SEC Rule 18f-4 Use of Derivatives for Registered Funds

In October 2020, the SEC adopted Rule 18f-4 (the “Rule”) which significantly updated the regulations surrounding the use of derivative instruments by registered investment companies, including mutual funds (excluding money market funds), exchange traded funds, closed-end funds, interval funds and business development companies. Rule 18f-4 was effective February 19, 2021 and will be required starting on August 19, 2022.

Prior to this new Rule, there were no specific rules regulating a registered investment company’s derivative as to whether they should be considered in the asset coverage requirement Section 18(f)(1) of the Investment Company Act of 1940 since they create leverage. For decades, the registered funds industry utilizing derivative products have been mainly relying on a General Statement of Policy published by the SEC back in 1979 referred to as “Release 10666.” Release 10666 stated that funds entering into derivative contracts would not be in violation of Section 18(f)(1) provided that they segregated cash or certain liquid assets sufficient to cover the outstanding obligation of the derivative contracts. Some funds have also been relying on various SEC no-action letters issued over the years.

Under Rule 18f-4, the abovementioned funds are permitted to enter into derivative transactions such as future, forward, and swap contracts and written option contracts provided they comply with certain conditions specified in the Rule designed to alleviate the leverage concerns identified under Section 18. The term derivative transaction under the Rule also includes short sale borrowing and reverse repurchase agreements, provided the fund elects to treat all reverse repurchase transactions as derivative transactions.

The key components of Rule 18f-4 are as follows:

• Appointment of a derivatives risk manager;
• Develop a risk management program;
• Imposes value-at-risk (VaR) based limits;
• Board oversight and reporting; and
• Rescission of Release 10666 and the elimination of the asset segregation guidance.

Derivatives Risk Manager

A derivatives risk manager is required to be approved by the board, be an officer of the investment advisor, not be a portfolio manager of the fund and have relevant experience regarding derivatives risk management. If the derivatives risk manager position consists of a group of individuals, a minority of the group may consist of fund portfolio managers.

Derivatives Risk Management Program

A fund that utilizes derivative instruments is required to adopt and implement a derivatives risk management program that includes policies and procedures reasonably designed to manage the fund’s derivatives risks. The program needs to include the following elements:

• Provide for the identification and assessment of the fund’s derivatives risks, taking into account the fund’s derivative transactions and other investments.
• Create risk guidelines, including establishing, maintaining and enforcing the guidelines. The guidelines should include investment, risk management and related guidelines that provide for quantitative or other measurable criteria, metrics or thresholds related to a fund’s risk.
• Include stress testing to evaluate potential losses to a fund’s portfolio under various market changes or changes in market risk factors. The stress testing must be conducted at least weekly.
• Include for backtesting of the results of the VaR calculation model (see description below) utilized by the fund in order to monitor the effectiveness of their VaR model. Backtesting must be performed at least weekly.
• Identify when the derivatives risk manager must notify the portfolio managers about the specific escalation of material risks, such as breaches of certain program guidelines or results of stress tests. The program should also require the derivatives risk manager directly inform the fund’s board when specified material risks from the fund’s derivative transactions occur.
• The derivatives risk manager is required to review the program at least annually to evaluate its effectiveness and implement changes if necessary. The review needs to include the VaR model utilized by the fund and the required backtesting.

Limits on Value-at-Risk

In lieu of the prior asset segregation requirements, Rule 18f-4 requires funds entering into derivative transactions to comply with one of two VaR limits. VaR is defined in the Rule as “an estimate of potential losses on an instrument or portfolio expressed as a percentage of the value of the portfolio’s assets over a specified time horizon and at a given confidence level.”

The Rule requires that the VaR model utilizes a 99% confidence level and a time horizon of 20 trading days, and be based on at least three years of historical market data. The Rule also requires the VaR model to incorporate all significant identifiable market risk factors associated with a fund’s investments.

A fund must use either utilize a “relative VaR” limit or an “absolute VaR” limit.

