SEC Proposes to Modernize Regulation of the Use of Derivatives by Registered Funds and Business Development Companies

November 25, 2019

Published: SEC

The Securities and Exchange Commission has voted to propose a new rule designed to enhance the regulation of the use of derivatives by registered investment companies, including mutual funds, exchange-traded 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 Commission’s proposal recognizes the extensive changes that have taken place in our capital markets and the fund industry over the past several decades, including the importance of derivatives in effective portfolio management,” said SEC Chairman Jay Clayton. “Funds frequently use derivatives to gain exposure to certain asset classes more efficiently and to mitigate risks, but in certain cases derivatives can heighten risks to investors and markets, including risks related to leverage. By standardizing the framework for funds’ derivatives risk management, the proposal would benefit investors, funds and our markets, including by providing for more-effective risk management across funds and enhanced investor protections.”

The Investment Company Act limits the ability of registered funds and business development companies to obtain leverage, including by engaging in transactions that involve potential future payment obligations. Leverage is commonly thought of in terms of purchasing securities with borrowed funds. However, derivatives, such as forwards, futures, swaps and written options, can also create future payment obligations. The proposed rule would permit these funds to use derivatives that create such obligations, provided that they comply with certain conditions designed to protect investors. 

These conditions include adopting a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may obtain, based on value-at-risk.  A streamlined set of requirements would apply to funds that use derivatives in a limited way. The proposed rule would also permit a fund to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments, subject to conditions tailored to these transactions.

Certain registered investment companies that seek to provide leveraged or inverse exposure to an underlying index—including leveraged ETFs—would not be subject to the proposed limit on fund leverage risk but instead would be subject to alternative requirements under the Commission’s proposal. These funds would have to limit the investment results they seek to 300% of the return (or inverse of the return) of their underlying index (i.e., three times leveraged). Sales of these funds also would be subject to proposed new sales practices rules. Under these new rules, a broker, dealer, or investment adviser that is registered with the Commission would have to exercise due diligence in approving a retail customer or client’s account to buy or sell shares of these funds, as well as shares of exchange-listed commodity or currency pools that have similar investment strategies. These proposed new rules are designed to help ensure that retail investors in these products are limited to those who are capable of evaluating their characteristics—including that the funds would not be subject to all of the leverage-related requirements under the proposed rule applicable to registered investment companies generally—and the unique risks they present.

The proposal will be published on and in the Federal Register. The comment period for the proposal will be 60 days after publication in the Federal Register.


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