Use of Derivatives by Investment Companies

As long as ICs comply with SEC regulations concerning asset coverage, there are no significant restrictions on their use of derivatives. However, an IC which uses derivatives more than just as a hedging strategy potentially faces the need to register with the CFTC as a CPO and may be required to comply with two different regulatory regimes.

Where an IC is registered with the SEC, its operator is not required to register with the CFTC as a CPO, if the IC enters into transactions in CFTC regulated derivatives for bona fide hedging purposes.

This exemption is dependent on the IC complying with the following conditions:

1. it commits no more than 5 per cent of its total net assets to initial margin and option premiums;
2. it is not marketed as a derivatives fund;
3. prospective participants are informed of the purpose of and restrictions on the IC’s use of derivatives.

JAPAN

For many years the regulatory environment for derivatives funds in Japan was unclear. This has now been largely resolved by the introduction of the Commodity Fund Law (CFL) in April 1991 and regulations under the CFL which have been in force since April 1992. Before the enactment of this law, conflicts developed between regulators with overlapping jurisdictions, largely the ministries of finance (MOF), international trade and industry (MITI) and agriculture, forestry and fisheries (MAFF).

1. MOF is responsible for the regulation of financial companies, banks and securities dealers, and supervises the Japanese financial markets. In addition to CFL, MOF permits derivatives investment by securities funds, as long as at least 50 per cent of the fund’s investments are in securities or securities derivatives.
2. MITI regulates trading companies and the Japanese metals, energy and rubber markets.
3. MAFF has been keen to encourage active domestic commodity futures markets for hedging purposes, and has sought ways to develop derivatives funds within its jurisdiction over the grain markets.

The Division of Supervision

Under the new CFL and its accompanying regulations, MOF will regulate funds which focus on securities and financial derivatives; MITI will cover those investing in primarily energy and base and precious metals while MAFF will look after those in agricultural commodities.

Investment Restrictions

The regulations from the three ministries follow broadly the same guidelines. Under them, 50 per cent of a derivative fund’s assets must be invested in grains, energy or other commodity futures. A maximum of 30 per cent of the fund’s value may be put up as margin or premium in overseas financial derivatives contracts, or other permitted financial derivatives. Funds are barred from using Japanese financial futures other than stock index futures and their investment in Nikkei-225 futures is restricted to one per cent of asset value. Beyond that, guidelines restrict investment in overseas stock index futures to 10 per cent of funds‘ assets.

Currently, the minimum investment in a derivatives fund in Japan is Y 100m. However, companies with a proven track record in the promotion of foreign

derivatives funds may sell Y 50m investments. Although the fund promoter is permitted to repurchase shares in the fund, no secondary market is permitted at present.

There are regulations which require strict separation between brokers and advisers. Advisers which are 50 per cent or more owned by a futures broker cannot use that broker. The legislation and regulations also establish detailed ongoing capital, reporting and disclosure requirements for fund operators. Both Japanese companies and foreign companies with an office in Japan are eligible to register as fund operators.

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