Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed
Published: 2008-01-24T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since the 1998 near collapse of Long-Term Capital Management (LTCM), a large hedge fund--a pooled investment vehicle that is privately managed and often engages in active trading of various types of securities and commodity futures and options--the number of hedge funds has grown, and they have attracted investments from institutional investors such as pension plans. Hedge funds generally are recognized as important sources of liquidity and as holders and managers of risks in the capital markets. Although the market impacts of recent hedge fund near collapses were less severe than that of LTCM, they recalled concerns about risks associated with hedge funds and they highlighted the continuing relevance of questions raised over LTCM. This report (1) describes how federal financial regulators oversee hedge fund-related activities under their existing authorities; (2) examines what measures investors, creditors, and counterparties have taken to impose market discipline on hedge funds; and (3) explores the potential for systemic risk from hedge fund-related activities and describes actions regulators have taken to address this risk. In conducting this study, GAO reviewed regulators' policy documents and examinations and industry reports and interviewed regulatory and industry officials, and academics. Regulators only provided technical comments on a draft of this report, which GAO has incorporated into the report as appropriate.
section_title: What GAO Found
paragraphs: Under the existing regulatory structure, the Securities and Exchange Commission and Commodity Futures Trading Commission can provide direct oversight of registered hedge fund advisers, and along with federal bank regulators, they monitor hedge fund-related activities conducted at their regulated entities. Since LTCM's near collapse, regulators generally have increased reviews--by such means as targeted examinations--of systems and policies of their regulated entities to mitigate counterparty credit risks, including those involving hedge funds. Although some examinations found that banks generally have strengthened practices for managing risk exposures to hedge funds, regulators recommended that they enhance firmwide risk management systems and practices, including expanded stress testing. Regulated entities have the responsibility to practice prudent risk management standards, but prudent standards do not guarantee prudent practices. As such, it will be important for regulators to show continued vigilance in overseeing hedge fund-related activities. According to market participants, hedge fund advisers have improved disclosures and transparency about their operations since LTCM as a result of industry guidance issued and pressure from investors and creditors and counterparties (such as prime brokers). But market participants also suggested that not all investors have the capacity to analyze the information they receive from hedge funds. Regulators and market participants said that creditors and counterparties have generally conducted more due diligence and tightened their credit standards for hedge funds. However, several factors may limit the effectiveness of market discipline or illustrate failures to properly exercise it. For example, because most large hedge funds use multiple prime brokers as service providers, no one broker may have all the data necessary to assess the total leverage of a hedge fund client. Further, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk. These factors can contribute to conditions that create systemic risk if breakdowns in market discipline and risk controls are sufficiently severe that losses by hedge funds in turn cause significant losses at key intermediaries or in financial markets. Financial regulators and industry participants remain concerned about the adequacy of counterparty credit risk management at major financial institutions because it is a key factor in controlling the potential for hedge funds to become a source of systemic risk. Regulators have used risk-focused and principles-based approaches to better understand the potential for systemic risk and respond more effectively to financial shocks that threaten to affect the financial system. For instance, regulators have collaborated to examine some hedge fund activities across regulated entities. The President's Working Group has taken steps such as issuing guidance and forming two private sector groups to develop best practices to enhance market discipline. GAO views these as positive steps, but it is too soon to evaluate their effectiveness.

section_title: Letter
paragraphs: In recent years, hedge funds have grown rapidly. According to industry  estimates, from 1998 to early 2007, the number of funds grew from more  than 3,000 to more than 9,000, and assets under management from more  than $200 billion to more than $2 trillion globally. An estimated $1.5  trillion of these assets is managed by U.S. hedge fund advisers. Hedge  funds are key players in many financial markets. For example, hedge funds  reportedly account for more than 40 percent of the trading volume in the  U.S. leveraged loan market, more than 85 percent of the distressed debt  market, and more than 80 percent of certain credit derivatives markets.  Institutional investors, such as endowments, foundations, insurance  companies, and pension plans, seeking to diversify their risks and increase  returns, have invested in hedge funds and contributed to the rapid growth  in these funds.
As active market participants, hedge funds generally are recognized to  provide benefits to financial markets by enhancing liquidity and promoting  market efficiency and price discovery. Especially in volatile markets,  hedge funds are generally willing to assume risks that more regulated  financial institutions are unwilling or unable to assume. Additionally, they  are recognized to spur financial innovation and help to reallocate financial  risk. Nevertheless, the rapid growth of funds that may adopt similar  investment strategies in interconnected markets with rapid trading  strategies raises questions as to whether large losses from one or more  hedge funds could cause widespread difficulties at other firms, in other  market segments, or in the financial system as a whole. For example,  hedge funds may impose losses on their creditors and counterparties and  thereby disrupt the credit availability to financial markets or through  market disruptions that could accompany liquidation of funds’ positions.
Market discipline plays a primary role, supplemented by indirect  regulatory oversight of commercial banks and securities and futures firms,  in constraining risk taking and leveraging by hedge fund managers  (advisers). Market participants (e.g., investors, creditors, and  counterparties) impose market discipline by rewarding well-managed  hedge funds and reducing their exposure to risky, poorly managed hedge  funds. However, according to several sources, for market discipline to be  effective, (1) investors, creditors, and counterparties must have access to,  and act upon, sufficient and timely information to assess a fund’s risk  profile; (2) investors, creditors, and counterparties must have sound risk  management policies, procedures, and systems to evaluate and limit their  credit risk exposures to hedge funds; and (3) creditors and counterparties  must increase the costs or decrease the availability of credit to their hedge  fund clients as the creditworthiness of the latter changes.
Inadequate market discipline is often cited as a contributing factor to the  near collapse in 1998 of Long-Term Capital Management (LTCM), a large  highly leveraged hedge fund. The subsequent 1999 report by the  President’s Working Group on Financial Markets (PWG) questioned the  adequacy of (1) market discipline that some creditors and counterparties  (commercial and investment banks, including their prime brokerage  business and futures firms) imposed on LTCM’s risk-taking activities, and  (2) LTCM’s disclosure and risk management practices. The report also  raised questions about the risk management practices of these entities and  the ability of federal financial regulators to supervise effectively the large  creditors and counterparties that extended credit to hedge funds. In its  1999 report, the PWG made recommendations to enhance market  discipline and the risk management practices of market participants.  Since LTCM, other hedge funds have experienced near collapses or  failures. Despite a few notable failures, hedge funds overall seem to have  held up well, and their counterparties have not sustained material losses in  the market turmoil that began in the summer of 2007. Although the market  impacts of the recent cases were less severe than that of LTCM, they  recalled concerns about risks associated with hedge funds and they  highlighted the continuing relevance of questions raised over LTCM.
Given the growing importance and continuing evolution of the hedge fund  sector since LTCM, you asked us to study the risks hedge funds may pose  to the financial markets and how hedge fund creditors and counterparties  and the regulatory framework can address those risks. Accordingly, this  report (1) describes how federal financial regulators provide oversight of  hedge fund-related activities under their existing authorities; (2) examines  what measures investors, creditors, and counterparties have taken to  impose market discipline on hedge funds; and (3) explores the potential  for systemic risk from hedge fund-related activities and actions regulators  have taken to address this risk. In addition, we provide information on  pension plan investments in hedge funds in appendix II.
In conducting our work, we reviewed and analyzed relevant regulatory  examination documentation and enforcement cases from federal financial  regulators. This included examination documentation and enforcement  cases from the following federal banking regulators—Office of the  Comptroller of the Currency (OCC), Board of Governors of the Federal  Reserve System (Federal Reserve), Federal Reserve Bank of New York  (FRBNY), and Federal Deposit Insurance Corporation (FDIC); a federal  securities regulator—Securities and Exchange Commission (SEC); and  futures markets regulators—Commodity Futures Trading Commission  (CFTC) and National Futures Association (NFA). We also analyzed  relevant laws and regulations, speeches, testimonies, studies, and prior  GAO reports, as well as principles and guidelines that the PWG issued  about private pools of capital—including hedge funds, PWG protocols, and  relevant industry best practices for hedge fund advisers, creditors, and  counterparties. We interviewed officials representing the U.S. regulators  identified above and the Office of Thrift Supervision (OTS), the PWG,  Department of Labor (DOL), and the Department of the Treasury  (Treasury). We also interviewed officials of the United Kingdom’s  Financial Services Authority (FSA), as well as representatives from market  participants such as commercial and investment banks, large hedge funds,  pension industry participants, credit rating agencies, a risk management  firm, a hedge fund law firm, trade groups representing hedge funds and  institutional investors, and academics. We conducted this performance  audit from September 2006 to January 2008 in accordance with generally  accepted government auditing standards. Those standards require that we  plan and perform the audit to obtain sufficient, appropriate evidence to  provide a reasonable basis for our findings and conclusions based on our  audit objectives. We believe that the evidence obtained provides a  reasonable basis for our findings and conclusions based on our audit  objectives. Appendix I provides a detailed description of our scope and  methodology.
subsections: section_title: Background
paragraphs: Hedge funds typically are organized as limited partnerships or limited  liability companies, and are structured and operated in a manner that  enables the fund and its advisers to qualify for exemptions from certain  federal securities laws and regulations that apply to other investment  pools, such as mutual funds. In addition, hedge funds operate to qualify  for exemptions from certain registration and disclosure requirements of  federal securities laws (including the Securities Act of 1933 and the  Securities Exchange Act of 1934). For example, hedge funds must refrain  from advertising to the general public and can solicit participation in the  fund from only certain large institutions and wealthy individuals.  Although certain advisers may be exempt from registration requirements,  they remain subject to anti-fraud (including insider trading), anti- manipulation, and large trading position reporting rules. For example,  upon acquiring a significant ownership position in a particular publicly  traded security or holding a certain level of futures or options positions, a  hedge fund adviser may be required to file a report disclosing the adviser’s  or hedge fund’s holdings with SEC or positions with CFTC, as applicable.
