March 9, 2006
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Remarks of Emil E. Henry Jr.
Assistant Secretary of the Treasury
Before the Fixed Income Forum
"Hedge Funds and Derivatives Markets: History, Issues, and Current Initiatives"
March 9, 2006

Good afternoon. It is a pleasure to be here with all of you. Thank you for the invitation to speak today. Before coming to Treasury, I spent the last 20 years on Wall Street, as an investment banker and also founder of investment organizations including a hedge fund business. This is my first public service position. And although I am truly enjoying my time at Treasury, I probably do not have to tell you that Washington is very different than Wall Street. So, in a sense, I feel very much at home addressing people like yourselves who manage money and whose livelihood is tied directly to the financial markets, asset allocation and profitable investment decisions.

One of the reasons the Administration asked me to come to Washington was because of the importance of having Wall Street expertise at Treasury. It is critically important for the government to stay ahead of the curve on issues like financial market system risks, especially systemic risks inherent in new and growing vehicles populating our complex and rapidly evolving capital markets. While this might not be the topic du jour in DC, if things start to go wrong, then I can guarantee you that it will be.

With that in mind, I wanted to take our time together today to talk about two interrelated topics: hedge funds and derivatives.

As you know, in the last few years, hedge funds have garnered much attention in Washington, largely the result of the Securities and Exchange Commission's rulemaking to bring hedge fund advisers further within the SEC's regulatory reach. Despite all of the attention directed towards this asset class in recent years, there is still significant misunderstanding surrounding it. Therefore, please accept my perspective as a Wall Street investment practitioner who also happens to be a Washington neophyte.

As you likely know, hedge funds represent about a trillion dollars of capital today. While the growth of hedge funds has not been perfectly linear, you can expect that the space will continue to grow. To understand why, it helps to look at how we got to where we are.

Hedge funds found their genesis in entrepreneurs reacting to the Investment Company Act of 1940's restrictions and limitations inherent in more traditional forms of money management. For example, mutual funds typically invest only in `long' positions, must be nearly 100 percent invested at all times, and might be further limited by a fund's charter's restrictions – for example, a health care mutual fund may only invest in health care equities. Other traditional money managers often place these very same restrictions upon themselves.

A hedge fund, by contrast, has virtually unlimited flexibility. All strategies are on the table - long positions, short selling, leveraged holdings, equities, bonds, currencies, derivatives, multiple industries, etc. All of these approaches are available and widely utilized by the hedge fund community. Because capital tends to gravitate to where it is least encumbered and restricted, and hence earns the highest risk-adjusted return, it is not surprising that capital migrated from traditional funds to hedge funds. Of course, like most things in life, one thing's greatest strength is often its greatest weakness. The great flexibility of the hedge fund structure also lends itself to conduct that can lead to trouble, the most common being outsized risk-taking, concentrated positions and over-leveraging.

Initially, hedge funds were solely the province of sophisticated high net-worth investors comfortable with the risk profile of such funds and lacking the risk aversion of the institutional investor class. During the 1990s, however, the growth of hedge funds began in earnest both in the size of the asset class and the profile of investor choosing to access the class. Such growth now has an inexorable feel of inevitability. It is a legitimate asset class widely sought out by institutions and validated by a vast community of pension consultants.

Why did this happen? For a number of reasons, all driven by the power of free-market capitalism. As the rising equity tide of the 1990s lifted all boats, traditional investment vehicles obviously delivered handsome returns, but alternative asset classes such as hedge funds did even better. It is, after all, not a tall order to beat positive indexes merely by adding leverage. Also, because of far superior compensation structures, skilled asset managers left traditional money management shops in droves to open hedge funds -- the so-called "brain drain". These funds required little infrastructure and offered the potential for outsized compensation.

With the bursting of the bubble, and the ensuing 3 year decline in equities (2000-2002) many hedge fund watchers anticipated the "unclothing" of the legions of newly-minted hedge fund stars – the theory being that all the leverage in the system would amplify returns negatively in the downdraft in mirror fashion to the updraft.

Indeed, the opposite happened for a number of reasons.

