Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, April 13, 1994.
DEFINITION AND CHARACITERISTICS OF HEDGE FUNDS
The Federal Reserve does not regulate hedge funds and does not have comprehensive information on their size or activities. Moreover,there is no formal definition of "hedge fund" that is universally accepted. Banks and other financial insitutions that deal with or monitor these entities have developed their own specific working definitions of the term. The definitions used by banks generally mention several elements in characterizing so-called hedge funds:
* an investment partnership or mutual fund that is unregulated;
* one that seeks high rates of return by investing or trading in virtually any form of financial instrument;
* an entity that may take long and short positions and invest in many markets:
* an entity that uses leverage;
* an entity whose manager's compensation is based on its financial performance.
A hedge fund might not exhibit all these characteristics all the tiem, and other financial institutions also exhibit many of these characteristics. Indeed, it is important to recognize that the activities of hedge funds are not fundamentally different from those of many other institutions.
Banks often distinguish between two categories of hedge funds. The first category consists of those organized by one or more individuals with particular trading philosophies such as Soros Fund Management, Tiger Management Corporation, and Steinhardt Management Company. The second category consists of funds that are advised by the proprietary trading desks of investment banks or internationally active commercial banks and bear a name linked to the advising entity.
So that managers of hedge funds can be free to use various trading strategies, and free to change those strategies quickly, the funds are structured to avoid the regulatory limitations on permissible assets, leverage, and concentration of assets that apply to other managed funds that are offered to the public. Hedge funds achieve their essential flexibility either by organizing offshore or by using the benefits of limited partnerships. For example, hedge funds may avoid registration as an investment company under the Investment Company Act of 1940 by restricting participation to fewer than 100 persons. In enacting the Investment Company Act, the Congress believed that these companies did not involve significant public policy issues and were not properly subject to federal regulation. The number of investors in hedge funds is also limited by their high minimum investments, typically from $25,000 to $1 million or more. Paticipation in some funds is further restricted to professional traders or persons with specialized knowledge of particular markets, regardless of their wealth.
There are currently hundreds of hedge funds. One market consultant specializing in hedge funds identified at least 800 hedge funds, up from about 100 in 1987, and others cite far higher number.(1) Other privately published directories of hedge funds indicate the Soros group of funds alone has about $9 billion of capital and the Tiger group has $6.5 billion of capital (net asset value). A few fund families, therefore, have capital comparable to or exceeding that of some large U.S. commercial and investment banks. It should be noted, however, that although funds under the same management may share similar trading strategies, they are separate entities operating on their own capital. According to published reports, perhaps a dozen hedge funds have net asset value greater than $1 billion, and perhaps another twenty-five have capital between $100 million and $1 billion. The vast majority of hedge funds that make up the 800 cited above, however, are quite small.
Hedge funds constitute only one of several categories of institutional investors that participate in financial markets. Even the largest hedge funds are small relative to the broader markets in which they operate. For example, turnover in the global foreign exchange market is estimated at more than $1 trillion a day. The capital available to hedge funds, is dwarfed by that of more traditional mutual funds. The total net asset value of the regulated mutual fund industry was $2.1 trillion at the end of 1993, about equally divided among equity, bond, and money market funds.(2) Currently at least ten mutual funds have a net asset value greater then $9 billion, and the largest has $32 billion of net assets.(3) Other institutional investors (for example, banks serving as trustees, pension plans, and insurance companies) had, as of the end of 1993, $6.5 trillion in assets under management.
RELATIONSHIPS WITH BANKS
Hedge funds, like other users of financial services, use the banking industry for some activities. U.S. banks provide several services to hedge funds, such as foreign exchange trading lines, repurchase lines for U.S. and foreign government bonds, other collateralized credit lines custodial services, and, in limited smounts, unsecured direct credit lines. In some cases, banks also organize and advise overseas funds that would meet the general definition of a hedge fund.
No comprehensive data are routinely collected on banks' activities with hedge funds. Moreover, any such data would need to be wiewed skeptically because of differing definitions of hedge funds and because of problems inherent in any attempt to aggregate the various risks and potential risks that might be involved in the range of products offered by banks to hedge funds. However, the Federal Reserve has reviewed the major banking activities of organizations with hedge funds through the regular examination process, supplemental examination projects, discussions with banks, and contacts with other bank regulatory authorities.
We have found that bank relationships with hedge funds are concentrated in traditional bank products, especially foreign exchange services. One of the major developments in markets in the past few years has been the globalization of institutional investment. As a result, institutional investors--mutual funds and pension funds, along with hedge funds--have been increasingly important users of foreign exchange services. These foreign exchange lines afforded by banks may be used to take outright foreign currency positions or to hedge positions that have arisen from other activities, such as the purchase of foreign government bonds or foreign equities.
