(Part 1 of a 3-part series)
The past few years have seen an array of efforts from the SEC to improve transparency and streamline regulatory requirements. A key element in that effort is the new Rule 18f-4 (the “Rule”), which is intended “to provide an updated, comprehensive approach to the regulation of funds’ use of derivatives,”1 while enhancing investor protections.
The Rule applies to registered investment companies, including the following, and allows these entities to enter into derivative transactions in excess of the Section 18 limits, subject to certain requirements:
- Mutual funds (other than money market funds that operate under Rule 2a-7 under the Investment Company Act of 1940, as amended)
- Exchange-traded funds
- Closed-end funds
- Business development companies
The key requirements include adoption of a derivatives risk management program (“Program”) and limits on the amount of leverage-related risk a fund may hold based on the amount of value-at-risk (VaR). Both of these aspects have a considerable amount of detail and will entail preparation during the 18-month period between the effective date (Feb. 19, 2021) and the compliance date (Aug. 19, 2022).
At U. S. Bank, our Global Fund Services team is already determining how we can best assist our clients with their compliance obligations. Below, we’ll present a general overview of the Rule – with more detailed analysis provided in additional articles.
The new Rule will impose measurable limits on the overall portfolio exposure of affected funds and require them to implement a formal risk management program. Funds with derivatives exposure of less than 10% of their net assets (excluding certain currency and interest rate hedging transactions) are considered “limited derivatives users.” This group, while exempt from the majority of the Rule’s requirements, will still be affected.
The following questions and answers apply to funds above the 10% threshold.
What are considered “derivative transactions” for the purposes of this Rule?
- Any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (a “derivatives instrument”), under which a fund is or may be required to make any payment or delivery of cash or other assets (i.e., the issuance of a senior security because the transaction involves a contractual future payment obligation)
- Any short sale borrowing.
- Reverse repurchase agreements and similar financing transactions, for those funds that choose to treat these transactions as derivatives transactions under the Rule.
What are the Rule’s major conditions?
- Limitations on a fund’s leverage risk, implemented by monitoring VaR testing.
- Adoption of a derivatives risk management program (Program).
- Oversight by the fund’s board of directors/trustees (Board).
What is required for a compliant Program?
- Appointment of a derivatives risk manager (DRM), who must be an officer (or officers) of the fund’s investment adviser
o The DRM will administer the Program and have a direct reporting line to the Board.
- Establishment, maintenance and enforcement of risk guidelines; formalizing risk identification, guidelines, and assessment that provide for the measurable criteria, metrics, or thresholds related to a fund’s derivatives risks
- Implementation of stress testing to evaluate a fund’s potential losses under stressed conditions, as well as backtesting of the VaR calculation model that the fund uses
- Provisions for internal reporting and escalation of certain matters to a fund’s Board.
What is required under the Rule to address risk?
- Implementation of VaR calculations is required, which estimate a fund’s potential losses over a given time period at a set confidence level.
- By default, the Rule requires a “relative VaR test” that compares the fund’s VaR to the VaR of a “designated reference portfolio.” However, an “absolute VaR test” may be used instead 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.
- VaR testing must be performed daily, at a consistent time, and any result in violation of established risk limitations must be addressed promptly.
- Weekly stress testing must be performed to evaluate potential losses to the fund’s portfolio.
- Weekly backtesting is also required. A fund must compare its actual gain or loss for each business day with the applicable VaR.
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 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.
- 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 usbank.com/globalfundservices.
Information is for general information only and should not be interpreted as legal advice.
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