Statement on Funds' Use of Derivatives
Washington D.C.
Oct. 28, 2020
Thank you, Mr. Chairman and my fellow commissioners.
In November of 2019, when the Commission proposed this derivatives rule, we had no idea how much the world would change in a few short months. This spring, we experienced historic economic turmoil, with more days of large market movements than we had experienced in decades,[1] and significant dislocations in credit markets. The Federal Reserve Board and Congress undertook extraordinary interventions to ensure that credit markets did not collapse. While with the benefit of those interventions registered funds have seemingly weathered the storm so far, it is not because our existing framework adequately addressed the risks that funds can entail. Next time, it could turn out very differently – badly – because many registered funds’ reliance on derivatives and leverage to achieve their investment objectives could lead to disaster in times of prolonged or dramatic market stress.[2]
The use of derivatives, the focus of today’s rule, can present an inordinate amount of risk to funds and the investors who hold them,[3] particularly in the face of market volatility.[4] Yet during this global pandemic, as we have seen increased trading in some of these products,[5] we have failed to address the significant risk that derivatives can pose to funds and investors. One of our core mandates is to protect investors – including retail investors who often use mutual funds and ETFs to save for retirement, their child’s education, or a down payment on a house. We had an opportunity today to ensure that some of the greatest risks to funds—derivatives and leverage risk—are appropriately constrained, but, unfortunately, the majority of the Commission is telling investors they are on their own. The world has been turned upside down. We should stop to reassess our views, but instead we have made things markedly worse than our original proposal.
For the following reasons, I cannot support this approach.
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First, today’s rule fails to provide a meaningful limit on registered funds’ ability to take on leverage. The rule is centered on funds’ use of VaR,[6] a risk model that has been criticized as an unreliable gauge of derivatives risk.[7] While the release suggests that the VaR test places an outer limit on fund leverage risk, VaR is not itself a leverage measure[8] and does not directly limit how extensive leverage-related losses could be when those losses occur.[9] Moreover, VaR assesses future risk by looking backward.[10] While registered funds weathered the turmoil of this spring, our experience with the sudden and volatile market distress brought on by this pandemic underscores why historical data, while valuable, should be integrated into an approach that is more holistic than the rule we adopt today.[11] Even if we assume that the VaR test we had originally proposed accurately and reliably gauges leverage risk, the majority today is effectively doubling the leverage we proposed that investors could be exposed to without requiring adequate protections for investors to mitigate this additional risk.
Second, the risk management program requirements fail to provide a reliable backstop against VaR’s limitations.[12] The program provides a level of flexibility that could undermine any attempt to limit excessive risk. For example, the rule allows a fund that has breached its risk limit to bring itself back into compliance on its own timeframe.[13] This ability to breach VaR without regulatory consequences sufficient to deter unduly risky behavior[14] undercuts the goals the program is designed to achieve.
Finally, I share Commissioner Lee’s well-articulated concern that the Commission today does not even try to address the risks retail investors face when buying leveraged and inverse funds. Evidence suggests retail investors buy these products without adequately understanding their features and risks, and often use them in a manner that is inconsistent with their objective. We know this has resulted in many instances of significant loss.[15] Just this morning, the Chairman, along with several division directors, released a statement acknowledging not only that investors face serious risks by buying these funds, but that the current safeguards – including Regulation Best Interest – will do virtually nothing to protect the many retail investors who buy these products through self-directed brokerage accounts. The proposal at least acknowledged these risks through a sales practice rule – an approach that broker-dealers are already familiar with in the options context. With today’s rule, however, we do virtually nothing. Every day that we fail to address this problem is a day where investors are exposed to undue risk.
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As always, while I may disagree on the policy we have chosen, I’m deeply grateful to Dalia, Sarah, Brian, Amanda, John, Thoreau, Joel, S.P., Alex, and the rest of IM and DERA teams for their hard work and dedication to protecting investors. I believe the Commission’s goal today is an important one and I could have supported a form of this rule with more meaningful limitations on derivative risk exposure. Risk, of course, comes part and parcel with investing. I am not suggesting that we can, or should, eliminate risk, even in the diversified funds many investors use to save for their retirement. But we should not take the path the majority has chosen, which leaves investors to fend for themselves. Instead, I would have preferred the Commission more closely consider the derivatives proposal released in 2015.[16] That approach, carefully thought through and developed by our expert staff over several years, would have more directly addressed the risks that derivatives can entail and provided practical parameters around a registered funds’ ability to take on leverage.[17] Today’s rule does none of those things.
