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Wall Street reform hardly a crackdown on hedge funds

by Melissa Aparicio
June 09, 2010


Citadel MA

Melissa Aparicio/MEDILL

Chicago-based hedge fund Citadel, which manages $12 billion in assets, is one of the thousands of hedge funds that would be required to register with the SEC in both the Senate and House financial reform bills.

MFA lobbying

Melissa Aparicio/MEDILL

The Managed Funds Association has steadily increased its lobbying spending. The largest hedge fund trade group spent $1.4 million in the first quarter of 2010, a 42 percent increase from the same period a year ago.

AUM

Melissa Aparicio/MEDILL

After suffering shattering losses during the financial crisis, hedge funds' assets under management are returning to pre-crisis levels, according to date from research firm Barclay Hedge.

As the Senate and House conference committee gets to work Thursday to flesh out a financial reform bill ready for President Obama’s signature by July 4, the hedge fund industry, which nearly doubled its lobbying spending in the first quarter of 2010, has largely escaped the crackdown.

Essentially under the radar for decades, hedge funds came under fire after the 2008 credit crisis. News that some hedge fund managers made billions in profits from short selling while Main Street was facing layoffs and foreclosures added to the public ire. Calls for transparency and regulation from politicians soon followed.

Industry professionals contend that hedge funds were not the source of financial instability during the crisis. There were no hedge funds that blew up and took down the financial system. Most importantly, they argue, no fund needed to be bailed out with taxpayer dollars.

“Hedge funds were not in my understanding, at fault in the credit crisis,” said David Ruder, former chairman of the Securities and Exchange Commission. “At the most what they did was to sell securities when some of their investments were declining and they needed to have liquid funds. They were not the architects of these problems.”

Still, the hedge fund lobby is playing catch up in Washington. The industry’s largest trade group, the Managed Funds Association, has increased its lobbying efforts significantly. Lobbying expenses were nearly $1.4 million in the first quarter of 2010 ended March 31, a 42 percent increase from the same period a year earlier and double the amount spent in the first quarter of 2008, according to data from the Center for Responsive Politics. The trade group is led by political insider Richard Baker, former congressman from 1986 to February 2008 and member of the House Financial Services Committee.

In the latest financial reform legislation for both the House and the Senate, the hedge fund industry is largely unscathed. In fact, the Senate bill’s provision to ban banks from proprietary trading would benefit the sector. The proprietary desks of investment banks compete with hedge funds and if those competitors leave the marketplace, additional opportunities for hedge funds will be left on the table.

“You have the same number of people chasing after the same very short-term arbitrage opportunities, where mispricings are occurring and you can trade two different contracts and earn the spread very quickly,” said Ben Alpert, a hedge fund analyst with Morningstar Research Inc. “That’s where there’s room for some of these funds to take over from what the banks are doing.”

James Cahn, chief investment officer at wealth management firm Vestian Group Inc. is already seeing a shift in the financial talent pool.

“There have been a number of high-profile defections of star traders from large banks to hedge funds. And that’s the beginning of the process of this migration of proprietary trading from banks to hedge funds,” he said.

By having access to low-interest Federal Reserve funds, the bank proprietary trading business has an unfair advantage over hedge funds, Cahn said. While a hedge fund would go out of business if it had a liquidity problem, banks could fund their draw downs and positions through the Fed funds window.

“There’s no reason why we should be supporting proprietary trading at a bank when we’re not supporting it at a hedge fund,” he said.

The legislation would require hedge fund advisers who manage more than $100 million (Senate bill) or $150 million (House bill) to register with the Securities and Exchange Commission and divulge risk positions to guard against a collapse that could create market chaos. Those hedge funds would also be required to disclose the amount of assets under management, leverage and counterparty credit risk, trading positions and practices to determine whether a firm poses systemic risk.

According to Viral Acharya, professor of finance at New York University’s Stern School of Business, leverage is dangerous, especially when an institution is too big to fail. The term has traditionally been associated with banks, but hedge funds are increasingly taking over a role that banks once held, that of market makers. By buying and selling securities, hedge funds provide essential liquidity to the market. This is why greater transparency is needed.

“The markets are tremendously liquid when times are good and hedge funds can leverage as much as they want, but we’ve just seen that there is a potential downside associated with liquidity that comes from high levels of leverage,” said Acharya. “This is something that ideally should be monitored by a systemic risk regulator just as it is monitored for banks because many things that were done traditionally by investment banks are now exactly the same functions that are being provided by hedge funds.”

Industry observers say hedge funds are supportive of the registration requirement, with some fund advisers already registering voluntarily.

Indeed, for Cahn, more information for market participants means more efficient capital markets. Knowing counterparty risk on swaps and options trades tells investors if a panic is warranted or not.

Whether the SEC has the capacity to effectively oversee and audit thousands of highly complex hedge funds is the real issue. “Do they really understand what these hedge funds are doing and can they figure out if they’re doing things that are dangerous or undisclosed to their investors?” Cahn said.

One hedge fund veteran questions the efficacy of oversight by a federal agency largely composed of lawyers and not economists.

“The SEC has not shown itself to be a proactive regulator and that even goes for the regulation of exchange markets,” said Dale Rosenthal, a professor of finance at the University of Illinois Chicago, citing the slow response to the recent flash crash as an example of an SEC misstep. Rosenthal was a former strategist at Long Term Capital Management, the brain trust hedge fund that collapsed in 1998. 

Hedge funds already face regulation, he argues, by abiding by the rules set forth by the exchanges on which they trade, such as the New York Stock Exchange.  Greater transparency can open hedge funds up to vindictive trading practices that would ultimately hurt the overall economy.

For example, funds hedge their positions and use cash flows from one position to pay for the other one. If someone becomes aware of a fund’s trading positions, they know that a significant market movement can mean a large margin account payment on one of these positions.

By having this information, another entity can stop the money from coming into the fund that is needed to support the other position, essentially causing a liquidity crisis. In a panic, the fund would have to sell its assets and lock in those losses, destabilizing the market.

According to Rosenthal, there aren't enough safeguards to protect the information hedge funds would provide to the SEC. Unlike the Chicago Mercantile Exchange, which would cease to exist if futures positions were leaked, the government doesn’t have an incentive to keep the information as secure as possible, he argued.

“If somebody finds it out from the government, what could happen? You might have a head of some agency forced to step down, but nobody goes out of business,” Rosenthal said.

Regardless, the hedge fund industry is picking up after suffering disastrous losses in 2008. Assets under management for the first quarter of 2010 totaled $1.6 billion, surpassing figures for full-year 2008 and 2009, according to hedge fund research firm Barclay Hedge Ltd.

If anything, shedding some light on the secretive world of hedge funds will alter their elusive reputation. “It hurts the marketing capability of these hedge funds because it takes away the allure; it takes away the black box, the secret sauce if you can see everything they hold,” Cahn said.