Keynote Address: Hedge Fund Best Practices Seminar
The Explorer’s Club, New York, New York
Sharon Brown-Hruska, Acting Chairman
Commodity Futures Trading Commission
September 14, 2004
It is a pleasure to address you today on best practices in the hedge fund industry from the regulatory perspective. Many of you are familiar with the CFTC due to your registration with us as either a Commodity Pool Operator or Commodity Trading Advisor. As many of you know, up until some recent rule modernizations, holding any futures in your portfolio meant you had to register via the CFTC’s delegated authority to the National Futures Association. Today I want to bring you up to date on the CFTC’s regulatory program and what it implies for fund management. I also hope to provide some context, much of which emanates from an approach endorsed by Congress in the Commodity Futures Modernization Act of 2000, which provides a blueprint for regulatory innovation that is both effective and appropriate for derivatives and the managed funds that use them.
I must note that the views I express today are not necessarily those of the Commission or the staff of the Commodity Futures Trading Commission. Instead, the views are those of one whose interest in alternative asset markets began when I was teaching courses in investments, venture capital, and derivatives in the business schools at Tulane and George Mason Universities. I hope that my observations today will prove informative and of value to you, and even perhaps to my colleagues in Washington as we go forward and contemplate what changes, if any, should be made to the way hedge funds or their advisors are regulated.
While I will leave it to the experts in other panels to comment directly on outstanding rule proposals or recommendations of official reports on hedge funds, I will offer some observations on hedge funds generally and their regulation that I hope provides insight. Let me begin with an observation based on data collected by the CFTC with help from the NFA. According to these data, the number of Institutional Investor’s Platinum 100 largest hedge funds that were registered as Commodity Pool Operators (CPOs) under the CFTC’s delegated authority grew from 55 in 2002, to 65 of the top 100 funds in 2003. In addition, 50 out of the 100 largest hedge funds were also registered with the CFTC as Commodity Trading Advisors (CTAs). Among the 25 largest hedge funds, the proportions get even higher, with 68% registered as CPOs in 2003. Thus, a significant proportion of the hedge fund industry is already registered with the CFTC.
In addition, and perhaps more importantly, any hedge fund that uses the markets under CFTC’s jurisdiction, even if they qualify for an exemption from registration, continue to fall under the legal definition of a CPO or CTA, meaning that certain of the CFTC’s rules and provisions of the Commodity Exchange Act—such as those proscribing fraud or manipulation –continue to apply. In short, the operators and advisers to hedge funds, as collective investment vehicles, are not distinct from CPOs and CTAs, but rather are an important, and apparently increasing, subset of the population we oversee as a whole.
Many had predicted that the regulatory relief we have granted to CPOs and CTAs under the Commodity Futures Modernization Act to rationalize regulation for sophisticated or otherwise regulated entities would lessen the proportion of hedge funds on our radar screen. Specifically, the CFTC has adopted exemptions from registration for those funds engaging in de minimus futures investments and whose investors can claim accredited investor status; otherwise regulated entities such as mutual funds, insurance companies, and banks; and funds that cater to highly sophisticated investors, or “qualified purchasers.”
Filing for an exemption from registration does not release any of these persons from complying with our statutes, including the prohibitions against fraud and manipulation. All CPOs and CTAs, regardless of their registration status, are subject to prescribed disclaimer requirements for hypothetical performance, the antifraud and anti-manipulation provisions of the Commodity Exchange Act and the CFTC’s rules, and all trader reporting requirements. In addition to large trader reporting, we have an active, real time surveillance program, and continuously monitor the activities of large hedge funds in our markets, from energy to precious metals, to stock index and interest rate products. In fact, the activity of hedge funds in the various markets is a routine part of the weekly surveillance briefings that I receive at the Commission.
A case in point is the energy markets. During the recent rise in crude oil prices, the Commission's market surveillance group has been closely monitoring the overall size and composition of hedge funds positions. During this period, we have analyzed positions of both individual funds and the fund community in aggregate. While the funds have become a more significant player in these markets, our analysis suggests that they have not been exerting a negative influence on markets. In many respects, funds appear to be adding liquidity and increasing price efficiency by their trading.
The exemptions from registration are also noteworthy because they derive from the instructions given by Congress to the CFTC in the Modernization Act, which endorse some important concepts that I think we should take to heart. Specifically, Congress instructed the CFTC to identify and adopt core principles and acceptable business practices to replace prescriptive rules and regulations; and, where prudent, use our exemptive authority to provide relief from such prescriptive rules. Moreover, the Modernization Act enabled a principles based, multi-tiered approach based on the sophistication of investors, consistent with the private versus public markets in securities regulation. Finally, in the context of jointly regulated single security futures, the Modernization Act instructed the CFTC and the SEC to avoid duplicative and inconsistent regulatory structures.
As in other securities market regulatory settings, the regulatory model prescribed in the Modernization Act recognizes that not all markets are created equal. The statutory framework adopted allows different levels of regulatory involvement depending on the type of market one is operating and the sophistication of the market participants using them. For example, institutional market participants not needing the same protections as retail market participants are subject to a less intrusive regulatory framework; and markets that primarily involve principal to principal transactions are less a concern than traditional markets like exchanges, which are more easily accessible to retail customers.
