SEC Rule 18f-4

Overview and Regulatory Purpose

Section 18(f) of the Investment Company Act prohibits registered open-end management investment companies from issuing senior securities — defined to include any obligation that takes precedence over the fund's equity securities with respect to distribution of assets or payment of dividends. Section 61 imposes parallel restrictions on BDCs. 

These prohibitions were enacted to protect fund shareholders from the risks of excessive fund leverage — the use of borrowed funds or other obligations to amplify investment returns, which simultaneously amplifies losses and creates the risk that creditors' claims will impair the fund's ability to meet its redemption obligations to shareholders.

Derivatives transactions — futures contracts, forward contracts, swap agreements, and written options — create obligations that are economically equivalent to leveraged positions in the underlying assets: a fund that enters into a futures contract to purchase the equivalent of $100 million in equity index exposure has created a leveraged position whose economic risk profile is indistinguishable from having borrowed $100 million to purchase the underlying stocks, yet the notional amount of the futures position was never characterised as a senior security under Section 18. 

The Commission's guidance in the 1970s and subsequent interpretive letters attempted to address this problem through an asset segregation approach — requiring funds to set aside liquid assets equal in value to the fund's obligations under derivatives transactions — but this approach was widely criticised as economically arbitrary, notional-amount-focused rather than risk-focused, and inconsistent across different types of derivatives.

Rule 18f-4 replaces the asset segregation regime with a framework that directly addresses the economic risk that derivatives create rather than the notional value of derivatives positions. 

By requiring funds that use derivatives beyond minimal levels to maintain a Value at Risk-based limit on portfolio leverage risk, the rule ensures that the economic leverage created by derivatives is bounded in a manner tied to the fund's actual risk exposure rather than to the face value of derivatives contracts whose notional amounts may dramatically overstate the actual economic risk they create.

Statutory Authority and Rulemaking History

Rule 18f-4 derives its statutory authority from Section 6(c) of the Investment Company Act, which authorises the Commission to exempt any person, security, or transaction from any provision of the Act to the extent such exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes of the Act. 

The Commission also relied on Section 38(a)'s general rulemaking authority. Section 6(c)'s exemptive authority is the foundational basis for Rule 18f-4's permission for funds to enter into derivatives transactions notwithstanding Section 18's senior securities restrictions — the rule operates as a standing, conditions-based exemptive order applicable to any fund satisfying its requirements.

The Commission first proposed a comprehensive derivatives rule for registered funds in 2015 and re-proposed it in 2019 — Investment Company Act Release No. IC-33704 — following extensive review of comment letters and changes in market practice. 

The final rule was adopted October 28, 2020 — Investment Company Act Release No. IC-34084, published at 85 FR 83162, December 21, 2020 — with an effective date of February 19, 2021 and a compliance date of August 19, 2022, providing funds and advisers with 18 months to design, test, and implement the derivatives risk management infrastructure the rule requires. No changes have been made to Rule 18f-4's operative provisions up to the present time.

Key Provisions and Operative Requirements

Rule 18f-4(c) — applicable to funds with derivatives exposure exceeding the 10% limited user threshold — establishes the primary compliance framework through three interconnected requirements.

The first requirement is the derivatives risk management programme. 

A fund relying on Rule 18f-4 as a non-limited user must adopt and implement a written derivatives risk management programme reasonably designed to assess and manage the fund's derivatives risks and to reasonably segregate the functions associated with the programme from the portfolio management of the fund. 

The programme must include six specified elements: risk identification and assessment addressing the material risks associated with the fund's use of derivatives including leverage risk, market risk, counterparty risk, liquidity risk, operational risk, and legal risk; risk guidelines establishing investment policies and procedures that are reasonably designed to address material aspects of the fund's derivatives risks; stress testing to reasonably assess the impact of adverse market conditions on the fund's portfolio; backtesting of the fund's VaR model at least weekly, comparing the fund's VaR model estimates against actual portfolio gains and losses; internal reporting and escalation protocols under which the derivatives risk manager reports to the fund's portfolio management team and board regarding material risks identified by the programme; and programme review at least annually to evaluate the programme's effectiveness and to make adjustments as needed.

The derivatives risk manager — an officer or officers of the fund's investment adviser responsible for administering the programme — must satisfy two mandatory conditions. 

The derivatives risk manager cannot be a portfolio manager of the fund, and if the role is assigned to multiple officers, portfolio managers cannot constitute a majority of the group — a segregation of duties requirement that prevents the same persons responsible for establishing derivatives positions from unilaterally determining whether those positions create unacceptable risk. 

