Is there a case for supervision of alternative investment funds? A new working paper

by Tarun Ramadorai.

The task of financial regulation can be broken up into consumer protection (where we worry about small consumers being cheated by financial firms), prudential regulation (where we worry about the possibility of bankruptcy of one financial firm) and systemic risk regulation (where we worry about the procyclicality of financial regulation). Everything that we do in financial regulation must be motivated by one of these three issues.

In the class of fund management mechanisms, there is one interesting special case: the `alternative investment management mechanisms' which include hedge funds, private equity funds, venture capital, etc. The defining feature of these is that each customer places a large sum of money under the control of the fund manager. A typical value for the minimum ticket size is $1 million.

Once this is done, it is no longer possible to argue that the investor is a small consumer who might be cheated by the fund manager. A person who places atleast $1 million with a fund manager has the capability and resources to protect his own interests. Hence, the mainstream strategy utilised all over the world has been to leave these fund managers completely unregulated.

Indeed, there has been a healthy competitive tension between these investment vehicles (which are unregulated) versus mutual funds (which are regulated). Large customers have the choice between going with mutual funds, where the cost of regulation is suffered, or going to an alternative investment mechanism where this cost is not suffered. If these customers feel the gains from regulation are not justified, they have the choice of walking away and not incurring the costs.

The world over, there are debates brewing about the need for hedge funds to begin disclosing regular information on performance, positions and counterparties to regulatory authorities. For example, the SEC recently proposed a rule requiring U.S.-based hedge funds to report such information to a new financial stability panel established under the Dodd-Frank Act. Unsurprisingly, hedge funds argued against this proposal, citing concerns that the government regulator responsible for collecting the reports could not guarantee that their contents would not eventually be made public.

In a recent paper, my coauthors Andrew J. Patton and Michael Streatfield and I examine one element of the relationship between a hedge fund and its customers: disclosure about returns. The paper is titled The reliability of voluntary disclosures: Evidence from hedge funds.

Hedge funds are notoriously protective of their proprietary trading models and positions, and generally disclose only limited information, even to their own investors. However they do voluntarily report their monthly returns and assets under management to a wider audience through one or more publicly available databases. These databases are widely used by researchers, current and prospective investors, and the media.

Our paper examines the reliability of these voluntary disclosures by hedge funds, by tracking snapshots of these hedge fund databases captured at different points in time between 2007 and 2011. In each vintage of these databases, hedge funds provide their entire historical records (rather than just the new performance information since the previous vintage). Using these data, we detect that older performance records of hedge funds are revised as a matter of course. Nearly 40% of the 18,000 or so hedge funds in our sample revise their previous returns at least once over the vintages that we consider.

We then categorize hedge funds in real-time into revising and non-revising funds, and find that on average revising funds significantly underperform non-revising funds, and have a higher risk of experiencing large negative returns. This suggests that mandatory, audited disclosures by hedge funds, such as those proposed by the SEC earlier this year, would be beneficial to investors and help to prevent such negative outcomes.

SEBI has recently put out a request for comments on a proposed strategy for regulation and supervision of alternative investment vehicles. Our paper can help in thinking about the issues faced in this field on the consumer protection, and analysing the policy choices faced there. While there is much merit to the mainstream strategy of leaving this industry unregulated, our paper suggests that a small dose of supervision, focusing on basic hygiene and motivated by consumer protection, may help.

Goodbye great moderation, hello financial fraud?

The calculations that lead up to fraud

Under normal circumstances, the checks and balances of capitalism work fairly well, particularly in good countries, when it comes to the problems of fraud. This reflects the rational decisions of individuals who compare the benefits from two paths:

Behaviour within the rules

This yields the NPV of cashflow from now until death from being able to work and earn profits in the business.

Breaking the rules

This yields some benefits immediately. There is a certain probability of getting caught and a certain delay in getting caught. Once the person is caught, a punishment is inflicted, and the NPV of cashflow from good behaviour is lost.

The system of checks and balances has been optimised for normal times and, by and large, in good countries, it does a good job of deterring misbehaviour.

