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[Senate Hearing 109-1051]
[From the U.S. Government Publishing Office]

                                                       S. Hrg. 109-1051

             THE ROLE OF HEDGE FUNDS IN OUR CAPITAL MARKETS

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                       SECURITIES AND INVESTMENT

                                 OF THE

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                                   ON

  EDUCATING AND INFORMING THE CONGRESS AND THE AMERICAN PEOPLE ON THE 
               ROLE OF HEDGE FUNDS IN OUR CAPITAL MARKETS

                               __________

                              MAY 16, 2006

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs

      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html

                                 -----

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48-525 PDF                  WASHINGTON : 2009
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                 ______

               Subcommittee on Securities and Investment

                    CHUCK HAGEL, Nebraska, Chairman

            CHRISTOPHER J. DODD, Connecticut, Ranking Member

MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
JOHN E. SUNUNU, New Hampshire        JACK REED, Rhode Island
MEL MARTINEZ, Florida                CHARLES E. SCHUMER, New York
ROBERT F. BENNETT, Utah              EVAN BAYH, Indiana
JIM BUNNING, Kentucky                DEBBIE STABENOW, Michigan
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
WAYNE ALLARD, Colorado
RICK SANTORUM, Pennsylvania

                     Joe Cwiklinski, Staff Director

               Alex Sternhell, Democratic Staff Director

                          Jim Johnson, Counsel

                 Dean V. Shahinian, Democratic Counsel

                                  (ii)

                            C O N T E N T S

                              ----------                              

                         TUESDAY, MAY 16, 2006

                                                                   Page

Opening statement of Senator Hagel...............................     1

Opening statements, comments, or prepared statements of:
    Senator Dodd.................................................     3
    Senator Crapo................................................     4
    Senator Reed.................................................     5
    Senator Sununu...............................................     5
    Senator Bunning..............................................     7
    Senator Allard...............................................     8

                               WITNESSES

Hon. Randal K. Quarles, Under Secretary for Domestic Finance, 
  U.S. Department of the Treasury................................     8
    Prepared statement...........................................    51
Susan Wyderko, Director, Office of Investor Education and 
  Assistance, Former Acting Director, Division of Investment 
  Management, U.S. Securities and Exchange Commission............    22
    Prepared statement...........................................    55
Patrick Parkinson, Deputy Director, Division of Research and 
  Statistics, Board of Governors of the Federal Reserve System...    24
    Prepared statement...........................................    61
James Overdahl, Chief Economist, U.S. Commodity Futures Trading
  Commission.....................................................    25
    Prepared statement...........................................    65
Hon. Richard McCormack, Senior Advisor, Center for Strategic and 
  International Studies..........................................    34
    Prepared statement...........................................    68
Dr. Adam Lerrick, Visiting Scholar, American Enterprise Institute    36
    Prepared statement...........................................    81
Kurt Schacht, Executive Director, Center for Financial Market 
  Integrity, Chartered Financial Analyst Institute...............    38
    Prepared statement...........................................    83
James Chanos, Chairman, Coalition of Private Investment 
  Companies, President, Kynikos Associates.......................    40
    Prepared statement...........................................    86
John Gaine, President, Managed Funds Association
    Prepared statement...........................................    96

                                 (iii)

 
                        THE ROLE OF HEDGE FUNDS
                         IN OUR CAPITAL MARKETS

                              ----------                              

                         TUESDAY, MAY 16, 2006

                               U.S. Senate,
         Subcommittee on Securities and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met, pursuant to notice, at 2:21 p.m., in 
room SD-538, Dirksen Senate Office Building, Senator Chuck 
Hagel (Chairman of the Subcommittee) presiding.

            OPENING STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. Good afternoon. Today's hearing will focus 
on the role of hedge funds in our capital markets. The intent 
of this hearing is to educate and inform the Congress and the 
American people on this growing sector of our financial 
markets. According to the Economist Magazine, a hedge fund is 
defined as a managed pool of capital for institutional or 
wealthy individual investors that employs one of various 
strategies in equities, bonds, or derivatives, attempting to 
gain from market inefficiencies and, to some extent, hedge 
underlying risks.
    Charles Mingus, an American jazz bassist and composer once 
said, quote, making the simple complicated is commonplace. 
Making the complicated simple, awesomely simple, now, that is 
creativity, end of quote. Suffice it to say we are looking for 
creativity from our witnesses today.
    Alfred Jones is credited as the father of hedge funds. He 
established the Jones Hedge Fund in 1949. Roy Neuberger and 
Benjamin Graham are also credited for laying the foundations 
for the industry; however, hedge funds did not begin to gain 
popularity until the 1960s. In 1969, almost 200 hedge funds 
managed $1.5 billion in assets. Since then, the growth of the 
hedge fund industry has exploded, with most of the growth 
occurring in the past decade. Currently, over 8,000 hedge fund 
managers are controlling over $1 trillion in assets.
    Today's hearing will look at the benefits and risks of 
hedge funds to investors and to our economy. We will explore 
the current oversight of hedge funds, the level of 
transparency, the different types of investors, and the cause 
for the explosive growth of this industry over the last decade. 
The hearing will also examine the current dynamic of the over-
the-counter derivatives market and assess the growing risks and 
benefits of this industry. We will look at the types of 
derivatives offered, the main users of derivatives, potential 
concerns for investors, and the industry's impact on our 
capital markets. And finally, we will consider whether the 
Federal Government should play a greater oversight and 
regulatory role in these areas and also assess the risks of 
overregulation.
    In today's global economy, large amounts of money can be 
transferred in a moment's notice, and it is important that our 
investors have confidence in the systems and funds that 
transfer and administer their investment and assets as well as 
a good understanding of both their investment benefits and 
risks. Just as important is keeping our capital markets here in 
the United States strong and dynamic and the envy of the world.
    I welcome our witnesses today, who will help us explore 
these important issues. Our first two panels feature 
representatives from the President's Working Group on Financial 
Markets. We will look at the work of the President's Working 
Group on this issue. Our first panel includes the Hon. Randal 
K. Quarles, Under Secretary for Domestic Finance at the U.S. 
Department of the Treasury.
    Our second panel includes Ms. Susan Wyderko, current 
Director of the Office of Investor Education and Assistance and 
former Acting Director of the Division of Investment Management 
at the Securities and Exchange Commission; Dr. Pat Parkinson, 
the Deputy Director of the Division of Research and Statistics 
at the Board of Governors of the Federal Reserve System; and 
Dr. James Overdahl, Chief Economist at the U.S. Commodity 
Futures Trading Commission.
    Our third panel today features five experts who will offer 
their thoughts on hedge funds. First, the Hon. Richard 
McCormack. Dr. McCormack is currently a senior advisor for the 
Center for Strategic and International Studies. He is a former 
Under Secretary of State for Economic Affairs, Assistant 
Secretary of State for Economic and Business, and deputy to the 
Assistant Secretary of Treasury for International Economic 
Affairs. He is an expert on the role of international financial 
institutions. Dr. Adam Lerrick is a visiting scholar at the 
American Enterprise Institute and a Professor of Economics at 
Carnegie Mellon University. Dr. Lerrick's expertise is in 
international capital markets and hedge funds. Mr. Kurt 
Schacht, Executive Director of the Center for Financial Market 
Integrity of the Chartered Financial Analysts Institute; he is 
former chief legal officer for the State of Wisconsin 
Investment Board and has an extensive background in hedge funds 
and corporate governance matters. Mr. Jim Chanos, President of 
Kynikos Associates and Chairman of the Coalition of Private 
Investment Companies. Mr. Chanos has extensive experience in 
managing hedge funds and represents a coalition of hedge fund 
investment companies.
    Our fifth panelist has sent word that he will be unable to 
be here with us today, although he is providing testimony. It 
is Mr. Jack Gaine, President of the Managed Funds Association. 
And to all of our panelists, we are most grateful and 
appreciate your testimony.
    Senator Hagel. Before we get to our witnesses, let me next 
call upon the Ranking Member of the Subcommittee, my colleague, 
Senator Dodd.

             STATEMENT OF SENATOR CHRISTOPHER DODD

    Senator Dodd. Thank you very much, Mr. Chairman, and you 
have underscored the points here, I think, and I want to 
commend you for holding the hearing. This is very worthwhile 
for us to spend some time and examine this remarkable success 
story of hedge funds. You pointed out the success of this 
vehicle over the years. I note that in just the last 14 or 15 
years, we have gone from a $50 billion industry, which is not 
small, obviously, to in excess of $1 trillion. Some 9,000 hedge 
funds are now operating in the United States, and in my State 
of Connecticut, and Fairfield County has become sort of the de 
facto capital in some ways of hedge funds.
    I have a lot of constituents who are directly involved in 
this and have been tremendously, tremendously successful with 
it, obviously, improving efficiencies in markets, great 
liquidity as well, so this has been a wealth creator. It has 
been a source of tremendous success. And obviously, there have 
been some impacts as well on the corporate decisionmaking which 
people are raising some issues about; increasingly become 
mainstream investment vehicles for pension plans, institutional 
investors, and in some cases, real estate or retail investors 
as well.
    In my view, we know far too little about the role that 
hedge funds play in our capital markets, and thus, this 
hearing, I think, is extremely important for us to learn more 
about the role that these funds can play. It is our 
responsibility; it is my hope that we will continue to help us 
better understand the benefits and potential concerns 
associated with hedge funds.
    If it is this Committee's responsibility, as I believe it 
is, to ensure proper statutory and regulatory oversight of 
hedge funds, then, regulation that we look at should be 
effective and efficient. If it is going to be implemented, it 
should protect, obviously, investors and prevent against 
systemic risks, while at the same time striking this balance of 
not being anywhere near overburdensome or irrelevant to 
industry participants. And while I recognize the SEC's recent 
registration requirements have just recently gone into effect, 
I hope that our witnesses, and we have some very good ones here 
today, that they can discuss the increased regulatory oversight 
of hedge funds and touch on some of the implementation issues 
that are associated with the just finalized regulations.
    At first blush, the registration requirements and the basic 
examination regime seem to provide some rudimentary 
transparency for investors and regulators alike. Greater 
transparency becomes particularly important, in my view, as the 
number of hedge funds increase, and they play a greater and 
greater role in our capital markets. One of the fundamental 
issues for this Member and I believe for others as well is 
whether unsophisticated investors are impacted either directly 
or indirectly by hedge funds and whether the standards for 
accredited investors should be raised by the SEC.
    Mr. Chairman, I am very eager to hear if these registration 
requirements are helping or hindering the hedge fund industry 
and if investors are getting better information about the 
practices and management of their investments. I think that it 
is appropriate, again, as I said earlier, to take a close, hard 
look at this. I commend the Chairman for doing so. We have got 
some wonderful witnesses. I would just caution again, I know 
there are some strong feelings about this issue, but having sat 
on this Committee now for 25 years, I have watched situations 
in the past where there were great concentrations of wealth, 
and we did not watch as carefully as we should, and we paid a 
price for it, the country paid a price for it.
    So I think it is extremely worthwhile that are undertaking 
this kind of examination today, and I would note that our last 
witness here is Jack Gaine. Truth in advertising: Jack and I 
went to high school together, so I am very interested in 
hearing what Jack Gaine has to say about hedge funds.
    Senator Hagel. Senator Dodd, thank you.
    Senator Crapo.

               STATEMENT OF SENATOR MICHAEL CRAPO

    Senator Crapo. Thank you very much, Senator Hagel, for 
holding this hearing. I think it is a very timely hearing, and 
it is important that we in this Subcommittee and as Members of 
the Banking Committee develop a much stronger expertise on the 
issue of hedge funds and their role in our capital markets.
    In recent years, we have been hearing more and more about 
the role of hedge funds, particularly as the amount of capital 
invested in this sector grows. The importance, in my opinion, 
is to understand what they are, and that is that they are 
alternative investment vehicles, alternatives available to 
qualifying investors, either institutional or individual. The 
securities laws have for decades imposed restrictions and other 
limitations on the nature of investors, the nature of 
solicitation activities, advertising, and aggregation of 
offerings applicable to alternative investment vehicles 
offering unregistered securities to investors, and this 
flexibility in our securities laws has been and continues to be 
beneficial to our capital markets.
    As we are learning with the Sarbanes-Oxley Act, a one size 
fits all statutory or regulatory model gives rise to inequities 
and unintended consequences. As we explore the role of 
alternative investment vehicles in our capital markets, we 
should keep this in mind.
    With respect to the SEC's Hedge Fund Advisor Registration 
Rule, I would note that in my opinion, it is this Subcommittee 
in the first instance and our Committee overall where these 
issues should be resolved. First, the SEC rule was challenged 
in Federal court, and I for one am hopeful that the D.C. 
Circuit Court of Appeals will invalidate the rule, because as I 
see it, the SEC lacks the statutory authority to require many 
of the changes that it has required.
    Second, the rule is not a logical outgrowth of SEC staff 
studies on hedge funds, which finds that there is no inherent 
hedge fund fraud; no retailization in the industry and that 
most hedge funds operate responsibly.
    Third, there is a legitimate concern expressed by 
Commissioner Atkins and the Government Accountability Office 
that the SEC lacks appropriate expertise and resources to 
enforce the rule properly. That is not to say that we should 
not conduct oversight. It is not to say that this Committee 
should not develop the expertise and the information necessary 
to assure that we properly review this issue. As Senator Dodd 
has indicated, we need to pay attention and make sure that we 
do not allow problems to arise.
    While the SEC is an independent agency, it seems to me that 
it should not be permitted to take the term independent to an 
extreme, and it is unauthorized to write new law through 
regulation, as it has tried, and it must not be encouraged to 
do so in the future. It should focus on the enforcement and 
implementation of laws that we pass in Congress, and it must 
apply its resources responsibly.
    Again, I thank you, Mr. Chairman, for holding this hearing, 
and I look forward to the testimony of the witnesses and to 
working with the Members of this Committee to be sure that we 
do strike the right balance and achieve the right legislative 
response to hedge funds.
    Senator Hagel. Senator Crapo, thank you.
    Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Well, thank you, Mr. Chairman. I want to 
commend you and Senator Dodd for holding this hearing. It is a 
very important topic. Our concern must be the safety and 
soundness of the financial system, and we have to pay special 
attention to any type of systemic risk, and it is important 
that we consider this topic, and I think it is important for 
the industry to be able to explain the benefits of hedge funds. 
And there are demonstrable benefits in terms of sources of 
liquidity, increases in efficiency, and decreases in 
volatility, and I think it is also incumbent on them to lay out 
potential risks.
    And the more comfortable we are with both the benefits and 
the risks of these funds, the better able we will be to 
legislate and to guide the regulatory agencies in their tasks, 
and I thank you for the opportunity to have this hearing today.
    Senator Hagel. Senator Reed, thank you.
    Senator Sununu.

                STATEMENT OF SENATOR JOHN SUNUNU

    Senator Sununu. Thank you, Mr. Chairman.
    I think it is important that we have open discussion 
hearings designed to give us better information about the 
financial services industry in general, and hedge funds are an 
important part of that for the reasons that have been 
discussed. Senator Dodd pointed out that the success story 
behind hedge funds, the wealth creation; the improvement in 
liquidity in the market, Senator Reed also mentioned. And I 
think it is important to underscore that behind that success is 
a tremendous amount of diversity as well.
    We will sit here as Members of Congress and speak in vague, 
general terms about hedge funds, but the fact remains that the 
strategies and the investment approaches are as diverse as the 
entire financial services industry: long-term investments 
versus short-term investments; focus on commodities; focus on 
bonds; focus on equities; focus on other types of securities; 
mathematical modeling of weather phenomena to technical trading 
of commodities and metals and some of the recent materials 
where we are seeing big changes in pricing, radically different 
strategies employed, and I think we can start from the very 
basic idea that it does us a disservice and this process a 
disservice if we speak about hedge funds in some vague and 
general terms.
    It is important to note that hedge funds are already 
subject to fraud statutes, trading requirements, trading 
regulations that any other financial service firm or trader is 
subjected to. They have to comply with all those trading rules 
and regulations. What we are really talking about, though, is a 
new set of regulations: the one mentioned by Senator Crapo, 
promulgated by the Securities and Exchange Commission requiring 
registration, and I think we have to ask very basically whether 
or not the SEC really is the appropriate agency to be 
undertaking that kind of regulatory requirement when their 
charter is to protect the small retail investor.
    And by definition, not our definition, the definition that 
is in statute, hedge funds are designed to be marketed, sold to 
very sophisticated investors. Senator Dodd is very right: I 
think there is a legitimate question as to whether we should 
revisit those accreditation standards. Perhaps they should be 
strengthened. The threshold should be raised.
    I think that is an important point of discussion, because 
it is essential that we maintain the distinction. And in fact, 
the anecdotal stories that we have heard about problems in this 
industry in some cases were created by provisions within the 
SEC that allowed funds of funds to be marketed to less 
sophisticated investors, allowing hedge fund vehicles to 
register under the Investment Company Act that in turn allowed 
them to be marketed to individuals who did not meet the 
accreditation standards, that did not meet the $1 million asset 
threshold, that did not meet the $200,000 income threshold.
    We need to be mindful that regulations can create as many 
or more problems than they were originally intended to solve. 
The point was made that the country paid a very high price at 
another time for not exercising good oversight. I think that 
was a reference to the S&L crisis, but I think it is worth 
pointing out that that was a case where the taxpayers were 
asked, under statute, to explicitly underwrite insurance for 
the industry.
    Now, we have another situation which is before us where 
taxpayers have been effectively asked to implicitly guarantee 
bonds within the GSEs, Fannie and Freddie, and here, we are not 
talking about billions. We are talking about a trillion, a 
trillion and a half in securities that are out there, and I 
would argue that our time would be at least as well spent if 
were to make a determined effort to deal with that systemic 
risk that we know exists and we know there is an implied 
guarantee. We do not have such an implied guarantee in this 
industry. We should not have an implied guarantee in this 
industry. I hope, I believe Congress will be smart enough not 
to create one, but we also ought not to create regulations that 
have unintended consequences.
    If the problem is that we do not want pensions investing in 
hedge funds, fine. Then, the approach should be to regulate the 
pensions and not allow pensions to invest in hedge funds. 
Again, if the problem is that we are worried about the retail 
investor, fine; we should draw a bright, clear, distinct line 
and not allow individuals of a certain means to invest in these 
vehicles.
    But we should not start crafting regulations in order to 
sort of gather information so that we can pass new regulations, 
and in any way you look at it, that is what the SEC has done. 
There is no problem that they have identified, no problem that 
they have discussed, that they have documented that has led to 
the registration requirement under the Investment Advisors Act, 
and I do not think we should be promulgating regulations 
without defining a specific problem that we wish to address.
    I hope today's hearing will address at least a few of those 
issues, and I hope that this Committee and Congress will be 
very cautious in looking for new areas of the financial service 
industries to regulate, because our past record has not always 
been a good one.
    Thank you, Mr. Chairman.
    Senator Hagel. Thank you, Senator Sununu.
    Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Chairman Hagel.
    I am glad we are taking some time to get a closer look at 
hedge funds. There has been a lot of news about hedge funds 
lately, because more and more people are putting money in them. 
They have even become popular investment vehicles for our 
universities and pensions. A lot of money and a lot of people's 
futures are riding on them, and that raises a lot of questions 
and concerns.
    Some people are even calling for regulation of the 
industry. I think it is important for us to take some time to 
know what we are talking about before we do anything. I think 
the biggest cause for concern about hedge funds is that we do 
not know a lot about them. Due to the lack of information, we 
cannot be sure just how much risk this sector is exposing our 
financial market system to. I think we need to know more, and 
hopefully, we will get some good answers in this hearing.
    We can all agree that it is important to take reasonable 
steps to protect investors, but even more importantly, we must 
be sure that we are keeping a close eye on threats to the 
stability of our financial markets. That is why we need to know 
more about the hedge funds and what they are doing and what 
they are not doing. We do not need to stop investors from 
taking any risk, but we do need to address risk to our 
financial markets and our overall economic wellbeing of this 
country.
    I hope we can get a better picture on what is going on so 
that investors can make smarter decisions, and government can 
determine what action, if any is necessary. The SEC is trying 
to do that by requiring hedge funds to register as investment 
advisors, but that rule is being challenged in the courts and 
could be thrown out at any time. Hopefully, this hearing will 
help us see where we need to go from here.
    Thank you, Mr. Chairman. I look forward to asking 
questions.
    Senator Hagel. Thank you, Senator Bunning.
    Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Well, thank you, Mr. Chairman.
    I would just like to thank you for convening the hearing of 
the Securities Subcommittee to examine the role of hedge funds 
in our capital markets. Historically, hedge funds have provided 
an investment vehicle for financially sophisticated investors 
with sizable capital to invest, and I realize that these 
investors and advisors that deal with hedge funds, these are 
complicated transactions, so I am glad that you are taking the 
time to kind of brief the Committee and myself on various 
aspects of the hedge funds and how you deal with them.
    Not all mutual funds are required to register with the SEC 
and are not required to provide the same level of disclosure. 
So I am interested to know how this phenomenon is operating in 
the marketplace. And as investors look for ways to maximize 
returns, I see more and more are turning to hedge funds, but do 
these investors, particularly those investing in registered 
funds of hedge funds absolutely understand the risks involved? 
And how does the looser regulation of hedge funds translate in 
the capital markets?
    So I think this hearing is going to be a good opportunity, 
Mr. Chairman, for us to explore these and other matters, and it 
looks like we have an excellent lineup of witnesses that will 
be able to provide helpful insight, and I thank you for holding 
the hearing today, and I look forward to their testimony, Mr. 
Chairman.
    Senator Hagel. Thank you, Senator Allard.
    Secretary Quarles.

                 STATEMENT OF RANDAL K. QUARLES

             UNDER SECRETARY FOR DOMESTIC FINANCE,

                U.S. DEPARTMENT OF THE TREASURY

    Mr. Quarles. Thank you, Mr. Chairman.
    Chairman Hagel, Ranking Member Dodd, Members of the 
Subcommittee, thank you very much for inviting me to testify 
and present the Treasury Department's views on the role of 
hedge funds in the capital markets. As you have all noted, it 
is an interesting and important issue, and I think the purpose 
here of this hearing and improving our understanding of a 
critical component of our capital markets should be viewed by 
everybody as a welcome one.
    Mr. Chairman, I have prepared written testimony that 
discusses the subject in some detail, and with your permission, 
I would like to submit that for the record and simply summarize 
my points briefly here.
    Senator Hagel. All of the written testimony will be 
submitted for the record. Please proceed.
    Mr. Quarles. Thank you.
    To begin, I want to emphasize that both my written 
testimony and my remarks today are focused on the topic of 
today's hearing, which is the role of hedge funds in our 
markets. That is a different question from the one that has 
gathered quite a bit of attention the last few years, which is 
the regulation of hedge funds. I also think it is the right 
question at this time.
    If government addresses the question of regulation of any 
financial institution or activity without a clear understanding 
of the place that it plays in our financial system, the risk of 
unnecessary or excessive or inappropriate legislation is 
increased, so while I am sure we will touch on certain 
regulatory aspects, I intend to focus my remarks on what hedge 
funds do in and for our financial markets.
    Second, I want to state that while capital in these 
vehicles has grown substantially in recent years, they are not 
a recent invention, as has been noted. Their history typically 
dates to 1949. Today, the term hedge fund is used to describe 
much more than those early funds that adopted hedging 
techniques. They follow a wide variety of investment 
strategies. They invest in a wide variety of assets. There is 
no generally accepted definition, but it might be useful to 
list some features that are generally common, recognizing that 
no single feature is a defining characteristic. Those features 
include a passthrough legal structure, flexible investment 
strategies, incentive compensation structures, a restricted 
investor base, and relative ease of investor subscription and 
withdrawal.
    Looking at it that way, I think it is clear that whether or 
not we characterize them as hedge funds, investment vehicles 
with those characteristics are likely to be around for a 
considerable period of time because of the obvious advantages 
and attractiveness of a number of those features.
    I think it is also important to note that while there has 
been rapid growth, particularly over the course of the last 
several years in the amount of money that is invested in hedge 
funds that that growth has been accompanied by a certain amount 
of private sector discipline. Originally, the hedge fund 
investor base was composed almost entirely of high net worth 
individuals. Later, university endowments and other endowments 
and foundations were added as investors. Still later, pension 
funds, with their sophisticated managers and the consequence of 
the evolution of the investor base has been an increasing 
professionalization of the evaluation of hedge funds and their 
investment strategies, and each of these investor groups has 
imposed certain forms of discipline on hedge funds, and the 
hedge fund market has become much more institutionalized as a 
result. So while the hedge fund market has grown dramatically, 
there is at least some reasonable to believe that that growth 
has been subject to private sector discipline.
    Let me summarize briefly some of the principal benefits 
that I see hedge funds bringing to the financial marketplace 
and then some of the risks. The first, as all of you have 
already noted, is liquidity. One of the reasons that the 
financial markets of the United States are so attractive to 
investors is because of their liquidity. Because of the varying 
strategies that hedge funds employ, they are often the willing 
buyers or sellers that provide additional liquidity to 
financial markets. Hedge funds represent the overwhelming 
majority of trading volume in the distressed debt markets, in 
convertible bond markets, in the exchange traded funds markets. 
They also bring the benefits of price efficiency.
    Many hedge funds seek to create returns by targeting price 
efficiencies where there is a discrepancy between one or more 
markets or where there are wide bid-ask spreads, and thus, this 
activity produces the public good of better price discovery and 
more efficient markets. They help distribute risk. 
Concentration of market wide risk is one of the greatest 
threats to a smoothly functioning marketplace, and hedge funds 
help distribute that risk.
    There are benefits to investors as well. They provide more 
choices to the investor community. They help produce excess 
returns or capital protection, but there are risks that we 
should be focused on. Our written testimony discusses these in 
some detail. I think the principal ones are the large use of 
leverage, which we need to be focused on and as well different 
ways that leverage can be generated, including it being 
embedded in some of the instruments that hedge funds trade in.
    There are evaluation issues with hedge funds' portfolios, 
particularly given that hedge funds calculate their returns on 
the basis of periodic valuations, and there is the issue of 
clearing and settlement systems. While I do not think that that 
is something that is specific to hedge funds, it is something 
that because of the instruments, some of the instruments that 
hedge funds trade in, is something that we should be looking at 
in connection with today's hearing.
    So in conclusion, I would want to stress that we see 
significant benefits in the financial marketplace from hedge 
funds. We see some risks. At the Treasury Department going 
forward, we are going to be focused on engaging with financial 
market participants generally in order to better understand 
these over the course of the next several months, and we will 
be involved with the President's working group in doing that, 
too.
    Thank you very much.
    Senator Hagel. Secretary Quarles, thank you.
    Let's begin with 5-minute rounds? We have three panels 
today, and we have good attendance, and I think we will have 
other Senators stop by as well, and we will ensure that 
everyone gets all the questions asked that they would like to 
ask.
    So I will begin my 5 minutes with this question: in your 
opinion, Mr. Secretary, as you ended in describing in summary 
fashion risks, benefits, in your opinion, should the Federal 
Government be looking at a more defined regulatory role for 
hedge funds?
    Mr. Quarles. Well, I think at this point, I would not see 
evidence that would suggest that there should be greater 
regulation of hedge funds or a different concept than so far we 
in the official sector have generally been approaching with 
respect to hedge fund regulation, which is following 
recommendations of the President's Working Group in the report 
in the late nineties to focus on counterparty risk management 
as the way to deal with the risk that hedge funds may pose in 
the financial marketplace.
    I think that it is incumbent upon us to understand how 
hedge fund activities are evolving, and that is the reason for 
this program that I described to you of the Treasury Department 
reaching out in the financial marketplace over the course of 
the next several months to ensure that we do have a good 
understanding in concert with the President's Working Group of 
some of these current issues that may pose risks to the 
financial markets, but on the basis of information we have now, 
I would not say that there is anything that would cause us to 
believe there is a particular area or particular type of 
regulation that is lacking or that would be useful.
    Senator Hagel. How much transparency is there in the hedge 
fund industry, starting with Treasury's oversight?
    Mr. Quarles. We have, as I described, since we are focused 
on counterparty risk management, obviously, the official sector 
in general, the members of the President's Working Group 
various regulators, the Treasury Department as chair of the 
President's Working Group has a significant amount of 
information about the exposure of various regulated 
counterparties to hedge funds.
    In addition, post-LTCM and some of the recommendations of 
the President's Working Group that were proposed, and many of 
them have been adopted afterwards, there has been an increasing 
focus in the private sector and private sector counterparties 
of hedge funds on ensuring that they have the information they 
need in order to assess the risk of their exposure to hedge 
funds.
    So both official sector transparency and private sector 
transparency, there is a great deal of information that is 
available to the relevant parties about hedge funds, certainly 
more than there was even five or 6 years ago.
    Senator Hagel. What is the level of regulation, oversight, 
transparency of hedge funds in other countries?
    Mr. Quarles. Well, it varies, in part because, as I 
indicated in my remarks, there is no universally accepted 
definition of hedge funds. I am not aware really of any 
jurisdiction that has a formal definition of a hedge fund and 
then seeks to regulate them. Most jurisdictions have 
registration and some regulation of investment advisors, and 
the way that that plays out with respect to the advisors of 
hedge funds differs from jurisdiction to jurisdiction. But for 
the most part, you know, while the regulatory schemes of 
various countries are quite different, as a practical matter, 
hedge funds operating globally are not subject to a significant 
amount of official sector regulation in any jurisdiction.
    Senator Hagel. So no country has any particularly strong 
oversight or regulatory function over hedge funds?
    Mr. Quarles. I am not aware of a country that has, again, 
that has regulation within their jurisdiction that defined 
hedge fund activity as such, and more importantly, 
significantly affects the operation of hedge funds that might 
be organized outside of that jurisdiction within the country in 
question.
    Senator Hagel. You noted, I notice, in your written 
testimony, which we had a chance to look at prior to your 
coming before the Committee as well as in your just recent 
reference to LTCM, which I think everyone knows, it is Long 
Term Capital Management and what happened there in the late 
1990s, what systemic risks do you see might be in some parallel 
way eventually facing the financial services industry not just 
in hedge funds, but I think of Fannie Mae, Freddie Mac, the 
leveraged funds that they are involved in, derivatives, and if 
we do not have adequate transparency, oversight, how fast can 
these explosions take down markets?
    Mr. Quarles. That is an interesting question. Obviously, 
with respect to Long Term Capital Management, LTCM, I think two 
of the significant issues there were leverage, as we have 
noted, a substantial amount of leverage, and lack of 
counterparty discipline, lack of market discipline, in part 
because of the just financial environment at the time, lack of 
understanding of what they were doing, and the genius factor of 
LTCM, so there was a lack of discipline on their strategies.
    You can draw some fair analogies on both of those points 
between the risks that we have long said that we see with the 
operation of the housing GSEs, Fannie Mae and Freddie Mac: 
leverage; obviously, with LTCM, you had an entity that was 
leveraged about 25 to 1, $4 billion of capital to $100 billion 
of assets. The GSEs are leveraged to a greater degree, almost 
33 to 1, so you have a greater degree of leverage there, and 
you have the same lack of market discipline because of the 
perceived Federal backstop.
    It is a different source of the lack of market discipline, 
but the concept and the effect is the same, and those two 
reasons are chief among those that we have argued that the risk 
in these entities needs to be addressed, and I think it is a 
very fair point to draw the analogy to some of the risks that 
we saw in the LTCM situation.
    Senator Hagel. Secretary Quarles, thank you.
    Senator Dodd.
    Senator Dodd. Yes, thanks, Mr. Chairman.
    Again, thank you, Secretary, for testifying, and I want to 
sort of just pick up on that last interview of the Chairman. 
There was a recent interview done with Maria Marteromo I guess 
is her last name here, and she was interviewing Tim Geithner of 
the Federal Reserve Bank of New York and asked specifically 
about the question the Chairman raised with you, and the 
question she raised, is there another Long Term Capital 
Management crisis lurking out there?
    And his answer was even though the core institutions are 
strong in terms of capital, and risk is now spread more 
broadly, rapid growth in derivatives and hedge funds creates 
risk that future financial stresses may be harder to manage. Do 
you agree with that?
    Mr. Quarles. I do not know that that is necessarily the 
case. Rapid growth in any area increases the importance of 
understanding what the implications of that growth are, and, 
you know, there can be growing pains. Mr. Geithner has 
addressed some of them in the credit derivatives market by 
working to clear up the backlog of confirmations that I think 
you are all aware of. There were back office operational 
difficulties as to which there have been made significant 
strides that he is working on, and you can trace those to sort 
of rapid growth in that market. I think that is a fair point.
    But I do not think it is necessarily the case. Certainly, 
since LTCM, there is much more focus by hedge fund 
counterparties on ensuring that they understand the financial 
position of the hedge funds that they are dealing with, that 
they are providing credit to or are otherwise counterparties 
of; that they have greater disclosure about the facts that they 
think are necessary in order to assess their own exposures to 
the hedge funds. Balance sheet leverage, certainly, to hedge 
funds is significantly less than it was in the past.
    Now, I think there is an issue about evaluating overall 
leverage. We have some difficulty in measuring that as you 
have, you know, increasingly complex financial instruments with 
embedded leverage in them, and that is an issue that we need to 
think about, but I would not draw the same conclusion at least 
as that quote that you described to me, at least if one 
interpreted the quote as saying that necessarily, because of 
this rapid growth, there is more risk.
    I think there are some things we need to look at, but I 
would not necessarily say there is more risk.
    Senator Dodd. OK, I appreciate that, and I want to 
underscore your point, the opening comment you made that there 
are the obvious benefits we have all identified here on the 
Committee that have occurred as a result of hedge funds and 
their growth. But you also point out that there are some 
potential systemic risks. This was one. I wonder if you would 
identify any further systemic risks that you think this 
Committee ought to be aware of and what prudent steps that you 
advise the Committee or the regulators to take regarding hedge 
funds.
    Mr. Quarles. I think in addition to leverage, which is 
something you need to look at, two additional risks that we 
will be focused on understanding better is, one, you could call 
the risk of crowded trades. I talk about that somewhat in my 
written testimony, that as you have an increasing number of 
hedge fund managers, that while one potential benefit of that 
is diversification, because you have a larger number of people 
following a variety of strategies, that you could, in fact, 
have a hurting behavior that smaller managers of capital, in 
order to be able to attract capital, have to follow strategies 
that have been proven by others to be effective, and so, you 
have a hurting effect rather than a diversification effect, and 
trades can become crowded.
    If trades become crowded in illiquid instruments, that can 
result in destabilization if there is an attempt by a large 
number of investment managers to liquidate similar positions in 
illiquid instruments at the same time. So I think that is one 
thing that we need to understand better. And I think in 
addition, research are the valuation issues that I also 
mentioned, which are thrown into greater relief with respect to 
hedge funds than some other alternative pools of investment 
capital because of the compensation structure of hedge funds, 
the practice of hedge funds in valuing their assets generally 
annually in order to determine their carry, the 20 percent 
compensation that they get.
    As hedge funds increasingly move into instruments that do 
not have a readily determinable market price and raise 
valuation issues, that is something that I think we need to 
understand better. So the question of leverage, the question of 
crowded trades, the question of valuation, those are some of 
the things that we will be seeking to understand better over 
the course of the next several months.
    Senator Dodd. What about the current accredited investor 
requirement? Senator Sununu raised this issue. Others have 
raised it as well, going after these greater risks of some of 
these vehicles that are being used where the smaller investor 
is losing; the sophisticated investor seems to be shrinking in 
size. I think Senator Sununu raised a very good point about 
that. What are your thoughts on that issue very quickly?
    Mr. Quarles. Well, I think it is an interesting question. I 
am not sure at this point, you know, maybe with more 
information as we look more into it, I would feel differently. 
I am not sure at this point that with respect to hedge funds, 
that would necessarily drive a change in the rules, since in 
addition, most hedge funds still have very substantial minimum 
investment requirements that even if one would view the 
accredited investor definition as shrinking in significance, 
the minimum investment requirements for most hedge funds are 
still quite substantial and thus ensure that were moved out of 
the retail area.
    But again, if our engagement with various market 
participants and others' engagement, other regulators' 
information that they continue to gather would suggest that 
those minimum investment requirements are not sufficient to 
prevent retailization of the sector, looking at the accredited 
investor definition is certainly a sensible approach.
    Senator Dodd. Thanks, Mr. Chairman.
    Senator Hagel. Senator Sununu.
    Senator Sununu. Thank you.
    I think I want to follow up on that a little bit. My 
question would be not if you think the accreditation level that 
is currently in Regulation D is problematic but if you think it 
would be unwise to raise that threshold. I mean, you set that 
threshold for a variety of reasons. One is the substantive 
protection that it affords a retail investor for whom these are 
not intended to be investment vehicles, but also, you send a 
message about the expectations, the relative level of 
sophistication and knowledge that you expect investors to have.
    It is my understanding that Regulation D does allow or does 
give the accredited label to people that have income in excess 
of $200,000 per year or net worth of $1 million, and the fact 
remains that both of those, I think, are thresholds that are 
much more readily attainable by people that at least elected 
officials rightly or wrongly might term middle class.
    So my question is, well, is there any harm? Is there any 
negative outfall that you see to raising those thresholds, 
because it easy to multiply by two, to $2 million and $400,000 
in individual income? What unintended consequences might that 
have, if any?
    Mr. Quarles. Before I would say, before I would be 
comfortable saying that there was no harm in raising the 
threshold, I would want to have done, you know, more of a 
comprehensive analysis than certainly we in the Treasury 
Department have, and I would certainly want to hear the views 
and expertise of the SEC and others on all of the uses of that 
definition, because it is, you know, very commonly used not 
just as a reference in various statutes but as a reference in 
various market practices.
    I would, in part for the reasons that I said that these 
very, very high minimum investment requirements, unless I were 
to learn that there was a trend away from that in the hedge 
fund space, in part, because I do not think that hedge fund 
activity in itself should drive that. I would be reluctant to 
take a concern that there might be some future retailization of 
the hedge fund industry and move from that to a change in the 
accredited investor definition without a much more 
comprehensive review of all the potential implications of that 
than I would be able to give you today.
    Still, that said, it is a sensible question to ask, and it 
is a sensible inquiry to undertake.
    Senator Sununu. I appreciate your support for my question.
    [Laughter.]
    Senator Sununu. Have there been any documented problems, to 
the best of your knowledge, in applying or enforcing the 
applicable fraud statutes, trading regulations to hedge funds? 
Is there anything about them that prevents enforcement 
officials from doing their job where applicable securities law, 
trading law, and anti-fraud statutes are concerned?
    Mr. Quarles. I am not aware of any at all, and I think it 
is an important point to stress that where there are concerns 
about, and there have been documented instances and certainly 
allegations of market manipulation by hedge funds as there are 
for other market participants, hedge funds are subject to all 
of the same rules against market manipulation, against investor 
fraud as any other market participant, and the SEC and other 
regulators have the same panoply of enforcement tools available 
to apply to hedge funds that they do to anyone else who 
participates in the financial markets, and we have seen them 
apply them.
    Senator Sununu. I appreciate that response and appreciate 
your point, although I think it is worth saying that the fact 
that something is already against the law and effectively 
enforced has never really prevented Congress from attempting to 
make it against the law again in a number of circumstances. So 
I think it is a good cautionary tale, and I hope that and I 
sense that that is not where we are headed in this case.
    Thank you, Mr. Chairman.
    Senator Hagel. A very high note to end on, Senator Sununu. 
Thank you.
    [Laughter.]
    Senator Hagel. Senator Reed.
    Senator Reed. Thank you, Mr. Chairman. Thank you, Secretary 
Quarles.
    I think the Chairman has touched on this issue of the 
international ramifications of hedge fund regulations, but I 
would note that Britain and Ireland and other countries are 
moving toward more retail access to hedge funds. Separating 
from the specifics of their proposals this notion of--do other 
regulatory schemes put pressure on our hedge funds, even though 
we are the biggest source of hedge funds in the world, our 
hedge funds to either move offshore, to change their practices, 
or to modify our practices here locally?
    Mr. Quarles. Let me answer that with two parts: one, I am 
not aware that there is at least at this point kind of a 
significant pull effect from other regulatory regimes being 
viewed as relatively attractive versus our current regulatory 
regime and pulling hedge fund domiciles offshore and hedge fund 
activity offshore in a way that could have an adverse effect on 
our financial markets.
    I do think that there is some concern and some reason for 
concern that in an increasingly global financial marketplace 
where hedge fund activity among other activities in the capital 
markets is able to move with relative ease to other 
jurisdictions, there is some concern that potential 
developments in hedge fund regulation or legislation in this 
country could serve to push hedge fund activity offshore. So I 
think as we look at the issue, I think that is one of the 
things that we need to evaluate. We do need to be careful as we 
look at what the proper official sector policy response ought 
to be that we do not push beneficial activity offshore, but 
with respect to what I think was the principal thrust of your 
question, is there already some pulling offshore because of 
more attractive or laxer regulatory regimes abroad, I have not 
seen that yet.
    Senator Reed. One of the risks you pointed out was 
leverage, and it raises an issue that Senator Sununu suggested. 
That is, you know, what is the proper venue for regulation? Is 
it the hedge fund, or is it in some cases, the financial 
institutions that are lending to these hedge funds? Could you 
comment on that?
    Mr. Quarles. I think that the framework that the official 
sector, the President's Working Group and all the regulators 
that are part of that identified some years ago as the right 
approach, I think we have seen as the recommendations for that 
counterparty risk management framework be implemented, both in 
the official sector and the private sector over time.
    I think that we have seen that it has been quite effective. 
There are still some issues, that, again, as I have indicated, 
we want to understand, but the regulation of counterparties and 
the aggregation of information from regulated counterparties of 
hedge funds and the improvement of private sector counterparty 
risk management both conceptually and I think we have seen in 
practice can have and has had beneficial effects for the 
financial marketplace and with respect to some of the concerns 
like excessive leverage in the hedge fund industry that we have 
seen earlier.
    If there is a way to improve that, I mean, it is then 
incumbent upon the official sector with respect to our own 
responsibilities, at least, that that is going to be the 
framework to ensure that we are appropriately aggregating and 
looking at the information that we can have from the various 
regulated entities that are counterparties to the hedge funds. 
There may be ways to improve that going forward, but as far as 
the general concept and the good effects of implementing that 
concept over the last several years, I would say that they have 
both been positive.
    Senator Reed. Is there a practical issue of sort of 
fragmented, where there is a hedge fund that has a relationship 
with one financial institution, maybe three or four financial 
institutions, that one regulator is looking at one small piece; 
another regulator is looking at another piece; those pieces 
seem good, but when you put them all together, it is a 
different story requiring more coordination among financial 
regulators? Is that----
    Mr. Quarles. Exactly. That was kind of the--that was the 
better articulated thrust of my response about organizing and 
possibly increasing the sharing of information among 
regulators. I would stress that we have not seen any kind of 
actual practical problems as a consequence of that, but if we 
are going to describe that, and I think it is a good approach 
as the right framework to think about official sector 
management of hedge fund risk and activity, then, it is 
incumbent on us to ensure that we are appropriately aggregating 
that information.
    Senator Reed. Thank you very much.
    Thank you, Mr. Chairman.
    Senator Hagel. Senator Reed, thank you.
    Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Have you seen any evidence that hedge funds are 
manipulating the market in any way, such as driving stock 
prices down, forcing companies to take actions they otherwise 
would not, or anything else?
    Mr. Quarles. When you say hedge funds, so the industry as a 
whole, I have not seen that evidence. Now, in any--if you are 
talking about any industry in which there are between 8,000 and 
9,000 different participants, it would be surprising if there 
were not at least a handful among them who were not turning 
corners.
    There have certainly been allegations that there have been 
some hedge funds, not hedge funds as an industry but some hedge 
fund managers that have engaged in activities that may be 
illegal or may have an adverse effect on the marketplace. In 
each of those cases of which I am aware, appropriate 
enforcement action is being considered or undertaken against 
them as it would be for any other market participant.
    So I would not, on the basis, again, of the isolated 
incidents of which I am aware conclude that there was an 
industry-specific problem or propensity.
    Senator Bunning. And you know for a fact that each and 
every one of those violations are being investigated by proper 
authorities?
    Mr. Quarles. All of those of which I am aware.
    Senator Bunning. As the hedge fund industry has evolved, 
even more people are investing in it through different 
investment vehicles such as a fund of funds without regulation. 
Is there an unfair advantage in the market by being able to 
choose an investment that is unregulated? Does the large 
investor have an unfair advantage over the individual investor, 
small investor?
    Mr. Quarles. That is an interesting question. I would not 
say that it is an unfair advantage. The evaluation of the risk 
that is involved in a variety of hedge fund strategies is 
complex. I think that it is appropriate to require a certain 
amount of investor sophistication to view that investment 
opportunity as appropriate. It certainly is an important part 
of our evaluation of the overall adequacy and appropriateness 
of our current regulatory stance toward hedge funds that they 
are limited to sophisticated investors and are not marketed or 
available in any significant degree to retail investors. So is 
that a disadvantage to the retail investor that they are not 
able to take advantage of a manager that is following a 
particular hedge fund strategy?
    I think when you balance benefit and risk and the need for 
a significant amount of sophistication to be able to evaluate a 
number of these hedge fund strategies, I think it is probably 
the right stance.
    Senator Bunning. In your written testimony, you said the 
President's Working Group on Financial Markets has made several 
recommendations to support a market discipline approach to 
controlling leverage. Would you go into more deal about these 
recommendations, and which do you support?
    Mr. Quarles. Yes, among the recommendations were 
recommendations for increased transparency from hedge funds to 
their private sector providers of leverage to ensure that those 
leverage providers were aware of the overall financial position 
of the hedge fund as they provided leverage. And conceptually, 
that is of a variety of more detailed recommendations. That is 
at the heart of the counterparty risk management strategy 
recommended by the President's Working Group.
    There have been a number of public and private sector 
groups that have moved to implement that. The Counterparty Risk 
Management Group II under Jerry Corrigan has also taken up the 
cause of enhancing counterparty credit risk management, and I 
think that the end result of all of these efforts has been a 
significant reduction in balance sheet leverage in the hedge 
fund industry as a whole and a much better sense of hedge fund 
counterparties of what the financial position of their hedge 
fund credits are, and as a consequence, significant benefits to 
the financial sector generally.
    Senator Bunning. My time has expired, Mr. Chairman.
    Senator Hagel. Thank you, Senator Bunning.
    Senator Carper.
    Senator Carper. Thanks, Mr. Chairman, and Secretary 
Quarles, welcome. Thank you for joining us today.
    I missed your testimony. I understand you did not talk for 
long. I am going to ask you to just give us a couple of 
nuggets, the most important elements of your testimony that you 
would want me to take out of here and never forget.
    [Laughter.]
    Mr. Quarles. I would be happy to do that. I did not talk 
for long, but I did talk for 45 seconds more than my 5 minutes, 
contrary to the strict injunction of my legislative affairs 
colleague.
    If I were to say to take three things away from what the 
Treasury Department has presented here today, it would be, one, 
that it is important that we understand the topic of this 
hearing, which is the role of hedge funds, before we move in 
any degree to seeking to further regulate or legislate with 
respect to hedge funds. So the order is important, and I think 
there is more that we need to understand about the role of 
hedge funds. There is a lot that we do understand about 
benefits and risks. The second point is that we need to 
understand that role.
    That role is, on balance, positive because of the benefits 
of increased liquidity, increased efficiency of markets, price 
discovery, increased investor choice, you know, increased 
competition in markets. All of these are positive benefits of 
hedge funds, and there are, however, some risks that I think it 
is incumbent on us in the official sector to understand better 
than we do. We can identify some of them. I mentioned leverage; 
I mentioned valuation issues; I mentioned the crowded trades 
issue.
    And as a consequence, the third point is that is why, you 
know, at the Treasury Department, we have identified that we 
will, over the course of the next several months, be actively 
engaged in reaching out to private sector market participants, 
both hedge fund counterparties, hedge fund managers themselves. 
We will be working to bring together members of the official 
sector through the President's Working Group to look at some of 
these current issues with respect to risk as well as the 
overall facts about the current role of hedge funds in the 
markets to make sure that we have a very sound understanding of 
that before we come to some conclusions about what, if any, 
policy response there ought to be.
    Senator Carper. OK, thanks. Do I understand that hedge fund 
registration has been required since February of this year?
    Mr. Quarles. I think that is right. It has been relatively 
recently.
    Senator Carper. Do you have any idea how compliance has 
been? And to what effect do you think the registration helps or 
hinders investors?
    Mr. Quarles. Well, I mean, it might be appropriate for me 
to--the SEC representative on the next panel, Ms. Wyderko, will 
have more detail about what the SEC has learned from its 
registration effort and how compliance has been. I think from 
our point of view, it would probably be premature for us at the 
Treasury Department to have any strong views as to what we can 
learn from that, because it is such early days in the 
implementation of the regulation.
    Senator Carper. OK, one last question I would have: a 
couple of weeks ago we marked up in this Committee legislation 
that we called Reg Relief, and during the discussion on Reg 
Relief, among the provisions we discussed were those that were 
designed to impede money laundering in our financial 
institutions. Let me just ask a related question: to the best 
of your knowledge, what are the hedge funds doing to impede 
money laundering, or what more should they be doing?
    Mr. Quarles. That is a good question. The hedge funds, 
obviously, are complying with any laws that are applicable to 
them about, you know, transfers of funds in or out over a 
certain size, and regulated financial institutions that are 
counterparties of hedge funds as they move client monies in and 
out of hedge funds themselves have to know who those clients 
are, and, you know, they have the Know Your Customer rules, and 
they also keep track of those financial flows. So I think in 
the current scheme of things, the principal tool, if you will, 
that we have for addressing those issues, the money laundering 
issues, is, again, through the regulation of counterparties.
    Senator Carper. My time has expired. Can I ask just one 
real short one, just one quick one? What further advice would 
you have for us other than holding hearings like this for this 
Committee with respect to hedge funds?
    Mr. Quarles. I am not sure that--I think I would just 
simply reemphasize that in this rapidly developing sector, I 
think it is important for the Members of this Committee, those 
in the administration, the independent regulators, to ensure 
that do we have a good finger on the pulse of this industry so 
that we know what developments are that we are not in some 
future period of stress moved to respond on the basis of an 
insufficient knowledge base but at the same time not to squeeze 
so hard that we cutoff circulation.
    Senator Carper. All right, thanks so much.
    Thanks, Mr. Chairman.
    Senator Hagel. Senator Carper, thank you.
    Senator Allard.
    Senator Allard. In the hedge funds, we have a lot of 
private contract agreements or not, or are those more into 
other derivatives?
    Mr. Quarles. I am sorry, do we have a lot of----
    Senator Allard. Sort of private contract type.
    Mr. Quarles. Yes.
    Senator Allard. And where do you draw the line between a 
private contract and maybe a more public transaction? Let us 
just say a stock transaction, for example, if we would just put 
it in those general terms, one extreme over the other; where do 
you draw the line?
    Mr. Quarles. Well, I think that if you are talking about--
if an instrument has been created that trades easily with 
retail investors or that moves easily through the financial 
marketplace in ways that could have knock-on consequences 
significantly beyond those of the counterparties, that is 
something that one might appropriately view as having public 
aspects, that the public might have an interest in. To the 
extent that you are dealing with a private contract affecting 
the financial relationship between two counterparties, even 
when that contract might key off in some way of a publicly 
traded instrument, then, I think it is not inappropriate for 
those parties to believe that the risks of that contract are 
for them to judge.
    Senator Allard. Usually, those are Ph.D.s and pretty well 
educated individuals, I would assume.
    Mr. Quarles. As a general rule.
    Senator Allard. If we just took an average, well, let us 
say an informed investor that meets the threshold, who makes 
$200,000 a year, and they have over $1 million in net assets, 
net value, is there enough information out there for that type 
of consumer to make an informed decision on hedge funds?
    Mr. Quarles. Well, that is a good question. I think one of 
the issues is that certainly, in this day and age, those 
criteria that you have described describe a broad range of 
people. Obviously, some people who fit in that category will be 
very able to evaluate the risks of a particular hedge fund 
investment. Others would not. It is, however, the case that 
most hedge funds in addition to those restrictions on who can 
invest have substantial additional minimum investment 
requirements that effectively restrict the investor pool well 
beyond those minimum limitations.
    Senator Allard. Do they have balance sheets and what not 
that an investor can go on, net value, net assets and----
    Mr. Quarles. They do. Each fund has, you know, each fund 
has a differing private practice with respect to the amount of 
information that it is willing to make public to its potential 
investors or to disclose to its potential investors, and for 
the most part, you know, the investor can then decide whether 
he feels that, on the basis of the information that a 
particular fund is willing to disclose to him, that he can make 
an informed judgment about whether he can invest in the fund.
    Senator Allard. What would you say were the main 
characteristics of a well managed hedge fund?
    Mr. Quarles. Certainly, sort of a very lively and close 
attention to the risks of their investment strategy; having a 
clear investment strategy; having a clear focus on risk; having 
a clear focus on how potential stresses in the overall 
financial environment could affect the investment strategy that 
they are following.
    Senator Allard. And a consumer visiting with a hedge fund 
manager could ascertain this information, or is it in written 
form, or do you have to basically pull it out of them?
    Mr. Quarles. Again, there is not a Website or a standard 
form of disclosure that the consumer would have, but each fund 
would have both differing methods in which they make 
disclosures and differing degrees of disclosure that they make 
to potential investors. Increasingly, again, as part of the 
increasing amount of competition that there is in the industry 
and the increasing number of participants, there is much more 
disclosure to potential investors than there had been even a 
few years ago.
    Senator Allard. Thank you, Mr. Chairman. I see my time is 
about ready to expire.
    Senator Hagel. Senator Allard, thank you.
    Senator Bunning had one additional question he wanted to 
ask, Mr. Secretary, as did Mr. Dodd, so I will ask Senator Dodd 
to proceed.
    Senator Dodd. Thank you, Mr. Chairman.
    Just very briefly, I just want to know about the corporate 
decisionmaking process. And to the extent that hedge funds are 
making that more difficult, there is certainly--there has been 
anecdotal evidence that this is creating difficulty for boards 
wanting to make longer term decisions, and given the rapidity 
with which hedge funds move, that is posing some problems. 
Anecdotally, we are hearing that. To what extent is that a 
problem, in your view?
    Mr. Quarles. We have certainly heard the same anecdotes. 
You know, we are familiar with the maxim that the plural of 
anecdote is not data, and we have not seen yet substantial data 
that would suggest that this is a problem. Conceptually, the 
fact that hedge funds, like any other investor in the 
marketplace, can purchase shares and then use those shares to 
influence company management in ways that they think will 
improve the value of the shares is not something that you would 
say, you would think is necessarily of itself something that is 
to be resisted in the marketplace.
    Senator Dodd. What about playing a positive role? Let me 
put it in that----
    Mr. Quarles. Yes, exactly. Conceptually and apart from, 
again, some of these isolated anecdotes that we have heard, you 
would say that that has to be a benefit, that the increased 
attention on the part of shareholders to the activities of 
management in an attempt to influence those activities to 
increase shareholder value, which is, of course, the interest 
of a hedge fund that owns the shares, is a positive for the 
marketplace.
    Senator Dodd. Thanks.
    Senator Hagel. Senator Dodd, thank you.
    Senator Bunning.
    Senator Bunning. Last question for me, anyway.
    In a regulated mutual fund industry, many questionable 
practices that were not in the best interests of the individual 
investor in the markets had to be corrected by government 
intervention. Why would we not assume in a lightly regulated 
hedge fund industry that we would not encounter similar 
practices by managers of hedge funds?
    Mr. Quarles. The generation of those rules governing 
registered funds many decades ago was principally a result of 
the losses sustained by unsophisticated retail investors who 
were drawn into funds that were following investment strategies 
that they were not as a practical matter in a position to 
assess.
    I think it is a very different situation where you have--
and in fact, that is how it is that funds that wish to follow 
more flexible investment strategies came to structure 
themselves the way they do. It was to ensure that they did not 
cross the thresholds that were deemed by our investment laws to 
entail a significant degree of retailization. So, you know, I 
think that it is an important element of our assessing the 
adequacy of our current approach to hedge funds.
    It is an important element that they are not--that retail 
investors do not form a significant part of the investor base, 
and as I say, we have not seen a lot of evidence that that 
trend is developing, and that is the principal reason I would 
say we can feel comfortable with the more flexible investment 
strategies that these funds follow.
    Senator Bunning. It seems to me that there are two sets of 
rules: one for the wealthy that make over $200,000 and have 
over $1 million in assets and another set of rules for the 
unsophisticated investor. And I think that is incorrect. I 
think that is wrong. And I will hope that the Treasury and all 
other regulating bodies of hedge funds would take a very 
thorough look and make recommendations to this Subcommittee so 
we can do our job better.
    Senator Hagel. Senator Bunning, thank you.
    Senator Allard, do you have any additional questions?
    Senator Allard. No more. Thank you, Chairman.
    Senator Hagel. Secretary Quarles, thank you. We may keep 
the record open to send additional questions in writing, and we 
would appreciate very much if you would address those, but for 
now, thank you for coming, and we appreciate your good work.
    Mr. Quarles. Thank you very much. Thank you.
    Senator Hagel. As Secretary Quarles leaves, if the second 
panel would come forward. Thank you.
    The second panel is comfortably ensconced, I presume. You 
look comfortable. You have water, all the necessary 
requirements for penetrating testimony. Thank you again. Since 
I have introduced this panel, I will ask Ms. Wyderko, who is 
representing the Securities and Exchange Commission, to begin 
the second panel's testimony. Thank you. Ms. Wyderko.

