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

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.
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    \509\ Throughout 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.
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    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.
---------------------------------------------------------------------------

    \510\ This analysis is included in the DERA White Paper, supra
note 73. See text surrounding supra note 87.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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

since 2010, alternative strategy funds also received a disproportionate
share of net fund flows. These funds received 10% of all industry net
inflows while comprising only 3% of industry AUM as of 2010. Excluding
commodity funds, alternative strategy funds received 11% of all
industry net inflows while comprising only 1.6% of industry AUM as of
2010.
---------------------------------------------------------------------------

    \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, 7% for taxable bond funds, 1% for municipal bond funds, and -
2% for commodity funds.
---------------------------------------------------------------------------

    DERA staff manually collected data regarding derivatives, financial
commitment transactions, and other senior security transactions from
the then-latest fund annual reports of a 10% random sample of all
registered management investment companies as well as business
development companies as of June, 2015.\517\ As discussed above, we
recognize that the review by DERA staff evaluated funds' investments as
reported in the funds' then-most recent annual reports. DERA staff,
however, 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.
DERA staff prepared an analysis of each sampled fund's aggregate
exposure by aggregating, for each fund: (1) The notional amounts of the
fund's derivatives transactions, as defined in the proposed rule; (2)
the financial commitment obligations associated with the fund's
financial commitment transactions, as defined in the proposed rule; and
(3) the indebtedness associated with any other senior securities
transactions.\518\
---------------------------------------------------------------------------

    \517\ DERA staff included in its sample open-end funds
(including ETFs), closed-end funds, and BDCs, but excluded money
market funds (because these funds do not invest in derivatives
transactions). For the alternative strategy funds, DERA staff
required in its sample a minimum of three funds selected from each
Morningstar subcategory. Morningstar subcategories include, among
others, managed futures, multicurrency, bear market,
multialternative, market neutral, long/short equity, trading inverse
and trading leveraged.
    \518\ The aggregate notional amount for derivatives in the DERA
random sample is approximately $350 billion. The Bank for
International Settlements reports that the aggregate notional amount
for derivatives worldwide at the end of 2014 was approximately $688
trillion ($58 trillion exchange traded and $630 trillion over-the-
counter). See http://www.bis.org/statistics/about_derivatives_stats.htm?m=6|32. BIS data on exchange-
traded derivatives is collected from over 50 organized exchanges and
includes information on interest rate and foreign exchange
derivatives only. BIS data on OTC derivatives is from large dealers
in 13 countries and includes forwards, swaps, and options on foreign
exchange, interest rates, and equities.
---------------------------------------------------------------------------

    In the resulting sample of 1,188 funds, 68% (53% in AUM) had zero
exposure to derivatives and approximately 89% (90% in AUM) had less
than 50% exposure as a percentage of NAV.\519\ Approximately 96% (95%
in AUM) of the funds had aggregate exposures below 150%.\520\ As a
result, we expect that a majority of funds would not be required to
modify their portfolios in order to comply with the proposed rule
because a substantial majority of funds do not appear (based on the
DERA sample) to engage in derivatives transactions or financial
commitment transactions and thus may not need to rely on the exemption
the proposed rule would provide, or do not appear to engage in those
transactions at a level that would exceed the proposed rule's exposure
limitations.\521\ Funds that do engage in derivatives transactions and
financial commitment transactions would, however, need to rely on the
proposed rule to continue to engage in these transactions.
---------------------------------------------------------------------------

    \519\ DERA White Paper, supra note 73, Figures 11.1, 12.1.
    \520\ DERA White Paper, supra note 73, Figures 9.1, 10.1.
    \521\ See supra note 212 and accompanying text. We recognize
that some of the funds in DERA's sample that had no exposure to
derivatives or financial commitment transactions in their then-most
recent annual reports also may engage in these transactions to some
extent. As discussed above, 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.
---------------------------------------------------------------------------

    DERA examined the detailed holdings for every fund in its sample
and found that alternative strategy funds hold the most derivatives and
have the highest exposure (expressed as aggregate notional amounts
relative to fund net asset value). Among alternative strategy funds,
73% had at least some exposure to derivatives and 52% had greater than
50% exposure to derivatives.\522\ For traditional mutual funds, 29% had
at least some exposure to derivatives and 6% had greater than 50%
exposure to derivatives. Not only did alternative strategy funds have
greater derivatives exposures, but their holdings also were larger (as
measured in terms of notional amount relative to fund net asset value).
For alternative strategy funds with derivatives, mean and median
notional values of derivatives were 167% and 99% of net assets,
respectively.\523\ As a point of comparison, for traditional mutual
funds, the comparable numbers were 36% and 10%, respectively.
Approximately 27% of alternative strategy funds had 150% or greater
aggregate exposure, compared to less than 2% for traditional mutual
funds.\524\
---------------------------------------------------------------------------

    \522\ DERA White Paper, supra note 73, Figure 11.4.
    \523\ DERA White Paper, supra note 73, Table 6, Panel D.
    \524\ DERA White Paper, supra note 73, Figures 9.4, 9.5.
---------------------------------------------------------------------------

    As noted above, as of June 2015, there were 560 closed-end funds
with total AUM of $250 billion. In DERA's random sample of the funds,
47% of closed-end funds had some exposure to derivatives.\525\ Nine
percent of closed-end funds had at least a 50% exposure to derivatives.
No closed-end fund had aggregate exposure over 150% of net assets.\526\
---------------------------------------------------------------------------

    \525\ DERA White Paper, supra note 73, Figure 11.7.
    \526\ DERA White Paper, supra note 73, Figure 9.7.
---------------------------------------------------------------------------

    Also as noted above, as of June 2015, there were 1,706 ETFs and 88
BDCs with total AUM of $1.8 trillion and $52.3 billion, respectively.
In DERA's random sample of the funds, 29% of ETFs and zero BDCs had
some exposure to derivatives.\527\ Eighteen percent of ETFs had
exposure to derivatives of 50% or more (86% among alternative strategy
ETFs). Eight percent of ETFs had aggregate exposure over 150% of net
assets.\528\
---------------------------------------------------------------------------

    \527\ DERA White Paper, supra note 73, Figures 11.10, 11.11.
    \528\ DERA White Paper, supra note 73, Figure 9.10.
---------------------------------------------------------------------------

    Our staff also analyzed, through a review of recent N-SAR filings,
the extent to which funds are permitted (as stated in fund disclosure
documents) to use certain derivatives as part of their investment
objective or strategy.\529\ In each case, more alternative funds \530\
were authorized to invest in derivatives than other funds.\531\ For
example, the number of alternative funds permitted to invest in options
on equities, options on stock indices, stock index futures, and options
on index futures was 20% greater than the number of traditional mutual
funds.\532\ Although not all of

these instruments would be deemed a ``derivatives transaction'' under
the proposed rule (e.g., a purchased option), information about the
extent to which funds are permitted to invest in these instruments may
provide an indication of the extent to which funds engage in strategies
that would involve the use of derivatives transactions subject to the
proposed rule.
---------------------------------------------------------------------------

    \529\ DERA White Paper, supra note 73. This portion of the DERA
analysis used a sample consisting of all funds filing form N-SAR for
2014 (12,360 in total). Form N-SAR, filed with the Commission and
made publicly available, is filed semi-annually by all registered
investment companies and provides census-type data about the
registrant (recently, the Commission proposed new rules that would
rescind Form N-SAR and replace it with a more modernized and updated
census form, proposed Form N-CEN). See Investment Company Reporting
Modernization Release, supra note 138. Form N-SAR requires funds to
answer questions with respect to whether they are allowed to invest
in the following derivatives: Options on equities, options on debt
securities, options on stock indices, interest rate futures, stock
index futures, options on futures, options on index futures, and
other commodity futures.
    \530\ Morningstar U.S. category ``Alternative funds.''
    \531\ DERA White Paper, supra note 73, Table 3, Panel A.
    \532\ DERA White Paper, supra note 73, Table 3, Panel A. The
comparable differences for options on debt securities, interest
rates futures, options on futures, and other commodity options are
8%, 12%, 16%, and 21%, respectively.
---------------------------------------------------------------------------

    Under the current regulatory framework, funds that invest in
derivatives and other senior securities generally segregate certain
assets with respect to those transactions. While our staff has observed
that some funds have interpreted the guidance differently in certain
cases, we assume for purposes of establishing the baseline that funds
generally segregate sufficient assets to cover at least any mark-to-
market liabilities on the funds' derivatives transactions, with some
funds segregating more assets for certain types of derivatives and
transactions (sufficient to cover the full notional amount of the
transaction or an amount in between the transaction's full notional
amount and any mark-to-market liability).
    There is currently no requirement for funds that invest in
derivatives to have a risk management program with respect to their
derivatives transactions, although we understand that the advisers to
many funds whose investment strategies could entail derivatives already
assess and manage the risks associated with derivatives transactions.
Funds' current risk management practices may not meet the proposed
rule's specific risk-management program requirements, however, and
therefore we believe that the baseline for the derivatives risk
management program requirement would be that all funds that would be
subject to the requirement would need to establish such a program or
conform their current practices to satisfy the requirements in the
proposed rule.