Many critics have chimed that this model leaves holes in our regulatory coverage that could allow train wrecks to occur that, they say, could otherwise be prevented. I believe, however, that the government cannot and should not be the engineer on every train, and that a hold-every-hand model is costly and not any more effective than an oversight model. Even in the exempt markets, the CFTC retains and has exercised its authority to police against fraud and manipulation. In the OTC energy markets, for example, we have vigorously pursued those who engaged in false price reporting and manipulation. In the retail foreign exchange markets, we have been equally effective in prosecuting fraudulent activity that takes place outside the confines of our contract markets. Rather than limiting our authority or our jurisdictional reach, the tiered oversight model has increased our strength and effectiveness as a regulatory agency.
In essence, our approach has been to use our exemptive authority such that customer protection is not compromised and in cases where unnecessary or duplicative burdens on market participants are removed. While we recognize that regulatory relief may change the landscape of firms over which we survey, a few factors come to mind that may lead to an increase in those funds registered as CPOs and CTAs.
First, the USA Patriot Act requires that all financial entities, including hedge funds, select and submit to an approved regulatory agency for identification of fund sources and fund flows. The expertise of the CFTC in the derivatives markets, its demonstrated comfort with the complexities of the global market, and the significant and increasing use of futures products by hedge funds makes the CFTC the agency most likely to be selected by these funds, given that they must demonstrate their compliance with the anti-money laundering requirements (AML).
In addition, pursuant to our delegated authority to the NFA, elective registration with the CFTC will get those firms an independent and expert review that includes periodic examinations, evaluation of internal controls, and review of required disclosure documents and financial statements. Pat McCarty, our General Counsel at the CFTC and appearing on an afternoon panel will discuss more fully the CFTC’s oversight and provide some background on the NFA program for review of registered entities. I, for one, believe that the NFA does a tremendous job. They have demonstrated an understanding of the complexities of the firms they examine, and a willingness to be tough when they find problems.
I believe strongly that firms have incentives to build reputational capital, and that firms will choose to subject themselves to regulation, if it is appropriate for the kind of market and market participant. The result is not only good business, but also good public policy.
But what is the appropriate level of regulation? In our case, Congress recognized that regulatory agencies must be able to cope with innovation, and that a prescriptive model, one packed with dos and don’ts, can stifle innovation and lead to regulatory arbitrage. Given the complexities of modern fund management, including innovations in pricing, financial engineering, risk management, and the opening and development of more global opportunities, regulatory agencies simply will not be able to define and then develop rules for every strategy or activity. Further, the finance literature presents numerous case studies that demonstrate that prescriptive regulation on innovative markets can chill the domestic market and lead market participants to migrate to less regulated settings.
There are numerous jurisdictions that can and do welcome US investment capital with fewer requirements and little in the form of customer protection. In addition to losing tax revenue that would accrue to capital gains and the value that derives from keeping financial intermediation services in our economy, our ability to go after wrongdoing once it occurs is seriously challenged. Thus, rather than burdening innovative markets with prescriptive regulations that tend to homogenize activity and chase business offshore, we should seek a measured regulatory approach that emphasizes a strong after the fact enforcement program. Such an ex post approach actually allows the CFTC to pursue more cases where fraud is suspected and use our resources more efficiently. Decisive and tough enforcement acts as a powerful deterrent to wrongdoing and can help blot out the fraudsters that can stain the reputation of reputable firms.
Borrowing from economics thought, I am suggesting that there is a kind of optimal regulation that recognizes a mapping from the regulatory structure to the market, its products, and its participants. The statutory exclusions from the definition of an investment company that allows nonpublic offerings by funds with 100 or fewer investors and those who sell their interests to sophisticated investors is one such mapping that results in little direct regulation of the private capital market by the SEC. Perhaps a middle tier for regulatory structure would be that of an oversight model, like that employed by the CFTC in its regulation of CPOs and CTAs. Such a structure advances the policy goals of market integrity and investor protection while avoiding inflexible mandates and conscription into a certain model of behavior.
How hedge funds are currently regulated is determined in large part by the character of the investors that use them and the products the funds trade in the regulated markets. When I began teaching venture capital and private finance, what struck me was the fact that hedge funds are constituted legally and operationally like private equity funds, and that they even draw to a large extent from the same pool of investors. Hedge funds cater to corporate investors, endowments and trusts, and high net worth individuals. These investors typically have long-term investment horizons, and their tax status makes large long run capital gains appealing.
The tendency of hedge funds to seek opportunities in inefficient markets, developing or dislocated markets, nascent markets that are often characterized by illiquidity, but which hold significant promise as those markets mature, makes them an appealing choice to the kind of patient money attracted to the private capital markets. Lock-up periods and limits on redemptions are often a necessary component of investing in these markets. Contrary to the view that hedge funds’ structure is driven by regulation (or a desire to avoid it), the evidence suggests that the needs and demands of investors explain how the funds are constituted, organized, and what the funds invest in.
