Abstract
This short comment illustrates a relatively concealed aspect of the
hedge fund industry which makes it part of the shadow banking system. It is
partly inspired by Mehrling’s analysis of the collapse of Long Term Capital
Management (LTCM) and his emphasis on the liquidity risks that brought the
hedge fund to its knees. The comment argues that a better understanding of
Mehrling’s ‘money view’ of the collapse of LTCM requires viewing hedge funds
(at least those funds engaging in maturity and liquidity transformation) as
part of the shadow banking system. Needless to say, depiction of hedge funds as
part of the shadow banking system and hence systemically important financial
institutions significantly contributes to the literature on hedge fund
regulation.
Introduction
A ‘hedge fund’ is a privately organized[1] investment
vehicle with a specific fee structure,[2]
not widely available to the public,[3]
aimed at generating absolute returns irrespective of the market movements
(Alpha),[4]
through active trading[5]
and use of a variety of trading strategies at its disposal. Hedge funds provide
several benefits to financial markets. They are additional sources of diversification[6]
and liquidity.[7]
Furthermore, by investing in ‘less liquid, more complex and hard-to-value’
markets such as convertible bonds, distressed debt, and credit default swaps,
they complete and deepen financial markets.[8]
More importantly, hedge funds’ focus on generating alpha is rooted in
exploiting market imperfections and discrepancies[9]
which facilitates the price discovery mechanism by eroding arbitrage opportunities.[10]
In addition, hedge funds are considered as contrarian positions takers in
financial markets.[11]
The mechanisms used to lock-up capital in hedge funds (such as limited
redemption rights and side-pocket arrangements) enable them to further sustain
their contrarian positions.[12]
Such sustained contrarian position can potentially smooth market volatilities
and reduce the number and magnitude of asset price bubbles.[13] Hence,
it is argued that since the emergence of hedge funds as major market
participants, markets became more resilient in times of market distress.
Despite their benefits, hedge funds can potentially pose risks to
financial systems and contribute to financial instability. Although their role
in financial instability is highly contested,[14] hedge funds’
size, leverage, their interconnectedness with Large Complex Financial
Institutions (LCFIs) and the likelihood of herding are among the features that
can make hedge funds systemically important. The data on hedge funds’ size[15]
and leverage[16]
show that these features are far from being systemically important.
Nevertheless, theoretical and empirical evidence on hedge fund
interconnectedness and herding is mixed and it remains a major concern for
regulators.[17]
In addition to the above risks that the hedge fund industry might pose to
financial systems, hedge funds can become systemically important if they
undertake functions originally performed by banking industry, namely, maturity
and liquidity transformation.
Mehrling and
Edward’s view of the collapse of LTCM
According to Mehrling, since LTCM extensively undertook liquidity
transformation function in international financial markets, it got caught by a
sudden liquidity shock in the aftermath of the Russian government’s default on
its debt. Dealing with the liquidity mismatch is typical to dealer’s business
in financial markets and Central Banks do not hesitate to extend their
emergency liquidity facilities to dealers whenever the illiquidity in the
markets questions the solvency of the firms and threatens the well-functioning
of the financial system. However, hedge funds getting caught by illiquidity
shocks with systemic implications were unprecedented. Indeed, from Mehrling
standpoint, the troubling aspect of hedge funds is that they can engage almost
freely in almost all investment strategies. This freedom in employing
investment strategies can enable hedge funds to employ financial instruments
and strategies to engage in liquidity and maturity transformation which is
traditionally performed by banking entities.
In Mehrling’s view, the liquidity transformation function of LTCM is
the most compelling argument for the bailout of LTCM by a consortium of bankers
and investment firms organized by the Federal Reserve Bank of New York.[18]
Indeed, what Mehrling highlights in the operations of hedge fund industry is
that they engage in liquidity transformation in the financial markets and that
is exactly what makes them systemically important. Put differently, hedge funds’
engagement in the liquidity and maturity transformation pushes them from the
periphery of the financial system to the apex of the hierarchy of finance.[19]
The policy implications of Mehrling’s view is that if hedge funds operate as
shadow banks they should be directly regulated because of systemic importance
of their activities in credit markets.
