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The Securities and Exchange Commission (SEC) recently adopted a wholesale revision of US mutual fund derivatives regulations in the form of new rule 18f-4. This rule replaces the existing regulatory regime, which was based on asset segregation, with new fund-level risk-management obligations for funds. Unfortunately, the rule is not entirely clear on how these obligations are to be met by funds and advisers who engage subadvisers — and especially by funds managed by multiple subadvisers.
In response to the change, we assembled a cross-functional team to analyze the rule and determine how we can help our clients adapt to these new regulations, which go into effect in August 2022.
In this paper, we share a snapshot of where we are in the process and outline what services we plan to offer our clients to help them meet these new obligations and comply with rule 18f-4’s provisions.
What does rule 18f-4 require?
The new regulations increase risk-management requirements for funds that invest in derivatives, with differing obligations for “limited derivatives users” and those funds with higher derivatives use.
Funds that invest in derivatives on a limited basis are only required to generally assess their derivatives risk. These funds may not invest in derivatives in excess of 10% of their assets on a notional basis, subject to some adjustments for certain hedging transactions.
The more significant obligations are for those funds with higher derivatives use. These funds are required to establish a derivatives risk-management program that includes seven primary elements:
- Appointing a derivatives risk manager (DRM)
- Complying with a 200% relative value-at-risk (VaR) or a 20% absolute VaR requirement
- Backtesting the VaR formula used for the VaR test
- Identifying and assessing their derivatives risks
- Establishing derivatives risk guidelines
- Stress testing the fund’s portfolio
- Reporting and escalating any derivatives risks and VaR exceedances
In addition to the above, rule 18f-4 requires funds to both maintain associated records and make certain new reports to the SEC. In our view, funds and advisers must now consider how best to comply with these provisions.
Although new rule 18f-4 places these new obligations on funds and their appointed DRMs, it also provides flexibility for funds and their DRMs to delegate functions to other parties, including subadvisers. As an investment subadviser, we believe that we are well positioned to perform the investment-related functions under the rule. In addition, there are other areas where…
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