Wednesday, April 11, 2012

SEC's Big Dig Into Hedge Fund Data?

Dow Jones Financial News published an article by Julie Chen of the WSJ, SEC begins big dig into hedge fund data:
The top US securities regulator has started to sift through a trove of new data on the nation's largest hedge funds and other private money managers to help identify firms whose behaviour might pose the greatest risks to their investors.

"Pick your fraud of the day and the question is, 'Can we extract information from this data system together with the other databases we have access to and home in on problems before they do damage?'" said Robert Plaze, deputy director in the division of investment management for the Securities and Exchange Commission.

About 1,400 new firms, including Moore Capital Management and Tiger Global Management, disclosed new details on their funds, investors, brokers and other facts ahead of a March 30 deadline.

The Dodd-Frank financial overhaul included a provision requiring hedge fund, private equity and other private fund advisers of a certain size to register with the SEC, in a bid to bring more transparency to one of the more secretive corners of Wall Street. The SEC is using the new disclosures to beef up the data it streams through its analytics to look for signs of trouble.

For one, the regulator now can zero in on funds that might pose greater risks to investors, including those that mark the value of their assets themselves rather rely on independent valuations.

Other information found in the advisers' disclosures, including the names of their prime brokers and auditors, can prove useful to the SEC, too.

Plaze said regulators now are able to "reverse engineer" the data across a wider range of scenarios to ferret out potential areas of weakness based on tips, complaints and the agency's own work, including instances where the fund advisers are the victims. For example, if a prime broker or auditor has drawn scrutiny, regulators could look for other clients of theirs that may be unaware of the issue, he said.

The SEC also could comb through the data for funds that are affiliated with a struggling broker, and track whether those funds are directing their clients to trade with that dealer to help the dealer recover. Such an arrangement would pose a conflict of interest, as fund managers are obliged to look out for their clients' interests first, according to the SEC.

Historically, the agency often knew little about a given manager until the manager landed on the radar of its enforcement division.

"It's sort of our first census of the industry," Plaze said of the new provision. "This gives us a powerful new tool to police the markets."

Hedge fund managers, particularly those who have registered with the SEC for the first time, have "a general level of apprehension" about how regulators will use the data, said Neil Morris, who consults with hedge funds on regulatory compliance for Kinetic Partners. But those worries should diminish as managers get used to the SEC's requirements of registered advisers, he added.

While many of the most high-profile hedge fund advisers have long registered voluntarily with the SEC, in part to attract money from institutional investors, others historically had relied on an exemption for advisers with fewer than 15 clients, or funds. Dodd-Frank did away with the 15-client exemption.

Should hedge funds register with the SEC? Yes, they all should, no matter what their size. But will this regulation provide the SEC with enough information to preempt the next financial meltdown? I'm skeptical and believe the SEC is sending out the wrong message.

Reading the article above makes it sound as if the SEC has position-level data on a daily basis and can slice, dice and aggregate this data at a moment's notice to quickly spot dangerous trends and stop any systemic risk before it occurs.

Nothing can be further from the truth. While hedge funds may be whining and bitching publicly, privately they're laughing at regulators because they still have an arsenal of ways to circumvent all these regulations, including high-frequency trading, naked short-selling and using credit-default swaps (CDS) traded in the over-the-counter (OTC) market to short securities. OTC markets are loosely (more like hardly) regulated, especially relative to the stock market.

Even if the SEC had up-to-the second transparency on all hedge fund data, it would need multi-million dollar computers and an army of 'quants' to slice and dice through the volumes of data to properly interpret it. This sounds nice if you believe in Hollywood and the movies where they always catch the bad guys, but in the cynical world that I live in, this is a bunch of huffing and puffing on the SEC's part.

Importantly, the system is built in such a way that hedge funds and private equity funds will always have a leg up on regulators. They spend hundreds of millions lobbying Congress to make sure that regulators never get ahead of them.

If the SEC wanted to really make a positive impact on markets, it would stop covering up Wall Street crimes and reinstate the uptick rule to curb abuses from high frequency trading platforms wreaking havoc on this wolf market (watch the CNBC interview at the end of this post).

