SEC Re-Proposes Derivatives Regulation; Fund Board Role in Play

November 26, 2019

The SEC voted to propose a new rule designed to enhance the regulation of the use of derivatives by mutual funds, ETFs and closed-end funds, as well as business development companies. The proposed rule would provide an updated and more comprehensive approach to the regulation of funds’ derivatives use, the SEC said in its release. Proposed rule 18f-4 would generally require a fund relying on the rule to adopt and implement a derivatives risk management program. The program would include policies and procedures reasonably designed to assess and manage the risks of the fund’s derivatives transactions. Under the proposed rule, fund boards would be required to approve the designation of the fund’s derivatives risk manager, among other things. The hefty proposal leaves much to be absorbed by the industry over the next several weeks. The comment period for the proposal will be 60 days after publication in the Federal Register. Following are a few excerpts from the proposing release:

The proposed rule would require: (1) a fund’s board of directors to approve the designation of the fund’s derivatives risk manager, (2) the derivatives risk manager to provide written reports to the board regarding the program’s implementation and effectiveness, and (3) the derivatives risk manager to provide written reports describing any exceedances of the fund’s guidelines and the results of the fund’s stress testing and back-testing.
The SEC estimates that the one-time operational costs necessary to establish and implement a derivatives risk management program would range from $70,000 to $500,000 per fund, depending on the particular facts and circumstances and current derivatives risk management practices of the fund.
Proposed rule 18f-4 includes an exception from the risk management program requirement and limit on fund leverage risk for “limited derivatives users.” The proposed exception would be available to a fund that either limits its derivatives exposure to 10% of its net assets, or that uses derivatives transactions solely to hedge certain currency risks.