18. Would the proposed derivatives risk manager requirement raise
any particular challenges for funds with smaller advisers and, if so,
what could we do to help mitigate these challenges? For example, should
we modify the rule to permit funds to authorize the use of third
parties not employed by the adviser to administer the program and, if
so, under what conditions? Why or why not? Would allowing third parties
to act as derivatives risk managers enhance the program by allowing
specialized personnel to administer the program or detract from it by
allowing for a derivatives risk manager who may not be as focused on
the specific risks of the particular fund or as accountable to its
board? Would the proposed requirement that a fund reasonably segregate
derivatives risk management from portfolio management pose particular
challenges for funds with smaller advisers? If so, how and why, and
would additional guidance on this proposed requirement or changes to
the proposed rule be useful? Conversely, would this proposed
requirement (which does not prescribe how funds must segregate
functions) provide appropriate flexibility for funds with smaller
advisers?
    19. Rule 38a-1(c) under the Investment Company Act prohibits
officers, directors, and employees of the fund and its adviser from,
among other things, coercing or unduly influencing a fund's chief
compliance officer in the

performance of his or her duties. Should we include such a prohibition
on unduly influencing a fund's derivatives risk manager in the proposed
rule? Why or why not?
    20. Should we include any other program administration
requirements? If so, what? For example, should we include a requirement
for training staff responsible for day-to-day management of the
program, or for portfolio managers, senior management, and any
personnel whose functions may include engaging in, or managing the risk
of, derivatives transactions? If we require such training, should that
involve setting minimum qualifications for staff responsible for
carrying out the requirements of the program? Why or why not? Should we
require training and education with respect to any new derivatives
instruments that a fund may trade? Why or why not? Should we require a
new instrument review committee?
3. Required Elements of the Program
a. Risk Identification and Assessment
    The proposed program requirement would require a fund to identify
and assess its derivatives risks in order to manage these risks.\117\
It would require that the fund's identification and assessment take
into account the fund's other investments as well as its derivatives
transactions. An appropriate assessment of derivatives risks generally
involves assessing how a fund's derivatives may interact with the
fund's other investments or whether the fund's derivatives have the
effect of helping the fund manage risks. For example, the risks
associated with a currency forward would differ if a fund is using the
forward to hedge the fund's exposure to currency risk associated with a
fund investment denominated in a foreign currency or, conversely, to
take a speculative position on the relative price movements of two
currencies. We believe that by assessing its derivatives use
holistically, a fund will be better positioned to implement a
derivatives risk management program that does not over- or understate
the risks its derivatives use may pose. Accordingly, we believe that
this approach would result in a more-tailored derivatives risk
management program.
---------------------------------------------------------------------------

    \117\ Proposed rule 18f-4(c)(1)(i).
---------------------------------------------------------------------------

    The proposed rule would define the derivatives risks that must be
identified and managed to include leverage, market, counterparty,
liquidity, operational, and legal risks, as well as any other risks the
derivatives risk manager deems material.\118\ In the context of a
fund's derivatives transactions:
---------------------------------------------------------------------------

    \118\ Proposed rule 18f-4(a). In the case of funds that are
limited derivatives users under the proposed rule, the definition
would include any other risks that the fund's investment adviser (as
opposed to the fund's derivatives risk manager) deems material,
because a fund that is a limited derivatives user would be exempt
from the requirement to adopt a derivatives risk management program
(and therefore also exempt from the requirement to have a
derivatives risk manager). See infra section II.E.
---------------------------------------------------------------------------

     Leverage risk generally refers to the risk that
derivatives transactions can magnify the fund's gains and losses; \119\
---------------------------------------------------------------------------

    \119\ See, e.g., Independent Directors Council, Board Oversight
of Derivatives Task Force Report (July 2008), at 12 (``2008 IDC
Report'').
---------------------------------------------------------------------------

     Market risk generally refers to risk from potential
adverse market movements in relation to the fund's derivatives
positions, or the risk that markets could experience a change in
volatility that adversely impacts fund returns and the fund's
obligations and exposures; \120\
---------------------------------------------------------------------------

    \120\ Funds should consider market risk together with leverage
risk because leveraged exposures can magnify such impacts. See,
e.g., NAPF, Derivatives and Risk Management Made Simple (Dec. 2013),
available at https://www.jpmorgan.com/cm/BlobServer/is_napfms2013.pdf?blobkey=id&blobwhere=1320663533358&blobheader=application/pdf&blobheadername1=Cache-Control&blobheadervalue1=private&blobcol=urldata&blobtable=MungoBlobs
.
---------------------------------------------------------------------------

     Counterparty risk generally refers to the risk that a
counterparty on a derivatives transaction may not be willing or able to
perform its obligations under the derivatives contract, and the related
risks of having concentrated exposure to such a counterparty; \121\
---------------------------------------------------------------------------

    \121\ See, e.g., Nils Beier, et al., Getting to Grips with
Counterparty Risk, McKinsey Working Papers on Risk, Number 20 (June
2010).
---------------------------------------------------------------------------

     Liquidity risk generally refers to risk involving the
liquidity demands that derivatives can create to make payments of
margin, collateral, or settlement payments to counterparties;
     Operational risk generally refers to risk related to
potential operational issues, including documentation issues,
settlement issues, systems failures, inadequate controls, and human
error; \122\ and
---------------------------------------------------------------------------

    \122\ See, e.g., 2008 IDC Report, supra note 119; RMA, Statement
on best practices for managing risk in derivatives transactions
(2004) (``Statement on best practices for managing risk in
derivatives transactions''), available at http://www.rmahq.org/securities-lending/best-practices.
---------------------------------------------------------------------------

     Legal risk generally refers to insufficient documentation,
insufficient capacity or authority of counterparty, or legality or
enforceability of a contract.\123\
---------------------------------------------------------------------------

    \123\ See, e.g., Raimonda Martinkut[edot]-Kaulien[edot], Risk
Factors in Derivatives Markets, 2 Entrepreneurial Business and
Economics Review 4 (2014); Capital, Margin, and Segregation
Requirements for Security-Based Swap Dealers and Major Security-
Based Swap Participants and Capital and Segregation Requirements for
Broker-Dealers, Exchange Act Release No. 86175 (June 21, 2019), 84
FR 43872 (Aug. 22, 2019), n.1055 (``Capital Margin Release'')
(``Market participants face risks associated with the financial and
legal ability of counterparties to perform under the terms of
specific transactions''); see also Office of the Comptroller of the
Currency, Risk Management of Financial Derivatives, Comptroller's
Handbook (Jan. 1997) (narrative), (Feb. 1998) (procedures).
    Because derivatives contracts that are traded over the counter
are not standardized, they bear a certain amount of legal risk in
that poor draftsmanship, changes in laws, or other reasons may cause
the contract to not be legally enforceable against the counterparty.
See, e.g., Comprehensive Risk Management of OTC Derivatives, supra
note 124. For example, some netting agreements or qualified
financial contracts contain so-called ``walkaway'' clauses, such as
provisions that, under certain circumstances, suspend, condition, or
extinguish a party's payment obligation under the contract. These
provisions would not be enforceable where the Federal Deposit
Insurance Act is applicable. See 12 U.S.C 1821(e)(8)(G). As another
example, many derivatives contracts and prime brokerage agreements
that hedge funds and other counterparties had entered into with
Lehman Brothers included cross-netting that allowed for payments
owed to and from different Lehman affiliates to be offset against
each other, and cross-liens that granted security interests to all
Lehman affiliates (rather than only the specific Lehman entity
entering into a particular transaction). In 2011, the U.S.
Bankruptcy Court for the Southern District of New York held that
cross-affiliate netting provisions in an ISDA swap agreement were
unenforceable against a debtor in bankruptcy. In the Matter of
Lehman Brothers Inc., Bankr. Case No. 08-01420 (JPM) (SIPA), 458
B.R. 134, 1135-137 (Bankr. S.D.N.Y. Oct. 4, 2011).

We believe these risks are common to most derivatives
transactions.\124\
---------------------------------------------------------------------------

    \124\ See Numerix, Comprehensive Risk Management of OTC
Derivatives; A Tricky Endeavor (July 16, 2013), available at http://www.numerix.com/comprehensive-risk-management-otc-derivatives-tricky-endeavor (``Comprehensive Risk Management of OTC
Derivatives''); Statement on best practices for managing risk in
derivatives transactions, supra note 122; 2008 IDC Report, supra
note 119; Lawrence Metzger, Derivatives Danger: internal auditors
can play a role in reigning in the complex risks associated with
financial instruments, FSA Times (2011), available at http://www.theiia.org/fsa/2011-features/derivatives-danger (``FSA Times
Derivatives Dangers''). See also 17 CFR 240.15c3-4(a) (``An OTC
derivatives dealer shall establish, document, and maintain a system
of internal risk management controls to assist it in managing the
risks associated with its business activities, including market,
credit, leverage, liquidity, legal, and operational risks.'').
Nonbank security-based swap dealers and broker-dealers authorized to
use internal models to compute net capital also are subject to rule
15c3-4. See Capital Margin Release, supra note 123.
---------------------------------------------------------------------------

    The proposed rule would not limit a fund's identification and
assessment of derivatives risks to only those specified in the rule.
The proposed definition of the term ``derivatives risks'' includes any
other risks a fund's derivatives risk manager deems material.\125\ Some
derivatives transactions could pose certain idiosyncratic risks. For
example,

some derivatives transactions could pose a risk that a complex OTC
derivative could fail to produce the expected result (e.g., because
historical correlations change or unexpected merger events occur) or
pose a political risk (e.g., events that affect currencies).
---------------------------------------------------------------------------

    \125\ See supra note 118.
---------------------------------------------------------------------------

    Commenters to the 2015 proposal generally supported its requirement
that a fund engage in a process of identifying and evaluating the
potential risks posed by its derivatives transactions.\126\
---------------------------------------------------------------------------

    \126\ See, e.g., ICI Comment Letter I; Comment Letter of the
Consumer Federation of America (Mar. 28, 2016) (``CFA Comment
Letter'').
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed requirement to
identify and assess a fund's derivatives risks, as well as the proposed
definition of the term ``derivatives risks.''
    21. Is the proposed definition of ``derivatives risks''
sufficiently clear? Why or why not?
    22. Are the categories of risks that we have identified in the
proposed rule appropriate? Why or why not? Should we remove any of the
identified risk categories? If so, what categories should be removed,
and why? Should we add any other specified categories of risks that
should be addressed? If so, what additional categories and why? Should
we provide further guidance regarding the assessment of any of these
risks? If so, what should the guidance be, and why?
    23. Do commenters believe the proposed approach with respect to
risk identification and assessment is appropriate? Why or why not?
    24. Do funds currently assess the risks associated with their
derivatives transactions by taking into account both their derivatives
transactions and other investments? If so, how do they perform this
assessment? Are there certain derivatives transactions whose risks do
not involve an assessment of other investments in a fund's portfolio?
If so, which derivatives transactions, and why?
    25. Should we require policies and procedures to include an
assessment of particular risks based on an evaluation of certain
identified risk categories as proposed? If not, why?
b. Risk Guidelines
    The proposed rule would require a fund's program to provide for the
establishment, maintenance, and enforcement of investment, risk
management, or related guidelines that provide for quantitative or
otherwise measurable criteria, metrics, or thresholds of the fund's
derivatives risks (the ``guidelines'').\127\ The guidelines would be
required to specify levels of the given criterion, metric, or threshold
that a fund does not normally expect to exceed and the measures to be
taken if they are exceeded. The proposed guidelines requirement is
designed to address the derivatives risks that a fund would be required
to monitor routinely as part of its program, and to help the fund
identify when it should respond to changes in those risks. We
understand that many funds today have established risk management
guidelines, with varying degrees of specificity.
---------------------------------------------------------------------------

    \127\ Proposed rule 18f-4(c)(1)(ii).
---------------------------------------------------------------------------

