Speech by SEC Commissioner:
Hedge Fund Regulation on the Horizon — Don’t Shoot the Messenger
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
Spring 2009 Hedgeworld Fund Services Conference
New York, New York
June 18, 2009
Thank you for that kind introduction. I am pleased to be here with you at the Spring 2009 Hedgeworld Fund Services Conference. This conference is timely given the current discussion regarding potential regulation of the hedge fund industry. Let me say at the outset, as is customary, my remarks today are my own and do not necessarily reflect the views of my fellow Commissioners or of the Commission staff.
My experience with the securities industry began in the late 1970’s. After three years with the SEC, I’ve spent the bulk of my 30 years as a lawyer focusing on the capital markets. Most of those years where in private practices in large law firms, although I spent most of the 90’s and the early part of this decade as General Counsel and Head of Compliance of a large global asset manager. While I’ve spent much of my professional career involved in capital formation though public and private offerings, a substantial portion has been spent working in the investment management industry, and I have worked with hedge funds.
As we all know, there has been much speculation about the impact of hedge fund activity on the broader capital markets. For example, there are questions about whether hedge funds may have contributed to the market turmoil and how hedge funds may have contributed to the demise of Bear Stearns, Lehman Brothers and others. Additionally, it is also not clear whether the lack of oversight of the industry resulted in large amounts of risk to the market through the use of short sales and derivatives, such as credit default swaps.
This year’s conference takes place at a key moment in the history of hedge funds. While hedge funds have remained largely unregulated, this seems to be coming to an end. All over the world, legislators, regulators, investor groups, industry representatives and others are loudly calling for the industry to be regulated.
In the United States, the calls for regulation are motivated by concerns that market integrity has been harmed and that systemic risk arose as a result of the exemptions and exclusions from the federal securities laws that permitted a private market to thrive in ways that may have harmed the public markets. In fact, the market turmoil clearly demonstrated that the private fund market does impact the broader capital markets. This does not mean that all fund activity must be equally regulated, but hedge funds, especially large ones, are thought to require greater regulatory oversight.
My goal with my remarks today is to:
- First, lay out a current state of affairs regarding the hedge fund industry;
- Second, describe the calls for regulation of the industry; and
- Third, discuss key considerations that need to be assessed as hedge fund regulation moves forward.
Multiple Voices Calling For Regulation
The hedge fund industry looks very different today than from where it started. Since the first hedge fund was organized by Alfred Jones in 1949 with $100,000, the industry has exponentially grown both in number of funds and in number of assets under management. In recent years, this growth has been fueled in part by institutional investors, such as endowments, foundations, insurance companies, and pension plans. To give you an idea of the growth, it is believed that the industry managed around $38 billion in 1990, $625 billion in 2002, and reached $1.9 trillion at the end of 2007, although that the number decreased to $1.3 trillion at the end of 2008. It is still incredible growth from the $100,000 start.
The industry’s growth, and the concerns over the impact of hedge funds on the marketplace, has created a renewed call for regulation in the U.S. and abroad. For example, the European Commission recently proposed to regulate the managers of hedge funds and all private equity funds with 100 million euros in assets under management. The proposed regulations would require extensive disclosure of risk management procedures and other aspects of fund governance.
In the U. S., a few years ago the SEC unsuccessfully attempted to regulate hedge funds. More recently, in March of this year, Treasury Secretary Timothy Geithner testified about his plan to more tightly oversee hedge funds. In addition, there recently have been at least a half-dozen bills introduced in Congress requiring regulation of the hedge fund industry. Just this past Tuesday, Senator Jack Reed introduced a bill that would require that advisers to hedge funds, and to certain other investment pools, to register with the SEC. And yesterday, of course, the Obama Administration released a draft white paper that, among other things, proposes that advisers to large hedge funds register with the SEC, and that very large advisers be subject to additional federal supervision by the Federal Reserve Board.
