Federal regulators are expressing growing concerns about certain hedge funds that may be jeopardizing the stability of the economy. In an effort to address this issue, the Financial Stability Oversight Council (FSOC) has recently implemented changes that will facilitate the designation of hedge funds, private-equity firms, and other nonbank financial institutions as systemically important financial institutions (SIFIs). Previously, this designation primarily applied to banks, subjecting them to Federal Reserve oversight as well as potential capital and liquidity requirements.
For years, nonbanks have been able to avoid this classification. However, during the Trump administration, the council modified its procedures in a manner that essentially made the SIFI designation a last-resort option. However, Friday’s FSOC vote signifies a reversal of this stance.
It is important to note that the revised regulations do not solely pertain to hedge funds; they also extend to a wide range of nonbank entities including mutual-fund managers and insurance companies. Nevertheless, it is evident that regulators are particularly concerned about the hedge-fund industry and the highly leveraged bets that some funds are placing in the Treasury bond market. According to Chris Niebuhr, a senior research analyst at Washington-based Beacon Policy Advisors, these leveraged bets are now a primary focus for regulators.
In recent years, certain funds have profited from what is known as the basis trade, which capitalizes on price discrepancies between the Treasury and futures markets. Typically, these trades involve substantial leverage. In 2020, the Federal Reserve had to intervene to stabilize the market after some funds rapidly sold off their Treasury bonds amidst the deepening COVID-19 pandemic. This prompted FSOC to reconvene a hedge-fund working group in the following year, specifically tasked with examining the stability risks posed by these funds.
Rather than immediately designating a fund as systemically important, regulators may use this opportunity to caution the industry. As Niebuhr explains, they could issue a warning, signaling the need for these funds to rein in their activities or face potential intervention measures.
Overall, these new regulations reflect regulators’ efforts to address systemic risk and promote stability within the financial markets. By extending oversight to nonbank entities, the FSOC aims to mitigate potential threats and ensure the overall soundness of the economy.
Hedge Fund Leverage Under Scrutiny
The Financial Stability Oversight Council (FSOC) met on Friday to discuss the use of leverage by hedge funds, a topic of concern for several members including Treasury Secretary Janet Yellen and Federal Reserve Chair Jerome Powell. This discussion marked an important step in revitalizing the Council’s designation process in line with Congress’s vision, according to Securities and Exchange Commission (SEC) Chair Gary Gensler.
Gensler emphasized the significance of addressing this issue, drawing on the memory of the near-collapse of Long-Term Capital Management in 1998 and the resulting threat to the financial system. However, hedge fund advocates argue that the FSOC’s concerns are misplaced. They believe that primary regulators like the SEC are fully equipped to oversee hedge fund activities and that classifying alternative asset managers as systemically important financial institutions (SIFIs) is inappropriate.
Managed Funds Association President Bryan Corbett dismissed the idea of SIFI designation for alternative asset managers, asserting that they do not pose the same risks as banks. Corbett argued that such a designation would not effectively mitigate systemic risk in the market. Additionally, hedge fund managers have voiced concerns that any attempts to restrict basis trading – a key strategy for these funds – could hinder liquidity in the Treasury market and potentially lead to higher interest rates.
Even if FSOC were to proceed with designating a hedge fund as systemically important, the lengthy process could extend well beyond the upcoming 2024 presidential election, making the potential changes irrelevant if President Joe Biden does not secure a second term.
Nevertheless, while Democrats are in power, it is evident that the hedge fund industry will remain under close regulatory scrutiny.