C. Economic Impacts, Including Effects on Efficiency, Competition, and
Capital Formation

    Below, we discuss anticipated economic impacts, including effects
on efficiency, competition, and capital formation that may result from
our proposals. Where possible, we have attempted to quantify the costs,
benefits, and effects of the proposed rule and amendments to Forms N-
PORT and N-CEN. In many cases, however, we are unable to quantify the
economic effects because we lack the information necessary to provide a
reasonable estimate.
    As discussed above, there is substantial diversity in the types and
strategies of funds and how and to what extent funds use derivatives.
Moreover, for those funds that do use derivatives, there is substantial
variability in how they comply with current Commission positions and
staff guidance on compliance with section 18 (including asset
segregation). There is also substantial variability in how any given
fund may react to the proposed rule, if adopted, and how the market may
react in turn. A fund that uses a moderate amount of derivatives may
increase or decrease its derivative usage, or shift within types of
derivatives (e.g., from cash-settled to physically-settled). A fund may
alter its investment strategy in order to comply with one of the
proposed rule's portfolio exposure limitations by reducing use of
derivatives and not substituting other instruments to achieve
equivalent exposures. To the extent that a fund alters its investment
strategy, this change may represent an opportunity cost to investors.
Such opportunity costs depend on investors' individual preferences and
are, as a result, difficult to quantify. Alternatively, a fund may
shift the composition of its portfolio away from derivatives covered by
the proposed rule, either by using derivatives not covered by the
proposed rule, or by substituting the purchase of derivatives with a
purchase of the underlying assets (or similar assets). Such a shift in
portfolio composition would involve transactions costs. Those
transactions costs would depend on both the amount of the portfolio to
be traded, as well as the liquidity of the assets to be traded, both of
which are likely to vary widely from fund to fund (and thus are
difficult to quantify). Finally, a fund may seek to operate in a
structure not subject to the limitations of section 18.\533\ We discuss
these potential economic impacts in more detail below. Although much of
the following discussion is qualitative in nature, we have sought to
quantify certain costs, benefits, and effects of the proposed rule,
where possible.\534\
---------------------------------------------------------------------------

    \533\ We quantify estimated costs related to a fund that chooses
to deregister under the Investment Company Act and liquidate and/or
offer the fund's strategy as a private fund or commodity pool. See
infra note 554 and accompanying text.
    \534\ We discuss below in section IV.D, other potential benefits
and quantified costs that we anticipate may result from certain core
aspects of the proposed rule, including the exposure-based and risk-
based portfolio limitations, the asset segregation requirements, the
derivatives risk management program, requirements for financial
commitment transactions, and amendments to proposed Forms N-PORT and
N-CEN.
---------------------------------------------------------------------------

    We believe that the proposed rule is likely to strengthen investor
protection. First, the proposed rule would limit the amount of leverage
that a fund may obtain through derivatives transactions and other
senior securities transactions. Under the proposed rule, a fund that
seeks to comply with the exposure-based portfolio limit would be
required to limit its aggregate exposure to 150% of the fund's net
assets, and a fund that seeks to comply with the risk-based portfolio
limit would be required to demonstrate, through a value-at-risk-based
test,\535\ that its use of derivatives reduces the fund's exposure to
market risk, and limit its aggregate exposure to 300% of the fund's net
assets. The proposed aggregate exposure limitations are likely to
reduce, but not eliminate, the risk that investors will experience
losses associated with leveraged investment exposures that
significantly exceed a fund's net assets. Second, the proposed rule
would require that a fund manage 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 under its derivatives transactions (and
financial commitment transactions). We expect that, to the extent the
proposed rule strengthens investor protection, the proposed rule should
also both sustain and promote investors' willingness to participate in
the market. This could lead to increased investment in funds, which in
turn could lead to increased demand for securities which could, in
turn, promote capital formation.
---------------------------------------------------------------------------

    \535\ The proposed rule would require that a fund seeking to
comply with the risk-based portfolio limit satisfy the VaR test
included in that portfolio limit, that is, limit its use of
derivatives transactions so that, immediately after entering into
any senior securities transaction, the fund's ``full portfolio VaR''
is less than the fund's ``securities VaR,'' as those terms are
defined in the proposed rule. A fund would also be required to limit
its aggregate exposure to 300% of the fund's net assets.
---------------------------------------------------------------------------

    As we have discussed above, leverage magnifies losses that may
result from adverse market movements. As a result, a fund that obtains
leverage through derivatives and other senior securities transactions
may suffer those magnified losses and, because losses on a fund's
derivatives transactions can create payment obligations for the fund,
the losses 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.
This could force the fund to enter into forced sales in stressed market
conditions, resulting in

large losses or even liquidation.\536\ The proposed rule, by
effectively imposing a limit on the amount of leverage a fund may
obtain through derivatives, should reduce the possibility of fund
losses attributable to leverage. This can have investor protection
benefits as well as reduce the risk of adverse effects on fund
counterparties. More robust asset segregation requirements also may
have the effect of increasing a fund's liquidity, decreasing default
risk, and decreasing the risk that a fund may be forced to sell
securities in a falling market to meet its obligations under its
derivatives transactions (e.g., to meet margin calls). For these
reasons, we believe that the proposed rule should encourage capital
formation by promoting investors' willingness to invest in funds (or to
remain invested in them even in a falling market) and market stability.
---------------------------------------------------------------------------

    \536\ See Thurner, Farmer & Geanakoplos, Leverage Causes Fat
Tails and Clustered Volatility (May 2012) (discussing investments
collateralized by margin and noting that ``[t]he nature of the
collateralized loan contract thus sometimes turns buyers of the
collateral into sellers, even when they might think it is the best
time to buy. . . . When the funds are unleveraged, they will always
buy into a falling market, i.e. when the price is dropping they are
guaranteed to be buyers, thus damping price movements away from the
fundamental value. When they are sufficiently leveraged, however,
this situation is reversed they sell into a falling market, thus
amplifying the deviation of price movements away from fundamental
value.''). See also Off-Balance-Sheet Leverage IMF Working Paper,
supra note 79 (``[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.'').
---------------------------------------------------------------------------

    The proposed rule may reduce costs and promote efficiency with
respect to certain uses of derivatives by replacing the current
regulatory framework that depends upon interpretation of Commission and
staff guidance with a more transparent and comprehensive regulatory
framework that addresses more effectively the purposes underlying
section 18. The proposed rule would eliminate disparities under the
current regulatory framework, where funds segregate the full notional
amount for certain derivatives and segregate only the mark-to-market
liability for other types of derivatives. For example, current staff
guidance generally calls for a fund to segregate liquid assets equal in
value to the full notional amount of a physically settled futures
contract. A fund that wishes to avoid encumbering a large portion of
its liquid assets might be incentivized to instead enter into a cash
settled OTC swap on the same futures contract and segregate only its
mark-to-market liability (if any) under the swap, even if the swap
entails higher transaction costs, is less liquid, and/or poses greater
counterparty risk. The risk may be compounded further because the mark-
to-market segregation approach potentially enables the fund to obtain a
level of leverage that is many times greater than its net assets. By
contrast, under the proposed rule's portfolio limitations, a physically
settled futures contract and a cash-settled swap on the futures
contract, both of which have the same notional amount, would be subject
to the same treatment. This approach should serve to reduce the
likelihood that a fund would choose a less efficient instrument to
obtain its investment exposures and also reduce the uncertainty that
exists regarding treatment of new products that are not addressed
specifically in existing Commission or staff guidance. By providing
consistency in how funds treat different derivatives transactions, we
believe that the proposed rule should reduce opportunities for
regulatory arbitrage where a fund prefers ``cheap-to-cover''
derivatives--those for which a fund applies the mark-to-market
segregation approach--and therefore promote a more efficient use of
derivatives instruments by funds when implementing their portfolio
strategies.
    As discussed above in section III.C.1, the proposed rule would
require that a fund maintain 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 the determination (the ``mark-
to-market coverage amount''), and (2) an amount that represents an
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''). The proposed rule is designed to be
flexible enough to allow a fund to determine these amounts both for
existing types of derivatives transactions and for new derivatives
instruments that are created in the future. For example, the proposed
rule provides that a derivatives transaction's risk-based coverage
amount would be an amount that represents an estimate of the potential
amount payable by the fund if the fund were to exit the derivatives
transaction under stressed conditions, determined in accordance with
policies and procedures that address certain considerations specified
in the rule. The proposed rule thus does not prescribe the particular
methodology that a fund must use to calculate its risk-based coverage
amount when segregating assets on its derivatives transactions.
Instead, the proposed rule permits a fund to make such determinations
in accordance with policies and procedures approved by the fund's
board, based on a fund's particular facts and circumstances. We believe
that this flexible approach would permit, and may promote, appropriate
innovation in the development and use of new derivative instruments
that may be beneficial for funds and investors. We also believe that
this may increase investor protection by requiring that funds assess
the risk of their derivatives transactions and segregate assets to
cover an amount in addition to the mark-to-market liability.
    Many of the impacts of the proposed rule will depend on how funds
react to the conditions it imposes. As an initial matter, based on the
DERA staff analysis, which shows that a substantial majority of funds
in the DERA sample did not use derivatives or used derivatives to a
limited extent, the portfolio limits under the proposed rule are not
expected to affect the investment activities of a majority of
funds.\537\ Funds that react to the rule, however, may do so in several
different ways.
---------------------------------------------------------------------------

    \537\ DERA White Paper, supra note 73, Table 6.
---------------------------------------------------------------------------

    Some funds will not be compelled by the proposed rule to modify
their derivatives exposure, but they might nonetheless respond to the
proposed rule's treatment of derivatives by modifying their derivatives
holdings. For example, because funds today apply the notional amount
segregation approach to certain derivatives, such as physically settled
Treasury futures or CDS, there exists, as discussed above, an incentive
for funds to invest in derivatives for which funds apply the mark-to-
market segregation approach. Because the proposed rule would remove the
disparate treatment for different derivatives with the same notional
amounts, it is possible that the proposed rule may result in greater
use of the types of derivatives that funds today may use less
extensively because of the need to apply the notional amount
segregation approach. By contrast, funds that today only segregate the
mark-to-market liability for their derivatives would need to segregate
a greater quantity of assets and, if the fund had not been segregating
cash and cash equivalents, would generally be required to segregate
assets that are more liquid. Such a fund could determine to reduce its
derivatives exposure to avoid segregating a greater quantity of assets
that are cash and cash equivalents. Similarly, funds that use

derivatives in an amount that minimally exceeds the threshold for
implementing a risk management program may reduce derivatives use below
that threshold in order to avoid that cost. To the extent that any
funds were hesitant to use derivatives (or any particular type of
derivative) given the lack of specific Commission or staff guidance
addressing certain derivatives, these funds might become more willing
to use those derivatives under the proposed rule. Thus, the proposed
rule may lead to an increase or decrease in the use of particular
derivatives or an increase or decrease in derivatives use by particular
funds.
    Because we do not know to what extent the current regulatory
framework for derivatives may have been influencing funds' use of
derivatives--for example, the extent to which differences in the two
approaches to asset segregation may have been distorting funds' choices
of products in the current market--we do not know to what extent funds
would change existing positions, or would enter into different
positions going forward, under the proposed rule. Accordingly, we
cannot quantify this potential effect. We discuss the potential effects
of each directional option (decreasing derivatives use, shifting
portfolio composition, or increasing derivatives use) below.
    A fund may incur costs to reduce derivatives use if it pays a
penalty or other amount to a counterparty to unwind a position, or if
the fund sells its position to a third party (or the fund enters into a
directly offsetting position to make use of the netting provision in
the proposed rule.) To the extent that a fund uses derivatives for
directional exposure, reducing the use of derivatives could reduce
returns to the fund's shareholders. This could potentially make the
fund (1) less attractive to existing shareholders who desire greater
market exposure; or (2) more attractive to new shareholders who prefer
lower levels of exposure (or encourage current shareholders to increase
their investment in the fund because of the lower derivatives
exposure). To the extent that a fund uses derivatives for hedging,
reducing derivatives use could change the risk profile of the fund's
portfolio, depending on the derivative position that the fund
determines to close as well as other related changes the fund
determines to make to its portfolio.\538\
---------------------------------------------------------------------------

