registered closed-end fund's ability to issue preferred stock, for
example, suggests that registered closed-end funds should be permitted
to obtain additional indebtedness leverage through derivatives
transactions.
---------------------------------------------------------------------------

    \210\ See supra notes 29-32 and accompanying paragraph
(discussing asset coverage requirements for different investment
company types).
    \211\ See supra note 30 and accompanying text.
    \212\ See supra note 31 and accompanying text.
---------------------------------------------------------------------------

    The Investment Company Act also provides greater flexibility for
BDCs to issue senior securities. BDCs, however, generally do not use
derivatives or do so only to a limited extent. To help evaluate the
extent to which BDCs use derivatives, our staff sampled 48 of the
current 99 BDCs by reviewing their most recent financial statements
filed with the Commission. The staff's sample included both BDCs with
shares listed on an exchange and BDCs whose shares are not listed. The
sampled BDCs' net assets ranged from $32 million to $7.4 billion. Of
the 48 sampled, 54% did not report any derivatives holdings, and a
further 29% reported using derivatives with gross notional amounts
below 10% of net assets. A few BDCs used derivatives more extensively,
when measured on a gross notional basis, mainly due to interest rate
swaps--which likely would have lower adjusted notional amounts if they
were converted to ten-year bond equivalents, as the proposed rule would
permit.\213\ Finally, two of the sampled BDCs used total return swaps
to gain a substantial portion of their exposure. We therefore believe
that most BDCs either would not use derivatives or would rely on the
exception for limited derivatives users.\214\
---------------------------------------------------------------------------

    \213\ Our staff did not have access to sufficient information to
adjust the notional amounts of the BDCs' interest rate derivatives
or options. Some of the 17% of the sampled BDCs with gross notional
amounts exceeding 10% of net assets likely would have lower notional
amounts after applying these adjustments.
    \214\ See infra section II.E (discussing the proposed exception
for limited derivatives users).
---------------------------------------------------------------------------

    In addition, the greater flexibility for BDCs to issue senior
securities allows them to provide additional equity or debt financing
to the ``eligible portfolio companies'' in which BDCs are required to
invest at least 70% of their total assets. Derivatives transactions, in
contrast, generally will not have similar capital formation benefits
for portfolio companies unless the fund's counterparty makes an
investment in the underlying reference assets equal to the notional
amount of the derivatives transaction. Allowing BDCs to leverage their
portfolios with derivatives to a greater extent than other funds
therefore would not appear to further the capital formation benefits
that underlie BDCs' ability to obtain additional leverage under the
Investment Company Act. We also understand that, even when BDCs do use
derivatives more extensively, derivatives generally do not play as
significant of a role in implementing the BDC's strategy, as compared
to many other types of funds that use derivatives extensively. BDCs are
required under the Investment Company Act to invest at least 70% of
their total assets in ``eligible portfolio companies,'' which may limit
the role that derivatives can play in a BDC's portfolio relative to
other kinds of funds that would generally execute their strategies
primarily through derivatives transactions (e.g., a managed futures
fund). For these reasons, and to provide a consistent framework
regarding funds' use of derivatives, we believe that it is appropriate
to set a single limit on fund leverage risk under the proposed rule for
derivatives transactions. The proposed rule would not restrict a fund
from issuing senior securities subject to the limits in section 18 to
the full extent

permitted by the Investment Company Act.\215\
---------------------------------------------------------------------------

    \215\ For purposes of calculating asset coverage, as defined in
section 18(h), BDCs have used derivatives transactions' notional
amounts, less any posted cash collateral, as the ``amount of senior
securities representing indebtedness'' associated with the
transactions. We believe this approach--and not the transactions'
market values--represents the ``amount of senior securities
representing indebtedness'' for purposes of this calculation. Open-
end funds cannot enter into derivatives transactions under section
18, absent relief from that section's requirements, because section
18 limits open-end funds' senior securities to bank borrowings.
Section 18(c) also limits a registered closed-end fund's ability to
enter into derivatives transactions absent such relief.
---------------------------------------------------------------------------

    We request comment on the following aspects of the proposed
relative VaR test.
    97. Is the proposed relative VaR test requirement appropriate? Why
or why not? As proposed, should funds be required to comply with a
relative VaR test, rather than an absolute VaR test, except where a
designated reference index is unavailable?
    98. Should the limit in the proposed relative VaR test be lower or
higher than 150% of the VaR of the designated reference index, and if
so why? For example, the relative VaR test applicable to UCITS funds
allows a UCITS fund to have a relative VaR up to 200% of the VaR of the
relevant index.\216\ Should rule 18f-4 similarly permit a fund to have
a VaR up to 200% of the VaR of its designated reference index? If so,
how should the rule incorporate investor protection provisions
consistent with section 18? Conversely, should the relative VaR test be
set at a lower level, such as 125% of the VaR of the designated
reference index? If so, why?
---------------------------------------------------------------------------

    \216\ See infra section II.D.6.c (discussing the UCITS
framework); see also ICI Comment Letter III (suggesting that a
Commission rule limiting the use of derivatives by registered
investment companies allow funds to use either ex ante stress
testing or UCITS VaR for that purpose).
---------------------------------------------------------------------------

    99. Should the proposed relative VaR test incorporate different
leverage limit levels according to fund type and corresponding to the
asset coverage requirements under the Investment Company Act? Why or
why not and how?
    100. Are there any challenges in calculating the VaR of the
designated reference index? If so, would certain types of funds
particularly encounter these challenges, and if so which ones? How
should we address any challenges?
    101. Are there any fund-type specific challenges to open-end funds,
registered closed-end funds, or BDCs complying with the VaR-based limit
on fund leverage risk? For example, would registered closed-end funds
or BDCs encounter any unique challenges in calculating VaR because of
the nature of their investments? If so, what kinds of challenges and
how should we address them? Please also explain specifically the nature
of any challenges given that a number of financial institutions such as
banks and UCITS funds calculate VaR for regulatory purposes, and these
institutions' portfolios hold a wide range of assets.
3. Absolute VaR Test
    We recognize that, for some funds, the derivatives risk manager may
be unable to identify an appropriate designated reference index. For
example, some multi-strategy funds manage their portfolios based on
target volatilities but implement a variety of investment strategies,
making it difficult to identify a single index (even a blended index)
that would be appropriate. If a derivatives risk manager is unable to
identify an appropriate designated reference index, a fund relying on
the proposed rule would be required to comply with the absolute VaR
test.\217\
---------------------------------------------------------------------------

    \217\ See supra note 173 and accompanying text (discussing the
proposed requirement for the fund's derivatives risk manager to
provide written reports to the fund's board of directors that must
include, among other things, the derivatives risk manager's basis
for the selection of the designated reference index or, if
applicable, an explanation of why the derivatives risk manager was
unable to identify a designated reference index appropriate for the
fund); infra notes 425-426 and accompanying text (discussing
proposed recordkeeping requirements for such written reports
provided to the fund's board).
---------------------------------------------------------------------------

    To comply with the proposed absolute VaR test, the VaR of the
fund's portfolio must not exceed 15% of the value of the fund's net
assets. In proposing an absolute VaR test of 15% of a fund's net
assets, we considered the comparison of a fund complying with the
absolute VaR test and a fund complying with the relative VaR test. A
fund that uses the S&P 500 as its benchmark index, as many funds do,
would be permitted to have a VaR equal to 150% of the VaR of the S&P
500 if the fund also used that index as its designated reference index.
The Division of Economic and Risk Analysis (``DERA'') staff calculated
the VaR of the S&P 500, using the parameters specified in this proposed
rule over various time periods. DERA staff's calculation of the S&P
500's VaR since inception, for example, produced a mean VaR of
approximately 10.4%, although the VaR of the S&P 500 varied over
time.\218\ Setting the level of loss in the proposed absolute VaR test
at 15% of a fund's net assets would therefore provide approximately
comparable treatment for funds that rely on the absolute VaR test and
funds that rely on the relative VaR test and use the S&P 500 as their
designated reference index during periods where the S&P 500's VaR is
approximately equal to the historical mean.
---------------------------------------------------------------------------

    \218\ DERA staff calculated descriptive statistics for the VaR
of the S&P 500 using Morningstar data from March 4, 1957 to June 28,
2019, based on daily VaR calculations, each using three years of
prior return data and calculated using historical simulation at a
99% confidence level for a 20-day horizon using overlapping
observations.
---------------------------------------------------------------------------

    DERA staff analyzed the S&P 500 because funds often select broad-
based large capitalization equities indexes such as the S&P 500 for
performance comparison purposes, including funds that are not broad-
based large capitalization equity funds.\219\ Many investors may
therefore understand the risk inherent in these indexes as the level of
risk inherent in the markets generally.\220\ An absolute VaR test set
to approximate, or not substantially exceed, this level of risk would
therefore often approximate the level of risk that investors may
understand, and frequently choose to undertake, through investments in
funds. We are proposing a single absolute VaR limit that would apply to
open-end funds and registered closed-end funds and BDCs for the same
reasons we are proposing that all funds relying on the relative VaR
test must limit their VaR to 150% of the VaR of their designated
reference index.\221\
---------------------------------------------------------------------------

    \219\ This is based on staff experience and analysis of data
obtained from Morningstar.
    \220\ Some commenters to the 2015 proposal also expressed the
view that the S&P 500 Index is an appropriate risk-based reference
point because it is widely used with a risk profile that is well
understood and commonly acceptable to investors. See, e.g., AQR
Comment Letter; Comment Letter of Millburn Ridgefield Corporation
(Mar. 28, 2016).
    \221\ See supra section II.D.2.b.
---------------------------------------------------------------------------

    The proposed absolute VaR test is also broadly consistent with the
European Union regulatory framework that that applies to UCITS
funds.\222\ Advisers that manage (or have affiliates that manage) UCITS
funds may derive some efficiencies from reasonably comparable
requirements across jurisdictions.\223\ Commenters to the 2015 proposal
also generally supported an absolute VaR test.\224\
---------------------------------------------------------------------------

    \222\ See CESR Global Guidelines, supra note 94, at 26. The
absolute VaR test for UCITS funds is similar to the proposed
absolute VaR test in rule 18f-4, although it sets a 20% limit for
UCITS funds, rather than 15% as we propose in rule 18f-4.
    \223\ See, e.g., ICI Comment Letter III (stating that, in
response to the Investment Company Institute's survey, ``45 percent
of respondents indicated that it would be only slightly burdensome
to implement a UCITS VaR test that used the same parameters as
prescribed for UCITS. An additional 34 percent reported that it
would be moderately burdensome.'').
    \224\ See, e.g., ICI Comment Letter I; Franklin Resources
Comment Letter; SIFMA Comment Letter; Comment Letter of T. Rowe
Price Associates, Inc. (Mar. 28, 2016) (``T. Rowe Price Comment
Letter'').

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

    We request comment on the proposed absolute VaR test requirement.
    102. Is the proposed absolute VaR test requirement appropriate? Are
we correct that in some cases a fund's derivatives risk manager may be
unable to identify an appropriate designated reference index? Why or
why not? What are examples of funds that would likely use the absolute
VaR test because a derivatives risk manager would be unable to identify
an appropriate designated reference index? Is it appropriate for these
funds to use an absolute VaR test? Why or why not?
    103. Should we provide additional guidance on the circumstances
under which a fund's derivatives risk manager would be ``unable'' to
identify an appropriate index? If so, what guidance should we provide?
Should the rule include a different standard than the inability to
identify a designated reference index for funds to be able to use the
absolute VaR test instead of the relative VaR test? If so, what
standard and why? For example, should we identify certain types of fund
strategies that may not typically have appropriate reference indexes or
for which absolute VaR would otherwise be appropriate? If so, which
fund strategies, and how would we keep any list of fund strategies
current over time?
    104. Should the proposed absolute VaR test include a limit other
than 15% of the fund's net assets? Please explain. For example, should
it be 12, 18, 20, or 25%? If so, which limit, and why? Would funds
using the absolute VaR test manage their VaRs to a certain amount below
the limit the Commission sets? If so, to what extent and should we take
this into account in determining the appropriate limit under this test?
Should we look to different market data in determining an appropriate
level of absolute VaR? Which other sources, and why would they be
appropriate?
    105. For funds that use an absolute VaR test as part of their risk
management practices, do risk managers set internal absolute VaR
limits, and if so, at what level and why? For funds that currently use
both absolute VaR and relative VaR, are the internal limits set at
comparable levels? Why or why not? Please describe each internal level
set with respect to these two VaR tests. Do certain fund types or
strategies more commonly use either absolute VaR or relative VaR for
risk management purposes? If so, why?
    106. Should the rule include both a relative and absolute VaR test,
as proposed, or should it include only a relative VaR test or an
absolute VaR test? Why, and which test should the rule include? Should
it use a different VaR-based test? If so, which one?
    107. Should the rule permit funds to choose which VaR test to
comply with regardless of the derivatives risk manager's ability or
inability to identify a designated reference index? If so, would this
be consistent with investor expectations and section 18?
4. Choice of Model and Parameters for VaR Test
    The proposed rule would require that any VaR model a fund uses for
purposes of the relative or absolute VaR test take into account and
incorporate all significant, identifiable market risk factors
associated with a fund's investments.\225\ The proposed rule includes a
non-exhaustive list of common market risk factors that a fund must
account for in its VaR model, if applicable. These market risk factors
are: (1) Equity price risk, interest rate risk, credit spread risk,
foreign currency risk and commodity price risk; (2) material risks
arising from the nonlinear price characteristics of a fund's
investments, including options and positions with embedded optionality;
and (3) the sensitivity of the market value of the fund's investments
to changes in volatility.\226\ VaR models are often categorized
according to three modeling methods--historical simulation, Monte Carlo
simulation, or parametric models.\227\ Each method has certain benefits
and drawbacks, which may make a particular method more or less
suitable, depending on a fund's strategy, investments and other
factors. In particular, some VaR methodologies may not adequately
incorporate all of the material risks inherent in particular
investments, or all material risks arising from the nonlinear price
characteristics of certain derivatives.\228\ We believe it should be
the responsibility of the derivatives risk manager to choose the
appropriate VaR model for the fund's portfolio, and the proposed
requirement is designed to allow funds to use a VaR model that is
appropriate for the fund's investments. Commenters that addressed the
same proposed requirement for VaR models in the 2015 proposal generally
supported it.\229\
---------------------------------------------------------------------------

    \225\ See proposed rule 18f-4(a) (defining the term ``value-at-
risk'' or ``VaR'').
    \226\ See id.
    \227\ Historical simulation models rely on past observed
historical returns to estimate VaR. Historical VaR involves taking a
fund's current portfolio, subjecting it to changes in the relevant
market risk factors observed over a prior historical period, and
constructing a distribution of hypothetical profits and losses. The
resulting VaR is then determined by looking at the largest (100
minus the confidence level) percent of losses in the resulting
distribution.
    Monte Carlo simulation uses a random number generator to produce
a large number (often tens of thousands) of hypothetical changes in
market values that simulate changes in market factors. These outputs
are then used to construct a distribution of hypothetical profits
and losses on the fund's current portfolio, from which the resulting
VaR is ascertained by looking at the largest (100 minus the
confidence level) percent of losses in the resulting distribution.
    Parametric methods for calculating VaR rely on estimates of key
parameters (such as the mean returns, standard deviations of
returns, and correlations among the returns of the instruments in a
fund's portfolio) to create a hypothetical statistical distribution
of returns for a fund, and use statistical methods to calculate VaR
at a given confidence level.
    See, e.g., Dowd, supra note 177; see also Thomas J. Linsmeier &
Neil D. Pearson, Value at Risk, 56 Journal of Financial Analysts 2
(Mar.-Apr. 2000) (``Linsmeier & Pearson'').
    \228\ For example, some parametric methodologies may be more
likely to yield misleading VaR estimates for assets or portfolios
that exhibit non-linear returns, due, for example, to the presence
of options or instruments that have embedded optionality (such as
callable or convertible bonds). See, e.g., Linsmeier & Pearson,
supra note 226 (stating that historical and Monte Carlo simulation
``work well regardless of the presence of options and option-like
instruments in the portfolio. In contrast, the standard [parametric]
delta-normal method works well for instruments and portfolios with
little option content but not as well as the two simulation methods
when options and option-like instruments are significant in the
portfolio.'').
    \229\ See, e.g., Oppenheimer Comment Letter; CFA Comment Letter.
---------------------------------------------------------------------------

    The proposed rule also requires that a fund's VaR model use a 99%
confidence level and a time horizon of 20 trading days.\230\ We
understand that market participants currently using VaR most commonly
use 95% or 99% confidence levels and often use time horizons of 10 or
20 days. The proposed confidence level and time horizon requirements
also are similar to those in other VaR-based regulatory schemes.\231\

VaR models that use relatively high confidence levels and longer time
horizons--as the proposed rule parameters reflect--result in a focus on
more-``extreme'' but less-frequent losses. We propose relatively high
confidence level and longer time horizon requirements so that the VaR
model is designed to measure, and seek to limit the severity of, these
less-frequent but larger losses. This is because a fund's VaR model
would be based on a distribution of returns, where a higher confidence
level would go further into the tail of the distribution (i.e., more-
``extreme'' but less-frequent losses) and a longer time horizon would
result in larger losses in the distribution (i.e., losses have the
potential to be larger over twenty days when compared, for example, to
over one day).
---------------------------------------------------------------------------

    \230\ See proposed rule 18f-4(a) (defining the term ``value-at-
risk'' or ``VaR'').
    We recognize that many market participants today also may
calculate VaR over a one-day time horizon. See also supra section
II.B.3.d (the proposed rule would require calculating a fund's one-
day VaR as part of the proposed backtesting requirement). A VaR
calculation based on a one-day time horizon can be scaled to a 20-
day time horizon. For example, a common VaR model time-scaling
technique is to multiply the one-day VaR by the square root of the
designated time period (i.e., for the proposed rule it would be the
square root of 20). But for funds with returns that are not
identically and independently normally distributed, simple time-
scaling techniques may be inaccurate. If this inaccuracy results in
meaningful underestimation of VaR, this simple time-scaling
technique would be inappropriate.
    \231\ See, e.g., CESR Global Guidelines, supra note 94
(providing default VaR calculation standards that require funds that
use the relative VaR or absolute VaR approach to calculate VaR using
a ``one-tailed confidence interval of 99%''); rule 15c3-1e under the
Exchange Act [17 CFR 240.15c3-1e] (Appendix E to 17 CFR 240.15c3-1)
(requiring VaR models to use ``a 99 percent, one-tailed confidence
level with price changes equivalent to a ten business-day movement
in rates and prices''). See also the Basel Committee on Banking
Supervision, Amendment To The Capital Accord To Incorporate Market
Risks (Jan. 1996), available at https://www.bis.org/publ/bcbs24.pdf
(contemplating banks' use of internal models for measuring market
risk based on a 10-day time horizon); CESR Global Guidelines, supra
note 94 (specifying generally a 20-day time horizon as a
quantitative requirement when calculating VaR for risk measurement
and the calculation of global exposure and counterparty risk for
UCITS).
---------------------------------------------------------------------------

    In proposing a higher confidence level and longer time horizon, we
considered whether this would result in a VaR model based on fewer data
points in comparison to lower confidence levels and shorter time
horizons. However, we understand that a longer trading day horizon only
results in reduced data points if the fund uses historical simulation
and measures historical losses using non-overlapping periods, which our
proposal would not require. For example, a fund measuring non-
overlapping twenty-day periods, assuming 250 trading days in a year,
would expect approximately 12 or 13 data points (250 trading days/20-
day time horizons). But if the fund measured the twenty-day periods on
a rolling and overlapping basis, it could expect as many as 250 data
points where each data point captures the return over the trailing 20
trading days. A fund could use either a non-overlapping or overlapping
approach under the proposed rule.
    The 2015 proposal similarly specified the particular confidence
level and time horizon parameters that funds would use in their VaR
models for purposes of the proposed risk-based portfolio limit. These
parameters were a 99% confidence level and a time horizon range of not
less than 10 and not more than 20 trading days.\232\ Comments were
mixed but generally supported a confidence level in the range of 95% to
99%.\233\ Rather than a time horizon range providing funds discretion
to select the number of trading days for which to compute their VaR
models, some commenters suggested that the rule should specify a
particular number of days.\234\ Because our proposal, unlike the 2015
proposal, includes an absolute VaR test, our proposed VaR model
parameters reflect commenter suggestions by proposing a confidence
level within the generally supported range and proposing a specific VaR
model time horizon rather than a range of permissible time horizons.
---------------------------------------------------------------------------

    \232\ 2015 Proposing Release, supra note 2, at section
III.B.2.b.
    \233\ See, e.g., AQR Comment Letter; ICI Comment Letter II.
    \234\ See, e.g., Morningstar Comment Letter; AIMA Comment
Letter; AQR Comment Letter; ICI Comment Letter II.
---------------------------------------------------------------------------

    In addition to specifying the confidence level and time horizon
that a fund's VaR model would use, we are also proposing that the
fund's chosen VaR model must be based on at least three years of
historical market data. We understand that the availability of data is
a key consideration when calculating VaR, and that the length of the
data observation period may significantly influence the results of a
VaR calculation. For example, a shorter observation period means that
each observation will have a greater influence on the result of the VaR
calculation (as compared to a longer observation period), such that
periods of unusually high or low volatility could result in unusually
high or low VaR estimates.\235\ Longer observation periods, however,
can lead to data collection problems, if sufficient historical data is
not available.\236\ We believe requiring a fund's chosen VaR model to
be based on at least three years of historical market data strikes an
appropriate balance.
---------------------------------------------------------------------------

    \235\ See Linsmeier & Pearson, supra note 226 (stating that,
because historical simulation relies directly on historical data, a
danger is that the price and rate changes in the last 100 (or 500 or
1,000) days might not be typical. For example, if by chance the last
100 days were a period of low volatility in market rates and prices,
the VAR computed through historical simulation would understate the
risk in the portfolio).
    \236\ See Dowd, supra note 177 (stating that ``[a] long sample
period can lead to data collection problems. This is a particular
concern with new or emerging market instruments, where long runs of
historical data don't exist and are not necessarily easy to
proxy'').
---------------------------------------------------------------------------

    The proposed historical market data requirement would permit a fund
to base its VaR estimates on a meaningful number of observations, while
also recognizing the concern that requiring a longer historical period
could make it difficult for a fund to obtain sufficient historical data
to estimate VaR for the instruments in its portfolio.\237\ The 2015
proposal would have required three years of market data for funds using
historical simulation (but did not require three years of market data
for VaR models based on Monte Carlo simulation or parametric
methods).\238\ A number of commenters supported our approach in the
2015 proposal to require three years of market data for funds using
historical simulation.\239\ However, some commenters suggested that the
rule should require a longer period of historical market data.\240\ As
discussed above, we believe that three years strikes an appropriate
balance. We also are proposing to require funds to use three years of
market data for all VaR calculations under the proposed rule--rather
than only historical simulation as in the 2015 proposal. We believe
this is appropriate because all methods for calculating VaR--not just
historical simulation--rely on historical data.
---------------------------------------------------------------------------

    \237\ See Michael Minnich, Perspectives On Interest Rate Risk
Management For Money Managers And Traders (Frank Fabozzi, ed.)
(1998) (stating that for historical simulation, ``[l]onger periods
of data have a richer return distribution while shorter periods
allow the VAR to react more quickly to changing market events'' and
that ``[t]hree to five years of historical data are typical''); see
also Darryll Hendricks, Evaluation of Value-at-Risk Models Using
Historical Data, FRBNY Economic Policy Review (Apr. 1996) (finding
that, when using historical VaR, ``[e]xtreme [confidence level]
percentiles such as the 95th and particularly the 99th are very
difficult to estimate accurately with small samples'' and that the
complete dependence of historical VaR models on historical
observation data ``to estimate these percentiles directly is one
rationale for using long observation periods'').
    \238\ See 2015 Proposing Release, supra note 2, at section
III.B.2.b; see also supra note 177 (discussing historical
simulation, Monte Carlo simulation, and parametric methods).
    \239\ See, e.g., Comment Letter of Abbey Capital (Mar. 28,
2016); AIMA Comment Letter; Comment Letter of Aspect Capital Limited
(Mar. 28, 2016); Comment Letter of Intercontinental Exchange (Apr.
15, 2016).
    \240\ See, e.g., materials attached to the memorandum included
in the comment file concerning a meeting between representatives of
AlphaSimplex Group LLC and members of the staff of the Division of
Investment Management (July 8, 2016); AQR Comment Letter.
---------------------------------------------------------------------------

