In the aftermath of the 2008 downturn, Congress and financial regulators have put derivatives trading under a microscope.
Derivatives, in the minds of most investors, are associated with investment banks and hedge funds. But a recent court decision has highlighted the extent to which mutual funds are also engaged in derivatives trading.
Ruling last week in a lawsuit that pitted the mutual fund industry against regulators, the D.C. Circuit upheld regulations that impose more stringent registration and reporting requirements on certain mutual funds that trade derivatives.
The ruling is expected to affect investors in a small but still significant group of funds. Among the main group of products impacted will be so-called "alternative funds," which use nontraditional strategies and frequently engage in derivatives trading. Regulators say the requirements will benefit investors, but the fund industry has warned that alternative funds could become more expensive to own.
Among alternative funds, commodities funds will perhaps be the most affected. Commodities are products such as gold, silver and oil. Derivatives are trading contracts based on the value of a particular thing. For instance, investors who want to bet on future commodities prices can do so through commodities futures contracts. Other types of derivatives used by commodities funds include options and swaps. The requirements will also affect funds that use financial derivatives, such as S&P 500 futures.
At issue in the D.C. Circuit case were regulations issued last year by the U.S. Commodity Futures Trading Commission. Under the regulations, certain mutual funds (and also exchange-traded funds) that engage in speculative – in other words, not just for hedging risks – trading of derivatives have to register with the CFTC. This requirement is similar to one that existed prior to a deregulation of certain forms of derivatives trading in 2003.
The CFTC claims that such registration, and the reporting obligations that come with it, will help guard against the very types of risky trading that brought the financial markets to their knees in 2008. Once a rarity in the mutual fund world, the use of derivatives is now somewhat common. The CFTC hopes that its regulations will increase the transparency of such trades and ensure that investors are adequately informed and protected.
By contrast, the Investment Company Institute, which is the trade group for mutual funds, and the Chamber of Commerce contend that the new regime is unnecessary because funds already have to register with the Securities and Exchange Commission. They also argue that the CFTC regulations will make funds – at least those that engage in derivatives trading – more expensive to own because the costs of compliance will be passed along to investors.
In its ruling last week, the D.C. Circuit concluded that the CFTC was acting within its authority when it enacted the reporting regulations. Following the ruling, the Chamber of Commerce issued a statement warning that the decision will harm investors.
"We believe this rule was improperly adopted and imposes duplicative compliance costs on American companies and investors," David Hirschmann, president and CEO of the Chamber's Center for Capital Markets Competitiveness, said.
In an effort to reduce the burden on funds, regulators will seek to "harmonize" the SEC and CFTC reporting requirements to reduce redundancies. The ICI said in a statement that it intends to be actively involved in that process. "While we continue to believe that the CFTC's recent [regulations] were improperly adopted, we intend to focus on ensuring that the CFTC's regulatory regime as it evolves does not adversely affect fund investors," Karrie McMillan, the ICI's general counsel, said.