Speech by SEC Commissioner:
Remarks Before the PLI Hedge Fund Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
New York, New York
June 6, 2007
Good morning. It is always a pleasure to participate in PLI conferences, and this one, dealing with such a timely topic as hedge funds, is no exception. I am especially pleased to have the chance to be here with Dan Townley, who somehow survived the experience of working closely with me at Davis Polk many moons ago. Before I begin today, I must convey that the views I express are my personal views and not those of the Securities and Exchange Commission or other individual members of the Commission or its staff.1
Your agenda today is very well organized in that it covers hedge funds from some of the various perspectives that we, at the Commission, have also been viewing them. First, you heard about hedge funds as alternative investments. As you know, due to the explosive growth of hedge funds and increasing concerns about the role that hedge funds play in our marketplace, the Commission attempted to impose a registration regime on hedge fund advisers. This regulation would have allowed us to collect information on these entities, conduct examinations, require compliance policies and procedures, and screen individuals associated with the adviser. Our rulemaking was struck down by the D.C. Court of Appeals in June 2006 in the Goldstein decision. Since that time we have considered what discrete steps might be appropriate in this area. First, we have sought to clarify, in light of the Goldstein decision, our ability to bring enforcement actions under Section 206 of the Advisers Act against investment advisers who defraud investors of investment companies and other pooled investment vehicles. We also proposed changes to Regulation D under the Securities Act (Reg D) that would define a new category of accredited investors called "accredited natural persons." Among other things, these investors would need to own at least $2.5 million in investments. This new category is designed to help ensure investors in hedge funds are capable of evaluating and bearing the risks associated with investing in these funds. Also, each of these proposed rulemakings evidences our commitment to address anti-fraud and investor protection concerns wherever they may occur, including the hedge fund arena.
Just this past month we proposed further changes to Reg D that may inform our thinking on the earlier rulemakings. We will analyze all of the comment letters carefully before taking any further steps. One of our goals, for example, will be to employ consistent definitions and concepts across these related rulemakings.
The second perspective on hedge funds covered in this morning's proceedings related to hedge fund activism. The Commission recently hosted three roundtable discussions dealing with proxy access issues. Among the many issues addressed in those proceedings was the more active role being played by some hedge funds in the shareholder voting and control area. As hedge funds engage in more active investment strategies, critics have expressed concerns about the short-term nature of many hedge fund investments and whether hedge funds are taking positions contrary to the long-term interests of shareholders. Some commentators have also raised issues about how traditional indicia for determining voting rights may be strained due to the increased ability investors have to separate share ownership from economic interests. Perhaps now more than ever, with hedge funds as well as other sophisticated investors engaging in a variety of derivatives and other synthetic strategies, it is possible to vote shares without being at true economic risk to a company's prospects. While this may not be a new concern, it is a relevant input nevertheless into our assessment of the voting mechanisms for U.S. shareholders, including issues relating to access to the proxy.
Finally, financial regulators, such as me, also view hedge funds in a broader context due to their role as market participants of potentially systemic importance. Hedge funds are significant counterparties to our largest regulated entities, including the banks overseen by the banking regulators and the Consolidated Supervised Entities (CSEs) overseen by the SEC. The CSEs, as you may know, are the SEC regulated holding companies of our five largest internationally active U.S. investment banks - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley. Hedge funds are trading counterparties to the CSEs and banks through a wide range of over-the-counter derivatives and secured financing transactions. They are both clients - as purchasers of clearing and ancillary services - and debtors - as borrowers under margin loans through prime brokerage arrangements. Sometimes they are also partners, through an increasing variety of principal transactions. And lest we forget, they are competitors, trading many of the same products that securities firms and banks trade.
It does not stop there, of course. As you are well aware by now, hedge funds play an increasingly important role in the financial markets generally. Commonly cited statistics put total assets managed by hedge funds at over $1 trillion.2 One study estimates that hedge funds are responsible for over 20% of equity trading volume in the U.S. They are the first movers in many less traversed spaces, such as credit derivatives, and are aggressive users of complex financial products and strategies. Hedge fund managers aggressively invest in structured products and derivatives and use leverage to boost returns on investments. They also actively participate in corporate governance matters, particularly proxy contests, to influence company management. A quick scan of the headlines in the financial press on any given day will invariably highlight the moving and shaking du jour in which hedge funds engage.
Less appreciated, perhaps, is the fact that hedge funds are important liquidity providers for certain high risk, relatively illiquid assets and instruments. In many instances, hedge funds support and make possible deep and wide markets for these products. For instance, without hedge funds to provide certain pieces of the capital structure, the securitization markets would probably not exist in the size and exert the influence on the lending markets that they do today.
