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Basel Committee on Banking
Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
Chapter 4
Hedge Funds
I. Introduction
While regulators recognise that hedge funds did not cause
the recent crisis, the crisis helped to focus attention on the
systemic role hedge funds may play and the way in which
regulators address the risks they may pose.
The question
is whether hedge funds, particularly the largest, most
leveraged, may pose systemic risks to other markets and the
global financial system in the event of a future crisis.
The question of how best to address these potential risks is
complicated by the continuing debate over whether hedge funds
helped or worsened the international liquidity crisis sparked by
the collapse of housing markets.
On the one hand,
hedge
funds benefit markets by providing liquidity and distributing
risk. On the other, hedge funds are complex investments not
easily understood by investors or regulators, and they operate
across borders, largely free of regulatory restrictions.
Because hedge funds are not required to fully and publicly
disclose their activities and risks, the exact level of risk -
systemic or not - that they may pose to markets and the global
financial system cannot be easily measured by investors or
mitigated by regulators.
Hedge funds
were caught up -
along with other investments and investors - in a crisis that
revealed just how quickly risks can spread across markets.
Hedge fund managers were forced to sell off portfolios to
raise cash as market prices plummeted.
These forced
sales drove down the value of hedge fund holdings, undermining
their credit worthiness, triggering a vicious circle of more
calls on loans, forced asset sales, and further losses. Many
hedge funds suffered losses; a few failed.
In hopes of
mitigating or preventing future crises, the IOSCO helped focus
attention on the risks hedge funds may pose and how regulators
may address them.
In June 2009, the IOSCO published
Hedge Funds Oversight: Final Report and outlined six high-level
principles to enable securities regulators to address the risks
hedge funds pose in a collective,
cooperative, and efficient
way across international jurisdictions while supporting a
globally consistent approach.
The Joint Forum supports
the IOSCO’s efforts and the six principles on the regulation of
hedge funds and their managers.
This report’s analysis
of hedge funds relies on the IOSCO’s work.
But to
leverage the work and to avoid duplication of efforts, the Joint
Forum focused on the macrosystemic and microprudential risks
that hedge funds pose.
The analysis for this report
focuses on four areas of concern.
•
Internal organisation, risk management, and measurement.
Failures in risk management by hedge fund managers can
cause problems for markets and are a matter of cross-border and
cross-sectoral concern.
Yet there is no common or
cross-border understanding of or requirements for how funds are
organised or how fund risks are managed and measured.
•
Reporting requirements and international
supervisory cooperation.
The risks posed by hedge
funds cannot be easily measured by supervisors or investors
because funds are not required to fully disclose their
activities.
The limited disclosure rules that funds do
face vary by jurisdiction and information collected is not
shared by supervisors for hedge funds operating across borders.
• Minimum initial and ongoing capital
requirements for systemically relevant fund operators.
Adequate financial reserves are needed to help fund
operators withstand the risks they incur, ensure their orderly
dissolution, and minimize potential harm to the financial
system.
Not all supervisors require such fund operators
to meet even minimum capital requirements.
•
Procyclicality and leverage-related risks
posed by the pool of assets.
The use of leverage
allows funds to magnify potential returns but also the
exposures, and, consequently, the risks for not only fund
investors, but also the financial system itself.
Supervisors do not constrain the use of leverage by funds.
II. Background
The Joint Forum assessed the risks posed by hedge funds that
may be subject to lesser levels of regulation than other
collective investment funds.
The Joint Forum believes
that the lack of a regime for monitoring and assessing hedge
funds creates a critical gap in the regulatory framework.
Because hedge funds are largely unregulated, they have been
identified, most notably by the G-20, as one of the most
significant groups in the “shadow” banking system.
Supervisors are concerned that failures of hedge funds,
particularly the largest ones, could have an adverse systemic
impact on hedge fund investors and spill over to other financial
institutions and markets.
The IOSCO’s June 2009 hedge
fund report addresses these concerns and identifies six
highlevel principles for regulating hedge funds.
The
following italicised bullets are the high-level principles,
quoted from the report:
i. Hedge funds and/or hedge fund
managers/advisers should be subject to mandatory registration.
ii. Hedge fund managers/advisers which are required to
register should also be subject to appropriate ongoing
regulatory requirements relating to:
a. Organisational
and operational standards;
b. Conflicts of interest and
other conduct of business rules;
c. Disclosure to
investors; and
d. Prudential regulation.
iii.
