In a December 2014 speech in New York, SEC Chair Mary Jo White discussed a variety of issues relating to registered investment funds. A number of her statements relate to potential rule-making activity involving investment funds and their use of derivatives.

The full text of her speech may be found at the following link:

http://www.sec.gov/News/Speech/Detail/Speech/1370543677722#.VJCd7010wy4

Our more detailed discussion of her remarks may be found at the following link:

http://www.bdiaregulator.com/2014/12/sec-to-require-living-wills-and-stress-testing-for-investment-advisers/

A few relevant excerpts from that discussion are set forth below:

The SEC is considering new rules that would require standardized reporting for derivatives used by funds and securities lending. The data-collection efforts may extend to private funds.

  • Our take: We can expect the SEC to require registered funds and private funds to report specific data concerning derivatives holdings and securities lending activities more regularly. This data might be used for the SEC’s surveillance and enforcement efforts, in a manner similar to how the SEC plans to use data derived from public company financial reporting and audit trail information.

Controls on risks related to portfolio composition: White identified liquidity risks and the use of derivatives as key staff priorities. Registered funds must establish controls that identify and manage those risks.

Consistent with the January 2014 guidance published by the Division of Investment Management, White said that the staff is concerned that mutual funds may have difficulty meeting redemptions if portfolios come under stress and are forced to sell securities at fire-sale prices, which, inturn, could drive down asset prices for other funds and other investors. The staff also is concerned that funds’ use of derivatives frequently results in “leveraged investment exposures and potential future obligations that can create risks.”

White called for a “comprehensive approach” to address risks related to liquidity and derivatives. While White was short on specifics, she said that the SEC’s staff is reviewing options such as updated liquidity standards, disclosures of liquidity risks, or limits on leverage created by use of derivatives.

  • Our take: It is not clear what the actual rule proposals would look like. An educated guess is that the SEC will refine the definition of “liquidity” — that is, when a fund should consider an investment to be illiquid. The current definition is buried in instructions to Form N-1A and, most recently, the 2014 amendments to the money market fund rules. A new definition may be more market-oriented, taking into account the perceived tightening of the fixed income market and shrinking bond inventories. The SEC may also attempt to pull in the reigns on leverage, or tighten asset segregation requirements. In any event, these proposals are likely to generate substantial controversy and public comment.