Rule 18f-4: The limited use exception

May 11, 2021

The U.S. Securities and Exchange Commission’s (SEC) new rule provides an exception for funds with limited derivatives exposure. Learn more about this exception, how to qualify and what obligations it requires.


(Part 2 of a 3-part series)

The new regulatory framework for derivatives provides a streamlined path to compliance for funds whose derivatives exposure falls below a specified threshold. Funds meeting this exception, known as “limited derivatives users,” will not be required to establish a derivatives risk management program or implement value-at-risk (VaR) testing.

The SEC estimates in the Rule’s adopting release that a significant number of funds will qualify for the limited derivatives user exception. The SEC expects that many funds with exposure below the threshold of 10% of net assets will choose to maintain that level, while some funds over the threshold may decide to reduce their exposure in order to qualify for the exception.

In this article, we’ll discuss the criteria and steps involved in qualifying for the limited derivatives user exception. Then we’ll discuss obligations under the Rule for funds relying on the exception.


Qualifying for the exception

What is necessary to qualify for the limited derivatives user exception?

A fund must have derivatives exposure that is no more than 10% of its net assets and is generally permitted to exclude from its calculations derivatives transactions that are used to hedge currency and interest rate risks. If currency hedges are excluded, the equity or fixed-income investments being hedged must be foreign-currency denominated – and the notional amounts of such derivatives may not exceed the value of the hedged instruments by more than 10%.

How is “derivatives exposure” defined by the Rule?

Derivatives exposure is defined as the sum of the following:

  • The gross notional amounts of a fund’s derivatives transactions such as futures, swaps, and options.
  • The value of any asset sold short in the case of short-sale borrowings.

For purposes of calculating derivatives exposure (and therefore, whether a fund qualifies for the exception), derivatives instruments that don’t involve a payment obligation aren’t included in a fund’s derivatives exposure. 

What other adjustments and exclusions are permitted under the Rule in calculating eligibility for limited derivatives user status?

In order to address the limitations associated with notional measures of market exposure, funds may make these adjustments:

  • Convert the notional amount of interest rate derivatives to 10-year bond equivalents.
  • Delta-adjust the notional amount of options contracts.
  • Exclude any closed-out positions from its derivatives exposure.

However, positions must be closed out with the same counterparty and must result in no credit or market exposure to the fund. 



If a fund qualifies for the limited derivatives user exception, what obligations does it have under the Rule?

Limited derivatives users must adopt and implement written policies and procedures that are reasonably designed to manage the fund’s derivatives risks. The SEC in its adopting release describes it this way:

“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 have more extensive policies and procedures.”

It’s important to note that funds relying on the limited derivatives use exception must still manage their derivatives risks – even though leverage risk may not be present. There are other risks for a fund to consider, such as counterparty risks and the risk of selling investments to meet a margin call. Therefore, the fund’s policies and procedures should address its compliance with the 10% threshold and continually support the fund’s reliance on the exception.

What happens if a fund relying on the limited derivatives user exception exceeds the 10% threshold?

If a fund’s derivatives exposure exceeds the 10% threshold for five business days, the fund’s investment adviser must provide a written report to the fund’s board of directors, identifying which of two remediation paths is being undertaken. The choices are:

  • Treat the exceedance as “temporary,” in which case the exposure level must be returned to compliance “promptly,” but within no more than thirty calendar days.
  • Establish a derivatives risk management program and comply with the VaR-based limit on fund leverage risk as soon as “reasonably practicable.” 

In either case, the fund’s next Form N-PORT filing must specify the number of business days (after the initial five-day period) that the fund exceeded the 10% threshold.

A fund cannot repeatedly go over 10%, even if it returns to compliance promptly, without calling into question its reliance on the limited derivatives user exception. In order for a fund’s compliance policies and procedures under Rule 38a-1 to be reasonably designed to achieve compliance with the Rule, they should be designed to prevent such repeated exceedances. 


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 3, we describe additional details about requirements and effects of the Rule for funds above the 10% threshold.
  • 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

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