In January, a week before the U.S. Senate confirmed Timothy Geithner as Treasury secretary, the 47-year-old former president of the Federal Reserve Bank of New York vowed to regulate over-the-counter trading in the vast global derivatives market and to pursue mandatory registration for hedge fund managers if he got the job. Last month, he made good on his first promise by sending a three-page letter to Congress calling for increased oversight of derivatives traded in OTC markets to scale back risk in the financial system.
Yet despite the warning, the news was an unpleasant reality check for broker-dealers and all other market participants accustomed to trading freely in the unregulated $592 trillion global OTC derivatives market — of which credit-default swaps, as of December 2008, still constituted $41.9 trillion, according to Bank for International Settlements. Geithner wants to make sure all firms whose activities create large market exposures adhere to “conservative capital requirements, business-conduct standards, reporting requirements and conservative requirements relating to initial margins on counterparty credit exposures.”
Ultimately, he wants better visibility into potential sources of systemic financial risk, more efficiency and transparency in the markets, a clampdown on price manipulation and new rules ensuring that derivatives are not marketed inappropriately to unsophisticated investors. The Treasury doesn’t want to shut down the OTC derivatives markets but rather wants to give regulators the ability to limit the value of derivatives contracts that any company can sell or any institution can hold.
Although Geithner has yet to tackle the part of his pledge regarding hedge fund registration, his conservative, level-headed approach to derivatives offers insight into how he intends to deal with that industry too. Still short on details, Geithner’s plan for derivatives regulation embraces some ideas that have been circulating on Capitol Hill in recent months — most telling, a call for mandatory centralized clearing of CDSs, the derivatives contracts used to insure against corporate defaults that contributed significantly to insurer American International Group’s record loss of $61.7 billion in the fourth quarter of 2008. But the proposal ultimately goes beyond any fear-driven focus on a single product by suggesting that securities laws be amended to require most OTC derivatives to be cleared through internationally recognized and regulated central clearing counterparties.
Derivatives markets that lend themselves readily to such standardization, such as that for equity-index-linked CDSs, would also have to be moved onto regulated exchanges to ensure market efficiency and price transparency. Lest industry participants be tempted to skirt the regulators by simply creating customized derivatives contracts, so-called look-alike contracts would be prohibited. But market participants are still wondering how, exactly, existing OTC derivatives markets are going to be divvied up. “The challenge is really where that line is going to be drawn between the customized world and the standardized world,” says Robert Pickel, executive director and CEO of the International Swaps and Derivatives Association. “That distinction has yet to be made.”
The broad conceptual sweep of Geithner’s proposal to identify and root out sources of systemic risk contrasts sharply with recent developments in Europe, where market overseers have shown greater zeal for regulating the activities of certain industry participants, such as hedge fund managers, than taking a wide-angle approach to the systemic risks posed by the sprawling and still-opaque global derivatives market. To date, the European Commission’s analogous effort on derivatives has focused closely on credit-default swaps, as a key source of risk, to the exclusion of other types of derivatives contracts. In mid-February, after a fierce battle of wills with nine of the leading global dealers of CDSs, Charlie McCreevy, European commissioner for the internal market and services, extracted a written commitment from them to use a central clearing house in the European Union to process what the commissioner in a statement called “systemically relevant” credit-default swaps.
Since winning that modest concession, however, the EC’s regulatory focus has shifted back to its favorite bête noire, the hedge fund industry. In the wake of the Group of 20 meetings in London in early April — at which French President Nicolas Sarkozy threatened to walk out if world leaders failed to tighten regulation of hedge funds, tax havens and credit-ratings agencies — the EC rushed to publish an ambitious proposal to curtail the activities of almost every type of alternative-investment fund manager in the EU.
The proposed legislation applies not only to hedge funds but also to commodity traders, private equity firms and infrastructure and real estate funds. If approved — and that could happen within the next year — the EC’s directive would override existing national regulations and create pan-European rules requiring every firm based in the EU to register in its own country. It would also provide regulators with details on holdings, leverage, risk controls, valuation metrics, custodial arrangements and reporting systems.
Critics such as John Godden, founder of IGS Group, a London-based alternatives advisory firm, say the EC initiative is more about micromanaging firms than improving the assessment of aggregate risk posed by what the EC calls “systemically important hedge funds,” which it defines as any fund that oversees more than €100 million ($136 million). “The new directive displays all the signs of being designed in a vacuum for political purposes,” Godden asserts. “What I find quite amazing is the lack of awareness from leaders in France and Germany that the hedge fund industry is a completely migratory business — if conditions here become unfavorable for them, managers will take their business outside the European community.”
In its fixation on the activities of hedge funds, moreover, the EC risks glossing over the fact that some of the riskiest — and ultimately illiquid — derivatives-based products that hedge fund managers were desperate to unload during the crisis, such as collateralized debt obligations, were engineered and marketed by well-regulated investment banks.
The most striking part of the EC’s directive, however, is not the power it would hand to regulators in Brussels to create a pan-European supervisory framework for all 27 national authorities. Rather it would be its intent to set a new global regulatory standard for hedge funds and other alternative-investment managers. No firm seeking to market such investment funds in the EU would be exempt from meeting an equivalent regulatory benchmark, and by 2012 those firms would have to comply or desist.
In drawing such a hard line, says Antonio Borges, chairman of the London-based Hedge Fund Standards Board, the EC clearly aims to influence any discussion about the greater regulation of hedge funds among G-20 leaders at the next meeting, in November. But by challenging major regulators in key jurisdictions such as the U.S. to implement “a parallel initiative,” the EC may have overstepped its authority, some experts say.
“It certainly risks damaging the collaborative process,” says Andrew Shrimpton, a member of London-based investment advisory group Kinetic Partners and former head of alternative investments supervision at the FSA. “This is an Anglo-American industry, which is yet another reason why it’s wrong for the EU to go off on its own with these regulations. If the directive becomes law, U.S. managers could look to market funds in Asia and the Middle East and bypass the EU entirely.”
Geithner may not have wished to tackle hedge fund regulation quite so soon, but he is likely to have little choice: The financial crisis has provided an unparalleled opportunity for European politicians to clamp down on an industry they deeply distrust. Though the financial industry’s addiction to complex derivatives may pose a greater macroprudential risk to the markets than do hedge fund managers’ self-defensive hoards of cash, European politicians are more eager to castigate the alternative-asset management industry than to force European banks to submit to independent regulatory stress tests and mark down the vast quantities of toxic, illiquid and now largely worthless derivatives that may still be lurking on their books.