Prime Brokers and banks which provide funding to hedge funds
should be subject to mandatory registration/regulation and
supervision.
They should have in place appropriate risk
management systems and controls to monitor their counterparty
credit risk exposures to hedge funds.
iv.
Hedge fund
managers/advisers and prime brokers should provide to the
relevant regulator information for systemic risk purposes
(including the identification, analysis and mitigation of
systemic risks).
v. Regulators should encourage and take
account of the development, implementation and convergence of
industry good practices, where appropriate.
vi.
Regulators should have the authority to co-operate and share
information, where appropriate, with each other, in order to
facilitate efficient and effective oversight of globally active
managers/advisers and/or funds and to help identify systemic
risks, market integrity and other risks arising from the
activities or exposures of hedge funds with a view to mitigating
such risks across borders.
The IOSCO report distinguished
hedge funds from other investments as “all those investment
schemes displaying a combination of some of the following
characteristics.”
The following italicised bullets are
quoted from the report:
• borrowing and leverage
restrictions, which are typically included in collective
investment schemes related regulation, are not applied, and many
(but not all) hedge funds use high levels of leverage;
•
significant performance fees (often in the form of a percentage
of profits) are paid to the manager in addition to an annual
management fee;
• investors are typically permitted to
redeem their interests periodically (eg quarterly, semi-annually
or annually);
• often significant “own” funds are
invested by the manager;
• derivatives are used, often
for speculative purposes, and there is an ability to short sell
securities;
• more diverse risks or complex underlying
products are involved.
As recognised in the IOSCO report,
the global financial system is tightly interlinked.
The
crisis demonstrated that systemic risks crystallising in one
country can have a serious impact on the stability of other
financial systems.
A strong argument exists for designing
a framework to monitor and control these risks at a global level
and to favour regulatory convergence across borders to prevent
these risks from causing disruptions.
Addressing these
risks is complicated by the divergent views of the role hedge
funds played in the recent crisis.
Some argue that hedge
funds increased their exposures by leveraging up their
portfolios and added stress on other market participants and the
financial system and that this amplified the asset price bubble
and reduced liquidity.
They cite recent events (eg
pressure on asset prices from forced unwinding) and previous
crises (eg the Long-Term Capital Management hedge fund crisis of
the late 1990s and the Asian currency crisis of 1997) as
evidence that the failure of a fund can impact investors and the
financial system.
Others argue that hedge funds reduced
volatility by selling overvalued assets and buying undervalued
assets.
They contend that hedge funds played an
essential role in maximising the impact of available investment
capital and were victims of a crisis caused by poor risk and
credit management by regulated banks and other financial
institutions.
They argue that 1,500 hedge funds in the
United States closed without counterparty disruption or other
apparent systemic impact to the financial system.
The
Joint Forum believes, however, that the following factors -
acting alone or in combination
- may transmit systemic
risk from hedge funds to other markets through two main
channels.
• Credit risk:
Exposures to hedge funds are important sources of counterparty
risk, especially if a hedge fund borrows from multiple brokers
or is engaged in multiple trading relationships and individual
counterparties do not have a full picture of the hedge fund’s
leverage or of its other risk exposures.
This lack of
transparency may constitute a major obstacle to risk mitigation.
Despite the focus on additional risk controls and
information provided by funds to their prime broker
counterparties following the LTCM crisis, it remains unclear
whether information is as extensive as some counterparties would
need.
• Market risk: A
disorderly or too rapid unwinding of large positions may fuel
market illiquidity, volatility, and a collapse of asset prices.
Although this channel is not confined to hedge funds and
capturing these effects is difficult, large individual hedge
funds and clusters of funds with significant and concentrated
exposures may
have the potential to disrupt markets,
particularly in the event of herding of positions in common
trades.
These two channels contributed to a deflationary
spiral during the financial crisis.
When prime brokers
reduced financing and requested more collateral, hedge funds
were forced to sell assets in declining markets.
This
forced selling led to downward pressure in asset prices, which
led to more collateral calls from the prime brokers.
