this regard we note that this treatment does not only apply to cash and
cash equivalents, but extends to any asset considered satisfactory as
collateral by a counterparty. Therefore, funds retain the flexibility
to optimize their collateral management and post their most cost-
efficient collateral, subject to limitations that counterparties or
other regulatory requirements may impose on the quality of acceptable
collateral.\604\ We also do not know if, or the extent to which, funds
might instead shift to investments other than derivatives transactions
(or financial commitment transactions) that would not be subject to the
proposed rule, including the rule's asset segregation requirements.
Finally, we do not know the specific manner in which funds' policies
and procedures would provide for the determination of risk-based
coverage amounts, and thus do not know the amount funds would segregate
under the proposed rule to cover the risk-based coverage amounts. For
these reasons, we are unable to quantify the impact of these potential
indirect costs.
---------------------------------------------------------------------------

    \604\ For example, as discussed above, ISDA reported in a 2015
survey that cash represented 77% of collateral received for
uncleared derivatives transactions (with government securities
representing an additional 13% percent), while for cleared OTC
transactions with clients, cash represented 59% of initial margin
received (with government securities representing an additional 39%)
and 100% of variation margin received. See supra note 370.
---------------------------------------------------------------------------

4. Risk Management Program
a. Requirements
    As discussed above in section III.D, a fund that seeks to enter
into derivatives transactions and rely on proposed rule 18f-4, except
with respect to funds that engage in only a limited amount of
derivatives transactions and that do not enter into certain complex
derivatives transactions, would be required to establish a formalized
derivatives risk management program, including the appointment of a
derivatives risk manager.
b. Benefits
    The proposed derivatives risk management program is designed to
complement the proposed rule's portfolio limitations and asset
segregation requirements by requiring that a fund subject to the
requirement assess and manage the particular risks presented by the
fund's use of derivatives. The derivatives risk management program
would not apply, however, to funds that make only limited use of
derivatives and do not use complex derivatives because we expect that
the risks and potential impact of these funds' derivatives transactions
may not be as significant in comparison to the risks of the funds'
overall investment portfolios and may be appropriately addressed by the
proposed rule's other requirements, including the requirement to
determine risk-based coverage amounts. The proposed rule, therefore,
provides a tailored approach that we expect would benefit funds and
investors by requiring funds that use derivatives more substantially to
establish derivatives risk management programs while allowing certain
funds to continue using derivatives (as deemed appropriate by a fund)
to help implement the fund's strategy without first having to establish
a derivatives risk management program under the proposed rule, provided
such use is limited.\605\
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    \605\ A fund that limits its derivatives exposure to no greater
than 50% of the value of the fund's net assets, and that does not
use ``complex derivatives transactions,'' would not be required to
adopt and implement a derivatives risk management program. See rule
18f-4(a)(3).
---------------------------------------------------------------------------

    The proposed derivatives risk management program requirement aims
to promote a minimum baseline in the fund industry with regard to the
use of derivatives transactions, and should improve funds' management
of the risks related to a fund's use of derivatives as well as the
awareness of, and oversight by, the fund's board (through the proposed
rule's derivatives risk manager's reporting). In this regard we
recognize that the benefits a particular fund and its investors would
enjoy and the costs that it would incur in establishing a derivatives
risk management program would vary depending on the particular fund's
current practices. We believe that the proposed rule's promotion of a
standardized level of risk management in the fund industry, however,
would promote investor protection by elevating the overall quality of
derivatives risk management across the fund industry. Improved quality
of risk management related to funds' use of derivatives, may, for
example, reduce the possibility of fund losses attributable to leverage
and other risks related to the use of derivatives.
    Investors should have increased confidence, for example, that a
fund that states that it uses derivatives as part of achieving its
investment strategy does so in ways that comply with regulatory
requirements, and are consistent with the fund's own stated investment
objectives, policies, and risk profile. Monitoring of the risks related
to derivatives may also help protect investors from losses stemming
from derivatives. To the extent that the derivatives risk management
program results in more robust monitoring of the risks related to
derivatives (including leverage risks that may magnify losses resulting
from negative market movements), the derivatives risk management
program may reduce the risk of a fund suffering unexpected losses.
This, in turn, may reduce adverse repercussions for other market
participants, including fund counterparties, and reduce the risk of
potential forced sales which can create or exacerbate stress on other
market participants. We also expect that the derivatives risk
management program (including its recordkeeping requirements) should
also improve the ability of the Commission, through its examination
program, to evaluate the risks incurred by funds with respect to their
derivatives transactions and how funds manage those risks.
c. Quantified Costs
    In addition to the costs discussed above regarding the exposure-
based and risk-based portfolio limitations and asset segregation
requirements, certain funds would also incur one-time costs to
establish and implement a derivatives risk management program in
compliance with proposed rule 18f-4, as well as ongoing program-related
costs. As discussed above, funds today employ a range of different
practices, with varying levels of comprehensiveness and sophistication,
for managing the risks associated with their use of derivatives.
Certain elements of the derivatives risk management program may entail
variability in related compliance costs, depending on a fund's
particular circumstances, including the fund's investment strategy, and
nature and type of derivatives transactions used by a fund.
    As discussed in section II.D, we understand that the advisers to
many funds whose investment strategies entail the use of derivatives
already assess and manage the risks associated with their derivatives
transactions. Funds whose current practices closely align with the
proposed derivatives risk management program would incur relatively
lower costs to comply with proposed rule 18f-4. Funds whose practices
regarding derivatives risk management are less comprehensive or not
closely aligned

with the risk management requirements in the proposed rule, on the
other hand, may incur relatively higher initial compliance costs. The
nature and extent of a fund's use of derivatives also may affect the
level of costs (and benefits) that the fund would incur. A fund that
uses derivatives more extensively may incur relatively greater costs in
in establishing a risk management program reasonably designed to assess
and manage the risk associated with the fund's derivatives,
particularly if the fund engages in complex derivatives transactions. A
fund that engages in derivatives to a lesser extent, or that uses fewer
complex derivatives transactions, may incur lower costs. In any case,
the costs associated with a fund's risk management program would
directly impact funds (and may indirectly impact fund investors if a
fund's adviser incurs costs and passes along its costs to investors
through increased fees).
    Our staff estimates that the one-time costs necessary to establish
and implement a derivatives risk management program would range from
$65,000 to $500,000 \606\ per fund, depending on the particular facts
and circumstances and current derivatives risk management practices of
the fund. These estimated costs are attributable to the following
activities: (1) Developing policies and procedures relating to each of
the required program elements and administration of the program
(including the designation of a derivatives risk manager); (2)
integrating and implementing the policies and procedures described
above; and (3) preparing training materials and administering training
sessions for staff in affected areas.
---------------------------------------------------------------------------

    \606\ See supra note 570. We note that some funds, and in
particular smaller funds for example, may not have appropriate
existing personnel capable of fulfilling the responsibilities of the
proposed derivatives risk manager, or may choose to hire a new
employee to act as the derivatives risk manager rather than
assigning that responsibility to a current employee or officer of
the fund or the fund's investment adviser who is not a portfolio
manager. We would expect that a fund that is required to hire a new
derivatives risk manager would likely incur costs on the higher end
of our estimated range of costs.
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    Staff estimates that each fund would incur ongoing program-related
costs, as a result of proposed rule 18f-4, that range from 65% to 75%
of the one-time costs necessary to establish and implement a
derivatives risk management program.\607\ Thus, staff estimates that a
fund would incur ongoing annual costs associated with proposed rule
18f-4 that would range from $42,250 to $375,000.\608\ These costs are
attributable to the following activities: (1) Assessing, monitoring,
and managing the risks associated with the fund's derivatives
transactions; (2) reviewing and updating periodically any models
(including VaR models), measurement tools, or policies and procedures
that are a part of, or used in, the program to evaluate their
effectiveness and reflect changes in risks over time; (3) providing
written reports to the fund's board, no less frequently than quarterly,
describing the adequacy of the fund's program and the effectiveness of
its implementation; and (4) additional staff training.
---------------------------------------------------------------------------

    \607\ In estimating the total quantified costs of our proposed
rule, we estimate that the derivatives risk management program
requirements, similar to the asset segregation requirements, would
likely impose ongoing costs that are proportionately larger than
initial costs. Accordingly, and based on staff experience and
outreach, we estimate that these ongoing costs would range from 65%
to 75% of the initial costs. See supra note 601.
    \608\ This estimate is based on the following calculations: 0.65
x $65,000 = $42,250; 0.75 x $500,000 = $375,000.
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    Under the proposed rule, a fund that limits its derivatives
exposure to 50% or less of net assets (and does not enter into complex
derivatives transactions) would not be required to establish a
derivatives risk management program.\609\ In the DERA staff analysis,
approximately 10% of all sampled funds had aggregate exposure from
derivatives transactions exceeding 50% of net assets.\610\ An
additional approximately 4% of the funds in DERA's sample had aggregate
exposure from derivatives of between 25-50% of net assets.\611\ In
light of this, Commission staff estimates that approximately 14% of
funds (1,676 funds \612\) would establish a derivatives risk management
program. As with the other quantified costs we discuss in this Release,
we believe that many funds belong to a fund complex and are likely to
experience economies of scale. We therefore expect that the lower-end
of the estimated range of costs ($65,000 in one-time costs; $42,250 in
annual costs) better reflects the total costs likely to be incurred by
many funds.
---------------------------------------------------------------------------

    \609\ A fund would be required to measure its aggregate exposure
associated with its derivatives transactions immediately after
entering into any senior securities transaction. See rule 18f-
4(a)(3)(i). Funds that use complex derivatives transactions, as
defined in the proposed rule, also would be required to establish
risk management programs, even if the funds' derivatives exposure
was less than 50% of net assets. The proposed rule's definition of
complex derivatives transactions is based on whether the amount
payable by either party to a derivatives transaction is dependent on
the value of the underlying reference asset at multiple points in
time during the term of the transaction, or is a non-linear function
of the value of the underlying reference asset, other than due to
the optionality arising from a single strike price. See rules 18f-
4(a)(4)(ii); 18f-4(c)(1).
    \610\ See DERA White Paper, supra note 73, Figure 11.1. DERA
staff was unable to determine the extent to which funds use
derivatives transactions that would be complex derivatives
transactions, based on the data available to the staff. The staff is
thus unable to estimate the number of funds that would be required
to have a risk management program solely as a result of their use of
complex derivatives transactions. See supra note 609.
    \611\ See DERA White Paper, supra note 73, Figure 11.1.
    \612\ This estimate is based on the following calculation:
11,973 funds x 14% = 1,676 funds. See supra note 578.
---------------------------------------------------------------------------

5. Financial Commitment Transactions
a. Requirements
    As discussed above in section III.E, the proposed rule would
require a fund that enters into financial commitment transactions in
reliance on the rule to maintain qualifying coverage assets, identified
on the books and records of the fund and determined at least once each
business day, with a value equal to the fund's aggregate financial
commitment obligations, which generally are the amounts of cash or
other assets that the fund is conditionally or unconditionally
obligated to pay or deliver under its financial commitment
transactions. The proposed rule would permit a fund to maintain as
qualifying assets for a financial commitment transaction assets that
are convertible to cash or that will generate cash, equal in amount to
the financial commitment obligation, prior to the date on which the
fund can be expected to be required to pay such obligation or that have
been pledged with respect to the financial commitment obligation and
can be expected to satisfy such obligation, determined in accordance
with policies and procedures approved by the fund's board of directors.
b. Benefits
    By requiring the fund to maintain qualifying coverage assets to
cover the fund's full potential obligation under its financial
commitment transactions, the proposed rule generally would take the
same approach to these transactions that we applied in Release 10666,
with some modifications (primarily to the types of segregated assets
that would be permitted under the proposed rule). The proposed rule
would limit a fund's obligations under financial commitment
transactions, in that the fund could not incur obligations under those
transactions in excess of the fund's qualifying coverage assets. This
would limit a fund's ability to incur obligations under financial
commitment transactions to 100% of the fund's net

assets, as discussed above in section III.E. As noted above, funds that
enter into financial commitment transactions today in reliance on
Release 10666 also do not incur obligations in excess of net
assets,\613\ and no fund in the DERA sample had greater than 100%
aggregate exposure resulting from financial commitment transactions
(the current economic baseline for such transactions).\614\ As
discussed above in section IV.C, we expect that proposed rule 18f-4
would permit a fund that enters solely into financial commitment
transactions to operate much in the same way as it does today.
---------------------------------------------------------------------------

