4's specific requirements tailored to address these transactions. We
are adopting these provisions as proposed.
---------------------------------------------------------------------------

    \782\ See amendment to Instruction 2 of Item 4.3 of Form N-2;
proposed amendment to Instruction 2 of Item 4.3 of Form N-2. This
amendment will apply to registration statements on a prospective
basis. Accordingly, the amendment does not require funds to modify
information provided for periods before a fund begins to rely on the
final rule.
---------------------------------------------------------------------------

    One commenter suggested the Commission clarify how a fund should
``not consider'' derivatives transactions for purposes of calculating
asset coverage under section 18(h), in light of the proposed provision
providing that derivatives transactions entered into under the proposed
rule will not be considered for purposes of computing asset coverage
under section 18(h).\783\ The commenter asked, for example, if a fund
should include the assets and liabilities associated with a written
option in the calculation, or the gains and losses associated with the
option's premium. We believe a fund would ``not consider'' a
derivatives transaction for purposes of calculating asset coverage, and
accordingly for disclosure in the senior securities table, by not
including the derivatives transaction or any component of the
derivatives transaction in the calculation. We do not believe that this
provision in the final rule requires the fund to track gains and losses
associated with the fund's investment of options' premium, margin, or
collateral received in connection with the fund's derivatives
transactions.
---------------------------------------------------------------------------

    \783\ See Comment Letter of Ernst Young LLP (Mar. 24, 2020).
---------------------------------------------------------------------------

L. Compliance Date

    The Commission is providing a transition period to give funds
sufficient time to comply with the provisions of rule 18f-4 and the
related reporting requirements.\784\ Specifically, we are adopting a
compliance date for rule 18f-4 and the related amendments in this
release that is eighteen months following the effective date. We
believe that an eighteen-month compliance period provides sufficient
time for all funds to come into compliance with the rule and the
related reporting requirements. Accordingly, we are also rescinding
Release 10666, effective August 19, 2022.\785\ In addition, staff in
the Division of Investment Management has reviewed its no-action
letters and other guidance addressing derivatives transactions and
other transactions covered by proposed rule 18f-4 to determine which
letters and other staff guidance, or portions thereof, should be
withdrawn in connection with the final rule. This review included, but
was not limited to, the staff no-action letters and other guidance
identified in the Proposing Release. Some of these letters and other
staff guidance, or portions thereof, will be moot, superseded, or
otherwise inconsistent with the final rule and, therefore, will be
withdrawn by the staff, effective upon the rescission of Release
10666.\786\
---------------------------------------------------------------------------

    \784\ The ``related reporting requirements'' include the
amendments to fund reporting requirements discussed in section II.G,
as well as the amendments to rule 30b1-10.
    \785\ See supra section I.C.
    \786\ We also intend, after appropriate notice and opportunity
for hearing, to rescind orders we have granted to funds providing
exemptive relief from section 18(f) relating to investments in
certain futures contracts, related options and/or options on stock
indices that is superseded by or otherwise inconsistent with rule
18f-4. Based on staff review of filings on Form N-CEN, no fund is
relying on these exemptive orders.
---------------------------------------------------------------------------

    Commenters urged the Commission to provide more time beyond the
one-year transition period we discussed in the Proposing Release,
generally suggesting an eighteen-month or two-year period to provide
time for funds to prepare to comply with the rule's requirements.\787\
In particular, commenters stated that a one-year transition period
would not provide sufficient time to implement the derivatives risk
management program and the VaR limit, and to designate a qualified
derivatives risk manager.\788\ Delaying the rescission of Release 10666
and the staff's rescission of its no-action letters and other guidance
for eighteen months is designed to provide additional time for funds to
prepare to transition their current approaches and come into compliance
with the final rule and the related reporting requirements.
---------------------------------------------------------------------------

    \787\ See e.g. Invesco Comment Letter; Fidelity Comment Letter;
Dechert Comment Letter I; Capital Group Comment Letter.
    \788\ See e.g. Dechert Comment Letter I; Fidelity Comment
Letter; Invesco Comment Letter.
---------------------------------------------------------------------------

    A fund may rely on rule 18f-4 after its effective date but before
the compliance date, provided that the fund satisfies the rule's
conditions.\789\ To promote regulatory consistency, however, any fund
that elects to rely on rule 18f-4 prior to the date when Release 10666
is rescinded may rely only on rule 18f-4, and not also consider Release
10666, staff no-action letters, or other staff guidance in determining
how it will comply with section 18 with respect to its use of
derivatives and the other transactions that rule 18f-4 addresses. In
addition, rule 18f-4 provides that, if a fund

experiences a reportable event on Form N-RN, the fund must file with
the Commission a report on Form N-RN within the period and according to
the instructions specified in that form.\790\ Until the Commission
staff completes the process of updating current Form N-LIQUID on EDGAR
to reflect the amendments we have adopted, including retitling the form
as ``Form N-RN,'' a fund relying on rule 18f-4 may satisfy the
requirement to file a report on Form N-RN by including information that
Form N-RN requires in a report on Form N-LIQUID filed on EDGAR. A fund
may contact Commission staff with any questions regarding this filing
process.
---------------------------------------------------------------------------

    \789\ Similarly, leveraged/inverse funds will be able to rely on
rule 6c-11 once rule 18f-4 is effective and the leveraged/inverse
funds comply with its conditions. In addition, we are rescinding the
exemptive orders provided to leveraged/inverse ETFs on the
compliance date for rule 18f-4. See supra footnote 622 and
accompanying text.
    \790\ Rule 18f-4(c)(7).
---------------------------------------------------------------------------

    Because the reporting requirements we are adopting will enhance the
Commission's ability to oversee funds' use of and compliance with rule
18f-4 effectively, we are requiring a fund that relies on rule 18f-4
prior to the rule's compliance date also to comply with the amendments
we are adopting to Form N-PORT and Form N-CEN, as applicable, once
these updated forms are available for filing on EDGAR. We appreciate
that funds will not be able to comply with these new reporting
requirements until Commission staff completes the process of updating
these amended forms for filing on EDGAR. Therefore, until this updating
process is complete, a fund may elect to rely on rule 18f-4 prior to
the rule's compliance date without also complying with these reporting
requirements. Commission staff will issue a notice to the public when
the updated forms are available for filing on EDGAR.

M. Other Matters

    Pursuant to the Congressional Review Act,\791\ the Office of
Information and Regulatory Affairs has designated this rule a ``major
rule,'' as defined by 5 U.S.C. 804(2). If any of the provisions of
these rules, or the application thereof to any person or circumstance,
is held to be invalid, such invalidity shall not affect other
provisions or application of such provisions to other persons or
circumstances that can be given effect without the invalid provision or
application.
---------------------------------------------------------------------------

    \791\ 5 U.S.C. 801 et seq.
---------------------------------------------------------------------------

III. Economic Analysis

    We are mindful of the costs imposed by, and the benefits obtained
from, our rules. Section 2(c) of the Investment Company Act provides
that when the Commission is engaging in rulemaking under the Act and is
required to consider or determine whether an action is consistent with
the public interest, the Commission shall also consider whether the
action will promote efficiency, competition, and capital formation, in
addition to the protection of investors. The following analysis
considers, in detail, the potential economic effects that may result
from the final rules, including the benefits and costs to investors and
other market participants as well as the broader implications of the
final rules for efficiency, competition, and capital formation.

A. Introduction

    Funds today use a variety of derivatives, both to obtain investment
exposure as part of their investment strategies and to manage risks. A
fund may use derivatives to gain, maintain, or reduce exposure to a
market, sector, or security more quickly, or to obtain exposure to a
reference asset for which it may be difficult or impractical for the
fund to make a direct investment. A fund may use derivatives to hedge
interest rate, currency, credit, and other risks, as well as to hedge
portfolio exposures.\792\ As funds' strategies have become increasingly
diverse over the past several decades, funds' use of derivatives has
grown in both volume and complexity. At the same time, a fund's
derivatives use may entail risks relating to, for example, leverage,
markets, operations, liquidity, and counterparties, as well as legal
risks.\793\
---------------------------------------------------------------------------

    \792\ See supra section I.A.
    \793\ See, e.g., supra footnotes 15-16 and accompanying text.
---------------------------------------------------------------------------

    Section 18 of the Investment Company Act is designed to limit the
leverage a fund can obtain through the issuance of senior
securities.\794\ As discussed above, a fund's derivatives use may raise
the investor protections concerns underlying section 18. In addition,
funds' asset segregation practices have developed such that funds'
derivatives use--and thus funds' potential leverage through derivatives
transactions--does not appear to be subject to a practical limit as the
Commission contemplated in Release 10666.
---------------------------------------------------------------------------

    \794\ See supra section I.B.1.
---------------------------------------------------------------------------

    Rule 18f-4 is designed to provide an updated, comprehensive
approach to the regulation of funds' use of derivatives and certain
other transactions. The final rule will permit a fund, subject to
certain conditions, to enter into derivatives or other transactions,
notwithstanding the prohibitions and restrictions on the issuance of
senior securities under section 18 of the Investment Company Act. We
believe that the final rule's requirements, including the derivatives
risk management program requirement and VaR-based limit on fund
leverage risk, will benefit investors by mitigating derivatives-related
risks, including those that may lead to unanticipated and potentially
significant losses for investors.
    Certain funds use derivatives in a limited manner, which we believe
presents a lower degree of risk or potential impact and generally a
lower degree of leverage than permitted under section 18. The final
rule will provide an exception from the derivatives risk management
program requirement and VaR-based limit on fund leverage risk and the
related board oversight and reporting provisions (collectively, the
``VaR and program requirements,'' as noted above) for these limited
derivatives users. Instead, the final rule will require a fund relying
on this exception to adopt policies and procedures that are reasonably
designed to manage its derivatives risks. Funds with limited
derivatives exposure will therefore not be required to incur costs and
bear compliance burdens that may be disproportionate to the resulting
benefits, while still being required to manage the risks their limited
use of derivatives may present.\795\
---------------------------------------------------------------------------

    \795\ See supra sections I.C and II.E.
---------------------------------------------------------------------------

    Leveraged/inverse funds generally will be subject to the
requirements of rule 18f-4 on the same basis as other funds subject to
that rule, including the VaR-based leverage risk limit.\796\ The rule
will, however, provide an exception from the VaR-based limit on fund
leverage risk for leveraged/inverse funds currently in operation that
seek to provide leveraged or inverse market exposure exceeding 200% of
the return or inverse return of the relevant index. The conditions to
this exception are designed to allow these funds to continue to operate
in their current form, but prohibit them from changing their index or
increasing the amount of their leveraged or inverse market exposure.
---------------------------------------------------------------------------

    \796\ The enhanced standard of conduct for broker-dealers under
Regulation Best Interest and the fiduciary obligations of registered
investment advisers also will apply in the context of recommended
transactions and transactions occurring in an advisory relationship
with respect to these funds and the listed commodity pools that
would have been subject to the proposed sales practices rules.
---------------------------------------------------------------------------

    Rule 18f-4 also contains requirements for funds' use of certain
senior securities that are not derivatives. Specifically, the final
rule permits a fund to either choose to limit its reverse repurchase
and other similar financing transaction

activity to the applicable asset coverage limit of the Act for senior
securities representing indebtedness, as proposed, or a fund may
instead treat them as derivatives transactions. This approach reflects
that reverse repurchase agreements and similar financing transactions
can be used to introduce leverage into a fund's portfolio just like
other forms of borrowings, or derivatives.\797\
---------------------------------------------------------------------------

    \797\ Similar financing transactions may include securities
lending arrangements and TOBs, depending on the particular facts and
circumstances of the individual transaction. See supra section II.H.
---------------------------------------------------------------------------

    In addition, the final rule will permit a fund to enter into
unfunded commitment agreements if it reasonably believes, at the time
it enters into such an agreement, that it will have sufficient cash and
cash equivalents to meet its obligations with respect to its unfunded
commitment agreements.\798\ This requirement is designed to address the
concern that a fund may experience losses as a result of having
insufficient assets to meet its obligations with respect to these
transactions, and we believe that the requirement will benefit
investors by mitigating such losses or other adverse effects if a fund
is unable to satisfy an unfunded commitment agreement.\799\
---------------------------------------------------------------------------

