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Improving The Limited Derivatives User Provisions Of Rule 18f-4 – Finance and Banking – United States – Mondaq News Alerts

United States: Improving The Limited Derivatives User Provisions Of Rule 18f-4

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Our last post explained why the Limited Derivatives User provisions
of Rule 18f-4(c)(4) may not “provide [the] objective standard to identify funds that use
derivatives in a limited manner” anticipated by the SEC.
Inconsistencies in methods of determining the notional amounts of
derivatives transactions may cause funds that use such transactions
in the same manner and to the same extent to be treated differently
under the rule. The previous post also questioned whether
requiring Limited Derivatives Users to perform the complex
calculations required to determine their derivatives exposure each
day might “incur costs and bear compliance burdens that may be
disproportionate to the resulting benefits.”

This post points out some alternatives that would address our
concerns, although it may be too late to implement one of them.

Base Notional Amounts on the Dollar Value of the Underlying

As reiterated in our last post, there should be three possible
prices that a fund might use to translate a non-dollar denominated notional amount
into a dollar equivalent
 when calculating its derivatives
exposure as a percentage of its net assets.

  1. The current market price of the underlying asset. This would be
    consistent with the treatment of short sale borrowings but would
    leave a fund’s status as a Limited Derivatives User at the
    mercy of changes in the market for the underlying assets.
  2. The market price of the underlying asset at the time a fund
    enters into the derivatives transaction. This would be consistent
    with the usage of “notional amount” in swap transactions,
    but may permit a fund’s derivatives exposure to impact its
    performance to a greater extent than the SEC intended.
  3. The contract price of the derivatives transaction. As
    illustrated by the oil futures discussed in our last post, this would produce inconsistent
    results unrelated to the extent funds use such futures.

Given that every alternative has drawbacks, we would recommend
that the SEC choose either the first or second alternative and
apply it consistently to all derivatives transactions. This would
at least prevent the rule from skewing derivatives strategies by
treating some types of derivatives as creating more derivatives
exposure than others.

Test Compliance at the Time of a Derivatives Transaction

The Limited Derivatives User requirements would better “identify funds that use derivatives in a limited manner”
if the requirements were applied when a
fund used  derivatives. This could have
been accomplished by requiring a fund to comply with the 10% limit
on derivatives exposure only when a fund enters into a derivatives
transaction rather than requiring daily compliance. While this
would have permitted some Limited Derivatives Users to temporarily
have derivatives exposures exceeding 10% of their net assets, it
would still prevent them from adding to their exposure during such

Testing compliance at the time of transactions would have given
funds control over their status as Limited Derivatives Users
without adding significantly to their derivatives risk. It would
have also eliminated the need for the cumbersome remediation
procedures outline in Part III of our 
Compliance Checklist for Limited Derivatives Users

What Alternatives Are Open?

Requiring Limited Derivatives Users to test compliance at the
time of a derivatives transaction rather than each day would
effectively amend Rule 18f-4(c)(4). We doubt that anyone is
interested in a third round of notice and comment on this rule. We
note, however, that the SEC staff used an FAQ (Question 50) to permit a government
money market fund to determine compliance with the 99.5% government
security requirement “each time it acquires a portfolio
security.” While we are troubled by the potential
circumvention of the Administrative Procedures Act, we doubt anyone
would object to a similar interpretation for Limited Derivatives

If Limited Derivatives Users were to determine compliance at the
time of a derivatives transaction, then it would make sense to use
the contemporaneous market price of the assets underlying all of
its derivatives transactions to calculate its derivatives exposure.
This would prevent the derivatives exposure of a Limited
Derivatives User from further increasing after changes in market
values and net assets caused it to exceed 10%.

If Limited Derivatives Users must calculate their derivatives
exposure daily, calculating the notional amount of a derivatives
transaction based on market values at the time of the transaction
would reduce cost and increase the fund’s control over its
status. Except for the notional amount of options sold (which must
still be delta adjusted daily), notional amounts would be
calculated at acquisition and would not need to be updated,
reducing compliance costs. As changes in the market values of the
underlying assets would not affect a fund’s derivatives
exposure, its continued status as a Limited Derivatives User would
depend primarily on changes in its net assets, making it less
likely that the derivatives exposure might exceed 10% of net

Our final post on Limited Derivatives Users will collect the
open issues we’ve identified in this series.

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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