{The G-30} Report implicitly assumes that, while regulated banking institutions will be dominant providers of financial services, a variety of capital market institutions will remain active. Organized markets and private pools of capital will be engaging in trading, transformation of credit instruments, and developing derivatives and hedging strategies, and other innovative activities, potentially adding to market efficiency and flexibility.

These institutions do not directly serve the general public and individually are less likely to be of systemic significance. Nonetheless, experience strongly points to the need for greater transparency. Specifically beyond some minimum size, registration of hedge and equity funds, should be required, and if substantial use of borrowed funds takes place, an appropriate regulator should be able to require periodic reporting and appropriate disclosure.

Furthermore, in those exceptional cases when size, leverage, or other characteristics pose potential systemic concerns, the regulator should be able to establish appropriate standards for capital, liquidity and risk management.

The changing business of the largest commercial banks means that threats to financial stability do not necessarily come from traditional sources such as a deposit run or a deterioration in a bank's portfolio of business loans. The largest banks' capital markets businesses have given rise to new threats to financial stability. These threats stem from banks' securitization activity, from the complexity of banks' capital markets activity, and from the services that banks provide to the asset-management industry, including hedge funds. And risks that are more traditional to banking, such as liquidity risk and concentration risk, have appeared in new forms.

MALONEY: Given recent news reports about hedge funds having made huge bets against the stock price of Bear Stearns during the week leading up to its collapse and now reports that Iceland is investigating whether certain hedge funds may have played a role in beating down its currency, do you believe there is a need for any new regulatory oversight of hedge funds? And, if so, what type of oversight?      

BERNANKE: Congresswoman, the concerns that you raise and similar ones are examples, if they were true, of course, of market manipulation, which is already the province of the Securities and Exchange Commission and which I am sure will look into these contentions. So I certainly don't have any objection or any problem with enforcement of securities laws and of investor protection in the context of hedge funds.

     It's been remarkable, the hedge funds have been less of a problem than we anticipated in some sense, and we've seen more problem in some other sectors.   So far, one of our main concerns had been that hedge funds that failed would create losses for their counterparties, the major financial institutions.  Thus far, we have not seen any significant losses taken by a major financial institution because of a hedge fund loss or failure. So in that respect, their behavior has not, so far, created risks for our major financial institutions.

From the Q&A session

Well, Mr. Chairman, the essence of making the market discipline approach work is that the counterparties, investors, and creditors be sophisticated and able to evaluate the investments that they're undertaking.  In the case of a pension fund, the pension fund manager has a fiduciary duty to make investments which are appropriate for the risk return needs of that fund.  So if that fiduciary manager has sufficient sophistication to use some of these things, that perhaps is OK.  But in most cases, I think that pension funds should probably not, you know, go heavily into these types of instruments {hedge funds}.

From Q&A session

And in private equity in particular, [private pools of capital and hedge funds] play an important role in the market for corporate control. We need to have a mechanism whereby poorly run companies, weak managements are subject to being taken over, replaced and their companies improved. And when it's working right, at least, private equity -- as LBOs in the past -- helps to serve that function. So they do serve some positive functions.  

They raise many issues of financial stability and the like, you know, making sure that their counterparties are taking appropriate attention to their risks and the like. And we've discussed those some in the president's working groups' principles. But they certainly are a benefit to the economy.  

In the Q&A session

The Federal Reserve's supervision of counterparty risk management practices is part of a broader, more comprehensive set of supervisory initiatives. The goal of these initiatives is to assess whether global banks' risk-management practices and financial market infrastructures are sufficiently robust to cope with stresses that could accompany a deterioration of market conditions, including a deterioration that might result from the rapid liquidation of hedge funds' positions.

The Board believes that the increased scale and scope of hedge funds has brought significant net benefits to financial markets. Indeed, hedge funds have the potential to reduce systemic risk by dispersing risks more broadly and by serving as a large pool of opportunistic capital that can stabilize financial markets in the event of disturbances. At the same time, the recent growth of hedge funds presents some formidable challenges to the achievement of public policy objectives, including significant risk-management challenges to market participants. If market participants prove unwilling or unable to meet these challenges, losses in the hedge fund sector could pose significant risks to financial stability.

