Economic and Political Weekly

August 20, 2005

Danger of Hedge Funds

FII Inflows and Regulatory Helplessness
Our political establishment is taking grave risks in allowing unrestricted FII inflows without appropriate disclosure and scrutiny. We cannot afford the luxury of waiting indefinitely till good sense dawns on the US regulatory and political establishments. We should therefore take the lead for concerted action by the developing countries, for in the coming months it is the currencies of these countries and some of their major corporate players that could be the obvious targets of hedge funds. The barbarians have crossed the gate and are inside our arena. Where is our strategy to discipline them?

D N Ghosh

It was last January that Reserve Bank of India governor Y V Reddy hinted, though somewhat indirectly, at the dangers of an unrestricted flow of foreign funds into our market and wondered whether imposition of quantitative restrictions was one of the options that should be explored in the interest of market stability. Finance minister P Chidambaram immediately reacted, ruling out any possibility of placing restrictions on inflows. This was to be expected. The dull, stodgy and incestuous clubs of politicians of yesteryears are now transformed institutions. They feel that they are well-equipped to handle vast sums pouring in from abroad. A talking point for our ruling politicians is that the country has at long last emerged as one of the preferred destinations for hard headed international fund managers. Are the regulators comfortable with the large inflow of funds? The surge of money can be a source of endless worry about macroeconomic stability. Two kinds of concerns about the possible impact on the stock market are apparent. First, what kind of money are the global players bringing in? The world over regulators are deeply concerned about the recycling and redeployment of huge funds which originate from activities that threaten the roots of society. Second, what kind of investors are they? What are the objectives and strategies of these global players? Some of them, particularly hedge funds, are extremely secretive and opaque in their operations; that is their trade mark. As more and more hedge funds choose to enter the new markets that are gradually opening up, regulators are caught in a crippling dilemma: Should they allow these funds to come in freely, accepting implicitly the regulatory judgment of the countries in which these are domiciled, and remain content to be passive spectators? Or should they dare to go against the flow of the market? Recently, M Damodaran, chairman of the Securities and Exchange Board of India (SEBI) spoke in general terms about the operations of hedge funds in our market. While hedge funds induce an

element of volatility, they also bring in liquidity that the market needs. And they have the money of the category of investors who are prepared to take that extra risk. For regulators, its a question of getting more players into the market and being comfortable with who the players are. You need to know the origin of money. In our context it is really know your investor requirementI think all regulators are comfortable with regulated entities and hedge funds are largely unregulated. [Business World, July 25, 2005, emphasis added] The SEBI chief has chosen his words carefully. As hedge funds, mostly of Wall Street origin, are virtually unregulated, what would be his concerns? Prima facie, going by the judgment of the guardian angel of Wall Street, he should have no worry. Alan Greenspan, chairman of the US Federal Reserve, lauds the basic objective of hedge fund strategy. Though they make extensive use of short positions, leverage and derivatives, they would normally be involved in an arbitrage strategy where when they are selling a stock, they are buying another. In the process they do an excellent job in identifying overvalued and undervalued stocks and selling or buying them accordingly. Hedge funds have become main contributors to the flexibility of the financial system. A development that proved essential to our ability to absorb so many economic shocks in recent years. Hedge Fund Concerns All this is well but such a regulatory stance does not enjoy universal acclaim. There are four sets of concerns. First, the structure of todays equity market. This is highly polarised, with the behaviour of a few shaping the fortunes of many. A substantial volume of assets is held in pure index-tracking portfolios; with the hedge fund handling a small segment of the total, as little as 2 per cent. The significance of hedge funds, however, far outstrips their size. In May, in its latest report on global financial security, the International Monetary Fund found that hedge funds might account for 80 per cent to 90 per cent of all participants in these markets. In the US and UK, for example, their activity accounts for about 40 per cent and sometimes as much as 70 per cent of daily trading in equity markets. With a phenomenal growth in size, number and capital, hedge funds are nearly double of what they were in 1998, at the time of the Long Term Capital Management (LTCM) debacle: more that one trillion dollars in capital, about 8,500 hedge funds and 1,500 funds of hedge funds themselves. The scale of their activities, supplemented by the proprietary trading desks of investment banks, has become too big for comfort. Second, their leverage is alarmingly high. Figures of bank lending to Cayman Islands where many hedge funds are domiciled, hint at a big increase in leverage since 1998. There are also indications that with margins in traditional banking business squeezed, big banks are falling over themselves to provide extensive credit facilities to hedge funds. Apart from risks inherent in