First, it turned out that those institutions that invested most heavily in hedge funds during this period turned in the best relative returns. For example, sophisticated university endowments, with significant hedge fund exposure, were rewarded handsomely. While they did not shoot the lights out, those endowments most heavily allocated to hedge funds actually turned in positive returns amidst the market meltdown. Their hedge fund managers, it turned out, exploited their natural flexibility to short stocks and, importantly, move to cash during market dislocations limiting exposure and mitigating loss.

Secondly, the endowment phenomenon did not go unnoticed by the broader investment community that was in tatters. Pension funds with traditional exposures – say 60 percent bonds, 40 percent equities – were devastated during this period of strain. The stark contrast of performance between the sophisticated endowment community and pensions put a white hot light on the protection ostensibly afforded by hedge funds in times of trouble.

Third, the underperformance of pension funds caught the attention of corporate CEOs. The corner office, often oblivious to sleepy pension activities, suddenly woke up to demonstrable negative returns that impacted that which CEOs hold dear: their income statements and earnings per share.

When the smoke cleared and the dust settled, the wrenching dislocation of the early millennium served, in a way, to define hedge funds, and many in the investment community – rightly or wrongly -- drew the following conclusion about hedge funds: they will reward you in good markets and protect capital in bad markets. A recipe for superior risk-adjusted returns.

That rubric, music to the ears of the institutional pension fund community, served as a catalyst for growth. The necessity to meet actuarial return targets and match liabilities drove pension interest in an asset class that held out the alluring possibility of delivering year-in year-out, positive, absolute-type returns. As a result, the pension community likely will continue to pour capital into this space. And when the pension community validates an alternative asset class, a flood of capital follows.

Even with the notable demise of LTCM, highlighting the "headline risk" and potential embarrassment it entailed for hedge fund investors, pensions are increasingly comfortable with the asset class because they recognize that market forces have acted in response to many of the concerns that lead to LTCM's doom. For example:

• Counterparties became more disciplined about extension of leverage and collateral requirements;
• Capital became more reluctant to seed a new hedge fund comprised of the proverbial "Three guys in a garage";
• Investors now demand transparency (you may recall that LTCM principals notoriously provided little, if any, transparency);
• There is now a more profound recognition among hedge fund professionals that liquidity is, indeed, king and that in its absence, all bets might be directional;
•  Investors recognize the infrastructure requirements of many arbitrage strategists (who seek Street treatment) and demand to see such infrastructure before committing their capital.

So, with all of the uncertainty in our financial marketplace, one thing seems likely: hedge funds will continue to grow.

I do not share the view of some in Washington that just because something is large and growing it needs to be feared. Indeed, market driven growth, as we have seen in the hedge fund space, is a reflection of healthy and functioning financial markets.

Instead, perhaps what we should fear most is the paucity of knowledge and/or interest around a space that is so dynamic and worthy of our attention. And of course, we must guard against knee-jerk impulses that might impede the growth of an asset class that adds to the efficiency and liquidity of our capital markets. Instead, fact finding and education are necessary threshold steps prior to a political response. As economic thought leaders, the Treasury is well served to take a closer look at this important subject.

So with that fact-finding framework in mind, at Treasury, we are asking: what impact will the growth of hedge funds have on our financial markets? The SEC – asking the same question -- concluded that this growth presented investor protection issues that needed to be addressed. I am not here to opine on that decision. I do believe that Treasury needs to look at the growth of hedge funds differently. From our perch at Treasury, we have the ability to study and analyze the financial markets broadly. We should look to see if the explosive growth of this asset class presents systemic concerns that require a proactive approach.

One area that deserves our attention is the nexus of the over-the-counter (OTC) derivatives markets with the hedge fund community. As an asset class, hedge funds are among the largest users of OTC derivatives, especially credit derivatives. This significant investment in credit derivatives by hedge funds presents overall market considerations that merit our attention.

In order to appreciate fully the ramifications of hedge fund growth, we need to understand the dynamics of the OTC derivatives marketplace and how that marketplace is changing. Like hedge funds, derivatives suffer from a lack of understanding by many in Washington and for that matter on Wall Street. Most acknowledge their complexity and this complexity breeds a certain amount of skepticism and fear. I think Jerry Corrigan said it best when he said "Derivatives are like Major League Baseball pitchers; they get too much of the credit and too much of the blame."

