Investment Company Notebook

Practical insight and analysis on the accounting, audit and tax issues impacting investment companies.

Your Funds Don't Employ Derivatives, or Use Them Sparingly? 5 Questions You Still Need To Ask About the SEC's New Derivatives Rule

On October 28, 2020, the SEC adopted a new rule designed to address the investor protection purposes and concerns underlying Section 18 of the Investment Company Act of 1940. More specifically, Rule 18f-4 provides an updated and more comprehensive approach to the regulation of funds’ use of derivatives.5 Things To Know About the Derivatives Rule This Rule is effective for all funds February 19, 2021, with a compliance date of August 19, 2022. While the final Rule offers a more than 450-page comprehensive framework for funds utilizing derivatives, management and Boards of funds not employing derivatives, or utilizing them on a limited basis, still should be aware of the impact of certain key points of the Rule.

Consider the following five questions:

1. Are all funds included within the scope of the Derivatives Rule? All mutual funds, exchange-traded funds, registered closed-end funds, and business development companies are subject to the Rule. Money market funds regulated under Rule 2a-7 of the Investment Company Act of 1940 are excluded, subject to the delayed-settlement securities provision.

2. What if I do not use derivatives in my fund? Am I still required to adopt the Rule? There is an exemption for limited derivative users. A fund that limits the gross notional amount of its derivatives exposure to 10% of its net assets will be exempt from the derivative risk management program requirement, the VaR-based limit on fund leverage risk, and the related Board oversight and reporting requirements. The fund will still be required to adopt and implement written policies and procedures that are reasonably designed to manage the fund’s derivatives risks.

3. How does the Rule define a derivatives transaction? The Rule defines derivatives in three ways:

  • Any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (“derivatives instrument”), under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payment or otherwise.
  • Any short sale borrowing
  • Reverse repurchase agreements and similar financing transactions, for those funds that choose to treat these transactions as derivatives transactions under the rule

Certain derivatives transactions that a fund uses to hedge currency and interest rate risks and positions closed out with the same counterparty can be excluded from the derivatives exposure calculation as long as they are closed out with the same counterparty and result in no credit or market exposure to the fund. 

TBAs and dollar rolls are included in the Rule’s definition of derivatives transactions. 

4. My fund qualified as a limited derivative user under the Rule but went over the 10% limitation. What am I required to do? The fund is required to reduce its derivatives exposure to under the 10% threshold within five business days. If reducing the fund’s exposure in five days to under the 10% limitation is not possible, the fund’s advisor is required to provide a written report to the fund’s Board informing it of which of the following plans of action the advisor intends to follow:

  • Temporary Exceedance – Promptly, but within no more than 30 calendar days of the exceedance, reduce the fund’s derivative exposure to be in compliance with the 10% threshold
  • Derivatives Risk Management Program Adoption – Establish a derivatives risk management program, comply with the VaR-based limit on fund leverage risk, and comply with the related Board oversight and reporting requirements as soon as reasonably practicable. The fund’s next filing of Form N-PORT must specify the number of business days that the fund’s exposure to derivatives exceeded 10% of its net assets in excess of the five-business day grace period. This reporting item disclosed in the new Form N-PORT will not be made public.
5. I qualify for the exemption. What do my written policies and procedures need to include? The written policies and procedures are required to be tailored to the extent and nature of the fund’s derivative use. A fund that uses complex derivatives with exposure close to approaching 10% of the fund’s net asset value should have robust procedures. Conversely, a fund that uses derivatives for a limited purpose, such as to equalize cash, or that only uses derivatives occasionally and for a limited purpose will have less extensive procedures. The new Rule enables funds to scale their policies and procedures to address the different strategies funds may pursue, the different level of derivative exposure they may seek, and the different risks associated with their derivatives transactions.