Hedge funds have significant business relationships with the largest  regulated commercial and investment banks. Hedge funds act as trading  counterparties for a wide range of over-the-counter (OTC) derivatives and  other financing transactions. They also act as clients through their  purchase of clearing and other services and as borrowers through their  use of margin loans from prime brokers.
Hedge funds generally are not restricted by regulation in their choice of  investment strategies, as are mutual funds. They may invest in a wide  variety of financial instruments, including stocks and bonds, currencies,  OTC derivatives, futures contracts, and other assets. Most hedge fund  trading strategies are dynamic, often changing rapidly to adjust to fluid  market conditions. To seek to generate “absolute returns” (performance  that exceeds and has low correlation with stock and bond markets  returns), advisers may use leverage, short selling, and a variety of  sophisticated investment strategies and techniques. However, while  hedge funds frequently borrow or trade in products with leverage to  magnify their returns, leverage also can increase their losses. Appendix III  provides examples of investment strategies used by hedge funds.
Advisers of hedge funds commonly receive a fixed compensation of 2  percent of assets under management plus 20 percent of the fund’s annual  profits. Some fund advisers can command higher fees. Since this  compensation scheme rewards hedge fund advisers for exceptional  performance, but does not directly penalize them for inferior performance,  advisers could be tempted to pursue excessively risky investment  strategies that might produce exceptional returns. To discourage  excessive risk taking, investors generally insist that the advisers and  principals also personally invest in their funds to more closely align  principals’ interests with those of fund investors.
section_title: Hedge Funds Generally Are Subject to Limited Direct Oversight, but Regulatory Focus Has Increased since LTCM
paragraphs: SEC’s ability to directly oversee hedge fund advisers is limited to those  that are required to register or voluntarily register with SEC as investment  advisers. Recent examinations of registered advisers raised concerns in  areas such as disclosure, reporting and filing, personal trading, and asset  valuation. Also, under a program established in 2004, SEC oversees, on a  consolidated basis, some of the largest internationally active securities  firms that engage in significant hedge fund-related activities. CFTC directly  oversees registered CPOs and CTAs (some of which may be hedge fund  advisers) through market surveillance, regulatory compliance surveillance,  an examination program delegated to NFA, and enforcement actions. The  banking regulators also monitor hedge fund-related activities at the  institutions under their jurisdiction. For instance, in recent years  regulators conducted targeted examinations and horizontal reviews that  have focused on areas such as stress testing, leverage, liquidity, due  diligence, and margining practices as well as overall credit risk  management.
subsections: section_title: With Limited Authority to Regulate Hedge Funds, SEC Largely Monitors Hedge Fund Activities and Related Risks through Consolidated Supervision of Large Securities Firms
paragraphs: Registered hedge fund advisers are subject to the same disclosure  requirements as all other registered investment advisers. These advisers  must provide current information to both SEC and investors about their  business practices and disciplinary history. Advisers also must maintain  required books and records, and are subject to periodic examinations by  SEC staff. Meanwhile, hedge funds, like other investors in publicly traded  securities, are subject to various regulatory reporting requirements. For  example, upon acquiring a 5 percent beneficial ownership position of a  particular publicly traded security, a hedge fund may be required to file a  report disclosing its holdings with SEC. Also, any institutional investment  adviser with investment discretion over accounts holding certain publicly  traded equity securities valued at $100 million or more must file on a  quarterly a report with SEC. SEC also plans to propose new rule making  that would require a registered adviser sponsoring a hedge fund to identify  and provide some basic information to SEC about the hedge fund’s  gatekeepers, i.e., auditor, prime broker, custodian, and administrator.
In December 2004, SEC adopted an amendment to Rule 203(b)(3)-1, which  had the effect of requiring certain hedge fund advisers that previously  enjoyed the private adviser exemption from registration to register with  SEC as investment advisers. In June 2006, a federal court vacated the  2004 amendment to Rule 203(b)(3)-1. According to SEC, when the rule  was in effect (from February 1, 2006, through August 21, 2006), SEC was  better able to identify hedge fund advisers. In August 2006, SEC estimated  that 2,534 advisers that sponsored at least one hedge fund were registered  with the agency. Since August 2006, SEC’s ability to identify an adviser  that manages a hedge fund has been further limited due to changes in  filing requirements and to advisers that chose to retain registered status.  As of April 2007, 488, or about 19 percent of the 2,534 advisers, had  withdrawn their registrations. At the same time, 76 new registrants were  added and some others changed their filing status, leaving an estimated  1,991 hedge fund advisers registered. While the list of registered hedge  fund advisers is not all-inclusive, many of the largest hedge fund  advisers—including 49 of the largest 78 U.S. hedge fund advisers—are  registered. These 49 hedge fund advisers account for approximately   $492 billion of assets under management, or about 33 percent of the  estimated $1.5 trillion in hedge fund assets under management in the  United States.
subsections: section_title: SEC Examinations of Hedge Fund Advisers Identified Areas of Concern
paragraphs: In fiscal year 2006, SEC took additional steps to oversee hedge fund  advisers by creating an examination module specifically for hedge fund  advisers and providing training for examiners in hedge fund-related topics.  The new examination module outlines how the examination of a hedge  fund adviser generally begins with an analysis of the adviser’s compliance  program and the work of its chief compliance officer and uses a control  scorecard as a guide. As part of this review of compliance programs,  examiners inspect the typical activities of advisers and are expected to  obtain a clear understanding of all activities of affiliates and how these  activities may affect or conflict with those of the hedge fund adviser being  examined. Examiners are to focus primarily on the following activities  during their examinations of hedge fund advisers:    brokerage arrangements and trading;    personal trading by access persons;    valuation of positions and calculations of net asset value;    safety of clients’ and funds’ assets;  fund investors and capital introduction;    violations of domestic or foreign laws that may directly harm fund  investors or other market participants, or cause harm to prime brokers;   books and records, fund financial statements, and investor reporting;    chief compliance officer, compliance culture, and program; and    boards of directors for offshore funds (fiduciary duties to shareholders of  the hedge funds and consistent disclosure to its investors).
In preparation for the registration of hedge fund advisers and because SEC  does not have a dedicated group of examiners that focus on hedge funds,  SEC and hedge fund industry officials noted the need for more experience  and ongoing training of examiners on hedge funds’ investment strategies  and complex financial instruments. SEC developed a specialized training  program to better familiarize its examiners with the operation of hedge  funds to improve effectiveness of examinations of hedge fund advisers. In  that regard, from October 2005 through October 2006, SEC held about 20  examiner training sessions on hedge fund-related topics. Industry  participants were instructors in many of these sessions. These sessions  covered topics such as hedge fund structure, hedge fund investment  vehicles, identification and examination of conflicts of interests at hedge  fund advisers, risk management, prime brokerage, valuation, current and  future regulation, examination issues, and investment risk. SEC continues  to offer hedge fund training to examiners and other staff on an ongoing  voluntary basis.
SEC uses a risk-based examination approach to select investment advisers  for inspections. Under this approach, higher-risk investment advisers are  examined every 3 years. One of the variables in determining risk level is  the amount of assets under management. SEC officials told us that most  hedge funds, even the larger ones, do not meet the dollar threshold to be  automatically considered higher-risk. As part of the overall risk-based  approach for conducting oversight of investment advisers, SEC uses a  database application called Risk Assessment Database for Analysis and  Reporting (RADAR), to identify the highest-risk areas designated by  examiners and to develop and recommend regulatory responses to  address these higher-risk areas. In fiscal year 2006, RADAR identified a  number of hedge fund-related risk areas, which although not exclusive to  hedge funds require additional regulatory attention, including the  following:    soft dollars (e.g., paying for a hedge fund’s office space without disclosing    market manipulation (e.g., the dissemination of false information to inflate  the price of a stock);    hedge fund custody and misappropriation (e.g., theft of hedge fund assets  by its advisers);   complexity of hedge fund products and suitability (e.g., inadequacy of  policies and procedures to assess the complexity of financial instruments  and the suitability of products for investors);   prime brokerage relationships (e.g., potential conflicts of interest where  prime brokers give hedge fund clients—who often pay large dollar  amounts of commissions—priority over non-hedge fund clients regarding  access to information/research);   performance fees (e.g., incorrect calculation of performance fees);    hedge fund valuation (e.g., inadequate policies and procedures to ensure  that asset valuations are accurate); fund of funds’ conflicts of interest (e.g., conflicts of interest between fund  of funds advisers and their recommendation to a fund of hedge fund to  invest in certain hedge funds); insider trading (e.g., trading on nonpublic information); and   hedge fund suitability (e.g., inadequate policies and procedures to ensure  the financial qualification of investors).
According to SEC officials, they plan to address these risks by primarily  focusing on these areas during subsequent examinations.