What are the concerns underlying the call for government oversight? I will tell you what we are hearing. The concerns touch on the classic financial regulatory interests: such as market integrity concerns, systemic risk concerns, and investor protection concerns. This state of affairs is what you would expect when markets are inextricably integrated and the impact of hedge funds is significant, but their actions and their risks are opaque. Simply stated, regulators, legislators and the public have little credible information as to who is out there and what they are doing.
Market Integrity Concerns
Let’s start with the SEC’s responsibility to maintain fair and orderly markets. One of the concerns about hedge funds involves how hedge fund operations impact upon the fairness and the integrity of the broader market. The lack of transparency and oversight over hedge funds gives rise to a number of concerns — for example, market integrity concerns about the nature and extent of counterparty risk, concerns about whether hedge funds engage in insider trading, and questions about how hedge funds drive the demand for derivatives, such as CDSs, as well as how they impact the demand for securitized products.
As a predicate for discussion, let’s be clear about the significant market activity of hedge funds. For example, hedge funds reportedly account for more than 85% of the distressed debt market, and more than 80% of certain derivatives markets. Moreover, although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume. In 2006, there were estimates that hedge funds were responsible for as much as half of the daily trading volume on the New York Stock Exchange.
Because hedge funds are not subject to leverage or diversification requirements, hedge fund managers can more easily take concentrated positions that can impact the market. For example, an entire fund or even multiple funds advised by the same hedge fund manager can be invested in a single position.
In addition, hedge funds are major players in the capital markets for reasons other than trading activity. As this audience knows well, hedge funds have significant business relationships with the largest regulated commercial and investment banks — and act as trading counterparties for a wide range of OTC derivatives and other financing transactions.
Counterparty Risk Concerns
Clearly, for all these reasons and others, hedge funds are significant players in the capital markets. As significant players, hedge funds are one source of counterparty risk, and this risk can be amplified by their leverage and opacity.
Today, commercial banks and prime brokers are called upon to bear and manage the credit and counterparty risks that hedge fund leverage creates. Up until now, it has been assumed that market discipline would effectively prevent hedge funds from detrimentally impacting the capital markets or from posing systemic risk. A January 2008 GAO Report, however, identified several concerns with that theory.1 For example, the report noted that hedge funds use multiple prime brokers and questioned whether any single prime broker has a complete picture of a hedge fund client’s total leverage. Accordingly, the stress tests and other tools that a prime broker uses to monitor a given counterparty’s risk profile only incorporate the positions known to that particular prime broker. Thus, no single prime broker has the whole picture.
The GAO Report also stated that some counterparties may lack the capacity to assess risk exposures because of the complex financial instruments and secret investment strategies that some hedge funds use.
Unfortunately, the GAO Report also indicates that counterparties facing these structural limitations may have also actively relaxed credit standards in order to attract and retain hedge fund clients in response to fierce competition.
In each of these instances, the risks of hedge funds are being externalized to the regulated market — prime brokers, banks, and their shareholders each were asked to bear the costs of managing hedge fund risks. A concrete example you may remember was when two Bear Stearns-sponsored hedge funds collapsed in 2007. Merrill Lynch, one of the prime brokers, had to absorb an enormous loss because it could only sell the funds’ collateral for a fraction of its purported value.
It’s been obvious that the regulatory oversight of hedge funds has not matched their level of market activity. This difference has led to other concerns affecting market integrity.
Risks of Insider Trading Create Market Wide Concerns
For example, in addition to concerns about counterparty risk, there have also been concerns about hedge funds engaging in insider trading. Clearly, there has been an increase in the number of insider trading cases brought by the Commission that have involved hedge funds. Admittedly, it is incredibly difficult for the Commission to assess the frequency of insider trading because of the opacity of hedge funds and the investments they make, especially in OTC derivatives. Moreover, when you couple this with the fragmented nature of the securities markets and the broad potential for hedge funds to obtain inside information, it is a tough oversight situation indeed. Hedge funds who participate in private placements, talk with trading desks, and maintain connections with the street are, in many cases, in a position to obtain inside information and to use it in a way that traditional surveillance may not detect. This potential for insider trading has been well publicized and public investors are concerned about the possible effects on market fairness and integrity.
