[Senate Hearing 109-1051]
[From the U.S. Government Publishing Office]
S. Hrg. 109-1051
THE ROLE OF HEDGE FUNDS IN OUR CAPITAL MARKETS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES AND INVESTMENT
OF THE
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
ON
EDUCATING AND INFORMING THE CONGRESS AND THE AMERICAN PEOPLE ON THE
ROLE OF HEDGE FUNDS IN OUR CAPITAL MARKETS
__________
MAY 16, 2006
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate/
senate05sh.html
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
______
Subcommittee on Securities and Investment
CHUCK HAGEL, Nebraska, Chairman
CHRISTOPHER J. DODD, Connecticut, Ranking Member
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
JOHN E. SUNUNU, New Hampshire JACK REED, Rhode Island
MEL MARTINEZ, Florida CHARLES E. SCHUMER, New York
ROBERT F. BENNETT, Utah EVAN BAYH, Indiana
JIM BUNNING, Kentucky DEBBIE STABENOW, Michigan
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
WAYNE ALLARD, Colorado
RICK SANTORUM, Pennsylvania
Joe Cwiklinski, Staff Director
Alex Sternhell, Democratic Staff Director
Jim Johnson, Counsel
Dean V. Shahinian, Democratic Counsel
(ii)
C O N T E N T S
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TUESDAY, MAY 16, 2006
Page
Opening statement of Senator Hagel............................... 1
Opening statements, comments, or prepared statements of:
Senator Dodd................................................. 3
Senator Crapo................................................ 4
Senator Reed................................................. 5
Senator Sununu............................................... 5
Senator Bunning.............................................. 7
Senator Allard............................................... 8
WITNESSES
Hon. Randal K. Quarles, Under Secretary for Domestic Finance,
U.S. Department of the Treasury................................ 8
Prepared statement........................................... 51
Susan Wyderko, Director, Office of Investor Education and
Assistance, Former Acting Director, Division of Investment
Management, U.S. Securities and Exchange Commission............ 22
Prepared statement........................................... 55
Patrick Parkinson, Deputy Director, Division of Research and
Statistics, Board of Governors of the Federal Reserve System... 24
Prepared statement........................................... 61
James Overdahl, Chief Economist, U.S. Commodity Futures Trading
Commission..................................................... 25
Prepared statement........................................... 65
Hon. Richard McCormack, Senior Advisor, Center for Strategic and
International Studies.......................................... 34
Prepared statement........................................... 68
Dr. Adam Lerrick, Visiting Scholar, American Enterprise Institute 36
Prepared statement........................................... 81
Kurt Schacht, Executive Director, Center for Financial Market
Integrity, Chartered Financial Analyst Institute............... 38
Prepared statement........................................... 83
James Chanos, Chairman, Coalition of Private Investment
Companies, President, Kynikos Associates....................... 40
Prepared statement........................................... 86
John Gaine, President, Managed Funds Association
Prepared statement........................................... 96
(iii)
THE ROLE OF HEDGE FUNDS
IN OUR CAPITAL MARKETS
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TUESDAY, MAY 16, 2006
U.S. Senate,
Subcommittee on Securities and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met, pursuant to notice, at 2:21 p.m., in
room SD-538, Dirksen Senate Office Building, Senator Chuck
Hagel (Chairman of the Subcommittee) presiding.
OPENING STATEMENT OF SENATOR CHUCK HAGEL
Senator Hagel. Good afternoon. Today's hearing will focus
on the role of hedge funds in our capital markets. The intent
of this hearing is to educate and inform the Congress and the
American people on this growing sector of our financial
markets. According to the Economist Magazine, a hedge fund is
defined as a managed pool of capital for institutional or
wealthy individual investors that employs one of various
strategies in equities, bonds, or derivatives, attempting to
gain from market inefficiencies and, to some extent, hedge
underlying risks.
Charles Mingus, an American jazz bassist and composer once
said, quote, making the simple complicated is commonplace.
Making the complicated simple, awesomely simple, now, that is
creativity, end of quote. Suffice it to say we are looking for
creativity from our witnesses today.
Alfred Jones is credited as the father of hedge funds. He
established the Jones Hedge Fund in 1949. Roy Neuberger and
Benjamin Graham are also credited for laying the foundations
for the industry; however, hedge funds did not begin to gain
popularity until the 1960s. In 1969, almost 200 hedge funds
managed $1.5 billion in assets. Since then, the growth of the
hedge fund industry has exploded, with most of the growth
occurring in the past decade. Currently, over 8,000 hedge fund
managers are controlling over $1 trillion in assets.
Today's hearing will look at the benefits and risks of
hedge funds to investors and to our economy. We will explore
the current oversight of hedge funds, the level of
transparency, the different types of investors, and the cause
for the explosive growth of this industry over the last decade.
The hearing will also examine the current dynamic of the over-
the-counter derivatives market and assess the growing risks and
benefits of this industry. We will look at the types of
derivatives offered, the main users of derivatives, potential
concerns for investors, and the industry's impact on our
capital markets. And finally, we will consider whether the
Federal Government should play a greater oversight and
regulatory role in these areas and also assess the risks of
overregulation.
In today's global economy, large amounts of money can be
transferred in a moment's notice, and it is important that our
investors have confidence in the systems and funds that
transfer and administer their investment and assets as well as
a good understanding of both their investment benefits and
risks. Just as important is keeping our capital markets here in
the United States strong and dynamic and the envy of the world.
I welcome our witnesses today, who will help us explore
these important issues. Our first two panels feature
representatives from the President's Working Group on Financial
Markets. We will look at the work of the President's Working
Group on this issue. Our first panel includes the Hon. Randal
K. Quarles, Under Secretary for Domestic Finance at the U.S.
Department of the Treasury.
Our second panel includes Ms. Susan Wyderko, current
Director of the Office of Investor Education and Assistance and
former Acting Director of the Division of Investment Management
at the Securities and Exchange Commission; Dr. Pat Parkinson,
the Deputy Director of the Division of Research and Statistics
at the Board of Governors of the Federal Reserve System; and
Dr. James Overdahl, Chief Economist at the U.S. Commodity
Futures Trading Commission.
Our third panel today features five experts who will offer
their thoughts on hedge funds. First, the Hon. Richard
McCormack. Dr. McCormack is currently a senior advisor for the
Center for Strategic and International Studies. He is a former
Under Secretary of State for Economic Affairs, Assistant
Secretary of State for Economic and Business, and deputy to the
Assistant Secretary of Treasury for International Economic
Affairs. He is an expert on the role of international financial
institutions. Dr. Adam Lerrick is a visiting scholar at the
American Enterprise Institute and a Professor of Economics at
Carnegie Mellon University. Dr. Lerrick's expertise is in
international capital markets and hedge funds. Mr. Kurt
Schacht, Executive Director of the Center for Financial Market
Integrity of the Chartered Financial Analysts Institute; he is
former chief legal officer for the State of Wisconsin
Investment Board and has an extensive background in hedge funds
and corporate governance matters. Mr. Jim Chanos, President of
Kynikos Associates and Chairman of the Coalition of Private
Investment Companies. Mr. Chanos has extensive experience in
managing hedge funds and represents a coalition of hedge fund
investment companies.
Our fifth panelist has sent word that he will be unable to
be here with us today, although he is providing testimony. It
is Mr. Jack Gaine, President of the Managed Funds Association.
And to all of our panelists, we are most grateful and
appreciate your testimony.
Senator Hagel. Before we get to our witnesses, let me next
call upon the Ranking Member of the Subcommittee, my colleague,
Senator Dodd.
STATEMENT OF SENATOR CHRISTOPHER DODD
Senator Dodd. Thank you very much, Mr. Chairman, and you
have underscored the points here, I think, and I want to
commend you for holding the hearing. This is very worthwhile
for us to spend some time and examine this remarkable success
story of hedge funds. You pointed out the success of this
vehicle over the years. I note that in just the last 14 or 15
years, we have gone from a $50 billion industry, which is not
small, obviously, to in excess of $1 trillion. Some 9,000 hedge
funds are now operating in the United States, and in my State
of Connecticut, and Fairfield County has become sort of the de
facto capital in some ways of hedge funds.
I have a lot of constituents who are directly involved in
this and have been tremendously, tremendously successful with
it, obviously, improving efficiencies in markets, great
liquidity as well, so this has been a wealth creator. It has
been a source of tremendous success. And obviously, there have
been some impacts as well on the corporate decisionmaking which
people are raising some issues about; increasingly become
mainstream investment vehicles for pension plans, institutional
investors, and in some cases, real estate or retail investors
as well.
In my view, we know far too little about the role that
hedge funds play in our capital markets, and thus, this
hearing, I think, is extremely important for us to learn more
about the role that these funds can play. It is our
responsibility; it is my hope that we will continue to help us
better understand the benefits and potential concerns
associated with hedge funds.
If it is this Committee's responsibility, as I believe it
is, to ensure proper statutory and regulatory oversight of
hedge funds, then, regulation that we look at should be
effective and efficient. If it is going to be implemented, it
should protect, obviously, investors and prevent against
systemic risks, while at the same time striking this balance of
not being anywhere near overburdensome or irrelevant to
industry participants. And while I recognize the SEC's recent
registration requirements have just recently gone into effect,
I hope that our witnesses, and we have some very good ones here
today, that they can discuss the increased regulatory oversight
of hedge funds and touch on some of the implementation issues
that are associated with the just finalized regulations.
At first blush, the registration requirements and the basic
examination regime seem to provide some rudimentary
transparency for investors and regulators alike. Greater
transparency becomes particularly important, in my view, as the
number of hedge funds increase, and they play a greater and
greater role in our capital markets. One of the fundamental
issues for this Member and I believe for others as well is
whether unsophisticated investors are impacted either directly
or indirectly by hedge funds and whether the standards for
accredited investors should be raised by the SEC.
Mr. Chairman, I am very eager to hear if these registration
requirements are helping or hindering the hedge fund industry
and if investors are getting better information about the
practices and management of their investments. I think that it
is appropriate, again, as I said earlier, to take a close, hard
look at this. I commend the Chairman for doing so. We have got
some wonderful witnesses. I would just caution again, I know
there are some strong feelings about this issue, but having sat
on this Committee now for 25 years, I have watched situations
in the past where there were great concentrations of wealth,
and we did not watch as carefully as we should, and we paid a
price for it, the country paid a price for it.
So I think it is extremely worthwhile that are undertaking
this kind of examination today, and I would note that our last
witness here is Jack Gaine. Truth in advertising: Jack and I
went to high school together, so I am very interested in
hearing what Jack Gaine has to say about hedge funds.
Senator Hagel. Senator Dodd, thank you.
Senator Crapo.
STATEMENT OF SENATOR MICHAEL CRAPO
Senator Crapo. Thank you very much, Senator Hagel, for
holding this hearing. I think it is a very timely hearing, and
it is important that we in this Subcommittee and as Members of
the Banking Committee develop a much stronger expertise on the
issue of hedge funds and their role in our capital markets.
In recent years, we have been hearing more and more about
the role of hedge funds, particularly as the amount of capital
invested in this sector grows. The importance, in my opinion,
is to understand what they are, and that is that they are
alternative investment vehicles, alternatives available to
qualifying investors, either institutional or individual. The
securities laws have for decades imposed restrictions and other
limitations on the nature of investors, the nature of
solicitation activities, advertising, and aggregation of
offerings applicable to alternative investment vehicles
offering unregistered securities to investors, and this
flexibility in our securities laws has been and continues to be
beneficial to our capital markets.
As we are learning with the Sarbanes-Oxley Act, a one size
fits all statutory or regulatory model gives rise to inequities
and unintended consequences. As we explore the role of
alternative investment vehicles in our capital markets, we
should keep this in mind.
With respect to the SEC's Hedge Fund Advisor Registration
Rule, I would note that in my opinion, it is this Subcommittee
in the first instance and our Committee overall where these
issues should be resolved. First, the SEC rule was challenged
in Federal court, and I for one am hopeful that the D.C.
Circuit Court of Appeals will invalidate the rule, because as I
see it, the SEC lacks the statutory authority to require many
of the changes that it has required.
Second, the rule is not a logical outgrowth of SEC staff
studies on hedge funds, which finds that there is no inherent
hedge fund fraud; no retailization in the industry and that
most hedge funds operate responsibly.
Third, there is a legitimate concern expressed by
Commissioner Atkins and the Government Accountability Office
that the SEC lacks appropriate expertise and resources to
enforce the rule properly. That is not to say that we should
not conduct oversight. It is not to say that this Committee
should not develop the expertise and the information necessary
to assure that we properly review this issue. As Senator Dodd
has indicated, we need to pay attention and make sure that we
do not allow problems to arise.
While the SEC is an independent agency, it seems to me that
it should not be permitted to take the term independent to an
extreme, and it is unauthorized to write new law through
regulation, as it has tried, and it must not be encouraged to
do so in the future. It should focus on the enforcement and
implementation of laws that we pass in Congress, and it must
apply its resources responsibly.
Again, I thank you, Mr. Chairman, for holding this hearing,
and I look forward to the testimony of the witnesses and to
working with the Members of this Committee to be sure that we
do strike the right balance and achieve the right legislative
response to hedge funds.
Senator Hagel. Senator Crapo, thank you.
Senator Reed.
STATEMENT OF SENATOR JACK REED
Senator Reed. Well, thank you, Mr. Chairman. I want to
commend you and Senator Dodd for holding this hearing. It is a
very important topic. Our concern must be the safety and
soundness of the financial system, and we have to pay special
attention to any type of systemic risk, and it is important
that we consider this topic, and I think it is important for
the industry to be able to explain the benefits of hedge funds.
And there are demonstrable benefits in terms of sources of
liquidity, increases in efficiency, and decreases in
volatility, and I think it is also incumbent on them to lay out
potential risks.
And the more comfortable we are with both the benefits and
the risks of these funds, the better able we will be to
legislate and to guide the regulatory agencies in their tasks,
and I thank you for the opportunity to have this hearing today.
Senator Hagel. Senator Reed, thank you.
Senator Sununu.
STATEMENT OF SENATOR JOHN SUNUNU
Senator Sununu. Thank you, Mr. Chairman.
I think it is important that we have open discussion
hearings designed to give us better information about the
financial services industry in general, and hedge funds are an
important part of that for the reasons that have been
discussed. Senator Dodd pointed out that the success story
behind hedge funds, the wealth creation; the improvement in
liquidity in the market, Senator Reed also mentioned. And I
think it is important to underscore that behind that success is
a tremendous amount of diversity as well.
We will sit here as Members of Congress and speak in vague,
general terms about hedge funds, but the fact remains that the
strategies and the investment approaches are as diverse as the
entire financial services industry: long-term investments
versus short-term investments; focus on commodities; focus on
bonds; focus on equities; focus on other types of securities;
mathematical modeling of weather phenomena to technical trading
of commodities and metals and some of the recent materials
where we are seeing big changes in pricing, radically different
strategies employed, and I think we can start from the very
basic idea that it does us a disservice and this process a
disservice if we speak about hedge funds in some vague and
general terms.
It is important to note that hedge funds are already
subject to fraud statutes, trading requirements, trading
regulations that any other financial service firm or trader is
subjected to. They have to comply with all those trading rules
and regulations. What we are really talking about, though, is a
new set of regulations: the one mentioned by Senator Crapo,
promulgated by the Securities and Exchange Commission requiring
registration, and I think we have to ask very basically whether
or not the SEC really is the appropriate agency to be
undertaking that kind of regulatory requirement when their
charter is to protect the small retail investor.
And by definition, not our definition, the definition that
is in statute, hedge funds are designed to be marketed, sold to
very sophisticated investors. Senator Dodd is very right: I
think there is a legitimate question as to whether we should
revisit those accreditation standards. Perhaps they should be
strengthened. The threshold should be raised.
I think that is an important point of discussion, because
it is essential that we maintain the distinction. And in fact,
the anecdotal stories that we have heard about problems in this
industry in some cases were created by provisions within the
SEC that allowed funds of funds to be marketed to less
sophisticated investors, allowing hedge fund vehicles to
register under the Investment Company Act that in turn allowed
them to be marketed to individuals who did not meet the
accreditation standards, that did not meet the $1 million asset
threshold, that did not meet the $200,000 income threshold.
We need to be mindful that regulations can create as many
or more problems than they were originally intended to solve.
The point was made that the country paid a very high price at
another time for not exercising good oversight. I think that
was a reference to the S&L crisis, but I think it is worth
pointing out that that was a case where the taxpayers were
asked, under statute, to explicitly underwrite insurance for
the industry.
Now, we have another situation which is before us where
taxpayers have been effectively asked to implicitly guarantee
bonds within the GSEs, Fannie and Freddie, and here, we are not
talking about billions. We are talking about a trillion, a
trillion and a half in securities that are out there, and I
would argue that our time would be at least as well spent if
were to make a determined effort to deal with that systemic
risk that we know exists and we know there is an implied
guarantee. We do not have such an implied guarantee in this
industry. We should not have an implied guarantee in this
industry. I hope, I believe Congress will be smart enough not
to create one, but we also ought not to create regulations that
have unintended consequences.
If the problem is that we do not want pensions investing in
hedge funds, fine. Then, the approach should be to regulate the
pensions and not allow pensions to invest in hedge funds.
Again, if the problem is that we are worried about the retail
investor, fine; we should draw a bright, clear, distinct line
and not allow individuals of a certain means to invest in these
vehicles.
But we should not start crafting regulations in order to
sort of gather information so that we can pass new regulations,
and in any way you look at it, that is what the SEC has done.
There is no problem that they have identified, no problem that
they have discussed, that they have documented that has led to
the registration requirement under the Investment Advisors Act,
and I do not think we should be promulgating regulations
without defining a specific problem that we wish to address.
I hope today's hearing will address at least a few of those
issues, and I hope that this Committee and Congress will be
very cautious in looking for new areas of the financial service
industries to regulate, because our past record has not always
been a good one.
Thank you, Mr. Chairman.
Senator Hagel. Thank you, Senator Sununu.
Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Chairman Hagel.
I am glad we are taking some time to get a closer look at
hedge funds. There has been a lot of news about hedge funds
lately, because more and more people are putting money in them.
They have even become popular investment vehicles for our
universities and pensions. A lot of money and a lot of people's
futures are riding on them, and that raises a lot of questions
and concerns.
Some people are even calling for regulation of the
industry. I think it is important for us to take some time to
know what we are talking about before we do anything. I think
the biggest cause for concern about hedge funds is that we do
not know a lot about them. Due to the lack of information, we
cannot be sure just how much risk this sector is exposing our
financial market system to. I think we need to know more, and
hopefully, we will get some good answers in this hearing.
We can all agree that it is important to take reasonable
steps to protect investors, but even more importantly, we must
be sure that we are keeping a close eye on threats to the
stability of our financial markets. That is why we need to know
more about the hedge funds and what they are doing and what
they are not doing. We do not need to stop investors from
taking any risk, but we do need to address risk to our
financial markets and our overall economic wellbeing of this
country.
I hope we can get a better picture on what is going on so
that investors can make smarter decisions, and government can
determine what action, if any is necessary. The SEC is trying
to do that by requiring hedge funds to register as investment
advisors, but that rule is being challenged in the courts and
could be thrown out at any time. Hopefully, this hearing will
help us see where we need to go from here.
Thank you, Mr. Chairman. I look forward to asking
questions.
Senator Hagel. Thank you, Senator Bunning.
Senator Allard.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Well, thank you, Mr. Chairman.
I would just like to thank you for convening the hearing of
the Securities Subcommittee to examine the role of hedge funds
in our capital markets. Historically, hedge funds have provided
an investment vehicle for financially sophisticated investors
with sizable capital to invest, and I realize that these
investors and advisors that deal with hedge funds, these are
complicated transactions, so I am glad that you are taking the
time to kind of brief the Committee and myself on various
aspects of the hedge funds and how you deal with them.
Not all mutual funds are required to register with the SEC
and are not required to provide the same level of disclosure.
So I am interested to know how this phenomenon is operating in
the marketplace. And as investors look for ways to maximize
returns, I see more and more are turning to hedge funds, but do
these investors, particularly those investing in registered
funds of hedge funds absolutely understand the risks involved?
And how does the looser regulation of hedge funds translate in
the capital markets?
So I think this hearing is going to be a good opportunity,
Mr. Chairman, for us to explore these and other matters, and it
looks like we have an excellent lineup of witnesses that will
be able to provide helpful insight, and I thank you for holding
the hearing today, and I look forward to their testimony, Mr.
Chairman.
Senator Hagel. Thank you, Senator Allard.
Secretary Quarles.
STATEMENT OF RANDAL K. QUARLES
UNDER SECRETARY FOR DOMESTIC FINANCE,
U.S. DEPARTMENT OF THE TREASURY
Mr. Quarles. Thank you, Mr. Chairman.
Chairman Hagel, Ranking Member Dodd, Members of the
Subcommittee, thank you very much for inviting me to testify
and present the Treasury Department's views on the role of
hedge funds in the capital markets. As you have all noted, it
is an interesting and important issue, and I think the purpose
here of this hearing and improving our understanding of a
critical component of our capital markets should be viewed by
everybody as a welcome one.
Mr. Chairman, I have prepared written testimony that
discusses the subject in some detail, and with your permission,
I would like to submit that for the record and simply summarize
my points briefly here.
Senator Hagel. All of the written testimony will be
submitted for the record. Please proceed.
Mr. Quarles. Thank you.
To begin, I want to emphasize that both my written
testimony and my remarks today are focused on the topic of
today's hearing, which is the role of hedge funds in our
markets. That is a different question from the one that has
gathered quite a bit of attention the last few years, which is
the regulation of hedge funds. I also think it is the right
question at this time.
If government addresses the question of regulation of any
financial institution or activity without a clear understanding
of the place that it plays in our financial system, the risk of
unnecessary or excessive or inappropriate legislation is
increased, so while I am sure we will touch on certain
regulatory aspects, I intend to focus my remarks on what hedge
funds do in and for our financial markets.
Second, I want to state that while capital in these
vehicles has grown substantially in recent years, they are not
a recent invention, as has been noted. Their history typically
dates to 1949. Today, the term hedge fund is used to describe
much more than those early funds that adopted hedging
techniques. They follow a wide variety of investment
strategies. They invest in a wide variety of assets. There is
no generally accepted definition, but it might be useful to
list some features that are generally common, recognizing that
no single feature is a defining characteristic. Those features
include a passthrough legal structure, flexible investment
strategies, incentive compensation structures, a restricted
investor base, and relative ease of investor subscription and
withdrawal.
Looking at it that way, I think it is clear that whether or
not we characterize them as hedge funds, investment vehicles
with those characteristics are likely to be around for a
considerable period of time because of the obvious advantages
and attractiveness of a number of those features.
I think it is also important to note that while there has
been rapid growth, particularly over the course of the last
several years in the amount of money that is invested in hedge
funds that that growth has been accompanied by a certain amount
of private sector discipline. Originally, the hedge fund
investor base was composed almost entirely of high net worth
individuals. Later, university endowments and other endowments
and foundations were added as investors. Still later, pension
funds, with their sophisticated managers and the consequence of
the evolution of the investor base has been an increasing
professionalization of the evaluation of hedge funds and their
investment strategies, and each of these investor groups has
imposed certain forms of discipline on hedge funds, and the
hedge fund market has become much more institutionalized as a
result. So while the hedge fund market has grown dramatically,
there is at least some reasonable to believe that that growth
has been subject to private sector discipline.
Let me summarize briefly some of the principal benefits
that I see hedge funds bringing to the financial marketplace
and then some of the risks. The first, as all of you have
already noted, is liquidity. One of the reasons that the
financial markets of the United States are so attractive to
investors is because of their liquidity. Because of the varying
strategies that hedge funds employ, they are often the willing
buyers or sellers that provide additional liquidity to
financial markets. Hedge funds represent the overwhelming
majority of trading volume in the distressed debt markets, in
convertible bond markets, in the exchange traded funds markets.
They also bring the benefits of price efficiency.
Many hedge funds seek to create returns by targeting price
efficiencies where there is a discrepancy between one or more
markets or where there are wide bid-ask spreads, and thus, this
activity produces the public good of better price discovery and
more efficient markets. They help distribute risk.
Concentration of market wide risk is one of the greatest
threats to a smoothly functioning marketplace, and hedge funds
help distribute that risk.
There are benefits to investors as well. They provide more
choices to the investor community. They help produce excess
returns or capital protection, but there are risks that we
should be focused on. Our written testimony discusses these in
some detail. I think the principal ones are the large use of
leverage, which we need to be focused on and as well different
ways that leverage can be generated, including it being
embedded in some of the instruments that hedge funds trade in.
There are evaluation issues with hedge funds' portfolios,
particularly given that hedge funds calculate their returns on
the basis of periodic valuations, and there is the issue of
clearing and settlement systems. While I do not think that that
is something that is specific to hedge funds, it is something
that because of the instruments, some of the instruments that
hedge funds trade in, is something that we should be looking at
in connection with today's hearing.
So in conclusion, I would want to stress that we see
significant benefits in the financial marketplace from hedge
funds. We see some risks. At the Treasury Department going
forward, we are going to be focused on engaging with financial
market participants generally in order to better understand
these over the course of the next several months, and we will
be involved with the President's working group in doing that,
too.
Thank you very much.
Senator Hagel. Secretary Quarles, thank you.
Let's begin with 5-minute rounds? We have three panels
today, and we have good attendance, and I think we will have
other Senators stop by as well, and we will ensure that
everyone gets all the questions asked that they would like to
ask.
So I will begin my 5 minutes with this question: in your
opinion, Mr. Secretary, as you ended in describing in summary
fashion risks, benefits, in your opinion, should the Federal
Government be looking at a more defined regulatory role for
hedge funds?
Mr. Quarles. Well, I think at this point, I would not see
evidence that would suggest that there should be greater
regulation of hedge funds or a different concept than so far we
in the official sector have generally been approaching with
respect to hedge fund regulation, which is following
recommendations of the President's Working Group in the report
in the late nineties to focus on counterparty risk management
as the way to deal with the risk that hedge funds may pose in
the financial marketplace.
I think that it is incumbent upon us to understand how
hedge fund activities are evolving, and that is the reason for
this program that I described to you of the Treasury Department
reaching out in the financial marketplace over the course of
the next several months to ensure that we do have a good
understanding in concert with the President's Working Group of
some of these current issues that may pose risks to the
financial markets, but on the basis of information we have now,
I would not say that there is anything that would cause us to
believe there is a particular area or particular type of
regulation that is lacking or that would be useful.
Senator Hagel. How much transparency is there in the hedge
fund industry, starting with Treasury's oversight?
Mr. Quarles. We have, as I described, since we are focused
on counterparty risk management, obviously, the official sector
in general, the members of the President's Working Group
various regulators, the Treasury Department as chair of the
President's Working Group has a significant amount of
information about the exposure of various regulated
counterparties to hedge funds.
In addition, post-LTCM and some of the recommendations of
the President's Working Group that were proposed, and many of
them have been adopted afterwards, there has been an increasing
focus in the private sector and private sector counterparties
of hedge funds on ensuring that they have the information they
need in order to assess the risk of their exposure to hedge
funds.
So both official sector transparency and private sector
transparency, there is a great deal of information that is
available to the relevant parties about hedge funds, certainly
more than there was even five or 6 years ago.
Senator Hagel. What is the level of regulation, oversight,
transparency of hedge funds in other countries?
Mr. Quarles. Well, it varies, in part because, as I
indicated in my remarks, there is no universally accepted
definition of hedge funds. I am not aware really of any
jurisdiction that has a formal definition of a hedge fund and
then seeks to regulate them. Most jurisdictions have
registration and some regulation of investment advisors, and
the way that that plays out with respect to the advisors of
hedge funds differs from jurisdiction to jurisdiction. But for
the most part, you know, while the regulatory schemes of
various countries are quite different, as a practical matter,
hedge funds operating globally are not subject to a significant
amount of official sector regulation in any jurisdiction.
Senator Hagel. So no country has any particularly strong
oversight or regulatory function over hedge funds?
Mr. Quarles. I am not aware of a country that has, again,
that has regulation within their jurisdiction that defined
hedge fund activity as such, and more importantly,
significantly affects the operation of hedge funds that might
be organized outside of that jurisdiction within the country in
question.
Senator Hagel. You noted, I notice, in your written
testimony, which we had a chance to look at prior to your
coming before the Committee as well as in your just recent
reference to LTCM, which I think everyone knows, it is Long
Term Capital Management and what happened there in the late
1990s, what systemic risks do you see might be in some parallel
way eventually facing the financial services industry not just
in hedge funds, but I think of Fannie Mae, Freddie Mac, the
leveraged funds that they are involved in, derivatives, and if
we do not have adequate transparency, oversight, how fast can
these explosions take down markets?
Mr. Quarles. That is an interesting question. Obviously,
with respect to Long Term Capital Management, LTCM, I think two
of the significant issues there were leverage, as we have
noted, a substantial amount of leverage, and lack of
counterparty discipline, lack of market discipline, in part
because of the just financial environment at the time, lack of
understanding of what they were doing, and the genius factor of
LTCM, so there was a lack of discipline on their strategies.
You can draw some fair analogies on both of those points
between the risks that we have long said that we see with the
operation of the housing GSEs, Fannie Mae and Freddie Mac:
leverage; obviously, with LTCM, you had an entity that was
leveraged about 25 to 1, $4 billion of capital to $100 billion
of assets. The GSEs are leveraged to a greater degree, almost
33 to 1, so you have a greater degree of leverage there, and
you have the same lack of market discipline because of the
perceived Federal backstop.
It is a different source of the lack of market discipline,
but the concept and the effect is the same, and those two
reasons are chief among those that we have argued that the risk
in these entities needs to be addressed, and I think it is a
very fair point to draw the analogy to some of the risks that
we saw in the LTCM situation.
Senator Hagel. Secretary Quarles, thank you.
Senator Dodd.
Senator Dodd. Yes, thanks, Mr. Chairman.
Again, thank you, Secretary, for testifying, and I want to
sort of just pick up on that last interview of the Chairman.
There was a recent interview done with Maria Marteromo I guess
is her last name here, and she was interviewing Tim Geithner of
the Federal Reserve Bank of New York and asked specifically
about the question the Chairman raised with you, and the
question she raised, is there another Long Term Capital
Management crisis lurking out there?
And his answer was even though the core institutions are
strong in terms of capital, and risk is now spread more
broadly, rapid growth in derivatives and hedge funds creates
risk that future financial stresses may be harder to manage. Do
you agree with that?
Mr. Quarles. I do not know that that is necessarily the
case. Rapid growth in any area increases the importance of
understanding what the implications of that growth are, and,
you know, there can be growing pains. Mr. Geithner has
addressed some of them in the credit derivatives market by
working to clear up the backlog of confirmations that I think
you are all aware of. There were back office operational
difficulties as to which there have been made significant
strides that he is working on, and you can trace those to sort
of rapid growth in that market. I think that is a fair point.
But I do not think it is necessarily the case. Certainly,
since LTCM, there is much more focus by hedge fund
counterparties on ensuring that they understand the financial
position of the hedge funds that they are dealing with, that
they are providing credit to or are otherwise counterparties
of; that they have greater disclosure about the facts that they
think are necessary in order to assess their own exposures to
the hedge funds. Balance sheet leverage, certainly, to hedge
funds is significantly less than it was in the past.
Now, I think there is an issue about evaluating overall
leverage. We have some difficulty in measuring that as you
have, you know, increasingly complex financial instruments with
embedded leverage in them, and that is an issue that we need to
think about, but I would not draw the same conclusion at least
as that quote that you described to me, at least if one
interpreted the quote as saying that necessarily, because of
this rapid growth, there is more risk.
I think there are some things we need to look at, but I
would not necessarily say there is more risk.
Senator Dodd. OK, I appreciate that, and I want to
underscore your point, the opening comment you made that there
are the obvious benefits we have all identified here on the
Committee that have occurred as a result of hedge funds and
their growth. But you also point out that there are some
potential systemic risks. This was one. I wonder if you would
identify any further systemic risks that you think this
Committee ought to be aware of and what prudent steps that you
advise the Committee or the regulators to take regarding hedge
funds.
Mr. Quarles. I think in addition to leverage, which is
something you need to look at, two additional risks that we
will be focused on understanding better is, one, you could call
the risk of crowded trades. I talk about that somewhat in my
written testimony, that as you have an increasing number of
hedge fund managers, that while one potential benefit of that
is diversification, because you have a larger number of people
following a variety of strategies, that you could, in fact,
have a hurting behavior that smaller managers of capital, in
order to be able to attract capital, have to follow strategies
that have been proven by others to be effective, and so, you
have a hurting effect rather than a diversification effect, and
trades can become crowded.
If trades become crowded in illiquid instruments, that can
result in destabilization if there is an attempt by a large
number of investment managers to liquidate similar positions in
illiquid instruments at the same time. So I think that is one
thing that we need to understand better. And I think in
addition, research are the valuation issues that I also
mentioned, which are thrown into greater relief with respect to
hedge funds than some other alternative pools of investment
capital because of the compensation structure of hedge funds,
the practice of hedge funds in valuing their assets generally
annually in order to determine their carry, the 20 percent
compensation that they get.
As hedge funds increasingly move into instruments that do
not have a readily determinable market price and raise
valuation issues, that is something that I think we need to
understand better. So the question of leverage, the question of
crowded trades, the question of valuation, those are some of
the things that we will be seeking to understand better over
the course of the next several months.
Senator Dodd. What about the current accredited investor
requirement? Senator Sununu raised this issue. Others have
raised it as well, going after these greater risks of some of
these vehicles that are being used where the smaller investor
is losing; the sophisticated investor seems to be shrinking in
size. I think Senator Sununu raised a very good point about
that. What are your thoughts on that issue very quickly?
Mr. Quarles. Well, I think it is an interesting question. I
am not sure at this point, you know, maybe with more
information as we look more into it, I would feel differently.
I am not sure at this point that with respect to hedge funds,
that would necessarily drive a change in the rules, since in
addition, most hedge funds still have very substantial minimum
investment requirements that even if one would view the
accredited investor definition as shrinking in significance,
the minimum investment requirements for most hedge funds are
still quite substantial and thus ensure that were moved out of
the retail area.
But again, if our engagement with various market
participants and others' engagement, other regulators'
information that they continue to gather would suggest that
those minimum investment requirements are not sufficient to
prevent retailization of the sector, looking at the accredited
investor definition is certainly a sensible approach.
Senator Dodd. Thanks, Mr. Chairman.
Senator Hagel. Senator Sununu.
Senator Sununu. Thank you.
I think I want to follow up on that a little bit. My
question would be not if you think the accreditation level that
is currently in Regulation D is problematic but if you think it
would be unwise to raise that threshold. I mean, you set that
threshold for a variety of reasons. One is the substantive
protection that it affords a retail investor for whom these are
not intended to be investment vehicles, but also, you send a
message about the expectations, the relative level of
sophistication and knowledge that you expect investors to have.
It is my understanding that Regulation D does allow or does
give the accredited label to people that have income in excess
of $200,000 per year or net worth of $1 million, and the fact
remains that both of those, I think, are thresholds that are
much more readily attainable by people that at least elected
officials rightly or wrongly might term middle class.
So my question is, well, is there any harm? Is there any
negative outfall that you see to raising those thresholds,
because it easy to multiply by two, to $2 million and $400,000
in individual income? What unintended consequences might that
have, if any?
Mr. Quarles. Before I would say, before I would be
comfortable saying that there was no harm in raising the
threshold, I would want to have done, you know, more of a
comprehensive analysis than certainly we in the Treasury
Department have, and I would certainly want to hear the views
and expertise of the SEC and others on all of the uses of that
definition, because it is, you know, very commonly used not
just as a reference in various statutes but as a reference in
various market practices.
I would, in part for the reasons that I said that these
very, very high minimum investment requirements, unless I were
to learn that there was a trend away from that in the hedge
fund space, in part, because I do not think that hedge fund
activity in itself should drive that. I would be reluctant to
take a concern that there might be some future retailization of
the hedge fund industry and move from that to a change in the
accredited investor definition without a much more
comprehensive review of all the potential implications of that
than I would be able to give you today.
Still, that said, it is a sensible question to ask, and it
is a sensible inquiry to undertake.
Senator Sununu. I appreciate your support for my question.
[Laughter.]
Senator Sununu. Have there been any documented problems, to
the best of your knowledge, in applying or enforcing the
applicable fraud statutes, trading regulations to hedge funds?
Is there anything about them that prevents enforcement
officials from doing their job where applicable securities law,
trading law, and anti-fraud statutes are concerned?
Mr. Quarles. I am not aware of any at all, and I think it
is an important point to stress that where there are concerns
about, and there have been documented instances and certainly
allegations of market manipulation by hedge funds as there are
for other market participants, hedge funds are subject to all
of the same rules against market manipulation, against investor
fraud as any other market participant, and the SEC and other
regulators have the same panoply of enforcement tools available
to apply to hedge funds that they do to anyone else who
participates in the financial markets, and we have seen them
apply them.
Senator Sununu. I appreciate that response and appreciate
your point, although I think it is worth saying that the fact
that something is already against the law and effectively
enforced has never really prevented Congress from attempting to
make it against the law again in a number of circumstances. So
I think it is a good cautionary tale, and I hope that and I
sense that that is not where we are headed in this case.
Thank you, Mr. Chairman.
Senator Hagel. A very high note to end on, Senator Sununu.
Thank you.
[Laughter.]
Senator Hagel. Senator Reed.
Senator Reed. Thank you, Mr. Chairman. Thank you, Secretary
Quarles.
I think the Chairman has touched on this issue of the
international ramifications of hedge fund regulations, but I
would note that Britain and Ireland and other countries are
moving toward more retail access to hedge funds. Separating
from the specifics of their proposals this notion of--do other
regulatory schemes put pressure on our hedge funds, even though
we are the biggest source of hedge funds in the world, our
hedge funds to either move offshore, to change their practices,
or to modify our practices here locally?
Mr. Quarles. Let me answer that with two parts: one, I am
not aware that there is at least at this point kind of a
significant pull effect from other regulatory regimes being
viewed as relatively attractive versus our current regulatory
regime and pulling hedge fund domiciles offshore and hedge fund
activity offshore in a way that could have an adverse effect on
our financial markets.
I do think that there is some concern and some reason for
concern that in an increasingly global financial marketplace
where hedge fund activity among other activities in the capital
markets is able to move with relative ease to other
jurisdictions, there is some concern that potential
developments in hedge fund regulation or legislation in this
country could serve to push hedge fund activity offshore. So I
think as we look at the issue, I think that is one of the
things that we need to evaluate. We do need to be careful as we
look at what the proper official sector policy response ought
to be that we do not push beneficial activity offshore, but
with respect to what I think was the principal thrust of your
question, is there already some pulling offshore because of
more attractive or laxer regulatory regimes abroad, I have not
seen that yet.
Senator Reed. One of the risks you pointed out was
leverage, and it raises an issue that Senator Sununu suggested.
That is, you know, what is the proper venue for regulation? Is
it the hedge fund, or is it in some cases, the financial
institutions that are lending to these hedge funds? Could you
comment on that?
Mr. Quarles. I think that the framework that the official
sector, the President's Working Group and all the regulators
that are part of that identified some years ago as the right
approach, I think we have seen as the recommendations for that
counterparty risk management framework be implemented, both in
the official sector and the private sector over time.
I think that we have seen that it has been quite effective.
There are still some issues, that, again, as I have indicated,
we want to understand, but the regulation of counterparties and
the aggregation of information from regulated counterparties of
hedge funds and the improvement of private sector counterparty
risk management both conceptually and I think we have seen in
practice can have and has had beneficial effects for the
financial marketplace and with respect to some of the concerns
like excessive leverage in the hedge fund industry that we have
seen earlier.
If there is a way to improve that, I mean, it is then
incumbent upon the official sector with respect to our own
responsibilities, at least, that that is going to be the
framework to ensure that we are appropriately aggregating and
looking at the information that we can have from the various
regulated entities that are counterparties to the hedge funds.
There may be ways to improve that going forward, but as far as
the general concept and the good effects of implementing that
concept over the last several years, I would say that they have
both been positive.
Senator Reed. Is there a practical issue of sort of
fragmented, where there is a hedge fund that has a relationship
with one financial institution, maybe three or four financial
institutions, that one regulator is looking at one small piece;
another regulator is looking at another piece; those pieces
seem good, but when you put them all together, it is a
different story requiring more coordination among financial
regulators? Is that----
Mr. Quarles. Exactly. That was kind of the--that was the
better articulated thrust of my response about organizing and
possibly increasing the sharing of information among
regulators. I would stress that we have not seen any kind of
actual practical problems as a consequence of that, but if we
are going to describe that, and I think it is a good approach
as the right framework to think about official sector
management of hedge fund risk and activity, then, it is
incumbent on us to ensure that we are appropriately aggregating
that information.