    \798\ See supra section II.I.
    \799\ We believe that the treatment of unfunded commitment
transactions is consistent with general market practices. Therefore,
we believe that the requirements for these transactions will not
have significant economic effects when measured against this
baseline.
---------------------------------------------------------------------------

    The final rule also includes a provision that will allow funds, as
well as money market funds, to invest in securities on a when-issued or
forward-settling basis, or with a non-standard settlement cycle,
subject to certain conditions.\800\ This provision reflects our view
that these short-term transactions generally do not raise the concerns
about fund leverage risk underlying section 18.
---------------------------------------------------------------------------

    \800\ See supra section II.A.
---------------------------------------------------------------------------

    This rule also includes certain recordkeeping requirements and
reporting requirements for funds that use derivatives.\801\ We expect
that the recordkeeping requirements will benefit investors by
facilitating fund compliance with the final rule and our staff's review
of funds' compliance. In addition, we expect that the amendments we are
adopting to Forms N-PORT, N-CEN, and N-LIQUID (which is being re-titled
as Form N-RN) will further benefit investors primarily by enhancing the
Commission's understanding of the impact of funds' use of derivatives
on fund portfolios, and by facilitating the Commission's ability to
oversee funds' use of derivatives and compliance with the final
rules.\802\
---------------------------------------------------------------------------

    \801\ See supra sections II.C and II.G.
    \802\ Because existing leveraged/inverse funds with a stated
target multiple that is equal to or below the VaR-based limit on
leveraged risk in rule 18f-4 will be subject to the VaR-based limit
on fund leverage risk, these funds will be subject to the related
reporting requirements on Forms N-PORT and N-RN. Conversely,
existing leveraged/inverse funds that seek to provide leveraged or
inverse market exposure exceeding 200% of the return of the relevant
index will not be subject to the condition of rule 18f-4 limiting
fund leverage risk and thus not subject to the related reporting
requirements on Forms N-PORT and N-RN. However, such funds will have
to disclose this exemption in their prospectuses. All leveraged/
inverse funds will also be subject to the new requirements on Form
N-CEN.
---------------------------------------------------------------------------

B. Economic Baseline

1. Fund Industry Overview
    The fund industry has grown and evolved substantially in past
decades in response to various factors, including investor demand,
technological developments, and an increase in domestic and
international investment opportunities, both retail and
institutional.\803\ As of July 2020, there were 10,092 mutual funds
(excluding money market funds) with $19,528 billion in total net
assets, 2,142 ETFs organized as an open-end fund or as a share-class of
an open-end fund with $3,462 billion in total net assets, 666
registered closed-end funds with $307 billion in total net assets, and
13 variable annuity separate accounts registered as management
investment companies on Form N-3 with $216 billion in total net assets.
There also were 420 money market funds with $3,881 billion in total net
assets.\804\ Finally, as of July 2020, there were 99 BDCs with $58
billion in total net assets.\805\
---------------------------------------------------------------------------

    \803\ See Proposing Release, supra footnote 1, at n.1.
    \804\ Estimates of the number of registered investment companies
and their total net assets are based on a staff analysis of Form N-
CEN filings as of July 8, 2020. For open-end funds that have mutual
fund and ETF share classes, which only one fund sponsor currently
operates, we count each type of share class as a separate fund and
use data from Morningstar to determine the amount of total net
assets reported on Form N-CEN attributable to the ETF share class.
Money market funds generally are excluded from the scope of rule
18f-4, but may rely on the provision in the rule for investments in
when-issued and similar securities. We therefore report their number
and net assets separately from those of other mutual funds.
    \805\ Estimates of the number of BDCs and their net assets are
based on a staff analysis of Form 10-K and Form 10-Q filings as of
July 30, 2020. Our estimate includes BDCs that may be delinquent or
have filed extensions for their filings, and it excludes 6 wholly-
owned subsidiaries of other BDCs.
---------------------------------------------------------------------------

2. Funds' Use of Derivatives and Reverse Repurchase Agreements
    DERA staff analyzed funds' use of derivatives and reverse
repurchase agreements based on Form N-PORT filings as of September
2020. The filings covered 9,700 mutual funds with $17,059 billion in
total net assets, 1,973 ETFs with $3,252 billion in total net assets,
672 registered closed-end funds with $276 billion in net assets, and 13
variable annuity separate accounts registered as management investment
companies with $179 billion in total net assets.\806\
---------------------------------------------------------------------------

    \806\ The analysis is based on each registrant's latest Form N-
PORT filing as of September 15, 2020. Money market funds are
excluded from the analysis; they do not file monthly reports on Form
N-PORT and generally are excluded from the scope of rule 18f-4. For
open-end funds that have mutual fund and ETF share classes, we count
each type of share class as a separate fund and use data from
Morningstar to determine the amount of total net assets reported on
Form N-PORT attributable to the ETF share class.
---------------------------------------------------------------------------

    Based on this analysis, 60% of funds reported no derivatives
holdings, and a further 26% of funds reported using derivatives with
gross notional amounts below 50% of net assets. These results are
comparable to and consistent with the findings of a white paper
prepared by DERA staff that studied a random sample of 10% of funds in
2015.\807\ The 14% of funds that reported derivatives holdings at or
above 50% of net assets reported combined net assets of $1,886 billion,
which represented 8% of fund industry net assets. One percent of funds
reported entering into reverse repurchase agreements.
---------------------------------------------------------------------------

    \807\ See Daniel Deli, Paul Hanouna, Christof Stahel, Yue Tang &
William Yost, Use of Derivatives by Registered Investment Companies,
Division of Economic and Risk Analysis (2015), available at https://www.sec.gov/dera/staff-papers/white-papers/derivatives12-2015.pdf.
---------------------------------------------------------------------------

    BDCs do not file Form N-PORT. To help evaluate the extent to which
BDCs use derivatives, our staff reviewed the most recent financial
statements of 48 of the current 99 BDCs as of July 2020.\808\ Based on
this analysis, we observe that most BDCs do not use derivatives
extensively. Of the sampled BDCs, 59.1% did not report any derivatives
holdings, and a further 31.8% reported using derivatives with gross
notional amounts below 10% of net assets. We do not believe that BDCs
use reverse repurchase agreements to a significant extent.\809\
---------------------------------------------------------------------------

    \808\ See supra footnote 397 and accompanying text.
    \809\ See also supra footnote 712 (stating our belief that BDCs
do not use reverse repurchase agreements and bank borrowings (or
similar transactions) in combined amounts that exceed 50% of NAV).

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

3. Current Regulatory Framework for Derivatives
    Funds generally have developed certain general asset segregation
practices to ``cover'' their derivatives positions, considering at
least in part the staff's no-action letters and guidance.\810\ However,
as discussed in the proposal, practices vary based on the type of
derivatives transaction, and funds use different practices regarding
the types of assets that they segregate to cover their derivatives
positions. For purposes of establishing the baseline, we assume that
funds generally segregate sufficient assets to at least cover any mark-
to-market liabilities on the funds' derivatives transactions, with some
funds segregating more assets for certain types of derivatives
transactions (sufficient to cover the full notional amount of the
transaction or an amount between the transaction's full notional amount
and any mark-to-market liability).\811\ The mark-to-market liability of
a derivative can be much smaller than the full investment exposure
associated with the position. As a result, funds' current asset
segregation practices do not appear to place a practical limit on their
use of derivatives: A fund that segregates only the mark-to-market
liability could theoretically incur virtually unlimited investment
leverage.\812\ Moreover, funds' current asset segregation practices may
not assure the availability of adequate assets to meet funds'
derivatives obligations, on account of both the amount and types of
assets that funds may segregate.
---------------------------------------------------------------------------

    \810\ See supra section II.B.1.
    \811\ See Proposing Release, supra footnote 1, at n.54-55 and
accompanying text.
    \812\ See supra section I.B.2; footnote 69 and accompanying
text.
---------------------------------------------------------------------------

4. Funds' Derivatives Risk Management Practices and Use of VaR Models
    There is currently no requirement for funds that use derivatives to
have a formalized derivatives risk management program. However, we
understand that advisers to many funds whose investment strategies
entail the use of derivatives already assess and manage risks
associated with their derivatives transactions to varying extents.\813\
In addition, we understand that funds engaging in derivatives
transactions have increasingly used stress testing as a risk management
tool over the past decade.\814\
---------------------------------------------------------------------------

    \813\ See, e.g., AQR Comment Letter I, at 4.
    \814\ See supra footnote 194.
---------------------------------------------------------------------------

    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
tools.\815\ Advisers to funds that use derivatives more extensively may
be particularly likely currently to use risk management or portfolio
management platforms that include VaR capability. Moreover, advisers
that manage (or that have affiliates that manage) UCITS funds may
already be familiar with using VaR models in connection with European
guidelines.\816\ One commenter submitted the results of a survey based
on responses from 24 fund complexes with $13.8 trillion in assets.\817\
The results of this survey indicate that 73% of respondents used some
form of both VaR and stress testing as derivatives risk management
tools. Other commenters also observed that VaR is commonly used.\818\
---------------------------------------------------------------------------

    \815\ See Proposing Release, supra footnote 1, at n.180.
    \816\ See e.g., ABA Comment Letter; Blackrock Comment Letter;
Dechert Comment Letter I; Vanguard Comment Letter. Based on a staff
analysis of Form ADV and Form N-CEN filings received through July
31, 2020, there were approximately 190 registered investment
advisers that are registered with a EU financial regulatory
authority and that are reported as the investment adviser, or sub-
adviser, for a registered fund. This estimate may not capture
instances where a U.S. registered investment adviser and a EU
registered investment adviser are affiliated but separate legal
entities.
    \817\ See Comment Letter of Investment Company Institute (Oct.
8, 2019) (``2019 ICI Comment Letter''). The commenter also indicated
that the surveyed ICI member firms accounted for 67% of mutual fund
and ETF assets as of June 2019 and that survey responses were
submitted by firms ``whose assets under management spanned the
spectrum from small to very large.'' However, these representations
alone do not provide sufficient information about whether the
surveyed firms were representative of all mutual funds and ETFs in
terms of the exact distribution of specific characteristics, such as
firm size or type of investment strategy.
    \818\ See, e.g., supra footnotes 287-291 and accompanying text.
---------------------------------------------------------------------------

5. Leveraged/Inverse Funds
    Leveraged/inverse investment funds generally target a daily return
(or a return over another predetermined time period) that is a
multiple, inverse, or inverse multiple of the return of an underlying
index; however over longer holding periods, the realized leverage
multiple of the returns of an investment in a leveraged/inverse
investment vehicle relative to the returns of its underlying index can
vary substantially from the vehicle's daily leverage multiple. To
achieve the stated leverage multiple, most leveraged/inverse investment
funds rebalance their exposure to the underlying index daily.\819\
---------------------------------------------------------------------------

    \819\ Leveraged/inverse funds that track the returns of an
underlying index over time periods that are longer than one day
rebalance their portfolios at the end of each such period.
Leveraged/inverse funds use derivatives to achieve their targeted
returns.
---------------------------------------------------------------------------

    Currently, there are 172 leveraged/inverse ETFs with $33.4 billion
in total net assets and 120 leveraged/inverse mutual funds with $4.6
billion in total net assets. Of these funds, 70 leveraged/inverse ETFs
with $15.7 billion in total net assets and none of the leveraged/
inverse mutual funds currently seek to provide leveraged or inverse
market exposure exceeding 200% of the return or inverse return of the
relevant index.\820\
---------------------------------------------------------------------------