As we explore issues in and around derivatives, we must not forget the multitude of benefits derivatives provide our financial system and the economy as a whole. Most notably, they provide opportunities to measure, manage, distribute, and transfer risk. They are significant and important risk management tools.

At the same time, as in many fast growing markets, there are questions at times about the availability of information and the adequacy of market infrastructure and market practices. Regulators face a delicate balancing act in developing policies that encourage financial innovation and competition and that also foster financial stability and well-functioning markets.

Just for some perspective, let me briefly note the long and colorful history of derivatives:

The existence of derivatives, in the broadest sense, dates back to Biblical times. The first exchange-traded derivatives are thought to have been traded on the Royal Exchange in London around 1565. The first futures contract apparently originated at the Yodoya rice market in Osaka, Japan around 1650.

Two hundred years later, the dramatic growth in the derivatives markets began much closer to home. The Chicago Board of Trade and the predecessor of the Chicago Mercantile Exchange were formed in 1848 and 1874. Given the enormous uncertainties faced by farmers and ranchers, the CBT and CME initially developed around contracts based on agricultural products. Financial derivatives took off in the 1970s when the CME and CBT--spurred by the surge in interest rate and exchange rate volatility during the 70s--introduced a number of contracts allowing investors to better hedge interest rate and exchange rate risk.

Advances in technology and in pricing models, most notably the Black-Scholes option pricing model in 1973, contributed greatly to the further growth of derivatives. During the 80s, market participants increasingly recognized the benefits of derivatives in hedging and risk management. Indeed, for the first time, derivatives became an important part of business school curricula.

During the nineties, we experienced some notable setbacks. Large derivatives users, such as Procter & Gamble, Orange County, and Barings Bank suffered large losses due to derivatives usage. These episodes spurred regulators and market participants to develop improved trading practices and conventions.

Because of the nature of derivatives our data is not precise, but the International Swap and Derivatives Association (ISDA) estimates that the notional value of global derivatives contracts today is about $219 trillion. It has grown from $29 trillion in the 1997 and $866 billion in the 1980s. One specific and important segment of the huge OTC derivatives market--credit derivatives has attracted a great deal of attention lately.

The birth of credit derivatives can be traced back to the 1980s with the introduction of collateralized debt obligations (CDOs). It is interesting to note that the growth of credit derivatives was, in part, the unintended consequence of a regulatory action – the Basel I Accord in 1988. The Basel I capital rules created incentives for banks to use credit derivatives to manage their exposure to corporate loans. Banks could transfer credit risk to entities that were not subject to the Basel capital requirements, while retaining ownership of and returns on such loans.

Thus, in the early 1990s, non-bank counterparties such as hedge funds, insurance companies, financial guarantors, securities firms, asset managers, and even some pension funds became active in this market. The market fully matured into a truly liquid market in 1999 when the ISDA developed standardized documentation for these transactions.

Although the notional value of all credit derivatives is estimated to be about $12-13 trillion, or only about four or five percent of financial derivatives, they have been the fastest growing segment, roughly doubling each year. This has resulted in some "growing pains," as the trading, processing, settlement, and legal infrastructures struggle to keep pace with product development and growth in volume. Policymakers have been actively working with industry to work toward a robust market infrastructure for credit derivatives. Some positive developments on that front -- indicating a market that is properly adjusting include:

• The Federal Reserve Bank of New York has initiated a project to improve trade confirmation and assignment, particularly with respect to credit derivatives. Processing backlogs of unconfirmed trades have been reduced by 54 percent since September 2005.
• The "Corrigan Group" has released two reports, and held a symposium last week, that contained recommendations related to trade processing, technological developments, and enhanced risk management, particularly regarding risk pricing and modeling, collateral, stress testing, transparency, and concentration risk.
• The new Basel II Accord recommendations are expected to clarify certain permissible uses of credit derivatives, which are expected to increase Asian bank participation.
• BIS's Committee on Payment and Settlement Systems has formed a working group to assess broader settlement and payment issues, and hopes to release a report in early 2006.
• The FASB has proposed rules that would make the accounting treatment of Credit Linked Notes more favorable.
• ISDA has sponsored two voluntary industry-wide protocols.
• And lastly, there are private-sector initiatives such as the Depository Trust and Clearing Corp. expansion of its automated bilateral confirmation service Deriv/SERV and its plan to create and provide a central database to record every CDS transaction as early as June 2006.

