June 11, 2007
hp-450

Treasury Assistant Secretary for Financial Markets
Anthony W. Ryan
Remarks before the
Managed Funds Association Conference

There must be 300 people in the audience and collectively, you represent a significant portion of the approximately $1.4 trillion in assets under management in hedge funds.  In addition, hedge funds represent anywhere from 30 to 60 percent of trading activity, depending on the asset class or instrument.  No wonder there has been a lot of discussion regarding your impact on the financial markets.  Private pools of capital bring many advantages to our capital markets but also pose challenges including systemic risk and investor protection. 

While it is important to address both of these challenges, I would like to focus on the issue of systemic risk.  We will never eliminate the potential for systemic risk, but we can seek to reduce the probability of it occurring and its impact.  My purpose today is to sensitize all of us as to how systemic risk operates and urge all stakeholders in our capital markets to take the necessary steps to implement policies, procedures and efforts to mitigate it.

Numbers

Let me begin by offering an observation.  You like to quantify and measure things.  You quantify returns, risk, hurdles, assets under management, leverage, spreads, premiums and discounts, drawdowns, locks ups and let's not forget fees.

Why do people like to quantify things so much?  I would argue that people gain comfort in being able to define and measure certain characteristics.  In doing so, they seek a framework and perspective in which to make assessments, draw comparisons and make forecasts – frequently with a great deal of conviction. As a group, you've gotten to be pretty good at defining characteristics and measuring them. 

That being said, I know you're a competitive lot and do not like to be outdone, but another group has you beat.  Like you they are passionate and committed to their pursuit.  This group also keeps copious and meticulous records, and makes fervent prognostications.  The group that I speak of is baseball fans.

In the investment community, one of the hardest things to do is to produce returns with the least risk possible, hence the frequently mentioned goal of a high Sharpe ratio.  In baseball the same is true.  Players seek to get hits with the least outs possible with the ultimate goal being a high batting average.

Now baseball has been played for a long time.  Players get several "at bats" per game and they play a lot of games in a season.  As a result, there is no shortage of observations. 

So how do hitters fare?  Admittedly, hitting a major league pitch is a tough thing to do.  It is also perhaps unfair to make comparisons across history.  Think about how many more eligible players there are today and how well trained they are versus when the game began over 100 years ago.  Because you like to measure things, let me share some numbers with you.  The batting average for the entire major league from 1876-1890 was .259.   Now, one hundred years later, despite all of the changes, the major league batting average for the decade ending in 1990 was .259.[i] 

All of those games, all of those at bats, and the league batting average did not change 1/1000.   But, something did change during that period.  During the first few decades of play, there were 34 different batters that had a season batting average over .400.[ii] Then, 11 years went by without a single player accomplishing the goal.  Finally, in 1941, the Boston Red Sox' Ted Williams batted .406.  During the last 65 years not a single major leaguer has batted over .400.

I know that getting 4 out of 10 investment decisions correct on average is unlikely to generate stellar returns, but in baseball it's likely to get you a ticket to the Hall of Fame.

Now most of you probably have never heard of Stephen Jay Gould.  He was not some great hedge fund manager or professional baseball player, but he was a prominent evolutionary biologist and Red Sox fan.  He postulated that like many other species through time, the .400 hitter has become extinct.   Using statistical measures – many of which are the same used by so many risk measurement systems and trading desks today – he concluded that .400 averages were simply outliers in the overall distribution of averages.[iii]

Gould wrote, "[V]ariation in batting averages must decrease as improving play eliminates the rough edges that great players could exploit."[iv]   There has been a compression of talent towards the league average; hence, the "tails of the distribution" have shortened because of better play.  This is true for the best batters, as well as for those batters with the lowest averages.  All players' batting averages moved towards the mean, despite the mean not moving over time.  It is something to think about. 

PWG

Let me return to hedge funds.  As I am sure you are all aware, the policymakers and regulators comprising the President's Working Group on Financial Markets (PWG) have evaluated hedge funds over the years.  The PWG is chaired by the Secretary of the Treasury and also includes the chairmen of the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission, and the Commodity Futures Trading Commission.  Since 1988, the PWG's overarching, non-partisan mission has been to maintain investor confidence and enhance the integrity, efficiency, orderliness, and competitiveness of U.S. financial markets.

Earlier this year the PWG released an agreement outlining its views on private pools of capital, which include hedge funds. The PWG stated its collective belief that the most effective mechanism to mitigate systemic risk is market discipline and that a combination of market discipline and regulatory policies is the best way to protect investors.

As I mentioned at the outset, I'd like to confine my remarks this afternoon to the issue of systemic risk.

Systemic Risk

Systemic risk can be defined as the potential that a single event, such as a financial institution's loss or failure, may trigger broad dislocation or a series of defaults that impact the financial system so significantly that the real economy is adversely affected.

