determination,
action, or review that these paragraphs describe.
(7) Current reports. A fund that experiences an event specified in
the parts of Form N-RN [referenced in 17 CFR 274.223] titled ``Relative
VaR Test Breaches,'' ``Absolute VaR Test Breaches,'' or ``Compliance
with VaR Test'' must file with the Commission a report on Form N-RN
within the period and according to the instructions specified in that
form.
(d) Reverse repurchase agreements. (1) A fund may enter into
reverse repurchase agreements or similar financing transactions,
notwithstanding the requirements of sections 18(c) and 18(f)(1) of the
Investment Company Act, if the fund:
(i) Complies with the asset coverage requirements of section 18,
and combines the aggregate amount of indebtedness associated with all
reverse repurchase agreements or similar financing transactions with
the aggregate amount of any other senior securities representing
indebtedness when calculating the asset coverage ratio; or
(ii) Treats all reverse repurchase agreements or similar financing
transactions as derivatives transactions for all purposes under this
section.
(2) A fund relying on paragraph (d) of this section must maintain a
written record documenting whether the fund is relying on paragraph
(d)(1)(i) or (ii) of this section for a period of not less than five
years (the first two years in an easily accessible place) following the
determination.
(e) Unfunded commitment agreements. (1) A fund may enter into an
unfunded commitment agreement, notwithstanding the requirements of
sections 18(a), 18(c), 18(f)(1), and 61 of the Investment Company Act,
if the fund reasonably believes, at the time it enters into such
agreement, that it will have sufficient cash and cash equivalents to
meet its obligations with respect to all of its unfunded commitment
agreements, in each case as they come due. In forming a reasonable
belief, the fund must take into account its reasonable expectations
with respect to other obligations (including any obligation with
respect to senior securities or redemptions), and may not take into
account cash that may become available from the sale or disposition of
any investment at a price that deviates significantly from the market
value of those investments, or from issuing additional equity. Unfunded
commitment agreements entered into by the fund in compliance with this
section will not be considered for purposes of computing asset
coverage, as defined in section 18(h) of the Investment Company Act (15
U.S.C. 80a-18(h)).
(2) For each unfunded commitment agreement that a fund enters into
under paragraph (e)(1) of this section, a fund must document the basis
for its reasonable belief regarding the sufficiency of its cash and
cash equivalents to meet its unfunded commitment agreement obligations,
and maintain a record of this documentation for a period of not less
than five years (the first two years in an easily
[[Page 83295]]
accessible place) following the date that the fund entered into the
agreement.
(f) When issued, forward-settling, and non-standard settlement
cycle securities transactions. Notwithstanding the requirements of
sections 18(a)(1), 18(c), 18(f)(1), and 61 of the Investment Company
Act (15 U.S.C. 80a-18(a)(1), 80a018(c), 80a-18(f)(1), and 80a-60), a
fund or registered open-end company that is regulated as a money market
fund under Sec. 270.2a-7 may invest in a security 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,
provided that: The fund intends to physically settle the transaction;
and the transaction will settle within 35 days of its trade date.
0
6. Amend Sec. 270.22e-4 by revising paragraph (b)(1)(ii)(C), note to
paragraph (b)(1)(ii)(C) and paragraph (b)(1)(iii)(B) to read as
follows:
Sec. 270.22e-4 Liquidity risk management programs.
* * * * *
(b) * * *
(1) * * *
(ii) * * *
(C) For derivatives transactions that the fund has classified as
moderately liquid investments, less liquid investments, and illiquid
investments, identify the percentage of the fund's highly liquid
investments that it has pledged as margin or collateral in connection
with derivatives transactions in each of these classification
categories.
Note to paragraph (b)(1)(ii)(C): For purposes of calculating
these percentages, a fund that has pledged highly liquid investments
and non-highly liquid investments as margin or collateral in
connection with derivatives transactions classified as moderately
liquid, less liquid, or illiquid investments first should apply
pledged assets that are highly liquid investments in connection with
these transactions, unless it has specifically identified non-highly
liquid investments as margin or collateral in connection with such
derivatives transactions.