    \820\ Estimates of the number of leveraged/inverse mutual funds
and leveraged/inverse ETFs and their total net assets are based on a
staff analysis of Form N-CEN filings as of July 7, 2020 and are
based on fund's responses to item C.3.c of the form. Information
about the market exposure funds seek to provide is based on a staff
review of funds' summary prospectuses and takes into account that
several leveraged/inverse funds that sought to provide 300%
leveraged or inverse market exposure recently reduced their target
exposures to 200% due to the increased market volatility caused by
COVID-19. See also supra footnote 24 and accompanying text.
---------------------------------------------------------------------------

    Two ETF sponsors currently rely upon exemptive relief from the
Commission that permits them to operate leveraged/inverse ETFs.\821\
Since 2009, the Commission has not granted leveraged/inverse ETF
exemptive relief to any additional sponsors. In addition, leveraged/
inverse ETFs are currently excluded from the scope of rule 6c-11, which
the Commission adopted in 2019 and allows ETFs satisfying certain
conditions to operate without obtaining an exemptive order from the
Commission.\822\ While certain exchange-listed commodity- or currency-
based trusts or funds that are not registered investment companies also
have strategies that are similar to leveraged/inverse funds, and other
investments like certain exchange-traded notes may provide a similar
investment exposure, the final rules' provisions for leveraged/inverse
funds address only registered investment companies with these
strategies.
---------------------------------------------------------------------------

    \821\ See Proposing Release, supra footnote 1, at nn.307 and
356. The exemptive orders of the two sponsors that operate
leveraged/inverse ETFs permit these sponsors to launch additional
funds under the terms and conditions of those orders.
    \822\ See supra footnotes 613-614 and accompanying text.
---------------------------------------------------------------------------

C. Benefits and Costs of the Final Rules and Amendments

    The Commission is sensitive to the economic effects that may result
from the final rules and form amendments, including benefits and costs.
Where possible, we have attempted to quantify the likely economic
effects; however, we are unable to quantify certain economic effects
because we lack the information

necessary to provide reasonable estimates. In some cases, it is
difficult to predict how market participants will act under the
conditions of the final rules. For example, we are unable to predict
whether the derivatives risk management program requirement and VaR-
based limit on fund leverage risk may make investors more or less
likely to invest in funds that would be subject to these requirements
or the degree to which these requirements may affect the use of
derivatives by these funds. Nevertheless, as described more fully
below, we are providing both a qualitative assessment and quantified
estimate of the economic effects, including the initial and ongoing
costs of the additional reporting requirements, where feasible.
    Direct costs that funds will incur, as discussed below, may to some
extent be absorbed by a fund's investment adviser or be passed on to a
fund's investors in the form of increased fees and expenses.\823\ The
share of these costs borne by funds, their advisers, and investors
depends on multiple factors, including the nature of competition
between advisers, and investors' relative sensitivity to changes in
fund fees, the joint effects of which are particularly challenging to
predict due to the number of assumptions that the Commission would need
to make.
---------------------------------------------------------------------------

    \823\ Several commenters stated that a fund may pass on some of
the costs associated with the rule's requirements to its investors.
See Dechert Comment Letter I; Dechert Comment Letter II; ICI Comment
Letter; Vanguard Comment Letter.
---------------------------------------------------------------------------

1. Derivatives Risk Management Program and Board Oversight and
Reporting
    Rule 18f-4 will require funds that enter into derivatives
transactions and are not limited derivatives users to adopt and
implement a derivatives risk management program. The program will have
to include risk guidelines, stress testing, backtesting, internal
reporting and escalation, and program review elements. The final rule
will require a fund's board of directors to approve the fund's
designation of a derivatives risk manager, who will be responsible for
administering the derivatives risk management program.\824\ The fund's
derivatives risk manager will have to report to the fund's board on the
derivatives risk management program's implementation and effectiveness
and the results of the fund's stress testing and backtesting.\825\
---------------------------------------------------------------------------

    \824\ See supra section II.C.1. for a discussion of the final
rule's requirements for board approval of the derivatives risk
manager and the comments we received on the proposal.
    \825\ See supra section II.C.2. for a discussion of the final
rule's board reporting requirements and the comments we received on
the proposal.
---------------------------------------------------------------------------

    We understand that advisers to many funds whose investment
strategies entail the use of derivatives already assess and manage
risks associated with their derivatives transactions.\826\ However,
rule 18f-4's requirement that funds establish written derivatives risk
management programs will create a standardized framework for funds'
derivatives risk management by requiring each fund's program to include
all of the rule's program elements. To the extent that the resulting
risk management activities are more comprehensive than funds' current
practices, this may result in more effective risk management across
funds. While the adoption of a derivatives risk management program
requirement may not eliminate all derivatives-related risks, including
that investors could experience large, unexpected losses from funds'
use of derivatives, we expect that investors may benefit from a
decrease in leverage-related risks.
---------------------------------------------------------------------------

    \826\ See supra section III.B.4. See also Blackrock Comment
Letter; ICI Comment Letter; and J.P. Morgan Comment Letter.
---------------------------------------------------------------------------

    Some funds may reduce or otherwise alter their use of derivatives
transactions to respond to risks identified after adopting and
implementing their derivatives risk management programs. In particular,
we expect that funds currently utilizing risk management practices that
are not tailored to their use of derivatives may decide to make such
changes to their portfolios.\827\
---------------------------------------------------------------------------

    \827\ As a consequence of reducing risk, such funds may earn
reduced returns.
---------------------------------------------------------------------------

    Rule 18f-4 will require a fund to reasonably segregate the
functions of its derivatives risk management program from those of its
portfolio management.\828\ This segregation requirement is designed to
enhance the program's effectiveness by promoting the objective and
independent identification and assessment of derivatives risk.\829\
Segregating the functions of a fund's derivatives risk management
program from those of its portfolio management may also mitigate the
risks posed by competing incentives between a fund's portfolio managers
and its investors.\830\
---------------------------------------------------------------------------

    \828\ See supra section II.B.1.
    \829\ In addition, while some portfolio managers may find it
burdensome to collaborate with a derivatives risk manager, to the
extent that portfolio managers already consider the impact of trades
on the fund's portfolio risk, we believe that having the involvement
of a derivatives risk manager may typically make a portfolio
manager's tasks more rather than less efficient.
    \830\ For example, portfolio managers of actively-managed funds
that are underperforming competing funds may have an incentive to
increase risk exposures through use of derivatives in an effort to
increase returns. This behavior may result in a fund also increasing
risk beyond investor expectations. See also SIFMA AMG Comment
Letter; ABA Comment Letter. (For theoretical motivation of such
behaviors see, e.g., Keith C. Brown, W.V. Harlow, & Laura T. Starks,
Of Tournaments and Temptations: An Analysis of Managerial Incentives
in the Mutual Fund Industry, 51 J. FIN. 85 (1996), available at
https://www.onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1996.tb05203.x; Judith Chevalier & Glenn Ellison, Risk-Taking
by Mutual Funds as a Response to Incentives, 105 J. POL. ECON. 1167
(1997), available at https://www.jstor.org/stable/10.1086/516389?seq=1#metadata_info_tab_contents).
---------------------------------------------------------------------------

    Finally, to the extent that the periodic stress testing and
backtesting requirements of the derivatives risk management program
result in fund managers developing a more complete understanding of the
risks associated with their use of derivatives, we expect that funds
and their investors will benefit from improved risk management.\831\
Such benefits will be in addition to benefits derived from the VaR-
based limit on fund leverage risk discussed below.\832\ VaR analysis,
while yielding a simple yet general measure of a fund's portfolio risk,
does not provide a complete picture of a fund's financial risk
exposures.\833\ Complementing VaR analysis with stress testing will
provide a more complete understanding of the fund's potential losses
under different sets of market conditions. For example, simulating
potential stressed market conditions not reflected in historical
correlations between fund returns and asset prices observed in normal
markets may provide derivatives risk managers with important
information pertaining to derivatives risks in stressed
environments.\834\ By incorporating the potential impact of future
economic outcomes and market volatility in its stress test analysis, a
fund may be able

to analyze future potential swings in its portfolio that may impact the
fund's long-term performance. Recent episodes of market volatility
related to the COVID-19 global health pandemic have highlighted the
importance of analyzing such future potential swings in a fund's
portfolio. This forward-looking aspect of stress testing will
supplement the final rule's VaR analysis requirement, which will rely
on historical data.
---------------------------------------------------------------------------

    \831\ See supra sections II.B.2.c and II.B.2.d; see also supra
section II.C.2 (discussing the requirements that a fund's
derivatives risk manager provide to the fund's board: (1) A written
report, at least annually, 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; and
(2) a written report, at the frequency determined by the board,
analyzing exceedances of the fund's risk guidelines and the results
of the fund's stress tests and backtesting).
    \832\ See infra section III.C.2.
    \833\ See id.
    \834\ See supra section II.B.2.c (rule 18f-4 will require the
program to provide for stress testing 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, taking into
account correlations of market risk factors as appropriate and
resulting payments to derivatives counterparties'').
---------------------------------------------------------------------------

    In addition, the final rule will require that a fund backtest the
results of its VaR analysis no less frequently than weekly, which will
assist funds in examining the effectiveness of the fund's VaR model.
The final rule will require that, for each weekly backtesting period,
the fund compare its actual gains or losses on each business day during
the weekly period, with the fund's VaR calculated for each business day
during the same weekly period.\835\ The weekly comparison will help
identify days where the fund's portfolio losses exceed the VaR
calculated for each day during the week, as well as systematic over- or
under-estimation of VaR, which would suggest that the fund may not be
accurately measuring all significant, identifiable market risk
factors.\836\
---------------------------------------------------------------------------

    \835\ See supra section II.B.2.d.
    \836\ See supra footnote 212; see also supra section II.B.2.d
for a discussion of comments the Commission received on the proposed
backtesting requirement.
---------------------------------------------------------------------------

    Commenters stated that weekly backtesting would be associated with
reduced burdens compared to the more frequent daily backtesting
requirement we proposed.\837\ We have not reduced our estimates from
the Proposing Release of one-time and ongoing program-related costs as
a result of the decreased backtesting frequency, however.\838\
Therefore, the cost estimates we provide below may overstate the costs
of the final rule's backtesting requirement.\839\
---------------------------------------------------------------------------

    \837\ See supra footnote 222 and associated text.
    \838\ See Proposing Release, supra footnote 1, at section
III.C.1.
    \839\ We anticipate that any cost savings compared to the
proposal as a result of the decreased backtesting frequency will be
small, as the development and implementation of processes for
backtesting likely have a significant fixed-cost component.
---------------------------------------------------------------------------

    Rule 18f-4 will also require that a fund's board of directors
approve the designation of the fund's derivatives risk manager.\840\ We
anticipate that this requirement, along with the derivatives risk
manager's direct reporting line to the board, will result in effective
communication between the board and the derivatives risk manager that
will enhance oversight of the program to the benefit of the fund and
its investors.
---------------------------------------------------------------------------

    \840\ See supra section II.C.1.
---------------------------------------------------------------------------

    Rule 18f-4 will require that the derivatives risk manager provide
the fund's board a written report at least once a year on the program's
effectiveness as well as regular written reports at a frequency
determined by the board that analyze exceedances of the fund's risk
guidelines and the results of the fund's stress tests and
backtests.\841\ The board reporting requirements may facilitate the
board's oversight of the fund and the operation of the derivatives risk
management program, to the extent the fund does not have such regular
reporting mechanisms already in place. In the event the derivatives
risk manager encounters material risks that need to be escalated to the
fund's board, the rule's provision that the derivatives risk manager
must directly inform the board of these risks in a timely manner as
appropriate may help prevent delays in resolving such risks.
---------------------------------------------------------------------------

    \841\ See id.
---------------------------------------------------------------------------

    Funds today employ a range of different practices, with varying
levels of comprehensiveness and sophistication, for managing the risks
associated with their use of derivatives.\842\ We expect that
compliance costs associated with the derivatives risk management
program requirement will vary based on the fund's current risk
management practices, as well as the fund's characteristics, including
in particular the fund's investment strategy, and the nature and type
of derivatives transactions used by the fund.
---------------------------------------------------------------------------

    \842\ See supra section III.B.4.
---------------------------------------------------------------------------

