• “I Feel the Earth Move Under My Feet”: Hedge Funds as Systemically Important Financial Institutions?
  • March 23, 2015
  • Law Firm: Sutherland Asbill Brennan LLP - Washington Office
  • Hedge fund managers have historically sought to minimize their regulatory burdens, and the proper level of regulation of the industry has been long and intensely debated. The regulatory burden on hedge fund managers has grown significantly in the aftermath of the financial crisis. Now, a seismic regulatory shift once viewed as an essentially theoretical risk inches closer to reality for a few, very large hedge funds.

    One of the goals of the Dodd-Frank Act was to reduce systemic risk by subjecting “systemically important financial institutions” (“SIFIs”) to prudential regulation by the Federal Reserve Board, including large U.S. bank holding companies (i.e., those with $50 billion or more in assets). The Dodd-Frank Act also established the Financial Stability Oversight Council (“FSOC”) and granted it authority to determine whether other types of entities posed a systemic risk and should be designated as SIFIs that would be subject to Federal Reserve Board oversight.

    In August 2014, after a long and contentious public debate with the SEC, the FSOC decided to focus on the effect of asset managers’ products and activities on systemic risk, rather than on the process for designation of particular asset managers as SIFIs. At the end of 2014, as part of its focus on asset managers, the FSOC sought public comments on four areas: liquidity and redemptions, leverage, operational risk and systemic risk arising from the failure or closure of a particular asset manager.

    The U.S. debate surrounding the SIFI designation process parallels an international debate. In addition, the FSOC and Federal Reseve Board coordinate with the Financial Stability Board (“FSB”) and the International Organization of Securities Commissions (“IOSCO”), which are tasked with identifying non-bank non-insurer global financial institutions (“NBNI G-SIFIs”) that present systemic risk. Most recently, in March 2015, the FSB and the IOSCO published a consultative paper, which proposed revised methodologies for identifying systemically important NBNI G-SIFIs, such as hedge funds. The FSB and IOSCO suggest that a hedge fund’s size (as measured by AUM and gross notional exposure) and leverage (as measured by gross notional exposure) should be considered in determining whether a hedge fund is systemically important. In discussing leverage, the FSB and IOSCO noted that market participants may not always serve as a “check” to a hedge fund’s leverage. The consultative paper highlights that leverage, if left unchecked, would present systemic risk by increasing counterparty credit risk and amplifying the effects of forced liquidations and market distortions.

    While the efforts of FSOC and the FSB have yet to result in SIFI designation for any hedge fund, large hedge funds may have a reason to be concerned. Given their size, and the leverage they may employ, it is possible that FSOC could seek to designate one or more large hedge funds as SIFIs in the future, subjecting such funds to oversight by the Federal Reserve Board. ¹

     

    1 - See, e.g., Chris Dieterich, Big, Leveraged Hedge Funds Could Be ‘Systemically Important,’ Regulators Say, Barron’s, Mar. 16, 2015, http://blogs.barrons.com/focusonfunds/2015/03/16/big-leveraged-hedge-funds-could-be-systemically-important-regulators-say/; Chris Flood, Sifi Rules Set to Net More Asset Managers, Financial Times, Mar. 15, 2015, http://on.ft.com/1xpobGG.