Banks have been the traditional major suppliers of foreign exchange services, and major U.S banks, in particular, are generally viewed as among the most efficient global providers of these services. Thus, it is not surprising that major U.S. banks are significant providers of foreign exchange facilities to hedge funds as well as to other institutional investors. Similarly, banks provide hedge funds with other services in which they are competitive, such as repurchase facilities on government debt and swap products.
As with other customers, banks enter into these relationships because they view them as profitable and believe that the risks can be adequately controlled. In addition, some banks believe that their own marketmaking and positioning activities are enhanced by dealing with all major market participants because this gives them additional information about the state of the market. It should be noted, however, that information on hedge fund transactions is only one piece of a vast array of information that flows through the marketmaking desks of the major banks.
Also, the size of the bank's business with hedge funds should not be exaggerated. Although estimates of the relative impotance of hedge fund business to banks are not hard numbers, data obtained from two of the most active banks indicate that all of their hedge fund customers (as defined by the banks) together account for well under 10 percent of their total net trading revenue. For most banks that deal with hedge funds, the share of their revenue derived from this source appears to be considerably less.
Generally, a fund that wishes to purchase or sell foreign exchange or other capital markets products with a bank on a regular basis will approach the bank to establish a trading facility. the bank will asses the fund to determine if it will allow the bank's traders to execute trades with that fund; if trading is permitted, it will set the total amount in which it will permit the traders to deal and establish appropriate collateralization arrangements to mitigate actual or potential credit risk. Elements of that assessment normally include a review of partnership documents, offering circulars, fund performance history, an analysis of the fund's financial statements, and, in many cases, an on-site review of the fund's risk management practices and capabilities.
Two types of facilities are normally extended to qualifying hedge funds. One type of facility must be collateralized at all times. For example, a bank might notify a hedge fund customer that it was prepared to deal in foreign exchange up to a nominal open position of $50 million, provided that collateral was maintained at 5 percent of the nominal foreign exchange open position plus an amount equal to any move in the actual mark-to-market value of the contract that was in the 6bank's favor.
Although the nominal amount of foreign exchange lines, repurchase facilities, or other capital market products often appears quite large, the bank's risk (with the exception of settlement risk, which either usually does not occur with hedge funds or can be eliminated by delivery against payment) is confined to the changes in value in the financial instrument that result from market movements, which is fraction of the nominal amount of the contracts. A bank would generally hedge the market risk it assumes when it sells foreign exchange of similar products to a hedge fund. However, if the contract moves in favor of the bank, the hedge fund would owe the 6bank money at maturity, resulting in a credit risk to the bank. Collateral is often used to guard against this type of credit risk. Banks closely monitor the level of collateral against their exposures, in many cases twenty-four hours a day, to make certain that adequate collateral is maintained at all times. Banks maintain the right to close out contracts if margin calls cannot be met and often for other reasons as well.
For more established hedge fund customers, most banks use a variation of this procedure. Funds are advised that a certain amount of business will be permitted without collateral. This is termed a "loss threshold." Once various pre-established limits are excceded, these customers are expected to either post collateral or settle their outstanding position with the bank in cash. For these "loss threshold" customers, banks can incur outright unsecured credit exposure up to the amount of the loss threshold.
Three major state member banks were reviewed as part of a special examination project; even if all funds viewed by each bank as hedge funds were aggregated, the total loss threshold amounts would not exceed 2 percent of equity capital at any of the three banking organizations. Actual mark-to-market exposures to these customers less collateral were even smaller; in the majority of cases, on the dates surveyed, most funds (including many loss threshold customers) actually held collateral with these banks in excess of the amounts owed to the band. Our more limited examination surverys of holding companies for national banks, along with information provided by the Office of the Comptroller of the Currency, indicate this situation also exists with respect to the major national banks and their holding company affiliates.
A risk with respect to these customers, as well as with the fully margined customers, is that the trades the hedge funds have with the bank could move further in favor of the bank, requiring additional margin calls. If margin calls could not be met, the bank would have to close out the position and realize the collateral, possibly at a lower value than expected, thereby causing a credit loss to the bank. Risks of this type are generally referred to as "postential credit exposures."
Banks attempt to derive conservative "worstcase" estimates of this potential exposure. In dealing with funds, banks set limits that directly or indirectly limit potential credit exposure. Individual banks assess potential exposure differently, making different assumptions, often about events that are highly unlikely to occur. Even under very broad measures of potential exposure, however, examiners have not found any bank's exposure to a fund or fund group that would approach the 15 percent of capital a bank is permitted to loan to a single borrower. Moreover examiners and bank supervisory personnel who have looked in detail at these exposures have informed me that they do not regard hedge fund exposures at banks, even in the aggregate, as at this time posing a significant risk to the safety and soundness of major banks or the banking system.
