Regulating the Hedge Fund Industry
In the current climate with public distrust with the financial sector in general and rich individuals in many countries, there has been a lot of clamour for regulating hedge funds in the media. The Dodd-Frank Act in the United States aims to put in the necessary checks and balances to regulate the financial services industry, and ensure that enough constraints are put on 'systemically important' financial organizations. The Financial Stability Oversight Council (FSOC) has been created specifically for this purpose, with a wide mandate to identify such organizations and impose checks on them. One of the key questions before the FSOC is whether hedge funds qualify under the ambit of 'systemically important' organizations.
In this guest interaction with Dr.Panchapagesan, Faculty of Finance at IIM Bangalore, tejas@iimb quizzes him on matters ranging from how the nature of the hedge fund industry prevents effective regulation to how regulators in India and the USA may go about addressing the challenge of regulation.
Nature of the Hedge Fund Industry
The hedge fund industry has been traditionally unregulated to a large extent. What are the market forces that allowed them to escape the scrutiny of the regulators, and is this sustainable?
Regulation often looks easy with perfect hindsight vision. Once things unravel, it is easy to say what went wrong and how to fix it. What has happened in this current crisis and our response to it has happened before, and will happen in the future in different forms and in different places. The reason behind that is that there is a fundamental disconnect between the goals of the regulator and the regulatee. Rules are created, but they often contain loopholes which people use to maximize their interests and wealth. New rules are created to fix those loopholes and inadvertently they open a new set of holes somewhere else. Soon the system drowns in a large set of incongruous rules written over multiple periods with multiple goals. Inevitably, someone comes along to deregulate and loosen some of these rules and we are back all over again. A fine example is the separation of commercial banking and investment banking that came out of Great Depression through the Glass-Steagall Act, which was subsequently repealed in the late 90s through the Gramm-Leach-Bliley Act. However, we are back to possibly reinstating the separation following the 2008 crisis. So, one should understand that regulation is a tough job and very few entities have been successful in striking a fine balance between over-regulating (and killing growth and opportunities) and under-regulating (and facing periodic crises).
Before I come to hedge fund regulation, I want to share with you my thoughts on how a good regulation should look like. First thing-it is good to know what you are regulating. Often people confound issues and some of these issues conflict with each other. So it is important to separate issues and be able to prioritize them on their importance. This way, when there are trade-offs to be made, it is easy to focus on the important goals than others. The second thing is to understand the incentives of people who are being regulated - why are they doing what they are doing in the first place? If regulation is enforced without giving the affected people an alternative, the regulation will often be short term in nature and people will figure out a way to achieve their objectives in some other way. The third thing is to be aware of externalities that different regulatory solutions cause. Many current problems like excessive leverage were unintended consequences of many governments' easy money policies intended to stimulate growth. The fourth thing is to appreciate and account for practical implications in regulations such as the difference in quality and compensation of the regulators & the regulated. For example, in the U.S., there is a vast salary difference between a SEC regulator & a Wall Street banker. Since most regulators leave and join the industry after a few years, their incentives to go hard on their future employers must be questioned. Lastly, we should be able to measure the effectiveness of any regulation. We can't manage what we can't measure.
Hedge funds were originally designed for sophisticated investors. These investors were deemed to be fit enough to take care of their own needs, and governments, by design, were less concerned as it did not affect retail investors. If a hedge fund were to go bust or simply disappear, there is very little that a government would do to protect its investors. With that in mind, hedge funds were allowed to operate as long as they had less than 100 investors and each investor was sophisticated & big enough to understand & withstand the risks involved. However, two issues arose on this arrangement. One, how do you treat large institutional investors who are merely intermediaries for retail investors? A large pension fund may in effect be representing the interests of hundreds of thousands of small individual investors. Second, there were no common rules on how much exposure a large institutional investor like a pension or an insurance fund can have on hedge funds since different regulatory bodies controlled different institutional investors. Given that most fund managers were driven by high short-term returns, it was not common for them to seek investments (including in hedge funds) that promised such returns.
