Use of Derivatives by Registered Investment Companies and Business Development Companies

SECURITIES AND EXCHANGE
COMMISSION
17 CFR Parts 270 and 274
[Release No. IC–31933; File No. S7–24–15] RIN 3235–AL60 Use of Derivatives by Registered Investment Companies and Business Development Companies AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. SUMMARY: The Securities and Exchange Commission (the ‘‘Commission’’ or ‘‘SEC’’) is proposing rule 18f–4, a new exemptive rule under the Investment Company Act of 1940 (the ‘‘Investment Company Act’’ or ‘‘Act’’) designed to address the investor protection purposes and concerns underlying section 18 of the Act and to provide an updated and more comprehensive approach to the regulation of funds’ use of derivatives. The proposed rule would permit mutual funds, exchange-traded funds (‘‘ETFs’’), closed-end funds, and companies that have elected to be treated as business development companies (‘‘BDCs’’) under the Act (collectively, ‘‘funds’’) to enter into derivatives transactions and financial commitment transactions (as those terms are defined in the proposed rule) notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18 of the Act, provided that the funds comply with the conditions of the proposed rule. A fund that relies on the proposed rule in order to enter into derivatives transactions would be required to:
comply with one of two alternative portfolio limitations designed to impose a limit on the amount of leverage the fund may obtain through derivatives transactions and other senior securities transactions; manage the risks associated with the fund’s derivatives transactions by maintaining an amount of certain assets, defined in the proposed rule as ‘‘qualifying coverage assets,’’ designed to enable the fund to meet its obligations under its derivatives transactions; and, depending on the extent of its derivatives usage, establish a formalized derivatives risk management program. A fund that relies on the proposed rule in order to enter into financial commitment transactions would be required to maintain qualifying coverage assets equal in value to the fund’s full obligations under those transactions. The Commission also is proposing amendments to proposed Form N–PORT and proposed Form N–CEN that would require reporting and disclosure of certain information regarding a fund’s derivatives usage. DATES: Comments should be received on or before March 28, 2016. ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments

• Use the Commission’s Internet
  comment form (http://www.sec.gov/ rules/concept.shtml);
• Send an email to rule-comments@
  sec.gov. Please include File Number S7– 24–15 on the subject line; or
• Use the Federal eRulemaking Portal
  (http://www.regulations.gov). Follow the instructions for submitting comments. Paper Comments
• Send paper comments to Brent J.
  Fields, Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549–1090. All submissions should refer to File Number S7–24–15. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s Internet Web site (http://www.sec.gov/ rules/proposed.shtml). Comments also are available for Web site viewing and printing in the Commission’s Public Reference Room, 100 F Street NE., Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make publicly available. Studies, memoranda or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission’s Web site. To ensure direct electronic receipt of such notifications, sign up through the ‘‘Stay Connected’’ option at www.sec.gov to receive notifications by email. FOR FURTHER INFORMATION CONTACT:
  With respect to proposed rule 18f–4, Adam Bolter, Jamie Lynn Walter, or Erin
  C. Loomis, Senior Counsels; Thoreau A.
  Bartmann, Branch Chief; Brian McLaughlin Johnson, Senior Special Counsel; or Aaron Schlaphoff or Danforth Townley, Attorney Fellows; and with respect to the proposed amendments to Form N–PORT and Form N–CEN, Jacob D. Krawitz, Senior Counsel, or Sara Cortes, Senior Special Counsel, at (202)–551–6792, Investment Company Rulemaking Office, Division of Investment Management, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549–8549. SUPPLEMENTARY INFORMATION: The Commission is proposing rule 18f–4 [17 CFR 270.18f–4] under the Investment Company Act of 1940 [15 U.S.C. 80a] and amendments to proposed Form N– PORT and proposed Form N–CEN.
  Table of Contents
  I. Introduction
  II. Background
  A. Background Concerning the Use of Derivatives by Funds B. Derivatives and the Senior Securities Restrictions of the Investment Company Act
  1. Requirements of Section 18
  2. Investment Company Act Release 10666
  3. Developments after Investment
  Company Act Release No. 10666
  4. Current Views Concerning Section 18
  C. Review of Funds’ Use of Derivatives
  D. Need for a New Approach
  1. The Current Regulatory Framework and
  the Purposes and Policies Underlying the Act
  2. Need for an Updated and More
  Comprehensive Approach
  III. Discussion
  A. Structure and Scope of Proposed Rule 18f–4
  1. Structure of Proposed Rule 18f–4
  2. Definitions of Derivatives Transactions
  and Financial Commitment Transactions B. Portfolio Limitations for Derivatives Transactions
  1. Exposure-Based Portfolio Limit
  2. Risk-Based Portfolio Limit
  3. Implementation and Operation of
  Portfolio Limitations
  C. Asset Segregation Requirements for
  Derivatives Transactions
  1. Coverage Amount for Derivatives
  Transactions
  2. Qualifying Coverage Assets
  D. Derivatives Risk Management Program
  1. Funds Subject to the Proposed Risk
  Management Program Condition
  2. Required Elements of the Program
  3. Administration of the Program
  4. Board Approval and Oversight
  E. Requirements for Financial Commitment Transactions
  1. Coverage Amount for Financial
  Commitment Transactions
  2. Qualifying Coverage Assets for Financial
  Commitment Transactions
  F. Recordkeeping
  G. Amendments to Proposed Forms N– PORT and N–CEN
  1. Reporting of Risk Metrics by Funds That
  Are Required To Implement a Derivatives Risk Management Program
  2. Amendments to Proposed Form N–PORT
  3. Amendments to Proposed Form N–CEN
  4. Request for Comment
  H. Request for Comments
  I. Proposed Rule 18f–4 and Existing
  Guidance

1 15 U.S.C. 80a. Unless otherwise noted, all references to statutory sections are to the Investment Company Act, and all references to rules under the Investment Company Act, including proposed rule 18f–4, will be to title 17, part 270 of the Code of Federal Regulations, 17 CFR part 270. 2Our staff has also issued no-action and other letters that relate to fund use of derivatives. In addition to Investment Company Act provisions, funds using derivatives (and financial commitment transactions) must comply with all other applicable statutory and regulatory requirements, such as other federal securities law provisions, the Internal Revenue Code (the ‘‘IRC’’), Regulation T of the Federal Reserve Board (‘‘Regulation T’’), and the rules and regulations of the Commodity Futures Trading Commission (the ‘‘CFTC’’). See also Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111–203, 124 Stat. 1376 (2010) (the ‘‘Dodd-Frank Act’’), available at http://www.sec.gov/about/laws/wallstreetreform￾cpa.pdf. 3See Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) [76 FR 55237 (Sept. 7, 2011)] (‘‘Concept Release’’), at n.3. 4See Concept Release, supra note 3, at n.5. 5See Concept Release, supra note 3, at n.6. As discussed in Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, Investment Company Act Release No. 31835 (Sept. 22, 2015) [80 FR 62273 (Oct. 15, 2015)] (‘‘Liquidity Release’’), long-standing Commission guidelines generally limit an open-end fund’s aggregate holdings of ‘‘illiquid’’ assets to 15% of the fund’s net assets. Under these guidelines, an asset is considered illiquid if it cannot be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the fund has valued the investment. These guidelines apply to all investments (including derivatives) held by an open-end fund. Proposed rule 22e–4, which we proposed in September 2015, would codify this standard along with other requirements that are designed to promote effective liquidity risk management for open-end funds. 6See Concept Release, supra note 3, at n.7. See also infra section II. 7See Concept Release, supra note 3.
IV. Economic Analysis
A. Introduction and Primary Goals of Proposed Regulation B. Economic Baseline
C. Economic Impacts, Including Effects on
Efficiency, Competition, and Capital Formation D. Specific Benefits and Quantifiable Costs
1. Exposure-Based Portfolio Limit
2. Risk-Based Portfolio Limit
3. Asset Segregation
4. Risk Management Program
5. Financial Commitment Transactions
6. Amendments to Form N–PORT To
Report Risk Metrics by Funds That Are Required To Implement a Derivatives Risk Management Program
7. Amendments to Form N–CEN To Report
Reliance on Proposed Rule 18f–4 E. Reasonable Alternatives F. Request for Comment
V. Paperwork Reduction Act
A. Introduction
B. Proposed Rule 18f–4
1. Portfolio Limitations for Derivatives
Transactions
2. Asset Segregation: Derivatives
Transactions
3. Asset Segregation: Financial
Commitment Transactions
4. Derivatives Risk Management Program
5. Amendments to Form N–PORT
6. Amendments to Form N–CEN
C. Request for Comments
VI. Initial Regulatory Flexibility Act Analysis
A. Reasons for and Objectives of the Proposed Actions B. Legal Basis
C. Small Entities Subject to Proposed Rule
18f–4 and Amendments to Form N– PORT and Form N–CEN D. Projected Reporting, Recordkeeping, and Other Compliance Requirements
1. Portfolio Limitations for Derivatives
Transactions
2. Asset Segregation
3. Derivatives Risk Management Program
4. Financial Commitment Transactions
5. Amendments to Proposed Form N–PORT
6. Amendments to Form N–CEN
E. Duplicative, Overlapping, or Conflicting Federal Rules F. Significant Alternatives
1. Proposed Rule 18f–4
2. Form N–PORT and Form N–CEN
G. General Request for Comment
VII. Consideration of Impact on the Economy
VII. Statutory Authority
I. Introduction
The activities and capital structures of funds are regulated extensively under the Investment Company Act,1 Commission rules, and Commission guidance.2 The use of derivatives by funds implicates certain requirements under the Investment Company Act, including section 18 of that Act. As discussed in more detail below, section 18 limits a fund’s ability to obtain leverage or incur obligations to persons other than the fund’s common shareholders through the issuance of senior securities, as defined in that
section.
Derivatives may be broadly described as instruments or contracts whose value is based upon, or derived from, some other asset or metric (referred to as the ‘‘reference asset,’’ ‘‘underlying asset’’ or ‘‘underlier’’).3 Funds employ derivatives for a variety of purposes, including to:
Seek higher returns through increased investment exposures; hedge interest rate, credit, and other risks in their investment portfolios; gain access to certain markets; and achieve greater transaction efficiency.4 At the same time, derivatives can raise risks for a fund relating to, for example, leverage, illiquidity (particularly with respect to complex over-the-counter (‘‘OTC’’) derivatives), counterparties, and the ability of the fund to meet its obligations.5 We are committed, as the primary regulator of funds, to designing regulatory programs that respond to the risks associated with the increasingly complex portfolio composition and operations of the asset management industry. The dramatic growth in the volume and complexity of the derivatives markets over the past two decades, and the increased use of derivatives by certain funds,6 led us to initiate a review of funds’ use of derivatives under the Investment Company Act to evaluate whether the regulatory framework, as it applied to funds’ use of derivatives, continues to fulfill the purposes and policies underlying the Act and is consistent with investor protection. We published a Concept Release on funds’ use of derivatives in 2011 (the ‘‘Concept Release’’) to assist with this review and solicit public comment on the current regulatory framework.7 As noted in the Concept Release, our staff has been exploring the benefits, risks, and costs associated with funds’ use of derivatives. Our staff’s review of these and other matters, together with input from commenters on the Concept Release and others, have informed our consideration of the regulation of funds’ use of derivatives, including in particular whether funds’ current practices, based on their application of Commission and staff guidance, are consistent with the investor protection purposes and concerns underlying
section 18 of the Investment Company
Act.
Today, we are proposing new rule 18f–4, which is designed to address the investor protection purposes and concerns underlying section 18 and to provide an updated and more comprehensive approach to the regulation of funds’ use of derivatives transactions and other transactions that implicate section 18 in light of the dramatic growth in the volume and complexity of the derivatives markets over the past two decades and the increased use of derivatives by certain funds. As discussed in more detail below, the proposed rule would permit a fund to enter into derivatives and financial commitment transactions, notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18 of the Act, provided that the fund complies with the conditions of the proposed rule. The proposed rule’s conditions are designed both to impose a limit on the leverage a fund may obtain through the use of derivatives and financial commitment transactions and other senior securities transactions, and to require the fund to have assets available to meet its obligations arising from those transactions, both of which are central

8For example, the reference asset of a Standard & Poor’s (‘‘S&P’’) 500 futures contract is the S&P 500 index. 9See, e.g., Concept Release, supra note 3, at nn.35–46 and accompanying text. 10See Concept Release, supra note 3, at n.22. 11A futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality, for an agreed upon price (the ‘‘futures price’’ or ‘‘strike price’’), with delivery and payment occurring at a specified future date (the ‘‘delivery date’’). The contracts are negotiated on a futures exchange which acts as an intermediary between the two parties. The party agreeing to buy the underlying asset in the future, the ‘‘buyer’’ of the contract, is said to be ‘‘long,’’ and the party agreeing to sell the asset in the future, the ‘‘seller’’ of the contract, is said to be ‘‘short.’’ The long position (buyer) hopes or expects that the asset price is going to increase, while the short position (seller) hopes or expects that it will decrease. For a general discussion of futures contracts, see, e.g., John C. Hull, Options, Futures, and Other Derivatives (9th ed. 2015), at 24. 12An option is the right to buy or sell an asset. There are two basic types of options, a ‘‘call option’’ and a ‘‘put option.’’ A call option gives the holder the right (but does not impose the obligation) to buy the underlying asset by or at a certain date for a certain price. The seller, or ‘‘writer,’’ of a call option has the obligation to sell the underlying asset to the holder if the holder exercises the option. A put option gives the holder the right (but does not impose the obligation) to sell the underlying asset by or at a certain date for a certain price. The seller, or ‘‘writer,’’ of a put option has the obligation to buy from the holder the underlying asset if the holder exercises the option. The price that the option holder must pay to exercise the option is known as the ‘‘exercise’’ or ‘‘strike’’ price. The amount that the option holder pays to purchase an option is known as the ‘‘option premium,’’ ‘‘price,’’ ‘‘cost,’’ or ‘‘fair value’’ of the option. See Concept Release, supra note 3, at n.23. 13Options on futures generally trade on the same exchange as the relevant futures contract. When a call option on a futures contract is exercised, the holder acquires from the writer a long position in the underlying futures contract plus a cash amount equal to the excess of the futures price over the strike price. When a put option on a futures contract is exercised, the holder acquires a short position in the underlying futures contract plus a cash amount equal to the excess of the strike price over the futures price. See Concept Release, supra note 3, at n.24. 14A ‘‘swap’’ is generally an agreement between two counterparties to exchange periodic payments based upon the value or level of one or more rates, indices, assets, or interests of any kind. For example, counterparties may agree to exchange
payments based on different currencies or interest rates. See Concept Release, supra note 3, at n.25. Except as otherwise specified or the context otherwise requires, we use the term ‘‘swap’’ in this Release to refer collectively to swaps, as defined in
section 1a of the Commodity Exchange Act, 7 U.S.C.
1a (the ‘‘CEA’’), and security-based swaps, as defined in section 3(a)(68) of the Exchange Act. 15A ‘‘swaption’’ is an option to enter into an interest rate swap where a specified fixed rate is exchanged for a floating rate. See Concept Release, supra note 3, at n.26. 16A forward swap (or deferred swap) is an agreement to enter into a swap at some time in the future (‘‘deferred swap’’). See Concept Release, supra note 3, at n.27. 17An OTC derivative may be more difficult to transfer or liquidate than an exchange-traded derivative because, for example, an OTC derivative may provide contractually for non-transferability without the consent of the counterparty, or may be sufficiently customized that its value is difficult to establish or its terms too narrowly drawn to attract transferees willing to accept assignment of the contract, unlike most exchange-traded derivatives. See Concept Release, supra note 3, at n.28. 18The Dodd-Frank Act, supra note 2, was signed into law on July 21, 2010. The Act mandates, among other things, substantial changes in the OTC derivatives markets, including new clearing, reporting, and trade execution mandates for swaps and security-based swaps, and both exchange￾traded and OTC derivatives are contemplated under the new regime. See Dodd-Frank Act sections 723 (mandating clearing of swaps) and 763 (mandating clearing of security-based swaps). We have noted that these Dodd-Frank Act requirements ‘‘were designed to provide greater certainty that, wherever possible and appropriate, swap and security-based swap contracts formerly traded exclusively in the OTC market are centrally cleared.’’ Process for Submissions for Review of Security-Based Swaps for Mandatory Clearing and Notice Filing Requirements for Clearing Agencies; Technical Amendments to Rule 19b–4 and Form 19b–4 Applicable to All Self-Regulatory Organizations, Securities Exchange Act Release No. 67286 (June 28, 2012) [77 FR 41602 (July 13, 2012)], at text accompanying n.5. 19See, e.g., infra notes 69–71. 20See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979) [44 FR 25128 (Apr. 27, 1979)] (‘‘Release 10666’’), at n.5. See also infra notes 21–22. 21The leverage created by such an arrangement is sometimes referred to as ‘‘indebtedness leverage.’’ See Concept Release, supra note 3, at n.31. See infra notes 70–72 and accompanying text. 22This type of leverage is sometimes referred to as ‘‘economic leverage.’’ See Concept Release, supra note 3, at n.32. 23See Concept Release, supra note 3, at n.33. A fund may also use derivatives to hedge current portfolio exposures (for example, when a fund’s portfolio is structured to reflect the fund’s long-term investment strategy and its investment adviser’s forecasts, interim events may cause the fund’s investment adviser to seek to temporarily hedge a portion of the portfolio’s broad market, sector, and/ or security exposures). Industry participants believe
that derivatives may also provide a more efficient hedging tool than reducing exposure by selling individual securities, offering greater liquidity, investor protection purposes and concerns underlying section 18. The proposed rule also would require funds that engage in more than a limited amount of derivatives transactions or that use certain complex derivatives transactions, as defined in the proposed rule, to establish formalized risk management programs to manage the risks associated with such transactions.
II. Background
A. Background Concerning the Use of Derivatives by Funds As noted above, derivatives may be broadly described as instruments or contracts whose value is based upon, or derived from, some reference asset. Reference assets can include, for example, stocks, bonds, commodities, currencies, interest rates, market indices, currency exchange rates, or other assets or interests.8 Common examples of derivatives used by funds include forwards, futures, swaps, and options.9 Derivatives are often characterized as either exchange-traded or OTC.10 Exchange-traded derivatives—such as futures,11 certain options,12 and options on futures 13—are standardized contracts traded on regulated exchanges, such as the Chicago Mercantile Exchange and the Chicago Board Options Exchange. OTC derivatives— such as certain swaps,14 non-exchange traded options, and combination products such as swaptions 15 and forward swaps 16—are contracts negotiated and entered into outside of an organized exchange. Unlike exchange-traded derivatives, OTC derivatives may be significantly customized, and may not be cleared by a central clearing organization. OTC derivatives that are not centrally cleared may involve greater counterparty credit risk, and may be more difficult to value, transfer, or liquidate than exchange￾traded derivatives.17 The Dodd-Frank Act and rules thereunder seek to establish a comprehensive new regulatory framework for two broad categories of derivatives—swaps and security-based swaps. The framework is designed to reduce risk, increase transparency, and promote market integrity within the financial system.18 While funds use derivatives for a variety of purposes, a common characteristic of most derivatives is that they involve leverage or the potential for leverage.19 We have stated that ‘‘[l]everage exists when an investor achieves the right to a return on a capital base that exceeds the investment which he has personally contributed to the entity or instrument achieving a return.’’ 20 Many derivatives transactions entered into by a fund, such as futures contracts, swaps, and written options, involve leverage or the potential for leverage in that they enable the fund to participate in gains and losses on an amount of reference assets that exceeds the fund’s investment, while also imposing a conditional or unconditional obligation on the fund to make a payment or deliver assets to a counterparty.21 Other derivatives transactions, such as purchased call options, provide the economic equivalent of leverage because they expose the fund to gains on an amount in excess of the fund’s investment but do not impose a payment obligation on the fund beyond its investment.22 Funds use derivatives both to obtain investment exposures as part of their investment strategies and to manage risk.23 A fund may use derivatives to

lower round-trip transaction costs, lower taxes, and reduced disruption to the portfolio’s longer-term positioning. Id. See also infra note 25 and accompanying text. 24See Concept Release, supra note 3, at section I. 25See, e.g., Comment Letter of BlackRock on Concept Release (Nov. 4, 2011) (File No. S7–33–11) (‘‘BlackRock Concept Release Comment Letter’’), available at http://www.sec.gov/comments/s7-33- 11/s73311-39.pdf; Comment Letter of AQR Capital Management on Concept Release (Nov. 7, 2011) (File No. S7–33–11) (‘‘AQR Concept Release Comment Letter’’), available at http://www.sec.gov/ comments/s7-33-11/s73311-26.pdf; Comment Letter of Vanguard on Concept Release (Nov. 7, 2011) (File No. S7–33–11) (‘‘Vanguard Concept Release Comment Letter’’), available at http://www.sec.gov/ comments/s7-33-11/s73311-38.pdf; Comment Letter of Oppenheimer Funds on Concept Release (Nov. 7,
2011) (File No. S7–33–11) (‘‘Oppenheimer Concept
Release Comment Letter’’), available at http:// www.sec.gov/comments/s7-33-11/s73311-44.pdf; Comment Letter of Loomis, Sayles and Company on Concept Release (Nov. 7, 2011) (File No. S7–33–11) (‘‘Loomis Concept Release Comment Letter’’), available at http://www.sec.gov/comments/s7-33- 11/s73311-25.pdf; Comment Letter of Investment Company Institute on Concept Release (Nov. 7,
2011) (File No. S7–33–11) (‘‘ICI Concept Release
Comment Letter’’), available at http://www.sec.gov/ comments/s7-33-11/s73311-46.pdf. 26See Concept Release, supra note 3, at n.34. 27See, e.g., Comment Letter of Mutual Fund Directors Forum on Concept Release (Nov. 7, 2011) (File No. S7–33–11) (‘‘MFDF Concept Release Comment Letter’’), available at http://www.sec.gov/ comments/s7-33-11/s73311-32.pdf, at 2 (agreeing with this statement in the Concept Release and suggesting that we ‘‘evaluate how any potential regulations will impact the ability of directors effectively to oversee their funds’ use of derivatives’’). 28See, e.g., sections 1(b)(7), 1(b)(8), 18(a), and 18(f) of the Investment Company Act. 29The definition of senior security in section 18(g) also includes ‘‘any stock of a class having priority over any other class as to the distribution of assets or payment of dividends’’ and excludes certain limited temporary borrowings. 30See section 1(b)(7) of the Investment Company Act; Release 10666, supra note 20, at n.8. 31See section 1(b)(8) of the Investment Company Act; Release 10666, supra note 20, at n.8. 32See Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess., pt. 1 (1940) (‘‘Senate Hearings’’) at 265–78. See also Mutual Funds and Derivative Instruments, Division of Investment Management Memorandum transmitted by Chairman Levitt to Representatives Markey and Fields (Sept. 26, 1994) (‘‘1994 Report’’), available at http://www.sec.gov/news/studies/deriv.txt, at 21 (describing the practices in the 1920s and 1930s that gave rise to section 18’s limitations on leverage). 33Section 5(a)(1) of the Investment Company Act defines ‘‘open-end company’’ as ‘‘a management company which is offering for sale or has outstanding any redeemable security of which it is the issuer.’’ 34 ‘‘Asset coverage’’ of a class of securities representing indebtedness of an issuer generally is defined in section 18(h) of the Investment Company Act as ‘‘the ratio which the value of the total assets of such issuer, less all liabilities and indebtedness not represented by senior securities, bears to the aggregate amount of senior securities representing indebtedness of such issuer.’’ Take, for example, an open-end fund with $100 in assets and with no liabilities or senior securities outstanding. The fund could, while maintaining the required coverage of 300% of the value of its assets subject to section 18 of the Act, borrow an additional $50 from a bank; the $50 in borrowings would represent one-third of the fund’s $150 in total assets, measured after the borrowing (or 50% of the fund’s $100 net assets). 35Section 5(a)(2) of the Investment Company Act defines ‘‘closed-end company’’ as ‘‘any management company other than an open-end company.’’ 36Section 18(a)(1)(A). 37See section 61(a)(1) of the Investment Company Act. BDCs, like registered closed-end funds, also may issue a senior security that is a stock (e.g., preferred
stock), subject to limitations in section 18. See section 18(a)(2) and section 61(a)(1) of the Investment Company Act. 38See Release 10666, supra note 20. 39See Release 10666, supra note 20, at discussion of ‘‘Reverse Repurchase Agreements’’ (noting that a reverse repurchase agreement may not have an agreed upon repurchase date, and in that case, the agreement would be treated as if it were reestablished each day). 40 In Release 10666, we described reverse repurchase agreements and firm and standby commitment agreements involving debt securities guaranteed as to principal and interest by the Continued gain, maintain, or reduce exposure to a market, sector, or security more quickly and/or with lower transaction costs and portfolio disruption than investing directly in the underlying securities.24 The comments we received on the Concept Release reflect some of the various ways in which funds use derivatives, including, for example: To hedge risks associated with the fund’s securities investments; to equitize cash to gain exposure quickly, such as by purchasing index futures rather than investing in the securities underlying the index; and to obtain synthetic positions.25 At the same time and as noted above, funds’ use of derivatives may entail risks relating to, for example, leverage, illiquidity (particularly with respect to complex OTC derivatives), and counterparty risk, among others.26 A fund’s use of derivatives presents challenges for its investment adviser and board of directors in managing derivatives use so that they are employed in a manner consistent with the fund’s investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements, including those under the federal securities laws.27 B. Derivatives and the Senior Securities Restrictions of the Investment Company Act

1. Requirements of Section 18
   Section 18 of the Act imposes various
   limitations on the capital structure of funds, including, in part, by restricting the ability of funds to issue ‘‘senior securities.’’ The protection of investors against the potentially adverse effects of a fund’s issuance of senior securities is a core purpose of the Investment Company Act.28 Section 18(g) of the Investment Company Act defines ‘‘senior security,’’ in part, as ‘‘any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness.’’ 29 Congress’ concerns underlying the limitations in section 18 were focused on: (1) Excessive borrowing and the issuance of excessive amounts of senior securities by funds which increased unduly the speculative character of their junior securities; 30 (2) funds operating without adequate assets and reserves; 31 and (3) potential abuse of the purchasers of senior securities.32 To address these concerns, section 18(f)(1) of the Investment Company Act prohibits an open-end fund 33 from issuing or selling any ‘‘senior security’’ other than borrowing from a bank and subject to a requirement to maintain 300% ‘‘asset coverage.’’ 34 Section 18(a)(1) of the Investment Company Act similarly prohibits a closed-end fund 35 from issuing or selling any ‘‘senior security that represents an indebtedness’’ unless it has at least 300% ‘‘asset coverage, ’’ although closed-end funds’ ability to issue senior securities representing indebtedness is not limited to bank borrowings, and closed-end funds also may issue senior securities that are a stock, subject to limitations in section
   18.36 A BDC is also subject to the
   limitations of section 18(a)(1)(A) to the same extent as if it were a closed-end investment company except that the applicable asset coverage amount for any senior security representing indebtedness is 200%.37
2. Investment Company Act Release
   10666
   In Investment Company Act Release 10666, issued in 1979, we considered the application of section 18’s restrictions on senior securities to the following transactions: reverse repurchase agreements, firm commitment agreements, and standby commitment agreements.38 As we described in more detail in Release 10666, in a reverse repurchase agreement, a fund transfers possession of a security to another party in return for a percentage of the value of the security; at an agreed upon future date, the fund repurchases the transferred security by paying an amount equal to the proceeds of the transaction plus interest.39 A firm commitment agreement is a buy order for delayed delivery under which a fund agrees to purchase a security—a Ginnie Mae, in the example we provided in Release 10666 40—from a seller at a future date,

Government National Mortgage Associations, or ‘‘Ginnie Maes.’’ We noted, however, that we referenced Ginnie Maes only as an example of the underlying security and the reference should not be construed as delimiting our general statement of policy; we further noted that we sought in Release 10666 to ‘‘address generally the possible economic effects and legal implications of all comparable trading practices which may affect the capital structure of investment companies in a manner analogous to the securities trading practices specifically discussed [in Release 10666].’’ Id., at discussion of ‘‘Areas of Concern.’’ See also infra
section III.A.2.
41See Release 10666, supra note 20, at discussion of ‘‘Firm Commitment Agreements,’’ and ‘‘Standby Commitment Agreements.’’ 42See Release 10666, supra note 20, at ‘‘The Agreements as Securities’’ discussion. See also infra note 61. 43Release 10666, supra note 20, at ‘‘The Agreements as Securities’’ discussion. 44 Id. (stating, among other things, that, ‘‘[t]he gains and losses from the transactions can be extremely large relative to invested capital; for this reason, each agreement has speculative aspects. Therefore, it would appear that the independent investment decisions involved in entering into such agreements, which focus on their distinct risk/ return characteristics, indicate that, economically as well as legally, the agreements should be treated as securities separate from the underlying Ginnie Maes for purposes of section 18 of the Act.’’) 45See Release 10666, supra note 20, at text accompanying n.15 (citing Guidelines for the Preparation of Form N–8B–1, Investment Company Act Release No. 7221 (June 9, 1972) at 6–8). 46See Release 10666, supra note 20, at discussion of ‘‘Segregated Account.’’ 47We stated that, under the segregated account approach, the value of the assets in the segregated account should be marked to the market daily, additional assets should be placed in the segregated account whenever the total value of the account falls below the amount of the fund’s obligation, and assets in the segregated account should be deemed frozen and unavailable for sale or other disposition. See id. We also cautioned that as the percentage of a fund’s portfolio assets that are segregated increases, the fund’s ability to meet current obligations, to honor requests for redemption, and to manage properly the investment portfolio in a manner consistent with its stated investment objective may become impaired. Id. We stated that the amount of assets to be segregated with respect to reverse repurchase agreements lacking a specified repurchase price would be the value of the proceeds received plus accrued interest; for reverse repurchase agreements with a specified repurchase price, the amount of assets to be segregated would be the repurchase price; and for firm and standby commitment agreements, the amount of assets to be segregated would be the purchase price. Id. 48 Id. 49The derivatives markets have expanded substantially since we issued Release 10666 in
1979. For example, the Options Clearing
Corporation reports that in 1979, only 64 million contracts were traded on 220 equity issues. By 2014, those numbers had risen to 3,845 million contracts traded on 4,278 equity issues. The CME Group reports that 313 of its 335 derivatives products began trading after 1979 (see http://www. cmegroup.com/company/history/cmegroup information.html). For example, the Chicago Mercantile Exchange launched its first cash-settled futures contract in 1981 and its first successful stock index future (S&P 500 index) in 1982 (see http://www.cmegroup.com/company/history/ timeline-of-achievements.html). See also Jennifer Lynch Koski & Jeffrey Pontiff, How Are Derivatives Used? Evidence from the Mutual Fund Industry, 54 The J. of Fin. 791, 792 (Apr. 1999), available at http://onlinelibrary.wiley.com/doi/10.1111/0022- 1082.00126/pdf (observing that the Taxpayer Relief Act of 1997’s repeal of the ‘‘short-short rule’’ would likely lead to increased derivative use by mutual funds because that rule ‘‘eliminate[d] preferential pass-through tax status for funds that realize more than 30 percent of their capital gains from positions held less than three months’’ and ‘‘inhibited derivative use because some derivative securities such as options and futures contracts involve realizing capital gains for holding periods of less than three months’’). 50Release 10666, supra note 20, at ‘‘Areas of Concern’’ and ‘‘Background’’ discussion. 51The Concept Release includes a discussion of certain staff no-action letters. See Concept Release, supra note 3, at section I. 52See, e.g., Comment Letter of Davis Polk & Wardwell LLP on Concept Release (Nov. 11, 2011) (File No. S7–33–11) (‘‘Davis Polk Concept Release Comment Letter’’), available at http://www.sec.gov/ comments/s7-33-11/s73311-49.pdf (‘‘[T]he Commission and the Staff, over the years, have addressed issues pertaining to the use of derivatives transactions by registered funds on an intermittent case-by-case basis. While this guidance has been helpful, it has not been able to keep pace with the dramatic expansion of the derivatives market over the past twenty years, both in terms of the types of instruments that are available and the extent to which funds use them.’’). stated price, and fixed yield; a standby commitment agreement similarly involves an agreement by the fund to purchase a security with a stated price and fixed yield in the future upon the counterparty’s exercise of its option to sell the security to the fund.41 We concluded that such agreements, while not securities for all purposes under the federal securities laws,42 ‘‘fall within the functional meaning of the term ‘evidence of indebtedness’ for purposes of section 18 of the Act,’’ which we noted would generally include ‘‘all contractual obligations to pay in the future for consideration presently received,’’ and thus may involve the issuance of senior securities.43 Further, we stated that ‘‘trading practices involving the use by investment companies of such
agreements for speculative purposes or to accomplish leveraging fall within the legislative purposes of section 18.’’ 44 We recognized, however, that although reverse repurchase agreements, firm commitment agreements, and standby commitment agreements may involve the issuance of senior securities and thus generally would be prohibited for open-end funds by section 18(f) (and limited by the 300% asset coverage requirement for closed-end funds), these and similar arrangements nonetheless could appropriately be used by funds subject to the constraints we described in Release 10666. We analogized to short sales of securities by funds, as to which our staff had previously provided guidance that the issue of section 18 compliance would not be raised if funds ‘‘cover’’ senior securities by maintaining ‘‘segregated accounts.’’ 45 We concluded that the use of segregated accounts ‘‘if properly created and maintained, would limit the investment company’s risk of loss.’’ 46 To avail itself of the segregated account approach, we stated that a fund could establish and maintain with the fund’s custodian a segregated account containing certain liquid assets, such as cash, U.S. government securities, or other appropriate high-grade debt obligations, equal to the obligation incurred by the fund in connection with the senior security (‘‘segregated account approach’’).47 We stated that the segregated account functions as ‘‘a practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock,’’ and that it ‘‘[would] assure the availability of adequate funds to meet the obligations arising from such activities.’’ 48 We did not specifically address derivatives in Release 10666.49 We did, however, state that although we were expressing our views about the particular trading practices discussed in that release, our views were not limited to those trading practices, in that we sought to ‘‘address generally the possible economic effects and legal implications of all comparable trading practices which may affect the capital structure of investment companies in a manner analogous to the securities trading practices specifically discussed in Release 10666.’’ 50
3. Developments After Investment
Company Act Release No. 10666 In the years following the issuance of Release 10666, our staff issued more than thirty no-action letters to funds concerning the maintenance of segregated accounts or otherwise ‘‘covering’’ their obligations in connection with various transactions that implicate section 18.51 In these letters and through other staff guidance, our staff has addressed questions as they were presented to the staff, generally on an instrument-by-instrument basis, regarding the application of our statements in Release 10666 to various types of derivatives and other transactions. As derivatives markets expanded and funds increased their use of derivatives,52 industry practices have developed over time, based at least in
part on our staff’s no-action letters and
other staff guidance, concerning the appropriate amount and type of assets that should be segregated in order to

53Our staff also has stated that it would not object to a fund covering its obligations by entering into certain cover transactions or holding the asset (or the right to acquire the asset) that the fund would be required to deliver under certain derivatives. See Concept Release, supra note 3, at text following nn.70–71. 54See, e.g., Concept Release, supra note 3, at n.78 and accompanying text (explaining that, ‘‘[i]n determining the amount of assets required to be segregated to cover a particular instrument, the Commission and its staff have generally looked to the purchase or exercise price of the contract (less margin on deposit) for long positions and the market value of the security or other asset underlying the agreement for short positions, measured by the full amount of the reference asset, i.e., the notional amount of the transaction rather than the unrealized gain or loss on the transaction, i.e., its current mark-to-market value’’). See also, e.g., Davis Polk Concept Release Comment Letter, at 3 (‘‘In Release 10666 and in no-action letters, the Commission and the Staff generally indicated that funds relying on the segregation method should segregate assets equal to the full notional value of the reference asset for a derivative (the ‘notional amount’), less any collateral or margin on deposit.’’). 55For example, if a fund enters into a long, physically settled forward contract, and the contract specifies the forward price that the fund will pay at settlement, the fund would, consistent with staff positions, segregate this forward/contract price. See, e.g., Dreyfus Strategic Investing and Dreyfus Strategic Income, SEC Staff No-Action Letter (June 22, 1987) (‘‘Dreyfus No-Action Letter’’), available at http://www.sec.gov/divisions/investment/imsenior securities/dreyfusstrategic033087.pdf. As another example, if a fund enters into a short, physically settled forward and the contract obligates the fund to deliver a specific quantity of an asset at settlement—but the total value of that deliverable obligation is unknown at the contract’s outset—the fund would, consistent with staff positions, segregate, on a daily basis, liquid assets with a value equal to the daily market value of the deliverable. See id.; Robertson Stephens Investment Trust, SEC Staff No-Action Letter (Aug. 24, 1995) (‘‘Robertson Stephens No-Action Letter’’), available at http://www.sec.gov/divisions/investment/ imseniorsecurities/robertsonstephens040395.pdf. See also supra note 47. 56See, e.g., Concept Release, supra note 3, at nn.75–77 and accompanying text (explaining that ‘‘[c]ertain swaps, for example, that settle in cash on a net basis, appear to be treated by many funds as requiring segregation of an amount of assets equal to the fund’s daily mark-to-market liability, if any’’). 57Our staff provided this guidance in the context of its review of certain funds’ registration statements. 58See, e.g., Comment Letter of Ropes & Gray LLP on Concept Release (Nov. 7, 2011)
(File No. S7–33–
11) (‘‘Ropes & Gray Concept Release Comment
Letter’’), available at http://www.sec.gov/ comments/s7-33-11/s73311-21.pdf, at 4 (‘‘It now appears to be an increasingly common practice for funds that engage in cash-settled swaps to segregate assets only to the extent required to meet the fund’s daily mark-to-market liability, if any, relating to such swaps.’’); Davis Polk Concept Release Comment Letter, at 3 (‘‘[F]und registration statements indicate that, in recent years, the Staff has not objected to the adoption by funds of policies that require segregation of the mark-to￾market value, rather than the notional amount, for a variety of swaps as well as for cash-settled futures and forward contracts.’’). 59See Merrill Lynch Asset Management, L.P., SEC Staff No-Action Letter (July 2, 1996) (‘‘Merrill Lynch No-Action letter’’), available at http://www. sec.gov/divisions/investment/imseniorsecurities/ merrilllynch070196.pdf. 60See Dear Chief Financial Officer Letter from Lawrence A. Friend, Chief Accountant, Division of Investment Management (Nov. 7, 1997), available at http://www.sec.gov/divisions/investment/imsenior securities/imcfo120797.pdf. 61See Release 10666, supra note 20, at ‘‘The Agreements as Securities’’ discussion. In addition, as we noted in the Concept Release, the Investment Company Act’s definition of the term ‘‘security’’ is broader than the term’s definition in other federal securities laws. Compare section 2(a)(36) of the Investment Company Act with sections 2(a)(1) and 2A of the Securities Act of 1933 (‘‘Securities Act’’) and sections 3(a)(10) and 3A of the Exchange Act. See also Concept Release, supra note 3, at n.57 and accompanying text (explaining that we have interpreted the term ‘‘security’’ in light of the policies and purposes underlying the Investment Company Act). 62See Release 10666, supra note 20, at ‘‘The Agreements as Securities’’ discussion. See also
section 18(g) (defining the term ‘‘senior security,’’
in part, as ‘‘any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness’’). Under the proposal, a fund would be permitted to enter into reverse repurchase agreements, short sale borrowings, or any firm or standby commitment agreement or similar agreement (collectively, ‘‘financial commitment transactions’’), notwithstanding the prohibitions and restrictions on the issuance of senior securities under section 18, provided the fund complies with the proposed rule’s conditions. See infra section III.A. ‘‘cover’’ various types of derivatives transactions.53 With respect to the amount of assets that funds have segregated, two general practices have developed:

• For some derivatives, funds
  generally segregate an amount equal to the full amount of the fund’s potential obligation under the contract, where that amount is known at the outset of the transaction, or the full market value of the underlying reference asset for the derivative (collectively, ‘‘notional amount segregation’’).54 Funds have applied this approach to, among other transactions, futures, forward contracts and written options that permit physical settlement, and credit default swaps (‘‘CDS’’) regardless of whether physical settlement or cash settlement is contemplated.55
• For certain derivatives that are
  required by their terms to be net cash settled, and thus do not involve physical settlement, funds often segregate an amount equal to the fund’s daily mark-to-market liability, if any (‘‘mark-to-market segregation’’).56 Funds initially applied this approach to specific types of transactions addressed through guidance by our staff: first interest rate swaps and later cash-settled futures and non-deliverable forwards (‘‘NDFs’’).57 We understand, however, that many funds now apply mark-to￾market segregation to a wider range of cash-settled instruments.58 Our staff has observed that some funds appear to apply the mark-to-market approach to any derivative that is cash settled. As noted above, in Release 10666, we stated that the assets eligible to be included in segregated accounts should be ‘‘liquid assets,’’ such as cash, U.S. government securities, or other appropriate high-grade debt obligations. In a 1996 staff no-action letter, the staff took the position that a fund could cover its senior securities-related obligations by depositing any liquid asset, including equity securities and non-investment grade debt securities, in a segregated account.59 With respect to the manner in which segregation may be effected, the staff took the position that a fund could segregate assets by designating such assets on its books, rather than establishing a segregated account at its custodian.60 As this discussion reflects, funds and their counsel, in light of the guidance we provided in Release 10666 and that provided by our staff through no-action letters and otherwise, have applied the segregated account approach to, or otherwise sought to cover, many types of transactions other than those specifically addressed in Release 10666, including various derivatives and other transactions that implicate section 18. These transactions include, for example, futures, written options, and swaps (both swaps and security-based swaps).

4. Current Views Concerning Section 18
   As we stated in Release 10666, we view the transactions described in that release as falling within the functional meaning of the term ‘‘evidence of indebtedness,’’ for purposes of section
   18.61 The trading practices described in
   Release 10666, as well as short sales of securities for which the staff initially developed the segregated account approach we applied in Release 10666, all impose on a fund a conditional or unconditional contractual obligation to pay or deliver assets in the future to a counterparty and thus involve the issuance of a senior security for purposes of section 18.62 We apply the same analysis to derivatives transactions under which the fund is or may be required to make any payment or deliver cash or other assets during the life of the instrument or at maturity or early termination, whether as a margin or settlement payment or otherwise (a ‘‘future payment obligation’’). As was the case with respect to the trading practices we described in Release 10666, where the fund has entered into a derivatives transaction and has a future payment obligation—a conditional or unconditional contractual obligation to

63Unless otherwise specified or the context otherwise requires, the term ‘‘derivative’’ or ‘‘derivatives transaction’’ as used in this Release means a ‘‘derivatives transaction,’’ as defined in proposed rule 18f–4(c)(2), which describes derivatives that impose a payment obligation on the fund. 64As we explained in Release 10666, we believe that an evidence of indebtedness, for purposes of
section 18, includes not only a firm and un￾contingent obligation, but also a contingent
obligation, such as the obligation created by a standby commitment or a ‘‘put’’ (or call) option sold by a fund. See Release 10666, supra note 20, at ‘‘Standby Commitment Agreements’’ discussion. We understand that it has been asserted that a contingent obligation created by a standby commitment or similar agreement does not implicate section 18 unless and until the fund would be required under generally accepted accounting principles (‘‘GAAP’’) to recognize the contingent obligation as a liability on the fund’s financial statements. The treatment of derivatives transactions under GAAP, including whether the derivatives transaction constitutes a liability for financial statement purposes at any given time or the extent of the liability for that purpose, is not determinative with respect to whether the derivatives transaction involves the issuance of a senior security under section 18. This is consistent with our analysis of a fund’s obligation, and the corresponding segregated asset amounts, under the trading practices described in Release 10666. See supra note 47 (describing the amount of assets to be segregated for the trading practices described in Release 10666, including that a fund should segregate the full purchase price of a standby commitment beginning on the date the fund entered into the agreement, which would represent a contingent obligation of the fund). 65Consistent with Release 10666, we are only expressing our views concerning section 18 of the Investment Company Act. 66Recognizing the breadth of the term ‘‘senior security,’’ we observed in the Concept Release that, ‘‘[t]o address [Congress’ concerns underlying
section 18], section 18(f)(1) of the Investment
Company Act prohibits an open-end fund from issuing or selling any ‘senior security’ other than borrowing from a bank.’’ (footnotes omitted) 67We similarly observed in Release 10666 that
section 18(f)(1), ‘‘by implication, treats all
borrowings as senior securities,’’ and that ‘‘[s]ection 18(f)(1) of the Act prohibits such borrowings unless entered into with banks and only if there is 300% asset coverage on all borrowings of the investment company.’’ See Release 10666, supra note 20, at ‘‘Reverse Repurchase Agreements’’ discussion. 68Section 18(c) provides further limitations on a closed-end fund’s ability to issue senior securities, in addition to the asset coverage and other limitations provided in section 18(a), with the proviso in section 18(c)(2) that ‘‘promissory notes or other evidences of indebtedness issued in consideration of any loan, extension, or renewal thereof, made by a bank or other person and privately arranged, and not intended to be publicly distributed, shall not be deemed to be a separate class of senior securities representing indebtedness within the meaning of [section 18(c)].’’ 69See Release 10666, supra note 20, at ‘‘Segregated Account’’ discussion. 70See, e.g., The Report of the Task Force on Investment Company Use of Derivatives and Leverage, Committee on Federal Regulation of Securities, ABA Section of Business Law (July 6,
2010) (‘‘2010 ABA Derivatives Report’’), available at
https://apps.americanbar.org/buslaw/blt/content/ ibl/2010/08/0002.pdf, at 8 (stating that ‘‘[f]utures contracts, forward contracts, written options and swaps can produce a leveraging effect on a fund’s portfolio’’ because ‘‘for a relatively small up-front payment made by a fund (or no up-front payment, in the case with many swaps and written options), the fund contractually obligates itself to one or more potential future payments until the contract terminates or expires’’). See also infra notes 72–74. 71BlackRock Concept Release Comment Letter, at 4. 72See, e.g., Board Oversight of Derivatives, Independent Directors Council Task Force Report (July 2008) (‘‘2008 IDC Report’’), available at http:// www.ici.org/pdf/ppr_08_derivatives.pdf, at 3 (‘‘The leverage inherent in these [derivatives] instruments magnifies the effect of changes in the value of the underlying asset on the initial amount of capital invested. For example, an initial 5% collateral deposit on the total value of the commodity would result in 20:1 leverage, with a potential 80% loss (or gain) of the collateral in response to a 4% movement in the market price of the underlying commodity.’’); Andrew Ang, Sergiy Gorovyy & pay in the future 63—we believe that such a transaction involves an evidence of indebtedness that is a senior security for purposes of section 18.64 This interpretation is supported by the express scope of section 18, which defines the term senior security broadly to include instruments and transactions that might not otherwise be considered securities under other provisions of the federal securities laws.65 For example,
section 18(f)(1) generally prohibits an
open-end fund from issuing or selling any senior security ‘‘except [that the fund] shall be permitted to borrow from any bank.’’ 66 This statutory permission to engage in a specific borrowing makes clear that such borrowings are senior securities, which otherwise would be prohibited absent this specific permission.67 Section 18(c)(2) similarly treats all promissory notes or evidences of indebtedness issued in consideration of any loan as senior securities except as specifically otherwise provided in that section.68 This view also is consistent with the fundamental statutory policy and purposes underlying the Act, as expressed in section 1(b) of the Act.
Section 1(b) provides that the provisions
of the Act shall be interpreted to mitigate and ‘‘so far as is feasible’’ to eliminate the conditions and concerns enumerated in that section. These include the conditions and concerns enumerated in sections 1(b)(7) and 1(b)(8) which declare, respectively, that ‘‘the national public interest and the interest of investors are adversely affected’’ when funds ‘‘by excessive borrowing and the issuance of excessive amounts of senior securities increase unduly the speculative character’’ of securities issued to common shareholders and when funds ‘‘operate without adequate assets or reserves.’’ Funds’ obligations under derivative transactions can implicate each of these concerns. As we stated in Release 10666, leveraging an investment company’s portfolio through the issuance of senior securities ‘‘magnifies the potential for gain or loss on monies invested and therefore results in an increase in the speculative character of the investment company’s outstanding securities’’ and ‘‘leveraging without any significant limitation’’ was identified ‘‘as one of the major abuses of investment companies prior to the passage of the Act by Congress.’’ We emphasized in Release 10666, and we continue to believe today, that the prohibitions and restrictions under the senior security provisions of section 18 should ‘‘function as a practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock’’ and that funds should not ‘‘operate without adequate assets or reserves.’’ 69 Funds’ use of derivatives, like the trading practices we addressed in Release 10666, implicate the undue speculation concern expressed in
section 1(b)(7) and the asset sufficiency
concern expressed in section 1(b)(8) as discussed below. First, with respect to the undue speculation concern expressed in
section 1(b)(7), we noted above and in
the Concept Release that a common characteristic of most derivatives is that they involve leverage or the potential for leverage because they typically enable the fund to participate in gains and losses on an amount that substantially exceeds the fund’s investment while imposing a conditional or unconditional obligation on the fund to make a payment or deliver assets to a counterparty. For example, a fund can enter into a total return swap referencing an equity or debt security and, in exchange for a contractual obligation to make payments in respect of changes in the value of the referenced security and the delivery of a limited amount of collateral, obtain exposure to the full notional value of the referenced security.70 As one commenter observed, ‘‘a fund’s purchase of an equity total return swap produces an exposure and economic return substantially equal to the exposure and economic return a fund could achieve by borrowing money from the counterparty in order to purchase the equities that are reference assets.’’ 71 This same analysis applies to various other types of derivatives under which the fund posts a small percentage of the notional amount as initial margin or collateral—or is not required to make any up-front payment or receives a premium payment—but is exposed to the gains or losses on the full notional amount of the reference asset.72

Gregory B. van Inwegen, Hedge Fund Leverage, NBER Working Paper 16801 (Feb. 2011) (‘‘Ang, Gorovyy & Inwegen’’), available at http:// www.nber.org/papers/w16801.pdf, at Table 1 (showing that under prevailing margin rates as of March 2010, a market participant could in theory obtain 10 times implied leverage under a total return swap (because the exposure under the swap would be ten times the initial margin amount); 33 times implied leverage under a financial future; and 100 times implied leverage under a foreign exchange or interest rate swap). 73For more information on the staff’s review, including the staff’s measurement of derivatives exposures, see infra section III.B.1.c and the White Paper entitled ‘‘Use of Derivatives by Investment Companies,’’ which was prepared by staff in the Division of Economic and Risk Analysis (‘‘DERA’’) and will be placed in the comment file for this Release contemporaneously with our publication of the Release. Daniel Deli, Paul Hanouna, Christof Stahel, Yue Tang & William Yost Use of Derivatives by Registered Investment Companies Division of Economic and Risk Analysis (2015) (‘‘DERA White Paper’’), available at http://www.sec.gov/dera/staff￾papers/white-papers/derivatives12-2015.pdf. 74 Id. 75See also infra section II.D (discussing concerns with the current approach and providing examples of situations in which funds’ use of derivatives has led to substantial losses). 76One commenter made this point directly. See Comment Letter of Stephen A. Keen on Concept Release (Nov. 8, 2011) (File No. S7–33–11) (‘‘Keen Concept Release Comment Letter’’), available at http://www.sec.gov/comments/s7-33-11/s73311- 45.pdf, at 3 (‘‘If permitted without limitation, derivative contracts can pose all of the concerns that section 18 was intended to address with respect to borrowings and the issuance of senior securities by investment companies.’’). See also, e.g., ICI Concept Release Comment Letter, at 8 (‘‘The Act is thus designed to regulate the degree to which a fund issues any form of debt—including contractual obligations that could require a fund to make payments in the future.’’). 77Some derivatives transactions, like physically settled futures and forwards, can require the fund to deliver the underlying reference assets regardless of whether the fund experiences losses on the transaction. 78See, e.g., supra note 72. 79See, e.g., Peter Breuer, Measuring Off-Balance￾Sheet Leverage, IMF Working Paper (Dec. 2000) (‘‘Off-Balance-Sheet Leverage IMF Working Paper’’), available at http://www.imf.org/external/pubs/ft/ wp/2000/wp00202.pdf, at 7–8 (‘‘[A] more leveraged investor facing a given adverse price movement may be forced by collateral requirements (i.e. margin calls) to unwind the position sooner than if the position were not leveraged. The unwinding decision of an unleveraged investor depends merely on the investor’s risk preferences and not on potentially more restrictive margin requirements.’’). 80See, e.g., ICI Concept Release
Comment Letter, at 11 (noting that, ‘‘[h]ypothetically, in an extreme scenario, a fund that used derivatives heavily and segregated most of its liquid assets to cover its obligation on a pure mark-to-market basis could potentially find itself with insufficient liquid assets to cover its derivative positions’’). 81 In this regard, we note that proposed rule 22e– 4 would, among other things, require an open-end fund (other than a money market fund) to: Classify, and review on an ongoing basis the classification of, the liquidity of each of the fund’s portfolio positions (or portions of a position), including derivatives, into one of six liquidity categories; and assess and periodically review the fund’s liquidity risk, considering various factors specified in the rule, including the fund’s use of borrowings and derivatives for investment purposes. Assessing liquidity risk under rule 22e–4 would involve an assessment of the fund’s derivatives positions themselves, and also may generally include an evaluation of the potential liquidity demands that may be imposed on the fund in connection with its use of derivatives. To the extent the fund is required to make payments to a derivatives counterparty, those assets would not be available to meet shareholder redemptions. See Liquidity Release, supra note 5, at sections III.B.2. and III. C.1.c. As discussed in more detail in sections II.D and III.B.1.c, our staff’s evaluation of the use of derivatives by funds also indicates that some funds make extensive use of derivatives to obtain notional investment exposures far in excess of the funds’ respective net asset values.73 Our staff’s review of funds’ use of derivatives found that, although many funds do not use derivatives, and most funds do not use a substantial amount of derivatives, some funds do use derivatives extensively. Some of the funds that use derivatives more extensively have derivatives notional exposures that are substantially in excess of the funds’ net assets, with notional exposures ranging up to almost ten times a fund’s net assets.74 These highly leveraged investment exposures appear to be inconsistent with the purposes and concerns underlying section 18 of the Act.75 We noted in Release 10666 that, given the potential for reverse repurchase agreements to be used for leveraging and their ability to magnify the risk of investing in a fund, ‘‘one of the important policies underlying section 18 would be rendered substantially nugatory’’ if funds’ use of reverse repurchase agreements were not subject to limitation. We similarly believe that if funds’ use of derivatives that impose a future payment obligation on the fund were not viewed as involving senior securities subject to appropriate limitations under section 18, the concerns underlying section 18, including the undue speculation concern expressed in section 1(b)(7) as discussed above, would be frustrated.76 Second, a fund’s use of derivatives under which the fund has a future payment
obligation also raises concerns with respect to a fund’s ability to meet its obligations, implicating the asset sufficiency concern expressed in section 1(b)(8) of the Act. Many derivatives investments entered into by a fund, such as futures contracts, swaps, and written options, pose a risk of loss that can result in payment obligations owed to the fund’s counterparties.77 Losses on derivatives therefore can result in payment obligations that can directly affect the capital structure of a fund and the relative rights of the fund’s counterparties and fund shareholders, in that the fund would be required to make payments or deliver fund assets to its derivatives counterparties under the terms negotiated with its counterparties. Because of the leverage present in many types of derivatives as discussed above, these senior payments of additional collateral or termination payments to counterparties can be substantially greater than any collateral initially delivered by the fund to initiate the derivatives transaction.78 Losses on a fund’s derivatives transactions, and the resulting payment obligation imposed on the fund, can force a fund’s adviser to sell the fund’s investments to generate liquid assets in order for the fund to meet its obligations. The use of derivatives for leveraging purposes can exacerbate this risk and make it more likely that a fund would be forced to sell assets, potentially generating losses for the fund.79 In an extreme situation, a fund could default on its payment obligations.80 The risks associated with derivatives transactions that impose a payment obligation on the fund differ from the risk of loss on other investments, which may result in a loss of asset value but would not require the fund to deliver cash or assets to a counterparty. The examples of fund losses discussed below in section II.D demonstrate the substantial and rapid losses that can result from a fund’s investments in derivatives, as well as the forced sales and other measures a fund may be required to take to meet its derivatives payment obligations, implicating the undue speculation concern expressed in section 1(b)(7) and the asset sufficiency concern expressed in section 1(b)(8).81 We recognize, however, that not every derivative will involve the issuance of a senior security because not every derivative imposes a future payment obligation on the fund. A fund that purchases an option, for example, generally will make a non-refundable premium payment to obtain the right to acquire (or sell) securities under the option but generally will not have any subsequent obligation to deliver cash or assets to the counterparty unless the fund chooses to exercise the option. A derivative that does not impose a future payment obligation on a fund in this respect generally resembles non￾derivative securities investments in that these investments may lose value but will not require the fund to make any

