Category Archives: Derivatives

IOSCO Examines Impact of Storage Infrastructure on Market Pricing of Commodity Derivatives

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IOSCO issued a report on the impact of storage and delivery infrastructure on the market pricing for commodity derivatives. The report is composed of six parts: (i) an introductory discussion of the importance of the physical delivery infrastructure to the financial markets, (ii) an overview of regulatory issues, including whether a regulator has the authority to regulate derivatives exchanges as well as clearinghouses that also serve as warehouses, (iii) an overview of operational issues, such as physical storage procedures, and storage and loading costs, (iv) a discussion of governance and conflicts of interest, e.g., whether persons who control a warehouse also are participants in the derivatives markets, (v) access to information and (vi) conclusions. The report concludes with recommendations for the development of industry best practices in order to avoid a breakdown in storage infrastructure or disruptions in the marketplace.

Lofchie Comment: Over the past several years, it has been asserted that derivatives prices in the aluminum market were manipulated by the warehouses, but the CFTC seems to have found no evidence to support those accusations. See Senate Agriculture Committee’s Stabenow Calls on “CTFC” to Review Alleged Manipulation of Aluminum Market (with Lofchie Comment); IOSCO to Survey Effects of Storage Warehouses on Price Formation in Commodity Derivatives Markets (with link to Streetwise Professor).

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

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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.

CFTC Issues Comparability Determination for European CCPs (Fed. Reg.)

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The CFTC published a notice in the Federal Register that it approved (i) a substituted compliance framework for dually registered central counterparties (“CCPs”) located in the European Union and (ii) a comparability determination with respect to certain EU rules. The CFTC’s determination allows European clearinghouses that are registered with the CFTC as derivatives clearing organizations, and that are also overseen by European regulators, to comply with EU requirements that satisfy equivalent CFTC requirements for financial resources, risk management, settlement procedures, and default rules and procedures.

The determination is effective immediately.

Lofchie Comment: At last, the CFTC is making meaningful progress in closing the regulatory rift between the United States and the European Union. Such progress is due to the persistence and determination of CFTC Chair Massad who managed to overcome his predecessor’s vision of a Europe surrendering to the dominance of U.S. regulation – a vision that failed completely and proved to be a waste of time and energy.

 

CFTC Chair Massad Cites Regulatory Progress and a Strengthened Financial System

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In response to the public’s concern about the economy in these “anxious times,” CFTC Chair Timothy M. Massad stated that uncertainty and volatility in markets are the “very reasons” that the derivatives markets exist. In remarks delivered at the FIA International Futures Industry Conference in Florida, he delineated five areas where there has been significant CFTC progress toward a stronger financial system.

Common Approach to Transatlantic CCPs. Chair Massad stated that the first action exemplifying the CFTC’s progress is the agreement reached with the EU that establishes a common approach to central clearing counterparties (“CCPs”). The agreement resolves issues surrounding Europe’s recognition of U.S. CCPs and the CFTC’s recognition of European CCPs, which is effected through “substituted compliance” that permits such CCPs to comply with U.S. rules by adhering to the corresponding EMIR requirements. Separately, Chair Massad announced that the CFTC will consider measures to enhance trading on and participation in swap execution facilities, including formalizing past “no-action” positions and considering whether the CFTC should play a greater role in the “made available to trade” determination process.

Clearinghouse Resiliency. CFTC Chair Massad outlined the work that international regulators are doing to promote recovery and resolution planning. Additionally, the CFTC, the FDIC and the U.S. Treasury Department met to “engage in an exercise” that explored how U.S. regulators might respond if a clearinghouse faced credit or liquidity shortfalls.

Promoting Customer Protection and a Robust Clearing Member Industry. The CFTC held a roundtable in the earlier part of March to discuss the “residual interest rule,” which addresses the conditions under which a futures commission merchant must cover a customer’s account if it becomes undermargined. He reported that the conclusion drawn by the roundtable was unanimous: “we should not accelerate the residual interest deadline because it would likely lead to operational difficulties.”

Addressing Emerging Threats to the Financial System. The fourth action demonstrating progress, he asserted, consists of the comment deadlines for two important proposed rules: (i) the deadline for the proposal to enhance cybersecurity protection in the markets and (ii) the deadline for the proposal on automated trading. Both proposals, he argued, show that the CFTC is looking ahead to address future cyber threats.