                   STATEMENT OF SUSAN WYDERKO

                           DIRECTOR,

          OFFICE OF INVESTOR EDUCATION AND ASSISTANCE

                    FORMER ACTING DIRECTOR,

               DIVISION OF INVESTMENT MANAGEMENT,

            U.S. SECURITIES AND EXCHANGE COMMISSION

    Ms. Wyderko. Chairman Hagel, Ranking Member Dodd, and 
Members of the Subcommittee, thank you for inviting me to 
testify today about hedge funds, the role they play in our 
securities markets, and the Commission's role in their 
oversight.
    The Commission has a substantial interest in the activities 
of hedge funds and their advisors which are today major 
participants in our securities markets. We estimate that hedge 
funds today have more than $1.2 trillion in assets, a 
remarkable growth of almost 3,000 percent in the last 16 years. 
Much of the growth of hedge funds is attributable to increased 
investments by institutions such a private and public pension 
plans, endowments, and foundations. Many of these investors 
sought out hedge funds during the recent bear markets in order 
to address losses from traditional investments.
    Hedge funds are operated so that they are not subject to 
the Investment Company Act of 1940, which contains many 
safeguards for retail investors. In addition, hedge funds, 
issue securities in private offerings that are not registered 
with the Commission under the Securities Act of 1933, and hedge 
funds are not required to make periodic reports under the 
Securities Exchange Act of 1934. However, hedge funds are 
subject to the same prohibitions against fraud as are other 
market participants, and their managers have the same fiduciary 
obligations as other investment advisors.
    Because hedge fund managers are investment advisors under 
the Investment Advisors Act of 1940, they owe the fund and its 
investors a fiduciary duty that requires the manager to place 
the interests of the hedge fund and its investors first or at 
least fully disclose any material conflicts of interest the 
manager may have with the fund and its investors. Hedge fund 
advisors have this fiduciary obligation as a matter of law, 
regardless of whether they are registered with the Commission.
    The Advisors Act provides the Commission with authority to 
enforce these obligations, which the Commission has exercised 
vigorously in order to protect investors. Examples of cases we 
have brought are included in my written testimony.
    Until recently, registration with the Commission was 
optional for many hedge fund advisors. In February of this 
year, new rules became effective that require that most hedge 
fund advisors register with the Commission under the Advisors 
Act. The new rules do not regulate hedge fund strategies, 
risks, or investments. The new rules have given the Commission 
basic census data about hedge fund advisors. The staff is in 
the process of evaluating these data and considering methods to 
refine its ability to target our examination resources by more 
precisely identifying those advisors, including hedge fund 
advisors, who pose greater compliance risks. In addition, 
registration has required hedge fund advisors to implement 
compliance programs, to detect, prevent, and correct compliance 
violations and to designate a chief compliance officer to 
administer each advisor's compliance program.
    Hedge funds provide many benefits to investors and our 
national securities markets that contribute substantially to 
market efficiency, price discovery, and liquidity. By actively 
participating, for example, in markets for derivative 
instruments, hedge funds can help counterparties reduce or 
manage their own risks, thus reducing risks assumed by other 
market participants.
    When market activity by hedge fund advisors, like any other 
participant in the securities markets, crosses the line and 
violates the law, the Commission has taken appropriate remedial 
action. My written testimony has illustrative examples.
    In conclusion, I would like to thank the Subcommittee for 
holding this hearing on a subject of growing importance to us 
and all American investors. Hedge funds play an important role 
in our financial markets, and the Commission will continue to 
vigorously enforce the Federal securities laws with respect to 
hedge funds, their advisors, and all market participants.
    Senator Hagel. Ms. Wyderko, thank you.
    Mr. Parkinson, who is here on behalf of the Federal Reserve 
System, welcome.

                 STATEMENT OF PATRICK PARKINSON

     DEPUTY DIRECTOR, DIVISION OF RESEARCH AND STATISTICS,

        BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Mr. Parkinson. Chairman Hagel, Senator Dodd, I thank you 
for the opportunity to testify on the role of hedge funds in 
the capital markets.
    Hedge funds clearly are playing an increasingly important 
role, especially as providers of liquidity and absorbers of 
risk. For example, a study of the markets in U.S. dollar 
interest rate options indicated that participants viewed hedge 
funds as a significant stabilizing force. Hedge funds 
reportedly are significant buyers of the riskier equity and 
subordinated tranches of collateralized debt obligations and of 
asset-backed securities, including securities backed by 
nonconforming residential mortgages.
    At the same time, however, the growing role of hedge funds 
has given rise to public policy concerns. These include 
concerns about whether hedge fund leverage is being constrained 
effectively and what potential risks the funds pose to the 
financial system if their leverage becomes excessive. The near 
failure of the hedge fund Long Term Capital Management in 
September 1998 illustrated the potential for a large hedge fund 
to become excessively leveraged and raised concerns that a 
forced liquidation of large positions held by a highly 
leveraged institution would create systematic risk by 
exacerbating market volatility and illiquidity.
    In the wake of the LTCM episode, the President's Working 
Group on Financial Markets considered how to best constrain 
excessive leverage by hedge funds and concluded that this could 
be achieved most effectively by promoting measures that enhance 
market discipline by improving credit risk management by hedge 
funds, counterparties, and creditors. Because those 
counterparties nearly all are regulated banks and securities 
firms, the Working Group termed this approach indirect 
regulation of hedge funds. The Working Group considered the 
alternative of direct government regulation of hedge funds, but 
it concluded that developing a regulatory regime for hedge 
funds would present formidable challenges in terms of cost and 
effectiveness.
    The Working Group made a series of recommendations for 
improving market discipline on hedge funds. According to 
supervisors and most market participants, counterparty risk 
management has improved significantly since the LTCM episode in 
1998. However, since that time, hedge funds have greatly 
expanded their activities and strategies in an environment of 
intense competition for hedge fund business among banks and 
securities firms. Furthermore, some hedge funds are among the 
most active investors in new, more complex structured financial 
products, for which valuation and risk management are 
challenging both to the funds themselves and to their 
counterparties.
    Counterparties and supervisors need to ensure that 
competitive pressures do not result in any significant 
weakening of counterparty risk management and that risk 
maintenance practices are evolving as necessary to address the 
increasing complexity of the financial instruments used by 
hedge funds.
    The Federal Reserve has also sought to limit hedge funds' 
potential to be a source of systemic risk by ensuring the 
robustness of the clearing and settlement infrastructure that 
supports the markets in which the funds trade. Very active 
trading by hedge funds has contributed significantly to the 
extraordinary growth in the past several years of the markets 
for credit derivatives. By last year, it had become apparent to 
many that the clearing and settlement infrastructure for credit 
derivatives had not kept pace with the volume of trading.
    In September of 2005, the Federal Reserve Bank of New York 
brought together 14 major U.S. and foreign derivatives dealers 
and their supervisors. The supervisors collectively made clear 
their concerns about the risks created by the infrastructure 
weaknesses and asked the dealers to develop plans to address 
those concerns. Since then, the dealers and their hedge fund 
clients have made remarkable progress toward addressing 
supervisors' concerns and have committed to making further 
progress within the next 6 months.
    Thank you.
    Senator Hagel. Mr. Parkinson, thank you.
    Mr. Overdahl, who is here with the Commodity Futures 
Trading Commission, welcome, thank you.

                  STATEMENT OF JAMES OVERDAHL

                        CHIEF ECONOMIST,

           U.S. COMMODITY FUTURES TRADING COMMISSION

    Mr. Overdahl. Mr. Chairman, Senator Dodd, and Members of 
the Subcommittee, I appear before you today in my capacity as 
Chief Economist of the Commodity Futures Trading Commission or 
CFTC, the Federal Government regulator of futures markets in 
the United States. To the expect that any subsidiary fund 
within a hedge fund complex uses exchange-traded derivatives, 
the operator of that subsidiary fund and its advisory may be 
subject under certain circumstances to registration reporting 
requirements under the Commodity Exchange Act, the statute 
administered by the CFTC.
    Futures markets serve an important role in our economy by 
providing a means of transferring risk from those who do not 
want it to those who are willing to accept it for a price. In 
order for businesses to hedge the risk they face in their day-
to-day commercial activities, they need to trade with someone 
willing to accept the risk the hedger is trying to shed. Data 
from the CFTC's large trader reporting system are consistent 
with the notion that hedge funds and other professionally 
managed funds are often the ones who facilitate the needs of 
hedgers.
    CFTC large trader data also show that hedge funds and other 
professionally managed funds hold significant spread positions; 
that is, positions across related contracts. These spread 
positions play a vital role in keeping the prices of related 
contracts in proper alignment with one another. Hedge funds 
also add to overall trading volume, which contributes to the 
formation of liquid and well functioning markets.
    One notable development over the past 5 years has been the 
increased participation by hedge funds and other institutional 
investors in futures markets for physical commodities. These 
institutions have allocated a portion of the investment 
portfolios they manage into commodity-linked index products. A 
significant portion of this investment finds its way into 
futures markets either through the direct participation of 
those whose commodity investments are benchmarked to a 
commodity index or through the participation of commodity index 
swap dealers who use futures markets to hedge the risks 
associated with their dealing activities.
    The CFTC relies on a program of market surveillance to 
ensure that markets under CFTC jurisdiction are operating in an 
open and competitive manner. The heart of the CFTC's market 
surveillance program is its large trader reporting system. For 
surveillance purposes, the large trader reporting requirements 
for hedge funds are the same as for any other large trader. In 
addition to regular market surveillance, the CFTC conducts an 
aggressive enforcement program that deters would-be violators 
by sending a clear message that improper conduct will not be 
tolerated.
    The financial distress of any large futures trader poses 
potential risks to other futures market participants. With 
respect to commodity pools operating as hedge funds, the CFTC 
addresses these risks through its oversight of futures 
clearinghouses and the clearing member firms of each 
clearinghouse. This oversight regime is designed to ensure that 
the financial distress of any single market participant, 
whether or not that participant is a hedge fund, does not have 
a disproportionate effect on the overall market.
    This concludes my remarks, and I look forward to your 
questions.
    Senator Hagel. Mr. Overdahl, thank you.
    Mr. Parkinson, let me begin the questioning with you. As 
you noted toward the end of your testimony that the Federal 
Reserve Bank of New York has been looking at some of these 
issues, and I am particularly interested in some of your 
thoughts on what the Federal Reserve-New York was looking at 
ways to improve industry practices and credit derivatives, and 
it is my understanding that Chairman Bernanke is addressing the 
Atlanta Federal Reserve tonight on these issues, hedge funds 
and credit derivatives. Let me begin with this question: what 
are the Federal Reserve's specific concerns about credit 
derivatives?
    Mr. Parkinson. Thank you, Chairman.
    I think broadly speaking, the Federal Reserve is concerned 
about whether banks and other participants in the credit 
derivatives markets are managing the risks associated with 
those instruments effectively, and then, second, alluding to 
the other thing you mentioned earlier, whether the market 
infrastructure is sufficiently robust.
    As I think has been mentioned in the previous panel, some 
credit derivatives are extremely complex and are traded on 
illiquid markets. And consequently the measurement or 
management of the risks poses challenges to even the most 
sophisticated market participants. And really, the Fed in that 
area has been conducting a variety of reviews of bank risk 
management practices with respect to these instruments, and it 
has communicated to the banks through our supervisory process 
and to the marketplace through speeches like the one that 
President Geithner gave this morning and the one that Chairman 
Bernanke will be giving this evening, areas in which risk 
management practices should be strengthened.
    With regard to clearance and settlement, the 
infrastructure, I think I discussed that in my testimony, that 
by last year, it had become apparent to many that the 
infrastructure simply was not keeping up with the growth of the 
markets, so last September, the New York Fed got together these 
large dealers and their supervisors and really said here are 
the problems. We want you to come up with a solution, and they 
have made remarkable progress since then. They have promised to 
address the remaining issues, so I think that has been a real 
success.
    Let me finally say that to put this in perspective, I think 
a point that President Geithner has emphasized and that I would 
like to emphasize, too is that while we have these concerns, 
the Federal Reserve officials feel that notwithstanding those 
concerns, the development of credit derivatives has made both 
banks and the financial system safer and more resilient, and 
the key thing is to make sure it continues to be by addressing 
those specific concerns.
    Senator Hagel. What is the timeframe on the solutions?
    Mr. Parkinson. In terms of the clearance and settlement 
infrastructure, the firms have committed to a variety of steps 
to complete them by October 31 of this year, so, really, quite 
an ambitious timetable.
    Senator Hagel. And what do you anticipate will be included 
in that solution agenda?
    Mr. Parkinson. There are many parts to it. I think that a 
key part is that they are already, one of the problems has been 
that there has been manual processing of transactions to a 
large degree, and in recent years, electronic platforms for 
processing trades had been developed, but the takeup was not 
very good, and they really have committed essentially that if a 
transaction can be confirmed electronically, it will be 
confirmed electronically.
    And then, with respect to the ones that cannot be confirmed 
electronically, they have set deadlines for processing those 
transactions, completing the conforms, and I think importantly, 
have agreed that very soon after the trade date, they will make 
sure that they have a common understanding of the material 
economic terms of the trade, so that notwithstanding delays and 
completing the legal confirmations that their books and records 
will be accurate, and therefore, their measures of counterparty 
risk and market risk will be accurate.
    Senator Hagel. Thank you.
    You noted in your testimony, I will quote just a line, 
quote, that hedge funds are increasingly consequential as 
providers of liquidity, end of your quote. Would you explain 
that in a little more detail, what you meant by that?
    Mr. Parkinson. Sure. I think that first, it is important to 
recognize that in recent years, our entire financial system has 
become less bank-centric and more market-centric. More credit 
demands are being met by the financial markets rather than 
being met directly by banks.
    And in that kind of environment, the liquidity of financial 
markets really is critical. In other words, the ability to buy 
and sell quickly and in size. Now, in normal times, liquidity 
tends to be ample. I think hedge funds contribute to that. But 
I think what is really important is that when economic 
conditions become uncertain and prices move rapidly, then, 
liquidity has a tendency to evaporate. As we say, markets have 
a tendency to seize up. Examples would be the equity markets in 
1987 and I think the interest rate options markets back in the 
summer of 2003.
    And what is needed in those circumstances is really someone 
that recognizes that those kinds of disorderly markets in fact 
create profit opportunities for those who are willing to engage 
in arbitrage transactions and that have the willingness to take 
the risk that that involves to exploit those opportunities and 
to bring stability back to those markets. And I think this is 
an instance where back in 2003, I think we observed that as the 
option markets became unstable and prices soared that the hedge 
funds stepped in and profited from that disorder by selling 
options and bringing liquidity back to that market.
    It is purely speculative, but I think it is an interesting 
question if we were again in a situation we were in October 
1987 when equity prices were falling rapidly, I think there is 
a real potential for hedge funds to play a stabilizing role in 
that kind of market circumstance, where I think back in 1987, 
ultimately, what turned things around was corporations going 
back into the market and buying their own shares at these very 
depressed prices. I think you have this large pool of capital 
now that is willing to take risks in the hedge fund sector that 
could perhaps perform that service more quickly and limit the 
damage.
    Senator Hagel. Thank you.
    Ms. Wyderko, let me ask a question of you regarding--I have 
in front of me an April 26, 2006, Washington Post story, Two 
Firms Claim Conspiracy in Analysts' Reports. I am sure you are 
familiar with this. These are issues that have surfaced 
recently, and the particular case I want to ask about is a case 
involving overstock where hedge funds are alleged to have paid 
securities analysts to issue misleading research to the 
marketplace. What is the SEC doing to monitor such situations?
    Ms. Wyderko. The Commission's staff carefully considers all 
allegations of fraud and manipulation. I cannot comment on that 
case, because, as you have read, it is a pending case. We have 
regulations in place to deter fraud, and we go after it 
vigorously when we find it.
    Senator Hagel. And I am aware of that limitation that you 
have in answering the question further. Let me just see if I 
can come at this in a little more general way. Does the SEC 
have the authority to guarantee that securities research and 
analysis that is held out is independent is actually so? Do you 
need additional tools?
    Ms. Wyderko. Well, we have got Reg AC, and if false 
research is deliberately issued by any broker-dealer, it 
implicates Reg AC, which seeks to promote the integrity of 
research. We do have the tools to go after market manipulation. 
We do.
    Senator Hagel. What are those tools? What are you doing 
about these such things? I know you will have to stay away from 
the specific case that I have mentioned, but how is the SEC 
ensuring that this research, in fact, is independent. You say 
that you have the tools. Explain that.
    Ms. Wyderko. We have the tools in Rule 10(b)(5), the anti-
fraud rule. Making or facilitating misrepresentations for the 
purpose of affecting a price of a stock is an illegal 
manipulative device, and that violates securities laws such as 
Rule 10(b)(5). We also have the tools to go after anyone who 
engages in transactions that are done in order to create actual 
or apparent trading in a security or to depress the price of a 
security for the purpose of inducing someone else to purchase 
or sell a security. So we have anti-fraud tools enforcement 
staff.
    Senator Hagel. Which covers the analysis aspect of this.
    Ms. Wyderko. Yes, sir.
    Senator Hagel. Ms. Wyderko, thank you.
    Let me ask a question of the three of you that I asked of 
Secretary Quarles, and it is the very basic question, realizing 
that your three agencies represent the President's Working 
Group on this general issue. Do we need additional oversight? 
Do we need greater regulation, if any additional regulation on 
hedge funds? Ms. Wyderko, begin with you.
    Ms. Wyderko. Well, as you know, we have just adopted a new 
regulation that went into effect in February to require 
registration of investment advisors. It might interest you to 
know that we have about 2,400 registered hedge fund investment 
advisors, and of that number, over half were registered prior 
to February 1. That means they were registered voluntarily. The 
data is now coming in. We are acquiring basic census 
information about the activities of the investment advisors, 
and we are monitoring that data, looking at it. We are also 
using our risk based analysis parameters to select hedge fund 
advisors like other advisors for examinations by our 
examinations staff.
    Senator Hagel. So your answer is you do not think anything 
additional is required?
    Ms. Wyderko. At this point, I think we need to see the 
effects of our registration requirement, and we are actively 
monitoring the information that we are receiving.
    Senator Hagel. Thank you.
    Mr. Parkinson.
    Mr. Parkinson. No, we do not see the need for any 
additional regulation. Again, we focus primarily on this 
financial stability or systemic risk issue. I think we still 
think that the indirect regulation approach is much more 
attractive than direct regulation and likely to be much more 
effective. We do see some specific issues around counterparty 
risk management that concern us, but we are addressing those 
issues through our bank exams and through encouraging market 
participants to tighten up where appropriate and necessary.
    Senator Hagel. Thank you.
    Mr. Overdahl.
    Mr. Overdahl. Based on the information I see today, I see 
no additional tools that we need. I think what we are focused 
on is understanding the role of funds in the markets under CFTC 
jurisdiction, and we have a sizable program underway right now 
looking at the role of funds, and pending the outcome of that, 
I cannot recommend anything.
    Senator Hagel. Let me ask each of you: in light of what you 
heard Secretary Quarles say, the line of questioning that he 
addressed here over the last hour, hour and a half a general 
question. First, are you each providing more oversight in the 
way of transparency of your own agency's involvement on hedge 
funds? That would be one of the questions, and you would take 
that, each of you, in any direction you would like depending on 
your agency and each of your responsibilities in your agencies.
    Also, I would like to get your reaction to some of the 
questioning of Secretary Quarles in the area of systematic 
risk. We talked here over the last hour and a half specifically 
about what happened in the late nineties. We talked about the 
GSEs, more leverage, more debt, use of derivatives. I would 
like your general comments in those areas that you heard us 
talk to Secretary Quarles about and his responses back.
    We will begin with you, Ms. Wyderko.
    Ms. Wyderko. The Commission focuses on broker-dealers' 
exposure to hedge fund risks and the broader implications that 
that might have to our financial system. Our Commission staff 
works regularly with other members of the President's Working 
Group on Financial Markets, and we work with the industry 
members that comprise the Counterparty Risk Management Policy 
Group in terms of transparency. And our consolidated 
supervision program for banks now allows us to examine not only 
the broker-dealer entities within a group but also the 
unregistered affiliates and holding companies where the certain 
financing transactions with hedge funds are generally booked.
    Senator Hagel. Would you like to address any other aspects 
of what we talked about here in the last hour and a half from 
the SEC perspective?
    Ms. Wyderko. Well, we work closely with the President's 
Working Group on systemic risk, so I think I will let my 
colleagues take over from that. We really focus on broker-
dealers' exposure at the SEC.
    Senator Hagel. OK, thank you.
    Mr. Parkinson.
    Mr. Parkinson. First, on transparency, I guess the first 
question I always ask is transparency to whom, and I think 
there are three possible categories of people; one, to 
investors, that is primarily an issue of investor protection. 
That is an SEC issue that we do not focus on.
    Importantly is the issue of transparency of hedge funds to 
their counterparties and their creditors, and that is where 
that was an important theme of the PWG recommendations, the 
need for greater transparency. We have also emphasized, I 
think, recently where there is not the kind of transparency 
that would be ideal that banks and other creditors adjust their 
credit terms so they are more conservative; so, for example, if 
there is not enough transparency about what the hedge fund is 
doing, they need to charge higher margins of that hedge fund 
and do that in a systematic way.
    And finally, transparency to regulators, again, because we 
believe in the indirect regulation approach, not a direct 
regulation approach. That is not an area where we are really 
seeking greater transparency.
    With regard to systemic risk, I keep coming back to our 
sort of two key points: how do we deal with concerns about 
systemic risk? We try to promote sound risk management 
practices, particularly counterparty credit risk management 
practices, which we do both through our exams of banks and 
cooperation with other regulators; increasingly, I think a lot 
of these inquiries about practices are done on a coordinated 
basis, particularly with the FSA and with the SEC, because 
between the U.S. banking regulators and those other two sets of 
regulators, that covers most of the major counterparties and 
creditors; and then, second, on strengthening the 
infrastructure of the financial markets, where again, 
particularly when it comes to securities markets, we work 
closely with the SEC, and when it comes to the exchange-traded 
derivatives markets, with the CFTC.
    Senator Hagel. Thank you.
    Mr. Overdahl.
    Mr. Overdahl. With respect to transparency, I have two 
comments to make. One, there is a lot of information about 
funds themselves that is transparent to us through our Large 
Trader Reporting System. These are reports that we receive on 
positions of all traders or most of the large traders in the 
market, between 70 percent and 90 percent of the open interest. 
We receive that information daily, and many of these 
participants are hedge funds, so we do see that as the 
regulator.
    From those reports, we compile a weekly report that we put 
out publicly, called the Commitments to Traders Report that 
goes out every Friday afternoon at 3:30, and many people look 
at that; many people have suggested to the CFTC that we 
disaggregate that report to break out, perhaps, hedge funds and 
other large traders.
    I think what we are going to do as the staff of the 
Commission is put options together for the Commission and have 
a process with public comment and full public participation to 
understand the costs and benefits of perhaps a finer breakout 
of those reports. With respect to systematic risk, we treat all 
large traders the same way no matter the source or who they are 
and how they affect risk in our market. With respect to GSEs 
specifically, I would defer to my colleagues here. We certainly 
participate with them in the PWG, but we have very little 
intersection with that area within the jurisdiction of the 
CFTC.
    Senator Hagel. Thank you.
    I want to refer back to a point that Senator Sununu made 
early in the hearing, and others picked up on it, regarding 
overregulation. And my question is this: do you believe that 
overregulation of any segment of our financial services market, 
in this case, particularly the hedge funds, would drive hedge 
fund investments off our shores, overseas? Basic question: does 
overregulation have an impact on investing in this country and 
our system or any country?
    We will start with you, Ms. Wyderko.
    Ms. Wyderko. I think we all agree that overregulation is 
bad.
    Senator Hagel. I am not sure that everybody does.
    [Laughter.]
    Ms. Wyderko. Our rules for registration of investment 
advisors are not based on the advisor's domicile. That is 
important to understand. Hedge fund managers, wherever based, 
if they accept money from 15 or more U.S. investors, they must 
register with the Commission as investment advisors. So I do 
not think that it is a question of driving advisors offshore. 
If investment advisors wish to access U.S. capital sources, 
U.S. investors, then, they will need to register with the SEC 
if they have 15 or more U.S. investors.
    Senator Hagel. But what I am asking is, aside, in addition 
to, aside from, in addition to, for example, what the SEC, in 
your area of responsibility, of regulation, protecting the 
consumer, the individual investor, if there was more 
regulation. That is what I am trying to get at, because if, for 
example, something were to happen in the hedge fund market, and 
we find some kind of a significant adjustment which, just as 
Senator Sununu noted, that tends to elicit an immediate 
reaction from the Congress. Sometimes it is the right thing; 
sometimes, it is not the right thing.
    And that is where the universe of overregulation lies. We 
talked earlier about are we not wiser to understand this 
industry now in anticipation not necessarily of that kind of 
adjustment but just knowledge, information, a basis to 
appreciate what this business is about so that we do not 
overregulate, so that we do not do something not in the 
interests of our economy and of our markets.
    So if we were to advance any regulatory regime within the 
SEC, any of the agencies represented here, my question is does 
that automatically or does it have very little consequence to 
how investors see, in this case, hedge funds, especially, as 
you recall, when I asked Secretary Quarles about how other 
countries regulate, where the regimes differ, and you heard 
what he said. You know, of course, what the answer is.
    So that is what I was trying to get at, because what we are 
trying to do in this hearing and maybe a series of hearings is 
establish some basis for us to better understand not just the 
role of hedge funds but what role those funds play in our 
overall economy, in our investment opportunities, therefore 
equipping us better to understand these things, not allowing us 
to overreact if something happens. So in anticipation of that--
that is my question--does overregulation or any degree of that 
in your data, your own analysis, tend to, in fact, undermine 
our markets or incentives or investment opportunities?
    Ms. Wyderko. Well, I think it is important to realize a 
couple of things. First of all, as Mr. Quarles said, at this 
point, we are working with foreign regulators, and we are 
imposing a regulatory regime that is remarkably consistent with 
other developed countries, so that is an important baseline 
comment.
    If we were to more heavily regulate hedge funds, for 
example, we do not currently regulate their strategies or their 
risks or their investments, if we were to impose more onerous 
regulations on hedge funds, it may be that we would diminish 
the utility of those investment vehicles for those investors 
who are investing in them. I mean, you have heard discussion 
today about the various uses that investors use hedge funds 
for: hedging other investments, trying to achieve returns that 
differ from recognized market indices. You may well diminish 
the utility of the hedge funds to provide that service for 
investors.
    Senator Hagel. Thank you.
    Mr. Parkinson.
    Mr. Parkinson. I guess I do not think we are concerned that 
overregulation is going to drive activity abroad for precisely 
the reasons that Ms. Wyderko mentioned. I do think that we 
worry about overregulation, and from our perspective, it is not 
that it would limit the investment opportunities of investors 
so much as it would impair the ability of hedge funds to 
provide the benefits they do to markets: the provision of 
liquidity, the bearing of risk. And if you got into in 
particular regulating the fund as opposed to the advisor, and 
the SEC currently regulates the advisors but not the funds; in 
particular, if that involved constraining their strategies, 
investments, et cetera, I think that is precisely the sort of 
thing that could have a very adverse effect on the markets. And 
that is the reason we would be concerned about overregulation, 
not driving the activity offshore.
    Senator Hagel. Thank you.
    Mr. Overdahl.
    Mr. Overdahl. I can think of some instances where, you 
know, a proposed regulation, for example, to achieve greater 
transparency might have the opposite effect and drive it 
outside of the jurisdiction of regulators where you see less of 
it than perhaps you would otherwise. And it is certainly 
something that we always consider in promulgating any 
regulations, the costs and benefits of that regulation.
    I would say one thing we have been particularly interested 
in is focusing regulation, trying to make sure that we are 
achieving the purposes of the statute Congress has given us 
without any more requirements than necessary. We have certainly 
sought to work with the SEC in coordinating our work with them 
so that participants are not facing duplicative standards. And 
so, we are trying to work that way to make sure that we do not 
have this situation.
    Senator Hagel. Thank you.
    Since a vote has been called, it is quite timely. This 
might be an appropriate time to break for a moment as we excuse 
our second panel and ask for the third panel, but before I do, 
not only do I want to thank you, but let me ask each of you if 
there are any additional comments or points that you would like 
to make to put on the record.
    Ms. Wyderko. No, sir.
    Mr. Parkinson. No, sir.
    Senator Hagel. Well, again, thank you. We will, again, as 
we did for Secretary Quarles, keep the record open in case 
colleagues have questions they would like to submit in writing.
    Thank you very much. This Committee is in recess until the 
Chairman votes and returns.
    [Recess.]
    Senator Hagel. All right, so, you are recording. You feel 
good about America and our future. All right. Is this an NSA 
hearing?
    [Laughter.]
    Senator Hagel. Welcome again.
    This is the third panel of our hearing today on the role of 
hedge funds in our capital markets, and I once again welcome 
our distinguished panelists. Each of you have had a long career 
in financial services, government, industry, and continue to 
contribute and be productive members of that segment of our 
economy, and we appreciate it.
    I have introduced each of you, as you know, and so, I will 
get right to your testimony. And then, if you have time, we 
will entertain some questions, and I appreciate, again, your 
testimony and your willingness to come before this Committee.
    With that, let me begin with Secretary McCormack. Secretary 
McCormack, welcome. Nice to have you here. Thank you.