82At least one commenter on the Concept Release asserted that a purchased option would impose a payment obligation on the fund because ‘‘[i]f the option is in the money at the time it expires, the fund’s manager has a fiduciary obligation to realize the intrinsic value of the option’’ and ‘‘to exercise the option, the fund must either pay the full strike price (for a call) or deliver the notional amount of the underlying asset (for a put).’’ See Keen Concept Release Comment Letter, at 16. 83See, e.g., ICI Concept Release Comment Letter, at 8 (‘‘The Act is thus designed to regulate the degree to which a fund issues any form of debt— including contractual obligations that could require a fund to make payments in the future. By adopting a definition of ‘leverage’ in the context of section 18 that relates solely to indebtedness leverage and clearly distinguishes it from economic leverage, the Commission could alleviate some of the confusion in this area while appropriately protecting investors and serving the purposes of the Act.’’). Although some derivatives instruments may not involve the issuance of a senior security for purposes of section 18, we generally would expect the fund’s adviser to consider the potential risks associated with these instruments, including the ‘‘economic’’ leverage they involve. 84See Concept Release, supra note 3, at section I (‘‘The Commission or its staff, over the years, has addressed a number of issues relating to derivatives on a case-by-case basis. The Commission now seeks to take a more comprehensive and systematic approach to derivatives-related issues under the Investment Company Act.’’). 85See Notice Seeking Comment on Asset Management Products and Activities 79 FR 77488 (Dec. 24, 2014) (‘‘FSOC Request for Comment’’). 86Comments submitted in response to the FSOC Notice are available at http://www.regulations.gov/ #!docketDetail;D=FSOC-2014-0001. 87We refer to alternative strategy funds in the same manner as the staff classified ‘‘Alt Strategies’’ funds in the DERA White Paper, supra note 73, as including the Morningstar categories of ‘‘alternative,’’ ‘‘nontraditional bond’’ and ‘‘commodity’’ funds. 88See supra note 73. 89Section 18 provides very limited statutory permission for open-end funds to borrow from any bank subject to the 300% asset coverage requirement and excludes from the definition of the term ‘‘senior security’’ any loans made for temporary purposes by a bank or other person and privately arranged in an amount not exceeding 5% of total assets. Release 10666 thus provided guidance for certain transactions that would otherwise be prohibited under the requirements of
section 18, and open-end funds have used this
guidance to enter into derivatives transactions that would otherwise be prohibited under section 18. See also infra note 141. 90Release 10666, supra note 20, at ‘‘Segregated Account’’ discussion. These concerns are reflected in sections 1(b)(7) and 1(b)(8) of the Act, as discussed above. We also noted in Release 10666 that ‘‘segregated accounts, if properly created and maintained, would limit the investment company’s risk of loss.’’ Id. 91We also believe these considerations are relevant when considering, as we are required to do payments in the future.82 Consistent with the views expressed by commenters, we preliminarily believe that a derivative that does not impose a future payment obligation on the fund would not involve a senior security transaction for purposes of section 18.83
C. Review of Funds’ Use of Derivatives
As we explained in the Concept Release, we now seek to take an updated and more comprehensive approach to the regulation of funds’ use of derivatives.84 To inform our consideration of the regulation of funds’ use of derivatives, we initiated a review of funds’ use of derivatives under the Investment Company Act. As we noted in the Concept Release, our staff has been exploring the benefits, risks, and costs associated with funds’ use of derivatives, as well as various issues relating to the use of derivatives by funds, including whether funds’ current practices, based on their application of Commission and staff guidance, are consistent with the investor protection purposes and concerns underlying
section 18 of the Investment Company
Act.
In considering these and other issues, our staff has engaged in a range of activities to inform our policymaking relating to the use of derivatives by funds. These include reviewing funds’ derivatives holdings and other sources of information concerning funds’ use of derivatives; examining advisers to funds that make use of derivatives; discussing funds’ use of derivatives with market participants; and considering other relevant information provided to the Commission concerning funds’ use of derivatives, including comment letters submitted in response to the Concept Release. This review has also included an evaluation of the comment letters submitted in response to a notice issued by the Financial Stability Oversight Council (‘‘FSOC’’) requesting comment on aspects of the asset management industry.85 Although our proposal is independent of FSOC, some commenters responding to the FSOC notice discussed issues concerning leverage, and we have considered and cited to relevant comments throughout this Release.86 The staff’s review of funds’ use of derivatives includes, as discussed below, a review of the derivatives and other holdings of a random sample of funds, as reported by those funds in their annual reports to shareholders. As
part of this effort, the staff reviewed and
compiled information concerning the holdings of randomly selected mutual funds (including a focused review and separate sampling of alternative strategy funds 87), closed-end funds, ETFs, and BDCs. Information derived from this review is discussed throughout this Release, and more details concerning the staff’s review and findings are provided in the DERA White Paper, which was prepared by staff in the Division of Economic and Risk Analysis and which will be placed in the comment file for this Release contemporaneously with our publication of the Release.88 As discussed below, in developing proposed rule 18f–4, we considered the information derived from our staff’s review concerning funds’ use of derivatives and other considerations, including the investor protection purposes and concerns underlying
section 18 as reflected in sections 1(b)(7)
and 1(b)(8).
D. Need for a New Approach

1. The Current Regulatory Framework
   and the Purposes and Policies Underlying the Act a. Background and Overview We have determined to propose a new approach to funds’ use of derivatives in order to address the investor protection purposes and concerns underlying
   section 18 of the Act and to provide an
   updated and more comprehensive approach to the regulation of funds’ use of derivatives transactions in light of the dramatic growth in the volume and complexity of the derivatives markets over the past two decades and the increased use of derivatives by certain funds. In Release 10666, we took the position that funds might engage in the transactions described in that release using the segregated account approach, notwithstanding the limitations in
   section 18.89 We took this position
   because we believed that the segregated account approach would address the investor protection purposes and concerns underlying section 18 by: (1) Imposing a ‘‘practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock’’; and (2) ‘‘assur[ing] the availability of adequate funds to meet the obligations arising [from the transactions described in Release 10666].’’ 90 We continue to believe that these are relevant considerations and that it may be appropriate for a fund to enter into transactions that create fund indebtedness, notwithstanding the prohibitions in section 18, if such transactions are subject both to a limit on leverage to prevent undue speculation and to measures designed to require the fund to have sufficient assets to meet its obligations.91 We are

for this proposed rule for purposes of section 6(c) of the Act, whether it would be necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act to provide an exemption from the requirements of sections 18 and 61 of Act and the appropriate conditions for any exemption. 92See Release 10666, supra note 20, at ‘‘Segregated Account’’ discussion. See also supra note 47. 93See, e.g., Ropes & Gray Concept Release Comment Letter, at 3 (in the context of Release 10666 ‘‘[a]s originally conceived by the Commission,’’ explaining that ‘‘[a]s a practical matter, requiring the segregation of assets but not limiting the permitted segregation to cash equivalents effectively permitted funds to incur investment leverage up to a theoretical limit equal to 100% of a fund’s net assets.’’) In addition and as we explained in Release 10666, as the percentage of a fund’s portfolio assets that are segregated increases, the fund’s ability to meet current obligations, to honor requests for redemption, and to manage properly the investment portfolio in a manner consistent with its stated investment objective may become impaired. See Release 10666, supra note 20, at ‘‘Segregated Account’’ discussion. 94See also supra note 47. 95See also, e.g., infra note 115 and accompanying text. 96See supra notes 56–58 and accompanying text. 97 Id. 98 Id. 99See Merrill Lynch No-Action Letter, supra note 59 (staff no-action letter in which the staff took the position that a fund could cover its derivatives￾related obligations by depositing any liquid asset, including equity securities and non-investment grade debt securities, in a segregated account). 100See, e.g., Vanguard Concept Release Comment letter, at 6 (‘‘[The Merrill Lynch No-Action Letter] greatly increased the amount funds could invest in derivatives because most of a fund’s portfolio securities could be used to cover its derivatives positions.’’); Ropes & Gray Concept Release Comment Letter, at 3 (‘‘The Staff’s subsequent no￾action letter issued to Merrill Lynch in 1996 provided greater flexibility by allowing a fund to segregate any liquid assets, including equity securities and non-investment grade debt—thus potentially expanding the nature of the investment leverage risks associated with derivatives.’’); 2010 ABA Derivatives Report, supra note 70, at 14 (‘‘This position [taken in the Merrill Lynch No-Action Letter] greatly increased the degree to which funds could use derivatives because all or substantially all of their portfolio securities could be used to ‘cover’ their derivatives positions.’’). 101See, e.g., id. 102For example, in a settled enforcement action discussed below involving funds that obtained exposure to certain commercial mortgage-backed securities (‘‘CMBS’’) mainly through TRS contracts, our order issued in connection with the matter noted that, unlike an actual purchase of CMBS, the TRS contracts
required no initial commitment of cash, which allowed the funds to take on large amounts of CMBS exposure without having to liquidate other positions, but it also caused them to take on leverage by adding market exposure on top of other assets on their balance sheets. See infra note 123 and accompanying text. 103See, e.g., Ropes & Gray Concept Release Comment Letter, at 3 (in the context of Release 10666 ‘‘[a]s originally conceived by the Commission,’’ explaining that ‘‘[a]s a practical matter, requiring the segregation of assets but not Continued concerned, however, that funds’ current practices, including their application of the segregated account approach to certain derivatives transactions, in some cases may not adequately address these considerations. The segregated account approach described in Release 10666 required a fund engaging in the transactions described in that release to segregate liquid assets, such as cash, U.S. government securities, or other appropriate high-grade debt obligations, equal in value to the full amount of the obligations incurred by the fund.92 A fund segregating an amount of the highly liquid assets described in Release 10666 equal in value to the full amount of potential obligations incurred through the transactions described in Release 10666 would be subject to a practical limit on the amount of leverage the fund could obtain through those transactions. The fund would not be able to incur obligations in excess of liquid assets that the fund could place in a segregated account, which generally would limit the fund’s obligations to the fund’s net assets, even if the fund’s net assets consisted solely of the high￾quality assets we described in Release
10666.93 Segregating liquid assets equal
in value to the full amount of the fund’s obligations—and doing so with the types of high-quality liquid assets we described in Release 10666—also provided assurances that the fund would have adequate assets to meet its obligations.94 The liquid assets we described in Release 10666 generally are less likely to experience volatility or to decline in value than lower quality debt securities or equity securities, for example, and the amount of the fund’s obligation under the trading practices addressed in Release 10666 generally would be known at the outset of the transaction.95 Today, in contrast, many funds apply the mark-to-market segregation approach to certain net cash-settled derivatives, and some funds use this form of asset segregation extensively.96 Under this approach, funds segregate an amount equal to the fund’s daily mark￾to-market liability on the derivative, if any.97 Although funds initially applied this approach to a few specific types of transactions addressed through guidance by our staff (interest rate swaps, futures required to cash-settle and NDFs), many funds now apply mark-to-market segregation to other cash-settled instruments, including total return swaps (‘‘TRS’’) and cash-settled written options.98 As we noted above, our staff has observed that some funds appear to apply the mark-to-market approach to any derivative that is cash settled. The amount of assets that a fund would segregate under the mark-to￾market approach is substantially less than under the approach contemplated in Release 10666. The mark-to-market approach therefore allows a fund to obtain greater exposures through derivatives transactions than the fund could obtain using the approach we contemplated in Release 10666 with respect to the trading practices described in that release, and also may result in a fund segregating an amount of assets that may not be sufficient to enable the fund to meet its potential obligations under the derivatives transactions, as discussed below. In addition to the smaller amount of segregated assets under the mark-to￾market approach, funds now segregate various types of liquid assets, rather than the more narrow range of high￾quality assets described in Release 10666, in reliance on a no-action letter issued by our staff.99 A fund that segregates any liquid asset may be able to obtain greater leverage than a fund that segregates only the types of assets we described in Release 10666, especially when the fund also is applying the mark-to-market segregation approach.100 This is because a fund segregating only the types of assets we described in Release 10666 would be more constrained in its ability to enter into transactions requiring asset coverage by the requirement to maintain those kinds of high-quality assets. A fund that segregates any liquid asset, in contrast, may invest in various types of securities, consistent with its investment strategy, while potentially also using a large portion of its portfolio to cover
transactions implicating section
18.101 This facilitates the fund’s ability
to obtain leverage because the fund, by using securities consistent with its strategy to cover derivatives transactions, can add additional exposure through derivatives without having to also maintain lower-risk assets.102 b. Concerns Regarding Funds’ Ability To Obtain Leverage Together, funds’ use of the mark-to￾market segregation approach with respect to various types of derivatives, plus the segregation of any liquid asset, enables funds to obtain leverage to a greater extent than was contemplated in Release 10666. Segregating only a fund’s daily mark-to-market liability—and using any liquid asset—enables the fund, using derivatives, to obtain exposures substantially in excess of the fund’s net assets.103 For derivatives for

limiting the permitted segregation to cash equivalents effectively permitted funds to incur investment leverage up to a theoretical limit equal to 100% of a fund’s net assets’’; also noting that ‘‘industry practice has evolved further since 1996 [when the staff issued the Merrill Lynch No-Action Letter, supra note 59] in a manner that could, in some instances, allow for investment leverage that exceeds the 100% limit that was implicit in earlier Commission and Staff positions’’.). 104The fund may, however, still be required to post collateral to comply with other regulatory or contractual requirements. See, e.g., Comment Letter of Rafferty Asset Management, LLC on Concept Release (Nov. 7, 2011) (File No. S7–33–11) (‘‘Rafferty Concept Release Comment Letter’’), available at http://www.sec.gov/comments/s7-33- 11/s73311-40.pdf, at 12 (noting that ‘‘all swap’’ contracts have an ‘‘out of the money value of the contract [of] zero’’ at inception, but that the firm’s swap contracts ‘‘typically require the Funds to post collateral equal to approximately 20% of the notional value of the swap transaction’’). 105Our staff also reviewed the extent to which funds used financial commitment transactions and the extent to which the funds entered into other types of senior securities transactions pursuant to
section 18 or 61.
106See, e.g., Ropes & Gray Concept Release Comment Letter, at 4 (noting that ‘‘[i]t now appears to be an increasingly common practice for funds that engage in cash-settled swaps to segregate assets only to the extent required to meet the fund’s daily mark-to-market liability, if any, relating to such swaps’’ but that, ‘‘[o]f course, in many cases this liability will not fully reflect the ultimate investment exposure associated with the swap position’’ and that, ‘‘[a]s a result, a fund that segregates only the market-to-market liability could theoretically incur virtually unlimited investment leverage using cash-settled swaps’’); Keen Concept Release Comment Letter, at 20 (stating that the mark-to-market approach, as applied to cash settled swaps, ‘‘imposes no effective control over the amount of investment leverage created by these swaps, and leaves it to the market to limit the amount of leverage a fund may use’’). 107Our staff also has stated that it would not object to a fund covering its obligations by entering into certain cover transactions or holding the asset (or the right to acquire the asset) that the fund would be required to deliver under certain derivatives. See supra note 53. See also infra
section III.B.1.d.
108See Concept Release, supra note 3, at text accompanying n.83. See also supra note 106. 109When a fund purchases a total return swap, the fund agrees with a counterparty that the fund will periodically pay a specified fixed or floating rate and will receive any appreciation and any interest or dividend payments on a specified reference asset(s), and will pay any depreciation on the reference asset(s). See, e.g., ISDA Product Descriptions and Frequently Asked Questions, available at http://www.isda.org/educat/ faqs.html#28 (‘‘A total return swap is a agreement in which one party (total return payer) transfers the total economic performance of a reference obligation to the other party (total return receiver). Total economic performance includes income from interest and fees, gains or losses from market movements, and credit losses.’’). 110See BlackRock Concept Comment Letter, at 4 and accompanying text. 111See supra note 47. 112See supra notes 54–55 and accompanying text. 113See, e.g., ICI Concept Release Comment Letter, at 11 (noting that ‘‘calculating a fund’s exposure daily based only on its net obligations—the ‘mark￾to-market’ approach—may create a risk that market movements could increase a fund’s exposure, so that the segregated assets are worth less than the fund’s obligation’’ and that ‘‘[h]ypothetically, in an extreme scenario, a fund that used derivatives heavily and segregated most of its liquid assets to cover its obligation on a pure mark-to-market basis which there is no loss for a given day, a fund applying the mark-to-market approach might not segregate any assets.104 This may be the case, for example, because the derivative is currently in a gain position, or because the derivative has a market value of zero (as will generally be the case at the inception of a transaction). The mark-to￾market approach therefore generally will not limit a fund’s ability to obtain substantial exposures through derivatives. To evaluate the extent of funds’ derivatives exposure, our staff reviewed funds’ holdings and compared the amount of exposure under the funds’ derivatives, based on the derivatives’ notional amounts, with the fund’s net assets.105 As discussed in more detail in the DERA White Paper, our staff found that, although many funds do not use derivatives, and most funds do not use a substantial amount of derivatives, some funds do use derivatives extensively. Some of the funds making extensive use of derivatives obtained notional exposures through derivatives that were substantially in excess of their net assets under a mark-to-market approach and these funds could obtain even higher exposures by applying such an approach. Funds included in our staff’s review sample had notional exposures ranging up to almost ten times a fund’s net assets. Although we recognize that funds use derivatives for various reasons, a fund with derivatives notional exposures of almost ten times its net assets and having the potential for additional exposures,
for example, does not appear to be subject to a practical limit on leverage as we contemplated in Release 10666.106 Funds are able to obtain such high levels of derivatives exposures relative to the funds’ net assets primarily because of their use of the mark-to￾market approach with respect to various types of derivatives, as discussed above.107 We observed the argument in the Concept Release that segregating only the mark-to-market liability ‘‘may understate the risk of loss to the fund [and] permit the fund to engage in excessive leveraging . . . .’’ 108 Concerns about the efficacy of the mark￾to-market approach may be exacerbated by funds’ application of the mark-to￾market approach to TRS in particular. This greatly expands the potential use of the mark-to-market approach because a TRS can reference any asset, including a range of securities, commodities, or other derivatives.109 Nearly any type of investment that a fund could make directly can be transformed into a cash￾settled TRS which, as noted above, may ‘‘produce[] an exposure and economic return substantially equal to the exposure and economic return a fund could achieve by borrowing money from the counterparty in order to purchase the equities that are reference assets’’ under the TRS.110
c. Concerns Regarding Funds’ Ability To
Meet Their Obligations
Funds’ current practices also may not ‘‘assure the availability of adequate [assets] to meet the obligations arising from [funds’ derivatives transactions],’’ as we contemplated in Release 10666, and thus may implicate the asset sufficiency concern expressed in section 1(b)(8) of the Act. In Release 10666, we stated a fund should segregate liquid assets equal in value to the fund’s full obligation under the transactions described in that release from the outset of the transaction.111 Consistent with Release 10666, funds applying the notional amount segregation approach segregate an amount of assets equal in value to the full amount of the fund’s potential obligation under derivatives, where that amount is known at the outset of the transaction, or the full market value of the underlying reference asset for the derivative.112 Segregating assets equal in value to the fund’s full potential obligation under a derivative generally would be expected to enable the fund to meet that obligation. A fund using the mark-to-market approach, however, segregates assets the fund deems liquid in an amount equal to the fund’s daily mark-to-market liability on the derivative, if any. This approach looks only to losses, and corresponding potential payment obligations under the derivative, that the fund already has incurred. A fund that follows this approach is not necessarily segregating assets in anticipation of possible future losses and any corresponding payment obligations, and the fund’s segregation of assets equal to its mark-to-market liability on any particular day provides no assurances that future losses will not exceed the amount of assets the fund has segregated or would otherwise have available to meet the payment obligations resulting from such losses. A fund’s mark-to-market liability on any particular day could be substantially smaller than the fund’s ultimate obligations under a derivative.113 As

could potentially find itself with insufficient liquid assets to cover its derivative positions’’); Vanguard Concept Release Comment Letter, at n.15 (noting that ‘‘using a market value [asset segregation] test for certain transactions can result in the under￾segregation of assets’’); AQR Concept Release Comment Letter, at 4 (‘‘The current asset segregation approach, while it has been effective in mitigating the risks section 18 was designed to address (i.e., excessive borrowing and operating without adequate assets and reserves), has some weaknesses. In particular, as applied to swaps, the daily end-of-day segregation of changes in market value do not reflect the likelihood of loss or volatility of the reference instrument. Intra-day value fluctuations are ignored. For futures, the issues are similar.’’); Ropes & Gray Concept Release Comment Letter, at 4 (noting that a swap’s mark￾to-market liability, if any, ‘‘in many cases . . . will not fully reflect the ultimate investment exposure associated with the swap position’’). 114See supra note 104 and accompanying text. 115See, e.g., Comment Letter of Better Markets, Inc. on Concept Release (Nov. 7, 2011) (File No. S7– 33–11), available at http://www.sec.gov/comments/ s7-33-11/s73311-42.pdf, at 5 (stating that ‘‘the broadening of segregated assets [permitted by the Merrill Lynch No-Action letter] increases the probability that the embedded credit associated with the derivatives will result in a senior payment of money from the Funds’’ . . . and, in addition, ‘‘the assets could be positively correlated with the derivatives risk being offset’’ and that ‘‘[l]oss on the derivatives risk could be compounded by loss on the asset’’); 2010 ABA Derivatives Report, supra note 70, at 16 (where only the mark-to-market liability, if any, is segregated, ‘‘a fund’s exposure under a derivative contract could increase significantly on an intraday basis, resulting in the segregated assets being worth less than the fund’s obligations (until the fund is able to place additional assets in the segregated account . . . . To the extent that a fund relying on the Merrill Lynch Letter segregates assets whose prices are somewhat volatile, this ‘shortfall’ could be magnified’’). 116We noted in Release 10666 that ‘‘in an extreme case an investment company which has segregated all its liquid assets might be forced to sell non￾segregated portfolio securities to meet its obligations upon shareholder requests for redemption. Such forced sales could cause an investment company to sell securities which it wanted to retain or to realize gains or losses which it did not originally intend.’’ See Release 10666, supra note 20, at ‘‘Segregated Account’’ discussion. See also infra note 123 and accompanying text. 117See, e.g., Keen Concept Release Comment Letter, at 20 (‘‘The out-of-the money value of a swap [segregated under the mark-to-market approach] only represents how much the fund already has lost, not the potential loss that might be
incurred during the term of the swap. The potential loss represents the risk of investment leverage, but the Division’s position [regarding the mark-to-market approach] does not require the fund to maintain any assets to cover this risk. The only practical limit is the fund’s need to maintain a buffer of unsegregated assets to cover fluctuations in the swap’s out-of-the￾money value.’’) (emphasis in original); MFDF Concept Release Comment Letter, at 4 (‘‘A fund can also have significant liability exposures connected with a derivative position, particularly if that position does not perform as expected. Because the extent of these liabilities can far outweigh the initial investment in the instrument, the use of derivatives raises potentially serious concerns under the Investment Company Act of 1940 . . . .’’). 118See, e.g., ICI Concept Release Comment Letter; Comment Letter of Invesco Advisers, Inc. on Concept Release (Nov. 7, 2011) (File No. S7–33–11) (‘‘Invesco Concept Release Comment Letter’’), available at http://www.sec.gov/comments/s7-33- 11/s73311-20.pdf (supporting the ICI’s recommendation concerning asset segregation); BlackRock Concept Release Comment letter; Comment Letter of Securities Industry and Financial Markets Association on Concept Release (Nov. 23, 2011) (File No. S7–33–11) (‘‘SIFMA Concept Release Comment Letter’’), available at http://www.sec.gov/comments/s7-33-11/s73311- 51.pdf; Vanguard Concept Release Comment Letter. 119See, e.g., ICI Concept Release Comment Letter, at 3 (‘‘When segregating less than the most conservative full notional amount, the segregation policy should require a more in depth analysis to ensure that the fund has a ‘cushion’ to address the potential loss from derivative contracts that could arise before the next time obligations are marked to market (often, the end of the next day’’); SIFMA Concept Release Comment Letter, at 4 (‘‘The ‘cushion’ would address some potential shortcomings of a simple mark-to-market value measure, such as the risk that a Fund’s indebtedness under a derivative could increase significantly on an intraday basis, resulting in a gap between the value of a Fund’s segregated assets and its actual payment obligations under the derivative.’’). 120See Vanguard Concept Release Comment Letter, at n.18 (‘‘We recognize that the SEC may have concerns about allowing funds to develop their own asset segregation approach based upon SEC examples. To allay those concerns, the SEC may wish to consider adopting an overall leverage limit that funds would be required to comply with, notwithstanding that they have segregated liquid assets to back their obligations.’’). See also, e.g., ICI Concept Release Comment Letter, at 12 (‘‘For funds that choose to segregate assets at less than the most conservative levels, we recommend that the SEC or its staff set forth general guidance that provides ‘guardrails’ to ensure appropriate protections for investors.’’). 121We observed in the Concept Release the
concern that the mark-to-market segregation approach, which we understand is increasingly used by funds with respect to various derivatives, ‘‘may understate the risk of loss to the fund, permit the fund to engage in excessive leveraging, fail to adequately set aside sufficient assets to cover the fund’s ultimate exposure, and, therefore, perhaps not adequately fulfill the purposes underlying the segregated account approach and section 18.’’ See Concept Release, supra note 3, at text accompanying n.83. 122See Release 10666, supra note 20, at ‘‘Segregated Account’’ discussion (stating that ‘‘[i]f an investment company continues to engage in the described securities trading practices and properly segregates assets, the segregated account will function as a practical limit on the amount of leverage which the investment company may undertake and on the potential increase in the speculative character of its outstanding common stock’’ and that ‘‘such accounts will assure the availability of adequate funds to meet the obligations arising from such activities’’) (emphasis added). noted above, if there is no mark-to￾market liability for the fund on a given day, for example because the derivative is currently in a gain position or the fund has just entered into a derivative like a swap for which there is no daily loss for either party at inception, the fund might not segregate any assets.114 Where a fund segregates any liquid asset, rather than the more narrow range of high-quality assets we described in Release 10666, the segregated assets may be more likely to decline in value at the same time as the fund experiences losses on its derivatives than if the fund had segregated the types of liquid assets we described in Release 10666.115 In this case, or when a fund’s derivatives payment obligations are substantial relative to the fund’s assets, the fund may be forced to sell portfolio securities to meet its derivatives payment obligations, potentially in stressed market conditions.116 That a fund has segregated assets it deems sufficiently liquid to cover a derivative’s daily mark￾to-market liability, if any, thus may not effectively assure the fund will have liquid assets to meet its future obligations under the derivative.117 Some commenters on the Concept Release appear to have recognized that segregation of a fund’s daily mark-to￾market liability alone may not be sufficient in at least some cases. As discussed in more detail below in
section III.C of this Release, some
commenters have suggested that we impose asset segregation requirements under which a fund would include in its segregated account for a derivative an amount determined by the fund, in addition to the daily mark-to-market liability, designed to address future losses.118 Some commenters stated that it may be appropriate for a fund to maintain this additional amount, sometimes referred to as a ‘‘cushion’’ by commenters, in addition to assets used to cover any daily mark-to-market liability.119 Some of these commenters further recommended that such an asset segregation requirement be complemented by additional guidance or requirements, with at least one commenter suggesting that we may wish to consider also imposing an ‘‘overall leverage limit.’’ 120 For all of these reasons, funds’ current practices, based on their application of Commission and staff guidance, may in some cases fail to impose an effective limit on the amount of leverage that funds can obtain through derivatives or necessarily require that funds have adequate assets to meet their obligations arising under the derivatives transactions.121 This is not consistent with our stated expectations in Release 10666 that funds’ use of the segregated account approach as described in that release would achieve these goals, consistent with the undue speculation concern expressed in section 1(b)(7) and the asset sufficiency concern expressed in section 1(b)(8).122 d. Examples of Substantial Derivatives￾Related Losses Three relatively recent settled enforcement actions provide examples of situations in which funds’ use of derivatives caused significant losses and

123See In the matter of OppenheimerFunds, Inc. and OppenheimerFunds Distributor, Inc., Investment Company Act Release No. 30099 (June 6, 2012) (settled action). 124See In the matter of Claymore Advisors, LLC, Investment Company Act Release No. 30308 (Dec. 19, 2012); In the matter of Fiduciary Asset Management, LLC, Investment Company Act Release No. 30309 (Dec. 19, 2012) (settled actions). 125 Variance swaps are essentially a bet on whether the actual or realized market volatility will be higher or lower than the market’s expectation for volatility (or ‘‘implied volatility’’). A party with a ‘‘long variance’’ position profits when realized volatility for the contract period is greater than the implied volatility. A party with a ‘‘short variance’’ position profits whenever realized volatility is less than the implied volatility. 126See 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). 127Section 3(c)(1) excludes from the definition of ‘‘investment company’’ any issuer whose outstanding securities are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities (other than short term paper). Section 3(c)(7) excludes from the definition of ‘‘investment company’’ any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Private funds that rely on section 3(c)(1) or 3(c)(7) are not required to comply with any of the capital structure or leverage limitations under the Act, and the use of leverage by private funds, including hedge funds, may be an important component of their investment strategies. 128See Ludwig B. Chincarini, A Case Study on Risk Management: Lessons from the Collapse of Amaranth Advisors L.L.C., 18 J. of Applied Fin. 152 (Spring/Summer 2008), available at http:// ludwigbc.com/pubs/pub9.pdf. 129See id., at 159 (‘‘The position is ‘hedged’ in the sense that if natural gas futures prices rise or fall, one position’s loss will be partly offset by the other’s gain. However, the position is focusing on a spread bet.’’). are relevant to our consideration of whether funds’ current practices, based on their application of Commission and staff guidance, are consistent with the investor protection purposes and concerns underlying section 18 of the Investment Company Act. The funds’ experiences in these cases demonstrate the substantial and rapid losses that can result from a fund’s investments in derivatives. The first action also demonstrates the further losses that can arise when a fund’s portfolio securities also experience declines in value at the same time that the fund is required to make additional payments under the derivatives contracts. The first
action involved two mutual funds that suffered losses driven primarily by their exposure to certain commercial mortgage-backed securities (‘‘CMBS’’), obtained mainly through TRS.123 Unlike an actual purchase of CMBS, these TRS contracts required no initial commitment of cash; this allowed the funds to take on large amounts of CMBS exposure without having to liquidate other positions, but it also caused them to take on leverage by adding market exposure on top of other assets on their balance sheets. In late 2008, CMBS spreads widened to unprecedented levels, triggering substantial payment obligations for the funds under the TRS contracts while market values for the funds’ portfolio securities also fell, further driving down the funds’ net asset value per share. Amidst this declining market the funds also were required to sell portfolio securities to raise cash to meet their obligations under the TRS contracts. In addition, the adviser provided sponsor support to one of the funds by investing $150 million in the fund in November 2008 to provide the fund with liquidity after its anticipated TRS payments for that month totaled approximately one￾third of the fund’s net assets and almost twice its available cash. Both of the funds experienced losses far greater than those suffered by their peer funds. One fund’s share price declined nearly 80% (compared to an average decline of approximately 26% among its peers), far more than any sector in which the fund invested. This occurred because the fund was substantially leveraged as a result of its derivatives, particularly TRS contracts. The other fund’s share price declined approximately 36% (compared to an average decline of approximately 4% among its peers). The second action 124 involved a registered closed-end fund that pursued an investment strategy involving written out-of-the money put options and short variance swaps.125 These derivatives transactions led to substantial losses for the fund in September and October 2008, when the fund realized a loss of approximately $45.4 million, or 45% of the fund’s net assets as of the end of August 2008, on five written put options and variance swaps, contributing to a 72.4% two-month decline in the Fund’s net asset value. The fund was liquidated in May 2009. The third action 126 involved a registered closed-end fund that primarily invested in distressed debt until 2008, when it changed course and shorted credit by purchasing large amounts of CDS. In 2008 and early 2009, the fund’s short exposure significantly increased as a result of large CDS purchases. The large CDS portfolio dramatically changed the fund’s risk profile. Starting around April 2009, credit conditions began to improve and distressed debt increased in value, leading to large mark-to-market losses for the fund’s CDS portfolio. In addition, the high cost of maintaining the CDS positions contributed to the fund’s losses. In 2012, the fund performed very poorly in large part because of its
short-credit CDS portfolio, and the fund’s board voted to liquidate the fund. Examples of the use of derivatives by investment funds that are not subject to the limitations under the Investment Company Act, including private funds, such as hedge funds, that are excluded from regulation under the Investment Company Act by section 3(c)(1) or 3(c)(7) of the Act also may be relevant in considering registered funds’ use of derivatives.127 Private funds’ experience with the use of derivatives can help demonstrate the risks associated with derivatives generally, and private funds’ experience also may be more directly relevant to the extent registered funds are obtaining leverage to a similar extent as private funds and pursuing similar investment strategies. As one example, a private fund with approximately $10.2 billion of net assets lost $4.9 billion in natural gas futures positions in a period of a few weeks in August and September 2006 and was forced to liquidate its entire portfolio and close.128 While the fund engaged in a range of investment strategies, its primary strategy involved a long-short strategy in one type of energy commodity—natural gas—that it traded through NYMEX futures and OTC swaps. The fund’s exposure on its long and short natural gas positions in August 2006 could have been viewed as balanced or hedged at the time it made the investments, in that the fund reportedly had a net exposure that was much less substantial than the fund’s substantial long and short gross exposures.129 However, losses incurred on a portion of the fund’s positions (which were not offset by gains on its other positions) resulted in substantial margin calls on the fund that it was unable to meet with its available cash, and the fund’s adviser liquidated the fund’s entire portfolio of natural gas positions and closed the fund, with losses to investors of almost 50% of the fund’s net asset value. This example demonstrates the challenges in assessing whether ostensibly hedged or covered positions will perform as intended (for example, whether a position intended to hedge another exposure may fail to have a hedging effect and instead result in additional, speculative exposure). In the example above, the private fund’s adviser may have expected that the fund’s long and short positions would

130See Registered Investment Company Use of Senior Securities-Select Bibliography, available at http://www.sec.gov/divisions/investment/ seniorsecurities-bibliography.htm (prepared by the staff and citing staff no-action letters). 131See, e.g., ICI Concept Release Comment Letter, at 9 (‘‘A principles based approach is necessary because the SEC staff’s traditional instrument by instrument approach to guidance has created, and would continue to create, regulatory uncertainty.’’). 132See Concept Release, supra note 3, at n.79 and accompanying text. 133See, e.g., Davis Polk Concept Release Comment Letter, at 1–2 (noting that ‘‘funds and their sponsors may interpret the available guidance differently, even when applying it to the same instruments, which may unfairly disadvantage some funds’’). 134See, e.g., ICI Concept Release Comment Letter, at n.19 (noting that funds segregate the notional amount of physically settled futures contracts, consistent with the Dreyfus no-action letter, while some funds disclose that they segregate only the marked-to-marked obligation in respect of cash￾settled futures and agreeing with the concern reflected in the Concept Release that this ‘‘results in differing treatment of arguably equivalent products’’); Davis Polk Concept Release Comment Letter, at 3 (noting that ‘‘[t]he current approach to segregation leaves many open questions and may lead to inconsistent results for financially similar instruments,’’ noting for example that very few funds use physically settled futures contracts because staff guidance has applied the notional segregation approach to these contracts and, ‘‘[i]nstead, funds enter into over-the-counter swaps that provide similar economic exposure, even though swaps tend to be more expensive and present other potential risks, such as counterparty risk and lack of liquidity’’). 135See, e.g., ICI Concept Release Comment Letter, at 9 (advocating for a principles-based approach and noting, among other things, that ‘‘the SEC staff’s approach to date of providing guidance with respect to specific types of instruments has created a patchwork of interpretations that is neither practical nor sustainable’’); Davis Polk Concept Release Comment Letter, at 1 (noting that while guidance from the Commission and staff ‘‘has been helpful, it has not been able to keep pace with the dramatic expansion of the derivatives market over the past twenty years, both in terms of the types of instruments that are available and the extent to which funds use them,’’ and that resulting ‘‘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,’’ which ‘‘can lead to inefficiencies that are detrimental to funds and their shareholders’’); BlackRock Concept Release Comment Letter, at 5 (‘‘Any set of mechanical rules cannot take account of the diversity of derivatives and the multiplicity of ways they may
be used by portfolio managers.’’); Invesco Concept Release Comment Letter; Loomis Concept Release Comment Letter; Comment Letter of American Bar Association on Concept Release (Nov. 11, 2011) (File No. S7–33–11) (‘‘ABA Concept Release Comment Letter’’), available at http:// www.sec.gov/comments/s7-33-11/s73311-47.pdf; MFDF Concept Release Comment Letter; Comment Letter of T. Rowe Price Associates, Inc. on Concept Release (Nov. 7, 2011) (File No. S7–33–11) (‘‘T. Rowe Price Concept Release Comment Letter’’), available at http://www.sec.gov/comments/s7-33- 11/s73311-35.pdf; Vanguard Concept Release Comment Letter. 136Concept Release, supra note 3, at 14. See also, e.g., Comment Letter of Capital Market Risk Advisors on Concept Release (Nov. 1, 2011) (File No. S7–33–11), available at http://www.sec.gov/ comments/s7-33-11/s73311-19.pdf (supporting risk management for derivatives, but also for all more complex and less liquid instruments). 137See, e.g., Oppenheimer Concept Release Comment Letter, at 3 (stating that ‘‘a core component in the oversight of the use of derivatives by funds should be the board’s awareness of the controls in place, and the effectiveness of the adviser’s governance of risk in maintaining this awareness’’ and that ‘‘[w]e believe it is reasonable for the SEC to expect large and sophisticated investment advisers to have in place a well￾developed risk governance framework incorporating an independent risk management function, governance structures designed to ensure the comprehensive review by appropriate levels of management of risk issues and reporting to a fund’s Continued hedge a substantial amount of the risk inherent in each set of positions, and this could have been the case under various circumstances. But it was not the case in August and September of 2006, when the fund experienced the substantial losses discussed above leading to its liquidation.
2. Need for an Updated and More
Comprehensive Approach
We now propose to take an updated and more comprehensive approach to the regulation of funds’ use of derivatives and the application of the senior security restrictions in section 18. The current approach has developed over the years since we issued Release 10666 as funds and our staff sought to apply our statements in Release 10666 to various types of derivatives and other transactions on an instrument-by￾instrument basis. We understand that, in determining how they will comply with section 18, funds consider various no-action letters issued by our staff. These letters were issued in the 1970s, 1980s, and 1990s, and addressed particular questions presented to the staff concerning the application of the approach enunciated in Release 10666 to various types of derivatives on an instrument-by-instrument basis.130 We understand that funds also consider, in addition to these letters, other guidance they may receive from our staff and the practices that other funds disclose in their registration statements. The current approach’s development on an instrument-by-instrument basis, together with the dramatic growth in the volume and complexity of the derivatives markets over the past two decades, has resulted in situations for which there is no specific guidance from us or our staff with respect to various types of derivatives.131 We noted in the Concept Release the concern that the segregated account approach, by calling for an instrument￾by-instrument assessment of the amount of cover required, may create uncertainty about the treatment of new products, and that new product development will inevitably lead to circumstances in which available guidance does not specifically address each new instrument subject to section 18 constraints.132 Under the current approach, different funds may treat the same kind of derivative differently, based on their own application of our staff’s guidance and observation of industry practice, which at least one commenter noted ‘‘may unfairly disadvantage some funds.’’ 133 Where there is no specific guidance, or where the application of existing guidance is unclear, funds may take approaches that involve a more extensive use of derivatives and that may not address the purposes and concerns underlying section 18 of the Act, as discussed above. The lack of guidance addressing some derivatives may create competitive pressures for funds to take approaches that involve a more extensive use of derivatives. The current approach, having developed over time, may treat similar derivatives in a manner that results in substantially different amounts of segregated assets, and may itself influence funds’ investment decisions.134 The lack of comprehensive guidance also makes it difficult for funds and our staff to evaluate and inspect for funds’ compliance with section 18. A number of commenters on the Concept Release supported a more comprehensive and systematic approach, rather than an approach in which we or our staff provide guidance
on an instrument-by￾instrument basis, which these commenters generally suggested would be less effective.135 A fund’s use of derivatives may involve counterparty, liquidity, leverage, market, and operational risks, as noted above. As we observed in the Concept Release, ‘‘[a] fund’s use of derivatives presents challenges for its investment adviser and board of directors to ensure that the derivatives are employed in a manner consistent with the fund’s investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements, including those under federal securities laws.’’ 136 In light of these considerations and those we discuss in
section III.D below, we believe that
funds that make significant use of derivatives, or that use certain complex derivatives, should have formalized risk management programs to manage the risks that derivatives may pose and to help address the challenges and investor protection concerns presented by their use.137

board designed to facilitate and enhance effective board oversight’’). 138Other initiatives include modernizing investment company reporting and disclosure and proposing liquidity risk management programs for open-end funds, including exchange-traded funds. See Investment Company Reporting Modernization, Investment Company Act Release No. 31610 (May 20, 2015) [80 FR 33590 (June 12, 2015)] (‘‘Investment Company Reporting Modernization Release’’); Amendments to Form ADV and Investment Advisers Act Rules, Advisers Act Release No. 4091 (May 20, 2015) [80 FR 33718 (June 12, 2015)]; Liquidity Release, supra note 5. 139The proposed rule would provide an exemption from certain provisions of section 18 and 61 of the Act, subject to conditions. The proposed rule could be used by any fund subject to the requirements of section 18 or 61, including mutual funds, closed-end funds, BDCs, most ETFs, and exchange-traded managed funds. (Exchange-traded managed funds, a hybrid between a traditional mutual fund and an ETF, are open-end funds that the Commission has approved. See Eaton Vance Management, et al., Investment Company Act Release Nos. 31333 (Nov. 6, 2014) (notice) and 31361 (Dec. 2, 2014) (order)). The rule would not apply to unit investment trusts (‘‘UITs’’), including ETFs structured as UITs, because UITs are not subject to the requirements of section 18. However, as the Commission has noted (in addressing futures contracts and commodities options), derivatives transactions generally require a significant degree of management and may not meet the requirements imposed on a UIT by the Investment Company Act, including section 4(2) thereof. See section 4 of the Act; see also Custody Of Investment Company Assets With Futures Commission Merchants And Commodity Clearing Organizations, Investment Company Act Release No. 22389 (Dec. 11, 1996), at n.18 (explaining that UIT portfolios are generally unmanaged). 140A fund relying on the proposed rule would also be able to maintain as qualifying coverage assets for a financial commitment transaction fund assets that have been pledged with respect to the financial commitment obligation and can be expected to satisfy such obligation, determined in accordance with policies and procedures approved by the fund’s board of directors. 141See infra section III.I.
III. Discussion
As noted above, the dramatic growth in the volume and complexity of the derivatives markets over the past two decades, and the increased use of derivatives by certain funds, led us to initiate a review of funds’ use of derivatives under the Investment Company Act. Based on that review, including the considerations we discussed in section II.D above and throughout this Release, we are today proposing rule 18f–4, an exemptive rule designed to address the investor protection purposes and concerns underlying section 18 and to provide an updated and more comprehensive approach to the regulation of funds’ use of derivatives transactions and financial commitment transactions. This proposal is part of a broader set of initiatives designed to address the increasingly complex portfolio composition and operations of the asset management industry.138 Proposed rule 18f–4 would permit a fund to enter into derivatives transactions, as defined in the rule, provided that the fund complies with three primary sets of conditions of the rule designed to address the purposes and concerns underlying section 18.139 First, the fund would be required to comply with one of two alternative portfolio limitations designed to impose a limit on the amount of leverage the fund may obtain through derivatives transactions and other senior securities transactions. The first portfolio limitation would place an overall limit on the amount of exposure (as defined in the rule) to underlying reference assets, and potential leverage, that a fund would be able to obtain through derivatives transactions and other senior securities transactions by limiting the fund’s exposure under these transactions to 150% of the fund’s net assets. The second portfolio limitation would focus primarily on a risk assessment of the fund’s use of derivatives, and would permit a fund to obtain exposure in excess of that permitted under the first portfolio limitation where the fund’s derivatives transactions, in aggregate, result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives, evaluated using a value-at-risk-based test. Second, the fund would be required to manage the risks associated with the fund’s derivatives transactions by maintaining an amount of certain assets, defined in the proposed rule as ‘‘qualifying coverage assets,’’ designed to enable the fund to meet its obligations under its derivatives transactions. To satisfy this requirement the fund would be required to maintain qualifying coverage assets to cover the fund’s mark-to-market obligations under a derivatives transaction, as well as an additional amount, determined in accordance with policies and procedures approved by the fund’s board, designed to address potential future losses and resulting payment obligations under the derivatives transaction. The fund’s qualifying coverage assets for its derivatives transactions generally would be required to consist of cash and cash equivalents.
Third, except with respect to funds that engage in only a limited amount of derivatives transactions and that do not use certain complex derivatives transactions as defined in the proposed rule, the fund would be required to establish a formalized derivatives risk management program administered by a designated derivatives risk manager. The derivatives risk management program requirement is designed to complement the proposed rule’s portfolio limitations and asset segregation requirements applicable to every fund that engages in derivatives transactions by requiring funds subject to the requirement to adopt and implement a derivatives risk management program that addresses the program elements specified in the rule, including the assessment and management of the risks associated with the fund’s derivatives transactions. The program would be administered by a derivatives risk manager designated by the fund and approved by the fund’s board of directors. The proposed rule also would permit a fund to enter into financial commitment transactions, which include the trading practices we described in Release 10666 and short sale borrowings, provided that the fund complies with conditions requiring the fund to maintain qualifying coverage assets equal in value to the fund’s full obligations under its financial commitment transactions. Because in many cases the timing of the fund’s payment obligations may be specified under the terms of a financial commitment transaction or the fund may otherwise have a reasonable expectation regarding the timing of the fund’s payment obligations with respect to its financial commitment transactions, a fund relying on the proposed rule would be able to maintain as qualifying coverage assets for a financial commitment transaction assets that are convertible to cash or that generate cash prior to the date on which the fund expects to be required to pay its obligations under the transaction, determined in accordance with policies and procedures approved by the fund’s board of directors.140 The proposed rule would supersede the guidance we provided in Release 10666, as well as the guidance provided by our staff concerning funds’ use of derivatives and financial commitment transactions, which we would rescind if we adopt the proposed rule.141 A. Structure and Scope of Proposed Rule 18f–4

1. Structure of Proposed Rule 18f–4
   Proposed rule 18f–4, as summarized above, is designed both to impose a limit on the leverage a fund relying on the rule may obtain through derivatives transactions and financial commitment transactions, and to require the fund to have qualifying coverage assets to meet its obligations under those transactions, in order to address the undue speculation concern expressed in

142Proposed rule 18f–4(c)(2).
143Title VII of the Dodd-Frank Act established a comprehensive framework for the regulation of swaps and security-based swaps. The definitions of these terms under section 1a of the Commodity Exchange Act and section 3(a)(68) of Securities Exchange Act, respectively, are detailed and expansive, and were designed to encompass a wide range of derivatives, including those that could be developed in the future. 144Proposed rule 18f–4(c)(4).
section 1(b)(7) and the asset sufficiency
concern expressed in section 1(b)(8). We discuss in this section of the Release the structure and general approach of proposed rule 18f–4, and discuss the scope of the defined terms ‘‘derivatives transactions’’ and ‘‘financial commitment transactions’’ in section III.A.2 below. As discussed in more detail in the sections that follow, in order to rely on the exemption provided by proposed rule 18f–4 to enter into derivatives transactions, a fund would be required to comply with one of two alternative portfolio limitations and, separately, to maintain qualifying coverage assets designed to enable the fund to meet its obligations under those transactions and to require the fund to manage the risks associated with those transactions. The proposed rule’s portfolio limitations are designed primarily to address concerns about a fund’s ability to obtain leverage through derivatives transactions, whereas the proposed rule’s requirements to maintain qualifying coverage assets are designed primarily to address concerns about a fund’s ability to meet its obligations. We believe that this approach for derivatives transactions—providing separate portfolio limitations and asset segregation requirements—would be more effective than an approach focusing only on asset segregation, particularly when it is coupled with a formalized risk management program for funds that engage in more than a limited amount of derivatives transactions or that use certain complex derivatives transactions, as we are proposing today. We have determined to propose portfolio limitation and risk management requirements for derivatives transactions, in addition to an asset segregation requirement, because as discussed in section II.D above, asset segregation alone in some cases may not provide a sufficient limit on the amount of leverage a fund can obtain through derivatives or sufficient assurances that a fund would have adequate assets to meet its obligations arising under derivatives transactions. The asset segregation approach described in Release 10666 achieved both of these goals—limiting leverage and addressing availability of assets— because that release contemplated that funds would segregate high-quality liquid assets equal in value to the fund’s full obligations. A fund that segregated liquid assets equal to the purchase price in a standby commitment agreement, for example, would be limited in its ability to enter into standby commitment agreements because the fund could not incur obligations under those agreements in excess of the fund’s available liquid assets; by segregating liquid assets equal to the purchase price of the standby commitment agreement, the fund would have assets available to meet its obligations under the agreement. Although this approach appears to have addressed the concerns underlying
section 18 for the particular instruments
described in Release 10666 and is similar to the approach we are proposing today for financial commitment transactions, applying it to derivatives transactions by requiring funds to segregate the kinds of liquid assets we described in Release 10666 equal in value to the full notional amount of each derivative could in some cases require funds to hold more liquid assets than may be necessary to address the investor protection purposes and concerns underlying section 18. The notional amount of a derivatives transaction does not necessarily equal, and often will exceed, the amount of cash or other assets that a fund ultimately would likely be required to pay or deliver under the derivatives transaction. By addressing concerns related to a fund’s ability to obtain leverage through derivatives transactions primarily through the proposed portfolio limitations and separately addressing concerns related to a fund’s ability to meets its derivatives obligations primarily through the proposed requirements to maintain qualifying coverage assets, the proposed rule is designed to address each concern more directly, while still providing a flexible framework that can be applied by funds to various types of derivatives as they are developed in the marketplace. These requirements also would be complemented by the proposed rule’s risk management requirements, which would require funds that engage in more than a limited amount of derivatives transactions or that use certain complex derivatives transactions, as defined in the proposed rule, to develop formalized risk management programs reasonably designed to assess and manage the risk associated with those transactions based on the fund’s own facts and circumstances. This requirement should serve to establish a standardized level of risk management for funds that engage in more than a limited amount of derivatives transactions or that use complex derivatives transactions.
2. Definitions of Derivatives
Transactions and Financial Commitment Transactions The proposed rule defines the term ‘‘derivatives transaction’’ to mean any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument (‘‘derivatives instrument’’) under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination.142 This definition is designed to describe those derivatives transactions that in our view involve the issuance of a senior security, as discussed in section II.B.4 above, because they involve a future payment obligation, that is, an obligation or potential obligation of the fund to make payments or deliver assets to the fund’s counterparty. The proposed rule’s definition of ‘‘derivatives transaction’’ incorporates a list of derivatives instruments. We believe this list of derivatives instruments, together with the proposed rule’s inclusion of ‘‘similar instruments,’’ covers the types of derivatives that funds currently use and that involve fund obligations that implicate section 18, and that this list is sufficiently comprehensive to include derivatives that may be developed in the future.143 We believe that this approach is preferable to having a more conceptual definition of derivatives transaction, such as an instrument or contract whose value is based upon, or derived from, some other asset or metric, which could be too broad or more difficult to apply, in that it could be understood to include or potentially include instruments or transactions that are sometimes referred to as ‘‘derivatives’’ but which typically would not be expected to implicate section 18. The proposed rule would define a ‘‘financial commitment transaction’’ as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement.144 This definition is designed to describe the trading practices addressed in Release 10666, as well as short sales of securities, for which the staff initially developed the

145See Release 10666, supra note 20, at ‘‘Reverse Repurchase Agreements,’’ ‘‘Firm Commitment Agreements,’’ and ‘‘Standby Commitment Agreements’’ discussions. 146Proposed rule 18f–4(c)(4). 147The definition would not include a transaction under which a fund merely is required to deliver cash or assets as part of regular-way settlement of a securities transaction (rather than a forward￾settling transaction or transaction in which settlement is deferred). Cf. Release 10666, supra note 20, at n.11. 148See, e.g., Phyllis A. Schwartz & Stephanie R. Breslow, Private Equity Funds: Formation and Operation (June 2015 ed.), at 2–34 (remedies private equity funds may apply in event of investor default include, among other things, the right to charge high interest on late payments, the right to force a sale of the defaulting investor’s interest, the right to continue to charge losses and expenses to defaulting investors while cutting off their interest in future profits, and the right to take any other action permitted at law or in equity). 149See, e.g., The Brinson Funds, SEC Staff No￾Action Letter (Nov. 25, 1997), available at https://www.sec.gov/divisions/investment/ noaction/1997/brinsonfunds112597.pdf (stating that, ‘‘[a]s a general matter, securities lending arrangements are regulated under Section 17(f) of the Investment Company Act of 1940, which governs custody arrangements,’’ but that ‘‘[t]he staff has stated that a fund’s loan of portfolio securities may involve the issuance of a senior security in light of the fund’s obligation to return the collateral upon termination of the loan’’). segregated account approach we applied in Release 10666. These transactions involve a conditional or unconditional contractual obligation to pay or deliver assets in the future and thus involve the issuance of a senior security, as discussed in section II.B.4 of this Release. The proposed rule’s definition of financial commitment transactions includes firm and standby commitment agreements, which we addressed in Release 10666,145 as well as any similar agreement.146 The rule includes, as a similar agreement, an agreement under which a fund has obligated itself, conditionally or unconditionally, to make a loan to a company or to invest equity in a company, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner.147 We understand that funds often refer to these transactions as ‘‘unfunded commitments.’’ In these transactions, as with respect to firm and standby commitment agreements, the fund has incurred a conditional or unconditional contractual obligation to pay or deliver assets in the future. The fund would be exposed to risks as a result of these transactions in that the fund may be required to liquidate other assets of the fund to obtain the cash needed by the fund to satisfy its obligations, and if the fund is unable to meet its obligations, the fund would be subject to default remedies
available to its counterparty. For example, if a fund fails to fulfill its commitments to invest in a private fund when called to do so, the fund could be subject to the remedies specified in the limited partnership agreement (or similar document) relating to that private fund, which can include, for example, a forfeiture of some or all of the fund’s investment in the private fund.148 The rule’s definitions of the terms ‘‘derivatives transactions’’ and ‘‘financial commitment transactions,’’ discussed above, would specify the types of transactions in which a fund would be permitted to engage under the rule, subject to its conditions. Other senior securities transactions that do not fall within either of these definitions, such as borrowings from a bank by mutual funds or the issuance of other debt securities or preferred equity by closed-end funds or BDCs, could only be done pursuant to the requirements of
section 18 (or section 61 in the case of
BDCs) or in accordance with some other exemption, rather than proposed rule 18f–4. We request comment on all aspects of the proposed rule’s definitions of the terms ‘‘derivatives transaction’’ and ‘‘financial commitment transaction.’’

