SEC Proposal on Derivatives Use by Open -End Funds
Securities
and Exchange Commission
Open
meeting – SEC Proposal on Derivatives Use by Open-End Funds
Friday,
December 11, 2015
Key
Topics & Takeaways
- Proposed
Rule Approved: SEC Commissioners approved, in a 3-1 vote, a
staff recommendation to release a proposed rule establishing conditions on
the use of derivatives by registered investment funds. Commissioner
Piwowar voted against the proposed rule, which he said “fails” to consider
existing rules that would either resolve regulatory concerns or enable the
Commission to make more thoughtful, informed rules based on empirical
evidence.
- Leverage
Limits: Commissioner Stein argued that this rule is necessary
to curb leverage limits resulting from funds’ derivatives exposures. She
claimed that registered investment companies “were never intended to be
highly levered” funds but that this had gradually eroded investor
protections over the years. Stein also explained that she was
“particularly pleased” that the proposed rule imposes a limit on notional
exposure, which she claimed serves as a “general measure” of funds’
economic exposure to derivatives assets.
- Three
Central Elements: The SEC’s Schlaphoff explained that the
proposed Rule 18(f)(4) would allow funds to use derivatives provided they
comply with three central elements: 1) a fund would be required to comply
with leverage limits; 2) a fund would be required to manage risks associated
with derivatives holdings by maintaining “qualifying coverage assets;” and
3) a fund whose derivatives exposure exceeds certain thresholds or uses
complex derivatives would be required to establish a derivatives risk
management program approved by its board of directors.
Speakers
-
Mary Jo White, Chair
- Michael Piwowar,
Commissioner
- Luis Aguilar,
Commissioner
- Kara Stein, Commissioner
- Mark Flannery, Chief Economist and Director of the Division of
Economic and Risk Analysis
- Aaron Schlaphoff,
Senior Counsel, Division of Investment Management
- Danforth Townley, Division of Investment Management
Opening Remarks
Chair
White opened
by explaining that the commissioners would consider staff recommendations to
propose for public comment a new rule aiming to update and more comprehensively
address the use of derivatives by registered investment funds. White
recalled that the day marked the anniversary of the announcement of her
“comprehensive” five-part
plan to address risks in the asset management industry, which includes: 1)
enhanced data reporting obligations; 2) liquidity risk management requirements;
3) measures to address risks related to funds’ use of derivatives; 4) planning
for the transition of client assets; and 5) stress testing requirements.
White
reflected on the evolution of funds’ use of derivatives and noted that funds’
use of derivatives can pose “significant risks” to funds and fund investors.
She further explained that the Securities and Exchange Commission’s (SEC)
Department of Economic and Risk Analysis (DERA) research illustrated that some
funds use derivatives “extensively” and are also using mark-to-market
segregation more often. Based on such analysis, White explained that the
current regulatory framework no longer addresses the goals of the Investment
Company Act and concluded that a new approach is needed. White provided
an overview of the three central elements of the proposed rule: 1) asset
segregation requirements; 2) limits on the amount of derivatives exposure; and
3) an obligation for certain funds to establish a formal risk management
program.
Staff Proposal: Derivatives Use by Registered Investment Funds
Danforth
Townley, Division of
Investment Management
Townley
explained that a new exemptive rule Section 18(f)(4) would limit the risk of
excessive leverage arising from a fund’s use of derivatives. Townley
noted that alternative funds appear more likely to “make significant use” of
derivatives, and that generally funds maintain insufficient assets to back such
transactions, which may pose risks. He further claimed that a “common
characteristic of derivatives” is that they involve leverage, or the potential
for leverage. To address these regulatory concerns, he explained, the staff
recommends two alternative limits be imposed on funds’ use of derivatives: 1)
an exposure-based limit; and 2) a risk-based limit for leverage.
Aaron Schlaphoff, Senior Counsel, Division of
Investment Management
Schlaphoff
explained that Rule 18(f)(4) would allow funds to use derivatives provided they
comply with three conditions. First, a fund would be required to comply
with one of two portfolio limits to leverage: 1) the exposure-based limit would
limit funds’ aggregate exposure to 150 percent of the fund’s net assets; 2) the
risk-based portfolio limit would permit a fund to maintain exposure up to 300
percent of portfolio assets if the fund can demonstrate that Value at Risk in
the portfolio is reduced as a result of the use of those derivatives. Second, a
fund would be required to manage risks associated with derivatives holdings by
maintaining “qualifying coverage assets” either based on mark-to-market values
or a risk-based analysis. Third, a fund whose derivatives exposure exceeds 150
percent of net assets or uses complex derivatives would be required to
establish a derivatives risk management program that includes policies and
procedures to assess and manage risks posed by derivatives transactions,
periodic reviews, and a designated derivatives risk manager approved by its
board of directors. Finally, Schlaphoff explained, that proposed rule would
revise certain reporting requirements in forms N-PORT and N-CEN to disclose
funds’ derivatives usage.
