I just came across this speech by a former Acting Chairman of the CFTC. The speech discusses Commodity Pool Operators in the context of hedge funds. The original speech can be found here.
Securities Industry Association Hedge Funds Conference
Sharon Brown-Hruska, Acting Chairman
Commodity Futures Trading Commission
November 30, 2004
It is a pleasure to have been invited here to New York to speak on the regulation of hedge funds. Let me begin by citing data collected by the CFTC with help from the National Futures Association. According to these data, the number of Institutional Investor’s Platinum 100 largest hedge funds that were registered as Commodity Pool Operators (CPOs) under the CFTC’s delegated authority grew from 55 in 2002, to 65 of the top 100 funds in 2003. In addition, 50 out of the 100 largest hedge funds were also registered with the CFTC as Commodity Trading Advisors (CTAs). Among the 25 largest hedge funds, the proportions get even higher, with 68% registered as CPOs in 2003. Thus, a significant proportion of advisors to hedge funds are currently registered with the CFTC.
Today there are approximately 1,900 CFTC-registered CPOs which sponsor, operate or advise some 3,500 commodity pools which hold over $600 billion in net assets. Many of these large commodity pools are “hedge funds” which are run by the biggest “names” in the hedge fund industry – Soros, Tudor, Citadel, Moore, Caxton, Rennaissance, etc. In addition, there are many new and growing CPO and CTAs that provide important asset diversification and non-correlated returns for pension funds, endowments, institutions and high net worth individuals.
In addition, and perhaps more importantly, any hedge fund manager that includes investments in the markets under CFTC’s jurisdiction, even if they qualify for an exemption from registration, continue to fall under the legal definition of a CPO or CTA, meaning that certain of the CFTC’s rules and provisions of the Commodity Exchange Act—such as those proscribing fraud or manipulation –continue to apply. In short, the operators and advisers to hedge funds, as collective investment vehicles, are an important and increasing subset of the population we oversee as a whole.
As many of you know, up until some recent rule modernizations, holding any futures in your portfolio meant you had to register via the CFTC’s delegated authority to the National Futures Association. Today I want to bring you up to date on the CFTC’s regulatory program and what it implies for fund management. I also hope to provide some context, much of which emanates from an approach endorsed by Congress in the Commodity Futures Modernization Act of 2000, which provides a blueprint for regulatory innovation that is both effective and appropriate for derivatives and the managed funds that use them.
Many had predicted that the regulatory relief we have granted to CPOs and CTAs under the Commodity Futures Modernization Act to rationalize regulation for sophisticated or otherwise regulated entities would lessen the proportion of hedge funds on our radar screen. Specifically, the CFTC has adopted exemptions from registration for those funds engaging in de minimus futures investments and whose investors can claim accredited investor status; otherwise regulated entities such as mutual funds, insurance companies, and banks; and funds that cater to highly sophisticated investors, or “qualified purchasers.”
Filing for an exemption from registration does not release any of these persons from complying with our statutes, including the prohibitions against fraud and manipulation. All CPOs and CTAs, regardless of their registration status, are subject to prescribed disclaimer requirements for hypothetical performance, the antifraud and anti-manipulation provisions of the Commodity Exchange Act and the CFTC’s rules, and all trader reporting requirements. In addition to large trader reporting, we have an active, real time surveillance program, and continuously monitor the activities of large hedge funds in our markets, from energy to precious metals, to stock index and interest rate products. In fact, the activity of hedge funds is a routine part of our ongoing surveillance of markets that is an integral part of our regulatory program at the Commission.
A case in point is the energy markets. During the recent rise in crude oil and natural gas prices, the Commission’s market surveillance group has been closely monitoring the overall size and composition of hedge funds positions. During this period, we have analyzed positions of both individual funds and the fund community in aggregate. While the funds have become a more significant player in these markets, our analysis suggests that they have not been exerting a negative influence on markets. In many respects, funds appear to be adding liquidity and increasing price efficiency by their trading.
The exemptions from registration are also noteworthy because they derive from the instructions given by Congress to the CFTC in the Modernization Act, which endorse some important concepts that I think we should take to heart. Specifically, Congress instructed the CFTC to identify and adopt core principles and acceptable business practices to replace prescriptive rules and regulations; and, where prudent, use our exemptive authority to provide relief from such prescriptive rules. Moreover, the Modernization Act enabled a principles based, multi-tiered approach based on the sophistication of investors, consistent with the private versus public markets in securities regulation. Finally, in the context of jointly regulated single security futures, the Modernization Act instructed the CFTC and the SEC to avoid duplicative and inconsistent regulatory structures.
As in other securities market regulatory settings, the regulatory model prescribed in the Modernization Act recognizes that not all markets are created equal. The statutory framework adopted allows different levels of regulatory involvement depending on the type of market one is operating and the sophistication of the market participants using them. For example, institutional market participants not needing the same protections as retail market participants are subject to a less intrusive regulatory framework; and markets that primarily involve principal to principal transactions are less a concern than traditional markets like exchanges, which are more easily accessible to retail customers.
