March 6, 2007
HP-296
Remarks of Assistant Secretary for Financial Markets
Anthony Ryan
On Hedge Funds
World Hedge Fund Forum
Greenwich, Conn. - Good afternoon. Thank you for inviting me to speak today. It's an honor to be here. Today, we are discussing hedge funds, their contributions and impact on our capital markets. I plan to introduce a framework to illustrate how, as federal policymakers, we look at some issues in addressing hedge funds.
Last November, in a speech to the Economic Club of New York, Secretary Paulson said, "Capital markets are the lifeblood of our economy." The vibrancy of American capital markets is an integral part of our ability to compete globally, and so, in reviewing the agenda for the day, I am pleased to see such a global perspective represented. After twenty years of working in the global capital markets, I know firsthand that few groups are more adept at identifying opportunities and moving capital around the world than those managing hedge funds.
In the United States, we have the strongest, deepest and most diverse capital markets in the world, and we are not taking our leadership for granted. One week from today, Secretary Paulson will convene a conference on capital markets competitiveness; we will hear from various market participants and experts in the regulatory, accounting and legal professions on how to ensure that our capital markets continue to enhance economic growth and bring benefits to all Americans.
As policymakers, we do not view hedge funds as an asset class or as an industry. Rather, a hedge fund is a business model that asset managers have adopted to manage capital. The objective of the business model is to attract and grow capital, generating superior returns through a defined investment strategy. It is too simplistic to measure success for a hedge fund by using a single metric. But if we were to do so, we might measure the greatest absolute return for a given amount of risk as measured by volatility.
If indeed maximizing return to risk is what a hedge fund manager is trying to do, how does one go about doing so? While there are many variations, successful hedge fund managers often have four elements in common: vested stakeholders, a well-defined philosophy, a well-executed process, and a commitment to ongoing evaluation.
First are "vested" stakeholders. In addition to investors, who are obviously impacted by the hedge fund's return, the business model is explicitly geared to vest the manager's success to that of his or her clients. So, the stakeholders also include the fund's analysts, portfolio managers, traders and operations professionals.
Second is a well-defined philosophy. Successful hedge fund managers have clearly established beliefs on how capital markets operate and how their strategies can generate superior returns. They also possess clear policies that define how they'll communicate and interact with their investors and counterparties, and how they'll address potential conflicts of interests.
Third is a well-executed process. Successful managers have a framework. Their approach may be flexible, but it is based on sound principles, guidelines and rules enabling the manager to respond to dynamic market conditions in a disciplined fashion.
Fourth is a commitment to ongoing evaluation. The most successful managers prove to be those who continually enhance their capabilities, systems and resources.
Each of these four elements is essential to obtaining success in an ever changing environment.
The objectives and framework I just outlined for defining successful hedge fund managers also serves as an interesting analogy to the broader issue of how the policymakers and regulators, comprising the President's Working Group on Financial Markets (PWG), define and evaluate our objectives regarding hedge fund policy. The PWG is chaired by Secretary Paulson and also includes the Chairmen of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. Since 1988, the PWG's overarching mission has been to maintain investor confidence and enhance the integrity, efficiency, orderliness, and competitiveness of U.S. financial markets.
The Comparative Assessment
Let me return to the framework of the successful hedge fund manager and apply it to the PWG. Broadly speaking, the objective is the same for both the hedge fund manager and the PWG. It comes down to enhancing rewards and mitigating risks. For the hedge fund manager, it is about having the highest return relative to risk; for the PWG, the highest benefit relative to cost.
Let's take a more in depth look at each of the four elements of this framework as it relates to policymaking.
The first element is vested stakeholders. Here, the PWG thinks about the market and all of the participants. In approaching the area of hedge funds, the PWG recognizes the interests and risks of the other vested stakeholders. These include investors, hedge fund managers, and creditors and counterparties. Each group is vested in the ultimate policy and structure, and like the hedge fund business model, it works best when there is an alignment of interests among the various stakeholders.
Regulators must constantly be aware of potential risks, make a determination as to whether they warrant direct attention, and then determine how best to address those risks. Regulators desire policies that encourage capital markets to be competitive, sound, and operate with integrity. These kinds of markets attract capital and have a broad array of participants--each with different objectives and time horizons. These capital markets also foster an environment conducive to innovation. All of these features serve to improve liquidity and facilitate the dispersion of risk. In turn, capital markets with these characteristics ultimately strengthen the economies they serve.