In contrast to Mehrling’s view which is a ‘money view’, Edwards’
view on hedge funds tends to lean towards banking or finance view which mostly
ignores or pays less attention to the role of liquidity in the potential
systemic importance of the hedge fund industry. For Edwards, hedge fund
regulation is unjustified. Instead the regulatory focus on hedge funds should
be shifted to banking regulation. In other words, Edwards advocates indirect
regulation of hedge funds[20]
through the regulation of hedge funds’ investors, counterparties, and creditors
such as banks, mutual funds, pension funds and other mainstream financial
institutions.[21]
He starts with the traditional investor protection argument for regulation of
hedge funds and repudiates such concerns because of hedge fund investor
sophistication and their high net worth which enables them to easily fend for
themselves. In the end, he argues that the real concern about hedge funds is
the systemic risks that they might pose. Nonetheless, even with systemic risk
concerns, he does not see the locus of systemic risk in the hedge fund industry
itself; instead he traces the risks (apparently stemming from hedge funds) down
to the banking industry.
In this short comment, I will endeavor to put hedge fund industry
in the ‘money view’ context, highlighting the hidden liquidity risks embedded
in hedge fund industry which can pose systemic risks to the financial markets.
What is shadow
banking and why can hedge funds be viewed as part of the shadow banking system?
From a money view, in order to understand systemic liquidity risk
about hedge funds and their relationship with banks, it is important to view
hedge funds as part of the shadow banking system. Shadow banking system is a
system of credit intermediation involving activities and institutions outside
the traditional banking system.[22]
It mostly refers to the origination, acquisition and pooling of debt
instruments into diversified pools of loans and financing the pools with short
term external debt.[23]
It is mostly because of this function that shadow banks are given the label of “non-banks
performing bank-like functions”.[24]
It is also due to its financial intermediation function that the shadow banking
system is considered as an alternative term for market finance[25]
because it “decomposes the process of credit intermediation into an articulated
sequence or chain of discrete operations typically performed by separate
specialist non-bank entities which interact across the wholesale financial
market”.[26]
In the recent global financial crisis, shadow banking system (also known as
securitized banking) played a major role;[27] however, it
attracted less attention in regulatory overhaul triggered by its repercussions.
Taking
the above definitions of shadow banking into account, it seems that the key to
identifying shadow banks is spotting maturity and liquidity transformation
function in their activities. Maturity transformation entails a mechanism for
intermediation through which the short-term deposits are transformed to
long-term credits, i.e., borrowing short and lending long. In other words, it
involves issuing short-term (liquid) liabilities to finance long-term
(illiquid) assets.[28]
Banks’ role in maturity transformation which involves holding longer term
assets than liabilities delivers major economic and social value by enabling
non-bank sectors of the economy to hold shorter term assets than liabilities,
ultimately encouraging long-term capital investments.[29]
The
maturity transformation though beneficial to the overall economy, involves
major risks. These risks arise from the nature of maturity mismatch between
assets (particularly long-term loans) and liabilities (particularly demand
deposits) of banking entity which historically resulted in many bank runs and
panics.[30]
The banks have developed specific arrangements to address risks arising from maturity
transformation which are mostly reflected in their liquidity policies. These
policies often involve limiting the extent of the maturity transformation of
banks, “the insurance via committed lines from other banks”,[31]
and borrowing from interbank repo markets.
In
addition to banks’ own risk mitigating strategies, to prevent the runs on
banks, their deposits are insured by the government. The main benefit from
deposit insurance is preventing bank runs and panics, thereby sustaining
financial stability.[32]
Further, banks are provided with access to the ‘discount window’ or the ‘lender
of last resort’ (LOLR) facilities of central banks. The LOLR function of
central banks is devised to prevent bank runs on illiquid but solvent banks
when they have liquidity problems due to their inability to borrow from
interbank market or other facilities of central banks.[33] All these
protections are to ensure that a banking entity’s main function, i.e., maturity
and liquidity transformation, and their role in payment system are not impaired
because of sudden liquidity shocks.