Rather than limiting our authority or our jurisdictional reach, the tiered oversight model has increased our strength and effectiveness as a regulatory agency. Even in the exempt markets, the CFTC retains and has exercised its authority to police against fraud and manipulation. In the OTC energy markets, for example, we have vigorously pursued those who engaged in false price reporting and manipulation. In the retail foreign exchange markets, we have been equally effective in prosecuting fraudulent activity that takes place outside the confines of our contract markets.
Pursuant to our delegated authority to the NFA, elective registration with the CFTC results in an independent and expert review that includes periodic examinations, evaluation of internal controls, and review of required disclosure documents and financial statements. In our review of the NFA’s audit and compliance program, the NFA has demonstrated the necessary understanding of the complexities of the firms they examine, and a willingness to be tough when problems are uncovered.
With regard the markets and intermediaries we oversee, Congress recognized that regulatory agencies must be able to cope with innovation, and that a prescriptive model, one packed with dos and don’ts, can stifle innovation and lead to regulatory arbitrage. Given the complexities of modern fund management, including innovations in pricing, financial engineering, risk management, and the opening and development of more global opportunities, regulatory agencies simply will not be able to define and then develop rules for every strategy or activity. The finance literature presents numerous case studies that demonstrate that prescriptive regulation on innovative markets can chill the domestic market and lead market participants to migrate to less regulated settings.
There are numerous jurisdictions that can and do welcome US investment capital with fewer requirements and little in the form of customer protection. In addition to losing tax revenue that would accrue to capital gains and the value that derives from keeping financial intermediation services in our economy, our ability to go after wrongdoing once it occurs is seriously challenged when such migration occurs. Thus, rather than burdening innovative markets with prescriptive regulations that tend to homogenize activity and chase business offshore, we should seek a measured regulatory approach that emphasizes a strong after-the-fact enforcement program. Such an ex post approach actually allows the CFTC to pursue more cases where fraud is suspected and use our resources more efficiently. Decisive and tough enforcement acts as a powerful deterrent to wrongdoing and can help blot out the fraudsters that can stain the reputation of reputable firms.
How hedge funds are currently regulated is determined in large part by the character of the investors that use them and the products the funds trade in the regulated markets. When I began teaching venture capital and private finance, what struck me was the fact that hedge funds are constituted legally and operationally like private equity funds, and that they even draw to a large extent from the same pool of investors. Hedge funds cater to corporate investors, endowments and trusts, and high net worth individuals. These investors typically have long-term investment horizons, and their tax status makes large long run capital gains appealing.
The tendency of hedge funds to seek opportunities in inefficient markets, developing or dislocated markets, nascent markets that are often characterized by illiquidity, but which hold significant promise as those markets mature, makes them an appealing choice to the kind of patient money attracted to the private capital markets. Lock-up periods and limits on redemptions are often a necessary component of investing in these markets. Contrary to the view that hedge funds’ structure is driven by regulation (or a desire to avoid it), the evidence suggests that the needs and demands of investors explain how the funds are constituted, organized, and what the funds invest in.
Diversification is the operative word here. It has driven the growth of hedge funds as a vehicle to provide investors exposure to commodity markets as well as adopt strategies that are uncorrelated with a publicly traded securities portfolio. Exchange traded futures and other derivatives that have been particularly popular with funds as a way to both speculate on and hedge market risks brought on by changes and uncertainty in the underlying marketplace.
There are numerous parallels between the commodity funds, private equity funds and hedge funds, hedge funds differ significantly from other pooled public equity investment vehicles like mutual funds. While the purpose of mutual funds is to generate investment income, there is far greater emphasis on long (buy) strategies and the preservation of capital. While mutual funds come with no guarantee of future performance, they nonetheless are a lower risk option for retail customers who can generally rely on book value as a floor for their investment. Mutual funds are homogeneous, which increases their appeal to average investors, but also makes for a robust competitive market where transactions costs are quite low and efficiency is quite high.
When I first started looking at hedge funds as a professor in risk management, in addition to their lack of homogeneity and their thirst for exploiting inefficiency, I saw that they were really on the cutting edge in terms of their use of asset selection, leverage, and pricing techniques that are commonly employed by users of the derivatives markets. Hedge fund managers recognize the appeal of uncorrelated assets as tools for diversification, as well as the natural appeal of derivatives to build uncorrelated portfolios. In derivatives, going short is as legitimate as going long, and to the extent that hedge funds trade in commodity interests, they are closely akin to the funds I have seen in the futures business.
So do hedge fund managers require increased regulatory scrutiny? 3 out of 5 Commissioners at the SEC think so. I have a number of concerns. One, of course, is that the new regime will utilize taxpayer money to essentially duplicate the efforts of the CFTC and the NFA. The second is that a registration regime by the SEC creates a moral hazard that would give would-be investors a false sense of security that they do not need to do the necessary due diligence to evaluate the advisor.