    We understand that VaR models are widely used in the industry and
that backtesting is commonly performed in conjunction with VaR
analyses. As a result, we believe that many funds that will be required
to establish derivatives risk management programs already have VaR
models with backtesting in place. Moreover, the final rule's
derivatives risk management program requirements, including stress
testing and backtesting requirements are, generally, high-level and
principles-based. As a result, as one commenter acknowledged, many
funds' current risk management practices may already be in line with
many of the rule's derivatives risk management program requirements or
could be readily conformed without material change.\843\ Thus, the
costs of adjusting funds current' practices and procedures to comply
with the parallel requirements of final rule 18f-4 may be minimal for
such funds.
---------------------------------------------------------------------------

    \843\ See Blackrock Comment Letter, at 8.
---------------------------------------------------------------------------

    Certain costs of the rule's derivatives risk management program may
be fixed, while other costs may vary with the size and complexity of
the fund and its portfolio allocation. For instance, costs associated
with purchasing certain third-party data used in the program's stress
tests may not vary much across funds. On the other hand, certain third-
party services may vary in terms of costs based on the portfolio
positions to be analyzed. Further, the extent to which a cost
corresponding to the program is fixed or variable may also depend on
the third-party service provider.
    Larger funds or funds that are part of a large fund complex may
incur higher costs in absolute terms but find it less costly, per
dollar managed, to establish and administer a derivatives risk
management program relative to a smaller fund or a fund that is part of
a smaller fund complex. For example, larger funds may have to allocate
a smaller portion of existing resources for the program, and fund
complexes may realize economies of scale in developing and implementing
derivatives risk management programs for several funds. In addition,
smaller funds or those that are part of a smaller fund complex may find
it more costly to appoint a derivatives risk manager, because they (1)
may not have existing officers of the fund's investment advisers who
are capable of fulfilling the responsibilities of the derivatives risk
manager; (2) may have existing officers of the fund's investment
advisers who are capable of fulfilling the responsibilities of the
derivatives risk manager but may be overburdened with other existing
responsibilities within the fund; or (3) may choose to hire a new
officer or promote a current employee to fulfill this role.
    We estimate that the one-time costs to establish and implement a
derivatives risk management program will range from $150,000 to
$500,000 per fund, depending on the particular facts and circumstances,
including whether a fund is part of a larger fund complex and therefore
may benefit from economies of scale.\844\ These estimated

costs are attributable to the following activities: (1) Assessing
whether a fund is subject to the derivatives risk management program
requirement; (2) analyzing the fund's current practices relative to the
final rule's requirements; (3) developing risk guidelines and processes
for stress testing, backtesting, internal reporting and escalation, and
program review; (4) integrating and implementing the guidelines and
processes described above; (5) preparing training materials and
administering training sessions for staff in affected areas; \845\ (6)
recruiting and hiring a derivatives risks manager, to the extent the
fund is unable to consider an existing officer of the investment
adviser that is equipped with the appropriate and relevant experience
necessary to be selected for the role of derivatives risk manager; and
(7) approval by the board of the fund's derivatives risk manager.\846\
---------------------------------------------------------------------------

    \844\ We believe that the low end of this range is reflective of
a fund that already has policies and procedures in place that could
be readily adapted to meet the final rule's requirements. Such a
fund would nevertheless incur costs associated with analyzing its
current practices relative to the final rule's requirements and
determining whether it is subject to the derivatives risk management
program; some funds may also incur costs associated with analyzing
whether and how they could modify their derivatives exposure in
order to qualify as a limited derivatives user. We increased our
estimate of the low end of this range compared to the proposal to
account for these costs as well as to account for comments we
received suggesting that the implementation of the program may be
more burdensome than the Commission estimated at proposal and
comments suggesting that requiring the fund's board of directors to
approve the designation of the fund's derivatives risk manager would
place increased burdens on the fund's board of directors. See
Dechert Comment Letter I; IDC Comment Letter; see also supra
sections II.C.1 and II.B. This increased estimate also takes into
account our assumption that a number of funds and their boards may
wish to employ outside legal services in connection with adopting
and implementing the fund's derivatives risk management program as
well as approving the derivatives risk manager. See infra sections
IV.B.1, IV.B.2.
    \845\ See also ProShares Comment Letter (stating that
``employees will need to read and be trained on the policies and
procedures.'')
    \846\ A fund that selects an existing officer of its investment
adviser for the role of derivatives risk manager may incur costs
associated with recruiting and hiring an additional officer to
assume some or all of the tasks that previously were allocated to
the officer who is selected as derivatives risk manager.
---------------------------------------------------------------------------

    We estimate that the ongoing annual program-related costs that a
fund will incur range from 65% to 75% of the one-time costs to
establish and implement a derivatives risk management program. Thus, a
fund will incur ongoing annual costs that range from $97,500 to
$375,000.\847\ These estimated costs are attributable to the following
activities: (1) Assessing, monitoring, and managing the risks
associated with the fund's derivatives transactions; (2) periodically
reviewing and updating (A) the program including any models or
measurement tools (including any VaR calculation models) to evaluate
the program's effectiveness and to reflect changes in risk over time,
and (B) the appropriateness of any designated reference portfolio; (3)
providing written reports to the fund's board; (4) additional staff
training; and (5) the derivatives risk manager's base salary and
compensation, to the extent a fund is unable to consider an existing
officer of the investment adviser that is equipped with the appropriate
and relevant experience necessary to be selected for the role of
derivatives risk manager. Under the final rule, a fund that is a
limited derivatives user will not be required to establish a
derivatives risk management program.\848\ Based on an analysis of Form
N-PORT filings, as well as financial statements filed with the
Commission by BDCs, we estimate that about 21% of funds, or 2,766 funds
total, will be required to implement a derivatives risk management
program.\849\ As many funds belong to a fund complex and are likely to
experience economies of scale, we expect that the lower end of the
estimated range of costs ($150,000 in one-time costs; $97,500 in annual
costs) better reflects the total costs likely to be incurred by those
funds.\850\ In addition, we believe that many funds already have a
derivatives risk management program in place that could be readily
adapted (and also already have personnel on staff who could serve as
derivatives risk manager) to meet the final rule's requirements without
significant additional cost.\851\ However, as we do not have data to
determine how many funds already have a program in place that will
substantially satisfy the final rule's requirements, and commenters did
not provide any such data, we over-inclusively assume that all funds
that will be required to establish a derivatives risk management
program will incur a cost associated with this requirement. Based on
these assumptions, we provide an upper-end estimate for total industry
cost in the first year of $684,585,000.\852\
---------------------------------------------------------------------------

    \847\ This estimate is based on the following calculations: 0.65
x $150,000 = $97,500; 0.75 x $500,000 = $375,000.
    \848\ The estimates of the one-time and ongoing costs described
in this section include the costs associated with determining
whether a fund is subject to the rule's VaR and program
requirements.
    \849\ We estimate that about 21% of funds hold some derivatives
and will not qualify as a limited derivatives user under the final
rule.
    \850\ A fund that uses derivatives in a complex manner, has
existing risk management practices that are not commensurate with
such use of derivatives, and may have to hire additional personnel
to fulfill the role of derivatives risk manager will be particularly
likely to experience costs at the upper end of this range.
    \851\ Prior to the proposal, one commenter indicated that
implementing stress testing, which would be one of the required
elements of the proposed derivatives risk management program, would
be only slightly burdensome for 27% of respondents to a survey of
ICI member firms and would be moderately burdensome for an
additional 50% of respondents. See Proposing Release, supra footnote
1, at n.501.
    \852\ This estimate is based on the following calculation: 2,766
funds x ($150,000 + $97,500) = $684,585,000.
---------------------------------------------------------------------------

2. VaR-Based Limit on Fund Leverage Risk
    The final rule will generally impose a VaR-based limit on fund
leverage risk on funds relying on the rule to engage in derivatives
transactions.\853\ This outer limit is based on a relative VaR test
that compares the fund's VaR to the VaR of a ``designated reference
portfolio.'' If the fund's derivatives risk manager reasonably
determines that a designated reference portfolio would not provide an
appropriate reference portfolio for purposes of the relative VaR test,
the fund will be required to comply with an absolute VaR test.\854\ In
either case a fund will apply the test at least once each business day.
---------------------------------------------------------------------------

    \853\ See supra section II.D.
    \854\ The final rule provides an exception from the rule's VaR
test for limited derivatives users. See supra section II.E.
---------------------------------------------------------------------------

    The relative VaR test will limit a fund's VaR to 200% of the VaR of
the fund's designated reference portfolio, unless the fund is a closed-
end fund that has then-outstanding shares of a preferred stock issued
to investors. For such closed-end funds, the VaR must not exceed 250%
of the VaR of the fund's designated reference portfolio.\855\ The
designated reference portfolio will have to be unleveraged--an
unleveraged designated index or the fund's securities portfolio--and
reflect the markets or asset classes in which the fund invests.\856\ By
comparing the VaR of a fund's portfolio to that of an unleveraged
reference portfolio, the relative VaR test restricts the incremental
risk associated with a fund's portfolio relative to a similar but
unleveraged investment strategy. In this sense, the relative VaR test
restricts the degree to which a fund can use derivatives to leverage
its portfolio.
---------------------------------------------------------------------------

    \855\ See supra section II.D.2 for a discussion of the comments
we received and the data commenters provided on the relative VaR
limit we proposed.
    \856\ See supra section II.D.2.b. The final rule's definition of
``designated index'' also includes other requirements, as discussed
above. See id. For example, a designated index cannot 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.
---------------------------------------------------------------------------

    The final rule will permit a fund to rely on the absolute VaR test
only if the fund's derivatives risk manager reasonably determines that
a designated reference portfolio would not provide an appropriate
reference portfolio for purposes of the relative VaR test. To

comply with the absolute VaR test, the VaR of the fund's portfolio must
not exceed 20% of the value of the fund's net assets, unless the fund
is a closed-end fund that has then-outstanding preferred stock. For
such closed-end funds, the VaR must not exceed 25% of the value of the
fund's net assets.\857\
---------------------------------------------------------------------------

    \857\ See supra section II.D.2.
---------------------------------------------------------------------------

    The 20% absolute VaR limit is based on DERA staff analysis that
calculated the VaR of the S&P 500 since inception that the Commission
used to propose a 15% absolute VaR limit, adjusted consistent with the
final rule's increases to the proposed relative VaR limit.\858\ Under
the final rule, for example, a fund that uses the S&P 500 as its
benchmark index would be permitted to have a VaR equal to 200% of the
VaR of the S&P 500 if the fund also uses that index as its designated
reference portfolio. The 20% absolute VaR test limit would therefore
provide approximately comparable treatment for funds that rely on the
absolute VaR test and funds that rely on the relative VaR test with a
200% limit and use the S&P 500 as their designated reference portfolio
during periods where the S&P 500's VaR is approximately equal to the
historical mean.\859\
---------------------------------------------------------------------------

    \858\ See supra section II.D.3 for a discussion of the comments
we received and the data commenters provided on the absolute VaR
limit we proposed.
    \859\ DERA staff analyzed the historical returns of the S&P 500
index since inception. Computing VaR based on historical simulation
using the parameters specified in the final rule, we find that the
S&P 500's VaR had an average VaR of approximately 10.5%. The VaR of
the index varied over time, with a minimum of approximately 4.1%
attained for much of the first quarter of 1994 and a maximum of
approximately 22.9% attained from late 1987 through the third
quarter of 1990.
---------------------------------------------------------------------------

    One common critique of VaR is that it does not reflect the
conditional distribution of losses beyond the specified confidence
level.\860\ In other words, the VaR tests will not capture the size and
relative frequency of losses in the ``tail'' of the distribution of
losses beyond the measured confidence level.\861\ As a result, two
funds with the same VaR level could differ significantly in the
magnitude and relative frequency of extreme losses, even though the
probability of a VaR breach would be the same for the two funds. The
Proposing Release contained a set of example calculations, based on a
simplified portfolio, that illustrate this point.\862\
---------------------------------------------------------------------------

