United States: Assessing The Limited Derivatives User Requirements Of Rule 18f-4—Notional Amounts
To print this article, all you need is to be registered or login on Mondaq.com.
This post continues our assessment of whether the Limited
Derivative User requirements of Rule 18f-4(c)(4) effectively and
efficiently accomplish the SEC’s aim of providing “an objective standard to identify funds that use
derivatives in a limited manner.” Here we question whether
the “gross notional amount” of a derivatives
transaction measures the means and consequences, rather than the
extent, of its use.
Successful and Unsuccessful Derivatives Users
We begin with an unambiguous example. On Monday, Gallant Fund
borrows shares of ABC Co. with a market value of $10,000; Goofus Fund borrows shares of XYZ Inc.
with the same market value. Both funds sell the shares short. At
the close on Tuesday, ABC Co. is down 1% and XYZ Inc. is up 1%.
The definition of derivatives exposure provides that “in
the case of short sale borrowings,” the derivatives exposure
is “the value of the assets sold short.” Hence, on
Tuesday, Gallant Fund’s short sale will add $9,900 to its
derivatives exposure while Goofus Fund’s short sale will add
$10,100. Did Gallant Fund use derivatives in a more limited manner
than Goofus Fund, or was its use more profitable? If XYZ Inc.
rallies on Wednesday and ABC Co. tanks, we do not believe this has
any bearing on whether one fund is a more extensive user of short
sales than the other.
Ambiguous Notional Amounts
What would Goofus Fund’s derivatives exposure be if it used
a total return swap with a notional amount of $10,000 to short XYZ
Inc. The guidance we found indicates that the gross notional amount
of a standard total return swap is its “notional principal amount or market value of
underlying reference asset.” In our example, the notional
principal amount is $10,000, but the market value of the underlying
reference asset on Tuesday is $10,100. How are we to interpret “or” in this context?
The FAQ providing this guidance says that
these are included among “some common methods used by funds
for determining a derivative transaction’s notional
amount,” which suggests a fund can elect to use either method
(presumably on a consistent basis). We could also imagine that a
conservative CCO might use whichever method results in the highest
derivatives exposure, but this would further complicate
calculations of derivatives exposure. Regardless, any use of the
notional amount of $10,000 would produce a different result than an
outright short sale borrowing, even though they are financially
equivalent transactions. We cannot find any principled basis for
such different results.
Converting to Dollar Amounts
An earlier post explained why Limited
Derivatives Users would have to translate the notional amount of
currency and commodity derivatives into dollar terms to calculate
their derivatives exposure as a percentage of net assets. Our post
noted three possible prices that could be used for conversion:
- the current market price of the underlying asset,
- the market price of the underlying asset at the time a fund
enters into the derivatives transaction, or
- the contract price of the derivatives transaction.
The first alternative would be consistent with the derivatives
exposure of short sale borrowings. The second alternative would be
consistent with the notional principal amount of a total return
The guidance does not resolve this question for FX futures
(“Number of contracts x notional contract
size (e.g., 12,500,000 Japanese yen)”). On the other hand, the
notional value of a commodity future is given as “number of
contracts x contract size (e.g., 1,000 barrels
of oil) x futures price.” We believe the “futures price” refers to the third of our price
This leads to an odd result, however. The current spot price of
West Texas Intermediate (“WTI”) is $77.68 per barrel. Oil
prices are expected to rise near term, so the contract (futures)
price of the November 2021 NYMEX WTI Crude Oil future is $81.16 per
barrel. The market expects prices to decline over the long-term, so
the November 2022 contract price is only $73.09. The size of the
futures contract is 1,000 barrels, so, according to the SEC’s
guidance, one November 2021 contract has a gross notional amount of
$81,160, while one November 2022 contract has a gross notional
amount of $73,090. Here again, we cannot imagine why a fund that
purchases the shorter-term futures should be treated as using
derivatives in a less limited manner.
In our next post, we consider how the Limited Derivatives User
requirements might be improved.
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.
POPULAR ARTICLES ON: Finance and Banking from United States