Proposed Rule 18f-4 on the Use of Derivative Instruments by Registered Investment Companies: Data and Economic Analysis

Abstract

I present data and analysis suggesting that the SEC’s proposed rule 18f-4, in its current form, is an inefficient and ineffective way for the Commission to achieve its regulatory goals of protecting investors and limiting the extent to which registered investment companies can take leveraged exposure to market risks. The rule as proposed uses a limit on risk exposure based on gross notional amounts which places an equal restriction on the use of derivatives whether they are used to take highly speculative positions or whether they are used as part of conservative, low-risk strategies. The proposed rule is likely to have unintended consequences, such as inducing certain types of funds to take on risk exposures using less liquid instruments. Alternative approaches that take risk into account can achieve the Commission’s regulatory goals without depriving investors of the benefits of efficient access to low-volatility, low-correlation strategies achievable through the responsible use of derivative instruments.