WASHINGTON (CN) – The Securities and Exchange Commission is asking if and how it should regulate the use of derivatives by mutual funds and other investment companies covered by the Investment Company Act.
“In 1940, when the Investment Company Act was adopted, derivatives as we now know them did not exist. The act imposes important leverage, valuation, diversification, and industry concentration requirements to help protect fund investors. However, those limitations were written with stocks and bonds in mind, not complex financial derivatives,” SEC Chairman Mary Schapiro said.
The SEC has been concerned about the way mutual funds use derivatives to gain exposure to stocks, bonds and other assets without owning the assets themselves, since before the financial crisis of 2008 when many major investment firms including Lehman Brothers and Citigroup suffered unexpected losses due to their inability to appreciate the downside risk of their derivative exposure.
According to Shapiro, “the controls in place to address fund investments in traditional securities can lose their effectiveness when applied to derivatives. This is particularly the case because a relatively small investment in a derivative instrument can expose a fund to a potentially substantial gain or loss – or outsized exposure to an individual counterparty.”
The SEC is using a concept release – a document that outlines the SEC’s areas of concern on a topic – to focus public input on the issue.
Generally, the concept release asks for information on how different types of funds use various types of derivatives, and the benefits, risks and costs of using derivatives.
Specifically, the SEC wants to know if there are substantive differences between owning an asset and owning a derivative that bets on the performance of that asset and, if there are differences, how to account for them under the limitations imposed by the act.
For instance, the act requires mutual funds to abide by their company and industry diversification policies as stated on their SEC registrations, but the funds do not have to include derivatives based on specific companies or industries against their diversification policies.
Given the recent mistakes in assessing the value of derivatives in investment company portfolios, the SEC is also interested in public comments on how such valuations should be done.
On a related question, since derivatives are mostly used to leverage a fund’s market exposure and are therefore similar to debt, the SEC to wants to know how to measure a fund’s leverage against debt limitations imposed by the act.
The SEC has issued two additional concept releases focusing on what is – and what is not – an “investment company” as that term is defined under the act.
Currently, real estate investment trusts and asset-backed securities issuers are exempt from the act’s limitations if they were rated by a credit rating agency recognized by the SEC.
However, the Dodd-Frank Wall Street Reform and Consumer Protection Act forbids the SEC from using ratings from these agencies when determining if an issuer is exempt under the Investment Company Act.
After the SEC’s solicitation for public comments is published in the federal register, the public will have 60 days to respond.