As part of its fiscal year 2006 routine inspection program, SEC conducted  examinations of 1,346 registered investment advisers, of which 321 were  believed to have involved hedge fund advisers. SEC used its new hedge  fund module, along with other modules as appropriate, to conduct the 321  examinations, which included 5 of the largest 78 U.S. hedge funds.  According to SEC officials, the 321 hedge fund advisers’ examinations  found that these advisers had the greatest deficiencies in the following  areas: (1) information disclosures, reporting, and filing—e.g., private  placement memorandum was outdated; (2) personal trading—e.g.,  quarterly reports were not filed or filed late for personal trading accounts;  and (3) compliance rule—e.g., policies and procedures were inadequate to  address compliance risks. Examiners also cited concerns with  performance advertising and marketing of portfolio management,  brokerage arrangement and execution, information processing and  protection, safety of clients’ funds and assets, pricing of clients’ portfolios,  trade allocations, and anti-money laundering.
In our review of 9 of the 321 examinations of hedge fund advisers, we  found that examiners cited deficiencies in 8 of these examinations.  Deficiencies found included all of the above mentioned categories except  for trade allocations. For example, examiners identified concerns in 5 of  the examinations regarding disclosures and in one of the examinations, for  instance, the hedge fund adviser’s marketing package did not disclose any  material conditions, objectives, or investment strategies used to obtain the  performance result portrayed. In another examination, the hedge fund  adviser failed to adequately disclose to investors that a conflict of interest  may be present when the hedge fund adviser places transactions through  broker-dealers who have invested in the hedge fund.
According to SEC officials, 294 (or approximately 92 percent) of the 321  hedge fund advisers examined received deficiency letters. Some 292 of  them provided satisfactory responses to SEC that they had taken or would  take appropriate corrective actions. Such actions can include advisers  implementing policies and procedures to address deficiencies. Those  hedge fund advisers that do not take or propose to take corrective actions  for a material deficiency may be referred to SEC’s Division of  Enforcement (Enforcement) for enforcement actions. According to SEC,  23 of the 321 examinations resulted in enforcement referrals, and most of  these referrals regarded situations in which the adviser appeared to have  engaged in fraud that harmed its clients.
As part of its oversight activities, SEC has brought a number of  enforcement actions involving hedge fund advisers. Sources of  information that led to SEC enforcement cases included examinations,  self-regulatory organizations, referrals, and tips. From October 1, 2001, to  June 12, 2007, SEC brought a total of 3,937 enforcement cases, of which  113, or 2.9 percent, were hedge fund-related. These cases involve hedge  fund advisers who misappropriated fund assets, engaged in insider trading,  misrepresented portfolio performance, falsified their experience and  credentials, or lied about past returns. As an example, in 2006, SEC  brought a case against a hedge fund adviser and its former portfolio  manager and charged them with making investment decisions based on  nonpublic insider information that certain public offerings were about to  be publicly announced. The hedge fund adviser agreed to pay  approximately $5.7 million in disgorgement, prejudgment interest, and  civil money penalty, and the former portfolio manager agreed to pay a civil  money penalty of $110,000 and be barred from associating with an  investment adviser for 3 years. SEC also has brought cases for inaccurate  disclosure of trading strategies, undisclosed preferential treatment of  hedge fund clients at the expense of other clients, market manipulation,  insider trading, illegal short selling, and improper valuation of assets.  During the same period, nine insider trading cases were brought against  hedge fund advisers, of which five have been settled and four remain in  litigation. The five settled cases resulted in disgorgements ranging from  $2,736 to $7.05 million, civil penalties ranging from $8,208 to $4.7 million, a  suspension, and bars from the securities industry.
According to an SEC enforcement official, SEC recognized that hedge  funds were becoming a prominent force in the financial industry, and in  anticipation that certain hedge fund advisers would be required to register  with SEC as investment advisers when the now vacated amendment to  Rule 203(b)(3)-1 was under consideration, SEC created a hedge fund  working group composed primarily of Enforcement and Office of  Compliance Inspections and Examinations staff and participants from  other divisions. The goals of this group are to enhance SEC’s staff  knowledge about the hedge fund industry to aid in its oversight role and  coordinate and strengthen the agency’s efforts to combat insider trading at  hedge funds. Currently, SEC is conducting investigations into potential  insider trading by hedge fund advisers.
section_title: SEC Monitors Risk Management Practices at the Largest Securities Firms with Significant Hedge Fund Activities
paragraphs: SEC also conducts oversight over hedge fund activities through the  supervision of the regulated securities firms that transact business with  hedge funds as brokers, creditors, and counterparties. SEC staff oversees  some large, internationally active U.S. securities firms with significant  hedge fund activities through its Consolidated Supervised Entity program  (CSE), which was established in June 2004. Between December 2004 and  November 2005, five large securities firms have elected to become CSEs.  The CSE program consists of four components: (1) a review of the firm’s  application to become a CSE; (2) a review of monthly, quarterly, and  annual filings, such as consolidated financial statements and risk reports,  substantially similar to those provided to the firm’s senior management;  (3) monthly meetings with senior management (senior risk managers and  financial controllers) at the holding company level to review financial and  risk reports and share written results of these meetings among staff and  commissioners; and (4) an examination of books and records of the  ultimate holding company, the broker-dealer, and material affiliates. SEC  relies on a number of regulatory tools, including margin, capital, and  reporting requirements to oversee CSEs. Margin rules within the broker- dealer help protect against losses resulting from defaults by requiring its  hedge fund clients to provide collateral in amounts that depend on the risk  of the particular position and help maintain safety and soundness of their  firms. Capital requirements are minimum regulatory required levels of  capital that a firm must hold against its risk-taking activities. These  requirements can help a firm withstand the failure of a counterparty or a  period of market or systemic stress.
One aspect of the CSE program involves how the securities firms manage  various risk exposures, including those from hedge fund activities such as  providing prime brokerage service and acting as creditors and  counterparties through financing and OTC derivatives trade transactions.  These large integrated financial institutions may be exposed to various  risks from hedge fund activities such as providing prime brokerage  services through a registered broker-dealer, acting as creditors and  counterparties, or owning a hedge fund. For example, the recent problems  at two hedge funds sponsored by Bear Stearns Asset Management that  invested in financial instruments tied to subprime mortgages (where Bear  Stearns ultimately provided some secured financing to the funds) highlight  such risks. As part of the application process that took place from  November 2004 through January 2006, SEC examined the five securities  firms’ risk management systems (market, credit, liquidity, operational, and  legal and compliance), internal controls, and capital adequacy calculations  and continues to do so on an ongoing basis. SEC did not target hedge fund  activities specifically within the scope of the five application  examinations, because hedge funds were not products or activities judged  to pose the greatest risks to the firms. Our review of the five CSEs’  application examinations found that examination findings generally were  related to firms’ documentation of compliance with rules and  requirements. SEC shared the findings with the firms and has monitored  the firms’ implementation of its recommendations. An SEC official said  that those issues have been resolved, but more recently, SEC’s  examinations of three of the firms identified a number of issues related to  capital computations, operational controls, and risk management.  Examination staff are addressing these issues with the firms.
SEC monitors CSEs continuously for financial and operational weakness  that might place regulated entities within the group or the broader  financial system at risk. According to an SEC official, the CSE program  allows SEC to conduct reviews across the five firms (i.e., cross-firm  reviews) to gain insights into business areas that are material by risk or  balance sheet measures, rapidly growing, pose particular challenges in  implementing the Basel regulatory risk-based capital regime, or have some  combination of these characteristics. For example, in fiscal year 2006,  SEC conducted two cross-firm reviews related to leveraged lending and  hedge fund derivatives, and in fiscal year 2007, SEC conducted two cross- firm reviews related to securitization and private equity and principal  investments. According to the official, SEC generally found that the firms  were in regulatory compliance, but there were areas where capital  computation methodology and risk management practices can be  improved. For example, four firms modified their capital computations as  a result of feedback from the leveraged lending project. For each review,  SEC produced a report that described the business model, related risk  management, and capital treatment to each review area, and provided  feedback to each firm on where it stood among the peer firms.
section_title: CFTC Can Monitor Hedge Fund Activities through Its Market Surveillance, Regulatory Compliance Surveillance, and Delegated Examination Programs
paragraphs: Although CFTC does not specifically target hedge funds, through its  general market and financial supervisory activities, it can provide  oversight of persons registered as CPOs and CTAs that operate or advise  hedge funds that trade in the futures markets. As part of its market  surveillance program, CFTC collects information on market participants,  regardless of their registration status, to monitor their activities and  trading practices. In particular, traders are required to report their futures  and options positions when a CFTC-specified level is reached in a certain  contract market and CFTC electronically collects these data through its  Large Trader Reporting System (LTRS). CFTC also uses the futures and  options positions information reported by traders through the LTRS as  part of its monitoring of the potential financial exposure of traders to  clearing firms, and of clearing firms to derivatives clearing organizations.  CFTC collects position information from exchanges, clearing members,  futures commission merchants (FCM), and foreign brokers and other  traders—including hedge funds—about firm and customer accounts in an  attempt to detect and deter manipulation. Customers, including hedge  funds, are required to maintain margin on deposit with their FCMs to  cover losses that might be incurred due to price changes. FCMs also are  required to maintain CFTC-imposed minimum capital requirements in  order to meet their financial obligations. Such financial safeguards are put  in place to mitigate the potential spillover effect to the broader market  resulting from the failure of a customer or of an FCM.
