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Testimony: 

Before the Subcommittee on Capital Markets, Insurance and Government 
Sponsored Enterprises, House of Representatives: 

United States Government Accountability Office: 
GAO: 

For Release on Delivery: 
Expected at 11:00 a.m. EDT:
Thursday, May 7, 2009: 

Hedge Funds: 

Overview of Regulatory Oversight, Counterparty Risks, and Investment 
Challenges: 

Statement of Orice M. Williams, Director: 
Financial Markets and Community Investment: 

GAO-09-677T: 

GAO Highlights: 

Highlights of GAO-09-677T, a testimony to Subcommittee on Capital 
Markets, Insurance, and Government Sponsored Enterprises, Committee on 
Financial Services, House of Representatives. 

Why GAO Did This Study: 

In 2008, GAO issued two reports on hedge funds—pooled investment 
vehicles that are privately managed and often engage in active trading 
of various types of securities and commodity futures and options 
contracts—highlighting the need for continued regulatory attention and 
for guidance to better inform pension plans on the risks and challenges 
of hedge fund investments. Hedge funds generally qualified for 
exemption from certain securities laws and regulations, including the 
requirement to register as an investment company. Hedge funds have been 
deeply affected by the recent financial turmoil. But an industry survey 
of institutional investors suggests that these investors are still 
committed to investing in hedge funds in the long term. For the first 
time hedge funds are allowed to borrow from the Federal Reserve under 
the Term-Asset Backed Loan Facility. As such, the regulatory oversight 
issues and investment challenges raised by the 2008 reports still 
remain relevant. 

This testimony discusses: (1) federal regulators’ oversight of hedge 
fund-related activities; (2) potential benefits, risks, and challenges 
pension plans face in investing in hedge funds; (3) the measures 
investors, creditors, and counterparties have taken to impose market 
discipline on hedge funds; and (4) the potential for systemic risk from 
hedge fund-related activities. To do this work we relied upon our 
issued reports and updated data where possible. 

What GAO Found: 

Under the existing regulatory structure, the Securities and Exchange 
Commission and Commodity Futures Trading Commission can provide direct 
oversight of registered hedge fund advisers, and along with federal 
bank regulators, they monitor hedge fund-related activities conducted 
at their regulated entities. Although some examinations found that 
banks generally have strengthened practices for managing risk exposures 
to hedge funds, regulators recommended that they enhance firmwide risk 
management systems and practices, including expanded stress testing. 
The federal government does not specifically limit or monitor private 
sector plan investment in hedge funds. Under federal law, fiduciaries 
must comply with a standard of prudence, but no explicit restrictions 
on hedge funds exist. 

Pension plans invest in hedge funds to obtain a number of potential 
benefits, such as returns greater than the stock market and stable 
returns on investment. However, hedge funds also pose challenges and 
risks beyond those posed by traditional investments. For example, some 
investors may have little information on funds’ underlying assets and 
their values, which limits the opportunity for oversight. Plan 
representatives said they take steps to mitigate these and other 
challenges, but doing so requires resources beyond the means of some 
plans. 

According to market participants, hedge fund advisers have improved 
disclosures and transparency about their operations as a result of 
industry guidance issued and pressure from investors and creditors and 
counterparties. Regulators and market participants said that creditors 
and counterparties have generally conducted more due diligence and 
tightened their credit standards for hedge funds. However, several 
factors may limit the effectiveness of market discipline or illustrate 
failures to properly exercise it. Further, if the risk controls of 
creditors and counterparties are inadequate, their actions may not 
prevent hedge funds from taking excessive risk and can contribute to 
conditions that create systemic risk if breakdowns in market discipline 
and risk controls are sufficiently severe that losses by hedge funds in 
turn cause significant losses at key intermediaries or in financial 
markets. 

Financial regulators and industry observers remain concerned about the 
adequacy of counterparty credit risk management at major financial 
institutions because it is a key factor in controlling the potential 
for hedge funds to become a source of systemic risk. Although hedge 
funds generally add liquidity to many markets, including distressed 
asset markets, in some circumstances hedge funds’ activities can strain 
liquidity and contribute to financial distress. In response to their 
concerns regarding the adequacy of counterparty credit risk, a group of 
regulators had collaborated to examine particular hedge fund-related 
activities across entities they regulate, and the President’s Working 
Group on Financial Markets (PWG). The PWG also established two private 
sector committees that recently released guidelines to address systemic 
risk and investor protection. 

