Leverage Concentrated In A Small Number Of Large Hedge Funds

Leverage Concentrated In A Small Number Of Large Hedge Funds by FSOC

Executive Summary

In the past year, concerns about slowing global growth, supply gluts in commodities markets, and shifts in exchange rate and monetary policies abroad led to significant price swings across a range of financial assets as U.S. interest rates remained low. Although these developments have created challenges for particular firms and sectors, financial regulatory reforms and a strengthening of market discipline since the global financial crisis have made the U.S. financial system more resilient, as vulnerabilities remained moderate.

U.S. financial regulators and market participants made progress in addressing a number of structural vulnerabilities highlighted in the Council’s previous annual reports. The Federal Reserve finalized a rule requiring that global systemically important banks (G-SIBs) increase their holdings of common equity relative to risk-weighted assets (RWAs) and proposed standards for mandatory long-term debt and total loss-absorbing capacity for G-SIBs. The Federal Reserve and the FDIC completed their review of the 2015 resolution plans of eight of the largest, most complex U.S. bank holding companies (BHCs). The agencies jointly determined that five of the firms had submitted plans that were not credible or would not facilitate an orderly resolution under bankruptcy and have notified these firms of the deficiencies in their plans. The Federal Reserve and the FDIC informed all eight firms of the steps they must take in response to the agencies’ findings. The International Swaps and Derivatives Association (ISDA) expanded the scope of its Universal Resolution Stay Protocol to cover securities financing transactions. In February 2016, the CFTC and the European Commission announced a common approach to the supervision of central counterparties (CCPs) operating in the United States and the European Union (EU). U.S. prudential regulators and the CFTC issued rules establishing minimum margin requirements for swaps that are not cleared through CCPs. The SEC finalized rules setting forth reporting requirements for securities-based swaps and establishing a process for the registration of securities-based swap dealers and major securities-based swap participants. The OFR, Federal Reserve System, and SEC collaborated on pilot projects to improve the collection and analysis of data on securities financing transactions. These and other actions undertaken over the last year can be expected to make the largest, most interconnected financial institutions more resilient, improve regulators’ and firm managers’ ability to manage potential distress at such institutions, and reduce the impact of contagion that may arise from interconnections among firms and markets. Despite these important, positive steps, this report identifies a number of structural vulnerabilities and emerging threats in the U.S. financial system that require action from market participants, regulators, and policymakers.

In addition, the Council continued its analysis of potential financial stability risks that may arise from certain asset management products and activities. Based on this work, the Council identified areas of potential financial stability risks and, in April 2016, publicly issued a written update regarding its evaluation. Since May 2015, the SEC has issued several proposed rules affecting the asset management industry. The SEC has proposed rules to enhance data reporting for registered investment companies and registered investment advisers of separately managed accounts, strengthen liquidity risk management programs and disclosure for registered funds, and limit the amount of leverage that registered investment companies may obtain through derivatives transactions.

Lastly, the Council remains focused on taking steps to appropriately address threats to financial stability. Recently, a federal court rescinded the Council’s designation of a nonbank financial company for Federal Reserve supervision and enhanced prudential standards. The government is appealing the court’s decision. The Council’s authority to designate nonbank financial companies remains a critical tool to address potential threats to financial stability, and the Council will continue to defend vigorously the nonbank designations process.

Cybersecurity

Cyber threats and vulnerabilities continue to be a pressing concern for companies and governments in the United States and around the world. Significant investment in cybersecurity by the financial services sector over the past several years has been critical to reducing cybersecurity vulnerabilities within companies and across the sector as a whole, and such investments should continue. Government agencies and the private sector should continue to work to improve and enhance information sharing, baseline protections such as security controls and network monitoring, and response and recovery planning.

Asset Management Products and Activities

The asset management industry’s increasing significance to financial markets and to the broader economy underscores the need for the Council’s consideration of potential risks to U.S. financial stability from products and activities in this sector. Building on work begun in 2014, including a public request for comment, the Council and staffs of its members and member agencies have carried out analyses and engaged in dialogue regarding these issues. Based on this work, the Council has identified certain areas of potential financial stability risk and provided its views on key areas of focus and next steps to respond to these potential risks.

Specifically, to help mitigate financial stability concerns that may arise from liquidity and redemption risks in pooled investment vehicles, the Council believes that robust liquidity risk management practices for mutual funds, establishment of clear regulatory guidelines addressing limits on the ability of mutual funds to hold assets with very limited liquidity, enhanced reporting and disclosures by mutual funds of their liquidity profiles and liquidity risk management practices, steps to allow and facilitate mutual funds’ use of tools to allocate redemption costs more directly to investors who redeem shares, additional public disclosure and analysis of external sources of financing, and measures to mitigate liquidity and redemption risks that are applicable to collective investment funds (CIFs) and similar pooled investment vehicles offering daily redemptions should be considered. Regarding potential financial stability risks associated with leverage, the Council’s review of the use of leverage in the hedge fund industry suggests a need for further analysis of the activities of hedge funds. Accordingly, the Council has created an interagency working group that will share and analyze relevant regulatory information in order to better understand whether certain hedge fund activities might pose potential risks to financial stability. With respect to its review of operational risks, securities lending, and resolvability and transition planning, work going forward will involve additional data collection, further engagement and analysis, and monitoring.