    The proposed rule would not impose specific risk limits for these
guidelines. It would, however, require a fund to adopt guidelines that
provide for quantitative thresholds that the fund determines to be
appropriate and that are most pertinent to its investment portfolio,
and that the fund reasonably determines are consistent with its risk
disclosure.\128\ Requiring a fund to establish discrete metrics to
monitor its derivatives risks would require the fund and its
derivatives risk manager to measure changes in its risks regularly, and
this in turn is designed to lead to more timely steps to manage these
risks. Moreover, requiring a fund to identify its response when these
metrics have been exceeded would provide the fund's derivatives risk
manager with a clear basis from which to determine whether to involve
other persons, such as the fund's portfolio management or board of
directors, in addressing derivatives risks appropriately.\129\
---------------------------------------------------------------------------

    \128\ See, e.g., Mutual Fund Directors Forum, Risk Principles
for Fund Directors: Practical Guidance for Fund Directors on
Effective Risk Management Oversight (Apr. 2010), available at http://www.mfdf.org/images/Newsroom/Risk_Principles_6.pdf (``MFDF
Guidance'').
    \129\ See proposed rule 18f-4(c)(1)(v); see also infra section
II.B.3.e.
---------------------------------------------------------------------------

    Funds may use a variety of approaches in developing guidelines that
comply with the proposed rule.\130\ This would draw on the risk
identification element of the program and the scope and objectives of
the fund's use of derivatives. A fund could use quantitative metrics
that it determines would allow it to monitor and manage its particular
derivatives risks most appropriately. We understand that today funds
use a variety of quantitative models or methodologies to measure the
risks associated with the derivatives transactions. With respect to
market risk, we understand that funds commonly use VaR, stress testing,
or horizon analysis. Concentration risk metrics are also being used in
connection with monitoring counterparty risk (e.g., requiring specific
credit committee approval for transactions with a notional exposure in
excess of a specified amount, aggregated with other outstanding
positions with the same of affiliated counterparties). In addition,
liquidity models have been designed to address liquidity risks over
specified periods (e.g., models identifying margin outlay requirements
over a specified period under specified volatility scenarios).
---------------------------------------------------------------------------

    \130\ See, e.g., Comprehensive Risk Management of OTC
Derivatives, supra note 124; Statement on best practices for
managing risk in derivatives transactions, supra note 122; 2008 IDC
Report, supra note 119.
---------------------------------------------------------------------------

    In developing the guidelines, a fund generally should consider how
to implement them in view of its investment portfolio and the fund's
disclosure to investors. For example, a fund may wish to consider
establishing corresponding investment size controls or lists of
approved transactions across the fund.\131\ A fund generally should
consider whether to implement appropriate monitoring mechanisms
designed to allow the fund to abide by the guidelines, including their
quantitative metrics.
---------------------------------------------------------------------------

    \131\ A fund could also consider establishing an ``approved
list'' of specific derivatives instruments or strategies that may be
used, as well as a list of persons authorized to engage in the
transactions on behalf of the fund. A fund may wish to provide new
instruments (or instruments newly used by the fund) additional
scrutiny. See, e.g., MFDF Guidance, supra note 128, at 8.
---------------------------------------------------------------------------

    While the 2015 proposal did not require funds to adopt risk
guidelines, commenters on the 2015 proposal generally supported the
concept of a requirement that a fund adopt and implement policies and
procedures reasonably designed to manage the risks of its derivatives
transactions, including by monitoring whether those risks continue to
be consistent with any investment guidelines established by the fund or
the fund's investment adviser.\132\
---------------------------------------------------------------------------

    \132\ See, e.g., BlackRock Comment Letter; CRMC Comment Letter;
ICI Comment Letter I.
---------------------------------------------------------------------------

    We request comment on the proposed rule's guidelines requirement.
    26. Should we require, as proposed, a fund's program to provide for
the establishment, maintenance, and enforcement of investment, risk
management, or related guidelines? Why or why not? Should we require,
as proposed, that the guidelines provide for quantitative or otherwise
measurable criteria, metrics, or thresholds of the fund's derivatives
risks? Why or why not? If not, is there an alternative program element
that would be more appropriate in promoting effective derivatives risk
management? Should we prescribe particular tools or

approaches that funds must use to manage specific risks related to
their use of derivatives? For example, should we require funds to
manage derivatives' liquidity risks by maintaining highly liquid assets
to cover potential future losses and other liquidity demands?
    27. Should we require a specific number or range of numbers of
guidelines that a fund should establish? For example, should we require
a fund to establish a minimum of 2, 3, 4, or more different guidelines
to cover a range of different risks? Why or why not?
    28. Do funds currently adopt, and monitor compliance with, such
guidelines? If so, do these guidelines provide for quantitative or
otherwise measurable criteria, metrics, or thresholds of the funds'
derivatives risks? If so, what criteria, metrics, or thresholds are
provided for? Should we require that funds use specific risk management
tools? If so, what tools should we require?
    29. Should we specify a menu of guideline categories that all funds
should use to promote consistency in risk management among funds? For
example, should we identify certain commonly-used types of guidelines
such as VaR, notional amounts, and duration, and require funds to
choose among those commonly-used types? If we were to do so, which
metrics should we allow funds to use? Would such a menu become stale as
new risk measurement tools are developed?
    30. Should we require, as proposed, that the guidelines specify set
levels of a given criterion, metric, or threshold that the fund does
not generally expect to exceed? Why or why not? If so, how would these
levels be set or calculated? Should we instead set maximum levels for
certain guidelines a fund would not exceed?
    31. Should we require that a fund publicly disclose the guidelines
it uses and the quantitative levels selected? If so, where (for
example, in the fund's prospectus, website, or on Form N-PORT or N-
CEN)? Should we instead require that funds confidentially report to us
the guidelines they use and the quantitative levels selected? If so, on
what form should they report this information?
    32. Should we require, as proposed, that the guidelines identify
measures to be taken when the fund exceeds a criterion, metric, or
threshold in the fund's guidelines? Why or why not?
    33. Should we require any form of public disclosure or confidential
reporting to us if a fund were to exceed its risk guidelines? Would
such reporting or disclosure result in funds setting guidelines that
are so restrictive or lax that they would be unlikely to be useful as a
monitoring and risk management tool?
    34. Should the rule require the guidelines to provide for other
elements? If so, what elements and why?
c. Stress Testing
    The proposed rule would require a fund's program to provide for
stress testing to evaluate potential losses to the fund's
portfolio.\133\ We understand that, as a derivatives risk management
tool, stress testing is effective at measuring different drivers of
derivatives risks, including non-linear derivatives risks that may be
understated by metrics or analyses that do not focus on periods of
stress. Stress testing is an important tool routinely used in other
areas of the financial markets and in other regulatory regimes, and we
understand that funds engaging in derivatives transactions have
increasingly used stress testing as a risk management tool over the
past decade.\134\ The Commission has also required certain types of
funds to conduct stress tests or otherwise consider the effect of
stressed market conditions on their portfolios.\135\ We believe that
requiring a fund to stress test its portfolio would help the fund
better manage its derivatives risks and facilitate board oversight.
---------------------------------------------------------------------------

    \133\ Proposed rule 18f-4(c)(1)(iii); see also infra section
II.D.6.a (discussing an alternative to the proposed limit on fund
leverage risk that would rely on a stress testing framework). The
proposed rule would require a fund that is required to establish a
derivatives risk mangement program to stress test its portfolio,
that is, all of the fund's investments, and not just the fund's
derivatives transactions.
    \134\ See, e.g., Comment Letter of Investment Company Institute
(Oct. 8, 2019) (``ICI Comment Letter III'') (stating that, based on
a survey of member firms, many funds perform ex ante stress
testing).
    \135\ See rule 2a-7 under the Investment Company Act [17 CFR
270.2a-7]; see also rule 22e-4 under the Investment Company Act [17
CFR 270.22e-4] (requiring a fund subject to the rule to assess its
liquidity risk by considering, for example, its investment strategy
and portfolio investment liquidity under reasonably foreseeable
stressed conditions).
---------------------------------------------------------------------------

    We also believe that stress testing would serve as an important
complement to the proposed VaR-based limit on fund leverage risk, as
well as any VaR testing under the fund's risk guidelines.\136\ During
periods of stress, returns, correlations, and volatilities tend to
change dramatically over a very short period of time. Losses under
stressed conditions--or ``tail risks''--would not be reflected in VaR
analyses that are not calibrated to a period of market stress and that
do not estimate losses that occur on the trading days with the highest
losses.\137\ Requiring funds to stress test their portfolios would
provide information regarding these ``tail risks'' that VaR and other
analyses may miss.
---------------------------------------------------------------------------

    \136\ See proposed rule 18f-4(c)(2); infra section II.D.
    \137\ The proposed rule would not require a fund to implement a
stressed VaR test. See infra section II.D.1.
---------------------------------------------------------------------------

    Under the proposed rule, the fund's stress tests would be required
to evaluate potential losses to the fund's portfolio in response to
extreme but plausible market changes or changes in market risk factors
that would have a significant adverse effect on the fund's
portfolio.\138\ The stress tests also would have to take into account
correlations of market risk factors and resulting payments to
derivatives counterparties.\139\ We believe that these requirements
would promote stress tests that produce results that are valuable in
appropriately managing derivatives risks by focusing the testing on
extreme events that may provide actionable information to inform a
fund's derivatives risk management.\140\ We understand that funds
commonly consider the following market risk factors: liquidity,
volatility, yield curve shifts, sector movements, or changes in the
price of the underlying reference security or asset.\141\ In addition,
we believe it is important for a fund's stress testing to take into
account payments to counterparties, as losses can result when the
fund's portfolio securities decline in value at the same time that the
fund is required to make additional payments under its derivatives
contracts.\142\
---------------------------------------------------------------------------

    \138\ Proposed rule 18f-4(c)(1)(iii).
    \139\ Id.
    \140\ Krishan Mohan Nagpal, Designing Stress Scenarios for
Portfolios, 19 Risk Management 323 (2017).
    \141\ See, e.g., ICI Comment Letter I; Thomas Breuer, et al.,
How to Find Plausible, Severe, and Useful Stress Scenarios,
International Journal of Central Banking 205 (Sept. 2009).
    \142\ See OppenheimerFunds Settled Action, supra note 22.
---------------------------------------------------------------------------

    To inform a fund's derivatives risk management effectively, a fund
should stress test its portfolio with a frequency that would best
position the derivative risk manager to appropriately administer, and
the board to appropriately oversee, a fund's derivatives risk
management, taking into account the frequency of change in the fund's
investments and market conditions. The proposed rule, therefore, would
permit a fund to determine the frequency of stress tests, provided that
the fund must conduct stress testing at least weekly. In establishing
such frequency, a fund

must take into account the fund's strategy and investments and current
market conditions. For example, a fund whose strategy involves a high
portfolio turnover might determine to conduct stress testing more
frequently than a fund with a more static portfolio. A fund similarly
might conduct more frequent stress tests in response to increases in
market stress. The minimum weekly stress testing frequency is designed
to balance the potential benefits of relatively frequent stress testing
with the burdens of administering stress testing.\143\ We also
considered a less frequent requirement, such as monthly stress testing.
A less frequent requirement, however, may fail to provide a fund's
derivatives risk manager adequate and timely insight into the fund's
derivatives risk, particularly where the fund has a high portfolio
turnover. In determining this minimum frequency, we also took into
account that this requirement would only apply to funds that do not
qualify for the limited derivatives user exception because they use
derivatives in more than a limited way. In addition, in view of the
proposed rule's internal reporting and periodic review requirements,
the weekly stress testing minimum would provide a fund's derivatives
risk manager and board with multiple sets of stress testing results,
which would allow them to observe trends and how the results may change
over time.\144\
---------------------------------------------------------------------------

    \143\ We recognize that the costs associated with stress testing
may increase with the frequency of conducting such tests. We
understand, however, that once a fund initially implements a stress
testing framework, subsequent stress tests could be automated and,
as a result, be less costly.
    \144\ See infra sections II.B.3.e and II.C.
---------------------------------------------------------------------------

    Although the 2015 proposal's risk management program did not
include a stress testing requirement, some commenters stated that
stress testing would serve as an important component of derivatives
risk management and recommended that the Commission require a fund's
designated risk manager to perform stress testing and report the
results to the fund's board.\145\
---------------------------------------------------------------------------

