SEC Updates the Rules that Regulate Funds' Use of Derivatives

November 9th | 2020

The SEC recently adopted amendments rule 18f-4 under the Investment Company Act to provide an updated, comprehensive approach to the regulation of funds’ use of derivatives. The rule sets up a new framework under which funds using derivatives generally will have to:

  1. adopt a derivatives risk management program and designate a derivatives risk manager to administer it, which fund’s board of directors must oversee;

  2. comply with an outer limit on fund leverage risk based on a value at risk ("VaR") test that compares the fund's VaR and the VaR of a "designated reference index;" and

  3. comply with reporting and recordkeeping requirements regarding their derivatives use.

Funds that use derivatives only in a limited manner will not be subject to these requirements, but they will have to adopt and implement policies and procedures reasonably designed to manage the fund’s derivatives risks. The amendments also modify rule 6c-11 under the Investment Company Act to allow leveraged/inverse ETFs that satisfy that rule’s conditions to operate without the expense and delay of obtaining an exemptive order.

A core purpose of the Investment Company Act is to protect investors against the potentially adverse effects of a fund’s issuance of senior securities, and in particular the risks associated with excessive leverage of investment companies.

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