Hedging Derivatives Under Rule 18f-4: Not An “All Or None” Exclusion – Finance and Banking – United States – Mondaq News Alerts

This post will address another ambiguity in the “10% buffer” Rule 18f-4 provides for
excluding the notional amount of derivative transactions that hedge
currency or interest rate risks (“Hedging Derivatives”)
when calculating the Derivatives Exposure of a Limited Derivatives User. The ambiguity is
whether, once the notional amount of a Hedging Derivative exceeds
the 10% buffer, a fund should add back to its Derivatives Exposure
(a) the entire notional amount of the Hedging Derivative or
(b) only the notional amount in excess of the 10% buffer. We
chose answer (b) in our post on The 10% Buffer and Changes in Hedged
Investments. This post explains why.

The Problematic Situation

In our earlier post, we posited a situation in which a fund had
sold 80 of the September 2022 Euro FX Futures to hedge equity
investments with a value of €10 million, which then fell to
€9 million. As Euro FX Futures have a notional amount of
€125,000, 72 contracts would now be sufficient to fully hedge
the investments. Our post argued that the remaining 8 contracts
should still be regarded as “maintained” for purposes of
hedging the equity investments, so the 10% buffer should allow the
fund to exclude the remaining 8 futures to the extent of
€900,000 in notional amount.

In application, our argument would allow the fund to exclude at
least 7 futures, with a combined notional amount of €875,000.
The question is whether the fund could use the remaining
€25,000 to exclude part of the notional amount of the
remaining contract, or whether the fund must include the entire
€125,000 notional amount of that contract in its Derivatives
Exposure?

Why the 10% Buffer is Ambiguous

Our last post quoted the following sentence
from the adopting release:

According to this sentence, if the 10% buffer is exceeded, “it” will no longer qualify for the exclusion. Does “it” refer to “the notional amount of a
derivatives transaction” or to “the notional amount
of a derivatives transaction exceed[ing] the value of the
hedged investments by more than 10%?”

Derivatives Are Multi-Purpose Tools

In our view, the 10% buffer should be interpreted in the context
of the clause that precedes it: that a Hedging Derivative must be “entered into and maintained by the fund for
hedging purposes.” The sentence in the adopting release
and many of the comment letters seem to presume that a derivative
transaction can serve only one purpose. This is not the case; a
derivative can hedge to the extent the fund has an offsetting
exposure and also create an additional exposure to the underlying
asset. For example, if a fund holds €5 million principal
amount of bonds, a forward contract to sell €10 million will
hedge these bonds as well as create a €5 million short
position in the euro. Our approach would recognize this possibility
by treating €5 million of the forward as entered into for
hedging purposes and including only €5 million of the notional
amount in the fund’s Derivatives Exposure.

Avoiding Arbitrary Distinctions

Recognizing that only part of the notional amount of a
derivative transaction may need to be included in a fund’s
Derivatives Exposure avoids arbitrary differences in applying the
10% buffer to different types of Hedging Derivatives. Because our
initial example involved 80 futures contracts, the impact of
exceeding the 10% buffer could be limited to a single contract.
This would not be the case if the fund entered into a single
€10 million forward and the fund had to include the entire
notional amount in its Derivatives Exposure once the value of the
hedged investments fell below €9.09 million.

A fund could avoid this result by breaking up the euro forward
in advance. For example, the fund could ask for 400 confirmations
of identical €25,000 forwards, and include only 4 of the
forwards in its Derivatives Exposure once the value of the
investments fell to €9 million. We trust the pointlessness of
such an exercise is obvious, and it is better to recognize that
some part of the notional amount of a derivative transaction can
serve a hedging purpose even as the remaining notional amount does
not.

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.