    \538\ We discuss below potential limitations on a fund's ability
to use derivatives for hedging purposes.
---------------------------------------------------------------------------

    A fund that determines to shift the composition of derivatives
used, for example toward physically-settled derivatives, would incur
transaction costs in modifying the portfolio--the costs to exit prior
positions and to enter into new ones. But the benefits to the fund of
holding a more ``optimal'' (from its perspective) composition of
derivatives--i.e., one that is not influenced by the differential
regulatory treatment of certain derivatives--could offset in whole or
in part, or even exceed, those costs.
    A fund that determines to increase its use of derivatives would
incur transaction costs to enter into the new positions and, if those
new positions were to cause the fund's exposure to exceed 50% of net
asset value, the fund would be required to adopt and implement a
formalized derivatives risk management program under the proposed rule
and incur the associated costs. The impacts to the funds' investors
would be different from those experienced by investors in funds that
determine to reduce derivatives exposure. If the derivatives are used
for directional exposure, the increase in leverage increases the
potential for increased returns but also increases risk of loss, which
some investors might prefer and others might not. If the derivatives
are used for hedging, the increase in derivatives could increase or
decrease the level of risk (and thus potential return) that the fund
assumes, depending on the particular derivatives entered into.
    With respect to each of the possibilities listed above, and for
several additional options discussed in greater detail below, we
describe the existence of transaction costs for the fund to terminate
or transfer existing obligations, and to enter into new ones. These
costs include fees, and operational and administrative costs, as well
as the spread paid to intermediaries and the market impact on prices,
if any. The degree of mark-ups and market impact can turn on the
transparency and liquidity of the market, as well as the size of other
market participants (i.e., counterparties) and competitiveness in the
market. There may also be tax costs. We lack the data to quantify these
potential transaction costs. While some of the derivatives instruments
are exchange-traded, many of these instruments are bilaterally
negotiated. We believe costs would generally be lower for more liquid,
exchange-traded derivatives when compared with more complicated,
bespoke, or OTC-traded derivatives. We also believe costs would
generally be lower for larger market participants that actively
transact in derivatives versus smaller market participants.\539\
---------------------------------------------------------------------------

    \539\ See, e.g., O'Hara, Wang & Zhou, The Best Execution of
Corporate Bonds, Working Paper (Oct. 26, 2015), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2680480 (finding that
insurance companies trading in corporate bonds receive better
execution prices if they are more active in the market, and that
trading with a dominant dealer or underwriter worsens those
differentials).
---------------------------------------------------------------------------

    Some types of funds use derivatives more extensively. Alternative
strategy funds, in particular, have experienced significant growth and
have been shown to be heavier users of derivatives. Four managed
futures funds in DERA's sample, for example, exhibited aggregate
notional exposures ranging from approximately 500% to 950% of net
assets, far greater than the exposure limits we are proposing today.
Some ETFs (or other funds) expressly use derivatives to obtain a
leveraged multiple of two or three times the daily performance (or
inverse performance) of an index. Some of these funds had derivatives
exposures exceeding 150% of net assets.\540\ A limited number of other
types of funds in DERA's sample also had aggregate exposures exceeding
150% of net assets. Funds that today operate with aggregate exposure
far in excess of 150% of net assets (or, for certain leveraged ETFs or
mutual funds, that seek to maintain a constant level of leveraged
investments that require exposure in excess of 150%) could not continue
operating as they do today under the proposed rule's 150% exposure
limit. Furthermore, we do not expect that funds that use derivatives
extensively in order to obtain market exposure generally would be able
to satisfy the VaR test included in the risk-based limit.\541\ These
types of funds thus appear most likely to be affected by the proposed
rule.
---------------------------------------------------------------------------

    \540\ As discussed above, these funds are sometimes referred to
as trading tools since they seek to provide a specific level of
leveraged exposure to a market index over a fixed period of time.
    \541\ See supra note 314 (explaining that a fund that holds only
cash and cash equivalents and derivatives would not be able to
satisfy the VaR test).
---------------------------------------------------------------------------

    Some funds within this category of heavier derivatives users might
be limited under the proposed rule from achieving high leverage through
derivatives, and they might choose to modify their investment
activities or portfolio composition in order to comply with the
proposed rule. They could do so in three principal ways. First, a fund
could react to the proposed rule's conditions (e.g., the restrictions
on the amount of aggregate exposure a fund may obtain under the 150%
and 300% exposure limits) by reducing its

derivatives use below the relevant limit, or by declining to enter into
transactions going forward that would exceed these limits. A fund that
is compelled to react to the proposed rule and that does so by reducing
its derivatives exposure would experience effects, including
transactions costs, similar to those discussed above for a fund that
reduces its derivatives exposure voluntarily.
    Second, a fund that is limited by the proposed rule from achieving
high leverage through derivatives might modify its investment
activities by engaging in transactions that might involve leverage but
not the issuance of a senior security that would be restricted by
section 18 (e.g., a purchased option). Some funds may also use fund of
funds investment structures to seek leverage through investments in
other funds, although the underlying funds in these arrangements also
would be subject to the limitations in section 18 and the requirements
of the proposed rule if those underlying funds are registered
funds.\542\ A fund may use these types of transactions to help it
remain in compliance with the proposed rule, or avoid reliance on the
proposed rule altogether. To the extent that a fund pursues leverage
other than through a derivative that is subject to the proposed rule,
the fund could incur transaction costs to close out positions covered
by the proposed rule, and enter into new positions not covered by the
proposed rule. These transaction costs are of the same nature as those
discussed above for funds that reduce their derivatives exposure in
response to the new rule. Further costs for this option are the
opposite of the discussion above with respect to shifting from cash-
settled to physically-settled instruments: Whereas there, investors
could benefit from a more optimally-designed portfolio not subjected to
regulatory arbitrage, here, investors may find it detrimental if the
transactions entered into by funds to avoid the proposed rule were less
efficient, or less calibrated to the fund's disclosed investment
approach or risk/reward profile, than would otherwise be the case.
---------------------------------------------------------------------------

    \542\ The Investment Company Act also imposes limitations on
fund of funds investments. See, e.g., sections 12(d)(1)(A), (B) and
(C) of the Investment Company Act. In addition, we understand that
funds generally elect federal income tax treatment as a ``regulated
investment company'' under Subchapter M of the Internal Revenue Code
and that diversification requirements under Subchapter M may also
limit certain fund of funds investments.
---------------------------------------------------------------------------

    Third, a fund that is limited by the proposed rule from achieving
high leverage through derivatives might modify its investment
activities and reduce its use of derivatives by purchasing the
securities underlying a derivative instrument (e.g., purchasing the
securities underlying an index future, rather than the index future
itself). Derivatives can provide a lower-cost method of achieving
desired exposures than purchasing the underlying reference asset
directly. For example, a fund may use index futures as a cheaper means
to gain exposure to certain markets or equitize cash, rather than
purchasing the underlying equities included in the index.\543\ Funds
responding to the proposed rule in this manner would incur the
incremental costs of trading constituent stocks of the index. As
another example, a fund might also gain exposure to (or hedge) credit
risk more cheaply through a credit default swap on an individual name
or on a CDS index rather than by purchasing or shorting bonds in the
cash market.\544\ To the extent that certain funds may be required to
reduce their use of derivatives, these funds may experience higher
trading costs. The transaction costs for exiting existing derivatives
instruments are described in greater detail above. The costs of
purchasing the underlying instruments can vary widely based on factors
relating to the number and liquidity of the underlying instruments, in
addition to the trading costs that various types of funds may incur in
order to transact in the underlying instruments.\545\ For example,
transaction costs might make it more expensive to replace a total
return swap on the S&P 500 by purchasing each of the underlying
instruments, or even a sampling thereof, but a total return swap based
on a narrower index might be more readily replaced.\546\
---------------------------------------------------------------------------

    \543\ See 2010 ABA Derivatives Report, supra note 70, at 8
(``[W]hen a fund has a large cash position for a short amount of
time, the fund can acquire long futures contracts to retain (or
gain) exposure to the relevant equity market. When the futures
contracts are liquid (as is typically the case for broad market
indices), the fund can eliminate the position quickly and frequently
at lower costs than had the fund actually purchased the reference
equity securities.'') For example, See Biswas, et al., The
Transaction Costs of Trading Corporate Credit, Working Paper (Mar.
1, 2015) (``Transaction Costs of Trading Corporate Credit''),
available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2532805 (``For institutional-size trades up
to $500K, bonds are up three times as expensive as the corresponding
position using credit default swaps'').
    \544\ The 2010 ABA Derivatives Report, supra note 70, at 8, also
observes that ``a fund could write a CDS, offering credit protection
to its counterparty. In doing so the fund gains the economic
equivalent of owning the security on which it wrote the CDS, while
avoiding the transaction costs that would have been associated with
the purchase of the security.''
    \545\ See supra note 539.
    \546\ In many cases, it is possible to obtain a proxy for an
index return with only a subsample of the index constituents. While
this option reduces the replication transaction cost, it introduces
a tracking error and is unlikely to be as cost efficient as
transacting in the total return swap. See generally, e.g., Joel M.
Dickson et al., Understanding synthetic ETFs Vanguard (June 2013),
available at https://pressroom.vanguard.com/content/nonindexed/6.14.2013_Understanding_Synthetic_ETFs.pdf, at 9.
---------------------------------------------------------------------------