View [hyperlink, http://www.gao.gov/products/GAO-09-677T] or key 
components. For more information, contact Orice M. Williams at (202) 
512-8678 or williamso@gao.gov. 

[End of section] 

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here to participate in today's hearing on hedge 
funds. A hedge fund is a pooled investment vehicle that is privately 
managed and often engages in active trading of various types of 
securities and commodity futures and options. In general, hedge funds 
qualify for exemption from certain securities laws and regulations, 
including the requirement to register as an investment company. 
[Footnote 1] When we conducted the two studies on hedge funds in 2007, 
the hedge fund sector was growing in importance and continuing to 
evolve within the financial system. Hedge funds, largely driven by 
investments from institutional investors, such as endowments, 
foundations, insurance companies, and pension plans, seeking to 
diversify their risks and increase returns, have grown dramatically 
over the last decade. From 1998 to early 2007, the estimated number of 
funds grew from more than 3,000 to more than 9,000 and assets under 
management from $200 billion to more than $2 trillion globally. 
[Footnote 2] An estimated $1.5 trillion of these assets is managed by 
U.S. hedge fund advisers. Hedge funds have significant business 
relationships with the largest regulated banking organizations. Hedge 
funds act as trading counterparties for a wide range of over-the-
counter derivatives and other financing transactions. They also act as 
clients through their purchase of clearing and other services and as 
borrowers through their use of margin loans from prime brokers. 

Much has happened in the financial markets since we issued our reports. 
Hedge funds have been deeply affected in the financial turmoil. 
According to an industry survey, most hedge fund strategies produced 
double-digit losses in 2008 and hedge funds saw approximately $70 
billion in redemptions between June and November 2008.[Footnote 3] Some 
observers blamed hedge funds for dramatic volatility in the stock and 
commodity markets last year and some funds of hedge funds were heavily 
invested in the alleged Madoff fraud. Nevertheless, an industry survey 
of institutional investors suggests that these investors are still 
committed to investing in hedge funds in the long term.[Footnote 4] 
Financial regulators' views on hedge funds appear to be shifting as 
well, perhaps signaling recognition that hedge funds have become an 
integral part of the financial markets. For example, hedge funds are 
allowed to borrow from the Federal Reserve for the first time under the 
Term Asset-Backed Securities Loan Facility (TALF) intended to support 
consumer credit. While the Federal Reserve Chairman and Treasury 
Secretary have supported the position of enhanced market discipline 
over stricter regulation of hedge funds in 2007, Treasury has recently 
called for greater regulatory oversight of hedge funds. Despite changes 
surrounding the hedge fund sector, the issues and concerns related to 
regulatory oversight of hedge funds and challenges posed by hedge fund 
investing that were raised in our 2008 reports remain relevant today. 

This statement is based on our January 24, 2008 and August 14, 2008 
reports.[Footnote 5] Specifically, I will discuss: (1) the oversight of 
hedge fund-related activities provided by federal financial regulators 
under their existing authorities; (2) the potential benefits, risks, 
and challenges pension plans face in investing in hedge funds; (3) the 
measures investors, creditors, and counterparties have taken to impose 
market discipline on hedge funds; and (4) the potential for systemic 
risk from hedge fund-related activities and actions regulators have 
taken to address this risk. 

To do this work, we reviewed and analyzed relevant regulatory 
examination documentation and enforcement cases from federal financial 
regulators. We also analyzed relevant laws and regulations, survey 
data, speeches, testimonies, studies, and industry protocols and 
guidelines about private pools of capital. In addition, we interviewed 
officials representing various U.S. regulators, as well as 
representatives from market participants such as commercial and 
investment banks, large hedge funds, pension industry participants, 
credit rating agencies, a risk management firm, trade groups 
representing hedge funds and institutional investors, and academics. We 
conducted these performance audits from September 2006 to August 2008 
in accordance with generally accepted government auditing standards. 
Those standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe that 
the evidence obtained provides a reasonable basis for our findings and 
conclusions based on our audit objectives. 

