Richard R. Lindsey, Director
Division of Market Regulation
Before the House Committee on Banking and Financial Services, Concerning Hedge Fund Activities in the U.S. Financial Markets
October 1, 1998
Chairman Leach and Members of the Committee:
I am pleased to appear today to testify on behalf of the Securities and Exchange Commission concerning the impact of hedge funds on the U.S. financial markets.
Over the past several years, hedge funds have become significant participants in the global marketplace, investing trillions of dollars in assets over time. Like other large market participants, hedge funds add depth to global markets and increase market liquidity. They are one of many important global players that link our markets together with those of other countries. Because they are largely unregulated, however, accurate information about hedge funds is hard to come by. The scarcity of information about hedge funds, combined with the recent activities of some large, aggressive funds, has raised concerns about their potential impact on the U.S. financial markets. The financial difficulties of Long-Term Capital Management LP ("Long-Term Capital" or "LTCM") have only heightened these concerns.
The Commission believes that it is time to reexamine the risks posed to our markets by the activities of hedge funds. Indeed, the President's Working Group on Financial Markets has announced it will initiate a study on the important questions raised by the recent acquisition of LTCM by its creditors. LTCM's potential impact on the world's financial markets raises legitimate questions about the activities of hedge funds in general, as well as the proper role that regulators should play with respect to those activities.
That being said, I would urge that Congress and the regulatory community move with caution in determining whether and to what extent we need to oversee hedge funds. It is too soon to tell whether LTCM's investment strategies represent the norm in the hedge fund industry or, whether LTCM was an overly aggressive player among otherwise responsible market participants. If we move too quickly to impose regulatory requirements on hedge funds organized in the U.S. based on the example set by LTCM, these sophisticated global players may simply shift their operations offshore. Such a move could significantly hinder our ability to assess the potential risk that hedge funds' activities may pose to U.S. markets.
I would like to focus the remainder of my testimony today on what we know about hedge funds in general, LTCM in particular, and the issues we believe warrant further consideration. We intend to work closely with the President's Working Group on Financial Markets to study these issues in greater depth.
Hedge Fund Structure and Activities
The term "hedge fund" is not defined or used in the federal securities laws. Over time, the term has come to be used to refer to a variety of pooled investment vehicles that are not registered under the federal securities laws as public corporations, investment companies, or broker-dealers.
Hedge funds are typically structured as foreign limited partnerships or other vehicles to provide pass-through tax treatment of investor earnings. When organized abroad, hedge funds are usually structured to avoid U.S. taxation of the earnings of foreign investors. Hedge fund sponsors, a few of which are registered as investment advisers under the federal securities laws, are responsible for managing the investments of the fund. As compensation, they typically receive a management or administrative fee based on the amount of the fund's assets, together with a share of the profits or some other allocation based on the fund's investment performance.
To maximize flexibility, hedge funds operating in the U.S. are structured so they will be exempt from regulation under the Investment Company Act of 1940.1 Typically, hedge funds also rely on the trader exception from broker-dealer registration.2 In addition, interests in hedge funds are sold privately to sophisticated, high net worth individuals to avoid registration of the interests under the Securities Act of 1933.3
Like other market participants, such as securities firms, banks, and insurance companies, hedge funds vary widely in size, trading strategies, degrees of leverage, and market influence. Some control relatively small amounts of capital and, like many individual investors, pursue conservative buy and hold strategies. Some trade aggressively to take advantage of predicted market movements. The more active hedge funds trade a broad range of financial products, including equities, U.S. and foreign government securities, commodities, financial futures, options, foreign currencies, and derivatives. Some also participate in merger and acquisition investments and various forms of direct investment activity around the globe. Most hedge fund trading strategies are dynamic, often changing rapidly to adjust to fluid market conditions.
There are no precise figures available regarding the number of hedge funds that are active in U.S. markets or the total value of assets under their management. However, some experts have estimated that the number of hedge funds operating in 1998 exceeded 3,000 and that they had over $200 billion in assets under management.4 The Commission receives limited information regarding the activities of various large market participants, including some hedge funds, through reports that are filed when they acquire 5% or more of a class of security issued by a publicly traded company.5 We also receive limited information about hedge funds through reports filed by managers exercising investment discretion over accounts having $100 million or more in equity securities.6 This information, however, does not reveal much detail about the trading activities of hedge funds and other large participants in our markets.