    In addition to the direct effects on the fund of transacting in the
derivatives rather than in the underlying assets, there are indirect
effects. A fund that reduces its use of derivatives or replaces them
with underlying assets may affect the fund's liquidity. We recognize
that certain derivatives can be more liquid than their underlying
reference assets. For example, it is cheaper to trade certain CDS
contracts than to trade the underlying bonds.\547\ In addition, some
derivatives instruments may continue to trade during a broader stock
market halt or during the halt in the trading of a particular security.
On the other hand, some derivatives may be less liquid than the
underlying assets. For example, OTC swaps are tied to a specific
counterparty and may be more customized; an OTC swap therefore may be
less liquid than the underlying securities (which may be exchange
traded and centrally cleared). Because the staff's data show that most
funds in DERA's sample were below the 150% proposed exposure
limitation, however, we expect that the proposed rule would not have a
material effect on the way in which the majority of funds operate
today, including how these funds manage their liquidity. Finally, if a
number of funds were to respond to the proposed rule by shifting to
purchasing the underlying assets, it is possible that demand for, and
thus liquidity of, certain derivatives might be reduced while demand
for, and liquidity of, the related underlying assets might be
increased.
---------------------------------------------------------------------------

    \547\ See The Transaction Costs of Trading Corporate Credit,
supra note 543.
---------------------------------------------------------------------------

    These three approaches all involve a fund changing its investment
strategy in order to comply with the rule and are likely to have
similar impacts on capital formation. A fund might seek to reduce its
aggregate exposure by replacing a derivative with the underlying
security. As a result, the overall demand for the underlying securities
may increase and therefore promote capital formation, assuming that
those underlying securities would not themselves have been held by the
counterparty to the fund's derivative contract to hedge that
exposure.\548\ On the other hand, if a

fund is unable to use derivatives to mitigate or eliminate certain
risks posed by its portfolio securities, a fund may find it less
desirable to hold such securities, adversely affecting capital
formation by potentially reducing demand for debt and equity
securities.\549\ A reduction in the use of derivatives may adversely
affect the pricing efficiency of underlying reference securities,\550\
thereby adversely affecting capital formation. In addition, to the
extent that a reduction in the use of derivatives adversely affects
pricing efficiency or transparency, it may become more difficult for a
fund (or its third-party pricing service) and its board of directors to
determine fair values where necessary. As we discuss below, however, we
believe that the proposed rule would affect only the small percentage
of funds that use derivatives to a much greater extent than funds
generally, and thus, any such aggregate effects are not likely to be
significant.\551\
---------------------------------------------------------------------------

    \548\ For example, a fund that obtains synthetic long exposure
to a corporate debt instrument by writing a credit default swap may
decide, instead, to hold the debt instrument directly.
    \549\ For example, if a fund can no longer use a credit default
swap to help mitigate credit risk, the fund might be less willing to
hold a high-yield bond, which may affect the issuance of high-yield
bonds.
    \550\ For example, option listings may incentivize market
analysts to research the underlying securities. Options trading may
also facilitate market pricing of the underlying securities. See
Arrata William, Alejandro Bernales & Virginie Coudert, The Effects
of Derivatives on Underlying Financial Markets: Equity Options,
Commodity Derivatives and Credit Default Swaps, SUERF 50th
Anniversary Volume 445 (2013).
    \551\ To the extent that aggregate derivatives usage by funds is
small compared to the world-wide derivatives market (see supra note
518), and to the extent that only some fraction of derivatives usage
by funds would potentially be affected, the expected effect on the
world-wide derivatives market would be negligible.
---------------------------------------------------------------------------

    Other funds that use derivatives extensively, including the types
of funds discussed above (as those most likely to be impacted by the
proposed rule), may be unable to scale down their aggregate exposures
or otherwise de-lever their funds in a way that allows the fund to
maintain its investment objectives or provide a product that has
sufficient investor demand. Such a fund may choose to deregister under
the Act and liquidate, and/or the fund's sponsor may choose to offer
the fund's strategy as a private fund or (public or private) commodity
pool.
    For example, a fund that must reduce its aggregate exposure may not
be able to offer the returns (and risks) that some investors demand.
ETFs (or other funds) that use derivatives to obtain a leveraged
multiple of the performance (or inverse performance) of an index and
that require exposures in excess of 150% of net assets could not
operate in their current form under the proposed rule, and may not have
sufficient demand at lower exposure levels. Some of these funds
therefore may be liquidated or merged into other funds.
    As discussed above, however, alternative strategy funds and certain
leveraged ETFs (the types of fund most likely to be particularly
affected by the proposed rule) represent a very small percentage of
fund assets under management--approximately 3% of all fund assets.\552\
Only a small subset of funds--primarily managed futures funds and
leveraged ETFs--would appear to be unable to operate as they do today
while complying with the proposed rule's aggregate exposure
limits.\553\ Therefore, we believe that the number of funds that may be
unable to scale down their aggregate exposures or otherwise de-lever
their funds in a way that allows the funds to maintain their investment
objectives or provide a product that has sufficient investor demand--
i.e., those that may have to pursue deregistration and liquidation--
would be limited in many instances to the small percentage of funds
that use derivatives to a much greater extent than funds generally, and
would not be significant to the industry as a whole.
---------------------------------------------------------------------------

    \552\ See DERA White Paper, supra note 73, Table 1.
    \553\ Based on our staff's review of fund filings with the
Commission and Morningstar data, we estimate that there are
approximately 60 managed futures funds. Based on information from
ETF.com, we estimate that there are 43 2x leveraged ETFs and 36 2x
inverse ETFs (79 total), and 36 3x leveraged ETFs and 28 3x inverse
ETFs (64 total). We note that some funds that seek to deliver two
times the performance of an index may be able to achieve this level
of exposure in compliance with the proposed rule's 150% exposure
limit by investing in securities included in the benchmark index and
obtaining additional exposure through derivatives transactions.
Although we understand that most of the funds 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 are ETFs, some mutual funds also pursue these strategies.
These mutual funds would be affected to same extent by the proposed
rule as leveraged ETFs.
---------------------------------------------------------------------------

    In the event that a fund is unable to operate under the proposed
rule's aggregate exposure limit, the fund's sponsor and/or investment
adviser may choose to: (1) Offer the fund as a private fund or (public
or private) commodity pool; (2) liquidate the fund's assets and
deregister the fund under the Act; or (3) merge the fund into another
fund. We estimate that the average cost associated with such actions
would range from $30,000 to $150,000, per fund, depending on the
particular actions taken by the fund (or its sponsor or investment
adviser).\554\ These costs are the direct costs to the fund. There are
also indirect costs associated with a fund's decision to deregister and
for the fund's sponsor to offer the fund's strategy as a private fund
or public or private commodity pool. To the extent that a fund becomes
unavailable to investors, or available only at a higher cost, investors
and competition will be adversely affected. For example, non-accredited
investors generally would not be able to purchase interests in
equivalent unregistered funds. However, accredited investors who prefer
unregistered funds, or who are agnostic about the form, could have the
same or greater choice of funds, and competition among funds offering
similar investment objectives or risk/return profiles as private funds
may increase. Similarly, registered funds that choose to operate as
public commodity pool investment partnerships, rather than SEC-
registered funds, would be accessible to a broad population of
investors. In addition, investment advisers, counterparties, and other
market participants whose business is concentrated on offering,
managing, or servicing these type of funds may similarly be adversely
affected.\555\ For example, it could mean substantially lower
management fees for advisers whose advisory business primarily involves
funds that would be unable to operate under the proposed rule's
exposure limits. It also could mean higher management and/or
performance fees if the new investment vehicle is a private fund. To
the extent that these parties are adversely affected, competition also
could be negatively affected. We are unable to quantify these indirect
costs because we cannot determine the extent to which adequate
substitutes would exist in the market.
---------------------------------------------------------------------------

    \554\ This estimate is based on staff outreach and experience
and includes, for example: Time costs to consult with appropriate
personnel of the investment adviser (e.g., portfolio managers and
other senior management) and prepare the necessary documentation
(e.g., documents related to fund liquidation, fund formation, fund
registration (general counsel and chief compliance officer); time
costs to obtain required fund board approvals; internal and external
costs related to required shareholder approvals; and external costs
for a fund's and/or fund board's outside legal counsel. We note that
a fund may incur costs substantially higher or lower than our
estimates, based on the size and complexity of the fund.
    \555\ See supra note 551.
---------------------------------------------------------------------------

    The proposed rule's aggregate exposure limits may, in certain
situations, constrain a fund's ability to use derivatives as a hedge in
connection with its investment strategies. Although the analysis
conducted by DERA staff indicates that most funds do not today have
aggregate exposure in excess of the proposed rule's 150% and 300%
exposure limitations, it is possible that a fund that uses a
substantial amount of

derivatives could be in a position where it could not engage in
additional derivatives transactions, including as a portfolio hedge in
certain circumstances. A fund that reaches the proposed aggregate
exposure limits would not be permitted to enter into additional
derivatives transactions unless the fund would be in compliance with
the applicable exposure limitation immediately after entering into each
transaction. As a consequence, it is possible that a fund may need to
limit its derivatives transactions, or close out existing derivatives
positions, in order to retain flexibility to enter into risk mitigating
derivatives transactions at a later date. Alternatively, a fund may, in
certain circumstances, refrain from derivatives transactions that it
expects would be risk mitigating, which could potentially have the
effect of increasing a fund's risks.
    For example, it is possible that a fund that complies with the
risk-based portfolio limit's VaR test could be precluded from entering
into additional derivatives to protect against a particular risk if the
fund had reached the risk-based portfolio limit's 300% limit on
aggregate exposure. Such a limitation would appear to apply only if the
fund engages in extensive use of derivatives. For example, a bond fund
could seek to protect its portfolio against 100% of its interest rate
risk and currency risk through derivatives transactions and also seek
to hedge a substantial amount of its credit risk while still having
room under the 300% limit to seek to hedge other risks such as
inflation risk.\556\ We acknowledge that any limitation, such as the
300% exposure limit in the risk-based portfolio limit, may constrain a
fund's ability to implement its strategy, and in particular
circumstances, may require a fund to take actions other than adding
additional derivatives to manage and reduce portfolio risks. In such a
circumstance, a fund may experience greater returns, albeit with
greater risk, if the fund is unable to enter into additional hedging
transactions because it has reached the 300% limit. A fund may decide
to maintain the riskier position, shift away from the underlying assets
that it had previously sought to hedge (so as to maintain its previous
level of risk), or hedge against the risk using instruments not within
the scope of this rule. Because we are unable to reasonably anticipate
the ways in which a fund is likely to respond to the 300% limitation,
we are unable to quantify the expected impact of the portfolio
limitation on a fund's returns.\557\
---------------------------------------------------------------------------

