UNITED STATES: SEC Adopts Modernized Regulatory Framework for Derivatives

Thursday October 29 2020

On 28^th October 2020, the Securities and Exchange Commission (SEC) announced that to enhance the regulatory framework for derivatives use by registered investment companies, including mutual funds (other than money market funds), exchange-traded funds (ETFs) and closed-end funds, as well as business development companies. The new rule and rule amendments will provide a modernized, comprehensive approach to the regulation of these funds’ derivatives use that addresses investor protection concerns and reflects developments over the past decades. The Commission is committed to designing regulatory programs that reflect the ever-broadening product innovation and investor choice available in today’s asset management industry, while also taking into account the risks associated with funds’ increasingly complex portfolio composition and operations.

The Investment Company Act limits the ability of registered funds and business development companies to engage in transactions that involve potential future payment obligations, including obligations under derivatives such as forwards, futures, swaps and written options. The new rule permits funds to enter into these transactions if they comply with certain conditions designed to protect investors. These conditions include adopting a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may obtain based on value-at-risk, or “VaR.”

A streamlined set of requirements will apply for funds that use derivatives in a limited way. The rule also permits a fund to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments, subject to conditions tailored to these transactions. Funds, including money market funds, will now be permitted under the rule to invest in securities on a forward-settling basis. Funds also will be subject to reporting and recordkeeping requirements regarding their derivatives use.

Finally, the new rule requirements also apply to leveraged or inverse ETFs. The Commission has directed the staff to review the effectiveness of existing regulatory requirements in protecting investors, particularly those with self-directed accounts, who invest in complex investment products (including leveraged or inverse products).  As part of this review, the staff will consider whether the Commission’s promulgation of any additional requirements for these products may be appropriate.

The new rule will be published on the Commission’s website and in the Federal Register. The rule and related rule and form amendments will become effective 60 days after publication in the Federal Register. The Commission has provided for an eighteen month transition period for funds to comply with the rule and related reporting requirements.

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