Understanding the two big recent blowups

The global economic turbulence changes the balance between these elements. For many people who have their backs against the wall, when faced with imminent disaster in their ordinary business, the payoff to the first option -- behaviour within the rules -- goes down sharply. This increases the temptation of breaking the rules.

I think this is one insight into the disclosures about fraud by Marc S. Dreier [link] and Bernard L. Madoff [link, link].

The Madoff story will inspire some to say that the concept of a hedge fund is fundamentally broken. They will argue that in good times, the checks and balances work out okay, but when volatility is high and some hedge funds have made very large losses, the temptation towards malpractice becomes irresistible, and the lack of hands-on government involvement in hedge funds is a fatal flaw.

The story is a little more complex. A more careful examination shows that both cases (Dreier and Madoff) were a bit out of the ordinary. In the Dreier case, as the NYT article by Alison Leigh Cowan, Charles V. Bagli and William K. Rashbaum says:

Mr. Dreier, 58, controlled the finances of his law firm to an unusual degree, according to lawyers there, because of the unusual way it was set up.
Mr. Dreier was the only equity partner in the firm, and deals were structured so that only he knew all the specifics and had access to all accounts, people with the firm said in court papers. Mr. Dreier convinced lawyers that such an arrangement was best by emphasizing that it would allow them to concentrate on their first love, the law, while he worried about running the firm.
There would be no executive committee. No partners meetings. Mr. Dreier would handle all administrative chores.

Their checks and balances were unusually weak for this organisation, even by the standards of tranquil times.

In Madoff's case, as Roger Ehrenberg says:

Hedge funds, the purported touchstone of the unregulated entity, are far more regulated and subject to many more checks and balances than Madoff every was. I've long made the argument that hedge funds are actually heavily regulated, not directly but indirectly through their relationships with the heavily regulated prime brokers. Forget about the negative PR and spin - it's true. Prime brokers have full transparency into the books of hedge funds, contribute data to the reporting of Net Asset Value (NAV), which is generally pumped out by the hedge funds' administrator. There is a further layer of protection offered by the hedge fund's auditor. Unless everyone is in cahoots it is pretty hard to see how a hedge fund is systematically mis-reporting NAV (except with respect to illiquid assets, but this is another issue entirely). 

Some of the biggest non-market risks of hedge funds include style drift (veering from the strategy outlined in the prospectus, such as when Amaranth's natural gas trades ceased to make it a multi-strategy fund), creeping illiquidy (taking advantage of the illiquid asset carve-out in the prospectus only to see the value of the liquid assets fall, resulting in a prospectus-breaching concentration in illiquids), overuse of side pockets (concentrated, balky public positions that don't fall under the rubric of illiquids yet result in a similar risk profile) and manager fatigue ("If I'm down 50% and it will take me years to dig out from under my high water mark, I'll just shut down"). Note that these risks have to do with the character of the manager, things that a good due diligence process should ferret out. But they really don't have to do with the veracity of the firm's positions, books and records, as third-party involvement together with the regulatory oversight of the prime brokers makes the Madoff kind of fraud highly unlikely.
But Madoff is a completely different kind of firm. It is a broker/dealer with an asset management division, enabling it to rely entirely on itself for trading and settlement. Further, it used a no-name, three-person accounting firm, unheard of for a firm of Madoff's size, scope and complexity. A purely rational trader of Madoff's stature would have set up a hedge fund business to extract 2/20 from his clients. I guess we now understand why; it would have subjected his portfolio to the unwanted scrutiny of his prime brokers. By keeping his game completely in-house and on the down low, it essentially fell through the cracks of our regulatory structure. Will this cause the SEC to redouble its efforts in regulating broker/dealers? Force changes in transparency, similar to what I've pushed for in the OTC derivatives market to the broker/dealer community? Or is it simply a matter of creating rules that ensure credible third-party involvement in the validation of assets under management/NAV in order that Madoff's brand self-dealing couldn't be sustained? 

When it comes to client funds, I believe the involvement of multiple third-parties in the validation of positions and NAV is critical. Checks and balances have to be built into the system, and by employing a structural approach to regulation as opposed to simply adding more regulations, I believe we can minimize the friction in the system while providing the necessary protections to individuals and institutions. The lack of trust so pervasive in today's financial markets just took another hit. But let's take a moment to think of the right way to address the issue (better due diligence, higher standards for fiduciaries, imposition of checks and balances with broker/dealers and asset managers working under the same roof), rather than the way that plays best for PR purposes.

