Investment Industry Groups Criticize SEC’s Proposal to Restrict Derivatives Use by Registered Funds

SIFMA AMG, the Managed Funds Association (“MFA”), the Alternative Investment Management Association (“AIMA”) and the Investment Company Institute (“ICI”) and, collectively, the “Fund Associations”) urged the SEC to make material changes to its proposed Rule 18f-4. In its current state, the proposed rule would restrict the use of derivatives by registered investment companies based on the notional size of derivative positions. The proposed rule also would impose size limits on such positions, expand asset segregation obligations by requiring funds to maintain specified values of “qualifying coverage assets,” and require certain funds to establish derivatives risk management programs.

The Fund Associations submitted three comment letters to the SEC that express similar concerns about the ways in which the SEC would trace and control derivatives risk under the proposed rule. The letters support other parts of the SEC’s proposal, particularly where they concern asset segregation, though the Fund Associations call for significant modifications to that aspect of the proposal as well.

The ICI’s comments contain a detailed analysis of the SEC’s proposal, provide suggestions for revisions, and include responses from an extensive survey of ICI members.

The deadline for comments on the proposal closed on March 28, 2016.

Lofchie Comment: The SEC’s proposal contains a number of aspects that should give pause to derivatives market participants.

First, the SEC’s use of the notional amounts of derivatives as a way to measure risk is inherently flawed. No one would accept the idea that investing $1,000 severally in U.S. government securities, junk bonds, S&P 100 stocks, gold and energy would entail comparable risks. The fact that a risk is taken with derivatives does not magically create parity. The risk originates with the underlying securities themselves and not from the bundling of those securities.

Second, the notion that derivatives are inherently more risky than other kinds of investments also is mistaken. During the financial crisis, it was not merely the derivatives market that crashed; it also was the housing market from which the funds were derived. The mistaken assumption that derivatives and not the underlying investments are the source of risk results in regulations that discourage the use of derivatives as a means to control risk (and, accordingly, those well-intended regulations increase risk). For an excellent discussion of this point, see “In Defense of Derivatives: From Beer to the Financial Crisis.”

Third, even if the SEC’s rule proposal is well intended and the proposed rule is good, it is still inappropriate for the SEC to reinterpret the term “senior security” to fit its current policy objectives. If the Investment Company Act does not serve the SEC’s purpose, then the SEC’s appropriate action should be to seek legislative change, not to create novel definitions for existing terms. Respect for the rule of law means that the government is not supposed to bend the meaning of established words to fit its immediate purpose.

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