Registered Investment Funds 2021: New Derivatives Risk Program

For US traders, risk managers, portfolio managers, and boards of directors of registered fund management firms trading in derivatives, 2021 will be the year they figure out which derivatives to trade and how many to trade for more reasons than just making higher investment returns.

Complying with the Securities and Exchange Commission’s new rule 18f-4 curtailing the amount of leverage a fund can incur trading in derivatives, will require fund management firms to do a lot of math to see if the rule applies to them, then more math when it applies, and even more administrative work to remain in compliance. Mutual funds and exchange-traded funds are increasingly using derivatives to match or outperform benchmarks, yet the Investment Company Act does not mention derivatives. The SEC has consistently urged registered investment advisers to control their leverage when trading derivatives, but until now offered little clarity on what that meant. The SEC’s subsequent guidance and no-action letters offer a patchwork of recommendations leaving fund managers to decide for themselves just how much risk is too much.

The SEC estimates that less than 20 percent of registered investment funds will need to worry about the rule based on their low level of derivatives trading and of those that do only a fraction have leverage of over 200 percent. Still, even a handful of funds has the regulatory agency worried. “Although fund managers trading heavily in derivatives were likely to measure their value at risk, their work was part of an overall risk management program,” says Michael Spafford, a partner in the investigations and white collar crimes practice at Paul Hastings in New York. “The SEC is now highlighting derivatives as a more significant risk and deciding that registered investment funds need to independently evaluate and calculate the risks associated with derivatives trading.” The SEC first floated the idea of a derivatives risk rule for registered investment funds back in 2015 and issued another proposal for industry feedback last year. The final Rule 18f-4 under the Investment Company Act is more lenient than previous proposals in increasing the percentage of leverage allowed and in permitting more exemptions. A registered investment fund’s board of directors doesn’t have to approve of a fund’s derivatives risk management program. The SEC describes the board’s role as one having oversight, rather than day-to-day management, with the board allowed to ask about material risks involving the fund’s use of derivatives, to seek follow-up information, and inquire about any corrective actions.

Registered investment funds which do a lot of trading in derivatives will need to set up a derivatives risk management program and tap a derivatives risk manager officer to administer it. The program will include the identification and assessment of a fund’s derivatives risk, risk guidelines with discrete metrics, at least weekly stress testing and back testing and an escalation policy in case the SEC’s parameters are breached. The derivatives risk manager is required to periodically review the program to evaluate its effectiveness and report to the fund’s board of directors. The SEC’s “limited use” exemption applies only if derivatives exposure comes to less than ten percent of the value of the net assets of the fund. Derivatives exposure refers to the sum of the gross notional value of the derivatives contracts and in the case of short sales the value of all assets sold short. Commonly-traded derivatives such as interest rate, currency, and credit default swaps must be included in the calculation, but derivatives used to hedge certain currency or interest rate risks are not. The SEC did not adopt a controversial provision in its previous proposal that would have required a broker-dealer or registered investment adviser to evaluate the ability of an investor in a leveraged or inverse fund to understand the risks of investing in these funds. The SEC also grandfathered leveraged or inverse funds launched before October 28, 2020 from meeting the cap on leverage through value-at-risk metrics, but they must follow the other requirements. Unlike the proposal, which did not allow fund management firms to include reverse repurchase agreements from their calculation of derivatives exposure, fund management firms have a choice of whether to do so or not. In another difference from the proposed rule, funds can enter into unfunded commitment agreements if the fund has sufficient cash to meet its obligations.

Determining whether a fund reaches the required 10 percent threshold to fall under the new SEC rule will require fund management firms to do daily value at risk calculations based on the notional value of trades booked in order execution and trade execution systems. Those order management and trade execution management systems must interconnect with trade compliance applications to alert risk managers a breach has occurred. Should the fund management firm exceed the level of derivatives exposure to 10 percent of net assets it has five days to correct the breach by changing trading strategy. If the breach lasts more than five days, the fund management firm has to explain to the board how it will fix the problem within thirty days or implement a derivatives risk program. “If there were multiple breaches of the 10 percent threshold for a fund there is a good likelihood the fund management firm will need to implement a derivatives risk program for the fund,” says Rachael Schwartz, an attorney specializing in investment funds with Sullivan & Worcester in New York.

Planning ahead is a good idea as exceeding the threshold could occur quickly with just a few trades. “Fund management firms which are consistently under the 10 percent threshold and know they will not exceed it don’t need to create a derivatives risk management program,” says Erik Olsen, a managing director specializing in investment funds at ACA Compliance Group, a New York-based regulatory compliance consultancy. “However, the fund manager will still need to adopt policies and procedures reasonably designed to manage the fund’s derivatives risk. Fund management firms that are always on the edge of the 10 percent threshold need to create a figure for when they will start thinking about a derivatives risk management program before they breach the 10 percent ceiling.” Each fund will have to decide just what the edge is.