As for private equity firms, the SEC needs to understand how they're valuing their assets but given that these assets are illiquid and valued infrequently, it's not clear what increasing oversight here will accomplish, except fatten the pockets of lawyers (watch clip below).

Sticking with regulatory reforms, Bloomberg reports, Bernanke Calls on Regulators to Curb Shadow Banking Risks:

Federal Reserve Chairman Ben S. Bernanke called for new steps to curb “shadow banking” operating beyond standard oversight while saying the economy has far to go before fully recovering from the credit crisis.

“The heavy human and economic costs of the crisis underscore the importance of taking all necessary steps to avoid a repeat of the events of the past few years,” Bernanke said yesterday in a speech in Stone Mountain, Georgia.

Bernanke supported efforts to increase the “resiliency” of money market funds, referring to Securities and Exchange Commission proposals to require firms to maintain capital buffers or to redeem shares at the market value of underlying assets rather than at a fixed price of $1. He also called for efforts to monitor financial innovation and backed curbs on intraday credit in tri-party repo markets.

An average of more than $2.8 trillion in securities was financed during the market peak in 2008 through tri-party transactions, many of which had short-term maturities. During the first quarter of 2010, the value of securities financed by tri-party repo had fallen to an average of $1.7 trillion, according to New York Fed calculations based on Bank of New York and JPMorgan Chase & Co. data and cited in a May 2010 Fed paper.

Following the bankruptcy of Lehman Brothers Holdings Inc. in 2008, Bernanke flooded the financial system with liquidity by opening facilities that provided credit to money market funds, primary dealers, commercial paper markets, banks and other borrowers.

Regulatory Overhaul

Congress under a 2010 regulatory overhaul known as Dodd- Frank mandated the Fed to safeguard stability partly by monitoring firms whose collapse may provoke turmoil across financial markets.

“About three and a half years have passed since the darkest days of the financial crisis, but our economy is still far from having fully recovered from its effects,” Bernanke said in his only reference to the economy’s current condition. He didn’t refer to current monetary policy.

U.S. stocks fell yesterday and yields on 10-year Treasuries slipped as job creation in the world’s biggest economy trailed estimates last week. The Standard & Poor’s 500 Index lost 1.1 percent to 1,382.20. The yield on the 10-year Treasury note fell to 2.047 percent from 2.054 percent on April 6.

Risk Taking

Responding to audience questions, Bernanke said a regulation known as the Volcker rule, which bans banks from risking capital by trading for their own accounts, raises a “lot of complexities” and internationally “it is not going to be a completely level playing field in that area.”

The rule, named for its original champion, former Fed Chairman Paul Volcker, is aimed at reducing the odds that banks will make risky investments with their own capital and put depositors’ money at risk. Bernanke said on Feb. 29 that the central bank and other regulators won’t meet the July deadline to complete work on the Volcker rule. The Fed has received over 17,000 comment letters on the proposal.

The Fed will seek an “appropriate balance” between a ban on proprietary trading and a rule that “allows appropriate market making,” Bernanke said.

International capital regulations known as Basel III will lead to “a very substantial increase in capital, and I think that is essential,” he said.

Bank Reserves

The higher level of required bank capital “probably will feed through” at least marginally to “the cost of credit” in the economy, Bernanke said. The costs of higher capital are small compared to the benefits from reducing the odds of a new financial crisis, he said.

“The cost-benefit test is very easily passed,” he said.

Bernanke said the Dodd-Frank Act had removed some of the Fed’s ability to make emergency loans, saying that “we can no longer lend to an individual firm as we did in the crisis.”

“Fortunately, I don’t think that they weaken our ability to provide backstop liquidity where necessary,” Bernanke said. The Fed is still able to lend through the discount window or to a broad class of borrowers in an emergency, he said.

Bernanke said that infrequent use of emergency programs as well as new abilities to supervise different types of firms should help reduce moral hazard, or excessive risking-taking by firms that expect a government bailout. “Anytime you have a safety net” regulators need a mechanism “to minimize moral hazard,” he said.

