Thursday, November 13, 2008

Former SEC Chair Ruder Calls for Regulation of Hedge Funds with SEC as Risk Management Assessor

As Congress examines the role of hedge funds in the ongoing financial crisis, former SEC Chair David Ruder urged Congress to empower the SEC to register hedge fund advisers and require them to disclose hedge fund risks and other activities. In testimony before the House Oversight and Government Reform Committee, he said that the Commission should also be authorized to monitor and assess the effectiveness of hedge fund risk management systems. As part of any legislation, he continued, the SEC should be required to share risk information about hedge funds on a confidential basis with the Federal Reserve Board, which should be given primary responsibility for systemic risk regulation.

Separately, the former official said that Congress should repeal the swaps exclusion included in the Commodity Futures Modernization Act of 2000 so that non-exchange traded derivative instruments can be regulated in a manner that will protect investors and help prevent destabilization of the financial markets.

While the main participants in the current crisis were loan originators, investment banks, rating agencies, and sellers of credit default swaps, noted the former chair, hedge funds were participants in several phases of the crisis. Hedge funds contributed to declines in stock and asset prices by liquidating stocks and other assets in order to meet other obligations and in order to pay investors seeking to withdraw funds.

According to the former SEC Chair, new regulations are needed in order to protect hedge fund investors and monitor hedge fund contributions to systemic risk. Systemic risk regulation of hedge funds is necessary because hedge funds’ size, strategies, and opacity pose risks to the financial markets. Highly leveraged hedge funds that borrow large sums and engage in complex transactions using exotic derivatives may severely disrupt the financial markets if they are unable to meet counter party obligations or must sell assets in order to repay investors.

Hedge funds are also major users of non-exchange traded derivatives. Although general characteristics of derivatives are well known, a tremendous void exists regarding the specific characteristics of many of these instruments, the amounts at risk, and the identity of their counter parties. The terms of these instruments are often unique and complicated, and the instruments are frequently not easily settled or offset.

A primary problem identified in the credit crisis has been the loss of confidence among market participants regarding the ability of counter parties to honor contractual obligations and to repay their debts. The main reason for the lack of confidence is lack of information, said Mr. Ruder. Regulation should exist allowing information about hedge fund risk positions to be known by regulators.

Noting that steps to prevent systemic calamities in the financial market should be based on comprehensive risk information, Mr. Ruder advocated a system requiring hedge funds to disclose to regulators information regarding the size and nature of their risk positions and the identities of their counter parties.

The SEC is the proper entity to obtain hedge fund risk information, he said, because the Commission understands the markets and the need to allow innovative risk taking. By monitoring and assessing hedge fund risk management systems, the Commission will be able to determine whether those systems are effective in meeting their protective goals.

Protection of investors must be a major goal of hedge fund regulation, declared the former chair. The SEC already has the power to discipline hedge fund investment advisers who defraud hedge fund investors. SEC powers over hedge fund investment advisers through registration and inspection will allow the Commission to learn about potential fraudulent activities at an earlier stage than is possible through after the fact enforcement activities.

Finally, Mr. Ruder opined that Congress made a serious mistake when it included in the CFMA a swaps exclusion preventing regulation of a broad range of non-exchange traded derivative instruments by either the CFTC or the SEC. These OTC derivatives, including credit default swaps, should be subject to federal regulation, he emphasized.

He urged Congress to repeal the swaps exclusion so that the non-exchange trading of derivative instruments can be regulated in a manner that will help protect investors and prevent destabilization of the financial system. One approach to regulating the systemic risk involved in derivatives would be to standardize the terms of OTC derivatives, such as credit default swaps, andcause those instruments to be traded on futures or options exchanges. Standardization would have the great benefit of reducing the opaque nature of the derivatives.