    Unlike the 2015 proposal, the proposed rule does not require a fund
to apply its VaR model consistently (i.e., the same VaR model applied
in the same way) when calculating the VaR of its portfolio and the VaR
of its designated reference index.\241\ The proposed rule would,
however, require that VaR calculations comply with the same proposed
VaR definition and its specified model requirements.\242\ Our proposal
does not include the 2015

proposal's model consistency requirement because if the proposed rule
required funds to apply the same VaR model to its portfolio and the
designated reference index, it could prevent funds from using less-
costly approaches. For example, under the proposed approach, in many
cases a fund could calculate the VaR of a designated reference index
based on the index levels over time without having to obtain access to
more-detailed information about the index constituents. A fund also
would have the flexibility to obtain the VaR from a third-party vendor
instead of analyzing it in-house. A model consistency requirement could
preclude these approaches, however, because a fund might not be able
apply the same approach to its portfolio. For example, if a fund
invested significantly in options, it generally would not be
appropriate to use certain parametric VaR models.\243\ The fund might
instead use Monte Carlo simulation, which is more computationally
intensive and takes more time to perform. A model consistency
requirement would require the fund to apply the same Monte Carlo
simulation model to its unleveraged designated reference index, for
which a parametric or other simpler and less costly VaR model might be
appropriate.
---------------------------------------------------------------------------

    \241\ See 2015 Proposing Release, supra note 2, at section
III.B.2.b.
    \242\ See infra section II.D.4 (discussing the proposed VaR
model requirements).
    \243\ See supra note 227 (explaining that some parametric
methodologies may be more likely to yield misleading VaR estimates
for assets or portfolios that exhibit non-linear returns, due, for
example, to the presence of options or instruments that have
embedded optionality).
---------------------------------------------------------------------------

    Although requiring a fund to apply the same VaR model to its
portfolio and the designated reference index could result in a more
precise comparison of the two values, we do not believe that the
additional precision is necessary for the relative VaR test to identify
where funds' use of derivatives is more likely to raise the concerns
underlying section 18 because the proposed rule would provide certain
common parameters for all VaR calculations under the rule. Because a
fund's designated reference index must be unleveraged, we believe it is
generally unlikely that different VaR models calibrated to these common
parameters would produce substantially different results for a fund's
designated reference index. Additionally, the derivatives risk manager
would be responsible for administering and maintaining the derivatives
risk management program, which includes the integrity of the VaR test.
On balance, we believe the proposed approach would not materially
diminish the efficacy of the proposed relative VaR test while
permitting less-costly approaches for funds.
    We request comment on the proposed requirements regarding a fund's
choice of VaR model, and the required parameters for a VaR model that
funds would use under the proposed rule.
    108. Should the rule specify a particular VaR model(s) that funds
must use (i.e., a historical simulation, Monte Carlo simulation, or
parametric methodology)? If so, which methodology (or methodologies)
and why?
    109. Is the proposed requirement that a fund's VaR model
incorporate all significant, identifiable market risk factors
associated with a fund's investments appropriate? Why or why not?
    110. The proposed rule would provide a non-exhaustive list of risk
factors that may be relevant in light of a fund's strategy and
investments. Should the final rule include this non-exhaustive list of
risk factors? Are risk factors included in the proposed list
appropriate? Should we include any additional risk factors to this
list? If so, which ones and why?
    111. The proposed rule would require a fund to use a 99% confidence
level for its VaR model. Is the proposed confidence level appropriate?
Should the rule include a different confidence level? If so, which
level and why, and if not, why not?
    112. The proposed rule would require a fund to use a time horizon
of 20 trading days for its VaR model. Is the proposed time horizon
appropriate? Should the rule include a different time horizon? If so,
which time horizon and why, and if not, why not?
    113. The proposed rule would require a fund to use at least three
years of historical market data for its VaR model. Is the historical
market data requirement appropriate? Should the rule set forth a
different length of time for requiring historical market data? Should
the requirement be limited to funds using historical simulation? Would
funds experience challenges in identifying sufficient data for
particular types of investments? If so, which types of investments and
how should the rule address these challenges? Please explain.
    114. The proposed rule does not include any requirement for third-
party validation of a fund's chosen VaR model, either at inception or
upon material changes, to confirm that the model is structurally sound
and adequately captures all material risks.\244\ Should we require
third-party validation? Why or why not?
---------------------------------------------------------------------------

    \244\ The Global Exposure Guidelines applicable to UCITS'
requires such validation. See CESR Global Guidelines, supra note 94.
---------------------------------------------------------------------------

    115. Should the rule require a fund's board to approve the VaR
model and any material changes to the model? Why or why not?
    116. Should the final rule also include a requirement that a fund
that uses the relative VaR test apply the same VaR model when
calculating the fund's portfolio and the VaR of the designated
reference portfolio? Would the requirement to apply the same VaR model
to the fund's portfolio and the designated reference portfolio address
any concerns that funds could inappropriately manipulate the results of
VaR testing under the proposed rule's requirements? What additional
cost, if any, would such a requirement impose on funds? Are there other
ways that we could prevent such manipulations? To what extent would
this requirement promote additional precision in the relative VaR test
and would any additional precision increase the efficacy of the test in
limiting fund leverage risk? Please explain.
5. Implementation
a. Testing Frequency
    The proposed rule would require a fund to determine its compliance
with the applicable VaR test at least once each business day.\245\
Although we believe that funds would calculate their VaRs at a
consistent time each day, which would generally be either in the
mornings before markets open or in the evenings after markets close, we
do not propose to require one at the exclusion of the other, to allow
funds to conduct their VaR tests at the time that is most efficient
based on each fund's facts and circumstances. We considered proposing
that funds determine compliance with the proposed VaR test at the time
of, or immediately after, entering into a derivatives transaction. We
recognize, however, that conducting a VaR test on a trade-by-trade
basis could present operational challenges for some funds and could
limit the fund's choice of VaR modeling. For example, we believe that
most funds would be unable to perform computationally-intensive Monte
Carlo simulations so frequently based on computing resources and
compliance costs. Requiring this VaR calculation each day, in contrast,
would provide funds flexibility to use VaR models they believe to be
appropriate while also providing for fairly frequent calculations. The
2015 proposal included a testing frequency of

immediately after entering into any senior securities transactions, but
many commenters raised concerns about operational complexity related to
transaction-by-transaction testing, and instead generally suggested a
daily testing frequency.\246\
---------------------------------------------------------------------------

    \245\ Proposed rule 18f-4(c)(2)(ii).
    \246\ See, e.g., ICI Comment Letter I; Franklin Resources
Comment Letter; SIFMA Comment Letter; AIMA Comment Letter; BlackRock
Comment Letter.
---------------------------------------------------------------------------

    We believe that determining compliance with the VaR test less
frequently than each business day would not be consistent with the
purpose of a condition to limit fund leverage risk. Section 18 sets
forth certain fund leverage risk protections that are fundamental to
protecting investors. If this testing requirement were less frequent
than each business day, then a fund could satisfy the condition only on
business days requiring a VaR test and modify its trading strategy to
circumvent the purpose of the test on other business days.
Additionally, we believe that testing each business day is appropriate
in light of the potential for market risk factors associated with a
fund's investments to change quickly.
    We request comment on the proposed frequency of conducting the
relative or absolute VaR test.
    117. Is the proposed required frequency for conducting the VaR test
appropriate? Should the rule require a fund to conduct the required VaR
test more frequently or less frequently, such as--respectively--either
before or after each transaction, multiple times throughout the day, or
on a weekly basis? Why or why not? Should the required frequency vary
depending on fund type or whether the fund is conducting an absolute
VaR test or relative VaR test? Please explain.
    118. Should the rule require funds to conduct the test at the same
time each day? If so, why? What compliance or operational challenges,
if any, would funds have to conduct the test at the same time each day?
Would the absence of such a requirement allow funds to ``game'' the
test?
b. Remediation
    If a fund determines that it is not in compliance with the
applicable proposed VaR test, then under our proposal a fund must come
back into compliance promptly and within no more than three business
days after such determination.\247\ If the fund is not in compliance
within three business days, then: (1) The derivatives risk manager must
report to the fund's board of directors and explain how and by when
(i.e., the number of business days) the derivatives risk manager
reasonably expects that the fund will come back into compliance; (2)
the derivatives risk manager must analyze the circumstances that caused
the fund to be out of compliance for more than three business days and
update any program elements as appropriate to address those
circumstances; and (3) the fund may not enter into derivatives
transactions (other than derivatives transactions that, individually or
in the aggregate, are designed to reduce the fund's VaR) until the fund
has been back in compliance with the applicable VaR test for three
consecutive business days and satisfied the board reporting requirement
and program analysis and update requirements.\248\
---------------------------------------------------------------------------

    \247\ See proposed rule 18f-4(c)(2)(ii).
    \248\ See proposed rule 18f-4(c)(2)(iii); see also infra section
II.H.2 (discussing the proposed requirement to submit a confidential
report to the Commission if the fund is out of compliance with the
applicable proposed VaR test for three business days).
---------------------------------------------------------------------------

    The proposed three-business-day remediation provision is designed
to provide funds with some flexibility in coming back into compliance
with the applicable proposed VaR tests. It reflects our view that it
would be inappropriate for a fund to purposefully exceed the VaR-based
limit on fund leverage risk, but allows funds to take reasonable steps
to come back into compliance without harming fund investors. The three-
business-day period is designed to provide an appropriate time period
to permit remediation efforts because it balances investor protections
related to fund leverage risk and potential harm to a fund if it were
required to sell assets or unwind transactions even more quickly. This
remediation approach is similar to the remediation approach that
section 18 of the Investment Company Act provides for asset coverage
compliance with respect to bank borrowings, which also includes a
three-day period to come back into compliance.\249\
---------------------------------------------------------------------------

    \249\ Section 18(f)(1) of the Investment Company Act.
---------------------------------------------------------------------------

    If the fund does not come back into compliance within three
business days, the proposed rule would not require the fund to exit its
derivatives transactions or make other portfolio adjustments.\250\
Although a fund remaining out of compliance with the applicable VaR
test raises investor protection concerns related to fund leverage risk,
if the proposed rule were to force a fund to exit derivatives
transactions immediately at the end of the three-day period, this could
harm investors, for example, by requiring the fund to realize trading
losses that could have been avoided under a more-flexible approach. The
proposed remediation provision reflects the balancing of these multiple
investor protection concerns.
---------------------------------------------------------------------------

    \250\ Under the proposed rule, a fund that is not in compliance
within three business days also would be required to file a report
to the Commission on proposed Form N-RN. See proposed rule 18f-
4(c)(7); infra section II.H.2.
---------------------------------------------------------------------------

    Instead of requiring a fund to come back into compliance under
these circumstances immediately, the fund must satisfy three
requirements before it can enter into derivatives transactions other
than those designed to reduce the fund's VaR. First, the derivatives
risk manager must report to the fund's board of directors and explain
how and by when (i.e., the number of business days) the derivatives
risk manager reasonably expects that the fund will come back into
compliance.\251\ This requirement is designed to facilitate the fund
coming back into compliance promptly by requiring the derivatives risk
manager to develop a specific course of action to come back into
compliance and to facilitate the board's oversight by requiring the
derivatives risk manager to report this information to the board.
---------------------------------------------------------------------------

    \251\ Proposed rule 18f-4(c)(2)(iii)(A).
---------------------------------------------------------------------------

