In a letter to the Financial Stability Oversight Council as it considers the criteria to designate if a hedge fund is systemically significant under Dodd-Frank, the hedge fund industry urged the Council to analyze financial institutions based on objective, quantitative data to determine which hedge funds and other nonbank financial companies should be deemed systemically significant and, therefore, subject to supervision by the Fed. The industry believes that the text and legislative history of the Dodd-Frank Act indicates Congress’s intention that the Council designate as systemically significant and regulate only those financial institutions that were previously considered too big to fail, which means firms whose failure would threaten U.S. financial stability. The Managed Funds Association also urged the Council to consider the profound changes in the hedge fund industry since the failure of Long Term Capital Management in 1998, which is often cited as an example of a hedge fund that created a systemic risk to the financial system.
In considering the potential systemic implications of hedge funds, the MFA also asked the Council to have a clear picture of the size, concentration, leverage and structure of hedge funds within the broader financial market. It is also vital that the Council consider the improvements made by hedge fund counterparties such as banks and brokers over the last decade to risk management practices, as well as the new regulatory requirements mandated in Dodd-Frank.
Specifically, the MFA urged the Council to consider that the hedge fund industry and individual hedge funds are relatively small in comparison to other financial market participants, the broader financial industry, and the financial markets in which hedge funds operate. Within the hedge fund industry, there is no significant concentration of assets under the management of any individual adviser or group of advisers. Further, hedge funds generally do not employ a significant amount of leverage and typically post collateral in connection with any leverage employed, thereby substantially reducing the risk to their counterparties. Also, the capital invested in hedge funds is subject to limited redemption rights, which helps ensure a stable equity base and helps prevent runs on the fund’s assets.
The MFA also pointed out that hedge funds typically structure their borrowings to avoid a mismatch between their equity capital and investments on the one hand and their secured financing on the other. More broadly, the enhanced regulation of hedge fund advisers and the markets in which they participate following the passage of the Dodd-Frank Act, including substantially enhanced reporting requirements, ensures that regulators will have a timely and complete picture of hedge funds and their activities.
In considering the interconnectedness of financial institutions, which was a major contributor to the financial crisis, the Council is rightly examining a firm’s relationships within a structure of related businesses and the firm’s relationships with third party institutions. With regard to the interconnectedness of hedge funds with other financial firms, the MFA asked the Council to consider important structural factors. For example, hedge fund advisers and managers do not have substantial assets; though the principals of the adviser have personal capital invested in the funds they manage. It is the funds that hold the financial assets, that transact with trading counterparties on a collateralized basis, and to which investors commit capital.
Thus, the risks and rewards of the funds’ investment portfolios are borne by a diverse group of underlying sophisticated investors, institutions or high net worth individuals, who typically invest in hedge funds as part of a diversified portfolio. Hedge funds neither transact with retail investors nor take in investments or deposits from retail investors.
Another structural aspect of hedge funds is the legal separation of different funds managed by the same adviser. These legally distinct funds, even when managed by the same adviser, often have different investors and can engage in entirely distinct trading activities in different assets and markets. Any losses at one fund are borne exclusively by the investors in and counterparties to that fund and do not subject other funds managed by the same adviser directly to losses.
Further, unlike related entities in a holding company or other similar structures prevalent elsewhere in the financial services industry, the different funds managed by a common adviser do not typically have the kind of intercompany loans or transactions that can create connectedness and tie the risks associated with one company to other companies in the same ownership structure.
Whatever interconnectedness hedge funds have, noted the MFA, arises from the relationships between a hedge fund and its prime brokers or similar financial counterparties. It is through these relationships that hedge funds typically receive financing. But such financing is generally obtained from large, sophisticated financial counterparties, such as global banks or broker-dealers, that conduct substantial due diligence and engage in ongoing risk monitoring.
Further, hedge fund borrowings are done almost exclusively on a secured basis, which limits the amount of leverage that any fund may obtain. In addition, this posting of collateral by hedge funds reduces the credit exposure of counterparty financial institutions to those funds. Consequently, hedge funds are substantially less likely to contribute to systemic risk by causing the failure of a systemically significant counterparty, such as a major bank.
Given the limited leverage and the collateral posted by hedge funds, any losses that hedge funds incur are almost exclusively borne by their investors, not their creditors, counterparties, the general financial system, or taxpayers. Moreover, the MFA noted that hedge funds often diversify their exposures across many counterparties, mitigating the risk that a fund poses to any one counterparty.
Finally, the MFA said that, since the failure of Long Term Capital Management in 1998, there have been significant changes in the market with respect to counterparty risk management. Counterparties now consistently limit the amount of leverage used by hedge funds by requiring the use of collateral to secure financing to hedge funds. Also, as a result of improvements to counterparty risk management best practices, financial institutions today conduct more in-depth due diligence on and have a much greater degree of transparency with respect to their hedge fund clients’ overall portfolios.