What’s contained in new rule 18f-4

Here’s a rundown on what it entails for those registered fund advisers that invest in derivatives

Nearly two years in the making, this month heralds the compliance date for the mutual fund derivatives rule, Investment Company Act rule 18f-4 (see related story). Here’s a rundown on what it entails for those registered fund advisers that invest in derivatives.

Full derivatives users will have to calculate their relative value-at-risk (can’t exceed 200% of the VaR of a designated reference portfolio or, for closed-end funds, 250%). The mutual fund/ETF/or BDC adviser also would have to assess the risks of its derivatives portfolio, considering factors ranging from the market, credit spread risk to how sensitive the investments are to “changes in volatility.”

For ‘full’ derivatives users

For registered funds with derivatives making up more than 10% of their portfolio—full users—these advisers would have to establish a derivatives risk management program, including naming a derivatives risk manager. These users also would have to:

      1. Identify risks.
      2. Develop risk guidelines (they “must specify levels of the given criterion, metric, or threshold that the fund does not normally expect to exceed, and measures to be taken if they are exceeded”).
      3. Conduct stress testing “no less frequently than weekly.”
      4. Do backtesting at least weekly “of the results of the VaR calculation model.”
      5. Establish internal reporting and escalation procedures to keep key persons informed of the program.
      6. Require the derivatives risk manager to “in a timely manner” keep the board, portfolio managers and others informed of the program’s substantive metrics.
      7. Review the program at least annually. This task would fall to the derivatives risk manager.
      8. Limit fund leverage risk. The derivatives risk manager would have to take certain steps if compliance with a VaR test fell out of line, e.g., providing a written report to the board within five business days explaining how “the fund will come back into compliance.”
      9. Mandate board oversight of the program. Board members could dictate the frequency of staff reporting on the program to them.

For ‘limited’ derivatives users

So-called limited derivatives users (those with less than 10% in their funds) wouldn’t have to adopt a derivatives risk program. However, they would have to produce written P&Ps “reasonably designed to manage the fund’s derivatives risk.”

These advisers also would have to set up a system to ensure derivatives don’t exceed the 10% threshold. If the percentage tops that amount, the adviser would have five business days to alert its board of what actions should be taken. These could include steps to revert back under the 10% ceiling or to become a full derivatives user.

Both limited and full derivatives users would be expected under the new rule to keep a slew of documentation tied to its compliance with the rule, e.g., records of stress test results and copies of written reports provided to the board. Records must be kept for five years.

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