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Regulation and Compliance > Federal Regulation > SEC

SEC Floats Rule to Rein In Funds’ Use of Derivatives

By Melanie Waddell

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The Securities and Exchange Commission released for public comment Friday a proposed rule that would restrict and limit mutual funds and exchange-traded funds’ use of derivatives, and also require such funds to put risk management measures in place.

SEC Chairwoman Mary Jo White said at the meeting at SEC headquarters in Washington that the proposal is part of the Commission’s agenda to identify and address risks in today’s asset management industry, which has more than $18 trillion in registered fund assets and $67 trillion in assets managed by registered investment advisors. 

“Inadequate controls on the use of derivatives can create significant risks for funds themselves and investors, as well as raise questions about the potential impacts on the broader financial system,” White said.

The proposal would create a “modernized, comprehensive regulatory framework to reflect the evolution of funds’ use of derivatives,” and would require funds to meet certain conditions to monitor and manage their risk in order to rely on an exemption from certain statutory restrictions, and in some cases, would also limit a fund’s use of derivatives, she said.  

Under the proposed rule, which is out for a 90-day comment period, a fund would be required to comply with one of two alternative portfolio limitations designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions. 

–Under the exposure-based portfolio limit, a fund would be required to limit its aggregate exposure to 150% of the fund’s net assets. A fund’s “exposure” generally would be calculated as the aggregate notional amount of its derivatives transactions, together with its obligations under financial commitment transactions and certain other transactions. 

–Under the risk-based portfolio limit, a fund would be permitted to obtain exposure up to 300% of the fund’s net assets, provided that the fund satisfies a risk-based test (based on value-at-risk). This test is designed to determine whether the fund’s derivatives transactions, in aggregate, result in a fund portfolio that is subject to less market risk than if the fund did not use derivatives.      

The SEC rule would also require a fund to segregate assets equal to the amount that the fund would pay if the fund exited the derivatives transaction at the time of the determination, and to also segregate an additional risk-based coverage amount representing a reasonable estimate of the potential amount the fund would pay if the fund exited the derivatives transaction under stressed conditions. SEC Commissioner Luis Aguilar, who will be leaving his post by the end of the month, stated at the meeting that as “demonstrated by the 2008 financial crisis, and the economic turmoil that followed, years of regulatory complacency and deregulation enabled an unregulated derivatives marketplace to cause significant losses to investors.”

He noted that the global derivatives market “remains huge, at an amount estimated in excess of $630 trillion in notional value worldwide,” with a “notable growth in the use of derivatives by registered investment companies.” That growth, he continued, “is particularly remarkable with alternative strategy funds, which tend to use derivatives in the hope of achieving higher returns.”

In 2010, Aguilar said, there were only about 590 alternative strategy funds, with around $320 billion in assets under management. By the end of 2014, however, there were more than 1,100 such funds, with total assets under management in excess of $469 billion.

Paul Schott Stevens, president and CEO of the Investment Company Institute, said after the rule plan was put out for comment that funds’ use of derivatives “is governed by the vital safeguards of the Investment Company Act of 1940, which ensure transparency and disclosure to shareholders,” and that while ICI welcomes the SEC’s examination of these rules, the “proposal is complex and it will take the fund industry some time to fully assess its breadth and implications.”

— Check out Bill Gross Doesn’t Let SEC Guidelines Stop Big Bond Bets on ThinkAdvisor.

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