Reducing Burdens on Commercial End Users. The fifth action, he announced, emerged from the unanimous approval of a final rule on trade options, which recognizes that trade options are different from the swaps that were the focus of Dodd-Frank reforms. The proposal eliminates certain reporting and recordkeeping obligations for commercial end users. Concurrently with these changes, he stated, the CFTC agreed on proposed guidance regarding the treatment of peaking supply and capacity contracts. He explained that the proposal is intended to make it easier for entities to use such contracts to maintain reliable energy supplies.

Lofchie Comment: Chair Massad deserves credit for undoing some of the damage that would have been caused by the prior CFTC Chair’s overreach. That said, the faster and more aggressively that Chair Massad can pursue the so-called “fine-tuning” of past mistakes, the better it will be for the economy. On a less positive note, the problems with central clearing are not easily correctable, and the solution will require far more significant action than simply shoring up individual clearinghouses in the event of their failure. (Assuming, of course, that the government will never let a clearinghouse fail.)

FINRA Issues Report on Digital Investment Advice Tools

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FINRA issued a report identifying effective practices that firms should consider when developing and using “digital investment advice tools.”

FINRA highlights five key regulatory principles and effective practices:

  • Governance and supervision of algorithms. This includes initially assessing the methodology of digital tools and the quality and reliability of data inputs, as well as ongoing evaluation such as testing the tools to ensure they are performing as expected, and determining whether models used by a tool remain appropriate as market conditions change;
  • Customer profiling. This includes assessing both a customers’ risk capacity and risk willingness, and addressing contradictory or inconsistent responses in customer-provided information;
  • Governance and supervision of portfolios and conflicts of interest. This includes determining the risk, return and diversification characteristics of a portfolio suitable for a given investor profile, and mitigating – through avoidance or disclosure – conflicts that can arise through the selection of securities for a portfolio;
  • Rebalancing. This includes providing descriptions of how the rebalancing works and procedures that define how the tools will act in the event of a major market movement;
  • Training. Training enables financial professionals to understand the key assumptions and limitations of individual digital investment advice tools, and determine when use of a tool may not be appropriate for a client.

In addition, investors should be apprised of (i) the soundness of the information gathered by the firm, (ii) the investment approach embodied in the digital tools, and (iii) the underlying assumptions used in such advice tools. FINRA cautioned that digital investment advice tools do not necessarily eliminate conflicts of interest, and that investors should understand the services provided by the tools, the costs of those services and how the services will be performed. FINRA stated that the report is not intended to create any new legal requirements or change the existing regulatory obligations of broker-dealers.

Lofchie Comment: This is a thorough and practical report. Although it focuses on providing e-advisory services to customers, much of the discussion is equally relevant to firms that provide personalized advice to customers (e.g., the section that pertains to asking customers about their objectives and potential risks: different results can arise from identical situations). This report should be reviewed by anyone (broker-dealer or adviser) who is responsible for providing advice to customers – or for supervising or monitoring that advice – regardless of how the advice might be delivered.

Senator Warren Asks CFTC to Withdraw EEMAC Report on Position Limits

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Senator Elizabeth Warren wrote to CFTC Commissioner J. Christopher Giancarlo asking that he withdraw the Energy and Environmental Markets Advisory Committee (“EEMAC”) report on the CFTC’s proposed rule on position limits for commodities futures and swaps until the CFTC reconvenes a committee that “complies with the law and that addresses both the procedural and factual errors in the present product.”

Senator Warren cited three principal problems with the EEMAC’s report:

  • the EEMAC consists almost entirely of energy industry leaders, which appears to violate Dodd-Frank Section 751;
  • the record of the EEMAC’s work reflects “significant procedural irregularities” that “resulted in major flaws and mischaracterizations” in the report; and
  • the report’s conclusions were not supported by the record before the EEMAC, and the report was adopted without public discussion of its findings and conclusions and with no public vote.

She also specifically expressed concern about the decision to include two witnesses at the EEMAC’s hearing: 1) a representative from the CME Group, “an energy derivatives exchange,” and 2) Dr. Craig Pirrong.

Senator Warren concluded that the report is “nothing more than a recitation of industry talking points, and should be treated as such.”