Accordingly, I respectfully dissent.
[1] See Dorsey Wright, Nasdaq, March 2020 had the Largest One-Day Moves Since 1985, But What Does That Mean for Investors? (Mar. 30, 2020) (stating “[n]o other month since 1985 has had nearly as many of the largest one day moves as March 2020 – October 2008 and October 1987 tie for second which [sic] each month owning five.”).
[2] See Kelly S. Kibbie, Dancing with the Derivatives Devil: Mutual Funds' Dangerous Liaison with Complex Investment Contracts and the Forgotten Lessons of 1940, 9 Hastings Bus. L.J. 195, 198, 203 (2013) (noting that, at the time, “44% of households in the United States own shares of registered investment companies, expecting them to be relatively safe, well-regulated investments….[h]owever, there is a strong concern that most investors understand neither the use of derivatives by mutual funds nor the risks inherent therewith” and that there have been many examples throughout history of the “disastrous losses” tied to derivatives that demonstrate their dangerous nature); Martin Mayer, Editorial, The Dangers of Derivatives, Brookings Institution, May 20, 1999 (noting the inherent danger in derivatives is that during a time of severe market turmoil the leverage that is often intertwined with the derivative “that once multiplied income will now devastate principal”).
[3] See In the Matter of OppenheimerFunds, Inc. and OppenheimerFunds Distributor, Inc., Investment Company Act Release No. 30099 (June 6, 2012) (settled action) (involving two mutual funds that suffered losses driven primarily by their exposure to certain commercial mortgage-backed securities, obtained mainly through total return swaps); In the Matter of Claymore Advisors, LLC, Investment Company Act Release No. 30308 (Dec. 19, 2012) and In the Matter of Fiduciary Asset Management, LLC, Investment Company Act Release No. 30309 (Dec. 19, 2012) (settled actions) (involving a registered closed-end fund that pursued an investment strategy involving written out-of-the-money put options and short variance swaps, which led to substantial losses for the fund); In the Matter of UBS Willow Management L.L.C. and UBS Fund Advisor L.L.C., Investment Company Act Release No. 31869 (Oct. 16, 2015) (settled action) (involving a registered closed-end fund that incurred significant losses due in part to large losses on the fund’s credit default swap portfolio); In the Matter of Team Financial Asset Management, LLC, Team Financial Managers, Inc., and James L. Dailey, Investment Company Act Release No. 32951 (Dec. 22, 2017) (settled action) (involving a mutual fund incurring substantial losses arising out of speculative derivatives instruments, including losing $34.67 million in 2013 from trading in derivatives such as futures, options, and currency contracts); In the Matter of Mohammed Riad and Kevin Timothy Swanson, Investment Company Act Release No. 33338 (Dec. 21, 2018) (settled action) (involving a registered closed-end fund incurring substantial losses resulting from the implementation of a new derivatives trading strategy); In the Matter of Top Fund Management, Inc. and Barry C. Ziskin, Investment Company Act Release No. 30315 (Dec. 21, 2012) (settled action) (involving a mutual fund engaged in a strategy of buying options for speculative purposes contrary to its stated investment policy, which permitted options trading for hedging purposes, losing about 69% of its assets as a result of this activity before liquidating); In the Matter of Catalyst Capital Advisors, LLC and Jerry Szilagyi, Investment Advisers Act Release No. 5436 (Jan. 27, 2020) (settled action) (involving a mutual fund that advises and invests primarily in options on S&P 500 index futures contracts incurring losses of 20% of its net asset value—more than $700 million—during the period December 2016 through February 2017). See also Prospectus, LJM Preservation and Growth Fund (Feb. 28, 2017).