Some may posit that the increasing sophistication of risk management systems coupled with other developments and efforts has placed systemic risk on the endangered species list.  For supportive proof they point to the lack of extensive ripple effects upon the financial markets following some relatively recent shocks.[v]

I'd like to elaborate why, given market conditions, I believe that subscribing to this thesis is both potentially misleading and imprudent.  Let's begin with answering the question: how could a systemic risk event manifest itself?   Meteorologists describe atmospheric conditions conducive to producing a perfect storm.  What are the atmospherics for a perfect financial storm?  While there would be several, let me name a few: easy credit and leverage, highly correlated strategies, connected and concentrated lenders, inadequate information, and underdeveloped financial market infrastructure.  Let's look at those elements more closely.

Credit and Leverage

We must understand the impact of the remarkable surge in liquidity available today to borrowers, such as private pools of capital.  Interest rates around the world are low and the competition to deploy this capital has evidenced itself in numerous ways including declining lending standards.  Institutions and investors have exposure to balance sheet leverage, and perhaps more importantly, embedded leverage as a result of both simple and complex strategies and instruments they utilize.  We must ensure that the implications of this degree of leverage are well understood.

Correlations

We should also consider the increase in the correlation of returns among hedge funds.  Returns moving in the same direction when facing similar market conditions could suggest an increasing concentration of risk.  Many will recall almost 10 years ago, the markets received a real shock when a highly levered hedge fund imploded as its diversification strategy was compromised by just such an occurrence of rising correlation.

In fact, we are seeing a rise in correlation of returns among hedge funds today.  The Federal Reserve Bank of New York recently commented on this and appropriately highlighted an important difference between the rising correlation of returns we witnessed a decade ago with what we see today.  The recent increase in correlation results mainly from a decline in the volatility of returns, while the earlier rise was driven by high covariance.[vi]  On the one hand that is comforting, but we need to appreciate that covariance can increase and correlations can change during periods of market stress.

Connectivity and Concentration

We must also appreciate the concentration among counterparties and creditors. A few large financial institutions serve as the principal counterparties and creditors to hedge funds.  The concentrated and connected network of these core financial institutions raises the specter of a major market event having a systemic impact.  This March, E. Gerald Corrigan, chairman of the Counterparty Risk Management Group, stated "the potential damage that could result from such shocks is greater due to the increased spread, complexity, and tighter linkages that characterize the global financial system."[vii]  Although these sophisticated institutions have improved their capital positions and risk management practices over the past decade, there is room for additional improvement.

Inadequate Information

The availability of information also plays an important role.  Only with accurate and timely information can counterparties, creditors, and investors understand and adequately assess their risk exposure.  Much of this information can only be disclosed by the managers of the private pools of capital.  If investors, counterparties and creditors are to define and create effective market discipline, they must have access to reliable and timely information.

Financial Market Infrastructure

It is also critical that we appreciate the importance of our financial systems' underlying structure.  It facilitates liquidity.  It includes the market-making capacity and the system for clearing and settlement of financial transactions.  Market infrastructure must adapt quickly to product innovation and increasing trading volume.  Not having effective and rapid clearing and settlement procedures could stimulate a systemic contagion effect if there were a failing counterparty or highly leveraged market participant.[viii]   

The state of these conditions contributes to defining the atmospheric environment for a systemic risk event.  We must now ask ourselves: Should we be concerned about systemic risk?

Returning to Gould

Let me return to Gould's prior conclusion regarding the .400 hitter.  Recall, he postulated that because of the better play, there has been a compression of talent towards the overall league batting average; hence, the tails of the distribution of individual players' batting averages have shortened.  As a result, the .400 hitter is extinct.

Could our capital markets practices' better play have influenced the distribution of risk events such that the tails of the distribution have shortened?  It is true that the dispersion of risk is greater.  The presence of so many derivatives strategies and instruments do help to hedge risk, and markets have adjusted to "tremors."  At the same time, we can also observe that the capital markets, with a few periodic exceptions, are not pricing risk and future volatility anywhere near close to long-term averages.[ix] 

Stakeholders in our markets must not operate under the false illusion that systemic risk is not a real possibility.  Whether examining batting averages or financial market risk, we must account for the possibility of outliers. 

Let's take it a step further.  Outliers, by definition, are long tail events.  They are distant from the norm.  But not all outliers, or long tails, significantly impact the norm.  Another .400 hitter would be a long tail event, but it would not significantly impact the overall major league batting average. 

When an outlier is impactful, it is considered a fat tail.  Look at baseball salaries. On a prorated basis, the New York Yankees will pay Roger Clemens $28 million this year.  That is almost seven times the average salary of his teammates, and as such, has a real impact on the team's average compensation. No wonder fans call Clemens the Rocket!

