The U.S. Securities and Exchange Commission has re-proposed a set of rules to limit leverage and use of derivatives by US funds. Dubbed 18f-4, the new SEC fund leverage rules, if adopted, will likely pose significant data management challenges for the investment management community. Any fund holding derivatives in their portfolio will be obliged to comply with certain process requirements (specifically around derivatives risk management) and leverage caps (restricting use of those derivatives). Those caps will be based on the daily computation of risk metrics and validation tests to ensure funds remain within their limits.
What are the Test Metrics?
The leverage caps will be based on either a ‘relative’ or ‘absolute’ test. The test metric being proposed is Value at Risk (VaR) calculated over a rolling 20-day period using a 99% confidence interval. The relative test will compare the fund’s VaR against a “designated reference index” (DRI) and would require that the ratio does not exceed 150%.
Should the fund not have an appropriate index to compare itself against, then the absolute test would require that the VaR measure does not exceed 15% of the fund’s value (in other words, that the fund is 99% likely not to fall by more than 15% over a 20-day period).
How Will VaR be Calculated?
At present, the proposed rules do not specify a methodology for calculating VaR, suggesting that derivatives risk managers should be able to choose between historical, parametric or Monte Carlo models depending on which is most appropriate for the fund and its situation. One specification is that funds choosing the historical simulation method should base its VaR calculation on at least three years of historical data. There is also guidance offered on which risk factors should be included in a firm’s VaR models. The “non-exhaustive” list includes delta (equity, interest rate, credit spread, FX and commodity prices); gamma, also known as curvature risk (nonlinear relationship with underlying, and vega or “volatility.”
Who is in Scope of the Rule?
The proposed rule would apply to any “fund,” including “open-end” mutual funds and exchange traded funds (ETFs) as well as “closed-end” investment funds or “business development companies” (BDCs). There will be exemptions to the rule. One fund category that would fall outside of the rule are money market funds, which are regulated under rule 2a-7 of the Investment Company Act. Also, if a fund’s total derivatives exposure is less than 10% of its net asset value or if it only uses derivatives to hedge currency risk, then it should also be exempt. Finally, another exemption applies to funds specifically designed to provide leveraged or inverse exposure to a particular index, which could have that leverage capped at 3x and subject to suitability checks when sold to retail investors.
Can Investment Managers Outsource Responsibility?
The proposed rule does not allow investment companies to contract a third party as their “derivatives risk manager.” However, risk managers can contract third parties to help administer the program by providing relevant “data” or “other analysis.”
Are firms required to back-test VaR models?
At present, the proposed back-testing requirements are relatively stringent. The proposed rule would require funds to back-test their models each business day. A fund would need to compare a one-day VaR measure, calculated at the close of the previous business day, against its actual gain or loss for that day. Using a 99% confidence interval would result in approximately 2 ½ expected breaches per year.
It is interesting to note that other equivalent regulations (such as UCITS in Europe) require less frequent back-testing (monthly, although using daily data). The SEC is proposing that funds be required to back-test daily so that a “derivatives risk manager could more readily and efficiently adjust or calibrate its VaR calculation model and more effectively manage the risks associated with its derivatives use.”
What needs to be reported?
Under the new proposals, firms would face reporting obligations that are both public (helping potential investors make decisions through more detailed risk disclosures) and non-public (alerting regulators to potential issues with a fund).
Reporting Limit Breaches
With regards to the relative and absolute test results, it is important to note that a single breach will not immediately trigger a reporting requirement. Instead, firms are afforded a few business days to come back into compliance. It is only if test limits (150% for the relative test, and 15% for absolute) have been breached for three consecutive days that a firm would have to file a report to the regulator (no later than the day after the third consecutive breach). Should this requirement be triggered, the information to be submitted includes:
- Dates on which the test breaches occurred (fund portfolio’s VaR exceeded 150% of the VaR of its designated reference index for relative test; or portfolio VaR exceeded 15% of net asset value for absolute test)
- The VaR of its portfolio for each of these days
- The value of the fund’s net assets for each of these days (if subject to absolute test)
- The VaR of its designated reference index for each of these days (if subject to relative test)
- The name of the designated reference index and index identifier (if subject to relative test)
Regular Monthly Reports
Under the current proposals some data will also be reported on a more regular basis – monthly – as part of the SEC’s new N-PORT filings. Although these will be made monthly, only data from every third month will be made public.
Data to be reported includes:
- Highest daily VaR (and VaR ratio if applicable) during the reporting period and its corresponding date,
- Median daily VaR (and VaR ratio if applicable) for the monthly reporting period
- Name of the fund’s designated reference index and index identifier (if applicable)
- Number of exceptions the fund identified from back-testing its VaR model
When Will This Happen?
SEC fund leverage rules 18f-4 was originally proposed in 2015, but received significant pushback from market participants and did not make it into law. Instead, the regulator has now taken on-board market feedback and made changes to the re-proposed rules. The current re-proposed rule is under consultation and one of the questions for consultation is how long participants feel it would take to be ready to implement the new rules – with options ranging from 6-12 months to more than 24 months.
How Should Firms Operationalise Compliance with the New Requirements?
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