              STATEMENT OF HON. RICHARD McCORMACK

 SENIOR ADVISOR, CENTER FOR STRATEGIC AND INTERNATIONAL STUDIES

    Mr. McCormack. Thank you very much, Senator. I am obviously 
very pleased to be here today.
    I thought I would say a few words about derivatives, about 
the macroeconomic environment in which hedge funds and 
derivatives are operating and what that macroeconomic 
environment might be in the years ahead and a few words about 
the potential for systemic risk.
    I have a full statement, which I will put on the record, 
and I will summarize my remarks briefly here now.
    Senator Hagel. Thank you. I would remind all of our 
witnesses that the full text of your testimony will be included 
in the record, so if you feel so inclined to abbreviate that or 
summarize it, that is certainly acceptable.
    Secretary McCormack, would you pull that mike down a little 
bit just so we can hear you better?
    Mr. McCormack. Is that better?
    Senator Hagel. I think that is better. Thank you.
    Mr. McCormack. Virtually everyone who understands the 
derivative industry recognizes its value in the economy and its 
ability to manage and defuse financial risks by individuals and 
companies. History shows, too, that some derivatives do contain 
the potential for abuse and mistakes. We all know spectacular 
examples of this, including the Long Term Capital Management 
debacle, which was an honest miscalculation by some very 
intelligent people.
    It is, of course, important to remember that for each Enron 
type problem that surfaces in connection with derivatives, 
there are thousands of transactions that occur every day that 
benefit all parties involved. The challenge we now have is to 
examine this industry and those involved in it, with the help 
of those deeply engaged to correct any structural or technical 
problems that could increase the likelihood of systemic risk 
following a future shock to financial markets, such as the 
Russian default in 1998.
    There is obviously no such a thing as a permanent fix to 
the problems in the derivative industry. This industry is so 
dynamic, and its strengths and weaknesses change every few 
years. Ten years ago, credit derivatives were a tiny blip on 
the screen. Today, these credit derivatives, which provide a 
default insurance to creditors, are the fastest growing segment 
of this industry, as much as $17 trillion of notional value.
    Last year, when serious and potentially dangerous 
operational problems in credit derivative markets alarmed 
regulators, Jerry Corrigan, the former Federal Reserve official 
now with Goldman Sachs led an effort to analyze and repair 
these problems. This effort was a good example of how the 
industry and regulators can work together to solve problems on 
the operational side of the derivative business.
    Beyond operational risk, however, credit risk and market 
risks pose other issues. Long periods of growth and prosperity 
tend to induce a certain amount of complacency in financial 
markets. It is important to remind recent entries to the 
derivative business that the business cycle still exists. There 
are potential vulnerabilities in the global economy that could 
impact financial markets at some point. Every decade, the two 
or three crises threaten the instability of financial markets.
    I would just like to conclude by making several general 
remarks:
    One, estimates of the total size of the notional value of 
over-the-counter derivative contracts vary widely. The 
President of the New York Federal Reserve estimates that number 
at $300 trillion. The Bank for International Settlement 
estimates that number at $270 trillion. The International 
Association of Swaps and Derivatives estimates the total 
outstanding value at $219 trillion.
    Even value at risk, which is a much smaller number, is 
subject to varying interpretations and estimates. When rounding 
errors for estimates of notional value of outstanding 
derivative contracts are in the tens of trillions of dollars, 
it is hard to have total confidence that we understand all the 
potential vulnerabilities that may exist in this industry.
    Two, in his February 28 presentation on financial risk, Mr. 
Geithner raises the possibility of a potential rush to the exit 
by highly leveraged derivative holders during any future period 
of financial turmoil. Obviously, the Federal Reserve can play a 
role in addressing certain kinds of liquidity shortages and 
crises, but individual investors should be mindful of the need 
for an adequate capital cushion to address potentially 
unfavorable market developments.
    Three, should early signs of possible vulnerabilities begin 
to emerge in financial markets, the most sophisticated 
investors will, of course, quickly shed risky investments. 
These hearings should serve as a reminder to investors of the 
oldest lesson in business dealings: caveat emptor--let the 
buyer beware. Complex derivatives are not a place for amateur 
investors. There is an enduring connection between high yields 
and high risks.
    Four, regulation of the derivative and hedge fund 
industries is faced with a fundamental dilemma: if government 
regulates these industries so tightly as to avoid all risk of 
market failure, it will kill a valuable part of the financial 
system. Finding the right middle path in this constantly 
changing environment is a challenging task.
    Five, the U.S. regulatory system monitoring the financial 
industry is highly fragmented, as you have seen today with the 
previous panel. If our government were to start today from 
scratch and design a regulatory system for today's financial 
system, it would not look like the system we now have in place, 
even though the existing system has generally served us well. 
But with the increasing globalization of the financial industry 
as a whole, it is clear that more of the regulatory emphasis 
and monitoring will have to be international in character. This 
will not be an easy task.
    The entire international global financial system is 
interconnected by hundreds of trillions of dollars of 
derivatives. Any future banking crisis in China which slows 
that economy will immediately impact commodity prices 
dramatically and the bonds of commodity producers. Any further 
sustained spike in oil prices could impact huge segments of the 
derivative industry. Those holding some credit derivatives 
against default could find them very costly indeed in this 
environment.
    In conclusion, in well-functioning capital markets 
governments should not be concerned about the possible gains 
and losses of individual investors. That is what capitalism is 
all about and one of the reasons why this country is so 
prosperous. We take risks. We invest capital. The market 
apportions the winners and losers. This needs to continue. 
Government's focus should be on potential systemic risk, any 
inappropriate market manipulation, fraud, and any structural 
problems that increase the likelihood of these broader 
concerns.
    Thank you very much.
    Senator Hagel. Dr. McCormack, thank you.
    Dr. Lerrick.

                 STATEMENT OF DR. ADAM LERRICK

        VISITING SCHOLAR, AMERICAN ENTERPRISE INSTITUTE

    Mr. Lerrick. Good afternoon, Mr. Chairman, and thank you 
for this opportunity.
    Every day, somewhere in the global marketplace, hedge funds 
are shaking up the comfortable status quo, and from China's 
central bank to Germany's chancellory, voices in high places 
are raised in protest. But are hedge funds really to blame for 
all the ills that befall the international financial system? 
Are they disruptive speculators or dispassionate agents that 
expose fundamental flaws and speed up inevitable change?
    Hedge funds are simply pools of money seeking the highest 
absolute return across the capital markets, where managers are 
compensated with a high share of profits. Like any financial 
innovation, they are following a normal life cycle. First, a 
small number of pioneers garner excess profits. Next, 
competition and capital are broadly attracted. Finally, the 
industry moves into the mainstream, matures, and is winnowed 
out.
    Managers search for momentary anomalies in the pricing of 
securities, currencies, and commodities around the world. They 
match holdings with short sales to isolate generalized market 
risk, they borrow heavily to leverage positions and magnify 
returns. Rewards have been overwhelming and consistent at 40 
percent per annum.
    Hedge funds are now a major force in the global financial 
markets. There are now over 8,000 funds holding $1.5 trillion 
in assets, double the level in 2000. Leverage in the use of 
derivatives multiply their real impact manyfold. They dominate 
the trading arena--they are the predominant source of Wall 
Street earnings.
    Hedge funds are constantly moving money around the globe to 
where it is most productive. They challenge private equity 
firms, venture capitalists, and real estate developers. They 
lend to companies in distress, they take large positions as 
shareholder activists to force corporate restructurings. The 
client base has moved from a closed society of the very rich to 
embrace the entire investor spectrum. Large institutions now 
account for more than half of hedge fund capital. A whole new 
layer of intermediaries known as funds of funds provide a 
conduit for the retail investor with as little as $25,000 to 
risk.
    Hedge funds depend on secrecy to prosper. They have a large 
investment in human capital, in technology, and in information, 
and none of these can be patented or protected. In a world that 
demands transparency, secrecy is a red flag for fear, 
suspicion, and calls for regulation. But the public interest 
can be satisfied without driving hedge funds to pack up and 
resettle offshore. The framework to monitor and to safeguard 
the global financial system and the unaware investor is already 
in place.
    Hedge funds do not operate in a vacuum. They interact 
through a marketplace where their lenders, their trading 
counterparties, and the markets themselves are already under 
the scrutiny of an array of regulators: the SEC, the Federal 
Reserve, the Comptroller of the Currency, the CFTC, and their 
counterparts in the capital markets around the world.
    Hedge fund objectives should not be confused with their 
tools. The hedge fund formula relies on leverage to magnify 
returns, but excessive leverage can disrupt markets. The danger 
to those who finance hedge funds and to the global system as a 
whole lies in ignorance of risks. Total exposure and total 
leverage across all lenders and across all national boundaries 
should now be aggregated and published to inform and improve 
the risk evaluations of market participants and regulators 
alike.
    Under U.S. securities laws, all hedge fund clients, the 
very rich, the institutional investors, and the managers of 
funds of hedge funds who are the stewards of funds of small 
investors, have the skills to inform their decisions without 
official help. The market will be ultimate regulator as ever 
more money competes for a diminishing set of opportunities. 
Average profitability is already approaching rates on more 
commonplace efforts, and during the shakeout, players with weak 
risk management will be winnowed away.
    Soon, there will be fewer but better hedge funds. Thank 
you, Mr. Chairman.
    Senator Hagel. Dr. Lerrick, thank you.
    Mr. Schacht.

                   STATEMENT OF KURT SCHACHT

                      EXECUTIVE DIRECTOR,

             CENTER FOR FINANCIAL MARKET INTEGRITY,

             CHARTERED FINANCIAL ANALYST INSTITUTE

    Mr. Schacht. Thank you, Senator Hagel. We appreciate the 
opportunity to add our views today.
    Our organization comes at this maybe a little bit 
differently than some of the perspectives that you heard 
yesterday, and that is that we approach this really as an 
investor advocate with an interest in promoting appropriate 
professional standards in the industry. And we have spent a 
good deal of focus in the past 18 months as an organization 
looking at trying to promote a comprehensive set of standards 
for hedge fund operators.
    We have been looking very closely at the issues of hedge 
fund performance reporting, investor education, and we have 
been meeting with regulators around the world to discuss this 
whole notion of hedge funds and how and who and why the 
industry should be regulated.
    Just to stay on topic, very quickly, to be true to our 
topic today, the role of hedge funds from the investor's 
perspective, I think it is evolving significantly. It has 
traditionally been high, uncorrelated historical returns, and I 
think everybody is hoping that it is not going to be just 
historical.
    But one of the newest opportunities, newest developments 
with respect to the role of hedge funds, we think, and sort of 
the elephant in the room is the entry of the pension fund 
industry into the hedge fund space in a big way, trying to get 
higher returns to meet some of those increasing liabilities, 
and we think that is an important issue to keep track of.
    This is a very interesting industry. It has all sorts of 
contradictions. I am not sure that we have ever seen an 
industry before where we have had huge and growing demand, huge 
and growing supply. We have had an absolute media frenzy with 
respect to this industry. One report says there are over 100 
stories on average a day about the industry in 2005, and 
consequently, increasingly, the suspicions of regulators around 
the world have grown dramatically in our travels in the last 18 
months, so it has been a sort of a jumble of dynamics.
    I think it continues to be viewed as an asset class with 
exposure sort of leaning all in one direction and subject to 
maybe a systemic meltdown. In essence, we agree with the Under 
Secretary that this is really the universal exposure. It is all 
assets, all markets, in all directions, and we sort of agree 
with this notion that it has become sort of the complete market 
concept.
    I think there are some specific concerns about leverage. 
There are some specific concerns about the level and interplay 
of counterparty exposure. Those are an issue. But I think in 
our view, this is not a house of cards but rather a broad-based 
industry with some pockets of concern.
    We mention in our written testimony several other 
regulatory concerns that we have been hearing from regulators 
around the world, and I would be happy to talk about those if 
you have any questions. I would note very quickly that we 
supported the recent move to register hedge fund managers under 
the 1940 act as an appropriate step, leaving some exemptions in 
that activity, but we think it does very little to get at this 
concern of leverage and of pockets of systemic imbalance, so 
just so nobody is confused by that, the hedge fund registration 
really does not get at that.
    Very quickly, I just wanted to talk about better investor 
education and proper hedge fund manager conduct, because those 
are two very important things to our organization, and I would 
mention that a key component of that, of investor understanding 
and industry transparency is understanding what a hedge fund 
manager should offer in terms of ethics and professional 
conduct to the investors that they serve. It is certainly the 
case, as we have heard today, that investors have some 
significant responsibility to know what the heck they are 
getting into, to know what to look for, but the fact of the 
matter is that on a global basis, this is a much less regulated 
industry and historically because it has been promoted to 
sophisticated, trained investors who understand the appropriate 
due diligence process.
    We are not sure that is still the case, and we have come 
out with something called the Asset Manager Code of 
Professional Conduct, which we think is a decent template for 
every investor, for the sort of things that every investor 
should expect and demand from their hedge fund managers, and it 
has done so with a self-regulatory approach to this.
    A number of things that it covers include portfolio 
evaluation and performance reporting, and I will wrap up 
quickly on performance reporting issues, because we have done a 
lot of work on that issue. It is one of the areas that we think 
is most prone to mischief in the investment management industry 
and certainly in the hedge fund industry. There has been a 
recent spate of articles and calls for regulation of hedge fund 
performance reporting, because the feeling is that it misleads 
investors, that it might be as much as 600 basis points off in 
certain cases.
    I would encourage you and the Committee when you are 
looking at this to look at it with some caution for several 
reasons. First of all, the performance that people are 
criticizing is really voluntary private data bases, and I think 
it has been acknowledged of all of the statistical shortcomings 
in those reports. Second of all, we would doubt highly whether 
any serious hedge fund investors are making investment 
decisions based on that information. I think they know the 
importance of looking at performance at the individual fund 
level and the importance of having a very quality due diligence 
program to confirm and verify that.
    Finally, just on performance and how you calculate it, we 
believe the industry benchmark for this is the global 
investment performance standards or GIPS. It is a standard that 
we have developed. It has been in use and development over the 
last 10 years. It is the industry standard in nearly 30 
countries around the world, and it provides a consistent and a 
verifiable process that is comparable across managers.
    So thank you very much. We commend you for continuing to 
oversee this industry, your vigilance with this as it evolves. 
We would encourage you to monitor the new investment advisor 
registration approach, allow that to settle in over the course 
of the next several months and determine if further regulation 
of either the manager or the fund itself would be warranted.
    Thank you.
    Senator Hagel. Mr. Schacht, thank you.
    Mr. Chanos.

                   STATEMENT OF JAMES CHANOS

                           CHAIRMAN,

           COALITION OF PRIVATE INVESTMENT COMPANIES,

                 PRESIDENT, KYNIKOS ASSOCIATES

    Mr. Chanos. Thank you, Chairman Hagel, and thank you to 
Ranking Member Dodd and other Members of your Subcommittee. My 
name is Jim Chanos. I am President of Kynikos Associates, a 
hedge fund management firm based in New York City. Thank you 
for the opportunity to appear today, and I am here today on 
behalf of the Coalition of Private Investment Companies.
    To paraphrase the great American Stan Lee, with great 
growth comes great responsibility. By any measurement or 
definition, the hedge fund industry has enjoyed great growth 
over the past decade. Now, we must meet the responsibility that 
comes with managing more than $1.2 trillion invested by pension 
funds, endowments, individuals, and other institutions. There 
is no shortage of activities by which hedge funds play an 
extremely vital role at making the U.S. capital markets the 
envy of the world. Other witnesses today have amply discussed 
that, and to avoid repetition, I would simply say that we share 
those views.
    I would like to draw the Subcommittee's attention to three 
particular areas that our coalition believes are issues that 
will be of significance to policymakers in the months to come. 
First, we believe that hedge funds are very important 
participants in our capital markets, and it makes sense to 
include them in any review of issues that arise within these 
markets. That said, we do not believe that the industry 
warrants greater scrutiny than other market participants 
engaged in the same or similar activities. In fact, we 
encourage policymakers to think horizontally, across market 
participants, rather than vertically, in which artificial 
distinctions are drawn between participants who are doing the 
same things.
    Taking this point one step further, CPIC also believes that 
regulatory treatment of private pools of capital should be 
consistent regardless of what those entities call themselves. 
We believe that too often, policymakers spend unneeded time and 
effort trying to draw distinctions between one kind of fund or 
another, while in the marketplace itself, the lines that 
formerly distinguished institutions from one another are either 
rapidly blurring or have ceased to exist altogether.
    Second, CPIC believes there is significant room for 
improvement in asset valuation and performance reporting by 
hedge funds. There is both opportunity for outright fraud, and 
there is also a lack of broadly accepted policies and 
procedures to conduct valuation of the investments for which 
market prices are not readily available. Our coalition believes 
that there is an important role for the Federal Government to 
play in fostering a dialog with market practitioners, 
academics, economists, and others to improve practices in this 
area. We also believe it is important for hedge fund managers 
to adopt practices that improve balance sheet transparency by 
breaking out unrealized gains and losses and assets that are 
not mark to market.
    Last on this point, we strongly encourage the participation 
of all members of the President's Working Group on Financial 
Markets in discussing this issue. Again, the activity should be 
more important than the entity.
    Third, we would like to bring to the Committee's attention 
the apparent rising incidence of corporate intimidation of 
analysts, shareholders, and reporters who report or offer 
opinions critical of company's management. The ability of 
business journalists to communicate with sources is of 
paramount interest to the functioning of our markets, as is the 
ability of analysts to disseminate their views free from the 
threat of retaliation and shareholders to question the managers 
they hire.
    Unfortunately, the recent subpoenas issued by the SEC staff 
and then hastily withdrawn had the potential to hinder the 
ability of the press to do its job and thus limit the 
information readily available to all investors. We commend 
Chairman Cox for clarifying SEC policy, which will be to the 
benefit all investors. We also hope that the Commission will be 
as zealous in investigating issuer intimidation as it appears 
to have been in pursuing the complaints of generally 
underperforming corporate managements.
    A free market only functions to the extent that competing 
views and opinions are allowed to mix without artificial 
constraints. This is at the heart of how a market discovers the 
true value of a company. If we do not allow investors, 
analysts, or reporters on both the long and short side, whether 
hedge funds, private capital, mutual funds, or other investors 
to openly question and test management's programs, plans, and 
projections, our markets and those who invest in them will 
suffer as a result. Honest skepticism does not equal market 
manipulation.
    As I said, there are a number of other issues that are more 
thoroughly addressed in my written statement, and I am happy to 
try to answer any questions the Subcommittee might have. Thank 
you again for the opportunity to present before you.
    Senator Hagel. Mr. Chanos, thank you, and again, to each of 
you, thank you. My questions will be broad enough that I would 
appreciate each of your response to them, and I want to begin 
with just a couple of very basic questions, because I think 
they are part of building a foundation in this hearing on what 
hedge funds are and further developing an appreciation of that 
knowledge that comes from these hearings. So here is the first 
question: what is the typical hedge fund? How large is the 
typical hedge fund? Is there a hedge fund? Secretary McCormack, 
I will start with you.
    Mr. McCormack. I do not think there is a typical hedge 
fund. They vary enormously in size, investment strategies, and 
earnings. They vary in the proprietary information that they 
use upon which they make these investments. So I do not think 
there is a typical hedge fund. They are involved in every kind 
of investment activity, from investment banking to real estate 
to currency speculation.
    Senator Hagel. Dr. Lerrick.
    Mr. Lerrick. Senator Hagel, I think that is one of the 
difficulties for the Committee. Twenty years ago, hedge funds 
were relatively easy to define in terms of the kind of 
activities they pursued. They mostly invested in liquid markets 
and used trading to try to find momentary misalignments of 
prices that would disappear very quickly, and they used 
leverage.
    Today, hedge fund can describe any private investment fund 
basically, because you read hedge funds are financing movies in 
Hollywood now. They are financing nuclear waste treatment 
plants in Europe. They are developing pipelines in Latin 
America. So how different are they than a private equity fund? 
How different are they than a real estate developer?
    And that is why I would reiterate Mr. Chanos' comment that 
to try to define a hedge fund I think is a waste of time. It is 
more of a question of defining the type of activity that funds 
do perform, and whether you call them hedge funds or private 
equity funds or real estate funds or arbitrage funds really is 
irrelevant once you look at the function they play, not what 
their name is.
    Senator Hagel. Let me ask you this before I get to the 
other two members of the panel. And you said it correctly: it 
is part of the difficulty of getting our arms around this for 
people to understand what it is when I cannot elicit an answer 
on what a typical hedge fund number is. But the difference to 
start with that most funds have some dynamic of accountability, 
whether it is a year end report, a quarterly report, a balance 
sheet, something that they send out to their investors--is that 
correct?
    Mr. Lerrick. True.
    Senator Hagel. So are we saying here that these are so 
nebulous that there are no numbers, we just cannot figure them 
out?
    Mr. Lerrick. No, not at all, Senator. What I am saying is 
that I assume that any responsible hedge fund or any hedge fund 
that can actually attract funds today, capital, has to report 
periodically, monthly or quarterly and certainly more 
frequently than annually on what its portfolio looks like, what 
types of activities it is pursuing, what its performance has 
been.
    But I think stepping back and trying to put myself in the 
position of a Senator and saying what should be my concerns, 
well, there are really only two concerns that should come 
before the Congress. One is, when it comes to investments, 
which is protection of unsophisticated investors, and that is 
clearly a concern. I think in the case of the hedge fund 
industry, that need not be a concern, because unsophisticated 
investors really do not have access to hedge funds. The only 
way they can get to hedge funds is through funds of funds, 
where there are professionals who are choosing their 
investments for them, so they actually have a professional 
intermediary who is making their choices.
    The second is the question of systemic risk, risk to the 
entire financial system. And there, it is not hedge funds that 
should be the concern. It should be what are the dangers to the 
financial system? Is the danger to the financial system 
excessive leverage, whether it is from a hedge fund, whether it 
is from a private individual; I mean, if you remember, there 
was a total market failure when Nelson Bunker Hunt tried to 
corner the silver market. Now, he was not a hedge fund. He was 
not regulated. He did not have to report to anyone. He was just 
large enough that he could do it by himself. And so, I think--
and again, the concentration of positions, which is something 
that Secretary Quarles raised.
    So I think those are the issues the Congress should focus 
on, not whether it is a hedge fund, whether it is a mutual fund 
with a performance base and the ability to short securities, 
whether it is a private individual, they should try to get to 
the source of the problem, not try to narrowly define who they 
want to look at.
    Senator Hagel. Which is going to lead to another round of 
questions on transparency as to what is appropriate and what is 
not, but let me ask the other two panelists to comment on any 
piece of the question and what the other two panelists have 
said.
    Mr. Schacht. Yes, thank you. Understanding that it is not a 
very simplistic definition for hedge funds, someone once said 
it is really a fee structure masquerading as an asset class, 
but there are approximately 8,600 funds, between 8,600 and 
9,000, depending on whether you count them at 8 in the morning 
or 5 at night, and the numbers we have been hearing are that 80 
percent of those funds are under $200 million in assets under 
management. So the bulk of the industry tends to be on the 
smaller end of a managed fund.
    Senator Hagel. Thank you.
    Mr. Chanos.
    Mr. Chanos. I would echo what Dr. Lerrick and Mr. Schacht 
said, in particular, the comment on the fee structure as 
opposed to an asset class. There is something to that. It is 
interesting, though, however, I will make a couple of 
additional observations in that first of all, the life span of 
a typical hedge fund is very, very short. They have a very high 
failure rate. The market works. Investors move quickly out of 
poorly performing hedge funds when they do not perform, often 
because of the structure of the hedge fund itself in which 
management teams get a piece of the profits but if they lose 
money must work strictly for the management fee before the 
performance bonus kicks back in.
    This leads investors to quickly flee any poorly performing 
fund, thus creating a vicious cycle as opposed to a virtuous 
circle. So the structure of most hedge fund management 
companies is very brittle, interestingly enough, and I think 
that that has led the industry to actually embrace less risky 
business practices if not investment practices, which hopefully 
will lead to more stability in the industry going forward. We 
shall see.
    But again, I would stress my earlier comments about 
singling out hedge funds which employ a wide variety of 
investment techniques today and using the prism of hedge funds 
to look at all those techniques as opposed to perhaps a better 
policy view, which is to look at the techniques themselves as 
practiced by all market participants, whether they be private 
equity, venture capital, hedge funds, large individual 
investors, or pension funds. I think we are going to get bogged 
down in trying to define this term hedge fund, and we are going 
to miss the forest for the trees.
    Senator Hagel. Thank you.
    Back to the issue of transparency, disclosure, how much 
should there be, how much need there be, starting with you now, 
Mr. McCormack.
    Mr. McCormack. Well, my sense is that the amount of 
disclosure that we have now, on the macro side, it is not 
sufficient. I mentioned the question we had earlier about one 
slice of the process, which is the involvement in the 
derivative side. We do not have a clear idea about the overall 
quantity of activity in the derivative area. We have very 
subjective decisions about what ``value at risk'' really means. 
Those very subjective judgments are sometimes even divergent 
within different parts of the same creditor institutions.
    So there is some need for a further attempt to get a more 
accurate sense of valuation in this process. I personally do 
not have any problem with requiring people to register who are 
in this business. We had a situation years ago where some of 
the smartest people in the world were running the Long Term 
Capital Management Hedge Fund. They were brilliant people. They 
had judgment. They were Nobel Prize winners. One served on the 
Federal Reserve Board.
    These were people of unquestioned judgment and integrity. 
They still made disastrous mistakes. It is safe to say that not 
everybody in this 8,000 member hedge fund industry is of the 
same standard brains and integrity. To have some additional 
information about who really is involved is probably not such a 
bad idea. The British, many other Europeans, and Japanese are 
certainly of this view.
    Senator Hagel. Thank you.
    Dr. Lerrick.
    Mr. Lerrick. Senator Hagel, I think you have to distinguish 
three levels of transparency. The first is the transparency or 
the information provided to investors in hedge funds, and 
there, the investors, given that we are dealing with a 
restricted universe of, quote, either sophisticated or large 
investors, they should be able to make their own determination 
of whether they have sufficient information or not from a hedge 
fund they are considering investing in.
    The second level is the lenders and the counterparties to 
these funds, and there again, when you are talking about major 
investment banks, major commercial banks, major universal banks 
that are the counterparties or the lenders, they should be able 
to take care of themselves and demand the kind of information 
that is required for them to do appropriate risk evaluations.
    The last group is basically those that must be concerned 
about systemic risk, the policymakers, the official sector. And 
there, I think there is a hole in the information process. And 
I think the danger there is that there is an ignorance of some 
of the risks that are in the international financial system. In 
that, there is a role for the official sector to require 
aggregation of the types of information about leverage, about 
borrowing, about concentrations, so that policymakers can 
themselves identify potential sources of risk. But I believe 
that information should also be disseminated to the public so 
other market participants can also make the correct 
adjustments.
    Remember, market crises come from surprises. If there are 
no surprises, markets adjust very smoothly. And so, the whole 
point is to make sure the market has as much information as it 
possibly can to make informed judgments on a continuous basis, 
and then, that is the easiest way of reducing the frequency and 
the severity of crises.
    Senator Hagel. Thank you.
    Mr. Schacht.
    Mr. Schacht. I will just talk very quickly on the 
transparency at level one that Dr. Lerrick mentioned, and that 
is at the investor level, and if Susan Wyderko's numbers are 
correct that 2,400 roughly hedge funds are registered, that 
says that somewhere in the range of 5,600 plus are not 
registered, so they are not required as a registered investment 
advisor to provide that level of disclosure.
    So it really becomes a matter of investor education, and 
that is the sort of thing that we have been trying to focus on: 
what an investor should demand and what they should know about 
from the hedge fund service providers that they select.
    Senator Hagel. Thank you.
    Mr. Chanos.
    Mr. Chanos. Speaking as an industry participant, I can tell 
you from a practitioner's point of view that in addition to 
weekly, monthly, and annual reporting that our fund does and 
most of our member firms do, as the industry has grown in the 
past 10 years and has become more institutionalized that the 
requirements of these institutional investors have basically 
from a business practices standpoint mandated better controls 
and better disclosure.
    We are often visited quarterly by our largest investors, 
and if they cannot visit onsite, they have conference calls 
with us to query us on positions, leverage, market outlook, so 
on and so forth. All of our investors, in our case, have 
ability for onsite complete visit. So not only now do we 
entertain the possibility of the SEC paying us visits, but our 
clients do often to exercise their due diligence, and we 
welcome it.
    So the industry has grown up quite a bit in terms of what 
it tells its investors by and large. There are always 
exceptions, as some of the preceding speakers have indicated. 
But as the industry has geared up for mandatory SEC 
registration, we have pointed out to a number of market 
observers that most reasonably large hedge fund management 
organizations already were employing the compliance, back 
office, and financial controls necessary to satisfy their 
clients, which go a long way to satisfying the SEC without a 
lot of added burden and cost.
    Senator Hagel. Thank you.
    Dr. McCormack, I am going to read from your testimony, and 
in fact, it is your summary, a line here. It says, quote, our 
concern should be potential systemic risk, fraud, and 
structural problems that increase the likelihood of these two 
broader potential problems, end of quote. Would you share with 
us, and I would ask the same question of the other three 
panelists, what you then think we should be doing, regulatory 
regimes, some of the things we have just talked about, 
compliance, more transparency? What should we be doing that we 
are now doing, or should we be doing anything? Define that a 
little more, not just the concern, but how do we address the 
concern?
    Mr. McCormack. Well, let me focus on the key problem as I 
see it or one of the key problems as I see it. If you look at 
some of the reports that have been done by the Federal Reserve 
and others about financial crisis management and what happens 
during a financial crisis, the key problem, of course, is that 
suddenly, liquidity dries up. Suddenly, there is not enough 
people wanting to buy when there are too many people wanting to 
sell. You wind up with a market meltdown.
    Your earlier witness from the Federal Reserve said that 
hedge funds were, in fact, an additional source of liquidity in 
this situation. That might be the case. But it is very 
important to remember that hedge fund investors are just as 
subject to panic reclaiming capital in the middle of a 
threatening market environment as any other part of the 
investment community. Hedge funds are now so important as a 
driver of markets that if sudden, large scale, capital 
repatriations occur in a crisis, you can wind up with that 
being an additional source of liquidity problems rather than 
that being an asset for easing a future crisis.
    That is another one of the reasons why I think we need to 
understand what is happening in this investment structure.
    Senator Hagel. So you would not advocate anything beyond 
what we have in place now with the Federal regulatory regimes.
    Mr. McCormack. One of the most important things that the 
Federal Government could do and should do is public warning of 
potential problems. One of the failures we had, for example, in 
the bubble that developed in the late 1990s was, Chairman 
Greenspan said only once, in 1996, that there was irrational 
exuberance in financial markets, and he did not say anything 
again for a very, very long time as the bubble built and built, 
even though there were concerns inside the U.S. regulatory 
system. Nobody said anything until the very end.
    I think the time is now where government's responsibility 
is to say yes, the environment now is good; yes, the U.S. 
economy is growing. Yes, the global economy is growing at a 5 
percent rate, but this will not last forever. There is such a 
thing as a business cycle. People need to watch very carefully 
their investments so that they do not get caught blindsided in 
the event that the situation deteriorates somewhat.
    Potential liquidity shortages also suggest the need for 
adequate capital cushions by investor groups are needed, so 
that they do not require the Federal Reserve to provide all of 
the liquidity in the event of a problem. Individual investor 
groups themselves, including hedge funds, should have larger 
capital cushions than they currently do.
    Now, that is a technical subject and one that is 
potentially expensive, and it is one I am not prepared today to 
make a definitive quantitive recommendation on. But that is the 
kind of issue that we need to explore: whether a larger capital 
cushion is necessary for hedge funds engaged in these markets 
to buffer against the inevitable day, the inevitable day, when 
there is a serious and sudden surprise to markets that causes 
liquidity to dry up.
    Senator Hagel. Thank you.
    Dr. Lerrick.
    Mr. Lerrick. Senator Hagel, very quickly, Secretary 
McCormack is absolutely right. There are going to be financial 
crises. They are going to come. There is no question about it. 
My colleague, Alan Meltzer, likes to say capitalism without 
losses is like religion without sin. It does not work. And that 
is true.
    And therefore, there are going to be crises. Trying to 
eliminate crises, in order to eliminate crises, you are going 
to have eliminate massive benefits from markets and capitalism, 
and it is certainly not worth that. I think in terms of--you 
asked a very specific question: what would be a recommendation 
for future government intervention, let us not call it 
necessarily regulation.
    I think the only advantage at this stage would be for the 
government to mandate the collection of information on leverage 
and exposures in the system. And that would serve both as a 
tool for the policymakers themselves to potentially identify 
sources of strain on the system and then to disseminate that 
information so that the other participants in the market can 
take appropriate action, and that will eliminate--that will 
reduce, it will not eliminate, the surprises that Secretary 
McCormack talked about, and that will increase dramatically the 
stability of the financial system.
    Senator Hagel. Thank you.
    Mr. Schacht.
    Mr. Schacht. Just two brief thoughts: make sure that the 
SEC has adequate resources to conduct those reviews of hedge 
fund managers on a consistent and a competent basis, No. 1; No. 
2, I am agreeing with Dr. Lerrick. If there is a concern about 
leverage and imbalances related to counterparties and so forth, 
addressing that through greater disclosure. And I think as you 
know, the Financial Services Authority in the United Kimgdom is 
in the process right now of doing an exposure draft on this, 
and they are feeling that you can reveal and correct these 
potential imbalances through more required disclosures from the 
counterparties that you already regulate.
    Senator Hagel. Thank you.
    Mr. Chanos.
    Mr. Chanos. Very quickly, in addition to agreeing with what 
most of my compatriots here have just said, I would add that 
one thing this Committee could do would be to continue to 
foster the President's Working Group to make outreaches to all 
industry participants on an ongoing basis, whether through 
symposia, formal or informal get-togethers, to make sure that 
ideas that are out there or that are perhaps not so visible 
from Washington's perspective can get out so policymakers can 
evaluate any possible questions or responses. And the industry 
stands ready to be asked to participate.
    Senator Hagel. Thank you. Gentlemen, last kind of summary 
question: of all of the comments that you have heard this 
afternoon, especially from the previous two panels representing 
our government, anything that you would like to get on the 
record in response to anything you heard or anything that you 
did not hear or anything you want to say specifically that was 
not asked today that you want to comment on?
    Secretary McCormack.
    Mr. McCormack. I support Secretary Quarles' comment about 
the importance of first looking at potential problems carefully 
before one rushes with remedies. We are dealing with an 
extremely complicated industry, about which there is 
insufficient knowledge, even within the very community of 
regulators.
    Senator I think what you are doing with these hearings and 
the more broad effort to look at potential vulnerabilities in 
financial markets is important. At the end of this process we 
will all have a much clearer idea where the holes are that 
governments and investor, working together, need to fix.
    Senator Hagel. Thank you.
    Dr. Lerrick.
    Mr. Lerrick. Senator Hagel, I always enjoy testifying on 
the same day as Secretary Quarles, because I always am amazed 
at how he answers the same question that I would answer, but he 
does it in such a diplomatic way.
    [Laughter.]
    Mr. Lerrick. You asked him sort of would regulation, and I 
do not want to use the word excessive, but large-scale 
regulation, drive hedge funds offshore? And Secretary Quarles 
said, well, the incentives, and people would move if it caused 
problems in their operations.
    Let me say very clearly: I do not know of a single large 
hedge fund that cannot move offshore in a matter of hours its 
entire operations. Any attempt to put large-scale regulation on 
hedge funds, private equity funds, these pools of money, will 
meet with total defeat. And I think that is something the 
Committee should keep in mind when it thinks of what it thinks 
might be appropriate action to take.
    The second point I would like to touch upon is that 
official policy always lags behind the market. That is just a 
given. And that is why, again, any attempts to try to catch up 
with overly heavy-handed regulation will just either limit the 
industry if it is effective or drive it outside of the U.S. 
regulatory environment.
    The other point I would like to raise is something that 
Senator Bunning raised when he talked about the concept of 
manipulation, when he asked the witnesses do they know of any 
manipulation? And he put in the category of manipulation 
something that I think is quite extraordinary. He said do you 
know any cases where hedge funds have forced companies to take 
actions they really would not have liked to do? And he viewed 
that as manipulation.
    I do not view that as manipulation. Hedge funds and 
investors and markets in general are every day forcing 
companies, forcing governments, forcing any participant to take 
actions they do not want to take, but that is their chief 
benefit for the global economy. And therefore, I think any 
attempt to reduce their ability to force those changes will 
only be detrimental both to this economy and to the financial 
markets in general.
    Senator Hagel. Thank you.
    Mr. Schacht.
    Mr. Schacht. Senator, I think we just all appreciate the 
fact that you are looking at this at a stage where it is 
beginning to be consequential. It was about 1.5 percent of the 
investment management business last year. It is probably 
somewhere in the range of 2, 2.5 percent of the overall 
industry, but that could change very quickly with the advent of 
the pension funds getting into this sector.
    So I think you continue to look at it and keep your eye on 
it.
    Senator Hagel. Thank you.
    Mr. Chanos.
    Mr. Chanos. And finally, in the interest of brevity, I 
would just add that for too long, the term hedge fund has been 
used as a pejorative, with images of managers hiding behind 
trees or sunbathing on yachts off the Cayman Islands. And the 
reality is that most hedge fund managers are hard working 
people based here in the United States who are trying very hard 
to compete in a viciously competitive side of the financial 
marketplace.
    I think the industry welcomes these hearings. It welcomes 
the opportunity to get into the glare of the spotlight as 
opposed to to remain in the shadows, which was never the case 
anyway, and we look forward to continuing working with the 
Committee, your Committee and others, as well as the members of 
the President's Working Group as you try to grapple with these 
issues.
    Thank you.
    Senator Hagel. Mr. Chanos, thank you.
    I would just add that politicians hate the glare of the 
spotlight.
    [Laughter.]
    Senator Hagel. You notice we had very limited participation 
here today, six United States Senators for a Subcommittee 
hearing, and that is rather significant, having nothing to do 
with the Chairman, I can assure you. It was the subject, and 
the subject is very important and really having nothing to do 
with the spotlight. But it gives you some reflection and 
understanding of how seriously policymakers are viewing 
responsibilities in these areas. And so, I think it is a good 
sign that we had this kind of turnout today.
    Secretary McCormack.
    Mr. McCormack. Just one final comment.
    You have seen the Corrigan Report of July 27, 2005, where 
he discussed the problems in the credit derivative industry. 
Just think how bad that situation got before it was finally 
identified and apprised. You had a situation where there was 
sometimes as much as 3 months between the day the trade was 
orally made and when it was actually confirmed, creating all 
kinds of problems and ambiguities in the event that the credit 
insurance actually was called on. You had situations where 
counterparties were not really vetted in terms of their 
creditworthiness.
    If this potentially dangerous situation could develop so 
fast and create such potential problems, it suggests that there 
is no room for complacency.
    Senator Hagel. Dr. Lerrick.
    Mr. Lerrick. Senator Hagel, Secretary McCormack is 
absolutely right. I mean, one of the key roles of the official 
sector is to try to identify problems before they occur, but 
that does not mean it has to regulate the solutions.
    The Federal Reserve took a very important step when it said 
we identified this problem; we are inviting all of the market 
participants in. We say this is a problem; we want you to solve 
it. Go to it. That is a very valid role for the official 
sector. The Federal Reserve did not come in and say we are just 
going to regulate you all and tell you how to do it. They said 
solve the problem, and the private sector did or is in the 
midst of doing it.
    Senator Hagel. Well, gentlemen, this Committee is grateful 
for your participation and your insights and your experience. 
It has been very helpful.
    I would like, as I did with the other two panels, to keep 
the record open in case any of my colleagues have additional 
questions, if you would be good enough to see if you could 
respond to, and we certainly will be calling upon you in the 
future, as all four of you have been involved with Committee 
activities before, and again, we thank you. It is good timing. 
I have another vote. So this Committee is adjourned.
    [Whereupon, at 5:26 p.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]
              PREPARED STATEMENT OF HON. RANDAL K. QUARLES
 Under Secretary for Domestic Finance, U.S. Department of the Treasury
                              May 16, 2006
    Chairman Hagel, Ranking Member Dodd, Members of the Subcommittee, 
good afternoon, it is a pleasure to be here today. Let me first thank 
you for holding this hearing and allowing the Treasury Department to 
present its views. I am particularly pleased to be here because our 
discussion today is an effort to gain a better understanding of a 
critical component of our financial markets.
    Our charge today is to examine the role of hedge funds in our 
financial markets. I note at the outset that this topic is different 
from an issue about which there has been considerable discussion in the 
past few years: the regulation of hedge funds. I think your choice of 
topic for today's hearing is the right one--if government addresses the 
question of regulation of any financial institution or activity without 
a clear understanding of the place it plays in our financial system, 
the risk of unnecessary, excessive, or inappropriate legislation is 
increased. While I am sure we will touch on certain regulatory aspects, 
I intend to focus my remarks on what hedge funds do for and in our 
financial markets.
    As we consider this issue, we should also keep in mind that the 
role of hedge funds in our financial markets is continuously evolving; 
and in recent years it has been evolving rapidly. While change like 
this often brings about improvements and efficiencies, it can also 
create insecurity or concern. The lens through which we examine the 
evolution of hedge funds' role in the financial markets often shapes 
our view of what, if anything, the government needs to do to react to 
the changes so we should ensure that this lens is as clear and polished 
as possible.
    Hedge funds are not a recent invention. Their history is typically 
tied to the fund created by Alfred Winslow Jones in 1949. During this 
time period, these new investment vehicles were created mainly as a 
reaction to significant regulatory restrictions on investment funds 
embodied in the Investment Company Act of 1940 (the '40 Act). Unlike 
mutual funds registered under the '40 Act, an unregistered fund could 
sell securities short, buy securities using leverage, and use diverse 
financial instruments and strategies. The name ``hedge fund'' was used 
to identify these new funds that were able to hedge or protect against 
loss of capital in down markets.
    Today, the term hedge fund is used to describe much more than a 
fund that employs hedging techniques. There is, however, no universally 
accepted definition of a hedge fund. In the late '90s, for example, the 
President's Working Group on Financial Markets (PWG) defined a hedge 
fund as ``any pooled investment vehicle that is privately organized, 
administered by professional investment managers, and not widely 
available to the public.'' This is a useful working definition for some 
purposes, but it does not distinguish hedge funds from other forms of 
unregistered capital pools that generally are recognized to have 
distinctive features, such as private equity funds and venture capital 
funds.
    Perhaps the most useful approach is to identify a list of features 
that distinguish hedge funds from other capital pools, recognizing that 
the list is evolving, that various combinations of such features are 
possible, that some are shared with other investment vehicles, and that 
no single feature is a defining characteristic. Such features would 
include legal structure (a private entity with unlimited life and with 
pass-through tax benefits); investment objective (positive absolute 
return in all market conditions, rather than measurement against an 
industry benchmark); investment strategy (flexible, including the 
ability to use short selling, leverage and derivatives in a wide 
variety of markets); compensation structure (usually 1-2 percent 
management fee and 15-25 percent performance fee, calculated annually 
on the basis of accrued gain); investor base (high net worth 
individuals and institutional investors; high minimum investment; not 
widely available to the public); investor capital commitment (full 
commitment paid at time of subscription rather than drawn down over 
time; withdrawals regularly available, usually monthly or quarterly); 
and disclosure (generally restricted to that contractually agreed upon 
between the manager and the investors, with limited public 
information).
    Hedge funds have experienced phenomenal growth during their history 
especially in recent years. They have grown from an estimated $50 
billion in assets in 1988 to about $300 billion in 1998 to over $1 
trillion in assets today.\1\ Current estimates suggest that there are 
about 9,000 hedge funds.
---------------------------------------------------------------------------
    \1\ The data about the hedge fund industry are not precise. 
Therefore, many of the figures noting the size and growth of the 
industry are estimates and Treasury has not independently verified 
them.
---------------------------------------------------------------------------
    Today, hedge funds employ a variety of investment strategies that 
vary considerably depending on the goals and needs of the investors and 
the types of instruments in which the fund invests. Much, if not all, 
of this growth has been market driven, and, as a consequence, it has 
been subject to a significant amount of market discipline. For example, 
as hedge funds have grown, their investor base has evolved. The 
original hedge fund investors were wealthy individuals. Then, 
university endowments began investing in hedge funds--most likely 
because the individuals that typically sit on these boards were already 
exposed to these types of investments. Later, institutional investors 
such as pension funds seeking greater diversification wanted to 
participate. Through this growth process, each of these investor groups 
imposed certain forms of discipline on hedge funds. Thus, the hedge 
fund market has become much more ``institutionalized'' as it has grown 
and evolved.
    Hedge fund growth and practices also have been tempered by 
significant market events, most notably, the failure of Long Term 
Capital Management (LTCM) in 1998. As a result, hedge fund investors 
now demand more transparency of their fund managers (you might recall 
that LTCM principals notoriously provided little transparency). Post 
LTCM, investors also recognize the need for more discipline regarding 
the use of leverage and collateral.
    Therefore, while the hedge fund market has grown drastically in the 
past twenty years, there is at least some reason to believe this growth 
has been subject to private sector discipline.
    What role this very large, trillion-dollar group of alternative 
investments plays in our financial markets is a very important 
question. While hedge funds provide certain benefits to the financial 
markets, they can also put stresses on it that need attention.
Benefits to the Financial Marketplace
Liquidity Provision
    One of the reasons that the U.S. financial markets are so 
attractive to investors is because of their liquidity. In general, the 
U.S. financial markets are the deepest and most liquid markets in the 
world. Hedge funds are significant liquidity providers in many 
marketplaces.
    Because of the varying strategies employed by hedge funds, they are 
often the willing buyers or sellers that provide additional liquidity 
to financial markets. For example, hedge funds' desire to seek 
arbitrage opportunities adds significantly to a markets' liquidity. In 
fact, some reports suggest that hedge funds account for between one-
third or one-half of the daily volume on the New York and London stock 
exchanges. Hedge funds contribute even more significantly to 
marketplace liquidity in less traditional markets. For example, hedge 
funds represent the overwhelming majority of trading volume in the 
distressed debt markets, the convertible bond markets, and the 
exchange-traded fund markets.
Price Efficiency
    Many hedge funds seek to create returns by targeting price 
inefficiencies. Such price inefficiencies might occur when there is 
discrepancy between two or more markets. A sophisticated investment 
manager can enter both of these markets and profit by taking advantage 
of this pricing anomaly. Former Federal Reserve Chairman Alan Greenspan 
characterized the ability of hedge fund managers to obtain profit from 
these inefficiencies as picking the ``low-hanging fruit'' in the 
marketplace. While this activity certainly benefits the hedge funds 
that are profiting from the trades, it has the salutary effect of 
creating more efficient markets.
    Similarly, hedge funds also target wide bid/ask spreads as ways to 
generate positive return, which generally has the effect of narrowing 
them. This private, profit-making activity on the part of hedge funds 
produces the public good of better price discovery and more efficient 
markets.
Risk Distribution
    Concentration of market-wide risk is one of the greatest threats to 
a smoothly functioning marketplace. Hedge funds can help mitigate this 
risk by helping to transfer and distribute market risk. For example, 
when financial institutions seek to lay off some of the very large 
risks inherent in their normal business activities by buying or selling 
derivatives, hedge funds are often the counterparties to these trades. 
Without market participants that are willing to trade these derivatives 
in significant quantities, financial institutions would have to retain 
more risk, which could have a ripple effect throughout the financial 
markets.
    There is no question that hedge funds are one of the dominant 
participants in the re-distribution of market risk. Among the most 
common risk distribution instruments used by hedge funds are credit 
default swaps. Most simply, these are insurance-like products that 
provide protection against default or bankruptcy, in that they pay 
bondholders some form of compensation after a defined credit event. Use 
of these instruments has grown substantially from about $631.5 billion 
in 2001 to about $17.3 trillion in 2005. The significant growth in 
these securities does raise some important public policy issues, which 
I will address below.
Further Globalization
    Because of the dynamic and evolving nature of hedge funds, I have 
tried to avoid over-generalizing them. However, I am comfortable making 
the observation that, in general, one attribute that is common across 
the entire hedge fund community is that the managers are involved in a 
relentless search for the next profit opportunity. In such a 
competitive marketplace, hedge funds often lead the way to identify new 
and emerging markets. These markets often provide opportunities that no 
longer exist in more mature marketplaces. This, in turn, leads to 
further globalization of our marketplace which provides more choice for 
investors and greater efficiency of markets globally.
Potential Investor Benefits
    Hedge funds can have a direct positive impact on the investing 
community. Speaking broadly, hedge funds can provide investors with 
opportunities for diversification, ``alpha'' or excess returns, and 
capital protection in down markets.
    Hedge funds provide more choices to the investing community. More 
choices allow investors the ability to diversify their investment 
portfolios, which is a common goal of many investors. A recent survey 
suggested that almost half of institutional investors had more than 10 
percent of their assets in hedge funds. Most of these allocations were 
made by reducing allocations to active and passive equity strategies. 
All of the surveyed investors said that their diversification needs 
were being met and over three-quarters of surveyed investors saw 
reductions in overall portfolio volatility.
    Historically, most non-professional investors were limited to 
investment vehicles that employed traditional ``go-long'' strategies. 
These funds attempt to outperform a particular index, such as the S&P 
500. Notably, these funds typically profit only in positive markets and 
try to mitigate losses in down markets. Some hedge funds try to fill 
the obvious gap here with strategies that attempt to produce positive 
returns in both bull and bear markets. The flexibility in the hedge 
fund structure can provide many opportunities to outperform indexes, 
even in thriving years. This is often referred to as generating 
``alpha'' or excess returns. A common technique employed by many hedge 
funds attempting to generate excess returns is employing leverage, 
which, of course, presents its own specific set of concerns.
    Producing positive returns in a down market is also assisted by the 
nimble structures of hedge funds. Indeed, many expected the high-flying 
hedge funds to be crippled after the bursting of the internet bubble in 
the late nineties. Some funds were punished, of course. However, many 
funds exploited their natural flexibility to short stocks and, 
importantly, to move to cash during market dislocations limiting 
exposure and mitigating loss.
    Therefore, hedge funds have the potential to provide investors with 
opportunities for excess returns or capital protection, but, of course, 
this is not always the case.
    It is worth noting that as the hedge fund industry grows and 
becomes more institutionalized, excess returns have become harder to 
find. Indeed, as more market-based demands are placed on hedge funds 
for added transparency, investors will demand significant higher 
returns to justify the hedge fund manager's fee. Armed with this added 
transparency, some observers suggest that there might be a shake-out of 
sorts with underperforming hedge funds suffering the consequences.
Marketplace Risks
    While hedge funds can provide benefits to investors and the overall 
marketplace, they present some risk as well. There are risks that hedge 
funds' aggregate employment of large amounts of leverage or over-
concentration of certain positions could have negative consequences for 
the marketplace. Certain valuation risks also are present in the hedge 
fund industry. Other risks involve operational challenges associated 
with the over-the-counter (OTC) clearance and settlement systems. Many 
of these risks, however, are not unique to hedge funds.
Large Use of Leverage
    Leverage refers to the use of repurchase agreements, short 
positions, derivative contracts, loans, margin, and other forms of 
credit extension to amplify returns. With increased leverage, of 
course, comes increased risk. We learned much about this topic after 
the LTCM failure.
    As discussed by the PWG in its report after the LTCM failure, 
excessive leverage can greatly magnify negative effects of market 
conditions. For example, the LTCM failure demonstrated the risks of 
extraordinary leverage when adverse financial market conditions occur. 
At the time of LTCM's downfall, it had an implied balance-sheet 
leverage ratio of more than 25 to 1 (assets of $125+ billion over 
equity capital of $4.8 billion). As market conditions worsened, LTCM's 
size and leverage, combined with the sheer number of trades it had on 
its books, contributed to a serious deterioration in the liquidity of 
many markets as LTCM and countless other market participants sought 
simultaneously to unwind losing positions.
    The magnitude of LTCM's leverage, and its dependence on numerous 
creditors and counterparties, heightened the threat that its problems 
could spill over to these other institutions and possibly lead to a 
general breakdown in the functioning of the markets. LTCM's excessive 
leverage posed very real systemic risks for our financial markets. It 
is important to note, however, that even though LTCM was a hedge fund, 
this issue is not confined to hedge funds. Many other types of market 
participants use leverage in their trading strategies, and some may be 
more highly leveraged than hedge funds. Moreover, it should be noted 
that innovations in the market are expanding the ways in which market 
participants can apply leverage. Many of the complex derivatives and 
other structured products in which there have been strong growth over 
the past few years have embedded leverage, which in certain 
circumstances can amplify changes in portfolio valuations to a greater 
degree than other forms of leverage.
    In its report, the PWG cautioned that problems can arise when 
financial institutions do not employ sufficient discipline in their 
credit practices with customers and counterparties. To this end, the 
PWG made several recommendations designed to help buttress the market-
discipline approach to constraining leverage. Numerous public and 
private sector groups, such as Counterparty Risk Management Group II 
(also known as the Corrigan Group), also took up the cause of enhancing 
counterparty credit risk management, and many have continued to focus 
on emerging developments such as the growth of products containing 
embedded leverage. These efforts and others have had the positive 
effects that I alluded to earlier.
Concentration of Positions
    Linked closely with the issue of leverage and the potential for 
impaired liquidity in a period of market stress is the issue of 
concentration of market positions or ``crowded trades.'' Sometimes 
referred to as ``herding,'' crowded trades can arise to the extent that 
hedge fund managers are inclined to pursue the same or similar 
investment strategies. Talented hedge fund managers are constantly 
searching for new opportunities and devising new strategies to exploit 
those opportunities, while simultaneously trying to anticipate crowded 
trades. But as more hedge fund managers open funds and more money flows 
in from new investors, crowded trades may become more likely. If 
numerous market participants establish large positions on the same side 
of a trade, especially in combination with a high degree of leverage, 
this concentration can contribute to a liquidity crisis if market 
conditions compel traders simultaneously to seek to unwind their 
positions. The risk, of course, is market disruption and illiquidity, 
possibly exacerbating the risk of a systemic financial market crisis.
Valuation Techniques and Models
    As hedge funds become larger, their valuation policies and 
procedures become more important to the marketplace as a whole. 
Valuation of many financial instruments, particularly complex or 
illiquid instruments, can be difficult. Indeed, valuation is often 
dependent on complex proprietary models. Because of their proprietary 
nature, these models have not been subject to broad-based scrutiny and 
there is a concern that there could be unanticipated changes that might 
only present themselves in certain market conditions. Moreover, 
valuation concerns are exacerbated in the hedge fund industry because 
hedge fund adviser compensation is tied to period returns which, of 
course, requires periodic asset valuations.
    Valuations and correlations can change rapidly in unexpected ways 
and these changes can have a ripple effect in the marketplace, 
especially if the instruments are concentrated and illiquid. There have 
been some reports on this topic. In July 2005, the Corrigan Group 
issued a number of ``guiding principles'' and recommendations for all 
types of participants. It recommended that: 1) investment in risk 
management systems should continue, with full model testing and 
validation and independent verification; and 2) analytics should 
include stress testing, scenario analysis, and expert judgment, with 
special attention to the inputs and assumptions.
    Treasury and the PWG can contribute significantly to this debate in 
the first instance by facilitating communication in the official sector 
and with industry participants and academics regarding valuation 
techniques and models.
Settlement and Clearance Systems
    Hedge funds as a group do not pose a greater operational risk to 
the OTC settlement and clearance systems than any other group of market 
participants. However, operational risks can be posed by certain market 
conditions and certain technological conditions in certain products, 
particularly new products, where technological and legal 
infrastructures tend to lag product development and volume growth. 
These acute ``growing pains'' have developed most recently in the 
credit derivatives market across a wide spectrum of participants.
    Thus, hedge funds, or any other group of participants, potentially 
could have a disruptive impact if there were concentrations of 
positions or attempted mass liquidation in illiquid markets. As I noted 
earlier, hedge funds are major participants in many of these markets 
such as distressed debt, collateralized debt obligations, and credit 
derivatives.
    The Federal Reserve Bank of New York, Counterparty Risk Management 
Group II, Bank for International Settlements, International Swap and 
Derivatives Association, The Bond Market Association, and Depository 
Trust & Clearing Corporation all have made recommendations and/or 
undertaken efforts to strengthen the technological and legal aspects of 
the settlement and clearance systems for all market participants. The 
International Monetary Fund has also raised issues generally related to 
market concentrations and illiquidity and the potential for systemic 
risk in its recent ``Global Financial Stability Report,'' and member 
countries and regulators continue to develop and coordinate policies 
and approaches to deal with these issues globally. The PWG also 
continues to discuss these issues and formulate and coordinate actions 
and plans. We are encouraged by these positive developments.
Conclusion
    Thank you again for allowing the Treasury Department to participate 
this afternoon. As I have mentioned, hedge funds play an important role 
in our financial marketplace. We are also aware that they can present 
certain risks as well.
    As a consequence, as I have noted elsewhere, we at Treasury will be 
examining in detail the issues I have discussed this morning, with a 
view to evaluating whether the growth of hedge funds--as well as other 
phenomena such as derivatives and additional alternative investments 
and investment pools--hold the potential to change the overall level or 
nature of risk in our markets and financial institutions. We will be 
engaging in a broad outreach to the financial community in the coming 
months to help us examine these questions. In addition, we plan, in 
concert with the PWG, to bring key government officials together to 
discuss these financial market issues. As I discussed, the PWG has 
already undertaken a detailed analysis regarding the causes and 
consequences of LTCM's failure. The PWG can and should build on this 
work to help develop a measured and market-based approach to the impact 
hedge funds have on our financial markets.
    Looking forward, we will be focused on seeking to understand in the 
most comprehensive way possible whether and how changes in the 
structure of the financial services industry--of which the rapid growth 
of new forms of capital accumulation, such as hedge funds, is just one 
example--have materially affected the efficiency with which markets 
intermediate risk, whether risk is pooled in different ways or in 
different places than it has been in the past--and if so, what 
appropriate policy responses might be. We will seek to be forward 
looking and to think about these changes not in a fragmented fashion, 
but in a comprehensive way. At the moment it is too soon to say what 
initiatives will result from this focus, but this is the lens through 
which we will filter the various ideas and efforts with which we will 
all be grappling over the next few years.
                                 ______
                                 