    Second, the derivatives risk manager must analyze the circumstances
that caused the fund to be out of compliance for more than three
business days and update any program elements as appropriate to address
those circumstances.\252\ That the fund was unable to come back into
compliance with the applicable VaR test within three business days may
suggest there are deficiencies in the fund's program. This requires the
derivatives risk manager to analyze and update any program elements as
appropriate before the fund is able to enter into derivatives
transactions other than those designed to reduce VaR.
---------------------------------------------------------------------------

    \252\ Proposed rule 18f-4(c)(2)(iii)(B).
---------------------------------------------------------------------------

    Finally, a fund may not enter into derivatives transactions (other
than those designed to reduce the fund's VaR) until the fund has been
back in compliance with the applicable VaR test for at least three
consecutive business days and has satisfied the applicable board
reporting and program analysis and update requirements.\253\ If the
proposed rule were to permit a fund that is out of compliance with the
limit on fund leverage risk to comply for just one day before entering
into derivatives transactions that would increase the fund's market
risk, this could potentially lead to some funds having persistently
high levels of leverage risk

beyond that permitted by the applicable VaR test.
---------------------------------------------------------------------------

    \253\ Proposed rule 18f-4(c)(2)(iii)(C).
---------------------------------------------------------------------------

    We request comment on the proposed remediation requirement for a
fund that is out of compliance with the applicable VaR test.
    119. Is the proposed three-business-day remediation provision
appropriate? Could such a limited remediation period exacerbate fund or
market instability and harm investors? Should the rule require a longer
or shorter period, such as one or seven days? Why or why not, and if
so, what should the alternative remediation period be? In light of the
balancing of investor protection concerns (fund compliance with the
VaR-based limit on fund leverage risk and not forcing asset sales or
unwinding transactions to comply), is there a more-effective means to
structure a remediation provision that balances these concerns? If so,
how?
    120. Should we change the rule's remediation provision to include
an escalating provision that requires longer periods of compliance
based on the number of three-day (or more) periods that a fund has been
out of compliance? If so, how should we structure such a provision?
    121. Should we change the rule to factor in the aggregate number of
days in a trailing year that a fund has been out of compliance? What
additional remediation consequences should a fund address before
entering into derivatives transactions (other than those designed to
reduce the fund's VaR)? Please explain.
    122. Should the remediation provision provide further or different
limitations for a fund that continuously goes in and out of compliance
with its VaR test? For example, should the rule provide that such a
fund is not permitted to rely on the proposed rule indefinitely or for
a set period of time? How should a rule define ``continuously going in
and out of compliance''? Should such a fund be subject to a lower VaR
requirement? If so, what level of VaR and why? How long should the fund
remain subject to any lower VaR requirement? Should the fund be subject
to limits on its derivatives exposure?
    123. Should the remediation provision, as proposed, require the
derivatives risk manager to report to the fund's board of directors
that the fund has been out of compliance with the VaR-based limit for
more than three consecutive business days? Why or why not? Should the
derivatives risk manager be required to explain how the fund will come
back into compliance promptly and by when? Should we change the rule to
require such a fund to take certain specific actions? Should we change
the rule to require fund compliance within a specific time period? If
so, how should we change the rule and why?
    124. Should the remediation provision, as proposed, require the
derivatives risk manager to analyze the circumstances for the fund
being out of compliance for more than three business days? Should we
change the rule to require specific program updates? Should we change
the rule to require a complete program review and update? What
challenges would such a remediation requirement impose on funds? What
are the benefits of specifying program updates? Under what
circumstances, if any, would a fund be out of compliance for more than
three business days and not have risk management program elements to
update? Please explain.
6. Other Regulatory Approaches To Limiting Fund Leverage Risk
a. Stress Testing
    In addition to our proposal to require stress testing as a
derivatives risk management program element, we considered a stress
testing requirement as a means to limit fund leverage risk in lieu of,
or in addition to, the proposed VaR tests. We understand that many
funds that use derivatives transactions already conduct stress tests
for purposes of risk management.\254\
---------------------------------------------------------------------------

    \254\ See, e.g., ICI Comment Letter III. While we do not propose
to require stress testing as a means for limiting a fund's leverage
risk, as discussed above, one element of the proposed program
requires stress testing for risk management purposes. See supra
section II.B.3.c.
---------------------------------------------------------------------------

    For example, we considered proposing a single-factor stress test
requirement that would enumerate a limited number of shocks,
corresponding to different asset classes in which funds commonly
invest, and specify the required shock levels for each asset class.
Similar to Form PF, the rule could categorize stress testing shocks
based on market factors such as equity prices, risk-free interest
rates, credit spreads, currency rates, commodity prices, option implied
volatilities, default rates for asset-backed securities, and default
rates for corporate bonds and credit-default swaps.\255\ The rule could
also include an ``other,'' general category for which the corresponding
shock level would be a specific or otherwise determinable factor based
on extreme but plausible market conditions determined by the
derivatives risk manager. A fund would ``fail'' this stress test if one
of the prescribed shocks would cause the fund to experience a level of
loss that we would specify.
---------------------------------------------------------------------------

    \255\ Question 42 on Form PF requires some private fund advisers
to report the impact on the fund's portfolio from specified changes
to the identified market factors.
---------------------------------------------------------------------------

    We could, for example, specify the shock levels for each market
factor based on a certain number of standard deviations from the mean
of historical distributions of returns for that factor, such as three
or four standard deviations, as a means of establishing standardized
shock levels.\256\ We could then specify that a fund fails the stress
test if any such shock leads to a loss of a certain percentage of the
fund's net assets over a single trading day or series of trading days,
such as 20% over one trading day. We could determine these metrics
based on how funds that do not engage in derivatives, but that have
borrowed up to and in compliance with the requirements of section 18,
would perform against the stress test. For example, the stress test
outer limit could be based on a fund that is not using derivatives but
has invested $150 in securities based on $100 of net assets and $50 in
bank borrowings. To be consistent with section 18, a fund that uses
derivatives and conducts a stress test resulting in losses greater than
the stress test losses of this hypothetical bank-borrowing-leveraged
fund would fail the single-factor stress test.
---------------------------------------------------------------------------

    \256\ If normally distributed, shock levels based on historical
returns of a market factor that is three standard deviations from
the mean of that market factor would correspond to approximately a
99.7% confidence level.
---------------------------------------------------------------------------

    This approach would have the benefit of setting forth a
comparatively simple-to-conduct test that a broad variety of funds
could apply. The challenges of a single-factor stress testing
requirement, however, include identifying an appropriate universe of
market risk factors for the broad universe of derivatives in which
funds invest and strategies they follow, setting the appropriate level
of each shock for each factor, and determining the level of losses that
would result in a fund ``failing'' the test. Making these
determinations would be particularly challenging in a rule that would
apply to all funds. Any prescribed shocks and related values could
become stale over time and necessarily would not include all of the
relevant risk factors for each fund. As funds continue to innovate,
there could be funds for which no prescribed shock would be relevant.
An approach that looks at a fund's losses in response to changes in a
single market risk factor also may not effectively take into account
correlations among market risk factors under stressed market
conditions. Stress testing is useful as a risk management tool because
it

provides a framework for advisers to consider a range of potential
scenarios tailored to each fund and refined over time. Its benefits as
a limit of fund leverage risk may not be fully realized, however, by
single-factor stress testing that includes static values that a rule
specifies.\257\
---------------------------------------------------------------------------

    \257\ We recognize that these concerns do not apply to all uses
of single-factor stress testing. For example, money market fund
stress testing does not raise similar concerns in part because of
money market funds' common strategies and limited universe of
investment holdings. See rule 2a-7(g)(8) under the Investment
Company Act (requiring periodic stress testing).
---------------------------------------------------------------------------

    We also considered requiring a multi-factor stress test based on
scenario analysis. Rather than a fund applying a single-factor shock to
each relevant asset class, this approach would require funds to create
a stress test model that takes into account multiple asset classes
simultaneously, which a fund would have to identify to tailor the
stress test to its fund. The fund would then run numerous scenarios
against the model, shocking the multiple asset classes identified,
based on a high number of iterations and permutations akin to a Monte
Carlo simulation. A multi-factor stress test would result in a matrix
or range of estimated potential losses during stressed market
conditions because each scenario permutation would create one estimated
potential loss calculation. The benefits of multi-factor stress testing
include tailoring the stress test to the investment and risk
characteristics of a fund's portfolio, which may result in more
meaningful derivatives risk management. But in considering a multi-
factor stress testing requirement, we would have to consider whether
such a framework, if highly particularized, would permit enough long-
term flexibility as an applicable regulatory limit on fund leverage
risk. For example, the multi-factor stress test could identify specific
correlations and assumptions that funds should reflect in their stress
tests based on their strategies and investments, or identify specific
historical market events to run as scenarios against their stress test
model. In addition, if we were to propose a principles-based multi-
factor stress testing requirement that would rely on funds to tailor
their stress tests, it would present regulatory challenges in
determining whether funds were adhering to a limit on fund leverage
risk consistent with section 18.
    Finally, our proposed VaR-based limit on fund leverage risk, as
opposed to stress testing, may better align with section 18's investor
protection goals concerning the level of risk in a registered fund.
This is because the limitations in section 18 apply under both normal
and stressed market conditions.\258\ For these reasons, as well as the
regulatory design challenges of specifying the universe of asset class
shocks and setting their corresponding levels, we are proposing a VaR-
based limit on fund leverage risk instead of a stress testing approach
to limiting fund leverage risk.
---------------------------------------------------------------------------

    \258\ See supra section I.B.1.
---------------------------------------------------------------------------

    We request comment on stress testing as a means to limit funds'
leverage risk.
    125. In addition to our proposed stress testing requirement as part
of the derivatives risk management program, should the rule require
stress testing as a means to limit fund leverage risk in lieu of or in
addition to the VaR-based limit on fund leverage risk? Why or why not?
Is a stress test an effective means to limit a fund's leverage risk?
Please explain. If we were to include a stress testing requirement in
addition to a VaR-based limit on fund leverage risk, should we require
a fund to comply with both requirements, or should we allow a fund to
choose one or the other? If we were to allow funds to comply with
either approach, would that result in inconsistent limits across funds
and would that be appropriate if so?
    126. To measure and/or limit fund leverage risk, do funds currently
use VaR tests, stress tests or both? If a fund uses VaR tests but not
stress tests (or vice versa), did the fund consider using the other
approach as a means to measure and limit its leverage risk? Why or why
not?
    127. If funds use both VaR tests and stress tests to measure and/or
limit fund leverage risk, why do they use both tests? Are there certain
fund types or strategies that are better suited for VaR or for stress
testing? If so, which ones and why?
    128. Should the limit of fund leverage risk focus on normal market
conditions, stressed market conditions, or both? Please explain.
    129. Should the rule require a single-factor stress test as an
alternative to the proposed VaR-based limit on fund leverage risk? If
so, what single-factor shocks should the test require? What would the
corresponding shock levels be for each factor? Are the example single-
factor shocks discussed above appropriate? Please explain. How
frequently and on what basis, if at all, do commenters anticipate that
the Commission would need to amend a rule that incorporated the
enumerated shocks and their corresponding levels?
    130. What number of standard deviations from the mean of historical
distributions of returns should the single-factor shock levels for each
market risk factor be? Would three standard deviations or four standard
deviations be appropriate? How should the rule define a failed stress
test? Would a loss expressed as a percentage of the fund's net assets
over a single trading day or series of trading days be appropriate?
What percentage and over what period would be appropriate? Would 20%
over one trading day be appropriate? How frequently, if at all, do
commenters anticipate that the Commission would need to amend the rule
to revise the specified loss level?
    131. Should the rule require a multi-factor stress test as an
alternative to the proposed VaR-based limit on fund leverage risk? If
so, how might the rule include a multi-factor stress testing
requirement that permits adequate flexibility and tailoring but could
also promote comparability and regulatory consistency in setting a
leverage risk limit?
    132. Should the single-factor or multi-factor stress testing
methods be required as part of the proposed program's stress testing
requirement? If so, which one and why?
b. Asset Segregation
    We considered applying an asset segregation approach to derivatives
transactions, similar to asset segregation under Release 10666, as a
tool to limit funds' leverage-related risks.\259\ Under this approach,
we could require a fund engaging in derivatives transactions to
segregate cash and cash equivalents equal in value to the full amount
of the conditional and unconditional obligations incurred by the fund
(also referred to as ``notional amount segregation''). We could allow
funds to segregate additional types of assets beyond cash and cash
equivalents subject to prescribed haircuts based on the assets'
volatilities. The 2016 DERA Memo, for example, analyzed different risk-
based ``haircuts'' that could apply to a broader range of assets.\260\
Allowing a broader range of segregated assets would have the effect of
allowing funds to take on additional leverage because it would increase
a fund's ability to obtain market exposure through a combination of
cash, market securities investments, and derivatives transactions.
Allowing funds to segregate a broader range of assets, even if subject
to haircuts, also may not effectively address all of the section 18
concerns underlying an asset segregation requirement. For example, if

a fund must raise cash to pay a derivatives counterparty by selling a
segregated security with unrealized trading losses, then the fund still
would realize trading losses on the sale of the security regardless of
whether the fund applied haircuts to the value of the security when
determining the amount of its segregated assets. The haircuts therefore
could help to prevent a fund from defaulting on its derivatives
transactions obligations, but may not prevent a fund from realizing
trading losses to meet those obligations.
---------------------------------------------------------------------------