More generally, hedge funds also play a significant role in what are called "pipeline" businesses of banks and securities firms. Pipeline businesses typically involve structuring products in order to distribute the more concentrated risks of the banks or broker-dealers more broadly to others, including hedge funds. Event financing, such as leveraged buy out financing, and mortgage securitizations are two examples of pipeline businesses. Specifically, banks and securities firms originate or accumulate loan assets, structure them into tranches, and distribute the resulting securities to investors, particularly hedge funds. Although the majority of the resulting securities in these deals are rated investment grade, each transaction has an unrated, equity first loss piece, or residual, associated with it. The returns on these can be quite high, but so then is the risk. Not surprisingly, regulators of banks and securities firms discourage their regulated firms from retaining these interests by requiring that relatively high levels of regulatory capital be held against any such positions on their books.
Hedge funds, on the other hand, as unregulated entities, are not required to hold regulatory capital. As such, hedge funds with the requisite risk appetite (and, one hopes, requisite expertise) have become major bidders for these equity tranches. Since they can sell the residual pieces to hedge funds, banks and securities firms have been able to do more and more transactions in the expectation of off-loading more and more risk. At the end of the day, this serves to lower the cost of financing for borrowers and provides investors with a wider range of risk-return investment choices.
But this increased market efficiency does not come without some potential cost. As hedge funds' importance to financial markets increases, their potential systemic impact also increases. I'd like to highlight two areas of current concern for regulators. One is whether the transfer of risk from banks and securities firms to hedge funds and other counterparties has been complete and irreversible (or is otherwise covered by adequate collateral) so that banks and securities firms are protected from potential counterparty failure. The second concern is whether any counterparty has grown so large in absolute terms, or accumulated an exposure so significant relative to the overall market, that a destabilizing event forces a broad scale unwinding of positions and otherwise disrupts the markets.
Obviously, as hedge funds have become a more significant participant in the marketplace, it is not surprising that the regulators' focus on their activities has commensurately increased.
In fact, the financial industry, particularly risk managers and regulators, have been grappling with these concerns in recent years. Most notably, there has been a strong focus on maintaining and strengthening counterparty credit risk management practices at regulated institutions. After the failure of Long-Term Capital Management in 1998, the Counterparty Risk Management Policy Group brought together senior risk managers from the major commercial and investment banks to consider the lessons of that event. Their report addressed systemic risk concerns by articulating best practices in counterparty risk management appropriate to regulated entities such as banks and securities firms. Many regulated firms responded to the recommendations by building the infrastructure necessary to quantify and monitor exposures that are tied to the value of complex financial products. Other efforts to reflect the best practices described in the report entailed tightening standards for, and discipline around, the extension of credit to counterparties, from obtaining initial margin to establishing the right to close out contracts should a counterparty fail to meet its obligations.
The Counterparty Risk Management Policy Group issued a second report, known as CRMPG II, in July of 2005 which dealt with developments since the initial report, including the proliferation of products with embedded leverage and securitizations. But the new report reemphasized the essential conclusion of the first report that, "[C]redit risk, and in particular counterparty credit risk, is probably the single most important variable in determining whether and with what speed financial disturbances become financial shocks with potential systemic traits." As in the case of the first report, many of the recommendations contained in the second report focused on strengthening credit risk assessment and measurement at financial institutions.
A similar line of reasoning underpins the current trilateral hedge fund review being conducted jointly by the New York Federal Reserve Bank, the UK Financial Services Authority, and the SEC. As part of this review, supervisory staff from the three bodies are meeting with business personnel and risk managers at firms to discuss and review practices related to prime brokerage and credit risk management of OTC derivatives counterparties. The first phase focused on financial institutions' margin and collateral practices. The second phase, which is currently underway, is focusing on credit risk exposure analytics, among other things.
Clearly, these are important initiatives. Strengthening the ability of banks and securities firms to assess, measure, and risk manage exposures to hedge funds is a key mitigant against counterparty credit-induced systemic risk.
We are now focusing on yet another area concerning risk transfer. This relates to the role of financial engineering through the use of derivatives and its implications for risk management.
In general, risk transfer is a very good thing. Say, for instance, a bank wishes to sell to a hedge fund its residual interest on a securitization deal it closed earlier in the year. An outright sale of the residual would transfer the risk of holding that position away from the bank to the hedge fund. Gains or losses would thus be borne by the hedge fund and hedge fund only.
But what if the hedge fund wants exposure to the residual in synthetic form? The bank could enter into a total return swap with the hedge fund. The swap would effectively pass the economics, or risk exposure, of the residual through to the hedge fund. The bank would then be market risk neutral, but would still retain the residual on its balance sheet.
Note, however, that should the residual fall in value, the hedge fund would owe the bank money under the swap agreement. While the losses on the retained residual would be theoretically offset by gains on the derivative, the bank is only truly market neutral if the hedge fund is both willing and able to pay. In other words, this form of risk transfer would simply transform market risk into credit risk. Unless the exposure were to be fully collateralized, the bank sheds market risk as if the residual were sold, but is left with potential credit exposure to what is, in all likelihood, a non-investment grade counterparty.