• Is the definition of ‘‘derivatives
  transaction’’ sufficiently clear? Are there additional types of derivatives instruments that we should include or any that we should exclude?
• The proposed rule’s definition of
  the term derivatives transactions is designed to describe those derivatives transactions that would involve the issuance of a senior security. Do commenters agree that this is an appropriate approach? Does the rule effectively describe all of the types of derivatives transactions that would involve the issuance of a senior security? The proposed rule’s definition of ‘‘derivatives transaction’’ incorporates a list of derivatives instruments, rather than a conceptual definition such as an instrument or contract whose value is based upon, or derived from, some other asset or metric, because we believe that the definition’s list of derivatives instruments would more clearly describe the types of derivatives that implicate section 18 than a conceptual definition. Do commenters agree? Why or why not?
• The proposed rule would define a
  ‘‘financial commitment transaction’’ as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement. The proposed rule includes, as a similar agreement, an agreement under which a fund has obligated itself, conditionally or unconditionally, to make a loan to a company or to invest equity in a company, including by making a capital commitment to a private fund that can be drawn at the discretion of the private fund’s general partner. Do commenters agree with the scope of this definition? Are these terms sufficiently clear? Do commenters agree that it is appropriate to include these transactions?
• Are there additional types of
  transactions that we should include in the definition of a ‘‘financial commitment transaction’’? Adding additional transactions to the definition would permit the fund to engage in those transactions by complying with the proposed rule, rather than section 18 or 61. Are there transactions that we should exclude from the definition and for which a fund should be required to comply with the requirements of section 18 (to the extent permitted under
  section 18), rather than the proposed
  rule’s conditions?
• Our staff has expressed the view
  that a fund’s loan of portfolio securities may involve the issuance of a senior security in light of the fund’s obligation to return the collateral upon termination of the loan and has expressed the view that ‘‘a mutual fund should not have on loan at any given time securities representing more than one-third of its total asset value.’’ 149 Should we address funds’ compliance with section 18 in connection with securities lending by, instead, including a fund’s obligation to return securities lending collateral as a financial commitment transaction? Alternatively, should we require a fund to include the obligation to return securities lending collateral for purposes of the proposed rule’s exposure limits, as discussed in more detail in section III.B? Or does the current approach under which funds do not have on loan at any given time securities representing more than one￾third of the funds’ total assets, together with other guidance from our staff concerning securities lending by funds, effectively address the senior security implications of securities lending such that we should not address securities lending in the proposed rule? Which approach would be most appropriate and why?
• The proposed rule would permit a
  fund to enter into a derivatives transaction or financial commitment transaction, notwithstanding the requirements of section 18 or 61 of the Act, if the fund complies with the rule’s conditions. Are there other rules or forms we should consider modifying if

150 ‘‘Asset coverage’’ of a class of securities representing indebtedness of an issuer generally is defined in section 18(h) of the Investment Company Act as ‘‘the ratio which the value of the total assets of such issuer, less all liabilities and indebtedness not represented by senior securities, bears to the aggregate amount of senior securities representing indebtedness of such issuer.’’ See supra note 34. 151Proposed rule 18f–4(a)(1). 152The proposed rule’s portfolio limitations, although designed to impose a limit on potential leverage, also could help to address concerns about a fund’s ability to meet its obligations. As noted above, the use of derivatives for leveraging purposes can exacerbate the risk that losses on the derivatives, and resulting payment obligations imposed on the fund, can force the fund’s adviser to sell the fund’s investments to generate liquid assets in order for the fund to meet its obligations. The proposed rule would directly address concerns about a fund’s ability to meet its obligations under its derivatives transactions primarily through the proposed rule’s requirements to maintain qualifying coverage assets, as discussed below in section III.C. 153Proposed rule 18f–4(a)(1)(i); proposed rule 18f–4(c)(10) (defining the term ‘‘senior securities transaction’’ to mean any derivatives transaction, financial commitment transaction, or any transaction involving a senior security entered into by the fund pursuant to section 18 or 61 of the Act without regard to the exemption provided by the proposed rule). 154Proposed rule 18f–4(c)(10). 155Proposed rule 18f–4(a)(1)(i). As discussed below in section III.B.2, the risk-based portfolio limit also includes an outside limit on a fund’s exposure. A fund’s exposure for purposes of the risk-based portfolio limit would be calculated as described in this section of the Release, but the exposure limit would be 300% of the fund’s net assets rather than 150%. Proposed rule 18f– 4(a)(1)(ii). we adopt the proposed rule? Should we, for example, amend Form N–2 to provide that funds required to file on that form should not include derivatives transactions and financial commitment transactions in the senior securities
table? Are there other aspects of our
rules and forms that we should consider amending if we were to adopt the proposed rule? If so, which rules and form items and why?

• Should any final rule address, or
  should we provide guidance concerning, funds’ compliance with other aspects of section 18 in connection with funds’ use of derivatives transactions or financial commitment transactions? For example, because the proposed rule would permit a fund to enter into derivatives transactions and financial commitment transactions notwithstanding section 18(a)(1) and section 18(f)(1), a fund relying on the proposed rule would not be required to comply with section 18’s 300% asset coverage requirement (or
  section 61’s 200% asset coverage
  requirement) with respect to such transactions.150 Should we, however, address in any final rule or provide guidance concerning the application of the asset coverage requirements under
  section 18 or 61 when a fund also enters
  into senior securities transactions in reliance on section 18 or 61 (such as bank borrowings or, in the case of a closed-end fund or BDC, the issuance of senior debt or preferred stock)? When a fund is calculating asset coverage under
  section 18(h) for senior securities
  transactions permitted by section 18 or 61, how should the fund treat its derivatives transactions or financial commitment transactions? When determining the ‘‘aggregate amount of senior securities representing indebtedness,’’ how should the fund treat any liabilities and indebtedness associated with the fund’s derivatives transactions and financial commitment transactions? Currently, when funds are determining the amount of their liabilities and indebtedness and the amount of their senior securities for purposes of calculations under section 18(h), are funds determining these amounts in accordance with U.S. generally accepted accounting principles? Should a fund also include any liabilities and indebtedness associated with derivatives transactions and financial commitment transactions based on U.S. generally accepted accounting principles? Alternatively, should a fund treat any liabilities and indebtedness for these transactions as ‘‘liabilities and indebtedness not represented by senior securities’’? What approach would be appropriate and why?
• Is there any guidance we should
  provide concerning funds’ compliance with other provisions of the Investment Company Act in connection with funds’ use of derivatives transactions or financial commitment transactions in reliance on the proposed rule? B. Portfolio Limitations for Derivatives Transactions The proposed rule would require a fund that engages in derivatives transactions in reliance on the rule to comply with one of two alternative portfolio limitations.151 As explained in more detail below, under the first portfolio limitation (the ‘‘exposure￾based portfolio limit’’), a fund generally would be required to limit its aggregate exposure to 150% of the fund’s net assets. A fund’s ‘‘exposure’’ for this purpose generally would be calculated as the aggregate notional amount of its derivatives transactions, together with its obligations under financial commitment transactions and other senior securities transactions. The second portfolio limitation (the ‘‘risk￾based portfolio limit’’) would permit a fund to obtain exposure in excess of that permitted under the exposure-based portfolio limit where the fund’s derivatives transactions, in aggregate, result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives, evaluated using a test based on value-at￾risk (‘‘VaR’’). A fund electing the risk￾based portfolio limit generally would be required to limit its exposure under derivatives transactions, financial commitment transactions, and other senior securities transactions to 300% of the fund’s net assets. As discussed below, these portfolio limitations are designed primarily to address the undue speculation concern expressed in
  section 1(b)(7) by imposing an overall
  limit on the amount of exposure to underlying reference assets, and potential leverage, that a fund would be able to obtain through derivatives and other senior securities transactions, while also providing flexibility for a fund to use derivatives for a variety of purposes.152

1. Exposure-Based Portfolio Limit
   a. Overview
   The first portfolio limit would be based on the fund’s overall exposure to:
   (1) Derivatives transactions, (2) financial commitment transactions, and (3) other transactions involving a senior security entered into by the fund pursuant to
   section 18 or 61 of the Act without
   regard to the exemption that would be provided by the proposed rule (i.e., senior securities transactions engaged in by a fund in reliance on the requirements of those provisions, rather than in reliance on the exemption that would be provided by the proposed rule).153 The proposed rule would collectively define these transactions as ‘‘senior securities transactions.’’ 154 A fund that relies on the exposure-based portfolio limit would be required to operate so that its aggregate exposure under senior securities transactions, measured immediately after entering into any such transaction, does not exceed 150% of the fund’s net assets.155 The exposure-based portfolio limit is designed to impose an overall limit on the amount of exposure, and thus the amount of potential leverage, that a fund would be able to obtain through derivatives and other senior securities transactions. We discuss and seek comment below on the exposure-based portfolio limit, including the proposed rule’s method of calculating a fund’s exposure and the rule’s limitation of exposure to 150% of the fund’s net assets.

156Proposed rule 18f–4(c)(3).
157Proposed rule 18f–4(c)(3)(i) (defining ‘‘exposure’’). 158Proposed rule 18f–4(c)(7) (defining ‘‘notional amount’’). 159 Derivatives may be broadly described as instruments or contracts whose value is based upon, or derived from, an underlying reference asset (see supra at text preceding note 8). The notional amount generally serves a measure of the underlying economic exposure because it reflects the value of the underlying reference asset for that derivative or the amount of the underlying reference asset on which payment obligations are based. 160See, e.g., Margin and Capital Requirements for Covered Swap Entities, 80 FR 74839 (Nov. 30, 2015) (‘‘Prudential Regulator Margin and Capital Adopting Release’’); Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 FR 59898 (Oct. 3, 2014) (‘‘CFTC Margin Proposing Release’’) (defining ‘‘material swaps exposure’’ by reference to average daily aggregate notional amounts of derivatives transactions). See also Further Definition of ‘‘Swap Dealer,’’ ‘‘Security-Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ ‘‘Major Security-Based Swap Participant’’ and ‘‘Eligible Contract Participant,’’ Exchange Act Release No. 66868 (Apr. 27, 2012) [77 FR 30596 (May 23, 2012)] (‘‘Swap Dealer/Major Swap Participant Release’’), at section II.D (discussing use of notional amounts as basis for de minimis exemption to swap dealer registration requirements). See also CFTC regulations 4.5(c)(ii)(3)(b) and 4.13(a)(3)(ii)(B) (exclusion from definition of commodity pool operator and exemption from commodity pool operator registration requirement, respectively, in respect of certain pools whose commodity interest positions do not exceed 100% of the liquidation value of the pool’s portfolio). See also infra section IV.E (discussing use of notional amounts under UCITS regulatory regime). 161For example, ‘‘notional value’’ with respect to futures has been defined as ‘‘the underlying value (face value), normally expressed in U.S. dollars, of the financial instrument or commodity specified in a futures or options on futures contract.’’ See CME Group Glossary, available at http:// www.cmegroup.com/education/glossary.html. ‘‘ ‘Notional principal’ or ‘notional amount’ of a derivative contract is a hypothetical underlying quantity upon which interest rate or other payment obligations are computed.’’ ISDA Online Product Descriptions and Frequently Asked Questions, available at http://www.isda.org/educat/ faqs.html#7. The Bank for International Settlements describes ‘‘notional amounts outstanding’’ as ‘‘a reference from which contractual payments are determined in derivatives markets.’’ Guide to the International Financial Statistics, Bank for International Settlements (July 2009) (‘‘BIS Guide’’), available at http://www.bis.org/statistics/ intfinstatsguide.pdf, at 31. See also 2010 ABA Derivatives Report, supra note 70, at n.11 (noting that the term ‘‘notional amount’’ is used differently by different
people in different contexts, but is used, in the Report, to refer to ‘‘the nominal or face amount that is used to calculate payments made on a particular instrument, without regard to whether its obligation under the instrument could be netted against the obligation of another party to pay the fund under the instrument’’). 162The methods for determining the notional amounts in the table are similar to those required to be used by UCITS funds that follow the commitment approach (discussed further below in
section IV.E. See European Securities and Markets
Authority (formerly Committee of European Securities Regulators), Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS, CESR/ 10–788 (July 28, 2010) (‘‘CESR Global Guidelines’’), available at http://www.esma.europa.eu/system/ files/10_788.pdf. b. Calculation of Exposure The proposed rule would define a fund’s ‘‘exposure’’ as the sum of: (1) The aggregate notional amounts of the fund’s derivatives transactions, subject to certain adjustments discussed below; (2) the aggregate obligations of the fund under its financial commitment transactions; and (3) the aggregate indebtedness (and with respect to any closed-end fund or business development company, involuntary liquidation preference) with respect to any other senior securities transactions entered into by the fund pursuant to
section 18 or 61 of the Investment
Company Act.156 We discuss each aspect of this definition below.
i. Exposure for Derivatives Transactions

1. Determination of Notional Amounts
   Under the proposed rule, a fund’s exposure would include the aggregate notional amounts of its derivatives transactions.157 The proposed rule would generally define the ‘‘notional amount’’ of a derivatives transaction, subject to certain adjustments required by the rule (discussed below), as the market value of an equivalent position in the underlying reference asset for the derivatives transaction, or the principal amount on which payment obligations under the derivatives transaction are calculated.158 We believe that, although derivatives vary widely in terms of structure, asset class, risks and potential uses, for most types of derivatives the notional amount generally serves as a measure of the fund’s economic exposure to the underlying reference asset or metric.159 A total return swap, for example, can provide economic exposure equivalent to a long or short position in the reference asset for the swap. Similarly, a fund can sell or buy a CDS to obtain exposure similar to a long or short position in the credit risk of an issuer of a fixed-income security. We also note that notional amounts are used in numerous other regulatory regimes as a means of determining the scale of the derivatives activities of market participants.160 We also believe that the definition of notional amount under the proposed rule is consistent with the way the term ‘‘notional amount’’ (or in some cases ‘‘notional value’’) generally is used with respect to derivatives transactions.161
   Table 1 below sets forth a list of
   different types of derivatives transactions that are commonly used by funds, together with the method by which we understand a fund, for risk management, reporting or other purposes, typically would calculate the transaction’s notional amount. We believe that the proposed rule’s definition of notional amount generally would allow a fund to use the calculation methods below to determine the notional amounts of such derivatives transactions (before applying any of the adjustments discussed below) for purposes of calculating the fund’s exposure under the proposed rule.162
   TABLE 1
   Forwards:
   FX forward .......................................... Notional contract value of currency leg(s). Forward rate agreement ..................... Notional principal amount. Futures:
   Treasury futures ................................. Number of contracts * notional contract size * (futures price * conversion factor + accrued interest). Interest rate futures ............................ Number of contracts * contract unit (e.g., $1,000,000). FX futures ........................................... Number of contracts * notional contract size (e.g., 12,500,000 Japanese yen). Equity index futures ............................ Number of contracts * contract unit (e.g., $50 per index point) * futures index level. Commodity futures ............................. Number of contracts * contract size (e.g., 1,000 barrels of oil) * futures price. Options on futures .............................. Number of contracts * contract size * futures price * underlying delta.163 Swaps:
   Credit default swap ............................. Notional principal amount or market value of underlying reference asset. Standard total return swap ................. Notional principal amount or market value of underlying reference asset. Currency swap .................................... Notional principal amount. Cross currency interest rate swaps .... Notional principal amount. Standardized Options:

163 Delta refers to the ratio of change in the value of an option to the change in value of the asset into which the option is convertible. The delta-adjusted notional value of options is needed to have an accurate measurement of the exposure that an option creates to the underlying reference asset. See, e.g., Comment Letter of Morningstar, Inc. on Concept Release (Nov. 7, 2011) (File No. S7–33–11) (‘‘Morningstar Concept Release Comment Letter’’), available at http://www.sec.gov/comments/s7-33- 11/s73311-23.pdf, at 2. 164See supra notes 158–160. 165While credit default swaps are often considered riskier than typical interest rate or currency derivatives, the staff has observed that even ‘‘plain vanilla’’ interest rate and currency derivatives can lead to significant losses for funds. See, e.g., Katherine Burton, Swiss Franc Trade Is Said to Wipe Out Everest’s Main Fund, Bloomberg (Jan. 18, 2015), available at http:// www.bloomberg.com/news/articles/2015-01-17/ swiss-franc-trade-is-said-to-wipe-out-everest-s￾main-fundv (noting significant and widespread losses following the Swiss National Bank’s decision to decouple the Swiss franc from the euro). 166See infra section III.B.1.d. 167See, e.g., An Overview of Leverage, AIMA Canada (Oct. 2006) (‘‘An Overview of Leverage’’), available at http://www.aima.org/filemanager/root/ site_assets/canada/publications/strategy_paper_-_ leverage.pdf (distinguishing between financial, construction and instrument leverage and describing the measurement of leverage using gross market exposure vs. net market exposure). See also Off-Balance-Sheet Leverage IMF Working Paper, supra note 79 (discussing means of measuring leverage in various types of derivatives and other off-balance-sheet transactions). See also Ang, Gorovyy & Inwegen, supra note 72 (discussing differences among gross leverage, net leverage and long-only leverage calculations, as applied to long￾only, dedicated long-short, general leveraged and dedicated short funds). See also Comment Letter of BlackRock, Inc. on Investment Company Reporting Modernization (Aug. 11, 2015) (File No. S7–08–15) (‘‘BlackRock Modernization Comment Letter’’), available at http://www.sec.gov/comments/s7-08- 15/s70815-318.pdf. In the BlackRock Reporting Modernization Comment Letter, the commenter proposed a high-level framework for an approach to measuring economic leverage that could potentially be applied across different types of funds and investment strategies, using comprehensive analysis of multiple different types of risk exposures. 168See infra section III.B.1.d. 169Proposed rule 18f–4(c)(7)(iii)(A). 170A similar requirement applies to the determination of de minimis thresholds for swap dealer and security-based swap dealer registration. See Swap Dealer/Major Swap Participant Release, Continued
TABLE 1—Continued
Security options .................................. Number of contracts * notional contract size (e.g., 100 shares per option contract) * market value of underlying equity share * underlying delta. Currency options ................................ Notional contract value of currency leg(s) * underlying delta. Index options ...................................... Number of contracts * notional contract size * index level * underlying delta. Although we believe that the notional amount generally serves as a measure of the fund’s exposure to the underlying reference asset or metric,164 we recognize that a derivative’s notional amount does not reflect the way in which the fund uses the derivative and that the notional amount is not a risk measure. An exposure-based test based on notional amounts therefore could be viewed as a relatively blunt measurement in that different derivatives transactions having the same notional amount but different underlying reference assets—for example, an interest rate swap and a credit default swap having the same notional amount—may expose a fund to very different potential investment risks and potential payment obligations.165 We also recognize that there are other approaches to evaluating leverage associated with a fund’s derivatives activities, including approaches that disregard or subtract the notional value of hedging transactions from the calculation of a fund’s exposure.166 Leverage can be calculated in numerous ways, however, and the appropriateness of a particular leverage metric may depend on various considerations, such as a fund’s strategy and types of investments, and the specific leverage￾related risks that are being considered.167 On balance, we believe that, for purposes of the proposed rule, a notional amount limitation would be a more effective and administrable means of limiting potential leverage from derivatives than a limitation which relies on other leverage measures that may be more difficult to adapt to different types of fund strategies or different uses of derivatives, including types of fund strategies and derivatives that may be developed in the future. The proposed rule would allow a fund operating under the exposure￾based portfolio limit to have exposure of up to 150% of the fund’s net assets (i.e., more than the fund’s net assets) in recognition of the various ways in which funds may use derivatives. The 150% limit, discussed in more detail below, is designed to balance concerns about the limitations of an exposure measurement based on notional amounts with the benefits of using notional amounts, such as the ability of funds to readily determine the notional amounts of their derivatives transactions and the expectation that notional amounts can generally serve as a measure of the size of a fund’s exposure to underlying reference assets or metrics, as discussed above. We believe that, for purposes of the exposure-based portfolio limit, a test that focuses on the notional amounts of funds’
derivatives transactions, coupled with an appropriate exposure limit, will better accommodate the broad diversity of registered funds and the ways in which they use derivatives than a test that would require consideration of the manner in which a fund uses derivatives in its portfolio (e.g., for hedging).168 The rule seeks to achieve a balance between providing flexibility regarding the use of derivatives while limiting the potential risks associated with leverage by, in addition to the exposure limits in the proposed rule, conditioning the rule’s exemptive relief on other requirements, such as the asset coverage requirements discussed in
section III.C below and, if applicable,
the derivatives risk management program requirements discussed in
section III.D below, which must be
tailored in light of the fund’s particular strategy and other characteristics. Although we believe that an exposure test that focuses on limiting the aggregate notional amounts of funds’ derivatives transactions is an appropriate means of limiting leverage, in some cases, the notional amount for a derivatives transaction may not produce a measure of exposure that we believe would be appropriate for purposes of the proposed rule’s exposure limitations. The proposed rule therefore includes three provisions relating to the calculation of exposure in respect of certain types of derivatives transactions for which we believe that an adjusted notional amount would better serve as a measure of a fund’s investment exposure for purposes of the rule. First, for derivatives that provide a return based on the leveraged performance of an underlying reference asset, the rule would require the notional amount to be multiplied by the applicable leverage factor.169 Thus, for example, the rule would require a total return swap that has a notional amount of $1 million and provides a return equal to three times the performance of an equity index to be treated as having a notional amount of $3 million. Absent this provision, a fund could enter into a derivative with a stated notional amount that did not reflect the magnitude of the fund’s leveraged investment exposure under the derivative.170 Such a transaction, if not

supra note 160, at n.427 and accompanying text (stating that, for purposes of the de minimis threshold for registration of swap dealers, ‘‘notional standards will be based on ‘effective notional’ amounts when the stated notional amount is leveraged or enhanced by the structure of the swap or security-based swap’’). 171Proposed rule 18f–4(c)(7)(iii)(B). The managed account or interests in the entity may be owned by the fund’s counterparty (e.g., a swap dealer), which hedges its obligations under the derivative through its ownership of such account or interests. In some cases, the derivative contract may describe the reference asset as an index comprising the performance of transactions ‘‘notionally’’ entered into by the trading manager, or the ‘‘notional’’ performance of an index comprising the managed account or entity together with cash and/or other positions. The proposed rule’s ‘‘look-through’’ for calculating notional amounts thus applies to derivatives transactions for which the underlying reference asset is a managed account or entity formed or operated primarily for the purpose of investing in or trading derivatives transactions, as well as an index that reflects the performance of such a managed account or entity. Id. 172Some funds appear to use these swaps in such a way that nearly all of the fund’s investment exposure is indirectly attributable to the derivatives traded by the third-party manager for the underlying managed account or entity, while the fund’s direct investments (other than the swap) are limited to cash and cash equivalents. 173For example, a fund might enter into a swap having a notional value of $10, corresponding to the value of an equity security issued by a trading entity. The fund’s counterparty could then invest $10 in the trading entity, which in turn could use these funds as margin or collateral for leveraged futures or currency forward transactions having a much larger aggregate notional amount, e.g., $100. Proposed rule 18f–4(c)(7)(iii)(B) would require the fund to treat the swap in this example as having a notional amount of $100 rather than $10. 174Thus, for example, if a fund enters into a swap on the performance of a trading entity that, in turn, enters into a swap that provides a return based on the leveraged performance of an equity index, the notional amount of the equity index would need to be multiplied by the applicable leverage factor, consistent with the method set forth in proposed rule 18f–4(c)(7)(iii)(A), for purposes of calculating the fund’s pro rata share of the notional amounts of the trading entity’s derivatives transactions in accordance with proposed rule 18f–4(c)(7)(iii)(B). 175See proposed rule 18f–4(c)(1) (defining ‘‘complex derivatives transaction’’) and proposed rule 18f–4(c)(7)(iii)(C) (describing the method for calculating the notional amount for a complex derivatives transaction for purposes of the proposed rule). 176See proposed rule 18f–4(c)(1)(i). 177See Paul Wilmott, Paul
Wilmott on Quantitative Finance (2nd ed. 2006) (‘‘Wilmott’’), at 371 (options that ‘‘have payoffs that depend on the path taken by the underlying asset, and not just the asset’s value at expiration . . . are called path dependent.’’ See also CESR Global Guidelines, supra note 162, at 12 (noting that ‘‘[c]ertain derivative instruments exhibit risk characteristics that mean the standard conversion approach is not appropriate as it does not adequately capture the inherent risks relating to this type of product. Some derivatives, for example, may exhibit path￾dependency, such features emphasising the need to have both robust models for risk management and pricing purposes, but also to reflect their complexity in the commitment calculation methodology’’). 178Wilmott, supra note 177, at 371. 179 Id. A third example would be an option with a lookback feature, which has a payoff that depends on whether a maximum or minimum value of the underlying asset occurred during some period prior to expiration. A lookback call option, for example, pays at settlement the difference between the final asset price and the lowest price of the asset observed during the term of the option. Because the payoff is contingent on two prices—the final asset price and the lowest observed price—a lookback call option would be a complex derivatives transaction. See id. at 383; see also Robert Whaley, Derivatives: Markets, Valuation, and Risk Measurement (2006) (‘‘Whaley’’), at 291. measured based on the leverage inherent in the derivative instrument, could otherwise provide a means of structuring transactions to avoid the proposed rule’s exposure limitations. Second, the proposed rule includes a ‘‘look-through’’ for calculating the notional amount in respect of derivatives transactions for which the underlying reference asset is a managed account or entity formed or operated primarily for the purpose of investing in or trading derivatives transactions, or an index that reflects the performance of such a managed account or entity.171 We understand that some funds, including funds that engage in managed futures or foreign currency strategies, obtain their investment exposures for such strategies by entering into a swap that references the performance of a managed account or entity, which in turn is managed on a discretionary basis by a third-party trading manager (such as a commodity trading advisor). Such swaps can be used by a fund to obtain a return that is economically nearly identical to a direct investment by the fund in the derivatives traded by the third-party trading manager for the managed account or entity.172 Absent a look-through to the derivatives transactions of the underlying reference vehicle, such structures could be used to avoid the exposure limitations that would be applicable under the proposed rule if the fund directly owned the managed account or securities issued by the reference entity.173 Accordingly, for such derivatives transactions, the rule would
require a fund to calculate the notional amount by reference to the fund’s pro rata portion of the notional amounts of the derivatives transactions of the underlying reference vehicle, which in turn must be calculated in a manner consistent with the requirements of the proposed rule.174 The provision thus would apply to transactions such as swaps on pooled investment vehicles that are formed or operated primarily for the purpose of investing in or trading derivatives transactions, which could include hedge funds, managed futures funds and leveraged ETFs, in order to prevent a fund from entering into a leveraged swap on the performance of shares or other interests issued by such vehicles and thereby indirectly obtain leverage in excess of what the rule would permit a fund to obtain directly. Third, the proposed rule contains specific provisions for calculating the notional amount for certain defined complex derivatives transactions. As explained further below, the proposed rule includes these provisions because, for complex derivatives transactions, the notional amounts of such transactions determined without regard to these specific provisions may not serve as an appropriate measure of the underlying market exposure obtained by a fund. The proposed rule would define a complex derivatives transaction as any derivatives transaction for which the amount payable by either party upon settlement date, maturity or exercise: (1) Is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction; or (2) is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price.175 We address each of these provisions below. The first type of complex derivatives transaction is a derivatives transaction for which the amount payable by either party upon settlement date, maturity or exercise is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction.176 This provision is designed to capture derivatives whose payouts are path dependent, i.e., the payouts depend on the path taken by the value of the underlying asset during the term of the transaction. Many types of non-standard options exhibit path dependency.177 An example of a path dependent derivative would be a barrier option. Barrier options (also known as knock-in or knock-out options) have a payoff that is contingent on whether the price of the underlying asset reaches some specified level prior to expiration.178 Another example would be an Asian option, which has a payoff that depends on the average value of the underlying asset from inception until expiration.179 By contrast, a standard put or call option having a single strike price would not be a complex derivatives transaction under this provision of the definition, because the payout of a standard put or call option depends on the value of the reference asset only upon
exercise, i.e., at a single point rather than multiple points in time during the term of the transaction. The second type of complex derivatives transaction is a derivatives transaction for which the amount

180See proposed rule 18f–4(c)(1)(ii). 181See, e.g., Sebastien Bossu, Introduction to Variance Swaps, Wilmott Magazine, available at http://www.wilmott.com/pdfs/111116_bossu.pdf, at 50–51. 182See, e.g., Peter Allen, Stephen Eincomb & Nicolas Granger, Variance Swaps, JPMorgan Investment Strategies: No. 28 (Nov. 17, 2006), at 11 (noting that ‘‘variance swap strikes are quoted in terms of volatility, not variance; but pay out based on the difference between the level of variance implied by the strike (in fact the strike squared) and the subsequent realised variance’’). 183See, e.g., Mark Rubinstein & Hayne E. Leland, Replicating Options with Positions in Stock and Cash, 51 Financial Analysts J. 113 (Jan./Feb. 1995) (demonstrating how a long or short position in a standard put or call can be replicated by holding a long or short position in a number of shares of the underlying stock corresponding to the option’s delta, which would have a value equal to the option delta multiplied by the underlying stock price). 184Proposed rule 18f–4(c)(7)(iii)(C). 185For example, a fund that invests in a total return swap on an equity index having a notional amount of $100 can be said to have exposure similar to a $100 investment in the index components. By contrast, it is not possible to draw a comparison between the notional amount of a variance swap on the same equity index and a direct investment in the index components. 186The UCITS Commitment Approach Guidelines express a similar concern. See CESR Global Guidelines, supra note 162, at 12 (noting that a common feature of non-standard derivatives is ‘‘the existence of a highly volatile delta which could, for example, result in significant losses’’ and therefore ‘‘many of these instruments will need to be assessed on a case by case basis’’). 187Proposed rule 18f–4(c)(7)(iii)(C). As discussed in section III.F below, the proposed rule would require the fund to maintain a written record demonstrating that immediately after the fund entered into any senior securities transaction, the fund complied with the portfolio limitation applicable to the fund immediately after entering into the senior securities transaction, including the fund’s aggregate exposure, among other things. Where the fund enters into a complex derivatives transaction, the fund, in documenting its exposure immediately after entering into the transaction, would be required to document the way it determined the notional amount of the complex derivatives transaction, that is, the notional amount(s) of substituted instruments that could reasonably be expected to offset substantially all of the market risk of the complex derivatives transaction at the time the fund entered into the transaction. 188The UCITS Global Exposure Guidelines similarly call for derivatives with complex structures to be ‘‘broken down into component parts’’ so that ‘‘the effect of layers of derivative exposures [can] be adequately captured.’’ CESR Global Guidelines, supra note 162,
at 12. See also Wilmott, supra note 177, at 506 (stating, with regard to ‘‘exotic’’ derivatives, that ‘‘[i]f a contract can be decomposed into simpler, vanilla products, then that’s what you should do for pricing and hedging’’). 189See generally Wilmott, supra note 177, at 969– 987 (describing methods for hedging barrier options using ‘‘vanilla’’ exchange-traded options); see also Peter Carr, Katrina Ellis & Vishal Gupta, Static Hedging of Exotic Options, 53 J. of Fin. 1165, 1169 (June 1998) (describing methods for hedging barrier options, lookback options and other ‘‘exotic’’ options using standard put and call options). payable by either party upon settlement date, maturity or exercise is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price.180 Most types of derivatives traded on an exchange or with standardized terms (other than exchange-traded or standardized options) involve payment amounts between the parties that change on a dollar-for-dollar basis tracking changes in the value of the underlying reference asset. We refer to these calculations under relatively standardized terms as involving a linear function of the value of the underlying reference assets. An example of a ‘‘non-linear’’ derivatives transaction that would be a complex derivatives transaction under this provision of the definition would be a variance swap. A variance swap is an instrument that allows investors to profit from the difference between the current implied volatility and future realized volatility of an asset; however, the payoff for a variance swap is a function of the difference between current implied variance and future realized variance of the asset.181 Because variance is the square of volatility, the payment obligations under a variance swap are non-linear.182 This second provision of the definition of complex derivatives transaction includes a carve-out that would exclude derivatives for which payout upon settlement date, maturity or exercise is non-linear due to optionality arising from a single strike price. This exception is designed to exclude standard put or call options from the complex derivatives transaction definition, which would otherwise be captured because their payout is non-linear. For example, the payout for a standard cash-settled written call option is either equal to zero (if the price of the underlying asset at maturity is less than or equal to the strike price) or equal to the difference between the value of the underlying asset and the strike price (if the price of the underlying asset at maturity is greater than the strike price), and is therefore non-linear. We believe that it is unnecessary to treat standard put and call options as complex derivatives transactions because the method for determining the notional amount for such derivatives, i.e., the market value of the underlying asset multiplied by its delta, serves as an appropriate measure of a
fund’s exposure for purposes of the rule because it generally would result in a notional amount that reflects the market value of an equivalent position in the underlying reference asset for the derivatives transaction.183 The proposed rule would include a special provision for calculating the notional amount of complex derivatives transactions for purposes of determining a fund’s exposure.184 This provision is designed to address two primary concerns. The first is that the notional amount for some complex derivatives, if determined without regard to this provision, may not appropriately reflect the fund’s underlying market exposure for purposes of the portfolio limitation. For example, the notional amount of a variance swap is typically expressed in terms of ‘‘vega notional,’’ i.e., a measure of volatility. This vega notional amount is used to calculate the payout for a variance swap, but it does not correspond to the market value or principal amount of a reference asset that can appropriately be compared against a fund’s net assets for purposes of the exposure-based portfolio limit.185 A second concern is that complex derivatives can have market risks that are difficult to estimate due to the presence of multiple forms of optionality or other non-linearities, which similarly may not be adequately reflected in a notional amount calculated without separately considering each of the risks as with the special provision in the proposed rule for complex derivatives transactions.186 The proposed rule seeks to address these concerns by specifying an alternative approach for determining the notional amount for a complex derivatives transaction. Under this approach, the notional amount of a complex derivatives transaction would be equal to the aggregate notional amount(s) of other derivatives instruments, excluding other complex derivatives transactions (together, ‘‘substituted instruments’’), reasonably estimated to offset substantially all of the market risk of the complex derivatives transaction at the time the fund enters into the transaction.187 This approach is designed to address the difficulty of determining the notional amount for some complex derivatives transactions and the concern that the reference asset or metric may not by itself be an appropriate measure of the underlying market exposure, by substituting, in effect, the notional amounts of non-complex instruments that mirror the market risk of the complex derivatives transaction.188 For example, a barrier option in some cases can be hedged using standard put and call options (which would not be complex derivatives transactions provided that they had a single strike price).189 In that case, a fund could use the aggregate notional amount of such puts and calls (i.e., the strike price multiplied by the delta) as the notional

190The proposed rule would not require a fund to actually invest in substituted instruments instead of investing in the complex derivatives transaction, but rather would require a fund to use the notional amounts of substituted instruments in order to determine its exposure for purposes of the proposed rule’s portfolio limitations. 191Proposed rule 18f–4(c)(3)(i). 192The netting provision under the proposed rule is not designed to enable a fund generally to disregard or subtract from the calculation of a fund’s exposure the notional amount of transactions that the fund deems to be hedging or risk mitigating. See section III.B.1.d. The netting provision applies only to directly offsetting derivatives transactions that are the same type of instrument and have the same underlying reference asset, maturity and other material terms. 193Proposed rule 18f–4(c)(3)(ii). 194Proposed rule 18f–4(c)(3)(iii). This could include, for example, bank borrowings and, for a closed-end fund or BDC, the issuance of debt or preferred shares. Section 18(g) of the Act excludes from the definition of senior security ‘‘any such promissory note or other evidence of indebtedness in any case where such a loan is for temporary purposes only and in an amount not exceeding 5 per centum of the value of the total assets of the issuer at the time when the loan is made.’’ Such borrowings that meet the requirements of the exclusion for temporary borrowings under section 18(g) would not be considered senior securities transactions for purposes of the proposed rule, and thus would not be included in the proposed rule’s exposure calculations. amount for purposes of determining the fund’s exposure.190 (2) Netting of Certain Derivatives Transactions The proposed rule includes a netting provision that would permit a fund, in determining its aggregate notional exposure, to net any directly offsetting derivatives transactions that are the same type of instrument and have the same underlying reference asset, maturity and other material terms.191 This limited netting provision is designed to apply to those types of derivatives transactions for which, due to regulation, transaction structure or market practice, a fund typically would use an offsetting transaction to effectively settle all or a portion of the transaction prior to expiration or maturity, such as certain futures and forward transactions. It would also apply to situations in which a fund seeks to reduce or eliminate its economic exposure under a derivatives transaction without terminating the transaction. This may be the case, for example, if terminating the transaction would be more costly to the fund (for example, because the fund would need to pay an early termination fee) than entering into an offsetting transaction with another counterparty, or if terminating the transaction would cause the fund to realize gain or loss for tax purposes earlier than would be required if the fund entered into an offsetting transaction. The
netting provision under the proposed rule accordingly would permit a fund to exclude from its aggregate exposure the notional amounts associated with transactions that are entered into by the fund to eliminate the fund’s exposure under another transaction through a directly offsetting transaction as described under the proposed rule.192 With respect to transactions that are directly offsetting but involve different counterparties, we note that, although a fund would remain exposed to counterparty risk, such offsetting transactions could reasonably be expected to eliminate market risk associated with the offsetting transactions if they are the same type of instrument and have the same underlying reference asset, maturity and other material terms. Accordingly, we believe that such transactions are an appropriate means to eliminate or reduce market exposure under derivatives transactions even if entered into with different counterparties for purposes of the rule’s exposure limits, which are designed to limit the extent of the fund’s exposure. By contrast, the netting provision would not apply to transactions that may have certain offsetting risk characteristics but do not have the same underlying reference asset, maturity and other material terms or involve different types of derivatives instruments. For example, while a long position in a March 2016 copper futures contract could directly offset a short position in the same March 2016 copper futures contract, it would not directly offset a short position with respect to copper options or April 2016 copper futures. Similarly, a purchased option would not offset a written option that has a different maturity date or a different underlying reference asset. With respect to transactions that do not have the same underlying reference asset, maturity and other material terms, we are concerned that these transactions may not merely have the effect of eliminating or reducing market exposure. For example, they might instead be used as paired ‘‘collar’’ or ‘‘spread’’ investment positions that could raise potential risks associated with strategies that seek to capture small changes in the value of such paired investments. We also believe that it would be difficult to develop standards for determining circumstances under which such transactions should be considered to have eliminated the market and leverage risks associated with the positions in a manner that would appropriately limit the potential for funds to incur excessive leverage or unduly speculative exposures.
ii. Exposure for Financial Commitment
Transactions and Other Senior Securities A fund also would be required to include, in calculating its exposure: (1) The amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under any financial commitment transactions (‘‘financial commitment obligations’’); 193 and (2) the aggregate indebtedness (and with respect to any closed-end fund or business development company, involuntary liquidation preference) with respect to any other senior securities transaction entered into by the fund pursuant to
section 18 or 61 of the Act without
regard to the exemption provided by the proposed rule.194 As explained below, these aspects of the exposure calculation are designed to require a fund that enters into derivatives transactions in reliance on the exemption provided by the proposed rule to include in its aggregate exposure all of the fund’s indebtedness or exposure obtained through senior securities transactions. Under the proposed rule, a fund would be required to include its exposure under these types of transactions in determining its compliance with the 150% exposure limit because, although we have determined to propose an exemption from the requirements of section 18 and 61 to permit funds to enter into derivatives and financial commitment transactions, we believe that, in order to address the investor protection purposes and concerns underlying section 18, a fund relying on the exemption should be subject to an overall limit on leverage. As discussed in more detail below in section III.B.1.b.2, we have proposed to set this limit at 150% of net assets (and at 300% of net assets for a fund operating under the risk-based portfolio limit) because we believe that is an appropriate limit on a fund’s exposure from derivatives, financial commitment transactions, and other senior securities transactions. If the proposed rule did not require exposure from all senior securities transactions to be included for purposes of calculating a fund’s exposure, a fund relying on the exemption the rule would provide could obtain aggregate exposure in excess of the proposed rule’s exposure limits. For example, a fund having net assets of $100 that complies with the exposure-based portfolio limit might otherwise, in theory, obtain $150 of leveraged exposure through

195See infra section III.B.2.b. derivatives plus additional leverage in the form of financial commitment transactions and other borrowings. We have determined to address this concern by requiring a fund to include exposure from all senior securities transactions, but subject to a 150% limit, rather than proposing a substantially lower limit that might be appropriate if the exposure calculation were based solely on derivatives exposure. We request comment on all aspects of the exposure determinations for derivatives transactions.

• Is the proposed rule’s use of
  notional amounts as the basis for calculating a fund’s exposure under a derivatives transaction appropriate? Does the notional amount of a derivatives transaction generally serve as an appropriate means of measuring a fund’s exposure to the applicable reference asset or metric? Are there particular types of derivatives transactions or reference assets for which the notional amount would or would not be effective in this regard? For such derivatives, what alternative measures might be used and why would they be more appropriate? Would such alternative measures be easier for funds and compliance staff to administer?
• For derivatives transactions that
  provide a return based on the leveraged performance of an underlying reference asset, the rule would require the notional amount to be multiplied by the applicable leverage factor. Do commenters agree that this is appropriate?
• The proposed rule includes a ‘‘look￾through’’ for calculating the notional
  amount in respect of derivatives transactions for which the underlying reference asset is a managed account or entity formed or operated primarily for the purpose of investing in or trading derivatives transactions, or an index that reflects the performance of such a managed account or entity. Do commenters agree that this is appropriate? Is this requirement sufficiently clear? Would the look￾through provision capture swaps or other derivatives on reference entities or assets that should not be covered by this provision? Why or why not? Would a fund that uses these types of transactions be able to obtain information from its counterparty regarding the fund’s pro rata portion of the notional amounts of the derivatives transactions of the underlying reference vehicle, in order for the fund to be able to determine its compliance with the exposure limitations under the proposed rule? Why or why not? Would funds that currently use these transactions find it necessary to amend their existing contracts with counterparties in order to obtain such information? Are there other ways we should consider addressing the concern, noted above, that absent a look-through to the derivatives transactions of the underlying reference vehicle, such structures could be used to avoid the exposure limitations that would be applicable under the proposed rule if the fund directly owned the managed account or securities issued by the reference entity? We understand that the accounts or entities that serve as the reference assets for these transactions generally are actively managed, such that the notional amounts of the derivatives transactions of such accounts or entities may change frequently. In light of this, and given the concern that the look-through requirement seeks to address, should the proposed rule also require a fund to determine its compliance with the exposure limitations of the rule whenever the notional amount of the fund’s pro rata portion of the notional amounts of the derivatives transactions of the underlying reference vehicle changes? Why or why not?
• To what extent do funds enter into
  derivatives transactions for which pooled investment vehicles (e.g., hedge funds or other registered funds, such as ETFs and mutual funds) serve as reference assets? For what purposes do funds enter into such derivatives transactions? To what extent do the referenced pooled investment vehicles themselves use derivatives, such that funds could use derivatives for which a pooled investment vehicle serves as a reference asset in order to obtain leverage in excess of the limits provided under the proposed rule? Would a fund that uses these types of derivatives transactions be able to obtain information from the underlying pooled investment vehicle regarding the notional amounts of the underlying pooled investment vehicle’s derivatives transactions, in order for the fund to be able to determine its compliance with the exposure limitations under the proposed rule’s look-through requirement? Why or why not? Should we specify standards for determining whether a pooled investment vehicle should be considered formed or operated primarily for the purpose of investing in or trading derivatives? What would be an appropriate standard?
• Do commenters agree with the
  proposed definition of ‘‘complex derivatives transaction’’? Are there derivatives transactions that may be considered complex derivatives transactions under the proposed definition but should not be, or vice versa? Does the method for calculating exposure for complex derivatives transactions create the potential for transactions to be structured to avoid this aspect of the rule? If so, how might that be avoided (e.g., by modifying the definition or through other means)?
• The proposed rule would require a
  fund to calculate the notional amount for a complex derivatives transaction by using the notional amount(s) of one or more instruments, excluding other complex derivatives transactions (collectively, ‘‘substituted instruments,’’ as noted above), that could reasonably be expected to offset substantially all of the market risk of the complex derivatives transaction Do commenters agree with this method for calculating exposure in respect of complex derivatives transactions? Should the rule specify a particular test or tests that a fund could elect to use, or be required to use, in order to establish that the notional amount it uses for a complex derivatives transaction meets this requirement? For example, should the rule provide that a group of substituted instruments will be deemed to reasonably be expected to offset substantially all of the market risk associated with a complex derivatives transaction if the fund can demonstrate, using a VaR model that meets the requirements of paragraph (c)(11)(ii) 195 of the proposed rule, that the combined VaR of the substituted instruments and the complex derivatives transaction is less than 1%, or some other percentage, of the VaR of the complex derivatives transaction by itself (in other words, if a complex derivative had a VaR of $100 but the combined VaR of the complex derivatives transaction and the substituted instruments were less than $1, the substituted instruments would be deemed to have offset substantially all of the market risk associated with the complex derivative)? What other approaches might a fund use?
• Are there complex derivatives
  transactions for which substantially all of the market risk cannot be offset using substituted instruments, and for which the fund would not be able to determine a notional amount under the proposed rule? What kinds of transactions, and do funds use such transactions? To the extent there are complex derivatives transactions for which a fund would not be able to offset substantially all of the market risks using substituted instruments, would the fund’s inability to offset substantially all of the market risks using substituted instruments indicate that the fund would be unable

196See CESR Global Guidelines, supra note 162, at 7, 12. 197See Abuse of Structured Financial Products:
Misusing Basket Options to Avoid Taxes and Leverage Limits, Report of the Permanent Subcommittee on Investigations, United States Senate (July 22, 2014), at p. 79 (‘‘The hedge funds told the Subcommittee that, rather than tax, a major motivating factor behind their participation in the basket options was the opportunity to obtain high levels of leverage, beyond the federal leverage limit of 2:1 normally applicable to [regulatory margin requirements for] brokerage accounts, an assertion supported by the banks.’’). 198These basket options, which typically have a strike price that is in-the-money at inception (reflecting the value of the initial premium payment) together with provisions that require the delivery of additional premium amounts or termination if the reference basket declines in value, thus function in a manner very similar to a swap that requires the delivery of collateral at inception and can be terminated if additional collateral is not delivered if the reference basket under the swap declines in value. 199Proposed rule 18f–4(a)(1)(i). 200The proposed rule’s portfolio limitations, although designed to impose a limit on leverage, also could help to address concerns about a fund’s ability to meet its obligations. See supra note 152. effectively to determine the degree of market risk inherent in the transaction? Would such transactions pose greater risks for funds because, for example, they are less liquid or more likely to expose funds to potential losses that may be difficult to quantify?

• We note that, under the CESR
  Global Guidelines, if the exposure for a non-standard derivative cannot be determined based on the market value of an equivalent position in underlying reference assets and such derivatives represent more than a negligible portion of the UCITS portfolio, a UCITS fund cannot use the commitment approach.196 Should the proposed rule similarly restrict a fund’s ability to use these kinds of transactions? Should the proposed rule prohibit a fund from using such transactions? If not, should the proposed rule provide an alternative method for determining the notional amount for a complex derivative for which substantially all of the market risk cannot be offset using substituted instruments? What method?
• Is the netting provision for
  calculating a fund’s exposure appropriate? Are there other circumstances under which netting should be permitted? Are there transactions that the provision would permit to be netted but should not be?
• Are there other adjustments
  pertaining to the use of notional amounts for purposes of determining a fund’s exposure appropriate that we should consider, either with respect to certain types of derivatives transactions or in general? For example, we understand that the notional amounts for Euribor and Eurodollar futures are often referenced by market participants by dividing the amount of the contract by four in order to reflect the three￾month length of the interest rate transaction, and our staff took this approach in evaluating funds’ notional exposures, as discussed in the DERA White Paper. For these very short-term derivatives transactions, calculating notional amounts without dividing by four would reflect a notional amount that could be viewed as overstating the magnitude of the fund’s investment exposure. Should the proposed rule permit or require this practice? Why or why not? Would a derivative’s notional amount adjusted in this way serve as a better measure of the fund’s exposure than the derivative’s unadjusted notional amount? Are there other futures contracts (or other standardized derivatives) for which an analogous adjustment should be permitted? Why or why not?
• Should we consider permitting or
  requiring that the notional amounts for interest rate futures and swaps be adjusted so that they are calculated in terms of 10-year bond equivalents or make other duration adjustments to reflect the average duration of a fund that invests primarily in debt securities? Would this result in a better assessment of a fund’s exposure to interest rate risk? Why or why not?
• Could derivatives transactions be
  restructured so that they provide a level of exposure to an underlying reference asset or metric that exceeds the notional amount as defined in our proposed rule, while nonetheless complying with the rule’s conditions? If so, what modifications should we make to address this?
• Should the calculation of exposure
  be broadened to include not only derivatives that involve the issuance of senior securities (because they involve a payment obligation) but also derivatives that would not generally be considered to involve senior securities, such as purchased options, structured notes, or other derivatives that provide economic leverage, given that such instruments can increase the volatility of a fund’s portfolio and thus cause an investment in a fund to be more speculative than if the fund’s portfolio did not include such instruments?
• Should the proposed rule require a
  fund to include the exposure associated with certain so-called ‘‘basket option’’ transactions, which are derivatives instruments that may nominally be documented in the form of an option contract but are economically similar to a swap transaction? We understand that these types of basket option transactions often involve a deposit by an investor of a cash ‘‘premium’’ that functions as collateral for the transaction, and all or a portion of which may be returned to the investor depending on the performance of the basket of reference assets.197 Should we require a fund to include the exposure associated with these transactions because they operate in a manner similar to swap transactions and differ significantly from the typical purchased option contract with a non￾refundable premium payment? 198
• Do commenters agree that it is
  appropriate to include exposure associated with a fund’s financial commitment transactions and other senior securities transactions in the calculation of the fund’s exposure for purposes of the 150% exposure limit in the exposure-based portfolio limit (and the 300% limit under the risk-based portfolio limit), as proposed, so that the exposure limit would include the fund’s exposure from all senior securities transactions? Should we, instead, include only exposure associated with a fund’s derivatives transactions but reduce the exposure limits so that a fund that would rely on the exemption provided by the proposed rule would be subject to a limit on leverage or potential leverage from all senior securities transactions? If we were to take this approach should we, for example, reduce the exposure limits to 50% in the case of the exposure-based portfolio limit and 100% in the case of the risk-based limit?
  c. 150% Exposure Limit
  As noted above, a fund that elects to comply with the exposure-based portfolio limit under the proposed rule would be required to limit its derivatives transactions, financial commitment transactions and obligations under other senior securities transactions, such that the fund’s aggregate exposure under these transactions, immediately after entering into any senior securities transaction, does not exceed 150% of the fund’s net assets.199 The exposure-based portfolio limit is designed to impose a limit on the amount of leverage a fund may obtain through senior securities transactions while also providing flexibility for funds to use derivatives transactions for a variety of purposes.200 As discussed above, and as noted by several commenters to the Concept Release, many derivatives transactions result in investment exposures that are economically similar to direct

201See Comment Letter of BlackRock on the FSOC Request for Comment (Mar. 25, 2015) (FSOC 2014–0001) (‘‘BlackRock FSOC Comment Letter’’), available at http://www.blackrock.com/corporate/ en-us/literature/publication/fsoc-request-for￾comment-asset-management-032515.pdf, at 8 (‘‘[D]erivatives can be used to lever a portfolio, in essence creating additional economic exposure.’’) See also BlackRock Concept Release Comment Letter, at 4 (noting that in circumstances where a derivative is effectively substituting for one or more ‘long’ physical security positions, ‘‘the full notional amount of the reference asset is at risk to the same extent as the principal amount of a physical holding, and any difference between the amount invested by the fund and the notional amount of the derivative is equivalent to a ‘borrowing’.’’). See also Keen Concept Release Comment Letter, at 8 (noting that, except with respect to hedging transactions, ‘‘the notional amount of swaps should be treated as creating investment leverage and subject to any asset coverage requirement the Commission imposes on the issuance of senior securities by investment companies’’). See also Morningstar Concept Release Comment Letter, at 2 (noting that, by using futures, a fund may only need $5 of initial margin to obtain $100 worth of notional exposure to the S&P 500 and that such position may represent ‘‘effectively a 100% equity investment’’). 202See supra note 34. 203We note that, at this level of exposure limitation, the corresponding limitation on BDCs could be set at 100% of net assets to reflect the increased borrowing capacity that Congress has permitted BDCs to obtain under section 61 of the Act. 204One of the commenters to the Concept Release indicated that this level of exposure would be the effective limit under Release 10666 ‘‘[a]s originally conceived by the Commission,’’ explaining that, ‘‘[a]s a practical matter, requiring the segregation of assets but not limiting the permitted segregation to cash equivalents effectively permitted funds to incur investment leverage up to a theoretical limit equal to 100% of a fund’s net assets.’’ See Ropes & Gray Concept Release Comment Letter. 205See, e.g., infra note 248 and accompanying text. See also BlackRock FSOC Comment Letter, at 8 (noting that in certain cases ‘‘derivatives are used to hedge (mitigate) risks and thus do not result in the creation of leverage and, in fact may specifically reduce economic leverage.); BlackRock Concept Release Comment Letter, at 4–5 (noting that ‘‘in the context of an overall portfolio, a derivative holding may increase overall leverage, decrease overall leverage or have no effect on overall leverage’’) (internal footnotes omitted). 206 In determining an appropriate exposure limit, we have also considered that, as noted below in
section III.B.1.d, derivatives transactions that are
intended to hedge or mitigate risks may not be effective, particularly in stressed market conditions. 207We also note that the payment obligations and potential payment obligations associated with derivatives transactions differ in certain respects from the payment obligations under borrowings permitted under section 18, including in that the fund’s payment obligations under a derivatives transaction would vary depending on changes in market prices, volatility, and other market events related to the derivatives transaction’s reference asset. See also sections III.E and IV.E. investments in the underlying reference assets financed through borrowings. According to one commenter, for example, an equity total return swap ‘‘produces an exposure and economic return substantially equal to the exposure and economic return a fund could achieve by borrowing money from the counterparty in order to purchase the equities that are reference assets.’’ 201 Because derivatives transactions can readily be used for leveraging purposes, we believe that limiting the aggregate notional amount of a fund’s derivatives transactions (subject to certain adjustments under the proposed rule) can appropriately serve to limit the amount of leverage the fund could potentially obtain through such transactions. We also believe that an exposure limitation based, in part, on the aggregate notional amount of a fund’s derivatives transactions should be set at an appropriate amount that reflects the various ways in which funds may use derivatives, while also imposing a limit on the amount of leverage a fund may obtain through derivatives transactions (and other senior securities transactions), consistent with the investor protection purposes and concerns underlying
section 18.
In determining to propose a 150% exposure limitation, we evaluated a range of considerations. First, we considered the extent to which a fund could borrow in compliance with the requirements of section 18. As discussed in more detail in section II, funds generally can incur indebtedness through senior securities under section 18 subject to the asset coverage requirement specified in that section, which effectively permits a fund to incur indebtedness of up to 50% of the fund’s net assets.202 For example, a mutual fund with $100 in assets and with no liabilities or senior securities outstanding could borrow an additional $50 from a bank. We therefore considered whether it would be appropriate to propose a 50% exposure limitation under the proposed rule, in order to limit a fund’s derivatives exposure to the same extent as section 18 limits a fund’s ability to borrow from a bank (or issue other senior securities representing indebtedness subject to
section 18’s 300% asset coverage
requirement).203 We also considered an exposure limitation of 100% of net assets, which would more closely track the level of exposure suggested by Release 10666 for the trading practices described in that release.204 We have not proposed these lower exposure limits of 50% or 100% of net assets primarily due to our consideration of the point made by numerous commenters that funds use derivatives for a range of purposes that may not, or may not be expected to, result in additional leverage for the fund.205 Commenters have noted that many funds use derivatives for hedging or risk-mitigation, or choose to use derivatives for reasons other than specifically to obtain leverage.206 Thus, although a lower exposure limit, like the 100% limitation suggested by Release 10666, may be appropriate for the trading practices described in that release, that exposure limit may not be appropriate when applied to derivatives’ notional exposure. Such a lower exposure limit, as well as the 50% limitation we considered, could limit a fund’s ability to use derivatives transactions for purposes other than leveraging the fund’s portfolio that may be beneficial to the fund and its investors.207 As described in greater detail below in section III.B.1.d, we considered whether to reflect the different ways in which funds might use derivatives by excluding from that calculation any exposure associated with derivatives transactions that may arguably be used to hedge or cover other transactions. This would be similar to the guidelines that apply to UCITS funds, which generally are subject to an exposure limit of 100% of net assets, but are not required to include exposure relating to certain hedging transactions. For the reasons discussed in section III.B.1.d, however, we have determined not to propose to permit a fund to reduce its exposure for purposes of the rule’s portfolio limitations for particular derivatives transactions that may be entered into for hedging (or risk￾mitigating) purposes or that may be ‘‘cover transactions.’’ As discussed in more detail in that section of this Release, we believe it would be difficult to develop a suitably objective standard for these transactions, and that confirming compliance with any such standard would be difficult, both for fund compliance personnel and for our staff. In addition, many hedges are imperfect, making it difficult to distinguish purported hedges from leveraged or speculative exposures or to provide criteria for this purpose in the proposed rule that would be appropriate for the diversity of funds subject to the proposed rule and the diversity of strategies and derivatives they use or may use in the future. In addition to these considerations, we also note that, as discussed in
section III.B.1.b.i, while an exposure￾based test based on notional amounts
could be viewed as a relatively blunt measurement, we believe that, on balance, a notional amount limitation would be more administrable, and thus more effective, as a means of limiting potential leverage from derivatives for purposes of the proposed rule than a limitation which seeks to define, and