Hedge Funds And The Demand For CDS and Securitized Products
Additionally, hedge funds were significant players in the exponential growth in the now much maligned credit default swaps market. As the market to create CDSs grew, there were funds that bought these instruments for reasons that made sense. For example, in 2005 there were hedge funds who noticed that the U.S. housing market was weakening and they bought CDS instruments on the protection buyer side. A logical move.
On the other hand, it is well known that the credit risk reflected by CDSs is equal to multiples of the actual credit risk of the underlying bond market. How did that happen? Many CDSs were heralded as hedging tools — they were supposed to transfer risk to parties that could bear it from parties that could not. Now we see only too clearly that this was not the case. Instead, many CDSs actually created risk, rather than hedged risk. Hedge funds that sought to create profits from leveraged risk may have played a crucial role driving the growth in these products.
The concerns about hedge funds and market integrity often go hand in hand with concerns about systemic risk. In their current form, hedge funds pose a systemic risk threat to our financial system in several ways. First, hedge funds have such significant assets under management that some fear that the loss of one or more large firms could potentially reverberate throughout the capital markets. In addition, if a counterparty fails to effectively withstand a hedge fund loss, then the failure of the counterparty could itself threaten market stability.
There is also the issue that can occur when several hedge funds take the same position, whether through coordination or simply through similar trading strategies. These funds can have a large impact on the market when they adjust their positions en masse.
Thus, the concerns that the lack of oversight over the hedge fund industry may present to market integrity and to systemic risks seem to be well founded.
In addition to concerns about market integrity, the SEC is also responsible for investor protection. Given the increase in complaints from hedge fund investors this has taken on a more immediate importance.
One of the underlying principles behind the idea that hedge funds could operate with little to no regulatory requirements was that interests in the funds were only sold in private offerings to wealthy investors. These investors were thought to be sufficiently “sophisticated” to protect their interests, and to be able to engage in effective arms-length negotiation in order to achieve fair and equitable terms.
I firmly believe that truly sophisticated investors in private deals should be held accountable to the terms that they knowingly negotiate — and if an investment were to go bad, they should bear the loss.
However, with the recent market turmoil and the ongoing economic upheaval that has caused trillions in wealth to vanish, millions of jobs to disappear and the liquidation of over 1,500 hedge funds, serious concerns have been raised about whether these wealthy and sophisticated investors are truly able to protect their interests. There seems to be evidence that these “sophisticated investors” may not have fully appreciated the risks they were taking. Perhaps it may make sense for the definitions of who qualifies as “sophisticated” under our rules to be reconsidered. For example, maybe the criteria for sophistication should focus on more relevant attributes — such as focusing on actual investment experience.
In any case, recent events have challenged the assumption that investors and market discipline can be relied upon to control the risks of hedge funds. And this is not surprising. First, these investors are typically passive and there is no legal obligation for hedge fund investors to monitor hedge fund activity. Second, even if investors wanted to actively monitor the investment, the nature of hedge fund activity and the information available may not currently support such a role.
Valuation and Performance
For example, it may be impossible for an investor to know the actual value of a hedge fund’s portfolio. Hedge funds are not subject to reporting requirements and because many instruments held by a hedge fund are illiquid or opaquely-priced OTC products, any information that is reported could be hard to evaluate.
Related to the concern of how a fund values its assets, is a hedge fund’s performance information — another hard to evaluate metric for investors. Without regulation, the only performance information that hedge funds provide is voluntary.