Mark Flannery, Chief Economist and Director of the Division of
Economic and Risk Analysis
Flannery
explained that DERA authored a white paper that will accompany the proposed
rulemaking. Flanner claimed that the DERA analysis illustrates that certain
funds use derivatives “extensively,” which he said could magnify losses in a
downturn scenario. Flannery argued that the segregation requirements
would promote more efficient use of funds’ assets, and that the requirement to
maintain highly liquid assets that are likely to retain their value in times of
stress should reduce risk of losses due to forced asset sales at fire-sale
prices. Overall, he claimed, the proposed rule should improve investor
protection, though he recognized that such benefits come with costs.
Flannery explained that funds that currently exceed the proposed ceiling on
derivatives exposure will likely incur costs to limit their derivatives
exposures or de-register the fund, if necessary. Such outcomes, he
claimed, would lead to further indirect costs such as diminished investor
choice and reduced fund competition. However, Flannery argued that the proposed
rule mitigates such costs by allowing a fund to determine its own appropriate
methodology for determining its segregation needs and leverage limits.
Commissioner Statements on Proposed Rule
In
his remarks,
Aguilar noted that years of “regulatory complacency” and de-regulation imposed
costs on investors during the financial crisis, and that the Dodd-Frank Act
required a new regulatory framework for derivatives. However, Aguilar noted
that the Commission has not yet adopted all of its rules under Title VII, and
he urged his fellow Commissioners to move forward “with urgency” to increase
transparency and accountability in derivatives markets.
Aguilar
noted the growth in use of derivatives by registered investment funds,
including mutual funds and exchange-traded funds (ETFs). According to
DERA analysis, he explained, some funds that use derivatives “have notional
exposures almost ten times in excess of the funds’ net assets,” which he argued
could undermine their ability to withstand a financial shock and pose risk to
retail investors. Aguilar explained that, under the proposed rule, all
registered funds would be required to put in a place a system to manage risk
associated with their use of derivatives, and that their regulatory
responsibilities would increase in tandem with their derivatives
exposures.
Aguilar
also highlighted the importance of funds’ corporate governance in identifying
potential risks before they manifest themselves in financial losses. He
also explained that the proposed rule would add specific duties to existing
board responsibilities, such as to establish a formal derivatives risk
management program which must be reviewed on a quarterly basis. Aguilar called
on funds’ boards to continue to evaluate risks as funds’ investments change
over time, and explained that investors must be able to be confident in a fund
board’s ability to uphold its fiduciary and regulatory responsibilities.
Aguilar
expressed his support for the staff’s rulemaking recommendation, which he said
was consistent with protection of investors, particularly retail investors.
Stein
noted that this particular proposal was a “long and massive undertaking” by
Commission staff., and she reiterated that it is important to be mindful of
“vital role” that registered funds play in enabling everyday Americans to save
for retirement and other long-term goals. Stein noted that when the 1940 Act
was enacted, the use of derivatives by funds was “nonexistent,” and as such
this rule would help modernize the SEC’s rules to address the increasing use of
financial innovations such as derivatives by mutual funds, ETFs and others.
While
she recognized the need for funds to use derivatives for hedging purposes,
Stein explained that this rule is necessary to curb leverage limits resulting
from derivatives exposures to protect retail investors. She also
explained that investment managers that cater to sophisticated investors will
still be able to pursue leveraged positions through hedge funds, since they are
not registered with the SEC. Stein explained that registered investment
companies “were never intended to be highly levered” funds but that this has
gradually eroded investor protections over the years. Stein also said she
was “particularly pleased” that the proposed rule imposes a limit on notional
exposure, which she claimed serves as a “general measure” of funds’ economic
exposure to derivatives assets. Stein lent her support for the proposed
rule, which she claimed should enable sufficient flexibility for fund
compliance while addressing concerns of excessive leverage.