[4] The extreme market volatility in March 2020 resulted in trading, liquidity, and pricing disruptions, valuation challenges, counterparty issues, and issues relating to derivatives’ underlying assets. See, e.g., ISDA and Greenwich Associates, The Impact of COVID-19 and Government Intervention on Swaps Market Liquidity (2020); CFTC, COVID-19 Commission Action, (discussing CFTC actions designed to help facilitate orderly trading and liquidity in the U.S. derivatives markets in response to the COVID-19 pandemic); CFTC Letter No. 20-17, Staff Advisory on Risk Management and Market Integrity Under Current Market Conditions (May 13, 2020) (advisory issued to remind certain CFTC-regulated market participants that they are expected to prepare for the possibility that certain contracts may continue to experience “extreme market volatility, low liquidity and possibly negative pricing”); FTI Consulting, Derivatives close-outs: COVID-19—Challenges to the valuation of derivatives upon early termination (June 2020); Nat’l Law Review, COVID-19 Update: The Impact of COVID-19 on Financial Contracts, Vol. X, No. 111 (Apr. 20, 2020) (discussing market volatility arising from the restrictions imposed to reduce the risk of spread of COVID-19, the impact of this volatility on existing contractual relationships, and illustrating practical issues that a counterparty to a financial contract might take into account using, as an example, a derivative transaction).
[5] For example, certain leveraged ETFs experienced record high daily trading volumes in March 2020. See Direxion, “Market Volatility Has Led to Several Leveraged ETFs Setting New Records for Inflows and Outflows” (Mar. 12, 2020).
[6] Value at Risk (“VaR”) is an estimate of an instrument or portfolio’s potential losses over a given time horizon and at a specified confidence level. For example, if a fund’s VaR calculated at a 99% confidence level is $100, this means the fund’s VaR model estimates that, 99% of the time, the fund would not be expected to lose more than $100. However, 1% of the time, the fund would be expected to lose more than $100, and VaR does not estimate the extent of this loss.
[7] Industry commenters emphasized the inherent limitations of VaR and questioned its reliability as a gauge of derivatives and leverage risk. See, e.g., AQR, Comment Letter on Proposed Rule on Use of Derivatives by Registered Investment Funds and Business Development Companies (Apr. 21, 2020) (“Despite the VaR test’s role as an outer bound limit, the inherent limitations of VaR as a metric mean that it may be somewhat ill-suited to serve this role.”); SIFMA, Comment Letter on Proposed Rule on Use of Derivatives by Registered Investment Funds and Business Development Companies, (April 21, 2020) (“From a policy perspective, we do not believe that the purpose of Sections 18 and 61 is to dictate the amount of risk that a Fund may offer. Instead, we believe that the statutory provisions are designed to limit the amount of leverage that a Fund may incur. The difficulty in the case of the Proposed Derivatives Rule is that it relies on the VaR model, which is a risk model.”).
[8] Use of Derivatives by Investment Companies and Business Development Companies, Release No. IC-34078 (Oct. 28, 2020) (“Adopting Release”) at 129 (“We recognize, however, that VaR itself is not itself a leverage measure and factors other than derivatives and leverage can cause a fund’s VaR to exceed the VaR of its designated reference portfolio, such as a fund’s security collection.”).
[9] See Adopting Release at 101 (“We also recognize that there are circumstances where VaR tests may potentially under- or overstate a particular fund’s leverage risk…”); Adopting Release at 99 (“Commenters highlighted concerns with one common critique of VaR: that it does not reflect the size of losses that may occur on the trading days during which the greatest losses occur—sometimes referred to as ‘tail risks.’ A related critique is that VaR calculations may underestimate the risk of loss under stressed market conditions.”). See also Andrew L. McElroy, Drastic Times Call For Drastic Risk Measures: Why Value-at-risk ls (Still) a Flawed Preventative of Financial Crises and What Regulators Can Do About It, 6 J. Bus. Entrepreneurship & L. Iss. 2 (2013) (describing the perverse incentive that VaR creates to overinvest in tail risk strategies, for example, by writing deep out-of-the-money put options that would face catastrophic losses only if the underlying asset experienced very extreme, very unlikely losses.).