                  PREPARED STATEMENT OF SUSAN WYDERKO
         Director, Office of Investor Education and Assistance
       Former Acting Director, Division of Investment Management,
                U.S. Securities and Exchange Commission
                              May 16, 2006
    Chairman Hagel, Ranking Member Dodd, and Members of the 
Subcommittee:
    Thank you for inviting me to testify today about hedge funds, the 
role they play in our securities markets, and the Commission's role in 
their oversight. The Commission has a substantial interest in the 
activities of hedge funds and their advisers, which only recently have 
become major participants in our securities markets.
    The Commission recognized the growing importance of hedge funds 
almost 4 years ago when it directed the staff of the Division of 
Investment Management to undertake a fact-finding mission aimed at 
reviewing the operation and practices of hedge funds and their 
advisers. That review led to the publication by the Commission of a 
staff report entitled ``Implications of the Growth of Hedge Funds,'' in 
which the staff described in detail the organization of the hedge fund 
industry, its growth, and regulation.\1\
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    \1\ Implications of the Growth of Hedge Funds, Staff Report to the 
United States Securities and Exchange Commission (Sept. 2003), 
available at http://www.sec.gov/news/studies/hedgefunds0903.pdf
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    While identifying a number of concerns and making several policy 
recommendations, the report also described the many benefits hedge 
funds provide investors and our national securities markets. They 
contribute substantially to market efficiency, price discovery and 
liquidity. By actively participating, for example, in markets for 
derivative instruments, hedge funds can help counterparties reduce or 
manage their own risks, thus reducing risk assumed by other market 
participants. Moreover, many hedge funds provide an important risk 
management tool for institutional investors wishing to allocate a 
portion of their portfolio to an investment with low correlation to 
overall market activity.\2\
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    \2\ A recent study reported that 78 percent of institutional 
investors surveyed said that hedge funds reduced the volatility of 
their portfolio. State Street Corporation, Hedge Fund Research Study 
(Mar. 2006) at 4.
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Background
    Hedge funds are pools of investment capital that are managed by 
professional investment advisers and that are not offered generally to 
the public. They are operated so that they are not subject to the same 
regulatory requirements of mutual funds, which are governed by the 
Investment Company Act of 1940 which contains many safeguards for 
retail investors. Hedge funds are not characterized by a single 
dominant investment strategy, although many seek to obtain returns that 
are not correlated to market returns and instead seek to obtain an 
``absolute return'' in a variety of market environments. Some adopt a 
``multi-strategy'' approach that permits the adviser to determine, at 
any given time, what investment strategy to follow to pursue returns 
for the investors. Hedge funds also do not have a single risk profile. 
Some utilize leveraging techniques that expose investors to substantial 
risks, while others adopt investment strategies more similar to mutual 
funds.
    Hedge funds do, however, share some organizational characteristics 
that distinguish them from most mutual funds. Most are organized by 
advisers that retain a substantial equity participation in the fund, 
and who receive compensation based, in large part, upon gains achieved 
by the fund (a ``performance fee''). A typical fee arrangement will pay 
the adviser 2 percent of the total amount of assets under management 
and 20 percent of both realized and unrealized gains. Hedge fund 
managers view these fee structures as better aligning their interests 
with the interests of their investors and providing substantial 
incentives for good performance.
    Hedge fund managers usually have a great deal of flexibility in 
managing the fund, which permits them to take advantage of market 
opportunities that may not be available to other types of institutional 
investors. They can change investment strategies, trade rapidly, and 
utilize leveraging techniques not permitted to mutual funds. And, in 
contrast to mutual funds, which must disclose publicly their portfolio 
holdings quarterly, many hedge funds do not even disclose portfolio 
holdings to all of their investors. Hedge fund advisers do, however, 
often offer disclosure to their investors about the extent and 
flexibility of their investment strategies.
Growth and Significance of Hedge Funds
    The ability of some hedge fund managers to generate significant 
returns has attracted a great deal of investor interest. It is 
estimated that hedge funds today have more than $1.2 trillion dollars 
of assets, a remarkable growth of almost 3,000 percent in the last 16 
years.\3\ In 2005, an estimated 2,073 new hedge funds opened for 
business.\4\ One report recently projected that assets of hedge funds 
may grow to $6 trillion by 2015.\5\
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    \3\ See Hedge Fund Research, HFR Q1 2006 Industry Report.
    \4\ See Hedge Fund Research, HFR Q1 2006 Industry Report. During 
2005, 848 funds were liquidated. Id.
    \5\ Van Hedge Fund Advisers, International, LLC, Hedge Fund Demand 
and Capacity 2005-2015 (Aug. 2005).
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    Much of the growth of hedge funds is attributable to increased 
investment by institutions, such as private and public pension plans, 
endowments and foundations.\6\ Many of these investors sought out hedge 
funds during the recent bear markets in order to address losses from 
traditional investments.
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    \6\ See Hennessee Group, 2004 Hennessee Hedge Fund Survey of 
Foundations and Endowments (reporting that the investors surveyed had 
an average commitment of 17 percent of assets, and a projected 
commitment of 19 percent by 2005).
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    The ability of hedge fund managers to sustain above-market returns 
is a matter of some debate, as is the likelihood that hedge funds as an 
asset class will continue to grow.\7\ Nonetheless, hedge funds play and 
will likely continue to play an important role in the securities 
markets, the significance of which exceeds the amount of their assets. 
Although hedge funds represent just 5 percent of all U.S. assets under 
management, they account for about 30 percent of all U.S. equity 
trading volume.\8\ They are highly active in the convertible bond and 
credit derivatives markets. Moreover, hedge funds are becoming more 
active in the markets for corporate control, \9\ private lending, and 
crude petroleum. Their activities affect all Americans directly or 
indirectly.
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    \7\ See Nicholas Chan, Mila Getmansky, Shane M. Haas, and Andrew W. 
Lo, ``Systemic Risk and Hedge Funds,'' (Aug. 1, 2005) (unpublished 
manuscript, to appear in M. Carey and R. Stulz, eds., The Risks of 
Financial Institutions and the Financial Sector, Chicago, IL: 
University of Chicago Press).
    \8\ See Pam Abramowitz, ``Trade Secrets,'' Institutional Investor's 
Alpha, January/February 2006.
    \9\ Mara Der Hovanesian, ``Attack of the Hungry Hedge Funds,'' 
Business Week (Feb. 2006); Henry Sender, ``Hedge Funds: The New 
Corporate Activists--Investment Vehicles Amass Clout In Public Firms, 
Then Demand Management Boost Share Price,'' The Wall Street Journal 
(May 13, 2005).
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Application of the Federal Securities Laws
    Press articles typically refer to hedge funds as ``lightly 
regulated'' investment pools. In a sense, they are correct. As noted 
above, hedge funds are organized and operated so that they are not 
subject to the Investment Company Act of 1940. In addition, hedge funds 
issue securities in ``private offerings'' that are not registered with 
the Commission under the Securities Act of 1933, and hedge funds are 
not required to make periodic reports under the Securities Exchange Act 
of 1934. However, hedge funds are subject to the same prohibitions 
against fraud as are other market participants, and their managers have 
the same fiduciary obligations as other investment advisers.
The Commission's Oversight of Hedge Fund Activities
    The Commission's oversight responsibilities with respect to hedge 
fund activities generally fall into three principal areas: fiduciary 
obligations; market abuse; and risks to broker-dealers. Each is 
described below.
Fiduciary Obligations
    Hedge fund managers are ``investment advisers'' under the 
Investment Advisers Act of 1940. As a result, a hedge fund manager owes 
the fund and its investors a fiduciary duty that requires the manager 
to place the interests of the hedge fund and its investors first, or at 
least fully disclose any material conflict of interest the manager may 
have with the fund and its investors. Hedge fund advisers have this 
fiduciary obligation as a matter of law regardless of whether they are 
registered with the Commission.
    The Advisers Act provides the Commission with authority to enforce 
these obligations, which the Commission has exercised vigorously in 
order to protect investors. Over the past several years the Commission 
has brought a number of enforcement cases against hedge fund advisers 
who have violated their fiduciary obligations to their hedge funds and 
investors. These cases involve advisers who have engaged in 
misappropriation of fund assets; portfolio pumping; misrepresenting 
portfolio performance; falsification of experience, credentials and 
past returns; misleading disclosure regarding claimed trading 
strategies; and improper valuation of assets. In some cases we have 
worked with criminal authorities.
    Recent examples of significant cases brought by the Commission 
include:

    SEC v. Samuel Israel III; Daniel E. Marino; Bayou 
        Management, LLC et al. The Commission alleged that the advisers 
        of a Connecticut-based group of hedge funds defrauded investors 
        in the funds and misappropriated millions of dollars in 
        investor assets for their personal use. Over $450 million was 
        raised from investors. The advisers issued fictitious account 
        statements to investors and used a sham accounting firm to 
        forge audited financial statements in order to hide substantial 
        losses. These losses resulted from, among other things, the 
        theft of funds by the advisers who withdrew ``incentive fees'' 
        to which they were not entitled. On September 29, 2005, the 
        Commission filed an action in U.S. District Court seeking 
        injunctions, disgorgement of ill-gotten gains, prejudgment 
        interest, and civil money penalties.\10\ Also on that date, 
        Israel and Marino pleaded guilty in a companion criminal case. 
        They have not yet been sentenced. On April 19, 2006, the 
        defendants in the civil case consented to an order permanently 
        enjoining them from future violations of the antifraud statutes 
        of the Federal securities laws.\11\
---------------------------------------------------------------------------
    \10\ Litigation Release No. 19406 (Sept. 29, 2005).
    \11\ Litigation Release No. 19692 (May 9, 2006).
---------------------------------------------------------------------------
    SEC v. Sharon E. Vaughn and Directors Financial Group, Ltd. 
        The Commission alleged that an Illinois hedge fund adviser 
        registered with the Commission defrauded fund investors by 
        improperly investing fund assets in a fraudulent ``prime bank'' 
        trading scheme contrary to the fund's disclosed trading 
        strategy. According to the Commission's complaint, the adviser 
        and its principal had an undisclosed profit sharing agreement 
        with one of the trading program promoters. The adviser and 
        principal consented to injunctions and agreed to disgorgement 
        of over $800,000.\12\ As a result of the SEC's action and a 
        subsequent criminal action brought by the U.S. Attorney's 
        office involving individuals associated with the trading 
        program, hedge fund investors were returned most of their 
        principal investment and profits prior to investment in the 
        trading program.
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    \12\ Litigation Release No. 19589 (Mar. 3, 2006).

    New registration requirement. Until recently, registration with the 
Commission was optional for many hedge fund advisers. In February of 
this year, new rules became effective that require that most hedge fund 
advisers register with the Commission under the Advisers Act.\13\ The 
new rules do not regulate hedge fund strategies, risks or investments. 
The new rules have given the Commission basic census data about hedge 
fund advisers. In addition, registration has required hedge fund 
advisers to implement compliance programs to prevent, detect and 
correct compliance violations and to designate a chief compliance 
officer to administer each adviser's compliance program. Registration 
also has provided the Commission authority to conduct compliance 
examinations of registered hedge fund advisers. Based upon registration 
data we now know that 24 percent of the 10,000 investment advisers 
currently registered with the Commission advise at least one hedge 
fund. Of the 2,456 hedge fund advisers registered with us as of the end 
of April, 1,179 (45 percent) registered in response to the new 
rule.\14\ The vast majority of the hedge fund advisers (88 percent) 
registered with the Commission are domiciled in the United States.
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    \13\ The Commission's recent rulemaking required certain hedge fund 
advisers to register as investment advisers with the Commission under 
the Investment Advisers Act of 1940, under which registration 
previously had been optional for many hedge fund advisers. 
Commissioners Glassman and Atkins dissented from the rulemaking. 
Registration Rule at 72089. With respect to the management of hedge 
funds whose advisers are registered with the Commission, the Commission 
in adopting the adviser registration requirement observed that, ``The 
[Advisers] Act does not require an adviser to follow or avoid any 
particular investment strategies, nor does it require or prohibit 
specific investments.'' Registration Rule at section II.A. 
[Registration Under the Advisers Act of Certain Hedge Fund Advisers, 
Investment Advisers Act Release No. 2333 (Dec. 2, 2004), 69 FR at 
72060, petition for review filed (D.C. Cir. No. 04-1434); argued Dec. 
9, 2005. (``Registration Rule'')]
    \14\ Registration forms indicate that these advisers report just 
over 13,000 hedge funds with aggregate assets of about $2 trillion. 
Because reported assets include assets of ``feeder'' funds as well as 
``master'' funds in which they invest, total reported assets likely are 
higher than if assets of ``feeder'' funds were excluded.
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    Examinations. As mentioned above, registered hedge fund advisers 
may be subject to onsite compliance examinations by SEC examiners in 
the Office of Compliance Inspections and Examinations (OCIE). The SEC 
maintains a risk-based examination program, and determines which firms 
to examine based on their risk characteristics. Hedge fund advisers 
have been included in the same pool as other registered advisers, and 
thus, like other advisers, the staff determines which firms to examine 
based on the compliance risks the firm presents to investors. 
Examination staff are working with the Division of Investment 
Management and Office of Risk Assessment to develop improved metrics to 
assess the compliance risks of registered advisers in order to continue 
to focus our exam resources. In addition, OCIE has developed a 
specialized training program to better familiarize examiners with the 
operation of hedge funds and thus improve the effectiveness of our 
examination of hedge fund advisers.
    During a routine compliance examination, the staff reviews the 
effectiveness of the compliance controls that every registered 
investment adviser must have in place to prevent or detect violations 
of the Federal securities laws. In those areas where controls appear to 
be weak, our examiners will obtain additional information to determine 
if the weak control environment has resulted in a violation of the 
securities laws. The staff also reviews disclosure documents, including 
any private placement memoranda provided to hedge fund investors, to 
determine whether the disclosure appears to accurately reflect the 
hedge fund adviser's management of the fund. In addition, the staff 
identifies areas of potential conflicts of interest with respect to the 
hedge fund adviser and the fund that it advises to determine whether 
appropriate disclosure has been made.
    It is the staff's experience that many of the compliance issues 
raised by an adviser's management of a hedge fund are similar to those 
raised by other advisers' asset management activities. For example, 
these compliance issues include: the use of soft dollar arrangements, 
the allocation of investment opportunities among clients, the valuation 
of securities, the calculation of performance, and the safeguards over 
customers' assets and non-public information. In this regard, let me 
identify a few areas in which we plan to focus our examinations of 
hedge fund advisers:

    Side-by-Side Management. Some hedge fund managers also 
        advise other types of advisory accounts, including mutual 
        funds.\15\ Because the adviser's fee from the hedge fund is 
        based in large measure on the fund's performance--and because 
        the adviser typically invests heavily in the hedge fund itself, 
        this ``side-by-side'' management presents significant conflicts 
        of interest that could lead the adviser to favor the hedge fund 
        over other clients. The staff will focus on whether the hedge 
        fund manager appears to have sufficient controls in place to 
        prevent such bias and whether, in fact, the adviser has favored 
        its hedge funds over other clients.
---------------------------------------------------------------------------
    \15\ Almost 15 percent (379) of the hedge fund advisers registered 
with the Commission report that they also advise at least one mutual 
fund.
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    Side Letter Agreements. Side letters are agreements that 
        hedge fund advisers enter into with certain investors that give 
        the investors more favorable rights and privileges than other 
        investors receive. Some side letters address matters that raise 
        few concerns, such as the ability to make additional 
        investments, receive treatment as favorable as other investors, 
        or limit management fees and incentives. Others, however, are 
        more troubling because they may involve material conflicts of 
        interest that can harm the interests of other investors. Chief 
        among these types of side letter agreements are those that give 
        certain investors liquidity preferences or provide them with 
        more access to portfolio information. Our examination staff 
        will review side letter agreements and evaluate whether 
        appropriate disclosure of the side letters and relevant 
        conflicts has been made to other investors.
    Valuation of Fund Assets. A hedge fund manager typically 
        values the assets of the hedge fund using the market value of 
        those securities. When the fund holds publicly traded 
        securities, that process is fairly simple. Many hedge funds, 
        however, own thinly traded securities and derivative 
        instruments whose valuation can be very complicated and, in 
        some cases, highly subjective. Unlike a mutual fund, hedge fund 
        valuation practices are not overseen by an independent board of 
        directors. A number of the Commission's enforcement cases 
        against hedge fund advisers involve the adviser's valuation of 
        fund assets in order to hide losses or to artificially boost 
        performance. Thus, a review of valuation policies and practices 
        is a key element of hedge fund adviser examinations.
    Custody of Fund Assets. A hedge fund manager typically has 
        access to and directs the use of fund assets. Such access 
        presents a significant risk to fund investors--as demonstrated 
        in a number of the Commission's enforcement actions involving 
        theft or misuse of fund assets by a hedge fund manager. 
        Therefore, Commission examiners focus attention on the controls 
        used to protect fund assets.
Market Abuse
    Hedge fund advisers' active trading plays an important role in our 
capital markets. The Federal securities laws and Commission regulations 
establish rules designed to prevent market abuses. When market activity 
by hedge fund advisers--like any other participant in the securities 
markets--crosses the line and violates the law, the Commission has 
taken appropriate remedial action. In the past year, the Commission has 
brought enforcement actions against hedge fund advisers for a variety 
of market abuses, including insider trading, improper activities in 
connection with short sales, market manipulation, scalping, and 
fraudulent market timing and late trading of mutual funds.
    Recent significant cases have included:

    In the Matter of Millennium Partners, L.P., Millennium 
        Management, L.L.C., Millennium International Management, 
        L.L.C., Israel Englander, Terence Feeney, Fred Stone, and Kovan 
        Pillai. The Commission brought an action against hedge fund 
        managers alleging that the managers generated tens of millions 
        of dollars in profits for their hedge funds through deceptive 
        and fraudulent market timing of mutual funds at the expense of 
        the mutual funds and their shareholders. The adviser and its 
        principals agreed to disgorgement and civil monetary penalties, 
        and have undertaken to implement particular compliance, legal, 
        and ethics oversight measures.\16\
---------------------------------------------------------------------------
    \16\ Investment Advisers Act Release No. 2453 (Dec. 1, 2005).
---------------------------------------------------------------------------
    SEC v. Hilary Shane. The Commission alleged a particular 
        type of insider trading involving a PIPE transaction, where the 
        hedge fund adviser agreed to buy shares of a public company in 
        a private offering--a transaction that the Commission alleged 
        was likely to have a significant dilutive effect on the value 
        of the company's shares--and then misused information she had 
        been given (and which she had agreed to keep confidential) 
        about the private offering by short-selling the company's 
        shares. The adviser agreed to disgorge the trading profits, 
        paid a civil penalty, and has consented to be barred from the 
        broker-dealer industry and suspended from the investment 
        advisory industry.\17\
---------------------------------------------------------------------------
    \17\ Litigation Release No. 19227 (May 18, 2005). Because she 
entered into the short sales prior to the effective date of the 
registration statement for the PIPE and then covered her short sales 
with those she obtained in the PIPE offering, the Commission also 
alleged that Ms. Shane violated section 5 of the Securities Act.
---------------------------------------------------------------------------
    SEC v. Scott R. Sacane, et al. The Commission alleged that 
        hedge fund advisers manipulated the market by creating the 
        appearance of greater demand for two stocks than actually 
        existed. The individual defendants in this case have both pled 
        guilty to related criminal charges and have been barred by the 
        Commission from associating with an investment adviser. In 
        addition, one of the defendants has agreed to pay disgorgement 
        and a civil penalty in the Commission's civil action, which 
        remains pending against the other defendants.\18\
---------------------------------------------------------------------------
    \18\ Litigation Release No. 19424 (Oct. 12, 2005). See also In the 
Matter of Scott R. Sacane, Investment Advisers Act Release No. 2483 
(Feb. 8, 2006); In the Matter of J. Douglas Schmidt, Investment 
Advisers Act Release No. 2491 (Feb. 28, 2006); SEC v. Scott R. Sacane, 
et al., Litigation Release No. 19515 (Dec. 22, 2005); SEC v. Scott R. 
Sacane, et al., Litigation Release No. 19605 (Mar. 9, 2006).

    Not only has the Commission brought enforcement actions against the 
hedge funds and hedge fund advisers that engage in these transactions, 
it has brought actions against fund service providers who facilitated 
these unlawful securities trading activities. Recently, for example, we 
settled an enforcement action against a large broker-dealer that helped 
hedge funds foil the efforts of mutual funds to detect the hedge funds' 
market timing, and made it possible for certain favored hedge fund 
clients to ``late trade'' mutual fund shares.\19\
---------------------------------------------------------------------------
    \19\ In the Matter of Bear, Stearns, and Co., Inc., and Bear, 
Stearns Securities Corp., Securities Act Release No. 8668 (Mar. 16, 
2006) (defendants agreed to censure, payment of disgorgement and civil 
monetary penalties, and have undertaken to implement particular 
compliance oversight measures).
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Risks to Broker-Dealers
    Hedge funds can (although we understand many do not) make 
significant use of leverage. Most hedge funds use one or more ``prime 
brokers,'' which provide clearing and related services to the fund and 
its adviser. One core service prime brokers offer their hedge fund 
customers is secured financing, notably margin lending, where the hedge 
fund borrows from the prime broker in order to buy securities, which 
then serve as collateral for the loan.\20\
---------------------------------------------------------------------------
    \20\ Prime brokers may also structure these financing transactions 
as repurchase agreements, where they buy the securities from the hedge 
fund subject to the fund's obligation to repurchase the securities from 
the broker in the future at a specified price. Prime brokers may also 
produce similar economics through the use of over-the-counter 
derivative contracts with hedge funds.
---------------------------------------------------------------------------
    The Commission continues to focus attention on broker-dealers' 
exposure to hedge fund risks and the broader implications this aspect 
of the financial system may have. The Commission staff meets regularly 
with other members of the President's Working Group on Financial 
Markets, and works with the industry members that comprise the 
Counterparty Risk Management Policy Group. In addition, the 
Commission's consolidated supervision program for certain investment 
banks now allows the staff to examine not only the broker-dealer 
entities within a group, but also the unregulated affiliates and 
holding company where certain financing transactions with hedge funds 
are generally booked. Commission staff meets at least monthly with 
senior risk managers at these broker-dealer holding companies to review 
material risk exposures, including those resulting from hedge fund 
financing and those related to sectors in which hedge funds are highly 
active.
Looking Forward
    As a result of our recently implemented hedge fund adviser 
registration rulemaking, the Commission now has more data about hedge 
funds and their advisers. The staff is in the process of evaluating 
those data and considering methods to refine its ability to target our 
examination resources by more precisely identifying those advisers, 
including hedge fund advisers, that pose greater compliance risks.
    In addition, the Commission staff is working with the United 
Kingdom's Financial Services Authority, to coordinate policy and 
oversight of the 165 hedge fund advisers registered with the Commission 
that are located in the United Kingdom. The staff also expects to 
coordinate examinations with the Commodity Futures Trading Commission 
(CFTC). To that end, we recently provided information to the CFTC 
indicating the identities of hedge fund advisers registered with the 
Commission who report on their registration forms that they are also 
actively engaged in commodities business (approximately 350 firms).
Conclusion
    In conclusion, I would like to thank the Subcommittee for holding 
this hearing on a subject of growing importance to us and to all 
American investors. Hedge funds play an important role in our financial 
markets. With respect to hedge funds, their advisers and all market 
participants, the Commission will continue to enforce vigorously the 
Federal securities laws.
                                 ______
                                 