Senator Reed. Thank you very much.
Thank you, Mr. Chairman.
Senator Hagel. Senator Reed, thank you.
Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
Have you seen any evidence that hedge funds are
manipulating the market in any way, such as driving stock
prices down, forcing companies to take actions they otherwise
would not, or anything else?
Mr. Quarles. When you say hedge funds, so the industry as a
whole, I have not seen that evidence. Now, in any--if you are
talking about any industry in which there are between 8,000 and
9,000 different participants, it would be surprising if there
were not at least a handful among them who were not turning
corners.
There have certainly been allegations that there have been
some hedge funds, not hedge funds as an industry but some hedge
fund managers that have engaged in activities that may be
illegal or may have an adverse effect on the marketplace. In
each of those cases of which I am aware, appropriate
enforcement action is being considered or undertaken against
them as it would be for any other market participant.
So I would not, on the basis, again, of the isolated
incidents of which I am aware conclude that there was an
industry-specific problem or propensity.
Senator Bunning. And you know for a fact that each and
every one of those violations are being investigated by proper
authorities?
Mr. Quarles. All of those of which I am aware.
Senator Bunning. As the hedge fund industry has evolved,
even more people are investing in it through different
investment vehicles such as a fund of funds without regulation.
Is there an unfair advantage in the market by being able to
choose an investment that is unregulated? Does the large
investor have an unfair advantage over the individual investor,
small investor?
Mr. Quarles. That is an interesting question. I would not
say that it is an unfair advantage. The evaluation of the risk
that is involved in a variety of hedge fund strategies is
complex. I think that it is appropriate to require a certain
amount of investor sophistication to view that investment
opportunity as appropriate. It certainly is an important part
of our evaluation of the overall adequacy and appropriateness
of our current regulatory stance toward hedge funds that they
are limited to sophisticated investors and are not marketed or
available in any significant degree to retail investors. So is
that a disadvantage to the retail investor that they are not
able to take advantage of a manager that is following a
particular hedge fund strategy?
I think when you balance benefit and risk and the need for
a significant amount of sophistication to be able to evaluate a
number of these hedge fund strategies, I think it is probably
the right stance.
Senator Bunning. In your written testimony, you said the
President's Working Group on Financial Markets has made several
recommendations to support a market discipline approach to
controlling leverage. Would you go into more deal about these
recommendations, and which do you support?
Mr. Quarles. Yes, among the recommendations were
recommendations for increased transparency from hedge funds to
their private sector providers of leverage to ensure that those
leverage providers were aware of the overall financial position
of the hedge fund as they provided leverage. And conceptually,
that is of a variety of more detailed recommendations. That is
at the heart of the counterparty risk management strategy
recommended by the President's Working Group.
There have been a number of public and private sector
groups that have moved to implement that. The Counterparty Risk
Management Group II under Jerry Corrigan has also taken up the
cause of enhancing counterparty credit risk management, and I
think that the end result of all of these efforts has been a
significant reduction in balance sheet leverage in the hedge
fund industry as a whole and a much better sense of hedge fund
counterparties of what the financial position of their hedge
fund credits are, and as a consequence, significant benefits to
the financial sector generally.
Senator Bunning. My time has expired, Mr. Chairman.
Senator Hagel. Thank you, Senator Bunning.
Senator Carper.
Senator Carper. Thanks, Mr. Chairman, and Secretary
Quarles, welcome. Thank you for joining us today.
I missed your testimony. I understand you did not talk for
long. I am going to ask you to just give us a couple of
nuggets, the most important elements of your testimony that you
would want me to take out of here and never forget.
[Laughter.]
Mr. Quarles. I would be happy to do that. I did not talk
for long, but I did talk for 45 seconds more than my 5 minutes,
contrary to the strict injunction of my legislative affairs
colleague.
If I were to say to take three things away from what the
Treasury Department has presented here today, it would be, one,
that it is important that we understand the topic of this
hearing, which is the role of hedge funds, before we move in
any degree to seeking to further regulate or legislate with
respect to hedge funds. So the order is important, and I think
there is more that we need to understand about the role of
hedge funds. There is a lot that we do understand about
benefits and risks. The second point is that we need to
understand that role.
That role is, on balance, positive because of the benefits
of increased liquidity, increased efficiency of markets, price
discovery, increased investor choice, you know, increased
competition in markets. All of these are positive benefits of
hedge funds, and there are, however, some risks that I think it
is incumbent on us in the official sector to understand better
than we do. We can identify some of them. I mentioned leverage;
I mentioned valuation issues; I mentioned the crowded trades
issue.
And as a consequence, the third point is that is why, you
know, at the Treasury Department, we have identified that we
will, over the course of the next several months, be actively
engaged in reaching out to private sector market participants,
both hedge fund counterparties, hedge fund managers themselves.
We will be working to bring together members of the official
sector through the President's Working Group to look at some of
these current issues with respect to risk as well as the
overall facts about the current role of hedge funds in the
markets to make sure that we have a very sound understanding of
that before we come to some conclusions about what, if any,
policy response there ought to be.
Senator Carper. OK, thanks. Do I understand that hedge fund
registration has been required since February of this year?
Mr. Quarles. I think that is right. It has been relatively
recently.
Senator Carper. Do you have any idea how compliance has
been? And to what effect do you think the registration helps or
hinders investors?
Mr. Quarles. Well, I mean, it might be appropriate for me
to--the SEC representative on the next panel, Ms. Wyderko, will
have more detail about what the SEC has learned from its
registration effort and how compliance has been. I think from
our point of view, it would probably be premature for us at the
Treasury Department to have any strong views as to what we can
learn from that, because it is such early days in the
implementation of the regulation.
Senator Carper. OK, one last question I would have: a
couple of weeks ago we marked up in this Committee legislation
that we called Reg Relief, and during the discussion on Reg
Relief, among the provisions we discussed were those that were
designed to impede money laundering in our financial
institutions. Let me just ask a related question: to the best
of your knowledge, what are the hedge funds doing to impede
money laundering, or what more should they be doing?
Mr. Quarles. That is a good question. The hedge funds,
obviously, are complying with any laws that are applicable to
them about, you know, transfers of funds in or out over a
certain size, and regulated financial institutions that are
counterparties of hedge funds as they move client monies in and
out of hedge funds themselves have to know who those clients
are, and, you know, they have the Know Your Customer rules, and
they also keep track of those financial flows. So I think in
the current scheme of things, the principal tool, if you will,
that we have for addressing those issues, the money laundering
issues, is, again, through the regulation of counterparties.
Senator Carper. My time has expired. Can I ask just one
real short one, just one quick one? What further advice would
you have for us other than holding hearings like this for this
Committee with respect to hedge funds?
Mr. Quarles. I am not sure that--I think I would just
simply reemphasize that in this rapidly developing sector, I
think it is important for the Members of this Committee, those
in the administration, the independent regulators, to ensure
that do we have a good finger on the pulse of this industry so
that we know what developments are that we are not in some
future period of stress moved to respond on the basis of an
insufficient knowledge base but at the same time not to squeeze
so hard that we cutoff circulation.
Senator Carper. All right, thanks so much.
Thanks, Mr. Chairman.
Senator Hagel. Senator Carper, thank you.
Senator Allard.
Senator Allard. In the hedge funds, we have a lot of
private contract agreements or not, or are those more into
other derivatives?
Mr. Quarles. I am sorry, do we have a lot of----
Senator Allard. Sort of private contract type.
Mr. Quarles. Yes.
Senator Allard. And where do you draw the line between a
private contract and maybe a more public transaction? Let us
just say a stock transaction, for example, if we would just put
it in those general terms, one extreme over the other; where do
you draw the line?
Mr. Quarles. Well, I think that if you are talking about--
if an instrument has been created that trades easily with
retail investors or that moves easily through the financial
marketplace in ways that could have knock-on consequences
significantly beyond those of the counterparties, that is
something that one might appropriately view as having public
aspects, that the public might have an interest in. To the
extent that you are dealing with a private contract affecting
the financial relationship between two counterparties, even
when that contract might key off in some way of a publicly
traded instrument, then, I think it is not inappropriate for
those parties to believe that the risks of that contract are
for them to judge.
Senator Allard. Usually, those are Ph.D.s and pretty well
educated individuals, I would assume.
Mr. Quarles. As a general rule.
Senator Allard. If we just took an average, well, let us
say an informed investor that meets the threshold, who makes
$200,000 a year, and they have over $1 million in net assets,
net value, is there enough information out there for that type
of consumer to make an informed decision on hedge funds?
Mr. Quarles. Well, that is a good question. I think one of
the issues is that certainly, in this day and age, those
criteria that you have described describe a broad range of
people. Obviously, some people who fit in that category will be
very able to evaluate the risks of a particular hedge fund
investment. Others would not. It is, however, the case that
most hedge funds in addition to those restrictions on who can
invest have substantial additional minimum investment
requirements that effectively restrict the investor pool well
beyond those minimum limitations.
Senator Allard. Do they have balance sheets and what not
that an investor can go on, net value, net assets and----
Mr. Quarles. They do. Each fund has, you know, each fund
has a differing private practice with respect to the amount of
information that it is willing to make public to its potential
investors or to disclose to its potential investors, and for
the most part, you know, the investor can then decide whether
he feels that, on the basis of the information that a
particular fund is willing to disclose to him, that he can make
an informed judgment about whether he can invest in the fund.
Senator Allard. What would you say were the main
characteristics of a well managed hedge fund?
Mr. Quarles. Certainly, sort of a very lively and close
attention to the risks of their investment strategy; having a
clear investment strategy; having a clear focus on risk; having
a clear focus on how potential stresses in the overall
financial environment could affect the investment strategy that
they are following.
Senator Allard. And a consumer visiting with a hedge fund
manager could ascertain this information, or is it in written
form, or do you have to basically pull it out of them?
Mr. Quarles. Again, there is not a Website or a standard
form of disclosure that the consumer would have, but each fund
would have both differing methods in which they make
disclosures and differing degrees of disclosure that they make
to potential investors. Increasingly, again, as part of the
increasing amount of competition that there is in the industry
and the increasing number of participants, there is much more
disclosure to potential investors than there had been even a
few years ago.
Senator Allard. Thank you, Mr. Chairman. I see my time is
about ready to expire.
Senator Hagel. Senator Allard, thank you.
Senator Bunning had one additional question he wanted to
ask, Mr. Secretary, as did Mr. Dodd, so I will ask Senator Dodd
to proceed.
Senator Dodd. Thank you, Mr. Chairman.
Just very briefly, I just want to know about the corporate
decisionmaking process. And to the extent that hedge funds are
making that more difficult, there is certainly--there has been
anecdotal evidence that this is creating difficulty for boards
wanting to make longer term decisions, and given the rapidity
with which hedge funds move, that is posing some problems.
Anecdotally, we are hearing that. To what extent is that a
problem, in your view?
Mr. Quarles. We have certainly heard the same anecdotes.
You know, we are familiar with the maxim that the plural of
anecdote is not data, and we have not seen yet substantial data
that would suggest that this is a problem. Conceptually, the
fact that hedge funds, like any other investor in the
marketplace, can purchase shares and then use those shares to
influence company management in ways that they think will
improve the value of the shares is not something that you would
say, you would think is necessarily of itself something that is
to be resisted in the marketplace.
Senator Dodd. What about playing a positive role? Let me
put it in that----
Mr. Quarles. Yes, exactly. Conceptually and apart from,
again, some of these isolated anecdotes that we have heard, you
would say that that has to be a benefit, that the increased
attention on the part of shareholders to the activities of
management in an attempt to influence those activities to
increase shareholder value, which is, of course, the interest
of a hedge fund that owns the shares, is a positive for the
marketplace.
Senator Dodd. Thanks.
Senator Hagel. Senator Dodd, thank you.
Senator Bunning.
Senator Bunning. Last question for me, anyway.
In a regulated mutual fund industry, many questionable
practices that were not in the best interests of the individual
investor in the markets had to be corrected by government
intervention. Why would we not assume in a lightly regulated
hedge fund industry that we would not encounter similar
practices by managers of hedge funds?
Mr. Quarles. The generation of those rules governing
registered funds many decades ago was principally a result of
the losses sustained by unsophisticated retail investors who
were drawn into funds that were following investment strategies
that they were not as a practical matter in a position to
assess.
I think it is a very different situation where you have--
and in fact, that is how it is that funds that wish to follow
more flexible investment strategies came to structure
themselves the way they do. It was to ensure that they did not
cross the thresholds that were deemed by our investment laws to
entail a significant degree of retailization. So, you know, I
think that it is an important element of our assessing the
adequacy of our current approach to hedge funds.
It is an important element that they are not--that retail
investors do not form a significant part of the investor base,
and as I say, we have not seen a lot of evidence that that
trend is developing, and that is the principal reason I would
say we can feel comfortable with the more flexible investment
strategies that these funds follow.
Senator Bunning. It seems to me that there are two sets of
rules: one for the wealthy that make over $200,000 and have
over $1 million in assets and another set of rules for the
unsophisticated investor. And I think that is incorrect. I
think that is wrong. And I will hope that the Treasury and all
other regulating bodies of hedge funds would take a very
thorough look and make recommendations to this Subcommittee so
we can do our job better.
Senator Hagel. Senator Bunning, thank you.
Senator Allard, do you have any additional questions?
Senator Allard. No more. Thank you, Chairman.
Senator Hagel. Secretary Quarles, thank you. We may keep
the record open to send additional questions in writing, and we
would appreciate very much if you would address those, but for
now, thank you for coming, and we appreciate your good work.
Mr. Quarles. Thank you very much. Thank you.
Senator Hagel. As Secretary Quarles leaves, if the second
panel would come forward. Thank you.
The second panel is comfortably ensconced, I presume. You
look comfortable. You have water, all the necessary
requirements for penetrating testimony. Thank you again. Since
I have introduced this panel, I will ask Ms. Wyderko, who is
representing the Securities and Exchange Commission, to begin
the second panel's testimony. Thank you. Ms. Wyderko.
STATEMENT OF SUSAN WYDERKO
DIRECTOR,
OFFICE OF INVESTOR EDUCATION AND ASSISTANCE
FORMER ACTING DIRECTOR,
DIVISION OF INVESTMENT MANAGEMENT,
U.S. SECURITIES AND EXCHANGE COMMISSION
Ms. Wyderko. Chairman Hagel, Ranking Member Dodd, and
Members of the Subcommittee, thank you for inviting me to
testify today about hedge funds, the role they play in our
securities markets, and the Commission's role in their
oversight.
The Commission has a substantial interest in the activities
of hedge funds and their advisors which are today major
participants in our securities markets. We estimate that hedge
funds today have more than $1.2 trillion in assets, a
remarkable growth of almost 3,000 percent in the last 16 years.
Much of the growth of hedge funds is attributable to increased
investments by institutions such a private and public pension
plans, endowments, and foundations. Many of these investors
sought out hedge funds during the recent bear markets in order
to address losses from traditional investments.
Hedge funds are operated so that they are not subject to
the Investment Company Act of 1940, which contains many
safeguards for retail investors. In addition, hedge funds,
issue securities in private offerings that are not registered
with the Commission under the Securities Act of 1933, and hedge
funds are not required to make periodic reports under the
Securities Exchange Act of 1934. However, hedge funds are
subject to the same prohibitions against fraud as are other
market participants, and their managers have the same fiduciary
obligations as other investment advisors.
Because hedge fund managers are investment advisors under
the Investment Advisors Act of 1940, they owe the fund and its
investors a fiduciary duty that requires the manager to place
the interests of the hedge fund and its investors first or at
least fully disclose any material conflicts of interest the
manager may have with the fund and its investors. Hedge fund
advisors have this fiduciary obligation as a matter of law,
regardless of whether they are registered with the Commission.
The Advisors Act provides the Commission with authority to
enforce these obligations, which the Commission has exercised
vigorously in order to protect investors. Examples of cases we
have brought are included in my written testimony.
Until recently, registration with the Commission was
optional for many hedge fund advisors. In February of this
year, new rules became effective that require that most hedge
fund advisors register with the Commission under the Advisors
Act. The new rules do not regulate hedge fund strategies,
risks, or investments. The new rules have given the Commission
basic census data about hedge fund advisors. The staff is in
the process of evaluating these data and considering methods to
refine its ability to target our examination resources by more
precisely identifying those advisors, including hedge fund
advisors, who pose greater compliance risks. In addition,
registration has required hedge fund advisors to implement
compliance programs, to detect, prevent, and correct compliance
violations and to designate a chief compliance officer to
administer each advisor's compliance program.
Hedge funds provide many benefits to investors and our
national securities markets that contribute substantially to
market efficiency, price discovery, and liquidity. By actively
participating, for example, in markets for derivative
instruments, hedge funds can help counterparties reduce or
manage their own risks, thus reducing risks assumed by other
market participants.
When market activity by hedge fund advisors, like any other
participant in the securities markets, crosses the line and
violates the law, the Commission has taken appropriate remedial
action. My written testimony has illustrative examples.
In conclusion, I would like to thank the Subcommittee for
holding this hearing on a subject of growing importance to us
and all American investors. Hedge funds play an important role
in our financial markets, and the Commission will continue to
vigorously enforce the Federal securities laws with respect to
hedge funds, their advisors, and all market participants.
Senator Hagel. Ms. Wyderko, thank you.
Mr. Parkinson, who is here on behalf of the Federal Reserve
System, welcome.
STATEMENT OF PATRICK PARKINSON
DEPUTY DIRECTOR, DIVISION OF RESEARCH AND STATISTICS,
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. Parkinson. Chairman Hagel, Senator Dodd, I thank you
for the opportunity to testify on the role of hedge funds in
the capital markets.
Hedge funds clearly are playing an increasingly important
role, especially as providers of liquidity and absorbers of
risk. For example, a study of the markets in U.S. dollar
interest rate options indicated that participants viewed hedge
funds as a significant stabilizing force. Hedge funds
reportedly are significant buyers of the riskier equity and
subordinated tranches of collateralized debt obligations and of
asset-backed securities, including securities backed by
nonconforming residential mortgages.
At the same time, however, the growing role of hedge funds
has given rise to public policy concerns. These include
concerns about whether hedge fund leverage is being constrained
effectively and what potential risks the funds pose to the
financial system if their leverage becomes excessive. The near
failure of the hedge fund Long Term Capital Management in
September 1998 illustrated the potential for a large hedge fund
to become excessively leveraged and raised concerns that a
forced liquidation of large positions held by a highly
leveraged institution would create systematic risk by
exacerbating market volatility and illiquidity.
In the wake of the LTCM episode, the President's Working
Group on Financial Markets considered how to best constrain
excessive leverage by hedge funds and concluded that this could
be achieved most effectively by promoting measures that enhance
market discipline by improving credit risk management by hedge
funds, counterparties, and creditors. Because those
counterparties nearly all are regulated banks and securities
firms, the Working Group termed this approach indirect
regulation of hedge funds. The Working Group considered the
alternative of direct government regulation of hedge funds, but
it concluded that developing a regulatory regime for hedge
funds would present formidable challenges in terms of cost and
effectiveness.
The Working Group made a series of recommendations for
improving market discipline on hedge funds. According to
supervisors and most market participants, counterparty risk
management has improved significantly since the LTCM episode in
1998. However, since that time, hedge funds have greatly
expanded their activities and strategies in an environment of
intense competition for hedge fund business among banks and
securities firms. Furthermore, some hedge funds are among the
most active investors in new, more complex structured financial
products, for which valuation and risk management are
challenging both to the funds themselves and to their
counterparties.
Counterparties and supervisors need to ensure that
competitive pressures do not result in any significant
weakening of counterparty risk management and that risk
maintenance practices are evolving as necessary to address the
increasing complexity of the financial instruments used by
hedge funds.
The Federal Reserve has also sought to limit hedge funds'
potential to be a source of systemic risk by ensuring the
robustness of the clearing and settlement infrastructure that
supports the markets in which the funds trade. Very active
trading by hedge funds has contributed significantly to the
extraordinary growth in the past several years of the markets
for credit derivatives. By last year, it had become apparent to
many that the clearing and settlement infrastructure for credit
derivatives had not kept pace with the volume of trading.
In September of 2005, the Federal Reserve Bank of New York
brought together 14 major U.S. and foreign derivatives dealers
and their supervisors. The supervisors collectively made clear
their concerns about the risks created by the infrastructure
weaknesses and asked the dealers to develop plans to address
those concerns. Since then, the dealers and their hedge fund
clients have made remarkable progress toward addressing
supervisors' concerns and have committed to making further
progress within the next 6 months.
Thank you.
Senator Hagel. Mr. Parkinson, thank you.
Mr. Overdahl, who is here with the Commodity Futures
Trading Commission, welcome, thank you.
STATEMENT OF JAMES OVERDAHL
CHIEF ECONOMIST,
U.S. COMMODITY FUTURES TRADING COMMISSION
Mr. Overdahl. Mr. Chairman, Senator Dodd, and Members of
the Subcommittee, I appear before you today in my capacity as
Chief Economist of the Commodity Futures Trading Commission or
CFTC, the Federal Government regulator of futures markets in
the United States. To the expect that any subsidiary fund
within a hedge fund complex uses exchange-traded derivatives,
the operator of that subsidiary fund and its advisory may be
subject under certain circumstances to registration reporting
requirements under the Commodity Exchange Act, the statute
administered by the CFTC.
Futures markets serve an important role in our economy by
providing a means of transferring risk from those who do not
want it to those who are willing to accept it for a price. In
order for businesses to hedge the risk they face in their day-
to-day commercial activities, they need to trade with someone
willing to accept the risk the hedger is trying to shed. Data
from the CFTC's large trader reporting system are consistent
with the notion that hedge funds and other professionally
managed funds are often the ones who facilitate the needs of
hedgers.
CFTC large trader data also show that hedge funds and other
professionally managed funds hold significant spread positions;
that is, positions across related contracts. These spread
positions play a vital role in keeping the prices of related
contracts in proper alignment with one another. Hedge funds
also add to overall trading volume, which contributes to the
formation of liquid and well functioning markets.
One notable development over the past 5 years has been the
increased participation by hedge funds and other institutional
investors in futures markets for physical commodities. These
institutions have allocated a portion of the investment
portfolios they manage into commodity-linked index products. A
significant portion of this investment finds its way into
futures markets either through the direct participation of
those whose commodity investments are benchmarked to a
commodity index or through the participation of commodity index
swap dealers who use futures markets to hedge the risks
associated with their dealing activities.
The CFTC relies on a program of market surveillance to
ensure that markets under CFTC jurisdiction are operating in an
open and competitive manner. The heart of the CFTC's market
surveillance program is its large trader reporting system. For
surveillance purposes, the large trader reporting requirements
for hedge funds are the same as for any other large trader. In
addition to regular market surveillance, the CFTC conducts an
aggressive enforcement program that deters would-be violators
by sending a clear message that improper conduct will not be
tolerated.
The financial distress of any large futures trader poses
potential risks to other futures market participants. With
respect to commodity pools operating as hedge funds, the CFTC
addresses these risks through its oversight of futures
clearinghouses and the clearing member firms of each
clearinghouse. This oversight regime is designed to ensure that
the financial distress of any single market participant,
whether or not that participant is a hedge fund, does not have
a disproportionate effect on the overall market.
This concludes my remarks, and I look forward to your
questions.
Senator Hagel. Mr. Overdahl, thank you.
Mr. Parkinson, let me begin the questioning with you. As
you noted toward the end of your testimony that the Federal
Reserve Bank of New York has been looking at some of these
issues, and I am particularly interested in some of your
thoughts on what the Federal Reserve-New York was looking at
ways to improve industry practices and credit derivatives, and
it is my understanding that Chairman Bernanke is addressing the
Atlanta Federal Reserve tonight on these issues, hedge funds
and credit derivatives. Let me begin with this question: what
are the Federal Reserve's specific concerns about credit
derivatives?
Mr. Parkinson. Thank you, Chairman.
I think broadly speaking, the Federal Reserve is concerned
about whether banks and other participants in the credit
derivatives markets are managing the risks associated with
those instruments effectively, and then, second, alluding to
the other thing you mentioned earlier, whether the market
infrastructure is sufficiently robust.
As I think has been mentioned in the previous panel, some
credit derivatives are extremely complex and are traded on
illiquid markets. And consequently the measurement or
management of the risks poses challenges to even the most
sophisticated market participants. And really, the Fed in that
area has been conducting a variety of reviews of bank risk
management practices with respect to these instruments, and it
has communicated to the banks through our supervisory process
and to the marketplace through speeches like the one that
President Geithner gave this morning and the one that Chairman
Bernanke will be giving this evening, areas in which risk
management practices should be strengthened.
With regard to clearance and settlement, the
infrastructure, I think I discussed that in my testimony, that
by last year, it had become apparent to many that the
infrastructure simply was not keeping up with the growth of the
markets, so last September, the New York Fed got together these
large dealers and their supervisors and really said here are
the problems. We want you to come up with a solution, and they
have made remarkable progress since then. They have promised to
address the remaining issues, so I think that has been a real
success.
Let me finally say that to put this in perspective, I think
a point that President Geithner has emphasized and that I would
like to emphasize, too is that while we have these concerns,
the Federal Reserve officials feel that notwithstanding those
concerns, the development of credit derivatives has made both
banks and the financial system safer and more resilient, and
the key thing is to make sure it continues to be by addressing
those specific concerns.
Senator Hagel. What is the timeframe on the solutions?
Mr. Parkinson. In terms of the clearance and settlement
infrastructure, the firms have committed to a variety of steps
to complete them by October 31 of this year, so, really, quite
an ambitious timetable.
Senator Hagel. And what do you anticipate will be included
in that solution agenda?
Mr. Parkinson. There are many parts to it. I think that a
key part is that they are already, one of the problems has been
that there has been manual processing of transactions to a
large degree, and in recent years, electronic platforms for
processing trades had been developed, but the takeup was not
very good, and they really have committed essentially that if a
transaction can be confirmed electronically, it will be
confirmed electronically.
And then, with respect to the ones that cannot be confirmed
electronically, they have set deadlines for processing those
transactions, completing the conforms, and I think importantly,
have agreed that very soon after the trade date, they will make
sure that they have a common understanding of the material
economic terms of the trade, so that notwithstanding delays and
completing the legal confirmations that their books and records
will be accurate, and therefore, their measures of counterparty
risk and market risk will be accurate.
Senator Hagel. Thank you.
You noted in your testimony, I will quote just a line,
quote, that hedge funds are increasingly consequential as
providers of liquidity, end of your quote. Would you explain
that in a little more detail, what you meant by that?
Mr. Parkinson. Sure. I think that first, it is important to
recognize that in recent years, our entire financial system has
become less bank-centric and more market-centric. More credit
demands are being met by the financial markets rather than
being met directly by banks.
And in that kind of environment, the liquidity of financial
markets really is critical. In other words, the ability to buy
and sell quickly and in size. Now, in normal times, liquidity
tends to be ample. I think hedge funds contribute to that. But
I think what is really important is that when economic
conditions become uncertain and prices move rapidly, then,
liquidity has a tendency to evaporate. As we say, markets have
a tendency to seize up. Examples would be the equity markets in
1987 and I think the interest rate options markets back in the
summer of 2003.
And what is needed in those circumstances is really someone
that recognizes that those kinds of disorderly markets in fact
create profit opportunities for those who are willing to engage
in arbitrage transactions and that have the willingness to take
the risk that that involves to exploit those opportunities and
to bring stability back to those markets. And I think this is
an instance where back in 2003, I think we observed that as the
option markets became unstable and prices soared that the hedge
funds stepped in and profited from that disorder by selling
options and bringing liquidity back to that market.
It is purely speculative, but I think it is an interesting
question if we were again in a situation we were in October
1987 when equity prices were falling rapidly, I think there is
a real potential for hedge funds to play a stabilizing role in
that kind of market circumstance, where I think back in 1987,
ultimately, what turned things around was corporations going
back into the market and buying their own shares at these very
depressed prices. I think you have this large pool of capital
now that is willing to take risks in the hedge fund sector that
could perhaps perform that service more quickly and limit the
damage.
Senator Hagel. Thank you.
Ms. Wyderko, let me ask a question of you regarding--I have
in front of me an April 26, 2006, Washington Post story, Two
Firms Claim Conspiracy in Analysts' Reports. I am sure you are
familiar with this. These are issues that have surfaced
recently, and the particular case I want to ask about is a case
involving overstock where hedge funds are alleged to have paid
securities analysts to issue misleading research to the
marketplace. What is the SEC doing to monitor such situations?
Ms. Wyderko. The Commission's staff carefully considers all
allegations of fraud and manipulation. I cannot comment on that
case, because, as you have read, it is a pending case. We have
regulations in place to deter fraud, and we go after it
vigorously when we find it.
Senator Hagel. And I am aware of that limitation that you
have in answering the question further. Let me just see if I
can come at this in a little more general way. Does the SEC
have the authority to guarantee that securities research and
analysis that is held out is independent is actually so? Do you
need additional tools?
Ms. Wyderko. Well, we have got Reg AC, and if false
research is deliberately issued by any broker-dealer, it
implicates Reg AC, which seeks to promote the integrity of
research. We do have the tools to go after market manipulation.
We do.
Senator Hagel. What are those tools? What are you doing
about these such things? I know you will have to stay away from
the specific case that I have mentioned, but how is the SEC
ensuring that this research, in fact, is independent. You say
that you have the tools. Explain that.
Ms. Wyderko. We have the tools in Rule 10(b)(5), the anti-
fraud rule. Making or facilitating misrepresentations for the
purpose of affecting a price of a stock is an illegal
manipulative device, and that violates securities laws such as
Rule 10(b)(5). We also have the tools to go after anyone who
engages in transactions that are done in order to create actual
or apparent trading in a security or to depress the price of a
security for the purpose of inducing someone else to purchase
or sell a security. So we have anti-fraud tools enforcement
staff.
Senator Hagel. Which covers the analysis aspect of this.
Ms. Wyderko. Yes, sir.
Senator Hagel. Ms. Wyderko, thank you.
Let me ask a question of the three of you that I asked of
Secretary Quarles, and it is the very basic question, realizing
that your three agencies represent the President's Working
Group on this general issue. Do we need additional oversight?
Do we need greater regulation, if any additional regulation on
hedge funds? Ms. Wyderko, begin with you.
Ms. Wyderko. Well, as you know, we have just adopted a new
regulation that went into effect in February to require
registration of investment advisors. It might interest you to
know that we have about 2,400 registered hedge fund investment
advisors, and of that number, over half were registered prior
to February 1. That means they were registered voluntarily. The
data is now coming in. We are acquiring basic census
information about the activities of the investment advisors,
and we are monitoring that data, looking at it. We are also
using our risk based analysis parameters to select hedge fund
advisors like other advisors for examinations by our
examinations staff.
Senator Hagel. So your answer is you do not think anything
additional is required?
Ms. Wyderko. At this point, I think we need to see the
effects of our registration requirement, and we are actively
monitoring the information that we are receiving.
Senator Hagel. Thank you.
Mr. Parkinson.
Mr. Parkinson. No, we do not see the need for any
additional regulation. Again, we focus primarily on this
financial stability or systemic risk issue. I think we still
think that the indirect regulation approach is much more
attractive than direct regulation and likely to be much more
effective. We do see some specific issues around counterparty
risk management that concern us, but we are addressing those
issues through our bank exams and through encouraging market
participants to tighten up where appropriate and necessary.
Senator Hagel. Thank you.
Mr. Overdahl.
Mr. Overdahl. Based on the information I see today, I see
no additional tools that we need. I think what we are focused
on is understanding the role of funds in the markets under CFTC
jurisdiction, and we have a sizable program underway right now
looking at the role of funds, and pending the outcome of that,
I cannot recommend anything.
Senator Hagel. Let me ask each of you: in light of what you
heard Secretary Quarles say, the line of questioning that he
addressed here over the last hour, hour and a half a general
question. First, are you each providing more oversight in the
way of transparency of your own agency's involvement on hedge
funds? That would be one of the questions, and you would take
that, each of you, in any direction you would like depending on
your agency and each of your responsibilities in your agencies.
Also, I would like to get your reaction to some of the
questioning of Secretary Quarles in the area of systematic
risk. We talked here over the last hour and a half specifically
about what happened in the late nineties. We talked about the
GSEs, more leverage, more debt, use of derivatives. I would
like your general comments in those areas that you heard us
talk to Secretary Quarles about and his responses back.
We will begin with you, Ms. Wyderko.
Ms. Wyderko. The Commission focuses on broker-dealers'
exposure to hedge fund risks and the broader implications that
that might have to our financial system. Our Commission staff
works regularly with other members of the President's Working
Group on Financial Markets, and we work with the industry
members that comprise the Counterparty Risk Management Policy
Group in terms of transparency. And our consolidated
supervision program for banks now allows us to examine not only
the broker-dealer entities within a group but also the
unregistered affiliates and holding companies where the certain
financing transactions with hedge funds are generally booked.
Senator Hagel. Would you like to address any other aspects
of what we talked about here in the last hour and a half from
the SEC perspective?
Ms. Wyderko. Well, we work closely with the President's
Working Group on systemic risk, so I think I will let my
colleagues take over from that. We really focus on broker-
dealers' exposure at the SEC.
Senator Hagel. OK, thank you.
Mr. Parkinson.
Mr. Parkinson. First, on transparency, I guess the first
question I always ask is transparency to whom, and I think
there are three possible categories of people; one, to
investors, that is primarily an issue of investor protection.
That is an SEC issue that we do not focus on.
Importantly is the issue of transparency of hedge funds to
their counterparties and their creditors, and that is where
that was an important theme of the PWG recommendations, the
need for greater transparency. We have also emphasized, I
think, recently where there is not the kind of transparency
that would be ideal that banks and other creditors adjust their
credit terms so they are more conservative; so, for example, if
there is not enough transparency about what the hedge fund is
doing, they need to charge higher margins of that hedge fund
and do that in a systematic way.
And finally, transparency to regulators, again, because we
believe in the indirect regulation approach, not a direct
regulation approach. That is not an area where we are really
seeking greater transparency.
With regard to systemic risk, I keep coming back to our
sort of two key points: how do we deal with concerns about
systemic risk? We try to promote sound risk management
practices, particularly counterparty credit risk management
practices, which we do both through our exams of banks and
cooperation with other regulators; increasingly, I think a lot
of these inquiries about practices are done on a coordinated
basis, particularly with the FSA and with the SEC, because
between the U.S. banking regulators and those other two sets of
regulators, that covers most of the major counterparties and
creditors; and then, second, on strengthening the
infrastructure of the financial markets, where again,
particularly when it comes to securities markets, we work
closely with the SEC, and when it comes to the exchange-traded
derivatives markets, with the CFTC.
Senator Hagel. Thank you.
Mr. Overdahl.
Mr. Overdahl. With respect to transparency, I have two
comments to make. One, there is a lot of information about
funds themselves that is transparent to us through our Large
Trader Reporting System. These are reports that we receive on
positions of all traders or most of the large traders in the
market, between 70 percent and 90 percent of the open interest.
We receive that information daily, and many of these
participants are hedge funds, so we do see that as the
regulator.
From those reports, we compile a weekly report that we put
out publicly, called the Commitments to Traders Report that
goes out every Friday afternoon at 3:30, and many people look
at that; many people have suggested to the CFTC that we
disaggregate that report to break out, perhaps, hedge funds and
other large traders.
I think what we are going to do as the staff of the
Commission is put options together for the Commission and have
a process with public comment and full public participation to
understand the costs and benefits of perhaps a finer breakout
of those reports. With respect to systematic risk, we treat all
large traders the same way no matter the source or who they are
and how they affect risk in our market. With respect to GSEs
specifically, I would defer to my colleagues here. We certainly
participate with them in the PWG, but we have very little
intersection with that area within the jurisdiction of the
CFTC.
Senator Hagel. Thank you.
I want to refer back to a point that Senator Sununu made
early in the hearing, and others picked up on it, regarding
overregulation. And my question is this: do you believe that
overregulation of any segment of our financial services market,
in this case, particularly the hedge funds, would drive hedge
fund investments off our shores, overseas? Basic question: does
overregulation have an impact on investing in this country and
our system or any country?
We will start with you, Ms. Wyderko.
Ms. Wyderko. I think we all agree that overregulation is
bad.
Senator Hagel. I am not sure that everybody does.
[Laughter.]
Ms. Wyderko. Our rules for registration of investment
advisors are not based on the advisor's domicile. That is
important to understand. Hedge fund managers, wherever based,
if they accept money from 15 or more U.S. investors, they must
register with the Commission as investment advisors. So I do
not think that it is a question of driving advisors offshore.
If investment advisors wish to access U.S. capital sources,
U.S. investors, then, they will need to register with the SEC
if they have 15 or more U.S. investors.
Senator Hagel. But what I am asking is, aside, in addition
to, aside from, in addition to, for example, what the SEC, in
your area of responsibility, of regulation, protecting the
consumer, the individual investor, if there was more
regulation. That is what I am trying to get at, because if, for
example, something were to happen in the hedge fund market, and
we find some kind of a significant adjustment which, just as
Senator Sununu noted, that tends to elicit an immediate
reaction from the Congress. Sometimes it is the right thing;
sometimes, it is not the right thing.
And that is where the universe of overregulation lies. We
talked earlier about are we not wiser to understand this
industry now in anticipation not necessarily of that kind of
adjustment but just knowledge, information, a basis to
appreciate what this business is about so that we do not
overregulate, so that we do not do something not in the
interests of our economy and of our markets.
So if we were to advance any regulatory regime within the
SEC, any of the agencies represented here, my question is does
that automatically or does it have very little consequence to
how investors see, in this case, hedge funds, especially, as
you recall, when I asked Secretary Quarles about how other
countries regulate, where the regimes differ, and you heard
what he said. You know, of course, what the answer is.
So that is what I was trying to get at, because what we are
trying to do in this hearing and maybe a series of hearings is
establish some basis for us to better understand not just the
role of hedge funds but what role those funds play in our
overall economy, in our investment opportunities, therefore
equipping us better to understand these things, not allowing us
to overreact if something happens. So in anticipation of that--
that is my question--does overregulation or any degree of that
in your data, your own analysis, tend to, in fact, undermine
our markets or incentives or investment opportunities?
Ms. Wyderko. Well, I think it is important to realize a
couple of things. First of all, as Mr. Quarles said, at this
point, we are working with foreign regulators, and we are
imposing a regulatory regime that is remarkably consistent with
other developed countries, so that is an important baseline
comment.
If we were to more heavily regulate hedge funds, for
example, we do not currently regulate their strategies or their
risks or their investments, if we were to impose more onerous
regulations on hedge funds, it may be that we would diminish
the utility of those investment vehicles for those investors
who are investing in them. I mean, you have heard discussion
today about the various uses that investors use hedge funds
for: hedging other investments, trying to achieve returns that
differ from recognized market indices. You may well diminish
the utility of the hedge funds to provide that service for
investors.
Senator Hagel. Thank you.
Mr. Parkinson.
Mr. Parkinson. I guess I do not think we are concerned that
overregulation is going to drive activity abroad for precisely
the reasons that Ms. Wyderko mentioned. I do think that we
worry about overregulation, and from our perspective, it is not
that it would limit the investment opportunities of investors
so much as it would impair the ability of hedge funds to
provide the benefits they do to markets: the provision of
liquidity, the bearing of risk. And if you got into in
particular regulating the fund as opposed to the advisor, and
the SEC currently regulates the advisors but not the funds; in
particular, if that involved constraining their strategies,
investments, et cetera, I think that is precisely the sort of
thing that could have a very adverse effect on the markets. And
that is the reason we would be concerned about overregulation,
not driving the activity offshore.
Senator Hagel. Thank you.
Mr. Overdahl.
Mr. Overdahl. I can think of some instances where, you
know, a proposed regulation, for example, to achieve greater
transparency might have the opposite effect and drive it
outside of the jurisdiction of regulators where you see less of
it than perhaps you would otherwise. And it is certainly
something that we always consider in promulgating any
regulations, the costs and benefits of that regulation.
I would say one thing we have been particularly interested
in is focusing regulation, trying to make sure that we are
achieving the purposes of the statute Congress has given us
without any more requirements than necessary. We have certainly
sought to work with the SEC in coordinating our work with them
so that participants are not facing duplicative standards. And
so, we are trying to work that way to make sure that we do not
have this situation.
Senator Hagel. Thank you.
Since a vote has been called, it is quite timely. This
might be an appropriate time to break for a moment as we excuse
our second panel and ask for the third panel, but before I do,
not only do I want to thank you, but let me ask each of you if
there are any additional comments or points that you would like
to make to put on the record.
Ms. Wyderko. No, sir.
Mr. Parkinson. No, sir.
Senator Hagel. Well, again, thank you. We will, again, as
we did for Secretary Quarles, keep the record open in case
colleagues have questions they would like to submit in writing.