Fund managers must determine whether they need to set up a derivatives risk management program for each fund separately based on the SEC’s litmus tests. The SEC does not specify who should be the derivatives risk manager leading the charge for each fund other than to say it cannot be a portfolio manager. Presumably that individual will have sufficient knowledge of both risk management and derivatives. To fill the spot in-house fund management firms might consider the chief compliance officer or chief risk officer of a fund, but if neither fit the bill, a committee can be appointed which the SEC says can include the fund’s portfolio manager. “It will be interesting to see whether funds rely on a single derivatives risk director or committee,” says Schwartz. “If the fund manager does not have anyone in-house with the necessary derivatives experience in-house, it may decide to hire someone from outside the firm.” Finding the right match won’t be easy. Although there is no shortage of risk management specialists at broker-dealers it is unclear whether they would want to jump ship for lower paying jobs at buy-side firms and for greater personal responsibility under the title of derivatives risk manager.

Funds that use derivatives in more than a limited manner are subject to a daily cap on the value at risk which depends on the methodology used. In the case of the “relative VAR test” that will come to 200 percent, instead of the 150 percent in the proposed rule. Funds using the “relative VAR test’ must rely on a reference portfolio against which to measure the fund’s exposure. The reference portfolio can be a designated index or in a change from the proposed rule if the fund actively traded, the same fund without the derivatives contracts. Leveraged and inverse funds launched after October 28, 2020 are also subject to the 200 percent cap on leverage based on the relative VAR test. Funds that don’t use the relative VAR test can rely on an “absolute VAR test” in which case the VAR cannot exceed a 20 percent leverage. For closed-end funds the relative VAR cannot exceed a 250 percent leverage while the absolute VAR cannot exceed 25 percent. Most funds are expected to rely on the relative VAR test.

As if number crunching and monitoring weren’t hard enough, derivatives risk managers will need to be adept at educating their boards of directors about their VAR calculations and technology used. While it might not be practical for directors to understand the mathematical formulas used, they should sufficiently understand how to evaluate the reports the derivatives risk manager provides on a quarterly and annual basis about the derivative risk management program’s effectiveness and any changes needed. Derivatives risk managers will be required to report to their boards of directors about any breach of the 10 percent threshold or the value at risk and how it will be corrected. Given that sophisticated knowledge and experience are critical to fulfilling the legal obligations, fund boards might seek outside consultants to help establish a proper derivatives risk management program and monitor trading risk levels to ensure they are not breached.

Risk, trading and compliance professionals will likely need to be in frequent contact to monitor trading and value at risk. The derivatives risk management program, say legal experts, needs to include an escalation policy for when risk managers will notify compliance managers if the 10 percent threshold is breached as well as when portfolio managers and trading desks must reduce or alter trading in derivatives. The derivatives risk program also must indicate who is responsible for calculating value at risk and how the trading desk and portfolio manager are notified when the thresholds of leverage are exceeded. “Funds that rely heavily on derivatives as part of their trading strategy will likely not change their trading strategy, but those that are on the fringe of the 10 percent net asset value limit might,” says Olsen. “The calculations might be done in-house using licensed technology or outsourced depending on whether the fund manager wants to collect all of the necessary data or have someone else do the work.”

Although derivatives risk management and liquidity risk management programs must be written separately, they complement each other. “Fund managers can leverage their project plans and cross-divisional groups,” says Olsen. Both derivatives risk management and liquidity risk management programs require a written policy overseen by an individual or group of individuals with an annual assessment provided to a board of directors. However, liquidity risk management programs do require board approval . “The derivatives risk management program should be designed to evaluate risks associated with offsetting or liquidating specific derivatives included in the portfolio, particularly those which are bespoke, complex contracts or trade in volatile markets,” says Paul Hastings’ Spafford. “The liquidity risk management program should look at similar liquidity risks on a portfolio basis and evaluate derivatives liquidity as part of that portfolio, considering any derivatives that could be problematic.”

The interdepartmental coordination required to comply with the new derivatives risk management rule might end up being more stressful to administer than the mathematical requirements. The good news is that fund managers have 18 months to adjust so it won’t be until late 2022 that they have to be up to speed on the new rule. Still an SEC examiner could start asking questions during the next exam. “The SEC might want to know how the fund manager is preparing for the new rule, so it would be a good idea to start thinking about the rule and planning for implementation now,” says Spafford.