These are all very heartening developments and proof of self-correcting free market capitalism at its best.

Many of these efforts are focused on market infrastructure and operational risks. But there are broader financial stability issues associated with credit derivatives as well, particularly in connection with the activities of hedge funds.

As I mentioned earlier, the hedge fund asset class is very large – about a trillion dollars. The derivatives to which they are counterparties to is an even larger number. These kinds of numbers should make anyone stand up and take notice.

Treasury is seeking to be proactive here. We are not expecting or responding to a particular crisis, but trying to prevent one from occurring. And the best way for us to be prepared is to ask a lot of good questions. Let me share with you some of the questions to which we are seeking answers.

• What are the unintended consequences of hedge fund growth on competition for lending and the provision of private equity?
• Is leverage properly disclosed for transactions such as credit default swaps in which no money is actually borrowed but where there can be high implied leverage?
• Do our largest financial institutions properly value and disclose their derivative exposure?
• Is the settlement infrastructure – even with recent attention and modification -- capable of handling the volume of activity in a manner that does not create undue risk – especially in a meltdown environment?
• Do counterparties such as banks and prime brokers take a false comfort in their myopic views of their individual exposure to and collateral with an individual hedge fund when there is little transparency on the broader financial community's aggregate exposure to that very same fund?
• Can the regulatory regime keep pace with the quickly evolving marketplace? Even so, will our oversight system devolve into tacit acceptance of the risk metrics they are provided.
• Are investment managers using derivatives to create near-term return in "hail Mary" fashion at the potential expense of their entire franchise?
• As prime brokerage grows to meet the needs of the hedge fund community, will such providers increase leverage and relax collateral requirements as these are their principal means of competition?

As we evaluate these questions, we also need to evaluate our current regulatory framework to ensure that this framework provides us with the tools and the information we need to get the job done. We seek to understand, in the most comprehensive way possible, whether and how changes in the structure of the financial services industry that I have referenced today have affected the way markets operate. Put another way, we need to examine whether the growth of certain types of institutions or instruments like hedge funds and derivatives have materially affected the manner in which markets intermediate risk, whether risk is placed or pooled in different ways or different places than it has been in the past – and if so, what appropriate policy responses might be.

For example, as Tim Geithner of the NY Federal Reserve Bank noted in a recent speech, the growth of non-bank participation in the financial sector and the increasing development of legal "technology" to allow the creation of similar economic relationships through instruments of quite different legal character creates a very real possibility of regulatory arbitrage, thus limiting the effectiveness of safety and soundness regulations promulgated for only one type of regulated entity. Furthering the already well-developed cooperation between our own national regulators, such as the Fed, the SEC, and the CFTC, will be useful, but when the additional challenges posed by the growth in capital accumulation vehicles that are quite lightly regulated and the increasing global integration of financial activity are factored in, the challenges for the regulatory framework become greater. The fundamental question we must be focused on is ensuring that we strike the right balance between the costs of regulatory fragmentation and the benefits of regulatory competition. These are very difficult issues, but they are ripe for discussion.

As the Treasury focuses in on these issues, it is important to emphasize that we need the private sector's continued help with these endeavors. We are eager to work closely and cooperatively with industry representatives to ensure we make the most informed judgments.

In this regard, I would like to announce that I plan to host a series of meetings – symposiums if you will – with the private sector over the next 12 months. In these candid, off-the-record discussions, I would like to discuss some of the questions I have raised here. I would welcome your suggestions as to participants. I expect that these will be wide-ranging fruitful discussions. Here at Treasury we have the unique ability to bring informed policymakers to the table. With the assistance of groups like yours, we can have the right members of the financial community there as well.

Thank you for the opportunity to be with you this afternoon, and I would be happy to take questions.