Hedge Funds Value-at-Risk: SEC Rule 18f-4

The Securities and Exchange Commission has announced a uniform risk management framework for derivatives to measure hedge funds’ value-at-risk on derivatives. This rule applies to Hedge Funds, Mutual Funds (40's Act Funds), Exchange-Traded Funds (leveraged and inverse), Closed-End Funds, and Business Development Companies with derivative exposure greater than 10% of a fund’s net assets. In order to comply, funds must adhere to an outer limit on leveraged risk as a computation of Value-at-Risk (VaR). Compliance is required starting August 19, 2022.

The SEC states that “derivatives can reference a range of assets or metrics, such as: stocks, bonds, currencies, interest rates, market indexes, currency exchange rates, or other assets or interests.” Practically, this means any counter-party agreement that includes securities as an asset to be exchanged at a later date given a set of terms and conditions, either over-the-counter (OTC) or traded on an exchange.

The functional requirements of the rule are daily VaR calculations and weekly stress-testing, along with storage of results as evidence of compliance, a “performance” review of VaR estimates compared to actual fund performance, and proper documentation of the workflow and board reporting.

Daily Value at Risk (VaR) Calculations

As a limit on overall fund leverage, a relative daily VaR test should be performed on a fund which is to be compared to a designated reference portfolio. A fund generally can use either an index, or the fund’s own portfolio (excluding derivatives), as its designated reference portfolio. If the fund’s derivatives risk manager determines that a relative VaR test isn’t appropriate, the fund can use an absolute VaR test. The outer VaR limits are set at 200% relative and 20% absolute.

Weekly Stress Test

Best practice is to perform a daily rolling stress test along with the daily VaR, and to perform a regular back-testing of VaR calculations against actual losses incurred. Models should be managed and tuned accordingly.

Derivatives Risk Management Program & Board Reporting

A written program with risk guidelines must be established and reviewed periodically. This should not be an elaborate or expensive project, but instead should be a documentation of the daily workflow, review of results and calibration of models, and how artifacts are stored as a matter of record.

Exclusion from Derivatives Risk Management Program and Board Oversight

The daily VaR test is the minimum requirement for all funds holding derivatives, but if the absolute VaR of the fund is below 10% then the fund is not required to have a risk manager that has a reporting line to the board, and the board does not need to approve a written program. However, the fund still needs written policies and procedures designed to manage derivative risks. If exposure exceeds the 10% threshold there is a series of protocols to adhere to in order to stay compliant. A fund can also exclude derivative transactions that it uses to hedge currency and interest rate risks.

Implementation and Technical Decisions

The technical details of implementing this rule will be covered in later posts, but there are many specifics to be worked out and there is substantial nuance to how calculations are calibrated and how benchmarks are selected and analyzed. There are a few choices that can be made with respect to benchmarking and approach to correlation of value, and the key is to maintain consistency over time, and to perform regular review of the models and calculated output.

Technical considerations include but are not limited to:

• Coverage of Securities and Derivatives across FX, Rate, Equity, Fixed Income and Structured Finance
• Value at Risk (VaR) Model and Calibration — Historical Simulation, Monte Carlo simulation, or Parametric Models are all appropriate under different circumstances
• Historical Data including asset holdings and prices for all securities including OTC derivatives
• Stress Testing and Backtesting
• Trading Workflows and Cure Periods
• High Data Costs

Conclusion

Rule 18f-4 sets out new requirements for hedge funds to track and disclose all derivatives holdings, and to limit the overall leverage in the system. Daily VaR calculations must be performed across all asset classes and their derivatives, with no more than 200% of the relative value or 20% of the absolute value of the portfolio at risk due to derivatives positions. Regular stress testing is best practice, as is regular back-testing of model results.

These new requirements are substantial but can be implemented quickly with the right solution.