* * * * *
(iii) * * *
(B) For purposes of determining whether a fund primarily holds
assets that are highly liquid investments, a fund must exclude from its
calculations the percentage of the fund's assets that are highly liquid
investments that it has pledged as margin or collateral in connection
with derivatives transactions that the fund has classified as
moderately liquid investments, less liquid investments, and illiquid
investments, as determined pursuant to paragraph (b)(1)(ii)(C) of this
section.
* * * * *
0
7. Revise Sec. 270.30b1-10 to read as follows:
Sec. 270.30b1-10 Current report for open-end and closed-end
management investment companies.
Every registered open-end management investment company, or series
thereof, and every registered closed-end management investment company,
but not a fund that is regulated as a money market fund under Sec.
270.2a-7, that experiences an event specified on Form N-RN, must file
with the Commission a current report on Form N-RN within the period and
according to the instructions specified in that form.
PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940
0
8. The authority for part 274 continues to read in part as follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m,
78n, 78o(d), 80a-8, 80a-24, 80a-26, 80a-29, and Pub. L. 111-203,
sec. 939A, 124 Stat. 1376 (2010), unless otherwise noted.
* * * * *
0
9. Amend Form N-2 (referenced in Sec. Sec. 239.14 and 274.11a-1) by
revising instruction 2. to sub-item ``3. Senior Securities'' of ``Item
4. Financial Highlights'' to read as follows:
Note: The text of Form N-2 does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form N-2
* * * * *
Item 4. Financial Highlights
* * * * *
3. Senior Securities
* * * * *
Instructions
* * * * *
2. Use the method described in section 18(h) of the 1940 Act [15
U.S.C. 80a-18(h)] to calculate the asset coverage to be set forth in
column (3). However, in lieu of expressing asset coverage in terms of a
ratio, as described in section 18(h), express it for each class of
senior securities in terms of dollar amounts per share (in the case of
preferred stock) or per $1,000 of indebtedness (in the case of senior
indebtedness). A fund should not consider any derivatives transactions,
or any unfunded commitment agreements, that it enters into in
compliance with rule 18f-4 under the Investment Company Act [17 CFR
270.18f-4] for purposes of computing asset coverage.
* * * * *
0
10. Amend Form N-CEN (referenced in Sec. Sec. 249.330 and 274.101) by
adding new Item C.7.n. to read as follows:
Note: The text of Form N-CEN does not, and this amendment will
not, appear in the Code of Federal Regulations.
FORM N-CEN
ANNUAL REPORT FOR REGISTERED INVESTMENT COMPANIES
* * * * *
Item C.7. * * *
n. Rule 18f-4 (17 CFR 270.18f-4):___
i. Is the Fund excepted from the rule 18f-4 (17 CFR 270.18f-4)
program requirement and limit on fund leverage risk under rule 18f-
4(c)(4) (17 CFR 270.18f-4(c)(4))? ___
ii. Is the Fund a leveraged/inverse fund that, under rule 18f-
4(c)(5) (17 CFR 270.18f-4(c)(5)), is excepted from the requirement to
comply with the limit on fund leverage risk described in rule 18f-
4(c)(2) (17 CFR 270.18f-4(c)(2))? ___
iii. Did the Fund enter into any reverse repurchase agreements or
similar financing transactions under rule 18f-4(d)(i) (17 CFR 270.18f-
4(d)(i))? ___
iv. Did the Fund enter into any reverse repurchase agreements or
similar financing transactions under rule 18f-4(d)(ii) (17 CFR 270.18f-
4(d)(ii))? ___
v. Did the Fund enter into any unfunded commitment agreements under
rule 18f-4(e) (17 CFR 270.18f-4(e))? ___
vi. Did the Fund invest in a security on a when-issued or forward-
settling basis, or with a non-standard settlement cycle, in reliance on
rule 18f-4(f) (17 CFR 270.18f-4(f))? ___
* * * * *
0
11. Amend Form N-PORT (referenced in Sec. 274.150) by:
0
a. Adding to General Instruction E. ``Definitions'' the parenthetical
``(including rule 18f-4 solely for Items B.9 and 10 of the Form)'' in
the introductory paragraph, and adding in alphabetical order, the
following definitions:
0
i. ``Absolute VaR Test'';
0
ii. ``Derivatives Exposure'';
0
iii. ``Designated Index'';
0
iv. ``Designated Reference Portfolio'';
0
v. ``Relative VaR Test'';
0
vi. ``Securities Portfolio'';
0
vii. ``Value-at-Risk''; and
0
viii. ``VaR Ratio''.
