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Steps to Strengthen Market Discipline, but Continued Attention Is
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Report to Congressional Requesters:
United States Government Accountability Office:
GAO:
January 2008:
Hedge Funds:
Regulators and Market Participants Are Taking Steps to Strengthen
Market Discipline, but Continued Attention Is Needed:
GAO-08-200:
GAO Highlights:
Highlights of GAO-08-200, a report to congressional requesters.
Why GAO Did This Study:
Since the 1998 near collapse of Long-Term Capital Management (LTCM), a
large hedge fund—a pooled investment vehicle that is privately managed
and often engages in active trading of various types of securities and
commodity futures and options—the number of hedge funds has grown, and
they have attracted investments from institutional investors such as
pension plans. Hedge funds generally are recognized as important
sources of liquidity and as holders and managers of risks in the
capital markets. Although the market impacts of recent hedge fund near
collapses were less severe than that of LTCM, they recalled concerns
about risks associated with hedge funds and they highlighted the
continuing relevance of questions raised over LTCM. This report (1)
describes how federal financial regulators oversee hedge fund-related
activities under their existing authorities; (2) examines what measures
investors, creditors, and counterparties have taken to impose market
discipline on hedge funds; and (3) explores the potential for systemic
risk from hedge fund-related activities and describes actions
regulators have taken to address this risk. In conducting this study,
GAO reviewed regulators’ policy documents and examinations and industry
reports and interviewed regulatory and industry officials, and
academics.
Regulators only provided technical comments on a draft of this report,
which GAO has incorporated into the report as appropriate.
What GAO Found:
Under the existing regulatory structure, the Securities and Exchange
Commission and Commodity Futures Trading Commission can provide direct
oversight of registered hedge fund advisers, and along with federal
bank regulators, they monitor hedge fund-related activities conducted
at their regulated entities. Since LTCM’s near collapse, regulators
generally have increased reviews—by such means as targeted
examinations—of systems and policies of their regulated entities to
mitigate counterparty credit risks, including those involving hedge
funds. Although some examinations found that banks generally have
strengthened practices for managing risk exposures to hedge funds,
regulators recommended that they enhance firmwide risk management
systems and practices, including expanded stress testing. Regulated
entities have the responsibility to practice prudent risk management
standards, but prudent standards do not guarantee prudent practices. As
such, it will be important for regulators to show continued vigilance
in overseeing hedge fund-related activities.
According to market participants, hedge fund advisers have improved
disclosures and transparency about their operations since LTCM as a
result of industry guidance issued and pressure from investors and
creditors and counterparties (such as prime brokers). But market
participants also suggested that not all investors have the capacity to
analyze the information they receive from hedge funds. Regulators and
market participants said that creditors and counterparties have
generally conducted more due diligence and tightened their credit
standards for hedge funds. However, several factors may limit the
effectiveness of market discipline or illustrate failures to properly
exercise it. For example, because most large hedge funds use multiple
prime brokers as service providers, no one broker may have all the data
necessary to assess the total leverage of a hedge fund client. Further,
if the risk controls of creditors and counterparties are inadequate,
their actions may not prevent hedge funds from taking excessive risk.
These factors can contribute to conditions that create systemic risk if
breakdowns in market discipline and risk controls are sufficiently
severe that losses by hedge funds in turn cause significant losses at
key intermediaries or in financial markets.
Financial regulators and industry participants remain concerned about
the adequacy of counterparty credit risk management at major financial
institutions because it is a key factor in controlling the potential
for hedge funds to become a source of systemic risk. Regulators have
used risk-focused and principles-based approaches to better understand
the potential for systemic risk and respond more effectively to
financial shocks that threaten to affect the financial system. For
instance, regulators have collaborated to examine some hedge fund
activities across regulated entities. The President’s Working Group has
taken steps such as issuing guidance and forming two private sector
groups to develop best practices to enhance market discipline. GAO
views these as positive steps, but it is too soon to evaluate their
effectiveness.
To view the full product, including the scope and methodology, click on
[hyperlink, http://www.GAO-08-200]. For more information, contact Orice
M. Williams at (202) 512-8678 or williamso@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Hedge Funds Generally Are Subject to Limited Direct Oversight, but
Regulatory Focus Has Increased since LTCM:
Investors, Creditors, and Counterparties Have Increased Efforts to
Impose Discipline on Hedge Fund Advisers, but Some Limitations Remain:
Regulators View Hedge Fund Activities as Potential Sources of Systemic
Risk and Are Taking Measures to Enhance Market Discipline and Prepare
for Financial Disruptions:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: Pension Plan Investments in Hedge Funds Have Increased but
Are Still a Small Percentage of Plans' Total Assets:
Appendix III: Various Hedge Fund Investment Strategies Defined:
Appendix IV: GAO Contacts and Staff Acknowledgments:
Table:
Table 1: Ten Defined Benefit Plans with the Largest Reported Hedge Fund
Investments for 2006:
Figure:
Figure 1: Investments in Hedge Funds Reported by Defined Benefit Plans
for the Period 2001-2006:
Abbreviations:
CDO: collateralized debt obligation:
CEA: Commodity Exchange Act of 1936:
CFTC: Commodity Futures Trading Commission:
CPO: commodity pool operator:
CTA: commodity trading advisor:
CRMPG: Counterparty Risk Management Policy Group:
CSE: Consolidated Supervised Entity:
DB: defined benefit:
DOL: Department of Labor:
ERISA: Employee Retirement Income Security Act of 1974:
FCM: futures commission merchant:
FDIC: Federal Deposit Insurance Corporation:
FRBNY: Federal Reserve Bank of New York:
FSA: Financial Services Authority (United Kingdom):
IOSCO: International Organization of Securities Commissions:
LTCM: Long-Term Capital Management:
LTRS: large trader reporting system:
MFA: Managed Funds Association:
NFA: National Futures Association:
OCC: Office of the Comptroller of the Currency:
OTC: over-the-counter:
OTS: Office of Thrift Supervision:
PPA: Pension Protection Act of 2006:
PPM: private placement memorandum:
PWG: President's Working Group on Financial Markets:
RADAR: Risk Assessment Database for Analysis and Reporting:
SEC: Securities and Exchange Commission:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
January 24, 2008:
The Honorable Barney Frank:
Chairman:
Committee on Financial Services:
House of Representatives:
The Honorable Paul E. Kanjorski:
Chairman:
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises:
House of Representatives:
The Honorable Michael E. Capuano:
House of Representatives:
In recent years, hedge funds have grown rapidly.[Footnote 1] According
to industry estimates, from 1998 to early 2007, the number of funds
grew from more than 3,000 to more than 9,000, and assets under
management from more than $200 billion to more than $2 trillion
globally.[Footnote 2] An estimated $1.5 trillion of these assets is
managed by U.S. hedge fund advisers. Hedge funds are key players in
many financial markets. For example, hedge funds reportedly account for
more than 40 percent of the trading volume in the U.S. leveraged loan
market, more than 85 percent of the distressed debt market, and more
than 80 percent of certain credit derivatives markets.[Footnote 3]
Institutional investors, such as endowments, foundations, insurance
companies, and pension plans, seeking to diversify their risks and
increase returns, have invested in hedge funds and contributed to the
rapid growth in these funds.
As active market participants, hedge funds generally are recognized to
provide benefits to financial markets by enhancing liquidity and
promoting market efficiency and price discovery.[Footnote 4] Especially
in volatile markets, hedge funds are generally willing to assume risks
that more regulated financial institutions are unwilling or unable to
assume. Additionally, they are recognized to spur financial innovation
and help to reallocate financial risk. Nevertheless, the rapid growth
of funds that may adopt similar investment strategies in interconnected
markets with rapid trading strategies raises questions as to whether
large losses from one or more hedge funds could cause widespread
difficulties at other firms, in other market segments, or in the
financial system as a whole. For example, hedge funds may impose losses
on their creditors and counterparties and thereby disrupt the credit
availability to financial markets or through market disruptions that
could accompany liquidation of funds' positions.[Footnote 5]
Market discipline plays a primary role, supplemented by indirect
regulatory oversight of commercial banks and securities and futures
firms, in constraining risk taking and leveraging by hedge fund
managers (advisers). Market participants (e.g., investors, creditors,
and counterparties) impose market discipline by rewarding well-managed
hedge funds and reducing their exposure to risky, poorly managed hedge
funds. However, according to several sources, for market discipline to
be effective, (1) investors, creditors, and counterparties must have
access to, and act upon, sufficient and timely information to assess a
fund's risk profile; (2) investors, creditors, and counterparties must
have sound risk management policies, procedures, and systems to
evaluate and limit their credit risk exposures to hedge funds; and (3)
creditors and counterparties must increase the costs or decrease the
availability of credit to their hedge fund clients as the
creditworthiness of the latter changes.
Inadequate market discipline is often cited as a contributing factor to
the near collapse in 1998 of Long-Term Capital Management (LTCM), a
large highly leveraged hedge fund. The subsequent 1999 report by the
President's Working Group on Financial Markets (PWG) questioned the
adequacy of (1) market discipline that some creditors and
counterparties (commercial and investment banks, including their prime
brokerage business and futures firms) imposed on LTCM's risk-taking
activities, and (2) LTCM's disclosure and risk management
practices.[Footnote 6] The report also raised questions about the risk
management practices of these entities and the ability of federal
financial regulators to supervise effectively the large creditors and
counterparties that extended credit to hedge funds. In its 1999 report,
the PWG made recommendations to enhance market discipline and the risk
management practices of market participants.[Footnote 7] Since LTCM,
other hedge funds have experienced near collapses or failures.[Footnote
8] Despite a few notable failures, hedge funds overall seem to have
held up well, and their counterparties have not sustained material
losses in the market turmoil that began in the summer of 2007.[Footnote
9] Although the market impacts of the recent cases were less severe
than that of LTCM, they recalled concerns about risks associated with
hedge funds and they highlighted the continuing relevance of questions
raised over LTCM.
Given the growing importance and continuing evolution of the hedge fund
sector since LTCM, you asked us to study the risks hedge funds may pose
to the financial markets and how hedge fund creditors and
counterparties and the regulatory framework can address those risks.
Accordingly, this report (1) describes how federal financial regulators
provide oversight of hedge fund-related activities under their existing
authorities; (2) examines what measures investors, creditors, and
counterparties have taken to impose market discipline on hedge funds;
and (3) explores the potential for systemic risk from hedge fund-
related activities and actions regulators have taken to address this
risk.[Footnote 10] In addition, we provide information on pension plan
investments in hedge funds in appendix II.
In conducting our work, we reviewed and analyzed relevant regulatory
examination documentation and enforcement cases from federal financial
regulators. This included examination documentation and enforcement
cases from the following federal banking regulators--Office of the
Comptroller of the Currency (OCC), Board of Governors of the Federal
Reserve System (Federal Reserve), Federal Reserve Bank of New York
(FRBNY), and Federal Deposit Insurance Corporation (FDIC); a federal
securities regulator--Securities and Exchange Commission (SEC); and
futures markets regulators--Commodity Futures Trading Commission (CFTC)
and National Futures Association (NFA).[Footnote 11] We also analyzed
relevant laws and regulations, speeches, testimonies, studies, and
prior GAO reports, as well as principles and guidelines that the PWG
issued about private pools of capital--including hedge funds, PWG
protocols, and relevant industry best practices for hedge fund
advisers, creditors, and counterparties. We interviewed officials
representing the U.S. regulators identified above and the Office of
Thrift Supervision (OTS), the PWG, Department of Labor (DOL), and the
Department of the Treasury (Treasury).[Footnote 12] We also interviewed
officials of the United Kingdom's Financial Services Authority (FSA),
as well as representatives from market participants such as commercial
and investment banks, large hedge funds, pension industry participants,
credit rating agencies, a risk management firm, a hedge fund law firm,
trade groups representing hedge funds and institutional investors, and
academics. We conducted this performance audit from September 2006 to
January 2008 in accordance with generally accepted government auditing
standards. Those standards require that we plan and perform the audit
to obtain sufficient, appropriate evidence to provide a reasonable
basis for our findings and conclusions based on our audit objectives.
We believe that the evidence obtained provides a reasonable basis for
our findings and conclusions based on our audit objectives. Appendix I
provides a detailed description of our scope and methodology.
Results in Brief:
Under the existing regulatory structure, SEC and CFTC regulate those
hedge fund advisers that are registered with them, but SEC, CFTC, as
well as the federal bank regulators (collectively, financial
regulators) monitor hedge fund-related activities of other regulated
entities such as broker-dealers and commercial banks.[Footnote 13]
Specifically, SEC regulates an estimated 1,991 hedge fund advisers that
are registered as investment advisers, which include 49 of the largest
U.S. hedge fund advisers that account for about one-third of hedge
funds' assets under management in the United States.[Footnote 14] As
registered investment advisers, hedge fund advisers are subject to SEC
examinations and reporting, record keeping, and disclosure
requirements. In fiscal year 2006, SEC examined 321 hedge fund advisers
and identified issues (such as information disclosure, reporting and
filing, personal trading, and asset valuation) that are not exclusive
to hedge funds. Also, in 2004 SEC established a program to oversee the
large internationally active securities firms on a consolidated basis.