Summary: 

Under the existing regulatory structure, the Securities and Exchange 
Commission's (SEC) ability to directly oversee hedge fund advisers is 
limited to those that are required to register or voluntarily register 
with SEC as an investment advisor. Examinations of registered advisers 
raised concerns in areas such as disclosure, reporting and filing, 
personal trading, and asset valuation. SEC also oversees some of the 
securities firms that engage in significant hedge fund-related 
activities. The Commodity Futures Trading Commission (CFTC) regulates 
those hedge fund advisers who are registered as registered as commodity 
pool operators (CPO) or commodity trading advisors (CTA). Federal 
banking regulators monitor hedge fund-related activities conducted at 
their regulated entities.[Footnote 6] Although some examinations found 
that banks generally have strengthened practices for managing risk 
exposures to hedge funds since the 1998 near collapse of Long-Term 
Capital Management (LTCM), a large highly leveraged hedge fund, 
regulators recommended that they enhance firmwide risk management 
systems and practices, including expanded stress testing.[Footnote 7] 
Regulated entities have the responsibility to practice prudent risk 
management standards, but prudent standards do not guarantee prudent 
practices. As such, it will be important for regulators to show 
continued vigilance in overseeing the hedge fund-related activities of 
regulated institutions. The federal government does not specifically 
limit or monitor private sector plan investment in hedge funds, and 
state approaches to public plans vary. Under federal law, fiduciaries 
must comply with a standard of prudence, but no explicit restrictions 
on hedge funds exist. 

Pension plans invest in hedge funds in order to achieve one or more of 
several goals, including steadier, less volatile returns, obtaining 
returns greater than those expected in the stock market, or 
diversification of portfolio investments. Nonetheless, hedge fund 
investments pose investment challenges beyond those posed by 
traditional investments in stocks and bonds. For example, some 
investors may have little information on funds' underlying assets and 
their values, which limits the opportunity for oversight. Plan 
officials and others described steps plans can take to address these 
challenges. However, they said that some of these steps require 
considerably greater effort and expertise from fiduciaries than is 
required for more traditional investments, and such steps may be beyond 
the capabilities of some pension plans, particularly smaller ones. 

According to market participants, hedge fund advisers had improved 
disclosures and transparency about their operations since LTCM as a 
result of industry guidance issued and pressure from investors and 
creditors and counterparties (such as prime brokers), but noted 
limitations. Regulators and market participants also said that 
creditors and counterparties had generally conducted more due diligence 
and tightened their credit standards for hedge funds. However, several 
factors may limit the effectiveness of market discipline or illustrate 
failures to properly exercise it. For example, because most large hedge 
funds use multiple prime brokers as service providers, no one broker 
may have all the data necessary to assess the total leverage of a hedge 
fund client. Further, if the risk controls of creditors and 
counterparties are inadequate, their actions may not prevent hedge 
funds from taking excessive risk. These factors can contribute to 
conditions that create systemic risk if breakdowns in market discipline 
and risk controls are sufficiently severe that losses by hedge funds in 
turn cause significant losses at key intermediaries or instability in 
financial markets. 

Financial regulators and industry observers remained concerned about 
the adequacy of counterparty credit risk management at major financial 
institutions because it is a key factor in controlling the potential 
for hedge funds to become a source of systemic risk. Although hedge 
funds generally add liquidity to many markets, including distressed 
asset markets, in some circumstances hedge funds' activities can strain 
liquidity and contribute to financial distress. For example, the 
concentration created by numerous market participants establishing 
large positions on the same side of a trade, especially in combination 
with a high degree of leverage, can contribute to a liquidity crisis if 
market conditions compel traders to simultaneously unwind their 
positions. In response to their concerns regarding the adequacy of 
counterparty credit risk, a group of regulators had collaborated to 
examine particular hedge fund-related activities across entities they 
regulate, mainly through international multilateral efforts and the 
President's Working Group on Financial Markets (PWG).[Footnote 8] The 
PWG also has established two private sector committees to identify best 
practices to address systemic risk and investor protection, which 
released reports for comments in 2008 and issued final reports in 2009 
respectively. 