    \613\ See supra note 93 and accompanying text.
    \614\ DERA White Paper, supra note 73, Table 6.
---------------------------------------------------------------------------

c. Quantified Costs
    We estimate above in section IV.D.3 the potential costs of the
asset segregation requirement for funds that enter into derivatives
transactions. We estimated that the potential costs would include: (1)
Developing and implementing policies and procedures to comply with the
proposed rule's requirement that the fund maintains the required
qualifying coverage assets, identified on the books and records of the
fund and determined at least once each business day; (2) planning,
coding, testing, and installing any system modifications relating to
the asset segregation requirements; and (3) preparing training
materials and administering training sessions for staff in affected
areas. A fund that enters solely into financial commitment transactions
would similarly have an asset segregation requirement.
    Although, as discussed above in section III.E, the amount and
nature of ``qualifying coverage assets'' required differ with regard to
derivatives transactions and financial commitment transactions, we
believe that the operational costs to implement the asset segregation
requirements would be the same. For both derivatives transactions and
financial commitment transactions, funds would be required to establish
policies and procedures regarding qualifying coverage assets, and in
both cases funds would be required to assess their obligations under
the transactions. For financial commitment transactions, a fund would
be required to maintain assets that are convertible to cash or that
will generate cash, equal in amount to the financial commitment
obligation, prior to the date on which the fund can be expected to be
required to pay its financial commitment obligation or that have been
pledged with respect to the financial commitment obligation and can be
expected to satisfy such obligation, determined in accordance with
policies and procedures approved by the fund's board of directors. For
derivatives transactions, funds would be required to determine, in
addition to a mark-to-market coverage amount, the transaction's risk-
based coverage amount, which would represent an estimate of the
potential amount payable by the fund if the fund were to exit the
derivatives transaction under stressed conditions, determined in
accordance with policies and procedures approved by the fund's board.
Although the required assessments would differ for derivatives
transactions and financial commitment transactions, we expect that
there would be no material difference in the activities involved (e.g.,
developing and implementing policies and procedures, and modifying
systems, to comply with the proposed rule's requirement that the fund
maintains the required qualifying coverage assets), and thus no
material difference in the associated costs.
    Accordingly, we estimate that the one-time operational costs
necessary to establish and implement the proposed asset segregation
requirements would range from $25,000 to $75,000 per fund.\615\ Staff
also estimates that each fund would incur ongoing costs related to
implementing the asset segregation requirements under proposed rule
18f-4. Staff estimates that such costs would range from 65% to 75% of
the one-time costs discussed above.\616\ Thus, staff estimates that a
fund would incur ongoing annual costs associated with the asset
segregation requirements that would range from $16,250 to $56,250.\617\
In the DERA staff analysis, approximately 3% of all sampled funds
entered into at least some financial commitment transactions, but had
no exposure from derivatives transactions.\618\ Staff estimates,
therefore, that 3% of funds (359 funds \619\) would comply with the
asset segregation requirements in proposed rule 18f-4 (applicable to
financial commitment transactions). The above estimate of affected
funds does not include money market funds or BDCs. We understand,
however, that both money market funds and BDCS may engage in certain
types of financial commitment transactions.\620\ Therefore, we estimate
that 537 money market funds and 88 BDCs would also comply with the
asset segregation requirements in proposed rule 18f-4 (applicable to
financial commitment transactions).\621\ As with the other quantified
costs we discuss in this Release, we believe that many funds belong to
a fund complex and are likely to experience economies of scale. We
therefore expect that the lower-end of the estimated range of costs
($25,000 in one-time costs; $16,250 in annual costs) better reflects
the total costs likely to be incurred by many funds.
---------------------------------------------------------------------------

    \615\ See supra note 600.
    \616\ See supra note 601.
    \617\ This estimate is based on the following calculations: 0.65
x $25,000 = $16,250; 0.75 x $75,000 = $56,250.
    \618\ We address a fund that invests in both derivatives
transactions and financial commitment transactions in section
IV.D.3.
    \619\ This estimate is based on the following calculation:
11,973 funds x 3% = 359 funds. See supra note 578.
    \620\ See supra note 578.
    \621\ See supra note 512 and accompanying text.
---------------------------------------------------------------------------

6. Amendments to Form N-PORT To Report Risk Metrics by Funds That Are
Required To Implement a Derivatives Risk Management Program
a. Requirements
    As discussed above in section III.G.2, proposed Form N-PORT would
require funds that are required to implement a derivatives risk
management program to disclose vega and gamma, risk metrics information
that is not currently required by the Commission. As we previously
stated, we believe that requiring certain funds to report vega and
gamma would assist the Commission in better assessing the risk in a
fund's portfolio. In consideration of the burdens of reporting selected
risk metrics to the Commission and the benefits of more complete
disclosure of a fund's risks, we are proposing to limit the reporting
of vega and gamma to only those funds that are required to implement a
derivatives risk management program.
    The current set of requirements under which registered management
investment companies (other than money market funds and SBICs) and ETFs
organized as UITs publicly report complete portfolio investment
information to the Commission on a quarterly basis, as well as the
current practice of some investment companies to voluntarily disclose
portfolio investment information, is the baseline from which we will
discuss the economic effects of vega and gamma disclosure. The baseline
is the same baseline from which we discussed the economic effects of
Form N-PORT in the Investment Company Reporting Modernization
Release.\622\
---------------------------------------------------------------------------

    \622\ See Investment Company Reporting Modernization Release,
supra note 138, at section IV.B.a.

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

b. Benefits
    The benefits of requiring certain funds to report vega and gamma on
Form N-PORT are largely the same benefits as those identified in the
Investment Company Reporting Modernization Release.\623\ As discussed
in that release, the information we would receive on Form N-PORT would
facilitate the oversight of funds and would assist the Commission to
better effectuate its mission to protect investors, maintain fair,
orderly, and efficient markets, and facilitate capital formation. For
example, as we discussed in the Release, risk sensitivity measures
improve the ability of Commission staff to efficiently analyze
information for funds (such as a fund's exposure to changes in price
and volatility) and identify funds with certain risk exposures that
appear to be outliers among peer funds. Moreover, the information we
would receive on Form N-PORT would improve the Commission's ability to
analyze fund industry trends, monitor funds, and, as appropriate,
engage in further inquiry or timely outreach in case of a market or
other event. In particular, requiring certain funds to report vega and
gamma on Form N-PORT could improve the Commission's ability to analyze
funds' exposures to volatility and to their exposures to more sizable
changes in the value of a derivative's reference security. These
measures could be used in considering whether additional guidance or
policy measures may be appropriate. The calculation of position-level
risk-measures for some derivatives, including derivatives with unique
or complicated payoff structures, sometimes requires time-intensive
computation methods or additional information that Form N-PORT as
proposed, would not require. In addition, the calculation of a second-
order derivative, such as gamma, can be more computationally intensive
than the calculation of a first-order derivative, such as delta and may
require additional modelling. As discussed in section III. G. above, we
believe that many of the funds that would be required to implement a
derivatives risk management program already calculate risk measures
such as gamma and vega as part of their portfolio management programs
or have gamma and vega calculated for them by a service provider.
Accordingly, we believe that requiring funds to calculate second-order
derivatives, such as gamma, and provide risk measures for derivatives,
such as vega, at the position-level, would improve the ability of staff
to efficiently identify risk exposures of funds regardless of the types
of derivatives.
---------------------------------------------------------------------------

    \623\ See Investment Company Reporting Modernization Release,
supra note 138, at section IV.B.b.
---------------------------------------------------------------------------

    The benefits of requiring certain funds to report vega and gamma on
Form N-PORT would also benefit investors, to the extent that they use
the information, to better differentiate investment companies based on
their investment strategies. In general, we expect that institutional
investors and other market participants would directly use the
information from Form N-PORT more so than individual investors.
Individual investors, however, could indirectly benefit from the
information in Form N-PORT to the extent that third-party information
providers and other interested parties are able to report on the
information and other entities utilize the information to help
investors make more informed investment decisions. An increase in the
ability of investors to differentiate investment companies would allow
investors to efficiently allocate capital across reporting funds more
in line with their risk preferences, increase the competition among
funds for investor capital, and could promote capital formation.
c. Costs
    As we discussed in the Investment Company Reporting Modernization
Release, to the extent that risk metrics are not currently contained in
fund accounting or financial reporting systems, funds would bear one-
time costs to update systems to adhere to the new filing
requirements.\624\ The one-time costs would depend on the extent to
which investment companies currently report the information required to
be disclosed. The one-time costs would also depend on whether an
investment company would need to implement new systems, such as to
calculate and report vega and gamma, and to integrate information
maintained in separate internal systems or by third parties to comply
with the new requirements. Based on staff outreach to funds, we believe
that, at a minimum, funds would incur systems or licensing costs to
obtain a software solution or to retain a service provider in order to
report data on risk metrics, as risk metrics are not currently required
to be reported on fund financial statements. Our experience with and
outreach to funds indicates that the types of systems funds use for
warehousing and aggregating data, including data on risk metrics, vary
widely.
---------------------------------------------------------------------------

    \624\ See Investment Company Reporting Modernization Release,
supra note 138, at section IV.B.c.
---------------------------------------------------------------------------

    Similar to our proposal in the Investment Company Modernization
Release,\625\ the proposed amendments to proposed Form N-PORT relating
to vega and gamma would increase the amount and availability of public
information about certain investment companies' portfolio positions and
investment strategy and could potentially harm fund shareholders by
expanding the opportunities for professional traders to exploit this
information by engaging in predatory trading practices, such as
``front-running,'' and ``copycatting/reverse engineering of trading
strategies.'' \626\ These practices can reduce the returns of
shareholders who invest in actively managed funds.\627\ These practices
can also reduce fund profitability from developing new investment
strategies, and therefore negatively affect innovation and impact
competition in the fund industry.
---------------------------------------------------------------------------

    \625\ See Investment Company Reporting Modernization Release,
supra note 138, at section II.A.4; see also Liquidity Release, supra
note 5.
    \626\ See Investment Company Reporting Modernization Release,
supra note 138, at n.170 and accompanying and following text.
    \627\ See Russ Wermers, The Potential Effects of More Frequent
Portfolio Disclosure on Mutual Fund Performance, 7 Investment
Company Institute Perspective No. 3 (June 2001), available at http://www.ici.org/pdf/per07-03.pdf.
---------------------------------------------------------------------------

    As with our proposed liquidity disclosures, we cannot currently
predict the extent to which the proposed enhancements to funds'
disclosures on Form N-PORT relating to risk metrics would give rise to
front-running, predatory trading, and other activities that could be
detrimental to a fund and its investors, and thus we are unable to
quantify potential costs related to these activities. The costs that
relate to the additional risk-sensitivity measures are also intertwined
with the overall costs to funds and market participants that could
result from the increased disclosure of currently non-public
information associated with Form N-PORT in its entirety.\628\ For
example, any analyses of the risk metric-related disclosure proposed to
be required could be affected by the enhanced reporting of any other
additional information that could more clearly reveal the investment
strategy of reporting funds.
---------------------------------------------------------------------------

    \628\ See id., at paragraphs accompanying nn.663-673.
---------------------------------------------------------------------------

    The potential costs associated with the increased disclosure of
currently non-public information on Form N-PORT are discussed in detail
in our recent proposal to modernize investment company reporting,\629\
as

well as our recent proposal regarding liquidity risk-management
programs.\630\ These proposals also discuss the ways in which we have
endeavored to mitigate these costs, including by proposing to maintain
the status quo for the frequency and timing of disclosure of publicly
available portfolio information.\631\ While proposed Form N-PORT would
be required to be filed monthly, it would be required to be disclosed
quarterly and would not be made public until 60 days after the close of
the period at issue. Because funds are currently required to disclose
their portfolio investments quarterly (and this disclosure is made
public with a 60-day lag), we believe that maintaining the status quo
with regard to the frequency and the time lag of publicly available
portfolio reporting would permit the Commission (as well as the fund
industry generally) to assess the impact of the Form N-PORT filing
requirements on the mix of information available to the public, and the
extent to which these changes might affect the potential for predatory
trading, before determining whether more frequent or more timely public
disclosure would be beneficial to investors in funds.\632\
---------------------------------------------------------------------------