Lofchie Comment: This is at least the second time that Senator Warren publicly launched a personal attack against an academic who has taken a position with which the Senator disagrees. In both cases, the Senator asserted that the academics withheld information about their beliefs or funding. Her assertions rest on uncertain ground. (See the Senator’s attack on Professor Robert Litan in this news article; see also Mr. Pirrong’s defense of himself on his blog, Streetwise Professor. These broadsides are in addition to Senator Warren’s personal attacks against SEC Chair Mary Jo White.) Attacks by the Senator on those who disagree with her can serve only to chill discussion on issues of financial regulation, perspectives which serve to benefit all concerned.

As to the notion that Craig Pirrong somehow concealed his views on energy matters, the professor has a blog (www.streewiseprofessor.com) on which he expresses them quite consistently, clearly and openly. His position is no more hidden than is Senator Warren’s. The Senator can disagree with his views, of course, but the claim that they are hidden seems not only unjustified, but inconsistent with her description of him in the letter as a well-known advocate in this space.

As to the substance of the Senator’s objections to the EEMAC’s report, the relevant language from Dodd-Frank Section 751 is as follows: The EEMAC shall have 9 members. The Committee shall “serve as a vehicle for discussion and communication on matters of concern to exchanges, firms, end users and regulators. . . ” The members shall have a “wide diversity of opinion and who represent a broad spectrum of interests, including hedgers and consumers.” Here are links to the lists of EEMAC Members and EEMAC Associate Members. There are distinguished people in both groups, possessing a wide range of viewpoints and economic interests; e.g., both buy-side and sell-side. Even if the Senator believes that a majority of the Committee’s members were inclined to disagree with her, this is not a group to be cowed. There was legitimate dissent and debate by these members.

The Senator criticizes the EEMAC for including representatives of “public utilities,” whom one would think would be inclined to favor regulation that might drive competing buyers (i.e., speculators) out of the market. The Senator also appears to criticize the decision to have representatives of the “government” on the Committee, whom she seems to imply would not be “objective” for reasons that she does not explain. Upon reading the letter more closely, it is easy to speculate that Senator Warren believes that there are likely alternative, more “objective” government employees who would have favored her views.

The Senator’s claim that the EEMAC report “dramatically mischaracterizes the recorded positions of its members” is not serious. The Committee voted 8-1 in favor of the report. Again, one can clearly disagree with the findings of the report, but it is hard to understand how exactly the report mischaracterizes an 8-1 vote. Senator Warren cites a 2006 report that is consistent with her views, but there are other studies that are inconsistent with Senator Warren’s views. There ought not to be any implication that the dispute over position limits must end with one report that Senator Warren elects to single out.

It is simply hard to see how anyone reading the newspapers these days can believe that energy position limits are needed to either maintain a sufficient energy supply or hold prices down. With so many producer nations (Iran, Russia, Saudi Arabia, Kuwait, Venezuela, the United States, Mexico, Canada) trying to bring oil and other energy products to market, it seems obvious that the power of suppliers to increase deliveries overwhelms any ability of speculators to store oil and create an artificial price spike. If there were even the briefest price spike, wouldn’t the energy suppliers (including those in the United States) rush to take advantage of it by pumping more oil?

Most worrisome about the Senator’s letter is not her stance on position limits nor that she seems disinclined to modify that stance in light of current events. Most worrisome is that the presentation of her views is done in a way that might discourage the presentation of legitimate alternative views.

SEC Chair White Embraces Regulatory Initiatives beyond Disclosure

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Chair Mary Jo White reviewed SEC progress on a number of prominent initiatives relating to: (i) asset management, (ii) equity markets structure, and (iii) SEC disclosure regimes. In remarks made at the annual “SEC Speaks” conference, Chair White stated that the SEC is “not only” a disclosure agency, and that SEC proposals reflect “careful consideration” of tools beyond disclosure. She said that complexity of products, changes in market participant behavior, pervasive network technology and systemic risks “call for additional protections.”

Regarding asset management, Chair White pointed to (i) a proposal to enhance reporting for investment advisers and mutual funds to improve the quality of information for investors; (ii) a proposal requiring that funds monitor and manage derivatives-related risks and provide limits on their use; and (iii) proposed reforms designed to promote stronger and more effective liquidity risk management across open-end funds and limit the adverse effects that liquidity risk can have on investors and potentially the broader markets. She stated that finalizing these rules will be 2016 priorities.

