with respect to various types of derivatives.\131\ We noted in the
Concept Release the concern that the segregated account approach, by
calling for an instrument-by-instrument assessment of the amount of
cover required, may create uncertainty about the treatment of new
products, and that new product development will inevitably lead to
circumstances in which available guidance does not specifically address
each new instrument subject to section 18 constraints.\132\
---------------------------------------------------------------------------

    \131\ See, e.g., ICI Concept Release Comment Letter, at 9 (``A
principles based approach is necessary because the SEC staff's
traditional instrument by instrument approach to guidance has
created, and would continue to create, regulatory uncertainty.'').
    \132\ See Concept Release, supra note 3, at n.79 and
accompanying text.
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    Under the current approach, different funds may treat the same kind
of derivative differently, based on their own application of our
staff's guidance and observation of industry practice, which at least
one commenter noted ``may unfairly disadvantage some funds.'' \133\
Where there is no specific guidance, or where the application of
existing guidance is unclear, funds may take approaches that involve a
more extensive use of derivatives and that may not address the purposes
and concerns underlying section 18 of the Act, as discussed above. The
lack of guidance addressing some derivatives may create competitive
pressures for funds to take approaches that involve a more extensive
use of derivatives. The current approach, having developed over time,
may treat similar derivatives in a manner that results in substantially
different amounts of segregated assets, and may itself influence funds'
investment decisions.\134\ The lack of comprehensive guidance also
makes it difficult for funds and our staff to evaluate and inspect for
funds' compliance with section 18. A number of commenters on the
Concept Release supported a more comprehensive and systematic approach,
rather than an approach in which we or our staff provide guidance on an
instrument-by-instrument basis, which these commenters generally
suggested would be less effective.\135\
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    \133\ See, e.g., Davis Polk Concept Release Comment Letter, at
1-2 (noting that ``funds and their sponsors may interpret the
available guidance differently, even when applying it to the same
instruments, which may unfairly disadvantage some funds'').
    \134\ See, e.g., ICI Concept Release Comment Letter, at n.19
(noting that funds segregate the notional amount of physically
settled futures contracts, consistent with the Dreyfus no-action
letter, while some funds disclose that they segregate only the
marked-to-marked obligation in respect of cash-settled futures and
agreeing with the concern reflected in the Concept Release that this
``results in differing treatment of arguably equivalent products'');
Davis Polk Concept Release Comment Letter, at 3 (noting that ``[t]he
current approach to segregation leaves many open questions and may
lead to inconsistent results for financially similar instruments,''
noting for example that very few funds use physically settled
futures contracts because staff guidance has applied the notional
segregation approach to these contracts and, ``[i]nstead, funds
enter into over-the-counter swaps that provide similar economic
exposure, even though swaps tend to be more expensive and present
other potential risks, such as counterparty risk and lack of
liquidity'').
    \135\ See, e.g., ICI Concept Release Comment Letter, at 9
(advocating for a principles-based approach and noting, among other
things, that ``the SEC staff's approach to date of providing
guidance with respect to specific types of instruments has created a
patchwork of interpretations that is neither practical nor
sustainable''); Davis Polk Concept Release Comment Letter, at 1
(noting that while guidance from the Commission and staff ``has been
helpful, it has not been able to keep pace with the dramatic
expansion of the derivatives market over the past twenty years, both
in terms of the types of instruments that are available and the
extent to which funds use them,'' and that resulting ``regulatory
uncertainty may lead a fund to select one type of instrument or
transaction over another for non-investment reasons, or to avoid
certain instruments or transactions altogether,'' which ``can lead
to inefficiencies that are detrimental to funds and their
shareholders''); BlackRock Concept Release Comment Letter, at 5
(``Any set of mechanical rules cannot take account of the diversity
of derivatives and the multiplicity of ways they may be used by
portfolio managers.''); Invesco Concept Release Comment Letter;
Loomis Concept Release Comment Letter; Comment Letter of American
Bar Association on Concept Release (Nov. 11, 2011) (File No. S7-33-
11) (``ABA Concept Release Comment Letter''), available at http://www.sec.gov/comments/s7-33-11/s73311-47.pdf; MFDF Concept Release
Comment Letter; Comment Letter of T. Rowe Price Associates, Inc. on
Concept Release (Nov. 7, 2011) (File No. S7-33-11) (``T. Rowe Price
Concept Release Comment Letter''), available at http://www.sec.gov/comments/s7-33-11/s73311-35.pdf; Vanguard Concept Release Comment
Letter.
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    A fund's use of derivatives may involve counterparty, liquidity,
leverage, market, and operational risks, as noted above. As we observed
in the Concept Release, ``[a] fund's use of derivatives presents
challenges for its investment adviser and board of directors to ensure
that the derivatives are employed in a manner consistent with the
fund's investment objectives, policies, and restrictions, its risk
profile, and relevant regulatory requirements, including those under
federal securities laws.'' \136\ In light of these considerations and
those we discuss in section III.D below, we believe that funds that
make significant use of derivatives, or that use certain complex
derivatives, should have formalized risk management programs to manage
the risks that derivatives may pose and to help address the challenges
and investor protection concerns presented by their use.\137\
---------------------------------------------------------------------------

    \136\ Concept Release, supra note 3, at 14. See also, e.g.,
Comment Letter of Capital Market Risk Advisors on Concept Release
(Nov. 1, 2011) (File No. S7-33-11), available at http://www.sec.gov/comments/s7-33-11/s73311-19.pdf (supporting risk management for
derivatives, but also for all more complex and less liquid
instruments).
    \137\ See, e.g., Oppenheimer Concept Release Comment Letter, at
3 (stating that ``a core component in the oversight of the use of
derivatives by funds should be the board's awareness of the controls
in place, and the effectiveness of the adviser's governance of risk
in maintaining this awareness'' and that ``[w]e believe it is
reasonable for the SEC to expect large and sophisticated investment
advisers to have in place a well-developed risk governance framework
incorporating an independent risk management function, governance
structures designed to ensure the comprehensive review by
appropriate levels of management of risk issues and reporting to a
fund's board designed to facilitate and enhance effective board
oversight'').

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III. Discussion

    As noted above, 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, led us to initiate a review of
funds' use of derivatives under the Investment Company Act. Based on
that review, including the considerations we discussed in section II.D
above and throughout this Release, we are today proposing rule 18f-4,
an exemptive rule designed to address the investor protection purposes
and concerns underlying section 18 and to provide an updated and more
comprehensive approach to the regulation of funds' use of derivatives
transactions and financial commitment transactions. This proposal is
part of a broader set of initiatives designed to address the
increasingly complex portfolio composition and operations of the asset
management industry.\138\
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    \138\ Other initiatives include modernizing investment company
reporting and disclosure and proposing liquidity risk management
programs for open-end funds, including exchange-traded funds. See
Investment Company Reporting Modernization, Investment Company Act
Release No. 31610 (May 20, 2015) [80 FR 33590 (June 12, 2015)]
(``Investment Company Reporting Modernization Release''); Amendments
to Form ADV and Investment Advisers Act Rules, Advisers Act Release
No. 4091 (May 20, 2015) [80 FR 33718 (June 12, 2015)]; Liquidity
Release, supra note 5.
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    Proposed rule 18f-4 would permit a fund to enter into derivatives
transactions, as defined in the rule, provided that the fund complies
with three primary sets of conditions of the rule designed to address
the purposes and concerns underlying section 18.\139\ First, the fund
would be required to 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. The first portfolio limitation would place an
overall limit on the amount of exposure (as defined in the rule) to
underlying reference assets, and potential leverage, that a fund would
be able to obtain through derivatives transactions and other senior
securities transactions by limiting the fund's exposure under these
transactions to 150% of the fund's net assets. The second portfolio
limitation would focus primarily on a risk assessment of the fund's use
of derivatives, and would permit a fund to obtain exposure in excess of
that permitted under the first portfolio limitation where the fund's
derivatives transactions, in aggregate, result in an investment
portfolio that is subject to less market risk than if the fund did not
use such derivatives, evaluated using a value-at-risk-based test.
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    \139\ The proposed rule would provide an exemption from certain
provisions of section 18 and 61 of the Act, subject to conditions.
The proposed rule could be used by any fund subject to the
requirements of section 18 or 61, including mutual funds, closed-end
funds, BDCs, most ETFs, and exchange-traded managed funds.
(Exchange-traded managed funds, a hybrid between a traditional
mutual fund and an ETF, are open-end funds that the Commission has
approved. See Eaton Vance Management, et al., Investment Company Act
Release Nos. 31333 (Nov. 6, 2014) (notice) and 31361 (Dec. 2, 2014)
(order)). The rule would not apply to unit investment trusts
(``UITs''), including ETFs structured as UITs, because UITs are not
subject to the requirements of section 18. However, as the
Commission has noted (in addressing futures contracts and
commodities options), derivatives transactions generally require a
significant degree of management and may not meet the requirements
imposed on a UIT by the Investment Company Act, including section
4(2) thereof. See section 4 of the Act; see also Custody Of
Investment Company Assets With Futures Commission Merchants And
Commodity Clearing Organizations, Investment Company Act Release No.
22389 (Dec. 11, 1996), at n.18 (explaining that UIT portfolios are
generally unmanaged).
---------------------------------------------------------------------------

    Second, the fund would be required to manage the risks associated
with the fund's derivatives transactions by maintaining an amount of
certain assets, defined in the proposed rule as ``qualifying coverage
assets,'' designed to enable the fund to meet its obligations under its
derivatives transactions. To satisfy this requirement the fund would be
required to maintain qualifying coverage assets to cover the fund's
mark-to-market obligations under a derivatives transaction, as well as
an additional amount, determined in accordance with policies and
procedures approved by the fund's board, designed to address potential
future losses and resulting payment obligations under the derivatives
transaction. The fund's qualifying coverage assets for its derivatives
transactions generally would be required to consist of cash and cash
equivalents.
    Third, except with respect to funds that engage in only a limited
amount of derivatives transactions and that do not use certain complex
derivatives transactions as defined in the proposed rule, the fund
would be required to establish a formalized derivatives risk management
program administered by a designated derivatives risk manager. The
derivatives risk management program requirement is designed to
complement the proposed rule's portfolio limitations and asset
segregation requirements applicable to every fund that engages in
derivatives transactions by requiring funds subject to the requirement
to adopt and implement a derivatives risk management program that
addresses the program elements specified in the rule, including the
assessment and management of the risks associated with the fund's
derivatives transactions. The program would be administered by a
derivatives risk manager designated by the fund and approved by the
fund's board of directors.
    The proposed rule also would permit a fund to enter into financial
commitment transactions, which include the trading practices we
described in Release 10666 and short sale borrowings, provided that the
fund complies with conditions requiring the fund to maintain qualifying
coverage assets equal in value to the fund's full obligations under its
financial commitment transactions. Because in many cases the timing of
the fund's payment obligations may be specified under the terms of a
financial commitment transaction or the fund may otherwise have a
reasonable expectation regarding the timing of the fund's payment
obligations with respect to its financial commitment transactions, a
fund relying on the proposed rule would be able to maintain as
qualifying coverage assets for a financial commitment transaction
assets that are convertible to cash or that generate cash prior to the
date on which the fund expects to be required to pay its obligations
under the transaction, determined in accordance with policies and
procedures approved by the fund's board of directors.\140\
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    \140\ A fund relying on the proposed rule would also be able to
maintain as qualifying coverage assets for a financial commitment
transaction fund assets 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.
---------------------------------------------------------------------------

    The proposed rule would supersede the guidance we provided in
Release 10666, as well as the guidance provided by our staff concerning
funds' use of derivatives and financial commitment transactions, which
we would rescind if we adopt the proposed rule.\141\
---------------------------------------------------------------------------

    \141\ See infra section III.I.
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A. Structure and Scope of Proposed Rule 18f-4

