Market turmoil shows need for more hedge fund scrutiny
Ructions in March put spotlight back on role of non-bank institutions in trading
Once again hedge funds are facing increased scrutiny for their role in a crisis moment in financial markets. This time, regulators need to take more action.
The Financial Stability Board, which gathers the world’s leading financial regulators and finance ministries, this week released a comprehensive review of the turmoil that gripped financial markets in March.
The report highlights the role played by non-bank market participants in fanning a fire that the US Federal Reserve ultimately put out with unprecedented liquidity. Yet the American counterpart to the FSB, the Financial Stability Oversight Council, has been notably silent.
Congress created the FSOC in 2010 to monitor and address threats to financial stability. In 2016, FSOC examined many of the vulnerabilities identified in the FSB report, but unfortunately, the current administration failed to act and buried this work. Remedying this should be a priority of president-elect Joe Biden’s new administration.
In March, we saw a preview of what the consequences might be. While the US Treasury market ordinarily serves as a haven for investors in turbulent times, this proposition was put to the test. Traditional measures of liquidity dramatically deteriorated and volatility reached a post-financial crisis peak.
Stress rippled through financial markets and was propagated by a variety of non-bank entities. Money market funds, which played such a central role in the 2008-09 crisis, once again faced redemptions. Mutual funds and exchange traded funds contributed to selling in corporate bond markets. Selling by international central banks is likely to have put downward pressure on Treasury prices.
Hedge fund trade associations have pointed to these additional factors to downplay their members’ role. However, the contribution of hedge funds cannot be ignored.
Contemporaneous reporting, as well as subsequent analysis by the Fed and now the FSB, all show that the unwinding of highly leveraged strategies by hedge funds exacerbated market stress. Price volatility triggered margin calls — demands from lenders that the funds pledge additional cash to back their trades — and led to forced selling that contributed to a self-reinforcing spiral.
Given these disruptions, the FSB proposes a series of steps to analyse and, if necessary, address the risks posed by non-banks. Their objective is not just to increase resilience but also to reduce the risk of “any unintended consequences, including moral hazard, due to expectations of central bank interventions”.
The FSB is a valuable international co-ordinating body, but solutions will require action by national authorities. In the US, only the FSOC, which is chaired by the Treasury Secretary and includes the heads of all major banking and markets regulators, is capable of prioritising this work and facilitating the necessary co-ordination.
It should do so by drawing on the groundwork laid in 2016 when the FSOC reviewed the use of leverage by hedge funds. Its initial analysis concluded that a relatively small number of hedge funds were engaged in very large trades in highly liquid markets using enormous amounts of leverage. In a preview of the March volatility, the report noted that forced selling by hedge funds could significantly disrupt trading or funding in key markets.
Addressing such risks will require an active FSOC and market regulators who view financial stability as within their core mandate.
Additional data will also be critical. Current hedge fund reporting is inadequate, limiting regulators’ ability to assess market risks in an era of high-speed algorithmic trading in massive volume.
Regulators should also consider ways to limit hedge-fund borrowing, whether from banks or in the derivatives markets. Policy considerations will be complex. However, areas to revisit could include “haircut” practices that limit how much can be borrowed against specific assets, margin requirements in derivatives trading, the degree of central clearing in Treasury markets, and how large hedge funds exposures are incorporated into existing bank and clearing firm stress tests.
After the events of March, one would expect hedge funds to take on even greater leverage as they test the Fed’s willingness to step in again. An engaged and empowered FSOC must not let history repeat itself. Next time could be far worse.