Overview/Intro
Fund Services Cayman provides support to US based advisors of Mutual Funds, Exchange Traded Funds, and Commodity Trading Pools who trade and manage commodity futures and other derivatives. More specifically, FSC delivers third party risk and performance monitoring, as well as consults on derivative hedging and rebalancing.
Derivative Risk Management
SEC Rule 18f-4 requires a fund to define and implement a derivatives risk management program. FSC develops and provides a bespoke written program that includes policies and procedures to identify and manage derivatives risks such as leverage, market, counterparty, liquidity, operational and legal risk in addition to any other risks.
FSC helps advisors apply this risk management framework to funds, while also permitting principles-based tailoring of each fund to the fund’s particular risks. FSC ensures that risk guidelines including stress testing, back testing, internal reporting and escalation, and program review elements and systemically implemented in compliance with rule 18f-4.
Specifically FSC ensures a fund determines its compliance with the applicable Value at Risk (“VaR”) test at least once each business day as well as performing stress testing to evaluate potential losses to a fund’s portfolio in response to “extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the fund’s portfolio, taking into account correlations of market risk factors and resulting payments to derivatives counterparties”. FSC also provides back testing of the results of the VaR calculation model used in connection with the VaR test. This back testing identifies as an exception any instance in which the fund experiences a loss exceeding the VaR calculation’s estimated loss.
Liquidity Risk Management
The Securities and Exchange Commission (the “SEC”) recognizes that because open-end funds are required to meet the statutory redemption requirement of Section 22(e) of the Investment Company Act of 1940, as amended (the “Act”) they have a responsibility to manage the liquidity of their investment portfolios in a manner consistent with those obligations and any other related representations. Long-standing SEC guidelines contained a liquidity standard that generally limited an open-end fund’s aggregate holdings of “illiquid assets” to no more than 15% of the Fund’s total net assets.
Rule 22e-4 of the Act seeks to promote effective liquidity risk management, thereby reducing the risk that open-end funds will be unable to meet their redemption obligations and mitigating dilution of the interests of fund shareholders. FSC helps advisors comply with the rule by developing, implementing, and maintain a Liquidity Management Program including the following elements:
- the classification of the liquidity of each portfolio investment based on the number of days within which it reasonably expects an investment could be sold or disposed of without significantly changing the market value of the investment;
- the assessment, management, and periodic review of each fund’s liquidity risk; and
- ongoing management of each fund’s liquidity risk, including determining and periodically reviewing a highly liquid investment minimum and limiting each fund’s investment in illiquid investments to no more than 15% of the fund’s total net assets.
FSC ensures ongoing compliance with the Act by helping the advisor monitor and categorize:
- Existence of an active market for the asset, including the number, diversity, and quality of market participants, the frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange) and the volatility of trading prices for the asset and bid-ask spreads for the asset;
- Whether the asset has a relatively standardized and simple structure;
- For fixed income securities – maturity and date of issue;
- Restrictions on trading of the asset and limitations on transfer of the asset;
- The size of the Fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding; and relationship of the asset to another portfolio asset.
Some background to the services
On October 28, 2020 the U.S. Securities and Exchange Commission (SEC) voted to adopt rule 18f-4 (the “Rule”). This regulatory framework addresses the use of derivatives by registered funds and their advisors to outsource some functions of their business, particularly some risk management functions. FSC address this requirement by offering two central services: