Increased disclosure and transparency of hedge funds, and investors who have pension funds invested in them, were at the forefront of a House Financial Services Committee hearing last week on whether hedge funds pose a systemic risk to the market.

While lawmakers and regulators acknowledged the risks associated with hedge funds, for the most part, they backed off the idea of requiring them to register or regulating them.

Testimony was heard from representatives of the President's Working Group on Financial Markets, which issued guidelines and principles for private pools of capital, which include hedge funds this year.

The President's Working Group was formed after the stock market crash of 1987. The group's leader is Treasury Secretary Henry Paulson and includes representatives from the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission.

Federal Reserve Governor Kevin Warsh told the House that the board at the Fed is focusing on five key supervisory initiatives of hedge funds. They are reviewing hedge funds' stress-testing practices, assessing leading global banks' current practices for managing their exposures to hedge funds, reviewing the risks associated with the rapid growth of leveraged lending, examining practices to manage liquidity risk and have continued efforts to reduce the risk associated with weaknesses in the clearing and settlement of credit derivatives.

Members of the House realize that hedge funds are vital to the market. However, there are concerns that they could pose a systematic risk to the market. "The role of hedge funds in the market continues to evolve, and they have a unique ability to bring liquidity to the market," said Rep. Ed Royce (R-Calif.).

"It is hard to wrap your arms around what the problem is," said Rep. Michael Castle (R-Del.). The industry shouldn't be overregulated, as it has tremendous ability to do good for the market, he said.

There are two groups of hedge funds-those that are registered and those that are not. Currently, there are approximately 9,000 hedge funds, 2,000 of which are registered. Hedge funds that are registered are required to retain documentation.

Rep. Barney Frank (D-Mass.), chairman of the House panel, questioned whether it would be beneficial for Congress to pass a law requiring that unregistered hedge funds retain documentation, as well.

Erik Sirri, director of market regulation at the SEC, cautioned that Congress would have to be careful to require such a thing from hedge funds. "The potential costs of something like that might cause hedge funds to leave the U.S. and operate overseas," he commented.

"I don't think anyone from the Republican side discounts that there is an existence of risk in the market, and it is an inherent risk from hedge funds," said Rep. Spencer Bachus (R-Ala.). "However, I don't think there is a way for Congress to constructively intervene at this point. I don't see how regulations can bring stability to the market."

Regarding increased transparency and disclosure of hedge funds, Bachus commented that there are problems with that due to a lot of hedge fund strategies being proprietary information. "We can't ask people to give up their right to proprietary information," he said. There might even be constitutional limitations to asking people to give up their property right, he noted.

Robert Steel, the Department of the Treasury's undersecretary for domestic finance, recognizes that transparency and disclosure are important, but "to whom for and to what end?" he questioned. He stated that the President's Working Group's guidelines address how much transparency and disclosure is appropriate.

Castle questioned what the SEC is doing in terms of collusion in the industry. Sirri said that the SEC is in the process of looking at front running. "We are very much aware of the issue," but detecting schemes is difficult, he said.

One comment echoed repeatedly during the meeting was the concern not for uber-wealthy investors invested in hedge funds, but for workers in pension funds that invest in hedge funds.

Many people in pension funds represent middle-class citizens, and while they may be knowledgeable about the financial market, they do not have the assets that wealthy investors do, said Rep. Al Green (D-Texas).

Knowledge alone does not make an individual a sophisticated investor, he said, adding that an individual needs a large sum of assets as well.

If an individual investor suffers a loss, as bad as it is, it only affects the individual and their family, not the market. If a pension fund takes a serious hit, then many people are impacted, he said. If that happens, those people will seek assistance, and ultimately the burden will be on taxpayers, Green noted.

Fiduciaries have a responsibility to their investors and would never plunge 50% or 60% of a fund's assets into a hedge fund, Sirri said. "A fiduciary has an obligation to invest prudently," he said.

However, "there is nothing that stops a fiduciary from doing the exact opposite of what you just said," Green argued. The problem is that a fiduciary might have a client's best interest at heart, but doesn't have the knowledge to invest wisely all the time, Frank said.

While no legislative action is being taken against hedge funds for now, "We have to remain on top of the issue and [be] aware of the problems and risks," Frank said. "We're not rushing to register and regulate hedge funds," he said. Nonetheless, Frank qualified that by adding, "Regulation shouldn't be a bad word."

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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