    \629\ See id.
    \630\ See Liquidity Release, supra note 5.
    \631\ See id., at section II.A.4 and paragraph accompanying n.
670.
    \632\ See id.
---------------------------------------------------------------------------

d. Quantified Costs
    As further discussed below \633\ and in our Investment Company
Modernization Release,\634\ we estimate that funds would incur certain
annual costs associated with preparing, reviewing, and filing reports
on Form N-PORT. The proposed amendments to proposed Form N-PORT would
require funds that are required to implement a derivatives risk
management program to report on Form N-PORT the vega and gamma for
certain investments.\635\ We estimate that 1,676 funds \636\ would be
required to file, on a monthly basis, additional information on Form N-
PORT as a result of the proposed amendments.\637\ Assuming that 35% of
funds (587 funds) would choose to license a software solution to file
reports on Form N-PORT in house,\638\ we estimate an upper bound on the
initial annual costs to file the additional information associated with
the proposed amendments for funds choosing this option of $3,352 per
fund \639\ with annual ongoing costs of $2,991 per fund.\640\ We
further assume that 65% of funds (1,089 funds) would choose to retain a
third-party service provider to provide data aggregation and validation
services as part of the preparation and filing of reports on Form N-
PORT,\641\ and we estimate an upper bound on the initial costs to file
the additional information associated with the proposed amendments for
funds choosing this option of $2,319 per fund \642\ with annual ongoing
costs of $1,517 per fund.\643\
---------------------------------------------------------------------------

    \633\ See infra section V.
    \634\ See Investment Company Reporting Modernization Release,
supra note 138, at nn.658-662 accompanying text.
    \635\ While we do not have a specific estimate of the number of
funds that calculate gamma and vega, based on our discussions with
members of the industry and due to the nature of those funds'
investment strategies, we-expect that many of those funds currently
calculate vega and gamma for its investment programs or have vega
and gamma calculated for them by a service provider. However, we
realize that it is possible that some funds may not calculate vega
and gamma and our cost estimates reflect those costs as well.
    \636\ Commission staff estimates, therefore, that approximately
14% of funds (1,676 funds) would be required to establish a
derivatives risk management program. See supra note 612 and
accompanying text.
    \637\ There were 8,734 open-end funds (excluding money market
funds, and including ETFs) as of the end of 2014. See Investment
Company Institute, 2015 Investment Company Fact Book (2015),
available at https://www.ici.org/pdf/2015_factbook.pdf, at 177, 184.
    \638\ This assumption tracks the assumption made in the
Investment Company Reporting Modernization Release that 35% of funds
would choose to license a software solution to file reports on Form
N-PORT. See Investment Company Reporting Modernization Release,
supra note 138, at nn.658-659 and accompanying text.
    \639\ See infra note 797 and accompanying text.
    \640\ See infra note 797.
    \641\ This assumption tracks the assumptions made in the
Investment Company Reporting Modernization Release that 65% of funds
would choose to retain a third-party service provider to provide
data aggregation and validation services as part of the preparation
and filing of reports on Form N-PORT. See Investment Company
Reporting Modernization Release, supra note 138, at nn.660-661 and
accompanying text.
    \642\ See infra note 803 and accompanying text.
    \643\ See infra note 804 and accompanying text.
---------------------------------------------------------------------------

7. Amendments to Form N-CEN To Report Reliance on Proposed Rule 18f-4
a. Requirements
    As discussed above in section III.G.3, our amendments to proposed
Form N-CEN would require funds to identify the portfolio limitation(s)
on which a fund relied during the reporting period. As we stated above,
this information would allow the Commission and others to monitor
reliance on the exemptions under proposed rule 18f-4.
    The current set of requirements--management companies must file
reports on Form N-SAR semi-annually \644\--is the baseline from which
we discuss the economic effects of Form N-CEN. The parties that could
be affected by the rescission of Form N-SAR and the introduction of
Form N-CEN include funds that currently file reports on Form N-SAR and
funds that would file reports on Form N-CEN; the Commission; and, other
current and future users of fund census information including
investors, third-party information providers, and other interested
potential users. The baseline is the same baseline from which we
discussed the economic effects of Form N-CEN in the Investment Company
Reporting Modernization Release.\645\
---------------------------------------------------------------------------

    \644\ See rule 30b1-1.
    \645\ See Investment Company Reporting Modernization Release,
supra note 138, at section IV.E.a.
---------------------------------------------------------------------------

b. Benefits
    The benefits of requiring funds to report reliance on certain
exemptive rules, including proposed rule 18f-4, on Form N-CEN are
largely the same benefits as those identified in the Investment Company
Reporting Modernization Release.\646\ As we discussed in that release,
proposed Form N-CEN would improve the quality and utility of the
information reported to the Commission and allow Commission staff to
better understand industry trends, inform policy, and assist with the
Commission's examination program. Similarly, identifying the portfolio
limitation(s) on which a fund relied during the reporting period would
identify for the staff funds that rely on proposed rule 18f-4. As
discussed in our recent proposal to modernize Investment Company
reporting, the information we would receive on Form N-CEN would
facilitate the oversight of funds and would assist the Commission to
better effectuate its mission to protect investors, maintain fair,
orderly, and efficient markets, and facilitate capital formation.\647\
---------------------------------------------------------------------------

    \646\ See Investment Company Reporting Modernization Release,
supra note 138, at section IV.E.b.
    \647\ See id.
---------------------------------------------------------------------------

c. Costs
    As we discussed above, to the extent that reliance on certain
exemptive rules is not currently contained in fund accounting or
financial reporting systems, funds would bear one-time costs to update
systems to adhere to the new filing requirements.\648\ The one-time
costs would depend on the extent to which funds currently report the
information required to be disclosed. The one-time costs would also
depend on whether a fund would need to implement new systems in order
to integrate information maintained in

separate internal systems with the new requirements.
---------------------------------------------------------------------------

    \648\ See Investment Company Reporting Modernization Release,
supra note 138, at section IV.B.c.
---------------------------------------------------------------------------

d. Quantified Costs
    As further discussed below \649\ and in our Investment Company
Modernization Release,\650\ we estimate that funds would incur certain
annual costs associated with preparing, reviewing, and filing reports
on Form N-CEN. The proposed amendments to proposed Form N CEN would
require funds to identify the portfolio limitation(s) on which they
relied during the reporting period.
---------------------------------------------------------------------------

    \649\ See infra section V.B.6.
    \650\ See Investment Company Reporting Modernization Release,
supra note 138, at nn.658-662 accompanying text.
---------------------------------------------------------------------------

    In the Investment Company Modernization Reporting Release, the
staff estimated that the Commission would receive an average of 3,146
reports per year, based on the number of existing Form N-SAR filers,
including 2,419 funds.\651\ We further estimated that management
investment companies would require 33.35 annual burden hours in the
first year \652\ and 13.35 annual burden hours in each subsequent year
for preparing and filing reports on proposed Form N-CEN. We estimated
that all Form N-CEN filers would have an aggregate annual expense of
$12,395,064 for reports on Form N-CEN.\653\
---------------------------------------------------------------------------

    \651\ This estimate is based on 2,419 management companies and
727 UITs filing reports on Form N-SAR as of Dec. 31, 2014. UITs
would not be required to complete Item 31 of proposed Form N-CEN.
See General Instruction A of proposed Form N-CEN.
    \652\ This estimate is based on the following calculation: 13.35
hours for filings + 20 additional hours for the first filing = 33.35
hours.
    \653\ This estimate is based on annual ongoing burden hour
estimate of 32,294 burden hours for management companies (2,419
management companies x 13.35 hours per filing) plus 6,623 burden
hours for UITs (727 UITs x 9.11 burden hours per filing), for a
total estimate of 38,917 burden ongoing hours. This was then
multiplied by a blended hourly wage of $318.50 per hour, $303 per
hour for Senior Programmers and $334 per hour for compliance
attorneys, as we believe these employees would commonly be
responsible for completing reports on proposed Form N-CEN ($318.50 x
38,917 = $12,395,064.50). See Investment Company Reporting
Modernization Release, supra note 138, at n.723 and accompanying
text.
---------------------------------------------------------------------------

    As part of this burden, funds would be required to identify if they
relied upon ten different rules under the Act.\654\ While the costs
associated with collecting and documenting the requirements under
proposed rule 18f-4 are discussed above,\655\ we believe that there are
additional costs relating to identifying the portfolio limitation(s) on
which a fund relied on proposed Form N-CEN. We therefore estimate that
2,419 funds would incur an average annual hour burden of .25 hours for
the first year to compile (including review of the information), tag,
and electronically file the additional information in light of the
proposed amendments, and an average annual hour burden of approximately
.1 hours for each subsequent year's filing. We further estimate an
upper bound on the initial costs to funds of $80 per fund \656\ with
annual ongoing costs of $32 per fund.\657\ We do not anticipate any
change to the total external annual costs of $1,748,637.\658\
---------------------------------------------------------------------------

    \654\ See Item 31 of Proposed Form N-CEN.
    \655\ See supra Sections IV.D.1. and IV.D.2.
    \656\ See infra note 815.
    \657\ See infra note 816.
    \658\ See infra note 821.
---------------------------------------------------------------------------

E. Reasonable Alternatives

    In formulating our proposal, we have considered various
alternatives to the individual elements of proposed rule 18f-4. Those
alternatives are outlined above in the sections discussing the proposed
rule elements, and we have requested comment on these
alternatives.\659\ The following discussion addresses significant
alternatives to proposed rule 18f-4, which involve broader issues than
the more granular alternatives to the individual rule elements
discussed above in section III of this Release. First, we discuss an
alternative approach focused on asset segregation. This approach would
allow funds to establish their own minimum asset segregation
requirements for derivatives transactions while taking into account a
variety of risk measures, but would not include additional limitations
designed to impose a limit on leverage. Second, we discuss an approach
that would require a fund engaging in derivatives transactions to
segregate liquid assets equal in value to the full amount of the
potential obligations under the derivatives transactions. This approach
would, in effect, apply the approach in Release 10666 to all types of
derivatives. Third, we discuss the European Union provisions relating
to UCITS funds and alternative investment funds (``AIFs'') \660\ as an
alternative approach to our proposed rule. Fourth, we discuss whether
it would be a reasonable alternative to rely on enhancing derivatives-
related disclosure. In addition to these discussions regarding
alternatives to proposed rule 18f-4, we also discuss below certain
alternatives to our proposed amendments to Proposed Form N-PORT.
---------------------------------------------------------------------------

    \659\ See supra sections III.B-III.F.
    \660\ AIFs are alternative investment funds that are marketed to
professional investors in the European Union.
---------------------------------------------------------------------------

1. Mark-to-Market Plus ``Cushion Amount'' Alternative
    In the Concept Release we discussed an alternative approach to
funds' current asset segregation approaches--generally, notional amount
and mark-to-market segregation as discussed above--that was originally
proposed in the 2010 ABA Derivatives Report. This alternative approach
would allow individual funds to establish their own asset segregation
standards for derivatives transactions but would not impose any
additional requirements or overall limits on a fund's use of
derivatives. Under this alternative, a fund would be required to adopt
policies and procedures that would include, among other things, minimum
asset segregation requirements for each type of derivatives instrument,
taking into account relevant factors such as the type of derivative,
the specific transaction, and the nature of the assets segregated
(``Risk Adjusted Segregation Amounts''). In developing these standards,
fund investment advisers might take into account a variety of risk
measures, including VaR and other quantitative measures of portfolio
risk, and would not be limited to the notional amount or mark-to-market
standards.\661\ This alternative is similar in some ways to the
proposed rule's asset coverage requirements for derivatives
transactions, as discussed in section IV.D.3. The proposed rule differs
from this alternative in that it imposes requirements in addition to
those related to asset coverage, including overall notional amount
limits and the requirement for certain funds to have derivatives risk
management programs.
---------------------------------------------------------------------------

    \661\ The 2010 ABA Derivatives Report recommended that these
minimum Risk Adjusted Segregated Amounts be reflected in policies
and procedures that would be subject to approval by the fund's board
of directors and disclosed (including the principles underlying the
Risk Adjusted Segregated Amounts for different types of derivatives)
in the fund's SAI.
---------------------------------------------------------------------------

