The August 19, 2022 compliance date of rule 18f-4 of the Investment Company Act of 1940 is approaching. The new rule is described by the Securities and Exchange Commission as an effort “to provide an updated, comprehensive approach to the regulation of funds’ “use of derivatives and certain other transactions”. It imposes derivatives management duties on mutual funds (other than money market funds), exchange traded funds, registered closed-end funds, and business development companies. An example of a necessary step in adhering to the new policy is a written derivatives risk management program, relying upon stress testing, led by a Derivatives Risk Manager. In addition, there are Value at Risk (VaR) measurements of leverage risk and Board derivatives oversight and reporting.
There is an exemption from those requirements for firms which qualify as a “Limited Derivatives User”. However, it’s not simply a matter of stating “this doesn’t apply to us.” In this article, we will review what will be involved in operating as a Limited Derivatives User.
What is a Limited Derivatives User? A fund qualifies if it limits its derivative exposure to 10% of its net assets. This exposure includes the gross notional value of securities including futures, options, and swaps. It also includes the value of any asset which is sold short. It may exclude some currency and interest rate hedging transactions, some repo and reverse repo transactions, and derivatives which “do not involve future payment obligations”, as these are not conveying derivatives risk by the SEC. Accurately measuring and properly aggregating total reportable derivative exposure is not something that many funds have needed to do in the past. Under the rule, the exposure amounts for derivatives must be calculated on gross notional amounts, meaning the sum of all the absolute values of the notional rather than the net of the long and short positions.
What does a Limited Derivatives User need to do? Although not subject to the more expansive Derivatives Risk Management program, a Limited Derivatives User must also commit to reasonably managing all derivatives risk for which it does incur (even if it remains under the 10% ceiling). These risks can include counterparty and margin risks, and delta-adjusted exposure for options. Risk Management must ensure there are written policy and procedures to support the fund’s typical derivative usage.
What happens if a fund breaches the ceiling? A fund will have 5 business days to cure a breach. If that is not possible or practical, the fund must report to its Board whether it plans to reduce its derivative exposure below the 10% limit within thirty calendar days (“temporary exceedance”). Alternatively, the firm may adopt the Derivatives Risk Management Program which entails the full requirements and forgo the exemption.
Will there be additional reporting requirements for a Limited Derivatives User? The number of business days during which the fund exceeded the 10% ceiling must be reported on form N-PORT, including details of any such breaches and its remediation. This implies that the actual derivative exposure will need to be calculated frequently enough to comply with this requirement. Form N-CEN will also require disclosure that the firm is relying upon the Limited Derivatives User designation.
The SEC estimates that about 21% of funds hold some derivatives and will not qualify as a Limited Derivatives User under the final rule. As with any new and improved regulations, there are many questions, which are not addressed here. However, unless you’re running an exempt money market fund, the chances are, you’ll have some homework due very shortly.
IMP has experience managing multiple facets of derivatives use by asset managers. Reach out to us at www.impconsults.com to find out more.
