Treasury Official Warns on Concentration of Hedge Fund Counterparties

A senior Treasury official has raised the specter of a major systemic shock to the markets due to the fact that a few large financial institutions serve as the principal counterparties and creditors to hedge funds. In remarks at a Managed Funds Association seminar, Anthony Ryan, Asst. Secretary for Financial Markets, cautioned that the improved sophistication of risk management programs cannot lull one into thinking that systemic risk has been defeated.

In this regard, he noted that E. Gerald Corrigan, chairman of the Counterparty Risk Management Group, recently testified to Congress that the potential damage that could result from such shocks is greater due to the increased spread, complexity, and tighter linkages that characterize the global financial system. Thus, although financial institutions have improved their capital positions and risk management practices over the past decade, acknowledged the Treasury officer, there is room for additional improvement.

In his view, the availability of information plays an important role. Only with accurate and timely information can counterparties, creditors, and investors understand and adequately assess their risk exposure. Similarly, if investors, counterparties and creditors are to define and create effective market discipline, he reasoned, they must have access to reliable and timely information. The point is that much of this information can only be disclosed by the hedge fund managers.

Market infrastructure is also important with increasing product innovation and trading volume. According to Mr. Ryan, not having effective and rapid clearing and settlement procedures could stimulate a systemic contagion effect if there were a failing counterparty or highly leveraged market participant.

He also described the recent guidelines set forth by the President’s Working Group on Financial Markets as a call to action to foster preparedness. The guidelines direct all stakeholders to mitigate the likelihood and impact of a systemic risk event. The guidelines highlight how potential systemic risk is best mitigated within the current regulatory framework by market discipline that is developed and applied by creditors, counterparties and investors.

More specifically, the guidelines call upon financial institutions to determine appropriate credit terms. In doing so, noted the official, they must assess credit and operational risk. He advised financial institutions to be disciplined and independent in quantifying valuations. Importantly, they need to guard against the risks to their reputation. The Treasury official cautioned banks that their regulators will closely monitor their management of these risks and assess whether their performance is in line with expectations set out in supervisory guidance.

To deal with these challenges, he continued, counterparties and creditors must maintain appropriate policies and protocols. They must clearly implement and continually enhance best risk management practices addressing how the quality of information from a client affects margin, collateral, and other aspects of counterparty risk management.
In order to combat the effects of increased risk concentration, the PWG guidelines encourage lenders to hedge funds to frequently measure their exposures, taking into account collateral to mitigate both current and potential future exposures