    \145\ See, e.g., Comment Letter of Blackstone Alternative
Investment Advisors LLC (Mar. 28, 2016) (``Blackstone Comment
Letter''); Comment Letter of Invesco Management Group, Inc. (Mar.
28, 2016) (``Invesco Comment Letter''); see also ICI Comment Letter
III.
---------------------------------------------------------------------------

    We request comment on the proposed rule's stress testing
requirement.
    35. Should we require, as proposed, that funds conduct stress
testing as part of the program requirement? Why or why not? How, if at
all, would stress testing serve as a complement for other risk
measurement tools, such as VaR? What does stress testing capture as
part of derivatives risk management that other tools do not, and why?
    36. Should the rule require funds to conduct a particular type of
stress testing? If so, what type, and what should the required elements
be? For example, should the rule require funds to conduct scenario
analysis?
    37. Should the rule identify specific stress events to be applied?
Should any required stress events vary based on the primary risks of
particular funds?
    38. Do funds currently conduct stress testing? If so, what types of
stress testing, for what purposes, and how does the stress testing that
funds currently conduct differ from the proposed rule's requirement?
    39. For funds that currently conduct stress testing, how frequently
do they conduct it? Daily, weekly, or monthly? Why? Does it depend on
the type of stress testing? On the investment objective or strategy of
a fund? With what minimum frequency should the rule require stress
testing be conducted? For example, instead of weekly tests should we
require daily tests? Conversely should we allow longer periods of time
between tests, such as monthly, or quarterly? Why? Should we require
more frequent testing for funds with some investment objectives or
strategies than other funds? If so, for which objectives or strategies
should we require more frequent testing?
    40. Is the proposed rule's reference to ``extreme but plausible
market changes or changes in market risk factors'' sufficiently clear?
Should we identify more quantitative changes, such as the worst change
in a specific risk factor seen in the last 10, 20, or 50 years? Is the
proposed rule's reference to ``significant adverse effect''
sufficiently clear? Should we instead identify quantitative levels of
NAV change, such as a drop of 20, 30, or 50% of the fund's NAV?
    41. Should we require stress tests to include certain identified
market risk factors such as changes in interest rates or spreads,
market volatility, market liquidity, or other market factors? If so,
which market risk factors should we identify, and why? If we were to
identify certain market risk factors to be tested, should we require a
fund to take action (such as reporting to its board or to the
Commission, or reducing its derivatives usage) if a stress test were to
show that one of these factors would result in the fund losing a
certain percentage of its NAV? If so, what level of NAV, what types of
risk factors, and what types of action should we consider?
    42. Should we require, as proposed, that funds take into account
their strategy, investments, and current market conditions in
considering the appropriate frequency for a fund's stress tests? Why or
why not? Should we require, as proposed, that funds to take into
account correlations of market risk factors and payments to derivatives
counterparties as part of the fund's stress tests? Why or why not?
Would any additional guidance help funds to better understand, and more
consistently conduct, the stress tests that the proposed rule would
require?
    43. We discuss and request comment below on the proposed rule's
requirements to provide information to a fund's board of directors,
including the derivatives risk manager's analysis of a fund's stress
testing. In addition to providing this information to the board, should
we require funds to disclose stress test results to investors or report
them confidentially to us? If so, what information should be disclosed
or reported?
d. Backtesting
    The proposed rule would require a fund to backtest the results of
the VaR calculation model used by the fund in connection with the
relative VaR or absolute VaR test, as applicable, as part of the
program.\146\ This proposed requirement is designed to require a fund
to monitor the effectiveness of its VaR model. It would assist a fund
in confirming the appropriateness of its model and related assumptions
and help identify when funds should consider model adjustments.\147\ We
are proposing this requirement in light of the central role that VaR
plays in the proposed VaR-based limit on leverage risk. This also is
consistent with the comments we received on the 2015 proposal
suggesting that we require backtesting, which we had not included in
that proposal.\148\
---------------------------------------------------------------------------

    \146\ See proposed rule 18f-4(c)(1)(iv).
    \147\ Some commenters on the 2015 proposal suggested that the
Commission require backtesting of a fund's VaR calculation models.
See, e.g., Blackstone Comment Letter; Comment Letter of Investment
Company Institute (Sept. 27, 2016) (``ICI Comment Letter II'');
Aviva Comment Letter; Comment Letter of the Global Association of
Risk Professionals (Mar. 21, 2016) (``GARP Comment Letter'').
    \148\ See, e.g., Blackstone Comment Letter; ICI Comment Letter
II; Aviva Comment Letter; GARP Comment Letter.
---------------------------------------------------------------------------

    Specifically, the proposed backtesting requirement provides that,
each business day, the fund must compare its actual gain or loss for
that business day with the VaR the fund had calculated for that day.
For purposes of the backtesting requirement, the VaR would be estimated
over a one-trading day time horizon. For example, on Monday at the

end of the trading day, a fund would analyze whether the gain or loss
it experienced that day exceeds the VaR calculated for that day. In
this backtesting example, the fund could calculate the VaR for Monday
on Friday evening (after Friday trading closes) or Monday morning
(before Monday trading begins). The fund would have to identify as an
exception any instance in which the fund experiences a loss exceeding
the corresponding VaR calculation's estimated loss. This approach is
generally consistent with the practice of firms that use internal
models to compute regulatory capital and other regulatory
approaches.\149\ Because the proposed rule would require that the
fund's backtest be conducted using a 99% confidence level and over a
one-day time horizon, and assuming 250 trading days in a year, a fund
would be expected to experience a backtesting exception approximately
2.5 times a year, or 1% of the 250 trading days.\150\ If the fund were
consistently to experience backtesting exceptions more (or less)
frequently, this could suggest that the fund's VaR model may not be
effectively taking into account and incorporating all significant,
identifiable market risk factors associated with a fund's investments,
as required by the proposed rule.\151\
---------------------------------------------------------------------------

    \149\ See, e.g., rule 15c3-1e under the Exchange Act [17 CFR
240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1) (``On the last
business day of each quarter, the broker or dealer must identify the
number of backtesting exceptions of the VaR model, that is, the
number of business days in the past 250 business days, or other
period as may be appropriate for the first year of its use, for
which the actual net trading loss, if any, exceeds the corresponding
VaR measure.''); CESR Global Guidelines, supra note 94 (``The UCITS
should carry out the back testing program at least on a monthly
basis, subject to always performing retroactively the comparison for
each business day,'' i.e., ``provid[ing] for each business day a
comparison of the one-day value-at-risk measure generated by the
UCITS model for the UCITS' end-of-day positions to the one-day
change of the UCITS' portfolio value by the end of the subsequent
business day''); see also infra note 152 (discussing frequency
variations for backtesting requirements).
    \150\ The proposed backtesting requirement would be based on a
one-day time horizon. See infra section II.D.4 (discussing the
proposed VaR model requirements that would be based on a twenty-day
time horizon).
    \151\ If 10 or more exceptions are generated in a year from
backtesting that is conducted using a 99% confidence level and over
a one-day time horizon, and assuming 250 trading days in a year, it
is statistically likely that such exceptions are a result of a VaR
model that is not accurately estimating VaR. See, e.g., Philippe
Jorion, Value at Risk: The New Benchmark for Managing Financial Risk
(3d ed. 2006), at 149-150 (``Jorion''). See also rule 15c3-1e under
the Exchange Act (requiring backtesting of VaR models and the use of
a multiplication factor based on the number of backtesting
exceptions).
---------------------------------------------------------------------------

    The proposed rule would require funds to conduct a backtest each
day so that a fund and its derivatives risk manager could more readily
and efficiently adjust or calibrate its VaR calculation model and,
therefore, could more effectively manage the risks associated with its
derivatives use. We understand that some funds perform these
calculations less frequently than daily.\152\ We are proposing a daily
backtesting requirement because market risk factors and fund
investments are dynamic, which might result in frequent changes to the
accuracy and effectiveness of a VaR model and calculations using the
model. Some commenters on the 2015 proposal supported a backtesting
requirement with a daily frequency.\153\ We also believe that the
additional costs associated with a daily backtesting requirement would
be limited because a fund would be required to calculate its portfolio
VaR each business day to satisfy the proposed limits on fund leverage
discussed in section II.D of this release.
---------------------------------------------------------------------------

    \152\ See, e.g., CESR Global Guidelines, supra note 94 (``The
UCITS should carry out the back testing program at least on a
monthly basis, subject to always performing retroactively the
comparison for each business day,'' i.e., ``provid[ing] for each
business day a comparison of the one-day value-at-risk measure
generated by the UCITS model for the UCITS' end-of-day positions to
the one-day change of the UCITS' portfolio value by the end of the
subsequent business day''); Blackstone Comment Letter (suggesting
monthly backtests); Aviva Comment Letter (recommending reporting to
the Commission on a semi-annual basis if a fund experienced a
certain number of backtest exceptions). Cf. rule 15c3-1e under the
Exchange Act [17 CFR 240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1)
(``On the last business day of each quarter, the broker or dealer
must identify the number of backtesting exceptions of the VaR model,
that is, the number of business days in the past 250 business days,
or other period as may be appropriate for the first year of its use,
for which the actual net trading loss, if any, exceeds the
corresponding VaR measure.'').
    \153\ See, e.g., GARP Comment Letter; Aviva Comment Letter; ICI
Comment Letter II.
---------------------------------------------------------------------------

    We request comment on the proposed backtesting requirement.
    44. Is the proposed requirement that a fund backtest its VaR model
each business day appropriate? Why or why not? Would less-frequent
backtesting be sufficient? Is backtesting an effective tool to promote
derivatives risk management and VaR model accuracy? Why or why not?
    45. Should the rule specify the number of exceedances, or the
number of consecutive days without an exceedance, that would require
VaR model calibration? Why or why not?
    46. How often do funds that currently use VaR backtest their VaR
models and why? Should the backtesting requirement be less frequent?
For example, should we require a fund to perform backtests weekly,
monthly, or quarterly, in each case considering the one-day value
change for each trading day in the period? Please explain.
    47. For funds that currently backtest their VaR models, how often
and for what reasons do funds recalibrate their VaR models? Are certain
market risk factors or investment types particularly prone to requiring
VaR model recalibrations (as well as backtesting)?
e. Internal Reporting and Escalation
    The proposed rule would require communication between a fund's risk
management and portfolio management regarding the operation of the
program.\154\ We believe these lines of communication are a key part of
derivatives risk management.\155\ Providing portfolio managers with the
insight of a fund's derivatives risk manager is designed to inform
portfolio managers' execution of the fund's strategy and recognize that
portfolio managers will generally be responsible for transactions that
could mitigate or address derivatives risks as they arise. The proposed
rule also would require communication between a fund's derivatives risk
manager and its board, as appropriate. We understand that funds today
often have a dialogue between risk professionals and fund boards.
Requiring a dialogue between a fund's derivatives risk manager and the
fund's board would provide the fund's board with key information to
facilitate its oversight function.
---------------------------------------------------------------------------

    \154\ Proposed rule 18f-4(c)(1)(v).
    \155\ See 2011 IDC Report, supra note 95.
---------------------------------------------------------------------------

    To provide flexibility for funds to communicate among these groups
as they deem appropriate and taking into account funds' own facts and
circumstances, the proposed rule would require a fund's program to
identify the circumstances under which a fund must communicate with its
portfolio management about the fund's derivatives risk management,
including its program's operation.\156\ A fund's program, in addition,
could require that the fund's derivatives risk manager inform the
fund's portfolio management, for example, by meeting with the fund's
portfolio management on a regular and frequent basis, or require that
the fund's portfolio management is notified of the fund's exceedances
or stress tests through software designed to provide automated updates.
---------------------------------------------------------------------------

    \156\ Proposed rule 18f-4(c)(1)(v)(A).
---------------------------------------------------------------------------