In this case also, the checks and balances that prevailed on Madoff's operation were not typical of what is found with the ordinary hedge fund. The Madoff story is not an indictment of the concept of a hedge fund, but a critique of the specific form through which his fund was organised.

Benefits from the involvement of a third party

I see an analogy with the idea of the third-party repo.

A repo is a collateralised loan. You give me a security worth Rs.100 and I give you a loan of Rs.80. As the price of the security fluctuates, marking to market needs to be done to ensure safety. The difference (Rs.20) is called the `haircut'. The size of the haircut is chosen based on the price risk and liquidity risk of the security between two consecutive marks-to-market.

It is possible to organise a repo properly with bilateral credit risk exposures. If both parties were good and efficient, then marking to market of collateral values would take place properly, haircuts would be computed correctly and always maintained. But there is the risk of operational failures or outright fraud. This is where the `third-party repo' greatly improves matters. The borrower and lender do not directly deal with each other: each deals with the 3rd party who supervises the proper functioning of the transaction as time passes.

This helps simply by bringing in a third party into the transaction. It increases the number of people reconciling accounts. But at the same time, if the third party is just an accountant, there is a greater risk of his doing work only on a best efforts basis. What will really bind the incentives of the third party is for him to do netting by novation: for him to be the legal counterparty to both sides. So when X borrows from Y, at a legal level, X borrows from the third-party and the third-party borrows from Y. This ensures incentive compatibility for the third-party who is then much less likely to make mistakes.

An Indian perspective

In India, under normal conditions, blocking fraud is difficult because the probability of being caught is low, the delay in imposing punishment is high, and the punishment is often quite small.
In this backdrop, the events of 2008 have induced massive profits and losses in unexpected places. I suspect some scandals will pop up.

By and large, the world of SEBI, NSE, NSCC, CCIL, BSE, NSDL, CDSL and mutual funds works fairly well in having strong checks and balances. The life of a typical securities firm in connection with these elements of securities infrastructure is tightly integrated into IT systems run from above. These IT systems correspond to a real-time offsite supervision system. They substantially remove room for fraud. While I expect things will work out okay there, there is always the possibility of some chinks in the armour showing up.

The famous scandals of the past are instructive. Harshad Mehta exploited the flaws of the depository for government bonds. Ketan Parekh exploited the weak risk management of Calcutta Stock Exchange. Home Trade exploited the flaws of the settlement system for bonds. Each of these took place in a part of the system where the real-time offsite supervision system described above was absent. That's a fair guide to what might happen in 2009.

Problems are perhaps more likely in the less regulated companies including listed companies. Some firms have a lot of leverage on their balance sheets and some CEOs have a lot of leverage on their personal balance sheets. Some CEOs have personally given buyback promises to institutional investors who got invested in their stock. These individuals are under a lot of pressure. The less ethical of them could buckle under this pressure and resort to breaking the law.

The global financial disturbance of 2007 and 2008

Broad events

In the graph above, the blue line is the VIX, the implied volatility of the S&P 500 as read off the options market. It is a good measure of US and global economic uncertainty. The horizonal yellow line is the long-run average value of VIX. It helps us place recent values of VIX in perspective.

The black line is the S&P 500. However, instead of the conventional index levels, I use the US Major Currencies Index (produced by the US Federal Reserve) to adjust for the decline of the US dollar. The black line can thus be seen as a measure of the S&P 500 as seen by someone who keeps score in a floating currency.

The VIX shows four peaks in the last one year, with the fourth peak being particularly high - this is the day Bear Stearns died. The black line shows a sharp drop across these events -- a 19% fall in all -- reflecting a combination of a poor showing by the S&P 500 and by the US dollar.

The key questions

Ever since the financial disturbances of last year began, there has been fresh interest in understanding how they came about and perhaps in then figuring out ways in which such disturbances can be avoided. Here's my attempt at organising the thinking which has been taking place on both diagnoses and remedies, which is also a linkfest so you get all the underlying materials.