Thank you very much. This Committee is in recess until the
Chairman votes and returns.
[Recess.]
Senator Hagel. All right, so, you are recording. You feel
good about America and our future. All right. Is this an NSA
hearing?
[Laughter.]
Senator Hagel. Welcome again.
This is the third panel of our hearing today on the role of
hedge funds in our capital markets, and I once again welcome
our distinguished panelists. Each of you have had a long career
in financial services, government, industry, and continue to
contribute and be productive members of that segment of our
economy, and we appreciate it.
I have introduced each of you, as you know, and so, I will
get right to your testimony. And then, if you have time, we
will entertain some questions, and I appreciate, again, your
testimony and your willingness to come before this Committee.
With that, let me begin with Secretary McCormack. Secretary
McCormack, welcome. Nice to have you here. Thank you.
STATEMENT OF HON. RICHARD McCORMACK
SENIOR ADVISOR, CENTER FOR STRATEGIC AND INTERNATIONAL STUDIES
Mr. McCormack. Thank you very much, Senator. I am obviously
very pleased to be here today.
I thought I would say a few words about derivatives, about
the macroeconomic environment in which hedge funds and
derivatives are operating and what that macroeconomic
environment might be in the years ahead and a few words about
the potential for systemic risk.
I have a full statement, which I will put on the record,
and I will summarize my remarks briefly here now.
Senator Hagel. Thank you. I would remind all of our
witnesses that the full text of your testimony will be included
in the record, so if you feel so inclined to abbreviate that or
summarize it, that is certainly acceptable.
Secretary McCormack, would you pull that mike down a little
bit just so we can hear you better?
Mr. McCormack. Is that better?
Senator Hagel. I think that is better. Thank you.
Mr. McCormack. Virtually everyone who understands the
derivative industry recognizes its value in the economy and its
ability to manage and defuse financial risks by individuals and
companies. History shows, too, that some derivatives do contain
the potential for abuse and mistakes. We all know spectacular
examples of this, including the Long Term Capital Management
debacle, which was an honest miscalculation by some very
intelligent people.
It is, of course, important to remember that for each Enron
type problem that surfaces in connection with derivatives,
there are thousands of transactions that occur every day that
benefit all parties involved. The challenge we now have is to
examine this industry and those involved in it, with the help
of those deeply engaged to correct any structural or technical
problems that could increase the likelihood of systemic risk
following a future shock to financial markets, such as the
Russian default in 1998.
There is obviously no such a thing as a permanent fix to
the problems in the derivative industry. This industry is so
dynamic, and its strengths and weaknesses change every few
years. Ten years ago, credit derivatives were a tiny blip on
the screen. Today, these credit derivatives, which provide a
default insurance to creditors, are the fastest growing segment
of this industry, as much as $17 trillion of notional value.
Last year, when serious and potentially dangerous
operational problems in credit derivative markets alarmed
regulators, Jerry Corrigan, the former Federal Reserve official
now with Goldman Sachs led an effort to analyze and repair
these problems. This effort was a good example of how the
industry and regulators can work together to solve problems on
the operational side of the derivative business.
Beyond operational risk, however, credit risk and market
risks pose other issues. Long periods of growth and prosperity
tend to induce a certain amount of complacency in financial
markets. It is important to remind recent entries to the
derivative business that the business cycle still exists. There
are potential vulnerabilities in the global economy that could
impact financial markets at some point. Every decade, the two
or three crises threaten the instability of financial markets.
I would just like to conclude by making several general
remarks:
One, estimates of the total size of the notional value of
over-the-counter derivative contracts vary widely. The
President of the New York Federal Reserve estimates that number
at $300 trillion. The Bank for International Settlement
estimates that number at $270 trillion. The International
Association of Swaps and Derivatives estimates the total
outstanding value at $219 trillion.
Even value at risk, which is a much smaller number, is
subject to varying interpretations and estimates. When rounding
errors for estimates of notional value of outstanding
derivative contracts are in the tens of trillions of dollars,
it is hard to have total confidence that we understand all the
potential vulnerabilities that may exist in this industry.
Two, in his February 28 presentation on financial risk, Mr.
Geithner raises the possibility of a potential rush to the exit
by highly leveraged derivative holders during any future period
of financial turmoil. Obviously, the Federal Reserve can play a
role in addressing certain kinds of liquidity shortages and
crises, but individual investors should be mindful of the need
for an adequate capital cushion to address potentially
unfavorable market developments.
Three, should early signs of possible vulnerabilities begin
to emerge in financial markets, the most sophisticated
investors will, of course, quickly shed risky investments.
These hearings should serve as a reminder to investors of the
oldest lesson in business dealings: caveat emptor--let the
buyer beware. Complex derivatives are not a place for amateur
investors. There is an enduring connection between high yields
and high risks.
Four, regulation of the derivative and hedge fund
industries is faced with a fundamental dilemma: if government
regulates these industries so tightly as to avoid all risk of
market failure, it will kill a valuable part of the financial
system. Finding the right middle path in this constantly
changing environment is a challenging task.
Five, the U.S. regulatory system monitoring the financial
industry is highly fragmented, as you have seen today with the
previous panel. If our government were to start today from
scratch and design a regulatory system for today's financial
system, it would not look like the system we now have in place,
even though the existing system has generally served us well.
But with the increasing globalization of the financial industry
as a whole, it is clear that more of the regulatory emphasis
and monitoring will have to be international in character. This
will not be an easy task.
The entire international global financial system is
interconnected by hundreds of trillions of dollars of
derivatives. Any future banking crisis in China which slows
that economy will immediately impact commodity prices
dramatically and the bonds of commodity producers. Any further
sustained spike in oil prices could impact huge segments of the
derivative industry. Those holding some credit derivatives
against default could find them very costly indeed in this
environment.
In conclusion, in well-functioning capital markets
governments should not be concerned about the possible gains
and losses of individual investors. That is what capitalism is
all about and one of the reasons why this country is so
prosperous. We take risks. We invest capital. The market
apportions the winners and losers. This needs to continue.
Government's focus should be on potential systemic risk, any
inappropriate market manipulation, fraud, and any structural
problems that increase the likelihood of these broader
concerns.
Thank you very much.
Senator Hagel. Dr. McCormack, thank you.
Dr. Lerrick.
STATEMENT OF DR. ADAM LERRICK
VISITING SCHOLAR, AMERICAN ENTERPRISE INSTITUTE
Mr. Lerrick. Good afternoon, Mr. Chairman, and thank you
for this opportunity.
Every day, somewhere in the global marketplace, hedge funds
are shaking up the comfortable status quo, and from China's
central bank to Germany's chancellory, voices in high places
are raised in protest. But are hedge funds really to blame for
all the ills that befall the international financial system?
Are they disruptive speculators or dispassionate agents that
expose fundamental flaws and speed up inevitable change?
Hedge funds are simply pools of money seeking the highest
absolute return across the capital markets, where managers are
compensated with a high share of profits. Like any financial
innovation, they are following a normal life cycle. First, a
small number of pioneers garner excess profits. Next,
competition and capital are broadly attracted. Finally, the
industry moves into the mainstream, matures, and is winnowed
out.
Managers search for momentary anomalies in the pricing of
securities, currencies, and commodities around the world. They
match holdings with short sales to isolate generalized market
risk, they borrow heavily to leverage positions and magnify
returns. Rewards have been overwhelming and consistent at 40
percent per annum.
Hedge funds are now a major force in the global financial
markets. There are now over 8,000 funds holding $1.5 trillion
in assets, double the level in 2000. Leverage in the use of
derivatives multiply their real impact manyfold. They dominate
the trading arena--they are the predominant source of Wall
Street earnings.
Hedge funds are constantly moving money around the globe to
where it is most productive. They challenge private equity
firms, venture capitalists, and real estate developers. They
lend to companies in distress, they take large positions as
shareholder activists to force corporate restructurings. The
client base has moved from a closed society of the very rich to
embrace the entire investor spectrum. Large institutions now
account for more than half of hedge fund capital. A whole new
layer of intermediaries known as funds of funds provide a
conduit for the retail investor with as little as $25,000 to
risk.
Hedge funds depend on secrecy to prosper. They have a large
investment in human capital, in technology, and in information,
and none of these can be patented or protected. In a world that
demands transparency, secrecy is a red flag for fear,
suspicion, and calls for regulation. But the public interest
can be satisfied without driving hedge funds to pack up and
resettle offshore. The framework to monitor and to safeguard
the global financial system and the unaware investor is already
in place.
Hedge funds do not operate in a vacuum. They interact
through a marketplace where their lenders, their trading
counterparties, and the markets themselves are already under
the scrutiny of an array of regulators: the SEC, the Federal
Reserve, the Comptroller of the Currency, the CFTC, and their
counterparts in the capital markets around the world.
Hedge fund objectives should not be confused with their
tools. The hedge fund formula relies on leverage to magnify
returns, but excessive leverage can disrupt markets. The danger
to those who finance hedge funds and to the global system as a
whole lies in ignorance of risks. Total exposure and total
leverage across all lenders and across all national boundaries
should now be aggregated and published to inform and improve
the risk evaluations of market participants and regulators
alike.
Under U.S. securities laws, all hedge fund clients, the
very rich, the institutional investors, and the managers of
funds of hedge funds who are the stewards of funds of small
investors, have the skills to inform their decisions without
official help. The market will be ultimate regulator as ever
more money competes for a diminishing set of opportunities.
Average profitability is already approaching rates on more
commonplace efforts, and during the shakeout, players with weak
risk management will be winnowed away.
Soon, there will be fewer but better hedge funds. Thank
you, Mr. Chairman.
Senator Hagel. Dr. Lerrick, thank you.
Mr. Schacht.
STATEMENT OF KURT SCHACHT
EXECUTIVE DIRECTOR,
CENTER FOR FINANCIAL MARKET INTEGRITY,
CHARTERED FINANCIAL ANALYST INSTITUTE
Mr. Schacht. Thank you, Senator Hagel. We appreciate the
opportunity to add our views today.
Our organization comes at this maybe a little bit
differently than some of the perspectives that you heard
yesterday, and that is that we approach this really as an
investor advocate with an interest in promoting appropriate
professional standards in the industry. And we have spent a
good deal of focus in the past 18 months as an organization
looking at trying to promote a comprehensive set of standards
for hedge fund operators.
We have been looking very closely at the issues of hedge
fund performance reporting, investor education, and we have
been meeting with regulators around the world to discuss this
whole notion of hedge funds and how and who and why the
industry should be regulated.
Just to stay on topic, very quickly, to be true to our
topic today, the role of hedge funds from the investor's
perspective, I think it is evolving significantly. It has
traditionally been high, uncorrelated historical returns, and I
think everybody is hoping that it is not going to be just
historical.
But one of the newest opportunities, newest developments
with respect to the role of hedge funds, we think, and sort of
the elephant in the room is the entry of the pension fund
industry into the hedge fund space in a big way, trying to get
higher returns to meet some of those increasing liabilities,
and we think that is an important issue to keep track of.
This is a very interesting industry. It has all sorts of
contradictions. I am not sure that we have ever seen an
industry before where we have had huge and growing demand, huge
and growing supply. We have had an absolute media frenzy with
respect to this industry. One report says there are over 100
stories on average a day about the industry in 2005, and
consequently, increasingly, the suspicions of regulators around
the world have grown dramatically in our travels in the last 18
months, so it has been a sort of a jumble of dynamics.
I think it continues to be viewed as an asset class with
exposure sort of leaning all in one direction and subject to
maybe a systemic meltdown. In essence, we agree with the Under
Secretary that this is really the universal exposure. It is all
assets, all markets, in all directions, and we sort of agree
with this notion that it has become sort of the complete market
concept.
I think there are some specific concerns about leverage.
There are some specific concerns about the level and interplay
of counterparty exposure. Those are an issue. But I think in
our view, this is not a house of cards but rather a broad-based
industry with some pockets of concern.
We mention in our written testimony several other
regulatory concerns that we have been hearing from regulators
around the world, and I would be happy to talk about those if
you have any questions. I would note very quickly that we
supported the recent move to register hedge fund managers under
the 1940 act as an appropriate step, leaving some exemptions in
that activity, but we think it does very little to get at this
concern of leverage and of pockets of systemic imbalance, so
just so nobody is confused by that, the hedge fund registration
really does not get at that.
Very quickly, I just wanted to talk about better investor
education and proper hedge fund manager conduct, because those
are two very important things to our organization, and I would
mention that a key component of that, of investor understanding
and industry transparency is understanding what a hedge fund
manager should offer in terms of ethics and professional
conduct to the investors that they serve. It is certainly the
case, as we have heard today, that investors have some
significant responsibility to know what the heck they are
getting into, to know what to look for, but the fact of the
matter is that on a global basis, this is a much less regulated
industry and historically because it has been promoted to
sophisticated, trained investors who understand the appropriate
due diligence process.
We are not sure that is still the case, and we have come
out with something called the Asset Manager Code of
Professional Conduct, which we think is a decent template for
every investor, for the sort of things that every investor
should expect and demand from their hedge fund managers, and it
has done so with a self-regulatory approach to this.
A number of things that it covers include portfolio
evaluation and performance reporting, and I will wrap up
quickly on performance reporting issues, because we have done a
lot of work on that issue. It is one of the areas that we think
is most prone to mischief in the investment management industry
and certainly in the hedge fund industry. There has been a
recent spate of articles and calls for regulation of hedge fund
performance reporting, because the feeling is that it misleads
investors, that it might be as much as 600 basis points off in
certain cases.
I would encourage you and the Committee when you are
looking at this to look at it with some caution for several
reasons. First of all, the performance that people are
criticizing is really voluntary private data bases, and I think
it has been acknowledged of all of the statistical shortcomings
in those reports. Second of all, we would doubt highly whether
any serious hedge fund investors are making investment
decisions based on that information. I think they know the
importance of looking at performance at the individual fund
level and the importance of having a very quality due diligence
program to confirm and verify that.
Finally, just on performance and how you calculate it, we
believe the industry benchmark for this is the global
investment performance standards or GIPS. It is a standard that
we have developed. It has been in use and development over the
last 10 years. It is the industry standard in nearly 30
countries around the world, and it provides a consistent and a
verifiable process that is comparable across managers.
So thank you very much. We commend you for continuing to
oversee this industry, your vigilance with this as it evolves.
We would encourage you to monitor the new investment advisor
registration approach, allow that to settle in over the course
of the next several months and determine if further regulation
of either the manager or the fund itself would be warranted.
Thank you.
Senator Hagel. Mr. Schacht, thank you.
Mr. Chanos.
STATEMENT OF JAMES CHANOS
CHAIRMAN,
COALITION OF PRIVATE INVESTMENT COMPANIES,
PRESIDENT, KYNIKOS ASSOCIATES
Mr. Chanos. Thank you, Chairman Hagel, and thank you to
Ranking Member Dodd and other Members of your Subcommittee. My
name is Jim Chanos. I am President of Kynikos Associates, a
hedge fund management firm based in New York City. Thank you
for the opportunity to appear today, and I am here today on
behalf of the Coalition of Private Investment Companies.
To paraphrase the great American Stan Lee, with great
growth comes great responsibility. By any measurement or
definition, the hedge fund industry has enjoyed great growth
over the past decade. Now, we must meet the responsibility that
comes with managing more than $1.2 trillion invested by pension
funds, endowments, individuals, and other institutions. There
is no shortage of activities by which hedge funds play an
extremely vital role at making the U.S. capital markets the
envy of the world. Other witnesses today have amply discussed
that, and to avoid repetition, I would simply say that we share
those views.
I would like to draw the Subcommittee's attention to three
particular areas that our coalition believes are issues that
will be of significance to policymakers in the months to come.
First, we believe that hedge funds are very important
participants in our capital markets, and it makes sense to
include them in any review of issues that arise within these
markets. That said, we do not believe that the industry
warrants greater scrutiny than other market participants
engaged in the same or similar activities. In fact, we
encourage policymakers to think horizontally, across market
participants, rather than vertically, in which artificial
distinctions are drawn between participants who are doing the
same things.
Taking this point one step further, CPIC also believes that
regulatory treatment of private pools of capital should be
consistent regardless of what those entities call themselves.
We believe that too often, policymakers spend unneeded time and
effort trying to draw distinctions between one kind of fund or
another, while in the marketplace itself, the lines that
formerly distinguished institutions from one another are either
rapidly blurring or have ceased to exist altogether.
Second, CPIC believes there is significant room for
improvement in asset valuation and performance reporting by
hedge funds. There is both opportunity for outright fraud, and
there is also a lack of broadly accepted policies and
procedures to conduct valuation of the investments for which
market prices are not readily available. Our coalition believes
that there is an important role for the Federal Government to
play in fostering a dialog with market practitioners,
academics, economists, and others to improve practices in this
area. We also believe it is important for hedge fund managers
to adopt practices that improve balance sheet transparency by
breaking out unrealized gains and losses and assets that are
not mark to market.
Last on this point, we strongly encourage the participation
of all members of the President's Working Group on Financial
Markets in discussing this issue. Again, the activity should be
more important than the entity.
Third, we would like to bring to the Committee's attention
the apparent rising incidence of corporate intimidation of
analysts, shareholders, and reporters who report or offer
opinions critical of company's management. The ability of
business journalists to communicate with sources is of
paramount interest to the functioning of our markets, as is the
ability of analysts to disseminate their views free from the
threat of retaliation and shareholders to question the managers
they hire.
Unfortunately, the recent subpoenas issued by the SEC staff
and then hastily withdrawn had the potential to hinder the
ability of the press to do its job and thus limit the
information readily available to all investors. We commend
Chairman Cox for clarifying SEC policy, which will be to the
benefit all investors. We also hope that the Commission will be
as zealous in investigating issuer intimidation as it appears
to have been in pursuing the complaints of generally
underperforming corporate managements.
A free market only functions to the extent that competing
views and opinions are allowed to mix without artificial
constraints. This is at the heart of how a market discovers the
true value of a company. If we do not allow investors,
analysts, or reporters on both the long and short side, whether
hedge funds, private capital, mutual funds, or other investors
to openly question and test management's programs, plans, and
projections, our markets and those who invest in them will
suffer as a result. Honest skepticism does not equal market
manipulation.
As I said, there are a number of other issues that are more
thoroughly addressed in my written statement, and I am happy to
try to answer any questions the Subcommittee might have. Thank
you again for the opportunity to present before you.
Senator Hagel. Mr. Chanos, thank you, and again, to each of
you, thank you. My questions will be broad enough that I would
appreciate each of your response to them, and I want to begin
with just a couple of very basic questions, because I think
they are part of building a foundation in this hearing on what
hedge funds are and further developing an appreciation of that
knowledge that comes from these hearings. So here is the first
question: what is the typical hedge fund? How large is the
typical hedge fund? Is there a hedge fund? Secretary McCormack,
I will start with you.
Mr. McCormack. I do not think there is a typical hedge
fund. They vary enormously in size, investment strategies, and
earnings. They vary in the proprietary information that they
use upon which they make these investments. So I do not think
there is a typical hedge fund. They are involved in every kind
of investment activity, from investment banking to real estate
to currency speculation.
Senator Hagel. Dr. Lerrick.
Mr. Lerrick. Senator Hagel, I think that is one of the
difficulties for the Committee. Twenty years ago, hedge funds
were relatively easy to define in terms of the kind of
activities they pursued. They mostly invested in liquid markets
and used trading to try to find momentary misalignments of
prices that would disappear very quickly, and they used
leverage.
Today, hedge fund can describe any private investment fund
basically, because you read hedge funds are financing movies in
Hollywood now. They are financing nuclear waste treatment
plants in Europe. They are developing pipelines in Latin
America. So how different are they than a private equity fund?
How different are they than a real estate developer?
And that is why I would reiterate Mr. Chanos' comment that
to try to define a hedge fund I think is a waste of time. It is
more of a question of defining the type of activity that funds
do perform, and whether you call them hedge funds or private
equity funds or real estate funds or arbitrage funds really is
irrelevant once you look at the function they play, not what
their name is.
Senator Hagel. Let me ask you this before I get to the
other two members of the panel. And you said it correctly: it
is part of the difficulty of getting our arms around this for
people to understand what it is when I cannot elicit an answer
on what a typical hedge fund number is. But the difference to
start with that most funds have some dynamic of accountability,
whether it is a year end report, a quarterly report, a balance
sheet, something that they send out to their investors--is that
correct?
Mr. Lerrick. True.
Senator Hagel. So are we saying here that these are so
nebulous that there are no numbers, we just cannot figure them
out?
Mr. Lerrick. No, not at all, Senator. What I am saying is
that I assume that any responsible hedge fund or any hedge fund
that can actually attract funds today, capital, has to report
periodically, monthly or quarterly and certainly more
frequently than annually on what its portfolio looks like, what
types of activities it is pursuing, what its performance has
been.
But I think stepping back and trying to put myself in the
position of a Senator and saying what should be my concerns,
well, there are really only two concerns that should come
before the Congress. One is, when it comes to investments,
which is protection of unsophisticated investors, and that is
clearly a concern. I think in the case of the hedge fund
industry, that need not be a concern, because unsophisticated
investors really do not have access to hedge funds. The only
way they can get to hedge funds is through funds of funds,
where there are professionals who are choosing their
investments for them, so they actually have a professional
intermediary who is making their choices.
The second is the question of systemic risk, risk to the
entire financial system. And there, it is not hedge funds that
should be the concern. It should be what are the dangers to the
financial system? Is the danger to the financial system
excessive leverage, whether it is from a hedge fund, whether it
is from a private individual; I mean, if you remember, there
was a total market failure when Nelson Bunker Hunt tried to
corner the silver market. Now, he was not a hedge fund. He was
not regulated. He did not have to report to anyone. He was just
large enough that he could do it by himself. And so, I think--
and again, the concentration of positions, which is something
that Secretary Quarles raised.
So I think those are the issues the Congress should focus
on, not whether it is a hedge fund, whether it is a mutual fund
with a performance base and the ability to short securities,
whether it is a private individual, they should try to get to
the source of the problem, not try to narrowly define who they
want to look at.
Senator Hagel. Which is going to lead to another round of
questions on transparency as to what is appropriate and what is
not, but let me ask the other two panelists to comment on any
piece of the question and what the other two panelists have
said.
Mr. Schacht. Yes, thank you. Understanding that it is not a
very simplistic definition for hedge funds, someone once said
it is really a fee structure masquerading as an asset class,
but there are approximately 8,600 funds, between 8,600 and
9,000, depending on whether you count them at 8 in the morning
or 5 at night, and the numbers we have been hearing are that 80
percent of those funds are under $200 million in assets under
management. So the bulk of the industry tends to be on the
smaller end of a managed fund.
Senator Hagel. Thank you.
Mr. Chanos.
Mr. Chanos. I would echo what Dr. Lerrick and Mr. Schacht
said, in particular, the comment on the fee structure as
opposed to an asset class. There is something to that. It is
interesting, though, however, I will make a couple of
additional observations in that first of all, the life span of
a typical hedge fund is very, very short. They have a very high
failure rate. The market works. Investors move quickly out of
poorly performing hedge funds when they do not perform, often
because of the structure of the hedge fund itself in which
management teams get a piece of the profits but if they lose
money must work strictly for the management fee before the
performance bonus kicks back in.
This leads investors to quickly flee any poorly performing
fund, thus creating a vicious cycle as opposed to a virtuous
circle. So the structure of most hedge fund management
companies is very brittle, interestingly enough, and I think
that that has led the industry to actually embrace less risky
business practices if not investment practices, which hopefully
will lead to more stability in the industry going forward. We
shall see.
But again, I would stress my earlier comments about
singling out hedge funds which employ a wide variety of
investment techniques today and using the prism of hedge funds
to look at all those techniques as opposed to perhaps a better
policy view, which is to look at the techniques themselves as
practiced by all market participants, whether they be private
equity, venture capital, hedge funds, large individual
investors, or pension funds. I think we are going to get bogged
down in trying to define this term hedge fund, and we are going
to miss the forest for the trees.
Senator Hagel. Thank you.
Back to the issue of transparency, disclosure, how much
should there be, how much need there be, starting with you now,
Mr. McCormack.
Mr. McCormack. Well, my sense is that the amount of
disclosure that we have now, on the macro side, it is not
sufficient. I mentioned the question we had earlier about one
slice of the process, which is the involvement in the
derivative side. We do not have a clear idea about the overall
quantity of activity in the derivative area. We have very
subjective decisions about what ``value at risk'' really means.
Those very subjective judgments are sometimes even divergent
within different parts of the same creditor institutions.
So there is some need for a further attempt to get a more
accurate sense of valuation in this process. I personally do
not have any problem with requiring people to register who are
in this business. We had a situation years ago where some of
the smartest people in the world were running the Long Term
Capital Management Hedge Fund. They were brilliant people. They
had judgment. They were Nobel Prize winners. One served on the
Federal Reserve Board.
These were people of unquestioned judgment and integrity.
They still made disastrous mistakes. It is safe to say that not
everybody in this 8,000 member hedge fund industry is of the
same standard brains and integrity. To have some additional
information about who really is involved is probably not such a
bad idea. The British, many other Europeans, and Japanese are
certainly of this view.
Senator Hagel. Thank you.
Dr. Lerrick.
Mr. Lerrick. Senator Hagel, I think you have to distinguish
three levels of transparency. The first is the transparency or
the information provided to investors in hedge funds, and
there, the investors, given that we are dealing with a
restricted universe of, quote, either sophisticated or large
investors, they should be able to make their own determination
of whether they have sufficient information or not from a hedge
fund they are considering investing in.
The second level is the lenders and the counterparties to
these funds, and there again, when you are talking about major
investment banks, major commercial banks, major universal banks
that are the counterparties or the lenders, they should be able
to take care of themselves and demand the kind of information
that is required for them to do appropriate risk evaluations.
The last group is basically those that must be concerned
about systemic risk, the policymakers, the official sector. And
there, I think there is a hole in the information process. And
I think the danger there is that there is an ignorance of some
of the risks that are in the international financial system. In
that, there is a role for the official sector to require
aggregation of the types of information about leverage, about
borrowing, about concentrations, so that policymakers can
themselves identify potential sources of risk. But I believe
that information should also be disseminated to the public so
other market participants can also make the correct
adjustments.
Remember, market crises come from surprises. If there are
no surprises, markets adjust very smoothly. And so, the whole
point is to make sure the market has as much information as it
possibly can to make informed judgments on a continuous basis,
and then, that is the easiest way of reducing the frequency and
the severity of crises.
Senator Hagel. Thank you.
Mr. Schacht.
Mr. Schacht. I will just talk very quickly on the
transparency at level one that Dr. Lerrick mentioned, and that
is at the investor level, and if Susan Wyderko's numbers are
correct that 2,400 roughly hedge funds are registered, that
says that somewhere in the range of 5,600 plus are not
registered, so they are not required as a registered investment
advisor to provide that level of disclosure.
So it really becomes a matter of investor education, and
that is the sort of thing that we have been trying to focus on:
what an investor should demand and what they should know about
from the hedge fund service providers that they select.
Senator Hagel. Thank you.
Mr. Chanos.
Mr. Chanos. Speaking as an industry participant, I can tell
you from a practitioner's point of view that in addition to
weekly, monthly, and annual reporting that our fund does and
most of our member firms do, as the industry has grown in the
past 10 years and has become more institutionalized that the
requirements of these institutional investors have basically
from a business practices standpoint mandated better controls
and better disclosure.
We are often visited quarterly by our largest investors,
and if they cannot visit onsite, they have conference calls
with us to query us on positions, leverage, market outlook, so
on and so forth. All of our investors, in our case, have
ability for onsite complete visit. So not only now do we
entertain the possibility of the SEC paying us visits, but our
clients do often to exercise their due diligence, and we
welcome it.
So the industry has grown up quite a bit in terms of what
it tells its investors by and large. There are always
exceptions, as some of the preceding speakers have indicated.
But as the industry has geared up for mandatory SEC
registration, we have pointed out to a number of market
observers that most reasonably large hedge fund management
organizations already were employing the compliance, back
office, and financial controls necessary to satisfy their
clients, which go a long way to satisfying the SEC without a
lot of added burden and cost.
Senator Hagel. Thank you.
Dr. McCormack, I am going to read from your testimony, and
in fact, it is your summary, a line here. It says, quote, our
concern should be potential systemic risk, fraud, and
structural problems that increase the likelihood of these two
broader potential problems, end of quote. Would you share with
us, and I would ask the same question of the other three
panelists, what you then think we should be doing, regulatory
regimes, some of the things we have just talked about,
compliance, more transparency? What should we be doing that we
are now doing, or should we be doing anything? Define that a
little more, not just the concern, but how do we address the
concern?
Mr. McCormack. Well, let me focus on the key problem as I
see it or one of the key problems as I see it. If you look at
some of the reports that have been done by the Federal Reserve
and others about financial crisis management and what happens
during a financial crisis, the key problem, of course, is that
suddenly, liquidity dries up. Suddenly, there is not enough
people wanting to buy when there are too many people wanting to
sell. You wind up with a market meltdown.
Your earlier witness from the Federal Reserve said that
hedge funds were, in fact, an additional source of liquidity in
this situation. That might be the case. But it is very
important to remember that hedge fund investors are just as
subject to panic reclaiming capital in the middle of a
threatening market environment as any other part of the
investment community. Hedge funds are now so important as a
driver of markets that if sudden, large scale, capital
repatriations occur in a crisis, you can wind up with that
being an additional source of liquidity problems rather than
that being an asset for easing a future crisis.
That is another one of the reasons why I think we need to
understand what is happening in this investment structure.
Senator Hagel. So you would not advocate anything beyond
what we have in place now with the Federal regulatory regimes.
Mr. McCormack. One of the most important things that the
Federal Government could do and should do is public warning of
potential problems. One of the failures we had, for example, in
the bubble that developed in the late 1990s was, Chairman
Greenspan said only once, in 1996, that there was irrational
exuberance in financial markets, and he did not say anything
again for a very, very long time as the bubble built and built,
even though there were concerns inside the U.S. regulatory
system. Nobody said anything until the very end.
I think the time is now where government's responsibility
is to say yes, the environment now is good; yes, the U.S.
economy is growing. Yes, the global economy is growing at a 5
percent rate, but this will not last forever. There is such a
thing as a business cycle. People need to watch very carefully
their investments so that they do not get caught blindsided in
the event that the situation deteriorates somewhat.
Potential liquidity shortages also suggest the need for
adequate capital cushions by investor groups are needed, so
that they do not require the Federal Reserve to provide all of
the liquidity in the event of a problem. Individual investor
groups themselves, including hedge funds, should have larger
capital cushions than they currently do.
Now, that is a technical subject and one that is
potentially expensive, and it is one I am not prepared today to
make a definitive quantitive recommendation on. But that is the
kind of issue that we need to explore: whether a larger capital
cushion is necessary for hedge funds engaged in these markets
to buffer against the inevitable day, the inevitable day, when
there is a serious and sudden surprise to markets that causes
liquidity to dry up.
Senator Hagel. Thank you.
Dr. Lerrick.
Mr. Lerrick. Senator Hagel, very quickly, Secretary
McCormack is absolutely right. There are going to be financial
crises. They are going to come. There is no question about it.
My colleague, Alan Meltzer, likes to say capitalism without
losses is like religion without sin. It does not work. And that
is true.
And therefore, there are going to be crises. Trying to
eliminate crises, in order to eliminate crises, you are going
to have eliminate massive benefits from markets and capitalism,
and it is certainly not worth that. I think in terms of--you
asked a very specific question: what would be a recommendation
for future government intervention, let us not call it
necessarily regulation.
I think the only advantage at this stage would be for the
government to mandate the collection of information on leverage
and exposures in the system. And that would serve both as a
tool for the policymakers themselves to potentially identify
sources of strain on the system and then to disseminate that
information so that the other participants in the market can
take appropriate action, and that will eliminate--that will
reduce, it will not eliminate, the surprises that Secretary
McCormack talked about, and that will increase dramatically the
stability of the financial system.
Senator Hagel. Thank you.
Mr. Schacht.
Mr. Schacht. Just two brief thoughts: make sure that the
SEC has adequate resources to conduct those reviews of hedge
fund managers on a consistent and a competent basis, No. 1; No.
2, I am agreeing with Dr. Lerrick. If there is a concern about
leverage and imbalances related to counterparties and so forth,
addressing that through greater disclosure. And I think as you
know, the Financial Services Authority in the United Kimgdom is
in the process right now of doing an exposure draft on this,
and they are feeling that you can reveal and correct these
potential imbalances through more required disclosures from the
counterparties that you already regulate.
Senator Hagel. Thank you.
Mr. Chanos.
Mr. Chanos. Very quickly, in addition to agreeing with what
most of my compatriots here have just said, I would add that
one thing this Committee could do would be to continue to
foster the President's Working Group to make outreaches to all
industry participants on an ongoing basis, whether through
symposia, formal or informal get-togethers, to make sure that
ideas that are out there or that are perhaps not so visible
from Washington's perspective can get out so policymakers can
evaluate any possible questions or responses. And the industry
stands ready to be asked to participate.
Senator Hagel. Thank you. Gentlemen, last kind of summary
question: of all of the comments that you have heard this
afternoon, especially from the previous two panels representing
our government, anything that you would like to get on the
record in response to anything you heard or anything that you
did not hear or anything you want to say specifically that was
not asked today that you want to comment on?
Secretary McCormack.
Mr. McCormack. I support Secretary Quarles' comment about
the importance of first looking at potential problems carefully
before one rushes with remedies. We are dealing with an
extremely complicated industry, about which there is
insufficient knowledge, even within the very community of
regulators.
Senator I think what you are doing with these hearings and
the more broad effort to look at potential vulnerabilities in
financial markets is important. At the end of this process we
will all have a much clearer idea where the holes are that
governments and investor, working together, need to fix.
Senator Hagel. Thank you.
Dr. Lerrick.
Mr. Lerrick. Senator Hagel, I always enjoy testifying on
the same day as Secretary Quarles, because I always am amazed
at how he answers the same question that I would answer, but he
does it in such a diplomatic way.
[Laughter.]
Mr. Lerrick. You asked him sort of would regulation, and I
do not want to use the word excessive, but large-scale
regulation, drive hedge funds offshore? And Secretary Quarles
said, well, the incentives, and people would move if it caused
problems in their operations.
Let me say very clearly: I do not know of a single large
hedge fund that cannot move offshore in a matter of hours its
entire operations. Any attempt to put large-scale regulation on
hedge funds, private equity funds, these pools of money, will
meet with total defeat. And I think that is something the
Committee should keep in mind when it thinks of what it thinks
might be appropriate action to take.
The second point I would like to touch upon is that
official policy always lags behind the market. That is just a
given. And that is why, again, any attempts to try to catch up
with overly heavy-handed regulation will just either limit the
industry if it is effective or drive it outside of the U.S.
regulatory environment.
The other point I would like to raise is something that
Senator Bunning raised when he talked about the concept of
manipulation, when he asked the witnesses do they know of any
manipulation? And he put in the category of manipulation
something that I think is quite extraordinary. He said do you
know any cases where hedge funds have forced companies to take
actions they really would not have liked to do? And he viewed
that as manipulation.
I do not view that as manipulation. Hedge funds and
investors and markets in general are every day forcing
companies, forcing governments, forcing any participant to take
actions they do not want to take, but that is their chief
benefit for the global economy. And therefore, I think any
attempt to reduce their ability to force those changes will
only be detrimental both to this economy and to the financial
markets in general.
Senator Hagel. Thank you.
Mr. Schacht.
Mr. Schacht. Senator, I think we just all appreciate the
fact that you are looking at this at a stage where it is
beginning to be consequential. It was about 1.5 percent of the
investment management business last year. It is probably
somewhere in the range of 2, 2.5 percent of the overall
industry, but that could change very quickly with the advent of
the pension funds getting into this sector.
So I think you continue to look at it and keep your eye on
it.
Senator Hagel. Thank you.
Mr. Chanos.
Mr. Chanos. And finally, in the interest of brevity, I
would just add that for too long, the term hedge fund has been
used as a pejorative, with images of managers hiding behind
trees or sunbathing on yachts off the Cayman Islands. And the
reality is that most hedge fund managers are hard working
people based here in the United States who are trying very hard
to compete in a viciously competitive side of the financial
marketplace.
I think the industry welcomes these hearings. It welcomes
the opportunity to get into the glare of the spotlight as
opposed to to remain in the shadows, which was never the case
anyway, and we look forward to continuing working with the
Committee, your Committee and others, as well as the members of
the President's Working Group as you try to grapple with these
issues.
Thank you.
Senator Hagel. Mr. Chanos, thank you.
I would just add that politicians hate the glare of the
spotlight.
[Laughter.]
Senator Hagel. You notice we had very limited participation
here today, six United States Senators for a Subcommittee
hearing, and that is rather significant, having nothing to do
with the Chairman, I can assure you. It was the subject, and
the subject is very important and really having nothing to do
with the spotlight. But it gives you some reflection and
understanding of how seriously policymakers are viewing
responsibilities in these areas. And so, I think it is a good
sign that we had this kind of turnout today.
Secretary McCormack.
Mr. McCormack. Just one final comment.
You have seen the Corrigan Report of July 27, 2005, where
he discussed the problems in the credit derivative industry.
Just think how bad that situation got before it was finally
identified and apprised. You had a situation where there was
sometimes as much as 3 months between the day the trade was
orally made and when it was actually confirmed, creating all
kinds of problems and ambiguities in the event that the credit
insurance actually was called on. You had situations where
counterparties were not really vetted in terms of their
creditworthiness.
If this potentially dangerous situation could develop so
fast and create such potential problems, it suggests that there
is no room for complacency.
Senator Hagel. Dr. Lerrick.
Mr. Lerrick. Senator Hagel, Secretary McCormack is
absolutely right. I mean, one of the key roles of the official
sector is to try to identify problems before they occur, but
that does not mean it has to regulate the solutions.
The Federal Reserve took a very important step when it said
we identified this problem; we are inviting all of the market
participants in. We say this is a problem; we want you to solve
it. Go to it. That is a very valid role for the official
sector. The Federal Reserve did not come in and say we are just
going to regulate you all and tell you how to do it. They said
solve the problem, and the private sector did or is in the
midst of doing it.
Senator Hagel. Well, gentlemen, this Committee is grateful
for your participation and your insights and your experience.
It has been very helpful.
I would like, as I did with the other two panels, to keep
the record open in case any of my colleagues have additional
questions, if you would be good enough to see if you could
respond to, and we certainly will be calling upon you in the
future, as all four of you have been involved with Committee
activities before, and again, we thank you. It is good timing.
I have another vote. So this Committee is adjourned.
[Whereupon, at 5:26 p.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF HON. RANDAL K. QUARLES
Under Secretary for Domestic Finance, U.S. Department of the Treasury
May 16, 2006
Chairman Hagel, Ranking Member Dodd, Members of the Subcommittee,
good afternoon, it is a pleasure to be here today. Let me first thank
you for holding this hearing and allowing the Treasury Department to
present its views. I am particularly pleased to be here because our
discussion today is an effort to gain a better understanding of a
critical component of our financial markets.
Our charge today is to examine the role of hedge funds in our
financial markets. I note at the outset that this topic is different
from an issue about which there has been considerable discussion in the
past few years: the regulation of hedge funds. I think your choice of
topic for today's hearing is the right one--if government addresses the
question of regulation of any financial institution or activity without
a clear understanding of the place it plays in our financial system,
the risk of unnecessary, excessive, or inappropriate legislation is
increased. While I am sure we will touch on certain regulatory aspects,
I intend to focus my remarks on what hedge funds do for and in our
financial markets.
As we consider this issue, we should also keep in mind that the
role of hedge funds in our financial markets is continuously evolving;
and in recent years it has been evolving rapidly. While change like
this often brings about improvements and efficiencies, it can also
create insecurity or concern. The lens through which we examine the
evolution of hedge funds' role in the financial markets often shapes
our view of what, if anything, the government needs to do to react to
the changes so we should ensure that this lens is as clear and polished
as possible.
Hedge funds are not a recent invention. Their history is typically
tied to the fund created by Alfred Winslow Jones in 1949. During this
time period, these new investment vehicles were created mainly as a
reaction to significant regulatory restrictions on investment funds
embodied in the Investment Company Act of 1940 (the '40 Act). Unlike
mutual funds registered under the '40 Act, an unregistered fund could
sell securities short, buy securities using leverage, and use diverse
financial instruments and strategies. The name ``hedge fund'' was used
to identify these new funds that were able to hedge or protect against
loss of capital in down markets.
Today, the term hedge fund is used to describe much more than a
fund that employs hedging techniques. There is, however, no universally
accepted definition of a hedge fund. In the late '90s, for example, the
President's Working Group on Financial Markets (PWG) defined a hedge
fund as ``any pooled investment vehicle that is privately organized,
administered by professional investment managers, and not widely
available to the public.'' This is a useful working definition for some
purposes, but it does not distinguish hedge funds from other forms of
unregistered capital pools that generally are recognized to have
distinctive features, such as private equity funds and venture capital
funds.