    \259\ We separately discuss below our consideration of asset
segregation as a complement to the proposed limitations on fund
leverage risk. See infra section II.F.
    \260\ See, e.g., 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------

    Notional amount segregation, although generally an effective way to
limit leverage risk, is a non-risk-sensitive and often more restrictive
approach to limiting potential leverage risk as compared to the
proposed VaR tests. Notional amount segregation could limit funds'
ability to engage in derivatives transactions that may not raise the
concerns underlying section 18. For example, if a fund had segregated
all available qualifying assets, it would not be permitted to enter
into a derivatives transaction that would reduce portfolio risk. The
proposed VaR tests would not constrain such a transaction because it
would reduce the fund's VaR.
    We also considered proposing an approach that would require funds
to segregate liquid assets in an amount equal to the fund's daily mark-
to-market liability plus a ``cushion amount'' designed to address
potential future losses. Requiring funds to segregate liquid assets
would indirectly limit a fund's leverage risk because each derivatives
transaction and segregation of liquid assets would limit the net assets
available for segregation to support additional derivatives. This
approach would require segregating a smaller amount of liquid assets
than the notional amount segregation approach.\261\ In light of the
smaller amount of segregated assets, we could provide that only a
specified percentage of a fund's assets can be segregated. We could
provide, for example, that a fund's segregated amount cannot exceed
one-third of its total assets or one-half of its net assets because
this is the maximum amount that an open-end fund can owe a bank under
section 18.
---------------------------------------------------------------------------

    \261\ See 2010 ABA Derivatives Report (recommending a risk-
adjusted segregated amounts approach); 2011 Concept Release, supra
note 3, at sections II.B.2, II.C.2 (citing and requesting comment on
the 2010 ABA Derivatives Report approach).
---------------------------------------------------------------------------

    This approach, however, would raise compliance complexities and may
not be as effective as the proposed VaR tests in limiting fund leverage
risk. For example, under this approach we would have to define the
risk-based ``cushion amount'' funds would segregate. We could define
this amount as we proposed in 2015: A reasonable estimate of the
potential amount payable by the fund if the fund were to exit the
derivatives transaction under stressed conditions.\262\ Some commenters
suggested determining these amounts could raise compliance
challenges.\263\ Another approach would be to use the amount of
required initial margin, for transactions subject to regulatory initial
margin requirements. Not all derivatives transactions are subject to
initial margin requirements, however, and these requirements generally
vary based on the type of derivatives instrument. An approach that were
to allow a fund to have more leverage when trading futures as compared
to swaps, for example, would not seem consistent with the concerns
underlying section 18.
---------------------------------------------------------------------------

    \262\ See 2015 proposed rule 18f-4(c)(9).
    \263\ We discuss these challenges in more detail below in
section II.F. See also, e.g., AAF Comment Letter; Angel; Comment
Letter of James J. Angel, Ph.D., CFA (Mar. 28, 2016).
---------------------------------------------------------------------------

    Requiring funds to segregate liquid assets in an amount equal to
the fund's daily mark-to-market liability plus a ``cushion amount''
therefore could introduce unnecessary complexity and compliance costs
and may not result in an effective limit on fund leverage. We believe
that the proposed VaR-based tests would be a more direct and effective
method of limiting fund leverage risk consistent with section 18.
    We request comment on asset segregation as an alternative or
complement to VaR.
    133. Should the rule require asset segregation in lieu of or in
addition to the proposed VaR-based limit on fund leverage risk? Is
asset segregation equally effective or more effective than the proposed
VaR tests in limiting a fund's leverage risk? Why or why not?
    134. Are there certain fund types or strategies for which an asset
segregation approach would be more effective or appropriate for
limiting a fund's leverage risk? Which ones and why?
    135. Should the proposed rule require notional amount segregation?
What challenges, if any, would funds have with complying with notional
amount segregation? Would this be an effective means to limit a fund's
leverage risk? If so, how? Please describe.
    136. Should the proposed rule require an asset segregation risk-
based approach based on the fund's daily mark-to-market liability and
``cushion amount''? Please explain why or why not. If so, how should
funds calculate the risk-based cushions? Should we use the approach in
the 2015 proposal for risk-based coverage amounts? Would funds
encounter challenges in determining stressed conditions for purposes of
that analysis? Would that approach lead to consistent segregated
amounts across funds for the same or similar investments? Why or why
not? Could we provide for greater consistency by prescribing a
standardized schedule for computing these amounts based on the
volatility of the underlying reference assets? What values should we
prescribe? Rather than the approach in the 2015 proposal, should we use
the amounts posted to satisfy regulatory margin requirements? Would it
be appropriate for different instruments that provide the same economic
exposure (e.g., futures and swaps that reference the same index) to
have different segregated amounts? Under this approach, how should
funds calculate risk-based cushions for transactions that are not
subject to regulatory initial margin requirements?
    137. Should we use the risk-based cushion amount approach to
indirectly limit leverage risk? If so, should we provide that a fund's
segregated amount cannot exceed one-third of its total assets, one-half
of its net assets, or some other percentage of a fund's total or net
assets? Would such an approach be sufficiently risk-sensitive and
dynamic? If we were to use such an approach, how should we address
derivatives transactions that may require little or no margin or
collateral to be posted?
    138. Are there other reasons that the proposed rule should include
asset segregation? Should the derivatives risk management program
specify asset segregation requirements? Would market practices
adequately address asset coverage concerns? If not, why?
    139. We included an asset segregation requirement as part of the
2015 proposal designed in part to address the asset sufficiency related
concerns underlying section 18. Would an asset segregation requirement
help to address fund leverage risk and complement the proposed VaR
tests? If so, what type of asset sufficiency test?
c. Exposure-Based Test
    We considered an exposure-based approach for limiting fund leverage
risk. For example, we could design an exposure-based approach that
permits a fund to enter into derivatives transactions so long as its
derivatives exposure does not exceed a specified percentage of the
fund's net assets, such as 50%. This would be similar to an exposure-
based test under the European

Union guidelines that apply to UCITS funds.\264\
---------------------------------------------------------------------------

    \264\ CESR (now known as the European Securities and Markets
Authority (``ESMA'')) issued its Guidelines on Risk Measurement and
the Calculation of Global Exposure and Counterparty Risk for UCITS
(``Global Exposure Guidelines'') in 2010, addressing the
implementation of the European Commission's 2009 revised UCITS
Directive (``2009 Directive''). See CESR Global Guidelines, supra
note 94, at 9.
     A UCITS fund may, instead of complying with the European
Union's VaR-based test, satisfy a ``commitment approach.'' The
commitment approach provides that a UCITS fund is in compliance with
the leverage limits under the guidelines if its derivatives notional
amounts (taking into account netting and hedging) do not exceed 100%
of the fund's net asset value. See 2009 Directive.
---------------------------------------------------------------------------

    A fund's ``derivatives exposure'' could be defined as in proposed
rule 18f-4.\265\ A similar approach would be to provide that the sum of
a fund's derivatives exposure and the value of its other investments
cannot exceed 150% of the fund's net asset value. This latter approach,
and particularly if cash and cash equivalents were not included in the
calculation, would allow a fund to achieve the level of market exposure
permitted for an open-end fund under section 18 using any combination
of derivatives and other investments.\266\
---------------------------------------------------------------------------

    \265\ Proposed rule 18f-4(a) (defining derivatives exposure to
mean the sum of the notional amounts of the fund's derivatives
instruments and, in the case of short sale borrowings, the value of
the asset sold short. In determining derivatives exposure a fund may
convert the notional amount of interest rate derivatives to 10-year
bond equivalents and delta adjust the notional amounts of options
contracts).
    \266\ This approach would exclude cash and cash equivalents
because they do not meaningfully contribute to a fund's market
exposure.
---------------------------------------------------------------------------

    This alternative approach would recognize that for most types of
derivatives, the notional amount generally serves as a measure of the
fund's economic exposure to the underlying reference asset or metric.
It also would provide a simple approach because a fund would just add
the relevant values rather than having to perform VaR tests.
    An exposure-based test does have certain limitations. One drawback
to this alternative approach is that a derivative's notional amount
does not reflect the way in which the fund uses the derivative and is
not a risk measurement. For this reason, an exposure-based approach may
be viewed as a relatively blunt measurement. It would not differentiate
between derivatives transactions having the same notional amount but
different underlying reference assets with potentially very different
risks.
    There are adjustments to notional amounts available that may better
reflect the risk associated with derivatives transactions. One way to
attempt to address these drawbacks would be to define the circumstances
under which funds could subtract the exposure associated with
``hedging'' and ``netting'' transactions from a fund's derivatives
exposure. This would be similar to the ``commitment method'' applicable
to UCITS funds.\267\ Defining these kinds of transactions can be
challenging. For example, determining whether transactions are
``hedges'' can involve an analysis of historical correlations and
predicting future price movements of related instruments or underlying
reference assets, among other things. Historical correlations also can
break down in times of market stress.\268\
---------------------------------------------------------------------------

    \267\ See, e.g., CESR Global Guidelines, supra note 94, at 13-14
(defining netting as ``combinations of trades on financial
derivative instruments and/or security positions which refer to the
same underlying asset, irrespective--in the case of financial
derivative instruments--of the contracts' due date; and where the
trades on financial derivative instruments and/or security positions
are concluded with the sole aim of eliminating the risks linked to
positions taken through the other financial derivative instruments
and/or security positions'' and hedging as ``combinations of trades
on financial derivative instruments and/or security positions which
do not necessarily refer to the same underlying asset and where the
trades on financial derivative instruments and/or security positions
are concluded with the sole aim of offsetting risks linked to
positions taken through the other financial derivative instruments
and/or security positions'').
    \268\ In times of extreme market stress, price correlations
between asset classes frequently break down. See Mico Loretan &
William B. English, Evaluating ``Correlation Breakdowns'' During
Periods of Market Volatility, Federal Reserve System International
Finance Working Paper No. 658 (Feb. 2000), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=231857 (``[I]n periods
of heightened market volatility correlations between asset returns
can differ substantially from those seen in quieter markets. The
problem of `correlation breakdown' during periods of greater
volatility is well known.''). During periods of stressed conditions,
correlations between asset classes with historically weak or inverse
correlations may change significantly. See Whitney Kisling, Greed
Beats Fear With Stock-Bond Correlation Falling, Bloomberg (Nov. 22,
2010) (stating that the 30-day correlation between S&P 500 prices
and 10-year Treasury yields showed equity and bond markets,
typically inversely correlated markets, moving in lockstep after the
2008 financial crisis); see also A Review of Financial Market Events
in Autumn 1998, Bank for International Settlements, Committee on the
Global Financial System (1999), available at http://www.bis.org/publ/cgfs12.htm (during the Russian financial crisis in August 1998
the average correlation between five-day changes in yield spreads
for 26 instruments in 10 economies rose from 11% in the first half
of 1998 to 37% during the height of the crisis).
---------------------------------------------------------------------------

