Despite concern from some lawmakers that the lack of transparency and soaring growth of hedge funds pose a risk to financial markets, top regulators shied away from imposing new regulations, instead favoring private sector discipline during a Senate Banking subcommittee hearing May 16.
Susan Wyderko, director of the SEC's Office of Investor Education and Assistance, said the SEC needs to see the "effects" of the regulator's hedge fund registration requirement before issuing more rules. "If we were to impose more onerous investment regulations, it may be that we would diminish the utility of those investment vehicles for the investors that invest in them," she said in her testimony.
Officials from the Federal Reserve and the Treasury Department did outline some inherent risks as the hedge fund market grows to include a wider swathe of the investing public through pension funds after hedge funds' significant returns.
Randal Quarles, Undersecretary for Domestic Finance, in an effort to quiet some lawmakers' fears, noted that another hedge fund implosion, such as that of Long-Term Capital management, which roiled the world financial markets in 1998, was unlikely. That's because there is much more initiative now by counterparties to understand hedge funds and the risks involved, he said. Indeed, Treasury itself will be communicating more with financial market participants to better understand hedge funds over the next several months.
One of the risks Treasury will be focusing on is the "crowded trade" issue, a herding behavior where smaller managers follow bigger ones, which can lead to destabilization if a large number of investment managers are looking to liquidate.
It is estimated that hedge funds today have more than $1.2 trillion dollars of assets, a growth of almost 3,000% in the last 16 years, Wyderko stated in her testimony, citing independent hedge fund research. In 2005, an estimated 2,073 new hedge funds opened for business. One report recently projected that assets of hedge funds may grow to $6 trillion by 2015.
Growth does not necessarily equal more risk--indeed, the more growth from high-net-worth investors to endowments to universities to pension funds, the more market discipline weighs in, according to Quarles.
However, the Federal Reserve warned in testimony that the SEC's hedge fund registration rule should not be a substitute for active risk examination. In other words, pension funds should know what they are getting into before they invest. "The SEC believes that the examination of registered hedge fund advisers will deter fraud. But fraud is very difficult to uncover, even through on-site examinations," testified Patrick Parkinson, Deputy Director of Research and Statistics for the Fed. "Therefore, it is critical that investors do not view the SEC registration of advisors as an effective substitute for their own due diligence in selecting funds and their own monitoring of hedge fund performance," Parkinson said.
Parkinson's boss, Fed Chairman Ben Bernanke remained skeptical of the idea embraced by some of a regulatory database of hedge fund positions. Such a limited financial markets database wouldn't be complete, it wouldn't address liquidity risk, and it might make counterparties less vigilant, Bernanke argued. "Rather, a focus on counterparty risk management places the responsibility for monitoring risk squarely on the private market participants with the best incentives and capacity to do so," the chairman stated in remarks at a conference in Sea Island, Georgia, the same day.