| Developments in hedge funds and global systemic stability: the case for regulation |
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| Ray Kinsella examines the nature and dynamic of the alternative investment markets (AIM), and the kind of regulatory system which the industry believes is appropriate, particularly in respect of hedge funds. He argues in favor of a normative and rigorous principles based regulatory system, for two reasons. Firstly, on the grounds of the latent instability of hedge funds, arising from their enormous leverage as well as developments in hedge fund markets in recent years. The second reason has to do with a more philosophical, but nonetheless important point, which relates to an emerging fracture between increasingly complex markets and their relationship to the real macro-economy. |
The EU Commission will shortly publish a White Paper on investment funds, including the future regulation of hedge funds. The Commission has consulted widely with the industry. It has also had input from two Expert Groups – on hedge funds and on market efficiency – which were set up following the earlier publication of a Green Paper. Notwithstanding the consultation process, the White Paper proposals will initiate a debate direct of fundamental importance to global financial services, and to financial stability, over the medium-term. Three base-line issues stand out as being of particular importance:
• What is the probability of a global systemic crises
• What reasons are there for believing that hedge funds, and developments in Hedge Fund-related markets, are more likely to play a ‘trigger’ role in the transmission of instability than are mainstream markets
• What form of regulation is most appropriate for hedge funds going forward
• The need for normative regulation
These questions are, of course, clearly inter-related. The near failure of Long-Term Capital Management (LTCM) was an ‘event’ which could, very easily, have triggered a wider market catharsis and liquidity crises than, in fact, it did. Importantly, they are not alarmist. While the possibility of global crises is discussed a good deal in the academic literature, as well as among central bankers, it is generally regarded as ‘sensationalist’ and not quite ‘good form’ to raise the matter within the public arena.
This is misconceived. There is positive probability of a systemic crisis, despite official and private–sector risk mitigating initiatives in recent years. The hedge fund industry, because of its size and its capacity, through leverage, to move asset prices, requires a rigorous regulatory framework, which recognizes both its positive and innovative nature in commoditising risk and its unique potential to generate and transmit contagion across markets.
It is difficult to imagine a systemic crisis originating in, and being propagated through, retail financial services. Contemporary analogies of, say, Herstatt, Continental Illinois or even BCCI, would be localised ‘events’, where the impact could be mitigated by local and cross-border regulatory action. Yet retail financial services operate under an enormous compliance burden that can only be partially explained by the (proper) emphasis in recent years on consumer protection. The fact is that retail financial services, from the authority’s perspective, are easy to regulate.
Not so hedge funds. The aggregate savings of pensioners are, for example, a major source of funding for pension funds. Informational asymmetries between, on the one hand, hedge funds managers strategies and, on the other hand, pensioners at the far end of the investment ‘food chain’, are enormous. More generally, the potential for volatility and, possibly, contagion, arising from an ‘event’ within the hedge fund sector, is significantly greater than within retail financial services. The temptation to trust to market discipline rather than normative regulation is understandable-but fraught with dangers to global financial stability
Lessons from market ‘events’
There have been a number of major financial market ‘events’ over the last decade or so.
By definition, it is not possible to foresee the next global ‘event’ and whether –and if so how-its effects can best be mitigated. It is, however, possible, to infer two points from what has been said. Firstly, there will be such an event. Financial history is not about to stop in 2007.Secondly, it is unlikely to be a single ‘event. Instead, what is likely is a ‘trigger’ event, whose impact will be amplified by contemporaneous events across asset markets, including relatively illiquid alternative investment markets, with ‘impact and feedback’ effects on the global macro-economy.
Developments in hedge funds as a ‘trigger event’
Hedge funds and FOHF continue to expand rapidly in depth and sophistication. There is currently in excess of $2.5 trillion under management .That represents a lot of leverage, especially in the wider context of their role in the Alternative Investment Markets.
