Watchdogs finally detect scent of hedge-fund risk
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
By Liam Proud
LONDON, Dec 18 (Reuters Breakingviews) -Hedge funds’ regulatory nightmare is slightly closer to becoming a reality. The Financial Stability Board (FSB), which makes policy recommendations for national watchdogs, on Wednesday published ideas including a leverage cap for non-bank financial firms - such as Israel Englander’s $72 billion Millennium Management and Ken Griffin’s $66 billion Citadel. The recommendation is unlikely to catch on soon, especially in the United States. Yet it’s still useful to have a tool if hedge funds’ indebtedness keeps rising.
The FSB has studied the leverage of non-bank market players for years, prompted by recent episodes like the March 2020 “dash for cash” and collapse of Archegos Capital Management. In both cases, forced selling by big borrowers caused a problem for the wider financial system, including banks: Credit Suisse’s Archegos hit contributed to its ultimate failure.
The broader context is a surge in hedge-fund borrowing, which rose 50% to $5.1 trillion in the two years to June 2024, according to the U.S. Office of Financial Research (OFR). So-called multi-strategy players like Millennium and Citadel, which run a vast range of investing styles, have ballooned. Their aggregate leverage, measured by the ratio of gross to net assets, rose from 3.2 in June 2022 to 4.2 this summer, though the biggest funds are probably well above this level. One risk is that a highly indebted behemoth runs into trouble, forcing it to offload positions and causing a market-wide panic.
The FSB has ideas to ward off that risk, the most eye-catching of which involves limiting non-bank financial firms’ leverage. Hedge-fund debt caps, which the FSB declined to quantify, could be analogous to banks’ minimum equity ratios. National regulators would design and implement them.
One hitch is that there isn’t an obvious authority to do this. The Federal Reserve, European Central Bank and Bank of England oversee traditional lenders but not hedge funds, many of which are registered in offshore hubs like the Cayman Islands. Markets regulators like the U.S. Securities and Exchange Commission, FINRA and the UK Financial Conduct Authority are not usually set up to make prudential policy. It would also be hard to create a rule that worked for the huge variety of hedge-fund strategies. Finally, U.S. President-elect Donald Trump seems to want less financial regulation, not more.
Still, it’s worth pursuing. The bank-capital regime shows that it’s possible to design rules that cover a vast array of assets and business models. Alternatively, watchdogs could implement a leverage cap through banks’ prime broking desks, rather than regulating Citadel and Millennium directly. After all, Goldman Sachs GS.N, Morgan Stanley MS.N and the rest of Wall Street account for 46% of hedge fund borrowing, OFR data shows.
The likeliest path to the leverage cap becoming a reality is another non-bank crisis. The ongoing concentration of hedge-fund assets into a few massive players implies that the next blowup could be even bigger than the last. If so, national regulators will at least have the FSB’s plan to reach for.
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CONTEXT NEWS
The Financial Stability Board on Dec. 18 recommended that national regulators should consider leverage limits for so-called non-bank financial firms, like hedge funds.
Local supervisors would decide on the levels of any debt caps, the international advisory body said, based on stress-testing of market players.
US-registered hedge funds' borrowing has surged https://reut.rs/3ZKLtvU
Multi-strats' rising prominence among hedge funds https://reut.rs/3ZFAIeA
Editing by George Hay and Streisand Neto
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