Comment letters on the SEC’s proposed rules for limiting leverage in registered funds (Premium)

Josh Galper

In December 2015, the US Securities and Exchange Commission proposed rule 18f-4 limiting the amount of leverage that registered funds could use. Funds could either use a portfolio limit of 150% total exposure or a risk-based limit based on VaR plus a maximum exposure of 300%. The rule would impact 32% of all funds that currently report to the SEC. We review the comment letters that have begun to roll in.

VaR is stupid. We were genuinely surprised to see the use of VaR as the sole risk measurement in the SEC’s proposal, given that it has been discredited pretty much everywhere. Further, the Basel Committee on Banking Supervision has gone so far as to formally propose a challenger model, the Expected Shortfall Method, for measuring market risk instead of VaR. Other commenters picked up on this as well. A letter from the InterContinental Exchange (ICE) noted that:

We strongly believe that the Commission should be more flexible in providing options to funds using a VaR or other risk methodologies under the risk-based portfolio limit in the Proposal and align the Proposal more closely with valuation requirements applied in other contexts, such as those by banking regulators…. If a reliance on a prescriptive type of VaR model under the risk-based portfolio limit remains the focus of the Commission in any approved rule, we agree with the approach taken to require a minimum of three years of data for developing a historical simulation.

Business Development Companies (BDCs) vs. other fund managers. Law firm Sutherland Asbill and Brennan noted that BDCs may be unduly caught up in the new proposed regulation:

We would like to highlight that our comments focus only on the regulation of unfunded commitments under the Proposed Rule and the Investment Company Act. In this regard, we have assumed that BDCs would be required to either segregate assets to cover unfunded commitment transactions in accordance with the Proposed Rule or account for unfunded commitments as senior securities in accordance with the asset coverage requirement under the Investment Company Act if the Proposed Rule is adopted in its current form.
“Qualifying coverage assets” should be more than cash and cash equivalents. The proposal has set up a potentially tricky situation for funds that trade derivatives but don’t hold cash; the rules would require much more cash to be held, which of course would reduce investable assets and lower returns. Fidelity’s comment letter picked up on this and proposed that other assets be included as qualifying, specifically following the logic of the upcoming Uncleared Swap Margin Rules:
Limiting qualifying coverage assets for derivatives transactions to cash and cash equivalents would be harmful to shareholders in certain funds
In the Uncleared Swap Margin Rules, the Prudential Regulators and CFTC recognized that limiting eligible collateral to cash “is inconsistent with current market practice” and “would drain the liquidity of financial end users by forcing them to hold more cash.”
The narrow category of qualifying coverage assets under the Proposed Rule may result in inconsistent treatment of funds that trade other types of derivatives, such as non-deliverable forwards.
Similarly, LCH.Clearnet says that “The scope of “qualifying coverage assets” that a fund would have to hold against derivatives positions should be aligned with similar assets permitted to meet collateral requirements within the broader global derivatives framework.”
Expanding the definition of qualifying coverage assets was a very frequent theme across the comment letters.
The proposed rules would have a dramatic impact. AQR says that “We expect that alternative mutual funds would be required to restructure their investment strategies, sometimes drastically, in a manner that will increase risks and reduce the benefits investors receive from such investments.” Citing an ICI draft study, they claim that “the Rule would require retooling and, in some cases, possible closure of funds with over $600 billion in aggregate assets.” AQR proposes some pretty straight-forward adjustments to the rule’s language in order to mitigate the most severe impacts. For example, they suggest VaR+ 400% in maximum exposure. Wells Fargo Asset Management takes a similar approach, recommending a portfolio limit of 200% instead of the SEC’s 150%.
Leveraged funds provide opportunities for retail investors. Quite a number of individual investors wrote in with the theme that leveraged investing was a real benefit to them. A sample comment comes from Nissar Vahora: “I don’t own a hedge fund, don’t have connections with big brokerage firms and am not able to use leverage in other ways that I feel comfortable doing (e.g. using margin, etc). These leveraged ETFs are my only way to compete against the big boys in this industry and achieve returns that are more than conventional. I understand the risks involved and want to be able to take advantage of them. Please do not limit my ability to purchase x2 or x3 leveraged ETFs.”
While it is highly likely that the SEC’s proposed rules will become regulation, we also expect that the definition of qualifying coverage assets will be expanded and harmonized with Uncleared Swap Margin Rules. And hopefully the SEC will do something about that unfortunate VaR mandate.

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