[[Page 83296]]
0
b. Revising General Instruction F ``Public Availability'' to add the
text ``Derivatives Exposure for limited derivatives users (Item B.9),
median daily VaR (Item B.10.a), median VaR Ratio (Item B.10.b.iii),''
and ``VaR backtesting results (Item B.10.c),''.
0
c. Revising Item B.8 to replace the text ``segregated to cover or
pledged to satisfy margin requirements'' with ``pledged as margin or
collateral,'' and to add after the enumerated liquidity categories the
text ``For purposes of Item B.8, when computing the required
percentage, the denominator should only include assets (and exclude
liabilities) that are categorized by the Fund as Highly Liquid
Investments.''
0
d. Adding Items B.9 and B.10.
The additions and revisions read as follows:
Note: The text of Form N-PORT does not, and this amendment will
not, appear in the Code of Federal Regulations.
FORM N-PORT
MONTHLY PORTFOLIO INVESTMENTS REPORT
* * * * *
GENERAL INSTRUCTIONS
* * * * *
E. Definitions
References to sections and rules in this Form N-PORT are to the
Act, unless otherwise indicated. Terms used in this Form N-PORT have
the same meanings as in the Act or related rules (including rule 18f-4
solely for Items B.9 and 10 of the Form), unless otherwise indicated.
* * * * *
``Absolute VaR Test'' has the meaning defined in rule 18f-4(a) [17
CFR 270.18f-4(a)].
* * * * *
``Derivatives Exposure'' has the meaning defined in rule 18f-4(a)
[17 CFR 270.18f-4(a)].
* * * * *
``Designated Index'' has the meaning defined in rule 18f-4(a) [17
CFR 270.18f-4(a)].
* * * * *
``Designated Reference Portfolio'' has the meaning defined in rule
18f-4(a) [17 CFR 270.18f-4(a)].
* * * * *
``Relative VaR Test'' has the meaning defined in rule 18f-4(a) [17
CFR 270.18f-4(a)].
* * * * *
``Securities Portfolio'' has the meaning defined in rule 18f-4(a)
[17 CFR 270.18f-4(a)].
* * * * *
``Value-at-Risk'' or VaR has the meaning defined in rule 18f-4(a)
[17 CFR 270.18f-4(a)].
* * * * *
``VaR Ratio'' means the value of the Fund's portfolio VaR divided
by the VaR of the Designated Reference Portfolio.
* * * * *
F. Public Availability
Information reported on Form N-PORT for the third month of each
Fund's fiscal quarter will be made publicly available 60 days after the
end of the Fund's fiscal quarter.
The SEC does not intend to make public the information reported on
Form N-PORT for the first and second months of each Fund's fiscal
quarter that is identifiable to any particular fund or adviser, or any
information reported with respect to a Fund's Highly Liquid Investment
Minimum (Item B.7), derivatives transactions (Item B.8), Derivatives
Exposure for limited derivatives users (Item B.9), median daily VaR
(Item B.10.a), median VaR Ratio (Item B.10.b.iii), VaR backtesting
results (Item B.10.c), country of risk and economic exposure (Item
C.5.b), delta (Items C.9.f.v, C.11.c.vii, or C.11.g.iv), liquidity
classification for portfolio investments (Item C.7), or miscellaneous
securities (Part D), or explanatory notes related to any of those
topics (Part E) that is identifiable to any particular fund or adviser.
However, the SEC may use information reported on this Form in its
regulatory programs, including examinations, investigations, and
enforcement actions.