Hedge Funds Generally Are Subject to Limited Direct Oversight and the 
Federal Government Does Not Specifically Limit or Monitor Private 
Sector Plans' Investments in Hedge Funds: 

SEC's ability to directly oversee hedge fund advisers is limited to 
those that are required to register or voluntarily register with SEC as 
investment advisers. Registered hedge fund advisers are subject to the 
same disclosure requirements as all other registered investment 
advisers. These advisers must provide current information to both SEC 
and investors about their business practices and disciplinary history. 
Advisers also must maintain required books and records, and are subject 
to periodic examinations by SEC staff. Meanwhile, hedge funds, like 
other investors in publicly traded securities, are subject to various 
regulatory reporting requirements. For example, upon acquiring a 5 
percent beneficial ownership position of a particular publicly traded 
security, a hedge fund may be required to file a report disclosing its 
holdings with SEC.[Footnote 9] 

In December 2004, SEC adopted an amendment to Rule 203(b)(3)-1, which 
had the effect of requiring certain hedge fund advisers that previously 
enjoyed the private adviser exemption from registration to register 
with SEC as investment advisers. In June 2006, a federal court vacated 
the 2004 amendment to Rule 203(b)(3)-1.[Footnote 10] According to SEC, 
when the rule was in effect (from February 1, 2006, through August 21, 
2006), SEC was better able to identify hedge fund advisers. In August 
2006, SEC estimated that 2,534 advisers that sponsored at least one 
hedge fund were registered with the agency. Since August 2006, SEC's 
ability to identify an adviser that manages a hedge fund has been 
further limited due to changes in filing requirements and to advisers 
that chose to retain registered status. As of April 2007, 488, or about 
19 percent of the 2,534 advisers, had withdrawn their registrations. At 
the same time, 76 new registrants were added and some others changed 
their filing status, leaving an estimated 1,991 hedge fund advisers 
registered. While the list of registered hedge fund advisers is not all-
inclusive, many of the largest hedge fund advisers--including 49 of the 
largest 78 U.S. hedge fund advisers--are registered. These 49 hedge 
fund advisers account for approximately $492 billion of assets under 
management, or about 33 percent of the estimated $1.5 trillion in hedge 
fund assets under management in the United States. In an April 2009 
speech, Chairman Schapiro stated that there are approximately150 active 
hedge fund investigations at SEC, some of which include possible Ponzi 
schemes, misappropriations, and performance smoothing. In a separate 
speech in April, Chairman Schapiro renewed SEC's call for greater 
oversight of hedge funds, including the registration of hedge fund 
advisers and potentially the hedge funds themselves. 

SEC uses a risk-based examination approach to select investment 
advisers for inspections. Under this approach, higher-risk investment 
advisers are examined every 3 years. One of the variables in 
determining risk level is the amount of assets under management. SEC 
officials told us that most hedge funds, even the larger ones, do not 
meet the dollar threshold to be automatically considered higher-risk. 
In fiscal year 2006, SEC examined 321 hedge fund advisers and 
identified issues (such as information disclosure, reporting and 
filing, personal trading, and asset valuation) that are not exclusive 
to hedge funds. Also, from 2004 to 2008, SEC oversaw the large 
internationally active securities firms on a consolidated 
basis.[Footnote 11] These securities firms have significant interaction 
with hedge funds through affiliates previously not overseen by SEC. One 
aspect of this program was to examine how the securities firms manage 
various risk exposures, including those from hedge fund-related 
activities such as providing prime brokerage services and acting as 
creditors and counterparties. SEC found areas where capital computation 
methodology and risk management practices can be improved. 

Similarly, CFTC regulates those hedge fund advisers registered as CPOs 
or CTAs. CFTC has authorized the National Futures Association (NFA), a 
self-regulatory organization for the U.S. futures industry, to conduct 
day-to-day monitoring of registered CPOs and CTAs. In fiscal year 2006, 
NFA examinations of CPOs included six of the largest U.S. hedge fund 
advisers. In addition, SEC, CFTC, and bank regulators can use their 
existing authorities--to establish capital standards and reporting 
requirements, conduct risk-based examinations, and take enforcement 
actions--to oversee activities, including those involving hedge funds, 
of broker-dealers, of futures commission merchants, and of banks, 
respectively. 

