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.
The Problematic Situation
In our earlier post, we posited a situation in which a fund had sold 80 of the September 2022 Euro FX Futures to hedge equity investments with a value of €10 million, which then fell to €9 million. As Euro FX Futures have a notional amount of €125,000, 72 contracts would now be sufficient to fully hedge the investments. Our post argued that the remaining 8 contracts should still be regarded as “maintained” for purposes of hedging the equity investments, so the 10% buffer should allow the fund to exclude the remaining 8 futures to the extent of €900,000 in notional amount.
In application, our argument would allow the fund to exclude at least 7 futures, with a combined notional amount of €875,000. The question is whether the fund could use the remaining €25,000 to exclude part of the notional amount of the remaining contract, or whether the fund must include the entire €125,000 notional amount of that contract in its Derivatives Exposure?
Why the 10% Buffer is Ambiguous
Our last post quoted the following sentence from the adopting release:
If the notional amount of a derivatives transaction exceeds the value of the hedged investments by more than 10%, …, it will no longer qualify as a hedge under the limited derivatives user exception.”
According to this sentence, if the 10% buffer is exceeded, “it” will no longer qualify for the exclusion. Does “it” refer to “the notional amount of a derivatives transaction” or to “the notional amount of a derivatives transaction exceed[ing] the value of the hedged investments by more than 10%?”
Derivatives Are Multi-Purpose Tools
In our view, the 10% buffer should be interpreted in the context of the clause that precedes it: that a Hedging Derivative must be “entered into and maintained by the fund for hedging purposes.” The sentence in the adopting release and many of the comment letters seem to presume that a derivative transaction can serve only one purpose. This is not the case; a derivative can hedge to the extent the fund has an offsetting exposure and also create an additional exposure to the underlying asset. For example, if a fund holds €5 million principal amount of bonds, a forward contract to sell €10 million will hedge these bonds as well as create a €5 million short position in the euro. Our approach would recognize this possibility by treating €5 million of the forward as entered into for hedging purposes and including only €5 million of the notional amount in the fund’s Derivatives Exposure.
Avoiding Arbitrary Distinctions
Recognizing that only part of the notional amount of a derivative transaction may need to be included in a fund’s Derivatives Exposure avoids arbitrary differences in applying the 10% buffer to different types of Hedging Derivatives. Because our initial example involved 80 futures contracts, the impact of exceeding the 10% buffer could be limited to a single contract. This would not be the case if the fund entered into a single €10 million forward and the fund had to include the entire notional amount in its Derivatives Exposure once the value of the hedged investments fell below €9.09 million.
A fund could avoid this result by breaking up the euro forward in advance. For example, the fund could ask for 400 confirmations of identical €25,000 forwards, and include only 4 of the forwards in its Derivatives Exposure once the value of the investments fell to €9 million. We trust the pointlessness of such an exercise is obvious, and it is better to recognize that some part of the notional amount of a derivative transaction can serve a hedging purpose even as the remaining notional amount does not.
In our next post, we wrap up our analysis of the Limited User Requirements with our standard compliance checklist.