SEC creates first-of-their-kind rules on derivatives

A 'framework' approach, summa of chairman Jay Clayton's SEC career, comes over Democratic objections.

Fund advisors will be allowed to risk up to 200 percent of their firms’ portfolios’ value in derivatives under first-of-their-kind rules adopted by a divided SEC on October 28.

The new rules, adopted over Democratic objections at the Commission’s open meeting, were accompanied by a joint statement from chairman Jay Clayton and three of the agency’s top civil servants – Division of Investment Management director Dalia Blass, Division of Corporation Finance director Bill Hinman and Division of Trading and Markets director Brett Redfearn – promising to “review” existing regulations to see whether they go far enough in protecting retail investors, especially those with self-directed brokerage accounts, from the high risks of increasingly complex products such as derivatives.

The derivatives rules are in many ways the summa of Clayton’s SEC tenure. It’s an attempt to impose what he calls “a framework” rather than a rigid set of guardrails to help balance the need for innovation with the need to set baseline protections for retail investors. “The recommendation before us today is another outstanding example of reforms that modernize our rules for the benefit of investors,” he said in a statement.

‘Framework approach’

Blass has already suggested that the framework approach used here – where regulators lay out “appropriate risk guidelines, standardized guidelines” and reporting requirements – will probably inform future rulemaking on money market and exchange-traded funds.

The Commission’s vote changes Investment Company Act rule 18f-4 to require investment company boards to appoint risk managers to create and implement risk guidelines, conduct back-end stress tests and to comply with internal reporting requirements. Firms whose derivatives investments are worth less than 10 percent of their net asset values are generally exempted from the new rules, as long as they have written P&Ps “reasonably designed to manage its derivatives risks.”

They also back away from more rigid risk caps on derivatives proposed by a unanimous Commission last year. Under the proposal, investment companies’ risk threshold would’ve been pegged to a “designated reference index” beyond a firm’s influence or control, such as a value at risk measure. Now, a fund’s risk threshold is pegged to a firm’s non-derivatives portfolios.

Dems dissent

That was too much for the Commission’s Democrats.

“Thus, a fund can simply change its own derivative risk limits by making changes in its non-derivatives portfolio,” Allison Herren Lee said in her dissent. “This could trigger an entirely perverse incentive for a fund that is approaching or has exceeded its derivative risk limit to actually increase risk in its securities portfolio rather than reduce risk from derivatives in order to come into compliance.”

Herren Lee also criticized her Republican colleagues for watering down disclosure requirements that appeared in the draft proposal.

This article first appeared in sister publication Regulatory Compliance Watch