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Nazareth Offers Views on Hedge Funds, Derivatives and Systemic Risk

Commissioner Annette Nazareth believes the events surrounding the loss of $6 billion in natural gas trading by the hedge fund Amaranth raises a number of questions, including whether the market conditions at the time permitted a "softer landing" than what may have occurred under more uncertain market conditions. In remarks before the Conference on Business Economists in Washington, D.C., Nazareth reviewed the events surrounding Amaranth's losses and the questions that should be answered going forward. The text of Nazareth's remarks was posted on the SEC's Web site.

Nazareth noted that despite the size of Amaranth's losses, there was little impact on other market participants. Clearly, the losses were painful for the investors, but from a systemic risk perspective, she said the system worked well. The banks and securities firms that functioned as dealers and counterparts in Amaranth's trades appeared to hold adequate collateral to secure their exposures.

Nazareth said that Amaranth began a voluntary liquidation of many of its positions in markets other than natural gas to boost the counterparts' liquidity position and provide more flexibility in liquidating their natural gas positions. She added that Amaranth met with major banks and securities firms before the extent of the losses were made public, which may have helped smooth the process. Banks and securities firms were able to continuously determine the extent of their exposures to Amaranth. Nazareth said she is not aware of any disputes over margin calls based on the marks-to-market of Amaranth's positions.

Even the products with extended settlements appeared to have been completed without any difficulty, according to Nazareth. She said the success of Amaranth's orderly liquidation is a testament to the progress made by banks and securities firms since the failure of Long-Term Capital Management in 1998 in enhancing risk management capacity. However, Nazareth warned against complacency in light of these successes.

Amaranth's "soft landing" may be attributable to the markets' liquidity and credit spreads which permitted the fund to voluntarily and systematically liquidate its positions. Since Long-Term Capital's failure, new channels have opened through which leverage can be created by hedge funds and others. Many highly structured derivative products have been developed that did not exist in 1998, Nazareth noted, some of which can embed enormous leverage. The largest funds may have multiple prime brokers which make it more difficult for a single prime broker to assess the overall leverage of a client.

Amaranth created its enormous exposure relative to its capital by using "fairly mundane" forward and futures contracts, which were mostly cleared through a single firm, according to Nazareth. Its banks and securities firm counterparties, including its clearing firm, apparently had de minimis uncollateralized exposure, she added. After Long-Term Capital's failure, heightened counterparty risk management by regulated firms was expected to constrain the leverage of unregulated hedge fund counterparties, she said. Amaranth's "melt-down" called that view into question, she said. The Amaranth experience also raises questions about the viability of alternatives to an asset-backed lending model for providing credit to hedge funds, in her view.

Hedge funds have moved beyond traditional prime brokerage relationships in exercising their trading strategies and have become active in the over-the-counter derivatives markets, according to Nazareth. These markets have a very different history from traditional prime brokerage business, she said, and can offer leveraged exposure to a number of risk factors. In many cases, the collateral obtained from some of the largest hedge funds in relation to over-the-counter derivatives trades may be sufficient to cover any current exposure but does not fully cover future exposure, she said.

The quantitative factors considered in rating counterparties, such as leverage and balance sheet strength, may not be particularly useful with hedge funds, Nazareth noted. The audited financials provide only a once-a-year snapshot of a trading book that may change very rapidly. Monthly balance sheet and net asset value numbers are also dated. She said there may be reasons to question the extent to which information and transparency can provide a partial substitute for the collateral of the traditional asset-backed lending model when hedge fund counterparties are involved.

Nazareth also addressed the increasing importance of hedge funds in the broader markets. The role of hedge funds as liquidity providers is not limited to markets for highly structured securitized products, she noted. A very small number of hedge funds are responsible for a significant proportion of the credit derivatives transactions in the markets today, according to Nazareth.

Nazareth said that risk management practices must continue to evolve with market conventions. Banks and securities firms must resist any temptation to relax their standards in response to the lack of any significant counterparty credit losses. Nazareth said that those who supervise the largest banks and securities firms must encourage dealers to continue to invest in risk management and operations infrastructure, but also must recognize the limits of those efforts. To the extent that the largest hedge funds raise systemic concerns, Nazareth said the supervisory authorities may have to get more involved.

Nazareth proposed that regulators and hedge funds could hold regular discussions about systemic risks. She believes the industry has shown a willingness to have a regular dialogue. These regular meetings could result in targeted approaches, developed with the input of the hedge funds that would be affected, to address systemic risk concerns.

Jacquelyn Lumb