    Certain commenters on the Concept Release suggested that
segregation of a fund's daily mark-to-market liability alone may not be
effective in at least some cases, and suggested that we impose asset
segregation requirements under which a fund would include in its
segregated account for a derivative an amount designed to address
future losses (a ``cushion amount'') in addition to the daily mark-to-
market liability for the derivative.\662\ Some commenters specifically
supported the 2010 ABA Derivatives Report alternative that used

Risk Adjusted Segregated Amounts and many commenters generally
supported using a ``principles-based approach'' to asset segregation
\663\ that would permit funds to adopt policies and procedures that
would include minimum asset segregation requirements for each type of
derivatives instrument, taking into account relevant factors.\664\ Some
commenters expressed the view that the optimal amount of cover for many
derivatives may be somewhere in between the full notional and mark-to-
market amounts and that the amount should be expected to cover the
potential loss to the fund.\665\ One of these commenters recommended
that fund boards should be responsible for designing asset segregation
policies with the objective of maintaining segregated assets sufficient
to meet obligations arising from the fund's derivatives under ``extreme
but plausible market conditions.'' \666\ Another commenter argued that
the cushion amount generally should be equal to the initial margin that
funds will generally be required to post for derivatives following the
implementation of margin requirements under the Dodd-Frank Act or, in
the alternative, a cushion amount determined by funds based on a
portfolio-wide analysis of their derivatives transactions.\667\ This
commenter suggested that initial margin represents an amount designed
to protect against potential future losses, and where regulators or
clearinghouses have determined the amount of initial margin that must
be posted, they have already made determinations about the level of
risk represented by an instrument.\668\
---------------------------------------------------------------------------

    \662\ See, e.g., SIFMA Concept Release Comment Letter; ICI
Concept Release Comment Letter.
    \663\ See, e.g., BlackRock Concept Release Comment Letter;
Invesco Concept Release Comment Letter; Loomis Concept Release
Comment Letter; ICI Concept Release Comment Letter; IDC Concept
Release Comment Letter; ABA Concept Release Comment Letter; Comment
Letter of Stradley Ronon Stevens & Young LLP (Nov. 7, 2011) (File
No. S7-33-11), available at http://www.sec.gov/comments/s7-33-11/s73311-27.pdf; MFDF Concept Release Comment Letter; T. Rowe Concept
Release Comment Letter; Vanguard Concept Release Comment Letter;
AlphaSimplex Concept Release Comment Letter; Oppenheimer Concept
Release Comment Letter; Rafferty Concept Release Comment Letter.
    \664\ See, e.g., ABA Concept Release Comment Letter; IDC Concept
Release Comment Letter; BlackRock Concept Release Comment Letter;
Invesco Concept Release Comment Letter; ICI Concept Release Comment
Letter; MFDF Concept Release Comment Letter; AlphaSimplex Concept
Release Comment Letter; Loomis Concept Release Comment Letter; T.
Rowe Price Concept Release Comment Letter; Comment Letter of
Security Investors, LLC (Nov. 7, 2011) (File No. S7-33-11),
available at http://www.sec.gov/comments/s7-33-11/s73311-36.pdf.
    \665\ See, e.g., ICI Concept Release Comment Letter; Invesco
Concept Release Comment Letter.
    \666\ ICI Concept Release Comment Letter (noting that ``extreme
but plausible market conditions'' is a statutory standard used by
swap execution facilities and derivatives clearing organizations to
determine the minimum amount of financial resources such entities
must have to ensure, with a reasonably high degree of certainty,
that they will be able to satisfy their obligations. See, e.g.,
section 5b(c)(2) of the Commodity Exchange Act, as amended by
section 725(c) of the Dodd-Frank Act.).
    \667\ See SIFMA Concept Release Comment Letter. See section
III.C. for a discussion of why we are not proposing to use initial
margin to determine asset segregation amounts.
    \668\ See SIFMA Concept Release Comment Letter.
---------------------------------------------------------------------------

    As discussed above in section IV.D.3, the rule we are proposing
today would require a fund that enters into derivatives transactions
and financial commitment transactions in reliance on the proposed rule
to maintain an appropriate amount of qualifying coverage assets. For
derivatives transactions, a fund would be required to maintain
qualifying coverage assets with a value equal to at least the sum of
the fund's aggregate mark-to-market coverage amounts and risk-based
coverage amounts.\669\ For financial commitment transactions, a fund
would be required to maintain qualifying coverage assets with a value
equal to at least the fund's aggregate financial commitment
obligations.\670\
---------------------------------------------------------------------------

    \669\ Proposed rule 18f-4(a)(2). See also proposed rule 18-
f(4)(c)(6) (definition of mark-to-market coverage amount) and 18-
f(4)(c)(9) (definition of risk-based coverage amount).
    \670\ Proposed rule 18f-4(b). See also proposed rule 18f-4(c)(5)
(definition of financial commitment obligation).
---------------------------------------------------------------------------

    The proposed rule's asset segregation requirement would in many
ways be consistent with the approaches recommended by the 2010 ABA
Derivatives Report and by commenters in that it would require funds to
maintain amounts intended to cover the fund's current mark-to-market
amount to cover the amount that would be payable by the fund if the
fund were to exit the derivatives transaction at such time, plus an
additional amount that represents a reasonable estimate of the
potential amount payable by the fund if the fund were to exit the
derivatives transaction under stressed conditions.
    However, the proposed rule would differ significantly from the
approach recommended in the 2010 ABA Derivatives Report and by some
commenters in that the proposed rule would impose portfolio
limitations, as discussed in section III.B.1.c, designed to impose a
limit on the amount of leverage a fund may obtain through derivatives
and other senior securities transactions. The 2010 ABA Derivatives
Report alternative, in contrast, focused on asset segregation without
any other limitation on a fund's use of senior securities transactions.
The proposed rule's inclusion of both portfolio limitations and asset
coverage requirements would be consistent with the recommendation of
one commenter, which supported a principles-based approach to asset
segregation but also recognized that we might ``wish to consider
adopting an overall leverage limit that funds would be required to
comply with, notwithstanding that they have segregated liquid assets to
back their obligations.'' \671\
---------------------------------------------------------------------------

    \671\ See Vanguard Concept Release Comment Letter, at n.18.
---------------------------------------------------------------------------

    The 2010 ABA Derivatives Report also recommended an asset
segregation approach that would give discretion to boards to determine
the segregation amount for each instrument and thus the amount of
derivatives exposures that the fund could obtain. The proposed asset
coverage requirements, by contrast, would be based in part on
procedures approved by the fund's board, but would also impose specific
requirements on the fund's asset coverage practices, including by
generally requiring the fund to segregate short-term, highly liquid
assets.
    As noted in section III.A, we believe that the proposed rule's
approach for derivatives transactions--providing separate portfolio
limitations and asset segregation requirements--would be more effective
than an approach focusing on asset segregation alone, particularly when
it is coupled with a risk management program for funds that engage in
more than a limited amount of derivatives transactions or that use
certain complex derivatives transactions, as we are proposing today.
Moreover, the approach recommended in the 2010 ABA Derivatives Report
and similar suggestions by some commenters would provide discretion to
funds to determine their derivatives-related requirements, and as a
result, the extent of their use of senior securities transactions. We
believe that this alternative approach under the 2010 ABA Derivatives
Report, without more, may not result in a meaningful limitation on
funds' use of derivatives, and thus would not address the undue
speculation concern expressed in section 1(b)(7) or the asset
sufficiency concern expressed in section 1(b)(8), as discussed above in
section II. We believe that relying solely on the discretion of funds
and their boards of directors for limitations on the use of derivatives
would not be a sufficient basis for an exemption from section 18, which
imposes a limit on the extent to which funds may issue senior
securities.

2. Applying Notional Amount Segregation to All Senior Securities
Transactions
    Another alternative approach we considered was to apply the
approach in Release 10666 to all types of derivatives, thereby
requiring that a fund engaging in any derivatives transaction segregate
liquid assets of the types we specified in Release 10666 equal in value
to the full amount of the conditional and unconditional obligations
incurred by the fund (also referred to as notional amount
segregation).\672\
---------------------------------------------------------------------------

    \672\ See supra note 54 and accompanying text.
---------------------------------------------------------------------------

    Although the approach in Release 10666 appears to have addressed
the concerns reflected in sections 1(b)(7) and 1(b)(8) for the trading
practices described in that release, applying it to derivatives by
requiring funds to segregate the types of liquid assets we described in
Release 10666 equal in value to the full notional amount of each
derivative may require funds to hold more liquid assets than may be
necessary to address the purposes and concerns underlying section 18,
as discussed above in section III.A. Furthermore, as discussed above in
section III.B.1.c., given the contingent nature of funds' derivatives
obligations and the various ways in which funds use derivatives--both
for investment purposes to increase returns but also to mitigate
risks--we believe it is appropriate to provide funds some additional
flexibility to use derivatives, subject to the limitations set forth in
the proposed rule.
3. UCITS Alternative
    In developing proposed rule 18f-4, we considered the current
guidelines that apply to UCITS funds. As discussed below, while our
proposed rule is similar in some respects to the guidelines that cover
UCITS funds, our proposed rule also differs in other respects. We also
considered the current guidelines that apply to AIFs. We discuss
further below how our proposed rule generally differs from the
guidelines that govern AIFs.
    The Committee of European Securities Regulators (``CESR'') (which,
as of January 1, 2011, became the European Securities and Markets
Authority, or ``ESMA''), conducted an extensive review and consultation
concerning exposure measures for derivatives used by UCITS funds.
CESR's Guidelines on Risk Measurement and the Calculation of Global
Exposure and Counterparty Risk for UCITS (``Global Exposure
Guidelines'') \673\ were issued in 2010, and addressed the
implementation of the European Commission's 2009 revised UCITS
Directive (``2009 Directive'').\674\ Under the 2009 Directive, UCITS
funds are permitted to engage in any type of derivatives investments
subject to compliance with one of two permissible, alternative methods
to limit their exposure to derivatives: (1) The ``commitment'' approach
and (2) the VaR approach.\675\
---------------------------------------------------------------------------

    \673\ See CESR Global Guidelines, supra note 162. In order for
CESR's Global Exposure Guidelines to be binding and operational in a
particular EU Member State, the Member State must adopt them. To
date, it appears that a few EU Member States, e.g., Ireland and
Luxembourg, have adopted them. The majority of UCITS funds, however,
are domiciled in either Ireland or Luxembourg.
    \674\ See Directive 2009/65/EC of the European Parliament and of
the Council of 13 July 2009 on the coordination of laws,
regulations, and administrative provisions relating to undertakings
for collective investment in transferable securities (UCITS)
(``Directive 2009/65/EC''), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0032:0096:en:PDF.
    \675\ See CESR Global Guidelines, supra note 162. The CESR's
Global Exposure Guidelines note that the ``use of a commitment
approach or VaR approach or any other methodology to calculate
global exposure does not exempt UCITS from the requirement to
establish appropriate internal risk management measures and
limits.'' Id., at 5. In addition, with respect to the selection of
the methodology used to measure global exposure, CESR's Global
Exposure Guidelines note that the ``commitment approach should not
be applied to UCITS using, to a large extent and in a systematic
way, financial derivative instruments as part of complex investment
strategies.'' Id., at 6.
---------------------------------------------------------------------------

    Under the commitment approach, a UCITS fund's net exposures from
derivatives may not exceed 100% of the fund's net asset value.\676\
CESR's Global Exposure Guidelines extensively address the calculation
of derivatives exposure and specify a method for calculating
derivatives exposure that generally uses the market value of the
equivalent position in the underlying asset.\677\ CESR's Global
Exposure Guidelines also incorporate a schedule of derivative
investments and their corresponding conversion methods to be used in
calculating global exposure.\678\ The applicable conversion method for
UCITS funds depends on the particular derivative.\679\ We believe that
the calculation of derivatives exposure under CESR's Global Exposure
Guidelines is generally similar to the method of calculating notional
amounts, which under our proposed rule would be included in a fund's
calculation of its exposure. Instead of specifying in the rule the
precise method of determining notional amounts for every particular
type of derivative transaction, we have proposed a definition of
notional amount that we believe can be more readily adapted both to
current and new types of derivatives transactions.
---------------------------------------------------------------------------