The Commission has statutory authority that enables it to identify large traders and obtain retrospective information about their equity trading activity, which in the case of LTCM, was a small percentage of its total portfolio. Specifically, Section 13(h) of the Exchange Act7 authorizes the Commission to develop a large trader reporting system to expedite trading reconstructions, such as those that were required to analyze the historic market declines in October 1987 and October 1989. Although this authority would allow us to identify hedge funds and other large traders, it would only allow us to collect information about their completed transactions in the U.S. equity markets.8 Because of this limited purpose, many in the industry have complained that a large trader reporting system would be unduly costly. As a result, the Commission has been working with the securities industry to ensure that any system that is developed is as cost effective and efficient as possible. Even if a large trader system had been in place, it would have had little relevance to LTCM's activities, few of which involved equity transactions.
A. Studies Conducted by the President's Working Group and the Commission
Recent revelations about LTCM have made clear that certain hedge funds may be capable, through aggressive strategies involving leverage, of creating risks both to the financial markets and to other market participants. This is not, however, the first time that we have considered these important issues. In 1994, in response to concerns at the time over the failure of three hedge funds managed by David Askin and the use of OTC derivatives by other hedge funds, we determined to learn more about new developments in hedge fund trading. As a result, the Commission, on its own and in coordination with the President's Working Group on Financial Markets, reviewed the structure and activity of a number of large traders, including hedge funds.
The President's Working Group on Financial Markets set up a task force, which released a summary of its observations in a September 27, 1994 report entitled "An Assessment of Developments with Potential Implications for Market Price Dynamics and Systemic Risk." The Task Force found that:
- Hedge funds, like other large investors, could exacerbate market movements if the funds need to sell to meet margin calls or unwind leveraged positions; and
- It may be difficult for banks and broker-dealers to monitor the creditworthiness of hedge funds because they do not typically know the overall positions of hedge funds, which can change rapidly. Therefore, hedge funds are often required to post initial collateral in connection with transactions they enter into with banks and broker-dealers, including OTC derivative transactions.
The Commission staff subsequently conducted its own review of hedge fund trading. Although the staff review was limited in scope and time, it provided us with useful insights into the operations of the hedge funds we studied.
Our review focused on two general areas of concern the hedge funds' potential market impact and investor protection issues. Based on this limited review, we found that the relatively small dollar amount of the hedge funds' trading activity in relation to the equity market as a whole made it unlikely that their activity significantly influenced the broader stock market declines experienced during the period of our study. Although we found instances where certain of the funds traded large positions in some securities, we did not find evidence suggesting that these funds contributed generally to price declines in these securities or the markets as a whole on the days of our review. We found no exacerbation of downward movements as a result of hedge fund sales in declining markets during the period studied. Indeed, there were a number of instances where large hedge funds bought a particular security in a declining market, thereby possibly helping to stabilize its price.
We also found that the hedge funds we studied marked their positions to the market daily, typically using an independent party, such as a prime broker (i.e., clearing broker). In addition, we did not find the funds we studied to have been highly leveraged. In fact, their leverage ratios were quite comparable to a sample of large broker-dealers.
Finally, we found that the hedge funds' investors are sophisticated and that the funds provide them with adequate information about the risks associated with investing in the funds.
Perhaps the most important point for today's discussion is that nothing in our study indicated that hedge funds at that time were any more or any less likely than other large traders to increase the risk of market participant failures or otherwise threaten the financial integrity of the markets.
B. Recent Events
Subsequent to these reviews, there have been a number of highly publicized events involving hedge funds, the most recent of which involve LTCM. LTCM is an institutional investment manager which acts as a general partner and investment adviser to Long Term Capital Partners, L.P., a Delaware limited partnership. Substantially all of this partnership's assets are invested through a master fund/feeder fund structure9 in Long Term Capital Portfolio, L.P. a Cayman Islands limited partnership. Other non-U.S. investment vehicles managed by LTCM also invest substantially all of their assets in Long-Term Capital Portfolio. (These entities are collectively referred to as "LTCM.")
Prior to 1998, LTCM had a capital base of approximately $4.8 billion, which represented investments in the fund by general partners and limited partners. The limited partners were wealthy individuals and institutional investors.
LTCM built its portfolio on sophisticated arbitrage trading strategies. In addition, LTCM used a significant degree of leverage to increase its expected returns. While LTCM used a wide variety of arbitrage and other trading strategies, one of the simpler strategies employed by LTCM was one in which it shorted Treasury bond futures while taking long positions on higher yielding (and higher risk) mortgage-backed or corporate debt securities. This strategy known as "buying a credit spread" can generate profit as long as the difference in the yields of the two types of instruments remains stable or declines.10
LTCM produced annual returns of more than 40% in its first few years. At the beginning of 1998, LTCM returned approximately $2.7 billion (or roughly one-half of its capital base) to its investors after LTCM management determined that investment opportunities were not sufficiently attractive to support adequate returns on this capital base.
Since July 1998, with mounting financial problems in Russia and other emerging markets, sovereign bond prices have steadily risen as investors have engaged in a "flight to quality" from higher, riskier debt instruments (such as emerging market debt, junk bonds, and mortgage-backed and corporate securities) toward sovereign instruments such as U.S. Treasuries. The speed and extent of this movement was apparently not anticipated by LTCM.
In August and September of 1998, as the global financial crisis worsened, it became clear to LTCM that many of the assumptions inherent in the arbitrage positions it held were incorrect. Due to LTCM's leverage (which at one point had exceeded 50-to-1), those incorrect assumptions resulted in substantial losses for the firm and eroded its capital base.
On September 2, 1998, LTCM announced that during the period from January through August 1998 it had lost $2.5 billion, or 52% of its $4.8 billion of equity since the beginning of 1998. Of those losses, 84%, or $2.1 billion, occurred in August. LTCM appears to have incurred some of its losses when bond spreads widened between U.S. Treasuries on the one side and swaps on the other side. They incurred similar losses from arbitraging sovereign debt of G-7 countries and swaps. Additional losses resulted from LTCM's exposures to emerging market bonds. LTCM also carried huge and subsequently costly positions in the equity derivatives market.
As a result of these losses, as of August 31, 1998, LTCM's capital base was reduced to $2.3 billion. This diminished capital base supported recorded trading positions totaling $107 billion, yielding a leverage ratio in excess of 50-to-1.11
In addition, LTCM's counterparties were marking its positions to market daily. As its losses mounted, LTCM's counterparties required that additional collateral be conveyed to them to make up for the mark-to-market losses on the positions. At the same time, LTCM's potential sources of liquidity and additional capital dried up, threatening the firm with insolvency. When LTCM found itself so squeezed that it risked not being able to cover its exposures, a workout by its creditors became the only alternative to liquidation.12 By this time, LTCM's capital had eroded to $600 million.13
LTCM Rescue Plan
To avoid the market impact of a disorderly winding down of LTCM's positions, several of its largest creditors created a rescue plan for LTCM. On Wednesday, September 23, 1998, LTCM reached an agreement with its principal lenders to continue operations. This agreement was brokered principally by the heads of The Goldman Sachs Group, L.P., Merrill Lynch & Co., J.P. Morgan & Co., and certain commercial banks, and facilitated by the Federal Reserve Bank of New York.
The plan, which calls for fifteen major domestic and foreign commercial and investment banks14 to infuse a total of $3.5 billion of equity capital into the hedge fund, provides LTCM a respite from loan repayments and with much needed liquid capital. This consortium will now own 90% of the equity in LTCM and will form an oversight committee to direct LTCM's overall strategy and manage its exposures.15
LTCM's creditors' decision to acquire the hedge fund was based, in part, on their concerns about possible disruptions in the U.S. and global marketplace if LTCM had failed. By September 23, the fund's equity capital had almost been wiped out. Hurried liquidations of LTCM's positions could have potentially disrupted these financial markets, resulting in losses for other participants in these markets.
C. The Commission's Role
Although the Commission does not regulate the activities of hedge funds such as LTCM, it does oversee broker-dealers that may act as creditors of, or counterparties to, these funds. Commission rules are designed to provide a capital cushion to help securities firms withstand the failure of a counterparty or periods of system-wide stress. The Commission's net capital rule, for example, addresses risk assumed by broker-dealers through the application of required capital charges and minimum net capital requirements.16 A broker-dealer must deduct from net worth 100 percent of the value of all loans not fully collateralized by liquid securities. In this way, the net capital rule insulates broker-dealers from credit risk. Margin rules help protect registered broker-dealers, as well as the financial system as a whole, against losses resulting from customer defaults by requiring customers to provide collateral in amounts that depend on the market risk of the position.17
Major U.S. securities firms also have controls in place to manage credit risk. These controls generally include credit functions, such as the capability to perform credit analysis, approve and set counterparty credit limits, approve specific transactions, recommend credit reserves, and manage overall credit exposure. Controls typically also include requirements that senior management approve transactions involving extensions of credit above authorized levels. In addition, information systems at some major firms enable risk managers to compute each firm's aggregate credit exposure by counterparty or product type and to monitor concentrations of counterparty risk.
Moreover, as the major U.S. broker-dealers are part of holding company structures, the Commission staff looks at the financial and operational activities of the material affiliates of broker-dealers. Through the Commission's risk assessment recordkeeping and reporting rules, these broker-dealers provide the Commission with comprehensive financial and operational information, on a periodic basis, which allows the Commission staff to evaluate the material risks to broker-dealers posed by their affiliates, including those that deal primarily in OTC derivatives.18 Finally, under the Commission's Derivatives Policy Group initiative, the SEC collects additional risk assessment data on credit and market risk related to the OTC derivatives activities of the five major U.S. securities firms.
When the Commission learned of LTCM's financial difficulties in August, the Commission staff and the New York Stock Exchange19 surveyed major broker-dealers known to have credit exposure to one or more large hedge funds. The results of our initial survey indicated that no individual broker-dealer had exposure to LTCM that jeopardized its required regulatory capital or its financial stability.
As the situation at LTCM continued to deteriorate, we learned that although significant amounts of credit were extended to LTCM by U.S. securities firms, this lending was on a secured basis, with collateral collected and marked-to-the-market daily. Thus, broker-dealers' lending to LTCM was done in a manner that was consistent with the firms' normal lending activity. The collateral collected from LTCM consisted primarily of highly liquid assets, such as U.S. Treasury securities or G-7 country sovereign debt. Any short falls in collateral were met by margin calls to LTCM. As of the date of the rescue plan, it appears that LTCM had met all of its margin calls by U.S. securities firms. Moreover, our review of the risk assessment information submitted to the Commission suggests that any exposure to LTCM existed outside the U.S. broker-dealer, either in the holding company or its unregistered affiliates.
When we last looked closely at hedge fund activity in 1994, their conservative use of leverage was a major factor in our conclusion that hedge funds posed relatively little risk to the financial system. In light of LTCM's use of leverage, it is time to consider whether the risks to the financial system posed by hedge funds have changed since 1994.
Given the size, the degree of leverage, and the scope of trading of certain hedge funds, we, as regulators, need more information to better understand and assess the risks and benefits hedge fund trading poses to our markets. At this point, however, it would be premature to conclude that regulation is necessary. Before we can make specific recommendations, we would need to determine whether LTCM's activities were unusual, or whether they were representative of the industry as a whole.
Indeed, one hedge fund investment adviser who tracks over 2600 hedge funds states that LTCM's leverage ratio is "extreme and the largest ever seen." According to this adviser, most hedge funds remain low in leverage. 30% of hedge funds do not use leverage at all, 55% are lowly leveraged (no more than a 2-to-1 basis), and only about 15% are highly leveraged (greater than a 2-to-1 basis). Although we have not verified these figures, preliminarily they suggest that LTCM may have been an extreme case since, as discussed above, at one point LTCM's leverage approached 50-to-1.