This quote by Harry Liem, a pension consultant, seems to sum it up when he said “It’s like someone walking into a casino and saying ‘I want everyone to come forward and tell me how much you have won or lost.’ Probably only the winners will come forward . . .”2
Not Being Able to Redeem
There is also the issue of investors not being able to redeem their investments from a fund. In recent times, due to the large amount of redemption requests and the current lack of an ability to raise cash, there are hedge fund managers who have put up gates and have restricted investors’ ability to redeem their monies. Although gates can benefit investors by giving the manager more time to sell off portfolio positions, for some investors it appeared to be a surprise.
On top of that, several hedge fund managers froze funds but continued to charge management fees on money that investors cannot access. Orin Kramer, a hedge fund manager, described the situation by stating: “It’s like telling someone at a hotel that they can’t check out and then charging them for the privilege of staying.”3
Let me be clear. I’m not saying that these situations are per se illegal. To the extent that sophisticated and qualified investors agreed to provisions providing for gates and the ongoing charge of management fees, one could say that investors walked into these agreements with open eyes.
However, because for the most part hedge funds are not registered with the SEC, we are not able to adequately oversee how they are operating. Moreover, this lack of transparency makes it difficult to assess whether the relationship between an investor and the hedge funds adviser, is functioning in the manner that underlie the presumptions that led to the exemptions.
Some recent reports do tend to show that investors are beginning to take their own initiatives, and give some indication that what investors may be willing to agree to in the future may be different. For example, a recent memo from CalPERS stated that it would no longer partner with managers whose fee structures result in a clear misalignment of interest between managers and investors. Moreover, more investors are now asking that hedge funds run assets in “managed accounts,” where their money is held separately and the holdings are transparent.
As you may expect based on concerns including ones I have mentioned, hedge fund investors have been calling the Commission in unprecedented numbers
Increased Cases Involving Hedge Funds
In fact, the Commission has more investigations involving hedge funds than ever before, and the number of cases actually brought also is increasing. In the first 4 months of 2009, the Commission filed 25 cases related to hedge funds. In contrast, we brought 19 cases in all of 2008, 24 in all of 2007, and 16 in 2006. Our cases cover the waterfront, charging everything from offering fraud and insider trading, to misrepresentations about performance and to misrepresentations about the actual due diligence undertaken. We are also seeing more cases involving conflicts of interest and outright theft of assets
Nature of Regulation
I have just laid out for you some of the concerns that are generally driving the calls for greater regulation and oversight of the hedge fund industry. Maybe even more important, it appears that some of the assumptions justifying the industry’s exclusion from regulation and oversight may be on faulty ground. As a result, it seems certain that regulation of the hedge fund industry is coming. But here is the harder question — what should it look like?
There are a number of questions as to exactly how, and to what extent, hedge funds may have contributed to the economic crisis and how they contributed to the overall systemic risk of the financial markets. To that end, I applaud Congress and President Obama for providing for an independent, bi-partisan Financial Crisis Inquiry Commission. By investigating and analyzing what happened, we can better assess whether the regulatory proposals should move forward.
Since coming to the Commission, I have been a vocal advocate for the Commission’s mission to protect investors, provide for fair and orderly markets, and promote capital formation. All aspects of this mission guide my thoughts as we consider the appropriate framework to regulate hedge funds.
Because of the size, complexity and market-wide impact of the hedge funds industry, potential regulation would need to be both comprehensive and flexible. Something not always easy to achieve.
I believe that the SEC must be an active participant in this process. Please remember that the SEC has been overseeing industry participants — such as, investment companies, investment advisers and broker-dealers — for over 69 years. The Commission staff has unsurpassed expertise in this area. Congress should take advantage of this expertise by providing the Commission with a broad mandate to oversee hedge funds. The Commission could then scale its regulation in a flexible manner to deal with the regulatory concerns of market integrity, investor protection, and, in coordination with other regulators, systemic risk.
Working with hedge fund advisers and with hedge fund investors, I am confident that we can find an appropriate balance.
