The Securities and Exchange Commission has proposed rules that, once finalized, will modernize and enhance existing regulations on the use of derivatives by registered investment companies. The proposed rule would limit the use of derivatives by mutual funds, exchange-traded funds, closed-end funds, and business development companies. It also requires them to establish new risk management measures.

“Derivatives can raise risks for a fund, including risks related to leverage, so it is important to require funds to monitor and manage derivatives-related risks and to provide limits on their use,” SEC Chairman Mary Jo White said prior to the Dec. 11 vote. 

The Investment Company Act limits the ability of funds to engage in transactions that involve potential future payment obligations, including derivatives such as forwards, futures, swaps and written options.  The proposed rule would permit funds to enter into these derivatives transactions, provided that they comply with certain conditions.

Those conditions include compliance with one of two alternative portfolio limitations designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions.

Under the exposure-based portfolio limit, a fund would be required to limit its aggregate exposure to 150 percent of the fund’s net assets.  A fund’s “exposure” would be calculated as the aggregate notional amount of its derivatives transactions, together with its obligations under financial commitment transactions.

Under the risk-based portfolio limit, a fund would be permitted to obtain exposure up to 300 percent of its net assets, provided that the fund satisfies a risk-based test (based on value-at-risk). This test is designed to determine whether the fund’s derivatives transactions, in aggregate, result in a fund portfolio that is subject to less market risk than if the fund did not use derivatives.     

Funds would also have to manage the risks associated with their derivatives transactions by segregating certain assets (generally cash and cash equivalents) in a suitable amount to meet obligations under stressed conditions.

Funds that engage in more than a limited amount of derivatives transactions, or that use complex derivatives, would be required to establish a formalized derivatives risk management program. Funds that engage in more than limited derivatives transactions or use complex derivatives would be required to establish a formalized derivatives risk management program consisting of certain components administered by a designated derivatives risk manager.  The fund’s board of directors would be required to approve and review the derivatives risk management program and approve the derivatives risk manager.

The proposed reforms also address funds’ use of certain financial commitment transactions, such as reverse repurchase agreements and short sales, by requiring funds to segregate certain assets to cover their obligations under such transactions.

Also up for consideration amendments to two reporting forms the Commission proposed in May 2015: Form N-PORT and Form N-CEN.

Form N-PORT would require registered funds other than money market funds to provide portfolio-wide and position-level holdings data to the Commission on a monthly basis. The proposal would amend the form to require a fund that is required to have a derivatives risk management program to disclose additional risk metrics related to a fund’s use of certain derivatives.

Form N-CEN would require registered funds to annually report certain census-type information to the Commission.  The proposal would amend the form to require that a fund disclose whether it relied on the proposed rule during the reporting period and the particular portfolio limitation applicable to the fund.

 A 90-day comment period for the proposed rule changes will follow their publication in the Federal Register.

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