According to CFTC officials, the demise (due to trading losses related to  natural gas derivatives) in the fall of 2006 of Amaranth Advisors, LLC  (Amaranth), a $9 billion multistrategy hedge fund, had no impact on the  integrity of the clearing system for CFTC-regulated futures and option  contracts. The officials said that at all times Amaranth’s account at its  clearing FCM was fully margined and the clearing FCM met all of its  settlement obligations to its clearinghouse. They also said that the  approximate $6 billion of losses suffered by Amaranth on regulated and  unregulated exchanges did not affect its clearing FCM, the other  customers of the clearing FCM, or the clearinghouse.
CFTC investigates and, as necessary, prosecutes alleged violators of the  Commodity Exchange Act (CEA) and CFTC regulations and may conduct  such investigations in cooperation with federal, state, and foreign  authorities. Enforcement referrals can come from several sources,  including CFTC’s market surveillance group or tips. Remedies sought in  enforcement actions generally include permanent injunctions, asset  freezes, prohibitions on trading on CFTC-registered entities, disgorgement  of ill-gotten gains, restitution to victims, revocation or suspension of  registration, and civil monetary penalties. On the basis of CFTC  enforcement data, from the beginning of fiscal year 2001 through May 1,  2007, CFTC brought 58 enforcement actions against CPOs and CTAs,  including those affiliated with hedge funds, for various violations. A  summary of the violations cited in the actions includes misrepresentation  with respect to assets under management or profitability; failure to  register with CFTC; failure to make required disclosures, statement, or  reports; misappropriation of participants’ funds; and violation of prior  prohibitions (i.e., prior civil injunction or CFTC cease and desist order).
Pursuant to CFTC-delegated authority, NFA, a registered futures  association under the CEA and a self-regulatory organization, oversees the  activities, and conducts examinations, of registered CPOs and CTAs. As  such, hedge fund advisers registered as CPOs or CTAs are subject to direct  oversight in connection with their trading in futures markets. More  specifically, to the extent that hedge fund operators or advisers trade  futures or options on futures on behalf of hedge funds, the funds are  commodity pools and the operators of, and advisers to, such funds are  required to register as CPOs and CTAs, respectively, with CFTC and  become members of NFA if they are not exempted from registration. Once  registered, CPOs and CTAs become subject to detailed disclosure, periodic  reporting and record-keeping requirements, and periodic on-site risk- based examinations. However, regardless of registration status, all CPOs  and CTAs (including those affiliated with hedge funds) remain subject to  CFTC’s anti-fraud and anti-manipulation authority.
Our review of NFA documentation found that 29 advisers of the largest 78  U.S. hedge funds (previously mentioned) are registered with CFTC as  CPOs or CTAs. In addition, 20 of the 29 also are registered with SEC as  investment advisers or broker-dealers. According to NFA officials, because  there is no legal definition of hedge funds, it does not require CPOs or  CTAs to identify themselves as hedge fund operators or advisers. NFA,  therefore, considers all CPOs and CTAs as potential hedge fund operators  or advisers. According to NFA, in fiscal year 2006 NFA examined 212  CPOs, including 6 of the 29 largest hedge fund advisers registered with  NFA. During the examinations, NFA staff performed tests of books and  records and other auditing procedures to provide reasonable assurance  that the firm was complying with NFA rules and all account balances of a  certain date were properly stated and classified. Our review of four of the  examinations found that 3 of the CPOs examined generally were in  compliance with NFA regulations and the remaining 1 was found to have  certain employees that were not properly registered with CFTC. According  to examination documentation, subsequent to the examination, the hedge  fund provided a satisfactory written response to NFA noting that it would  soon properly register the employees.
According to an NFA official, since 2003 NFA has taken 23 enforcement  actions against CPOs and CTAs, many of which involved hedge funds.  Some of the violations found included filing fraudulent financial  statements with NFA, not providing timely financial statements to  investors, failure to register with CFTC as a CPO, failure to maintain  required books and records, use of misleading promotional materials, and  failure to supervise staff. The penalties included barring CPOs and CTAs  from NFA membership temporarily or permanently or imposing monetary  fines ranging from $5,000 to $45,000.
section_title: Bank Regulators Have Conducted Some Examinations Relating to Hedge Fund Business at Banks
paragraphs: Bank regulators (the Federal Reserve, OCC, and FDIC) monitor the risk  management practices of their regulated institutions’ interactions with  hedge funds as creditors and counterparties. They are responsible for  ensuring that the organizations under their jurisdiction are complying with  supervisory guidance and industry sound practices regarding prudent risk  management throughout their business, including the guidance and  practices applicable to their activities with hedge funds. The 1999 PWG  report recommended that bank regulators encourage improvements in the  risk management systems of the regulated entities and promote the  development of a more risk-based approach to capital adequacy.
In overseeing banks’ hedge fund-related activities, the bank regulators  examine the extent to which banks are following sound practices as part  of their reviews of banks’ capital market activities. Bank regulators  conduct routine supervisory examinations of risk management practices  relating to hedge funds and other highly leveraged counterparties to  ensure that the supervised entities (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 identify, measure, and manage counterparty credit  risk; and (4) deploy appropriate internal controls to ensure the integrity of  their processes for managing counterparty credit risk.
The Federal Reserve’s supervision of banks’ hedge fund-related activities  is part of a broader, more comprehensive set of supervisory initiatives to  assess whether banks’ risk management practices and financial market  infrastructures are sufficiently robust to cope with stresses that could  accompany deteriorating market conditions. Specifically, the Federal  Reserve has been focusing on five key supervisory initiatives: (1)  comprehensive reviews of firms’ corporate-level stress testing practices,  (2) a multilateral supervisory assessment of the leading global banks’  current practices for managing their exposures to hedge funds, (3) a  review of the risks associated with the rapid growth of leveraged lending,  (4) a new assessment of practices to manage liquidity risk, and (5)  continued efforts to reduce risks associated with weaknesses in the  clearing and settlement of credit derivatives and other OTC derivatives.
The bank regulators also have performed targeted examinations of the  credit risk management practices of regulated entities that are major  hedge fund creditors or counterparties. From 2004 through 2007, FRBNY  conducted various reviews that addressed aspects of certain banks’  counterparty credit risk management practices that involved hedge fund  activities. These reviews were motivated by the rapid growth of the hedge  fund industry and also done to gauge progress made in improving risk  management practices pursuant to supervisory guidance and industry  recommendations. Examiners conducted meetings with management and  reviewed policies and procedures primarily by performing transactional  testing, relying on internal audits, and studying other functional regulators’  reviews.
According to a Federal Reserve official, while global banks have  significantly strengthened their risk management practices and procedures  for managing risk exposures to hedge funds, further progress is needed.  For example, in a 2006 firmwide examination of stress-testing practices at  certain U.S. banks, FRBNY indicated a need for the banks “to enhance  their capacity to aggregate credit exposures at the firm wide level,  including across counterparties; to assess the potential for counterparty  credit losses to be compounded by losses on the banks’ proprietary  trading positions; and to assess the potential effects of a rapid and  possibly a protracted decline in asset market liquidity.” According to this  official, the Federal Reserve has begun a review of liquidity risk  management practices at the largest U.S. bank holding companies,  focusing on the firms’ efforts to ensure adequate funding in more adverse  market conditions.
Federal Reserve examiners made a variety of other recommendations as a  result of the various reviews. Many of their recommendations were  developed as ways that banks could continue to enhance their risk  management processes associated with hedge fund counterparties. The  examiners found a range of practices for counterparty stress testing for  hedge funds and noted that there was room for improvement even at the  banks with the most advanced practices. Where examiners identified  deficiencies, specific recommendations were made. Although credit  officers often adjusted credit terms for degree of transparency, examiners  recommended that banks’ policies explicitly link transparency to credit  terms and that banks monitor evolving credit terms for hedge fund  counterparties. Moreover, examiners found that the banks that were part  of the reviews needed to enhance their policies to more specifically  address due diligence requirements or standards to provide clearer  standards and guidance for reviewing hedge fund valuation processes.
In 2005 and 2006, OCC conducted an examination of hedge fund-related  activities—mainly counterparty credit risk management practices (such as  due diligence of their hedge fund customer’s business), and margining and  collateral monitoring processes—at the three large U.S. banks. OCC  generally found the overall risk management practices of these banks to  be satisfactory. However, examiners identified concerns in the lack of  transparency in the banks’ hedge fund review processes and issued  recommendations accordingly. For example, examiners found in certain  banks a lack of adequate credit review policies that clearly outline risk  assessment criteria for levels of leverage, risk strategies and  concentrations, and other key parameters and documentation to support  accuracy of a bank’s credit analysis and risk rating system. Examiners also  found that financial information provided by some hedge fund borrowers  has been incomplete and that banks should document the lack of such  information in their credit review process. OCC noted that the banks have  taken satisfactory steps in response to examination issues raised.
In addition, in 2005 and 2006, FDIC conducted an examination of hedge  fund lending at one of its banks. FDIC noted that the bank was not in  compliance with the bank’s lending policy to diversify its hedge fund loans  and that certain policies should be updated, but generally found the risk  management practices of the bank’s hedge fund lending program to be  satisfactory.
Bank regulators largely rely on their oversight of hedge fund-related  activities at those regulated entities that transact with hedge funds in their  efforts to mitigate the potential for hedge funds to contribute to systemic  risk. Since 2004, regulators have increased their attention to these  activities. In particular, bank regulators are reviewing the entities’ ability  to identify and manage their counterparty credit risk exposures, including  those that involve hedge funds. Regulated entities have the responsibility  to practice prudent risk management standards, but prudent standards do  not guarantee prudent practices. As such, it will be important for  regulators to show continued vigilance in overseeing banks’ hedge fund- related activities.
section_title: Investors, Creditors, and Counterparties Have Increased Efforts to Impose Discipline on Hedge Fund Advisers, but Some Limitations Remain
paragraphs: Investors, creditors, and counterparties impose market discipline—by  rewarding well-managed hedge funds and reducing their exposure to risky,  poorly managed hedge funds—during due diligence exercises and through  ongoing monitoring. During due diligence, hedge funds should be asked to  provide credible information about risks and prospective returns. Market  participants told us that growing investments by institutional investors  with fiduciary responsibilities and guidance from regulators and industry  groups led hedge fund advisers to improve disclosure and transparency in  recent years. Creditors and counterparties also can impose market  discipline through ongoing management of credit terms (such as collateral  requirements). However, some market participants and regulators  identified limitations to market discipline or failures to exercise it  properly. For instance, large hedge funds use multiple prime brokers,  making it unlikely that any single broker would have all the data needed to  assess a client’s total leverage. Others were concerned that some creditors  and counterparties may lack the capacity to assess risk exposures because  of the complex financial instruments and investment strategies that some  hedge funds use, which could illustrate a failure to exercise market  discipline properly if the creditor or counterparty continued to do  business with the fund. Further, regulators have raised concerns that  creditors may have relaxed credit standards to attract and retain hedge  fund clients, another potential failure of market discipline.
subsections: section_title: Better Due Diligence and Greater Demand for Transparency from Investors Have Resulted in Increased Hedge Fund Disclosure, but Some Investors May Lack the Capacity to Assess Risk Exposures
paragraphs: By evaluating hedge fund management, the fund’s business activities, and  its internal controls, investors are imposing discipline on hedge fund  advisers. Market participants who generally transact with large hedge  funds and institutional investors told us that before investing in a hedge  fund, potential investors usually conduct a due diligence exercise of the  business, management, legal, and operational aspects of the hedge fund  under consideration for investment. Market participants further noted that  the exercise moves from an initial screening to quickly identify the funds  that do meet the potential investor’s investment criteria to a detailed  evaluation that involves addressing a series of questions about the  business, management, legal, and operational aspects of the hedge fund.  Among other things, investors may take into account investment strategies  hedge funds use to produce their returns, the types of investments traded,  and the fund’s risk management practices and risk profiles. Investors  analyze this information to determine whether the investment’s risks and  reward warrant further consideration.
Typically, prospective investors receive written information from the  hedge fund manager in the form of a private offering memorandum or  private placement memorandum (PPM). We could not obtain hedge fund  offering documents, but market participants who have reviewed PPMs told  us that there are no standard disclosure requirements for PPMs and the  information disclosed is often general in scope. Consequently, investors  may seek information beyond that provided in PPMs and sometimes  beyond what hedge funds are willing to provide. For instance, they may  request from hedge fund managers a list of hedge fund securities positions  and holdings (position transparency) or information about the risks  associated with the hedge fund’s market positions (risk transparency).
However, according to market participants we interviewed, although most  hedge funds may be willing to provide information on aggregate position  and holdings, many hedge funds decline to share specific position  transparency, citing the need to keep such information confidential for  fear that disclosure might permit other market participants to take  advantage of their trading positions to the detriment of the fund and its  investors. Additionally, some prospective investors also may obtain from  hedge fund managers access to the hedge funds’ prime brokers and other  service providers such as auditors, lawyers, fund administrators, and  accountants for background checks. A representative of a group that  represents institutional investors we met with told us that after making an  investment, investors typically will monitor their investment on an  ongoing basis to evaluate portfolio performance and track how well  investments are moving toward investment goals and benchmarks.
Recently, hedge fund advisers have increased their level of disclosure in  response to demands from institutional investors. Institutional  investments in hedge funds have grown substantially in recent years. Over  the last 3 years, institutional investors in search of higher returns and risk  diversification, such as pension funds, endowments, and funds of hedge  funds, have accounted for a significant portion of the inflows to hedge  funds assets under management. (See app. II for information on pension  plan investments in hedge funds). According to market participants and  industry literature, the increasing popularity of hedge funds among these  institutional investors has led to changes in the industry. That is, hedge  fund advisers have responded to the requirements of these clients by  providing disclosure that allows them to meet fiduciary responsibilities.  For example, one market participant we met with stated that a trustee to a  pension plan that is subject to the “prudent person” standard of the  Employee Retirement Income Security Act of 1974 (ERISA) is required to  make investment decisions for the plan in accordance with a “prudent  person” standard of care that may require plan trustees to demand greater  quality oversight of their capital; in consequence, they may demand greater  transparency, risk information, and valuation techniques than individual  investors. Market participants with whom we met also told us that the  trend toward permanent capital also has been driving hedge fund  transparency. Markets participants further noted that as hedge funds reach  a certain size, they tend to seek more permanent capital through the public  markets to avoid the liquidity risks inherent with sudden investor  redemptions.
The ability of market discipline to control hedge funds’ risk taking is  limited by some investors’ inability to fully understand and evaluate the  information they receive on hedge fund activities or these investors’  willingness to hire others to evaluate that information for them. An  example can be found in the Amaranth case. According to market  participants we interviewed and industry coverage that documented the  event, Amaranth noted in its periodic letters to investors that it had a large  concentration in the natural gas sector. The market participants and the  documents noted that some investors became concerned about the  potential risks associated with concentrated positions and withdrew their  money from Amaranth several months before Amaranth failed. They also  said that other investors did not heed potential warning signs included in  the investor letter and kept their money in Amaranth either in pursuit of  higher investment returns or because they did not fully comprehend the  changing risk profile of the hedge fund.
Regulators, market participants, and academics generally agree that hedge  funds have improved disclosure and risk management practices since the  LTCM crisis and have largely adopted the guidance from various industry  groups and the PWG. Regulators told us that from their examinations of  regulated entities that transact business with hedge funds as creditors and  counterparties, they have observed that hedge fund disclosure and risk  management practices have improved since LTCM. For example, in  response to the 1999 PWG report recommendation that hedge funds  establish a set of sound practices for risk management and internal  controls, private sector entities such as the Managed Funds Association  (MFA), and the Counterparty Risk Management Policy Group (CRMPG),  as well as the public sector International Organization of Securities  Commissions (IOSCO) published guidance for hedge funds and their  advisers. Market participants told us that many hedge fund advisers with  which they conduct business have adopted these best practices, including  risk management models that go beyond measuring “value at risk,” and  now regularly stress-test portfolios under a wide range of adverse  conditions. Representatives from a risk management firm told us that in  the past, hedge fund advisers viewed risk management practices as  proprietary. However, as the trading environment evolved, advisers  realized they needed to provide results of risk assessments to investors to  attract investments.
section_title: Creditors and Counterparties Can Impose Some Market Discipline on Hedge Fund Advisers as Part of Credit Extension, but the Complexity of Counterparty Credit Risk Management Poses Ongoing Challenges for Financial Institutions
paragraphs: By evaluating hedge fund management, the fund’s business activities, and  its internal and risk management controls, creditors and counterparties  exert discipline on hedge fund advisers. According to market participants,  entering into contracts with hedge funds as creditors or counterparties is  the primary mechanism by which financial institutions’ credit exposures to  hedge funds arise, and exercising counterparty risk management is the  primary mechanism by which financial institutions impose market  discipline on hedge funds. According to the staff of the member agencies  of the PWG, the credit risk exposures between hedge funds and their  creditors and counterparties arise primarily from trading and lending  relationships, including various types of derivatives and securities  transactions. As part of the credit extension process, creditors and  counterparties typically require hedge funds to post collateral that can be  sold in the event of default. According to market participants we  interviewed, collateral most often takes the form of cash or high-quality,  highly liquid securities (e.g., government securities), but it can also include  lower-rated securities (e.g., BBB rated bonds) and less liquid assets (e.g.,  CDOs). They told us they take steps to ensure that they have clear control  over collateral that is pledged, which according to some creditors and  counterparties we interviewed, that was not the case with LTCM.  Creditors and counterparties generally require hedge funds to post  collateral to cover current credit exposures (this generally occurs daily)  and, with some exceptions, require additional collateral, or initial margin,  to cover potential exposures that could arise if markets moved sharply.  Creditors to hedge funds said that they measure a fund’s current and  potential risk exposure on a daily basis to evaluate counterparty positions  and collateral.