As you know, there has been a general discussion over whether hedge fund advisers and/or hedge funds should register. In my mind, hedge funds advisers with over $25 million in assets should register with the Commission, but that may not be enough. Many hedge fund advisers are currently registered with the SEC but we still lack a complete picture of what is going on in the industry. Some have suggested that hedge funds should also register. Others have suggested that it may be appropriate to apply limited concepts from within the Investment Company Act of 1940 to hedge funds — what some have called a “40 Act-lite” regime.
Perhaps a tiered approach to registration, based on a fund’s potential to affect the market, would make sense. At the lowest tier would be small funds. These funds could be subject to a simple recordkeeping requirement as to positions and transactions, kept in a standardized format, to permit the SEC to efficiently oversee their activities. As funds grow in size, different standards may be appropriate.
For funds that could significantly affect the market, it may be appropriate to require more than recordkeeping. For example, it may be appropriate to think through whether some of the risk limitation concepts built into the Investment Company Act make sense to apply to these hedge funds — such as imposing limits on leverage.
Of course, these are only a few suggestions. Many others have been made — and others will follow — as the discussion turns from “whether to regulate” to “how to regulate.” The nature of the business of hedge funds is trading, and this necessarily requires interaction with the public marketplace — and the larger the investment fund, the greater the potential impact on the overall capital markets. When the hedge industry has the ability to significantly impact the market or other market participants, the public interest needs to be protected. A lesson of this economic crisis is that the U.S. regulatory interest in hedge funds arises because of the impact of the funds on the financial market, regardless of the sophistication of its investors or the number of investors.
When discussing “how to regulate,” it is clear to me that regulation is more than the bare requirements of registering and reporting — it should also include inspection authority. To have a chance to prevent problems before they occur, the SEC has to be able to inspect all hedge fund advisers, and the funds that they manage, and otherwise engage in oversight through surveillance systems. The public expects nothing less.
Greater Resources to SEC to Provide Effective Oversight
As we talk about regulation of the hedge fund industry, there is also the question of regulatory resources. Any future registration of hedge fund advisers and/or hedge funds will require that the SEC receive increased resources to provide effective oversight. We will need to hire staff and implementing new technology to effectively deal with a large and complex industry. To that end, I have previously called for Congress to pass legislation establishing the SEC as a self-funded agency, similar to the way other financial regulators are funded — such as the Federal Reserve Bank, the FDIC, OTS and OCC. This would help to solve the problem.
To the extent that funds are registering and reporting to the SEC, I encourage Congress to couple the authority increasing the SEC’s jurisdiction with the appropriate self-funding mechanism to allow us to provide effective oversight.
In conclusion, I am confident that regulation of the hedge fund industry can be done right — in a way that balances the needs of the industry with the needs of investors and the needs of the market. And if it is, it will be a good thing for all of us. The Congressional Oversight Panel’s Special Report on Regulatory Reform4 said it best with the following summary:
“By limiting the opportunities for deception and allowing for the necessary trust to develop between interconnected parties, regulation can enhance the vitality of the markets. Historically, new regulation has served that role.
For example, as the money manager Martin Whitman has observed, far from stifling the markets, the new regulations of the Investment Company Act enabled the targeted industry to flourish:
“’Without strict regulation, I doubt that our industry could have grown as it has grown, and also be as prosperous as it is for money managers. Because of the existence of strict regulation, the outside investor knows that money managers can be trusted. Without that trust, the industry likely would not have grown the way it had grown.’”5
The lack of transparency, potential imbalance of power between investors and managers, and impact on the entire capital market are driving the calls to regulate the hedge fund industry. The hedge fund industry has a lot to offer in determining how these calls are answered. Addressing these issues in an intelligent and rational manner is important, and ultimately will result in a stronger and more vibrant hedge fund industry. I welcome the ongoing discussion.
Thank you for inviting me here today.