The interests of investors, hedge fund managers, and counterparties and creditors all benefit from policies that promote sound, competitive, and innovative capital markets.
The second element that is necessary for success is a well-defined philosophy.
Just two weeks ago, the PWG released an agreement outlining its views on private pools of capital. This diverse group of regulators and policy makers spoke with one voice and reiterated its well-defined position that there are two main public policy challenges with private pools of capital: systemic risk and investor protection. They further stated their collective belief that the most effective mechanism to mitigate the potential for systemic risk is market discipline, and that a combination of market discipline and regulatory policies is the best way to protect investors.
The third element of the framework is a well-executed process. Here, the PWG put forth a comprehensive framework based on sound principles and guidelines.
The PWG agreement provides a foundation for how stakeholders should enhance their practices and fulfill their respective responsibilities. The agreement articulates principles and guidelines for each of the four stakeholders: Regulators, Investors, Managers, and Counterparties and Creditors. Let's take a look at the issues surrounding these stakeholders and the policy the PWG articulated for each of these groups.
First, the PWG asserted that regulators should use their existing authorities with respect to creditors, counterparties, investors and fiduciaries to enhance market discipline. The regulators' clear communication of expectations regarding prudent management of counterparty credit exposures to hedge funds is critical. This is especially so given that many managers utilize leverage and complex instruments, including OTC derivatives and structured securities, such as collateralized debt obligations. Derivatives are very useful tools and bring many advantages to our capital markets, but regulators must continue to monitor market developments given the tremendous growth in OTC derivatives and revise their policies and associated guidance, as appropriate.
Recognizing that key creditors and counterparties are organized in various jurisdictions, policy collaboration and coordination among regulators are essential.
We must also recognize the other important role that regulators play. They provide the enforcement mechanisms of our laws. They ensure that every participant is abiding by the rules. So, in addition to providing guidance, the appropriate regulators must vigorously deter and investigate fraud, manipulation, and other misconduct.
Second, the PWG stated that, for more sophisticated investors, private pools of capital can be an appropriate investment vehicle. Hedge funds offer potential benefits to investors, including the opportunity to diversify their portfolios, as some hedge fund strategies have only modest correlations to traditional asset classes. In addition to diversification, these vehicles may offer investors the opportunity for potentially higher returns.
Like any investment, these strategies also introduce risks. These risks range beyond volatility to opacity and complicated valuation and performance calculations. Investors need to evaluate the appropriateness of such investments. The risks associated with direct investment in these funds are most appropriately borne by investors with the sophistication to identify, analyze and bear these risks. As with all investment products, clear and meaningful disclosure is essential for investors to properly evaluate their investment decisions.
Historically, those who invested in hedge funds were high net worth individuals. This has changed over the past five years and today the majority of assets in hedge funds belong to institutional investors, including endowments and pension plans. The PWG established that concerns about indirect exposure of less sophisticated investors to hedge funds through holdings of pension funds, fund-of-funds, or other similar investment vehicles can best be addressed through sound practices on the part of the fiduciaries who oversee such vehicles. Fiduciaries have an ongoing responsibility to perform due diligence. They must continually ensure that their investment decisions are prudent and conform to sound practices, including diversification.
The PWG was also specific in prescribing guidelines for hedge fund managers. Hedge funds as a group have grown substantially over the past five years. They have doubled in number and have had a significant influence globally, and even locally. These deployers of capital exist in large financial services companies and in small boutiques; some are diversified across multiple strategies, others manage concentrated portfolios.
Their growth in number is a testament to the potential rewards that exist. The model creates the opportunity for managers to implement their best investment ideas. It also encourages and incentivizes managers to do so, often with few constraints. They have more flexibility across asset classes and sectors and are not held to an arbitrary benchmark. This flexibility enables managers to focus and take risks based on their specific skill. And if that were not enough, the financial rewards for success are great. Compensation of "2 and 20" can generate a lot of income on even a modest amount of assets under management. But, again there are risks. Besides the challenges associated with investing, including liquidity risk, credit risk and trading risk--there are others, including operational risk, valuation risk, reputation risk, and regulatory risk.
In response to these challenges, managers should deploy sufficient resources to create and maintain information, valuation, and risk management systems that meet sound industry practices. In doing so, managers should provide accurate and material information to creditors, counterparties, and investors with appropriate frequency, breadth, and detail. Managers should also continue to strengthen and enhance their processing, clearing, and settlement arrangements, particularly for OTC derivatives.
