Closing the Regulatory Gap: Derivatives and the Hedge Fund Industry

An Interview with David Ruder

David Ruder was chair of the Securities and Exchange Commission from 1987 to 1989. He is currently a professor at the Northwestern University School of Law, and served as the school’s dean from 1977 to 1985. He is also chair of the Mutual Fund Directors Forum, an organization providing education to independent directors of mutual funds.

Multinational Monitor: What is a hedge fund?

David Ruder: A hedge fund is a pooled investment vehicle administered by professional managers and not open to the public. A hedge fund will seek greater than market returns by engaging in complicated strategies, using leverage, and investing in derivative instruments. It is a means of investment that is appropriate primarily for sophisticated investors because the investments are complex and because the use of leverage may create greater risks than would ordinarily be the case.

MM: What is the Security and Exchange Commission's (SEC's) jurisdiction over hedge funds?

Ruder: Hedge funds themselves are usually exempt from SEC oversight. The SEC has jurisdiction over some hedge fund advisers that are registered as investment advisers under the Investment Advisers Act of 1940. It also has power to bring actions against registered and unregistered hedge fund advisers who lie to prospective investors or to their own investors.

MM: Why doesn't the SEC have jurisdiction? Is there a rationale for this regulatory gap?

Ruder: Congress has not given the SEC jurisdiction over the management of hedge funds because hedge funds are usually owned by financially sophisticated investors who are presumed not to need regulatory protection.

MM: What's been the consequence of having this regulatory gap?

Ruder: The consequence has been that hedge funds' investment strategies are unknown to the regulators. In recent times the hedge funds have not been transparent as to their risk positions and the identities of their counterparties. Hedge funds have not, however, been responsible for the recent crisis in the credit markets or the decline in the stock markets, other than the fact that they have had to sell liquid securities in order to make refunds to investors.

MM: Can you explain what that means?

Ruder: Hedge funds are not like mutual funds that allow their investors to redeem their shares on a daily basis based upon net asset values. Hedge fund contracts usually restrict withdrawal rights for investors, sometimes locking them into place for a year or two, and then only permitting withdrawals on a periodic basis, typically with substantial notice requirements.

When large hedge fund investors do exercise their rights to withdraw their money, the hedge funds have to find cash. In those circumstances, they usually sell liquid assets in order to get cash, putting downside pressure on the values of those assets - stocks being the best example.

MM: Those kinds of sell offs are believed to have led to some of the steep drops in the market of the last three to four months.

Ruder: Sell offs of hedge fund assets are believed to have provided recent downside pressure on the markets. I don't believe they have been responsible for the steep declines or volatility in the markets.

MM: What should be the regulatory standards for hedge funds?

Ruder: I think hedge funds and other large liquid pools of capital ought to reveal their risk positions to a risk regulator charged with guarding against excess risk to the financial markets. That regulator should be able to aggregate the risk positions, know about the counterparty risk positions and anticipate strains on the markets. If the hedge funds are not regulated, then it's hard for the financial risk regulator to know about their risk positions.

A second area of regulation should be regulation of hedge fund risk management systems. Some regulator, probably the SEC, ought to be able to look at whether a hedge funds' management systems for risk are sound.

A third area of hedge fund regulation would seek greater protections against hedge fund dishonesty. I think the Madoff matter might result in this kind of regulation.

MM: Do you think there should be any restraints on hedge funds' use of leverage?

Ruder: As a general matter, hedge funds are investing the capital of sophisticated investors. As long as there is disclosure to those investors about the leverage and other risks, the hedge funds should be able to take those risks.

One possible exception would be that as a collective matter hedge funds might be so highly leveraged that they created undue risk to the market as a whole. Then you might want to give a regulator power to take steps to cause decreases in leverage.

Additionally, a single highly leveraged hedge fund might cause problems for the entire market. A regulator looking at hedge fund risk positions might be given the power to restrict the risk positions of a hedge fund that is engaged in practices that might bring a market down. The best example of such a situation is Long Term Capital Management, a single hedge fund that came close to causing substantial problems for the markets in 1998.

MM: Is it then fair to say that you support no blanket rule, but authority for a regulator to impose some restraint where an individual hedge fund or hedge funds overall are posing systemic risk?

Ruder: I think there should be some way in which a regulator could take steps necessary to prevent injury to the economy. I can't say that I have an answer as to what exactly should be done, and my views here are still developing.

The problem is that the hedge fund industry is not uniform. Some hedge funds are engaged in practices which are fairly easy to understand, such as a so-called long-short strategy, where the hedge fund is buying and selling stocks in a liquid market.

If the hedge fund is engaged in complicated risk strategies, including use of derivative instruments in which the risks are embedded in the instruments themselves and not as easy to ascertain, and including situations in which counterparties are not well known, it may be very difficult for a regulator to know what to do.

Here, my thinking has been more toward trying to insist that the hedge funds themselves have good risk management systems in place. Then the regulator would ask whether or not the hedge fund knew what it was doing.

There's also the possibility of creating a hedge fund self-regulatory organization (SRO), in which you force the hedge funds to obey rules regarding risk and transparency that are set by the self-regulatory organization, which would itself be regulated by a regulator.

One reason for insisting on self regulation, whether individually or through an SRO, is the cost factor. The more exotic the instruments and the more complicated the practices are, the more difficult it is to be able to afford to pay a regulator sufficiently well so that the regulator can know what's going on. The cost question is a serious one, particularly because of the highly complicated nature of the hedge fund industry.

MM: Is there an argument for some overall approach that mandates a reduction in complexity? If the instruments are too complicated for it to be feasible for government regulators to handle, is the system out of control?

Ruder: That is a philosophical question of some weight. I think that regulation ought to provide a good blend of safety for the system and permissible risk. I do not believe that restricting the kinds of instruments that one may enter into is the right approach.

What I could subscribe to is a kind of transparency in which the instruments have to be written in such a way that they could be understood by sophisticated people. You would get to the right result by requiring a form of simplicity rather than prohibitions.

If I could put the proposition in an illustrative manner, the market for credit default swaps is currently undergoing what I might call a commoditization approach. The theory is that if credit default swaps, which are contracts between two parties, have similar provisions, they could be traded on an organized exchange. If they can be exchange traded, then you can set up a trading system similar to the trading systems that exist in the futures exchanges, in which the instruments are uniform enough so that they have similar characteristics. The trading can be centralized and regulated by a clearing corporation that steps in between the parties.

This development has the effect of creating transparency and dealing with what is known as the counterparty risk problem. That is, when there are two parties to a contract, one of them might fail or might sell its position off to another party who might fail. If you insert a clearing corporation between the two parties, then the credit risk is on the clearing corporation. The clearing corporation then will see that the instruments are uniform and will impose restrictions on risks that will limit losses for the clearing corporation, with resulting benefits for the economy.

MM: To take a step back, what are financial derivatives?

Ruder: A financial derivative is a contract that derives its values from the value of an underlying commodity, financial asset or other reference. In a derivative instrument you are betting about the future value of the underlying asset or reference. Exchange traded derivatives have long been supported as a means of providing hedges against changes in the value of the asset or reference. If you want to make a bet on the future value of an underlying asset such as a stock, you could enter into a contract with another party to make that bet and protect yourself against ups and downs in the market in that underlying asset. So the derivative is not evidence of ownership in anything. Again it is essentially a contract regarding future values of an underlying reference.

MM: How are financial derivatives regulated in the United States?

Ruder: The financial derivatives that have uniform language will usually be traded on a futures exchange. The futures exchange clearing corporation then becomes the counter party to both sides of the contract so that people can know that the obligations under the derivative will be met by the clearing corporation.

If you don't have a commoditized, uniform contract, then you have individual contracts. These are one-on-one contracts which are entered into by two parties. They can be as complicated as the parties wish. These contracts are basically unregulated. Currently, the law in the United States says that over-the-counter non-exchange traded derivatives are not futures that can be regulated by the Commodity Futures Trading Commission and are not securities that can be regulated by the Securities and Exchange Commission.

So there's a gap in regulation. That gap is widely being challenged now by many who argue that the so-called "swap exclusion" - which creates that gap - should be eliminated so that we can have regulation of over-the-counter derivative instruments.

Once one starts regulating hedge funds and their contracts, one may also want to look at whether there is sufficient understanding of these derivative instruments so that risks can be known. Determining the appropriate level of regulation is highly complicated and difficult.

MM: One idea being floated is that all of these instruments should be exchange tradable. You would not mandate that?

Ruder: No, I would not. Once you start down that road, you have to ask how you would define the derivatives required to be traded on exchanges.

There are many private hedging contracts that depend on future values. It would be very difficult to determine which ones should be required to be commoditized and traded on exchanges. Efforts to create exchange trading of derivatives ought not to prevent you from having private contracts with derivative characteristics. So I don't agree that everything should be commoditized.