Similar outcomes may occur when financial institutions finance their hedge fund clients' positions, for instance through a repo. The bank above may decide it does not want to do the total return swap and thus sells the residual outright to the hedge fund. However, if it agrees to finance that purchase through a repurchase agreement, it ends up with that credit risk exposure anyway. Where less liquid assets are involved, the risk of exposure is greater in both of these types of financing arrangements.
As these and similar arrangements grow in volume and complexity, monitoring actual risk transfer will become increasingly challenging. It will require not only robust market risk and credit risk analytics capabilities, but also mindful, holistic, and well-coordinated risk management functions. Add to this the growth in portfolio margining, cross-product margining, term margin agreements, and a host of other arrangements designed to "optimize" hedge fund clients' leverage, and the strong focus on counterparty credit risk appears to be wholly justified.
Indeed, even more focus would be well advised. This is an area in which market practices evolve rapidly. Consider, for example, the traditional prime brokerage lending model. It involves secured lending with sufficient collateral to essentially protect the bank under virtually all scenarios. Today, in the OTC derivatives trading arena, banks and securities firms lend not solely on the basis of the collateral, but rather based upon an assessment of the creditworthiness of the counterparty as well. To the extent that these practices migrate to the prime brokerage space, it could have a significant impact on the credit risk assumed by the regulated entities, and ultimately could impact the leverage in the financial system as a whole. To assess the creditworthiness of a counterparty is certainly a more complex analysis. It involves an evaluation of the counterparty's internal risk management as well as balance sheet strength and leverage. This may be particularly difficult when transparency regarding the counterparty is limited, as is typically the case with hedge funds.
And the possible failure in counterparty risk management is considerable. A large, systemically important hedge fund could potentially destabilize other institutions to the extent that it is forced to liquidate positions in a disorderly manner. To understand this possibility, I think it helps to consider the recent demise of Amaranth, which did not cause such a situation, but certainly had the potential to do so.
In September 2006, the hedge fund Amaranth lost over $6 billion. Despite the astounding size and speed of the losses to Amaranth and its unfortunate investors, there were no significant effects on the markets from a systemic risk point of view.
One could conclude that things worked well and risk management performed as it should. As far as we can tell, all of the dealer banks held adequate collateral to secure their exposures. It appears that they were able to continuously determine the extent of their exposures to Amaranth by aggregating positions across the entire spectrum of trading desks, and then marking these positions to market. We are not aware of any disputes over the margin calls that were made, even for less liquid instruments. In fact we know of a few cases where dealers actually returned excess collateral to Amaranth, which is unusual.
Further, Amaranth voluntarily liquidated sizeable positions in markets other than natural gas to improve their liquidity and to allow them more flexibility in liquidating their remaining natural gas positions. This rapid unwinding of positions in several markets other than natural gas appears to have occurred with no disruptions to those markets.
Before we get too complacent, however, several things should be noted. First, the losses at Amaranth occurred while the markets were awash in liquidity and credit spreads stood at (and remained at) very tight levels. Navigating in such calm waters, when no other funds were in distress, risk managers at banks and securities firms could devote their attention fully to monitoring the Amaranth positions.
This benign environment helped Amaranth successfully walk a tightrope. As their dealer bank counterparties exercised prudent credit risk management by making timely margin calls, the fund was able to liquidate large parts of its portfolio unrelated to the natural gas positions that had caused the massive losses. This included positions in fairly illiquid assets. That Amaranth's traders were able to do so without depressing prices reflects the benign market environment at the time. In a less stable market, where creditors would be more aggressive about exercising their rights and debtors less willing to return collateral owed the fund, the liquidation of those positions may have led to the feared downward spiral where falling prices lead to more margin calls, which lead to more liquidation, and so on, with contagion effects on unrelated markets.
Yet the leverage employed by hedge funds may be more and more difficult to control indirectly simply by maintaining strong capital and risk management requirements at the regulated banks and securities firms. A range of highly structured derivatives products exists today that can embed enormous leverage, often with respect to fairly illiquid or complex exposures. The largest hedge funds typically utilize multiple prime brokers, which makes it more difficult for any single prime broker to assess the overall leverage employed by a client. And to the extent that credit is extended on the basis of the rating of the counterparty rather than solely on the value of the collateral, leverage is at least potentially increased further.
So what should we be doing, short of regulating hedge funds? I think regulators will clearly need to engage with certain key hedge funds more holistically and more directly than in the past.
What form might this take? Regulatory attention may stop well short of legislative action and formal regulation. For instance, structured and regular dialogue between the largest hedge funds and supervisors may be very useful. Some of these funds, which would surely be of greatest interest from the systemic risk perspective, have already indicated a willingness to interact with Commission staff on a voluntary basis. I am hopeful that this dialogue will expand substantially over time and give rise to thoughtful, targeted approaches, crafted with input from the hedge funds themselves, to better address the systemic risk concerns I have alluded to today.