Perhaps the most useful approach is to identify a list of features
that distinguish hedge funds from other capital pools, recognizing that
the list is evolving, that various combinations of such features are
possible, that some are shared with other investment vehicles, and that
no single feature is a defining characteristic. Such features would
include legal structure (a private entity with unlimited life and with
pass-through tax benefits); investment objective (positive absolute
return in all market conditions, rather than measurement against an
industry benchmark); investment strategy (flexible, including the
ability to use short selling, leverage and derivatives in a wide
variety of markets); compensation structure (usually 1-2 percent
management fee and 15-25 percent performance fee, calculated annually
on the basis of accrued gain); investor base (high net worth
individuals and institutional investors; high minimum investment; not
widely available to the public); investor capital commitment (full
commitment paid at time of subscription rather than drawn down over
time; withdrawals regularly available, usually monthly or quarterly);
and disclosure (generally restricted to that contractually agreed upon
between the manager and the investors, with limited public
information).
Hedge funds have experienced phenomenal growth during their history
especially in recent years. They have grown from an estimated $50
billion in assets in 1988 to about $300 billion in 1998 to over $1
trillion in assets today.\1\ Current estimates suggest that there are
about 9,000 hedge funds.
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\1\ The data about the hedge fund industry are not precise.
Therefore, many of the figures noting the size and growth of the
industry are estimates and Treasury has not independently verified
them.
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Today, hedge funds employ a variety of investment strategies that
vary considerably depending on the goals and needs of the investors and
the types of instruments in which the fund invests. Much, if not all,
of this growth has been market driven, and, as a consequence, it has
been subject to a significant amount of market discipline. For example,
as hedge funds have grown, their investor base has evolved. The
original hedge fund investors were wealthy individuals. Then,
university endowments began investing in hedge funds--most likely
because the individuals that typically sit on these boards were already
exposed to these types of investments. Later, institutional investors
such as pension funds seeking greater diversification wanted to
participate. Through this growth process, each of these investor groups
imposed certain forms of discipline on hedge funds. Thus, the hedge
fund market has become much more ``institutionalized'' as it has grown
and evolved.
Hedge fund growth and practices also have been tempered by
significant market events, most notably, the failure of Long Term
Capital Management (LTCM) in 1998. As a result, hedge fund investors
now demand more transparency of their fund managers (you might recall
that LTCM principals notoriously provided little transparency). Post
LTCM, investors also recognize the need for more discipline regarding
the use of leverage and collateral.
Therefore, while the hedge fund market has grown drastically in the
past twenty years, there is at least some reason to believe this growth
has been subject to private sector discipline.
What role this very large, trillion-dollar group of alternative
investments plays in our financial markets is a very important
question. While hedge funds provide certain benefits to the financial
markets, they can also put stresses on it that need attention.
Benefits to the Financial Marketplace
Liquidity Provision
One of the reasons that the U.S. financial markets are so
attractive to investors is because of their liquidity. In general, the
U.S. financial markets are the deepest and most liquid markets in the
world. Hedge funds are significant liquidity providers in many
marketplaces.
Because of the varying strategies employed by hedge funds, they are
often the willing buyers or sellers that provide additional liquidity
to financial markets. For example, hedge funds' desire to seek
arbitrage opportunities adds significantly to a markets' liquidity. In
fact, some reports suggest that hedge funds account for between one-
third or one-half of the daily volume on the New York and London stock
exchanges. Hedge funds contribute even more significantly to
marketplace liquidity in less traditional markets. For example, hedge
funds represent the overwhelming majority of trading volume in the
distressed debt markets, the convertible bond markets, and the
exchange-traded fund markets.
Price Efficiency
Many hedge funds seek to create returns by targeting price
inefficiencies. Such price inefficiencies might occur when there is
discrepancy between two or more markets. A sophisticated investment
manager can enter both of these markets and profit by taking advantage
of this pricing anomaly. Former Federal Reserve Chairman Alan Greenspan
characterized the ability of hedge fund managers to obtain profit from
these inefficiencies as picking the ``low-hanging fruit'' in the
marketplace. While this activity certainly benefits the hedge funds
that are profiting from the trades, it has the salutary effect of
creating more efficient markets.
Similarly, hedge funds also target wide bid/ask spreads as ways to
generate positive return, which generally has the effect of narrowing
them. This private, profit-making activity on the part of hedge funds
produces the public good of better price discovery and more efficient
markets.
Risk Distribution
Concentration of market-wide risk is one of the greatest threats to
a smoothly functioning marketplace. Hedge funds can help mitigate this
risk by helping to transfer and distribute market risk. For example,
when financial institutions seek to lay off some of the very large
risks inherent in their normal business activities by buying or selling
derivatives, hedge funds are often the counterparties to these trades.
Without market participants that are willing to trade these derivatives
in significant quantities, financial institutions would have to retain
more risk, which could have a ripple effect throughout the financial
markets.
There is no question that hedge funds are one of the dominant
participants in the re-distribution of market risk. Among the most
common risk distribution instruments used by hedge funds are credit
default swaps. Most simply, these are insurance-like products that
provide protection against default or bankruptcy, in that they pay
bondholders some form of compensation after a defined credit event. Use
of these instruments has grown substantially from about $631.5 billion
in 2001 to about $17.3 trillion in 2005. The significant growth in
these securities does raise some important public policy issues, which
I will address below.
Further Globalization
Because of the dynamic and evolving nature of hedge funds, I have
tried to avoid over-generalizing them. However, I am comfortable making
the observation that, in general, one attribute that is common across
the entire hedge fund community is that the managers are involved in a
relentless search for the next profit opportunity. In such a
competitive marketplace, hedge funds often lead the way to identify new
and emerging markets. These markets often provide opportunities that no
longer exist in more mature marketplaces. This, in turn, leads to
further globalization of our marketplace which provides more choice for
investors and greater efficiency of markets globally.
Potential Investor Benefits
Hedge funds can have a direct positive impact on the investing
community. Speaking broadly, hedge funds can provide investors with
opportunities for diversification, ``alpha'' or excess returns, and
capital protection in down markets.
Hedge funds provide more choices to the investing community. More
choices allow investors the ability to diversify their investment
portfolios, which is a common goal of many investors. A recent survey
suggested that almost half of institutional investors had more than 10
percent of their assets in hedge funds. Most of these allocations were
made by reducing allocations to active and passive equity strategies.
All of the surveyed investors said that their diversification needs
were being met and over three-quarters of surveyed investors saw
reductions in overall portfolio volatility.
Historically, most non-professional investors were limited to
investment vehicles that employed traditional ``go-long'' strategies.
These funds attempt to outperform a particular index, such as the S&P
500. Notably, these funds typically profit only in positive markets and
try to mitigate losses in down markets. Some hedge funds try to fill
the obvious gap here with strategies that attempt to produce positive
returns in both bull and bear markets. The flexibility in the hedge
fund structure can provide many opportunities to outperform indexes,
even in thriving years. This is often referred to as generating
``alpha'' or excess returns. A common technique employed by many hedge
funds attempting to generate excess returns is employing leverage,
which, of course, presents its own specific set of concerns.
Producing positive returns in a down market is also assisted by the
nimble structures of hedge funds. Indeed, many expected the high-flying
hedge funds to be crippled after the bursting of the internet bubble in
the late nineties. Some funds were punished, of course. However, many
funds exploited their natural flexibility to short stocks and,
importantly, to move to cash during market dislocations limiting
exposure and mitigating loss.
Therefore, hedge funds have the potential to provide investors with
opportunities for excess returns or capital protection, but, of course,
this is not always the case.
It is worth noting that as the hedge fund industry grows and
becomes more institutionalized, excess returns have become harder to
find. Indeed, as more market-based demands are placed on hedge funds
for added transparency, investors will demand significant higher
returns to justify the hedge fund manager's fee. Armed with this added
transparency, some observers suggest that there might be a shake-out of
sorts with underperforming hedge funds suffering the consequences.
Marketplace Risks
While hedge funds can provide benefits to investors and the overall
marketplace, they present some risk as well. There are risks that hedge
funds' aggregate employment of large amounts of leverage or over-
concentration of certain positions could have negative consequences for
the marketplace. Certain valuation risks also are present in the hedge
fund industry. Other risks involve operational challenges associated
with the over-the-counter (OTC) clearance and settlement systems. Many
of these risks, however, are not unique to hedge funds.
Large Use of Leverage
Leverage refers to the use of repurchase agreements, short
positions, derivative contracts, loans, margin, and other forms of
credit extension to amplify returns. With increased leverage, of
course, comes increased risk. We learned much about this topic after
the LTCM failure.
As discussed by the PWG in its report after the LTCM failure,
excessive leverage can greatly magnify negative effects of market
conditions. For example, the LTCM failure demonstrated the risks of
extraordinary leverage when adverse financial market conditions occur.
At the time of LTCM's downfall, it had an implied balance-sheet
leverage ratio of more than 25 to 1 (assets of $125+ billion over
equity capital of $4.8 billion). As market conditions worsened, LTCM's
size and leverage, combined with the sheer number of trades it had on
its books, contributed to a serious deterioration in the liquidity of
many markets as LTCM and countless other market participants sought
simultaneously to unwind losing positions.
The magnitude of LTCM's leverage, and its dependence on numerous
creditors and counterparties, heightened the threat that its problems
could spill over to these other institutions and possibly lead to a
general breakdown in the functioning of the markets. LTCM's excessive
leverage posed very real systemic risks for our financial markets. It
is important to note, however, that even though LTCM was a hedge fund,
this issue is not confined to hedge funds. Many other types of market
participants use leverage in their trading strategies, and some may be
more highly leveraged than hedge funds. Moreover, it should be noted
that innovations in the market are expanding the ways in which market
participants can apply leverage. Many of the complex derivatives and
other structured products in which there have been strong growth over
the past few years have embedded leverage, which in certain
circumstances can amplify changes in portfolio valuations to a greater
degree than other forms of leverage.
In its report, the PWG cautioned that problems can arise when
financial institutions do not employ sufficient discipline in their
credit practices with customers and counterparties. To this end, the
PWG made several recommendations designed to help buttress the market-
discipline approach to constraining leverage. Numerous public and
private sector groups, such as Counterparty Risk Management Group II
(also known as the Corrigan Group), also took up the cause of enhancing
counterparty credit risk management, and many have continued to focus
on emerging developments such as the growth of products containing
embedded leverage. These efforts and others have had the positive
effects that I alluded to earlier.
Concentration of Positions
Linked closely with the issue of leverage and the potential for
impaired liquidity in a period of market stress is the issue of
concentration of market positions or ``crowded trades.'' Sometimes
referred to as ``herding,'' crowded trades can arise to the extent that
hedge fund managers are inclined to pursue the same or similar
investment strategies. Talented hedge fund managers are constantly
searching for new opportunities and devising new strategies to exploit
those opportunities, while simultaneously trying to anticipate crowded
trades. But as more hedge fund managers open funds and more money flows
in from new investors, crowded trades may become more likely. If
numerous market participants establish large positions on the same side
of a trade, especially in combination with a high degree of leverage,
this concentration can contribute to a liquidity crisis if market
conditions compel traders simultaneously to seek to unwind their
positions. The risk, of course, is market disruption and illiquidity,
possibly exacerbating the risk of a systemic financial market crisis.
Valuation Techniques and Models
As hedge funds become larger, their valuation policies and
procedures become more important to the marketplace as a whole.
Valuation of many financial instruments, particularly complex or
illiquid instruments, can be difficult. Indeed, valuation is often
dependent on complex proprietary models. Because of their proprietary
nature, these models have not been subject to broad-based scrutiny and
there is a concern that there could be unanticipated changes that might
only present themselves in certain market conditions. Moreover,
valuation concerns are exacerbated in the hedge fund industry because
hedge fund adviser compensation is tied to period returns which, of
course, requires periodic asset valuations.
Valuations and correlations can change rapidly in unexpected ways
and these changes can have a ripple effect in the marketplace,
especially if the instruments are concentrated and illiquid. There have
been some reports on this topic. In July 2005, the Corrigan Group
issued a number of ``guiding principles'' and recommendations for all
types of participants. It recommended that: 1) investment in risk
management systems should continue, with full model testing and
validation and independent verification; and 2) analytics should
include stress testing, scenario analysis, and expert judgment, with
special attention to the inputs and assumptions.
Treasury and the PWG can contribute significantly to this debate in
the first instance by facilitating communication in the official sector
and with industry participants and academics regarding valuation
techniques and models.
Settlement and Clearance Systems
Hedge funds as a group do not pose a greater operational risk to
the OTC settlement and clearance systems than any other group of market
participants. However, operational risks can be posed by certain market
conditions and certain technological conditions in certain products,
particularly new products, where technological and legal
infrastructures tend to lag product development and volume growth.
These acute ``growing pains'' have developed most recently in the
credit derivatives market across a wide spectrum of participants.
Thus, hedge funds, or any other group of participants, potentially
could have a disruptive impact if there were concentrations of
positions or attempted mass liquidation in illiquid markets. As I noted
earlier, hedge funds are major participants in many of these markets
such as distressed debt, collateralized debt obligations, and credit
derivatives.
The Federal Reserve Bank of New York, Counterparty Risk Management
Group II, Bank for International Settlements, International Swap and
Derivatives Association, The Bond Market Association, and Depository
Trust & Clearing Corporation all have made recommendations and/or
undertaken efforts to strengthen the technological and legal aspects of
the settlement and clearance systems for all market participants. The
International Monetary Fund has also raised issues generally related to
market concentrations and illiquidity and the potential for systemic
risk in its recent ``Global Financial Stability Report,'' and member
countries and regulators continue to develop and coordinate policies
and approaches to deal with these issues globally. The PWG also
continues to discuss these issues and formulate and coordinate actions
and plans. We are encouraged by these positive developments.
Conclusion
Thank you again for allowing the Treasury Department to participate
this afternoon. As I have mentioned, hedge funds play an important role
in our financial marketplace. We are also aware that they can present
certain risks as well.
As a consequence, as I have noted elsewhere, we at Treasury will be
examining in detail the issues I have discussed this morning, with a
view to evaluating whether the growth of hedge funds--as well as other
phenomena such as derivatives and additional alternative investments
and investment pools--hold the potential to change the overall level or
nature of risk in our markets and financial institutions. We will be
engaging in a broad outreach to the financial community in the coming
months to help us examine these questions. In addition, we plan, in
concert with the PWG, to bring key government officials together to
discuss these financial market issues. As I discussed, the PWG has
already undertaken a detailed analysis regarding the causes and
consequences of LTCM's failure. The PWG can and should build on this
work to help develop a measured and market-based approach to the impact
hedge funds have on our financial markets.
Looking forward, we will be focused on seeking to understand in the
most comprehensive way possible whether and how changes in the
structure of the financial services industry--of which the rapid growth
of new forms of capital accumulation, such as hedge funds, is just one
example--have materially affected the efficiency with which markets
intermediate risk, whether risk is pooled in different ways or in
different places than it has been in the past--and if so, what
appropriate policy responses might be. We will seek to be forward
looking and to think about these changes not in a fragmented fashion,
but in a comprehensive way. At the moment it is too soon to say what
initiatives will result from this focus, but this is the lens through
which we will filter the various ideas and efforts with which we will
all be grappling over the next few years.
______
PREPARED STATEMENT OF SUSAN WYDERKO
Director, Office of Investor Education and Assistance
Former Acting Director, Division of Investment Management,
U.S. Securities and Exchange Commission
May 16, 2006
Chairman Hagel, Ranking Member Dodd, and Members of the
Subcommittee:
Thank you for inviting me to testify today about hedge funds, the
role they play in our securities markets, and the Commission's role in
their oversight. The Commission has a substantial interest in the
activities of hedge funds and their advisers, which only recently have
become major participants in our securities markets.
The Commission recognized the growing importance of hedge funds
almost 4 years ago when it directed the staff of the Division of
Investment Management to undertake a fact-finding mission aimed at
reviewing the operation and practices of hedge funds and their
advisers. That review led to the publication by the Commission of a
staff report entitled ``Implications of the Growth of Hedge Funds,'' in
which the staff described in detail the organization of the hedge fund
industry, its growth, and regulation.\1\
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\1\ Implications of the Growth of Hedge Funds, Staff Report to the
United States Securities and Exchange Commission (Sept. 2003),
available at http://www.sec.gov/news/studies/hedgefunds0903.pdf
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While identifying a number of concerns and making several policy
recommendations, the report also described the many benefits hedge
funds provide investors and our national securities markets. They
contribute substantially to market efficiency, price discovery and
liquidity. By actively participating, for example, in markets for
derivative instruments, hedge funds can help counterparties reduce or
manage their own risks, thus reducing risk assumed by other market
participants. Moreover, many hedge funds provide an important risk
management tool for institutional investors wishing to allocate a
portion of their portfolio to an investment with low correlation to
overall market activity.\2\
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\2\ A recent study reported that 78 percent of institutional
investors surveyed said that hedge funds reduced the volatility of
their portfolio. State Street Corporation, Hedge Fund Research Study
(Mar. 2006) at 4.
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Background
Hedge funds are pools of investment capital that are managed by
professional investment advisers and that are not offered generally to
the public. They are operated so that they are not subject to the same
regulatory requirements of mutual funds, which are governed by the
Investment Company Act of 1940 which contains many safeguards for
retail investors. Hedge funds are not characterized by a single
dominant investment strategy, although many seek to obtain returns that
are not correlated to market returns and instead seek to obtain an
``absolute return'' in a variety of market environments. Some adopt a
``multi-strategy'' approach that permits the adviser to determine, at
any given time, what investment strategy to follow to pursue returns
for the investors. Hedge funds also do not have a single risk profile.
Some utilize leveraging techniques that expose investors to substantial
risks, while others adopt investment strategies more similar to mutual
funds.
Hedge funds do, however, share some organizational characteristics
that distinguish them from most mutual funds. Most are organized by
advisers that retain a substantial equity participation in the fund,
and who receive compensation based, in large part, upon gains achieved
by the fund (a ``performance fee''). A typical fee arrangement will pay
the adviser 2 percent of the total amount of assets under management
and 20 percent of both realized and unrealized gains. Hedge fund
managers view these fee structures as better aligning their interests
with the interests of their investors and providing substantial
incentives for good performance.
Hedge fund managers usually have a great deal of flexibility in
managing the fund, which permits them to take advantage of market
opportunities that may not be available to other types of institutional
investors. They can change investment strategies, trade rapidly, and
utilize leveraging techniques not permitted to mutual funds. And, in
contrast to mutual funds, which must disclose publicly their portfolio
holdings quarterly, many hedge funds do not even disclose portfolio
holdings to all of their investors. Hedge fund advisers do, however,
often offer disclosure to their investors about the extent and
flexibility of their investment strategies.
Growth and Significance of Hedge Funds
The ability of some hedge fund managers to generate significant
returns has attracted a great deal of investor interest. It is
estimated that hedge funds today have more than $1.2 trillion dollars
of assets, a remarkable growth of almost 3,000 percent in the last 16
years.\3\ In 2005, an estimated 2,073 new hedge funds opened for
business.\4\ One report recently projected that assets of hedge funds
may grow to $6 trillion by 2015.\5\
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\3\ See Hedge Fund Research, HFR Q1 2006 Industry Report.
\4\ See Hedge Fund Research, HFR Q1 2006 Industry Report. During
2005, 848 funds were liquidated. Id.
\5\ Van Hedge Fund Advisers, International, LLC, Hedge Fund Demand
and Capacity 2005-2015 (Aug. 2005).
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Much of the growth of hedge funds is attributable to increased
investment by institutions, such as private and public pension plans,
endowments and foundations.\6\ Many of these investors sought out hedge
funds during the recent bear markets in order to address losses from
traditional investments.
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\6\ See Hennessee Group, 2004 Hennessee Hedge Fund Survey of
Foundations and Endowments (reporting that the investors surveyed had
an average commitment of 17 percent of assets, and a projected
commitment of 19 percent by 2005).
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The ability of hedge fund managers to sustain above-market returns
is a matter of some debate, as is the likelihood that hedge funds as an
asset class will continue to grow.\7\ Nonetheless, hedge funds play and
will likely continue to play an important role in the securities
markets, the significance of which exceeds the amount of their assets.
Although hedge funds represent just 5 percent of all U.S. assets under
management, they account for about 30 percent of all U.S. equity
trading volume.\8\ They are highly active in the convertible bond and
credit derivatives markets. Moreover, hedge funds are becoming more
active in the markets for corporate control, \9\ private lending, and
crude petroleum. Their activities affect all Americans directly or
indirectly.
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\7\ See Nicholas Chan, Mila Getmansky, Shane M. Haas, and Andrew W.
Lo, ``Systemic Risk and Hedge Funds,'' (Aug. 1, 2005) (unpublished
manuscript, to appear in M. Carey and R. Stulz, eds., The Risks of
Financial Institutions and the Financial Sector, Chicago, IL:
University of Chicago Press).
\8\ See Pam Abramowitz, ``Trade Secrets,'' Institutional Investor's
Alpha, January/February 2006.
\9\ Mara Der Hovanesian, ``Attack of the Hungry Hedge Funds,''
Business Week (Feb. 2006); Henry Sender, ``Hedge Funds: The New
Corporate Activists--Investment Vehicles Amass Clout In Public Firms,
Then Demand Management Boost Share Price,'' The Wall Street Journal
(May 13, 2005).
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Application of the Federal Securities Laws
Press articles typically refer to hedge funds as ``lightly
regulated'' investment pools. In a sense, they are correct. As noted
above, hedge funds are organized and operated so that they are not
subject to the Investment Company Act of 1940. In addition, hedge funds
issue securities in ``private offerings'' that are not registered with
the Commission under the Securities Act of 1933, and hedge funds are
not required to make periodic reports under the Securities Exchange Act
of 1934. However, hedge funds are subject to the same prohibitions
against fraud as are other market participants, and their managers have
the same fiduciary obligations as other investment advisers.
The Commission's Oversight of Hedge Fund Activities
The Commission's oversight responsibilities with respect to hedge
fund activities generally fall into three principal areas: fiduciary
obligations; market abuse; and risks to broker-dealers. Each is
described below.
Fiduciary Obligations
Hedge fund managers are ``investment advisers'' under the
Investment Advisers Act of 1940. As a result, a hedge fund manager owes
the fund and its investors a fiduciary duty that requires the manager
to place the interests of the hedge fund and its investors first, or at
least fully disclose any material conflict of interest the manager may
have with the fund and its investors. Hedge fund advisers have this
fiduciary obligation as a matter of law regardless of whether they are
registered with the Commission.
The Advisers Act provides the Commission with authority to enforce
these obligations, which the Commission has exercised vigorously in
order to protect investors. Over the past several years the Commission
has brought a number of enforcement cases against hedge fund advisers
who have violated their fiduciary obligations to their hedge funds and
investors. These cases involve advisers who have engaged in
misappropriation of fund assets; portfolio pumping; misrepresenting
portfolio performance; falsification of experience, credentials and
past returns; misleading disclosure regarding claimed trading
strategies; and improper valuation of assets. In some cases we have
worked with criminal authorities.
Recent examples of significant cases brought by the Commission
include:
SEC v. Samuel Israel III; Daniel E. Marino; Bayou
Management, LLC et al. The Commission alleged that the advisers
of a Connecticut-based group of hedge funds defrauded investors
in the funds and misappropriated millions of dollars in
investor assets for their personal use. Over $450 million was
raised from investors. The advisers issued fictitious account
statements to investors and used a sham accounting firm to
forge audited financial statements in order to hide substantial
losses. These losses resulted from, among other things, the
theft of funds by the advisers who withdrew ``incentive fees''
to which they were not entitled. On September 29, 2005, the
Commission filed an action in U.S. District Court seeking
injunctions, disgorgement of ill-gotten gains, prejudgment
interest, and civil money penalties.\10\ Also on that date,
Israel and Marino pleaded guilty in a companion criminal case.
They have not yet been sentenced. On April 19, 2006, the
defendants in the civil case consented to an order permanently
enjoining them from future violations of the antifraud statutes
of the Federal securities laws.\11\
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\10\ Litigation Release No. 19406 (Sept. 29, 2005).
\11\ Litigation Release No. 19692 (May 9, 2006).
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SEC v. Sharon E. Vaughn and Directors Financial Group, Ltd.
The Commission alleged that an Illinois hedge fund adviser
registered with the Commission defrauded fund investors by
improperly investing fund assets in a fraudulent ``prime bank''
trading scheme contrary to the fund's disclosed trading
strategy. According to the Commission's complaint, the adviser
and its principal had an undisclosed profit sharing agreement
with one of the trading program promoters. The adviser and
principal consented to injunctions and agreed to disgorgement
of over $800,000.\12\ As a result of the SEC's action and a
subsequent criminal action brought by the U.S. Attorney's
office involving individuals associated with the trading
program, hedge fund investors were returned most of their
principal investment and profits prior to investment in the
trading program.
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\12\ Litigation Release No. 19589 (Mar. 3, 2006).
New registration requirement. Until recently, registration with the
Commission was optional for many hedge fund advisers. In February of
this year, new rules became effective that require that most hedge fund
advisers register with the Commission under the Advisers Act.\13\ The
new rules do not regulate hedge fund strategies, risks or investments.
The new rules have given the Commission basic census data about hedge
fund advisers. In addition, registration has required hedge fund
advisers to implement compliance programs to prevent, detect and
correct compliance violations and to designate a chief compliance
officer to administer each adviser's compliance program. Registration
also has provided the Commission authority to conduct compliance
examinations of registered hedge fund advisers. Based upon registration
data we now know that 24 percent of the 10,000 investment advisers
currently registered with the Commission advise at least one hedge
fund. Of the 2,456 hedge fund advisers registered with us as of the end
of April, 1,179 (45 percent) registered in response to the new
rule.\14\ The vast majority of the hedge fund advisers (88 percent)
registered with the Commission are domiciled in the United States.
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\13\ The Commission's recent rulemaking required certain hedge fund
advisers to register as investment advisers with the Commission under
the Investment Advisers Act of 1940, under which registration
previously had been optional for many hedge fund advisers.
Commissioners Glassman and Atkins dissented from the rulemaking.
Registration Rule at 72089. With respect to the management of hedge
funds whose advisers are registered with the Commission, the Commission
in adopting the adviser registration requirement observed that, ``The
[Advisers] Act does not require an adviser to follow or avoid any
particular investment strategies, nor does it require or prohibit
specific investments.'' Registration Rule at section II.A.
[Registration Under the Advisers Act of Certain Hedge Fund Advisers,
Investment Advisers Act Release No. 2333 (Dec. 2, 2004), 69 FR at
72060, petition for review filed (D.C. Cir. No. 04-1434); argued Dec.
9, 2005. (``Registration Rule'')]
\14\ Registration forms indicate that these advisers report just
over 13,000 hedge funds with aggregate assets of about $2 trillion.
Because reported assets include assets of ``feeder'' funds as well as
``master'' funds in which they invest, total reported assets likely are
higher than if assets of ``feeder'' funds were excluded.
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Examinations. As mentioned above, registered hedge fund advisers
may be subject to onsite compliance examinations by SEC examiners in
the Office of Compliance Inspections and Examinations (OCIE). The SEC
maintains a risk-based examination program, and determines which firms
to examine based on their risk characteristics. Hedge fund advisers
have been included in the same pool as other registered advisers, and
thus, like other advisers, the staff determines which firms to examine
based on the compliance risks the firm presents to investors.
Examination staff are working with the Division of Investment
Management and Office of Risk Assessment to develop improved metrics to
assess the compliance risks of registered advisers in order to continue
to focus our exam resources. In addition, OCIE has developed a
specialized training program to better familiarize examiners with the
operation of hedge funds and thus improve the effectiveness of our
examination of hedge fund advisers.
During a routine compliance examination, the staff reviews the
effectiveness of the compliance controls that every registered
investment adviser must have in place to prevent or detect violations
of the Federal securities laws. In those areas where controls appear to
be weak, our examiners will obtain additional information to determine
if the weak control environment has resulted in a violation of the
securities laws. The staff also reviews disclosure documents, including
any private placement memoranda provided to hedge fund investors, to
determine whether the disclosure appears to accurately reflect the
hedge fund adviser's management of the fund. In addition, the staff
identifies areas of potential conflicts of interest with respect to the
hedge fund adviser and the fund that it advises to determine whether
appropriate disclosure has been made.
It is the staff's experience that many of the compliance issues
raised by an adviser's management of a hedge fund are similar to those
raised by other advisers' asset management activities. For example,
these compliance issues include: the use of soft dollar arrangements,
the allocation of investment opportunities among clients, the valuation
of securities, the calculation of performance, and the safeguards over
customers' assets and non-public information. In this regard, let me
identify a few areas in which we plan to focus our examinations of
hedge fund advisers:
Side-by-Side Management. Some hedge fund managers also
advise other types of advisory accounts, including mutual
funds.\15\ Because the adviser's fee from the hedge fund is
based in large measure on the fund's performance--and because
the adviser typically invests heavily in the hedge fund itself,
this ``side-by-side'' management presents significant conflicts
of interest that could lead the adviser to favor the hedge fund
over other clients. The staff will focus on whether the hedge
fund manager appears to have sufficient controls in place to
prevent such bias and whether, in fact, the adviser has favored
its hedge funds over other clients.
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\15\ Almost 15 percent (379) of the hedge fund advisers registered
with the Commission report that they also advise at least one mutual
fund.
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Side Letter Agreements. Side letters are agreements that
hedge fund advisers enter into with certain investors that give
the investors more favorable rights and privileges than other
investors receive. Some side letters address matters that raise
few concerns, such as the ability to make additional
investments, receive treatment as favorable as other investors,
or limit management fees and incentives. Others, however, are
more troubling because they may involve material conflicts of
interest that can harm the interests of other investors. Chief
among these types of side letter agreements are those that give
certain investors liquidity preferences or provide them with
more access to portfolio information. Our examination staff
will review side letter agreements and evaluate whether
appropriate disclosure of the side letters and relevant
conflicts has been made to other investors.
Valuation of Fund Assets. A hedge fund manager typically
values the assets of the hedge fund using the market value of
those securities. When the fund holds publicly traded
securities, that process is fairly simple. Many hedge funds,
however, own thinly traded securities and derivative
instruments whose valuation can be very complicated and, in
some cases, highly subjective. Unlike a mutual fund, hedge fund
valuation practices are not overseen by an independent board of
directors. A number of the Commission's enforcement cases
against hedge fund advisers involve the adviser's valuation of
fund assets in order to hide losses or to artificially boost
performance. Thus, a review of valuation policies and practices
is a key element of hedge fund adviser examinations.
Custody of Fund Assets. A hedge fund manager typically has
access to and directs the use of fund assets. Such access
presents a significant risk to fund investors--as demonstrated
in a number of the Commission's enforcement actions involving
theft or misuse of fund assets by a hedge fund manager.
Therefore, Commission examiners focus attention on the controls
used to protect fund assets.
Market Abuse
Hedge fund advisers' active trading plays an important role in our
capital markets. The Federal securities laws and Commission regulations
establish rules designed to prevent market abuses. When market activity
by hedge fund advisers--like any other participant in the securities
markets--crosses the line and violates the law, the Commission has
taken appropriate remedial action. In the past year, the Commission has
brought enforcement actions against hedge fund advisers for a variety
of market abuses, including insider trading, improper activities in
connection with short sales, market manipulation, scalping, and
fraudulent market timing and late trading of mutual funds.
Recent significant cases have included:
In the Matter of Millennium Partners, L.P., Millennium
Management, L.L.C., Millennium International Management,
L.L.C., Israel Englander, Terence Feeney, Fred Stone, and Kovan
Pillai. The Commission brought an action against hedge fund
managers alleging that the managers generated tens of millions
of dollars in profits for their hedge funds through deceptive
and fraudulent market timing of mutual funds at the expense of
the mutual funds and their shareholders. The adviser and its
principals agreed to disgorgement and civil monetary penalties,
and have undertaken to implement particular compliance, legal,
and ethics oversight measures.\16\
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\16\ Investment Advisers Act Release No. 2453 (Dec. 1, 2005).
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SEC v. Hilary Shane. The Commission alleged a particular
type of insider trading involving a PIPE transaction, where the
hedge fund adviser agreed to buy shares of a public company in
a private offering--a transaction that the Commission alleged
was likely to have a significant dilutive effect on the value
of the company's shares--and then misused information she had
been given (and which she had agreed to keep confidential)
about the private offering by short-selling the company's
shares. The adviser agreed to disgorge the trading profits,
paid a civil penalty, and has consented to be barred from the
broker-dealer industry and suspended from the investment
advisory industry.\17\
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\17\ Litigation Release No. 19227 (May 18, 2005). Because she
entered into the short sales prior to the effective date of the
registration statement for the PIPE and then covered her short sales
with those she obtained in the PIPE offering, the Commission also
alleged that Ms. Shane violated section 5 of the Securities Act.
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SEC v. Scott R. Sacane, et al. The Commission alleged that
hedge fund advisers manipulated the market by creating the
appearance of greater demand for two stocks than actually
existed. The individual defendants in this case have both pled
guilty to related criminal charges and have been barred by the
Commission from associating with an investment adviser. In
addition, one of the defendants has agreed to pay disgorgement
and a civil penalty in the Commission's civil action, which
remains pending against the other defendants.\18\
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\18\ Litigation Release No. 19424 (Oct. 12, 2005). See also In the
Matter of Scott R. Sacane, Investment Advisers Act Release No. 2483
(Feb. 8, 2006); In the Matter of J. Douglas Schmidt, Investment
Advisers Act Release No. 2491 (Feb. 28, 2006); SEC v. Scott R. Sacane,
et al., Litigation Release No. 19515 (Dec. 22, 2005); SEC v. Scott R.
Sacane, et al., Litigation Release No. 19605 (Mar. 9, 2006).
Not only has the Commission brought enforcement actions against the
hedge funds and hedge fund advisers that engage in these transactions,
it has brought actions against fund service providers who facilitated
these unlawful securities trading activities. Recently, for example, we
settled an enforcement action against a large broker-dealer that helped
hedge funds foil the efforts of mutual funds to detect the hedge funds'
market timing, and made it possible for certain favored hedge fund
clients to ``late trade'' mutual fund shares.\19\
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\19\ In the Matter of Bear, Stearns, and Co., Inc., and Bear,
Stearns Securities Corp., Securities Act Release No. 8668 (Mar. 16,
2006) (defendants agreed to censure, payment of disgorgement and civil
monetary penalties, and have undertaken to implement particular
compliance oversight measures).
---------------------------------------------------------------------------
Risks to Broker-Dealers
Hedge funds can (although we understand many do not) make
significant use of leverage. Most hedge funds use one or more ``prime
brokers,'' which provide clearing and related services to the fund and
its adviser. One core service prime brokers offer their hedge fund
customers is secured financing, notably margin lending, where the hedge
fund borrows from the prime broker in order to buy securities, which
then serve as collateral for the loan.\20\
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\20\ Prime brokers may also structure these financing transactions
as repurchase agreements, where they buy the securities from the hedge
fund subject to the fund's obligation to repurchase the securities from
the broker in the future at a specified price. Prime brokers may also
produce similar economics through the use of over-the-counter
derivative contracts with hedge funds.
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The Commission continues to focus attention on broker-dealers'
exposure to hedge fund risks and the broader implications this aspect
of the financial system may have. The Commission staff meets regularly
with other members of the President's Working Group on Financial
Markets, and works with the industry members that comprise the
Counterparty Risk Management Policy Group. In addition, the
Commission's consolidated supervision program for certain investment
banks now allows the staff to examine not only the broker-dealer
entities within a group, but also the unregulated affiliates and
holding company where certain financing transactions with hedge funds
are generally booked. Commission staff meets at least monthly with
senior risk managers at these broker-dealer holding companies to review
material risk exposures, including those resulting from hedge fund
financing and those related to sectors in which hedge funds are highly
active.
Looking Forward
As a result of our recently implemented hedge fund adviser
registration rulemaking, the Commission now has more data about hedge
funds and their advisers. The staff is in the process of evaluating
those data and considering methods to refine its ability to target our
examination resources by more precisely identifying those advisers,
including hedge fund advisers, that pose greater compliance risks.
In addition, the Commission staff is working with the United
Kingdom's Financial Services Authority, to coordinate policy and
oversight of the 165 hedge fund advisers registered with the Commission
that are located in the United Kingdom. The staff also expects to
coordinate examinations with the Commodity Futures Trading Commission
(CFTC). To that end, we recently provided information to the CFTC
indicating the identities of hedge fund advisers registered with the
Commission who report on their registration forms that they are also
actively engaged in commodities business (approximately 350 firms).
Conclusion
In conclusion, I would like to thank the Subcommittee for holding
this hearing on a subject of growing importance to us and to all
American investors. Hedge funds play an important role in our financial
markets. With respect to hedge funds, their advisers and all market
participants, the Commission will continue to enforce vigorously the
Federal securities laws.
______
PREPARED STATEMENT OF PATRICK PARKINSON
Deputy Director, Division of Research and Statistics,
Board of Governors of the Federal Reserve System
May 16, 2006
Chairman Hagel, Senator Dodd, and members of the Subcommittee,
thank you for the opportunity to testify on the role of hedge funds in
the capital markets. In my remarks today, I will discuss the increasing
importance of that role, the public policy issues associated with it,
and what the Federal Reserve has been doing to address concerns about
potential systemic risks from hedge funds' activities.
The Role of Hedge Funds in the Capital Markets
The role that hedge funds are playing in capital markets cannot be
quantified with any precision. A fundamental problem is that the
definition of a hedge fund is imprecise, and distinctions between hedge
funds and other types of funds are increasingly arbitrary. Hedge funds
often are characterized as unregulated private funds that can take on
significant leverage and employ complex trading strategies using
derivatives or other new financial instruments. Private equity funds
are usually not considered hedge funds, yet they are typically
unregulated and often leverage significantly the companies in which
they invest. Likewise, traditional asset managers more and more are
using derivatives or are investing in structured securities that allow
them to take on leverage or establish short positions.
Although several data bases on hedge funds are compiled by private
vendors, they cover only the hedge funds that voluntarily provide
data.\1\ Consequently, the data are not comprehensive. Furthermore,
because the funds that choose to report may not be representative of
the total population of hedge funds, generalizations based on these
data bases may be misleading. Data collected by the Securities and
Exchange Commission (SEC) from registered advisers to hedge funds are
not comprehensive either. The primary purpose of registration is to
protect investors by discouraging hedge fund fraud. The SEC does not
require an adviser to a hedge fund, regardless of how large it is, to
register if the fund does not permit investors to redeem their
interests within 2 years of purchasing them.\2\ While registration of
advisers of such funds may well be unnecessary to discourage fraud, the
exclusion from the data base of funds with long lock-up periods makes
the data less useful for quantifying the role that hedge funds are
playing in the capital markets.
---------------------------------------------------------------------------
\1\ Examples of hedge fund data bases include Trading Advisors
Selection System (TASS), Centre for International Securities and
Derivatives Markets (CISDM) Hedge Fund Data base, and Hedge Fund
Research Data base.
\2\ The commission decided not to require such funds to register
because it had not encountered significant problems with fraud at
private equity or venture capital funds, which are similar in some
respects to hedge funds but usually require investors to make long-term
commitments of capital.
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Even if a fund is included in a private data base or its adviser is
registered with the SEC, the information available is quite limited.
The only quantitative information that the SEC currently collects is
total assets under management. Private data bases typically provide
assets under management as well as some limited information on how the
assets are allocated among investment strategies, but they do not
provide detailed balance sheets. Some data bases provide information on
funds' use of leverage, but their definition of leverage is often
unclear. As hedge funds and other market participants increasingly use
financial products such as derivatives and securitized assets that
embed leverage, conventional measures of leverage have become much less
useful. More meaningful economic measures of leverage are complex and
highly sensitive to assumptions about the liquidity of the markets in
which financial instruments can be sold or hedged.\3\
---------------------------------------------------------------------------
\3\ For a discussion of the definition and construction of
economically meaningful measures of leverage, see appendix A in
Counterparty Risk Management Policy Group (1999), Improving
Counterparty Risk Management Practices (New York: CRMPG, June).
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Although the role of hedge funds in the capital markets cannot be
precisely quantified, the growing importance of that role is clear.
Total assets under management are usually reported to exceed $1
trillion.\4\ Furthermore, hedge funds can leverage those assets through
borrowing money and through their use of derivatives, short positions,
and structured securities. Their market impact is further magnified by
the extremely active trading of some hedge funds. The trading volumes
of these funds reportedly account for significant shares of total
trading volumes in some segments of fixed income, equity, and
derivatives markets.\5\
---------------------------------------------------------------------------
\4\ Some of these estimates may double count investments in funds
of funds. At the end of last year, and excluding fund of funds, the
TASS data base included funds that had $979.3 billion in assets. Of
course, not all funds are included in this data base.