Piwowar
argued that it is “imperative” for the Commission to update its guidance on the
use of derivatives and leverage by investment funds, which he claimed had for
“too long” navigated this space without clear guidance from the
Commission. Piwowar added the Commission has an “obligation” to ensure
that all limitations imposed on funds are “clearly justifiable” based on
economic consequences to funds and investors. He further argued that such
rulemakings should be based on high quality empirical analysis and consider
other rules that address regulatory concerns. However, he stated that certain
elements of the proposed rule “fail that basic standard” and consequently he
explained that he could not support all parts of the
proposal.
Piwowar
lent his support for the proposed asset segregation requirements, which he
claimed will address the inadequacies of current market practices by ensuring
that cash and cash equivalents would meet a fund’s future needs. Piwowar noted
that these new requirements should serve as a functional leverage limit on
funds and ensure funds are able to meet their derivatives obligations.
However,
he explained that he cannot support other rule requirements, such as the
alternative leverage limit and the requirement to establish a risk management
program overseen by a designated derivatives risk manager for two main
reasons. First, Piwowar argued that the proposed asset segregation
requirement should limit leverage levels, so absent data indicating that a
separate leverage limit is necessary, there is no need for it. Second, he
claimed that the timing of the new rule proposal is not appropriate given other
recently adopted or proposed rules that would address funds’ use of derivatives
– such as the modernized and enhanced information reporting requirements and
the proposed liquidity risk management standards. Piwowar explained that
the data gathering requirements under the SEC’s modernized and enhanced
reporting rules would enable the Commission to assess funds’ use of derivatives
and leverage, which would enable them to analyze whether any further leverage
limits are necessary in a thoughtful, empirically driven manner. Further,
he explained that the proposed liquidity risk management rules would require
funds to consider their use of derivatives and their associated liquidity
characteristics. Piwowar noted that the Title VII framework for
derivatives has not been fully adopted by the SEC – and he argued that “good
governance” implores them to implement Title VII and examine its effectiveness
before moving forward with an entirely new, perhaps duplicative, regime.
Chair
White asked her fellow commissioners to vote on whether the proposed rule
imposing conditions on the use of derivatives by registered funds would be
publicly disseminated for public comment. The motion was approved by the
Commissioners in a 3-1 vote, with Piwowar dissenting.
More
information about this proposal can be accessed here.
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Securities
and Exchange Commission
Open
meeting – SEC Proposal on Derivatives Use by Open-End Funds
Friday,
December 11, 2015
Key
Topics & Takeaways
- Proposed
Rule Approved: SEC Commissioners approved, in a 3-1 vote, a
staff recommendation to release a proposed rule establishing conditions on
the use of derivatives by registered investment funds. Commissioner
Piwowar voted against the proposed rule, which he said “fails” to consider
existing rules that would either resolve regulatory concerns or enable the
Commission to make more thoughtful, informed rules based on empirical
evidence. - Leverage
Limits: Commissioner Stein argued that this rule is necessary
to curb leverage limits resulting from funds’ derivatives exposures. She
claimed that registered investment companies “were never intended to be
highly levered” funds but that this had gradually eroded investor
protections over the years. Stein also explained that she was
“particularly pleased” that the proposed rule imposes a limit on notional
exposure, which she claimed serves as a “general measure” of funds’
economic exposure to derivatives assets. - Three
Central Elements: The SEC’s Schlaphoff explained that the
proposed Rule 18(f)(4) would allow funds to use derivatives provided they
comply with three central elements: 1) a fund would be required to comply
with leverage limits; 2) a fund would be required to manage risks associated
with derivatives holdings by maintaining “qualifying coverage assets;” and
3) a fund whose derivatives exposure exceeds certain thresholds or uses
complex derivatives would be required to establish a derivatives risk
management program approved by its board of directors.
Speakers
-
Mary Jo White, Chair
- Michael Piwowar,
Commissioner
- Luis Aguilar,
Commissioner
- Kara Stein, Commissioner
- Mark Flannery, Chief Economist and Director of the Division of
Economic and Risk Analysis
- Aaron Schlaphoff,
Senior Counsel, Division of Investment Management
- Danforth Townley, Division of Investment Management
Opening Remarks
Chair
White opened
by explaining that the commissioners would consider staff recommendations to
propose for public comment a new rule aiming to update and more comprehensively
address the use of derivatives by registered investment funds. White
recalled that the day marked the anniversary of the announcement of her
“comprehensive” five-part
plan to address risks in the asset management industry, which includes: 1)
enhanced data reporting obligations; 2) liquidity risk management requirements;
3) measures to address risks related to funds’ use of derivatives; 4) planning
for the transition of client assets; and 5) stress testing requirements.