208For example, for a fund that determines to use derivatives as an alternative to investments in securities, this proposed exposure-based limit would permit a fund with $100 in assets and with no liabilities or senior securities to obtain market exposure through a derivatives transaction with a notional amount of up to 150% of the fund’s net assets, with the fund’s non-derivatives assets invested in cash and cash equivalents. This would match the degree of market exposure the fund could obtain by borrowing up to $50 from a bank as permitted under section 18 and investing the fund’s $150 in total assets in securities. 209See supra notes 123–124 and 126. 210See infra note 211. 211See supra note 87 (describing the funds included as alternative strategy funds as part of the staff’s review). 212We understand that, in stable environments, samples including longer periods of time are preferable because their larger sample sizes offer greater precision in estimating a given relation or characteristic. DERA staff analysis shows, however, that funds that make the greatest use of derivatives have received disproportionately large net inflows since the end of 2010. Extending DERA’s sample back in time thus would tend to include data in the sample that is no longer consistent with industry practice with respect to derivatives usage as it exists today. 213 DERA White Paper, supra note 73, at Figures
9.5 and 11.5.
rely on, more precise measurements of leverage. We note that setting the exposure limitation at 150%, as proposed, would allow the fund to use derivatives transactions to obtain a level of indirect market exposure solely through derivatives transactions that could approximate the level of market exposure that would be possible through securities investments augmented by borrowings as permitted under section 18.208 We also considered whether higher exposure limitations might be appropriate, such as exposure levels ranging from 200% to 250% of net assets. We are concerned, however, that exposure levels in excess of 150% of net assets, if not tempered by the risk mitigating aspects of the VaR test as we have proposed under the risk-based limit, could be used to take on additional speculative investment exposures that go beyond what would be expected to allow for hedging arrangements, and thus could implicate the undue speculation and asset sufficiency concerns expressed in sections 1(b)(7) and 1(b)(8) of the Act. Second, we considered the extent to which different exposure limits would affect funds’ ability to pursue their strategies. In this regard we considered the extent to which different potential exposure limitations would affect funds and their investors, as well as section 18’s strict limitations on senior securities transactions and the concerns we discuss above regarding funds’ ability to obtain leverage through derivatives and other senior securities transactions. We also considered the extent to which different types of funds, and funds collectively, use senior securities transactions today. Given that, as discussed below, most funds use relatively low notional amounts of derivatives transactions (or do not use any derivatives), we have proposed an exposure limitation at a level that we believe would appropriately constrain funds that use derivatives to obtain highly leveraged exposures. Third, we recognize and have considered that funds using any derivatives transactions can experience derivatives-related losses, including funds with exposures below the limits we are proposing today as well as the other limits that we discuss above. In this regard, we recognize that the information available in the administrative orders described in
section II.D.1.d indicates that some of
the losses described as resulting from derivatives in those matters occurred at exposure levels below the exposure limits that we are proposing today.209 The proposed rule’s exposure limits are not designed to prevent all derivatives￾related losses, however. Importantly, the exposure limits would be complemented by the rule’s asset segregation requirements, which would apply to all funds that engage in derivatives transactions in reliance on the rule, and the proposed rule’s risk management requirements, which would apply to funds that have derivatives exposure exceeding a lower threshold of 50% of net assets or that use complex derivatives transactions. Based on these considerations, we have determined to propose an exposure-based portfolio limit set at 150% of net assets, rather than a lower limit, including the 50% and 100% limits discussed above. We believe that a 150% exposure limit would account for the variety of purposes for which funds may use derivatives, including to hedge risks in the fund’s portfolio and to make investments where derivatives may be a more efficient means to obtain exposure. As discussed in more detail below, we have determined not to permit funds to reduce their exposure for potentially hedging or cover transactions and, instead, have proposed an exposure limit that we believe would be high enough to provide funds sufficient flexibility to engage in these kinds of transactions. We also believe that a 150% exposure limitation would appropriately balance the proposed rule’s effects on funds and their investors, on the one hand, with concerns related to funds’ ability to obtain leverage through derivatives and other senior securities transactions, on the other. We understand based on the DERA analysis that, although most funds would be able to comply with an exposure-based portfolio limit of 150% of net assets, the limit would constrain the use of derivatives by the small percentage of funds that use derivatives to a much greater extent than funds generally. The analysis also indicates that funds and their advisers generally would be able to continue to operate and to pursue a variety of investment strategies, including alternative strategies.210 As discussed in more detail in the DERA White Paper, DERA staff reviewed the portfolio holdings of a random sample of mutual funds (including a separate category of alternative strategy funds, which includes index-based alternative strategy funds 211), closed-end funds, BDCs, and ETFs. DERA staff randomly selected 10% of the funds from each of these categories and reviewed the funds’
schedule of investments included in
their most recently filed annual reports to identify the fund’s derivatives transactions, financial commitment transactions, and other senior securities transactions. DERA staff then calculated the funds’ exposures under these transactions, using the notional amounts to calculate the funds’ derivatives exposures and the amounts of the funds’ obligations and contingent obligations under financial commitment transactions and other senior securities transactions, and compared the funds’ aggregate exposures to the funds’ reported net assets. Although we recognize that the review by DERA staff evaluated funds’ investments as reported in the funds’ then-most recent annual reports, DERA staff is not aware of any information that would provide any different data analysis of the current use of senior securities transactions by registered funds and business development companies.212 This analysis showed that, for mutual funds other than alternative strategy funds (which we discuss separately below), more than 70% of the sampled mutual funds did not identify any derivatives transactions in their schedules of investments; about 6% of sampled mutual funds had derivatives exposures in excess of 50% of the funds’ net assets; and about 99% of sampled mutual funds had aggregate exposures that were less than 150% of the funds’ net assets.213 None of the sampled closed-end funds had aggregate exposure in excess of 150% of net assets

214 DERA White Paper, supra note 73, at Figure 9.7. 215 DERA White Paper, supra note 73, at Figures
9.11 and 11.11.
216 DERA White Paper, supra note 73, at Figures
4.6 and 9.9.
217 DERA White Paper, supra note 73, at Figure 4.5. 218We refer to alternative strategy funds in the same manner as the staff classified ‘‘Alt Strategies’’ funds in the DERA White Paper, supra note 73, as including the Morningstar categories of ‘‘alternative,’’ ‘‘nontraditional bond’’ and ‘‘commodity’’ funds. 219 DERA White Paper, supra note 73, at Figures
9.4 and 11.4.
220Our staff’s experience suggests, however, that funds in one Morningstar alternative strategy category—Managed Futures—may find it difficult to limit their exposures to less than 150%. These funds generally obtain their investment exposures through derivatives transactions, and thus can be expected to have high derivatives exposures relative to net assets. This is consistent with DERA’s analysis, in which the funds with the highest exposures were managed futures funds. 221See supra note 220 regarding funds in the Morningstar managed futures category. 222 In this regard we note that our staff has observed that derivatives transactions may be used by a fund almost entirely to substitute for the purchase of physical securities, with the result that different funds may pursue the same strategy with one fund doing so primarily through derivatives and the other primarily through securities investments. For example, a long/short equity fund that engages in cash transactions could purchase long investment securities and borrow securities in connection with its short sale transactions. Alternatively, the long/short equity fund might invest primarily in Government securities or other short-term investments and pursue its long/short equity strategy solely through a few portfolio total return swaps, under which the fund designates long and short positions and receives the net performance on these reference securities in substantially the same manner as if the fund had invested directly in the reference securities. 223We also discuss these and other implications of the proposed rule’s 150% exposure limitation below in section IV of this Release. A fund with exposure in excess of 150% of net assets might be able to comply with the risk-based portfolio limit, discussed below, which includes an exposure limit of 300% of net assets. We note, however, that a fund that holds only cash and cash equivalents and derivatives—like certain alternative strategy funds and leveraged ETFs—would not be able to satisfy the VaR test because, in this case, the fund’s derivatives, in aggregate, generally would add, rather than reduce, the fund’s exposure to market risk and thus generally would not result in a full portfolio VaR that is lower than the fund’s securities VaR, as required under the VaR test. See infra note 314 and accompanying text. 224 In this regard we also note that, as discussed above, the DERA staff analysis shows that approximately 73% of the sampled alternative strategy funds, which are as a group more substantial users of derivatives, had less than 150% exposure. Only those funds that used derivatives to a much greater extent than funds generally, including a limited percentage of alternative strategy funds, had exposures in excess of 150% of net assets. (and only about 2% of those funds had aggregate exposures exceeding 100% of net assets).214 None of the sampled BDCs reported any derivatives transactions, although some of them did report financial
commitment transactions (and they also had issued other senior securities).215 The sampled ETFs included alternative strategy ETFs and ETFs pursuing other strategies. Of the non-alternative strategy ETFs, only one of the sampled funds had aggregate exposure in excess of 150% of net assets, and the other sampled non￾alternative strategy ETFs with relatively higher exposures had exposures of approximately 100% of net assets.216 With respect to alternative strategy ETFs, the sampled funds with the highest exposures were leveraged ETFs; several of these funds had aggregate exposure exceeding 150% of net assets, with exposure ranging up to approximately 280% of net assets.217 Based on this analysis we believe that, except for alternative strategy funds and certain leveraged ETFs, most funds should be able to comply with a 150% exposure portfolio limitation without modifying their portfolios. The sampled alternative strategy funds in DERA’s analysis tended to be more significant users of derivatives.218 Fifty-two percent of the sampled alternative strategy funds had at least 50% notional exposure from derivatives, and approximately 73% of these funds had aggregate exposure that represented less than 150% of net assets.219 The approximately 73% of funds with exposure under 150% included at least one fund in every Morningstar alternative mutual fund category.220 The remaining approximately 27% of the sampled alternative strategy funds with aggregate exposure of 150% or more pursued a variety of strategies including, among others, absolute return, managed futures, unconstrained bond, and currency strategies. The funds with the highest exposures in the sample generally followed managed futures strategies. We believe the proposed 150% exposure limitation appropriately balances the proposed rule’s effects on funds and their investors, on the one hand, with the concerns we discuss above concerning funds’ ability to obtain leverage and incur obligations through derivatives transactions (and other senior securities transactions), on the other. The information provided in the DERA staff analysis indicates, as discussed above, that most funds in the DERA random sample would be able to comply with a 150% exposure limit without modifying their portfolios. The analysis also indicates that alternative strategy funds, the heaviest users of derivatives in the DERA random sample, generally would be able to continue to operate and to pursue a variety of alternative strategies. As noted above, approximately 73% of the sampled alternative strategy funds had less than 150% exposure and included funds in every alternative mutual fund category.221 The majority of the sampled ETFs also had exposures of 150% or less of net assets. Our staff’s analysis indicates that it should be possible to pursue, in some form, almost all existing types of investment strategies in compliance with a 150% exposure limitation.222 We recognize, however, that particular funds, including particular
alternative strategy funds and certain leveraged ETFs, would need to modify their portfolios to reduce their use of derivatives in order to comply with a 150% exposure limitation, and that these funds may view it to be disadvantageous or less efficient to reduce their use of derivatives and the potential returns that they may seek to obtain from such derivatives.223 On balance, however, we believe a 150% limit provides an appropriate amount of flexibility for funds to engage in derivatives transactions in reliance on the exemption the proposed rule would provide, which otherwise would be prohibited for mutual funds by section 18 (and limited for other types of funds).224 We believe it is appropriate, and consistent with the investor protection concerns underlying section 18, for funds that engage in derivatives securities transactions in reliance on the exemption that would be provided by proposed rule 18f–4 to be subject to an exposure limit, given that exposures resulting from borrowings and other senior securities are also subject to a limit under section 18. Funds with exposure in excess of the proposed 150% limit thus would have to reduce their exposure in order to rely on the rule. We recognize that a very small percentage of funds may find it difficult to modify their portfolios in order to comply with the proposed 150% exposure limit while pursuing their current strategies. Some managed futures funds and currency funds, for example, pursue their strategies almost exclusively through derivatives transactions, with the funds’ assets generally consisting of cash and cash equivalents. For example, four funds in DERA’s sample had exposures in excess of 500% of net assets, and three of them were managed futures funds, with exposures ranging up to approximately 950% of net assets. These funds may find it impractical to reduce their exposures below the

225We note that managed futures funds account for approximately 3% of alternative mutual fund assets under management, and 0.09% of mutual fund assets under management. We thus expect that, although the proposed rule would have a greater effect on managed futures funds than most other types of funds, the effect would be small relative to alternative fund assets under management, and especially small relative to overall mutual fund assets under management. 226The applicants did not seek, and their orders do not provide, any exemption from the requirements of section 18. The proposed rule, if adopted, would prohibit funds, including leveraged ETFs, from obtaining exposure in excess of the proposed rule’s exposure limits. 227ProShares Trust, et al., Investment Company Release Nos. 27323 (May 18, 2006) (notice) and 27394 (June 13, 2006) (order). 228 In this Release we generally refer to ETFs that seek to achieve performance results, over a specified period of time, that are a multiple of or inverse multiple of the performance of an index or benchmark collectively as ‘‘leveraged ETFs.’’ 229Rydex ETF Trust, et al., Investment Company Release Nos. 27703 (Feb. 20, 2007) (notice) and 27754 (Mar. 20, 2007) (order); Rafferty Asset Management, LLC, et al., Investment Company Release Nos. 28379 (Sept. 12, 2008) (notice) and 28434 (Oct. 6, 2008) (order). See also ProShares Trust, et al., Investment Company Release Nos. Investment Company Release Nos. 28696 (Apr. 14,
2009) (notice) and 28724 (May 12, 2009) (order)
(amending the applicant’s prior order); Rafferty Asset Management, LLC, et al., Investment Company Release Nos. 28889 (Aug. 27, 2009) (notice) and 28905 (Sept. 22, 2009) (order) (amending the applicant’s prior order). These orders (as amended) relate to leveraged ETFs that seek investment results of up to 300% of the return (or inverse of the return) of the underlying index. 230 Investor Alert and Bulletins, Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors (Aug. 18, 2009), available at http://www.sec.gov/investor/pubs/ leveragedetfs-alert.htm. FINRA also has sanctioned a number of brokerage firms for making unsuitable sales of leveraged and inverse ETFs. See, e.g., FINRA News Release, FINRA Orders Stifel, Nicolaus and Century Securities to Pay Fines and Restitution Totaling More Than $1 Million for Unsuitable Sales of Leveraged and Inverse ETFs, and Related Supervisory Deficiencies (Jan. 9, 2014), available at https://www.finra.org/newsroom/2014/ finra-orders-stifel-nicolaus-and-century-securities￾pay-fines-and-restitution-totaling; see also FINRA News Release, FINRA Sanctions Four Firms $9.1 Million for Sales of Leveraged and Inverse Exchange-Traded Funds (May 1, 2012), available at https://www.finra.org/newsroom/2012/finra￾sanctions-four-firms-91-million-sales-leveraged￾and-inverse-exchange-traded. Following losses incurred by certain ETF investors during 2008– 2009, a lawsuit was brought against one of the sponsors of leveraged ETFs alleging that the funds’ registration statements contained material misstatements or omissions. The Circuit Court of Appeals for the Second Circuit affirmed the district court’s dismissal of the plaintiffs’ claims. In affirming, the court noted, among other things, that, as a disclosure matter, ‘‘[a]ll the ProShares I prospectuses make clear that ETFs used aggressive financial instruments and investment techniques that exposed the ETFs to potentially ‘dramatic’ losses ‘in the value of its portfolio holdings and imperfect correlation to the index underlying.’ ’’ In re ProShares Trust Securities Litigation, 728 F.3d 96 (2d Cir. 2013) (internal citations omitted). 231See SEC Press Release 2010–45, SEC Staff Evaluating the Use of Derivatives by Funds (Mar. 25, 2010), available at http://www.sec.gov/news/ press/2010/2010-45.htm. 232See Derivatives Use by Actively-Managed ETFs (Dec. 6, 2012), available at http://www.sec. gov/divisions/investment/noaction/2012/ moratorium-lift-120612-etf.pdf (announcing that the staff will no longer defer consideration of exemptive requests under the Act relating to actively-managed ETFs that make use of derivatives provided that they include representations to address some of the concerns expressed in the March 2010 press release). 233See section IV below for a discussion of possible effects associated with funds’ decision to deregister under the Investment Company Act and for their sponsors to offer the fund’s strategy as private funds or
commodity pools. proposed limit of 150%.225 As we discussed above in section II.D.1 of this Release, however, funds with derivatives notional exposures of almost ten times net assets and having the potential for additional exposures do not appear to be subject to a practical limit on leverage as we contemplated in Release 10666. Certain ETFs and mutual funds expressly use derivatives to achieve performance results, over a specified period of time, that are a multiple of or inverse multiple of the performance of an index or benchmark. Certain of these funds have derivatives exposures exceeding 150% of net assets (e.g., a fund that seeks to deliver two or three times the inverse of a benchmark and achieves this exposure through derivatives transactions), as reflected in the DERA sample and noted above. These funds are sometimes referred to as trading tools because they seek to provide a specific level of leveraged exposure to a market index over a fixed period of time (e.g., a single trading day). Initially only certain mutual funds pursued these strategies. Today, most of these funds are ETFs operating pursuant to exemptive orders granted by the Commission that provide relief from certain provisions of the Act other than
section 18.226 The first exemptive order
that contemplated leveraged ETFs, which was issued by the Commission in 2006,227 stated that the applicants intended to operate ETFs that would seek investment results of 125%, 150%, or 200% of the return of the underlying securities index on a daily basis (or an inverse return of 100%, 125%, 150%, or 200% of such index on a daily basis).228 Subsequent orders were issued for two other ETF sponsors seeking to launch and operate leveraged ETFs, some of which involved higher amounts of leverage.229 No exemptive orders for leveraged ETFs have been issued since 2009. The Commission and the staff have continued to consider funds’ use of derivatives, including the use of derivatives by ETFs and leveraged ETFs. In August 2009, the staff of our Office of Investor Education and Advocacy and FINRA jointly issued an Investor Alert regarding leveraged ETFs, expressing certain concerns regarding such ETFs.230 In March 2010, we issued a press release announcing that the staff was conducting a review to evaluate the use of derivatives by registered investment companies, including ETFs, and we indicated that, pending completion of this review, the staff would defer consideration of exemptive requests under the Act relating to ETFs that would make significant investments in derivatives.231 Although the staff is no longer deferring consideration of exemptive requests under the Act relating to all actively-managed ETFs that make use of derivatives,232 the staff continues not to support new exemptive relief for leveraged ETFs. Funds that do not wish to rely on the proposed rule may wish to consider deregistering under the Investment Company Act, with the fund’s sponsor offering the fund’s strategy as a private fund or as a public (or private) commodity pool, which do not have statutory limitations on the use of leverage.233 These alternative fund structures would be marketed to a more targeted investor base (i.e., those with higher incomes or net worth, in the case of private funds, and those familiar with commodity pool investment partnerships, in the case of public commodity pools) and would not be expected by their investors to have the protections provided by the Investment Company Act. We also note that our staff has observed that certain of these highly leveraged funds (e.g., managed futures funds) often do not make significant investments in securities and the securities investments they do make generally do not meaningfully contribute to their returns. We request comment on all aspects of the proposed exposure-based portfolio limit of 150% of a fund’s net assets.

• Is 150% an appropriate exposure
  limit? If not, should it be higher or lower, for example 200% or 100%? Does the 150% exposure limit, together with the rule’s other limitations, achieve an appropriate balance between providing flexibility and limiting the amount of leverage a fund could obtain (and thus the potential risks associated with leverage)? Does the 150% exposure limit effectively address the varying ways in which funds use derivatives, including for hedging purposes?
• Are certain types of funds likely to
  use the 150% exposure limit exclusively for leveraging purposes? If so, do commenters believe that such a level of exposure would be inappropriate? Should any concerns about a fund using

234See supra notes 34–36 and accompanying text. derivatives transactions exclusively for leveraging purposes be addressed through a reduced exposure limitation? Conversely, would the other conditions and requirements of the rule, including the requirement to have a derivatives risk management program meeting specified requirements (discussed in
section III.D below), address concerns
regarding the leverage that the fund might be able to obtain under the 150% exposure limit, in light of the policy concerns underlying section 18 of the Act?

• Do commenters agree that the
  proposed 150% exposure limitation appropriately balances concerns regarding, on the one hand, the extent to which the exposure limit would affect funds’ investment strategies and, on the other hand, section 18’s limitations on the issuance of senior securities and the concerns we discuss above concerning funds’ ability to obtain leverage through derivatives transactions and other senior securities transactions?
• As discussed above, our staff’s
  analysis indicates that certain funds, including certain alternative funds, today have exposures exceeding 150% of their net assets. What types of modifications would these funds be required to make and how would the modifications affect their investors? Would they be able to make such modifications? Are there other types of funds that also would expect to have exposure exceeding 150%? If so, what kinds of funds and what types of modifications would they be required to make and how would the modifications affect their investors? What types of costs would funds that need to modify their investment strategies in order to comply with the 150% limit be likely to incur? Would funds that would be required to make modifications to comply with a 150% exposure limit generally be able to follow the same investment strategy as they do today after making any modifications? How would such modifications likely affect such funds?
• What types of funds would be
  unable to modify their investment program in order to comply with the 150% exposure limit? Would these funds be likely to continue their investment programs as private funds or public (or private) commodity pools? What would be the effects, positive and negative, on the funds’ investors in these cases?
• The 150% exposure limit (and the
  300% exposure limit in the risk-based portfolio limit) would apply to all funds without regard to the type of fund or the fund’s strategy. Are there certain types of funds for which a higher or lower exposure limit would be appropriate? Æ Should we consider a higher limit for ETFs (or other funds) that seek to replicate the leveraged or inverse performance of an index? Would a higher exposure limit be appropriate for these funds because they may operate as trading tools that seek to provide a specific level of leveraged exposure to a market index over a fixed period of time, and because the amount of leverage is an integral part of their strategy? Conversely, do those same considerations suggest that these funds—which are not restricted to sophisticated investors—should be subject to the same exposure limitations as other types of funds? Some of these funds are ETFs that operate pursuant to exemptive orders granted by the Commission. Would it be more appropriate to consider these funds’ use of derivatives transactions in the exemptive application context, based on the funds’ particular facts and circumstances, rather than in rule 18f– 4, which would apply to funds generally? Would the exemptive application process be a more appropriate way to evaluate these funds in order to consider their use of leverage together with other features of these products (such as their objective of seeking daily returns) that are not shared by funds generally? Æ As discussed in more detail above, some managed futures funds and currency funds pursue their strategies almost exclusively through derivatives transactions, with the funds’ other assets generally consisting of cash and cash equivalents. Managed futures and currency funds with derivatives exposures substantially in excess of the funds’ net assets may find it impractical to reduce their exposures below the proposed limit of 150%. Do commenters agree that it may be feasible, for the reasons discussed above, for funds that do not wish to rely on the proposed rule to deregister under the Investment Company Act and for the fund’s sponsor to offer the fund’s strategy as a private fund (which can be offered solely to a limited range of investors) or as a public or private commodity pool? Are these alternatives, which do not have statutory limitations on the use of leverage, feasible vehicles for these types of strategies? Conversely, should we permit managed futures or currency funds (or other specified fund categories) to obtain exposure in excess of 150% of the funds’ net assets under the exposure-based portfolio limit? If so, what limit and what other restrictions or limitations on their use of derivatives would be appropriate? Are there ways that we could permit such funds to obtain additional exposure while still addressing the undue speculation concern expressed in section 1(b)(7) and the asset sufficiency concern expressed in section 1(b)(8)? How could we permit such funds to obtain additional exposure while
  also imposing an effective limit on leverage and on the speculative nature of such funds? Æ Section 61 permits a BDC to issue senior securities to a greater extent than other types of funds in that BDCs are subject to a lower asset coverage requirement of 200% (as opposed to the 300% asset coverage requirement that applies to other types of funds).234 The proposed rule would not restrict the ability of a BDC to continue to issue senior securities pursuant to section 61 subject to a 200% asset coverage requirement. The proposed rule would, however, require a BDC that engages in derivatives transactions in reliance on the proposed rule to comply with the rule’s aggregate exposure limitations, which would include exposure associated with senior securities issued by a BDC pursuant to section 61 (as well as exposure from financial commitment transactions entered into by a BDC pursuant to the proposed rule). Should the proposed rule provide BDCs greater exposure limits under the rule in recognition of the greater latitude that BDCs have to issue senior securities provided by section 61? Would any increase be needed given that our staff’s review suggests BDCs do not use derivatives to any material extent? Æ Are there other types of funds for which, or circumstances under which, we should provide higher or lower exposure limits? What kinds of funds or circumstances and why? Should we provide for differing exposure limits based on characteristics of the fund’s derivatives? Which characteristics and how should they affect the level of exposure the fund should be permitted to obtain? Æ Should we grandfather funds that are operating in excess of the proposed rule’s portfolio limits as of a specified date? If we were to grandfather funds, which funds should we grandfather and why? Should we apply any grandfathering to funds that are operating on the date of this proposal, for example? Alternatively, should we, for example, grandfather leveraged ETFs on the basis that they operate pursuant to the terms and conditions of exemptive orders granted by the Commission? If we were to grandfather funds, should the grandfathering be subject to conditions? Should any

235See infra note 244. The proposed rule would, however, permit a fund to net certain transactions when determining its exposure, as noted above, where the transactions to be netted are directly offsetting derivatives that are the same type of instrument and have the same underlying reference asset, maturity and other material terms. See proposed rule 18f–4(c)(3)(i). 236As discussed in section IV.E, the CESR commitment approach for UCITS funds permits funds to reduce their calculated derivatives exposure for certain netting and hedging transactions, while providing for a lower exposure limit (100% of net assets) than the proposed rule. We note, however, that the challenges of distinguishing between hedging and speculative activity have been considered in numerous regulatory and financial contexts. One recent regulatory example is the exemption for certain risk-mitigating hedging activities from the prohibition on proprietary trading by banking entities in the final rules implementing section 13 of the Bank Holding Company Act (commonly known as the ‘‘Volcker Rule’’). See Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, Release No. BHCA–1 (Dec. 10, 2013) [79 FR 5536 (Jan. 31, 2014)] (‘‘Volcker Rule Adopting Release’’), at 5629, 5627. The complexity of distinguishing hedging from speculation in this context is notable because the exemption is designed for entities that would not otherwise be engaged in speculative activity. We believe it would be even more difficult to make such a distinction in the context of funds that in the ordinary course are permitted, and often likely, to use derivatives for both speculative and hedging purposes. 237See, e.g., MFDF Concept Release Comment Letter, at 4 (noting that ‘‘in recent years, funds have adopted more complex and more nuanced investment strategies, and thus are using derivatives—and sometimes the same type of derivative—in many different ways, including as a way of hedging and mitigating other risks present in fund portfolios. Therefore, any detailed and purportedly all-inclusive approach to regulations governing funds’ use of derivatives is almost necessarily destined to be out-of-date the moment it is issued.’’). 238See, e.g., Federal Reserve Bank of Chicago, Understanding Derivatives: Markets and Infrastructure (Aug. 2013), available at https:// www.chicagofed.org/publications/understanding– derivatives/index, at 27–28 (noting that exchange￾traded contracts often give rise to basis risk, i.e., the risk that arises when ‘‘the exposure to the underlying asset, liability or commodity that is being hedged and the hedge contract (the derivatives contract) are imperfect substitutes’’ and that mitigating basis risk may necessitate OTC derivatives that can be tailored to meet specific requirements). 239One commenter to the Concept Release offered the following hypothetical: A fund holds euro￾denominated shares with a
market value of Ö2 million and hedges against exchange rate fluctuations by entering into a 3-month forward contract to sell Ö2 million for $2.75 million. If the euro value of the shares falls below the notional amount of the currency contract, then it could be viewed as a form of investment leverage, but the alternative—requiring the fund to continuously adjust its hedge to match the value of its security position—could be prohibitively expensive and contrary to the best interest of the fund’s shareholders. See Keen Concept Release Comment Letter, at 11. 240See Dreyfus No-Action Letter, supra note 55. See also Concept Release, supra note 3, at nn.70– 71 and accompanying text (discussing circumstances under which the staff has provided guidance with respect to whether certain ‘‘obligations may be covered by funds transacting in futures, forwards, written options, and short sales’’). 241 In contrast to the types of hedging (or risk￾mitigating) or cover transactions that we discuss in this section, we believe that the proposed rule’s netting provision is sufficiently limited in scope and purpose such that allowing netting would be unlikely to raise the concerns discussed in this
section. See supra section III.B.1.b.i.2.
242See ICI Concept Release Comment Letter, at 14. grandfathered funds be required to comply with some, but not all, aspects of the proposed rule? For example, should they be required to comply with the proposed rule’s asset segregation requirements and the requirement to have a formalized derivatives risk management program? Should they be required to comply with any other conditions? d. Treatment of Hedging and Cover Transactions We believe that the 150% exposure￾based portfolio limit would permit funds to engage in derivatives transactions to an extent that we believe is appropriate when done in compliance with the proposed rule’s other conditions, and would permit a fund relying on the rule to use derivatives for a variety of purposes under the proposed rule, including to seek to hedge or mitigate risks. We have not separately included any provision in the proposed rule to permit a fund to reduce its exposure for purposes of the rule’s portfolio limitations for particular derivatives transactions that may be entered into for hedging (or risk￾mitigating) purposes or that may be ‘‘cover transactions’’ as described below.235 We believe that the DERA staff analysis, discussed in section III.B.1.c, suggests that such a reduction is not necessary in order to permit the use of derivatives for hedging or risk￾mitigating purposes because most of the funds in DERA’s sample did not have aggregate exposure in excess of 150% of net assets. In addition, while we expect that the proposed rule’s exposure limitation would be applied relatively consistently across funds, we believe that providing for a hedging reduction may hinder our efforts toward establishing a consistent and effective approach toward the regulation of funds’ use of derivatives, and that the exposure limits under the proposed rule are more easily administrable than some other potential alternatives that could entail a more tailored approach. One substantial concern regarding any hedging or cover transaction exception is that we believe it would be difficult to develop a suitably objective standard for these transactions, and that confirming compliance with any such standard would be difficult, both for fund compliance personnel and for our staff.236 Our staff has noted that funds may enter into a variety of derivatives transactions based on their portfolio managers’ views of the expected performance correlations between such transactions and other investments (including other derivatives instruments) made by the funds, and these relationships may be difficult to describe effectively and comprehensively in an exemptive rule of general applicability such as the proposed rule.237 In addition, many hedges are imperfect,238 which makes it difficult to distinguish purported hedges from leveraged or speculative exposures. For example, while a fund might use interest rate or currency derivatives primarily for hedging particular investments, the same instruments could be used by the fund to obtain,
or could inadvertently result in, leveraged or speculative exposures in a fund’s portfolio.239 The Concept Release sought comment on the ‘‘cover transaction’’ alternative to liquid asset segregation first addressed by our staff in the Dreyfus Letter as a means of limiting a fund’s leverage and risk of loss from derivatives.240 In the Dreyfus Letter, our staff stated that it would not object to a fund covering its obligations by entering into certain other transactions that were intended to position the fund to meet its obligations under the derivatives transaction to be covered or by holding the asset (or the right to acquire the asset) that the fund would be required to deliver under certain derivatives, rather than following the segregated account approach set forth in Release 10666. While commenters to the Concept Release generally argued for retaining the flexibility offered by the cover transaction approach, they also raised numerous issues that demonstrate the difficulties in identifying transactions that should be viewed as providing adequate coverage.241 One commenter noted that, although entering into cover transactions ‘‘can mitigate the potential for loss and thus the effect of indebtedness leverage,’’ the determination of which transactions actually offset others can be ‘‘very complicated.’’ 242 Other issues raised by commenters and in the 2010 ABA Derivatives Report included: Whether transactions involving two different counterparties could provide adequate cover for each other; whether positions that are ‘‘substantially correlated’’ could offset each other; whether transactions

243See, e.g., ICI Concept Release Comment Letter, at 14; 2010 ABA Derivatives Report, at 19; Oppenheimer Concept Release Comment Letter, at 5; SIFMA Concept Release Letter, at 8. 244See, e.g., T. Rowe Price Concept Release Comment Letter, at 3 (‘‘Under a principles-based approach, the SEC should also acknowledge that it is possible for a fund to conclude that in certain cases, transactions that are not identical can be offset for coverage purposes (factors that may impact this conclusion are the credit quality of the counterparties, expected correlation between the two transactions, etc.’’). 245AQR Concept Release Comment Letter, at 4. 246Proposed rule 18f–4(a)(1)(ii). 247See section 1(b)(7) of the Investment Company Act; see also supra section II.B. 248See, e.g., BlackRock Concept Release Comment Letter, at 25 (noting ‘‘the use of a derivative to mitigate some or all of the risk inherent in physical positions held in a fund portfolio, such as purchase of a put option on a stock ‘to provide downside price protection, use of an interest rate swap to shorten the duration of a bond portfolio or the sale of a currency forward to reduce the currency exposure of a bond denominated in a currency other than US dollars’’); ICI Concept Release Comment Letter, at 25 (‘‘[f]ixed income funds frequently use derivatives to structure and control duration, yield curve, sector, and/or credit exposures’’). that are ‘‘demonstrably fully or partially offsetting’’ could cover each other; and whether the cover transaction approach extended to, or should be extended to, other transactions not addressed in the Dreyfus Letter, such as whether a currency forward could be covered with a currency swap, or whether a written CDS could be covered by holding the underlying reference bond.243 Some commenters endorsed a ‘‘principles-based approach’’ to these questions, broadly advocating that we allow funds to determine which transactions should be deemed to cover the exposure of another derivatives transaction.244 Our staff has found through examinations that funds have expanded their reliance on a cover transaction approach for a variety of different strategies involving written and purchased options and long and short futures, which in the staff’s view raises concerns regarding whether the risks under such complex combinations of derivatives are in fact covered. We note in this regard that an incorrect determination that two or more transactions are actually covered could leave a fund unprotected against the risks relating to these transactions and could result in undue speculative activity. A principles-based approach to these issues could also implicate a concern raised by one commenter that ‘‘different funds could end up with different determinations, perhaps some taking more aggressive positions to allow for greater use of derivatives to drive performance.’’ 245 We therefore do not believe it would be appropriate to permit funds broad discretion under the proposed rule to
determine, based on their own interpretations, the types of derivatives transactions that should be exempt from the restrictions underlying
section 18 based on their different
characteristics purportedly covering the risks associated with other derivatives transactions. For all of these reasons, we believe it would be more effective to provide for a 150% exposure-based portfolio limit that we believe would provide funds sufficient flexibility to use derivatives for a variety of purposes, including to hedge or mitigate risks as discussed above, rather than proposing a lower exposure limit that includes exceptions for potentially hedging or cover transactions. We request comment on our determination not to provide for exclusions for hedging and offsetting transactions in the proposed rule.

• As discussed above, the proposed
  rule generally would not permit a fund to reduce its exposure for purposes of the rule’s portfolio limitations for particular types of potentially hedging, risk-mitigating or cover transactions, and instead would seek to provide funds sufficient flexibility to engage in these transactions by permitting a fund to have exposure of up to 150% of net assets (or 300% under the risk-based limit discussed below). Do commenters agree that this is an appropriate approach?
• Should we, instead, reduce the
  amount of aggregate exposure a fund would be permitted to obtain but permit funds to reduce their exposure for particular derivatives transactions that are entered into for hedging or risk￾mitigating purposes or that are cover transactions? If we were to take this approach, what would be an appropriate exposure limit? Should we, for example, limit a fund’s exposure under this approach to 100% of the fund’s net assets? Would it be possible to provide comprehensive guidance or prescribe in a rule the types of transactions that appropriately should be permitted to reduce a fund’s exposure without requiring the kinds of instrument-by￾instrument determinations required under the current approach? If so, how?

2. Risk-Based Portfolio Limit
   As an alternative to the exposure￾based portfolio limit, the proposed rule includes a risk-based portfolio limit that would permit a fund to enter into derivatives transactions, and obtain exposure in excess of that permitted under the exposure-based portfolio limit, if the fund complies with the VaR￾based test described below (the ‘‘VaR test’’). The risk-based portfolio limit, including the VaR test, is designed to provide an indication of whether a fund’s derivatives transactions, in aggregate, have the effect of reducing the fund’s exposure to market risk, as measured by the VaR test. A fund that elects the risk-based portfolio limitation under the proposed rule would also be subject to an exposure limit, but would be permitted to obtain exposure under its derivatives transactions and other senior securities transactions of up to 300% of the fund’s net assets.246 As discussed in section II.B above, the concerns underlying section 18 include the undue speculation concern expressed in section 1(b)(7) of the Act that ‘‘excessive borrowing and the issuance of excessive amounts of senior securities’’ may ‘‘increase unduly the speculative character’’ of a fund’s common stock.247 As we noted in Release 10666, leveraging a fund’s portfolio through the issuance of senior securities ‘‘magnifies the potential for gain or loss on monies invested’’ and therefore ‘‘results in an increase in the speculative character’’ of the fund’s outstanding securities. Section 18 seeks to address this concern by limiting the obligations a fund could incur through senior securities transactions. However, although derivatives transactions involve the issuance of senior securities, funds can use derivatives in ways that may not necessarily magnify a fund’s potential for gain or loss, or result in an increase in the speculative character of the fund. For example, commenters have indicated that some fixed-income funds use a range of derivatives, including CDS, interest rate swaps, swaptions and futures, and currency forwards, and that these derivatives are being used, in part, to seek to mitigate the risks associated with a fund’s bond investments, or to achieve particular risk targets, such as a specified duration.248 Such strategies, or other strategies that funds currently use or may develop in the future, may involve the use of derivatives that, in the aggregate, have relatively high notional amounts, but which are used in a manner that could be expected to reduce a fund’s potential for gain or loss due to market movements and thereby result in a fund being less speculative than if the fund did not use derivatives. We believe that it may be appropriate for a fund to be able to obtain exposure in excess of that permitted under a portfolio limitation focused solely on the level of a fund’s exposure where the fund’s use of derivatives, in aggregate,

249As used in this Release, ‘‘market risk’’ refers to the risk of financial loss resulting from movements in market prices, and includes both general market risk, which refers to the risk associated with movements in the markets as a whole, and specific market risk, which refers to the risk associated with movements in the price of a particular asset. See, e.g., Edward Platen & Gerhard Stahl, A Structure for General and Specific Market Risk, 18 Computational Statistics 355 (Sept. 2003), available at http://www.fe-tokyo.kier.kyoto-u.ac.jp/ symposium/platen/sympo_platen_02.pdf.; see also Gregory Brown & Nishad Kapadia, Firm-Specific Risk and Equity Market Development, 84 J. of Fin. Econ. 358 (May 2007), available at http:// www.sciencedirect.com/science/article/pii/ S0304405X06002145. 250We believe that the inclusion of the risk-based alternative in the proposed rule, and in particular its use of the VaR test, is consistent with the views expressed by some commenters to the Concept Release and the FSOC Notice suggesting that concerns about leverage be addressed by using risk￾based measures, such as VaR, as an alternative or supplement to traditional leverage metrics. See, e.g., Comment Letter of Nuveen Investments to the FSOC Request for Comment (Mar. 25, 2015) (‘‘Nuveen FSOC Comment Letter’’), available at http://www.regulations.gov/ #!documentDetail;D=FSOC-2014-0001-0051, at 6–7 (noting the firm’s use of ‘‘different tools to measure the effects of leverage and its accompanying risks,’’ and noting, when using VaR, that ‘‘[i]t is helpful, for example, to ‘‘determine the VaR of a fund’s portfolio both before and after the addition of leverage, to compare both the unleveraged and leveraged metrics to those of the benchmark’’); Oppenheimer Concept Release Comment Letter, at 3 (advocating for ‘‘the use of VaR for measuring and mitigating the potential exposure and risks of derivatives in an investment company’s portfolio for funds making sophisticated and extensive use of derivatives’’). Some commenters also suggested the use of VaR as a means of determining asset segregation requirements for funds. See, e.g., SIFMA Concept Release Comment Letter, at 7; BlackRock Concept Release Comment Letter, at 5; ICI Concept Release Comment Letter, at 12. 251Proposed rule 18f–4(a)(1)(ii). 252Proposed rule 18f–4(c)(11)(i)(B). 253Proposed rule 18f–4(c)(11)(i)(A). Although the proposed rule uses the term ‘‘securities VaR,’’ some instruments that a fund could hold, and that would need to be included in the fund’s securities VaR, may not be ‘‘securities’’ for all purposes under the federal securities laws. For example, a fund’s securities VaR would include any direct holdings of non-U.S. currencies. A fund’s securities VaR would also include derivative instruments that do not entail a future payment obligation for a fund (and thus are not ‘‘derivatives transactions’’ as defined in the rule), such as most purchased options. 254Proposed rule 18f–4(c)(11). See, e.g., Form
PF (defining VaR as ‘‘[f]or a given portfolio, the loss over a target horizon that will not be exceeded at some specified confidence level’’). See also Volcker Rule Adopting Release, supra note 236, at
Appendix A (defining Value-at-Risk as ‘‘the
commonly used percentile measurement of the risk of future financial loss in the value of a given set of aggregated positions over a specified period of time, based on current market conditions.’’ See also Darrell Duffie & Jun Pan, An Overview of Value at Risk, 4 The J. of Derivatives 7 (Spring 1997) (‘‘For a given time horizon t and confidence level p, the value at risk is the loss in market value over the time horizon t that is exceeded with probability 1– p’’). See also Michael Minnich, Perspectives on Interest Rate Risk Management for Money Managers and Traders (Frank Fabozzi, ed.) (‘‘Minnich’’), at 39 (‘‘VAR can be defined as the maximum loss a portfolio is expected to incur over a specified time period, with a specified probability’’). 255See Kevin Dowd, An Introduction to Market Risk Measurement (Oct. 2002) (‘‘Dowd’’), at 10 (VaR ‘‘provides a common consistent measure of risk across different positions and risk factors. It enables us to measure the risk associated with a fixed￾income position, say, in a way that is comparable to and consistent with a measure of the risk associated with equity positions’’). See also Zvi Weiner, Introduction to VaR (Value-at-Risk) (‘‘Weiner’’) (May 1997), available at http:// pluto.mscc.huji.ac.il/∼mswiener/research/ Intro2VaR3.pdf (noting that VaR provides ‘‘an integrated way to deal with different markets and different risks and to combine all of the factors into a single number’’ that indicates the overall risk level). 256See Weiner, supra note 255. 257See id. We have proposed to require certain funds to report some of these metrics on proposed Form N-PORT, such as portfolio-level duration (DV01 and SDV01) and position-level delta, because we believe that such information would be useful to the Commission and to investors. See Investment Company Reporting Modernization Release, supra note 138. 258See, e.g., Katerina Simons, The Use of Value at Risk by Institutional Investors (‘‘Simons’’), New Eng. Econ. Rev. 21 (Nov./Dec. 2000), available at http://www.bostonfed.org/economic/neer/neer2000/ neer600b.pdf (noting that VaR is ‘‘particularly has the effect of reducing the fund’s exposure to market risk.249 The risk-based alternative under the proposed rule therefore is designed to provide an alternative portfolio limitation that focuses primarily on a risk assessment of a fund’s use of derivatives, in contrast to the exposure￾based portfolio limit, which focuses solely on the level of a fund’s exposure.250 The risk-based portfolio limit reflects our belief that if a fund’s use of derivatives, in the aggregate, can reasonably be expected to result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives—if the fund’s derivatives use reduces rather than magnifies the potential for loss from market movements—then the fund’s derivatives use is also less likely to implicate the undue speculation concern expressed in section 1(b)(7). As discussed further below, we
believe that the VaR test would be an appropriate way to evaluate if a fund’s derivatives use, in the aggregate, decreases the fund’s overall exposure to market risk, and that it therefore may be appropriate for the proposed rule to allow a fund that satisfies the VaR test to have greater exposure under its derivatives transactions than would be permitted for a fund operating under the exposure￾based portfolio limit. a. VaR Test Under the Risk-Based Portfolio Limit To satisfy the VaR test under the risk￾based portfolio limit, a fund’s full portfolio VaR would have to be less than the fund’s securities VaR immediately after the fund enters into any senior securities transaction.251 A fund’s ‘‘full portfolio VaR’’ would be defined as the VaR of the fund’s entire portfolio, including securities, derivatives transactions and other investments.252 A fund’s ‘‘securities VaR’’ would be defined as the VaR of the fund’s portfolio of securities and other investments, but excluding any derivatives transactions.253 As explained below, we believe that the determination by a fund that its full portfolio VaR is less than its securities VaR would be an appropriate indication that the fund’s derivatives use, in the aggregate, decreases the fund’s overall exposure to market risk. The proposed rule defines VaR as ‘‘an estimate of potential losses on an instrument or portfolio, expressed as a positive amount in U.S. dollars, over a specified time horizon and at a given confidence level,’’ which we believe is generally consistent with definitions of VaR that are used in other regulatory regimes as well as in academic literature.254 While VaR can be calculated using several different approaches and a wide range of parameters (as discussed further below), VaR has certain characteristics that we believe make it an appropriate metric, when used as part of the VaR test, for assessing the effect of derivatives use on a fund’s exposure to market risk. First, VaR generally enables risk to be measured in a comparable and consistent manner across diverse types of instruments that may be included in a fund’s portfolio, and provides a means of integrating the market risk associated with different instruments into a single number that provides an overall indication of market risk.255 By contrast, many other risk metrics used by funds are suited to particular categories of instruments and, given the diverse investment portfolios of many funds, may be less suitable as a means of assessing risk for purposes of the risk￾based alternative under the proposed rule.256 For example, risk measures for government bonds can include duration, convexity and term-structure models; for corporate bonds, ratings and default models; for stocks, volatility, correlations and beta; for options, delta, gamma and vega; and for foreign exchange, target zones and spreads.257 Because proposed rule 18f-4 is intended to apply generally to all funds that use derivatives, however, and because VaR can be
applied across diverse types of instruments that may be included in the portfolios of funds that pursue different strategies, we believe that VaR is a more appropriate metric for purposes of the proposed rule.258

useful’’ for an investor that ‘‘has a multi-asset-class portfolio and needs to measure its exposure to a variety of risk factors. VaR can measure the risk of stocks and bonds, commodities, foreign exchange, and structured products such as asset-backed securities and collateralized mortgage obligations (CMOs), as well as off-balance sheet derivatives such as futures, forwards, swaps, and options.’’ See also infra section III.B.2.b. 259See Dowd, supra note 255, at 117–118 (defining incremental VaR (or ‘‘IVaR’’) as the change in VaR associated with the addition of a new position to a portfolio, and noting that ‘‘IVaR gives us an indication of how [portfolio] risks change when we change the portfolio itself. In practice, we are often concerned with how the portfolio risk changes when we take on a new position, in which case the IVaR is the change in portfolio VaR associated with adding the new position to our portfolio.’’). 260See also, e.g., Nuveen FSOC Comment Letter, at 6 (noting the firm’s use of different ‘‘tools to measure the effects of leverage and its accompanying risks,’’ and noting, when using VaR, that ‘‘[i]t is helpful, for example, to determine the VaR of a fund’s portfolio both before and after the addition of leverage, to compare both the unleveraged and leveraged metrics to those of the benchmark’’). 261By contrast, if a fund used derivatives transactions solely for the purpose of leveraging its physical portfolio—for example, by holding a long￾only portfolio of large cap equity and obtaining further exposure to those securities through a basket total return swap—the additional market risk incurred by the fund would cause the fund’s full portfolio VaR to be greater than its securities VaR. See, e.g., Jacques N. Gordon & Elysia Wai Kuen Tse, VaR: A Tool to Measure Leverage Risk, 29 The J. of Portfolio Management 62 (Summer 2003) (demonstrating how VaR increases as the degree of leverage added to a portfolio increases and noting that ‘‘[b]y comparing the value at risk of different leverage levels to the unleveraged result, we can calculate the incremental risk due to leverage’’). 262See, e.g., 1994 Report, supra note 32, at 27 (noting that the Act ‘‘imposes few substantive limits on mutual fund investments’’ and that funds ‘‘generally are permitted to make investments without regard to their volatility’’). 263See, e.g., BNY Mellon, Risk Roadmap: Hedge Funds and Investors’ Evolving Approach to Risk (Aug. 2012), available at http:// www.thehedgefundjournal.com/sites/default/files/ riskroadmap.pdf (noting that third-party administrators to hedge funds ‘‘provide advanced risk functions’’ to investors such as ‘‘[d]aily VaR analysis using multiple models’’. See also Christopher L. Culp, Merton H. Miller & Andres M. P. Neves, Value at Risk: Uses and Abuses, 10 J. of Applied Corp. Fin. 26 (Jan. 1998) (VaR is ‘‘used regularly by nonfinancial corporations, pension plans and mutual funds, clearing organizations, brokers and futures commission
merchants, and insurers’’). 264See infra section III.B.2.b. For example, fund advisers that manage UCITS funds may already be using VaR to comply with the requirements of the ‘‘relative VaR’’ and ‘‘absolute VaR’’ approaches under the UCITS regulatory scheme (discussed below in this section and in section IV.E.). See, e.g., AQR Concept Release Comment Letter (noting that the firm is ‘‘familiar with the ‘value at risk’ or VaR methodologies, both through [its] management of UCITS funds and as an effective tool for day-to-day overall firm risk management’’). Second, VaR can be used to assess the effect of the addition of a position, or group of positions, on the overall market risk of a portfolio. If the addition of a position to a portfolio increases VaR, the position can generally be viewed as adding to a fund’s exposure to market risk, while if the addition of a position decreases VaR, it can be viewed as reducing the fund’s exposure to market risk.259 We believe that these characteristics allow the VaR test to be used as a means of evaluating whether a fund uses derivatives in a manner that would be less likely to implicate the concerns underlying section 18. Section 18 does not restrict a fund’s ability to invest in securities and other investments that would be included in a fund’s securities VaR, but rather, restricts the ability of a fund to leverage its exposure to such investments by borrowing, or issuing debt or preferred equity, through senior securities. This reflects the concern that the addition of leverage generally will cause a fund to become more speculative and expose investors to potentially greater risk of loss due to market movements than if the fund were unlevered. As discussed above, a fund’s use of derivatives transactions may cause a fund to become more speculative or expose investors to greater risk of loss, but may also be used to mitigate risks in the fund’s portfolio. Whether a fund’s use of derivatives exposes the fund to greater risk or less risk than if the fund did not use derivatives requires consideration of the risk characteristics of a fund’s non￾derivatives investments and its derivatives transactions, and the interaction of the risk characteristics of these investments and transactions with each other. The VaR test provides a means for making such an assessment, by providing an indication of whether the market risk associated with a fund’s portfolio of securities and other investments exclusive of derivatives (as measured by the fund’s securities VaR), is greater than or less than the market risk associated with the fund’s portfolio as a whole (as measured by the fund’s full portfolio VaR), inclusive of derivatives transactions and taking into account the offsetting risk characteristics of different instruments in a fund’s portfolio. If a fund’s full portfolio VaR is less than its securities VaR—i.e., if the fund can satisfy the VaR test—we believe that the fund’s derivatives use, in the aggregate, can be
viewed as decreasing the fund’s overall exposure to market risk.260 In this way, we believe that a fund’s compliance with the VaR test would indicate that the fund’s derivatives transactions do not, in the aggregate, result in an increase in the speculative character of the fund, and that the fund’s use of derivatives transactions thus would be less likely to implicate the undue speculation concern expressed in
section 1(b)(7).261
We also believe permitting a fund to use derivatives transactions in these circumstances, and subject to the other requirements in the proposed rule, is broadly consistent with the policies and provisions of the Investment Company Act, which seeks to prevent funds from becoming unduly speculative by means of leveraging their assets through the issuance of senior securities, but generally does not impose limitations on a fund’s ability to invest in risky or volatile securities instruments.262 Similarly, the VaR test is designed to limit a fund’s ability to use derivatives transactions in order to address undue speculation concern expressed in
section 1(b)(7) of the Act, but does not
seek to limit the risk or volatility of the fund’s investments more generally. An additional benefit of using VaR in the risk-based portfolio limit is that, based on outreach conducted by our staff, we understand that VaR calculation tools are widely available and that many advisers already use risk management or portfolio management platforms that include VaR capability.263 We expect that the funds that would rely on the risk-based portfolio limit are funds with exposure approaching, or in excess of, the 150% exposure limit included in the exposure-based portfolio limit, and advisers to the funds that use derivatives more extensively may be particularly likely to already use risk management or portfolio management platforms that include VaR capability. Further, as discussed in section III.B.2.b below, VaR models also can be tailored in numerous ways in order to incorporate and reflect the risk characteristics of a fund’s particular strategy and investments.264 The following example demonstrates how the VaR test would be used under the proposed rule to assess whether a fund’s derivatives, in aggregate, result in an investment portfolio that is subject to more or less market risk than if the fund did not use such derivatives. Suppose that a fund has a net asset value of $100 million and holds a portfolio of non￾U.S. debt securities, and that the fund calculates the VaR of such securities, using a VaR model that meets the requirements of the proposed rule, to be $3 million. Suppose further that the fund wishes to hedge some of its credit risk by purchasing CDS, adjust its duration by entering into interest rate swaps, and enter into currency forwards both to obtain exposure to certain foreign currencies and to hedge some of