While none of the regulators we interviewed specifically monitored 
hedge fund activities on an ongoing basis, generally regulators had 
increased reviews--by such means as targeted examinations--of systems 
and policies to mitigate counterparty credit risk at the large 
regulated entities. For instance, from 2004 to 2007, the Federal 
Reserve Bank of New York (FRBNY) had conducted various reviews-- 
including horizontal reviews--of credit risk management practices that 
involved hedge fund-related activities at several large banks.[Footnote 
12] On the basis of the results, FRBNY noted that the banks generally 
had strengthened practices for managing risk exposures to hedge funds, 
but the banks could further enhance firmwide risk management systems 
and practices, including expanded stress testing. 

The federal government does not specifically limit or monitor private 
sector pension investment in hedge funds and, while some states do so 
for public plans, their approaches vary. Although the Employee 
Retirement and Income Security Act (ERISA) governs the investment 
practices of private sector pension plans, neither federal law nor 
regulation specifically limit pension investment in hedge funds or 
private equity. Instead, ERISA requires that plan fiduciaries apply a 
"prudent man" standard, including diversifying assets and minimizing 
the risk of large losses. The prudent man standard does not explicitly 
prohibit investment in any specific category of investment. The 
standard focuses on the process for making investment decisions, 
requiring documentation of the investment decisions, due diligence, and 
ongoing monitoring of any managers hired to invest plan assets. Plan 
fiduciaries are expected to meet general standards of prudent investing 
and no specific restrictions on investments in hedge funds or private 
equity have been established. The Department of Labor is tasked with 
helping to ensure plan sponsors meet their fiduciary duties; however, 
it does not currently provide any guidance specific to pension plan 
investments in hedge funds or private equity. 

Conversely, some states specifically regulate and monitor public sector 
pension investment in hedge funds, but these approaches vary from state 
to state. While states generally have adopted a "prudent man" standard 
similar to that in ERISA, some states also explicitly restrict or 
prohibit pension plan investment in hedge funds or private equity. For 
instance, in Massachusetts, the agency overseeing public plans will not 
permit plans with less than $250 million in total assets to invest 
directly in hedge funds. Some states have detailed lists of authorized 
investments that exclude hedge funds and/or private equity. Other 
states may limit investment in certain investment vehicles or trading 
strategies employed by hedge fund or private equity fund managers. 
While some guidance exists for hedge fund investors, specific guidance 
aimed at pension plans could serve as an additional tool for plan 
fiduciaries when assessing whether and to what degree hedge funds would 
be a prudent investment. 

Pension Plans Seek Various Investment Objectives through Hedge Funds, 
and Such Investments Pose Challenges That Require Considerable Effort 
and Expertise to Address: 

According to several 2006 and 2007 surveys of private and public sector 
plans, investments in hedge funds are typically a small portion of 
total plan assets--about 4 to 5 percent on average--but a considerable 
and growing number of plans invest in them.[Footnote 13] Updates to the 
surveys indicated that institutional investors plan to continue to 
invest in hedge funds. One 2008 survey reported that nearly half of 
over 200 plans surveyed had hedge funds and hedge-fund-type strategies. 
This was a large increase when compared to the previous survey when 80 
percent of the funds had no hedge fund exposure.[Footnote 14] Pension 
plans' investments in hedge funds n part were a response to stock 
market declines and disenchantment with traditional investment 
management in recent years. Officials with most of the plans we 
contacted indicated that they invested in hedge funds, at least in 
part, to reduce the volatility of returns. Several pension plan 
officials told us that they sought to obtain returns greater than the 
returns of the overall stock market through at least some of their 
hedge fund investments. Officials of pension plans that we contacted 
also stated that hedge funds are used to help diversify their overall 
portfolio and provide a vehicle that will, to some degree, be 
uncorrelated with the other investments in their portfolio. This 
reduced correlation was viewed as having a number of benefits, 
including reduction in overall portfolio volatility and risk. 

