Institutional Investor's Alpha Magazine - December 2008 / January 2009 - (Page 28)

Hedge Fund Regulation $530 trillion notional value has been largely exempt from regulatory oversight. Credit default swaps, in particular, have become a cause of great concern — both in terms of the risk of big swap counterparties going bankrupt à la Lehman and how the purchase of CDSs by hedge funds and other investors may have contributed to the downfall of some banks and ﬁnancial ﬁrms. Most of the recent focus has been on creating a centralized clearinghouse, which would reduce counterparty risk as well as create a more orderly and transparent market. Since his appointment to the New York Fed in 2003, Geithner has urged participants in the CDS market to identify the problems and develop their own solutions — like the clearinghouse being offered by Citadel Investment Group and the Chicago Mercantile Exchange. But as Treasury secretary he is unlikely to be satisﬁed with a purely private sector approach. One question that needs to be addressed: Which regulator will have jurisdiction? The last major effort to regulate OTC derivatives began in 1998 — before the troubles at LTCM — when the Commodity Futures Trading Commission undertook a controversial study of that market. The result was a bitter turf war with the SEC, fears of regulation and uncertainty as to the future of the industry. Although further U.S. regulatory oversight of OTC derivatives was ultimately rejected, many market participants say the uncertainty led to London’s Canary Wharf, not Wall Street, beneﬁting from the boom in structured ﬁnance. chairman of the Committee on Agriculture, Nutrition and Forestry, introduced the Derivatives Trading Integrity Act of 2008, which would amend the Commodity Exchange Act to require all contracts and transactions with respect to commodities (including credit derivatives and swap contracts) be carried out on a regulated exchange. His proposal would grant the CFTC sole regulatory authority over CDSs and could set off another turf war with the SEC. Of course, the future of the SEC is itself up in the air. Chairman Christopher Cox has said he will step down in January, rather than serve out his term. William Donaldson, who as SEC chairman from 2003 to 2005 pushed for hedge fund registration, is among those on the Obama transition team charged with ﬁnding Cox’s replacement. The presidentelect has not ruled out combining the SEC with another regulator, such as the CFTC, or folding it into a new superregulator as part of a broad restructuring like the one proposed by Treasury Secretary Paulson last spring. Whatever happens, hedge fund managers are worried about a potential repeat of the decision by the SEC in September, at the height of the banking crisis, to temporarily restrict short-selling of ﬁnancial stocks. With no warning the rules of the game changed, and a lot of money was lost as a consequence, as hedge fund managers scrambled to cover their shorts and close their positions. Potentially even worse was the SEC’s initial demand, later withdrawn, that hedge funds publicly disclose their short positions as they do their long-only holdings. Hedge funds have been in talks with the SEC about short-selling, including the possibility of introducing circuit breakers during periods of stress that would limit it. Another area of potential reform is in the use of leverage. In the U.S. there are no rules directly limiting how much leverage hedge funds can use. (Hedge fund leverage is limited indirectly by Regulation T, a Federal Reserve Board rule that stipulates how much can be lent against certain securities.) Unlike mutual funds, broker-dealers and commercial banks, hedge funds are exempt from regulatory capital restrictions. As a 1999 President’s Working Group report explains: “Hedge funds are limited in their use of leverage only by the willingness of their creditors and counterparties to provide such leverage.” Congress could pass new laws that would put direct limits on hedge fund borrowing. They could also seek to place stricter parameters on leverage by banks and other ﬁnancial institutions, which would have a knock-on effect on how much capital hedge funds can borrow. But even if regulators were to do nothing, the transformation by investment banks into more heavily regulated commercial banks means that they will have less available capital on their balance sheets to provide their hedge fund clients. With so much in ﬂux, one thing is clear. The largely hands-off approach to market regulation that began with President Bill Clinton’s administration and accelerated under the Bush presidency ended the moment that Treasury Secretary Paulson stepped in to help rescue Bear Stearns last March. For hedge funds the world will never be the same. “The pendulum may swing toward greater regulation of hedge funds and capital markets more broadly.” — SANDRA URIE, CAMBRIDGE ASSOCIATES “It breaks my heart when I go to Canary Wharf and I look at the thousands and thousands of highly paid jobs in London in the derivatives markets that belong in America,” Citadel founder Grifﬁn told Congress in November. Grifﬁn’s lament echoes the U.S. hedge fund industry’s longtime argument against regulation: that it will send ﬁnancial innovation overseas. That reasoning isn’t likely to carry much weight with Congressman Frank, who has indicated he intends to seek more regulation of credit default swaps. Getting a jump on the issue, Frank’s fellow Massachusetts representative Edward Markey in October reintroduced legislation he had ﬁrst proposed in 1994 to enhance oversight of derivatives by the SEC. Markey’s new bill includes reporting requirements for hedge funds. In late November, Democratic Senator Tom Harkin, 28 • INSTITUTIONAL INVESTOR’S ALPHA • DECEMBER 2008/JANUARY 2009

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - December 2008

Institutional Investor's Alpha Magazine - December 2008 Contents Letter from the Editor Longs & Shorts Inside the Trade Pension Corner The Good Guys Interview: Stanley Fink Cover Story: The New Regulatory Reality United States: The Usual Suspects Europe: Flirting with Unity Asia-Pacific: What Asian Contagion? In Theory In Focus Strategies Research Center Alpha Bytes Unhedged Commentary

Institutional Investor's Alpha Magazine - December 2008

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