The issue is not whether hedge funds have an important role to play. They obviously do. The question is whether there is an adequate global regulatory system in place to regulate and to monitor hedge funds - and whether initiatives aimed at market efficiency are sufficient to guarantee an easy night’s sleep to regulators and pensioners. There are reasons for believing that this may not be the case.
The ECB’s most recent Financial Stability Report points out that persistent low interest rates and an increased appetite for risk in mainstream markets has contributed to an expansion in the AIMs. Even with recent interest rate changes, ,the search for yield has provided powerful impetus to the growth of AIMs, which are subject to bouts of discontinuities and illiquidity. Hedge funds are at the heart of these markets. .In particular, the ECB analysis points to:
1. An increase in absolute and relative allocations by institutional investors to hedge funds
2. An increase in market concentration of under management, especially in FOHF
3. Evidence of lower hedge fund returns relative to longer-term averages;these diminishing returns reflecting in part a reduction in perceived arbitrage opportunities
4. Higher correlation of returns across hedge fund strategies, reaching levels in late 2005 that exceeded those that prevailed just prior to the LTCM crises
More generally, the ECB made the point that, 'The fact that correlations are trending higher not only within some strategies but among strategies, raises concerns that a triggering event could lead to highly correlated exits across large parts of the hedge fund industry. These highlights, in the starkest terms, the questions: Who would be charge in these circumstances, what regulatory framework would they operate within, and what instruments and resources would they have at their disposal to mitigate a crises?
Financial innovation and the constitutive purpose of markets
There is another largely ignored dimension of hedge funds that bears directly on the need for regulation and the fact that ideas of a ‘light regulatory touch’ are simply misconceived. It relates to the constitutive purpose of markets.
Professionals, up close and personal with a market that even regulators- let alone ordinary savers and pensioners( who provide a key part of the funding)-find it hard to comprehend, seldom find time to reflect on this matter. Yet it is central to the whole issue of regulation- and the kind of regulation that is appropriate for hedge fund-related market .The point is that markets are an essential economic and social artifact-but they are a means to an end. Their whole raison d’etre is to serve the real economy. In this context, the Compendium issued by the ISCJ notes:
‘A financial economy that is an end unto itself is destined to contradict its goals since it is no longer in touch with its roots and has lost sight of its constitutive purpose, In other words, it has abandoned its original and essential role of serving the real economy and ultimately of contributing to the development of people and the human community’
In a world of the financial exotica – of algorithms and arbitrage-it is easy to loose touch with what its all about -and the potentially catastrophic consequences and spillover effects in the wider system if something goes wrong. Regulation is there to see to this- and to leave regulation of such opaque and pivotally important markets primarily in the hands of the industry is both unrealistic and irresponsible. This does not exclude a role for the industry in relation to market efficiency-quite the contrary.
System-strengthening initiatives and the global ‘regulatory gap’
There are a number of factors which make full-blown systemic crises less likely than, say, ten years ago –but do not change its probable locus .Financial stability has emerged as a specific discipline within the domain of Central Banking. There is greater understanding of the propagation of ‘events ’across markets. Basle11[and its counterpart in insurance] has impelled institutions towards a greater understanding of risk - and the reality of emerging risks(e.g. ‘crowded trades’) in potentially volatile and brittle markets - but there is a limit to what better risk adjusted capital allocation can achieve.
There has been significant investment in systems to minimise counterpart /collateral risk. All institutions carry out ‘stress-testing’ and, at an aggregate level, so do central banks. There is increased cooperation amongst market regulators. The International Monetary Fund plays a role in market surveillance and the Bank of International Settlements continues to play a key role as a developed countries Stability Club, as well as producing the most incisive and elegant reports in the business. But no one is in charge. LTCM proved that.
At the same time, the reality is that the scale, and the potential volatility of AIMs - and indeed the wider set of markets, of which they are a sub-set- is highly fragmented. Within a global financial markets domain, there is no single global financial authority, combining the roles of surveillance, fostering market discipline, and providing of liquidity in the event of ‘spill -over’ effects in major market events. This has evolved, not through any conscious decision in favor of an evidenced-based ‘decentralised’ global financial architecture. It’s happened by default, and through co-operative ‘ad-hocery’.