    The proposed rule would also require a fund's derivatives risk
manager to communicate material risks to the fund's portfolio
management and, as appropriate, its board of directors.\157\
Specifically, the rule would require the

derivatives risk manager to inform, in a timely manner, persons
responsible for the fund's portfolio management--and the fund's board
of directors, as appropriate--of material risks arising from the fund's
derivatives transactions.\158\ The proposed rule would not require a
fund's derivatives risk manager to escalate these risks to the fund's
board automatically, but would require that the derivatives risk
manager directly inform the fund's board of directors regarding these
material risks if the manager determines board escalation to be
appropriate. A fund's derivatives risk manager, for example, could
determine to inform the fund's adviser's senior officers of material
derivatives risks after informing the fund's portfolio management, and
before informing the fund's board. As another example, a fund's
derivatives risk manager could determine that it would be appropriate
to communicate certain material derivatives risks (for example, those
that put more than a certain percentage of the fund's assets at
imminent risk) to the board at the same time it informs the fund's
portfolio management. We believe that a fund's derivatives risk manager
is best positioned to determine when to appropriately inform the fund's
portfolio management and board of material risks.
---------------------------------------------------------------------------

    \157\ Proposed rule 18f-4(c)(1)(v)(B).
    \158\ Id.
---------------------------------------------------------------------------

    The proposed rule would require that these material risks include
any material risks identified by the fund's guideline exceedances or
stress testing. For example, an unexpected risk may arise due to a
sudden market event, such as a downgrade of a large investment bank
that is a substantial derivatives counterparty to the fund. This
requirement is designed to inform portfolio managers of material risks
identified by a fund's derivatives risk management function so that
portfolio managers can take them into account in managing the fund's
portfolio and address or mitigate them as appropriate. It also would
facilitate board oversight by empowering the derivatives risk manager
to escalate a material risk directly to the fund's board where
appropriate. Requiring that a fund's derivatives risk manager have this
direct line of communication with the board regarding material risks
arising from the fund's derivatives transactions is designed to foster
an open and effective dialogue among the derivatives risk manager and
the board.
    We request comment on the internal reporting and escalation
elements of the proposed program requirement.
    48. Are the proposed internal reporting and escalation requirements
appropriate? Why or why not? Should the rule describe the circumstances
under which a fund must inform its portfolio management regarding the
operation of the program, including any exceedances of its guidelines
and the results of its stress tests? Why or why not? If so, what should
the circumstances be and why? Should the rule require a fund to report
to others at the fund or its adviser (e.g., the fund's chief compliance
officer)? If so, who should a fund report to and why?
    49. Should we prescribe the types of internal reporting information
that persons responsible for a fund's portfolio management or the
fund's board should receive, and the means by which these persons
receive such information? Why or why not? If so, what should we
prescribe and why?
    50. Are the proposed requirements to escalate material risks to the
fund's portfolio management (and, as appropriate, the fund's board of
directors) appropriate? Why or why not? Should these material risks
include risks identified by the fund's guideline exceedances or stress
testing? Why or why not? Should a fund's derivatives risk manager be
required to report all material derivatives risks to the fund's board,
as well as to its portfolio management? Why or why not?
    51. Should the rule, as proposed, permit a fund to determine what
risks arising from its derivatives transactions are material to the
fund, for purposes of the proposed escalation requirement? Why or why
not? If so, should the rule specifically require a fund's derivatives
risk manager to make this determination?
    52. Should the rule require the means by which internal reporting
and/or material risk escalation occur? For example, should the rule
specify that certain communications must be in writing? Why or why not?
    53. Should the rule require a fund's derivatives risk manager to
inform the fund's portfolio management regarding the operation of the
program on a regular basis? Why or why not? If so, what should the
frequency be and why?
    54. Should the rule require a fund to report material risks to us?
Why or why not? If so, what should a fund report and how should it be
reported? For example, should a fund be required to report material
exceedances to its guidelines? Why or why not? Should such a report be
confidential?
    55. Should the rule permit a fund to determine whether the material
risk warrants informing the fund's board? Why or why not? If so, which
person or persons at the fund or its adviser should be responsible for
that determination? Should a fund's board always be informed of
material risks regarding the fund's derivatives use? Why or why not? If
so, under what circumstances and frequency should the board be
informed, and why?
    56. Should we require that a fund's derivatives risk manager be
permitted to communicate directly with the fund's board of directors?
If not, how should we otherwise address the concern that a board may
not receive the derivatives risk manager's independent risk assessments
if the derivatives risk manager is not empowered to communicate
directly with the board?
f. Periodic Review of the Program
    The proposed rule would require a fund's derivatives risk manager
to review the program at least annually to evaluate the program's
effectiveness and to reflect changes in the fund's derivatives risks
over time.\159\ The review would apply to the overall program,
including each of the specific program elements discussed above.
---------------------------------------------------------------------------

    \159\ Proposed rule 18f-4(c)(1)(vi).
---------------------------------------------------------------------------

    The periodic review would also cover the VaR model a fund uses to
comply with the proposed VaR-based limit on fund leverage risk and
related matters. As discussed below, the proposed rule would require a
fund to comply with a relative or absolute VaR test.\160\ For the
relative VaR test, the fund would compare its VaR to a ``designated
reference index,'' as defined in the rule and selected by the fund's
derivatives risk manager. The proposed periodic review would therefore
include the VaR calculation model that the fund used in connection with
either of the proposed VaR tests (including the fund's backtesting of
the model) and any designated reference index that the derivatives risk
manager selected, to evaluate whether the calculation model and
designated reference index remain appropriate.
---------------------------------------------------------------------------

    \160\ See proposed rule 18f-4(c)(2); infra section II.D.
---------------------------------------------------------------------------

    We believe that the periodic review of a fund's program and VaR
calculation model is necessary to determine whether the fund is
appropriately addressing its derivatives risks. A fund's derivatives
risk manager, as a result of the review, could determine whether the
fund should update its program, its VaR calculation model, or any
designated reference index. Commenters on the 2015 proposal generally
supported a similar proposed requirement that a fund review and

update its derivatives risk management program at least annually.\161\
---------------------------------------------------------------------------

    \161\ See, e.g., Vanguard Comment Letter.
---------------------------------------------------------------------------

    The proposed rule would not prescribe review procedures or
incorporate specific developments that a derivatives risk manager must
consider as part of its review. We believe a derivatives risk manager
generally should implement periodic review procedures for evaluating
regulatory, market-wide, and fund-specific developments affecting the
fund's program so that it is well positioned to evaluate the program's
effectiveness.
    We believe that a fund should review its program, VaR calculation
model, and designated reference index on at least an annual basis,
because derivatives and fund leverage risks, and the means by which
funds evaluate such risks, can change. The proposed rule would require
at least an annual review so that there would be a recurring dialogue
between a fund's derivatives risk manager and its board regarding the
implementation of the program and its effectiveness. This frequency
also mirrors the minimum period in which the fund's derivatives risk
manager would be required to provide a written report on the
effectiveness of the program to the board.\162\ A fund's derivatives
risk manager could, however, determine that more frequent reviews are
appropriate based on the fund's particular derivatives risks, the
fund's policies and procedures implementing the program, market
conditions, or other facts and circumstances.\163\
---------------------------------------------------------------------------

    \162\ See infra section II.C.2.
    \163\ See also proposed rule 18f-4(c)(2)(iii)(A) (requiring, for
a fund that is not in compliance with the applicable VaR test within
three business days, the derivatives risk manager to report to the
fund's board of directors and explain how and by when (i.e., number
of business days) the derivatives risk manager reasonably expects
that the fund will come back into compliance).
---------------------------------------------------------------------------

    We request comment on the proposed rule's periodic review
requirement.
    57. Should the rule, as proposed, specifically require that a
fund's derivatives risk manager periodically review the program's
effectiveness, including the program's VaR calculation model and any
designated reference index? Why or why not?
    58. Should the rule, as proposed, require this review to take place
at least annually, or should it require a more frequent review, such as
quarterly? Should we, instead, not prescribe a minimum frequency for
the periodic review? Why or why not?
    59. Are there certain review procedures that the proposed rule
should require and/or on which the Commission should provide guidance?
If so, what are they? For example, should the periodic review involve
board input? Should the Commission provide any additional guidance on
regulatory, market-wide, and fund-specific developments that a fund's
review procedures might cover? Why or why not? If so, how?
    60. Should the rule, as proposed, specifically require that other
program elements be periodically reviewed? Why or why not? If so, which
elements and why, and should they be reviewed with the same frequency?

C. Board Oversight and Reporting

    The proposed rule would require: (1) A fund's board of directors to
approve the designation of the fund's derivatives risk manager and (2)
the derivatives risk manager to provide regular written reports to the
board regarding the program's implementation and effectiveness, and
describing any exceedances of the fund's guidelines and the results of
the fund's stress testing.\164\ Requiring a fund's derivatives risk
manager approved by the fund's board and with relevant experience as
determined by the fund's board to be responsible for the day-to-day
administration of the fund's program, subject to board oversight, is
consistent with the way we believe many funds currently manage
derivatives risks.\165\ It is also consistent with a board's duty to
oversee other aspects of the management and operations of a fund.
---------------------------------------------------------------------------

    \164\ Proposed rule 18f-4(c)(5). The board could designate a
committee of directors to receive the report.
    \165\ See, e.g., Comment Letter of the Independent Directors
Council (June 22, 2016) (providing views regarding the appropriate
oversight role of fund directors).
---------------------------------------------------------------------------

    The proposed rule's requirements regarding board oversight and
reporting are designed to further facilitate the board's oversight of
the fund's derivatives risk management.\166\ Board oversight should not
be a passive activity. Consistent with that view, we believe that
directors should understand the program and the derivatives risks it is
designed to manage as well as participate in determining who should
administer the program. They also should ask questions and seek
relevant information regarding the adequacy of the program and the
effectiveness of its implementation. The board should view oversight as
an iterative process. Therefore, the board should inquire about
material risks arising from the fund's derivatives transactions and
follow up regarding the steps the fund has taken to address such risks,
including as those risks may change over time. To facilitate the
board's oversight, the proposed rule, as discussed below, would require
the fund's derivatives risk manager to provide reports to the board.
---------------------------------------------------------------------------

    \166\ Many commenters to the 2015 proposal expressed the view
that the appropriate role of the board in the context of funds'
derivatives risk management is one of oversight. See, e.g., Comment
Letter of Mutual Fund Directors Forum (Mar. 28, 2016) (stating it
has long taken the position that boards and independent trustees
have an important role to play in overseeing the risks associated
with funds' use of derivatives, including the manner in which those
risks are managed); see also Comment Letter of the Independent
Directors Council (Mar. 28, 2016) (``IDC Comment Letter'');
Morningstar Comment Letter.
---------------------------------------------------------------------------

    A fund's board would also be responsible for overseeing a fund's
compliance with proposed rule 18f-4. Rule 38a-1 under the Investment
Company Act requires a fund's board, including a majority of its
independent directors, to approve policies and procedures reasonably
designed to prevent violation of the federal securities laws by the
fund and its service providers.\167\ Rule 38a-1 provides for oversight
of compliance by the fund's adviser and other service providers through
which the fund conducts its activities. Rule 38a-1 would encompass a
fund's compliance obligations with respect to proposed rule 18f-4.
---------------------------------------------------------------------------

    \167\ See rule 38a-1 under the Investment Company Act;
Compliance Programs of Investment Companies and Investment Advisers,
Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR
74714 (Dec. 24, 2003)] (discussing the adoption and implementation
of policies and procedures required under rule 38-1) (``Compliance
Program Release'').
---------------------------------------------------------------------------

1. Board Approval of the Derivatives Risk Manager
    The proposed rule would require a fund's board to approve the
designation of the fund's derivatives risk manager, taking into account
the derivatives risk manager's relevant experience regarding the
management of derivatives risk.\168\ This requirement is designed to
establish the foundation for an effective relationship and line of
communication between a fund's board and its derivatives risk manager,
and to ensure that the board receives information it needs to approve
the designation.\169\ The requirement that the board consider the
derivatives risk manager's relevant experience is designed to provide
flexibility for a fund's board to take into account a derivatives risk
manager's specific experience, rather than the rule taking a more
prescriptive approach in identifying a specific amount or type of
experience that a derivatives risk

manager must have. Detailing a derivatives risk manager's required
experience in the rule would not be practical, given the numerous ways
in which a person could obtain experience with derivatives or risk
management. Any specification in the rule of the specific experience
required to serve as a derivatives risk manager likely would be over-
or under-inclusive and would not take into account the way that any
particular fund uses derivatives. We believe that a fund's board, in
its oversight role, is best-positioned to consider a prospective
derivatives risk manager's experience based on all the facts and
circumstances relevant to the fund in considering whether to approve
the derivatives risk manager's designation.
---------------------------------------------------------------------------