* * * * *
PART B. * * *
Item B.8. Derivatives Transactions. For portfolio investments of
open-end management investment companies, provide the percentage of the
Fund's Highly Liquid Investments that it has pledged as margin or
collateral in connection with derivatives transactions that are
classified among the following categories as specified in rule 22e-4
[17 CFR 270.22e-4]:
1. Moderately Liquid Investments
2. Less Liquid Investments
3. Illiquid Investments
For purposes of Item B.8, when computing the required percentage, the
denominator should only include assets (and exclude liabilities) that
are categorized by the Fund as Highly Liquid Investments.
Item B.9. Derivatives Exposure for limited derivatives users. If
the Fund is excepted from the rule 18f-4 [17 CFR 270.18f-4] program
requirement and limit on fund leverage risk under rule 18f-4(c)(4) [17
CFR 270.18f-4(c)(4)], provide the following information:
a. Derivatives exposure (as defined in rule 18f-4(a) [17 CFR
270.18f-4(a)]), reported as a percentage of the Fund's net asset value.
b. Exposure from currency derivatives that hedge currency risks, as
provided in rule 18f-4(c)(4)(i)(B) [17 CFR 270.18f-4(c)(4)(i)(B)],
reported as a percentage of the Fund's net asset value.
c. Exposure from interest rate derivatives that hedge interest rate
risks, as provided in rule 18f-4(c)(4)(i)(B) [17 CFR 270.18f-
4(c)(4)(i)(B)], reported as a percentage of the Fund's net asset value.
d. The number of business days, if any, in excess of the five-
business-day period described in rule 18f-4(c)(4)(ii) [17 CFR 270.18f-
4(c)(4)(ii)], that the Fund's derivatives exposure exceeded 10 percent
of its net assets during the reporting period.
Item B.10. VaR information. For Funds subject to the limit on fund
leverage risk described in rule 18f-4(c)(2) [17 CFR 270.18f-4(c)(2)],
provide the following information, as determined in accordance with the
requirement under rule 18f-4(c)(2)(ii) to determine the fund's
compliance with the applicable VaR test at least once each business
day:
a. Median daily VaR during the reporting period, reported as a
percentage of the Fund's net asset value.
b. For Funds that were subject to the Relative VaR Test during the
reporting period, provide:
i. As applicable, the name of the Fund's Designated Index, or a
statement that the Fund's Designated Reference Portfolio is the Fund's
Securities Portfolio.
ii. As applicable, the index identifier for the Fund's Designated
Index.
iii. Median VaR Ratio during the reporting period, reported as a
percentage of the VaR of the Fund's Designated Reference Portfolio.
c. Backtesting Results. Number of exceptions that the Fund
identified as a result of its backtesting of its VaR calculation model
(as described in rule 18f-4(c)(1)(iv) [17 CFR 270.18f-4(c)(1)(iv)]
during the reporting period.
* * * * *
0
12. Revise Sec. 274.223 to read as follows:
Sec. 274.223 Form N-RN, Current report, open- and closed-end
investment company reporting.
This form shall be used by registered open-end management
investment companies, or series thereof, and closed-end management
investment companies, to file reports pursuant to
[[Page 83297]]
Sec. 270.18f-4(c)(7) and Sec. 270.30b1-10 of this chapter.
0
13. Revise Form N-LIQUID (referenced in Sec. 274.223) and its title to
read as follows:
Note: The text of Form N-RN does not, and this amendment will
not, appear in the Code of Federal Regulations.
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM N-RN
CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT COMPANIES AND
BUSINESS DEVELOPMENT COMPANIES
Form N-RN is to be used by a registered open-end management
investment company or series thereof, but not including a fund that is
regulated as a money market fund under rule 2a-7 under the Act (17 CFR
270.2A-7) (a ``registered open-end fund''), a registered closed-end
management investment company (a ``registered closed-end fund''), or a
closed-end management investment company that has elected to be
regulated as a business development company (a ``business development
company''), to file current reports with the Commission pursuant to
rule 18f-4(c)(7) and rule 30b1-10 under the Investment Company of 1940
Act [15 U.S.C. 80a] (``Act'') (17 CFR 270.18f-4(c)(7); 17 CFR 270.30b1-
10). The Commission may use the information provided on Form N-RN in
its regulatory, disclosure review, inspection, and policymaking roles.