The
degree of leverage through borrowing, repurchase agreements,
short sales, or derivative products amplified these risks in a
procyclical way.
Even moderate price changes can force
market participants to liquidate positions to meet margin calls,
causing a ripple effect across markets.
Hedge fund
operators (eg the managers or the advisers ultimately
responsible for the undertaking of investment decisions on
behalf of the hedge fund) employ investors’ money and face
traditional principal-agent related problems; their payoff could
theoretically cause them to undertake unreasonable risks.
These compensation arrangements, however, are negotiated
with fund investors.
The incentive to limit the use of
unduly risky strategies is principally the desire to stay in
business but also the desire to attract and retain investors
(those incurring the investment risks).
In circumstance of a
general decline of market prices, improvement of fund
performance may be achieved only by making wide use of leverage,
such as investing in derivatives or employing short selling
techniques.
These strategies may exacerbate negative
market trends, thus further contributing to procyclical effects,
although the closing of short positions is generally
counter-cyclical.
Similar to other market participants,
hedge funds face microprudential risks in performing their
activities, such as market risks, funding liquidity risks
(including possible liquidity mismatches), credit risks
(including default and settlement risks and the disorderly
insolvency of custodians), and operational risks (including
reputation risk as well as legal and compliance-related risks) .
The financial crisis highlighted failures by hedge fund
operators (and many other market participants) with respect to
risk management and due diligence, excessive and concentrated
counterparty risk, and trend-following.
Management of
funding liquidity risks70 proved to be particularly difficult,
especially in situations combining increasing redemption
requests and illiquid asset markets.
Transmission of
shocks may go both ways. As highlighted by the near-collapse of
Bear Stearns and the bankruptcy of Lehman Brothers, the failure
of prime brokers may impair hedge funds, particularly when their
collateral is tied up.
Prime brokers and banks that
provide financing and other services to hedge funds are subject
to both conduct of business and prudential regulations in all
jurisdictions.
This regulation includes standards on
risk management of counterparty risk exposures.
In fact,
as mentioned, the prevailing indirect approach to addressing
risks posed by hedge funds has,thus far, been through
supervision and regulation of relevant regulated counterparties.
Therefore, although counterparties and investors can be a
transmission mechanism for financial distress, the Joint Forum
in this report focuses on existing gaps in the direct prudential
regulation of hedge fund operators and relevant hedge funds.
Trading desks of banks and securities firms, as well as of
some investment schemes operators are subject to internal risk
management functions, regulatory capital requirements, business
continuity requirements and by public disclosure of the firm’s
activity.
Such regulation has not been generally applied
to hedge fund operators.
This report presents a number of
recommendations and, where there was no consensus achieved
within the group, policy options to tackle the risks posed by
the operation of hedge funds and other similar pools of capital
from a prudential standpoint.
It is worth noting that
since most of the concerns relating to the activities of hedge
funds are shared with other categories of market participants
using similar investment techniques, such as comparable types
of less regulated investment fund operators and their investment
schemes, the Joint Forum has developed sufficiently broad
recommendations and policy options.
These recommendations
and options should be applicable to all those operators and
their pools of capital that engage in activities posing similar
risks, regardless to how they are denominated or qualified
domestically.
This approach is aimed at encompassing
existing differences in the definition or legal structure of
hedge funds at the national level, so as to avoid regulatory
arbitrage and contribute to a level playing field.
This
report nonetheless avoids a “one size fits all” approach; these
recommendations are functional enough to be adapted to the
characteristics of the business, to the different type of assets
under management and the specific risks behind the investment
policies or strategies employed.
In addition to general
recommendations applicable to all hedge fund operators, the
report highlights a number of tailored recommendations and
policy options to be applied only to those funds/operators
falling within a specific category (eg systematic use of
leverage, systemic relevance of the fund or the fund operator).
III. Key issues and gaps
These key issues and gaps raise fundamental concerns.
A Internal organisation, risk management, and risk measurement
The effective management of microprudential risks by the
hedge fund manager is a matter of cross-border and
cross-sectoral concern.
Failures in risk management
practises may cause problems for financial markets.
Effective management of risks depends upon a common
understanding of the duties applicable to the fund operators to
address market, liquidity, counterparty and operational risks.
