By James Hamilton, J.D., LL.M.
The light market-based approach to the regulation of hedge funds has worked well, said Federal Reserve Board chairman Ben Bernanke in remarks at NYU Law school, although many improvements can still be made, especially in the area of risk management. In a system of market-based discipline, he noted, hedge fund managers have both the incentive and the duty to manage risk effectively, to develop consistent methods for valuing assets and liabilities, and to provide timely and accurate information to their investors, creditors, and counterparties.
He believes that the light regulatory touch is justified because hedge funds deal with highly sophisticated counterparties and investors make no claims on the federal safety net. That said, however, the growing market share of hedge funds has raised concerns about possible systemic risk. Their complexity and the rapid change inherent in their strategies make hedge funds relatively opaque to outsiders. They are also either highly leveraged or hold positions in derivatives that make their net asset positions very sensitive to changes in asset prices.
The Fed chair observed that the failure of a highly leveraged hedge fund holding large, concentrated positions could involve the forced liquidation of those positions, possibly at fire-sale prices, thereby imposing heavy losses on counterparties. In the worst case scenario, these counterparty losses could lead to further defaults or threaten systemically important institutions.
The market discipline provided by creditors and investors can fail, he said, and an example of this is the 1998 collapse of the hedge fund Long-Term Capital Management, whose investors and counterparties did not ask the tough questions necessary to understand the risks they were taking. In his view, these risk-management lapses were a major source of the LTCM crisis.
While Congress could have responded to the LTCM episode by imposing an intrusive regulatory regime on private pools of capital, the regulatory approach taken in the United States has followed recommendations set forth in 1998 by the President’s Working Group on Financial Markets and recently reaffirmed in a set of principles by the same group. This market-discipline approach to regulating hedge funds imposes responsibilities on four sets of actors: hedge fund investors, counterparties, regulators, and the hedge funds themselves.
Additional protection is provided by the fact that the securities laws allow only institutions and high-wealth individuals to invest in hedge funds, assured the Fed chair, and these investors have the resources and incentive to monitor the activities of the hedge funds. Large investors are well equipped to assess the strategies and risk-management practices of individual hedge funds, he pointed out, and also have the clout to demand the information that they need to make their evaluations.
The Fed official conceded that small investors may obtain indirect exposure to hedge funds through pension funds. But he added that pension fund managers have a fiduciary duty to their investors to understand their investments and ensure that their overall risk profile is appropriate for their clientele. In practice, he said, most pension funds have only a small exposure to hedge funds.
In Bernanke’s view, counterparties are an important source of market discipline. The principal counterparties of most hedge funds are large commercial and investment banks, which provide the funds with credit and a range of other services. As creditors, he reasoned, they have an economic incentive to monitor and impose limits on hedge funds’ risk-taking, as well as an incentive to protect themselves from large losses should one or more of their hedge-fund customers fail.
Counterparties seek to protect themselves against large losses through risk management and risk mitigation. Risk management includes the use of stress tests to estimate potential exposure under adverse market conditions, he noted, while risk-mitigation include collateral agreements under which hedge funds must daily mark to market and fully collateralize their current exposures.
While the incentives of hedge fund counterparties dovetail with regulatory objectives, he said, private counterparties may not fully account for risks to general financial stability. Thus, regulators must ensure that hedge-fund counterparties protect themselves and, in so doing, protect the broader financial system. Regulators should also monitor markets and key institutions, coordinate with their domestic and foreign counterparts, and work with the private sector to strengthen market infrastructures. In this context, he praised the Federal Reserve Bank of New York’s joint public-private effort to improve the clearing and settlement of credit derivatives as just the type of coordination that improves market functioning and reduces risks to financial stability without harming market discipline.
At the end of the day, market discipline does not prevent hedge funds from taking risks, suffering losses, or even failing, he noted, nor should it. According to Chairman Bernanke, if hedge funds did not take risks, their social benefits of providing market liquidity, improving risk-sharing, and supporting financial innovation would largely disappear.