Big Price Decline

Following the collapse of the housing bubble, regulators will take steps to guard against another large decline in home prices, Bernanke said.

“Obviously, we have already taken steps and the Consumer Financial Protection Bureau will continue to take further steps to provide additional protections and try to avoid any similar event in the future,” Bernanke said.

Bernanke used his remarks at the 2012 Federal Reserve (FDTR) Bank of Atlanta Financial Markets Conference to summarize the Fed’s progress in implementing the Dodd-Frank Act and to highlight current challenges.

“Additional steps to increase the resiliency of money market funds are important for the overall stability of our financial system and warrant serious consideration,” he said.

The SEC is working on revamping rules for money market funds, as regulators have debated how to make the funds more stable since the 2008 collapse of the $62.5 billion Reserve Primary Fund, which triggered an industry-wide run by clients that helped freeze global credit markets.

Enacted Changes

The agency enacted changes two years later in an attempt to prevent runs, including new liquidity requirements, shorter maturity limits and enhanced disclosure mandates. SEC Chairman Mary Schapiro has called for further steps to fix “weaknesses” with the funds.

Bernanke, 58, also called on participants in the tri-party repo market to eliminate intraday credit, something an industry task force supported in 2010, he said.

“Although some progress has been made, securities dealers and clearing banks have yet to fully implement that recommendation,” Bernanke said. “Through supervision and other means, we continue to push the industry toward this critical goal.”

The Fed has been seeking to strengthen the tri-party repurchase agreement market, which almost collapsed in 2008 amid the demise of Bear Stearns Cos. and bankruptcy of Lehman Brothers.

More Oversight

In February, the central bank said it will increase oversight of efforts to protect the market for borrowing and lending securities after an industry group, the Tri-Party Repo Infrastructure Task Force, said more time was needed for it to meet goals for reducing risk.

Repos are transactions used by the Fed’s primary dealers for short-term funding and typically involve the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to the lender, typically a money-market mutual fund.

In a tri-party arrangement, a third party, one of two clearing banks, functions as the agent for the transaction and holds the security as collateral.

Again, more huffing and puffing, this time from the Fed. Most of these proposed measures should have been in place a long time ago. Will it make a huge difference in 'regulating' the shadow banking system? I'm not convinced.

Some banks are moving to close their prop trading desks ahead of Basel III but most are hesitant to touch their capital markets operations because they are a huge cash cow, bringing in much needed revenues during sluggish economic times.

As far as the so-called "Volcker rule", the Fed is hesitant to fully endorse it. I happen to agree with the Council on Foreign Relations, it's time to move beyond this rule as a ban on proprietary trading by commercial banks would have done nothing to mitigate the worst financial crisis since the Great Depression:

The riskiness of proprietary trading depends entirely on the nature of the assets being traded, the trading strategy, and the leverage applied. The idea that proprietary trading is inherently riskier than traditional banking activities—transforming short-term liquid deposits into long-term illiquid loans—is surely false. The maturity mismatch between a bank's deposits (its liabilities) and traditional loans (its assets) is itself a major source of risk to its solvency, one that is much smaller when the bank's assets are liquid securities.

Banking under a Volcker rule is still a risky business. Banking without a Volcker rule may be more risky or less risky, depending on the specifics of the actual proprietary activities undertaken. Volcker rightly points out that proprietary trading "is essentially speculative in nature," yet so is lending to commercial real estate ventures—a traditional banking activity.

In short, proprietary risk taking is the issue to be concerned with. Proprietary trading may not involve taking much risk, and proprietary risks can be large without much trading.

If a primary aim of the Volcker rule is to reduce the risk that deposit insurance funds will need to be used, a proprietary trading ban makes little sense. Policy can achieve this directly through so-called narrow banking rules—simply requiring banks to invest only in "safe" assets.

The result would be the demise of credit provision by way of bank deposits, and a shift of such credit activity toward securities markets—the liquidity of which is necessarily sustained by speculative trading activity. There is no escaping this fact. The risk to depositors' funds can only be systematically reduced at the expense of lower deposit yields and less credit provision by way of bank lending.