To control their risk exposures, creditors and counterparties to generally  large hedge funds told us that, unlike in the late 1990s, they now conduct  more extensive due diligence and ongoing monitoring of a hedge fund  client. According to OCC, banks also conduct “abbreviated” underwriting  procedures for small hedge funds in which they do not conduct much due  diligence. OCC officials also told us that losses due to the extension of  credit to hedge funds were rare. Creditors and counterparties of large  hedge funds use their own internal rating and credit or counterparty risk  management process and may require additional collateral from hedge  funds as a buffer against increased risk exposure. They said that as part of  their due diligence, they typically request information that includes hedge  fund managers’ background and track record; risk measures; periodic net  asset valuation calculations; side pockets and side letters; fees and  redemption policy; liquidity, valuations, capital measures, and net changes  to capital; and annual audited statements. According to industry and  regulatory officials familiar with the LTCM episode, this was not  necessarily the case in the 1990s. At that time, creditors and  counterparties had not asked enough questions about the risks that were  being taken to generate the high returns. Creditors and counterparties told  us they currently establish credit terms partly based on the scope and  depth of information that hedge funds are willing to provide, the  willingness of the fund managers to answer questions during on-site visits,  and the assessment of the hedge fund’s risk exposure and capacity to  manage risk. If approved, the hedge fund receives a credit rating and a line  of credit. Several prime brokers told us that losses from hedge fund clients  were extremely rare due to the asset-based lending they provided such  funds. Also, one prime broker noted that during the course of its  monitoring the risk profile of a hedge fund client, it noticed that the hedge  fund manager was taking what the broker considered to be excessive risk,  and requested additional information on the fund’s activity. The client did  not comply with the prime broker’s request for additional information, and  the prime broker terminated the relationship with the client.
Through continuous monitoring of counterparty credit exposure to hedge  funds, creditors and counterparties can further impose market discipline  on hedge fund advisers. Some creditors and counterparties also told us  that they measure counterparty credit exposure on an ongoing basis  through a credit system that is updated each day to determine current and  potential exposures. Credit officers at one bank said that they receive  monthly investor summaries from many of their hedge fund clients. The  summaries provide information for monitoring the activities and  performance of hedge funds. Officials at another bank told us that they  generally monitor their hedge fund clients on a quarterly basis and may  alter credit terms or terminate a relationship if it is determined that the  fund is not dealing with risk adequately or if it does not disclose requested  information.
Some creditors also said that they may provide better credit terms to  hedge funds that consolidate all trade executions and settlements at their  firm than to hedge funds that use several prime brokers because they  would know more about the fund’s exposure. However, large hedge funds  may limit the information they provide to banks and prime brokers for  various reasons. Unlike small hedge funds that generally depend on a  single prime broker for a large number of services ranging from capital  introductions to the generation of customized accounting reports, many  large hedge funds are less dependent on the services of any single prime  broker and, according to several market participants, use multiple prime  brokers as a means to protect proprietary trading positions and strategies,  and to diversify their credit and operational risks.
Despite improvements in disclosure and counterparty credit risk  management, regulators noted that the effectiveness of market discipline  may be limited or market discipline may not be exercised properly for  several reasons. First, because large hedge funds use several prime  brokers as creditors and counterparties, no single prime broker may be  able to assess the total amount of leverage used by a large hedge fund  client. The stress tests and other tools that prime brokers use to monitor a  given counterparty’s risk profile can incorporate only those positions  known to a trading partner. Second, the increasing complexity of  structured financial instruments has raised concerns that counterparties  lack the capacity (in terms of risk models and resources) to keep pace  with and assess actual risk, illustrating a possible failure to exercise  market discipline properly. More specifically, despite improvements in  risk modeling and risk management, the Federal Reserve believes that  further progress is needed in the procedures global banks use to manage  exposures to highly leveraged counterparties such as hedge funds, in part  because of the increasing complexity of products such as structured credit  products and CDOs in which hedge funds are active participants. The  complexity of structured credit products can add to the already complex  task of measuring and managing counterparty credit risk. For example,  another Federal Reserve official has noted that the measurement of  counterparty credit risk requires complex computer simulations and that  “the management of counterparty risk is also complicated further by hedge  funds’ complicated organizational structures, legal rights, collateral  arrangements, and frequent trading. It is important that banks develop the  systems capability to regularly gather and analyze data across diverse  internal systems to manage their counterparty credit risk to hedge funds.”  One regulatory official further noted the challenges faced by institutions in  finding, developing and retaining individuals with the expertise required to  analyze the adequacy of these increasingly complex models. The lack of  talented staff can affect counterparty credit risk monitoring and the ability  to impose market discipline on hedge fund risk taking activities. Third,  some regulators have expressed concerns that some creditors and  counterparties may have relaxed their counterparty credit risk  management practices for hedge funds, which could weaken the  effectiveness of market discipline as a tool to limit the exposure of hedge  fund managers. They noted that competition for hedge fund clients may  have led some to reduce the initial margin in collateral agreements,  reducing the amount of collateral to cover potential credit exposure.
section_title: Regulators View Hedge Fund Activities as Potential Sources of Systemic Risk and Are Taking Measures to Enhance Market Discipline and Prepare for Financial Disruptions
paragraphs: Financial regulators and industry observers remain concerned about the  adequacy of counterparty credit risk management at major financial  institutions because it is a key factor in controlling the potential for hedge  funds to become a source of systemic risk. While hedge funds generally  add liquidity to many markets, including distressed asset markets, in some  circumstances hedge funds’ activities can strain liquidity and contribute to  financial distress. In response to their concerns regarding the adequacy of  counterparty credit risk, a group of regulators have, over the past year,  been collaborating to examine particular hedge fund-related activities  across entities they regulate, mainly through international multilateral  efforts and the domestic PWG. The PWG also has established two private  sector committees to identify best practices to address systemic risk and  investor protection issues and has formalized protocols to respond to  financial shocks.
subsections: section_title: Despite Intensified Market Discipline, Concerns about Hedge Funds Creating Systemic Risk Remain
paragraphs: Financial regulators believe that the market discipline imposed by  investors, creditors, and counterparties is the most effective mechanism  for limiting the systemic risk from the activities of hedge funds (and other  private pools of capital). The most important providers of market  discipline are the large, global commercial and investment banks that are  hedge funds’ principal creditors and counterparties. While regulators and  others recognize that counterparty credit risk management has improved  since LTCM, the ability of financial institutions to maintain the adequacy  of these management processes in light of the dramatic growth in hedge  fund activities remains a particular focus of concern. In its July 2005  report, CRMPG noted that “credit risk and, in particular counterparty  credit risk, is probably the single most important variable in determining  whether and with what speed financial disturbances become financial  shocks with potential systemic traits.” CRMPG further noted that no  single hedge fund today is leveraged on a scale comparable to that of  LTCM in 1998 and that the risk management capabilities of hedge funds  had improved. Although CRMPG concluded that the chance of systemic  financial shocks had declined, Treasury officials noted that regulators  continually review whether the failure of one or more large market  participants, including hedge funds, could destabilize regulated financial  institutions or financial markets in a way that generates broader  macroeconomic consequences.
Effective market discipline requires that the creditors and counterparties  to hedge funds obtain sufficient information to reliably assess clients’ risk  profiles and that they have systems to monitor and limit exposures to  levels commensurate with each client’s risk and creditworthiness. A  number of large commercial banks and prime brokers bear and manage  the credit and counterparty risks that hedge fund leverage creates.  According to a Federal Reserve official, the recent growth of hedge funds  poses formidable challenges, including significant risk management  challenges to these market participants. If market participants prove  unwilling or unable to meet these challenges, losses in the hedge fund  sector could pose significant risk to financial stability. Concerns remain  that creditors and counterparties face constant challenges in measuring  and managing counterparty credit risk exposures to hedge funds, and in  maintaining qualified staff to implement the various elements of  counterparty credit risk management, including stress testing.
In addition to counterparty credit risk, Treasury officials noted that  regulators continually review the liquidity of markets to determine  whether the trading behavior of market participants, including hedge  funds, could serve as a source of systemic risk. While hedge funds often  provide liquidity to stressed markets by buying securities that are  temporarily distressed, herding behavior by market participants, including  hedge funds, could strain available market liquidity. According to a  Treasury official, “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 to simultaneously unwind their  positions.” Some market participants noted that the consequences of  these “crowded” trades were difficult to anticipate.
Some Federal Reserve officials noted in a journal article that “in a crisis,  interlocking credit exposures would be the key mechanism by which risks  would be transmitted from one institution to another, potentially  transforming a run-of-the-mill disturbance into a systematic situation.”  The forced sale of assets is recognized by regulators as a potential  transmission mechanism for systemic risk. According to these officials,  regulators in general share concerns that “in illiquid markets, hedge funds  may be forced to sell positions to meet margin requirements, driving down  market prices. In severe cases, the hedge fund may drive down the value  of existing positions by more than they receive from the original sale,  forcing further sales.” However, this transmission mechanism is not  unique to hedge funds but is a characteristic of leverage. Even when the  failure of a hedge fund does not result in a large-scale liquidation of assets,  the concerns raised by the failure can disrupt credit markets. For instance,  concerns regarding the valuation of illiquid subprime mortgages, such as  those held by Bear Stearns Asset Management’s hedge funds, have  contributed to questions about credit quality in this and other markets,  and this broader questioning of credit quality may have contributed to the  subsequent tightening of credit.
section_title: Regulators Are Taking Steps to Strengthen Market Discipline to Address Systemic Risk Concerns Stemming from Hedge Fund Activities
paragraphs: To enhance market discipline and help mitigate the potential systemic  risks that hedge fund activities could pose, financial regulators recently  have increased collaboration with each other, foreign financial regulators,  and industry participants. They have been conducting these efforts  primarily through an international review of large financial institutions and  actions initiated by the PWG. As discussed earlier, hedge funds are a  potential source of systemic risk if the capacity of their creditors and  counterparties to value positions and manage risk does not keep pace with  developments such as the increasing complexity of financial instruments  and of investment strategies. Because the use of these instruments and  strategies is not exclusive to hedge funds, a regulator said that collecting  data on hedge fund activities to monitor buildup of this risk would be  difficult and not meaningful. Instead, regulators have taken a risk-focused  and principles-based approach by monitoring counterparty risk  management practices across regulated entities and issuing guidance to  help strengthen market discipline. Currently, regulators are reviewing  issues related to the valuation of complex, illiquid, and stressed  instruments by all types of entities. The PWG has also formalized  protocols for coordination among the financial regulators in the event of a  financial market crisis.