borrowing leverage, we have to reckon with economic leverage that includes risks arising from derivatives and other complex arrangements. Economic leverage can be high even when borrowing or balance sheet leverage is moderate. A study in 2003 by the Centre for International Securities and Derivatives Markets found balance sheet leverage at hedge funds 25 times their capital. This is an average and the variations among the hedge funds may widely vary. Also, hedge funds can shift positions or increase leverage almost instantaneously and static information may turn out to be deceptive. And true economic leverage may be impossible to understand without the full disclosure of all of a hedge funds commitments. In LTCM, fund managers were found subsequently to have taken the leverage to as high as 250. Even if we take leverage at an average of 25, we get a strike force of enormous dimensions in the hands of the managers of these entities at the very heart of the US financial system. Completely unregulated, nobody has the complete picture. Third, the dramatic growth in the derivatives market. Currently, the notional value of outstanding derivatives held by US banks is about $ 84 trillion, of which credit derivatives are about $ 4.5 trillion. There is a high degree of concentration in the holding of these derivatives by the US banks. The largest five US banks hold 95 per cent of the total stock of derivatives. JP Morgan Chase holds more than half of the total stock. With so much of the derivatives concentrated in a few, there is a risk that any attempt to reduce exposure in the face of a shock could magnify rather than diminish the shock. Credit derivatives permit risks to be unbundled and transferred to those players in the financial market best able to absorb them, a new paradigm of credit management, as Greenspan describes it. But the real worry is that risks are being transferred to where they are least visible and least supervised. Moreover, where financial instruments are new, risk can be easily mispriced and if it is on a large scale, there can be systemic consequences. Timothy Geithner of the Federal Reserve Bank of New York has warned, The models used to assess risks in the more novel areas of finance are, by definition, less grounded in experience and less valuable in anticipating how prices and correlations change in conditions of stress. Fourth, there are concerns about the kind of incentives that drive fund managers to achieve returns that are much higher than those obtained by mainstream managers. The incentive to take risks with all that money is huge. A typical fee structure called 2 and 20 gives managers 2 per cent of the assets under management and 20 per cent of gains realised by the fund. The market gossip is that at large funds a single years earnings can set up the managers for life. Some market observers call these perverse incentives tempting managers to find new and riskier ways to maintain their spectacular returns. In a global financial market getting progressively integrated, we are witnessing the highly concentrated power of a class of financial elite, driven to make profit on a short-term time horizon,