1. Structure of Proposed Rule 18f-4
    Proposed rule 18f-4, as summarized above, is designed both to
impose a limit on the leverage a fund relying on the rule may obtain
through derivatives transactions and financial commitment transactions,
and to require the fund to have qualifying coverage assets to meet its
obligations under those transactions, in order to address the undue
speculation concern expressed in

section 1(b)(7) and the asset sufficiency concern expressed in section
1(b)(8). We discuss in this section of the Release the structure and
general approach of proposed rule 18f-4, and discuss the scope of the
defined terms ``derivatives transactions'' and ``financial commitment
transactions'' in section III.A.2 below.
    As discussed in more detail in the sections that follow, in order
to rely on the exemption provided by proposed rule 18f-4 to enter into
derivatives transactions, a fund would be required to comply with one
of two alternative portfolio limitations and, separately, to maintain
qualifying coverage assets designed to enable the fund to meet its
obligations under those transactions and to require the fund to manage
the risks associated with those transactions. The proposed rule's
portfolio limitations are designed primarily to address concerns about
a fund's ability to obtain leverage through derivatives transactions,
whereas the proposed rule's requirements to maintain qualifying
coverage assets are designed primarily to address concerns about a
fund's ability to meet its obligations. We believe that this approach
for derivatives transactions--providing separate portfolio limitations
and asset segregation requirements--would be more effective than an
approach focusing only on asset segregation, particularly when it is
coupled with a formalized 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.
    We have determined to propose portfolio limitation and risk
management requirements for derivatives transactions, in addition to an
asset segregation requirement, because as discussed in section II.D
above, asset segregation alone in some cases may not provide a
sufficient limit on the amount of leverage a fund can obtain through
derivatives or sufficient assurances that a fund would have adequate
assets to meet its obligations arising under derivatives transactions.
The asset segregation approach described in Release 10666 achieved both
of these goals--limiting leverage and addressing availability of
assets--because that release contemplated that funds would segregate
high-quality liquid assets equal in value to the fund's full
obligations. A fund that segregated liquid assets equal to the purchase
price in a standby commitment agreement, for example, would be limited
in its ability to enter into standby commitment agreements because the
fund could not incur obligations under those agreements in excess of
the fund's available liquid assets; by segregating liquid assets equal
to the purchase price of the standby commitment agreement, the fund
would have assets available to meet its obligations under the
agreement.
    Although this approach appears to have addressed the concerns
underlying section 18 for the particular instruments described in
Release 10666 and is similar to the approach we are proposing today for
financial commitment transactions, applying it to derivatives
transactions by requiring funds to segregate the kinds of liquid assets
we described in Release 10666 equal in value to the full notional
amount of each derivative could in some cases require funds to hold
more liquid assets than may be necessary to address the investor
protection purposes and concerns underlying section 18. The notional
amount of a derivatives transaction does not necessarily equal, and
often will exceed, the amount of cash or other assets that a fund
ultimately would likely be required to pay or deliver under the
derivatives transaction. By addressing concerns related to a fund's
ability to obtain leverage through derivatives transactions primarily
through the proposed portfolio limitations and separately addressing
concerns related to a fund's ability to meets its derivatives
obligations primarily through the proposed requirements to maintain
qualifying coverage assets, the proposed rule is designed to address
each concern more directly, while still providing a flexible framework
that can be applied by funds to various types of derivatives as they
are developed in the marketplace.
    These requirements also would be complemented by the proposed
rule's risk management requirements, which would require funds that
engage in more than a limited amount of derivatives transactions or
that use certain complex derivatives transactions, as defined in the
proposed rule, to develop formalized risk management programs
reasonably designed to assess and manage the risk associated with those
transactions based on the fund's own facts and circumstances. This
requirement should serve to establish a standardized level of risk
management for funds that engage in more than a limited amount of
derivatives transactions or that use complex derivatives transactions.
2. Definitions of Derivatives Transactions and Financial Commitment
Transactions
    The proposed rule defines the term ``derivatives transaction'' to
mean any swap, security-based swap, futures contract, forward contract,
option, any combination of the foregoing, or any similar instrument
(``derivatives instrument'') under which a fund is or may be required
to make any payment or delivery of cash or other assets during the life
of the instrument or at maturity or early termination.\142\ This
definition is designed to describe those derivatives transactions that
in our view involve the issuance of a senior security, as discussed in
section II.B.4 above, because they involve a future payment obligation,
that is, an obligation or potential obligation of the fund to make
payments or deliver assets to the fund's counterparty.
---------------------------------------------------------------------------

    \142\ Proposed rule 18f-4(c)(2).
---------------------------------------------------------------------------

    The proposed rule's definition of ``derivatives transaction''
incorporates a list of derivatives instruments. We believe this list of
derivatives instruments, together with the proposed rule's inclusion of
``similar instruments,'' covers the types of derivatives that funds
currently use and that involve fund obligations that implicate section
18, and that this list is sufficiently comprehensive to include
derivatives that may be developed in the future.\143\ We believe that
this approach is preferable to having a more conceptual definition of
derivatives transaction, such as an instrument or contract whose value
is based upon, or derived from, some other asset or metric, which could
be too broad or more difficult to apply, in that it could be understood
to include or potentially include instruments or transactions that are
sometimes referred to as ``derivatives'' but which typically would not
be expected to implicate section 18.
---------------------------------------------------------------------------

    \143\ Title VII of the Dodd-Frank Act established a
comprehensive framework for the regulation of swaps and security-
based swaps. The definitions of these terms under section 1a of the
Commodity Exchange Act and section 3(a)(68) of Securities Exchange
Act, respectively, are detailed and expansive, and were designed to
encompass a wide range of derivatives, including those that could be
developed in the future.
---------------------------------------------------------------------------

    The proposed rule would define a ``financial commitment
transaction'' as any reverse repurchase agreement, short sale
borrowing, or any firm or standby commitment agreement or similar
agreement.\144\ This definition is designed to describe the trading
practices addressed in Release 10666, as well as short sales of
securities, for which the staff initially developed the

segregated account approach we applied in Release 10666. These
transactions involve a conditional or unconditional contractual
obligation to pay or deliver assets in the future and thus involve the
issuance of a senior security, as discussed in section II.B.4 of this
Release.
---------------------------------------------------------------------------

    \144\ Proposed rule 18f-4(c)(4).
---------------------------------------------------------------------------

    The proposed rule's definition of financial commitment transactions
includes firm and standby commitment agreements, which we addressed in
Release 10666,\145\ as well as any similar agreement.\146\ The rule
includes, as a similar agreement, an agreement under which a fund has
obligated itself, conditionally or unconditionally, to make a loan to a
company or to invest equity in a company, including by making a capital
commitment to a private fund that can be drawn at the discretion of the
fund's general partner.\147\ We understand that funds often refer to
these transactions as ``unfunded commitments.'' In these transactions,
as with respect to firm and standby commitment agreements, the fund has
incurred a conditional or unconditional contractual obligation to pay
or deliver assets in the future.
---------------------------------------------------------------------------

    \145\ See Release 10666, supra note 20, at ``Reverse Repurchase
Agreements,'' ``Firm Commitment Agreements,'' and ``Standby
Commitment Agreements'' discussions.
    \146\ Proposed rule 18f-4(c)(4).
    \147\ The definition would not include a transaction under which
a fund merely is required to deliver cash or assets as part of
regular-way settlement of a securities transaction (rather than a
forward-settling transaction or transaction in which settlement is
deferred). Cf. Release 10666, supra note 20, at n.11.
---------------------------------------------------------------------------

    The fund would be exposed to risks as a result of these
transactions in that the fund may be required to liquidate other assets
of the fund to obtain the cash needed by the fund to satisfy its
obligations, and if the fund is unable to meet its obligations, the
fund would be subject to default remedies available to its
counterparty. For example, if a fund fails to fulfill its commitments
to invest in a private fund when called to do so, the fund could be
subject to the remedies specified in the limited partnership agreement
(or similar document) relating to that private fund, which can include,
for example, a forfeiture of some or all of the fund's investment in
the private fund.\148\
---------------------------------------------------------------------------

    \148\ See, e.g., Phyllis A. Schwartz & Stephanie R. Breslow,
Private Equity Funds: Formation and Operation (June 2015 ed.), at 2-
34 (remedies private equity funds may apply in event of investor
default include, among other things, the right to charge high
interest on late payments, the right to force a sale of the
defaulting investor's interest, the right to continue to charge
losses and expenses to defaulting investors while cutting off their
interest in future profits, and the right to take any other action
permitted at law or in equity).
---------------------------------------------------------------------------

    The rule's definitions of the terms ``derivatives transactions''
and ``financial commitment transactions,'' discussed above, would
specify the types of transactions in which a fund would be permitted to
engage under the rule, subject to its conditions. Other senior
securities transactions that do not fall within either of these
definitions, such as borrowings from a bank by mutual funds or the
issuance of other debt securities or preferred equity by closed-end
funds or BDCs, could only be done pursuant to the requirements of
section 18 (or section 61 in the case of BDCs) or in accordance with
some other exemption, rather than proposed rule 18f-4.
    We request comment on all aspects of the proposed rule's
definitions of the terms ``derivatives transaction'' and ``financial
commitment transaction.''
     Is the definition of ``derivatives transaction''
sufficiently clear? Are there additional types of derivatives
instruments that we should include or any that we should exclude?
     The proposed rule's definition of the term derivatives
transactions is designed to describe those derivatives transactions
that would involve the issuance of a senior security. Do commenters
agree that this is an appropriate approach? Does the rule effectively
describe all of the types of derivatives transactions that would
involve the issuance of a senior security? The proposed rule's
definition of ``derivatives transaction'' incorporates a list of
derivatives instruments, rather than a conceptual definition such as an
instrument or contract whose value is based upon, or derived from, some
other asset or metric, because we believe that the definition's list of
derivatives instruments would more clearly describe the types of
derivatives that implicate section 18 than a conceptual definition. Do
commenters agree? Why or why not?
     The proposed rule would define a ``financial commitment
transaction'' as any reverse repurchase agreement, short sale
borrowing, or any firm or standby commitment agreement or similar
agreement. The proposed rule includes, as a similar agreement, an
agreement under which a fund has obligated itself, conditionally or
unconditionally, to make a loan to a company or to invest equity in a
company, including by making a capital commitment to a private fund
that can be drawn at the discretion of the private fund's general
partner. Do commenters agree with the scope of this definition? Are
these terms sufficiently clear? Do commenters agree that it is
appropriate to include these transactions?
     Are there additional types of transactions that we should
include in the definition of a ``financial commitment transaction''?
Adding additional transactions to the definition would permit the fund
to engage in those transactions by complying with the proposed rule,
rather than section 18 or 61. Are there transactions that we should
exclude from the definition and for which a fund should be required to
comply with the requirements of section 18 (to the extent permitted
under section 18), rather than the proposed rule's conditions?
     Our staff has expressed the view that a fund's loan of
portfolio securities may involve the issuance of a senior security in
light of the fund's obligation to return the collateral upon
termination of the loan and has expressed the view that ``a mutual fund
should not have on loan at any given time securities representing more
than one-third of its total asset value.'' \149\ Should we address
funds' compliance with section 18 in connection with securities lending
by, instead, including a fund's obligation to return securities lending
collateral as a financial commitment transaction? Alternatively, should
we require a fund to include the obligation to return securities
lending collateral for purposes of the proposed rule's exposure limits,
as discussed in more detail in section III.B? Or does the current
approach under which funds do not have on loan at any given time
securities representing more than one-third of the funds' total assets,
together with other guidance from our staff concerning securities
lending by funds, effectively address the senior security implications
of securities lending such that we should not address securities
lending in the proposed rule? Which approach would be most appropriate
and why?
---------------------------------------------------------------------------

