Securities and Exchange Commission Open Meeting
Securities and Exchange Commission
Thursday, October 28th, 2020
Key Topics & Takeaways
- Final Rule on Funds’ Use of Derivatives: In a 3-2 vote, the Commission approved a final rule which updates the regulatory framework for the use of derivatives by registered investment funds.
Staff Presentation: Use of Derivatives by Registered Investment Companies and Business Development Companies
- Dalia Blass, Director, Division of Investment Management, Securities and Exchange Commission
- John Lee, Division of Investment Management, Securities and Exchange Commission
- Hari Phatak, Associate Director, Division of Economic and Risk Analysis, Securities and Exchange Commissions
Blass stated that ineffective derivative risk management contributes to significant investor losses. She characterized the final rule as a uniform, comprehensive, and modern approach to regulate funds’ use of derivatives. Blass continued, referencing commentary on leveraged and inverse ETFs, saying that these funds use derivatives extensively and that the rule does not increase the risk associated with these funds. She stated that the final rule provides clear direct articulation of the Investment Company Act’s investor protection purposes.
Lee described the rule’s conditions in more detail, explaining; (1) funds that are not limited to users would have to adopt a written derivative risk management program; (2) funds would generally have to comply with the value-at-risk (VaR) based outer limit on fund leverage risk; (3) funds that use limited derivatives would be subject to a streamlined set of requirements; and (4) the rule would not adopt the proposed sales practice rules for broker dealers and investors. Additionally, Lee detailed the rule’s treatment of other types of transactions, notably reverse repurchase agreements. He recommended the Commission amend the Investment Company Act rule 6c-11 and rescind the 1979 general statement of policy addressing funds’ use of derivatives and other transactions covered by rule 18f-4.
Phatak explained that the rule will benefit investors by mitigating derivative-related risks. Phatak noted that the final rule also includes certain reporting requirements, which he said will further benefit investors by allowing the Commission and its staff to oversee and monitor reporting funds’ compliance with the final rule and identify trends in the use of derivatives and investment products. In closing, he explained that funds with limited derivative exposure will not be required to incur costs and bear compliance burdens that may be disproportionate to the resulting benefits.
Chairman Jay Clayton
In his statement, Clayton expressed support for the SEC’s proposed rule. He characterized the rule as an “outstanding example of reforms that modernize our rules for the benefit of investors.” Clayton explained that the current regulatory approach to the use of derivatives by registered funds rests on a Commission statement issued in 1979, and that since then, a lack of clear policy has led to regulatory uncertainty, asymmetry in application, and resulting limitation on oversight and enforcement.
Clayton explained that derivatives, when appropriately risk managed, can be an important part of executing a variety of investment strategies. However, he noted that derivatives can and often do create the type of exposure, including the risk of significant losses to fund investors, that the Investment Company Act Section 18 restriction on “senior securities” was intended to limit. Clayton stated that the Commission’s task is to continue to permit funds to use derivatives in a manner that best serves the investment objectives of the fund while addressing the concerns underlying Section 18; and to do so in a manner that provides clarity and consistency. He stated that the rule (1) requires funds that use derivatives in a more than limited manner put in place derivative risk management programs; (2) imposes an outer limit on fund leverage risk based on VaR; and (3) imposes specific reporting and recordkeeping requirements to allow the Commission to monitor and evaluate a fund’s compliance with the rule’s requirements.
Commissioner Hester M. Peirce
In her statement, Peirce expressed support for the final rule for its “broadly sensible approach born of an understanding that funds use derivatives for important purposes and that to stop them from doing so would be harmful to investors.” Peirce explained that the final rule addresses a number of important concerns that commenters raised in response to the proposed rule. Specifically, she said she was pleased that rule 18f-4 preserves an investor’s opportunity to invest in 200 percent leveraged/inverse products. However, she expressed concern over the final rule’s setting of precedent regarding the devolution of duties to fund boards, which she said should belong with the adviser. Despite her concerns, Peirce said there is much to commend in this rule, both in its general approach and in its specifics.
Commissioner Elad L. Roisman
In his statement, Roisman explained that throughout the rulemaking process, the Commission endeavored to find a balance between requiring careful risk management strategies by funds that use derivatives while recognizing that advisors need a degree of flexibility in order to responsibly manage their portfolios. Roisman posed three considerations for industry to address during the rules comment period: (1) what types of products should fall into the category of “complex” (2) what best practices have distributors of complex products developed and implemented in order to preempt, prevent, or address investor complaints; and (3) what types of measures investors believe would best protect them and allos them access to investment opportunities. In closing, Roisman expressed support for the final rulemaking and thanked the agency’s staff for their work in crafting the rule.
Commissioner Allison Herren Lee
In her statement, Lee explained that over the past several decades, the regulatory framework governing funds’ use of derivatives has been “piecemeal at best” and that comprehensive rulemaking is needed to establish a systematic approach that more meaningfully limits fund risk-taking. However, Lee stated that the final rule changes and abandons key elements that were included in last year’s proposal, including (1) changing risk limits designed to place sensible boundaries around speculative investing into outer bounds calibrated to have little to no effect on funds’ existing practices; (2) changes in the rule that allows funds to manipulate those outer bounds; and (3) the removal of the proposed sales practice rules related to leveraged and inverse ETFs. For these reasons, Lee stated that she would respectfully dissent.
Commissioner Caroline A. Crenshaw
In her statement, Crenshaw warned that in times of prolonged market stress, registered funds’ reliance on derivatives and leverage to achieve their investment objectives could lead to disaster without the proper regulatory framework. For the following reasons, Crenshaw said she could not support the final rule: (1) the rule fails to provide a meaningful limit on registered funds’ ability to take on leverage; (2) the risk management program requirements fail to provide a reliable backstop against VaR’s limitations; and (3) the Commission did not address the risk real investors face when buying leveraged and inverse funds. In closing, she said the Commission’s goal is important and she would have supported a form of the rule with more meaningful limitations on derivatives, risk and exposure.
The final rule was approved 3-2, with Commissioners Lee and Crenshaw dissenting.
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