While any plan investment may fail to deliver expected returns over 
time, hedge fund investments pose investment challenges beyond those 
posed by traditional investments in stocks and bonds. These include the 
reliance on the skill of hedge fund managers, who often have broad 
latitude to engage in complex investment techniques that can involve 
various financial instruments in various financial markets; use of 
leverage, which amplifies both potential gains and losses; and higher 
fees, which require a plan to earn a higher gross return to achieve a 
higher net return. In addition to investment challenges, hedge funds 
pose additional challenges, including: (1) limited information on a 
hedge fund's underlying assets and valuation (limited transparency); 
(2) contract provisions which limit an investor's ability to redeem an 
investment in a hedge fund for a defined period of time (limited 
liquidity); and (3) the possibility that a hedge fund's active or risky 
trading activity will result in losses due to operational failure such 
as trading errors or outright fraud (operational risk). 

Pension plans that invest in hedge funds take various steps to mitigate 
the risks and challenges posed by hedge fund investing, including 
developing a specific investment purpose and strategy, negotiating 
important investment terms, conducting due diligence, and investing 
through funds of funds. Such steps require greater effort, expertise 
and expense than required for more traditional investments. As a 
result, according to plan officials, state and federal regulators, and 
others, some pension plans, especially smaller plans, may not be 
equipped to address the various demands of hedge fund investing. 

Investors, Creditors, and Counterparties Have Increased Efforts to 
Impose Discipline on Hedge Fund Advisers, but Some Limitations Remain: 

Investors, creditors, and counterparties have the power to impose 
market discipline--rewarding well-managed hedge funds and reducing 
their exposure to risky, poorly managed hedge funds--during due 
diligence exercises and through ongoing monitoring. Creditors and 
counterparties also can impose market discipline through ongoing 
management of credit terms (such as collateral requirements). According 
to market participants doing business with larger hedge funds, hedge 
fund advisers have improved disclosure and become more transparent 
about their operations, including risk management practices, partly as 
a result of recent increases in investments by institutional investors 
with fiduciary responsibilities, such as pension plans, and guidance 
provided by regulators and industry groups. 

Despite the requirement that fund investors be sophisticated, some 
market participants suggested that not all prospective investors have 
the capacity or retain the expertise to analyze the information they 
receive from hedge funds, and some may choose to invest in a hedge fund 
largely as a result of its prior returns and may fail to fully evaluate 
its risks. Since the near collapse of LTCM in 1998, investors, 
creditors, and counterparties have increased their efforts to impose 
market discipline on hedge funds. Regulators and market participants 
also said creditors and counterparties have been conducting more 
extensive due diligence and monitoring risk exposures to their hedge 
fund clients since LTCM. The creditors and counterparties we 
interviewed said that they have exercised market discipline by 
tightening their credit standards for hedge funds and demanding greater 
disclosure. 

However, regulators and market participants also identified issues that 
limit the effectiveness of market discipline or illustrate failures to 
properly exercise it. For example, most large hedge funds use multiple 
prime brokers as service providers. Thus, no one broker may have all 
the data necessary to assess the total leverage used by a hedge fund 
client. In addition, the actions of creditors and counterparties may 
not fully prevent hedge funds from taking excessive risk if these 
creditors' and counterparties' risk controls are inadequate. For 
example, the risk controls may not keep pace with the increasing 
complexity of financial instruments and investment strategies that 
hedge funds employ. Similarly, regulators have been concerned that in 
competing for hedge fund clients, creditors sometimes relaxed credit 
standards. These factors can contribute to conditions that create the 
potential for systemic risk if breakdowns in market discipline and the 
risk controls of creditors and counterparties are sufficiently severe 
that losses by hedge funds in turn cause significant losses at key 
intermediaries or instability in financial markets. 

Regulators View Hedge Fund Activities as Potential Sources of Systemic 
Risk and Are Taking Measures to Enhance Market Discipline and Prepare 
for Financial Disruptions: 

Although financial regulators and market participants recognize that 
the enhanced efforts by investors, creditors, and counterparties since 
LTCM impose greater market discipline on hedge funds, some remain 
concerned that hedge funds' activities are a potential source of 
systemic risk. Counterparty credit risk arises when hedge funds enter 
into transactions, including derivatives contracts, with regulated 
financial institutions.[Footnote 15] Some regulators regard 
counterparty credit risk as the primary channel for potentially 
creating systemic risk. At the time of our work in 2007, financial 
regulators said that the market discipline imposed by investors, 
creditors, and counterparties is the most effective mechanism for 
limiting the systemic risk from the activities of hedge funds (and 
other private pools of capital). The most important providers of market 
discipline are the large, global commercial and investment banks that 
are hedge funds' principal creditors and counterparties. As part of the 
credit extension process, creditors and counterparties typically 
require hedge funds to post collateral that can be sold in the event of 
default. OCC officials told us that losses at their supervised banks 
due to the extension of credit to hedge funds were rare. Similarly, 
several prime brokers told us that losses from hedge fund clients were 
extremely rare due to the asset-based lending they provided such funds. 
While regulators and others recognize that counterparty credit risk 
management has improved since LTCM, the ability of financial 
institutions to maintain the adequacy of these management processes in 
light of the dramatic growth in hedge fund activities remained a 
particular focus of concern. 