White
reflected on the evolution of funds’ use of derivatives and noted that funds’
use of derivatives can pose “significant risks” to funds and fund investors.
She further explained that the Securities and Exchange Commission’s (SEC)
Department of Economic and Risk Analysis (DERA) research illustrated that some
funds use derivatives “extensively” and are also using mark-to-market
segregation more often. Based on such analysis, White explained that the
current regulatory framework no longer addresses the goals of the Investment
Company Act and concluded that a new approach is needed. White provided
an overview of the three central elements of the proposed rule: 1) asset
segregation requirements; 2) limits on the amount of derivatives exposure; and
3) an obligation for certain funds to establish a formal risk management
program.
Staff Proposal: Derivatives Use by Registered Investment Funds
Danforth
Townley, Division of
Investment Management
Townley
explained that a new exemptive rule Section 18(f)(4) would limit the risk of
excessive leverage arising from a fund’s use of derivatives. Townley
noted that alternative funds appear more likely to “make significant use” of
derivatives, and that generally funds maintain insufficient assets to back such
transactions, which may pose risks. He further claimed that a “common
characteristic of derivatives” is that they involve leverage, or the potential
for leverage. To address these regulatory concerns, he explained, the staff
recommends two alternative limits be imposed on funds’ use of derivatives: 1)
an exposure-based limit; and 2) a risk-based limit for leverage.
Aaron Schlaphoff, Senior Counsel, Division of
Investment Management
Schlaphoff
explained that Rule 18(f)(4) would allow funds to use derivatives provided they
comply with three conditions. First, a fund would be required to comply
with one of two portfolio limits to leverage: 1) the exposure-based limit would
limit funds’ aggregate exposure to 150 percent of the fund’s net assets; 2) the
risk-based portfolio limit would permit a fund to maintain exposure up to 300
percent of portfolio assets if the fund can demonstrate that Value at Risk in
the portfolio is reduced as a result of the use of those derivatives. Second, a
fund would be required to manage risks associated with derivatives holdings by
maintaining “qualifying coverage assets” either based on mark-to-market values
or a risk-based analysis. Third, a fund whose derivatives exposure exceeds 150
percent of net assets or uses complex derivatives would be required to
establish a derivatives risk management program that includes policies and
procedures to assess and manage risks posed by derivatives transactions,
periodic reviews, and a designated derivatives risk manager approved by its
board of directors. Finally, Schlaphoff explained, that proposed rule would
revise certain reporting requirements in forms N-PORT and N-CEN to disclose
funds’ derivatives usage.
Mark Flannery, Chief Economist and Director of the Division of
Economic and Risk Analysis
Flannery
explained that DERA authored a white paper that will accompany the proposed
rulemaking. Flanner claimed that the DERA analysis illustrates that certain
funds use derivatives “extensively,” which he said could magnify losses in a
downturn scenario. Flannery argued that the segregation requirements
would promote more efficient use of funds’ assets, and that the requirement to
maintain highly liquid assets that are likely to retain their value in times of
stress should reduce risk of losses due to forced asset sales at fire-sale
prices. Overall, he claimed, the proposed rule should improve investor
protection, though he recognized that such benefits come with costs.
Flannery explained that funds that currently exceed the proposed ceiling on
derivatives exposure will likely incur costs to limit their derivatives
exposures or de-register the fund, if necessary. Such outcomes, he
claimed, would lead to further indirect costs such as diminished investor
choice and reduced fund competition. However, Flannery argued that the proposed
rule mitigates such costs by allowing a fund to determine its own appropriate
methodology for determining its segregation needs and leverage limits.
Commissioner Statements on Proposed Rule
In
his remarks,
Aguilar noted that years of “regulatory complacency” and de-regulation imposed
costs on investors during the financial crisis, and that the Dodd-Frank Act
required a new regulatory framework for derivatives. However, Aguilar noted
that the Commission has not yet adopted all of its rules under Title VII, and
he urged his fellow Commissioners to move forward “with urgency” to increase
transparency and accountability in derivatives markets.