    \860\ See supra footnote 295 and accompanying text.
    \861\ The term ``relative frequency'' here refers to the
frequency of loss outcomes in the tail of the distribution relative
to other loss outcomes that are also in the tail of the
distribution. This relative frequency of the loss outcomes together
with the magnitude of the associated losses describe the conditional
distribution of losses in the tail of the distribution.
    \862\ See Proposing Release, supra footnote 1, at section
IV.C.2.
---------------------------------------------------------------------------

    As discussed in more detail above, the VaR tests are designed to
address the concerns underlying section 18, but they are not a
substitute for a fully-developed derivatives risk management
program.\863\ Recognizing VaR's limitations, the final rule will also
require the fund to adopt and implement a derivatives risk management
program that, among other things, will require the fund to establish
risk guidelines and to stress test its portfolio in part because of
concerns that VaR as a risk management tool may not adequately reflect
tail risks.
---------------------------------------------------------------------------

    \863\ See supra footnote 297 and accompanying text.
---------------------------------------------------------------------------

    Below is an analysis using benchmark and other data that is an
effort to produce estimates of how many funds (out of the 2,696) that
we estimate will be subject to the final rule's VaR-based limit on fund
leverage risk would have operated in exceedance of such limit.\864\ The
analysis supporting these estimates relies on various assumptions that
limit the applicability of the estimates to the population of funds
subject to the final rule. More specifically, the analysis is limited
in the following ways: (1) The estimated VaR is based on funds'
historical portfolio and benchmark returns throughout the look-back
period, rather than returns of the funds' current portfolio and
composition of the benchmark index at the end of the look-back period,
as will be required of funds under the final rule, (2) the calculations
do not take into account the VaR of funds' securities portfolios,
because we do not have historical data regarding the returns of those
portfolios, and (3) the calculations generally assume that funds will
use their primary prospectus benchmarks for purposes of the relative
VaR test, even though the final rule permits them to use a different
index or their own securities portfolio. Accordingly, the estimates
approximate the effects of the final rule's VaR limits using the
available information, and that approximation, as discussed below, may
not reflect the actual manner in which the limits apply to funds under
the final rule.
---------------------------------------------------------------------------

    \864\ This analysis is based on Morningstar data with three-year
look-back periods ending in December 31, 2018 and June 30, 2020.
DERA staff computed the VaR of each fund and that of the related
index using historical simulation from three years of prior daily
return data. Staff generally computed the relative VaR test based on
a fund's primary prospectus benchmark. In cases where historical
return data for the primary prospectus benchmark was not available
or where the primary prospectus benchmark did not appear to capture
the markets or asset classes in which a fund invests, DERA staff
instead used a broad-based unleveraged index that captures a fund's
markets or asset classes or a broad-based U.S. equity index.
---------------------------------------------------------------------------

    The analysis estimates VaR based on the historical returns of fund
portfolios and benchmark indexes because it would be impractical for
staff to estimate VaR based on the exact composition, as of the end of
the look-back period, for every fund's portfolio and benchmark index.
As a result, the VaR estimates we derive reflect changes to the
composition of funds' portfolios and the benchmark indexes throughout
the look-back period rather than just at the end of the look-back
period.\865\ Funds computing their own VaRs, in contrast, would analyze
their current portfolios and benchmark indexes, if applicable, at the
time of calculation, taking into consideration at least three years of
historical market data. We also were not able to evaluate VaR levels of
funds' securities portfolios because we do not have historical data
regarding the returns of funds' securities portfolios, as defined in
the final rule.
---------------------------------------------------------------------------

    \865\ For example, our methodology would under-estimate VaR for
volatility-targeting funds in a period of low volatility that was
preceded by a period of higher volatility earlier in the look-back
period. This is because these funds increase the size of their
positions when market risks are lower in order to target a constant
level or range of volatility. See also supra footnote 451 and
accompanying text.
---------------------------------------------------------------------------

    We analyzed the effects of the final rule's VaR limits for two
three-year lookback periods: The first ending on December 31, 2018 and
the second ending on June 30, 2020. The former period is the period we
analyzed in the Proposing Release and reflects a relatively calm market
environment.\866\ The latter period is more recent and includes parts
of the more volatile market environment following the onset of COVID-
19.
---------------------------------------------------------------------------

    \866\ See Proposing Release, supra footnote 1, at section
III.C.2.
---------------------------------------------------------------------------

    For the three-year period ending on December 31, 2018, we did not
estimate that any funds would fail the relative VaR test from the pool
of funds that would have been subject to the VaR-based limit.\867\ For
the three-year period ending on June 30, 2020, which included a period
of significantly heightened market volatility, our analysis yields an
estimate of 383 funds that may fail the relative VaR test from the pool
of funds that will be subject to the VaR-based limit.\868\ None of the
383 funds are closed-end funds that have outstanding shares of
preferred stock

and thus are subject to the higher 250% relative-VaR based limit.\869\
Differences between the composition of the benchmarks and the funds'
portfolios--together with heightened market volatility during the
lookback period--likely contributed to some funds being estimated to
fail the VaR tests. In addition, this estimate is limited by the
information available to the Commission, which generally compared the
funds' VaRs to the VaRs of the funds' primary prospectus
benchmarks.\870\ To the extent that these funds' derivatives risk
managers would have determined that the fund's securities portfolio or
an index other than the disclosed benchmark would have been more
appropriate for purposes of computing the relative VaR test, some of
these funds could have satisfied the relative VaR test. Conversely, if
the indexes selected by the funds, or their securities portfolios, had
lower volatility than the index selected here, funds that are estimated
to have passed the relative VaR test may not ultimately satisfy that
test under the final rule.
---------------------------------------------------------------------------

    \867\ In the Proposing Release we identified six funds that
would have failed the relative VaR test at the lower 150% limit we
proposed. See id.
    \868\ For the purposes of this analysis, we assumed that all
leveraged/inverse funds with exposures up to 200% will be able to
satisfy the relative VaR test.
    \869\ We identified one closed-end fund that has outstanding
shares of preferred stock that is subject to the VaR-based limit
with a relative VaR level that exceeds 200% but not 250%. Thus, this
fund would not be able to satisfy the relative VaR test absent the
higher limit for closed-end funds that have outstanding shares of
preferred stock.
    \870\ See supra footnote 858.
---------------------------------------------------------------------------

    In addition, some of these funds could have applied the absolute
VaR test if the funds' derivatives risk managers reasonably determined
that a designated reference portfolio would not provide an appropriate
reference portfolio for purposes of the relative VaR test. Most of the
funds with VaRs exceeding 200% of the relevant index VaR (351 of 383)
had portfolio VaRs below the final rule's 20% absolute VaR limit.
Conversely, we recognize that some funds that are estimated to pass the
relative VaR test could have applied the absolute VaR test and may not
have satisfied that test.\871\
---------------------------------------------------------------------------

    \871\ DERA staff also examined funds' absolute VaR levels in
isolation as a result of the volatile market environment following
the onset of COVID-19. Specifically, we observe that 396 funds that
we estimated would satisfy the relative VaR test had absolute VaR
levels above 20% for the three-year lookback period ending on June
30, 2020. However, we believe this observation is of limited value
in estimating the impact of the absolute VaR test. First, because
the relative VaR test is the default test under the final rule, we
do not believe that this observation is indicative of the number of
funds that will not be able to satisfy the rule's VaR-based limit on
fund leverage risk because they rely on the absolute VaR test.
Second, because we lack the information necessary to identify the
subset of funds that are likely to rely on the absolute VaR test
under the rule, it is not clear that this observation is
representative of the likelihood that such funds would exceed the
absolute VaR limit.
---------------------------------------------------------------------------

    One commenter provided the results from a survey that asked
respondents to evaluate whether they would anticipate relying on the
proposed absolute or relative VaR test and whether they would satisfy
their applicable test, assuming various alternative specifications of
limits for these tests.\872\ The commenter reported that 0.9% of funds
that indicated that they use derivatives and do not qualify as a
limited derivatives user (under the proposed definition) would not have
been able to satisfy their applicable VaR test at the end of 2019 using
a 200% limit for the relative VaR test and a 20% limit for the absolute
VaR test. Using the staff estimate of the number of funds that will be
subject to the VaR-based test under the final rule, this result implies
that 24 funds would have failed their applicable VaR test.\873\ The
commenter also asked respondents to evaluate their VaR levels during a
stressed market period, and reported that 1.8% of funds would have
failed their applicable VaR test (using assumed 200% and 20% levels for
the relative VaR test and absolute VaR test, respectively).\874\ Using
the staff estimate of the number of funds that we estimate will be
subject to the VaR-based test under the final rule, this result implies
that 49 funds would have failed their applicable VaR test.\875\ We
believe that these survey-based results of the proposed VaR-based tests
using a 200% limit for the relative VaR test and a 20% limit for the
absolute VaR test help inform an assessment of the final rule's likely
effects and complement the staff's own analysis of the VaR-based tests
under the final rule.
---------------------------------------------------------------------------

    \872\ See ICI Comment Letter.
    \873\ This number is based on the following calculation: 2,696
funds x 0.9% = 24 funds.
    \874\ The commenter indicated that the survey did not specify a
specific stressed period but that the majority of respondents
included the global financial crisis. See ICI Comment Letter.
    \875\ This number is based on the following calculation: 2,696
funds x 1.8% = 49 funds.
---------------------------------------------------------------------------

    Two commenters stated that the VaR-based limit on fund leverage
risk would not benefit investors, because only a relatively small
number of funds will have to adjust their portfolios in order to comply
with the VaR based limit on leverage risk.\876\ However, we believe
that the VaR-based limit on fund leverage risk will benefit investors
by establishing an outer bound on fund leverage risk, which will
prevent funds from using strategies that expose investors to a degree
of fund leverage risk that is inconsistent with the investor protection
concerns of section 18.
---------------------------------------------------------------------------

    \876\ See ProShares Comment Letter and Direxion Comment Letter.
---------------------------------------------------------------------------

    Funds that will have to adjust their portfolios to comply with the
VaR-based limit on fund leverage risk will incur associated trading
costs. If a fund has to adjust its portfolio so significantly that it
could no longer pursue its investment strategy, such a fund may also
lose investors or, if it chooses to cease operating, incur costs
associated with unwinding the fund.
    In addition, funds could be required to adjust their portfolios to
comply in the future and, if so, will incur associated trading costs.
For example, as market conditions change, a fund's VaR could exceed the
VaR-based limit, especially if a fund relies on the absolute VaR test.
The final rule's VaR tests also will eliminate the flexibility that
funds currently have to leverage their portfolios to a greater extent
than the VaR tests permit. Although funds currently may not be
exercising this flexibility, they may nevertheless value the ability to
increase leverage beyond the rule's VaR-based limit. While, on the one
hand, the VaR-based tests impose costs on funds by restricting the
strategies they can employ, the limit on fund leverage risk will
benefit fund investors, to the extent that it prevents these investors
from experiencing losses from a fund's increased risk exposure that is
prohibited by the VaR-based limit on fund leverage risk.
    By establishing a bright-line limit on the amount of leverage risk
that a fund can take on using derivatives, the final rule may make some
funds and their advisers more comfortable with using derivatives. As a
result, some funds that currently use derivatives to an extent that
will result in the fund's VaR being below the limit may react by
increasing the extent of their derivatives usage.
    The requirement could also indirectly result in changing the amount
of investments in funds. On the one hand, the final rule could attract
additional investment, if investors become more comfortable with funds'
general level of riskiness as a result of funds' compliance with an
outside limit on fund leverage risk. On the other hand, to the extent
that investors currently expect funds to limit their risk to levels
below those which the limits will produce, or to the extent that the
rule's bright-line limit on the amount of leverage risk leads some
funds to increase their derivatives usage, the limits may result in
investors re-evaluating how much risk they are willing to take and
reducing their investments in funds. Due to a lack of data regarding
current investor expectations about fund risk, however,

we are unable to predict which of the two effects will more likely
dominate the other.
    As the requirements will prevent funds that are subject to the
outer limit on fund leverage risk from offering investment strategies
that exceed the outer limit, those investors who prefer to invest in
such funds because they value the increased potential for gains that is
generally associated with riskier investment strategies may see their
investment opportunities restricted by the final rules.\877\ As a
result, such investors may instead invest in alternative products that
can provide leveraged market exposure but will not be subject to the
VaR-based limit on fund leverage risk of rule 18f-4 and incur any
transactions costs associated with changing their investments.\878\
Examples of such alternative products include existing leveraged/
inverse funds with exposures exceeding 200%, as well as products that
are not registered investment companies, such as alternative investment
vehicles (including the listed commodity pools that would have been
subject to the proposed sales practices rules), exchange-traded notes
(``ETNs''), and structured products.\879\ Some of these alternatives
may present additional risks. For example, some investors could choose
to invest in ETNs, which are subject to issuer default. Alternatively,
such investors, particularly institutional ones, may instead borrow
themselves or trade on margin to achieve leverage.
---------------------------------------------------------------------------