The search for high yield and less stringent regulatory norms drove a lot of institutional money to hedge funds. Hedge funds, in turn, sought more and more exotic investments to differentiate themselves. Less regulatory scrutiny on their investments made it easier for them to operate. Here, it is important to highlight the lack of coordination among regulators of different markets that hedge funds and others were part of. Regulatory arbitrage, or the desire to seek less regulation to more, caught on not just with hedge funds but also with broader market participants as regulation in one part lagged another and some parts fell through the cracks completely. Organized markets had stricter disclosure and regulation but activity moved to over the counter markets where such requirements didn't exist. How does the regulator exercise control on those who are not registered with them or those who do not operate within their jurisdiction? Many hedge funds in the US are registered in places like the Cayman Islands, Bermuda, Mauritius etc. and hence outside the jurisdiction of American and European regulators. The global nature of trading made it difficult for regulators to take cognizance of risks that existed across national borders. All these factors collectively contributed to systemic risks being generated across different regulatory jurisdictions that a single regulator could not fully wrap their hands around.
Clearly, one thing that has happened post-2008 crisis is the greater need for cooperation among regulators, both within a country and across countries. Cooperation between CFTC and SEC within the US and between American and European regulators is now considered a necessity. A fundamental problem, however, exists in its practical implementation. Countries compete for capital and ideas and less regulation is often preferred by those who have them. So though such coordination may work well in times of crisis, it may be difficult to enforce it when countries are competing on the basis of lower regulation to attract new business. So, it is important that we have good metrics for regulation and keep monitoring them to ensure that we are neither too restrictive nor too lax in effective regulation. This is an iterative process and difficult to get right over a short period of time.
The year 2008 could be considered a watershed year in the hedge fund industry and the financial sector in general. What, if any, are the ways in which hedge funds have modified their operations since then?
2008 was a crisis year for the financial industry but I wouldn't say it was that bad for hedge funds. While broader market indices such as S&P 500 dropped by 35-40%, hedge fund indices were down by 20-25%. So in a relative sense, the hedge funds did not fare as badly as the market. In fact, a lot of them delivered significant returns that year, and would perhaps, welcome another such year given the extent of arbitrage opportunities that existed following the crisis. However, it was a watershed year in other dimensions. Due to decreasing liquidity and risk appetite among investors, the amount of money flowing into hedge funds dried up considerably. Investment opportunities also dried up since there was a major flight to quality and liquidity. Increased disclosure and regulation restricted their operations and many funds had to beef up their compliance and disclosure standards to keep up with the new times.
Major changes were noticed in the hedge fund industry post 2008. For instance, the amount of leverage that hedge funds employed came down significantly due to tighter risk management and reduction in funding liquidity. Assets under management came down sharply because institutional investors redeemed their investments & stopped the flow of new capital into hedge funds. Hence, asset values dropped significantly. All this meant that a lot of arbitrage opportunities available in the market in the immediate aftermath of the crisis could not be exploited by these funds.
On the operational side, investors ramped up compliance and risk management increasing the hurdle rate of return for investment significantly. The sharp drop in hedge fund returns in 2008 set new high water marks (the return threshold that funds have to reach before any performance based fees can be paid out) making it difficult for smaller funds to stay in business. Also, an interesting fall out of the crisis was that the commonality of the hedge funds' trading strategies was exposed. Despite their secretive nature, most hedge funds realized that they were making and losing money together. Moreover funds that were working under the assumption that large drops in the market (like two or three return standard deviation events) occur once in many hundred years had to face reality that tail risk was much more imminent and likely in practice. In short, the large hedge funds survived, became more restrictive in their investments, tightened their risk and controls and were forced to become more transparent as a consequence of the crisis.
The Case for Regulation
Considering that hedge funds account for a large share of transactions today, if they were to be regulated along the lines of other financial institutions, what would be the impact on the markets, and would it not stifle innovation?