In late 2006, FRBNY, SEC, OCC, FSA, and bank regulators of Germany and  Switzerland—collectively, the “multilateral effort”—jointly conducted a  review of the largest commercial and investment banks that transacted  business with hedge funds as counterparties and creditors. The agencies  met with nine major U.S. and European bank and securities firms to  discuss risk management policies and procedures related to interactions  with hedge funds through prime brokerage, direct lending, and over-the- counter derivative transactions. According to one U.S. regulator, the  reviewers found that the current and potential credit exposures of these  banks to hedge funds were small relative to the banks’ capital because of  their extensive use of collateral agreements. However, the reviewers  identified a number of issues related to the management of exposures to  hedge funds and the measurement of potential exposures in adverse  market conditions. The regulators participating in this effort have been  addressing these issues by gathering additional data or information to help  regulators learn more about the condition and quality of the firms’ risk  management practices. The regulators are conducting an ongoing follow- up review, which entails more detailed work by the principal regulator of  each firm.
In February 2007, the PWG issued principles-based guidance for  approaching issues related to private pools of capital, including hedge  funds. The principles are intended to guide market participants (for  example, hedge fund advisers, creditors, counterparties, and investors), as  well as U.S. financial regulators as they address investor protection and  systemic risk issues associated with the rapid growth of private pools of  capital and the complexity of financial instruments and investment  strategies they employ. The efforts for each group of stakeholders  enumerated in the principles and guidelines that the PWG issued entitled  “Agreement Among PWG and U.S. Agency Principals on Principles and  Guidelines Regarding Private Pools of Capital” are briefly summarized  below:  “Private Pools of Capital: maintain and enhance information, valuation,  and risk management systems to provide market participants with  accurate, sufficient, and timely information.
Investors: consider the suitability of investments in a private pool in light  of investment objectives, risk tolerances, and the principle of portfolio  diversification.
Counterparties and Creditors: commit sufficient resources to maintain  and enhance risk management practices.
Regulators and Supervisors: work together to communicate and use  authority to ensure that supervisory expectations regarding counterparty  risk management practices and market integrity are met.”
The PWG’s principles and guidelines are intended to enhance market  discipline, which the PWG stated most effectively addresses systemic risk  posed by private pools of capital, without deterring the benefits such pools  of capital provide to the U.S. economy. According to a Treasury official  involved in developing the PWG guidance, the PWG believes that self- interested, more sophisticated, informed investors, creditors, and  counterparties have their own economic incentives to take actions to  reduce and manage their own risks, which will reduce systemic risk  overall and enhance investor protection. Also, the PWG continues to  believe that regulators have an important role to play in addressing these  issues.
Further, in September 2007, the PWG established two private sector  committees. One committee comprised asset managers, and the other  comprised investors, including labor organizations, endowments,  foundations, corporate and public pension funds, investment consultants,  and other U.S. and non-U.S. investors. The first task of these committees  will be to develop best practices using the PWG’s principles-based  guidance released in February 2007 as a foundation to enhance investor  protection and systemic risk safeguards. According to the mission  statement of the asset managers’ committee, best practices will cover  asset advisers having information, valuation, and risk management  systems that meet sound industry practices. In turn, these systems would  enable them to provide accurate information to creditors, counterparties,  and investors with appropriate frequency, breadth, and detail. According  to the mission statement of the investors’ committee, best practices would  cover information, due diligence, risk management, and reporting and  build on the PWG guidelines related to disclosure, due diligence, risk  management capabilities, the suitability of the strategies of private pools  given an investor’s risk tolerance, and fiduciary duties. According to staff  of the PWG member agencies, the PWG expects both committees to have  drafts of the best practices available for public comment early in 2008 and  to issue final products in the spring.
Finally, recognizing that financial shocks are inevitable, the PWG told us  that it adopted more formalized protocols in fall 2006 to coordinate  communications among the appropriate regulatory bodies in the event of  market turmoil, including a liquidity crisis. The protocols include a  detailed list of contact information for domestic and international  regulatory bodies, financial institutions, risk managers, and traders, and  procedures for communications. According to staff of the PWG member  agencies, the protocols were used to handle recent events such as the  fallout from the Amaranth losses in 2006 and the losses from subprime  mortgage investments by two Bear Stearns hedge funds in summer 2007.
Addressing potential systemic risk posed by hedge fund activities involves  actions by investors, creditors and counterparties, hedge fund advisers,  and regulators. The regulators and the PWG’s recent initiatives are  intended to bring together these various groups to improve current  practices related to hedge fund-related activities and to better prepare for  a potential financial crisis. We view these initiatives as positive steps taken  to address systemic risk. However, it is too soon to evaluate their  effectiveness.
section_title: Agency Comments
paragraphs: We provided a draft of this report to CFTC, DOL, Federal Reserve, FDIC,  OCC, OTS, SEC, and Treasury for their review and comment. None of the  agencies provided written comments. All except for FDIC and OTS  provided technical comments, which we have incorporated into the report  as appropriate.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days after the  date of this report. At that time, we will send copies of this report to the  Ranking Member of the Committee on Financial Services, House of  Representatives; the Chairman and Ranking Member of the Committee on  Banking, Housing, and Urban Affairs, U.S. Senate; Ranking Member of the  Subcommittee on Capital Markets, Insurance and Government Sponsored  Enterprises, House of Representatives; and other interested congressional  committees. We are also sending copies to the Chairman, Board of  Governors of the Federal Reserve System; Chairman, Commodity Futures  Trading Commission; Chairman, Federal Deposit Insurance Corporation;  Secretary of Labor; Comptroller of the Currency, Office of the Comptroller  of the Currency; Director, Office of Thrift Supervision; Chairman,  Securities and Exchange Commission; Secretary of the Treasury; and  other interested parties. We will make copies available to others upon  request. The report will also be available at no charge on our Web site at  http://www.gao.gov.
If you or your staff have any questions regarding this report, please  contact me at (202) 512-8678 or williamso@gao.gov. Contact points for our  Office of Congressional Relations and Public Affairs may be found on the  last page of this report. GAO staff who made major contributions to this  report are listed in appendix IV.
section_title: Appendix I: Scope and Methodology
paragraphs: To address the first objective (regulatory oversight of hedge fund-related  activities), we reviewed regulatory examination documents (for example,  examination modules, scoping, examination reports and findings,  corrective actions taken or proposed by firms, and regulatory follow-ups).  We selected for review some of the recent examinations—conducted by  the Office of the Comptroller of the Currency (OCC), Federal Reserve  Bank of New York (FRBNY), Federal Deposit Insurance Corporation  (FDIC), Securities and Exchange Commission (SEC), and National  Futures Association (NFA)—of regulated entities engaged in transactions  with hedge funds as creditors or counterparties. We reviewed  examinations of financial institutions that are creditors or counterparties  to hedge funds conducted from fiscal years 2004 through 2006 and other  supervisory materials. We reviewed 3 OCC examinations, 7 FRBNY  examinations, 1 FDIC examination, 14 (9 for hedge fund advisers and 5 for  Consolidated Supervised Entities) SEC examinations, and 4 NFA  examinations. We reviewed information that the federal financial  regulators provided on enforcement cases brought for hedge fund-related  activities. In addition, we interviewed U.S. federal financial regulatory  officials to gain an understanding of how they oversee hedge fund-related  activities at the financial institutions over which they have regulatory  authority. More specifically, we spoke with officials from the banking  regulators—OCC, Board of Governors of the Federal Reserve System,  FRBNY, FDIC, and Office of Thrift Supervision; a securities regulator— SEC; and commodities regulators—Commodity Futures Trading  Commission and NFA. We interviewed officials representing Department  of Treasury (Treasury), the United Kingdom’s Financial Services  Authority, and the President’s Working Group (PWG) as well. To  determine which of the Institutional Investor’s Alpha Magazine 2007  Annual Hedge Fund 100 listing of global hedge fund advisers were U.S.- based and registered with SEC as a hedge fund investment adviser or with  CFTC as a commodity pool operator (CPO) or commodity trading advisor  (CTA), we asked the compliance staff at SEC and NFA to compare their  registrants’ listing with the largest 100 listing. Representatives from both  organizations said that they made their best attempt to match the names in  the largest 100 listing with the registrants’ listings, which was difficult  because the names were not always identical in both listings. SEC  estimates that of the 78 of the largest 100 hedge fund advisers identified by  Alpha Magazine as U.S.-based, 49 were registered with SEC as investment  advisers. NFA estimates that 29 of the 78 U.S.- based hedge fund advisers  were registered with CFTC as CPOs or CTAs. We also reviewed prior GAO  reports.