    \877\ See also ProShares Comment Letter (mentioning a
``reduction of investment opportunities for investors'' as a result
of the VaR-based test.)
    \878\ See also ProShares Comment Letter (mentioning ``costs
incurred if [investors] switched to alternative investment vehicles
[from funds that cannot satisfy the VaR-based test].'')
    \879\ As part of the staff review discussed above, the staff
will review the effectiveness of the existing regulatory
requirements in protecting investors who invest in leveraged/inverse
products and other complex investment products. See supra section
II.F.4.
---------------------------------------------------------------------------

    Funds that will be subject to the VaR-based limit on fund leverage
risk will incur the cost of determining their compliance with the
applicable VaR test at least once each business day. Part of these
costs will be associated with obtaining the necessary data required for
the VaR calculation, to the extent that a fund does not already have
this data available. Funds implementing the relative VaR test and using
a designated index as the reference portfolio will likely incur larger
data costs compared to funds implementing the absolute VaR test, as the
absolute VaR test will require funds to obtain data only for the VaR
calculation for the fund's portfolio, whereas the relative VaR test in
this case also will require funds to obtain data for the VaR
calculation for their designated index. In addition, some index
providers may charge licensing fees to funds for including indexes in
their regulatory documents or for access to information about the
index's constituent securities and weightings.\880\ Funds may avoid
these index-related costs by using their securities portfolio. That
approach may, however, involve some operational burdens in that it
would require a fund to be able to identify and exclude the fund's
derivatives transactions, as defined in the rule, in order to calculate
the VaR of the fund's securities and other investments.
---------------------------------------------------------------------------

    \880\ We understand that industry practices around licensing
indexes for regulatory purposes vary widely, with some providers not
charging any fees and others charging fees in excess of $10,000 per
year.
---------------------------------------------------------------------------

    Funds that do not already have systems to perform the VaR
calculations in place will also incur the costs associated with setting
up these systems or updating existing systems.\881\ Both the data costs
and the systems costs will likely be larger for funds that use multiple
types of derivatives, use derivatives more extensively, or otherwise
have more complicated derivatives portfolios, compared to funds with
less complicated derivatives portfolios.
---------------------------------------------------------------------------

    \881\ In advance of the proposal, one commenter indicated that
implementing a UCITS VaR test will be only slightly burdensome for
45% of respondents to a survey of ICI member firms and would be
moderately burdensome for an additional 34% of respondents. The
commenter also indicated that respondents commonly reported that the
burden will increase, in some cases very substantially, if a VaR
test has different parameters or is more prescriptive than UCITS
VaR. See 2019 ICI Comment Letter. As the requirements of the VaR
test in the final rule are generally consistent with existing market
practice, including that of UCITs funds, the results of this survey
therefore support our view that many funds will likely experience
efficiencies in implementing the VaR test.
---------------------------------------------------------------------------

    Larger funds or funds that are part of a large fund complex may
incur higher costs in absolute terms but find it less costly, per
dollar managed, to perform VaR tests relative to a smaller fund or a
fund that is part of a smaller fund complex. For example, larger funds
may have to allocate a smaller portion of existing resources for the
VaR test and fund complexes may realize economies of scale in
implementing systems to compute VaR. In particular, the costs
associated with implementing or updating systems to calculate VaR will
likely only be incurred once at the level of a fund complex, as such
systems can be used to perform VaR tests for all funds in the complex
that are subject to the VaR test requirement. Similarly, larger fund
complexes may incur lower costs associated with purchasing data on a
per-fund basis, to the extent that the VaR calculations for multiple
funds in the complex partially or completely require the same data. For
these reasons, smaller funds or funds that are not part of a large fund
complex may be particularly likely to find it more economical to rely
on a third-party vendor to calculate VaR compared to incurring the
associated systems and data costs directly.
    Under the final rule, a fund that holds derivatives that is not a
limited derivatives user will generally be subject to the VaR-based
limit on fund leverage risk.\882\ Based on an analysis of Form N-PORT
filings and financial statements filed with the Commission by BDCs, we
estimate that about 21% of funds, or 2,696 funds total, will be
required to implement VaR tests. We estimate that the incremental
annual cost associated with the VaR test will range from $5,000 to
$100,000 per fund, depending on the particular facts and circumstances,
including whether the fund currently computes VaR; whether the fund is
implementing the relative or absolute VaR test; and whether a fund that
is part of a larger complex may be able to realize economies of scale
or compliance efficiencies with UCITS requirements.\883\ Funds that
currently already compute VaR, and especially funds that are managed by
an adviser (or are managed by an affiliate of an adviser) that manages
UCITS funds, will be particularly likely to experience costs at the
very low end of this range.\884\ Assuming that the midpoint of this
range reflects the cost to the average fund subject to the VaR
requirement, we

estimate a total additional annual industry cost of $141,540,000.\885\
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    \882\ The final rule will permit leveraged/inverse funds in
operation today that seek investment results in excess of the 200%
leverage risk limit, and that cannot comply with the relative VaR
test, to continue operating at their current leverage levels,
provided they meet certain requirements. See supra section II.F.5.
    \883\ One commenter criticized our estimates for the incremental
annual cost associated with the VaR test, and pointed out that our
estimates are lower than the estimated range of $60,000 to $180,000
per fund that the Commission provided in the 2015 Proposing Release.
See ProShares Comment Letter. The commenter did not, however,
provide data to inform more precise cost estimates. Conversely,
other commenters said that many advisers that use derivatives
already use risk management platforms that include VaR tools,
indicating that many funds may experience lower marginal costs than
we estimated in 2015. See supra footnotes 729-732 and accompanying
text. We are therefore not revising the cost estimates we provided
in the Proposing Release.
    \884\ We estimate that there are 190 registered investment
advisers that are registered with a EU financial regulatory
authority and that are reported as the investment adviser, or sub-
adviser, for a registered fund. See supra footnote 816.
    \885\ This estimate is based on the following calculation: 2,696
funds x 0.5 x ($5,000 + $100,000) = $141,540,000. Some funds may
find it more cost effective to restrict their use of derivatives in
order to be able to rely on the final rule's exception for limited
derivatives users compared to complying with the VaR-based limit on
fund leverage risk. See supra section II.E; infra section III.C.3.
As in the proposal, we do not have data that would allow us to
quantify the costs and benefits that define the tradeoff for any
particular fund of changing its use of derivatives in order to
qualify for the limited derivatives user exception, and commenters
did not provide any such data. Thus, we are still unable to quantify
how many funds would make this choice.
---------------------------------------------------------------------------

    In addition, a fund that currently operates in a manner that could
result in the fund's portfolio VaR being just under the final rule's
limit on fund leverage risk may need to alter its portfolio during
periods of increased market volatility in order to avoid falling out of
compliance with this limit. We expect such a scenario to be more likely
for a fund that will rely on the absolute VaR test, because the
relative VaR test will allow a fund to operate with a higher portfolio
VaR when the VaR of its designated reference portfolio increases.
    A fund that determines to eliminate some of its leverage risk
associated with derivatives in order to comply with the VaR-based limit
on leverage risk might do so through unwinding or hedging its
derivatives transactions or through some other means. These portfolio
adjustments may be costly, particularly in conditions of market stress
and reduced liquidity, such as the recent experience during COVID-19.
The final rule will, however, give a fund the flexibility to mitigate
these potential costs by not requiring the fund to exit positions or
change its portfolio if it is out of compliance with its VaR test. If a
fund determines that it is not in compliance with the applicable VaR
test, the final rule provides that a fund must come back into
compliance promptly after such determination, in a manner that is in
the best interests of the fund and its shareholders.\886\ If the fund
is not in compliance within five business days, the rule requires the
derivatives risk manager to report to the fund's board of directors
certain specified information about the fund coming back into
compliance, as well as requiring him or her to analyze the
circumstances that caused the fund to be out of compliance and update
as appropriate program elements to address those circumstances. If the
fund remains out of compliance with the applicable VaR test for thirty
calendar days since the exceedance, the derivatives risk manager's
written report must update the initial report to the board explaining
how and by when he or she reasonably expects the fund will come back
into compliance, and the derivatives risk manager must update the board
of directors on the fund's progress in coming back into compliance at
regularly scheduled intervals at a frequency determined by the
board.\887\ These provisions of the final rule collectively provide
some flexibility for a fund that is out of compliance with the VaR test
to make any portfolio adjustments. The final rule expressly requires a
fund's prompt coming back into compliance with its applicable VaR test
to be in a manner that is in the best interests of the fund and its
shareholders. This provision recognizes the investor protection
concerns arising from the harm and costs to funds and their
shareholders if funds were forced to exit derivatives transactions
immediately or at the end of the five-day period. Under this more
flexible approach, funds will have the ability to avoid some of the
costs that otherwise could result from a fund being forced to exit its
derivatives transactions within a short timeframe.
---------------------------------------------------------------------------

    \886\ See rule 18f-4(c)(2)(ii).
    \887\ See rule 18f-4(c)(2)(iii); see also supra section II.G.2
(discussing the requirement to submit a confidential report to the
Commission if the fund is out of compliance with the applicable VaR
test for five business days).
---------------------------------------------------------------------------

3. Limited Derivatives Users
    Rule 18f-4 includes an exception from the VaR-based limit on fund
leverage risk and program requirements for limited derivatives
users.\888\ The exception will be available for a fund that limits its
derivatives exposure to 10% of its net assets, excluding for this
purpose derivative transactions that are used to hedge certain currency
and/or interest rate risks. The final rule also provides certain
adjustments for interest rate derivatives and options, in computing
derivatives exposure, and permits funds to exclude positions closed out
with the same counterparty. A fund relying on the exception is required
to adopt and implement policies and procedures reasonably designed to
manage the fund's derivatives risks.\889\
---------------------------------------------------------------------------

    \888\ See supra section II.E for a discussion of the comments we
received on the proposed limited derivatives user exception and for
a discussion of the final rule's exclusions of certain hedging
transactions and offsetting of closed-out derivatives positions.
    \889\ See supra section II.E.4 for a discussion of the final
rule's two alternative paths for remediation if a fund's derivatives
exposure exceeds the 10% derivatives exposure threshold for five
business days.
---------------------------------------------------------------------------

    We expect that the risks and potential impact of these funds'
derivatives use may not be as significant, compared to those of funds
that do not qualify for the exception.\890\ Therefore, we believe that
a principles-based policies and procedures requirement would
appropriately address these risks. We believe that investors in funds
that use derivatives in a limited manner will benefit from the
requirement, which we anticipate will reduce, but not eliminate, the
frequency and severity of derivatives-related losses for such funds. In
addition, to the extent that the final rule's framework is more
comprehensive than funds' current practices, the requirement may result
in more effective risk management across funds and increased fund
industry stability.
---------------------------------------------------------------------------

    \890\ See supra footnote 488 and accompanying and immediately-
following text.
---------------------------------------------------------------------------

    We estimate that the one-time costs would range from $15,000 to
$100,000 per fund, depending on the particular facts and circumstances,
including whether a fund is part of a larger fund complex; the extent
to which the fund uses derivatives within the parameters of the limited
derivatives user exception, including whether the fund uses more
complex derivatives; and the fund's current derivatives risk management
practices.\891\ These estimated costs are attributable to the following
activities: (1) Assessing whether a fund is a limited derivatives user,
which may include determining whether a fund's derivatives positions
are used to hedge certain currency and/or interest rate risks or are
closed out with the same counterparty; (2) analyzing the fund's current
practices relative to the final rule's requirements; (3) developing
policies and procedures reasonably designed to manage a fund's
derivatives risks; (4) integrating and implementing the policies and
procedures; and (5) preparing training materials and administering
training sessions for staff in affected areas.
---------------------------------------------------------------------------

    \891\ We believe that the low end of this range is reflective of
a fund that already has policies and procedures in place that could
be readily adapted to meet the final rule's requirements. Such a
fund would nevertheless incur costs associated with analyzing its
current practices relative to the final rule's requirements and
determining whether it could qualify as a limited derivatives user.
We increased our estimate of the low end of this range compared to
the proposal to account for this cost as well as to account for the
potential that funds may implement additional policies and
procedures related to the changes we have incorporated into the
final rule to address exceedances of the 10% derivatives exposure
threshold. This increased estimate also takes into account our
assumption that a number of funds that qualify as limited
derivatives users may wish to employ outside legal services in
connection with adopting and implementing policies and procedures
reasonably designed to manage their derivatives risks. See infra
section IV.B.6.

