On Dec. 11, the Securities and Exchange Commission voted by a 3-1 margin to issue a proposed rule limiting how much investment companies such as mutual funds and exchange-traded funds can invest in derivatives such as futures, forwards and swaps. The proposed rule also contains a number of requirements aimed at addressing the risks of holding derivatives in investment portfolios.
The proposed rule, which is open for public comment until March 28, marks a major development in the SEC's approach to regulating the use of derivatives. The agency noted that its existing approach is based on decades-old rules and staff letters that have not kept pace with changes in the size and complexity of derivatives markets, and explained it drafted this rule to provide "an updated and more comprehensive approach" to the use of derivatives by funds.
"Derivatives can raise risks for a fund, including risks related to leverage, so it is important to require funds to monitor and manage derivatives-related risk and to provide limits on their use," said SEC Chair Mary Jo White.
Under the proposed rule, funds would be required to limit their aggregate exposure to derivatives to 150% of net assets. The proposed rule also includes an alternative approach that would allow exposures up to 300% if the funds can show that the derivatives reduce its market risk. The definition of derivatives includes swaps, futures, forwards and options. Derivatives exposures would be based on notional values,
The SEC acknowledged that certain existing funds, notably managed futures funds and leveraged ETFs, may not be able to comply with the restrictions on leverage if the proposed rule is adopted in its current form. In practical terms, these funds would have to shut down or restructure themselves as private funds or commodity pools, which would effectively make them off-limits to most retail investors.
The SEC also published a white paper on the use of derivatives that was prepared by its division of economic and risk analysis. According to this paper, 32% of U.S. registered funds use derivatives, with currency forwards, equity futures and interest rate futures being the most commonly used. Derivatives exposures averaged 20% of net asset value, and 96% of all funds had aggregate exposure below 150%.
