In the crosshairs: US hedge fundsā leverage strategies to be scrutinised
11 May 2021
The US Treasuryās revived hedge fund working group will continue where it left off, says Jonah Crane, who led the group in 2016, after the pandemic focused minds from both sides of the political aisle on market stressors
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The new head of the US Treasury has revived a dedicated committee to scrutinise the role hedge funds play in amplifying market stresses.
Janet Yellen, President Bidenās new pick to head up the US Treasury, revived the working group ā put on hiatus under the Trump administration ā to look into vulnerabilities in non-bank financial intermediation.
The working group will look at the way that leverage strategies of some hedge funds can amplify the sort of market stresses the economy faced during the pandemic.
Addressing her first Financial Stability Oversight Council (FSOC) meeting as chair in April, Yellen said the re-establishment of the working group means āthat we can better share data, identify risks, and work to strengthen our financial systemā.
Jonah Crane, who led the original hedge fund working group, is now a partner at law firm Klaros Group in Washington, DC. Here he provides some insights into what the revived group may be focusing on and what challenges it may face.
You led the hedge fund working group under the Obama administration ā in what way do you think the concerns of the group in 2021 will be different from back then, or similar?
The concerns are likely to be similar. Recent events, including the apparent role that leveraged hedge funds played in the March 2020 market disruptions that led to unprecedented Fed intervention, were precisely what we suggested might occur. Other recent events, such as the Archegos meltdown, may cause regulators to look at a slightly broader set of leveraged strategies than we were initially focused on.
At the time, the vast majority of leverage was focused in highly liquid markets. Archegos is a reminder regulators should scan for leverage more broadly, although the remedy for Archegos may be narrower ā it appears to have been more of a lapse of risk management at the prime brokers, and therefore an issue that lends itself to supervisory attention.
Was it a proactive decision to nix the hedge fund working group, or was it simply a case of the Trump administration not being able to populate the federal government with Trump acolytes?
It was mostly a matter of priorities, and a general view by those taking over the relevant roles that they didnāt want to pursue most of the work our administration had been focused on and they seemed to downgrade the role of the FSOC generally. Ideologically, people like Randy Quarles ā a Republican and vice chair for supervision of the Federal Reserve Board of Governors ā have warned for years about the potential of systemic risk posed by leveraged hedge funds, going back to the aftermath of the Long Term Capital Management blowup. And, post-March 2020, Quarles has led work at the Financial Stability Board looking at the role of non-bank financial institutions. So I donāt think it was a broadly ideological decision.
Calls to create enhanced oversight of and transparency in the US hedge fund space have been made repeatedly over the years, often immediately following a market downturn or period of volatility. Do you think this time around will be different?
I hope so. When we were examining hedge fund risks, the Long Term Capital Management episode was nearly 20 years old and there was perhaps a lack of a sense of urgency. I think the events of March 2020, while not solely a hedge fund phenomenon, impaired market functioning to the point the Fed had to step in, and that appears to have focused peopleās minds. Now-Secretary Yellen was Fed chair when the HFWG began its work, and she highlighted that work in the aftermath of last March.
Shouldnāt efforts be made proactively, not reactively? How would you see that working?
Yes, indeed thatās the point of the HFWG, and FSOC in general. The precise solution here has not yet been identified, but a few ideas that should clearly be on the table are: More comprehensive, timely, and useful reporting by hedge funds so regulators have a better sense of where risks might lie; enhanced supervision over the intermediaries providing leverage; improvements to market infrastructure, such as increased use of central clearing in various Treasury markets; and minimum haircuts on repo transactions. FSOC has unfortunately lost four years during which it could have been identifying and refining ideas.
Are these ideas you wanted to pursue or tried to pursue when you were leading the group, or are these things you think the current group will be pursuing or should be pursuing?
Both, in short. The report from the HFWG that I delivered to FSOC at an open meeting in 2016 lays out the state of play at that time and is focused mostly on data. The other ideas have not, to my knowledge, been formally considered by the HFWG ā but should be. Central clearing for treasuries has been discussed in other contexts, but not by HFWG.
So beyond data these are mostly my ideas for solutions HFWG should consider ā some of which were discussed in the group previously but, outside of data, not part of the formal recommendations of the working group.
Yellen may find significant public and political support for any proposal seen to be cracking down on what is perceived to be an under-regulated market demographic ā do you think that is justified?
As I mentioned, Randy Quarles has identified the need to protect against systemic risk coming from hedge funds, so itās not a partisan issue. There will be pushback from the industry, and itās not a high-salience issue with the public, so I am not sure which way āpoliticsā cuts here. I think Secretary Yellen will want to get to the right answer, and get ahead of potential future market disruptions.
I should note that we had constructive engagement with the industry, particularly in the area of making hedge fund disclosures more meaningful and more focused on actual risk, rather than check-the-box reporting that is burdensome for the industry to report and at the same time not useful to regulators.
The HFWG will look into vulnerabilities in nonbank financial intermediation ā how much support for this will Yellen get, do you think?
I think she will have a willing partner at the US Ķų±¬³Ō¹Ļ and Exchange Commission (SEC) in chairman Gensler, which will help. The Fed is also focused on addressing this and other vulnerabilities that have contributed to several episodes of market volatility. We donāt know who will lead the Commodity Futures Trading Commission yet, but I would be surprised if they are not also supportive. If you have those regulators, you have plenty of critical mass.
Has the HFWG ever authored anything that has had a lasting impact?
In the past the HFWG has identified several areas which have required further analysis, starting with the data available to federal regulators. That work now appears poised to continue after a considerable four-year pause.
When it comes to hedge funds, what are the current rules for leverage and what are the reporting rules for leverageāand what rules would you change?
