Managing the systemic risk created by hedge funds by regulating their counterparties is difficult. Making it work will require concerted effort by regulators from different jurisdictions.
Hedge funds play an important role in promoting financial innovation, increasing market liquidity, improving market efficiency through arbitrage activity and stabilising the markets by adopting "contrarian" investment styles. But the systemic risks they bring about cannot be ignored and are often difficult to manage. Most regulators address the issue by regulating the counterparties of the hedge funds, mostly the banks and securities firms. But the effectiveness of this indirect regulatory approach depends on two critical factors: market discipline and how well the regulated institutions manage their counterparty risks.
There are good reasons to doubt the regulated counterparties' ability to impose market discipline on hedge funds, especially when hedge funds have become an important source of their revenue. Fierce competition for prime brokerage business is likely to put pressure on these institutions to compromise, eventually leading to a relaxation of risk management. With management fees tied to performance, hedge fund managers are more inclined to take risks than to abide by market discipline. It is also unclear to me whether the current level of transparency in most hedge funds can really provide sufficient, accurate and timely information for market discipline to work effectively.
There is also debate on whether the counterparty-risk management of the regulated institution is sufficient to address the potential risks posed by hedge funds. Its effectiveness depends on the robustness of the risk models used. Most of these risk models are developed in a benign economic and financial environment and may fail to capture the risks of low-probability events, the so-called tail risks. Some people even argue that some of the risk-management practices, such as margin requirements, may destabilise financial markets by reinforcing the downward momentum during periods of stress.
Is the relatively limited systemic impact of the recent failure of Amaranth a sufficient source of comfort? Probably not. The fact that Amaranth could manage to accumulate highly concentrated positions in the energy futures markets without the market knowing it suggests that counterparty-risk management may not be working as well as most regulators would have expected. The incident also shows how the opaqueness of hedge funds can prevent early detection of concentrated risks by their counterparties and the regulators. Hedge funds have no statutory obligation to report to regulators, and they usually disclose as little information to their counterparties as possible. It is also easy for hedge funds to hide their positions by employing multiple prime brokers.
Despite all the inadequacies of the indirect oversight approach, it is in the interest of all concerned to give it our best shot. To make this approach more effective will require hedge funds to be more co-operative in improving their transparency and following the best codes of conduct and disclosure. I am glad to see that some industry organisations, such as the Alternative Investment Management Association and Managed Funds Association, are working hard on this front by establishing codes and standards on disclosure and governance. It is a good start, but more effort will be needed to convince fund managers to follow these codes and standards.
Of course, we cannot rely solely on the co-operation of hedge funds to maintain financial stability. Regulators should continue to closely monitor the risk of hedge funds through the exposures of their counterparties. A good example is the semi-annual survey of London-based prime brokers by the Financial Services Authority (FSA) of the UK. However, as most hedge funds and their counterparties operate in the global financial markets, it is important for regulators of different jurisdictions to co-ordinate their monitoring efforts.
Regulators can also play a more active role in formulating an appropriate disclosure framework for the hedge fund industry. I think the recent guidelines published by the FSA on hedge fund transparency are of great reference value to other regulators. I agree with the FSA that disclosures by hedge funds should achieve at least three purposes – investor protection, financial stability and market integrity. This means that the disclosure must be sufficient for investors to make informed investment decisions, accurate enough for creditors to assess the creditworthiness of the hedge funds, and comprehensive enough to comply with the rules and regulations.
Joseph Yam
12 July 2007
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