However, unlike banks that are allowed to accept (government
guaranteed) deposits, shadow banks mostly rely on credit markets for funding and
are prohibited from accepting deposits.[34] In addition,
shadow banks also are not provided with a similar mechanism to deposit
insurance scheme to insure their short-term liabilities. Furthermore, shadow
banks do not enjoy other explicit government guarantees such as access to
liquidity back up (discount window). One of the markets that hedge funds use
for their liquidity management purposes is the repo markets. However, these
markets are also prone to runs[35]
partly because of the bankruptcy proof nature of repurchase agreements[36]
and partly because there is no government guarantee of those contracts. And
here is where the risks lie in the shadow banking system.
Structured
Investment Vehicles (SIVs), investment banks, and mutual funds created deposit
like investment opportunities with the prospects of upside gain by attracting
investment from investors by promising on-demand redemption rights and implicit
or explicit guarantees to the investors that the capital invested in the fund
will not fall below its initial investment value.[37] However, the
risk in a system which heavily relies on short term liquid liabilities is that
if a liquidity crisis hits, the financial institutions have to immediately sell
long term illiquid assets to meet redemptions by investors. Needless to say,
such a behavior contributes to the systemic liquidity crises.[38]
Such maturity and liquidity mismatches in shadow banks causing deleveraging and
resulting in fire sales and liquidity spirals are vastly evidenced in the
recent financial crisis.[39]
Likewise, the maturity transformation in hedge fund industry can
happen through hedge funds or hedge fund-like entities’ engagement in
originating derivative instruments such as mortgage backed securities (MBSs)[40]
and collateralized debt obligations (CDOs). Although most hedge funds may not
engage in maturity transformation, they are certainly engaging in the liquidity
transformation when they invest in securitized debt instruments especially
mortgage backed securities.[41]
Therefore, if not all, certainly some types of hedge funds can be considered as
shadow banks. As mentioned above, absent government safety nets, because of the
engagement of shadow banks in maturity, credit, and liquidity transformation,
they can be as fragile as traditional banks.[42]
Conclusion
Due to hedge funds’ potential role in maturity and liquidity
transformation, they can be viewed as part of the shadow banking system. Given
hedge funds’ freedom in engaging in almost all types of investment strategies,
they can combine financial instruments and strategies to engage in liquidity
and maturity transformation and hence functionally become part of the shadow
banking system. Combined with the fact that at least theoretically hedge funds
can take unlimited amount of leverage, the risks embedded in liquidity transformation
can be amplified by the excessive use of leverage. In this regard, the case of
LTCM is a case in point.
Performing banking functions without enjoying the regulatory
privileges of a banking entity, i.e., explicit and implicit government guarantees
such as deposit insurance and access to LOLR facilities of central banks, can make
shadow banks extremely fragile. Given the inherent risks in shadow banking
system, public policy responses are needed to address the potential systemic
aspects of hedge funds functioning as shadow banks.
[1] Mostly in the
form of a Limited Liability Partnership (LLP) or a Limited Liability Company
(LLC)
[2] A typical
hedge fund charges 2% of the net asset value under management as management fee
and 20% of the profits as performance or incentive fee (certain high-water
marks and hurdle rates may apply).
[3] In the US, the
Jumpstart Our Business Startups (JOBS) Act directs the SEC to amend the rule
506 of regulation D to remove the ban on hedge fund general solicitation.
However, the sale of hedge fund products is still restricted to the accredited
investors. See: 15 USCA § 77d–1 (2012)
[4] William A. Roach Jr., "Hedge Fund Regulation- “What
Side of the Hedges are You on?" The University of Memphis Law Review 40
(2009-2010), 166. See
also: Andreas Engert, "Transnational Hedge Fund
Regulation," European Business Organization Law Review 11, no. 03 (2010),
pp. 333-335.
