- International Monetary Fund. Monetary and Capital Markets Department
- Published Date:
- October 2004
Counterparty Risk Management Policy Group (CRMPG), 1999, “Improving Counterparty Risk Management Practices” (June).
Eichengreen, Barry, and DonMathieson, 1998, Hedge Funds and Financial Market Dynamics, IMF Occasional Paper No. 166 (Washington: International Monetary Fund).
Financial Stability Forum (FSF), 2000, “Report of the Working Group on Highly Leveraged Institutions” (April).
Financial Stability Forum (FSF), 2002, “The FSF Recommendations and Concerns Raised by Highly Leveraged Institutions (HLIs): An Assessment” (March).
Fung, William, DavidA. Hsieh, and KonstantinosTsatsaronis, 2000, “Do Hedge Funds Disrupt Emerging Markets?” (Basel: Bank for International Settlements).
Greenwich Associates, 2004, “For Hedge Fund Investors, New Notes of Caution,” (Greenwich, CT).
IMF, 2004a, Global Financial Stability Report, World Economic and Financial Surveys (Washington: International Monetary Fund, April).
Joint Forum, 2004, Financial Disclosure in the Banking, Insurance and Securities Sectors: Issues and Analysis, Basel Committee on Banking Supervision (Basel: Bank for International Settlements, May).
Managed Funds Association, 2003, Sound Practices for Hedge Fund Managers (Washington).
National Association of Insurance Commissioners (NAIC), 2004, “Modernizing the Insurance Regulatory Framework for a National System of State-Based Regulation.” Available via the Internet: http://www.naic.org/docs/naic_framework.pdf.
President’s Working Group on Financial Markets, 1999, “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management” (Washington, April).
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This study is a continuation of an overview of hedge fund activity published in the April 2004 Global Financial Stability Report(IMF, 2004a), where we reviewed the industry’s growth since 1998 (Eichengreen and Mathieson, 1998). Earlier studies included a broad range of recommendations, seeking to improve counterparty risk management, enhance disclosure and transparency, and strengthen market discipline to improve industry surveillance. See, for example, President’s Working Group on Financial Markets (1999), Counterparty Risk Management Policy Group (CRMPG, 1999), and FSF (2000 and 2002).
Our views on the issues discussed in this section were developed through numerous meetings with fund managers and risk managers from hedge funds, funds of hedge funds, and the main banks and prime brokers in the hedge fund industry, as well as national authorities in several of the major financial centers.
Non-money market mutual fund shares, as reported in U.S. flow of funds accounts (U.S. Board of Governors of the Federal Reserve System, 2004).
The SEC Commissioners voted on July 14, 2004 to publish for comment a proposed rule that would require the registration of hedge fund advisors under the Investment Advisers Act of 1940. Many of the largest hedge funds are already registered with the SEC (and, for those that are commodity pool operators and commodity trading advisors, with the U.S. Commodity Futures Trading Commission). Requiring the registration of hedge fund advisors would allow the SEC to collect more information about hedge funds, such as the number of funds that an advisor manages, the amount of assets in hedge funds, the number of employees and types of clients, and the identity of persons that control or are affiliated with the advisor. Through this requirement, the SEC staff would have access to all funds with assets in excess of $25 million. However, the threshold amount is one of several issues on which the SEC has requested industry comment until September 15, 2004.
CRMPG (1999) called for the development of liquidation-based estimates of potential credit exposures when assessing credit, and integrated risk management combining market and credit risk, which the FSF also endorsed. Today, credit procedures most often evaluate current and potential exposures, and risk management techniques employed by banks and prime brokers address multiple sources of risks, as well as their correlations. Current exposure is evaluated by marking to market the value of liabilities. Potential exposure uses the calculated value at risk (VaR) for a given period, typically 10 days, and sets loss limits with a confidence interval, typically 95 or 99 percent, of likely losses. This risk management approach contrasts sharply with the silo approach of dividing market, credit, and operational risk commonly practiced in the past.
Prime brokerage traditionally focused on equity trading. For historical reasons, the risk “buckets” into which hedge fund clients are often classified by prime brokers are relatively conservative. Based on a rolling 10-day VaR, margin is set by some brokers to cover potential losses at the 95 percent confidence level for the highest-quality customers, and at the 99 percent level for the lowest-quality counterparty. Margin limits are further adjusted by scrutinizing the portfolio for other sources of risks and characteristics (e.g., liquidity, concentrations, and how positions fit into the broader book at a prime broker).