    \676\ Directive 2009/65/EC, supra note 674 at Article 51(3) at
62 (``The exposure is calculated taking into account the current
value of the underlying assets, the counterparty risk, future market
movements and the time available to liquidate the positions''). See
also CESR Global Guidelines, supra note 162 (``The commitment
conversion methodology for standard derivatives is always the market
value of the equivalent position in the underlying asset. This may
be replaced by the notional value or the price of the futures
contract where this is more conservative. For non-standard
derivatives, where it is not possible to convert the derivative into
the market value or notional value of the equivalent underlying
asset, an alternative approach may be used provided that the total
amount of the derivatives represent a negligible portion of the
UCITS portfolio.'').
    \677\ The market value of the underlying reference asset may be
``replaced by the notional value or the price of the futures
contract where this is more conservative.'' See CESR Global
Guidelines, supra note 162, at 7.
    \678\ See id., at 7-12.
    \679\ Id., at 8. For example, for bond futures, the applicable
conversion method is the number of contracts multiplied by the
notional contract size multiplied by the market price of the
cheapest-to-deliver reference bond. For plain vanilla fixed/floating
interest rate and inflation swaps, the applicable conversion method
is the market value of the underlier (though the notional value of
the fixed leg may also be applied). Id. For foreign exchange
forwards, the prescribed conversion method is the notional value of
the currency leg(s). Id., at 9. With respect to non-standard
derivatives, where it is not possible to convert the derivative into
the market value or notional value of the equivalent underlying
asset, CESR's Global Exposure Guidelines note that ``an alternative
approach may be used provided that the total amount of the
derivatives represent a negligible portion of the UCITS portfolio.''
Id., at 7.
---------------------------------------------------------------------------

    Although the CESR commitment approach is similar with respect to
our proposed method of calculating derivatives exposure, the commitment
approach differs from our proposed exposure-based alternative in
several ways. First, the commitment approach permits exposures of up to
only 100% of the fund's net assets rather than our proposed rule's
exposure-based portfolio limit of 150%. Second, the commitment approach
permits UCITS funds to reduce their calculated derivatives exposure for
certain netting and hedging transactions. With respect to netting,
CESR's Global Exposure Guidelines allow netting of derivatives
transactions regardless of the derivatives' due dates, provided that
the trades are ``concluded with the sole aim of eliminating the risks
linked to the positions.'' \680\ In addition, UCITS funds are permitted
to reduce their exposures for hedging arrangements--these are described
in CESR's Global Exposure Guidelines as transactions that do not
necessarily refer to the same underlying asset but are entered into for
the ``sole

aim of offsetting risks'' linked to other positions.\681\
---------------------------------------------------------------------------

    \680\ See CESR Global Guidelines, supra note 162, at 13.
    \681\ See CESR Global Guidelines, supra note 162, at 18. The
UCITS requirements also permit the fund to reduce its exposures if
the derivative directly swaps the performance of financial assets
held by the fund for other reference assets or the derivative, in
combination with cash held by the fund, represents the equivalent of
a cash investment in the reference asset.
---------------------------------------------------------------------------

    As discussed above in section III.B, given the flexibility provided
by our proposed 150% exposure limit (and the requirements provided
under our proposed risk-based portfolio limit discussed above), the
proposed rule does not permit a fund to reduce its exposure for
purposes of the rule's portfolio limitations for particular types of
hedging, risk-mitigating or offsetting transactions. For all of the
reasons discussed in that section, we believe that it would be more
appropriate, in lieu of a reduction for hedging on a transaction-by-
transaction basis, to provide funds with the flexibility to enter into
derivatives transactions for a variety of purposes, including those
that are partially or primarily for hedging, through a 150% exposure
limitation.
    Similar to our proposed rule, the UCITS guidelines also provide an
alternative risk-based approach. This alternate method for UCITS
compliance is the VaR (or other advanced risk measurement) approach,
designed to measure potential losses due to market risk rather than
measure leverage exposures.\682\ When following the VaR approach to
calculate global exposure, a UCITS fund may use either an absolute VaR
approach or a relative VaR approach.\683\ The absolute VaR approach
limits the maximum VaR that a UCITS fund can have relative to its net
assets, and as a general matter, the absolute VaR is limited to 20
percent of the UCITS fund's net assets.\684\ Under the relative VaR
approach, the VaR of the portfolio cannot be greater than twice the VaR
of an unleveraged reference portfolio.\685\
---------------------------------------------------------------------------

    \682\ Id., at 22 (``More particularly, the VaR approach measures
the maximum potential loss at a given confidence level (probability)
over a specific time period under normal market conditions.'').
    \683\ Id., at 23. A global exposure calculation using the VaR
approach should consider all the positions in the UCITS' portfolio.
Id., at 22. The VaR approach measures the probability of risk of
loss rather than the amount of leverage in portfolio and the VaR
calculation is required to have a ``one-tailed confidence interval
of 99%,'' a holding period of one month (20 business days), an
observation period of risk factors of at least one year (unless a
shorter observation period is justified by a significant increase in
price volatility), at least quarterly updates, and at least daily
calculation. Id. at 26. UCITS employing the VaR approach are
required to conduct a ``rigorous, comprehensive and risk-adequate
stress testing program.'' Id., at 30-34.
    \684\ Id., at 25-26.
    \685\ CESR's Global Exposure Guidelines note that the relative
VaR approach does not directly measure leverage of the UCITS'
strategies but instead allows the UCITS to double the risk of loss
under a given VaR model as compared to a reference benchmark. Id.,
at 24.
---------------------------------------------------------------------------

    While our proposed rule also uses a VaR ratio comparison as a risk
measurement method to limit the use of derivatives, we have determined
not to propose the use of an absolute VaR method that would limit the
fund's VaR amount to a specified percentage of net assets, or a
relative VaR that would measure a fund's VaR as compared to a reference
benchmark. As discussed above in the section III.B.2.b, our concern
with respect to an absolute VaR method is that the calculation of VaR
on a historical basis is highly dependent on the historical trading
conditions during the measurement period and can change dramatically
both from year to year and from periods of benign trading conditions to
periods of stressed market conditions. As discussed above in section
III.B.1.c, we believe that our exposure-based portfolio limit of 150%
and our risk-based portfolio limit of 300% are appropriately designed
to impose a limit on the amount of leverage a fund may obtain through
certain derivatives and other senior securities transactions while also
providing flexibility for funds to use derivatives transactions for a
variety of purposes. However, a limitation based on an absolute VaR
method could potentially allow a fund to obtain very substantial
amounts of leveraged exposures that the fund could then be required to
unwind during stressed market conditions, which could adversely affect
the fund and its investors. In addition, our staff has noted that some
UCITS funds relying on the absolute VaR method disclose gross notional
amounts for their portfolios that are substantially in excess of our
proposed portfolio limitations that we believe are appropriate for
funds subject to section 18 of the Act as discussed above in section
III.B.1.c.
    The relative VaR method for UCITS funds, under which a fund would
compare its total portfolio VaR to an unleveraged reference portfolio
or benchmark, allows a UCITS fund to use derivatives in its portfolio
so long as the VaR of the UCITS fund is not greater than two times the
VaR of the reference portfolio or benchmark. As discussed above in
section III.B.2.a, we have not proposed this particular approach for
several reasons, including concerns regarding difficulties in
determining whether a reference index or benchmark is itself leveraged.
Our staff has also noted that a number of UCITS funds do not use the
relative VaR method and many alternative funds use a benchmark that is
a money market rate (such as LIBOR), oftentimes because an analogous
investment benchmark is not available for the fund strategy, which
suggests that a VaR comparison to a benchmark would not provide a
suitable method for many fund strategies.\686\
---------------------------------------------------------------------------

    \686\ See supra notes 268-270 and accompanying text.
---------------------------------------------------------------------------

    In addition to the two alternative exposure limitations, CESR's
Global Exposure Guidelines also subject UCITS funds to ``cover rules''
for investments in financial derivatives.\687\ Under these cover rules,
a UCITS fund should, at any given time, be capable of meeting all its
payment and delivery obligations incurred by transactions involving
financial derivative investments, and should monitor to make sure that
financial derivatives transactions are adequately covered.\688\ More
specifically, in the case of a derivative that provides, automatically
or at the counterparty's choice, for physical delivery of the
underlying financial instrument, a UCITS fund: (1) Should hold the
underlying financial instrument in its portfolio as cover, or, (2) if
the UCITS fund deems the underlying financial instrument to be
sufficiently liquid, it may hold as coverage other assets (including
cash) as cover on the condition that these assets (after applying
appropriate haircuts), held in sufficient quantities, may be used at
any time to acquire the underlying financial instrument that is to be
delivered.\689\ In the case of a derivative that provides,
automatically or at the UCITS fund's choice, for cash settlement, the
UCITS fund should hold enough liquid assets after appropriate haircuts
to allow the UCITS fund to make the contractually required
payments.\690\ Similar to the UCITS cover rules, the asset segregation
requirements of our proposed rule are also designed to assure that a
fund has sufficient assets to pay its derivatives related

obligations. However, our proposed asset segregation requirements
differ from the UCITS requirements for the reasons discussed above in
section III.C.
---------------------------------------------------------------------------

    \687\ CESR Global Guidelines, supra note 162, at 40.
    \688\ Id.
    \689\ Id.
    \690\ Id. On April 14, 2011, ESMA published a final report on
the guidelines on risk measurement and the calculation of the global
exposure for certain types of structured UCITS funds. See Guidelines
to Competent Authorities and UCITS Management Companies on Risk
Measurement and the Calculation of Global Exposure for Certain Types
of Structured UCITS, Final Report Ref.: ESMA/2011/112 (Apr. 14,
2011), available at http://www.esma.europa.eu/popup2.php?id=7542
(these guidelines, which will need to be adopted and implemented by
Member States, propose for certain types of structured UCITS, an
optional regime for the calculation of the global exposure).
---------------------------------------------------------------------------

    ESMA has also more recently adopted guidelines to assess the
leverage used by AIFs marketed to professional investors in the
European Union.\691\ These guidelines supplement a directive proposed
by the European Commission, the Alternative Investment Fund Managers
Directive (``AIFMD''), which had the objective to create a
comprehensive and effective regulatory and supervisory framework for
AIF managers at the European level.\692\ AIFMD defines leverage as
``any method by which the [AIF manager] increases the exposure of an
AIF it manages whether through borrowing of cash or securities, or
leverage embedded in derivative positions or by any other means.''
\693\ For each AIF that it manages, the AIF manager is required to
establish a maximum level of leverage which it may employ on behalf of
the AIF and to report the AIF's leverage to investors and supervisory
authorities.\694\ Unlike the UCITS regime, AIFMD does not restrict the
amount of leverage that may be used by an AIF; instead it requires
managers to set their own limitation for each AIF. The requirements in
AIFMD thus serve primarily to provide a consistent method of measuring
and reporting of the amount of leverage used by AIFs.
---------------------------------------------------------------------------

    \691\ See Commission Delegated Regulation (EU) No 231/2013 of
Dec. 19, 2012 supplementing Directive 2011/61/EU of the European
Parliament and of the Council with regard to exemptions, general
operating conditions, depositaries, leverage, transparency and
supervision (``Commission Delegated Regulation No. 231/2013''),
available at http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32013R0231 (providing for the calculation of leverage for
alternative investment funds).
    \692\ Directive 2011/61/EU of the European Parliament and of the
Council of 8 June 2011 on Alternative Investment Fund Managers and
amending Directives 2003/41/EC and Regulations (EC) No 1060/2009 and
(EU) No 1095/2010 (``Directive 2011/61/EU''), available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32011L0061&from=EN.
    \693\ See Directive 2011/61/EU, supra note 692, at Article
4(1)(v).
    \694\ See id., at Articles 15(4) and 7(3)(a).
---------------------------------------------------------------------------

    AIF managers are required to calculate leverage used by AIFs both
under a gross method and a commitment method. As described by ESMA,
``[t]he gross method gives the overall exposure of the AIF whereas the
commitment method gives insight in the hedging and netting techniques
used by the manager.'' \695\ The measurement of exposure relating to
derivatives and borrowings in our proposed rule generally is similar to
AIFMD requirements with respect to the measurement of the gross
exposure relating to derivatives and borrowings.\696\ The commitment
method under AIFMD, however, allows an AIF also to report its exposure
after reduction for netting and hedging arrangements. The determination
of whether a set of transactions are eligible for netting or hedging
treatment would be made by the AIF manager subject to general
principles focusing on whether the transactions result in an
``unquestionable reduction of the general market risk'' or
alternatively whether the transactions are part of an arbitrage
strategy that is seeking to generate a return based on the relative
performance of two correlated assets.\697\
---------------------------------------------------------------------------

    \695\ See Commission Delegated Regulation No. 231/2013, supra
note 691, at preamble paragraph (12).
    \696\ The AIFMD requirements do allow for a reduction to account
for cash equivalents held by the fund while requiring leverage from
reinvestment of collateral held by the fund to be added to the
leverage calculation.
    \697\ For example, the AIF directive notes that a ``portfolio
management practice which aims to keep the alpha of a basket of
shares (comprising a limited number of shares) by combining the
investment in that basket of shares with a beta-adjusted short
position on a future on a stock market index should not be
considered as complying with the hedging criteria. Such a strategy
does not aim to offset the significant risks linked to the
investment in that basket of shares but to offset the beta (market
risk) of that investment and keep the alpha. The alpha component of
the basket of shares may dominate over the beta component and as
such lead to losses at the level of the AIF. For that reason, it
should not be considered as a hedging arrangement.'' See Commission
Delegated Regulation No. 231/2013, supra note 691, at preamble
paragraph (23).
---------------------------------------------------------------------------

    For reasons discussed above, we have decided not to propose a rule
that would allow fund managers to set their own exposure limitation for
each fund. In addition, as discussed above, we believe it would be
difficult to develop standards for determining circumstances under
which transactions are offsetting other transactions, and thus we have
chosen not to incorporate a hedging reduction into the proposed
exposure limitations. Accordingly, and as discussed above in section
III.B.1.c, we believe that a test that focuses on the notional amounts
of funds' derivatives transactions, coupled with an appropriate
exposure limit, will better accommodate the broad diversity of
registered funds and the ways in which they use derivatives. We also
believe that, to the extent fund managers may wish to include more
specific risk metrics with respect to their funds, they may do so by
including such metrics within the proposed derivatives risk management
program.
4. Disclosure Alternative and Considerations
    We considered whether enhancements to funds' disclosure obligations
with respect to a fund's use of derivatives would be a reasonable
alternative to the proposed rule.\698\ We received a range of comments
on the Concept Release regarding the efficacy of disclosure. Some
commenters that recommended disclosure enhancements also suggested
approaches that went beyond enhanced disclosure,\699\ and at least one
commenter specifically argued that disclosure alone was not
sufficient.\700\ For example, this commenter noted that the financial
crisis of 2007-2008 demonstrated that disclosure alone is not adequate
because markets may do a poor job of regulating the use of leverage by
financial institutions, thus allowing leverage to increase until there
are catastrophic failures.\701\ On the other hand, some commenters
specifically argued that in at least certain circumstances the use of
derivatives by a fund should be addressed solely through disclosure.
For example, one commenter suggested that disclosure requirements would
be suitable for transactions that possess only economic leverage, which
the commenter argued would implicate the risks and volatility of a fund
similar to that of other types of non-derivative investments.\702\
Another commenter argued that leveraged funds, particularly leveraged
exchange-traded funds, present fewer concerns than do other funds that
use derivatives due in part to their robust level of disclosure, and
should not have any additional derivatives limitations imposed on
them.\703\
---------------------------------------------------------------------------

    \698\ See, e.g., Security Investors Comment Letter (arguing that
significant changes to the current regulatory scheme are not
warranted, but that the existing regulatory scheme could be improved
upon the clarification of existing guidance, including greater
disclosure about funds' investments in derivatives); Ropes and Gray
Comment Letter (suggesting that absent any indication that funds are
not making adequate disclosure with respect to derivatives, or that
fund boards are not fulfilling their oversight responsibilities,
there is no compelling reason for the Commission to impose new
restrictions on the use of derivatives).
    \699\ See, e.g., ABA Concept Release Comment Letter; ICI Concept
Release Comment Letter.
    \700\ See, e.g., Keen Concept Release Comment Letter.
    \701\ See Keen Concept Release Comment Letter.
    \702\ See ABA Concept Release Comment Letter. See also T. Rowe
Price Concept Release Comment Letter; ICI Concept Release Comment
Letter.
    \703\ See Rafferty Concept Release Comment Letter.
---------------------------------------------------------------------------

    Although disclosure is an important mechanism through which funds
inform existing and prospective shareholders of the fund's use of
derivatives, we do not believe that an approach that focuses on

disclosure would address the purposes and concerns underlying section
18 of the Act as effectively as the approach we are proposing today,
particularly given that section 18 itself imposes a specific limitation
on the amount of senior securities that may be issued by a fund
regardless of the risk associated with the particular senior
securities. In this regard we note that investment company abuse of
leverage was a primary concern that led to enactment of the Investment
Company Act.\704\ In the Investment Company Act's preamble, Congress
cited excessive leverage as a major abuse that it meant to correct,
declaring in section 1(b)(7) of the Act that the public interest and
the interest of investors are adversely affected ``when investment
companies by excessive borrowing and the issuance of excess amounts of
senior securities increase unduly the speculative character of their
junior securities.'' \705\ The proposed rule is designed to impose a
limit on the amount of leverage a fund may obtain through derivatives
and financial commitment transactions, whereas requiring enhancement to
derivatives disclosure, absent additional requirements to limit
leverage or potential leverage, would not appear to provide any limit
on the amount of leverage a fund may obtain, and thus would not provide
any regulatory distinction between funds regulated by the Act and
private funds not regulated by the Act in respect of their respective
ability to obtain leverage through derivatives. An approach focused on
enhanced disclosure requirements thus does not appear to provide a
sufficient basis for an exemption from the requirements of section 18
of the Act.
---------------------------------------------------------------------------

    \704\ In 1939, the Commission Released an exhaustive study of
the investment company industry that laid the foundation for the
Investment Company Act. SEC, Investment Trusts and Investment
Companies, H.R. Doc. No. 707, 75th Cong., 3d Sess. pt. 1 (1939);
SEC, Investment Trusts and Investment Companies, H.R. Doc. No. 70,
76th Cong., 1st Sess. pt. 2 (1939); SEC, Investment Trusts and
Investment Companies, H.R. Doc. No. 279 Cong., 1st Sess. pt. 3
(1939). For a discussion of leveraged capital structures of
investment companies, see Investment Trust Study pt.3, Ch. V,
``Problems in Connection with Capital Structure,'' 1563-1940.
    \705\ Section 1(b)(7) of the Investment Company Act.
---------------------------------------------------------------------------

    We do, however, believe that disclosure is an important aspect of
the existing regulatory framework and that effective derivatives-
related disclosure would complement the limitations on derivatives use
in the proposed rule. Indeed, in May 2015, we proposed enhanced
reporting and disclosure requirements for investment companies that
include new reporting requirements for derivatives transactions,
including, for most funds, more detailed reporting of the terms and
conditions of each derivatives contract in a fund's portfolio on a
monthly basis in a structured format.\706\ The proposal also would
require reporting of the fund's monthly net realized gain (or loss) and
net change in unrealized appreciation (or depreciation) attributable to
derivatives.\707\
---------------------------------------------------------------------------

    \706\ Such information would be reported on proposed Form N-
PORT. See Proposed Form N-PORT, Item C.11.; Investment Company
Reporting Modernization Release, supra note 138. Our staff also has
previously addressed funds' disclosure with respect to their use of
derivatives in 2010 and 2013. See Letter from Barry D. Miller,
Associate Director, Division of Investment Management, U.S.
Securities and Exchange Commission, to Karrie McMillan, General
Counsel, Investment Company Institute (July 30, 2010); SEC,
Disclosure and Compliance Matters for Investment Company Registrants
That Invest in Commodity Interests, IM Guidance Update (Aug. 2013)
(No. 2013-05), available at https://www.sec.gov/divisions/investment/guidance/im-guidance-2013-05.pdf.
    \707\ Proposed Form N-PORT Item B.5.
---------------------------------------------------------------------------

    As discussed in the Investment Company Reporting Modernization
Release, these proposed requirements would, among other things, help
the Commission and investors better understand the exposures that the
derivatives create or hedge, which can be important to understanding a
fund's investment strategy, use of leverage, and potential for risk of
loss.\708\ Such information would allow the Commission to better assess
industry trends regarding the use of derivatives, which the Commission
could use to better carry out its regulatory functions, such as the
formulation of policy and guidance, the review of registration
statements, and the examination of funds.\709\ The Investment Company
Reporting Modernization Release also included amendments to Regulation
S-X that would require similar enhanced derivatives disclosures in fund
financial statements, which would increase transparency of a fund's use
of derivatives and comparability among funds to help investors better
assess funds' use of derivatives and make more informed investment
decisions.\710\
---------------------------------------------------------------------------

    \708\ See Investment Company Reporting Modernization Release,
supra note 138, at Part II.A.2.d. and Part II.A.2.g.iv.
    \709\ See Investment Company Reporting Modernization Release,
supra note 138, at Part II.A.
    \710\ See Investment Company Reporting Modernization Release,
supra note 138, at Part II.C.
---------------------------------------------------------------------------

Amendments to Proposed Form N-PORT
    The Commission is also proposing to require additional position
level risk-sensitivity measures on Form N-PORT, vega and gamma, for
funds that are required to implement a derivatives risk management
program by proposed rule 18f-4(a)(3). These measures would improve the
ability of Commission staff to efficiently understand and approximate
the risk exposures of reporting funds.
    A reasonable alternative is to require portfolio- and position-
level risk-sensitivity measures in addition to vega and gamma that
would provide Commission staff a more precise approximation of the risk
exposures of reporting funds. For example, Form N-PORT could require
the risk-sensitivity measures theta and rho at the position-level; and
at the portfolio level measures that describe the sensitivity of a
reporting fund to a 50 or 100 basis point change in interest rates and
credit spreads or a measure of convexity. These measures could improve
the ability of Commission staff to monitor the fund industry in
connection with other risks and more sizable changes in prices and
rates. While potentially valuable, requiring these additional measures
could increase the burden on funds, and the additional precision might
not significantly improve the ability of Commission staff to monitor
the fund industry in most market environments. Another reasonable
alternative is to not require any additional risk-sensitivity measures.
Although the burden to investment companies to provide the information
would be less if fewer or no risk-sensitivity measures were required by
the Commission, we believe that the benefits from requiring the
measures, including the ability to efficiently identify and size
specific investment risks, justify the costs to investment companies to
provide the measures.
    Our proposal would require only those funds that are required to
implement a derivatives risk management program to report vega and
gamma on proposed Form N-PORT. As an alternative, we could require
funds with lower exposures than those funds would be required to
implement a derivatives risk management program to also report vega and
gamma. Alternatively, we could redefine the basis for funds to
implement a derivatives risk management program and therefore require a
different set of funds to report the additional risk-sensitivity
measures. However, as we discussed above, we believe that the current
requirements will capture most of the funds that use derivatives as a
significant factor of their returns, while not imposing burdens on
funds that do not generally rely on derivatives as an

important part of their investment strategies.\711\
---------------------------------------------------------------------------

    \711\ See supra section III.G.2.
---------------------------------------------------------------------------

F. Request for Comment

    The Commission requests comment on all aspects of this initial
economic analysis, including whether the analysis has: (1) Identified
all benefits and costs, including all effects on efficiency,
competition, and capital formation; (2) given due consideration to each
benefit and cost, including each effect on efficiency, competition, and
capital formation; and (3) identified and considered reasonable
alternatives to the proposed new rule and rule amendments. We request
and encourage any interested person to submit comments regarding the
proposed rule, our analysis of the potential effects of the proposed
rule and proposed amendments, and other matters that may have an effect
on the proposed rule. We request that commenters identify sources of
data and information as well as provide data and information to assist
us in analyzing the economic consequences of the proposed rule and
proposed amendments. We also are interested in comments on the
qualitative benefits and costs we have identified and any benefits and
costs we may have overlooked.
    In addition to our general request for comment on the economic
analysis associated with the proposed rule and proposed amendments, we
request specific comment on certain aspects of the proposal:
     What factors, taking into account a fund's particular
risks and circumstances, would cause particular variance in funds'
compliance costs related to the proposed rule?
     We request comment on our estimates of the one-time and
ongoing costs associated with proposed rule 18f-4, including the
exposure-based and risk-based portfolio limits, asset segregation
requirement, and risk management program requirement. Do commenters
agree with our cost estimates? If not, how should our estimates be
revised, and what changes, if any, should be made to the assumptions
forming the basis for our estimates? Are there any significant costs
that have not been identified within our estimates that warrant
consideration? To what degree would economies of scale affect
compliance costs for funds?
     We request comment on our estimate of the number of funds
that would seek to comply with the exposure-based and risk-based
portfolio limits, asset segregation requirements, and the derivatives
risk management program requirement. Do commenters agree that a fund
that belongs to a fund complex is likely to achieve economies of scale
that make it more likely that a fund will incur costs closer to the
low-end of the range of estimated costs?
     Do commenters agree with our belief that the benefits and
costs associated with the asset segregation requirement for a fund that
invests solely in financial commitment transactions would be the same
as those we estimate for the asset segregation requirements that would
apply to a fund that also enters into derivatives transactions? Why or
why not?
     To what extent do commenters anticipate that proposed rule
18f-4 could lead funds to modify their investment strategies or
decrease their use of derivatives?
     To what extent do funds' current practices regarding
derivatives risk management, if applicable, currently align with the
proposed derivatives risk management program, and what operational and
other costs would funds incur in modifying their current practices to
comply with the proposed requirements?