In this particular segment of the industry, in the case of
pools of assets which are managed by an operator, the risks
faced at the level of the fund operator have to be separated
from the risks that arise from the management of funds.
In jurisdictions where such issues have already been addressed,
there are rules requiring the fund operator to implement
appropriate risk management practice and procedures which ensure
that the:
• investments for each fund managed are in line
with the investment strategy, the objective and the risk profile
of the fund, as disclosed to investors;
• risks
associated with each investment position of the fund and their
effect on the portfolio are identified, measured and monitored
at any time;
• investments comply with the liquidity
profile of the fund and with the redemption policy as disclosed
to investors;
• risks associated with counterparty risks
in case of over-the-counter transactions are correctly evaluated
or measured and mitigated;
• risks associated with
positions in derivatives and with the level of leverage are
correctly evaluated or measured and mitigated;
• risks
associated with particular trading techniques such as short
selling are correctly evaluated or measured and mitigated.
The Joint Forum believes that supervisors should consider
establishing minimum requirements for the internal organisation,
risk management, and risk measurement of fund operators.
These recommendations could be considered core
recommendations applicable to all fund operators regardless of
whether they are systemically relevant.
B. Reporting to regulators and international supervisory
cooperation
Currently, regulators have only limited information on which
to assess the risks posed by hedge funds.
Regulators
need to be able to assess clearly and in a timely fashion the
existence and scale of financial risks.
The recent
crisis revealed the need for data collection, and information
sharing between supervisors.
Regulators need this to get
a clear picture of risk concentrations, leverage, liquidity and
the size and volatility of positions.
Weaknesses in this
respect affect the ability to perform proper oversight of
systemic risks and financial stability.
A major obstacle
to the effective monitoring of risks is the different
jurisdictional regulatory reporting requirements and some lack
of cross-border, macroprudential cooperation.
Macroprudential oversight requires not only the collection of
relevant data on leverage, trading activity, risk concentration
and performance, but also the existence of appropriat domestic
and cross-border information-sharing.
The assessment of
potential macroprudential risks to financial stability posed by
the operation of hedge funds supports more comprehensive
monitoring and collaboration by supervisors.
The Joint
Forum recognises the merit of developing a reporting mechanism
that enables collection of cross-sectoral information on a
regular basis on:
• principal markets and instruments in
which systemically important funds trade; concentration of
investments in private and illiquid assets;
• principal
exposures, performance data and concentration of the risks;
• principal exposures and concentration of risks of key
prime brokers and counterparties of systemically important
funds;
• aggregate leverage in all forms, the main
sources of leverage and the main collateral arrangements
employed.
In this respect, the Joint Forum acknowledges
the initiatives currently being undertaken by the IOSCO Task
Force on Unregulated Financial Entities.
In particular,
the IOSCO Task Force is developing principles for hedge fund
reporting.
The IOSCO Task Force on unregulated financial
entities is also considering the development of a common format
for gathering the above information on a regular basis from
hedge fund operators at national level.
The aim is to
gather data in a consistent way in order to enable data from
different jurisdictions to be comparable across different
operators and funds, allowing regulators to have a common view
in relation to the systemic risks that hedge funds may pose.
The Joint Forum could define in more detail which pieces of
information collected would be “relevant” for the purpose of
gathering information related to systemic risk on a
cross-sectoral basis.
To avoid duplication, the Joint
Forum recommends that this is considered further following the
conclusion of the IOSCO Task Force on the reporting of hedge
funds related information.
To foster the pooling of
information on systemic risks and the monitoring of
macroprudential risks at an international level, the Joint Forum
could also devote some effort to discussing whether some
mechanisms and arrangements should exist for sharing information
internationally on a cross-sector basis.
In particular,
regulators from all financial sectors could, subject to
appropriate confidentiality safeguards and national law
restrictions, share information on hedge funds, relevant
operators and key counterparties on a timely and ongoing basis
in order to support effective macroprudential oversight.
These information-sharing mechanisms should assist
supervisors’ ability to evaluate the implications of hedge fund
operations in their jurisdiction.
C. Minimum initial and ongoing capital requirements for fund
operators
The Joint Forum believes that systemically important fund
operators should have adequate financial resources to meet their
business commitments and withstand the operational risks they
incur, depending on the type and complexity of the activities
performed.
