GAO Report Finds Market Discipline Alone Cannot Manage Hedge Fund Risk

While market discipline is becoming more effective for managing hedge fund risk, concluded a GAO report, it may not be enough by itself since a number of factors limit its effectiveness and it is not always properly exercised. For example, because most large hedge funds use multiple prime brokers as service providers, no one broker may have all the data necessary to assess the total leverage of a hedge fund client. Further, the GAO found that, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk. These factors can contribute to conditions that create systemic risk if breakdowns in market discipline and risk controls are sufficiently severe that losses by hedge funds in turn cause significant losses at key intermediaries or in financial markets.

The exhaustive report also found that financial regulators and industry participants remain /concerned about the adequacy of counterparty credit risk management at major financial institutions because it is a key factor in controlling the potential for hedge funds to become a source of systemic risk. The GAO applauded regulators for using risk-focused and principles-based approaches to better understand the potential for systemic risk and respond more effectively to financial shocks that threaten to affect the financial system.

For example, regulators have collaborated to examine some hedge fund activities across regulated entities. In addition, the President's Working Group on Financial Markets has issued guidance for hedge funds and formed two private sector groups to develop best practices for investors and asset managers. The President’s Working Group is composed of the Secretary of the Treasury and the chairs of the SEC, the CFTC, and the Federal Reserve Board.

The SEC, CFTC, and the bank regulators are authorized to establish capital standards and reporting requirements, conduct risk-based examinations, and take enforcement actions, to oversee activities, including those involving hedge funds, of broker-dealers, of futures commission merchants, and of banks, respectively. While these financial regulators do not specifically monitor hedge fund activities on an ongoing basis, they have increased targeted examinations of systems and policies to mitigate counterparty credit risk at the large regulated entities. For their part, regulated entities have the responsibility to practice prudent risk management standards, noted the GAO, but prudent standards do not guarantee prudent practices. As such, it will be important for regulators to show continued vigilance in overseeing the hedge fund-related activities of regulated institutions.

The GAO found that hedge fund advisers have improved disclosure and become more transparent about their operations, including risk management practices, partly as a result of recent increases in investments by institutional investors with fiduciary responsibilities, such as pension plans, as well as guidance provided by regulators and industry groups. But the report also noted that, despite the requirement that fund investors be sophisticated, not all prospective investors have the capacity or retain the expertise to analyze the information they receive from hedge funds, and some may choose to invest largely as a result of the fund’s prior returns without fully evaluating its risks.

Regulators and market participants also said that creditors and counterparties have been conducting more extensive due diligence and monitoring risk exposures to their hedge fund clients since the LTCM debacle. Creditors and counterparties exercise market discipline by tightening their credit standards for hedge funds and demanding greater disclosure.
But the actions of creditors and counterparties may not fully prevent hedge funds from taking excessive risk if their risk controls are inadequate. For example, the risk controls may not keep pace with the increasing complexity of financial instruments and investment strategies that hedge funds employ. Similarly, regulators have been concerned that, in competing for hedge fund clients, creditors sometimes relax credit standards.

The SEC’s ability to directly oversee hedge fund advisers is limited to those that are required to register or voluntarily register with SEC as investment advisers. That said, the SEC actually regulates 1,991 hedge fund advisers that are registered as investment advisers, which include 49 of the largest U.S. hedge fund advisers that account for about one-third of hedge funds’ assets under management in the United States. As registered investment advisers, hedge fund advisers are subject to SEC examinations and reporting, record keeping, and disclosure requirements.