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48–525 PDF 2009

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 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

RICHARD C. SHELBY, Alabama, Chairman 

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

RICK SANTORUM, Pennsylvania 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

JOHN E. SUNUNU, New Hampshire 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

PAUL S. SARBANES, Maryland 

CHRISTOPHER J. DODD, Connecticut 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

DEBBIE STABENOW, Michigan 

ROBERT MENENDEZ, New Jersey 

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 

JOHN E. SUNUNU, New Hampshire 

MEL MARTINEZ, Florida 

ROBERT F. BENNETT, Utah 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

ELIZABETH DOLE, North Carolina 

WAYNE ALLARD, Colorado 

RICK SANTORUM, Pennsylvania 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

DEBBIE STABENOW, Michigan 

THOMAS R. CARPER, Delaware 

ROBERT MENENDEZ, New Jersey 

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)

(1) 

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 

2 

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. 

3 

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 witVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 S:\DOCS\0516PM.TXT JASON
4 

nesses. 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 

5 

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 emVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 S:\DOCS\0516PM.TXT JASON
6 

ployed, 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. 

7 

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. 

8 

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 

9 

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 

10 

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. 

11 

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 

12 

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 

13 

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 

14 

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. 

15 

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 antifraud 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 

16 

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. 

17 

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 leverVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 S:\DOCS\0516PM.TXT JASON
18 

age 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 

19 

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. 

20 

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 

21 

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 indusVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 S:\DOCS\0516PM.TXT JASON
22 

try 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 

23 

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. 

24 

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, 

25 

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 

26 

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 menVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00030 Fmt 6633 Sfmt 6633 S:\DOCS\0516PM.TXT JASON
27 

tioned 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. 

28 

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 

29 

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 

30 

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 

31 

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 overregulaVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00035 Fmt 6633 Sfmt 6633 S:\DOCS\0516PM.TXT JASON
32 

tion. 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. 

33 

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. 

34 

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 

35 

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-thecounter 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 

36 

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 

37 

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. 

38 

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 apVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00042 Fmt 6633 Sfmt 6633 S:\DOCS\0516PM.TXT JASON
39 

propriate 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 

40 

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 

41 

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 

42 

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. 

43 

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 

44 

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. 

45 

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 fiVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00049 Fmt 6633 Sfmt 6633 S:\DOCS\0516PM.TXT JASON
46 

nancial 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. 

47 

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. 

48 

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 heavyhanded 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. 

49 

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. 

50 

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:] 

51 

1The 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. 

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. 

52 

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, profitmaking 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 insurVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00056 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
53 

ance-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 marketbased 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. 

54 

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 balancesheet 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. 

55 

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 ComVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00059 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
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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 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. 3See Hedge Fund Research, HFR Q1 2006 Industry Report. 

4See 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). 

mission 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

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

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

57 

6See 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). 7See 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). 8See Pam Abramowitz, ‘‘Trade Secrets,’’ Institutional Investor’s Alpha, January/February 

2006. 9Mara 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). 

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. 

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. 

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 

58 

10Litigation Release No. 19406 (Sept. 29, 2005). 11Litigation Release No. 19692 (May 9, 2006). 12Litigation Release No. 19589 (Mar. 3, 2006). 13The 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. 

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

• 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. 

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. 

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. 

59 

15 Almost 15 percent (379) of the hedge fund advisers registered with the Commission report 

that they also advise at least one mutual fund. 

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 ‘‘sideby-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. 

• 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 

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16 Investment Advisers Act Release No. 2453 (Dec. 1, 2005). 17Litigation 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. 18Litigation 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). 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). 20Prime 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. 

tion 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

• 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 shortselling 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

• 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

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

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

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 

61 

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. 2The 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 

Continued 

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 advisVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00065 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
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in some respects to hedge funds but usually require investors to make long-term commitments 

of capital. 3For 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). 4Some 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. 5Greenwich 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. 6Federal 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). 7See Fitch Ratings (2005), Hedge Funds: An Emerging Force in the Global Credit Markets 

(New York: Fitch Ratings, 2005), p. 6. 8The 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. 

ers 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. 

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

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

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

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 

63 

9See 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. 10For 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. 11See Greenwich associates (2004), p. 3. 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. 13President’s Working Group (1999). 

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. 

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

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. 

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 

64 

14See President’s Working Group (1999), p. 42. 15See CRMPG (1999). 16 Counterparty Risk Management Policy Group II (2005), Toward Greater Financial Stability: 

A Private Sector Perspective (New York: CRMPG II, July). 

concerns about systemic risks from hedge funds most effectively and would avoid 

the potential attendant costs of direct regulation.14

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

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 overthe-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. 

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 

65 

17See Federal Reserve Bank of New York press release dated March 13, 2006. (http:// 

www.newyorkfed.org/newsevents/news/markets/2006/an060313.html). 18See press release by the Managed Funds Association dated March 13, 2006. (http:// 

www.mfainfo.org/images/PDF/MFAlFed14lStmtl3l13l06.pdf). 

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

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 regVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00069 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
66 

istration 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. 

67 

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 CFTCregistered 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. 

68 

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 

69 

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 

70 

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. 

71 

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 

72 

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. 

73 

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 longterm 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. 

74 

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: 

75 

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 

76 

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 conVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00080 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
77 

tributes $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. 

78 

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 LongTerm 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. 

79 

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. 

80 

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 shortterm 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 

81 

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 

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1The SEC has recently required registration of most hedge funds with assets above $30 million and with 15 or more clients. 

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. 

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 

83 

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 

84 

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 

85 

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/assetlmanagerlcode.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/GIPSl2006.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. 

86 

1Prior 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. 2See 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 

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. 