It depends on how they get regulated. I feel that they will be very hard to regulate as they are not homogenous. Would the entry into hedge funds get more restrictive? Would the definition of who can be a hedge fund investor change? Would entities like pension funds be restricted from investing in hedge funds? Would countries coordinate in their regulation of hedge funds? Would hedge funds be forced to register in countries where their primary operations exist? It'll be very hard to measure the effect of regulation on hedge funds unless they are forced to comply with sweeping disclosure norms. Given their business model, a greater and more timely disclosure of their holdings would certainly soften their edge over other institutional asset managers. Such disclosure should, however, be holistic and must cover their full operations as opposed to being limited to only a few markets. For example, in the US, all investment advisers are required to disclose their quarterly holdings in stocks. Such disclosure is only partial since hedge funds may have hedged these positions using other means like options, swaps etc. that are not disclosed. Another important aspect is that equity holdings normally come with voting rights, and a hedge fund, after completely hedging its investment in a company in which it has no real interest, can push changes on the basis of the size of its equity holding. This may unfairly provide them with a greater say in management and control issues without a corresponding economic interest.
From a market perspective, a lower risk appetite and lower leverage by hedge funds would translate to lower volumes and lower open positions (or open interest). Since many hedge funds provide liquidity in markets, we may see lower liquidity by way of higher bid-ask spreads and increased volatility. Increased regulation may lower the systemic risk that some large hedge funds pose to markets. For example, if a large market participant goes bust, its counter parties are also adversely affected. This is what happened to Bear Stearns. If one entity defaults on its payments, an entire chain of defaults may be triggered. We have had only one case of a large hedge fund (LTCM) coming close to a default so far. Aside of counterparty issues, an imminent default could also trigger opportunistic front-running that may destabilize prices and cause short-term volatility in markets. We saw both in the case of LTCM. Its imminent collapse made its large holdings vulnerable to opportunistic front running as well as cause panic among counter parties.
We do not know if a hedge fund crash will bring down the markets like Lehman did. But clearly a large hedge fund with about 6-7 billion dollars and a 25:1 leverage could have a huge impact on several markets and counterparties. It is possible to regulate hedge funds by putting a cap on big they can grow (in terms of AUM) as well as a cap on leverage or a cap on the number of counterparties. But it is more of an art rather than a science. It's difficult to know what is big, and the definition of big also changes with time. LTCM was large in 1998 but by today's standards, it may not be big.
Even though hedge funds trade with the money of HNIÃs, they have an ability to influence the markets at the expense of the common investor. For example, the May 2010 flash crash of the Dow Jones industrial index was allegedly caused by hedge funds. Does this not undercut hedge fundsÃ argument to keep them out of the loop of regulation?
The Flash Crash was not caused by hedge funds; it was triggered by the action of a mutual fund. I do not think Flash Crash opened up the regulatory debate on hedge funds as much as the 2008 crisis and the LTCM collapse did. The Flash Crash was more on high frequency trading and not all hedge funds engage in that. However, in this age of high integration and interconnectedness among market participants, an action of one could be followed by actions of other participants at lightning speeds that things can get out of control very quickly. High frequency traders are supersonic market makers who have the ability to go in and out fast, in microseconds and milliseconds. Most of the larger hedge funds I know actually stay away from high frequency trading as their signals are more slow moving and are indifferent to price changes at a microsecond level. Contrary to popular beliefs, hedge funds (as well as high frequency traders) actually provide liquidity in many markets and limiting them could increase costs of trading in these markets. They also do not increase volatility, in fact, their actions as market makers may help reduce volatility. A lot of studies have looked at the Flash Crash and high frequency trading and have found that high frequency traders were offering liquidity throughout this period. If they caused the crash, they would be the first ones to demand liquidity, but that was not the case. A good high frequency trader is usually market agnostic, they does not care whether the market is going up or down - they just buy and sell before everyone else does. High frequency traders care more about volatility and less about market trends. Many hedge funds, however, would care of trends as that is their main source of alpha.
Nature of Regulation
There is a lot of talk about regulating hedge funds in the aftermath of the financial crisis. The Financial Stability Oversight Council (FSOC) has been created to identify systemically important organizations and impose checks on them. Do you think it is justified to include hedge funds in this category, and if so, what should be the criteria on which individual funds should be evaluated to be considered systemically important?