The IOSCO Final Report states that “Some
members of the IOSCO Technical Committee believe that adequate
capital requirements are important to ensure that hedge fund
managers can face the risks incurred in their activities and
have less of an impact on the wider financial system. These
prudential requirements should be broadly consistent with those
required of firms with similar business profiles.
Therefore, hedge fund managers should be subject to prudential
requirements that reflect the risks they take (and which are
most likely to be akin to other asset manager requirements),
e.g. operational risk, client money, etc.”
Accordingly,
capital adequacy standards could be designed so fund operators
can absorb losses arising from operational failures (including
compliance, legal and reputation risks) and continue to run,
without damaging investors and without disrupting the orderly
functioning of financial markets.
The holding of capital
also may allow for an orderly winding down of a fund operator in
the event of bankruptcy.
The advantages of imposing
minimum capital requirements are that fund operators could
better cover fraud, operational risks, and increase market
confidence.
There is general acknowledgement that
capital is just one component of regulation, along with other
components such as insurance, compliance, conflicts management,
segregation and custody
of assets.
On the other hand,
raising capital requirements could directly impact on
competition and entry to the marketplace.
Therefore,
there is a need to ensure that any capital requirement should
not be set at unrealistically high levels and could be
calibrated to the nature of the operator’s business.
Imposing capital requirements on a fund operator (which is a
legally distinct entity from the hedge fund) may not cover
systemic risk stemming from the fund itself.
Any capital
requirements applied to a hedge fund operator should be
developed acknowledging the similarities between hedge funds and
other investment schemes.
Any requirements should be
comparable to those that may apply to other operators of
investment schemes, except where justified by the particular
systemic risks assumed by the fund operator to avoid the
possibility of arbitrage opportunities between different types
of investment schemes.
However, capital requirements may
not be necessary for all fund operators in all circumstances.
Such requirements may indeed restrict the formation of
funds while providing only limited protection against fraud.
Capital at the hedge fund operator may not be legally
accessible to fund investors.
If the requirement is on
the fund itself, a capital reserve would prevent a fund from
fully investing in its stated strategy.
In addition,
capital reserves should not be used to protect against poor
investment decisions.
From a systemic risk perspective,
regulators may want to consider only imposing capital adequacy
requirements upon a financial entity whose combination of size,
nature, leverage (including off-balance sheet exposures), and
interconnectedness could pose a threat to financial stability if
it failed.
The capital requirements for such an entity
should maximise financial stability at the lowest cost to
long-term financial economic growth and should reflect the large
negative externalities associated with the financial distress,
rapid deleveraging, or disorderly failure of each entity.
Therefore, capital requirements should be strict enough to
be effective under stressful economic and financial conditions.
Entities should be required to have enough high-quality
capital during good economic times to keep them above prudential
minimum capital requirements during difficult economic times.
In addition to the capital adequacy requirements described
above, regulators may mitigate risk through other approaches
focused on hedge funds or their operators.
For example,
there should be regulation of systemically important payment,
clearing, and settlement systems.
Regulators also could
require that all standardized over-the-counter (OTC) derivatives
are cleared through regulated central counterparties (CCP).
To make this measure effective, regulators would need to
require that CCPs impose robust margin requirements.
In
addition, it should be ensured that other necessary risk
controls and customized OTC derivatives are not used solely as a
means to avoid using a CCP.
Furthermore, regulators
could require hedge fund operators to hold fund assets with
certain financial institutions and/or be subject to surprise
annual audits by independent public accountants.
Regulators
also could require business continuity plans for operators,
focusing on operational risk.
From an investor protection
perspective, another option is to forego capital adequacy
requirements and substantively regulate the conduct of hedge
fund operators.
Such regulation could impose fiduciary
duties upon advisers or require them to adopt and implement
written policies and procedures reasonably designed to prevent
securities laws violations.
Therefore, regulators should
consider, in view of the risks posed, risk-based capital
requirements for all systemically relevant hedge fund operators.
From a macro perspective, this approach is consistent with
the purpose of addressing systemic risks, while avoiding undue
entry barriers.
From a microprudential standpoint, the
operational risks posed by smaller hedge fund operators proved
not to be an issue during the recent financial turmoil.