Nonetheless, banks' busines with hedge funds has grown significantly over the past couple of years and may expand further. Like any other growth area in banks, management must make certain that adequate controls on risk accompany growth and that undue risk concentrations do not arise. A special examination project focusing on hedge funds, which the Federal Reserve Bank of New York has been conducting over the past few months, has identified some issues relating to banks' managment of their relationships with hedge funds that we are addressing through the ongoing supervisory process.
Our review indicates that banks that deal with hedge funds spend considerable effort in analyzing and controlling the risks involved in these relationships and employ personnel with the expertise required to carry out these responsibilities. The actual number of people with experience in this area, however, is quite limited, and risk management procedures are still evolving rapidly. Although these characteristics of rapidly growing new business areas are not unusual, it is incumbent on banks to increase personnel with expertise in dealing with hedge funds, strengthen internal controls, and improve senior management review capability. We also believe that the potential for concentrations of exposure need to be evaluated by banks and, in doing so that banks need to consider carefully the assumptions that are used in defining aggregate hedge fund exposure. In particular, we question the practice of some banking organizations of viewing hedge funds managed by major institutions differently from other hedge funds, apparently, at least in part, on the assumption of implied financial pupport from the sponsoring institution.
We do not believe, however, that this is an area in which increased disclosure and regulatory reporting by banks is warranted. Actual exposures currently appear in only a few banks and are not substantial. There are already general rules on public disclosure of concentrations of exposures, and the Federal Reserve believes that additional reporting burdens should not be routinely imposed to address the perceived problem of the moment. Moreover, as mentioned, most of the risks are associated with estimates of possible future exposure, which do not easily lend themselves to standardized reporting. The focus should be on proper risk management procedures in banks, an issue that can be addressed most efficiently through the examination and supervision process.
HEDGE FUNDS, MARKET VOLATILITY, AND SYSTEMIC RISK
The risk that hege funds might pose to banks 6directly is one of the concerns sometimes voiced about hedge funds. The possibility that the behavior of hedge funds adds to volatility in financial markets is another.
Bond markets around the world have experienced an increase in volatility in the past couple of months, with volatility in some European markets reaching record or near-record levels. Although day-to-day volatility in the U.S government band market (measured by the standard deviation of daily changes in yield in the cash market or by implied volatility in the options market) has risen in recent weeks, it has by no means been extraordinarily high.What has been extraordinary has been the extent of the net movement in U.S. bond yields over the past two months or so. Indeed, yields on the ten-year and thirty-year bonds rose 150 and 120 basis points respectively between January 28 and April 4.
Recent press reports have attibuted at least part of the recent increase in global bond market volatility and the increases in rates to the activities of hedge funds and have alleged variously that these funds were all moving the same way at the same time; that the loss in value of their bond holdings was leading to margin calls that forced further liquidation of bond positions; that losses in some markets caused liquidations in other markets; and that mounting losses and increasing market volatility led, through internal risk management procedures, to further reductions in exposures and, hence, further pressure on prices.
We do not have the necessary data to rigorously test each of these propositions. We do know that not all hedge funds behave the same way. Some tend to specialize in certain markets or instruments, whereas others operate in a wide variety of markets looking for the best investment opportunities at a given time. Some tend to have longer time horizons and rely on fundamental analysis, while others have very short term trading strategies and may place more emphasis on market dynamics. Teh degree of leverage is variable, both across funds and within each fund ove time, depending upon the risk-reward profile of a particular position and of the entire portfolio. With these differences, it is not surprising that investment performance varies widely over a given time period. In the first two months of this year, for example, according to data voluntarily supplied to a private data collection firm by ninety-four hedge funds, returns varied from 20 percent to -17 percent, with more than 40 percent of the funds reporting negative returns. Evidently all hedge funds did not have the same positions or behavior over this period.
From our conversations with market participants--hedge funds, banks, and securities firms--it seems clear that the rumors of widespread margin calls by lenders to hedge funds were exaggerated. The grain of truth in these reports involved margin guidelines internal to the hedge funds. As the value of their bond asset positions declined, reducing their capital cushions, several large hedge funds sold bonds to reduce their degree of leverage. Frankly, this seems to me to be normal, prudent behavior. Press reports of hedge fund selling in the U.S. Treasury market likely have been exaggerated.
Many other types of institutions were trying to reduce positions as well. Bond mutual funds, for example, are reported to have experienced significant net redemptions beginning in late February as shareholders reacted to declines in net asset values when rates backed up. Much fuel for the strong bond market rally over the previous few years had come from huge inflows, approximately $340 billion, into bond mutual funds in 1991-93. In recent years, some inflows to both stock and bond mutual funds were driven not only by the persistnce of high rates of return relative to certificates of deposit, resulting in part from capital gains on bonds and stocks, but also by a deceptive stability, quarter-to-quarter, of such returns. This pattern probably imparted a false sense of low risk to these insruments.