Let's turn now to counterparties and creditors. For the most part, this is a group of investment banks that have large prime brokerage operations and commercial banks that act as derivatives counterparties and repo lenders to hedge funds. Collectively, they play a very critical role. While relatively few in number, these entities facilitate the implementation of many of the hedge fund managers' strategies and provide the capital that enable managers to leverage their exposures. Hedge funds now represent a large and growing portion of their client base and bottom line. Hedge fund managers implement strategies that generate significant trading volume, and they provide these banks with the opportunity to create and customize more complex transactions. All of this adds up to not only the possibility for greater financial rewards, but also potential risks.
Chief among these risks is counterparty risk. As a result, these institutions must understand the risks inherent in their clients' investment strategies and operations. They must determine appropriate credit terms. In doing so, they must assess liquidity risk and operational risk. And they also need to be disciplined and independent in quantifying valuations. Importantly, they need to guard against the risks to their reputation. They should expect that their prudential regulators will closely monitor their management of these risks and assess whether their performance is in line with expectations set out in supervisory guidance.
To deal with these challenges, counterparties and creditors should maintain appropriate policies, procedures, and protocols. They should clearly define, implement and continually enhance best risk management practices. These practices must address how the quality of information from a client affects margin, collateral, and other credit terms and aspects of counterparty risk management. Like the managers, counterparties and creditors must also continue to strengthen and enhance the processing, clearing, and settlement arrangements for OTC derivatives.
The PWG principles and guidelines address all market participants. Our focus is on enhancing market discipline since it is a combination of efforts that will most effectively address systemic risk. Here it makes sense to emphasize that, for financial stability purposes, the interests of policy makers and key counterparties are closely correlated. Thus, when these counterparties make appropriate self-interested assessments and decisions, these decisions help to make our system more stable and resilient.
The combination of market discipline and existing regulatory authorities are well positioned to protect investors. The SEC continues to provide strong leadership on this issue. They have proposed raising the accredited investor standard, and already possess broad anti-fraud and anti-manipulation authority to investigate any manager--whether registered or not. I should add that the SEC is proposing an additional anti-fraud provision under its existing authority with respect to defrauding current or prospective investors.
Tackling these issues is complicated. No group has a greater interest, has spent more time evaluating all of the potential options, or is more concerned with addressing the challenges most effectively, than the PWG. If the solution were as simple as granting additional regulatory authority, regulators would have certainly asked for it. The fact of the matter is--at this time, no regulator feels that it needs additional regulatory authority to achieve its goals of protecting investors or mitigating systemic risk.
Although progress has occurred in the past several years, there is much more to do and every stakeholder has a role to play. The PWG has clearly articulated guidance to each group of stakeholders and believes every one of them, ourselves included, must step up their efforts. Diligence breeds excellence. Complacency breeds mediocrity.
The PWG is also committed to ongoing evaluation--the fourth and final element of the framework. The principles and guidelines released two weeks ago are simply another step in the PWG's response to the continually evolving marketplace. The fact that the PWG came together on this topic, and spoke with a unified voice for the first time since 1999, is a significant statement. It was not done in response to a problem or the failure of a large hedge fund or a study requested by Congress. It was a result of Secretary Paulson's and the PWG's leadership. It reflects our desire to be proactive and put forth a practical and forward looking principles-based framework.
Conclusion
While the challenges are real, we believe that implementing a coherent set of best practices is the best way to address them. All stakeholders must be accountable to ensure the integrity of our capital markets. Successful capital markets generate investor confidence.
Investors, because they entrust their capital, deserve protection from fraud and manipulation. They expect nothing more, and should accept nothing less. Potential systemic risks must be identified and mitigated. High-quality standards of excellence must be established, implemented and continually enhanced by all market participants. Transparency matters and timely disclosure of information is critical. Competition is beneficial. In fact, we seek to encourage competition--but we will not tolerate anyone seeking to gain an unfair advantage by compromising the trust and integrity of the market.
It is a privilege to work to ensure the vitality of our capital markets. With such a privilege comes responsibility. To achieve our goals we need to recognize that the responsibility is borne by both the private and public sectors. Building upon the efforts to date, all stakeholders must continue to do more. Collectively, we can strengthen the stability and integrity of our capital markets. The system works when all stakeholders recognize the benefits, mitigate the risks, and choose to be diligent. I urge you to do so.
Thank you for the opportunity to speak here today.