    \556\ For example, the fund could enter into interest rate
derivatives with a notional amount of 100% of the fund's net assets
in order to seek to hedge interest rate risk; enter into currency
derivatives with a notional amount of 100% of the fund's net assets
in order to seek to hedge currency risk; and enter into credit
derivatives with a notional value that is less than 100% of the
fund's net assets to seek to hedge credit risk. The fund in this
example would have aggregate exposure of something less than 300%
and thus could obtain some additional derivatives exposure--up to
the 300% aggregate limit--provided the fund complied with the VaR
test under the risk-based portfolio limit and the proposed rule's
other conditions.
    \557\ See text surrounding supra note 534.
---------------------------------------------------------------------------

    Proposed rule 18f-4 would also 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 full
obligations under those transactions. The proposed rule generally would
take the same approach to financial commitment transactions that we
applied in Release 10666, with some modifications discussed above in
III.E. The proposed rule's requirements for financial commitment
transactions, similar to the approach we applied in Release 10666,
would limit the extent to which a fund could engage in financial
commitment transactions, in that 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 100% of the fund's net assets, as
discussed above in III.E. We believe that the proposed rule is not
likely to impose any significant additional limitation on the extent to
which a fund can incur obligations under financial commitment
transactions (as compared with the current economic baseline) because,
as noted above, funds that enter into these transactions today do so in
reliance on Release 10666, which generally would limit the fund's
obligations under these transactions to the fund's net assets.\558\
This is consistent with DERA staff's analysis, which showed that no
fund in the DERA sample had greater than 100% aggregate exposure
resulting from financial commitment transactions (the current economic
baseline for such transactions).\559\ Accordingly, we believe that the
proposed rule's asset segregation requirements for financial commitment
transactions would have no measurable effect on efficiency,
competition, or capital formation.
---------------------------------------------------------------------------

    \558\ See supra note 93 and accompanying text.
    \559\ DERA White Paper, supra note 73, Table 6.
---------------------------------------------------------------------------

    We also note that the proposed asset segregation requirements, to
the extent that a fund is required to increase its holdings of cash and
cash equivalents (for derivatives transactions) or assets convertible
to cash or that can generate cash (for financial commitment
transactions), may adversely affect efficiency, competition, and
capital formation. For example, holding higher levels of these assets
may reduce efficiency by requiring a fund's investment adviser to
invest the fund's assets in cash and cash equivalents or assets
convertible to cash or that can generate cash to a greater extent than
the adviser otherwise would invest the fund's assets, given the fund's
investment strategy and investor base. This, in turn, could adversely
affect investors by reducing a fund's investment returns, and reduce
competition by decreasing a fund's investment opportunities to generate
higher returns. In addition, a fund that holds greater amounts of cash
and cash equivalents (all other things, such as fund flows, being
equal) necessarily holds a smaller amount of securities in its
portfolio, which may adversely affect capital formation. As discussed
in Section III.C.2 above, however, we understand that cash and cash
equivalents are commonly used for posting collateral or margin for
derivatives transactions.\560\ Also, given that the margin posted is
permitted to be offset against the assets that would be required to be
segregated under the proposed rule, the magnitude of funds' shift into
cash and cash equivalents under the proposed rule may not be as
significant as it would be otherwise, thereby mitigating the negative
impact on capital formation that the asset segregation requirements of
the proposed rule may cause.
---------------------------------------------------------------------------

    \560\ See supra note 370 and accompanying text.
---------------------------------------------------------------------------

    Finally, we note that the size of a fund, or the complex of funds
to which a fund belongs, could have certain competitive effects with
respect to a fund's compliance with proposed rule 18f-4, including the
implementation of its derivatives risk management program, where
applicable. For example, if there are economies of scale in creating
and administering multiple derivatives risk management programs, a fund
that is part of a large fund complex would have a competitive
advantage. A fund in a smaller complex, on the other hand, may use a
greater portion of its resources to create and administer a derivatives
risk management program, which may increase barriers to entry in the
fund industry, and lead to an adverse effect on competition. The size
of a fund complex also could produce competitive advantages or
disadvantages with respect to a fund's use of products developed by
third parties to assist a fund in calculating

and monitoring its compliance with the proposed rule's portfolio
limitations and asset segregation requirements. For example, a fund in
a large complex could receive relatively more favorable pricing for
third-party risk management tools, if the fund complex were to purchase
discounted bulk services from the tool developer or receive
relationship-based pricing discounts. Regardless of the extent to which
a third-party provides its product at a discounted rate, the proposed
rule may positively impact third-party service providers by increasing
sales. We note that the competitive effects discussed above in the
context of funds and/or fund families may, instead, apply to a fund's
investment adviser. This may occur where the investment adviser (rather
than the fund) incurs the costs associated with implementing the
proposed rule's requirements, and does not, or is unable to, pass such
costs along to the fund (for example, through increases in its advisory
fees).

D. Specific Benefits and Quantifiable Costs

    We have discussed above a number of general benefits and costs,
including effects on efficiency, competition, and capital formation
that we believe would generally result from the proposed rule. Taking
into account the goals of the proposed rule and the economic baseline,
as discussed above, this section explores specific benefits and
quantified costs, in the context of each core element of the proposed
rule.
    We note that the following analyses and estimates are made on a per
fund basis, and are not made on a fund complex basis. We have made
these estimates on a per fund basis because the DERA sample analysis
upon which we rely in our economic analysis was performed at a fund
level. In addition, we believe that the extent of derivatives use
varies widely between funds. Accordingly, we believe that estimating
costs on a per fund basis is likely to provide more meaningful
estimates, consistent with the approach taken in the DERA sample. We
recognize, however, that many funds are part of a fund complex, and
thus may realize economies of scale in complying with the proposed
rule.\561\ As discussed below, our estimated ranges of per fund costs
take this into account. The low end of our range of costs reflects the
estimated costs for a fund that is part of a fund complex (which is
likely to experience economies of scale), while the high end of our
range of costs reflects the estimated costs likely borne by a stand-
alone fund that is not part of a fund complex or that is the only fund
in a complex that relies on the rule.
---------------------------------------------------------------------------

    \561\ The extent of the economies of scale may depend, in part,
on the extent to which multiple funds in the same fund complex use
derivatives transactions and financial commitment transactions in
similar ways.
---------------------------------------------------------------------------

1. Exposure-Based Portfolio Limit
a. Requirements
    As discussed above in section III.B.1, the proposed rule would
require that a fund that engages in derivatives transactions in
reliance on the rule comply with one of two alternative portfolio
limitations. The first portfolio limitation--the exposure-based
portfolio limit--would place an overall limit on the amount of exposure
to underlying reference assets, and potential leverage, that a fund
would be able to obtain from derivatives transactions covered by the
proposed rule by limiting the fund's exposure under these derivatives
transactions and other senior securities transactions to 150% of the
fund's net assets.
b. Benefits
    The 150% aggregate exposure limit in the exposure-based portfolio
limit (as well as the 300% exposure limit in the risk-based portfolio
limit discussed below) is designed primarily to impose 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
subject to the rule and other senior securities transactions, while
also providing flexibility for a fund to use derivatives for a variety
of purposes.\562\ An outer limit on aggregate exposure would prevent
funds from obtaining extremely high leverage that we believe may be
inconsistent with the Act's stated concern about senior securities that
increase unduly the speculative nature of a fund's outstanding
securities. The proposed rule, therefore, is expected to benefit
investors by providing a clear and workable framework in which funds
may continue to use derivatives covered by the proposed rule for a
variety of purposes, but subject to a limit on the potential leverage
(and leverage-related risks) that could be obtained through these
covered instruments. By explicitly limiting a fund's aggregate exposure
from derivatives and other senior securities transactions, the proposed
rule also may reduce the likelihood of extreme fund losses associated
with leveraged portfolios under stressed market conditions. As a
result, the proposed rule may reduce the possibility of a fund needing
to liquidate and the associated adverse impacts on market participants
and thus may promote market stability.\563\ As we discussed above, the
DERA staff analysis also indicates that most funds and their advisers
would be able to continue to operate and to pursue a variety of
investment strategies, including alternative strategies (under the 150%
exposure limitation).\564\
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    \562\ The 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. See supra note 152.
    \563\ While we lack empirical evidence that a registered fund's
liquidation under stressed market conditions, including the
potential forced sale of assets, could have adverse effects on
market participants, we believe that the avoidance of potential
negative externalities from a fund's liquidation into a stressed
market broadly promotes market resiliency and stability.
    \564\ See supra note 210 and accompanying text.
---------------------------------------------------------------------------

    The proposed rule's definition of exposure for derivatives
transactions would require that a fund aggregate the notional amounts
of those derivatives (with certain adjustments specified in the
proposed rule).\565\ For most types of derivatives, the notional amount
can serve as a measure of the fund's investment exposure to the
derivative's underlying reference asset or metric. While there are
other measures that could be used, the notional amount is a measure
that is well-understood and recognized, and readily determinable by
funds.\566\ In addition, the notional amount is a measure for
determining

exposure that is adaptable 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. Funds, particularly
smaller or less sophisticated funds, may benefit from the ease of
application of a bright-line, straightforward metric such as this one,
as compared to a test that would require consideration of the manner in
which a fund uses derivatives in its portfolio (e.g., whether
particular derivatives are used for hedging.
---------------------------------------------------------------------------

