The SEC Investment Management staff is reviewing the use of derivatives by mutual funds, exchange-traded funds and other investment companies. The review will examine if additional protections are necessary for those funds under the Investment Company Act.
The initiative will have a significant impact on new ETF applications. ETFs come to market through an exemption granted by the SEC under Investment Company Act Section 6(c). Pending the review's completion, the staff will defer consideration of new exemptive requests to permit ETFs that would make significant investments in derivatives. The staff's decision will affect new and pending exemptive requests from certain actively-managed and leveraged ETFs that particularly rely on swaps and other derivative instruments to achieve their investment objectives. The deferral does not affect any existing ETFs or other types of fund applications.
Elizabeth G. Osterman from the division staff emphasized this morning at the PLI SEC Speaks conference that the applications are being deferred and not denied. She stated that the Office of Investment Company Regulation, which is responsible for the review of exemptive applications, is not a rulemaking office. It was appropriate, however, for the staff to step back and examine the standards they apply to these requests.
"Although the use of derivatives by funds is not a new phenomenon, we want to be sure our regulatory protections keep up with the increasing complexity of these instruments and how they are used by fund managers," said Andrew Donohue, director of the SEC's Division of Investment Management. At the PLI conference this morning, Director Donohue stated that he was not being "judgmental" on derivatives use by funds, but he observed that the 1940 Act does not deal well with these instruments.
The staff generally intends to explore issues related to the use of derivatives by funds, including, among other things, whether
1) current market practices involving derivatives are consistent with the leverage, concentration and diversification provisions of the Investment Company Act,
2) funds that rely substantially upon derivatives, particularly those that seek to provide leveraged returns, maintain and implement adequate risk management and other procedures in light of the nature and volume of the fund's derivatives transactions,
3) fund boards of directors are providing appropriate oversight of the use of derivatives by funds,
4) existing rules sufficiently address matters such as the proper procedure for a fund's pricing and liquidity determinations regarding its derivatives holdings,
5) existing prospectus disclosures adequately address the particular risks created by derivatives, and
6) funds' derivative activities should be subject to special reporting requirements.
The staff also will seek to determine what, if any, changes in Commission rules or guidance may be warranted.