Rule18f-4: An look at the derivative risk management program and value-at-risk

May 11, 2021

The U.S. Securities and Exchange Commission’s (SEC) new rule places compliance requirements on funds with derivatives exposure of more than 10% of net assets. Learn the details here.

 

(Part 3 of a 3-part series)

Rule 18f-4 (the “Rule”) was adopted by the SEC in 2020 for several reasons:

  • To address the investor protection purposes and concerns underlying Section 18 of the Investment Company Act of 1940, as amended
  • To provide an updated, more comprehensive approach to the regulation of funds’ use of derivatives and other transactions
  • In this article, we’ll explore the details of the rule’s two major conceptual structures: a derivative risk management program and value-at-risk (VaR).
     

It’s important to note that these requirements don’t apply to funds relying on the “Limited Derivatives User” exception provided in the Rule, designed to minimize the regulatory burden on funds whose derivatives exposure is no more than 10% of its net assets. However, for funds that fall above the 10% threshold, the Rule outlines compliance requirements for the derivatives risk management program including the VaR.

 

Derivative risk management program

The Program must be designed to align derivatives transactions with the fund’s investment objectives, policies and restrictions, its risk profile and relevant regulatory requirements. The Program must be reasonably designed to manage a fund’s derivatives risk and should take into account the way the fund uses derivatives – whether in a way that increases portfolio risks or conversely, to reduce portfolio risks or facilitate efficient portfolio management.

The Program must provide for the establishment, maintenance and enforcement of investment, risk management and related guidelines that provide for the measurable criteria, metrics or thresholds related to a fund’s derivatives risks (risk guidelines). The risk guidelines must do the following: 

  • Specify levels of the given metric that a fund does not normally expect to exceed and the measures to be taken if they are exceeded 
  • Address the risks a fund would be required to routinely monitor as part of its Program
     

The Program must be administered by an officer or officers of the fund’s investment adviser, who is designated as the derivatives risk manager (DRM). The DRM must be approved by the Board and must inform the Board of any material risks arising from the fund’s derivatives use. These would include risks that are derived when a fund exceeds its guidelines, as well as risks derived by the results of the fund’s stress testing. If the DRM is a single person, that person may not be the fund’s portfolio manager. If multiple officers serve as the DRM, a majority of these persons may not be composed of portfolio managers.

The Program must provide for stress testing to evaluate a fund’s potential losses under stressed conditions. This must involve testing all the fund’s investments, not just the derivative transactions, and it must evaluate potential losses in response to “extreme but plausible” market risk factors that would have a significant adverse effect on the fund’s portfolio. Stress-testing must be performed at least weekly.

The Program must also provide for backtesting to monitor effectiveness of the fund’s VaR model. This too must be performed at least weekly, taking into account the fund’s actual gains or losses on each business day that occurred during the weekly backtesting period. 

 

Value-at-risk

VaR is an estimate of a portfolio’s potential losses over a given time horizon at a specified confidence level.

The VaR test must be performed daily, at a consistent time. And if the fund is found to be out of compliance, it must come back into compliance promptly after such determination and in a matter that serves “the best interests of the fund and its shareholders.” If the fund is still not in compliance after five business days, the DRM must report this fact to the Board, and a report must be made to the SEC on Form N-RN (formerly known as Form N-LIQUID).

The default according to Rule 18f-4 is a “relative VaR test” that compares the fund’s VaR to the VaR of a “designated reference portfolio.” There are two options for the designated reference portfolio: 

  • An index that meets certain requirements 
  • The fund’s own securities portfolio (excluding derivatives transactions)

An open-end fund will satisfy the relative VaR test if its portfolio VaR does not exceed 200% of the VaR of its designated reference portfolio. The relative VaR limit for a closed-end fund is 250%.

An alternative to the relative VaR test may be used if a fund’s DRM reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for the purpose of the relative VaR test. This “absolute VaR test” will be satisfied if an open-end fund’s portfolio VaR does not exceed 20% of the value of the fund’s net assets. The absolute VaR limits for a closed-end fund is 25%. 

 

Additional requirements provided in the Rule

Rule 18f-4 provides additional information regarding compliance requirements. Topics include:

  • Reverse repurchase agreements and similar financing transactions
  • Alternatives for certain leveraged/inverse funds
  • New recordkeeping obligations
  • Changes to reporting requirements, including Forms N-CEN, N-PORT and N-RN
  • Board reporting requirements

 

Additional resources

The changes associated with Rule 18f-4 are significant, so we’re publishing a three-part article series to provide a high-level guide to the Rule’s major provisions.

  • In part 1, we provide a general overview of the new Rule and its regulatory updates.
  • In part 2, we explain the qualifying criteria for funds relying on the limited derivatives user exception and review requirements they will have to meet under Rule 18f-4.
  • We also developed a timeline that highlights key tasks and considerations for funds to help ease your transition into this new regulatory framework. Download the timeline PDF here.

 

At U.S. Bank, we’re here to help you with implementing Rule 18f-4. Please contact us or reach out to your relationship manager if you have immediate questions about this new regulatory framework. To learn more about our other products and solutions, visit usbank.com/globalfundservices.

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