SEC and hedge funds in talks over risks

Date: Thursday, June 7, 2007
Author: Reuters

NEW YORK, June 6 (Reuters) - U.S. securities regulators, looking to allay systemic risks posed by hedge funds, have begun holding informal talks with some of the biggest funds, a U.S. Securities and Exchange Commissioner said on Wednesday.

The talks, which have taken place in recent months, are aimed at assessing leverage levels, risks to trading counterparties like banks and securities firms, derivative risk and other factors, according to Annette Nazareth, one of five SEC commissioners.

The talks involve a handful of major hedge funds and came after the SEC's efforts force most hedge funds to register as investment advisors were overturned in federal court.

Registration would have given the SEC power to conduct spot audits of hedge funds to prevent fraud. But it would also have given regulators a window into the increasing market power of hedge funds, which have been estimated to be behind as much as 20 percent of U.S. market activity.

Since registration was overturned, the SEC has been looking for ways to assess the risk of a systemic breakdown should one or more hedge funds fail, as in the oft-cited case of Long-Term Capital Management in 1998, which forced a government-sponsored bailout.

Such fears have been magnified by the meteoric rise in the use of derivatives, computerized 'program' trading and other factors that could amplify such an event.

Nazareth, speaking before several hundred lawyers at the Practising Law Institute in New York, said the SEC is leaning away from proposing further hedge fund regulation, a stance reflected by a government panel headed by Treasury Secretary Henry Paulson in February. The panel suggested that existing laws are adequate to oversee private investment pools like hedge funds.

Nazareth said the SEC was approached by various hedge funds and trade associations including the Managed Funds Association, who proposed a regular voluntary dialogue after registration was overturned.

The hedge fund groups were concerned not just that the SEC may propose additional regulations, but also that some hedge funds with poor risk controls could threaten the whole trading community, Nazareth said.

"I am hopeful that this dialogue will expand substantially over time and give rise to thoughtful, targeted approaches," said Nazareth.

She said the agency would benefit from "a structured and regular dialogue" with the largest hedge funds, similar to the British system, where hedge funds hold regular talks with regulators over the state of the market.

Nazareth's comments come nine months after the dramatic collapse of Amaranth Advisors, a formerly $9 billion hedge fund group that is liquidating after $6 billion in losses in wrong-way energy trades. The implosion had little impact on the overall market, due to sufficient market liquidity to buy out the Amaranth positions.

Nazareth said "in a less stable market, where creditors would be more aggressive... the liquidation of these positions may have led to the feared downward spiral... with contagion effects on unrelated markets."