Although there is no precise legal definition, the term "hedge fund" generally refers to a pooled investment vehicle that is privately organized, administered by a professional investment manager, and not widely available to the public..  By the end of 2006, more than 9,000 funds managed more than $1-1/2 trillion of assets.³ Assets managed in the United States are estimated to account for about 60 percent of the total. The hedge fund industry remains small relative to the U.S. mutual fund industry, which included more than 8,000 funds with about $10-1/2 trillion of assets under management at the end of 2006.⁴ Hedge funds, however, can make greater use of leverage than mutual funds. Their market impact is further magnified by the active trading of some funds. The aggregate trading volumes of hedge funds reportedly account for significant shares of total trading volumes in some segments of the financial markets.⁵

Leveraged arbitrage activity, so some of the literature suggests, is likely to reduce volatility in normal times and increase it in times of stress, because of the greater financial constraints faced by leveraged funds relative to larger, more diversified banks and investment banks. Whether this matters in a systemic sense or not depends on the heterogeneity of funds and how correlated their exposures are with those of the major banks and investment banks.

In thinking about how, or whether, to regulate innovative financial institutions (such as hedge funds) or instruments (such as credit derivatives), we should be wary of drawing artificial distinctions. Are the characteristics of hedge funds or credit derivatives that arouse concern peculiar to these institutions and instruments, or are they associated with others as well? If the characteristics in question are in fact a feature of the broader financial landscape, then a narrowly focused approach to regulation will be undermined by the incentives such an approach creates for regulatory arbitrage.

For example, while the complexity of new financial instruments and trading strategies is potentially a concern for policy, as I will discuss, not all credit derivatives are complex and--to state the obvious--not all complex financial instruments are linked to credit risk. Single-name credit default swaps and credit default swap indexes are relatively simple instruments, whereas derivatives based on other asset classes--such as exotic interest-rate and foreign-exchange options--can, by contrast, be quite complex. Moreover, derivatives in general are not necessarily more complex than some types of structured securities. In short, if complexity per se is the concern, we cannot address that concern by focusing on a single class of financial instruments. Similarly, hedge funds are hardly a homogeneous group of institutions, nor can their trading strategies be unambiguously distinguished from those of large global banks or of some traditional asset managers. A consistent regulatory strategy needs to be tailored to the essential characteristics of institutions or instruments that pose risks for policy objectives, not to arbitrary categories.

Some commentators have sought to draw a sharp distinction between the approach to financial regulation in the United States and that in the United Kingdom. These observers have characterized the British approach as being principles-based and as using a "light touch"--the implication being that these two features somehow go together. In a speech in February of this year, Sir Callum McCarthy, the head of the United Kingdom's Financial Services Authority (FSA), took issue with this interpretation.¹ Sir Callum confirmed that the FSA's approach is built on a framework of principles, although he noted that the FSA also has an 8,500-page rulebook to accompany the eleven principles it has laid out. But the FSA head rejected the view that their approach is "light touch." Rather, he said, it is risk-based, which means that regulatory resources and attention are devoted to firms, markets, or instruments in proportion to the perceived risks to the FSA's regulatory objectives.

...I have argued today that we should strive to implement a regulatory regime that is principles-based, risk-focused, and consistently applied. Enhancing market discipline can complement and strengthen such an approach. As in the United Kingdom, a principles-based approach is not inconsistent with the use of rules, which can provide needed clarity or a safe haven from legal and regulatory risks. However, rules should implement principles rather than develop in an ad hoc manner.

The conditions we see prevailing in global financial markets today reflect a range of different factors, some fundamental and others that are less likely to be enduring. The most effective thing that policymakers and market participants can do in what is a necessarily uncertain world is to work to ensure that the shock absorbers are strong relative to the range of potential economic and financial outcomes.

The hedge funds' share of this market increased from 3 percent to 28 percent between 2000 and 2006.  If credit experience gets rocky, will these participants stay in the market? And could they affect liquidity if they leave?

As reported by Bloomberg News

Thus far, the market-based approach to the regulation of hedge funds seems to have worked well, although many improvements can still be made (Bernanke, 2006). In particular, risk-management techniques have become considerably more sophisticated and comprehensive over the past decade. To be clear, market discipline does not prevent hedge funds from taking risks, suffering losses, or even failing--nor should it. If hedge funds did not take risks, their social benefits--the provision of market liquidity, improved risk-sharing, and support for financial and economic innovation, among others--would largely disappear.

Regulatory oversight of hedge funds is relatively light. Because hedge funds deal with highly sophisticated counterparties and investors, and because they have no claims on the federal safety net, the light regulatory touch seems largely justified.