MM: The problem you raise about defining what a derivative is seems inescapable if there is to be any regulation. Should everything with derivative-like characteristics be covered by some regulator, or would that lead to what you view as improper interference with private contracts?

Ruder: To take the position that there should be no regulation is an extreme, just as a theory that everything should be regulated is an extreme. You need to have a system in which the regulator can decide what financial instruments have sufficient public interest so that you should regulate them, and what instruments should be excluded from that regulation because the public interest lies on the side of promoting risk and innovation.

Remembering that I support risk-based regulation of large entities that are engaged in risk activities, I believe direct regulation of over-the-counter derivatives should concentrate on fraud and misreprensentation, and perhaps something called suitability, rather than regulating for content.

MM: What is suitability?

Ruder: Suitability is a theory in the securities industry that says one ought not to sell a security to a party that is too risky for that party. The concept comes out of the sale of speculative securities to unsophisticated investors. The suitability concept says, "Don't sell high-risk securities to people who can't afford to lose their money."

If you extend the suitability concept to the derivative instrument area, you may be talking about suitability of products being sold to sophisticated investors. The concept of the suitability of very complicated derivative instruments arose in the financial area when sales were made to corporations and other large institutions when the seller of the instrument didn't make sure that the buyer of the instrument understood the risks. If you can't understand the risks, then you probably ought not to be buying the instrument.

The concept of being able to understand these complicated financial instruments has become the basis for a suitability analysis involving sales to institutions. The rules of FINRA, the broker-dealer self-regulatory association, provide that a seller of derivative securities ought to be confident that the buyer understands them, even if the buyer is a very sophisticated and well-financed institution.

MM: Should we rethink rules that permit higher levels of risk and speculation for sophisticated investors? Does the Madoff scandal suggest that even sophisticated investors are actually not able to protect their own interests?

Ruder: One of the interesting areas in the financial regulatory arena is the concept that there are bright-line tests for sophistication based upon wealth. So when one sells a security to a sophisticated, wealthy investor, that security need not be registered with the Securities and Exchange Commission. This is the so-called private placement exemption. It is the same exemption that's used when hedge funds sell securities to wealthy investors. A similar exemption allows investment advisers to advise a small number of wealthy investors without registering with the SEC. I think the concept needs to be re-evaluated when the instruments are extremely complicated or when the risks are very great.

Apparently, at some point the SEC required Madoff to register as an investment adviser. What happened in the Madoff instance was that both before and after he registered as an investment adviser, his supposedly sophisticated investors did not take the steps necessary to monitor their investments. They did not make sure that the person with whom they were investing had in place the kind of reporting, auditing and other protections that a sophisticated investor is assumed to insist upon.

So here we may have an example of a bright-line wealth test not being an adequate means of determining that the investor is capable of adequately monitoring investment activities. Of course, reports indicate that there were a number of highly sophisticated institutions who did engage in adequate due diligence regarding Madoff and decided not to invest because his activities weren't transparent enough.

MM: Do you believe the Madoff episode represents a failure by the SEC?

Ruder: We don't have enough information to know what was going on in terms of the SEC investigations. One gets the impression that there were warning signals out there, that the SEC investigated, and didn't do a thorough enough job in the investigation, but we can't be certain. If you ask, "How do you investigate a person who is engaging in a deliberate fraud?" you might end up with some different answers. In that case, you are talking about an investigation of someone who is highly motivated to lie and cover up. Apparently, Madoff had several sets of books, so that when the regulators came in they would be shown a false set of books when a private, more accurate set of books also existed.

We do not know whether the warning signals were strong enough so that an investigator should have found the fraud. Certainly, it looks like the regular complaints made by the money manager Harry Markopolos were enough that there should have been a more thorough investigation. It may very well be that whoever went up to Madoff's office was not diligent enough, smart enough or alert enough to see that something bad was going on.

On the other hand, it may be that Madoff simply outsmarted the investigators. You had a man with a tremendously positive reputation on Wall Street. He was someone known to me in the early 1990s, and I certainly found him to be reputable and trustworthy. I think the entire regulatory community felt that way about him.

As a former chairman of the Securities and Exchange Commission, I certainly believe that the Madoff situation needs to be investigated. We should know why his fraud was not discovered, and whether the failure to make those discoveries demonstrates some inherent flaws in the Commission's inspection and enforcement system. Certainly, that's a starting point that I think the new chairman of the Commission will have to take. How did this happen? That, of course, is what everyone is asking.