The Investment Company Act limits the ability of registered funds and business development companies to engage in transactions that involve potential future payment obligations, including obligations under derivatives such as forwards, futures, swaps and written options. The new rules, which apply to mutual funds, exchange-traded funds (ETFs), close-end funds, as well as business development companies, will permit funds to enter into these transactions if they comply with certain conditions outlined below, which are designed to increase investor protection.
Overview of Rule 18f-4
Derivatives Risk Management Program
Funds using derivative in more than a limited manner will have to adopt a derivatives risk management program. The program must include:
- Stress testing,
- Internal reporting and escalation, and
- Program review elements
Limit on Fund Leverage Risk
Funds are subject to an outer limit on leverage based on value at risk. The outer limit is based on a relative VaR test that compares the fund’s VaR to the VaR of a “designated reference portfolio” for that fund. A fund generally can use either an index that meets certain requirements or the fund’s own securities portfolio (excluding derivatives transactions) as its designated reference portfolio.
If the fund’s derivatives risk manager reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test, the fund would be required to comply with an absolute VaR test.
The fund’s VaR generally is not permitted to exceed 200% of the VaR of the fund’s designated reference portfolio under the relative VaR test or 20% of the fund’s net assets under the absolute VaR test.
Exception for Limited Users of Derivatives
The rule provides ex exceptions for limited derivatives users from the derivatives risk management program requirement, the VaR-based limit on fund leverage risk, and the related board oversight and reporting requirements, provided that the fund adopts and implements written policies and procedures reasonably designed to manage the fund’s derivatives risks.
This exception will be available to a fund that limits its derivatives exposure to 10% of its net assets, excluding certain currency and interest rate hedging transactions.
Alternative Requirements for Certain Leveraged/ Inverse Funds
Leveraged/inverse funds will generally be subject to rule 18f-4 like other funds, including the requirement to comply with the VaR-based limit on fund leverage risk. This will effectively limit leveraged or inverse funds’ targeted daily return to 200% of the return (or inverse of the return) of the fund’s underlying index. The final rule provides an exception from the VaR requirement for leveraged or inverse funds currently in operation that seek an investment return above 200% of the return (or inverse of the return) of the fund’s underlying index and satisfy certain conditions.
Reverse Repurchase Agreements and Unfunded Commitment Agreements
The rule permits a fund to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments, subject to conditions tailored to these transactions.
Funds will be subject to increased reporting and recordkeeping requirements related to derivatives use.
Funds will also be required to report confidentially to the Commission on a current basis on Form N-RN if the fund is out of compliance with the VaR-based limit on fund leverage risk for more than five business days.
Funds currently required to file reports on Forms N-PORT and N-CEN will be required to provide certain information regarding a fund’s derivatives use. This will include information regarding the fund’s VaR, as applicable, and information about the fund’s derivatives exposure (for funds that rely on the limited derivatives user exception in rule 18f-4).
The new rule, and related rule and form amendments, will be published on the Commission’s website and in the Federal Register. All will be effective 60 days after publication in the Federal Register.
The rule then provides for an 18-month compliance transition period.
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