"Implicit" Hedge Fund Regulation: Moving in the Right Direction

Today's article in the Financial Times chronicling concerns over hedge fund collateral has only reinforced a theme that I've pounded on for the past six months: HEDGE FUNDS ARE ALREADY REGULATED. Why this realization is only now coming to the fore in mainstream media and, potentially, in our regulatory bodies is beyond me, but thankfully it seems to be here. Now this is an issue worth thinking about. And it is properly being addressed to the banks and prime brokers extending credit to hedge funds, in their capacity as entities regulated by the Federal Reserve and the OCC.

US, UK and European regulators have expressed concern in recent meetings that investment banks may be allowing hedge funds to increase their borrowing capacity using collateral that could lose its value rapidly in a financial crisis.

The regulators have asked banking executives in the meetings on Wall Street to detail exactly how they use portfolio netting, a practice that allows hedge funds to use relatively illiquid securities such as credit default and total return swaps as collateral to reduce overall margin requirements.

The fear among some regulators and outside observers is that in a big market dislocation the funds might be unable to sell those securities, increasing the likelihood of widespread defaults.

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One Wall Street executive acknowledged that regulators had a "legitimate concern" that such agreements might not be enforceable in the face of a hedge fund collapse. However, he did not believe regulators would find that banks were taking on excessive risk.

The questions are part of a broad new effort by the New York Federal Reserve, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the UK's Financial Services Authority and European regulatory bodies to understand better how much exposure large banks have to hedge funds and whether that could present a significant risk to the financial system in the event of a market disruption.

So far, detailed discussions have been held with a group of five of the largest Wall Street securities firms that some time ago agreed to volunteer for a "consolidated supervised entities programme". Members of the programme are among the most active in lending to hedge funds.

Officials have found that some firms have been extending credit on less liquid instruments but relatively little credit is being extended under these circumstances - and at higher cost to borrowers, regulators say.

This is great stuff. This is the way it should work. Regulators spending time interviewing the market participants in order to gain a deep understanding of the issues. They then develop cooperative relationships with the top players in the market in order to standardize data collection, have early visibility into trends across the industry, and have a direct line into senior management should urgent questions or concerns arise. This is a process for intelligent, fact-based oversight outside the reach of political agendas and perverse motives. What a breath of fresh air.

And the issue they've targeted, the appropriateness of collateral practices, seems particulary timely in light of the frothy markets and ever-tightening credit spreads (the FT is on a roll - they also had a story on this today). The credit markets appear priced for perfection, and we know what happens when most large players are caught leaning one way: inevitable pain and suffering ensues. Selling premium seems like a good way to generate returns; I mean, the real economy is strong, earnings are strong, corporate balance sheets are healthy (except those that have been LBO-ed in the private equity frenzy), so what could go wrong? Oh, I don't know, maybe Iran, Iraq, terrorism, return of Russian stateism, and about 300 other things? Naaaaah. And this same motivation is what can drive, shall we say, more liberal collateral lending practices in the prime brokerage community? This would seem to be a logical extension of tightness in the credit derivatives market, but somehow I'm not getting this vibe. Banks have gotten much, much smarter in the wake of LTCM and other hedge fund meltdowns. Risk controls have, in fact, gotten much more sophisticated and robust. This doesn't mean that someone won't drop a several hundred large in some purportedly 10-sigma outcome (ha!), but I really don't think that banks are going hog wild lending to hedge funds. The risk/return is just not skewed in their favor by making stupid loans with crappy collateral. They don't have to do this to mint money. I mean, they've still got stock lending, right?

Anyway, I am just happy to see the bodies that should be doing the overseeing actually doing it without the assistance of Congress or like bodies in the UK. Let's hope this favorable trend continues for the good of the hedge fund community, the financial markets and investors everywhere.

Comments

[evan andersen]

I agree with you on global reporting. The Bank of International Settlements does have some good reporting on such things but you are right when you say that offshore borrowing is tough to determine and how much that does play into that role.

Evan Andersen Lydia Capital

[Evan Andersen]

I have always taken the view that hedge funds need scrutiny and regulation. It is to the benefit of the consumer that there is full disclosure along the way. Although there are many myths about hedge funds that are not true, like they are full of lofty managers aimed at hurting the economy when if fact they are serving to make it more efficient and stable.

Hedge Funds by name are kind of misleading. I think what needs to happen in American regulation is that we distinguish between what traditionally would be known as hedging, protecting ones capital, and an Investment Fund that takes positions in the markets. It would be nice to have some legislation clarify the difference. They have Investment Funds in Ireland and I think that this is what they should properly be called.

Evan Andersen, Lydia Capital

[EC]

Just thought I'd give a little follow-up on a topic that was brought up in a prior post about hedge fund performance. According to an article (link below), Renaissance's Medallion Fund was bought out by its owners. Thus no performance was given for 2006.

Here's a funny little "arbitrage": Rack up enough returns over the course of the year on the 800lb gorrilla that is RIEF, then in December shuffle some of the excess return from RIEF to Medallion to pick up the relative $ exposure of Jim Simon's wealth to Medallion performance versus RIEF. Heck, marked to market RIEF wouldn't even have to give up any returns at all. It could simply do glorified front running with some additional vig all year round, padding Renaissance returns at the slight expense of RIEF.

Link: http://www.financialnews-us.com/?page=ushome&contentid=1047106333

[Yaser Anwar]

A good spiel by a FSA Director

http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2006/1019_dw.shtml

[Yaser Anwar]

I think there should be an international clearinghouse or credit registry that would assemble information from national sources on the borrowings of HFs and other highly leveraged financial entities.

Supervisors could collect information on their banks' exposure and report it to an international registry. The result would resemble the Bank for Int. Settlements quarterly publication of figures on international banks cross-border exposures.

What do you think?

[Roger]

Yaser, I think you are mixing up a few things. If the big issue is systemic risk (which I believe it is - who cares if a fund like Amaranth fails besides its investors?), whether hedge funds themselves move offshore is irrelevant. Because their lenders are not. Your point about not having a comprehensive, consolidated, global picture of hedge fund lending is true, and is also likely unachievable.

However, if the Fed, the OCC and the SEC gain visibility into the lending practices of the top 5 prime brokers, they are going to be addressing probably 80%+ of this part of the supervisory problem. And that's pretty good. Further, in the absence of perfect global coordination among lenders and government regulators alike, I've got to say that this type of approach is a big step forward.

And also note the recent cooperation and collaboration between the SEC and the FSA - this is another good sign that the two global financial capitals are taking their responsibility to supervise and protect market functioning seriously.

[Yaser Anwar]

There are still quite a lot of difficulties which persist in determining how and where to collect HF borrowing figures on a global basis, and whether, if they are required, some funds might shift their legal domiciles to offshore havens.

Furthermore, no single national regulator can know the exposure of financial intermediaries as a whole to HFs that obtain credit from international banks based in different countries.

Think LTCM where US regulators may have known the outlines of US banks exposure and Swiss regulators may have been aware of the exposure of Swiss banks, but they did not know the exposure of one another's banks and therefore the risks to the international financial system as a whole. More recently the Wolfgang Flöttl story.

Despite a plethora of suggestions for reforms, no consensus exists on the implications of hedge fund activity for financial stability, or on how policy should be adapted. Hence, I'm quite skeptical about this move but am glad they have finally awaken to what the Basle Committee has been suggesting- Prime Brokers should share information more systematically.

Good Bernanke remarks for further reading
http://www.federalreserve.gov/Boarddocs/speeches/2006/200605162/default.htm