Global regulators shine spotlight on hedge fund risks

Hedge and PE funds could be considered systemically important financial institutions and have onerous capital requirements placed on them, suggests a new report by international watchdogs.
Global regulators shine spotlight on hedge fund risks

The inquiry into whether asset managers should be considered ‘too big to fail’ is turning its attention to hedge funds and private equity funds.

A new report suggests that highly-leveraged funds may be considered as ‘systemically important’ for the risks they pose to counterparties.

This second consultation paper from the Financial Stability Board (FSB) in association with the International Organisation of Securities Commissions (Iosco), argues that leveraged funds should be subject to further analysis as to the risks they pose to the global financial system.

If such entities are labelled as ‘globally systemically important financial institutions’ (G-Sifis), they would be subject to greater regulatory scrutiny and higher capital requirements.

Private funds, which the report defines as hedge funds and private equity funds, are in the firing line, with the report noting their high usage of derivatives, or borrowings from banks and broker-dealers to leverage up their trades, could mean their collapse would have a “cascading” effect in the event of a broad market crisis.

“The distress or forced liquidation of an investment fund that has extensive exposures and liabilities in the financial system could destabilise other market participants or counterparties,” the intergovernmental groups highlighted.

Amongst various criteria used to identify whether a fund should be considered a G-Sifi, the report suggests analysis of its ‘gross notional exposure’ (GNE) to financial markets.

A hedge fund with a GNE of $400 billion would be marked for a Sifi review, it said. GNE takes into account a fund’s balance sheet leverage (repos, prime broker financing, secured and unsecured lending) and synthetic leverage.

Retail funds may breathe a sigh of relief, with the report acknowledging that mutual funds and exchange-traded funds are often restricted in their leverage strategies under regulatory rules.

But while that may be the case, Iosco continues to highlight the fact that it is still possible for traditional funds to become highly leveraged, especially through derivatives use that is not centrally-cleared.

One proposed option to identify potential Sifi traditional funds is to measure the extent of a strategy’s use of leverage. For example, if a fund of $30 billion in net assets value (NAV) has three times leverage, with a size-only backstop of $100 billion net assets under management (AUM), then it could be identified for Sifi consideration.

Another method could be to capture funds with $200 billion in gross AUM for further scrutiny, as this would measure both their leverage and their size.

Meanwhile, the report is suggesting that fund house entities, and the funds they manage, should be viewed separately given that they have different risk exposures.

For example, litigation, the departure of key individuals, or operational problems such as inadequate or failed internal processes, could create distress for a fund house, but not necessarily to the fund itself.

The $1.27 trillion fund house Pimco made global headlines last year following the departure of co-founder and chief investment officer Bill Gross, which precipitated a $200 billion outflow. While the individual Pimco funds will have seen a dramatic fall-off in AUM, the distress, in terms of loss of fees, was mostly felt by the fund house itself.

But overall, the regulators view the risk of the collapse of a fund house as less systematically significant than the collapse of a fund itself, since the core function of an asset manager is managing assets on behalf of others, rather than the safekeeping of the fund.

“Asset managers tend to have small balance sheets and the forced liquidation of their own assets would not generally create market disruptions,” the report noted.

Risks could still exist though, the report added, as a fund house failure could lead to losses for their counterparties, including banks or brokers that have extended them financing.

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