These securities firms have significant interaction with hedge funds
through affiliates previously not overseen by SEC. One aspect of this
program is to examine how the securities firms manage various risk
exposures, including those from hedge fund-related activities such as
providing prime brokerage services and acting as creditors and
counterparties. Similarly, CFTC regulates those hedge fund advisers
registered as commodity pool operators (CPO) or commodity trading
advisors (CTA).[Footnote 15] CFTC has authorized NFA to conduct day-to-
day monitoring of registered CPOs and CTAs; in fiscal year 2006, NFA
examinations of CPOs included six of the largest U.S. hedge fund
advisers. In addition, SEC, CFTC, and bank regulators can use their
existing authorities--to establish capital standards and reporting
requirements, conduct risk-based examinations, and take enforcement
actions--to oversee activities, including those involving hedge funds,
of broker-dealers, of futures commission merchants, and of banks,
respectively. While none of the regulators we interviewed specifically
monitored hedge fund activities on an ongoing basis, generally
regulators have increased reviews--by such means as targeted
examinations--of systems and policies to mitigate counterparty credit
risk at the large regulated entities. For instance, from 2004 to 2007,
FRBNY conducted various reviews--including horizontal reviews--of
credit risk management practices that involved hedge fund-related
activities at several large banks[Footnote 16]. On the basis of the
results, FRBNY noted that the banks generally had strengthened
practices for managing risk exposures to hedge funds, but the banks
could further enhance firmwide risk management systems and practices,
including expanded stress testing.[Footnote 17] Regulated entities have
the responsibility to practice prudent risk management standards, but
prudent standards do not guarantee prudent practices. As such, it will
be important for regulators to show continued vigilance in overseeing
the hedge fund-related activities of regulated institutions.
Since the near collapse of LTCM in 1998, investors, creditors, and
counterparties have increased their efforts to impose market discipline
on hedge funds. However, regulators and market participants also
identified issues that limit the effectiveness of these efforts.
Investors, creditors, and counterparties impose market discipline on
hedge funds by providing more funding or better terms to those hedge
funds willing to disclose credible information about the fund's risks
and prospective returns. According to market participants doing
business with larger hedge funds, hedge fund advisers have improved
disclosure and become more transparent about their operations,
including risk management practices, partly as a result of recent
increases in investments by institutional investors with fiduciary
responsibilities, such as pension plans, and guidance provided by
regulators and industry groups. Despite the requirement that fund
investors be sophisticated, some market participants suggested that not
all prospective investors have the capacity or retain the expertise to
analyze the information they receive from hedge funds, and some may
choose to invest in a hedge fund largely as a result of its prior
returns and may fail to fully evaluate its risks. Regulators and market
participants also said creditors and counterparties have been
conducting more extensive due diligence and monitoring risk exposures
to their hedge fund clients since LTCM. The creditors and
counterparties we interviewed said that they have exercised market
discipline by tightening their credit standards for hedge funds and
demanding greater disclosure. However, several factors limit the
effectiveness of market discipline or illustrate failures to properly
exercise it. For example, most large hedge funds use multiple prime
brokers as service providers. Thus, no one broker may have all the data
necessary to assess the total leverage used by a hedge fund client.
Further, the actions of creditors and counterparties may not fully
prevent hedge funds from taking excessive risk if these creditors' and
counterparties' risk controls are inadequate. For example, the risk
controls may not keep pace with the increasing complexity of financial
instruments and investment strategies that hedge funds employ.
Similarly, regulators have been concerned that in competing for hedge
fund clients, creditors sometimes relaxed credit standards. These
factors can contribute to conditions that create the potential for
systemic risk if breakdowns in market discipline and the risk controls
of creditors and counterparties are sufficiently severe that losses by
hedge funds in turn cause significant losses at key intermediaries or
in financial markets.
Although financial regulators and market participants recognize that
the enhanced efforts by investors, creditors, and counterparties since
LTCM impose greater market discipline on hedge funds, some remain
concerned that hedge funds' activities are a potential source of
systemic risk. Counterparty credit risk arises when hedge funds enter
into transactions, including derivatives contracts, with regulated
financial institutions.[Footnote 18] Some regulators regard
counterparty credit risk as the primary channel for potentially
creating systemic risk. As discussed earlier, some regulators
questioned whether some creditors and counterparties could manage
counterparty credit risk effectively. In addition to counterparty
credit risk, other factors such as trading behavior can create
conditions that contribute to systemic risk. Given certain market
conditions, the simultaneous liquidation of similar positions by hedge
funds that hold large positions on the same side of a trade could lead
to losses or a liquidity crisis that might aggravate financial
distress. Recognizing that market discipline cannot eliminate the
potential systemic risk posed by hedge funds and others, regulators
have been taking steps to better understand the potential for systemic
risk and respond more effectively to financial disruptions that can
spread across markets. For instance, they have examined particular
hedge fund activities across regulated entities, mainly through
international multilateral efforts. The PWG has issued guidelines that
provide a framework for addressing risks associated with hedge funds
and implemented protocols to respond to market turmoil. Finally, the
PWG recently established two private sector committees comprising hedge
fund advisers and investors to address investor protection and systemic
risk concerns, including counterparty credit risk management issues. We
view these actions as positive steps to address systemic risk, but it
is too soon to evaluate their effectiveness.
We provided a draft of this report to CFTC, DOL, Federal Reserve, FDIC,
OCC, OTS, SEC, and Treasury for their review and comment. None of the
agencies provided written comments. All except for FDIC and OTS
provided technical comments, which we have incorporated into the report
as appropriate.
Background:
Hedge funds typically are organized as limited partnerships or limited
liability companies, and are structured and operated in a manner that
enables the fund and its advisers to qualify for exemptions from
certain federal securities laws and regulations that apply to other
investment pools, such as mutual funds.[Footnote 19] In addition, hedge
funds operate to qualify for exemptions from certain registration and
disclosure requirements of federal securities laws (including the
Securities Act of 1933 and the Securities Exchange Act of 1934). For
example, hedge funds must refrain from advertising to the general
public and can solicit participation in the fund from only certain
large institutions and wealthy individuals.[Footnote 20] Although
certain advisers may be exempt from registration requirements, they
remain subject to anti-fraud (including insider trading), anti-
manipulation, and large trading position reporting rules. For example,
upon acquiring a significant ownership position in a particular
publicly traded security or holding a certain level of futures or
options positions, a hedge fund adviser may be required to file a
report disclosing the adviser's or hedge fund's holdings with SEC or
positions with CFTC, as applicable.
Hedge funds have significant business relationships with the largest
regulated commercial and investment banks. Hedge funds act as trading
counterparties for a wide range of over-the-counter (OTC) derivatives
and other financing transactions. They also act as clients through
their purchase of clearing and other services and as borrowers through
their use of margin loans from prime brokers.
Hedge funds generally are not restricted by regulation in their choice
of investment strategies, as are mutual funds. They may invest in a
wide variety of financial instruments, including stocks and bonds,
currencies, OTC derivatives, futures contracts, and other assets. Most
hedge fund trading strategies are dynamic, often changing rapidly to
adjust to fluid market conditions. To seek to generate "absolute
returns" (performance that exceeds and has low correlation with stock
and bond markets returns), advisers may use leverage, short selling,
and a variety of sophisticated investment strategies and techniques.
[Footnote 21] However, while hedge funds frequently borrow or trade
in products with leverage to magnify their returns, leverage also
can increase their losses. Appendix III provides examples of
investment strategies used by hedge funds.
Advisers of hedge funds commonly receive a fixed compensation of 2
percent of assets under management plus 20 percent of the fund's annual
profits. Some fund advisers can command higher fees. Since this
compensation scheme rewards hedge fund advisers for exceptional
performance, but does not directly penalize them for inferior
performance, advisers could be tempted to pursue excessively risky
investment strategies that might produce exceptional returns. To
discourage excessive risk taking, investors generally insist that the
advisers and principals also personally invest in their funds to more
closely align principals' interests with those of fund investors.
Hedge Funds Generally Are Subject to Limited Direct Oversight, but
Regulatory Focus Has Increased since LTCM:
SEC's ability to directly oversee hedge fund advisers is limited to
those that are required to register or voluntarily register with SEC as
investment advisers. Recent examinations of registered advisers raised
concerns in areas such as disclosure, reporting and filing, personal
trading, and asset valuation. Also, under a program established in
2004, SEC oversees, on a consolidated basis, some of the largest
internationally active securities firms that engage in significant
hedge fund-related activities. CFTC directly oversees registered CPOs
and CTAs (some of which may be hedge fund advisers) through market
surveillance, regulatory compliance surveillance, an examination
program delegated to NFA, and enforcement actions. The banking
regulators also monitor hedge fund-related activities at the
institutions under their jurisdiction. For instance, in recent years
regulators conducted targeted examinations and horizontal reviews that
have focused on areas such as stress testing, leverage, liquidity, due
diligence, and margining practices as well as overall credit risk
management.
With Limited Authority to Regulate Hedge Funds, SEC Largely Monitors
Hedge Fund Activities and Related Risks through Consolidated
Supervision of Large Securities Firms:
Registered hedge fund advisers are subject to the same disclosure
requirements as all other registered investment advisers. These
advisers must provide current information to both SEC and investors
about their business practices and disciplinary history. Advisers also
must maintain required books and records, and are subject to periodic
examinations by SEC staff. Meanwhile, hedge funds, like other investors
in publicly traded securities, are subject to various regulatory
reporting requirements. For example, upon acquiring a 5 percent
beneficial ownership position of a particular publicly traded security,
a hedge fund may be required to file a report disclosing its holdings
with SEC.[Footnote 22] Also, any institutional investment adviser with
investment discretion over accounts holding certain publicly traded
equity securities valued at $100 million or more must file on a
quarterly a report with SEC.[Footnote 23] SEC also plans to propose new
rule making that would require a registered adviser sponsoring a hedge
fund to identify and provide some basic information to SEC about the
hedge fund's gatekeepers, i.e., auditor, prime broker, custodian, and
administrator.
In December 2004, SEC adopted an amendment to Rule 203(b)(3)-1, which
had the effect of requiring certain hedge fund advisers that previously
enjoyed the private adviser exemption from registration to register
with SEC as investment advisers.[Footnote 24] In June 2006, a federal
court vacated the 2004 amendment to Rule 203(b)(3)-1.[Footnote 25]
According to SEC, when the rule was in effect (from February 1, 2006,
through August 21, 2006), SEC was better able to identify hedge fund
advisers. In August 2006, SEC estimated that 2,534 advisers that
sponsored at least one hedge fund were registered with the agency.
Since August 2006, SEC's ability to identify an adviser that manages a
hedge fund has been further limited due to changes in filing
requirements and to advisers that chose to retain registered status. As
of April 2007, 488, or about 19 percent of the 2,534 advisers, had
withdrawn their registrations. At the same time, 76 new registrants
were added and some others changed their filing status, leaving an
estimated 1,991 hedge fund advisers registered. While the list of
registered hedge fund advisers is not all-inclusive, many of the
largest hedge fund advisers--including 49 of the largest 78 U.S. hedge
fund advisers--are registered. These 49 hedge fund advisers account for
approximately $492 billion of assets under management, or about 33
percent of the estimated $1.5 trillion in hedge fund assets under
management in the United States.[Footnote 26]
SEC Examinations of Hedge Fund Advisers Identified Areas of Concern:
In fiscal year 2006, SEC took additional steps to oversee hedge fund
advisers by creating an examination module specifically for hedge fund
advisers and providing training for examiners in hedge fund-related
topics. The new examination module outlines how the examination of a
hedge fund adviser generally begins with an analysis of the adviser's
compliance program and the work of its chief compliance officer and
uses a control scorecard as a guide. As part of this review of
compliance programs, examiners inspect the typical activities of
advisers and are expected to obtain a clear understanding of all
activities of affiliates and how these activities may affect or
conflict with those of the hedge fund adviser being examined. Examiners
are to focus primarily on the following activities during their
examinations of hedge fund advisers:
* portfolio management;
* brokerage arrangements and trading;
* personal trading by access persons;
* valuation of positions and calculations of net asset value;
* leverage;
* safety of clients' and funds' assets;
* performance calculations;
* fund investors and capital introduction;
* violations of domestic or foreign laws that may directly harm fund
investors or other market participants, or cause harm to prime brokers;
* books and records, fund financial statements, and investor reporting;
* chief compliance officer, compliance culture, and program; and:
* boards of directors for offshore funds (fiduciary duties to
shareholders of the hedge funds and consistent disclosure to its
investors).
In preparation for the registration of hedge fund advisers and because
SEC does not have a dedicated group of examiners that focus on hedge
funds, SEC and hedge fund industry officials noted the need for more
experience and ongoing training of examiners on hedge funds' investment
strategies and complex financial instruments. SEC developed a
specialized training program to better familiarize its examiners with
the operation of hedge funds to improve effectiveness of examinations
of hedge fund advisers. In that regard, from October 2005 through
October 2006, SEC held about 20 examiner training sessions on hedge
fund-related topics. Industry participants were instructors in many of
these sessions. These sessions covered topics such as hedge fund
structure, hedge fund investment vehicles, identification and
examination of conflicts of interests at hedge fund advisers, risk
management, prime brokerage, valuation, current and future regulation,
examination issues, and investment risk. SEC continues to offer hedge
fund training to examiners and other staff on an ongoing voluntary
basis.
SEC uses a risk-based examination approach to select investment
advisers for inspections. Under this approach, higher-risk investment
advisers are examined every 3 years.[Footnote 27] One of the variables
in determining risk level is the amount of assets under management. SEC
officials told us that most hedge funds, even the larger ones, do not
meet the dollar threshold to be automatically considered higher-risk.
As part of the overall risk-based approach for conducting oversight of
investment advisers, SEC uses a database application called Risk
Assessment Database for Analysis and Reporting (RADAR), to identify the
highest-risk areas designated by examiners and to develop and recommend
regulatory responses to address these higher-risk areas. In fiscal year
2006, RADAR identified a number of hedge fund-related risk areas, which
although not exclusive to hedge funds require additional regulatory
attention, including the following:
* soft dollars (e.g., paying for a hedge fund's office space without
disclosing it);
* market manipulation (e.g., the dissemination of false information to
inflate the price of a stock);
* hedge fund custody and misappropriation (e.g., theft of hedge fund
assets by its advisers);
* complexity of hedge fund products and suitability (e.g., inadequacy
of policies and procedures to assess the complexity of financial
instruments and the suitability of products for investors);
* prime brokerage relationships (e.g., potential conflicts of interest
where prime brokers give hedge fund clients--who often pay large dollar
amounts of commissions--priority over non-hedge fund clients regarding
access to information/research);
* performance fees (e.g., incorrect calculation of performance fees);
* hedge fund valuation (e.g., inadequate policies and procedures to
ensure that asset valuations are accurate);
* fund of funds' conflicts of interest (e.g., conflicts of interest
between fund of funds advisers and their recommendation to a fund of
hedge fund to invest in certain hedge funds);
* insider trading (e.g., trading on nonpublic information); and:
* hedge fund suitability (e.g., inadequate policies and procedures to
ensure the financial qualification of investors).
According to SEC officials, they plan to address these risks by
primarily focusing on these areas during subsequent examinations.
As part of its fiscal year 2006 routine inspection program, SEC
conducted examinations of 1,346 registered investment advisers, of
which 321 were believed to have involved hedge fund advisers. SEC used
its new hedge fund module, along with other modules as appropriate, to
conduct the 321 examinations, which included 5 of the largest 78 U.S.
hedge funds.[Footnote 28] According to SEC officials, the 321 hedge
fund advisers' examinations found that these advisers had the greatest
deficiencies in the following areas: (1) information disclosures,
reporting, and filing--e.g., private placement memorandum was outdated;
(2) personal trading--e.g., quarterly reports were not filed or filed
late for personal trading accounts; and (3) compliance rule--e.g.,
policies and procedures were inadequate to address compliance risks.
Examiners also cited concerns with performance advertising and
marketing of portfolio management, brokerage arrangement and execution,
information processing and protection, safety of clients' funds and
assets, pricing of clients' portfolios, trade allocations, and anti-
money laundering.
In our review of 9 of the 321 examinations of hedge fund advisers, we
found that examiners cited deficiencies in 8 of these examinations.
Deficiencies found included all of the above mentioned categories
except for trade allocations. For example, examiners identified
concerns in 5 of the examinations regarding disclosures and in one of
the examinations, for instance, the hedge fund adviser's marketing
package did not disclose any material conditions, objectives, or
investment strategies used to obtain the performance result portrayed.
In another examination, the hedge fund adviser failed to adequately
disclose to investors that a conflict of interest may be present when
the hedge fund adviser places transactions through broker-dealers who
have invested in the hedge fund.
According to SEC officials, 294 (or approximately 92 percent) of the
321 hedge fund advisers examined received deficiency letters.[Footnote
29] Some 292 of them provided satisfactory responses to SEC that they
had taken or would take appropriate corrective actions. Such actions
can include advisers implementing policies and procedures to address
deficiencies. Those hedge fund advisers that do not take or propose to
take corrective actions for a material deficiency may be referred to
SEC's Division of Enforcement (Enforcement) for enforcement actions.
According to SEC, 23 of the 321 examinations resulted in enforcement
referrals, and most of these referrals regarded situations in which the
adviser appeared to have engaged in fraud that harmed its clients.
As part of its oversight activities, SEC has brought a number of
enforcement actions involving hedge fund advisers. Sources of
information that led to SEC enforcement cases included examinations,
self-regulatory organizations, referrals, and tips. From October 1,
2001, to June 12, 2007, SEC brought a total of 3,937 enforcement cases,
of which 113, or 2.9 percent, were hedge fund-related. These cases
involve hedge fund advisers who misappropriated fund assets, engaged in
insider trading, misrepresented portfolio performance, falsified their
experience and credentials, or lied about past returns. As an example,
in 2006, SEC brought a case against a hedge fund adviser and its former
portfolio manager and charged them with making investment decisions
based on nonpublic insider information that certain public offerings
were about to be publicly announced. The hedge fund adviser agreed to
pay approximately $5.7 million in disgorgement, prejudgment interest,
and civil money penalty, and the former portfolio manager agreed to pay
a civil money penalty of $110,000 and be barred from associating with
an investment adviser for 3 years. SEC also has brought cases for
inaccurate disclosure of trading strategies, undisclosed preferential
treatment of hedge fund clients at the expense of other clients, market
manipulation, insider trading, illegal short selling, and improper
valuation of assets. During the same period, nine insider trading cases
were brought against hedge fund advisers, of which five have been
settled and four remain in litigation. The five settled cases resulted
in disgorgements ranging from $2,736 to $7.05 million, civil penalties
ranging from $8,208 to $4.7 million, a suspension, and bars from the
securities industry.
According to an SEC enforcement official, SEC recognized that hedge
funds were becoming a prominent force in the financial industry, and in
anticipation that certain hedge fund advisers would be required to
register with SEC as investment advisers when the now vacated amendment
to Rule 203(b)(3)-1 was under consideration, SEC created a hedge fund
working group composed primarily of Enforcement and Office of
Compliance Inspections and Examinations staff and participants from
other divisions. The goals of this group are to enhance SEC's staff
knowledge about the hedge fund industry to aid in its oversight role
and coordinate and strengthen the agency's efforts to combat insider
trading at hedge funds. Currently, SEC is conducting investigations
into potential insider trading by hedge fund advisers.
SEC Monitors Risk Management Practices at the Largest Securities Firms
with Significant Hedge Fund Activities:
SEC also conducts oversight over hedge fund activities through the
supervision of the regulated securities firms that transact business
with hedge funds as brokers, creditors, and counterparties. SEC staff
oversees some large, internationally active U.S. securities firms with
significant hedge fund activities through its Consolidated Supervised
Entity program (CSE), which was established in June 2004.[Footnote 30]
Between December 2004 and November 2005, five large securities firms
have elected to become CSEs.[Footnote 31] The CSE program consists of
four components: (1) a review of the firm's application to become a
CSE; (2) a review of monthly, quarterly, and annual filings, such as
consolidated financial statements and risk reports, substantially
similar to those provided to the firm's senior management; (3) monthly
meetings with senior management (senior risk managers and financial
controllers) at the holding company level to review financial and risk
reports and share written results of these meetings among staff and
commissioners; and (4) an examination of books and records of the
ultimate holding company, the broker-dealer, and material
affiliates.[Footnote 32] SEC relies on a number of regulatory tools,
including margin, capital, and reporting requirements to oversee CSEs.
Margin rules within the broker-dealer help protect against losses
resulting from defaults by requiring its hedge fund clients to provide
collateral in amounts that depend on the risk of the particular
position and help maintain safety and soundness of their firms. Capital
requirements are minimum regulatory required levels of capital that a
firm must hold against its risk-taking activities. These requirements
can help a firm withstand the failure of a counterparty or a period of
market or systemic stress.
One aspect of the CSE program involves how the securities firms manage
various risk exposures, including those from hedge fund activities such
as providing prime brokerage service and acting as creditors and
counterparties through financing and OTC derivatives trade
transactions. These large integrated financial institutions may be
exposed to various risks from hedge fund activities such as providing
prime brokerage services through a registered broker-dealer, acting as
creditors and counterparties, or owning a hedge fund. For example, the
recent problems at two hedge funds sponsored by Bear Stearns Asset
Management that invested in financial instruments tied to subprime
mortgages (where Bear Stearns ultimately provided some secured
financing to the funds) highlight such risks. As part of the
application process that took place from November 2004 through January
2006, SEC examined the five securities firms' risk management systems
(market, credit, liquidity, operational, and legal and compliance),
internal controls, and capital adequacy calculations and continues to
do so on an ongoing basis. SEC did not target hedge fund activities
specifically within the scope of the five application examinations,
because hedge funds were not products or activities judged to pose the
greatest risks to the firms. Our review of the five CSEs' application
examinations found that examination findings generally were related to
firms' documentation of compliance with rules and requirements. SEC
shared the findings with the firms and has monitored the firms'
implementation of its recommendations. An SEC official said that those
issues have been resolved, but more recently, SEC's examinations of
three of the firms identified a number of issues related to capital
computations, operational controls, and risk management. Examination
staff are addressing these issues with the firms.
SEC monitors CSEs continuously for financial and operational weakness
that might place regulated entities within the group or the broader
financial system at risk. According to an SEC official, the CSE program
allows SEC to conduct reviews across the five firms (i.e., cross-firm
reviews) to gain insights into business areas that are material by risk
or balance sheet measures, rapidly growing, pose particular challenges
in implementing the Basel regulatory risk-based capital regime, or have
some combination of these characteristics.[Footnote 33] For example, in
fiscal year 2006, SEC conducted two cross-firm reviews related to
leveraged lending and hedge fund derivatives, and in fiscal year 2007,
SEC conducted two cross-firm reviews related to securitization and
private equity and principal investments.[Footnote 34] According to the
official, SEC generally found that the firms were in regulatory
compliance, but there were areas where capital computation methodology
and risk management practices can be improved. For example, four firms
modified their capital computations as a result of feedback from the
leveraged lending project. For each review, SEC produced a report that
described the business model, related risk management, and capital
treatment to each review area, and provided feedback to each firm on
where it stood among the peer firms.
CFTC Can Monitor Hedge Fund Activities through Its Market Surveillance,
Regulatory Compliance Surveillance, and Delegated Examination Programs:
Although CFTC does not specifically target hedge funds, through its
general market and financial supervisory activities, it can provide
oversight of persons registered as CPOs and CTAs that operate or advise
hedge funds that trade in the futures markets. As part of its market
surveillance program, CFTC collects information on market participants,
regardless of their registration status, to monitor their activities
and trading practices. In particular, traders are required to report
their futures and options positions when a CFTC-specified level is
reached in a certain contract market and CFTC electronically collects
these data through its Large Trader Reporting System (LTRS).[Footnote
35] CFTC also uses the futures and options positions information
reported by traders through the LTRS as part of its monitoring of the
potential financial exposure of traders to clearing firms, and of
clearing firms to derivatives clearing organizations. CFTC collects
position information from exchanges, clearing members, futures
commission merchants (FCM), and foreign brokers and other traders--
including hedge funds--about firm and customer accounts in an attempt
to detect and deter manipulation.[Footnote 36] Customers, including
hedge funds, are required to maintain margin on deposit with their FCMs
to cover losses that might be incurred due to price changes. FCMs also
are required to maintain CFTC-imposed minimum capital requirements in
order to meet their financial obligations. Such financial safeguards
are put in place to mitigate the potential spillover effect to the
broader market resulting from the failure of a customer or of an FCM.
According to CFTC officials, the demise (due to trading losses related
to natural gas derivatives) in the fall of 2006 of Amaranth Advisors,
LLC (Amaranth), a $9 billion multistrategy hedge fund, had no impact on
the integrity of the clearing system for CFTC-regulated futures and
option contracts. The officials said that at all times Amaranth's
account at its clearing FCM was fully margined and the clearing FCM met
all of its settlement obligations to its clearinghouse. They also said
that the approximate $6 billion of losses suffered by Amaranth on
regulated and unregulated exchanges did not affect its clearing FCM,
the other customers of the clearing FCM, or the clearinghouse.[Footnote
37]
CFTC investigates and, as necessary, prosecutes alleged violators of
the Commodity Exchange Act (CEA) and CFTC regulations and may conduct
such investigations in cooperation with federal, state, and foreign
authorities. Enforcement referrals can come from several sources,
including CFTC's market surveillance group or tips. Remedies sought in
enforcement actions generally include permanent injunctions, asset
freezes, prohibitions on trading on CFTC-registered entities,
disgorgement of ill-gotten gains, restitution to victims, revocation or
suspension of registration, and civil monetary penalties. On the basis
of CFTC enforcement data, from the beginning of fiscal year 2001
through May 1, 2007, CFTC brought 58 enforcement actions against CPOs
and CTAs, including those affiliated with hedge funds, for various
violations.[Footnote 38] A summary of the violations cited in the
actions includes misrepresentation with respect to assets under
management or profitability; failure to register with CFTC; failure to
make required disclosures, statement, or reports; misappropriation of
participants' funds; and violation of prior prohibitions (i.e., prior
civil injunction or CFTC cease and desist order).
Pursuant to CFTC-delegated authority, NFA, a registered futures
association under the CEA and a self-regulatory organization, oversees
the activities, and conducts examinations, of registered CPOs and
CTAs.[Footnote 39] As such, hedge fund advisers registered as CPOs or
CTAs are subject to direct oversight in connection with their trading
in futures markets.[Footnote 40] More specifically, to the extent that
hedge fund operators or advisers trade futures or options on futures on
behalf of hedge funds, the funds are commodity pools and the operators
of, and advisers to, such funds are required to register as CPOs and
CTAs, respectively, with CFTC and become members of NFA if they are not
exempted from registration. Once registered, CPOs and CTAs become
subject to detailed disclosure, periodic reporting and record-keeping
requirements, and periodic on-site risk-based examinations. However,
regardless of registration status, all CPOs and CTAs (including those
affiliated with hedge funds) remain subject to CFTC's anti-fraud and
anti-manipulation authority.
Our review of NFA documentation found that 29 advisers of the largest
78 U.S. hedge funds (previously mentioned) are registered with CFTC as
CPOs or CTAs. In addition, 20 of the 29 also are registered with SEC as
investment advisers or broker-dealers. According to NFA officials,
because there is no legal definition of hedge funds, it does not
require CPOs or CTAs to identify themselves as hedge fund operators or
advisers. NFA, therefore, considers all CPOs and CTAs as potential
hedge fund operators or advisers. According to NFA, in fiscal year 2006
NFA examined 212 CPOs, including 6 of the 29 largest hedge fund
advisers registered with NFA. During the examinations, NFA staff
performed tests of books and records and other auditing procedures to
provide reasonable assurance that the firm was complying with NFA rules
and all account balances of a certain date were properly stated and
classified. Our review of four of the examinations found that 3 of the
CPOs examined generally were in compliance with NFA regulations and the
remaining 1 was found to have certain employees that were not properly
registered with CFTC. According to examination documentation,
subsequent to the examination, the hedge fund provided a satisfactory
written response to NFA noting that it would soon properly register the
employees.