It is easy to blame (say) the flawed models at credit rating agencies for securitisation paper as the root cause of the problem. But to focus exclusively on that would miss out on the tremendous demand for this paper which was present from institutional investors. Dodgy practices amongst originators and ratings agencies were a response to a surge in demand for this paper. I think it is useful to structure the discussion around a few big questions:

1. Why was there such a surge in demand for a yield pickup? This leads to explanations emphasising monetary policy and the impact of interest rates on risk taking.
2. Why did dodgy practices with home loans and their securitisation process flourish? This leads to explanations emphasising the difficulties in regulation. The brunt of this story seems to be in the US, since the bulk of sub-prime loans happened there. As an example, there isn't much sub-prime housing debt in the UK.
3. When difficulties arose, why did liquidity collapse in key markets? Why did we get a run on Northern Rock - despite its excellent portfolio? Why did we get a run on non-bank players like Northern Rock and Bear Stearns? How can the role of monetary policy be changed so that key markets stay resolutely liquid in the future?

There are a few other questions out there which, in my mind, are better understood. Why did a modest rate of default in a relatively small part of finance lead to such a crisis? (My answer: There was a lot of leverage out there). Did the Fed do right in rescuing Bear Stearns? (In my opinion, Yes). Why has the impact on the real economy of these events been relatively modest? (My answer: There is little leverage amongst the firms, and firm profitability has been pretty good, so there hasn't yet been a wave of layoffs). I feel these things are relatively better understood. So I will focus on the big three questions that are the puzzle.

Q1: Why was there a surge in demand for a yield pickup

One element of the story is the USD pegs run by many countries. This led to a massive scale of purchase of US government bonds by foreign governments, thus depressing yields of US government bonds. On one hand, this led to a lack of market discipline from the bond market upon the expenditure patterns of US government and households. On the other hand, it gave many institutional investors acutely low interest rates on their traditional fixed income portfolios, and led to a quest for non-traditional products that would achieve a yield pickup.

John Taylor points out that Greenspan diverged substantially from a reasonable notion of what the Taylor rule should do, in keeping interest rates too low, too long.

How might government-induced interest rate distortions lead to trouble in Finance? Raghuram Rajan had a great speech from June 2006 sketching channels of influence from low interest rates to risk taking.

Q2: Why did dodgy practices on home loan origination and securitisation flourish?

Raghuram Rajan wrote an article in FT emphasising the mismatch in time horizons between compensation and portfolio performance that afflicts senior employees of banks. This falls in the larger context of the deeper difficulties of banking as a business from the viewpoint of public policy. However, as the story of Bear Stearns shows, employees do have a lot to lose if the firm goes wrong. It isn't asif they walk away scot free. With hedge funds, there is absolutely no difficulty of this nature. (Gary Becker is not convinced that compensation policies are flawed; he points out that many hedge funds and PE funds - where compensation practices are perfect in terms of aligning the interests of staff - also suffered large losses).

The reforms proposal from the US treasury is focused on problems of US financial regulation, on why a byzantine system of regulation failed to see difficulties and resolve them [backdrop]. See the press release, fact sheet, full report, main web page. Here's an analysis of the Paulson proposal by Howard Davies. Sebastian Mallaby reviews the experience of hedge funds in these months.

Jayanth Varma thinks this is the end of the beginning of housing finance, that when we pick up the pieces and do it again, we could do it right. In all these difficulties, it is fair to point out that Basle-II (with a fresh think on some issues such as the role for credit rating agencies) would help.

Q3: Why did liquidity collapse in key markets thus doing damage to Finance?

Act 1: Northern Rock. A few months ago, I think a fair consensus built up around the ideas that the ECB's more relaxed rules of collateral have worked better, and that the UK's effort at having less deposit insurance didn't work. Jayanth Varma is not happy about the FSA review of the supervision of Northern Rock. Also see his review of evidence and diagnoses of the Northern Rock espiode.

Act 2: Bear Stearns. The hearings of US Senate Committee on Banking are a great resource on the story of Bear Stearns. In particular, see Ben Bernanke Christopher Cox Robert Steel Timothy Geithner Jamie Dimon Alan Schwartz.

