THE PROBLEM
Currently in the US, the RIA’s filing monthly/quarterly holdings data that hold derivative instruments to regulators did not provide complete information for investors to help understand the exposure and the impact of these instruments on the overall portfolio.
In October 2020, SEC completed the rules for in the US that provide an updated, comprehensive approach to regulating funds’ use of derivatives and certain other transactions. This new rule ‘SEC 18f-4’ requires qualified funds to comply by August 19, 2022.
Key parts of the regulation apply to firms that have derivative exposure greater than 10% of net assets
Besides the need for having a robust Derivatives Risk Management Program, some of the key functionality necessary include –
1. Calculation of Absolute VaR and Relative VaR
– Use 99% confidence level with time horizon of 20 trading days
– Use at least three years of historical market data
– Consider the Equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk
2. Stress Testing
– To evaluate potential losses to the fund’s portfolio in response to extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the fund’s portfolio, considering correlations of market risk factors and resulting payments to derivatives counterparties.
– To be conducted every week
3. VaR Backtesting
– Backtesting compares the VaR results to the fund’s gain or loss that occurs on each business day during the backtesting period with the corresponding VaR calculation for that day, using one trading day time horizon, and identifying as an exception any instance in which the fund experiences a loss exceeding the corresponding VaR calculation’s estimated loss.
– This also needs to be performed every week
4. Reporting of data from above into amended requirements for N-PORT, N-CEN and N-RN accordingly.
HOW TO PREPARE FROM A SYSTEM STANDPOINT?
Review current risk systems and define operational workflows to ensure the calculations of VaR, Stress testing and Backtesting can meet the needs mandated by the regulations.
Make necessary upgrades or changes to the processes/systems to ensure smooth reporting without added cost for manual workflows.
Firms need to upgrade their risk systems with a new ‘cloud’ technology framework using microservices to enable a ‘pay per use’ model for businesses to scale dynamically as volumes grow without ongoing large expenses.
In addition, providing access to such data for BI to users and or regulatory reporting will be an ongoing requirement given the growing demand for increased transparency and additional insights into the portfolios managed by investment firms.