It is therefore important to carefully and judiciously review both the events leading to the recent private-sector rescue of LTCM and the overall strength of the hedge fund industry, in general. We must avoid the temptation to readily label certain investment instruments as inherently dangerous or risky. Rather, we should focus our attention on the risky strategies used by LTCM, such as the use of excess leverage. We must not act in haste, but rather, move deliberately to determine whether or not the LTCM situation is an aberration caused by the fund's excessive reliance on leverage, or if the hedge fund industry overall presents risks to our financial system. We intend to work closely with the members of the President's Working Group on Financial Markets to study these issues.
1Most hedge funds rely on the so-called "private" investment company exclusions in sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 ("Investment Company Act") (15 U.S.C. § 80a-3(c)(1), -3(c)(7)). These exclusions exempt certain pooled investment vehicles from the definition of "investment company" and from substantive regulation under the Investment Company Act.
A fund relying on the section 3(c)(1) exclusion may not have more than 100 investors. A fund relying on the section 3(c)(7) exclusion may sell its securities only to persons who are "qualified purchasers" generally, natural persons who own at least $5 million of investments or institutions that own or manage on a discretionary basis at least $25 million of investments. A fund relying on either of these exclusions may not make a public offering of its securities. Section 3(c)(7) was added to the Investment Company Act in 1996 as part of the National Securities Markets Improvement Act of 1996. P.L. No. 104-290 (1996).
Fund managers may be exempt from investment adviser registration under Section 203(b)(3) of the Investment Advisers Act of 1940 (15 U.S.C. § 80b-203(b)(3)), which exempts from registration any adviser who, during the preceding twelve months, has had fewer than fifteen clients and who does not hold itself out generally to the public as an investment adviser. For purposes of computing the number of clients under Section 203(b), Rule 203(b)(3)-1 (17 CFR § 275.203(b)(3)-1) permits a limited partnership to count as only one client of the general partner or any other person acting as investment adviser to the partnership.
2Hedge funds typically claim an exclusion from registration as securities dealers under Section 15(a) of the Securities Exchange Act of 1934 ("Exchange Act") (15 U.S.C. § 78o(a)) based on the "trader" exception to the definition of "dealer." In general, a trader is an entity that trades securities solely for its own investment account and does not carry on a public securities business. On the other hand, a dealer buys and sells securities as part of a regular business, deals directly with public investors, engages in market intermediary activities, and may provide other services to investors.
3Sales of interests in hedge funds typically are structured to take advantage of the "private offering" exemption under Section 4(2) of the Securities Act of 1933 (15 U.S.C. § 77d(2)), or the related safe harbors under Regulation D thereunder.
4Bethany McLean, "Everybody's Going Hedge Funds," Fortune (June 8, 1998) at 180; Hal Lux, "Hedge Fund? Who Me?," Institutional Investor (Aug. 1998) at 33.
5Section 13(d) of the Exchange Act (15 U.S.C. § 78m(d)) and Rule 13d-1(a) (17 CFR § 240.13d-1(a)) thereunder require any person who, after acquiring directly or indirectly the beneficial ownership of any security registered under Section 12 of the Exchange Act (15 U.S.C. § 78l), is directly or indirectly the beneficial owner of more than 5% of such class, to file with the Commission within 10 days of such event, a Schedule 13D. Certain persons, however, including registered broker-dealers, banks, insurance companies, registered investment companies, registered investment advisers, and employee benefit plans, who acquire such holdings in the ordinary course of business and without the purpose of changing or influencing the control of the issuer, are eligible to file a short form statement on Schedule 13G within 45 days after the end of the calendar year in which the reporting obligation arises. Rule 13d-1(b)(1) (17 CFR § 240.13d-1(b)(1)).
6Section 13(f) of the Exchange Act (15 U.S.C. § 78m(f)) requires "institutional investment managers" exercising investment discretion with respect to accounts having $100,000,000 or more in equity securities on the last trading day of any month to file a Form 13F with the Commission. This information, however, only is required to be filed on a quarterly basis. "Institutional investment manager" is defined in subsection (5)(A) to include any person (other than a natural person) investing in or buying and selling securities for its own account, and any person exercising investment discretion with respect to the account of any other person.
