February 27, 2007
HP-280

Remarks of Under Secretary for Domestic Finance
Robert K. Steel
On Private Pools of Capital
Treasury Department Cash Room

Washington, DC- Welcome. I appreciate your being here today.

Last week, the President's Working Group on Financial Markets unanimously moved to enhance hedge fund oversight within our current regulatory system by releasing Principles and Guidelines on Private Pools of Capital. Secretary Paulson, in his capacity as Chairman of the President's Working Group, led this effort. Today, the focus is to provide additional insight into the motivation for releasing the principles and guidelines and to explain the responsibilities we believe they place on all market participants in this industry, including regulators, investors, counterparties and the hedge funds themselves.

United States capital markets are the envy of the world. Our markets are deep, efficient and transparent. Creativity, innovation and entrepreneurship have long been the hallmark of U.S. markets, and their benefits to our economy are clear. Private pools of capital – which include venture capital, private equity, and hedge funds – have helped make us the world's leading financial innovator. As Secretary Paulson noted in a speech last November, private pools of capital are an essential part of what keeps our capital markets the most competitive in the world.

We must be committed to maintaining that competitive edge, and in doing so, continually assess current conditions and areas for change. One sector of our capital markets that has experienced particularly dramatic change in recent years has been the tremendous growth of private pools of capital. This growth has come from two areas: strong performance and the new capital that has been attracted.

Over the years, as the financial marketplace has evolved, public policy views have also adapted. In fact, the genesis of the President's Working Group can be traced back to a market event, when President Reagan formed the Group to study and issue recommendations regarding the events of October 19, 1987. Since then, the Working Group - chaired by the Secretary of the Treasury and composed of the chairmen of three independent financial regulators (the Federal Reserve Board, the Securities and Exchange Commission and the Commodity Futures Trading Commission) - has continued to convene under an overarching, non-partisan mission of maintaining investor confidence and enhancing the integrity, efficiency, orderliness and competitiveness of U.S. financial markets.

The group has periodically provided their perspective on important issues, ranging from over-the–counter derivatives to, most recently, terrorism insurance as specifically requested by the Congress. Almost eight years ago, the Working Group chaired by Treasury Secretary Robert Rubin released a report entitled "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management." That well-received report contained a series of recommendations. Those proposals successfully served to provide a foundation for many of the practices of today. However, much has changed in the intervening period and the President's Working Group strongly believes that now is an opportune time to reinforce the positions of 1999 and provide further guidance.

I will begin by offering some perspective on how the financial markets in the U.S. have evolved, then provide additional context to the recently-released principles and guidelines. It is the strong view of the President's Working Group that two issues, systemic risk and investor protection, are the key areas where policymakers should and must focus their attention. I will conclude with my most important observation: We expect that all four groups of stakeholders, led by the regulators, will adopt and use these principles and guidelines.

Let me also articulate what the principles and guidelines are not. They are not an endorsement of the status quo. Instead, they represent a uniform view from the Treasury Department and the group of key independent regulators that heightened vigilance is necessary and desired to address market developments.

Evolution and Change in the Financial Markets

Markets should connect those in need of capital with those willing to lend or invest. Our modern financial marketplace is vibrant and efficient in matching providers of capital and users of capital. The asset management industry collects capital on behalf of others and seeks to put that capital to work for investors. And today, these investors have a great menu of opportunities to choose from so as to best match their investment objectives.

Our investor base is growing and becoming increasingly diversified. Today's investors have a global perspective, and include both individuals and institutional investors. They include insurance companies, pension funds, endowments, and foundations. It is important to recognize that in many cases, these "institutional" investors represent a collection of individual beneficiaries. While these individuals themselves may not be sophisticated investors, their agents or fiduciaries may expose them indirectly to the benefits and risks associated with complex investment strategies.

The opportunities available to investors are also increasingly varied. Today, they may select from a wide array of investments, ranging from large to small cap equities, value to growth stocks, government to corporate bonds, and high yield to convertibles. The universe of asset classes also includes international securities, currencies, commodities, private equity, venture capital, and real estate, in addition to more conventional stocks and bonds.