In addition to counterparty credit risk, other factors such as trading 
behavior can create conditions that contribute to systemic risk. Given 
certain market conditions, the simultaneous liquidation of similar 
positions by hedge funds that hold large positions on the same side of 
a trade could lead to losses or a liquidity crisis that might aggravate 
financial distress. Recognizing that market discipline cannot eliminate 
the potential systemic risk posed by hedge funds and others, regulators 
have been taking steps to better understand the potential for systemic 
risk and respond more effectively to financial disruptions that can 
spread across markets. For instance, they have examined particular 
hedge fund activities across regulated entities, mainly through 
international multilateral efforts. The PWG has issued guidelines that 
provide a framework for addressing risks associated with hedge funds 
and implemented protocols to respond to market turmoil. Finally, in 
September 2007, the PWG formed two private sector committees comprising 
hedge fund advisers and investors to address investor protection and 
systemic risk concerns, including counterparty credit risk management 
issues. On January 15, 2009, these two committees, the Asset Managers' 
Committee and the Investors' Committee, released their final best 
practices reports to hedge fund managers and investors. The final best 
practices for the asset managers establishes a framework on five 
aspects of the hedge fund business--disclosure, valuation of assets, 
risk management, business operations, compliance and conflicts of 
interest--to help hedge fund managers take a comprehensive approach to 
adopting best practices and serve as the foundation upon which those 
best practices are established. The final best practices for investors 
include a Fiduciary's Guide, which provides recommendations to 
individuals charged with evaluating the appropriateness of hedge funds 
as a component of an investment portfolio, and an Investor's Guide, 
which provides recommendations to those charged with executing and 
administering a hedge fund program if one is added to the investment 
portfolio. 

In closing, I would like to include a final thought. It is likely that 
hedge funds will continue to be a source of capital and liquidity in 
financial markets, by providing financing to new companies, industries 
and markets, as well as a source of investments for institutional 
investors. Given our recent experience with the financial crisis, it is 
important that regulators have the information to monitor the 
activities of market participants that play a prominent role in the 
financial system, such as hedge funds, to protect investors and manage 
systemic risk. 

Mr. Chairman, this completes my prepared statement. I would be happy to 
respond to any questions you or other Members of the Subcommittee may 
have at this time. 

GAO Contact: 

For further information on this testimony, please contact Orice M. 
Williams on (202) 512-8678 or at williamso@gao.gov.Contact points for 
our Office of Congressional Relations and Public Affairs may be found 
on the last page of this statement. 

[End of section] 

Footnotes: 

[1] To avoid being required to register as an investment company under 
the Investment Company Act of 1940 (Investment Company Act), hedge 
funds typically rely on sections 3(c)(1) or 3(c)(7) of that act. Hedge 
fund advisers also typically satisfy the "private manager" exemption 
from registration under section 203(b)(3) of the Investments Advisers 
Act of 1940 (Advisers Act). 

[2] By comparison, assets under management in the mutual fund industry 
grew from about $5.5 trillion in 1998 to about $10.4 trillion in 2006. 

[3] Greenwich Associates and SEI Knowledge Partnership, Hedge Funds 
Under the Microscope: Examining Institutional Commitment in Challenging 
Times (January 2009). 

[4] SEI Knowledge Partnership and Greenwich Associates, Hedge Funds 
Under the Microscope. 