    Another potential way to modify an exposure-based test would be to
adjust the notional amounts that contribute to a fund's derivatives
exposure based on the volatility of their underlying reference assets.
Some commenters on the 2015 proposal suggested we take this approach,
and DERA staff prepared an analysis of commenters' suggestions.\269\
This would make an exposure-based test more risk-sensitive, but would
not provide the more-comprehensive analysis of portfolio risk that VaR
provides. An exposure-based test, even with these various adjustments
to notional amounts for purposes of calculating a fund's derivatives
exposure, still would be a relatively blunt measurement. For example,
this approach could limit certain fund strategies that rely on
derivatives more extensively but that do not seek to take on
significant leverage risk.
---------------------------------------------------------------------------

    \269\ See 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------

    While we do not propose an exposure-based test element as a means
for limiting all funds' leverage risk, we are proposing an exposure-
based test for limited derivatives users (as discussed below).\270\
---------------------------------------------------------------------------

    \270\ See proposed rule 18f-4(c)(3).
---------------------------------------------------------------------------

    We request comment on an exposure-based test as a means to limit
funds' leverage risk.
    140. Should the rule incorporate an exposure-based approach in
addition to, or in lieu of, the proposed VaR-based limit on fund
leverage risk? If so, what derivatives exposure amount should this
approach permit? For example, should we modify the proposed rule so
that a fund would not be required to satisfy either VaR test if the
fund limited its derivatives exposure, as defined for purposes of the
limited derivatives user exception discussed below, to 50% of a fund's
net assets? Should an exposure-based approach focus on a fund's overall
gross market exposure and be based on the sum of the fund's derivatives
exposure and the value of its other investments, less any cash and cash
equivalents? If so, should a fund's gross market exposure be limited to
150% of net assets to allow a fund to achieve the level of market
exposure permitted for an open-end fund under section 18 using any
combination of derivatives and other investments? Would any of these
approaches to implementing an exposure-based limit on fund leverage
risk effectively address the potential leverage associated with a
fund's derivatives transactions? If so, would funds find it more cost
effective or otherwise preferable to have the option to comply with an
exposure-based test in lieu of the proposed VaR tests? Please explain.
    141. If the rule were to incorporate an exposure-based approach,
should we permit funds to make netting and hedging adjustments when
calculating their derivatives exposures? If so, why? How should we
define permissible

netting and hedging transactions? If we permit netting and hedging to
be incorporated into the exposure calculation, should the rule include
third-party verification to test whether a fund's netting and hedging
calculations were reasonable and appropriate? What other provisions
could achieve these concerns with netting and hedging? Please describe.
    142. If the rule were to incorporate an exposure-based approach,
should we permit funds to make risk-sensitive adjustments as discussed
in the 2016 DERA Memo? If so, why? How should we define the permissible
risk-adjusted notional amounts? If we permit these adjustments to be
incorporated into the exposure calculation, should the rule include
third-party verification to test whether a fund's adjustments were
reasonable and appropriate? What other provisions could achieve these
concerns with risk-adjusted notional amounts? Please describe.
    143. Are there certain fund types or strategies where an exposure-
based test would be more appropriate? If so, which ones and why? Would
these fund types or strategies have difficulty conducting either a
relative VaR test or absolute VaR test? If so, why would an exposure-
based test be less challenging to conduct than a VaR-based test?
    144. What challenges, if any, would funds have in conducting an
exposure-based test? How could an exposure-based test rule account for
these challenges?
    145. Do funds currently conduct exposure-based tests as a means of
measuring and limiting a fund's leverage risk? If so, which ones and
why? Are these exposure-based tests in place of or in addition to VaR-
based tests or other risk measurements? Should the rule be modified to
require both, and what benefits do funds find when running an exposure-
based test and VaR-based test and comparing results? Would these
additional compliance burdens result in a more-accurate limit on fund
leverage risk? If so, how much so, and what would the additional
compliance burdens be?
    146. In what ways is the proposed approach to limiting leverage
risk superior or inferior to the current regulatory approach or
alternative approaches, including the stress testing, asset segregation
and exposure-based alternatives discussed herein?

E. Limited Derivatives Users

    We are proposing an exception from the proposed rule's risk
management program requirement and VaR-based limit on fund leverage
risk for funds that use derivatives in a limited manner. Requiring
funds that use derivatives only in a limited way to adopt a derivatives
risk management program that includes all of the proposed program
elements could potentially require funds (and therefore their
shareholders) to incur costs and bear compliance burdens that may be
disproportionate to the resulting benefits.\271\ We recognize that the
risks and potential impact of derivatives transactions on a fund's
portfolio generally increase as the fund's level of derivatives usage
increases and when funds use derivatives for speculative purposes.
---------------------------------------------------------------------------

    \271\ The cost burden concern extends to smaller funds as well,
which could experience an even more disproportionate cost than
larger funds. See infra sections III.C.3and V.D.1.c.
---------------------------------------------------------------------------

    The proposed exception would cover two alternative types of limited
derivatives use. It would be available to a fund that either limits its
derivatives exposure to 10% of its net assets, or that uses derivatives
transactions solely to hedge certain currency risks.\272\ A fund that
relies on the proposed exception would also be required to adopt
policies and procedures that are reasonably designed to manage its
derivatives risks.\273\ We believe 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, and that a
principles-based policies and procedures requirement would
appropriately address these risks. We discuss and request comment on
each of the elements of this proposed exception below.
---------------------------------------------------------------------------

    \272\ See proposed rule 18f-4(c)(3)(i)-(ii); see also infra
sections II.E.1 and II.E.2 (discussing the specific requirements for
funds relying on either alternative of the proposed exception).
    \273\ See proposed rule 18f-4(c)(3).
---------------------------------------------------------------------------

1. Exposure-Based Exception
    Under one alternative set of conditions, a fund would be permitted
to rely on the limited derivatives user exception if its derivatives
exposure does not exceed 10% of its net assets. The proposed rule would
generally define the term ``derivatives exposure'' to mean the sum of
the notional amounts of the fund's derivatives instruments and, for
short sale borrowings, the value of any asset sold short.\274\ This
definition is designed to provide a measure of the market exposure
associated with a fund's derivatives transactions entered into in
reliance on proposed rule 18f-4.\275\
---------------------------------------------------------------------------

    \274\ See proposed rule 18f-4(a) (defining the term
``derivatives exposure'').
    \275\ Id.
---------------------------------------------------------------------------

    We recognize that using notional amounts as a measure of market
exposure could be viewed as a relatively blunt measurement in that
different derivatives transactions having the same notional amount but
different underlying reference assets--for example, an interest rate
swap and a credit default swap having the same notional amount--may
expose a fund to very different potential investment risks and
potential payment obligations. The derivatives exposure threshold in
the limited derivatives user exception, however, is not designed to
provide a precise measure of a fund's market exposure or to serve as a
risk measure, but rather to serve as an efficient way to identify funds
that use derivatives in a limited way.
    The proposed definition of ``derivatives exposure'' would, however,
include two adjustments designed to address certain limitations
associated with measures of market exposure that use derivatives'
notional amounts without adjustments. Specifically, the proposed rule
would permit a fund to convert the notional amount of interest rate
derivatives to 10-year bond equivalents and delta adjust the notional
amounts of options contracts.\276\ Converting interest rate derivatives
to 10-year bond equivalents would provide for greater comparability of
the notional amounts of different interest rate derivatives that
provide similar exposure to changes in interest rates but that have
different unadjusted notional amount. In addition, absent this
adjustment, short-term interest rate derivatives in particular can
produce large unadjusted notional amounts that may not correspond to
large exposures to interest rate changes.\277\ Permitting funds to
convert these and other interest rate derivatives to 10-year bond
equivalents is designed to result in adjusted notional amounts that
better represent a fund's exposure to interest rate changes. Similarly,
permitting delta adjusting of options is designed to provide for a more
tailored notional amount that better reflects the exposure that an
option creates to the underlying reference asset.
---------------------------------------------------------------------------

    \276\ Id. Delta refers to the ratio of change in the value of an
option to the change in value of the asset into which the option is
convertible. A fund would delta adjust an option by multiplying the
option's unadjusted notional amount by the option's delta.
    \277\ Id.
---------------------------------------------------------------------------

    These adjustments are therefore designed to provide for more
tailored notional amounts that better reflect the exposure that a
derivative creates to the underlying reference asset. Providing these
adjustments also would be efficient for funds because the adjustments
are consistent with the

reporting requirements in Form PF and Form ADV.\278\ We do not believe
additional adjustments are necessary for purposes of identifying
limited derivatives users. For example, commenters on the 2015 proposal
suggested an approach to adjusting notional amounts based on the
volatility of the underlying reference assets, and DERA staff analyzed
these suggestions.\279\ We believe, however, that whether a fund is
using derivatives in a limited way for purposes of the limited
derivatives user exception should not depend on the volatility of the
underlying reference assets, but rather on the extent to which a fund
uses derivatives to implement its investment strategy.
---------------------------------------------------------------------------

    \278\ See, e.g., General Instruction 15 to Form PF; Item B.30 of
Section 2b of Form PF; Glossary of Terms, Gross Notional Value of
Form ADV; Schedule D of Part 1A of Form ADV.
    \279\ See 2016 DERA Memo, supra note 12.
---------------------------------------------------------------------------

    The proposed 10% derivatives exposure condition represents a
threshold that is designed to exclude funds from the program
requirement and the VaR-based limit on fund leverage risk when their
derivatives exposure is relatively limited. This proposed threshold is
based in part on staff analysis of funds' practices regarding
derivatives use. Specifically, DERA staff analyzed funds' use of
derivatives based on Form N-PORT filings as of September 2019. As
discussed in more detail in section III, these filings covered mutual
funds, ETFs, registered closed-end funds, and variable annuity separate
accounts registered as management investment companies. Based on this
analysis, 59% of funds report no derivatives holdings and 14% of funds
report derivatives holdings with gross notional amounts above 50% of
NAV.
    DERA staff also analyzed the levels of these funds' derivatives
exposure after adjusting interest rate derivatives and options, as
permitted under the proposed rule. Taking these adjustments into
account, DERA staff's analysis showed that 78% of funds have adjusted
notional amounts below 10% of NAV; 80% of funds have adjusted notional
amounts below 15% of NAV; 81% of funds have adjusted notional amounts
below 20% of NAV; and 82% of funds have adjusted notional amounts below
25% of NAV. Although BDCs are not required to file reports on Form N-
PORT, our staff separately analyzed a sampling of BDCs, finding that of
the sampled BDCs, 54% did not report any derivatives holdings and a
further 29% reported using derivatives with gross notional amounts
below 10% of net assets.\280\
---------------------------------------------------------------------------

    \280\ See infra section III.B.2. As noted above, our staff did
not have sufficient information to adjust the notional amounts of
the BDCs' interest rate derivatives or options. Some of the 17% of
the sampled BDCs with gross notional amounts exceeding 10% of net
assets likely would have lower notional amounts after applying these
adjustments.
---------------------------------------------------------------------------

    We recognize that not all funds are currently required to file
reports on Form N-PORT.\281\ It appears, however, that funds' use of
derivatives reflected in the Form N-PORT data is generally consistent
with that in the representative sample studied in the White Paper
prepared in connection with the 2015 proposal, entitled ``Use of
Derivatives by Investment Companies.'' \282\ For example, DERA staff
compared the percentages of funds in both data sets that reported no
derivatives and the percentage with gross notional amounts less than
50% of net assets. These figures were comparable, suggesting that the
Form N-PORT data provides a representative sample of current funds, and
not just the set of funds currently required to file reports on Form N-
PORT.\283\ Taking these results into account, we are proposing to
permit a fund to operate as a limited derivatives user if its
derivatives exposure is below 10% of net assets. DERA staff analysis
suggests that most funds either do not use derivatives or do so to a
more limited extent, and that setting the derivatives exposure
threshold for the limited user exception at 10%, 15%, 20%, or 25%, for
example, would result in nearly the same percentages of funds
qualifying for the exception. We therefore are proposing a lower
threshold of 10% because the lower threshold would result in nearly the
same percentage of funds qualifying for the exception based on current
practices while potentially providing greater investor protections in
the future by requiring funds that exceed the lower 10% threshold to
establish a program and comply with the VaR-based limit on fund
leverage risk.
---------------------------------------------------------------------------