As the asset management industry in the U.S. has grown and changed, it has mirrored the interests of the increasingly broad range of investors and all their myriad investment objectives. The largest asset management firms are growing at a dramatic rate. Just five years ago, the average top-ten firm controlled about $500 billion in assets and today that figure is over $1 trillion. Yet other firms remain purposely quite small, so as to engage in niche investment strategies. Some managers are public, others are private; some are broadly diversified while others have expertise in a specific asset class.

The universe of financial instruments that asset managers utilize is similarly diverse and changing. No longer do asset managers simply buy and hold stocks and bonds, but their toolbox includes currencies, forwards, futures, options, swaps, and exchange-traded and over-the-counter (OTC) derivatives. Likewise, the range of the vehicles or structures utilized to implement investment strategies is equally diverse and includes mutual funds, closed-end funds, exchange-traded-funds (ETFs) and limited partnerships.

The point I am trying to illustrate is that our capital markets are quite diverse and evolve at a rapid rate. This diversity of investing and savings alternatives has been good for the American public, the financial marketplace, the U.S. economy, and global stability.

Private pools of capital, which broadly encompass pooled investment vehicles that are privately organized, administered by a professional manager and generally not available to the public, have experienced tremendous growth and dramatic change in recent years. Many of these changes have been well documented:

• In the last five years, the number of hedge funds has more than doubled, growing to over 9,000 funds today.
• Since 1999, hedge fund assets under management have grown by more than 400%, totaling approximately $1.4 trillion.
• Last year, the 100 largest hedge fund firms had combined assets of representing about 65% of the industry total.
• Hedge funds are also generating an increasing share of trading volume. Some experts estimate they may represent up to 50% of trading in certain circumstances.
• The number and nature of investment strategies that hedge fund managers deploy have also continued to grow. There are now over 20 categories of investment strategies.
• Some credit rating agencies have begun to issue public ratings on hedge funds.
• Their clientele, originally wealthy individuals, also has shifted to become one that is comprised much more of institutional investors. According to a study by McKinsey & Company, 2007 will be the first year in which institutional investors account for more than half, 52%, of the flows into hedge funds.
• And the business model has developed an impressively global presence with over 35% of assets managed outside of the United States, and other managers within the U.S. operating funds offshore.

The historical boundary between hedge fund managers and traditional asset managers is now beginning to blur. The distinction between private equity investors and hedge fund investors is also becoming less well-defined, as more hedge fund managers seek to earn the premium associated with less-liquid capital and accept features such as lock-ups and side pockets.

In short, we continue to witness the evolution and increasing importance of private pools of capital specifically and the asset management industry more generally. Significant growth has generated new opportunities and new challenges for investment managers, investors, counterparties, creditors and regulators. This is the context in which the President's Working Group chose to speak out.

Before discussing the principles and guidelines more specifically, let me provide a bit more insight into the motivation for their development, and outline their underlying philosophy.

Managers of private pools of capital are currently regulated both directly and indirectly. Enforcement agencies, like the SEC and the CFTC, have broad, existing regulatory authority on matters such as fraud, manipulation, civil liability and other aspects of market behavior. No manager is exempt from those provisions and none should be.

Many managers conduct much of their business with creditors and counterparties, such as prime brokers and other lenders who provide the managers with additional capital and services. This may help provide flexibility to their investment strategies and facilitate the use of leverage. These corresponding counterparties are explicitly monitored and supervised by a regulator armed with sophisticated risk-management procedures. It was in recognition of this business model that the President's Working Group in 1999 formed its view on the importance of counterparty risk management.

Given the substantial growth in size and importance of private pools of capital since 1999, the President's Working Group believes it appropriate to broaden and update its position. Recently, the Treasury Department conducted a series of educational meetings with stakeholders representing the entire spectrum of the hedge fund marketplace. Representatives from the pension and investment management communities, the accounting, auditing and legal professions, asset consulting firms, fund administrators, commercial banks and investment banks were interviewed in order to review current practices. As a result of these efforts, along with those conducted by and within the agencies comprising the President's Working Group, we decided to offer some fresh perspective and to create a forward-looking, principle-based framework that recognizes the evolving financial landscape and the challenges presented.