265See infra section IV.E.
266We understand that some UCITS funds also may use an absolute VaR approach, which limits the maximum VaR that a UCITS fund can have relative to its net assets, generally at 20 percent of the UCITS fund’s net assets. See section IV.E. As discussed in more detail below, we believe that our proposed rule’s use of VaR—to assess whether a fund’s derivatives as a whole directionally increase or mitigate risk, rather than to precisely estimate potential losses—may be a more effective way to use VaR to provide a risk assessment of a fund’s use of derivatives for purposes of section 18 of the Investment Company Act. 267For example, a sector-focused equity fund (e.g., focusing on financial or commodity-focused stocks) that used a broad-based large cap equity index as its benchmark under a relative VaR test could potentially fail to comply with the test if the sector experienced a period of unexpected volatility, even if the fund did not use a significant amounts of derivatives. In this case the volatility associated with the fund’s equity investments, rather than its derivatives transactions, could cause the fund to fail the relative VaR test. 268The difficulty of identifying appropriate benchmarks for purposes of assessing the performance of alternative funds illustrates some of the potential challenges that identifying an appropriate benchmark for purposes of a relative VaR test could entail. For example, our staff has noted that many alternative funds use LIBOR or a Treasury bill rate of interest plus a spread (e.g., 4 percentage points) for their performance benchmark. It has been observed, however, that although such benchmarks reflect return, they may understate risk, which raises concerns that they may not be effective for purposes of a test that would compare a fund’s VaR to a benchmark VaR. See Richard J. Harper, Absolute Tracking: Moving Past Absolute Return for Hedge Fund Benchmarking (May 2013), available at http:// www.nepc.com/writable/research_articles/file/ 2013_03_nepc_absolute_tracking_update.pdf (noting that the ‘‘fundamental problem with absolute return benchmarks’’ is that they ‘‘reflect only return’’ and ‘‘understate risk’’). 269Our staff has observed that some alternative funds use hedge fund indices for performance benchmarking, but such indices would not be appropriate for comparing a fund’s VaR to the benchmark VaR because the hedge funds included in the benchmark generally can be expected to use leverage. See id. (hedge fund benchmarks ‘‘vary widely with regard to long/short exposure, leverage, capitalization, sector focus, international diversification, and optionality’’). 270See Daisy Maxey, Benchmarking Alternative Funds an Inexact Science, Wall Street Journal (Apr. 10, 2014), available at http://www.wsj.com/articles/ SB1000142405270230405820457949359037728940 8 (citing statement from Morningstar’s director of alternative funds research that ‘‘more often than not, there is no single good measure’’ for benchmarking
alternative funds and therefore ‘‘multiple benchmarks must be used’’). 271See, e.g., James O’Brien & Pawel J. Szerszen, An Evaluation of Bank VaR Measures for Market Risk During and Before the Financial Crisis, Federal Reserve Board Staff Working Paper (Mar. 7, 2014) (‘‘[c]riticism of banks’ VaR measures became vociferous during the financial crisis as the banks’ risk measures appeared to give little forewarning of the loss potential and the high frequency and level of realized losses during the crisis period’’). See also Pablo Triana, VaR: The Number That Killed Us, Futures Magazine (Dec. 1, 2010), available at http://www.futuresmag.com/2010/11/30/var￾number-killed-us (noting 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’’). 272 In the regulatory context, VaR gained widespread usage by banks and other financial institutions following the 1996 Market Risk Amendment to the Basel II Capital Accords (the ‘‘Market Risk Amendment’’), which set forth a framework of qualitative and quantitative standards for allowing banks to determine capital charges for market risks they incurred, by using proprietary internal models. The Basel Committee on Bank Supervision (BCBS) modified this framework in 2009, by introducing an additional capital charge based on a ‘‘stressed VaR’’ calculation—that is, VaR calibrated to a period of significant financial stress. More recently, the BCBS has proposed the use of ‘‘stressed expected shortfall’’. Expected shortfall is similar to VaR but differs from VaR in that it accounts for tail risk by taking the average or expected losses beyond the specified confidence level; ‘‘stressed’’ expected shortfall refers to expected shortfall calculated using a model that is calibrated to a period of significant financial stress. The BCBS has recognized that, while it believes that a shift to stressed expected shortfall would ‘‘account[] for the tail risk in a more comprehensive manner, considering both the size and likelihood of losses above a certain threshold’’, it also presents challenges, including the difficulty of identifying a stress period using a full set of risk factors for which historical data is available and potentially greater sensitivity of expected shortfall to extreme outlier losses. See Bank for International Settlements, Basel Committee on Banking Supervision, Fundamental review of the trading book: A revised market risk framework (Oct. 2013) (‘‘BCBS Trading Book Review—Oct. 2013). 273See, e.g., Amit Mehta, Max Neukirchen, Sonja Pfetsch & Thomas Poppensieker, Managing Market Risk: Today and Tomorrow, McKinsey Working Papers on Risk, No. 32 (May 2012). its exposure to euro and yen currency risk. If the VaR of its full portfolio (i.e., its securities investments plus its derivatives transactions) immediately after entering into these derivatives transactions is less
than $3 million, the fund would comply with the risk-based portfolio limit’s VaR test. The VaR test under the risk-based portfolio limit is similar in certain ways to the ‘‘relative VaR’’ approach used by some UCITS funds. Under the relative VaR approach, the VaR of the UCITS fund’s portfolio cannot be greater than twice the VaR of an unleveraged benchmark securities index (referred to as a ‘‘reference portfolio’’).265 In contrast to the relative VaR approach for UCITS funds, the VaR test under the proposed risk-based portfolio limit would use a fund’s own portfolio of securities and other investments (exclusive of derivatives) as the baseline against which the fund’s full portfolio VaR (inclusive of derivatives) would be compared. For the reasons discussed below, we believe the proposed rule’s VaR test offers advantages over a relative VaR approach based on a hypothetical reference portfolio.266 First, we believe that the VaR test under the proposed rule is more consistent with the policies and provisions of the Investment Company Act, which restricts in section 18 a fund’s ability to issue senior securities but otherwise generally does not impose limitations on a fund’s ability to invest in risky or volatile securities investments, provided that such investments are consistent with the investment strategy described to investors. Using the fund’s own portfolio as the baseline for the VaR test under the proposed rule—and thus providing a risk assessment of the fund’s use of derivatives in the context of the fund’s investment strategy disclosed to investors, which may include risky or volatile securities— would be more consistent with the Act. A relative VaR test, by contrast, could be viewed as a limitation on risk or volatility generally—as opposed to a limitation on the issuance of senior securities—because it would measure the VaR of a fund’s portfolio, including non-senior securities investments, against a hypothetical reference portfolio, and such non-senior securities investments could cause the fund to fail a relative VaR test.267 Second, we are also concerned that under a relative VaR approach it would be difficult, in light of the wide range of fund strategies and potential benchmarks, to require funds to select benchmarks that are appropriate (particularly in connection with alternative strategies),268 are unleveraged,269 and would otherwise serve as an appropriate baseline against which the relative VaR should be measured.270 While we believe that there are significant benefits to using VaR in the risk-based portfolio limit, we also recognize that significant attention has been given (especially since the 2007– 2009 financial crisis) to the limitations of VaR and the risks of overreliance on VaR as a risk management tool.271 One widely expressed concern with VaR is that it does not adequately reflect ‘‘tail risks’’ (i.e., the size of losses that may occur on the trading days during which the greatest losses occur).272 Another concern
is that VaR calculations may underestimate the risk of loss under stressed market conditions.273 Under the proposed rule, however, VaR would be used to focus primarily on the relationship between a fund’s securities VaR and its full portfolio VaR, rather than on the absolute magnitude of the potential loss of any particular investment or the fund’s portfolio as a whole. We believe that this use of VaR— to assess whether a fund’s derivatives as a whole directionally increase or mitigate risk, rather than to precisely estimate potential losses—mitigates some of the concerns that have been

274See infra section III.B.2.b (discussing the proposed rule’s requirements concerning the VaR models that a fund would be permitted to use for purposes of the VaR test and the requirement that, regardless of which VaR model the fund chooses, the fund must use the same VaR model, and apply it consistently, in the calculation of the fund’s securities VaR and full portfolio VaR). 275See, e.g., Frank J. Ambrosio, An Evaluation of Risk Metrics, Vanguard Investment Counseling & Research (2007), available at https:// personal.vanguard.com/pdf/flgerm.pdf (discussing various risk metrics used by fund managers, including absolute risk measures such as standard deviation (the degree of fluctuation in a portfolio’s return), risk of loss (the percentage of outcomes below a certain total return level) and shortfall risk (the probability that an investment’s value will be less than is needed to meet portfolio objectives), and relative risk measures such as excess return (a security’s return above or below that of a benchmark or risk-free asset), tracking error (the standard deviation of excess return), Sharpe ratio (a measurement of how much return is being obtained for each theoretical unit of risk), information ratio (the risk-adjusted return of a portfolio versus a benchmark), beta (the magnitude of an investment’s price fluctuations relative to the ups and downs of the overall market) and Treynor ratio (the risk￾adjusted return of a portfolio or security versus the market). 276As discussed below in section III.D, the proposed rule would require a fund that relies on proposed rule 18f-4 to enter into derivatives transactions to have a formalized risk management program unless the fund limits its exposure from derivatives transactions to 50% or less of the fund’s net assets (and does not use complex derivatives transactions). We expect that all funds that would operate under the risk-based limit would have derivatives exposure in excess of 50% of net assets, and thus would be required to have risk management programs, because funds with derivatives exposure of 50% or less would be able to comply with the 150% exposure limit and have no need to avail themselves of the higher 300% exposure limit for funds that comply with the risk￾based portfolio limit. 277Proposed rule 22e–4 also would require a fund subject to that rule to assess and periodically review the fund’s liquidity risk, considering various factors specified in the rule, including the fund’s use of borrowings and derivatives for investment purposes. See supra note 81 and accompanying text. 278See supra note 275 (discussing different types of absolute and relative risk measures). expressed about the use of VaR.274 In addition, the VaR test under the risk￾based portfolio limit would be coupled with an outside limit on exposure, which, as discussed in section III.B.2.c below, would provide an independent limit on a fund’s use of senior securities transactions under the proposed rule that would not be
based on VaR. We also recognize that funds may use measures other than VaR in order to assess the risks posed by a fund’s derivatives and other investments.275 The VaR test is designed to serve as a means of limiting a fund’s ability to leverage its assets in a manner that would implicate the undue speculation concern in section 1(b)(7) of the Act, but it is not intended as a substitute for other measures that a fund may consider in connection with its derivatives risk management. For example, those funds that are subject to the requirement to have formalized derivatives risk management programs should consider other appropriate measures to assess risk, including stress tests that are tailored to a fund’s particular characteristics, as part of their derivatives risk management programs, as discussed in section III.D below.276 We also recognize that the use of derivatives poses other risks, such as counterparty risk and liquidity risk, that may not be addressed by the VaR test under the proposed rule; however, we believe, as discussed in section III.D below, that funds making significant use of derivatives generally should address these risks as part of their risk management programs.277 We have proposed that the risk-based portfolio limit include a VaR-based test because of the characteristics of VaR we discussed above, which we believe allow VaR to be used as part of the VaR test to provide an indication of whether a fund’s derivatives as a whole directionally increase or mitigate risk. We request comment immediately below on the proposed rule’s inclusion of a risk-based portfolio limitation based on VaR and, in section III.B.2.b below, we request comment on the proposed rule’s requirements regarding funds’ use of particular VaR models in connection with the VaR test and the proposed rule’s requirements for any VaR model chosen by the fund.

• Do commenters agree that the
  proposed rule should include, in addition to the exposure-based portfolio limit, an alternative portfolio limitation that focuses primarily on a risk assessment of a fund’s use of derivatives? Do commenters agree that, where a fund’s derivatives transactions, in the aggregate, result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives, it would be appropriate to permit the fund to engage in derivatives transactions to a greater extent than would be permitted under any exposure-based portfolio limit?
• As noted above, we are proposing to
  include the risk-based portfolio limit in the proposed rule because we recognize that, because derivatives transactions may be used for a variety of purposes, some funds may make use of derivatives that in the aggregate result in relatively high notional amounts, but which are not used to leverage the fund’s assets in a manner that increases the fund’s exposure to market risk. What types of funds have or could have exposure in excess of the limit provided in the exposure-based portfolio limit (150% of net assets) but use derivatives transactions that, in the aggregate, result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives? Are there funds that today use derivatives in amounts greater than the exposure￾based portfolio limit but could comply with the risk-based portfolio limit? If so, what kinds of funds? If funds would have to restructure their portfolios to comply with the risk-based portfolio limit, how would they do so? Would they be able to pursue strategies or obtain investment exposures similar to their current strategies and exposures? If not, what types of strategies or investment exposures would not be possible?
• The proposed rule would use the
  VaR test to determine if a fund’s derivatives transactions, in aggregate, result in an overall portfolio that is subject to less market risk than if the fund did not use such derivatives. Do commenters agree that VaR, as used in the VaR test, is an effective approach for this purpose? Are there other measures we should permit a fund to use, either in lieu of or in addition to VaR, to assess whether the fund’s derivatives transactions, in the aggregate, have the effect of mitigating the fund’s exposure to market risk? For example, would absolute risk measures (such as standard deviation, risk of loss or shortfall risk), relative risk measures (such as excess return, tracking error, Sharpe ratio, information ratio, beta or Treynor ratio), or stress testing/scenario generation, better address the purposes that the VaR test is intended to fulfill? 278 If so, how would such risk measures be incorporated into a test for purposes of the risk-based portfolio limit?
• As discussed above, we believe that
  the manner in which VaR would be used under the proposed rule, which focuses on the relationship between a fund’s securities VaR and its full portfolio VaR, would mitigate some of the concerns that have been expressed regarding the risks and limitations of relying on VaR as a risk measure. Do commenters agree? If not, what alternative measures could be implemented to address these concerns? For example, would these concerns be addressed by requiring funds to comply with a test that is similar to the VaR test, but that uses expected shortfall instead of VaR (i.e., that would require a fund to compare the expected shortfall of its

279See supra note 272 (discussing the use of expected shortfall under BCBS proposal). 280Proposed rule 18f–4(c)(11). 281See supra note 280. 282Proposed rule 18f–4(c)(11)(ii)(A). 283Proposed rule 18f–4(c)(11)(ii)(B). 284Proposed rule 18f–4(c)(11)(ii)(B). 285Proposed rule 18f–4(c)(11)(ii)(C). 286Proposed rule 18f–4(c)(11)(i)(C). 287Proposed rule 18f–4(c)(11)(ii)(A). ‘‘Market risk’’ for this purpose includes both general market risk and specific market risk. See supra note 249. 288Proposed rule 18f–4(c)(11)(ii)(A)(1). 289Proposed rule 18f–4(c)(11)(ii)(A)(2). 290Proposed rule 18f–4(c)(11)(ii)(A)(3). 291Historical simulation models rely on past observed historical returns to estimate VaR. Historical VaR involves taking a fund’s current portfolio, subjecting it to changes in the relevant market risk factors observed over a prior historical period, and constructing a distribution of hypothetical profits and losses. The resulting VaR is then determined by looking at the largest (100 minus the confidence level) percent of losses in the resulting distribution. See, e.g., Dowd, supra note 255, at 56–68. See also Thomas J. Linsmeier & Neil D. Pearson, Value at Risk, Fin. Analysts J. (Mar.– Apr. 2000) (‘‘Linsmeier & Pearson’’), at 50–53. securities portfolio with the expected shortfall of its full portfolio)? 279

• The risk-based portfolio limit
  would require a fund’s full portfolio VaR to be less than its securities VaR. Should the test be more restrictive or less restrictive? For example, should we permit a fund’s full portfolio VaR to exceed its securities VaR up to a specified limit (e.g., allow the fund’s full portfolio VaR to exceed its securities VaR by not more than a specified percentage)? For example, would it be appropriate for the fund’s full portfolio VaR to exceed its securities VaR by 10% or 20%? Conversely, should we make the test more restrictive and require that the fund’s full portfolio be less than the fund’s securities VaR by an amount specified in the rule? Should we, for example, require that the full portfolio VaR be 10% or 20% less than the fund’s securities VaR?
• For purposes of the risk-based
  portfolio limit, should the proposed rule use an approach such as (or similar to) the relative VaR or absolute VaR approach for UCITS funds, instead of or as an alternative to the proposed VaR test? Why or why not? Would it be more efficient to allow funds to use such an approach—e.g., because some advisers already use this approach for UCITS funds? Under a relative VaR approach, what sort of benchmarks would or would not be appropriate, and how should the benchmarks be chosen? Under an absolute VaR approach, what would be an appropriate VaR limit (e.g., 20%, as for UCITS funds, or a higher or lower limit)? Would a relative VaR or absolute VaR approach appropriately address the undue speculation concern underlying section 18? Why or why not?
• A fund’s securities VaR would be
  the VaR of the fund’s investments other than derivatives transactions which, as defined in the proposed rule, would include derivatives transactions that involve the issuance of a senior security. The VaR associated with derivatives that do not involve the issuance of a senior security, such as a typical purchased option, would be included in the fund’s securities VaR. Although
  section 18 does not limit a fund’s ability
  to acquire such derivatives, they could be volatile and thus could generate a securities VaR that would provide the fund additional latitude to engage in derivatives transactions under the risk￾based portfolio limit. Should we, therefore, require the fund to exclude the VaR associated with all of the fund’s derivatives from the securities VaR, whether or not they involve the issuance of a senior security, and, if so, how should we define ‘‘derivatives’’ for this purpose? If so, what would be the effects on funds’ strategies?
• Should we place other limitations
  on a fund’s ability to use borrowings or other financial commitment transactions to obtain leveraged exposures if the fund elects to use derivatives at the higher level permitted under the risk￾based portfolio limit? Should we, for example, further restrict a fund’s ability to use financial commitment transactions or other borrowings, the proceeds of which could be used by the fund to purchase securities investments that would increase the fund’s securities VaR?
• Are there certain types of securities,
  derivatives or other instruments that would be difficult to model using VaR (taking into account the requirements for a fund’s VaR model, discussed in
  section III.B.2.b below)? For example,
  would it be difficult for a fund to model an investment in a private fund, or in other types of illiquid investments that lack frequent valuations or transparency? Are there ways that we should modify the VaR test to allow a fund that invests in instruments that are difficult to model using VaR to demonstrate in some other way that its derivatives, in aggregate, are risk mitigating? b. Choice of Model and Parameters for VaR Test The proposed rule defines VaR as ‘‘an estimate of potential losses on an instrument or portfolio, expressed as a positive amount in U.S. dollars, over a specified time horizon and at a given confidence interval.’’ 280 We believe that this is generally consistent with the commonly understood definition of VaR as a risk measure.281 We also believe that, while VaR can be calculated using a number of different approaches and a wide range of parameters, this definition is broad enough to encompass most methods of calculating VaR. However, while we believe it is appropriate for funds to have flexibility in the selection of a VaR model and its parameters for purposes of the risk-based portfolio limit, we also believe that a fund’s VaR model should meet certain minimum requirements. As discussed further below, the proposed rule therefore would require a fund’s VaR model to take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments.282 In addition, the proposed rule would require a fund to use a minimum 99% confidence interval,283 a time horizon of not less than 10 and not more than 20 trading days,284 and a minimum of three years of historical data to estimate historical VaR.285 A fund would also be required to apply its VaR model consistently when calculating its securities VaR and full portfolio VaR.286 We discuss these aspects of the proposed rule below. First, the proposed rule would require a fund’s VaR model to take into account and incorporate all significant, identifiable market risk factors associated with a fund’s investments.287 Absent this requirement, the fund’s VaR calculations, when used in the VaR test, may not provide a reliable indication of whether the fund’s derivatives, in aggregate, are increasing or decreasing the fund’s overall portfolio’s exposure to market risk. The proposed rule provides a non-exclusive list of risk factors that may be relevant in light of a fund’s strategy and investments, including equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk,288 material risks arising from the nonlinear price characteristics of options and positions with embedded optionality,289 and the sensitivity of the market value of the fund’s derivatives to changes in volatility or other material market risk factors.290 We understand that VaR models are often categorized into three methods— historical simulation,291 Monte Carlo

292Monte Carlo simulation uses a random number generator to produce a large number (often tens of thousands) of hypothetical changes in market values that simulate changes in market factors. These outputs are then used to construct a distribution of hypothetical profits and losses on the fund’s current portfolio, from which the resulting VaR is ascertained by looking at the largest (100 minus the confidence level) percent of losses in the resulting distribution. See, e.g., Dowd, supra note 255, at 221; Linsmeier & Pearson, supra note 291, at 53–56 (discussing the ‘‘delta-normal approach,’’ a form of parametric method). 293Parametric methods to calculating VaR rely on estimates of key parameters (such as the mean returns, standard deviations of returns, and correlations among the returns of the instruments in a fund’s portfolio) to create a hypothetical statistical distribution of returns for a fund, and use statistical methods to calculate VaR at a given confidence level. See, e.g., Dowd, supra note 255, at 37; Linsmeier & Pearson, supra note 291, at 56– 57. 294For example, some parametric methodologies may be more likely to yield misleading VaR estimates for assets or portfolios that exhibit non￾linear returns, due, for example, to the presence of options or instruments that have embedded optionality (such as callable or convertible bonds). See, e.g., Linsmeier & Pearson, supra note 291, at 57 (noting that historical and Monte Carlo simulation ‘‘work well regardless of the presence of options and option-like instruments in the portfolio. In contrast, the standard [parametric] delta-normal method works well for instruments and portfolios with little option content but not as well as the two simulation methods when options and option-like instruments are significant in the portfolio.’’). 295Proposed rule 18f–4(a)(3)(i)(D). 296Backtesting refers to ‘‘the application of quantitative, typically statistical, methods to determine whether a model’s risk estimates are consistent with the assumptions on which a model is based.’’ Dowd, supra note 255, at 141. If backtesting indicates that a model consistently overestimates or underestimates VaR, it may be because a fund’s VaR model is not taking into account and incorporating the appropriate market risk factors associated with the fund’s investments. 297Proposed rule 18f–4(c)(11)(ii)(C). 298See Linsmeier & Pearson, supra note 291, at 59 (noting 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 will understate the risk in the portfolio.’’). 299See Dowd, supra note 255, at 68 (noting that ‘‘[a] long sample period can lead to data collection problems. This is a particular concern with new or emerging market instruments, where long
runs of historical data don’t exist and are not necessarily easy to proxy.’’). 300See also Minnich, supra note 254, at 43 (noting that for historical simulation, ‘‘[l]onger periods of data have a richer return distribution while shorter periods allow the VAR to react more quickly to changing market events’’ and that ‘‘[t]hree to five years of historical data are typical.’’) See also Darryll Hendricks, Evaluation of Value-at￾Risk Models Using Historical Data, FRBNY Econ. Policy Rev. (Apr. 1996), at 44 (finding that, when using historical VaR, ‘‘[e]xtreme [confidence interval] percentiles such as the 95th and particularly the 99th are very difficult to estimate accurately with small samples’’ and that the complete dependence of historical VaR models on historical observation data ‘‘to estimate these percentiles directly is one rationale for using long observation periods.’’). 301Proposed rule 18f–4(c)(11)(ii)(B). 302For example, UCITS funds that use the relative VaR or absolute VaR approach are required to calculate the fund’s VaR using a 99% confidence interval. See CESR Global Guidelines, supra note 162, at 26 (requiring funds that use the relative VaR or absolute VaR approach to calculate VaR using a ‘‘one-tailed confidence interval of 99%’’). As noted in section III.B.2.a above and in section IV.E below, the VaR test under the risk-based portfolio limit is similar in certain respect to the relative VaR approach for UCITS funds. 303Proposed rule 18f–4(c)(11)(ii)(B). 304See, e.g., infra at discussion accompanying notes 295–296. 305See, e.g., Bank for International Settlements, Basel Committee on Banking Supervision, Messages Continued simulation,292 or parametric models.293 We also understand that each method has certain benefits and drawbacks, which may make a particular method more or less suitable, depending on a fund’s strategy, investments and other factors. In particular, some VaR methodologies may not adequately incorporate all of the material risks inherent in particular investments, or all material risks arising from the nonlinear price characteristics of certain derivatives.294 While the proposed rule does not specify that a fund must use any particular type of VaR model, the proposed rule would require that any VaR model used by the fund take into account and incorporate all significant, identifiable market risk factors associated with the fund’s investments, as discussed above, and to meet the rule’s other requirements for a VaR model. As discussed below in section III.D, the proposed rule would require funds that are subject to the requirement to have a formalized derivatives risk management program under the proposed rule to periodically review and update any VaR calculation models used by the fund, in order to evaluate their effectiveness and reflect changes in risks over time.295 As part of its derivatives risk management program, a fund that relies on the risk-based portfolio limit may wish to consider periodic backtesting or
other procedures to assess the effectiveness of its VaR model, and in particular, may wish to use such testing to periodically assess whether its VaR model takes into account and incorporates all significant, identifiable market risk factors associated with the fund’s investments.296 The proposed rule would require a fund using historical VaR to have at least three years of historical market data.297 We understand that the availability of data is a key consideration when using historical simulation to estimate VaR, and that the length of the data observation period may significantly influence the results of a VaR calculation. For example, a shorter observation period means that each observation will have a greater influence on the result of the VaR calculation (as compared to a longer observation period), such that periods of unusually high or low volatility could result in unusually high or low VaR estimates.298 Longer observation periods, however, can lead to data collection problems, if sufficient historical data is not available.299 By requiring a fund using historical VaR to have at least three years of historical market data, the proposed rule is designed to require a fund to base its VaR estimates on a sufficient number of observations, while also recognizing the concern that requiring a longer historical period could make it difficult for a fund to obtain sufficient historical data to estimate VaR for the instruments in its portfolio.300 The proposed rule would also require a fund to use a 99% confidence level for its VaR test.301 Many regulatory schemes that use VaR require a 99% confidence level, which can be expected to result in higher estimates of absolute losses than a lower confidence interval.302 As discussed above, the VaR test under the proposed rule’s risk-based portfolio limit is designed to focus on the relationship between a fund’s securities VaR and its full portfolio VaR, rather than to serve as an absolute measure of potential losses. Although the VaR test is not designed to provide an estimate of a fund’s potential absolute losses, we believe that a 99% confidence interval would be more appropriate, as compared to a lower confidence interval, because a higher confidence level would provide a stronger indication that a fund’s derivatives use, in aggregate, can be expected to have a risk-mitigating effect on the fund’s exposure to market risk on the days on which the fund’s securities portfolio would be expected to incur the greatest losses. The proposed rule also would require a fund to calculate VaR using a time horizon of at least 10 trading days but not more than 20 trading days.303 We understand that when VaR is used for risk management purposes, the time horizon that is selected by the user typically reflects the expected holding period for an instrument (or portfolio of instruments).304 The holding period, in turn, may depend on factors such as the liquidity of an instrument and the purpose for which it is held,
which may vary across different types of instruments in a portfolio.305 When VaR

from the Academic Literature on Risk Measurement for the Trading Book, Working Paper No. 19 (Jan. 31, 2011) (‘‘Basel Risk Measurement Working Paper’’) (noting, based on a survey of academic literature on VaR-based approaches to risk management, that ‘‘[t]here seems to be consensus among academics and the industry that the appropriate horizon for VaR should depend on the characteristics of the position’’). 306The underlying regulatory purpose could include, for example, limiting the amount of market risk that could be incurred by an investment vehicle and thus mitigating the risk of potential losses that investors would bear, or establishing capital requirements. See infra at notes 310–311 and accompanying text. 307See, e.g., Dowd, supra note 255, at 73–74 (showing how parametric VaR can initially result in increasing estimates of loss as the time horizon increases, but that estimates of loss can decrease over longer time horizons). Estimated VaR losses over longer time horizons can also be affected by the tendency of volatility to be mean-reverting over time. See generally Stephen Figlewski, Estimation Error in the Assessment of Financial Risk Exposure (2003). 308Thus, for example, a fund that invests a greater proportion of its assets in liquid instruments and trades frequently might choose a 10-day holding period, while a fund that invests in less liquid instruments or trades less frequently might choose a longer holding period (but not longer than 20 days). 309While a fund could in theory model different instruments using different VaR time horizons, it is not clear that a fund would be able to incorporate different time horizons into a portfolio-wide VaR test. See, e.g., Basel Risk Measurement Working Paper, supra note 305 (noting, based on a survey of academic literature on VaR-based approaches to risk management, that ‘‘[a]t present, there is no widely accepted approach for aggregating VaR measures based on different horizons’’). 310See BCBS Trading Book Review—Oct. 2013, supra note 272. The BCBS has implemented and continues to develop new standards which, among other things, would call for five different ‘‘liquidity horizon categories’’ for broad categories of risk factors, ranging from 10 days to one year. As noted above, however, the VaR test under the proposed rule effectively requires a fund to select a single time horizon. See supra note 272 and accompanying text. 311See CESR Global Guidelines, supra note 162, at 26 (requiring funds that use the relative VaR or absolute VaR approach to calculated VaR using a ‘‘holding period equivalent to 1 month (20 business days’’). See also infra section IV.E. is used for regulatory purposes, however, the applicable regulation typically specifies a time horizon or range of permissible time horizons (even in cases where the regulated entity may hold instruments or a portfolio having a longer or shorter expected holding period), in order to promote consistency across regulated entities and use a
time horizon for the VaR calculation is appropriate in light of the underlying regulatory purpose.306 In light of this, we considered the factors discussed below in determining to propose a 10- to 20-day time horizon for a fund’s VaR model under the proposed rule. First, we understand that very short time horizons (e.g., one day) can be less effective at capturing the effects of fluctuations in risk factors on VaR, particularly with respect to out-of-the￾money options (or implicit options, for securities and other investments that contain option-like features). At the same time, we understand that, while VaR estimates of potential losses typically increase as the time horizon increases over short- to medium-term periods, over longer periods VaR estimates of potential losses may eventually decrease.307 Thus, we considered that if the proposed rule did not specify a time horizon or range of acceptable time horizons, some funds that rely on the risk-based portfolio limit could select a time horizon for their VaR model that is either too short or too long and thereby underestimate potential losses, as reflected in the VaR test. In light of these concerns, we believe it would be appropriate for the proposed rule to place some limitations on a fund’s ability to use shorter or longer time horizons that could produce less reliable VaR estimates, while also providing some flexibility for a fund to select a time horizon that is appropriate based on the fund’s particular characteristics.308 Second, we considered that the VaR test is designed to provide an indication, through a fund’s comparison of its securities VaR to its full portfolio VaR, that the fund’s derivatives transactions, in aggregate, have the effect of reducing the fund’s exposure to market risk. This means that the VaR test requires a portfolio-level calculation, and for such purposes the fund would need to select a single time horizon, even if the fund expected to hold different instruments in its portfolio for different lengths of time.309 A consequence of this is that even if a fund uses VaR for internal risk￾management purposes and applies different time horizons to different types of instruments for such purposes, the fund nevertheless would need to select a single holding period for purposes of the VaR test. Third, we considered the time horizons in other regulatory regimes that use VaR. In this regard, we noted that the most commonly used time horizons appear to be either 10 days or 20 days. For example, the 1996 Market Risk Amendment to the Basel II Capital Accord, which contemplated banks’ use of internal models for measuring market risk, incorporated a 10-day time horizon.310 For UCITS funds that rely on the relative VaR or absolute VaR approach, the CESR Global Exposure Guidelines specify a 20-day time horizon.311 A consequence of the use of 10- and 20-day time horizons under these regimes is that we believe that these time horizons are widely used by funds and other financial
market participants. In light of these considerations, including balancing concerns about a time horizon potentially being too long or too short with the benefit of providing some level of flexibility for funds to select a time horizon in light of their particular characteristics, we believe the proposed rule’s requirement that the time horizon for the VaR model used by a fund that complies with the risk-based portfolio limit is appropriate. Finally, regardless of which VaR model the fund chooses, the fund must apply its VaR model consistently when calculating the fund’s securities VaR and the fund’s full portfolio VaR. This requirement is designed to prevent a fund from using different models to manipulate the results of the VaR test— for example, by overestimating the fund’s securities VaR using one VaR model and underestimating its full portfolio VaR using a different model in order to take on riskier derivatives positions. In addition, because the VaR test would be used to focus on the relationship between the fund’s securities VaR and its full portfolio VaR as discussed above, requiring the fund to use the same VaR model for purposes of the VaR test would help to ensure that the test generates comparable estimates of the fund’s securities VaR and full portfolio VaR. We request comment on the proposed rule’s minimum requirements concerning the VaR model used by the fund.

• Do funds today use VaR models for
  risk management purposes or otherwise that would meet the proposed rule’s minimum requirements? If funds use VaR models that would not meet these requirements, how do they differ?
• Should the proposed rule specify a
  particular VaR model(s) that funds must use (i.e., a historical simulation, Monte Carlo simulation, or parametric methodology)? If so, which methodology (or methodologies) and why?
• A fund would only be permitted to
  use a historical VaR methodology if at least three years of historical data is available. Do commenters agree that this is an appropriate requirement? Would requiring three years of historical data make it difficult to model some instruments? Should we require that a fund have additional historical return data in order to use a historical VaR methodology? Conversely, would less than three years of historical return data be sufficient?
• The proposed rule would require
  that the VaR model used by the fund (whether based on the historical

312See, e.g., supra note 128 and accompanying discussion. 313While we have proposed in the Investment Company Reporting Modernization Release to obtain additional information regarding derivatives transactions on proposed Form N–PORT, we do not currently have sufficient information in a structured format to evaluate derivatives holdings in the DERA sample of funds discussed in the White Paper to estimate those funds’ securities VaRs and full portfolio VaRs. simulation, Monte Carlo simulation, or parametric method) incorporate all significant, identifiable market risk factors associated with a fund’s investments. Do commenters agree that this is an appropriate standard? Is it sufficiently clear?

• The proposed rule would provide a
  non-exclusive list of risk factors that may be relevant in light of a fund’s strategy and investments, including equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk, all material risks arising from the nonlinear price characteristics of options, and positions with embedded optionality, and the sensitivity of the market value of the fund’s derivatives to changes in volatility or other material market risk factors. Do commenters agree that these are appropriate risk factors? Are there others we should include? Rather than include a non-exclusive list of risk factors that funds must consider, should we specify in any final rule the particular risk factors that must be included in specified circumstances? Would it be possible to do so in a way that would address the diversity of funds and their strategies?
• The proposed rule would require a
  fund to use a 99% confidence level for its VaR test. Do commenters agree that this is an appropriate confidence level? In particular, should we permit funds to use a lower confidence interval? Why or why not?
• The proposed rule would require a
  fund to calculate VaR using a time horizon of at least 10 trading days, but not more than 20 trading days. Do commenters agree that it is appropriate to provide a range of trading days, to give funds some flexibility in selecting a time horizon based on the fund’s own particular characteristics? Do commenters agree that a range of 10 to 20 trading days would be appropriate? Should the number of trading days be lower than 10, or higher than 20? Should the number of trading days be a specific number, instead of a range? Why or why not? If so, which specific number would be appropriate? Should we, for example, specify 10 or 20 trading days?
• Regardless of which VaR model the
  fund chooses, the proposed rule would require the fund to apply its VaR model consistently when calculating the fund’s securities VaR and the fund’s full portfolio VaR. Do commenters agree that this requirement is appropriate? If not, how could we otherwise prevent the VaR test from being easily manipulated?
• We believe that the proposed rule
  affords appropriate flexibility for funds to tailor the VaR test in light of a fund’s strategy, investments and other relevant factors. Does this flexibility increase the risk that funds will be able to game or manipulate the test in order to obtain riskier investment exposures? If so, should the rule impose more specific requirements on a fund’s VaR model or its parameters, and how?
• Should the proposed rule place
  restrictions on a fund’s ability to change its VaR model? For example, should changes be permitted only with the approval of the fund’s derivatives risk manager, or subject to other approval or oversight requirements?
  c. 300 Percent Exposure Limit Under the
  Risk-Based Portfolio Limitation A fund that relies on the risk-based portfolio limit would be required to limit its exposure to not more than 300% of the fund’s net assets, rather than 150% (as would be required under the exposure-based portfolio limit). While we believe that the VaR test generally would indicate that the fund’s derivatives transactions do not, in the aggregate, result in an increase in the speculative character of the fund as discussed above, we also believe it is appropriate for the risk-based portfolio limit to include an outside limit on exposure as discussed in this section. If the risk-based portfolio limit did not include an outside limit on exposure, a fund might be able to use strategies that may not produce significant measurable amounts of VaR during normal market periods, but which employ derivatives exposures at a level that could subject a fund to a significant speculative risk of loss if markets become stressed. For example, some funds use strategies that entail large long and short notional exposures, with the expectation that the risk of the fund’s long positions is largely offset by the fund’s short positions during normal market conditions, and this may result in the fund having a low full portfolio VaR. During periods of market stress, however, correlations across different positions may break down, leading to the possibility of significant losses and payment obligations with respect to the fund’s derivatives transactions.312 Although a fund pursuing such a strategy might be considered hedged or balanced, we believe that its activities may be speculative—and that its use of derivatives could implicate the undue speculation concern expressed in
  section 1(b)(7) of the Act—if the fund’s
  derivatives exposures are very large in comparison to the fund’s net assets. In these circumstances the fund’s use of derivatives could create an amount of leverage—and a resulting potential for large losses and payment obligations under derivatives—that we believe under some circumstances or market conditions could ‘‘increase unduly the speculative character’’ of the fund’s securities issued to common shareholders. Coupling the VaR test with a 300% exposure limit, instead of permitting such a fund to obtain unlimited exposures, is designed to address these considerations by placing an outside limit on the fund’s exposure that is not based on a VaR or other risk￾based assessment. We believe that the proposed rule’s outside exposure limit of 300% is important to address possible concerns regarding the effectiveness of the VaR test in all possible circumstances and market conditions while also preserving the utility of the risk-based portfolio limit for funds that use derivatives, in aggregate, to result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives. In determining to propose a 300% exposure limit as part of the risk￾based portfolio limit we considered, as discussed above in connection with the exposure-based portfolio limit, that the vast majority of funds would be able to comply with a 150% exposure limit without modifying their portfolios. In considering the extent to which the risk￾based portfolio limit should permit a fund to obtain additional exposure, in light of the derivatives’ aggregate reduction in the fund’s exposure to market risk, we also considered the extent to which funds included in the DERA sample with exposures exceeding 150% of net assets would appear to be able to satisfy the VaR test (including by modifying their portfolios to a certain extent in order to do so). Although the information disclosed by the sampled funds and otherwise available to our staff was not sufficient to allow our staff to calculate the funds’ securities VaRs and full portfolio VaRs,313 the available information about the funds does provide an indication of whether the funds reasonably could be expected to comply with the VaR test. As discussed above, most of the funds included in the analysis conducted by DERA staff with the highest exposures were alternative strategy funds, with

314A fund that holds only cash and cash equivalents and derivatives would not be able to satisfy the VaR test. In this case the fund’s securities VaR would reflect the VaR of the cash and cash equivalents, and thus would be very low. The fund’s derivatives, in aggregate, generally would add to, rather than reduce, the fund’s exposure to market risk and thus generally would not result in a full portfolio VaR that is lower than the fund’s securities VaR, as required under the VaR test. 315Proposed rule 18f–4(a)(5)(i). 316Other exemptive rules under the Act similarly require the fund’s board to take certain actions in order for the fund to rely on the exemption provided by the rule. See, e.g., rules 18f–3, 17a–7, 10f–3, and 2a–7. 317Proposed rule 18f–4(a)(1)(i) and (ii). 318We similarly proposed an acquisition test (in contrast to a maintenance test) in proposed rule 22e–4, under which a fund would not be permitted to acquire any less liquid asset if, immediately after the acquisition, the fund would have invested less than its three-day liquid asset minimum in three￾day liquid assets. Proposed rule 22e–4(b)(2)(iv)(C). In the Liquidity Release we noted that forced sales required under a maintenance test could require the fund to sell the less liquid assets at prices that incorporate a significant discount to the assets’ stated value, or even at fire sale prices; we also noted that, if a fund needed to rebalance its portfolio frequently to maintain a specified percentage of the fund’s net assets invested in three￾day liquid assets, this could produce unnecessary transaction costs adversely affecting the fund’s NAV, and could cause a fund to sell portfolio assets when it is not advantageous to do so (e.g., when an asset’s price is low, or when sales of an asset would have an undesirable tax impact). See Liquidity Release, supra note 5, at text accompanying nn.344–48. We similarly believe that requiring a approximately 27% of these funds having exposures in excess of 150% of net assets, with the funds’ exposures ranging up to approximately 950% of net assets. The funds with the highest exposures were managed futures funds—as noted above, three of the four funds in DERA’s sample with exposures exceeding 500% of net assets were managed futures funds with exposures ranging from a little over 500% to approximately 950% of net assets. Managed futures funds, and other funds that use derivatives primarily to obtain market exposure (rather than to reduce the fund’s exposure to market risk) and whose physical holdings consist mainly of cash and cash equivalents, would not satisfy the VaR test.314 Alternative strategy funds with exposures exceeding 150% that potentially could choose to use derivatives in a manner that would satisfy the VaR test had lower exposures. Funds in this group with lower exposures included those with unconstrained bond and multi￾alternative strategies; the exposures of funds within these strategies that were in excess of 150% ranged from
around 175% to just under 350% of net assets. These funds, and particularly unconstrained bond funds, may have securities investments that involve market risks that could be reduced by derivatives transactions, and thus could consider electing to comply with the risk-based portfolio limit (including by modifying their portfolios to a certain extent in order to do so). We believe that including a 300% exposure limit as part of the risk-based portfolio limit thus would appear to provide a limit that may be appropriate for the kinds of funds that could seek to operate under the risk-based portfolio limit. We note that the 300% exposure limit is only expected to serve as an adjunct limitation on a fund given the primary importance of the VaR test with respect to the risk-based portfolio limit. While we are seeking comment regarding the sufficiency of this exposure limit, we note that setting the exposure limit higher than 300% of net assets—in addition to potentially raising concerns about a fund operating with exposures at that level—would not appear to further the purposes of the risk-based portfolio limit. This is because funds in the DERA sample that have exposures substantially in excess of 300% of net assets would not appear to be able to satisfy the VaR test in any event, as discussed above. Accordingly, we believe that the 300% exposure limit is appropriate as a meaningfully higher limit than the 150% portfolio limit while providing an upper bound that does not appear to unduly constrain funds that may use derivatives on balance for risk-mitigating purposes. We believe, based on these considerations and those discussed above in section III.B.1, that the proposed rule’s outside exposure limit of 300% would address the concerns that led us to propose an exposure limit as part of the risk-based portfolio limit, while also preserving the utility of the risk-based portfolio limit for funds that use derivatives, in aggregate, to result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives. We request comment on all aspects of the proposed risk-based portfolio limitation’s inclusion of an outside limit of 300% of net assets.

• Do commenters agree that an
  outside limit on exposure can mitigate the concerns we discuss above concerning fund’s use of strategies that could be considered hedged or balanced but that might experience speculative losses under certain circumstances? Why or why not? Are there other means to address these concerns that we should consider either in addition to or in lieu of an outside limit on the fund’s exposure?
• Do commenters agree that the
  proposed 300% outer limit on exposure is appropriate? Do commenters agree that a 300% exposure limit would address the concerns we discuss above while also preserving the utility of the risk-based portfolio limit for funds that use derivatives, in aggregate, to result in an investment portfolio that is subject to less market risk than if the fund did not use such derivatives? Should we make it higher or lower, for example 250% or 350%, and how would a different limit address the concerns we discuss above?

3. Implementation and Operation of
   Portfolio Limitations
   The proposed rule would require, to the extent that a fund elects to rely on the rule, the fund’s board of directors, including a majority of the directors who are not interested persons of the fund, to approve which of the two alternative portfolio limitations will apply to the fund.315 We believe that requiring a fund’s board, including a majority of the fund’s independent directors, to approve the fund’s portfolio limitation would appropriately focus the board’s attention on the nature and extent of a fund’s use of derivatives and other senior securities transactions as
   part of its investment strategy. We
   believe that requiring the fund’s board to approve a fund’s portfolio limitation would be an appropriate role for the board.316 A fund relying on the rule would be required to comply with the applicable portfolio limitation after entering into any senior securities transaction, that is, any derivatives transaction or financial commitment transaction entered into by the fund pursuant to the proposed rule, or any other senior security transaction entered into by the fund pursuant to
   section 18 or 61 of the Act.317 A fund
   therefore would not be required to terminate or otherwise unwind a senior securities transaction solely because the fund’s exposure subsequently increased beyond the exposure limits included in either of the portfolio limitations. The fund, however, would not be permitted to enter into any additional senior securities transactions while relying on the exemption provided by the rule unless the fund would be in compliance with the applicable portfolio limitation immediately after entering into the transaction. This aspect of the proposed rule is designed to prevent a fund from having to unwind or terminate a senior securities transaction that the fund was permitted to enter into under the proposed rule at a later time when terminating or unwinding the transactions may be disadvantageous to the fund.318 The Act and our rules

fund to unwind or otherwise terminate derivatives transactions as a result of subsequent changes in the fund’s net assets could have adverse consequences for the fund. 319This acquisition test (in contrast to a maintenance test) reflects approaches that Congress and the Commission have historically taken in other parts of the Investment Company Act and the rules thereunder. See, e.g., Investment Company Act section 5(c) (a registered diversified company that at the time of its qualification meets the diversification requirements specified in Investment Company Act section 5(b)(1) shall not lose its status as a diversified company because of any subsequent discrepancy between the value of its various investments and the requirements of
section 5(b)(1), so long as any such discrepancy
existing immediately after its acquisition of any security or other property is neither wholly nor partly the result of such acquisition); rule 2a–7(d)(3) (portfolio diversification requirements of rule 2a–7 are determined at the time of portfolio securities’ acquisition); rule 2a–7(d)(i) (limit on a money market fund’s acquisition of illiquid securities if, immediately after the acquisition, the money market fund would have invested more than 5% of its total assets in illiquid securities); rule 2a– 7(d)(4)(ii) and (iii) (minimum daily liquidity requirement and minimum weekly liquidity requirement of rule 2a–7 are determined at the time of portfolio securities’ acquisition). 320For example, suppose that a fund’s exposure was initially 140% but subsequently increased to 160% solely due to losses in the value of the fund’s securities portfolio. The fund would not be required to unwind its senior securities transactions in order to bring its exposure below 150%. However, if the fund entered into any new senior securities transaction then, immediately after entering into such transaction, the fund would be required to be in compliance with the 150% exposure limit. 321Proposed rule 18f–4(a)(2), (c)(6), (c)(8), (c)(9). 322See section 1(b)(8) of the Investment Company Act. The asset segregation requirements in the proposed rule also are based in part on the considerations that informed our guidance in Release 10666 that maintaining assets in the segregated account would help ‘‘assure the availability of adequate funds to meet the obligations’’ arising from the trading practices described in that release. See Release 10666, supra note 20, at n.8. 323See section 1(b)(7) of the Investment Company Act. Under the proposed rule, a fund would be required to maintain a certain amount of qualifying coverage assets—which generally would be required to be cash and cash equivalents—with respect to its derivatives transactions. A fund could determine not to enter into derivatives transactions that would otherwise be permitted under the proposed rule’s exposure limits in order to avoid having to maintain qualifying coverage assets for the transactions. In addition, under certain circumstances, the asset segregation requirements could limit a fund’s ability to enter into a derivatives transaction that would otherwise be permitted under the proposed rule’s exposure limits because the fund does not have and is unable to acquire sufficient qualifying coverage assets to comply with the proposed rule. The proposed rule also would address concerns about leverage directly, though the proposed rule’s portfolio limitations discussed in section V.B.1. 324See proposed rule 18f–4(a)(2), (a)(5)(ii), (c)(6), (c)(8), (c)(9). similarly measure compliance with certain portfolio limitations immediately after a fund acquires a security.319 However, if a fund’s exposure exceeded the applicable exposure limit and the fund entered into a new senior securities transaction, including a new
senior securities transaction that was intended to reduce the fund’s exposure, the fund would be required to reduce its exposure so that in the aggregate, its exposure was in compliance with the exposure limit.320 We request comment on all aspects of the operation of the proposed portfolio limitations.

• Does requiring a fund to comply
  with the proposed rule’s portfolio limitations immediately after entering into any senior securities transaction pose any operational challenges, for example, in determining the notional amount of the transaction, the fund’s net assets, or the fund’s securities VaR or full portfolio VaR (if applicable)?
• The proposed rule would not
  require a fund to terminate a derivatives transaction if the fund complied with the applicable portfolio limitation immediately after entering into the transaction, even if, for example, the fund’s net assets later declined with the result that the fund’s exposure at that later time exceeded the relevant exposure limit. Do commenters agree that this is appropriate? Conversely, should we instead require a maintenance test for notional amounts such that funds would be required to adjust their derivatives transactions if the exposure exceeds 150% of net assets for longer than a certain period of time, even if the fund has not entered into any senior securities transactions? If so, should we consider including a cushion amount—for example, by only requiring a fund to adjust its positions if its exposure reaches a higher level, such as 175%? Should we limit the time period (e.g., to 30 days, 60 days, or 90 days) in which a exposure could exceed 150% of net assets (or 300% under the risk-based portfolio limit) as a result of changes in the fund’s net assets so that a fund cannot persistently exceed the rule’s exposure limits? Would such an approach better promote investor protection? Would there be operational challenges with this requirement?
• If a fund’s exposure were to exceed
  the applicable exposure limit, should the proposed rule permit the fund to engage in a series of derivatives transactions where those transactions ultimately would reduce the fund’s exposure below the applicable exposure limit, even if the fund’s exposure were not below the applicable limit immediately after entering into certain of these transactions, in order to make it easier for funds to reduce their exposure under multiple derivatives transactions on a pro rata basis? If so, how would we permit these kinds of transactions without providing a means for funds to maintain exposure levels in excess of the applicable exposure limit for long periods of time? Should we, for example, permit funds to engage in a group of substantially contemporaneous derivatives transactions where the fund’s exposure is below 150% immediately after entering into the group of transactions? Should we permit a fund to engage in derivatives transactions that reduce the fund’s exposure, even if the reduced exposure still exceeds the applicable exposure limit? Could funds use such a provision to maintain exposure amounts in excess of the rule’s limits for long periods of time? Could we address that concern by, for example, permitting a fund to engage in these exposure-reducing derivatives transactions provided that the fund brings its exposure below the applicable limit within a specified period of time, like thirty days?
  C. Asset Segregation Requirements for
  Derivatives Transactions
  In addition to requiring funds to comply with one of two alternative portfolio limitations designed to impose a limit on the amount of leverage a fund could obtain through derivatives transactions and other senior securities transactions as described in section III.B.1.c above, the proposed rule would require a fund that enters into derivatives transactions in reliance on the rule to manage the risks associated with its derivatives transactions by maintaining an amount of certain assets (defined in the proposed rule as ‘‘qualifying coverage assets’’) designed to enable the fund to meet its obligations arising from such transactions.321 This requirement is designed to address the asset sufficiency concern reflected in section 1(b)(8) of the Act.322 In addition, the asset segregation requirement in the proposed rule would help to address the undue speculation concern reflected in section 1(b)(7) of the Act to the extent that funds limit their derivatives usage in order to comply with the asset segregation requirements.323 To rely on the proposed rule, a fund would be required to manage the risks associated with its derivatives transactions by maintaining a certain amount of qualifying coverage assets for each derivatives transaction, determined pursuant to policies and procedures approved by the fund’s board of directors.324 For each derivatives transaction, a fund would be required to maintain qualifying coverage assets with a value equal to the amount that would be payable by the fund if the fund were to exit the derivatives transaction as of the time of determination and an

325Proposed rule 18f–4(a)(2), (c)(6), (c)(8), (c)(9). 326Proposed rule 18f–4(a)(2). 327See proposed rule 18f–4(c)(8); infra note 369 and accompanying text. The exceptions to the requirement to maintain cash and cash equivalents, discussed below, are for derivatives transactions under which a fund may satisfy its obligation by delivering a particular asset, in which case that particular asset would be a qualifying coverage asset. See proposed rule 18f–4(c)(8). 328We note that, pursuant to proposed rule 22e– 4, funds subject to that rule would be required to consider, in assessing the liquidity of a position in a particular portfolio asset, whether the fund invests in the asset because it is connected with an investment in another portfolio asset. See proposed rule 22e–4(b)(2)(ii)(I). As explained in more detail in the Liquidity Release, assets segregated to cover derivatives and other transactions would be classified, for purposes of rule 22e–4, using the liquidity of the transaction they are covering because such assets would only be available for sale to meet fund redemptions once the related transaction is disposed of or unwound. See Liquidity Release, supra note 5, at section III.B.2. Thus, for purposes of proposed rule 22e–4, the liquidity of qualifying coverage assets segregated pursuant to proposed rule 18f–4 to cover derivatives transactions would be classified using the liquidity of the corresponding derivatives transactions. Similarly, the liquidity of qualifying coverage assets segregated pursuant to proposed rule 18f–4 to cover a financial commitment transaction would be classified using the liquidity of the corresponding financial commitment transaction. 329See infra note 332. 330Other exemptive rules under the Act similarly require the fund’s board to take certain actions in order for the fund to rely on the exemption provided by the rule. See, e.g., rules 18f–3, 17a–7, 10f–3, and 2a–7. 331Proposed rule 18f–4(a)(2), (c)(6), (c)(9). 332See, e.g., ICI Concept Release Comment Letter, at 11 (‘‘The optimal amount of cover for many instruments may be somewhere in between full notional and mark to market amounts. It should be an amount expected to cover the potential loss to the fund, determined with a reasonably high degree of certainty. This amount—mark-to-market plus a ‘cushion’—is more akin to the way portfolio officers and risk managers assess the portfolio risks created through the use of derivatives.’’); SIFMA Concept Release Comment Letter, at 4 (‘‘. . . the AMG recommends that the Commission formulate a standard for asset segregation that would be calculated as the sum of (i) the current mark-to￾market value of the derivative (representing the indebtedness on the instrument), plus (ii) a ‘cushion’ amount that would reflect potential future indebtedness); Comment Letter of AlphaSimplex Group, LLC on Concept Release (Nev. 7, 2011) (File No. S7–33–11) (‘‘AlphaSimplex Concept Release Comment Letter’’), available at http://www.sec.gov/
comments/s7-33-11/s73311-41.pdf, at 5 (‘‘So long as the derivative in question has daily liquidity and daily margin calls . . . a fund may segregate assets equal to the sum of the daily marked-to-market obligation of the fund plus an allowance for some daily price move that could increase the fund’s outstanding obligations . . .’’); BlackRock Concept Release Comment Letter, at 5 (‘‘Under a principles￾based approach, the amount that would need to be segregated is the net payment amount to which the fund is potentially exposed under plausible scenarios, plus a risk premium.’’); Vanguard Concept Release Comment Letter, at 7 (‘‘In our view, a fund’s potential future exposure is the market value of the derivative (calculated daily) plus an additional amount that takes into account the derivative’s potential intra-day price changes based on its volatility during reasonably foreseeable market conditions.’’). 333Proposed rule 18f–4(c)(6). In some cases the fund would not be required to make any payments if the fund were to exit the derivatives transaction, such as where the fund invested in a swap that appreciates in value and the fund determines that it would receive a payment if it were to exit the transaction at that time. In this case the mark-to￾market coverage amount would be equal to zero, but the fund would still be required to consider the risk-based coverage amount for such transaction, as discussed below. The mark-to-market coverage amount should reflect any accrued but unpaid premiums or other similar periodic payments owed under the derivatives transaction, as these amounts would influence the amount the fund would pay if it were to exit the derivatives transaction. additional amount that represents a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions.325 Qualifying coverage assets for derivatives transactions would need to be identified on the books and records of the fund at least once each business day.326 With certain exceptions, the proposed rule would define qualifying coverage assets for derivatives transactions to mean cash and cash equivalents because, as further described below, these assets are extremely liquid and may be less likely to experience volatility in price or decline in value in times of stress than other types of assets.327 The proposed rule, by requiring a fund to hold a sufficient amount of these types of assets, is designed to enable the fund to meet its obligations under its derivatives transactions.328 The proposed rule’s approach to asset segregation is designed to provide a flexible framework that would allow funds to apply the requirements of the proposed rule to particular derivatives transactions used by funds at this time as well as those that may be developed in the future as financial instruments and investment strategies change over time. As discussed in more detail below, the proposed rule’s approach to asset
segregation is designed to provide this flexibility by requiring funds to determine the amount of qualifying coverage assets in a way that can be applied by funds to various types of transactions and by permitting these amounts to be determined in accordance with board-approved policies and procedures. The proposed rule’s approach to asset segregation also is consistent with the views expressed by many commenters on the Concept Release, as discussed below.329 We believe that requiring the fund’s board to approve the policies and procedures for asset segregation, including a majority of the fund’s independent directors, appropriately would focus the board’s attention on the fund’s management of its obligations under derivatives transactions and the fund’s use of the exemption provided by the proposed rule. We believe that requiring the fund’s board to approve these policies and procedures, in conjunction with the board’s oversight of the fund’s investment adviser more generally, would be an appropriate role for the board.330

1. Coverage Amount for Derivatives
   Transactions
   Under the proposed rule, a fund would be required to manage the risks associated with its derivatives transactions by maintaining qualifying coverage assets for each derivatives transaction in an amount equal to the sum of (1) the amount that would be payable by the fund if the fund were to exit the derivatives transaction at the time of determination (the ‘‘mark-to￾market coverage amount’’), and (2) a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions (the ‘‘risk￾based coverage amount’’).331 The proposed rule’s asset coverage requirements reflect that, although a fund will be able to determine its current mark-to-market payable under a derivatives transaction on a daily basis, the fund’s investment in the derivatives transaction can involve future losses, and thus potential payments by the fund to counterparties, that will depend on future changes related to the derivative’s reference asset or metric. The proposed rule’s asset coverage requirements for derivatives transactions also are consistent in many respects with the approach suggested by many commenters to the Concept Release.332 These commenters suggested that, for derivatives transactions, a fund should segregate its daily mark-to￾market liability as well as an additional amount, sometimes referred to as a ‘‘cushion’’ by commenters, designed to address future potential losses. a. Mark-to-Market Coverage Amount Under the proposed rule, the ‘‘mark￾to-market coverage amount’’ for a particular derivatives transaction, at any time of determination, would be equal to the amount that would be payable by the fund if the fund were to exit the derivatives transaction at such time.333 We expect that the mark-to-market coverage amount generally would be consistent with a fund’s valuation of a derivatives transaction because the amount of a fund’s mark-to-market coverage amount would generally correspond to the amount of the fund’s