The work carried out by International Monetary Fund on systemic
importance market and institutions could be used to identify
criteria for a proper definition of systemically relevant fund
operators.
D. Addressing procyclicality and leverage-related risks posed by
the pool of assets
Leverage permits hedge funds to magnify their potential
returns, but also their exposures and, consequently their risks.
Following the crisis, the issue of whether regulators
should limit the level of leverage to which a hedge fund can
have access has been debated.
Leverage may be constrained
through several regulatory tools.
For instance, the
European Commission Proposal for a Directive on Alternative
Investment Fund Managers, if adopted as it currently stands,
would have the ability to impose leverage limits on alternative
funds' operators where this is required to ensure stability and
integrity of the financial system.
The proposal also
would grant emergency powers to national authorities to restrict
the use of leverage by alternative funds' operators in
exceptional circumstances.
However, in ongoing
discussions at the European level, the Commission’s first
proposal (imposing leverage limits by the Commission) is one of
the most controversial whereas the second (emergency powers on
national regulators) seems more accepted.
Some argue
that sophisticated investors invest in a hedge fund to follow a
certain strategy and the fund’s strategy should be restricted
only if leverage could cause systemic risk.
In addition,
setting leverage caps could be extremely difficult and complex.
This is particularly true given the different strategies
and activities of hedge funds and because the true extent of
leverage cannot be easily figured out without analysing the
embedded leverage in each underlying investment.
In
addition, setting an arbitrary cap could cause market
distortion.
Granting prudential supervisors the ability
to cap leverage for a fund identified as posing systemic risk
could be more easily recommended.
One way to overcome
market distortions might be to impose a leverage limit in a
flexible manner.
From an economic prospective, an
appropriate approach for avoiding procyclicality in financial
markets could be to tighten such limits during market upturns
while prohibiting excessive marketing activity (preventing
bubbles) and relaxing limits during downturns.
This would
help prevent funds from having to sell assets and thus amplify
downward pressures during market declines.
For example,
regulation could result in building risk buffers in the system
procyclically and relying on these buffers anti-cyclically.
For the time being, these issues remain under discussion by
the European Union Council and Parliament.
Another more
thorough approach could be to limit leverage through rules
applicable to all market participants, such as the amounts that
may be loaned or borrowed against traded stock.
Another
issue under consideration is whether regulation should focus
directly on the hedge fund itself.
One example is
provided by the European Union with the Undertakings for
Collective Investments in Transferable Securities Directive.
This Directive provides for regulation on the portfolio
composition of the pool of assets (i.e, type of assets that can
be purchased, minimum degree of diversification, maximum level
of leverage, etc.).
This regulatory approach is
usually
justified on the basis of retail investor protection.
Other examples include requirements applicable to pension funds
and insurance funds that may be subject to own funding
requirements proportionate to the pool of assets’ exposure to
risks.
These seek to reduce the risk that defined
benefits would not be paid by fund providers (see Europe the
Pension Funds Directive and the Solvency II Directive).
The approach of regulating only the operator is under discussion
within the European Union, since it has been endorsed by the
European Commission Proposal for the aforementioned Directive on
Alternative Investment Fund Managers.
In the European
Commission’s view, the regulatory approach focussing on fund
operators would not imply that the investment fund itself is not
effectively monitored.
This is because rules on the fund
operators, including selfmanaged investment companies, can be
ultimately aimed at determining how the funds and the associated
risks are managed.
Indeed, in the context of hedge funds,
there may be reasons to focus on the fund operator rather than
the pool of assets.
From a prudential standpoint, the
risks associated with the management of the fund depends on
decisions undertaken by the fund operator (investment decisions,
including trading and level of leverage, maintenance of a
governance structure and internal control systems, relationships
with investors, organisation of administrative functions,
including valuation, selection of depository for the assets
safekeeping).
The investment strategies of hedge funds
are more diverse and complex than retail products.
Also,
investors are predominantly professionals.
However, the
recent crisis showed that hedge funds may pose systemic risks
that may not be controlled solely by organisational and risk
management tools.
Therefore, other tools may be
necessary, including:
• Haircuts
and margin requirements.
As market prices fluctuate, the mark-to-market of the position
may deteriorate and trigger a margin call.