The derivatives risk manager must have relevant experience regarding the management of derivatives risk, ensuring that the risk assessment function is performed by personnel with the knowledge and expertise necessary to identify and evaluate the risks associated with complex derivatives instruments.

The second requirement is board oversight and reporting. 

The fund's board of directors must approve the fund's designation of the derivatives risk manager and must receive quarterly and annual written reports from the derivatives risk manager assessing the adequacy of the programme and identifying any material risks arising from the fund's derivatives use during the reporting period. 

The board must provide oversight of the programme through active engagement with these reports — reviewing whether the programme's risk limits and guidelines remain appropriate and whether any material risks identified by the derivatives risk manager have been adequately addressed by fund management. 

The board oversight requirement directly integrates Rule 18f-4's derivatives governance into the comprehensive investment company governance framework established by Rule 38a-1, since the adequacy of the fund's derivatives risk management programme is a component of the Rule 38a-1 compliance programme that the board and chief compliance officer must oversee.

The third requirement is the VaR-based limit on fund leverage risk. A fund relying on Rule 18f-4 must comply with one of two alternative VaR tests that limit the economic leverage the fund's derivatives positions create relative to the fund's overall portfolio.

The relative VaR test limits the VaR of the fund's entire portfolio — calculated on a one trading day time horizon at a 99% confidence level — to no more than 200% of the VaR of the fund's designated reference portfolio — a portfolio without derivatives or financial leverage that reflects the fund's investment policy without its derivative positions. For closed-end funds, the relative VaR limit is 250%. 

The reference portfolio may be the fund's securities portfolio excluding derivatives, a represented benchmark index, or a combination of these, provided the derivatives risk manager determines that the reference portfolio accurately reflects the fund's investment policy. 

The relative VaR test is the primary VaR mechanism for most fund strategies, since it compares the fund's actual leverage-adjusted risk to what the fund's risk profile would be without derivatives — measuring economic leverage in terms of actual risk rather than notional exposure.

The absolute VaR test — available as an alternative where the derivatives risk manager reasonably determines that the reference portfolio methodology would not provide an appropriate reference portfolio — limits the VaR of the fund's entire portfolio to no more than 20% of the fund's net assets. 

For closed-end funds, the absolute VaR limit is 25%. The absolute VaR test is designed for funds whose investment strategies make it difficult to construct a meaningful reference portfolio — funds that systematically use derivatives as a core investment strategy rather than as an overlay or hedge, where any reference portfolio without derivatives would not meaningfully represent the fund's risk baseline.

Where the fund's VaR exceeds the applicable limit, the fund must come back into compliance promptly — within five business days — through portfolio adjustments designed to reduce derivatives exposure and associated leverage risk to within the applicable limit. 

The five-day cure period acknowledges the operational reality that VaR breaches may result from rapid market movements rather than from deliberate policy choices, and that forced immediate liquidation of derivatives positions in response to a momentary VaR breach could itself cause market disruption and harm the fund's remaining shareholders.

Rule 18f-4(c)(2)(ii) establishes the backtesting requirement that accompanies VaR-based testing. A fund using the relative or absolute VaR test must backtest its VaR model at least weekly by comparing the VaR estimates the model produced for each of the past 20 trading days against the fund's actual portfolio gains and losses on those days. 

Where the number of exceptions — days on which the actual loss exceeded the predicted VaR — exceeds five for any 20-trading-day period, the derivatives risk manager must report that result to the fund's board as a potential model deficiency, triggering board review of whether the VaR model continues to provide an adequate measure of the fund's leverage risk.

Rule 18f-4(c)(4) — the limited derivatives user exception — provides a substantially less burdensome compliance pathway for funds whose derivatives use is limited to hedging and other low-exposure applications. A fund may elect limited derivatives user status if its derivatives exposure does not exceed 10% of its net assets. 

For purposes of this threshold, a fund may exclude from the calculation certain derivatives transactions that hedge currency or interest rate risks — recognising that these routine portfolio management applications present materially lower leverage risk than directional derivatives positions. 

A fund relying on the limited derivatives user exception must adopt policies and procedures reasonably designed to manage the fund's derivatives risks, must note its limited user status on Form N-CEN, and must come into compliance with the full Rule 18f-4 framework within five business days if its derivatives exposure exceeds the 10% threshold.

Rule 18f-4(d) addresses reverse repurchase agreements and similar financing transactions. A fund may elect to treat reverse repurchase agreements — transactions in which the fund sells a security and simultaneously agrees to repurchase it at a later date at a slightly higher price, effectively using the security as collateral for a short-term borrowing — as derivative transactions subject to Rule 18f-4's framework, or as borrowings subject to Section 18's traditional asset coverage requirements. 