Why bank risk models failed by Avinash Persaud reminds us of an argument that he made a few years ago, about too many Ph.D.s armed with the same mental infrastructure, analysing the same data, come up with correlated trading strategies. We have not adequately taken into account the implications for asset pricing and liquidity at large, of a large number of traders behaving in optimising fashion in the small when armed with correlated micro models. Persaud suggests that this world suffers from a heightened risk of `liquidity black holes' when too much money wants to buy or sell en masse and the counterparties aren't to be found. Of course, some of these Ph.D.s will see this reversion in the data and become contrarian. Persaud's argument, is that we're at the first flush of the quantification of trading and money management and we're still learning how the game shapes up.

Jayanth Varma points to the great work that the researchers are rapidly coming out with in this field. On 12th December, the US Fed announced the Term Auction Facility (TAF). Stephen Cecchetti summarises the new efforts of the US Fed in overcoming the difficulties of traditional methods for implementing monetary policy. In April 2008, John Taylor and John Williams had a paper out titled A black swan in the money market modelling the collapse in liquidity and measuring the impact of the TAF (they say there isn't much of an impact).

In my mind, recent events emphasise the benefits of both exchange-traded derivatives and the clearing corporation [link]. A lot more can be done using exchange-traded products than is presently the case, but some regulators have an inexplicable bias against exchange traded. See this article in The Economist on this issue also.

Big picture responses

Alan Greenspan has an interesting response to these diagnoses. His pithy ending: We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?

In his article Percy Mistry interprets the sources of difficulty. Richard Katz compares the US today against Japan in its difficult years.

Howard Davies did a great speech on 15 January titled The future of financial regulation.

Also see Options paper from Financial Safety Forum.

The Economist does not see much of an opportunity for progress. As they say:

It would be convenient to blame the regulators for all that, but the system is stacked against them. They are paid less than those they oversee. They know less, they may be less able, they think like the financial herd, and they are shackled by politics. In an open economy, business can escape a regulatory squeeze in one country by skipping offshore.

...

The notion that the world can just regulate its way out of crises is thus an illusion. Rather, crisis is the price of innovation, so governments face a choice. They can embrace new financial ideas by keeping markets open. Regulation will be light, but there will be busts. The state will sometimes have to clear up and regulation must be about cure as well as prevention. Or governments can aim for safety and opt for dumbed-down financial systems that hobble their economies and deprive their people of the benefits of faster growth. And even then a crisis may strike.

And, see Robert Shiller on innovation.

A careful look at the most recent events

The figure shows the movement of VIX and the S&P 500 (once again, adjusted for fluctuations of the USD) in the most-recent episode. The vertical yellow line is 17th of March. We see a sharp outburst of fear and then it subsided. See an article that I wrote on 18th afternoon in Indian time (i.e. early morning of 18th in the US). Also see the associated blog entry.

Unregulated exchanges

A system of checks and balances

Financial regulation is not always a good thing. Regulation can be over-zealous. It is too easy for a safety-first mentality to set in, where a regulator who bans everything achieves great safety and soundness, without a whiff of scandal. As an example, if the initial margin of a futures market is 100% of the notional value of the position, the clearing corporation is surely safe, but then you've lost the futures market.

It is useful to have a system of checks and balances whereby the regulated market is forced to compete, to some extent, with an unregulated market. Atleast some customers should make the choice of whether they want to be in the unregulated market. This will put pressure on regulators to not be over-zealous.

The natural participants on unregulated markets are `big' customers who can generally be expected to look after themselves, so that governments do not need to step into markets to protect them on the grounds of investor protection. The role of the State can then drop down to contract enforcement. On this subject, you might like to see page 150-152 of the MIFC report.

Unregulated fund management

The great success story of this approach, of course, is the hedge fund: an unregulated fund management vehicle accessible only to rich people. Rich people have a choice between going to a regulated mutual fund vs. an unregulated hedge fund. If the government is adding value through regulation of mutual funds, rich people will use mutual funds; else hedge funds will gain favour. The remarkable success of hedge funds worldwide suggests, to me, that regulation of mutual funds has gone too far in terms of imposing restrictions.