    \149\ See, e.g., The Brinson Funds, SEC Staff No-Action Letter
(Nov. 25, 1997), available at https://www.sec.gov/divisions/investment/noaction/1997/brinsonfunds112597.pdf (stating that,
``[a]s a general matter, securities lending arrangements are
regulated under Section 17(f) of the Investment Company Act of 1940,
which governs custody arrangements,'' but that ``[t]he staff has
stated that a fund's loan of portfolio securities may involve the
issuance of a senior security in light of the fund's obligation to
return the collateral upon termination of the loan'').
---------------------------------------------------------------------------

     The proposed rule would permit a fund to enter into a
derivatives transaction or financial commitment transaction,
notwithstanding the requirements of section 18 or 61 of the Act, if the
fund complies with the rule's conditions. Are there other rules or
forms we should consider modifying if

we adopt the proposed rule? Should we, for example, amend Form N-2 to
provide that funds required to file on that form should not include
derivatives transactions and financial commitment transactions in the
senior securities table? Are there other aspects of our rules and forms
that we should consider amending if we were to adopt the proposed rule?
If so, which rules and form items and why?
     Should any final rule address, or should we provide
guidance concerning, funds' compliance with other aspects of section 18
in connection with funds' use of derivatives transactions or financial
commitment transactions? For example, because the proposed rule would
permit a fund to enter into derivatives transactions and financial
commitment transactions notwithstanding section 18(a)(1) and section
18(f)(1), a fund relying on the proposed rule would not be required to
comply with section 18's 300% asset coverage requirement (or section
61's 200% asset coverage requirement) with respect to such
transactions.\150\ Should we, however, address in any final rule or
provide guidance concerning the application of the asset coverage
requirements under section 18 or 61 when a fund also enters into senior
securities transactions in reliance on section 18 or 61 (such as bank
borrowings or, in the case of a closed-end fund or BDC, the issuance of
senior debt or preferred stock)? When a fund is calculating asset
coverage under section 18(h) for senior securities transactions
permitted by section 18 or 61, how should the fund treat its
derivatives transactions or financial commitment transactions? When
determining the ``aggregate amount of senior securities representing
indebtedness,'' how should the fund treat any liabilities and
indebtedness associated with the fund's derivatives transactions and
financial commitment transactions? Currently, when funds are
determining the amount of their liabilities and indebtedness and the
amount of their senior securities for purposes of calculations under
section 18(h), are funds determining these amounts in accordance with
U.S. generally accepted accounting principles? Should a fund also
include any liabilities and indebtedness associated with derivatives
transactions and financial commitment transactions based on U.S.
generally accepted accounting principles? Alternatively, should a fund
treat any liabilities and indebtedness for these transactions as
``liabilities and indebtedness not represented by senior securities''?
What approach would be appropriate and why?
---------------------------------------------------------------------------

    \150\ ``Asset coverage'' of a class of securities representing
indebtedness of an issuer generally is defined in section 18(h) of
the Investment Company Act as ``the ratio which the value of the
total assets of such issuer, less all liabilities and indebtedness
not represented by senior securities, bears to the aggregate amount
of senior securities representing indebtedness of such issuer.'' See
supra note 34.
---------------------------------------------------------------------------

     Is there any guidance we should provide concerning funds'
compliance with other provisions of the Investment Company Act in
connection with funds' use of derivatives transactions or financial
commitment transactions in reliance on the proposed rule?

B. Portfolio Limitations for Derivatives Transactions

    The proposed rule would require a fund that engages in derivatives
transactions in reliance on the rule to comply with one of two
alternative portfolio limitations.\151\ As explained in more detail
below, under the first portfolio limitation (the ``exposure-based
portfolio limit''), a fund generally would be required to limit its
aggregate exposure to 150% of the fund's net assets. A fund's
``exposure'' for this purpose generally would be calculated as the
aggregate notional amount of its derivatives transactions, together
with its obligations under financial commitment transactions and other
senior securities transactions. The second portfolio limitation (the
``risk-based portfolio limit'') would permit a fund to obtain exposure
in excess of that permitted under the exposure-based portfolio limit
where the fund's derivatives transactions, in aggregate, result in an
investment portfolio that is subject to less market risk than if the
fund did not use such derivatives, evaluated using a test based on
value-at-risk (``VaR''). A fund electing the risk-based portfolio limit
generally would be required to limit its exposure under derivatives
transactions, financial commitment transactions, and other senior
securities transactions to 300% of the fund's net assets. As discussed
below, these portfolio limitations are designed primarily to address
the undue speculation concern expressed in section 1(b)(7) by imposing
an overall limit on the amount of exposure to underlying reference
assets, and potential leverage, that a fund would be able to obtain
through derivatives and other senior securities transactions, while
also providing flexibility for a fund to use derivatives for a variety
of purposes.\152\
---------------------------------------------------------------------------

    \151\ Proposed rule 18f-4(a)(1).
    \152\ The proposed rule's portfolio limitations, although
designed to impose a limit on potential leverage, also could help to
address concerns about a fund's ability to meet its obligations. As
noted above, the use of derivatives for leveraging purposes can
exacerbate the risk that losses on the derivatives, and resulting
payment obligations imposed on the fund, can force the fund's
adviser to sell the fund's investments to generate liquid assets in
order for the fund to meet its obligations. The proposed rule would
directly address concerns about a fund's ability to meet its
obligations under its derivatives transactions primarily through the
proposed rule's requirements to maintain qualifying coverage assets,
as discussed below in section III.C.
---------------------------------------------------------------------------

1. Exposure-Based Portfolio Limit
a. Overview
    The first portfolio limit would be based on the fund's overall
exposure to: (1) Derivatives transactions, (2) financial commitment
transactions, and (3) other transactions involving a senior security
entered into by the fund pursuant to section 18 or 61 of the Act
without regard to the exemption that would be provided by the proposed
rule (i.e., senior securities transactions engaged in by a fund in
reliance on the requirements of those provisions, rather than in
reliance on the exemption that would be provided by the proposed
rule).\153\ The proposed rule would collectively define these
transactions as ``senior securities transactions.'' \154\ A fund that
relies on the exposure-based portfolio limit would be required to
operate so that its aggregate exposure under senior securities
transactions, measured immediately after entering into any such
transaction, does not exceed 150% of the fund's net assets.\155\
---------------------------------------------------------------------------

    \153\ Proposed rule 18f-4(a)(1)(i); proposed rule 18f-4(c)(10)
(defining the term ``senior securities transaction'' to mean any
derivatives transaction, financial commitment transaction, or any
transaction involving a senior security entered into by the fund
pursuant to section 18 or 61 of the Act without regard to the
exemption provided by the proposed rule).
    \154\ Proposed rule 18f-4(c)(10).
    \155\ Proposed rule 18f-4(a)(1)(i). As discussed below in
section III.B.2, the risk-based portfolio limit also includes an
outside limit on a fund's exposure. A fund's exposure for purposes
of the risk-based portfolio limit would be calculated as described
in this section of the Release, but the exposure limit would be 300%
of the fund's net assets rather than 150%. Proposed rule 18f-
4(a)(1)(ii).
---------------------------------------------------------------------------

    The exposure-based portfolio limit is designed to impose an overall
limit on the amount of exposure, and thus the amount of potential
leverage, that a fund would be able to obtain through derivatives and
other senior securities transactions. We discuss and seek comment below
on the exposure-based portfolio limit, including the proposed rule's
method of calculating a fund's exposure and the rule's limitation of
exposure to 150% of the fund's net assets.

b. Calculation of Exposure
    The proposed rule would define a fund's ``exposure'' as the sum of:
(1) The aggregate notional amounts of the fund's derivatives
transactions, subject to certain adjustments discussed below; (2) the
aggregate obligations of the fund under its financial commitment
transactions; and (3) the aggregate indebtedness (and with respect to
any closed-end fund or business development company, involuntary
liquidation preference) with respect to any other senior securities
transactions entered into by the fund pursuant to section 18 or 61 of
the Investment Company Act.\156\ We discuss each aspect of this
definition below.
---------------------------------------------------------------------------

    \156\ Proposed rule 18f-4(c)(3).
---------------------------------------------------------------------------

i. Exposure for Derivatives Transactions
1. Determination of Notional Amounts
    Under the proposed rule, a fund's exposure would include the
aggregate notional amounts of its derivatives transactions.\157\ The
proposed rule would generally define the ``notional amount'' of a
derivatives transaction, subject to certain adjustments required by the
rule (discussed below), as the market value of an equivalent position
in the underlying reference asset for the derivatives transaction, or
the principal amount on which payment obligations under the derivatives
transaction are calculated.\158\
---------------------------------------------------------------------------

    \157\ Proposed rule 18f-4(c)(3)(i) (defining ``exposure'').
    \158\ Proposed rule 18f-4(c)(7) (defining ``notional amount'').
---------------------------------------------------------------------------

    We believe that, although derivatives vary widely in terms of
structure, asset class, risks and potential uses, for most types of
derivatives the notional amount generally serves as a measure of the
fund's economic exposure to the underlying reference asset or
metric.\159\ A total return swap, for example, can provide economic
exposure equivalent to a long or short position in the reference asset
for the swap. Similarly, a fund can sell or buy a CDS to obtain
exposure similar to a long or short position in the credit risk of an
issuer of a fixed-income security. We also note that notional amounts
are used in numerous other regulatory regimes as a means of determining
the scale of the derivatives activities of market participants.\160\ We
also believe that the definition of notional amount under the proposed
rule is consistent with the way the term ``notional amount'' (or in
some cases ``notional value'') generally is used with respect to
derivatives transactions.\161\
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    \159\ Derivatives may be broadly described as instruments or
contracts whose value is based upon, or derived from, an underlying
reference asset (see supra at text preceding note 8). The notional
amount generally serves a measure of the underlying economic
exposure because it reflects the value of the underlying reference
asset for that derivative or the amount of the underlying reference
asset on which payment obligations are based.
    \160\ See, e.g., Margin and Capital Requirements for Covered
Swap Entities, 80 FR 74839 (Nov. 30, 2015) (``Prudential Regulator
Margin and Capital Adopting Release''); Margin Requirements for
Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 FR
59898 (Oct. 3, 2014) (``CFTC Margin Proposing Release'') (defining
``material swaps exposure'' by reference to average daily aggregate
notional amounts of derivatives transactions). See also Further
Definition of ``Swap Dealer,'' ``Security-Based Swap Dealer,''
``Major Swap Participant,'' ``Major Security-Based Swap
Participant'' and ``Eligible Contract Participant,'' Exchange Act
Release No. 66868 (Apr. 27, 2012) [77 FR 30596 (May 23, 2012)]
(``Swap Dealer/Major Swap Participant Release''), at section II.D
(discussing use of notional amounts as basis for de minimis
exemption to swap dealer registration requirements). See also CFTC
regulations 4.5(c)(ii)(3)(b) and 4.13(a)(3)(ii)(B) (exclusion from
definition of commodity pool operator and exemption from commodity
pool operator registration requirement, respectively, in respect of
certain pools whose commodity interest positions do not exceed 100%
of the liquidation value of the pool's portfolio). See also infra
section IV.E (discussing use of notional amounts under UCITS
regulatory regime).
    \161\ For example, ``notional value'' with respect to futures
has been defined as ``the underlying value (face value), normally
expressed in U.S. dollars, of the financial instrument or commodity
specified in a futures or options on futures contract.'' See CME
Group Glossary, available at http://www.cmegroup.com/education/glossary.html. `` `Notional principal' or `notional amount' of a
derivative contract is a hypothetical underlying quantity upon which
interest rate or other payment obligations are computed.'' ISDA
Online Product Descriptions and Frequently Asked Questions,
available at http://www.isda.org/educat/faqs.html#7. The Bank for
International Settlements describes ``notional amounts outstanding''
as ``a reference from which contractual payments are determined in
derivatives markets.'' Guide to the International Financial
Statistics, Bank for International Settlements (July 2009) (``BIS
Guide''), available at http://www.bis.org/statistics/intfinstatsguide.pdf, at 31. See also 2010 ABA Derivatives Report,
supra note 70, at n.11 (noting that the term ``notional amount'' is
used differently by different people in different contexts, but is
used, in the Report, to refer to ``the nominal or face amount that
is used to calculate payments made on a particular instrument,
without regard to whether its obligation under the instrument could
be netted against the obligation of another party to pay the fund
under the instrument'').
---------------------------------------------------------------------------

    Table 1 below sets forth a list of different types of derivatives
transactions that are commonly used by funds, together with the method
by which we understand a fund, for risk management, reporting or other
purposes, typically would calculate the transaction's notional amount.
We believe that the proposed rule's definition of notional amount
generally would allow a fund to use the calculation methods below to
determine the notional amounts of such derivatives transactions (before
applying any of the adjustments discussed below) for purposes of
calculating the fund's exposure under the proposed rule.\162\
---------------------------------------------------------------------------

    \162\ The methods for determining the notional amounts in the
table are similar to those required to be used by UCITS funds that
follow the commitment approach (discussed further below in section
IV.E. See European Securities and Markets Authority (formerly
Committee of European Securities Regulators), Guidelines on Risk
Measurement and the Calculation of Global Exposure and Counterparty
Risk for UCITS, CESR/10-788 (July 28, 2010) (``CESR Global
Guidelines''), available at http://www.esma.europa.eu/system/files/10_788.pdf.

                                                     Table 1
----------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
Forwards:
    FX forward...................................................  Notional contract value of currency leg(s).
    Forward rate agreement.......................................  Notional principal amount.
Futures:
    Treasury futures.............................................  Number of contracts * notional contract size
                                                                    * (futures price * conversion factor +
                                                                    accrued interest).
    Interest rate futures........................................  Number of contracts * contract unit (e.g.,
                                                                    $1,000,000).
    FX futures...................................................  Number of contracts * notional contract size
                                                                    (e.g., 12,500,000 Japanese yen).
    Equity index futures.........................................  Number of contracts * contract unit (e.g.,
                                                                    $50 per index point) * futures index level.
    Commodity futures............................................  Number of contracts * contract size (e.g.,
                                                                    1,000 barrels of oil) * futures price.
    Options on futures...........................................  Number of contracts * contract size * futures
                                                                    price * underlying delta.\163\
Swaps:
    Credit default swap..........................................  Notional principal amount or market value of
                                                                    underlying reference asset.
    Standard total return swap...................................  Notional principal amount or market value of
                                                                    underlying reference asset.
    Currency swap................................................  Notional principal amount.
    Cross currency interest rate swaps...........................  Notional principal amount.
Standardized Options:

    Security options.............................................  Number of contracts * notional contract size
                                                                    (e.g., 100 shares per option contract) *
                                                                    market value of underlying equity share *
                                                                    underlying delta.
    Currency options.............................................  Notional contract value of currency leg(s) *
                                                                    underlying delta.
    Index options................................................  Number of contracts * notional contract size
                                                                    * index level * underlying delta.
----------------------------------------------------------------------------------------------------------------

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

    \163\ Delta refers to the ratio of change in the value of an
option to the change in value of the asset into which the option is
convertible. The delta-adjusted notional value of options is needed
to have an accurate measurement of the exposure that an option
creates to the underlying reference asset. See, e.g., Comment Letter
of Morningstar, Inc. on Concept Release (Nov. 7, 2011) (File No. S7-
33-11) (``Morningstar Concept Release Comment Letter''), available
at http://www.sec.gov/comments/s7-33-11/s73311-23.pdf, at 2.
---------------------------------------------------------------------------

    Although we believe that the notional amount generally serves as a
measure of the fund's exposure to the underlying reference asset or
metric,\164\ we recognize that a derivative's notional amount does not
reflect the way in which the fund uses the derivative and that the
notional amount is not a risk measure. An exposure-based test based on
notional amounts therefore could be viewed as a relatively blunt
measurement in that different derivatives transactions having the same
notional amount but different underlying reference assets--for example,
an interest rate swap and a credit default swap having the same
notional amount--may expose a fund to very different potential
investment risks and potential payment obligations.\165\ We also
recognize that there are other approaches to evaluating leverage
associated with a fund's derivatives activities, including approaches
that disregard or subtract the notional value of hedging transactions
from the calculation of a fund's exposure.\166\ Leverage can be
calculated in numerous ways, however, and the appropriateness of a
particular leverage metric may depend on various considerations, such
as a fund's strategy and types of investments, and the specific
leverage-related risks that are being considered.\167\ On balance, we
believe that, for purposes of the proposed rule, a notional amount
limitation would be a more effective and administrable means of
limiting potential leverage from derivatives than a limitation which
relies on other leverage measures that may be more difficult to adapt
to different types of fund strategies or different uses of derivatives,
including types of fund strategies and derivatives that may be
developed in the future.
---------------------------------------------------------------------------

    \164\ See supra notes 158-160.
    \165\ While credit default swaps are often considered riskier
than typical interest rate or currency derivatives, the staff has
observed that even ``plain vanilla'' interest rate and currency
derivatives can lead to significant losses for funds. See, e.g.,
Katherine Burton, Swiss Franc Trade Is Said to Wipe Out Everest's
Main Fund, Bloomberg (Jan. 18, 2015), available at http://www.bloomberg.com/news/articles/2015-01-17/swiss-franc-trade-is-said-to-wipe-out-everest-s-main-fundv (noting significant and
widespread losses following the Swiss National Bank's decision to
decouple the Swiss franc from the euro).
    \166\ See infra section III.B.1.d.
    \167\ See, e.g., An Overview of Leverage, AIMA Canada (Oct.
2006) (``An Overview of Leverage''), available at http://www.aima.org/filemanager/root/site_assets/canada/publications/strategy_paper_-_leverage.pdf (distinguishing between financial,
construction and instrument leverage and describing the measurement
of leverage using gross market exposure vs. net market exposure).
See also Off-Balance-Sheet Leverage IMF Working Paper, supra note 79
(discussing means of measuring leverage in various types of
derivatives and other off-balance-sheet transactions). See also Ang,
Gorovyy & Inwegen, supra note 72 (discussing differences among gross
leverage, net leverage and long-only leverage calculations, as
applied to long-only, dedicated long-short, general leveraged and
dedicated short funds). See also Comment Letter of BlackRock, Inc.
on Investment Company Reporting Modernization (Aug. 11, 2015) (File
No. S7-08-15) (``BlackRock Modernization Comment Letter''),
available at http://www.sec.gov/comments/s7-08-15/s70815-318.pdf. In
the BlackRock Reporting Modernization Comment Letter, the commenter
proposed a high-level framework for an approach to measuring
economic leverage that could potentially be applied across different
types of funds and investment strategies, using comprehensive
analysis of multiple different types of risk exposures.
---------------------------------------------------------------------------

    The proposed rule would allow a fund operating under the exposure-
based portfolio limit to have exposure of up to 150% of the fund's net
assets (i.e., more than the fund's net assets) in recognition of the
various ways in which funds may use derivatives. The 150% limit,
discussed in more detail below, is designed to balance concerns about
the limitations of an exposure measurement based on notional amounts
with the benefits of using notional amounts, such as the ability of
funds to readily determine the notional amounts of their derivatives
transactions and the expectation that notional amounts can generally
serve as a measure of the size of a fund's exposure to underlying
reference assets or metrics, as discussed above.
    We believe that, for purposes of the exposure-based portfolio
limit, 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 than a test that would require
consideration of the manner in which a fund uses derivatives in its
portfolio (e.g., for hedging).\168\ The rule seeks to achieve a balance
between providing flexibility regarding the use of derivatives while
limiting the potential risks associated with leverage by, in addition
to the exposure limits in the proposed rule, conditioning the rule's
exemptive relief on other requirements, such as the asset coverage
requirements discussed in section III.C below and, if applicable, the
derivatives risk management program requirements discussed in section
III.D below, which must be tailored in light of the fund's particular
strategy and other characteristics.
---------------------------------------------------------------------------

    \168\ See infra section III.B.1.d.
---------------------------------------------------------------------------

    Although we believe that an exposure test that focuses on limiting
the aggregate notional amounts of funds' derivatives transactions is an
appropriate means of limiting leverage, in some cases, the notional
amount for a derivatives transaction may not produce a measure of
exposure that we believe would be appropriate for purposes of the
proposed rule's exposure limitations. The proposed rule therefore
includes three provisions relating to the calculation of exposure in
respect of certain types of derivatives transactions for which we
believe that an adjusted notional amount would better serve as a
measure of a fund's investment exposure for purposes of the rule.
    First, for derivatives that provide a return based on the leveraged
performance of an underlying reference asset, the rule would require
the notional amount to be multiplied by the applicable leverage
factor.\169\ Thus, for example, the rule would require a total return
swap that has a notional amount of $1 million and provides a return
equal to three times the performance of an equity index to be treated
as having a notional amount of $3 million. Absent this provision, a
fund could enter into a derivative with a stated notional amount that
did not reflect the magnitude of the fund's leveraged investment
exposure under the derivative.\170\ Such a transaction, if not

measured based on the leverage inherent in the derivative instrument,
could otherwise provide a means of structuring transactions to avoid
the proposed rule's exposure limitations.
---------------------------------------------------------------------------

    \169\ Proposed rule 18f-4(c)(7)(iii)(A).
    \170\ A similar requirement applies to the determination of de
minimis thresholds for swap dealer and security-based swap dealer
registration. See Swap Dealer/Major Swap Participant Release, supra
note 160, at n.427 and accompanying text (stating that, for purposes
of the de minimis threshold for registration of swap dealers,
``notional standards will be based on `effective notional' amounts
when the stated notional amount is leveraged or enhanced by the
structure of the swap or security-based swap'').
---------------------------------------------------------------------------

    Second, the proposed rule includes a ``look-through'' for
calculating the notional amount in respect of derivatives transactions
for which the underlying reference asset is a managed account or entity
formed or operated primarily for the purpose of investing in or trading
derivatives transactions, or an index that reflects the performance of
such a managed account or entity.\171\ We understand that some funds,
including funds that engage in managed futures or foreign currency
strategies, obtain their investment exposures for such strategies by
entering into a swap that references the performance of a managed
account or entity, which in turn is managed on a discretionary basis by
a third-party trading manager (such as a commodity trading advisor).
Such swaps can be used by a fund to obtain a return that is
economically nearly identical to a direct investment by the fund in the
derivatives traded by the third-party trading manager for the managed
account or entity.\172\ Absent a look-through to the derivatives
transactions of the underlying reference vehicle, such structures could
be used to avoid the exposure limitations that would be applicable
under the proposed rule if the fund directly owned the managed account
or securities issued by the reference entity.\173\ Accordingly, for
such derivatives transactions, the rule would require a fund to
calculate the notional amount by reference to the fund's pro rata
portion of the notional amounts of the derivatives transactions of the
underlying reference vehicle, which in turn must be calculated in a
manner consistent with the requirements of the proposed rule.\174\ The
provision thus would apply to transactions such as swaps on pooled
investment vehicles that are formed or operated primarily for the
purpose of investing in or trading derivatives transactions, which
could include hedge funds, managed futures funds and leveraged ETFs, in
order to prevent a fund from entering into a leveraged swap on the
performance of shares or other interests issued by such vehicles and
thereby indirectly obtain leverage in excess of what the rule would
permit a fund to obtain directly.
---------------------------------------------------------------------------