So, the long tails of some distributions may also be a lot fatter than people frequently assume.  Besides baseball salaries, there are many other data series where the distributions are anything but normally distributed.  Look at "book sales per author…populations of cities…numbers of speakers per language, damage caused by earthquakes, deaths in war, deaths from terrorist incidents…or the sizes of companies."[x]

Could the same be true of capital markets, commodity prices, inflation rates, and economic data?  If so, what are the implications?   What if such events occur with much more frequency than people recognize, and what are the consequences if we do a particularly poor job in preparing for them?

One student of such distributions is Nassim Taleb.  He defines an occurrence such as a systemic risk event as follows: "First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility.  Second, it carries an extreme impact.  Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable."[xi]

If we can not predict a systemic market event in advance, and we seek to reduce the impact of such an event, we must prepare.[xii]  The PWG's Principles and Guidelines released last February are a call to action to foster preparedness.  They direct all stakeholders to undertake efforts that seek to mitigate the likelihood and impact of a systemic risk event.[xiii]

These Principles and Guidelines highlight how potential systemic risk is best mitigated within the current regulatory framework by market discipline that is developed and applied by creditors, counterparties and investors. 

Let's return to the environmental conditions that I outlined earlier: easy credit and leverage; rising correlations, connected and concentrated lenders; information flow; and financial market infrastructure.

Credit and Leverage

First, the Principles and Guidelines call upon financial institutions to determine appropriate credit terms.  In doing so, they must assess market, credit, liquidity and operational risk.  Financial institutions also need to be disciplined and independent in quantifying valuations.  Importantly, they need to guard against the risks to their reputation.  They should expect their prudential regulators to 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 must maintain appropriate policies, procedures, and protocols.  They must 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 other aspects of counterparty risk management. 

Correlations, Connectivity and Concentration

In terms of combating the network effects of increased risk concentration, the PWG guidelines encourage lenders to private pools of capital to frequently measure their exposures, taking into account collateral to mitigate both current and potential future exposures.   Credit exposures, in addition to being measured frequently, should also be subject to rigorous stress testing, not just at the level of an individual counterparty, but also aggregated across counterparties and should consider scenarios of adverse liquidity conditions.  The liquidity of the counterparty's positions should be a factor in exposure measurement, since concentrated or illiquid positions can lead to crowded trades and unexpected exposures in the event of a counterparty default or market volatility.

Inadequate Information

A debate has emerged over disclosure.  While the arguments are somewhat confused, the premise is somewhat less so.  Disclosure does help.  The PWG expects enhanced disclosure and communication between three explicit groups: managers and investors, managers and their counterparties, and creditors and their regulators.

Information should be disclosed frequently enough and with sufficient detail that investors, counterparties and creditors stay informed of strategies and the amount of risk being taken.  On a regular basis, investors, counterparties and creditors should seek to obtain from the manager both quantitative data and qualitative information on the pool's net asset value, performance, market and credit risk exposure, and liquidity.

The PWG articulated that regulators' clear communication of expectations regarding prudent management of counterparty credit exposures to hedge funds is also critical. 

Financial Market Infrastructure

Regarding post-trade obligations, managers, counterparties and creditors should also continue to strengthen and enhance their processing, clearing, and settlement arrangements, particularly for OTC derivatives.  This will limit the contagion effect of weak post-trade processes if there is a failing counterparty or highly leveraged institution.

Conclusion

We cannot get lulled into a false sense of confidence because of the increased dispersion of risk, the presence of diverse and flexible instruments and strategies to manage and hedge risk, or the abundance of capital and liquidity characterizing the recent benign market environment.

I began my remarks this afternoon with an observation, so I will conclude with another.  Maybe the tails are longer than Gould thought.  I'd bet that somewhere in the world there is a kid dreaming about being the next .400 hitter.  I have enough suspicion in models and statistics to think the potential for that kid to accomplish that dream is a real possibility.  While I hope it does occur, another .400 hitter may or may not happen.  If it does, it will have a big impact on sports media but virtually no impact on the overall league batting average.

So the tails may be longer than people imagine, and the tails could also easily be fatter.  We must therefore be humble enough to realize that a systemic event in the financial markets cannot be discounted and its impact will be significant.  Preparedness is therefore key and all stakeholders in the capital markets must contribute to the effort.

As Taleb illustrates, fat tail events occur.  When one does, it will be rare, have a big impact, and many experts retrospectively, although not prospectively, will argue it was predictable.   When the next outlier occurs, regardless of its type, let's make sure the experts are commenting on something positive like the baseball player's hitting acumen rather than some systemic event in our capital markets.

Thank you very much.