On October 28, 2020, the U.S. Securities and Exchange Commission voted to adopt rule 18f-4. This regulatory framework addresses the use of derivatives by registered funds and business development companies.
The rule is effective starting on February 19, 2021 and the compliance date is on August 19, 2022, leaving just a few months to comply with the rule and related reporting requirements
Regulated funds using derivatives, including mutual funds (other than money market funds), exchange-traded funds (ETFs) and closed-end funds, as well as business development companies.
Exception: limited derivatives users,i.e. funds for which the derivatives exposure is limited to 10% of its net assets.
The rule requires a fund to define and implement a derivatives risk management program. The written program has to include policies and procedures to identify and manage derivatives risks such as leverage, market, couterparty, liquidity, operational and legal risk in addition to any other risks.
The program will institute a standardized risk management framework for funds, while also permitting principles-based tailoring of each fund to the fund’s particular risks. The program must include risk guidelines as well as stress testing, backtesting, internal reporting and escalation, and program review elements.
A derivatives risk manager approved by the fund’s board of directors will administer the program and report to the fund's board on the program's effect.
The risk guidelines must provide for quantitative thresholds of the fund’s derivatives risks, and must specify the levels that a fund is not usually expectd to exceed.
A fund relying on the rule must comply with an outer limit on fund leverage risk based on two VaR (Value-at-Risk) limits - a relative VaR limit or an absolute VaR limit. This statistical measurement is used to calculate probable losses on an investment. VaR can help assess the impact of derivatives use on a fund, including whether such transactions are being used to leverage the fund or instead to hedge portfolio investments.
Under the relative test, a fund’s VaR must not exceed 200% of the designated reference portfolio’s VaR and under the absolute test it must not exceed 20% of the fund's AUM. The “designated reference portfolio” used in the relative VaR test can be an index or its own securities portfolio (defined as the fund’s investment portfolio, excluding derivatives transactions).
The Rule requires a fund to determine its compliance with the applicable VaR test at least once each business day.
The Program must include stress testing to evaluate potential losses to a fund’s portfolio in response to “extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the fund’s portfolio, taking into account correlations of market risk factors and resulting payments to derivatives counterparties”. The frequency of the testing must be undertaken at least on a weekly basis.
The Program must provide for backtesting of the results of the VaR calculation model used in connection with the VaR test. The backtesting must identify as an exception any instance in which the fund experiences a loss exceeding the VaR calculation’s estimated loss. The frequency of the testing must be undertaken at least on a weekly basis.
If a fund is not compliant with the VaR test, the fund has to return to compliance promptly.
If the fund remains out of compliance with the VaR-based limit for more than five business days, the Derivatives Risk Manager must provide a written report (Form N-RN) to explain why, how and when (number of business days) the fund will return to being in compliance and follow his compliance program with regular reporting to the fund’s board.
Confidential report : Form N-RN if the fund is out of compliance with the VaR-based limit on fund leverage risk for more than five business days.
Public report: Forms N-PORT and N-CEN will be required to provide certain information regarding a fund’s derivatives use. This will include information regarding the fund’s VaR, as applicable, and information about the fund’s derivatives exposure (for funds that rely on the limited derivatives user exception in rule 18f-4).
Monitoring Risk for rule 18f-4
to regulate use of derivatives for funds
Rule 18f-4 requires extensive modeling, daily computations of risk metrics and compliance monitoring. AMINDIS provides funds managers with AM-DIS, an automatable transparent modeling tool producing high-quality analytics and reports, keys to controlled costs.
The AM-DIS solution stands out by:
- Data control (relational database)
- Risk factor approach
- Consistent calculations
- High flexibility and transparency in modeling
- Large number of scenarios
- Data storage and historization
- Process automation
- Parallel processing for efficient handling of high numbers of portfolios
- Easy adaptation of guidelines (threshold criteria, frequency...)
- High reporting capacity
- Possibility to designate a reference portfolio other than an index