\5\ Greenwich Associates estimates that hedge funds in 2004
accounted for 20 to 30 percent of trading volumes in markets for below-
investment-grade debt, credit derivatives, collateralized debt
obligations, emerging-market bonds, and leveraged loans, and 80 percent
of trading in distressed debt. See Greenwich Associates (2004), Hedge
Funds: The End of the Beginning? (Greenwich Associates, December).
These estimates were based on interviews with hedge funds and other
institutional investors that Greenwich Associates conducted from
February through April 2004.
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In various capital markets, hedge funds clearly are increasingly
consequential as providers of liquidity and absorbers of risk. For
example, a study of the markets in U.S. dollar interest rate options
indicated that participants viewed hedge funds as a significant
stabilizing force. In particular, when the options and other fixed
income markets were under stress in the summer of 2003, the willingness
of hedge funds to sell options following a spike in options prices
helped restore market liquidity and limit losses to derivatives dealers
and investors in fixed-rate mortgages and mortgage-backed
securities.\6\ Hedge funds reportedly are significant buyers of the
riskier equity and subordinated tranches of collateralized debt
obligations (CDOs) and of asset-backed securities, including securities
backed by nonconforming residential mortgages.\7\
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\6\ Federal Reserve Board (2005), Concentration and Risk in the OTC
Markets for U.S. Dollar Interest Rate Options (http://
www.Federalreserve.gov/boarddocs/surveys/OpStudySum/
OptionsStudySummary.pdf).
\7\ See Fitch Ratings (2005), Hedge Funds: An Emerging Force in the
Global Credit Markets (New York: Fitch Ratings, 2005), p. 6.
---------------------------------------------------------------------------
At the same time, however, the growing role of hedge funds has
given rise to public policy concerns. These include concerns about
whether hedge fund investors can protect themselves adequately from the
risks associated with such investments, whether hedge fund leverage is
being constrained effectively, and what potential risks the funds pose
to the financial system if their leverage becomes excessive.
Investor Protection
Hedge funds and their investment advisers historically were exempt
from most provisions of the Federal securities laws.\8\ Those laws
effectively allow only institutions and relatively wealthy individuals
to invest in hedge funds. Such investors arguably are in a position to
protect themselves from the risks associated with hedge funds.\9\
However, in recent years hedge funds reportedly have been marketed
increasingly to a less wealthy clientele. Furthermore, pension funds,
many of whose beneficiaries are not wealthy, have increased investments
in hedge funds.
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\8\ The antifraud provisions of the Securities Act and the
Securities Exchange Act apply to the sale of a private fund's
securities, whether or not the private fund is registered under the
Investment Company Act.
\9\ See President's Working Group on Financial Markets (1999),
Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management
(Washington: President's Working Group, April), p. B-13.
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Concerns about the potential direct and indirect exposures of less
wealthy investors from hedge fund investments and hedge fund fraud
contributed to the SEC's decision in December 2004 to require many
advisers to hedge funds that are offered to U.S. investors to register
with the commission.
The SEC believes that the examination of registered hedge fund
advisers will deter fraud. But fraud is very difficult to uncover, even
through onsite examinations.\10\ Therefore, it is critical that
investors do not view the SEC registration of advisers as an effective
substitute for their own due diligence in selecting funds and their own
monitoring of hedge fund performance. Most institutional investors
probably understand this well. In a survey several years ago of U.S.
endowments and foundations, 70 percent of the respondents said that a
hedge fund adviser's registration or lack of registration with the SEC
had no effect on their decision about whether or not to invest because
the institutions conducted their own due diligence.\11\
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\10\ For example, three Federal Reserve examinations of the New
York branch of Daiwa Bank between 1992 and 1994 failed to uncover $1.1
billion of hidden trading losses. See Alan Greenspan (1996),
``Statement before the Committee on Banking, Housing, and Urban
Affairs, U.S. Senate, November 27, 1995,'' Federal Reserve Bulletin,
vol. 82 (January), pp. 31-35.
\11\ See Greenwich associates (2004), p. 3.
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In the case of pension funds, sponsors and pension fund regulators
should ensure that pension funds conduct appropriate due diligence with
respect to all their investments, not just their investments in hedge
funds. Pension funds and other institutional investors seem to have a
growing appetite for a variety of alternatives to holding stocks and
bonds, including real estate, private equity and commodities, and
investments in hedge funds are only one means of gaining exposures to
those alternative assets. The registration of hedge fund advisers
simply cannot protect pension fund beneficiaries from the failures of
plan sponsors to carry out their fiduciary responsibilities.
As for individual investors, the income and wealth criteria that
define eligible investors in hedge funds unavoidably are a crude test
for sophistication.\12\ If individuals with relatively little wealth
increasingly become the victims of hedge fund fraud, it may become
appropriate to tighten the criteria for an individual to be considered
an eligible investor.
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\12\ Each individual investor in a hedge fund that is subject to
the Investment Advisers Act and whose adviser charges a performance fee
generally must have a net worth of at least $1.5 million or have at
least $750,000 of assets under management with the adviser. In
addition, most hedge funds avoid regulation under the Investment
Company Act by meeting a requirement that each investor in the fund
must be a ``qualified purchaser,'' which for individual investors means
having assets of at least $5 million.
---------------------------------------------------------------------------
Excessive Leverage and Systemic Risk
The near failure of the hedge fund Long-Term Capital Management
(LTCM) in September 1998 illustrated the potential for a large hedge
fund to become excessively leveraged and raised concerns that a forced
liquidation of large positions held by a highly leveraged institution
would create systemic risk by exacerbating market volatility and
illiquidity. In our market-based economy, the primary mechanism that
regulates firms' leverage is the market discipline imposed by creditors
and counterparties. Even when the government has oversight of leverage,
as in the case of banks and broker-dealers, such oversight is intended
to supplement market discipline rather than to replace it. In the case
of LTCM, however, market discipline broke down.
In the wake of the LTCM episode, the President's Working Group on
Financial Markets considered how best to constrain excessive leverage
by hedge funds. The Working Group concluded that hedge funds' leverage
could be constrained most effectively by promoting measures that
enhance market discipline by improving credit risk management by hedge
funds' counterparties and creditors, nearly all of which are regulated
banks and securities firms.\13\ The Working Group termed this approach
``indirect regulation'' of hedge funds. The Working Group considered
the alternative of direct government regulation of hedge funds, but it
concluded that developing a regulatory regime for hedge funds would
present formidable challenges in terms of cost and effectiveness. It
believed that indirect regulation would address concerns about systemic
risks from hedge funds most effectively and would avoid the potential
attendant costs of direct regulation.\14\
---------------------------------------------------------------------------
\13\ President's Working Group (1999).
\14\ See President's Working Group (1999), p. 42.
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The Federal Reserve and Hedge Funds
The President's Working Group made a series of recommendations for
improving market discipline on hedge funds. These included
recommendations for improvements in credit risk management practices by
the banks and securities firms that are hedge funds' counterparties and
creditors and improvements in supervisory oversight of those banks and
securities firms. As a regulator of banks and bank holding companies,
the Federal Reserve has worked with other domestic and international
regulators to implement the necessary improvements in supervisory
oversight. Regulatory cooperation is essential in this area because
hedge funds' principal creditors and counterparties include foreign
banks as well as U.S. banks and securities firms.
In January 1999, the Basel Committee on Banking Supervision (BCBS)
published a set of recommendations for sound practices for managing
counterparty credit risks to hedge funds and other highly leveraged
institutions. Around the same time, the Federal Reserve, the SEC, and
the Treasury Department encouraged a group of twelve major banks and
securities firms to form a Counterparty Risk Management Policy Group
(CRMPG), which in July 1999 issued its own complementary
recommendations for improving counterparty risk management
practices.\15\
---------------------------------------------------------------------------
\15\ See CRMPG (1999).
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The BCBS sound practices have been incorporated into Federal
Reserve supervisory guidance and examination procedures applicable to
banks' capital market activities. In general terms, routine supervisory
reviews of counterparty risk management practices with respect to hedge
funds and other counterparties seek to ensure that banks (1) perform
appropriate due diligence in assessing the business, risk exposures,
and credit standing of their counterparties; (2) establish, monitor,
and enforce appropriate quantitative risk exposure limits for each of
their counterparties; (3) use appropriate systems to measure and manage
counterparty credit risk; and (4) deploy appropriate internal controls
to ensure the integrity of their processes for managing counterparty
credit risk. Besides conducting routine reviews and continually
monitoring counterparty credit exposures, the Federal Reserve
periodically performs targeted reviews of the credit risk management
practices of banks that are major hedge fund counterparties. These
targeted reviews examine in depth the banks' practices against the BCBS
and Federal Reserve sound practices guidance and the CRMPG
recommendations.
According to supervisors and most market participants, counterparty
risk management has improved significantly since the LTCM episode in
1998. However, since that time, hedge funds have greatly expanded their
activities and strategies in an environment of intense competition for
hedge fund business among banks and securities firms. Furthermore, some
hedge funds are among the most active investors in new, more-complex
structured financial products, for which valuation and risk measurement
are challenging both to the funds themselves and to their
counterparties. Counterparties and supervisors need to ensure that
competitive pressures do not result in any significant weakening of
counterparty risk management and that risk management practices are
evolving as necessary to address the increasing complexity of the
financial instruments used by hedge funds.
The Federal Reserve has also sought to limit hedge funds' potential
to be a source of systemic risk by ensuring that the clearing and
settlement infrastructure that supports the markets in which the funds
trade is robust. Very active trading by hedge funds has contributed
significantly to the extraordinary growth in the past several years of
the markets for credit derivatives. A July 2005 report by a new
Counterparty Risk Management Policy Group (CRMPG II) called attention
to the fact that the clearing and settlement infrastructure for credit
derivatives (and over-the-counter derivatives generally) had not kept
pace with the volume of trading.\16\ In particular, a backlog of
unsigned trade confirmations was growing, and the acceptance by dealers
of assignments of trades by one counterparty without the prior consent
of the other, despite trade documentation requirements for such
consent, was becoming widespread.
---------------------------------------------------------------------------
\16\ Counterparty Risk Management Policy Group II (2005), Toward
Greater Financial Stability: A Private Sector Perspective (New York:
CRMPG II, July).
---------------------------------------------------------------------------
To address these and other concerns about the clearing and
settlement of credit derivatives, in September 2005 the Federal Reserve
Bank of New York brought together fourteen major U.S. and foreign
derivatives dealers and their supervisors. The supervisors collectively
made clear their concerns about the risks created by the infrastructure
weaknesses and asked the dealers to develop plans to address those
concerns. With supervisors providing common incentives for the
collective actions that were necessary, the dealers have made
remarkable progress since last September. The practice of unauthorized
assignments has almost ceased, and dealers are now expeditiously
responding to requests for the authorization of assignments. For the
fourteen dealers as a group, total credit derivative confirmations
outstanding for more than 30 days fell 70 percent between September
2005 and March 2006. The reduction in outstanding confirmations was
made possible in part by more widespread and intensive use of an
electronic confirmation-processing system operated by the Depository
Trust and Clearing Corporation (DTCC). The dealers have worked with
their largest and most active clients, most of which are hedge funds,
to ensure that they can electronically confirm trades in credit
derivatives. By March 2006, 69 percent of the fourteen dealers' credit
derivatives trades were being confirmed electronically, up from 47
percent last September.
Supervisors and market participants agree that further progress is
needed, and in March the fourteen dealers committed themselves to
achieving by October 31, 2006, a ``steady state'' position for the
industry.\17\ The steady state will involve (1) the creation of a
largely electronic marketplace in which all trades that can be
processed electronically will be; (2) the creation by DTCC of an
industry trade information warehouse and support infrastructure to
standardize and automate processing of events throughout each
contracts's life; (3) new processing standards for those trades that
cannot be confirmed electronically; and (4) the creation of an
automated platform to support notifications and consents with respect
to trade assignments. The principal trade association for the hedge
fund industry has stated its support for plans embodied in the dealers'
commitments.\18\
---------------------------------------------------------------------------
\17\ See Federal Reserve Bank of New York press release dated March
13, 2006. (http://www.newyorkfed.org/newsevents/news/markets/2006/
an060313.html).
\18\ See press release by the Managed Funds Association dated March
13, 2006. (http://www.mfainfo.org/images/PDF/
MFA_Fed14_Stmt_3_13_06.pdf).
---------------------------------------------------------------------------
Summary
Hedge funds clearly are becoming more important in the capital
markets as sources of liquidity and holders and managers of risk. But
as their importance has grown, so too have concerns about investor
protection and systemic risk.
The SEC believes that the examination of registered hedge advisers
will deter fraud. But investors must not view SEC regulation of
advisers as an effective substitute for their own due diligence in
selecting funds and their own monitoring of hedge fund performance.
After the LTCM episode, the President's Working Group on Financial
Markets considered how best to address concerns about potential
systemic risks from excessive hedge fund leverage. The Working Group
concluded that hedge funds' leverage could be constrained most
effectively by promoting measures that enhance market discipline by
improving credit risk management by funds' counterparties and
creditors, nearly all of which are regulated banks and securities
firms. The Working Group considered the alternative of direct
government regulation of hedge funds but concluded that it would be
more costly and would be less effective than an approach focused on
strengthening market discipline.
The Federal Reserve has been seeking to ensure appropriate market
discipline on hedge funds by working with other regulators to promote
effective counterparty risk management by hedge funds' counterparties
and creditors. It has also sought to limit the potential for hedge
funds to be a source of systemic risk by ensuring that the clearing and
settlement infrastructure that supports the markets in which they trade
is robust.
______
PREPARED STATEMENT OF JAMES OVERDAHL
Chief Economist, U.S. Commodity Futures Trading Commission
May 16, 2006
Mr. Chairman, Senator Dodd, and Members of the Subcommittee, I
appear before you today in my capacity as Chief Economist of the
Commodity Futures Trading Commission (CFTC), the Federal Government
regulator of futures and futures options markets in the United States.
The term ``hedge fund'' is not a term we use in our regulatory work at
the CFTC. To the extent that any subsidiary fund within a hedge fund
complex uses exchange-traded derivatives, the operator of that
subsidiary fund and its advisor may be subject, under certain
circumstances, to registration and reporting requirements under the
Commodity Exchange Act, the statute administered by the CFTC.
In my testimony today I will address several topics. First, I will
describe the role that hedge funds play in futures markets in general,
and the role they play in commodity futures markets in particular.
Second, I will briefly describe the surveillance methods used by the
CFTC to monitor large traders, including many hedge funds, in order to
ensure market integrity. Third, I will describe the financial safeguard
system in place to ensure that the financial distress of a single
futures market participant, whether or not that participant is a hedge
fund, does not have a disproportionate effect on the overall market.
Last, I will describe the CFTC's oversight authority with respect to
the operators of pooled investment vehicles trading commodity futures
or options.
The Role of Hedge Funds in Futures Markets
Futures markets serve an important role in our economy by providing
a means of transferring risk from those who do not want it to those
willing to accept it for a price. Traders who are trying to reduce
their risks are called ``hedgers,'' a group that typically includes
those who have an underlying commercial interest in the commodity upon
which the futures contract is written. Futures exchanges know from
experience that the markets they host cannot exist with hedgers alone.
In order for hedgers to reduce the risk they face in their day-to-day
commercial activities, they need to trade with someone willing to
accept the risk the hedger is trying to shed. Data from the CFTC's
Large Trader Reporting System are consistent with the notion that hedge
funds, and other professionally managed funds, are often the ones who
facilitate the needs of hedgers.
CFTC large trader data also show that hedge funds and other
professionally managed funds hold significant ``spread'' positions,
that is, positions across related contracts. These spread positions are
structured to speculate on relative price differences between contracts
(e.g., prices for October delivery vs. prices for November delivery),
and when structured as such, are unrelated to the overall level of
futures prices. These spread trades play a vital role in keeping prices
of related markets (and prices of related contracts within the same
market complex) in proper alignment with one another. Hedge funds also
add to overall trading volume, which contributes to the formation of
liquid and well-functioning markets.
One notable development over the past 5 years has been the
increased participation by pension funds, university endowments, hedge
fund investors, and other financial institutions in futures markets for
physical commodities. These institutions view commodities as a distinct
``asset class'' and have allocated a portion of the portfolios they
manage, either directly or indirectly, into futures contracts tied to
commodity indexes. The total investment in commodity-linked index
products by pension funds, hedge funds and other institutional
investors has been estimated by industry observers to exceed $100
billion. A significant portion of this amount finds it way into futures
markets, either through direct participation by those whose commodity
investments are benchmarked to a commodity index, or through
participation by commodity index swap dealers who use futures markets
to hedge the risk associated with their dealing activities.
The greater participation by funds and commodity index investors
has raised questions by some market observers about whether their
activity is distorting prices in commodity futures markets. These
issues strike at the heart of what the futures markets are all about.
Futures markets exist because they provide two vital functions for the
marketplace: risk management and price discovery. The job of the CFTC
is to ensure the integrity of these vital market functions and public
confidence in them.
In that regard, some in the industry have urged greater
transparency in the CFTC's Commitment of Traders Report (COT) by
distinguishing among the market participants that currently comprise
the category of ``commercials'' for each market. They argue that the
current reporting system does not appropriately distinguish between
traditional commercial activity and non-traditional commercial
activity, such as that involving the hedging of commodity index
exposure by swap dealers. Questions also have been raised as to whether
the COT report should show professionally managed funds, including
hedge funds, as a separate category, rather than include them with
other non-commercial traders. On the opposing side, however, are those
who argue that greater transparency may come at the cost of
compromising the confidentiality of traders' proprietary information.
In the coming months, the CFTC will consider these issues in a
deliberative fashion through a process that is fully transparent to the
public.
Surveillance Methods Used To Monitor Large Traders--Including Hedge
Funds
The CFTC relies on a program of market surveillance to ensure that
markets under CFTC jurisdiction are operating in an open and
competitive manner, free of manipulative influences or other price
distortions. The heart of the CFTC's market surveillance program is its
Large Trader Reporting System. This system captures end-of-day
position-level data for market participants meeting certain criteria.
Positions captured in the Large Trader Reporting System make up 70 to
90 percent of all positions in a particular market. The Large Trader
Reporting System is a powerful tool for detecting the types of
concentrated and coordinated positions required by a trader or group of
traders attempting to manipulate the market. For surveillance purposes,
the large trader reporting requirements for hedge funds are the same as
for any other large trader.
Using the large trader reports, CFTC economists monitor futures
market trading activity, looking for large positions and large trades
that might be used to manipulate prices. Each day, for all active
futures and option contract markets, surveillance staff members monitor
the daily activities of large traders and key price relationships. In
addition, CFTC market analysts maintain close awareness of supply and
demand factors and other developments in the underlying cash markets
through review of trade publications, government reports, and through
industry and exchange contacts. The CFTC's surveillance staff routinely
reports to the Commission on surveillance activities at weekly
surveillance meetings.
In addition to the efforts of the Commission staff, each futures
exchange is required under the Commodity Exchange Act to affirmatively
and effectively supervise trading, prices, and positions, and the
Commission examines the exchanges to ensure that they have devoted
appropriate resources and attention to fulfillment of this important
responsibility. All of these efforts are reported upon regularly to the
CFTC's commissioners. The Commission's reports on its rule enforcement
reviews of the different futures exchanges are posted on our Website at
www.cftc.gov.
Finally, the CFTC conducts an aggressive enforcement program that
prosecutes and punishes those who break the rules. Nearly one-third of
the CFTC's resources are devoted to its enforcement program. The
punishment meted out as the result of enforcement proceedings deters
would-be violators by sending a certain and clear message that improper
conduct will be detected and will not be tolerated. The Commission has
brought approximately 72 enforcement actions involving commodity pools
and commodity pool operators in the last 7 years. The defendants in
these enforcement actions offered investments in what were advertised
as hedge funds or commodity pools in which investor funds were
misappropriated or misused, or where customers were solicited based
upon false track records.
Hedge Funds and the Futures Industry's Clearing System
The collapse of Long Term Capital Management in 1998 highlighted
concerns about the risks potentially posed by a large hedge fund on the
financial system as a whole. Within the futures industry, the
clearinghouse affiliated with each exchange and the clearing member
firms of each clearinghouse play a critical role in ensuring that the
financial distress of any single futures market participant, whether or
not that participant is a hedge fund, does not have a disproportionate
effect on the overall market.
All market participants must have their futures transactions, and
the positions resulting from such transactions, cleared at a futures
clearinghouse through a clearing member firm of that clearinghouse.
Such clearing member firms must be CFTC-registered futures commission
merchants (FCMs). FCMs are financial intermediaries that must adhere to
CFTC-specified minimum net capital requirements.
Futures clearinghouses use a variety of financial safeguards to
protect the clearing system from the financial difficulties of any firm
that is part of that system. A clearinghouse's financial safeguard
system involves multiple tiers. The first tier includes the margin
money deposited by clearing member firms on behalf of their customers
and their own proprietary accounts. The second tier may include the
capital of the clearinghouse in excess of the working capital required
for continuing clearinghouse operations. Clearinghouses also maintain
guarantee funds that accrue value over time. If all of these funds are
exhausted, many clearinghouses have the right to assess clearing
members for unsatisfied obligations. Clearinghouses also hold credit
lines to ensure that funds are immediately available in the case of an
emergency. Finally, clearinghouses perform periodic risk evaluations of
clearing member firms in an attempt to detect potential weaknesses in
financial condition or risk controls. In addition, each clearing member
firm has its own financial safeguards in place to protect itself from
the financial distress of a customer--including a hedge fund customer.
The CFTC's Oversight Authority With Respect to Hedge Funds
A hedge fund with positions in contracts under CFTC jurisdiction is
a ``commodity pool'' and its operator or its adviser are required to
register with the CFTC as a Commodity Pool Operator (CPO) or Commodity
Trading Advisor (CTA), unless an exclusion or exemption from
registration is available. Notably, the operators and advisors of
commodity pools, but not the pools themselves, are required to register
with the CFTC. Once registered, the CPO must comply with certain
disclosure, reporting, and recordkeeping requirements and become
subject to periodic examinations. Currently, there are approximately
1,800 CPOs and 2,600 CTAs registered with the CFTC.
The disclosure and financial reporting format for registered CPOs
and CTAs is designed to ensure that prospective and actual participants
in commodity pools receive all information that would be material to
their decision to make, or maintain, an investment in a pool. To that
end, at the point of sale, CPOs and CTAs are required to provide
certain disclosures to prospective investors regarding the pool's
investment program, principal risks factors, their conflicts of
interests, and performance data and fees. Thereafter, CPOs must provide
pool participants with an account statement at least quarterly and an
annual report containing a financial statement, which must be audited
by an independent public accountant and presented in accordance with
Generally Accepted Accounting Principles (GAAP).
CFTC regulations provide a simplified regulatory framework for CPOs
and CTAs under certain conditions. Many hedge funds are eligible for
this simplified framework. The most significant relief is for pools
that are offered only to ``qualified eligible persons'' who meet
certain net worth and sophistication standards under CFTC Regulation
4.7.
CPOs and CTAs registered as such generally must be members of the
National Futures Association (NFA), an industry self-regulatory
organization. In practice, the CFTC has delegated many of its
regulatory responsibilities in this area to the NFA, including the
registration processing function, and review of disclosure documents
and financial statements.
To this point, I have outlined what CFTC regulation involves. It is
equally important to note the limits of that regulation. The CFTC does
not prescribe the form of organization of pooled investment vehicles,
nor does it impose limits on the fund's market risk appetite, the
instruments that may be traded, the fees charged, or who may
participate. Although the CFTC reviews financial statements to see that
they include all required information and conform to applicable
accounting standards, the review does not include an analysis of the
transactions themselves.
This concludes my remarks. I look forward to your questions.
______
PREPARED STATEMENT OF HON. RICHARD McCORMACK
Senior Advisor, Center for Strategic and International Studies
May 16, 2006
Mr. Chairman and Distinguished Members of the Subcommittee:
My name is Richard McCormack. I am a senior advisor for the Center
for Strategic and International Studies and a former Under Secretary of
State for Economics. I appreciate the opportunity to testify before
this Subcommittee on the issue of derivatives and hedge funds. The
hearings today are very timely.
During the past several months, there have been a number of
important speeches by U.S. officials on derivatives and hedge funds. A
February 28 presentation by Timothy Geithner, President of the Federal
Reserve Bank of New York, describes some of the potential challenges to
financial stability posed by this very large industry. On March 9,
Assistant Secretary of the Treasury, Emil Henry, formerly from Wall
Street, provided an excellent overview of the industry and noted some
of the technical questions that require further attention.
Virtually everyone who understands the derivative industry
recognizes its value to the economy in its ability to manage and
diffuse financial risks by individuals and companies. It also generates
large profits for many of those participating in this industry, as well
as the potential for losses, particularly during periods of turmoil in
financial markets.
Some derivatives also contain the potential for abuse. For example,
Italy secured entrance into the Euro by purchasing exotic derivatives
that obscured the true financial condition of the country until after
they were admitted. A similar situation occurred when some Japanese
banks purchased derivative instruments which disguised the actual
catastrophic state of their balance sheets at the time. And we all
remember problems with Enron and other institutions where derivatives
played a key role in clouding the actual financial condition of
individual institutions.
We also know that in the past there have been spectacular examples
of turmoil in financial markets that were caused by honest
miscalculations by important players in the derivative industry. The
Long-Term Capital Management debacle of 1998 was the most recent
example, and it potentially threatened the integrity of the financial
system.
It is important to remember, however, that for each Enron type
problem that surfaces in connection with derivatives, there are
thousands of derivative transactions that occur every day which benefit
all parties involved. For that reason, it is important to approach the
potential problems with great care and sophistication.
The challenge we have now is to examine this industry, with the
help of those deeply involved in it, to correct, if we can, any
structural or technical problems that could increase the likelihood of
systemic risk in the event of future shock to the financial system,
such as the Russian default in 1998. Political risk and market over
reaction in a crisis are difficult to prevent or completely factor into
economic risk modeling.
History suggests that we may not be totally successful in efforts
of prevention, and that any future financial turmoil may well resonate
in parts of the derivative market.
Furthermore, there is no such thing as a permanent fix to problems
in the derivative industry. This industry is so dynamic that its
strengths and weaknesses change every few years. Ten years ago, credit
derivatives were a tiny blip on the screen. Today these credit
derivatives, which provide a kind of default insurance to creditors,
are the fastest growing segment of this industry, as much as $15
trillion notional value.
Last year when serious operational problems in credit derivative
markets alarmed regulators, Gerald Corrigan, a former senior Federal
Reserve official, now with Goldman Sachs, led an effort to identify and
repair these problems. This effort was a good example of how industry
and regulators can work together to address problems on the operational
side of the derivative business. The Report of the Counterparty Risk
Management Policy Group of July 27, 2005, is a masterpiece of its kind.
The larger institutions in the derivative business have subsequently
moved to comply with needed reforms by hiring expensive software and
putting systems in place to expedite the clearance process.
It has taken some effort, however, by the New York Federal Reserve
to get the second tier hedge funds which were involved in this business
to make the needed investment in back office staff and systems. Other
potential problems have also been addressed, such as credit risk that
poorly vetted counterparties might pose if those offering derivative
insurance do not have the capital strength to pay up in event of major
defaults. These and other reforms make it more likely that institutions
will only have to worry about market risk, not potential legal
challenges and operational uncertainties.
Beyond operational risk, market risks pose another set of issues.
The global macro economic picture today is highly positive, with
global growth at 5 percent and with several years of U.S. growth
exceeding 4 percent. Long periods of growth and prosperity tend to
induce a certain amount of complacency in financial markets. It is
important, however, to remind the growing number of pension funds and
other more recent derivative investors that the business cycle still
exists. There are potential vulnerabilities in the global economy that
could impact financial markets at some point, as I have noted in a
recently published analysis, which I would like to attach as an
appendix to my testimony.
Mr. Chairman and Distinguished Members, I would like to conclude my
remarks by making several recommendations and observations.
First, all involved need to continue efforts to better understand
the rapidly evolving derivative and hedge fund industries. For example,
estimates of the total size of the notional value of over-the-counter
derivative contracts outstanding vary widely. The President of the New
York Federal Reserve Bank estimates the number at $300 trillion. The
Bank for International Settlements places the number at $270 trillion,
while the International Swaps and Derivative Association estimates a
notional value of $219 trillion.
Even value at risk, which is a much smaller number, is subject to
varying interpretations and estimates.
When rounding errors for estimates for notional value of
outstanding derivative contracts are in the tens of trillions of
dollars, it is hard to have total confidence that we understand all the
potential vulnerabilities that may exist in this industry.
Second, in his February 28, 2006, presentation on financial risk,
Mr. Geithner raises the possibility of a potential rush to the exit by
highly leveraged derivative holders during a future period of market
turmoil. This development could lead to liquidity shortages and markets
failing to clear efficiently. Liquidity shortages are why markets melt
down so fast and overshoot in some crises, as was the case in the 1987
stock market debacle. Obviously the Federal Reserve can play a role in
addressing certain kinds of liquidity shortages in a crisis, but
individual investors should be mindful of the need for an adequate
capital cushion to address potentially unfavorable market developments.
The issue of potential liquidity shortages during a crisis is one that
deserves further study.
As more and more investor groups and pension funds become involved
in the derivative business, after a long period of growth and economic
stability, some investors may be tempted to take on risks that they do
not fully understand. Should early signs of possible vulnerability
begin to appear, the most sophisticated investors will, of course,
quickly shed risky investments. Remember for example, what happened to
Argentine bonds: Before the spectacular default, they ended up in the
hands of Belgian dentists and Italian pensioners. These hearings should
serve as a reminder to investors of the oldest lesson in business
dealings: caveat emptor--let the buyer beware. Complex derivatives are
not a place for amateur investors. There is an enduring connection
between high yields and high risk.
The derivative industry itself has a powerful incentive to avoid
the fraud, abuse, and blunders that could lead to massive losses,
scandals, and crippling future regulation. The statesmen in the
derivative industry are also best positioned to point out to regulators
potential structural problems and those few in their ranks who may be
engaged in unscrupulous or sloppy business practices.
Third, regulation of the derivative industry is faced with a
fundamental dilemma; if government regulates the industry so tightly as
to avoid all risk of market failure, it will kill a valuable part of
the financial system. Finding the right middle path in this constantly
changing environment is a challenging task that can only happen with
the closest collaboration between the most sophisticated parts of the
industry and their counterparts in the regulatory and political
systems.
The U.S. regulatory system monitoring the financial industry is
highly fragmented. Because of rapid changes in the industry itself,
investment banks, hedge funds, and government-sponsored groups such as
Fanny Mae have taken over functions that were once the prerogative of
banks. Since banks are more highly regulated, there has been a trend of
doing more and more financial business in areas where there is less
official regulation. This includes the offshoring of some of the
industry to places such as the Cayman Islands.
If the government were to start from scratch and design a
regulatory system for today's financial system, it would not look like
the system we now have in place, even though the existing system has
generally served us well. But with the increasingly globalization of
the financial industry as a whole, it is clear that more of the
regulatory emphasis will have to be international in character. We need
to make sure that derivatives continue to be remarkable instruments of
wealth creation, global development, and risk diffusion, and not as
Barton Biggs, Morgan Stanley's chief global strategist once feared
``the nuclear weapon that ultimately blows us all to smithereens.''
Finally, all of us hope that the current global economic boom can
be gently managed downward to avoid potential inflationary problems.
But with the dollar under pressure from our current account problem and
with oil and commodity markets under strain, the potential exists for a
somewhat more rapid market correction at some point.
The entire global financial system is interconnected by the
hundreds of trillions of dollars in derivatives, which are the subject
of these hearing. For example, any future banking crisis in China,
which slows that economy, will immediately impact commodity prices and
bonds of commodity producers. Any further sustained spike in oil prices
could impact huge segments of the derivative industry. Those holding
some credit derivatives against default could find them costly indeed.
During this current period of relative tranquility and prosperity,
it is important for government and industry to continue efforts to
monitor closely financial markets that could come under future strain
and address new structural problems as they are identified. It will
require judgment, sophistication, common sense, and contingency
planning by all those involved in this valuable industry and their
regulators.
In conclusion, we should not be concerned about the gains and
losses of individual derivative investors. That is what capitalism is
all about, and one of the reasons why this country is so prosperous. We
take risks, we invest capital, and the market apportions the winners
and the losers. Out concern should be potential systemic risk, fraud,
and structural problems that increase the likelihood of these two
broader potential problems. Thank you.
Addendum
LOOKING FORWARD IN WARTIME: SOME VULNERABLE POINTS IN THE GLOBAL
ECONOMY
Ambassador Richard T. McCormack
(March 30, 2005)
The purpose of this analysis is to address several key economic
issues facing the United States and the world at a time when war and
terrorism-related activities may potentially further stress the global
economy. In some ways the global economy today resembles a large truck
racing down the highway at 70 miles an hour, with four or five bald
tires. The odds are that the truck will make it to its destination
intact. But a major accident is also possible. This paper explores some
of those vulnerabilities and is based on recent conversations with
political and financial leaders on five continents. Such confidential
conversations are necessary in today's global economy, because what
happens in one part of the globe often has major consequences,
sometimes quite unexpected, in other parts of the globe. For example, a
ruble crisis in Moscow 7 years ago triggered a meltdown of derivative
positions on Wall Street that posed a threat to the U.S. financial
system itself. That is just one example of the global
interconnectedness of everything.
The consequences of the collapse of large segments of global equity
markets in 2001 continue to plague the global economy. The vast
monetary and fiscal stimuli needed to re float the U.S. economy may
have led to new forms of asset inflation, a bubble in real estate and
very probably also in bond markets, and not just in the United States.
Vast global economic imbalances have also developed, partly as a
consequence of this titanic U.S. macro-economic stimulus.
These imbalances and other current global economic conditions
remind us of several enduring economic lessons, with powerful future
implications. Wise leadership and much good luck may be required to
achieve a soft landing and a gradual shift in global trading patterns
later in this decade.
Equity Markets
How the Stock Market Bubble Grew and Burst
The bursting of the U.S. stock market bubble erased at one point
somewhere between 8 and 9 trillion dollars of wealth. When you add to
this the immense sums that were lost in overseas equity markets during
the same period, the magnitude of liquidity destruction was simply
enormous.
Students of history will remember the famous cartoon by Thomas Nast
about the corrupt Tweed Ring in New York in the late 19th century. The
title of the cartoon was: ``Who stole the people's money?'' It featured
a group of well-fed men standing in a circle, each man pointing his
finger at the next person in the circle.
A similar cartoon could be drawn about the great asset bubble and
bust of the late 1990s. The former head of the Securities and Exchange
Commission points to Congress for failure to heed his warnings.
Congress points to some dishonest people on Wall Street for having
misled investors. Wall Street analysts point to the Federal Reserve
complaisance. The Federal Reserve points to the irrationally exuberant
investors and greedy corporate leaders. The greedy corporate leaders
point to their auditors. The auditors point to permitted complexities
in derivative and accounting rules. And so on around the circle of
blame.
The fact of the matter is the blame is widely shared. There was a
massive systems failure here and a massive loss of wealth when the
bubble burst, particularly for the least sophisticated members of the
investment community, including the elderly, many of whom were left
holding the bag. The leadership of the Federal Reserve has come in for
special criticism because the Federal Reserve is, after all, the
ultimate regulator of the health of the nation's financial system, and
controls margin requirements and the amount of liquidity made available
to the system.
The equity bubble was fuelled in part by accommodative monetary
policies in the latter part of the 1990s. Indeed the world was awash in
liquidity during most of the bubble years. Attractive investment
opportunities grew harder and harder to find. Traditional value
analysts of stocks were increasingly discredited, as market momentum
confounded one after another of their bearish predictions. Available
cash continued to flow into already overpriced stocks, and also into
over-investment in capacity for the production of goods and services.
Telecoms were a prominent example.
People running U.S. monetary policies were obviously highly
competent and experienced individuals. A question now often raised is
why monetary authorities did not heed the timely warnings that appeared
regularly in the Economist Magazine and other respected publications,
and tighten liquidity, or at the very least, increase margin
requirements as a warning signal to dampen the raging speculative
fever.
We also know from subsequently released minutes of the 1996
deliberations of the Board of Governors of the Federal Reserve, that
some of the Governors, including Larry Lindsey and Chairman Greenspan
himself, appeared concerned about the potential for a future
catastrophic asset inflation bubble, as happened in Japan during the
late 1980s.
These troubled deliberations inside the FED occurred shortly before
Chairman Greenspan made his famous ``Irrational Exuberance'' comment at
the American Enterprise Institute.
According to remarks by former Governor Kelly at a conference at
CSIS in the summer of 2004, Kelly in retrospect greatly regretted the
fact that, after 1996, the subject of a potential asset inflation
building in U.S. equity markets never again appeared on the agenda of a
single meeting of the open market committee of the Fed. One wonders why
this lapse occurred.
Experienced financial leaders, such as former New York Federal
Reserve official, Henry Kaufmann, later faulted U.S. monetary
authorities for failure to take preemptive action to slow the
developing asset inflation. They questioned why Chairman Greenspan did
not use his bully pulpit to repeat his warnings about irrational
exuberance.
Friends of Chairman Greenspan reply that, as in the Japanese asset
bubble of the 1980s, low consumer price inflation might have made it
difficult for him to justify to Wall Street and their friends in
Congress the sustained increases in interest rates that would have been
necessary to deflate the bubble when it was much smaller. Some critics
would doubtless have accused him of gratuitously damaging capital
markets. Yet this was the very policy advocated by the IMF, the
Economist Magazine and others.
Several other developments that took place in the latter part of
the 1990s also made it difficult to use a tight money policy to dampen
the U.S. economy and financial markets. In the latter part of 1997, the
Asian financial crisis unfolded with a vengeance. With the strong
encouragement of the U.S. Treasury Department, monetary authorities
poured high-powered liquidity into U.S. financial markets to cushion
the blow from Asia. Interest rates were cut by 75 basis points the
following year.
The Russian ruble and banking crisis subsequently triggered a
series of worldwide repercussions that eventually undermined the highly
leveraged derivative investments of a number of New York hedge funds,
including the respected Long Term Capital Management firm. This
particular hedge fund had leveraged few billion dollars worth of
capital into over a trillion dollars worth of notional value on
derivative markets. Creditors to these derivative speculators from the
money center banks were also sucked into the threatening vortex, which
briefly imperiled the U.S. financial system itself.
Finally, stating worries about the potential impact of the Year
2000 computer glitch, the U.S. central bank preemptively injected large
amounts of liquidity into financial institutions in the fourth quarter
of 1999, delaying the impact of a tightening cycle that began in July
1999.
Chairman Greenspan later said that market warnings unaccompanied by
large and sustained curbs on available liquidity would have had no more
impact on raging bull markets than his original ``irrational
exuberance'' speech.
In 2000 the Federal Reserve System resumed tightening and the
enormous bubble eventually burst after the Presidential elections
amidst widespread recriminations. There is some talk now about the
possible desirability of limits of two terms for future incumbents of
the Chairmanship of the Federal Reserve, the nation's second most
powerful job. The advantage of a Chairman with four successive terms is
that the incumbent accumulates valuable experience from past successes
and mistakes as his tenure in office rolls on. The disadvantage is that
any deep-seated biases and blind spots on the part of a powerful and
influential chairman inevitably become increasingly imbedded in
personnel appointments throughout the institution. The temptation
potentially also may exist for a Chairman wishing successive
reappointments to get too close to political authorities in a position
to reappoint him. Some years from now, economists will have a clearer
idea of the balance of benefits of a very long serving chairman, when
they will be able to assess with the clarity of hindsight the full
impact of the Greenspan legacy.
The Bubble's Consequences and Aftershocks
The vast loss of wealth and purchasing power that accompanied the
erasure of stock values, plus the excess capacity that easy money made
possible, contributed to a threatened imbalance between supply and
demand in some key markets. Profits further weakened and the new
concern became deflation and recession.
To help stimulate demand and off-set the massive loss of wealth
from the collapse of the stock market, the Federal Reserve reversed
itself in 2001 and progressively lowered interest rates, in part to
stimulate the housing market and the borrowing power and net wealth of
homeowners and consumers. Many believe that a new bubble in housing and
real estate has thus been created. The question is if, how much, and
how soon will overall property markets weaken?