Aguilar
noted the growth in use of derivatives by registered investment funds,
including mutual funds and exchange-traded funds (ETFs). According to
DERA analysis, he explained, some funds that use derivatives “have notional
exposures almost ten times in excess of the funds’ net assets,” which he argued
could undermine their ability to withstand a financial shock and pose risk to
retail investors. Aguilar explained that, under the proposed rule, all
registered funds would be required to put in a place a system to manage risk
associated with their use of derivatives, and that their regulatory
responsibilities would increase in tandem with their derivatives
exposures.
Aguilar
also highlighted the importance of funds’ corporate governance in identifying
potential risks before they manifest themselves in financial losses. He
also explained that the proposed rule would add specific duties to existing
board responsibilities, such as to establish a formal derivatives risk
management program which must be reviewed on a quarterly basis. Aguilar called
on funds’ boards to continue to evaluate risks as funds’ investments change
over time, and explained that investors must be able to be confident in a fund
board’s ability to uphold its fiduciary and regulatory responsibilities.
Aguilar
expressed his support for the staff’s rulemaking recommendation, which he said
was consistent with protection of investors, particularly retail investors.
Stein
noted that this particular proposal was a “long and massive undertaking” by
Commission staff., and she reiterated that it is important to be mindful of
“vital role” that registered funds play in enabling everyday Americans to save
for retirement and other long-term goals. Stein noted that when the 1940 Act
was enacted, the use of derivatives by funds was “nonexistent,” and as such
this rule would help modernize the SEC’s rules to address the increasing use of
financial innovations such as derivatives by mutual funds, ETFs and others.
While
she recognized the need for funds to use derivatives for hedging purposes,
Stein explained that this rule is necessary to curb leverage limits resulting
from derivatives exposures to protect retail investors. She also
explained that investment managers that cater to sophisticated investors will
still be able to pursue leveraged positions through hedge funds, since they are
not registered with the SEC. Stein explained that registered investment
companies “were never intended to be highly levered” funds but that this has
gradually eroded investor protections over the years. Stein also said she
was “particularly pleased” that the proposed rule imposes a limit on notional
exposure, which she claimed serves as a “general measure” of funds’ economic
exposure to derivatives assets. Stein lent her support for the proposed
rule, which she claimed should enable sufficient flexibility for fund
compliance while addressing concerns of excessive leverage.
Piwowar
argued that it is “imperative” for the Commission to update its guidance on the
use of derivatives and leverage by investment funds, which he claimed had for
“too long” navigated this space without clear guidance from the
Commission. Piwowar added the Commission has an “obligation” to ensure
that all limitations imposed on funds are “clearly justifiable” based on
economic consequences to funds and investors. He further argued that such
rulemakings should be based on high quality empirical analysis and consider
other rules that address regulatory concerns. However, he stated that certain
elements of the proposed rule “fail that basic standard” and consequently he
explained that he could not support all parts of the
proposal.
Piwowar
lent his support for the proposed asset segregation requirements, which he
claimed will address the inadequacies of current market practices by ensuring
that cash and cash equivalents would meet a fund’s future needs. Piwowar noted
that these new requirements should serve as a functional leverage limit on
funds and ensure funds are able to meet their derivatives obligations.
However,
he explained that he cannot support other rule requirements, such as the
alternative leverage limit and the requirement to establish a risk management
program overseen by a designated derivatives risk manager for two main
reasons. First, Piwowar argued that the proposed asset segregation
requirement should limit leverage levels, so absent data indicating that a
separate leverage limit is necessary, there is no need for it. Second, he
claimed that the timing of the new rule proposal is not appropriate given other
recently adopted or proposed rules that would address funds’ use of derivatives
– such as the modernized and enhanced information reporting requirements and
the proposed liquidity risk management standards. Piwowar explained that
the data gathering requirements under the SEC’s modernized and enhanced
reporting rules would enable the Commission to assess funds’ use of derivatives
and leverage, which would enable them to analyze whether any further leverage
limits are necessary in a thoughtful, empirically driven manner. Further,
he explained that the proposed liquidity risk management rules would require
funds to consider their use of derivatives and their associated liquidity
characteristics. Piwowar noted that the Title VII framework for
derivatives has not been fully adopted by the SEC – and he argued that “good
governance” implores them to implement Title VII and examine its effectiveness
before moving forward with an entirely new, perhaps duplicative, regime.
Chair
White asked her fellow commissioners to vote on whether the proposed rule
imposing conditions on the use of derivatives by registered funds would be
publicly disseminated for public comment. The motion was approved by the
Commissioners in a 3-1 vote, with Piwowar dissenting.
More
information about this proposal can be accessed here.