According to an NFA official, since 2003 NFA has taken 23 enforcement
actions against CPOs and CTAs, many of which involved hedge funds. Some
of the violations found included filing fraudulent financial statements
with NFA, not providing timely financial statements to investors,
failure to register with CFTC as a CPO, failure to maintain required
books and records, use of misleading promotional materials, and failure
to supervise staff. The penalties included barring CPOs and CTAs from
NFA membership temporarily or permanently or imposing monetary fines
ranging from $5,000 to $45,000.
Bank Regulators Have Conducted Some Examinations Relating to Hedge Fund
Business at Banks:
Bank regulators (the Federal Reserve, OCC, and FDIC) monitor the risk
management practices of their regulated institutions' interactions with
hedge funds as creditors and counterparties. They are responsible for
ensuring that the organizations under their jurisdiction are complying
with supervisory guidance and industry sound practices regarding
prudent risk management throughout their business, including the
guidance and practices applicable to their activities with hedge funds.
The 1999 PWG report recommended that bank regulators encourage
improvements in the risk management systems of the regulated entities
and promote the development of a more risk-based approach to capital
adequacy.
In overseeing banks' hedge fund-related activities, the bank regulators
examine the extent to which banks are following sound practices as part
of their reviews of banks' capital market activities. Bank regulators
conduct routine supervisory examinations of risk management practices
relating to hedge funds and other highly leveraged counterparties to
ensure that the supervised entities (1) perform appropriate due
diligence in assessing the business, risk exposures, and credit
standing of their counterparties; (2) establish, monitor, and enforce
appropriate quantitative risk exposure limits for each of their
counterparties; (3) use appropriate systems to identify, measure, and
manage counterparty credit risk; and (4) deploy appropriate internal
controls to ensure the integrity of their processes for managing
counterparty credit risk.
The Federal Reserve's supervision of banks' hedge fund-related
activities is part of a broader, more comprehensive set of supervisory
initiatives to assess whether banks' risk management practices and
financial market infrastructures are sufficiently robust to cope with
stresses that could accompany deteriorating market conditions.
Specifically, the Federal Reserve has been focusing on five key
supervisory initiatives: (1) comprehensive reviews of firms' corporate-
level stress testing practices, (2) a multilateral supervisory
assessment of the leading global banks' current practices for managing
their exposures to hedge funds, (3) a review of the risks associated
with the rapid growth of leveraged lending, (4) a new assessment of
practices to manage liquidity risk, and (5) continued efforts to reduce
risks associated with weaknesses in the clearing and settlement of
credit derivatives and other OTC derivatives.
The bank regulators also have performed targeted examinations of the
credit risk management practices of regulated entities that are major
hedge fund creditors or counterparties. From 2004 through 2007, FRBNY
conducted various reviews that addressed aspects of certain banks'
counterparty credit risk management practices that involved hedge fund
activities. These reviews were motivated by the rapid growth of the
hedge fund industry and also done to gauge progress made in improving
risk management practices pursuant to supervisory guidance and industry
recommendations. Examiners conducted meetings with management and
reviewed policies and procedures primarily by performing transactional
testing, relying on internal audits, and studying other functional
regulators' reviews.
According to a Federal Reserve official, while global banks have
significantly strengthened their risk management practices and
procedures for managing risk exposures to hedge funds, further progress
is needed. For example, in a 2006 firmwide examination of stress-
testing practices at certain U.S. banks, FRBNY indicated a need for the
banks "to enhance their capacity to aggregate credit exposures at the
firm wide level, including across counterparties; to assess the
potential for counterparty credit losses to be compounded by losses on
the banks' proprietary trading positions; and to assess the potential
effects of a rapid and possibly a protracted decline in asset market
liquidity."[Footnote 41] According to this official, the Federal
Reserve has begun a review of liquidity risk management practices at
the largest U.S. bank holding companies, focusing on the firms' efforts
to ensure adequate funding in more adverse market conditions.[Footnote
42]
Federal Reserve examiners made a variety of other recommendations as a
result of the various reviews. Many of their recommendations were
developed as ways that banks could continue to enhance their risk
management processes associated with hedge fund counterparties. The
examiners found a range of practices for counterparty stress testing
for hedge funds and noted that there was room for improvement even at
the banks with the most advanced practices. Where examiners identified
deficiencies, specific recommendations were made. Although credit
officers often adjusted credit terms for degree of transparency,
examiners recommended that banks' policies explicitly link transparency
to credit terms and that banks monitor evolving credit terms for hedge
fund counterparties. Moreover, examiners found that the banks that were
part of the reviews needed to enhance their policies to more
specifically address due diligence requirements or standards to provide
clearer standards and guidance for reviewing hedge fund valuation
processes.
In 2005 and 2006, OCC conducted an examination of hedge fund-related
activities--mainly counterparty credit risk management practices (such
as due diligence of their hedge fund customer's business), and
margining and collateral monitoring processes--at the three large U.S.
banks. OCC generally found the overall risk management practices of
these banks to be satisfactory. However, examiners identified concerns
in the lack of transparency in the banks' hedge fund review processes
and issued recommendations accordingly. For example, examiners found in
certain banks a lack of adequate credit review policies that clearly
outline risk assessment criteria for levels of leverage, risk
strategies and concentrations, and other key parameters and
documentation to support accuracy of a bank's credit analysis and risk
rating system. Examiners also found that financial information provided
by some hedge fund borrowers has been incomplete and that banks should
document the lack of such information in their credit review process.
OCC noted that the banks have taken satisfactory steps in response to
examination issues raised.
In addition, in 2005 and 2006, FDIC conducted an examination of hedge
fund lending at one of its banks. FDIC noted that the bank was not in
compliance with the bank's lending policy to diversify its hedge fund
loans and that certain policies should be updated, but generally found
the risk management practices of the bank's hedge fund lending program
to be satisfactory.
Bank regulators largely rely on their oversight of hedge fund-related
activities at those regulated entities that transact with hedge funds
in their efforts to mitigate the potential for hedge funds to
contribute to systemic risk. Since 2004, regulators have increased
their attention to these activities. In particular, bank regulators are
reviewing the entities' ability to identify and manage their
counterparty credit risk exposures, including those that involve hedge
funds. Regulated entities have the responsibility to practice prudent
risk management standards, but prudent standards do not guarantee
prudent practices. As such, it will be important for regulators to show
continued vigilance in overseeing banks' hedge fund-related activities.
Investors, Creditors, and Counterparties Have Increased Efforts to
Impose Discipline on Hedge Fund Advisers, but Some Limitations Remain:
Investors, creditors, and counterparties impose market discipline--by
rewarding well-managed hedge funds and reducing their exposure to
risky, poorly managed hedge funds--during due diligence exercises and
through ongoing monitoring. During due diligence, hedge funds should be
asked to provide credible information about risks and prospective
returns. Market participants told us that growing investments by
institutional investors with fiduciary responsibilities and guidance
from regulators and industry groups led hedge fund advisers to improve
disclosure and transparency in recent years. Creditors and
counterparties also can impose market discipline through ongoing
management of credit terms (such as collateral requirements). However,
some market participants and regulators identified limitations to
market discipline or failures to exercise it properly. For instance,
large hedge funds use multiple prime brokers, making it unlikely that
any single broker would have all the data needed to assess a client's
total leverage. Others were concerned that some creditors and
counterparties may lack the capacity to assess risk exposures because
of the complex financial instruments and investment strategies that
some hedge funds use, which could illustrate a failure to exercise
market discipline properly if the creditor or counterparty continued to
do business with the fund. Further, regulators have raised concerns
that creditors may have relaxed credit standards to attract and retain
hedge fund clients, another potential failure of market discipline.
Better Due Diligence and Greater Demand for Transparency from Investors
Have Resulted in Increased Hedge Fund Disclosure, but Some Investors
May Lack the Capacity to Assess Risk Exposures:
By evaluating hedge fund management, the fund's business activities,
and its internal controls, investors are imposing discipline on hedge
fund advisers. Market participants who generally transact with large
hedge funds and institutional investors told us that before investing
in a hedge fund, potential investors usually conduct a due diligence
exercise of the business, management, legal, and operational aspects of
the hedge fund under consideration for investment. Market participants
further noted that the exercise moves from an initial screening to
quickly identify the funds that do meet the potential investor's
investment criteria to a detailed evaluation that involves addressing a
series of questions about the business, management, legal, and
operational aspects of the hedge fund. Among other things, investors
may take into account investment strategies hedge funds use to produce
their returns, the types of investments traded, and the fund's risk
management practices and risk profiles. Investors analyze this
information to determine whether the investment's risks and reward
warrant further consideration.
Typically, prospective investors receive written information from the
hedge fund manager in the form of a private offering memorandum or
private placement memorandum (PPM).[Footnote 43] We could not obtain
hedge fund offering documents, but market participants who have
reviewed PPMs told us that there are no standard disclosure
requirements for PPMs and the information disclosed is often general in
scope. Consequently, investors may seek information beyond that
provided in PPMs and sometimes beyond what hedge funds are willing to
provide. For instance, they may request from hedge fund managers a list
of hedge fund securities positions and holdings (position transparency)
or information about the risks associated with the hedge fund's market
positions (risk transparency). However, according to market
participants we interviewed, although most hedge funds may be willing
to provide information on aggregate position and holdings, many hedge
funds decline to share specific position transparency, citing the need
to keep such information confidential for fear that disclosure might
permit other market participants to take advantage of their trading
positions to the detriment of the fund and its investors. Additionally,
some prospective investors also may obtain from hedge fund managers
access to the hedge funds' prime brokers and other service providers
such as auditors, lawyers, fund administrators, and accountants for
background checks. A representative of a group that represents
institutional investors we met with told us that after making an
investment, investors typically will monitor their investment on an
ongoing basis to evaluate portfolio performance and track how well
investments are moving toward investment goals and benchmarks.
Recently, hedge fund advisers have increased their level of disclosure
in response to demands from institutional investors. Institutional
investments in hedge funds have grown substantially in recent years.
Over the last 3 years, institutional investors in search of higher
returns and risk diversification, such as pension funds, endowments,
and funds of hedge funds, have accounted for a significant portion of
the inflows to hedge funds assets under management. (See app. II for
information on pension plan investments in hedge funds). According to
market participants and industry literature, the increasing popularity
of hedge funds among these institutional investors has led to changes
in the industry. That is, hedge fund advisers have responded to the
requirements of these clients by providing disclosure that allows them
to meet fiduciary responsibilities. For example, one market participant
we met with stated that a trustee to a pension plan that is subject to
the "prudent person" standard of the Employee Retirement Income
Security Act of 1974 (ERISA) is required to make investment decisions
for the plan in accordance with a "prudent person" standard of care
that may require plan trustees to demand greater quality oversight of
their capital; in consequence, they may demand greater transparency,
risk information, and valuation techniques than individual
investors.[Footnote 44] Market participants with whom we met also told
us that the trend toward permanent capital also has been driving hedge
fund transparency. Markets participants further noted that as hedge
funds reach a certain size, they tend to seek more permanent capital
through the public markets to avoid the liquidity risks inherent with
sudden investor redemptions.
The ability of market discipline to control hedge funds' risk taking is
limited by some investors' inability to fully understand and evaluate
the information they receive on hedge fund activities or these
investors' willingness to hire others to evaluate that information for
them. An example can be found in the Amaranth case. According to market
participants we interviewed and industry coverage that documented the
event, Amaranth noted in its periodic letters to investors that it had
a large concentration in the natural gas sector. The market
participants and the documents noted that some investors became
concerned about the potential risks associated with concentrated
positions and withdrew their money from Amaranth several months before
Amaranth failed. They also said that other investors did not heed
potential warning signs included in the investor letter and kept their
money in Amaranth either in pursuit of higher investment returns or
because they did not fully comprehend the changing risk profile of the
hedge fund.
Regulators, market participants, and academics generally agree that
hedge funds have improved disclosure and risk management practices
since the LTCM crisis and have largely adopted the guidance from
various industry groups and the PWG. Regulators told us that from their
examinations of regulated entities that transact business with hedge
funds as creditors and counterparties, they have observed that hedge
fund disclosure and risk management practices have improved since LTCM.
For example, in response to the 1999 PWG report recommendation that
hedge funds establish a set of sound practices for risk management and
internal controls, private sector entities such as the Managed Funds
Association (MFA), and the Counterparty Risk Management Policy Group
(CRMPG), as well as the public sector International Organization of
Securities Commissions (IOSCO) published guidance for hedge funds and
their advisers.[Footnote 45] Market participants told us that many
hedge fund advisers with which they conduct business have adopted these
best practices, including risk management models that go beyond
measuring "value at risk," and now regularly stress-test portfolios
under a wide range of adverse conditions.[Footnote 46] Representatives
from a risk management firm told us that in the past, hedge fund
advisers viewed risk management practices as proprietary. However, as
the trading environment evolved, advisers realized they needed to
provide results of risk assessments to investors to attract
investments.