What the Volcker rule is actually getting at is not an evaluation of risk so much as a judgment on the relative societal benefits of lending versus proprietary trading. Yet the debate over the extent of legitimate carve-outs from the rule for "market making"—which has an important role in supporting the liquidity of debt markets—highlights just how blurry the boundary can be. It is thanks to securitized debt markets that many companies have been able to access cheap capital even in times when traditional banks—with impaired balance sheets from prior bad lending—have been retrenching.

The present regulatory effort to distinguish acceptable market-making activities and hedging from unacceptable proprietary trading—an effort hopelessly based on divining the "intent" of a given transaction—is a recipe for inflating compliance costs and encouraging new and wasteful forms of regulatory arbitrage. Since market making is a capital-intensive—that is, relatively costly—form of liquidity provision, there is no reason why policymakers should be privileging it in the first place. Automated trading in the equity and derivatives markets, for example, can often supply market liquidity in the form of limit orders (that is, orders to buy or sell securities at a given price) at lower cost. The "intent" of the firm placing these orders is irrelevant. Such trading can also be less risky than market making.

The debate over the Volcker rule has necessarily taken on a major international dimension, as it directly affects foreign institutions operating in the United States and U.S. institutions whose market-making activities support government debt markets overseas. That the Dodd-Frank Act exempted U.S. Treasury and agency debt, but not foreign debt, from the Volcker rule has naturally rankled foreign governments. They cannot understand why the U.S. government only considers market making a worthy economic activity when it is directed at its own securities.

A Better Way to Ensure Financial Stability

Plowing forward with the Volcker rule is not sensible. The rule does not get to the heart of the problem that fueled the financial crisis: excessive debt, particularly of the short-term variety.

A direct means of addressing the risks bank behavior can pose to financial stability is limiting their leverage, which invariably rises during booms—and reverses, with enormous collateral damage, during the subsequent busts. In the run-up to the financial crisis, large banks in both the United States and Europe financed a lending surge by rapidly expanding their non-deposit liabilities—that is, borrowing short-term using tools such as overnight repurchase (repo) agreements and financial commercial paper. The explosive growth of debt securitization (like asset-backed securities, mortgage-backed securities, and collateralized debt obligations) was fueled by parallel growth in the short-term bank borrowing necessary to fund it.

The United States needs to take two broad steps to constrain this process. The first is for the Fed to impose hard limits on the total assets a bank may acquire as a multiple of its common equity—what the shareholders themselves have at risk. This will restrict the ability of a bank to fund asset expansion through short-term borrowing, which increases its vulnerability to runs and sudden credit stops.

This approach differs markedly from that of existing international bank capital regulation, enshrined in the so-called Basel rules, which applies an arbitrary risk weight to each of the bank's assets based on a political judgment of how risky they are—a process through which Greek government debt emerged as "risk free."

The Basel approach considers reliance on funding through instruments such as reverse repos—the purchase of securities with the agreement to sell them at a higher price in the very near future—minimally risky simply because the credit risk is low. A leverage limit, in contrast, would recognize the risk to the bank's solvency inherent in the volatile funding conditions in the wider market for this sort of short-term securitized lending.

Optimally, such a reform would be implemented globally, not just in the United States. American banks may complain of an unlevel playing field. But the twenty-five-year history of Basel regulation shows that implementation is so uneven across countries as to make this ambition more platonic than practical.

However, Congress could take an important second step that would mitigate the banks' incentives to over-leverage in the first place: reducing the massive incentive for debt financing in the U.S. tax code. According to the Congressional Budget Office, U.S. corporations face an astounding 42-percentage-point effective tax rate penalty for equity-financed investments (36 percent) vis-à-vis debt-financed investments (-6 percent). This naturally encourages banks to operate at very high levels of leverage, and made them dangerously vulnerable financially as borrowing costs soared during the financial crisis.

Below, Bloomberg's Cristina Alesci reports on the March 30th deadline for private equity firms to register with the SEC and the fees the firms will face. She speaks on Bloomberg Television's "Money Moves."

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