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A Modern Approach to Regulating Derivatives and ETFs

Learn more about the details behind the SEC's proposed and amended rules to the Investment Company Act of 1940.

SEC Proposes Rule 18f-4 to Investment Company Act of 1940

In November, the SEC proposed a modernized version of rule 18f-4 under the Investment Company Act of 1940. The rule, which sets new conditions under which funds can trade derivatives and financial commitment transactions, was initially proposed in 2015 but was dropped.

Section 18 of the Act aims to prohibit or limit mutual funds from issuing senior securities. According to the SEC, a senior security includes reverse repurchase agreements, firm commitment agreements, standby commitment agreements, short sales, written options, forwards, futures, and other derivatives transactions involving senior securities issued on the fund’s behalf. Proposed rule 18f-4 supports section 18’s objective by enacting investor protection measures to prevent excess leveraging of investment companies.

The proposed rule would not apply to unit investment trusts, but if adopted, it would require the following changes for ETFs, open-ended funds, and closed-ended funds:

  • A written derivatives risk management program that would define risk guidelines, stress testing, internal reporting, escalation processes, how the fund uses derivatives and how derivatives affect the fund’s investing.
  • An outer limit on fund leverage risk based on value at risk (VaR) when funds engage in derivatives transactions.
  • A designated derivatives risk manager with approval from the fund’s board of directors. The risk manager would be responsible for implementing and maintaining the risk management program and would report directly to the board.
  • An exception for limited derivative users from the derivative risk management program and the VaR-based limit on fund leverage risk.
    • This applies to funds that limit derivative exposure to 10% of net assets or use derivative transactions solely to hedge certain currency risk, since  the derivative risk program could require the fund to bear cost and compliance burdens disproportionate to the resulting benefits.
  • An exception for certain leveraged/inverse funds with additional safeguards from the limit on a fund leverage risk
    • Under the sales practice rules, allows funds to exercise due diligence on retail investors before approving their account to invest in the fund(s).
    • Preserves the choice for investors to believe the investment advisor or broker-dealer has reasonably sufficient financial knowledge and experience to evaluate the risk of the funds.
  • Record-keeping requirements designed to provide the Commission’s staff, the fund’s board, and the internal compliance team with the ability to evaluate a fund’s adherence to the proposed rule.
  • Permission for funds to enter into reverse repurchase agreements as long as the fund meets the asset coverage requirements under section 18 and unfunded commitments.
  • Confidential SEC reporting on Form N-LIQUID (to be renamed “Form N-RN”) if the fund is out of compliance with the VaR-based limit on fund leverage risk for more than three consecutive business days.

With 18f-4’s proposed changes come amendments to SEC reporting processes. View all rule updates to N-PORT, N-LIQUID, N-CEN, and BDC reporting in the SEC’s full proposal.

More information about the overall rule can be found on the SEC’s website.

SEC Amends Rule 6c-11 to Investment Company Act of 1940

In September, the SEC amended rule 6c-11 of the Investment Company Act of 1940 — a stipulation which generally permits ETFs that are indexed-based and actively managed open-ended funds to operate with an exemption order. The amendment to the rule will instead allow ETFs who meet the laid-out  criteria to forgo applying for an exemption and instead go directly to market, saving time and expense for investors. The exemption permits ETFs to:

  • Redeem shares only in creation unit aggregations.
  • Have shares purchased and sold at market prices, rather than the NAV.
  • Engage in in-kind transactions with certain affiliates.
  • In certain limited circumstances, pay authorized participants the proceeds from the redemption of shares in more than seven days.

In order to operate without applying for an exemption per the amendment, ETFs are subject to several conditions designed to address concerns for relevant statutory provisions and to allow the funds to operate in the public interest and consistent with the investor protection outlined in the Act:

  • Disclosure of portfolio holdings each business day on its website before the market opening with the ETF NAV, market price, and the premium or discount.
  • Disclosure of the ETF median bid-ask spread over the last 30 calendar days.
  • Adoption and implementation of written policies and procedures that govern the construction of baskets, inclusive of custom baskets, and the process that will be used for the acceptance of baskets.
  • Record retention for each basket exchange with an authorized participant.

Rule 6c-11 will also include a condition that excludes  ETFs that seek  to provide investment  returns over a period of time that corresponds to the performance of a market index by a specified multiple or which has an inverse relationship to performance of a market index (i.e. leverage/inverse ETFs). However, the rule does not include conditions relating to index-based ETFs with affiliated index  providers  (“self- indexed ETFs”).

The rule changes must be made to forms N-1A, N-8B-2, and N-CEN. N-1A and N-8B-2 are designed to provide investors with specific information regarding the cost associated with investing in ETFs. A new disclosure will be required to help investors better understand and compare specific funds, with the end aim of fostering greater competition.

ETFs that rely on rule 6c-11 will be exempt from the form N-1A disclosure requirements related to bid- ask spreads and premiums or discounts to NAV per share. Form N-CEN will now require identification of ETFs that rely on rule 6c-11.

Compliance date for the enhanced N-1A, N-8B-2, and N-CEN is December 22, 2020. More information about the overall rule can be found on the SEC’s website.

Learn More

Northern Trust will continue to monitor the rule changes and provide additional updates as they become available. Want to know more about the adjustments rules 18f-4 and 6c-11 will require? Contact your Northern Trust representative or visit

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