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.
What Is the SEC Trying to Accomplish?
According to the release adopting Rule 18f-4:
The SEC sought to avoid:
Requiring funds that use derivatives only in a limited way to comply with these requirements [to adopt a derivatives risk management program and test their VaR, which] could potentially require funds … to incur costs and bear compliance burdens that may be disproportionate to the resulting benefits.”
The potential cost savings was an important aspect of the SEC’s economic analysis. The SEC estimated that the one-time cost to comply with the Limited User Requirements would range from $15,000 to $100,000, while the one-time cost to establish and implement a derivatives risk management program would range from $150,000 to $500,000. In both cases, annual costs were estimated at between 65% and 75% of one-time costs, with an incremental annual cost associated with VaR testing ranging from $5,000 to $100,000.
How Many Funds Will Be Limited Derivatives Users?
The SEC’s estimate of how many funds might benefit from the estimated cost savings seems inconsistent. In explaining why the SEC chose a 10% derivatives exposure limit for Limited Derivatives Users, they cited an analysis of September 2020 N-PORT filings by the Division of Economic and Risk Analysis, “reflecting that 79% of funds had adjusted notional amounts [of derivatives exposure] below 10% of NAV.” The economic analysis, however, citing what we assume is the same N-PORT analysis, estimated “that about 19% of funds … will qualify as limited derivatives users.”
Could Calculating Derivatives Exposure Be as Hard as VaR Testing?
The SEC’s economic analysis included an incremental annual cost for daily VaR testing, but no corresponding cost for the daily calculation of a Limited Derivatives User’s derivatives exposure. In this context, we note that a VaR Fund does not need to determine the gross notional amounts of its derivatives transactions. A VaR test automatically includes the incremental risks created or hedged by portfolio investments, regardless of whether investments are derivatives. Thus, only a fund that uses its securities portfolio to measure relative VaR will need to identify derivatives transactions excluded from the securities portfolio. Such a fund would not need to determine the gross notional amount of the excluded derivatives transactions or adjust for delta or 10-year bond equivalents to calculate its VaR relative to its securities portfolio.
This means that VaR Funds that use an index as their designated reference portfolio or use the absolute VaR test need not take the steps outlined in our Step-by-Step Approach to Calculating Derivatives Exposure, and a VaR Fund using its securities portfolio as its designated reference portfolio will only need to take the first step. Given that a Limited Derivatives User must perform every step every business day for every derivatives transaction, we wonder if the cost savings as compared to a VaR Fund will prove as significant as the SEC estimated.