To address the second objective (market discipline), we interviewed  relevant market participants (such as investors, creditors, and  counterparties), and regulatory officials, to get their opinions on (1) how  market participants impose market discipline on hedge funds’ risk taking  and leveraging (and whether they have improved since 1998); (2) the type  and frequency of information such participants would need from hedge  fund advisers to gauge funds’ risk profiles and internal controls to make  informed initial and ongoing investment decisions; and (3) the extent to  which hedge fund disclosures to market participants have improved since  the 1998 near failure of the large hedge fund, Long-Term Capital  Management. We also interviewed large hedge funds and the Managed  Funds Association—a membership organization representing the hedge  fund industry. In addition, we conducted a literature search to identify  research on hedge funds and reviewed a selection of relevant regulatory  and industry studies, speeches, and testimonies on the matter.
To address the third objective (systemic risk), we reviewed relevant  speeches, testimonies, studies, principles and guidelines that the PWG  issued about private pools of capital in 2007 entitled “Agreement Among  PWG and U.S. Agency Principals on Principles and Guidelines Regarding  Private Pools of Capital,” regulatory examination documents and relevant  industry best practices for investors, hedge fund advisers, creditors, and  counterparties. We also reviewed PWG protocols (“PWG Crisis  Management Protocols”) for dealing with a financial market crisis. And we  interviewed officials representing U.S. federal financial regulators,  Treasury, and the PWG to get their views on systemic risk issues.
To address pension plan investments in hedge funds discussed in  appendix II, we reviewed and analyzed annual survey data from 2001  through 2006 from Pensions & Investments. Also, we reviewed Greenwich  Associates data from 2004 through 2006 that focused on pensions’ hedge  fund investments. We conducted data reliability assessments on the data  from Pensions & Investments and Greenwich Associates that we used,  and determined that the data were sufficiently reliable for our purposes.  We also reviewed provisions of the Pension Protection Act of 2006 (PPA)  that changed requirements for how hedge funds hold pension plan assets.  We interviewed pension industry officials (such as pension plan sponsors  of public and private funds, trade groups, pension consultants, pension  plan and hedge fund database providers, a hedge fund law firm, and hedge  funds), an academic and regulatory officials from the Department of  Labor, SEC, and Treasury to get their opinions on the matter, including  trends in such investments over the last few years and the impact of PPA  on pension plan hedge fund investments. We also reviewed other relevant  documents.
We conducted this performance audit from September 2006 to January  2008 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Pension Plan Investments in Hedge Funds Have Increased but Are Still a Small Percentage of Plans’ Total Assets
paragraphs: This appendix presents summary information about the potential impact  that pension law reform may have on the ability of hedge funds to attract  pension plan investments and statistics on the extent of pension plan  investments in hedge funds in recent years.
Section 611(f) of the Pension Protection Act of 2006 (PPA) amended the  Employee Retirement Income Security Act (ERISA) to, among other  things, provide a statutory definition for “plan assets,” which essentially  codified, with some modification, the Department of Labor’s (DOL)—the  primary regulator of pension plans—existing plan asset regulation  (sometimes referred to as the 25 percent benefit plan investor test). By  modifying the 25 percent benefit plan investor test, the PPA amendment  has the effect of permitting hedge funds to accept unlimited investments  from certain “non-ERISA benefit plans” (governmental plans, foreign  plans, and most church plans) while still accepting investments from plans  that are subject to ERISA (ERISA benefit plans) without becoming subject  to ERISA’s fiduciary duty requirements. What constitutes “plan assets” is  significant because a person who exercises discretionary authority or  control over the assets of an ERISA benefit plan or who provides  investment advice for a fee with respect to plan assets is a “fiduciary”  subject to the fiduciary responsibility provisions of ERISA.
As ERISA did not provide a definition for “plan assets” prior to the  enactment of PPA, DOL, in 1986, adopted Rule 2510.3-101 to describe the  circumstances under which the assets of an entity in which an ERISA  benefit plan invests (for example, a hedge fund) would be deemed to  include “plan assets” so that the manager of the entity (for example, a  hedge fund manager) would be subject to the fiduciary responsibility rules  of ERISA. Rule 2510.3-101 excludes from the definition of plan assets, the  assets of an entity in which there is no significant aggregate investment by  “benefit plan investors,” which is defined to include both ERISA and non- ERISA benefit plans. Participation in an entity would be significant if 25  percent or more of the value of any class of equity securities of the entity  were held by the benefit plan investors collectively (i.e., the 25 percent  benefit plan investor rule). By now excluding from the 25 percent  calculation those equity securities held by non-ERISA benefit plans, the  allowable proportionate share of investments by ERISA benefit plans has  increased.
We asked several large hedge funds as well as some regulators whether  hedge fund advisers were actively soliciting investments from pension  plans due to the reform. They were unable to comment on whether hedge  fund advisers were taking steps to attract these institutional investments.  However, according to one regulator and two large hedge funds, some  hedge fund advisers do not seek pension investments, and others do seek  out pension investments but are careful not to reach the 25 percent  threshold that would require hedge fund advisers to assume fiduciary  responsibilities. According to one regulator and an industry source,  pension plans are attracted to various hedge fund investment strategies,  depending on their portfolio composition. They also suggested that  pension plans tend to invest in hedge funds through funds of hedge funds.
From 2001 through 2006, investments by defined benefit (DB) plans in  hedge funds increased, but the share of total pension plan assets invested  in hedge funds remained small. Two key reasons pension plans invest in  hedge funds are to diversify their investment risks and increase investment  returns. Much of the recent growth (and expected continued growth) in  hedge fund investments is attributable to investments by institutions such  as pension funds, endowments, insurance companies, and foundations.
Two recent surveys of DB plan sponsors describe the prevalence of hedge  fund investments.
According to a Greenwich Associates survey of pensions plans with $250  million or more in assets, the share of private and public DB plans (not  including union plans) invested in hedge funds was 27 percent and 24  percent, respectively, in 2006. Among DB plans with $250 million to $500  million in assets, 16 percent were invested in hedge funds. About 29  percent of DB plans with $1 billion or more in assets were invested in  hedge funds.
The number of DB plans investing in hedge funds has increased over time.
According to a survey of the largest pension plans by Pensions &  Investments, the share of DB plans reporting investments in hedge funds  increased from 11 percent in 2001 to 36 percent in 2006.
Evidence from surveys of DB plans shows that between about 1 to 2  percent of total assets were invested in hedge funds. Among only those  plans that invested in hedge funds, average allocations to hedge funds  ranged from about 3 percent to 7 percent of a plan’s portfolio.
A very small number of pension plans reported substantially larger  allocations to hedge funds. Two of the 48 largest pension plans that  reported investments in hedge funds in the Pensions & Investments  survey had allocations of about 30 percent (Missouri State Employees’  Retirement System and Pennsylvania State Employees’ Retirement  System—both of these plans primarily invest in hedge funds through funds  of funds). See table 1.
Survey data indicate that most pension plans invested in hedge funds do  so, at least partially, through funds of hedge funds. According to the  Pensions & Investments’ survey, 35 of the largest 48 DB plans that  reported investments in hedge funds used funds of hedge funds for at least  some of their hedge fund investments. Overall, funds of hedge funds  represented 54 percent of total hedge fund investments for this group.
Compared with pension plans, endowments and foundations were much  more likely to invest in hedge funds. Greenwich Associates’ survey found  that 75 percent of endowments and foundations (with at least $250 million  in assets) were invested in hedge funds in 2006. These investments  amounted to slightly more than 12 percent of total assets for all  endowments and foundations in their sample.
According to Pensions & Investments, hedge fund investments reported  among the largest pension plans increased from about $3.2 billion in 2001  to about $50.5 billion in 2006, approximately a 1,500 percent increase (see  fig. 1).
Furthermore, for those DB plans that reported hedge fund investments in  the 2006 Pensions & Investments survey, the investments represented  about 3 percent of their total DB assets under management.
section_title: Appendix III: Various Hedge Fund Investment Strategies Defined
paragraphs: Hedge funds seek absolute rather than relative return—that is, look to  make a positive return whether the overall (stock or bond) market is up or  down—in a variety of market environments and use various investment  styles and strategies, and invest in a wide variety of financial instruments,  some of which follow:  Convertible arbitrage: Typically attempt to extract value by purchasing  convertible securities while hedging the equity, credit, and interest rate  exposures with short positions of the equity of the issuing firm and other  appropriate fixed-income related derivatives.
Dedicated shorts: Specialize in short-selling securities that are perceived  to be overpriced—typically equities.
Emerging market: Specialize in trading the securities of developing  economies.
Equity market neutral: Typically trade long-short portfolios of equities  with little directional exposure to the stock market.
Event driven: Specialize in trading corporate events, such as merger  transactions or corporate restructuring.
Fixed income arbitrage: Typically trade long-short portfolios of bonds.
Macro: Take bets on directional movements in stocks, bonds, foreign  exchange rates, and commodity prices.
Long/short equity: Typically exposed to a long-short portfolio of equities  with a long bias.
Managed futures: Specialize in futures trading—typically employing  trend following strategies.
section_title: Appendix IV: GAO Contacts and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, Karen Tremba (Assistant  Director), M’Baye Diagne, Sharon Hermes, Joe Hunter, Marc Molino,  Akiko Ohnuma, Robert Pollard, Carl Ramirez, Omyra Ramsingh, Barbara  Roesmann, and Ryan Siegel made major contributions to this report.