    \281\ Larger fund groups--funds that together with other
investment companies in the same ``group of related investment
companies'' have net assets of $1 billion or more as of the end of
the most recent fiscal year of the fund--currently are required to
file reports on N-PORT. Smaller fund groups must begin to file
reports on Form N-PORT by April 30, 2020. While only larger fund
groups are currently required to file reports on Form N-PORT,
existing filings nevertheless covered 89% of funds representing 94%
of assets. See infra note 457 and accompanying text.
    \282\ DERA White Paper, supra note 1; see also ICI Comment
Letter III (regarding a survey related to funds' use of derivatives
sent to its member firms, the Investment Company Institute stated
``The survey was distributed to smaller fund complex members, yet
relatively few responses were received from these smaller fund
members. Based on anecdotal conversations with staff at these member
complexes, the smaller fund firms described no to minimal use of
derivatives.'').
    \283\ Specifically, the DERA White Paper observes that 68% of
funds held no derivatives and 89% of funds had gross notional
amounts less than 50% of net assets. See DERA White Paper, supra
note 1. The respective figures from the N-PORT data were 59% and 86%
of funds.
---------------------------------------------------------------------------

    The 2015 proposal also included an exception from that proposal's
risk management program requirement for funds: (1) Whose notional
derivatives exposure does not exceed 50% of net assets; and (2) that do
not enter into ``complex derivatives transactions,'' defined in that
proposal to include certain path-dependent and non-linear
transactions.\284\ The 2015 proposal permitted funds to use delta-
adjusted notional amounts for options but did not provide an adjustment
for interest rate derivatives.
---------------------------------------------------------------------------

    \284\ Specifically, the 2015 proposal defined the term ``complex
derivatives transaction'' to mean any derivatives transaction for
which the amount payable by either party upon settlement date,
maturity or exercise: (1) Is dependent on the value of the
underlying reference asset at multiple points in time during the
term of the transaction; or (2) is a non-linear function of the
value of the underlying reference asset, other than due to
optionality arising from a single strike price. 2015 proposed rule
18f-4(c)(1).
---------------------------------------------------------------------------

    We are proposing a 10% derivatives exposure threshold that takes
into account certain adjustments rather than a higher figure, like the
50% threshold we proposed in 2015 that did not include adjustments for
interest rate derivatives, because we believe this approach would more
effectively identify funds whose derivatives may be effectively managed
without a fund needing to establish a derivatives risk management
program that includes all of the proposed program elements. A fund with
derivatives exposure equal to 50% of net assets, for example, would be
at risk of substantial losses, notwithstanding that an open-end fund
could borrow an amount equal to 50% of its net assets from a bank.\285\
Conversely, if a fund were entering into interest rate derivatives--and
especially short-term interest rate derivatives--those transactions'
unadjusted notional amounts could cause a fund to exceed the threshold
we proposed in 2015 even though the fund's derivatives risks could be
less significant than those of

other funds that would qualify for the exception. The approach the
Commission proposed in 2015 therefore could have permitted some funds
to rely on the exception while still taking on significant derivatives
risks, while disqualifying other funds whose derivatives transactions
may have posed less-significant risks but that had high unadjusted
notional amounts. Here, our proposal is designed to address these
concerns by proposing a lower derivatives exposure threshold while also
allowing funds to adjust interest rate derivatives' notional amounts
because the unadjusted values may be more likely to overstate a fund's
market exposure.
---------------------------------------------------------------------------

    \285\ See, e.g., CFA Comment Letter (stating that the commenter
did not believe it was ``appropriate that a fund with 40 or 45
percent notional exposure should be viewed as having a limited
amount of exposure obviating the requirement for that fund to
implement a formal risk management program'' and that ``Section 18's
limit reflects a congressional determination on the level of
exposure funds may not exceed; it does not reflect the level of
exposure at which funds should begin to establish formal risk
management practices'').
---------------------------------------------------------------------------

    We also are not proposing to prohibit funds relying on the
exception from entering into complex derivatives transactions as we
proposed in 2015 because, as discussed in more detail below, we are
proposing to require that limited derivatives users manage all of the
risks associated with their derivatives transactions, including any
complex derivatives transactions. In addition, if these or other
complex or exotic derivatives were to embed multiple forms of
optionality or other non-linearities such that the fund could not
reliably compute the transaction's notional amount, the fund would not
be able to confirm that its derivatives exposure is below 10% of the
fund's net assets and therefore would not be able to rely on the
limited derivatives user exception. Finally, if these complex
derivatives transactions were to cause a fund's derivatives exposure to
exceed 10% of the fund's net assets--or the fund were to exceed the
limit for any other reason--the fund would have to reduce its
derivatives exposure promptly or establish a derivatives risk
management program and comply with the VaR-based limit on fund leverage
risk as soon as reasonably practicable.
    We also considered an alternative approach to identifying funds
that use derivatives in a limited way based on a fund's disclosure.
Specifically, we considered providing that a fund would be a limited
derivatives user if its principal investment strategies disclosed in
its prospectus do not involve the use of derivatives.\286\ A fund that
does not identify the use of derivatives in its principal investment
strategies should generally be using derivatives less extensively than
a fund that does include the use of derivatives as a principal
investment strategy. This approach would provide some efficiencies for
funds because they already are required to make this disclosure.\287\
---------------------------------------------------------------------------

    \286\ See, e.g., ICI Comment Letter III (stating that an
appropriate threshold for limited derivatives users could be whether
a fund listed derivatives in its prospectus as a principal
investment strategy). Form N-1A requires an open-end fund to
disclose its principal investment strategies, including the
particular type or types of securities in which the fund principally
invests or will invest. See Item 9 of Form N-1A. Form N-1A also
provides, in part, that ``[i]n determining what is a principal
investment strategy, consider, among other things, the amount of the
Fund's assets expected to be committed to the strategy, the amount
of the Fund's assets expected to be placed at risk by the strategy,
and the likelihood of the Fund's losing some or all of those assets
from implementing the strategy.'' See Instruction 2 to Item 9 of
Form N-1A. Form N-2 requires a closed-end fund to concisely describe
the fund's investment objectives and policies that will constitute
its principal portfolio emphasis, including the types of securities
in which the fund invests or will invest principally. See Item 8 of
Form N-2. The instructions to this item direct the fund to briefly
describe the significant investment practices or techniques that the
fund employs or intends to employ with several examples, including
examples related to derivatives transactions.
    \287\ See ICI Comment Letter III (stating that 92% of the firms
surveyed indicated that their firms have funds that list derivatives
as a principal investment strategy in their prospectus).
---------------------------------------------------------------------------

    This approach would, however, have certain drawbacks. For example,
whether a fund's use of derivatives is a principal investment strategy
is a facts-and-circumstances-based analysis. Funds that may appear
broadly similar could provide different disclosures, leading to less
consistency in the application of the derivatives risk management
program requirement and in the application of the VaR-based limit on
leverage risk.
    Taking these considerations into account, we are proposing to look
at a uniform metric of a fund's derivatives exposure, rather than at
the more fact-specific question of whether a fund views the use of
derivatives as a principal investment strategy. We believe the proposed
approach should result in more-consistent determinations by funds and
would be more appropriate in determining whether a fund should qualify
for the limited derivatives user exception.
    We request comment on the proposed exposure-based exception.
    147. Is it appropriate to permit funds to rely on the limited
derivatives user exception if their derivatives exposure does not
exceed 10% of their net assets? Why or why not? Should we lower or
raise the proposed derivatives exposure threshold, for example to 5% or
to 15%? Why or why not? Should we lower it to a de minimis amount, such
as 1% or 3%, and provide that a fund with derivatives exposure below
these levels is not required to adopt policies and procedures designed
to manage derivatives risk? Should the threshold vary based on whether
a fund is an open-end fund, registered closed-end fund, or BDC? If so,
why, and which levels would be appropriate for each kind of fund?
    148. The derivatives exposure of certain types of transactions may
be difficult to calculate or may change rapidly, which may make it
difficult for a fund to consistently comply with the limited
derivatives user exception. Should we provide that a fund relying on
the limited derivatives user exception may not enter into complex or
exotic derivatives transactions, whose risks may not be fully reflected
in their notional amounts? If so, what kinds of complex or exotic
transactions? For example, should we provide that a fund relying on the
exception may not enter into complex derivatives transactions, as
defined in the 2015 proposal? Should we only permit a fund to have a
more-limited amount of derivatives exposure associated with these
transactions, such as 1% or 5% of net assets? Why or why not?
    149. Should we prescribe how a fund must calculate its notional
amounts, or is that term in the proposed rule sufficiently clear? If we
should prescribe the calculation, what should we prescribe? For
example, in 2015 the Commission proposed to define a derivatives
transaction's notional amount to mean, among other things: (1) The
market value of an equivalent position in the underlying reference
asset for the derivatives transaction (expressed as a positive amount
for both long and short positions); or (2) the principal amount on
which payment obligations under the derivatives transaction are
calculated. Should we include this definition in rule 18f-4? The 2015
proposal also included specific provisions for calculating a
derivatives transaction's notional amount for: (1) Derivatives that
provide a return based on the leveraged performance of a reference
asset; and (2) derivatives transactions for which the reference asset
is a managed account or entity formed or operated primarily for the
purpose of investing in or trading derivatives transactions, or an
index that reflects the performance of such a managed account or
entity.\288\ Should we include either or both of these provisions in
rule 18f-4? Why or why not? Would funds calculate their notional
amounts consistently with these provisions even if they were not
included in the rule text because the calculations would be consistent
with the way market participants determine

derivatives transactions' notional amounts?
---------------------------------------------------------------------------

    \288\ See 2015 Proposing Release, supra 2, at n.158 and
accompanying text.
---------------------------------------------------------------------------