334We believe that the mark-to-market coverage amount also would generally be consistent with the practices of funds that segregate the mark-to-market liability associated with a derivatives transaction. See, e.g., Rafferty Concept Release Comment Letter, at 12 (‘‘For example, because the swap transactions in which the Direxion Trusts engage are fully cash settled, the Direxion Trusts segregate: (1) The amount (if any) by which the swap is out of the money to the fund (i.e., the estimated amount that the fund would be required to pay upon an early termination, hereinafter referred to as the ‘‘fund’s out of the money amount’’), marked-to-market daily, plus (2) the amount of any accrued but unpaid premiums or similar periodic payments, net of any accrued but unpaid periodic payment payable by the counterparty.’’); Loomis Concept Release Comment Letter (indicating that the mark￾to-market value of the derivative contract covers ‘‘the amount of the unrealized gain or loss on the transaction’’). 335Proposed rule18f–4(a)(2). We expect that funds would calculate their mark-to-market coverage amount as part of their determination of their net asset value, for those funds that calculate their net asset value each day. In addition, although the proposed rule does not require a fund to calculate the mark-to-market coverage amount more than once each business day, a fund may determine to calculate this amount more frequently. 336See, e.g., Options Clearing Corporation, Understanding Stock Options (1994), available at http://www.cboe.com/learncenter/pdf/ understanding.pdf, at 8 (noting that the holder or writer of an exchange-traded option ‘‘can close out his position at any time simply by making an offsetting, or closing, transaction’’ which ‘‘cancels out an investor’s previous position as the holder or writer of the option’’). 337Proposed rule 18f–4(c)(6)(i). Under the proposed rule, the total amount of a fund’s qualifying coverage assets must equal at least the sum of the fund’s aggregate mark-to-market coverage amounts and risk-based coverage amounts. Proposed rule 18f–4(a)(2). Thus, qualifying coverage assets could not be used to cover more than one derivatives transaction unless the transactions are subject to a netting agreement and the fund calculates its coverage amounts with respect to such transactions on a net basis. In addition, qualifying coverage assets used to cover a derivatives transaction could not also be used to cover a financial commitment transaction. Proposed rule 18f–4(c)(8). 338See also section III.D. 339Proposed rule 18f–4(c)(6)(ii). 340The custody of fund assets is regulated by
section 17(f) of the Act and the rules thereunder.
Section 17(f) generally requires a fund to place and
maintain its securities and similar investments in the custody of a qualified custodian of the type specified in section 17(f) and the rules thereunder. When we refer in this Release to assets being ‘‘posted’’ or ‘‘delivered,’’ as margin or collateral, we are referring to a fund’s posting or delivering those assets in compliance with the requirements of
section 17 and the rules thereunder. We
understand, for example, that in order to comply with these requirements in respect of non-centrally cleared OTC derivatives, funds generally do not deliver collateral directly to their counterparties, but instead hold posted collateral in a custody account (maintained with the fund’s bank custodian) that is administered pursuant to a tri￾party control agreement among the fund, its custodian and its counterparty, under which the counterparty maintains a security interest in the collateral, but may only have access to the collateral in the event of a fund’s default. liability with respect to the derivatives transaction.334 The proposed rule’s requirement that the fund manage the risks associated with its derivatives transactions by maintaining qualifying coverage assets with a value equal to the fund’s mark-to-market coverage amount thus is designed to require the fund to have assets sufficient to meet its obligations under the derivatives transaction, which may include margin or similar payments demanded by the fund’s counterparty as a result of mark￾to-market losses, or payments that the fund may make in order to exit the transaction. A fund would be required to calculate the mark-to-market coverage amount at least once each business day under the proposed rule in order to provide the fund with a reasonably current estimate of the amount that may be payable by the fund with respect to the derivatives transaction.335 For example, if a fund has a swap position that has moved against the fund (i.e., decreased in value) as a result of a change in the market value of the underlying reference asset, the fund’s mark-to-market coverage amount would generally be equal to the fund’s liability with respect to the swap because that would be the amount payable by the fund if the fund were to exit the swap at that time. The mark-to-market coverage amount thus would reflect the amount that would be payable by the fund based on market values and conditions existing at the time of determination. We understand that in many cases funds can readily calculate such amounts because they are already calculating their liability under the derivatives transaction for purposes of determining their net asset value, and that such mark-to-market amounts may reflect the amounts that would be payable by the fund at such time if the fund were to exit the derivatives transaction due to a default or pursuant to other actions by the fund, such as a negotiated agreement with the fund’s counterparty, a transfer to another party, or a close out of the position through execution of an offsetting transaction. As another example, if a fund has written an option, it will generally have received a premium payment that would represent the option’s fair value at that time. The amount of the premium initially received by the fund for writing the option thus would represent the fund’s mark-to-market coverage amount at the inception of the transaction because it would represent the amount that
would be payable by the fund at that time if the fund were to exit the transaction (in this case, by purchasing an offsetting option).336 The fund generally would be able to satisfy the proposed rule’s requirement to maintain qualifying coverage assets with a value equal to the fund’s mark-to￾market coverage amount at the inception of the trade by maintaining the premium it received for writing the option because the mark-to-market coverage amount, at that time, would generally equal the amount of such premium received. If the option moved against the fund, however, the amount that would be payable by the fund if the fund were to exit the transaction would increase, and this increased amount would represent the fund’s mark-to￾market coverage amount. Under the proposed rule, if a fund has entered into a netting agreement that allows the fund to net its payment obligations with respect to multiple derivatives transactions, the mark-to￾market coverage amount for all derivatives transactions covered by the netting agreement could be calculated on a net basis, to the extent such calculation is consistent with the terms of the netting agreement.337 This aspect of the proposed rule thus is designed so that the mark-to-market coverage amount more accurately reflects the fund’s current net amounts payable with respect to the derivatives transactions covered by such netting agreements.338 The proposed rule would only allow a fund to net derivatives transactions for purposes of determining mark-to-market coverage if the fund has a netting agreement that allows the fund to net its payment obligations with respect to such transactions because, absent such an agreement, the fund generally would not have the right to net its payment obligations and could be required to tender the full amount payable under all of its derivatives transactions. The proposed rule would also allow a fund to reduce the mark-to-market coverage amount for a derivatives transaction by the value of any assets that represent variation margin or collateral to cover the fund’s mark-to￾market loss with respect to the transaction.339 This aspect of the proposed rule would allow a fund to receive credit for assets that the fund posts to cover the fund’s current obligations under the derivatives transaction, and which would be applied as security for, or to satisfy, those obligations under the derivatives transaction.340 For example, if a fund that has entered into an OTC swap and has delivered collateral equal to its mark-to-market loss on the OTC swap, the fund generally would not also be required to segregate qualifying coverage assets with respect to the swap’s mark-to-market coverage amount, because the collateral delivered

341 Depending on the rules of the applicable futures exchange and local law, a variation margin payment with respect to a futures transaction may be deemed to settle the fund’s liability for the daily mark-to-market loss on the futures transaction, and such a payment once made would also eliminate the fund’s liability under the futures transaction. A fund that paid variation margin to settle the full amount of its mark-to-market loss on a futures transaction would not, at that time, have to pay any additional amount if the fund were to exit the transaction. If, at the time the fund determines its mark-to-market coverage amount, the fund would be required to pay an additional amount in excess of variation margin to exit the futures transaction, then the fund would need to have qualifying coverage assets in respect of such additional amount in order to comply with the mark-to-market coverage requirement. 342 If the fund has posted variation margin or collateral in excess of its current liability under the derivatives transaction, such excess amount would not under the proposed rule reduce the fund’s mark-to-market coverage amount for other derivatives transactions, except as otherwise permitted under a netting agreement as described above. 343The proposed rule would, however, allow a fund to reduce a derivative’s risk-based coverage amount by the value of assets posted as initial margin, as discussed below. 344See supra section II.D.1. would equal the amount payable by the fund, based on market conditions, if the fund were to exit the transaction at that time. As another example, if a fund that has invested in a futures contract posts variation margin to settle its daily margin obligations under the futures contract, the fund would not be required to also segregate qualifying coverage assets under the proposed rule to cover this same mark-to-market amount under the proposed rule.341 In order to reduce the mark-to-market coverage amount, the assets must represent variation margin or collateral to cover the mark-to-market exposure of the transaction. Thus, initial margin (sometimes referred to as an ‘‘independent amount’’ with respect to certain OTC derivatives transactions) would not reduce the fund’s mark-to￾market coverage amount with respect to the derivatives transaction because initial margin represents a security guarantee to cover potential future amounts payable by the fund and is not used to settle or cover the fund’s mark￾to-market exposure.342 Initial margin amounts would not be expected to be available to satisfy the fund’s variation margin requirements under a derivatives contract absent a default by the fund— and thus the fund would need additional assets to cover these mark-to￾market payments—notwithstanding that the fund had previously posted initial margin with respect to such derivatives transaction.343 We expect that funds will be readily able to determine their mark-to-market coverage amounts because they are already engaging in
similar calculations on a daily basis. For example, as described in more detail in section II.D.1 above, funds today are determining their current mark-to￾market losses, if any, each business day with respect to the derivatives for which they currently segregate assets on a mark-to-market basis.344 Funds also already calculate their liability under derivatives transactions on a daily basis for various other purposes, including to satisfy variation margin requirements and to determine the fund’s NAV. Funds also calculate their liability under derivatives transactions on a periodic basis in order to provide financial statements to investors. We generally expect that funds would be able to use these calculations to determine their mark-to-market coverage amounts. We request comment on all aspects of the proposed rule’s requirements concerning the mark-to-market coverage amount.

• Is the definition of ‘‘mark-to-market
  coverage amount’’ sufficiently clear? Are there any derivatives transactions for which the definition of mark-to￾market coverage amount would not provide an appropriate calculation of the amounts payable by the fund if the fund were to exit the transaction? Are there types of derivatives transactions for which funds may not be able to determine a mark-to-market coverage amount at least once each business day as proposed?
• Although we have not incorporated
  accounting standards with respect to the determination of mark-to-market coverage amount in the proposed rule, the mark-to-market coverage amount generally would be consistent with a fund’s valuation of a derivatives transaction, as noted above. Should we instead define a fund’s mark-to-market coverage amount based on accounting standards? Should we, for example, define the term mark-to-market coverage amount to mean the amount of the fund’s liability under the derivatives transaction? Would this approach result in mark-to-market coverage amounts that would differ from mark-to-market coverage amounts determined as proposed? If so, how would they differ? If we were to define a fund’s mark-to￾market coverage amount based on accounting standards, are there adjustments to these accounting standards that we should make for purposes of the proposed rule?
• The proposed rule would allow a
  fund to determine its net mark-to￾market coverage amount for multiple derivatives transactions if a fund has entered into a netting agreement that allows the fund to net its payment obligations for the transactions. Is this appropriate? Should we impose further limitations on a fund’s ability to net transactions, including, for example, prohibiting netting across asset classes or across different types of derivatives? Should we, in contrast, permit netting more extensively? Are there other situations in which funds today net their obligations with derivatives counterparties that would not be permitted under the proposed rule and for which funds believe netting would be appropriate? Should we include specific parameters in the rule regarding the enforceability of the agreement in a bankruptcy or similar proceeding?
• The proposed rule would allow a
  fund to reduce its mark-to-market coverage amount by the value of assets that represent variation margin or collateral. Is this appropriate? Should we instead restrict this provision to variation margin or collateral that meets certain minimum requirements (e.g., cash, cash equivalents, high-quality debt securities)? Should we permit the fund to reduce its mark-to-market coverage for initial margin?
• Should we permit a fund to reduce
  its mark-to-market coverage amount in circumstances not involving netting or posting of margin or collateral? Should we, for example, permit funds to reduce their mark-to-market coverage amount for a derivatives transaction to reflect gains in other transactions that the fund believes would mitigate such losses? If we were to permit a fund to reduce its mark-to-market coverage amount in these circumstances, what limitations should we impose to assure that a fund would have liquid assets to meet its obligations under a particular derivatives transaction if a counterparty to a potentially mitigating transaction were to default on its obligation to the fund or that transaction did not perform in a way that would mitigate such losses?
• As noted above, we believe that
  many funds will be readily able to determine their mark-to-market coverage amounts because they today are determining their liability, if any, each business day with respect to the derivatives for which they apply mark￾to-market segregation or for other purposes. Should the mark-to-market coverage amount be determined more than once per day? Is once per day too frequent? Should we require funds to make this determination at the same time they determine their NAV? Should closed-end funds or BDCs or both be subject to different requirements? If we were to permit closed-end funds or BDCs or any other fund to determine

345See, e.g., The Report of the Task Force on Investment Company Use of Derivatives and Leverage, Committee on Federal Regulation of Securities, ABA Section of Business Law (July 6,
2010) (‘‘2010 ABA Derivatives Report’’); SIFMA
Concept Release Comment Letter.
346Moreover, there may be no mark-to-market coverage amount if, as a result of the appreciation of a derivatives transaction, the fund would not be required to make a payment (but rather would receive a payment from its counterparty) if the fund were to exit the derivatives transaction at such time. 347See Concept Release, supra note 3, at n.83. 348See supra note 332. 349Proposed rule 18f–4(a)(2), (c)(9). 350See, e.g., ICI Concept Release Comment Letter, supra note 8; Comment Letter of the Asset Management Group of the Securities Industry and Financial Markets Association (Nov. 23, 2011) (File No. S7–33–11). 351See SIFMA Concept Release Comment Letter; ICI Concept Release Comment Letter; Loomis Sayles Concept Release Comment Letter; BlackRock Concept Release Comment Letter. 352See SIFMA Concept Release Comment Letter. 353See ICI Concept Release Comment Letter. 354Proposed rule 18f–4(a)(2), (a)(5), (c)(9). 355See Concept Release, supra note 3, at n.27. 356Proposed rule 18f–4(c)(9). their mark-to-market coverage amounts less frequently, what additional limitations, if any, should we impose to assure that the funds would have liquid assets to meet their obligations under derivatives transactions? b. Risk-Based Coverage Amount As discussed above, the mark-to￾market coverage amount generally represents the amount that would be payable by the fund if the fund were to exit the derivatives transaction at such time. The fund’s payment obligations under a derivatives transaction could vary significantly over time, however, potentially resulting in a significant gap between the mark-to-market coverage amount, if any, and the fund’s future payment obligations under the derivatives transaction.345 The mark-to￾market coverage amount, if any, may thus be substantially smaller than the potential amounts payable by the fund in the future under the derivatives transaction.346 We observed the argument in the Concept Release that segregating only the mark-to-market liability ‘‘may understate the risk of loss to the fund’’ 347 and many commenters suggested that we require funds to segregate assets in addition to a derivative’s mark-to-market liability.348 Because the fund’s mark-to-market coverage amount for a derivatives transaction would not reflect the potential amounts payable by the fund in the future under the derivatives transaction, the proposed rule would require a fund to segregate an additional amount called the ‘‘risk-based coverage amount’’ that would represent a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions.349 A fund would be required to determine this amount at least once each business day, consistent with the timing applicable to the calculation of the mark-to-market coverage amount as described above, in order to provide the fund with a reasonably current estimate of the potential amounts payable under the derivatives transaction, based on the current
market values and conditions existing at the time the fund makes this determination. This risk-based coverage requirement in the proposed rule is consistent with the views expressed by several commenters to the Concept Release that funds should segregate, not only their current liability under the contract, but also an additional amount meant to cover future losses.350 Several commenters recognized that a fund may be obligated to make future payments in excess of its current liabilities under a derivatives transaction.351 For example, one commenter stated that funds should ‘‘segregate not just the mark-to-market value, but also an additional amount calculated using a measure of potential future losses.’’ 352 Another commenter also noted that requiring funds to segregate a mark-to-market amount under the contract as well as an additional amount meant to cover future losses ‘‘is more akin to the way portfolio managers and risk officers assess the portfolio risks created through the use of derivatives.’’ 353 Under the proposed rule, the risk￾based coverage amount for each derivatives transaction would be determined in accordance with policies and procedures approved by the fund’s board of directors.354 By requiring funds to establish appropriate policies and procedures, rather than prescribing specific segregation amounts or methodologies, the proposed rule is designed to allow funds to assess and determine risk-based coverage amounts based on their specific derivatives transactions, investment strategies and associated risks. We expect that funds may be best situated to evaluate and determine the appropriate risk-based coverage amount for each of their derivatives transactions based on a careful assessment of their own particular facts and circumstances. We believe an approach to asset segregation that is based, in part, on a fund’s assessment of its own particular facts and circumstances would be more appropriate than a requirement to segregate only a fund’s mark-to-market liability, on one hand, or the full notional amount, on the other. As we noted in the Concept Release, ‘‘both notional amount and a mark-to-market amount have their limitations.’’ 355 A fund’s segregation only of any mark-to￾market liability, if any, may not effectively assure the fund will have sufficient assets to meet its obligations under the derivatives transaction for the reasons we discuss above in section II.D.1.c. A fund’s segregation of the full notional amount for all of its derivatives transactions, in contrast, could in some cases require funds to hold more liquid assets than may be necessary to address the investor protection purposes and concerns underlying section 18 because the notional amount of a derivatives transaction does not necessarily equal, and often will exceed, the amount of cash or other assets that fund ultimately would likely be required to pay or deliver under the derivatives transaction. The proposed rule seeks to address these concerns, which
also were shared by commenters on the Concept Release, by requiring a fund to segregate the mark-to-market and risk-based coverage amounts associated with its derivatives transactions. Under the proposed rule, a fund’s policies and procedures for determining the risk-based coverage amount for each derivatives transaction would be required to take into account, as relevant, the structure, terms and characteristics of the derivatives transaction and the underlying reference asset.356 The fund’s risk-based coverage amount for a derivatives transaction, therefore, would be an amount determined in accordance with the fund’s policies and procedures that takes into account these and any other relevant factors in determining a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions. This may include, for example, consideration of the fund’s ability to terminate the trade or otherwise exit the position under stressed conditions, which could include an assessment of the derivative’s terms and the fund’s intended use of the derivative in connection with its investment strategy. We note that, if a fund has a derivatives transaction that is not traded or has an underlying reference asset that is not traded (or, in either case, is not traded on a regular basis) or the fund does not have the ability to terminate the transaction, then a fund’s policies and procedures should consider whether the risk-based coverage amount should, in certain circumstances, be increased to reflect the full potential amount that

357Stressed VaR refers to a VaR model that is calibrated to a period of market stress. As noted in
section III.B.2.a, a concern that has been recognized
with VaR is that it may not adequately reflect ‘‘tail risks,’’ i.e., the size of losses that may occur on the trading days on which the greatest losses occur, and that VaR may underestimate the risk of loss under stressed market conditions. However, by calibrating VaR to a period of market stress, stressed VaR may better reflect the potential losses that a fund could incur through a derivatives transaction, and thus serve as an appropriate method for determining a reasonable estimate of the potential amount payable by the fund if the fund were to exit the transaction under stressed conditions. 358Proposed rule 18f–4(c)(9)(i). 359Proposed rule 18f–4(c)(9)(ii). 360Assets that represent variation margin are used to satisfy the fund’s current mark-to-market liability under the derivatives transaction and would not be available to cover the fund’s potential future liabilities under the transaction. Thus, assets that represent variation margin would not reduce the fund’s risk-based coverage amount with respect to the derivatives transaction. We believe it is appropriate to count only initial margin given that the risk-based coverage amount is designed to cover potential future amounts payable by the fund. 361The proposed rule requires the fund to calculate risk-based coverage amounts on a transaction-by-transaction basis in respect of each of the fund’s derivatives transactions. Assets delivered as collateral for a particular derivatives transaction thus cannot be used to cover other derivatives transactions unless the transactions are covered by a netting agreement. In the event that a fund posts initial margin or collateral to cover multiple derivatives transactions, the risk-based coverage amount for all derivatives transactions covered by such initial margin or collateral cannot be reduced by more than the total amount of the initial margin or collateral. 362See SIFMA Concept Release Comment Letter. may be payable by the fund under the derivatives transaction. In any case, the risk-based coverage amount must be a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions, regardless of whether the fund is currently required to make such payments under the terms of the derivatives contract. The requirements that we are proposing with respect to a fund’s determination of the risk-based coverage amount are intended to permit a fund to tailor its procedures for determining the risk-based coverage amount to respond to the particular risks and circumstances associated with a fund’s derivatives transactions. In developing policies and procedures to determine the risk-based coverage amount, a fund could use one or more financial models to determine the risk-based coverage amount, provided that the calculation reflects a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions and takes
into account, as relevant, the structure, terms and characteristics of the derivatives transaction and the underlying reference asset, as required by the proposed rule. These tools may be useful in estimating the potential amounts payable by the fund under certain derivatives transactions, and may be an efficient way for a fund to determine the risk￾based coverage amount for its derivatives, particularly for those funds that already use such methods for other purposes. For example, as discussed in section III.D.2 below, a fund’s policies and procedures under its derivatives risk management program could include stress testing. A fund that uses stress testing could consider using this approach to estimate the potential amount payable by the fund to exit a derivatives transaction by estimating the effects of various adverse events. Alternatively, a fund’s policies and procedures could provide that, for a particular type of derivatives transaction, the fund’s adviser would use a stressed VaR model to estimate the potential loss the fund could incur, at a given confidence level, under stressed conditions.357 As noted above, a fund’s policies and procedures for determining its risk￾based coverage amount would be required to take into account, as relevant, the structure, terms and characteristics of the derivatives transaction and the underlying reference asset. In calculating its risk-based coverage amount, a fund may take into account considerations in addition to these factors. For example, if a fund elects to conduct stress testing for other purposes and such stress tests incorporate factors other than those specified under the proposed rule, the fund should consider incorporating the results of this stress testing into the determination of its risk-based coverage amount. As with the calculation of mark-to￾market coverage amounts, if the fund has entered into a netting agreement that allows the fund to net its payment obligations with respect to multiple derivatives transactions, the proposed rule would allow a fund to calculate its risk-based coverage amount on a net basis for all derivatives transactions covered by the netting agreement, in accordance with the terms of the netting agreement.358 This aspect of the proposed rule is designed to recognize that if a fund has a netting agreement in effect, the potential amounts payable by the fund under a derivatives transaction covered by such agreement could be reduced by any future payments owed to the fund under other derivatives transactions covered by the netting agreement, with the fund being required to pay only the net amount. Thus, the proposed rule would allow the fund to calculate its risk-based coverage amount for all derivatives transactions covered by the netting agreement on a net basis. For example, if a fund has two derivatives transactions that are covered by a netting agreement, and one of the transactions is inversely correlated with the other position, the fund could determine its
risk-based coverage amount for both derivatives transactions on a net basis, taking into account anticipated gains that it reasonably expects may reduce potential amounts payable by the fund under stressed conditions under other derivatives transactions covered by the same netting agreement. The proposed rule would only allow a fund to net derivatives transactions for purposes of determining risk-based coverage if the fund has a netting agreement that allows the fund to net its payment obligations with respect to such transactions because, absent such an agreement, the fund may not have the right to reduce its payment obligations and could potentially be required to tender the full amount payable under each derivatives transaction. The proposed rule would also allow a fund to reduce the risk-based coverage amount for a derivatives transaction by the value of any assets that represent initial margin or collateral in respect of such derivatives transaction.359 This would allow a fund to receive credit for assets that are already posted as a security guarantee to cover potential future amounts payable by the fund under the derivatives transaction, and which could ultimately be used by the fund’s counterparty to satisfy those obligations if needed. In order to reduce the risk-based coverage amount, the assets must represent initial margin or collateral to cover the fund’s future potential amounts payable by the fund under the derivatives transaction.360 Further, initial margin or collateral can only reduce the risk-based coverage amount for the specific derivatives transaction for which such assets were posted.361 The proposed rule therefore would give a fund credit for initial margin by not requiring the fund to maintain risk￾based coverage assets in respect of future amounts payable that could be satisfied by the fund’s initial margin. We believe that giving a fund credit for initial margin in this way is more appropriate than an approach suggested by at least one commenter under which we would provide that a fund’s ‘‘cushion’’ would be equal to the required initial margin for a particular transaction.362 Final rules regarding the

363See Prudential Regulator Margin and Capital Adopting Release, supra note 160; CFTC Margin Proposing Release, supra note 160; cf. Capital, Margin, and Segregation Requirements for Security￾Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, Exchange Act Release No. 68071 (Oct. 18, 2012) [77 FR 70214 (Nov. 23, 2012)] (‘‘Margin and Capital Proposing Release’’). Under rules adopted by the banking regulators and rules proposed by the CFTC, initial margin may be calculated using either an internal models approach (under which initial margin would be calculated using an approved model calibrated to a period of stress conditions) or a standardized initial margin approach (under which initial margin would be calculated using a standardized initial margin
schedule). Under these rules, however, not all funds
would be required to post initial margin. For example, under rules adopted by the banking regulators, a covered swap entity, such as a bank, would only be required to collect initial margin from a swap counterparty, such as a fund, if the fund has ‘‘material swaps exposure,’’ which is a threshold under the rule that would apply if a fund and its affiliates have average daily aggregate notional exposure from swaps, security-based swaps, foreign exchange forwards, and foreign exchange swaps that exceeds $8 billion. See Prudential Regulator Margin and Capital Adopting Release, supra note 160. The rules proposed by the CFTC have a similar threshold and would only require a covered swap entity to collect initial margin from a swap counterparty, such as a fund, if the fund has material swaps exposure that exceeds $3 billion. See CFTC Margin Proposing Release, supra note 160. Thus, these rules would generally only require a fund to post initial margin if the fund has average daily exposure to swaps in excess of $8 billion or $3 billion. See Prudential Regulator Margin and Capital Adopting Release, supra note 160; CFTC Margin Proposing Release, supra note 160. (The initial margin rules proposed by the Commission for uncleared security-based swaps do not impose minimum thresholds for the collection of initial margin. See Margin and Capital Proposing Release, supra). 364See Prudential Regulator Margin and Capital Adopting Release, supra note 160; CFTC Margin Proposing Release, supra note 160. margin requirements for OTC swaps have not been adopted by all federal agencies, and we note that not all funds may be required to post initial margin for their OTC swaps under those rules.363 Therefore, while these margin requirements may provide benchmarks that may assist a fund in the evaluation of risk-based coverage amounts, they do not appear to provide a means of implementing a risk-based coverage amount requirement for all funds that engage in the use of derivatives.364 A fund could, however, consider any applicable initial margin requirements when determining its risk-based coverage amount for a derivatives transaction. But if a fund determines that its risk-based coverage amount— that is, a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions— is greater than the initial margin the fund would be required to post, the fund would need to maintain qualifying coverage assets equal to such greater amount in order to comply with the proposed rule. We request comment on all aspects of the proposed rule’s requirement that a fund manage the risks associated with its derivatives transactions by maintaining qualifying coverage assets equal to the fund’s aggregate risk-based coverage amounts for its derivatives transactions.

• Is the definition of risk-based
  coverage amount sufficiently clear to allow a fund to develop policies and procedures to determine a risk-based coverage amount for all derivatives transactions?
• Rather than determining the risk￾based coverage amount in accordance
  with policies and procedures approved by the board, should we prescribe risk￾based coverage amounts in the proposed rule? Should we, for example, provide that the risk-based coverage amount must be determined based on a specific financial model (i.e., VaR at a particular confidence level)? Should we specify a percentage of the derivative’s notional value? If so, what percentage should we choose? Should it vary for different types of derivatives? For example, should the proposed rule include a standardized schedule that specifies the risk-based coverage amount for particular derivatives transactions? If so, should the schedule be similar to, or different from, the standardized schedules under rules that have been proposed or adopted for swap entities that are required to collect initial margin and elect to use a standardized schedule approach instead of an internal model approach? If so, should the standardized
  schedule approach be in addition to, or
  in place of, the approach currently described in the proposed rule? Why or why not?
• Should we retain the proposed
  rule’s approach that the risk-based coverage amount be determined in accordance with board-approved policies and procedures, but also provide funds the option to use certain prescribed standards for the calculation of the risk-based coverage amount? In other words, should the proposed rule prescribe a specific financial model or amount of the derivative’s notional amount that could be used by funds to determine the risk-based coverage amount without the need for additional policies and procedures? If so, which models or notional amounts should we specify? Should we provide, for example, that a fund may use as its risk￾based coverage amount for a particular derivatives transactions the VaR calculated using a VaR model that meets the minimum criteria for a VaR model under the proposed rule and that provides stressed VaR estimates?
• Are there additional items that a
  fund should be required to consider when preparing policies and procedures in respect of the risk-based coverage amount?
• The risk-based coverage amount as
  proposed would be a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions. Is the term ‘‘stressed conditions’’ clear? If not, how could the term ‘‘stressed conditions’’ be made more clear? Is ‘‘stressed conditions’’ an appropriate standard? Is there an alternative standard that would be more appropriate? Should it be an estimate that does not involve stressed conditions?
• The proposed rule would allow a
  fund to net derivatives transactions for purposes of determining the risk-based coverage amount if a fund has a netting agreement in effect that would allow the fund to net its payment obligations for such transactions. Is this appropriate? Should we impose further limitations on a fund’s ability to net transactions, including, for example, prohibiting netting across asset classes or different types of derivatives? Should we, in contrast, permit netting more extensively? Are there situations in which initial margin for funds is calculated on a net basis that would not be permitted under the proposed rule and for which funds believe netting would be appropriate? Are there other situations in which funds today net their obligations with derivatives counterparties that would not be permitted under the proposed rule and for which funds believe netting would be appropriate? Should we include specific parameters in the rule regarding the enforceability of the agreement in a bankruptcy or similar proceeding?
• In situations not involving a netting
  agreement, should we allow a fund to reduce its risk-based coverage amount for a derivatives transaction to reflect anticipated or actual gains in other transactions that the fund believes are likely to produce gains for the fund at the same time as other derivatives experience losses? If so, what parameters or guidelines should we prescribe to address market risk, counterparty risk or other payment risks if netting is permitted under the proposed rule for these separate transactions?
• The proposed rule would allow a
  fund to reduce its risk-based coverage amount by the value of assets that represent initial margin or collateral. Is this appropriate? Should we instead

365Proposed rule 18f–4(c)(8). 366Proposed rule 18f–4(c)(8). The proposed rule would not require funds to place qualifying coverage assets in a separate segregated account. In this Release when we refer to assets that a fund would ‘‘segregate’’ under the proposed rule, these are assets that the fund would identify as qualifying coverage assets on the fund’s books and records determined at least once each business day, as noted above. 367FASB Accounting Standards Codification paragraph 305–10–20l; see also Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014) [79 FR 47736 (Aug. 14, 2014)] (‘‘2014 Money Market Fund Reform Adopting Release’’), at sections III.A.7 and III.B.6 (clarifying that the reforms to the regulation of money market funds adopted by the Commission in 2014 should not preclude an investment in a money market fund from being classified as a cash equivalent under U.S. GAAP under normal circumstances). 368See Liquidity Release, supra note 5; FASB Accounting Standards Codification paragraph 305– 10–20l; Form PF: Glossary of Terms (defining ‘‘cash and cash equivalents’’). 369See Liquidity Release, supra note 5, at 123 (‘‘Cash and cash equivalents are extremely liquid (in that they either are cash, or could be easily and nearly immediately converted to cash without a loss in value), and significant holdings of these instruments generally decrease a fund’s liquidity risk because the fund could use them to meet redemption requests without materially affecting the fund’s NAV.’’). 370 ISDA Margin Survey 2015 (Aug. 2015), available at https://www2.isda.org/functional￾areas/research/surveys/margin-surveys. The ISDA Margin Survey included 41 ISDA members, approximately 90% of whom were banks or broker￾dealers, in the Americas (32%), Europe/Middle East Africa (53%) and Asia (16%). Figures for uncleared margin reflect responses of large firms, i.e., those having more than 3,000 active non-cleared ISDA collateral agreements. Under the ISDA Margin Survey, government agency and government sponsored entity securities, US municipal bonds and supranational bonds were categorized separately from the ‘‘government securities’’ category and therefore are not included in the percentages cited above. As previously noted, examples of items commonly considered to be ‘‘cash equivalents’’ include certain Treasury bills, agency securities, bank deposits, commercial paper, and shares of money market funds (see supra note 368 and accompanying text). In light of the global nature of the survey and the types of entities surveyed, we request comment below on whether cash and cash equivalents are the assets most commonly used by funds for posting initial and variation margin to their counterparties. restrict this reduction to initial margin or collateral that meets certain minimum requirements (e.g., cash, cash equivalents, high-quality debt securities)? Should we, in contrast, give the fund more flexibility to reduce
its risk-based coverage?

• Should we require the risk-based
  coverage amount to be calculated based expressly on initial margin requirements, rather than requiring funds to determine these amounts in accordance with policies and procedures, as proposed, which could be informed by margin requirements? Should we require the risk-based coverage amount to be no less than the initial margin requirement, without regard to minimum transfer amounts or limits that would apply to a particular fund?
• Should we require any type of
  stress testing or back-testing with respect to the calculation of the risk￾based coverage amount?
• Should the risk-based coverage
  amount be determined more than once per day? Is once per day too frequent?
• The risk-based coverage amount as
  proposed would generally be determined on an instrument-by￾instrument basis (but would permit the fund to determine risk-based coverage amounts on a net basis in certain circumstances as discussed above). Should we, instead, permit or require funds to determine the risk-based coverage amount on a fund’s entire portfolio? Alternatively, should we permit the risk-based coverage amount to be determined on a net basis with respect to particular subsets of the portfolio? For example, should we allow a fund to calculate separate risk-based coverage amounts for instruments that fall within different broad risk categories, such as equity, credit, foreign exchange, interest rate, and commodity risk? If so, how should funds calculate such risk-based coverage amounts? Would either of these approaches be more or less effective at assuring funds will have liquid assets to meet their obligations under their derivatives transactions? Would either of these approaches be more or less cost efficient for funds?

2. Qualifying Coverage Assets
   As described above, the proposed rule would require a fund to manage the risks associated with its derivatives transactions by maintaining qualifying coverage assets, identified on the books and records of the fund and determined at least once each business day, in respect of each derivatives transaction. Under the proposed rule, ‘‘qualifying coverage assets’’ in respect of a derivatives transaction would be fund assets that are either: (1) Cash and cash equivalents; or (2) with respect to any derivatives transaction under which the fund may satisfy its obligations under the transaction by delivering a particular asset, that particular asset. The total amount of a fund’s qualifying coverage assets could not exceed the fund’s net assets.365 a. Cash and Cash Equivalents Under the proposed rule, a fund would generally be required to segregate cash and cash equivalents as qualifying coverage assets in respect of its coverage obligations for its derivatives transactions.366 Current U.S. generally accepted accounting principles define cash equivalents as short-term, highly liquid investments that are readily convertible to known amounts of cash and that are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates.367 Examples of items commonly considered to be cash equivalents include certain Treasury bills, agency securities, bank deposits, commercial paper, and shares of money market funds.368 We believe that cash and cash equivalents are appropriate qualifying coverage assets for derivatives transactions because these assets are extremely liquid because they are cash or could be easily and nearly immediately converted to known amounts of cash without a loss in value.369 Other types of assets, in contrast, may be more likely to experience volatility in price or to decline in value in times of stress, even if subject to a haircut. We are not proposing to include as qualifying coverage assets other types of assets, such as equity securities or other debt securities, because we are concerned about the risk that such assets could decline in value at the same time the fund’s potential obligations under the derivatives transactions increase, thus increasing the possibility that such assets could be insufficient to cover the fund’s obligations under derivatives transactions. In addition, we understand that cash and cash equivalents are commonly used for posting collateral or margin for derivatives transactions. For example, ISDA reported in a 2015 survey that cash represented 77% of collateral received for uncleared derivatives transactions (with government securities representing an additional 13% percent), while for cleared OTC transactions with clients, cash represented 59% of initial margin received (with government securities representing an additional 39%) and 100% of variation margin received.370 Given that the proposed rule’s requirements relating to the mark-to￾market coverage amount and
   risk-based coverage amount are conceptually similar to initial margin (which represents an amount collected to cover potential future exposures) and variation margin (which represents an collected to cover current exposures), and that the proposed rule would permit the mark-to-market coverage amount and risk-based coverage amount to be reduced by the value of assets that represent initial or variation margin, we believe that limiting qualifying coverage

371See, e.g., AQR Concept Release Comment Letter, at 4 (‘‘If the Merrill Lynch Letter were withdrawn, we believe investors in certain funds would be harmed. Equity funds or high yield funds, for example, would find it difficult to utilize derivatives because these funds do not usually hold large quantities of cash and high grade debt obligations that could be used as collateral.’’); BlackRock Concept Release Comment Letter, at 5 (‘‘Holding cash and U.S. Government securities to satisfy asset coverage requirements may be in conflict with the stated investment objectives of a fund and effectively would prevent many equity and certain bond funds from being able to use derivatives when derivatives are the most effective ways of implementing portfolio strategies.’’). 372Proposed rule 18f–4(c)(8). 373We note that, in this type of ‘‘covered call’’ transaction where a fund owns the security that is required to be delivered under the written option, the fund could reasonably conclude that the sum of the mark-to-market coverage amount and the risk-based coverage amount for such written option is equal to the value of the security. Thus, the fund could satisfy the asset segregation requirements of the proposed rule by segregating the security itself, without segregating additional qualifying coverage assets. 374We note, however, that if a fund entered into two transactions that were covered by a netting agreement, the proposed rule would permit the mark-to-market coverage amount and risk-based coverage amount to be determined on a net basis, which could result in a reduction in the amount of qualifying coverage assets that the fund would need to segregate if such transactions were offsetting. As discussed in section III.B.1.b.ii, for purposes of the exposure limits under the proposed rule, a fund may net directly offsetting derivatives transactions that are the same type of instrument and have the same underlying reference asset, maturity and other material terms, even if those transactions are entered into with different counterparties and without regard to whether those transactions are subject to a netting agreement. See proposed rule 18f–4(c)(3)(i). We believe that it is appropriate to allow such netting for purposes of the proposed rule’s exposure limits because in those circumstances, netting can be expected to eliminate a fund’s market exposure. By contrast, the proposed rule’s asset coverage requirements are designed to address a different primary concern, namely, the ability of a fund to meet its obligations arising from derivatives transactions. 375See, e.g., ICI Concept Release Comment Letter; SIFMA Concept Release Comment Letter; Oppenheimer Concept Release Comment Letter. 376Proposed rule 18f–4(c)(8). assets to cash and cash equivalents would be appropriate. We note that some commenters on the Concept Release opposed a more restrictive requirement for asset segregation, such as the one we are proposing today, stating that a more restrictive
approach could limit certain funds’ ability to use derivatives.371 However, we note that these comments were made in the context of the Concept Release, which sought comment on the appropriate amount of segregated assets for a derivatives transaction in the context of the current approach, under which funds segregate the full notional amount for some types of derivatives transactions. The proposed rule, however, would not require funds to segregate a derivative’s full notional amount, and instead would require the fund to segregate its mark-to-mark and risk-based coverage amounts. Given the proposed rule’s requirement to segregate these amounts with respect to their derivatives transactions, we believe it is appropriate to require that the segregated assets be assets that are extremely liquid. b. Assets Required To Be Delivered Under the Derivatives Transaction With respect to any derivatives transaction under which a fund may satisfy its obligations under the transaction by delivering a particular asset, the proposed rule would allow the fund to segregate that particular asset as a qualifying coverage asset.372 Because, in such derivatives transactions, the fund could satisfy its obligations by delivering the asset itself, we believe that these assets would be an appropriate qualifying coverage asset for such transactions. For example, if the fund has written a call option on a particular security that the fund owns, then the security could be considered a qualifying coverage asset in respect of the written option.373 In that example, the fund’s delivery of such security would satisfy its obligations under the written option and any change in the value or liquidity of such security should not affect the ability of the fund to satisfy its payment obligation under the call option. Under the proposed rule, the particular asset that the fund may deliver to satisfy its obligations under the derivatives transaction would be a qualifying coverage asset. However, a qualifying coverage asset for a derivatives transaction generally would not include a derivative that provides an offsetting exposure. For example, if a fund has written a CDS on a bond, a purchased CDS on the same bond entered into with a different counterparty generally would not be considered a qualifying coverage asset in respect of the written CDS because the fund would be exposed to the risk that its counterparty could default or fail to perform its obligation under the purchased CDS, thereby potentially leaving the fund without sufficient assets to satisfy its obligations under the written CDS.374 Such a result would be inconsistent with the purpose of the asset segregation requirement in the proposed rule, which is designed to enable the fund to meet its obligations arising from the derivatives transaction. In addition, and as discussed in more detail in section III.B.1.d above, we have not included in the proposed rule provisions for particular types of potential hedging and other
cover transactions. The same considerations we discuss above in section III.B.1.d similarly weigh against our including exceptions to the asset coverage requirements in the proposed rule for these kinds of transactions. We recognize that commenters to the Concept Release generally advocated for retaining the flexibility offered by the cover transaction approach.375 The proposed rule is designed instead to provide some flexibility to funds to determine the appropriate risk-based coverage amount (rather than a derivative’s full notional amount), and in this context, we believe that additional flexibility regarding particularized cover transactions (other than those covered by a netting agreement as described above) may not address the asset sufficiency concern under the Act.
c. Limit on the Total Amount of
Qualifying Coverage Assets Under the proposed rule, the total amount of a fund’s qualifying coverage assets could not exceed the fund’s net assets.376 This aspect of the proposed rule is designed to require a fund to have sufficient qualifying coverage assets to meet its obligations under its derivatives transactions and also prohibit a fund from entering into a financial commitment transaction or otherwise issuing senior securities pursuant to section 18 or 61 of the Act and then using the additional assets resulting from such leveraging transactions to support an additional layer of leverage through senior securities transactions. Thus, if a fund borrowed from a bank, for example, the aggregate amount of the fund’s assets that the fund might otherwise use as qualifying coverage assets for derivatives transactions would be reduced by the amount of the outstanding bank borrowing. We believe it is appropriate for a fund that enters into derivatives transactions in reliance on the proposed rule to have qualifying coverage assets in excess of the amounts the fund owes to other counterparties so that the fund’s qualifying coverage assets would be available to satisfy the fund’s obligations under its derivatives transactions if necessary. Therefore, under the proposed rule, the total amount of a fund’s qualifying coverage assets could not exceed the fund’s net assets. We request comment on all aspects of the proposed rule’s definition of qualifying coverage assets.

• For derivatives transactions, the
  proposed rule contains the same

377See Margin and Capital Proposing Release, supra note 363. 378See Prudential Regulator Margin and Capital Adopting Release, supra note 160. 379See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin Requirements for Non-Centrally Cleared Derivatives (Mar. 2015), available at http://www.bis.org/bcbs/publ/d317.pdf. 380See, e.g., Investment Company Act sections 1(b)(7), 1(b)(8), 18(a), and 18(f); see also section II.B.1. 381See, e.g., 2008 IDC Report, supra note 72. See also Mutual Funds and Derivative Instruments, Division of Investment Management. requirements for qualifying coverage assets in respect of the mark-to-market coverage amount and the risk-based coverage amount. Should there be a difference in the requirements for qualifying coverage assets in respect of the mark-to-market coverage amount and the risk-based coverage amount? If so, what changes should be made? Should we, for example, permit funds to use a broader range of assets as qualifying coverage assets with respect to a fund’s risk-based coverage amount because that amount reflects potential amounts payable by the fund, rather than the mark-to-market payable amounts represented by the fund’s mark-to-market coverage amount?

• Under the proposed rule, a fund
  would generally be required to segregate cash and cash equivalents. Is the range of assets that would be included as cash and cash equivalents sufficiently clear? Are there other types of assets that commenters believe are cash equivalents that we should identify by way of example? Should we instead define ‘‘cash equivalents’’ in the proposed rule? If so, how should we define ‘‘cash equivalents’’?
• Should we allow funds to segregate
  other types of assets in addition to cash and cash equivalents? If so, what other types of assets should we allow? For example, should we permit funds to segregate any U.S. government security (i.e. any security issued or guaranteed as to principal and interest by the U.S. government)? Should we allow funds to segregate high grade debt obligations as discussed in Release 10666? If so, how should we define high grade debt obligations for this purpose? Should we permit funds to segregate assets that would be eligible as collateral for margin under the rules that have been proposed or adopted for swap entities? Should we instead allow funds to segregate any Three-Day Liquid Asset as defined in proposed rule 22e–4? If we were to permit funds to segregate other types of assets in addition to cash and cash equivalents, should we place restrictions on these other types of assets to protect against the risk that the gains and losses on these coverage assets held by the fund may be correlated with the performance of reference assets underlying the fund’s derivatives transactions in such a way that they could lose value in stressed market conditions when the fund’s liabilities under derivatives transactions may be increasing?
• If we were to allow funds to
  segregate other assets as qualifying coverage assets (whether for all purposes or only the fund’s risk-based coverage amount), what additional measures, if any, should we require funds to undertake in order to protect against potential changes in the value and/or liquidity of such assets? For example, should we impose haircuts on such assets? If so, how should we determine the appropriate haircut? For example, should we incorporate the haircuts described in the SEC’s proposed margin requirements for security-based swap dealers and major security-based swap participants? 377 Or, should we incorporate the haircut
  schedule included in the rules adopted
  by the banking regulators for covered swap entities? 378 Is there a different haircut schedule that would be more appropriate for the proposed rule?
• If we were to allow funds to
  segregate other assets as qualifying coverage assets (whether for all purposes or only the fund’s risk-based coverage amount), should we impose additional restrictions if the assets are closely correlated with the exposure created by the derivatives transaction? What types of requirements should we impose for assessing these correlations?
• Under the proposed rule, qualifying
  coverage assets for derivatives transactions generally would not include a derivative that provides an offsetting exposure. Is this appropriate? Why or why not?
• Some commenters to the Concept
  Release stated that requiring funds to segregate cash and other high-quality debt obligations could make it difficult for certain funds to use derivatives.379 Given that the proposed rule would not require funds to segregate assets equal to the full notional value of its derivatives transactions, and would permit a fund to reduce its mark-to-market and risk￾based coverage amounts to take account of margin posted by the fund, do such concerns remain?
• Under the proposed rule, the total
  amount of a fund’s qualifying coverage assets could not exceed the fund’s net assets. Do commenters agree that this is appropriate? Should we, instead, specify that qualifying coverage assets must not be ‘‘otherwise encumbered’’? Is there a different approach we should take to prevent a fund from using assets to cover multiple different obligations or potential obligations?
• The proposed rule’s asset
  segregation requirements for derivatives transactions, although designed primarily to enable the fund to meet its obligations arising from its derivatives transactions, also could serve to limit a fund’s ability to obtain leverage through derivatives transactions to the extent that a fund limits its derivatives usage in order to comply with the asset segregation requirements. As noted above, a fund might limit its derivatives transactions in order to avoid having to maintain qualifying coverage assets for the transactions, and the asset segregation requirements may limit a fund’s ability to enter into a derivatives transaction if the fund does not have, and cannot acquire, sufficient qualifying coverage assets to engage in additional derivatives transactions. To what extent do commenters believe that the proposed rule’s asset segregation requirements would impose a practical limit on the amount of leverage a fund could obtain? D. Derivatives Risk Management Program The use of derivatives can pose a variety of risks to funds and their investors, although the extent of the risk may vary depending on how a fund uses derivatives as part of the fund’s investment strategy. As discussed previously, these risks can include the risk that a fund may operate with excessive leverage or without adequate assets and reserves, which are both core concerns of the Act.380 Other potential risks associated with derivatives use can include market, counterparty, leverage, liquidity, and operational risk. While many of these risks are not limited to derivatives investments, the complexity and character of derivatives investments may heighten such risks.381 The proposed rule’s portfolio limitations and asset coverage requirements are intended to help limit the extent of the fund’s exposure to many of these risks. These requirements are designed both to impose a limit on the amount of leverage a fund may obtain from derivatives and to require the fund to manage its risks by having qualifying coverage assets to meet its obligations while providing funds with flexibility to engage in a wide variety of derivatives transactions and investment strategies. These restrictions on funds’ use of derivatives are generally intended to provide limits on the magnitude of funds’ derivatives exposures, and in the case of a fund operating under the risk￾mstockstill on DSK4VPTVN1PROD with PROPOSALS2

382See supra section II.D.1.d.
383See, e.g., Mutual Fund Derivative Holdings:
Fueling the Need for Improved Risk Management, JPMorgan Thought Magazine (Summer 2008) (‘‘2008 JPMorgan Article’’), available at http:// www.jpmorgan.com/cm/BlobServer?blobcol =urldata&blobtable=Mungo Blobs&blobkey=id&blobwhere =1158494213964&blobheader=application %2Fpdf&blobnocache=true&blobheadername1 =Content; 2008 IDC Report, supra note 72. 384See supra note 27 and accompanying text. 385See, e.g., 2008 IDC Report, supra note 72; Fund Board Oversight of Risk Management, Independent Directors Council (Sept. 2011) (‘‘2011 IDC Report’’), available at http://www.ici.org/pdf/ pub_11_oversight_risk.pdf. 386See, e.g., 2011 IDC Report, supra note 385, at 9. 387Proposed rule 18f–4(a)(3). As discussed in greater detail below, the derivatives risk management program requirement that we are proposing today would only apply to ‘‘derivatives transactions,’’ and not to other senior securities transactions, such as financial commitment transactions as defined under the rule. 388See proposed rule 18f–4(a)(3). 389Proposed rule 18f–4(a)(3)(ii). 390Proposed rule 18f–4(a)(3)(ii)(B). based limit, to require that the fund’s derivatives transactions, in the aggregate, have the effect of reducing the fund’s exposure to market risk. These limits and associated risk management requirements would be complemented by the proposed rule’s formalized derivatives risk management program requirement, which would require funds that engage in more than a limited amount of derivatives transactions, or that use complex derivatives transactions as defined in the proposed rule, to also have a formalized program that includes policies and procedures reasonably designed to assess and manage the particular risks presented by the fund’s use of derivatives. We have observed that fund investments in derivatives can pose risk management challenges, and poor risk management may cause significant harm to funds and their investors.382 We understand that, today, the advisers to many funds whose investment strategies could entail derivatives risk routinely conduct risk management to evaluate a fund’s derivatives usage.383 A fund’s use of derivatives presents challenges for its investment adviser and board of directors in managing derivatives transactions so that they are employed in a manner consistent with the fund’s investment objectives, policies, and restrictions, its risk profile, and relevant regulatory requirements, including those under the federal securities laws.384 Funds and their advisers may face liability under the antifraud provisions of the federal securities laws if their use of derivatives is inconsistent with these constraints. Accordingly, we understand that advisers to many funds whose investment strategies entail the use of derivatives already assess and manage such risk. Fund advisers that today engage in active risk management of their derivatives may use a variety of tools. Depending on the fund and its derivatives use, these tools might include a formalized
derivatives risk management program led by a dedicated risk manager or risk committee, the use of other checks and balances put in place by a fund’s portfolio management team, or other tools.385 We understand that many fund boards oversee the fund adviser’s risk management process as
part of their general oversight of the
fund.386 As a result, we believe that the proposed program would likely have the effect of enhancing practices that are in place at many funds today by specifying requirements for funds that rely on the rule to evaluate the risks associated with the funds’ use of derivatives and to inform the funds’ boards of directors about these risks as part of a regular dialogue with officers of the fund or its adviser. The proposed measures will help enhance derivatives risk management by requiring that any fund that engages in more than a limited amount of derivatives transactions pursuant to the proposed rule, or that uses complex derivatives transactions, adopt and implement a formalized derivatives risk management program (a ‘‘program’’).387 The program’s requirements would be in addition to the requirements related to derivatives risk management that would apply to every fund that enters into derivatives transactions, including, for example, the requirement to manage derivatives risk through determining the risk-based coverage amounts on a daily basis, and the requirement to monitor compliance with the proposed portfolio limit under which the fund’s derivatives exposure may not exceed 50% of net assets and the fund may not enter into complex derivatives transactions. The formalized risk management program condition would require a fund to have policies and procedures reasonably designed to:

• Assess the risks associated with the
  fund’s derivatives transactions, including an evaluation of potential leverage, market, counterparty, liquidity, and operational risks, as applicable, and any other risks considered relevant;
• Manage the risks of the fund’s
  derivatives transactions, including by monitoring the fund’s use of derivatives transactions and informing portfolio management of the fund or the fund’s board of directors, as appropriate, regarding material risks arising from the fund’s derivatives transactions;
• Reasonably segregate the functions
  associated with the program from the portfolio management of the fund; and
• Periodically (but at least annually)
  review and update the program.388 The program, which would be administered by a designated derivatives risk manager, would require funds, at a minimum, to adopt policies and procedures reasonably designed to implement certain specified elements, and would include administration and oversight requirements. The program is expected to be tailored by each fund and its adviser to the particular types of derivatives used by the fund and the manner in which those derivatives relate to the fund’s investment portfolio and strategy. Funds that make only limited use of derivatives would not be subject to the proposed condition requiring the adoption of a formalized derivatives risk management program under the proposed rule. Proposed rule 18f–4 would include board oversight provisions related to the derivatives risk management program requirement. Specifically, a fund’s board would be required to approve the fund’s derivatives risk management program, any material changes to the program, and the fund’s designation of the fund’s derivatives risk manager (who cannot be a portfolio manager of the fund).389 The board also would be required to review written reports prepared by the designated derivatives risk manager, at least quarterly, that review the adequacy of the fund’s derivatives risk management program and the effectiveness of its implementation.390 A fund might, as it determines appropriate, expand its derivatives risk management procedures beyond the required program elements and should consider doing so whenever it would be necessary to ensure effective derivatives risk management. The proposed derivatives risk management program would serve as an important complement to the other conditions of proposed rule 18f–4. We expect that the rule’s portfolio limitations and asset coverage requirements would provide ‘‘guard rails’’ designed to impose a limit on leverage and to require funds to have qualifying coverage assets to meet their obligations, which should help to limit funds’ exposure to some of the risks associated with the use of derivatives. Nonetheless, for funds that engage in more than a limited amount of

391Under section 18(h), ‘‘asset coverage’’ of a class of senior security representing an indebtedness of an issuer means the ratio which the value of the total assets of such issuer, less all liabilities and indebtedness not represented by senior securities, bears to the aggregate amount of senior securities representing indebtedness of such issuer.’’ Take, for example, an open-end fund with $100 in assets and with no liabilities or senior securities outstanding. The fund could, while maintaining the required coverage of 300% of the value of its assets subject to section 18 of the Act, borrow an additional $50 from a bank; the $50 in borrowings would represent one-third of the fund’s $150 in total assets, measured after the borrowing (or 50% of the fund’s $100 net assets). 392As discussed in section III.B.1.c above, we also have considered whether the 50% limitation that Congress established for obligations and leverage through the use of bank borrowings should also be applied to limit the use of derivatives transactions and have noted that derivatives differ in certain respects from borrowings permitted under section
18. See supra note 207 and accompanying text.
393We note that under the proposed rule, the threshold for implementing a derivatives risk management program would be triggered by the notional exposure of the fund’s derivatives transactions only, and would not include the exposure to a fund’s financial commitment or other senior securities transactions. This is in contrast to other aspects of the proposed rule’s calculations of exposure, which would include in the calculation all senior securities transactions, not just derivatives. Rule 18f–4(a)(4). We are taking this approach because, as discussed throughout this Release, the risks of derivatives transactions often differ in magnitude and kind from the risks of other senior securities transactions. 394See supra section II.D.1.d. See also supra note 207 and accompanying text. 395This risk management requirement is discussed in detail in section III.C of this Release. 396Proposed rule 18f–4(4). derivatives use, or that use complex derivatives, we believe that the outside limits set by the proposed portfolio limitations and the protections provided by the asset coverage requirements should be coupled with a formalized risk management program tailored to the ways which funds use derivatives and the specific risks to which funds are exposed. While we recognize that many funds already engage in significant risk management of their derivatives transactions, we have observed that the quality and extent of such practices vary among funds in that some funds have carefully structured risk management programs with clearly allocated functions and reporting responsibilities while others are left largely to the discretion of the portfolio manager. In light of the dramatic growth in the volume and complexity of the derivatives markets over the past two decades, and the increased use of derivatives by certain funds, we believe that in connection with providing exemptive relief from section 18, it is appropriate to require certain funds to have a formalized risk management program focused on the particular risks of these transactions. We believe that requiring a risk management program that meets the requirements in the proposed rule should serve to establish a standardized level of risk management for funds that engage in more than a limited amount of derivatives use or that use complex derivatives, and thus should provide valuable additional protections for the shareholders of such funds.