    \565\ The proposed rule includes certain adjustments to the way
in which a fund would generally be required to determine the
``notional amount'' with respect to its derivatives transactions.
For any derivatives transaction that provides a return based on the
leveraged performance of a reference asset, the notional amount must
be multiplied by the leverage factor; for any derivatives
transaction for which the reference asset is a managed account or
entity formed primarily for the purpose of investing in derivatives
transaction, or an index that reflects the performance of such a
managed account or entity, the notional amount must be determined by
reference to the fund's pro rata share of the notional amounts of
the derivatives transactions of such account or entity (``look-
through provision''); and for any ``complex derivatives
transaction,'' (defined in rule 18f-4(c)(1) and discussed above in
section III.B), the notional amount must be an amount equal to the
aggregate notional amount of derivatives instruments, excluding
other complex derivatives transactions, reasonably estimated to
offset substantially all of the market risk of the complex
derivatives transaction. See proposed rule 18f-4(c)(7)(iii)(C). The
estimated operational costs associated with these aspects of the
proposed rule are included in our cost estimates discussed below in
section IV.D.1.c.
    \566\ See, e.g., Michael Chui, Derivatives markets, products and
participants: an overview (Bank of International Settlements, IFC
Bulletin No. 35 (Feb. 2012), available at http://www.bis.org/ifc/publ/ifcb35a.pdf (``Notional amount is the total principal of the
underlying security around which the transaction is structured. It
is easy to collect and understand.'').
---------------------------------------------------------------------------

c. Quantified Costs
    Funds that elect to rely on the rule would incur one-time and
ongoing operational costs to establish and implement a 150% exposure-
based portfolio limitation.\567\ As discussed above, funds today employ
a range of different practices, with varying levels of
comprehensiveness, for complying with section 18's prohibitions,
Commission positions, and staff guidance. Although the 150% exposure-
based portfolio limit would be new for all funds that seek to comply
with the proposed rule, we anticipate that the relative costs to a
particular fund are likely to vary, depending on the extent to which a
fund enters into derivatives transactions, and, for example, the level
of sophistication of a fund's current risk management processes
surrounding its use of derivatives.
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    \567\ As discussed below in section IV.D.4, a fund that seeks to
rely on the proposed rule would not be required to have a
derivatives risk management program provided the fund limits its
aggregate exposure from derivatives transactions to no greater than
50% of the fund's net assets (and does not use complex derivatives
transactions). The costs that we estimate here for a fund to comply
with the 150% exposure-based portfolio limit would include the costs
for a fund to determine and monitor its compliance with the proposed
50% exposure-based test (and complex derivatives transaction
limitation) for establishing a derivatives risk management program.
---------------------------------------------------------------------------

    The extent to which a fund currently engages in derivatives
transactions may affect the costs the fund would incur. For example,
funds that today use derivatives more extensively may already have
systems that can be used to determine a fund's exposure or that could
more readily be updated to include that functionality. Proposed Form N-
PORT would require funds to report the notional amounts of certain
derivatives on the form and, if we adopt Form N-PORT, the systems or
enhancements put in place by funds in connection with Form N-PORT's
reporting requirements may provide an efficient means to calculate
notional amounts for proposed rule 18f-4. Conversely, a fund that uses
derivatives only modestly may not have existing systems that can be as
readily used to determine a fund's exposure, but a fund that uses
derivatives modestly may be able to determine its exposure without the
need to establish the kinds of more extensive systems that might be
required or desired by funds that use derivatives more extensively.
    The types of derivatives a fund uses also may affect the costs the
fund would incur. Funds that enter into complex derivatives
transactions, as defined in the proposed rule, would be required to
determine the notional amounts of those transactions using the
alternative approach specified in the proposed rule for complex
derivatives transactions. Under this approach, the notional amount of a
complex derivatives transaction would be equal to the aggregate
notional amount(s) of derivatives instruments, excluding other complex
derivatives transactions, reasonably estimated to offset substantially
all of the market risk of the complex derivatives transaction at the
time the fund enters into the transaction.\568\ It may require
additional resources or analysis to determine a complex derivative's
notional amount than, for example, a non-complex derivatives
transaction with a stated notional amount that can be used for purposes
of the proposed rule's exposure limitations. It may similarly require
additional resources or analysis to determine the notional amount of a
derivatives transaction for which the 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, because
the notional amount of such a derivatives transaction under the
proposed rule would be determined by reference to the fund's pro rata
share of the notional amounts of the derivatives transactions of such
account or entity.\569\ In any case, the costs associated with the
exposure-based portfolio limit would directly impact funds (and may
indirectly impact fund investors if a fund's adviser incurs costs and
passes along its costs to investors through increased fees).
---------------------------------------------------------------------------

    \568\ Proposed rule 18f-4(c)(7)(iii)(C).
    \569\ Proposed rule 18f-4(c)(7)(iii)(B).
---------------------------------------------------------------------------

    Our staff estimates that the one-time operational costs necessary
to establish and implement an exposure-based portfolio limitation would
range from $20,000 to $150,000 \570\ per fund, depending on the
particular facts and circumstances and current derivatives risk
management practices of the fund.\571\ These estimated costs are
attributable to the following activities: (1) Developing and
implementing policies and procedures \572\ to comply with the proposed
rule's 150% exposure-based portfolio limit; (2) planning, coding,
testing, and installing any system modifications relating to the 150%
exposure-based portfolio limitation; \573\ and (3) preparing training
materials and administering training sessions for staff in affected
areas.
---------------------------------------------------------------------------

    \570\ These cost estimates, and the other quantified costs
discussed below, are based, in part (adjusting such estimates to
reflect specific provisions of the proposed rule), on staff
experience and outreach, as well as consideration of recent staff
estimates of the one-time and ongoing systems costs associated with
other Commission rulemakings. See, e.g., 2014 Money Market Fund
Reform Adopting Release, supra note 367, at sections III.A.5 and
III.B.8 (estimating the one-time and ongoing operational costs to
money market funds and others in the distribution chain to modify
systems and implement certain reforms including liquidity fees and
gates and/or a floating NAV); Liquidity Release, supra note 5, at
section IV.C.1 (estimating the one-time and ongoing operational
costs to most registered open-end funds to modify systems and
implement new proposed rule 22e-4, requiring a liquidity risk
management program). Although the substance and content of systems
associated with establishing and implementing policies and
procedures to comply with proposed rule 18f-4 would be different
from the substance and content of systems associated with, for
example, implementing the money market fund reforms or a new
proposed liquidity risk management program, the costs associated
with the core requirements of proposed rule 18f-4, like the 2014
adopted money market fund reforms and the 2015 proposed liquidity
risk management program reforms, would entail: Developing and
implementing policies and procedures; planning, coding, testing, and
installing any relevant system modifications; and preparing training
materials and administering training sessions for staff in affected
areas.
    \571\ We estimate that the costs discussed throughout this
section would apply equally across affected fund types, including
open-end funds, closed-end funds, ETFs, and BDCs.
    \572\ Throughout this economic analysis, we include in
``developing and implementing policies and procedures'' cost
estimates (both for initial and ongoing costs) associated with
internal and external costs (e.g., compliance consultants, outside
legal counsel), as well as staff costs (e.g., legal, compliance,
portfolio management, risk management, and other administration
personnel).
    \573\ Throughout this economic analysis, these cost estimates
assume that affected funds would incur systems costs (i.e.,
computer-based systems costs) to assist them in complying with the
requirements of proposed rule 18f-4. As discussed below, some funds
may determine that computer-based systems are not required (e.g.,
the fund engages only in limited amounts of derivatives transactions
for which notional exposures are easily determinable) and choose to
implement a less automated system for complying with the proposed
rule's requirements. We expect that such a fund would not incur
costs related to this particular activity, and more likely, would
incur total costs closer to the lower-end of the estimated range of
costs.
---------------------------------------------------------------------------

    Our staff estimates that a fund that is part of a fund complex will
likely benefit from economies of scale and incur costs closer to the
low-end of the estimated range of costs, while a standalone fund is
more likely to incur costs closer to the higher-end of the

estimated range of costs. Our staff also estimates that a standalone
fund that is a light or moderate user of derivatives may choose to
comply with the proposed rule by implementing a less automated system,
and thus be more likely to incur costs closer to the low-end of the
estimated range of costs. We anticipate that if there is demand to
develop systems and tools related to the exposure-based portfolio
limitation, market participants (or other third parties) may develop
programs and applications that a fund could purchase at a cost likely
less than our estimated cost to develop the programs and applications
internally. In addition, the proposed rule may increase the demand for
information services relating to derivatives to the extent that funds
and advisers use third-party providers of such information services,
such as risk management tools (e.g., VaR measures) and pricing data,
and thus could potentially affect these third-party providers as well.
    Staff also estimates that each fund would incur ongoing costs
related to implementing a 150% exposure-based portfolio limitation
under proposed rule 18f-4. Staff estimates that such costs would range
from 20% to 30% of the one-time costs discussed above.\574\ Thus, staff
estimates that a fund would incur ongoing annual costs associated with
the 150% exposure-based portfolio limit that would range from $4,000 to
$45,000.\575\ These costs are attributable to the following activities:
(1) Complying with the proposed rule's 150% aggregate exposure limit;
(2) systems maintenance; and (3) additional staff training.
---------------------------------------------------------------------------

    \574\ See supra note 570. In estimating the total quantified
costs of our proposed rule, we estimate that the portfolio
limitation requirements would likely impose initial costs that are
proportionately larger than ongoing costs. Accordingly, and based on
staff experience and outreach, we estimate that the ongoing costs
would range from 20% to 30% of the initial costs.
    \575\ This estimate is based on the following calculations: 0.20
x $20,000 = $4,000; 0.30 x $150,000 = $45,000.
---------------------------------------------------------------------------

    In the DERA staff analysis, 68% of all of the sampled funds did not
have any exposure to derivatives transactions.\576\ These funds thus do
not appear to use derivatives transactions or, if they do use them, do
not appear to do so to a material extent. We therefore estimate that
approximately 32% of funds--the percentage of funds that did have
derivatives exposure in the DERA sample--are more likely to enter into
derivatives transactions and therefore are more likely to incur costs
associated with either the exposure-based portfolio limit or the risk-
based portfolio limit. Excluding approximately 4% of all funds
(corresponding to the percentage of sampled funds that had aggregate
exposure of 150% or more of net assets and for which we have estimated
costs for the risk-based limit),\577\ we estimate that 28% of funds
(3,352 funds \578\) would incur the costs associated with the exposure-
based portfolio limit.
---------------------------------------------------------------------------

