The proposed rule defines derivatives transactions broadly to include any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument under which a Fund is or may be required to make a payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination. Under the proposed rule, a Fund may invest in a derivatives transaction only if the Fund:
- complies with one of two alternative portfolio limitations;
- maintains certain qualifying assets and segregates such assets on its books and records; and
- depending upon the extent of a Fund’s derivatives usage, adopts a formal derivatives risk management program.
Portfolio Limitations. A Fund engaging in derivatives transactions would be required to comply with one of two alternative portfolio limitations that are intended to limit a Fund’s overall exposure and limit speculation by constraining its use of leverage. Each portfolio limitation would be measured at the time the Fund enters into any derivatives transaction.
- Exposure-Based Portfolio Limitation. The exposure-based portfolio limitation would impose a ceiling on a Fund’s exposure at 150% of its net assets. Exposure would be determined by aggregating the total notional amounts of the Fund’s derivatives transactions, its total obligations under financial commitment transactions and its total amount of indebtedness with respect to senior securities. Additionally, the notional amount for any derivatives transaction would be adjusted if:
- enhanced leverage is embedded into such derivatives transaction;
- the underlying reference asset is a managed account or entity formed primarily for the purpose of investing or trading derivatives transactions; or
- it is a complex derivatives transaction in which the amount payable at maturity is variable (e.g., knock-out or barrier trades or volatility swaps).
- Risk-Based Portfolio Limitation. The risk-based portfolio limitation would impose a ceiling on a Fund’s exposure at 300% of its net assets. A Fund would be permitted to utilize this portfolio limitation only if the derivatives transactions reduce the Fund’s market risk. In making this determination, the proposed rule would require the Fund to analyze market risk using a value-at-risk (VaR) test designed to estimate its potential losses on an instrument or portfolio over a 10-to-20-day time horizon at a confidence level of 99%.
Asset Coverage and Segregation Requirement. A Fund engaging in derivatives transactions would be required to maintain qualifying coverage assets and to identify and segregate such assets on its books and records on a daily basis. The amount of qualifying coverage assets is calculated based on the sum of two components:
- a mark-to-market coverage amount; and
- a risk-based coverage amount.
The mark-to-market coverage amount is the amount payable by the Fund if it were to exit the transaction. This coverage amount would be reduced by an amount equal to any variation margin that the Fund has posted as collateral under the relevant derivatives transaction. Additionally, if the Fund were to have a netting agreement in place, the mark-to-market coverage amount for each derivatives transaction could also be netted.
Qualifying coverage assets would include cash and cash equivalents or, if the Fund may satisfy its obligations under a derivatives transaction by delivery of a particular asset, such asset.
Risk Management Program. A Fund would be required to have a formal derivatives risk management program if:
- its derivatives exposure exceeds 50% of the Fund’s net assets; or
- it engages in any complex derivatives transactions (regardless of its exposure).
The SEC notes in the release for proposed Rule 18f-4 that, at a minimum, the risk management program would be required to address leverage risk, market risk, counterparty risk, liquidity risk and operational risk.
If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or
John A. MacKinnon
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James C. Munsell
+1 212 839 5609
Laurin Blumenthal Kleiman
+1 212 839 5525
Michael S. Sackheim
+1 212 839 5503
Sara N. Shouse
+1 212 839 5331
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