General Instructions
A. Rules as To Use of Form N-RN
(1) Form N-RN is the reporting form that is to be used for current
reports of registered open-end funds (not including funds that are
regulated as money market funds under rule 2a-7 under the Act),
registered closed-end funds, and business development companies
(together, ``registrants'') required by, as applicable, section 30(b)
of the Act and rule 30b1-10 under the Act, as well as rule 18f-4(c)(7)
under the Act. The Commission does not intend to make public
information reported on Form N-RN that is identifiable to any
particular registrant, although the Commission may use Form N-RN
information in an enforcement action.
(2) Unless otherwise specified, a report on this Form N-RN is
required to be filed, as applicable, within one business day of the
occurrence of the event specified in Parts B-G of this form. If the
event occurs on a Saturday, Sunday, or holiday on which the Commission
is not open for business, then the one business day period shall begin
to run on, and include, the first business day thereafter.
(3) For registered open-end funds required to comply with rule 22e-
4 under the Investment Company Act [17 CFR 270.22e-4], complete Parts
B-D of this form, as applicable. For registrants that are subject to a
VaR test under rule 18f-4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)],
complete Parts E-G of this form, as applicable.
B. Application of General Rules and Regulations
The General Rules and Regulations under the Act contain certain
general requirements that are applicable to reporting on any form under
the Act. These general requirements should be carefully read and
observed in the preparation and filing of reports on this form, except
that any provision in the form or in these instructions shall be
controlling.
C. Information To Be Included in Report Filed on Form N-RN
Upon the occurrence of the event specified in Parts B-G of Form N-
RN, as applicable, a registrant must file a report on Form N-RN that
includes information in response to each of the items in Part A of the
form, as well as each of the items in the applicable Parts B-G of the
Form.
D. Filing of Form N-RN
A registrant must file Form N-RN in accordance with rule 232.13 of
Regulation S-T (17 CFR part 232). Form N-RN must be filed
electronically using the Commission's Electronic Data Gathering,
Analysis and Retrieval System (``EDGAR'').
E. Paperwork Reduction Act Information
A registrant is not required to respond to the collection of
information contained in Form N-RN unless the form displays a currently
valid Office of Management and Budget (``OMB'') control number. Please
direct comments concerning the accuracy of the information collection
burden estimate and any suggestions for reducing the burden to the
Secretary, Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549-1090. The OMB has reviewed this collection of
information under the clearance requirements of 44 U.S.C. 3507.
F. Definitions
References to sections and rules in this Form N-RN are to the
Investment Company Act (15 U.S.C 80a), unless otherwise indicated.
Terms used in this Form N-RN have the same meaning as in the Investment
Company Act, rule 22e-4 under the Investment Company Act (for Parts B-D
of the Form), or rule 18f-4 under the Investment Company Act (for Part
E-G of the Form), unless otherwise indicated. In addition, as used in
this Form N-RN, the term registrant means the registrant or a separate
series of the registrant, as applicable.
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM N-RN
CURRENT REPORT FOR REGISTERED MANAGEMENT INVESTMENT COMPANIES AND
BUSINESS DEVELOPMENT COMPANIES
PART A. General Information
Item A.1. Report for [mm/dd/yyyy].
Item A.2. Name of Registrant.
Item A.3. CIK Number of registrant.
Item A.4. Name of Series, if applicable.
Item A.3. EDGAR Series Identifier, if applicable.
Item A.4. Securities Act File Number, if applicable.
Item A.5. Provide the name, email address, and telephone number of
the person authorized to receive information and respond to questions
about this Form N-RN.
PART B. Above 15% Illiquid Investments
If more than 15 percent of the registrant's net assets are, or
become, illiquid investments that are assets as defined in rule 22e-4,
then report the following information:
Item B.1. Date(s) on which the registrant's illiquid investments
that are assets exceeded 15 percent of its net assets.