Creditors and Counterparties Can Impose Some Market Discipline on Hedge
Fund Advisers as Part of Credit Extension, but the Complexity of
Counterparty Credit Risk Management Poses Ongoing Challenges for
Financial Institutions:
By evaluating hedge fund management, the fund's business activities,
and its internal and risk management controls, creditors and
counterparties exert discipline on hedge fund advisers. According to
market participants, entering into contracts with hedge funds as
creditors or counterparties is the primary mechanism by which financial
institutions' credit exposures to hedge funds arise, and exercising
counterparty risk management is the primary mechanism by which
financial institutions impose market discipline on hedge funds.
According to the staff of the member agencies of the PWG, the credit
risk exposures between hedge funds and their creditors and
counterparties arise primarily from trading and lending relationships,
including various types of derivatives and securities
transactions.[Footnote 47] As part of the credit extension process,
creditors and counterparties typically require hedge funds to post
collateral that can be sold in the event of default. According to
market participants we interviewed, collateral most often takes the
form of cash or high-quality, highly liquid securities (e.g.,
government securities), but it can also include lower-rated securities
(e.g., BBB rated bonds) and less liquid assets (e.g., CDOs). They told
us they take steps to ensure that they have clear control over
collateral that is pledged, which according to some creditors and
counterparties we interviewed, that was not the case with LTCM.
Creditors and counterparties generally require hedge funds to post
collateral to cover current credit exposures (this generally occurs
daily) and, with some exceptions, require additional collateral, or
initial margin, to cover potential exposures that could arise if
markets moved sharply.[Footnote 48] Creditors to hedge funds said that
they measure a fund's current and potential risk exposure on a daily
basis to evaluate counterparty positions and collateral.
To control their risk exposures, creditors and counterparties to
generally large hedge funds told us that, unlike in the late 1990s,
they now conduct more extensive due diligence and ongoing monitoring of
a hedge fund client. According to OCC, banks also conduct "abbreviated"
underwriting procedures for small hedge funds in which they do not
conduct much due diligence. OCC officials also told us that losses due
to the extension of credit to hedge funds were rare. Creditors and
counterparties of large hedge funds use their own internal rating and
credit or counterparty risk management process and may require
additional collateral from hedge funds as a buffer against increased
risk exposure. They said that as part of their due diligence, they
typically request information that includes hedge fund managers'
background and track record; risk measures; periodic net asset
valuation calculations; side pockets and side letters; fees and
redemption policy; liquidity, valuations, capital measures, and net
changes to capital; and annual audited statements. According to
industry and regulatory officials familiar with the LTCM episode, this
was not necessarily the case in the 1990s. At that time, creditors and
counterparties had not asked enough questions about the risks that were
being taken to generate the high returns. Creditors and counterparties
told us they currently establish credit terms partly based on the scope
and depth of information that hedge funds are willing to provide, the
willingness of the fund managers to answer questions during on-site
visits, and the assessment of the hedge fund's risk exposure and
capacity to manage risk. If approved, the hedge fund receives a credit
rating and a line of credit. Several prime brokers told us that losses
from hedge fund clients were extremely rare due to the asset-based
lending they provided such funds. Also, one prime broker noted that
during the course of its monitoring the risk profile of a hedge fund
client, it noticed that the hedge fund manager was taking what the
broker considered to be excessive risk, and requested additional
information on the fund's activity. The client did not comply with the
prime broker's request for additional information, and the prime broker
terminated the relationship with the client.
Through continuous monitoring of counterparty credit exposure to hedge
funds, creditors and counterparties can further impose market
discipline on hedge fund advisers. Some creditors and counterparties
also told us that they measure counterparty credit exposure on an
ongoing basis through a credit system that is updated each day to
determine current and potential exposures. Credit officers at one bank
said that they receive monthly investor summaries from many of their
hedge fund clients. The summaries provide information for monitoring
the activities and performance of hedge funds. Officials at another
bank told us that they generally monitor their hedge fund clients on a
quarterly basis and may alter credit terms or terminate a relationship
if it is determined that the fund is not dealing with risk adequately
or if it does not disclose requested information.
Some creditors also said that they may provide better credit terms to
hedge funds that consolidate all trade executions and settlements at
their firm than to hedge funds that use several prime brokers because
they would know more about the fund's exposure. However, large hedge
funds may limit the information they provide to banks and prime brokers
for various reasons. Unlike small hedge funds that generally depend on
a single prime broker for a large number of services ranging from
capital introductions to the generation of customized accounting
reports, many large hedge funds are less dependent on the services of
any single prime broker and, according to several market participants,
use multiple prime brokers as a means to protect proprietary trading
positions and strategies, and to diversify their credit and operational
risks.
Despite improvements in disclosure and counterparty credit risk
management, regulators noted that the effectiveness of market
discipline may be limited or market discipline may not be exercised
properly for several reasons. First, because large hedge funds use
several prime brokers as creditors and counterparties, no single prime
broker may be able to assess the total amount of leverage used by a
large hedge fund client. The stress tests and other tools that prime
brokers use to monitor a given counterparty's risk profile can
incorporate only those positions known to a trading partner. Second,
the increasing complexity of structured financial instruments has
raised concerns that counterparties lack the capacity (in terms of risk
models and resources) to keep pace with and assess actual risk,
illustrating a possible failure to exercise market discipline properly.
More specifically, despite improvements in risk modeling and risk
management, the Federal Reserve believes that further progress is
needed in the procedures global banks use to manage exposures to highly
leveraged counterparties such as hedge funds, in part because of the
increasing complexity of products such as structured credit products
and CDOs in which hedge funds are active participants. The complexity
of structured credit products can add to the already complex task of
measuring and managing counterparty credit risk. For example, another
Federal Reserve official has noted that the measurement of counterparty
credit risk requires complex computer simulations and that "the
management of counterparty risk is also complicated further by hedge
funds' complicated organizational structures, legal rights, collateral
arrangements, and frequent trading. It is important that banks develop
the systems capability to regularly gather and analyze data across
diverse internal systems to manage their counterparty credit risk to
hedge funds." One regulatory official further noted the challenges
faced by institutions in finding, developing and retaining individuals
with the expertise required to analyze the adequacy of these
increasingly complex models. The lack of talented staff can affect
counterparty credit risk monitoring and the ability to impose market
discipline on hedge fund risk taking activities. Third, some regulators
have expressed concerns that some creditors and counterparties may have
relaxed their counterparty credit risk management practices for hedge
funds, which could weaken the effectiveness of market discipline as a
tool to limit the exposure of hedge fund managers. They noted that
competition for hedge fund clients may have led some to reduce the
initial margin in collateral agreements, reducing the amount of
collateral to cover potential credit exposure.
Regulators View Hedge Fund Activities as Potential Sources of Systemic
Risk and Are Taking Measures to Enhance Market Discipline and Prepare
for Financial Disruptions:
Financial regulators and industry observers remain concerned about the
adequacy of counterparty credit risk management at major financial
institutions because it is a key factor in controlling the potential
for hedge funds to become a source of systemic risk. While hedge funds
generally add liquidity to many markets, including distressed asset
markets, in some circumstances hedge funds' activities can strain
liquidity and contribute to financial distress. In response to their
concerns regarding the adequacy of counterparty credit risk, a group of
regulators have, over the past year, been collaborating to examine
particular hedge fund-related activities across entities they regulate,
mainly through international multilateral efforts and the domestic PWG.
The PWG also has established two private sector committees to identify
best practices to address systemic risk and investor protection issues
and has formalized protocols to respond to financial shocks.
Despite Intensified Market Discipline, Concerns about Hedge Funds
Creating Systemic Risk Remain:
Financial regulators believe that the market discipline imposed by
investors, creditors, and counterparties is the most effective
mechanism for limiting the systemic risk from the activities of hedge
funds (and other private pools of capital). The most important
providers of market discipline are the large, global commercial and
investment banks that are hedge funds' principal creditors and
counterparties. While regulators and others recognize that counterparty
credit risk management has improved since LTCM, the ability of
financial institutions to maintain the adequacy of these management
processes in light of the dramatic growth in hedge fund activities
remains a particular focus of concern. In its July 2005 report, CRMPG
noted that "credit risk and, in particular counterparty credit risk, is
probably the single most important variable in determining whether and
with what speed financial disturbances become financial shocks with
potential systemic traits."[Footnote 49] CRMPG further noted that no
single hedge fund today is leveraged on a scale comparable to that of
LTCM in 1998 and that the risk management capabilities of hedge funds
had improved. Although CRMPG concluded that the chance of systemic
financial shocks had declined, Treasury officials noted that regulators
continually review whether the failure of one or more large market
participants, including hedge funds, could destabilize regulated
financial institutions or financial markets in a way that generates
broader macroeconomic consequences.[Footnote 50]
Effective market discipline requires that the creditors and
counterparties to hedge funds obtain sufficient information to reliably
assess clients' risk profiles and that they have systems to monitor and
limit exposures to levels commensurate with each client's risk and
creditworthiness. A number of large commercial banks and prime brokers
bear and manage the credit and counterparty risks that hedge fund
leverage creates. According to a Federal Reserve official, the recent
growth of hedge funds poses formidable challenges, including
significant risk management challenges to these market participants. If
market participants prove unwilling or unable to meet these challenges,
losses in the hedge fund sector could pose significant risk to
financial stability. Concerns remain that creditors and counterparties
face constant challenges in measuring and managing counterparty credit
risk exposures to hedge funds, and in maintaining qualified staff to
implement the various elements of counterparty credit risk management,
including stress testing.
In addition to counterparty credit risk, Treasury officials noted that
regulators continually review the liquidity of markets to determine
whether the trading behavior of market participants, including hedge
funds, could serve as a source of systemic risk. While hedge funds
often provide liquidity to stressed markets by buying securities that
are temporarily distressed, herding behavior by market participants,
including hedge funds, could strain available market liquidity.
According to a Treasury official, "If numerous market participants
establish large positions on the same side of a trade, especially in
combination with a high degree of leverage, this concentration can
contribute to a liquidity crisis if market conditions compel traders to
simultaneously unwind their positions."[Footnote 51] Some market
participants noted that the consequences of these "crowded" trades were
difficult to anticipate.
Some Federal Reserve officials noted in a journal article that "in a
crisis, interlocking credit exposures would be the key mechanism by
which risks would be transmitted from one institution to another,
potentially transforming a run-of-the-mill disturbance into a
systematic situation."[Footnote 52] The forced sale of assets is
recognized by regulators as a potential transmission mechanism for
systemic risk. According to these officials, regulators in general
share concerns that "in illiquid markets, hedge funds may be forced to
sell positions to meet margin requirements, driving down market prices.
In severe cases, the hedge fund may drive down the value of existing
positions by more than they receive from the original sale, forcing
further sales."[Footnote 53] However, this transmission mechanism is
not unique to hedge funds but is a characteristic of leverage. Even
when the failure of a hedge fund does not result in a large-scale
liquidation of assets, the concerns raised by the failure can disrupt
credit markets. For instance, concerns regarding the valuation of
illiquid subprime mortgages, such as those held by Bear Stearns Asset
Management's hedge funds, have contributed to questions about credit
quality in this and other markets, and this broader questioning of
credit quality may have contributed to the subsequent tightening of
credit.[Footnote 54]
Regulators Are Taking Steps to Strengthen Market Discipline to Address
Systemic Risk Concerns Stemming from Hedge Fund Activities:
To enhance market discipline and help mitigate the potential systemic
risks that hedge fund activities could pose, financial regulators
recently have increased collaboration with each other, foreign
financial regulators, and industry participants. They have been
conducting these efforts primarily through an international review of
large financial institutions and actions initiated by the PWG. As
discussed earlier, hedge funds are a potential source of systemic risk
if the capacity of their creditors and counterparties to value
positions and manage risk does not keep pace with developments such as
the increasing complexity of financial instruments and of investment
strategies. Because the use of these instruments and strategies is not
exclusive to hedge funds, a regulator said that collecting data on
hedge fund activities to monitor buildup of this risk would be
difficult and not meaningful. Instead, regulators have taken a risk-
focused and principles-based approach by monitoring counterparty risk
management practices across regulated entities and issuing guidance to
help strengthen market discipline. Currently, regulators are reviewing
issues related to the valuation of complex, illiquid, and stressed
instruments by all types of entities. The PWG has also formalized
protocols for coordination among the financial regulators in the event
of a financial market crisis.
In late 2006, FRBNY, SEC, OCC, FSA, and bank regulators of Germany and
Switzerland--collectively, the "multilateral effort"--jointly conducted
a review of the largest commercial and investment banks that transacted
business with hedge funds as counterparties and creditors. The agencies
met with nine major U.S. and European bank and securities firms to
discuss risk management policies and procedures related to interactions
with hedge funds through prime brokerage, direct lending, and over-the-
counter derivative transactions. According to one U.S. regulator, the
reviewers found that the current and potential credit exposures of
these banks to hedge funds were small relative to the banks' capital
because of their extensive use of collateral agreements. However, the
reviewers identified a number of issues related to the management of
exposures to hedge funds and the measurement of potential exposures in
adverse market conditions. The regulators participating in this effort
have been addressing these issues by gathering additional data or
information to help regulators learn more about the condition and
quality of the firms' risk management practices. The regulators are
conducting an ongoing follow-up review, which entails more detailed
work by the principal regulator of each firm.
In February 2007, the PWG issued principles-based guidance for
approaching issues related to private pools of capital, including hedge
funds. The principles are intended to guide market participants (for
example, hedge fund advisers, creditors, counterparties, and
investors), as well as U.S. financial regulators as they address
investor protection and systemic risk issues associated with the rapid
growth of private pools of capital and the complexity of financial
instruments and investment strategies they employ. The efforts for each
group of stakeholders enumerated in the principles and guidelines that
the PWG issued entitled "Agreement Among PWG and U.S. Agency Principals
on Principles and Guidelines Regarding Private Pools of Capital" are
briefly summarized below:
* "Private Pools of Capital: maintain and enhance information,
valuation, and risk management systems to provide market participants
with accurate, sufficient, and timely information.