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

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 CommisVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00090 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
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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 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 § 78n(f). 8 15 U.S.C. § 78j. 9 17 CFR § 240.10b-5. 10See 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’’). 

sion, 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

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 counterparties 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. 

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 

88 

11See 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. 14 Bernanke Statement, supra n.4 

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 superaccredited ‘‘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). 

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. 

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

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 

89 

15Quarles Remarks, supra n.3 16The 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. 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 18See 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/dp05l04.pdf 20 Andrew Ross Sorkin, To Battle, Armed with Shares, N.Y. Times, Jan. 4, 2006 at C1. 21 Economic Report of the President, 196 (Washington: U.S. G.P.O., Feb. 1985). 

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. 

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. 

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. 

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 comVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00093 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
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22Wright, 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 23This 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. 24 Barry Rosenstein, Why activism is good for all shareholders, Fin. Times, Mar. 9, 2006. 25SEC 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). 26SEC v. Langley Partners, L.P., SEC Litigation Release No. 19607, 2006 WL 623053 (Mar.14, 

2006). 27See Registration Under the Advisers Act of Certain Hedge Fund Advisers, Release No. IA2333 (Dec. 2, 2004), 69 Fed. Reg. 72054, 72092—72096 (Dec. 10, 2004) (dissenting statement 

of Commissioners Glassman and Atkins). 

pensation 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

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. 

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. 

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 

91 

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 30Further, 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. 

abuse. In the discussion below, we note that the area of valuation is an area of concern. 

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 nonstandardized. 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

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 antifraud 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. 

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 proVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00095 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
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31See 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/fvlmeasurement.shtml 32We 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. 33See, 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). 34The 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. 35The 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 36See 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/dp05l04.pdf 37See 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 

mulgate 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

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

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 

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38Staff Report, supra n.10, at 80. 39 Compare 10 Cal. Code Regs. Tit. 10, § 260.140.01; 18 N.C. Admin. Code 6-1206 (20060; with 

003-14-006 Ark. Code R. § 504 (Weil 2006). 40 Registration of Certain Hedge Fund Advisers, supra n.27 at 72057. 41Staff Report, supra n.10 at xii, 68–72. 42 Id. at 81. 43 Id. at 99. 44Staff 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.’’ 

vestors 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. 

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

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

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

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

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, 

94 

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. 46See, 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). 47Press 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 48Kara Scannelli, Cox Knocks Journalist Subpoenas, Wall St. J., Feb. 28, 2006, at C1. 49Press 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 

some of the most spectacular corporate frauds—Enron, Tyco, Conseco, and Sunbeam, to name just a few—were first uncovered by short sellers. 

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

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. 

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

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

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

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 

95 

50See J.S. Mill, On Liberty, (1859); Abrams v. United States, 250 U.S. 616, 630, 40 S.Ct. 17, 

(1919) (Holmes, J., dissenting). 51Thomas 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)] 52Letter 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. 53See, e.g., Roddy Boyd Trash Stalkers, N.Y. Post, Mar. 3, 2006. 54Mary Flood, Skilling Told Team ‘‘They’re On to Us,’’ Witness Says, Houston Chronicle, Mar. 

3, 2006. 

Amendment itself is that its protections recognize the value of a ‘‘marketplace of 

ideas.’’ 50

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

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

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

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

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 subVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00099 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
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55To 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). 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. 

poenas 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. 

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. 

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 

97 

3More 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. 4This 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. 

‘‘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.’’ 

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 

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5See Robert Jaeger, All About Hedge Funds, McGraw-Hill (2003), at 57. 

6 2005 NACUBO Endowment Study. 

7 Bank of New York and Casey, Quick and Acito, ‘‘Institutional Demand for Hedge Funds: 

New Opportunities and New Standards’’ (September 2004). 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. 10See 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. 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). 

place, there are thousands of small firms managing hedge fund assets under $50 

million each.5

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

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

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

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

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

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. 

99 

12President’s Working Group Report at 2–3. 13 ‘‘Hedge Funds and Financial Market Dynamics,’’ Occasional paper 166, International Monetary Fund (May 1998), at 29. 14The 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). 15P.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. 16S. Rep. No. 104-293, at 10 (1996). 

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

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

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. 

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: 

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

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 

100 

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. 18For further information on regulatory filings required of these hedge funds, please see 

MFA’s ‘‘2005 Sound Practices for Hedge Fund Managers’’ at Appendix II. 

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. 

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

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 

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19Staff Report at 73. 20Testimony 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). 21See Letter to Jonathan Katz from John Gaine, ‘‘Registration Under the Advisers Act of Certain Hedge Fund Advisers,’’ September 15, 2004. 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). 23 IMF, Global Financial Stability Report (April 2006), Chapter II, pp. 51–84. 24See 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). 

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

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. 

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. 

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

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 novaVerDate Aug 31 2005 11:35 Apr 08, 2009 Jkt 048080 PO 00000 Frm 00105 Fmt 6633 Sfmt 6621 S:\DOCS\0516PM.TXT JASON
102 

25The Report of the Counterparty Risk Management Policy Group II, ‘‘Toward Greater Financial Stability: A Private Sector Perspective,’’ July 27, 2005. 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). 

tions transactions. These concerns were also expressed in the Counterparty Risk 

Management Policy Group II in their 2005 Report.25

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 buyside and sell-side representatives led to a positive result. 

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 

103 

27See MFA ‘‘White Paper on Increasing Financial Eligibility Standards for Investors in Hedge 

Funds’’ (July 7, 2003). 28Greenwich Associates, ‘‘Alternative Investments May Disappoint Dabblers’’ (January 21, 

2004). 29Greenwich Associates, ‘‘The Alternative Balancing Act’’ (December 31, 2003). 

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

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

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.