As a result, the principles put forth are comprehensive yet flexible. The framework is consistent with the mission of the President's Working Group, and is focused on two key goals: mitigating the potential for systemic risk in financial markets and protecting investors.

The philosophy underlying these principles and guidelines is to encourage and improve transparency and disclosure by pools and managers to counterparties, creditors, fiduciaries and investors, as well as continued encouragement by supervisors to strengthen market and counterparty discipline. However, the President's Working Group recognizes that this transparency, disclosure and supervisory vigilance should not discourage innovation. There are certain strategies and positions which are sensitive proprietary information that managers should not be expected to disclose.

The Working Group's principles and associated guidelines apply to all each category of industry participants: (1) Private pools of capital and their managers; (2) Counterparties and creditors; (3) Fiduciaries and investors; and (4) Regulators or supervisors. Each participant should look to these principles to justify further enhancement of their current practices.

One of the primary areas of responsibility of the President's Working Group is the stability and soundness of the financial market system. Therefore, mitigating potential systemic risk posed by private pools of capital was a key motivation behind the development of these principles.

First, let me be clear on the meaning of systemic risk in this context: it is the potential for financial distress in a particular firm or group of firms to trigger broad spillover effects in a financial market or system. Systemic risk is 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 affect the financial system so significantly that the real economy is adversely affected.

Concerns of systemic risk are more than just theoretical, and we must remain open to the possibility that losses by a highly leveraged institution could threaten the stability of the broader financial system and our economy. These principles and guidelines highlight how this potential risk is best mitigated within the current regulatory framework by market discipline that is developed and applied by creditors, counterparties and investors.

Creditors and counterparties to private pools of capital are generally large and well capitalized. And furthermore, sophisticated financial firms have both the direct financial incentives and expertise to provide for effective market discipline. By ensuring credit terms are appropriate given the risks posed, these institutions limit not only their own potential exposure to losses from default, but also help constrain overall borrowing, thereby decreasing the potential for systemic risk.

We believe that the collective decisions of self-interested and informed counterparties, reviewed by regulators, provide the very best protection against systemic risk.

The principles and guidelines recommend that key counterparties and lenders commit resources and maintain appropriate policies and protocols to define, implement, and continually enhance sound risk-management practices. The guidelines hold that those policies should address how the quality of information from private pools of capital should affect credit terms and other aspects of counterparty risk management. These are not static responsibilities; they are important, capital-intensive, ongoing obligations.

Thus, this is not a green light to go forward with business as usual. A market as dynamic as this one requires concerted updating and review of processes and procedures. Firms should also be willing to make the necessary investment to meet the goals of these principles and guidelines. Knowing these principles have the support of each member of the regulatory community should help facilitate these changes.

In establishing these terms, it is critical that creditors and counterparties undertake effective due diligence before extending credit to a private pool of capital. Once the initial credit is approved and extended, the same diligence should be regularly applied. The initial and ongoing due diligence process should clearly include a review of the counterparty's ability to measure and manage its exposure to market, credit, liquidity, and operational risks. This process should also establish the breadth, detail and frequency of information sharing that will occur during the course of the credit relationship.

The 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. The liquidity of the counterparty's positions should be a factor in exposure measurement, since concentrated or illiquid positions can lead to unexpected exposures in the event of a counterparty default or market volatility.

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.

On a regular basis, counterparties and creditors should seek to obtain from the pool both quantitative data and qualitative information on the private pool's net asset value, performance, market and credit risk exposure, and liquidity. In developing disclosure requirements, the level of detail expected by the creditors should recognize the very legitimate interest of a private pool in protecting its proprietary trading strategies.

These guidelines do not require the disclosure of every position, but reinforce the precept that for market discipline to be truly effective, counterparties and creditors should adjust credit terms where sufficient information is not forthcoming from a particular private pool, which is consistent with a market-based approach.

Federal Reserve Chairman Bernanke, in a speech last year, questioned the usefulness of various proposals for regulatory authorities to create and maintain registration databases containing detailed information about the positions of hedge funds. The Chairman said, "I understand the concerns that motivate these proposals but, at this point, remain skeptical about their utility in practice." He went on to add, "Continued focus on counterparty risk management is likely the best course for addressing systemic concerns related to hedge funds."