playing about with massive leveraged finance, building up complex trading positions all over the globe for all kinds of products, commodities and services and unwinding them with no less alacrity. There is nothing on the horizon to assure us that the activities of these perennial breeders of systemic risks are under proper surveillance. The LTCM debacle gave Wall Street an opportunity to the regulators, but the entire political establishment, backed by the Federal Reserve chairman, side-stepped the issue on the ground that such regulation would be inconsistent with the commitment to preserve and nourish the creativity of the free market. (This has been discussed in Hedge Fund Terrorism and Regulatory Inertia, EPW, January 16-23, 1999.) Discomfort about such permissiveness has continued to haunt the regulators. Let us hear what the last incumbent of the US Securities Exchange Commission, William Donaldson, had to say. In a press conference on June 1, announcing his early resignation, Donaldson made it clear that he was being forced to leave and that the primary issue of contention was his effort to regulate hedge funds. He observed that few of the hedge funds were actually hedged; these were virtually pooled vehicles that you can do anything you want with It would be almost impossible for me to conceive of a Securities and Exchange Commission that didnt recognise an industry that was at a $ 3 trillion level and wasnt being regulated at all. And we set about to regulate that industry in a rather benign way, simply to get the most fundamental knowledge about the hedge fund industry. Who is running the money? What is their investment record? What is their track record as far as infractions of the law? How do they do their accounting? This was the simplest kind of thing that will pertain to anybody that runs money. And, of course, the other part is that this kind of knowledge will help us, I believe, understand better what impact the hedge funds are having on the other side of the market. Donaldson had difficulty even in introducing a small rule change, requiring the hedge funds to register with SEC and submit to regular audit and inspection. The industry is now up in arms. They will accept no regulation. They want the securities regulator to understand that hedge funds are a form of mutual funds for the super rich, and if they are engaged in aggressive speculative activities prohibited to ordinary mutual funds, are not the rich investors themselves bearing the risks? And so why these regulatory jitters? A legalistic rollback seems to be on the cards. The new SEC appointee Christopher Cox, an anti-regulation fanatic, has assured the funds that there would be virtually no government regulations in the securities industry. Our Approach Wall Street regulators claim that they set standards for others to follow. For corporate sector governance, they have stringent parameters; for banks, strict capital adequacy requirements for

their risk exposure. And, for mutual funds, compliance requirements are back-breaking. And, here we are, with the logic reversed for the hedge fund industry. While Greenspan talks of dispersion of risk and flexibility as the benefits flowing from hedge fund operations, he keeps silent over the obfuscation issue which many others see as inbuilt risk of the highest order. Recent research by the London Stock Exchange has brought out that almost half of all listed UK companies have gaps in their knowledge of the identity of their shareholders. (Financial Times, August 9, 2005). If hedge funds have been operating without any kind of regulation in Wall Street, would we be comfortable in allowing them unrestricted entry into India? The argument that risks are being borne by the super rich investors of hedge funds does not wash. In an open financial market, it is the unintended systemic consequences of their market operations, their exposure and investment strategies, that are worrying. Can we forget too easily the audacious bets that hedge fund managers were found to have taken in several episodes over the last decade? Take the south Asian crisis in 1997: a single hedge fund had reportedly taken an exposure of about 20 per cent of the official reserves of Thailand. Should our regulators allow such kind of permissiveness? We do not possess the kind of resilience that the US economy has. As the regulator in the nerve centre of the global financial world seems reluctant to take any initiative, we have to explore ways as to how to protect our system from operators that some have described as locusts and, some others as financial terrorists. Whenever a crisis, originating from any hedge fund exposure, hits a country, Wall Street takes the view, somewhat routinely and nonchalantly, that their targets countries or corporates are the victims of their own follies. In recent months several hedge funds have played pivotal roles in high profile takeover bids: the ousting of the head of the Deutsche exchange and the forced sale of Wyevale, the garden centre group. No wonder, panicked calls have now started emanating even from developed markets in Europe. A few weeks ago, Jochen Sanio, president of the German financial supervision agency BaFin, referred to hedge funds as black holes of the international financial system. We cannot remain passive spectators. The SEBI chairman has recently observed, Regulating hedge funds is an issue before most of the financial regulators globally. This has to be addressed globally (The Economic Times, August 2, 2005). This is complacency. The episode where a particular fund refused to divulge details should not be taken lightly. Secrecy is the stock in trade of these operators and they will and can muster political clout from the US political establishment. Look how quickly they succeeded in removing the powerful SEC chief who was found to be just toying with the idea of setting up a structure of regulation.

Our political establishment is taking grave risks in allowing unrestricted FII inflows without appropriate disclosure and scrutiny. We cannot afford the luxury of waiting indefinitely till good sense dawns on the American regulatory and political establishments. In any event, in the near future, with the change in guard at the SEC, there is little likelihood of any move towards an effective global forum. We should therefore take the lead for concerted action by the developing countries, for in the coming months it is the currencies of these countries and some of their major corporate players that could be the obvious targets of hedge funds. The barbarians have crossed the gate and are inside our arena. Where is our strategy to discipline them?