To protect
against counterparty risks, regulators could require that
margins and collateral are set by application of risk-based
haircuts, so that a sufficient buffer can be established to
protect against a margin call.
•
Closed-end fund and redemption gates.
In order to
limit excessive funding liquidity risks, regulators might
require that hedge funds significantly investing in illiquid
assets (eg more than a certain percentage of their portfolio)
are to be set up as closed-end funds or should adopt adequate
gating structure in order to address liquidity mismatches.
During 2008, many hedge funds used gates and suspensions to
effectively avoid liquidity mismatches.
• Limits to borrowing and overall fund
financial exposure.
Credit risk could be limited
by imposing a requirement that hedge funds comply with an
overall level of maximum indebtedness, although these limits
should be no stricter than those applied to other market
participants;
• Limiting leverage.
To limit excessive leverage contributing to systemic
risks, regulation may establish strategy-by-strategy limits - or
ex ante caps - on leverage at the fund level (eg by setting
limits on the maximum potential exposure to derivatives),
subject to the same limits applicable to other market
participants and similar strategies
•
Risk-based capital ratios.
Regulators could limit leverage, including exposures arising
from derivatives and/or financing, etc., as a function of
risk-weighted assets, so that limits become stricter when assets
are riskier.
These options may help reduce systemic risks
that, due to externalities, information asymmetries and lack of
adequate private incentives, individual market participants
would not limit satisfactorily.
This approach also would
favor the creation of a more level playing field between hedge
funds and regulated market participants potentially posing
similar prudential risks, including for instance bank trading
desks.
On the other hand, it should be noted that these
tools would not protect against poor investment decisions.
They would restrict the formation of funds and limit the
ability of each fund to follow their own stated trading
strategy.
In addition, they would result in operating
restrictions that may unduly curtail the efficient activity of
hedge funds and diminish their beneficial impact of market
liquidity and price discovery.
Therefore, restrictions
should be justified by a level and type of leverage actually
causing systemic risks.
Setting leverage limits,
liquidity caps or capital reserve requirements could be
difficult, considering the different strategies and activities
of hedge funds.
Arbitrary limits could cause market
distortions. Furthermore, direct regulation on hedge fund
leverage may increase moral hazard or shift the activity to a
less regulated jurisdiction.
To avoid this regulatory
arbitrage, international convergence of regulation and
supervisory practices are critical.
Basel Committee on
Banking Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
Conglomerates
- Part 1:
Introduction, Mandate, Focus and guiding principles of this study,
Key issues and gaps
Conglomerates - Part 2:
Supervision and regulation of financial groups. Mortgage
origination. Hedge funds
Conglomerates - Part 3:
Recommendations and options for effective and consistent
financial regulation across sectors. Reducing key regulatory
differences across the banking, securities, and insurance sectors.
Strengthening supervision and regulation of financial groups.
Promoting consistent and effective underwriting standards for
mortgage origination. Broadening the scope of regulation to hedge
fund activities
Conglomerates - Part 4:
Strengthening regulatory oversight of credit risk transfer
products. Key differences in regulation across the banking,
securities, and insurance sectors.
Background and approach adopted by the Joint Forum. Key issues
and gaps
Conglomerates - Part 5:
Recommendations to reduce key differences in regulation across
the banking, securities, and insurance sectors. Supervision and
Regulation of Financial Groups. SPEs. Key issues and gaps.
Recommendations to strengthen supervision and regulation of
financial groups
Conglomerates - Part 6:
Mortgage Origination. United Kingdom, United States, Spain,
Canada, Germany. Key issues and gaps. Recommendations to promote
consistent and effective underwriting standards for mortgage
origination
Conglomerates - Part 7:
Hedge Funds. Key issues and gaps
Conglomerates - Part 8:
Recommendations and policy options to broaden the scope
of regulation to hedge fund activities.
Credit Risk Transfer Products.
Key issues and gaps common to both CDS and FG insurance (CDS -
Credit default swaps, FG - Financial guarantee)
Conglomerates - Part 9:
Key issues and gaps specific either to CDS or FG insurance.
Recommendations and policy options to strengthen regulatory
oversight of credit risk transfer products
Conglomerates - Part 10:
Annex 1-9
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