Regarding equity market structure, the Chair commented that the SEC proposed two rules to enhance the SEC supervision of markets: (i) a proposal to broaden the oversight of active proprietary trades, including high-frequency traders; and (ii) the first-ever major update to the regulations for alternative trading systems. Chair White noted that the SEC issued an advance notice of proposed rulemaking on transfer agents. She said that the SEC will look to finalize these proposals this year, as well as to advance order routing disclosures and trading algorithm risk controls.

Concerning disclosure effectiveness, Chair White said that the SEC will address the form and content of financial statements by entities other than Regulation S-X registrants.

Beyond the three core areas, Chair White discussed: (i) shortening the settlement cycle from T+3 to T+2 to reduce potential systemic risk; (ii) enhancing filings through the expanded use of structured data; (iii) finalizing rules updating the intrastate offering exemption; (iv) considering recommendations for a universal proxy; and (v) examining final rules for resource extraction.

Lofchie Comment: Chair White recognizes that the SEC imposes requirements that go beyond disclosure and makes a fair point that the SEC needs more tools. That said, it is important to question both the work that the SEC has done with the tools that it has, and who actually benefits from use of these tools. As to the SEC’s proposed requirements regarding risk management, these proposals have been sharply criticized by the Investment Company Institute as increasing risk for investors. As to the rules regarding resource extraction, it would be hard to make any serious argument that they can, in any way, really benefit investors.

 

CFTC Chair Massad Cites Progress in Commodity Market Regulation

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CFTC Chair Timothy E. Massad outlined CFTC actions involving recordkeeping and margin requirements for uncleared swaps. In a speech before the Commodity Markets Council, he asserted that the CFTC has made “significant progress” in “protecting end-users from overly onerous regulatory burdens.”

Chair Massad highlighted several recent actions concerning the regulation of the swaps market. They included the following:

  • Recordkeeping. The CFTC revised a rule to allow members of exchanges and swap execution facilities who are not registered with the CFTC – such as end users – to delete pre-trade communications and text messages. The amended rule also states that commodity trading advisors do not have to record oral communications regarding their transactions.
  • Centralized Treasury Units. The CFTC worked on legislation with lawmakers on Capitol Hill and in the Administration that would assist end users who employ “centralized treasury units.”
  • De Minimis Exception. The CFTC released a staff report that takes a “fresh look” at the issue. Although the report does not recommend a precise level for the de minimis limit, it invites public comment on the data and methodology to be used.

Chair Massad also discussed several “matters” on the CFTC’s agenda:

  • Trade Options. This CFTC proposal would eliminate the obligation of commercial participants to report trade options to swap data repositories.
  • Position Limits. The CFTC proposed modifications to the provisions of the rules that would “streamline the process for waiving aggregation requirements when one entity does not control another’s trading, even if they are under common ownership.” The CFTC also is considering “the possibility of further modifications, which would have the exchanges play a greater role in granting exemptions for non-enumerated hedges.”
  • Clearinghouse Strength and Resiliency. “[C]onsiderable efforts” are being made domestically and internationally to ensure that clearinghouses are strong and safe, including developing recovery and resolution planning standards for stress-testing. The CFTC approved the registration of Eurex Clearing. However, a determination of “equivalence” has yet to be issued by the European Commission.
  • Cybsecurity. The CFTC unanimously approved two new rules to (i) enhance cybersecurity protections and (ii) minimize the risk that automated trading will cause market disruptions. The rules will require adequate risk controls, monitoring and other measures.

Chair Massad expressed his disappointment with the lack of a budgetary increase for the CFTC in the 2015 federal spending bill:

[T]he CFTC’s appropriation simply doesn’t match our responsibilities. The markets we oversee are critical to commercial businesses, and profoundly affect the prices all Americans pay for many goods and services in our daily lives. Sensible regulation requires adequate resources, and is a good investment for our economy. So we’ll continue working to ensure Congress understands the important work we do, he said.

Chair Massad delivered his keynote speech before the Commodity Markets Council at its 2016 program on the State of the Industry.

