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E-MailLuis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s recent public statement at an open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.
Today [December 11, 2015], the Commission considers new rules that are designed to protect investors by addressing the use of derivatives by registered investment companies. As demonstrated by the 2008 financial crisis, and the economic turmoil that followed, years of regulatory complacency and deregulation enabled an unregulated derivatives marketplace to cause significant losses to investors. In response to that crisis, in 2010, Congress passed the Dodd-Frank Act to address the causes of the financial crisis, and specifically included provisions in Title VII of the Act mandating the establishment of a regulatory framework for addressing broad categories of derivatives. This process is still ongoing.
Meanwhile, the global derivatives market remains huge, at an amount estimated in excess of $630 trillion in notional value worldwide. In addition, there has been a notable growth in the use of derivatives by registered investment companies. The growth is particularly remarkable with alternative strategy funds, which tend to use derivatives in the hope of achieving higher returns. For example, in 2010, there were only about 590 alternative strategy funds, with around $320 billion in assets under management. By the end of 2014, however, there were more than 1,100 such funds, with total assets under management in excess of $469 billion.
Other types of registered funds also make extensive use of derivatives. As a point of comparison, according to a white paper authored by the Commission’s Division of Economic and Risk Analysis (DERA), as of April 2015, the derivatives exposure of traditional mutual funds, exchange-traded funds, and alternative strategy funds were 29%, 29%, and 73%, respectively. In fact, some of the funds that use derivatives have notional exposures almost ten times in excess of the funds’ net assets. This raises obvious questions as to whether these exposures place undue risks on the funds’ investors and whether they negatively affect a fund’s ability to withstand financial shocks.
The increased use of derivatives by registered funds is a particular risk for retail investors. As a former Director of the Division of Investment Management has said, retail investors might find it challenging and difficult to comprehend and appropriately weigh the trade-offs posed by sophisticated and complex investment strategies. This is a concern that has grown in recent years, as retail investors continued to pour money into alternative mutual funds, a subcategory of alternative strategy funds. In fact, the alternative mutual fund market grew from about $76 billion in assets at the end of 2009 to over $311 billion in assets at the end of 2014. Because alternative mutual funds tend to rely more heavily on derivatives to achieve their investment goals, there can be an accompanying rise in complexity—and risk. With retail investors expected to continue to drive the growth of alternative mutual funds in coming years, the potential risk to retail investors will only increase. The Commission’s mandate to protect investors, therefore, calls for a sharper focus on funds’ use of derivatives and for putting in place prudent safeguards to ensure funds properly manage the associated risks.
Today, in order to begin addressing the issues arising from registered funds’ increased use of derivatives, the Commission considers new rules that will require a fund entering into derivatives transactions to comply with certain portfolio limitations; maintain an amount of assets to enable the fund to meet its obligations; and establish a derivatives risk management program if the fund’s exposure reaches a certain threshold. More importantly, all registered funds with exposures to derivatives must put in place a system to manage and monitor risks, as well as segregate assets. Simply stated, while all funds would be expected to keep an eye on what they are doing with derivatives, their regulatory responsibilities will increase in tandem with their exposure to risks posed by derivatives.
Protecting Investors from the Risks Posed By Derivatives
Today’s rules are part of the Commission’s broader focus on derivatives. For example, the Commission has focused on the risks posed by derivatives to investors through, among other things, enforcement actions, the examination program, investor education, and rulemaking initiatives. In recent years, the SEC has brought a number of enforcement cases involving derivatives, including more than 25 cases in Fiscal Year 2015 alone, and brought several cases where a fund’s use of derivatives caused significant investor losses—losses driven mainly by exposures to certain commercial mortgage-backed securities, out-of-money put options, short variance swaps, or credit default swaps.