The President's Working Group also believes that the executive management of financial services firms with large exposures to private pools of capital have certain responsibilities. Management should institute protocols so they are kept informed of large exposures. They must appreciate the implications of these exposures and possess a commitment to ensure that sound risk management practices are developed and implemented. In doing so, a firm's senior management would seek to ensure that a firm's aggregate exposure to such pools is consistent with its tolerance for bearing losses in adverse markets.

Now let us turn to the investor. One of the more encouraging developments, as it relates to mitigating systemic risk, is the development of better practices as a result of the increasing market discipline brought on by investors, both individual and in particular institutional investors. As institutional investors have become an increasingly important source of capital to private pools, market discipline from investors has increased. Today, institutional investors represent 60% of assets under management in these strategies and the number continues to climb.

Institutional investors in private pools of capital have a responsibility to prudently evaluate the strategies and risk management capabilities of private pools of capital and ensure that pools' risk profiles are compatible with their own appetites for risk. In doing so, they should undertake effective due diligence before investing in a private pool of capital and on an ongoing basis. Due diligence should include a review of the manager's ability to manage its exposure to market, credit, liquidity, and operational risks. These investors can complement the market discipline created by counterparty risk management practices by carrying out effective and robust due diligence, and seeking assurances that the private pool in which they invest complies at a minimum with established industry sound practices, including practices for risk management, reporting, and internal controls. In doing so, they can influence better disclosure and stronger institutional standards and practices within the asset management community.

If counterparties, creditors, and investors are to define and create effective market discipline, they must have access to reliable information. Much of the information can only be disclosed by the managers of the private pools of capital.

As a result, the principles and guidelines encourage managers of private pools of capital to have information and risk management systems that enable them to provide accurate disclosure to counterparties, creditors, and investors with appropriate frequency, breadth, and detail.

This information should be disclosed frequently enough and with sufficient detail that counterparties, creditors, and investors stay informed of strategies and the amount of risk being taken by the pools, and any material changes. The guidance being given to investors is that a lack of information should affect your investment decisions. If you are not obtaining the type of information you seek, you should act accordingly.

Complementing the efforts and responsibilities of the counterparties and creditors, the benefits contributed by investors, and the disclosure provided by the managers, is the role of supervisors.

Here too, our principles are clear and unambiguous. The guidelines encourage supervisors to continue to clearly communicate their expectations regarding prudent management of counterparty credit exposures to private pools of capital, and ensure counterparties take into account new developments in financial markets and advances in credit risk management best practices. In order to do so, supervisors should actively monitor such developments and revise their policies and associated guidance as appropriate in a timely manner. In turn, supervisors should actively monitor and enforce compliance with established policies and guidance regarding counterparty credit risk management with respect to leveraged counterparties. Let me again remind you that all regulators have signed on to this principles-based framework.   Regulated entities should recognize that, although their competition might have a different regulator, they should expect consistent treatment for these broad issues.

Our capital markets continue to become ever more interconnected with other capital markets around the world. No group of investors is more adept at moving capital globally to where it offers the best risk-adjusted return than managers of private pools of capital.

The principles and guidelines were developed recognizing the global marketplace. Since key counterparties and creditors to pools are organized in various jurisdictions, the principles encourage policy collaboration and coordination amongst global supervisors.

The principles encourage supervisors to take full advantage of both formal and informal channels of coordination and cooperation across financial industry sectors and international borders when conducting supervisory activities that address internationally active financial institutions' management of exposures to private pools and leveraged counterparties.

By directly addressing the challenges associated with the activities of private pools of capital, one can see that the principles, if adopted and applied, are designed to serve as a strong and effective check on the potential of systemic risk.

In addition to systemic risk, for the first time, the President's Working Group addresses the difficult issue of investor protection. At the outset, we need to recognize that we are talking about investments that are not offered to just any investor. These are private investment options offered only to certain approved investors.

