This post will bring to a close, for now, our survey of the requirements of new Rule 18f-4, which investment companies must comply with by August 19, 2022. This post considers whether a Chief Compliance or Risk Officer should seek to treat some or all of their funds as Limited Derivatives Users and how that choice, in turn, relates to the decision about whether to treat reverse repurchase agreements as derivatives transactions. But first, we review the compliance procedures required by Rule 18f-4 for (nearly) every fund. We also provide links to compliance checklists provided in earlier posts.
Compliance Checklist for Limited Derivatives Users
As has been our practice in this series on new Rule 18f-4, we end our survey of its Limited Derivatives User requirements with a compliance checklist. This checklist reiterates much of our earlier post on Derivatives Exposure: Why It Matters And How To Calculate It, but provides more details and includes required
Hedging Derivatives under Rule 18f-4: Not an “All or None” Exclusion
This post will address another ambiguity in the “10% buffer” Rule 18f-4 provides for excluding the notional amount of derivative transactions that hedge currency or interest rate risks (“Hedging Derivatives”) when calculating the Derivatives Exposure of a Limited Derivatives User. The ambiguity is whether, once the notional amount of a Hedging Derivative exceeds the 10% buffer, a fund should add back to its Derivatives Exposure (a) the entire notional amount of the Hedging Derivative or (b) only the notional amount in excess of the 10% buffer. We chose answer (b) in our post on The 10% Buffer and Changes in Hedged Investments. This post explains why.
Rule 18f-4: One 10% Buffer or Many?
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, par or principal amount of the hedged equity and fixed-income investments. In this post we consider whether funds should apply the 10% buffer to Hedging Derivatives in the aggregate or on a “hedge-by-hedge” basis.
Rule 18f-4: The 10% Buffer and Changes in Hedged Investments
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.
Rule 18f-4: The 10% Buffer and Adjusting Notional Amounts of Hedges
We promised a few posts back to discuss how a Limited Derivatives User should apply what we termed the “10% buffer” to determine whether currency and interest-rate derivatives may be excluded from its derivatives exposure. This post begins to tackle the question What is the 10% Buffer? and explain how it might work.
Limited Derivatives Users—Applying the Interest Rate Hedging Exclusion
Our last post examined examples of currency hedges that we believe Rule 18f‑4(c)(4)(i)(B) should allow a fund seeking to comply with the Limited Derivatives User requirements to exclude from its derivatives exposure. This post struggles with examples of interest-rate hedges that may, or may not, be excluded.
Rule 18f-4: Trimming Hedges—Hedges Included in Derivatives Exposure
This post continues our examination of how a fund must treat hedges when calculating its derivatives exposure to qualify as a limited derivatives user. Commenters on proposed Rule 18f-4 suggested several types of derivatives hedges, in addition to currency derivatives, that the Commission might exclude from derivatives exposure. In the release adopting Rule 18f-4 (the “Adopting Release”), the Commission agreed to exclude interest rate derivatives from the calculation of derivatives exposure, but rejected the other suggestions. These other hedging strategies should therefore be included in a fund’s derivatives exposure.
We previously discussed covered call options and purchased option spreads, which are derivatives transactions and should be included in derivatives exposure. Other potential hedges that should be included in derivatives exposure include the following.
Rule 18f-4: Trimming Hedges—Hedges Excluded from Derivatives Exposure
Our post on the derivatives exposure equation began with a separate equation concerning interest rate and currency hedges. This post explains the significance of this equation and what hedges should be excluded from a fund’s derivatives exposure. Our next post will address hedges included in derivatives exposures before we raise some interpretive questions about how the exclusion should be applied.
The Derivatives Exposure Equation
Our last post provided a big picture summary of the steps required to calculate a Fund’s “derivatives exposure” for purposes of new Rule 18f-4. The post may have left an impression that this process should not be that difficult. To provide additional perspective, we offer the following equation for calculating derivatives exposure.
If interest rate and currency hedges satisfy the following condition:
Then a Fund will be a limited derivatives user when:
Where: