Last year as capital markets shifted across the globe, it became clear that stronger risk management is needed to protect investors. With equity markets seeing deep downside and extreme volatility, the use of derivatives would either become a safe haven for the hedges they provided, or a curse for those who were using them for leverage and got caught on the wrong side. As derivatives continue to play a role in the asset management space, the need for a strong risk regulatory framework is as important as ever. In October 2020, the SEC issued their final rule on 18f-4, which would allow registered funds to utilize derivatives, as well as put a robust framework around ensuring the risks and impact of leverage were properly captured and monitored.
What’s Required
Under the new rule, Registered Investment Companies including mutual funds, leveraged/inverse funds, closed-ended funds and business development companies will need to develop a Derivatives Risk Management (DRM) program if they are positioned with more than 10% of their funds NAV in gross derivative exposure. The program is designed to protect investor interest as well as provide clear compliance requirements around managing the market risk of the fund through both qualitative and quantitative methods. This becomes challenging as it requires these funds to have a robust risk management solution in place, as well as the right data and tools to produce the necessary computations daily. The DRM program is designed to standardize the way these funds operate from a risk management perspective, including internal procedures and escalation points controlled by a risk manager appointed by the fund’s board of directors.
Under the previous adaptation, the Investment Company Act limited the use of derivatives, or future payment obligations, across registered funds. The new implementation will allow for the use of derivatives, albeit with restrictions, new reporting capabilities and implementation of a more robust risk management framework. Deploying a derivative risk management program can shape the way these funds utilize these instruments and how they adhere to certain compliance rules around the fund’s structure. Funds that do fall in scope will need to deploy a set of risk measures that focus on monitoring daily VaR calculations relative to a specific Index (as well as absolute), stress testing on events that are “extreme but plausible,” as well as ensure that these methods capture the correct risk model governance, via backtesting. Funds that fall within this program will need to ensure that their VaR limit does not exceed that of 20% (25% for closed-end funds) or 200% of its designated index (250% for closed-ended funds). The choice of utilizing either a designated benchmark or reference portfolio (which is prescribed as a portfolio without derivatives) allows managers to choose the appropriate level of active risk for the fund they are managing. This is important as funds that are out of compliance regarding the VaR-based limit on fund leverage risk for more than five days will be required to report on Form N-RN, as well as disclose information on the use of derivatives under N-PORT and N-CEN.
Key Challenges
During a recent poll taken by SS&C, the findings were clear that the industry is faced with several key challenges when implementing a derivative risk management program with respect to 18f-4 analytics. The final rule provides a clear means to measuring derivative exposure but puts an emphasis on both the input data required to calculate the exposure profile of the fund as well as a number of outputs in that area needed to measure the fund in compliance.
First, rule coding and input data determining which instruments are used for leverage versus a hedge create a challenge around sourcing how derivatives are treated. Firms that are using interest rate and currency derivatives to hedge exposure are exempt from including these transactions in their exposure profile but need to be able to map hedges with their respective instruments, which also need to maintain a maximum 10% deviation to remain netted. For funds that do not exceed the 10% exposure threshold but are close, this can mean a difference in determining if they need to comply with the additional requirements, which will incur additional costs. Mismanaging the exposure calculation for these funds can result in unnecessary compliance breaches and regulatory reporting elements. Capturing this data requires granular levels of detail regarding trade data, and can pose challenges in correctly mapping hedged instruments from leverage.
Second, calculating and understanding the risk measures requires in-depth knowledge of the analytics and how they impact the management of the fund. Implementing the new Value at Risk measures requires an understanding of how managers deploy leverage and how it impacts the volatility of their fund. Fund managers will now have to manage their leverage to that of a designated benchmark, ensuring that they do not breach prescribed limits on active risk. Ensuring that their risk model is appropriate also adds a layer of complexity as backtesting such methods is now required when using derivatives for leverage. In addition, implementing the stress testing framework requires correlations of risk factors, which can be challenging for organizations not currently capturing this data. In today’s modern capital market environment, identifying specific risk factors to protect portfolios from extreme downside measurement has become more and more complex. Computing all of these measures on a daily and weekly basis requires firms to build complex risk systems or outsource to vendors such as fund administrators and risk specialists.
Any of these compliance breaches incur board escalation and reporting, enacting a change in the investment strategy to bring the fund back into compliance, and in some instances reporting to the SEC. Ensuring that the appropriate model has been identified and implemented requires a deep understanding of risk modeling and can create challenges for organizations that have not been focusing on this aspect of market risk measurement.
Flexible Data and Technology Deployment
Outside of ensuring that funds are in line with the appropriate risk measurement framework, there is a technology component that may not be required but should be considered. Funds leveraging their fund administrator can enhance and streamline their data models to maximize operational efficiencies and start to think about how this data can be plugged into their organization, generating a more enterprise-wide risk management framework. Modern fund administrators should have the capability to leverage microservices, or APIs, to extract and disseminate this information across the firm in an agile manner. Such firms have access to a wealth of data and information that can be supplemented with these risk analytics to provide a true profile of their firm. Outside of the benefits that this provides to the firm’s internal procedures, this also bodes well with a sound regulatory program, where the regulatory calculations and data are aligned with the business on a day-to-day basis.
Why Act Now?
Although 18f-4 does not require compliance until August 2022, there are several benefits to being an early adopter. Investments in risk management technology and personnel provide a strong foundation for managing market risk, as well as demonstrating that the fund understands the inherent risks in the deployment of derivatives to enhance the fund’s profile. It not only captures the quantitative aspect of risk but also entails a cultural shift to engage various levels of the firm in understanding its risks day-to-day.
