This post continues our discussion of the calculation of “gross notional amounts” included in a fund’s “derivatives exposure” under Rule 18f-4. Previously, we identified the best guidance we could find on how to calculate a derivatives transaction’s gross notional amount, and three adjustments to such amounts permitted by the rule’s definition of derivatives exposure. In this post, we discuss another adjustment not anticipated by Rule 18f‑4, but which we believe is necessary to avoid a fund that purports to be a limited derivatives user from circumventing the 10% limit on its derivatives exposure.
Continue Reading Derivatives Exposure: Adjusting for Multipliers

Our previous post gave the best account we could of what the SEC staff has said about calculating the “gross notional amount” of derivatives transactions. In this post, we examine three adjustments that a fund may (but is not required to) make when calculating its “derivatives exposure.” Specifically, a fund may:

  • exclude any closed-out positions;
  • delta adjust the notional amounts of options contracts; and
  • convert the notional amount of interest rate derivatives to 10-year bond equivalents.

We anticipate that a fund seeking to qualify as a “limited derivatives user” would make these adjustments to lower its derivatives exposure.
Continue Reading Derivatives Exposure: Adjusting Notional Amounts

In this post, we tackle the question of how to calculate the “gross notional amount” of a derivatives transaction for purposes of the limited derivatives user provision of Rule 18f-4. This is a surprisingly difficult question because, although the adopting release for Rule 18f-4 (the “Adopting Release”) refers to “notional amount” 63 times, the release never directly addresses what the term means. We think we found an answer, but it required us to wind our way through a series of earlier SEC statements.
Continue Reading Derivatives Exposure: A Circuitous Path to “Gross Notional Amounts”

Having provided two “big pictures” of the calculation of a fund’s “derivatives exposure,” we resume with an in-depth examination. We begin by considering how to determine the “gross notional amount” of a derivatives transaction. This post may contain our only categorical conclusion regarding derivatives exposure: gross notional amounts must be absolute values expressed in U.S. dollars.
Continue Reading Derivatives Exposure under Rule 18f-4: Notional Apples and Oranges

Our last post outlined the essential differences between VaR Funds and Limited Derivatives Users: primarily that the former must adopt a derivatives risk management program (a “DRM Program”) while the latter need only have policies and procedures. Our post observed that the less prescriptive regulatory requirements may make operating as a Limited Derivative User an attractive alternative for many management investment companies (including business development companies but excluding money market funds, a “Fund”). As promised at the end of that post, this post initiates our exploration of the challenges of qualifying as a Limited Derivatives User. We begin by providing a high-level step-by-step guide to calculating a Fund’s “derivatives exposure.”
Continue Reading Derivatives Exposure: Why It Matters And How To Calculate It

Our last post explained the two basic alternatives for managing derivatives risks under new Rule 18f-4 by qualifying either as a Limited Derivatives User or a VaR Fund. This post outlines the essential differences between VaR Funds and Limited Derivatives Users, primarily that the former must adopt a derivatives risk management program (a “DRM Program”) while the latter need only have policies and procedures.
Continue Reading VaR Funds vs. Limited Derivatives Users—Programs vs. Procedures

Rule 18f-4 is somewhat unusual in that it gives management investment companies (including business development companies but excluding money market funds, “Funds”) alternative means of complying with its exemption from Sections 18 and 61. A Fund may either:

  • Limit the way and extent to which the Fund engages in derivatives transactions (a “Limited Derivatives User”), or
  • Adopt a Derivatives Risk Management Program (a “DRM Program”) that, among other requirements, limits the Fund’s Value-at-Risk (“VaR”) relative to an index, its non-derivatives portfolio or its net assets (a “VaR Fund”).


Continue Reading What Kind of Derivatives User Is Your Fund?

Having completed our review of derivatives transactions, we now consider the risks such transactions may pose. Rule 18f-4(a) defines “derivatives risks” to include “leverage, market, counterparty, liquidity, operational, and legal risks and any other [material] risks.” The adopting release (the “Release”) provides helpful descriptions of these risks and some examples.
Continue Reading What Risks May Be Associated with Derivatives Transactions

This post completes our exploration of the definition of “derivatives transactions” in Rule 18f-4, which is relevant to business development companies, closed-end funds and open-end funds other than a money market fund (“Funds”). Our object is to generate a fairly comprehensive list of what is, is not, and may be a “derivatives transaction” by using our touchstone of a “future payment obligation” in combination with the literal definition in the rule and points made in earlier posts.
Continue Reading Rule 18f-4 Derivatives Transactions Recap

In this post, we continue our exploration of the definition of “derivatives transaction” in new Rule 18f-4, which is relevant to business development companies, closed-end funds and open-end funds other than a money market fund (“Funds”). Our last post discussed examples of derivatives that fall outside of the definition. This post considers transactions that may not pose the risks addressed by Rule 18f-4 but which are nevertheless subject to the rule. Subsequent posts will explain why this overbreadth is not as bad as it might seem.
Continue Reading Transactions that Are “Derivatives Transactions” under Rule 18f-4