Large hedge funds do produce systemic risk, so they do need to be regulated. As I mentioned before, one can regulate them on the size of assets and the extent of leverage they can take. Given their global nature, regulation must be well coordinated across different countries, else it will fail. Determining what is too big to fail needs to be carefully thought out. You can take a look at various factors - assets under management, leverage, complexity of the product, number of counter parties they have - there are many dimensions, but you need to do it in such a way that you can measure it, so that the data can clearly indicate when a hedge fund has grown too big. Since hedge funds employ diverse and complex set of strategies, regulators must be able to understand them and determine systemic risks by collating risks across instruments and strategies. Regulation also needs to be dynamic in the sense that they need to keep up with the times and market conditions.
It is often argued that regulation is welcome and good only if it does not impinge on innovation, competitiveness and the industry's ability to evolve. How do you think this can be achieved?
It is a fine line that regulators need to walk. Also the need and desire for regulation changes with business cycles. Regulators need to keep focus on what can go wrong when things are going well and vice versa. Often they tend to become lax and resist restraint when economy is growing in the fear that they would be the ones to derail it. Similarly when things are not going well they tend to over regulate and delay recovery. Since regulators operate under public and political oversight, this may be unavoidable but we need regulators who can take a longer term view, avoid knee jerk decisions and be able to articulate their view well to public and to their political bosses. Having a framework for making decisions that is transparent and being able to measure the effectiveness of these decisions are necessary tools to walk this fine line.
The Scenario in India
As of today, no hedge funds are domiciled in India. SEBI seems to have adopted a very conservative stance in allowing hedge funds to operate in Indian markets. What are the reasons for that, and what should be the future course of action?
Even in the US, 80-85% of the hedge funds are domiciled in the Cayman Islands. The domicile decision has to do with several factors - taxation, legal requirements and regulation. Why would you be domiciled in Mumbai when you can pay no tax and be domiciled in Mauritius? In India, we are super conservative which is good and bad. It is good in the sense that extreme outcomes are averted. It is bad because we do not achieve the full benefits of a well-functioning market system. Bad regulation can derail creativity and productivity in more ways than one. SEBI is more focused on tactical regulation, regulation to address imminent issues and taken with a much more short-term view in mind. What we need is more of a strategic regulation, regulation that is holistic, proactive and accounts for underlying people's incentives so that it can provide reasonable boundaries without constricting creativity. SEBI also needs to develop local expertise to regulate complex or more systemic issues. Given that many participants nowadays are large global players, domestic regulators like SEBI need to understand developments in global markets and how these players operate.
Currently, the Indian financial markets are dominated by FIIs. If hedge funds were to start operating in India directly, what impact do you see on the other players in the financial markets?
Hedge funds will also be under the umbrella of FIIs if they are operating with foreign institutional investors' capital. To that extent, they will compete with other FIIs such as private equity and offshore funds for the capital. From the markets' perspective, they may improve price efficiency, increase volumes and may lower transaction costs if they offer liquidity like in the US. They may be restricted in their strategies given the extent of disclosure and regulatory scrutiny here but I would think they will still add to the overall development of the Indian financial markets if managed properly.
According to Dr. Venky Panchapagesan, regulating the financial services industry and hedge funds in particular, is not an easy task. The events of 2008 have led to a clamor for increased regulation, but blindly enacting rules and regulations is not the solution. If more regulation is put into place, then the focus should be on large players with a systemic impact on the financial markets. Emerging economies like India would do well to recognize the necessity of having a regulatory framework in place before their markets are significantly exposed to the effects of hedge funds.
Venky Panchapagesan is a visiting faculty of Finance at IIM Bangalore. He has had extensive experience in the financial sector and hedge funds, having worked at Bridgewater Associates and Goldman Sachs, and served as Professor of Finance at Washington University and Olin School of Business. He has also been invited to NYSE and NASDAQ as an academician.