SEC Derivatives Regulation for Funds - Industry Considerations and Opportunities

As per Investment Company Act of 1940 of Securities Exchange Commission (SEC) of USA, investment management firms and business development companies can use derivatives in mutual funds, ETFs, and closed end funds, except money market funds, with exposure up to ten percent of their assets under management. SEC introduced a new rule under section 18f-4 under this act to permit these firms to use derivatives by introducing a comprehensive framework for derivatives risk management. This new rule reflects upon recent market developments in past few decades, while addressing investor protection concerns and creates a level playing field.

Derivatives Risk Manager for Funds

With this new rule, SEC introduced the role of Derivatives Risk Manager (DRM) and a comprehensive derivatives risk management program (DRMP) to manage derivative risk, ensure stipulated compliance norms, and report non-compliance to the fund’s board of directors and SEC confidentially. This rule covers risk management of hedging and leverage instruments such as derivatives, short sale borrowings, reverse repo, unfunded commitment agreements, and forward-settling securities.

This rule exempts funds with less than 10% of derivatives exposure as “Limited Users” who need not implement this risk management program but need to have policy and procedures in place to manage fund’s derivatives risk management. Other funds must implement a DRMP for each fund by defining policies and procedures.

Implications for Asset Management Firms

This regulation affects existing funds which use derivatives for hedging and increased exposure, and acts as an enabler for funds who are not heavy derivative users now. With implementation of this new rule by August 2022, funds must use VaR (Value at Risk) calculation model for managing derivative risk along with VaR model for back testing and stress testing of the fund portfolio to unearth hidden risk. They need not follow asset segregation process to earmark liquid assets with a market value equivalent to their commitments. This rule allows funds the option to treat reverse repurchase agreements or similar financing transactions as derivatives transactions, rather than including such transactions in the fund’s asset coverage calculations.

Asset management firms should perform a detailed impact assessment on their current exposure into derivatives in all their funds. At present, the derivatives risk management functions are handled at firm level. As per this new rule it should be handled at fund level by the DRM, for funds that have more than 10% of derivatives exposure compared to fund’s net assets. The DRM is responsible for establishment, maintenance, and enforcement of risk management guidelines. So, firms must recruit DRM positions and get them approved by respective fund’s board of directors. This helps board of directors in fulfilling their responsibility to keep derivative risks under regulatory limits.

The DRM identifies a designated reference portfolio which will act as a benchmark to perform Relative VaR test. The Relative VaR is used to understand leverage risk generated due to use of derivatives and to compare it with internal and regulatory limits. In the absence of suitable designated reference portfolio, the DRM must perform Absolute VaR test to achieve the above objectives. The DRM will have to closely work with portfolio managers to handle program administration and risk methodology and modelling. The risk methodology involves fund risk identification, leverage assessment, pre-trade derivatives risk management, VaR methodology and modelling, back testing, stress testing, model risk management and governance. DRM should keep the board updated on insights of risk management function, the basis for DRMP implementation strategy, annual or more frequent status of the program, and non-compliance reports on each occurrence.

Changes to business capability

Investment management firms should enhance key business capabilities in their derivatives risk management offerings and solutions. The major focus areas are reference index selection, risk methodology and modelling, product specific treatment, derivatives exposure management, record keeping, limit management, derivatives risk policy and procedures and derivatives risk governance. Firms will have to enhance their capability on fund derivatives risk assessment by relooking at VaR computation, stress testing, back testing, and other derivatives risk assessment solutions. They will also need fund, portfolio, benchmark, market, and reference data along with derivatives risk results for enhancements in reporting, user interfaces and downstream extracts. This will help them in adhering to new risk management regulatory guidelines flawlessly and enable them to provide holistic and unbundles services to their customers.

Changes to Regulatory Reports

As per this rule, there are major changes to regulatory reports N-PORT, N-CEN and N-RN which is retitled from N-LIQUID. VaR test deviations beyond threshold for more than five business days should be reported by DRM to SEC through Form N-RN by next business day confidentially. Form N-RN should be sent again once the test results are back in compliance with the applicable VaR based limit.  The monthly report N-PORT is modified to include additional derivatives related information, which also affects Limited Users of derivatives. A new section is added to the yearly report N-CEN to identify whether it relied on any of the exceptions from various requirements under the rule and information on derivatives transactions for all purposes mentioned in this rule. Some of these reports are extended to closed end funds and business development companies. Hence firms must evaluate changes required in applications for sourcing new data required for creating these reports and applications which create and send these reports.

Opportunity to adopt Cloud and AI for regulatory compliance

The capabilities required to comply with this regulation present ample opportunity to evaluate cloud and AI to improve scalability of solution and reduce cost the compliance through automation.

Cloud adoption for portfolio risk computation is picking up in the asset management industry given the cost advantages and scalability. Computationally intensive tasks such as daily VaR computation and weekly computation of stress testing are some of the apt cases to consider for cloud adoption. While cloud models provide scalability, before embarking on implementation, firms must consider certain aspects like lead time to meet requirements, system configuration as per requirements, access controls, level of control over data & infrastructure and data security aspects.

As firms continue to embrace an automation first approach towards improving efficiency and cost, there are multiple use cases for deployment within this context. For example, machine learning models can be evaluated for application of time series modelling which will be used for VaR computation and stress testing. Other techniques such as natural language generation (NLG) are increasingly becoming popular to simplify repetitive data analysis and report writing tasks. VaR, stress testing and back testing result analysis and reporting to board and portfolio managers is one area where adoption and suitability of NLG can be assessed.

The Bottom Line

US based investment management firms should decide their strategy on usage of derivatives in all their funds and ETFs, except money market funds. Based on the decided strategy, for funds identified for DRMP implementation, a gap analysis must be performed for business and technology requirements. Required partnerships needs to be considered for enhancing current capabilities in processing derivatives risk calculations, comparing with benchmark, stress testing and back testing, analysis of test results and external and internal reporting. To summarize, it is important for firms to start identifying and engaging with the right partners immediately to ensure an efficient and cost effective solution is put in place before the deadline.