    \171\ Proposed rule 18f-4(c)(7)(iii)(B). The managed account or
interests in the entity may be owned by the fund's counterparty
(e.g., a swap dealer), which hedges its obligations under the
derivative through its ownership of such account or interests. In
some cases, the derivative contract may describe the reference asset
as an index comprising the performance of transactions
``notionally'' entered into by the trading manager, or the
``notional'' performance of an index comprising the managed account
or entity together with cash and/or other positions. The proposed
rule's ``look-through'' for calculating notional amounts thus
applies to derivatives transactions for which the underlying
reference asset is a managed account or entity formed or operated
primarily for the purpose of investing in or trading derivatives
transactions, as well as an index that reflects the performance of
such a managed account or entity. Id.
    \172\ Some funds appear to use these swaps in such a way that
nearly all of the fund's investment exposure is indirectly
attributable to the derivatives traded by the third-party manager
for the underlying managed account or entity, while the fund's
direct investments (other than the swap) are limited to cash and
cash equivalents.
    \173\ For example, a fund might enter into a swap having a
notional value of $10, corresponding to the value of an equity
security issued by a trading entity. The fund's counterparty could
then invest $10 in the trading entity, which in turn could use these
funds as margin or collateral for leveraged futures or currency
forward transactions having a much larger aggregate notional amount,
e.g., $100. Proposed rule 18f-4(c)(7)(iii)(B) would require the fund
to treat the swap in this example as having a notional amount of
$100 rather than $10.
    \174\ Thus, for example, if a fund enters into a swap on the
performance of a trading entity that, in turn, enters into a swap
that provides a return based on the leveraged performance of an
equity index, the notional amount of the equity index would need to
be multiplied by the applicable leverage factor, consistent with the
method set forth in proposed rule 18f-4(c)(7)(iii)(A), for purposes
of calculating the fund's pro rata share of the notional amounts of
the trading entity's derivatives transactions in accordance with
proposed rule 18f-4(c)(7)(iii)(B).
---------------------------------------------------------------------------

    Third, the proposed rule contains specific provisions for
calculating the notional amount for certain defined complex derivatives
transactions. As explained further below, the proposed rule includes
these provisions because, for complex derivatives transactions, the
notional amounts of such transactions determined without regard to
these specific provisions may not serve as an appropriate measure of
the underlying market exposure obtained by a fund.
    The proposed rule would define a complex derivatives transaction as
any derivatives transaction for which the amount payable by either
party upon settlement date, maturity or exercise: (1) Is dependent on
the value of the underlying reference asset at multiple points in time
during the term of the transaction; or (2) is a non-linear function of
the value of the underlying reference asset, other than due to
optionality arising from a single strike price.\175\ We address each of
these provisions below.
---------------------------------------------------------------------------

    \175\ See proposed rule 18f-4(c)(1) (defining ``complex
derivatives transaction'') and proposed rule 18f-4(c)(7)(iii)(C)
(describing the method for calculating the notional amount for a
complex derivatives transaction for purposes of the proposed rule).
---------------------------------------------------------------------------

    The first type of complex derivatives transaction is a derivatives
transaction for which the amount payable by either party upon
settlement date, maturity or exercise is dependent on the value of the
underlying reference asset at multiple points in time during the term
of the transaction.\176\ This provision is designed to capture
derivatives whose payouts are path dependent, i.e., the payouts depend
on the path taken by the value of the underlying asset during the term
of the transaction. Many types of non-standard options exhibit path
dependency.\177\ An example of a path dependent derivative would be a
barrier option. Barrier options (also known as knock-in or knock-out
options) have a payoff that is contingent on whether the price of the
underlying asset reaches some specified level prior to expiration.\178\
Another example would be an Asian option, which has a payoff that
depends on the average value of the underlying asset from inception
until expiration.\179\ By contrast, a standard put or call option
having a single strike price would not be a complex derivatives
transaction under this provision of the definition, because the payout
of a standard put or call option depends on the value of the reference
asset only upon exercise, i.e., at a single point rather than multiple
points in time during the term of the transaction.
---------------------------------------------------------------------------

    \176\ See proposed rule 18f-4(c)(1)(i).
    \177\ See Paul Wilmott, Paul Wilmott on Quantitative Finance
(2nd ed. 2006) (``Wilmott''), at 371 (options that ``have payoffs
that depend on the path taken by the underlying asset, and not just
the asset's value at expiration . . . are called path dependent.''
See also CESR Global Guidelines, supra note 162, at 12 (noting that
``[c]ertain derivative instruments exhibit risk characteristics that
mean the standard conversion approach is not appropriate as it does
not adequately capture the inherent risks relating to this type of
product. Some derivatives, for example, may exhibit path-dependency,
such features emphasising the need to have both robust models for
risk management and pricing purposes, but also to reflect their
complexity in the commitment calculation methodology'').
    \178\ Wilmott, supra note 177, at 371.
    \179\ Id. A third example would be an option with a lookback
feature, which has a payoff that depends on whether a maximum or
minimum value of the underlying asset occurred during some period
prior to expiration. A lookback call option, for example, pays at
settlement the difference between the final asset price and the
lowest price of the asset observed during the term of the option.
Because the payoff is contingent on two prices--the final asset
price and the lowest observed price--a lookback call option would be
a complex derivatives transaction. See id. at 383; see also Robert
Whaley, Derivatives: Markets, Valuation, and Risk Measurement (2006)
(``Whaley''), at 291.
---------------------------------------------------------------------------

    The second type of complex derivatives transaction is a derivatives
transaction for which the amount

payable by either party upon settlement date, maturity or exercise is a
non-linear function of the value of the underlying reference asset,
other than due to optionality arising from a single strike price.\180\
Most types of derivatives traded on an exchange or with standardized
terms (other than exchange-traded or standardized options) involve
payment amounts between the parties that change on a dollar-for-dollar
basis tracking changes in the value of the underlying reference asset.
We refer to these calculations under relatively standardized terms as
involving a linear function of the value of the underlying reference
assets. An example of a ``non-linear'' derivatives transaction that
would be a complex derivatives transaction under this provision of the
definition would be a variance swap. A variance swap is an instrument
that allows investors to profit from the difference between the current
implied volatility and future realized volatility of an asset; however,
the payoff for a variance swap is a function of the difference between
current implied variance and future realized variance of the
asset.\181\ Because variance is the square of volatility, the payment
obligations under a variance swap are non-linear.\182\
---------------------------------------------------------------------------

    \180\ See proposed rule 18f-4(c)(1)(ii).
    \181\ See, e.g., Sebastien Bossu, Introduction to Variance
Swaps, Wilmott Magazine, available at http://www.wilmott.com/pdfs/111116_bossu.pdf, at 50-51.
    \182\ See, e.g., Peter Allen, Stephen Eincomb & Nicolas Granger,
Variance Swaps, JPMorgan Investment Strategies: No. 28 (Nov. 17,
2006), at 11 (noting that ``variance swap strikes are quoted in
terms of volatility, not variance; but pay out based on the
difference between the level of variance implied by the strike (in
fact the strike squared) and the subsequent realised variance'').
---------------------------------------------------------------------------

    This second provision of the definition of complex derivatives
transaction includes a carve-out that would exclude derivatives for
which payout upon settlement date, maturity or exercise is non-linear
due to optionality arising from a single strike price. This exception
is designed to exclude standard put or call options from the complex
derivatives transaction definition, which would otherwise be captured
because their payout is non-linear. For example, the payout for a
standard cash-settled written call option is either equal to zero (if
the price of the underlying asset at maturity is less than or equal to
the strike price) or equal to the difference between the value of the
underlying asset and the strike price (if the price of the underlying
asset at maturity is greater than the strike price), and is therefore
non-linear. We believe that it is unnecessary to treat standard put and
call options as complex derivatives transactions because the method for
determining the notional amount for such derivatives, i.e., the market
value of the underlying asset multiplied by its delta, serves as an
appropriate measure of a fund's exposure for purposes of the rule
because it generally would result in a notional amount that reflects
the market value of an equivalent position in the underlying reference
asset for the derivatives transaction.\183\
---------------------------------------------------------------------------

    \183\ See, e.g., Mark Rubinstein & Hayne E. Leland, Replicating
Options with Positions in Stock and Cash, 51 Financial Analysts J.
113 (Jan./Feb. 1995) (demonstrating how a long or short position in
a standard put or call can be replicated by holding a long or short
position in a number of shares of the underlying stock corresponding
to the option's delta, which would have a value equal to the option
delta multiplied by the underlying stock price).
---------------------------------------------------------------------------

    The proposed rule would include a special provision for calculating
the notional amount of complex derivatives transactions for purposes of
determining a fund's exposure.\184\ This provision is designed to
address two primary concerns. The first is that the notional amount for
some complex derivatives, if determined without regard to this
provision, may not appropriately reflect the fund's underlying market
exposure for purposes of the portfolio limitation. For example, the
notional amount of a variance swap is typically expressed in terms of
``vega notional,'' i.e., a measure of volatility. This vega notional
amount is used to calculate the payout for a variance swap, but it does
not correspond to the market value or principal amount of a reference
asset that can appropriately be compared against a fund's net assets
for purposes of the exposure-based portfolio limit.\185\ A second
concern is that complex derivatives can have market risks that are
difficult to estimate due to the presence of multiple forms of
optionality or other non-linearities, which similarly may not be
adequately reflected in a notional amount calculated without separately
considering each of the risks as with the special provision in the
proposed rule for complex derivatives transactions.\186\
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    \184\ Proposed rule 18f-4(c)(7)(iii)(C).
    \185\ For example, a fund that invests in a total return swap on
an equity index having a notional amount of $100 can be said to have
exposure similar to a $100 investment in the index components. By
contrast, it is not possible to draw a comparison between the
notional amount of a variance swap on the same equity index and a
direct investment in the index components.
    \186\ The UCITS Commitment Approach Guidelines express a similar
concern. See CESR Global Guidelines, supra note 162, at 12 (noting
that a common feature of non-standard derivatives is ``the existence
of a highly volatile delta which could, for example, result in
significant losses'' and therefore ``many of these instruments will
need to be assessed on a case by case basis'').
---------------------------------------------------------------------------

    The proposed rule seeks to address these concerns by specifying an
alternative approach for determining the notional amount for a complex
derivatives transaction. Under this approach, the notional amount of a
complex derivatives transaction would be equal to the aggregate
notional amount(s) of other derivatives instruments, excluding other
complex derivatives transactions (together, ``substituted
instruments''), reasonably estimated to offset substantially all of the
market risk of the complex derivatives transaction at the time the fund
enters into the transaction.\187\ This approach is designed to address
the difficulty of determining the notional amount for some complex
derivatives transactions and the concern that the reference asset or
metric may not by itself be an appropriate measure of the underlying
market exposure, by substituting, in effect, the notional amounts of
non-complex instruments that mirror the market risk of the complex
derivatives transaction.\188\ For example, a barrier option in some
cases can be hedged using standard put and call options (which would
not be complex derivatives transactions provided that they had a single
strike price).\189\ In that case, a fund could use the aggregate
notional amount of such puts and calls (i.e., the strike price
multiplied by the delta) as the notional

amount for purposes of determining the fund's exposure.\190\
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    \187\ Proposed rule 18f-4(c)(7)(iii)(C). As discussed in section
III.F below, the proposed rule would require the fund to maintain a
written record demonstrating that immediately after the fund entered
into any senior securities transaction, the fund complied with the
portfolio limitation applicable to the fund immediately after
entering into the senior securities transaction, including the
fund's aggregate exposure, among other things. Where the fund enters
into a complex derivatives transaction, the fund, in documenting its
exposure immediately after entering into the transaction, would be
required to document the way it determined the notional amount of
the complex derivatives transaction, that is, the notional amount(s)
of substituted instruments that could reasonably be expected to
offset substantially all of the market risk of the complex
derivatives transaction at the time the fund entered into the
transaction.
    \188\ The UCITS Global Exposure Guidelines similarly call for
derivatives with complex structures to be ``broken down into
component parts'' so that ``the effect of layers of derivative
exposures [can] be adequately captured.'' CESR Global Guidelines,
supra note 162, at 12. See also Wilmott, supra note 177, at 506
(stating, with regard to ``exotic'' derivatives, that ``[i]f a
contract can be decomposed into simpler, vanilla products, then
that's what you should do for pricing and hedging'').
    \189\ See generally Wilmott, supra note 177, at 969-987
(describing methods for hedging barrier options using ``vanilla''
exchange-traded options); see also Peter Carr, Katrina Ellis &
Vishal Gupta, Static Hedging of Exotic Options, 53 J. of Fin. 1165,
1169 (June 1998) (describing methods for hedging barrier options,
lookback options and other ``exotic'' options using standard put and
call options).
    \190\ The proposed rule would not require a fund to actually
invest in substituted instruments instead of investing in the
complex derivatives transaction, but rather would require a fund to
use the notional amounts of substituted instruments in order to
determine its exposure for purposes of the proposed rule's portfolio
limitations.
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(2) Netting of Certain Derivatives Transactions
    The proposed rule includes a netting provision that would permit a
fund, in determining its aggregate notional exposure, to net any
directly offsetting derivatives transactions that are the same type of
instrument and have the same underlying reference asset, maturity and
other material terms.\191\ This limited netting provision is designed
to apply to those types of derivatives transactions for which, due to
regulation, transaction structure or market practice, a fund typically
would use an offsetting transaction to effectively settle all or a
portion of the transaction prior to expiration or maturity, such as
certain futures and forward transactions. It would also apply to
situations in which a fund seeks to reduce or eliminate its economic
exposure under a derivatives transaction without terminating the
transaction. This may be the case, for example, if terminating the
transaction would be more costly to the fund (for example, because the
fund would need to pay an early termination fee) than entering into an
offsetting transaction with another counterparty, or if terminating the
transaction would cause the fund to realize gain or loss for tax
purposes earlier than would be required if the fund entered into an
offsetting transaction. The netting provision under the proposed rule
accordingly would permit a fund to exclude from its aggregate exposure
the notional amounts associated with transactions that are entered into
by the fund to eliminate the fund's exposure under another transaction
through a directly offsetting transaction as described under the
proposed rule.\192\
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    \191\ Proposed rule 18f-4(c)(3)(i).
    \192\ The netting provision under the proposed rule is not
designed to enable a fund generally to disregard or subtract from
the calculation of a fund's exposure the notional amount of
transactions that the fund deems to be hedging or risk mitigating.
See section III.B.1.d. The netting provision applies only to
directly offsetting derivatives transactions that are the same type
of instrument and have the same underlying reference asset, maturity
and other material terms.
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    With respect to transactions that are directly offsetting but
involve different counterparties, we note that, although a fund would
remain exposed to counterparty risk, such offsetting transactions could
reasonably be expected to eliminate market risk associated with the
offsetting transactions if they are the same type of instrument and
have the same underlying reference asset, maturity and other material
terms. Accordingly, we believe that such transactions are an
appropriate means to eliminate or reduce market exposure under
derivatives transactions even if entered into with different
counterparties for purposes of the rule's exposure limits, which are
designed to limit the extent of the fund's exposure.
    By contrast, the netting provision would not apply to transactions
that may have certain offsetting risk characteristics but do not have
the same underlying reference asset, maturity and other material terms
or involve different types of derivatives instruments. For example,
while a long position in a March 2016 copper futures contract could
directly offset a short position in the same March 2016 copper futures
contract, it would not directly offset a short position with respect to
copper options or April 2016 copper futures. Similarly, a purchased
option would not offset a written option that has a different maturity
date or a different underlying reference asset. With respect to
transactions that do not have the same underlying reference asset,
maturity and other material terms, we are concerned that these
transactions may not merely have the effect of eliminating or reducing
market exposure. For example, they might instead be used as paired
``collar'' or ``spread'' investment positions that could raise
potential risks associated with strategies that seek to capture small
changes in the value of such paired investments. We also believe that
it would be difficult to develop standards for determining
circumstances under which such transactions should be considered to
have eliminated the market and leverage risks associated with the
positions in a manner that would appropriately limit the potential for
funds to incur excessive leverage or unduly speculative exposures.
ii. Exposure for Financial Commitment Transactions and Other Senior
Securities
    A fund also would be required to include, in calculating its
exposure: (1) The amount of cash or other assets that the fund is
conditionally or unconditionally obligated to pay or deliver under any
financial commitment transactions (``financial commitment
obligations''); \193\ and (2) the aggregate indebtedness (and with
respect to any closed-end fund or business development company,
involuntary liquidation preference) with respect to any other senior
securities transaction entered into by the fund pursuant to section 18
or 61 of the Act without regard to the exemption provided by the
proposed rule.\194\ As explained below, these aspects of the exposure
calculation are designed to require a fund that enters into derivatives
transactions in reliance on the exemption provided by the proposed rule
to include in its aggregate exposure all of the fund's indebtedness or
exposure obtained through senior securities transactions.
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    \193\ Proposed rule 18f-4(c)(3)(ii).
    \194\ Proposed rule 18f-4(c)(3)(iii). This could include, for
example, bank borrowings and, for a closed-end fund or BDC, the
issuance of debt or preferred shares. Section 18(g) of the Act
excludes from the definition of senior security ``any such
promissory note or other evidence of indebtedness in any case where
such a loan is for temporary purposes only and in an amount not
exceeding 5 per centum of the value of the total assets of the
issuer at the time when the loan is made.'' Such borrowings that
meet the requirements of the exclusion for temporary borrowings
under section 18(g) would not be considered senior securities
transactions for purposes of the proposed rule, and thus would not
be included in the proposed rule's exposure calculations.
---------------------------------------------------------------------------

    Under the proposed rule, a fund would be required to include its
exposure under these types of transactions in determining its
compliance with the 150% exposure limit because, although we have
determined to propose an exemption from the requirements of section 18
and 61 to permit funds to enter into derivatives and financial
commitment transactions, we believe that, in order to address the
investor protection purposes and concerns underlying section 18, a fund
relying on the exemption should be subject to an overall limit on
leverage. As discussed in more detail below in section III.B.1.b.2, we
have proposed to set this limit at 150% of net assets (and at 300% of
net assets for a fund operating under the risk-based portfolio limit)
because we believe that is an appropriate limit on a fund's exposure
from derivatives, financial commitment transactions, and other senior
securities transactions.
    If the proposed rule did not require exposure from all senior
securities transactions to be included for purposes of calculating a
fund's exposure, a fund relying on the exemption the rule would provide
could obtain aggregate exposure in excess of the proposed rule's
exposure limits. For example, a fund having net assets of $100 that
complies with the exposure-based portfolio limit might otherwise, in
theory, obtain $150 of leveraged exposure through

derivatives plus additional leverage in the form of financial
commitment transactions and other borrowings. We have determined to
address this concern by requiring a fund to include exposure from all
senior securities transactions, but subject to a 150% limit, rather
than proposing a substantially lower limit that might be appropriate if
the exposure calculation were based solely on derivatives exposure.
    We request comment on all aspects of the exposure determinations
for derivatives transactions.
     Is the proposed rule's use of notional amounts as the
basis for calculating a fund's exposure under a derivatives transaction
appropriate? Does the notional amount of a derivatives transaction
generally serve as an appropriate means of measuring a fund's exposure
to the applicable reference asset or metric? Are there particular types
of derivatives transactions or reference assets for which the notional
amount would or would not be effective in this regard? For such
derivatives, what alternative measures might be used and why would they
be more appropriate? Would such alternative measures be easier for
funds and compliance staff to administer?
     For derivatives transactions that provide a return based
on the leveraged performance of an underlying reference asset, the rule
would require the notional amount to be multiplied by the applicable
leverage factor. Do commenters agree that this is appropriate?
     The proposed rule includes a ``look-through'' for
calculating the notional amount in respect of derivatives transactions
for which the underlying reference asset is a managed account or entity
formed or operated primarily for the purpose of investing in or trading
derivatives transactions, or an index that reflects the performance of
such a managed account or entity. Do commenters agree that this is
appropriate? Is this requirement sufficiently clear? Would the look-
through provision capture swaps or other derivatives on reference
entities or assets that should not be covered by this provision? Why or
why not? Would a fund that uses these types of transactions be able to
obtain information from its counterparty regarding the fund's pro rata
portion of the notional amounts of the derivatives transactions of the
underlying reference vehicle, in order for the fund to be able to
determine its compliance with the exposure limitations under the
proposed rule? Why or why not? Would funds that currently use these
transactions find it necessary to amend their existing contracts with
counterparties in order to obtain such information? Are there other
ways we should consider addressing the concern, noted above, that
absent a look-through to the derivatives transactions of the underlying
reference vehicle, such structures could be used to avoid the exposure
limitations that would be applicable under the proposed rule if the
fund directly owned the managed account or securities issued by the
reference entity? We understand that the accounts or entities that
serve as the reference assets for these transactions generally are
actively managed, such that the notional amounts of the derivatives
transactions of such accounts or entities may change frequently. In
light of this, and given the concern that the look-through requirement
seeks to address, should the proposed rule also require a fund to
determine its compliance with the exposure limitations of the rule
whenever the notional amount of the fund's pro rata portion of the
notional amounts of the derivatives transactions of the underlying
reference vehicle changes? Why or why not?
     To what extent do funds enter into derivatives
transactions for which pooled investment vehicles (e.g., hedge funds or
other registered funds, such as ETFs and mutual funds) serve as
reference assets? For what purposes do funds enter into such
derivatives transactions? To what extent do the referenced pooled
investment vehicles themselves use derivatives, such that funds could
use derivatives for which a pooled investment vehicle serves as a
reference asset in order to obtain leverage in excess of the limits
provided under the proposed rule? Would a fund that uses these types of
derivatives transactions be able to obtain information from the
underlying pooled investment vehicle regarding the notional amounts of
the underlying pooled investment vehicle's derivatives transactions, in
order for the fund to be able to determine its compliance with the
exposure limitations under the proposed rule's look-through
requirement? Why or why not? Should we specify standards for
determining whether a pooled investment vehicle should be considered
formed or operated primarily for the purpose of investing in or trading
derivatives? What would be an appropriate standard?
     Do commenters agree with the proposed definition of
``complex derivatives transaction''? Are there derivatives transactions
that may be considered complex derivatives transactions under the
proposed definition but should not be, or vice versa? Does the method
for calculating exposure for complex derivatives transactions create
the potential for transactions to be structured to avoid this aspect of
the rule? If so, how might that be avoided (e.g., by modifying the
definition or through other means)?
     The proposed rule would require a fund to calculate the
notional amount for a complex derivatives transaction by using the
notional amount(s) of one or more instruments, excluding other complex
derivatives transactions (collectively, ``substituted instruments,'' as
noted above), that could reasonably be expected to offset substantially
all of the market risk of the complex derivatives transaction Do
commenters agree with this method for calculating exposure in respect
of complex derivatives transactions? Should the rule specify a
particular test or tests that a fund could elect to use, or be required
to use, in order to establish that the notional amount it uses for a
complex derivatives transaction meets this requirement? For example,
should the rule provide that a group of substituted instruments will be
deemed to reasonably be expected to offset substantially all of the
market risk associated with a complex derivatives transaction if the
fund can demonstrate, using a VaR model that meets the requirements of
paragraph (c)(11)(ii) \195\ of the proposed rule, that the combined VaR
of the substituted instruments and the complex derivatives transaction
is less than 1%, or some other percentage, of the VaR of the complex
derivatives transaction by itself (in other words, if a complex
derivative had a VaR of $100 but the combined VaR of the complex
derivatives transaction and the substituted instruments were less than
$1, the substituted instruments would be deemed to have offset
substantially all of the market risk associated with the complex
derivative)? What other approaches might a fund use?
---------------------------------------------------------------------------