Unregulated exchanges

A new frontier seems to be opening up in this debate: unregulated exchanges. In the US, the Commodity Futures Modernisation Act setup a light regulatory mechanism for exchanges where there are no retail customers. This paved the way for Internet websites that do trading, and injected a new level of competition into the exchange industry.

The next frontier in private exchanges is exchanges where professionals trade in shares of unlisted companies. See this blog entry by Roger Ehrenberg. I think there are a few different fascinating angles here.

At the simplest, one can think of this as a harmless pre-IPO trading mechanism. At present, before the IPO, transactions do take place. They are preceded by old-fashioned negotiation through human networks and face to face meetings. So it seems natural to ask: Can computer technology be applied to reduce the frictions of trading? Since the firms are unlisted, and the participants are private equity investors, it seems reasonable to think that this is entirely unregulated.

But there are other, deeper implications. Suppose this works well. Then unlisted firms could treat this as a legitimate alternative to going public! Some firms could think they're better off without the entire barrage of legal and regulatory complexity which comes from doing an IPO.

In the old world, the stark tradeoff given to firms was: Stay unlisted, you have full freedom and flexibility, but there is no liquidity, and valuations are terrible. Alternatively, the firm could get listed, gain liquidity and improve valuations, but then there was a barrage of regulatory constraints.

These private exchanges could mature into offering a third path: where no constraints are imposed, a little liquidity is obtained, and maybe valuations are not as bad as used to be the case without liquidity.

I personally believe in the virtues of the `package deal' of listing on public exchanges and large-scale direct shareholding by households, backed by rules about disclosure and corporate governance, which gives remarkable liquidity and market efficiency. I've spent half my life trying to help build that ecosystem.

But we should not assume that this `package deal' is good. A viable framework for trading shares of unlisted firms, without any of the legal and regulatory overheads that come from going IPO, would improve competition against this package deal, and induce greater checks and balances in the economy.

The wonderful world of algorithmic trading

A pair of articles by Will Acworth and Bennett Voyles in Futures Industry Magazine take you to the edge of the wonderful new world of algorithmic trading. A few remarkable things that I found:

• CME gives you co-location facilities for $6,000 per connection (not counting co-location facility charges), so that you can place your servers closer to the exchange and reduce latency.
• Eurex's co-location gets you a round-trip of below 10 milliseconds, when compared with 29 milliseconds for a connection in London and 128 milliseconds for a connection from Chicago.
• ICE is worrying about a new notion of quality of service: no more than 0.1% of the messages should get processed in worse than 50 milliseconds, once a new trading engine is in place.
• Acworth says: In the old days, a trader might be watching four screens at the same time, commented one speaker. Now its two rows of four, with one row displaying the markets and the other row displaying network conditions.
• People like the fact that in C++ you get to control when garbage collection is done, so as to avoid unpredictable glitches in performance. (Ugh!)
• The average order size on the E-mini has dropped to 2 contracts.
• The biggest systems are nearing a million messages a second.
• Some firms have started moving functions from software to FPGA in the quest for speed.

A million messages a second is a lot! I remember in the late 1990s, when I worked on the PRISM system (which does the realtime VaR at NSE), our goal was to be able to handle 100 trades/s, which is 200 VaR calculations a second. We were thrilled because the system evolved into exceeding 1000 trades a second.

For those interested in algorithmic trading, you may like to see Chapter 5 of the MIFC report.

Finance materials in the Economic Times

Today, there is an ET debate on hedge funds, with three pieces by Samir Barua, Rashesh Shah and S. V. Prasad. And, Shaji Vikraman has an article on Bombay as an international financial centre.

Three interesting opinion pieces on finance & monetary economics

Mythili Bhusnurmath complains about RBI surprising the market; a Business Standard editorial on hedge funds; and another responding to recent SEBI proposals. Coincidentally, a great Foreign Affairs article on hedge funds just appeared by Sebastian Mallaby, and he wrote up a small version of this for Washington Post. And, Lars Nyberg, the deputy governer of the Swedish central bank, has a nice speech on hedge funds. I get really impressed by the speechwriters found in OECD countries.