Hedge World - It would be a stunning understatement to say that hedge funds and related alternative asset managers are keeping a close eye on the rapidly changing regulatory landscape. Set against the backdrop of plummeting financial markets, unprecedented fraud in the Bernard Madoff investment scandal, the new Obama administration, and the Troubled Asset Relief Program (TARP), regulators and elected officials stand ready to enact historic reforms in securities markets regulation. Private investment pools and hedge funds are one key investor constituency keenly aware of the pending structural changes. In fact the hedge fund industry, normally reserved about openly advocating its interests, has recently publicly acknowledged the need for stepped-up law enforcement and regulation to prevent financial fraud and excessive risk taking. What form will increased hedge regulation take? What does the Madoff scandal mean for fraud detection and regulation in the future? Who will regulate hedge fund investment managers in the future? The important details of greater hedge fund regulation have yet to emerge, but to borrow a recent campaign phrase, "change is coming" to the hedge fund industry, and the industry is keenly aware of that fact. This article intends to shed some light on the form and structure of such likely oversight.
Background
Last October a number of prominent hedge fund managers testified at the U.S. House of Representatives Committee on Oversight and Government Reform. Rep. Henry A. Waxman (D-Calif.), the committee chairman, had summoned the hedge fund managers to inquire about their roles in the ongoing credit crisis. Surprisingly, most of the managers testifying felt some regulation of hedge funds was justified and that hedge funds could pose a "systematic" risk to market integrity. James Simons, chief of Renaissance Technologies LLC, said regulation of hedge funds dealing with market safety and soundness "would be useful and welcome" and could be monitored by "an appropriate regulator." Unsurprisingly, their testimony generally focused on poor regulation of other market participants like investment banks and mortgage finance firms as a cause of the market crisis. George Soros of Soros Fund Management even challenged regulators, saying that "the regulators must accept responsibility for controlling asset bubbles."
Not long after the hearing a bombshell dropped with the revelation of Bernard Madoff's hedge fund fraud. Mr. Madoff, a former chairman of the Nasdaq stock exchange and considered beyond reproach at one point among financial regulators, had allegedly engineered a Ponzi scheme defrauding clients of as much as $50 billion. The scale and breadth of this crime have staggered an already severely bruised hedge fund industry. The scandal's fallout and Congressional hearing have served as a kind of public acknowledgement from legislators, regulators, hedge fund managers and the wider financial industry that sweeping change is needed.
Until now there had been just one discernible attempt by a U.S. regulator to impose even limited regulation on hedge funds. In 2004, the Securities and Exchange Commission attempted to require all hedge funds to register under the Investment Advisors Act of 1940. Hedge funds had been avoiding registration under the 1940 Act by claiming exemptions such as limiting the number of owners to fewer than 100 people and limiting the hedge fund stakes of their investors to at least $5 million. That SEC action, however, was struck down in a 2006 federal court decision. Though registration is a critical aspect of any new regulatory scheme, more fundamental work remains in Washington to reorganize or even overhaul the entire federal regulatory structure.
First and foremost, Washington will attempt to fix the fragmentation of current federal securities regulation. Last year, the Treasury Department in an influential report made the case for wholesale reorganization and elimination of duplicative and competing regulatory interests. Currently a multitude of regulators oversee markets in which hedge funds invest. An incomplete list includes the SEC, the Commodity Futures Trading Commission, the Federal Reserve, the Office of the Comptroller of the Currency, the Departments of Treasury and Labor, the Financial Industry and Regulatory Authority, and the National Futures Association. The key questions regulators and elected officials need to ask are: What kind of regulations should we impose on hedge funds, and what ultimate regulatory body is best equipped to monitor and enforce them?
Regulatory Toolkit
Because regulation can take many forms, it is helpful to think of different tools in a "regulatory toolkit." The tools can be used independently or in concert and can sometimes address vastly different operational areas. Potential regulation can broadly be categorized into the following "tools": 1) registration and monitorship of individual firms; 2) regulation of general market trading by all entities including hedge funds (e.g. short-selling, uptick rule); 3) promotion of transparency and improvement in professional standards; and 4) quantitative financial metrics to ensure the "safety and soundness" of the financial system. Each tool needs to be addressed separately.
Registration
Registration and monitorship is the most obvious first step. It is the starting point for greater disclosure and transparency. Registration helps regulators monitor firms and recognize their fiduciary obligations to investors. In fact, many notable hedge funds have been voluntarily registered with the SEC for many years. John Paulson of Paulson & Co. testified that his firm had voluntarily registered with the SEC as an investment adviser back in February of 2004. Of course, registration is merely a first step and is certainly no fraud prevention panacea. Bernard Madoff's prominent stance with industry and regulators along with his SEC registration serves as ample evidence alone.
The SEC will likely institute this requirement, primarily because it already handles disclosure related regulation. Registration could require full disclosure of conflicts of interest and explicit prohibition of fraud against clients. Registration is not expected to hinder a hedge fund manager's ability to engage in proprietary trading. In fact, as of the initial registration rule implementation by the SEC in 2004, five of the ten largest hedge fund advisers were voluntarily registered with the SEC under the Advisers Act of 1940.