1. Funds Subject to the Proposed Risk
   Management Program Condition We are proposing that funds that exceed a 50% threshold of notional derivatives exposure would be subject to the specific risk management program condition discussed here. Under section 18, open- and closed-end funds are permitted to engage in certain senior securities transactions, as discussed above, subject to a 300% asset coverage requirement or a 200% coverage requirement for closed-end fund issuance of preferred equity. A mutual fund therefore can borrow from a bank (and a closed-end fund can issue other senior securities) under section 18 provided that the amount of such borrowings (or other senior securities) does not exceed one-third of the fund’s total assets, or 50% of the fund’s net assets.391 This threshold represents a determination by Congress of an appropriate amount of senior security transactions that funds may achieve through bank borrowings (and certain other transactions in the case of closed￾end funds).392 As discussed previously, for a number of reasons we have determined to propose to permit a fund to engage in derivatives transactions provided it complies with all of the conditions in proposed rule 18f–4. Under the proposal, if a fund exceeds a threshold of 50% notional amount of derivatives transactions, that fund must adopt and implement a formalized risk management program.393 We believe that a threshold analogous to the statutorily defined threshold for senior securities under section 18 represents a level of derivatives use, which if exceeded, should be managed through such a derivatives risk management program.394 Because we expect that a risk management program should help mitigate the risks associated with a fund incurring obligations from the use of derivatives above the statutory defined level that would be permitted for borrowings, we believe that this requirement is consistent with the exemption we are providing today for these transactions. While we are proposing that a formalized risk management program would be a requirement only for those funds that exceed the 50% threshold or that use complex derivatives transactions, all funds that enter into derivatives transactions in reliance on the proposed rule would also be required to manage risks relating to their derivatives transactions through compliance with various other requirements of the proposed rule and other rules under the Act. For example, under our proposal, a fund that engages in even a single derivatives transaction would be required to manage the risks of those derivatives transactions by segregating qualifying coverage assets determined at least once each business day.395 This would require the fund each business day to determine the risk￾based coverage amount for each of its derivatives transactions which we believe would enable the funds to better manage their risks relating to the use of derivatives. This risk-based coverage amount would be determined in accordance with policies and procedures approved by the
   fund’s board and would represent a reasonable estimate of the amount payable by the fund if it were to exit the derivatives transaction under stressed conditions. Thus, the fund would be required to monitor and manage the potential risk of loss associated with each of its derivatives transactions on a daily basis as part of the fund’s determination of its risk-based coverage amounts, and all funds would therefore be required under the proposed rule to make an assessment of potential losses associated with their derivatives transactions under stressed conditions. This risk management requirement applies to every fund that uses derivatives, regardless of whether it is also subject to the formalized derivatives risk management program condition. In addition, a fund that is not required to establish a formalized risk management program must comply, and monitor its compliance, with the portfolio limitation under which the fund may not permit its derivatives exposure to exceed 50% of the fund’s net assets immediately after entering into any derivatives transactions and may not enter into any complex derivatives transactions.396 A fund that uses any derivatives would be required to monitor the types and notional amounts of the fund’s derivatives transactions and the fund’s aggregate exposure to prevent the fund’s derivatives exposure from exceeding 50% of net assets and to prevent the fund from entering into complex

397 In addition, rule 38a–1 would also require funds to have policies and procedures reasonably designed to prevent the fund from exceeding any other applicable portfolio limitation under the proposed rule. See Compliance Programs of Investment Companies and Investment Advisers, Release Nos. IA–2204 and IC–26299 (December 17, 2003). If a fund were to breach the portfolio limitation established by the board, this would likely be a material compliance matter that would be required to be disclosed in writing to the fund’s board in the CCO’s annual report to the board. We expect that this may serve to further enhance funds’ risk management practices. In addition, a fund’s exceeding its portfolio limit also could be a serious compliance issue that should be brought to the board’s attention promptly. See infra note 449. 398We acknowledge that derivatives can be used for both hedging and speculative purposes, but even if primarily used for hedging purposes, we believe that significant use of derivatives instruments poses additional risks that may need to be assessed, monitored, and managed. See, e.g., David Weinberger, et al., Using Derivatives: What senior managers must know, Har. Bus. Rev. (Jan.–Feb. 1995), available at https://hbr.org/1995/01/using￾derivatives-what-senior-managers-must-know; Sergey Chernenko & Michael Faulkender, The Two Sides of Derivatives Usage: Hedging and Speculating with interest rate swaps, J. of Fin. and Quantitative Analysis, (Dec. 2011), available at http://journals.cambridge.org/download.php?file= %2FJFQ%2FJFQ46_06%2FS002210 9011000391a.pdf&code=0d15622321dedaa274f024 857fd4885c. 399Funds that are not required to adopt and implement a derivatives risk management program should generally still consider the risks of derivatives, because even small amounts of derivatives may pose significant risks if engaged in by an entity that is an inexperienced user of such instruments or when adverse market events occur. See, e.g., Rene M. Stulz, Should we fear derivatives?, J. of Econ. perspectives (Summer 2004), available at http://fisher.osu.edu/ supplements/10/10402/Should-We-Fear￾Derivatives.pdf. 400Proposed rule 18f–4(a)(4). 401Although we believe that any fund that engages in derivatives would likely evaluate the risks of such transactions as part of the adviser’s management of the fund’s portfolio, we are not proposing that funds that keep their use of derivatives below the 50% threshold be subject to the proposed program requirements under rule 18f– 4 unless the fund uses complex derivatives transactions, as discussed below. 402We note that no BDC’s identified in the DERA White Paper used derivatives at any level, and thus we do not expect that any BDCs would be required to implement a program under the proposed condition. 403We note the exception of certain leveraged index ETFs that serve as trading tools and that commonly have notional exposure of 200 or 300% of assets. 404Proposed rule 18f–4(b). derivatives transactions.397
Thus, funds that are not subject to the proposed formalized risk management program condition would nevertheless need to manage risks relating to their use of derivatives through their compliance with the risk assessment, monitoring, and other regulatory requirements discussed above. The risks and potential impact of derivatives transactions on a fund’s portfolio generally increase as the fund’s level of derivatives usage increases.398 When derivatives are used to a significant extent, we expect the risks relating to their use, and the challenge of managing risks relating to expected or intended interactions among derivatives and other investments and managing relationships with counterparties, may increase. Complex derivatives also may involve more significant risks and potential impacts. Conversely, for funds that make only limited use of derivatives and do not use complex derivatives, we expect that the risks and potential impact of these funds’ derivatives transactions may not be as significant in comparison to the risks of the funds’ overall investment portfolios and may be appropriately addressed by the rule’s other requirements, including the requirement to determine risk-based coverage amounts.399 Therefore, we believe that a formalized risk management program that includes the specific program elements included in the proposed rule is most appropriate for funds that meet a threshold level of derivatives usage (or that use complex derivatives transactions). Accordingly, proposed rule 18f–4 would not require that a fund adopt a formalized derivatives risk management program if the fund’s board determines that the fund will comply, and monitor its compliance, with a portfolio limitation under which the fund limits its aggregate exposure to derivatives transactions to no more than 50% of its NAV and does not use complex derivatives transactions as defined in the rule.400 We believe that a fund that limits its exposure to derivatives in such a way (in conjunction with the other requirements of the rule) should be able to limit the derivatives’ associated risk so that their usage is consistent with the concerns of the Act.401 Requiring a formalized program for managing derivatives when a fund engages in non￾complex derivatives transactions below the statutorily defined limit established by Congress with respect to senior securities transactions could potentially require funds (and therefore their shareholders) to incur costs that might be disproportionate to the resulting benefits, and thus we are not proposing to require that all funds that use derivatives to any extent implement one. Nonetheless, as discussed in greater detail below, we request comment on whether the risks of derivatives use are significant enough (or significantly different from securities investments) that we should require funds that engage in any derivative use at all to comply with the proposed formalized risk management program condition. To identify the number of
funds that would need to adopt a program under this condition we evaluated the DERA White Paper data and evaluated which funds would be likely to be subject to this proposed condition. Based on this analysis, approximately 10% of the sampled open-end funds (representing about 10% of such funds’ assets under management (‘‘AUM’’)) and approximately 9% of the sampled closed-end funds (representing about 13% of their AUM) would be required to adopt a program.402 We further note that this condition also would effectively sort funds that would need to adopt a program based on fund strategy. For example, approximately 52% of sampled alternative strategy funds (representing around 70% of AUM) would need to implement a program. On the other hand, the analysis shows that only about 6% of sampled funds (representing about 8% of their AUM) that employ more traditional strategies use derivatives in excess of a 50% level.403 This 50% exposure condition would include exposures from derivatives transactions entered into by a fund in reliance on the proposed rule, but would not include exposure from financial commitment transactions or other senior securities transactions entered into by the fund pursuant to
section 18 or 61 of the Act. We are
proposing to focus this exposure threshold on exposures from derivatives transactions for several reasons. Derivatives transactions generally can pose different kinds of risks than many other kinds of senior securities transactions, in that the amount of a fund’s market exposure and payment obligations under many derivatives transactions often will be more uncertain than for other types of senior securities transactions. In contrast, the fund’s payment obligation may be largely known and fixed at the time the fund enters into many financial commitment transactions, such as reverse repurchase agreements or firm commitment agreements. In addition, the proposed rule would require a fund that engages in financial commitment transactions in reliance on the rule to maintain qualifying coverage assets equal in value to the fund’s conditional and unconditional obligations under its financial commitment transactions.404 Requiring a fund to maintain qualifying coverage assets sufficient to cover its full obligations under a financial commitment transaction may effectively address many of the risks that otherwise would be managed through a risk

405See, e.g., Comment Letter of T. Rowe Price Associates, Inc. on the FSOC Request for Comment (Mar. 25, 2015) (FSOC 2014–0001) (‘‘T. Rowe Price FSOC Comment Letter’’), available at http:// www.regulations.gov/#!documentDetail;D=FSOC￾2014-0001-0038, at 3; Comment Letter of State Street Corporation on the FSOC Request for Comment (Mar. 25, 2015) (FSOC 2014–0001) (‘‘State Street FSOC Comment Letter’’), available at http:// www.regulations.gov/#!documentDetail;D=FSOC￾2014-0001-0042 at 11; Oppenheimer Concept Release Comment Letter, at 1–2; Comment Letter of Independent Directors Council on Concept Release (Nov. 7, 2011) (File No. S7–33–11) (‘‘IDC Concept Release Comment Letter’’), available at http:// www.sec.gov/comments/s7-33-11/s73311-24.pdf, at 2–4. management program. The mark-to￾market segregation approach would not be permitted under the proposed rule for financial commitment transactions. Finally, commenters on the Concept Release and on the FSOC Request for Comment have suggested that funds obtain leverage primarily from the use of derivatives and not financial commitment transactions, further indicating that derivatives use poses a different set of challenges than other types of senior securities transactions.405 We also are proposing to require a fund that engages in any complex derivatives transaction as defined under the proposed rule to implement a program. We believe that complex derivatives transactions pose special risk management challenges in light of their complicated structure and the difficulties they can pose in evaluating their impact on a fund’s portfolio. As discussed in more detail above in
section III.B.1, a complex derivatives
transaction may expose a fund to greater risk of loss and can have market risks that are difficult to estimate due to the effect of multiple contingencies, path dependency or other non-linear factors associated with complex derivatives. We believe that a fund that engages in complex derivatives transactions under the proposed rule should be required to implement a derivatives risk management program to manage these risks as they are more complex and difficult to assess and manage than typical derivatives. Because of their potentially highly asymmetric and unpredictable outcomes, complex derivatives transactions may pose risks that are not as correlated to the size of a fund’s exposure, and thus we believe that if a fund engages in any of these transactions, those risks should be assessed and managed through a formalized derivatives risk management program overseen by a risk manager and the funds’ board. Accordingly, we are proposing that a fund that engages in any amount of complex derivatives transactions adopt a derivatives risk management program. We request comment on our proposed approach for identifying funds that must comply with the program requirement for funds that engage in a limited amount of derivatives transactions.

• Should the formalized derivatives
  risk management program apply not just to derivatives transactions, but to all senior securities transactions? Should it apply to just derivatives and financial commitment transactions? Do commenters agree that derivatives transactions generally can pose different kinds of risks than many other kinds of senior securities transactions, and that requiring a fund to maintain qualifying coverage assets sufficient to cover its full obligations under a financial commitment transaction may effectively address many of the risks that otherwise would be managed through a risk management program?
• As we are proposing, should we
  exclude from the formalized program requirement funds that engage in a limited amount of derivatives transactions? Are the risks associated with derivatives use significant enough (or significantly different from securities investments) that a fund should be required to adopt a program if it engages in any derivatives transactions? Should we instead require any fund that engages in derivatives transactions to any extent be subject to the program requirement?
• Should we require a formalized risk
  management program for funds that engage in even lower levels of derivatives use than under the proposed condition if they rely on the proposed rule? Should this condition not be based on the statutory threshold but instead on a different threshold? For example, are the risks of derivatives use significant enough that we should require a fund to have a program at a lower threshold, for example at 0%, 10%, 25%, or 33% of net assets? On the other hand, are the risks of derivatives use manageable enough that we should increase the threshold to avoid requiring funds to incur costs associated with a derivatives risk management program unless they make more extensive use of derivatives? For example, should the threshold for exposure instead be 66% or 75% of net assets? If we were to use a higher threshold, would that permit funds to obtain levels of derivative exposure that could pose more substantial risks to the fund before the fund would be required to establish a formalized derivatives risk management program?
• The 50% exposure condition only
  includes exposure from a fund’s derivatives transactions but not its financial commitment transactions or other senior securities transactions. Do commenters agree that it is appropriate to exclude exposures from other senior securities transactions in determining whether to require a formalized derivatives risk management program? Should we treat particular types of derivatives transactions or financial commitment transactions differently for purposes of the 50% exposure condition? Should we, for example, require a fund to include the exposure associated with financial commitment transactions other than reverse repurchase agreements, which may be more similar to bank borrowings and thus may not involve some of the risks and uncertainties associated with other senior securities transactions?
• Should we vary the condition based
  on fund characteristics or the types of derivatives transactions? For example, should we provide tiered thresholds based on a fund’s assets under management, requiring funds of a larger size to be subject to a lower threshold? Would such a tiered threshold provide material protections for investors at a reasonable cost? Would it create disparate competitive effects on different sized funds? Is the size of the fund an appropriate metric to scale requirements designed to manage the risk of derivatives use? Should we provide for higher thresholds if a fund engages only in certain kinds of derivatives transactions? If so, then what types of derivatives transactions would be expected to present less risk?
• Should we use some test other than
  an exposure threshold for excluding funds that make a limited use of derivatives from the program requirement? For example, should we use a risk-based test? If so, should we specify what kind of test (e.g., VaR, expected shortfall, or some other metric) and what threshold should we use? Should we require a specified threshold at all, or should we instead allow a board to determine a risk-based threshold?
• As we are proposing, should we
  require that all funds that engage in any complex derivatives transactions implement a program? Why or why not? Should we instead permit funds to obtain a limited amount of exposure through complex derivatives transactions (e.g., 1% or 5% of net assets) before being required to implement a derivatives risk management? As discussed above, a risk management program should be tailored to the scale of the fund’s usage of derivatives, as well as the particular

406Although, as discussed previously, we note that all funds, even those not subject to the formalized risk management condition, would be required to manage the risks associated with their derivative transactions through compliance with our regulatory requirements, and we request comment on whether we should apply the program’s requirements to all funds that engage in derivatives transactions at any level. 407While these risks are not unique to a fund’s use of derivatives and may be associated with the fund’s investments in other instruments as well, the proposed condition would require that the program assess and manage the risks associated with the derivatives transactions engaged in by the fund, but would not generally apply to other fund transactions. Proposed rule 18f–4(a)(3). 408Proposed rule 18f–4(a)(3)(i)(A). See also Comprehensive Risk Management of OTC Derivatives; A Tricky Endeavour, Numerix (July 16,
2013) (‘‘Comprehensive Risk Management of OTC
Derivatives’’), available at http:// www.numerix.com/comprehensive-risk￾management-otc-derivatives-tricky-endeavor; Statement on best practices for managing risk in derivatives transactions, RMA (‘‘Statement on best practices for managing risk in derivatives transactions’’), available at http://www.rmahq.org/ securities-lending/best-practices; 2008 IDC Report, supra note 72; Derivatives Danger: Internal auditors can play a role in reigning in the complex risks associated with financial instruments, Lawrence Metzger, FSA Times (‘‘FSA Times Derivatives Dangers’’), available at http://www.theiia.org/fsa/ 2011-features/derivatives-danger. 409See, e.g., 2008 IDC Report, supra note 72, at 12. 410See, e.g., An Overview of Leverage, supra note 167 (distinguishing between financial, construction and instrument leverage and measurement of leverage using gross market exposure vs. net market exposure). See also Off-Balance-Sheet Leverage IMF Working Paper, supra note 79 (discussing means of measure leverage in various derivatives and other off-balance-sheet transactions). See also Ang, Gorovyy & Inwegen, supra note 72 (discussing differences among gross leverage, net leverage and long-only leverage calculations as applied to long￾only, dedicated long-short, general leveraged and dedicated short funds). 411We note that commenters have suggested a variety of methods of calculating leverage for various purposes. For example, one commenter on our recent proposal to modernize reporting for investment companies suggested a possible methodology for calculating leverage that might be reported to the Commission. See, Comment Letter of Blackrock on Data Gathering Release (Aug. 11,
2015) (File No. S7–09–15), available at http://
www.sec.gov/comments/s7-09-15/s70915-39.pdf, at
20. We request comment below in section II.G on
whether we should require the reporting of leverage (including potentially using this approach) to us on N–PORT. risks of the derivatives used by the fund. Therefore, funds that engage in significant amounts of derivatives transactions, or that use complex derivatives transactions, are likely to have more detailed and complex programs, while funds that make more minimal use or limit their use to more standard derivatives may have more streamlined programs tailored to their particular usage. As proposed, all of the elements of the proposed risk management program, however, would apply equally to all funds that exceed the 50% threshold.406 We expect that providing a single set of requirements for all funds that engage in more than a limited amount of derivatives transactions or that use complex derivatives transactions should provide a consistent baseline for these funds’ risk management programs. Nonetheless, we acknowledge that this approach may cause certain funds to bear higher costs in complying with all of the requirements of the program than if we were to further scale or otherwise tailor the program depending on the amount or type of fund derivatives use.

• We request comment on whether
  we should further tailor or scale the program depending on the fund’s use of derivatives. For example, should we have multiple tiered thresholds, with differing program requirements tailored to each level of use? If so, which thresholds should we use and which program elements should be included at each level? Should we otherwise tier or scale the program such as, for example, by requiring certain additional program elements for funds that engage in specific types of derivatives? If so, how should we tailor such a requirement? For example, should we require funds that only engage in certain simple types of derivatives not to have a derivatives risk manager?
• If we were to eliminate the
  proposed 50% threshold and require funds that engage in any amount of derivatives transactions to comply with the risk management program condition, should we provide a more streamlined or simpler program that does not include all of the elements of the full program we are proposing today? If so, which elements should we not include in such a more limited program? If we were to provide for a more limited program for such funds, should we continue to require all of the proposed program elements for funds that use derivatives above the proposed 50% threshold?

2. Required Elements of the Program
   Under the proposal, a derivatives risk management program must include, at a minimum, four specified elements, discussed in detail below. a. Assessment of Risks The first proposed element of the program would be to require funds subject to the condition to have policies and procedures reasonably designed to assess the risks associated with the fund’s derivatives transactions, including an evaluation of potential leverage, market, counterparty, liquidity, and operational risks, as applicable, and any other risks considered relevant.407 This element would require funds to engage in a process of identifying and evaluating the potential risks posed by their derivatives transactions. This element provides flexibility for funds to customize their derivatives risk management programs so that the scope, and related costs and burdens, of such programs are appropriate to manage the anticipated derivatives risks faced by a particular fund. Thus, in complying with this element, a fund generally should identify the types of derivatives it currently uses, as well as any potential derivatives transactions it reasonably expects to use in the future and then evaluate the risks of engaging in those transactions as contemplated. This program element would require policies and procedures for evaluating certain identified potential risks that are common to most derivatives transactions, as appropriate.408 The first is the potential leverage risks associated with a fund’s derivatives transactions. Leverage risk, which includes the risk associated with potential magnified effects on a fund resulting from changes in the market value of assets underlying its derivatives transactions where the value of the underlying assets exceeds the amount paid by the fund under the derivatives transactions, would need to be assessed under the fund’s risk management program.409 Leverage can be calculated in different ways, and the appropriateness of a leverage metric used by the fund, if any, to assess leverage risk may depend on various factors, such as a fund’s strategy, the fund’s particular investments and investment exposures, and the historical and expected correlations among the fund’s investments.410 While the proposed exposure limitations included in each of the portfolio limitations are designed to provide a limit on the amount of leverage a fund may obtain by placing an outside limit on the overall amount of market exposures that a fund can achieve through derivatives transactions, the exposure limitations are not designed to be used as a precise measure of the leverage used by funds. A fund, in assessing the leverage risk associated with its derivatives, could consider using metrics for measuring the extent of its leverage, and which metrics to use, in light of these and other relevant factors.411 Assessing leverage risks might include, for example, a review of the fund’s derivatives transactions to evaluate the leverage resulting from the fund’s derivatives transactions,
   whether such leverage is consistent with any

412See supra note 167 and section III.B.1.d regarding ways that commenters have noted that they engage in an evaluation of leverage used by funds. 413Market risk should be considered together with leverage risk because leveraged exposures can magnify such impacts. See, e.g., Derivatives and Risk Management Made Simple, NAPF (Dec. 2013), available at https://www.jpmorgan.com/cm/ BlobServer/is_napfms2013.pdf? blobkey=id&blobwhere= 1320663533358&blobheader=application/ pdf&blobheadername1=Cache-Control&blob headervalue1=private&blobcol=urldata&blobtable =MungoBlobs. 414See, e.g., Top ten best practices for managing model risk, FinCAD, available at http:// www.fincad.com/resources/resource-library/ whitepaper/top-10-best-practices-managing-model￾risk. In addition, as discussed in more detail below, one of the elements of the proposed program would require the fund to adopt and implement written policies and procedures to periodically review and update the program and any tools that are used as
part of the program. See infra section III.D.2.d.
415See, e.g., Nils Beier, et al., Getting to Grips with Counterparty Risk, McKinsey Working Papers on Risk, Number 20 (June 2010). 416We have recently proposed a comprehensive set of reforms designed to enhance funds’ liquidity management processes, which includes evaluating the liquidity of fund derivative holdings, as well as a definition of liquidity risk. See Liquidity Release, supra note 5. If we were to adopt the liquidity risk management program, we expect that such program would serve as a complement to the proposed derivatives risk management program with respect to assessing the liquidity of fund derivatives and that these programs might coordinate and overlap regarding assessment of liquidity risk for derivatives. We note that overlapping activities associated with the program would not need to be duplicated for each program, but that a fund might assess and monitor liquidity risk in a holistic way, consistent with the individual requirements of each program. 417See, e.g., Peter Neu & Pascal Vogt, Liquidity Risk Management, The Boston Consulting Group (Oct. 2010), available at http:// www.bostonconsulting.com.au/documents/ file93481.pdf; Board of the International Organization of Securities Commissions, Principles of Liquidity Risk Management for Collective Investment Schemes, OICU–IOSCO (Mar. 2013), available at http://www.iosco.org/library/pubdocs/ pdf/IOSCOPD405.pdf. 418See, e.g, 2008 IDC Report, supra note 72; Statement on best practices for managing risk in derivatives transactions, supra note 408. 419Because derivatives contracts that are traded over the counter are not standardized, they bear a certain amount of legal risk in that poor draftsmanship, changes in laws, or other reasons may cause the contract to not be legally enforceable against the counterparty. See, e.g., Comprehensive Risk Management of OTC Derivatives, supra note 408. 420For example, many derivatives contracts and prime brokerage agreements that hedge funds and other counterparties had entered into with Lehman guidelines established by the fund, and whether the leverage used by the fund is consistent with its disclosure to investors.412 The second risk that the fund would be required to have policies and procedures reasonably designed to evaluate is the market risk associated with its derivatives transactions. Market risk includes the risk related to the potential that markets may move in an adverse direction in relation to the fund’s derivatives positions and so adversely impact fund returns and the fund’s obligations and exposure.413 Evaluating market risk could include examining any models or metrics used to measure and monitor market movements, reviewing historical market movements to help develop an understanding of the potential impact of future market movements, and assessing the method and sources for receiving information about current events that may have market impacts. Scenario or stress testing can also serve as an important tool in assessing
market risk. To effectively monitor market risk, the adequacy of any assumptions and parameters underlying a fund’s techniques for estimating potential market risk should generally be reviewed periodically against actual experience and updated market information, especially during periods of heightened market volatility.414 The third risk the fund would be required to have policies and procedures reasonably designed to evaluate is counterparty risk. This might include, for example, an evaluation of the risk that the counterparty on a derivatives transaction may not be willing or able to perform its obligations under the derivatives contract, and the related risks of having a concentration of transactions with any one such counterparty. Assessing counterparty risk could involve reviewing the creditworthiness or financial position of significant derivatives counterparties, understanding the level of counterparty concentration in the fund, and evaluating contractual protections, such as collateral or margin requirements, netting agreements and termination rights.415 The fourth risk the fund would be required to have policies and procedures reasonably designed to evaluate is liquidity risk. Under this program element, a fund should assess the potential liquidity of the fund’s derivatives positions, an evaluation which might include both normal and stressed scenarios.416 Assessing liquidity risk could involve understanding the secondary market liquidity of the fund’s derivatives holdings; whether the fund has the right to terminate a particular derivative or the ability to enter into offsetting transactions; the relationship between a particular derivative and other portfolio positions of the fund, including whether the derivative is intended to hedge risks relating to other positions; and the potential effect of market stress events on the liquidity of the fund’s derivatives transactions. In addition to the liquidity of the derivatives positions themselves, assessing liquidity risk generally should include an evaluation of the potential liquidity demands that may be imposed on the fund in connection with its use of derivatives. As discussed in more detail above in section III.C, each fund would be required under the proposed rule to manage the risks associated with its derivatives transactions by maintaining qualifying coverage assets to cover the funds’ mark-to-market coverage amount and risk-based coverage amount with respect to the fund’s derivatives transactions. In addition, counterparties or applicable regulations generally require funds to post variation margin when derivatives positions move against the fund, and the coverage amounts required under the proposed rule can be expected to increase during periods of increased market stress or volatility. A risk management program, as part of the assessment of liquidity risk, generally should consider how the fund would address potential liquidity demands during reasonably foreseeable stressed
market periods.417 Finally, the fund would be required to have policies and procedures reasonably designed to assess the operational risks associated with the fund’s derivatives transactions. Operational risk encompasses a wide variety of possible events, including risks related to potential documentation issues, settlement issues, systems failures, inadequate controls, and human error.418 Policies and procedures for evaluating such risks could include, for example, assessments of the robustness of relevant systems and procedures and reviews of training processes. These five identified potential categories of risk discussed above are common to many derivatives transactions. However, this proposed element would not limit this assessment to an examination of only those identified risks. This element should also generally include evaluation of other applicable risks associated with derivatives transactions. For example, some derivatives transactions could pose certain idiosyncratic risks, such as the legal risk associated with the potential that a bespoke OTC contract 419 or netting agreement might not be held to be legally valid or binding or compliant with other legal requirements, or that have provisions that may be one-sided or difficult to enforce in the event of a counterparty’s default.420 Such risks should also be

Brothers included cross-netting that allowed for payments owed to and from different Lehman affiliates to be offset against each other, and cross￾liens that granted security interests to all Lehman affiliates (rather than only the specific Lehman entity entering into a particular transaction). In 2011, the U.S. Bankruptcy Court for the Southern District of New York held that cross-affiliate netting provisions in an ISDA swap agreement were unenforceable against a debtor in bankruptcy. In re Lehman Brothers Inc., Bankr. Case No. 08–01420 (JPM) (SIPA), 458 B.R. 134, 1135–137 (Bankr. S.D.N.Y. Oct. 4, 2011). 421Proposed rule 18f–4(a)(3)(i)(B). 422Such systems may provide notifications of red flags, such as frequent or unusual overrides of policies. Funds may wish to consider whether such monitoring mechanisms are sophisticated enough to identify outlier activity caused by unapproved employee activity (such as a rogue trader). See, e.g., Geoff Kates, No Surprises-Combatting Rogue Trading, LEPUS, available at http://www.isda.org/ c_and_a/ppt/Rogue_Traders_presentation.ppt; Banking Tech, Stopping the rogues: Reactions to the UBS rogue trader (Oct. 6, 2011), available at http:// www.bankingtech.com/48103/Stopping-the-rogues￾Reactions-to-the-UBS-rogue-trader/. 423See, e.g., Mutual Fund Directors Forum, Risk Principles for Fund Directors: Practical Guidance for Fund Directors on Effective Risk Management Oversight (Apr. 2010) (‘‘MFDF Guidance’’), available at http://www.mfdf.org/images/ Newsroom/Risk_Principles_6.pdf. 424 Investment guidelines may be established by the fund or the adviser and approved by the board and typically provide a set of limits on the fund’s investment activities. These guidelines may be of varying degrees of specificity and typically are distinct from the fund’s disclosure to investors. The rule does not require funds to establish such guidelines, but we understand that most funds do have such guidelines in place. This element would require that funds manage the risks of their derivatives transactions so that they are consistent with any such established guidelines, as well as being consistent with relevant portfolio limitations and disclosure. 425See, e.g., Comprehensive Risk Management of OTC Derivatives, supra note 408; Statement on best practices for managing risk in derivatives transactions, supra note 408; 2008 IDC Report, supra note 72. 426This could also include creating maximum effective leverage limits for the fund, if such limits are determined to be useful tools for managing the risks of derivatives transactions. 427Funds may wish to provide new instruments (or instruments newly used by a fund) additional scrutiny. See, e.g., MFDF Guidance, supra note 423, at 8. 428See, e.g., Christina Ginfrida, Mitigating Counterparty Risk in Derivatives Trades, Treasury & Risk (June, 2013), available at http:// www.treasuryandrisk.com/2013/06/19/mitigating￾counterparty-risk-in-derivatives-trades. 429An important consideration may be
whether a counterparty is a central counterparty or a counterparty dealing in over the counter instruments. included in the fund’s risk assessment, if applicable. We request comment on all aspects of this proposed element of the program.

• Should we require policies and
  procedures to include an assessment of particular risks based on an evaluation of certain identified risk categories as proposed? If not, why?
• Are the categories of risks that we
  have identified in the proposed rule appropriate? Should we remove any of the identified risk categories? Should we provide further guidance regarding the assessment of any of these risks?
• Should we add any other categories
  of required risks that would be required for each fund to have policies and procedures reasonably designed to evaluate as part of its program? If so what additional categories and why?
• Should we require policies and
  procedures for any additional evaluation of derivatives positions that are used by a fund to provide a hedge for, or otherwise reduce risks with respect to, other investments by the fund, to evaluate the effectiveness of the hedging or risk reduction? b. Management of Risks The second proposed element of the program would be a requirement that the fund have policies and procedures reasonably designed to manage the risks of its derivatives transactions, including by monitoring whether those risks continue to be consistent with any investment guidelines established by the fund or the fund’s investment adviser, the fund’s portfolio limitation established under the proposed rule, and relevant disclosure to investors, and informing portfolio management of the fund or the fund’s board of directors, as appropriate, regarding material risks arising from the fund’s derivatives transactions.421 Implementing this element might include building or enhancing portfolio tracking systems, exception reporting, or other mechanisms designed to monitor the risks associated with the fund’s derivatives transactions and provide current information regarding those risks to relevant personnel.422 We believe that various kinds of stress testing may also be useful tools to monitor and manage risks. Under this element, a fund would be required to have policies and procedures reasonably designed to manage the risks of derivatives transactions, but this element would not require a fund to impose particular risk limits.423 Instead, it would require a fund to have policies and procedures reasonably designed to manage the risks of derivatives transactions so that they are consistent with any investment guidelines established by the fund or the fund’s investment adviser and the fund’s portfolio limitations, disclosure, and investment strategy.424 Funds may use a variety of approaches in developing policies and procedures to manage the risks associated with the fund’s derivatives transactions.425 As a preliminary step, a fund would likely review its relevant disclosure and investment guidelines to establish the appropriate risks that the fund could undertake through derivatives transactions (for example through specified allowable types of derivatives transactions or overall limits). This review could involve establishing an appropriate limit for allowable fund risk, and its relationship to the risks associated with the derivatives transactions in which the fund engages.426 Funds today use a variety of models or methodologies to measure the risks associated with these transactions (for example, VaR, stress testing, or horizon analysis) to help manage those risks. In managing and monitoring the relevant risks, a fund might consider establishing written guidelines describing the scope and objectives of the fund’s use of derivatives. A fund could also consider establishing an ‘‘approved list’’ of specific derivative instruments or strategies that may be used, as well as a list of
  persons authorized to engage in the transactions on behalf of the fund.427 Funds may also wish to consider establishing corresponding investment size controls or limits for approved transactions across the fund, along with appropriate risk measurement monitoring mechanisms designed to prevent the fund from violating any portfolio limitations or investment guidelines, along with implementing tools to monitor such restrictions. Establishing clear risk management processes for approving exceptions to any established limits, with oversight and approval of any exceptions from senior management, generally is also a key aspect of effective risk management, and something funds may wish to consider implementing. Effective risk management generally also may include evaluation of counterparties, for example, through review of their financial position, overall trading relationship with the fund, and total credit exposure.428 Funds may wish to consider establishing an approved list of counterparties, or trade-by-trade decision making in some cases.429 In addition, counterparty risk mitigation also could include requirements related to the type and amount of collateral posted. Managing derivatives transaction risk could also involve reviewing existing, and potentially establishing new, contingency plans and tools in case of adverse market or system events. This could include establishing committed

430Proposed rule 18f–4(a)(3)(i)(B)(ii). 431Proposed rule 18f–4(a)(3)(i)(C). 432See, e.g., Comptroller of the Currency Administrator of National Banks, Risk Management of Financial derivatives: Comptroller’s handbook, (Jan. 1997), at 9 (discussing the importance of independent risk management functions in the banking context). 433See, e.g., COSO, Internal Control Issues in Derivatives Usage, available at http://coso.org/ documents/Internal%20Control%20Issues %20in%20Derivatives%20Usage.pdf; see also, FSA Times Derivatives Dangers, supra note 408. 434Another important segregation tool may be ensuring that the compensation of the risk management oversight personnel is not tied to or dependent on the performance of the fund. See, e.g., Raffaelle Scalcione, The Derivatives Revolution: a trapped innovation and a blueprint for change (2011), at 334. 435 In particular, we recognize that this segregation requirement may pose challenges for certain entities that may have a limited number of employees. In such cases, the program should still have policies and procedures designed to reasonably segregate the functions of the program from fund portfolio management. As noted previously, however, the proposed rule would require reasonable segregation, not complete segregation of functions. We also note that the derivatives risk manager would not be permitted to be a portfolio manager of the fund, which we believe is likely to encourage reasonable segregation of functions as a result of such separation of roles. reserve lines of credit, evaluating potential legal remedies in the case of counterparty default, and having robust systems (including back-ups as appropriate) across front, mid, and back office operations. Funds may also consider establishing processes to manage the particular accounting, custody, legal, and other operational risks posed by derivatives transactions. The element also would require policies and procedures for informing the portfolio manager or board of risks associated with the fund’s derivatives transactions.430 We believe that such communication would generally be a key part of any risk management and monitoring program, because information about relevant risks should not remain solely with the derivatives risk manager, but should be shared up the chain as needed so that appropriate action to address risks can be taken if warranted. We understand that funds today use various tools (for example, risk dashboards) to identify evolving risks that may serve as a key signal indicating when information should be provided to relevant parties. We believe that this communication requirement should help ensure that information about derivatives transactions risks is not siloed, but instead is shared with parties who can take actions as needed to mitigate risks. This requirement is also intended to encourage the derivatives risk manager to engage in communication with relevant parties on a current and ongoing basis as needed, and not limit
communication solely to quarterly reports. The potential risk management and monitoring mechanisms discussed above are just examples of the techniques funds might consider including in their policies and procedures to manage the risks of their derivatives transactions under this proposed element. To effectively manage its own particular risks, a fund generally should carefully review its current and planned use of derivatives well as any relevant limitations (including internal limitations established by the fund’s adviser), and develop risk management tools and processes effectively tailored to its own circumstances. We request comment on the proposed element of the program requiring funds to have policies and procedures reasonably designed to manage the risks of the derivatives transactions.

• Should we establish any additional
  risk management requirements within the program element itself, or should we keep it generally principles based as we are proposing? For example, should we specifically require the creation of approved transactions lists or derivative size controls? Should we require that funds use specific risk management tools such as stress testing? If so, what tools should we require?
• Should we require that a fund
  institute specific investment guidelines regarding its use of derivatives transactions? If so what would those guidelines be?
• Should we require the derivatives
  risk manager to provide material risk information to portfolio management or the board as appropriate, or would this be generally included in the quarterly reports provided by the officer to the board? If we did not include such an information requirement, would risk information potentially become stale and not be acted upon in a timely manner?
  c. Segregation of Functions
  We are also proposing to require, as an element of the program, that a fund have policies and procedures reasonably designed to reasonably segregate the functions associated with the program from the portfolio management of the fund.431 We believe that independence of risk management from portfolio management should promote objective and independent risk assessment to complement and cross check portfolio management,432 and that maintaining separation of these functions should enhance the protections provided by the program. We understand that funds today often make efforts to reasonably segregate risk management from portfolio management and believe that this proposed requirement would therefore be consistent with existing practices. Many commentators have observed that independent oversight of derivatives activities by compliance and internal audit functions is valuable.433 Because fund management personnel may be compensated in part based on the returns of the fund they manage, the incentives of portfolio managers may not always be consistent with the restrictions imposed by a risk management program. Thus, we believe that keeping the functions separate should help mitigate the possibility that the program’s effectiveness could be diminished if it were not independent of portfolio management. Separation of functions creates important checks and balances and can be instituted through a variety of methods such as independent reporting chains, oversight arrangements, or separate monitoring systems and personnel.434 However, this segregation of functions is not meant to indicate that the derivatives risk manager and portfolio management should be subject to a communications ‘‘firewall.’’ 435 We recognize the important perspective and insight to the fund’s use of derivatives that the portfolio manager can provide and would expect that the derivatives risk manager would work closely with portfolio management as he or she implements all aspects of the program. We believe that regular communication between the risk manager and portfolio management should be a part of any well-functioning program. Indeed, as discussed above, the derivatives risk management program would require that risk management personnel monitor the risks associated with the fund’s derivatives transactions and inform portfolio management (or the fund’s board) regarding those risks as appropriate. We request comment on the proposed element requiring funds to maintain controls reasonably segregating the program functions from portfolio management.
• Do commenters agree that
  segregation of risk management functions from portfolio management would enhance the protections provided by the proposed derivatives risk management program requirement?
• Would this element pose
  difficulties for particular entities, for example, funds managed by small advisers? Should we provide any additional clarification of what it means to have reasonable segregation of

436Proposed rule 18f–4(a)(3)(i)(D).
437Because of the importance of VaR calculations in the proposed rule for funds that operate under the risk-based portfolio limitation, the proposed element would specifically require that any VaR models used by the fund during the covered period be included as part of this periodic review and update. 438Proposed rule 18f–4(a)(3)(ii)(C). This would differ from the approach taken in our recent liquidity rulemaking proposal, which would not require the designation of a specific person to administer the program, but would instead allow the designation of the fund’s adviser or multiple employees to administer the program. We note that the derivatives risk management program condition would apply only to a limited subset of funds that choose to use derivatives to obtain exposure exceeding 50% of the fund’s net assets (or that choose to use complex derivatives), while all open￾end funds (other than money market funds) and ETFs would be required to have a liquidity program under proposed rule 22e–4. As noted above, we believe that the risks of derivatives transactions are complex and significant. Having a specific person designated as responsible for administering the program rather than a committee or group should help to more clearly delineate lines of responsibility and oversight over these risks for those funds that choose to engage in them. 439See, e.g., Investment Company Institute, Chief Risk Officers in the Mutual Fund Industry: Who are they and what is their role within the organization (2007), available at http://www.ici.org/pdf/ 21437.pdf. 440A fund could also formally designate an employee or officers of the fund’s sub-adviser to be responsible for administering the derivatives risk management program. 441See, e.g., MFDF Guidance, supra note 423. functions in such cases? If so, what changes should we make?

• Are there other ways to incentivize
  objective and independent risk assessment of portfolio strategies that we should consider? d. Periodic Review The fourth element of the proposed program is that a fund would need to have policies and procedures reasonably designed to periodically (but at least annually) review and update the program, including any models (including any VaR calculation models used during the covered period), measurement tools, or policies and procedures that are part of, or used in, the program to evaluate their effectiveness and reflect changes in risks over time.436 Under the proposed derivatives risk management program requirement, each fund would need to develop and adopt policies and procedures to review the fund’s derivatives risk, tailored as appropriate to reflect the fund’s particular facts and circumstances. As part of this program, funds are likely to use a variety of models, tools, and policies and procedures as part of its implementation. The derivatives markets are dynamic and evolving, and tools and processes should be reviewed and modified as appropriate. We believe that the periodic review of a fund’s derivatives risk management program is necessary to determine whether, in light of current circumstances, these risks are appropriately being addressed. The proposed program review requirement would require each fund to develop and adopt procedures to annually review and update the fund’s derivatives risk management program. This review and update would need to include any models (including any VaR calculation models used during the covered period),437 measurement tools, or policies and procedures that are part of, or used in, the program to evaluate their effectiveness and reflect changes in risks relating to the use of derivatives. However, beyond this, proposed rule 18f–4 would not include prescribed review procedures or incorporate specific developments that a fund must consider as part of its review. A fund might generally consider whether its periodic review procedures should include procedures for evaluating regulatory, market-wide, and fund￾specific developments affecting its program. We are also proposing that this periodic review take place at least annually. We believe that the program should be reviewed and updated on at least an annual basis because the risks of derivatives transactions and tools available change and evolve rapidly. An annual review is a minimum requirement, but a fund should consider whether more frequent reviews are appropriate depending on the circumstances. We expect that such a review and update should take place frequently enough to take into account the particular risks that may be presented by the fund’s use of derivatives, including the potential for rapid or significant increases in risks in changing market conditions. We request comment on the proposed element requiring funds to periodically review and update the program.
• Do commenters agree that the rule
  should specifically require that a fund periodically review and update the program and any tools that are used as
  part of the program as proposed?
• As proposed, should we require this
  review to take place at least annually, or should we require a more frequent review, such as quarterly (to coincide with proposed reporting to the fund’s board discussed below)? Should we instead not prescribe a minimum frequency for the periodic review and update?
• Are there certain review procedures
  that the Commission should require and/or on which the Commission should provide guidance? Should the Commission expand its guidance on regulatory, market-wide, and fund￾specific developments that a fund’s review procedures might cover?

3. Administration of the Program
   Proposed rule 18f–4 would expressly require a fund to designate an employee or officer of the fund or the fund’s investment adviser (who may not be a portfolio manager of the fund) responsible for administering the policies and procedures of the derivatives risk management program, whose designation must be approved by the fund’s board of directors, including a majority of the directors who are not interested persons of the fund.438 We believe that having a designated individual responsible for managing the program should enhance its accountability and effectiveness. The derivatives risk manager may also have other roles, including, for example, serving as the fund’s chief compliance office or chief risk manager (if it has one).439 Under the proposed rule, the derivatives risk manager must be an employee of the fund or its investment adviser, but may not be a portfolio manager for the fund.440 We recognize that some small advisers may have a limited number of employees or officers who are not portfolio managers of the fund. In such a case, the fund’s chief compliance officer might be designated as the program’s risk manager (with assistance from third parties as appropriate) or the fund or adviser may determine that they need to hire new personnel to administer the program. In any event, the derivatives risk manager should generally be sufficiently knowledgeable about the risks and use of derivatives that he or she can effectively fulfill the responsibilities of their position. For the same reasons discussed above regarding the maintenance of controls that segregate functions of the program from portfolio management, we believe that independence of the derivatives risk manager is important for a well￾functioning program.441 If a derivatives risk manager were a person making portfolio management decisions, the risk manager may be influenced to selectively apply or otherwise weaken or not fully comply with the program’s requirements if the restrictions of the program potentially conflict with the preferred investment strategy of the portfolio manager. Unlike the chief compliance officer under rule 38a–1, proposed rule 18f–4

442This approach is also consistent with the designation process we recently proposed in the liquidity rulemaking proposal. See Liquidity Release, supra note 5. 443See, e.g., 2011 IDC Report, supra note 385, at 9; MFDF Guidance, supra note 423. See also, Gene Gohlke, If I Were a Director of a Fund Investing in Derivatives-Key Areas of Risk on Which I Would Focus (Nov. 2007), available at http://www.sec.gov/ news/speech/2007/spch110807gg.htm. 444 In this Release, we refer to directors who are not ‘‘interested persons’’ of the fund as ‘‘independent directors.’’ Section 2(a)(19) of the Investment Company Act identifies persons who are ‘‘interested persons’’ of a fund. 445See, e.g., Liquidity Release, supra note 5, at 175. would not require that a derivatives risk manager only be removable by the board, nor would the board need to approve the derivatives risk manager’s compensation. While we expect that a derivatives risk manager would play an important role, we do not believe that his or her removal or compensation would in all cases be so central to the fund’s investment activities or compliance function to require that risk managers should generally be appointed or removed only by the board.442 We request comment on the proposed requirement that a program be administered by a derivatives risk manager.

• Under the proposed rule, the
  derivatives risk manager may not act as a portfolio manager of the fund. Do commenters agree that this is appropriate and would improve the effectiveness of the program? If not, why?
• Under the proposed rule, a specific
  person who is an employee or officer of the fund or its adviser would be designated as the risk manager. Is this appropriate? Should we instead allow the fund to designate the adviser as a whole or a group of people (such as a risk committee) as the program’s risk manager?
• Is it appropriate to specify that the
  derivatives risk manager may not be a portfolio manager for the fund and must be an employee or officer of the fund or its adviser? Would any small fund complexes have difficulty meeting the proposed requirement?
• Rule 38a–1(c) prohibits officers,
  directors, and employees of the fund and its adviser from, among other things, coercing or unduly influencing a fund’s CCO in the performance of their duties. Should we include such a prohibition on unduly influencing a fund’s derivatives risk officer in the proposed risk management condition? Why, or why not? Should the Commission prohibit any officers, directors, or employees of a fund and its adviser from, directly or indirectly, taking any action to coerce, manipulate, mislead, or fraudulently influence the derivatives risk officer in the performance of his or her responsibilities?
• This requirement would effectively
  bar funds from outsourcing the administration of the derivatives risk manager to third parties. Is this appropriate, or should we instead allow third parties to administer the program as some funds and investment advisers do with respect to their chief compliance officer? Would allowing third parties to act as risk managers enhance the program by allowing specialized personnel to administer the program or detract from it by allowing for a risk manager who may not be as focused on the specific risks of the particular fund and its program?
• If we were not to require the
  independence between the derivatives risk manager and the fund’s portfolio managers, how could we ensure that the program management is not unduly influenced by portfolio management personnel who may have conflicting incentives?
• Do commenters agree that it would
  be appropriate to require a fund to designate the fund’s derivatives risk manager, subject to board approval?
• Should we require the derivatives
  risk manager to be removable only by the fund’s board and the manager’s compensation to be approved by the board as is the case with the chief compliance officer of a fund? If so why? Would such a requirement pose significant burdens on fund boards?
• Should we include any other
  administration requirements? For example, should we include a requirement for training staff responsible for day-to-day management of the program, or for portfolio managers, senior management, and any personnel whose functions may include engaging in, or managing the risk of, derivatives transactions? If we require such training, should that involve setting minimum qualifications for staff responsible for carrying out the requirements of the program? Should training and education be required with respect to any new derivatives instruments that a fund may trade?

4. Board Approval and Oversight
   Under the proposed rule, the fund’s derivatives risk management program would be administered by the derivatives risk manager, with oversight provided by the board. Requiring the derivatives risk manager to be responsible for the day-to-day administration of the fund’s derivatives risk management program, subject to board oversight, is consistent with the way we believe many funds currently manage derivatives risk. We believe that boards should understand the derivatives risk management program and the risks it is designed to manage.443 Accordingly, proposed rule 18f–4 would require each fund to obtain initial approval of its written derivatives risk management program from the fund’s board of directors, including a majority of independent directors.444 Directors, and particularly independent directors, play a critical role in overseeing fund operations, although they may delegate day-to-day management to a fund’s adviser.445 Given the board’s historical oversight role, we believe it is appropriate to require a fund’s board to approve the fund’s derivatives risk management program. This requirement is designed to facilitate scrutiny by the board of directors of the derivatives risk management program—an area where there may potentially be conflicts of interest between the investment adviser and the fund with respect to the use of derivatives by the fund. In considering whether to approve the program or any material changes to it, boards generally should consider the types of derivatives transactions in which the fund engages or plans to engage, their particular risks, and whether the program sufficiently addresses the fund’s compliance with its investment guidelines, any applicable portfolio limitation, and relevant disclosure. Boards generally should consider the adequacy of the program from time to time in light of past experience (both by the fund in particular and with market derivatives use in general) and recent compliance experiences. Boards may also wish to consider best practices used by other fund complexes, or consult with other experts familiar with derivatives risk management by similar funds or market participants. Directors may satisfy their obligations with respect to this initial approval by reviewing summaries of the derivatives risk management program prepared by the fund’s derivatives risk manager, legal counsel, or other persons familiar with the derivatives risk management program. The summaries might familiarize directors with the salient features of the program and provide them with an understanding of how the derivatives risk management program addresses the fund’s use of derivatives. In considering whether to approve a fund’s derivatives risk management program, the board may

446See also Liquidity Release, supra note 5 (which provides similar board oversight of liquidity risk management). 447Proposed rule 18f–4(a)(3)(ii)(B). 448The derivatives risk manager generally should consider whether significant issues should be reported to the adviser or board more quickly than in the quarterly report, for example pursuant to the requirement laid out in proposed rule 18f– 4(a)(3)(i)(B)(ii). 449See Compliance Programs of Investment Companies and Investment Advisers Release No. 2204, at n.84 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)] (‘‘2003 Adopting Release’’)(noting, in the case of a rule 38a–1 compliance program, that ‘‘[s]erious compliance issues must, of course, always be brought to the board’s attention promptly’’). 450Proposed rule 18f–4(c)(4). The rule includes, as a similar agreement, an agreement under which a fund has obligated itself, conditionally or unconditionally, to make a loan to a company or to invest equity in a company, including by making a capital commitment to a private fund that can be drawn at the discretion of the fund’s general partner. 451Proposed rule 18f–4(b)(1), (c)(5). 452Proposed rule 18f–4(c)(8)(iii) (defining ‘‘qualifying coverage assets’’ for purposes of financial commitment transactions). wish to consider the nature of the fund’s derivatives risk exposures. A board also may wish to consider the adequacy of the fund’s derivatives risk management program in light of recent experiences regarding the fund’s use of derivatives.446 Proposed rule 18f–4 also would require each fund to obtain approval of any material changes to the fund’s derivatives risk management program from the fund’s board of directors, including a majority of independent directors. As with the initial approval of a fund’s derivatives risk management program, the requirement to obtain approval of any material changes to the fund’s derivatives risk management program from the board is designed to facilitate independent scrutiny of material changes to the derivatives risk management program by the board of directors. The fund’s board would be required under the proposed rule to review a written report from the fund’s derivatives risk manager, provided no less frequently than quarterly, that reviews the adequacy of the fund’s derivatives risk management program and the effectiveness of its implementation.447 We believe regular reporting to the board should assist boards in being adequately informed about the effectiveness and implementation of the program, enhancing their oversight ability.448 To the extent that a serious compliance issue arises under the program, it should be brought to the board’s attention promptly.449 Regular reporting will also help to reduce the risk that issues are not addressed promptly and increase the likelihood that the derivatives risk manager is actively involved in addressing issues as they arise. We believe that this reporting should take place on at least a quarterly basis, rather than an annual
one, in light of the significant impact that derivatives transactions can have on a fund over a short period of time. We request comment on the proposed board approval and oversight requirements.

