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SEC Addresses Fund Leverage Risk with Rule 18f-4

Regulations

By Nels Ylitalo  |  May 11, 2021

The 2008 financial crisis cast a long regulatory shadow. New Rule 18f-4 addressing funds’ use of derivatives has an August 19, 2022, compliance date, which is nearly 11 years to the day following the original concept release from the U.S. Securities and Exchange Commission (SEC). On the heels of Rule 22e-4, which required U.S. open-end funds to implement a liquidity risk management program, Rule 18f-4 adds another board-level risk management program to funds’ risk management frameworks and workloads. In this article, we review the principal features of Rule 18f-4—its motivation, the in-scope funds, and key requirements—and we discuss the impact on funds with respect to data and system requirements.

Motivation Behind Rule 18f-4

The SEC cited three primary purposes of Rule 18f-4: investor protection, risk transparency for regulatory oversight, and standardization of the patchwork quilt of section 18 compliance practices and guidance. 18f-4’s investor protection purpose is primarily fulfilled by placing leverage limits based on value at risk (VaR) on funds’ use of derivatives to reduce leverage-related risks and volatility. Transparency is achieved via a number of new reporting requirements, ranging from certain prospectus disclosures (depending on specific factors) to new elements in Form N-PORT, updates to Form N-RN (formerly “N-LIQUID”) and N-CEN, and fund-defined internal risk management reports with at least annual board program reporting. Lastly, standardization is achieved via Rule 18f-4’s codification of comprehensive derivatives risk management program requirements.

In-Scope Funds

In contrast to Rule 22e-4, which applies to registered open-end management investment companies and open-end exchange-traded funds, Rule 18f-4 applies to registered open-end and closed-end companies as well as business development companies. Both rules exclude money market funds regulated under Rule 2a-7. The differing scope of the rules relates to the nature and degree of risk inherent in the different types of funds as well as parallel and more stringent requirements for money market funds under 2a-7.

While registered open-end and closed-end funds are generally in-scope for 18f-4, in practice the rule has variable impact on funds depending on the extent to which they use derivatives. In broad terms: (i) funds that do not engage in derivatives transactions face no practical compliance requirements under the rule, (ii) funds with “derivatives exposure” (as defined in the rule) less than 10% of net assets (so-called “limited derivatives users” or “LDUs”) must measure and report the level of exposure, but are not required to implement the full range of VaR-based tests, backtests, and stress tests, and (iii) funds that engage in derivatives transactions, and are not LDUs, must adopt and implement the full program requirements.

Key Requirements

18f-4’s high level requirements are enumerated in section (c) of the rule, summarized as follows:

  • Derivatives risk management program: Funds must adopt and implement a written derivatives risk management program, including (i) risk identification and assessment, (ii) risk guidelines, (iii) “extreme but plausible” stress testing (at least weekly), (iv) backtesting of daily VaR test results (at least weekly), (v) internal reporting and escalation, and (vi) periodic review of the program (at least annually).
  • Limit on fund leverage risk: In-scope funds must (under paragraphs (i) and (ii)), determine compliance, at least daily, with either the relative VaR test (default/preferred) or absolute VaR test (where relative VaR would not be appropriate) and establish “prompt” return to compliance in the event of an exceedance; and, (iii), for protracted non-compliance—greater than five business days—undertake multi-stage internal reporting, analysis and correction.
  • Board oversight and reporting: A fund’s board must (i) approve a derivatives risk manager who must provide (ii) initial and periodic (at least annual) reporting to the board on the overall program implementation and effectiveness, and (iii) periodic board reporting (as determined by the board) in relation to exceedances, stress testing, and backtesting results.
  • Limited derivatives users: Funds with “derivatives exposure” less than or equal to 10% of fund net assets are not subject to the requirements outlined in the preceding paragraphs; however, they must still “adopt and implement written policies and procedures reasonably designed to manage the fund’s derivatives risk.” Protracted non-compliance with the 10% derivatives exposure limit entails various report and response procedures, including a decision whether to include the relevant fund in the full compliance program.

Rule 18f-4 contains additional sections pertaining to leveraged/inverse funds, record-keeping, current reports (Form N-RN), and addresses particulars regarding reverse repurchase agreements, unfunded commitment agreements and non-standard settlement cycle securities, with corresponding disclosure requirements on Form N-PORT, N-CEN and elsewhere, as sketched above.

Impact

As noted, 18f-4 has variable impact on funds depending on their use of derivatives, with the primary impact falling on the approximately 40% of in-scope funds that are either LDUs or require a full 18f-4 compliance operating model. For its part, the SEC estimated that the one-time per fund costs to establish and implement a derivatives risk management program will range from $150,000 to $500,000, for an aggregate first year cost to the industry of $685 million. The SEC estimated ongoing annual program costs at 65% to 75% of the one-time start-up costs, ranging from $97,500 to $375,000 per fund.

Although the SEC intentionally selected a VaR-based approach for regulating funds’ use of derivatives on the understanding that use of VaR-based risk management is already widespread in the industry, the rule’s risk model specifications and exceedance limits and reporting could entail more changes and challenges than initially appreciated. The requirement to capture derivative-specific risks exceed, for example, equity risk model capabilities. The daily, weekly, monthly, quarterly, annual, and event-based components will require a carefully geared compliance operating model in which funds’ testing, monitoring, recording and reporting tools are properly integrated to reduce friction, cost, and compliance risk.

Numerous funds have already launched internal 18f-4 working groups and are in the midst of designing their target compliance operating models, which includes making decisions such as whether to include all funds within the program, whether to apply the relative or absolute VaR test to a given fund, identifying internal and vendor systems that will best meet the workflow requirements, and the nature and type of monitoring and specific reporting items to institute. With respect to the latter, for example, funds are considering options for daily dashboard-style monitoring, enabling root cause analysis of exceedances via risk decomposition, and packaged or pre-defined board reporting on the program’s effectiveness.

Although 18f-4’s compliance date is August 19, 2022, few fund risk teams intend to wait until the final quarterly board meeting before the go-live date to present a program and plan for board approval. Many risk managers are actively designing their operating models today. Risk managers who have not yet commenced preparing for 18f-4 compliance are encouraged to do so—they are likely to find along the way that there is unexpected complexity to achieving a smoothly functioning and comprehensive compliance program.

GIPS 2020 Webcast (Part II)

Nels Ylitalo

Vice President, Director Product Strategy, Regulatory Solutions

Mr. Nels Ylitalo is Director of Product Strategy for Regulatory Solutions at FactSet. Previously, he worked in signals intelligence in the United States Navy prior to attending law school at Yale where he earned a JD in 2007. Following law school, he was a corporate/M&A attorney representing VC and PE funds as well as corporate clients in M&A transactions. Mr. Ylitalo’s portfolio covers a broad range of financial services regulations with a current focus on buy-side regulatory requirements and challenges, globally.

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