US buy-side firms have warned that current derivatives rules are confusing and open to interpretation, backing regulators’ plans for a rethink of the Investment Company Act of 1940.
The overhaul by the Securities and Exchange Commission (SEC) would go beyond current regulatory changes under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which seeks to bring a large proportion of OTC derivatives volume onto new centrally-cleared platforms called swap execution facilities.
“Because derivatives can be complex instruments, the application of certain regulatory requirements to these instruments under [current rules] raises interpretive issues,” Baltimore-based asset manager T. Rowe Price warned.
“In light of the increased use of derivatives by certain funds, the evolution of derivative products and the market disruptions of 2008, we believe that it is appropriate for the SEC to re-visit and modernise such rules,” mutual fund provider Vanguard said in a letter to the SEC.
The warnings came in response to a consultation launched in August by the SEC on the use of derivatives by mutual funds and other investment companies regulated under the Investment Company Act.
“The derivatives markets have undergone significant changes in recent years, and the commission is taking this opportunity to seek public comment and ensure that our regulatory approach and interpretations under the Investment Company Act remain current, relevant, and consistent with investor protection,” said SEC chairman Mary L. Schapiro at the time the consultation was opened.
The activities of funds, including their use of derivatives, are regulated extensively under the Act, commission rules and guidance. Mutual funds employ derivatives for a variety of purposes, including increasing leverage to boost returns, gain access to certain markets, achieve greater transaction efficiency, and hedge interest rate, credit, and other risks.
But the SEC is concerned derivatives can raise risk management issues relating to leverage, illiquidity – particularly with respect to complex OTC derivatives – and counterparty risk.
For this reason, the watchdog is reviewing existing rules to see if current market practices are consistent with leverage, concentration and diversification provisions and that existing rules sufficiently address matters such as the proper procedures for a fund’s pricing and liquidity determinations regarding its derivatives holdings. The SEC also wants to ensure funds that rely substantially on 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 their derivatives investments.
Almost 50 submissions were filed with the SEC over the two-month consultation period, from organisations such as asset managers Invesco, Vanguard, State Street Global Advisers and T. Rowe Price, lobby group the Mutual Fund Directors Forum, and the Chicago Board Options Exchange.
Both T. Rowe Price and Vanguard said they supported a principles-based approach to rules regarding the issuance of senior debt securities and asset segregation as applied to derivative investments.
“The development of regulatory guidance tailored specifically to derivatives would allow fund complexes to adopt a clear and consistent approach for segregating assets in respect of derivatives,” Vanguard said. “Given the broad diversity of derivative products, and the regular development of new products, we support a principles-based approach where the SEC would promulgate clear general guidelines dealing with asset segregation and related issues such as offsets, accompanied by examples of how the guidelines might apply to the most common types of derivatives.”
T. Rowe Price added that it believed a principles-based approach should determine asset coverage based on realistic determinations of expected potential future liability of a fund’s derivatives exposure.
Law firm Davis Polk & Wardell criticised current rules, noting that SEC guidance had not kept pace with the expansion of the derivatives market over the last 20 years.
“In some cases, the regulatory uncertainty may lead a fund to select one type of instrument or transaction over another for non-investment reasons, or to avoid certain instruments or transactions altogether,” the firm said in its submission to the SEC. “This can lead to inefficiencies that are detrimental to funds and their shareholders.”
Davis Polk said mutual funds and their sponsors ran the risk of interpreting current guidance differently, even when applying it to the same instruments. Such difference in interpretation could unfairly disadvantage some funds, the firm warned.
“Incomplete or ambiguous guidance complicates discussions with derivative dealers, who often face substantial uncertainty in navigating the regulatory landscape faced by their registered fund clients,” the firm said.
The review is ongoing.