[5] J. S. Aikman, When Prime Brokers Fail: The Unheeded Risk
to Hedge Funds, Banks, and the Financial Industry (Hoboken, New Jersey:
Bloomberg Press, 2010), p. 60. In addition, investment in hedge funds is often illiquid and may
only be redeemed intermittently. J. S. Aikman, When Prime Brokers Fail: The Unheeded Risk
to Hedge Funds, Banks, and the Financial Industry (Hoboken, New Jersey:
Bloomberg Press, 2010), p. 60. Prior to the introduction
of the Post-crisis financial regulation, the absence of registration
requirement and legal restraints on their investment strategies were among the
defining features of hedge funds. See for example: United Stated Securities and Exchange Commission, Implications of
the Growth of Hedge Funds,[2003]).; Houman B. Shadab, "The Law and
Economics of Hedge Funds: Financial Innovation and Investor
Protection," Berkley Business Law Journal 6 (2009), p. 245.
[6] Wouter Van Eechoud et al., "Future Regulation of
Hedge Funds—A Systemic Risk Perspective," Financial Markets, Institutions
& Instruments 19, no. 4 (2010), pp. 275-278. Thomas Schneeweis, Vassilios N. Karavas and Georgi Georgiev,
"Alternative Investments in the Institutional Portfolio," CISDM
Working Paper Series (2002). , See also: William F. Sharpe, "Asset Allocation: Management Style and
Performance Measurement," Journal of Portfolio Management 18, no. 2
(Winter92, 1992), 7-19.
[7] Robert J. Bianchi and Michael E. Drew, "Hedge Fund
Regulation and Systemic Risk," Griffith Law Review 19, no. 1 (2010), pp.
13-15 .
[8] Eechoud et al., Future Regulation of Hedge Funds—A
Systemic Risk Perspective, Vol. 19, 2010), pp. 275-278. & Bianchi and Drew, Hedge Fund Regulation and Systemic
Risk, Vol. 19, 2010), pp. 13-15 .
[9] In fact, the
lack of legal restrictions on the use of financial instruments, strategies, and
investment concentration of hedge funds enables them to use a wide range of
techniques to exploit market imperfections.
[10] Andrew Crockett, "The Evolution and Regulation of Hedge
Funds," in Financial Stability Review; Special Issue, Hedge Funds, ed.
Banque de France, 2007), p. 22. See also: Roach Jr., Hedge Fund Regulation- “What Side of the
Hedges are You on?, Vol. 40, 2009-2010), p. 173. and Crockett, The Evolution and Regulation of Hedge Funds, ed. Banque
de France, 2007), pp. 22-23.
[11] Andrew Ang, Sergiy Gorovyy and Gregory B. van Inwegen, "Hedge
Fund Leverage," Journal of Financial Economics 102, no. 1 (2011), 102-126.
[13] Eechoud et al., Future Regulation of Hedge Funds—A
Systemic Risk Perspective, Vol. 19, 2010), pp. 275-278.
Hence, it is argued that since the emergence of hedge funds as
major market participants, markets became more resilient in times of market
distress. See Roger T. Cole, Greg Feldberg and David Lynch, "Hedge Funds,
Credit Risk Transfer and Financial Stability," in Financial
Stability Review; Special Issue, Hedge Funds, ed. Banque de France, 2007), pp.
11-12. Although, the severity of the recent
financial crisis and the collapse of some hedge funds during the crisis shed
substantial doubts on these claims, evidence suggests that many other hedge
funds were launched to profit from price dislocations in securitized markets
during the crisis. See for instance: Dixon Lloyd, Noreen Clancy and Krishna B. Kumar, Hedge Funds and
Systemic Risk (Santa Monica, CA: RAND Corporation, 2012), pp. 47-49. Most
commentators agree on the fact that hedge funds provide a significant
stabilizing influence by providing liquidity and spreading risk across a broad
range of investors. See: Jean-Pierre Mustier and Alain Dubois, "Risks and Return of
Banking Activities Related to Hedge Funds," Banque De France, Financial
Stability Review; Special Issue, Hedge Funds (April 2007), pp. 88-89.
[14] Nicolas Papageorgiou and Florent Salmon, "The Role of Hedge
Funds in the Banking Crisis: Victim Or Culprit," in The Banking Crisis
Handbook, ed. Greg N. Gregoriou (Boca Raton, FL: CRC Press, Taylor &
Francis Group, 2010), 183-201.
