Address by Reuben Jeffery III
Chairman, Commodity Futures Trading Commission
Managed Funds Association
February 7, 2006
Thank you, it is a pleasure for me to be here today. I also want to thank the MFA and Jack Gaine for inviting me.
In the past few years, the hedge fund industry has experienced nothing short of absolutely explosive growth. We all know the statistics. Worldwide, total assets under management are well in excess of $1 trillion – up from $400 billion in 2001. These are invested in more than 8,000 hedge funds, of all sizes and investment styles. By all accounts, growth in the sector continues to be robust. So, too, in the futures business. Those of you who are primarily or exclusively in futures are well aware of the sustained growth globally in exchange-traded futures products.
I could cite many other statistics, but in the end it is the dollars entrusted to your management that provide the best yardstick. And by this measure, whether you are a futures-focused CPO or a multi-market, multi-style hedge fund, you have been extremely successful in taking advantage of opportunities presented by the marketplace.
Equally important, but perhaps less apparent, is the contribution that hedge funds can make to the smooth functioning of our financial markets, and the futures markets in particular. First and foremost, hedge funds can contribute to market efficiency and enhance liquidity. Through their arbitrage activities, they can improve pricing efficiency. And by serving as counterparties to those seeking to manage exposures, hedge funds may offer other market participants an efficient means of transferring risk.
Of course, I am not telling anyone in this audience anything you do not already know. So what can someone from the CFTC add to your deliberations during this conference? What I offer are the observations of someone who has some direct familiarity with your world and a growing appreciation of the important role for, but also the limitations of, government regulation.
As some of you may be aware, I spent most of my career in the financial sector, primarily in investment banking where I specialized in the financial services sector. More recently, I’ve had the great privilege of working for the Federal Government for the past four years, in a variety of capacities and, since July, in my current role.
Fairly or not, hedge funds have long been conspicuous more for their perceived risks to the financial system and the mystique surrounding their operations than for the benefits they can bring to the marketplace and to their investors. More recently, hedge funds have attracted the attention of the media, legislators, and regulators, who, in the wake of widespread corporate scandals, are keeping an active watch on the sector. This is true not just in the US, but internationally as well.
And yet for all of the attention, there lacks a general consensus on hedge funds and what they mean for the financial system. Gerald Corrigan, former president of the Federal Reserve Bank of New York, is fond of commenting that hedge funds are like NFL quarterbacks: They get too much of the credit and too much of the blame.
I am not here today to engage in the ongoing debate over the role hedge funds play in the global markets or whether the hedge fund industry should be regulated; or if it is to be regulated, to advocate for any particular regulatory approach. Instead, I want to share with you some thoughts -- based on having observed your industry grow, prosper, and mature from my particular vantage point as a regulator and as an erstwhile market participant.
First, I’ll comment on what we as regulators, at the CFTC no less than our sister agencies, are most concerned about as we think about policy and implement our statutory mandates. Of course, those of you who are CTA’s or CPO’s know us well in this regard. Then, I’ll offer my own views as to what you, as an association, and as individual firms and individual professionals, can and should be doing to help yourselves.
What We as Regulators are Concerned About
What are financial regulators most concerned about? The answer is simple, and relatively universal: first, market integrity; second, investor protection; and third, systemic risk. These are the kinds of things taxpayers pay us to worry about.
In a sense, the hedge fund industry is a victim of its own success, because the reality is that today, given your scale, geographic scope and product reach, this industry implicates all three. Gone are the days when this community was, and could think of itself as a “cottage industry.” For those of you who are CTA’s and CPO’s, you are generally viewed under the “generic hedge fund rubric.” Hedge funds are now big players in just about every corner of the global markets and will face the public and regulatory scrutiny that invariably follows.
Let me talk briefly about each of these three issues.
Market Integrity: Market integrity is about keeping the markets fair and open, and free of price distortions. In the CFTC’s world of regulated, exchange-traded futures markets, market integrity is essential to preserving the important functions of risk management and price discovery that the futures markets perform in the broader economy.
An integral part of the CFTC’s surveillance of the futures markets is the Large Trader Reporting System, which requires traders to report if the size of the positions they hold in certain markets reaches “reportable” levels. Through Large Trader Reports, we know that managed funds, including hedge funds, are a substantially larger presence in futures markets today than they were a decade ago.
Active market participation does not necessarily raise market integrity concerns, but this increased presence has made hedge funds an inviting target for accusations of improper market behavior. For example, critics are questioning the speculative role of hedge funds in contributing to what are possible unwarranted movements in commodity prices -- particularly in the energy futures markets, where hedge funds have often been criticized for exacerbating price volatility.
CFTC economists have closely followed the energy markets and the role of hedge funds using the large-trader data, and have found that such criticisms, to date, generally have not been supported by empirical data. Yet, given that you have become such significant players in the markets we regulate, we must consider such allegations carefully in order to fulfill our statutory responsibility to protect the integrity of those markets.
