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Donohue Outlines Derivatives Concerns for Funds

In a recent address before the 2010 Retirement Income Industry Association Awards Dinner, Andrew J. Donohue, the director of the SEC's Division of Investment Management, talked briefly about the direction his division is taking in looking at the way funds use derivatives.  After reviewing some of the Commission's work to improve disclosure, a brief discussion of Rule 12b-1 reform, target-date funds, and money market fund reforms, Donohue discussed funds' use of derivatives and sophisticated financial products as an area of concern for the Division.  

[O]ne area of concern that has arisen in conjunction with our interdependent markets and which I feel exemplifies the need to look across silos at the market as a whole, is in regard to derivatives. I have spoken often of my concerns regarding funds’ use of derivatives and my belief that these instruments, while affording the opportunity for efficient portfolio management and risk mitigation, also can present potentially significant additional risk as well as raise issues of investor protection.


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The regulatory challenge in this area is that the current investment company regulatory scheme didn’t contemplate these types of investments. Rather, its approach is geared to a very different environment.

Donohue's main concern is that the ways funds use complex securities may expose them to risks against which the regulations as currently written are not designed to protect investors. 

[N]ow, with so many derivative instruments available to enhance an investment strategy, a fund’s manager can design a portfolio in a multitude of ways to create different exposures that are unrelated to the amount of money invested and are not necessarily reflective of the types of instruments the fund holds. Furthermore, utilizing derivative instruments may expose the fund to a host of risks, including market, liquidity, leverage, counterparty, legal and structural risks, not otherwise addressed through regulations that anticipated more traditional investments.

To get to the heart of these concerns, Donohue stated that the Division has engaged in a review of derivatives activities of funds, and the implications of those activities for the regulatory framework.  According to Mr. Donohue, the review is focusing on the "fundamental questions:"

  • How should we measure the derivative instrument itself for purposes of say leverage protections?
  • Do existing regulations sufficiently address whether funds’ procedures for pricing and liquidity determinations of their derivatives holdings are appropriate and do the current disclosure requirements adequately address the risks created by derivatives?
  • Has the Commission provided adequate guidance concerning leverage issues?
  • Generally, how are funds addressing risk in this area?
  • Is board oversight sufficient and do funds have the appropriate expertise and maintain robust risk management systems and procedures in light of their investments?

Donohue gave no indication of the timeframe of this reform.  Yet, it is clear from Donohue's remarks that the Commission sees value in the way that funds' use derivatives and complex securities, but that the Commission and Division see the area as "extremely important and one that needs to be addressed in a manner that permits the appropriate use of derivatives consistent with the protection or fund investors and the policies underlying the 1940 Act." The full text of Donohue's address is available at:  http://www.sec.gov/news/speech/2010/spch100410ajd.htm