United States: Assessing The Limited Derivatives User Requirements Of Rule 18f-4—Costs
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Our last series of posts on Rule 18f-4 have struggled to
understand how its Limited Derivatives User
requirements are supposed to work. We have done the best we could
to explain the process for calculating a fund’s
derivatives exposure, including determining the gross notional amount of
derivatives transactions and adjustments thereto, excluding
closed-out positions and currency and interest-rate derivatives
entered into for hedging purposes, and applying the “10% buffer” for these
hedges. In this series of posts, we shift our perspective to
assessing whether these requirements effectively and efficiently
accomplish the SEC’s objectives.
What Is the SEC Trying to Accomplish?
According to the release adopting Rule 18f-4:
The SEC sought to avoid:
Requiring funds that use derivatives only in a limited way to
comply with these requirements [to adopt a derivatives risk
management program and test their VaR, which] could potentially
require funds . to incur costs and bear compliance burdens that may
be disproportionate to the resulting benefits.”
The potential cost savings was an important aspect of the
SEC’s economic analysis. The SEC estimated that the one-time
cost to comply with the Limited User Requirements would range from $15,000 to $100,000,
while the one-time cost to establish and implement a derivatives
risk management program would range from $150,000 to
$500,000. In both cases, annual costs were estimated at between
65% and 75% of one-time costs, with an incremental annual cost
associated with VaR testing ranging from $5,000 to
$100,000.
How Many Funds Will Be Limited Derivatives Users?
The SEC’s estimate of how many funds might benefit from the
estimated cost savings seems inconsistent. In explaining why the
SEC chose a 10% derivatives exposure limit for Limited Derivatives
Users, they cited an analysis of September 2020 N-PORT filings by
the Division of Economic and Risk Analysis, “reflecting that 79% of funds had
adjusted notional amounts [of derivatives exposure] below 10% of
NAV.” The economic analysis, however, citing what we
assume is the same N-PORT analysis, estimated “that about 19% of funds . will
qualify as limited derivatives users.”
Could Calculating Derivatives Exposure Be as Hard as VaR
Testing?
The SEC’s economic analysis included an incremental annual
cost for daily VaR testing, but no corresponding cost for the daily
calculation of a Limited Derivatives User’s derivatives
exposure. In this context, we note that a VaR Fund does not need to
determine the gross notional amounts of its derivatives
transactions. A VaR test automatically includes the incremental
risks created or hedged by portfolio investments, regardless of
whether investments are derivatives. Thus, only a fund that uses
its securities portfolio to measure relative VaR will need to
identify derivatives transactions excluded from the securities
portfolio. Such a fund would not need to determine the gross
notional amount of the excluded derivatives transactions or adjust
for delta or 10-year bond equivalents to calculate its VaR relative
to its securities portfolio.
This means that VaR Funds that use an index as their designated
reference portfolio or use the absolute VaR test need not take the
steps outlined in our Step-by-Step Approach to
Calculating Derivatives Exposure, and a VaR Fund using its
securities portfolio as its designated reference portfolio will
only need to take the first step. Given that a Limited Derivatives
User must perform every step every business day for every
derivatives transaction, we wonder if the cost savings as compared
to a VaR Fund will prove as significant as the SEC estimated.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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