In addition, under Chair White’s leadership, the Commission has continued to be active on the regulatory side. Indeed, the Commission has now proposed all of the Title VII rules under the Dodd-Frank Act, and adopted a number of these rules. Still, several rules remain to be adopted. Today, more than five years after the passage of the Dodd-Frank Act, the presumptive regulatory regime for the securities-based swap market is still a work-in-progress. Specifically, the regulatory regime for these derivatives, and its main components, has not yet gone into effect. To this end, as I have done on prior occasions. I urge my fellow Commissioners to move with urgency to adopt the rest of the long-overdue Title VII rules. These rules are necessary to promote transparency and accountability in the derivatives market.
The Importance of Fund Governance
Now, I want to highlight the importance of a fund’s corporate governance. As I have stated on other occasions, a robust corporate governance structure goes a long way in protecting investors by, among other things, identifying potential risks before they metastasize into larger problems. I recognize that this is easier said than done. As today’s release points out, a fund’s use of derivatives—and the associated risks—presents challenges not only for the fund’s investment adviser but also for a fund’s board of directors.
Fund boards already have extensive regulatory responsibilities in overseeing fund operations and protecting investor interests. Under the current regulatory regime, a fund board needs to oversee the fund’s compliance with the relevant federal securities laws and other regulatory requirements. Among other things, this includes the responsibility for ensuring that fund assets are invested in a way that is consistent with the fund’s investment objectives, policies, restrictions, and risk profile.
Although existing board responsibilities already include a general obligation to oversee a fund’s derivatives use, today’s proposed rules would add specific responsibilities. Under the proposed rules, fund boards would be required to do a number of things:
- First, if applicable, a fund board must approve a fund’s derivatives risk management program, any material changes to the program, and the fund’s designation of the fund’s derivatives risk manager. Under the proposed rules, this formalized program must be reasonably designed to assess the risks of derivatives transactions, manage and monitor risks, segregate functions of fund personnel, and require annual updates and reviews.
- Second, a fund board must review written reports prepared by the derivatives risk manager, at least on a quarterly basis, and review the adequacy and effectiveness of the derivatives risk management program.
Imposing these responsibilities on fund boards is necessary and appropriate. As the investors’ representatives, fund boards play a critical role in overseeing fund operations. Thus, if a fund chooses to integrate derivatives into its investment strategies, it is only appropriate to require that its board also take on the responsibilities outlined in our proposed rules today.
Still, every time the Commission votes to add responsibilities to boards of directors, I consider whether boards are prepared and equipped to take on those added responsibilities, which seem only to increase in number and complexity over time. Taking on additional responsibilities will require more time, resources, and, of course, expertise. Given that fund board members generally serve the fund on a “part-time basis,” increasing the size and complexity of their obligations, legal responsibilities, and exposures to liability is something to consider thoughtfully. This is particularly true in the context of derivatives risk management, given the complexities of a derivatives marketplace that is only expected to continue to evolve and grow over time. Nevertheless, under our existing corporate structure, these burdens are inherently part of a fund board’s responsibilities.
The vital role that boards have in fostering integrity in our capital markets and for setting the appropriate tone from the top, safeguarding assets, and promoting accountability are well-recognized. As the spectrum of risk increases, the overall supervision of risk management will become even more crucial to fulfilling a board’s obligations. Accordingly, I urge fund boards to be proactive in foreseeing the challenges and opportunities that lie ahead, and to how best to navigate them. To this end, fund boards must continue to evaluate—such as through periodic reviews—whether its members, collectively, have the requisite skills, experience, time, and resources that are needed as a fund’s operations, objectives, and investment strategies change over time.
Ultimately, investors rely on fund boards to be competent stewards of the fund’s assets and investors’ interests. Investors must be able to remain confident that a fund board can effectively execute all of its fiduciary and regulatory responsibilities. I am hopeful, and confident, that boards will do so.
Conclusion
To conclude, I will support today’s proposing release. This rulemaking is a positive and important step in the right direction, and it is consistent with the SEC’s investor protection mandate—particularly, the protection of retail investors.
Finally, I want to thank the SEC staff for your work in this release, especially the staff in the Division of Investment Management and DERA. I appreciate your engagement with my office and for responding to all of my questions and comments.
Thank you.
