The Securities and Exchange Commission's concept release on the use of derivatives by mutual funds, exchange-traded funds and other investment companies could serve as a valuable guide for other institutional investors.
It also could serve as a framework for examining other complex securities such as collateralized debt obligations.
Key issues the SEC is examining include the effects of using derivatives on an investment fund's leverage, diversification, portfolio concentration and valuation.
An important SEC regulatory objective of the concept release — a method the SEC uses to solicit comment to determine what, if any, rule-making or guidance on issues it should propose — should be to bring greater transparency to derivatives use and risk exposure, so investors can determine the instruments' appropriateness for their own investments, and to gauge the risk to the financial system.
That transparency should include more information on the risk management processes of funds in their use of derivatives, and more information on counterparty risk for over-the-counter derivatives. Risk management, needless to say, needs to be improved for entire funds, not just for one type of instrument like derivatives.
The examination should be important for defined contribution plans, as mutual fund and other investment portfolios sometimes use derivatives.
Defined contribution plan participants bear the investment risk. Plan sponsors have the fiduciary obligation when selecting investment choices to understand them so they can provide appropriate transparency and disclosures for participants.
But defined benefit plans and other institutional investors also should be concerned about the issues raised in the concept release, which was issued Aug. 31.
To obtain a broader evaluation, the SEC should expand its examination to include all users of derivatives.
Transparency should include disclosure not just of individual fund positions and usage, but also should provide marketwide statistics providing daily or other periodic detail of exposures, so regulators can assess systemic risk. Funds, for example, should report all their derivatives use, including short selling, in their disclosure to investors and in their 13(f) filing with the SEC.
Pension funds, endowments, foundations, investment management firms, mutual funds and ETFs long have been major users of derivatives. They employ both exchange-traded futures and options contracts, as well as OTC derivatives, such as swaps tailored for specific uses.
The information gathered on uses should include a breakdown of types of derivative instruments and their valuation, including notional value of derivatives and margin collateral. It should include a description of the purposes of the use of derivatives and how they fit into an investment strategy: Is it to improve return or mitigate risk, or for some other purpose, such as facilitating access to a market or asset class?
The SEC concept release asks whether disclosure should include information on leverage and liquidity, especially for over-the-counter derivatives. It should. That disclosure should include reporting on long and short positions by type of derivatives and counterparty risk.
In addition, disclosure should include information on procedures for valuing derivatives, on internal risk management structures and methods for controlling counterparty risk, as well as determining the risk exposure and reserves of counterparties. Also, it should require descriptions of the lines of accountability from staff to management to a firm's board.
In a comment letter submitted Nov. 1 to the SEC, Capital Market Risk Advisors raises a good point that should be part of any new regulation.
Scrutiny “should be based on complexity” and risk level, not whether instruments “are labeled "derivatives',” wrote Leslie Rahl and Peter Niculescu, managing partners of CMRA, a risk advisory consultant.
That is an important distinction the SEC should include in its evaluation. The level of risk often is not revealed initially in the type of instruments, as investors discovered with AAA-rated mortgage-related securities whose attested low-risk level proved elusive in the financial market crisis.
The SEC, as it should be, is concerned with the “dramatic growth in the volume and complexity of derivatives investments over the past two decades, and funds' increased use of derivatives.”
Sophisticated users — that is, many large fiduciary funds — might not need regulatory disclosures, but even they sometimes don't fully understand the risk, as witnessed by lawsuits against credit-rating agencies alleging investors were misled on risk level of mortgage-related securities. But all fiduciary investors, large and small, would benefit from greater disclosure of systemic risk.
The SEC goal should be transparency and strong risk management, but it should not seek to limit the use of derivatives, whether through a Department of Labor regulation or through congressional action.