    \168\ Proposed rule 18f-4(c)(5)(i).
    \169\ Cf. rules 22e-4 and 38a-1 under the Investment Company
Act.
---------------------------------------------------------------------------

    Commenters on the 2015 proposal generally supported a requirement
that the board approve a fund's derivatives risk manager, although some
of these commenters objected to the proposed requirement that only a
single individual could serve in that role. These commenters asserted
that requiring the board to approve a single individual as the
derivatives risk manager would have required the board to participate
too closely in the management function of the fund.\170\ This re-
proposal, in contrast, would permit a fund's board to approve the
designation of a single individual or group of individuals, subject to
the other proposed requirements about who may serve as a derivatives
risk manager.
---------------------------------------------------------------------------

    \170\ See, e.g., Comment Letter of Guggenheim (Mar. 28, 2016)
(``Guggenheim Comment Letter''); Dechert Comment Letter; IDC Comment
Letter; American Beacon Comment Letter; Fidelity Comment Letter; IAA
Comment Letter; ICI Comment Letter I; Invesco Comment Letter.
---------------------------------------------------------------------------

    We request comment on the proposed requirement that a fund's board
approve the designation of the fund's derivatives risk manager.
    61. Should we require, as proposed, that a fund's board approve the
designation of the fund's derivatives risk manager? Why or why not? Are
there any specific requirements we should include with respect to the
derivatives risk manager's relationship with the board? For example,
should we require the board to meet with the derivatives risk manager
in executive session? Should we also require the derivatives risk
manager to be removable only by the fund's board? Should we require the
derivatives risk manager's compensation be approved by the board, like
a fund's chief compliance officer? If so, why? Would such a requirement
pose undue burdens on fund boards or place the board in an
inappropriate role? If so, why?
    62. Should the rule permit a board committee to approve the
designation of the derivatives risk manager, rather than the full board
(and a majority of directors who are not interested persons of the
fund) as proposed? Why or why not? If so, should there be any
requirements or guidance with respect to such a board committee (e.g.,
composition or responsibilities)?
    63. Should the rule, as proposed, require that a fund's board in
approving the fund's derivatives risk manager, take into account the
derivatives risk manager's relevant experience regarding the management
of derivatives risk? Why or why not? Would a fund's board, in approving
the designation of the fund's derivatives risk manager, only approve
individuals with relevant experience even without this express
requirement? Is the proposed requirement that a fund's board must take
into account the derivatives risk manager's ``relevant experience
regarding the management of derivatives risk'' sufficiently clear?
Would this raise questions for a fund's board about whether portfolio
management experience, or experience outside of formal derivatives risk
management, would suffice for purposes of the rule? Should the rule,
instead, require that a fund's board take into account the derivatives
risk manager's ``relevant experience''? Or should the rule identify
specific qualifications or experience of a fund's derivatives risk
manager that the fund's board must consider? Why or why not? If so,
what should they be and why?
    64. Should we require a fund's board, or a committee thereof, to
approve the derivatives risk management program or any material changes
to the program? Why or why not? If so, should we require that the
committee have a majority that are disinterested? Would such an
approval requirement promote greater board engagement and oversight? Do
a fund's derivatives use and related derivatives risks present matters
for which it would be appropriate to require the fund's board, or
committee thereof, to approve the program or any material changes to
the program? Why or why not?
2. Board Reporting
    The proposed rule would require the derivatives risk manager to
provide a written report on the effectiveness of the program to the
board at least annually and also to provide regular written reports at
a frequency determined by the board. This requirement is designed to
facilitate the board's oversight role, including its role under rule
38a-1.\171\
---------------------------------------------------------------------------

    \171\ See Compliance Program Release, supra note 166, at n.33
and accompanying text.
---------------------------------------------------------------------------

    Many commenters to the 2015 proposal did not support the proposal's
requirement that the board approve material changes to the program.
Many commenters did state, however, that a fund's board of directors
should be provided with notices of changes to the policies and
procedures implementing the derivatives risk management program and
that the fund's derivatives risk manager should provide the board with
a written report describing the adequacy of the derivatives risk
management program and the effectiveness of its implementation and the
results of the fund's stress testing.\172\
---------------------------------------------------------------------------

    \172\ See, e.g., BlackRock Comment Letter; Vanguard Comment
Letter.
---------------------------------------------------------------------------

Reporting on Program Implementation and Effectiveness
    The proposed rule would require a fund's derivatives risk manager
to provide to the fund's board, on or before the implementation of the
program and at least annually thereafter, a written report providing a
representation that the program is reasonably designed to manage the
fund's derivatives risks and to incorporate the required elements of
the program as well as the basis for the representation.\173\ This
requirement, as discussed below, is designed to provide a fund's board
with information about the effectiveness and implementation of the
program so that the board may appropriately exercise its oversight
responsibilities, including its role under rule 38a-1.
---------------------------------------------------------------------------

    \173\ Proposed rule 18f-4(c)(5)(ii).
---------------------------------------------------------------------------

    To facilitate the board's oversight, the proposed rule would
require the written report to include the basis for the derivatives
risk manager's representation along with such information as may be
reasonably necessary to evaluate the adequacy of the fund's program and
the effectiveness of its implementation. In addition, the
representation may be based on the derivatives risk manager's
reasonable belief after due inquiry. A derivatives risk manager, for
example, could form its reasonable belief based on an assessment of the
program and taking into account input from fund personnel, including
the fund's portfolio management, or from third parties. We propose to
require that the derivatives risk manager include this representation
and its basis, because we believe the derivatives risk manager--rather
than the board--is best positioned to make this determination.
Requiring the

derivatives risk manager to include the information in a board report
would also reinforce that the fund and its adviser are responsible for
derivatives risk management while the board's responsibility is to
oversee this activity. Reports following the initial implementation of
the program must also address the effectiveness of the program. This
requirement is designed to provide the board with appropriate and
useful information so it can exercise its judgment in overseeing the
program, and in light of its role under rule 38a-1.
    The proposed rule would also require the written report to include
a fund's derivatives risk manager's basis for the selection of the
designated reference index used under the proposed relative VaR test
or, if applicable, an explanation of why the derivatives risk manager
was unable to identify a designated reference index appropriate for the
fund such that the fund relied on the proposed absolute VaR test
instead. The derivatives risk manager's selection of a particular
designated reference index, or conclusion that one is not available,
can affect the amount of leverage risk a fund may obtain under the
proposed rule.\174\ We therefore believe it is important that a fund's
board have sufficient information to oversee this activity.
---------------------------------------------------------------------------

    \174\ See infra section II.D.2.b. The proposed rule would not
limit a derivatives risk manager from receiving input from the
fund's portfolio managers or others regarding the fund's designated
reference index.
---------------------------------------------------------------------------

Regular Board Reporting
    The proposed rule would require a fund's derivatives risk manager
to provide to the fund's board, at a frequency determined by the board,
a written report analyzing any exceedances of the fund's risk
guidelines and the results of the fund's stress tests and
backtesting.\175\ Requiring the derivatives risk manager to provide
information about how the fund performed relative to these measures and
at a board-determined frequency is designed to provide the board with
timely information to facilitate its oversight of the fund and the
operation of the program. The program's guidelines and stress testing
requirements are designed to address a fund's particular derivatives
risks and are areas the fund should routinely monitor. The program's
backtesting requirement is designed to require a fund to monitor the
effectiveness of the fund's VaR model, which plays a central role in
the proposed VaR-based limit on fund leverage risk. Therefore, we
believe that a board overseeing a fund's derivatives risk management
should receive regular reporting regarding the derivatives risk
manager's analysis of guideline exceedances and the results of stress
testing and backtesting. We also understand that many fund advisers
today provide regular reports to fund boards, often in connection with
quarterly board meetings, regarding a fund's use of derivatives and
their effects on a fund's portfolio, among other information.
---------------------------------------------------------------------------

    \175\ Proposed rule 18f-4(c)(5)(iii); see also proposed rule
18f-4(c)(1)(ii)-(iv); see also supra sections II.B.3.b, II.B.3.c,
and II.B.3.d.
---------------------------------------------------------------------------

    Accordingly, the proposed rule would require that the report
include the derivatives risk manager's analysis of any exceedances and
stress testing and backtesting results, and to include such information
as may be reasonably necessary for the board to evaluate the fund's
response to any exceedances and the stress testing and backtesting
results. This requirement is designed to provide the board with
information in a format, and with appropriate context, that would
facilitate the board's understanding of the information. A simple
listing of exceedances and stress testing and backtesting results
without context, in contrast, would provide less useful information for
a fund's board and would not satisfy this proposed requirement.
    Under the proposed regular board reporting requirement, a fund's
board would determine the frequency of this written report. Boards
should be allowed flexibility in determining the frequency of reporting
so that they can tailor their oversight to their funds' particular
facts and circumstances.
    We request comment on the proposed board reporting requirements.
    65. Are the proposed requirements for the fund's derivatives risk
manager to provide written reports to the fund's board on the program's
implementation and effectiveness appropriate? Why or why not? Should
the board receive a written report on or before the implementation of
the program? Why or why not? Should we modify the proposed rule to
require funds to provide boards reports with greater frequency than
annually? Why or why not?
    66. Is the proposed representation that the derivatives risk
manager would have to make in the report appropriate? Why or why not?
What should the representation entail, and why? Should we provide
guidance as to what the representation should look like? Why or why
not? Would the representation be helpful for a fund's board in
exercising its oversight responsibilities? Why or why not? What effect,
if any, would the representation have on a fund's derivatives risk
management apart from the board's oversight of such risk management?
    67. Would the responsibilities the proposed rule allocates to a
fund's derivatives risk manager affect a fund's ability to hire or
retain a derivatives risk manager? If so, how?
    68. Is the proposed requirement for the written report to include
the basis for the derivatives risk manager's representation along with
information to evaluate the program's adequacy and effectiveness,
appropriate? Why or why not? Should the rule require specific
information in the written report? Why or why not? If so, what
information and why? Should the rule, as proposed, permit the
representation to be based on the derivatives risk manager's reasonable
belief after due inquiry? Why or why not? Should we provide more
guidance regarding the basis for the representation? If so, what should
we provide? For example, should we provide guidance regarding the types
of information on which a fund's derivatives risk manager may base this
representation? Why or why not? Is the reference to due inquiry
appropriate in this context? Is the reference sufficiently clear?
    69. Should the rule require the written report to include a fund's
derivatives risk manager's basis for the selection of the designated
reference index or, if applicable, an explanation of why the
derivatives risk manager was unable to identify a designated reference
index appropriate for the fund? Why or why not? Should the rule require
the written report to identify and explain any difference between the
selected index and any indices that are used for performance
comparisons in the fund's registration statement and shareholder
reports? Why or why not?
    70. Should the rule require a fund's derivatives risk manager to
provide a written report regarding any exceedances to thresholds
provided for in the fund's guidelines? Why or why not? Should the rule
require a fund's derivatives risk manager to provide a written report
regarding the results of the stress tests and backtests? Why or why
not?
    71. Should the rule require that a fund's derivatives risk manager
report to the board? Why or why not? If not, should the fund determine
who should report to the board, and why? Should the rule permit the
derivatives risk manager to delegate its reporting obligations under
the rule to other officers or employees of the adviser? Why or why not?
If so, to whom should they be able to delegate these obligations?

    72. Should the rule permit a fund's board to determine the
frequency with which it receives the written report? Why or why not? Or
should the rule require that the derivatives risk manager provide the
written report with a certain frequency? Why or why not? If so, what
frequency should the rule require, and why? Should the rule permit a
fund's derivatives risk manager to determine to report to the board
sooner than the frequency determined by the board if appropriate? Why
or why not?
    73. Should the rule require that the written report include such
information as may be reasonably necessary for the board to evaluate a
fund's response to any exceedances and the results of the fund's stress
testing? Why or why not? What information may be reasonably necessary
for the board's evaluation? Should the rule require certain information
to be provided in the written report? Why or why not? If so, what
information should be required to be provided?
    74. Should the rule require the report to be written? Why or why
not? Should the rule require that the derivatives risk manager prepare
the written report? Why or why not?
    75. Would the approach provided by the proposed rule's board
oversight provisions appropriately provide the board the ability to
oversee a fund's derivatives risk management? Why or why not? Does the
proposed rule provide an appropriate balance between the board's role
of general oversight and the fund's roles of day-to-day risk management
and portfolio management? Why or why not?
    76. Should the board be required to approve the program, including
initially, and any material changes to the program? Why or why not?
What is current industry practice with respect to the board's oversight
of a fund's derivatives risk management?

