Securities Law Blog

The Securities and Exchange Commission (SEC) has put a halt on any new or pending exemptive requests by exchange-traded funds (ETFs) that are seeking to make “significant investments” in derivatives. The purpose of this decision is to allow the SEC time to review the use of financial derivatives by mutual funds, ETFs, and other investments, in order to determine whether new protections are needed for investors. The action will have no affect on already existing ETFs or other funds.

According to SEC Chairman Mary Schapiro, “It’s appropriate to engage in a more thorough review of the use of derivatives by ETFs and mutual funds given the questions surrounding the risks associated with the derivative instruments underlying many funds.”

The SEC’s review will seek to evaluate whether the current use of derivatives is compliant with provisions of the Investment Company Act in relation to leverage, concentration and diversification. They will look at whether there is adequate risk management implemented and maintained, as well as rules in place for the “proper procedure for a fund’s pricing and liquidity determinations regarding its derivatives holdings.”

Furthermore, the SEC will explore whether appropriate oversight of the use of derivatives is being provided by fund boards of directors. As well as if the risks created by derivatives are being adequately disclosed and if there should be special reporting requirements for funds’ derivative activity.
Derivatives are being faulted for playing a role in the financial crisis, and have since come under increased scrutiny in the U.S. and Europe. Greater federal regulation for derivatives is included in pending legislation, and would grant the SEC more policing authority.