The G7 Meetings and the Regulation of Hedge Funds
This past weekend at the G7 meeting, Christine Lagarde, the French finance minister, called for tighter regulation of hedge funds. She seems particularly worried that the “momentum” towards heavy regulation of the financial system has been put on the back-burner by the growing economic crisis. Hedge funds are, however, a particularly odd financial institution to focus on.
One of my favorite columns of this crisis was written by John Gapper of the Financial Times this past December. He starts his article with a quote from Shakespeare’s Macbeth by Malcolm on the Thane of Cawdor, “Nothing in his life became him like the leaving it.” Gapper was talking about hedge funds and, in his view, the fact that they are going down with dignity.
While it is certainly true that some hedge funds have taken the unpopular move (in investors’ eyes) of putting up gates, the general behavior of hedge funds provides a stark contrast to the banking industry. Hedge funds acknowledge they placed bets on illiquid assets, pocketed the spread in normal times, and now are being humbled, or should we say crushed, as the illiquidity has come back to bite them. But, unlike the banks, there is no whining about mark-to-market accounting. They understand there is no free lunch in financial markets.
One only has to go to CSPAN and download the Congressional hearings in which they had the five highest paid hedge fund managers of 2007 and, more recently, the eight CEOs of the largest banks testify to know what Gapper is talking about. The comparison is quite enlightening.
The French finance minister’s main focus seems to be on pushing prime brokers to regulate hedge funds, in other words, to do the dirty work for them. This isn’t a crazy suggestion. One only has to look at the SEC’s regulation of the managed accounts of Bernard Madoff to worry about whether regulators are up to the task. And as we have seen, lack of transparency of financial institutions can magnify financial crises due to counterparty concerns.
But there is a cost to public transparency of a hedge fund’s investment strategy, its asset positions, and its trades. Position and trade disclosure by a hedge fund facilitates imitation by others, which likely leads to deterioration in the hedge fund’s performance. And it is not clear that prime brokers are the most discreet of entities. Since the largest concern relating to transparency is indeed counterparty risk, these counterparty issues are most relevant with OTC derivatives. It may be that by fixing the cracks elsewhere in the system, e.g., creating a clearing house/exchange structure for large OTC derivative markets, the transparency goal can be reached without having to impose onerous regulation on the hedge fund community.
That said, it is certainly the case that, by the proprietary nature of their trading, hedge funds are not very transparent to the market. So it seems that a minimal condition would be that, in order to help regulators measure and manage possible systemic risk, hedge funds (of sufficient size) should be required to provide regulators with regular and timely information about both their asset positions (especially their asset concentration) and leverage levels.
The other main proposal of the French finance minister is to increase the control of hedge funds by compelling banks that act as prime brokers to hold more capital. Higher capital requirements are the bane of banks so this would in theory lead to greater oversight and, in essence, more prudent lending. Hedge funds must view this proposal with some irony. After all, it was the failure of a prime broker, namely Lehman Brothers, which created such havoc in the hedge fund industry when billions of dollars of hypothecated securities disappeared into thin air in the system.
Imposing higher capital requirements for banks that face greater systemic risk is sensible. In the forthcoming NYU Stern School book, “Restoring Financial Stability: How to Repair a Failed System”, we propose a systemic risk regulator, a way to measure systemic risk and various pricing (and taxing) schemes for the negative externality inflicted by this risk. There are many types of risks banks take – principal investing, commercial real estate loans, consumer loans, etc... It is an empirical question, however, where prime brokerage lies in terms of the ranking of the different risks taken by banks.
Since hedge funds do not receive guarantees from the government and so are not subject to the moral hazard problems associated with such guarantees, any additional regulation of hedge funds over and above greater transparency to regulators is in general not warranted. The exception is when hedge funds impose externalities on the financial system.
There are three possible ways hedge funds can be systemic:
- If a hedge fund falls into the class of large complex financial institutions, then that fund needs to be treated as a systemic institution to be regulated (and taxed) as such.
- If a hedge fund is small but acts in ways that are similar to many other funds (i.e., your typical crowded trade), then the fund may mirror many of the characteristics of a systemic institution. This may not be easy for regulators to uncover but they should be aware of the possibility. Knowing each fund’s size, leverage and asset concentration, however, would be helpful here.
- Managed funds (mutual funds, money market funds, SIVs, and hedge funds) are subject to bank-like runs on their assets. These runs can trigger systemic liquidity spirals. Of course, the remarkable diversity of management styles under the “hedge fund” banner makes this less likely. Indeed, during the current crisis, it was the homogenous fund classes, like the asset-backed commercial paper market (in August 2007) and money market (in September 2008), that seized up. Nevertheless, it is worth putting on the table the issue that hedge funds in a systemic-risk subset may need regulation that discourages investors from withdrawing funds after bad performance. One way to do this is to impose a systemic tax that naturally leads to different fee structures and lockup periods, depending on the hedge fund style.
One can argue that to the extent there have been excesses in hedge funds, they have arisen due to imprudent regulation of banks, who through prime brokerage, have provided subsidized financing. The fundamental root cause of regulatory problems is mispriced subsidies to the banking sector that infects the entire financial system. Rather than plucking hedge funds out as the poster child for regulation, therefore, a more consistent regulatory approach might be to fix the cause rather than the symptom. Our guess – hedge funds probably will come out rather well in the spectrum of the need for heavy-handed regulation.
Matthew Richardson is a professor who has contributed to the NYU Stern School of Business book project, “Restoring Financial Stability: How to Repair a Failed System."