In contrast to equity transactions, funds engaged in fixed-income trades tend to have more counterparties to trade with, and collateral arrangements may only cover 95 percent of potential losses, as calculated by a rolling 10-day VaR. The principal difficulty is that each leg of a fixed-income transaction is likely to be financed separately. For example, creating a fixed-income position could require a certain amount of collateral from the hedge fund. The fund may then hedge the purchase using a swap arrangement obtained at another bank or broker. The fund could then ask that less collateral be charged on the first transaction because it is now hedged. In addition, the fund could seek further swap or futures trades related to this position, thereby creating different exposures. Most banks and brokers would prefer to finance most or all legs of such transactions; however, hedge funds continue to resist such pressures. Ideally, collateral should reflect the risk profile of the entire trade, not each individual leg. However, in some cases, a more collateralized position on each leg or a particular leg may make the transaction uneconomic.
In addition to the steps outlined in footnotes 9 and 10, several brokers recently have attempted to use information from the credit derivatives market to manage collateral requirements—using spread movements on credit default swaps to adjust collateral requirements and exposures.
It should also be noted that Basel II and its market risk approach has also positively influenced the analysis and management of hedge fund exposure by the larger banks and brokers.
The report of the President’s Working Group on Financial Markets (1999) observed that risk management weaknesses revealed by the LTCM episode “… were also evident, albeit to a lesser extent, in investment and commercial banks’ dealings with other highly leveraged counterparties, including other investment and commercial banks.” Industry representatives have said that obtaining information about leverage and risk positions among hedge funds alone would provide only a partial picture. Indeed, the FSF broadened its analysis to include proprietary trading desks of regulated banks and securities firms.
By comparison, the report of the President’s Working Group on Financial Markets (1999) stated that LTCM leveraged their capital as much as 28 times in 1997 and 1998.
Recently, 11 of the 36 hedge funds that responded to a Greenwich Associates survey reported an increase in their use of leverage, although not dramatically higher, spurred in part by easier credit terms and more margin credit provided by prime brokers (Greenwich Associates, 2004).
See Managed Funds Association (2003) for a recent compendium of alternative measures of leverage.
FOFs charge investors administrative and performance fees (often 1 percent of total assets under management and a 10 percent performance fee), in addition to passing along the fees of the underlying hedge funds (e.g., generally 1 to 2 percent of assets, and 20 percent (or more) for performance).
Interestingly, several hedge funds and FOF managers we met believed the recent poor performance of convertible arbitrage strategies was exacerbated in part due to FOFs withdrawing capital from this non-core strategy to satisfy liquidity requirements related to principal or capital protected products. It should also be noted that a few insurance companies have begun to market these structured credit products to FOFs in competition with traditional bank providers.
As part of our study, we reviewed a variety of reports for investors and counterparties. We found that a typical hedge fund’s monthly or quarterly report provides a summary update on performance, exposure represented by the top 5 or 10 positions, attribution of returns, aggregated exposures by sector and/or geographic area, concentrations of these sectoral breakdowns, and, for some, an assortment of risk management metrics, including volatility and VaR. Those funds providing monthly or quarterly risk management data represent a growing minority—and are considered best practice by larger hedge funds.
The availability of hedge fund products to retail investors in Western Europe (e.g., France, Germany, and Italy), Hong Kong, and Singapore has raised regulatory attention concerning disclosure standards for retail investors.
See Joint Forum (2004), page 3.
The President’s Working Group on Financial Markets (1999) and FSF (2000) are two prominent examples. Indeed, the President’s Working Group on Financial Markets (1999) concluded that it was the breakdown of market discipline that led to an unusually large buildup of leveraged positions in LTCM’s portfolio, and high risk exposures for its investors and counterparties (p. viii).
See FSF (2000) for further discussion.
FOFs often require monthly reporting by hedge funds so as to update their own valuations and reports to their investors. However, a more thorough review of a hedge fund for strategic shifts and changes in risk profile generally occurs once or twice a year for newer hedge fund investments, and may only be triggered by specific events or poor performance for older investments.
See Eichengreen and Mathieson (1998) and Chapter IV of IMF (2004a) for further details. Eichengreen and Mathieson (1998) noted that while hedge funds sometimes take sizable positions, so do banks and other institutional investors. Moreover, hedge funds are concerned about the liquidity and other risks of their positions, not just returns, and are therefore less inclined to take large positions in small, relatively illiquid markets. Fung, Hsieh, and Tsatsaronis (2000) also present similar empirical evidence on the role of hedge funds during the Asian crisis.
The FSF, in the 2000 Report of the Working Group on Highly Leveraged Institutions, noted that “A number of conditions are necessary for market discipline to operate effectively… [including] information on counterparties’ liabilities and risks.”
The FSF (2000) noted that ”National monetary authorities, supervisors and regulators should consider proactive market surveillance as a means to help provide useful early warning signals about speculative activity in financial markets.”
We recognize that it may be challenging to design and maintain such a common matrix. However, we remain hopeful that authorities can cooperate and agree on a set of at least basic common and useful information. Furthermore, we believe, from a financial stability perspective, that much can be gained from a more comprehensive view and understanding of regulated institutions’ exposures to hedge funds and those entities engaged in related activities.