    \576\ DERA White Paper, supra note 73, Figure 11.1. As discussed
above, we recognize that the DERA staff analysis used a sample of
funds and reviewed the funds' then-most recent annual reports. The
number of funds that may enter into senior securities transactions
may be higher or lower than our estimate. We believe, however, that
the results of the DERA staff analysis provide a reasonable basis to
estimate the extent to which funds engage in derivatives and other
senior securities transactions, and thus provide a reasonable basis
to estimate the potential costs of the proposed rule to funds.
    \577\ DERA White Paper, supra note 73, Figure 9.1.
    \578\ This estimate is based on the following calculation:
11,973 funds x 28% = 3,352 funds. The number of funds is based on
the following calculation, as of June 2015: (9,707 open-end funds +
560 closed-end funds + 1,706 ETFs = 11,973). See supra note 511 and
accompanying text. In estimating the potential costs to funds
related to their use of derivatives (both here and throughout this
Release), we have estimated the total fund universe excluding money
market funds and BDCs because money market funds do not enter into
derivatives transactions and because we understand, and the DERA
staff analysis shows, that BDCs do not use derivatives to a material
extent (no BDC in the DERA staff sample had exposures to derivatives
transactions). We have considered, however, the potential costs on
these funds to the extent that such funds use financial commitment
transactions (see supra section IV.D.5), and if a BDC were to engage
in derivatives transactions, we expect that the BDC would incur the
costs estimated here and throughout this Release for funds that
engage in derivatives transactions.
---------------------------------------------------------------------------

    As discussed above, we have not aggregated the estimated range of
costs across the entire fund industry. We note, however, that the vast
majority of funds operate as part of a fund complex, and therefore we
expect that many funds would achieve economies of scale in implementing
the proposed rule. Accordingly, we believe that the lower-end of the
estimated range of costs ($20,000 in one-time costs; $4,000 in annual
costs) better reflects the total costs likely to be incurred by many
funds.
    As noted above, based on the DERA sample, 68% of all sampled funds
(8,142 funds' \579\) do not appear to use derivatives transactions (or
if they do, do not appear to use them to a material extent). We do,
however, recognize that although we do not estimate costs for these
funds to comply with the proposed rule, some of these funds may wish to
preserve the flexibility to do so in the future. Accordingly, we
estimate that a fund that would otherwise not comply with proposed rule
18f-4 would incur approximately $10,000 to evaluate the proposed rule
and for the fund's board to consider approving the fund's use of the
exemption provided by the rule (and therefore preserve the flexibility
to comply in the future).\580\
---------------------------------------------------------------------------

    \579\ This estimate is based on the following calculation:
11,973 funds x 68% = 8,142 funds.
    \580\ This estimate is based on staff outreach and experience
and includes estimates for time spent by a fund's chief compliance
officer, consultation with portfolio managers and other senior
management of the fund's adviser, as well as the fund's board of
directors.
---------------------------------------------------------------------------

2. Risk-Based Portfolio Limit
a. Requirements
    As discussed above in section III.B.2, the proposed rule would
require that a fund that engages in derivatives transactions in
reliance on the rule comply with one of two alternative portfolio
limitations. The second portfolio limitation is the risk-based
portfolio limit, which 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 the 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 VaR-
based test.
b. Benefits
    The principal benefit of the risk-based portfolio limit is that it
recognizes that funds may use derivatives to not only seek higher
returns through increased investment exposures, but importantly, also
as a low-cost and efficient means to reduce and/or mitigate risks
associated with the fund's portfolio. Some funds may have or develop
investment strategies that include the use of derivatives that, in the
aggregate, have relatively high notional amounts, but that are used in
a manner that could be expected to reduce the fund's exposure to market
risk rather than to increase exposure to market risk through the use of
leverage. We expect that investors, and the markets in general, would
benefit from 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. We also expect that funds should benefit from having
the flexibility to select a VaR model that best addresses the funds'
particular investment strategy and the nature of its portfolio
investments, while also specifying certain minimum requirements in the
proposed rule.\581\
---------------------------------------------------------------------------

    \581\ See supra sections III.b.2.a, b.

---------------------------------------------------------------------------

    In addition to the VaR test, the risk-based portfolio limit also
includes an outer limit on aggregate exposure. Investors should also
benefit from a flexible approach that allows for greater aggregate
exposure (as compared with the 150% exposure-based portfolio
limitation), and thus may promote the use of derivatives when, in
aggregate, the result is an investment portfolio that is subject to
less market risk than if the fund did not use such derivatives.
Including an outer exposure limit, in addition to the VaR test, should
provide benefits similar to those discussed above in section IV.D.1.
Those benefits include improved investor protection, increased market
stability through explicit limitations on potential leverage, and an
exposure calculation that uses notional amounts that are widely
available and adaptable to the varied types of derivatives instruments
used by funds. We also believe that increasing the aggregate exposure
limit from 150% (under the exposure-based portfolio limitation) to 300%
of net assets when a fund's use of derivatives, in aggregate, has the
effect of reducing the fund's exposure to market risk, should benefit
investors by permitting funds to engage in increased use of derivatives
to mitigate risks in the fund's portfolio.\582\ Setting the exposure
limit at 300% as part of the risk-based portfolio limit would provide a
limit for funds that could seek to operate under the risk-based
portfolio limit that permits additional capacity for hedging
transactions while still setting an overall limit on the amount of
leverage that can be obtained through derivatives that are subject to
the rule. Moreover, based on the DERA staff analysis, many of the funds
with aggregate exposure in excess of 300% of net assets appear to use
derivatives primarily to obtain market exposure (rather than to reduce
the fund's exposure to market risk).\583\
---------------------------------------------------------------------------

    \582\ See supra note 239 and accompanying text (acknowledging
that a hedging transaction may not always result in mitigating
risk).
    \583\ See supra note 314.
---------------------------------------------------------------------------

c. Quantified Costs
    As with the quantified costs we discuss above regarding the
exposure-based portfolio limit (section IV.D.1), we expect that funds
would incur one-time and ongoing operational costs to establish and
implement a risk-based exposure limit, including the VaR test. We
expect that a fund that seeks to comply with the 300% aggregate
exposure limit would incur the same costs as those that we estimated
above in order to establish and implement the 150% exposure-based
portfolio limit.\584\ Accordingly, we estimate below the costs we
believe a fund would incur to comply with the VaR test. Although the
VaR test and outer limit on aggregate exposure would be new for all
funds that seek to comply with the proposed rule's risk-based exposure
limit, we anticipate that the costs to a particular fund are likely to
vary, depending on the extent to which a fund enters into derivatives
transactions and the level of sophistication of a fund's existing risk
management processes surrounding its use of derivatives. For example,
funds that use derivatives extensively may already use a VaR model to
evaluate and monitor the risks associated with derivatives
transactions. As a result, these funds may incur lower costs as
compared with other funds that do not already have sophisticated tools
in place to monitor the risks associated with derivatives. In this
regard, we note that funds that would seek to comply with the risk-
based portfolio limit, rather than the exposure-based portfolio limit,
may be more likely to be more extensive users of derivatives because we
expect that less extensive derivatives users generally would choose to
operate under the exposure-based portfolio limit. These costs would
directly impact funds (and may indirectly impact fund investors if a
fund's adviser incurs costs and passes along its costs to investors
through increased fees).
---------------------------------------------------------------------------

    \584\ The only difference would be an increased outer limit of
aggregate exposure (from 150% to 300% of the fund's net asset
value).
---------------------------------------------------------------------------

    Our staff estimates that the one-time operational costs necessary
to establish and implement a VaR test would range from $60,000 to
$180,000 \585\ per fund, depending on the particular facts and
circumstances and current derivatives risk management practices of the
fund. These estimated costs are attributable to the following
activities: (1) Developing and implementing policies and procedures to
comply with the proposed rule's requirement that the fund's full
portfolio VaR is less than the fund's securities VaR; (2) planning,
coding, testing, and installing any system modifications relating to
the VaR test; and (3) preparing training materials and administering
training sessions for staff in affected areas.
---------------------------------------------------------------------------

    \585\ See supra note 570.
---------------------------------------------------------------------------

    Our staff estimates that a fund that is part of a fund complex
would likely benefit from economies of scale and incur costs closer to
the low-end of the estimated range of costs, while a standalone fund is
more likely to incur costs closer to the higher-end of the estimated
range of costs. Our staff also estimates that a standalone fund that is
a light or moderate user of derivatives may choose to comply with the
proposed rule by implementing a less automated system, and thus be more
likely to incur costs closer to the low-end of the estimated range of
costs. We anticipate that if there is demand to develop systems and
tools related to the risk-based portfolio limitation, market
participants (or other third parties) may develop programs and
applications that a fund could purchase at a cost likely less than our
estimated cost to develop the programs and applications internally.
    Staff also estimates that each fund would incur ongoing costs
related to implementing a VaR test under proposed rule 18f-4. Staff
estimates that such costs would range from 20% to 30% of the one-time
costs discussed above.\586\ Thus, staff estimates that a fund would
incur ongoing annual costs associated with the VaR test aspect of the
risk-based exposure limit that would range from $12,000 to
$54,000.\587\ These costs are attributable to the following activities,
as applicable to each fund: (1) Complying with the VaR test (i.e.,
that, immediately after entering into any senior securities
transaction, the fund's full portfolio VaR is less than the fund's
securities VaR); (2) systems maintenance; and (3) additional staff
training.
---------------------------------------------------------------------------

    \586\ See supra notes 570 and 574.
    \587\ This estimate is based on the following calculations: 0.20
x $60,000 = $12,000; 0.30 x $180,000 = $54,000.
---------------------------------------------------------------------------

    DERA staff analysis shows that approximately 4% of all funds
sampled had aggregate exposure of 150% or more of net assets.\588\ We
estimate, therefore, that 4% of funds (479 funds \589\) may seek to
comply with the risk-based portfolio limit.\590\ As with the other
quantified costs we discuss in this Release, we believe that many funds
belong to a fund complex and are likely to experience economies of
scale. We therefore expect that the lower-end of the estimated range of
costs ($60,000 in one-time costs; $12,000 in annual costs) better
reflects the total costs likely to be incurred by many funds.
---------------------------------------------------------------------------

    \588\ DERA White Paper, supra note 73, Figure 9.1.
    \589\ This estimate is based on the following calculation:
11,973 funds x 4% = 479 funds. See also supra note 578.
    \590\ We recognize, however, that it is possible that some (or
all) of these funds may decide, after evaluating the particularized
costs and benefits, to reduce (or even eliminate) their use of such
transactions and therefore rely on the 150% exposure-based portfolio
limitation, or not rely on proposed rule 18f-4 at all. We discuss
these potential effects on efficiency, competition, and capital
formation above. See supra section IV.C.