• Should the board be required to
  approve the program and any material changes as proposed? If not, why? In the absence of such board approval, would a board be able to effectively oversee the adequacy of a program?
• Should we require reporting to the
  board about the effectiveness of the program as proposed? Should we require a frequency other than quarterly? If so, how frequent and why? Should we not require a frequency but instead require periodic reporting as appropriate?
• Instead of requiring boards to
  review the report, should we instead take an approach similar to rule 38a–1 and require reports to be submitted to the board? E. Requirements for Financial Commitment Transactions The proposed rule also would address and limit funds’ use of financial commitment transactions. The proposed rule would define a ‘‘financial commitment transaction’’ as any reverse repurchase agreement, short sale borrowing, or any firm or standby commitment agreement or similar agreement.450 The requirements applicable to financial commitment transactions in the proposed rule thus would address funds’ use of the trading practices described in Release 10666, as well as short sales of securities. The proposed rule would require a fund that engages in financial commitment transactions in reliance on the rule to maintain qualifying coverage assets equal in value to the amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under each of its financial commitment transactions.451 The proposed rule thus is designed to require the fund to maintain qualifying coverage assets equal in value to the fund’s full obligations under its financial commitment transactions. Because in many cases the timing of the fund’s payment obligations under a financial commitment transaction may be specified under the terms of the transaction or the fund may otherwise have a reasonable expectation regarding the timing of the fund’s payment obligations with respect to its financial commitment transactions, the proposed rule would allow the fund to maintain as qualifying coverage assets certain other assets in addition to cash and cash equivalents, as generally required for derivatives transactions.452 Qualifying coverage assets for each financial commitment transaction would need to be identified on the books and records of the fund at least once each business day. By requiring the fund to maintain qualifying coverage assets to cover the fund’s full potential obligation under its financial commitment transactions, the proposed rule generally would take the same approach to these transactions that we applied in Release 10666, with some modifications. As we discussed above in
  section III.A, requiring a fund to
  segregate assets equal in value to the fund’s full obligations under financial commitment transactions may be an effective way both to impose a limit on the amount of leverage a fund could obtain through those transactions, and to require the fund to have adequate assets to meet its obligations. The asset segregation requirement in the proposed rule is designed to limit the amount of leverage the fund could obtain through financial commitment transactions because the fund could not incur obligations under those transactions in excess of the fund’s qualifying coverage assets. This would limit a fund’s ability to incur obligations under financial commitment transactions to an amount not greater than the fund’s net assets. This approach also is designed to help the fund to have adequate assets to meet its obligations under financial commitment transactions by requiring the fund to have qualifying coverage assets equal in value to those obligations. Under the proposed rule, the fund’s board of directors (including a majority of the directors who are not interested persons of the fund) would be required to approve policies and procedures reasonably designed to provide for the fund’s maintenance of qualifying coverage assets. We believe that requiring the fund’s board to approve the policies and procedures, including a majority of the fund’s independent directors, appropriately would focus the board’s attention on the fund’s management of its obligations under financial commitment transactions and the fund’s use of the exemption provided by the proposed rule. We

453Other exemptive rules under the Act similarly require the fund’s board to take certain actions in order for the fund to rely on the exemption provided by the rule. See, e.g., rules 2a–7, 10f–3, 17a–7, and 18f–3. 454Proposed rule 18f–4(b)(1). 455Proposed rule 18f–4(c)(5). 456Similarly, if a fund commits, conditionally or unconditionally, to pay cash or other assets as an additional loan or contribution to an existing portfolio company under an agreement, the fund would be required to maintain qualifying coverage assets equal in value to the stated commitment amount. 457Proposed rule 18f–4(c)(5). 458Proposed rule 18f–4(b)(1), (c)(5), (c)(8)(ii). As described in more detail below, if the fund has pledged assets with respect to the short sale borrowing and such assets could be expected to satisfy the fund’s obligation under the transaction, the fund could also satisfy the proposed rule’s asset segregation requirement by segregating such pledged assets. See proposed rule 18f–4(c)(8)(iii). 459Proposed rule 18f–4(c)(8). believe that requiring the fund’s board to approve these policies and procedures, in conjunction with the board’s oversight of the fund’s investment adviser more generally, would be an appropriate role for the board.453

1. Coverage Amount for Financial
   Commitment Transactions
   Under the proposed rule, a fund would be required to maintain qualifying coverage assets for each financial commitment transaction with a value equal to at least the amount of the financial commitment obligation associated with the transaction.454 The proposed rule would define the term ‘‘financial commitment obligation’’ to mean the amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under a financial commitment transaction.455 Thus, for example, if a fund commits, conditionally or unconditionally, to purchase a security for a stated price at a later time under a firm or standby commitment agreement or similar agreement, the fund would be required to maintain qualifying coverage assets equal in value to the stated purchase price.456 In addition, where the fund is conditionally or unconditionally obligated to deliver a particular asset, the financial commitment obligation under the proposed rule would equal the value of the asset, determined at least once each business day.457 Thus, for example, if a fund commits to return a security at a later time under a short sale borrowing, the fund would be required to maintain qualifying coverage assets equal to the value of the security, determined at least once each business day. If the fund owns the security it would be required to deliver under the short sale borrowing, the fund would satisfy the proposed rule’s asset segregation requirement by segregating that particular security for the same reasons we discuss above in section III.C.2.b.458 The proposed rule would require the fund to maintain qualifying coverage assets to cover the full amount of the fund’s obligations under its financial commitment transactions, rather than a mark-to-market and risk-based coverage amount as proposed for derivatives transactions, because a fund may in many cases be required to fulfill its full obligation under a financial commitment transaction as compared to a derivatives transaction. For example, if a fund enters into a firm commitment agreement under which it is obligated to purchase a security in the future, the fund is required under the agreement, and must be prepared, to have sufficient assets to complete the transaction. Similarly, if a fund borrows a security from a broker as part of a short sale borrowing, the fund is obligated to return the security to the broker at the termination of the transaction and must be prepared to meet this obligation, either by owning the security or having assets available to purchase it in the market. By contrast, under many types of derivatives transactions, a fund would generally not expect to make payments or deliver assets equal to the full notional amount. We recognize that certain financial commitment transactions, such as standby commitment agreements, are contingent in nature and may not always require a fund to fulfill its full potential obligation under the transaction. We also recognize that certain
   derivatives transactions, such as written options, could result in a fund having to fulfill its full potential obligation under the contract. On balance, however, we believe it would be appropriate to require a fund to maintain qualifying coverage assets to cover its financial commitment obligations, as proposed, to require the fund to have assets to meet its financial commitment obligations. We also note that, as discussed in more detail below, the proposed rule would permit a fund to use assets other than cash and cash equivalents as qualifying coverage assets for financial commitment transactions. In this way the proposed rule is designed both to require a fund to have assets to meet its financial commitment obligations and to address concerns that might be raised if the fund were required to maintain cash and cash equivalents for the fund’s longer-term financial commitment obligations. We also believe that this approach would be consistent with funds’ current practices in that we understand that funds that rely on Release 10666 when entering into financial commitment transactions generally segregate assets to cover the funds’ full potential obligations under these transactions. In addition, by requiring the fund to maintain qualifying coverage assets equal in value to the fund’s aggregate financial commitment obligations, the proposed rule also would impose a limit on the amount of leverage a fund could obtain through financial commitment transactions. This is because a fund relying on the rule would not be permitted to incur obligations under financial commitment transactions in excess of the fund’s qualifying coverage assets. As noted in section III.C.2.c, the total amount of a fund’s qualifying coverage assets could not exceed the fund’s net assets.459 As a result, the fund’s financial commitment obligations could not exceed the fund’s net assets under the proposed rule. We have proposed to limit the total amount of fund assets available for use as qualifying coverage assets because, absent this provision, the proposed rule would not impose an effective limit on the amount of leverage a fund could obtain through financial commitment transactions. This is because, in addition to creating a liability for the fund, some financial commitment transactions also generate proceeds that increase the total assets of the fund. If the total amount of a fund’s qualifying coverage assets was not reduced to reflect the fund’s liability from these transactions, the requirement to maintain qualifying coverage assets would not provide an effective limit on the fund’s ability to enter into those transactions because a financial commitment transaction can generate fund assets that could otherwise be used as qualifying coverage assets. Take, for example, a fund that has $100 in assets and no liabilities or senior securities outstanding. The fund then borrows a security from a broker and sells it short, generating $10 on the sale. The fund would then have $110
   in total assets and a corresponding liability of $10. If the fund were not required to reduce the total amount of its qualifying coverage assets by the amount of the liability from this transaction, the fund would have $110 in total assets that potentially could be used as qualifying coverage assets if they otherwise met the rule’s requirements for qualifying coverage assets; the fund’s selling a security short could be viewed as increasing the fund’s ability to engage in

460 In addition, and as discussed in more detail in section III.C.2.c, the limit on the total amount of a fund’s qualifying coverage assets also is designed to prohibit a fund from entering into financial commitment transactions or issuing other senior securities and then using the proceeds of such leveraging transactions as assets that would then support an additional layer of leverage through financial commitment transactions or derivatives transactions under the proposed rule. 461Proposed rule 18f–4(b)(1). 462See Release 10666, supra note 20, at discussion of ‘‘Segregated Account.’’ 463Proposed rule 18f–4(c)(8). 464Proposed rule 18f–4(c)(8). In addition, qualifying coverage assets used to cover a financial commitment transaction could not also be used to Continued transactions requiring asset segregation under the proposed rule because the transaction itself generated assets. The proposed rule would require the fund to reduce the amount of otherwise available qualifying coverage assets by the amount of the liability from the short sale in this example (i.e., $10) so that the requirement to maintain qualifying coverage assets would impose an effective limit on the amount of leverage a fund could obtain through financial commitment transactions.460 Finally, as noted above, a fund’s qualifying coverage assets for its financial commitment transactions, like the qualifying coverage assets for the fund’s derivatives transactions, would be required to be identified on the fund’s books and records and determined at least once each business day.461 This requirement is designed so that the fund’s assessments of the extent of its financial commitment obligations and the eligibility of its segregated assets as qualifying coverage assets (discussed below) remain reasonably current because the value of certain qualifying coverage assets and the amount of certain financial commitment obligations may fluctuate on a daily basis. Based on staff experience, we believe that this frequency of determination would be consistent with funds’ current practices because funds that engage in financial commitment transactions today do so in reliance on Release 10666.’’ 462 We request comment on all aspect of the proposed rule’s requirement that a fund maintain assets in respect of the financial commitment obligation for its financial commitment transactions and the requirement that the fund’s qualifying coverage assets be identified on the fund’s books and records and determined at least once each business day.

• The proposed rule’s approach to
  financial commitment transactions, as discussed above, is based on the approach we took in Release 10666 for financial commitment transactions and is designed to impose a limit on the amount of leverage a fund could obtain through those transactions, and to require the fund to have adequate assets to meet its obligations. Do commenters agree with the proposed rule’s approach to financial commitment transactions? Do commenters believe that it would be effective in addressing concerns about leverage and adequacy of assets in connection with a fund’s use of financial commitment transactions?
• Is the definition of financial
  commitment transaction obligation sufficiently clear to allow a fund to determine the amount of assets necessary to comply with the rule? Does the definition adequately capture all of a fund’s potential obligations under a financial commitment transaction?
• Should we continue to require
  funds to segregate their full potential obligation under financial commitment transactions, consistent with Release 10666? Or, should we instead treat financial commitment transactions similar to derivatives transactions and require funds to segregate the mark-to￾market coverage amount and a risk￾based coverage amount for each financial commitment transaction? If we were to take this approach, are there types of financial commitment transactions for which it may be difficult to determine a mark-to-market coverage amount because, for example, there are not market prices available for the transactions?
• Under the proposed rule, all
  financial commitment transactions would be subject to the same asset segregation requirement, regardless of whether the fund’s obligation under the transaction is conditional or whether the amount of the financial commitment obligation could fluctuate over time. Should we treat conditional financial commitment transactions, such as standby commitment agreements, differently than financial commitment transactions where the obligations are not conditional? If so, how should the asset segregation requirement differ? Should these conditional financial commitment transactions be treated like derivatives transactions? Should we treat short sales, which have a financial commitment obligation that can vary over time, differently than other financial commitment transactions that have a fixed financial commitment obligation amount? If so, how should the asset segregation requirement differ? Should short sales be treated like derivatives transactions and require a risk-based coverage amount or some other amount designed to address future losses?
• The asset segregation requirement
  in the proposed rule would effectively impose a limit on the fund’s ability to enter into financial commitment transactions by limiting the total amount of a fund’s qualifying coverage assets and providing that qualifying coverage assets shall not exceed the fund’s net assets. Does the proposed rule appropriately limit the extent to which funds should be permitted to enter into financial commitment transactions? Should the proposed rule include a separate portfolio limitation, similar to the 150% portfolio limitation on derivatives transactions in the exposure-based portfolio limit, rather than limiting the extent to which a fund could incur obligations under financial commitment transactions indirectly through the asset segregation requirement? If so, should that limit be 100% of the fund’s net assets (consistent with the proposed rule’s limit on the total amount of qualifying coverage assets)? Should it be lower, such as 50% of the fund’s net assets, or higher, such as the 150% limitation applicable to derivatives transactions under the exposure-based portfolio limit? Are there other limits, higher or lower, that would be appropriate?
• The proposed rule would require a
  fund to identify and determine its qualifying coverage assets for its financial commitment obligations at least once each business day. Should the proposed rule instead require the fund to identify and determine these qualifying coverage assets more or less frequently?

2. Qualifying Coverage Assets for
   Financial Commitment Transactions Under the proposed rule, ‘‘qualifying coverage assets’’ in respect of a financial commitment transaction would be fund assets that are: (1) Cash and cash equivalents; (2) with respect to any financial commitment transaction under which the fund may satisfy its obligations under the transaction by delivering a particular asset, that particular asset; or (3) assets that are convertible to cash or that will generate cash, equal in amount to the financial commitment obligation, prior to the date on which the fund can be expected to be required to pay such obligation or that have been pledged with respect to the financial commitment obligation and can be expected to satisfy such obligation, determined in accordance with policies and procedures approved by the fund’s board of directors.463 The total amount of a fund’s qualifying coverage assets could not exceed the fund’s net assets.464

cover a derivatives transaction. Proposed rule 18f– 4(c)(8). 465Proposed rule 18f–4(c)(8). 466Proposed rule 18f–4(c)(8)(iii). As noted above, where the fund is conditionally or unconditionally obligated to deliver a particular asset, the fund also could satisfy the proposed rule’s asset segregation requirements by segregating that particular asset. Proposed rule 18f–4(c)(8)(ii). 467Proposed rule 18f–4(c)(8). 468Proposed rule 18f–4(c)(8). 469Proposed rule 22e–4(b)(2)(i). 470Liquidity Release, supra note 5. 471Liquidity Release, supra note 5. Specifically, proposed rule 22e–4 would require the fund to consider the following factors, to the extent applicable: (1) Existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants; (2) frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange); (3) volatility of trading prices for the asset; (4) bid-ask spreads for the asset; (5) whether the asset has a relatively standardized and simple structure; (6) for fixed income securities, maturity and date of issue; (7) restrictions on trading of the asset and limitations on transfer of the asset; (8) the size of For financial commitment transactions, the proposed rule would permit a fund to maintain assets in addition to cash and cash equivalents, as proposed for derivatives transactions, as qualifying coverage assets for the fund’s financial commitment transactions.465 This is because we understand that funds use financial commitment transactions for a variety of financial and investment purposes, including obtaining financing for investments acquired (or to be acquired) by the fund and establishing contractual relationships under which the fund agrees to make or acquire loans, debt securities or additional interests in portfolio companies in the future. In many cases, the timing of the fund’s payment obligations may be specified under the terms of the financial commitment or the fund may otherwise have a reasonable expectation regarding the timing of the fund’s payment obligations with respect to its financial commitment transactions. In addition, certain financial commitment transactions require a fund to pledge assets having an aggregate value that is greater than the financial commitment obligation and, given that the amount and value of these assets will have been evaluated both by the fund and its counterparty, we believe that such assets would generally be expected to satisfy the fund’s obligation under such financial commitment transaction unless there subsequently occurs a material reduction in the value of such assets. The proposed rule therefore would permit a fund to maintain assets that are convertible to cash or that will generate cash, equal in amount to the financial commitment obligation, prior to the date on which the fund can be expected to
be required to pay its financial commitment obligation or that have been pledged with respect to a financial commitment obligation and can be expected to satisfy such obligation, determined in accordance with policies and procedures approved by the fund’s board of directors.466 For example, if a fund enters into a firm commitment agreement whereby the fund agrees to purchase a security from a counterparty at a future date and at a stated price, the fund would know at the outset of the transaction the date on which the obligation is due and the full amount of the obligation. Rather than being required to maintain cash and cash equivalents equal in value to the amount of this obligation—which the fund may not be required to pay for some time—the proposed rule would permit the fund to maintain assets that are convertible to cash or that will generate cash prior to the date on which the fund can be expected to be required to pay such obligation, determined in accordance with board-approved policies and procedures. In this example, if the purchase price of the firm commitment is $100 and the transaction will be completed on a fixed date, the fund, if consistent with its policies and procedures relating to qualifying coverage assets, could segregate a fixed-income security with a value of $100 or more that would pay $100 or more upon maturity and would mature in time for the fund to use the principal payment to complete the firm commitment transaction. As another example, the fund could, if consistent with its policies and procedures relating to qualifying coverage assets, segregate a fixed-income security with a value of $100 or more that would generate $100 or more in interest payments that the fund could use to complete the firm commitment agreement. Qualifying coverage assets under the proposed rule include assets that are convertible to cash or able to generate cash, equal in amount to the financial commitment obligation, prior to the date on which the fund can be expected to be required to pay such obligation.467 Where the fund can be expected to pay the obligation on a short-term basis, the assets maintained by the fund as qualifying coverage assets also would have to be convertible to cash or able to generate cash on a short-term basis. For example, if the fund has entered into a standby commitment agreement and the fund could be expected to be required to pay the purchase price under the agreement on a short-term basis, the fund would need to segregate assets that could be convertible to cash or able to generate cash in a short period of time to enable the fund to meet its expected obligation. We would expect these assets to be highly liquid assets given the short-term nature of the fund’s obligation under the transaction and the proposed rule’s requirement that qualifying coverage assets be convertible to cash or generate cash, equal in amount to the financial commitment obligation, prior to the date on which the fund can be expected to be
required to pay such obligation. The proposed rule would require that an asset’s convertibility to cash or the ability to generate cash, and the date on which the fund can be expected to be required to pay the financial commitment obligation, be determined in accordance with policies and procedures approved by the fund’s board of directors.468 By requiring funds to establish appropriate policies and procedures, rather than prescribing specific segregation methodologies, the proposed rule is designed to allow funds to assess and determine when they can be required to pay financial commitment obligations and their assets’ convertibility to cash or ability to generate cash based on the funds’ specific financial commitment transactions and investment strategies. As with respect to the determination of risk-based coverage amounts for derivatives transactions, we believe that funds are best situated to evaluate their obligations under their financial commitment transactions and the eligibility of their assets to be used as qualifying coverage assets based on an assessment of their own particular facts and circumstances. We note that, if we adopt proposed rule 22e–4, funds subject to that rule already would be considering their assets’ convertibility to cash in order to comply with rule 22e–4, as explained in more detail in the Liquidity Release.469 In classifying and reviewing the liquidity of portfolio positions, proposed rule 22e–4 would require the fund to consider the number of days within which the fund’s position in a portfolio asset (or portions of a position in a particular asset) would be convertible to cash at a price that does not materially affect the value of that asset immediately prior to sale.470 Proposed rule 22e–4 would require the fund to consider certain specified factors in classifying the liquidity of its portfolio positions.471 Funds

the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding; and (9) relationship of the asset to another portfolio asset. See Id., at section III.A. 472Money market funds also are not proposed to be subject to the requirements of proposed rule 22e–4 because they are subject to extensive requirements concerning the liquidity of their portfolio assets under rule 2a–7. See Liquidity Release, supra note 138. Under rule 2a–7, money market funds are required to limit their investments to short-term, high-quality debt securities that fluctuate very little in value under normal market conditions. Money market funds thus do not engage in derivatives transactions, but may enter into certain financial commitment transactions to the extent permitted under rule 2a–7. Although money market funds could choose to evaluate their assets’ convertibility to cash using the factors in proposed rule 22e–4, we generally would expect that they would not need to do so for purposes of proposed rule 18f–4 because we expect that a money market fund, in order to comply with the conditions of rule 2a–7 (including the rule’s liquidity requirements and limitations on the maturity of portfolio assets), already would be evaluating when its assets will generate cash (or be convertible to cash) and when it could be expected to pay its financial commitment obligations. 473Proposed rule 18f–4(c)(8)(iii). 474See Margin and Capital Proposing Release, supra note 363. undertaking this analysis for purposes of rule 22e–4 thus already would have considered their assets’ convertibility to cash and could use this analysis (and related policies and procedures) for purposes of rule 18f–4. Although not every fund that would be subject to proposed rule 18f–4 would be subject to proposed rule 22e–4, to the extent that fund advisers and third-party service providers develop methodologies or other tools for assessing positions’ convertibility to cash in a manner consistent with proposed rule 22e–4, we anticipate that such tools could be used by all funds subject to proposed rule 18f–4 in assessing convertibility to cash for purposes of rule 18f–4. Thus, closed￾end funds and BDCs, which are not within the scope of proposed rule 22e– 4 but which may enter into financial commitment transactions, could nevertheless employ tools that were developed in response to proposed rule 22e–4 in determining whether an asset is a qualifying coverage asset.472 In sum, although proposed rule 18f–4 would not require the fund’s policies and procedures to include the factors specified in proposed rule 22e–4, funds may find it efficient to consider those factors and methodologies and tools designed to address them. The proposed rule would also allow a fund to use, as qualifying coverage assets, assets that have been pledged with respect to a financial commitment obligation and can be expected to satisfy such obligation.473 For
example, assets that are pledged by a fund to its broker in connection with a short sale borrowing that can be expected to satisfy the fund’s obligations under such transaction could, if consistent with the fund’s policies and procedures relating to qualifying coverage assets, be segregated on the fund’s books and records as qualifying coverage assets for such short sale transaction. Assets that a fund has transferred to its counterparty in connection with a reverse repurchase agreement could be regarded as having been pledged by the fund for purposes of paragraph (c)(8)(iii) of the proposed rule. If such assets can be expected to satisfy the fund’s obligations under such transaction, the fund could, if consistent with its policies and procedures relating to qualifying coverage assets, segregate such assets on its books and records as qualifying coverage assets for such transaction. We request comment on all aspects of the proposed rule’s requirements for qualifying coverage assets for financial commitment transactions.

• Do commenters agree that it is
  appropriate to permit a fund to maintain assets in addition to cash and cash equivalents as qualifying coverage assets for the fund’s financial commitment transactions? Should we, instead, require funds to use cash and cash equivalents, as proposed for derivatives transactions, or otherwise specify the types or liquidity profiles of assets that may be used? Should we specify that certain types of assets should not be included as qualifying coverage assets?
• Do commenters agree that, in many
  cases, the timing of the fund’s payment obligations may be specified under the terms of the financial commitment or the fund may otherwise have a reasonable expectation regarding the timing of the fund’s payment obligations with respect to its financial commitment transactions? If so, do commenters agree that the proposed rule appropriately recognizes this aspect of many types of financial commitment transactions by permitting a fund to segregate assets that are convertible to cash or that will generate cash prior to the date on which the fund can be expected to be required to pay its financial commitment obligations, determined in accordance with board-approved policies and procedures?
• Under the proposed rule, qualifying
  coverage assets in respect of a financial commitment transaction would include fund assets that have been pledged by the fund with respect to the financial commitment obligation and can be expected to satisfy such obligation. Do commenters agree that such assets should be considered qualifying coverage assets? Does the proposed rule appropriately describe such assets? Are there additional requirements that we should impose on the use of such assets as qualifying coverage assets?
• The proposed rule would require
  that an asset’s convertibility to cash or the ability to generate cash, and the date on which the fund can be expected to be required pay the financial commitment obligation, be determined in accordance with policies and procedures approved by the fund’s board of directors. Do commenters agree that it is appropriate to allow funds to assess and determine when they can be expected to be required to pay financial commitment obligations and their assets’ convertibility to cash or ability to generate cash based on the funds’ specific financial commitment transactions and investment strategies?
• The proposed rule would not
  specify the particular factors that must be included in a fund’s policies and procedures for purposes of determining an asset’s convertibility to cash or the ability to generate cash, and the date on which the fund can be expected to be required to pay the financial commitment obligation. Are there particular factors we should specify in any final rule? We noted above that, in developing these policies and procedures, a fund could consider the factors specified in proposed rule 22e–

4. Should we specifically require that a
   fund’s policies and procedures include the factors specified in rule 22e–4 if we adopt that rule? If so, should only those funds subject to the requirements of proposed rule 22e–4 be required to include those factors? Should we specify additional factors? If so, what factors should be specified?

• The proposed rule would allow a
  fund to segregate as qualifying coverage assets any assets that are convertible to cash or that will generate cash equal in amount equal to the financial commitment obligation prior to the date on which the fund can be expected to be required to pay such obligation. Should we instead allow a fund to segregate specific types of assets subject to a haircut? If so, how should we determine the appropriate haircut? For example, should we incorporate the haircuts described in the SEC’s proposed rule on Capital, Margin, and Segregation Requirements for Security￾Based Swap Dealers and Major Security￾Based Swap Participants and Capital Requirements for Broker-Dealers? 474 Or should we incorporate the haircut
  schedule included in the rules adopted
  by the banking regulators for covered

475See Prudential Regulator Margin and Capital Adopting Release, supra note 160. 476Proposed rule 18f–4(a)(6). 477The proposed recordkeeping time period is consistent with the retention periods in rule 38a– 1 and proposed rule 22e–4. As we explained in the Liquidity Release with respect to proposed rule 22e–4, we believe consistency in these retention periods is appropriate because funds currently have program-related recordkeeping procedures in place incorporating a five-year retention period, which we believe would lessen the compliance burden to funds slightly, compared to choosing a different retention period, such as the six-year recordkeeping retention period under rule 31a–2 under the Act. Taking this into account, we believe a five-year retention period is a sufficient period of time for our examination staff to evaluate whether a fund is in compliance (and has been in compliance) with the proposed rule and anticipate that such information would become less relevant if extended beyond a five-year retention period. Furthermore, we believe that the proposed five-year retention period appropriately balances recordkeeping￾related burdens on funds. See Liquidity Release, supra note 5, concerning the five-year retention periods included in proposed rule 22e–4. 478See proposed rule 18f–4(a)(6)(i). The fund would be required to maintain this record for a period of not less than five years (the first two years in an easily accessible place) following each determination. 479See proposed rule 18f–4(a)(6)(ii) (derivatives transactions); proposed rule 18f–4(b)(3) (financial commitment transactions). The fund would be required to maintain these policies and procedures that are in effect, or at any time within the past five years were in effect, in an easily accessible place. 480See proposed rule 18f–4(a)(6)(iv). The fund would be required to maintain this record for a period of not less than five years (the first two years in an easily accessible place) following each senior securities transaction. 481See proposed rule 18f–4(a)(6)(v); proposed rule 18f–4(b)(3)(ii). The fund would be required to determine these amounts and identify qualifying coverage assets at least once each business day, and would be required to maintain these records for a period of not less than five years (the first two years in an easily accessible place). 482See proposed rule 18f–4(a)(6)(v). 483See proposed rule 18f–4(b)(3)(ii). 484See proposed rule 18f–4(a)(6)(iii). 485See proposed rule 18f–4(a)(6)(iii)(A). The fund would be required to maintain a written copy of the policies and procedures that are in effect, or at any time within the past five years were in effect, in an easily accessible place. 486See proposed rule 18f–4(a)(6)(iii)(B). The fund would be required to maintain these records for at least five years after the end of the fiscal year in which the documents were provided to the fund’s board, the first two years in an easily accessible place. 487Specifically, the
fund would be required to maintain records documenting the periodic reviews and updates conducted in accordance with paragraph (a)(3)(i)(D) of the proposed rule (including any updates to any VaR calculation models used by the fund and the basis for any material changes thereto), for a period of not less than five years (the first two years in an easily accessible place) following each review or update. See Proposed rule 18f–4(a)(6)(iii)(C). We note that, because of the importance of VaR models under the rule, this provision would require funds to maintain records explaining the basis for any material changes to the VaR calculation models used during the covered period. swap entities? 475 Is there a different haircut schedule that would be more appropriate for the proposed rule? F. Recordkeeping Proposed rule 18f–4 also would include certain recordkeeping requirements relating to the fund’s selection of a portfolio limitation; its compliance with the other requirements of the proposed rule; and if the fund is required to implement a formalized derivatives risk management program, records of the program’s policies and procedures, and any materials provided to the board of directors related to its operation.476 All the records would be required to be kept for 5 years (the first 2 years in an easily accessible place).477 First, the proposed rule would require a fund to maintain a record of each determination made by the fund’s board that the fund will comply with one of the portfolio limitations under the proposed rule, which would include the fund’s initial determination as well as a record of any determination made by the fund’s board to change the portfolio limitation.478 Such a record should allow our examiners to better evaluate compliance with the proposed exemptive rule. Second, the proposed rule would require the fund to maintain certain records so that the fund’s ongoing compliance with the conditions of the proposed rule can be evaluated by our examiners or the fund’s board or compliance personnel. Specifically, the fund would be required to maintain a written copy of the policies and procedures approved by the board regarding the fund’s maintenance of qualifying coverage assets, as required under the proposed rule.479 The fund also would be required to maintain a written record demonstrating that immediately after the fund entered into any senior securities transaction, the fund complied with the portfolio limitation applicable to the fund immediately after entering into the senior securities transaction, reflecting the fund’s aggregate exposure, the value of the fund’s net assets and, if applicable, the fund’s full portfolio VaR and its securities VaR.480 The fund also would be required to maintain written records reflecting the fund’s mark-to-market and risk-based coverage amounts and the fund’s financial commitment obligations, and identifying the qualifying coverage assets maintained by the fund to cover these amounts.481 For
derivatives transactions, the fund would be required to maintain written records identifying the qualifying coverage assets maintained by the fund to cover the aggregate amount of its mark-to￾market and risk-based coverage amounts—rather than identifying the qualifying coverage assets maintained in respect of each specific derivatives transaction—because the proposed rule generally would require the fund to maintain cash and cash equivalents for its derivatives transactions.482 For financial commitment transactions, the fund would be required to maintain written records identifying the specific qualifying coverage assets maintained by the fund to cover each financial commitment transaction in order to allow our examination staff to evaluate whether, as required under the proposed rule, the qualifying coverage assets maintained for specific financial commitment transactions are assets that are convertible to cash or that will generate cash, equal in amount to the financial commitment obligation, prior to the date on which the fund can be expected to be required to pay such obligation or that have been pledged with respect to the financial commitment obligation and can be expected to satisfy such obligation, determined in accordance with the fund’s policies and procedures.483 Finally, the proposed rule would require a fund to maintain records relating to the derivatives risk management program, if the fund is required to adopt and implement a derivatives risk management program.484 The proposed rule would require funds to maintain a written copy of the policies and procedures approved by the board.485 It would also require funds to maintain records of any materials provided to the board in connection with its approval of the program, as well as any written reports provided to the board relating to the program 486 and records documenting periodic updates and reviews required as part of the risk management program.487 Such records should serve to provide data about the operation of a fund’s program to better allow our examiners and compliance personnel to evaluate compliance with the conditions of the proposed rule. We request comment on the proposed rule’s recordkeeping requirements.

• Should we require such
  recordkeeping provisions? Are there any other records relating to a fund’s senior securities transactions that a fund should be required to maintain?
• The proposed rule’s recordkeeping
  requirements generally are designed to allow our examiners or the fund’s board or compliance personnel to evaluate the fund’s ongoing compliance with the proposed rule’s conditions. Do commenters believe that the proposed rule’s recordkeeping requirements

488Submissions on Form N–PORT would be required to be submitted no later than 30 days after the close of each month. Only information reported for the third month of each fund’s fiscal quarter on Form N–PORT would be publicly available, and such information would not be made public until 60 days after the end of the third month of the fund’s fiscal quarter. See Investment Company Reporting Modernization Release, supra note 138. 489See id. 490See Item C.11.c.iii.1 of proposed Form N– PORT. 491See Item B.3.a of proposed Form N–PORT. 492See Item B.3.b of proposed Form N–PORT. 493See Investment Company Reporting Modernization Release, supra note 138. 494 Id. 495 Item 31 of proposed Form N–CEN. 496See Investment Company Reporting Modernization Release, supra note 138, at Part II.E.4.c.iv. 497See, e.g., Comment Letter of CFA Institute on Investment Company Reporting Modernization (Aug. 10, 2015) (File No. S7–08–15), available at http://www.sec.gov/comments/s7-08-15/s70815- 228.pdf, at 6–7; Comment Letter of Interactive Data Pricing and Reference Data LLC on Investment Company Reporting Modernization (Aug. 10, 2015) (File No. S7–08–15), available at http:// www.sec.gov/comments/s7-08-15/s70815-329.pdf, at 1, 9–11; Comment Letter of State Street Corporation on Investment Company Reporting Modernization (Aug. 11, 2015) (File No. S7–08–15), available at http://www.sec.gov/comments/s7-09- 15/s70915-27.pdf, at 3–4 (specifically recommending, among other risk metrics, that Form N–PORT require disclosure of vega); Comment Letter of Pioneer Investments (Aug. 11, 2015) (File No. S7–08–15), available at http://www.sec.gov/ comments/s7-08-15/s70815-302.pdf, at 13 (supporting the Commission’s desire to standardize disclosure and increase transparency regarding a fund’s derivative usage, and recommending that derivative reporting be subject to a de minimis threshold). 498See, e.g., Comment Letter of Dreyfus Corporation on Investment Company Reporting Modernization (Aug. 11, 2015) (File No. S7–08–15), available at http://www.sec.gov/comments/s7-08- 15/s70815-333.pdf, at 3, 10. 499See, e.g., Comment Letter of Investment Company Institute on Investment Company Reporting Modernization (Aug. 12, 2015) (File No. S7–08–15), available at http://www.sec.gov/ comments/s7-08-15/s70815-315.pdf, at 7, 21–22, 41–42, 46–47; Comment Letter of Vanguard on Investment Company Reporting Modernization (Aug. 11, 2015) (File No. S7–08–15), available at Continued would appropriately balance recordkeeping-related burdens on funds? Are there feasible alternatives to the proposed recordkeeping requirements that would minimize recordkeeping burdens, including the costs of maintaining the required records?

• We specifically request comment on
  any alternatives to the proposed recordkeeping requirements that would minimize recordkeeping burdens on funds, on the utility and necessity of the proposed recordkeeping requirements in relation to the associated costs and in view of the public benefits derived, and on the effects that additional recordkeeping requirements would have on funds’ internal compliance policies and procedures. Are the record retention time periods that we have selected appropriate? Should we require records to be maintained for a longer or shorter period? If so for how long? G. Amendments to Proposed Forms N– PORT and N–CEN On May 20, 2015, in an effort to modernize and enhance the reporting and disclosure of information by investment companies, we issued a series of proposals, including proposals for two new reporting forms. First, our proposal would require registered management investment companies and ETFs organized as unit investment trusts, other than registered money market funds or small business investment companies, to electronically file with the Commission monthly portfolio investment information on proposed Form N–PORT.488 As we discussed in the Investment Company Reporting Modernization Release, we believe that the information that would be filed on proposed Form N–PORT would enhance the Commission’s ability to effectively oversee and monitor the activities of investment companies in order to better carry out its regulatory functions. We also stated that we believe that the information on proposed Form N–PORT would allow investors and other potential users to better understand investment strategies and risks, and help investors make more informed investment decisions.489 Among other things, proposed Form N–PORT would require funds to disclose certain risk metrics— specifically, the delta for derivatives instruments with optionality,490 as well as the portfolio’s interest rate risk (DV01) 491 and credit spread risk (SDV01/CR01/CS01).492 As we stated in the Investment Company Reporting Modernization Release, disclosure of delta—a measure of the sensitivity of an option’s value to changes in the price of the referenced asset—would provide the Commission, investors, and other potential users with an important measurement of the impact, on a fund or group of funds that hold options on an asset, of a change in such asset’s price. Moreover, disclosure of delta would assist the Commission and others with measuring exposure to leverage through options, which would allow the Commission, investors, and other potential users to better understand the risks that the fund faces as asset prices change, because the use of this type of leverage can magnify losses or gains in assets. Second, all registered investment companies, including money market funds but excluding face amount certificate companies, would be required to file annual reports on proposed Form N–CEN.493 Proposed Form N–CEN would require these registered investment companies to provide census-type
  information that would assist our efforts to modernize the reporting and disclosure of information by registered investment companies and enhance the staff’s ability to carry out its regulatory functions, including risk monitoring and analysis of the industry.494 Among other things, proposed Form N–CEN would require funds to report whether they relied upon certain enumerated rules under the Act during the reporting period.495 We proposed to collect this information to better monitor reliance on exemptive rules and assist us with our accounting, auditing and oversight functions, including, for some rules, compliance with the Paperwork Reduction Act.496

1. Reporting of Risk Metrics by Funds
   That Are Required To Implement a Derivatives Risk Management Program In the Investment Company Reporting Modernization Release, we requested comment on our proposal to require funds to report on Form N–PORT certain portfolio- and position-level risk metrics. We also requested comment on additional risk metrics such as gamma, which enables more precise position￾level estimation of sensitivity to underlying price movements, and vega, which provides position-level sensitivity to volatility. The proposal requested comment on whether gamma and vega would enhance the utility of the derivatives information reported in Form N–PORT and the costs and burdens to funds and benefits to investors and other potential users of requiring funds to report such risk metrics. We received several comment letters relating to our proposal to require funds to report certain portfolio- and position￾level risk metrics. Some commenters reflected positively on our proposal, noting that risk metrics could allow the Commission to better understand the risks associated with investments in derivatives.497 However, another commenter questioned the utility of reporting risk metrics, such as delta, given the time-lag associated with reporting on Form N–PORT.498 Others expressed concern with making specific risk metrics public, as, given the inherent subjectivity of computing risk metrics, disclosure could be of limited utility and potentially confusing for investors.499

http://www.sec.gov/comments/s7-09-15/s70915- 28.pdf, at 3 (recommending that the Commission omit risk metrics from Form N–PORT, and, instead, use the raw data reported in Form N–PORT to perform its own calculation of risk metrics in order to ensure comparable results between funds); BlackRock Modernization Comment Letter, at 3. 500See supra section III.D.; see also proposed rule 18f–4(a)(3). 501 Item C.11.c.viii of proposed Form N–PORT. 502 Item C.11.c.vii of proposed Form N–PORT. 503See supra note 499 and accompanying text. 504See supra Section III.B. 505 Items 31(k) and 31(l) of Proposed Form N– CEN. If a fund relied on the exposure based portfolio limit during part of the reporting period, and the risk-based portfolio limit during part of the same reporting period, it would be required to so indicate. 506Comments regarding the proposed amendments to Forms N–PORT and N–CEN should be submitted to the comment file for this Release. We recognize that collecting and reporting alternative risk metrics, such as vega and gamma, could be more burdensome than reporting delta only. However, we believe that requiring funds to report information about the fund’s exposures with metrics such as vega and gamma would assist the Commission in better assessing the risk in a fund’s portfolio. In consideration of the additional burdens of reporting selected risk metrics to the Commission and the benefits of more complete disclosure of a fund’s risks, we are proposing to limit the reporting of vega and gamma to only those funds that are required to implement a formalized derivatives risk management program as required by proposed rule 18f– 4(a)(3).500 Our reasons for limiting the reporting of vega and gamma are two￾fold: First, we understand that there are added burdens to reporting risk metrics and we are therefore proposing to limit the reporting of these risk metrics to only those funds who are engaged in more than a limited amount of derivatives transactions or that use certain complex derivatives transactions, as opposed to funds that engage in a more limited use of derivatives. Second, based on staff experience regarding portfolio management practices and outreach to service providers that calculate risk metrics we believe many of the funds that would be required to implement a derivatives risk management and that invest in derivatives as part of their investment strategy currently calculate risk metrics for their own internal risk management programs, or have risk metrics calculated for them by a service provider, albeit, for internal reporting purposes.
2. Amendments to Proposed Form N–
PORT
Part C of proposed Form N–PORT
would require a fund and its consolidated subsidiaries to disclose its
schedule of investments and certain
information about the fund’s portfolio of investments. We propose to add Item C.11.c.viii to Part C of proposed Form N–PORT, which would require funds that are required to implement a formalized risk management program under proposed rule 18f–4(a)(3) to provide the gamma and vega for options and warrants, including options on a derivative, such as swaptions.501 As discussed above, gamma measures the sensitivity of delta 502 in response to price changes in the underlying instrument. Thus, gamma, in concert with delta, facilitates sensitivity analysis, which would provide the Commission and others with a more precise estimate of the effect of underlying price changes on a fund’s investments, particularly for large price movements in the underlying reference asset. Vega, which measures the amount that an option contract’s price changes in relation to a one percent change in the volatility of an underlying asset, would assist the Commission and others with measuring an investment’s volatility. This would permit the Commission and others to, among other things, estimate changes in a portfolio based on changes in market volatility, as opposed to changes in asset prices. Vega would accordingly give the Commission and others the tools necessary to construct more comprehensive risk analyses as appropriate. We anticipate that the enhanced reporting proposed in these amendments would help our staff better monitor price and volatility trends and various funds’ risk profiles. Risk metrics data reported on Form N–PORT that is made publicly available also would inform investors and assist users in assessing funds’ relative price and volatility risks and the overall price and volatility risks of the fund industry— particularly for those funds that use investments in derivatives as an important part of their trading strategy. For example, third-party data analyzers could use the reported information to produce useful metrics for investors about the relative price and volatility risks of different funds with similar strategies. Moreover, gamma, vega, and delta would help the Commission, investors, and others determine the source of a fund’s risk and return. We recognize that determining certain of the inputs that go into computing gamma and vega inherently involve some level of judgment and that some commenters expressed concern that this type of information could be confusing to investors.503 Nevertheless, for the reasons discussed above, we believe that the reporting of gamma and vega would provide valuable information to us and market participants about current fund expectations regarding their use of certain derivatives and better understand the risks that the fund faces as asset prices and volatility change.
3. Amendments to Proposed Form N–
CEN
As discussed above, proposed rule 18f–4 would require funds that engage in derivatives transactions to comply with one of two alternative portfolio limitations: The exposure-based portfolio limit under proposed rule 18f– 4(a)(1)(i) or the risk-based portfolio limit under proposed rule 18f–4(a)(1)(ii).504 We are proposing to amend Item 31 of
Part C of proposed Form N–CEN to
require a fund to identify the portfolio limitation on which the fund relied during the reporting period.505 This information would allow the Commission to identify funds that rely on the exemptions under proposed rule 18f–4.
4. Request for Comment
We seek comment on each of the Commission’s proposed amendments to proposed Form N–PORT and proposed Form N–CEN.506

• How, if at all, should we modify the
  scope of the proposed requirements to report gamma or vega? For example, as we discussed above, in the Investment Company Modernization Release, we requested comment on whether we should require all funds to report gamma and vega. Our current proposal would limit the reporting of gamma and vega to funds that are required to implement a derivatives risk management program. Is this appropriate, or should we require all funds that invest in derivatives with optionality to report these metrics? Alternatively, should we require reporting of these risk metrics for funds with a higher or lower exposure than 50%? Additionally, should we require funds that are required to have a risk management program by virtue of the complexity of the derivatives they invest in, as proposed, to report such metrics, even if their exposure falls below 50%?
• We are also proposing to limit the
  reporting of gamma and vega to options and warrants, including options on a derivative, such as swaptions. Are there other investment products for which we should require disclosure of gamma and vega? If so, which products and why?

507See Liquidity Release, supra note 5 (generally categorizing funds that together with other investment companies in the same ‘‘group of related investment companies’’ have net assets of $1 billion or more as of the end of the most recent fiscal year as larger entities and funds that together with other investment companies in the same ‘‘group of related investment companies’’ have net assets of less than $1 billion as of the end of the most recent fiscal year as smaller entities). For example, should we require funds to report gamma and vega for convertible bonds? To what extent would the inputs and assumptions underlying the methodology by which funds calculate gamma and vega affect the values reported? Are there potential liability or other concerns associated with the reporting of such measures according to such inputs and assumptions? For example, how would the comparability of information reported between funds be affected if funds used different inputs and assumptions in their methodologies?

• Are there additional or alternative
  metrics that we should consider requiring to be reported? Would the disclosure of risk metrics such as theta—the change in value of an option with changes in time to expiration— enhance the utility of the derivatives information reported in Form N–PORT? What would be the costs and burdens to funds and benefits to investors and other potential users of requiring funds to report such additional or alternative metrics? How would the comparability of information reported by different funds be affected if funds used different inputs and assumptions in their methodologies, such as different assumptions regarding the values of the funds’ portfolios?
• We believe that funds that would be
  required to implement a derivatives risk management program already track certain derivative risk metrics, such as gamma and vega. Is our assumption correct? To the extent this is correct, what would be the incremental cost and burden of reporting such information to the Commission? As discussed above, in the Investment Company Reporting Modernization Release, we proposed that portfolio-level risk metrics and the delta for relevant investments be disclosed on each report on Form N– PORT that is made public (i.e., quarterly). Likewise, we are proposing that gamma and vega be made publicly available. Should gamma and vega be made public? Are the factors that the Commission should consider when determining whether to make such measures public the same as for the other risk metrics proposed in the Investment Company Modernization Release, or are there additional factors relevant to gamma and vega that we should consider?
• As discussed above, proposed rule
  18f–4 would require funds that engage in derivatives transactions to comply with one of two alternative portfolio limitations: The exposure-based portfolio limit or the risk-based portfolio limit. While we are proposing to require that funds maintain certain records relating to their compliance with the applicable portfolio limitation, we are not proposing that they report to the public or the Commission the funds’ aggregate exposure or, for funds that operate under the risk-based portfolio limit, the results of the funds’ VaR tests. Would there be a benefit to publicly reporting this information? Should we require funds to report on proposed Form N–CEN or Form N–PORT either or both of the funds’ aggregate exposures or their securities’ VaRs and full portfolio VaRs (if applicable)? Additionally, as proposed, the derivative risk management program would apply to funds with an aggregate exposure to derivatives transactions that exceeds 50% of net assets. Should funds be required to report on proposed Form N–CEN or Form N–PORT their aggregate exposure to derivatives transactions?
• Form N–PORT also requires funds
  to report their notional amounts for certain derivatives transactions. Should we define ‘‘notional amount’’ for purposes of Form N–PORT with the same definition as proposed by rule 18f–4?
• Our proposal would require funds
  to identify in reports on Form N–CEN whether they relied upon the proposed rule by identifying the portfolio limitation(s) on which the fund relied during the reporting period. Do commenters agree that this is appropriate? Should we instead require a fund to only identify if it relied upon rule 18f–4 during the reporting period, rather than requiring the fund to identify the specific portfolio limitation(s) on which the fund relied? Are there other mediums, such as the Statement of Additional Information, that would be more appropriate to report such information?
• Should we provide a compliance
  period for the proposed amendments to Forms N–PORT and N–CEN? If so, what factors should we consider, if any, when setting the compliance dates for the proposed amendments to Forms N– PORT and N–CEN? How long of a compliance period would be appropriate for the proposed amendments? If we provide a compliance period for the proposed amendments, should we provide a tiered compliance date for entities based on their size? H. Request for Comments We request and encourage any interested person to submit comments regarding the proposed rule and the proposed amendments to Form N–PORT and Form N–CEN, specific issues discussed in this Release, and other matters that may have an effect on the proposed rule and the proposed changes to Form N–PORT and Form N–CEN. With regard to any comments, we note that such comments are of particular assistance to our rulemaking initiative if accompanied by supporting data and analysis of the issues addressed in those comments.
  I. Proposed Rule 18f–4 and Existing
  Guidance
  If we adopt proposed rule 18f–4, we would rescind Release 10666 and our staff’s no-action letters addressing derivatives and financial commitment transactions. Funds would only be permitted to enter into derivatives transactions and financial commitment transactions to the extent permitted by, and consistent with the requirements of, rule 18f–4 or section 18 or 61. At this time, however, we are not rescinding Release 10666 or any no-action letters issued by our staff, and funds may continue to rely on Release 10666, our staff no-action letters, and other guidance from our staff. A fund would be able to rely on the rule after its effective date as soon as the fund could comply with the rule’s conditions. We would, in addition, expect to provide a transition period during which we would permit funds to continue to rely on Release 10666, our staff no-action letters, and other guidance from our staff, including with respect to derivatives transactions and financial commitment transactions entered into by a fund after the rule’s effective date but before the end of any transition period. We request comment on any transition period:
• Do commenters agree that a
  transition period would be appropriate?
• What would be an appropriate
  amount of time for us to provide before rescinding Release 10666 and our staff’s no-action letters?
• In recently proposed rule 22e–4, we
  proposed tiered compliance dates for funds that would be required to establish liquidity risk management programs under that rule, generally proposing to provide a compliance period of 18 months for larger entities and an extra 12 (or 30 total months) for smaller entities.507 Would these time periods provide sufficient time for funds to transition to proposed rule 18f–4?

508As discussed above, the proposed rule would limit indebtedness leverage created through derivatives transactions that involve the issuance of senior securities (i.e., because these transactions involve a payment obligation). The proposed rule would not limit economic leverage created through derivatives (e.g., purchased options) that would generally not be considered to involve the issuance of senior securities (i.e., because these transactions do not involve a payment obligation). Would they provide more time than may be necessary or appropriate?

• Would it be appropriate, for
  purposes of a transition period (rather than setting a compliance date), to provide different periods of time for larger and smaller entities? Would it be appropriate to instead require all funds that engage or seek to engage in derivatives or financial commitment transactions to do so in reliance on proposed rule 18f–4 after a period of time that would be the same for all affected funds, for example 18 months after any adoption of proposed rule 18f– 4?
• Should we provide a longer
  transition period for particular types of funds? If so, which kinds of funds and how much time should we provide? Should we, for example, provide a longer transition period for leveraged ETFs on the basis that they operate pursuant to the terms and conditions of exemptive orders granted by the Commission? In section III.B.1.c, we requested comment as to whether it would be more appropriate to consider these funds’ use of derivatives transactions in the exemptive application context, based on the funds’ particular facts and circumstances, rather than in rule 18f–4. If commenters believe this would be appropriate, would a longer transition period for these funds also be appropriate in order to provide time for these funds to prepare, and for the Commission to consider, any exemptive applications?
  IV. Economic Analysis
  A. Introduction and Primary Goals of Proposed Regulation The Commission is sensitive to the economic effects that could result from proposed rule 18f–4 and the proposed amendments to proposed Forms N– PORT and N–CEN. The economic effects of proposed rule 18f–4 include the benefits and costs of the proposed rule, as well as effects on efficiency, competition, and capital formation. The economic effects of the proposed rule are discussed below in the context of the primary goals of the proposed regulation. We discuss the benefits, costs, and economic effects associated with our proposed amendments to proposed Forms N–PORT and N–CEN in sections IV.D.6 and IV.D.7, below. In summary, and as discussed in greater detail throughout this Release, the proposed rule would require a fund that enters into derivatives transactions in reliance on the rule to:
• Comply with one of two alternative
  portfolio limitations designed to impose a limit on the amount of leverage the fund may obtain through derivatives transactions and other senior securities transactions; 508
• Manage the risks associated with its
  derivatives transactions by maintaining qualifying coverage assets in an amount designed to enable the fund to meet its obligations under its derivatives transactions; and
• Establish a formalized derivatives
  risk management program (unless otherwise exempt based on the extent of its derivatives usage). The proposed rule would also require a fund that enters into financial commitment transactions in reliance on the rule to maintain qualifying coverage assets equal in value to the fund’s full obligations under those transactions. As discussed above in section II.D.1.a, we have determined to propose a new approach to funds’ use of derivatives in order to address the investor protection purposes and concerns underlying
  section 18 of the Act and to provide an
  updated and more comprehensive approach to the regulation of funds’ use of derivatives transactions. The investor protection purposes and concerns include the concern that leveraging an investment company’s portfolio through the issuance of senior securities magnifies the potential for gain or loss and therefore results in an increase in the speculative character of the investment company’s outstanding securities. In Release 10666, we permitted funds to engage in the transactions described in that release using the segregated account approach, notwithstanding the limitations in
  section 18, because we believed that the
  segregated account approach would address the investor protection purposes and concerns underlying section 18 by imposing a practical limit on the amount of leverage a fund may undertake and assuring the availability of adequate assets to meet the fund’s obligations arising from such transactions. As we discussed above, the current regulatory framework, including application of the segregated account approach enunciated in Release 10666 to derivatives transactions, has developed over the years since we issued Release 10666 as funds and our staff sought to apply our statements in Release 10666 to various types of derivatives and other transactions on an instrument-by-instrument basis. One significant result of this process has been funds’ expanded use of the mark￾to-market segregation approach with respect to various types of derivatives, together with the segregation of a variety of liquid assets. Funds’ use of the mark￾to-market segregation approach with respect to various types of derivatives, plus the segregation of any liquid asset, enables funds to obtain leverage in amounts that may not be consistent with the concerns underlying section 18 of the Act. As we noted above, segregating only a fund’s daily mark-to-market liability—and using any liquid asset— enables the fund, using derivatives, to obtain exposures substantially in excess of the fund’s net assets. In addition, a fund’s segregation of any asset that the fund deems sufficiently liquid to cover a derivative’s daily mark-to-market liability may not effectively result in the fund having sufficient liquid assets to meet its future obligations under the derivative. The proposed rule is designed to address the investor protection purposes and concerns underlying section 18 and to provide an updated and more comprehensive approach to the regulation of funds’ use of derivatives transactions in light of the dramatic growth in the volume and complexity of the derivatives markets over the past two decades and the increased use of derivatives by certain funds. Under the proposed rule, funds would be permitted to enter into derivatives transactions and financial commitment transactions in reliance on the rule, subject to its conditions. The proposed rule provides both for an outside limit on the magnitude of funds’ derivatives exposures designed primarily to address concerns about excessive leverage and undue speculation and a requirement to manage risks associated with its derivatives transactions by maintaining qualifying coverage assets that is designed primarily to address concerns about a fund’s ability to meet its obligations in connection with its derivatives and financial commitment transactions. The proposed rule also seeks to provide a balanced and flexible approach by permitting funds to obtain additional derivatives exposure (under the risk-based portfolio limit) where the fund’s derivatives, in the aggregate, have a risk-mitigating effect on the fund’s overall portfolio. As noted
  above, the proposed rule includes asset segregation requirements for both derivatives transactions and financial commitment transactions. With regard to derivatives, a fund would

509Throughout the economic analysis we discuss the potential effects of the proposed rule and estimate the costs to funds to perform the enumerated types of activities that we anticipate would be required to comply with the proposed rule’s specific requirement(s). We note that these costs may be incurred, in whole, or in part, by a fund, its investment adviser, or one of its service providers (e.g., fund custodian, or fund administrator). Except where addressed specifically below, we do not, however, have information available to us to reasonably estimate how the costs for such activities may be allocated among these parties. 510This analysis is included in the DERA White Paper, supra note 73. See text surrounding supra note 87. 511 DERA White Paper, supra note 73, Table 1. These figures do not include money market funds or BDCs. Under rule 2a–7 of the Act, money market funds are required to limit their investments to short-term, high-quality debt securities that fluctuate very little in value under normal market conditions. Money market funds thus do not engage in derivatives transactions, but may enter into certain financial commitment transactions to the extent permitted by rule 2a–7. See supra note 472. Similarly, BDCs, based on the DERA sample, do not appear to enter into derivatives transactions to a material extent (no sampled BDC reported any derivatives transactions in its then-most recent annual report). BDCs do, however, appear to enter into financial commitment transactions as defined in the proposed rule based on the DERA sample. We provide aggregate figures for money market funds and BDCs separately. See infra note 578. 512 Data taken from reports filed on Form N–MFP for June 2015. 513 DERA White Paper, supra note 73, Table 1. We refer to alternative strategy funds in the same manner as the staff classified ‘‘Alt Strategies’’ funds in the DERA White Paper as including the Morningstar categories of ‘‘alternative,’’ ‘‘nontraditional bond’’ and ‘‘commodity’’ funds. 514 DERA White Paper, supra note 73, Table 2. 515 During the 2010–2014 time period, the annual growth rate of US equity funds was 14%, the sector equity funds growth rate was 18%, the international equity fund growth rate was 9%, the allocation fund growth rate was 16%, the taxable bond fund growth rate was 10%, and the municipal bond fund growth rate was 6%. 516 During the 2010–2014 time period, annual net flows as a percent of fund AUM were 0% for US equity funds, 10% for sector equity funds, 6% for international equity funds, 7% for allocation funds, Continued be required to assess both the current and future payment obligations (and therefore, potential losses) arising from its derivatives transactions. With regard to financial commitment transactions, a fund would be required to maintain qualifying coverage assets equal in value to the fund’s full obligations under those transactions. Finally, except for funds that engage in only a limited amount of derivatives
transactions and that do not use certain complex derivatives transactions, the fund would be required to establish a derivatives risk management program, including the appointment of a derivatives risk manager. The derivatives risk management program requirement is designed to complement the portfolio limitations and asset coverage requirements by requiring a fund subject to the requirement to assess and manage the particular risks presented by the fund’s use of derivatives. B. Economic Baseline The proposed rule would affect funds and their investors, investment advisers, and market participants engaged in the issuance, trading, and servicing of derivatives, financial commitment transactions, and securities. Market participants include fund counterparties and other third-party service providers such as fund custodians and administrators.509 The effects on all of these parties are discussed below in the discussion of the costs and benefits of the proposed rule. The economic baseline of the proposed rule is the current industry practice established in light of Commission and staff positions that funds rely upon when determining whether they are permitted under the Act to engage in derivatives transactions and financial commitment transactions. As discussed above in section II.B.3, funds that engage in these types of transactions typically segregate ‘‘liquid’’ assets using one of two general practices: Notional amount segregation or mark-to-market segregation. The current approach has developed over the years since we issued Release 10666 as funds and our staff sought to apply our statements in Release 10666 to various types of derivatives and other transactions. We understand that, in determining how they will comply with
section 18, funds consider various no￾action letters issued by our staff. These
staff letters, issued primarily in the 1970s through 1990s, addressed particular questions presented to the staff concerning the application of the approach enunciated in Release 10666 to various types of derivatives on an instrument-by-instrument basis. We understand that funds also consider, in addition to these letters, other guidance they may have received from our staff and the practices that other funds disclose in their registration statements. The current approach’s development on an instrument-by-instrument basis, together with the dramatic growth in the volume and complexity of the derivatives markets over the past two decades, has resulted in situations for which there is no specific guidance from us or our staff with respect to various types of derivatives. Our staff economists have analyzed recent industry-wide trends and certain funds’ portfolio holdings in order to provide information about funds’ use of derivatives and to inform our consideration of the proposed rule and assess its economic effects.510 Below we discuss the size and recent growth of the U.S. fund industry generally, as well as the growth of specific fund types within the industry. As discussed below, the fund industry has grown significantly since 2010 and certain funds that make greater use of derivatives have received a disproportionately large share of fund inflows. This information highlights the importance of a new approach to regulating derivatives transactions under section 18 and, together with the information we discuss below concerning the extent to which certain funds use derivatives, has helped to shape the scope and substance of the proposed rule, as well as identify the benefits, costs, and effects on efficiency, competition, and capital formation. According to Morningstar, at the end of June 2015, there were 9,707 registered open-end funds, 560 closed-end funds, and 1,706 ETFs (11,973 total funds) with a total reported AUM of $17.9 trillion.511 Of that total, open-end funds held $15.9 trillion, closed-end funds held $250 billion, and ETFs held $1.8 trillion. In terms of fund categories, 3,361 US equity funds held the largest percentage (38%) of industry AUM, followed by 2,073 taxable bond funds (19%), 1,914 allocation funds (17%), and 1,877 international equity funds (15%). As of June 2015, there were 537 money market funds with an estimated $3.0 trillion in AUM.512 In addition, based on Commission records (Form 10–Ks and 10–Q’s), at the end of June 2015, there were 88 active business development companies (‘‘BDCs’’) with an estimated $52.3 billion in AUM. Although not large in terms of industry AUM (less than 3% as of June 2015 513), the growth in AUM of alternative strategy funds, which tend to be greater users of derivatives, is notable. In 2010, there were a total of 591 alternative strategy funds with a total AUM of $320 billion.514 By the end of 2014 those numbers had risen to 1,125 funds with a total AUM of $469 billion. The annual growth rate
in the AUM of alternative strategy funds from the end of 2010 through the end of 2014 was 10%.515 Excluding commodity funds (which had a negative growth rate during this period), alternative strategy funds had an annual growth rate of 22%. During this four-year period, alternative strategy funds received the largest net inflows (14% annually) relative to their total asset base. Excluding commodity funds, alternative strategy funds had an annual net inflow of 28%.516 Over the four-year period