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Five key things you need to know about 18F-4

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Last year the SEC announced sweeping requirements for funds engaging in derivatives trading. Here, we present the five things they need to know before the rules go live in August 2022.

1. Funds that are affected

In scope funds are those that engage in substantial derivatives trading, and funds must comply with the new rule in order to continue to use derivatives. There is an exception for limited users of derivatives, with the SEC providing an exemption from the program and VaR test requirements if the fund’s derivatives exposure is limited to 10% of net assets, excluding certain currency and hedging transactions.

Otherwise the rule will cover all mutual funds, ETFs, registered close-ended funds and companies that have been elected to be treated as BDCs under the 40 Act. So it’s worth checking the derivatives use of your funds; 10% is not a huge amount in order to fall in scope, and you may find that it applies to more funds than you initially thought.

2. There are a lot of rules to get ready for

Although the changes were announced last year, compliance plans must be fully implemented by 19 August 2022. That means that each company’s risk management team, legal and compliance experts, and board of directors should be engaged in making the initial decisions now – and at least preparing for the new rules.

And the rules are quite onerous, with affected funds having to implement a derivatives risk management program that will require them to bolster several types of risk analysis – on a daily and weekly basis.

Affected funds will have to: 

  • Appoint a specialist and separate derivative risk manager (i.e. not portfolio manager) 
  • Deliver a specific risk management strategy 
  • Stay within the limits on fund leverage based on VaR 

The allowed VaR limit is based on the VaR of a ‘designated reference portfolio’ for that fund. This can be done at an index or security portfolio level. If the derivatives risk manager cannot determine a reference, however, the fund may be required to comply with an absolute VaR test.

Generally speaking, the fund won’t be allowed to exceed 200% of the VaR of the fund’s designated reference portfolio under the VaR test, or 20% of the fund’s total net assets under the absolute test.

3. Daily VaR, weekly stress tests

The new rules and limits on fund leverage mean that VaR analysis will have to be done daily. The idea is that you’re never exceeding your VaR limit and that you can gauge this on a regular basis.

To complement the overall VaR analysis, though, you’ll also have to do stress testing and backtests on a weekly basis. Stress tests are designed to evaluate the potential losses to a  fund’s portfolio, particularly during redemptive stresses, while VaR is really there to capture the historical data and correlations between assets to inform the stress tests.

Because of the previous SEC fund liquidity requirements, many firms already run historical stress tests (GFC, European Sovereign Debt Crisis etc.) and backtests on a monthly or quarterly basis. But to make sure that you’re always aware of the limitations of your VaR testing, as well as working off the latest correlations and market factors, affected funds should do this weekly.

In theory, you could be doing this daily if you wanted to, as some of our more sophisticated clients already do for their stress testing. 18F-4 also requires funds to consider other risks that VaR may not (such as counterparty or liquidity or redemptive risks), and so this is where the stress testing is really important. You want to make sure you’ve covered every possible scenario, and you want to be doing it weekly.

4. There’s a lot of work to do before it goes live

Although the rules don’t need to be implemented for over a year, there is a lot of work to be done before then. Internal teams should now be well aware of the changes coming down the line, and should be looking at appointing a specialist and separate derivative risk manager. Once this is done, you can look at delivering a specific risk management strategy that incorporates the above.

Many funds will already have some existing expertise and infrastructure, especially those that have been running regular stress tests before. But it’s just important to understand that there are additional rules and requirements coming. As we saw last year with ESMA’s liquidity stress testing rules, those firms that get out ahead early are usually best positioned, as there are always delays and disruptions.

5. Third party solutions?

There are a range of third party platforms that have inbuilt liquidity stress test tools available. Many have been specifically designed to help firms meet existing SEC and ESMA liquidity guidelines and include: VaR calculations, historical data, stress tests (historic and hypothetical), redemptive stress tests (including slicing and waterfall), and should be be set-up to do as frequently as you want, including daily if you’d like.

And there are an increasing number of providers offering specific 18F-4 solutions too, including the regular external 18F-4 reporting. Using a third party in this way may help you meet your 18F-4 reporting and compliance requirements.

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