                PREPARED STATEMENT OF PATRICK PARKINSON
         Deputy Director, Division of Research and Statistics,
            Board of Governors of the Federal Reserve System
                              May 16, 2006
    Chairman Hagel, Senator Dodd, and members of the Subcommittee, 
thank you for the opportunity to testify on the role of hedge funds in 
the capital markets. In my remarks today, I will discuss the increasing 
importance of that role, the public policy issues associated with it, 
and what the Federal Reserve has been doing to address concerns about 
potential systemic risks from hedge funds' activities.
The Role of Hedge Funds in the Capital Markets
    The role that hedge funds are playing in capital markets cannot be 
quantified with any precision. A fundamental problem is that the 
definition of a hedge fund is imprecise, and distinctions between hedge 
funds and other types of funds are increasingly arbitrary. Hedge funds 
often are characterized as unregulated private funds that can take on 
significant leverage and employ complex trading strategies using 
derivatives or other new financial instruments. Private equity funds 
are usually not considered hedge funds, yet they are typically 
unregulated and often leverage significantly the companies in which 
they invest. Likewise, traditional asset managers more and more are 
using derivatives or are investing in structured securities that allow 
them to take on leverage or establish short positions.
    Although several data bases on hedge funds are compiled by private 
vendors, they cover only the hedge funds that voluntarily provide 
data.\1\ Consequently, the data are not comprehensive. Furthermore, 
because the funds that choose to report may not be representative of 
the total population of hedge funds, generalizations based on these 
data bases may be misleading. Data collected by the Securities and 
Exchange Commission (SEC) from registered advisers to hedge funds are 
not comprehensive either. The primary purpose of registration is to 
protect investors by discouraging hedge fund fraud. The SEC does not 
require an adviser to a hedge fund, regardless of how large it is, to 
register if the fund does not permit investors to redeem their 
interests within 2 years of purchasing them.\2\ While registration of 
advisers of such funds may well be unnecessary to discourage fraud, the 
exclusion from the data base of funds with long lock-up periods makes 
the data less useful for quantifying the role that hedge funds are 
playing in the capital markets.
---------------------------------------------------------------------------
    \1\ Examples of hedge fund data bases include Trading Advisors 
Selection System (TASS), Centre for International Securities and 
Derivatives Markets (CISDM) Hedge Fund Data base, and Hedge Fund 
Research Data base.
    \2\ The commission decided not to require such funds to register 
because it had not encountered significant problems with fraud at 
private equity or venture capital funds, which are similar in some 
respects to hedge funds but usually require investors to make long-term 
commitments of capital.
---------------------------------------------------------------------------
    Even if a fund is included in a private data base or its adviser is 
registered with the SEC, the information available is quite limited. 
The only quantitative information that the SEC currently collects is 
total assets under management. Private data bases typically provide 
assets under management as well as some limited information on how the 
assets are allocated among investment strategies, but they do not 
provide detailed balance sheets. Some data bases provide information on 
funds' use of leverage, but their definition of leverage is often 
unclear. As hedge funds and other market participants increasingly use 
financial products such as derivatives and securitized assets that 
embed leverage, conventional measures of leverage have become much less 
useful. More meaningful economic measures of leverage are complex and 
highly sensitive to assumptions about the liquidity of the markets in 
which financial instruments can be sold or hedged.\3\
---------------------------------------------------------------------------
    \3\ For a discussion of the definition and construction of 
economically meaningful measures of leverage, see appendix A in 
Counterparty Risk Management Policy Group (1999), Improving 
Counterparty Risk Management Practices (New York: CRMPG, June).
---------------------------------------------------------------------------
    Although the role of hedge funds in the capital markets cannot be 
precisely quantified, the growing importance of that role is clear. 
Total assets under management are usually reported to exceed $1 
trillion.\4\ Furthermore, hedge funds can leverage those assets through 
borrowing money and through their use of derivatives, short positions, 
and structured securities. Their market impact is further magnified by 
the extremely active trading of some hedge funds. The trading volumes 
of these funds reportedly account for significant shares of total 
trading volumes in some segments of fixed income, equity, and 
derivatives markets.\5\
---------------------------------------------------------------------------
    \4\ Some of these estimates may double count investments in funds 
of funds. At the end of last year, and excluding fund of funds, the 
TASS data base included funds that had $979.3 billion in assets. Of 
course, not all funds are included in this data base.
    \5\ Greenwich Associates estimates that hedge funds in 2004 
accounted for 20 to 30 percent of trading volumes in markets for below-
investment-grade debt, credit derivatives, collateralized debt 
obligations, emerging-market bonds, and leveraged loans, and 80 percent 
of trading in distressed debt. See Greenwich Associates (2004), Hedge 
Funds: The End of the Beginning? (Greenwich Associates, December). 
These estimates were based on interviews with hedge funds and other 
institutional investors that Greenwich Associates conducted from 
February through April 2004.
---------------------------------------------------------------------------
    In various capital markets, hedge funds clearly are increasingly 
consequential as providers of liquidity and absorbers of risk. For 
example, a study of the markets in U.S. dollar interest rate options 
indicated that participants viewed hedge funds as a significant 
stabilizing force. In particular, when the options and other fixed 
income markets were under stress in the summer of 2003, the willingness 
of hedge funds to sell options following a spike in options prices 
helped restore market liquidity and limit losses to derivatives dealers 
and investors in fixed-rate mortgages and mortgage-backed 
securities.\6\ Hedge funds reportedly are significant buyers of the 
riskier equity and subordinated tranches of collateralized debt 
obligations (CDOs) and of asset-backed securities, including securities 
backed by nonconforming residential mortgages.\7\
---------------------------------------------------------------------------
    \6\ Federal Reserve Board (2005), Concentration and Risk in the OTC 
Markets for U.S. Dollar Interest Rate Options (http://
www.Federalreserve.gov/boarddocs/surveys/OpStudySum/
OptionsStudySummary.pdf).
    \7\ See Fitch Ratings (2005), Hedge Funds: An Emerging Force in the 
Global Credit Markets (New York: Fitch Ratings, 2005), p. 6.
---------------------------------------------------------------------------
    At the same time, however, the growing role of hedge funds has 
given rise to public policy concerns. These include concerns about 
whether hedge fund investors can protect themselves adequately from the 
risks associated with such investments, whether hedge fund leverage is 
being constrained effectively, and what potential risks the funds pose 
to the financial system if their leverage becomes excessive.
Investor Protection
    Hedge funds and their investment advisers historically were exempt 
from most provisions of the Federal securities laws.\8\ Those laws 
effectively allow only institutions and relatively wealthy individuals 
to invest in hedge funds. Such investors arguably are in a position to 
protect themselves from the risks associated with hedge funds.\9\ 
However, in recent years hedge funds reportedly have been marketed 
increasingly to a less wealthy clientele. Furthermore, pension funds, 
many of whose beneficiaries are not wealthy, have increased investments 
in hedge funds.
---------------------------------------------------------------------------
    \8\ The antifraud provisions of the Securities Act and the 
Securities Exchange Act apply to the sale of a private fund's 
securities, whether or not the private fund is registered under the 
Investment Company Act.
    \9\ See President's Working Group on Financial Markets (1999), 
Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management 
(Washington: President's Working Group, April), p. B-13.
---------------------------------------------------------------------------
    Concerns about the potential direct and indirect exposures of less 
wealthy investors from hedge fund investments and hedge fund fraud 
contributed to the SEC's decision in December 2004 to require many 
advisers to hedge funds that are offered to U.S. investors to register 
with the commission.
    The SEC believes that the examination of registered hedge fund 
advisers will deter fraud. But fraud is very difficult to uncover, even 
through onsite examinations.\10\ Therefore, it is critical that 
investors do not view the SEC registration of advisers as an effective 
substitute for their own due diligence in selecting funds and their own 
monitoring of hedge fund performance. Most institutional investors 
probably understand this well. In a survey several years ago of U.S. 
endowments and foundations, 70 percent of the respondents said that a 
hedge fund adviser's registration or lack of registration with the SEC 
had no effect on their decision about whether or not to invest because 
the institutions conducted their own due diligence.\11\
---------------------------------------------------------------------------
    \10\ For example, three Federal Reserve examinations of the New 
York branch of Daiwa Bank between 1992 and 1994 failed to uncover $1.1 
billion of hidden trading losses. See Alan Greenspan (1996), 
``Statement before the Committee on Banking, Housing, and Urban 
Affairs, U.S. Senate, November 27, 1995,'' Federal Reserve Bulletin, 
vol. 82 (January), pp. 31-35.
    \11\ See Greenwich associates (2004), p. 3.
---------------------------------------------------------------------------
    In the case of pension funds, sponsors and pension fund regulators 
should ensure that pension funds conduct appropriate due diligence with 
respect to all their investments, not just their investments in hedge 
funds. Pension funds and other institutional investors seem to have a 
growing appetite for a variety of alternatives to holding stocks and 
bonds, including real estate, private equity and commodities, and 
investments in hedge funds are only one means of gaining exposures to 
those alternative assets. The registration of hedge fund advisers 
simply cannot protect pension fund beneficiaries from the failures of 
plan sponsors to carry out their fiduciary responsibilities.
    As for individual investors, the income and wealth criteria that 
define eligible investors in hedge funds unavoidably are a crude test 
for sophistication.\12\ If individuals with relatively little wealth 
increasingly become the victims of hedge fund fraud, it may become 
appropriate to tighten the criteria for an individual to be considered 
an eligible investor.
---------------------------------------------------------------------------
    \12\ Each individual investor in a hedge fund that is subject to 
the Investment Advisers Act and whose adviser charges a performance fee 
generally must have a net worth of at least $1.5 million or have at 
least $750,000 of assets under management with the adviser. In 
addition, most hedge funds avoid regulation under the Investment 
Company Act by meeting a requirement that each investor in the fund 
must be a ``qualified purchaser,'' which for individual investors means 
having assets of at least $5 million.
---------------------------------------------------------------------------
Excessive Leverage and Systemic Risk
    The near failure of the hedge fund Long-Term Capital Management 
(LTCM) in September 1998 illustrated the potential for a large hedge 
fund to become excessively leveraged and raised concerns that a forced 
liquidation of large positions held by a highly leveraged institution 
would create systemic risk by exacerbating market volatility and 
illiquidity. In our market-based economy, the primary mechanism that 
regulates firms' leverage is the market discipline imposed by creditors 
and counterparties. Even when the government has oversight of leverage, 
as in the case of banks and broker-dealers, such oversight is intended 
to supplement market discipline rather than to replace it. In the case 
of LTCM, however, market discipline broke down.
    In the wake of the LTCM episode, the President's Working Group on 
Financial Markets considered how best to constrain excessive leverage 
by hedge funds. The Working Group concluded that hedge funds' leverage 
could be constrained most effectively by promoting measures that 
enhance market discipline by improving credit risk management by hedge 
funds' counterparties and creditors, nearly all of which are regulated 
banks and securities firms.\13\ The Working Group termed this approach 
``indirect regulation'' of hedge funds. The Working Group considered 
the alternative of direct government regulation of hedge funds, but it 
concluded that developing a regulatory regime for hedge funds would 
present formidable challenges in terms of cost and effectiveness. It 
believed that indirect regulation would address concerns about systemic 
risks from hedge funds most effectively and would avoid the potential 
attendant costs of direct regulation.\14\
---------------------------------------------------------------------------
    \13\ President's Working Group (1999).
    \14\ See President's Working Group (1999), p. 42.
---------------------------------------------------------------------------
The Federal Reserve and Hedge Funds
    The President's Working Group made a series of recommendations for 
improving market discipline on hedge funds. These included 
recommendations for improvements in credit risk management practices by 
the banks and securities firms that are hedge funds' counterparties and 
creditors and improvements in supervisory oversight of those banks and 
securities firms. As a regulator of banks and bank holding companies, 
the Federal Reserve has worked with other domestic and international 
regulators to implement the necessary improvements in supervisory 
oversight. Regulatory cooperation is essential in this area because 
hedge funds' principal creditors and counterparties include foreign 
banks as well as U.S. banks and securities firms.
    In January 1999, the Basel Committee on Banking Supervision (BCBS) 
published a set of recommendations for sound practices for managing 
counterparty credit risks to hedge funds and other highly leveraged 
institutions. Around the same time, the Federal Reserve, the SEC, and 
the Treasury Department encouraged a group of twelve major banks and 
securities firms to form a Counterparty Risk Management Policy Group 
(CRMPG), which in July 1999 issued its own complementary 
recommendations for improving counterparty risk management 
practices.\15\
---------------------------------------------------------------------------
    \15\ See CRMPG (1999).
---------------------------------------------------------------------------
    The BCBS sound practices have been incorporated into Federal 
Reserve supervisory guidance and examination procedures applicable to 
banks' capital market activities. In general terms, routine supervisory 
reviews of counterparty risk management practices with respect to hedge 
funds and other counterparties seek to ensure that banks (1) perform 
appropriate due diligence in assessing the business, risk exposures, 
and credit standing of their counterparties; (2) establish, monitor, 
and enforce appropriate quantitative risk exposure limits for each of 
their counterparties; (3) use appropriate systems to measure and manage 
counterparty credit risk; and (4) deploy appropriate internal controls 
to ensure the integrity of their processes for managing counterparty 
credit risk. Besides conducting routine reviews and continually 
monitoring counterparty credit exposures, the Federal Reserve 
periodically performs targeted reviews of the credit risk management 
practices of banks that are major hedge fund counterparties. These 
targeted reviews examine in depth the banks' practices against the BCBS 
and Federal Reserve sound practices guidance and the CRMPG 
recommendations.
    According to supervisors and most market participants, counterparty 
risk management has improved significantly since the LTCM episode in 
1998. However, since that time, hedge funds have greatly expanded their 
activities and strategies in an environment of intense competition for 
hedge fund business among banks and securities firms. Furthermore, some 
hedge funds are among the most active investors in new, more-complex 
structured financial products, for which valuation and risk measurement 
are challenging both to the funds themselves and to their 
counterparties. Counterparties and supervisors need to ensure that 
competitive pressures do not result in any significant weakening of 
counterparty risk management and that risk management practices are 
evolving as necessary to address the increasing complexity of the 
financial instruments used by hedge funds.
    The Federal Reserve has also sought to limit hedge funds' potential 
to be a source of systemic risk by ensuring that the clearing and 
settlement infrastructure that supports the markets in which the funds 
trade is robust. Very active trading by hedge funds has contributed 
significantly to the extraordinary growth in the past several years of 
the markets for credit derivatives. A July 2005 report by a new 
Counterparty Risk Management Policy Group (CRMPG II) called attention 
to the fact that the clearing and settlement infrastructure for credit 
derivatives (and over-the-counter derivatives generally) had not kept 
pace with the volume of trading.\16\ In particular, a backlog of 
unsigned trade confirmations was growing, and the acceptance by dealers 
of assignments of trades by one counterparty without the prior consent 
of the other, despite trade documentation requirements for such 
consent, was becoming widespread.
---------------------------------------------------------------------------
    \16\ Counterparty Risk Management Policy Group II (2005), Toward 
Greater Financial Stability: A Private Sector Perspective (New York: 
CRMPG II, July).
---------------------------------------------------------------------------
    To address these and other concerns about the clearing and 
settlement of credit derivatives, in September 2005 the Federal Reserve 
Bank of New York brought together fourteen major U.S. and foreign 
derivatives dealers and their supervisors. The supervisors collectively 
made clear their concerns about the risks created by the infrastructure 
weaknesses and asked the dealers to develop plans to address those 
concerns. With supervisors providing common incentives for the 
collective actions that were necessary, the dealers have made 
remarkable progress since last September. The practice of unauthorized 
assignments has almost ceased, and dealers are now expeditiously 
responding to requests for the authorization of assignments. For the 
fourteen dealers as a group, total credit derivative confirmations 
outstanding for more than 30 days fell 70 percent between September 
2005 and March 2006. The reduction in outstanding confirmations was 
made possible in part by more widespread and intensive use of an 
electronic confirmation-processing system operated by the Depository 
Trust and Clearing Corporation (DTCC). The dealers have worked with 
their largest and most active clients, most of which are hedge funds, 
to ensure that they can electronically confirm trades in credit 
derivatives. By March 2006, 69 percent of the fourteen dealers' credit 
derivatives trades were being confirmed electronically, up from 47 
percent last September.
    Supervisors and market participants agree that further progress is 
needed, and in March the fourteen dealers committed themselves to 
achieving by October 31, 2006, a ``steady state'' position for the 
industry.\17\ The steady state will involve (1) the creation of a 
largely electronic marketplace in which all trades that can be 
processed electronically will be; (2) the creation by DTCC of an 
industry trade information warehouse and support infrastructure to 
standardize and automate processing of events throughout each 
contracts's life; (3) new processing standards for those trades that 
cannot be confirmed electronically; and (4) the creation of an 
automated platform to support notifications and consents with respect 
to trade assignments. The principal trade association for the hedge 
fund industry has stated its support for plans embodied in the dealers' 
commitments.\18\
---------------------------------------------------------------------------
    \17\ See Federal Reserve Bank of New York press release dated March 
13, 2006. (http://www.newyorkfed.org/newsevents/news/markets/2006/
an060313.html).
    \18\ See press release by the Managed Funds Association dated March 
13, 2006. (http://www.mfainfo.org/images/PDF/
MFA_Fed14_Stmt_3_13_06.pdf).
---------------------------------------------------------------------------
Summary
    Hedge funds clearly are becoming more important in the capital 
markets as sources of liquidity and holders and managers of risk. But 
as their importance has grown, so too have concerns about investor 
protection and systemic risk.
    The SEC believes that the examination of registered hedge advisers 
will deter fraud. But investors must not view SEC regulation of 
advisers as an effective substitute for their own due diligence in 
selecting funds and their own monitoring of hedge fund performance.
    After the LTCM episode, the President's Working Group on Financial 
Markets considered how best to address concerns about potential 
systemic risks from excessive hedge fund leverage. The Working Group 
concluded that hedge funds' leverage could be constrained most 
effectively by promoting measures that enhance market discipline by 
improving credit risk management by funds' counterparties and 
creditors, nearly all of which are regulated banks and securities 
firms. The Working Group considered the alternative of direct 
government regulation of hedge funds but concluded that it would be 
more costly and would be less effective than an approach focused on 
strengthening market discipline.
    The Federal Reserve has been seeking to ensure appropriate market 
discipline on hedge funds by working with other regulators to promote 
effective counterparty risk management by hedge funds' counterparties 
and creditors. It has also sought to limit the potential for hedge 
funds to be a source of systemic risk by ensuring that the clearing and 
settlement infrastructure that supports the markets in which they trade 
is robust.
                                 ______
                                 
                  PREPARED STATEMENT OF JAMES OVERDAHL
       Chief Economist, U.S. Commodity Futures Trading Commission
                              May 16, 2006
    Mr. Chairman, Senator Dodd, and Members of the Subcommittee, I 
appear before you today in my capacity as Chief Economist of the 
Commodity Futures Trading Commission (CFTC), the Federal Government 
regulator of futures and futures options markets in the United States. 
The term ``hedge fund'' is not a term we use in our regulatory work at 
the CFTC. To the extent that any subsidiary fund within a hedge fund 
complex uses exchange-traded derivatives, the operator of that 
subsidiary fund and its advisor may be subject, under certain 
circumstances, to registration and reporting requirements under the 
Commodity Exchange Act, the statute administered by the CFTC.
    In my testimony today I will address several topics. First, I will 
describe the role that hedge funds play in futures markets in general, 
and the role they play in commodity futures markets in particular. 
Second, I will briefly describe the surveillance methods used by the 
CFTC to monitor large traders, including many hedge funds, in order to 
ensure market integrity. Third, I will describe the financial safeguard 
system in place to ensure that the financial distress of a single 
futures market participant, whether or not that participant is a hedge 
fund, does not have a disproportionate effect on the overall market. 
Last, I will describe the CFTC's oversight authority with respect to 
the operators of pooled investment vehicles trading commodity futures 
or options.
The Role of Hedge Funds in Futures Markets
    Futures markets serve an important role in our economy by providing 
a means of transferring risk from those who do not want it to those 
willing to accept it for a price. Traders who are trying to reduce 
their risks are called ``hedgers,'' a group that typically includes 
those who have an underlying commercial interest in the commodity upon 
which the futures contract is written. Futures exchanges know from 
experience that the markets they host cannot exist with hedgers alone. 
In order for hedgers to reduce the risk they face in their day-to-day 
commercial activities, they need to trade with someone willing to 
accept the risk the hedger is trying to shed. Data from the CFTC's 
Large Trader Reporting System are consistent with the notion that hedge 
funds, and other professionally managed funds, are often the ones who 
facilitate the needs of hedgers.
    CFTC large trader data also show that hedge funds and other 
professionally managed funds hold significant ``spread'' positions, 
that is, positions across related contracts. These spread positions are 
structured to speculate on relative price differences between contracts 
(e.g., prices for October delivery vs. prices for November delivery), 
and when structured as such, are unrelated to the overall level of 
futures prices. These spread trades play a vital role in keeping prices 
of related markets (and prices of related contracts within the same 
market complex) in proper alignment with one another. Hedge funds also 
add to overall trading volume, which contributes to the formation of 
liquid and well-functioning markets.
    One notable development over the past 5 years has been the 
increased participation by pension funds, university endowments, hedge 
fund investors, and other financial institutions in futures markets for 
physical commodities. These institutions view commodities as a distinct 
``asset class'' and have allocated a portion of the portfolios they 
manage, either directly or indirectly, into futures contracts tied to 
commodity indexes. The total investment in commodity-linked index 
products by pension funds, hedge funds and other institutional 
investors has been estimated by industry observers to exceed $100 
billion. A significant portion of this amount finds it way into futures 
markets, either through direct participation by those whose commodity 
investments are benchmarked to a commodity index, or through 
participation by commodity index swap dealers who use futures markets 
to hedge the risk associated with their dealing activities.
    The greater participation by funds and commodity index investors 
has raised questions by some market observers about whether their 
activity is distorting prices in commodity futures markets. These 
issues strike at the heart of what the futures markets are all about. 
Futures markets exist because they provide two vital functions for the 
marketplace: risk management and price discovery. The job of the CFTC 
is to ensure the integrity of these vital market functions and public 
confidence in them.
    In that regard, some in the industry have urged greater 
transparency in the CFTC's Commitment of Traders Report (COT) by 
distinguishing among the market participants that currently comprise 
the category of ``commercials'' for each market. They argue that the 
current reporting system does not appropriately distinguish between 
traditional commercial activity and non-traditional commercial 
activity, such as that involving the hedging of commodity index 
exposure by swap dealers. Questions also have been raised as to whether 
the COT report should show professionally managed funds, including 
hedge funds, as a separate category, rather than include them with 
other non-commercial traders. On the opposing side, however, are those 
who argue that greater transparency may come at the cost of 
compromising the confidentiality of traders' proprietary information.
    In the coming months, the CFTC will consider these issues in a 
deliberative fashion through a process that is fully transparent to the 
public.
Surveillance Methods Used To Monitor Large Traders--Including Hedge 
        Funds
    The CFTC relies on a program of market surveillance to ensure that 
markets under CFTC jurisdiction are operating in an open and 
competitive manner, free of manipulative influences or other price 
distortions. The heart of the CFTC's market surveillance program is its 
Large Trader Reporting System. This system captures end-of-day 
position-level data for market participants meeting certain criteria. 
Positions captured in the Large Trader Reporting System make up 70 to 
90 percent of all positions in a particular market. The Large Trader 
Reporting System is a powerful tool for detecting the types of 
concentrated and coordinated positions required by a trader or group of 
traders attempting to manipulate the market. For surveillance purposes, 
the large trader reporting requirements for hedge funds are the same as 
for any other large trader.
    Using the large trader reports, CFTC economists monitor futures 
market trading activity, looking for large positions and large trades 
that might be used to manipulate prices. Each day, for all active 
futures and option contract markets, surveillance staff members monitor 
the daily activities of large traders and key price relationships. In 
addition, CFTC market analysts maintain close awareness of supply and 
demand factors and other developments in the underlying cash markets 
through review of trade publications, government reports, and through 
industry and exchange contacts. The CFTC's surveillance staff routinely 
reports to the Commission on surveillance activities at weekly 
surveillance meetings.
    In addition to the efforts of the Commission staff, each futures 
exchange is required under the Commodity Exchange Act to affirmatively 
and effectively supervise trading, prices, and positions, and the 
Commission examines the exchanges to ensure that they have devoted 
appropriate resources and attention to fulfillment of this important 
responsibility. All of these efforts are reported upon regularly to the 
CFTC's commissioners. The Commission's reports on its rule enforcement 
reviews of the different futures exchanges are posted on our Website at 
www.cftc.gov.
    Finally, the CFTC conducts an aggressive enforcement program that 
prosecutes and punishes those who break the rules. Nearly one-third of 
the CFTC's resources are devoted to its enforcement program. The 
punishment meted out as the result of enforcement proceedings deters 
would-be violators by sending a certain and clear message that improper 
conduct will be detected and will not be tolerated. The Commission has 
brought approximately 72 enforcement actions involving commodity pools 
and commodity pool operators in the last 7 years. The defendants in 
these enforcement actions offered investments in what were advertised 
as hedge funds or commodity pools in which investor funds were 
misappropriated or misused, or where customers were solicited based 
upon false track records.
Hedge Funds and the Futures Industry's Clearing System
    The collapse of Long Term Capital Management in 1998 highlighted 
concerns about the risks potentially posed by a large hedge fund on the 
financial system as a whole. Within the futures industry, the 
clearinghouse affiliated with each exchange and the clearing member 
firms of each clearinghouse play a critical role in ensuring that the 
financial distress of any single futures market participant, whether or 
not that participant is a hedge fund, does not have a disproportionate 
effect on the overall market.
    All market participants must have their futures transactions, and 
the positions resulting from such transactions, cleared at a futures 
clearinghouse through a clearing member firm of that clearinghouse. 
Such clearing member firms must be CFTC-registered futures commission 
merchants (FCMs). FCMs are financial intermediaries that must adhere to 
CFTC-specified minimum net capital requirements.
    Futures clearinghouses use a variety of financial safeguards to 
protect the clearing system from the financial difficulties of any firm 
that is part of that system. A clearinghouse's financial safeguard 
system involves multiple tiers. The first tier includes the margin 
money deposited by clearing member firms on behalf of their customers 
and their own proprietary accounts. The second tier may include the 
capital of the clearinghouse in excess of the working capital required 
for continuing clearinghouse operations. Clearinghouses also maintain 
guarantee funds that accrue value over time. If all of these funds are 
exhausted, many clearinghouses have the right to assess clearing 
members for unsatisfied obligations. Clearinghouses also hold credit 
lines to ensure that funds are immediately available in the case of an 
emergency. Finally, clearinghouses perform periodic risk evaluations of 
clearing member firms in an attempt to detect potential weaknesses in 
financial condition or risk controls. In addition, each clearing member 
firm has its own financial safeguards in place to protect itself from 
the financial distress of a customer--including a hedge fund customer.
The CFTC's Oversight Authority With Respect to Hedge Funds
    A hedge fund with positions in contracts under CFTC jurisdiction is 
a ``commodity pool'' and its operator or its adviser are required to 
register with the CFTC as a Commodity Pool Operator (CPO) or Commodity 
Trading Advisor (CTA), unless an exclusion or exemption from 
registration is available. Notably, the operators and advisors of 
commodity pools, but not the pools themselves, are required to register 
with the CFTC. Once registered, the CPO must comply with certain 
disclosure, reporting, and recordkeeping requirements and become 
subject to periodic examinations. Currently, there are approximately 
1,800 CPOs and 2,600 CTAs registered with the CFTC.
    The disclosure and financial reporting format for registered CPOs 
and CTAs is designed to ensure that prospective and actual participants 
in commodity pools receive all information that would be material to 
their decision to make, or maintain, an investment in a pool. To that 
end, at the point of sale, CPOs and CTAs are required to provide 
certain disclosures to prospective investors regarding the pool's 
investment program, principal risks factors, their conflicts of 
interests, and performance data and fees. Thereafter, CPOs must provide 
pool participants with an account statement at least quarterly and an 
annual report containing a financial statement, which must be audited 
by an independent public accountant and presented in accordance with 
Generally Accepted Accounting Principles (GAAP).
    CFTC regulations provide a simplified regulatory framework for CPOs 
and CTAs under certain conditions. Many hedge funds are eligible for 
this simplified framework. The most significant relief is for pools 
that are offered only to ``qualified eligible persons'' who meet 
certain net worth and sophistication standards under CFTC Regulation 
4.7.
    CPOs and CTAs registered as such generally must be members of the 
National Futures Association (NFA), an industry self-regulatory 
organization. In practice, the CFTC has delegated many of its 
regulatory responsibilities in this area to the NFA, including the 
registration processing function, and review of disclosure documents 
and financial statements.
    To this point, I have outlined what CFTC regulation involves. It is 
equally important to note the limits of that regulation. The CFTC does 
not prescribe the form of organization of pooled investment vehicles, 
nor does it impose limits on the fund's market risk appetite, the 
instruments that may be traded, the fees charged, or who may 
participate. Although the CFTC reviews financial statements to see that 
they include all required information and conform to applicable 
accounting standards, the review does not include an analysis of the 
transactions themselves.
    This concludes my remarks. I look forward to your questions.
                                 ______
                                 
              PREPARED STATEMENT OF HON. RICHARD McCORMACK
     Senior Advisor, Center for Strategic and International Studies
                              May 16, 2006
     Mr. Chairman and Distinguished Members of the Subcommittee:
    My name is Richard McCormack. I am a senior advisor for the Center 
for Strategic and International Studies and a former Under Secretary of 
State for Economics. I appreciate the opportunity to testify before 
this Subcommittee on the issue of derivatives and hedge funds. The 
hearings today are very timely.
    During the past several months, there have been a number of 
important speeches by U.S. officials on derivatives and hedge funds. A 
February 28 presentation by Timothy Geithner, President of the Federal 
Reserve Bank of New York, describes some of the potential challenges to 
financial stability posed by this very large industry. On March 9, 
Assistant Secretary of the Treasury, Emil Henry, formerly from Wall 
Street, provided an excellent overview of the industry and noted some 
of the technical questions that require further attention.
    Virtually everyone who understands the derivative industry 
recognizes its value to the economy in its ability to manage and 
diffuse financial risks by individuals and companies. It also generates 
large profits for many of those participating in this industry, as well 
as the potential for losses, particularly during periods of turmoil in 
financial markets.
    Some derivatives also contain the potential for abuse. For example, 
Italy secured entrance into the Euro by purchasing exotic derivatives 
that obscured the true financial condition of the country until after 
they were admitted. A similar situation occurred when some Japanese 
banks purchased derivative instruments which disguised the actual 
catastrophic state of their balance sheets at the time. And we all 
remember problems with Enron and other institutions where derivatives 
played a key role in clouding the actual financial condition of 
individual institutions.
    We also know that in the past there have been spectacular examples 
of turmoil in financial markets that were caused by honest 
miscalculations by important players in the derivative industry. The 
Long-Term Capital Management debacle of 1998 was the most recent 
example, and it potentially threatened the integrity of the financial 
system.
    It is important to remember, however, that for each Enron type 
problem that surfaces in connection with derivatives, there are 
thousands of derivative transactions that occur every day which benefit 
all parties involved. For that reason, it is important to approach the 
potential problems with great care and sophistication.
    The challenge we have now is to examine this industry, with the 
help of those deeply involved in it, to correct, if we can, any 
structural or technical problems that could increase the likelihood of 
systemic risk in the event of future shock to the financial system, 
such as the Russian default in 1998. Political risk and market over 
reaction in a crisis are difficult to prevent or completely factor into 
economic risk modeling.
    History suggests that we may not be totally successful in efforts 
of prevention, and that any future financial turmoil may well resonate 
in parts of the derivative market.
    Furthermore, there is no such thing as a permanent fix to problems 
in the derivative industry. This industry is so dynamic that its 
strengths and weaknesses change every few years. Ten years ago, credit 
derivatives were a tiny blip on the screen. Today these credit 
derivatives, which provide a kind of default insurance to creditors, 
are the fastest growing segment of this industry, as much as $15 
trillion notional value.
    Last year when serious operational problems in credit derivative 
markets alarmed regulators, Gerald Corrigan, a former senior Federal 
Reserve official, now with Goldman Sachs, led an effort to identify and 
repair these problems. This effort was a good example of how industry 
and regulators can work together to address problems on the operational 
side of the derivative business. The Report of the Counterparty Risk 
Management Policy Group of July 27, 2005, is a masterpiece of its kind. 
The larger institutions in the derivative business have subsequently 
moved to comply with needed reforms by hiring expensive software and 
putting systems in place to expedite the clearance process.
    It has taken some effort, however, by the New York Federal Reserve 
to get the second tier hedge funds which were involved in this business 
to make the needed investment in back office staff and systems. Other 
potential problems have also been addressed, such as credit risk that 
poorly vetted counterparties might pose if those offering derivative 
insurance do not have the capital strength to pay up in event of major 
defaults. These and other reforms make it more likely that institutions 
will only have to worry about market risk, not potential legal 
challenges and operational uncertainties.
    Beyond operational risk, market risks pose another set of issues.
    The global macro economic picture today is highly positive, with 
global growth at 5 percent and with several years of U.S. growth 
exceeding 4 percent. Long periods of growth and prosperity tend to 
induce a certain amount of complacency in financial markets. It is 
important, however, to remind the growing number of pension funds and 
other more recent derivative investors that the business cycle still 
exists. There are potential vulnerabilities in the global economy that 
could impact financial markets at some point, as I have noted in a 
recently published analysis, which I would like to attach as an 
appendix to my testimony.
    Mr. Chairman and Distinguished Members, I would like to conclude my 
remarks by making several recommendations and observations.
    First, all involved need to continue efforts to better understand 
the rapidly evolving derivative and hedge fund industries. For example, 
estimates of the total size of the notional value of over-the-counter 
derivative contracts outstanding vary widely. The President of the New 
York Federal Reserve Bank estimates the number at $300 trillion. The 
Bank for International Settlements places the number at $270 trillion, 
while the International Swaps and Derivative Association estimates a 
notional value of $219 trillion.
    Even value at risk, which is a much smaller number, is subject to 
varying interpretations and estimates.
    When rounding errors for estimates for notional value of 
outstanding derivative contracts are in the tens of trillions of 
dollars, it is hard to have total confidence that we understand all the 
potential vulnerabilities that may exist in this industry.
    Second, in his February 28, 2006, presentation on financial risk, 
Mr. Geithner raises the possibility of a potential rush to the exit by 
highly leveraged derivative holders during a future period of market 
turmoil. This development could lead to liquidity shortages and markets 
failing to clear efficiently. Liquidity shortages are why markets melt 
down so fast and overshoot in some crises, as was the case in the 1987 
stock market debacle. Obviously the Federal Reserve can play a role in 
addressing certain kinds of liquidity shortages in a crisis, but 
individual investors should be mindful of the need for an adequate 
capital cushion to address potentially unfavorable market developments. 
The issue of potential liquidity shortages during a crisis is one that 
deserves further study.
    As more and more investor groups and pension funds become involved 
in the derivative business, after a long period of growth and economic 
stability, some investors may be tempted to take on risks that they do 
not fully understand. Should early signs of possible vulnerability 
begin to appear, the most sophisticated investors will, of course, 
quickly shed risky investments. Remember for example, what happened to 
Argentine bonds: Before the spectacular default, they ended up in the 
hands of Belgian dentists and Italian pensioners. These hearings should 
serve as a reminder to investors of the oldest lesson in business 
dealings: caveat emptor--let the buyer beware. Complex derivatives are 
not a place for amateur investors. There is an enduring connection 
between high yields and high risk.
    The derivative industry itself has a powerful incentive to avoid 
the fraud, abuse, and blunders that could lead to massive losses, 
scandals, and crippling future regulation. The statesmen in the 
derivative industry are also best positioned to point out to regulators 
potential structural problems and those few in their ranks who may be 
engaged in unscrupulous or sloppy business practices.
    Third, regulation of the derivative industry is faced with a 
fundamental dilemma; if government regulates the industry so tightly as 
to avoid all risk of market failure, it will kill a valuable part of 
the financial system. Finding the right middle path in this constantly 
changing environment is a challenging task that can only happen with 
the closest collaboration between the most sophisticated parts of the 
industry and their counterparts in the regulatory and political 
systems.
    The U.S. regulatory system monitoring the financial industry is 
highly fragmented. Because of rapid changes in the industry itself, 
investment banks, hedge funds, and government-sponsored groups such as 
Fanny Mae have taken over functions that were once the prerogative of 
banks. Since banks are more highly regulated, there has been a trend of 
doing more and more financial business in areas where there is less 
official regulation. This includes the offshoring of some of the 
industry to places such as the Cayman Islands.
    If the government were to start from scratch and design a 
regulatory system for today's financial system, it would not look like 
the system we now have in place, even though the existing system has 
generally served us well. But with the increasingly globalization of 
the financial industry as a whole, it is clear that more of the 
regulatory emphasis will have to be international in character. We need 
to make sure that derivatives continue to be remarkable instruments of 
wealth creation, global development, and risk diffusion, and not as 
Barton Biggs, Morgan Stanley's chief global strategist once feared 
``the nuclear weapon that ultimately blows us all to smithereens.''
    Finally, all of us hope that the current global economic boom can 
be gently managed downward to avoid potential inflationary problems. 
But with the dollar under pressure from our current account problem and 
with oil and commodity markets under strain, the potential exists for a 
somewhat more rapid market correction at some point.
    The entire global financial system is interconnected by the 
hundreds of trillions of dollars in derivatives, which are the subject 
of these hearing. For example, any future banking crisis in China, 
which slows that economy, will immediately impact commodity prices and 
bonds of commodity producers. Any further sustained spike in oil prices 
could impact huge segments of the derivative industry. Those holding 
some credit derivatives against default could find them costly indeed.
    During this current period of relative tranquility and prosperity, 
it is important for government and industry to continue efforts to 
monitor closely financial markets that could come under future strain 
and address new structural problems as they are identified. It will 
require judgment, sophistication, common sense, and contingency 
planning by all those involved in this valuable industry and their 
regulators.
    In conclusion, we should not be concerned about the gains and 
losses of individual derivative investors. That is what capitalism is 
all about, and one of the reasons why this country is so prosperous. We 
take risks, we invest capital, and the market apportions the winners 
and the losers. Out concern should be potential systemic risk, fraud, 
and structural problems that increase the likelihood of these two 
broader potential problems. Thank you.
Addendum

   LOOKING FORWARD IN WARTIME: SOME VULNERABLE POINTS IN THE GLOBAL 
                                ECONOMY

                    Ambassador Richard T. McCormack
                            (March 30, 2005)
    The purpose of this analysis is to address several key economic 
issues facing the United States and the world at a time when war and 
terrorism-related activities may potentially further stress the global 
economy. In some ways the global economy today resembles a large truck 
racing down the highway at 70 miles an hour, with four or five bald 
tires. The odds are that the truck will make it to its destination 
intact. But a major accident is also possible. This paper explores some 
of those vulnerabilities and is based on recent conversations with 
political and financial leaders on five continents. Such confidential 
conversations are necessary in today's global economy, because what 
happens in one part of the globe often has major consequences, 
sometimes quite unexpected, in other parts of the globe. For example, a 
ruble crisis in Moscow 7 years ago triggered a meltdown of derivative 
positions on Wall Street that posed a threat to the U.S. financial 
system itself. That is just one example of the global 
interconnectedness of everything.
    The consequences of the collapse of large segments of global equity 
markets in 2001 continue to plague the global economy. The vast 
monetary and fiscal stimuli needed to re float the U.S. economy may 
have led to new forms of asset inflation, a bubble in real estate and 
very probably also in bond markets, and not just in the United States. 
Vast global economic imbalances have also developed, partly as a 
consequence of this titanic U.S. macro-economic stimulus.
    These imbalances and other current global economic conditions 
remind us of several enduring economic lessons, with powerful future 
implications. Wise leadership and much good luck may be required to 
achieve a soft landing and a gradual shift in global trading patterns 
later in this decade.
Equity Markets
How the Stock Market Bubble Grew and Burst
    The bursting of the U.S. stock market bubble erased at one point 
somewhere between 8 and 9 trillion dollars of wealth. When you add to 
this the immense sums that were lost in overseas equity markets during 
the same period, the magnitude of liquidity destruction was simply 
enormous.
    Students of history will remember the famous cartoon by Thomas Nast 
about the corrupt Tweed Ring in New York in the late 19th century. The 
title of the cartoon was: ``Who stole the people's money?'' It featured 
a group of well-fed men standing in a circle, each man pointing his 
finger at the next person in the circle.
    A similar cartoon could be drawn about the great asset bubble and 
bust of the late 1990s. The former head of the Securities and Exchange 
Commission points to Congress for failure to heed his warnings. 
Congress points to some dishonest people on Wall Street for having 
misled investors. Wall Street analysts point to the Federal Reserve 
complaisance. The Federal Reserve points to the irrationally exuberant 
investors and greedy corporate leaders. The greedy corporate leaders 
point to their auditors. The auditors point to permitted complexities 
in derivative and accounting rules. And so on around the circle of 
blame.
    The fact of the matter is the blame is widely shared. There was a 
massive systems failure here and a massive loss of wealth when the 
bubble burst, particularly for the least sophisticated members of the 
investment community, including the elderly, many of whom were left 
holding the bag. The leadership of the Federal Reserve has come in for 
special criticism because the Federal Reserve is, after all, the 
ultimate regulator of the health of the nation's financial system, and 
controls margin requirements and the amount of liquidity made available 
to the system.
    The equity bubble was fuelled in part by accommodative monetary 
policies in the latter part of the 1990s. Indeed the world was awash in 
liquidity during most of the bubble years. Attractive investment 
opportunities grew harder and harder to find. Traditional value 
analysts of stocks were increasingly discredited, as market momentum 
confounded one after another of their bearish predictions. Available 
cash continued to flow into already overpriced stocks, and also into 
over-investment in capacity for the production of goods and services. 
Telecoms were a prominent example.
    People running U.S. monetary policies were obviously highly 
competent and experienced individuals. A question now often raised is 
why monetary authorities did not heed the timely warnings that appeared 
regularly in the Economist Magazine and other respected publications, 
and tighten liquidity, or at the very least, increase margin 
requirements as a warning signal to dampen the raging speculative 
fever.
    We also know from subsequently released minutes of the 1996 
deliberations of the Board of Governors of the Federal Reserve, that 
some of the Governors, including Larry Lindsey and Chairman Greenspan 
himself, appeared concerned about the potential for a future 
catastrophic asset inflation bubble, as happened in Japan during the 
late 1980s.
    These troubled deliberations inside the FED occurred shortly before 
Chairman Greenspan made his famous ``Irrational Exuberance'' comment at 
the American Enterprise Institute.
    According to remarks by former Governor Kelly at a conference at 
CSIS in the summer of 2004, Kelly in retrospect greatly regretted the 
fact that, after 1996, the subject of a potential asset inflation 
building in U.S. equity markets never again appeared on the agenda of a 
single meeting of the open market committee of the Fed. One wonders why 
this lapse occurred.
    Experienced financial leaders, such as former New York Federal 
Reserve official, Henry Kaufmann, later faulted U.S. monetary 
authorities for failure to take preemptive action to slow the 
developing asset inflation. They questioned why Chairman Greenspan did 
not use his bully pulpit to repeat his warnings about irrational 
exuberance.
    Friends of Chairman Greenspan reply that, as in the Japanese asset 
bubble of the 1980s, low consumer price inflation might have made it 
difficult for him to justify to Wall Street and their friends in 
Congress the sustained increases in interest rates that would have been 
necessary to deflate the bubble when it was much smaller. Some critics 
would doubtless have accused him of gratuitously damaging capital 
markets. Yet this was the very policy advocated by the IMF, the 
Economist Magazine and others.
    Several other developments that took place in the latter part of 
the 1990s also made it difficult to use a tight money policy to dampen 
the U.S. economy and financial markets. In the latter part of 1997, the 
Asian financial crisis unfolded with a vengeance. With the strong 
encouragement of the U.S. Treasury Department, monetary authorities 
poured high-powered liquidity into U.S. financial markets to cushion 
the blow from Asia. Interest rates were cut by 75 basis points the 
following year.
    The Russian ruble and banking crisis subsequently triggered a 
series of worldwide repercussions that eventually undermined the highly 
leveraged derivative investments of a number of New York hedge funds, 
including the respected Long Term Capital Management firm. This 
particular hedge fund had leveraged few billion dollars worth of 
capital into over a trillion dollars worth of notional value on 
derivative markets. Creditors to these derivative speculators from the 
money center banks were also sucked into the threatening vortex, which 
briefly imperiled the U.S. financial system itself.
    Finally, stating worries about the potential impact of the Year 
2000 computer glitch, the U.S. central bank preemptively injected large 
amounts of liquidity into financial institutions in the fourth quarter 
of 1999, delaying the impact of a tightening cycle that began in July 
1999.
    Chairman Greenspan later said that market warnings unaccompanied by 
large and sustained curbs on available liquidity would have had no more 
impact on raging bull markets than his original ``irrational 
exuberance'' speech.
    In 2000 the Federal Reserve System resumed tightening and the 
enormous bubble eventually burst after the Presidential elections 
amidst widespread recriminations. There is some talk now about the 
possible desirability of limits of two terms for future incumbents of 
the Chairmanship of the Federal Reserve, the nation's second most 
powerful job. The advantage of a Chairman with four successive terms is 
that the incumbent accumulates valuable experience from past successes 
and mistakes as his tenure in office rolls on. The disadvantage is that 
any deep-seated biases and blind spots on the part of a powerful and 
influential chairman inevitably become increasingly imbedded in 
personnel appointments throughout the institution. The temptation 
potentially also may exist for a Chairman wishing successive 
reappointments to get too close to political authorities in a position 
to reappoint him. Some years from now, economists will have a clearer 
idea of the balance of benefits of a very long serving chairman, when 
they will be able to assess with the clarity of hindsight the full 
impact of the Greenspan legacy.
The Bubble's Consequences and Aftershocks
    The vast loss of wealth and purchasing power that accompanied the 
erasure of stock values, plus the excess capacity that easy money made 
possible, contributed to a threatened imbalance between supply and 
demand in some key markets. Profits further weakened and the new 
concern became deflation and recession.
    To help stimulate demand and off-set the massive loss of wealth 
from the collapse of the stock market, the Federal Reserve reversed 
itself in 2001 and progressively lowered interest rates, in part to 
stimulate the housing market and the borrowing power and net wealth of 
homeowners and consumers. Many believe that a new bubble in housing and 
real estate has thus been created. The question is if, how much, and 
how soon will overall property markets weaken?
    In considering these questions, it is important to remember that 
while mortgage interest rates in recent years were at historically low 
levels, rising insurance rates, local taxes and energy bills in the 
United States and elsewhere have steadily added to the cost of real 
estate ownership. It is also important to remember that current low 
interest rates will not last indefinitely. Indeed, a rising cycle of 
interest rates is already underway. Rising commodity and producer 
prices and other indicators suggest possible future inflationary 
pressures in sectors of the U.S. economy. Should broad inflation return 
and interest rates rise beyond the levels that many now anticipate, 
large-scale holders of fixed rate mortgages and their derivatives will 
be vulnerable. Fanny Mae, Freddy Mac, and those who hold the riskier 
paper hived off in massive derivative transactions are sometimes cited 
as weak links in such scenarios. This potential vulnerability has 
belatedly become apparent to U.S. regulatory authorities, some of whom 
are now calling for an 80 percent reduction in the trillion and a half 
dollar mortgage asset holdings of Fanny Mae and Freddy Mac.
    In England, where housing costs rose 25 percent in a single recent 
year, history suggests a possible repeat of the housing bubble that was 
created and burst during the tenure of former Chancellor Nigel Lawson. 
This bubble, before collapse, triggered inflation and required 
draconian monetary retrenchment. This in turn contributed to the sour 
political climate that ended Margaret Thatcher's historic prime 
ministership, and helped leave the Conservative Party in shambles from 
which it has not yet recovered 10 years later. Recently the latest boom 
in English property markets was noted with concern by the IMF, and is 
now the subject of close attention by the Bank of England.
    The behavior of bond markets is also a troubling phenomenon. Short 
and long-term yields show remarkable little differentiation, by 
comparison with historical standards. The same can be said for the 
collapse in spreads between government and corporate bonds. Markets 
seem to have forgotten the recent default of Argentina on its 100 
billion dollar bond portfolio, and the fact that during the next 
serious downward move in the global business cycle, other 
democratically elected leaders in emerging markets will face 
constituent pressures to use President Kirchner's 70 percent write off 
as the standard against which to negotiate with their own bond holders. 
But the problems go well beyond emerging markets. What are the 
prospects that Japan's titanic quantity of l percent bonds will be an 
attractive proposition 5 years from now? The same can be said for other 
bonds, including the remarkably low spread on France's recent 50 year 
bond offering. Those bringing the bonds to market will pocket their 
commissions. Whether the long-term bond-holders will be as fortunate, 
is a very large question. Earlier relatively low consumer inflation 
meant that central banks in many countries, including the United 
States, Japan, and England, had the opportunity to generate a vast 
amount of liquidity, big piles of which have wound up in asset markets 
of all kinds. The question remains about the medium and long term 
sustainability of these bond and other asset prices, leading to a 
further question about a possibly painful hang over after the party 
ends.
    In property, bond, and equity markets, as in much else, a great 
deal obviously depends upon the future trajectory of the U.S. business 
cycle. Massive fiscal and monetary stimulus has been applied in the 
past several years, a need anticipated by President Bush's economic 
advisors as he came into office. This enormous economic stimulus has, 
however, also contributed to a massive increase in the U.S. current 
account deficit and a dramatic weakening in the U.S. dollar. No one 
should be surprised at this latter development. The oldest rule in 
economics, following the law of supply and demand, is that the surest 
way to weaken a currency is to print too much of it. Today's dollar 
buys half the house, a fraction of the college costs and medical 
attention, and far less gasoline than it could have purchased a decade 
ago. As the dollar weakens on international markets, its purchasing 
power in other areas is also likely to erode with time.
    Members of the Austrian monetary school take a grimmer view of the 
long-term consequences of the generous monetary policies of recent 
years. They believe that the subsidized interest rates, repeated bail-
outs, and asset inflations they have financed since 1997 will only 
postpone a far larger future economic and financial crisis. The 
Austrian school favors a cautious monetary policy and a prevention of 
asset inflation, rather than the bailout model now favored by the Fed 
and supported by Wall Street.
    Because of a lack of information, most outside observers are not 
yet ready to offer a definitive judgment on this dispute between the 
Austrian school and Greenspan policy preferences. We may all know the 
answer to this very large question, however, within 5 years, unless the 
tipping point trigger which sets off any future large scale crisis is 
in itself so dramatic that it obscures the true role of any past 
underlying monetary policy mistakes and vulnerabilities.
U.S. Vulnerabilities
Future Prospects--A Global Tour
    Should the Iraq war end soon, not spread to other neighboring 
countries such as Iran and Turkey, and terrorism problems remain 
manageable, prospects for continued growth in the American economy in 
2005 appear positive at present.
    A gradually weakening dollar, although a potential source of 
sectoral inflation and higher U.S. capital costs, should also 
eventually encourage more investment in manufacturing and in the 
production of other tradable goods in the United States. However, any 
rapid fall in the dollar would create many problems both domestically 
and abroad. Export dependent economies would face recession and 
financial dislocations, and the United States would experience both 
sectoral inflation and increase in the cost of capital, which would 
also impact housing markets and consumers here.
    Should the conflict and follow up with Iraq prove longer and more 
expensive than anticipated, should terrorists strike key economic 
targets in the United States, or sabotage impact oil shipping and 
production facilities beyond those damaged in Iraq itself, U.S. and 
global economic recovery could be derailed for a period depending on 
the severity and duration of the disruptions.
    In 1990, the first Bush Administration delayed release of oil from 
the stockpile until the very eve of the Gulf war. This decision, plus 
the firing of the Kuwaiti oil fields and the embargo against Iraq's 
oil, led to an increase in oil prices and inflation in the United 
States and elsewhere. At present oil markets are already tight. Should 
the conflict with Iraq spread to neighboring oil-producing economies, 
directly or indirectly through terrorism or civil unrest, the oil 
shortage scenario of 1990 could easily be repeated on a larger scale. 
Because oil prices are already very high, the impact of any further 
tightening of oil markets could be quite dramatic.
Japan's Malaise
    Vast fiscal efforts to prime the pump and delay painful 
restructuring of the Japanese economy in the aftermath of the collapse 
of the Japanese asset bubble in 1990 have contributed to a massive 
public debt. The OECD estimates that this debt equals at present 169 
percent of Japan's entire gross national product, the largest by far of 
any member of the industrialized world. Other well informed observers 
believe that Japan's actual public debt and contingent liabilities are 
far higher than even the OECD estimates. Japan is able to service a 
debt of this magnitude only because interest rates, in a deflating 
economy, are only about 1 percent in nominal terms. But what happens to 
all those 1 percent bonds when the inevitable day comes that interest 
rates rise to support the greater risk that this huge and growing debt 
entails? Who will want to buy these bonds should perceived risk and 
inflation mount? And what will happen to the banks and insurance 
companies now holding many of these 1 percent bonds as collateral and 
capital? Indeed, the Governor of the Bank of Japan recently worried 
aloud about the exposure of his own institution's balance sheet, should 
future inflation and interest rates undermine the value of the Bar s 
vast and growing bond holdings. According to media accounts, today the 
Bank of Japan holds a greater percentage of Japanese Government bonds 
than even during the peak war year of 1944. If true, that is an 
astounding fact.
    Dealing with Japan's multiple structural, financial, and economic 
problems must inevitably involve some short-term increase in 
bankruptcies and unemployment, as part of a fundamental transition. 
More so-called zombie companies, kept alive by constant transfusions of 
loans from banks, will eventually have to be closed. Alternative policy 
would involve ever more bad debt piling up in the banks. Much of 
Japan's political class was resistant to policies involving short-term 
adjustment pain in the interest of social and political stability, so 
the debt buildup continued and continued. Japanese officials were, 
however, remarkably skillful and successful at the management of most 
perceptions abroad about the actual state of the Japanese economy and 
finance at any given moment, despite the 15 years of stagnation and 
false recoveries since the bursting of the great Japanese asset bubble.
    A year ago, however, former Finance Vice Minister Ito published in 
the Financial Times a credible plan for addressing some of Japan's 
financial and structural problems. It contained the following elements:

