14/09/2011 Author: Andrew Baker

Comment: Andrew Baker

You may recall that in early 2009, at an important moment for our industry, the Alternative Investment Management Association (Aima) came out in support of several measures including improved transparency to regulators and the registration/authorisation of all hedge fund managers globally. This made clear that the hedge fund industry was neither opaque nor uncooperative, and it helped create a spirit of constructive engagement that marked our subsequent discussions with policymakers.  

We recognised that by having managers register with, and report to, the likes of the Securities and Exchange Commission (SEC) and the Financial Services Authority (FSA), more data would be available to allow better monitoring and assessment of markets. As such, hedge funds would be able to contribute to a more effective global systemic risk-monitoring system.

However, we also were quick to add an important caveat – that it was important managers were not forced to supply too much unnecessary information for regulators to have to process. I am reminded of this as we wait to hear whether any hedge fund firm will be designated a ‘systemically important financial institution’ (SIFI) and, therefore, subject to further regulatory scrutiny including additional oversight by the Federal Reserve. As the Financial Stability Oversight Council (FSOC) in the US is expected to clarify soon the criteria by which it will determine what non-bank financial companies may be deemed systemically important, it is our strong contention that no hedge fund firm today should be designated as a SIFI.

We believe that no single hedge fund firm today is sufficiently large, leveraged, complex or interconnected that its failure or financial stress would cause a “market disruption sufficient to destabilise the financial system” – the basic definition of a SIFI. It should be remembered that the FSA has stated that, based on its risk reporting framework, none of the large hedge funds it examines (currently) poses “a significant systemic risk to the financial system”. It is also significant that the FSA’s most recent hedge fund survey found that major hedge funds do not pose a potentially destabilising credit counterparty risk, and that the levels of leverage employed remain relatively low, which in the words of the FSA suggests a “contained level of risk”.

The key issue, of course, is whether a hedge fund firm is ‘too big to fail’. Casting our minds back to 2008, more than 1,400 individual hedge funds were closed or were liquidated, almost all in an orderly manner. It has been acknowledged by many regulators and policymakers that those closures had virtually no impact on hedge fund firms’ counterparties or the stability of the financial system at large. This difficult period provided an up-to-date and significant stress test concerning hedge fund risks to markets.

Sebastian Mallaby of the Council on Foreign Relations has a memorable way of describing this – he says that hedge funds are “safe to fail, even if they are not fail-safe”. We are not suggesting that hedge funds do not fail, only that when they do, they do not bring the rest of the financial system crashing down with them.

Size matters in this debate. In our discussions with policymakers, we always stress that hedge funds collectively represent a relatively small group of extremely heterogeneous and often small businesses. The global hedge fund industry is dispersed, approximately 9,500 hedge funds manage a combined $2trn in assets, according to Hedge Fund Research, whereas a small number of financial institutions’ balance sheets are much larger on their own than the entire global hedge fund industry. Even their collective positions and exposures are not such that individual failures pose a risk to financial stability. And hedge fund firms employ significantly lower levels of leverage than banks and some other financial institutions.

Moreover, hedge fund activities do not typically contribute to pro-cyclical market dynamics; they tend to be contrarian or to look for market inefficiencies and, through their investment activities, they tend to make markets more efficient. As such, hedge funds enhance diversity of market behaviour and, therefore, contribute positively to financial stability. We hope the FSOC and other authorities recognise this and that common sense will prevail.

Andrew baker is CEO of Aima