[10] See, e.g., Thomas J. Linsmeier & Neil D. Pearson, Value at Risk, 56 Journal of Financial Analysts 2 (2000) (stating that, because historical simulation relies directly on historical data, a danger is that the price and rate changes in the last 100 (or 500 or 1,000) days might not be typical. For example, if by chance the last 100 days were a period of low volatility in market rates and prices, the VaR computed through historical simulation would understate the risk in the portfolio). See also Pablo Triana, VaR: The Number That Killed Us, Futures Magazine (Dec. 1, 2010) (stating that “in mid-2007, the VaR of the big Wall Street firms was relatively quite low, reflecting the fact that the immediate past had been dominated by uninterrupted good times and negligible volatility”); AQR, Comment Letter on Proposed Rule on Use of Derivatives by Registered Investment Funds and Business Development Companies (Apr. 21, 2020) (stating that one of the firm’s fund’s VaR experienced a “precipitous drop” in its VaR heading into 2012. According to this commenter, “[t]his drop is not the result of a large de-risking of the fund, but rather the consequence of the financial crisis data dropping out of the 3-year lookback period.”).
[11] While the rule requires portfolio stress testing as part of a fund’s risk management program, it provides funds discretion to choose the particular stress conditions that apply to their fund. The stress conditions they apply may not adequately reflect the risks that the fund is exposed to. See Adopting Release at 72 (“The specific factors to consider in a particular stress test may vary from fund to fund and will require judgment by fund risk professionals in designing stress tests. The rule’s principles-based approach to stress testing will provide flexibility to enable those professionals to exercise their judgment in designing and implementing the stress tests required by the rule.”).
[12] Id.
[13] The rule generally requires the fund to come back into compliance “promptly” and “in a manner that is in the best interests of the fund and its shareholders.” The release states that, “[t]hese provisions of the final rule collectively provide some flexibility for a fund that is out of compliance with the VaR test to make any portfolio adjustments.” See Adopting Release at 298-299.
[14] The rule requires a fund’s derivatives risk manager to report to the fund’s board and the fund to report to the Commission when a fund’s VaR has exceeded the limits in its VaR test for five business days. See Adopting Release at 163-164. However, these reporting requirements are unlikely to provide sufficient incentive to come back into compliance in an expeditious manner.
[15] Securities Litigation and Consulting Group, Leveraged ETFs, Holding Periods and Investment Shortfalls (2010) at 12 (“The percentage of investors that we estimate hold [leveraged/inverse ETFs] longer than a month is quite striking.”). The Commission’s Office of Investor Education and Advocacy has received complaints and other communications from investors following the onset of the market volatility related to COVID-19 expressing concerns that these funds did not behave as these investors had expected, with some of these investors experiencing significant losses. In addition, the Commission’s Office of Investor Education and Advocacy and FINRA have issued alerts in the past decade to highlight issues investors should consider when investing in leveraged/inverse funds. SEC Investor Alert and Bulletins, Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors (Aug. 1, 2009). This investor alert, jointly issued by SEC staff and FINRA, followed FINRA’s June 2009 alert, which raised concerns about retail investors holding leveraged/inverse ETFs over periods of time longer than one day. See FINRA Regulatory Notice 09-31, Non-Traditional ETFs–FINRA Reminds Firms of Sales Practice Obligations Relating to Leveraged and Inverse Exchange-Traded Funds (June 2009).
[16] See Use of Derivatives by Registered Investment Companies and Business Development Companies, 80 Fed. Reg. 80883 (Dec. 28, 2015).
[17] This approach would more faithfully fulfill the policies and purposes underlying Section 18 of the Investment Company Act and Release No. 10666. Section 18 addresses concerns that funds might engage in undue speculation by borrowing excessively and operate without sufficient assets to meet their obligations. The Commission first articulated a framework under Section 18 for regulating funds’ use of derivatives in 1979. See Securities Trading Practices of Registered Investment Companies, 44 Fed. Reg. 25128 (Apr. 27, 1979). Under that framework, funds were required to manage their derivatives risks by maintaining “segregated accounts” that would allow the funds to “cover” their derivatives obligations. Id at 25132. Asset segregation would, “if properly created and maintained,” function as a “practical limit on the amount of leverage” funds could obtain and would “assure the availability of adequate funds to meet the obligations arising from such activities.” Id. Rather than recalibrate the asset segregation framework to more faithfully fulfill its original purpose, the Commission has rescinded Release 10666, dispensing entirely with the eminently sensible concept of asset segregation. See Adopting Release at 36.