Perfect Hedge: Adding Precision to the Proposed SEC Rule on Investment Company Use of Derivatives with a Hedging Exception

Abstract

Derivatives are complex financial instruments that derive their value from an underlying asset. Used and valued by commercial and financial institutions, derivatives are booming. Indeed, the growing $600 trillion derivative market dwarfs the $67 trillion stock market. Yet, the magnification effect of derivative leverage on losses has well-documented ties to the 2008 Financial Crisis when AIG, Lehman Brothers, and other financial institutions found themselves indebted on hundreds of billions of dollars in derivative transactions. Since the crisis, investment companies and funds constrained by the Investment Company Act to protect unsophisticated and vulnerable investors have increased their use of derivatives. In response to a dearth of regulation of investment company use of derivatives, the SEC introduced Proposed Rule 18f-4 in 2015. The proposed rule would control risky derivative use through mandating portfolio limitations, asset segregation requirements, the establishment of Derivative Risk Management Programs, and additional recordkeeping requirements. The current wind in government, however, blows against such a rule. This Note argues that Proposed Rule 18f-4 should not be abandoned but rather implemented to prevent hazardous derivative use by investment companies. The rule, if implemented, should allow for the beneficial and vital use of hedging in its calculation of fund risk exposure and use expected shortfall instead of Value at Risk in making such a calculation. These augmentations to the rule would allow investment companies to benefit from derivatives and still follow the Investment Company Act’s goal of protecting unsophisticated investors.