[15] Data on hedge fund size demonstrates its relatively modest size
compared with mainstream financial institutions. One of the most recent
estimate of hedge fund industry size in March 2012 indicates that hedge fund
industry’s assets under management (AUM) amounts to $2.55 trillion. See: Citi Prime Finance, Hedge Fund Industry Snapshot, 2012). Consistent with the
industry's modest size, hedge fund liquidation had overall very limited impact
on financial markets. See: Ben S. Bernanke, "Hedge Funds and Systemic Risk: Remarks
Delivered at the Federal Reserve Bank of Atlanta’s 2006 Financial Markets
Conference—Hedge Funds: Creators of Risk." 2006).
[16] Hedge fund leverage is significantly less than depository
institutions, listed investment banks, and broker dealers. See: Anurag Gupta and Bing Liang, "Do Hedge Funds have
enough Capital? A Value-at-Risk Approach," Journal of Financial Economics
77, no. 1 (2005), 219-253.; Ang, Gorovyy and van Inwegen, Hedge Fund Leverage,
Vol. 102, 2011), p. 121.
[17] Nicole M. Boyson, Christof W. Stahel and René M. Stulz, "Hedge
Fund Contagion and Liquidity Shocks," Journal of Finance 65, no. 5 (10,
2010), p. 1814. . Fung and Hsieh find evidence of hedge
fund herding in the European Exchange Rate Mechanism (ERM) crisis and evidence
of herding in the Asian Crisis; however, they could find little evidence of
systematically causal relationship of hedge funds behavior and deviation of
market prices from economic fundamentals. See: William Fung and David A. Hsieh, "Measuring the
Market Impact of Hedge Funds," Journal of Empirical Finance 7, no. 1
(2000), 1-36.
[18] Perry Mehrling, "Minsky and Modern Finance," The Journal
of Portfolio Management 26, no. 2 (2000), pp. 85-87.
[19] From the point of view of law and finance literature, it might be
said that hedge funds will try to push themselves from the periphery to the
core or the apex of the system to get a better regulatory treatment and also
exert influence in the financial system. See: Katharina Pistor, "A Legal Theory of Finance," Journal of
Comparative Economics 41 (2013), 315-330.
[20] ‘indirect
regulation’ is “market discipline-inspired regulatory measures targeting the creditors
and counterparties of hedge funds (mainly, but not exclusively, their prime
brokers and securities brokers).” See: Athanassiou, Hedge
Fund Regulation in the European Union: Current Trends and Future
Prospects, , p. 227. He further
adds that “The aim of such measures would be to enhance the counterparty risk
management practices that financial institutions apply in their dealings with
hedge funds and/or to impose disclosure duties on prime brokers and other
crucial hedge fund counterparties in respect of their hedge fund exposures. An
indirect approach could be complemented by the obligatory ‘registration’ of
managers of hedge funds in conjunction with the (voluntary) improvement, by the
hedge fund industry itself, of its transparency, risk management and asset
valuations standards and practices.”
[21] F. R. Edwards, "Hedge Funds and the Collapse
of Long-Term Capital Management," Journal of Economic
Perspectives 13, no. 2 (1999), pp. 204-208.
[22] Financial Stability Board, Progress in the Implementation of the
G20 Recommendations for Strengthening Financial Stability: Report of the
Financial Stability Board to G20 Finance Ministers and
Central Bank Governors,[2011]).
[23] Nicola Gennaioli, Andrei Shleifer and Robert W. Vishny, "A
Model of Shadow Banking," NBER Working Paper no. 1711 (2011).
[24] “non-banks credit intermediation” is the term used by the FSB,
See: Financial Stability Board, Progress in the Implementation of the
G20 Recommendations for Strengthening Financial Stability: Report of the
Financial Stability Board to G20 Finance Ministers and
Central Bank Governors, 2011).
[26] European Repo Council, Shadow Banking and Repo,[2012]). See also: European Commission, Green Paper: Shadow Banking, 2012).