D. Proposed Limit on Fund Leverage Risk

    The proposed rule would also generally require funds relying on the
rule when engaging in derivatives transactions to comply with a VaR-
based limit on fund leverage risk. This outer limit would be based on a
relative VaR test that compares the fund's VaR to the VaR of a
``designated reference index.'' If the fund's derivatives risk manager
is unable to identify an appropriate designated reference index, the
fund would be required to comply with an absolute VaR test.\176\
---------------------------------------------------------------------------

    \176\ A fund that is a leveraged/inverse investment vehicle, as
defined in the proposed sales practices rules, would not be required
to comply with the proposed VaR-based limit on fund leverage risk.
Broker-dealers and investment advisers would be required to approve
retail investors' accounts to purchase or sell shares in these
funds. See infra section II.G (discussing leveraged/inverse
investment vehicles). The proposed rule also would provide an
exception from the proposed VaR tests for funds that use derivatives
to a limited extent or only to hedge currency risks. See infra
sections II.E and II.G (discussing the proposed rule's provisions
regarding limited derivatives users and leveraged/inverse funds
covered by the sales practices rules).
---------------------------------------------------------------------------

1. Use of VaR
    VaR is an estimate of an instrument or portfolio's potential losses
over a given time horizon and at a specified confidence level. VaR will
not provide, and is not intended to provide, an estimate of an
instrument or portfolio's maximum loss amount. For example, if a fund's
VaR calculated at a 99% confidence level was $100, this means the
fund's VaR model estimates that, 99% of the time, the fund would not be
expected to lose more than $100. However, 1% of the time, the fund
would be expected to lose more than $100, and VaR does not estimate the
extent of this loss.
    We propose to use VaR tests to limit fund leverage risk associated
with derivatives because VaR generally enables risk to be measured in a
reasonably comparable and consistent manner across diverse types of
instruments that may be included in a fund's portfolio. One benefit of
the proposed VaR-based approach is that different funds could, and
would be required to, tailor their VaR models to incorporate and
reflect the risk characteristics of their fund's particular
investments.\177\ VaR is a commonly-known and broadly-used industry
metric that integrates the market risk associated with different
instruments into a single number that provides an overall indication of
market risk, including the market risk associated with the fund's
derivatives transactions.\178\ We recognize that funds use many other
risk analytic metrics suited to particular financial instrument
categories.\179\ Given the diverse portfolios of many funds, these more
category-specific risk metrics may be less suitable for establishing a
proposed limit on fund leverage risk that is applied more generally.
---------------------------------------------------------------------------

    \177\ See infra section II.D.4 (discussing the choice of model
and parameters for the VaR test).
    \178\ See Kevin Dowd, An Introduction to Market Risk Measurement
(Oct. 2002), at 10 (``Dowd'') (VaR ``provides a common consistent
measure of risk across different positions and risk factors. It
enables us to measure the risk associated with a fixed-income
position, say, in a way that is comparable to and consistent with a
measure of the risk associated with equity positions''); see also
Jorion, supra note 151, at 159 (stating that VaR ``explicitly
accounts for leverage and portfolio diversification and provides a
simple, single measure of risk based on current positions'').
    \179\ See Jorion, supra note 151. For example, risk measures for
government bonds can include duration, convexity and term-structure
models; for corporate bonds, ratings and default models; for stocks,
volatility, correlations and beta; for options, delta, gamma and
vega; and for foreign exchange, target zones and spreads. Certain
funds are required to report on Form N-PORT some of these metrics,
such as portfolio-level duration (DV01 and SDV01) and position-level
delta. See Investment Company Reporting Modernization, Investment
Company Act Release No. 32314 (Oct. 13, 2016) [81 FR 81870 (Nov. 18,
2016)] (``Investment Company Reporting Modernization Adopting
Release'').
---------------------------------------------------------------------------

    We recognize that VaR is not itself a leverage measure. But a VaR
test, and especially one that compares a fund's VaR to an unleveraged
index that reflects the markets or asset classes in which the fund
invests, can be used to analyze whether a fund is using derivatives
transactions to leverage the fund's portfolio, magnifying its potential
for losses and significant payment obligations of fund assets to
derivatives counterparties. At the same time, VaR tests can also be
used to analyze whether a fund is using derivatives with effects other
than leveraging the fund's portfolio that may be less likely to raise
the concerns underlying section 18. For example, fixed-income funds use
a range of derivatives instruments, including credit default swaps,
interest rate swaps, swaptions, futures, and currency forwards. These
funds often use these derivatives in part to seek to mitigate the risks
associated with a fund's bond investments or to achieve particular risk
targets, such as a specified duration. If a fund were using derivatives
extensively, but had either a low VaR or a VaR that did not
substantially exceed the VaR of an appropriate benchmark, this would
indicate that the fund's derivatives were not substantially leveraging
the fund's portfolio.
    We also understand that VaR calculation tools are widely available,
and many advisers that enter into derivatives transactions already use
risk management or portfolio management platforms that include VaR
capability.\180\ Advisers to the funds that

use derivatives transactions more extensively may be particularly
likely to already use risk management or portfolio management platforms
that include VaR capability, as compared to advisers to the funds that
are within the scope of the proposed provision for limited derivatives
users and that would not be subject to the proposed VaR tests.\181\
---------------------------------------------------------------------------

    \180\ See, e.g., ICI Comment Letter III (``73 percent of
respondents [to an Investment Company Institute survey of its member
firms] use both some form of VaR and stress testing as derivatives
risk management tools.)''; Comment Letter of OppenheimerFunds (Mar.
28, 2016) (``Oppenheimer Comment Letter''); Federated Comment
Letter; Franklin Resources Comment Letter; see also Christopher L.
Culp, Merton H. Miller & Andres M. P. Neves, Value at Risk: Uses and
Abuses, 10 Journal of Applied Corporate Finance 26 (Jan. 1998) (VaR
is ``used regularly by nonfinancial corporations, pension plans and
mutual funds, clearing organizations, brokers and futures commission
merchants, and insurers.''). Moreover, the proposed relative VaR
test is similar to a relative VaR approach that applies to UCITS
under European guidelines. See infra section II.D.6.c (discussing
the UCITS approach).
    \181\ See, e.g., ICI Comment Letter III.
---------------------------------------------------------------------------

    While we believe there are significant benefits to using the
proposed VaR-based limit on fund leverage risk, we recognize risk
literature critiques of VaR (especially since the 2007-2009 financial
crisis). One common critique of VaR is that it does not reflect the
size of losses that may occur on the trading days during which the
greatest losses occur--sometimes referred to as ``tail risks.'' \182\ A
related critique is that VaR calculations may underestimate the risk of
loss under stressed market conditions.\183\ These critiques often arise
in the context of discussing risk managers' use of additional risk
tools to address VaR's shortcomings. Our proposed VaR tests are
designed to provide a metric that can help assess the extent to which a
fund's derivatives transactions raise concerns underlying section 18,
but we do not believe they should be the sole component of a
derivatives risk management program.\184\ We do not intend to encourage
risk managers to over-rely on VaR as a stand-alone risk management
tool.\185\ Instead, as discussed above, the proposed rule would require
a fund to establish risk guidelines and to stress test its portfolio as
part of its risk management program in part because of concerns that
VaR as a risk management tool may not adequately reflect tail
risks.\186\ We also recognize that a fund's use of derivatives
transactions may pose other risks (such as counterparty risk and
liquidity risk) that VaR does not capture. A fund that adopts a
derivatives risk management program under the proposed rule would have
to consider these risks as part of its derivatives risk management
program.\187\
---------------------------------------------------------------------------

    \182\ See Chris Downing, Ananth Madhavan, Alex Ulitsky & Ajit
Singh, Portfolio Construction and Tail Risk, 42 The Journal of
Portfolio Management 1, 85-102 (Fall 2015), available at https://jpm.iijournals.com/content/42/1/85 (``for especially fat-tailed
return distributions the VaR threshold value might appear to be low,
but the actual amount of value at risk is high because VaR does not
measure the mass of distribution beyond the threshold value'').
    With respect to VaR, the ``tail'' refers to the observations in
a probability distribution curve that are outside the specified
confidence level. ``Tail risk'' describes the concern that losses
outside the confidence level may be extreme.
    \183\ See Jorion, supra note 151, at 357 (VaR ``quantif[ies]
potential losses under `normal' market conditions, where normal is
defined by the confidence level, typically 99 percent. . . . In
practice, [VaR] measures based on recent historical data can fail to
identify extreme unusual situations that could cause severe
losses.'').
    \184\ See supra section II.B.3.
    \185\ See, e.g., James O'Brien & Pawel J. Szerszen, An
Evaluation of Bank VaR Measures for Market Risk During and Before
the Financial Crisis, Federal Reserve Board Staff Working Paper
2014-21 (Mar. 7, 2014), available at https://www.federalreserve.gov/pubs/feds/2014/201421/201421pap.pdf (``Criticism of banks' VaR
measures became vociferous during the financial crisis as the banks'
risk measures appeared to give little forewarning of the loss
potential and the high frequency and level of realized losses during
the crisis period.''); see also Pablo Triana, VaR: The Number That
Killed Us, Futures Magazine (Dec. 1, 2010), available at http://www.futuresmag.com/2010/11/30/var-number-killed-us (stating that
``in mid-2007, the VaR of the big Wall Street firms was relatively
quite low, reflecting the fact that the immediate past had been
dominated by uninterrupted good times and negligible volatility'').
    \186\ See supra section II.B.3.b.
    \187\ See supra section II.B.3.a.
---------------------------------------------------------------------------

    We also considered proposing tests based on stressed VaR, expected
shortfall, or both. Stressed VaR refers to a VaR model that is
calibrated to a period of market stress. A stressed VaR approach would
address some of the VaR test critiques related to tail risk and
underestimating expected losses during stressed conditions. Calibrating
VaR to a period of market stress, however, can pose quantitative
challenges by requiring funds to identify a stress period with a full
set of risk factors for which historical data is available. Expected
shortfall analysis is similar to VaR, but accounts for tail risk by
taking the average of the potential losses beyond the specified
confidence level. For example, if a fund's VaR at a 99% confidence
level is $100, the fund's expected shortfall would be the average of
the potential losses in the 1% ``tail.'' Because there are fewer
observations in the tail, however, there is an inherent difficulty in
estimating the expected value of larger losses. Expected shortfall
analysis also could involve potentially greater sensitivity to extreme
outlier losses because it is based on an average of a smaller number of
observations that are in the tail. Taking these considerations into
account, we are proposing tests based on VaR, which is commonly used
and does not present all of the quantitative challenges associated with
stressed VaR and expected shortfall, complemented by elements in the
proposed risk management program designed to address VaR's limitations.
    We request comment on the proposed definition of VaR, the proposed
use of VaR as a means to limit funds' leverage risk, as well as
alternative VaR-based methodologies (stressed VaR and expected
shortfall). We also request comment and discuss alternatives to VaR and
VaR-based methodologies in section II.D.6 below.
    77. Is the proposed definition of the term ``VaR'' appropriate? Why
or why not? If not, how should we define it?
    78. Is a VaR-based test an appropriate way to limit funds' leverage
risk? Why or why not? Do commenters agree with our observations
regarding VaR's characteristics and its critiques? Do commenters
believe that the proposed derivatives risk management program
requirement would help to address VaR's limitations? Please explain.
    79. Should we change the rule to require stressed VaR, either as
part of the program's stress testing requirement or as part of the
limit on fund leverage risk? If so, how should we implement a stressed
VaR requirement? Should the rule provide, for example, that the
historical data used to calculate VaR must include a period of market
stress? What VaR model requirements should we include if the rule
required stressed VaR? Please describe in detail. Are there any other
corresponding changes we should make to the proposed VaR model
requirements or proposed VaR tests if we used stressed VaR? Why or why
not?
    80. Should we change the rule to require expected shortfall or
stressed expected shortfall, either as part of the program's stress
testing requirement or as part of the limit on fund leverage risk? If
so, how should we implement this element? What VaR model requirements
should we include if the rule required expected shortfall or stressed
expected shortfall? Please describe in detail. Are there any other
corresponding changes we should make to the proposed VaR model
requirements or proposed VaR tests if we were to require expected
shortfall or stressed expected shortfall? Why or why not?
    81. Are there risk metrics or measurements other than VaR that
similarly can be applied to a wide breadth of fund strategy types and
investments and used to limit fund leverage risk? Please explain.
    82. Should we use VaR as the only methodology to establish an
outside limit on funds' leverage risk in rule 18f-4? We discuss below
additional alternatives to VaR for this purpose. Should we include in
rule 18f-4 some combination of the proposed VaR tests and the
alternatives discussed in that section, and provide flexibility to
funds to comply with the approach that they believe is most appropriate
based on their strategies and investments? If so,

