This post will bring to a close, for now, our survey of the requirements of new Rule 18f-4, which investment companies must comply with by August 19, 2022. This post considers whether a Chief Compliance or Risk Officer should seek to treat some or all of their funds as Limited Derivatives Users and how that choice, in turn, relates to the decision about whether to treat reverse repurchase agreements as derivatives transactions. But first, we review the compliance procedures required by Rule 18f-4 for (nearly) every fund. We also provide links to compliance checklists provided in earlier posts.

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The release adopting Rule 18f-4 (the “Adopting Release”) devotes an entire section to discussing how “a fund that invests in other registered investment companies (‘underlying funds’)” should comply with the value-at-risk (“VaR”) requirements of the rule. This post considers three circumstances in which a fund investing in underlying funds:

  1. Does not invest in any derivatives transactions (a “Non-User Fund-of-Funds”);
  2. Allows its derivatives exposure to exceed 10% of its net assets (a “VaR Fund-of-Funds”) ; and
  3. Limits its derivatives exposure to 10% of its net assets (a “Limited Derivatives User Fund-of-Funds”).

We use the term “Fund-of-Funds” for convenience, meaning to include funds that hold both direct investments and underlying funds in compliance with Rule 12d1-4 or other exemptions.

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As with Fund-of-Funds, the release adopting Rule 18f-4 (the “Adopting Release”) devotes a section to sub-advised funds. We again consider three types of funds:

  • VaR Funds in which a sub-adviser manages their entire portfolio (“Single Sub-Adviser Funds”);
  • VaR Funds in which one or more sub-advisers manage a portion or “sleeve” of their portfolio (“Sleeve Funds”); and
  • Sub-advised funds that seek to qualify as Limited Derivatives Users.

The Adopting Release discusses the first two circumstances but is silent on the third.

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This post continues our assessment of whether the Limited Derivatives 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.

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The financial press is awash this morning with reports that the launch of a bitcoin futures exchange-traded fund (a “BTC Futures ETF“) may be imminent.

Before recommending that clients invest directly in bitcoin or in a BTC Futures ETF, a registered investment adviser (RIA) should analyze: Continue Reading RIAs and Bitcoin Futures ETFs: Forget Not Thy CPO and CTA Analysis

Our last series of posts on Rule 18f-4 have struggled to understand how its Limited Derivatives User requirements are supposed to work. We have done the best we could to explain the process for calculating a fund’s derivatives exposure, including determining the gross notional amount of derivatives transactions and adjustments thereto, excluding closed-out positions and currency and interest-rate derivatives entered into for hedging purposes, and applying the “10% buffer” for these hedges. In this series of posts, we shift our perspective to assessing whether these requirements effectively and efficiently accomplish the SEC’s objectives.

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As has been our practice in this series on new Rule 18f-4, we end our survey of its Limited Derivatives User requirements with a compliance checklist. This checklist reiterates much of our earlier post on Derivatives Exposure: Why It Matters And How To Calculate It, but provides more details and includes required policies and procedures and steps required if a fund exceeds the 10% limit on its derivatives exposure. Given the length of the checklist and the difficulty in controlling the format of printed copies of this blog, we are providing the compliance checklist through a link to a PDF.

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.

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This post continues our examination of the “10% buffer” for Hedging Derivatives, which refers to the amount by which the notional amounts of Hedging Derivatives can exceed the value, par or principal amount of the hedged equity and fixed-income investments. In this post we consider whether funds should apply the 10% buffer to Hedging Derivatives in the aggregate or on a “hedge-by-hedge” basis.

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By Stephen A. Keen and Andrew P. Cross

This post continues our examination of the “10% buffer” for Hedging Derivatives, which refers to the amount by which the notional amounts of Hedging Derivatives can exceed the value of hedged equity investments, par amount of hedged fixed-income investments or principal amount of hedged borrowings. In this post we examine what it means for Hedging Derivatives to exceed the 10% buffer.

Application of the 10% Buffer

The 10% buffer is intended to address:

situations, such as shareholder redemptions or fluctuations in the market value of a hedged investment, that can temporarily cause the notional amounts of the hedges to exceed the value of the hedged investments by more than a negligible amount.”

This should

avoid funds frequently trading (and incurring the attendant costs) to resize their hedges in response to small changes in value of the hedged investments.”

Consider, for example, a Limited Derivatives User holding euro denominated equity investments with a current value of €10 million that enters into 80 of the September 2022 Euro FX Futures to sell a total of €10 million for a total of $11,908,000. What would the consequences under Rule 18f-4 be if, a month later, the value of the equity investments has fallen to €9 million?

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