In considering these questions, it is important to remember that
while mortgage interest rates in recent years were at historically low
levels, rising insurance rates, local taxes and energy bills in the
United States and elsewhere have steadily added to the cost of real
estate ownership. It is also important to remember that current low
interest rates will not last indefinitely. Indeed, a rising cycle of
interest rates is already underway. Rising commodity and producer
prices and other indicators suggest possible future inflationary
pressures in sectors of the U.S. economy. Should broad inflation return
and interest rates rise beyond the levels that many now anticipate,
large-scale holders of fixed rate mortgages and their derivatives will
be vulnerable. Fanny Mae, Freddy Mac, and those who hold the riskier
paper hived off in massive derivative transactions are sometimes cited
as weak links in such scenarios. This potential vulnerability has
belatedly become apparent to U.S. regulatory authorities, some of whom
are now calling for an 80 percent reduction in the trillion and a half
dollar mortgage asset holdings of Fanny Mae and Freddy Mac.
In England, where housing costs rose 25 percent in a single recent
year, history suggests a possible repeat of the housing bubble that was
created and burst during the tenure of former Chancellor Nigel Lawson.
This bubble, before collapse, triggered inflation and required
draconian monetary retrenchment. This in turn contributed to the sour
political climate that ended Margaret Thatcher's historic prime
ministership, and helped leave the Conservative Party in shambles from
which it has not yet recovered 10 years later. Recently the latest boom
in English property markets was noted with concern by the IMF, and is
now the subject of close attention by the Bank of England.
The behavior of bond markets is also a troubling phenomenon. Short
and long-term yields show remarkable little differentiation, by
comparison with historical standards. The same can be said for the
collapse in spreads between government and corporate bonds. Markets
seem to have forgotten the recent default of Argentina on its 100
billion dollar bond portfolio, and the fact that during the next
serious downward move in the global business cycle, other
democratically elected leaders in emerging markets will face
constituent pressures to use President Kirchner's 70 percent write off
as the standard against which to negotiate with their own bond holders.
But the problems go well beyond emerging markets. What are the
prospects that Japan's titanic quantity of l percent bonds will be an
attractive proposition 5 years from now? The same can be said for other
bonds, including the remarkably low spread on France's recent 50 year
bond offering. Those bringing the bonds to market will pocket their
commissions. Whether the long-term bond-holders will be as fortunate,
is a very large question. Earlier relatively low consumer inflation
meant that central banks in many countries, including the United
States, Japan, and England, had the opportunity to generate a vast
amount of liquidity, big piles of which have wound up in asset markets
of all kinds. The question remains about the medium and long term
sustainability of these bond and other asset prices, leading to a
further question about a possibly painful hang over after the party
ends.
In property, bond, and equity markets, as in much else, a great
deal obviously depends upon the future trajectory of the U.S. business
cycle. Massive fiscal and monetary stimulus has been applied in the
past several years, a need anticipated by President Bush's economic
advisors as he came into office. This enormous economic stimulus has,
however, also contributed to a massive increase in the U.S. current
account deficit and a dramatic weakening in the U.S. dollar. No one
should be surprised at this latter development. The oldest rule in
economics, following the law of supply and demand, is that the surest
way to weaken a currency is to print too much of it. Today's dollar
buys half the house, a fraction of the college costs and medical
attention, and far less gasoline than it could have purchased a decade
ago. As the dollar weakens on international markets, its purchasing
power in other areas is also likely to erode with time.
Members of the Austrian monetary school take a grimmer view of the
long-term consequences of the generous monetary policies of recent
years. They believe that the subsidized interest rates, repeated bail-
outs, and asset inflations they have financed since 1997 will only
postpone a far larger future economic and financial crisis. The
Austrian school favors a cautious monetary policy and a prevention of
asset inflation, rather than the bailout model now favored by the Fed
and supported by Wall Street.
Because of a lack of information, most outside observers are not
yet ready to offer a definitive judgment on this dispute between the
Austrian school and Greenspan policy preferences. We may all know the
answer to this very large question, however, within 5 years, unless the
tipping point trigger which sets off any future large scale crisis is
in itself so dramatic that it obscures the true role of any past
underlying monetary policy mistakes and vulnerabilities.
U.S. Vulnerabilities
Future Prospects--A Global Tour
Should the Iraq war end soon, not spread to other neighboring
countries such as Iran and Turkey, and terrorism problems remain
manageable, prospects for continued growth in the American economy in
2005 appear positive at present.
A gradually weakening dollar, although a potential source of
sectoral inflation and higher U.S. capital costs, should also
eventually encourage more investment in manufacturing and in the
production of other tradable goods in the United States. However, any
rapid fall in the dollar would create many problems both domestically
and abroad. Export dependent economies would face recession and
financial dislocations, and the United States would experience both
sectoral inflation and increase in the cost of capital, which would
also impact housing markets and consumers here.
Should the conflict and follow up with Iraq prove longer and more
expensive than anticipated, should terrorists strike key economic
targets in the United States, or sabotage impact oil shipping and
production facilities beyond those damaged in Iraq itself, U.S. and
global economic recovery could be derailed for a period depending on
the severity and duration of the disruptions.
In 1990, the first Bush Administration delayed release of oil from
the stockpile until the very eve of the Gulf war. This decision, plus
the firing of the Kuwaiti oil fields and the embargo against Iraq's
oil, led to an increase in oil prices and inflation in the United
States and elsewhere. At present oil markets are already tight. Should
the conflict with Iraq spread to neighboring oil-producing economies,
directly or indirectly through terrorism or civil unrest, the oil
shortage scenario of 1990 could easily be repeated on a larger scale.
Because oil prices are already very high, the impact of any further
tightening of oil markets could be quite dramatic.
Japan's Malaise
Vast fiscal efforts to prime the pump and delay painful
restructuring of the Japanese economy in the aftermath of the collapse
of the Japanese asset bubble in 1990 have contributed to a massive
public debt. The OECD estimates that this debt equals at present 169
percent of Japan's entire gross national product, the largest by far of
any member of the industrialized world. Other well informed observers
believe that Japan's actual public debt and contingent liabilities are
far higher than even the OECD estimates. Japan is able to service a
debt of this magnitude only because interest rates, in a deflating
economy, are only about 1 percent in nominal terms. But what happens to
all those 1 percent bonds when the inevitable day comes that interest
rates rise to support the greater risk that this huge and growing debt
entails? Who will want to buy these bonds should perceived risk and
inflation mount? And what will happen to the banks and insurance
companies now holding many of these 1 percent bonds as collateral and
capital? Indeed, the Governor of the Bank of Japan recently worried
aloud about the exposure of his own institution's balance sheet, should
future inflation and interest rates undermine the value of the Bar s
vast and growing bond holdings. According to media accounts, today the
Bank of Japan holds a greater percentage of Japanese Government bonds
than even during the peak war year of 1944. If true, that is an
astounding fact.
Dealing with Japan's multiple structural, financial, and economic
problems must inevitably involve some short-term increase in
bankruptcies and unemployment, as part of a fundamental transition.
More so-called zombie companies, kept alive by constant transfusions of
loans from banks, will eventually have to be closed. Alternative policy
would involve ever more bad debt piling up in the banks. Much of
Japan's political class was resistant to policies involving short-term
adjustment pain in the interest of social and political stability, so
the debt buildup continued and continued. Japanese officials were,
however, remarkably skillful and successful at the management of most
perceptions abroad about the actual state of the Japanese economy and
finance at any given moment, despite the 15 years of stagnation and
false recoveries since the bursting of the great Japanese asset bubble.
A year ago, however, former Finance Vice Minister Ito published in
the Financial Times a credible plan for addressing some of Japan's
financial and structural problems. It contained the following elements:
1. Since Japan's central bank had failed to grow the money supply
sufficiently with lower interest rates alone--the money supply
grew by only 2 percent during one recent 12 month period--Ito
urged unconventional measures to inject money into the economy.
In current circumstances, broad deflation could only be cured
by a monetary expansion.
2. Japan must gradually control excesses in deficit financing to
avoid a fatal debt buildup, and eventual crisis in debt
servicing. Ito also believes that the tax system and public
spending patterns must be reconfigured to encourage greater
aggregate demand.
3. The non-performing loan problem must be progressively solved, so
that Japan's capital could be put to higher and more productive
uses than supporting zombie companies. The banking system
needed reform, injection of public money, nationalization of
some banks, more mergers of others, and the outright closure of
some weaker banks.
If a program such as this is not consistently implemented over the
next few years, the debt buildup in Japan may eventually trigger a
crisis that could shake the Nation to its roots, destroy an immense
amount of wealth, require a massive use of the printing press at the
Central Bank that will be highly inflationary, and force Japan to face
its problems with a vastly reduced capital and savings base. Even with
interest rates at slightly over 1 percent, government debt service
charges already absorb more than one fifth of Japan's annual budget.
Prolonged oil price increases, a war in Korea, or a deep future
U.S. recession would of course put immense new pressure on the Japanese
economy and finances. Fortunately, a highly competent man, Mr. Fukui,
has recently been named head of the Bank of Japan and has begun a
reform effort. No one should envy this man. He has inherited a massive
problem now under increasingly stressful geopolitical conditions: The
dollar weakens. The competition from China intensifies. Aging Japan's
demographic trends accelerate. The public debt mounts.
The Argentina Example
Argentina is an example of a country which delayed facing its
problems until it was too late. The Argentine economy eventually shrank
by 25 percent over a 4-year period. The banking system and a large part
of the country's domestically held savings were lost. Capital flight
added to the disaster. The crisis itself accompanied desperate last
minute measures by Finance Minister Cavallo, which further undermined
the country's capital-base and economy. The political class was largely
discredited. Demagoguery and finger pointing formed an important part
of the public discourse. A key problem in Argentina, as in Japan, was
that the abler parts of political class were unable for years to
implement a sustainable reform program. In the end, foreign holders of
a hundred billion dollars worth of Argentine bonds were left holding
the bag in one of history's largest defaults. After an excruciating 2
years, soaring global prices for Argentina's agricultural and commodity
exports and the default on Argentina's foreign creditors, allowed
growth to resume in Argentina, but at the cost of Argentina's long term
creditworthiness and foreign investment prospects.
The most expensive bill from the Argentina default may be the new
precedent for other future bond defaulters in emerging markets. Which
future democratically elected leader with debt service problems will be
able to demand less than President Kirchner extracted and received from
his defaulted bond holders? This is likely to become a very live issue
during the next serious downturn in the global business cycle.
Brazil's Highwire Act
The high ratio of debt to GDP of Brazil is a major source of
concern. International institutions consider that ratios above 50
percent in emerging markets could expose countries to crisis. Such high
ratios may not seem threatening in Europe and the United States because
of higher capacity of raising government revenue. Theory and data do
not provide a reliable measurement of the sustainable debt/GDP ratio
for any country. The internal debt of Brazil was 55.5 percent of GDP in
2002, increased to 57.2 percent in 2003 and declined to 51.1 percent in
2004. Vulnerability exists at the point when investors may not be
willing to purchase government securities at a ``reasonable'' cost,
forcing default. It may not be feasible empirically to measure such a
point. In order to reduce the debt/GDP ratio, Brazil must continue its
prudential fiscal management of primary budget surplus, which is now
close to 5 percent of GDP. Simultaneously, Brazil converted a current
account deficit into a current account surplus of close to 2 percent of
GDP by reversing a trade deficit into a trade surplus of more than $30
billion. Simultaneously, the economy is growing again. There are still
many challenges in Brazil, in particular, tax and labor reform, which
would modernize the country, allowing better control of its own
destinies.
Similar problems exist in other major Latin American nations. Much
of the work done in the 1980s to encourage the adoption of market based
economic reforms in Latin America has been undermined by policy
failure, some corrupt and discredited privatizations, and similar
mistakes. But as the former President of Bolivia stated 2 years ago:
``The hangover facing our region is not due to the reforms we have
made, but to the reforms which we have not yet made.''
As in Argentina, however, soaring world commodity prices have
boosted economic growth in many parts of Latin America to levels not
seen since the commodity boom of 1980, a boom which ended in tears in
1982, and a lost subsequent decade of economic growth for the whole
continent. There is no substitute for getting overall policies right
for sustainable balanced economic development. Otherwise heavily
indebted commodity dependent economies will continue to be hostage to
the full impact of the booms and busts that accompany the global
business cycles.
The United States has a very large stake in the outcome of the
intensifying struggle between the demagogues and the sound economists
in many parts of Latin America. Our stake in economic growth is equally
high in other parts of the globe. Unsustainable U.S. trade deficits
cannot be corrected without a major global recession unless growth and
demand elsewhere contribute to the solution. This plus other measures
would then help permit an orderly shifting of global trading patterns.
The Euro Dilemma
In Europe, Germany's key economy is weakening with core
unemployment exceeding 10 percent. Major structural reforms in labor
markets, pension systems, and other aspects of the German economy are
urgently needed. Prime Minister Schroeder has accomplished a modest
increase in labor market flexibility. Politics impedes a broader
assault on imbedded problems, which may not be resolved until Germany's
two large parties join in a broad coalition to force through needed
legislation. Other serious structural problems exist elsewhere within
the Euro zone, recently worsened by the European Union's strengthening
currency against the dollar zone. Because of the internal trade within
the expanding European Union, and because of favorable relative energy
prices in Euros, the impact on Europe's economy of the latest currency
shift is less dramatic than some predicted. Still, Europe depends upon
exports to the dollar zone for millions of jobs, and reduced
competitiveness because of its strengthening currency may encourage
some European leaders to turn even more heavily to high profile global
politics in controversial areas to secure export markets. The Middle
East and China are only two of several such theaters where
international politics heavily impact local procurement and mineral
concession decisions. This then could create more strain on Europe's
ties with the United States, and potentially more strain on the
economic side of the relationship in future discussions of trade and
technology across the Atlantic.
The China Question
China's intense national ambition rapidly to become the dominant
Asian power, its low wages and its undervalued currency have unleashed
trends that threaten to turn that country into an engine of deflation
in sectors of manufacturing. Over supply of goods continues to cause
profit problems for competitors both within China and abroad. Many of
China's 150,000 state owned enterprises, burdened with antiquated
facilities and heavy benefit programs for their workers, remain in
business only because banks are required to provide ``loans'' to
subsidize their operations and prevent unemployment. This is
contributing to a bad loan problem that may rival that of Japan in its
size and potential implications for the future.
Indeed, mismanagement of banking and finance has been the
traditional Achilles heel of the Asian development model, and China is
not likely to prove a long-term exception to this rule. But in the
meantime, China's exports are expanding at a frantic pace--more than 30
percent per year on a compound basis. According to The Economist
magazine, export industries and international commerce now contribute
directly and indirectly more than 50 percent of China's entire two
tiered national economy. This soaring trend in export growth cannot
continue indefinitely without major consequences for the stability of
China, China's trading partners, and for the global trading system as a
whole.
The U.S. Deficit
This brings us full circle to the United States, where we have a
net debt from accumulated trade deficits now approaching three trillion
dollars, a debt that must be serviced with interest and profit
remittances. This year the U.S. trade deficit is projected to increase
to a yearly total of over 700 billion dollars. (China alone contributes
$135 billion to this figure.) This unsustainable trend has already
helped drive the dollar down against the Euro and other floating
currencies.
Predicting short-term currency trends in today's volatile
conditions is difficult, partly because of massive intervention in
Asia, and partly because the dollar's competitors, the yen and the
Euro, are based on economies that are themselves deeply troubled.
Nevertheless, the massive, growing U.S. current account problems leave
the dollar extremely vulnerable in the short and medium term. Should
the dollar continue to fall, the U.S. market will be less available to
overseas exporters, regardless of our trade and tariff policies.
Past U.S. trade policy concentrated on opening U.S. and global
markets. We are now engaged in a new round of trade negotiations aimed
at further trade liberalizations. But if we do not succeed in creating
opportunities for the United States to reduce its trade deficit--which
continued at record levels even during a past recession--the dollar may
continue to fall and this will have consequences.
Moreover, persistent global ill-will toward, or misunderstanding
of, U.S. foreign policies could trigger a de facto overseas boycott of
U.S. goods and services far beyond Macdonald's currently flagging sales
in the Arab world, or the disappearance of the Marlborough cowboy from
many of its earlier marketing sites throughout Europe, as a now
negative symbol. Such attitudes overseas could have long-term
implications for Boeing and other big-ticket U.S. exporters, which now
contribute importantly to our balance of payments. They could also
create long-term strategic commercial opportunities for U.S.
competitors in Europe, the Middle East, Latin America, and Asia.
The Promise--and Limits--of Economic Prospects
As we consider the economic developments of the past century, the
trends are overwhelmingly positive. Technology, science, democracy,
education, and productivity have improved the quality of life for
billions of people on this planet. Ancient illnesses have been fought
and defeated. Drudgery in daily life and work has been dramatically
reduced. These trends will certainly continue and intensify in our
present century.
But there have also been bumps in the road of progress. Debt
problems, demagogues, wars, asset and consumer price inflation, and
over investment in capacity, have taken their toll in blighted lives,
recessions, and a major depression during the past century. We believe
we understand now, better than before, how to cope with fundamental
economic problems. While we can learn from the past, it is important,
however, to recognize that each major economic accident impacting the
national, regional, and global economy has been unique. Attempting to
build precise models based on past situations has thus far not been
very successful in predicting the next economic crisis. In this sense,
notwithstanding all the advanced mathematics and powerful computers,
economics is still a young science, still learning, still attempting to
build paradigms that will allow us all to peer into the future with
more confidence to avoid costly debacles. In the meantime we have to
look beyond our computers to assess deeper vulnerabilities.
This is not going to be easy. Human nature, with all of its
complexity and vulnerabilities, operates on the basis of emotions,
values, drives and ambitions the impact of which is difficult to
quantify. Statistics will continue to be flawed by false data fed into
powerful computers. Confidence will suddenly collapse from time to
time, triggering runs on banks and countries. Poorly supervised rogue
traders in banks and hedge funds will periodically trigger vast losses
to shareholders and investors. Political leaders will not always be
totally candid with their followers and their countries' creditors.
Politics itself is an unpredictable factor, as is war. People also make
honest mistakes.
Painful old lessons about such dangers as asset inflation and over
concentration in the financial industry will have to be relearned. As
each generation dies off with its deeply imbedded memories of booms and
busts, the snake oil salesmen will again appear in force, together with
their witting and unwitting accomplices in corporate and public life.
There will always be a powerful lobby for a major redistribution of
wealth, whether through taxes or monetary policy measures.
Three other issues deserving special attention are problems in the
global exchange rate system, some aspects of the derivatives industry,
and any underestimation of strain on public finances that could produce
renewed inflation.
Global Exchange Rates
When floating exchange rates were adopted after the collapse of the
Bretton Woods system, policymakers expected the new system to trigger
automatic adjustments in the balance of payments.
Reality proved more complicated. Some mercantilist countries
endeavor to influence currency directions with interventions, dirty
floats, fixed arrangements, and large-scale capital transfers of
various kinds. Competitive currency devaluations can substitute for
tariffs and other non-tariff barriers as an important regulator of the
terms of international trade.
Over the long term, floating exchange rates have proven their value
to most countries with sound regulatory systems. But in the short term,
currency interventions by those with fixed exchange rates of various
kinds have greatly complicated international trade, and contributed to
the large sustained U.S. trade deficit. Such undervalued currencies
disadvantage competing manufacturers in the U.S. and elsewhere. The
export-favorable currency of China also encourages more investment in
local manufacturing than the global market can absorb without producing
future deflationary pressures and broader dislocations.
China's economic development is a good thing, not a bad thing. But
some of China's policies to jump-start a once moribund state run
economy can be dangerous to China and others if continued too long.
Recent international efforts were made to persuade China to allow its
currency to appreciate. This is because the undervaluation of China's
currency does not involve only China, but the whole East Asian
production complex. None of the neighboring countries that form China's
hub and spokes trading system can afford to revalue its own currency
unless China leads the way.
Appeals for an immediate currency revaluation have been rejected.
China cites concerns for its strained banking and political system if
growth and export rates taper off for any reason.
Therein lies the great dilemma. China says that it cannot afford to
slow down its titanic export drive, and the United States simply cannot
afford to accumulate current account debts at the accelerating pace of
the past few years.
Thus, if internal problems with China's banking system, energy
supplies, politics, and environmental conditions do not ease China's
torrid pace of export expansion, China's competitors abroad will surely
seek ways to slow down the juggernaut. This would allow time and space
for other economies, including those in the Western Hemisphere, to grow
and adjust. This is what happened in the mid 1980s to blunt Japan's
massive export drive, which also was fueled in part by state
capitalism, an undervalued currency, multiple non-tariff barriers,
rampant theft of intellectual property and an intense national ambition
by the country's leadership to achieve U.S. standards. The fact remains
that the U.S. cannot continue to accumulate debt via its collapsing
current account position at this pace much longer without undermining
the dollar as a reserve currency, radicalizing its domestic politics,
and eventually compromising its global strategic position.
Although China has accumulated more than 600 billion dollars worth
of foreign exchange reserves to cushion any future problems, China's
fears about its own vulnerabilities should not be ignored. China's
economy faces serious problems, problems not always fully captured by
released official statistics. Although China's economy is stated to be
growing at a 9 percent annual pace, China's stock market is at a 6-year
low, as of early 2005. Presumably the companies listed on the stock
exchange are among China's best. Their sagging value may say a great
deal about the financial health of the other building blocks of the
Chinese economy, namely the individual companies. Stock markets tend to
be leading, not lagging, economic indicators.
The Problem With Derivatives
In our time, derivatives have added vast new areas of uncertainty.
There is somewhere between 100 and 125 trillion dollars worth of those
useful instruments outstanding today. While derivatives do reduce risk
to individuals and companies, they also spread that risk, often in
highly leveraged form, to other individuals, institutions, and in
extreme form to the financial system itself--as we saw with the Long-
Term Capital Management hedge fund debacle. Some large money-center
banks, which are creditors to major derivative issuers, are thought by
some to be at risk under some possible scenarios.
It requires a high degree of technical skill, and unusual
dedication and effort for outsiders to penetrate constantly evolving
derivative markets and understand where the evershifting
vulnerabilities lie. This cannot be accomplished by the average
investor, who is likely to have no idea what recent gambles a firm's
management may have made on derivative markets until the bad news of a
massive loss suddenly hits the street. Many have urged greater
transparency in derivative reporting. Even Warren Buffett and his
skilled associates threw up their hands after attempting to penetrate
the explanatory footnotes on the potential derivative related
liabilities of some money-center banks.
Fighting Terrorism: Balancing Short-Term Costs and Long-Term Goals
Beyond the problem of finding a solution to the global imbalances,
the greatest uncertainty facing the American economy undoubtedly has to
do with the unpredictable elements of war and terrorism, and the
potential for disruption of economic targets, including energy related
production and transportation facilities. The Venezuelan and Nigerian
oil production disruptions have complicated all this.
Each year since 9/11, economists at the IMF have attempted to
calculate the potential economic impact of perceived geo-political
uncertainties that could cut projected global economic growth.
One of the reasons for this effort is the vast disproportion
between the costs of mounting terrorist attacks and the damage that
such attacks can inflict on advanced, open and vulnerable economies
like ours. A year after the 9/11 attack, one of Washington's major
public policy institutes assembled a group of economists to assess
these relative costs. At that time, they concluded that the 9/11
attacks on the Twin Towers and Pentagon had cost Al-Qaeda about
$250,000 to mount. The assembled economists calculated that the net
cost to the American economy of this attack, direct and indirect,
exceeded $800 billion dollars. This included the damage to financial
markets, transportation industry, insurance industry, hotel industry,
the buildings themselves and the titanic costs of striking back at
terrorists and protecting the country from future attacks. In the
meantime, new costs have arisen as pressure for more domestic defensive
measures has developed.
Knowledge that terrorists have targeted civilian aircraft with
cheap anti-aircraft missiles, for example, generated proposals to equip
civilian planes with anti-missile systems at a cost of $10 billion
dollars. The war with Iraq, partly aimed at avoiding possible future
Iraqi cooperation with terrorists, will certainly cost many hundreds of
billions of dollars before it is over, plus the large sums our allies
asked to secure their cooperation. Since 9/11 the price of oil has
doubled. If there is a deeper oil crisis, or terrorist-related economic
disruption, this cost will increase. It should be remembered that each
thousand point decline in the Dow Jones costs share holders roughly a
trillion dollars. It should also be remembered that inflation and other
financial instabilities have the potential to jolt bond and derivative
markets.
Unless the United States successfully shifts budget priorities, the
American economy does not have a limitless ability to absorb the costs
from war and terrorism without eventually returning to a sharper cycle
of inflation and recession.
The Federal Reserve can indeed cushion massive unexpected blows to
the American economy and financial markets, but only at a high risk of
future inflation, subsequent monetary restraint, and recession.
The U.S. obviously had no choice but to defend itself from evil. We
have moved vigorously to strike at Al-Qaeda and their Taliban hosts and
now Iraq. But we also have an obligation to look beyond the immediate
issue to seek means to drain the other swamps that help spawn
terrorists and recurrent regional wars. That is partly why the
President's vision of a Middle East settlement with a secure Israel and
a democratic Palestine was so well received by diplomats. It is vital
that future scenes of cooperation among the leaders of the three great
faiths involved replace the constant mayhem on television throughout
the Islamic world from violent events in what was once called ``The
Holy Land.''
History suggests that the U.S. will eventually pass through today's
problems and uncertainties. Unlike Japanese economic managers who tend
to bury their problems for years and compound their costs, the U.S.
tends to address its Enron-like problems brutally and move on. Every 4
years, the Presidential election provides the American people with the
opportunity to change, if needed, both policies and personnel. We can
also expect that new inventions and technologies will generate whole
new areas of economic activity and growth, improving the lives of
billions of people.
A key to this happy outcome is wise U.S. leadership and effective
diplomacy, plus keeping our economy open, flexible, market oriented,
and with a heavy emphasis on quality education. We must also
successfully address certain problems in the global trading system that
contribute to our current account problem. As long as we continue to
master these basic requirements, we will drive over any bumps in the
road and continue to lead the world.
Operative Lessons for Policy Makers
Based on the key conclusions from this brief review of potential
global economic vulnerabilities, a list follows of some key principles
that should be noted by policymakers even during the distractions and
turmoil of war-time:
1. It is better to prevent inflation than to have to control it,
once unleashed. This is also true of serious asset inflation,
which produces bubbles that tend to trap the least
sophisticated investors.
2. Excessively loose monetary policy which subsequently generates
asset inflation also tends to produce excess investment in
capacity, including real estate. In effect, such monetary
policies borrow economic growth from the future. This resultant
excess capacity ultimately weakens profits, banks, and stock
values, and can hang over markets for years before a
combination of liquidation of excess capacity and new economic
growth allows markets to clear.
3. Wars destroy and waste wealth. Financing by governments of past
wars has often generated inflation, unless policymakers were
vigilant.
4. Stimulating the housing market in an effort to ease the wealth
destructive consequences of a burst stock market asset bubble
can either kill or cure the patient, depending on how long the
medicine is applied. The same can also be said about bond
markets, where serious questions have arisen about the
sustainability of current bond market trends.
5. During inflationary times, low fixed rate mortgages on housing
can generate serious problems for those institutions holding
large portfolios of mortgages or higher risk housing
derivatives. Future higher interest rates will tend to make it
more difficult for potential buyers to qualify for mortgages
when people want to sell their houses. Higher local taxes,
which are often indexed, and rising insurance costs are adding
to the cost of home ownership, and will tend to reduce the pool
of people able to afford such housing at existing prices.
6. The large-scale debt accumulations, via balance of payment
deficits, cannot continue indefinitely without triggering a
further weakening of the nation's currency, contributing to
sectoral inflationary pressures and increasing the cost of
capital. U.S. trade deficits are not merely a macroeconomic
phenomenon involving the U.S. budget deficit and monetary
aggregates, important though that is, but also and powerfully
an accumulation of many micro economic problems. These include
currency misalignments, failure to enforce successfully past
trade opening deals, including China's WTO agreements, subtle
but powerful non tariff barriers involving such things as local
standards, the European VAT rebate system for exports, poorly
negotiated past trade deals such as the 1992 airbus agreement
which allowed subsidized and risk free financing of new
aircraft, wholesale theft of U.S. intellectual property and
trademarks in many parts of the world, complaints about U.S.
worker literacy by potential investors, etc. Viewed
individually, the impact of some of the micro economic
obstacles to U.S. exports and competitiveness may seem modest.
The collective impact of all the micro economic obstacles on
American competitiveness and exports, however, is titanic and
strategic. U.S. trade deficits have increased steadily since
1990, regardless of the fluctuating U.S. budget position,
suggesting that we must look beyond the fiscal macro issue to
help address our current account problems.
7. It is nevertheless essential that projected U.S. Fiscal deficits
be brought under control. They contribute to excess U.S.
demand, cause confidence problems at home and abroad, and will
otherwise lead to higher future U.S. interest rates.
8. Foreign policy rationales for trade policy measures need to be
considered from time to time, but only if the collective impact
of generous trade policies conducted on this basis does not
generate potentially disastrous current account problems.
9. Encouraging more economic growth abroad is the painless textbook
solution to a global imbalance problem in trade. Realism
compels us to consider the political obstacles likely to delay
such growth in Europe and Japan, and understand as well that
more export led growth in places like China will only compound
our problems. We also need to remember the catastrophic results
of efforts in the mid-1980s to encourage Japan to engage in
expansionary monetary policies aimed stimulating more domestic
demand. In short, we may need to look beyond this textbook
solution to help ease our pressing current account problem.
10. As Argentina demonstrates, delay in addressing an underlying
national economic imbalance can cause an economy to contract
severely when problems have to be addressed in the middle of an
urgent crisis. If this happens to the American economy, the
consequences will be massive and global.
11. As in Brazil, funding a large public debt with short-term
borrowings can be dangerous if, for any reason, markets lose
confidence in the borrower's ability to service the debt.
12. Floating exchange rates have proven their value over the long-
term for most countries with sound regulatory systems, but such
countries can suffer short-term competitiveness problems
against trade sold with fixed and undervalued currencies. Major
countries like China with such fixed exchange rates and large
pools of savings and inexpensive labor can dominate some
sections of global markets for years, but at a risk of future
financial, banking and political instabilities for themselves
and for their trading partners.
13. Past models of financial disasters are imperfect guides for
predicting future financial debacles. There are several reasons
for this. One key problem is a lack of transparency in
information. Political and business leaders with financial
problems are seldom candid. Political responses to crises are
unpredictable. Part of modem finance relies heavily on opaque
derivative operations whose individual and collective impact
during a crisis cannot be quantified in advance. Human nature
itself is volatile, subject on occasion to credulity, panic,
and the other manifestations of ``the madness of crowds.''
Relying wholly on computers and the statistics in them can
dangerously mislead policymakers who fail to understand the
limitations of their economic models.
14. Allowing the economy to operate on the basis of market signals
remains the best available means of running a modem economy.
Rapid advances in science and technology will continue to place
a tremendous premium on flexibility, quality education, and on
the optimum use of capital and labor that a market driven
process makes most likely.
15. Notwithstanding current overall global economic growth, today's
world is filled with economic vulnerabilities, large and small.
Policymakers and economists need to monitor and address the
more obvious individual problems to lessen potential future
systemic risks.
______
PREPARED STATEMENT OF DR. ADAM LERRICK
Visiting Scholar, American Enterprise Institute
May 16, 2006
Demystifying Hedge Funds
Every day, somewhere in the global marketplace, hedge funds are
shaking up the comfortable status quo and voices from high places are
raised in protest. The Governor of China's central bank Zhou tried to
deflect G7 censure of the under-valuation of the yuan by pointing at
unruly hedge funds as a greater threat to the world economy. In the
American heartland, Warren Staley, CEO of agricultural giant Cargill,
accused hedge funds of distorting fundamentals and roiling the
commodities markets. In Germany and Japan, politicians denounced hedge
fund corporate activists as ``locusts'' that destroy and disrupt in
order to extract quick profits.
Are hedge funds really to blame for all the ills that befall the
international financial system? Are they disruptive speculators or
dispassionate agents that expose fundamental flaws and speed up
inevitable change? Does their search for the highest absolute economic
return eliminate inefficiencies and bring balance and liquidity to the
market? Or does it lead to excessive risk-taking that may one day
entrain widespread crisis?
Hedge funds are simply pools of money seeking the highest absolute
rate of return across the capital markets with a management
compensation structure that commands a high share of profits. They have
been here for more than a generation and, like any financial
innovation, are following a normal life cycle. First, a small number of
pioneers garner excess profits; next, competition and capital are
broadly attracted; finally, the concept moves into the mainstream,
matures and is winnowed out until the risk/reward ratio approaches that
of other instruments.
When floating exchange rates and volatile interest rate movements
transformed the capital markets in the late 1970s, hedge funds entered
quietly with an irresistible offer to investors: make money whether the
market rises or falls. These were small groups of innovative traders,
some inside large investment banks funded by the bank's own capital,
others in independent firms financed by less than 100 rich individuals
prepared to commit millions to a new technology.
Managers searched for momentary anomalies in the pricing of
securities, currencies and commodities around the world. They matched
holdings with short sales to isolate generalized market risk. They
borrowed heavily to leverage positions and magnify returns. Rewards
were overwhelming and consistent at 40 percent per annum. Managers were
paid for performance: they received 20 percent of profits. As investors
and managers plowed back their gains, small funds quickly grew into
multi-billion dollar forces.
Hedge funds are now a major force in the global financial markets.
Over 8,000 hedge funds hold $1.5 trillion in assets, double the level
in 2000. Leverage and the use of derivative instruments multiply their
real impact many-fold. They dominate the trading arena: one-third of
equity volumes; one-fifth of the bond and currency markets; one-half of
the commodities sector. They are a mainstay of profits for the large
investment banks through commissions on trading and interest on
borrowing; when added to the revenues of in-house proprietary trading,
hedge funds overall are the predominant source of Wall Street earnings.
Trading figures are no longer the sole measure of hedge fund power.
As more funds and more money chase the same opportunities, hedge funds
are constantly moving money around the globe to where it is most
productive. They challenge private equity firms, venture capitalists
and real estate developers. They lend to companies in distress. They
take large positions as shareholder activists to force corporate
restructurings. They search the world to manage infrastructure projects
and to develop natural resources.
The client base has moved from a closed society of the very rich to
embrace the entire investor spectrum. Large institutions that oversee
the retirement savings of the nation's workforce and endowments that
guard the resources of universities and charitable trusts now account
for more than half of hedge fund capital. High rates of return were the
initial attraction but even as returns tend toward lower equilibrium
levels, hedge funds are valued to reduce over-all portfolio risk
because their returns are uncorrelated with general market trends.
A whole new layer of intermediaries has developed to proffer
guidance through the maze of proliferating hedge fund choices and to
distribute institutional investor assets among specialized funds. These
``funds of hedge funds'', when marketed by banks and securities firms,
provide a conduit for the retail investor with as little as $25,000 to
risk. In the planning stages at Citigroup is a $30 billion fund of
hedge funds to be marketed to its retail client base with the frequent
redemption options now offered by mutual funds. Funds of hedge funds
now control 50 percent of industry assets and have brought in 60
percent of recent inflows. Each layer adds more fees and reduces
investor returns.
The original hedge fund image was a ``black box'': investors put
their money in and asked no questions about what went on inside. Hedge
funds continue to depend upon secrecy to prosper. They have a large
investment--in human capital from the world's top mathematics, physics
and finance institutions; in technology based upon complex quantitative
statistical models; in information costly to collect and process--that
cannot be patented or protected. A strategy disclosed is a strategy
destroyed as immediate imitation by the market wipes out the benefits
of expensive proprietary innovation.
In a world that demands transparency, secrecy is a red flag for
fear, suspicion and calls for regulation.\1\ But the public interest
can be satisfied without driving hedge funds to pack up and resettle
off-shore. The framework to monitor and safeguard the global financial
system and to watch over the unaware investor is already in place.
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\1\ The SEC has recently required registration of most hedge funds
with assets above $30 million and with 15 or more clients.
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Hedge funds do not operate in a vacuum. They interact through a
marketplace where their lenders, their trading counter-parties and the
markets themselves are already under the scrutiny of an array of
regulators--the SEC, the Federal Reserve, the Comptroller of the
Currency, the CFTC and their counterparts in capital markets around the
world.
Hedge fund objectives should not be confused with their tools. The
hedge fund formula has always relied on leverage to magnify returns,
whether through borrowing or derivative instruments, but as margins
narrow there is the pressure to take on more risk to generate the same
profit rates. Leverage alone does not add value and excessive leverage
can disrupt markets. The danger to those that finance hedge funds and
to the global system as a whole lies in ignorance of risks. Total
exposure and total leverage across all lenders and across all national
boundaries should now be aggregated and published to inform and improve
the risk evaluations of market participants and regulators alike.
Under U.S. securities law, all hedge fund clients--the very rich,
the institutional investors and the managers of funds of hedge funds
who are stewards of the savings of small investors--have the skills to
inform their decisions without official help. Many analysts believe
that the industry would benefit from standardized disclosure of fund
structures and track records. But government agencies need not
regulate. If they take the lead to establish uniform benchmarks, the
market will enforce their use as funds that refuse to comply will lose
clients and capital to those that inform investors.
The marketplace is the ultimate regulator and will control the
hedge funds' future. Ever more money is competing for a diminishing set
of opportunities. Average profitability is already approaching rates on
more commonplace assets when risk is factored in. Industry leaders are
raising fees, returning money to their long time deep-pocketed backers
and focusing on their own capital. Of the 8,000 current hedge funds, 20
percent will close their doors within 1 year. Retail investors, enticed
by now-outdated headline returns, will move on as profits fall. During
the shake-out, players with weak risk management will be winnowed out.
There will be fewer but better hedge funds.
______
PREPARED STATEMENT OF KURT SCHACHT
Executive Director, Center for Financial Market Integrity,
Chartered Financial Analyst Institute
May 16, 2006
Good afternoon. I am Kurt Schacht, the Executive Director of the
CFA Centre for Financial Market Integrity, the advocacy arm of CFA
Institute. I would like to thank Senator Hagel, Senator Dodd, and other
members of this committee for the opportunity to speak to you this
afternoon on the role of hedge funds. It has come to dominate much of
the financial services industry discussion recently and we are
supportive of your committee taking a closer look.
First, some background about CFA Centre and its parent
organization, CFA Institute. CFA Institute is a non-profit professional
membership organization with over 82,000 members in 126 countries. Its
mission is to lead the investment profession globally by setting the
highest standards of ethics, education, and professional excellence.
CFA Institute is most widely recognized as the organization that
administers the CFA examination and awards the CFA designation, a
designation that I share with nearly 68,000 investment professionals
worldwide. I direct the advocacy efforts of CFA Institute through the
newly created CFA Centre for Financial Market Integrity, which develops
research, education projects and promotes ethical standards within the
investment industry. The CFA Centre has been actively involved in the
hedge fund debate for several years and has developed a number of
initiatives related to the industry from the investor's perspective.
For the record, CFA Institute is a staunch proponent of self-
regulation. This approach is embodied not just in our Code of Ethics,
but also in a number of additional guidelines and standards we have
established in areas such as performance reporting and asset manager
conduct. As discussed herein, these standards may provide useful models
for how to address some of the issues before the Subcommittee today.
In most cases, we believe that self-regulation is a preferred
alternative to government-imposed regulation, which adds complexities
and increases the costs of capital, which are ultimately shouldered by
investors large and small. This, of course, is a view shared by
regulators and standard-setters themselves, which is why we frequently
have worked closely with these groups, including the Securities and
Exchange Commission, to develop such standards.
Our Perspective on Hedge Funds
Our organization comes at this topic from a number of perspectives
but primarily as an investor advocate with an interest in promoting
appropriate professional standards in this industry. We advocate before
investor groups, industry associations and the world regulators. Our
focus includes industry ethics, asset manager conduct and performance
reporting.
As with most membership organizations in the financial services
area, we have a growing proportion of our own membership, estimated at
approximately 6 percent (about 5,000), directly involved in the
industry as hedge fund or fund of funds participants, not to mention
the many others in our membership who are involved as buyers or
consumers of hedge fund products.
Our work in this area includes a comprehensive set of standards for
hedge fund operators. We have been meeting with regulators around the
world to discuss hedge fund and manager regulation and recently
completed a survey and study of the hedge fund industry in the Asia
Pacific region. We continue to review and comment on the issues of
hedge fund performance reporting and investor education as well. I will
cover each of these aspects below.
The Role of Hedge Funds
First, the role of hedge funds in overall portfolio construction
and management is evolving. Generally, such investment vehicles are
sought for high, uncorrelated historical returns, their attractiveness
relative to other investment alternatives and returns in excess of
growing liability streams as expected pension portfolio returns have
begun to fall short of these growing liabilities. These uncorrelated
returns reduce portfolio volatility and actually ``hedge'' other
portfolio exposures. Perhaps most importantly, hedge funds offer access
to some of the premier asset managers in the world.
Conversely, hedge funds are not a panacea and there are most
certainly a large number of operators that will fail to deliver
sustained performance, net of fees. The level of investor knowledge is
also a concern when discussing the role of hedge funds. That role is
prone to being oversold to retail investors and certain institutions
looking to chase the latest hot strategy and quick returns. The
appropriate role of hedge funds is therefore subject to being
misunderstood and misapplied in certain cases.
