On November 25, 2019, the Securities and Exchange Commission voted to propose a new rule regarding the regulation of the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds (ETFs) and closed-end funds, as well as business development companies. See the Press Release.
Under the new proposed rule the General Statement of Policy (Release 10666) would be withdrawn after a one-year transition period.
The new rule is in some regards similar to the Commission proposal made in 2015 with respect to the use of derivatives by funds, particularly with respect to its Value at Risk or VaR approach.
On June 22, the Alternative Reference Rates Committee (the “ARRC”) identified a broad Treasuries repo financing rate (the “Broad Treasuries Financing Rate”) that, according to the ARRC, in its consensus view represents best practice for use in certain new U.S. dollar derivatives and other financial contracts.
The work of the ARRC grew out of the past instances of manipulation of the LIBOR market which caused a loss of confidence in LIBOR – particularly as it had previously been determined and reported – as a reliable interest rate benchmark. That led the G20 to instruct the Financial Stability Board to review broadly-recognized interest rate benchmarks and devise a plan to ensure that the construction of these benchmarks are sound and used appropriately in the markets. According to the Working Group on Alternative Interest Rates initiated by the Federal Reserve in furtherance of the plan, the goals were two-fold: (1) strengthen the integrity of existing benchmark rates, and (2) develop alternative reference rates that would be free of many of the risks (including manipulation) associated with existing benchmarks. The Broad Treasuries Financing Rate would be one such alternative rate.
Lender Beware: The custody assets you are lending against may not actually be held in custody.
Lenders to funds and other borrowers often extend credit based on a security interest over assets that are held in custody. The lender is granted a security interest in the relevant custody account and all of the cash, securities and other assets therein, and then perfects the security interest by entering into a “control agreement” with the custodian. The lender may have made two big assumptions: (1) the custodian has “custody” of the assets, and (2) upon receipt of instructions from the lender after default, the custodian can readily transfer or otherwise dispose of the relevant assets. Upon closer examination, however, these assumptions may prove to be incorrect.
There are two broad categories of assets that are capable of being held in custody:
(1) Assets such as a bearer bond, a stock certificate in the name of the borrower (together with an undated stock power in blank), or gold bullion. This is referred to as “on premises custody” or “direct custody”; the custodian has physical custody of the asset. In each of these cases, the custodian has the power to transfer title to the asset by delivery thereof – it may not have the right vis-à-vis the borrower (i.e., the custodian may be liable for breach of its duty to the borrower), but it does have the power.
(2) Assets that are held in an indirect holding system. This is referred to as “off premises custody” or “indirect custody.” One typical example of how an indirect holding system works: a clearing company (such as Depository Trust Company) holds a master share certificate for 500 million shares of an S&P 500 publicly‑traded company. The clearing company identifies on its books and records 10 million of such shares as being held for the account of the custodian (in its capacity as a member of the clearing company) and, in turn, the custodian identifies on its books and records 100,000 of such shares as being held for the account of the borrower. In this case, the custodian has the power to (a) “move” some or all of those 100,000 shares on its books and records to another of its custody clients, or (b) advise the clearing company that some or all of such shares have been transferred to a third party that does not maintain an account with the custodian (in which case the clearing company would revise its books and records to reflect that such shares are held by or through another member of such clearing company). In any event, as a general rule, the custodian has the power to transfer the borrower’s interests in these shares.
It’s clear to anyone paying attention that the market for initial public offerings of closed‑end funds has fallen off dramatically over the last few years. Undoubtedly, the primary cause of this fall off has been the gaping average trading discount of existing closed‑end funds (i.e., on average these funds have been trading at steep discounts to net asset values). That made it difficult, if not a practical impossibility, for asset managers to sell shares of a new closed-end fund when investors could simply purchase shares of a similar, existing closed-end fund at a significant discount.
Also contributing somewhat to this fall off has been the relative increase in the cost of leverage as a result of the phasing in of new capital rules for banks. Many closed-end funds employ leverage to deliver additional returns to investors; these increased costs (which correspondingly reduce returns to investors) have made it incrementally more difficult for asset managers looking to launch new closed-end funds to make their case to investors.
On top of all of this, according to many industry observers the so-called “fiduciary rule” (finalized on April 6, 2016) would make it nearly impossible for financial advisors to recommend to investors that they purchase shares of a closed‑end fund at the IPO stage. The key problem for closed-end fund IPOs under the fiduciary rule is not necessarily inherent; it arises out of the fact that, at times, while many closed-end funds trade at a premium at and shortly after the initial offering, thereafter they begin to trade at a discount. This can have the effect of creating at best a short-term paper loss, and at worst a short-term actual loss, for investors.
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