It was inevitable that a break in that pattern would occur. Over time, high returns are associated with high risk. At least some price adjustment in bond and stock markets can be viewed as an unavoidable correction to an unsustainable situation. It may be useful in the very short run to look at who was selling and who was buying and the role of technical aspects of market dynamics related to investment strategies, degree of leverage, and risk management techniques; but this approach is seldom the basis for a satisfactory analysis of price movements over a longer time horizon. For that analysis, we have to look at changes in economic fundamentals, including the underlying parameters of the economy and economic policies. Indeed, it is here we would focus in attempting to explain the sharp backup in global bond yields over the past couple of months. There have been very important changes in market participants' perceptions of economic fundamentals, both in the United States and abroad, and these changes in perceptions have caused all types of insitutions and individuals to desire to reduce their bond holdings. Much stronger recent and prospective economic growth in the United States has caused market participants to sharply raise their expected path of interest rates, and the Federal Reserve took steps in its reserve management that had the effect of raising short-term interest rates somewhat.
In some other nations, as well, changes in the outlook for economic activity and for monetary and fiscal policies led to some backup in interest rates. Finally, many market commentators have cited the possibility of a significant increase in risk premia in long-term bond rates related to the U.S.-Japan trade policy dispute and to increased political uncertainties in several nations.
Although we would not deny some influence of so-called positive feedback market dynamics in contributing to the recent backup in global bond rates, we feel the fundamental factors account for the bulk of the movement. At the same time, we do not rule out the possibility that swings in market optimism and pessimism may have resulted in some overshooting of band prices, both the rise last year and the decline this year. Although some activities involved with derivative instruments, for example, dynamic hedging of options portfolios, including the options embedded in fixed rate mortgages and mortgagbacked securities, may have tended to exaggerate price movements, other elements involving derivatives, such as the availability of highly liquid futures markets on organized exchanges, probably smoothed price developments in the cash market for bonds.
Whatever the explanation, financial asset valuse have declined significantly. Actual and potential changes in asset prices obviously are an element of risk facing financial firms. The interpaly of this risk--so-called market risk--and the counterparty credit risk, which I discussed earlier, can lead to systemic problems. Risks that may seem quite reasonable in normal circumstances may become more problematic if the financial positions of borrowers erode as a result of market moves.
It is for this reason that Federal Reserve 6staff--bank examiners and others--have been talking extensively to banks over the past year or so about their risk management procedures. The 6Federal Reserve is not alone in trying to address these concerns. Central banks of the major industrial nations frequently discuss together issues of concern with regard to systemic risk. The G-10 governors, for example, in early March evaluated the recent price weakness in bond markets and the role of highly leveraged funds and derivative instruments in such price changes. German Bundesbank president tietmeyer, chairman of the G-10 governors, indicated that the governors viewed recent bond market developments to some extent as a reflection of previous overshooting and indicated that they did not see the need for new regulations on derivatives and hedging techniques.
In conclusion, let me reiterate that, because hedge funds are large and are willing to take large positions, they can have important effects on financial markets. But they are certainly not unique in that regard--other types of firms are enen large and may have more important effects. Moreover, like the activites of other firms who have been successful over a long period and whose management, by and large, is responsible, the activities of hedge funds add depth and liquidity to financial markets and can be stabilizing influences. It would be wrong to single out hedge funds as being responsible for moving global prices of financial assets or as being a major source of risk in financial markets. Nevertheless, banks and other counterparties to hedge funds need to carefully monitor their relationships with hedge funds, just as they should monitor their other business relationships. financial firms should continue to 6place the highest priority on reviewing, assessing, and improving their overall risk management practices. The Federal Reserve intends to continue to use its bank supervisory authority to make certain that further progress is made in this area and that risks are being adequately controlled. At the same time, the Federal Reserve will continue to work with other U.S. agencies and with foreign central banks to monitor important developments in financial markets and to ensure that it is in a position to react promptly to any problems that migh arise.
(1.)E. Lee Hennessee, "Flowering Hedges," Barron's, (December 13, 1993).
(2.)Investment Company Institute, Washington, D.C.
(3.)Morningstar Mutual Funds (February 18, 1994).
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||Statements to Congress|
|Publication:||Federal Reserve Bulletin|
|Date:||Jun 1, 1994|
|Previous Article:||Profits and balance sheet developments at U.S. commercial banks in 1993.|
|Next Article:||Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Telecommunications and Finance of...|