It is true that many of these strategies and vehicles are by their very nature potentially more opaque, illiquid, and complex than other products. But these facts alone should not by definition suggest that private pools of capital are either appropriate or inappropriate. Private pools of capital can be a suitable investment vehicle in which more sophisticated investors devote an appropriate amount of their assets. Given certain characteristics of these investments, it is prudent for public policy to limit direct investment in private pools of capital by unsophisticated investors, and we applaud the Security and Exchange Commission's recent proposals to raise the investor accreditation standard.

While investors should be neither encouraged nor discouraged from allocating an appropriate amount of their investable assets to private pools, they should certainly be encouraged to understand their investments and the corresponding risks and should not expose themselves to intolerable risk levels.

In addition to individuals, concerns exist about the possibility of a retiree having his or her pension reduced or eliminated as a result of losses from a poorly performing hedge fund investment.

Let's be clear here – hedge funds are not immune to challenges. In fact, we should assume that not all hedge fund strategies are successful at any one time. With as many different strategies as exist today, it should not be news or a surprise when a particular strategy is unsuccessful. Just because a strategy is not working, does not mean more regulation is necessary. Regulation is not designed to ensure the successful performance of investment strategies or prevent losses to investors, and we should be concerned when any regulatory proposal conveys this false impression.

What does matter is that managers disclose risks to investors and investors assess and understand the risks associated with their investments. We therefore need to also ensure the governance and management of the pension plans are as robust as possible. Fiduciaries are the first and most important line of defense for investors who are indirectly participating in private pools of capital. No one should suggest that plan sponsors will not invest in risky assets – in fact they must take risks in order to generate the desired return, but given their fiduciary responsibility, how do we ensure they know what is necessary to fulfill their obligation given the characteristics of many of these strategies?

All investment fiduciaries have a duty to perform due diligence to ensure that their investment decisions on behalf of their beneficiaries and clients are prudent and conform to established sound practices consistent with their responsibilities.

When investing in private pools on behalf of clients and beneficiaries, fiduciaries should consider the suitability of those pools for their clients and beneficiaries within the context of the overall portfolio. As with all investment products and vehicles, clear and meaningful disclosure is essential for investors to evaluate properly their investment decisions. Fiduciaries should therefore assure themselves that the pool and its managers have provided adequate and accurate disclosure prior to investment.

As part of an appropriate due diligence effort, fiduciaries should review and understand the manager's valuation methodologies. A decade ago, they simply relied on having actively-traded securities priced off of independent pricing feeds. That is no longer the case. Many of these strategies today contain illiquid investments – with assets often priced by complex quantitative models….in many instances built by the managers themselves.

Performance calculation processes and business and operational risk management systems employed by a private pool should all be part of the review by investors. In addition, expectations and terms regarding client reporting should be clearly defined in advance of any investment.

Investors are encouraged to evaluate the investment objective, strategy, risks, fees, liquidity, performance history and other relevant characteristics of a private pool. They should evaluate the manager and personnel, and assess the service providers and their independence from the manager. And finally, accurate and timely access to this information should govern investment decisions.

As mentioned previously, private pools of capital provide many benefits to their investors, the financial system and the economy. Their unique characteristics give them the flexibility to pursue investment strategies that make financial markets more efficient and the economy more resilient. However, to ensure that we continue to realize these benefits and, at the same time, mitigate potential systemic risks and protect investors, there are responsibilities that all industry participants must accept, and these principles and guidelines highlight the responsibilities for each of these four groups of industry participants:

• Regulators and Supervisors: The first group of participants – regulators and supervisors – is expected to communicate their expectations regarding counterparty risk management practices and use their authority to enforce these expectations. Regulators and supervisors should continually refine and augment their policies to reflect market developments, and use anti-fraud and anti-manipulation authority to preserve and enhance the integrity of our capital markets.
• Counterparties and Creditors: The next group – counterparties and creditors – should commit sufficient resources and maintain appropriate policies to implement and enhance sound risk management practices, including appropriate and effective due diligence, frequent measurement of credit exposures, stress testing, and prudentially established credit terms.
• Private Pools of Capital: Third, private pools of capital should themselves create and maintain information, valuation, and risk management systems that provide counterparties, creditors, and investors with accurate, sufficient, and timely information.
• Pool Investors and Fiduciaries: The fourth group – investors and fiduciaries – should always consider the suitability of investments in private pools of capital in light of their investment objectives, risk tolerances and the principle of portfolio diversification. There are special obligations for investors with fiduciary responsibilities who are investing on behalf of others. Their standard of diligence should be an especially high one.