* Investors: consider the suitability of investments in a private pool
in light of investment objectives, risk tolerances, and the principle
of portfolio diversification.
* Counterparties and Creditors: commit sufficient resources to maintain
and enhance risk management practices.
* Regulators and Supervisors: work together to communicate and use
authority to ensure that supervisory expectations regarding
counterparty risk management practices and market integrity are met."
The PWG's principles and guidelines are intended to enhance market
discipline, which the PWG stated most effectively addresses systemic
risk posed by private pools of capital, without deterring the benefits
such pools of capital provide to the U.S. economy. According to a
Treasury official involved in developing the PWG guidance, the PWG
believes that self-interested, more sophisticated, informed investors,
creditors, and counterparties have their own economic incentives to
take actions to reduce and manage their own risks, which will reduce
systemic risk overall and enhance investor protection. Also, the PWG
continues to believe that regulators have an important role to play in
addressing these issues.
Further, in September 2007, the PWG established two private sector
committees. One committee comprised asset managers, and the other
comprised investors, including labor organizations, endowments,
foundations, corporate and public pension funds, investment
consultants, and other U.S. and non-U.S. investors. The first task of
these committees will be to develop best practices using the PWG's
principles-based guidance released in February 2007 as a foundation to
enhance investor protection and systemic risk safeguards. According to
the mission statement of the asset managers' committee, best practices
will cover asset advisers having information, valuation, and risk
management systems that meet sound industry practices. In turn, these
systems would enable them to provide accurate information to creditors,
counterparties, and investors with appropriate frequency, breadth, and
detail. According to the mission statement of the investors' committee,
best practices would cover information, due diligence, risk management,
and reporting and build on the PWG guidelines related to disclosure,
due diligence, risk management capabilities, the suitability of the
strategies of private pools given an investor's risk tolerance, and
fiduciary duties. According to staff of the PWG member agencies, the
PWG expects both committees to have drafts of the best practices
available for public comment early in 2008 and to issue final products
in the spring.
Finally, recognizing that financial shocks are inevitable, the PWG told
us that it adopted more formalized protocols in fall 2006 to coordinate
communications among the appropriate regulatory bodies in the event of
market turmoil, including a liquidity crisis. The protocols include a
detailed list of contact information for domestic and international
regulatory bodies, financial institutions, risk managers, and traders,
and procedures for communications. According to staff of the PWG member
agencies, the protocols were used to handle recent events such as the
fallout from the Amaranth losses in 2006 and the losses from subprime
mortgage investments by two Bear Stearns hedge funds in summer 2007.
Addressing potential systemic risk posed by hedge fund activities
involves actions by investors, creditors and counterparties, hedge fund
advisers, and regulators. The regulators and the PWG's recent
initiatives are intended to bring together these various groups to
improve current practices related to hedge fund-related activities and
to better prepare for a potential financial crisis. We view these
initiatives as positive steps taken to address systemic risk. However,
it is too soon to evaluate their effectiveness.
Agency Comments:
We provided a draft of this report to CFTC, DOL, Federal Reserve, FDIC,
OCC, OTS, SEC, and Treasury for their review and comment. None of the
agencies provided written comments. All except for FDIC and OTS
provided technical comments, which we have incorporated into the report
as appropriate.
As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after the date of this report. At that time, we will send copies of
this report to the Ranking Member of the Committee on Financial
Services, House of Representatives; the Chairman and Ranking Member of
the Committee on Banking, Housing, and Urban Affairs, U.S. Senate;
Ranking Member of the Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises, House of Representatives; and other
interested congressional committees. We are also sending copies to the
Chairman, Board of Governors of the Federal Reserve System; Chairman,
Commodity Futures Trading Commission; Chairman, Federal Deposit
Insurance Corporation; Secretary of Labor; Comptroller of the Currency,
Office of the Comptroller of the Currency; Director, Office of Thrift
Supervision; Chairman, Securities and Exchange Commission; Secretary of
the Treasury; and other interested parties. We will make copies
available to others upon request. The report will also be available at
no charge on our Web site at [hyperlink, http://www.gao.gov].
If you or your staff have any questions regarding this report, please
contact me at (202) 512-8678 or williamso@gao.gov. Contact points for
our Office of Congressional Relations and Public Affairs may be found
on the last page of this report. GAO staff who made major contributions
to this report are listed in appendix IV.
Signed by:
Orice M. Williams:
Director, Financial Markets and Community Investment:
[End of section]
Appendix I: Scope and Methodology:
To address the first objective (regulatory oversight of hedge fund-
related activities), we reviewed regulatory examination documents (for
example, examination modules, scoping, examination reports and
findings, corrective actions taken or proposed by firms, and regulatory
follow-ups). We selected for review some of the recent examinations--
conducted by the Office of the Comptroller of the Currency (OCC),
Federal Reserve Bank of New York (FRBNY), Federal Deposit Insurance
Corporation (FDIC), Securities and Exchange Commission (SEC), and
National Futures Association (NFA)--of regulated entities engaged in
transactions with hedge funds as creditors or counterparties. We
reviewed examinations of financial institutions that are creditors or
counterparties to hedge funds conducted from fiscal years 2004 through
2006 and other supervisory materials. We reviewed 3 OCC examinations, 7
FRBNY examinations, 1 FDIC examination, 14 (9 for hedge fund advisers
and 5 for Consolidated Supervised Entities) SEC examinations, and 4 NFA
examinations. We reviewed information that the federal financial
regulators provided on enforcement cases brought for hedge fund-related
activities. In addition, we interviewed U.S. federal financial
regulatory officials to gain an understanding of how they oversee hedge
fund-related activities at the financial institutions over which they
have regulatory authority. More specifically, we spoke with officials
from the banking regulators--OCC, Board of Governors of the Federal
Reserve System, FRBNY, FDIC, and Office of Thrift Supervision; a
securities regulator--SEC; and commodities regulators--Commodity
Futures Trading Commission and NFA. We interviewed officials
representing Department of Treasury (Treasury), the United Kingdom's
Financial Services Authority, and the President's Working Group (PWG)
as well. To determine which of the Institutional Investor's Alpha
Magazine 2007 Annual Hedge Fund 100 listing of global hedge fund
advisers were U.S.-based and registered with SEC as a hedge fund
investment adviser or with CFTC as a commodity pool operator (CPO) or
commodity trading advisor (CTA), we asked the compliance staff at SEC
and NFA to compare their registrants' listing with the largest 100
listing. Representatives from both organizations said that they made
their best attempt to match the names in the largest 100 listing with
the registrants' listings, which was difficult because the names were
not always identical in both listings. SEC estimates that of the 78 of
the largest 100 hedge fund advisers identified by Alpha Magazine as
U.S.-based, 49 were registered with SEC as investment advisers. NFA
estimates that 29 of the 78 U.S.-based hedge fund advisers were
registered with CFTC as CPOs or CTAs. We also reviewed prior GAO
reports.[Footnote 55]
To address the second objective (market discipline), we interviewed
relevant market participants (such as investors, creditors, and
counterparties), and regulatory officials, to get their opinions on (1)
how market participants impose market discipline on hedge funds' risk
taking and leveraging (and whether they have improved since 1998); (2)
the type and frequency of information such participants would need from
hedge fund advisers to gauge funds' risk profiles and internal controls
to make informed initial and ongoing investment decisions; and (3) the
extent to which hedge fund disclosures to market participants have
improved since the 1998 near failure of the large hedge fund, Long-Term
Capital Management. We also interviewed large hedge funds and the
Managed Funds Association--a membership organization representing the
hedge fund industry. In addition, we conducted a literature search to
identify research on hedge funds and reviewed a selection of relevant
regulatory and industry studies, speeches, and testimonies on the
matter.
To address the third objective (systemic risk), we reviewed relevant
speeches, testimonies, studies, principles and guidelines that the PWG
issued about private pools of capital in 2007 entitled "Agreement Among
PWG and U.S. Agency Principals on Principles and Guidelines Regarding
Private Pools of Capital," regulatory examination documents and
relevant industry best practices for investors, hedge fund advisers,
creditors, and counterparties. We also reviewed PWG protocols ("PWG
Crisis Management Protocols") for dealing with a financial market
crisis. And we interviewed officials representing U.S. federal
financial regulators, Treasury, and the PWG to get their views on
systemic risk issues.
To address pension plan investments in hedge funds discussed in
appendix II, we reviewed and analyzed annual survey data from 2001
through 2006 from Pensions & Investments. Also, we reviewed Greenwich
Associates data from 2004 through 2006 that focused on pensions' hedge
fund investments.[Footnote 56] We conducted data reliability
assessments on the data from Pensions & Investments and Greenwich
Associates that we used, and determined that the data were sufficiently
reliable for our purposes. We also reviewed provisions of the Pension
Protection Act of 2006 (PPA) that changed requirements for how hedge
funds hold pension plan assets. We interviewed pension industry
officials (such as pension plan sponsors of public and private funds,
trade groups, pension consultants, pension plan and hedge fund database
providers, a hedge fund law firm, and hedge funds), an academic and
regulatory officials from the Department of Labor, SEC, and Treasury to
get their opinions on the matter, including trends in such investments
over the last few years and the impact of PPA on pension plan hedge
fund investments. We also reviewed other relevant documents.
We conducted this performance audit from September 2006 to January 2008
in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe that
the evidence obtained provides a reasonable basis for our findings and
conclusions based on our audit objectives.
[End of section]
Appendix II: Pension Plan Investments in Hedge Funds Have Increased but
Are Still a Small Percentage of Plans' Total Assets:
This appendix presents summary information about the potential impact
that pension law reform may have on the ability of hedge funds to
attract pension plan investments and statistics on the extent of
pension plan investments in hedge funds in recent years.[Footnote 57]
Section 611(f) of the Pension Protection Act of 2006 (PPA) amended the
Employee Retirement Income Security Act (ERISA) to, among other things,
provide a statutory definition for "plan assets," which essentially
codified, with some modification, the Department of Labor's (DOL)--the
primary regulator of pension plans--existing plan asset regulation
(sometimes referred to as the 25 percent benefit plan investor
test).[Footnote 58] By modifying the 25 percent benefit plan investor
test, the PPA amendment has the effect of permitting hedge funds to
accept unlimited investments from certain "non-ERISA benefit plans"
(governmental plans, foreign plans, and most church plans) while still
accepting investments from plans that are subject to ERISA (ERISA
benefit plans) without becoming subject to ERISA's fiduciary duty
requirements. What constitutes "plan assets" is significant because a
person who exercises discretionary authority or control over the assets
of an ERISA benefit plan or who provides investment advice for a fee
with respect to plan assets is a "fiduciary" subject to the fiduciary
responsibility provisions of ERISA.[Footnote 59]
As ERISA did not provide a definition for "plan assets" prior to the
enactment of PPA, DOL, in 1986, adopted Rule 2510.3-101 to describe the
circumstances under which the assets of an entity in which an ERISA
benefit plan invests (for example, a hedge fund) would be deemed to
include "plan assets" so that the manager of the entity (for example, a
hedge fund manager) would be subject to the fiduciary responsibility
rules of ERISA.[Footnote 60] Rule 2510.3-101 excludes from the
definition of plan assets, the assets of an entity in which there is no
significant aggregate investment by "benefit plan investors," which is
defined to include both ERISA and non-ERISA benefit plans.
Participation in an entity would be significant if 25 percent or more
of the value of any class of equity securities of the entity were held
by the benefit plan investors collectively (i.e., the 25 percent
benefit plan investor rule). By now excluding from the 25 percent
calculation those equity securities held by non-ERISA benefit plans,
the allowable proportionate share of investments by ERISA benefit plans
has increased.
We asked several large hedge funds as well as some regulators whether
hedge fund advisers were actively soliciting investments from pension
plans due to the reform. They were unable to comment on whether hedge
fund advisers were taking steps to attract these institutional
investments. However, according to one regulator and two large hedge
funds, some hedge fund advisers do not seek pension investments, and
others do seek out pension investments but are careful not to reach the
25 percent threshold that would require hedge fund advisers to assume
fiduciary responsibilities. According to one regulator and an industry
source, pension plans are attracted to various hedge fund investment
strategies, depending on their portfolio composition. They also
suggested that pension plans tend to invest in hedge funds through
funds of hedge funds.
From 2001 through 2006, investments by defined benefit (DB) plans in
hedge funds increased, but the share of total pension plan assets
invested in hedge funds remained small.[Footnote 61] Two key reasons
pension plans invest in hedge funds are to diversify their investment
risks and increase investment returns. Much of the recent growth (and
expected continued growth) in hedge fund investments is attributable to
investments by institutions such as pension funds, endowments,
insurance companies, and foundations.
Two recent surveys of DB plan sponsors describe the prevalence of hedge
fund investments.[Footnote 62]
* According to a Greenwich Associates survey of pensions plans with
$250 million or more in assets, the share of private and public DB
plans (not including union plans) invested in hedge funds was 27
percent and 24 percent, respectively, in 2006.[Footnote 63] Among DB
plans with $250 million to $500 million in assets, 16 percent were
invested in hedge funds. About 29 percent of DB plans with $1 billion
or more in assets were invested in hedge funds.
* The number of DB plans investing in hedge funds has increased over
time. According to a survey of the largest pension plans by Pensions &
Investments, the share of DB plans reporting investments in hedge funds
increased from 11 percent in 2001 to 36 percent in 2006.[Footnote 64]
Evidence from surveys of DB plans shows that between about 1 to 2
percent of total assets were invested in hedge funds.[Footnote 65]
Among only those plans that invested in hedge funds, average
allocations to hedge funds ranged from about 3 percent to 7 percent of
a plan's portfolio.
