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Letter on SEC Derivatives Proposed Rule

Comments on proposals on use and classifications of derivatives


Managed Funds Association (MFA) and the Alternative Investment Management Association (AIMA) are pleased to have the opportunity to provide comments to the US Securities and Exchange Commission on its proposed rule on the ‘Use of Derivatives by Registered Investment Companies and Business Development Companies.’


MFA and AIMA generally support portions of the Proposed Rule but take strong exception to certain aspects of it. Although we acknowledge the Commission’s investor protection concerns regarding the use of derivatives by mutual funds and other registered investment companies, we question whether it is necessary to redefine and then regulate derivatives as ‘senior securities’ under Section 18 of the 1940 Act. We also have serious concerns that the Proposed Rule’s notional-based leverage limits are too blunt a risk mitigation tool for most derivatives used by funds.

Despite our concerns, we generally support the Commission’s activities-based approach in providing an updated and more comprehensive framework to regulate funds’ use of derivatives. As summarised below, we agree with several key aspects of the Proposed Rule, including requirements as to: asset segregation, a formalised derivatives risk management program (a ‘DRM Program’), and recordkeeping. In our view, these key pillars of the Proposed Rule render the imposition of any new notional-based limit unnecessary and inappropriate to address the policy objectives of Section 18 of the 1940 Act. More specifically, we believe the proposed asset segregation requirements would function as an effective leverage limit on funds’ use of derivatives as well as ensure funds’ ability to meet their payment obligations stemming from derivatives transactions. The combined effect of the DRM program and the proposed recordkeeping requirements would reinforce and support the proper application of the proposed asset segregation requirements.

Policy concerns with redefining derivatives as senior securities

We are fundamentally concerned with the Commission’s view in the Proposed Rule that derivatives transactions entered into by a fund, in compliance with the SEC’s long-standing policy and staff no-action guidance on asset segregation, should now be considered ‘senior securities’ under Section 18 and, in turn, become subject to the substantial conditions and restrictions in the Proposed Rule. In our view, the Commission’s sudden proposed reversal of its long-established policy on the treatment of derivatives under Section 18 of the 1940 Act lacks sufficient justification. However, if the Commission proceeds with redefining derivatives transactions as senior securities in a final rule, we agree with the Commission’s view in the Proposed Rule that a derivative that does not impose a future payment obligation on a fund would not involve a senior security transaction for purposes of Section 18 of the 1940 Act, because there would be no evidence of indebtedness.

Notional-based leverage limits are unjustified

In addition to our threshold policy concerns, we have serious concerns with the Proposed Rule’s alternative notional-based leverage limits. We believe such an overall leverage limit is both unnecessary and inappropriate because it lacks sufficient justification, given the practical effect of the Commission’s proposed asset segregation requirements and the potential reinforcing effect of the Commission’s other related regulations after their adoption. We note additionally that the notional-based limits are too insensitive to risk to be effective tools for gauging a permissible level of risk and leverage. If the Commission does proceed with adopting leverage limits and certain other aspects of the Proposed Rule, we respectfully urge the Commission to consider our proposed recommendations for modifications to the final rule. We suggest that the Commission’s policy objective to protect investors would be well-served by establishing a better balance between authorising funds to use derivatives for hedging, risk-mitigation and investment purposes, and imposing reasonable, practical restrictions that address the risks derivatives may present to funds and their investors.

Summary of our recommended alternatives to notional-based portfolio limits

As we discuss in Section IV of our letter, we believe that notional amount has inherent problems as a measure of risk and leverage. Basing funds’ portfolio exposure limits on the aggregate notional amounts of derivatives transactions is too blunt a measure, and will force many funds that do not, in fact, have a material amount of risk due to leverage to substantially alter their strategies or de-register without good reason. This outcome will have the potential unintended effects of limiting investor choice and undermining investor protection by depriving investors of opportunities to invest in alternative mutual fund strategies and their potential benefits. We believe these outcomes are not warranted, and accordingly, in our letter:

• We explain why we believe that the notional-based exposure limitation is unjustified and why we believe that a risk-based coverage amount and the mark-to-market coverage amount would be sufficient on their own. More specifically, we believe that a fund’s board should be authorised to base the proposed risk-based coverage amount on no less than the required initial margin for each of the derivatives transactions in the fund’s portfolio.

• We suggest that the Commission provide managed futures funds with the option to use a margin-based approach in lieu of both a notional-based limit and the riskbased coverage amount, pursuant to which the fund would segregate on its books and records an amount equal to, and in addition to, the initial margin requirement that the fund is otherwise required to satisfy in respect of each of its derivatives transactions.

• Alternatively, should the Commission proceed with adopting a notional-based exposure limitation in its final rule, we recommend that such limits be subject to certain risk-based adjustments or notional exposure ‘haircuts' based on the asset class of the derivatives transaction. We believe that such haircuts, together with a modified value-atrisk (VaR) test, would account more effectively for the risk of the underlying asset class and reflect more accurately the actual risk of the derivatives transaction.

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