• Relative VaR – Under the relative VaR limit test, the derivatives risk manager selects a designated reference portfolio (DRP). A DRP can be a either an unleveraged designated index, which reflects the markets or asset classes the fund invests in, or the fund’s securities portfolio, excluding derivative transactions. The fund’s VaR cannot exceed 200% of the VaR of the fund’s DRP. For a closed-end fund with then-outstanding shares of preferred stock, the VaR cannot exceed 250% of the VaR of the fund’s DRP.
• Absolute VaR – If the derivatives risk manager cannot identify an appropriate DRP, the fund must comply with the absolute VaR test, which requires the fund’s VaR cannot exceed 20% of the value of the fund’s net assets. In the case of closed-end funds with then-outstanding shares of preferred stock, the limit is 25% of the value of the fund’s net assets.

The fund must analyze its compliance with the applicable VaR test at least once per day.

If it’s determined that the fund is not in compliance with the applicable VaR test, the fund must come back into compliance within five business days. If the non-compliance extends beyond five business days, then the derivatives risk manager must take the following steps:

• Provide a written report to the fund’s board as to when the fund is expected to be back in compliance;
• Analyze the circumstances that caused the non-compliance and update any elements of the derivatives risk management program to address the circumstances; and
• Provide a written report within 30 calendar days after the non-compliance to the fund’s board explaining the results of the analysis performed, any updates to the derivatives risk management program, and how the fund came back into compliance.

Limited Derivatives User Exception

Rule 18f-4 includes an exception from the derivatives risk management program requirements, the appointment of a derivatives risk manager, the VaR limitations and the board oversight and reporting obligations. To qualify for the exception, a fund’s derivative exposure must not exceed 10% of the fund’s net assets, excluding certain currency or interest rate derivatives used for hedging purposes. The Rule does require the fund to adopt and implement written policies and procedures reasonably designed to manage the fund’s derivative risks. Funds relying on the limited user exception are required to report their derivatives exposure on Form N-PORT and disclosure of their reliance of the limited user exception on Form N-CEN.

A fund that exceeds the 10% limitation will have five business days to return to compliance. A fund that is unable to get back into compliance within five business days will need to have its investment advisor provide a written report to its board as to whether it will either promptly, within 30 days of the breach, reduce the fund’s derivatives exposure to less than 10% of its net assets or establish a derivatives risk management program, begin to follow one of the VaR based limits on fund leverage, and comply with the related board oversight and reporting requirements as soon as reasonably possible.

Board Oversight and Reporting

The role of the fund’s board under Rule 18f-4 is one of general oversight and they are not required to approve the program. The derivatives risk manager is required to provide a written report on the effectiveness of the derivatives risk program to the board at least annually. The derivatives risk manager is also required to provide the board with a written report regarding instances where the fund has violated any of its risk guidelines, as well as the results of the fund’s stress testing and backtesting. The reports should include the information necessary for the board members to be able to properly analyze and evaluate the information presented. The frequency of these reports is determined by the board.

Reverse Repurchase Agreements and Unfunded Commitment Agreements

Rule 18f-4 allows a fund to enter into reverse repurchase agreements or similar financing transactions notwithstanding the requirements of Sections 18(c) and 18(f)(1) of the Investment Company Act of 1940 provided the fund either complies with the asset coverage requirements of Section 18 and combines the aggregate amount of indebtedness associated with all reverse repurchase agreements or similar financing transactions with the aggregate amount of any other senior securities representing indebtedness when calculating the asset coverage ratio or it may it treat all reverse repurchase agreements or similar financing transactions as derivative transactions for all purposes under the Rule.

The Rule also permits a fund to enter into unfunded commitment agreements if it reasonably believes at the time it enters into the agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to its unfunded commitment agreements as they come due.

Conclusion

Rule 18f-4 drastically changes how funds registered under the Investment Company Act of 1940 are required to manage their derivative risk exposure. Release 10666 and related no-action letters will be rescinded effective August 19, 2022, when Rule 18f-4 will become required, provided the transition period is not extended. For those funds currently still operating under the prior guidance, the time to convert over to the new guidance is growing short to avoid any disruptions in the fund’s derivative trading usage once Rule 18f-4 becomes mandatory.

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