  1.  Since Japan's central bank had failed to grow the money supply 
        sufficiently with lower interest rates alone--the money supply 
        grew by only 2 percent during one recent 12 month period--Ito 
        urged unconventional measures to inject money into the economy. 
        In current circumstances, broad deflation could only be cured 
        by a monetary expansion.
  2.  Japan must gradually control excesses in deficit financing to 
        avoid a fatal debt buildup, and eventual crisis in debt 
        servicing. Ito also believes that the tax system and public 
        spending patterns must be reconfigured to encourage greater 
        aggregate demand.
  3.  The non-performing loan problem must be progressively solved, so 
        that Japan's capital could be put to higher and more productive 
        uses than supporting zombie companies. The banking system 
        needed reform, injection of public money, nationalization of 
        some banks, more mergers of others, and the outright closure of 
        some weaker banks.

     If a program such as this is not consistently implemented over the 
next few years, the debt buildup in Japan may eventually trigger a 
crisis that could shake the Nation to its roots, destroy an immense 
amount of wealth, require a massive use of the printing press at the 
Central Bank that will be highly inflationary, and force Japan to face 
its problems with a vastly reduced capital and savings base. Even with 
interest rates at slightly over 1 percent, government debt service 
charges already absorb more than one fifth of Japan's annual budget.
    Prolonged oil price increases, a war in Korea, or a deep future 
U.S. recession would of course put immense new pressure on the Japanese 
economy and finances. Fortunately, a highly competent man, Mr. Fukui, 
has recently been named head of the Bank of Japan and has begun a 
reform effort. No one should envy this man. He has inherited a massive 
problem now under increasingly stressful geopolitical conditions: The 
dollar weakens. The competition from China intensifies. Aging Japan's 
demographic trends accelerate. The public debt mounts.
The Argentina Example
    Argentina is an example of a country which delayed facing its 
problems until it was too late. The Argentine economy eventually shrank 
by 25 percent over a 4-year period. The banking system and a large part 
of the country's domestically held savings were lost. Capital flight 
added to the disaster. The crisis itself accompanied desperate last 
minute measures by Finance Minister Cavallo, which further undermined 
the country's capital-base and economy. The political class was largely 
discredited. Demagoguery and finger pointing formed an important part 
of the public discourse. A key problem in Argentina, as in Japan, was 
that the abler parts of political class were unable for years to 
implement a sustainable reform program. In the end, foreign holders of 
a hundred billion dollars worth of Argentine bonds were left holding 
the bag in one of history's largest defaults. After an excruciating 2 
years, soaring global prices for Argentina's agricultural and commodity 
exports and the default on Argentina's foreign creditors, allowed 
growth to resume in Argentina, but at the cost of Argentina's long term 
creditworthiness and foreign investment prospects.
    The most expensive bill from the Argentina default may be the new 
precedent for other future bond defaulters in emerging markets. Which 
future democratically elected leader with debt service problems will be 
able to demand less than President Kirchner extracted and received from 
his defaulted bond holders? This is likely to become a very live issue 
during the next serious downturn in the global business cycle.
Brazil's Highwire Act
    The high ratio of debt to GDP of Brazil is a major source of 
concern. International institutions consider that ratios above 50 
percent in emerging markets could expose countries to crisis. Such high 
ratios may not seem threatening in Europe and the United States because 
of higher capacity of raising government revenue. Theory and data do 
not provide a reliable measurement of the sustainable debt/GDP ratio 
for any country. The internal debt of Brazil was 55.5 percent of GDP in 
2002, increased to 57.2 percent in 2003 and declined to 51.1 percent in 
2004. Vulnerability exists at the point when investors may not be 
willing to purchase government securities at a ``reasonable'' cost, 
forcing default. It may not be feasible empirically to measure such a 
point. In order to reduce the debt/GDP ratio, Brazil must continue its 
prudential fiscal management of primary budget surplus, which is now 
close to 5 percent of GDP. Simultaneously, Brazil converted a current 
account deficit into a current account surplus of close to 2 percent of 
GDP by reversing a trade deficit into a trade surplus of more than $30 
billion. Simultaneously, the economy is growing again. There are still 
many challenges in Brazil, in particular, tax and labor reform, which 
would modernize the country, allowing better control of its own 
destinies.
    Similar problems exist in other major Latin American nations. Much 
of the work done in the 1980s to encourage the adoption of market based 
economic reforms in Latin America has been undermined by policy 
failure, some corrupt and discredited privatizations, and similar 
mistakes. But as the former President of Bolivia stated 2 years ago: 
``The hangover facing our region is not due to the reforms we have 
made, but to the reforms which we have not yet made.''
    As in Argentina, however, soaring world commodity prices have 
boosted economic growth in many parts of Latin America to levels not 
seen since the commodity boom of 1980, a boom which ended in tears in 
1982, and a lost subsequent decade of economic growth for the whole 
continent. There is no substitute for getting overall policies right 
for sustainable balanced economic development. Otherwise heavily 
indebted commodity dependent economies will continue to be hostage to 
the full impact of the booms and busts that accompany the global 
business cycles.
    The United States has a very large stake in the outcome of the 
intensifying struggle between the demagogues and the sound economists 
in many parts of Latin America. Our stake in economic growth is equally 
high in other parts of the globe. Unsustainable U.S. trade deficits 
cannot be corrected without a major global recession unless growth and 
demand elsewhere contribute to the solution. This plus other measures 
would then help permit an orderly shifting of global trading patterns.
The Euro Dilemma
    In Europe, Germany's key economy is weakening with core 
unemployment exceeding 10 percent. Major structural reforms in labor 
markets, pension systems, and other aspects of the German economy are 
urgently needed. Prime Minister Schroeder has accomplished a modest 
increase in labor market flexibility. Politics impedes a broader 
assault on imbedded problems, which may not be resolved until Germany's 
two large parties join in a broad coalition to force through needed 
legislation. Other serious structural problems exist elsewhere within 
the Euro zone, recently worsened by the European Union's strengthening 
currency against the dollar zone. Because of the internal trade within 
the expanding European Union, and because of favorable relative energy 
prices in Euros, the impact on Europe's economy of the latest currency 
shift is less dramatic than some predicted. Still, Europe depends upon 
exports to the dollar zone for millions of jobs, and reduced 
competitiveness because of its strengthening currency may encourage 
some European leaders to turn even more heavily to high profile global 
politics in controversial areas to secure export markets. The Middle 
East and China are only two of several such theaters where 
international politics heavily impact local procurement and mineral 
concession decisions. This then could create more strain on Europe's 
ties with the United States, and potentially more strain on the 
economic side of the relationship in future discussions of trade and 
technology across the Atlantic.
The China Question
    China's intense national ambition rapidly to become the dominant 
Asian power, its low wages and its undervalued currency have unleashed 
trends that threaten to turn that country into an engine of deflation 
in sectors of manufacturing. Over supply of goods continues to cause 
profit problems for competitors both within China and abroad. Many of 
China's 150,000 state owned enterprises, burdened with antiquated 
facilities and heavy benefit programs for their workers, remain in 
business only because banks are required to provide ``loans'' to 
subsidize their operations and prevent unemployment. This is 
contributing to a bad loan problem that may rival that of Japan in its 
size and potential implications for the future.
    Indeed, mismanagement of banking and finance has been the 
traditional Achilles heel of the Asian development model, and China is 
not likely to prove a long-term exception to this rule. But in the 
meantime, China's exports are expanding at a frantic pace--more than 30 
percent per year on a compound basis. According to The Economist 
magazine, export industries and international commerce now contribute 
directly and indirectly more than 50 percent of China's entire two 
tiered national economy. This soaring trend in export growth cannot 
continue indefinitely without major consequences for the stability of 
China, China's trading partners, and for the global trading system as a 
whole.
The U.S. Deficit
    This brings us full circle to the United States, where we have a 
net debt from accumulated trade deficits now approaching three trillion 
dollars, a debt that must be serviced with interest and profit 
remittances. This year the U.S. trade deficit is projected to increase 
to a yearly total of over 700 billion dollars. (China alone contributes 
$135 billion to this figure.) This unsustainable trend has already 
helped drive the dollar down against the Euro and other floating 
currencies.
    Predicting short-term currency trends in today's volatile 
conditions is difficult, partly because of massive intervention in 
Asia, and partly because the dollar's competitors, the yen and the 
Euro, are based on economies that are themselves deeply troubled. 
Nevertheless, the massive, growing U.S. current account problems leave 
the dollar extremely vulnerable in the short and medium term. Should 
the dollar continue to fall, the U.S. market will be less available to 
overseas exporters, regardless of our trade and tariff policies.
    Past U.S. trade policy concentrated on opening U.S. and global 
markets. We are now engaged in a new round of trade negotiations aimed 
at further trade liberalizations. But if we do not succeed in creating 
opportunities for the United States to reduce its trade deficit--which 
continued at record levels even during a past recession--the dollar may 
continue to fall and this will have consequences.
    Moreover, persistent global ill-will toward, or misunderstanding 
of, U.S. foreign policies could trigger a de facto overseas boycott of 
U.S. goods and services far beyond Macdonald's currently flagging sales 
in the Arab world, or the disappearance of the Marlborough cowboy from 
many of its earlier marketing sites throughout Europe, as a now 
negative symbol. Such attitudes overseas could have long-term 
implications for Boeing and other big-ticket U.S. exporters, which now 
contribute importantly to our balance of payments. They could also 
create long-term strategic commercial opportunities for U.S. 
competitors in Europe, the Middle East, Latin America, and Asia.
The Promise--and Limits--of Economic Prospects
    As we consider the economic developments of the past century, the 
trends are overwhelmingly positive. Technology, science, democracy, 
education, and productivity have improved the quality of life for 
billions of people on this planet. Ancient illnesses have been fought 
and defeated. Drudgery in daily life and work has been dramatically 
reduced. These trends will certainly continue and intensify in our 
present century.
    But there have also been bumps in the road of progress. Debt 
problems, demagogues, wars, asset and consumer price inflation, and 
over investment in capacity, have taken their toll in blighted lives, 
recessions, and a major depression during the past century. We believe 
we understand now, better than before, how to cope with fundamental 
economic problems. While we can learn from the past, it is important, 
however, to recognize that each major economic accident impacting the 
national, regional, and global economy has been unique. Attempting to 
build precise models based on past situations has thus far not been 
very successful in predicting the next economic crisis. In this sense, 
notwithstanding all the advanced mathematics and powerful computers, 
economics is still a young science, still learning, still attempting to 
build paradigms that will allow us all to peer into the future with 
more confidence to avoid costly debacles. In the meantime we have to 
look beyond our computers to assess deeper vulnerabilities.
    This is not going to be easy. Human nature, with all of its 
complexity and vulnerabilities, operates on the basis of emotions, 
values, drives and ambitions the impact of which is difficult to 
quantify. Statistics will continue to be flawed by false data fed into 
powerful computers. Confidence will suddenly collapse from time to 
time, triggering runs on banks and countries. Poorly supervised rogue 
traders in banks and hedge funds will periodically trigger vast losses 
to shareholders and investors. Political leaders will not always be 
totally candid with their followers and their countries' creditors. 
Politics itself is an unpredictable factor, as is war. People also make 
honest mistakes.
    Painful old lessons about such dangers as asset inflation and over 
concentration in the financial industry will have to be relearned. As 
each generation dies off with its deeply imbedded memories of booms and 
busts, the snake oil salesmen will again appear in force, together with 
their witting and unwitting accomplices in corporate and public life. 
There will always be a powerful lobby for a major redistribution of 
wealth, whether through taxes or monetary policy measures.
    Three other issues deserving special attention are problems in the 
global exchange rate system, some aspects of the derivatives industry, 
and any underestimation of strain on public finances that could produce 
renewed inflation.
Global Exchange Rates
    When floating exchange rates were adopted after the collapse of the 
Bretton Woods system, policymakers expected the new system to trigger 
automatic adjustments in the balance of payments.
    Reality proved more complicated. Some mercantilist countries 
endeavor to influence currency directions with interventions, dirty 
floats, fixed arrangements, and large-scale capital transfers of 
various kinds. Competitive currency devaluations can substitute for 
tariffs and other non-tariff barriers as an important regulator of the 
terms of international trade.
    Over the long term, floating exchange rates have proven their value 
to most countries with sound regulatory systems. But in the short term, 
currency interventions by those with fixed exchange rates of various 
kinds have greatly complicated international trade, and contributed to 
the large sustained U.S. trade deficit. Such undervalued currencies 
disadvantage competing manufacturers in the U.S. and elsewhere. The 
export-favorable currency of China also encourages more investment in 
local manufacturing than the global market can absorb without producing 
future deflationary pressures and broader dislocations.
    China's economic development is a good thing, not a bad thing. But 
some of China's policies to jump-start a once moribund state run 
economy can be dangerous to China and others if continued too long. 
Recent international efforts were made to persuade China to allow its 
currency to appreciate. This is because the undervaluation of China's 
currency does not involve only China, but the whole East Asian 
production complex. None of the neighboring countries that form China's 
hub and spokes trading system can afford to revalue its own currency 
unless China leads the way.
    Appeals for an immediate currency revaluation have been rejected. 
China cites concerns for its strained banking and political system if 
growth and export rates taper off for any reason.
    Therein lies the great dilemma. China says that it cannot afford to 
slow down its titanic export drive, and the United States simply cannot 
afford to accumulate current account debts at the accelerating pace of 
the past few years.
    Thus, if internal problems with China's banking system, energy 
supplies, politics, and environmental conditions do not ease China's 
torrid pace of export expansion, China's competitors abroad will surely 
seek ways to slow down the juggernaut. This would allow time and space 
for other economies, including those in the Western Hemisphere, to grow 
and adjust. This is what happened in the mid 1980s to blunt Japan's 
massive export drive, which also was fueled in part by state 
capitalism, an undervalued currency, multiple non-tariff barriers, 
rampant theft of intellectual property and an intense national ambition 
by the country's leadership to achieve U.S. standards. The fact remains 
that the U.S. cannot continue to accumulate debt via its collapsing 
current account position at this pace much longer without undermining 
the dollar as a reserve currency, radicalizing its domestic politics, 
and eventually compromising its global strategic position.
    Although China has accumulated more than 600 billion dollars worth 
of foreign exchange reserves to cushion any future problems, China's 
fears about its own vulnerabilities should not be ignored. China's 
economy faces serious problems, problems not always fully captured by 
released official statistics. Although China's economy is stated to be 
growing at a 9 percent annual pace, China's stock market is at a 6-year 
low, as of early 2005. Presumably the companies listed on the stock 
exchange are among China's best. Their sagging value may say a great 
deal about the financial health of the other building blocks of the 
Chinese economy, namely the individual companies. Stock markets tend to 
be leading, not lagging, economic indicators.
The Problem With Derivatives
    In our time, derivatives have added vast new areas of uncertainty. 
There is somewhere between 100 and 125 trillion dollars worth of those 
useful instruments outstanding today. While derivatives do reduce risk 
to individuals and companies, they also spread that risk, often in 
highly leveraged form, to other individuals, institutions, and in 
extreme form to the financial system itself--as we saw with the Long-
Term Capital Management hedge fund debacle. Some large money-center 
banks, which are creditors to major derivative issuers, are thought by 
some to be at risk under some possible scenarios.
    It requires a high degree of technical skill, and unusual 
dedication and effort for outsiders to penetrate constantly evolving 
derivative markets and understand where the evershifting 
vulnerabilities lie. This cannot be accomplished by the average 
investor, who is likely to have no idea what recent gambles a firm's 
management may have made on derivative markets until the bad news of a 
massive loss suddenly hits the street. Many have urged greater 
transparency in derivative reporting. Even Warren Buffett and his 
skilled associates threw up their hands after attempting to penetrate 
the explanatory footnotes on the potential derivative related 
liabilities of some money-center banks.
Fighting Terrorism: Balancing Short-Term Costs and Long-Term Goals
    Beyond the problem of finding a solution to the global imbalances, 
the greatest uncertainty facing the American economy undoubtedly has to 
do with the unpredictable elements of war and terrorism, and the 
potential for disruption of economic targets, including energy related 
production and transportation facilities. The Venezuelan and Nigerian 
oil production disruptions have complicated all this.
    Each year since 9/11, economists at the IMF have attempted to 
calculate the potential economic impact of perceived geo-political 
uncertainties that could cut projected global economic growth.
    One of the reasons for this effort is the vast disproportion 
between the costs of mounting terrorist attacks and the damage that 
such attacks can inflict on advanced, open and vulnerable economies 
like ours. A year after the 9/11 attack, one of Washington's major 
public policy institutes assembled a group of economists to assess 
these relative costs. At that time, they concluded that the 9/11 
attacks on the Twin Towers and Pentagon had cost Al-Qaeda about 
$250,000 to mount. The assembled economists calculated that the net 
cost to the American economy of this attack, direct and indirect, 
exceeded $800 billion dollars. This included the damage to financial 
markets, transportation industry, insurance industry, hotel industry, 
the buildings themselves and the titanic costs of striking back at 
terrorists and protecting the country from future attacks. In the 
meantime, new costs have arisen as pressure for more domestic defensive 
measures has developed.
    Knowledge that terrorists have targeted civilian aircraft with 
cheap anti-aircraft missiles, for example, generated proposals to equip 
civilian planes with anti-missile systems at a cost of $10 billion 
dollars. The war with Iraq, partly aimed at avoiding possible future 
Iraqi cooperation with terrorists, will certainly cost many hundreds of 
billions of dollars before it is over, plus the large sums our allies 
asked to secure their cooperation. Since 9/11 the price of oil has 
doubled. If there is a deeper oil crisis, or terrorist-related economic 
disruption, this cost will increase. It should be remembered that each 
thousand point decline in the Dow Jones costs share holders roughly a 
trillion dollars. It should also be remembered that inflation and other 
financial instabilities have the potential to jolt bond and derivative 
markets.
    Unless the United States successfully shifts budget priorities, the 
American economy does not have a limitless ability to absorb the costs 
from war and terrorism without eventually returning to a sharper cycle 
of inflation and recession.
    The Federal Reserve can indeed cushion massive unexpected blows to 
the American economy and financial markets, but only at a high risk of 
future inflation, subsequent monetary restraint, and recession.
    The U.S. obviously had no choice but to defend itself from evil. We 
have moved vigorously to strike at Al-Qaeda and their Taliban hosts and 
now Iraq. But we also have an obligation to look beyond the immediate 
issue to seek means to drain the other swamps that help spawn 
terrorists and recurrent regional wars. That is partly why the 
President's vision of a Middle East settlement with a secure Israel and 
a democratic Palestine was so well received by diplomats. It is vital 
that future scenes of cooperation among the leaders of the three great 
faiths involved replace the constant mayhem on television throughout 
the Islamic world from violent events in what was once called ``The 
Holy Land.''
    History suggests that the U.S. will eventually pass through today's 
problems and uncertainties. Unlike Japanese economic managers who tend 
to bury their problems for years and compound their costs, the U.S. 
tends to address its Enron-like problems brutally and move on. Every 4 
years, the Presidential election provides the American people with the 
opportunity to change, if needed, both policies and personnel. We can 
also expect that new inventions and technologies will generate whole 
new areas of economic activity and growth, improving the lives of 
billions of people.
    A key to this happy outcome is wise U.S. leadership and effective 
diplomacy, plus keeping our economy open, flexible, market oriented, 
and with a heavy emphasis on quality education. We must also 
successfully address certain problems in the global trading system that 
contribute to our current account problem. As long as we continue to 
master these basic requirements, we will drive over any bumps in the 
road and continue to lead the world.
Operative Lessons for Policy Makers
    Based on the key conclusions from this brief review of potential 
global economic vulnerabilities, a list follows of some key principles 
that should be noted by policymakers even during the distractions and 
turmoil of war-time:

  1.  It is better to prevent inflation than to have to control it, 
        once unleashed. This is also true of serious asset inflation, 
        which produces bubbles that tend to trap the least 
        sophisticated investors.
  2.  Excessively loose monetary policy which subsequently generates 
        asset inflation also tends to produce excess investment in 
        capacity, including real estate. In effect, such monetary 
        policies borrow economic growth from the future. This resultant 
        excess capacity ultimately weakens profits, banks, and stock 
        values, and can hang over markets for years before a 
        combination of liquidation of excess capacity and new economic 
        growth allows markets to clear.
  3.  Wars destroy and waste wealth. Financing by governments of past 
        wars has often generated inflation, unless policymakers were 
        vigilant.
  4.  Stimulating the housing market in an effort to ease the wealth 
        destructive consequences of a burst stock market asset bubble 
        can either kill or cure the patient, depending on how long the 
        medicine is applied. The same can also be said about bond 
        markets, where serious questions have arisen about the 
        sustainability of current bond market trends.
  5.  During inflationary times, low fixed rate mortgages on housing 
        can generate serious problems for those institutions holding 
        large portfolios of mortgages or higher risk housing 
        derivatives. Future higher interest rates will tend to make it 
        more difficult for potential buyers to qualify for mortgages 
        when people want to sell their houses. Higher local taxes, 
        which are often indexed, and rising insurance costs are adding 
        to the cost of home ownership, and will tend to reduce the pool 
        of people able to afford such housing at existing prices.
  6.  The large-scale debt accumulations, via balance of payment 
        deficits, cannot continue indefinitely without triggering a 
        further weakening of the nation's currency, contributing to 
        sectoral inflationary pressures and increasing the cost of 
        capital. U.S. trade deficits are not merely a macroeconomic 
        phenomenon involving the U.S. budget deficit and monetary 
        aggregates, important though that is, but also and powerfully 
        an accumulation of many micro economic problems. These include 
        currency misalignments, failure to enforce successfully past 
        trade opening deals, including China's WTO agreements, subtle 
        but powerful non tariff barriers involving such things as local 
        standards, the European VAT rebate system for exports, poorly 
        negotiated past trade deals such as the 1992 airbus agreement 
        which allowed subsidized and risk free financing of new 
        aircraft, wholesale theft of U.S. intellectual property and 
        trademarks in many parts of the world, complaints about U.S. 
        worker literacy by potential investors, etc. Viewed 
        individually, the impact of some of the micro economic 
        obstacles to U.S. exports and competitiveness may seem modest. 
        The collective impact of all the micro economic obstacles on 
        American competitiveness and exports, however, is titanic and 
        strategic. U.S. trade deficits have increased steadily since 
        1990, regardless of the fluctuating U.S. budget position, 
        suggesting that we must look beyond the fiscal macro issue to 
        help address our current account problems.
  7.  It is nevertheless essential that projected U.S. Fiscal deficits 
        be brought under control. They contribute to excess U.S. 
        demand, cause confidence problems at home and abroad, and will 
        otherwise lead to higher future U.S. interest rates.
  8.  Foreign policy rationales for trade policy measures need to be 
        considered from time to time, but only if the collective impact 
        of generous trade policies conducted on this basis does not 
        generate potentially disastrous current account problems.
  9.  Encouraging more economic growth abroad is the painless textbook 
        solution to a global imbalance problem in trade. Realism 
        compels us to consider the political obstacles likely to delay 
        such growth in Europe and Japan, and understand as well that 
        more export led growth in places like China will only compound 
        our problems. We also need to remember the catastrophic results 
        of efforts in the mid-1980s to encourage Japan to engage in 
        expansionary monetary policies aimed stimulating more domestic 
        demand. In short, we may need to look beyond this textbook 
        solution to help ease our pressing current account problem.
  10.  As Argentina demonstrates, delay in addressing an underlying 
        national economic imbalance can cause an economy to contract 
        severely when problems have to be addressed in the middle of an 
        urgent crisis. If this happens to the American economy, the 
        consequences will be massive and global.
  11.  As in Brazil, funding a large public debt with short-term 
        borrowings can be dangerous if, for any reason, markets lose 
        confidence in the borrower's ability to service the debt.
  12.  Floating exchange rates have proven their value over the long-
        term for most countries with sound regulatory systems, but such 
        countries can suffer short-term competitiveness problems 
        against trade sold with fixed and undervalued currencies. Major 
        countries like China with such fixed exchange rates and large 
        pools of savings and inexpensive labor can dominate some 
        sections of global markets for years, but at a risk of future 
        financial, banking and political instabilities for themselves 
        and for their trading partners.
  13.  Past models of financial disasters are imperfect guides for 
        predicting future financial debacles. There are several reasons 
        for this. One key problem is a lack of transparency in 
        information. Political and business leaders with financial 
        problems are seldom candid. Political responses to crises are 
        unpredictable. Part of modem finance relies heavily on opaque 
        derivative operations whose individual and collective impact 
        during a crisis cannot be quantified in advance. Human nature 
        itself is volatile, subject on occasion to credulity, panic, 
        and the other manifestations of ``the madness of crowds.'' 
        Relying wholly on computers and the statistics in them can 
        dangerously mislead policymakers who fail to understand the 
        limitations of their economic models.
  14.  Allowing the economy to operate on the basis of market signals 
        remains the best available means of running a modem economy. 
        Rapid advances in science and technology will continue to place 
        a tremendous premium on flexibility, quality education, and on 
        the optimum use of capital and labor that a market driven 
        process makes most likely.
  15.  Notwithstanding current overall global economic growth, today's 
        world is filled with economic vulnerabilities, large and small. 
        Policymakers and economists need to monitor and address the 
        more obvious individual problems to lessen potential future 
        systemic risks.
                                 ______
                                 
                 PREPARED STATEMENT OF DR. ADAM LERRICK
            Visiting Scholar, American Enterprise Institute
                              May 16, 2006
Demystifying Hedge Funds
    Every day, somewhere in the global marketplace, hedge funds are 
shaking up the comfortable status quo and voices from high places are 
raised in protest. The Governor of China's central bank Zhou tried to 
deflect G7 censure of the under-valuation of the yuan by pointing at 
unruly hedge funds as a greater threat to the world economy. In the 
American heartland, Warren Staley, CEO of agricultural giant Cargill, 
accused hedge funds of distorting fundamentals and roiling the 
commodities markets. In Germany and Japan, politicians denounced hedge 
fund corporate activists as ``locusts'' that destroy and disrupt in 
order to extract quick profits.
    Are hedge funds really to blame for all the ills that befall the 
international financial system? Are they disruptive speculators or 
dispassionate agents that expose fundamental flaws and speed up 
inevitable change? Does their search for the highest absolute economic 
return eliminate inefficiencies and bring balance and liquidity to the 
market? Or does it lead to excessive risk-taking that may one day 
entrain widespread crisis?
    Hedge funds are simply pools of money seeking the highest absolute 
rate of return across the capital markets with a management 
compensation structure that commands a high share of profits. They have 
been here for more than a generation and, like any financial 
innovation, are following a normal life cycle. First, a small number of 
pioneers garner excess profits; next, competition and capital are 
broadly attracted; finally, the concept moves into the mainstream, 
matures and is winnowed out until the risk/reward ratio approaches that 
of other instruments.
    When floating exchange rates and volatile interest rate movements 
transformed the capital markets in the late 1970s, hedge funds entered 
quietly with an irresistible offer to investors: make money whether the 
market rises or falls. These were small groups of innovative traders, 
some inside large investment banks funded by the bank's own capital, 
others in independent firms financed by less than 100 rich individuals 
prepared to commit millions to a new technology.
    Managers searched for momentary anomalies in the pricing of 
securities, currencies and commodities around the world. They matched 
holdings with short sales to isolate generalized market risk. They 
borrowed heavily to leverage positions and magnify returns. Rewards 
were overwhelming and consistent at 40 percent per annum. Managers were 
paid for performance: they received 20 percent of profits. As investors 
and managers plowed back their gains, small funds quickly grew into 
multi-billion dollar forces.
    Hedge funds are now a major force in the global financial markets. 
Over 8,000 hedge funds hold $1.5 trillion in assets, double the level 
in 2000. Leverage and the use of derivative instruments multiply their 
real impact many-fold. They dominate the trading arena: one-third of 
equity volumes; one-fifth of the bond and currency markets; one-half of 
the commodities sector. They are a mainstay of profits for the large 
investment banks through commissions on trading and interest on 
borrowing; when added to the revenues of in-house proprietary trading, 
hedge funds overall are the predominant source of Wall Street earnings.
    Trading figures are no longer the sole measure of hedge fund power. 
As more funds and more money chase the same opportunities, hedge funds 
are constantly moving money around the globe to where it is most 
productive. They challenge private equity firms, venture capitalists 
and real estate developers. They lend to companies in distress. They 
take large positions as shareholder activists to force corporate 
restructurings. They search the world to manage infrastructure projects 
and to develop natural resources.
    The client base has moved from a closed society of the very rich to 
embrace the entire investor spectrum. Large institutions that oversee 
the retirement savings of the nation's workforce and endowments that 
guard the resources of universities and charitable trusts now account 
for more than half of hedge fund capital. High rates of return were the 
initial attraction but even as returns tend toward lower equilibrium 
levels, hedge funds are valued to reduce over-all portfolio risk 
because their returns are uncorrelated with general market trends.
    A whole new layer of intermediaries has developed to proffer 
guidance through the maze of proliferating hedge fund choices and to 
distribute institutional investor assets among specialized funds. These 
``funds of hedge funds'', when marketed by banks and securities firms, 
provide a conduit for the retail investor with as little as $25,000 to 
risk. In the planning stages at Citigroup is a $30 billion fund of 
hedge funds to be marketed to its retail client base with the frequent 
redemption options now offered by mutual funds. Funds of hedge funds 
now control 50 percent of industry assets and have brought in 60 
percent of recent inflows. Each layer adds more fees and reduces 
investor returns.
    The original hedge fund image was a ``black box'': investors put 
their money in and asked no questions about what went on inside. Hedge 
funds continue to depend upon secrecy to prosper. They have a large 
investment--in human capital from the world's top mathematics, physics 
and finance institutions; in technology based upon complex quantitative 
statistical models; in information costly to collect and process--that 
cannot be patented or protected. A strategy disclosed is a strategy 
destroyed as immediate imitation by the market wipes out the benefits 
of expensive proprietary innovation.
    In a world that demands transparency, secrecy is a red flag for 
fear, suspicion and calls for regulation.\1\ But the public interest 
can be satisfied without driving hedge funds to pack up and resettle 
off-shore. The framework to monitor and safeguard the global financial 
system and to watch over the unaware investor is already in place.
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    \1\ The SEC has recently required registration of most hedge funds 
with assets above $30 million and with 15 or more clients.
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    Hedge funds do not operate in a vacuum. They interact through a 
marketplace where their lenders, their trading counter-parties and the 
markets themselves are already under the scrutiny of an array of 
regulators--the SEC, the Federal Reserve, the Comptroller of the 
Currency, the CFTC and their counterparts in capital markets around the 
world.
    Hedge fund objectives should not be confused with their tools. The 
hedge fund formula has always relied on leverage to magnify returns, 
whether through borrowing or derivative instruments, but as margins 
narrow there is the pressure to take on more risk to generate the same 
profit rates. Leverage alone does not add value and excessive leverage 
can disrupt markets. The danger to those that finance hedge funds and 
to the global system as a whole lies in ignorance of risks. Total 
exposure and total leverage across all lenders and across all national 
boundaries should now be aggregated and published to inform and improve 
the risk evaluations of market participants and regulators alike.
    Under U.S. securities law, all hedge fund clients--the very rich, 
the institutional investors and the managers of funds of hedge funds 
who are stewards of the savings of small investors--have the skills to 
inform their decisions without official help. Many analysts believe 
that the industry would benefit from standardized disclosure of fund 
structures and track records. But government agencies need not 
regulate. If they take the lead to establish uniform benchmarks, the 
market will enforce their use as funds that refuse to comply will lose 
clients and capital to those that inform investors.
    The marketplace is the ultimate regulator and will control the 
hedge funds' future. Ever more money is competing for a diminishing set 
of opportunities. Average profitability is already approaching rates on 
more commonplace assets when risk is factored in. Industry leaders are 
raising fees, returning money to their long time deep-pocketed backers 
and focusing on their own capital. Of the 8,000 current hedge funds, 20 
percent will close their doors within 1 year. Retail investors, enticed 
by now-outdated headline returns, will move on as profits fall. During 
the shake-out, players with weak risk management will be winnowed out. 
There will be fewer but better hedge funds.
                                 ______
                                 
                   PREPARED STATEMENT OF KURT SCHACHT
       Executive Director, Center for Financial Market Integrity,
                 Chartered Financial Analyst Institute
                              May 16, 2006
    Good afternoon. I am Kurt Schacht, the Executive Director of the 
CFA Centre for Financial Market Integrity, the advocacy arm of CFA 
Institute. I would like to thank Senator Hagel, Senator Dodd, and other 
members of this committee for the opportunity to speak to you this 
afternoon on the role of hedge funds. It has come to dominate much of 
the financial services industry discussion recently and we are 
supportive of your committee taking a closer look.
    First, some background about CFA Centre and its parent 
organization, CFA Institute. CFA Institute is a non-profit professional 
membership organization with over 82,000 members in 126 countries. Its 
mission is to lead the investment profession globally by setting the 
highest standards of ethics, education, and professional excellence. 
CFA Institute is most widely recognized as the organization that 
administers the CFA examination and awards the CFA designation, a 
designation that I share with nearly 68,000 investment professionals 
worldwide. I direct the advocacy efforts of CFA Institute through the 
newly created CFA Centre for Financial Market Integrity, which develops 
research, education projects and promotes ethical standards within the 
investment industry. The CFA Centre has been actively involved in the 
hedge fund debate for several years and has developed a number of 
initiatives related to the industry from the investor's perspective.
    For the record, CFA Institute is a staunch proponent of self-
regulation. This approach is embodied not just in our Code of Ethics, 
but also in a number of additional guidelines and standards we have 
established in areas such as performance reporting and asset manager 
conduct. As discussed herein, these standards may provide useful models 
for how to address some of the issues before the Subcommittee today.
    In most cases, we believe that self-regulation is a preferred 
alternative to government-imposed regulation, which adds complexities 
and increases the costs of capital, which are ultimately shouldered by 
investors large and small. This, of course, is a view shared by 
regulators and standard-setters themselves, which is why we frequently 
have worked closely with these groups, including the Securities and 
Exchange Commission, to develop such standards.
Our Perspective on Hedge Funds
    Our organization comes at this topic from a number of perspectives 
but primarily as an investor advocate with an interest in promoting 
appropriate professional standards in this industry. We advocate before 
investor groups, industry associations and the world regulators. Our 
focus includes industry ethics, asset manager conduct and performance 
reporting.
    As with most membership organizations in the financial services 
area, we have a growing proportion of our own membership, estimated at 
approximately 6 percent (about 5,000), directly involved in the 
industry as hedge fund or fund of funds participants, not to mention 
the many others in our membership who are involved as buyers or 
consumers of hedge fund products.
    Our work in this area includes a comprehensive set of standards for 
hedge fund operators. We have been meeting with regulators around the 
world to discuss hedge fund and manager regulation and recently 
completed a survey and study of the hedge fund industry in the Asia 
Pacific region. We continue to review and comment on the issues of 
hedge fund performance reporting and investor education as well. I will 
cover each of these aspects below.
The Role of Hedge Funds
    First, the role of hedge funds in overall portfolio construction 
and management is evolving. Generally, such investment vehicles are 
sought for high, uncorrelated historical returns, their attractiveness 
relative to other investment alternatives and returns in excess of 
growing liability streams as expected pension portfolio returns have 
begun to fall short of these growing liabilities. These uncorrelated 
returns reduce portfolio volatility and actually ``hedge'' other 
portfolio exposures. Perhaps most importantly, hedge funds offer access 
to some of the premier asset managers in the world.
    Conversely, hedge funds are not a panacea and there are most 
certainly a large number of operators that will fail to deliver 
sustained performance, net of fees. The level of investor knowledge is 
also a concern when discussing the role of hedge funds. That role is 
prone to being oversold to retail investors and certain institutions 
looking to chase the latest hot strategy and quick returns. The 
appropriate role of hedge funds is therefore subject to being 
misunderstood and misapplied in certain cases.
The Current State of the Industry and Regulation
    The current industry is a jumble of contradictions we have seldom 
witnessed. We have huge and growing demand for the products with assets 
under management approaching $1.5 trillion and huge and growing supply 
with nearly 9,000 funds. We have an all out media frenzy concerning the 
industry with 100 stories per day in 2005, according to one study. 
Meanwhile, we continue to hear about shaky investor confidence, while 
every regulator we talk to is increasingly suspicious of what is going 
on with these funds. They are often described as, mysterious and 
largely unregulated investment vehicles of the wealthy, sophisticated 
investor. It is a rather combustible mixture.
    To be sure, it is a highly misunderstood industry that is often 
mistaken for a single asset class, leaning in one direction and prone 
to a systemic melt down. In reality, the collective industry represents 
the universal exposure; to all assets, in all directions, in all 
markets. U.S. Treasury Under Secretary Randal Quarles referred to them 
recently as part of the evolution to ``complete markets.'' We would 
agree. There are legitimate regulatory concerns related to the extent 
of leverage by certain funds and the level and interplay of 
counterparty exposures on OTC positions. In our view however, this is 
not a house of cards poised for systemic disruption, rather a broad 
based, universal market exposure with pockets of concern.
    We are uncertain as to how to address this aspect of the hedge fund 
concern but would encourage a less prescriptive approach focused on 
greater disclosure by regulated counterparty entities that will reveal 
any serious imbalances in a market. The Financial Services Authority in 
the U.K. is currently reviewing whether regulators can get at the issue 
of potential systemic risk through more detailed and aggregated 
disclosures from the counterparty firms they already regulate.
    Over the last year, we have been meeting with global regulatory 
authorities about investment management practices and hedge fund 
practices in particular. The additional concerns we hear regarding 
hedge funds are as follows:

    There are concerns with side letters issued by hedge fund 
        managers that give priority for favored clients on things like 
        early exit or allow problem investments to be concealed.
    There are concerns that prime brokers have created hedge 
        fund ``incubator'' shops that are inducing very high trading 
        volumes and portfolio turnover in exchange for free office 
        space and operations support. There may be arrangements to get 
        hedge fund managers preferred access to issuers and breaking 
        information. These relationships are increasingly being viewed 
        as too cozy as hedge funds begin to dominate trading activities 
        in the stock market.
    Hedge fund promotion has become more attractive for pension 
        consultants due to the better fee structures. This may result 
        in conflicts with client knowledge and suitability.
    There are concerns with investor protection for retail 
        investors as products become more generally available.
    There are growing concerns about market integrity: such as 
        market manipulation, poor internal controls, and fraud by hedge 
        funds.

