May 22, 2006

Bernanke: Counterparty Risk Management Suits Hedge Funds Fine

SEA ISLAND, Ga. (HedgeWorld.com)--Market oversight of hedge funds has limited the spread of systemic risk, and a regulatory database of hedge fund positions to gauge market risk is both unnecessary and unrealistic, Benjamin Bernanke said in his first public comments on hedge funds since taking over as chairman of the Federal Reserve.

In a speech before the Federal Reserve Bank of Atlanta's 2006 Financial Markets Conference, Mr. Bernanke said that counterparty risk management has proven effective in mitigating systemic risk arising from hedge fund activities, and remains the best policy going forward.

"Investors, creditors, and counterparties have significant incentives to rein in hedge funds' risk-taking," Mr. Bernanke said. Market participants have strong incentives to be vigilant in their dealings with counterparties, and to have the best access to information required to do so--such an approach "makes good economic sense," he said.

Echoing the sentiments of his predecessor, Alan Greenspan, Mr. Bernanke argued that direct regulation of the hedge fund industry would create "moral hazard" while discouraging private market discipline and limiting hedge funds' ability to provide liquidity to markets.

While systemic risk will never be entirely eliminated, Mr. Bernanke said, significant strides have been made since the 1998 demise of Long-Term Capital Management, which prompted a $3.6 billion private bailout.

All indications are that hedge funds in 2006 are less highly leveraged than they were in 1998, according to Mr. Bernanke, and while many hedge funds have shut down in that time, the residual damage to creditors and counterparties has not been major. Meanwhile there have been advances in counterparty risk management. Mr. Bernanke noted two reports issued by the Counterparty Risk Management Policy Group, one that included principles for institutions to use in measuring, monitoring and managing risk, and another with reviews conducted by bank supervisors in 2004 and 2005 that showed banks to be more diligent in their dealings with hedge funds, with more funding and staff for hedge fund-related risk management functions. All dealers now require hedge funds to cover current credit exposures with collateral, and in most cases they require additional collateral to cover any exposures that could come with a sudden market shift.

That said, Mr. Bernanke cautioned that some concerns remain, and may have grown in importance in recent years:

  • Competition for hedge fund business among dealers may have eroded initial margin levels.
  • As the volume of complex hedge fund transactions increases, there is concern that counterparty exposures in those transactions may not be measured accurately.
  • More extensive stress-testing could be broadened beyond exposures at the individual hedge fund counterparty level, while aggregate stress testing should be done more frequently.
  • And the assessment of counterparty risks should be better tied to the level of transparency offered by hedge funds, i.e., the availability and terms of credit should be linked to the fund's openness with regard to its strategy and risk profile.

Mr. Bernanke also stressed the role of prime brokers in maintaining market discipline and said they need to be certain their information is accurate enough to protect against counterparty risk arising from both the client and the executing dealer. Internal controls are also necessary to monitor hedge funds' transactions and ensure that they are meeting the terms of the prime brokerage agreement.

The growth of more complex strategies employed by hedge funds has brought about the use of new over-the-counter derivatives products, which firms are finding more difficult to settle in a timely fashion, said Mr. Bernanke. Supervisors have encouraged those firms to improve their processes for confirming and assigning trades of these types, and while some progress has been made, more is needed, he said.

Also noteworthy was cooperation among financial authorities in encouraging market discipline among these participants. "The Federal Reserve has devoted more effort in recent years to maintaining a dialogue with international supervisors, such as the U.K. Financial Services Authority, and we will continue to do so," Mr. Bernanke said. "Domestically, the Federal Reserve is coordinating with the [Securities and Exchange Commission], which is the primary regulator of several large firms that deal in OTC derivatives or engage in prime brokerage activities."

Proposed hedge fund database unwieldy, unnecessary

Mr. Bernanke's remarks also addressed proposals to create a regulator-administered database of hedge fund positions and portfolios, in response to concerns that hedge funds' operations are too opaque to regulators.

Proposals include a database in which regulators would collect submitted portfolio information from hedge funds, aggregate it and release it to the market while keeping positions confidential, as well as a public database with hedge fund portfolio information open to all. Proponents of a hedge fund database argue that it would allow authorities to look at sources of systemic risk and move to address any buildup before it leads to a large-scale catastrophe.

Such a database, Mr. Bernanke said, would raise more issues than it would resolve. To get an accurate picture of market liquidity risk would require regulators to collect data not just from hedge funds, but from all major financial market participants, and pulling together that much information with enough detail on a daily basis (at least) would be a Herculean task. If it could be gathered, it is unclear how authorities would use such information, or whether they would be able to force hedge funds to reduce positions--and how they might avoid giving competing funds an advantage.

There is also the risk that counterparties would relax their own oversight if regulators threw their hat in the hedge fund regulation ring: "A risk of any prescriptive regulatory regime is that, by creating moral hazard in the marketplace, it leaves the system less rather than more stable," Mr. Bernanke said.

The Fed chairman's comments came one day after a subcommittee of the Senate Banking Committee heard from representatives of the Federal Reserve, the SEC, the Treasury Department, the Commodity Futures Trading Commission and others on the role of hedge funds in capital markets. Three panels discussed the ways in which the hedge fund industry's role in the financial marketplace has changed in recent years, as the industry has experienced unprecedented growth.

JBunge@HedgeWorld.com

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.

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