A fund that makes the election to treat reverse repurchase agreements as derivative transactions under Rule 18f-4 must apply that treatment consistently to all similar financing transactions — it cannot selectively characterise some reverse repurchase agreements as derivatives and others as borrowings based on which treatment produces a more favourable compliance result for a particular transaction.

Scope of Application

Rule 18f-4 applies to mutual funds other than money market funds, ETFs, registered closed-end funds, and BDCs — the complete universe of registered funds that use derivatives as a component of their investment strategy or operational practice. Money market funds are specifically excluded because their portfolio quality and maturity restrictions under Rule 2a-7 already effectively prohibit the use of derivatives that would create meaningful leverage risk.

Leveraged and inverse ETFs — which provide daily returns that are a multiple or inverse multiple of the return of a reference index, and which by their construction require substantial derivatives exposure — are subject to Rule 18f-4's requirements as non-limited users, since their derivatives exposure necessarily exceeds the 10% threshold. 

Leveraged and inverse ETFs that were in operation before October 28, 2020 and that seek investorment returns exceeding 200% of the reference index return are subject to a specific exception from the VaR-based limit that reflects the Commission's recognition that existing leveraged and inverse products had established operational and investor disclosure frameworks under their prior exemptive orders that the VaR-based test could not accommodate without disrupting their intended investment exposure. New leveraged and inverse ETFs launched under the Rule 6c-11 framework — which Rule 18f-4's adoption simultaneously amended to permit leveraged and inverse ETF launches without individual exemptive orders — are subject to Rule 18f-4's full VaR-based requirements including the leverage limit.

Relationship to Related Rules and Regulations

Rule 18f-4's derivatives risk management programme connects directly and explicitly to Rule 38a-1's comprehensive compliance programme framework. 

The derivatives risk management programme required under Rule 18f-4(c)(1) is a component of the fund's overall compliance infrastructure, and the board oversight and reporting requirements of Rule 18f-4(c)(3) — through which the derivatives risk manager reports to the board on programme adequacy and material risks — must be integrated with the board reporting and compliance programme oversight that Rule 38a-1 establishes for all aspects of the fund's regulatory compliance. 

A fund's Rule 38a-1 compliance programme must specifically address how the fund monitors and enforces compliance with Rule 18f-4's VaR limits, how potential VaR breaches are identified and escalated, and how the derivatives risk manager's independence from portfolio management is maintained and verified.

Rule 22e-4's liquidity risk management requirements interacts with Rule 18f-4's VaR-based leverage limit in a manner that creates complementary but distinct risk governance obligations. A fund that uses derivatives to create significant leveraged exposure may face concentrated liquidity risk if it needs to unwind derivatives positions rapidly to meet redemption demands — the liquidity risk management programme required by Rule 22e-4 must account for the liquidity risk associated with unwinding derivatives positions under stress conditions, while Rule 18f-4's VaR limit addresses the leverage risk dimension of the same derivatives exposure. 

The two rules address different dimensions of derivatives risk — leverage and liquidity — that are related but not identical, and both must be addressed in the fund's comprehensive risk management framework.

Rule 18f-4's treatment of leveraged and inverse ETFs, and its simultaneous amendment of Rule 6c-11, represents one of the most consequential interactions among the Investment Company Act's rules governing ETFs. 

The amendment to Rule 6c-11 that Rule 18f-4's adoption introduced permitted new leveraged and inverse ETFs to launch under Rule 6c-11's standardised framework — bringing the most derivatives-intensive category of ETF within the same standardised operational framework as conventional index and actively managed ETFs, while subjecting those leveraged and inverse products to Rule 18f-4's VaR-based leverage limits rather than the bespoke conditions that had governed them under prior individual exemptive orders.

Rule 2a-5's fair value determination framework applies to the derivative positions that Rule 18f-4 governs. The VaR calculation that Rule 18f-4 requires for the relative and absolute VaR tests depends on the accurate valuation of the fund's derivatives positions — if the fair values used to compute portfolio-level VaR are inaccurate, the VaR test result will be distorted and the fund may believe it is within its leverage limit when it is not, or vice versa. 

The quality of the fund's Rule 2a-5 fair value determination process for its derivatives holdings is therefore a direct determinant of the accuracy of its Rule 18f-4 VaR compliance.

Rule 35d-1's Names Rule interacts with Rule 18f-4's derivatives framework in the context of funds whose names incorporate leverage or inverse characteristics — specifically leveraged and inverse ETFs, whose names communicate investment objectives that are defined entirely through their derivatives exposure. The rule's 80% investment policy requirement must be evaluated for leveraged and inverse funds in the context of their derivatives-based investment strategy, where the 80% basket's treatment of derivatives providing investment exposure to the named investment category is directly applicable.

