By Jacquelyn Lumb
The Financial Stability Oversight Council was recently briefed by its hedge fund working group about the potential financial stability risks from the use of leverage by large hedge funds. The working group reported that, due to the increase of information available through the SEC’s Form PF and the establishment of swap data repositories, its understanding of this segment of the financial markets is greatly improved. This additional transparency helped the working group identify channels for the potential transmission of risks, relevant factors for assessing those channels, data gaps that make it difficult to identify evolving risks, and metrics for measuring the risks associated with hedge fund leverage.
The working group has been reviewing asset management products and activities since May 2014 when it held a public conference, followed by a request for public input about whether certain asset management activities could pose risks to U.S. financial stability. An initial analysis was issued in April of this year in which the working group reported ample evidence that leverage, in combination with other factors, can contribute to risks to financial stability.
As the hedge fund industry continues to grow, the working group found that the use of leverage appears to be concentrated among a small number of hedge funds. Fund strategies that employ the highest amounts of leverage have grown as a percentage of overall hedge fund assets so their market footprint far exceeds their assets under management.
Risk factors. The working group identified factors that could increase or mitigate risks, and areas where regulators do not have the necessary data to assess the extent of the risks. One factor is the potential market disruption from forced selling. The use of significant leverage means that even small changes in asset prices could lead to margin calls or funding pressures.
A second factor is the potential for hedge funds to transmit risk to their counterparties, although the working group found this risk to be somewhat mitigated by increased central clearing of derivatives and other regulatory reforms.
Data gaps. During the next phase of its work, the group plans to focus on data gaps and limitations, and on the continued monitoring of potential financial stability risks. The working group said that data sharing among regulators is essential but difficult at this time due to a lack of standardized reporting across agencies. Form PF also could be refined to improve the timeliness and usefulness of the reported data.
The working group also urged regulators to periodically review and analyze funds’ use of leverage and share their findings with FSOC and other regulators. Hedge funds are important participants in the financial markets, the working group noted, but no single regulator has the authority or the information to identify the risks that their use of leverage could pose. The working group identified four categories of leverage measures that should be incorporated into the analysis of potential risks, which include gross measures, adjusted gross measures, net exposure measures, and risk-based metrics, such as value-at-risk.
Brown’s statement. Following the FSOC meeting, Senator Sherrod Brown (D-Ohio) released a statement in which he advised President-elect Trump of the importance of FSOC’s work. He said the next Treasury secretary should understand that any actions that undermine FSOCs mission could threaten the ability to address risky Wall Street practices and could leave taxpayers and the economy vulnerable to another crisis. If President-elect Trump is serious about stopping Wall Street and hedge funds from ‘getting away with murder’ as he said during his campaign, he will make sure that FSOC can keep doing its job, Brown advised.