Investor Protection: From an investor protection standpoint, hedge fund fraud allegations are big news. The examples of Philadelphia Alternative Asset Management, Bayou Management, and Millennium Partners are illustrative. While these situations are the exception, not the rule, when they happen they tend to be noteworthy.
Exacerbating these episodes of high profile problem cases is growing participation by institutional investors in the hedge fund market. A substantial portion of the inflows to hedge funds in recent years reportedly has come from pension funds, state funds, and endowments – fiduciaries for the savings of individuals. This greater interest by mainstream investors in hedge funds, traditionally viewed as the exclusive province of wealthy individuals, has inevitably raised the level of public scrutiny.
Systemic Risk: The third issue involves systemic risk -- the possibility that a failure of a large hedge fund or a group of hedge funds could seriously harm other financial institutions and the broader markets. This is a concern that was highlighted by Long-Term Capital Management, though it existed well before then.
The potential consequences of a large hedge fund implosion is both a reminder of the risks endemic to hedge funds and the need for overall market discipline to mitigate those risks. Given the sheer scale of the industry, systemic risks will remain very much in the forefront of the minds of legislators and regulators alike.
What These Realities Mean for You: Hedge Fund “Self-Regulation”
What does this mean for you? The issues I have just identified -- market integrity, investor protection and systemic risk -- call for industry commitment to good governance, operational integrity, and risk management that is self-imposed and vigilantly monitored by the industry itself. After all, it is the industry -- and each of you -- that is best situated to ensure that hedge fund practices do not put at risk public trust and confidence.
Lasting success can be sustained only on a foundation of public confidence, and that public confidence must be earned. This has been demonstrated vividly and repeatedly in recent years by the corporate meltdowns of companies like Enron, Worldcom, Tyco, and Refco, which remain fresh in the public’s mind.
Thus, my message here is straightforward: Given the realities of the hedge fund industry today, and the high public visibility you have attained, the bar has been raised. With great success comes great visibility. But, with visibility, comes even greater responsibility.
To be sure, the concepts of good governance, operational integrity, and sound risk management are not new to the financial services industry -- and certainly not to you. They are embedded in the core business model of any successful financial services firm. But it is incumbent on each of you, as leaders in your firms, to step up to the challenge of making sure that as the industry continues to evolve, these basic elements essential to long-term success are not left behind.
It is simply a matter of good business for a firm to promote and cultivate the highest standards of ethics and professionalism in the operation of the firm and management of funds under its stewardship. In this, the firm’s top management must lead by example to ensure that the message of ethical and professional conduct has real meaning.
You also understand the importance of ensuring the integrity of your firm’s operations and risk management, as well as other mission-critical functions, such as internal controls and compliance. These must be made central to firm operations, and sufficient resources - and the right people - must be devoted to support them. Of course, these are not profit centers, at least not in the normal sense. But short-term considerations should not lead a fund to shortchange investment in these critical aspects of its business.
Investment in those processes that will prevent problems from arising, and the concerns of a sometimes skeptical public and regulators from being realized in the first instance, is ultimately cost-effective and efficient.
Your industry, under the aegis of MFA, has demonstrated leadership in this area with the issuance of the Sound Practices for Hedge Fund Managers. The Sound Practices set forth updated guidelines to assist hedge fund advisers in developing an appropriate framework of internal policies and practices relating to key functions, such as risk monitoring, valuation, business continuity and disaster recovery planning. These guidelines should inform and enhance members’ ability to better manage their operations and meet their responsibilities.
Similarly, other private sector initiatives to improve counter-party credit risk management practices such as those recommended by the Counterparty Risk Management Policy Group II (CRMPR) can be extremely valuable. As many of you are aware, the group’s findings provided recommendations and established guiding principles intended to enhance counter-party credit risk management, risk monitoring, and the transparency of capital market activities.
The collaboration of the MFA, ISDA, and the dealer community to address the problems of novations of various swap contracts and to cleanup the backlog of unsigned credit default swap confirmations is laudable. This is the kind of industry collaboration and self-help that we as regulators applaud.
To wrap up, as Vince Lombardi said about “winning,” in the world in which you operate, “reputation isn’t everything; it’s the only thing!” Reputation is best served by observing the fundamental principles of good governance, operational integrity, and risk management in the way you run your business every day. To be sure, these functions do not generate tangible returns in the short-run; but, without them, any firm puts at risk the public confidence so essential to long-term success. As individuals, as firms and as an industry, the more you do for yourselves in this regard, the less government may feel compelled to do on your behalf.
The hedge fund industry today stands as a symbol of the success that can be achieved through unbridled energy and creativity in the marketplace. I am confident that you bring that same commitment and ingenuity to the task of strengthening good governance in each of your firms and to the industry overall. Ultimately, we all benefit as a result.
Last Updated: April 2, 2007