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Pan-Regulatory Effort on Hedge Fund Exposures

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The Financial Times, as is often the case, carried a story on hedge fund risks that was not covered in the Wall Street Journal or the New York Times. Titled “Regulators concerned at hedge fund collateral,” it discusses how an international group of financial regulators is working with some of the biggest Wall Street firms to see if they can develop a “consolidated supervised entities programme.”

What is striking is the number of bodies involved: the Fed, the SEC, the Office of the Comptroller of the Currency, the UK’s FSA and European regulators. It’s hard simply to have US authorities get over their turf issues and work together. You seldom see this level of cooperation in the absence of a crisis, which suggests how deeply worried they are.

US, UK and European regulators have expressed concern in recent meetings that investment banks may be allowing hedge funds to increase their borrowing capacity using collateral that could lose its value rapidly in a financial crisis.

The regulators have asked banking executives in the meetings on Wall Street to detail exactly how they use portfolio netting, a practice that allows hedge funds to use relatively illiquid securities such as credit default and total return swaps as collateral to reduce overall margin requirements.

The fear among some regulators and outside observers is that in a big market dislocation the funds might be unable to sell those securities, increasing the likelihood of widespread defaults.

“Is it inherently dangerous that funds are doing this? Yes, it is,” said Brian Shapiro, president of CarbonBased Consulting, the New York-based research group. “You just have to trust that these funds are going through adequate risk management, including liquidity risk.”

Brokerage executives say they are careful in their collateral requirements and have legal agreements governing the arrangements.

One Wall Street executive acknowledged that regulators had a “legitimate concern” that such agreements might not be enforceable in the face of a hedge fund collapse. However, he did not believe regulators would find that banks were taking on excessive risk.

The questions are part of a broad new effort by the New York Federal Reserve, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the UK’s Financial Services Authority and European regulatory bodies to understand better how much exposure large banks have to hedge funds and whether that could present a significant risk to the financial system in the event of a market disruption.

So far, detailed discussions have been held with a group of five of the largest Wall Street securities firms that some time ago agreed to volunteer for a “consolidated supervised entities programme”. Members of the programme are among the most active in lending to hedge funds.

Officials have found that some firms have been extending credit on less liquid instruments but relatively little credit is being extended under these circumstances – and at higher cost to borrowers, regulators say.

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