new rules / sefa ozel

Despite misgivings from one regulator, the U.S. Securities and Exchange Commission (SEC) is adopting a new regulatory framework to govern the use of derivatives by mutual funds, ETFs and other investment funds.

The SEC said that a new rule and amendments to existing rules that were passed on Wednesday aim to modernize the regulation of derivatives usage by funds. Among other things, the commission is adopting a new rule that will enable funds to enter into derivatives transactions subject to certain conditions, such as implementing a risk management program and limiting leverage.

The rule also introduces streamlined requirements for funds that make limited use of derivatives, allows funds to enter into certain financing transactions and sets reporting and record-keeping requirements.

The new framework was adopted despite the dissent of SEC commissioner Allison Herren Lee.

In a statement, Lee said that while she supported the regulator’s initial proposal for modernizing the rules for funds’ use of derivatives, the final rule is far different.

“Risk limits designed to place sensible boundaries around speculative investing have now been converted to outer bounds calibrated specifically to ensure that they will have no impact on funds’ existing practices. Moreover, changes in the rule allow funds to tinker with or manipulate those outer bounds, further undermining the notion that the rule imposes meaningful, extrinsic limits,” Lee said.

The final rule also expands leverage limits and abandons disclosure of those risks, and scraps planned sales practices requirements for leveraged and inverse ETFs that were designed to protect investors, Lee said.

“The commission’s concern about leveraged and inverse ETFs is not academic or theoretical. Numerous enforcement cases, both at the commission and FINRA, have shown that even investment professionals often lack a basic understanding of these complex products,” she said.

“Unfortunately, this rule did not live up to the promise of the proposal,” Lee concluded. “In fact, it underwent a substantial overhaul — increasing risk, reducing transparency around that risk, and dropping basic sales practice rules for extremely complex products — all to the detriment of retail investors.”

The SEC said that the new requirements will apply to leveraged or inverse ETFs. The SEC added that it will be considering additional requirements for these products, following a planned review of the existing protections for retail investors in complex products (particularly self-directed investors) by SEC staff.

“The staff may consider requirements that include, among other things, additional obligations for broker-dealers and investment advisers relating to complex products, as well as point-of-sale disclosures or policies and procedures tailored to the risks of complex products,” noted a joint statement from SEC chairman Jay Clayton and trio of SEC division heads.

In the meantime, Clayton said, the new rule “provides for a comprehensive framework for funds’ derivatives use that provides both meaningful protections for investors and regulatory certainty for funds and their advisers.”