When a regulator has jurisdiction over an industry, or individuals, they assume responsibility for what happens in that industry or to the individuals involved. When we see favoritism in the mutual fund industry or the fraud and accounting abuses that took place at Enron or Tyco or World Com, regulators are obligated to take action, as they also should if abuses are found to exist in the hedge fund industry. But there is no evidence that hedge funds are the preferred vehicle of fraudsters, anymore than any other equity or commodity funds are.
Looking at the CFTC’s enforcement activities against commodity pools, for example, we found that over the last five years, we average about 10 cases per year, and that a substantial majority of those cases were unregistered pool cases that generally involved outright misappropriation of investor funds. This means they did not trade futures, they did not actually operate a hedge fund, regardless of what kind of name they might call themselves, they just stole other people’s money.
The purported jump in enforcement cases brought by the SEC with regard to hedge funds from 7 to 12 is in absolute terms, since as a percentage of their total enforcement actions, it was unchanged at 2%. Moreover, I would note that many of the cases involved charging advisors with operating a Ponzi scheme. Since, by definition, a Ponzi scheme is illusory, I am not sure what it means to classify one as a hedge fund. Notwithstanding this caveat, combined with the evidence collected by the SEC, it appears that only about 2% of the combined CFTC and SEC enforcement actions from 1997 to 2003 were hedge fund/commodity pool actions.
Quite recently, the SEC and the CFTC have been investigating questionable trading practices in the registered mutual fund industry that in some instance have involved hedge funds. While I cannot comment on ongoing investigations, rest assured that where wrongdoing is uncovered, serious action will be taken. One important lesson is, even with registration and its associated mandates on mutual funds, the most prescriptive regulation cannot completely filter or deter opportunistic or unethical behavior. To suggest that registered mutual funds “on the other side” were somehow victimized by hedge funds is ludicrous and seems driven more by a desire to deflect culpability from where it properly lies.
Whatever action is ultimately taken by the regulators, we must not stifle the innovative and entrepreneurial spirit that has characterized the hedge fund industry. And just as we seek not to overly restrict hedge fund activity, we must also strive not to burden funds with duplicative requirements and regulations. For example, developing a homogeneous disclosure regime similar to securities law requirements on these types of investments is complicated by the predominance of illiquid assets as well as derivative characteristics like leverage and notional value that do not easily parallel the securities world. An even greater risk to enacting a prescriptive regulatory program that includes a securities style disclosure regime is that it will chill innovation by forcing fund managers to reveal too much information about their holdings and their asset selection stategy.
As I have said, I believe that the CFTC model of oversight deserves recognition in the form of a specific exclusion from the forthcoming requirements for registration adopted by the SEC. In my comment to the SEC, I requested that the SEC provide a registration exemption for CFTC-registered CPOs and CTAs that sponsor, operate or advise privately-offered commodity pools and that do not hold themselves out to the general public as investment advisers. It is my view that such a registration exemption would avoid duplicative regulation and would be consistent with good government, the principle of functional regulation, and current exclusions and exemptions in the Advisers Act for regulated financial institutions. This exemption for CFTC-registered CPOs and CTAs would be complemented by a formal information sharing agreement between the CFTC and SEC related to CFTC registrants.
The future of the hedge fund/commodity pool industry is full of promise. My vision is to look forward on hedge fund/CPO issues to ensure that innovation continues in a rational regulatory framework.
With that in mind, I am happy to announce that the CFTC will be holding a Hedge Fund/CPO Roundtable in late February, 2005. As noted above, the CFTC has registered and regulated CPOs and commodity pools for 30 years. Our experience is clear: the vast majority of hedge fund/commodity pool advisers are innovative, highly specialized professionals that provide investors in futures, currencies, securities, and other asset classes significant opportunity. The industry – and it is an industry – has grown and matured during that time.
The February Roundtable will look at the entire hedge fund/commodity pool industry and the current issues the industry is facing – including regulation. I have observed that there is a paucity of knowledge about this industry, and it seems to come as a surprise to many that the CFTC has a significant amount of information about the fund managers and the funds through our regulatory program. The February Roundtable will be an important step in educating and working through the challenges that a regulatory program for fund and fund advisors presents.
I am very excited about moving forward in this area and look forward to a close partnership with other regulators. The CFTC has a long history of working cooperatively with State and Federal Regulators on investor protection issues and investigations. We have worked with State securities regulators – individually and through NASAA (North American Securities Administrators Association) – and will continue to reach out to state and federal regulators.
As I have noted, a significant portion of the hedge funds and their activity is already regulated by the CFTC. As we move forward, the CFTC and the SEC must endeavor to work together and, to the extent possible, rely on each other’s knowledge, expertise, and regulatory programs to monitor the fund industry.
Other HFLB articles: