The Director of Market Regulation Erik Sirri provided a detailed and rare snapshot of how the SEC’s consolidated supervised entity (CSE) program interacts with and impacts hedge funds in testimony before the House Financial Services Committee. Under the CSE program, the Commission supervises five global securities firms on a group-wide basis. For such firms, the Commission oversees not only the U.S-registered broker-dealer, but also the consolidated entity, which may include foreign-registered broker-dealers and banks, as well as unregulated entities, such as derivatives dealers and the holding company itself.
The CSE program is designed to provide holding company supervision that is broadly consistent with Fed oversight of bank holding companies. The aim of this program is to diminish the likelihood that weakness in the holding company itself or any of its unregulated affiliates places a regulated bank or broker-dealer, or the broader financial system, at risk.
All five of the CSEs are of potentially systemic importance since they trade a wide range of
financial products, connected through counterparty relationships to other large institutions. The primary concern of the CSE program with regard to hedge funds revolves around the risks they potentially pose to the firms specifically and, through the CSEs, to the financial system.
Hedge funds present a variety of management challenges to CSEs, said the SEC official. For example, a hedge fund may grow so large in absolute terms that a forced liquidation could lead to a broader unwinding of positions and otherwise disrupt the markets.
The rapid development of risk transfer mechanisms, such as credit derivatives and securitization, evidences that markets have better shock absorbers today than in the past. However, noted the director, the transfer of risk from banks and securities firms to hedge funds and other market participants may not be as definitive as some believe.
The CSE program monitors and assesses these risks in several ways. First, SEC staff meet monthly with senior risk managers at the CSEs to review risk exposures, including those to hedge funds. This process provides information not only concerning the potential risks to CSEs, but also a broad window into their relationship with hedge funds and these hedge funds’ potential impact on the broader financial markets. Importantly, the meetings allow SEC staff to monitor trends in the extension of credit to hedge funds through a variety of channels, including prime brokerage relationships, secured financings, and OTC derivative trades.
Through this monthly process, the SEC tracks changes in margin terms and other credit mitigants. Where warranted and where the information is timely, the SEC can respond with respect to CSEs by requiring that they hold additional capital against such exposures.
The director also said that SEC staff recently engaged in targeted discussions with the CSEs about the challenges of measuring credit exposures to hedge funds. For example, risk managers cite the need for stress testing their exposures to hedge fund counterparties. There is a general consensus that measures such as value-at-risk may not be sufficient for judging the risk presented by hedge fund counterparties implementing complex strategies, observed Mr. Sirri, and hence the adequacy of the collateral protecting the bank and securities firms that provide financing.