[27] Gary Gorton and Andrew Metrick, "Securitized Banking and
the Run on Repo," Journal of Financial Economics 104, no. 3
(2012), 425-451. The
role of shadow banks in the recent financial crisis is well illustrated in
detail in: Gary B. Gorton, Slapped by the Invisible Hand: The Panic
of 2007 (New York: Oxford University Press, 2010a).
[28] Alessio M. Pacces and Heremans Dirk, "Regulation of Banking
and Financial Markets”," in Forthcoming in ‘Regulation and
Economics’ in Encyclopedia of Law and Economics, ed. Pacces,
Alessio, M. & Van den Bergh, RJ, 2nd ed. (Cheltenham: Elgar, 2011).
More often than not, the maturity transformation in banking is
accompanied by liquidity transformation; however, there might be instances that
banks engage in liquidity transformation without engaging in maturity
transformation.
[29] Financial Services Authority (FSA), The Turner Review: A Regulatory
Response to the Global Banking Crisis, March 2009), p. 21.
[30] Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics, and
Crashes: A History of Financial Crises, 5th ed. (Hoboken, New Jersey: John
Wiley & Sons, Inc., 2005).
[31] Financial Services Authority (FSA), The Turner Review: A Regulatory
Response to the Global Banking Crisis, March 2009), p. 21.
[32] Alan S. Blinder and Robert F. Wescott, Reform of Deposit Insurance:
A Report to the FDIC,[March 20, 2001]).
protection of small depositors is indeed an incidental benefit of the
deposit insurance schemes.
[33] For more information on the Lender of Last Resort (LOLR) function
of central banks, see: Xavier Freixas et al., "Lender of Last Resort: What have we
Learned since Bagehot?" Journal of Financial Services Research 18, no. 1
(2000), 63-84. See
also: Xavier Freixas and Bruno M. Parigi, "The Lender of Last Resort
of the 21st Century," in The First Global Financial Crisis of the 21st
Century: Part Ll June-December 2008, eds. Andrew Felton and Carmen M.
ReinhartVoxEU.org Publication, 2009), 163-167. Historically, the LOLR function in the market was played by
private financial institutions. A bold example of taking up of such a role in
the crisis of 1907 was J. P. Morgan’s provision of liquidity to markets and
institutions in those years. See: Robert F. Bruner and Sean D. Carr, The Panic of 1907: Lessons
Learned from the Market's Perfect Storm (Hoboken, New Jersey: John Wiley &
Sons, Inc., 2007).
However, after the 1913, the year in which the Federal Reserve came into being,
it took up such a function.
[34] Even with all
those prohibitions, money market mutual funds developed products that were
similar to demand deposits.
[35] Gary B. Gorton, Slapped by the Invisible Hand: The Panic
of 2007 (New York: Oxford University Press, 2010b).
[36] Nathan Goralnik, "Bankruptcy-Proof Finance and the Supply of
Liquidity," Yale Law Journal 122 (2012), 460-506.
[37] These were
sometimes called Negotiable Order of Withdrawal accounts or (NOW accounts).
[38] Financial Services Authority (FSA), The Turner Review: A Regulatory
Response to the Global Banking Crisis, March 2009), p. 21.
[39] Markus K. Brunnermeier, "Deciphering the 2007–2008 Liquidity
and Credit Crunch," Journal of Economic Perspectives 23, no. 1 (2009),
77-100. See also: Markus K. Brunnermeier and Lasse Heje Pedersen, "Market
Liquidity and Funding Liquidity," The Review of Financial Studies 22, no.
6 (Jun., 2009), 2201-2238.
[40] To see how investment in MBS can be considered as shadow banking,
see: Admati and Hellwig, The Bankers' New Clothes: What's Wrong with
Banking and what to do about It (Princeton, New Jersey: Princeton University
Press, 2013).
[41] For the distinction between maturity transformation and liquidity
transformation, see: Anat R. Admati and Martin Hellwig, The Bankers' New Clothes: What's
Wrong with Banking and what to do about It (Princeton, New Jersey: Princeton
University Press, 2013).
