Deborah Fuhr Welcome to ETF TV, I’m Deborah Fuhr. Today, we will be discussing the new SEC derivatives rule with Kevin Gustafson, general counsel and CCO at Innovator ETFs, and Graham Day, head of product and strategy at Innovator ETFs. Welcome, Kevin and Graham.
Kevin Gustafson Thanks for having us, Debbie. Appreciate it.
Graham Day It’s great to be here, Debbie. Thank you.
Deborah Fuhr Tell us the background on the derivatives rule?
Kevin Gustafson The rule itself is a culmination of about 40 years worth of regulatory patchwork with the SEC. We saw in the last 10 years or so a move by the SEC to have a more coordinated framework. They started with a consultation in 2011. There was a proposal back in 2015. And then obviously the actual proposed rule, which we saw introduced at the end of last year in 2019, with the adoption this week of across the board equally applicable rules. So I think that’s welcome in the industry and something that we’ve all been looking for.
Deborah Fuhr In reality, what does the rule mean?
Kevin Gustafson In the ETF space, exemptive relief hadn’t been granted for leveraged and inverse ETFs since 2009. So the SEC really focused on a bright line test for that category, which is called the VAR test or valuate at risk with regards to portfolio assets. There’s a recognition that a lot of funds do provide leverage with a small L, with regards to either managing the currency risk or interest rate risk. Then there’s a lot of firms that use leverage for things like performance enhancements or risk protection. And so they wanted to be able to provide a framework that applied to all of these instances at once. There’s also some key elements as well that go to the adoption of a written program with regards to risk management and a lot of details around that. And then you’re also seeing with regards to not just border reporting, but also SEC related reporting. And so I think each of those are key features about what the rule actually is.
Graham Day From an advisor perspective, this doesn’t really change a whole lot. When we look at how advisors are using leveraged ETFs, for the most part, they aren’t. They’re not using that as core allocations within their client portfolios. And even on this levels, the playing field at an ETF industry level, we don’t necessarily think that’s going to lead to a greater adoption of leveraged ETFs. I think there’s still the sour taste left in a lot of the wire houses’ mouths about what’s happened in the past when their advisors have utilized leveraged ETFs. And so although this has made it easier now for people to come in, I don’t think the adoption of these ETFs is necessarily going to grow as a result of this real change.
Deborah Fuhr In the guidance the SEC has stated a specific amount of leveraged and inverse that is allowable. Can you talk a little bit about that, please?
Graham Day The SEC has capped the amount of leverage at 3X. And so if you wanted to go and try to get 4X or 5X, that’s just not going to happen. However, they’ve also provided guidance that if you are seeking anything higher than 2X or 200% of a reference index, you’re going to have to go and get their stamp of approval before you can bring those products to market. This VaR test that they’ve put in place I think is important for funds that utilize, what we’d call more simple derivatives like options that sometimes people think that they’re complicated and there’s a lot of leverage embedded, but you can build a portfolio utilizing options that has no leverage. And so by putting forth this test, a lot of firms are now able to show that, look, our funds are not leveraged. They fall well below this VaR threshold of 200%. In fact, a lot of times the VaR can be under one or right around one. So I think this is going to just provide a little more clarity to fund issuers as to what they can do. And then also, hopefully they’ll allow advisors to know that even though this fund may use options or other derivatives, that does not necessarily imply that they are leveraged.
Deborah Fuhr And up until now, any ETF that was using derivatives did not have the ability to rely on the new ETF rule. Does that change now that the derivatives rule is out there?
Kevin Gustafson Yes, Debbie, it does. You saw with the issuance of the ETF rule last year, there was a specific carve out in the rule that said, ‘for purposes of adoption and the reliance on the benefits of 6c-11, this would not apply to leveraged and inverse ETFs.’ So the derivatives rule actually cross references that provision and says the ETF rule will be amended, so that those firms that rely on leveraged and inverse relief will be able to also take full advantage of the ETF rule. And so it’s kind of going backwards and saying, ‘as long as you comply with the derivatives rule and you comply with the ETF rule, you’re able to do that now.’
Deborah Fuhr In addition to passing the rule, they have said that there will be now a review of complex products and leveraged ans inverse. What does this really mean practically?
Kevin Gustafson Sure. So what we saw in the proposed rule was that there were going to be these enhanced sales practices and designations with regards to leverage, in particular ETFs. There was a lot of criticism, and so the SEC in essence said, ‘we are not going to do this right now. We’re going to take it out of the rule in terms of adoption. And we’re going to consider for purposes of something that might be a complex product, like a leveraged and inverse fund, doing a more comprehensive review of not just those, but other complex products that are providing, let’s say, leverage, such as structured notes, closed end funds, exchange traded notes, and then possibly other instruments or products such as annuities.’ And so the SEC previewed the fact that they’re probably going to do another rulemaking around how to handle, how to advertise, and suitability with regards to complex products holistically.
Deborah Fuhr Yeah, these are all really helpful and timely updates, given the SEC just passed this. So I really appreciate you joining us today.
Kevin Gustafson Thanks for having us on, Debbie.
Graham Day Thanks, Debbie.
Deborah Fuhr I’d like to thank Kevin and Graham for sharing their expertize with us today. I’d also like to thank you, our viewers, for watching us. If you’d like to see further episodes, go to ETFTV.NET and TRADERTV.NET.