The Current State of the Industry and Regulation
The current industry is a jumble of contradictions we have seldom
witnessed. We have huge and growing demand for the products with assets
under management approaching $1.5 trillion and huge and growing supply
with nearly 9,000 funds. We have an all out media frenzy concerning the
industry with 100 stories per day in 2005, according to one study.
Meanwhile, we continue to hear about shaky investor confidence, while
every regulator we talk to is increasingly suspicious of what is going
on with these funds. They are often described as, mysterious and
largely unregulated investment vehicles of the wealthy, sophisticated
investor. It is a rather combustible mixture.
To be sure, it is a highly misunderstood industry that is often
mistaken for a single asset class, leaning in one direction and prone
to a systemic melt down. In reality, the collective industry represents
the universal exposure; to all assets, in all directions, in all
markets. U.S. Treasury Under Secretary Randal Quarles referred to them
recently as part of the evolution to ``complete markets.'' We would
agree. There are legitimate regulatory concerns related to the extent
of leverage by certain funds and the level and interplay of
counterparty exposures on OTC positions. In our view however, this is
not a house of cards poised for systemic disruption, rather a broad
based, universal market exposure with pockets of concern.
We are uncertain as to how to address this aspect of the hedge fund
concern but would encourage a less prescriptive approach focused on
greater disclosure by regulated counterparty entities that will reveal
any serious imbalances in a market. The Financial Services Authority in
the U.K. is currently reviewing whether regulators can get at the issue
of potential systemic risk through more detailed and aggregated
disclosures from the counterparty firms they already regulate.
Over the last year, we have been meeting with global regulatory
authorities about investment management practices and hedge fund
practices in particular. The additional concerns we hear regarding
hedge funds are as follows:
There are concerns with side letters issued by hedge fund
managers that give priority for favored clients on things like
early exit or allow problem investments to be concealed.
There are concerns that prime brokers have created hedge
fund ``incubator'' shops that are inducing very high trading
volumes and portfolio turnover in exchange for free office
space and operations support. There may be arrangements to get
hedge fund managers preferred access to issuers and breaking
information. These relationships are increasingly being viewed
as too cozy as hedge funds begin to dominate trading activities
in the stock market.
Hedge fund promotion has become more attractive for pension
consultants due to the better fee structures. This may result
in conflicts with client knowledge and suitability.
There are concerns with investor protection for retail
investors as products become more generally available.
There are growing concerns about market integrity: such as
market manipulation, poor internal controls, and fraud by hedge
funds.
The recent move in the U.S. to require registration of certain
hedge fund managers under the Investment Advisers Act of 1940 may have
addressed some of these concerns and we viewed such registration as an
appropriate step. Registration does provide some level of deterrence
and allows regular examination of managers directly. It also requires a
documented compliance framework. However, it does little to address the
primary systemic imbalance concern.
Investor Education and Hedge Fund Manager Conduct
Our organization has been discussing the importance of investor
education in the context of hedge funds. Investors must understand that
they have a serious and significant responsibility to understand all
investments, but in particular those that are less liquid and
transparent. We have been working with other groups to address
educational needs in the hedge fund sector and to provide investors
with templates for reviewing, selecting and monitoring these managers.
These include Hedge Funds http://www.cfainstitute.org/investors/
hedgefunds101.html that outlines five keys for would be hedge fund
investors, including rules for investigating credentials, track record,
the investment strategy and fee structure and the process for valuation
and performance reporting. There are many other excellent resources
available including: Best Practices in Hedge Fund Investing: Due
Diligence for Global Macro and Managed Futures Strategies, developed by
Greenwich Roundtable.
Another key component of investor education is to understand what
the manager of a hedge fund product should offer in terms of
professional conduct and ethics to their investors. Investors in these
funds need some assurance that they are being dealt with fairly and
honestly. While we do not see any more prevalent fraud in this sector
than in other areas of financial management, it remains the case that
this is a less regulated, more independent sector of the funds
management business. This is due to the fact that the hedge fund sector
has traditionally been limited to more ``knowledgeable and
sophisticated'' investors that understand the risks and engage in
appropriate due diligence. We are not sure this is always the case and
wanted to assist investors with their responsibility to know what they
are getting into and what to look for.
The Asset Manager Code of Professional Conduct (http://
www.cfainstitute.org/cfacentre/positions/pdf/asset_manager_code.pdf)
sets forth a comprehensive template for what we believe every investor
should expect and demand from their hedge fund manager. Its purpose is
to promote an honest and verifiable approach to hedge fund management
and to promote a self-regulatory approach to concerns being expressed
by investors and regulators. It covers client loyalty, trading
practices and compliance procedures, as well as a comprehensive process
for disclosures, portfolio valuation and performance reporting.
Hedge Fund Performance Reporting
On the issue of performance reporting, we have done much work. One
of the more ``mischief prone'' areas in investment management is
performance reporting and that certainly applies to the hedge fund
industry as well. Recently, there have been a significant number of
studies and articles on the topic of hedge fund performance numbers and
calls for its regulation. On the matter of regulating performance
reporting, we encourage caution. First, the performance data that
people are generally critical of are broad-based, voluntary, private
services that have all sorts acknowledged statistical shortcomings.
Commentators claim these data significantly overstate hedge fund
performance by 100 to 600 basis points and are misleading to investors.
Second, we doubt whether many hedge fund investors are making
investment decisions based on this information. A more appropriate
solution is investor education. Any serious investor will understand
that these are merely a general proxy for hedge fund performance. They
will understand the critical importance of performance reporting at the
individual fund level and the quality of the due diligence the investor
must conduct to confirm and verify this performance.
The Asset Manager Code provides a template for investors and
managers to understand the various procedures needed to calculate and
verify performance and promotes The Global Investment Performance
Standards or GIPS' standards http://www.cfainstitute.org/
cfacentre/ips/gips/pdf/GIPS_2006.pdf. We believe the industry benchmark
for historical performance reporting is the GIPS standards, which has
been in development and use for nearly 10 years. The GIPS standards
have become the industry standard in nearly 30 countries around the
world. The broad GIPS standards do provide a framework for calculating
and reporting hedge fund performance. For example, section 4.A.5,
requires firms to disclose the presence, use and extent of leverage or
derivatives (if material), including a sufficient description of the
use, frequency and characteristics of the instruments to identify
risks. In all, the GIPS standards provide a consistent and verifiable
process that is comparable across managers. We believe this self-
regulatory approach to industry standards has been very constructive.
Conclusion
Again we commend the members of the Subcommittee for your continued
vigilance and leadership on this important industry topic. We fully
expect hedge funds to continue to evolve and become a mature feature of
the overall investment industry. Their ongoing regulation and oversight
should match the pace of this evolution, with a view to foster
flexibility and creativity but not at the expense of market integrity
and confidence. We would encourage the Subcommittee and Congress to
allow the new advisor registration to settle in and determine if
further regulation of managers or funds is warranted.
______
PREPARED STATEMENT OF JAMES CHANOS
Chairman, Coalition of Private Investment Companies,
President, Kynikos Associates
May 16, 2006
Chairman Hagel, Ranking Member Dodd, and Members of the
Subcommittee. My name is James Chanos, and I am President of Kynikos
Associates, a New York private investment management company that I
founded in 1985.\1\ I am appearing today on behalf of the Coalition of
Private Investment Companies (``CPIC''), whose members and associates
manage or advise an aggregate of over $30 billion in assets. I want to
thank the Chairman and other Senators for their efforts to better
understand how this important segment of the financial markets
operates. I am honored to have the opportunity to testify before this
Subcommittee.
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\1\ Prior to founding Kynikos Associates, I was a securities
analyst at Deutsche Bank Capital and Gilford Securities. My first job
on Wall Street was as an analyst at the investment banking firm of
Blyth Eastman Paine Webber, a position I took in 1980 upon graduating
from Yale University with a B.A. in Economics and Political Science.
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Since I last testified before the Senate Banking Committee in July
of 2004 at its hearing on hedge fund regulation, the hedge fund
industry has continued to grow and evolve, and the activities of
industry members continue to generate attention by the press and by
regulators. Indeed, the growth in the industry alone--which is now
estimated to include over 10,000 funds with over $1 trillion under
management \2\--is a matter of governmental interest, prompting recent
statements by a Treasury Department official that the growth of capital
accumulation through entities such as hedge funds and private equity
funds is one of a number of ``structural'' changes in the markets
warranting further examination by the Department.\3\
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\2\ See A Review of Current Securities Issues before the S. Comm.
On Banking, Housing, and Urban Affairs (statement of Christopher Cox,
Chairman, SEC) Apr. 25, 2006 (unpublished transcript). Estimates of the
number of hedge funds vary but the number of funds clearly is
increasing. See Dane Hamilton, U.S. SEC says to target ``high risk''
hedge funds, Reuters, May 3, 2006, available at http://
today.reuters.com/misc (stating that industry estimates vary widely,
but funds ``conservatively estimated to hold $1.1 trillion in assets
and possibly much more.'') Liz Moyer, Why Hedge Funds?, Forbes.com Jan.
11, 2006 (stating 8,350 funds in existence). Financial journals, citing
Hedge Fund Research, stated that 2,073 new hedge funds--a record
number--were created in 2005, while 848 were liquidated. These totals
include 498 new funds of hedge funds launched and 165 funds of hedge
funds liquidated. Amanda Cantrell, Hedge Funds Launch, Close In Record
Numbers, CNNMoney.com Mar. 1, 2006; Liz Moyer, Hedge Fund Business
Still Attracts Big Players, Forbes.com Mar. 1, 2006.
\3\ Randall K. Quarles, Under Secretary of the Treasury for
Domestic Finance, Remarks before the Annual Washington Conference of
the Institute of International Bankers (Mar. 13, 2006), available at
http://www.treas.gov/press/releases/js4114.htm
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The Coalition of Private Investment Companies hopes to be helpful
in furthering governmental understanding of the industry, and in the
testimony below, we discuss the importance of the hedge fund industry
and certain key issues and concerns that have been raised about it.
There are a number of issues confronting policymakers in Washington in
which hedge funds are involved. Some of these are broad issues about
the evolution, safety and integrity of U.S. capital markets--where
hedge funds are one of many key market participants, and some are
issues that are unique to the hedge fund industry itself.
Hedge Funds--In General
Importance of the Hedge Fund Industry to the Financial Markets
The financial and capital markets in the United States and in the
developed world have been stunningly successful in providing capital
and financing for economic growth and development, both in the United
States and abroad. The fundamental integrity of the U.S. markets--and
the knowledge that money can be invested in a staggering array of
products, free from rampant corruption on the one hand and overly
burdensome government control on the other--creates a powerful
incentive for all kinds of businesses and individuals to invest in this
country.
Our markets benefit from the wide diversity of players--investment
bankers and broker-dealers, commercial banks and savings institutions,
mutual funds, commodity futures traders, exchanges and markets of all
types, traders of all sizes, and a variety of managed pools of capital,
including venture funds, private equity funds, commodity pools, and
hedge funds, among others. While hedge funds are but one category of
market participant, they serve a vitally important role in the United
States and global markets. The importance of hedge funds to our markets
has been acknowledged in the past by the President's Working Group on
Financial Markets, the Commodity Futures Trading Commission, the
Securities and Exchange Commission, and former Federal Reserve Board
Chairman Alan Greenspan, as well as by the current Federal Reserve
Board Chairman Bernard Bernanke, who in testimony before this committee
last year called hedge funds a ``positive force in the American
financial system.'' \4\
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\4\ Hearing on the Nomination of Bernard S. Bernanke to be Member
and Chairman of the Federal Reserve Board, S. Comm. on Banking,
Housing, and Urban Affairs; (Nov. 15, 2005) (statement of Bernard
Bernanke) (unpublished transcript). Other financial regulators also
view hedge funds as a positive force. For example, the United Kingdom's
Financial Services Authority, releasing a March 2006 report on hedge
funds, reiterated its view that hedge funds are ``a vital segment of
the financial services industry. In particular they play a fundamental
role in the efficient reallocation of capital and risk, and remain an
important source of liquidity and innovation in today's markets.''
Press Release, FSA (Mar. 23, 2006) available at www.fsa.gov.uk/pages/
Library/Communication/PR/2006/026.shtml
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As the SEC has acknowledged, there is no statutory or regulatory
definition of the term ``hedge fund.'' The term generally is used to
refer to privately offered investment funds that invest primarily in
liquid securities and derivatives, that are managed by professional
investment managers, that in many cases use leverage, short-selling,
active trading and arbitrage as investment techniques, and that are
exempt from registration under the Investment Company Act of 1940 (the
``1940 Act''). Interests in these funds are sold in private offerings,
primarily to high net worth individuals and institutions.
Hedge funds are as diverse as the individual managers who run them.
They may invest in or trade a variety of financial instruments,
including stocks, bonds, currencies, futures, options, other
derivatives and physical commodities. Although funds that invest
primarily in illiquid assets such as real estate, venture capital and
private equity generally are not considered ``hedge funds,'' some hedge
funds invest to some degree in private, illiquid investments. Some
invest in securities and hold long term; some, such as the short fund
managed by Kynikos, sell short; and some are long-short funds. Some are
strictly traders. Many serve as important counter-parties to other
players in the market who wish to offset risk. Others may become
``activists'' and use a large equity position in a company to encourage
management to make changes to increase shareholder value. Hedge funds,
as a group, add to the depth, liquidity, and vibrancy of the markets in
which they participate. Indeed, some of the most talented individuals
in the financial markets are hedge fund managers, who bring their
research and insight to bear on the value of various assets, thereby
adding to the price discovery and efficiency of the markets as a whole.
Securities Regulation of Hedge Funds
Hedge funds are an important alternative to the mutual fund model
and provide flexibility to their managers to invest or trade using
whatever products and strategies they choose in order to maximize
returns. They are not, however, unregulated. Hedge funds are subject to
the same restrictions on their investment and portfolio trading
activities as most other securities investors, including such
requirements as the margin rules \5\ (which limit their use of leverage
to purchase and carry publicly traded securities and options), SEC
Regulation SHO, \6\ (which regulates short-selling), the Williams Act
amendments to the Securities Exchange Act of 1934 \7\ and related SEC
rules (which regulate and require public reporting on the acquisition
of blocks of securities and other activities in connection with
takeovers and proxy contests), and the NASD's ``new issues'' rule 2790
(which governs allocations of IPOs). Hedge funds must also abide by the
rules and regulations of the markets in which they seek to buy or sell
financial products. And, perhaps most important, hedge funds are
subject to anti-fraud and anti-manipulation requirements, such as
Section 10(b) of the Securities Exchange Act of 1934 \4\ and Rule 10b-
5, \9\ as well as insider trading prohibitions, both in the funds'
investment and portfolio trading activities, and in the funds' offers
and sales of units to their own investors.
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\5\ 12 C.F.R. 220, 221.
\6\ 17 C.F.R. 242.200-.203
\7\ 7 Exchange Act 13(d), 13(e), 14(d), 14(e) and 14(f), 15
U.S.C. 78m(d), 78m(e), 78n(d), 78n(e) and Sec. 78n(f).
\8\ 15 U.S.C. 78j.
\9\ 17 CFR 240.10b-5.
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Hedge funds are also regulated by the terms of certain exemptions
from registration under the Securities Act of 1933, the 1940 Act, and
in some cases the Commodity Exchange Act, under which they operate.\10\
To meet these exemptions, they must limit their offerings to private
placements with sophisticated investors, who are able to understand and
bear the risks of the investment. The hedge fund must either limit its
beneficial owners to not more than 100 persons and entities (typically
all or most of whom are ``accredited investors''), or limit its
investors to super-accredited ``qualified purchaser'' individuals with
over $5 million in investments and institutions with over $25 million
in investments. Hedge funds typically file exemptive notices with the
SEC and state securities commissioners under Regulation D, and many
also file with the National Futures Association under the Commodity
Exchange Act exemptions by which they operate (which impose their own,
additional restrictions on sophistication and qualifications of
investors).
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\10\ See Implications of the Growth of Hedge Funds, Staff Report to
the United States Securities and Exchange Commission, at x, 68-72
(Sept. 2003), available at http://www.sec.gov/news/studies/
hedgefunds0903.pdf (``Staff Report'').
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These exemptions are not ``loopholes'' or accidental omissions from
regulatory coverage, but are instead well-considered exemptions enacted
by Congress and implemented by the SEC and CFTC, through carefully
crafted rules, developed in notice and comment rulemakings and in
recognition of the importance and functions of private investment funds
to investors and to the markets. The fact that hedge funds are not
regulated as mutual funds and, therefore, not subject to the additional
restrictions imposed by the 1940 Act--restrictions intended to protect
the less wealthy and less experienced investors who invest in those
traditional retail funds--not only gives investors (those who qualify
under the various conditional exemptions imposed by the SEC) more
choices, but adds to the diversity, depth and efficiency of the
markets.
The SEC's New Hedge Fund Adviser Registration Rule
Earlier this year, it was reported that more than 900 hedge fund
managers newly registered with the SEC as a result of the hedge fund
adviser rule.\11\ SEC Chairman Cox more recently testified that,
together with those who were registered prior to the rule's adoption,
there now are 2400 hedge fund managers registered with the SEC as
investment advisers.\12\ Thus, a substantial portion of the industry,
as measured by assets under management, is now subject to SEC
examination and oversight. However, in order to exclude managers of
private equity funds from the adviser registration requirement, the SEC
drafted the rule to exclude advisers to funds with lockup periods of 2
years or more, thus providing a relatively easy avenue for managers who
wish to avoid registration.\13\ We continue to believe that the
Investment Advisers Act (the ``Advisers Act'') is an awkward statute
for providing the SEC with the information it seeks--since many fund
managers still are not registering--and for dealing with the broader
issues that are outside the Act's purposes and which also cross the
jurisdictions of several agencies.
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\11\ See Eleanor Laise and Rachel Emma Silverman, Dissecting Hedge-
Fund Secrets--Wealth Managers Say SEC-Required Revelations Won't
Replace Due Diligence, Wall St. J., Feb. 4, 2006 at B5.
\12\ Cox Statement, supra n.2.
\13\ Alternatives were suggested to the Commission. For example,
comments filed by Kynikos on the proposed rule recommended that the
SEC, by rule, make the safe harbor counting rule previously utilized by
hedge fund managers under SEC Rules 203(b)(3)-1 and 222-2 under the
Advisers Act, which implemented the client counting rules in Sections
203(b)(3) and 203A of the Advisers Act, contingent upon written receipt
by the SEC of certain basic information about the fund, as well as
certification by managers of the fund of certain key investor
protections provided in the Advisers Act and related SEC rules.
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Key Issues for Policy Makers
Hedge Funds, Financial Markets, and Systemic Risk
There are those who argue that hedge funds, as an industry, should
not be considered as a factor in evaluating potential systemic risks to
the U.S. and global financial system. While we agree that hedge funds
do not warrant greater scrutiny than any other market participant--such
as depository institutions, investment banks, insurance companies,
mutual funds or exchanges--we do not believe that hedge funds should
somehow be exempt from consideration. Moreover, we understand that key
U.S. policymakers are adopting the approach of including hedge funds--
as a group--in their ongoing oversight of the financial markets in
order to evaluate the potential for problems that could affect the
financial system more broadly. For example, Federal Reserve Board
Chairman Bernanke, appearing before this Committee last November,
testified that it is important for the Federal Reserve to be aware of
what is going on in the market and to understand hedge fund strategies
and positions by working through banks, which are the counter-parties
of many hedge funds. He also said he believed that much had changed
since the near-collapse of Long-Term Capital Management in 1998--and
that the hedge fund industry has become more sophisticated, more
diverse, less leveraged, and more flexible.\14\
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\14\ Bernanke Statement, supra n.4
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Further, the Department of the Treasury also has noted the
importance of understanding hedge funds and their impact on the
financial markets. In March of this year, Treasury Under Secretary
Quarles announced that the Department is examining whether the growth
of derivatives and hedge funds holds the potential to change the
overall level or nature of risk in markets and financial
institutions.\15\ However, keeping this in perspective, he listed the
growth of hedge funds, as well as private equity funds, as among a
number of structural changes to be reviewed by Treasury.\16\ We commend
Under Secretary Quarles for emphasizing that Treasury will think about
these changes not in a fragmented fashion, broken out by industry or
product, as has been done in the past, but in a comprehensive way.
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\15\ Quarles Remarks, supra n.3
\16\ The other changes he identified include the greater systemic
importance of a smaller number of large bank-centered financial
institutions, the greater role played by non-bank financial
institutions, the rapid growth of GSEs, greater operational demands on
the core of the clearing and settlement structure, an increase in the
complexity of risk management and compliance challenges, and the extent
of global financial integration.
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We also note that in one fast growing market--that for credit
default swaps and other types of over-the-counter credit derivatives--
hedge funds are playing a very significant role as purchasers and
liquidity providers. Because of the unique nature of these products,
this is one market where several regulators, including the Treasury
Department \17\ and the Federal Reserve Bank of New York, \18\ are
focusing attention and have recently taken steps to facilitate
coordination among market participants. We also believe that the
comments of the United Kingdom's Financial Services Authority regarding
potential risks in this market warrant consideration.\19\ This market
has become increasingly important for companies who access the credit
markets, as well as for market participants, including hedge funds,
that provide significant liquidity and pricing efficiency. We believe
this is a market that merits the continued attention of regulators and
policymakers.
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\17\ Emil Henry, Treasury Assistant Secretary for Fin.
Institutions, Remarks to the Federal Reserve Bank of Atlanta (Apr. 18,
2006), available at http://www.treasury.gov/press/releases/js4187.htm
\18\ See e.g., Ramez Mikdashi and Mark Whitehouse Derivatives Firms
Tackle Backlog Wall St. J., Mar. 14, 2006, at C4.
\19\ ``Regulators watched with interest the recent, surprisingly
significant (given the degree of anticipation of the event), impact of
the credit rating downgrade of General Motors (GM) and Ford upon the
hedge fund sector and related market participants. In this situation,
no financial stability event developed, however, it was interesting to
observe commonalities in losses by hedge funds pursuing similar
strategies (together with losses in counterparties to these funds) and
losses in individual funds or clusters of funds leading to investor
redemption and enforced liquidation of assets. The full effects of this
event may not yet have been felt, with possible changes to structuring,
trading, risk management, liquidity and investment remaining a
possibility (with potential implications for the long term viability of
individual funds/fund managers.)'' Hedge Funds: A discussion of risk
and regulatory engagement; Discussion Paper 05/4;Financial Services
Authority of the United Kingdom at 20-21 (June 2005), available at
www.fsa.gov.uk/pubs/discussion/dp05_04.pdf
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Rise of ``Activist'' Funds
Well-known corporate lawyer Marty Lipton has warned about a group
of ``activist'' hedge funds who are pressuring companies to make
changes in order to increase their share prices.\20\ He calls this
activity a ``replay of the attempt to drive American business to short-
term results instead of long-term values,'' and he terms this more
dangerous than the ``junk bond bust-up greenmail activity of the '70s
and '80s.'' While activist investors represent only a small part of the
overall picture, they have had a higher profile due to press accounts
of their activities at companies like Time Warner and Wendy's
International. The press also has been quick to report on management's
characterization of these investors as ``raiders'' or short-term
investors, intent upon pushing a company to take actions to bump up
share prices for quick profits.
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\20\ Andrew Ross Sorkin, To Battle, Armed with Shares, N.Y. Times,
Jan. 4, 2006 at C1.
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These arguments are not new but are similar to ones made during the
wave of corporate takeover and restructuring activity in the 1980s.
Yet, after a lengthy examination of that activity and dozens of
studies, reports, and congressional hearings, neither the Congress, the
SEC, nor any other government agency took steps to curb the activity,
which many believed was beneficial. The 1985 Economic Report of the
President stated that ``mergers and acquisitions increase national
wealth, [t]hey improve efficiency, transfer scarce resources to higher
valued uses, and stimulate effective corporate management.'' \21\
Active investors have helped to weed out deficient management, or
unlock value by pressuring management to separate a firm's productive
units into independent operations that can produce goods, services and
employment more efficiently than if they were otherwise bound together.
A recent study also showed that activist institutional shareholders can
cause CEO compensation to more closely track return on investment,
rather than balloon with increases in firm size.\22\ Activist investors
offer ideas and business expertise that should not be dismissed by
corporate managers.\23\
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\21\ Economic Report of the President, 196 (Washington: U.S.
G.P.O., Feb. 1985).
\22\ Wright, Kroll, and Elenkov, Acquisition Returns, Increase in
Firm Size, and Chief Executive Officer Compensation: The Moderating
Role of Monitoring, Academy of Management Journal, v. 45, June 2002,
available at www.aomonline.org
\23\ This was reported to be the case with Lear, a manufacturer of
vehicle seats and interiors, which had earlier ignored the advice of a
large shareholder to refinance its debt. Jesse Eisinger, Long and
Short: Lear Case Shows Sometimes Investors Can Detect Crises Before
Management, Wall St. J., Mar. 15, 2006, at C1. After announcing recent
restructuring efforts, its share value climbed almost 50 percent.
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This is not to say that all such activity produces optimum business
results. However, the beauty of our market system is that business
owners--the shareholders--are free to make choices in the marketplace
for competing ideas about how a business should be managed.
Jana Partner's Barry Rosenstein recently wrote that
characterization of activists as ``sharks,'' ``raiders,'' and ``short-
term investors'' versus CEOs defending the ``long term'' investors
misses the point.\24\ Of course activist hedge funds invest for
profit--after all, that's the American way--and they seek to shake up
poor performing managers in order to cause the stock price to reflect a
company's real value, which is in the best interests of all
shareholders. As Rosenstein points out, portraying managers as
``defenders'' of a corporation versus its ``attackers'' misrepresents
the nature of these contests, which really are campaigns between
managers and the activists for the support of the company's
shareholders. As this Committee knows too well, corporate CEOs and
managers often need ``watchdogs'' to monitor their actions. When those
watchdogs are activist shareholders pushing managers to take steps to
increase shareholder value, the ultimate beneficiaries of their
activity are the shareholders--the owners--of the corporation. One of
the goals of the Sarbanes-Oxley Act was to make management more
responsive to shareholders. It is ironic that shareholders who are
willing to engage themselves to push management to be more accountable
should be so miscast.
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\24\ Barry Rosenstein, Why activism is good for all shareholders,
Fin. Times, Mar. 9, 2006.
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Unlawful Hedge Fund Activity
Another criticism of hedge funds relates to charges of illegal
activity by funds--a criticism often coupled with statements about the
``unregulated'' nature of hedge funds. As discussed above, although
hedge funds are exempt from registration under the Investment Company
Act, they are subject to a panoply of legal requirements and liability,
including liability for fraud, insider trading, and market
manipulation. Recent high profile cases have involved misappropriation
of investor assets (e.g., Bayou Funds, International Management
Associates, LLC), \25\ and cases such as those announced earlier this
year where the SEC settled charges against three affiliated hedge funds
and their portfolio manager for insider trading, wash trades and
illegally using restricted stock to cover short sales.\26\ While we do
not have personal knowledge of these particular cases, CPIC strongly
supports vigorous action by the SEC, and criminal authorities where
appropriate, against any market participant engaged in these types of
activities, which not only harm investors, but foster mistrust and lost
of confidence in our markets.
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\25\ SEC v. Samuel Israel III, SEC Litigation Release No. 19406,
2005 WL 2397234 (Sept. 29, 2005) (According to the SEC, managers of a
group of hedge funds known as the Bayou Funds grossly exaggerated
claims regarding the funds' performance, when in fact, the funds had
never posted a year-end profit); SEC v. Kirk S. Wright, SEC Litigation
Release No. 19581 2006 WL 487825 Feb. 28, 2006) (According to the SEC,
fund managers engaged in an ongoing fraud involving sales of interests
in hedge funds, based upon false claims of profits and bogus account
statements).
\26\ SEC v. Langley Partners, L.P., SEC Litigation Release No.
19607, 2006 WL 623053 (Mar.14, 2006).
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That said, it would be inaccurate and unfair to suggest that
unlawful activity in the hedge fund industry is disproportionate to
that in other, more regulated, areas of the financial markets.\27\
There are miscreants in every industry, and all participants in our
markets--whether they are hedge fund managers, brokers, issuers, or
accountants--need to do a better job of vigilance to assure that crooks
do not undermine confidence in the integrity of our markets and the
millions of honorable professionals who work in them. In addition,
changes in practice, standards, and regulation can and should be made
where appropriate to lessen the opportunities for abuse. In the
discussion below, we note that the area of valuation is an area of
concern.
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\27\ See Registration Under the Advisers Act of Certain Hedge Fund
Advisers, Release No. IA-2333 (Dec. 2, 2004), 69 Fed. Reg. 72054,
72092--72096 (Dec. 10, 2004) (dissenting statement of Commissioners
Glassman and Atkins).
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Valuation--Performance Reporting
We believe valuation is an area of hedge fund activity open to
abuse--both as to the potential for outright fraud, and as to the lack
of or failure of adequate models or policies and procedures to conduct
valuation of derivatives, other illiquid assets, or securities for
which market prices are not readily available. Performance reporting is
another area of confusion and potential for abuse. Neither problem is
addressed by the requirement that hedge fund advisers register with the
SEC.
Proper valuation of fund assets is an extremely important component
of investor protection. Valuations serve many crucial functions, and it
therefore is important that they be accurate and performed in an
unbiased, consistent and transparent manner. Valuations of assets and
liabilities are used to determine the value of the units of the fund
owned by investors. As a reported number, this tells the investor what
his or her investment is worth at a given point in time. These numbers
also determine the price at which new units are issued and existing
units are redeemed. To avoid dilution and unfairness, these numbers
must be accurate and unbiased. Valuations are used to determine the
compensation of the hedge fund's managers which typically is a
percentage of the asset value of the fund during a month, quarter or
year, and a percentage of the increase in value of the fund of the past
year. Valuations are also used to calculate performance reporting
numbers, to inform investors how the fund is performing over time, both
in absolute return terms, relative to the relevant market index
benchmarks, and under various statistical measures of volatility and
tracking that are designed to measure risk and the degree to which the
fund manager sticks to its investment strategy.
The consistency and uniformity of performance reporting also is an
area of concern. It goes to the heart of an investor's ability to
choose wisely among a myriad of financial and investment products--
giving the investor an ``apples vs. apples'' choice--a true comparison.
However, as discussed in a recent article coauthored by noted economist
Burton Malkiel, \28\ the main sources of comparative statistics on the
performance of hedge fund managers are the data bases of private
vendors, which he says have systematically overstated annual
performance by hedge funds and funds of funds. He notes that managers
can select a starting date for reporting to maximize returns, that the
data bases have a ``survivorship bias'' (they do not take into account
funds that have gone out of existence), and that the returns are non-
standardized. Others have noted the temptation for some hedge fund
managers to manage returns upward at year end in order to achieve
performance-based incentive compensation--just as managers of
registered investment companies may inflate year-end portfolio
prices.\29\
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\28\ Burton G. Malkiel and Atanu Saha, Hedge Funds: Risk and
Return, Fin. Analysts J., Vol. 61, No. 6 (2005), available at http://
www.cfapubs.org
\29\ Vikas Agarwal, Naveen D. Daniel, and Narayan Y. Naik, ``Why Is
Santa so Kind to Hedge Funds? The December Return Puzzle!'' (Mar. 9,
2006), available at http://ssrn.com/abstract=891169
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Hedge funds are subject both to GAAP accounting standards, and to
Federal and state anti-fraud restrictions in their performance
reporting. The SEC Staff has issued a long series of letters
delineating performance calculation, reporting and disclosure
requirements for registered and exempt investment advisers, under the
anti-fraud provisions of the Advisers Act, and SEC enforcement orders
in this area further illuminate the expectations of the SEC on
performance reporting.\30\ Those managers who stray from the SEC's
valuation and performance reporting precepts are subject to
administrative enforcement actions and private civil liability under
the anti-fraud provisions of the Federal securities laws. When
investment managers miscalculate and misrepresent performance
statistics they are engaging in fraud. They are like baseball players
using corked bats and steroids to improve their statistics.
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\30\ Further, an academic and industry organization, the CFA
Institute (formerly known as AIMR) headquartered in Charlottesville
near the University of Virginia, promulgates widely followed but
voluntary standards for performance reporting by investment managers.
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It is true that registered investment advisers are required to
adopt policies and procedures on valuation issues, provide GAAP
accounting statements, and follow SEC Staff guidance on performance
reporting for their hedge funds. Unfortunately, SEC guidance on
valuation of securities, derivatives and other assets for which a
market quotation is not readily available was adopted decades ago in a
different and less sophisticated era, and essentially requires the use
of good faith estimates, not a clear and uniform methodology. Guesswork
and proprietary models are what are available. GAAP is not much better,
and FASB has been struggling of late to promulgate clearer guidance on
valuation issues.\31\ As active trading vehicles, hedge funds that
provide audited financial statements (as most do) are subject to
accounting requirements that the values of all of their portfolio
positions be calculated at current market or fair value (i.e. ``marked
to market'') for each reporting period. For many assets--including many
of the newer or exotic derivatives that do not trade on an exchange--
the standard is not mark to market, it may be instead mark to your best
guess of current value.\32\ Consequently, unscrupulous investment
managers can exploit these deficiencies to artificially inflate both
the value of their investments and their profitability. Indeed,
registered investment companies have long been subject to detailed
portfolio valuation requirements and performance reporting standards
under the 1940 Act, and yet false and inaccurate valuation and
performance reporting has remained a vexing problem for investors in
registered funds.\33\
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\31\ See FASB Report: FASB Adds Project To Improve Fair Value
Measurement Guidance, (June 30, 2003) (announcing project to codify and
improve guidance for measuring fair value) and Project Updates: Fair
Value Measurements (Jan. 30, 2006) (On January 25, 2006, FASB discussed
issues raised by reviewers on an October, 2005 working draft of a final
FASB Statement, Fair Value Measurements), available at www.fasb.org/
project/fv_measurement.shtml
\32\ We note that the 2-year lock-up exemption from private fund
manager registration under the Advisers Act lends itself best to funds
that invest in illiquid assets--and illiquid assets are the ones for
which valuation issues are most extreme. Therefore, the current hedge
fund manager registration requirement is not particularly well targeted
at improving valuation practices at these types of private investment
funds in particular.
\33\ See, e.g., In the Matter of FT Interactive Data, f/k/a
Interactive Data Corp., Investment Company Act Release No. 26291 (Dec.
11, 2003); SEC v. Heartland Group, Inc., Litigation Release No. 16938,
2001 WL 278474 (Mar. 22, 2001); White v. Heartland High-Yield Mun. Bond
Fund, 237 F. Supp. 2d 982 (E.D. Wis. 2002); In the Matter of Piper
Capital Mgmt., Inc., Investment Company Act Release No. 26167 80 S.E.C.
Docket 2791 (Aug. 26, 2003); In the Matter of the Rockies Fund,
Investment Company Act Release No. 26202 81 S.E.C. Docket 534 (Oct. 2,
2003).
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Despite the existing requirements on valuations and performance
reporting, there is substantial room for improvement in this area by
hedge funds, mutual funds and other investment management vehicles.\34\
We believe that valuation and performance reporting issues are
appropriate governmental concerns--but first and foremost, they should
be the concern of any fund manager or other market participant, as well
as hedge fund investors.\35\ In our view, the appropriate role for
government in this area is to facilitate and encourage a dialog among
experts from across the financial services industry, academia, the
accounting profession, economists and others, on valuation issues and
best practices. For example, the U.K.'s Financial Services Authority
and the International Organization of Securities Commissions have a
project underway to examine the valuation policies and procedures
employed by hedge funds and their counterparties and to work with
industry representatives to develop a global set of principles that
will attract global consensus.\36\
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\34\ The situation is most acute for positions in complex and
illiquid assets, for which there is not a reporting market providing a
transparent daily consensus valuation. By necessity, estimates and
pricing models must be used to value these types of fund portfolio
positions, and there is much opportunity for mischief. In the
derivatives area in particular, hedge funds should delineate their
unrealized derivative gains and losses by breaking them out on the
income statement and balance sheet. This will aid transparency and is
simply good public policy.
\35\ The Managed Fund Association, for example, in its publication
``MFA's 2005 Sound Practices for Hedge Fund Managers,'' addresses the
importance of hedge fund managers establishing valuation policies and
procedures that are fair, consistent and verifiable, and it discusses a
number of steps hedge fund managers should take in pricing assets and
performing valuations. Available at www.mfaininfo.org/images/PDF/
MFA2005SoundPracticesPublished.pdf
\36\ See Hedge Funds: A discussion of risk and regulatory
engagement, Feedback Statement 06/2 Financial Services Authority of the
United Kingdom, at 24-26 (March 2006) available at www.fsa.gov.uk/pubs/
discussion/dp05_04.pdf
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We would also point out that valuation issues cannot be solved by
the SEC acting alone. Valuation of over-the-counter derivatives or
other types of illiquid investments is a topic that rightly must
involve all of the members of the President's Working Group, and in
particular, the Board of Governors of the Federal Reserve System, to
ensure consistency and harmony.
The ``Retailization'' of Hedge Funds
An area of concern raised by both the SEC and state regulators has
been the ``retailization'' of hedge funds, \37\ meaning, the sale of
hedge funds to a broader group of less wealthy, less sophisticated
investors than in the past. The Federal securities laws and SEC rules
have long recognized that sophisticated and high net worth investors
are able to bear greater risks than those with less sophistication or
modest means. Thus, hedge funds generally accept investments only from
``accredited investors'' or ``qualified purchasers,'' as defined in SEC
rules that set out minimum qualifications for individuals relating to
their net worth and income. CPIC believes these same concepts should
apply in the future, though they should be updated.
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\37\ See Investor Protector Implications of Hedge Funds before the
S. Comm. on Banking, Housing, and Urban Affairs, (Apr. 10, 2003)
(statement of William Donaldson, Chairman, SEC), available at
www.banking.senate.gov/03-04hrg.04103.donaldsn.pdf
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When Regulation D, the SEC's private offering exemption, was
adopted over twenty years ago, its definitions of ``accredited
investor'' included individuals whose annual income exceeded $200,000,
or whose net worth (or joint net worth with that of a spouse) exceeded
$1 million. Those standards remain unchanged today. Meanwhile, as the
SEC has acknowledged, inflation and growth in income levels have led to
a substantial increase in the number of investors who are now
``accredited,'' though not necessarily financially sophisticated.\38\
---------------------------------------------------------------------------
\38\ Staff Report, supra n.10, at 80.
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In general, the investment strategies of private investment funds
involve substantial risk and illiquidity, and they are not appropriate
for the average investor. It may be time to re-examine the accredited
investor standard. When Congress enacted an expansion of the qualified
purchaser exemptions in 1996, it used the criteria of $5 million in
``investible assets''--a more selective barrier than that used to
define ``accredited investor''--as the presumptive basis for market
sophistication. Other approaches might include a higher net worth
requirement together with a limit on investment in a fund to a
percentage of an individual's net worth (some states, such as
California and North Carolina, historically have used a cap on
privately placed investments at 10 percent of the investor's net worth
as a rough benchmark or limit, while others have used a 20 percent
limit).\39\
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\39\ Compare 10 Cal. Code Regs. Tit. 10, Sec. 260.140.01; 18 N.C.
Admin. Code 6-1206 (20060; with 003-14-006 Ark. Code R. Sec. 504 (Weil
2006).
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Funds of Hedge Funds
Another aspect of the retailization issue is the growth of ``funds
of funds''--the term used to describe an investment company that
invests in hedge funds rather than individual securities. Some of these
funds of hedge funds have registered their securities with the SEC,
enabling them to sell shares to retail investors. The SEC Release
accompanying its private fund registration rule stated that, although
``[m]ost funds of hedge funds are today offered only to institutional
investors . . . there are no statutory limitations on the public
offering of these funds.'' \40\ The SEC Staff Report on hedge funds
also noted the Staff's concern that investors may not understand the
impact of multiple layers of fees in funds of hedge funds, or that
funds of hedge funds may expose them to levels and types of risks that
are not appropriate.\41\ We note that some of the more publicized funds
of hedge funds being marketed to the ``retail'' investor are being sold
by large broker-dealers with significant retail distribution networks.
The Staff Report also expressed concern with ``the reliability of
registered [funds of hedge funds] calculations of net asset value
[because] [t]here are no readily available market prices for hedge fund
securities.'' \42\
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\40\ Registration of Certain Hedge Fund Advisers, supra n.27 at
72057.
\41\ Staff Report, supra n.10 at xii, 68-72.
\42\ Id. at 81.