    \195\ See infra section III.B.2.b.
---------------------------------------------------------------------------

     Are there complex derivatives transactions for which
substantially all of the market risk cannot be offset using substituted
instruments, and for which the fund would not be able to determine a
notional amount under the proposed rule? What kinds of transactions,
and do funds use such transactions? To the extent there are complex
derivatives transactions for which a fund would not be able to offset
substantially all of the market risks using substituted instruments,
would the fund's inability to offset substantially all of the market
risks using substituted instruments indicate that the fund would be
unable

effectively to determine the degree of market risk inherent in the
transaction? Would such transactions pose greater risks for funds
because, for example, they are less liquid or more likely to expose
funds to potential losses that may be difficult to quantify?
     We note that, under the CESR Global Guidelines, if the
exposure for a non-standard derivative cannot be determined based on
the market value of an equivalent position in underlying reference
assets and such derivatives represent more than a negligible portion of
the UCITS portfolio, a UCITS fund cannot use the commitment
approach.\196\ Should the proposed rule similarly restrict a fund's
ability to use these kinds of transactions? Should the proposed rule
prohibit a fund from using such transactions? If not, should the
proposed rule provide an alternative method for determining the
notional amount for a complex derivative for which substantially all of
the market risk cannot be offset using substituted instruments? What
method?
---------------------------------------------------------------------------

    \196\ See CESR Global Guidelines, supra note 162, at 7, 12.
---------------------------------------------------------------------------

     Is the netting provision for calculating a fund's exposure
appropriate? Are there other circumstances under which netting should
be permitted? Are there transactions that the provision would permit to
be netted but should not be?
     Are there other adjustments pertaining to the use of
notional amounts for purposes of determining a fund's exposure
appropriate that we should consider, either with respect to certain
types of derivatives transactions or in general? For example, we
understand that the notional amounts for Euribor and Eurodollar futures
are often referenced by market participants by dividing the amount of
the contract by four in order to reflect the three-month length of the
interest rate transaction, and our staff took this approach in
evaluating funds' notional exposures, as discussed in the DERA White
Paper. For these very short-term derivatives transactions, calculating
notional amounts without dividing by four would reflect a notional
amount that could be viewed as overstating the magnitude of the fund's
investment exposure. Should the proposed rule permit or require this
practice? Why or why not? Would a derivative's notional amount adjusted
in this way serve as a better measure of the fund's exposure than the
derivative's unadjusted notional amount? Are there other futures
contracts (or other standardized derivatives) for which an analogous
adjustment should be permitted? Why or why not?
     Should we consider permitting or requiring that the
notional amounts for interest rate futures and swaps be adjusted so
that they are calculated in terms of 10-year bond equivalents or make
other duration adjustments to reflect the average duration of a fund
that invests primarily in debt securities? Would this result in a
better assessment of a fund's exposure to interest rate risk? Why or
why not?
     Could derivatives transactions be restructured so that
they provide a level of exposure to an underlying reference asset or
metric that exceeds the notional amount as defined in our proposed
rule, while nonetheless complying with the rule's conditions? If so,
what modifications should we make to address this?
     Should the calculation of exposure be broadened to include
not only derivatives that involve the issuance of senior securities
(because they involve a payment obligation) but also derivatives that
would not generally be considered to involve senior securities, such as
purchased options, structured notes, or other derivatives that provide
economic leverage, given that such instruments can increase the
volatility of a fund's portfolio and thus cause an investment in a fund
to be more speculative than if the fund's portfolio did not include
such instruments?
     Should the proposed rule require a fund to include the
exposure associated with certain so-called ``basket option''
transactions, which are derivatives instruments that may nominally be
documented in the form of an option contract but are economically
similar to a swap transaction? We understand that these types of basket
option transactions often involve a deposit by an investor of a cash
``premium'' that functions as collateral for the transaction, and all
or a portion of which may be returned to the investor depending on the
performance of the basket of reference assets.\197\ Should we require a
fund to include the exposure associated with these transactions because
they operate in a manner similar to swap transactions and differ
significantly from the typical purchased option contract with a non-
refundable premium payment? \198\
---------------------------------------------------------------------------

    \197\ See Abuse of Structured Financial Products: Misusing
Basket Options to Avoid Taxes and Leverage Limits, Report of the
Permanent Subcommittee on Investigations, United States Senate (July
22, 2014), at p. 79 (``The hedge funds told the Subcommittee that,
rather than tax, a major motivating factor behind their
participation in the basket options was the opportunity to obtain
high levels of leverage, beyond the federal leverage limit of 2:1
normally applicable to [regulatory margin requirements for]
brokerage accounts, an assertion supported by the banks.'').
    \198\ These basket options, which typically have a strike price
that is in-the-money at inception (reflecting the value of the
initial premium payment) together with provisions that require the
delivery of additional premium amounts or termination if the
reference basket declines in value, thus function in a manner very
similar to a swap that requires the delivery of collateral at
inception and can be terminated if additional collateral is not
delivered if the reference basket under the swap declines in value.
---------------------------------------------------------------------------

     Do commenters agree that it is appropriate to include
exposure associated with a fund's financial commitment transactions and
other senior securities transactions in the calculation of the fund's
exposure for purposes of the 150% exposure limit in the exposure-based
portfolio limit (and the 300% limit under the risk-based portfolio
limit), as proposed, so that the exposure limit would include the
fund's exposure from all senior securities transactions? Should we,
instead, include only exposure associated with a fund's derivatives
transactions but reduce the exposure limits so that a fund that would
rely on the exemption provided by the proposed rule would be subject to
a limit on leverage or potential leverage from all senior securities
transactions? If we were to take this approach should we, for example,
reduce the exposure limits to 50% in the case of the exposure-based
portfolio limit and 100% in the case of the risk-based limit?
c. 150% Exposure Limit
    As noted above, a fund that elects to comply with the exposure-
based portfolio limit under the proposed rule would be required to
limit its derivatives transactions, financial commitment transactions
and obligations under other senior securities transactions, such that
the fund's aggregate exposure under these transactions, immediately
after entering into any senior securities transaction, does not exceed
150% of the fund's net assets.\199\
---------------------------------------------------------------------------

    \199\ Proposed rule 18f-4(a)(1)(i).
---------------------------------------------------------------------------

    The exposure-based portfolio limit is designed to impose a limit on
the amount of leverage a fund may obtain through senior securities
transactions while also providing flexibility for funds to use
derivatives transactions for a variety of purposes.\200\ As discussed
above, and as noted by several commenters to the Concept Release, many
derivatives transactions result in investment exposures that are
economically similar to direct

investments in the underlying reference assets financed through
borrowings. According to one commenter, for example, an equity total
return swap ``produces an exposure and economic return substantially
equal to the exposure and economic return a fund could achieve by
borrowing money from the counterparty in order to purchase the equities
that are reference assets.'' \201\ Because derivatives transactions can
readily be used for leveraging purposes, we believe that limiting the
aggregate notional amount of a fund's derivatives transactions (subject
to certain adjustments under the proposed rule) can appropriately serve
to limit the amount of leverage the fund could potentially obtain
through such transactions. We also believe that an exposure limitation
based, in part, on the aggregate notional amount of a fund's
derivatives transactions should be set at an appropriate amount that
reflects the various ways in which funds may use derivatives, while
also imposing a limit on the amount of leverage a fund may obtain
through derivatives transactions (and other senior securities
transactions), consistent with the investor protection purposes and
concerns underlying section 18.
---------------------------------------------------------------------------

    \200\ The proposed rule's portfolio limitations, although
designed to impose a limit on leverage, also could help to address
concerns about a fund's ability to meet its obligations. See supra
note 152.
    \201\ See Comment Letter of BlackRock on the FSOC Request for
Comment (Mar. 25, 2015) (FSOC 2014-0001) (``BlackRock FSOC Comment
Letter''), available at http://www.blackrock.com/corporate/en-us/literature/publication/fsoc-request-for-comment-asset-management-032515.pdf, at 8 (``[D]erivatives can be used to lever a portfolio,
in essence creating additional economic exposure.'') See also
BlackRock Concept Release Comment Letter, at 4 (noting that in
circumstances where a derivative is effectively substituting for one
or more `long' physical security positions, ``the full notional
amount of the reference asset is at risk to the same extent as the
principal amount of a physical holding, and any difference between
the amount invested by the fund and the notional amount of the
derivative is equivalent to a `borrowing'.''). See also Keen Concept
Release Comment Letter, at 8 (noting that, except with respect to
hedging transactions, ``the notional amount of swaps should be
treated as creating investment leverage and subject to any asset
coverage requirement the Commission imposes on the issuance of
senior securities by investment companies''). See also Morningstar
Concept Release Comment Letter, at 2 (noting that, by using futures,
a fund may only need $5 of initial margin to obtain $100 worth of
notional exposure to the S&P 500 and that such position may
represent ``effectively a 100% equity investment'').
---------------------------------------------------------------------------

    In determining to propose a 150% exposure limitation, we evaluated
a range of considerations. First, we considered the extent to which a
fund could borrow in compliance with the requirements of section 18. As
discussed in more detail in section II, funds generally can incur
indebtedness through senior securities under section 18 subject to the
asset coverage requirement specified in that section, which effectively
permits a fund to incur indebtedness of up to 50% of the fund's net
assets.\202\ For example, a mutual fund with $100 in assets and with no
liabilities or senior securities outstanding could borrow an additional
$50 from a bank. We therefore considered whether it would be
appropriate to propose a 50% exposure limitation under the proposed
rule, in order to limit a fund's derivatives exposure to the same
extent as section 18 limits a fund's ability to borrow from a bank (or
issue other senior securities representing indebtedness subject to
section 18's 300% asset coverage requirement).\203\ We also considered
an exposure limitation of 100% of net assets, which would more closely
track the level of exposure suggested by Release 10666 for the trading
practices described in that release.\204\
---------------------------------------------------------------------------

    \202\ See supra note 34.
    \203\ We note that, at this level of exposure limitation, the
corresponding limitation on BDCs could be set at 100% of net assets
to reflect the increased borrowing capacity that Congress has
permitted BDCs to obtain under section 61 of the Act.
    \204\ One of the commenters to the Concept Release indicated
that this level of exposure would be the effective limit under
Release 10666 ``[a]s originally conceived by the Commission,''
explaining that, ``[a]s a practical matter, requiring the
segregation of assets but not limiting the permitted segregation to
cash equivalents effectively permitted funds to incur investment
leverage up to a theoretical limit equal to 100% of a fund's net
assets.'' See Ropes & Gray Concept Release Comment Letter.
---------------------------------------------------------------------------

    We have not proposed these lower exposure limits of 50% or 100% of
net assets primarily due to our consideration of the point made by
numerous commenters that funds use derivatives for a range of purposes
that may not, or may not be expected to, result in additional leverage
for the fund.\205\ Commenters have noted that many funds use
derivatives for hedging or risk-mitigation, or choose to use
derivatives for reasons other than specifically to obtain
leverage.\206\ Thus, although a lower exposure limit, like the 100%
limitation suggested by Release 10666, may be appropriate for the
trading practices described in that release, that exposure limit may
not be appropriate when applied to derivatives' notional exposure. Such
a lower exposure limit, as well as the 50% limitation we considered,
could limit a fund's ability to use derivatives transactions for
purposes other than leveraging the fund's portfolio that may be
beneficial to the fund and its investors.\207\
---------------------------------------------------------------------------