Trading Rules
Broadly defined trading rules for various products and specific trading strategies are bound to remain in flux for all financial traders. The prohibition of insider trading, compliance with anti-takeover laws, and the disclosure requirements for large stakes in thinly traded equities are regulations in place today. New regulations will stem in part from the recent proliferation of specific investment products and services. It's no secret now that the rapid growth in sub-prime mortgage backed securities, credit default swaps, collateralized debt obligations and other derivatives contributed to the current financial fiasco.
The use of centralized exchanges for the trading of standardized securities and derivatives which are currently traded over-the-counter is a highly likely first step. The use of various trading restrictions in order to realign the risk-reward equilibrium is a likely second step. Specific examples include mandatory holding periods for securities, limits on off-balance sheet financing, limits on loan securitizations, and re-emphasized fair value accounting rules.
Trading rules such as the elimination of the uptick rule for short sellers and short selling itself are likely to once again undergo close scrutiny and evaluation. For example, naked short selling is probably a permanent strategy of the past. The uptick rule is particularly interesting because it was repealed by the SEC in July 2007 shortly before the start of the current bear market. The uptick rule, which only allowed for short selling after upward movement or "upticks" in a stock's price, had been in effect for 70 years prior to its repeal. Reinstatement of this rule ought to dampen downward volatility and is certainly possible.
Ethical and Professional Standards
While hedge funds' collective culpability for the financial crisis is debatable, what's not is the need to overtly demonstrate strong ethics and professional standards in the future to a highly skeptical public investor. Written statements of fiduciary duties of investment managers, commitments to sound business practices and investor protections, rapid disclosure of conflicts of interest, and effective compliance programs are just some of the elements being discussed.
Regulators' efforts to enact explicit ethics and professional standards are more difficult. Ethics, integrity, and other behavioral standards have historically been promoted by self-regulating non-governmental groups. Two influential investor and investment manager advocacy groups, The Managed Funds Association and the CFA Institute's Centre for Financial Market Integrity, have recently renewed the industry's commitment to ethics training with the republication of "Sound Practices for Hedge Fund Managers" and the "Asset Manager Code of Professional Conduct," respectively. In addition, the President's Working Group on Financial Markets, a federal multi-agency board, established the private sector Asset Manager's and Investors' Committees back in 2007 to review investment manager best practices. In January 2009, the Asset Managers' Committee released its finalized "Best Practices for the Hedge Fund Industry" which includes guidelines for a hedge fund code of ethics and compliance.
Despite this government initiative, do not look for Washington to dictate ethics and professional standards rules to hedge fund managers. A related topic, the formal licensing of investment managers by state or federal authorities, has been raised but will not go far. The industry is far too highly fragmented and investment management is not widely viewed as a "professional services" career along the lines of the legal and tax professions.
Systematic Risk Standards
Ensuring the "safety and soundness" of financial markets in the future is the last, and perhaps most important, area of regulation expected to change significantly. Many rightly argued that the current systematic financial risk resulted from too many commercial banks and broker/dealers borrowing too heavily to finance risky assets (loans, securitized debt, etc.). Without adequate capital cushions, bankruptcy risk, as we have seen in 2008 much to our consternation, becomes the all-compassing risk facing management and investors. Capital structures with reasonable levels of debt, effective counterparty credit risk management, and adequate asset diversification principles are among the goals of any new systematic risk regulation.
Though hedge funds do not fall under the same category as commercial and investment banks, they have often borrowed heavily in order to engage in risky trading strategies. The 1998 collapse of Long-Term Capital Management highlighted the systematic fear hedge fund failures can cause across financial markets. The consensus in the industry and in government is that internal risk management functions at hedge funds have heretofore failed to mitigate liquidity and bankruptcy risk, and the recent historic spike in hedge fund redemptions and failures serves as ample evidence.
Detailed plans for systematic risk regulation remain unpublished, but Congress and the Obama administration have both indicated that the Federal Reserve is likely to be the best regulatory body equipped to tackle safety and soundness regulation. Look for minimum capital requirements, risk-adjusted return metrics, and requirements for the monitoring of internal risk management functions at banks, hedge funds, insurers and other financial intermediaries. Market, liquidity, leverage, counterparty credit and operational risks are just some of the risk categories the plan will encompass.
Conclusion
Given the unprecedented financial turmoil, it should surprise no one that Congress and the Obama administration plan to re-write the book on financial market regulation. In fact, hedge fund legislation efforts have already begun in Congress. Two weeks ago, the "Hedge Fund Transparency Act" was introduced in Congress requiring SEC registration of all private investment pools, the filing of an annual information form with the SEC, and cooperation with SEC inquiries and requests for information. Though this potential bill is only an initial regulation salvo, it demonstrates that debate about specifics has begun. What is often lost in the debates is the vast array of regulatory structures and options available. Elected officials seemed to have now moved beyond the over-simplistic "more or less regulation" arguments. For hedge funds heretofore unaccustomed to federal oversight, 2009 will indeed be a time for change.
By Robert McDonald