V. Paperwork Reduction Act

A. Introduction

    Proposed rule 18f-4 contains several ``collections of information''
within the meaning of the Paperwork Reduction Act of 1995
(``PRA'').\712\ The proposed amendments to proposed Form N-PORT and
Form N-CEN would impact the collections of information burdens
associated with that proposed form described in the Investment Company
Reporting Modernization Release.\713\ In the Investment Company
Reporting Modernization Release, we submitted new collections of
information for proposed Form N-PORT and Form N-CEN.\714\ The title for
these new collections of information is ``Form N-PORT under the
Investment Company Act, Monthly Portfolio Investments Report'' and
``Form N-CEN Under the Investment Company Act, Annual Report for
Registered Investment Companies.'' We are submitting new collections of
information for proposed new rule 18f-4 under the Investment Company
Act of 1940. The titles for this new collection of information would
be: ``Rule 18f-4 under the Investment Company Act of 1940, Use of
Derivatives by Registered Investment Companies and Business Development
Companies.''
---------------------------------------------------------------------------

    \712\ 44 U.S.C. 3501 through 3521.
    \713\ See Investment Company Reporting Modernization Release,
supra note 138, at section V.
    \714\ See id.
---------------------------------------------------------------------------

    The Commission is submitting these collections of information to
the OMB for review in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11. An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless it displays
a currently valid control number.
    The Commission is proposing new rule 18f-4 and is proposing to
amend proposed Form N-PORT and Form N-CEN. The proposed rule and
amendments are designed to address the investor protection purposes and
concerns underlying section 18 of the Act and to provide an updated and
more comprehensive approach to the regulation of funds' use of
derivatives transactions in light of the dramatic growth in the volume
and complexity of the derivatives markets over the past two decades and
the increased use of derivatives by certain funds. We discuss below the
collection of information burdens associated with these reforms.\715\
---------------------------------------------------------------------------

    \715\ We discuss below these collection of information burdens
on each fund, but note that certain of the estimated costs may be
incurred instead, at least in part, by other third parties,
including a fund's investment adviser.
---------------------------------------------------------------------------

B. Proposed Rule 18f-4

    Proposed rule 18f-4 would require a fund that relies on the rule in
order to enter into derivatives transactions to: (1) Comply with one of
two alternative portfolio limitations designed to impose a limit on the
amount of leverage the fund may obtain through derivatives transactions
and other senior securities transactions; (2) manage the risks
associated with its derivatives transactions by maintaining an amount
of certain assets, defined in the rule as ``qualifying coverage
assets,'' designed to enable the fund to meet its obligations under its
derivatives transactions; and (3) depending on the extent of its
derivatives usage, establish a derivatives risk management program. A
fund that relies on the proposed rule in order to enter into financial
commitment transactions would be required to maintain qualifying
coverage assets equal in value to the fund's full obligations under
those transactions. As discussed in greater detail below, a number of
the proposed requirements are collections of information under the PRA.
The respondents to proposed rule 18f-4 would be certain registered
open- and closed-end management investment companies and BDCs.
Compliance with proposed rule 18f-4 would be mandatory for all funds
that seek to

engage in derivatives transactions and financial commitment
transactions in reliance on the rule, which would otherwise be subject
to the restrictions of section 18. No information would be submitted
directly to the Commission under proposed rule 18f-4. To the extent
that records required to be created and maintained by funds under the
rule are provided to Commission staff in connection with examinations
or investigations, such information would be kept confidential subject
to the provisions of applicable law. We believe that our collection of
information cost estimates below are an upper bound because, as
discussed in section IV, many funds are part of a fund complex and will
likely benefit from economies of scale.
1. Portfolio Limitations for Derivatives Transactions
    Proposed rule 18f-4 would require a fund that engages in
derivatives transactions in reliance on the rule to comply with one of
two alternative portfolio limitations.\716\ Under the exposure-based
portfolio limit, a fund generally would be required to determine that,
immediately after entering into any senior securities transaction, its
aggregate exposure does not exceed 150% of the value of the fund's net
assets.\717\ Under the risk-based portfolio limit, a fund generally
would be required to determine that, immediately after entering into
any senior securities transaction, (1) the fund's full portfolio VaR
does not exceed its securities VaR and (2) the fund's aggregate
exposure does not exceed 300% of the value of the fund's net
assets.\718\ In addition, a fund that engages in derivatives
transactions in reliance on the proposed rule would not be required to
have a derivatives risk management program if the fund complies with a
portfolio limitation under which, immediately after entering into any
derivatives transaction, the fund's aggregate exposure does not exceed
50% of the value of the fund's net assets and the fund does not use
complex derivatives transactions.\719\
---------------------------------------------------------------------------

    \716\ Proposed rule 18f-4(a)(1).
    \717\ Proposed rule 18f-4(a)(1)(i).
    \718\ Proposed rule 18f-4(a)(1)(ii).
    \719\ Proposed rule 18f-4(a)(1).
---------------------------------------------------------------------------

    As discussed above in section IV.D.1 and IV.D.2, in the DERA staff
analysis, 68% of all of the sampled funds did not have any exposure to
derivatives transactions, and these funds thus do not appear to use
derivatives transactions or, if they do use them, do not appear to do
so to a material extent.\720\ Staff thus estimates that the remaining
32% of funds (3,831 funds \721\) will seek to rely on this part of
proposed rule 18f-4, and therefore comply with the portfolio limitation
requirements. These funds would be subject to the collections of
information described below with respect to their applicable portfolio
limitations.
---------------------------------------------------------------------------

    \720\ None of the BDCs in the DERA sample had exposure to
derivatives transactions.
    \721\ This estimate is based on the following calculation:
11,973 funds x 32% = 3,831 funds. See supra note 578.
---------------------------------------------------------------------------

Initial Determination of Portfolio Limitations
    The proposed rule would require a fund's board of directors,
including a majority of the directors who are not interested persons of
the fund, to approve (a) the fund's determination to comply with either
the exposure-based portfolio limit or the risk-based portfolio limit
under the proposed rule, and (b) if applicable, the fund's
determination to limit its aggregate exposure under derivatives
transactions to not more than 50% of its NAV and not to use complex
derivatives transactions.\722\ We estimate a one-time burden of 3 hours
per fund associated with a board's review and approval of a fund's
portfolio limitation or, amortized over a three-year period, a burden
of approximately 1 hour annually per fund. We therefore estimate that
the total hourly burden for the initial reviews and approvals of funds'
portfolio limitations would be 11,493 hours.\723\ We estimate that each
fund would incur a time cost of approximately $5,121 to obtain this
initial approval, for a total initial time cost for all funds of
approximately $19,618,551.\724\ In addition to the internal costs
described above, we also estimate that each fund would incur a one-time
average external cost of $800 associated with a fund board consulting
its outside legal counsel with regard to the required board
approvals.\725\
---------------------------------------------------------------------------

    \722\ Proposed rule 18f-4(a)(5)(i). The cost burdens associated
with a fund board's approvals include costs incurred to prepare
materials for the board's determinations, as well as the board's
review and approval of determinations required by the proposed rule.
See infra note 724.
    \723\ This estimate is based on the following calculation: 3
hours x 3,831 funds = 11,493 hours.
    \724\ This estimate is based on the following calculations: 0.6
hours x $301 (hourly rate for a senior portfolio manager) = $181;
0.6 hours x $455.5 (blended hourly rate for assistant general
counsel ($426) and chief compliance officer ($485) = $273; 1.0 hours
x $4,400 (hourly rate for a board of 8 directors) = $4,400; 0.8
hours (for a fund attorney's time to prepare materials for the
board's determinations) x $334 (hourly rate for a compliance
attorney) = $267. $181 + $273 + $4,400 + $267 = $5,121; $5,121 x
3,831 funds = $19,618,551. The hourly wages used are from SIFMA's
Management & Professional Earnings in the Securities Industry 2013,
modified to account for an 1800-hour work-year and multiplied by
5.35 to account for bonuses, firm size, employee benefits, and
overhead. The staff previously estimated in 2009 that the average
cost of board of director time was $4,000 per hour for the board as
a whole, based on information received from funds and their counsel.
Adjusting for inflation, the staff estimates that the current
average cost of board of director time is approximately $4,400.
    \725\ This estimate is based on the following calculation: 2
hours x $400 (hourly rate for outside legal services) = $800.
---------------------------------------------------------------------------

Recordkeeping
    The proposed rule would require a fund to maintain a record of each
determination made by the fund's board that the fund will comply with
one of the portfolio limitations under the proposed rule, which would
include the fund's initial determination as well as a record of any
determination made by the fund's board to change the portfolio
limitation.\726\ We estimate a one-time burden of 0.6 hours per fund
associated with maintaining a record of a board's initial determination
of the fund's portfolio limit or, amortized over a three-year period, a
burden of about 0.2 hours annually per fund. We therefore estimate that
the total burden for maintaining a record of a board's initial
determination of the fund's portfolio limit would be 2,299 hours.\727\
We also estimate that each fund would incur a time cost of
approximately $38 to meet this requirement, for a total initial time
cost of approximately $164,733.\728\
---------------------------------------------------------------------------

    \726\ Proposed rule 18f-4(a)(6)(i). The fund would be required
to maintain this record for a period of not less than five years
(the first two years in an easily accessible place) following each
determination.
    \727\ This estimate is based on the following calculation: 0.6
hours x 3,831 funds = 2,299 hours.
    \728\ This estimate is based on the following calculation: 0.3
hours x $57 (hourly rate for a general clerk) = $17; 0.3 hours x $87
(hourly rate for a senior computer operator) = $26. $17 + $26 = $43;
$43 x 3,831 funds = $164,733.
---------------------------------------------------------------------------

    In addition, a fund that relies on the proposed rule also would be
subject to an ongoing requirement to maintain a written record
demonstrating that immediately after the fund entered into any senior
securities transaction, the fund complied with its applicable portfolio
limit, with such record reflecting the fund's aggregate exposure, the
value of its net assets and, if applicable, the fund's full portfolio
VaR and its securities VaR.\729\ We estimate that each fund would incur
an average burden of 50 hours to retain these

records.\730\ We therefore estimate that the total annual burden for
maintaining these records would be 191,550 hours.\731\ We also estimate
that each fund would incur an annual time cost of approximately $3,600,
and a total annual time cost for all funds of approximately
$13,791,600.\732\ We estimate that there are no external costs
associated with this collection of information.\733\
---------------------------------------------------------------------------

