SEC derivatives proposal could impact US-listed leveraged ETFs

Dec 14th, 2015 | By | Category: ETF and Index News

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The US Securities and Exchange Commission (SEC) has proposed a new rule that would limit the use of derivatives by registered investment companies, including exchange-traded funds. If it were to come into force, the proposed rule could have a significant impact on US-listed leveraged and inverse ETFs, potentially forcing providers such as Direxion and ProShares to change the legal structure or leverage factor of affected products, or even close them down.

SEC proposes enhanced investor protection through regulation of derivatives in ETFs

SEC Chair Mary Jo White, following her nomination for the role by US President Barack Obama.

SEC Chair Mary Jo White, commented: “Today’s proposal is designed to modernize the regulation of funds’ use of derivatives and safeguard both investors and our financial system. Derivatives can raise risks for a fund, including risks related to leverage, so it is important to require funds to monitor and manage derivatives-related risks and to provide limits on their use.”

The Investment Company Act limits the ability of funds to engage in transactions that involve potential future payment obligations, including derivatives such as forwards, futures, swaps and written options. The proposed rule would permit funds to enter into these derivatives transactions, provided that they comply with certain conditions.

Under the proposed rule, a fund would be required to comply with one of two alternative portfolio limitations designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions.

Exposure-Based Portfolio Limit: Under the exposure-based portfolio limit, a fund would be required to limit its aggregate exposure to 150 percent of the fund’s net assets. A fund’s “exposure” generally would be calculated as the aggregate notional amount of its derivatives transactions, together with its obligations under financial commitment transactions and certain other transactions.

Risk-Based Portfolio Limit: Under the risk-based portfolio limit, a fund would be permitted to obtain exposure up to 300 percent of the fund’s net assets, provided that the fund satisfies a risk-based test (based on value-at-risk). This test is designed to determine whether the fund’s derivatives transactions, in aggregate, result in a fund portfolio that is subject to less market risk than if the fund did not use derivatives.

These limits would affect those 2x and 3x leveraged long and short ETFs structured via the Investment Company Act of 1940. This encompasses the majority of leveraged ETFs providing exposure to equities and fixed income. Some leveraged commodity-based ETFs would escape the proposed rules, however, by virtue of their registration as ‘commodity pools’ with the CFTC. This alternative vehicle could potentially provide an option for issuers of affected short and leveraged ETFs to restructure the products to circumvent the proposed rule changes.

Whilst the SEC’s proposal will be a cause of concern for providers of leveraged ETFs, it is worth noting that what the SEC has published is just a proposal. Proposed rules frequently change significantly before adoption, or are never adopted at all. If a rule is ultimately adopted, it will only impact funds after it is implemented, which could be many months, if not years, from now.

According to SEC proceedings, the rule will be published in the Federal Registrar, allowing market participants a period of 90 days to comment on the proposal.

A statement released by ProShares, said: “We will continue to monitor this process closely. After we’ve had a chance to review the full text of the proposal, we will evaluate whether any changes in the management of our funds would be appropriate. Ultimately, we believe we will be able to continue to offer leveraged and inverse ETFs and mutual funds to help investors manage risk and enhance returns.”

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