In March 2020, we published a post entitled Master Agreements and Volatile Markets: Decline in Net Asset Value Provisions.

We believe that the March 2020 post is particularly relevant in light of the cascading nature of stock market declines over the past year, and on-going market commentary and debates about the likelihood and extent of a recession. Regardless of the ultimate outcome of these debates, increased market volatility presents buy-side firms with the opportunity to re-familiarize themselves with the key terms and conditions of their derivatives trading documentation, including decline in net asset value (“NAV”) provisions.

In short, everything that we mentioned about decline in NAV provisions in March 2020 continues to be true today, although we are taking this opportunity to supplement the March 2020 post with the following considerations:

  • In addition to inventorying the terms of decline in NAV provisions, we recommend that investment managers review and analyze their trading agreements for provisions that may effectively import a close-out event from one trading agreement into another (or even every other) trading agreement.
  • For example, it is possible that a Master Securities Forward Trading Agreement (“MSFTA“) with a broker-dealer (“Party A“) may include a provision that could result in the early termination of all transactions under that MSFTA if a default or early termination occurs under any other trading agreement with Party A or any of its affiliates.
  • So, by way of further example, the forward transactions under the MSFTA could be subject to early termination by Party A, if a Decline in NAV event with respect to the investment manager’s client is triggered under an ISDA Master Agreement with an affiliate of Party A.

The March 2020 article is available here.

Good day. Good, as we mentioned in March 2020, to be especially mindful of “the basics”. DR2

On September 14, 2022, the SEC proposed amendments (the Proposal) to regulations for clearing agencies under the Securities Exchange Act of 1934 (the Exchange Act). The Proposal would increase the central clearing of U.S. Treasury securities, to be defined as “any security issued by the U.S. Department of the Treasury.” According to the SEC’s press release, “the proposal would require that clearing agencies in the U.S. Treasury market adopt policies and procedures designed to require their members to submit for clearing certain specified secondary market transactions.”

FICC: The Covered Clearing Agency

The proposal would amend Rule 17Ad-22 under the Exchange Act regarding any clearing agency registered with the SEC that (a) acts as a central counterparty or central securities depository (a covered clearing agency or CCA) and (b) provides central counterparty (CCP) services for U.S. Treasury securities. “The Commission defines a CCP as a clearing agency that interposes itself between the counterparties to securities transactions, acting functionally as the buyer to every seller and the seller to every buyer.” A CCP accomplishes this through the process of “novation,” in the sense of “replacing a party to an agreement with a new party.” Effectively, the trade between the buyer and seller is replaced by two trades, one in which the clearing agency agrees to sell the Treasury security to the buyer and the other in which the clearing agency agrees to buy that Treasury security from the seller. After novation, the seller and buyer no longer have delivery obligations to one another.

“Currently, only one registered clearing agency, the Fixed Income Clearing Corporation (‘FICC’), provides CCP services for U.S. Treasury securities transactions.” Given the FICC’s unique position, we will refer to the FICC, rather than to a “CCA that provides CCP services,” when discussing the proposed changes to Rule 17Ad-22.

Additional Central Clearing Requirements

Although not required by Rule 17Ad-22, “FICC’s current rules generally require that FICC direct participants submit for clearing all trades with other FICC direct participants.” The Proposal would codify and expand this to “[r]equire that any direct participant … submit for clearance and settlement all of the eligible secondary market transactions to which such direct participant is a counterparty.” The FICC would have to monitor the submission of transactions by its participants and have rules to address a failure to submit transactions. The FICC would also have to ensure that it has the capacity to clear and settle all eligible secondary market transactions.

Eligible Secondary Market Transactions

The “eligible secondary market transactions” that the Proposal would require direct participants of the FICC to submit for clearance and settlement are:

  • all repurchase and reverse repurchase agreements collateralized by U.S. Treasury securities entered into by a participant;
  • all purchase and sale transactions for U.S. Treasury securities entered into by a participant that is an interdealer broker; and
  • all purchase and sale transactions for U.S. Treasury securities entered into between a participant and either a registered broker-dealer, a government securities broker, a government securities dealer, a hedge fund, or a particular type of leveraged account.

Transactions with a central bank, a sovereign entity, an international financial institution, or a natural person would be excluded. We will discuss the scope of transactions covered by the Proposal in more detail in later posts.

Margin Requirements

Rule 17Ad-22(e)(6) currently requires CCAs to collect daily margin from participants “commensurate with, the risks and particular attributes of each relevant product, portfolio, and market.” As the Proposal will require the FICC to novate transactions with a participant’s customers, the FICC participants engaged in these transactions will need to post margin on their customers’ behalf. The Proposal would amend Rule 17Ad-22(e)(6)(i) to require the FICC to calculate and hold margin for a participant’s proprietary positions separately from margin held for the participant’s customers. In its sponsored member repo program, the FICC already holds margin amounts for its sponsoring members separately from their sponsored members.

The formula for determining customer and proprietary account reserve requirements would have a corresponding amendment allowing a broker-dealer to deduct FICC margin held for its customers from its reserve requirement. This would prevent a broker-dealer from having to maintain reserves in addition to the FICC margin for an eligible secondary market transaction.

Our next post will examine what the SEC intends to accomplish with the Proposal.

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.

Continue to the full blog post at The Asset Management ADVocate

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.

Continue to the full blog post at The Asset Management ADVocate.

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.

Continue to the full blog post at The Asset Management ADVocate.

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.

Continue to full post at Asset Management ADVocate

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.

Continue to the full post at Asset Management ADVocate

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.

Continue to full post at Asset Management ADVocate.