715 U.S.C. § 78m(h).
8A large trader system would not permit the Commission to monitor hedge fund positions to anticipate potential problems, but would be designed to facilitate trading reconstructions following a major market event, such as the market decline on October 27, 1997. Rules to implement the large trader reporting system were reproposed in 1994 in order to address concerns raised by the initial rule proposal issued in 1991. Nevertheless, commentators continued to cite concerns over the breadth and effect of the proposal. Accordingly, the Commission is continuing to examine whether there are less costly, but still productive, alternatives that will build off of existing trade reporting systems in the securities markets.
9In a master fund/feeder fund structure investors purchase interests in one or more investment vehicles (the "feeder funds" or "top tier") that invests exclusively in the securities of another investment vehicle (the "master fund" or "bottom tier"). Because the value of shares of the feeder fund are tied to the value of the assets of the master fund, investors in a feeder fund have a direct economic interest in the value of the assets of the master fund. These structures are common and exist for tax and other reasons.
10LTCM employed a wide variety of trading strategies involving debt and equity instruments, including derivatives. In general, LTCM's overall fixed income strategy can be characterized as being long credit spreads. Their principal debt instrument trading strategies were geared to generate profits in the event credit spreads between high quality sovereign securities and other debt securities narrowed.
11The 50-to-1 leverage ratio was calculated by comparing LTCM's total assets to its total equity as of August 31, 1998. The 50-to-1 leverage ratio includes receivables related to off-balance sheet item, which reflect, among other things, LTCM's positions in swaps and fixed income arbitrage.
12"LTCM Bailout Reassures," CNNfn (Sept. 24, 1998).
13"Fear of Wider Damage Fueled Long-Term Bailout," Reuters (Sept. 24, 1998).
14The initial fifteen commercial and investment banks that agreed to contribute $3.5 billion to rescue LTCM are Bankers Trust, Barclays Bank, Chase Manhattan, Deutsche Bank, UBS, J.P. Morgan, Goldman Sachs, Merrill Lynch, Credit Suisse First Boston, Morgan Stanley Dean Witter, Salomon Smith Barney, Societe General, Credit Agricole, Bank Paribas, and Lehman Brothers. In addition, Bear Stearns, LTCM's clearing broker, has been involved in the rescue plan from the start. Recent news reports indicate that another 30 or more financial services firms have agreed to assist with the rescue efforts. "LTCM Gets More Rescuers," CNNfn (Sept. 30, 1998).
15"Now, Are Some Funds Too Big To Fail'?," USA Today (Sept. 24, 1998).
16Exchange Act Rule 15c3-1 (17 CFR § 240.15c3-1).
17margin rules are administered by the Federal Reserve Board and enforced by the Commission. Self-regulatory organizations ("SRO"), which the Commission oversees, also impose margin requirements on their members.
18Among other things, the Commission's risk assessment rules requires broker-dealers to report certain information about the volume of derivatives activities conducted in material affiliates of the broker-dealer. This information is provided to the Commission quarterly, on a confidential basis, and is monitored by the Commission staff. With regard to credit risk of certain OTC derivative products, broker-dealers are required to furnish a counterparty breakdown where credit risk exceeds a materiality threshold set at the greater of $100 million or 10% of tentative net capital. For large securities firms, this threshold generally would not be met until counterparty concentration reaches between $200 million and $400 million. The Commission's risk assessment program has been fully effective since December 1992. No entity that is commonly referred to as a hedge fund has triggered reporting under the credit risk concentration provisions.
17 CFR §§ 240.17h-1T and 240.17h-2T. See Securities Exchange Act Release No. 30929 (July 16, 1992), 57 FR 32159. Under the rules, broker-dealers are required to file information concerning the financial and securities activities of affiliates that are likely to have a material impact on the broker-dealer's financial and operational condition, and to provide the Commission with immediate and more detailed information in response to Commission concerns regarding a broker-dealer's financial or operational condition. In addition, broker-dealers are required to make and keep records concerning their policies, procedures, and systems for monitoring and controlling financial and operational risks resulting from the activities of their affiliates. The Commission's staff current analyzes quarterly filing information obtained from approximately 250 securities firms.
19The NYSE shares responsibility with the Commission for monitoring the activities of member broker-dealers and their capital adequacy.