which approaches should we include in the rule and why?
2. Relative VaR Test
    The proposed relative VaR test would require a fund to calculate
the VaR of the fund's portfolio and compare it to the VaR of a
``designated reference index.'' As discussed in more detail below, a
fund's designated reference index must be unleveraged and reflect the
markets or asset classes in which the fund invests, among other
requirements. This index is designed to create a baseline VaR that
approximates the VaR of a fund's unleveraged portfolio. To the extent a
fund entered into derivatives to leverage its portfolio, the relative
VaR test is designed to identify this leveraging effect. If a fund is
using derivatives and its VaR exceeds that of the designated reference
index, this difference may be attributable to leverage risk.
    A fund would be required to comply with the relative VaR test
unless a designated reference index is unavailable. We propose a
relative VaR test as the default means of limiting fund leverage risk
because it resembles the way that section 18 limits a fund's leverage
risk. Section 18 limits the extent to which a fund can potentially
increase its market exposure through leveraging by issuing senior
securities, but it does not directly limit a fund's level of risk or
volatility. For example, a fund that invests in less-volatile
securities and leverages itself to the maximum extent may not be as
volatile as a completely unleveraged fund that invests in more-volatile
securities. The proposed relative VaR test likewise is designed to
limit the extent to which a fund increases its market risk by
leveraging its portfolio through derivatives, while not restricting a
fund's ability to use derivatives for other purposes. For example, if a
derivatives transaction reduces (or does not substantially increase) a
fund's VaR relative to the VaR of the designated reference index, the
transaction would not be restricted by the relative VaR test.
    In addition, allowing funds to rely on the proposed absolute VaR
test may be inconsistent with investors' expectations where a
designated reference index is available. For example, a fund that
invests in short-term fixed income securities would have a relatively
low level of volatility. The fund's investors could reasonably expect
that the fund might exhibit a degree of volatility that is broadly
consistent with the volatility of the markets or asset classes in which
the fund invests, as represented by the fund's designated reference
index. This fund's designated reference index would be composed of
short-term fixed income securities, and could, for example, have a VaR
of 4%. If the fund were permitted to rely on the absolute VaR test,
however, the fund could substantially leverage its portfolio almost
four times its designated reference index's VaR to achieve a level of
volatility that substantially exceeds the volatility associated with
fixed-income securities.
a. Designated Reference Index
    A fund would satisfy the proposed relative VaR test if the VaR of
its entire portfolio does not exceed 150% of the VaR of its designated
reference index.\188\ The proposed rule would define a ``designated
reference index'' as an unleveraged index that is selected by the
derivatives risk manager, and that reflects the markets or asset
classes in which the fund invests.\189\ The proposed definition also
would require that the designated reference index not be administered
by an organization that is an affiliated person of the fund, its
investment adviser, or principal underwriter, or created at the request
of the fund or its investment adviser, unless the index is widely
recognized and used.\190\ Additionally, the designated reference index
must either be an ``appropriate broad-based securities market index''
or an ``additional index'' as defined in Item 27 of Form N-1A.\191\ A
fund would have to disclose its designated reference index in the
annual report, together with a presentation of the fund's performance
relative to the designated reference index.\192\
---------------------------------------------------------------------------

    \188\ See proposed rule 18f-4(a) (defining the term ``relative
VaR test''); proposed rule 18f-4(c)(2)(i); infra section II.D.2.b
(discussing the 150% limit under the relative VaR test).
    \189\ See proposed rule 18f-4(a) (defining the term ``designated
reference index'').
    \190\ Furthermore, for a blended index, none of the indexes that
compose the blended index may be administered by an organization
that is an affiliated person of the fund, its investment adviser, or
principal underwriter, or created at the request of the fund or its
investment adviser, unless the index is widely recognized and used.
See id.
    \191\ See proposed rule 18f-4(a) (defining the term ``designated
reference index''); see also Instructions 5 and 6 to Item
27(b)(7)(ii) of Form N-1A (discussing the terms ``appropriate broad-
based securities market index'' and ``additional index'').
    \192\ See proposed rule 18f-4(c)(2)(iv).
---------------------------------------------------------------------------

    The requirement that the designated reference index reflect the
markets or asset classes in which the fund invests is designed to
provide an appropriate baseline for the relative VaR test. Because of
this requirement, differences between the fund's VaR and the VaR of the
designated reference index are more likely to represent leverage than
other factors, like differences between the securities in the fund's
portfolio and those in the index, as compared to a relative VaR test
that compares the fund's VaR to an index that does not reflect the
markets or asset classes in which the fund invests.\193\ Take, for
example, a fund that invests primarily in S&P 500 index options and
uses that index as its designated reference index. Differences between
the fund's VaR and the VaR of the S&P 500 would be more likely
attributable to the leverage risk associated with the options than, for
example, if the fund were permitted to use an index that did not
reflect the markets or assets classes in which the fund invests, such
as an index of small capitalization stocks in this example. The
derivatives risk manager could select a designated reference index that
is a blended index under the proposed rule (assuming that the blended
index meets the proposed requirements for a designated reference
index), which would give some flexibility in identifying or
constructing a designated reference index that provides an appropriate
baseline for the relative VaR test.\194\ For example, the derivatives
risk manager of a balanced fund may determine that a blended index of
an unleveraged equity index and an unleveraged fixed income index would
be an appropriate designated reference index.
---------------------------------------------------------------------------

    \193\ To the extent a fund discloses in its annual report an
``appropriate broad-based securities market index'' that does not
reflect the markets or asset classes in which the fund invests, such
a fund may satisfy the performance disclosure requirements of Form
N-1A, but it would not satisfy the proposed designated reference
index requirement. For example, a fund that pursues its strategy
primarily through commodity futures contracts could select the S&P
500 to satisfy its performance disclosure requirement under Form N-
1A, but such an index would not satisfy the proposed designated
reference index requirement because a commodity fund would not
invest in stocks included in the S&P 500 or large cap stocks
generally.
    \194\ If the derivatives risk manager selects a designated
reference index that is a blended index, the designated reference
index would have to be disclosed as an ``additional index'' (as
opposed to an ``appropriate broad-based securities market index'')
as defined in the instruction to Item 27 in Form N-1A. Form N-1A
defines the term ``appropriate broad-based securities market index''
to mean an index ``that is administered by an organization that is
not an affiliated person of the [f]und, its investment adviser, or
principal underwriter, unless the index is widely recognized and
used.'' See Instruction 5 to Item 27(b)(7)(ii) of Form N-1A. A
blended index that is administered by the fund's investment adviser,
for example, would therefore not qualify as an ``appropriate broad-
based securities market index.''
---------------------------------------------------------------------------

    The requirement that the designated reference index be an
unleveraged index also is designed to provide an appropriate baseline
against which to measure a fund's portfolio VaR for

purposes of assessing the fund's leverage risk. Conducting a VaR test
on a designated reference index that itself is leveraged would distort
the leverage-limiting purpose of the VaR comparison by inflating the
volatility of the index that serves as the reference portfolio for the
relative VaR test. For example, an equity fund might select as its
designated reference index an index that tracks a basket of large-cap
U.S. listed equity securities such as the S&P 500. But the fund could
not select an index that is leveraged, such as an index that tracks
200% of the performance of the S&P 500. A relative VaR test based on
this index would effectively permit additional leveraging inconsistent
with the Investment Company Act.\195\
---------------------------------------------------------------------------

    \195\ See supra section I.B.1. But see infra section II.G
(discussing leveraged/inverse funds covered by the proposed sales
practices rules).
---------------------------------------------------------------------------

    Our proposal would prohibit the designated reference index from
being an index administered by an organization that is an affiliated
person of the fund, its investment adviser, or its principal
underwriter, or created at the request of the fund or its investment
adviser. This proposed prohibition would not, however, extend to
indexes that are ``widely recognized and used.'' \196\ We believe that
the indexes permissible under the proposed rule would be less likely to
be designed with the intent of permitting a fund to incur additional
leverage-related risk.
---------------------------------------------------------------------------

    \196\ See proposed rule 18f-4(a) (defining the term ``designated
reference index''). This ``widely recognized and used'' standard has
historically been used to permit a fund to employ affiliated-
administered indexes for disclosure purposes, when the use of such
indexes otherwise would not be permitted. See supra note 193.
---------------------------------------------------------------------------

    The proposed rule would require that a fund publicly disclose to
its investors in its annual reports the designated reference index. An
open-end fund would have to disclose its designated reference index in
the fund's annual report as the fund's ``appropriate broad-based
securities market index'' or an ``additional index'' that Form N-1A
describes in the context of the annual report performance presentation
requirements.\197\ Form N-2, on the other hand, does not require
closed-end funds to disclose a benchmark index for comparing a fund's
performance. Nevertheless, some closed-end funds choose to disclose a
benchmark index in their annual reports to shareholders. Under the
proposed rule, a closed-end fund seeking to satisfy the relative VaR
test would have to disclose the fund's designated reference index in
its annual report together with a presentation of the fund's
performance.\198\ In proposing this approach, we considered the role of
investor expectations in selecting funds that correspond to investors'
desired level of investment risk.\199\ We believe that investors could
reasonably expect that their fund might exhibit a degree of volatility
that is broadly consistent with the volatility of the markets or asset
classes in which the fund invests, as represented by the fund's
designated reference index. Requiring a fund to select a designated
reference index that it publicly discloses would promote the fund's
selection of an appropriate index that reflects the fund's portfolio
risks and its investor expectations.
---------------------------------------------------------------------------

    \197\ See proposed rule 18f-4(c)(2)(iv); Item 27(b)(7)(ii) of
Form N-1A.
    See also Instructions to Items 4 and 27(b)(7)(ii) of Form N-1A.
Form N-1A provides that ``New Funds,'' as defined in the form, are
not required to disclose an appropriate broad-based securities
market index and the fund's performance in the annual report because
of the fund's limited operating history. See Instruction 6 to Item 3
of Form N-1A (defining a ``New Fund'' to mean a ``Fund that does not
include in Form N-1A financial statements reporting operating
results or that includes financial statements for the Fund's initial
fiscal year reporting operating results for a period of 6 months or
less''). For the same reason, the proposed rule would provide that a
fund would not be required to disclose its designated reference
index in the fund's annual report if the fund is a ``New Fund,'' or
would meet that definition if it were filing on Form N-1A, at the
time the fund files its annual report. See proposed rule 18f-
4(c)(2)(iv).
    \198\ See proposed rule 18f-4(c)(2)(iv).
    \199\ To the extent a fund's use of derivatives transactions is
part of its principal investment strategy or is a principal risk, it
is required to be disclosed as such in the fund's prospectus. See
Item 4 of Form N-1A; Item 8 of Form N-2.
---------------------------------------------------------------------------

    Some registered closed-end funds currently elect to provide a
Management's Discussion of Fund Performance (``MDFP'') in their annual
reports.\200\ These registered closed-end funds could disclose their
performance relative to the performance of the designated reference
index in the fund's MDFP. BDCs that are publicly traded must disclose,
in their annual reports filed on Form 10-K, a line graph comparing the
yearly percentage change in fund share price with the return of a broad
equity market index.\201\ A publicly-traded BDC could choose to include
its designated reference index in this line graph disclosure.
---------------------------------------------------------------------------