* A very small number of pension plans reported substantially larger
allocations to hedge funds. Two of the 48 largest pension plans that
reported investments in hedge funds in the Pensions & Investments
survey had allocations of about 30 percent (Missouri State Employees'
Retirement System and Pennsylvania State Employees' Retirement System-
-both of these plans primarily invest in hedge funds through funds of
funds). See table 1.
* Survey data indicate that most pension plans invested in hedge funds
do so, at least partially, through funds of hedge funds. According to
the Pensions & Investments' survey, 35 of the largest 48 DB plans that
reported investments in hedge funds used funds of hedge funds for at
least some of their hedge fund investments. Overall, funds of hedge
funds represented 54 percent of total hedge fund investments for this
group.
Table 1: Ten Defined Benefit Plans with the Largest Reported Hedge Fund
Investments for 2006 (Assets in millions of dollars based on September
2006 data):
Defined benefit plan: Pennsylvania State Employees' Retirement System;
Direct investment: $1,384;
Funds of hedge funds (indirect investment): $7,814;
Total hedge fund investment: $9,198;
Total DB assets: $30,372;
Total hedge fund investment as a percentage of total DB assets: 30.3.
Defined benefit plan: New York State Common Retirement Fund;
Direct investment: $655;
Funds of hedge funds (indirect investment): $3,095;
Total hedge fund investment: $3,750;
Total DB assets: $144,289;
Total hedge fund investment as a percentage of total DB assets: 2.6.
Defined benefit plan: California Public Employees' Retirement System;
Direct investment: $3,710;
Funds of hedge funds (indirect investment): [Empty];
Total hedge fund investment: $3,710;
Total DB assets: $217,648;
Total hedge fund investment as a percentage of total DB assets: 1.7.
Defined benefit plan: Massachusetts Pension Reserves Investment
Management Board;
Direct investment: [Empty];
Funds of hedge funds (indirect investment): $3,032;
Total hedge fund investment: $3,032;
Total DB assets: $43,535;
Total hedge fund investment as a percentage of total DB assets: 7.0.
Defined benefit plan: General Electric Co.;
Direct investment: $2,344;
Funds of hedge funds (indirect investment): [Empty];
Total hedge fund investment: $2,344;
Total DB assets: $51,736;
Total hedge fund investment as a percentage of total DB assets: 4.5.
Defined benefit plan: Virginia Retirement System;
Direct investment: $2,209;
Funds of hedge funds (indirect investment): [Empty];
Total hedge fund investment: $2,209;
Total DB assets: $50,311;
Total hedge fund investment as a percentage of total DB assets: 4.4.
Defined benefit plan: Missouri State Employees' Retirement System;
Direct investment: $752;
Funds of hedge funds (indirect investment): $1,443;
Total hedge fund investment: $2,195;
Total DB assets: $7,150;
Total hedge fund investment as a percentage of total DB assets: 30.7.
Defined benefit plan: Pennsylvania Public School Employees' Retirement
System;
Direct investment: $2,098;
Funds of hedge funds (indirect investment): [Empty];
Total hedge fund investment: $2,098;
Total DB assets: $58,490;
Total hedge fund investment as a percentage of total DB assets: 3.6.
Defined benefit plan: General Motors Corp.;
Direct investment: [Empty];
Funds of hedge funds (indirect investment): $1,975;
Total hedge fund investment: $1,975;
Total DB assets: $98,612;
Total hedge fund investment as a percentage of total DB assets: 2.0.
Defined benefit plan: Citigroup;
Direct investment: $1,887;
Funds of hedge funds (indirect investment): [Empty];
Total hedge fund investment: $1,887;
Total DB assets: $11,549;
Total hedge fund investment as a percentage of total DB assets: 16.3.
Defined benefit plan: Total;
Direct investment: $15,039;
Funds of hedge funds (indirect investment): $17,359;
Total hedge fund investment: $32,398;
Total DB assets: $713,692;
Total hedge fund investment as a percentage of total DB assets: 4.5%.
Source: Pensions & Investments (January 2007 annual survey).
[End of table]
Compared with pension plans, endowments and foundations were much more
likely to invest in hedge funds. Greenwich Associates' survey found
that 75 percent of endowments and foundations (with at least $250
million in assets) were invested in hedge funds in 2006. These
investments amounted to slightly more than 12 percent of total assets
for all endowments and foundations in their sample.
According to Pensions & Investments, hedge fund investments reported
among the largest pension plans increased from about $3.2 billion in
2001 to about $50.5 billion in 2006, approximately a 1,500 percent
increase (see fig. 1).
Figure 1: Investments in Hedge Funds Reported by Defined Benefit Plans
for the Period 2001-2006:
[See PDF for image]
This figure is a vertical bar graph depicting the following data:
Year: 2001;
Investment, dollars in billions: $3.2.
Year: 2002;
Investment, dollars in billions: $8.5.
Year: 2003;
Investment, dollars in billions: $14.4.
Year: 2004;
Investment, dollars in billions: $21.1.
Year: 2005;
Investment, dollars in billions: $29.9.
Year: 2006:
Investment, dollars in billions: $50.5.
Source: Pensions & Investments.
Note: The investments are aggregated among DB plans in the top 200
pension plans (measured by combined DB and defined contribution assets)
surveyed by Pensions & Investments. In 2006, 48 DB plans reported
investments in hedge funds.
[End of figure]
Furthermore, for those DB plans that reported hedge fund investments in
the 2006 Pensions & Investments survey, the investments represented
about 3 percent of their total DB assets under management.
[End of section]
Appendix III: Various Hedge Fund Investment Strategies Defined:
Hedge funds seek absolute rather than relative return--that is, look to
make a positive return whether the overall (stock or bond) market is up
or down--in a variety of market environments and use various investment
styles and strategies, and invest in a wide variety of financial
instruments, some of which follow:
Convertible arbitrage: Typically attempt to extract value by purchasing
convertible securities while hedging the equity, credit, and interest
rate exposures with short positions of the equity of the issuing firm
and other appropriate fixed-income related derivatives.
Dedicated shorts: Specialize in short-selling securities that are
perceived to be overpriced--typically equities.
Emerging market: Specialize in trading the securities of developing
economies.
Equity market neutral: Typically trade long-short portfolios of
equities with little directional exposure to the stock market.
Event driven: Specialize in trading corporate events, such as merger
transactions or corporate restructuring.
Fixed income arbitrage: Typically trade long-short portfolios of bonds.
Macro: Take bets on directional movements in stocks, bonds, foreign
exchange rates, and commodity prices.
Long/short equity: Typically exposed to a long-short portfolio of
equities with a long bias.
Managed futures: Specialize in futures trading--typically employing
trend following strategies.
[End of section]
Appendix IV: GAO Contacts and Staff Acknowledgments:
GAO Contact:
Orice Williams on (202) 512-8678 or williamso@gao.gov:
Staff Acknowledgments:
In addition to the contacts named above, Karen Tremba (Assistant
Director), M'Baye Diagne, Sharon Hermes, Joe Hunter, Marc Molino, Akiko
Ohnuma, Robert Pollard, Carl Ramirez, Omyra Ramsingh, Barbara Roesmann,
and Ryan Siegel made major contributions to this report.
[End of section]
Footnotes:
[1] Although there is no statutory definition of hedge funds, the term
is commonly used to describe pooled investment vehicles that are
privately organized and administered by professional managers and that
often engage in active trading of various types of securities and
commodity futures and options contracts.
[2] By comparison, assets under management in the mutual fund industry
grew from about $5.5 trillion in 1998 to about $10.4 trillion in 2006.
[3] Greenwich Associates, "In U.S. Fixed Income, Hedge Funds Are The
Biggest Game In Town," August 30, 2007.
[4] Price discovery refers to the process by which market prices
incorporate new information.
[5] A counterparty is the opposite party in a bilateral agreement,
contract, or transaction.
[6] The PWG was established by Executive Order 12631, signed on March
18, 1988. The Secretary of the Treasury chairs the PWG, the other
members of which are the chairpersons of the Board of Governors of the
Federal Reserve System, Securities and Exchange Commission, and
Commodity Futures Trading Commission. The group was formed in 1988 to
enhance the integrity, efficiency, orderliness, and competitiveness of
the U.S. financial markets and maintain the public's confidence in
those markets. Prime brokerage is the name for a bundled package of
services (e.g., clearance and settlement of securities trades, margin
loans, and risk management services) offered by investment banks to
hedge funds.
[7] See the President's Working Group on Financial Markets, Hedge
Funds, Leverage, and the Lessons of Long-Term Capital Management (April
28, 1999).
[8] For example, in fall 2006, a fund operated by Amaranth Advisors,
LLC, lost more than $6 billion as a result of natural gas trading. In
summer 2007, two hedge funds sponsored by Bear Stearns Asset Management
experienced losses from its holdings of collateralized debt obligations
(CDO) that contained subprime mortgages. A CDO is a security backed by
a pool of bonds, loans, or other assets.
[9] Federal Reserve Chairman Ben S. Bernanke, The Recent Financial
Turmoil and Its Economic and Policy Consequence (Speech at the Economic
Club of New York, Oct. 15, 2007).
[10] Systemic risk generally is defined as the risk that a disruption
(at a firm, in a market segment, to a settlement system, etc.) could be
transmitted to and potentially pose risks to other firms, other market
segments, or the financial system as a whole.
[11] NFA is a self-regulatory organization for the U.S. futures
industry.
[12] We do not discuss OTS's examination program in this report because
at the time of our review OTS officials noted that no thrifts were
making loans to hedge funds or serving in any significant trading
counterparty capacity.
[13] The hedge funds themselves are not registered with any regulators.
[14] We were not able to find any estimate of the total number of hedge
fund advisers.
[15] Except as may otherwise be provided by law, a CPO is an individual
or organization that operates an enterprise, and who, in connection
therewith, solicits or receives funds from third parties, for the
purpose of trading in any commodity for future delivery on a contract
market or derivatives execution facility. 7 U.S.C. § 1a(5). A CTA is,
except as otherwise provided by law, any person who, for compensation
or profit, (1) directly or indirectly advises others on the
advisability of buying or selling any contract of sale of a commodity
for future delivery, commodity options or certain leverage transactions
contracts, or (2) as part of a regular business, issues analyses or
reports concerning the activities in clause (1). 7 U.S.C. § 1a(6). In
addition to statutory exclusions to the definition of CPO and CTA, CFTC
has promulgated regulations setting forth additional criteria under
which a person may be excluded from the definition of CPO or CTA. See
17 C.F.R. §§ 4.5 and 4.6 (2007).
[16] A horizontal review is a coordinated supervisory review of a
specific activity, business line, or risk management practice conducted
across a group of peer institutions.
[17] Stress testing measures the potential impact of various scenarios
or market movements on an asset, counterparty exposure, or the value of
a firm's portfolio.
[18] Counterparty credit risk is the risk that a loss will be incurred
if a counterparty to a transaction does not fulfill its financial
obligations in a timely manner.
[19] To avoid being required to register as an investment company under
the Investment Company Act of 1940 (Investment Company Act), hedge
funds typically rely on sections 3(c)(1) or 3(c)(7) of that act.
Section 3(c)(1) excludes from the definition of "investment company"
under the Investment Company Act hedge funds that do not make or
propose to make a public offering of their shares and whose share are
not beneficially owned by more than 100 investors. 15 U.S.C. § 80a-
3(c)(1). Section 3(c)(7) excludes from the definition of "investment
company" hedge funds that do not make or propose to make a public
offering of their shares and whose shares are offered exclusively by
"qualified purchasers" and is exempt from most of the provisions of the
Investment Company Act. 15 U.S.C. § 80a-3(c)(7). Generally, "qualified
purchasers" are individuals who own at least $5 million in investments
or companies that own at least $25 million in investments. 15 U.S.C. §
80a-2(a)(51).
Hedge fund advisers also typically satisfy the "private manager"
exemption from registration under section 203(b)(3) of the Investments
Advisers Act of 1940 (Advisers Act). Section 203(b)(3) exempts from
registration an adviser (1) that has had fewer than 15 clients in the
12 months preceding the claim of exemption and (2) that neither holds
himself out generally to the public as an investment adviser nor acts
as an investment adviser to any registered investment company or any
"business development company" as defined under the Investment Company
Act. 15 U.S.C. § 80b-3. Unless its falls within an exclusion from the
definition of CPA or CTA, a hedge fund or hedge fund adviser that
trades on U.S. commodity futures or option markets, may be subject to
the registration requirement under the Commodity Exchange Act (CEA) for
CPOs or CTAs, respectively. CFTC has promulgated regulations setting
forth criteria for exemption from registration under the CEA. See 17
C.F.R. §§ 4.13 and 4.14 (2007). However, a person claiming to fall
outside of the definition of CPO or CTA, as well as those CPOs and CTAs
claiming an exemption from registration must file with the NFA a notice
of eligibility for the claimed exclusion or exemption, as the case may
be, and must submit to any special calls the CFTC may make to require
the person to demonstrate its eligibility for such exclusion or
exemption.
[20] Under the Securities Act of 1933, a public offering or sale of
securities must be registered with SEC, unless otherwise exempted. In
order to exempt an offering or sale of hedge fund shares (ownership
interests) to investors from registration under the Securities Act of
1933, most hedge funds restrict their sales to accredited investors in
compliance with the safe harbor requirements of Rule 506 of Regulation
D. See 15 U.S.C. § 77d and § 77e; 17 C.F.R. § 230.506 (2007). Such
investors must meet certain wealth and income thresholds. SEC generally
has proposed a rule that would raise the accredited investor
qualification standards for individual investors (natural persons) from
$1 million in net worth to $2.5 million in investments. See Revisions
to Limited Offering Exemptions in Regulation D, 72 Fed. Reg. 45116
(Aug. 10, 2007) (proposed rules and request for additional comments).