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3. Asset Segregation
a. Requirements
    As discussed above in section III.C, the proposed rule would
require a fund that seeks to enter into derivatives transactions 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 under such 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 (the ``mark-to-market coverage amount,'' as noted above),
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 ``risk-based coverage amount,'' as noted
above).
b. Benefits
    The proposed asset segregation will likely improve a fund's ability
to meet its obligations under its derivatives transactions. The
proposed rule's requirement that the fund maintain qualifying coverage
assets with a value equal to the fund's mark-to-market coverage amount
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. The proposed rule's requirement that the fund
maintain qualifying coverage assets with a value equal to the fund's
risk-based coverage amount is designed to require the fund to have
qualifying coverage assets to cover future losses and any resulting
future payment obligations.\591\ These aspects of the proposed rule's
asset segregation requirements for derivatives transactions are
consistent with suggestions of many commenters on the Concept Release,
including a commenter that observed 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.'' \592\
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    \591\ In addition, the asset segregation requirement in the
proposed rule would limit a fund's derivatives exposure to the
extent that the fund limits its derivatives usage in order to comply
with the asset segregation requirements. See supra note 323 and
accompanying text.
    \592\ See ICI Concept Release Comment Letter.
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    By requiring a fund to determine its risk-based coverage amounts in
accordance with board-approved policies and procedures, 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.
    In addition, the proposed asset segregation requirements may
benefit investors by eliminating the existing practice by some funds
(under existing staff guidance) to segregate for certain derivatives
transactions (e.g., derivatives that permit physical settlement), the
notional amount. As we noted above, 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.
Existing staff guidance contemplates that a fund will segregate assets
equal to a derivative's full notional amount for certain derivatives
and the derivative's daily mark-to-market liability for others. The
proposed rule would benefit investors by requiring funds to evaluate
their obligations under a derivatives transaction--including by
considering future potential payment obligations represented by the
derivative's risk-based coverage amount--rather than segregating assets
equal to either a derivative's notional value or a mark-to-market
liability based solely on the type of derivative involved, as under the
current approach.
    The proposed rule generally would require a fund to segregate cash
and cash equivalents as qualifying coverage assets in respect of its
coverage obligations for its derivatives transactions. To the extent
that a fund currently posts collateral to counterparties for
derivatives transactions,\593\ the fund's mark-to-market coverage
amount would be reduced by the value of the posted assets that
represent variation margin, and the fund's risk-based coverage amount
would be reduced by the value of the posted assets that represent
initial margin, mitigating the need for the fund to segregate
additional cash and cash equivalents. We believe that cash equivalents
are an appropriate component of qualifying coverage assets for
derivatives transactions because these securities usually settle within
one day \594\ and do not generally fluctuate in value with market
conditions.\595\ Therefore, cash and cash equivalents are readily
available to support derivatives positions should the need for
additional funding arise at short notice, for example due to margin
calls, without a fund having to unwind such positions.\596\ The
immediacy of funding needs for derivatives transactions may mean that
other types of assets commonly used for short-term needs (such as
meeting fund redemption requests which can take three days to settle
when redeemed through a broker-dealer \597\) would be insufficiently
liquid to meet the fund's obligations under a derivatives contract.
Furthermore, we understand that cash and cash equivalents are commonly
used for posting collateral or margin for derivatives
transactions.\598\
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    \593\ See, e.g., ISDA Margin Survey 2015, supra note 370.
    \594\ See, e.g., http://www.sec.gov/answers/tplus3.htm.
    \595\ This is in contrast to funds' segregating any liquid asset
under existing staff guidance, which may increase the likelihood
that a fund's segregated assets decline in value at the same time
the fund experiences losses on the derivatives transaction.
    \596\ We recognize that requiring funds generally to maintain
cash and cash equivalents may have other associated effects. We
discuss these potential effects above in section IV.C.
    \597\ Open-end funds that are redeemed through broker-dealers
must meet redemption requests within three business days because
broker-dealers are subject to rule 15c6-1 under the Securities
Exchange Act of 1934. See Liquidity Release, supra note 5, at n.21.
    \598\ See the discussion of the ISDA margin Survey 2015 in
footnote 370.
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    For all of these reasons, we believe that the proposed asset
segregation requirements should more effectively result in a fund
having sufficient assets to meet its obligations under its derivatives
transactions. By requiring the fund to maintain qualifying coverage
assets--generally cash equivalents--sufficient to cover the fund's
current mark-to-market obligation and an additional amount designed to
address future losses, the proposed rule is designed to reduce the risk
that the fund would be required to sell portfolio assets in order to
generate assets to satisfy the fund's derivatives payment obligations,
particularly in an environment where those assets may have experienced
a temporary decline in value, thereby magnifying the fund's losses on
the forced sale. In addition to the benefit to investors, as discussed
above, counterparties to the derivatives transactions may benefit from
an

increased expectation of repayment given the higher quality of assets
that are set aside for the funds' performance of their contractual
obligations. The proposed asset segregation requirements may also
provide a number of additional positive effects on efficiency,
competition, and capital formation as discussed above in section IV.C.
c. Quantified Costs
    As with the quantified costs we discuss above regarding the
exposure-based and risk-based portfolio limits (section III.B.1), we
expect that funds would incur one-time and ongoing operational costs to
establish and implement systems in order to comply with the proposed
asset segregation requirements. As discussed above, and pursuant to
existing Commission statements and staff guidance, two general
practices have developed: the notional amount segregation approach and
the mark-to-market segregation approach. Also as discussed 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, and 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. We believe that funds
that currently calculate their liability under their derivatives
transactions on a daily basis would likely calculate the proposed mark-
to-market coverage amount in the same manner, and therefore would not
likely incur significant new costs when calculating the fund's mark-to-
market coverage amount under the proposed rule.\599\
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    \599\ See supra section III.C.1.a (noting that funds already
calculate their liability under derivatives transactions on a daily
basis for other purposes, including to satisfy variation margin
requirements, and to determine the fund's NAV). We discuss below in
section IV.D.5, the estimated costs for the proposed asset
segregation requirements for a fund that enters solely into
financial commitment transactions.
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    The risk-based coverage amount would be determined in accordance
with policies and procedures approved by the fund's board that are
required to take into account certain factors specified in the proposed
rule. 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.
As a result, we expect that, for funds that are significant users of
derivatives, these funds may already use VaR or other risk-management
tools to manage associated risks, and may be able to reduce costs by
using these tools to calculate the risk-based coverage amount. We
therefore anticipate that the relative costs to a particular fund are
likely to vary, depending on the extent to which a fund enters into
derivatives transactions and the level of sophistication of a fund's
risk management processes surrounding its use of derivatives. These
costs will directly impact funds (and may indirectly impact fund
investors if a fund's adviser incurs costs and passes along its costs
to investors through increased fees).
    Our staff estimates that the one-time operational costs necessary
to establish and implement the proposed asset segregation requirements
would range from $25,000 to $75,000 \600\ per fund, depending on the
particular facts and circumstances and current derivatives risk
management practices of the fund. These estimated costs are
attributable to the following activities: (1) Developing and
implementing policies and procedures to comply with the proposed rule's
requirement that, at least once each business day, the fund maintains
the required qualifying coverage assets in respect of its derivatives
transactions; (2) planning, coding, testing, and installing any system
modifications relating to the asset segregation requirements; and (3)
preparing training materials and administering training sessions for
staff in affected areas.
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    \600\ See supra note 570.
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    As we discussed above, a fund that is part of a fund complex would
likely benefit from economies of scale and incur costs closer to the
low-end of the estimated range of costs, while a standalone fund is
more likely to incur costs closer to the higher-end of the estimated
range of costs. Our staff also estimates that a standalone fund that is
a light or moderate user of derivatives may choose to comply with the
proposed rule by implementing a less automated system, and thus be more
likely to incur costs closer to the low-end of the estimated range of
costs. We anticipate that if there is demand to develop systems and
tools related to the asset segregation requirements, market
participants (or other third parties) may develop programs and
applications that a fund could purchase at a cost likely less than our
estimated cost to develop the programs and applications internally.
    Staff also estimates that each fund would incur ongoing costs
related to implementing the asset segregation requirements under
proposed rule 18f-4. Staff estimates that such costs would range from
65% to 75% of the one-time costs discussed above.\601\ Thus, staff
estimates that a fund would incur ongoing annual costs associated with
the asset segregation requirements that would range from $16,250 to
$56,250.\602\ These costs are attributable to the following activities:
(1) At least once each business day, the fund verifies that it
maintains the required qualifying coverage assets in respect of its
derivatives transactions; (2) systems maintenance; and (3) additional
staff training.
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    \601\ In estimating the total quantified costs of our proposed
rule, we estimate that the asset segregation requirements (as
compared with the portfolio limitation requirements) would likely
impose ongoing costs that are proportionately larger than initial
costs (e.g., because of the need to determine and identify
qualifying coverage assets each business day). Accordingly, and
based on staff experience and outreach, we estimate that these
ongoing costs would range from 65% to 75% of the initial costs. See
supra notes 570 and 574.
    \602\ This estimate is based on the following calculations: 0.65
x $25,000 = $16,250; 0.75 x $75,000 = $56,250.
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    As discussed above in section IV.D.1, in the DERA staff analysis,
68% of all of the sampled funds did not have any exposure to
derivatives transactions. These funds thus do not appear to use
derivatives transactions or, if they do use them, do not appear to do
so to a material extent. Staff estimates that the remaining 32% of
funds (3,831 funds \603\) would seek to rely on the proposed rule, and
therefore comply with the rule's asset segregation requirements. As
with the other quantified costs we discuss in this Release, we believe
that many funds belong to a fund complex and are likely to experience
economies of scale. We therefore expect that the lower-end of the
estimated range of costs ($25,000 in one-time costs; $16,250 in annual
costs) better reflects the total costs likely to be incurred by many
funds.
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    \603\ This estimate is based on the following calculation:
11,973 funds x 32% = 3,831 funds. See supra note 578.
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    The proposed asset segregation requirements may also impose
indirect costs, such as the potential reduction in fund returns that
could result if funds are required to segregate cash and cash
equivalents, rather than potentially higher-yielding liquid assets
(such as equities, as permitted under existing staff guidance). We are
unable to quantify this cost because we do not have sufficient data
with respect to the nature and extent to which funds segregate assets
under existing staff

guidance, or sufficient data to determine the amount of the reduction
in return under the proposed rule. However, because the proposed rule
would permit a fund to reduce its mark-to-market and risk-based
coverage amounts by the value of assets that represent variation margin
and initial margin, respectively, such costs are likely mitigated. In