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We suggest that the SEC consider some of the measures suggested by
the Staff in its hedge fund report. In particular, the SEC may wish to
consider rules prohibiting registered investment companies from
investing in hedge funds unless their directors have adopted procedures
designed to ensure that the funds value those assets consistently with
the requirements of the 1940 Act.\43\
---------------------------------------------------------------------------
\43\ Id. at 99.
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Role of Short Sellers
Let me say a brief word about short selling, which is one of the
strategies used by hedge funds. The SEC and self-regulatory
organizations repeatedly have recognized that short sellers bring
important liquidity and a sense of skepticism to the marketplace.\44\
Short sellers test the ideas put forward by management; they often help
the marketplace and enforcement agencies ferret out genuine fraud. In
fact, some of the most spectacular corporate frauds--Enron, Tyco,
Conseco, and Sunbeam, to name just a few--were first uncovered by short
sellers.
---------------------------------------------------------------------------
\44\ Staff Report at 40. According to the SEC staff, ``Short
selling . . . can contribute to the pricing efficiency of the markets.
. . . When a short seller speculates on . . . a downward movement in a
security, the transaction is a mirror image of the person's who
purchases the security based upon speculation that the security's price
will rise . . . . Market participants who believe a stock is overvalued
may engage in short sales in an attempt to profit from a perceived
divergence of prices from true economic values. Such short sellers add
to stock pricing efficiency because their transactions inform the
market of their evaluation of future stock price performance. This
evaluation is reflected in the resulting market price of the
security.''
---------------------------------------------------------------------------
But notwithstanding these benefits, short selling is subject to
significant regulatory restraints and costs, as well as attacks from
issuers and other market participants who have a stake in seeing the
price of a security go up. Short sellers must borrow stock that is sold
short, must post collateral, pay interest, carry the costs of borrowing
often for months or longer, risk upward price movement, post additional
collateral requirements if the price of the stock moves against them,
and bear the risk that borrowed shares will suddenly be recalled by the
lender. Short sellers are subject to potential ``short squeeze''
manipulation. Short selling is costly, and risky--prompting one
commentator to write, ``It's a wonder anyone does it at all.'' \45\
---------------------------------------------------------------------------
\45\ Jesse Eisinger, Long and Short: It's a Tough Job, So Why Do
They Do It? The Backward Business of Short Selling, Wall St. J., Mar.
1, 2006, at C1.
---------------------------------------------------------------------------
The SEC has an ongoing examination program to determine compliance
with Regulation SHO, which became effective less than 2 years ago, and
Chairman Cox has stated that he will recommend changes in the rule if
the exams demonstrate the need for such modifications. The SEC also has
been aggressive in bringing enforcement actions against market
participants who use short selling strategies to manipulate and drive
down the price of a security.\46\ We support these actions by the SEC
and believe they are essential to protect investors and ensure the
integrity of the markets as a whole, as well as to assure that short
sellers who play by the rules will continue to perform the important
role they have played in bringing healthy skepticism and liquidity to
the markets.
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\46\ See, e.g., SEC v. Langley Partners, L.P., SEC Litigation
Release No. 19607, 2006 WL 623053 (Mar. 14, 2006); SEC v. Andreas
Badian, SEC Litigation Release No. 19639, 2006 WL 859248 (Apr. 4,
2006).
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The Importance of the Financial Press and Independent Research and
Analysis
Bearing these principles in mind, I want to take this opportunity
to discuss an important issue, which was highlighted by the controversy
over SEC-issued subpoenas to financial reporters earlier this year.
Just as the U.S. and global financial and securities markets
benefit from a wide diversity of market participants with competing
views and trading and investing strategies, they also benefit from a
vigilant, hard-working, and skeptical financial press.
Earlier this year, the SEC enforcement staff sent subpoenas to
certain financial reporters requiring the production of any evidence of
communications between the reporters and certain stock analysts and
short-selling funds that had expressed criticism of particular
companies and their management. The subpoenas were quickly recalled,
and SEC Chairman Cox issued the following statement, ``The sensitive
issues that such a subpoena raises are of sufficient importance that
they should, and will be, considered and decided by the Commission
before this matter proceeds further.\47\
---------------------------------------------------------------------------
\47\ Press Release, SEC, Statement by Securities and Exchange
Commission Chairman Christopher Cox Concerning Subpoenas of
Journalists, (Feb. 27, 2006), available at http://www.sec.gov/news/
press/2006-24.htm
---------------------------------------------------------------------------
In an interview in the Wall Street Journal appearing the following
day, Chairman Cox cited the ``symbiosis'' between the work of the SEC
and the business media, and explained that in order not to chill the
disclosure of information that both government and reporters should
promote, such subpoenas would be ``extraordinary.'' Chairman Cox noted
that the SEC's ``regulatory mission in major part requires us to ensure
all material information is divulged in the first instance. Unless it
is publicized . . . markets cannot function. We don't want to do
anything therefore to chill that activity.'' \48\
---------------------------------------------------------------------------
\48\ Kara Scannelli, Cox Knocks Journalist Subpoenas, Wall St. J.,
Feb. 28, 2006, at C1.
---------------------------------------------------------------------------
On April 12, the SEC expanded on these concepts in a policy
statement, stating ``Effective journalism complements the Commission's
efforts to ensure that investors receive the full and fair disclosure
that the law requires, and that they deserve. Diligent reporting is an
essential means of bringing securities law violations to light and
ultimately helps to deter illegal conduct.'' \49\
---------------------------------------------------------------------------
\49\ Press Release, SEC, Policy Statement of the SEC Concerning
Subpoenas to Members of the News Media (Apr. 12, 2006), available at
http://www.sec.gov/news/press/2006/2006-55.htm
---------------------------------------------------------------------------
These statements demonstrate an awareness of the legitimate role of
the business press and the critical need for the free interchange of
information and opinion in the nation's securities markets. Indeed, the
principal theory behind the First Amendment itself is that its
protections recognize the value of a ``marketplace of ideas.'' \50\
---------------------------------------------------------------------------
\50\ See J.S. Mill, On Liberty, (1859); Abrams v. United States,
250 U.S. 616, 630, 40 S.Ct. 17, (1919) (Holmes, J., dissenting).
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The ability of business journalists to communicate with sources is
of paramount interest to the functioning of the markets, as is the
ability of securities analysts to disseminate their views free from
retaliation by issuers. Independent analysts, who sell their research
and analyses to customers who pay for their services, whether by
subscription or by individual report, offer a particularly valuable
service to our markets. They are not associated with investment banking
firms and do not face the temptation to issue overly bullish analyses
in order to acquire other business. As this Committee is all too aware,
the pervasive conflicts of interest among securities analysts employed
by major investment banks led to the adoption of Title V of the
Sarbanes-Oxley Act of 2002 and subsequent rulemaking proceedings, as
well as enforcement actions by the SEC, the self-regulatory
organizations, and state securities regulators--all designed to reduce
or eliminate the source of their conflicts within investment banking
firms and make analysts reports more objective and useful to investors
who rely on them. Hearings before this Committee in 2002 revealed that,
not only were analysts induced to write favorable reports by receiving
compensation from their firms for their role in capturing investment
banking business, but they faced retaliation from issuers for negative
coverage.\51\
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\51\ Thomas Bowman, President and CEO of the Association for
Investment Management and Research, testified that ``[i]ssuers . . .
bring lawsuits against firms and analysts personally for negative
coverage. But more insidiously, they `blackball' analysts by not taking
their questions on conference calls or not returning their individual
calls to investor relations or other company management. This puts the
`negative' analyst at a distinct competitive disadvantage, increases
the amount of uncertainty an analyst must deal with in doing valuation
and making a recommendation, and disadvantages the firm's clients, who
pay for that research.'' [S. Rep. No. 107-205, at 38 (2002)]
---------------------------------------------------------------------------
The Sarbanes-Oxley Act does not address retaliation by issuers.
Nonetheless, in a letter to Senator Ron Wyden in September 2005,
Chairman Cox stated that it was a matter of concern, and that the SEC
was contemplating action to protect stock analysts from retaliation by
issuers. In a memorandum accompanying the letter, the SEC staff related
that it had contacted nine unidentified ``multi-service'' broker-
dealers and found that at least six believed they had experienced
retaliation from issuers for negative reports. This is all the more
troubling, in that such ``multi-service'' firms are, most likely,
investment banking powerhouses with the clout and deep pockets to
defend themselves.\52\
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\52\ Letter from Christopher Cox, Chairman, Securities and Exchange
Commission, to the Honorable Ronald Wyden, U.S. Senate, (Sept. 1,
2005). Unfortunately, issuer retaliation appears to be a continuing
problem. See Michael Mayo, Why Independent Research Is Still Rare, CFA
Magazine, May/June 2006, at 8-9.
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Independent securities analysts can offer a refreshingly skeptical
view of particular companies, but they too face threats and
intimidation, including the threat of lawsuits by issuers, who seek to
discredit negative analyst reports. Harassing tactics employed by
issuers (at shareholder expense, I should note) have even included
spying by private investigators and rummaging through the trash of the
offending party.\53\
---------------------------------------------------------------------------
\53\ See, e.g., Roddy Boyd Trash Stalkers, N.Y. Post, Mar. 3, 2006.
---------------------------------------------------------------------------
The reforms of the research practices of major investment and
commercial banks as a result of Sarbanes-Oxley and the Global Research
Analyst Settlement are important and should not be allowed to be
undermined by issuer intimidation. We strongly believe that all
analysts should be free to express their views without fear of
intimidation by issuers or over-zealous government agents, regardless
of where they are working. If there is any doubt about the beneficial
role that such hard-hitting independent research plays in the financial
marketplace, it should be put to rest by testimony in the trial of Ken
Lay and Jeff Skilling over the past 2 months in Houston. In that
testimony, a former Enron executive described a critical research piece
written by an independent analyst that questioned the company's
financials and practices--practices that have already led to the
conviction for fraud of several top officers of the company. The report
concluded that the company's shares should be valued at half their
then-going price. With Ken Lay present, Skilling's reaction to this
report was: ``They're on to us.'' \54\
---------------------------------------------------------------------------
\54\ Mary Flood, Skilling Told Team ``They're On to Us,'' Witness
Says, Houston Chronicle, Mar. 3, 2006.
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Financial reporters, analysts, and active market participants all
provide an important counterweight to overly optimistic or sugar coated
statements made by public companies and their financial advisers. In
seeking to compel production of evidence of communications between
business journalists and their sources, the SEC subpoenas had the
potential to chill communications between reporters and significant
sources of expert analysis, thus limiting the information available to
investors.\55\ We believe all investors will benefit from the action
taken by the SEC Chairman in making it clear that such subpoenas will
be considered only in extraordinary circumstances.
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\55\ To be distinguished, of course, are cases where journalists
participate in some scheme relating to the very transactions that they
report. See Carpenter v. United States, 484 U.S. 19, 108 S. Ct. 316, 98
(1987).
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______
PREPARED STATEMENT OF JOHN GAINE
President, Managed Funds Association
May 16, 2006
As the largest and most diverse U.S.-based association representing
the hedge fund industry, Managed Funds Association (``MFA'') is pleased
to provide this testimony to the Senate Subcommittee on Securities and
Investment regarding the Role of Hedge Funds in the Capital Markets.
The hedge fund industry has experienced significant growth in
recent years, with assets under management estimated at $1.5
trillion.\1\ MFA believes this is a direct result of the demand largely
from institutional investors for investment vehicles that offer a
diversity of investment styles and that help them meet their future
funding obligations and other investment objectives. As former Federal
Reserve Chairman Alan Greenspan has noted, hedge funds have ``become
increasingly valuable in our financial markets.'' \2\ Hedge funds
enhance market liquidity and contribute to pricing efficiency and
market stability. Hedge funds also foster financial innovation and risk
sophistication among the market participants with which they deal.
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\1\ Based on reported estimates by Hedge Fund Intelligence
(London).
\2\ Remarks by Chairman Alan Greenspan, ``Risk Transfer and
Financial Stability,'' to the Federal Reserve Bank of Chicago's Forty-
first Annual Conference on Bank Structure, Chicago, Illinois, May 5,
2005.
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MFA recognizes that with the growth and evolution of the hedge fund
industry have come new responsibilities and challenges. The hedge fund
industry and policymakers currently face an important challenge, namely
to preserve the benefits offered by hedge funds while addressing
legitimate investor protection issues presented by the growth in hedge
fund investments.
Background on MFA
Founded in 1991, MFA is the U.S.-based global membership
organization dedicated to serving the needs of the professionals who
specialize in the alternative investment industry. MFA's over 1,000
members include professionals in hedge funds, funds of funds, managed
futures funds, and other financial and commodity-linked investments.
They also include financial and commodity trading advisors, pool
operators, and trading managers. MFA members manage a substantial
portion of the estimated $1.5 trillion invested in these investment
vehicles. Members include representatives of a majority of the 50
largest hedge funds groups in the world. MFA membership also includes
the sponsors, investment managers and brokers for substantially all of
the financial and commodity pools marketed on either a public or
private basis in the United States. The larger hedge fund managers
represented within MFA collectively manage in excess of $500 billion in
assets and pursue a wide range of investment strategies.
As further explained below, MFA's activities include educational
outreach to and representation before the Securities and Exchange
Commission (``SEC''), Commodity Futures Trading Commission (``CFTC''),
Federal Reserve, Treasury Department, State and international
regulatory agencies, and Congress. MFA also participates in a number of
private sector initiatives, including development of industry sound
practices, participation in Treasury-sponsored advisory committees, and
work with the major dealers in improving credit derivative market
practices.
Overview of Hedge Funds and Their Strategies
Definition of Hedge Fund
The term ``hedge fund'' is not a defined term under the Federal
securities laws, except generally to connote a private investment fund
that is not required to register as an investment company under the
Investment Company Act of 1940 (the ``Investment Company Act'').\3\ It
is thus a term that is susceptible of different meanings to different
people. In general, and for purposes of this testimony, MFA considers a
``hedge fund'' to be a privately offered investment company that is
administered by a professional investment manager that seeks attractive
absolute return.\4\ In this regard they are similar to venture capital,
private equity, leveraged buyout, oil and gas, and real estate funds,
although MFA does not intend to capture them within its definition of
``hedge fund.''
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\3\ More technically, a ``hedge fund'' is an investment company
that is not required to register with the SEC by virtue of Section
3(c)(1) or 3(c)(7) of the Investment Company Act and that conducts only
private offerings under the SEC's Regulation D.
\4\ This is in keeping with the definition used by the President's
Working Group on Financial Markets, of ``any pooled investment vehicle
that is privately organized, administered by professional investment
managers, and not widely available to the public.'' President's Working
Group on Financial Markets Report, ``Hedge Funds, Leverage and the
Lessons of Long-Term Capital Management,'' April 1999, at 1.
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Investment Profiles
As noted above, hedge funds are more easily defined in relation to
what they are not. They are investment companies that are not publicly
offered. The hedge fund universe is characterized by a wide variety of
strategies, with different risk characteristics and different return
expectations. Many hedge funds managers engage in ``absolute return''
strategies, meaning that their returns do not depend on, nor are they
benchmarked against, the long-term return of the markets or the assets
in which they invest. In other words, hedge funds seek to achieve
positive returns based on the skill or strategy of the manager rather
than meet or exceed the performance of the underlying market or asset
class. Many hedge fund strategies employ ``enhanced active
management,'' in which managers combine traditional active management
with techniques such as short selling and leverage. Some hedge fund
strategies may not be based on traditional techniques at all, such as
risk arbitrage, convertible hedging, and distressed debt.
Major hedge fund investment strategy classifications include the
following:
Long/short strategies for trading in equities.
``Macro'' or global directional investment strategies,
which take positions in domestic and international currency,
interest rate and equity markets based on global economic
conditions and opportunities perceived to be presented by them.
``Market-neutral,'' ``relative value,'' or arbitrage
strategies, which take offsetting long and short positions or
otherwise hedged positions to reduce market risk and utilize
leverage to achieve desired returns.
Event-driven strategies, which seek to profit from
anticipated events or special situations, such as mergers,
restructurings, distressed securities.
Regional strategies, which concentrate on a particular
geographic region (such as emerging markets).
Sector strategies, which focus on a particular industry.
Long only, or ``buy and hold,'' equity strategies, similar
to traditional equity mutual fund strategies, but which may
also include active efforts to become involved in the
management of holdings.
Dedicated short sale equity strategies focusing on selling
short securities that are deemed to be overvalued.
Specific asset class strategies (such as currencies,
commodities, interest rates).
The significance of these broad array of strategies should not be
underestimated, as it reflects the increasing segmentation of the hedge
fund industry, and with that the growing segmentation of risk. Today's
hedge fund industry is thus actually comprised of many sub-industries,
with separate and distinct pockets of risk. Each strategy can prudently
withstand different levels of leverage, and each strategy has a
different time horizon for investment and varying levels of volatility.
The diversity of strategies employed by hedge funds also presents
important considerations for policymakers seeking to accurately
understand the scope of potential challenges as well as the efficacy of
potential remedies.
Size
Because of the non-public nature of hedge funds, there is no
universally accepted estimate on the size of the hedge fund universe;
MFA believes it consists of 5,000 to 7,000 funds with total assets of
approximately $1.5 trillion. A small number of these hedge funds are
part of large organizations with assets over $1 billion and performance
records extending 10 years or more. At the other end of the
marketplace, there are thousands of small firms managing hedge fund
assets under $50 million each.\5\
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\5\ See Robert Jaeger, All About Hedge Funds, McGraw-Hill (2003),
at 57.
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Beneficial Role of Hedge Funds in Capital Markets
Diversification for Institutional Investor
Much of the growth in hedge funds since the 1980s can be attributed
to the increasing recognition by institutional investors that hedge
funds can help diversify returns and thereby reduce the overall risk of
an investment portfolio. The majority of direct investment in hedge
funds by institutional investors has come from endowments and
foundations. From 2004 to 2005, endowments increased their hedge fund
allocations from 7.3 percent to 8.7 percent on average.\6\
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\6\ 2005 NACUBO Endowment Study.
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According to a study by the Bank of New York, ``the hedge fund
industry is midway through an important transition in its source of
capital.''
Five years ago, hedge funds derived virtually all of their
assets from wealthy individuals. Institutional interest was
limited to a small number of endowments and foundations. Over
the next 5 years, institutions (including pension funds) are
likely to provide an additional $250 billion of hedge fund
capital, accounting for 35 percent of net new flows in this
period.\7\
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\7\ Bank of New York and Casey, Quick and Acito, ``Institutional
Demand for Hedge Funds: New Opportunities and New Standards''
(September 2004).
Corporation and public pension plan investments in hedge funds
continue to grow both through direct investments and through fund of
hedge funds vehicles.\8\ Former Federal Reserve Chairman Alan Greenspan
has noted that these inflows may be attributed to institutional
investors seeking alternatives to long-only investment strategies in
the wake of the bursting of the equity bubble in 2001.\9\
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\8\ A Morgan Stanley Prime Brokerage report suggests that corporate
pension plans prefer direct allocations to hedge funds while public
pension plans prefer indirect allocations.
\9\ Remarks by Chairman Alan Greenspan, ``Risk Transfer and
Financial Stability,'' to the Federal Reserve Bank of Chicago's Forty-
first Annual Conference on Bank Structure (May 5, 2005), at 6.
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These institutional investors understand that hedge funds provide
attractive mechanisms for portfolio diversification because hedge
funds' absolute returns tend to have little or no correlation to those
of more traditional stock and bond investments. Many hedge fund
categories may therefore outperform stock and bond investments when the
latter perform poorly. Investment in hedge funds can thus help
diversify risk in many institutional investment portfolios. Drawdowns
in individual hedge funds--largest drop from peak value to trough
value--are often less than in publicly traded indices. Academic
research recognizes that hedge fund investments can reduce overall risk
of investment portfolios for investors such as endowments and public
and private pension plans.\10\
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\10\ See Written Statement of Managed Funds Association before the
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises of the House Committee on Financial Services, U.S. House of
Representatives, May 22, 2003, at Annex A.
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Source of Liquidity
As active trading participants in international capital markets,
hedge funds add depth and liquidity to markets. This characteristic of
hedge funds has been recognized by commentators including former
Federal Reserve Chairman Alan Greenspan. He testified before the Senate
Banking Committee in 2004, ``it's so important that [hedge funds] are
left free to supply the extent of liquidity that they are supplying to
our financial markets. . . . the degree of flexibility in our economy
has been instrumental in enabling us to absorb the shocks which have
been so extraordinary in recent years. One of the most successful parts
of our system is our ability to absorb financial shocks.'' \11\
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\11\ ``Renomination of Alan Greenspan as Chairman of the Federal
Reserve Board of Governors: Hearing Before the Senate Banking, Housing,
and Urban Affairs Committee'' (testimony of Alan Greenspan, Chairman of
the Board of Governors of the Federal Reserve) (June 15, 2004).
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Increase in Efficiency
By trading based on sophisticated and extensive market research,
hedge funds provide markets with price information that translates into
pricing efficiency. In targeting temporary price inefficiencies and
market dislocations, hedge funds effectively help to minimize market
distortions and eliminate these dislocations. The President's Working
Group described this function:
Hedge funds and other investors with high tolerance for risk
play an important supporting role in the financial system in
which various risks have been distributed across a broad
spectrum of tradable financial instruments. With financial
intermediation increasingly taking place in the capital markets
instead of banking markets, prices play a larger role in the
allocation of capital and risk. In this world, investors such
as hedge funds that undertake a combination of long and short
positions across markets help maintain the relative prices of
related financial instruments.\12\
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\12\ President's Working Group Report at 2-3.
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Decrease in Volatility
The increase in hedge fund growth has coincided with a decrease in
overall market volatility. This may be due to the added liquidity that
hedge funds provide to the market. This may also result from the fact
that hedge funds generally eschew the ``momentum trading'' that many
individual investors engage in. Because hedge fund investors generally
have accepted longer redemption horizons, hedge funds have fewer
incentives to engage in momentum trading. By contrast, more traditional
investors, such as mutual funds, are more likely to buy into rising
markets and sell into falling markets as a result of purchases and
redemptions by individual retail investors, accentuating market
volatility.\13\
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\13\ ``Hedge Funds and Financial Market Dynamics,'' Occasional
paper 166, International Monetary Fund (May 1998), at 29.
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Regulation of Hedge Funds
Under the Investment Company Act, any company that is engaged
primarily in investing in securities must register as an investment
company, unless an exemption or exclusion is available. To be excluded
from this registration requirement, hedge funds rely on one of two
exceptions from the definition of investment company.
The first, Section 3(c)(1) of the Investment Company Act, was part
of the Act as enacted in 1940. It provides that an investment fund will
not be required to register as an investment company if: (a) it has no
more than 100 investors, and (b) it does not offer its shares publicly.
In order to comply with the latter requirement, a fund sponsor will
effectively limit the offering of fund shares to ``accredited
investors,'' as defined in the SEC's Regulation D.\14\ In addition to
banks and other institutional investors, accredited investors include
natural persons with individual or joint net worth of $1 million or
individual income in each of the last 2 years in excess of $200,000, or
joint income for the same period of $300,000.
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\14\ The SEC staff has confirmed in a series of no-action letters
that hedge funds and other private investment vehicles that conduct
offerings pursuant to Regulation D can rely on Section 3(c)(1). Santa
Barbara Securities, SEC No-Action Letter (Mar. 8, 1983).
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The second, Section 3(c)(7) of the Investment Company Act, was
enacted as part of the National Securities Markets Improvement Act of
1996.\15\ It excepts funds from registration as investment securities
if each investor in the pool is a ``qualified purchaser'' and the pool
does not undertake a public offering. The term qualified purchaser
includes institutional investors; natural persons who have at least $5
million in investments; persons who, acting for themselves or the
accounts of other qualified purchasers, in the aggregate own and invest
on a discretionary basis not less than $25 million in investments; and
certain qualifying trusts. The Senate report on the legislation
provided the following rationale:
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\15\ P.L. No. 104-290, 110 Stat. 3416, 3432-33 (1996). The
legislation followed a 1992 report by the SEC's Division of Investment
Management that recommended the adoption of a new exception for private
funds sold exclusively to ``qualified purchasers.'' SEC, Division of
Investment Management, ``Protecting Investors: A Half Century of
Investment Company Regulation'' (1992), at 104-05.
The qualified purchaser pool reflects the Committee's
recognition that financially sophisticated investors are in a
position to appreciate the risks associated with investment
pools that do not have the Investment Company Act's
protections. Generally, these investors can evaluate on their
own behalf matters such as the level of a fund's management
fees, governance provisions, transactions with affiliates,
investment risk, leverage, and redemption rights.\16\
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\16\ S. Rep. No. 104-293, at 10 (1996).
That hedge funds are not registered does not mean that their
activities are unregulated. Hedge funds and their managers are subject
to a variety of regulations and are required to furnish significant
information and reports to regulators in connection with their trading
activities.
SEC Registration of Hedge Fund Advisers
The SEC has recently implemented rule requiring registration of
many hedge fund advisers that were not previously required to register.
Section 203(b)(3) of the Investment Advisers Act of 1940 (the
``Advisers Act'') provides that an investment adviser may be exempt
from SEC registration requirements if such adviser (i) had fewer than
15 ``clients'' during the preceding 12 months; (ii) does not hold
itself out generally to the public as an investment adviser; and (iii)
does not act as an adviser to any registered investment company.
The new hedge fund adviser rule requires a hedge fund adviser to
count each ``owner'' of a ``private fund'' \17\ it advises as a
``client'' for purposes of determining the adviser's eligibility for
the private adviser exemption cited above. The term ``private fund''
was intended to capture advisers to hedge funds and not other private
investment vehicles, such as private equity or venture capital funds.
Under this new rule, hedge fund advisers are required to ``look
through'' clients that are private funds and count the underlying
investors to determine the number of clients to whom the adviser
provides investment advisory services. If, after taking into account
the aggregate number of investors in the private funds it advises, an
adviser has 15 or more clients in the prior 12 months, and has in the
aggregate at least $30 million in assets under management, then the
adviser will be required to register with the SEC as an investment
adviser. Hedge fund advisers that advise ``private funds'' were
required to comply with this new rule by February 1, 2006.
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\17\ Under Investment Adviser Act Rule 203(b)(3)-2, a ``private
fund'' is defined as a company that: (i) would be an investment company
under the Investment Company Act of 1940, as amended, but for an
exception from the definition of ``investment company'' provided under
either Section 3(c)(1) or 3(c)(7) thereunder; (ii) permits an investor
to redeem its investment within 2 years of investment; and (iii) is
offered based on its adviser's expertise. A pooled investment vehicle
that does not meet any one of the above three elements is not a
``private fund.'' Advisers to unregistered funds that are not ``private
funds'' may continue to rely on the language of Rule 203(b)(3)-1 that
permits an adviser to count these unregistered funds as a single
client. This would include advisers to hedge funds that have redemption
periods for their investors that are longer than 2 years.
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CFTC Regulation
Many hedge fund managers are also registered with the Commodity
Futures Trading Commission as commodity pool operators (``CPOs''). Such
registration is required under the Commodity Exchange Act for managers
of hedge funds that trade futures and options contracts on a futures
exchange. A hedge fund manager that provides advice to a hedge fund
regarding such futures and options contracts may also become subject to
regulation as a commodity trading advisor (``CTA''). CPOs and CTAs are
subject to registration, recordkeeping, and reporting requirements and
fraud prohibitions under the Commodity Exchange Act and the regulations
of the CTFC and the National Futures Association. In 2004, 63 of the
100 largest hedge funds were registered with the CFTC and subject to
its reporting and recordkeeping requirements. Hedge funds that are
significant traders in the futures markets may also become subject to
the CFTC's large trader reporting system, which requires the reporting
of certain information on exchange-traded contracts to the CFTC for
purposes of market surveillance.
NASD Regulation
Broker-dealers that sell interests in hedge funds are subject to
NASD regulation. NASD requires broker-dealers to comply with
suitability requirements that, among other things, require the broker-
dealer to have both a reasonable basis for believing that the product
is suitable for any investor and to determine that its recommendation
to invest in a hedge fund is suitable for the particular investor.
Reporting Requirements
As with other market participants, hedge funds are required to
comply with certain reporting requirements designed to increase market
transparency. These requirements include various SEC equity ownership
and portfolio reporting requirements and large position and other
reporting requirements of the Treasury Department and the Federal
Reserve in connection with government securities and foreign exchange
transactions. The Treasury Department requires weekly and monthly
reports for certain large participants in the foreign exchange markets
and imposes reporting requirements on entities, including hedge funds,
that have large positions in recently issued or to-be-issued Treasury
securities.\18\
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\18\ For further information on regulatory filings required of
these hedge funds, please see MFA's ``2005 Sound Practices for Hedge
Fund Managers'' at Appendix II.
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Antifraud and Insider Trading Prohibitions
As the SEC has explained, hedge fund advisers, whether or not
registered under the Advisers Act, are subject to the antifraud and
anti-manipulation provisions of the Advisers Act, the Securities Act of
1933, and the Securities Exchange Act of 1934, as well as to
prohibitions on insider trading under the U.S. securities laws. In
addition, there are safeguards covering the activities of hedge funds
to the extent that they interact with regulated third parties such as
registered broker-dealers and banks and, to the extent that they engage
in futures trading, with futures commission merchants. Hedge funds are
also subject to State antifraud provisions, just as are other providers
of financial services.
There is no fraud crisis with regard to private investment
vehicles. The 2003 SEC staff report entitled ``Implications of the
Growth of Hedge Funds'' stated there is ``no evidence indicating that
hedge funds or their advisers engage disproportionately in fraudulent
activity.'' \19\ Former SEC Chairman William Donaldson testified that
there is ``no reason to believe that fraud is more prevalent in hedge
funds than it is anywhere else.'' \20\
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\19\ Staff Report at 73.
\20\ Testimony of William Donaldson, Chairman of the SEC, ``Recent
Developments in Hedge Funds,'' Hearing Before the Committee on Banking,
Housing, and Urban Affairs, U.S. Senate, 108th Congress (April 10,
2003).
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Current Issues Regarding Hedge Funds
Since its creation, MFA has been an advocate for the alternative
investment industry on a number of important legislative, regulatory
and private sector initiatives. Following is a summary of a few of the
major initiatives on which MFA is focusing.
Compliance With Hedge Fund Adviser Registration Rule
As described above, MFA's membership encompasses both registered
investment advisers as well as those managers that are exempt from the
SEC's hedge fund adviser registration rule. Prior to adoption of the
rule, MFA raised concerns that the costs of the rule would outweigh its
benefits.\21\ However, since promulgation of the rule on October 26,
2004, MFA has worked with its members to prepare for implementation of
the rule and has offered recommendations to the SEC staff to help
develop internal agency training programs on hedge fund subject areas.
This work is ongoing and MFA hopes to continue its positive interaction
with the SEC staff.
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\21\ See Letter to Jonathan Katz from John Gaine, ``Registration
Under the Advisers Act of Certain Hedge Fund Advisers,'' September 15,
2004.
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Over the past 18 months, MFA has hosted six educational seminars to
help its members prepare for the compliance with this new rule.\22\ At
each seminar held last year, an SEC Commissioner or senior staff member
delivered the keynote address or served as moderator. MFA is continuing
its dialog with the SEC staff to address any issues that may arise now
that the new hedge fund adviser registration rule has gone into effect.
We discuss with our members how they are complying with the rule and
their observations about SEC examinations.
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\22\ ``Guidance on the SEC's New Regulatory Framework for Hedge
Fund Advisers,'' held January 12, 2005 (New York, NY) and February 9,
2005 (Key Biscayne, FL); ``Practical Guidance for Hedge Fund CCOs,''
held May 5, 2005; ``The SEC's New Hedge Fund Rules and Implications for
Managers in Europe,'' held July 12, 2005 (London); ``MFA's 2005 Sound
Practices for Hedge Funds Managers--A Practitioner's Guide to Strong
Internal Controls in Today's Regulatory Environment,'' held September
29, 2005 (New York); and ``A New Era Begins: Hedge Fund Advisers and
Today's SEC Regulatory Environment,'' held February 7, 2006 (Key
Biscayne, FL).
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Growth in Credit Derivatives and Concerns of Systemic Risk
The growth in the use of derivatives products has been widely
reported. According to the International Swaps and Derivatives
Association (``ISDA''), the outstanding notional value of credit
derivative contracts rose from an estimated $4 trillion at year-end
2003 to an estimated $17 trillion at year-end 2005. The International
Monetary Fund devoted an entire chapter of a recent report to examining
the influence of credit derivatives on financial stability.\23\
---------------------------------------------------------------------------
\23\ IMF, Global Financial Stability Report (April 2006), Chapter
II, pp. 51-84.
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Last year, the rising use of credit derivatives attracted the
attention of regulators in the United States and overseas.\24\ Of
particular concern was the growing trend of unconfirmed assignments of
credit derivative transactions, known as ``novations,'' and the threat
that this would pose to systemic risk in the event of a large credit
event. Regulators in the United Kingdom and in the United States feared
that problems could emerge as a result of the high number of unsigned
confirmations of novations transactions. These concerns were also
expressed in the Counterparty Risk Management Policy Group II in their
2005 Report.\25\
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\24\ See Speech by Timothy Geithner, Remarks at the Institute of
International Finance, Inc.'s Annual Membership Meeting in Washington,
D.C, September 25, 2005; and, Financial Services Authority, ``Hedge
Funds: A Discussion of Risk and Regulatory Engagement'' (Discussion
Paper 05/4).
\25\ The Report of the Counterparty Risk Management Policy Group
II, ``Toward Greater Financial Stability: A Private Sector
Perspective,'' July 27, 2005.
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Last fall, MFA members who are active participants \26\ in the
credit derivatives markets took part in discussions with
representatives of ISDA, the 14 major derivatives dealer firms (the
``Fed 14''), and the Federal Reserve Bank of New York on the
finalization of the ISDA 2005 Novation Protocol. These parties worked
together to ensure that novations could be transacted successfully
under the Protocol. Overall, that experience demonstrated that
meaningful buy-side participation can be essential to ensuring the
success of these industry-wide initiatives to curb operational or
systemic risk. In this instance, focused and constructive dialog among
both buy-side and sell-side representatives led to a positive result.
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\26\ Hedge funds make up only a small percentage of the credit
derivatives market, approximately 7-16 percent, according to a
September 2004 study released by the British Bankers' Association. See
British Banker's Association Credit Derivatives Report 2003/2004
(available at http://www.bba.org.uk).
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As an outgrowth of the dialog between the hedge fund and derivative
dealer communities that occurred in late 2005, MFA continues its dialog
with representatives of the Fed 14 and ISDA. MFA continues its work
with the Fed 14 representatives to share its views, along with those of
other traditional asset managers, on the Fed 14's proposed strategy for
reducing confirmation backlogs in credit derivatives.
MFA has pledged its support to work with the Fed 14 in the
development and implementation of their targeted objectives for
improving credit derivatives market practices. MFA appreciates the
dealers' commitment to work with hedge funds and other buy-side
representatives to develop and implement standard processing guidelines
for credit derivatives. MFA has also expressed its support for improved
transparency to reduce the backlog of unexecuted confirmations and the
development of automated solutions for the processing of standardized
products. Our statement made recommendations to the Fed 14 on how to
achieve these goals and emphasized that, above all, meaningful buy-side
input is essential for achieving improvements in these market
practices.
MFA is now working on the development of industry-wide electronic
platforms to warehouse credit derivative transactions, as well as on
standards for transactions not eligible for electronic processing. MFA
is committed to educating its members and keeping them informed
regarding the latest operational developments in derivatives. As major
participants in the credit derivatives markets, MFA's members have
shown their willingness to work on private sector initiatives with
their sell-side counterparties on steps to reduce systemic risk.
Investor Eligibility Standards or ``Retailization''
In recent years, a concern has grown among regulators and others
that hedge funds are becoming investment vehicles open to the retail
public. This concern, coupled with the legally required non-public
nature of hedge funds, has led regulators to inquire whether investors
without the requisite financial means or sophistication were coming
exposed to investments that might not be suitable for them.
From all available information, hedge funds remain an investment
vehicle for institutional investors and high-net worth individuals. The
SEC in recent years has permitted the registration of investment
companies that themselves invest in hedge funds. In these
circumstances, the Investment Company Act, the Advisers Act, and all
the investor protection mechanisms of the Federal securities laws come
into play. These funds are subject to the rule range of protections
afforded by SEC registration and oversight, as they are registered with
the SEC and sold in registered public offerings. In addition, advisers
of registered funds of hedge funds are required to be registered under
the Advisers Act. The SEC therefore has authority to address any
investor protection issues that may be presented.
To the extent that retail investors may be exposed to hedge fund
investments without the intermediation of an institutional investor,
Congress might want to inquire into the impact of inflation over the
past quarter century on the SECs Regulation D. Regulation D defines
``accredited investors'' to include natural persons with individual or
joint net worth of $1 million or individual income in each of the last
2 years in excess of $200,000, or joint income for the same period of
$300,000. In the 25 years since the SEC last updated Regulation D,
these dollar thresholds have come within the range of many middle class
investors. The SEC might want to consider raising the Regulation D
thresholds for investments in private funds.
MFA believes that concerns regarding investor qualification for
participation in hedge funds should be addressed directly by raising
the Regulation D standards. If the concern about the number of
investors qualifying as ``accredited investors'' is valid, it is one
the SEC should address through changes to Regulation D. MFA has
expressed support for doubling the minimum net worth and minimum annual
individual income standards from their current level, so that the
monetary thresholds reflect the inflation in wealth and incomes since
1982.\27\
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\27\ See MFA ``White Paper on Increasing Financial Eligibility
Standards for Investors in Hedge Funds'' (July 7, 2003).
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While investments in hedge funds by public and private pension
funds appear to be growing, it is far from a level that would suggest
undue risk to individual investors. In 2003, U.S., European, and
Canadian pension funds reported that about 1 percent of their portfolio
assets were invested in hedge funds.\28\ By comparison, U.S. pension
investments in real estate and private equity have been estimated at
3.4 percent and 3 percent of pension fund assets respectively.\29\
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\28\ Greenwich Associates, ``Alternative Investments May Disappoint
Dabblers'' (January 21, 2004).
\29\ Greenwich Associates, ``The Alternative Balancing Act''
(December 31, 2003).
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Publicly offered funds of hedge funds are subject to the full range
of protections afforded by SEC registration and oversight, as they are
registered with the SEC as investment companies and sold in registered
public offerings. In addition, advisers of funds of hedge funds are
required to be registered under the Advisers Act. The SEC therefore has
authority to address any investor protection issues that may be
presented by these registered funds.
Continued Development of MFA's Sound Practices
MFA has a longstanding and ongoing commitment to promoting sound
practices in the hedge fund industry. ``Sound Practices for Hedge Fund
Managers'' were first published by industry participants in 2000 in
response to a 1999 recommendation by the President's Working Group on
Financial Markets that hedge funds establish a set of sound practices
for their risk management and internal controls. These sound practices
were updated and expanded in 2003 by MFA as a response to industry
developments.
Recognizing the valuable guidance provided by our 2003 guidance, on
August 2, 2005, MFA published MFA's 2005 Sound Practices for Hedge Fund
Managers. The 2005 iteration of MFA's Sound Practices were widely
disseminated to policymakers on Capitol Hill and to U.S. and
international regulators. The recommendations set forth in our 2005
Sound Practices provide a framework of internal policies, practices and
controls for and by hedge fund managers. Our document provides relevant
guidance on areas that are often of concern to regulators. These
include hedge fund managers' internal trading controls,
responsibilities to investors, valuation, risk management, regulatory
compliance, transactional practices and business continuity and
disaster recovery. New recommendations address guidance for developing
compliance manuals, codes of ethics, and certain transactional
practices including best execution and soft dollar practices.
Our document has been widely praised by regulators and industry
participants alike, including in the Counterparty Risk Management
Policy Group II Report. MFA continues to encourage hedge fund managers
to incorporate its recommendations into their particular internal
policies and procedures. As new industry practices develop,
particularly under the new regulatory framework and with the rise of
even more complex derivative instruments, MFA will update and expand
its document within the next 12 to 18 months.
Conclusion
The hedge fund industry has experienced significant growth in
recent years. Much of this growth can be attributed to institutional
investors seeking to diversify their returns and thereby reduce the
overall risk of their investment portfolios. This growth has enabled
hedge funds to serve as source of liquidity in global capital markets,
increasing efficiency and decreasing risks.
With the growth and evolution of the hedge fund industry have come
new responsibilities and challenges. On behalf of its members, MFA is
committed to working with Congress, regulatory agencies, and on private
sector initiatives to ensure an appropriate regulatory framework for
the industry that allows the benefits to continue while addressing
legitimate investor protection concerns. MFA appreciates the
opportunity to share its views with the Subcommittee and will continue
its work with both the SEC and its members to promote implementation of
and compliance with the hedge fund adviser registration rule, as well
as its efforts to reduce systemic risks and promote sound practices.