These principles and guidelines encourage transparency and disclosure by pools and managers to counterparties, lenders, creditors, fiduciaries, and investors, as well as continued encouragement by supervisors to strengthen market and counterparty discipline.

Over the past several months, the President's Working Group - both at the principal and staff levels - has been carefully assessing these issues. Our efforts encompassed not just the four agencies of the President's Working Group (Treasury, Federal Reserve Board, the SEC and the CFTC), but also the Federal Reserve Bank of New York and the Office of the Comptroller of the Currency. Treasury would be remiss in not acknowledging the substantial contributions of all our colleagues who worked to develop these principles and guidelines.

We evaluated both the benefits and challenges these pools pose to investors, our capital markets, creditors and counterparties, and regulators. While seeking to address these challenges, we explicitly developed the principles to preserve the many benefits these investment strategies contribute to our capital markets but also to provide a fresh perspective.

Today's capital markets are global and competition is fierce. The two largest and most important markets, the U.S. and the U.K., share a similar regulatory philosophy. The goals put forth by these principles align with the approach used by the Financial Services Authority in the U.K. So we are endorsing a principle-based approach that is consistent with a global perspective.

Private pools of capital play an important part in our economic system and bring many benefits to our markets. They provide a vital role by materially enhancing market liquidity. Also, by bringing information to markets, they enhance market efficiency and are a crucial ingredient in the price discovery process. Private pools help to segment and disperse risk and also help foster innovation in developing new risk-management tools and techniques. They generate substantial transaction volumes and introduce significant leverage into the system. Furthermore, these pools are also beneficial to investors, as they potentially offer diversification benefits and attractive Sharpe ratios. And, as a result of these innovative investment vehicles, new businesses begin, existing businesses expand, and new jobs and opportunities are created.

The growth of private pools of capital has promoted efficiency, liquidity and risk dispersion in capital markets. Yet, whenever something is growing quickly, it bears periodic review. With the many benefits brought by the growth of this industry also come some new challenges. The Working Group's recently released principles and guidelines highlight how risks posed by private pools of capital are best addressed through market discipline, disclosure and transparency, not through new laws, regulations or registration.

So far, these principles and guidelines have been extremely well received by policymakers, regulators, industry leaders and the general public, both in the U.S. and abroad. Yet, a vocal few have criticized our recommendations, calling them "vague" and "unenforceable," and sought increased authority for federal regulators.

Some had a similar reaction to the 1999 President's Working Group report. Then as now, we reject calling for more regulation just for regulation's sake. That being said, the Working Group does believe there is work to be done. However, altering the current regulatory structure is not the remedy.

The President's Working Group did not view this issue through an anti-regulatory lens. In fact, if the Group believed that our regulators needed more authority to address these issues, Secretary Paulson would have led the charge in asking for it. However, as I hoped to convey in these remarks today, the issues and challenges presented are complex and, unfortunately, will not be solved with a one-time regulatory fix. After serious and open-minded debate, we came to the conclusion that the principles and guidelines released last week provide the best answer.

Given the rapid changes in market strategies and instruments, the President's Working Group believed the public will be best served with a flexible, principles-based approach that applies to more than just a snapshot in time.

These principles emphasize that the stability and integrity of our capital markets are a shared responsibility between the private and public sectors. Concerns regarding systemic risk and investor protection posed by private pools of capital can be addressed most effectively through market discipline and a balanced regulatory approach, with supervisors utilizing their existing authority.

Private pools of capital were born here in the U.S., and this country remains their largest home. This industry exemplifies the competitiveness and innovation that make our capital markets the strongest in the world. A thriving, competitive hedge fund industry brings many benefits to the U.S. economy, and our aim is to continue providing a welcome environment for these investment vehicles.

We envision these principles and guidelines serving a constructive purpose, and my colleagues and I will continually monitor and assess their effectiveness and the market response.

Thank you. I now have a few minutes to answer two or three questions.