Recent examinations of registered advisers raised concerns in  areas such as disclosure, reporting and filing, personal trading, and asset  valuation. The  banking regulators also monitor hedge fund-related activities at the  institutions under their jurisdiction. For instance, in recent years  regulators conducted targeted examinations and horizontal reviews that  have focused on areas such as stress testing, leverage, liquidity, due  diligence, and margining practices as well as overall credit risk  management. In fiscal year 2006, RADAR identified a  number of hedge fund-related risk areas, which although not exclusive to  hedge funds require additional regulatory attention, including the  following:    soft dollars (e.g., paying for a hedge fund’s office space without disclosing    market manipulation (e.g., the dissemination of false information to inflate  the price of a stock);    hedge fund custody and misappropriation (e.g., theft of hedge fund assets  by its advisers);   complexity of hedge fund products and suitability (e.g., inadequacy of  policies and procedures to assess the complexity of financial instruments  and the suitability of products for investors);   prime brokerage relationships (e.g., potential conflicts of interest where  prime brokers give hedge fund clients—who often pay large dollar  amounts of commissions—priority over non-hedge fund clients regarding  access to information/research);   performance fees (e.g., incorrect calculation of performance fees);    hedge fund valuation (e.g., inadequate policies and procedures to ensure  that asset valuations are accurate); fund of funds’ conflicts of interest (e.g., conflicts of interest between fund  of funds advisers and their recommendation to a fund of hedge fund to  invest in certain hedge funds); insider trading (e.g., trading on nonpublic information); and   hedge fund suitability (e.g., inadequate policies and procedures to ensure  the financial qualification of investors). Bank regulators largely rely on their oversight of hedge fund-related  activities at those regulated entities that transact with hedge funds in their  efforts to mitigate the potential for hedge funds to contribute to systemic  risk. Since 2004, regulators have increased their attention to these  activities. Regulated entities have the responsibility  to practice prudent risk management standards, but prudent standards do  not guarantee prudent practices. As such, it will be important for  regulators to show continued vigilance in overseeing banks’ hedge fund- related activities. For instance, large hedge funds use multiple prime brokers,  making it unlikely that any single broker would have all the data needed to  assess a client’s total leverage. An  example can be found in the Amaranth case. Regulators told us that from their examinations of  regulated entities that transact business with hedge funds as creditors and  counterparties, they have observed that hedge fund disclosure and risk  management practices have improved since LTCM. Third,  some regulators have expressed concerns that some creditors and  counterparties may have relaxed their counterparty credit risk  management practices for hedge funds, which could weaken the  effectiveness of market discipline as a tool to limit the exposure of hedge  fund managers. Regulators View Hedge Fund Activities as Potential Sources of Systemic Risk and Are Taking Measures to Enhance Market Discipline and Prepare for Financial Disruptions

Financial regulators and industry observers remain concerned about the  adequacy of counterparty credit risk management at major financial  institutions because it is a key factor in controlling the potential for hedge  funds to become a source of systemic risk. The PWG also has established two private  sector committees to identify best practices to address systemic risk and  investor protection issues and has formalized protocols to respond to  financial shocks. Despite Intensified Market Discipline, Concerns about Hedge Funds Creating Systemic Risk Remain

Financial regulators believe that the market discipline imposed by  investors, creditors, and counterparties is the most effective mechanism  for limiting the systemic risk from the activities of hedge funds (and other  private pools of capital). Instead, regulators have taken a risk-focused  and principles-based approach by monitoring counterparty risk  management practices across regulated entities and issuing guidance to  help strengthen market discipline. We view these initiatives as positive steps taken  to address systemic risk. However, it is too soon to evaluate their  effectiveness. All except for FDIC and OTS  provided technical comments, which we have incorporated into the report  as appropriate. To address the second objective (market discipline), we interviewed  relevant market participants (such as investors, creditors, and  counterparties), and regulatory officials, to get their opinions on (1) how  market participants impose market discipline on hedge funds’ risk taking  and leveraging (and whether they have improved since 1998); (2) the type  and frequency of information such participants would need from hedge  fund advisers to gauge funds’ risk profiles and internal controls to make  informed initial and ongoing investment decisions; and (3) the extent to  which hedge fund disclosures to market participants have improved since  the 1998 near failure of the large hedge fund, Long-Term Capital  Management. According to one regulator and an industry source,  pension plans are attracted to various hedge fund investment strategies,  depending on their portfolio composition.
Why GAO Did This Study

Since the 1998 near collapse of Long-Term Capital Management (LTCM), a large hedge fund--a pooled investment vehicle that is privately managed and often engages in active trading of various types of securities and commodity futures and options--the number of hedge funds has grown, and they have attracted investments from institutional investors such as pension plans. Hedge funds generally are recognized as important sources of liquidity and as holders and managers of risks in the capital markets. Although the market impacts of recent hedge fund near collapses were less severe than that of LTCM, they recalled concerns about risks associated with hedge funds and they highlighted the continuing relevance of questions raised over LTCM. This report (1) describes how federal financial regulators oversee hedge fund-related activities under their existing authorities; (2) examines what measures investors, creditors, and counterparties have taken to impose market discipline on hedge funds; and (3) explores the potential for systemic risk from hedge fund-related activities and describes actions regulators have taken to address this risk. In conducting this study, GAO reviewed regulators' policy documents and examinations and industry reports and interviewed regulatory and industry officials, and academics. Regulators only provided technical comments on a draft of this report, which GAO has incorporated into the report as appropriate.

What GAO Found

Under the existing regulatory structure, the Securities and Exchange Commission and Commodity Futures Trading Commission can provide direct oversight of registered hedge fund advisers, and along with federal bank regulators, they monitor hedge fund-related activities conducted at their regulated entities. Since LTCM's near collapse, regulators generally have increased reviews--by such means as targeted examinations--of systems and policies of their regulated entities to mitigate counterparty credit risks, including those involving hedge funds. Although some examinations found that banks generally have strengthened practices for managing risk exposures to hedge funds, regulators recommended that they enhance firmwide risk management systems and practices, including expanded stress testing. Regulated entities have the responsibility to practice prudent risk management standards, but prudent standards do not guarantee prudent practices. As such, it will be important for regulators to show continued vigilance in overseeing hedge fund-related activities. According to market participants, hedge fund advisers have improved disclosures and transparency about their operations since LTCM as a result of industry guidance issued and pressure from investors and creditors and counterparties (such as prime brokers). But market participants also suggested that not all investors have the capacity to analyze the information they receive from hedge funds. Regulators and market participants said that creditors and counterparties have generally conducted more due diligence and tightened their credit standards for hedge funds. However, several factors may limit the effectiveness of market discipline or illustrate failures to properly exercise it. For example, because most large hedge funds use multiple prime brokers as service providers, no one broker may have all the data necessary to assess the total leverage of a hedge fund client. Further, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk. These factors can contribute to conditions that create systemic risk if breakdowns in market discipline and risk controls are sufficiently severe that losses by hedge funds in turn cause significant losses at key intermediaries or in financial markets. Financial regulators and industry participants remain concerned about the adequacy of counterparty credit risk management at major financial institutions because it is a key factor in controlling the potential for hedge funds to become a source of systemic risk. Regulators have used risk-focused and principles-based approaches to better understand the potential for systemic risk and respond more effectively to financial shocks that threaten to affect the financial system. For instance, regulators have collaborated to examine some hedge fund activities across regulated entities. The President's Working Group has taken steps such as issuing guidance and forming two private sector groups to develop best practices to enhance market discipline. GAO views these as positive steps, but it is too soon to evaluate their effectiveness.