There are no limits per se. Hedge funds of a certain size are required to report quarterly to the SEC, but itās not very timely or useful. The shortcomings of that reporting is covered extensively in the report from the HFWG.
Janet Yellen, President Bidenās new pick to head up the US Treasury, revived the working group ā put on hiatus under the Trump administration ā to look into vulnerabilities in non-bank financial intermediation.
The working group will look at the way that leverage strategies of some hedge funds can amplify the sort of market stresses the economy faced during the pandemic.
Addressing her first Financial Stability Oversight Council (FSOC) meeting as chair in April, Yellen said the re-establishment of the working group means āthat we can better share data, identify risks, and work to strengthen our financial systemā.
Jonah Crane, who led the original hedge fund working group, is now a partner at law firm Klaros Group in Washington, DC. Here he provides some insights into what the revived group may be focusing on and what challenges it may face.
You led the hedge fund working group under the Obama administration ā in what way do you think the concerns of the group in 2021 will be different from back then, or similar?
The concerns are likely to be similar. Recent events, including the apparent role that leveraged hedge funds played in the March 2020 market disruptions that led to unprecedented Fed intervention, were precisely what we suggested might occur. Other recent events, such as the Archegos meltdown, may cause regulators to look at a slightly broader set of leveraged strategies than we were initially focused on.
At the time, the vast majority of leverage was focused in highly liquid markets. Archegos is a reminder regulators should scan for leverage more broadly, although the remedy for Archegos may be narrower ā it appears to have been more of a lapse of risk management at the prime brokers, and therefore an issue that lends itself to supervisory attention.
Was it a proactive decision to nix the hedge fund working group, or was it simply a case of the Trump administration not being able to populate the federal government with Trump acolytes?
It was mostly a matter of priorities, and a general view by those taking over the relevant roles that they didnāt want to pursue most of the work our administration had been focused on and they seemed to downgrade the role of the FSOC generally. Ideologically, people like Randy Quarles ā a Republican and vice chair for supervision of the Federal Reserve Board of Governors ā have warned for years about the potential of systemic risk posed by leveraged hedge funds, going back to the aftermath of the Long Term Capital Management blowup. And, post-March 2020, Quarles has led work at the Financial Stability Board looking at the role of non-bank financial institutions. So I donāt think it was a broadly ideological decision.
Calls to create enhanced oversight of and transparency in the US hedge fund space have been made repeatedly over the years, often immediately following a market downturn or period of volatility. Do you think this time around will be different?
I hope so. When we were examining hedge fund risks, the Long Term Capital Management episode was nearly 20 years old and there was perhaps a lack of a sense of urgency. I think the events of March 2020, while not solely a hedge fund phenomenon, impaired market functioning to the point the Fed had to step in, and that appears to have focused peopleās minds. Now-Secretary Yellen was Fed chair when the HFWG began its work, and she highlighted that work in the aftermath of last March.
Shouldnāt efforts be made proactively, not reactively? How would you see that working?
Yes, indeed thatās the point of the HFWG, and FSOC in general. The precise solution here has not yet been identified, but a few ideas that should clearly be on the table are: More comprehensive, timely, and useful reporting by hedge funds so regulators have a better sense of where risks might lie; enhanced supervision over the intermediaries providing leverage; improvements to market infrastructure, such as increased use of central clearing in various Treasury markets; and minimum haircuts on repo transactions. FSOC has unfortunately lost four years during which it could have been identifying and refining ideas.
Are these ideas you wanted to pursue or tried to pursue when you were leading the group, or are these things you think the current group will be pursuing or should be pursuing?
Both, in short. The report from the HFWG that I delivered to FSOC at an open meeting in 2016 lays out the state of play at that time and is focused mostly on data. The other ideas have not, to my knowledge, been formally considered by the HFWG ā but should be. Central clearing for treasuries has been discussed in other contexts, but not by HFWG.
So beyond data these are mostly my ideas for solutions HFWG should consider ā some of which were discussed in the group previously but, outside of data, not part of the formal recommendations of the working group.
Yellen may find significant public and political support for any proposal seen to be cracking down on what is perceived to be an under-regulated market demographic ā do you think that is justified?
As I mentioned, Randy Quarles has identified the need to protect against systemic risk coming from hedge funds, so itās not a partisan issue. There will be pushback from the industry, and itās not a high-salience issue with the public, so I am not sure which way āpoliticsā cuts here. I think Secretary Yellen will want to get to the right answer, and get ahead of potential future market disruptions.
I should note that we had constructive engagement with the industry, particularly in the area of making hedge fund disclosures more meaningful and more focused on actual risk, rather than check-the-box reporting that is burdensome for the industry to report and at the same time not useful to regulators.
The HFWG will look into vulnerabilities in nonbank financial intermediation ā how much support for this will Yellen get, do you think?
I think she will have a willing partner at the US Ķų±¬³Ō¹Ļ and Exchange Commission (SEC) in chairman Gensler, which will help. The Fed is also focused on addressing this and other vulnerabilities that have contributed to several episodes of market volatility. We donāt know who will lead the Commodity Futures Trading Commission yet, but I would be surprised if they are not also supportive. If you have those regulators, you have plenty of critical mass.
Has the HFWG ever authored anything that has had a lasting impact?
In the past the HFWG has identified several areas which have required further analysis, starting with the data available to federal regulators. That work now appears poised to continue after a considerable four-year pause.
When it comes to hedge funds, what are the current rules for leverage and what are the reporting rules for leverageāand what rules would you change?
There are no limits per se. Hedge funds of a certain size are required to report quarterly to the SEC, but itās not very timely or useful. The shortcomings of that reporting is covered extensively in the report from the HFWG.
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