[5] GAO, Hedge Funds: Regulators and Market Participants Are Taking 
Steps to Strengthen Market Discipline, but Continued Attention Is 
Needed, [hyperlink, http://www.gao.gov/products/GAO-08-200] 
(Washington, D.C. Jan. 24, 2008) and Defined Benefit Pension Plans: 
Guidance Needed to Better Inform Plans of the Challenges and Risks of 
Investing in Hedge Funds and Private Equity, GAO-08-692 (Washington, 
D.C. Aug. 14, 2008) 

[6] Banking regulators include the Office of the Comptroller of the 
Currency (OCC), Board of Governors of the Federal Reserve System 
(Federal Reserve), and Federal Deposit Insurance Corporation (FDIC). 

[7] Inadequate market discipline is often cited as a contributing 
factor to the near collapse in 1998 of LTCM. 

[8] The PWG was established by Executive Order 12631, signed on March 
18, 1988. The Secretary of the Treasury chairs the PWG, the other 
members of which are the chairpersons of the Board of Governors of the 
Federal Reserve System, Securities and Exchange Commission, and 
Commodity Futures Trading Commission. The group was formed in 1988 to 
enhance the integrity, efficiency, orderliness, and competitiveness of 
the U.S. financial markets and maintain the public's confidence in 
those markets. 

[9] Under the Securities Act of 1933, a public offering or sale of 
securities must be registered with SEC, unless otherwise exempted. In 
order to exempt an offering or sale of hedge fund shares (ownership 
interests) to investors from registration under the Securities Act of 
1933, most hedge funds restrict their sales to accredited investors in 
compliance with the safe harbor requirements of Rule 506 of Regulation 
D. See 15 U.S.C. § 77d and § 77e; 17 C.F.R. § 230.506 (2007). Such 
investors must meet certain wealth and income thresholds. SEC generally 
has proposed a rule that would raise the accredited investor 
qualification standards for individual investors (natural persons) from 
$1 million in net worth to $2.5 million in investments. See Revisions 
to Limited Offering Exemptions in Regulation D, 72 Fed. Reg. 45116 
(Aug. 10, 2007) (proposed rules and request for additional comments). 
In addition, hedge funds typically limit the number of investors to 
fewer than 500, so as not to fall within the purview of Section 12(g) 
of the Securities Exchange Act of 1934, which requires the registration 
of any class of equity securities (other than exempted securities) held 
of record by 500 or more persons. 15 U.S.C. § 78l(g). 

[10] See Goldstein v. Securities and Exchange Commission, 451 F.3d 873 
(D.C. Cir. 2006). In Goldstein, the U.S. Circuit Court of Appeals for 
the District of Columbia held that SEC's hedge fund rule was arbitrary 
because it departed, without reasonable justification, from SEC's long- 
standing interpretation of the term "client" in the private adviser 
exemption as referring to the hedge fund itself, and not to the 
individual investors in the fund. See footnote 19, supra, for a 
description of the private adviser exemption from registration under 
the Advisers Act. 

[11] In September 2008, SEC ended the Consolidated Supervised Entities 
program, created in 2004 as a way for global investment bank 
conglomerates that lack a supervisor under law to voluntarily submit to 
regulation. The agency plans for enhancing SEC oversight of the broker- 
dealer subsidiaries of bank holding companies regulated by the Federal 
Reserve, based on a Memorandum of Understanding between the two 
agencies. 

[12] A horizontal review is a coordinated supervisory review of a 
specific activity, business line, or risk management practice conducted 
across a group of peer institutions. 

[13] We reviewed data from surveys of defined benefit pension plans 
conducted by three organizations--Greenwich Associates (covering mid- 
to large-size pension plans, with $250 million or more in total 
assets), Pyramis Global Advisors (covering mid-to large-size pension 
plans, with $200 million or more in total assets), and Pensions & 
Investments (limited to large plans, which generally had $1 billion or 
more in total assets). Greenwich Associates is an institutional 
financial services consulting and research firm; Pyramis Global 
Advisors, a division of Fidelity Investments, is an institutional asset 
management firm; and Pensions & Investments is a money management 
industry publication. These data cannot be generalized to all plans. 

[14] Pyramis Global Advisers. Pyramis Defined Benefit Survey Shows 
Institutional Investors Seek Balance in a Volatile World, October, 2008 

[15] Counterparty credit risk is the risk that a loss will be incurred 
if a counterparty to a transaction does not fulfill its financial 
obligations in a timely manner. 

[End of section] 

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