Even the growth of hedge funds of funds mirrors the venture capital and private equity markets, in that they provide a way for smaller (but still quite large) investors to diversify their holdings, which would be unavailable to them if they invested in a single fund. As investment minimums have climbed, high net worth investors found that they were unable to invest or attain the diversification they desired. Hedge funds of funds allow investors of high net worth to attain some diversification of their exposure to funds with different investment objectives.
Because of the array of risks associated with these types of investments, great pains are taken to make sure that hedge fund manager’s incentives are aligned with the investors. One way is for hedge funds managers typically to invest in the funds themselves. Another way, perhaps the most maligned feature of hedge funds, is the performance based compensation structure. While many are concerned about conflict of interest here, corporate finance teaches us that in fund management, performance-based compensation is heralded for its capacity to align manager incentives with investors.
Yet, while there are numerous parallels between the venture capital and private equity funds and hedge funds, hedge funds differ significantly from other pooled equity investment vehicles like mutual funds. While, like hedge funds, the purpose of mutual funds is to generate investment income, there is also a far greater emphasis on long strategies and the preservation of capital in these investments. In the case of mutual funds, while they come with no guarantee of future performance, they nonetheless are the workhorse investment vehicle for retail customers. They are homogeneous, which increases their appeal to average investors, but also makes for a robust competitive market where transactions costs are quite low and efficiency is quite high.
When I first started looking at hedge funds as a professor in risk management, in addition to their lack of homogeneity and their thirst for exploiting inefficiency, I saw that they were really on the cutting edge in terms of their use of asset selection, leverage, and pricing techniques that are commonly employed by users of the derivatives markets. Hedge fund managers recognize the appeal of uncorrelated assets as tools for diversification, as well as the natural appeal of derivatives to build uncorrelated portfolios. In derivatives, going short is as legitimate as going long, and to the extent that hedge funds trade in commodity interests, they are closely akin to the funds I have seen in the futures business.
So do hedge fund managers require a higher level of regulatory scrutiny? Certain aspects of hedge fund investment are commonly observed in seed-stage venture capital or speculating in futures contracts. Those investing in these vehicles know, or should know, that these are complex vehicles that carry no guarantees. To the extent that we as regulators want to limit the participation of investors who cannot afford to lose their stake, a higher threshold for an accredited investor is a good proxy for lessening the participation of those investors in need of additional protections. The retailization of hedge funds, which is a significant concern among regulators, would be addressed by an increase in the financial requirements for accredited investors.
When a regulator has jurisdiction over an industry, or individuals, they assume responsibility for what happens in that industry or to the individuals involved. When we see favoritism in the mutual fund industry or the fraud and accounting abuses that took place at Enron or Tyco or World Com, regulators are obligated to take action, as they also should if abuses are found to exist in the hedge fund industry. But there is no evidence that hedge funds are the preferred vehicle of fraudsters, anymore than any other equity or commodity funds are.
Looking at the CFTC’s enforcement activities against commodity pools, for example, we found that over the last five years, we average about 10 cases per year, and that a substantial majority of those cases were unregistered pool cases that generally involved outright misappropriation of investor funds. This means they did not trade futures, they did not actually operate a hedge fund, regardless of what kind of name they might call themselves, they just stole other people’s money.
The purported jump in enforcement cases brought by the SEC with regard to hedge funds from 7 to 12 is in absolute terms, since as a percentage of their total enforcement actions, it was unchanged at 2%. Moreover, I would note that many of the cases involved charging advisors with operating a Ponzi scheme. Since, by definition, a Ponzi scheme is illusory, I am not sure what it means to classify one as a hedge fund. Notwithstanding this caveat, combined with the evidence collected by the SEC, it appears that only about 2% of the combined CFTC and SEC enforcement actions from 1997 to 2003 were hedge fund/commodity pool actions.
Quite recently, the SEC and the CFTC have been investigating questionable trading practices in the registered mutual fund industry that in some instance have involved hedge funds. While I cannot comment on ongoing investigations, rest assured that where wrongdoing is uncovered, serious action will be taken. One important lesson is, even with registration and its associated mandates, the most prescriptive regulation cannot completely filter or deter opportunistic or unethical behavior.
Ultimately, the mission of regulators is to ensure investor protection and financial and economic integrity of the marketplace. It is not clear, nor proven by the evidence, that a highly prescriptive, one-size-fits all regulatory model is any better than a targeted, flexible model that takes into account the sophistication of the investors and the kinds of markets the invest in. Certainly, hedge funds invest in multiple asset classes, and use a variety of strategies, and this brings in multiple agencies and different levels of regulatory involvement, at different stops along the value chain.
Whatever action is ultimately taken by the regulators we must not stifle this innovative and entrepreneurial spirit. And just as we seek not to overly restrict hedge fund activity, we must also strive not to burden funds with duplicative requirements and regulations. As I have noted, a significant portion of the hedge funds and their activity is already regulated by the CFTC. As we move forward, the CFTC and the SEC must endeavor to work together and, to the extent possible, rely on each other’s knowledge, expertise, and regulatory programs to monitor the fund industry.