    The recent move in the U.S. to require registration of certain 
hedge fund managers under the Investment Advisers Act of 1940 may have 
addressed some of these concerns and we viewed such registration as an 
appropriate step. Registration does provide some level of deterrence 
and allows regular examination of managers directly. It also requires a 
documented compliance framework. However, it does little to address the 
primary systemic imbalance concern.
Investor Education and Hedge Fund Manager Conduct
    Our organization has been discussing the importance of investor 
education in the context of hedge funds. Investors must understand that 
they have a serious and significant responsibility to understand all 
investments, but in particular those that are less liquid and 
transparent. We have been working with other groups to address 
educational needs in the hedge fund sector and to provide investors 
with templates for reviewing, selecting and monitoring these managers. 
These include Hedge Funds http://www.cfainstitute.org/investors/
hedgefunds101.html that outlines five keys for would be hedge fund 
investors, including rules for investigating credentials, track record, 
the investment strategy and fee structure and the process for valuation 
and performance reporting. There are many other excellent resources 
available including: Best Practices in Hedge Fund Investing: Due 
Diligence for Global Macro and Managed Futures Strategies, developed by 
Greenwich Roundtable.
    Another key component of investor education is to understand what 
the manager of a hedge fund product should offer in terms of 
professional conduct and ethics to their investors. Investors in these 
funds need some assurance that they are being dealt with fairly and 
honestly. While we do not see any more prevalent fraud in this sector 
than in other areas of financial management, it remains the case that 
this is a less regulated, more independent sector of the funds 
management business. This is due to the fact that the hedge fund sector 
has traditionally been limited to more ``knowledgeable and 
sophisticated'' investors that understand the risks and engage in 
appropriate due diligence. We are not sure this is always the case and 
wanted to assist investors with their responsibility to know what they 
are getting into and what to look for.
    The Asset Manager Code of Professional Conduct (http://
www.cfainstitute.org/cfacentre/positions/pdf/asset_manager_code.pdf) 
sets forth a comprehensive template for what we believe every investor 
should expect and demand from their hedge fund manager. Its purpose is 
to promote an honest and verifiable approach to hedge fund management 
and to promote a self-regulatory approach to concerns being expressed 
by investors and regulators. It covers client loyalty, trading 
practices and compliance procedures, as well as a comprehensive process 
for disclosures, portfolio valuation and performance reporting.
Hedge Fund Performance Reporting
    On the issue of performance reporting, we have done much work. One 
of the more ``mischief prone'' areas in investment management is 
performance reporting and that certainly applies to the hedge fund 
industry as well. Recently, there have been a significant number of 
studies and articles on the topic of hedge fund performance numbers and 
calls for its regulation. On the matter of regulating performance 
reporting, we encourage caution. First, the performance data that 
people are generally critical of are broad-based, voluntary, private 
services that have all sorts acknowledged statistical shortcomings. 
Commentators claim these data significantly overstate hedge fund 
performance by 100 to 600 basis points and are misleading to investors. 
Second, we doubt whether many hedge fund investors are making 
investment decisions based on this information. A more appropriate 
solution is investor education. Any serious investor will understand 
that these are merely a general proxy for hedge fund performance. They 
will understand the critical importance of performance reporting at the 
individual fund level and the quality of the due diligence the investor 
must conduct to confirm and verify this performance.
    The Asset Manager Code provides a template for investors and 
managers to understand the various procedures needed to calculate and 
verify performance and promotes The Global Investment Performance 
Standards or GIPS' standards http://www.cfainstitute.org/
cfacentre/ips/gips/pdf/GIPS_2006.pdf. We believe the industry benchmark 
for historical performance reporting is the GIPS standards, which has 
been in development and use for nearly 10 years. The GIPS standards 
have become the industry standard in nearly 30 countries around the 
world. The broad GIPS standards do provide a framework for calculating 
and reporting hedge fund performance. For example, section 4.A.5, 
requires firms to disclose the presence, use and extent of leverage or 
derivatives (if material), including a sufficient description of the 
use, frequency and characteristics of the instruments to identify 
risks. In all, the GIPS standards provide a consistent and verifiable 
process that is comparable across managers. We believe this self-
regulatory approach to industry standards has been very constructive.
Conclusion
    Again we commend the members of the Subcommittee for your continued 
vigilance and leadership on this important industry topic. We fully 
expect hedge funds to continue to evolve and become a mature feature of 
the overall investment industry. Their ongoing regulation and oversight 
should match the pace of this evolution, with a view to foster 
flexibility and creativity but not at the expense of market integrity 
and confidence. We would encourage the Subcommittee and Congress to 
allow the new advisor registration to settle in and determine if 
further regulation of managers or funds is warranted.
                                 ______
                                 
                   PREPARED STATEMENT OF JAMES CHANOS
          Chairman, Coalition of Private Investment Companies,
                     President, Kynikos Associates
                              May 16, 2006
    Chairman Hagel, Ranking Member Dodd, and Members of the 
Subcommittee. My name is James Chanos, and I am President of Kynikos 
Associates, a New York private investment management company that I 
founded in 1985.\1\ I am appearing today on behalf of the Coalition of 
Private Investment Companies (``CPIC''), whose members and associates 
manage or advise an aggregate of over $30 billion in assets. I want to 
thank the Chairman and other Senators for their efforts to better 
understand how this important segment of the financial markets 
operates. I am honored to have the opportunity to testify before this 
Subcommittee.
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    \1\ Prior to founding Kynikos Associates, I was a securities 
analyst at Deutsche Bank Capital and Gilford Securities. My first job 
on Wall Street was as an analyst at the investment banking firm of 
Blyth Eastman Paine Webber, a position I took in 1980 upon graduating 
from Yale University with a B.A. in Economics and Political Science.
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     Since I last testified before the Senate Banking Committee in July 
of 2004 at its hearing on hedge fund regulation, the hedge fund 
industry has continued to grow and evolve, and the activities of 
industry members continue to generate attention by the press and by 
regulators. Indeed, the growth in the industry alone--which is now 
estimated to include over 10,000 funds with over $1 trillion under 
management \2\--is a matter of governmental interest, prompting recent 
statements by a Treasury Department official that the growth of capital 
accumulation through entities such as hedge funds and private equity 
funds is one of a number of ``structural'' changes in the markets 
warranting further examination by the Department.\3\
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    \2\ See A Review of Current Securities Issues before the S. Comm. 
On Banking, Housing, and Urban Affairs (statement of Christopher Cox, 
Chairman, SEC) Apr. 25, 2006 (unpublished transcript). Estimates of the 
number of hedge funds vary but the number of funds clearly is 
increasing. See Dane Hamilton, U.S. SEC says to target ``high risk'' 
hedge funds, Reuters, May 3, 2006, available at http://
today.reuters.com/misc (stating that industry estimates vary widely, 
but funds ``conservatively estimated to hold $1.1 trillion in assets 
and possibly much more.'') Liz Moyer, Why Hedge Funds?, Forbes.com Jan. 
11, 2006 (stating 8,350 funds in existence). Financial journals, citing 
Hedge Fund Research, stated that 2,073 new hedge funds--a record 
number--were created in 2005, while 848 were liquidated. These totals 
include 498 new funds of hedge funds launched and 165 funds of hedge 
funds liquidated. Amanda Cantrell, Hedge Funds Launch, Close In Record 
Numbers, CNNMoney.com Mar. 1, 2006; Liz Moyer, Hedge Fund Business 
Still Attracts Big Players, Forbes.com Mar. 1, 2006.
    \3\ Randall K. Quarles, Under Secretary of the Treasury for 
Domestic Finance, Remarks before the Annual Washington Conference of 
the Institute of International Bankers (Mar. 13, 2006), available at 
http://www.treas.gov/press/releases/js4114.htm
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     The Coalition of Private Investment Companies hopes to be helpful 
in furthering governmental understanding of the industry, and in the 
testimony below, we discuss the importance of the hedge fund industry 
and certain key issues and concerns that have been raised about it. 
There are a number of issues confronting policymakers in Washington in 
which hedge funds are involved. Some of these are broad issues about 
the evolution, safety and integrity of U.S. capital markets--where 
hedge funds are one of many key market participants, and some are 
issues that are unique to the hedge fund industry itself.
Hedge Funds--In General
Importance of the Hedge Fund Industry to the Financial Markets
    The financial and capital markets in the United States and in the 
developed world have been stunningly successful in providing capital 
and financing for economic growth and development, both in the United 
States and abroad. The fundamental integrity of the U.S. markets--and 
the knowledge that money can be invested in a staggering array of 
products, free from rampant corruption on the one hand and overly 
burdensome government control on the other--creates a powerful 
incentive for all kinds of businesses and individuals to invest in this 
country.
    Our markets benefit from the wide diversity of players--investment 
bankers and broker-dealers, commercial banks and savings institutions, 
mutual funds, commodity futures traders, exchanges and markets of all 
types, traders of all sizes, and a variety of managed pools of capital, 
including venture funds, private equity funds, commodity pools, and 
hedge funds, among others. While hedge funds are but one category of 
market participant, they serve a vitally important role in the United 
States and global markets. The importance of hedge funds to our markets 
has been acknowledged in the past by the President's Working Group on 
Financial Markets, the Commodity Futures Trading Commission, the 
Securities and Exchange Commission, and former Federal Reserve Board 
Chairman Alan Greenspan, as well as by the current Federal Reserve 
Board Chairman Bernard Bernanke, who in testimony before this committee 
last year called hedge funds a ``positive force in the American 
financial system.'' \4\
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    \4\ Hearing on the Nomination of Bernard S. Bernanke to be Member 
and Chairman of the Federal Reserve Board, S. Comm. on Banking, 
Housing, and Urban Affairs; (Nov. 15, 2005) (statement of Bernard 
Bernanke) (unpublished transcript). Other financial regulators also 
view hedge funds as a positive force. For example, the United Kingdom's 
Financial Services Authority, releasing a March 2006 report on hedge 
funds, reiterated its view that hedge funds are ``a vital segment of 
the financial services industry. In particular they play a fundamental 
role in the efficient reallocation of capital and risk, and remain an 
important source of liquidity and innovation in today's markets.'' 
Press Release, FSA (Mar. 23, 2006) available at www.fsa.gov.uk/pages/
Library/Communication/PR/2006/026.shtml
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    As the SEC has acknowledged, there is no statutory or regulatory 
definition of the term ``hedge fund.'' The term generally is used to 
refer to privately offered investment funds that invest primarily in 
liquid securities and derivatives, that are managed by professional 
investment managers, that in many cases use leverage, short-selling, 
active trading and arbitrage as investment techniques, and that are 
exempt from registration under the Investment Company Act of 1940 (the 
``1940 Act''). Interests in these funds are sold in private offerings, 
primarily to high net worth individuals and institutions.
    Hedge funds are as diverse as the individual managers who run them. 
They may invest in or trade a variety of financial instruments, 
including stocks, bonds, currencies, futures, options, other 
derivatives and physical commodities. Although funds that invest 
primarily in illiquid assets such as real estate, venture capital and 
private equity generally are not considered ``hedge funds,'' some hedge 
funds invest to some degree in private, illiquid investments. Some 
invest in securities and hold long term; some, such as the short fund 
managed by Kynikos, sell short; and some are long-short funds. Some are 
strictly traders. Many serve as important counter-parties to other 
players in the market who wish to offset risk. Others may become 
``activists'' and use a large equity position in a company to encourage 
management to make changes to increase shareholder value. Hedge funds, 
as a group, add to the depth, liquidity, and vibrancy of the markets in 
which they participate. Indeed, some of the most talented individuals 
in the financial markets are hedge fund managers, who bring their 
research and insight to bear on the value of various assets, thereby 
adding to the price discovery and efficiency of the markets as a whole.
Securities Regulation of Hedge Funds
    Hedge funds are an important alternative to the mutual fund model 
and provide flexibility to their managers to invest or trade using 
whatever products and strategies they choose in order to maximize 
returns. They are not, however, unregulated. Hedge funds are subject to 
the same restrictions on their investment and portfolio trading 
activities as most other securities investors, including such 
requirements as the margin rules \5\ (which limit their use of leverage 
to purchase and carry publicly traded securities and options), SEC 
Regulation SHO, \6\ (which regulates short-selling), the Williams Act 
amendments to the Securities Exchange Act of 1934 \7\ and related SEC 
rules (which regulate and require public reporting on the acquisition 
of blocks of securities and other activities in connection with 
takeovers and proxy contests), and the NASD's ``new issues'' rule 2790 
(which governs allocations of IPOs). Hedge funds must also abide by the 
rules and regulations of the markets in which they seek to buy or sell 
financial products. And, perhaps most important, hedge funds are 
subject to anti-fraud and anti-manipulation requirements, such as 
Section 10(b) of the Securities Exchange Act of 1934 \4\ and Rule 10b-
5, \9\ as well as insider trading prohibitions, both in the funds' 
investment and portfolio trading activities, and in the funds' offers 
and sales of units to their own investors.
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    \5\ 12 C.F.R.  220, 221.
    \6\ 17 C.F.R.  242.200-.203
    \7\ 7 Exchange Act  13(d), 13(e), 14(d), 14(e) and 14(f), 15 
U.S.C.  78m(d), 78m(e), 78n(d), 78n(e) and Sec.  78n(f).
    \8\ 15 U.S.C.  78j.
    \9\ 17 CFR  240.10b-5.
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    Hedge funds are also regulated by the terms of certain exemptions 
from registration under the Securities Act of 1933, the 1940 Act, and 
in some cases the Commodity Exchange Act, under which they operate.\10\ 
To meet these exemptions, they must limit their offerings to private 
placements with sophisticated investors, who are able to understand and 
bear the risks of the investment. The hedge fund must either limit its 
beneficial owners to not more than 100 persons and entities (typically 
all or most of whom are ``accredited investors''), or limit its 
investors to super-accredited ``qualified purchaser'' individuals with 
over $5 million in investments and institutions with over $25 million 
in investments. Hedge funds typically file exemptive notices with the 
SEC and state securities commissioners under Regulation D, and many 
also file with the National Futures Association under the Commodity 
Exchange Act exemptions by which they operate (which impose their own, 
additional restrictions on sophistication and qualifications of 
investors).
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    \10\ See Implications of the Growth of Hedge Funds, Staff Report to 
the United States Securities and Exchange Commission, at x, 68-72 
(Sept. 2003), available at http://www.sec.gov/news/studies/
hedgefunds0903.pdf (``Staff Report'').
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    These exemptions are not ``loopholes'' or accidental omissions from 
regulatory coverage, but are instead well-considered exemptions enacted 
by Congress and implemented by the SEC and CFTC, through carefully 
crafted rules, developed in notice and comment rulemakings and in 
recognition of the importance and functions of private investment funds 
to investors and to the markets. The fact that hedge funds are not 
regulated as mutual funds and, therefore, not subject to the additional 
restrictions imposed by the 1940 Act--restrictions intended to protect 
the less wealthy and less experienced investors who invest in those 
traditional retail funds--not only gives investors (those who qualify 
under the various conditional exemptions imposed by the SEC) more 
choices, but adds to the diversity, depth and efficiency of the 
markets.
The SEC's New Hedge Fund Adviser Registration Rule
    Earlier this year, it was reported that more than 900 hedge fund 
managers newly registered with the SEC as a result of the hedge fund 
adviser rule.\11\ SEC Chairman Cox more recently testified that, 
together with those who were registered prior to the rule's adoption, 
there now are 2400 hedge fund managers registered with the SEC as 
investment advisers.\12\ Thus, a substantial portion of the industry, 
as measured by assets under management, is now subject to SEC 
examination and oversight. However, in order to exclude managers of 
private equity funds from the adviser registration requirement, the SEC 
drafted the rule to exclude advisers to funds with lockup periods of 2 
years or more, thus providing a relatively easy avenue for managers who 
wish to avoid registration.\13\ We continue to believe that the 
Investment Advisers Act (the ``Advisers Act'') is an awkward statute 
for providing the SEC with the information it seeks--since many fund 
managers still are not registering--and for dealing with the broader 
issues that are outside the Act's purposes and which also cross the 
jurisdictions of several agencies.
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    \11\ See Eleanor Laise and Rachel Emma Silverman, Dissecting Hedge-
Fund Secrets--Wealth Managers Say SEC-Required Revelations Won't 
Replace Due Diligence, Wall St. J., Feb. 4, 2006 at B5.
    \12\ Cox Statement, supra n.2.
    \13\ Alternatives were suggested to the Commission. For example, 
comments filed by Kynikos on the proposed rule recommended that the 
SEC, by rule, make the safe harbor counting rule previously utilized by 
hedge fund managers under SEC Rules 203(b)(3)-1 and 222-2 under the 
Advisers Act, which implemented the client counting rules in Sections 
203(b)(3) and 203A of the Advisers Act, contingent upon written receipt 
by the SEC of certain basic information about the fund, as well as 
certification by managers of the fund of certain key investor 
protections provided in the Advisers Act and related SEC rules.
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Key Issues for Policy Makers
Hedge Funds, Financial Markets, and Systemic Risk
    There are those who argue that hedge funds, as an industry, should 
not be considered as a factor in evaluating potential systemic risks to 
the U.S. and global financial system. While we agree that hedge funds 
do not warrant greater scrutiny than any other market participant--such 
as depository institutions, investment banks, insurance companies, 
mutual funds or exchanges--we do not believe that hedge funds should 
somehow be exempt from consideration. Moreover, we understand that key 
U.S. policymakers are adopting the approach of including hedge funds--
as a group--in their ongoing oversight of the financial markets in 
order to evaluate the potential for problems that could affect the 
financial system more broadly. For example, Federal Reserve Board 
Chairman Bernanke, appearing before this Committee last November, 
testified that it is important for the Federal Reserve to be aware of 
what is going on in the market and to understand hedge fund strategies 
and positions by working through banks, which are the counter-parties 
of many hedge funds. He also said he believed that much had changed 
since the near-collapse of Long-Term Capital Management in 1998--and 
that the hedge fund industry has become more sophisticated, more 
diverse, less leveraged, and more flexible.\14\
---------------------------------------------------------------------------
    \14\ Bernanke Statement, supra n.4
---------------------------------------------------------------------------
    Further, the Department of the Treasury also has noted the 
importance of understanding hedge funds and their impact on the 
financial markets. In March of this year, Treasury Under Secretary 
Quarles announced that the Department is examining whether the growth 
of derivatives and hedge funds holds the potential to change the 
overall level or nature of risk in markets and financial 
institutions.\15\ However, keeping this in perspective, he listed the 
growth of hedge funds, as well as private equity funds, as among a 
number of structural changes to be reviewed by Treasury.\16\ We commend 
Under Secretary Quarles for emphasizing that Treasury will think about 
these changes not in a fragmented fashion, broken out by industry or 
product, as has been done in the past, but in a comprehensive way.
---------------------------------------------------------------------------
    \15\ Quarles Remarks, supra n.3
    \16\ The other changes he identified include the greater systemic 
importance of a smaller number of large bank-centered financial 
institutions, the greater role played by non-bank financial 
institutions, the rapid growth of GSEs, greater operational demands on 
the core of the clearing and settlement structure, an increase in the 
complexity of risk management and compliance challenges, and the extent 
of global financial integration.
---------------------------------------------------------------------------
    We also note that in one fast growing market--that for credit 
default swaps and other types of over-the-counter credit derivatives--
hedge funds are playing a very significant role as purchasers and 
liquidity providers. Because of the unique nature of these products, 
this is one market where several regulators, including the Treasury 
Department \17\ and the Federal Reserve Bank of New York, \18\ are 
focusing attention and have recently taken steps to facilitate 
coordination among market participants. We also believe that the 
comments of the United Kingdom's Financial Services Authority regarding 
potential risks in this market warrant consideration.\19\ This market 
has become increasingly important for companies who access the credit 
markets, as well as for market participants, including hedge funds, 
that provide significant liquidity and pricing efficiency. We believe 
this is a market that merits the continued attention of regulators and 
policymakers.
---------------------------------------------------------------------------
    \17\ Emil Henry, Treasury Assistant Secretary for Fin. 
Institutions, Remarks to the Federal Reserve Bank of Atlanta (Apr. 18, 
2006), available at http://www.treasury.gov/press/releases/js4187.htm
    \18\ See e.g., Ramez Mikdashi and Mark Whitehouse Derivatives Firms 
Tackle Backlog Wall St. J., Mar. 14, 2006, at C4.
    \19\ ``Regulators watched with interest the recent, surprisingly 
significant (given the degree of anticipation of the event), impact of 
the credit rating downgrade of General Motors (GM) and Ford upon the 
hedge fund sector and related market participants. In this situation, 
no financial stability event developed, however, it was interesting to 
observe commonalities in losses by hedge funds pursuing similar 
strategies (together with losses in counterparties to these funds) and 
losses in individual funds or clusters of funds leading to investor 
redemption and enforced liquidation of assets. The full effects of this 
event may not yet have been felt, with possible changes to structuring, 
trading, risk management, liquidity and investment remaining a 
possibility (with potential implications for the long term viability of 
individual funds/fund managers.)'' Hedge Funds: A discussion of risk 
and regulatory engagement; Discussion Paper 05/4;Financial Services 
Authority of the United Kingdom at 20-21 (June 2005), available at 
www.fsa.gov.uk/pubs/discussion/dp05_04.pdf
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Rise of ``Activist'' Funds
    Well-known corporate lawyer Marty Lipton has warned about a group 
of ``activist'' hedge funds who are pressuring companies to make 
changes in order to increase their share prices.\20\ He calls this 
activity a ``replay of the attempt to drive American business to short-
term results instead of long-term values,'' and he terms this more 
dangerous than the ``junk bond bust-up greenmail activity of the '70s 
and '80s.'' While activist investors represent only a small part of the 
overall picture, they have had a higher profile due to press accounts 
of their activities at companies like Time Warner and Wendy's 
International. The press also has been quick to report on management's 
characterization of these investors as ``raiders'' or short-term 
investors, intent upon pushing a company to take actions to bump up 
share prices for quick profits.
---------------------------------------------------------------------------
    \20\ Andrew Ross Sorkin, To Battle, Armed with Shares, N.Y. Times, 
Jan. 4, 2006 at C1.
---------------------------------------------------------------------------
    These arguments are not new but are similar to ones made during the 
wave of corporate takeover and restructuring activity in the 1980s. 
Yet, after a lengthy examination of that activity and dozens of 
studies, reports, and congressional hearings, neither the Congress, the 
SEC, nor any other government agency took steps to curb the activity, 
which many believed was beneficial. The 1985 Economic Report of the 
President stated that ``mergers and acquisitions increase national 
wealth, [t]hey improve efficiency, transfer scarce resources to higher 
valued uses, and stimulate effective corporate management.'' \21\ 
Active investors have helped to weed out deficient management, or 
unlock value by pressuring management to separate a firm's productive 
units into independent operations that can produce goods, services and 
employment more efficiently than if they were otherwise bound together. 
A recent study also showed that activist institutional shareholders can 
cause CEO compensation to more closely track return on investment, 
rather than balloon with increases in firm size.\22\ Activist investors 
offer ideas and business expertise that should not be dismissed by 
corporate managers.\23\
---------------------------------------------------------------------------
    \21\ Economic Report of the President, 196 (Washington: U.S. 
G.P.O., Feb. 1985).
    \22\ Wright, Kroll, and Elenkov, Acquisition Returns, Increase in 
Firm Size, and Chief Executive Officer Compensation: The Moderating 
Role of Monitoring, Academy of Management Journal, v. 45, June 2002, 
available at www.aomonline.org
    \23\ This was reported to be the case with Lear, a manufacturer of 
vehicle seats and interiors, which had earlier ignored the advice of a 
large shareholder to refinance its debt. Jesse Eisinger, Long and 
Short: Lear Case Shows Sometimes Investors Can Detect Crises Before 
Management, Wall St. J., Mar. 15, 2006, at C1. After announcing recent 
restructuring efforts, its share value climbed almost 50 percent.
---------------------------------------------------------------------------
    This is not to say that all such activity produces optimum business 
results. However, the beauty of our market system is that business 
owners--the shareholders--are free to make choices in the marketplace 
for competing ideas about how a business should be managed.
    Jana Partner's Barry Rosenstein recently wrote that 
characterization of activists as ``sharks,'' ``raiders,'' and ``short-
term investors'' versus CEOs defending the ``long term'' investors 
misses the point.\24\ Of course activist hedge funds invest for 
profit--after all, that's the American way--and they seek to shake up 
poor performing managers in order to cause the stock price to reflect a 
company's real value, which is in the best interests of all 
shareholders. As Rosenstein points out, portraying managers as 
``defenders'' of a corporation versus its ``attackers'' misrepresents 
the nature of these contests, which really are campaigns between 
managers and the activists for the support of the company's 
shareholders. As this Committee knows too well, corporate CEOs and 
managers often need ``watchdogs'' to monitor their actions. When those 
watchdogs are activist shareholders pushing managers to take steps to 
increase shareholder value, the ultimate beneficiaries of their 
activity are the shareholders--the owners--of the corporation. One of 
the goals of the Sarbanes-Oxley Act was to make management more 
responsive to shareholders. It is ironic that shareholders who are 
willing to engage themselves to push management to be more accountable 
should be so miscast.
---------------------------------------------------------------------------
    \24\ Barry Rosenstein, Why activism is good for all shareholders, 
Fin. Times, Mar. 9, 2006.
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Unlawful Hedge Fund Activity
    Another criticism of hedge funds relates to charges of illegal 
activity by funds--a criticism often coupled with statements about the 
``unregulated'' nature of hedge funds. As discussed above, although 
hedge funds are exempt from registration under the Investment Company 
Act, they are subject to a panoply of legal requirements and liability, 
including liability for fraud, insider trading, and market 
manipulation. Recent high profile cases have involved misappropriation 
of investor assets (e.g., Bayou Funds, International Management 
Associates, LLC), \25\ and cases such as those announced earlier this 
year where the SEC settled charges against three affiliated hedge funds 
and their portfolio manager for insider trading, wash trades and 
illegally using restricted stock to cover short sales.\26\ While we do 
not have personal knowledge of these particular cases, CPIC strongly 
supports vigorous action by the SEC, and criminal authorities where 
appropriate, against any market participant engaged in these types of 
activities, which not only harm investors, but foster mistrust and lost 
of confidence in our markets.
---------------------------------------------------------------------------
    \25\ SEC v. Samuel Israel III, SEC Litigation Release No. 19406, 
2005 WL 2397234 (Sept. 29, 2005) (According to the SEC, managers of a 
group of hedge funds known as the Bayou Funds grossly exaggerated 
claims regarding the funds' performance, when in fact, the funds had 
never posted a year-end profit); SEC v. Kirk S. Wright, SEC Litigation 
Release No. 19581 2006 WL 487825 Feb. 28, 2006) (According to the SEC, 
fund managers engaged in an ongoing fraud involving sales of interests 
in hedge funds, based upon false claims of profits and bogus account 
statements).
    \26\ SEC v. Langley Partners, L.P., SEC Litigation Release No. 
19607, 2006 WL 623053 (Mar.14, 2006).
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    That said, it would be inaccurate and unfair to suggest that 
unlawful activity in the hedge fund industry is disproportionate to 
that in other, more regulated, areas of the financial markets.\27\ 
There are miscreants in every industry, and all participants in our 
markets--whether they are hedge fund managers, brokers, issuers, or 
accountants--need to do a better job of vigilance to assure that crooks 
do not undermine confidence in the integrity of our markets and the 
millions of honorable professionals who work in them. In addition, 
changes in practice, standards, and regulation can and should be made 
where appropriate to lessen the opportunities for abuse. In the 
discussion below, we note that the area of valuation is an area of 
concern.
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    \27\ See Registration Under the Advisers Act of Certain Hedge Fund 
Advisers, Release No. IA-2333 (Dec. 2, 2004), 69 Fed. Reg. 72054, 
72092--72096 (Dec. 10, 2004) (dissenting statement of Commissioners 
Glassman and Atkins).
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Valuation--Performance Reporting
    We believe valuation is an area of hedge fund activity open to 
abuse--both as to the potential for outright fraud, and as to the lack 
of or failure of adequate models or policies and procedures to conduct 
valuation of derivatives, other illiquid assets, or securities for 
which market prices are not readily available. Performance reporting is 
another area of confusion and potential for abuse. Neither problem is 
addressed by the requirement that hedge fund advisers register with the 
SEC.
    Proper valuation of fund assets is an extremely important component 
of investor protection. Valuations serve many crucial functions, and it 
therefore is important that they be accurate and performed in an 
unbiased, consistent and transparent manner. Valuations of assets and 
liabilities are used to determine the value of the units of the fund 
owned by investors. As a reported number, this tells the investor what 
his or her investment is worth at a given point in time. These numbers 
also determine the price at which new units are issued and existing 
units are redeemed. To avoid dilution and unfairness, these numbers 
must be accurate and unbiased. Valuations are used to determine the 
compensation of the hedge fund's managers which typically is a 
percentage of the asset value of the fund during a month, quarter or 
year, and a percentage of the increase in value of the fund of the past 
year. Valuations are also used to calculate performance reporting 
numbers, to inform investors how the fund is performing over time, both 
in absolute return terms, relative to the relevant market index 
benchmarks, and under various statistical measures of volatility and 
tracking that are designed to measure risk and the degree to which the 
fund manager sticks to its investment strategy.
    The consistency and uniformity of performance reporting also is an 
area of concern. It goes to the heart of an investor's ability to 
choose wisely among a myriad of financial and investment products--
giving the investor an ``apples vs. apples'' choice--a true comparison. 
However, as discussed in a recent article coauthored by noted economist 
Burton Malkiel, \28\ the main sources of comparative statistics on the 
performance of hedge fund managers are the data bases of private 
vendors, which he says have systematically overstated annual 
performance by hedge funds and funds of funds. He notes that managers 
can select a starting date for reporting to maximize returns, that the 
data bases have a ``survivorship bias'' (they do not take into account 
funds that have gone out of existence), and that the returns are non-
standardized. Others have noted the temptation for some hedge fund 
managers to manage returns upward at year end in order to achieve 
performance-based incentive compensation--just as managers of 
registered investment companies may inflate year-end portfolio 
prices.\29\
---------------------------------------------------------------------------
    \28\ Burton G. Malkiel and Atanu Saha, Hedge Funds: Risk and 
Return, Fin. Analysts J., Vol. 61, No. 6 (2005), available at http://
www.cfapubs.org
    \29\ Vikas Agarwal, Naveen D. Daniel, and Narayan Y. Naik, ``Why Is 
Santa so Kind to Hedge Funds? The December Return Puzzle!'' (Mar. 9, 
2006), available at http://ssrn.com/abstract=891169
---------------------------------------------------------------------------
    Hedge funds are subject both to GAAP accounting standards, and to 
Federal and state anti-fraud restrictions in their performance 
reporting. The SEC Staff has issued a long series of letters 
delineating performance calculation, reporting and disclosure 
requirements for registered and exempt investment advisers, under the 
anti-fraud provisions of the Advisers Act, and SEC enforcement orders 
in this area further illuminate the expectations of the SEC on 
performance reporting.\30\ Those managers who stray from the SEC's 
valuation and performance reporting precepts are subject to 
administrative enforcement actions and private civil liability under 
the anti-fraud provisions of the Federal securities laws. When 
investment managers miscalculate and misrepresent performance 
statistics they are engaging in fraud. They are like baseball players 
using corked bats and steroids to improve their statistics.
---------------------------------------------------------------------------
    \30\ Further, an academic and industry organization, the CFA 
Institute (formerly known as AIMR) headquartered in Charlottesville 
near the University of Virginia, promulgates widely followed but 
voluntary standards for performance reporting by investment managers.
---------------------------------------------------------------------------
    It is true that registered investment advisers are required to 
adopt policies and procedures on valuation issues, provide GAAP 
accounting statements, and follow SEC Staff guidance on performance 
reporting for their hedge funds. Unfortunately, SEC guidance on 
valuation of securities, derivatives and other assets for which a 
market quotation is not readily available was adopted decades ago in a 
different and less sophisticated era, and essentially requires the use 
of good faith estimates, not a clear and uniform methodology. Guesswork 
and proprietary models are what are available. GAAP is not much better, 
and FASB has been struggling of late to promulgate clearer guidance on 
valuation issues.\31\ As active trading vehicles, hedge funds that 
provide audited financial statements (as most do) are subject to 
accounting requirements that the values of all of their portfolio 
positions be calculated at current market or fair value (i.e. ``marked 
to market'') for each reporting period. For many assets--including many 
of the newer or exotic derivatives that do not trade on an exchange--
the standard is not mark to market, it may be instead mark to your best 
guess of current value.\32\ Consequently, unscrupulous investment 
managers can exploit these deficiencies to artificially inflate both 
the value of their investments and their profitability. Indeed, 
registered investment companies have long been subject to detailed 
portfolio valuation requirements and performance reporting standards 
under the 1940 Act, and yet false and inaccurate valuation and 
performance reporting has remained a vexing problem for investors in 
registered funds.\33\
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    \31\ See FASB Report: FASB Adds Project To Improve Fair Value 
Measurement Guidance, (June 30, 2003) (announcing project to codify and 
improve guidance for measuring fair value) and Project Updates: Fair 
Value Measurements (Jan. 30, 2006) (On January 25, 2006, FASB discussed 
issues raised by reviewers on an October, 2005 working draft of a final 
FASB Statement, Fair Value Measurements), available at www.fasb.org/
project/fv_measurement.shtml
    \32\ We note that the 2-year lock-up exemption from private fund 
manager registration under the Advisers Act lends itself best to funds 
that invest in illiquid assets--and illiquid assets are the ones for 
which valuation issues are most extreme. Therefore, the current hedge 
fund manager registration requirement is not particularly well targeted 
at improving valuation practices at these types of private investment 
funds in particular.
    \33\ See, e.g., In the Matter of FT Interactive Data, f/k/a 
Interactive Data Corp., Investment Company Act Release No. 26291 (Dec. 
11, 2003); SEC v. Heartland Group, Inc., Litigation Release No. 16938, 
2001 WL 278474 (Mar. 22, 2001); White v. Heartland High-Yield Mun. Bond 
Fund, 237 F. Supp. 2d 982 (E.D. Wis. 2002); In the Matter of Piper 
Capital Mgmt., Inc., Investment Company Act Release No. 26167 80 S.E.C. 
Docket 2791 (Aug. 26, 2003); In the Matter of the Rockies Fund, 
Investment Company Act Release No. 26202 81 S.E.C. Docket 534 (Oct. 2, 
2003).
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    Despite the existing requirements on valuations and performance 
reporting, there is substantial room for improvement in this area by 
hedge funds, mutual funds and other investment management vehicles.\34\ 
We believe that valuation and performance reporting issues are 
appropriate governmental concerns--but first and foremost, they should 
be the concern of any fund manager or other market participant, as well 
as hedge fund investors.\35\ In our view, the appropriate role for 
government in this area is to facilitate and encourage a dialog among 
experts from across the financial services industry, academia, the 
accounting profession, economists and others, on valuation issues and 
best practices. For example, the U.K.'s Financial Services Authority 
and the International Organization of Securities Commissions have a 
project underway to examine the valuation policies and procedures 
employed by hedge funds and their counterparties and to work with 
industry representatives to develop a global set of principles that 
will attract global consensus.\36\
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    \34\ The situation is most acute for positions in complex and 
illiquid assets, for which there is not a reporting market providing a 
transparent daily consensus valuation. By necessity, estimates and 
pricing models must be used to value these types of fund portfolio 
positions, and there is much opportunity for mischief. In the 
derivatives area in particular, hedge funds should delineate their 
unrealized derivative gains and losses by breaking them out on the 
income statement and balance sheet. This will aid transparency and is 
simply good public policy.
    \35\ The Managed Fund Association, for example, in its publication 
``MFA's 2005 Sound Practices for Hedge Fund Managers,'' addresses the 
importance of hedge fund managers establishing valuation policies and 
procedures that are fair, consistent and verifiable, and it discusses a 
number of steps hedge fund managers should take in pricing assets and 
performing valuations. Available at www.mfaininfo.org/images/PDF/
MFA2005SoundPracticesPublished.pdf
    \36\ See Hedge Funds: A discussion of risk and regulatory 
engagement, Feedback Statement 06/2 Financial Services Authority of the 
United Kingdom, at 24-26 (March 2006) available at www.fsa.gov.uk/pubs/
discussion/dp05_04.pdf
---------------------------------------------------------------------------
    We would also point out that valuation issues cannot be solved by 
the SEC acting alone. Valuation of over-the-counter derivatives or 
other types of illiquid investments is a topic that rightly must 
involve all of the members of the President's Working Group, and in 
particular, the Board of Governors of the Federal Reserve System, to 
ensure consistency and harmony.
The ``Retailization'' of Hedge Funds
    An area of concern raised by both the SEC and state regulators has 
been the ``retailization'' of hedge funds, \37\ meaning, the sale of 
hedge funds to a broader group of less wealthy, less sophisticated 
investors than in the past. The Federal securities laws and SEC rules 
have long recognized that sophisticated and high net worth investors 
are able to bear greater risks than those with less sophistication or 
modest means. Thus, hedge funds generally accept investments only from 
``accredited investors'' or ``qualified purchasers,'' as defined in SEC 
rules that set out minimum qualifications for individuals relating to 
their net worth and income. CPIC believes these same concepts should 
apply in the future, though they should be updated.
---------------------------------------------------------------------------
    \37\ See Investor Protector Implications of Hedge Funds before the 
S. Comm. on Banking, Housing, and Urban Affairs, (Apr. 10, 2003) 
(statement of William Donaldson, Chairman, SEC), available at 
www.banking.senate.gov/03-04hrg.04103.donaldsn.pdf
---------------------------------------------------------------------------
    When Regulation D, the SEC's private offering exemption, was 
adopted over twenty years ago, its definitions of ``accredited 
investor'' included individuals whose annual income exceeded $200,000, 
or whose net worth (or joint net worth with that of a spouse) exceeded 
$1 million. Those standards remain unchanged today. Meanwhile, as the 
SEC has acknowledged, inflation and growth in income levels have led to 
a substantial increase in the number of investors who are now 
``accredited,'' though not necessarily financially sophisticated.\38\
---------------------------------------------------------------------------
    \38\ Staff Report, supra n.10, at 80.
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    In general, the investment strategies of private investment funds 
involve substantial risk and illiquidity, and they are not appropriate 
for the average investor. It may be time to re-examine the accredited 
investor standard. When Congress enacted an expansion of the qualified 
purchaser exemptions in 1996, it used the criteria of $5 million in 
``investible assets''--a more selective barrier than that used to 
define ``accredited investor''--as the presumptive basis for market 
sophistication. Other approaches might include a higher net worth 
requirement together with a limit on investment in a fund to a 
percentage of an individual's net worth (some states, such as 
California and North Carolina, historically have used a cap on 
privately placed investments at 10 percent of the investor's net worth 
as a rough benchmark or limit, while others have used a 20 percent 
limit).\39\
---------------------------------------------------------------------------
    \39\ Compare 10 Cal. Code Regs. Tit. 10, Sec.  260.140.01; 18 N.C. 
Admin. Code 6-1206 (20060; with 003-14-006 Ark. Code R. Sec.  504 (Weil 
2006).
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Funds of Hedge Funds
    Another aspect of the retailization issue is the growth of ``funds 
of funds''--the term used to describe an investment company that 
invests in hedge funds rather than individual securities. Some of these 
funds of hedge funds have registered their securities with the SEC, 
enabling them to sell shares to retail investors. The SEC Release 
accompanying its private fund registration rule stated that, although 
``[m]ost funds of hedge funds are today offered only to institutional 
investors . . . there are no statutory limitations on the public 
offering of these funds.'' \40\ The SEC Staff Report on hedge funds 
also noted the Staff's concern that investors may not understand the 
impact of multiple layers of fees in funds of hedge funds, or that 
funds of hedge funds may expose them to levels and types of risks that 
are not appropriate.\41\ We note that some of the more publicized funds 
of hedge funds being marketed to the ``retail'' investor are being sold 
by large broker-dealers with significant retail distribution networks. 
The Staff Report also expressed concern with ``the reliability of 
registered [funds of hedge funds] calculations of net asset value 
[because] [t]here are no readily available market prices for hedge fund 
securities.'' \42\
---------------------------------------------------------------------------
    \40\ Registration of Certain Hedge Fund Advisers, supra n.27 at 
72057.
    \41\ Staff Report, supra n.10 at xii, 68-72.
    \42\ Id. at 81.
---------------------------------------------------------------------------
    We suggest that the SEC consider some of the measures suggested by 
the Staff in its hedge fund report. In particular, the SEC may wish to 
consider rules prohibiting registered investment companies from 
investing in hedge funds unless their directors have adopted procedures 
designed to ensure that the funds value those assets consistently with 
the requirements of the 1940 Act.\43\
---------------------------------------------------------------------------
    \43\ Id. at 99.
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Role of Short Sellers
    Let me say a brief word about short selling, which is one of the 
strategies used by hedge funds. The SEC and self-regulatory 
organizations repeatedly have recognized that short sellers bring 
important liquidity and a sense of skepticism to the marketplace.\44\ 
Short sellers test the ideas put forward by management; they often help 
the marketplace and enforcement agencies ferret out genuine fraud. In 
fact, some of the most spectacular corporate frauds--Enron, Tyco, 
Conseco, and Sunbeam, to name just a few--were first uncovered by short 
sellers.
---------------------------------------------------------------------------
    \44\ Staff Report at 40. According to the SEC staff, ``Short 
selling . . . can contribute to the pricing efficiency of the markets. 
. . . When a short seller speculates on . . . a downward movement in a 
security, the transaction is a mirror image of the person's who 
purchases the security based upon speculation that the security's price 
will rise . . . . Market participants who believe a stock is overvalued 
may engage in short sales in an attempt to profit from a perceived 
divergence of prices from true economic values. Such short sellers add 
to stock pricing efficiency because their transactions inform the 
market of their evaluation of future stock price performance. This 
evaluation is reflected in the resulting market price of the 
security.''
---------------------------------------------------------------------------
    But notwithstanding these benefits, short selling is subject to 
significant regulatory restraints and costs, as well as attacks from 
issuers and other market participants who have a stake in seeing the 
price of a security go up. Short sellers must borrow stock that is sold 
short, must post collateral, pay interest, carry the costs of borrowing 
often for months or longer, risk upward price movement, post additional 
collateral requirements if the price of the stock moves against them, 
and bear the risk that borrowed shares will suddenly be recalled by the 
lender. Short sellers are subject to potential ``short squeeze'' 
manipulation. Short selling is costly, and risky--prompting one 
commentator to write, ``It's a wonder anyone does it at all.'' \45\
---------------------------------------------------------------------------
    \45\ Jesse Eisinger, Long and Short: It's a Tough Job, So Why Do 
They Do It? The Backward Business of Short Selling, Wall St. J., Mar. 
1, 2006, at C1.
---------------------------------------------------------------------------
    The SEC has an ongoing examination program to determine compliance 
with Regulation SHO, which became effective less than 2 years ago, and 
Chairman Cox has stated that he will recommend changes in the rule if 
the exams demonstrate the need for such modifications. The SEC also has 
been aggressive in bringing enforcement actions against market 
participants who use short selling strategies to manipulate and drive 
down the price of a security.\46\ We support these actions by the SEC 
and believe they are essential to protect investors and ensure the 
integrity of the markets as a whole, as well as to assure that short 
sellers who play by the rules will continue to perform the important 
role they have played in bringing healthy skepticism and liquidity to 
the markets.
---------------------------------------------------------------------------
    \46\ See, e.g., SEC v. Langley Partners, L.P., SEC Litigation 
Release No. 19607, 2006 WL 623053 (Mar. 14, 2006); SEC v. Andreas 
Badian, SEC Litigation Release No. 19639, 2006 WL 859248 (Apr. 4, 
2006).
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The Importance of the Financial Press and Independent Research and 
        Analysis
    Bearing these principles in mind, I want to take this opportunity 
to discuss an important issue, which was highlighted by the controversy 
over SEC-issued subpoenas to financial reporters earlier this year.
    Just as the U.S. and global financial and securities markets 
benefit from a wide diversity of market participants with competing 
views and trading and investing strategies, they also benefit from a 
vigilant, hard-working, and skeptical financial press.
    Earlier this year, the SEC enforcement staff sent subpoenas to 
certain financial reporters requiring the production of any evidence of 
communications between the reporters and certain stock analysts and 
short-selling funds that had expressed criticism of particular 
companies and their management. The subpoenas were quickly recalled, 
and SEC Chairman Cox issued the following statement, ``The sensitive 
issues that such a subpoena raises are of sufficient importance that 
they should, and will be, considered and decided by the Commission 
before this matter proceeds further.\47\
---------------------------------------------------------------------------
    \47\ Press Release, SEC, Statement by Securities and Exchange 
Commission Chairman Christopher Cox Concerning Subpoenas of 
Journalists, (Feb. 27, 2006), available at http://www.sec.gov/news/
press/2006-24.htm
---------------------------------------------------------------------------
    In an interview in the Wall Street Journal appearing the following 
day, Chairman Cox cited the ``symbiosis'' between the work of the SEC 
and the business media, and explained that in order not to chill the 
disclosure of information that both government and reporters should 
promote, such subpoenas would be ``extraordinary.'' Chairman Cox noted 
that the SEC's ``regulatory mission in major part requires us to ensure 
all material information is divulged in the first instance. Unless it 
is publicized . . . markets cannot function. We don't want to do 
anything therefore to chill that activity.'' \48\
---------------------------------------------------------------------------
    \48\ Kara Scannelli, Cox Knocks Journalist Subpoenas, Wall St. J., 
Feb. 28, 2006, at C1.
---------------------------------------------------------------------------
    On April 12, the SEC expanded on these concepts in a policy 
statement, stating ``Effective journalism complements the Commission's 
efforts to ensure that investors receive the full and fair disclosure 
that the law requires, and that they deserve. Diligent reporting is an 
essential means of bringing securities law violations to light and 
ultimately helps to deter illegal conduct.'' \49\
---------------------------------------------------------------------------
    \49\ Press Release, SEC, Policy Statement of the SEC Concerning 
Subpoenas to Members of the News Media (Apr. 12, 2006), available at 
http://www.sec.gov/news/press/2006/2006-55.htm
---------------------------------------------------------------------------
    These statements demonstrate an awareness of the legitimate role of 
the business press and the critical need for the free interchange of 
information and opinion in the nation's securities markets. Indeed, the 
principal theory behind the First Amendment itself is that its 
protections recognize the value of a ``marketplace of ideas.'' \50\
---------------------------------------------------------------------------
    \50\ See J.S. Mill, On Liberty, (1859); Abrams v. United States, 
250 U.S. 616, 630, 40 S.Ct. 17, (1919) (Holmes, J., dissenting).
---------------------------------------------------------------------------
    The ability of business journalists to communicate with sources is 
of paramount interest to the functioning of the markets, as is the 
ability of securities analysts to disseminate their views free from 
retaliation by issuers. Independent analysts, who sell their research 
and analyses to customers who pay for their services, whether by 
subscription or by individual report, offer a particularly valuable 
service to our markets. They are not associated with investment banking 
firms and do not face the temptation to issue overly bullish analyses 
in order to acquire other business. As this Committee is all too aware, 
the pervasive conflicts of interest among securities analysts employed 
by major investment banks led to the adoption of Title V of the 
Sarbanes-Oxley Act of 2002 and subsequent rulemaking proceedings, as 
well as enforcement actions by the SEC, the self-regulatory 
organizations, and state securities regulators--all designed to reduce 
or eliminate the source of their conflicts within investment banking 
firms and make analysts reports more objective and useful to investors 
who rely on them. Hearings before this Committee in 2002 revealed that, 
not only were analysts induced to write favorable reports by receiving 
compensation from their firms for their role in capturing investment 
banking business, but they faced retaliation from issuers for negative 
coverage.\51\
---------------------------------------------------------------------------
    \51\ Thomas Bowman, President and CEO of the Association for 
Investment Management and Research, testified that ``[i]ssuers . . . 
bring lawsuits against firms and analysts personally for negative 
coverage. But more insidiously, they `blackball' analysts by not taking 
their questions on conference calls or not returning their individual 
calls to investor relations or other company management. This puts the 
`negative' analyst at a distinct competitive disadvantage, increases 
the amount of uncertainty an analyst must deal with in doing valuation 
and making a recommendation, and disadvantages the firm's clients, who 
pay for that research.'' [S. Rep. No. 107-205, at 38 (2002)]
---------------------------------------------------------------------------
    The Sarbanes-Oxley Act does not address retaliation by issuers. 
Nonetheless, in a letter to Senator Ron Wyden in September 2005, 
Chairman Cox stated that it was a matter of concern, and that the SEC 
was contemplating action to protect stock analysts from retaliation by 
issuers. In a memorandum accompanying the letter, the SEC staff related 
that it had contacted nine unidentified ``multi-service'' broker-
dealers and found that at least six believed they had experienced 
retaliation from issuers for negative reports. This is all the more 
troubling, in that such ``multi-service'' firms are, most likely, 
investment banking powerhouses with the clout and deep pockets to 
defend themselves.\52\
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    \52\ Letter from Christopher Cox, Chairman, Securities and Exchange 
Commission, to the Honorable Ronald Wyden, U.S. Senate, (Sept. 1, 
2005). Unfortunately, issuer retaliation appears to be a continuing 
problem. See Michael Mayo, Why Independent Research Is Still Rare, CFA 
Magazine, May/June 2006, at 8-9.
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    Independent securities analysts can offer a refreshingly skeptical 
view of particular companies, but they too face threats and 
intimidation, including the threat of lawsuits by issuers, who seek to 
discredit negative analyst reports. Harassing tactics employed by 
issuers (at shareholder expense, I should note) have even included 
spying by private investigators and rummaging through the trash of the 
offending party.\53\
---------------------------------------------------------------------------
    \53\ See, e.g., Roddy Boyd Trash Stalkers, N.Y. Post, Mar. 3, 2006.
---------------------------------------------------------------------------
    The reforms of the research practices of major investment and 
commercial banks as a result of Sarbanes-Oxley and the Global Research 
Analyst Settlement are important and should not be allowed to be 
undermined by issuer intimidation. We strongly believe that all 
analysts should be free to express their views without fear of 
intimidation by issuers or over-zealous government agents, regardless 
of where they are working. If there is any doubt about the beneficial 
role that such hard-hitting independent research plays in the financial 
marketplace, it should be put to rest by testimony in the trial of Ken 
Lay and Jeff Skilling over the past 2 months in Houston. In that 
testimony, a former Enron executive described a critical research piece 
written by an independent analyst that questioned the company's 
financials and practices--practices that have already led to the 
conviction for fraud of several top officers of the company. The report 
concluded that the company's shares should be valued at half their 
then-going price. With Ken Lay present, Skilling's reaction to this 
report was: ``They're on to us.'' \54\
---------------------------------------------------------------------------
    \54\ Mary Flood, Skilling Told Team ``They're On to Us,'' Witness 
Says, Houston Chronicle, Mar. 3, 2006.
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    Financial reporters, analysts, and active market participants all 
provide an important counterweight to overly optimistic or sugar coated 
statements made by public companies and their financial advisers. In 
seeking to compel production of evidence of communications between 
business journalists and their sources, the SEC subpoenas had the 
potential to chill communications between reporters and significant 
sources of expert analysis, thus limiting the information available to 
investors.\55\ We believe all investors will benefit from the action 
taken by the SEC Chairman in making it clear that such subpoenas will 
be considered only in extraordinary circumstances.
---------------------------------------------------------------------------
    \55\ To be distinguished, of course, are cases where journalists 
participate in some scheme relating to the very transactions that they 
report. See Carpenter v. United States, 484 U.S. 19, 108 S. Ct. 316, 98 
(1987).
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                                 ______
                                 