    \200\ The Commission recently proposed to amend Form N-2 to
require registered closed-end funds to include MDFP disclosure in
their annual reports. See Securities Offering Reform for Closed-End
Investment Companies, Investment Company Act Release No. 33427 (Mar.
20, 2019) [84 FR 14448 (Apr. 10, 2019)], at 14471-72 (``Securities
Offering Reform Proposing Release'').
    \201\ 17 CFR 229.201(e)(1)(i).
---------------------------------------------------------------------------

    We recognize the concern that funds could have the incentive to
select an inappropriate designated reference index composed of more
volatile securities to allow the fund to obtain more leverage risk
under the relative VaR test. The proposed rule includes three
provisions designed to address this concern. In addition to requiring
that the designated reference index reflect the markets or asset
classes in which the fund invests, and that the index not be
administered by certain affiliated persons or created at the request of
the fund or its investment adviser, as described above, the proposed
rule would require: (1) The derivatives risk manager to select the
designated reference index and to periodically review it; (2) the fund
to disclose the designated reference index, relative to its
performance, in its annual report, creating the disincentive for a fund
to present performance that may be significantly lower than, or not
related to, the disclosed index; and (3) the board of directors to
receive a written report providing the derivatives risk manager's basis
for selecting the designated reference index.\202\ These requirements,
collectively, are designed to require funds to use designated reference
indexes that provide an appropriate baseline for the relative VaR test
and to prohibit funds from, instead, selecting indexes solely for the
purpose of maximizing the fund's permissible leverage risk under the
proposed rule.
---------------------------------------------------------------------------

    \202\ See proposed rule 18f-4(a), (c)(1)(vi), (c)(2)(iii),
(c)(5)(ii)-(iii); see also supra sections II.B.3.f, II.C.2.
---------------------------------------------------------------------------

    We recognize that some (but not all) popular benchmark indexes
charge funds a licensing fee for their inclusion in fund prospectuses
and annual reports. Funds could incur licensing fees if their
derivatives risk managers select a designated reference index whose
provider charges such a fee and the fund is not already using the
index. We are nevertheless proposing this disclosure requirement
because the relative VaR test's ability to limit a fund's leverage risk
is directly tied to the appropriateness of its designated reference
index. This disclosure requirement is designed to address concerns
about inappropriate indexes, as discussed above, by creating the
disincentive for a fund to select an inappropriate index because the
fund would have to disclose its performance against that index in its
annual report and likely would not want to present performance that is
significantly lower than, or not related to, the disclosed index.\203\
At the same time, the proposed rule provides funds flexibility to use
any index that meets the proposed requirements. The proposed rule would
provide this flexibility in light of the conditions discussed above

designed to require that a fund use a designated reference index that
is appropriate for the relative VaR test.
---------------------------------------------------------------------------

    \203\ See supra note 201 and accompanying paragraph.
---------------------------------------------------------------------------

    The 2015 Proposing Release also included a risk-based portfolio
limit based on VaR.\204\ The 2015 proposal provided that a fund would
satisfy its risk-based portfolio limit condition if a fund's full
portfolio VaR was less than the fund's ``securities VaR'' (i.e., the
VaR of the fund's portfolio of securities and other investments, but
excluding any derivatives transactions).\205\ Our proposal, however,
differs from the 2015 proposal in that the proposed relative VaR test
compares the fund's VaR to the VaR of the fund's designated reference
index, rather than the fund's ``securities VaR.'' This is because some
funds that use derivatives extensively hold primarily cash, cash
equivalents, and derivatives. These funds' ``securities VaRs'' would be
based primarily on the fund's cash and cash equivalents. As some
commenters on the 2015 proposal noted, this would not provide an
appropriate comparison for a relative VaR test because the VaR of the
cash and cash equivalents would be very low and would not provide a
reference level of risk associated with the fund's strategy.\206\
---------------------------------------------------------------------------

    \204\ See 2015 Proposing Release, supra note 2, at section
III.B.2.
    \205\ Under that proposal, a fund that satisfied this VaR test
was also required to limit its aggregate exposure--including
derivatives exposure--to 300% of the fund's net assets. See id.
    \206\ See, e.g., AlphaSimplex Comment Letter; AQR Comment
Letter; ICI Comment Letter I.
---------------------------------------------------------------------------

    We request comment on the proposed requirements regarding the
selection and disclosure of a designated reference index for purposes
of compliance with the proposed relative VaR test.
    83. Is the proposed definition of the term ``designated reference
index'' appropriate? Why or why not? Should the Commission provide
additional guidance, or requirements in the proposed rule, addressing
when an index reflects the markets or asset classes in which a fund
invests? Are there particular types of indexes that would not be
appropriate as a designated reference index? Why or why not? If so,
what types of indexes and why would they be inappropriate for this
purpose?
    84. Should the rule require that the designated reference index be
an unleveraged index? Should the rule specify with greater
particularity what constitutes an unleveraged index? Please explain.
Alternatively, should the Commission provide guidance on when an index
will be ``leveraged''?
    85. Are there other considerations that would present challenges
for funds in light of the proposed requirement to select a designated
reference index for purposes of the proposed relative VaR test
requirement? If so, what?
    86. To what extent do funds expect that the requirement to disclose
the designated reference index would result in additional licensing
fees? Please explain. What consequences would such charges create?
    87. Should we change the proposed definition of the term
``designated reference index'' to no longer track in part the
definition of an ``appropriate broad-based securities market index'' in
Form N-1A (Instruction 5 of Item 27(b)(7)) and allow a derivatives risk
manager to select an index administered by an affiliated person of the
fund, its investment adviser, or principal underwriter? Should we
change the proposed definition to allow a derivatives risk manager to
select an index created at the request of the fund or its investment
adviser? Is it appropriate to exclude such indexes from the definition
of ``designated reference index,'' and is it appropriate that widely
recognized and used indexes be carved out from this exclusion, as
proposed? Would the proposed exclusion help ensure the selection of
indexes that are appropriately designed to create a baseline VaR that
approximates the VaR of a fund's unleveraged portfolio? Please explain.
Would allowing funds to use indexes that would fall within the proposed
exclusion raise concerns that the indexes would not be appropriate,
or--if the Commission were to permit the use of such indexes--would the
rule's other proposed conditions designed to address this concern work
equally well for all indexes? If the Commission were to permit the use
of indexes that would fall within the proposed exclusion, would any
additional limits on the use of these indexes be appropriate? If so,
what limits and why?
    88. If we were to further limit or restrict the types of indexes
that a fund could select as its designated reference index under the
proposed rule, what additional limits would be appropriate? Should we,
for example, provide that a fund's designated reference index must meet
the definition of an ``appropriate broad-based securities market
index'' as defined in Form N-1A? Should we require that the index be
widely recognized and used?
    89. Similar to UCITS guidelines, should the proposed definition
specifically require that the risk profile of the designated reference
index be consistent with the fund's investment objectives and policies,
as well as investment limits? \207\ Why or why not?
---------------------------------------------------------------------------

    \207\ See infra section II.D.6.c (discussing the UCITS
framework).
---------------------------------------------------------------------------

    90. Should the rule require funds to disclose their designated
reference indexes in their annual reports to shareholders, as proposed?
Should such disclosure also appear in the fund's prospectus? What
reasons, if any, should the designated reference index not be an index
a fund includes as part of its performance disclosure? Please explain.
Should a fund be required to specify that the index it includes in its
performance disclosure is the fund's designated reference index, which
has been selected for purposes of the fund's compliance with rule 18f-
4? If so, what other information or explanations should a fund also
have to include (if any), in order to best promote investor
understanding of how the fund's designated reference index affects the
fund's ability to use leverage, and how this in turn affects the risks
associated with an investment in the fund? For example, should a fund
also be required to disclose the index's historical (e.g., 1-year)
average VaR? What accompanying narrative disclosure would help
investors best understand the significance of this information? Would
this disclosure be useful to supplement the VaR information that a fund
would be required to disclose on Form N-PORT under the proposal?
    91. Should the rule permit a fund to compare its portfolio VaR to
its ``securities VaR'' for purposes of the rule's relative VaR test, as
provided for in the 2015 proposed rule, in addition to its designated
reference index? \208\ Why or why not? If the relative VaR test
permitted a fund to compare its porfolio's VaR against its designated
reference index or its ``securities VaR,'' would funds prefer to use
their ``securities VaRs''? If so, why? In what circumstances or what
fund strategies would ``securities VaR'' be a more or equally
appropriate baseline for funds calculating their relative VaR? What
benefits or drawbacks are there with respect to this approach? Please
explain.
---------------------------------------------------------------------------

    \208\ See supra note 204 and accompanying text.
---------------------------------------------------------------------------

    92. For a registered closed-end fund, is the proposed requirement
that it must disclose its designated reference index in its annual
report together with a presentation of the fund's performance
appropriate? Why or why not? What challenges, if any, would the
proposed disclosure requirement have for closed-end funds that do not
currently disclose their performance relative to a benchmark index in
their annual reports? Please explain.

    93. For a registered closed-end fund, should we prescribe in rule
18f-4 or Form N-2 where in the fund's annual report it must disclose
its designated reference index? Why or why not?
    94. What challenges, if any, would a BDC have in disclosing its
designated reference index together with its performance in the BDC's
annual report? Please explain.
    95. Should we also amend Forms N-1A and/or N-2 to require a fund
relying on rule 18f-4 and subject to the relative VaR test to disclose
its performance relative to the performance of its designated reference
index? Would it be helpful to have this requirement both in rule 18f-4
and in the registration forms?
    96. What changes should we make to the rule in light of the concern
that a fund could have an incentive to select an inappropriate
designated reference index to obtain more leverage risk? Is the
proposed requirement that the derivatives risk manager select the
designated reference index useful for this purpose? Is the proposed
requirement that the designated reference index be an appropriate
broad-based securities index or an additional index effective for this
purpose? Is the proposed requirement that the fund disclose the
designated reference index relative to its performance in the annual
report useful for this purpose? Is the proposed requirement that the
board of directors receive a written report from the derivatives risk
manager about the basis for the designated reference index subject to
periodic review useful for this purpose? Please explain.
b. 150% Limit Under Proposed Relative VaR Test
    We are proposing that a fund's VaR must not exceed 150% of the VaR
of the fund's designated reference index.\209\ In proposing a 150%
limit, we first considered the extent to which a fund could borrow in
compliance with the requirements of section 18. For example, a mutual
fund with $100 in assets and no liabilities or senior securities
outstanding could borrow an additional $50 from a bank. With the
additional $50 in bank borrowings, the mutual fund could invest $150 in
securities based on $100 of net assets. This fund's VaR would be
approximately 150% of the VaR of the fund's designated reference index.
The proposed 150% limit would therefore effectively limit a fund's
leverage risk related to derivatives transactions similar to the way
that section 18 limits a registered open- or closed-end fund's ability
to borrow from a bank (or issue other senior securities representing
indebtedness for registered closed-end funds) subject to section 18's
300% asset coverage requirement. We recognize that while a fund could
achieve certain levels of market exposure through borrowings permitted
under section 18, it may be more efficient to obtain those exposures
through derivatives transactions. Allowing a fund to have a VaR that is
150% of its designated reference index, rather than a higher or lower
relative VaR, is designed to provide what we believe is an appropriate
degree of flexibility for funds to use derivatives.
---------------------------------------------------------------------------

    \209\ See proposed rule 18f-4(a) (defining the term ``relative
VaR test'').
---------------------------------------------------------------------------

    We considered proposing different relative VaR tests for different
types of investment companies, tied to the asset coverage requirements
applicable to registered open-end funds, registered closed-end funds,
and BDCs.\210\ Registered closed-end funds, like open-end funds, are
only permitted to issue senior securities representing indebtedness
under section 18 subject to a 300% asset coverage requirement, although
closed-end funds' indebtedness is not limited to bank borrowings.\211\
Using the example above, a registered closed-end fund with $100 in
assets likewise could only borrow $50. Although registered closed-end
funds also are permitted to issue senior securities that are
stocks,\212\ proposed rule 18f-4 is focused on the indebtedness
leverage that derivatives transactions create. We do not believe that a