Lofchie Comment: Given the scope of its responsibilities under Dodd-Frank, the CFTC is underfunded. Many of those responsibilities might be ill-conceived, but that is not the fault of the CFTC; the blame belongs with Congress. Indeed, Chair Massad has pointed out that the CFTC is in the process of reducing some of the burdens it had imposed previously. Even so, progress in that direction should be faster.

That said, it is difficult to feel sympathy for an agency that continues to push for rules that will be enormously burdensome to implement, for both the agency itself and for the economy as a whole. In light of the events of the past few years, on what possible policy basis can the CFTC justify the imposition of position limits on energy? Haven’t events made clear that the ability of energy speculators to withhold energy from the market and drive up prices would prove trivial compared to the power of sovereign nations – e.g., Saudi Arabia, Iran, Russia and private suppliers of oil, including in the United States – to pump more oil into the market and take advantage of any supposedly artificial price bump? If the regulators continue to expend resources on rules predicated on flimsy premises, does it make sense to increase their funding?

SIFMA Provides Notice to Banking Regulators on Treatment of CCPs’ Variation Margin

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SIFMA provided notice to banking regulators (the Board of Governors of the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC) of a forthcoming change in the treatment of variation margin payments for over-the-counter derivatives by central clearing counterparties (“CCPs”). Historically, variation margin payments have been treated as collateral for outstanding exposure, a treatment that a SIFMA comment letter refers to as the “collateralized to market” (“CTM”) model. Going forward, the CCPs will adopt a model by which variation margin payments are treated as settlement of the exposure under the contract, a treatment that the SIFMA comment refers to as the “settled to market” (“STM”) model.

According to SIFMA, it is expected that in addition to the CCPs, other market participants will amend or clarify their terms, rules and procedures to determine circumstances under which the payment of variation margin for cleared derivatives will be deemed to constitute settlement of any exposure under the agreement, as opposed to collateralization of the outstanding exposure.

The SIFMA comment letter states that while “both models achieve the same expose-mitigating objective, they differ in their implications for the rights and obligations of the counterparties.” The STM model is “recognized as preferable to the CTM model within the regulatory capital framework” and results in “clearing member firms having higher capital and supplementary leverage ratios” SIFMA stated. The following steps are “typically pursued by clearing member firms” prior to considering a cleared OTC derivative contract to be executed under the STM model:

  • verifying that the CCP terms, rules, and procedures, as approved by the CCP’s primary regulator, and the terms of their client clearing agreements, are consistent with the STM model;
  • working with in-house and outside counsel to review such terms, rules, and procedures, and obtain legal analysis that the relevant derivative contracts are STM;
  • working with internal and independent accountants to determine the appropriate accounting treatment for relevant exposures and payments; and
  • coordinating with impacted internal functions (e.g., tax, operations, financial reporting, risk, etc.) to reflect derivative contracts as STM rather than CTM, as appropriate.

Lofchie Comment: The need for this change in the documentation of contracts is driven by the fact that the banking regulators previously took a fundamentally punitive and economically unsound position with respect to the regulatory capital treatment of collateral for cleared derivatives. As the banking regulators stretch their regulatory authority into new types of transactions (e.g., cleared derivatives), the limits of their pre-existing regulatory expertise become clear.

Recently, the banking regulators acknowledged that central clearing creates a number of systemic risks that they failed to anticipate (although they should have done so). Conversely, the banking regulators’ treatment of collateral for cleared derivatives (effectively treating posted collateral as if it were a loan of assets to the secured party) has been likewise faulty, in effect, treating a risk-reducing transfer, as if it were risk-increasing.

SEC Proposes Restricting the Use of Derivatives for Regulated Funds

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In a 3-to-1 vote, the SEC proposed a new rule that would restrict the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds and closed-end funds as well as business development companies that are subject to Investment Company Act Section 18 (“Capital Structure of Investment Companies”).

In support of the proposal, SEC Chair Mary Jo White said that funds use derivatives extensively for a variety of purposes, which can raise risks relating to leverage and the fund’s ability to meet future obligations. She remarked on the current practice of mark-to-market segregation, raising concerns that a fund may not have sufficient liquid assets to cover potential future losses. Chair White highlighted three elements that addressed these concerns: 1) new requirements that funds segregate assets to cover their mark-to-market liability, plus an additional risk-based coverage amount designed to address potential future losses on derivatives; 2) portfolio limitations based either on a fund’s aggregate derivatives exposure or on a risk-based analysis; and 3) the requirement that certain funds establish formalized risk management programs.

