Having completed our detour into regulations and interpretations other than re-proposed Rule 18f-4, this post returns to considering possible justifications for carving out “unfunded commitment agreements” from the proposed Value at Risk limitations of Rule 18f-4. We have previously explained why the first two justification identified in the proposing release are ill-founded, which leaves only the following argument for a carveout:

Commenters also asserted that unfunded commitment agreements do not give rise to the risks that Release 10666 identified and do not have a leveraging effect on the fund’s portfolio because they do not present an opportunity for the fund to realize gains or losses between the date of the fund’s commitment and its subsequent investment when the other party to the agreement calls the commitment.”

We believe this is true of some, but not all, commitments. To explain why, we begin with the most important element of the proposed definition of “unfunded commitment agreement:” that it is a commitment to the company receiving the loan or other investment.

Not content with Steve’s detour into the relationship between Rule 2a-7 and re-proposed Rule 18f-4, we would also like to point out a set of rules under which the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) have wrestled with the distinctions between “swaps, security-based swaps and security-based swap agreements” and non-derivative transactions. Release No. 33-9938 (the “Release”) not only adopted regulations distinguishing swaps from other types of derivatives instruments (such as securities forwards) and securities, but also included interpretive guidance for distinguishing swaps from consumer and commercial agreements, contracts, and transactions. Several of the commercial transactions discussed in this Release correspond to the type of loan commitments the SEC proposes to include in the definition of “unfunded commitment agreement” in Rule 18f‑4. We suggest that some factors used to distinguish one type of derivative instrument (a swap) from commercial lending transactions may also help distinguish these transactions from derivatives instruments more generally.

This post continues my consideration of why certain “unfunded commitment agreements” should be carved out of the valuation at risk limitations of re-proposed Rule 18f-4. My previous post explained why two of the justifications offered for this carve out do not bear scrutiny. My current view is that the scope of the carve out depends on the third proposed justification: that some commitments may not have “leveraging effects.” This requires an understanding of the leveraging effects regulated by Section 18 of the Investment Company Act.

I will use the example of money market funds to explore “leveraging effects” because (a) it allows me to answer a question raised in the proposing release and (b) it illustrates another means of limiting leverage.

This post continues my assessment of the proposed treatment of unfunded commitments under re-proposed Rule 18f-4. My previous post questioned whether the proposed definition of an “unfunded commitment agreement” successfully carved these transactions out of the definition of “derivatives transactions.” This post begins my evaluation of why such a carve out may be warranted.

The SEC’s release cites three factors offered by commenters that the SEC agreed “distinguish unfunded commitment agreements from … derivatives transactions.” Unfortunately, the first two of these factors do not provide a sound basis for drawing such a distinction.

My initial posts on re-proposed Rule 18f-4 reflect my generally favorable reactions to the SEC’s attempt to develop a practical, hence imperfect, means of implementing the limitations on senior securities required by Section 18 of the Investment Company Act of 1940. My initial series of post written at the time Rule 18f-4 was first proposed attempted to explain some of the inherent difficulties of this task.

I will now turn to a more problematic matter: the proposed treatment of so-called “unfunded commitment agreements.” While I basically agree with the proposed approach of limiting commitments by requiring a reasonable means of meeting the fund’s obligations, I have reservations about how and why the rule proposes to implement this approach.

In my initial post on the SEC’s reproposed rules for regulating the use of derivatives by investment companies (“funds”), I noted favorably that the regulations would extend beyond funds to registered broker/dealers and investment advisers. I think this reflects a more comprehensive, less piecemeal, approach to these proposed rules. I also appreciate the coordination of the Divisions of Investment Management and Trading and Markets in drafting the proposed rules.

There are other praiseworthy aspects of the general approach taken in developing the revised proposals. Chief among these is the SEC’s willingness to take a fresh look at the means of regulating the risks of derivatives usage. Historically, the SEC’s principal means for regulating these risks was to require funds to “segregate” liquid assets to cover a fund’s potential obligations for derivative transactions. The revised proposals would eliminate asset segregation in favor of more direct limits on potential volatility resulting from derivative transactions. Risks posed by payment or delivery obligations would represent just one, no longer paramount, component of a comprehensive risk management program.

 In an earlier post, I noted that Release No. IC-10666 was issued before interest rate swaps were invented. This may have been unfortunate, because swaps present unique challenges to Release 10666’s approach to asset segregation. I believe that difficulty with applying Release 10666 to swaps has contributed to inconsistency in the segregation requirements for different derivatives.

Swaps: The Revenge of Middle School Algebra

I’ve been discussing comments on the SEC’s proposed Rule 18f-4 in light of the SEC’s initial regulation of derivatives in Release No. IC-10666 (“Release 10666”). As explained in my first post, the objectives of the proposed rule include limiting the “speculative character” of funds that use derivatives and assuring they have sufficient assets to cover their obligations. Release 10666 used one means, asset segregation, to achieve both ends. Several comment letters appear to question whether this approach is still tenable.

This post continues my consideration of some conceptual questions underlying the SEC’s proposed Rule 18f-4. The following comment on the proposal caught my attention:

Congress is stating [in Section 1(b) of the Investment Company Act] that there is a problem when leverage unduly increases the “speculative character” (what we now call risk) of the investments. This was particularly a problem back in the 1930s … [when the] combination of opaque products, complex capital structures, pyramiding, bad corporate governance, and leverage created a toxic brew that resulted in serious losses for unwary investors.

Although this wasn’t the commenter’s point, it struck me that derivatives have the potential to present today all of the problems that senior securities presented in the 1930.