    \205\ See, e.g., infra note 248 and accompanying text. See also
BlackRock FSOC Comment Letter, at 8 (noting that in certain cases
``derivatives are used to hedge (mitigate) risks and thus do not
result in the creation of leverage and, in fact may specifically
reduce economic leverage.); BlackRock Concept Release Comment
Letter, at 4-5 (noting that ``in the context of an overall
portfolio, a derivative holding may increase overall leverage,
decrease overall leverage or have no effect on overall leverage'')
(internal footnotes omitted).
    \206\ In determining an appropriate exposure limit, we have also
considered that, as noted below in section III.B.1.d, derivatives
transactions that are intended to hedge or mitigate risks may not be
effective, particularly in stressed market conditions.
    \207\ We also note that the payment obligations and potential
payment obligations associated with derivatives transactions differ
in certain respects from the payment obligations under borrowings
permitted under section 18, including in that the fund's payment
obligations under a derivatives transaction would vary depending on
changes in market prices, volatility, and other market events
related to the derivatives transaction's reference asset. See also
sections III.E and IV.E.
---------------------------------------------------------------------------

    As described in greater detail below in section III.B.1.d, we
considered whether to reflect the different ways in which funds might
use derivatives by excluding from that calculation any exposure
associated with derivatives transactions that may arguably be used to
hedge or cover other transactions. This would be similar to the
guidelines that apply to UCITS funds, which generally are subject to an
exposure limit of 100% of net assets, but are not required to include
exposure relating to certain hedging transactions. For the reasons
discussed in section III.B.1.d, however, we have determined not to
propose to permit a fund to reduce its exposure for purposes of the
rule's portfolio limitations for particular derivatives transactions
that may be entered into for hedging (or risk-mitigating) purposes or
that may be ``cover transactions.'' As discussed in more detail in that
section of this Release, we believe it would be difficult to develop a
suitably objective standard for these transactions, and that confirming
compliance with any such standard would be difficult, both for fund
compliance personnel and for our staff. In addition, many hedges are
imperfect, making it difficult to distinguish purported hedges from
leveraged or speculative exposures or to provide criteria for this
purpose in the proposed rule that would be appropriate for the
diversity of funds subject to the proposed rule and the diversity of
strategies and derivatives they use or may use in the future.
    In addition to these considerations, we also note that, as
discussed in section III.B.1.b.i, while an exposure-based test based on
notional amounts could be viewed as a relatively blunt measurement, we
believe that, on balance, a notional amount limitation would be more
administrable, and thus more effective, as a means of limiting
potential leverage from derivatives for purposes of the proposed rule
than a limitation which seeks to define, and

rely on, more precise measurements of leverage. We note that setting
the exposure limitation at 150%, as proposed, would allow the fund to
use derivatives transactions to obtain a level of indirect market
exposure solely through derivatives transactions that could approximate
the level of market exposure that would be possible through securities
investments augmented by borrowings as permitted under section 18.\208\
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    \208\ For example, for a fund that determines to use derivatives
as an alternative to investments in securities, this proposed
exposure-based limit would permit a fund with $100 in assets and
with no liabilities or senior securities to obtain market exposure
through a derivatives transaction with a notional amount of up to
150% of the fund's net assets, with the fund's non-derivatives
assets invested in cash and cash equivalents. This would match the
degree of market exposure the fund could obtain by borrowing up to
$50 from a bank as permitted under section 18 and investing the
fund's $150 in total assets in securities.
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    We also considered whether higher exposure limitations might be
appropriate, such as exposure levels ranging from 200% to 250% of net
assets. We are concerned, however, that exposure levels in excess of
150% of net assets, if not tempered by the risk mitigating aspects of
the VaR test as we have proposed under the risk-based limit, could be
used to take on additional speculative investment exposures that go
beyond what would be expected to allow for hedging arrangements, and
thus could implicate the undue speculation and asset sufficiency
concerns expressed in sections 1(b)(7) and 1(b)(8) of the Act.
    Second, we considered the extent to which different exposure limits
would affect funds' ability to pursue their strategies. In this regard
we considered the extent to which different potential exposure
limitations would affect funds and their investors, as well as section
18's strict limitations on senior securities transactions and the
concerns we discuss above regarding funds' ability to obtain leverage
through derivatives and other senior securities transactions. We also
considered the extent to which different types of funds, and funds
collectively, use senior securities transactions today. Given that, as
discussed below, most funds use relatively low notional amounts of
derivatives transactions (or do not use any derivatives), we have
proposed an exposure limitation at a level that we believe would
appropriately constrain funds that use derivatives to obtain highly
leveraged exposures.
    Third, we recognize and have considered that funds using any
derivatives transactions can experience derivatives-related losses,
including funds with exposures below the limits we are proposing today
as well as the other limits that we discuss above. In this regard, we
recognize that the information available in the administrative orders
described in section II.D.1.d indicates that some of the losses
described as resulting from derivatives in those matters occurred at
exposure levels below the exposure limits that we are proposing
today.\209\ The proposed rule's exposure limits are not designed to
prevent all derivatives-related losses, however. Importantly, the
exposure limits would be complemented by the rule's asset segregation
requirements, which would apply to all funds that engage in derivatives
transactions in reliance on the rule, and the proposed rule's risk
management requirements, which would apply to funds that have
derivatives exposure exceeding a lower threshold of 50% of net assets
or that use complex derivatives transactions.
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    \209\ See supra notes 123-124 and 126.
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    Based on these considerations, we have determined to propose an
exposure-based portfolio limit set at 150% of net assets, rather than a
lower limit, including the 50% and 100% limits discussed above. We
believe that a 150% exposure limit would account for the variety of
purposes for which funds may use derivatives, including to hedge risks
in the fund's portfolio and to make investments where derivatives may
be a more efficient means to obtain exposure. As discussed in more
detail below, we have determined not to permit funds to reduce their
exposure for potentially hedging or cover transactions and, instead,
have proposed an exposure limit that we believe would be high enough to
provide funds sufficient flexibility to engage in these kinds of
transactions.
    We also believe that a 150% exposure limitation would appropriately
balance the proposed rule's effects on funds and their investors, on
the one hand, with concerns related to funds' ability to obtain
leverage through derivatives and other senior securities transactions,
on the other. We understand based on the DERA analysis that, although
most funds would be able to comply with an exposure-based portfolio
limit of 150% of net assets, the limit would constrain the use of
derivatives by the small percentage of funds that use derivatives to a
much greater extent than funds generally. The analysis also indicates
that funds and their advisers generally would be able to continue to
operate and to pursue a variety of investment strategies, including
alternative strategies.\210\
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    \210\ See infra note 211.
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    As discussed in more detail in the DERA White Paper, DERA staff
reviewed the portfolio holdings of a random sample of mutual funds
(including a separate category of alternative strategy funds, which
includes index-based alternative strategy funds \211\), closed-end
funds, BDCs, and ETFs. DERA staff randomly selected 10% of the funds
from each of these categories and reviewed the funds' schedule of
investments included in their most recently filed annual reports to
identify the fund's derivatives transactions, financial commitment
transactions, and other senior securities transactions. DERA staff then
calculated the funds' exposures under these transactions, using the
notional amounts to calculate the funds' derivatives exposures and the
amounts of the funds' obligations and contingent obligations under
financial commitment transactions and other senior securities
transactions, and compared the funds' aggregate exposures to the funds'
reported net assets. Although we recognize that the review by DERA
staff evaluated funds' investments as reported in the funds' then-most
recent annual reports, DERA staff is not aware of any information that
would provide any different data analysis of the current use of senior
securities transactions by registered funds and business development
companies.\212\
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    \211\ See supra note 87 (describing the funds included as
alternative strategy funds as part of the staff's review).
    \212\ We understand that, in stable environments, samples
including longer periods of time are preferable because their larger
sample sizes offer greater precision in estimating a given relation
or characteristic. DERA staff analysis shows, however, that funds
that make the greatest use of derivatives have received
disproportionately large net inflows since the end of 2010.
Extending DERA's sample back in time thus would tend to include data
in the sample that is no longer consistent with industry practice
with respect to derivatives usage as it exists today.
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    This analysis showed that, for mutual funds other than alternative
strategy funds (which we discuss separately below), more than 70% of
the sampled mutual funds did not identify any derivatives transactions
in their schedules of investments; about 6% of sampled mutual funds had
derivatives exposures in excess of 50% of the funds' net assets; and
about 99% of sampled mutual funds had aggregate exposures that were
less than 150% of the funds' net assets.\213\ None of the sampled
closed-end funds had aggregate exposure in excess of 150% of net assets

(and only about 2% of those funds had aggregate exposures exceeding
100% of net assets).\214\ None of the sampled BDCs reported any
derivatives transactions, although some of them did report financial
commitment transactions (and they also had issued other senior
securities).\215\ The sampled ETFs included alternative strategy ETFs
and ETFs pursuing other strategies. Of the non-alternative strategy
ETFs, only one of the sampled funds had aggregate exposure in excess of
150% of net assets, and the other sampled non-alternative strategy ETFs
with relatively higher exposures had exposures of approximately 100% of
net assets.\216\ With respect to alternative strategy ETFs, the sampled
funds with the highest exposures were leveraged ETFs; several of these
funds had aggregate exposure exceeding 150% of net assets, with
exposure ranging up to approximately 280% of net assets.\217\ Based on
this analysis we believe that, except for alternative strategy funds
and certain leveraged ETFs, most funds should be able to comply with a
150% exposure portfolio limitation without modifying their portfolios.
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    \213\ DERA White Paper, supra note 73, at Figures 9.5 and 11.5.
    \214\ DERA White Paper, supra note 73, at Figure 9.7.
    \215\ DERA White Paper, supra note 73, at Figures 9.11 and
11.11.
    \216\ DERA White Paper, supra note 73, at Figures 4.6 and 9.9.
    \217\ DERA White Paper, supra note 73, at Figure 4.5.
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    The sampled alternative strategy funds in DERA's analysis tended to
be more significant users of derivatives.\218\ Fifty-two percent of the
sampled alternative strategy funds had at least 50% notional exposure
from derivatives, and approximately 73% of these funds had aggregate
exposure that represented less than 150% of net assets.\219\ The
approximately 73% of funds with exposure under 150% included at least
one fund in every Morningstar alternative mutual fund category.\220\
The remaining approximately 27% of the sampled alternative strategy
funds with aggregate exposure of 150% or more pursued a variety of
strategies including, among others, absolute return, managed futures,
unconstrained bond, and currency strategies. The funds with the highest
exposures in the sample generally followed managed futures strategies.
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    \218\ We refer to alternative strategy funds in the same manner
as the staff classified ``Alt Strategies'' funds in the DERA White
Paper, supra note 73, as including the Morningstar categories of
``alternative,'' ``nontraditional bond'' and ``commodity'' funds.
    \219\ DERA White Paper, supra note 73, at Figures 9.4 and 11.4.
    \220\ Our staff's experience suggests, however, that funds in
one Morningstar alternative strategy category--Managed Futures--may
find it difficult to limit their exposures to less than 150%. These
funds generally obtain their investment exposures through
derivatives transactions, and thus can be expected to have high
derivatives exposures relative to net assets. This is consistent
with DERA's analysis, in which the funds with the highest exposures
were managed futures funds.
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    We believe the proposed 150% exposure limitation appropriately
balances the proposed rule's effects on funds and their investors, on
the one hand, with the concerns we discuss above concerning funds'
ability to obtain leverage and incur obligations through derivatives
transactions (and other senior securities transactions), on the other.
The information provided in the DERA staff analysis indicates, as
discussed above, that most funds in the DERA random sample would be
able to comply with a 150% exposure limit without modifying their
portfolios. The analysis also indicates that alternative strategy
funds, the heaviest users of derivatives in the DERA random sample,
generally would be able to continue to operate and to pursue a variety
of alternative strategies. As noted above, approximately 73% of the
sampled alternative strategy funds had less than 150% exposure and
included funds in every alternative mutual fund category.\221\ The
majority of the sampled ETFs also had exposures of 150% or less of net
assets. Our staff's analysis indicates that it should be possible to
pursue, in some form, almost all existing types of investment