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

    We estimate that the ongoing annual costs that a fund that is a
limited derivatives user will incur range from 65% to 75% of the one-
time costs associated with these requirements. Thus, we estimate that a
fund will incur ongoing annual costs that range from $9,750 to
$75,000.\892\ These estimated costs are attributable to the following
activities: (1) Assessing, monitoring, and managing the risks
associated with the fund's derivatives transactions; (2) periodically
reviewing and updating a fund's policies and procedures; (3) additional
staff training; and (4) preparing a written report to the fund's board
if a fund exceeds the 10% derivatives exposure threshold and does not
reduce its exposure within five business days.
---------------------------------------------------------------------------

    \892\ This estimate is based on the following calculations: 0.65
x $15,000 = $9,750; 0.75 x $100,000 = $75,000.
---------------------------------------------------------------------------

    Based on an analysis of Form N-PORT filings, as well as financial
statements filed with the Commission by BDCs, we estimate that about
19% of funds, or 2,437 funds total, will qualify as limited derivatives
users.
    Because many funds belong to a fund complex and are likely to
experience economies of scale, we expect that the lower end of the
estimated range of costs ($15,000 in one-time costs; $9,750 in annual
costs) better reflects the total costs likely to be incurred by many
funds. In addition, commenters suggested that many funds already have
policies and procedures in place to manage certain risks associated
with their derivatives transactions.\893\ We believe that these
policies and procedures could be readily adapted to meet the final
rule's requirements without significant additional cost. However, we do
not have data to determine how many funds already have such policies
and procedures in place that will substantially satisfy the final
rule's requirements, and commenters did not provide any such data. All
funds that seek to qualify as limited derivatives users also will need
to evaluate both the final rule and their current policies and
procedures to identify any needed modifications. We therefore assume
that all funds that seek to qualify as limited derivatives users will
incur a cost associated with this requirement. Based on these
assumptions, we estimate the total industry cost in the first year of
$60,315,750, but we believe that this estimate is likely over-inclusive
for the reasons stated above.\894\
---------------------------------------------------------------------------

    \893\ See Fidelity Comment Letter; IAA Comment Letter.
    \894\ This estimate is based on the following calculation: 2,437
funds x ($15,000 + $9,750) = $60,315,750. This cost estimate assumes
that none of the funds that currently do not hold any derivatives
will choose to establish and implement policies and procedures
reasonably designed to manage the fund's derivatives risks in
anticipation of a future limited use of derivatives. Notwithstanding
this assumption, we acknowledge some funds that currently do not use
derivatives may still choose to establish and implement such
policies and procedures prophylactically in order to preserve the
flexibility to engage in a limited use of derivatives on short
notice.
---------------------------------------------------------------------------

    Some funds may change how they use derivatives in order to qualify
for the limited derivatives user exception and thereby avoid the
potentially increased compliance cost associated with the final rule's
VaR and program requirements. For example, a fund with derivatives
exposure just below 10% of its net assets may forego taking on
additional derivatives positions, while a fund with derivatives
exposure just above 10% of its net assets might close out some existing
derivatives positions. As a result, the final rule's exception for
limited derivatives users may reduce the extent to which some funds use
derivatives.\895\
---------------------------------------------------------------------------

    \895\ As we do not have data that allow us to quantify the costs
and benefits that define the tradeoff for any particular fund of
changing its use of derivatives in order to qualify for the limited
derivatives user exception, and commenters did not provide any such
data, we are unable to estimate how many funds will make this
choice.
---------------------------------------------------------------------------

4. Reverse Repurchase Agreements and Similar Financing Transactions
    Reverse repurchase agreements and similar financing transactions
represent secured loans, which can be used to introduce leverage into a
fund's portfolio just like other forms of borrowings, or derivatives.
Accordingly, the final rule permits a fund to either choose to limit
its reverse repurchase and other similar financing transaction activity
to the applicable asset coverage limit of the Act for senior securities
representing indebtedness, or a fund may instead treat them as
derivative transactions. A fund's election will apply to all of its
reverse repurchase agreements and similar financing transactions so
that all such transactions are subject to a consistent treatment under
the final rule.\896\
---------------------------------------------------------------------------

    \896\ Rule 18f-4(d)(1)(i) and (ii).
---------------------------------------------------------------------------

    Today, funds rely on the asset segregation approach that Release
10666 describes with respect to reverse repurchase agreements, which
funds may view as separate from the limitations established on bank
borrowings (and other senior securities that are evidence of
indebtedness) by the asset coverage requirements of section 18.\897\ As
a result, the degree to which funds can engage in reverse repurchase
agreements under the final rule may differ from the baseline.
---------------------------------------------------------------------------

    \897\ See supra section II.H.
---------------------------------------------------------------------------

    A fund that engages in both reverse repurchase agreements and bank
borrowings (or similar transactions), in excess of the asset coverage
requirements of section 18, may be affected by the rule's requirements.
If such a fund chose to treat its reverse repurchase and other similar
financing transaction activity under the applicable asset coverage
limit of the Act for senior securities representing indebtedness, the
fund would be required to reduce the size of its activity to satisfy
this limit. Conversely, such a fund could choose to treat its reverse
repurchase and other similar financing transaction activity as
derivatives for all purposes of the final rule. Whether and how this
election would affect a fund would depend on the amount of other
derivatives and the degree to which the fund engages in reverse
repurchase agreements and similar financing transactions. This election
could cause a fund that otherwise did not engage in any derivatives
transactions to be required to adopt and implement policies and
procedures reasonably designed to manage the fund's derivatives risks
in order to qualify as a limited derivatives user (assuming that the
fund's use of reverse repurchase agreements and similar financing
transactions was limited to 10% of its net assets).\898\ Similarly, a
fund that otherwise could qualify as a limited derivatives user
(because it otherwise engaged in only a limited amount of derivatives
transactions) may no longer be able to rely on this exception to the
final rule's VaR and program requirements.
---------------------------------------------------------------------------

    \898\ As discussed further below in this section, we did not
identify any funds that used reverse repurchase agreements and bank
borrowings in combined amounts that exceed the asset coverage
requirement that also did not otherwise hold any derivatives.
Nevertheless, this fact pattern could affect some funds in the
future.
---------------------------------------------------------------------------

    To the extent that funds today separately analyze their asset
coverage requirements with respect to reverse repurchase agreements
under Release 10666 and bank borrowings and similar senior securities
under section 18, the treatment of reverse repurchase agreements under
the final rule could have the effect of limiting the overall scale of
these transactions. In addition, if a fund does not qualify as a
limited derivatives user due to its other investment activity or its
treatment of reverse repurchase agreements and similar financing
transactions as derivatives, any portfolio leveraging effect of reverse
repurchase agreements, similar financing transactions, and

borrowings will also be restricted indirectly through the VaR-based
limit on fund leverage risk. As a result, a fund could be restricted
through the VaR-based limit on fund leverage risk from investing the
proceeds of borrowings through reverse repurchase agreements to the
full extent otherwise permitted by the asset coverage requirements in
section 18 if the fund does not qualify as a limited derivatives user.
    DERA staff analyzed funds' use of reverse repurchase agreements and
borrowings using Form N-PORT filings as well as financial statements
filed with the Commission by BDCs. Based on the staff's analysis of
Form N-PORT filings, we estimate that about 0.27% of funds, or 35 funds
total, used these transactions in combined amounts that exceeded the
asset coverage requirement.\899\ All of these funds also otherwise
engaged in derivatives transactions, but only one of them would no
longer qualify as a limited derivatives user if it elected to treat its
reverse repurchase transactions as derivatives for all purposes of the
final rule.\900\
---------------------------------------------------------------------------

    \899\ In our review of form N-PORT filings, we observed that
several of the funds that used reverse repurchase agreements and
similar financing transactions (bank borrowings and similar
securities) in combined amounts that exceeded 50% of net assets
already exceeded the 50% limit for either repurchase agreements,
similar financing transactions (bank borrowings and similar
securities, or both, when considered separately. In our review of
financial statements filed by the Commission by BDCs, we observed
that no BDCs exceeded the asset coverage requirement.
    \900\ For purposes of our analysis in other parts of the
economic analysis (specifically, sections III.C.1-III.C.3), we
assumed that this fund would not qualify for the limited derivatives
user exception.
---------------------------------------------------------------------------

5. Treatment of Existing Leveraged/Inverse Funds That Seek To Provide
Leveraged or Inverse Market Exposure Exceeding 200% of the Return of
the Relevant Index
    Rule 18f-4 permits existing leveraged/inverse funds that cannot
satisfy the final rule's relative VaR test and that seek to provide
leveraged or inverse market exposure exceeding 200% of the return or
inverse return of the relevant index as of October 28, 2020 to continue
operating, provided they meet certain requirements. This exception is
limited to funds currently in operation, and would therefore not apply
to any new funds.
    Because the final rule limits this provision to funds currently in
operation, the number of funds with exposure above 200% may fall over
time, to the extent that fund sponsors remove existing funds from the
market. This may particularly affect funds that are less popular or
become less popular with investors over time. For the same reason, the
final rule may limit the growth (or lead to a decline) of assets
managed by leveraged/inverse funds with a market exposure above these
limits over time. At the same time, because leveraged/inverse funds
that are already in operation today will be permitted to continue
operating at their current exposure levels and because fund sponsors
will likely be hesitant to remove funds relying on the exception from
the market (because the exception applies only to funds currently in
operation), the final rule is not likely to have a significant
immediate effect on the number of these funds and the size of the
assets they manage.
    Any reduction in the variety (including future variety) of
leveraged/inverse funds with exposures exceeding 200% will affect
investors. While investors generally benefit from increased investment
opportunities, the effects on any particular investor also depend on
how well an investor is able to evaluate the characteristics and risks
of leveraged/inverse funds, particularly those with exposures exceeding
200%. On the one hand, there is a body of academic literature that
provides empirical evidence that some retail investors may not fully
understand the risks inherent in their investment decisions and not
fully understand the effects of compounding.\901\ In addition, the
Commission received some comments on the proposal suggesting that
retail investors do not understand the unique risks of leveraged/
inverse funds.\902\ On the other hand, we also received a large number
of comments from individual investors asserting they understand the
risks involved in these funds.\903\
---------------------------------------------------------------------------

