Treasury Official Provides Insights on Hedge Fund Guidelines

A senior Treasury official has emphasized that the hedge fund guidelines issued by the President’s Working Group on Financial Markets are not an endorsement of the status quo. Instead, they represent a uniform view from Treasury, the SEC, the Fed and the CFTC that heightened vigilance is needed to address market developments. Robert Steel, Under Secretary for Domestic Finance, also pointed out that there is no one-time regulatory fix that will solve the complex challenges presented by hedge funds.

He explained that the philosophy underlying the guidelines is to encourage and improve transparency and disclosure by hedge funds to counterparties and investors, as well as continued encouragement by regulators to strengthen market and counterparty discipline. Hedge funds should maintain information, valuation, and risk management systems that provide counterparties and investors with accurate and timely information.

A key motivation behind the guidelines is mitigating potential systemic risk posed by private pools of capital. In this context, he defined systemic risk as the potential that a single event, such as a financial institution's failure, may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected. The Working Group believes that the collective decisions of informed counterparties, reviewed by regulators, provide the very best protection against systemic risk.

The guidelines recommend that key counterparties commit resources and maintain appropriate policies and protocols to implement, and continually enhance, sound risk management practices. These are not static responsibilities, emphasized the official, but important ongoing obligations. It is critical that counterparties undertake effective due diligence before extending credit to a private pool of capital.

Similarly, the guidelines encourage lenders to hedge funds to frequently measure their exposures, taking into account collateral to mitigate both current and potential future exposures. Credit exposures, in addition to being measured frequently, should also be subject to rigorous stress testing, not just at the level of an individual counterparty, but also aggregated across counterparties.

The Working Group also believes that the senior managers of financial services firms with large exposures to private pools of capital have duties. Management should institute protocols so they are kept informed of large exposures, the senior official instructed, and they must appreciate the implications of these exposures and ensure that sound risk management practices are implemented. In doing so, senior management should ensure that a firm's aggregate exposure to hedge funds is consistent with its tolerance for bearing losses in adverse markets.

For their part, institutional investors in private funds have a responsibility to prudently evaluate the strategies and risk management capabilities of hedge funds and ensure that the funds’ risk profiles are compatible with their own appetites for risk. In doing so, they should undertake effective due diligence before investing in a hedge fund and perform due diligence on an ongoing basis after investing.

The Working Group expects regulators to communicate their expectations regarding counterparty risk management practices and use their authority to enforce these expectations.

Finally, noted the Treasury official, the guidelines encourage investors to consider the suitability of investments in hedge funds in light of their investment objectives, risk tolerances and the principle of portfolio diversification. Moreover, the standard of diligence for investors with fiduciary responsibilities who are investing on behalf of others should be an especially high one.