Use of Derivatives

December 22, 2020

The Securities and Exchange Commission (the “SEC”) adopted Rule 18f-4 (the “Rule”) under the Investment Company Act of 1940 (the “1940 Act”), including rule and form amendments, to provide an updated approach to the regulation of funds’ use of derivatives and certain other transactions. The Rule allows mutual funds (other than money market funds), ETFs, registered closed-end funds, and business development companies, to enter into derivatives transactions and certain other transactions despite the restrictions under Section 18 of the 1940 Act.

The following entities have been amended in connection with the Rule

• Rule 6c-11, to allow leveraged or inverse ETFs to operate without obtaining an exemptive order;
• Form N-PORT;
• Form N-LIQUID (to be re-titled as “Form N-RN”);
• Form N-CEN;
• Form N-2.

In order to enter into these types of transactions, the following conditions must be met including:

• Adopting and implementing a written Derivatives Risk Management Program* containing:
  • Program Administration
  • Risk Identification and Assessment
  • Risk Guidelines
  • Stress Testing
  • Backtesting
  • Internal Reporting and Escalation
  • Periodic Review of the Program (at least annually),
• Complying with an outer limit on fund leverage risk based on Value-at-Risk (“VAR”) test (relative or absolute test),
• and Recordkeeping.

If a fund is a “limited derivatives user,” it is not required to meet the first two conditions listed above, so long as it adopts and implements written policies and procedures reasonably designed to manage its derivatives risks.

* Must be administered by a Board-approved derivatives risk manager. This person must be an officer (or officers) of the fund’s investment adviser, and may not be a portfolio manager of the fund.

Reporting Requirements

Form N-PORT. Amendments require a fund to report information regarding its derivatives exposure if it is relying on the limited derivatives user exception, and (for applicable funds) information regarding its compliance with the VAR-based limit on leverage risk. Certain information will be reported confidentially to the SEC.

Such amendments to Form N-PORT consist of reporting:

• Derivatives Exposure (non-public).
  • Funds that rely on the limited derivatives user exception in the Rule will be required to report derivatives exposure information, including:
    • its derivatives exposure;
    • its exposure from currency derivatives that hedge currency risks;
    • its exposure from interest rate derivatives that hedge interest rate risks;
    • the number of business days, if any, in excess of the five-business-day remediation period that the fund’s derivatives exposure exceeded 10 percent of its net assets during the reporting period.
  • VAR Information (VAR data non-public; designated reference portfolio public).
    • Funds that are subject to the VAR-based limit on fund leverage risk during the reporting period will be required to report their median daily VAR for the monthly reporting period and, as applicable, the name of the designated index and its index identifier.
  • Backtesting Results (non-public).
    • A fund will have to report the number of exceptions it identified during the reporting period arising from backtesting the fund’s VAR calculation model.

Form N-RN (formerly Form N-LIQUID). Amendments require a fund to notify the SEC confidentially when a fund exceeds its applicable VAR limit for five business days. A fund must report this information within one business day (following the fifth business day after its VAR limit exceedance). The fund must file a second report when it is back in compliance.

Form N-CEN. Amendments require funds to check a box to identify whether they relied on the Rule during the reporting period, including on whether they relied on various specific provisions of the Rule.

Form N-2. Amendments conform Form N-2’s senior securities table to the provisions of the Rule that provide that a fund’s derivatives transactions and unfunded commitment agreements entered into in compliance with the Rule will not be considered for purposes of computing asset coverage under Section 18(h) of the 1940 Act.

Final Rule

https://www.federalregister.gov/documents/2020/12/21/2020-24781/use-of-derivatives-by-registered-investment-companies-and-business-development-companies 

Compliance Dates*

Rule Effective Date:

February 19, 2021

Rule Compliance Date (and Release 10555 rescinded):

August 19, 2022

* A fund may rely on the Rule after its effective date but before the compliance date, provided that the fund satisfies the Rule’s conditions. In addition to meeting certain other conditions, funds that rely on the Rule before the compliance date must also comply with amendments to Form N-PORT and Form N-CEN, once the updated forms are available for filing on EDGAR.

The FilePoint Solution

FilePoint aims to be the most knowledgeable, cost-effective, and efficient source of investment management products. We know the rules and can help your fund comply with new requirements. Contact us today for more information about how we can help your fund comply with the new rule.