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SEC Proposes Derivatives Rules

Last Friday, the SEC voted 3-1 to propose a new rule related to the use of derivatives by mutual funds, closed-end funds, ETFs, and business development companies. At the open meeting, SEC Chair Mary Jo White noted that “[d]erivatives can raise risks for a fund, including risks related to leverage, so it is important to require funds to monitor and manage derivatives-related risks and to provide limits on their use.”

The proposal would require a comply fund to comply with one of two portfolio limitations with respect to its use of derivatives. Under the “Exposure-Based Portfolio Limit” option, the fund’s aggregate notional amount of derivatives transactions, “financial commitment transactions” (“e.g., reverse repurchase agreements, short sale borrowings, or firm or standby commitment agreements or similar agreements”), and certain other transactions would be limited to 150 percent of the fund’s net assets. Under the “Risk-Based Portfolio Limit” option, a fund’s derivatives exposure could reach 300 percent if the fund satisfies a test based on value-at-risk that “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 proposal would also require funds using derivatives to segregate assets equal to the amount the fund would need to pay to exit the derivatives transaction at the time of determination (“mark-to-market coverage amount”) plus an additional risk-based amount of “a reasonable estimate of the potential amount the fund would pay if the fund exited the derivatives transaction under stressed conditions.” The segregated assets would be limited to cash and cash equivalents.  Funds that enter into financial commitment transactions, would need to “segregate assets with a value equal to the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under those transactions.”

All funds that use derivatives would be subject to “certain requirements related to derivatives risk management.” Those funds that use complex derivatives or “engage in more than limited derivatives transactions” would need to establish a derivatives risk management program and appoint a derivatives risk manager. Fund boards would be required to approve a fund’s derivatives risk management program, any material changes to the program, and approve the derivatives risk manager who would administer the program. The board also would be required to review written reports from the derivatives risk manager quarterly “that review the adequacy of the fund’s derivatives risk management program and the effectiveness of its implementation.” The proposal would also update Forms N-PORT and N-CEN to collect additional data on a fund’s derivative’s use.

Chair White, along with Commissioners Luis Aguilar and Kara Stein voted to issue the proposal. Commissioner Michael Piwowar dissented, while still expressing “strong support for Commission action in this area.” Piwowar supported the asset segregation portion of the proposal which “addresses the inadequacies of the current market practices,” but is still consistent with prior Commission action. He noted that the asset segregation requirement serves as a functional limit on a fund’s use of derivatives and thus the leverage limit is unnecessary and unjustified. Piwowar also argued that the other requirements imposed by the proposal are premature given other recent Commission actions. He suggested that the Commission should review the data from the reporting modernization proposal and examine the effects of the liquidity risk management proposal before moving forward with the other aspects of the derivatives proposal. Lastly, he noted that certain provisions in Dodd Frank require the CFTC and the SEC to regulate the over-the-counter derivatives marketplace. While the CFTC has completed its section of the rulemaking, the SEC has not, and Piwowar argued that the SEC should first focus on that task.