    \901\ See, e.g., Annamaria Lusardi & Olivia S. Mitchell, The
Economic Importance of Financial Literacy: Theory and Evidence, 52
J. Econ. Literature 5 (2014), available at https://www.aeaweb.org/articles?id=10.1257/jel.52.1.5, which reviews a body of recent
survey-based work indicating that many retail investors have limited
financial literacy. As the Commission pointed out in the Proposing
Release, this literature studies investor inattention to financial
products generally and does not specifically examine retail
investors' understanding of leveraged/inverse funds. Two commenters
stated that the arguments provided in the Proposing Release do not
represent evidence that investors misunderstand the risks of
leveraged/inverse funds. See Comment Letter of Chester Spatt, Ph.D.
(Mar. 31, 2020); Flannery Comment Letter. One of those commenters
specifically raised the limitations of this literature. See Flannery
Comment Letter. We continue to believe that this literature may be
informative of investors' understanding of leveraged/inverse funds,
as it includes an examination of investors' understanding of
interest compounding, which may directly apply in the context of the
(generally) daily compounding feature of leveraged/inverse funds.
    \902\ See supra footnote 572 and accompanying text.
    \903\ See supra footnote 571 and accompanying text. See also
Flannery Comment Letter, supra footnote 901 (finding a negative
historical relationship between the returns of some leveraged/
inverse funds and subsequent changes in outstanding shares and
arguing that this relationship is consistent with some investors
using leveraged/inverse funds for short-term trading strategies).
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    The final rule's treatment of leveraged/inverse funds with
exposures above 200% could benefit some investors, to the extent that
the rule has the effect of reducing the number of investors in these
funds who are not capable of evaluating the risks they pose. These
benefits would be limited, however, to the extent that they overlap
with the effects of current requirements that apply to investment
advisers or broker-dealers, including the best interest standard of
conduct for broker-dealers under Regulation Best Interest and the
fiduciary obligations of investment advisers.\904\ Conversely, the
final rule may impose a cost on those investors who are capable of
evaluating the risks these funds pose, by limiting the investment
opportunities available to those investors.\905\
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    \904\ See supra section II.F.2.
    \905\ See, e.g., Flannery Comment Letter, supra footnote 901
(stating that an investor may rationally hold a leveraged/inverse
fund for multi-day holding periods and that leveraged/inverse funds
provide a cost-efficient means of achieving investors' objectives).
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    The final rule also includes a requirement that a fund that seeks
to provide leveraged or inverse market exposure exceeding 200% of the
return or inverse return of the relevant index disclose in its
prospectus that it is not subject to the final rule's limit on fund
leverage risk. We believe that this requirement may benefit investors
and the market, by providing transparency regarding which funds are
exempt from rule 18f-4's limit on fund leverage fund risk.
    As discussed below in section IV.B.4, rule 18f-4 requires an over-
200% leveraged/inverse fund currently in operation to disclose in its
prospectus that it is not subject to the VaR-based limits on fund
leverage risks. We estimate that the total industry cost associated
with this disclosure requirement in the first year will be
$71,400.\906\
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    \906\ The burdens associated with this estimate are all
paperwork-related burdens, and thus they are also estimated in the
Paperwork Reduction Act Analysis section of this release. See infra
section IV.B.4. The estimate is based on the following calculations:
First, we calculate the one-time cost to an over-200% leveraged/
inverse fund for the disclosure, to be 1.5 hours x $312 (compliance
manager) + 1.5 hours x $368 (compliance attorney) = $468 + $552 =
$1,020 per year. The total industry cost to over-200% leveraged/
inverse funds, in the first year, is (70 over-200% leveraged/inverse
funds) x $1,020 = $71,400.

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6. Amendments to Rule 6c-11 Under the Investment Company Act and
Rescission of Exemptive Relief for Leveraged/Inverse ETFs
    Existing leveraged/inverse ETFs rely on exemptive relief, which the
Commission has not granted to a leveraged/inverse ETF sponsor since
2009. We are amending the provision in rule 6c-11 that excludes
leveraged/inverse ETFs from its scope to allow a leveraged/inverse ETF
to operate under rule 6c-11 if the fund complies with the applicable
requirements of rule 18f-4. As a result, fund sponsors will be
permitted to operate a leveraged/inverse ETF subject to the conditions
in rules 6c-11 and 18f-4 without obtaining an exemptive order.
    The amendments to rule 6c-11 will benefit any fund sponsors seeking
to launch leveraged/inverse ETFs whose target multiple is equal to or
less than 200% of its reference index that did not obtain the required
exemptive relief due to the Commission's moratorium on granting such
relief. A fund sponsor planning to seek exemptive relief from the
Commission to form and operate a leveraged/inverse ETF that could
operate under rules 6c-11 and 18f-4 will also no longer incur the cost
associated with applying for an exemptive order.\907\ To the extent
that the amendments result in new leveraged/inverse ETFs with exposures
not exceeding 200% coming to market, the industry-wide assets under
management of such leveraged/inverse ETFs could increase and investors
who are able to evaluate the risks they pose could benefit from an
increase in investment choices. Conversely, the amendment may also have
the effect of increasing the number of investors in these funds who may
not be capable of evaluating the risks they pose.\908\
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    \907\ In the ETFs Adopting Release, we estimated that the direct
cost of a typical fund's application for ETF relief (associated
with, for example, legal fees) is approximately $100,000. As
exemptive applications for leveraged/inverse ETFs are significantly
more complex than those of the average fund, we estimate that the
direct costs of an application for leveraged/inverse ETF relief
amounts to approximately $250,000. See ETFs Adopting Release, supra
footnote 76, at nn.537-539 and accompanying text.
    \908\ See supra section III.C.5 for a discussion of investors'
understanding of leveraged/inverse funds and the comments we
received on this topic in the context of leveraged/inverse funds
with exposures exceeding 200%, for which the effects of these fund's
unique characteristics are more pronounced due to the higher levels
of exposure they seek to provide.
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    Because our amendments to rule 6c-11 will permit leveraged/inverse
ETFs to rely on that rule, we also are rescinding the exemptive orders
the Commission has previously granted to sponsors of leveraged/inverse
ETFs. As a result, existing and future leveraged/inverse ETFs will
operate under a consistent regulatory framework with respect to the
relief necessary to operate as an ETF. We believe that the costs to
leveraged/inverse ETFs of complying with the conditions of rule 6c-11
instead of those contained in their exemptive orders will be minimal
(other than the costs of complying with rule 18f-4, which we discuss
separately), as we anticipate that all existing leveraged/inverse ETFs
will be able to continue operating as they do currently, while also
being required to comply with rule 6c-11's requirements for additional
website disclosures and basket asset policies and procedures.\909\
While we do anticipate that these funds will incur costs from having to
comply with the applicable provisions of rule 18f-4, as referenced in
the amendments to rule 6c-11, we estimate these costs in the
subsections of this section III.C that discuss the costs and benefits
of rule 18f-4. Sponsors of leveraged/inverse ETFs with existing
exemptive orders describing exposures exceeding 200% will no longer be
able to launch additional leveraged/inverse ETFs with exposures
exceeding this limit. The economic effects of this restriction are
discussed above.\910\ Additional economic considerations that the
treatment of leveraged/inverse ETFs presents with regards to efficiency
and competition are discussed below in section III.D.
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    \909\ In this section as well as in section III.D below, we have
accounted for the costs and benefits to leveraged/inverse ETFs as a
result of the removal of the current exclusion of these funds from
rule 6c-11. We believe that the additional considerations the
Commission analyzed in the ETFs Adopting Release for ETFs other than
leveraged/inverse ETFs that were included in the scope of rule 6c-11
at adoption apply substantially similarly to leveraged/inverse ETFs.
See ETFs Adopting Release, supra footnote 76.
    \910\ See infra section III.C.5.
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7. Unfunded Commitment Agreements
    Rule 18f-4 will permit a fund to enter into unfunded commitment
agreements to make certain loans or investments if it reasonably
believes, at the time it enters into such an agreement, that it will
have sufficient cash and cash equivalents to meet its obligations with
respect to its unfunded commitment agreements, in each case as they
come due.\911\ While a fund should consider its unique facts and
circumstances, the final rule will prescribe certain specific factors
that a fund must take into account in having such a reasonable belief.
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    \911\ See supra section II.I.
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    We continue to believe that the final rule's requirements are
consistent with current industry practice.\912\ As a result, we do not
believe that the rule's treatment of unfunded commitment agreements
represents a change from the baseline, although we acknowledge that
there may be some variation in the specific factors that funds consider
today, as well as the potential for some variation between those
factors and those prescribed in the final rule. Because we believe that
the final rule's approach is consistent with general industry
practices, we believe this requirement will not lead to significant
economic effects.\913\
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    \912\ See supra footnote 763 and accompanying text.
    \913\ See supra footnote 763 and accompanying text.
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8. Recordkeeping
    Rule 18f-4 includes certain recordkeeping requirements.\914\
Specifically, the final rule will require a fund to maintain certain
records documenting its derivatives risk management program's written
policies and procedures, along with its portfolio's stress test
results, VaR backtesting results, any internal reporting or escalation
of material risks under the program, and periodic reviews of the
program.\915\ It will also require a fund to maintain records of any
materials provided to the fund's board of directors in connection with
approving the designation of the derivatives risk manager and any
written reports relating to the derivatives risk management
program.\916\
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    \914\ See supra section II.J.
    \915\ Rule 18f-4(c)(i)(A).
    \916\ Rule 18f-4(c)(6)(i)(B).
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    A fund that will be required to comply with the VaR-based limit on
fund leverage risk will also have to maintain records documenting the
determination of: Its portfolio's VaR; the VaR of its designated
reference portfolio, as applicable; its VaR ratio (the value of the VaR
of the Fund's portfolio divided by the VaR of the designated reference
portfolio), as applicable; and any updates to any of its VaR
calculation models and the basis for any material changes to its VaR
models.\917\ The rule also will require a fund to keep records of any
written reports provided to the board that the rule requires regarding
the fund's non-compliance with the applicable VaR

test.\918\A fund that will be a limited derivatives user under the
final rule will have to maintain a written record of its policies and
procedures that are reasonably designed to manage derivatives risks, as
well any written reports to the fund's board regarding the fund's
exceeding the exception's 10% derivatives exposure threshold.\919\ In
light of the final rule providing two separate treatment options for a
fund that enters into a reverse repurchase agreement or similar
financing transactions, a fund must also maintain a written record
documenting whether the fund is treating these transactions, as set
forth in the rule, under (1) an asset coverage requirements approach or
(2) a derivatives transactions treatment approach.\920\ Finally, a fund
engaging in unfunded commitment agreements will be required to maintain
records documenting the basis for its reasonable belief regarding the
sufficiency of its cash and cash equivalents to meet its obligations
with respect to each unfunded commitment agreement, with such a record
made each time it enters such an agreement.\921\ Rule 18f-4 will
require funds to maintain required records for a period of five years
(the first two years in an easily accessible place).\922\
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    \917\ Rule 18f-4(c)(6)(i)(C).
    \918\ Rule 18f-4(c)(6)(i)(B).
    \919\ Rule 18f-4(c)(6)(i)(D).
    \920\ Rule 18f-4(d)(2).
    \921\ See rule 18f-4(e)(2).
    \922\ See rule 18f-4(c)(6)(ii); rule 18f-4(d)(2); rule 18f-
4(e)(2).
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    We believe that these requirements will increase the effectiveness
of the Commission's oversight of the fund industry, which will, in
turn, benefit investors. Further, the requirement to keep records
documenting the derivatives risk management program, including records
documenting periodic review of the program and written reports provided
to the board of directors relating to the program, will help our staff
evaluate a fund's compliance with the derivatives risk management
program requirements. We anticipate that these recordkeeping
requirements will generally not impose a large additional burden on
funds, as most funds would likely choose to keep such records, even
absent the requirement to do so, in order to support their ongoing
administration of the derivatives risk management program and their
compliance with the associated requirements.
    As discussed below in section IV.B.7, our estimated average one-
time and ongoing annual costs associated with the recordkeeping
requirements take into account the fact that some funds, such as those
that can rely on the final rule's limited derivatives user exception,
may incur less extensive recordkeeping costs relative to other funds