IOSCO Report Shows Need to Regulate Hedge Funds for Systemic Risk

As the US and EU try to pass legislation to regulate hedge fund operators and advisers, a report by an IOSCO working group concluded that hedge funds can have a systemic impact on financial stability and hence the lack of a prudential regime for monitoring hedge funds is a critical gap in the regulatory framework. The failure of a large, highly leveraged hedge fund could systemically impact its investors, other financial institutions and the markets. Further, the G-20 identified hedge funds as one of the most significant group of institutions in the “shadow” banking system.

Exposures to hedge funds are important sources of counterparty risk, noted IOSCO, especially if a hedge fund borrows from multiple brokers or is engaged in multiple trading relationships and individual counterparties do not have a full picture of the hedge fund’s leverage or of its other risk exposures. The current lack of transparency constitutes a major obstacle to risk mitigation.

The report recommends that hedge fund operators be required to develop and maintain proportionate and documented risk management policies to identify and monitor all risks stemming from the activity of each managed hedge fund, consistent with its intended risk profile. Appropriate reporting lines should be established to ensure frequent and timely reporting to senior management about the actual level of risk. The risk management function should be hierarchically and independent from the hedge fund management function.

The hedge fund operator should be required, for each hedge fund it manages, to deploy liquidity risk management systems in order to ensure that the liquidity profile of the fund’s investments complies with its obligations and the redemption policy that has been disclosed to its investors, including possible suspensions. The hedge fund operator should also be required to conduct stress tests to assess the liquidity risk under normal and exceptional circumstances for consistency with the fund liquidity profiles.

Hedge fund managers delegating the performance of risk management to a third party must remain fully responsible for the selection of the third party and for the proper performance of the risk management activity.

Legislation should be passed imposing reporting requirements on hedge fund operators to disclose current or potential sources of systemic risk and to enable cross-sectoral monitoring of systemically important hedge funds. Regulators should be authorized to collect meaningful information from hedge funds to enable them to monitor, evaluate, and exchange information on systemic risks on a cross-sectoral basis.

There should be initial and ongoing capital requirements for relevant hedge fund operators as a condition of registration and ongoing supervision. Such requirements could be designed to absorb losses arising from operational failures and may allow for orderly winding down of a fund operator in the event of bankruptcy. The level of minimum capital standards should be enough to allow an orderly liquidation of or transfer of funds managed by a failing hedge fund operator and take account of the obligations of the operator.

To mitigate counterparty credit risk, IOSCO would require hedge funds to provide collateral in excess of the value of the funds borrowed. This option would limit leverage only if generally imposed by all counterparties, since otherwise the collateral for one counterparty could be financed by borrowing from the other. To limit excessive funding liquidity risks, hedge funds that significantly invest in illiquid assets should be set up as closed-end funds. To avoid excessive risk-taking, said the report, regulators should impose direct and simple caps on leverage, including from exposures arising from derivatives.

Leverage may also be constrained through several other regulatory tools, said IOSCO. For example, the European Commission’s proposed Directive on Alternative Investment Fund Managers would impose leverage limits on alternative fund operators where this is required to ensure stability and integrity of the financial system. The proposal also would grant emergency powers to national authorities to restrict the use of leverage by alternative fund operators in exceptional circumstances.

However, imposing leverage limits is controversial, with some arguing that sophisticated investors invest in a hedge fund to follow a certain strategy and the fund’s strategy should be restricted only if leverage could cause systemic risk. In addition, setting leverage caps could be extremely difficult and complex, particulary because the true extent of leverage cannot easily be figured without analyzing the embedded leverage in each underlying investment.

As a compromise, IOSCO recommended imposing flexible leverage limits. In order to avoid procyclicality in financial markets, leverage could be tightened during market upturns and relaxed during downturns. This would help prevent funds from having to sell assets, reasoned IOSCO, and thus amplify downward pressures during market declines. For example, regulation could result in building risk buffers in the system procyclically and relying on these buffers anti-cyclically.

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