On 28 October 2020, the Securities and Exchange Commission (SEC) finalized its long gestating Derivatives Rule, which limits the amount of imbedded leverage in mutual funds and Exchange-Traded Funds (ETFs). The proposal is an outgrowth from policymakers’ concerns about the potential systemic risk posed by aspects of asset management. The Derivatives Rule was first proposed in 2015, but it was abandoned due to fierce industry criticism that it was overly prescriptive and could restrict product offerings. However, last year the SEC attempted to address many of the industry concerns with a revised proposal.
With the Derivatives Rule now finalized, asset managers can assess what it means for their businesses.
Three Things to Know
Know Your Limits
Under the Derivatives Rule, funds are subject to a leverage limit of 200%, based on Value at Risk (VaR) calculations of a designated benchmark or 20% of the fund’s net assets using an absolute VaR test. As a result, previously approved 300% leveraged ETFs have been grandfathered and any future leveraged ETF will need to comply with the 200% limit. Funds that limit their derivatives use to 10% of their net assets are exempt from the VaR test limits. Additionally, there are exemptions for currency and interest-rate hedging.
A critique of the revised proposal was that certain elements were out of step with the Undertakings for the Collective Investment in Transferable Securities (UCITS) derivatives rules. However, the final rule has corrected this and introduces leverage limits that are in line with the UCITS derivatives rules. Now, similar to the UCITS derivative rules, it allows a fund to measure its VaR against its investment strategy, rather than against a general index. Asset managers welcome this harmonization, as it will make it easier to manage derivatives programs across their global fund ranges. This is another example of the recent cross-pollination between the US and EU regulators. “The US liquidity rules also borrowed from the UCITS tool kit by allowing funds to deploy swing-pricing,” says Kelli O’Brien, Director of Fund Administration at Citi Securities Services. “For an industry that is increasingly global, this sort of incremental harmonization creates a framework for firms to maintain a more unified operating model, which can help control costs.”
More Reporting Requirements
As often occurs with new regulations, the Derivatives Rule comes with additional reporting requirements. Asset managers will have to establish a written derivatives risk management program that includes risk guidelines, stress and back testing, internal reporting, and program review procedures. The fund board will have to approve a derivatives risk manager that will be responsible for administering the program. In addition, fund N-PORT, N-CEN, and N-LIQUID (renamed N-RN) reporting will have to be updated with information regarding its derivatives use. In broad strokes, the new derivatives risk management requirements are similar in design to the liquidity risk management requirements that were introduced in 2018.
For asset managers with European funds much of this will be familiar because the Derivatives Rule is comparable to the derivatives reporting requirements for UCITS funds. These firms may look to leverage their existing UCITS derivatives programs for their US funds.
Mainstreaming Leveraged ETFs
Under the new rule, it could be easier to launch leveraged ETFs. Previously, launching a leveraged ETF has been challenging for managers as it required exemptive relief from the SEC, which had not been granted since 2012. However, assuming that ETFs comply with the Derivatives Rule and the 200% leverage limit, exemptive relief will no longer be required. Last year the SEC removed its exemptive relief requirements for non-complex ETF products. The completion of the Derivatives Rule means that the SEC no longer considers leveraged ETFs complex, so they can avail of the streamlined ETF approval process.
“The move to fold leveraged ETFs into the ETF Rule is consistent with the SEC’s push to replace the current mosaic of guidance and exemptive relief with harmonized industry-wide rules,” notes Peggy Vena, Director of ETF Product Development at Citi Securities Services. “It will be interesting to see what this means for the future of ETF innovation; by folding leveraged ETFs into the streamlined authorization process, the SEC may have more bandwidth to focus on approving more exotic products, such as Bitcoin ETFs.” The SEC has rejected numerous cryptocurrency ETF proposals over the last seven years, citing concerns about the potential for fraud and compatibility with the custody regulations. However, in recent public statements the SEC has indicated that it is willing to reconsider the issue.
Where do we go from here?
While the industry has broadly welcomed the final Derivatives Rule, not everyone is satisfied. Consumer advocates are concerned that allowing more leveraged ETFs could harm investor protection because retail investors may not fully understand the risks associated with these products.
The SEC had considered requiring advisers to determine whether investors are capable of understanding the risk of leveraged and inverse ETFs before selling them. In the end, the SEC decided that its Regulation Best Interest rules sufficiently address the concerns around these products and that additional rules aren’t required. The SEC has said that it will continue to investigate the issue of pre-sale disclosure and this could be wrapped into its ongoing work to update its Fund Name rule. “It’s likely that the issue will not fade away and that there could be a push for further regulation that applies to all retail fund sales and not just leveraged ETFs,” notes O’Brien.
The Derivatives Rule will go live in February and there is an 18 month transposition period. So, impacted firms will have until August 2022 to get their derivatives risk management programs in place. However, firms looking to avail of the streamlined approval process for leveraged ETFs may want to comply with the rules from an earlier date.