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.”
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?
Each Euro FX Future has a notional amount of €125,000, so 72 of the contracts are now sufficient to hedge the euro denominated investments. The 10% buffer would be €900,000, covering 7 contracts with €25,000 to spare. Would the fund have to sell the remaining contract?
We think this depends on whether the fund derivatives exposure has room for whatever is the US dollar equivalent of €100,000. The notional amount of currency derivatives over the 10% buffer should just be included in the fund’s derivatives exposure, and the fund can continue to qualify as a Limited Derivatives User if its derivatives exposure does not exceed 10% of its net assets. So, the fund could retain the futures contract over the 10% buffer if it would not cause the resulting derivatives exposure to exceed the 10% limit.
Are Derivatives in the 10% Buffer “Maintained” for Hedging Purposes?
A potential wrinkle in our analysis is that Rule 18f‑4(c)(4)(B) excludes only currency and interest rate derivatives “entered into and maintained by the fund for hedging purposes.” In the example, all 80 futures contracts were “entered into” for hedging purposes, but after the value of the equity investments drops to €9 million, can the fund still claim that more than 72 contracts are “maintained” for that purpose?
While neither the rule nor the adopting release addresses this question, we think the answer must be yes, otherwise the 10% buffer could not accomplish its intended purpose of avoiding requiring Limited Derivatives Users to constantly resize their Hedging Derivatives. This entails a nuanced interpretation of “maintained,” viz. that a derivative that would hedge a potential increase in the value of a specific investment is “maintained” for hedging purposes. The 10% buffer limits the potential increase that a fund might hedge in this manner and still exclude the hedge from its derivatives exposure.
This interpretation should be further refined for fixed-income investments and borrowings for which the 10% buffer is based on their par or principal amounts, rather than their value. The par amount of a bond will not increase, so we don’t think a fund can rely on the 10% buffer to short €11 million when “hedging” bonds with a par value of €10 million; €1 million of the short would not have been “entered into” for hedging purposes.
On the other hand, if a fund shorts €10 million to hedge bonds with a par value of €10 million and then sells €500,000 par amount of bonds to raise cash to cover shareholder redemptions, it may still be permitted to exclude the full amount of the euro hedge. The language we quoted mentioned temporary changes caused by shareholder redemptions, so it would make sense to allow the fund to continue to exclude the euro hedge if it expected to repurchase the bonds as soon as it had sufficient cashflow. Absent such an expectation, however, it may be more consistent with the purpose of the 10% buffer to add €500,000 of the short to the fund’s derivatives exposure.
Absent other guidance, we are suggesting that funds apply the 10% buffer in a manner that its most consistent with the purpose expressed in the adopting release to “avoid funds frequently trading … to resize their hedges in response to small changes in value of the hedged investments.” This would give Limited Derivatives Users the greatest leeway when hedging the value of investments, but may be of limited application when hedging an invariable par or principal amount.
Next, we consider how the 10% buffer should apply to hedges of multiple currencies.