Amendment History and Regulatory Evolution

Rule 18f-4 has not been substantively amended since its October 2020 adoption — no changes have been made to its operative provisions up to the present time. 

The Commission's post-adoption regulatory engagement with Rule 18f-4 has focused primarily on examination findings addressing the adequacy of derivatives risk management programme implementation, the accuracy and robustness of VaR model backtesting, and the independence and qualifications of derivatives risk managers — areas identified through the Division of Examinations' programme-focused reviews that have informed the practical standards applied to Rule 18f-4 compliance.

The rule's VaR-based framework represented a deliberate departure from the notional amount approaches that had characterised prior derivatives regulation in multiple jurisdictions, and its adoption was followed by significant industry investment in VaR model development, data infrastructure, and risk management personnel — investments that the compliance date's 18-month delay from the effective date was specifically designed to accommodate. 

The maturation of industry VaR models and derivatives risk management programmes in the years following the compliance date has progressively improved the practical functionality of the rule's risk measurement framework.

Enforcement Context and SEC Action Patterns

Rule 18f-4 enforcement has concentrated on three primary categories since the rule's compliance date. The first involves failures of the derivatives risk management programme — cases where funds' programmes lacked the specificity, independence, or comprehensiveness required by Rule 18f-4(c)(1)'s specified elements, including inadequate risk identification processes, insufficient stress testing methodologies, and deficient internal reporting and escalation protocols. 

The Division of Examinations has identified programme adequacy as a primary examination focus for funds relying on Rule 18f-4, with recurring findings related to the adequacy of risk guidelines and the robustness of backtesting procedures.

The second enforcement category involves VaR limit compliance failures — cases where funds' VaR exceeded the applicable relative or absolute limit, either as a result of rapid market movements, model deficiencies, or inadequate monitoring that delayed identification of the breach. 

The five-business-day cure period is the operative compliance standard once a breach is identified, and failures to take prompt and effective action within that period have been identified as independent compliance failures.

The third category involves derivatives risk manager independence failures — cases where the derivatives risk manager position was staffed by portfolio managers in violation of Rule 18f-4's segregation requirements, or where the reporting relationship between the derivatives risk manager and the fund's portfolio management team created de facto reporting lines that undermined the independence the rule requires.

Examination Relevance and Key Takeaways

Rule 18f-4 is examined at the Series 65 level in the context of registered investment company use of derivatives and the governance framework applicable to derivatives-intensive fund strategies. 

The two alternative compliance pathways — the full derivatives risk management programme and VaR-based leverage limit framework for funds with derivatives exposure above 10% of net assets, and the limited derivatives user exception available where exposure is 10% or less excluding hedging transactions — are the primary structural examination concepts. 

The two VaR tests — the relative VaR test limiting portfolio VaR to 200% of reference portfolio VaR, and the absolute VaR test limiting portfolio VaR to 20% of net assets — are examined as the operative leverage limits that define the outer boundary of permissible derivatives leverage for Rule 18f-4 filers.

The derivatives risk manager's mandatory independence from portfolio management — the prohibition on portfolio managers serving as derivatives risk managers, or constituting a majority of a multi-person derivatives risk management team — is examined as the key segregation of duties requirement that gives the derivatives risk management programme its independence from the investment decision-making function it is designed to assess.

The key points to retain are these. Rule 18f-4 permits mutual funds, ETFs, closed-end funds, and BDCs to enter into derivatives transactions notwithstanding Section 18's senior securities restrictions. Funds with derivatives exposure above 10% of net assets must implement a written derivatives risk management programme with six specified elements, have the board approve and oversee the designated derivatives risk manager — who cannot be a portfolio manager of the fund — and comply with VaR-based leverage limits. 

The relative VaR test limits portfolio VaR to 200% of reference portfolio VaR (250% for closed-end funds); the absolute VaR test limits portfolio VaR to 20% of net assets (25% for closed-end funds); VaR models must be backtested weekly. 

Funds with derivatives exposure at or below 10% of net assets — excluding certain currency and interest rate hedging transactions — may rely on the limited derivatives user exception, which requires only policies and procedures reasonably designed to manage derivatives risks and Form N-CEN disclosure. 

Leveraged and inverse ETFs are subject to Rule 18f-4 and may launch under Rule 6c-11 following Rule 18f-4's simultaneous amendment of that rule. Money market funds are excluded. Rule 18f-4 was adopted October 28, 2020, with compliance required from August 19, 2022. No changes have been made to its operative provisions up to the present time.