    \729\ Proposed rule 18f-4(a)(6)(iv). The fund would be required
to maintain this record for a period of not less than five years
(the first two years in an easily accessible place) following each
senior securities transaction. This written record requirement would
also apply to a fund's monitoring of the 50% portfolio limit for
purposes of the derivatives risk management program requirement
(discussed below).
    \730\ We assume for purposes of this estimate that funds would
implement automated processes for creating a written record of their
compliance with the applicable portfolio limit immediately after
entering into any senior securities transaction, and that a fund
would enter into at least one derivatives transaction or other
senior securities transaction per trading day. Based on 250 trading
days per year, and assuming 0.1 hours per trading day spent by a
general clerk and 0.1 hours per trading day spent by a senior
computer operator, we estimate the annual time cost to be (0.1 x
250) = 25 hours per year per fund for each general clerk and senior
computer operator.
    \731\ This estimate is based on the following calculations: 50
hours x 3,831 funds = 191,550 hours.
    \732\ This estimate is based on the following calculation: 25
hours x $57 (hourly rate for a general clerk) = $1,425; 25 hours x
$87 (hourly rate for a senior computer operator) = $2,175. $1,425 +
$2,175 = $3,600; $3,600 x 3,831 funds = $13,791,600.
    \733\ Except as provided for above, we have estimated (both for
purposes of the economic analysis and the PRA) the cost burdens
associated with the proposed rule using a fund's internal resources,
rather than third party solutions which may develop in the future.
See, e.g., supra text in paragraph following note 573.
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    Accordingly, we estimate that, for recordkeeping associated with a
fund's portfolio limitations, including maintenance of a record of a
board's initial determination of the fund's portfolio limit and
maintenance of written records demonstrating the fund's ongoing
compliance with applicable portfolio limits, the time burden per fund
would be 50.6 hours and the time cost per fund would be $3,638.\734\ We
therefore estimate that the total burden for maintaining such records
would be 193,849 hours, at an aggregate time cost of $13,937,178.\735\
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    \734\ This estimate is based on the following calculations: 0.6
hours (maintenance of a record of board's initial determination of
fund's portfolio limit) + 50 hours (maintenance of written records
demonstrating fund's compliance with applicable portfolio limits) =
50.6 hours; $38 (maintenance of a record of a board's initial
determination of a fund's portfolio limit) + $3,600 (maintenance of
written records demonstrating funds' compliance with applicable
portfolio limits) = $3,638.
    \735\ This estimate is based on the following calculations: 50.6
hours x 3,831 funds = 193,849 hours; $3,638 x 3,831 funds =
$13,937,178.
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Estimated Total Burden
    Amortized over a three-year time period, the hour burdens and time
costs for collections of information associated with portfolio
limitations under proposed rule 18f-4, including the burdens associated
with (a) board review and approval of funds' initial portfolio
limitations, (b) maintenance of records of initial board determinations
of funds' portfolio limits, and (c) maintenance of written records
demonstrating funds' compliance with applicable portfolio limits, are
estimated to result in an aggregate average annual hour burden of
196,147 hours and aggregate time cost of $20,386,028.\736\ In addition
to the internal costs described above, we also estimate that each fund
would incur a one-time average external cost of $800.
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    \736\ These estimates are based on the following calculations:
(11,493 hours (year 1) + 2,299 hours (year 1) + (3 x 191,550 hours)
(years 1, 2 and 3)) / 3 = 196,147 hours; ($19,618,551 (year 1) +
($164,733 (year 1) + (3 x $13,791,600)) / 3 = $20,386,028.
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2. Asset Segregation: Derivatives Transactions
    Proposed rule 18f-4 would require a fund that enters into
derivatives transactions \737\ in reliance on the rule to manage the
risks associated with its derivatives transactions by maintaining an
amount of specified assets (defined in the proposed rule as
``qualifying coverage assets'') designed to enable the fund to meet its
obligations arising from such transactions.\738\ A fund would be
required to identify on the books and records of the fund, at least
once each business day, qualifying coverage assets with a value equal
to at least the fund's aggregate ``mark-to-market coverage amounts''
and ``risk-based coverage amounts.'' \739\ The mark-to-market coverage
amount would mean the amount that would be payable by the fund, for
each derivatives transaction, if the fund were to exit the derivatives
transaction at the time of determination.\740\ The risk-based coverage
amount would mean the potential amount payable by the fund if the fund
were to exit the derivatives transaction under stressed conditions,
determined in accordance with board-approved policies and
procedures.\741\ A fund would be permitted to adjust these coverage
amounts, at its discretion, if the fund has entered into certain
netting agreements, or the fund has posted variation margin (for the
mark-to-market coverage amount) or initial margin (for the risk-based
coverage amount), or collateral for such amounts payable by the
fund.\742\ A fund would be required to have policies and procedures
approved by its board of directors (and maintained by the fund in an
easily accessible place \743\) that are reasonably designed to provide
for the fund's maintenance of qualifying coverage assets.\744\
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    \737\ We include in this analysis a fund that enters into
derivatives transactions, as well as financial commitment
transactions and other senior securities. We discuss estimated PRA
costs for a fund that enters solely into financial commitment
transactions below.
    \738\ Proposed rule 18f-4(a)(2), (c)(6), (c)(8), (c)(9).
    \739\ Proposed rule 18f-4(a)(2). Qualifying coverage assets for
derivatives transactions would generally mean cash and cash
equivalents. The exceptions to the requirement to maintain cash and
cash equivalents are for derivatives transactions under which a fund
may satisfy its obligation by delivering a particular asset, in
which case that particular asset would be a qualifying coverage
asset. See proposed rule 18f-4(c)(8).
    \740\ Proposed rule 18f-4(c)(6).
    \741\ Proposed rule 18f-4(c)(9).
    \742\ Proposed rules 18f-4(c)(6)(i), (ii); 18f-4(c)(9)(i), (ii).
    \743\ A fund must maintain a written copy of the fund's policies
and procedures, approved by the fund's board, in effect, or at any
time within the past five years were in effect, in an easily
accessible place. Proposed rule 18f-4(a)(6)(ii).
    \744\ Proposed rule 18f-4(a)(5)(ii).
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    As discussed above in section IV.D.3, DERA staff analysis shows
that 68% of all sampled funds do not appear to use derivatives
transactions (or if they do, do not appear to use them to a material
extent). Staff estimates that the remaining 32% of funds (3,831 funds)
and no BDCs will seek to rely on this aspect of proposed rule 18f-4,
and therefore comply with the asset segregation requirements. These
funds would be subject to the collections of information described
below with respect to asset segregation requirements.
Identification of Qualifying Coverage Assets
    The qualifying coverage assets requirement would subject funds to a
collection of information insofar as they are required to make a daily
identification on a fund's books and records of its maintenance of
qualifying coverage assets, including determinations of the mark-to-
market and risk-based coverage amounts. Although we expect that these
activities would generally be automated and/or routine, our estimates
below include estimates for anticipated time costs by a fund's staff to
make manual adjustments to these determinations (e.g., to reflect
netting agreements, or account for assets posted as initial or
variation margin or collateral). The cost estimates below also reflect
the fact that, with regard to the mark-to-market coverage amount, we
believe that funds already calculate their liability under derivatives
transactions on a daily basis for various other purposes, including to
satisfy variation margin requirements and to determine the fund's NAV.
Funds also calculate their liability under derivatives transactions on
a periodic

basis in order to provide financial statements to investors. We
generally expect that funds would be able to use these calculations to
determine their mark-to-market coverage amounts.
    We do not expect that this aspect of the proposed rule will impose
any initial, one-time ``collection of information'' burdens on funds.
We do estimate, however, that each fund would incur an average annual
burden of 110 hours associated with the identification of qualifying
coverage assets. We therefore estimate that the total annual burden for
the identification of qualifying coverage assets would be 421,410
hours.\745\ We also estimate that each fund would incur an annual time
cost of approximately $11,530 to identify qualifying coverage assets,
for a total annual time cost for all funds of approximately
$44,171,430.\746\ We estimate that there are no external costs
associated with this collection of information.\747\
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    \745\ This estimate is based on the following calculation: 110
hours x 3,831 funds = 421,410 hours.
    \746\ This estimate is based on the following calculations: 100
hours x $87 (hourly rate for a senior computer operator) = $8,700;
10 hours x $283 (hourly rate for compliance manager) = $2,830.
$8,700 + $2,830 = $11,530; $11,530 x 3,831 funds = $44,171,430.
    \747\ See supra note 733.
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Board-Approved Policies & Procedures
    Proposed rule 18f-4 would require funds to have written policies
and procedures reasonably designed to provide for the fund's
maintenance of qualifying coverage assets. For purposes of this PRA
analysis, we estimate that a fund would incur a one-time average burden
of 15 hours associated with documenting its policies and procedures.
The proposed rule would also require that the fund's board approve such
policies and procedures and we estimate a one-time burden of 1 hour per
fund associated with fund boards' review and approval of its policies
and procedures. Amortized over a three-year period, this would be an
annual burden per fund of approximately 5.3 hours. We estimate that the
total one-time burden for the initial documentation, and board approval
of, written policies and procedures to provide for a fund's maintenance
of qualifying coverage assets would be 61,296 hours.\748\ We also
estimate that each fund would incur a time cost of approximately
$6,291, and a total initial time cost for all funds of approximately
$38,593,494.\749\ We estimate that there are no ongoing annual costs
associated with this collection of information. In addition to the
internal costs described above, we also estimate that each fund would
incur a one-time average external cost of $800 associated with a fund
board consulting its outside legal counsel with regard to the required
board approvals.\750\
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    \748\ This estimate is based on the following calculation: 16
hours x 3,831 funds = 61,296 hours.
    \749\ This estimate is based on the following calculations: 7.5
hours x $301 (hourly rate for a senior portfolio manager) = $2,258;
7.5 hours x $455.5 (blended hourly rate for assistant general
counsel ($426) and chief compliance officer ($485)) = $3,416; 1 hour
x $4,400 (hourly rate for a board of 8 directors) = $4,400. $2,258 +
$3,416 + $4,400= $10,074; $10,074 x 3,831 funds = $38,593,494.
    \750\ This estimate is based on the following calculation: 2
hours x $400 (hourly rate for outside legal services) = $800.
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Recordkeeping
    The proposed rule would require a fund to maintain a written copy
of the policies and procedures approved by the fund's board of
directors that are in effect, or at any time within the past five years
were in effect, in an easily accessible place. We estimate a one-time
burden (and no ongoing annual burden) of 1 hour per fund associated
with maintaining a written copy of the fund's board-approved policies
and procedures or, amortized over a three-year period, a burden of
approximately 0.3 hours annually per fund. We therefore estimate that
the total one-time burden for maintaining this record would be 3,831
hours.\751\ We also estimate that each fund would incur a time cost of
approximately $57, and a total initial time cost for all funds of
approximately $218,367.\752\ We estimate that there are no external
costs associated with this collection of information.
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    \751\ This estimate is based on the following calculation: 1
hour x 3,831 funds = 3,831 hours.
    \752\ This estimate is based on the following calculation: 1
hour x $57 (hourly rate for a general clerk) = $57. $57 x 3,831
funds = $218,367.
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    In addition, a fund that relies on the proposed rule also would be
subject to an ongoing requirement to maintain a written record
reflecting the mark-to-market coverage amount and risk-based coverage
amount for each derivatives transaction entered into by the fund and
identifying the associated qualifying coverage assets, as determined by
the fund at least once each business day, for a period of not less than
five years (the first two years in an easily accessible place).\753\ We
estimate that each fund would incur an average annual burden of 50
hours to retain these records.\754\ We therefore estimate that the
total annual burden for maintaining these records would be 191,550
hours.\755\ We also estimate that each fund would incur an annual time
cost of approximately $3,600, and a total annual time cost for all
funds of approximately $13,791,600.\756\ We estimate that there are no
external costs associated with this collection of information.
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    \753\ Proposed rule 18f-4(a)(6)(v).
    \754\ We assume for purposes of this estimate that funds would
implement automated processes for creating a written record of their
compliance with the qualifying coverage asset requirements and that
a fund would enter into at least one derivatives transaction per
trading day. Based on 250 trading days per year, and assuming 0.1
hours per trading day spent by a general clerk and 0.1 hours per
trading day spent by a senior computer operator, we estimate the
annual time cost to be (0.1 x 250) = 25 hours per year per fund for
each general clerk and senior computer operator.
    \755\ This estimate is based on the following calculations: 50
hours x 3,831 funds = 191,550 hours.
    \756\ This estimate is based on the following calculation: 25
hours x $57 (hourly rate for a general clerk) = $1,425; 25 hours x
$87 (hourly rate for a senior computer operator) = $2,175. $1,425 +
$2,175 = $3,600; $3,600 x 3,831 funds = $13,791,600.
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Estimated Total Burden
    Amortized over a three-year time period, the hour burdens and time
costs for collections of information associated with the asset
segregation requirement for derivatives transactions under proposed
rule 18f-4, including the burdens associated with (a) identifying
qualifying coverage assets; (b) documenting board-approved policies and
procedures; and (c) maintaining required records, are estimated to