Item B.2. The current percentage of the registrant's net assets
that are illiquid investments that are assets.
Item B.3. Identification of illiquid investments. For each
investment that is an asset that is held by the registrant that is
considered illiquid, disclose (1) the name of the issuer, the title of
the issue or description of the investment, the CUSIP (if any), and at
least one other identifier, if available (e.g., ISIN, Ticker, or other
unique identifier (if ticker and ISIN are not available)) (indicate the
[[Page 83298]]
type of identifier used), and (2) the percentage of the fund's net
assets attributable to that investment.
PART C. At or Below 15% Illiquid Investments
If a registrant that has filed Part B of Form N-RN determines that
its holdings in illiquid investments that are assets have changed to be
less than or equal to 15 percent of the registrant's net assets, then
report the following information:
Item C.1. Date(s) on which the registrant's illiquid investments
that are assets fell to or below 15 percent of net assets.
Item C.2. The current percentage of the registrant's net assets
that are illiquid investments that are assets.
PART D. Assets That Are Highly Liquid Investments Below the Highly
Liquid Investment Minimum
If a registrant's holdings in assets that are highly liquid
investments fall below its highly liquid investment minimum for more
than 7 consecutive calendar days, then report the following
information:
Item D.1. Date(s) on which the registrant's holdings of assets that
are highly liquid investments fell below the fund's highly liquid
investment minimum.
PART E. Relative VaR Test Breaches
If a registrant is subject to the relative VaR test under rule 18f-
4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)], and the fund determines that it
is not in compliance with the relative VaR test and has not come back
into compliance within 5 business days after such determination,
provide:
Item E.1. The dates on which the VaR of the registrant's portfolio
exceeded 200% or 250% (as applicable under rule 18f-4 [17 CFR 270.18f-
4]) of the VaR of its designated reference portfolio.
Item E.2. The VaR of the registrant's portfolio on the dates each
exceedance occurred.
Item E.3. The VaR of the registrant's designated reference
portfolio on the dates each exceedance occurred.
Item E.4. As applicable, either the name of the registrant's
designated index, or a statement that the registrant's designated
reference portfolio is the registrant's securities portfolio.
Item E.5. As applicable, the index identifier for the registrant's
designated index.
PART F. Absolute VaR Test Breaches
If a registrant is subject to the absolute VaR test under rule 18f-
4(c)(2)(i) [17 CFR 270.18f-4(c)(2)(i)], and the fund determines that it
is not in compliance with the absolute VaR test and has not come back
into compliance within 5 business days after such determination,
provide:
Item F.1. The dates on which the VaR of the registrant's portfolio
exceeded 20% or 25% (as applicable under rule 18f-4 [17 CFR 270.18f-4])
of the value of the registrant's net assets.
Item F.2. The VaR of the registrant's portfolio on the dates each
exceedance occurred.
Item F.3. The value of the registrant's net assets on the dates
each exceedance occurred.
PART G. Compliance With VaR Test
If a registrant that has filed Part E or Part F of Form N-RN has
come back into compliance with either the relative VaR test or the
absolute VaR test, as applicable, then report the following
information:
Item G.1. Dates on which the VaR of the registrant's portfolio
exceeded applicable VaR limit described in Item E.1 or Item F.1.
Item G.2. The current VaR of the registrant's portfolio.
PART H. Explanatory Notes (if any)
A registrant may provide any information it believes would be
helpful in understanding the information reported in response to any
Item of this Form.
Signatures
Pursuant to the requirements of the Investment Company Act of 1940, the
registrant has duly caused this report to be signed on its behalf by
the undersigned hereunto duly authorized.
-----------------------------------------------------------------------
(Registrant)
Date-------------------------------------------------------------------
-----------------------------------------------------------------------
(Signature)*
* Print name and title of the signing officer under his/her
signature.
By the Commission.
Dated: November 2, 2020.
Vanessa A. Countryman
Secretary.
[FR Doc. 2020-24781 Filed 12-18-20; 8:45 am]
BILLING CODE 8011-01-P