This post continues our assessment of whether the Limited Derivative 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.

Successful and Unsuccessful Derivatives Users

We begin with an unambiguous example. On Monday, Gallant Fund borrows shares of ABC Co. with a market value of $10,000; Goofus Fund borrows shares of XYZ Inc. with the same market value. Both funds sell the shares short. At the close on Tuesday, ABC Co. is down 1% and XYZ Inc. is up 1%.

The definition of derivatives exposure provides that “in the case of short sale borrowings,” the derivatives exposure is “the value of the assets sold short.” Hence, on Tuesday, Gallant Fund’s short sale will add $9,900 to its derivatives exposure while Goofus Fund’s short sale will add $10,100. Did Gallant Fund use derivatives in a more limited manner than Goofus Fund, or was its use more profitable? If XYZ Inc. rallies on Wednesday and ABC Co. tanks, we do not believe this has any bearing on whether one fund is a more extensive user of short sales than the other.

Ambiguous Notional Amounts

What would Goofus Fund’s derivatives exposure be if it used a total return swap with a notional amount of $10,000 to short XYZ Inc. The guidance we found indicates that the gross notional amount of a standard total return swap is its “notional principal amount or market value of underlying reference asset.” In our example, the notional principal amount is $10,000, but the market value of the underlying reference asset on Tuesday is $10,100. How are we to interpret “or” in this context?

The FAQ providing this guidance says that these are included among “some common methods used by funds for determining a derivative transaction’s notional amount,” which suggests a fund can elect to use either method (presumably on a consistent basis). We could also imagine that a conservative CCO might use whichever method results in the highest derivatives exposure, but this would further complicate calculations of derivatives exposure. Regardless, any use of the notional amount of $10,000 would produce a different result than an outright short sale borrowing, even though they are financially equivalent transactions. We cannot find any principled basis for such different results.

Converting to Dollar Amounts

An earlier post explained why Limited Derivatives Users would have to translate the notional amount of currency and commodity derivatives into dollar terms to calculate their derivatives exposure as a percentage of net assets. Our post noted three possible prices that could be used for conversion:

  1. the current market price of the underlying asset,
  2. the market price of the underlying asset at the time a fund enters into the derivatives transaction, or
  3. the contract price of the derivatives transaction.

The first alternative would be consistent with the derivatives exposure of short sale borrowings. The second alternative would be consistent with the notional principal amount of a total return swap.

The guidance does not resolve this question for FX futures (“Number of contracts x notional contract size (e.g., 12,500,000 Japanese yen)”). On the other hand, the notional value of a commodity future is given as “number of contracts x contract size (e.g., 1,000 barrels of oil) x futures price.” We believe the “futures price” refers to the third of our price alternatives.

This leads to an odd result, however. The current spot price of West Texas Intermediate (“WTI”) is $77.68 per barrel. Oil prices are expected to rise near term, so the contract (futures) price of the November 2021 NYMEX WTI Crude Oil future is $81.16 per barrel. The market expects prices to decline over the long-term, so the November 2022 contract price is only $73.09. The size of the futures contract is 1,000 barrels, so, according to the SEC’s guidance, one November 2021 contract has a gross notional amount of $81,160, while one November 2022 contract has a gross notional amount of $73,090. Here again, we cannot imagine why a fund that purchases the shorter-term futures should be treated as using derivatives in a less limited manner.

In our next post, we consider how the Limited Derivatives User requirements might be improved.