    150. Would funds be able to calculate notional amounts for complex
derivatives and, if so, would they reflect the market risk in the
transactions? Why or why? If we permit funds to enter into complex
derivatives transactions as defined in the 2015 proposal while relying
on the limited derivatives user exception, should we require that funds
calculate these transactions' notional amounts as the Commission
proposed in 2015? That proposal would have provided that the notional
amount of a complex derivatives transaction would be the aggregate
notional amounts of derivatives transactions (excluding complex
derivatives transactions) reasonably estimated to offset substantially
all of the market risk of the complex derivatives transaction.
    151. For purposes of determining a fund's derivatives exposure,
should the proposed rule treat differently derivatives that create
synthetic positions where the fund holds cash and cash equivalents with
a value equal to the derivative's notional amount less any posted
margin? These transactions may not leverage the fund's portfolio
because of the fund's holding cash and cash equivalents equal to the
notional amount of the derivatives transaction less any posted margin,
rather than investing in additional securities or making other
investments. Take, for example, a fund with $100 that posts $20 of
initial margin to initiate a long position in a swap contract
referencing a market index. If the fund posted cash and cash
equivalents as initial margin and maintains the remaining $80 in cash
and cash equivalents as well, the fund would have a market exposure
that would be similar to having invested the fund's $100 in the stocks
composing the index. Such a transaction could, however, present other
risks, such as counterparty risk. Because these synthetic transactions
may not leverage a fund's portfolio, should we permit a fund to exclude
these transactions from its derivatives exposure? Conversely, because
they can raise other risks, such as counterparty risks, should they be
included in derivatives exposure as proposed?
    152. Should the rule define limited derivatives users using an
alternative methodology other than the proposed threshold tied to
derivatives exposure (or, as discussed below, for funds that use
derivatives to hedge currency risks)? Why or why not? For example,
should the limited derivatives user exception be defined to include
funds that do not disclose the use of derivatives as a principal
investment strategy in their prospectuses? Would this disclosure-based
exception threshold be over- or under-inclusive? Would it lead to less
consistency in the requirement to establish a derivatives risk
management program and comply with a VaR-based limit on leverage risk
and potentially create uncertainty for funds as to when they would
qualify for the limited user exception? Why or why not? If this could
lead to less consistency, would any additional instructions in funds'
registration forms, regarding what a fund should disclose as a
principal investment strategy in its prospectus, help mitigate this
concern, and if so, what should those instructions be? Is it
appropriate to tie an exception to the derivatives risk management
program requirement and VaR-based limit on fund leverage risk to a
prospectus disclosure requirement? Why or why not?
    153. Should the condition that a limited derivatives user's
derivatives exposure not exceed 10% of the fund's net assets address
exceedances and remediation? Why or why not? For example, as noted
above, if a fund's derivatives exposure were to exceed 10% of the
fund's net assets, the fund would have to promptly reduce its
derivatives exposure or establish a derivatives risk management program
and comply with the VaR-based limit on fund leverage risk as soon as
reasonably practicable. Should we provide in rule 18f-4 specific time
periods for these actions and, if so, which time periods would be
appropriate? As an alternative way to address temporary exceedances,
should the rule provide that a fund will be a limited derivatives user
if it adopts a policy providing that, under normal circumstances, the
fund's derivatives exposure will not exceed 10% of the fund's net
assets? If so, what should be considered ``normal circumstances''?
Would this standard be too subjective such that funds would have
substantial derivatives exposures while still qualifying as limited
derivatives users? Rather than a policy referring to ``normal
circumstances,'' should we require a fund to disclose in its prospectus
that it does not expect its derivatives exposure to exceed 10% of the
fund's net assets? Should this disclosure also appear in the fund's
annual report?
    154. Should we prohibit a fund whose derivatives exposure
repeatedly exceeds 10% of net assets from relying on the exception
again for a period of time? For example, if a fund were to exceed this
limit more than two or three times in a year, should we provide that
the fund cannot rely on the limited derivatives user exception for one
or two years?
    155. In calculating derivatives exposure, should we permit a fund
to convert the notional amount of interest rate derivatives to 10-year
bond equivalents and delta adjust the notional amounts of options
contracts, as proposed? Would delta adjusting options raise the concern
that a fund's delta-adjusted options exposure would be small, allowing
a fund to avoid establishing a program, but could quickly grow in
response to large price changes in the option's reference asset? How
should we address this concern? Should we permit additional
adjustments? Why or why not? If so, what additional adjustments should
we permit? For example, should we permit funds to adjust notional
amounts based on the volatility of the underlying reference assets? Why
or why not?
    156. The proposed rule provides that, for a fund to operate as a
limited derivatives user under the exposure-based prong, the fund's
derivatives exposure must not exceed 10% of net assets. The rule does
not, however, prescribe the frequency with which funds must calculate
their derivatives exposure to evaluate their compliance. Should we
require that a fund calculate its notional amounts daily, or at some
other specified frequency? Are there other requirements we should
specify regarding a fund's calculation of its derivatives exposure? If
so, what are they, and why would these other requirements more
accurately address a fund's derivatives exposure?
    157. Should we permit a fund to adjust its derivatives exposure for
purposes of the proposed exception to account for certain netting and
hedging transactions? \289\ Why or why not? If so, how should we define
netting and hedging transactions for this purpose? How should we
prescribe in rule 18f-4 the circumstances under which different
derivatives--and particularly derivatives with different reference
assets--should be treated as hedged or offsetting? If the rule were to
permit funds to exclude hedging or netting transactions from their
derivatives exposure, should we require funds to maintain records
concerning these transactions to help our staff and fund compliance
personnel evaluate if the transactions reasonably could be viewed as
hedging or netting? If so, what information should those records
reflect? For example, the regulations under section 13 of the Bank
Holding Company Act, commonly known as the Volcker Rule, require
certain banking entities to maintain certain

documentation relating to hedging strategies, including positions and
techniques.\290\ Should the proposed rule take this or a similar
approach? As another example, should we require funds to identify both
the asset being hedged or netted and the derivatives transaction used
to hedge or net that asset? How should we consider the risk that the
historical correlations underlying an adviser's view that assets will
have inverse price correlations can break down in times of market
stress? How could a standard in the rule be reasonably objective such
that funds and our staff could confirm a fund's compliance? Should we
permit funds to account for netting but not hedging or vice versa? Why
or why not? Would the compliance burden to calculate netting and
hedging transactions for purposes of such adjustments justify the
benefits of permitting these adjustments? Why or why not? What other
challenges could funds face in accounting for netting and hedging
transactions that could increase the costs associated with this
exercise, or that could negatively affect a fund's ability to assess
its derivatives exposure accurately? Could these challenges be
mitigated in any way? If so, how?
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    \289\ See paragraph accompanying supra notes 266-267.
    \290\ See 17 CFR 255.5(c).
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    158. Should we specify in the rule that a fund calculating its
derivatives exposure may net any directly-offsetting derivatives
transactions that are the same type of instrument and have the same
underlying reference asset, maturity and other material terms, as we
proposed in 2015? Why or why not?
    159. In determining a fund's derivatives exposure, or the level of
derivatives exposure a fund may obtain while remaining a limited
derivatives user, should we consider other types of investments, like
structured notes, that have return profiles that are similar to many
derivatives instruments? Take, for example, a fund with derivatives
exposure exceeding the proposed 10% threshold by 2% that reallocates
that 2% of its net asset value from a derivatives instrument to a
structured note with a similar return profile. The fund would be a
limited derivatives user on the basis that its derivatives exposure was
below the threshold, but would present a similar risk profile to its
prior portfolio that exceeded the threshold. Are there circumstances
where we should require the fund in this example to include the value
of the structured note (or similar investment) in determining its
derivatives exposure? If so, which circumstances and what kinds of
instruments should be included? As another alternative, should we
provide that, when funds that invest in derivatives also invest in
structured notes or similar investments, they should be subject to a
lower threshold of derivatives exposure to remain a limited derivatives
user? If so, what lower level would be appropriate?
2. Currency Hedging Exception
    Under the second alternative set of conditions, a fund could rely
on the limited derivatives user exception if it limits its use of
derivatives transactions to currency derivatives for hedging purposes
as specified in the proposed rule.\291\ Under this exception, a fund
could only use currency derivatives to hedge currency risk associated
with specific foreign-currency-denominated equity or fixed-income
investments in the fund's portfolio. In addition, the notional amount
of the currency derivatives the fund holds could not exceed the value
of the instruments denominated in the foreign currency by more than a
negligible amount.\292\
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    \291\ See proposed rule 18f-4(c)(3)(ii).
    \292\ Id.
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    The proposed currency hedging exception reflects our view that
using currency derivatives solely to hedge currency risk does not raise
the policy concerns underlying section 18. While distinguishing most
hedging transactions from leveraged or speculative transactions is
challenging, we believe that the currency hedging described in the
proposed rule is definable because it involves a single risk factor
(currency risk) and requires that the derivatives instrument must be
tied to specific hedged investments (foreign-currency-denominated
securities held by the fund).\293\ Although we recognize that most
funds that use derivatives do not use them solely to hedge currency
risks, these currency hedges are not intended to leverage the fund's
portfolio, and conversely could mitigate potential losses.\294\
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    \293\ Many hedges are imperfect, which makes it difficult to
distinguish purported hedges from leveraged or speculative
exposures. See 2015 Proposing Release, supra 2, at n.238 and
accompanying text.
    \294\ See infra section III.C.3 (discussing the number of funds
whose current derivatives transactions practices would qualify them
for the currency hedging exception).
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    We also recognize that certain funds hedge all of the foreign
currency risk associated with their foreign securities investments. A
fund that invests all or substantially all of its assets in foreign
securities and currency derivatives to hedge currency risks associated
with the foreign securities necessarily would have derivatives exposure
exceeding 10% of net asset value. This is because such a fund could
have derivatives exposure up to approximately 100% of the fund's net
assets to hedge the risks associated with all of its foreign security
investments. We therefore are proposing a separate basis for the
limited derivatives user exception for currency hedging because certain
funds that hedge currency risks would be unable to qualify for the
exposure-based limited derivatives user exception discussed above.
    Rather than proposing two alternative bases to qualify for the
limited derivatives user exception, we considered permitting a fund to
qualify as a limited derivatives user if its derivatives exposure does
not exceed 10% of net assets, excluding any currency hedges as
discussed above. We are not taking this combined approach, however, to
preclude a fund that is operating as a limited derivatives user from
engaging in a broad range of derivatives transactions that may raise
risks that we believe should be managed through a derivatives
management program and subject to the proposed VaR-based limit on fund
leverage risk.
    We request comment on the proposed currency hedging exception.
    160. Is the proposed currency risk hedging exception appropriate?
Why or why not? Should we modify the proposed exception in any way? Why
or why not? For example, should we limit the derivatives exposure of a
fund that relies on the currency hedging exception, and if so, what
should be that exposure threshold? Should we prescribe the kinds of
currency derivatives that a fund may use while relying on the
exception? If so, which derivatives should be permitted and which
should be prohibited and why? Should the rule refer to other foreign-
currency-denominated assets in addition to equity or fixed-income
investments? For example, do funds hedge holdings of foreign currencies
themselves in addition to foreign-currency-denominated investments?
    161. Are there other types of derivatives that funds use that are
less likely to raise the policy concerns underlying section 18? If so,
which derivatives, and how do funds use them? For instance, we are
aware that funds use interest rate derivatives to hedge interest rate
risk arising from fixed income investments in their portfolios. Should
we modify the proposed hedging-based exception to also include interest
rate derivatives that funds use for hedging purposes? Why or why not?
If so, what challenges could funds encounter in identifying interest
rate derivatives that are used for hedging purposes (instead of for
speculation or to accomplish

leveraging)? How could we define interest rate hedging in rule 18f-4 in
a way that would allow hedging transactions while not permitting
transactions that simply are speculating on the direction of interest
rates? How could conditions in the rule help identify interest rate
derivatives that funds use for ``true'' hedging? For example, should we
require that any interest rate derivative that is treated as a hedge be
tied to specific fixed-income securities or groups of specific fixed-
income securities in the fund's portfolio? This would be analogous to
the proposed nexus between a fund's currency derivatives and the fund's
hedged foreign-currency-denominated investments. Should we similarly
allow a fund to treat as a hedging transaction an interest rate
derivative that converts a fund's fixed rate borrowings to floating
rate borrowings or vice versa? To what extent do funds engage in these
transactions? For funds that do engage in these transactions, how large
are the notional amounts of these transactions, in ten-year bond
equivalents, as a percentage of the fund's net assets?
    162. Should the rule address what happens if a fund using currency
derivatives exceeds the notional amount of the value of the instruments
denominated in a foreign currency by more than a negligible amount? If
so, how should we address exceedances? Should we provide further
guidance on what a negligible amount would be? For example, should we
provide guidance or provide in rule 18f-4 that exceedances of 1% or 2%,
for example, would be negligible?
    163. Should we permit funds that rely on the first alternative set
of limited derivatives user conditions (limiting their derivatives
exposure to 10% of net assets) to deduct the notional amounts of their
currency derivatives used for hedging purposes when calculating their
derivatives exposure for purposes of the proposed exception? Why or why
not? Should we allow funds to rely on both exceptions at the same time,
instead of the exceptions being alternatives? If the exceptions were
combined, could that result in funds relying on the limited derivatives
user exception developing larger and potentially more complex
derivatives portfolios that that may raise risks more appropriately
managed through a derivatives management program and subject to the
proposed VaR-based limit on fund leverage risk? Why or why not?
3. Risk Management
    A fund relying on the limited derivatives user exception would be
required to manage the risks associated with its derivatives
transactions by adopting and implementing policies and procedures that
are reasonably designed to manage the fund's derivatives risks.\295\
The requirement that funds relying on the exception manage their
derivatives risks recognizes that even a limited use of derivatives can
present risks that should be managed.
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    \295\ See proposed rule 18f-4(c)(3); see also proposed rule 18f-
4(a) (definition of ``derivatives risks'') and supra note 118 and