On March 24, 2020, Better Markets submitted a comment letter on the Securities and Exchange Commission’s re-proposal of a new exemptive regulation establishing a number of sensible risk management, governance, and leverage requirements designed to mitigate risks associated with the use of derivatives by most registered open-end or closed-end funds and business development companies under the Investment Company Act of 1940. Although we express significant reservations about certain elements of the re-proposal and in particular, the abandonment of the asset segregation framework and the introduction of new proposed derivatives-related leverage limitations (the relative and absolute value-at-risk (VaR) approach), we support initial steps to implement a comprehensive regulatory framework for funds using derivatives-related leverage and posing derivatives-related risks to the U.S. financial system and investors.
The use of leverage by funds, including so-called “synthetic” leverage obtained through derivatives, can present significant risks to U.S. financial stability and investors. Although derivatives-related leverage can amplify positive returns for investors and be risk reducing, it also can exacerbate risks arising from asset price or risk attribute movements not only to the fund itself and its investors but also to other market participants. These risks are likely to be most pronounced in adverse market conditions requiring funds to de-leverage, resulting in correlated “fire” sales of securities with other leveraged firms and often, requiring sales of already de-valued assets to meet redemption requests and other liquidity needs, including margin calls. Furthermore, these stresses may occur as funds experience other market and liquidity stresses, which, in turn, can be expected to affect availability and costs of short-term funding for fund investment activities.
These financial stability concerns contextualize the public interest reflected in the Investment Company Act’s mandate that the SEC protect fund investor interests that may be “adversely affected” by “excessive borrowing.” The Act finds that such leverage “increase[s] unduly the speculative character” of securities held by fund shareholders and presents concerns about whether funds operate with “adequate assets or reserves.” A significant value of the re-proposal is that it would institute a single, uniform derivatives framework in place of the current bibliography of more than 30 releases, including a 40-year old SEC policy statement, dozens of SEC staff no-action letters, and informal guidance based on specific representations and fact-specific, instrument-by-instrument analyses. Read more here, or by clicking the button below.