In presenting the proposal, SEC staff highlighted the following requirements for derivatives:

  • Portfolio Limitations for Derivatives Transactions: A fund would be required to comply with one of two alternative portfolio limitations (“Exposure-Based Portfolio Limit” or “Risk-Based Portfolio Limit”) designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions. Under the exposure-based limitation, a fund would be required to limit its aggregate notional derivatives exposure to 150% of the fund’s assets. As an alternative, the risk-based limitation permits a fund to have aggregate notional derivatives exposure of up to 300% of the fund’s assets but only if the fund’s portfolio is subject to less market risk determined by a value-at-risk test.
  • Asset Segregation for Derivatives Transactions: A fund would be required to manage the risks associated with derivatives by segregating certain assets (generally cash and cash equivalents) equal to the sum of “market-to-market coverage amount” and a “risk-based coverage amount.”
    A fund would be required to segregate respectively:

    (i) assets equal to the amount that the fund would pay if the fund exited the transaction at the time of the determination; and

    (ii) an additional risk-based coverage amount representing a reasonable estimate of the potential amount the fund would pay if the fund exited the transaction under stressed conditions.

  • Derivatives Risk Management Program: Funds that engage in more than limited derivatives transactions or use complex derivatives would be required to establish a formalized derivatives risk management program consisting of certain components administered by a designated derivatives risk manager.

  • Requirements for Financial Commitment Transactions: A fund that enters into financial commitment transactions would be required to segregate assets with a value equal to the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under those transactions.

  • Disclosure and Reporting: Two forms the SEC proposed in May 2015, Form N-PORT and Form N-CEN, would be amended respectively: (i) require a fund that is required to have a derivatives risk management program to disclose additional risk metrics related to a fund’s use of certain derivatives; and (ii) require that a fund disclose whether it relied on the proposed rule during the reporting period and the particular portfolio limitation applicable to the fund.

The majority of Commissioners relied on the white paper for evidence of the necessity for new regulation. They also referenced Section 1(b) of the Investment Company Act (which cites the Policy of the Investment Company Act) as evidence of the statutory need to eliminate undue leverage by registered funds.

Commissioner Aguilar supported the proposal but questioned whether the proposed rules place too large of a burden on fund boards. However, the Commissioner concluded that boards must be proactive in foreseeing the challenges in executing all of their fiduciary and regulatory responsibilities.

Commissioner Piwowar supported the asset segregation requirements but dissented from the portfolio limitations. He reasoned that asset segregation should be enough to address current derivative risks, therefore, absent data indicating that a separate specified leverage limit is warranted there is no justification for imposing any additional requirements or burdens on funds. In addition, the Commission has recently adopted other proposed rules that will either have a direct impact on the risks of derivatives positions held by funds, or will provide us with data that could be used to better understand how we should regulate.

Lofchie Comment: Commissioner Piwowar’s dissent from the proposal of the rule is well-reasoned. The SEC does not have adequate information needed for proper analysis of the proposal at the current time.

As the Commissioner argues, the SEC justifies the proposed derivatives framework as an “exemption” from Section 18 of the Investment Company Act (“Capital Structure of Investment Companies”), even though the SEC is in fact limiting behavior that it has previously sanctioned. It is not at all obvious that the conduct requires an exemption from Section 18; and the fact that the SEC had previously sanctioned the conduct would seem to indicate that no such exemption is required. If no exemption is required, it raises the question of the specific authority under which the SEC proposes to act.

The proposal also raises the question of whether the SEC acted appropriately in further restricting the activities of SEC-registered investment companies that have made appropriate disclosure of the risks involved in their investment strategies. The safety that SEC-registered investment companies provide to investors necessarily comes at a cost, whether it is the increased cost of managing the fund or the implicit cost to investors being denied investment opportunities. It is far from obvious that the subsequent costs that the SEC proposes here are justifiable.

As for the risk of derivatives, the idea that such risk may be judged based on a predetermined notional “size” measure is inherently inexact. Beyond that, the requirement of specified derivatives management procedures has the feel of more government-required formalities that have the potential to provide more benefits to consultants than to investors.