Large, Complex, Interconnected Financial Institutions

The size, scope, and interconnectedness of the nation’s largest financial institutions warrant continued close attention from financial regulators. While the capital and liquidity positions of the largest BHCs have improved considerably since the financial crisis, the low and relatively flat yield curve, rising credit risk in some market segments, litigation expenses, and other factors have put pressure on BHC equity valuations and profitability. Regulators should continue working to ensure that there is enough capital and liquidity at financial institutions to reduce systemic risk, including finalizing rules setting standards for the minimum levels of total loss-absorbing capacity and long-term debt maintained by G-SIBs and large foreign banking organizations (FBOs) operating in the United States.

Central Counterparties

CCPs can enhance financial stability and increase market resilience by improving transparency, imposing robust risk management and margin standards on clearing members, expanding multilateral netting, and facilitating the orderly management of counterparty credit losses. Because of the critical role these infrastructures play in financial markets, it is essential that they be resilient and resolvable. Member agencies should continue to evaluate whether existing rules and standards for CCPs and their clearing members are sufficiently robust to mitigate potential threats to financial stability. Moreover, with clearing mandates for selected interest rate and credit default index swaps in effect in the United States, and similar mandates either in effect or planned in a number of foreign jurisdictions, member agencies should continue working with international standard setting bodies to implement more granular guidance with respect to international risk management standards in order to enhance the safety and soundness of CCPs. Such guidance should also minimize the potential for material differences between jurisdictions’ standards, which could potentially result in regulatory arbitrage by market participants.

Short-Term Wholesale Funding

Intraday counterparty risk exposure in the tri-party repurchase (repo) market contracted significantly in recent years, but more work is needed to bring the settlement of General Collateral Finance (GCF) repo transactions in line with post-crisis reforms. The potential for fire sales of collateral by creditors of a defaulted broker-dealer also remains a significant risk. Additionally, data gaps continue to limit regulators’ ability to monitor the aggregate repo market and identify interdependencies among firms and market participants. Regulators will need to monitor market responses to new SEC money market mutual fund (MMF) rules, which become effective this year, and assess where there may be unforeseen risks, as well as potential regulatory and data gaps associated with other types of cash management vehicles.

Reliance on Reference Rates

Post-crisis reforms by the official sector and market participants have improved the resilience of the London Interbank Offered Rate (LIBOR) by subjecting the rate and its administrator to more direct oversight, eliminating many little-used currency/tenor pairings, and embargoing the submissions of individual banks for a three-month period. However, because the volume of unsecured wholesale lending has declined markedly, it is difficult to firmly root LIBOR submissions in a sufficient number of observable transactions. This development makes LIBOR more reliant on the judgment of submitting banks and poses the risk that it may not be possible to publish the benchmark on an ongoing basis if transactions decline further. Regulators and market participants should continue their efforts to develop alternative rates and implementation plans to achieve a smooth transition to these new rates.

Data Gaps and Challenges to Data Quality, Collection, and Sharing

While Council members have made progress in filling gaps in the scope, quality, and accessibility of data available to regulators, much work remains. Regulators face challenges comprehensively monitoring and understanding developments across financial markets, as each agency’s data, information, and analysis are focused primarily on the entity types or market segments for which they have regulatory purview. More broadly, markets continually evolve and financial transactions cross regulatory jurisdictions, making data sharing and integration among regulators both at home and abroad, as well as cooperative data analysis, imperatives. Regulators and market participants should continue to work together to improve the scope, quality, and accessibility of financial data.

Housing Finance Reform

The government-sponsored enterprises (GSEs) are now into their eighth year of conservatorship. While regulators and supervisors have taken great strides to work within the constraints of conservatorship to promote greater investment of private capital and improve operational efficiencies with lower costs, federal and state regulators are approaching the limits of their ability to enact wholesale reforms that are likely to foster a vibrant, resilient housing finance system. Housing finance reform legislation is needed to create a more sustainable system that enhances financial stability.

Risk Management in an Environment of Low Interest Rates and Rising Asset Price Volatility

The Council has long been attentive to the possibility that low interest rates may lead some market participants to take on risk to gain higher yields by reducing the duration of their liabilities, by increasing leverage, or by shifting toward assets that are less liquid or embed greater market or credit risk. Such behavior can contribute to excessive asset valuations, which can leave investors susceptible to rapid, unexpected price declines. Elevated asset price volatility associated with downward movement in asset valuations can pose challenges for those market participants that are highly leveraged or hold concentrated and inadequately hedged exposures to affected market segments. The persistent fall in energy and metals commodities prices, large swings in equity valuations, and upward movement in high-yield debt spreads underscore the need for supervisors, regulators, and managers to remain vigilant in ensuring that firms and funds maintain robust risk management standards.

Changes in Financial Market Structure

With the growing importance in certain markets of proprietary trading firms and other market participants that rely heavily on automated trading systems, access to those markets has increased and costs for investors and issuers have generally fallen. However, this shift in market structure may introduce new vulnerabilities, including operational risks associated with the very high speed and volume of trading activity and potential destabilizing price feedback dynamics arising from interactions among high-speed algorithmic trading decisions. Increased coordination among regulators is needed to evaluate and address these risks, particularly in circumstances where economically similar products, such as cash Treasuries and Treasury futures, are traded in different markets and fall under the purview of different regulators.

Financial Innovation and Migration of Activities

New financial products, delivery mechanisms, and business practices, such as marketplace lending and distributed ledger systems, offer opportunities to lower transaction costs and improve the efficiency of financial intermediation. However, innovations may also embed risks, such as credit risk associated with the use of new and untested underwriting models. In other instances, risks embedded in new products and practices may be difficult to foresee. Financial regulators will need to continue to be vigilant in monitoring new and rapidly growing financial products and business practices, even if those products and practices are relatively nascent and may not constitute a current risk to financial stability.