In addition, hedge funds typically limit the number of investors to
fewer than 500, so as not to fall within the purview of Section 12(g)
of the Securities Exchange Act of 1934, which requires the registration
of any class of equity securities (other than exempted securities) held
of record by 500 or more persons. 15 U.S.C. § 78l(g).
[21] Leverage is the use of various financial instruments or borrowed
capital to increase the potential return of an investment. Short
selling is the selling of a security that the seller does not own, or
any sale that is completed by the delivery of a security borrowed by
the seller.
[22] See 15 U.S.C. § 78m(d), (g) and 17 C.F.R. §§ 240.13d-1 et seq.
(2007).
[23] See 15 U.S.C. § 78m(f) and 17 C.F.R. 240.13f-1 (2007). For
purposes of this provision "institutional investment manager" is
defined as "any person, other than a natural person, investing in or
buying and selling securities for its own account, and any person
exercising investment discretion with respect to the account of any
person."
[24] See Registration under the Advisers Act of Certain Hedge Fund
Advisers, 69 Fed. Reg. 72087 (Dec. 10, 2004). The rule essentially
amended the definition of "client" so that rather than viewing a hedge
fund as a single client of the hedge fund advisers, all limited
partners investing in the hedge fund were deemed to be a client,
thereby putting the number of clients well above the 14-client limit
for the private adviser exemption. The new rule did not require the
registration of advisers to funds with certain characteristics, such as
a lockup periods of 2 years or more--typically venture capital and
private equity funds.
[25] See Goldstein v. Securities and Exchange Commission, 451 F.3d 873
(D.C. Cir. 2006). In Goldstein, the U.S. Circuit Court of Appeals for
the District of Columbia held that SEC's hedge fund rule was arbitrary
because it departed, without reasonable justification, from SEC's long-
standing interpretation of the term "client" in the private adviser
exemption as referring to the hedge fund itself, and not to the
individual investors in the fund. See footnote 19, supra, for a
description of the private adviser exemption from registration under
the Advisers Act.
[26] According to the May 2007 edition of Institutional Investor's
Alpha Magazine, which lists the largest 100 global hedge funds based on
assets as of December 31, 2006, 78 of the largest 100 hedge funds are
U.S.-based hedge funds. According to HedgeFund Intelligence, $1.5
trillion in hedge fund assets were under management in the United
States as of March 2007.
[27] See GAO, Securities and Exchange Commission: Steps Being Taken to
Make Examination Program More Risk-Based and Transparent, GAO-07-1053
(Washington, D.C.: Aug. 14, 2007).
[28] SEC did not identify the largest U.S. hedge funds cited in
industry reports prior to conducting these hedge fund adviser
examinations. Twenty-seven of the largest hedge fund advisers were
examined by SEC from fiscal years 2005 to 2007.
[29] For non-hedge fund investment advisers, the percentage that
received a deficiency letter is 84 percent.
[30] See Supervised Investment Bank Holding Companies, 69 Fed. Reg.
34472 (Jun. 21, 2004) [codified primarily at 17 C.F.R. § 240.17i-1 et
seq.]. Section 17(i) of the Securities Exchange Act authorizes SEC to
supervise investment bank holding companies (IBHCs) on a consolidated
basis. An IBHC is any person (other than a natural person) that owns or
controls one or more brokers or dealers, and the associated persons of
the IBHC. 15 U.S.C. § 78q(i)(5)(A). The CSE program implements section
§ 17(i). The purpose of the CSE program is to reduce the likelihood
that weaknesses in the holding company or an unregulated affiliate
(such as a CSE-owned hedge fund) endangers a regulated entity or the
broader financial system, to provide consolidated oversight for
internationally active firms required to meet international
consolidated supervisor requirements established by the European
Union's Financial Conglomerates Directive, and to meet a PWG
recommendation to expand risk assessment authority for the unregulated
affiliates of broker-dealers.
[31] The five CSEs are: Merrill Lynch & Co., Inc.; Morgan Stanley Inc.;
Bear Stearns Companies Inc.; Goldman Sachs Group, Inc.; and Lehman
Brothers Holdings Inc.
[32] SEC is required by statute: (1) to focus its CSE examinations to
the holding company, its associated registered broker-dealers and any
affiliates that could have a material adverse effect on the operational
or financial condition of the broker or dealer; and (2) with respect to
affiliates of the holding company that are banks, licensed insurance
companies and certain other financial institutions, to defer to the
appropriate federal banking agencies and state insurance regulators
with regard to all interpretations of, and the enforcement of
applicable federal banking laws and state insurance laws relating to
the activities and operations of such affiliates. 15 U.S.C. § 78a(i)(3)-
(4).
[33] Basel regulatory capital standards were developed by the Basel
Committee on Banking Supervision, which consists of central bank and
regulatory officials from 13 member countries. The standards aim to
align minimum capital requirements with enhanced risk measurement
techniques and to encourage internationally actively banks to develop a
more disciplined approach to risk management.
[34] A cross-firm review is a coordinated supervisory review of a
specific activity, business line, or risk management practice conducted
across a group of peer institutions. All five of the CSEs were
reviewed.
[35] According to CFTC officials, the LTRS captures 70 to 90 percent of
the daily activity on registered futures exchanges.
[36] FCMs are individuals, associations, partnerships, corporations, or
trusts that solicit or accept orders for the purchase or sale of any
commodity for future delivery on or subject to the rules of any
contract market or derivatives transaction execution facility; and in
connection with such solicitation or acceptance of orders, accept
money, securities, or property (or extend credit in lieu thereof) to
margin, guarantee, or secure any trades or contracts that result or may
result therefrom.
[37] In the CFTC complaint filed against Amaranth Advisors, LLC;
Amaranth Advisors (Calgary), ULC, and Brian Hunter, CFTC alleged that
the defendants attempted to manipulate the price of natural gas
contracts on the New York Mercantile Exchange, Inc., in 2006. Complaint
for Injunctive and Other Equitable Relief and Civil Monetary Penalties
under the Commodity Exchange Act, CFTC v. Amaranth Advisors, LLC, No.
07-6682 (S.D.N.Y., July 25, 2007).
[38] Because "hedge fund" is not a defined term under the CEA or any
other federal statute, CFTC and NFA records do not identify whether a
commodity pool is a hedge fund. Thus, CFTC cannot report on the exact
number of examinations that involve hedge funds. In the event the CPO
or CTA self-designates itself as a hedge fund, the Division of
Enforcement typically incorporates that designation in the enforcement
action, and that designation is often used in the press release
notifying the public of the enforcement action.
[39] A registered CPO or CTA seeking to engage in futures business with
the public or with any member of NFA must itself be a member of NFA.
[40] For the purpose of this report the term "hedge fund advisers"
includes, as the context requires, CPOs, CTAs, or securities investment
advisers.
[41] Testimony of Kevin Warsh, Governor, Board of Governors of the
Federal Reserve Board System, before the House Committee on Financial
Services, 110th Congress, 1st Sess., July 11, 2007.
[42] Liquidity risk is the potential that a firm will be unable to meet
its obligations as they come due because of an inability to liquidate
assets or obtain adequate funding or that it cannot easily unwind or
offset specific exposures without significantly lowering market prices
because of inadequate market depth or market disruptions.
[43] According to an SEC report and some market participants we
interviewed, PPMs discuss in broad terms the fund's investment
strategies and practices; risk factors; information on the general
partner or investment manager; management fees and incentive
compensation; key personnel of the fund manager; synopsis of the
limited partnership agreement or other organizational documents;
conflicts of interest; side letters (preferential redemption terms that
may be granted to one class of investors) and side pockets (illiquid
investments held separately from the primary fund); investment,
withdrawal, and transfer procedures; and valuation.
[44] ERISA § 404(a)(1)(B) [ 29 U.S.C. 1104(a)(1)(B)] requires a
fiduciary to act with the care, skill, prudence, and diligence under
the prevailing circumstances that a prudent person acting in a like
capacity and familiar with such matters would use.
[45] MFA is a hedge fund trade group.
CRMPG is an industry policy group that formed in 1999 after the near
collapse of LTCM and comprises the 12 largest internationally active
commercial and investment banks.
IOSCO is an international organization that brings together the
regulators of the world's securities and futures markets. IOSCO and its
sister organizations, the Basel Committee on Banking Supervision and
the International Association of Insurance Supervisors, make up the
Joint Forum of international financial regulators.
[46] Value at risk is a calculation used to determine the amount that
could be expected to be lost from an investment or a portfolio of
investments over a specified time under certain circumstances.
[47] A derivative is a financial instrument, such as an option or
futures contract, the value of which depends on the performance of an
underlying security or asset. Securities financing transactions include
repurchase agreements, securities lending transactions, and other types
of borrowing transactions that, in economic substance, utilize
securities as collateral for the extension of credit. A repurchase
agreement is a financial transaction in which a dealer borrows money by
selling securities and simultaneously agreeing to buy them back at a
later date.
[48] According to the literature, (1) current exposure represents the
current replacement cost of financial instrument transactions, i.e.,
their current market value; (2) potential exposure is an estimate of
the future replacement cost of financial instrument transactions; and
(3) an initial margin is the good-faith deposit that protects the
counterparty against a loss from adverse market movements in the
interval between periodic marking-to-market.
[49] See Counterparty Risk Management Policy Group II, Toward Greater
Financial Stability: A Private Sector Perspective (July 27, 2005).
[50] Reasons cited by CRMPG for a reduction in the probability of
systemic financial shock from hedge fund activity included (1) the
strength of the key financial institutions at the core of the financial
system, (2) improved risk management techniques, (3) improved official
supervision, (4) more effective disclosure and greater transparency,
(5) strengthened financial infrastructure, and (6) more effective
techniques to hedge and widely distribute financial risk.
[51] Testimony of Randal K. Quarles, Under Secretary for Domestic
Finance, Department of the Treasury, before the Senate Committee on
Banking, Housing, and Urban Affairs, 110th Congress, 1st Sess., July
25, 2006.
[52] Roger T. Cole, Greg Feldberg, and David Lynch, "Hedge Funds,
Credit Risk Transfer and Financial Stability," Financial Stability
Review, April 2007, p. 13.
[53] Cole, Feldberg, and Lynch, "Hedge Funds, Credit Risk Transfer and
Financial Stability," p. 15.
[54] For example, according to press reports, the tightening of credit
markets that followed the collapse of two Bear Stearns-sponsored hedge
funds in June 2007 was partly triggered by a revaluation of the CDOs.
Merrill Lynch, one of the funds' prime brokers, seized $850 million of
the funds assets held as collateral, including CDOs, but it reportedly
only sold a fraction of the assets because the value of these
securities had fallen.
[55] See GAO, Commodity Futures Trading Commission: Trends in Energy
Derivatives Markets Raise Questions about CFTC's Oversight, GAO-08-25
(Washington, D.C.: Oct. 19, 2007); Credit Derivatives: Confirmation
Backlogs Increased Dealers' Operational Risks, but Were Successfully
Addressed after Joint Regulatory Action, GAO-07-716 (Washington, D.C.:
June 13, 2007); Financial Market Regulation: Agencies Engaged in
Consolidated Supervision Can Strengthen Performance Measurement and
Collaboration, GAO-07-154 (Washington, D.C.: Mar. 15, 2007); and Long-
Term Capital Management: Regulators Need to Focus Greater Attention on
Systemic Risk, GAO/GGD-00-3 (Washington, D.C.: Oct. 29, 1999).
[56] Pensions & Investments is an industry publication that has
conducted the annual survey for the last 33 years. Greenwich and
Associates is an institutional financial services consulting and
research firm.
[57] A forthcoming GAO report (to be issued in the summer of 2008) will
provide more detailed information about various aspects of pension plan
investments in hedge funds.
[58] Pub. L. No. 109-280, § 611(f), 120 Stat. 952, 972 (2006) (codified
at 29 U.S.C. § 1002(42)).
[59] Section 3(21) of ERISA defines "fiduciary." 29 U.S.C. § 1002(21).
[60] See Final Regulation Relating to the Definition of Plan Assets, 51
Fed. Reg. 41262 (Nov. 13, 1986) (final rule codified at 29 C.F.R.
2510.3-101). Rule 2510.3-101 describes what constitutes "plan assets"
with respect to a plan's investment in another entity for purposes of
Subtitle A (definitional and coverage provisions) and Parts 1 and 4
(reporting and disclosure and fiduciary provisions) of Subtitle B of
ERISA and for purposes of section 4975 of the Internal Revenue Code
(excise tax provisions relating to prohibited transactions).
[61] Defined benefit plans commonly provide a guaranteed monthly
benefit based on a formula that considers salary and years of service
to a company. Defined contribution plan benefits are based on
contributions and investment returns (gains and losses).
[62] If pension plan sponsors have more than one DB plan, they may
collectively manage assets for these plans and thus may provide survey
answers for the combined fund, rather than for each individual pension
plan.
[63] Greenwich Associates surveyed pension plans, endowments, and
foundations, that had a minimum of $250 million in assets and used at
least two external investment advisers. Greenwich Associates obtained
asset allocation information regarding hedge funds from 584 of the 652
DB plans it interviewed in 2006.
[64] The top 200 pension plans surveyed by Pensions & Investments are
ranked by combined assets in DB and defined contribution plans. These
plans reported almost $6 billion or more in combined DB and defined
contribution assets in 2006. Of these top 200 pension plans, 135 were
DB plans that completed the survey and provided asset allocation
information, and 48 of these plans reported investments in hedge funds
in 2006.
[65] Survey data were not available for DB plans with less than $200
million in assets.
[End of section]
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