With the adoption of Rule 18f-4, the Securities and Exchange Commission provides an updated approach to the regulation of derivatives used by registered investment companies as well as by business development companies.

New Rule 18f-4, an exemptive rule under the Investment Company Act of 1940 (the “Act”), permits mutual funds (other than money market funds), exchange-traded funds (“ETFs”), registered closed-end funds, and business development companies to enter into derivatives transactions and certain other transactions notwithstanding the restrictions under section 18 of the Act. In addition, the Commission amended Rule 6c-11 under the Act to allow leveraged or inverse ETFs to operate without obtaining an exemptive order.

Highlights of Rule 18f-2:

Derivatives Risk Management Program

Rule 18f-4 will require a fund using derivatives (other than a limited derivatives user) to adopt a written derivatives risk management program, with policies and procedures reasonably designed to manage the fund’s derivatives risks. A fund adviser’s officer or officers or persons with a comparable degree of seniority and authority, and not any third party, must serve as the fund’s Derivatives Risk Manager and administer the program. The Derivatives Risk Manager must have relevant experience regarding derivatives risk management, and be approved by the fund’s board. Although the functions of the program must be segregated from portfolio management functions, the SEC commented that it does not intend to subject the Derivatives Risk Manager and portfolio management to a communications firewall, recognizing the important perspective portfolio management might provide to risk management. As such, the new rule will prohibit a fund’s portfolio manager from solely filling the Derivatives Risk Manager position or constituting a majority of the officers who compose the Derivatives Risk Manager position but otherwise will allow fund portfolio managers to serve in the position. The program must include risk guidelines as well as stress testing, backtesting, internal reporting and escalation, and program review elements. The fund’s derivatives risk manager will have to report to the fund’s board on the derivatives risk management program’s implementation and effectiveness to facilitate the board’s oversight of the fund’s derivatives risk management.

Limit on Fund Leverage Risk

A fund relying on the rule generally must comply with an outer limit on fund leverage risk based on value-at-risk, or “VaR.” This outer limit is based on a relative VaR test that compares the fund’s VaR to the VaR of a “designated reference portfolio” for that fund. A fund generally can use either an index that meets certain requirements or the fund’s own securities portfolio (excluding derivatives transactions) as its designated reference portfolio. If the fund’s derivatives risk manager reasonably determines that a designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test, the fund would be required to comply with an absolute VaR test. The fund’s VaR generally is not permitted to exceed 200% of the VaR of the fund’s designated reference portfolio under the relative VaR test or 20% of the fund’s net assets under the absolute VaR test.

Exception for Limited Users of Derivatives

Rule 18f-4 incorporates an exception from the program and VaR test requirements provided that the fund adopts and implements written policies and procedures reasonably designed to manage its derivatives risks. A fund may rely on this exception if the fund’s derivatives exposure is limited to 10% of its net assets, excluding certain currency and interest rate hedging transactions.

Alternative Requirements for Certain Leveraged /Inverse Funds

Leveraged/inverse funds will generally be subject to Rule 18f-4. All leveraged/inverse funds, since they provide a leveraged or inverse return of an index, must comply with the rule’s relative VaR test and use the index as their designated reference portfolio. Over-200 percent leveraged/inverse funds generally could not satisfy the limit on fund leverage risk in the new rule. The SEC, therefore grandfathered existing over-200 percent leveraged/inverse funds into the new framework, permitting them to continue operating provided they comply with Rule 18f-4 (other than the VaR-based limit on fund leverage) and meet certain other requirements. Specifically, an over-200 percent leveraged/inverse fund relying on the exception may not change its underlying market index or increase the level of leveraged or inverse market exposure the fund seeks, directly or indirectly, to provide. In addition, the fund must disclose that it is not subject to the condition of Rule 18f-4 limiting fund leverage risk.

When-Issued, Forward-Settling, and Non-Standard Settlement Cycle Securities.

The rule permits money market funds (and other funds) to invest in securities on a when-issued or forward-settling basis or with a non-standard settlement cycle, provided the fund intends to physically settle the transaction and the transaction will settle within 35 days of its trade date.

Reverse Repurchase Agreements and Unfunded Commitment Agreements

Rule 18f-4 permits a fund to enter into reverse repurchase agreements and similar financing transactions, as well as “unfunded commitments” to make certain loans or investments, subject to conditions tailored to these transactions.


The rule requires that the fund comply with certain recordkeeping requirements.

Amendments to Rule 6c-11

Amendments to Investment Company Act Rule 6c-11 permit leveraged or inverse ETFs to rely on Rule 6c-11 if they comply with all applicable provisions of Rule 18f-4. The SEC is rescinding the exemptive orders previously issued to the sponsors of leveraged or inverse ETFs in connection with these amendments.


Funds will be required to report confidentially to the SEC on a current basis on Form N-RN (formerly N-LIQUID) if the fund is out of compliance with the VaR-based limit on fund leverage risk for more than five business days. Funds currently required to file reports on Forms N-PORT and N-CEN will be required to provide certain information regarding a fund’s derivatives use. This will include information regarding the fund’s VaR, as applicable, and information about the fund’s derivatives exposure (for funds that rely on the limited derivatives user exception in rule 18f-4).

Effective Date

The rule’s effective date is February 19, 2021. The Release provides for an 18-month transition period following the rule’s effective date for funds to prepare to come into compliance with the rule. As such, the compliance date is August 19, 2022. Following the 18-month transition period, Release 10666 (issued in 1979) will be rescinded and related no-action letters and other staff guidance (or portions thereof) will be withdrawn. At that time, funds could enter into derivatives transactions, reverse repurchase agreements and similar financing transactions and unfunded commitments only as permitted by the rule and Section 18.

View the full text of the rule