Sarbanes-Oxley has highlighted the dangers of regulatory imperialism and ad-hocery. Whether, or not, SOX was a measured and proportionate regulatory response to deficiencies in auditing, accounting and internal controls, especially as regards the governance of global banks, is open to question. Leadership does have a role to play, as was all too evident in the case of LTCM. But SOX also highlighted the equally pressing problems of ‘regulatory unilateralism’. Its de facto global roll-out took little account of alternative approaches. The iterative consultation-based approach taken in developing the EU Eight Directive-which incorporated the principal of Subsidiary in regard to national standard-setting over and above ‘core’ provisions-leads to more informed and balanced outcomes.
The key point is that in a global commercial, including financial, environment characterised by integration, linkages as well as multiple -transmission mechanisms for propagating ‘contagion’ across markets’ fundamentally different regulatory models, let alone provisions is an indulgence that puts the entire system at risk. Unilateralism cannot be the answer. In the case of SOX /ex post/ consultations between the US and the EU were very much a second-best means of achieving a global regulatory ‘level playing field’.
It is equally the case that financial regulation in the US is not alone fragmented- but it’s also highly politicised. This is a reality –and it’s not conducive to achieving global Financial Stability, in the face of very real prospective threats.
Against this background- where the US de facto sets the tone and substance of global regulation- the absence of a single global regulator which has both a mandate and instruments to deal with a future systemic event, is disturbing. And it reinforces the argument that those sectors of the market- notably Hedge-Funds- which are particularly sensitive to, as well as being a potential transmission mechanism for,shocks, simply cannot be left to the industry or to the markets to regulate.
Developments in hedge fund markets as a trigger event
The Expert Groups set up by the EU Commission on hedge funds and, also on the key issue of Market Efficiency, set out a wide range of important initiatives. But the underlying theme, that what is needed is a light regulatory touch, is wrong. In fact, the possibility of it being wrong is, in itself, a sufficient reason for a risk-averse regulatory approach. Insipient strains in AIMs - within which hedge funds play a pivotal role- reinforce this argument. There is increasing pressure to generate returns which are not possible within mainstream markets. The unrealistic burden of investor expectations is itself a latent source of instability. The efficiency of hedge funds, using derivative-type products, has to be set against new forms of risk and the volatility associated with factors set-out above.
Equally, the issue of whether, or not, hedge funds are losing touch with their constitutive purpose has to be at least debated. Severing the umbilical chord between highly exotic and increasingly zero-sum game markets, and the real economy- (especially the economies of developing countries which do not benefit from financial innovation, but which are highly exposed to the negative effects of ‘event shocks’) - creates both the preconditions for a systemic crises, as well as pointing to the obvious need for a global Sheriff.’
No one-especially those with a vested interest in the status-quo ever anticipate catastrophe - but it happens. In these circumstances, there are compelling arguments for a normative, principles-based framework for the monitoring and regulation of hedge-funds. The EU White Paper provides an ideal opportunity for the EU to play a leadership role both in regard to the need for regulation that ‘will protect the stability of the financial system in all its intricate expressions, foster competition between intermediaries, and ensure the greatest transparency to the benefit of investors’. (Compendium, paragraph 369).
Particular reference is made in this article to: Bank of England’s ‘Financial Stability Report, Issue 20 (2000); The European Central Bank, ‘Financial Stability Review’, (June 2006), Finance Dublin, Fiona Redden ‘Expert Groups give Opinion on Future Direction of the European Funds Markets’, (July 2006), ICSJ Compendium of Social Teaching. |
Professor Ray Kinsella is on the faculty of the Smurfit Graduate School of Business and the Management Institute of Paris.
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| Article appeared in the November 2006 issue.
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