                    PREPARED STATEMENT OF JOHN GAINE
                  President, Managed Funds Association
                              May 16, 2006
    As the largest and most diverse U.S.-based association representing 
the hedge fund industry, Managed Funds Association (``MFA'') is pleased 
to provide this testimony to the Senate Subcommittee on Securities and 
Investment regarding the Role of Hedge Funds in the Capital Markets.
    The hedge fund industry has experienced significant growth in 
recent years, with assets under management estimated at $1.5 
trillion.\1\ MFA believes this is a direct result of the demand largely 
from institutional investors for investment vehicles that offer a 
diversity of investment styles and that help them meet their future 
funding obligations and other investment objectives. As former Federal 
Reserve Chairman Alan Greenspan has noted, hedge funds have ``become 
increasingly valuable in our financial markets.'' \2\ Hedge funds 
enhance market liquidity and contribute to pricing efficiency and 
market stability. Hedge funds also foster financial innovation and risk 
sophistication among the market participants with which they deal.
---------------------------------------------------------------------------
    \1\ Based on reported estimates by Hedge Fund Intelligence 
(London).
    \2\ Remarks by Chairman Alan Greenspan, ``Risk Transfer and 
Financial Stability,'' to the Federal Reserve Bank of Chicago's Forty-
first Annual Conference on Bank Structure, Chicago, Illinois, May 5, 
2005.
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    MFA recognizes that with the growth and evolution of the hedge fund 
industry have come new responsibilities and challenges. The hedge fund 
industry and policymakers currently face an important challenge, namely 
to preserve the benefits offered by hedge funds while addressing 
legitimate investor protection issues presented by the growth in hedge 
fund investments.
Background on MFA
    Founded in 1991, MFA is the U.S.-based global membership 
organization dedicated to serving the needs of the professionals who 
specialize in the alternative investment industry. MFA's over 1,000 
members include professionals in hedge funds, funds of funds, managed 
futures funds, and other financial and commodity-linked investments. 
They also include financial and commodity trading advisors, pool 
operators, and trading managers. MFA members manage a substantial 
portion of the estimated $1.5 trillion invested in these investment 
vehicles. Members include representatives of a majority of the 50 
largest hedge funds groups in the world. MFA membership also includes 
the sponsors, investment managers and brokers for substantially all of 
the financial and commodity pools marketed on either a public or 
private basis in the United States. The larger hedge fund managers 
represented within MFA collectively manage in excess of $500 billion in 
assets and pursue a wide range of investment strategies.
    As further explained below, MFA's activities include educational 
outreach to and representation before the Securities and Exchange 
Commission (``SEC''), Commodity Futures Trading Commission (``CFTC''), 
Federal Reserve, Treasury Department, State and international 
regulatory agencies, and Congress. MFA also participates in a number of 
private sector initiatives, including development of industry sound 
practices, participation in Treasury-sponsored advisory committees, and 
work with the major dealers in improving credit derivative market 
practices.
Overview of Hedge Funds and Their Strategies
Definition of Hedge Fund
    The term ``hedge fund'' is not a defined term under the Federal 
securities laws, except generally to connote a private investment fund 
that is not required to register as an investment company under the 
Investment Company Act of 1940 (the ``Investment Company Act'').\3\ It 
is thus a term that is susceptible of different meanings to different 
people. In general, and for purposes of this testimony, MFA considers a 
``hedge fund'' to be a privately offered investment company that is 
administered by a professional investment manager that seeks attractive 
absolute return.\4\ In this regard they are similar to venture capital, 
private equity, leveraged buyout, oil and gas, and real estate funds, 
although MFA does not intend to capture them within its definition of 
``hedge fund.''
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    \3\ More technically, a ``hedge fund'' is an investment company 
that is not required to register with the SEC by virtue of Section 
3(c)(1) or 3(c)(7) of the Investment Company Act and that conducts only 
private offerings under the SEC's Regulation D.
    \4\ This is in keeping with the definition used by the President's 
Working Group on Financial Markets, of ``any pooled investment vehicle 
that is privately organized, administered by professional investment 
managers, and not widely available to the public.'' President's Working 
Group on Financial Markets Report, ``Hedge Funds, Leverage and the 
Lessons of Long-Term Capital Management,'' April 1999, at 1.
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Investment Profiles
    As noted above, hedge funds are more easily defined in relation to 
what they are not. They are investment companies that are not publicly 
offered. The hedge fund universe is characterized by a wide variety of 
strategies, with different risk characteristics and different return 
expectations. Many hedge funds managers engage in ``absolute return'' 
strategies, meaning that their returns do not depend on, nor are they 
benchmarked against, the long-term return of the markets or the assets 
in which they invest. In other words, hedge funds seek to achieve 
positive returns based on the skill or strategy of the manager rather 
than meet or exceed the performance of the underlying market or asset 
class. Many hedge fund strategies employ ``enhanced active 
management,'' in which managers combine traditional active management 
with techniques such as short selling and leverage. Some hedge fund 
strategies may not be based on traditional techniques at all, such as 
risk arbitrage, convertible hedging, and distressed debt.
    Major hedge fund investment strategy classifications include the 
following:

    Long/short strategies for trading in equities.
    ``Macro'' or global directional investment strategies, 
        which take positions in domestic and international currency, 
        interest rate and equity markets based on global economic 
        conditions and opportunities perceived to be presented by them.
    ``Market-neutral,'' ``relative value,'' or arbitrage 
        strategies, which take offsetting long and short positions or 
        otherwise hedged positions to reduce market risk and utilize 
        leverage to achieve desired returns.
    Event-driven strategies, which seek to profit from 
        anticipated events or special situations, such as mergers, 
        restructurings, distressed securities.
    Regional strategies, which concentrate on a particular 
        geographic region (such as emerging markets).
    Sector strategies, which focus on a particular industry.
    Long only, or ``buy and hold,'' equity strategies, similar 
        to traditional equity mutual fund strategies, but which may 
        also include active efforts to become involved in the 
        management of holdings.
    Dedicated short sale equity strategies focusing on selling 
        short securities that are deemed to be overvalued.
    Specific asset class strategies (such as currencies, 
        commodities, interest rates).

    The significance of these broad array of strategies should not be 
underestimated, as it reflects the increasing segmentation of the hedge 
fund industry, and with that the growing segmentation of risk. Today's 
hedge fund industry is thus actually comprised of many sub-industries, 
with separate and distinct pockets of risk. Each strategy can prudently 
withstand different levels of leverage, and each strategy has a 
different time horizon for investment and varying levels of volatility. 
The diversity of strategies employed by hedge funds also presents 
important considerations for policymakers seeking to accurately 
understand the scope of potential challenges as well as the efficacy of 
potential remedies.
Size
    Because of the non-public nature of hedge funds, there is no 
universally accepted estimate on the size of the hedge fund universe; 
MFA believes it consists of 5,000 to 7,000 funds with total assets of 
approximately $1.5 trillion. A small number of these hedge funds are 
part of large organizations with assets over $1 billion and performance 
records extending 10 years or more. At the other end of the 
marketplace, there are thousands of small firms managing hedge fund 
assets under $50 million each.\5\
---------------------------------------------------------------------------
    \5\ See Robert Jaeger, All About Hedge Funds, McGraw-Hill (2003), 
at 57.
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Beneficial Role of Hedge Funds in Capital Markets
Diversification for Institutional Investor
    Much of the growth in hedge funds since the 1980s can be attributed 
to the increasing recognition by institutional investors that hedge 
funds can help diversify returns and thereby reduce the overall risk of 
an investment portfolio. The majority of direct investment in hedge 
funds by institutional investors has come from endowments and 
foundations. From 2004 to 2005, endowments increased their hedge fund 
allocations from 7.3 percent to 8.7 percent on average.\6\
---------------------------------------------------------------------------
    \6\ 2005 NACUBO Endowment Study.
---------------------------------------------------------------------------
    According to a study by the Bank of New York, ``the hedge fund 
industry is midway through an important transition in its source of 
capital.''

        Five years ago, hedge funds derived virtually all of their 
        assets from wealthy individuals. Institutional interest was 
        limited to a small number of endowments and foundations. Over 
        the next 5 years, institutions (including pension funds) are 
        likely to provide an additional $250 billion of hedge fund 
        capital, accounting for 35 percent of net new flows in this 
        period.\7\
---------------------------------------------------------------------------
    \7\ Bank of New York and Casey, Quick and Acito, ``Institutional 
Demand for Hedge Funds: New Opportunities and New Standards'' 
(September 2004).

    Corporation and public pension plan investments in hedge funds 
continue to grow both through direct investments and through fund of 
hedge funds vehicles.\8\ Former Federal Reserve Chairman Alan Greenspan 
has noted that these inflows may be attributed to institutional 
investors seeking alternatives to long-only investment strategies in 
the wake of the bursting of the equity bubble in 2001.\9\
---------------------------------------------------------------------------
    \8\ A Morgan Stanley Prime Brokerage report suggests that corporate 
pension plans prefer direct allocations to hedge funds while public 
pension plans prefer indirect allocations.
    \9\ Remarks by Chairman Alan Greenspan, ``Risk Transfer and 
Financial Stability,'' to the Federal Reserve Bank of Chicago's Forty-
first Annual Conference on Bank Structure (May 5, 2005), at 6.
---------------------------------------------------------------------------
    These institutional investors understand that hedge funds provide 
attractive mechanisms for portfolio diversification because hedge 
funds' absolute returns tend to have little or no correlation to those 
of more traditional stock and bond investments. Many hedge fund 
categories may therefore outperform stock and bond investments when the 
latter perform poorly. Investment in hedge funds can thus help 
diversify risk in many institutional investment portfolios. Drawdowns 
in individual hedge funds--largest drop from peak value to trough 
value--are often less than in publicly traded indices. Academic 
research recognizes that hedge fund investments can reduce overall risk 
of investment portfolios for investors such as endowments and public 
and private pension plans.\10\
---------------------------------------------------------------------------
    \10\ See Written Statement of Managed Funds Association before the 
Subcommittee on Capital Markets, Insurance and Government Sponsored 
Enterprises of the House Committee on Financial Services, U.S. House of 
Representatives, May 22, 2003, at Annex A.
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Source of Liquidity
    As active trading participants in international capital markets, 
hedge funds add depth and liquidity to markets. This characteristic of 
hedge funds has been recognized by commentators including former 
Federal Reserve Chairman Alan Greenspan. He testified before the Senate 
Banking Committee in 2004, ``it's so important that [hedge funds] are 
left free to supply the extent of liquidity that they are supplying to 
our financial markets. . . . the degree of flexibility in our economy 
has been instrumental in enabling us to absorb the shocks which have 
been so extraordinary in recent years. One of the most successful parts 
of our system is our ability to absorb financial shocks.'' \11\
---------------------------------------------------------------------------
    \11\ ``Renomination of Alan Greenspan as Chairman of the Federal 
Reserve Board of Governors: Hearing Before the Senate Banking, Housing, 
and Urban Affairs Committee'' (testimony of Alan Greenspan, Chairman of 
the Board of Governors of the Federal Reserve) (June 15, 2004).
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Increase in Efficiency
    By trading based on sophisticated and extensive market research, 
hedge funds provide markets with price information that translates into 
pricing efficiency. In targeting temporary price inefficiencies and 
market dislocations, hedge funds effectively help to minimize market 
distortions and eliminate these dislocations. The President's Working 
Group described this function:

        Hedge funds and other investors with high tolerance for risk 
        play an important supporting role in the financial system in 
        which various risks have been distributed across a broad 
        spectrum of tradable financial instruments. With financial 
        intermediation increasingly taking place in the capital markets 
        instead of banking markets, prices play a larger role in the 
        allocation of capital and risk. In this world, investors such 
        as hedge funds that undertake a combination of long and short 
        positions across markets help maintain the relative prices of 
        related financial instruments.\12\
---------------------------------------------------------------------------
    \12\ President's Working Group Report at 2-3.
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Decrease in Volatility
    The increase in hedge fund growth has coincided with a decrease in 
overall market volatility. This may be due to the added liquidity that 
hedge funds provide to the market. This may also result from the fact 
that hedge funds generally eschew the ``momentum trading'' that many 
individual investors engage in. Because hedge fund investors generally 
have accepted longer redemption horizons, hedge funds have fewer 
incentives to engage in momentum trading. By contrast, more traditional 
investors, such as mutual funds, are more likely to buy into rising 
markets and sell into falling markets as a result of purchases and 
redemptions by individual retail investors, accentuating market 
volatility.\13\
---------------------------------------------------------------------------
    \13\ ``Hedge Funds and Financial Market Dynamics,'' Occasional 
paper 166, International Monetary Fund (May 1998), at 29.
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Regulation of Hedge Funds
    Under the Investment Company Act, any company that is engaged 
primarily in investing in securities must register as an investment 
company, unless an exemption or exclusion is available. To be excluded 
from this registration requirement, hedge funds rely on one of two 
exceptions from the definition of investment company.
    The first, Section 3(c)(1) of the Investment Company Act, was part 
of the Act as enacted in 1940. It provides that an investment fund will 
not be required to register as an investment company if: (a) it has no 
more than 100 investors, and (b) it does not offer its shares publicly. 
In order to comply with the latter requirement, a fund sponsor will 
effectively limit the offering of fund shares to ``accredited 
investors,'' as defined in the SEC's Regulation D.\14\ In addition to 
banks and other institutional investors, accredited investors include 
natural persons with individual or joint net worth of $1 million or 
individual income in each of the last 2 years in excess of $200,000, or 
joint income for the same period of $300,000.
---------------------------------------------------------------------------
    \14\ The SEC staff has confirmed in a series of no-action letters 
that hedge funds and other private investment vehicles that conduct 
offerings pursuant to Regulation D can rely on Section 3(c)(1). Santa 
Barbara Securities, SEC No-Action Letter (Mar. 8, 1983).
---------------------------------------------------------------------------
    The second, Section 3(c)(7) of the Investment Company Act, was 
enacted as part of the National Securities Markets Improvement Act of 
1996.\15\ It excepts funds from registration as investment securities 
if each investor in the pool is a ``qualified purchaser'' and the pool 
does not undertake a public offering. The term qualified purchaser 
includes institutional investors; natural persons who have at least $5 
million in investments; persons who, acting for themselves or the 
accounts of other qualified purchasers, in the aggregate own and invest 
on a discretionary basis not less than $25 million in investments; and 
certain qualifying trusts. The Senate report on the legislation 
provided the following rationale:
---------------------------------------------------------------------------
    \15\ P.L. No. 104-290, 110 Stat. 3416, 3432-33 (1996). The 
legislation followed a 1992 report by the SEC's Division of Investment 
Management that recommended the adoption of a new exception for private 
funds sold exclusively to ``qualified purchasers.'' SEC, Division of 
Investment Management, ``Protecting Investors: A Half Century of 
Investment Company Regulation'' (1992), at 104-05.

        The qualified purchaser pool reflects the Committee's 
        recognition that financially sophisticated investors are in a 
        position to appreciate the risks associated with investment 
        pools that do not have the Investment Company Act's 
        protections. Generally, these investors can evaluate on their 
        own behalf matters such as the level of a fund's management 
        fees, governance provisions, transactions with affiliates, 
        investment risk, leverage, and redemption rights.\16\
---------------------------------------------------------------------------
    \16\ S. Rep. No. 104-293, at 10 (1996).

    That hedge funds are not registered does not mean that their 
activities are unregulated. Hedge funds and their managers are subject 
to a variety of regulations and are required to furnish significant 
information and reports to regulators in connection with their trading 
activities.
SEC Registration of Hedge Fund Advisers
    The SEC has recently implemented rule requiring registration of 
many hedge fund advisers that were not previously required to register. 
Section 203(b)(3) of the Investment Advisers Act of 1940 (the 
``Advisers Act'') provides that an investment adviser may be exempt 
from SEC registration requirements if such adviser (i) had fewer than 
15 ``clients'' during the preceding 12 months; (ii) does not hold 
itself out generally to the public as an investment adviser; and (iii) 
does not act as an adviser to any registered investment company.
    The new hedge fund adviser rule requires a hedge fund adviser to 
count each ``owner'' of a ``private fund'' \17\ it advises as a 
``client'' for purposes of determining the adviser's eligibility for 
the private adviser exemption cited above. The term ``private fund'' 
was intended to capture advisers to hedge funds and not other private 
investment vehicles, such as private equity or venture capital funds. 
Under this new rule, hedge fund advisers are required to ``look 
through'' clients that are private funds and count the underlying 
investors to determine the number of clients to whom the adviser 
provides investment advisory services. If, after taking into account 
the aggregate number of investors in the private funds it advises, an 
adviser has 15 or more clients in the prior 12 months, and has in the 
aggregate at least $30 million in assets under management, then the 
adviser will be required to register with the SEC as an investment 
adviser. Hedge fund advisers that advise ``private funds'' were 
required to comply with this new rule by February 1, 2006.
---------------------------------------------------------------------------
    \17\ Under Investment Adviser Act Rule 203(b)(3)-2, a ``private 
fund'' is defined as a company that: (i) would be an investment company 
under the Investment Company Act of 1940, as amended, but for an 
exception from the definition of ``investment company'' provided under 
either Section 3(c)(1) or 3(c)(7) thereunder; (ii) permits an investor 
to redeem its investment within 2 years of investment; and (iii) is 
offered based on its adviser's expertise. A pooled investment vehicle 
that does not meet any one of the above three elements is not a 
``private fund.'' Advisers to unregistered funds that are not ``private 
funds'' may continue to rely on the language of Rule 203(b)(3)-1 that 
permits an adviser to count these unregistered funds as a single 
client. This would include advisers to hedge funds that have redemption 
periods for their investors that are longer than 2 years.
---------------------------------------------------------------------------
CFTC Regulation
    Many hedge fund managers are also registered with the Commodity 
Futures Trading Commission as commodity pool operators (``CPOs''). Such 
registration is required under the Commodity Exchange Act for managers 
of hedge funds that trade futures and options contracts on a futures 
exchange. A hedge fund manager that provides advice to a hedge fund 
regarding such futures and options contracts may also become subject to 
regulation as a commodity trading advisor (``CTA''). CPOs and CTAs are 
subject to registration, recordkeeping, and reporting requirements and 
fraud prohibitions under the Commodity Exchange Act and the regulations 
of the CTFC and the National Futures Association. In 2004, 63 of the 
100 largest hedge funds were registered with the CFTC and subject to 
its reporting and recordkeeping requirements. Hedge funds that are 
significant traders in the futures markets may also become subject to 
the CFTC's large trader reporting system, which requires the reporting 
of certain information on exchange-traded contracts to the CFTC for 
purposes of market surveillance.
NASD Regulation
    Broker-dealers that sell interests in hedge funds are subject to 
NASD regulation. NASD requires broker-dealers to comply with 
suitability requirements that, among other things, require the broker-
dealer to have both a reasonable basis for believing that the product 
is suitable for any investor and to determine that its recommendation 
to invest in a hedge fund is suitable for the particular investor.
Reporting Requirements
    As with other market participants, hedge funds are required to 
comply with certain reporting requirements designed to increase market 
transparency. These requirements include various SEC equity ownership 
and portfolio reporting requirements and large position and other 
reporting requirements of the Treasury Department and the Federal 
Reserve in connection with government securities and foreign exchange 
transactions. The Treasury Department requires weekly and monthly 
reports for certain large participants in the foreign exchange markets 
and imposes reporting requirements on entities, including hedge funds, 
that have large positions in recently issued or to-be-issued Treasury 
securities.\18\
---------------------------------------------------------------------------
    \18\ For further information on regulatory filings required of 
these hedge funds, please see MFA's ``2005 Sound Practices for Hedge 
Fund Managers'' at Appendix II.
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Antifraud and Insider Trading Prohibitions
    As the SEC has explained, hedge fund advisers, whether or not 
registered under the Advisers Act, are subject to the antifraud and 
anti-manipulation provisions of the Advisers Act, the Securities Act of 
1933, and the Securities Exchange Act of 1934, as well as to 
prohibitions on insider trading under the U.S. securities laws. In 
addition, there are safeguards covering the activities of hedge funds 
to the extent that they interact with regulated third parties such as 
registered broker-dealers and banks and, to the extent that they engage 
in futures trading, with futures commission merchants. Hedge funds are 
also subject to State antifraud provisions, just as are other providers 
of financial services.
    There is no fraud crisis with regard to private investment 
vehicles. The 2003 SEC staff report entitled ``Implications of the 
Growth of Hedge Funds'' stated there is ``no evidence indicating that 
hedge funds or their advisers engage disproportionately in fraudulent 
activity.'' \19\ Former SEC Chairman William Donaldson testified that 
there is ``no reason to believe that fraud is more prevalent in hedge 
funds than it is anywhere else.'' \20\
---------------------------------------------------------------------------
    \19\ Staff Report at 73.
    \20\ Testimony of William Donaldson, Chairman of the SEC, ``Recent 
Developments in Hedge Funds,'' Hearing Before the Committee on Banking, 
Housing, and Urban Affairs, U.S. Senate, 108th Congress (April 10, 
2003).
---------------------------------------------------------------------------
Current Issues Regarding Hedge Funds
    Since its creation, MFA has been an advocate for the alternative 
investment industry on a number of important legislative, regulatory 
and private sector initiatives. Following is a summary of a few of the 
major initiatives on which MFA is focusing.
Compliance With Hedge Fund Adviser Registration Rule
    As described above, MFA's membership encompasses both registered 
investment advisers as well as those managers that are exempt from the 
SEC's hedge fund adviser registration rule. Prior to adoption of the 
rule, MFA raised concerns that the costs of the rule would outweigh its 
benefits.\21\ However, since promulgation of the rule on October 26, 
2004, MFA has worked with its members to prepare for implementation of 
the rule and has offered recommendations to the SEC staff to help 
develop internal agency training programs on hedge fund subject areas. 
This work is ongoing and MFA hopes to continue its positive interaction 
with the SEC staff.
---------------------------------------------------------------------------
    \21\ See Letter to Jonathan Katz from John Gaine, ``Registration 
Under the Advisers Act of Certain Hedge Fund Advisers,'' September 15, 
2004.
---------------------------------------------------------------------------
    Over the past 18 months, MFA has hosted six educational seminars to 
help its members prepare for the compliance with this new rule.\22\ At 
each seminar held last year, an SEC Commissioner or senior staff member 
delivered the keynote address or served as moderator. MFA is continuing 
its dialog with the SEC staff to address any issues that may arise now 
that the new hedge fund adviser registration rule has gone into effect. 
We discuss with our members how they are complying with the rule and 
their observations about SEC examinations.
---------------------------------------------------------------------------
    \22\ ``Guidance on the SEC's New Regulatory Framework for Hedge 
Fund Advisers,'' held January 12, 2005 (New York, NY) and February 9, 
2005 (Key Biscayne, FL); ``Practical Guidance for Hedge Fund CCOs,'' 
held May 5, 2005; ``The SEC's New Hedge Fund Rules and Implications for 
Managers in Europe,'' held July 12, 2005 (London); ``MFA's 2005 Sound 
Practices for Hedge Funds Managers--A Practitioner's Guide to Strong 
Internal Controls in Today's Regulatory Environment,'' held September 
29, 2005 (New York); and ``A New Era Begins: Hedge Fund Advisers and 
Today's SEC Regulatory Environment,'' held February 7, 2006 (Key 
Biscayne, FL).
---------------------------------------------------------------------------
Growth in Credit Derivatives and Concerns of Systemic Risk
    The growth in the use of derivatives products has been widely 
reported. According to the International Swaps and Derivatives 
Association (``ISDA''), the outstanding notional value of credit 
derivative contracts rose from an estimated $4 trillion at year-end 
2003 to an estimated $17 trillion at year-end 2005. The International 
Monetary Fund devoted an entire chapter of a recent report to examining 
the influence of credit derivatives on financial stability.\23\
---------------------------------------------------------------------------
    \23\ IMF, Global Financial Stability Report (April 2006), Chapter 
II, pp. 51-84.
---------------------------------------------------------------------------
    Last year, the rising use of credit derivatives attracted the 
attention of regulators in the United States and overseas.\24\ Of 
particular concern was the growing trend of unconfirmed assignments of 
credit derivative transactions, known as ``novations,'' and the threat 
that this would pose to systemic risk in the event of a large credit 
event. Regulators in the United Kingdom and in the United States feared 
that problems could emerge as a result of the high number of unsigned 
confirmations of novations transactions. These concerns were also 
expressed in the Counterparty Risk Management Policy Group II in their 
2005 Report.\25\
---------------------------------------------------------------------------
    \24\ See Speech by Timothy Geithner, Remarks at the Institute of 
International Finance, Inc.'s Annual Membership Meeting in Washington, 
D.C, September 25, 2005; and, Financial Services Authority, ``Hedge 
Funds: A Discussion of Risk and Regulatory Engagement'' (Discussion 
Paper 05/4).
    \25\ The Report of the Counterparty Risk Management Policy Group 
II, ``Toward Greater Financial Stability: A Private Sector 
Perspective,'' July 27, 2005.
---------------------------------------------------------------------------
    Last fall, MFA members who are active participants \26\ in the 
credit derivatives markets took part in discussions with 
representatives of ISDA, the 14 major derivatives dealer firms (the 
``Fed 14''), and the Federal Reserve Bank of New York on the 
finalization of the ISDA 2005 Novation Protocol. These parties worked 
together to ensure that novations could be transacted successfully 
under the Protocol. Overall, that experience demonstrated that 
meaningful buy-side participation can be essential to ensuring the 
success of these industry-wide initiatives to curb operational or 
systemic risk. In this instance, focused and constructive dialog among 
both buy-side and sell-side representatives led to a positive result.
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    \26\ Hedge funds make up only a small percentage of the credit 
derivatives market, approximately 7-16 percent, according to a 
September 2004 study released by the British Bankers' Association. See 
British Banker's Association Credit Derivatives Report 2003/2004 
(available at http://www.bba.org.uk).
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    As an outgrowth of the dialog between the hedge fund and derivative 
dealer communities that occurred in late 2005, MFA continues its dialog 
with representatives of the Fed 14 and ISDA. MFA continues its work 
with the Fed 14 representatives to share its views, along with those of 
other traditional asset managers, on the Fed 14's proposed strategy for 
reducing confirmation backlogs in credit derivatives.
    MFA has pledged its support to work with the Fed 14 in the 
development and implementation of their targeted objectives for 
improving credit derivatives market practices. MFA appreciates the 
dealers' commitment to work with hedge funds and other buy-side 
representatives to develop and implement standard processing guidelines 
for credit derivatives. MFA has also expressed its support for improved 
transparency to reduce the backlog of unexecuted confirmations and the 
development of automated solutions for the processing of standardized 
products. Our statement made recommendations to the Fed 14 on how to 
achieve these goals and emphasized that, above all, meaningful buy-side 
input is essential for achieving improvements in these market 
practices.
    MFA is now working on the development of industry-wide electronic 
platforms to warehouse credit derivative transactions, as well as on 
standards for transactions not eligible for electronic processing. MFA 
is committed to educating its members and keeping them informed 
regarding the latest operational developments in derivatives. As major 
participants in the credit derivatives markets, MFA's members have 
shown their willingness to work on private sector initiatives with 
their sell-side counterparties on steps to reduce systemic risk.
Investor Eligibility Standards or ``Retailization''
    In recent years, a concern has grown among regulators and others 
that hedge funds are becoming investment vehicles open to the retail 
public. This concern, coupled with the legally required non-public 
nature of hedge funds, has led regulators to inquire whether investors 
without the requisite financial means or sophistication were coming 
exposed to investments that might not be suitable for them.
    From all available information, hedge funds remain an investment 
vehicle for institutional investors and high-net worth individuals. The 
SEC in recent years has permitted the registration of investment 
companies that themselves invest in hedge funds. In these 
circumstances, the Investment Company Act, the Advisers Act, and all 
the investor protection mechanisms of the Federal securities laws come 
into play. These funds are subject to the rule range of protections 
afforded by SEC registration and oversight, as they are registered with 
the SEC and sold in registered public offerings. In addition, advisers 
of registered funds of hedge funds are required to be registered under 
the Advisers Act. The SEC therefore has authority to address any 
investor protection issues that may be presented.
    To the extent that retail investors may be exposed to hedge fund 
investments without the intermediation of an institutional investor, 
Congress might want to inquire into the impact of inflation over the 
past quarter century on the SECs Regulation D. Regulation D defines 
``accredited investors'' to include natural persons with individual or 
joint net worth of $1 million or individual income in each of the last 
2 years in excess of $200,000, or joint income for the same period of 
$300,000. In the 25 years since the SEC last updated Regulation D, 
these dollar thresholds have come within the range of many middle class 
investors. The SEC might want to consider raising the Regulation D 
thresholds for investments in private funds.
    MFA believes that concerns regarding investor qualification for 
participation in hedge funds should be addressed directly by raising 
the Regulation D standards. If the concern about the number of 
investors qualifying as ``accredited investors'' is valid, it is one 
the SEC should address through changes to Regulation D. MFA has 
expressed support for doubling the minimum net worth and minimum annual 
individual income standards from their current level, so that the 
monetary thresholds reflect the inflation in wealth and incomes since 
1982.\27\
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    \27\ See MFA ``White Paper on Increasing Financial Eligibility 
Standards for Investors in Hedge Funds'' (July 7, 2003).
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    While investments in hedge funds by public and private pension 
funds appear to be growing, it is far from a level that would suggest 
undue risk to individual investors. In 2003, U.S., European, and 
Canadian pension funds reported that about 1 percent of their portfolio 
assets were invested in hedge funds.\28\ By comparison, U.S. pension 
investments in real estate and private equity have been estimated at 
3.4 percent and 3 percent of pension fund assets respectively.\29\
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    \28\ Greenwich Associates, ``Alternative Investments May Disappoint 
Dabblers'' (January 21, 2004).
    \29\ Greenwich Associates, ``The Alternative Balancing Act'' 
(December 31, 2003).
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    Publicly offered funds of hedge funds are subject to the full range 
of protections afforded by SEC registration and oversight, as they are 
registered with the SEC as investment companies and sold in registered 
public offerings. In addition, advisers of funds of hedge funds are 
required to be registered under the Advisers Act. The SEC therefore has 
authority to address any investor protection issues that may be 
presented by these registered funds.
Continued Development of MFA's Sound Practices
    MFA has a longstanding and ongoing commitment to promoting sound 
practices in the hedge fund industry. ``Sound Practices for Hedge Fund 
Managers'' were first published by industry participants in 2000 in 
response to a 1999 recommendation by the President's Working Group on 
Financial Markets that hedge funds establish a set of sound practices 
for their risk management and internal controls. These sound practices 
were updated and expanded in 2003 by MFA as a response to industry 
developments.
    Recognizing the valuable guidance provided by our 2003 guidance, on 
August 2, 2005, MFA published MFA's 2005 Sound Practices for Hedge Fund 
Managers. The 2005 iteration of MFA's Sound Practices were widely 
disseminated to policymakers on Capitol Hill and to U.S. and 
international regulators. The recommendations set forth in our 2005 
Sound Practices provide a framework of internal policies, practices and 
controls for and by hedge fund managers. Our document provides relevant 
guidance on areas that are often of concern to regulators. These 
include hedge fund managers' internal trading controls, 
responsibilities to investors, valuation, risk management, regulatory 
compliance, transactional practices and business continuity and 
disaster recovery. New recommendations address guidance for developing 
compliance manuals, codes of ethics, and certain transactional 
practices including best execution and soft dollar practices.
    Our document has been widely praised by regulators and industry 
participants alike, including in the Counterparty Risk Management 
Policy Group II Report. MFA continues to encourage hedge fund managers 
to incorporate its recommendations into their particular internal 
policies and procedures. As new industry practices develop, 
particularly under the new regulatory framework and with the rise of 
even more complex derivative instruments, MFA will update and expand 
its document within the next 12 to 18 months.
Conclusion
    The hedge fund industry has experienced significant growth in 
recent years. Much of this growth can be attributed to institutional 
investors seeking to diversify their returns and thereby reduce the 
overall risk of their investment portfolios. This growth has enabled 
hedge funds to serve as source of liquidity in global capital markets, 
increasing efficiency and decreasing risks.
    With the growth and evolution of the hedge fund industry have come 
new responsibilities and challenges. On behalf of its members, MFA is 
committed to working with Congress, regulatory agencies, and on private 
sector initiatives to ensure an appropriate regulatory framework for 
the industry that allows the benefits to continue while addressing 
legitimate investor protection concerns. MFA appreciates the 
opportunity to share its views with the Subcommittee and will continue 
its work with both the SEC and its members to promote implementation of 
and compliance with the hedge fund adviser registration rule, as well 
as its efforts to reduce systemic risks and promote sound practices.

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